|
The U.S. Constitution lays down several bedrock principals, among them the separation of church and state and the right to free speech. But it is the common law that determines the practical shape these values assume, and how they are protected and enforced. The Common Law system, which derives from broad principles based on notions of justice, reason and common sense rather than the strict adherence to codes, originated in England and was adopted in the United States. Importantly, these principles, however, can change to respond to changing social, economic and political conditions. Judges, who make the Common Law, must honor rulings in similar cases. When judges wish to depart from this doctrine of stare decisis, they must elucidate, in writing, a good cause for doing so. And they are subject to reversal by a higher court. In the U.S., Congress and state legislatures are charged with enacting laws. But since no legislative body could possibly maintain oversight over all industries, legislative bodies enable administrative and regulatory agencies like the Securities and Exchange Commission (SEC) to flesh out the basic laws with due concern to the social affects as dictated by our Common Law philosophy. Thus, an agency like the SEC deals not only with what brokerage houses and investment banks do, in fact – i.e. their actual conduct – but with what they ought to do.
Soros has actually shown his concern for social consequences and conditions by actively engaging in a range of socio-political endeavors, ranging from promoting democracy in Eastern Europe to supporting schools in New York City. But we don’t buy the notion that in the fiercely competitive struggle for profits “playing by the rules” is all that can be asked – or expected – of any participant. For given the nature of our Common Law, any securities market manager who engages in unethical action may not only find himself in serious personal trouble, he may well harm his firm and the reputation of his industry. In fact, we are convinced that, given recent developments in regulation, legislation, and technology, ethical and socio-political insights and skills should be required of every manager with authority to act for his firm in securities markets operations.
Crime and Punishment Until very recently, corporations were generally not held criminally liable for illegal actions taken by their employees. But in 1984, Congress passed the Sentencing Reform Act, which set up a Federal Sentencing Commission. As an outgrowth of the Commission’s work, Congress in 1991 enacted Chapter 8 of the Federal Sentencing Guidelines, which dealt with white-collar crime and organizations. As a result, organizations themselves can now be held responsible for violations of any of 3,000-odd federal laws dealing with securities, commercial banking, anti-trust, and governmental fraud, listed in 46 separate categories.
Chapter 8 is evidence of official government recognition of an important ethical reality: that much of the illegal action of an organization’s employees arises out of the corporate culture within which they function. For under the guidelines, the way a company and its executives behave and conduct themselves bears a direct relationship to the severity of the penalty. The Federal Sentencing Guidelines specifies penalties for specified violations, which judges must faithfully apply – unless their reasons for deviation are fully explained and justified, in writing. Offenses are ranked on a scale. Minor offenses are ranked at six or less, and can carry fines of $5,000, while more serious ones, such as certain anti-trust offenses, can be ranked as high as 38 and carry fines of up to $72.5 million. enalties may be adjusted upward or downward within the mandated categories depending upon the steps the organization has previously taken to avoid criminal conduct, upon cooperation with the government, and upon the involvement of high-level personnel in the infraction. These elements become the basis for what is referred to as the organizational “culpability score,” ranging from a low fraction up to four. If a particular corporate crime is at level 38 or above, and the culpability score is at four, the total fine for that one infraction would be a sobering $290 million. Conversely, corporations may have taken actions that would mitigate the offense level, say down to 28. Given an insignificant “culpability score,” the total penalty could be $10 million rather than $290 million. One major before-the-fact mitigating factor is the existence within the organization of “an effective program to prevent and detect violations of the law.” There are 10 elements that make up such a program, including compliance standards and procedure, oversight by high-level personnel, and a “reporting system” employees might use without fear of retaliation. As part of the punishment, the government can place a company on probation and force it to install “an effective program.” The government could also assign an overseer to watch over the new program, on site. The Guidelines are, to our knowledge, the only such body of law in the world focused on corporate behavior and calculated to motivate the maintenance of a corporate culture that actively promotes lawful and ethical behavior. To be sure, the word “ethics” does not appear specifically in Chapter 8. But in practice, government regulators are very much affected by the presence, or the absence, of a corporate code of ethics that supports a corporate compliance program. The Organizational Sentencing Guidelines, however, do not substitute the corporate offender for the individual offender. In fact, corporate punishments can be mitigated if the corporation proactively self-reports its offenses and helps identify individuals responsible for the criminal conduct. Employees who continue to believe that they are acting properly as long as what they do satisfies the prevailing corporate behavior are in for a rude awakening when that same corporation suddenly hangs them out to dry. The numbers are beginning to add up. In 1999, in addition to bargained and settled organizational cases under the Guidelines, 255 organizations were sentenced under Chapter 8, a 15.9% increase from 1998. Fines were imposed on 200 organizations. The sentenced organizations pled guilty in 91.4% of the cases; 8.2% were convicted after trial. As in 1998, fraud was the most frequent offense committed by an organization. The highest fine in 1999 was $500 million. Some 56,000 individual defendants were reported to the Commission under the Guidelines in 1999, up from some 51,000 in 1998. Behind drug trafficking, fraud was the section of the Guidelines most frequently applied. The Federal Sentencing Guidelines are the legal result of a Common Law process whose basic purpose is to eschew the civil law function of reducing all behavior to inviolate rules. And while many securities firms have run afoul of the Sentencing Guidelines in such areas as insider trading and other forms of fraud, some securities firms have run into trouble with behavior that was seemingly within commonly accepted Wall Street rules but was nonetheless ethically and legally questionable – as the following examples show.
Spinning IPOs In the 1990s, a practice on Wall Street known as spinning initial public offerings was relatively common. As a way of building up goodwill and attracting future business, investment banks would allocate shares of IPOs to the accounts they held for individual corporate executives and venture capitalists. Brokers at the investment banks would quickly sell – or spin – the stock if the IPO took off. According to the rules of Wall Street, there was nothing wrong with this practice. But fiduciaries like corporate officers and brokers have an affirmative duty not to profit by virtue of their position as a fiduciary; and an affirmative duty to disclose to principals – i.e. other brokerage customers – any and all information in their possession that bears upon any decision the principals might make. And in spinning stocks for top clients, brokers seemed to violate this duty. Many firms who spun IPO stock for major firms’ officers had been effectively preventing lesser customers of the firm, who manage to get a small piece of an IPO, from “flipping” the very same stock. hen the process was exposed in the press, the “justice, reason and common sense” of the Common Law process was set in motion. The SEC is investigating spinning. State securities regulators like those in Massachusetts charged brokerage firms with wrongdoing and stated that “requiring firms to abandon (these) policies is one of the more severe sanctions we will impose.” If it hasn’t been abandoned entirely, spinning has been significantly reduced. And those who insist on playing that game are now opened up to lawsuits, in which the “rules” will be no defense.
Is Bear Baron’s Keeper? Or consider the case of Bear Stearns and A. R. Baron & Co. Bear Stearns is one of the leading clearing firms on Wall Street. Clearing firms are large brokerage houses that are hired by smaller firms, called introducing brokers, to execute and settle trades for them, and to maintain and process client records. The clearing firm requires introducing firms to put up a deposit, usually about $250,000, levies a “ticket charge” of $10 to $25 on each trade it conducts, and charges interest, usually 1% per month, on margin loans it makes to these customers.
Since 1982, when commissions were deregulated, clearing firms have not had legally determined oversight responsibilities for their introducing brokers. No rule specifically stated that the clearing firm had to be concerned with the ethical character of the introducing firm. One of the clearing clients of Bear Stearns, whose clearing operations represented more than 25% of its multi-billion dollar business in recent years, was A.R. Baron & Co., a highly dysfunctional firm. In 1995, Baron’s credit was so bad it was unable to qualify for a corporate gasoline credit card and it paid a $1.5 million fine to settle NASD charges that it bilked customers. But when Baron’s capital fell below the regulatory minimum and a Baron customer notified Bear Stearns of unauthorized trading in its accounts, Bear Stearns simply referred the matter back to Baron and injected $1.1 million into the company to keep it afloat. After a range of investigations, the SEC ordered Baron to halt all operations in May, 1996. Baron was also charged by the Manhattan District Attorney with being a criminal enterprise that defrauded investors out of $75 million. The firm ultimately went bankrupt. How could a major investment bank fail to see changes blowing in the wind? It could be that Bear Stearns’ admittedly strong compliance culture (nobody there is allowed to actually break the law) did not focus on ethical sensitivity at all. More likely is that it overlooked the Common Law notion that the system assigns basic duties of care to those who are paid to provide skilled services to others for a fee – and the definition and application of these duties are susceptible to change and evolution.
Common Law for a Cyber World? The growth of technology has further complicated some of these issues, as the advent of online trading has already changed the structure of the securities industry. Online transactions in 1998 rose from less than 11% of total stock trades in the first quarter to 13% in the fourth quarter. Today, many customers trade on the Internet much as they would on the ground, while others day trade, darting in and out of stocks rapidly.
It might be argued that we are in a brave new world in securities trading, where the true ethic is “assumption of the risk.” As customers place and execute orders by themselves online, they may be fully responsible for their choices, win or lose. But an ethic calling for the consumer’s full and complete assumption of the risk is no ethic at all. To negate meaningful duty to investors in the presence of technological leaps would be to argue that constitutional values are now outmoded. The Rule of Law will, and must, prevail, even on the Internet. But in keeping with our Common Law tradition, new workable, practical legal and regulatory shapes that cannot now be foreseen will have to emerge, just as they always have. Offline, all stockbrokers have some form of legal duty to every single client. A broker receiving a simple buy order from a sophisticated client must properly execute the trade. A broker advising an elderly widow has a far higher duty of care. And if the broker is handling a “discretionary” account in which she has full authority to buy and sell for the client’s portfolio, then the broker’s duty is fiduciary. An investor choosing to invest online with the advice and assistance of a broker is entitled to broker duties of care equal to any on-the-ground transaction. The New York Stock Exchange requires that brokers in all instances know their clients’ overall goals, risk preferences and time horizon before they execute an order. This is referred to as the “suitability” rule. The NASD holds brokers firmly to a suitability rule when the seller has recommended the transaction, and is considering enlarging the duty to all transactions in cyberspace. Certainly, what is reasonable in cyberspace may require different suitability rules depending upon the nature of the relationship; however, some duty of suitability must be implied, even in cyberspace – whether it involves mandatory pre-trading customer information filing or trade blocking for particular customers of specified risky investments. The form this takes must be dictated by the presence of transparency, honesty, and non-misleading behavior and by reasonable accommodation to the new structure and function of existing technology.
Much of the burden in forging this brave new world will fall, at it has in the past, on the regulators. This is a challenge. Technology-driven market change has outrun our capacity to comprehend fully the meaning of what has already happened in our securities markets, much less what ought to be happening in the future. Nonetheless, regulators ought first to examine where current securities markets changes appear to be taking us – in the direction of rapid institutional and product development and diffused delivery systems. And they must be sensitive to the potential conflicts of interest posed by the new developments. Newly formed computerized stock trading services known as electronic communications networks, or ECNs, are applying to the SEC to become new stock exchanges. But customers may find that best execution and best price may not always be forthcoming from an ECN owned by a brokerage firm. Meanwhile, in response to such upstarts, established exchanges like the NASDAQ and NYSE are contemplating selling shares to the public and becoming publicly-held for-profit companies. One might also legitimately ask whether a publicly owned NYSE, with self-regulating powers, could be truly dependable and fair to all customers in the face of the Wall Street imperative to make as much money as possible for its owners. Dealing with these issues, even in the absence of cyberspace technology has not been – and still is not – easy. But our trump card has always been an established culture of public interest protection. For more than two centuries, our Common Law-based system has allowed for effective legal and regulatory responses to social demand. In essence, it has promoted adherence to the spirit, as well as to the letter, of the law. Maintaining this law and regulatory system in the face of rapid technological development will be ever more difficult, but ever more essential, if we are to protect and preserve the Constitutional value system upon which we – as investors and citizens – all depend for safety, growth and fulfillment.
Larry Alan Bear is visiting professor of business ethics and Rita Maldonado-Bear is professor of finance, are professors at NYU Stern. An expanded version of this article is to appear in a special issue of The Journal of Banking and Finance, June 2002 |
he
securities markets have been at the epicenter of the ongoing revolution
in technology, finance and globalization. And in this hypercompetitive
environment – in which every trade is viewed as a zero-sum game
– the ground has been about as solid as quicksand. Traders are
seen as modern-day gunslingers, using sharp elbows to gain whatever
advantage they can while adhering to the established rules. But as stock-trading
moves online, and as new players and structures continue to transform
the market, the rules seem to be shifting. What was acceptable in 1996
may not be acceptable today. And common practices today may be outmoded
and deemed unfair in 2003. Despite several scandals and setbacks, the
U.S. markets have weathered the changes rather well. And for that, we
can thank our unique age-old legal tradition – the Common Law –
which should continue to guide market participants and regulators as
we enter the 21st century.
y
early June 1997, NYSE and NASD officials met with several clearing firm
officials. One firm, Oppenheimer & Co., announced plans to stop
processing trades for any introducing broker client accused by regulators
of charging excess commissions. But Bear Stearns took the position that
a clearing broker had neither access to, nor control over, any introducing
broker, and that if it were subjected to customer claims, the firm might
well get out of the business altogether. The SEC then let Bear Stearns
know it was preparing to consider making civil securities fraud charges
against it, with attendant Sentencing Guidelines penalties if the U.S.
Attorney went further with criminal charges. Bear Stearns settled, agreeing
to pay a fine and $25 million in restitution to A.R. Baron customers.
The Bear Stearns senior executive in charge of the clearing business
later resigned. 