How to Eliminate and Manage Conflicts in Investment Banking - dummies

How to Eliminate and Manage Conflicts in Investment Banking

By Matt Krantz, Robert R. Johnson

The potential for conflicts exist in investment banking, but how can they be eliminated or managed? The following are methods that investment banks use to both eliminate and manage conflicts.

Build a wall

For investment research to have any real value, it must be independent and objective. It must be based on the facts in evidence and not influenced by any relationships between the investment banking firm and the firm being researched.

The best way to prevent information flow from the mergers and acquisitions and corporate finance personnel to the sales and traders at an investment bank is to erect a Chinese wall — the colloquial term for information and physical barriers implemented within a firm to separate and isolate people who make investment decisions from people who are privy to material nonpublic information that could influence those decisions.

A Chinese wall can refer to both informational and physical barriers. Investment banking firms often locate personnel with different functions on different floors or in other geographical locations. Also, information systems are designed to prevent unintended sharing of information between functional personnel.

Place restrictions

Firms often place restrictions on personal trading by employees and carefully monitor both proprietary trading and personal trading by employees. Firms often place companies on a restricted list when an investment banking firm has or may have material nonpublic information on companies.

Ensure compliance

Compliance has often been ridiculed as a necessary evil of investment firms, but that’s changing. As the name suggests, the compliance function at investment banking firms is charged with the task of making sure the firm is not violating any laws in conducting business. At many firms, compliance is also responsible for ensuring that personnel are operating within the bounds of the firm’s code of ethics.

All investment banking firms have compliance functions, but the emphasis some firms place on compliance and education regarding acceptable practices differs greatly. For compliance to truly matter at firms, the message must come from top management.

Disclose potential conflicts of interest

Disclosure is the best disinfectant. Federal securities laws require that investment banking firms disclose certain facts and relationships that could be (or could be interpreted as) potential conflicts of interest. These disclosures help clients and potential clients get the lay of the land and allow for more informed decisions.

Things that must be disclosed include, but aren’t limited to, the following:

  • Conflicts: Whether the investment banking firm is acting as a manager or co-manager of an impending underwriting for the company

  • Ownership: Whether the investment banking firm owns more than one percent of the common stock of the company

  • Payments: Whether the investment banking firm has received compensation for investment banking services from the company in the past 12 months

  • Market making: Whether the investment banking firm makes a market in the securities or derivatives of the company

Establish a code of ethics

Codes of ethics are no panacea. Enron had a 64-page code of ethics that was distributed to all employees. Take the time to read it if you need a good laugh. Having said that, a robust code of ethics that is emphasized by top management sends a strong signal that the investment banking firm takes ethical behavior seriously.

Two nonprofit organizations of investment professionals — the CFA Institute and the Chartered Alternative Investment Analyst Association (CAIA) — require their members to abide by a robust code of ethics. This gives clients and other investment professionals a strong signal about the ethical orientation of these professionals and the organization that employs them.