Archive for the ‘investing’ Category

Will the UK Outlaw Ethical Investing?

OK, so the answer to the question in the title is almost certainly “no,” but outlawing ethical investing is precisely what is being implied, no doubt inadvertently, by a new plan being attributed to the UK’s Labour Party.

Over the weekend, several UK news sources reported on a press release indicating that the Labour Party’s leader, Ed Miliband, was about to announce his intention (if elected) to impose tough new rules on the financial industry. The idea was to be put forward during a speech at the party’s annual conference this past weekend. According to the Daily Mail,

Mr Miliband is proposing a sweeping new legal duty on any financial service which manages savings, including pension funds and banks, to maximise the saver’s returns. Failure to do so would mean them breaking the law.

(While I haven’t seen the actual press release upon which this analysis is based, a very similar report appeared in The Guardian.)

On the face of it, this is just another promise by a politician to fight for the little guy by imposing constraints on big business.

But hold on a minute. As Tim Worstall at astutely points out, requiring a bank to maximise a saver’s financial returns implies a legal duty not to pay attention to any factor other than money. No more attention to sustainability. No more doing good deeds. No more avoiding investing in tobacco or arms dealers. It’s gotta be all about the money.

But focusing on something other than money is precisely what financial institutions promise to do when then offer various ‘ethical’ or values-based investment instruments. The promise made by such funds is that they’ll aim at a “solid” return on investment, while at the same time paying due attention to social and/or environmental concerns. Miliband’s proposal would make such funds illegal. Indeed, if taken seriously, Miliband’s proposal goes much farther than that: it would criminalize all attempts at corporate social responsibility by financial services companies.

Indeed, legally requiring banks to maximize return to savers is exactly parallel to the (fictional) requirement for corporations to maximize return to shareholders. (Why “fictional?” Because the directors of a corporation are only legally obligated to serve loyally, not to maximize profits per se.)

Now as Worstall points out, such announcements regarding what a politician is going to say sometimes don’t come true. And heaven knows that even if Mr. Miliband does or did make the promise out loud, there’s no guarantee that he will make good on it, even if he has the opportunity. Hopefully he or his advisors have seen the folly in such a law, and will find some subtler way to achieve their policy objectives.

Vancity vs Enbridge

It was recently reported that Vancity Investment Management is divesting its shares in beleaguered Canadian oil company, Enbridge.

Enbridge has made the news repeatedly over the last few years because of leaks in its pipelines. Not unrelatedly, the company has faced opposition from native and environmental groups with regard to its planned pipeline across northern Alberta and British Columbia. The combination of errors in its past and risks in its future is apparently just too much for Vancity, and perhaps for other socially- and environmentally-conscious investors.

This new announcement is, on the surface at least, a good example of the connection between ethics and business. It is often pointed out that, in order to stay in business, a company needs to maintain its ‘social license to operate.’ But more specifically it needs to retain the goodwill of key stakeholders, and investors are very high on that list.

But of course, investors can turn on a company for all kinds of reasons; the perception that the company isn’t doing well socially or environmentally (or more generally, ethically) is just one. Companies can take a hit to their shares for any number of reasons. Even if we limit ourselves to broadly “social” reasons, there are good and bad reasons, reasons about which there is broad social consensus (e.g., child labour) and ones that are socially divisive (e.g., contributions to pro-choice or anti-abortion groups). And so on.

This points to an interesting question about the obligation that managers and boards have to manage risk. It is increasingly clear that the obligation to manage risk includes not just financial risk, but just about any risk to which the company might be subject. That includes environmental risks and reputational risks. Understandably, the two are intertwined. According to the story cited above, one “ethical investment” company (Northwest & Ethical Investments LP) has expressed concern about Enbridge not (just?) because of the risks its pipeline poses, but because of the risk posed by opposition.

Should Enbridge (and its shareholders) be concerned about the Vancity divestment? That’s unclear. The divestment itself doesn’t sound catastrophic, but things could change if other investors follow suit. How likely that might be is also unclear. The interesting question is which kind of worry is more likely contagious: worries over environmental risks (and financial risks that go with those) or worries over risks of opposition.

In the end, it may not matter much. As I’ve argued before, oil companies need to do a better job of managing environmental risks. If they can succeed at that, they may well see the risks of social opposition melt away at the same time.

MBA’s, Ethics, and the Facebook IPO

I’m an educator, so my natural bias is always to assume that yes, education matters. But it is in part because of this bias that it pains me when I see someone who is plainly overstating the case. And that’s the feeling I got when I read the Washington Post‘s Vivek Wadhwa asking, “Would the Facebook IPO have bombed if Mark Zuckerberg had an MBA?”

The answer — contrary to what Wadhwa argues — is “well, probably, yes!” The IPO almost certainly still would have bombed even if Facebook’s CEO had had an MBA. The fate of the company’s IPO depended a great deal on the way it was handled by Morgan Stanley, and on the appetite of institutional investors for the company’s stock. And that appetite depended a great deal on investors’ thinking on a lot of different questions, including things like whether Facebook still has room to grow or not. But there’s little readon to think that the educational pedigree of the CEO would have made much difference on its own.

It’s also worth pointing out that while Zuckerberg doesn’t have an MBA, he presumably has more than a few MBA’s working for him, and he certainly could afford to hire more. It’s pretty hard to make the case that the man himself having an MBA was utterly essential. So, while Wadhwa may well be right that having an MBA would mean that “Zuckerberg would have better understood the rules of corporate finance and capital markets,” it can hardly be argued that there was no one around with the relevant training to advise Zuckerberg on such matters.

Interestingly, Wadhwa twice mentions the importance of ethics in business, and rightly points to the ethics as being of central importance in an MBA education. But it’s far from clear just how Wadhwa thinks that is connected to the Facebook IPO having “bombed.”

Hopefully no one really thinks that getting an MBA is going to make you more ethical. If the ethics course you take during your MBA is a good one, it may do something to enrich and deepen the way you think about ethics, and to help you design and manage the kinds of systems that will help your employees act ethically. But even on the broadest and most inclusive understanding of the word “ethics,” there’s little reason to think that learning about ethics is going to make you better able to shepherd a company through an IPO. Nor is training in ethics any guarantee that individuals won’t engage in the kind of selective disclosure of information that is at the heart of the company’s post-IPO legal woes. The kind of ethics education that goes along with an MBA may well teach you more than you already knew about the nature of fiduciary duties and the importance of fostering trust, but an MBA-level ethics course is neither necessary, not sufficient, to make a business leader ethical.

Should JPMorgan Fire the London Whale?

Would you fire an employee responsible for losing your company a couple billion dollars? I mean, hey, mistakes happen. But we’re talking two billion, here, with a “B”.

It’s not a hypothetical question, at least not for one major financial institution. As has been widely reported, JP Morgan Chase has now acknowledged that recent trading losses of two billion dollars are “somewhat related” to the controversial activities of a single London-based broker. The broker, whose real name is Bruno Iksil but who is often referred to as The London Whale, made enormous bets on U.S. corporate bonds…and lost.

I don’t think anyone has seriously suggested firing The Whale, at least not in public. But it does make you wonder. Even a company the size of JPMorgan can’t quite shrug off losses of that magnitude. And as others have pointed out, the hit to the company’s reputation may be more damaging, in the long run, than the short-run hit to its bottom line.

It’s worth noting that The London Whale was not a rogue trader. Indeed, his strategy was widely known, and apparently approved of by top executives at the company’s chief investment office.

Still, executive approval or no, it would be easy enough to make a scapegoat of The London Whale. But of course, that would be disingenuous, and the complicity of the Whale’s bosses is now public knowledge. And anyway, it’s entirely possible that the company will continue to see him as a valuable trader. He lost money this time around, but only insiders have the numbers to know how much he has made or lost for the company during his years there. And it’s entirely possible for even a losing bet to be regarded as one that it was smart to make in the first place.

There is also a public interest angle here. One of the key lessons of the last 4 years has been that innovative risk-taking by financial institutions can be a threat to the public good, not to mention the public purse. So even if The London Whale, and his overseers, aren’t destined to be axed by those who serve the company’s shareholders, that doesn’t mean they don’t collectively deserve our opprobrium, in addition to warranting stricter regulation.

Financial Advice, Competency, and Consent

I blogged recently on a California case about an insurance agent who was sentenced to jail for selling an Indexed Annuity — a complex investment instrument — to an elderly woman who may have been showing signs of dementia. I argued that giving investment advice is just the sort of situation in which we should expect professionals to live up the standard of ‘fiduciary’, or trust-based duty. An investment advisor is not — cannot be — just a salesperson.

But asserting that investment advisors have fiduciary duties doesn’t settle all relevant ethical questions. It settles how strong or how extensive the advisor’s obligation is; but it doesn’t settle just how the financial advisor should go about living up to it.

The story alluded to above again serves as a good example of that complexity. How should a financial advisor, in his or her role as fiduciary, handle a situation in which the client shows signs of a lack of decision-making competency? Sure, the advisor needs to give good advice, but in the end the decision is still the client’s. How can an advisor know whether a client is competent to make such a decision?

In the field of healthcare ethics, there is an enormous literature on the question of ‘informed consent,’ including the conditions under which consent may not be fully valid, and the steps health professionals should take to safeguard the interests of patients in such cases.

The way the concept is explained in the world of healthcare ethics, informed consent has three components, namely disclosure, capacity and voluntariness. Before a health professional can treat you, he or she needs to disclose the relevant facts to you, make sure you have the mental and emotional capacity to make a decision, and then make sure your decision is voluntary and uncoerced. And the onus is on the professional to ensure that those three conditions are met. But there’s really nothing very special about healthcare in this regard. Selling someone an Indexed Annuity isn’t as invasive, perhaps, as sticking a needle in them, but it often has much more serious implications.

Of the three conditions cited above — disclosure, capacity and voluntariness — disclosure is of course the easiest for those in the investment professions to agree to. Of course you need to tell your client the risks and benefits of the product you’re suggesting to them. But of course, many financial products have an enormous range of obscure and relatively small risks — must the client be told about those, too? There’s only so much time in a day, and most clients won’t care about — or be able to evaluate — those tiny details.

Voluntariness might also be thought of as pretty straightforward. A client who shows up alone and who doesn’t seem distressed is probably acting voluntarily, and it’s unlikely that we want investment professionals poking around our personal lives to find out if there’s a greedy nephew lurking in the background and badgering Aunt Florence to invest in penny stocks.

What about capacity? That’s the tough one, the one implicated in the court decision alluded to above. Notice that in most areas of the market, no one tries to assess your capacity before selling to you. I bought a car recently, and all the salesperson cared about was a driver’s licence and my ability to pay. No one tried very hard to figure out if I was of sound mind — beyond immediate appearances — and hence able to make a rational purchase.

Investment professionals do typically recognize a duty to ensure the “suitability” of an investment, and presumably whether an investment is suitable depends on more than just the client’s financial status. It also depends in part upon whether the client is capable of understanding the relevant risks. Being a true professional and earning the social respect that goes with that designation is going to require that financial advisors of all sorts adopt a fiduciary view of their role. That means learning at least a bit about the signs of dementia and other forms of diminished capacity. It also means knowing how and when to refer a client to a relevant health professional. Finally and most crucially, it means putting the client first — solidly and entirely first — and hence being willing to forego a sale when that is clearly the right thing to do.

Investment Advice and Fiduciary Duties

Most of us rely on accredited professionals for a range of services. Doctors, lawyers, accountants and so on play a huge role in our lives, giving us advice and rendering services that we would be foolish to provide for ourselves. Some topics, in other words, are beyond the ken of even the dedicated do-it-yourselfer. Financial planning is in that category. If you plan to do anything much beyond storing your money in a mattress, you probably want help from a professional. And you hope — really, really hope — that that professional is on the ball and has your best interests at heart.

A recent story highlights some of the difficulties in this regard. The story is about an independent insurance agent facing jail time for selling a particular kind of investment — an indexed annuity — to an 83-year-old woman. The catch: prosecutors say the woman showed signs of dementia, and the implication is that the agent took advantage of the fact that the buyer may not have understood the limits and disadvantages of the investment instrument she was buying.

Even minus the question of the buyer’s competency, there are worries here. For perspective on this story, I talked to Prof. John Boatright, who literally wrote the book on ethics in finance. He pointed out to me that Equity-Indexed Annuities are so complex that they’re a dubious product quite generally. He also pointed out that such annuities are investment instruments sold by people in the insurance industry who are not truly investment specialists. Most investment instruments are regulated such that they can only be sold by investment professionals with suitable training and credentials.

But regardless of the kind of professional you go to for investment advice, the underlying ethical question is whether that professional is going to have your best interests at heart. When the thing you’re buying is too complex to understand, you have to put your trust in the seller. Such trust is best underpinned by what are called fiduciary duties. A fiduciary, roughly speaking, is someone to whom something of value is entrusted. And a professional who bears a fiduciary duty has a stronger obligation than a mere salesman. Someone out to sell you something — a car, a stereo, whatever — has a plain obligation not to deceive you, but generally isn’t obligated to make sure that the product is right for you. Whether the product is right for you is up to you to decide. But a fiduciary is held to a higher standard. As Alexei Marcoux points out, we are vulnerable in various ways to professionals of various kinds, and that vulnerability generates duties on the part of those professionals, not just to be honest to us but to put our interests first. The transaction between a professional and a client is not a regular market transaction; rather, it is (or ought to be) governed by the higher standard implied by a fiduciary relationship.

Whether financial advisors and financial planners proclaim and live up to such a high standard is another matter. It certainly seems they should. In some places, financial professionals are explicitly expected to live up to the standard applied by a fiduciary duty, and other jurisdictions are moving in that direction. If ever there were a circumstance in which we were vulnerable, a situation in which we are trusting a stranger to tell us what to do with our life’s savings seems to fit the bill.

Ethical Investing and Values-Based Investing

If you’re an investor, and if you want your money invested in companies that will not just bring you a return on investment, but will also some good in the world, that means you’re interested in what is variously called “responsible investing” or “ethical investing” or “values-based investing.”

I was recently interviewed for a documentary on the topic. Here it is: “Responsible Investing: An Evolving Story.” The 20-minute video was produced by the Ontario Teachers’ Pension Plan (OTPP). OTPP (colloquially known as “Teachers”) is one of the biggest institutional investors in Canada, managing a fund of just over a hundred billion dollars.

One of the main points I tried to make in the segments I’m in is that the key to thinking about values-based investing is to think of it as a mechanism for value-alignment. That is, it’s a way for investors to invest in companies whose values are like their own. It allows pacifists to avoid investing in arms manufacturers, and allows anyone who is stridently anti-tobacco to avoid investing in that industry. It’s not about all of us investing in products or industries that are “more ethical”, overall. Such global judgments are difficult to arrive at, and even harder to find consensus on.

That is, it’s best not to think of values-based investing as “ethical” investing, as if in contrast to all that other, unethical, investing. Indeed, referring to it as “ethical” investing probably makes the same mistake as references to “ethical oil” or “ethical food” does: it confuses the fact that there is ethical reasoning involved in such investing with a much grander claim that your investments are the only (or most) ethical ones.

Chasing Madoff (movie review)

Chasing Madoff (movie)The documentary Chasing Madoff opens this week. I had a chance to attend a preview of the movie last night (courtesy of eOne Films).

The film is really the story of fraud investigator Harry Markopolos, the guy who, while working as an options trader at Rampart Investment Management, discovered Madoff’s scheme and worked valiantly to get the Securities and Exchange Commission to take notice.

It’s kind of a fun film, but not a great film. The film lacks a narrator, opting instead to tell the entire story through the first-hand accounts of a handful of people (primarily Markopolos and a couple of colleagues, along with a few of Madoff’s victims) and snippets from newscasts. The focus on first-person accounts gives the film a personal feel, but it also inevitably means a perspective that is slanted, though perhaps not fatally so.

There are a few laughs in the film. Markopolos is a bit of a strange cat. He’s a likeable guy, and apparently a man of integrity, but also a bit paranoid-sounding. On-screen, he tells us that he feared Madoff so much that he was ready to pre-emptively shoot the guy, if Madoff had discovered his investigation. He also describes what his strategy would be in the event of an armed standoff with the SEC, should they ever come to his home to get his files — files that included damning evidence of SEC complacency. Just for emphasis, one scene shows him leaning against his desk, brandishing a pump-action shotgun. These humourous parts are, I think, intentional, or at least surely the director (Jeff Prosserman) must have known they would spark laughter. And humour is fine, but it tends to undercut the filmmakers’ stated intention of generating outrage in their audience.

What’s most striking, perhaps, about Chasing Madoff is what it doesn’t tell us about the Madoff scandal. For example, it points fingers at the SEC, but tells us nothing about the agency’s funding levels, and whether it had the capacity to keep up with complaints like Markopolos’s as they flowed in. There are also allegations that “someone higher up” at the Wall Street Journal tried to stifle the story before it broke, but little evidence to back that up. And there are intriguing hints about the large number of individuals and organizations that must have been complicit in Madoff’s crimes, and hints at why they had no economic incentive not to keep putting faith in his results. There’s even a claim that Madoff “paid top dollar” to those that would bring him “new victims.” But the relevant parties are not named and the film makes little effort to explain the connections.

Bottom line: I’m a university professor — would I show this movie in my Business Ethics classroom? Probably not. It’s a fine portrayal of man of integrity fighting the good fight, but it teaches relatively little about how the financial crime of the century happened, or what if anything would prevent it from happening again.

Corruption and Ethics in the Russian Economy

Back in February I blogged about Russian Business Ethics, and about the way that watching a developing economy helps us see the significance of ethics in the functioning of any economy. If you want to understand the role of honesty, trust, and transparency in a market, you just need to look at a society experiencing a severe deficit of those things.

Here’s more in a similar vein, by Sergei L. Loiko, for the LA Times: Taking on Russian corruption

Moscow lawyer and blogger Alexei Navalny has been singlehandedly taking on Russia’s state-controlled energy giants, accusing them of large-scale embezzlement and corruption….

(See also this piece on fighting corruption in India: Wake-up call on anti-graft laws, from The Hindu Business Line. I also blogged last year about Business Ethics in China.)

It’s perhaps worth pointing out that there really is no ethical debate over corruption: there is no pro-corruption case to be made. No one is in favour of corruption, generally — though of course the corrupt are in favour of those instances of corruption that help them. There just is no systemic upside to bribery, embezzlement, and unremediated conflict of interest. But this fact sometimes go unnoticed when people lump bribery, for example, in with various other dubious practices that North American companies might engage in overseas. I recently had a senior academic suggest to me, in the context of a discussion of labour standards, that third-world sweatshops are just another money-grubbing technique that corporations use whenever they can get away with it — just like, you know, bribery. But there is an important distinction to be made there: sweatshops may sometimes play the role of unfortunate-but-necessary engine of economic growth. Bribery is just a drag on an economy. As seen by competing businesses, it’s a zero-sum game: either my bribe works or yours does. From a social point of view, it results in misallocation of resources: contracts go not to the most efficient producer, but to the producer that excels at the bribery game. This is another example of why it’s so important, in our normative evaluation of business practices, to maintain a mental distinction between things that are unfortunate, and things that are wrong.

Rajaratnam: Insider Trading, Soft Skills, and Slippery Slopes

Yesterday, Raj Rajaratnam, founder and head of hedge-fund management firm, The Galleon Group, was found guilty of 14 separate counts of securities fraud and conspiracy.

I think two things are worth talking about, with regard to this case.

1) One is the extent to which Rajaratnam was apparently a master of the so-called ‘soft skills’ of business. Rajaratnam’s success (and his eventual downfall) was rooted to a large extent in his talent for extracting insider information from his network of corporate contacts, charming them into revealing their employers’ secrets. To get a sense of this, it’s worth reading this richly detailed piece by Peter Lattman and Azad Ahmed, for the New York Times: Galleon Chief’s Web of Friends Proved Crucial to Scheme. Here’s a taste:

In his soft-spoken manner, shaped by his years at secondary school and college in England, Mr. Rajaratnam alternately prodded, chided, ridiculed and flattered his sources. Above all, he was a good listener, saying little as those on the other end of the phone, eager to impress the hedge fund titan, kept talking….

In other words, this ‘hedge fund titan’ used the same interpersonal skills in pursuit of millions as the common scam artist uses in pursuit of the little old lady’s retirement savings. This fact reinforces the importance of teaching these skills — and teaching about the dangers inherent in misusing them — in business schools.

2) The second point worth discussing has to do with grey zones and slippery slopes. Rajaratnam was found guilty of a criminal variant of something that professional investors do all the time, namely gathering information from people who know stuff about the firms those investors are considering investing in. In order to make their case, prosecutors would have had to convince the jury that Rajaratnam’s intelligence-gathering wasn’t just the run-of-the-mill kind.

But it’s also worth pointing out that there’s more than just a binary distinction to be made here. Somewhere between benign information-gathering, on one hand, and criminal insider trading, on the other, is a category of ethically-suspect behaviour that involves asking corporate insiders to provide ‘perspective’ or an ‘overview’ of, for example, the financial health of their firms. Such behaviour can be unethical for the same reason actual insider trading is illegal. Corporate insiders have fiduciary duties — duties rooted in trust — and providing information to outsiders so that they can have a trading advantage is a betrayal of that trust. And Rajaratnam’s methods played on his accomplices’ uncertainty about where to draw the relevant lines. The slope from benign to unethical to illegal is, it seems, quite slippery, especially when that slope is greased with flattery and a few hundred thousand dollars.


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