Friday, 11 October 2013

Ethics in Finance : The State and the Change We Need

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Ethics in Finance : The State and the Change We Need
by Mustafa Mustansir, FIFC


When we talk about the financial world, corporations and economies, we can recall its negatives well. These days they remind us of the global recession, austerity, rising sovereign debt, higher taxes, exploitation of market-illiterate customers, higher bonuses for bank executives, Eurozone crisis etc. People associated with the financial sector suffer a lack of trust from the society.

The paper discusses why people want to be unethical, and the types of unethical behaviours. How do they do it and live with it successfully? It also makes recommendations to help us improve the situation. The case for ethics in finance is a much broader topic for discussion and discovery than just financiers and their malpractices and the economic meltdown. It is a global disease which infects the sacred function of finance in every economy of world.

What is ethical? Who decides?

Ethics have a different meaning in every environment and so does what is ethical. Often what is ethical cannot be defined and is thought of as being something deterministic. But defining what is ethical and eliminating who decides what is ethical is not as difficult. It is a fact that individual benefit is only maximised when he seeks to increase his as well as other’s benefit. Hence, anything which is done only out of benefit for oneself at the cost of others’ interests is unethical then.

Why do financiers want to be unethical?

People want to be unethical because of some reasons and a basic reason for being unethical is greed. Wherever there is money, there is greed. Greed has no limits and it can tempt one to go way beyond acceptable limits. Greed made Bernard Madoff run a giant Ponzi scheme, which lasted longer, reached wider and cut deeper than any similar scheme in history. After its collapse, regulators say Madoff himself estimated $50 billion in personal and institutional wealth from around the world was gone.i An already successful investment broker, adviser and financier, with only one department of his firm involved in the crime, what else than greed could have made him do it?

Moreover, according to the hypothesis of Donald Cressey and as published on the website of the Association of Certified Fraud Examiners, a Fraud Triangle can be used to explain fraud emanating from one or more of the three components i.e. Perceived unshareable financial need, perceived opportunity and rationalization.

Today, fund managers, wealth managers, investment banks etc. are under a constant pressure to perform. Making money is becoming difficult day by day and the clients want to be making money the next day they invest. Plus, with several specialist designations in finance like CFA, CFP, CPA, CIM, CHP, RHU, CAIA, CIIA, MFCii etc., there are more highly educated, experienced and sophisticated institutional and private portfolio managers and other financiers than there were ever before.

At the same time the pool of wealthy customers is growing shallow as businesses from which these customers make monies are itself slowing down leading to a natural loss of wealth, leaving little for them to invest in funds and making them desperate for returns like never before. It follows a domino effect. The global recession though routed out to a great extent still prevails in the form of uncertainty and shaky consumer confidence the world over. People seem like spending but they are not spending. They have grown more prone to risk aversion and shy away from the lucrative products offered by financial institutions.

Another pressure factor is the bonuses which are tied to individual performance. This is where the financiers do their very best every year. Some of them employ absolutely cunning schemes to attract new clients, sell overly risked products, bet against what they are selling their clients, run Ponzi schemes, short-sell and also indulge in insider trading. It is interesting to note that no matter what the outcome, bonuses remain high and are paid out every year.

In 2008, the worst year of the financial crisis, nine banks, including Citigroup Inc. and Merrill Lynch & Co., paid over $32. 6 billion in bonuses while receiving $175 billion in tax payer funds, according to a report by New York Attorney General Andrew Cuomo (iii). Institutions declare bankruptcies, and it is the clients who are forced into streets and even poverty. Taxpayers foot the bill to save the job losses and the economy. But the bankers who sold risky products which drowned money lose not even a dime! This is because the seller is always protected. This is the beauty of the system-a source of opportunity.

Further, the opportunity to engage in unethical behaviour is also an important factor. This opportunity emanates from the fact that financiers are not dealing with their own money but their client’s money i.e. someone else’s money. They are merely agents. Hence, risky bets and trades are made with utmost courage and confidence. Sometimes bets are counter bet and transactions hedged in such a way that win or lose, the financial institution always wins.

The same opportunity is also created with a majority of customers being illiterate about the market and its dynamics. Some of them even have no idea where the economy is headed. All they have is money which they want to invest somewhere to safeguard its value and make a return on it. Plus, today’s financial products have grown so sophisticated that even their very sellers are unsure about how they would work out and the risks involved, let alone the client to whom they are selling it too.

All this makes it very easy to unethically drive-in business by fraudulent targeting of customers by selling them products they don’t need or have no risk appetite for or in worst cases products you yourself aren’t sure about, in fact you are betting against them! If it helps get business, why not go for it? All this leaves the client with no choice but to trust you and you know you can manipulate him or her and get away by blaming everything on the market and the economy.

Moreover, regulators too at times also fail to undertake the right investigations and scrutiny despite surprising facts and figures posted by some funds and investment institutions. In an interview from prison, the infamous Bernard Madoff cited a failure to conduct normal scrutiny by any partner institutions or the regulators. He also claimed that they had to know but showed an attitude that, “If you are doing something wrong, we don’t want to know.” (iv)

Finally, a culture of acceptance towards unethical behaviour, where being unethical is no more seen as deviance but rather the practice itself becomes the norm. (Rationalization) This is the worst scenario. People belonging to corporate cultures where boundaries between what generally ought to be ethical and unethical are narrow, are much likely to engage rather involve in enhanced ways to breach ethical values.

An investment bank where it is common culture to sell high-risk products and betting against them yourself, talking otherwise would sound unethical! Similarly, in a small fund, where the manager resorts to insider information from dispersed sources regularly to drive returns, insider trading would never be perceived as unethical but a part of business. To sum it, acceptance changes perception and leads to breach of ethics on a regular and in some cases, on a mandatory basis.

Types of unethical behaviours
Having discussed why people from the financial world want to or are forced into being unethical, it is time for us to examine in further detail the types of unethical behaviours they indulge in. Here we will talk about companies from all sectors including the financial sector because at the core of it all breach is either carried out by a financier or effectively covered by one.

Fraudulent financial reporting

Fraudulent financial reporting is the single most committed unethical act in the financial world. Almost every company has been involved in fraudulent financial reporting over time. Every reporting period there are transactions, adjustments and facts which are ignored intentionally or intentionally taken note of by those responsible for preparation of financial information. They know where they want to take the organization and how they could take it there.

Hence, to a good extent the numbers we see as the indicators of a company’s financial performance and position, lack intrinsic value. In case of companies which do not face statutory requirements for publishing their financial information the situation is even worse. Companies are out of business long before they declare bankruptcy. It is only by virtue of fraudulent financial reporting that these companies are able to prolong their fall in hopes of improved conditions in future-which rarely improves.

Fraudulent client targeting
Fraudulent client targeting basically refers to targeting clients to buy products or services which they actually do not need or which would harm them more than they would do them good but in all scenarios the seller will benefit. This is a common practice among investment banking firms currently. Nobody questions such exploitation because at the time when such decisions are being made, all those present share a common interest of getting the client and believe they are doing the right thing. We have talked about client exploitation in detail already in the section ‘Why do financiers want to be unethical?’

Collusion with regulators
Breach of ethics also involves collusion with the regulators directly or indirectly colluding with the ones responsible to enforce the will of regulators, including collusion with the auditors of the company. History bears witness to hundreds of scandals involving collusion between the company’s management and their auditors. The Enron incident of 2001 shook the financial world and the audit profession leading to the end of the Group and their auditors (one of the top firms in world).

Unfortunately, in some parts of the world, the practice of auditing the financial information of a company has become more or less a drama performed by the auditors and the company’s management in front of the shareholders and regulators like the Securities & Exchange Commission. In order to maintain fruitful relations with the client, the auditors agree to numbers for provisioning and profitability and allow suspicious adjustments and reversals which improve the company’s profitability.

Everything as long as it would not get noticed in the eyes of law is allowed and done in partnership. This is one major reason why corporations with clean audit reports and absolutely no doubts about them being a going concern in the foreseeable future just so suddenly file for bankruptcy. The sudden effect was never there, this is what we think after having believed and trusted the financial viability of a company for years through its audited information when in fact it was all cooked up.

Circumventing the law and Money Laundering
Another quite regular unethical move which is in fact ethical in the eyes of law is actually circumventing the law. The impact of such circumvention is different for all dependent upon their sphere of influence and the amount of society’s trust breached. Every year countries are robbed of billions of tax revenue monies because cunning tax advisers and consultants (almost all of them with a finance background) help people evade the law by not actually breaking the law.

Illegal activities like money laundering are also aided by financiers the world over to keep clients happy and to make profits. Places like the Cayman Islands, Bahamas, Bermuda, Switzerland, Luxembourg, Singapore, Hong Kong etc. notoriously offer tax havens for wealth which has more or less come from black sources and illicit activities. According to a report by Tax Justice Network, there may be as much as $32 trillion of hidden financial assets held offshore by high net worth individuals (v).

Is this ethical? Yes! It is quite ethical because without this black money the economies and the banking systems in particular in these countries would collapse. But it is their existence which shall never help but in fact sustain and reinforce the evil practices from which this money is made; practices like money laundering, tax evasion, drugs and arms smuggling, looted funds of countries and proceeds from human trafficking to name a few.

Discrimination & Harassment
Finally, one must not ignore the instances of discrimination and harassment which occur in the financial world. Reported or not, they are an important aspect to how much what is ethical and moral is honoured by the financiers. The frequency of these instances and their gravity reflect the value systems of those belonging to the financial world.

In 2010, Goldman Sachs was in the limelight for sexual discrimination and harassment against its women employees in a suit filed by a group of female employees, led by Miss Cristina Chen-Oster-the initiator of the suit. The women plaintiffs recall absolutely horrific and disgusting treatment at the hands of their male colleagues and seniors and discrimination in pay, promotions and the terms and conditions of their jobs (vi).

Moreover, the Equality & Human Rights Commission in Britain initiated an inquiry into sex discrimination and unequal pay in the financial services sector in 2009 and later published its report. The detailed report examines the case for recruitment, pay, promotion and terms and conditions of jobs for women in particular in the financial services sector of Britain. According to the report the sector is prone to significant pay gaps between the two genders with full-time working women earning 55% less annual gross salary than their male colleagues (vii). Follow-ups on this report by the Commission continue to this day and the situation is still far from improved.

In addition, age discrimination among financial institutions is also a common practice worse than sexual discrimination at times. According to a study published in the Financial Times, in London, age discrimination is now seen as a more widespread problem than sex discrimination according to a survey of 1,600 finance sector workers (viii). In 2008, as businesses cut jobs to slash costs, in addition to women, it was the ageing workers who mostly lost their jobs owing to age discrimination in organisations. Thousands of petitions are still underway in US Courts for the same.

What are we lacking?
The reason why history has witnessed so many instances of ethical breaches in the financial world and these include only those ever discovered by the public eye; the reason why ethics are being breached even at this moment somewhere in the world of finance is because of a virtual inexistence of an ethical framework for finance. We are either not sure or try to turn a blind eye to its existence.

Ethical values are only what we publish every year in our annual reports, business plans, prospectuses and press releases. We may give lecture after lecture and speeches after speeches, we may have programs dedicated to educating future financiers to learn and respect ethics at work but still fail. In some cases, the whole cultures of organisations are flawed.

Recognition and adherence to ethical values should not be something individualistic. It ought to be streamlined and benchmarked, so that there is no room for individual perception because if there is, then as discussed earlier, ethics would be breached some way or the other. There has to be a framework restricting liberal thinking about following ethics. A framework which would enforce ethical values in the financial system and help restore public trust in financial institutions.

Way Forward

Going forward one must accept and take responsibility for the current state of ethics in finance. However, this picture can be improved with time. In the following sections, we will discuss a few measures, which might be radical and difficult to enforce at once but which if enforced in good faith and with the fist of law, will certainly improve the state of ethical following in financial institutions.

It must be noted that all breaches are undertaken because financiers think they have the ability to get away with it. It’s a simple fact nobody would risk their reputation and careers without preparing to cover up for it later. They might not initially sometimes but they have to eventually. Such is the case with financiers too.

Moreover, the financial information of any financial institution is not only its image to the world but also its most comprehensive cover. The financial information plays the role of a man’s clothes. Just as like the clothes project the status of a man or woman in the society, in addition to indicating a thousand other things about the person, they also cover the ills of the body and the evils within. Hence, even the most evil could be projected as angels.

Similarly, companies, in particular the financial institutions constantly manipulate their financial information in order to project a positive image. It is here where they try to hide all the breaches they were involved in, all the frauds, all the fake numbers, all the offshore dealings, all the questionable deals and transactions.

Therefore, a solution must address this vulnerability of financial information to ensure that they are prepared true and fair and are in no matter manipulated. The solution must also have the capacity to be able to bring to public knowledge the state of ethics in the organisation so that we have a bigger picture of all the affairs.

Surprise Audit
The concept is fairly comprehensible by its name, and is under practice in many places. However, what is being suggested is to set-up a body responsible for auditing financial institutions as well as their auditors, different than the quality control audits that follow. These surprise audits must focus only the vulnerable areas of the audit engagement.

For instance, auditors A, B & Co. audited M/s. X& Y Inc. in the year 2012. Now a surprise audit should be expected by both of them, but only one of them would get selected. The surprise auditors should either be another audit firm or a state-backed authority and their scope of engagement should focus components, off-shore vehicles and in particular prior year adjustments and adjustments and reversals made at period end.

In case of the company, the auditors must evaluate the authenticity and ethical soundness of their actions and practices. Whereas, in case of A, B & Co. the auditors must evaluate the work performed to verify such transactions by the auditor, the auditor’s professional judgement and his audit risk coverage. This exercise would certainly not eliminate fraudulent financial reporting but would ensure that those who still go for it take a mighty risk.

This scheme would also restrict collusion and any circumvention of laws by the company and the auditor. If the company does it, the auditor must prove his case to allow so without qualifying or mentioning the facts in his audit report, and if he does not then he risks his reputation and the reputation of the whole profession. As for the auditor alone, he has no motive to commence such a practice in the first place. The impetus plus incentive always comes from the management.

The results of such audits must be published publically and those audited must be assigned ratings just like credit ratings. Even though the scope of such surprise audits is targeted, auditing every corporation each year is not practicable. Hence, a surprise audit must be undertaken at least once every three years but a subsequent audit should also be expected next year. The idea is to establish unpredictability so as to enhance the quality of preparation of financial statements and their subsequent audit increasing integrity and ethical compliance.

Ethical Audit
Just as like corporations are required to have their financial information audited by an independent auditor, companies should also be required to have an ethical audit done once every two years. This concept is quite novel and in its early stages. It may be argued that financial audit suffices for ethical compliances and that audit of financial statements does not only have to do with audit of financial statements alone but the auditors also look into other aspects of the company including any ethical malpractices. There is also a so-called review report issued to shareholders in addition to the audit report for compliance with Ethics and Code of Corporate Governance.

However, it is important that we understand that even though today’s audits are multi-dimensional and a product of thorough planning and risk coverage; for the sake of efficiency and in order to avoid costly audits, only areas which may affect the preparation of financial statements are looked into. The International Standards on Auditing pronounce quite clearly that an auditor’s job is to identify material misstatements in financial statements of a company whether it may be due to fraud or error.

They further state that it is not the job of an auditor to detect fraud but he must be aware of the circumstances which might indicate existence of fraud and hence, the repercussions on the preparation of financial statements (ix). An audit to check the ethical side of a company would focus completely on ethics in the company. Such an audit would be planned to specifically audit the Ethics Department of the company, to audit the dealings with clients, how the company dealt with any statutory non-compliances and dealings with its employees.

By commissioning the need for ethical audit of companies worldwide, at least in the developed world, we are also encouraging growth of a whole new profession, an industry, an institution and opening gates to a future where there will be specialist ethical auditors with specialist certifications, improving the quality of ethical audits for future.
A typical Ethical Audit Engagement would comprise five basic components:
  • Engagement Acceptance
  • Scope of Engagement
  • Methodology
  • Time
  • Reporting
Engagement Acceptance/Continuance: 
An engagement for Ethical Audit shall be accepted taking into account that the audit to be performed is being performed based on an acceptable framework .i.e. the auditor agrees to the ethical compliance requirements in the same manner as required of the company he is about to audit. Further, the management of the company being audited shall also agree to provide complete access to premises, information and personnel to the auditors for the purposes of audit.
The auditors undertaking the engagement must also be competent in terms of education, experience and resources and adequately licensed to perform ethical audits. It would be preferable if they belong to an autonomous body of professionals chartered for the purpose. The auditors must also be independent of all interests in the client by virtue of exercising professional and organisational safeguards. Further, they need to be more cautious in their acceptance and approach specially in relation to clients which have had a history of ethical breaches.
Scope of Engagement:

The scope of engagement should focus on the activities of the Ethics Department in the company. It should also focus the controls and procedures and processes defined by the company to protect ethics and for whistle blowers and how whistle blowers are dealt with. They must also examine the cases reported during the year, any litigations and their likely outcome, involvement of senior executives and the consequences for the victims.
Further the engagement must examine the protocols followed in selling products to clients, internal correspondence among front-office staff and team leaders, the outcome of bets prescribed and the ethical standards of gains made by the company on sale of such products.
The methodology for the engagement should follow a risk based approach. Controls on business processes should be evaluated for their ability to safeguard ethics and if they qualify for the same and are also being implemented effectively, be a reliable source of evidence. Where controls do not exist and/or the area under question is more prone to encounter breach of ethics, detailed substantive testing should be performed.
The timing of the audit must coincide the timing for financial audit so that it is efficient and convenient for the client to prepare for it. The engagement must be planned and have a deadline before the deadline for financial audit so that the findings could be presented in time to the Board of Directors and shareholders along with the audited financial information.
All ethical audits must end with the objective to deliver a report on the findings. The report must state a rating like benchmark ratings used by Credit Rating Agencies. Any significant matters which ought to be disclosed to the public for their better understanding, and significant matters affecting the engagement must also be disclosed in the report.
Corporate Reporting Changes 
Since the beginning of the new millennium there has been a surge towards improved corporate reporting. Competition and regulatory requirements have forced companies to report more and report better. Today corporations go a step further each year in order to enhance their reports and also to improve the picture their investors get about the company. In relation to helping ethics in finance, corporate reporting can play an important role.
In addition to the system of mandatory Special and Ethical Audits, it ought to be stipulated under law and stock exchange listing regulations, that all incorporated entities having a certain amount of capital and number of employees, are to have a dedicated Ethics Department separate from the Human Resource Function. This department would be responsible for ensuring sustenance and carrying out of the ethical values of the company, addressing employee grievances, be responsible to deal with whistle blowers, take note of any ethical breaches including fraud and investigating them objectively.
Also corporate reporting must make provision for a dedicated section about Ethics and their Standards in the company for the period. This section must highlight the findings of special audits, ethical audits as well as the activities of the dedicated Ethics Department of the company. The section should further disclose the number of ethical breaches reported to the Ethics department, summarize how significant complaints were dealt with, any litigations brought against the company, whether senior management was involved in any instances, how were these personnel dealt with.
The same section must also disclose the initiatives taken by the company to promote intolerance of discrimination against age, sex and race of its employees and business partners. The section should include testimonies by representatives of different age groups, sex and race regarding their treatment at the company. The idea is to disclose as much so that companies are forced to change!
The Outcome

Companies with unclean reports for either Special or Ethical audit or both, and/or non-compliance with corporate reporting disclosure requirements for ethics, shall be made answerable in front of the regulators. They must be given an opportunity to justify their case, failing which, they may be subject to fines, penalties and even criminal prosecution, and any further investigations if needed.
Action shall also be determined as per the ethical standards for the respective jurisdiction, industry and profession. The damage to the entity and its representatives’ reputations will be much intense with punitive spill-over effects extending into future.
A Final Word 
If the ideas discussed are implemented in the spirit that they have been discussed here, the problem of abuse of ethics should cease to aggravate and the situation should improve to a greater extent. As said in the beginning of this paper, abuse of ethics is the outcome of more than one cause and most of the causes relate to greed, pressure to perform, or an opportunity to abuse and get away and in the more miserable cases, an acceptable attitude towards such abuse. All of them are natural. 

Therefore, no matter what we do to improve the situation, nothing will work unless it has the element of virtually forcing people to respect and maintain ethical standards in everything they do. The paper only tries to put forward what, if stipulated, would at least force corporations, especially financial corporations towards improving their ethical scale, and this is what we all want today. Despite better law enforcement agencies than in the past crime still exists. 

However, it is more difficult to commit today than the past, there is a better chance of investigation and the perpetrators being punished and certainly, in some societies people feel safer than ever. They trust the law enforcement agencies with their security. The ideas here will help people trust financiers with their money. This paper will restore trust.
Today we find the issue of ethics almost in turmoil. But in a future where companies would be subject to Special Audits and Ethical Audits, and corporate reporting changes, ethics will get promoted naturally and the picture would be clearer and hopeful than today. Financial institutions would be at least forced to adhere to ethical values and respect social welfare in the wake of  safeguarding their own interests. This would help restore public trust and make financial institutions better places to work and do business with. These institutions are sacred because they are the blood of the modern economy. Finance breathes life into human endeavours from economics to politics to civics to science. The state of ethics in finance has to be improved for a better world. It is a change we need!
i ‘Madoff Scheme Kept Rippling Outward, Crossing Borders.’- The New York Times (New York Edition), page A1, December 20, 2008.
ii CFA, CFP, CPA, CIM, CHP, RHU, CAIA, CIIA, MFC-The letters are all registered trademarks and property of the respective professional institutes.
iii ‘Banks Paid $32.6 Billion in Bonuses Amid US Bailout (Update 4)’-Bloomberg News by Karen Freifeld, July 30, 2009-Mr. Andrew Cuomo is the former Attorney General of New York from 2007 to 2010.
iv ‘Madoff Says From Prison That Banks ‘Had to Know’’-The New York Times (New York Edition), page A1, February 16, 2011.
v The Price of Offshore Revisited-Tax Justice Network, July 22, 2012.
vi ‘Goldman Sachs sex discrimination case: court papers reveal the inside story’-by Philip Sherwell, New York-The Telegraph, September 19, 2010.
vii Financial Services Inquiry Report, commissioned by the Equality & Human Rights Commission UK, 2009.
viii ‘Ageism more widespread than sexism’ by Brian Groom, Business &
Employment Editor-Financial Times (UK), March 31, 2013.
ix Refer the Handbook of International Quality Control, Auditing, Review, Other Assurance, and Related Services Pronouncements-PART I (2010 Edition-Pakistan), International Standard on Auditing 240, ‘Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements’, Paragraphs 3-8 and Explanations, (Latest on or after December 15, 2009) published by the International Federation of Accountants (IFAC), USA.

Word Count: 4,866 words or 29,990 characters (with spaces), excluding bibliography.

This was my submission for the 2013 Robin Cosgrove Prize to the Robin Cosgrove Foundation. Please provide me your valuable feedback. You can contact me by commenting here and I will get back to you!