Friday, November 3, 2017

The la la land of financial market ethics

An FT investigation shows that top executives at Guggenheim Partners, the $240 bn asset manager, invested their client's money in companies with close personal ties to its leadership, without proper due-diligence and in cases even despite red-flags raised by the firm's own compliance department. This case of self-dealing and pursuing transactions against client interests is the latest in the endless series of scandals about governance and ethics violations that have become the norm in recent years. 

While there are elaborate "safeguards" against self-dealing, insider-trading, and the like, they rest of very flimsy, often completely unrealistic, foundations. Consider this,
There is nothing necessarily improper about investing with former business partners or close associates, as long as transactions between the groups are conducted at “arm’s length”, with full disclosure of deal terms to all parties involved in the transaction.
And there are academic apologists who lend the veneer of credibility to such relationships and transactions,
James Cox, a securities law professor at Duke University, says such conflicts are normally policed aggressively by compliance departments and a series of violations would indicate a failure of leadership at any Wall Street firm.
One of the less discussed agency problems with modern financial markets is the conflicts that arise at the intersection of the executive's professional and personal roles. It is a reality that top executives in the largest financial institutions today are simultaneously managing client and personal investments within the umbrella of the same institution and sometimes even the same financial instruments. This naturally raises the possibility of conflict between their fiduciary responsibility and their personal interests. The likelihood of investing client money being dictated by personal motivations is non-trivial.

In fact, given the very high stakes involved, the ease of obscuring personal relationships and making transactions opaque, the thin line between compliance and compromise, the difficulty of establishing culpability for transgressions like self-dealing and insider trading, and the pervasive erosion of corporate ethics, it is difficult to believe that such "arm's length" transactions are likely to be the norm. Adding to this, when executives from financial market titans have been found to have indulged in malfeasance involving cross-selling, self-dealing, asset-stripping, and insider trading on numerous occasions, and have escaped without any personal damage, the incentive misalignment and agency failure is almost complete. 

This was one of the reasons why financial institutions were historically structured as partnerships. As long these institutions remained small, the individual limited partners had enough leverage to keep incentives aligned. Gradually, as these entities have expanded massively, become public, and attracted impersonal institutional investors like pension and insurance funds, the relationship between the principal and agents diffused, and the former's leverage weakened as to become insignificant. 

It would require individuals of increasingly rare personal character to be able to resist the temptations of massive returns and exercise self-restraint in elevating their personal interests over their fiduciary responsibilities. The vast majority, when presented an opportunity, are most likely to fall prey to these temptations. The belief that "Chinese walls" and "arm's length" relationships are effective at deterring malfeasance is just a figment of one's imagination. 

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