9.2 Ethical Considerations in Securities Underwriting and Trading
3 min read•august 6, 2024
Securities underwriting and trading involve complex ethical considerations. Investment banks must balance their profit motives with fair dealing and market integrity. Key issues include preventing , ensuring fair order handling, and providing accurate disclosures to investors.
Ethical practices in securities markets are crucial for maintaining investor trust and market efficiency. Regulations aim to prevent deceptive practices like and . Proper disclosure of and adherence to principles are essential for ethical conduct.
Market Manipulation and Unfair Practices
Deceptive Practices in Securities Markets
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- Market manipulation involves intentionally distorting securities prices or trading volume to create false impressions and mislead investors
- Pump and dump schemes artificially inflate the price of a security through false and misleading positive statements to sell the cheaply purchased security at a higher price (microcap fraud)
- Front-running occurs when a broker executes trades for their own account ahead of their customers' trades to benefit from the expected price movement caused by the pending orders
- Engaging in manipulative and deceptive practices undermines the integrity and efficiency of securities markets, eroding investor confidence
Ensuring Fair Dealing and Price Stability
- Fair dealing principles require that all clients be treated fairly and equitably, without giving preferential treatment or taking advantage of certain clients
- Investment banks and broker-dealers must establish policies and procedures to prevent manipulative practices and ensure fair dealing among clients
- Price stabilization involves supporting the price of a security during a public offering by engaging in permissible activities (, buybacks) to prevent or slow a decline in the security's price
- Stabilization activities must be disclosed in the offering prospectus and are subject to specific rules and restrictions to prevent market manipulation
Short Selling and Order Handling
Short Selling Practices and Regulations
- Short selling involves selling borrowed securities with the expectation of buying them back at a lower price to profit from the price decline
- Naked short selling occurs when a short seller sells shares without first borrowing them or ensuring they can be borrowed, potentially causing failed trades and market disruption
- Regulations require short sellers to locate shares to borrow before executing a short sale and impose restrictions on short selling during significant price declines (uptick rule)
- Abusive short selling practices, such as spreading false rumors to drive down prices, are prohibited and subject to enforcement actions
Best Execution and Order Handling Requirements
- Best execution requires broker-dealers to seek the most favorable terms reasonably available for customer orders, considering price, speed, likelihood of execution, and other relevant factors
- Order handling rules require broker-dealers to establish and enforce written policies and procedures designed to obtain best execution for customer orders
- Broker-dealers must not interject a third party between the customer and the best available market without meaningful added value or service
- Order handling rules also require broker-dealers to disclose their order routing practices and any payment for order flow arrangements to customers
Disclosure and Material Information
Prospectus Disclosure Requirements
- A prospectus is a legal document that provides detailed information about a securities offering, including the issuer's business, financial condition, risks, and terms of the offering
- Securities laws require that a prospectus contain all material information necessary for investors to make informed investment decisions
- Material information is any information that a reasonable investor would consider important in making an investment decision or that would significantly alter the total mix of available information
- Omitting material information or making false or misleading statements in a prospectus can result in liability for the issuer, underwriters, and other participants in the offering
Greenshoe Option and Overallotment
- A , also known as an overallotment option, allows underwriters to sell additional shares (typically 15% of the original offering) at the offering price to cover overallotments
- Overallotment occurs when underwriters sell more shares than the issuer initially offered to meet excess demand and stabilize the price in the aftermarket
- The greenshoe option provides flexibility for underwriters to manage the offering process and helps stabilize the price of the newly issued securities
- If the greenshoe option is exercised, the issuer receives additional proceeds from the sale of the extra shares, but if not exercised, the underwriters cover the overallotment by buying back shares in the open market
Key Terms to Review (24)
AICPA Code of Professional Conduct: The AICPA Code of Professional Conduct is a set of ethical guidelines and standards established by the American Institute of Certified Public Accountants to guide the behavior and decision-making of CPAs in their professional duties. This code is essential for maintaining public trust and ensuring that accountants uphold integrity, objectivity, and professionalism in their work. It serves as a framework for ethical reasoning and applies to various scenarios in accounting and finance, influencing how professionals interact with stakeholders, handle ethical dilemmas, and fulfill their responsibilities.
Audit committee: An audit committee is a specialized group within a company's board of directors responsible for overseeing the financial reporting process, monitoring the effectiveness of internal controls, and ensuring compliance with legal and regulatory requirements. This committee plays a critical role in enhancing corporate governance by providing an independent check on the management's financial practices and fostering ethical behavior within the organization.
Best Execution: Best execution refers to the obligation of financial professionals to execute client orders at the most favorable terms available, taking into account factors like price, speed, and likelihood of execution. This principle ensures that clients receive the best possible outcomes in their trades, promoting fairness and transparency in financial markets.
Board Independence: Board independence refers to the concept where a company's board of directors is composed of members who are not part of the company's management and do not have any significant relationships with the company that could compromise their ability to make unbiased decisions. This independence is crucial for ensuring accountability, transparency, and ethical governance, as it helps prevent conflicts of interest and promotes a focus on the long-term interests of shareholders.
CFA Institute Code of Ethics: The CFA Institute Code of Ethics is a set of principles and standards designed to guide investment professionals in their ethical conduct and decision-making. This code emphasizes integrity, professionalism, and the responsibility to act in the best interests of clients and the public. It serves as a foundational framework for ethical behavior in finance, impacting various aspects of financial practices, including the application of ethical frameworks and considerations in securities underwriting and trading.
Deontologism: Deontologism is an ethical theory that emphasizes the importance of rules, duties, and obligations in determining the morality of actions, rather than focusing solely on the consequences. This approach asserts that certain actions are inherently right or wrong, regardless of their outcomes, which is particularly relevant in contexts where ethical standards guide professional behavior and decision-making.
Dodd-Frank Act: The Dodd-Frank Act is a comprehensive piece of financial reform legislation passed in 2010 in response to the 2008 financial crisis, aimed at reducing risks in the financial system. It established numerous regulations to enhance transparency, protect consumers, and ensure accountability among financial institutions, thus impacting areas such as shareholder rights, insider trading, market manipulation, investment banking conflicts of interest, securities underwriting ethics, whistleblower protections, and accounting standards.
Dual Agency: Dual agency refers to a situation where a single agent represents both the buyer and the seller in a transaction, creating a potential conflict of interest. This arrangement can lead to ethical concerns as the agent may struggle to remain impartial, balancing the interests of both parties. In securities underwriting and trading, dual agency can complicate fiduciary duties, as the agent must navigate the conflicting needs of clients while upholding transparency and integrity.
Enron Scandal: The Enron scandal was a major accounting fraud that led to the bankruptcy of the Enron Corporation in 2001, revealing widespread corporate corruption and ethical violations. This scandal highlighted failures in regulatory compliance and exposed serious ethical considerations within financial practices, affecting investor trust and prompting changes in legislation.
Fiduciary Duty: Fiduciary duty refers to the legal and ethical obligation of one party to act in the best interest of another. This duty is particularly significant in finance and accounting, where professionals must prioritize their clients' interests above their own, ensuring trust and integrity in financial transactions and advice.
Front-running: Front-running is the unethical practice where a broker executes orders on a security for their own account while taking advantage of advance knowledge of pending orders from their clients. This act creates a conflict of interest, as brokers prioritize their own financial gain over the best interests of their clients. It raises significant ethical concerns regarding trust, transparency, and fairness in investment transactions.
Greenshoe option: A greenshoe option is a provision in an underwriting agreement that allows underwriters to buy additional shares from the issuer if the demand for an initial public offering (IPO) exceeds expectations. This mechanism helps stabilize the stock price after the IPO by allowing underwriters to cover short positions and manage excess demand, which can lead to ethical considerations in securities underwriting and trading.
Insider Trading: Insider trading refers to the illegal practice of trading stocks or other securities based on non-public, material information about a company. This unethical behavior undermines market integrity and creates an uneven playing field, affecting investor trust and the overall financial system.
Market manipulation: Market manipulation refers to the act of artificially inflating or deflating the price of a security or other financial instruments through deceptive or fraudulent practices. This behavior undermines the integrity of the financial markets, leading to unfair advantages for some investors while exposing others to undue risk. Market manipulation is often closely related to insider trading, where individuals leverage non-public information to influence market outcomes, and has serious legal and ethical implications for those involved.
Material Information: Material information refers to any data or facts that could influence an investor's decision to buy or sell a security. This type of information is crucial in the context of securities underwriting and trading because it ensures that all parties have equal access to information, promoting fair and transparent markets.
Overallotment: Overallotment refers to a practice in securities underwriting where underwriters are allowed to sell more shares than initially planned, typically up to 15% more. This allows underwriters to accommodate high demand for a new issue of securities while providing them with some flexibility to stabilize the price in the secondary market after the offering. It's an important mechanism that can reflect market confidence and demand but also raises ethical considerations regarding transparency and fairness in the underwriting process.
Principled Negotiation: Principled negotiation is a conflict resolution method that focuses on the interests of the parties involved rather than their positions, emphasizing collaboration and mutual gain. This approach helps negotiators find solutions that are fair and beneficial to all sides, promoting transparency and ethical conduct in decision-making. It aligns with ethical considerations in finance by advocating for integrity and fairness while also connecting to social contract theory, which stresses the importance of rights and obligations in negotiations.
Pump-and-dump schemes: Pump-and-dump schemes are fraudulent practices where the price of a stock is artificially inflated through false or misleading statements, followed by the selling of the stock at the inflated price. This unethical strategy often targets low-volume stocks and leaves other investors with worthless shares once the price plummets after the scammers sell their holdings. Such practices raise serious ethical concerns in the realm of securities underwriting and trading as they undermine market integrity and investor trust.
SEC v. Rajaratnam: SEC v. Rajaratnam was a landmark insider trading case in which the U.S. Securities and Exchange Commission (SEC) charged hedge fund manager Raj Rajaratnam with insider trading based on confidential information he obtained from corporate insiders. The case highlighted ethical issues surrounding securities trading, including the importance of maintaining market integrity and the consequences of violating securities laws.
Securities Act of 1933: The Securities Act of 1933 is a federal legislation that was enacted to ensure transparency in the securities markets and to protect investors by requiring companies to disclose important financial information before offering securities for sale. This act aimed to curb fraud and misrepresentation in the securities industry, promoting ethical behavior in underwriting and trading practices.
Self-dealing: Self-dealing refers to situations where a person in a position of authority, such as a corporate director or executive, engages in transactions that benefit themselves at the expense of the organization they represent. This behavior raises ethical concerns because it can lead to conflicts of interest, undermine trust, and potentially harm the company and its shareholders. Understanding self-dealing is crucial in the context of governance and financial practices to ensure accountability and maintain integrity.
Stakeholder theory: Stakeholder theory is an ethical framework that suggests that organizations should consider the interests and well-being of all stakeholders—such as employees, customers, suppliers, and the community—rather than just focusing on maximizing shareholder value. This approach emphasizes the interconnectedness of various parties and highlights the moral responsibilities businesses have towards those affected by their operations.
Transparency: Transparency refers to the openness and clarity with which an organization communicates its operations, financial conditions, and decision-making processes. It fosters trust among stakeholders by ensuring that relevant information is accessible and understandable, thereby reducing ambiguity and enhancing accountability.
Utilitarianism: Utilitarianism is an ethical theory that suggests that the best action is the one that maximizes overall happiness or utility. This principle emphasizes the consequences of actions, promoting choices that lead to the greatest good for the greatest number of people.