How the Ethical Wall Works on Wall Street

A Chinese Wall is an ethical concept of separation between groups, departments, or individuals within the same organization—a virtual barrier that prohibits communications or exchanges of information that could cause conflicts of interest. While the wall concept exists in a variety of industries and professions—including journalism, law, insurance, computer science, reverse engineering, and computer security—it’s most often associated with the financial services sector. The offensive and racist term is commonly used at investment banks, retail banks, and brokerages. U.S. historical milestones illustrate why an ethics wall was needed in the first place and why legislation was created to keep it in place.

The Chinese Wall and the 1929 Stock Market Crash

Deriving from the Great Wall of China, the ancient impervious structure erected to protect the Chinese from invaders, the term “Chinese wall” came into popular parlance—and the financial world—during the early 1930s. Spurred by the stock market crash of 1929 (partly attributed at the time to price manipulation and trading on inside information), Congress passed the 1933 Glass-Steagall Act (GSA), demanding the separation of commercial and investment banking activities—that is, investment banks, brokerage firms, and retail banks.

Although the act did cause the breakup of some securities and financial monoliths, such as J.P. Morgan & Co. (which had to spin off brokerage operations into a new company, Morgan Stanley), its main intention was to prevent conflicts of interest. An example of this would be a broker recommending clients buy shares of a new company whose initial public offering (IPO) the broker’s investment banking colleagues just happen to be handling. Rather than forcing companies to participate in either the business of providing research or providing investment banking services, Glass-Steagall attempted to create an environment in which a single company could engage in both endeavors. It simply mandated a division between departments: the Chinese Wall.

This wall was not a physical boundary, but rather an ethical one which financial institutions were expected to observe. Inside or nonpublic information was not allowed to pass between departments or be shared. If the investment banking team is working on a deal to take a company public, their broker buddies on the floor below are not to know about it—until the rest of the world does.

As Linguisitics Discrimination & Racism

The term is often seen as culturally insensitive and an offensive reflection on Chinese culture. Unfortunately, it is now widespread throughout the global marketplace. It has even been argued in the courts.

It surfaced in a concurring opinion in Peat, Marwick, Mitchell & Co. vs. Superior Court (1988), in which the Justice Haning wrote, “‘Chinese Wall’ is one such piece of legal flotsam which should be emphatically abandoned. The term has an ethnic focus which many would consider a subtle form of linguistic discrimination. Certainly, the continued use of the term would be insensitive to the ethnic identity of the many persons of Chinese descent. Modern courts should not perpetuate the biases which creep into language from outmoded, and more primitive, ways of thought.”

The alternative that the judge suggested is “ethical wall”. The American Bar Association rules of conduct suggest “screen” or “to screen” as a way to describe the concept as it pertains to address conflicts of interest in law firms.

The Chinese Wall and 1970s Deregulation

This arrangement went unquestioned for decades. Then, some 40 years later, the deregulation of brokerage commissions in 1975 served as a catalyst for increased concern about conflicts of interest.

This change abolished the fixed-rate minimum commission on security trades, causing profits to plummet at brokerage operations. This became a major problem for sell-side analysts, who conduct securities research and make the information available to the public. Buy-side analysts, on the other hand, work for mutual fund companies and other organizations. Their research is used to guide investment decisions made by the firms that employ them.

Once the pricing changed on brokerage commissions, sell-side analysts were encouraged to craft reports that helped sell stocks and were given financial incentives when their reports promoted their firm’s IPOs. Large year-end bonuses were based on such successes.

This all helped to create the roaring bull market and the go-go, anything-goes era on Wall Street during the 1980s—along with some high-profile insider trading cases and a nasty market correction in 1987. As a result, the Securities and Exchange Commission‘s (SEC) Division of Market Regulation conducted several reviews of Chinese Wall procedures at six major broker-dealers. And partly as a result of its findings, Congress enacted the Insider Trading and Securities Fraud Enforcement Act of 1988, which increased the penalties for insider trading, and also granted the SEC broader rulemaking authority concerning Chinese Walls.

The Chinese Wall and the Dotcom Boom

Chinese Walls, or ethics walls, returned to the spotlight in the later 1990s, during the heyday of the dotcom era, when superstar analysts such as Morgan Stanley’s Mary Meeker and Salomon Smith Barney’s Jack Grubman became household names for their avid promotion of specific securities. 

During this time, a few words from a top analyst could literally cause a stock’s price to soar or plummet as investors bought and sold based on the recommendations of the analysts. Also, the Gramm-Leach-Bliley Act (GLBA) of 1999 repealed much of the Glass-Steagall Act that prohibited banks, insurance companies, and financial services companies from acting as a combined firm.

The collapse of the dotcom bubble in 2001 shed some light on the flaws in this system. Regulators took notice when it was discovered that big-name analysts were privately selling personal holdings of the stocks they were promoting and had been pressured into providing good ratings (despite personal opinions and research that indicated the stocks were not good buys). Regulators also discovered that many of these analysts personally owned pre-IPO shares of the securities and stood to earn massive personal profits if they were successful, gave “hot” tips to institutional clients, and favored certain clients, enabling them to make enormous profits off of unsuspecting members of the public.

Interestingly, there were no laws against such practices. Weak disclosure requirements enabled the practice to flourish. Likewise, it was discovered that few analysts ever put a “sell” rating on any of the companies they covered. Encouraging investors to sell a specific security didn’t sit well with the investment bankers because such a rating would discourage the poorly rated company from doing business with the bank—though often the analysts and their cronies were selling those very same securities. Investors who were buying securities on the advice of their favorite analysts, believing their counsel was unbiased, lost significant amounts of money.

The Dotcom Aftermath

In the wake of the dotcom crash, Congress, the National Association of Securities Dealers (NASD), and the New York Stock Exchange (NYSE) all became involved in the effort to craft new regulations for the industry. Ten big-name firms including Bear Stearns & Co.; Credit Suisse First Boston (CS); Goldman Sachs & Co. (GS); Lehman Brothers; J.P. Morgan Securities (JPM); Merrill Lynch, Pierce, Fenner & Smith; Morgan Stanley & Co. (MS); and Citigroup Global Markets were forced to separate their research and investment banking departments.

The legislation led to the creation or strengthening of the separation between analysts and underwriters. It also included reforms in compensation practices, as prior practices gave analysts a financial incentive to provide favorable evaluations of underwriting clients.

Are Ethics Walls Effective?

Today, there are additional protections in place, such as prohibitions on linking analyst compensation to the success of a particular IPO, restrictions on providing information to some clients and not others, rules against analysts conducting personal trades in securities that they cover, and additional disclosure requirements designed to protect investors.

But legislators are still grappling with the role conflicts of interest played in the subprime mortgage crisis of 2007, which led to the Great Recession—and wondering to what extent ethics walls helped or hindered the practices that preceded the collapse. There seem to be indications rules to ensure the separation between product-rating services and their client companies were being flouted.

Another issue: One arm of an investment firm would recommend collateralized mortgage obligations (or other products) to investors, while another arm of the same firm was selling them short. In other words, they were betting against their own recommendation at investors’ expense.

Beyond the legalities, all these dark events and scandal-ridden eras reveal some ugly truths about ethics, greed, and the ability of professionals to police themselves. There have always been those who have doubted ethics walls’ efficacy; certainly, they test self-regulation to the limit. The moral of the last century, sadly, seems to be that the ethics walls concept helped define ethical limits—but it did little to prevent fraud.