Why Ethics Codes Don't Work

CFA Institute

Why Ethics Codes Don't WorkAuthor(s): John DobsonSource: Financial Analysts Journal, Vol. 59, No. 6 (Nov. - Dec., 2003), pp. 29-34Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4480525 .

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PERSPECTIVES

Why Ethics Codes Don't Work

John Dobson T he recent stock market downturn brought

to light various legal and ethical trans- gressions committed during the euphoria of the 1990s market boom. Government

and judicial authorities are investigating the behavior of investment bankers, securities analysts, and other individuals engaged in the finance industry. The New York State Attorney General's Office, U.S. SEC, U.S. Justice Department, and a Congressional subcommittee on capital markets have each initi- ated investigations focusing primarily on the exist- ence and extent of conflicts of interest faced by finance professionals (such as analysts, brokers, and underwriters). Although many specific issues are being addressed in these investigations, two broad questions are attracting the most attention: How do underwriters of IPOs make share alloca- tion decisions? And why do financial analysts so rarely issue sell recommendations?

In addition to these institutional investigations, individual investors are seeking restitution through the law. A typical example is the suit brought by Debasis Kanjilal, an individual investor with a brokerage account at Merrill Lynch & Com- pany: During 2000, Kanjilal's account dropped from a market value of $1.2 million to about $95,000. His assertion is that Merrill Lynch's brokerage arm was urging him to buy stocks- InfoSpace and JDS Uniphase Corporation-that Merrill Lynch's consulting arm had a vested interest in supporting. To back up his accusation of conflict of interest, Kanjilal notes that during the time he was being urged to buy, the CEOs of both InfoSpace and JDS were heavy sellers. A spokes- person for Merrill Lynch has countered that Kan- jilal was an experienced investor who made his own investment decisions.

Several other individual investors have brought class action suits against major investment banks. Underwriters at Morgan Stanley, for example, are accused of soliciting and receiving commis- sions from certain investors in return for larger portions of IPOs than legally allowed. They are also accused of reaching pre-offer agreements with some wealthy customers to allocate IPO shares

preferentially to these customers. The suit alleges that, as a sweetener, Morgan Stanley guaranteed these customers the opportunity to buy additional shares in the aftermarket at predetermined prefer- ential prices. This practice is known as "spinning."

All this attention being paid to the finance profession is not flattering. Although some of the allegations may prove unfounded, the evidence already brought to light is sufficient cause for concern. The behavior of some finance professionals, whether acting as individuals or under the auspices of an organization, appears to have fallen well short of what would generally be regarded as professional conduct.

Ironically, at the same time, ethical guidelines and codes of conduct have never been more wide- spread in the financial services industry. Profes- sional certifications, such as the Chartered Financial Analyst (CFA) and the Certified Finan- cial Planner (CFP) designations, involve a significant ethics component. Few contemporary financial services professionals, therefore, can have escaped some exposure to guidelines on ethics and professional responsibility. So, why have some individuals ignored even the most basic pre- cepts of these guidelines?

My answer involves acculturation-that is, implicit education into a certain moral value system. Individuals become acculturated by the day- to-day behavior they see around them because they assume such behavior is what is rational and acceptable in their field. In the financial services industry, the implied moral education comes through exposure to the value systems displayed in educational institutions, the industry, and people's firms, particularly by the firm's senior managers. Acculturation comes from observing the actual behavior of other individuals. The school, firm, professional bodies in the industry-all may publish codes of ethics, but if the codes are not internalized in the values of individuals and manifested in individual behavior, the codes will have little impact on the acculturation of individuals in the industry. So, for example, in-house corporate training programs may well expose individuals to some explicit discussion of ethics, but if the discussion is only talk, such programs are not part of acculturation. A code of "ethics" may be no more than a legalistic gloss over the real ethos that pervades the organization.

John Dobson is associate professor offinance at Califor- nia Polytechnic State University, San Luis Obispo.

November/December 2003 29



Financial Analysts Journal

Where, then, do the behavioral norms for the real ethos come from if not from the accepted codes of ethics?

The behavior espoused in finance education and in financial institutions has its origin and ultimate justification in a particular moral philosophy, namely, neoclassical economic theory. For most individuals, the process of acculturation thus begins with the values implied in their explicit business school education. Here, they are exposed continually to modem interpretations of a narrow, utilitarian notion of what constitutes rational- hence, reasonable-behavior.

The construct of neoclassical economic rationality focuses on a narrow notion of self-interest. It promotes the idea that the only conceivable justification for individual behavior is the persistent, atomistic, exclusive, and endless pursuit of personal material wealth. In financial economic theory, rational agents are always assumed to be material opportunists who will readily jettison honesty and integrity in favor of guile and deceit whenever the latter are more likely to maximize some payoff function; indeed, to act other than opportunistically in this manner is, by definition, irrational. Used outside the context of pure economics, this rationality construct in an educational setting inculcates business students and professional trainees with a moral agenda that is very different from that espoused in professional codes of conduct.

Because neoclassical economic rationality is the real ethics education that those entering the finance professions receive, what officially passes for ethics education comes too little, too late. Pro- fessional neophytes already know-or think they know-what the behavioral ideal is: material opportunism.

In essence, therefore, individuals in financial organizations are faced with two incompatible notions of rational behavior-two moral philoso- phies. One, neoclassical economic rationality, provides the foundation for their early educational experience and is reinforced through their acculturation into the financial services industry. The other, a code of ethics that espouses some rationality premise other than that of neoclassical economics, may be touched on in their early educational experience but generally appears to play little part in the industry.

Source of the Problem Rationality in financial economics is founded on the five axioms of cardinal utility as first expounded by John von Neumann and Oskar Morgenstern (1947)

plus one additional axiom. The original five axioms are as follows: * Comparability. The individual is able to make

comparisons of preferences. * Consistency. The comparisons are consistent for

an array of alternatives. * Independence. Original preference orderings are

independent of new preference alternatives. * Measurability. Preferences are measurable. * Ranking. Preferences can be consistently and

ordinally ranked. In essence, the five axioms define rationality in

terms of an individual's ability to make consistent preference orderings among a broad spectrum of choices. As Von Neumann and Morgenstern themselves put it:

We wish to find the mathematically complete principles which define "rational behavior" for the participants in a social economy, and derive from them the general characteristics of that behavior. (p. 31)

Furthermore, "people are assumed to be able to make these rational choices among thousands of alternatives" (Copeland and Weston 1988, p. 80).

The axioms are thus based on a mathematical and instrumental notion of what it means to be rational: They are all concerned with defining instrumental rationality in terms of the consistent ranking of preferences. For example, if you are an investor choosing stocks in which to invest and you prefer IBM to Microsoft, and you prefer Microsoft to Netscape, then to be rational, you must prefer IBM to Netscape; furthermore, your degree of preference for IBM over Netscape, together with your preferences for thousands of other securities, must stay constant no matter how many more stocks are added to your opportunity set.

Note that these five axioms make no normative statement about whether you have any specific goal or what your goal should be. The axioms simply require that the agent act in a consistent manner in ordering preferences.

Financial economic theory's sixth axiom, however, has just such prescriptive implications. As Thomas Copeland and Fred Weston's popular finance textbook states: "Having established the five axioms, we add to them the assumption that individuals always prefer more wealth to less" (1988, p. 80; emphasis added). Personal wealth maximization is, therefore, a rational agent's sine qua non. No matter what the context, no other ultimate end is allowed or considered.

In relating the five axioms to this sixth axiom, a useful distinction can be made between instrumental rationality and substantive rationality. As distinguished by Max Weber (1948), instrumental

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(or formal) rationality concerns how the agent goes about achieving the desired objective and substantive (or values-based) rationality concerns identifying the desired objective itself. Jennifer Moore (1991) distinguished between the two concepts as follows:

The primary feature of instrumental rationality is that it does not choose ends, but accepts them as given and looks for the best means to achieve them. In instrumental rationality, reason is sub- ordinated to and placed at the service of ends outside itself. In ... [substantive rationality], in contrast, reason is free ranging. It is not the servant of any end. Rather, it subjects every end to its own standards of evaluation and criticism. (p. 63; emphasis added)

The five Von Neumann-Morgenstern axioms clearly pertain to instrumental rationality. They do not stipulate an ultimate objective; they merely require that agents pursue some given objective in a consistent and logical manner. The substantive rationality premise of financial economics-the opportunistic and atomistic pursuit of material gain ad infinitum-is provided by the sixth axiom. The finance literature supplies no justification in the form of empirical evidence to support this substantive rationality premise (indeed, ample evidence shows that in many environments, individuals are not motivated primarily by personal wealth maximization) nor any normative argument to defend the notion that agents should act consistently with the sixth axiom.

The first five axioms should be looked upon as merely a framing device-a way of placing behavior in a simple mathematical context. They neither claim to be factually accurate in all situations (or even most situations) in which finance professionals find themselves, nor should they be viewed as prescribing how individuals should behave in any given situa- tion. As John Boatright observed, "Economics does not make any value judgement about the goods that people prefer or about the selfishness that is assumed" (1999, p. 48). Financial economic rationality is a simplifying assumption, nothing more.

Confronting the Problem Many professional organizations in the finance industry publish ethical guidelines for practitioners. AIMR (1999), for example, provides the following succinct code of ethics:

Members of the Association for Investment Management and Research shall: 1. Act with integrity, competence, dignity,

and in an ethical manner when dealing with the public, clients, prospects, employ- ers, employees, and fellow members.

2. Practice and encourage others to practice in a professional and ethical manner that will reflect credit on members and their profession.

3. Strive to maintain and improve their competence and the competence of others in the profession.

4. Use reasonable care and exercise independent professional judgment. (p. 1)

Similarly, those individuals endeavoring to qualify as Certified Financial Planners are exhorted "to take responsibility to act in an ethical and professionally responsible manner in all professional services and activities" (CFP Board 2003, p. 5). The certification body defines seven core principles designed to provide financial planners sound ethical guidance-integrity, objectivity, competence, fairness, confidentiality, professionalism, and diligence.

In the introduction to Code of Ethics and Profes- sional Responsibility (Code of Ethics), the CFP gover- nors state that the principles "are aspirational in character," which raises the question again of why so many finance professionals fail to aspire to following these and similar principles.

The first step in answering this question is to recall the type of behavioral education that those pursuing careers in finance receive. Before candi- dates for CFA or CFP certification are presented with explicit ethical guidelines in their preparation for these charters, they have probably been in an MBA program or some form of apprenticeship in a financial organization. As noted, they will have been learning what constitutes reasonable or rational behavior in their field. In most business school curricula, the definition will be the one supplied by financial economic theory. As Richard Thaler (1992) observed:

The same basic assumptions about behavior are used in all applications of economic analysis, be it the theory of the firm, financial markets, or consumer choice. The two key assumptions are rationality and self-interest. People are assumed to want to get as much for themselves as possible, and are assumed to be quite clever in figuring out how best to accom- plish this aim. (p. 2)

Eric Noreen (1988) defined this opportunistic notion of rationality as one in which individuals always pursue personal material gain with "if necessary, guile and deceit" (p. 359). Clearly, such a rational economic agent is a very different individual from the one conjured by professional codes of ethics.

The notion of rationality that lies at the heart of financial education and training is rarely dis- cussed in depth; individuals are simply assumed to





be opportunistic wealth maximizers, which is tac- itly accepted as a law of nature.

If this narrow notion of self-interest is the only rational way to behave, then to hold some principle other than material opportunism, such as honesty, as an ultimate justification for behavior is irrational and, by implication, wrong. Intrinsically honest behavior would be considered in financial economic theory to be "deviant" or "off the equilib- rium path."

All this theory would be relatively harmless and of little practical ethical import if it had no effect on the actual behavior of those in the finance professions. But the evidence is that the narrow, self-interest-based behavioral assumptions do influence actual behavior. For example, on the basis of his 30 years of experience as a business professor at the University of Minnesota, Norman Bowie (1991) observed that business school students

believe that they will have to be unethical to keep their jobs. They believe that everyone else will put their [own] interests first .... the evidence here is not merely anecdotal ... economics graduate students are more inclined to behave in a self-interested fashion." (p. 9)

Bowie's assertion is supported by an extensive laboratory study that involved business students and nonbusiness students in more than 200 scenarios similar to the Prisoner's Dilemma non-zero-sum game (Frank, Gilovich, and Regan 1993).1 The authors found that the business students defected (i.e., failed to adopt a cooperative strategy) 60 percent of the time whereas the nonbusiness students defected only 30 percent of the time. Also, when compared with students in other disciplines, business students were less honest in hypothetical situations and less likely to donate to charity.

How do people really behave? Are they economic rationalizers, profit maximizers? And what about the payoff to their self-interested behavior? Thaler (1988) found that individuals tend not to adhere closely to the dictates of economic rationality and that those who do, tend to be financially compromised as a result:

The conclusion that subjects' utility functions have arguments other than money is recon- firmed.... We have seen that [zero-sum] game theory is unsatisfactory as a positive model of behavior. It is also lacking as a prescriptive tool. While none of the subjects in [the laboratory] experiments came very close to using the game-theoretic strategies, those who most closely approximated this strategy did not make the most money. (p. 202)

Thaler's findings imply that economic rationality is neither particularly accurate descriptively nor

desirable prescriptively, even from an economic perspective.

Nevertheless, if the people around one are espousing "me first," one is apt to adopt the same philosophy. Bowie observed that "people change their behavior when confronted with assumptions about how other people behave" (p. 9). He concluded:

Looking out for oneself is a natural, powerful motive that needs little, if any, social reinforce- ment.... Altruistic motives, even if they too are natural, are not as powerful: they need to be socially reinforced and nurtured. (p. 19)

Such nurturing is clearly not to be found from those who buy into the rationality assumptions of neoclassical economics.

In a similar vein, Gregory Dees (1992) argued that the value systems of business theory influence those of business practice. He observed that "how concepts are introduced in an academic setting can have a significant influence on their use later on" (p. 38).

Finally, commenting on the value system underlying business theory, Ronald Duska (1992) noted that "as it gets accepted as a legitimating reason for certain behavior in our form of life, it becomes subtly self-fulfilling" (p. 149).

Economic rationality has limitations. It is concerned purely with instrumental rationality and says nothing about the substantive issue of which goal or goals the rational preference ordering will serve. But because finance professionals and students are not generally exposed to broader discus- sions of rationality, narrow economic rationality has been stretched beyond its appropriate (descrip- tive) role into the prescriptive arena of a moral prerogative.

For example, finance theory generally pre- scribes that decisions within a public company be made on the basis of maximizing stock price (or shareholder wealth). Finance theory justifies this stance by observing that stockholders are the resid- ual claimants; they supply the risk capital and so should be compensated accordingly. Thus, stock price maximization is proffered as not only an ethic but the ethic: It is the correct justification for decisions made by individuals within the company.

Identifying the Solution The argument that maximizing shareholder wealth is the company's goal is fine as far as it goes. Cer- tainly individuals in a public company should pursue the interests of the stockholders in preference to their own material interests when the two conflict. What is generally not made clear is that in many actual decision situations, the effect of an action on

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the stockholders is difficult to determine. For example, an action may benefit short-term stockholders but be at the expense of long-term stockholders, or it may increase expected stock price while simulta- neously increasing stock price volatility.

Many factors affect a company's stock price: As a decision criterion, stock price maximization is the ultimate gray area. Individuals in organizations are faced with an array of decisions with uncertain economic impacts. Finance theory would address this uncertainty quantitatively: Probabilities of the outcomes on the stock price would be assigned to each outcome, sensitivity and scenario analysis would be carried out. Nothing is wrong with these approaches. But given the uncertainty of outcomes, might not other decision criteria also be useful- criteria that are not heavily dependent on quantita- tive estimates and that are sensitive to other con- siderations?

Professional codes of conduct, such as those supplied by AIMR and the CFP Board, provide just such criteria. They articulate sound guidelines for behavior that, far from conflicting with the organization's financial goals, should guide individuals operating in complex and uncertain environments toward achieving these goals.

Furthermore, as studies by Thaler, Axelrod (1984), Frank (1988), and others have shown, concepts embraced by ethics codes-such as honesty, integrity, and trustworthiness-are as economi- cally rational as the wealth-maximizing ideals of financial economics. The ethical concepts merely rest on the broader notions of rationality laid out in moral philosophy. These broad notions fully recognize economic goals, but they also recognize that the achievement of individual self-interest requires a primary respect for such principles as honesty, integrity, and trustworthiness-in short, the principles traditionally associated with professional conduct.

Indeed, as any cursory scan of the financial press reveals, the economic cost of ethical transgres- sions can be substantial. John Swanda noted that "[t]he value of the firm's moral character ... can result in a market value of the firm that is greater than the firm's net assets" (1990, p. 752). He conjec- tured that "[e]ven in the short run one can argue that the firm with an excellent ethical reputation can have a special economic advantage" (p. 753). Swanda characterized an ethical reputation as both an asset and a source of income, as a stock and a flow:

While morality as a resource cannot be considered in the same context as tangible assets or goods, it can be considered, however, as a highly valuable but volatile asset, one which reflects the perception of the community. ... In this sense, it will use outflows of resources to estab-

lish stocks of morality in order to encourage various publics to hold the firm in trust. (p. 757)

Finance professionals and initiates need to be made aware of the financial value attached to "stocks of morality." It is not a case of ethics versus profits, but a case of ethics leading to profits. For example, Richard De George (1993) noted:

Competing with integrity does not imply either a reluctance to compete or an inability to compete aggressively.... In fact, it demands pre- cisely the institutional discipline that often gives a competitive edge. Competing success- fully with integrity is in fact the aim and the norm of individuals who compete with integrity. (p. 7)

Thus, attributes such as integrity or honesty need not conflict with the individual's or the organization's pursuit of material self-interest; in fact, quite the opposite. Robert Solomon stated that

ethics is not a burden or a business disadvan- tage but the very ground rules of business as such and the key to business success. (1994, p. xv)

For honesty and integrity to become truly instilled in an organization, however, such values must be recognized as possessing intrinsic and primary worth. The most fundamental and crucial point is that ethics must come first. As Robert Frank pointed out,

[Slatisfaction from doing the right thing must not be premised on the fact that material gains may follow; rather it must be intrinsic to the act itself. (1988, p. 254)

This point is important because if honesty and integrity are seen merely as efficacious means to an economic end, they will be jettisoned as soon as the economic calculus dictates; they will be merely pseudo honesty and pseudo integrity.

Therefore, acculturation into a broader notion of rationality is crucial. Finance professionals need to be made aware that to be honest is eminently rational because being honest is generally the best foundation for behavior. Honesty, fair dealing, integrity-upon these premises are successful careers in finance built.

The solution for making codes of ethics work- able, therefore, lies in reconciling the inconsistency between, on the one hand, the behavioral preroga- tives implied by economic rationality and, on the other hand, the explicit behavioral guidelines of professional codes of ethics. The crucial lesson is that the type of behavior espoused by professional codes of ethics is fully rational and completely consistent with the agent achieving his or her long- term self-interest: Self-interest, when correctly





defined, is best achieved by adherence to the ethical guidelines. Furthermore, organizations populated by individuals who respect and adhere to ethically sound guidelines will excel in long-term financial performance.

To return substance to the notion of "professionalism" in the financial services industry requires, first and foremost, a commitment to the principles laid down in codes of conduct, such as those supplied by AIMR and the CFP Board. As in the medical or legal professions, the integrity of the investment profession is nurtured and sustained by a concern primarily not for the self or the shareholder but for the investor who has placed her or his trust in the professional's expertise, integrity,

and honesty-in short, trust in the individual's professionalism. Aristotle observed:

The life of money-making is one undertaken under compulsion, and wealth is evidently not the good we are seeking: for it is merely useful and for the sake of something else. (Nichoma- chean Ethics)

That something else is the intrinsic reward to be obtained from a life of professional service. This is the notion of rationality that requires dissemination and discussion within business schools and at all levels of financial organizations. It is a notion of rationality entirely consistent with professional codes of conduct, as well as being entirely consistent with long-term financial success.

Note 1. For a full description of the classic Prisoner's Dilemma

game, see "Introduction" (1995) or Milinski and Wedekind (1998).

References AIMR. 1999. Standards of Practice Handbook. 8th ed. Charlottesville, VA: AIMR: www.aimr.org/standards/ethics.

Axelrod, Robert. 1984. The Evolution of Cooperation. New York: Basic Books.

Boatright, John. 1999. Ethics in Finance. New York: Blackwell.

Bowie, Norman E. 1991. "Challenging the Egoistic Paradigm." Business Ethics Quarterly, vol. 1, no. 1 (January):1-21.

CFP Board. 2003. Code of Ethics and Professional Responsibility (Code of Ethics): www.cfp.net/certificants/conduct.asp.

Copeland, Thomas, and Fred Weston. 1988. Financial Theory and Corporate Policy. 3rd ed. Reading, MA: Addison-Wesley.

Dees, Gregory J. 1992. "Principals, Agents, and Ethics." In Ethics and Agency Theory. Edited by Norman E. Bowie and R. Edward Freeman. New York: Oxford University Press.

De George, Richard T. 1993. Competing with Integrity in International Business. New York: Oxford University Press.

Duska, Ronald F. 1992. "Why Be a Loyal Agent? A Systematic Ethical Analysis." In Ethics and Agency Theory. Edited by Norman E. Bowie and R. Edward Freeman. New York: Oxford University Press.

Frank, Robert. 1988. Passions within Reason. New York: W.W. Norton.

Frank, R., T. Gilovich, and D. Regan. 1993. "Does Studying Economics Inhibit Co-Operation?" Journal of Economic Perspectives, vol. 7, no. 2 (Spring):159-171.

"Introduction: We Are All Prisoners." 1995. The Prisoner's Dilemma: www.spectacle.org/995/pd.html.

Milinski, Manfred, and Claus Wedekind. 1998. "Working Memory Constrains Human Cooperation in the Prisoner's Dilemma." Proceedings of the National Academy of Sciences, USA, vol. 95 (November):13755-58 (see www.pnas.org/cgi/reprint/ 95/23/13755.pdf).

Moore, Jennifer. 1991. "Autonomy and the Legitimacy of the Liberal Arts." In Business Ethics: The State of the Art. Edited by R. Edward Freeman. New York: Oxford University Press.

Noreen, Eric. 1988. "The Economics of Ethics: A New Perspective on Agency Theory." Accounting Organizations and Society, vol. 13, no. 4:359-369.

Solomon, Robert C. 1994. The New World of Business. Lanham, MD: Rowman and Littlefield.

Swanda, John R., Jr. 1990. "Goodwill, Going Concern, Stocks and Flows: A Prescription for Moral Analysis." Journal of Business Ethics, vol. 9, no. 9 (September):751-760.

Thaler, Richard H. 1988. "Anomalies: The Ultimatum Game." Journal of Economic Perspectives, vol. 2, no. 4 (Fall):195-206.

. 1992. The Winner's Curse: Paradoxes and Anomalies of Economic Life. New York: The Free Press.

Von Neumann, John, and 0. Morgenstern. 1947. Theory of Games and Economic Behavior. 2nd ed. Princeton, NJ: Princeton University Press.

Weber, Max. 1948. The Protestant Work Ethic and the Spirit of Capitalism. New York: Scribner's.

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Why Ethics Codes Don't Work