THE IMPORTANCE OF ETHICAL CONDUCT IN THE INVESTMENT

INDUSTRY
Why are high ethical standards so important for the investment industry and investment professionals? As
the global financial crisis of 2008 demonstrated, isolated and seemingly unimportant individual decisions, such
as approving loans to individuals unable to provide proof of stable income, in aggregate can precipitate a
market crisis that can lead to economic difficulties and job losses for millions of individuals. In an
interconnected global economy and marketplace, each market participant must strive to understand how his
or her decisions and actions, and the products and services he or she provides, may affect others not just in
the short term but also the long term.

The investment industry serves society by matching those who supply capital, or money, with those who seek
capital to finance, or fund, their activities. For simplicity, let us refer to those who supply capital as investors
and those who seek capital as borrowers. Borrowers may seek capital to achieve long- term goals, such as
building or upgrading factories, schools, bridges, highways, airports, railroads, or other facilities. They may
also seek short- term capital to fund short- term goals and/or support their daily operations. Borrowers
seeking capital to meet short- and long- term objectives include sovereign entities, businesses, schools,
hospitals, companies, and other organizations that serve others. Some borrowers will turn to banks or other
lending institutions to finance their activities; others will turn to the financial markets to access the funds they
need to achieve their goals. In exchange for supplying capital to fund the borrowers’ endeavors, investors
expect that their investments will generate returns that compensate them for the use of their funds and the
risks involved. Before providing capital, diligent and disciplined investors will evaluate the risks and rewards
of providing the capital. Some risks, such as a downturn in the economy or a new competitor, could adversely
affect the returns expected from the investment. To help evaluate the potential risks and rewards of the
investment, investors conduct research, reading and evaluating the borrower’s financial statements,
management’s business plan, research reports, industry reports, and competitive analyses. Responsible
investors will not invest their capital unless they trust that their capital will be used in the way that has been
described and is likely to generate the returns they desire. Investors and society benefit when capital flows to
borrowers that can create the most value from the capital through their products and services.

Capital flows more efficiently between investors and borrowers when financial market participants are
confident that all parties will behave ethically. Ethical behavior builds and fosters trust, which has benefits for
individuals, firms, the financial markets, and society. When people believe that a person or institution is
reliable and acts in accordance with their expectations, they are more willing to take risks involving those
people and institutions. For example, when people trust their financial advisers, institutions, and the financial
markets, they are more likely to invest their money and accept the risk of short- term price fluctuations
because they can reasonably believe that their investments will provide them with long- term benefits.
Entrepreneurs are more likely to accept the risk of expanding their businesses, and hiring additional
employees, if they believe they will be able to attract investors with the funds needed to expand at a
reasonable cost. The higher the level of trust in the financial system, the more people are willing to participate
in the financial markets. Broad participation in the financial markets enables the flow of capital to fund the
growth in goods, services, and infrastructure that benefits society with new and often better hospitals,
bridges, products, services, and jobs. Broad participation in the financial markets also means that the need
and demand for investment professionals increase, resulting in more job opportunities for those seeking to
use their specialized skills and knowledge of the financial markets in service to others.

Ethics always matter, but ethics are of particular importance in the investment industry because the
investment industry and financial markets are built on trust. Trust is important to all business, yet it is
especially important in the investment industry for several reasons, including the nature of the client
relationship, differences in knowledge and access to information, and the nature of investment products and
services.

In the client relationship, investors entrust their assets to financial firms for care and safekeeping. By doing
so, clients charge the firm and its employees with a special responsibility; they are putting their faith and trust
in the firm and its employees to protect their assets. If the firm and its employees fail to protect clients’ assets,
it could have severe consequences for those clients. Without trust in that protection, the firm and its
employees would not have any business.

Those who work in the investment industry, as well as those who work in other professions, have specialized
knowledge and sometimes better access to information. Having specialized knowledge and better access to
information is an advantage in any relationship, giving one party more power than the other. Investors trust
that the professionals they hire will not use their knowledge to take advantage of them. They rely on the
investment professional to use his or her specialized knowledge to serve or benefit their clients’ interests.

Another reason why trust is so important in the investment industry has to do with the nature of its products
and services. In other industries—such as the transportation industry, the technology industry, the retail
industry, or the food industry—companies produce products and/or provide services that are tangible and/or
clearly visible. We can hold an electronic tablet in our hands and inspect it. We can use software programs,
shop at retailers, dine at restaurant chains, and watch films. We can judge the quality of the product or service
based on a variety of factors: How well does it perform its intended function? How efficient is it? How durable
is it? How appealing is it? Is the price reasonable or appropriate for the product or service?

In the investment industry, many investments are intangible and appear only as numbers on a page or a
screen. Investors cannot hold, inspect, or test their intended purchases as they can a smartphone or a
television set, each of which often come with warranties should they fail to function as advertised. Without
tangible products to inspect, and with no warranties for protection should the product or service fail to
perform as expected, investors must rely on the information provided about the investment—both before
and after purchase. When they call their financial adviser and ask to see their investments, they receive either
an electronic or printed statement with a list of holdings. They trust that the information is accurate and
complete—a fair representation—just as they trust that the investment professionals with whom they are
dealing will protect their interests. The globalization of finance also means that investment professionals are
likely to have business opportunities in new or unfamiliar places. Without trust, financial transactions,
including global transactions, are less likely to occur.

Because of these factors, trust is the very foundation of the financial markets. This trust is built, fostered, and
maintained by the ethical actions of all the individuals who work and/or participate in the markets, including
those who work for companies, banks, investment firms, sovereign entities, rating agencies, accounting firms,
financial advisers and planners, and institutional and retail investors. When market participants act ethically,
investors and others can trust that the numbers on the screen or the page are accurate representations and
be confident that investing and participating in the financial markets is worthwhile.

Ethical behavior by all market participants can lead to broader participation in the markets, protection of
clients’ interests, and more opportunities for investment professionals and their firms. Ethical behavior by
firms can lead to higher levels of success and profitability for the firms as well as their employees. Clients are
attracted to firms with trustworthy reputations, leading to more business, higher revenues, and more profits.
Ethical firms may also enjoy lower relative costs than unethical firms because regulators are less likely to have
cause to initiate costly investigations or impose significant fines on firms in which high ethical standards are
the norm.
Conversely, unethical behavior erodes and can even destroy trust. When clients and investors suspect that
they are not receiving accurate information or that the market is not a level playing field, they lose trust.
Investors with low trust are less willing to accept risks. They may demand a higher return for the use of their
capital, choose to invest elsewhere, or choose not to invest at all. Any of these actions would increase costs
for borrowers seeking capital to finance their activities. Without access to capital, borrowers may not be able
to meet their goals of building new factories, bridges, or hospitals. Decreases in investments can harm society
by reducing jobs, growth, and innovation. Unethical behavior ultimately harms not only clients, but also the
firm, its employees, and others. Diminished trust in financial markets can reduce growth in the investment
industry and tarnish the reputation of firms and individuals in the industry, even if they did not participate in
the unethical behavior. Unethical behavior interferes with the ability of markets to channel capital to the
borrowers that can create the most value from the capital, contributing to economic growth. Both markets
and society suffer when unethical behavior destroys trust in financial markets. For you personally, unethical
behavior can cost you your job, reputation, and professional stature and can lead to monetary penalties and
possibly time in jail.

ETHICAL VS. LEGAL STANDARDS

Many times, stakeholders have common ethical expectations. Other times, different stakeholders will have
different perceptions and perspectives and use different criteria to decide whether something is beneficial
and/or ethical.

Laws and regulations often codify ethical actions that lead to better outcomes for society or specific groups
of stakeholders. For example, some laws and regulations require businesses and their representatives to tell
the truth. They require specific considered an ethical action; it creates a more satisfactory outcome that
conforms to stakeholders’ ethical expectations. As an example, consider disclosure requirements mandated
by securities regulators regarding the risks of investing. Complying with such rules creates better outcomes
for you, your clients, and your employer. First, compliance with the rule reduces the risk that clients will invest
in securities without understanding the risks involved, which, in turn, reduces the risk that clients will file
complaints and/or take legal action if their investments decline in value. Complying with the rules also reduces
the risk that regulators will initiate an investigation, file charges, or/and discipline or sanction you and/or your
employer. Any of these actions could jeopardize the reputation and future prospects of you and your
employer. Conduct that reduces these risks (e.g., following disclosure rules) would be considered ethical; it
leads to better outcomes for you, your clients, and your employer and conforms to the ethical expectations
of various stakeholders.

Although laws frequently codify ethical actions, legal and ethical conduct are not always the same. Think about
the diagram in Exhibit 1. Many types of conduct are both legal and ethical, but some conduct may be one and
not the other. Some legal behaviors or activities may be considered unethical, and some behaviors or activities
considered ethical may be deemed illegal in certain jurisdictions. Acts of civil disobedience, such as peaceful
protests, may be in response to laws that individuals consider unethical. The act of civil disobedience may
itself be considered ethical, and yet it violates existing local laws.

The investment industry has examples of conduct that may be legal but considered by some to be unethical.
Some countries, for example, do not have laws prohibiting trading while in possession of material nonpublic
information, but many investment professionals and CFA Institute consider such trading unethical. Another
area in which ethics and laws may conflict is the area of “whistleblowing.” Whistleblowing refers to the
disclosure by an individual of dishonest, corrupt, or illegal activity by an organization or government.
Depending on the circumstances, a whistleblower may violate organizational policies and even local laws with
the disclosure; thus, a whistleblower’s actions may be deemed illegal and yet considered by some to be
ethical.
Some people advocate that increased regulation and monitoring of the behavior of participants in the
investment industry will increase trust in the financial markets. Although this approach may work in some
circumstances, the law is not always the follow market practices; regulators may proactively design laws and
regulations to address existing or anticipated practices that may adversely affect the fairness and efficiency
of markets or reactively design laws and regulations in response to a crisis or an event that resulted in
significant monetary losses and loss of confidence/trust in the financial system. Regulators’ responses typically
take significant time, during which the problematic practice may continue or even grow. Once enacted, a new
law may be vague, conflicting, and/or too narrow in scope. A new law may reduce or even eliminate the
existing activity while simultaneously creating an opportunity for a different, but similarly problematic,
activity. Additionally, laws vary across countries or jurisdictions, allowing questionable practices to move to
places that lack laws relevant to the questionable practice. Laws are also subject to interpretation and
compliance by market participants, who may choose to interpret the law in the most advantageous way
possible or delay compliance until a later date. For these reasons, laws and regulations are insufficient to
ensure the ethical behavior of investment professionals and market participants.

Ethical conduct goes beyond what is legally required and encompasses what different societal groups or
communities, including professional associations, consider to be ethically correct behavior. To act ethically,
individuals need to be able to think through the facts of the situation and make good choices even in the
absence of clear laws or rules. In many cases, there is no simple algorithm or formula that will always lead to
an ethical course of action. Ethics requires judgment—the ability to make considered decisions and reach
sensible conclusions. Good ethical judgment requires actively considering the interests of stakeholders and
trying to benefit multiple stakeholders— clients, family, colleagues, employers, market participants, and so
forth and minimize risks, including reputational risk.