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Dr. Linda Ferrell
Conflicts of Interest Arising From the Prudent Investor Rule:
Ethical Implications for Over-the-Counter Derivative Securities
By
John M. Clark, Ph.D., CFA
Henry W. Bloch School of Business and Public Administration
University of Missouri - Kansas City
5110 Cherry Street
Kansas City, MO 64110
(816) 235-2325
Fax: (816) 235-6506
clarkjm@umkc.edu
Linda Ferrell
College of Business
Department of Management and Marketing
University of Wyoming
Laramie, WY
(307)766-3723
Fax : ( 307)766-3488
LFerrell@uwyo.edu
O.C. Ferrell*
College of Business
Department of Marketing
Colorado State University
Fort Collins, CO 80523-1278
(970)491-4398
Fax : (970)491-5956
OC.Ferrell@colostate.edu
Accepted to the Journal of Business Ethics-May, 2003
*Contact Author
Conflicts of Interest Arising From the Prudent Investor Rule: Ethical
Implications for Over-the-Counter Derivative Securities
ABSTRACT
The Prudent Investor Rule creates a potential ethical dilemma for
investment advisors selling over-the-counter financial products issued by
their firms. The “opportunity” to defraud investors using complex,
over-the-counter derivative securities designed for client-specific risk
management is much higher than for exchange- traded securities. This paper
emphasizes the ethical responsibility held by trustees and their
organizations to eliminate potential conflict of interests through
internal control and monitoring. Independent evaluations of the
performance of investment advisors and independent appraisals of complex
over-the-counter securities are important in reducing the risks of
conflicts of interest. Recent lessons learned from the corporate ethics
crisis and requirements of the 2002 Sarbanes Oxley Act would suggest that
conflict of interest must be eliminated with third party validation of
derivative pricing. By performing due diligence and validation, the
trustee is able to satisfy the requirements under the Prudent Investor
Rule.
Conflicts of Interest Arising From the Prudent Investor Rule: Ethical
Implications for Over-the-Counter Derivative Securities
Introduction
The pricing of complex financial products, such as derivative securities
or options is an example of an area that requires ethical standards and
the avoidance of conflict of interest. The capacity of the
legal-regulatory environment to control deceptive schemes that provide
false information in the securities markets is challenged by the numerous
opportunities available for such fraud. Companies that adopt a strategic
approach to ethical issues develop proactive organizational values and
compliance programs that identify areas of risk and include formal
communication and standards, training, and continuous improvement to avoid
fraud as well as other areas of misconduct (Murphy, 2002).
There is a need for ethical standards and corporate cultures that
communicate ethical values based on the number of scandals that have
developed in the securities industry. Best practices in corporate
governance and recent reform legislation holds the board of directors
responsible for oversight of a code of ethics for the CEO and top
financial officers. Managers have an obligation to educate shareholders
how ethical decisions affect stakeholders, especially clients (Spurgin,
2002). Ethical evaluations of leadership requires standards of assessment
that are independent of the leaders control (McCall, 2002).
More recently some of the most respected securities firms have been fined
for not maintaining ethical regulatory compliance (Smith and Drucker,
2002). Merrill Lynch agreed to pay $80 million in connection with charges
of aiding and abetting securities fraud (Wall Street Journal, March 17,
2003). Securities companies have been accused of failing to put the proper
ratings on securities due to relationships that investment banks have with
companies they rate. One analyst allegedly upgraded AT&T stock after his
children were admitted to a private school (Gasparino, 2002). The public
has lost confidence in business with recent polls showing 77% surveyed
feel that business scandals are a crisis or major problem (Walczak,
Walczak and Dwyer, 2002).
These examples provide evidence that problems exist in implementing
ethical and legal standards in the securities industry. Even with no
intent to deceive or engage in conflict of interest, unqualified or
trained financial advisors can make a mistake that could be very damaging
to clients. While mistakes are a concern, a conflict of interest exists
when an individual must choose whether to advance his or her own
interests, those of the organization, or those of some other group. To
avoid conflicts of interest, employees must be able to separate their
private interests from their business dealings. Organizations, too must
avoid potential conflicts of interest in providing goods or services.
Unethical conflicts of interest are of particular concern when they stifle
fair competition and take advantage of an unknowing participant in a
transaction (Ferrell, Fraedrich and Ferrell, 2002). Fraud is purposeful,
unlawful acts to deceive, manipulate, or provide false statements in order
to damage others. In general, fraud is viewed as false communication that
conceals or contains a scheme to create a materially false statement or
representation (U.S. Code: Title 18, Section 1001). According to the
Securities and Exchange Commission, an individual who does not disseminate
the misrepresentation, but aids and facilitates fraud, is also a violator
of antifraud provisions. Fraud can be used to take advantage of being in a
position of trust, such as a financial advisor.
Recent scandals in the derivative securities markets have led to a general
skepticism regarding the ethical standards upheld by the securities
industry (MacKenzie and Richard, 2002). In the absence of specific
regulations designed to enforce high ethical standards, market
participants have turned to internal control mechanisms and related
government regulations to encourage the desired behavior. These attempts
to create checks and balances, as well as third party opinions can
increase costs but decrease conflicts of interest. Unregulated financial
instruments played a key role in Enron’s questionable energy trades.
Business executives maintain that derivatives are essential to hedging
strategies (Walczak, Dunham and Dwyer, 2002). Warren Buffet questions the
value of derivative contracts unless that are guaranteed (Buffet, 2003).
On the other hand, the role of financial services is to guarantee the
fluidity of transactions that are essential to economic activity by
ensuring the best possible use of available capital (Bonvin and Dembinski,
2002).
The concept of monitoring and auditing has been a cornerstone of financial
theory for many years; however, it is generally only performed by
sophisticated investors when legally required. As more unsophisticated
investors enter the market, there is a great need for identifying
potential ethical conflicts in pricing securities, particularly more
complex securities such as derivatives. Most errors in pricing derivatives
will be honest, but there are enormous incentives to cheat because
valuation is so complex (Buffet, 2003). By identifying the potential
conflicts in pricing derivatives it is possible to inform investors of the
benefits of independent appraisals. This concept is especially important
for individuals serving as trustee of a fund with multiple beneficiaries.
Here the trustee caries a duty to represent each beneficiary in a
responsible and diligent manner. The liabilities for pricing mistakes or
fraud are considerable.
This paper analyzes the potential ethical issues that could exist for
investment advisors that are selling over-the-counter derivative
securities. Under the Prudent Investor Rule trustees are allowed to
delegate some or all of the investment decision making authority to a
professional investment advisor, however these trustees maintain the duty
to monitor the performance of the investment advisors. The objective is to
identify ethical issues related to potential conflict of interest. The
discussion begins with a brief overview of ethical issues in derivative
pricing and a review of the Prudent Investor Rule and then continues to
identify specific issues related to the responsibilities of delegation.
The next section elaborates on potential conflicts of interest faced by
some investment advisors in recommending over-the-counter derivative
products underwritten by their firms. Implications for investment advisors
are provided from current regulatory reform such as the Sarbannes Oxley
Act. The paper concludes by emphasizing the importance of independent
evaluations in monitoring an investment advisors performance.
Ethical Issues in Derivatives Pricing
Derivatives are financial instruments whose value is based on underlying
commodities or financial instruments such as interest rates, stock or bond
prices or precious metals. This financial instrument speculates on some
future price or event. Over-the-counter derivatives (or options) are
custom designed to meet an individual clients needs. The client arranges
the tailored instrument from a bank or broker rather than obtaining an
instrument that is traded on an exchange market. These options cannot be
traded but they can be sold back to the bank or creator. They are used
mainly for hedging vehicle. Sometimes derivatives are due to be settled
many years in the future and depend on the creditworthiness of the
counterparties that will reap profits or losses (Buffet, 2003).
Because of the complex nature of these securities, the “opportunity” to
defraud potential investors is much higher than for exchange traded
products that have an established public market and greater regulation as
well as transparency. As a result a trustee faced with an investment
opportunity underwritten by the investment advisor’s firm has a duty to
seek an independent valuation of the proposed product. The potential for
conflict of interest is always present when there is a lack of outside
verification. Independent valuation has been commonplace for institutional
investors since derivatives first began trading over-the-counter because
the institutions recognize the existence of this potential ethical
dilemma. The ensuing analysis identifies the need for trustees using
professional investment advisors to seek independent evaluations of the
advisors overall performance and security selection.
The potential for unethical behavior by investment advisors is enhanced by
the features of the Prudent Investor Rule. By allowing delegation of the
investment management responsibilities, the Prudent Investor Rule provides
a mechanism that no longer forces the trustee to be a trained investment
professional. At the same time, by taking a more aggressive approach to
portfolio management, the trustee is allowed to utilize a wider variety of
complex financial instruments to meet the objectives of the trust. Thus,
the new environment allows less sophisticated participants to act as
trustees, where they have the opportunity to purchase more sophisticated
securities. A survey of financial accountants indicated that the majority
reported some pressure to achieve short-term performance targets (D’Aquila,
2001). Clearly, this creates an opportunity and pressure for unethical
behavior to occur. This behavior can be minimized by implementing a system
of independent price/valuation verification. There remains a need for such
trustees to be informed of their duty to eliminate the “temptation” for
unethical behavior.
The Prudent Investor Rule
The Prudent Investor Rule was developed by the American Law Institute in
1991 in its RESTATEMENT (THIRD) OF TRUSTS to replace the Prudent Man
standard, which has been deemed overly restrictive for trust managers.
Under the Prudent Man standard a trustee was forced into a portfolio
objective of capital preservation and held responsible for any losses that
might occur. Advisors worried about liability issues which led to
suboptimal investing. With an emphasis on capital preservation, many
trusts were unable to keep pace with inflation and thus saw the purchasing
power of the underlying capital decline. It also created an ethical
dilemma for the trustees of trusts that were designed to provide income
for a life beneficiary as well as provide the remaining capital to the
remaindermen of the trust. In this case, the “income” beneficiary may have
a preference for more income, while remaindermen or “principal”
beneficiaries may have a preference for more capital gains. Clearly, it
was impossible to maximize the wealth of both sets of beneficiaries, which
created an ethical conflict for the trustee.
This conflict is resolved under the Uniform Prudent Investor Act of 1994,
which has been adopted in some form by more than 40 states. The premises
that led to the development of this act were derived from modern portfolio
theory and the documented benefits of diversification. This act requires a
trustee to invest and manage the funds of the trust as a prudent investor
would, given the income, liquidity and time horizon constraints defined in
the trust. This standard is applied to the portfolio as a whole as part of
an overall investment strategy, which should incorporate risk and return
objectives that are appropriate for the trust. One improvement provided by
this standard is that the trustee is given the duty to diversify the
investments of the trust unless it is not deemed prudent to do so. This
situation could potentially arise with a taxable portfolio that contains a
sizable position in one security with an exceptionally low cost basis. In
some cases, it may not be prudent to diversify such a portfolio, since it
would result in an immediate capital gains tax consequence that could
reduce the portfolio value by 20% or more. Mittleman (2000) defines ten
guidelines for trustees that are provided by the Prudent Investor Rule.
These guidelines include:
1. Diversification is fundamental to management of risk
2. Trustees have a duty to diversify
3. Risky or speculative investments are not prohibited from a portfolio,
per se.
4. Losses are not prohibited in a diversified portfolio.
5. Diversification minimizes overall risk to a portfolio and permits a
portfolio to assume greater risk in individual investments and for the
portfolio as a whole, rather than a portfolio without diversification.
6. A diversified portfolio with greater risk in its individual investments
can have less overall risk than an undiversified portfolio with lower risk
individual investments.
7. The “old rule” of the RESTATEMENT (SECOND) OF TRUSTS that forbade any
form of speculation inhibits truly effective trust management.
8. Overall return of the portfolio is more important than never having a
loss.
9. Income tax consequences can be a valid consideration in determining an
investment strategy.
10. There is no one single investment strategy that should apply to all
portfolios.
Thus the Prudent Investor Rule allows fiduciaries to take more risk and
work towards maximizing the total return of the portfolio. By extending
the focus to the entire portfolio, the standard of prudence is applied to
any investment relative to its additional risk to the portfolio, rather
than as an individual investment. Thus the tradeoff between risk and
return of the portfolio becomes the main consideration of the fiduciary.
It is also important that the Prudent Investor Rule eliminates category
restrictions on the types of securities that can be included in the
portfolio. This distinction makes a number of previously excluded
securities, such as derivatives, eligible for the portfolio assuming there
is a compelling risk reducing argument for including them in the
portfolio. As the complexity of eligible securities rises the need for
professional advice will clearly increase. To answer this problem the
Prudent Investor Rule provides for the delegation of investment management
duties.
The key improvement over the Prudent Man standard is that the performance
of the trustee can now be evaluated based on the quality of the investment
plan rather than on the performance of individual securities. A trustee is
not liable for poor performance as long as reasonable care, skill, and
caution has been exercised in establishing the trust portfolio. Instead
the trustee is evaluated by the extent the investment strategy
incorporates risk and return objectives appropriate for the trust.
Delegating Responsibility Under the Prudent Investor Rule
One of the advantages of the Prudent Investor Rule framework is that it
encourages fiduciaries to delegate investment responsibilities to
investment professionals. However, it does not free the fiduciary from the
duty of monitoring the delegated authority. Thompson (1996) outlines the
safe harbor provisions for transferring liability to a “prudent expert”.
However, Goodwin and McDowell (1999) point out that the trustee is still
required to exercise “core control” after the decision to delegate is made
and the investment advisor has been chosen. Thus the trustee is
responsible and possibly liable for identifying which responsibilities to
delegate to each agent, negotiating the terms of the delegating agreement,
and monitoring the performance of the delegated party.
The Prudent Investor Act also requires fiduciaries honor their duty to
control costs. As a result, the fee structure negotiated for each delegate
should be carefully scrutinized. Goodwin and McDowell (1999) also point
out that a trustee should document the case for delegating investment
authority, so as to justify additional expenses. They also emphasize the
importance of monitoring the performance of the delegated party. These
evaluations should be completed by independent parties with an investment
background. This oversight requirement is also confirmed by Duronio
(1996).
Conflicts of Interest Resulting from the use of Derivatives
If an investment advisor recommends adding derivative securities to the
portfolio managed by a trustee there are potential risks. One potential
risk is that many of the derivative products marketed for portfolio
management purposes are not exchange traded on open markets. These
products are traded over-the-counter by some of the same firms that are
providing the investment advice for the portfolio. There is a potential
conflict of interest similar to accounting firms that have been barred
from providing consulting and auditing for the same client. In addition
the number of firms in this derivative market may not be sufficient to
provide a competitive market with comparisons of costs and value.
Some of the more common derivative products that are traded
over-the-counter are designed to provide risk reduction in the portfolio
or security for loans against the portfolio. These products include
zero-cost collars, long-term put options, various forward rate agreements,
and certain types of proprietary liquidity contracts. The pricing of each
of these products involves a number of assumptions, which can greatly
affect the ultimate price charged to the client. The trustee has a
fiduciary responsibility for verifying the accuracy of these assumptions.
There are increasing concerns about the over use of derivatives by banks.
Banks may at times have inside information about a client and even bet
against their client’s credit through the purchase of default protection
derivatives. Regardless of the purpose or type of derivate, the barrier
for wider investor participation is accurate information and objective
pricing (MacKenzie and Richard, 2002). Over the counter derivatives are
prone to ethical concerns related to objectivity, transparency and third
party verification of terms and prices. The need for quality control and
verification is needed to protect the interest of investors.
Based on scandals and a decrease in investor confidence, securities
regulators are trying to ensure that small investors have access to
independent analysis (Valdmanis, 2002). In addition, the securities
industries appear to have widespread problems with conflict of interest,
favoritism, and a general failure to maintain quality and integrity in
transactions (Knox, 2002). For example, the Securities and Exchange
Commission has fined many companies and analysts for such activities as
disclosing market-moving news to skew stock prices and withholding
meaningful information that influences securities prices from small
investors and the public (Smith and Drucker, 2002).
Regulatory Reform Considerations in Derivative Pricing
It is possible that financial advisers who also price and sell
over-the-counter financial products such as derivatives may not have
considered the ethical principle embedded in the 2002 Sarbanes-Oxley
financial reform act. To deal with many problems in the securities
industry, the Sarbanes-Oxley Act of 2002 created a public accounting
oversight board to improve ethics and quality control standards in most
transactions. The Act includes the directive for public companies to adopt
a Code of Ethics for financial officers, increases the maximum penalty for
mail and wire fraud to 10 years and protects whistle blowers who lawfully
disclose employer information in a judicial proceeding. One of the most
significant requirements of Sarbanes-Oxley is the principle that auditing
and consulting or advising be done by independent parties. This
requirement was designed to avoid conflicts of interest. This reform act
has provisions that could help protect small investors by increasing
transparency and increasing the penalties for failing to provide oversight
to insure financial integrity. Public accounting firms were prohibited
from providing consulting, including appraisal or valuation, fairness
opinions, broker or dealer investment advisor or investment banking
services for the same company they are contracted to audit. Applying this
principle of eliminating conflict of interest opportunities when both
recommending and pricing a financial product, requires an outside
validation of the price. The Prudent Investor rule provides flexibility in
investment decisions but increases the ethical responsibilities to provide
objectivity fairness and transparency in investment decisions. There are
many examples of investment advisors engaging in conflict of interests for
their own self interest.
When an investment advisor is employed by the issuing firm, it is
important for the trustee to recognize that a potential conflict of
interest exists for the investment advisor. As a result the trustee has a
fiduciary duty to recognize when an investment advisor could potentially
be acting as security dealer. Jennings (2000) describes this conflict as
an ethical dilemma, which must be solved by the issuing firm. However, the
trustee has no way of measuring the success of the issuing firm at solving
this dilemma. As a result the existence of such a conflict makes the
trustee responsible for independently verifying any prices that are
provided. Failure to do so could potentially result in huge losses to the
portfolio that would adversely affect the beneficiaries. The liability
associated with this potential conflict of interest has increased with
accounting reform associated with the Sarbanes-Oxley Act.
A failure to verify would be analogous to accepting the original quoted
price from a used car salesperson as the fair market value of the vehicle
without checking any independent pricing service, such as the Kelly Blue
Book or some other similar service. The average consumer in this example
will find some significant discrepancies in the quoted price and the
independently determined fair market value. This discrepancy can be
explained by the existence of a conflict of interest maintained by the
salesperson, which often has the incentive to maximize the selling price.
This same conflict arises with the derivatives dealer. As a result, the
trustee is left with the fiduciary duty to verify the values of any
securities that are purchased where a potential conflict of interest
arises. Clearly, failure to do so could lead to potential litigation
against the trustee for violating the duty to monitor the delegated
investment advisors performance.
Implications and Conclusions
The development of the Prudent Investor Rule eliminates many of the
conflicts faced by trustees, since it allows them to concentrate on the
portfolio’s total return rather than the returns on individual
investments. Because it encourages trustees to hire professional
investment advisors, it allows the person creating the trust to name
trusted individuals as the trustee. This creates an environment where
potential conflict of interest can occur. To resolve these problems it is
imperative that all trustees become aware that delegating investment
decisions to an investment advisor creates a new ethical duty to monitor
the actions of the advisor. The trustee becomes responsible for evaluating
the performance of the advisor as well as for eliminating any potential
conflicts of interest that could result from the investment advisory firm
serving as a dealer for recommended securities.
This analysis of the potential conflicts of interest in implementation of
the Prudent Investor Rule is important because it provides an excellent
example of the role of business ethics in financial advising. While there
may not be a specific legal requirement to have third party validation in
derivative pricing, the legal system through civil law suites or
enforcement of fraud statutes may attempt to determine justice for
misconduct. Without recognition of the potential ethical risks,
individuals could make serious mistakes in carrying out responsibilities
toward their clients. The burden of ethical conduct relates to the
financial industries’ values and traditions, not just on individual’s
personal ethical philosophies. The ability to plan and implement ethical
business standards depends on understanding ethical issues and structuring
resources and activities to achieve integrity in all business decisions.
Leadership is needed to shape an organizational climate that allocates
rewards for making the right decisions (Sims and Brinkman, 2002).
Research is needed to determine the extent to which the over-the-counter
derivatives pricing are adopting third party validations. In addition, the
basic principles of fairness opinions, appraisals and valuations in other
financial and accounting standards should be applied to the pricing of
complex derivative products. This will require the development of an
inventory of standards that can be applied to investment advisors
operating under the Prudent Investor Rule. Finally, codes of ethics should
be developed to guide investment advisors and securities dealers that may
experience conflicts of interest.
The primary implication of this paper is that even though the Prudent
Investor Rule allows trustees the right to delegate all or some of the
investment advising responsibility to a professional investment advisor,
these trustees have a fiduciary duty to confirm that prices of complex
derivative products sold over-the-counter are fairly priced. As a result,
there is a need for independent price verification for these derivative
products. The need for independent performance appraisal of delegated
parties creates an opportunity for third parties including banks, public
accounting firms, certified financial consultants, and these independent
parties need to be aware of their responsibilities through industry codes
of ethics that delineate appropriate relationships, independence, and
standards.
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