Governance, ethics and values should be fundamental to the participants and service providers of a capital market. Service providers include Stock Brokers, Investment Advisors, Research Analysts, Rating agencies. A capital market runs on trust, knowledge, values and ethics. Any intent to deviate from these fundamentals could damage the entire system. The cause of the financial crisis is now being related to the lack of knowledge of the market participants and to the lack of ethics and values of the service providers. A common view is that- Year-end bonus was the only determinant behind the complex financial derivatives which was a reflection of weak corporate governance structures and an absence of ethical decision making frame work, sometimes arising from a lack of knowledge.
Capital markets in developing countries provide little incentive for better corporate governance, because the ethical ones will not get enough business. This is primarily due to the dominance of a few large investors, low trading volumes and liquidity, absence of long-term debt instruments and inactivity of institutional shareholders. Such a situation promotes the stock broker to manipulate the market for short term gains.
The analyst, advisor and stock broker roles are played by the same party in Sri Lanka. Though the advisor must act professionally, and place client before self, the stock broker’s commission depends on the amount of trades he promotes. In such a conflicting situation, the stock broker will place himself before the client. Since the investor relies upon the advisor/stock broker to operate within the confines of established corporate ethics and at all times act in the interest of the investor, it leads to an expectation gap.
Everyone talks of the manipulation by investors. How about manipulations and unethical behaviors of brokers- not all but one of them. Examples of stock broker fraud practices include:
> Misrepresentation: when risk factors associated with a particular stock are not fully disclosed.
> Pump & Dump: when a broker in cahoots with one investor pushes prices of undesirable stocks and then dumps on other investors, often resulting in substantial loss to the other.
> Institutionalized Brokerage Fraud: misrepresentation to tout an investment recommendation, when the only reason for the favorable opinion is an undisclosed back-door payment (this is common with local IPO stocks).
> Churning: Stock fraud through churning requires a large number of transactions and consists of selling stocks with small gains in order to show a profit. The broker abuses his customer’s confidence for personal gain by initiating transactions that are excessive in view of the character of the account.
> Unauthorized trades: trade without authorization, to move the market.
> Insider trading: brokerages committing stock fraud by selling IPO stocks before the release date to favored clients and friends.
> Over-pricing: as sponsoring broker over-price IPO stocks and dump them on unsuspecting investors by not disclosing facts.
A governance framework should set out the fiduciary responsibilities of a broker to his customer as follows, and embed it in their people and remuneration structures:
(1) the duty to recommend a stock only after studying it sufficiently to become informed as to its nature, price, and financial prognosis;
(2) the duty to carry out the customer’s orders promptly in a manner best suited to serve the customer’s interests;
(3) the duty to inform the customer of the risks involved in purchasing or selling a particular security;
(4) the duty to refrain from self-dealing or refusing to disclose any personal interest the broker may have in a particular recommended security;
(5) the duty not to misrepresent any material fact to the transaction; and
(6) the duty to transact business only after receiving prior authorization from the customer.