Tag Archives: ethics

CFA Society Minnesota Annual Dinner Recap

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By Claire Underhill, undergraduate Finance major at the Carlson School of Management. Claire is also on the Healthcare team of the Carlson Growth Equity Fund, and has been involved with the program on a volunteer basis for over a year. 

The 2019 CFA Society Minnesota Annual Dinner featured a conversation with author Bethany McLean, moderated by Andrew Rem, CFA (CFA Society of Minnesota Board member), and aided by Past President Josh Howard, CFA. McLean is currently a contributing editor at Vanity Fair, and has also written multiple books such as “The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron.” The evening featured a wonderful discussion as McLean tracked the progression of her career from starting as an analyst at Goldman Sachs, to joining Fortune Magazine as a fact-checker, which ultimately led to her first novel and current role.

Her latest work, “Saudi America: The Truth about Fracking and How It’s Changing the World,” explores the economics around fracking. McLean is skeptical of the drive for energy independence, and makes the case for how fracking might change the geopolitical landscape – though not in the way you might think.

Throughout her career, Mclean has documented multiple instances of business gone wrong and has learned a few things about what she calls “the progression of rationalization.” She talked about the need we have as a society to find who the bad guys were in the wake of crisis, and punish those responsible. Oftentimes, though, the world is not so clear-cut. The line between a visionary and a fraudster can become blurred by the complex human drama and emotions that naturally surround the process of building something innovative. McLean’s key tool in deciphering these dramas? Curiosity. When asked about how she gets people to talk to her, McLean stated that being genuinely interested in what people have to say goes a long way. Through this approach, McLean has developed a unique lens for people who have crossed ethical lines. Good people taking gambles to cover-up for their last mistake. Powerful culture that inflates egos.  

What can be done to fix these problems? McLean said the challenge with regulation is that it is always backward looking and often lacking in imagination. Regulators are always stuck trying to fix yesterday’s problems without the ability to predict what might happen next. Furthermore, even if all accidents are prevented, McLean argues that creativity would also leave the system. This system has failed in front of McLean many times, yet she still views business as a signal of hope. After spending so much time writing about unethical behavior, McLean describes herself as a skeptic, not a cynic, and loves to see the transformative power that business can have in a community.

Facing an Ethical Dilemma?

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The CFA Society has long been an advocate for strong ethics in the Investment Profession. The Code of Ethics and Standard of Professional Conduct are an integral part of the testing process, and underscores the importance to the Society of practicing the craft while adhering to those principles. As stated in the CFA Society’s Mission & Vision Statement:

High ethical principles and professional standards are essential to positive outcomes; rules and regulations, while necessary, are not sufficient by themselves.

We think that the CFA Society’s commitment to strong ethics is part of what sets charterholders apart from other professionals in the Investment Profession. We think this is particularly important in light of highly publicized ethical failures and an increasingly skeptical attitude toward the Investment Profession from the public. We would like to reinforce this message by starting a dialogue on FreezingAssets to help promote ethical decision making. The CFA designation comes with an obligation to do more than determine what is legal. We must go beyond the bare minimum of what is required. We want to understand what is right. And to understand what is right, we need to engage in dialogue. We would like to solicit questions and concerns from members, and then tap into our member base and professional experts to explore the ethical issues involved.

So, here are the ground rules.

1) Questions should be submitted anonymously. We don’t want anyone to worry about experiencing negative career impact from engaging in dialogue. So, no real names, no company names. Just situations.

2) Real situations are better. No trying to trick the panel with things like “If God is all powerful, can he make a planet so big that he himself can’t lift?”

3) Freezing Assets is not providing legal advice. So don’t ask for it.

There is a form on Freezingassets.org for submitting questions, situations, or concerns – access the form here. As with much of what we do, this is an experiment. Maybe everybody already knows everything. But we kind of hope there are a few folks out there who are able to challenge us all to think more deeply about what we do. We think that’s really what the Code and Standards are all about.

When submitting an inquiry, you agree to the following. Neither the Blog nor the Society is giving legal advice. If you think you need to consult a lawyer or compliance professional you should do so. The Society disclaims any liability for any advice or commentary on this website. The Blog respects the privacy of its participants.

On Thin Ice

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[an occasional series skating on the edge of ethics, investing and SRI (Sustainability, Responsibility, Impact)]

Diane Brehmer

The winner of this year’s Moskowitz prize for excellence in quantitative SRI research is Dr. Caroline Flammer, Ivey Business School, for “Does Corporate Social Responsibility Lead to Superior Financial Performance? A Regression Discontinuity Approach”. The approach taken in this study finds a positive causal relationship between CSR and financial performance.

This paper uses a new approach to assess, quantitatively, whether CSR[1] is beneficial to companies. What is novel is the use of a regression discontinuity design that allows the author to draw sharp causal inference on the impact of CSR on financial performance.

Prior studies of the effect of CSR on performance have found, in general, a small positive correlation between CSR and financial performance.[2] A common concern with these studies is that endogenous factors, not reflected in the model or that cannot be measured, can just as easily explain the higher financial performance associated with CSR.

To address these concerns, Dr. Flammer’s study uses a different approach. It examines the impact of shareholder-sponsored CSR proposals that pass or fail by a small margin – “close-call” proposals – on stock prices. This approach addresses the above concerns in two ways:

  • Shareholder-sponsored proposals are developed by external shareowner groups, and hence are independent of company management. Unlike management-sponsored proposals, they cannot be strategically withdrawn by the management if the outcome is expected to be unfavorable to the management.
  • Restricting the analysis to close-call votes eliminates proposals that pass or fail by a wide margin (“wide-margin” proposals). The rationale for eliminating wide-margin proposals is that the outcomes of wide-margin proposals are anticipated and reflected in stock prices before the vote takes place. In contrast, close-call votes have a random element: their outcomes are uncertain. Close-call votes are not reflected in prices in advance and therefore are more useful for estimating the causal effect of CSR on financial performance.

Continue reading →

FUNDAMENTALLY FLAWED: Why We Vote Against All Stock Option Plans

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Disciplined Growth Investors

The theory behind stock options is quite sound. That is, options are a form of de facto stock ownership that should provide managers strong incentive to focus on operating the business in a way that would maximize shareholder value. Unfortunately, in practice stock options suffer from four fundamental flaws that subvert this basic premise:

 

1. option holders have limited financial risk,
2. options holders often profit from sub-par performance,
3. short vesting periods encourage a short-term business focus, and
4. options are blunt incentive/retention tools.

Close examination of the impact of these structural flaws combined with a dearth of corroborative evidence tying option use to long-term value creation have led us to the conclusion that stock options as they are structured today simply do not work. Therefore, we have reluctantly decided to vote against all stock option plans.  Over the balance of this paper, we discuss the aforementioned fundamental flaws and detail how each works to prevent stock options from fulfilling the promise of enhancing long-term value creation.

FUNDAMENTAL FLAW #1:

Option Holders Have Limited Financial Risk

Stock option proponents passionately argue that options place senior executives in the same financial camp as long-term shareholders. After all, both option holders and shareholders benefit from stock price appreciation and are penalized by declines in the price of the stock…right?  Well, not exactly. While it is true that both option holders and shareholders benefit from stock price appreciation, they are not equally at risk to declines in the price of the stock.

Remember that an option confers the right to purchase stock at a fixed price, a.k.a. the exercise price. However, corporate employees and directors do not pay for this valuable right. Additionally, if the stock declines in value, option holders are not required to exercise their options, i.e. purchase stock. They simply let them expire. Since option holders put no personal capital at risk upfront and there is no future obligation to invest, option holders have no financial downside.

In contrast, shareholders assume significant financial risk when they purchase a company’s stock. Because shareholders exchange cash for their ownership position, they can actually lose money if the stock declines. Ultimately, shareholders only benefit if the total return from holding the stock exceeds the rate of return required to compensate them for the potential loss of principal plus the opportunity cost of foregoing other investments.

The difference in financial risk assumed by option holders and shareholders is evidenced by the change in behavior that occurs after options are exercised. In our experience, the vast majority of option exercises are followed by the immediate sale of all the exercised stock. This behavior suggests that option holders recognize the difference in financial risk between options and direct stock ownership and typically act swiftly to eliminate that risk by converting their holdings to cash.

Some option proponents contend that the lack of financial risk for the option holder is irrelevant, because the issuing company incurs no cost. There is no cash outlay and therefore no cost to the business, so the argument goes. We beg to differ. The company (and by proxy the existing shareholders) incur a clear economic cost when an option is issued. Focusing on the lack of cash outlay from the option grant obfuscates the value transfer that occurs. The issuance of an option clearly confers a valuable right to purchase stock at a fixed cost. This right represents a real claim on the future cash flows of the business.

One final counter argument we often hear regarding the absence of financial risk to options holders relates to options as part of an overall compensation package.  These option proponents contend that option holders do indeed have financial risk, because they are accepting option grants in lieu of additional cash compensation. In other words, option holders have essentially put a portion of their cash compensation at risk by agreeing to substitute options. We give little credence to this argument given there is scant evidence of corporate executives in the United States being under-compensated on a cash basis (salary plus cash bonus). Continue reading →

The CFA’s Code of Ethics and Standards of Professional Conduct May Be More Influential than You Think

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Jonathan Levy, J.D.

As you know, CFA members and candidates, must follow the CFA’s Code of Ethics and observe the Standards of Professional Conduct. These rules set a high standard of conduct that sets CFA members apart from other participants in the capital markets. Recent scandals in the financial services industry support the notion that CFA membership reflects a higher calling.

Code of Ethics

Among other things, the Code of Ethics requires that members act with integrity, competence, diligence, and respect,  Members must act ethically to the public, clients, employers, colleagues and other participants in the capital markets.

Standards of Professional Conduct

The Standards of Professional Conduct set specific behavioral requirements on professionalism, integrity, and discharging duties to clients,  employers, and the Institute. Members must comply with laws and regulations, and exercise independence and objectivity. For capital markets, members are of course prohibited from insider trading, tipping and market manipulation. Members must exercise duties of loyalty, fair dealing, and suitability. Members must present performance data accurately and preserve client confidentiality. Members also owe duties of loyalty to employers, and may not accept benefits that might create conflicts of interest. Members must be diligent, independent and thorough in making investment recommendations, and have a reasonable basis for recommendations supported by research. Members owe disclosure duties to clients and must retain records to support investment recommendations. Conflicts of interest must be disclosed fully, fairly, and prominently.  Transactions for clients must take priority over member’s own transactions. Finally, members may not engage in conduct that harms the reputation or integrity of the Institute including avoiding misrepresenting or exaggerating the meaning of membership. Continue reading →