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Yesterday’s Sunday New York Times’ business section featured a lengthy article on the proposed takeover of the New York Stock Exchange by an Atlanta based company with the unfortunate three letter acronym of ICE. Here are parts of this story that caught my attention.

ICE, the IntercontinentalExchange, is located in a modest, nondescript office building in Atlanta. There are not enough employees working there to fill the building – at least two other companies have marquees out front. ICE personnel eat their lunch in the same cafeteria with those other companies’ employees. The small personnel footprint is a direct result of the computer based management of the exchanges that ICE already has. This fact has caused anxiety among the traders on the floor of the NYSE who still handle the orders.

While ICE founder and CEO Jeffrey Sprecher maintains that he knows investors will still want a human being on the other end of the phone overseeing the trading, I doubt that he will need as many such people physically present on the pricey NYSE trading floor as opposed to sitting at computers in Atlanta or anywhere else. In short the computer leverage that is already a powerful force in the trading process is likely to increase.

At the same time, Sprecher recognizes that the flash crashes that occasionally occur with individual stocks and less frequently with an entire market, are not a good thing for the long haul. According to the Times’ story, ICE “has been praised as one of the first exchanges to put limits on lightning-quick, high-frequency trading.” Having that mind-set at the helm should be welcomed by investors, and would lend some hope to addressing the ethical issues of high-frequency trading that we have discussed in a prior post.

The Wrapper On 2012

What a year it was. I started this blog and its associated Twitter account, @ethicsbite, in March and since that time have covered and commented on an amazing number of stories. When I scroll down the list of tweets I realize first hand the extent of ethically questionable (and many times illegal) corporate behavior in our country. Ponzi schemes, insider trading, money laundering and (in the UK) phone hacking are among the illegal. Providing financial advice to clients while your own firm profits by the reverse position is unprofessional. Manipulating the rate determination for an international banking benchmark is likely a violation of regulations. I’ll stop there as the full list would no doubt cause my readers to move on. So we’ll switch to sex.

The Petraeus sex scandal seemed to dominate the corporate ethics news at the end of the year. The New York Times story regarding Walmart’s Mexico operations was more significant in scale.  But all of that was eclipsed by juicy, titillating tales from Washington, Tampa and Afghanistan.

2012 Awards

In addition to being amazed at the plethora of unethical activity, I have marveled at the crassness of the people involved. One has to wonder how they would explain their actions to Mom.

In terms of sheer and utter crassness, the 2012 award truly has to go to the News of the World, whose employees allegedly hacked into the cell phone of a young British girl who had disappeared, then proceeded to delete some of the messages on her cell phone so they could capture potential new incoming messages. Her parents detected that something was going on and informed the police. That case led to the demise of one Rebekah Brooks, a Rupert Murdoch “protégé” and the editor of News of the World. Ms. Brooks and her husband’s relationship with David Cameron, the British Prime Minister, tainted 10 Downing Street and created a political situation that could not be ignored. As the investigation continued, Rupert found himself testifying at Parliament and Ms. Brooks was formally charged in May, together with her husband and four others, with conspiring to interfere with the investigation. She allegedly attempted to carry off the evidence in boxes she took out of News of the World’s offices. Moreover it has turned out that phone hacking may have been a relatively common tool at News of the World as close to 200 individuals, many of them celebrities and political figures, have filed suit over the hacking of their personal cell phones. News of the World was shut down by Mr. Murdoch and he subsequently re-organized the News Corp. entity.

A close second place in crassness would be Chesapeake Energy’s founder, Aubrey McClendon. Mr. McClendon showed little bounds in his use of the company’s money and making a name for himself with it. From such relatively small amounts as corporate payment of his personal staff (to be reimbursed at year end without interest on the amounts advanced) to the millions of dollars he authorized be invested in a local NBA team and the construction of a shopping mall that just happened to have eateries owned by Mr. McClendon, the CEO continually used corporate funds to “match” expenditures from his personal wealth to foster his interests. Chesapeake by this time was a publicly held company traded on the NASDAQ and the CEO’s use of money in this manner should have been overseen by the Board. But as is often the case, the Board was beholding to the CEO.  Chesapeake’s stock fell on bad times (from around $34 on 8/1/2011 to around $17 on 12/14/2012), four new independent board members were elected and McClendon was stripped of his Chairman title. But those who paid the cost were the shareholders, of course.

What Will We See In 2013?

Here are our predictions: Rebekah Brooks will go to trial. JPMorgan will further increase its reserve for bad trades by “The Whale.” No one in the investment banking industry will go to jail for anything other than insider trading. Goldman Sachs will continue to be bad. The global economy will continue to improve. Slowly. More dirt will come out regarding Walmart’s non-US operations. Somewhere in the US a bank will go under.

And there will be at least one big sex scandal.

As the French say, “the more things change, the more they stay the same.”

Today’s biggest news on the corporate ethics front was the federal government’s settlement with Bank of America and other large banks related in part to their foreclosure processes.

According the Reuters story:

  • “The [foreclosure] reviews had already cost more than $1.5 billion. They turned up evidence that around 6.5 percent of the loan files contained some error requiring compensation, but most of those errors involved payouts much less than $125,000.”
  • Under the settlement the banks will provide “up to $125,000 to homeowners whose homes were being foreclosed when the paperwork problems emerged.”
  • Bank of America “also announced about $11.6 billion of settlements with … Fannie Mae to end allegations the bank improperly sold mortgages that later soured, and to resolve questions about foreclosure delays.”
  • “The bank is moving closer to the day when it can stop worrying about mortgages and start focusing on growth, analysts and investors said.”

This is great news for BoA and the other banks involved and the investors who lost money on the mortgage backed CDOs and other vehicles. They can get back to growth.

As for the people, often “sub-prime” mortgagees, who went through the traumas of foreclosure – locked out of their homes, their furniture on the street or ruined, their credit destroyed – the most they can get is up to $125,000. And how were they foreclosed on? Illegally. Paperwork not processed properly. Mortgages that had been sold to investors without a legal trail of ownership of the collateral – the home. Unable to pay for lawyers and court fees to protect their rights. Being told to re-finance and then foreclosed on when they followed the bank’s directions. We all remember reading those stories in the paper don’t we? And let us not forget our soldiers in uniform overseas whose homes were foreclosed in spite of clear federal law prohibiting that from happening.

Yes this was a great settlement for some and a life altering event for others.

Friday’s tragedy in Connecticut made any problems I have seem miniscule. I almost typed “by comparison,” but there really is no comparison between the two. None. At the same time, we all seek to draw lessons from what has happened and wrestle with how to make sure this never happens again. One focal point of course is the second amendment, the right to bear arms. That is the law.

Then there is ethics. Ethics is doing what is “right” using whatever yardstick we measure our lives by. The Law allows us to bear arms. That doesn’t mean we have to, nor that we should. We still have a choice to make individually and as a nation.

Just in case we had all forgotten about it, Sex once again reminded us that Greed and Power are not the only players in town. Our corporate ethics related news this year has been so focused on financial Greed (Libor manipulation, Iran money laundering, insider trading) and ego driven Power (London Whale, anything Murdock) that we totally and completely forgot about the oldest corruptor of the human race: Sex.

But here is Sex right back in the news immediately on the heels of election night. The CIA Director, generals, a possible FBI agent, a famous biographer living in the same neighborhood as John Edwards’ former mistress, a Tampa socialite…. it doesn’t get any juicier than this folks. I mean really, this could have been a new episode of the Dallas TV soap. All of that overshadowed the relatively tame announcement from Lockheed Martin  that its named future CEO and then current COO resigned because of a “close personal relationship” with a subordinate.

How could military discipline break down at the the highest levels?  Lest we forget, the military is a vast organization run by executives called generals and subject to the same fundamental forces of organizational and human behavior that face Goldman Sachs, JPMorgan Chase and your own employer.

The forces of individual behavior are more or less clear: the temptation to commit adultery, no matter how dumb an idea it is. As of today, November 13, 2012, there are at least two generals and possibly one FBI investigator whose behavior has or may have strayed over the line due to sex.

The organizational culture forces involved are not nearly as clear, unless you frame the issue in the context of organizational culture in general together with a long history of prejudice against women. The problems women have faced in our 21st century military are well known: harassment on and off post, sexual assaults, rape, reported rapes being ignored or downplayed and few women in the highest levels of authority. An organization that can so easily overlook charges of rape will surely knowingly wink its eye at a mere affair.

Yet at the same time, organizational culture can be a force for good. The CIA hides its internal operations for obvious reasons, but one thing it has always been clear about is this: no member of the agency, regardless of rank, can conduct their personal life in a way that invites blackmail from a foreign entity. That’s why the General submitted his resignation so quickly when he was found out.

It is said that great events can test one’s character. This week’s storm has provided – and will continue to provide – a test of our national ethics. So far we are doing well. Professional ethics at its best has come to the fore in the past few days:

  • The actions of the NYU Langone Medical Center – doctors, nurses, staff and administrators – in reacting to the loss of power was an effort they can always be proud of. Saving the lives of young babies who were dependent upon respirators that no longer functioned; removing their patients down the dark stairwells from many floors up; and maintaining throughout a sense of order and calm was ethical professional behavior at its best.
  • The New York Fire Department, the people who never say “we can’t,” fought a raging fire in Queens at the edge of the incoming ocean in the midst of the storm.
  • The brave helicopter pilots and rescuers from the Coast Guard saved all but two of the crew of the Bounty, plucking them one by one from the massive waves in the Atlantic.

These and untold others are the many heroes we have among us. People who risked their lives to save others.

Now we have another test that will soon be upon us – a test of corporate and political ethics. The one that comes when ordinary citizens file their insurance claims.

We have some good friends who lost their home to Hurricane Katrina years ago. They were lucky enough to be out of town at the time; neighbors who stayed were never seen again. When they were able to return there was nothing left but a handful of personal items and a lot of memories. A total loss.

Many years later they were still fighting the insurance company who had their policy. Read the fine print. Disaster is tricky. Was their home destroyed by flooding? Or was it the wind? Or was it the storm surge? No camera was there to record what happened. No neighbor could serve as an eye witness. You think you have insurance… but you don’t.

Sandy is a huge insurance industry event. Enormous. My bet is that some in the industry will do everything they can to forestall and avoid paying claims. Call me a cynic, but there is a history. We will see. And regardless of who wins on Tuesday, I don’t expect any substantive new legislation that oversees the writing of the fine print to eliminate the question marks and loopholes for future natural disaster victims.

Meantime, kudos go to the airline industry. They have fine print too, but they waived the $150 change fees for people who had to cancel or desired to cancel their travel. The airlines lost money on this one and their financial health is not nearly as strong as the insurers. The airlines lead the way.

Remember Jeff Skilling, the former ENRON CEO now serving time in the federal pen? One of Skilling’s infamous remarks while CEO was this joke: “What’s the difference between the Titanic and California? The Titanic still had the lights on when it went down.” Skilling was referring to the audacious energy trading and hedging activity being conducted by Enron that drove up the spot prices for electricity, forcing California to pay dearly. Later on we found out that Enron traders often engaged in a “game” in which market demand was temporarily created by other Enron traders for the sole purpose of driving the prices up. Enron would then profit from a trade, with California energy buyers on the other end, and release their position. Cute, huh?

This past weekend, Michael Hiltzik had an article in the Los Angeles Times discussing JPMorgan Chase’s activity in the California energy market. Hiltzik’s article was focused predominantly on the legal maneuvers the big bank and its attorneys have been taking in response to a FERC investigation of their trading activity. But along the way, almost as a sidebar to his discussion, he describes the scale of  JPMorgan’s impact in this market:

  • The bank has trading rights related to ten power generation stations in the state
  • After the California Independent System Operator, which manages the wholesale power market for California, closed a regulatory loophole, the bank found another one to exploit, thereby costing ratepayers over $ 5 million in five days
  • The bank does not actually own any power plants

JPMorgan Chase has been allegedly exploiting “loopholes” in the trading regulations and forcing consumers to pay more for their home electric bill so the bank can have more profits — at least ENRON was in the “b’dness” as Texans put it. JPMorgan is a bank. It’s time to get the banks back to banking and out of trading commodities directly for their own profits. When banks and investment banks, acting as traders for their own accounts, increase prices that ordinary people pay for basic necessities such as food, clothing (via cotton), oil and electricity, the foundation of supply and demand based pricing slips away. For the big banks to generate profits by forcing consumers to pay higher prices than market supply and demand would have dictated is unethical.

News of the World Still Making News

Rupert Murdoch may have shut down his phone hacking London tabloid, but that hasn’t stopped it from generating news. This month’s stories include:

  • Parent company News Corp. named a new person to its Board of Directors – Mr. Alvaro Uribe, a former president of Columbia. Appropriately enough Mr. Uribe’s former chief of staff was arrested last year in connection with a case involving illegal wiretapping.
  • A number of prominent individuals have recently filed their own lawsuits seeking damages for the alleged hacking of their own phones. Among the names are Neil Kinnock, former head of Britain’s Labour Party, Stephen Byers, a former cabinet minister, and an assortment of actors and other celebrities.  A total of 53 new claims were submitted earlier this month bringing the total to 174.

News in the World of Banking

  • JPMorgan Chase may have been recently added to the list of banks included in the Iran money laundering investigation.
  • JPMorgan is also facing growing pressure in the US Senate regarding the losses in its risk management operation.
  • Freddie Mac stands to recover several $ Billion-with-a-B from various banks which had entered into mortgage repurchase agreements with Freddie Mac.
  • And then there was/is Lehman Brothers. Remember those guys? Well what’s left of their company has just sued JPMorgan Chase for over $ 2 Billion related to derivatives obligations. Lehman is also fighting JPMChase over the $ 6 Billion the big bank claims they are owed by Lehman.
  • And last but not least in the world of banking, a report just out from Better Markets claims that Americans have lost a total of $12.8 TRILLION since the collapse of Lehman Brothers.
  • In the meantime, asset manager Blackrock was fined $ 15 million by a UK regulatory agency for not following certain rules aimed at protecting investors’ money in the event that Blackrock went under.

Observation: Every piece of harm the banking industry has done ends up being an aggregate multi-billion loss for investors and consumers. Every successful prosecution ends up with a multi-million dollar fine and no one going to jail. What’s wrong with this picture?

Justice in the News

  • Stanford Financial’s former chief investment officer, Laura Pendergest Holt, was sentenced to three years in prison for her involvement in the Houston company’s multi-year ponzi operation.
  • A whistle-blower who testified against UBS was awarded $104 million by a federal court. The case was a significant test of the government’s ability to successfully award individual whistle-blowers. The particular case involved UBS’ alleged attempts to entice US citizens to evade taxes. UBS had settled with the US by paying $780 million to avoid being prosecuted.

Tracking Your Eyeballs on the Internet

An announcement was made last week that Microsoft’s upcoming latest version of Internet Explorer will automatically default to the “do not track” option. Why is that an important ethical step in the online world?

Remember the term “eyeballs” – that quaint concept in the earlier days of the World Wide Web? The key to marketing success was to get as many eyeballs on your page as possible.  But as competition for eyeballs increased, mere “eyeball” count gave way to more sophisticated concepts such as “click through” and “driving traffic.” A whole new consulting opportunity sprang forth called Search Engine Optimization or SEO.

Swiftly and surely the focus then shifted from driving traffic to your site (still highly important) to getting as much information as possible about the site visits obtained. Cookies are being placed on your computer not just from the sites you actually visit but also from their web oriented marketing vendors who want to gather more data on YOU. Targeted marketing based on that information has created whole new companies which present you with specific online “coupons” in an attempt to get you to buy.

The web browsers, principally Internet Explorer, Safari, Firefox and others, provide a way for you to browse the web without such tracking going on, but most of us never use it. As a result our privacy is disregarded on the basis that we have given our permission to be tracked. However, that “permission” is based on a default selection chosen by others together with a lack of training and transparency for all but the more technical among us.

This week’s announcement that Microsoft’s newest version of Internet Explorer, still the most widely used browser, will automatically default to “do not track” and, more importantly, provide a visible alert of that fact to the user, is an important first step in increasing public awareness of the digital privacy issue. Unfortunately it only occurs when the browser is installed; not every time the browser is launched.

HFT is computer trading. In and out of a position in less than 50 milliseconds. Think it doesn’t affect your portfolio? Think again. Even though a trade may last such a very short time, it can impact your portfolio in two ways.

One impact, though rare thus far, can be quite dramatic. It is the software error that produces a “flash crash.” A flash crash occurs when one computer’s programming mistakenly identifies a sudden drop in a stock’s price or in a broader segment of the market. The computer immediately initiates orders to sell stock and, just like a human based panic, this triggers other programs on other computers to sell as well. Individual investors can be caught in this sharp decline before the bounce back either because they are on line at that time and see it occur or because they have stop loss orders set up on some of their investments. Their stock is sold at a greatly reduced price and the next day or 30 minutes later, prices are back up where they had been.

The second impact is in the overall perceived fairness and reliability of the market. Many recent analyses have been written about the large percentage of potential investors who are on the sidelines because they don’t trust the market. Knowing that flash crashes can now occur, knowing that a large percentage (some estimate as much as 60%) of the average day’s trading volume is initiated by computers, knowing their human stock broker and her firm cannot control this phenomena — all combine to discourage investment. When investment is discouraged, prices are depressed. When investors stay out, they miss potential market upswings.

But the debate I want to participate in is whether or not HFT is ethical. This weekend’s New York Times Business section devoted coverage to two stock brokers, Sal Arnuk and Joseph Saluzzi, who have written a book on HFT and are highly critical of this type of trading. The Times’ article mentions a heated exchange between Mr. Saluzzi and another guest on a CNBC program that resulted when he raised the “ethical” question.

Here is why I believe that the practice is ethically flawed: it violates the ethical standards in two layers of my Seven Layers of Integrity® — the community standards of fair play and moral and spiritual values.

Community Standards

The basic premise behind the market is that stock prices are “free market driven.” Perceived value of a share of stock is determined by supply and demand, by investors bidding for a share but limiting their bid to a particular value. HFT damages the free market for publicly traded stocks by manipulating prices to its advantage within a far shorter interval than humans can react:

  • As noted in the Times article, HFT does not just place trades. HFT is capable of gaining price intelligence, and then acting on that intelligence, in literally less time than you can blink your eye.
  • Programs submit trades, learn that the trade is not accepted, then cancel the trade all within a few milliseconds. The trade is re-opened in a smaller block or at a slightly better price.
  • An investor who sees a posted price on the exchange is not able to get that price as the computer on the other end alters its selling price by a penny, tempting the investor to move up.

None of these activities can be replicated by humans due to the rapid time span (hence, “high frequency”) in which the computers can operate. In short, it is like the IBM chess playing computer versus a human non-expert chess player. And the nature of what takes place alters the market pricing in a way that has nothing to do with the “free market” concept.

HFT eliminates a level playing field on the exchanges for all investors. No one is saying that all investors have equal intelligence, but all investors do have the right to expect their trades to be honored. I have personally seen my own limit orders go unexecuted even though the electronic ticker at my online brokerage service shows that the price dropped to below my limit during that timeframe and a buyer existed.

Moral and Spiritual Values

HFT has a tendency to create and increase instability in the market, thereby impacting the portfolios, savings and net assets of private citizens around the globe, not just the few investors in a particular stock on a particular date.

  • No computer program ever written is flawless.
  • As instability from one piece of software arises, it has a strong tendency, as seen in actual examples, to cause other programs on other computers to react negatively.
  • Crashes can occur at the speed of computer interaction.

As I have commented in other posts concerning the financial industry and its failure to acknowledge culpability in events that impact millions of people, there is no spiritual principle I am aware of that justifies risking the life savings and jobs of ordinary people around the world so that a few firms and their partners can have even more money. HFT has sent a few warning shots across the nation’s economic bow. As long as we allow it we are risking a much deeper impact across a much wider swath of the world’s economy.