Insider trading is a clear manifestation of conflict of interest

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BY MULEI MUTAVA MICHAEL

Insider trading is just but one way through which conflict of interest manifests, but there sure are other ways, some more subtle than others.

A person with vested interests, such as money, status, reputation or knowledge, which casts doubt on their ability to discharge fiduciary duties is said to have a conflict of interest.

Is this familiar; a board member of a company who insists on powering the organization with solar but actually runs a solar company privately? Or a CEO who insists that all employees flying abroad on official business must sail to the airport through the Nairobi River while he owns a few boats?

Granted, my examples are remote and by the way, it is not always the case that conflict of interest is a bad thing or will result to losses, but it sure needs full disclosure. This reminds me of the case of Jonathan Ciano, the former CEO of Uchumi, who together with his wife were found to be the biggest vegetable suppliers to the former retail giant. Why this detail had to come out in a KPMG forensic audit is beyond me. In an ideal world, he should have disclosed it earlier on.

Well, financial markets transcend internal boardroom wrangles as there are varied actors each looking out for their own interests. In keeping with the current momentum about insider trading, it would seem an opportune time to cast light on some existent relationships between the various economic agents like investment banks, commercial banks, credit rating bureaus, brokers, financial advisors and listed corporations. As has been observed in other jurisdictions, there are potential pitfalls in the manner in which these institutions interact with one another.

Commercial and investment banks differ in that, the former takes deposits and lends money to retail and corporate customers, whereas the latter is typically a financial middleman. The raging debate on whether the two should be mixed is not new, but peaked during the 2008 global crisis. To bring this into perspective, Bank of America suffered reputational damage in 2002, after its investment banking arm; Merrill Lynch was slammed with a $100million (Sh10 billion) fine for issuing choreographed reviews of stocks. Essentially, they would paint overly rosy pictures for clients from whom there was prospective business and gave negative and punitive reviews for those that overlooked their services.  In the wake of 21st century universal banking, most major banks in Kenya have an investment bank subsidiary which then raises questions about the objectivity of their assessments. Given that parent banks have multiple interests in other companies, does that mean that the reviews given for those companies are exaggerated? And what do the subsidiaries say of their own parent companies? Are they used to discredit their competition in subtle ways?

Another real concern is the contagion effect of the two models. Having them co-joined poses a systemic risk to the economy. Typically, investment banking is riskier than commercial banking and should it go down, it would probably go down with the commercial segment. However, underwriting activities are more profitable and lucrative than the commercial ones. Some economists argue that the two can cross subsidize one another. Paradoxically, while this can be construed as a benefit, it also comes out as its weakness in the sense that it acts as a cover up for when rain is beating either business.

In the aftermath of the financial crisis in 2007, research has shown that large diversified banks that focused mainly on commercial banking survived very well, while financial conglomerates built on investment banking, structuring of complex derivatives and proprietary trading suffered crippling losses. Moreover, several economists have argued that large financial conglomerates which engage in a broad range of diverse activities can be socially harmful – the too big to fail debate. As such the mechanics and the social welfare implications of universal banking have become an important issue in contemporary finance.

Closer home, we are aptly reminded of the turmoil Genghis Capital went through upon the closure of Chase Bank, to the extent of seeking a strategic investor to inject liquidity in their operations. According to local media reports, the broker held most of its cash with the bank owing to cross ownership. Assuming this to be the gospel truth, then the broker and bank must have been feeding off each other in a very efficient way, where the bank serving as the principal banker had a ready pool of cash from the broker. The case of Genghis and Chase bank is one of speculative cross ownership, but what about where we know for certain that a commercial bank wholly owns a subsidiary investment bank? It follows naturally that the parent bank is the principal banker. Some analysts will argue that there is nothing wrong with such a model and I concur. If anything, this is an exciting case of a win-win situation except when you consider that in exercise of prudence, the investment bankers might have preferred to consider a syndicate of custodians to avoid a situation where they have to be looking for strategic investors. The influence of the parent commercial bank overrides what may seem to be an obvious precaution on the side of their subsidiary investment banks, and could potentially grind each other to a halt.

Let us revisit the case of Merrill Lynch as discussed earlier in this narrative. A key source of revenue for investment banks is underwriting services during initial public offers. The bank ensures that each stock or unit of security is spoken for during an offer, the result of which is a full subscription, undersubscription or oversubscription. In the event of undersubscription, the bank takes on the securities and discretionally releases them in the market.

Conflict of interest rears its head when the underwriting team and the research team begin making business for one another. They highly recommend shares they have underwritten, even when there is sufficient public information to the contrary. In the past, presence of a Chinese wall has been used as sufficient and admissible defence by courts to rule out any potential conflict of interest. A Chinese wall describes the steps taken by an organization to prevent information exchanges within the same organization, but we know better; sometimes the heftiest deals are sealed in the most unorthodox places and times.

Even when they are not pushing for a subscription, underwriters double up as brokers and still flip flop in recommendations depending on the master they are serving. A case in point is that of Jack Grubman of Salomon brothers who was heavily penalized for issuing research reports that concealed material facts which misled investors. Investment banks and commercial banks are important institutions underpinning the financial eco system of any country. We cannot take away the lustre they add especially when they are efficient.

There is a considerable amount of nascent literature pointing to the fact that investment and commercial banking should be ripped apart. Incidentally, the contrary is true in practice, as more and more banks evolve into conglomerates with a universal approach to banking. Given that we are a growing market, we should be weary of the gloom that often accompanies growth.

Regulatory bodies are useful in arresting these malpractices, but they are wittingly and unsuspiciously executed by the perpetrators. Therefore, it is incumbent on every investor to interrogate the facts presented to them, be abreast with market happenings and stay informed to avoid falling prey. It is important to remember that they earn fees and commissions on client transactions and their role is basically to keep you transacting even when you need a bathroom break.

Having said that, it would be interesting to see the nature of reviews Kestrel Capital made about Kenol Kobil, ahead of their insider trading expose.