Ethical Wall (Chinese Wall) in Finance: Definition, Examples, and Regulations
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What Is an Ethical Wall (Chinese Wall)?
“Chinese wall,” an insensitive term that has been replaced with “ethical wall,” refers to a virtual barrier designed to stop information sharing between departments if it might lead to unethical or illegal activities.
In the U.S., corporations and banks use ethical walls to maintain confidentiality and prevent conflicts of interest. Over the years, large financial institutions have used ethical wall policies as a means to self-regulate their business dealings by creating ethical boundaries between departments. These efforts haven’t always worked, so the Securities and Exchange Commission (SEC) created rules on how financial institutions share information. The SEC enforces fines, penalties, and legal actions for companies that violate these rules.
Key Takeaways
- Ethical walls act as barriers to prevent the sharing of sensitive information, reducing conflicts of interest in financial institutions.
- The term “ethical wall” replaced “Chinese wall” to avoid cultural insensitivity and promote inclusive language.
- The Gramm-Leach-Bliley Act of 1999 increased the need for ethical walls by allowing financial institutions to merge services.
- Ethical walls are crucial in industries like investment banking to safeguard privileged information and prevent insider trading.
- The concept extends to legal professions where temporary barriers can be used to avoid conflicts of interest in representing multiple parties.
How Does an Ethical Wall Work?
The policy of building an ethical wall within a company is common in investment banking. Through their client relationships, investment bankers frequently have access to non-public, material information concerning publicly traded companies or companies that are about to become public through an initial public offering (IPO). Investment bankers create barriers to manage the flow of confidential information within the bank.
The need for an ethical wall in the financial industry became more critical after the enactment of the Gramm-Leach-Bliley Act of 1999 (GLBA). The law removed rules that stopped companies from offering both banking and insurance services. The GLBA reversed restrictions on such combinations that had been in place since the Great Depression. The GLBA helped create financial giants like Citigroup and JPMorgan Chase.
The GLBA faces criticism for its consumer impact and role in financial crises. It weakened consumer protections by allowing financial service consolidation, which limited choice and bargaining power. The GLBA increased risk by concentrating financial activities, making institutions “too big to fail,” and worsening downturns.
Important
Ethical walls gained attention during the dotcom bubble as the GLBA stopped firms from merging to protect customer data.
What Is an Example of an Ethical Wall?
A financial services firm might have a corporate investment arm that is acting on behalf of a public company planning a takeover of a rival company. The talks are highly confidential, not least because of the potential for illegal insider trading on the information. Yet, the same firm has investment advisers in another division who may be actively advising clients to buy or sell stock in the companies involved. An ethical wall is supposed to prevent any knowledge of the takeover talks from reaching the investment advisers.
The need for an ethical wall policy was strengthened in 2002 by the passage of the Sarbanes-Oxley Act (SOX), which mandated that companies have stricter safeguards against insider trading.
The concept of an ethical wall exists in other professions. An ethical wall can be temporary or permanent. For example, if a legal firm is representing both sides in an ongoing legal dispute, a temporary wall may be placed between the two legal teams to prevent actual or perceived collusion or bias.
Why the Term Was Changed to “Ethical Wall”
The original term for an ethical wall comes from the Great Wall of China, built to protect against enemies. It started being used in the U.S. shortly after the stock market crash of 1929, when Congress began debating the need to put regulatory barriers between brokers and investment bankers.
The term has since been widely denounced as culturally insensitive. In 1988, Justice Low, a judge in Peat, Marwick, Mitchell & Co. vs. the Superior Court, wrote extensively about the offensiveness of the phrase and its negative connotation towards Chinese culture and business practices.
For that matter, the judge noted, the metaphor wasn’t even appropriate. The phrase was meant to define a two-way seal to prevent communication between parties, while the actual Great Wall of China was a one-way barrier to keep invaders out. Justice Low offered the term “ethics wall” as an alternative.
How Do You Create an Ethical Wall?
In a business, an ethical wall is established when a person or department is required to withhold and not disclose information from another part of the business. These information barriers are often common across financial institutions and legal professions.
What Is Involved in an Ethical Wall Process?
An ethical wall can be created through the process of notifying upper management of any conflicts of interest and any related or external parties involved in the business. An ethical wall is then put in place to ensure that information remains confidential to the respective person or department, and is not disclosed to other parties. In this way, the other party should not have access to this information when there is a conflict of interest in order to protect the customer and prevent any action that could potentially lead to personal or corporate gain.
What Is the Gramm-Beach-Bliley Act?
The Gramm-Beach-Bliley Act was introduced in 1999 to protect customers from financial firms sharing their sensitive data and information. The act repealed parts of the Glass-Steagall Act of 1933, which had previously prohibited banks from offering investment, commercial banking, and insurance services. The GLBA aimed to modernize the financial industry by allowing these different types of financial institutions to merge and operate under a single holding company.
The Bottom Line
Ethical walls are commonly used to maintain confidentiality and prevent conflicts of interest across various industries, particularly in finance and law. The Sarbanes-Oxley Act and the Gramm-Leach-Bliley Act reinforce the necessity of these information barriers in protecting sensitive information.
Ethical walls were previously referred to as Chinese walls, in reference to the Great Wall of China, but the term has been replaced to address insensitivities and promote inclusivity.
Ethical walls remain crucial in protecting customer data and regulating the sharing of information, particularly in the financial sector. However, the practice of establishing ethical walls is not always foolproof in preventing information leaks and unethical activities, which still occur.
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