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The Case of Due Diligence

Thomas Shanks, S.J.

Ethical principles and values are, of course, key to ethical decision making, but how should they be applied to actual business situations? Thomas Shanks, S.J., executive director of the Markkula Center for Applied Ethics, was asked to walk readers through a real-life case for The Monitor, the publication of the Investment Management Consultants Association. Here, he shows how ethics can guide the conduct of a brokerage firm rewarding sales representatives with trips for the sale of a particular fund. This case was presented at a workshop for Dean Witter.

When it comes to ethics, I often recommend that most of us need to develop an "ethics reflex," almost a second-nature ethical instinct that enables us to know the right thing to do well before the loss of business, reputation, or (self)respect that comes from making a moral mistake. We develop this reflex only by focusing on fundamentals. For example, when we bump into a questionable business practice (or when we have to make a decision ourselves), we can analyze it using three basic questions:

1. What are the ethical issues?
2. Who are the stakeholders?
3. What is the ethically appropriate decision-considering the consequences of my action, the rights of individuals involved, and fairness?

Consider this case, based on a true story. Suppose a stock brokerage rewards in-house sales with trips, offering double credits and five-day "due diligence trips" to European and U.S. resort towns for brokers with more than $500,000 in production in a particular fund. The firm currently owns 20 percent of the fund group, and its ownership stake apparently grows with increased sales. Although the firm has a policy against sales contests on mutual funds, and in the past, reps were unable to accept trips from other funds because of a strict interpretation of NASD rules, the firm says these are not sales contests and the trips are "informational and related to due-diligence." Apparently, reps are not being forced to sell the fund. "No pressure to do more or less," says one of the firm's brokers. However, the firm says, "participants do need to qualify (for the trips) by doing business with a particular product and expressing an interest in doing more." The firm considers the trips "advanced training."

Let's consider the questions briefly.

What are the ethical issues?

If the firm's response as reported in the story makes you say, "Give me a break!" it's probably because the justification for the trips isn't consistent with your own moral standards or what many (most?) people in the industry would accept. Ethical issues are not the same as legal or business issues. Let's assume that the firm's actions represent a good business decision and are consistent with the laws and regulations. Are they ethical?

The earliest known texts with ethical content date back some 5000 years to the inhabitants of Mesopotamia and reflect on our earliest attempts to live together and form societies. Over those many years, philosophers have described ethics as focusing on:

1. character...and encouraging individual, corporate, and community virtues (like integrity, trust, and responsibility)
2. relationships...where we treat all people as free and rational human beings capable of making their own decisions, and where we treat everyone fairly (in other words, we distribute benefits and burdens equally to everyone, unless there's some clearly relevant moral reason to treat people differently)
3. consequences...where we attempt to produce the greatest balance of benefits over harms, considering everyone's interests.

What do you think are the ethical issues here?

Who are the stakeholders?

When you consider the ethics of any case, consider all the stakeholders, i.e., any person or group who will be directly and significantly affected by a decision. In this case, let's just consider the key stakeholders as the firm, brokers, and clients. What questions are clients likely to ask about this case? Are they being treated the way they want to be treated? Why would this case pose some serious ethical questions for them?

What is the ethically appropriate decision?

Consider just a few of the main ethical standards. One asks us to consider possible consequences and to be sure that the overall benefits outweigh the harms of a particular course of action. Clients might rightfully ask who benefits the most from involvement with the fund-they, the broker, or the firm? In the best world, all will benefit equally. When might that not be the case?

Another standard says that each individual has a right to be treated as a free and equal human being capable of making his or her own decision. In this case, how would clients react if the broker told them ahead of time that the broker would qualify for "advanced training" from the firm in return for involvement with the fund? How would the clients react if they found out later, without the broker telling them? Most clients would probably feel that they should have had all the information they needed to make their own decision.

The third standard is related to the second: fairness, an equal distribution of benefits and burdens. Clients should feel that this fund was presented to them because it represented the broker's best judgment of a valuable client opportunity, not because it had an edge due to some irrelevant criterion (i.e., the broker's personal gain or the firm's larger ownership stake in the fund.) In other words, clients should feel that they would benefit from purchase of the fund; the fund should not be a burden to them and a benefit for broker and firm.

The broker is clearly in a conflict of interest here. Clients don't generally like to deal with brokers in such a situation. Most brokers will try to avoid even the appearance of a conflict of interest, no matter the reality. Feeling that something else guides the broker's judgment besides the client's best interest is the quickest way to erode trust and business.

This case was written by Thomas Shanks, S.J., Executive Director of the Markkula Center for Applied Ethics.

Feb 1, 2000

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