Conflict of Interest in Investment Banking

Investment banking institutions are engaged in multimillion-dollar transactions. This means that if an investment bank is perceived to be operating in a conflict of interest situation, it could severely damage the reputation of the bank. This lost reputation could end up becoming a financial loss is no time. There have been several instances where conflict of interest situations have quickly escalated into bad press and even litigation!

The leading investment banks of the world are well aware of this threat. This is the reason why they keep on educating their employees about the perils of conflict of interest and how they must be avoided. In this article, we will have a closer look at the conflict of interest in the investment banking industry as well as steps that can be taken to avoid the same.

What is a Conflict of Interest?

A company hires an investment bank to pursue its interests. These interests could be of different types. They could be related to raising capital or scouting for potential merger and acquisition targets. The investment bank is supposed to pursue the interests of their clients. Hence, if an investment bank takes any actions which are in their own interest but not in the interest of their client, then such an action can be called a "conflict of interest." In simple words, if the objectives of the client and the investment bank are not aligned, it could lead to a conflict of interest scenario. It is important to note that it is not necessary for the investment bank to actually act in an unethical manner. Even if the actions of the firm are perceived to be compromised but arent really compromised, it could land up in big trouble.

What Causes Conflicts of Interest?

Conflicts of interest can manifest in multiple ways within the investment banking industry. Here are some of the common ways in which conflicts of interests commonly happen:

Sometimes investment banks may themselves be a party to a transaction. Investment banks control several firms, and it is likely that one of their own firms may be dealing with the client

Investment banks may have a stake in the company whose merger of acquisition they are advising. This stake could be related to debt or equity. Either way, having a stake would skew their priorities, and they would not be able to advise the firm objectively.

An investment banker may be privy to certain information about the firm, which has not come out in the public domain as of now. Once again, this could put them in information wherein they could benefit at the expense of their clients.

An investment bank may have multiple clients who have an interest in a particular transaction. Hence, it would be impossible for the investment bank to objectively manage their interests.

Example of Conflicts of Interest

Conflict of interest has proved to be a major problem for investment banks such as Goldman Sachs as well. For instance, prior to 2008, Goldman Sachs was deeply involved in the issuance of mortgage-based securities. This meant that Goldman Sachs was extensively advising its clients to buy these securities. The advice issued by Goldman Sachs meant that it was bullish on mortgage-backed securities.

However, later information was revealed which showed that Goldman Sachs had placed several large bets against the housing market on its own account. This meant that as far as its own money was concerned, Goldman Sachs was bearish on the future of these securities. It finally meant that Goldman Sachs was deliberately giving wrong advice to its clients in order to profit off the same. This meant that Goldman Sachs was not acting in the best interests of their clients, causing an ethical conundrum for the multinational bank.

In the end, the Securities and Exchange Commission filed Goldman Sachs $1 billion for the deliberate wrongdoing. Conflict of interest poses a serious threat. If the mistakes are repeated too often by the bank, it could be broken up into different entities.

Avoiding Conflict of Interest

It is the duty of the investment bank to disclose any potential conflict of interest they might have. This involved training and educating employees about the importance of identifying conflict of interests as well as reporting them. The legal department of the investment bank must be kept in the loop in order to get the correct advice on a case to case basis. However, as a thumb rule, it is better for investment banks to avoid certain activities. These activities include:

Arranging to finance for a client whom they are also advising in a transaction. The genuineness of the advice may be compromised since the investment bank also stands to gain from the financing

Making investments which go against the advice which the organization is giving to clients

Taking on a client who is a competitor or an adversary to an existing client and advising them against the former.

It is important to know that trust can still be established between the investment bank and the client, even if a conflict of interest exists. However, it is the fiduciary duty of the investment bank to disclose all conflicts and create a transparent environment. Proactively disclosing any conflicts may go a long way in building rapport and winning over the client for the long term.