Financial conglomerates and information barriers.

• Author: Tuch, Andrew F.

1. INTRODUCTION II. FINANCIAL CONGLOMERATES A. Organizational Structure B. Regulatory Challenges 1. Legal Challenge 2. Practical Challenge C. Illustrations III. INFORMATION BARRIERS A. Intended Effect B. Actual Effect C. Assessment IV. THE VOLCKER RULE A. Terms B. Potential Benefits C. Limitations 1. Scope of Application 2. Definitional Ambiguities 3. Reliance on Information Barriers 4. Offsetting Costs D. Assessment V. PROPOSED REGULATORY STRATEGY A. Methodology 1. Underlying Intuition 2. Illustration 3. Limitations on Use B. Design 1. Mandatory Reporting of Quantitative Metrics a. Preferred Model to Generate Quantitative Metrics b. Alternative Models to Generate Metrics 2. Imposition of Liability 3. Scope of Application C. Possible Objections 1. Unreliability of Statistical Evidence 2. Sufficiency of Existing Protections 3. Risk of Gaming 4. Risk of Statistical Dueling VI. CONCLUSION I. INTRODUCTION

   Financial conglomerates--firms such as JP Morgan and Goldman Sachs--adopt an organizational structure that poses fundamental regulatory challenges. The challenges are legal and practical. They arise because, under this structure, financial conglomerates act for numerous clients across a broad and diverse range of financial activities, all the while acting as principals in a similarly broad and diverse range of activities. (1) Legally, the structure subjects firms to multiple, incompatible client duties: complying with one duty leads to violating another, almost inevitably. Practically, the structure provides firms with vast reservoirs of non-public information as well as the opportunities and incentives to exploit that information, potentially harming clients and third parties.

   The primary regulatory response to these challenges is the information barrier. Also known as the Chinese wall or firewall, (2) the information barrier is designed to prevent, or at least to limit, flows of non-public information within financial conglomerates. It comprises intra-firm policies and procedures to physically and electronically isolate people and records with non-public information and thus to prevent or limit the spread of that information to other parts of a firm. (3) The information barrier addresses the legal challenge by allowing a financial conglomerate to be treated conceptually as multiple distinct firms, thus providing a basis for the enterprise as a whole to discharge the otherwise incompatible duties it owes to clients. The information barrier is intended to meet the practical challenge by, in fact, constraining intra-firm information flows, thereby preventing financial conglomerates from exploiting their opportunities to use that information, such as by trading on it. The information barrier thus stands as an essential component of the financial regulatory architecture; indeed, it is probably no exaggeration to say that financial conglomerates owe their continued existence to the information barrier.

   The problem for regulators, clients, and securities markets, however, is that information barriers do not function as intended. While courts and regulators permit information barriers to resolve the legal challenge of incompatible duties, empirical and other evidence indicates that information barriers fail to meet the practical challenge. It has long been suspected, and is now demonstrated, that in important contexts information barriers have failed to prevent the spread of non-public information within financial conglomerates. (4) For example, empirical studies show that information often leaks from the investment banking units of firms to trading units, where it is used for profitable trading. (5) Information barriers are thus accorded legal effect, despite often failing to have practical effect.

   More than this, information barriers are routinely used publicly as a shield by financial conglomerates when they are suspected of exploiting their clients' non-public information. Especially when suspicious trading activity occurs, financial conglomerates stand behind their information barriers, insisting on their integrity in restricting information flows. In the court of public opinion, such claims may or may not be accepted, but they are rarely disproved because information flows seldom leave a trace. (6) In light of these evidential difficulties, firms have powerful incentives to rely on information barriers to defend their conduct.

   Against this backdrop, the core problem for regulators lies in detecting and proving the failure of information barriers. While regulators may inspect the policies and procedures underpinning information barriers' operation, they can do little after an event to determine whether, in fact, barriers operated as intended. A firm's trading when in possession of non-public information may be so fortuitously timed as to attract suspicion, and yet plausible alternative explanations--such as the superior intellect or skill of its traders or mere coincidence--are difficult to discredit. In the absence of direct evidence, the task of detection and proof seems beyond regulators. In consequence, suspicion remains, empirical evidence mounts, and financial conglomerates continue to trumpet the integrity of their information barriers.

   Consider the following example. In early 2007, Verizon hired JP Morgan to advise on its proposed multi-billion dollar acquisition of Rural Cellular Corporation (RCC). (7) Like other financial conglomerates, JP Morgan's investment banking unit advises on such merger and acquisition transactions. The firm also had a trading operation that traded for the firm's own account as well as for firm clients. (8) At the time of its engagement, JP Morgan owned no stock in RCC. (9) However, while its investment bankers were counseling Verizon on the still-secret acquisition, JP Morgan's traders began buying stock in RCC. (10) In July that year, when Verizon publicly announced its intended acquisition of RCC, RCC's price jumped 34%. JP Morgan earned a generous return on the stake in RCC it had by then accumulated. JP Morgan's trading showed uncanny prescience, but was it the result of an information leak from the firm's bankers to its traders--and thus the failure of information barriers--or benign factors, such as coincidence, superior intellect, or trading skill?

   In a front-page story the following year, The Wall Street Journal (the Journal) inquired into the transaction. (11) When questioned by Journal reporters, JP Morgan adopted the routine pose of standing behind its information barriers, claiming that these barriers had prevented information about the deal from leaking to its traders. (12) Naturally, the story had no direct evidence to the contrary, but it did disclose numerous other transactions--by a range of financial conglomerates--involving similar conduct. These firms also made fortuitously timed investments in target companies while their investment bankers were simultaneously advising the acquirers. (13) Other financial conglomerates questioned in the article stood behind their information barriers. (14) The story referred to empirical evidence showing that information barriers systematically failed in these circumstances, but no evidence could pinpoint failures by any particular firm. Regulators claimed to be investigating, (15) but have taken no public action.

   This Article discusses the phenomenon of failing information barriers, explains why it occurs, and proposes a regulatory solution. By examining information barriers, the Article contributes to the long-running debate in legal and financial economic literature on the merits of information barriers in addressing the regulatory challenges of financial conglomeration. (16) To date, legal scholars have questioned the practical effectiveness of information barriers and suggested denying them legal effect, but they have not considered how to detect and prove the failure of information barriers and thereby provide incentives for firms to ensure their effectiveness. (17) Business and economic scholars have focused on establishing the existence of the phenomenon of failing information barriers, but apparently without considering regulatory reforms. (18) This Article contributes to these strands of literature primarily by explaining why information barriers fail and suggesting how regulators can address those failures.

   The Article argues that both market and regulatory factors explain the failure of information barriers. (19) Market factors include the inadequacy of client discipline arising from agency costs within client corporations and the incidence of harm on third parties. The regulatory explanations stem from the difficulty of detecting and proving the ineffectiveness of information barriers, which is largely the result of the nature of information: its flow rarely leaves a trace, especially where those individuals involved collaborate and seek to avoid detection.

   The Article also evaluates the so-called Volcker Rule's potential influence on information barriers' effectiveness. A core plank of the Dodd-Frank Wall Street Reform and Financial Protection Act (Dodd-Frank Act), (20) the Volcker Rule bans certain financial institutions from engaging in proprietary trading. By assessing this issue, the Article extends recent scholarship on the Volcker Rule, which has focused on the rule's implications for the financial stability of financial institutions. (21) Although primarily intended to promote financial stability, the rule's prohibition on proprietary trading will significantly reduce opportunities and incentives for financial conglomerates to use nonpublic client information in violation of information barriers, especially considering that proprietary trading was a key driver of financial conglomerates' revenues. (22) In defending the eponymously named rule, Paul Volcker, a former Chairman of the Federal Reserve, asserted that he is not "so naive as to think that, even with the best efforts of boards and...