Ethics@Work: Protecting investors from themselves

To what extent are regulators obligated to prevent a fool and his money from being soon parted?

By ASHER MEIR
December 30, 2010 22:25
4 minute read.
Asher Meir.

58_asher meir. (photo credit: Courtesy)

 
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The impressive natural-gas finds off Israel’s coast have set off a frenzy of international interest. Early this week, there was more encouraging news as optimistic projections of the field’s potential were reconfirmed by subsequent tests. The finds will likely have an immense impact on the Israeli economic landscape, but in the meantime, they raise a number of interesting ethical questions.

In a recent column I discussed the question of changing the royalties demanded from energy firms. When a sovereign country signs a contract, there can be a conflict between its role as a signatory, for whom reneging on the contract is ethically improper, and its role as sovereign, for whom establishing an equitable taxation policy is an ethical obligation.

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An additional question relates to the conduct of energy companies and their regulation. Any time there is a new and promising investment horizon, it creates an opportunity for copycat firms to attract naive investors by stating, hinting or implying that they provide a way to buy in to the craze.

This occurred in the “tron” craze four decades ago, when firms went out of the way to include those magic letters in the firm name to ride on the coattails of the electronics revolution; it occurred during the “dot.com” craze, when firms tried to give names that indicated they were part of the Internet boom; and it is evidently happening now in the Israeli energy sector.

“We saw new players – and these skeleton entities that had nothing to do with oil, had no experience or know-how – buying and trading leases, making baseless claims,” The Wall Street Journal quoted National Infrastructures Minister Uzi Landau as saying. “We decided we had to stop this crazy atmosphere engulfing the market.”

Officials at the Israel Securities Authority expressed concern about “an ongoing pattern in which small energy companies publish vague or misleading reports that cause their share prices to skyrocket, and often to plummet later,” the Journal reported.

An example would be to buy up worthless leases in areas where no gas is presumed to be hiding and to wave the leases in the faces of star-struck investors.



Is there a basis for regulators intervening in the market in cases like this? Fraud is certainly a basis for action, as is the desire to prevent fraud. But to what extent are regulators obligated to prevent a fool and his money from being soon parted? There are two basic justifications for such action, and the relationship between them is instructive. One is the paternalistic justification. Markets are effective when market participants are rational and fully informed. But when they are swept away by sentiment or confused by the news, then it is time for government to play concerned parent and step in to protect investors from themselves.

This attitude views security regulation as a divergence from the market.

But an equally compelling motivation is the signaling motivation. Whenever there is asymmetric information, firms and individuals like to tell the consumer they are the “real thing”: they have a quality product, reliable books, excellent prospects, etc. The problem is that talk is cheap, and in a free market, low-quality competitors can trumpet their supposed advantages. In this case, the firm would like to be able to prove to the consumer that it has its money where its mouth is, and it would like to make a binding commitment to keep its word.

Reputable firms will be motivated to seek out a hard-nosed regulator who will keep all its clients in line. In our example, reputable firms will prefer to be listed on a stock exchange that makes stringent ethical demands on member companies and to be located in countries that have a reputation for careful oversight.

This point is sometimes lost on naive free-market advocates.

The claim is often heard that there is no need for government agencies such as the Consumer Protection Agency; i.e., if there really is a demand for oversight of consumer products, the market will create one – something along the lines of Underwriters Laboratories in the United States, a private organization that is in some ways parallel to the Standards Institute in Israel.

One answer to this claim is that the market did create one: the Consumer Protection Agency. When firms want to establish a regulatory body, it is in their own interest to establish one with real teeth so that their claims of quality are credible. The government has a “competitive advantage” in regulation due to its sovereign powers.

“Paternalistic” legislation is often justified on free-market grounds. People are often rational about their lack of rationality and prefer to take part in a marketplace they know will help protect them from themselves.

ethics-at-work@besr.org Asher Meir is research director at the Business Ethics Center of Jerusalem, an independent institute in the Jerusalem College of Technology (Machon Lev).

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