Recently, a major brokerage firm in India came out with two different reports on Punj Lloyd Ltd on the same day but with opposite recommendations. In one report, the firm wanted institutional investors to ‘sell’ shares of Punj Lloyd, with a 12-month target price of INR 97 or 29% lower than the then trading price of INR 137 as on 28th May. On the other hand, the second report issued on the same date recommended its private client group to ‘buy’ Punj Lloyd shares with a target price of INR 158. Later the firm stated that its retail and institutional research teams are separated by ‘Chinese walls’ and these groups are distinct and separate. A global investment bank was also in news recently for alleged violations in its Chinese wall policy.
The concept of Chinese wall is very relevant in today’s world of complex financial institutions wearing too many hats at the same time. Chinese walls are widely used by financial conglomerates to manage conflict of interest and to prevent insider trading. Lord Millett has defined Chinese walls as the existence of established organisational arrangements which preclude the passing of information in the possession of one part of the business to other parts of the business.1 Conflicts of interest situations may arise as a result of the different activities/ roles undertaken by a financial institution. For example, if a financial institution extends credit facility to a company while its proprietary trading wing buys and sells securities issued by that company, it will result in a conflict of interest situation. 2 Through a series of posts, I attempt demystify the concept of Chinese walls in financial institutions through an analysis of the origin of the concept, its importance, mechanisms and most importantly the current SEBI rules and regulations in this regard. This post will discuss the origin of the concept of Chinese wall and the major mechanisms used in implementing the Chinese wall.
Origin of the concept of Chinese wall
The use of Chinese wall to guard against the misuse of material, non public information was first endorsed by the Securities and Exchange Commission (SEC) in 1968 in an administrative proceeding involving Merrill Lynch, Pierce, Fenner & Smith, Inc3. Merrill Lynch was the lead underwriter for a potential public offering of debentures by Douglas Aircraft Company and it learned that the company was about to issue a revised estimate of its earnings with substantially lower figures. This information was passed on by the underwriters to the sales department, who in turn told several mutual funds and other large institutional clients. During the three-day period before Douglas publicly disclosed this information, Merrill Lynch and its clients sold the stock to avoid substantial losses. As part of the settlement Merrill Lynch reached with the SEC, the firm adopted a statement of policy that "prohibits disclosure by any member of the underwriting division of material information obtained from a corporation . . . and not disclosed to the investing public." In effect, this statement of policy was the first Chinese wall established in any financial institution in the history of financial institutions. Following this, various brokerage firms voluntarily implemented Chinese wall policy in their institutions. Later various regulators, around the world, felt the need to make Chinese wall policy, a mandatory requirement in every such institution and enacted laws which make it binding for firms to implement it.4
Mechanisms and arrangements under Chinese wall
Basel Committee of Banking Supervision recommended that the policies made by board of directors should ensure that the bank’s business activities that may give rise to conflicts of interest are carried out with a sufficient degree of independence from each other. This independence can be achieved by establishing information barriers between different activities and by providing for separate reporting lines and internal controls.5 Thus the prime objective of Chinese wall policy is to prevent the spill over of confidential information from one department to another. In order to achieve this, the financial institution has to separate departments with access to confidential information from the departments which deal with sale/marketing/investment advise or other departments providing support services. The various steps involved in this process are mentioned below.
Firstly, the institution should identify and designate “Insider Areas” and “Public Areas” in the institution. Insider Areas are those areas/ groups of the institution which routinely have access to confidential information. These areas are also known as “information recipients” as they receive confidential information as a part of conduct of their business. Public Areas are those areas/ groups of the organisation that trade securities or give investment advice or do sale/marketing and they depend on publicly available information for the conduct of their business. These areas are also known as “information processors”. Secondly, the institution should separate the information recipients (Insider Areas) from the others (Public Areas). The institution should also restrict access to confidential information only on a “need to know” basis and thus eliminate access by unauthorized persons.
The UK Law Commission6 defined Chinese wall as the compliance with the following requirements (subsequently approved by Lord Millett in Bolkiah7 and Jacobson J in Australian Securities and Investments Commission v. Citigroup Global Markets Australia Pty Limited8): -
• The physical separation of departments to insulate them from each other;
• An educational programme, normally recurring, to emphasize the importance of not improperly or inadvertently divulging confidential information;
• Strict and carefully defined procedures for dealing with situations where it is thought the wall should be crossed, and the maintaining of proper records where this occurs;
• Monitoring by compliance officers of the effectiveness of the Chinese wall; and
• Disciplinary sanctions where there has been a breach of the wall.
In the next post, I will discuss the requirements of Chinese wall under the SEBI rules and regulations.
1. Prince Jefri Bolkiah v. KPMG(A firm),  UKHL 52;  2 AC 222.
2. Basel Committee of Banking Supervision, Enhancing Corporate Governance for Banking Organizations, Feb. 2006 (new version, first published 1999), Para. 27.
3. In re Merrill Lynch, Pierce, Fenner & Smith, Inc., SEC Rel. No. 34-8459.
4. Section 15(f) and Section 204A of the Investment Advisers Act, 1940 and Section 15D of the Securities Exchange Act of 1934 in USA, Section 1043F of the Corporations Act, 2001 in Australia, Regulation 3B (1) of SEBI (Prohibition of Insider Trading) Regulations, 1992 in India etc.
5. Supra n.2
6. Law Commission, United Kingdom, Fiduciary Duties and Regulatory Rules, Consultation Paper No 124 (1992) at [4.5]. The final report is Report No 236 (1995).
7. Supra n.1
8.  FCA 963