Definition and Examples in Business and Finance

What Is a Chinese Wall?

The offensive term Chinese wall describes a virtual barrier intended to block the exchange of information between departments if it might result in business activities that are ethically or legally questionable. Today, the term is considered problematic given its cultural insensitivities, and “ethical wall” is seen as a more appropriate term to prevent linguistic discrimination.

In the United States, corporations, brokerage firms, investment banks, and retail banks have used ethical walls to describe situations where there is a need to maintain confidentiality in order to prevent conflicts of interest.

Over the years, large financial institutions have used ethical wall policies as a means to self-regulate their business dealings by creating ethical boundaries between departments. However, these efforts have not always been effective. Thus, the Securities and Exchange Commission (SEC) has enacted regulations governing how financial institutions share information. The SEC has implemented fines, penalties, and legal consequences for companies that break these regulations.

Key Takeaways

  • An ethical wall is a business term used to describe a virtual barrier erected to block the exchange of information between departments in a company.
  • The wall is not a physical one, but an virtual one intended to prevent the sharing of information that might lead to ethical or legal violations.
  • In the financial industry, the need for such barriers grew with the enactment of the Gramm-Leach-Bliley Act of 1999 (GLBA), which repealed federal laws banning firms from any combination of banking, investing, and insurance services.

How Does an Ethical Wall Work?

The policy of building an ethical wall within a company is common in investment banking. Through their client relationships, investment bankers frequently have access to non-public, material information concerning publicly traded companies or companies that are about to become public through an initial public offering (IPO). Investment bankers are responsible for developing information barriers that control the flow of confidential information from one department of the bank to another and to other business units within the bank.

The need for an ethical wall in the financial industry became more critical after the enactment of the Gramm-Leach-Bliley Act of 1999 (GLBA). The law repealed federal regulations prohibiting companies from providing any combination of banking, investing, and insurance services. The GLBA reversed restrictions on such combinations that had been in place since the Great Depression. The GLBA also enabled the creation of today’s financial giants such as Citigroup and JPMorgan Chase.

Ethical walls increasingly came into the spotlight during the dotcom bubble, when the Gramm-Leach-Bliley Act of 1999 prevented banks, insurance, and financial firms from merging in order to protect customers’ information.

What Is an Example of an Ethical Wall?

A financial services firm might have a corporate investment arm that is acting on the behalf of a public company planning a takeover of a rival company. The talks are highly confidential, not least because of the potential for illegal insider trading on the information. Yet, the same firm has investment advisers in another division who may be actively advising clients to buy or sell stock in the companies involved. An ethical wall is supposed to prevent any knowledge of the takeover talks from reaching the investment advisers.

The need for an ethical wall policy was strengthened in 2002 by the passage of the Sarbanes-Oxley Act (SOX), which mandated that companies have stricter safeguards against insider trading.

The concept of an ethical wall exists in other professions. The ethical wall may be temporary or permanent. For example, if a legal firm is representing both sides in an ongoing legal dispute, a temporary wall may be placed between the two legal teams to prevent actual or perceived collusion or bias.

Why the Term Is Culturally Insensitive

The original, offensive term for an ethical wall got its name from the Great Wall of China, erected in ancient times to protect China from its enemies. The term entered the language shortly after the stock market crash of 1929 when Congress began debating the need to put regulatory barriers between brokers and investment bankers.

In more recent times, the term has been denounced as culturally insensitive. In 1988, Justice Low, a judge in Peat, Marwick, Mitchell & Co. vs. the Superior Court, wrote extensively about the offensiveness of the phrase and its negative connotation towards Chinese culture and business practices.

For that matter, the judge noted, the metaphor isn’t even appropriate. The phrase is meant to define a two-way seal to prevent communication between parties, while the actual Great Wall of China is a one-way barrier to keep invaders out. Justice Low offered the term “ethics wall” as an alternative.

How Do You Create an Ethical Wall?

In a business, an ethical wall is established when a person or department is required to withhold and not disclose information from another part of the business. These information barriers are often common across financial institutions and legal professions.

What Is Involved in an Ethical Wall Process?

An ethical wall can be created through the process of notifying upper management of any conflicts of interest and any related or external parties involved in the business. An ethical wall is then put in place to ensure that information remains confidential to the respective person or department, and is not disclosed to other parties. In this way, the other party should not have access to this information when there is a conflict of interest in order to protect the customer and prevent any action that could potentially lead to personal or corporate gain.

What Is the Gramm-Beach-Bliley Act?

The Gramm-Beach-Bliley Act was introduced in 1999 to protect customers from financial firms sharing their sensitive data and information. Through this act, financial firms were required to provide one type of service, instead of combining insurance, banking, and investment services. Along with this, financial institutions are required to disclose to customers their information-sharing practices.

The Bottom Line

Ethical walls are commonly used in business, financial, and legal professions to protect customers’ information from external departments in order to prevent conflicts of interest. In the financial services sector, ethical walls came to the forefront during the height of the dotcom boom, with regulatory changes requiring financial firms to provide only one type of service, instead of combining insurance, banking, and investment management businesses.

While an ethical wall has come a long way from the original, offensive term that was used for the concept, it remains an important part of business ethics to help ensure the privacy of customers’ data while improving disclosure of information-sharing practices, especially in the financial industry.