John Peters had just arrived at the Memphis branch offices of Bull Steins (BS) brokerage firm. BS is one of the top 50 firms in the industry with a wide range of financial products. Five years prior, John had graduated from Midwest State University and started work at Marell and Pew Brokerage. While at Marell and Pew, he had learned that in finance, one must follow both the letter and the spirit of the law. BS started courting John after he had worked at Marell for four years because he had a good reputation and an investment portfolio worth approximately $100 million with some 400 investors.

A hard worker, John acquired his clients through various networking avenues, including family, the country club, cocktail parties, and serving on boards of charitable organizations. He called one client group the Sharks. These were investors who took risks, made multiple transactions every month, and looked for short-term, high-yield investments. The second group he called the Cessnas because most of them owned twin-engine planes. This group was primarily employed in the medical field but included a few bankers and lawyers. He called the final group the Turtles because they wanted stability and security. This group would normally trade only a few times a year.

John was highly trained and was not only comfortable discussing numbers with bankers and medical billing with physicians, but he also had the people skills to convey complex financial products and solutions in understandable terms to his Turtles, who were primarily older and semi retired. This was one of the main reasons Al Dryer had wanted to hire him. “You’ve got charisma, John, and you know your way around people and financial products,” Dryer explained.

At Marell and Pew, Skyler had been John’s trainer. Skyler had been in the business for 15 years and had worked for three of the top brokerage firms in the world. Skyler quickly taught John some complicated tricks of the trade. For example, “Your big clients [Sharks and Cessnas] will like IPOs [initial public offerings], but you have to be careful about picking the right ones,” Skyler said. “Before suggesting one, look at who is on their board of directors and cross-reference them with other IPO boards in the last 5 to 7 years. Next, cross-check everyone to see where the connections are, especially if they have good ties to the SEC (Securities and Exchange Commission). Finally, you want to check these people and the companies they have been associated with. Check every IPO these people were involved in and what Moody’s ratings were prior to the IPO. As you know, Moody’s is one of two IPO rating companies in the United States, and they’re hurting for revenue because of the financial downturn. If you see a bias in how they rate because of personal relations to the IPO people, you’ve got a winner,” Skyler smiled.

During his five years at the company, Skyler had taught John about shorting, naked shorting, and churning. She explained shorting by using an example. “If I own 1,000 shares at $100/share and you think the stock is going to tank (go down), you ‘borrow’ my shares at $100/share, sell them, and the next week the stock goes down to $80/share. You call your broker and buy back the 1,000 shares at $80 and give me my 1,000 shares at $80/share. Do you see what happened?” Skyler asked. “You borrowed my shares and sold them for $100,000. The following week, when the company stock fell to $80, you repurchased those 1,000 shares for $80,000 and gave them back to me. In the meantime, you pocketed the difference of $20,000.” Skyler went on, “Naked short selling is the same as shorting but you don’t pay any money for the stock. There is a three-day grace period between buying and selling. That means you have at least three days of free money!”

Al Dryer instructed John to wait to resign from Marell and Pew until late on Friday so that BS could send out packets to each of his accounts to explain that he was switching companies. John thought about this, but was told by others this was standard practice. “But what about the noncompete clause I signed? It says I can’t do that,” said John to a few brokers not associated with either firm. Their response was, “It’s done all the time.” On Friday John did what BS asked, and there were no negative consequences for either John or the firm. Six months went by and John’s portfolio increased to $150 million. Other brokers began imitating John’s strategy. For example, for his Sharks, John would buy and sell at BS and call some of his buddies to do the same thing using money from the Sharks. Another tactic involved selling futures contracts without providing evidence that he held the shares sold (naked shorting). While much of what he was doing was risky, John had become so successful that he guaranteed his Turtles against any loss.

Several years later John was buying and selling derivatives, a form of futures contract that gets its value from assets such as commodities, equities (stocks), bonds, interest rates, exchange rates, or even an index of weather conditions. While his risk-taking Shark group had expanded threefold, John’s Cessna pool had all but dried up. However, his Turtles had grown dramatically to an average worth of $500,000. The portfolio he managed had topped $750 million, a lot more than he had when he started at BS ($500 million in Sharks and $250 million for Turtles).

“This year is going to be better than last year,” said John to some of the brokers at BS. But expenses were rising fast. John’s expense account Chapter 1: The Importance of Business Ethics 5 included country club memberships, sports tickets, and trips for clients. Instead of charging the firm, John always paid for these out of his own pocket. He was indirectly letting his clients know that it was his money he was spending on them; the clients were grateful for his largess, and those who would have grumbled about delays in the delivery of securities purchased were less apt to do so. John saw a great opportunity to make his heavy hitters happy. Unbeknownst to them, he would buy and sell stocks for these clients and later surprise them with the profits.

By this time, John was training new hires at BS, which would have taken a lot of his personal and professional time if he had done it right. For example, because John was a senior partner, he had to sign off on every trade they made; he needed to budget an hour a day just to sign the four other brokers’ trades. But John also had a lot of other things on his mind. He had decided to get married and adopt children. His soon-to-be wife, Leslie, quit her job to be a full-time mom and was designing their new 18,000-square-foot home. With all these activities going on at once, John was not paying much attention to the four new brokers and their training.

Then one Monday morning, John received a call from the SEC asking about some trades made by the four new brokers. “It appears to us there may be some nonpublic information your brokers have concerning several IPOs,” the agent said. “If they do have such information, this could be considered insider information. John, I’m calling you as a courtesy because we go way back to our college days, but I have to know,” said the agent. John thanked him and went straight to the new brokers and asked them about the IPO. One of the new brokers replied, “John, you told us that in order to excel in this business, you need to be an expert on knowing exactly where things become legal and illegal. You said, ‘Trust me, I’ve been doing this for 15 years, and I’ve never had a problem.’ We just did what you’ve taught us.”

John knew that if they did have insider information, he would probably be found partially responsible because he was supposed to be training them. At the very least, the SEC would start checking his trades over the past several years. He also knew that, when subjected to scrutiny, some of his past trades might be deemed questionable as well. What should John do?

Discuss the implications of each decision John has made thus far and may make in the future to handle his situation.