The Chinese wall is made up of the formal and informal barriers within a company that limit the information shared between different divisions that might cause a conflict of interest.

Example of a Chinese Wall

For example, the wealth management division of a bank will not have access to the content of on-going mergers and acquisitions deals that are taking place, as the wealth management division could hypothetically gain an illegal benefit in making investment decisions based on that privileged information.

Purpose of a Chinese Wall

The Chinese wall within a company is designed to protect against the appearance of impropriety, and not just impropriety itself. Whenever possible, the Chinese wall within a company should ensure that there is no possible question of any impropriety having taken place.

Fiduciary financial institutions, such as banks, operate based on a great degree of trust from their clients and customers. This trust is based on the belief that the organization as a whole will only be knowingly working in the client’s best interest in respect to the organization’s fiduciary duty to that client.

When even the appearance of impropriety arises, clients and customers become justifiably concerned that the enormous trust placed in the organization may be misplaced. Since customers and clients often entrust a large portion of their wealth and/or professional reputation to financial organizations, they are rightfully concerned by even the slightest possibility of impropriety on the organization’s part.

Breach of a Chinese Wall

Breaching the formal and/or informal rules that govern conflicts of interest within a financial institution can lead to warnings, sanction and criminal prosecution.

Generally a warning will be given when the misconduct is minor, the impact of the misconduct if negligible or non-existent and the error was made due to inexperience or a miscommunication. Repeated warnings can lead to more serious sanctions, even if the impact of the breaches remain minor.

In-house sanctions occur when the breach is not criminal, but still threatens the confidence of clients and the image of the institution or was the result of negligence or a knowing violation of company policies. These sanctions can include termination, demotion and a variety of other forms of appropriate legal punishments.

Some breaches of the Chinese wall are also criminal offenses that breach relevant laws on fraud or securities and financial regulations. These breaches will be prosecuted by the relevant governing authority, and will also likely lead to some form of company sanction, most often termination.

Trading with the Chinese Wall

The Chinese wall is most important to traders who seek out criminal or irresponsible financial institutions in an attempt to short sell these companies. A company facing a criminal trial or public knowledge of impropriety makes an excellent target for short sellers, so seeking out potential conflicts of interest and breaches of the Chinese wall is a popular tactic among short sellers.

Final Thoughts

The Chinese wall is an element of the contemporary markets that is important for all traders to understand. The Chinese wall shapes how fiduciary financial institutions are structured and operate, and it can be the source of a significant blow to the reputation and value of a company that breaches it.