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What is a “Chinese Wall”?

This term describes the division within a brokerage firm that separates the investment analysts, who provide objective analysis of stocks, and the investment bankers, who bring IPOs to market. It helps to prevent illegal practices.

Named after the Great Wall of China, it is of course not an actual physical barrier, but describes the regulations put in place after the stock market crash of 1929 by the U.S. Government, to prevent any conflict of interest. Here’s a simplified example. If a brokerage house is considering an IPO (initial public offering), it is the job of the investment bankers to assess the new company’s business plan and profit potential, and provide insight to the brokerage on the company’s particular industry. Using this information, the brokerage firm will decide how to promote the company’s stock through an IPO or merger and acquisition. Quite separately, the investment analysts are assigned specific industries and companies to assess in terms of their profit potential and provide recommendations as to whether to buy, sell or hold. These reports are distributed to institutional investors. Why is the wall needed? Since analysts are compensated in part through a percentage of the trading volume of the stock, it would be in their company’s interest to see that the IPO is a successful one. Hence, the potential for conflict of interest. The Chinese Wall is supposed to ensure that analysts are not unduly influenced by the investment-banking department, the ones who have an interest in seeing an IPO succeed. That’s the theory. The reality is that many problems exist with this system, and today both the U.S. and Canada are grappling with new ways to further protect investors. In the U.S., regulators are investigating securities firms to determine whether or not analysts published research that showed companies in a positive light in order to promote higher stock prices for various security issues, at the cost of giving investors an accurate assessment of their potential. In Canada, the Ontario Securities Commission (OSC) and the Investment Dealers’ Association (IDA) have both made recommendations for changes to disclosure rules and analyst compensation.