Chinese Wall

What Is a Chinese Wall?

The term Chinese wall, as it is used in the business world, 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. In the United States, corporations, brokerage firms, investment banks, and retail banks have used Chinese 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 Chinese 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.

How a Chinese Wall Works

The policy of building a Chinese 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 confidential information from one department of the bank to another and to other business units within the bank.

The need for a Chinese 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 The law repealed federal regulations prohibiting companies from providing any combination of banking, investing, and insurance services.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.

In recent times, the use of the term Chinese wall has been denounced as culturally insensitive. One judge suggested an "ethics wall" as an alternative.

Examples of a Chinese 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. The Chinese wall is supposed to prevent any knowledge of the takeover talks from reaching the investment advisers.

The need for a Chinese 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 a Chinese wall exists in other professions. They 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.

Special Considerations

The Chinese wall got its name from the Great Wall of China, the impervious structure 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.