Net Net: Promoting innovation and managing change
Net Net: Promoting innovation and managing change

Protecting JPMorgan from China's corruption

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When the news first broke that the government was investigating JPMorgan Chase for allegedly hiring Chinese princelings in an effort to win investment banking business, a lot of people kind of shrugged their shoulders.

Investment banking is largely a "relationship" business, and China is a "relationship" country—of course this sort of thing was going on.

Andrew Ross Sorkin wrote a column about how nonscandalous and common the hiring of the well-connected is in finance—especially in the U.S. Arthur Levitt just penned a piece for The Wall Street Journal defending the practice.

A good friend recently explained that since you can't trust some people in other countries to tell the truth about their qualifications, pretty much the only thing you can trust is their connections. You can't fake a billionaire uncle on your résumé (at least not for very long).

But the latest installment of The New York Times coverage of the JPMorgan China hiring scandal is damning. Seriously damning. It's just not really damning about JPMorgan.

China's hot IPO market
China's hot IPO market

Here's what happened. JPMorgan had a program called "Sons and Daughters" aimed at ensuring that its hiring of the relatives of big shots in China would "pass legal and regulatory muster," according to The New York Times.

Under the Foreign Corrupt Practices Act it is illegal to secure any improper business advantage from a foreign official. It's very well-accepted that providing employment to the friends or relatives of a foreign official to win business violates the law.

The Justice Department and the Securities and Exchange Commission both have enforcement responsibilities over aspects of the FCPA. Helpfully, they've identified a number of red flags that should trigger caution by U.S. companies that want to avoid breaking the law.

These include doing business in a "country known to have had widespread corruption" and with someone who "has family or business ties with government officials."

Keep in mind that the distinction between government and private sectors is crucial. It's more or less hunky-dory to hire the kids of the native moguls so long as the moguls run entirely private sector entities and aren't public officials or important in party politics. Even if your only reason for hiring them is to win investment banking mandates from their parent's company, that doesn't break the law.

Every investment bank on Wall Street employs a sizable number of sons and nephews (and, occasionally, daughters and nieces) of firm clients for this very reason.

So the main purpose of Sons and Daughters was presumably to make sure that JPMorgan's hires in China weren't connected to efforts to win business there from any organization connected with the government. And there's the rub: so much of China's investment banking business is connected to the government in some way. State-owned enterprises selling shares to the public is one of the cash cows of contemporary investment banking in China.

It seems that the main problem JPMorgan had was that it's FCPA program was working too well.

From The New York Times:

In a series of late-night emails, JPMorgan Chase executives in Hong Kong lamented the loss of a lucrative assignment.

"We lost a deal to DB today because they got chairman's daughter work for them this summer," one JPMorgan investment banking executive remarked to colleagues, using the initials for Deutsche Bank. ...

JPMorgan's investment banking business began to lose market share in China, the data from Thomson Reuters shows. By the time JPMorgan lost the 2009 deal to Deutsche Bank, the Hong Kong executives at JPMorgan's investment bank decided that it needed to step up its hiring.

The thrust of the latest Times piece is that JPMorgan allegedly felt competitive pressure from other financial firms that were winning lots of business in China because, at least in the eyes of some at JPMorgan, they were hiring the right sort of people—namely, the kids of the elite.

The whole piece almost reads like a defense of JPMorgan. It had to hire the princelings because everyone else was doing it. (Which raises the question: Who leaked these internal emails to The New York Times?)

Matt Levine points out that JPMorgan may have gotten in trouble because it just wasn't corrupt early enough.

If it had just understood the game of hiring the well connected in China from the get-go, it would never have had to make the perhaps incriminating changes in its hiring policy. Certainly, there wouldn't have been these awkward emails. Banks that just made it a practice to hire every princeling they could get their hands on didn't produce documentary evidence of allegedly corrupt motives.

When thinking about these things, it's quite helpful to put them in context.

The opening of China to foreign investment banks has created a situation almost unprecedented in the history of investment banking. Past episodes of globalization have involved the introduction of foreign competition with domestic firms.

When Goldman Sachs hung out a shingle in London, it had to fight for market share against entrenched British banks (and vice versa). But China is different. It's an open field, a gold rush, a vast unclaimed investment banking territory.

(Read more: China's big warning for US markets)

This has dollar signs (or pound signs, or yen signs, or euro signs) flashing in the eyes of investment bankers around the globe. Everyone wants his pan in the brook.

The money funnels are poking around everywhere, while the tentacles reach for something firm to grasp. Everyone in a corner office in a glassy tower of finance senses the opportunity but also the fear that if they don't get established fast, someone else will become the entrenched power.

Losing deals—as JPMorgan reportedly was—to a Deutsche Bank or a Goldman Sachs is not just about losing those particular deals. It's about losing your claim. It's about someone else planting his stakes in the ground where you wanted to be. It's time, that is, for panic.

So why bother enforcing the FCPA at all? If the price of doing business in China is corrupt hiring, why not let everyone compete for the princelings? What's the harm? Something like a dozen firms are now under investigation for the practice, so it hardly seems as if anyone was getting an unfair advantage.

To see why the FCPA is worth enforcing, it helps to remember its core purpose: preventing U.S. companies from competing for business with each other through bribery. The law was initially passed in the aftermath of Watergate, when investigations revealed that hundreds of U.S. companies maintained slush funds for bribing officials in emerging markets.

But it wasn't really ever a "crackdown" on bribery as much as an anti-bribery cartelization among U.S. businesses.

You see, corrupt compensation to foreign officials is a deadweight loss for corporations and the American economy. They'd prefer not to pay bribes, and we're better off if they don't. But absent a law against it, companies find themselves in a sort of bribery arms war.

No one company could afford to unilaterally disarm itself in the bribery war—it would just lose all that business to the companies that kept on bribing. So the FCPA was a sort of arms control treaty to which everyone agreed.

What appears to have happened in China is that the arms control measures broke down. Corrupt hiring of the friends and relatives of Chinese officials became regular enough that the arms race was back on. And JPMorgan, allegedly, found itself needing to rearm.

But rather than looking at this as an unfair investigation of JPMorgan—or the other banks that may or may not be involved—we should look at it as a restoration of the anti-bribery cartel that everyone, including JPMorgan, really does want to work.

—By CNBC's John Carney. Follow him on Twitter @Carney