The October murders of two New York stock promoters with questionable financial reputations prompted frenzied speculation of securities fraud gone deadly. Investigators are still sorting through the facts surrounding the gangland-style hits on Alain Chalem, 41, and Mayir Lehmann, 37, and we may never know if their deaths were indeed linked to their penny-stock promotion web site, Stock Investor. But the grim episode highlights an undeniable fact: The phenomenal rise in the US equity markets has attracted a growing white-collar element eager to manipulate the rules to their advantage.
The SEC has been particularly vocal on the issue of securities fraud, and stock promotion has figured high on its list of trouble spots. In a recent speech before the Economic Club of New York, SEC chairman Arthur Levitt assailed ‘a web of dysfunctional relationships’ between analysts and public companies. Analysts, he said, face difficulty trying to fairly assess a company’s performance without upsetting their firm’s investment banking relationship. To illustrate his point, Levitt noted that today, ‘a ‘sell’ recommendation from an analyst is as common as a Barbara Streisand concert.’
While it’s unclear if the chairman wants to see more Streisand appearances, there was no mistaking his displeasure with the state of financial reporting by analysts. ‘We cannot settle for boilerplate disclosure, cloudy language that masks a firm’s position, or small type disclaimers at the end of the document. In addition, firms should reexamine their compensation practices for analysts and ask themselves this simple question: Do they ensure unbiased and quality information?’
Interestingly, the chairman went out of his way to criticize the Wall Street establishment, rather than just attacking penny stock promoters. Naturally, not everyone agreed with his assessment, especially since the speech touched upon some time-honored traditions. The fact is, most investment houses maintain investment banking and other compensatory relationships with the companies they cover through research. This is commonplace – and legal.
At the other end of the spectrum are those would-be analysts who get into trouble for failing to disclose compensation received for writing reports. The SEC’s enforcement division launched a massive sweep in October 1998, filing 23 enforcement actions against 44 individuals and entities for illegal touting. It subsequently did two smaller seeps, and by September 1999 the SEC had filed 29 enforcement actions as part of its effort to combat the spread of securities fraud on the internet
Currently, illegal touting seems a US-specific problem. In the UK, for example, the rules are largely adhered to. ‘To the extent that there’s a brokerage relationship, it’s always displayed on the report. It’s very upfront,’ says Pouneh Taheri, portfolio manager of the Sanwa United Kingdom Growth Trust.
Smaller markets seem to have defenses that come built-in with their size. ‘There’s a huge potential for abuse on the internet, but I haven’t seen it here,’ says Denis Marsh, a portfolio manager at Beutel Goodman in Toronto. ‘One of the first things you do in Canada when you see a research report that interests you, is you get on the phone and talk to the analyst. Most of the work is in Toronto, so you know them, or you ask the salesman what the analyst’s experience is. And you find out pretty quickly if there is an underwriting or other relationship.’
Seeking exposure
In fact many companies are used to paying for analyst coverage and are above board about it. Especially for small and micro-cap companies, the reality is this: to boost their exposure, they need analyst coverage, and to get that coverage, they need to provide compensation. ‘The analyst report brings exposure,’ explains Jennifer Mundine, IR manager at Houston-based Telescan, which came to market gradually through acquisitions rather than an IPO. ‘We’ve been around since 1983, but we didn’t have an investment banking relationship or immediate coverage. It’s difficult for the market to assess your performance when there’s no consensus out there. The relationship between the analysts we now have helps us get in front of investors, which is important. But it’s difficult. If you’re Coca-Cola, you have plenty of coverage. When you’re a small-cap company and you have one analyst, it’s a problem.’
Telescan now has four firms covering the stock, two of which are compensated, whether through warrants, underwriting or other means. Mundine says it’s important compensatory relationships are fully disclosed. ‘That way, the investment community can take the scope of the relationship into consideration when evaluating the report’s quality.’
But although Mundine says two of the firms covering the stock are compensated, one of those firms, Stonegate Securities, disputes her assessment. ‘You’d have to speak to our investment bankers to see what services we’ve provided or what compensation they’ve received, but we’ve never been paid to write research,’ maintains Tim Stobaugh, the analyst at Stonegate Securities covering Telescan. Stobaugh says his research report, which carries a buy rating on the stock, includes a section outlining the relationship with Telescan. ‘It notes whether we’ve been compensated for services provided in the form of fees, and/or warrants and/or options. I don’t think the amounts and the numbers are given, but the relationship is disclosed in every instance.’
But if warrants or options are included in any form of compensation, the conflict of interest, or at least the pressure to write a positive report, would seem apparent. As Mundine admits, ‘It is usually in the analysts’ best interest to be favorable. For example, if an analyst group has been issued stock or warrants and they issue a negative report, they create an environment in which the value of their ‘compensation’ is decreased.’
Unbiased research
The integrity of research reports can clearly be compromised when the authors’ employers have economic ties to the companies being covered. But to Bennet Weintraub, CFO of Valentis, a biotechnology company based in Burlingame, California, compensatory relationships, at least in the case of his company, have not affected the integrity of the coverage. And Valentis does maintain compensatory relationships with at least one firm issuing research reports on the stock: SmallCaps Online, owned by Bridge Technology. It provides investor relations and media relations services to Valentis.
SmallCaps Online was recently in the news when the Wall Street Journal claimed the company failed to disclose its corporate relationships with many of the firms recommended on its site, one of which was Valentis. Weintraub, however, maintains that the coverage is unbiased. ‘We make the same information available to SmallCaps Online that we make available to the public, so it’s an independent report.’
Either way, SmallCaps Online does not rank among the elite in the investment community, and many investment professionals believe this is the problem; smaller firms are running loose with securities rules and tarnishing the image of the industry. ‘I think the lack of disclosure is limited to many of these smaller businesses,’ says Jon Ender, executive VP and CIO at ABN Amro Chicago Corp. ‘It’s done very seldom in the normal course of institutional operations. Most of us are too well trained in the potential hazards of inadequate disclosure to permit it in our organizations.’
As for reports written in return for compensation, Ender says he wouldn’t purchase research from those engaging in the practice. ‘We wouldn’t even look at their information. Maybe that’s biased and unfair, but someone’s got to show us that they are legitimate in the business before we use their research.’
Looking for bigger fish
Still, Levitt and the SEC seem to have set their sights higher than a firm like SmallCaps Online, calling into question the integrity of the larger establishment. Take the well-publicized skirmish between Bear Stearns banking analyst Sean Ryan and First Union. According to many reports, Ryan, who had begun issuing bearish comments on the bank this summer, was silenced by his bosses after First Union suspended its bond trading business with Bear Stearns. Both Bear Stearns and First Union deny the episode; and Ryan, who still covers First Union but has curiously not written a report on the stock since July, says he is not allowed to speak to the media or comment on the bank.
According to an SEC insider, this issue isn’t going to go away soon. ‘Around here, the initiative gets started with a speech by the chairman. Then we follow that up. We either ask the industry to conform voluntarily, or we look at rule making, or enforcement. We’re at the speechmaking stage, with an opportunity for the industry to correct the problems voluntarily. I would suspect that if sufficient changes don’t happen, you’ll hear more from an enforcement standpoint. Of course, if the right case came along now, we’d bring it.’
