When Eliot Spitzer settled with Merrill Lynch in late May, the core issue was whether analysts had been truthful and fair in their public pronouncements on companies for which the number one US brokerage firm did, or was seeking to do, investment banking. The settlement came after Spitzer, who is New York State’s attorney general, aired various items of Merrill’s dirty laundry, including e-mails in which analysts privately scorned stocks they had publicly lauded. A pattern of almost systematic misinformation had emerged.
Given the terms of the settlement, it’s safe to assume the attorney general was not convinced Merrill analysts were always ‘truthful and fair’. The brokerage agreed to pay a $100 mn fine and reorganize the way it compensated analysts. One legal source suggests Spitzer would have capped the fine at $50 mn if Merrill Lynch would publicly admit that as an organization it had behaved reprehensibly. The bank, however, was adamant: it did not wish to admit to any wrongdoing, though it did agree to issue an apology. In fact, it is standard practice to agree to a fine without admitting wrongdoing. This may seem absurd – after all, who would pay $100 mn and apologize if they had done nothing wrong? But Merrill had good reason.
No encouragement
First, the settlement allowed Merrill Lynch to imply that, although some analysts might have behaved irresponsibly, or even willfully published faulty research, the bank itself was not responsible for this behavior, and certainly did not encourage or sanction it. That argument holds little water. Merrill Lynch and the numerous other brokerage firms now under investigation cannot deny the close correlation between the bonuses paid to analysts and the investment banking mandates from companies those analysts cover. Indeed, in some cases this correlation was explicit. It was, in practice, a tacit nod to analysts to cultivate chummy relations with the firms they covered.
An example: in December 1999, while the internet investment company CMGI, whose shares traded in the $120-160 range at the time, was still buying everything in sight (and was therefore a source of regular banking fees), Merrill’s influential internet analyst Henry Blodget set a price target of $300 per share. In internal e-mails eventually handed over to Spitzer, Blodget was less than complimentary about CMGI. One message said, ‘This is going all the way to 5.’ In June 2002, CMGI traded at less than a dollar. In other internal e-mails, analysts referred to some companies with which Merrill had banking relationships as ‘dogs’ or ‘disasters’.
A more important implication of Merrill Lynch’s non-admission of wrongdoing is that plaintiffs cannot use the settlement as evidence in private litigation. Numerous class actions have already been launched against Merrill Lynch, Blodget and other analysts, as well as against a number of other brokerages including Goldman Sachs and Credit Suisse First Boston. WorldCom’s recent implosion has led to litigation against Jack Grubman, telecoms analyst at Salomon Smith Barney, giant Citibank’s investment bank arm. One client has made a $10 mn arbitration claim against Grubman, whose repeatedly bullish calls on WorldCom are alleged to be a direct result of Salomon’s investment banking relationship with the company. Henry Hu, professor of securities law at the University of Texas, says that banks’ collective liability in private litigation is likely to be ‘substantial.’ Some estimates put the combined total possible liability at around $3 bn.
Compromising objectivity
In a paper for the Association of Investment Management Research (AIMR) in October 2001, John Gavin stated that investment banking influences ‘remain as the most significant of the compromises to analysts’ objectivity.’ Many Wall Street firms protest that this is not so, and that sell-side analysts are not paid for specific banking deals. Nonetheless, if analysts had no influence on the decisions of the companies they covered, why were they regularly trotted out as star attractions at so many roadshows when these same companies sought funding from the capital markets?
The case of Lucent Technologies shows a clear disincentive for analysts to produce serious and thorough research, which might put at risk their bank’s chances of doing business with the networking giant. In 1999, various aspects of Lucent’s accounting came under the scrutiny of the SEC, but at the time, the company was hot on the acquisition trail and sell-side analysts chose to ignore the SEC probe. Investment banking firms were not keen to challenge a potential client with such deep pockets.
In what some cynics suggested was an attempt to preempt the Merrill settlement, the NYSE and Nasdaq proposed new rules which were passed by the SEC in early May. The cornerstone of the new rules is financial disclosure: in any research report, analysts must now state clearly and unequivocally whether they or their firms have any financial interest in the stocks they cover. SEC chairman Harvey Pitt said these rules will go a long way towards addressing the concerns of conflicts of interest raised by Congress and others, but he also promised that ‘our efforts are not yet concluded.’ And Juanita Scarlett, a spokeswoman for Eliot Spitzer’s office, affirms that ‘in light of the [Merrill Lynch] case, the rules [that the SEC] came out with… don’t go far enough,’ concluding that ‘much further reform is needed.’
Spokesmen at some sell-side firms will only say efforts are underway to restore public confidence in the impartiality of analyst research. Others, like Merrill Lynch’s PR team, wouldn’t respond for this article. Elizabeth Ventura, Bear Stearns’ IRO, offers no comment on what effects the settlement may eventually have on IROs in the banking world because Bear Stearns is also under investigation. She does, however, point out that the majority of shareholders in the major banks are institutional investors and, as such, are well-versed in the language of sell-side analysts. But what about private investors? John Gavin writes that in recent years, the investing public has significantly increased its participation in the stock market, but as less sophisticated investors, their trust in the professional objectivity of analysts has often been misplaced. Suffice to say that the trust of these investors in the research of sell-side analysts has been seriously undermined.
Consequences for research
In the opinion of Lou Thompson, president and CEO of the National Investor Relations Institute, the settlement will have many far-reaching implications for investor relations.
For one, it will lead to a heavy reduction in the research departments of many of the major investment banks, leading to a period of growth for independent research firms. This, he says, is because the most important investment banks with research arms spend several hundred million dollars a year on research, much of which was previously geared towards gaining investment banking business. Now, says Thompson, with analysts forced to take a more objective stance, it is less likely that they can be used to gain such business. ‘Merrill Lynch spent something like $1.4 bn on research last year. That is too high a price to pay for a simple marketing tool.’
A second effect, according to Thompson, is that buy-side analysts will be willing to pay more for independent research that is not geared towards obtaining banking business.
In the end, the Merrill settlement will bring many other much needed changes. For one, when a research report is issued, it will have to reveal whether the firm has received or is entitled to receive compensation from companies covered by its analysts over the preceding twelve months. There will also be a far clearer monitoring of the performance of the analysts, whose bonuses will now be based on the accuracy of their recommendations and earnings estimates.
Severing the link
In the case of public offerings, the SEC has recommended a quiet period during which a firm acting as lead manager or co-manager for an IPO may not issue research on the fledgling company. The quiet period would be 40 days before and after the issue. In another development, Merrill Lynch has had to appoint a monitor (an appointment subject to the attorney general’s approval) whose role will be to ensure that the bank complies with the agreement.
According to Spitzer, ‘This agreement will change the way Wall Street will operate, severing the link between the research and banking operations that tainted investment advice.’ Indeed, many of the major investment banks are scrambling to introduce the same rules the agreement forces upon Merrill, conditions they had for years resisted. Failure to do so would mean falling behind in terms of transparency. And New York’s top cop is now turning his attention towards many other major banks. Any attempt to put their own houses in order will cast them in a better light should they be required to justify their own past modus operandi.
AIMR’s John Gavin reminds us how vital it is that investors be able trust those upon whom they rely for investment advice: ‘Low cost investment capital,’ he writes, ‘can only be raised in countries where investors believe the markets are truly open and fair.’ The next few months will see how much progress has been and can still be made towards restoring some degree of transparency and objectivity to the world of sell-side research.
