Article mentions Ray DIRKS who midwifed LOAX:"Attention-Starved Companies
'Buy' Wall Street Coverage
By CHARLES GASPARINO
Staff Reporter of THE WALL STREET JOURNAL
The shares of Telesoft Corp. were languishing in the spring of 1998, and
its officials figured they knew why. Like thousands of smaller concerns in a
universe of about 7,300 publicly held U.S. companies, the Phoenix
telecommunications stock was simply being overlooked. No major Wall
Street firm had a research report on it.
Then along came a Dallas securities firm called ComVest Partners. In a
letter to Telesoft, ComVest President Andrew May says, he laid out a plan
to add "an additional $15" to the $5 stock through, among other
promotional and financial services, "in-depth research." But, Mr. May
says, there was a price: 100,000 warrants allowing ComVest to buy
Telesoft shares for $5 each.
Telesoft was aghast. "Exchanging warrants for research was unequivocally
the wrong way to go," says its chief financial officer, Michael Zerbib.
Although ComVest closed its doors three months ago, for unrelated
reasons, its Mr. May says the offer was neither unusual nor unethical in the
world of small stocks. To him, "what's interesting" about the case is that
Telesoft "wasn't willing to give up anything" to get a securities firm to push
the stock and do a report on it.
Mutual Benefit
It is one of the most nettlesome issues in the securities business. Wall
Street research done even by prestigious firms has always been treated by
investment pros with a certain skepticism, since reports usually come from
firms that either have or want the company in question as an
investment-banking client. But the potential conflicts are more stark in
research on small-capitalization stocks. There, "unfortunately, there's often
a pay-to-play relationship between investment banks and the companies
they cover," says David Rothschild, a New York money manager who
referred Telesoft to ComVest.
The most common payment: warrants entitling the securities firm to buy
shares at a set price -- and thus to profit if the stock goes up after the firm
issues its report.
Firms typically insist, however, that this compensation isn't for doing a
report, but for investment advisory services -- which, they note, some
small companies can't afford to pay for with cash.
Big-name Wall Street firms generally won't accept warrants from
companies on which they issue research reports. But regulators such as the
National Association of Securities Dealers say that doing so isn't improper
so long as the securities firm discloses its holdings. "Maybe this is
something we ought to look at," says Alden Adkins, general counsel for
the NASD's regulatory arm. "The issue is whether disclosure is enough, or
should these practices be completely prohibited?"
Analysts and Bankers
Magnifying the issue at some securities firms is a blurring of the lines
between investment banking and research. M.H. Meyerson & Co. in
Jersey City, N.J., employs traders, salesmen, analysts and bankers, all
dedicated to the small-stock market. "We don't have a 'Chinese wall' "
between analysts and bankers, Mr. Meyerson says. "The bankers and the
analysts work together. People doing research have a right to
communicate with the persons assigned to a project so they can exchange
confidential information."
Last November, Meyerson issued a report on Dental/Medical Diagnostic
Systems Inc., of Westlake Village, Calif. It said the company "has
emerged as a leading marketer of high-tech dental products" and "is
projected to rapidly grow earnings and revenue." The report called it a
"strong buy."
Meyerson held 180,000 options on Dental/Medical's stock and 180,000
options to buy warrants on the stock, all received as part of an
investment-advisory and financing agreement dating from Meyerson's
work on a 1997 offering of stock. The report noted that the firm "holds
underwriter's options to acquire securities of the company."
Meyerson and Dental/Medical both say there was no improper quid pro
quo. "They issued a research report on us and they provide
investment-banking services," says Dental/Medical's CFO, Stephen Ross.
Mr. Meyerson says the payment was for financing work, not research.
"M.H. Meyerson never accepts warrants as payment for research. You
can't buy M.H. Meyerson," he says. Warrants, he explains, are "a
time-honored form of payment" for small companies that don't have
enough money to pay investment-banking fees.
Stealth Downgrade
That said, it can be difficult for investors to interpret research provided in
the course of these relationships. Consider Meyerson's report in March on
Virtual Technology Corp., a Minneapolis electronic-commerce company.
The report noted that "M.H. Meyerson Inc. has received options and cash
as part of the Investment Banking agreement." The deal called for
Meyerson to get $25,000 in cash and up to 400,000 warrants to buy the
stock at $2 a share.
Meyerson's report said the company might face some "downward
pressure on the future stock price." But it also said Virtual Technology
stood to "benefit from the explosion in E-commerce activity," and
projected a "target price of $10" a share in 18 months -- nearly $4 higher
than where it was trading at the time. It termed the shares "attractive."
Mr. Meyerson says this was actually a downgrade, because a previous
Meyerson report had rated the stock a "buy." The report didn't mention
any earlier report or rating, however. Asked about this vagueness, Mr.
Meyerson says, "It's certainly in the public domain that we put out a buy
recommendation" previously. "Anybody looking to find that information
can find it very easily."
Sometimes, payment goes beyond warrants. A year ago, J-Bird Music
Group retained Security Capital Trading Inc., a New York firm run by
analyst Ray Dirks. As part of the financial-advisory deal, Mr. Dirks would
issue a research report and promote the Internet music company, says
J-Bird Chief Executive Officer Jay Barbieri, and J-Bird would provide the
Dirks firm with 500,000 shares, which were restricted as to when they
could be sold.
J-Bird figured it had hit pay dirt. After all, Mr. Dirks was a famous analyst.
In a celebrated 1973 case, he tipped his clients to the impending collapse
of an insurance company called Equity Funding. The Securities and
Exchange Commission charged him with insider trading, but 10 years later
the Supreme Court ruled in Mr. Dirks's favor, setting a precedent that
shaped the way business is conducted on Wall Street.
A Dirks analyst, Steve Monte, spent a day at J-Bird's Wilton, Conn.,
headquarters, and then issued a 14-page report labeled "Purchase
Recommendation." Because J-Bird shares trade "on the Electronic Bulletin
Board (and for only $1.18 a share), the company and its huge potential
has not yet been discovered by the investment community," Mr. Monte
wrote in July 1998. "We suspect that this condition could change very
rapidly." The report stated prominently that J-Bird had retained it in a
financial-advisory capacity, but it didn't mention that J-Bird had supplied it
with 500,000 shares.
J-Bird's potential has yet to be discovered. By late last summer, Mr. Dirks
had stopped offering the stock to his institutional and individual clients,
though he says he is still trying to work with the company. He says his firm
continues to hold J-Bird shares. They now trade at about 48 cents apiece.
Mr. Dirks isn't bashful about accepting warrants or shares. "This happens
all the time," he says. "It's a common practice, and I've been around 40
years."
But to J-Bird's Mr. Barbieri, "This is a terrible game, when you leave guys
like me in the position to deal with these types of promoters or we get no
visibility."
More Warrants, Please
Riviera Tool Co. certainly soured on such arrangements. The Grand
Rapids, Mich., company had an initial public offering in 1997 that was
handled by National Securities Corp., which later also handled a private
placement of its preferred stock. For the two deals, National Securities got
warrants for a total of 151,000 shares. It also put out a buy rating on the
stock -- until last year, when the analyst who wrote the report left. The
securities firm then stopped covering Riviera.
However, not long afterward, a National Securities investment banker who
had worked with Riviera made a proposal: National would continue as
Riviera's investment bank and pitch the company to analysts interested in
small-cap stocks. The securities firm's price: $4,000 a month, plus 25,000
more warrants.
Officials at Riviera were irked. "We felt it would be in their own financial
interest to support the company and their stock. Why should we give them
any more warrants to do that?" says Riviera's CFO, Peter Canepa. The
company decided to refuse to give the securities firm more warrants, even
at the cost of not getting analyst coverage. Its stock now trades at $4.75,
far below the $10.50 exercise price on the warrants given to National
Securities. Robert Daskal, CFO of National's parent, Seattle-based
Olympic Cascade Financial Corp., says the firm did nothing improper; he
says decisions to issue research are unrelated to investment-banking
services.
Ending Up in Court
In a case involving Ladenburg Thalmann & Co., one of the oldest New
York Stock Exchange member firms, acrimony with the client eventually
led to litigation. A leasing company called Employee Solutions Inc.
retained Ladenburg in 1994 to do investment advisory work and provided
it with warrants convertible into 150,000 shares. The next year, Ladenburg
launched coverage of the company, rating it a buy and saying it was on the
verge of becoming a "national leader in the niche of staff leasing."
The stock rose. By early 1996 it was trading at about $20. Ladenburg
converted warrants into stock, sold and walked away with a profit of
nearly $4.8 million, court documents indicate.
But because Employee Solutions had decided to issue additional stock for
an acquisition, Ladenburg demanded more. A suit Ladenburg filed in New
York federal court in 1997 claimed that an antidilution clause in its
agreement with Employee Solutions entitled the securities firm to 88,586
more shares.
By the spring of 1997, Ladenburg had dropped coverage of the company,
says Marv Brody, Employee Solutions' former chairman. This past March,
the court dismissed Ladenburg's suit. Ladenburg declines to comment on
the matter.
Employee Solutions says it will think twice before giving up warrants in the
future. "The past is the past, and I can't change that," said Mark Gambill,
chief of marketing. "But we know that the best way to get positive
research is through earnings."
Analyst and Shareholder
Sometimes the conflicts aren't with the companies but with individual
analysts. A retailer of used compact disks called CD Warehouse Inc.
credits ComVest Partners -- the firm whose offer Telesoft spurned -- with
"opening the door to the money-market world" through
investment-banking services in 1998. CD Warehouse gave ComVest
warrants and a fee for financial services, according to a company official.
Tomas Escamilla, a ComVest analyst, bought 29,000 CD Warehouse
shares at $10 apiece in a private placement in May 1998, according to
CD Warehouse's chairman, Jerry Grizzle. In August, Mr. Escamilla was
the author of a ComVest research report setting a 12-month price "target"
for the stock of $50. "CD Warehouse is positioned to seize a significant
share of the rapidly growing $1 billion pre-owned CD market," said a
news release that included Mr. Escamilla's name.
When CD Warehouse didn't meet his earnings projections, its stock got
hit. After having touched $18.75 after the report, it sank as low as $5.50
in the fall of 1998. It rebounded, then slid back to its current price of about
$8. It isn't clear whether Mr. Escamilla had sold.
"It was a very self-serving report," CD Warehouse's Mr. Grizzle says. "A
lot of people were reading the report not knowing this guy" had shares.
ComVest's Mr. May says the relationship was fully disclosed in the report.
As for Mr. Escamilla, he says that "ComVest legal counsel said it was
legal." He adds: "I was buying the same time everyone else was buying... I
am putting my money where my mouth is.' |
