Requiem for an Honorable Profession on Wall
Street
By GRETCHEN MORGENSON
t is hard to pinpoint when it happened,
because culture changes incrementally.
But Stefan D. Abrams, the chief investment
officer for asset allocation at Trust Company
of the West, dates the shift in Wall Street's
research culture to about 1996.
The mergers business was in full bloom,
bringing in huge fees for securities firms and
the promise of more to come. The dot-com
and telecommunications boom was starting to
build, and with it came the prospect of many
initial public offerings — more gold for Wall
Street investment banks. The stock market
was embarked on the biggest run-up of all
time, and individual investors — with easy
online trading — were joining professional
traders in droves, suggesting even more
business, albeit at low margins, for the
nation's brokerages.
That is when, Mr. Abrams argues, the major
firms figured out how valuable a popular,
high-profile analyst could be in grabbing a
bigger share of those lucrative investment
banking fees. That is when analysts showed
exactly how much they had become
salesmen and saleswomen for their
investment banking departments in their
routine communications. In one 1999 memo
titled "Managing the Banking Calendar for
Internet Research," for example, Henry
Blodget, Merrill Lynch's then-renowned
Internet analyst, outlines an 85 percent
banking, 15 percent research schedule for the coming week and adds, "Every
day I get a call or two from bankers I don't yet know with interesting
opportunities."
Mr. Abrams said, "Forty years ago, when I joined this business, to be an
analyst was an honorable job." No more.
Exactly how perfidious the culture had become at some Wall Street firms
during the stock market mania began to sink in only last month, when Eliot L.
Spitzer, the New York attorney general, released hundreds of documents,
including e-mail messages, written by Merrill Lynch analysts deriding
companies whose shares they were simultaneously recommending to
investors.
Merrill said that the conclusions in the affidavit were allegations, not fact, and
that the e-mail messages had been misconstrued and taken out of context.
But Merrill is hardly alone in the criticism it has received. Mr. Spitzer's
investigation is expected to turn up evidence of analysts behaving badly at
other firms, too.
Interviews with former analysts, each of whom has worked at a variety of
large Wall Street firms, along with internal evaluation and compensation
documents from many of them, provide even more evidence that in recent
years research analysts were driven not to provide the best advice for
investors but rather to excel in two areas: banking and ranking. They were
supposed to generate investment banking fees by producing positive research
reports on companies and to attain the highest ranking on the annual analyst
rankings published each fall by Institutional Investor magazine.
The two goals were related, former analysts say. Without a No. 1 ranking on
Institutional Investor's list — the result of a beauty-contest poll on analysts
among portfolio managers — investment banking deals were likely to migrate
to firms whose analysts were atop the list. The most powerful analyst,
company executives knew, could drum up investor interest and get the highest
price for their stock or bond offering or for a company in a merger. Ranking
high on Institutional Investor became paramount to analysts not only because
their firms demanded it, but also because their paychecks grew exponentially
when they secured a top post in the poll, reflecting the investment banking fees
the analysts helped attract.
"I've worked at several Wall Street firms, both institutional and retail, and none
actively encouraged their analysts to do objective, critical research and protect
their noninvestment-banking clients' interests," said Gary Vineberg, an
independent analyst covering consumer stocks at his own firm, Cyrano Equity
Research in New York. For a decade, ending in 1998, Mr. Vineberg covered
the supermarket industry; half of his career as an analyst was spent at Merrill
Lynch, and for six years he was the top-ranked supermarket analyst in the
Institutional Investor poll.
Mr. Vineberg gained a reputation at Merrill for advising clients to sell a stock if
he saw trouble ahead and for refusing to write positively about companies
solely to bring in banking business.
But, Mr. Vineberg said, "at Merrill Lynch, the overriding concerns were with
investment-banking deals and marketing for the Institutional Investor survey."
He added: "Little else seemed to matter. The final product, overall, was highly
marketed mediocrity."
Wall Street probably started its obsession with marketing in its research
departments — and the ensuing shift from honor to improbity — without
thinking about long-term consequences. "Each step along the way looked quite
innocent," Mr. Abrams said. "Until we got to the Merrill Lynch e-mails."
The e-mail messages and other documents produced under subpoena to Mr.
Spitzer's investigators confirm Mr. Vineberg's assessment that Merrill analysts
were marketers first, enlisted to help the firm attract investment banking fees.
In one message, dated April 26, 2000, Matt Young, a director at Merrill Lynch
Investment Banking, asks a member of the research department about how to
lure LookSmart, an internet company that was a client of Goldman Sachs, to
Merrill Lynch.
"Do you think we should aggressively link coverage with banking?" Mr. Young
wrote. "That is what we did with Go2Net (Henry was involved)." The
reference is to Mr. Blodget, who declined to comment and has left Merrill.
James Wiggins, a Merrill spokesman, said: "One of the most important roles of
management is to make sure those potential conflicts are managed and to give
analysts space to make an independent decision. There is a perception we
haven't done that very well and obviously we need to do it better."
The company is in negotiations with Mr.
Spitzer about terms of a settlement that
would include the payment of a penalty and a
reorganization of its research department.
Similar reorganizations may well be needed at
other firms, which also transformed their
research departments into sales forces. All of
the analysts who spoke of their experiences
at the largest firms on the Street, including
Merrill, Salomon Smith Barney, J. P. Morgan
Securities and Morgan Stanley Dean Witter,
said that most of their time was spent not in
analyzing companies' financial statements and
operations, making the right calls for
investors, but in selling their firms' services.
"You were not so much an analyst as a
marketing machine," said one former analyst
who spoke on condition of anonymity.
"Market to the sales force, to the bankers, to
the issuers, to the big investors so you could
get that following that perpetuates your
banking capabilities."
How helpful analysts were to the investment
bankers was central to their compensation
and to their job security, the former analysts
said. Firms typically provided analysts with a
memorandum at the end of the year,
identifying which deals they had been helpful
on and guidance about how they could do
better in the future. At many firms, there were self-evaluation memos that
asked analysts to critique their roles in every securities offering they were
involved in.
At Merrill, an October 2000 memo to all equity analysts from Deepak Raj, the
director of Global Equity Research, surveyed analysts' contributions to
investment banking during the year. "Please provide complete details on your
involvement in the transaction, paying particular attention to the degree that
your research coverage played a role in origination, execution and follow-up,"
the memo stated.
Another self-evaluation memo, dated 1996 and supplied by a former Smith
Barney analyst, asked for comments on how the analyst did at identifying a
securities underwriting opportunity, soliciting the transaction, securing the
mandate and "liaising with bankers."
This former analyst said Smith Barney, now Salomon Smith Barney and part
of Citigroup, supplied members of its research department at the end of the
year with a breakdown of their compensation that had been generated by
investment banking fees. This figure showed up on this analyst's pay stub as a
"helper fee."
A Salomon spokeswoman said that industry pay practices had changed a lot in
the last five years, and that its policy did not directly link analyst compensation
to investment banking transactions.
But gunning for investment banking fees meant keeping stock prices high to
satisfy corporate clients, whether or not those prices were justified. That goal
put analysts at odds with their individual investor customers who looked to
them for unprejudiced advice.
Andy Schopick, an independent analyst at Nutmeg Securities, a small
brokerage in Fairfield, Conn., was an analyst at major Wall Street firms for
two decades but left 10 years ago. He pointed out one huge change in
research reports over the years — the obvious absence of any oversight or
discipline in financial forecasts or company assessments. "In the 60's, 70's and
80's," Mr. Schopick said, "there was a process, and analysts could not put out
wild, unsupported statements and price targets like those we saw taking place
without being challenged. The old research director function seemed to just
disappear into thin air."
A former telecommunications analyst supported this view and said that it
wasn't until mid-2000, after the technology stock slide had begun, that his
research director called together the firm's analysts and advised them to keep
individual investors' interests in mind when doing research. "When the bull
market took off because of the competition for banking dollars, you saw a real
dilution of ethics," this person said. "The pressure was, the valuations were up,
keep them up, keep the banking up and you're always looking over your
shoulder because if the firm didn't think you had it in you to be I.I., they
whacked you."
The race for the latest Institutional Investor rankings, which appear in the
autumn, is now in progress. The ballots go out to portfolio managers in April
and are returned in May. This is why, research veterans say, analysts are
rarely at their desks in New York during May. They are all on road trips,
hoping to snare votes.
Typically, analysts visit fund managers at big customers like Fidelity, Putnam,
Alliance Capital, T. Rowe Price and Janus. But even small shops get face time
— because every vote counts. "Analysts show up in these out-of-the-way
places by the boatload," one analyst said.
The obsession with the Institutional Investor poll explains another research
anomaly: analysts seem to make more positive calls on high-profile stocks
during May than in any other month. That is because institutional investors
who own the stocks analysts cover like to hear positive things about their
holdings, analysts say.
The securities firms place so much emphasis on rankings in the Institutional
Investor poll because it is a sort of Good Housekeeping seal of approval that
gets them investment banking deals. Some firms even have high-level
employees acting as sort of I.I. czars, charged with improving the firm's
appearance in the ranking.
Until recently, securities regulators, charged with protecting the investing
public, seemed unaware of how deeply conflicted analysts were. Perhaps they
should not have been.
Eric P. Von der Porten, portfolio manager at Leeward Investments in San
Carlos, Calif., was disturbed by some outlandish research reports he saw in the
late 1990's, and he complained to the National Association of Securities
Dealers about the work of three technology stock analysts, Jamie Kiggen, then
at Credit Suisse First Boston, Mr. Blodget of Merrill Lynch and Jeetil Patel at
Deutsche Banc Alex. Brown.
"Some of it appeared to me to be inaccurate and misleading and far too
optimistic," Mr. Von der Porten recalled. "I made several efforts to either
contact analysts directly about their research, to point out to the media some of
the problems with the research and to notify regulators when I thought there
were abuses."
Mr. Von der Porten said he wrote to the N.A.S.D. because its manual warned
member firms against just the kind of practices he found common among
technology analysts.
The manual states, for example, that "in making a recommendation a member
must have a reasonable basis for the recommendation." It adds: "No material
fact or qualification may be omitted if the omission, in the light of the context
of the material presented, would cause the communication to be misleading"
and, finally, "exaggerated, unwarranted or misleading statements or claims are
prohibited in all public communications of members."
But none of the cases identified by Mr. Von der Porten in 2000 and 2001 as
having flouted these rules resulted in any action by the N.A.S.D. In all three
cases, the association wrote Mr. Von der Porten saying that an investigation
had been conducted and that no action against the analysts was necessary.
Testifying before Congress on analyst conflicts last February, Robert R.
Glauber, chairman of the N.A.S.D., said the regulator had not hesitated to
crack down on analysts "whose conduct has undermined market integrity." Mr.
Von der Porten later wrote Mr. Glauber expressing disappointment about the
organization's inaction in the cases of dubious research he had identified. In
late April, Mr. Von der Porten received a letter from Mr. Glauber saying that
he had asked Mary L. Schapiro, president of the regulatory arm of the
N.A.S.D., to review the decisions on the three analysts.
Ms. Schapiro declined to comment. Mr. Patel did not return a phone call
seeking comment, and Mr. Kiggen could not be reached.
Meanwhile, Wall Street watches and waits as Merrill Lynch and Mr. Spitzer
wrestle over solutions to the problem of tainted research. All the former
analysts interviewed for this article said they were not surprised that brokerage
firms had been less than eager to reform their firms and eliminate the potential
for conflicts. Research, after all, does not generate income; it drains it.
"Short of separating origination of securities from research and distribution of
securities," said Mr. Vineberg, of Cyrano Equity Research, "the only way for
Wall Street to end the pattern of corruption in research is to enforce a strict
culture of professionalism. Starting when they're young, analysts have to be
indoctrinated that they have a responsibility to conduct thorough analyses on
companies and to protect the interests of investors, especially the
unsophisticated ones who aren't in a position to know better."
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