Wall St.'s conflict-of-interest crisis
Commentary: The right incentive is a stiff penalty
By Bambi Francisco, CBS.MarketWatch.com
Last Update: 12:11 AM ET April 30, 2002
SAN FRANCISCO (CBS.MW) - Preserving independent perspective within any organization is an age-old problem.
Just because there is supposed to be institutional separation of interests and responsibilities doesn't mean it happens.
We know from countless examples across various industries that the attempt to insulate objectivity is easier said than done, whether in the media, the courts, Congress, government intelligence or a town hall.
Books have been written about these kinds of conflicts of interest because they are part of the human condition: the human will often is not in sync with reason.
Why then is there ongoing scrutiny about sell-side analysts and their inherent conflicts of interest over corporate banking relationships with the companies they cover? The brokerage industry has become the latest ignominious pillar of society in which truth has been sacrificed for commerce. This we know. Their credibility is shot. Now, shouldn't we just let it go?
I don't believe so.
Yet, some roll their eyes in disbelief that investment banks, such as Merrill Lynch (MER: news, chart, profile), Salomon Smith Barney (C: news, chart, profile), Goldman Sachs (GS: news, chart, profile) and others, have to answer to investigators and attorneys for distributing poor research. After all, analysts are giving their opinion and they have no fiduciary duty to individual investors.
"Investors should have known that "sell-side" analysts are biased towards the companies they research," the argument goes. "Who listens to analysts anyway? The best ones leave to manage money. We all played the game, and individual investors should be accountable. If we change the structure, we'll eliminate free research altogether and what's to happen to the free analysis that serves as a good basis to, at the very least, stay informed about companies and industries."
Stiff penalty
All this is true. But the arguments won't defeat the growing clamor for some penalty commensurate with the scope of the problem: the loss of the public's trust in the nation's stock market.
The crux of the issue is in the way Wall Street compensates and evaluates analysts. Even if there is no hard evidence that analysts compromised their objectivity in order to win a banking client, it's not hard to imagine there is temptation in place to do so.
It's not so much that analysts were unethical, but that they operated in a system with perverse incentives.
Therefore, it's hard to believe we can get beyond this scandal until a just penalty paid by the investment banking houses is exacted.
There is too much money and reputation at stake. If all we get is an outline of best practices and an apology from Merrill. It won't be enough.
In order to have meaningful change, there must be an incentive to do so. Short of splitting up the banking and research arms of Wall Street investment houses, the incentive should come in the form of a stiff penalty and a change in rules.
"The investment public would be better off if the government regulators found a swift and appropriate penalty or means of resolving and deterring, like a government fine or sanction eliminating practices altogether," said Norm Blears, a securities lawyer at Heller Ehrman.
"Something criminal will come out of this," said David Tice, a portfolio manager who testified before Congress last year regarding the conflict of interests on Wall Street. "I'm a believer that there needs to be some criminal penalties in a number of white collar crime areas."
Will criminal charges or fines be enough, though? The charge might not bring back credibility just yet, but it's a step. At least it sends the message that those in the driver's seat of these financial institutions must accept responsibility.
Last week Merrill Lynch's CEO, David Komansky, issued a public apology after New York State Attorney General Eliot Spitzer unveiled in-house e-mails from analysts trashing the very Net stocks they were touting as "strong buys."
Spitzer's move helped spark the SEC, which launched its own probe as well, if only to recapture the moral high ground as champion of investor rights, according to some observers.
But efforts to spin and minimize the damage have already begun.
On Monday, Komansky went on CNBC saying he disagreed with a report last week by Prudential Securities, which said that the conflict-of-interest case could cost the nation's largest brokerage some $2 billion in a worst-case scenario. Instead, a resolution is likely to come in the next two weeks, Merrill's CEO said. See full story.
I'd still wager that the penalty is far steeper than we think and will make CS First Boston's $100 million in charges for its IPO dealings look like a drop in the bucket.
After all, banking IPOs might bring in a nice check, but the follow-on business offers even more rewards.
In 1998 and 1999, U.S. investment firms helping to bank follow-on offerings generated $6.29 billion in fees, according to Dealogic. This compares to the $5.87 billion generated through the participation of IPOs when the IPO market was still booming. In 2000, banking convertible securities helped generate $1.5 billion in fees while follow-ons generated $4.3 billion. IPOs in that year generated a mere $3.4 billion.
Alternate resolutions
If not fines, one remedy seemingly gaining traction is the linking of analysts' bonuses to their stock picks and making them buy stock each time they reiterate a "buy" rating.
"I'd love to have analysts own the stock," said David Keating, who is a consultant for the National Taxpayers' Union, and who was tapped in 1996 to serve on a Congressional advisory commission on the failings of the Internal Revenue Service. A bill was finally passed into law in 1998 that changed the ways IRS employees were evaluated, and eliminating bonuses tied to money collected or how many cases they closed. The restructuring of the IRS serves as an interesting analogy as the government did step in to ensure fair treatment of taxpayers.
VeriSign (VRSN: news, chart, profile) had 20 "buy" ratings in January, according to Thomson Financial/First Call. At least a couple of independent analysts had been calling for shares to tumble well over a year ago. Shares are down nearly 80 percent since January.
Adelphia (ADLAE: news, chart, profile) had 10 "strong buy" ratings in January. Shares of Adelphia traded at $31 this past January. They now trade at sub-$10 levels.
But regardless of what the final regulatory response is to Wall Street's latest scandal, the harshest penalties have already, to some extent, come from the marketplace.
Investment banks have lost clients as they watch companies they helped raise money for go bankrupt in record numbers. Just over 250 public companies filed for bankruptcy last year, or twice the number that filed in the last recession, according to a survey by PricewaterhouseCoopers. (See report). PWC expects 200 more bankruptcies this year, with Global Crossing and Kmart kicking off the major bankruptcies this year.
In the past 12 months, 45,000 banking jobs were lost, according to the Bureau of Labor Statistics.
We all know the countless jobs lost in the investment banking and research industry, where former analysts feel some Puritan scorn as they wear the stigma of poor research by wearing a virtual embroidered "P" on their pin-striped jackets.
But the steepest penalty, I believe, is the loss in credibility. And that's been deteriorating for the past year, if not longer. Certainly, buy-siders aren't listening to the expectations put forth by analysts and the companies they follow.
UBS Warburg just released a report surveying a small group of "buy-siders."
The investment bank asked: "Do we believe the sell-side growth estimates in 2002 and 2003?" The answer: No. In fact, buy-siders expect a decline of 1 percent in earnings growth this year. This compares to Wall Street sell-side estimates projecting profits to grow by 38 percent this year, with 137 percent year-over-year growth expected in the third quarter.
The buy-side also expects profits to grow by 24 percent in 2003, well below the 48 percent expected by Wall Street analysts. |
