TOPICS > Economy

Misleading Investors?

May 21, 2002 at 12:00 AM EDT


GWEN IFILL: The stock market roller coaster has exacted an especially high toll on Internet and telecommunications companies. But the financial services industry, where analysts and investment bankers fueled each boom and bust, has come under tough scrutiny, too, with government investigators now making a case against Wall Street itself, specifically, that many Wall Street analysts hyped companies their own firms were doing business with.

Such behavior would be a violation of what is often called a "Chinese Wall" — an understood separation between a firm’s analysts, who are supposed to give independent advice, and the work of its investment bankers. At this recent hearing, senators told Wall Street analysts that the collapse of that wall is part of what drove the Enron debacle.

SEN. JOSEPH LIEBERMAN: Have the Wall Street analysts kept their part of the bargain? I regret to say that based on the investigation our committee has done, my answer is no, they have not. Ten out of fifteen analysts who follow Enron were still rating the stock as a buy or a strong buy as late as November 8.

SEN. GEORGE VOINOVICH: You now have a problem of appearances. Okay? Before this, you didn’t — the issue of appearances of a conflict of interest. What we are trying to do as quickly as possible is restore people’s faith in the financial markets in this country so we can get back to business.

GWEN IFILL: New York Attorney General Eliot Spitzer has been investigating such conflicts of interest involving Merrill Lynch, the nation’s largest brokerage firm. As part of his case, Spitzer released a set of private e-mails from Henry Blodget, once the star Internet analyst for Merrill Lynch.

In one of the messages, Blodget dismissed the Internet firm Excite@Home, but he touted the stock publicly. He also publicly recommended the Internet stock, but wrote in a private e-mail: "Nothing interesting about this company." Today, Merrill-Lynch settled the case brought by the Attorney General.

ELIOT SPITZER: This agreement provides real reform. It changes the way Wall Street operates, severing the direct links between the research and banking divisions that tainted investment advice.

GWEN IFILL: Merrill Lynch agreed to pay a $100 million fine to New York and 11 other states, separate completely its analysts and investment bankers, and to ban analysts from being paid based on investment banking profits. The firm also issued a public statement of contrition, apologizing to clients and shareholders. Merrill Lynch CEO David Komansky spoke today on CNBC.

DAVID KOMANSKY: We clearly will be above and beyond reproach, have a much stronger system of checks and balances.

GWEN IFILL: The Merrill Lynch settlement does not end the investigation. Several other analysts working at firms like Morgan Stanley, Citigroup, and Goldman Sachs have also been subpoenaed. And late last month, the Federal Securities and Exchange Commission launched its own inquiry.

GWEN IFILL: For more, we’re joined by: John McConnell, professor of finance at Purdue University’s Krannert School of Management; Paul Kedrosky, professor of business at the University of British Columbia — he was an equity analyst at HSBC Securities, an investment bank, in the mid-1990s; and Gretchen Morgenson, a financial writer and columnist for The New York Times. Gretchen, what was the significance of today’s settlement?

GRETCHEN MORGENSON: Well, $100 million is a sizable amount, although to a firm the size of Merrill Lynch, it really is not as large as it is to you and me. And their public apology, I think, is meaningful; however, I do think that we do have to keep an eye on things at these firms because even though they said there were policies and procedures in place to prevent this kind of thing from happening, they obviously weren’t minding their p’s and q’s and Mr. Spitzer found out.

GWEN IFILL: Professor McConnell, do you think this was a significant settlement today?

JOHN McCONNELL: I see good news and bad news in the settlement. The good news is that the sanctions or the agreement was quite mild. It the not going to have much impact on the way business is done. The bad news as I perceive it is that Mr. Spitzer was able to get away with it, basically legislating by the threat criminal indictment, I think that’s a very unfortunate precedent to set for the Attorney General.

GWEN IFILL: How about that Professor Kedrosky, was there an unfortunate precedent set by the Attorney General’s prosecution of this?

PAUL KEDROSKY: Well, you know, obviously you would much rather see the firms deal with these problems themselves. Whenever you have analysts saying one thing in public and doing something else in private or in any way, you know, misrepresenting or even saying anything that suggests something different from what their public position is, I’d like to see the firms, you know, manage that problem inside the firm and not have to resort to having an Attorney General show up and introduce discipline because it is a bad precedent in a sense.

I’d rather not see litigators show up telling companies how to run their own businesses certainly. But in this case, there is just no sign that the major brokerage firms were doing very much concrete to change the way they’ve done business for many, many years now.

GWEN IFILL: Gretchen, let’s talk about they way they’ve done business. Is this a widespread practice, what was happening at Merrill Lynch and which apparently he is investigating other companies for as well?

GRETCHEN MORGENSON: It is hard to know. We do not have all the documents from the other firms, but can I tell you that during the mania, the tech stock boom that we had in the late ’90s and in 2000, "anything goes" was the mantra.

That meant as long as the investment banking fees were coming in, rolling in, and as long as investors were eager to have the next offering, really there was nobody minding the store, nobody policing, nobody making sure that these recommendations had some basis in fact. There were crazy evaluations given on these stocks by these analysts that were held out as independent observers.

GWEN IFILL: Professor McConnell, if you believe the Attorney General should not have been involved in this, then who should have been minding the store?

JOHN McCONNELL: First, I’ve looked at the e-mail messages in detail including the one that Mrs. Morgenson had in her New York Times article. And in that particular e-mail, she excised, deliberately excised the last sentence, which completely exonerated Henry Blodget. So having looked at the evidence I don’t–.

GWEN IFILL: How did it exonerate–

JOHN McCONNELL: — know that I’ve seen any evidence that there’s anything wrong. So I’m bewildered to the rush to somehow correct a problem I don’t perceive existing.

GWEN IFILL: Share with us, how do you believe that that last detail in the mail exonerated Henry Blodget?

JOHN McCONNELL: Sure, let me read it to you. I’ll be happy to do so — if I can find it in my notes — the last sentence was as follows: It is hugely ironic to me that we are being investigated for potential conflict of interests over a stock that we put a neutral on and after that we upgraded it, doubled it and downgraded and it dropped 40 percent. If there was ever a better example of independent high-quality research, I don’t know what it was.

GWEN IFILL: Gretchen, is that exoneration?

GRETCHEN MORGENSON: Not in my view at all. I mean his idea of what a neutral was on that stock was eight pages of breathless recommendation to buy it — it really was not neutral at all.

GWEN IFILL: Professor McConnell, is there a possibility, is it even possible for complete separation between these two parts of the same whole, which is to say the analysts, the research arm of a company, and the investment banking? Is that even doable?

JOHN McCONNELL: Well, I tend to think in terms of letting the markets separate and regulate our enterprises, and an institution such as Merrill Lynch or any other financial institution is not providing its customers with the services they demand and expect. There are many, many, many alternatives available — discount brokerage firms, full service brokerage firms, incredible opportunities for individuals within the U.S. to trade through any number of mechanisms.

And if Merrill Lynch or any firm is somehow deceiving their customers and clients, they will go elsewhere. That’s the beauty of the American capital market. We are not forced to participate and if we do choose to participate, we can participate by any mechanism or any vehicle or any avenue that we desire.

GWEN IFILL: Professor Kedrosky?

PAUL KEDROSKY: I think that’s true, but having been on both sides of the fence on this one, there is a deeper context here, which is that insiders in the business, the sophisticated investors, people like Fidelity, the big institutions buying stocks, they know that analysts’ estimates aren’t worth the paper it’s written on, it’s generally obfuscation and cheerleading, general confusion and noise.

But people in retail investors, the waves and waves of people like you and I who showed up in the markets the last decade, they didn’t know that. No one gave them a crib sheet telling them this is the way the game works.

So now we are all standing back saying you should known better, and I think to some extent, Caveat Emptor, buyer beware, does apply but by the same token you know there’s a lot of – you know – sub-message here that these folks didn’t get — they didn’t know that analysts estimates largely come back from the company. They don’t know that the recommendations that analysts make, it’s very difficult not to be influenced by investment banking relationships. I’ve been there. I saw it.

GWEN IFILL: Well, Gretchen, tell us who was hurt by this. Are we talking about individual investors, are we talking about large investors, small time? What are we talking about?

GRETCHEN MORGENSON: We’re pretty much talking about probably newcomers to the market, which were coming in in droves as you know in ’95, ’96 and through 2000. They were lured, of course, in by low cost trading, which was, you know, much different from the way it had been in the early ’90s or ’80s.

I guess my fear about the whole thing, Gwen, is that this really goes to the heart of the trust in the capital markets, the idea that a firm’s research is somehow related to its investment banking deals is going to give investors pause about whether or not they should buy stocks at all. So the fact that there were no internal police mechanisms at these firms to prevent this thing from happening is troubling to me because I know America has the best capital markets in the world, and they ought to stay that way.

GWEN IFILL: Professor McConnell, what about that? Has trust been undermined by individual investors in the market and in these companies?

JOHN McCONNELL: Let me go back to the point that there was no internal monitoring. Again, I’ve looked at the evidence and I have not seen the massive breakdown in the internal mechanisms that have been so widely declared. That’s the first point.

As regards trust, we have money invested in our capital markets from every country in the world. I have basically my entire retirement fund invested in equity markets, and have had for 30 years. So I personally have complete faith in the integrity of our capital markets. Does that mean I haven’t lost money? No, of course not. But that’s to be expected. It is a risky undertaking, and sometimes we are going to lose and sometimes we are going to win.

GWEN IFILL: Let me ask you about the things that Merrill Lynch agreed to today in the settlement with the Attorney General. They agreed to change compensation for analysts, to put that in a different stream, and they agreed to the complete separation we are talking about. Was that an admission by Merrill Lynch that they were doing things the wrong way before?

JOHN McCONNELL: First, I don’t know what their compensation strategy was before the fact, so I don’t know to what extent this is a change in their practice. My understanding has been, and I defer to Professor Kedrosky on this point because he has worked on the street — my understanding is that the analysts are by and large paid on the basis of their evaluation by customers; that is the retail and wholesale brokerage customers. I really don’t know to what extent that is a change in Merrill Lynch’s compensation strategy or techniques.

GWEN IFILL: Let me give that question to Professor Kedrosky as well.

PAUL KEDROSKY: You know, it’s all money to the same pod. In a sense, it is hard to get away from the research salaries coming from investment banking, so the question from my point of view is just how explicit that connection is made.

And Elliot Spitzer gave some documents showing how there had been explicit connections in a cases of a number of analysts, a couple between the business they brought in from an investment banking standpoint and how they were paid as analysts. That’s not a widespread phenomenon, to make an explicit connection like that.

But by the same token, money is I mean money, whether it comes in from investment banking or it comes in from other ways. At the end of the day, if it shows up in my paycheck, I’m not done [ph] and I can recognize that and I know how my bread gets buttered.

GWEN IFILL: Now that the SEC is talking about getting involved in the investigation, what do you expect them to do and what can their role be in this that the Attorney General hasn’t taken on himself?

GRETCHEN MORGENSON: Well, of course they are the nation’s securities regulators so they’re, you know, on a federal level, obviously the top dog in this department. And they are already formulating new rules and regulations that they want the firms to adhere to with the other regulators like the National Association of Securities Dealers. So, and they have said today in a statement that they will continue to investigate this; that this is by no means the last word on this matter. So I think that they will continue to do so.

GWEN IFILL: Does the settlement today protect these companies from civil lawsuits?

GRETCHEN MORGENSON: Not at all. They are obviously open to any case that can be made by a lawyer. Of course it has a lower threshold than a criminal case — the proof of it. But I think that these firms are still very vulnerable to that kind of civil litigation, whether it’s in an arbitration or a class action lawsuit.

GWEN IFILL: So, Professor McConnell, in your opinion, will today’s settlement change the way business is done on Wall Street?

JOHN McCONNELL: I want to go back to this point that Mrs. Morgenson, noted that the firms — particularly Merrill Lynch – are very vulnerable – that that presumes that the evidence is, in fact, at it has been portrayed. I’m personally not yet convinced of that case. So I think it is yet to be determined to the extent to which they’re vulnerable.

Now, the second point you just asked me, will it change the behavior? My own sense of reading the wire service reports on the settlement is that it is a relatively mild set of recommendations to which Merrill Lynch has agreed. Again, I defer to Mr. Kedrosky– Dr. Kedrosky, but my impression is that it is a little bit to do with compensation and there is going to be a committee, an oversight committee. It’s my experience, and again I defer to Professor Kedrosky–.

GWEN IFILL: Will let me divert that question to Professor Kedrosky again.

JOHN McCONNELL: Oh, sure, absolutely.

PAUL KEDROSKY: Is it going to make a change? Yes and no but – it’s going to make a change but not for the reason that I think it has been presented as. The thing that is going to change in the industry is there is now kind of a sea change and people’s awareness of what independence really means. I don’t think the specific sort of rule-making that you see going on is going to materially change the way analysts work.

But I think – you know — forcing people to be more aware that there are people out there who actually, you know didn’t understand the role of analysts and what objectivity means, you know, maybe that’s in a small way a change that’s rippling through the industry – will it change things in a wholesale way, I don’t think so, unfortunately. I’m kind of pessimistic about that.

GWEN IFILL: Thank you very much for joining us.