Wall Street Firms Paying Up

TERENCE SMITH:

Since last April, federal and state prosecutors and industry regulators have investigated conflicts of interest at high-profile Wall Street securities firms, including Citigroup, Merrill Lynch and Goldman Sachs. Today they announced a $1.4 billion settlement. Among the provisions: A ban on Wall Street firms offering exclusive "initial public offerings" in a company's stock to executives who could also influence investment decisions at the firms. New York Attorney General Eliot Spitzer announced the settlement this afternoon.

ELIOT SPITZER:

We do have to insulate analysts. We cannot permit analysts to have their compensation be contingent upon investment banking revenues or their success at bringing in investment banking business. It simply can't be permitted to happen, and so we have tried to build what we call a cocoon around the analysts at the investment banks.

Second, we need transparency. What does that mean? It means the American public needs to be able to understand, are these analysts good or not? We will provide independent research. The investment banks will provide it. Why? So that retail investors will have a counterpoint against which they can judge the research that is being provided to them by the investment houses. They may use it, they may ignore it, but it will be a reference point which will provide comparison and analytical value, and that's why all of us believe this is instrumental. We will have fines, and as Steve said, those fines, to the extent practicable, can be and we hope will be returned to the investing public.

This has been only about one thing: It has been about insuring that retail investors getting a fair shake. Retail investors know there is no guaranteed return in the market. They know there is risk, but the one thing they deserve is honest advice and fair dealing. That is what this deal is designed to produce.

TERENCE SMITH:

Now for more on today's settlement, we're joined by James Cox, professor of corporate and securities law at Duke University, and Charles Elson, director of the Center for Corporate Governance at the University of Delaware. Welcome to you both.

Charles Elson, the essential conflict here is about analysts who were giving stock tips on companies that their firms either were doing business with or hoped to do business with. How does this settlement resolve that conflict?

CHARLES ELSON:

Well, I think the idea is now that you've insulated the analyst from the pressures of the investment banking side, the underwriting side in the investment bank so that the advice that they now render will be truly independent advice. The difficulty up to now, as we discovered through the revelations of these investigations, was that their advice was compromised; that they were thinking about not only the company's future but apparently their own or their bank's future as well and that was totally and completely inappropriate.

TERENCE SMITH:

James Cox, how do you create this so-called "cocoon" around this analyst around investment banks?

JAMES COX:

Today's settlement doesn't add anything to the cocoon. The cocoon was really finalized and woven last may 8 when the SEC approved industry wide rules proposed by the New York Stock Exchange and the NASD that laid out strong framework for making sure the analysts are not beholden to the investment banking side. Those rules are rather elaborate. They went on the books May 8. And today's settlement doesn't really change anything one iota. What is new about today's settlement is putting some money on the table, $800,000 in restitution, $450,000 commitment–.

TERENCE SMITH:

$800 million I think you mean.

JAMES COX:

$800 million. And $450 million guaranteed for buying research over the next five years and $85 million for investor education. All told, like you said, $1.4 billion. For this group of investment bankers, for this industry, that's essentially walking around money, a very small settlement, very underwhelming.

TERENCE SMITH:

Underwhelming, Charles Elson, a very small amount of money?

CHARLES ELSON:

I don't think $1.4 billion is underwhelming, at least not to me. And even I think to the banks, that's a substantial penalty. But you have to understand, it is not just the fines they are paying. The reputational damage that they've suffered through this effective admission that something had gone wrong is far more devastating to them long-term than the fines that are paid. Their reputations have been hit very severely for delivering independent advice. And I think that the admission that this settlement represents– or if not admission, certainly acquiescence, is the key to it. Wall Street works on reputation. Their reputation took a terrible hit, in my view at least, through this settlement. And I think the punishment that they will derive from this effective acquiescence really goes way beyond the $1.5 billion, which I might add is not an insubstantial sum, I might add.

TERENCE SMITH:

James Cox, the agreement also requires firms to provide their customers with so- called independent research. What is independent research in this case, and how valuable is it?

JAMES COX:

Well, I think independent research… this is based on a hopefulness that this research will be independent. The devil is going to be in the details. Just exactly how we are going to make sure the investment bankers are going to be totally neutral in who they select to provide this independent research under their contract. My guess would be that there is going to be a strong bent toward selecting research firms that have a tendency to have "buy" and "strong buy" recommendations, not "sell" recommendations. And, so… and I think the genie is out of the bottle on that. Anybody who wants to get these contracts with Merrill Lynch or Credit Suisse or anybody else is knowing they have to be able to persuade individuals at the banking investment houses that they will have research that will not embarrass Merrill Lynch, Credit Suisse or anybody else.

TERENCE SMITH:

Charles Elson, will that independent research be credible and independent?

CHARLES ELSON:

I think any time you look at research in front of you, both the research from the bank and the independent research, it enables you to make a more informed decision. I think the key coming out of this, though, is that people are going to be a bit suspicious of what they're going to be reading coming out of the banks because of this. It is going to take a while, a long time, I think, for the credibility to be restored. And I think having those two items sort of side by side as you review an investment decision I think will be very important to you.

But remember, you are always going to have in the back of your mind the fact that there was a scandal that led to this. And I think that people will probably discount a bit the advice they're getting. At least they'll have it in their mind, and I think that will strengthen at least the push to the banks themselves to ensure that these analysts, their own analysts, are in fact independent. But it is not going to happen overnight vis-à-vis public perception. I think it is quite effective. I don't know what else they could have done or how much further they could have gone here. Certainly an action that would have bankrupted these banks wouldn't have been in the interest of anybody. I think, again, the reputational hit that they took, the fines they paid, and the idea that they're going to have to insulate their analysts will keep everyone certainly on their toes for the next couple of years. And I think the public will recognize this as well.

TERENCE SMITH:

James Cox…

JAMES COX:

There is no doubt you are going to bankrupt the firms. Their accumulative net worth is in the hundreds of billions of dollars. That's small compared to the trillions of dollars suffered in the capital markets as a result of the financial manipulation the firms allegedly participated in.

TERENCE SMITH:

Mr. Cox, one of the provisions in this agreement is against spinning, which is essentially giving favored customers the inside track on initial public offerings, offerings on which they make money very quickly. How widespread a practice was that and how effective is this agreement going to be in ending it?

JAMES COX:

Well, that practice was reported in the press four or five years before the market bubble burst. Nobody brought any prosecutions at the SEC. It violated about five or six major principles of SEC rules — not to mention the general rule of fair dealings by… that's imposed on all broker-dealers by the NASD. And I think these practices will come back when the market is back and a hot market. The real question is aggressive enforcement. I don't know why we didn't bring enforcement actions against these matters before. I suspect it's because we didn't have an adequate enforcement budget or that there are too many other things to chase after. So… and by the way, this only bars it for these ten individuals. Again, it's already barred in a lot of other rules. I think the settlement has less… there's less in this settlement than really meets the eye, frankly.

TERENCE SMITH:

Charles Elson, what is your view on the spinning provisions? Do you think there is real protection there?

CHARLES ELSON:

Well, again, you have to look at the sort of flip side of this. I think the practice itself was completely inappropriate and totally unacceptable. But think of it this way. The spinning practice, not only is an offense to those who trade in the market, but also to the directors, the boards of these companies who are overseeing these executives. The executives were effectively taking a side payment. And the folks who are going to be enforcing this will not only be the SEC, But the directors of their companies are going to be very vigilant and very questioning on this matter going forward. Because effectively it was a side payment, it appeared to be a side payment to an executive that the company was unaware of and didn't share in. It was inappropriate. And I think that's really the issue here; that going forward, the boards of these companies are going to be very, very concerned about this. It is going to be the sort of thing that comes out at board meetings going forward. And that combined, I think, with hopefully strong enforcement by the SEC — and I agree with Professor Cox on this completely. This is a practice that is just a terrible practice. And they should enforce against it. But that combined with a more vigilant board of directors, which is coming out of the reforms that we saw this summer, the independent boards, the equity holding, I should say, independent boards, I think this will become much less likely to occur.

TERENCE SMITH:

James Cox, Elliott Spitzer said the central purpose is to restore confidence in the markets, convince the investor that he or she gets a fair shake. Is this agreement going to do that?

JAMEX COX:

Well, I think every enforcement action we bring successfully has some modicum of movement in that direction. I think what is really driving the settlement here is a need for an exit strategy for everybody who had been sort of pumping this matter for all it was worth and saw it was soon going to be a dry hole. Spitzer had limited resources, the SEC's leadership at this point, the NASD and NYSE were both embarrassed about this scandal. It was a game strategy for everybody to put this behind them. They did it and the settlement is an underwhelming settlement, a small amount of money compared to the amount of losses suffered or the amount that these investment banking firms could have paid. It was a win-win strategy for the respondents and the regulators, but at the end of the day that it doesn't really bring much change in the marketplace.

TERENCE SMITH:

Just a final comment from you on that, Charles Elson?

CHARLES ELSON:

think it was a good settlement and I think that hopefully these practices will come to an end. Again, the embarrassment factor, and I think additionally, the fact that people are going to be looking out for this going forward. I think the point was made, the issue is not the past at this point, but how do we stop it from happening again? I think with the attention and public focus on this both from the boards' standpoint, the public's standpoint and the regulatory standpoint, hopefully this will be a practice that died a very quick and painful death.

TERENCE SMITH:

Charles Elson, James Cox, thank you both very much.