Confessions of a Wall Street Analyst (50 page)

But since many of these factors are subjective, there’s still plenty of room for management to reward “banker-friendly” analysts with higher compensation. This means that the analyst can never really stay entirely free of banking as long as the investment banking department still pays many of the bills.

One possible alternative is that firms could pay research from the profits earned by the sales and trading departments, not by investment banking. Analysts could be still be evaluated based on a variety of quantifiable factors: stock performance, sales force feedback, survey rankings, quantities (of reports, morning calls, buy-side client meetings, and phone calls), trading volumes, and trading profits, although this, too, creates a conflict—who gets information from the analyst first, outside investors or internal traders? It might clean up the banking conflict, and analyst pay might fall significantly, but this arrangement might also increase pressures on analysts to put in-house trading interests ahead of those of outside investors.

2. Research Cannot Report to Anyone in Investment Banking

Merely redesigning the organization chart does not solve the conflict-of-interest problem, nor remove the temptation for investment banks to put the interests of its corporate clients above those of its investor clients.

Theoretically, research could report directly to the CEO, ostensibly insulating research analysts from business units within the firm. However, it is not practical for a CEO to directly supervise an entire research team given
the demands on his time. Even if it were, such an arrangement would not eliminate the basic conflict of interest. The fact remains that the CEO’s ultimate goal is to increase profits. Since investment banking generates profits and research doesn’t, the CEO and other top executives still have a powerful incentive to reward employees who contribute to the firm’s profitability or, at least, to look the other way when bankers are applying pressure on analysts.

This was not my personal experience, however. I worked and traveled with five CEOs and presidents of Wall Street firms: Dan Tully, David Komansky, and Herb Allison at Merrill; Allen Wheat at CSFB; and John Mack at CSFB and Morgan Stanley. None of them ever asked me to alter my research opinions or tone, and none of them ever asked me to take a “fresh look” at any of the stocks I covered, as Sandy Weill admitted asking Jack Grubman to do on AT&T shares. But there is no doubt that each of them served as their firm’s consummate banker and supersalesperson. In the end, not allowing research to report to banking prevents some overt conflicts, but it shouldn’t be seen as a panacea.

3. “Independent” Research Mandated for Five Years

The Spitzer settlement requires each of the major Wall Street firms to offer its clients multiple research reports on each stock it covers, including reports written by “independent research” professionals, that is, firms with no involvement in investment banking activities.
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Each bank is required to pay the independent firms from the $1.4 billion in fees paid in the settlement. So, for example, if you are a client of Merrill Lynch and you are thinking of investing in Google, upon your request your broker must now send you several reports on Google, one written by a Merrill equity analyst and the others by independent research firms hired by Merrill.

I think this “reform” should be ended as soon as possible. It is a waste of money, gives individual investors a false sense of trust, and it is rife with potential conflicts anyway. For starters, I’m not too sure what makes the researchers employed by the “independent” firms so independent. If their firms are competing for contracts with the top investment banks, wouldn’t their analyst be tempted to be more bullish in order to help those banks build better relationships with their banking clients?

It’s also a safe assumption that the pay for research analysts at these independent firms will be lower than at the big banks. So won’t these “junior” analysts be out to impress the investment banks and then get hired by them?
And, in order to counterbalance the bullish bias of the banks, the independent firms may end up with a negative bias. The final problem is that, of course, there is no guarantee that independent research will have much quality. Mostly younger and less experienced analysts will be hired. And since the settlement set a time limit of only five years for the independent-research requirement, the employees will have short-term mind-sets.

4. Analysts Can No Longer Participate in Road Shows or Beauty Contests

Analysts should be banned from attending “beauty contests,” which are competitions where companies choose underwriters, but I think they should be allowed to attend “road shows,” the traveling circus of presentations to large investors where managements pitch their stock.

In the past, analysts played a key role in explaining a new offering, such as an IPO, to investors. They often accompanied the company’s management on the “road show.” Under pressure from Eliot Spitzer and the SEC, the NASD concluded that analyst participation in road shows can heighten pressure on the analyst to be bullish on that stock in exchange for the banking business. The NASD’s solution was to ban analysts’ participation in and attendance at road shows.

I think the decision is absurd. I don’t see how accompanying management to meetings with big investors makes the conflict question any more or less problematic. The rule does, however, constrain an analyst’s ability to understand the company and do good research. I attended road-show presentations because I wanted to hear what kinds of questions potential investors were asking and I wanted to hear how management answered those questions. Getting this perspective helped me do my job, which was to know this company, its management, its financials, and its strategy inside and out. What is even more absurd is that under the new rule, analysts from other banks are allowed to attend some of the meetings but an analyst whose firm is managing the offering cannot. If an analyst ends up less informed than he or she otherwise would be, it’s a disservice to all investors.

Now let’s look at beauty contests, which are the inverse of road shows. Here, a bank, not a company, showcases its services in the hope of winning the right to handle a company’s upcoming stock or bond offering. Typically, company management sits on one side of a table while groups of bankers and analysts traipse in, one after another, spreadsheets at the ready, hoping
to convince the company that their firm should handle the deal. In my view, banning analysts from attending beauty contests does little to eliminate or even reduce conflicts. If an investment banker wants to pressure an analyst for positive coverage of a company
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if the analyst is willing to bend to that pressure, skipping a beauty contest won’t make much difference. That said, unlike at the road show, the analyst doesn’t learn much about the company at beauty contests that would improve his research. For that reason, I don’t have a problem with prohibiting analyst attendance at these meetings.

5. Analysts Should Not Attend Board Meetings

This is not a formal rule, but it is becoming the de facto way of doing business on Wall Street. I think it is silly. A really good analyst is an expert in his or her industry, which means that members of boards of directors, who often are
not
industry experts, could benefit from his or her insights. If a board wants to hear those insights, why can’t an analyst make a presentation?

The key is to keep analysts and all outsiders away from observing actual board deliberations. That is what creates the potential for analysts revealing inside information.

6. Each Analyst Must Have a Certain Percentage of Sell Recommendations in His Portfolio

This is not officially part of the NASD’s new rules. However, some investment banks have set sell quotas for their analysts, such as my former firm, CSFB, which requires each of its analysts to rate at least 15 percent of his or her coverage list “Underperform” or “Sell.” This is true even if the analyst thinks that investors should be overweighted in his sector versus the broader market indices.

The problem with this rule is that mandating sell recommendations only leads to bad stock picking. It is true that sell recommendations were as rare as a blue-footed booby during the 1990s and that the inflation of investment recommendation ratings—in effect, grade inflation—was truly out of control.

The problem here is that this is one of those rules that sounds great but is far too easily circumvented. I, for one, never wasted time writing reports on companies or stocks that looked like bad investments. My job was to
find good investments for my clients, which naturally skewed my attention toward companies with better-than-average prospects and, therefore, my ratings to the positive side. With quotas for Sell-or Underperform-rated stocks, analysts will simply add a few bad companies to their coverage lists to meet the quota. It does not necessarily mean that stocks of banking clients will now be rated Sell, nor does it mean the analyst will be free from conflicts or pressures to be bullish.

Moreover, what many people have forgotten is that a Sell recommendation can sometimes be very bad advice. In the 1990s, most Sell ratings would have been the wrong ratings because the bull market, as it turned out, was an extremely powerful one that took on a life of its own.

7. Analysts Must Certify That Their Opinions Are Their Own

As of April 14, 2003, analysts must sign a form attesting that they believe what they have written in a given report.
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This might be helpful in the sense that it reminds analysts every time they write a report that they are expected to be independent of the bankers and to publish honest research. But in my view, analyst certification does nothing more than that.

The reality is that liars will be liars, whether they sign a certification form or not. Does anyone really believe that someone who was willing to recommend a stock for reasons other than the merits of the stock would hesitate to lie on the analyst certification form? The same can be said about the Sarbanes-Oxley requirement that CEOs and CFOs of publicly-traded companies must certify in writing the accuracy of the company’s accounting and financial statements. Would WorldCom’s Scott Sullivan or Enron’s Andrew Fastow have been honest CFOs if they were required to certify their company’s financial statements? Dishonest analysts will have no trouble signing their names to anything. Honest analysts are already publishing honest research. That said, requiring certification doesn’t have a downside, as long as investors don’t allow themselves a false sense of comfort.

What Needs to Be Done

1. Stop Making Crime Pay: Vigorously Prosecute Insider Trading

Investment banks are sieves when it comes to insider information. Sometimes it is as simple as a driver or corporate security guard overhearing a conversation or noticing that some high-level executives from another company have come in for a sudden visit. Sometimes, it happens when analysts go over the Wall and are tempted to share some of what they’ve learned so that they seem better-connected in their industry. It’s a self-reinforcing, vicious cycle: the more “in the flow” an analyst is perceived to be, the more influential he or she will be, because investors will be more willing to follow his or her advice. The more influential he or she is, the more corporate executives will seek out his or her research support, which of course leads to pressure on the analyst to write positive research. As a result, that analyst can bring in bigger and bigger banking fees.

The only way to put an end to the cycle is to make it clear that insider trading in any form, including knowingly trafficking in inside information, will get you substantial time in the clink. Anyone who acts illegally as a tipper or tippee, including lawyers, secretaries, drivers, delivery services, printers, bankers, or analysts, should be harshly prosecuted with much longer sentences than currently exist. That would have tremendous deterrent impact. As we’ve seen, the enforcement of insider-trading laws has been spotty at best. The spread of inside information is much more pervasive than people know, and it will continue to flourish until the law is vigorously enforced by securities regulators and government prosecutors.

Wall Street is an extraordinarily tempting place. Money is everywhere, in huge, unfathomable quantities. Everything there—one’s stature, one’s self-esteem, one’s past, one’s future—is defined in terms of money. In view of this, shouldn’t we offset those temptations with more vigorous enforcement of insider-trading laws?

2. Force Insiders to Repay Fraud-Inflated Stock Profits

Second, I propose a new federal law that requires corporate insiders to repay profits obtained by selling shares that have been artificially boosted by
fraudulent financial disclosures. I first became aware of this idea when I stumbled upon a blogger named Mark Pincus.
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His idea is essentially that any insider who sells stock during a time of accounting fraud (and subsequent restatement) must return his or her profits to the extent they are attributable to the fraud, regardless of whether the insider knew about the fraud.

Of course, some constraints would be necessary. For example, “insider” would have to be clearly and quite narrowly defined; government attorneys and private plaintiffs would have to convincingly quantify the degree to which the relevant stock price was inflated; and a statute of limitations must apply.

A law like this could have a profound deterrent effect on corporate accounting fraud. Corporate executives who might not investigate wrongdoing or who might ignore it altogether might, instead, dig deeper to make sure the company’s financial reporting and accounting are legitimate.

Government attorneys and private plaintiffs would have to overcome two hurdles. First, they would have to prove the seller fit the definition of an “insider.” Perhaps the law could define an insider as the top 50 executives of a publicly traded company, plus members of its board of directors. Second, they would have to establish the amount by which the security’s price was fraudulently boosted. That would involve subjective estimates and valuation work, but juries and judges often make judgments of this sort when awarding damages and imposing penalties. In contrast to current laws, government attorneys and private plaintiffs would not need to prove the insider had knowledge of the fraud or used material, nonpublic information in the decision to sell.