Confessions of a Wall Street Analyst (51 page)

3. End Analysts’ Wall Crossings

In the end, going over the Wall is just not worth the hazards. It has become an experience that offers more risks than rewards. The potential for disclosure of nonpublic inside information is simply too great. The Chinese Wall should be rebuilt to what it was supposed to be in the first place—an impenetrable barrier that protects the private information of an investment bank’s corporate clients and keeps that information from falling into inappropriate hands, including those of stock and bond research analysts.

4. Extend the Post-Issuance “Restricted Periods” During Which Analysts Cannot Publish

In 2002, the NASD extended what it calls its “restricted period” for IPOs from 30 to 40 days and left the one for secondary offerings unchanged, at 10 days. A restricted period is the amount of time a securities firm and its analysts must wait after an investment banking client issues securities before discussing or publishing a research report on that company. Although the extension was the right idea, these periods are still not anywhere near long enough to reduce the pressures discussed in this book.

We need much longer restricted periods to disconnect corporate executives from the idea that their investment bank should provide supportive research. If the restricted period were as long as a year, companies would then hire bankers with the full understanding that the investment bank’s researcher will be silent for a very long time.

There should also be a long restricted period for M&A transactions, say six months from the time a deal closes, in addition to the many months between the deal’s announcement and its approval by regulators and shareholders. At best, this would encourage corporate executives to hire investment banks for their excellent advice and execution, not for favorable research. At worst, it would encourage companies to hire investment banks that do not have well-followed research analysts, flipping the influential research analyst from an asset who might attract banking business to a liability. What better way to sever these financial ties than to turn temptation upside down?

It is true that this may hurt small investors, especially individuals who have only one brokerage account and thus only one source of research. A year or more is a long time for investors to wait for research reports from the underwriter. Nevertheless, the tradeoff is a positive one.

5. Prohibit Analyst Commentary on M&A Banking No More SEC No-Action Letters

Talk about unintended consequences. The SEC’s 1997 No-Action Letter—the one I discussed in detail in chapter 6 that allows analysts to write about mergers even when a deal is still pending and when their own banks are involved—did as much to corrupt Wall Street research as any of the crooks did themselves. This rule actually put the analyst in an often explic
itly conflicted position. It was inadvertent; the intent was to help out individual investors who might not have access to more than one firm’s research as a deal was unfolding.

But that’s not what happened. Arthur Levitt, who was chairman of the SEC in 1997 when the letter was issued, may have given lots of speeches castigating analyst conflicts of interest. But with this letter, his agency also unleashed one of the most pernicious conflicts in the history of the analyst profession. Before the No-Action Letter, analysts whose firms were advising a company involved in a merger were prohibited from commenting on the deal or on its implications for the two stocks involved in the transaction. So a firm with an influential, well-respected,
and
bullish analyst sometimes lost a deal because the corporations involved knew the analyst couldn’t publish any reports while the deal was in process. Companies did not want to lose that analyst’s positive influence in the marketplace.

The SEC’s move turned that upside down. The regulators apparently forgot that most M&A fees aren’t paid to bankers until and unless the deal closes. So once analysts were cleared to write about pending deals, fee-hungry bankers had every incentive to push them to write positive reports. It wasn’t long before some corporate executives demanded positive research coverage as a quid pro quo for hiring investment banks as advisers on M&A deals. That, in turn, meant it now made sense for corporations, in search of supportive research commentary and higher stock prices, to hire firms with bullish or pliable analysts, fostering blatant conflicts of interest.

As suggested in point four, analysts working for banks handling mergers or acquisitions should be totally restricted from commenting on the involved companies for a long period of time, say until six months beyond the day the deal closes. That means no reports, no target prices, no investment rating, not even bare-bones, factual “outlines of the deal” reports, and no talking to clients about it. The only acceptable research, in my view, would be reports analyzing a deal’s implications for other companies in the industry, provided the implications for the two companies involved in the deal are not discussed in the report.

The implications of this reversal could be radical. Muzzling the analyst would, in my view, turn the incentive and conflict structures on their heads, just as longer restricted periods would. At best, corporate executives might hire investment banks for their excellent advisory and underwriting skills, not for favorable opinions from influential research analysts. And, at worst, companies might intentionally hire bankers whose research analyst is bear
ish in order to silence that analyst and, conversely, avoid hiring investment banks whose analyst is bullish in order to keep that bullish voice alive.

Under these rules, investment banks would have to completely reevaluate whether they wanted to pay top dollar for highly influential analysts, since research could become not just a cost center but also a repellent for investment banking fees. That’s because the more bullish and influential a firm’s researchers, the fewer deals and thus fewer banking fees might be collected. Analyst pay would go way down, as it would no longer be subsidized by the investment banking department. While this raises the risk of lessening the quality and frequency of research, it could significantly reduce the financial incentives that led to much of the dishonest and fraudulent research in the 1990s.

6. Make the Boss Accountable

Although he later pushed all the way to the top of the organization in companies like AIG, Eliot Spitzer, for some reason, ended his investigations of Wall Street firms before finding out whether the top executives of investment banks were involved in encouraging tainted research, IPO spinning, and other misdeeds. I think it was an enormous missed opportunity to change the culture of the Street and deter more bad behavior. Employees (in this case, analysts) often follow the cues and encouragements of their bosses. So, if only the analyst is pursued, the bosses may continue to condone or encourage bad or fraudulent behavior.

7. Tell Individual Investors the Painful Truth

Individuals should
not
be buying individual stocks. I know this is a radical statement, especially coming from a guy who researched individual stocks for a living. But there are simply too many insiders with too many unfair advantages. Biased research or not, insider trading or not, the markets are, and will remain, rampant with uneven information flow. Some privileged or talented professionals will always receive or ferret out information earlier than everyone else. To be an investor in this environment is like being a drug-free athlete whose competitors are all juiced up on steroids.

As you’ve read, analysts were subject to numerous and intense pressures—pressures from bankers, retail brokers, institutional money managers, buy-side analysts, hedge funds, in-house traders, even the press. Most
of these people wanted bullish calls on particular stocks. Some wanted bullish calls on every stock. Some firms—usually hedge funds—pushed for bearish calls on particular stocks they had sold short. Traders often simply wanted more trade-inducing action—more research reports, more presentations to the morning meeting, more break-in calls on the squawk box, and, if possible, louder and more extreme, or “marketable,” calls. The individual investor has no clue about all of these crosscurrents. But professional investors often use these conflicting agendas as part of their investment strategy.

Stronger enforcement of insider-trading rules can help to reduce some but not all of this unevenness. Nevertheless, individual investors should assume that the information and advice they receive regarding individual stocks are stale and, to a large degree, already incorporated into stock prices. Even the majority of professional investors find the deck is stacked against them, since it is only a minority of well-connected, high-commission-paying, deal-absorbing institutions that receive the favored information flow.

In my opinion, it’s better to buy stock indexes or broad-based mutual funds where the edge one professional fund manager may have in one stock may be offset by the advantage another fund manager has on a second stock. Hopefully, one of those groups is managing your money. But if individual investors do buy individual stocks and bonds, the rule should be
caveat emptor:
investors need to be reminded that the various strands of advice they are receiving come from people who have their own, potentially conflicted, agendas. That could be anyone from television commentators to journalists, analysts, bankers, or other groups.

In some cases, these advisers have their own investments and are trying to condition the market to support their position; in other cases, “experts” may be paid by the companies they tout. Of course, there are independent voices, but the point is that it’s impossible to know who really is and who really isn’t independent.

Of all the lessons I’ve learned in my time on the Street, the most difficult one to swallow is that I no longer believe in the transparency of the American financial system. When I came to the Street, I saw it as a place where there were plenty of sharks, but also as a place where American capitalism reigned supreme, a place where everyone had a chance to do well if they were smart, hardworking, and a little bit lucky. It was a game I enjoyed playing—at least until I realized how corrupted the game had become.

But I also came to realize that for people who don’t have access to this
inner sanctum, Wall Street is not a game at all. It’s deadly serious, and it’s rigged against most of its participants—everyone but the few with a seat at Wall Street’s special tables. If you take anything away from this book, I hope it is this unfortunate truth.