If you’re like a lot of people, you rely on the Web site Yahoo! Finance for an up-to-the-minute summary of market news. And well you should. There it is, all neatly lined up: “Today’s Markets,” “Stock Research,” “Financial News,” and other useful categories on one side of the page. One of the most useful features is something called “Popular Stories”—recent articles from news agencies and press-release wire services, posted because they were most frequently accessed by users. If you accessed the Yahoo! Finance site at midday on January 19, 2005, you would have seen that ConocoPhillips was applying for a new liquid-natural-gas terminal. Below was word that John M. Dutton & Associates, a Wall Street research firm, had upgraded the shares of Ampex Corporation to “strong buy.” Below that, you’d have read that Pfizer stock was surging because of strong drug sales.
The Dutton report, which you could have accessed by clicking on the hyperlink, looked very much like the announcement of a typical analyst report. Down at the bottom, under “About John M. Dutton,” you would have found that “Dutton & Associates is one of the largest independent investment research firms in the U.S.” Then you’d have read that “its 29 senior analysts are primarily CFAs”—that is, chartered financial analysts, with certificates on the wall attesting to that—and that it covered 85 companies. And then, if you’d bothered to read down to the very bottom, this is what you would have seen:
The cost of enrollment in our one-year continuing research program is US $33,000 prepaid for 4 Research Reports, typically published quarterly, and requisite Research Notes. The Firm does not accept any equity compensation. We received $33,000 from the Company for 4 quarterly Research Reports with coverage commencing on 12/02/2004.
Yes, Wall Street research can be yours. All you have to do is pay for it.
The reason this is necessary is clear enough. Spending on research at the largest Wall Street firms declined by 40 percent between 2000 and 2004, according to a study of the subject by Sanford C. Bernstein & Co. Another survey showed 29 percent of companies complaining about reduced research coverage of their firms, as Wall Street firms have slashed their research divisions. That’s known as sell-side research, as the purpose (which investors learned all too well in the Internet bubble) is to sell stocks to the public. At the same time, there was a growth in independent research firms, what is known on the Street as buy-side research, financed by large institutional investors—firms like Bernstein, Value Line, Argus Research, and other outfits that mainly focus on large and midsize companies. That has left in the lurch little public companies, which have trouble attracting research coverage, buy side or sell side or any side, in the best of times.
So they’re paying for it. Straightforward enough, I guess, except when you think a bit about what that means—and particularly if you dwell a bit on uncomfortable phrases like “conflict of interest,” and discomfiting words like tout and shill. Those are hard concepts to overcome. So when the Nasdaq Stock Market joined with Reuters in June 2005 to create something called Independent Research Network, which will provide analyst coverage to companies for $100,000 a year, the immediate reaction was skeptical. Phrases like “conflict of interest” and “how’s that different from advertising” filled the scant coverage, which was a little remarkable because it was—well, scant. After all, hadn’t two very prestigious organizations, one of which was a stock market, just endorsed a rather dubious way of providing research for investors?
Still, there are two sides to every story. Research firms that take money from companies have a spokesman, a tireless advocate. Let’s meet him. He’s a nice guy and—who knows?—maybe he’ll convince you. He says that paid research is in your best interests.
To reach this man, it is necessary to go to Rego Park, a neighborhood of the New York City borough of Queens. There, in the basement office of a plain brick house, can be found a soft-spoken gent in his mid-sixties by the name of Gayle Essary.
Gayle, who hails from Texas and has had a varied career, is the putative savior of the great silent majority of American publicly traded companies—the 60 percent that don’t enjoy the benefits of coverage by Wall Street research. It doesn’t matter if your company is in the black or bleeding white. You don’t even need a product, but just an idea for one—that makes you “development stage.” You can have a bankruptcy lawyer on late-night standby at the courthouse. Your company can be such a disaster area that you are blaming the all-purpose bogeyman—short-sellers who bet against your stock—for your misfortunes. It doesn’t matter. Enhanced Visibility and Shareholder Empowerment are just a phone call away. Be sure to have your credit card or checkbook ready.
Gayle is an interesting story in his own right. He is one of Wall Street’s most glowing and unqualified successes—a really remarkable tale, even if you don’t much care for what he does for a living. He is a man of many talents and occupations. He is a journalist of sorts, owner of a conduit for press releases and snippets of financial news that he calls FinancialWire. He is founder of a group called the CEO Council, which lobbies whomever will listen against the evils of naked short-selling and other supposed small-business concerns. Gayle is a would-be wheeler-dealer, having played a central role in the last IPO of the old millennium, though that was a source of endless aggravation, as bold ventures often are.
Above all he was one of the first visionaries to grasp the potential of the Internet in propagating information about the stocks that would benefit most from the propagation—the thinly traded, sometimes dreadful, but always popular microcap stocks. He began with an Internet stock-promotion mailing list. Over the years, his mind creatively turning, he saw his opportunities and he took them. Today he is believed to be the leading practitioner of paid research, through a company he founded that has gone through various names but is, for the moment, called Investrend Communications, Inc. The company boasts, or, to put it more precisely, Gayle boasts, that it has a stable of 70 analysts on contract and “research coverage” on some 170 companies. Actually determining just which companies are covered by Investrend is not a simple matter, because its Web site lists a lot of companies that have long since said sayonara as well as companies just tangentially mentioned, or briefly profiled for no apparent reason. Even if you factor in the padding, Gayle is definitely among the largest players in the field—and definitely the most outspoken in the ever-expanding universe of paid research.
Let’s begin by defining the bad guys—nonpaid Wall Street research. Most of us wouldn’t ordinarily say “nonpaid,” as that is usually a given, but let’s do that just this once for the sake of clarity. Nonpaid research is conducted by Wall Street investment banks, brokerage firms, and small non-brokerage-affiliated research firms. One of their common characteristics is that this research is usually costly for investors to purchase, or is distributed only to brokerage customers and the media. Paid research is usually as free as the wind.
A lot of Wall Street research is pretty good, but overall it has, of course, taken on an aroma of scandal that the Street has worked hard to counteract. You probably know how the whole field of research has been terribly torn by opprobrium, mainly as a result of the high-tech boom and bust and the IPO scandals. One would really have to work very hard to make Street research look good, considering its general reputation for bias and overoptimism. As a matter of fact, the general unreliability of Wall Street research has been studied and quantified so minutely that one can say very precisely how bad it really has been. For that we have to thank three leading Wall Street watchers in academia—Brad M. Barber of the University of California at Davis, Reuven Lehavy of the University of Michigan, and Brett Trueman from UCLA—who had their computers rip through the performance of analyst stock picks between 1996 and 2003.
Barber, Lehavy, and Trueman found that the stock picks of nonbrokerage research firms (not including company-paid research) outperformed investment-bank-analyst stock picks at an annualized rate of 8.1 percentage points. That’s a lot. They credit this differential to a “reluctance to downgrade stocks whose performance dimmed during the early 2000s bear market.”
That, in a nutshell, is the problem with Wall Street analysts. They are overoptimistic, they are basically engaged in dressed-up stock pushing—in other words, they just generally stink. During Artie Levitt’s term at the SEC, the big accomplishment was something called Regulation FD, which did absolutely nothing to reduce the amount of misinformation that analysts and companies spread, but was aimed at seeing to it that everybody got the same crap at the same time.
So that’s what passes for Wall Street research, and that’s what passes for the self-regulatory pyramid’s regulation of Wall Street research. Pretty lousy, isn’t it? Can’t get much worse, you would think. Well, hold that thought.
Paid research firms don’t seem very different from nonpaid firms if you don’t look at them very closely. They have boutique-sounding names like Taglich Brothers, J.M. Dutton (who we just met on the Yahoo! Web site), BlueFire Research, Fieldstone Research, and Equity Research Services. Their reports are superficially quite similar to what you find in Wall Street research. Put a Morgan Stanley research report next to a Dutton research report and you’ll see the same jargon, the same target prices and buy or sell recommendations. You’ll also find analysts who tend to have “CFA” after their names, meaning that they got their certificate from the CFA Institute—a perfectly respectable institution that, as a matter of fact, might want to think hard about letting paid analysts call themselves CFAs. Paid-firm analysts, CFAs or not, tend to be less experienced than brokerage analysts, however.
So there you have it—two types of research. Yet brokerage research has seen its reputation go into a free fall, while paid research hasn’t. That’s because in order for your reputation to go into a free fall, you have got to have a halfway decent reputation to begin with. Paid research does not. In fact, one not-unreasonable way of viewing company-commissioned stock research is that its very existence is a scandal, and that the self-regulatory pyramid has been lax in not wiping it off the face of the earth.
This is where Gayle Essary comes in. He is about to change all that. Being an organizing kind of guy, he has lassoed the ten largest players of company-paid-research-land into a FIRST Research Consortium. Its motto is “Putting Investors FIRST.” The acronym stands for Financial Independent Research Standards Task Consortium. A little acronym-cheating there. Perhaps a better T could have resulted from more concentrated thinking. (Troubadours?) The Forest Hills post office box and phone number of the consortium are the same as Gayle’s, and his guiding hand is apparent from other inimitable touches, such as the lofty, uplifting, “shareholder empowerment” theme of its various pronouncements and correspondence.
Gayle has an uphill but certainly not insurmountable battle ahead of him. The pot of gold lamentably—for Gayle & Co.—not at the end of the rainbow is the $432 million that the major investment banks are required to spend on independent research, under the terms of the global settlement hammered out by the banks with Eliot Spitzer in April 2003. Each of the major investment banks is required to hire three independent research firms, and distribute their output to consumers. That is supposed to be Standard & Poor’s or Argus or Sanford Bernstein or some other dull mainstay of the Wall Street establishment. Paid firms were excluded from the settlement, but the SEC has shown some flexibility on the subject. In October 2005, it ruled that banks, under certain circumstances, could distribute paid research without violating the settlement. A welcome step, even though settlement moneys still couldn’t go to paid research.
No doubt about it: In their battle for respectability, Gayle and his friends have an ally in our self-regulatory system. The entire concept of companies paying for regulation has not been a front-burner issue for the pyramid, and, most of the time, isn’t even on the stove. There is something called Section 17B of the Securities Act of 1933, which requires that these paid firms tell the rest of us that they are being paid by the companies. As long as they comply with that (and even if they don’t, actually) everything will be just fine.
As a result of this regulation-by-inertia, what you have is a frontier in which the cowboys, Indians, trappers, and gunslingers are free to do pretty much what they want. Gayle, the unelected leader of the paid-research crowd, is truly the man of the hour. He sets the standards. He chastises transgressors. Above all, he fights hard to deal with what might be called the “R factor.” R as in reputation. R as in respectability.
That is the elephant in Gayle’s basement. There is a line, a thin and some would say nonexistent line, between company-paid stock research by reputable firms and touting by slimy stock promoters whose “research” sings the praises of crumb-bum stocks. It is an area that has been ignored for years by the SEC under all of its various leaders, and all the rest of the broad expanse of the pyramid. The subject hasn’t interested state regulators or Eliot Spitzer either. The man he enjoyed humiliating for several years in a row, Bill Donaldson, felt no particular need to get out in front on this issue, not even to make a splash and get a happy-talk story written about him.
It could be that the subject makes Donaldson uncomfortable. Before coming to the SEC, back when he was just another retired rich guy, he served on the board of a little company, EasyLink Services, which paid for research as a way of reeling in investors. In April 2005 the SEC, with Donaldson conspicuously recused, slapped its wrist for some accounting improprieties that improperly boosted its revenues. The SEC said EasyLink “was able to tout in press releases” that “the company met or exceeded analysts’ revenue expectations”—saying that advertising revenues in one quarter were up 47 percent, when they “had actually declined 32.8 percent.” Way to go, EasyLink Audit Committee member Bill Donaldson!
As you can see, some companies are in dire need of upbeat analyst coverage. In general, regulators have tended to mention paid research only in passing, when dealing with boiler rooms and stock promoters that pump and dump crummy stocks like EasyLink. As telephone cold-calling banks have fallen out of favor in this country (overseas is another matter), the Internet has taken over, and Internet stock scamsters rely on nice-looking “analyst reports” that are tailor-made for the occasion. Gayle and other paid-research people go to great lengths to distance themselves from that end of the business.
The Street itself, as represented by the two major analyst and investor-relations associations, hasn’t much to say on the subject. The analyst community’s only effort to grapple with paid research has been a terse, caveat-filled, ultra-cautious few paragraphs of “best practice guidelines” for stock research overall. These were proposed for comment in March 2004 by the Association for Investment Management and Research, which later changed its name to the CFA Institute, and the National Investor Relations Institute, a trade group of the people who write annual reports and such. The AIMR/NIRI guidelines said as follows: “Issuer-paid research is fraught with potential conflicts. Depending upon how the research is written and distributed, investors can be misled into believing that issuer-funded research appears to be from an independent source, when, in reality, it is solicited and paid for by the subject company.”
Note the disdain, the sneering tone. It was grudging, it was cautious, and it was a little insulting. Note too how AIMR/NIRI pretty explicitly took the position that what paid-research firms produce is not independent. It must have really galled the folks in the paid-research biz, as “independent” is almost literally their middle name. Imagine how miserable they must have felt.
Well, here is how Gayle played it on the Investrend.com Web site, on a Web page entitled “Endorsements”: AIMR and NIRI, he said, “recognizing the growing disparity between the public company ‘haves’ and ‘have nots,’ are institutionalizing the practice of paid-for independent research that meets high standards of practice in yet another industry quake in what already has been termed ‘The Year of Independent Research.’”
When I first read this, I doubled back to see if Gayle was referring to the same grudging, picky document that I had read. Actually, AIMR and NIRI had only halfheartedly and conditionally accepted paid research—but what the heck, why put too fine a point on the thing? After all, anything resembling ratification of the rent-an-analyst community was music to the ears of the paid-research folks. “This is truly a momentous announcement,” Gayle quoted himself as saying in the undated statement. The tough language remained in the final AIMR/NIRI document, published in December 2004, and was actually strengthened a little, but Gayle’s joy was undiminished.
I suppose Gayle had reason to be happy. After all, AIMR and NIRI could have simply recommended that paid research be banned. It would not have been a bad idea. In fact, to put it another way, it would have been a good idea. Instead, it was almost as if mainstream analysts wanted the whole thing to go away. But paid research is like that pesky ex-spouse who keeps sending you Valentine’s Day cards. It isn’t going away. In fact, it is taking the apartment next door. To Gayle and his colleagues, respectability is just one press release away.
Gayle is the antithesis of the nonpaid research crowd in pretty much every way possible. He has no MBA. He has never worked for Wall Street. He is a self-made man, more the kind of individual one might find in a 1920s shoeshine-boy-to-mogul narrative of Wall Street than the yuppified recent era. He started out working for small publications in Texas, moved into marketing, and then, in the late 1960s, was infected by the virus of politics. By the end of the 1960s he was in Washington as head of a political consulting firm called the Institute of Motivational Sciences.
That makes sense. Politics, now a tedious and spirit-destroying enterprise, was alive and zippy back in the 1960s, while Wall Street had all the appeal of a sticky waxed floor. Gayle ran the institute from a town house on Capitol Hill, and had clients that included Democrat Tom Dodd, father of Chris Dodd, and the Republican Missouri senator and future UN ambassador John Danforth.
Not being the complacent and settle-down type, Gayle tired of the political scene during the 1970s and moved to California to try his hand as a publishing magnate. He did his publishing-magnating with a publication called Dental Lab World. Other ventures followed that took him to New York—and destiny.
Gayle’s march on Wall Street is quite a story. He told me about it in his basement headquarters, with his thirtyish son Todd working nearby and his cat snoozing on the sofa upstairs. It was a scene of modest middle-class respectability and not conspicuous prosperity. Still, what Gayle has done is impressive, particularly when you consider that he was able to make a decent living on the investment end of Wall Street without knowing very much about investing. Unlike Dick Grasso, he built a better mousetrap, though exactly what can be considered the mice chewing at the bait are, in this instance, open to debate.
Gayle stumbled into stocks, the way many of us stumbled into stocks in the early 1990s. The difference is that when you or I stumble into something, we continue to stumble (or at least I do). Gayle immediately found his niche. He is that kind of guy—a niche-finding guy. He began by day trading—actually a subspecialty known at the time as “Dorfman trading.” Back then a stock market columnist named Dan Dorfman made a daily appearance on CNBC, and almost every day he said something that moved the markets. Dan would speak, Gayle would buy, watch the stock go up, and then sell. “After a while I timed it out so that I knew that seven minutes after I bought was the time to sell. It would go crazy for seven minutes and then people would start taking profits.” It was an early demonstration of how easily stocks could move in price. The quality of the information, which in Dan’s case varied widely, was of no consequence. What mattered was that people believed.
A new form of information transmogrification was on the horizon, and Gayle stumbled into it. If trading was his drug, Prodigy, the online service, was his enabler. He began running a message board on Prodigy devoted to day trading, and when he tired of that he decided to start his own email group. Day trading wasn’t out, but small-cap stocks were definitely in. They were so far in that thousands of investors were being fleeced every day. It was 1995, carefree 1995. The Investor’s Champion, Artie Levitt, headed the SEC, and the Internet was viewed in the regulatory community as a kind of nuisance that could be dealt with through the concentrated application of lip service, and was paid almost no attention at all. As the regulators dozed, Gayle established an email list called the Waaco Kid, and that was the beginning of the then-fiftysomething Gayle’s new career as a small-cap stocks guy.
The name was appropriate. This was a frontier, after all—and the nearest sheriff was three days’ ride away. It was also a, well, wacky frontier.
Gayle quickly recognized the genius of the Internet as a populist, all-encompassing, low-cost method of information exchange, as well as a potential source of spare cash. Every list member, who had to pay ten dollars a month for the privilege, would have the right to post stock tips on the list. It was democracy in action, albeit a kind of grimy, Wall Street–style democracy. In fact, in their own little way, the Waaco Kid members could do what the big boys like Dorfman were doing—move the market. Members of the list could generally be counted on to buy the list’s stocks, and then they would go up. It was an excellent example of what might be called the Greater Moron Theory of Investing. No matter how odiferous a stock may be, it can always be sold to a moron at a higher price. It helped that this was 1995, the Chinese Year of the Moron.
Looking back during his basement chat with me a decade later, Gayle recalled the Waaco Kid as a kind of online investment club that eschewed stock pumping and decorously minded its p’s and q’s. He said, “We kept the picks just to the community” because, gosh darn it, it was the right thing to do. “Today people don’t seem to care about this, but we thought it would be wrong to submit this out to the general public” when the group was buying a stock, he said with the benefit of years of hindsight. After Gayle turned over reins to someone else, the Waaco Kid issued press releases proclaiming its picks in 1997. “The legendary Waaco Kid, as usual, made the outrageous seem normal over the 4th of July with his suggestion that we give the Boston Harbor back to the British,” said one Waaco Kid press release in July 1997, again displaying the Kid’s gift for understatement, by way of introducing its latest stock picks.
Even at this early moment in its history, the Internet was acting as a kind of echo chamber without which the Waaco Kid, and other stock-pushing outfits of the era, would have been hard-pressed to find their Greater Morons. Since Gayle’s stocks were strictly for trading and not for investment, the risk—if you stayed in the stocks too long—was that you would be the Final Moron. If so, you might wind up being the proud owner of Innovacom, “Stock of the Year” for 1997, and thus be in a position to enjoy the thrills and chills of its bankruptcy in 2001. Or another high-adrenaline stock, HealthTech International, which the Waaco Kid highlighted in March 1995, after which it climbed from $3 to $4 in one day. A month later it was back down to $2.50. * Or you might have wound up with a real toilet splasher called Genesis International Financial, which Waaco Kid members had once hyped as the most “undervalued stock in America.” Its shares became subjected to de-acceleration g-forces even before various alleged nastiness persuaded Artie Levitt’s SEC to halt trading in the stock in 1997. Eight years later it was trading at one-hundredth of a cent per share. You can say it remained undervalued, in the sense that it was probably worth less than the scrap value of all the papers it had to file with the SEC during its miserable existence.
The Genesis International Financial disaster was a black eye for the Waaco Kid. But the Kid survived, as did Gayle. By then he was keeping his distance from the Waaco Kid. He had other fish to fry by 1997. Gayle had sniffed out a niche. The Waaco Kid had made him a Wall Street guy as well as a small-cap guy. He quit his job consulting for a financial publisher in 1996 and decided to go into business for himself, this time as a promoter of all those small-cap stocks that he had been pushing on the Waaco Kid, all the Innovacoms and Genesis International Financial and HealthTechs and all the promising biotechs like NeoTherapeutics, an emerging pharmaceutical company in 1997 that was still emerging eight years later under another name and at a fraction of the share price.
All these companies needed to get their stories out to the public, for the benefit of the shareholders. There was clearly a market here. Sure, there were stock touters out there—sleazy newsletters that very often accepted shares or stock-purchase warrants in return for touting the stocks, usually in newsletters. Gayle was against that. His enterprise had to be ethical, had to empower shareholders. He would eschew payment in stock and require payment in cash in advance—in theory, at least, imposing a lead shield before the green kryptonite of inherent conflict that comes from having a company pay for research. He began to compare himself to the bond-rating agencies, such as Standard & Poor’s and Moody’s, which charge companies and local governments to rate their debt (albeit not to issue purchase recommendations; Gayle, though not the agencies, views that as a distinction without a difference).
Gayle was now a genuine, bona fide research guy, an independent-research advocate. No tout he. Would a tout be allowed to sponsor forums for small-cap companies at the New York Society of Securities Analysts (a staid organization that hosts corporate presentations for analysts)? Hell no! The perennially undervalued Genesis International Financial was one notable early forum client. It was a brilliant move, associating himself with the drowsy, establishmentarian NYSSA. Gayle gave his new paid-research venture the sonorous name Investors Research Institute, which made it seem less like a stock-promotion outfit than an operating theater in which investors were dissected and analyzed. He called it an “organization of individual investors,” which made it sound even better, even though that was a somewhat imprecise description of his enterprise.
The IRI did good things for ordinary folks, such as announcing in June 1999 that “113 public companies have now pledged to adhere to higher standards of ‘accessibility,’ ‘scrutiny’ and ‘disclosure,’ acquiring the right to display the organization’s ‘Seal of Best Practices in Investor Relations.’” Fourteen of these companies had automatically earned their seal by enrolling in the “unique” “Public Analysis & Review (PAR) program, which assigns an independent analyst to regularly follow and report on companies with little or no coverage.” True, this was not the world’s most exclusive club. It says farther down in the release that “anyone may enroll a public company in the PAR program,” at a cost he didn’t feel moved to disclose at the time, and thereby earn that seal, maybe without even knowing it.
With this bit of promotion, the likes of which would have shamed a street necktie hawker in 1930s New York, the dingy field of paid research was getting a new lease on life, with nice-sounding words slapped on like a fresh coat of shellac. The timing was outstanding—the beginning of a bear market that caused Street research departments to reduce tremendously the number of companies they covered. By 2004, according to First Call, 60 percent of companies were not covered by Wall Street research. Surprisingly large numbers were paying for the privilege, to Gayle and others. According to a 2002 survey by NIRI, 10 percent of all companies surveyed paid for equity research, with more than one-fifth of all microcap companies using paid research. Only 12 of the 378 companies surveyed said they would never consider paying for research.
These are substantial—and, viewed from a different perspective—dismaying numbers. They show that, with Gayle as its voluble spokesman and advocate, company-paid research, like online dating and weblogs, has achieved respectability in what had once been a fringe endeavor utilized by losers. Horror-show companies always have to pay for stock research, much as a fat man of eighty-five with bad skin would have to pay for sex (unless he is a retired rich guy). But as those numbers indicate, not all the companies that pay for research are repulsive, fat, or otherwise unappealing.
Some of them are decent, clean-cut but bland, geeky companies that aren’t in industries the Street cares for very much, or don’t have the corporate version of social skills. They just find it hard to put on a clean necktie, go out there in the meat market, and sell themselves to Wall Street. Or perhaps they are the misfits of Corporate America, the inhabitants of the Over the Counter Bulletin Board. These are companies so tiny or insolvent or just so damn scary that they don’t qualify for listing on any stock exchange or market, not even the crippled and stinky little Amex.
Paid research costs money—but look what you get. Gayle charges $39,840 a year for something he calls Wall Street Coverage. That is the Modified American Plan of paid research. You get a report of twenty-four to thirty-six pages, a quarterly research update, and research notes as needed. You get a stock rating and a target valuation. You also get “all components of Investrend Research Coverage Platforms,” which means “announcement of coverage and initial report via Investrend Research Syndicate, FinancialWire™ & Global Press release, AnalystBroadcast™ (including separate announcement of web-cast distribution via Investrend Research Syndicate, FinancialWire™ & Global Press Release).” And that’s not all, folks. You also get a “permanent Investor-Power™ Page on Investrend Website” and, last but not least, for the entire term of coverage plus six months you get “news following via FinancialWire™ & FirstAlert network.”
Whew! That’s a lot. Now, if you want to pay less than that, you can go for Institutional Coverage—a somewhat inappropriate name, given institutional investors’ aversion to stocks that haven’t attracted bona fide analyst coverage. It costs $29,800 a year (12 percent discount for twenty-four months) and gets you an eight-page report and everything else you get in Wall Street Coverage. Shave $10,000 off that price and you’re in the bargain basement already. You get a rating only “if appropriate” (which kind of implies that folks who pay more get a rating whether or not it’s appropriate). You don’t get any target valuation, thereby depriving potential investors of the fantasy that comes from thinking that an independent analyst believes the stock is worth such-and-such. Real cheapskates can go for a Criterion report—“One-time, 6-8 page ‘expanded view’ report by credentialed independent analyst (with Rating, if appropriate)”—and total pikers can head for the bottom of the barrel, the Focus report, which merely bestows a “one-time, 4-6 page ‘snapshot’ by credentialed independent analyst (no Rating or Target Valuation).” That costs you $4,950.
As time went on, Gayle built up a clientele of small, not necessarily good but usually gutsy little companies involved in all kinds of interesting if not profitable little businesses. There was Retractable Technologies, a maker of hypodermic needles out in Texas somewhere that struggled relentlessly against the big boys of the pharmaceutical business. There was International Monetary Systems, Ltd., described in a research report as “a provider of financial intelligence programs” (it runs an exchange that lets companies barter goods and services with each other, in case simply buying stuff is not to their liking). And then there was a gaming company called Starnet Communications. A hell of a company.
Starnet was one of Gayle’s most illustrious and best-known clients. It was one of those ethical 113 companies that proudly could emboss the Seal of Best Practices on whatever they wished. On March 8, 1999, Starnet enrolled in the PAR, and was awarded a “buy” rating by none other than John M. Dutton, a PAR analyst at the time who later went on to run a paid-research outfit of his very own. Now, not even the best analyst can predict the future. It is certainly no reflection on Gayle or John that in August of that year, more than a hundred local cops and Royal Canadian Mounted Police raided Starnet’s offices in Vancouver, arresting six company officials and charging them with illegal gambling and distributing pornography. The pornography charges were later dropped, but the gambling charges were serious stuff, gambling not being allowed in Vancouver. The stock declined 70 percent in one day.
Hey, stuff happens. Was John discouraged? Certainly not. Would he abandon Starnet? Not this guy. If this were a Wall Street nonpaid research firm, he’d have turned tail and run. Instead, John slapped a “temporarily avoid” rating on the stock, a unique rating that implied what happened next—off came the rating. Two months later he assigned Starnet a “strong speculative buy” rating. “We expect the Company can address the remaining legal issues,” said Gayle’s man on the Starnet beat. Throughout 2000, unsigned research updates tersely recorded the company racking up red ink and accepting its CEO’s resignation, and noted that the RCMP held on to $7 million in company funds pending resolution of those criminal charges. The rating was never dropped, as best as I can tell from the Web site, except that at some point the “strong” came off. Also at some point along the way Starnet dropped Investrend (and not vice versa, as a cowardly Street analyst would have done). Even so, for years afterward a “speculative buy” rating for Starnet (under its new name, World Gaming Plc) could be found on the Investrend Web site. Nowhere on the site was it mentioned that in August 2001, the company pleaded guilty to gambling charges and was fined $6 million. A January 2003 FinancialWire item called the Vancouver raid “a political fracas.”
In September 2004, after pretty much everyone else had forgotten about the company, the SEC rushed to the scene, sort of like firemen in some old Keystone comedy rushing to a house after it had already burned to the ground. They took a hard look at the smoldering ruins that were charred to ashes seven years earlier, and slapped Starnet’s former executives (though not the company itself) with cease-and-desist orders alleging all kinds of bad things—such as sale of unregistered securities, fraud, false financial statements, and so on—that had been going on while all that “research” was skipping out over the Internet. In July 2005, an SEC judge handed down an eighty-four-page ruling imposing fines and bars from the industry and generally banging everybody’s heads together.
This is no knock on Investrend/PAR/IRI or Gayle or John. Stuff happens. But when a company’s officials are arrested by the Mounties, doesn’t that raise a red flag? What does a company have to do to be dropped by Investrend?
Well, it helps if the company is going to do the dropping.
By the summer of 2004, Investrend was pushing ahead full throttle. The IRI had just kind of faded away by then, and the PAR had long since vanished from the company’s press releases. Dutton had left to set up his own firm, which became a promoter of, among other stocks, Bill Donaldson’s favorite microcap, EasyLink Services. Gayle would regularly rail against ethical transgressions by his competitors, and late in 2004 Gayle had an opportunity to show just how upstanding he was. He was clearly not going to let another Starnet pull any fast ones.
One of his clients, Retractable Technologies, was growing restless. All that paid research, at $28,000 a year and higher, wasn’t allowing its shareholders to dump their shares at a reasonably elevated price, even though Investrend had been rating Retractable a “strong buy” from the moment it began coverage in September 2001. “Stock is substantially undervalued relative to competitors,” said the first report. Unsigned updates said much the same thing throughout 2002, 2003, and 2004. In October 2004, this era of good feeling ended. All of a sudden Investrend didn’t like Retractable Technologies anymore. As Gayle tells it, it was a matter of principle, a matter of shareholder protection. Retractable stopped talking to his analyst.
Now, that is bad. That is worse than a company being convicted of a crime or its execs being tossed in the can. Literally. After all, Starnet never lost its rating for tangling with the Mounties. But Starnet did not attack the sanctity of the analyst-company-shareholder relationship, something that would irreparably hurt what Gayle never tires of saying is his only client, the shareholder.
On October 11, 2004, Investrend issued a report withdrawing its “strong buy” rating and target share price. It was the kind of fearless research to which any Wall Street analyst could point with pride: “A previous report (and previous analyst) on RVP rated the Company Strong Buy with a target valuation of $11 per share,” said analyst Ryan C. Fuhrman. “The current analyst can neither refute nor support this rating due to an inability to speak with the Company and due to a current lack of visibility regarding future operations as a result of the below detailed developments. As such, the current rating has been revised downward to 3/No Rating.”
Retractable fired back two weeks later by issuing a press release attacking Investrend for inaccuracies—and by pointing out a little detail omitted from the October 11 report. The company said in an October 22, 2004, statement that “Retractable notified Investrend president Gayle Essary of its decision to terminate the relationship in a letter dated August 13, 2004.” It seems that nasty analyst report came out two months after Retractable fired Investrend. The October 11 Investrend report doesn’t say that.
Gayle was not taking any of that lying down. He responded by lowering the rating again, on the grounds that the analyst hadn’t said anything inaccurate and that Retractable was being inaccurate for saying that, and that shareholders shouldn’t be misled in that fashion. Then Retractable filed a routine Form 8-K with the SEC containing its press release. “Looks like the company isn’t going to let the matter die,” Gayle emailed me the night that happened, “…what we call in Texas waking sleeping dogs.”
So went the Battle of Retractable Needle Junction. It sputtered on for a little while like that. Clearly Retractable viewed the Investrend analysts as hired hands who could be told to take a hike like any other hired hand, and didn’t buy any of that hooey about Investrend “representing the shareholders” or its analysts being “independent.” As CFO Douglas Cowan put it in the October 22 press release, “We simply felt after more than three years of using the service that neither the company nor its shareholders had realized any benefit from it.” You’d think that letting shareholders know what was going on would be benefit enough. You’d think that—if paid research were the real thing, and not dressed-up stock touting.
Regulators could put an end to all this phony-baloney posturing and play-acting malarkey by simply slapping an “86” on paid research. Or they could let the paid-research purveyors ply their questionable trade, but require that they say on the front page of each “research report,” in boldface, THE COMPANY PAID $XX, XXX FOR THIS REPORT. That would go a long way to take the stink out of paid research.
Meanwhile, it would be awfully nice if the SEC would enforce the rules that are on the books right now. That shouldn’t be too difficult. For one thing, most of the stuff cranked out by the rent-an-analyst shops is published on the Internet. They don’t have to do very much legal spadework because there is only one rule (apart from the laws against fraud) that applies specifically to paid research—Rule 17b of the Securities Act of 1933. That’s the one requiring disclosure of sums that companies pay to be analyzed. However, Rule 17b isn’t worth anything unless it is enforced—with zero tolerance for violations.
In September 2004, years after these outfits started springing up all over the place, the SEC took action against a major rent-an-analyst mill. That was the first time it seems to have been done so against a major player in this rapidly growing field. The pinnacle of our self-regulatory pyramid found that Taglich Brothers, a leading vendor of paid research that also operates a brokerage, allegedly disregarded Rule 17b, systematically and “willfully,” over a two-year period. The firm would put on its reports that it was being paid, but wouldn’t say how much—which is, after all, the whole point of Rule 17b. You’ve got to tell investors how much you are paid to tout stock. It’s really not that complicated.
The SEC had a golden opportunity to tell the paid-research crowd that it was all over them like a cheap suit, and that it would brook no further nonsense. Instead, Taglich was censured, ordered not to violate the rule in the future, and socked, very gently, with a $50,000 civil penalty. That for a firm which charges dozens of companies $20,000 a year for “research coverage.” Taglich exemplified the problem with paid research—it looks like the real thing but really isn’t. The SEC, unfortunately, reacted by imposing a penalty that looked like the real thing but really wasn’t. Instead of giving Taglich a good thrashing with a tire iron, it flayed the firm with a wet soba noodle.
The SEC did not even get the satisfaction of hearing Taglich rend its garments and tearfully admit guilt. It neither admitted nor denied the charges, as part of a settlement with the SEC in which it agreed to the “sanctions” imposed. This is standard SEC practice in settlements, by the way. A transgressor is allowed to say “I am not going to do X, Y, and Z ever again, so help me, but I’m not going to say if I just did X, Y, or Z.”
The SEC, fresh from its triumph over Taglich, tucked away its soba noodles in a Ziploc bag, and hauled them out again a day before Inauguration Day. On January 19, 2005, the same day that Dutton & Associates made the Yahoo! Finance site, the SEC announced its second regulatory action in history against a major purveyor of paid research—John M. Dutton. According to the SEC, Dutton had been told quite some time before that he was not following that pesky Rule 17b. Yet darn it, he just kept on forgetting about the only rule specifically applying to his business. Back in July 2002, the SEC staff notified Dutton, “through counsel, that the general disclaimers used by Dutton in published research reports were insufficient and violated Section 17(b) of the Securities Act.” Dutton didn’t clearly disclose that the companies were paying for the reports. Despite the warning, Dutton allegedly continued violating Rule 17b through the end of 2002. Good news, though. After six months of thinking it over, Dutton changed its ways in 2003, and had complied with the rule since then.
Still, the SEC had to act. After all, it had been ignored. So, after the usual “let’s sit around for two years and think about it” delay, the SEC and Dutton worked out a deal. Without admitting or denying the allegations, Dutton agreed to the sanctions ordered. From now to the end of time, Dutton would “cease and desist from committing or causing any violation or future violation of Section 17(b) of the Securities Act.” That was that. No other penalties, not even the fifty-buck fine you get for parking in front of the SEC building in downtown DC (providing you are not booted or towed). Two days later, the SEC imposed a $25,000 penalty on the firm, which is less than one of those eighty-five companies pays for one year of coverage. There were no further penalties imposed on Dutton personally.
Now, don’t get the wrong idea. If you think that the SEC wasn’t on top of all this, you are very much mistaken. Bill Donaldson was personally involved, though he’d probably like you not to know that he was personally involved. If you looked at the list of companies that Dutton forgot to disclose were paying him, you would find EasyLink—the little tech company that Donaldson had the honor of serving as a director before he moved to the SEC.
The Taglich and Dutton settlements received little attention, despite the latter’s uncomfortable association with the SEC chairman. Ditto for a soba-noodle slap on paid-report mill BlueFire Resarch ($50,000 penalty; no admission of guilt) in July 2005. That was not surprising, as SEC soba-noodle slaps happen all the time, and too many other events were taking place that diverted attention from this major league case of regulatory nonfeasance. A particularly vacuous presidential campaign had come and gone, meaningless “market structure” and dumb hedge fund reforms were under way, and, above all, the SEC was playing catch-up with Spitzer on the mutual fund extravaganza and a variety of scandals that were monopolizing everyone’s attention.
After the Bush victory, word began to circulate that Bill Donaldson’s job was in jeopardy. Business lobbyists were urging the president to get rid of him before completion of his term in 2006. He was just too tough.
Despite all the backbiting, Donaldson managed to keep his focus on the important things, such as small companies of the kind that he used to proudly serve as a diligent board member and audit-committee watchdog. So it was no real surprise that he received some help in that regard from Gayle’s CEO Council.
On March 7, 2005, Donaldson announced the creation of the SEC Advisory Committee on Smaller Public Companies, established “to examine the impact of the Sarbanes-Oxley Act and other aspects of the federal securities laws on smaller companies.” One of the charter members of this prestigious advisory panel was Investrend’s director of corporate relations, the operator of a small New Jersey investment firm named James A. “Drew” Connolly III. The SEC announcement observed that “Mr. Connolly was a founding member of the CEO Council, an organization of executives of smaller public companies.” Connolly’s job on the SEC committee would be to “represent smaller over the counter companies and professionals who work with them, as well as investors in these companies.”
Had anyone at the SEC bothered to look, they might have been able to locate a list, which was available for a time on the Internet, that identified some of the founding members of the CEO Council. Right there they could have found some familiar names that might have made them feel right at home.
There was Gabor S. Acs, CEO of a firm called Penny King Holdings, an alleged penny-stock huckster who had just been sanctioned by the SEC and socked with $643,962.81 in penalties and disgorgements for making false statements in press releases and on Web sites.
There was Ed Loessi, CEO of a firm called Build the Board, whose name was on a March 1998 list of brokers posted on the Web by a transnational boiler room called International Asset Management. Ed told me in an email that he was surprised he was on that list, because he just “stuck around” there for a couple of months. He left, he said, after he realized his job would involve pushing OTC stocks on people throughout Asia and his license was never transferred there. (Well…he says he was there in August 1997 and the list was posted in May 1998, but what the hell—the important thing is he was doing absolutely nothing for two or whatever months as he stuck around.)
And then there was the true star of the CEO Council inaugural list: Jonathan Lebed, who received some small measure of prominence in late 2000 as being one of the few fifteen-year-olds to ever be prosecuted by the SEC for securities fraud.
We’ll be picking up again with Jonathan in a later chapter. For the time being, though, let’s just leave Jonathan right there—a CEO, proudly on the roster of the CEO Council, right there with the Penny King and the totally innocent ex-IAM-broker-in-1997-or-1998, Ed Loessi. It’s a good image to have in the back of your mind as you read this book, particularly the next chapter.