PLENTY OF LAWS, ethics policies, and regulations have been changed in hopes of cleaning up the Street. But will they make one whit of difference? Sadly, I think that few of them will have much impact in the long run. In part, that’s because many create their own set of unintended consequences. I also think that the role of the analyst on Wall Street is filled with inherent conflicts, none of which can be solved by these rule changes.
I didn’t realize this at first, however. Way back in 1989, when I started as an analyst at Morgan Stanley, I learned everything I needed to know about analyst independence, or so I thought, from Ed Greenberg. Ed was my mentor at Morgan Stanley, the consummate professional, and the guy who talked me into leaving MCI for the Street. His philosophy was simple, and I stuck with it for my entire career: think independently and don’t let yourself be influenced by the “noise,” as he called it. “Stay focused on analysis and valuation,” he said. “The stock picking will flow from that.”
It sounded pretty straightforward to me. But Ed warned that all the people around me, from the company executives to the traders, the bankers, and the buy-side clients, had different, and often competing, objectives. Paying too much attention to any of them would only distract me from my job, which was to figure out the future direction of the stocks on my coverage list. There was another reason for staying independent, and it was the most essential one. If I altered my opinions to serve some objective other than giving investors the best possible advice, it would mislead anyone who read my research and acted upon it.
If I ever needed a reality check, I got one every time I spoke to my parents, Muriel and Jack. They were on my mailing list and received all of my reports throughout the years. My father was in many ways a typical individual investor. He watched CNBC constantly and listened to the talking heads as if they were speaking the gospel. He also read virtually every single word I wrote and constantly talked to his friends about my stock picks. Every time I came down to Florida for a visit, I’d be mobbed by my mom’s and dad’s friends, living on their modest retirement incomes, who would ask me again and again what they should do with various stocks.
“You know, Danny, I own a lot of AT&T,” a cheerful Aaron Beckwith would say, as I was still “Danny” with this crowd. “It’s my largest stock position. What should I do with it?”
These were real people with real life-savings taking the advice of the supposed pros quite literally. In these cases, my recommendation might make the difference between a comfortable retirement and a miserable one. It was a very big deal. I eventually crystallized my feelings about Aaron and my parents into what I called the “grandma” approach to research: I should never recommend a stock that I wasn’t comfortable recommending to my parents, my closest friends, or someone’s grandmother.
That didn’t mean that I shouldn’t consider startups or risky stocks, but rather that I always had to do my homework, seriously investigate all the issues surrounding a stock, and do my best to come up with the right ratings, including the risk level. I wouldn’t be right all the time, but I was obligated to do my best. Even though the clients I focused on were primarily large institutional investors, those institutions were often investing on the part of mutual and pension funds that perhaps managed my parents’ or Aaron Beckwith’s retirement savings.
Although the pressures from my larger, more powerful constituencies kept intensifying as the bull market picked up steam, I managed to stick to the Ed/Grandma approach pretty well over the course of my career. It was relatively easy at first, since very few people knew who I was and my calls didn’t move stocks. Over time, as my work become more widely read, my rankings rose, and other analysts began to get cozier with the banking side of the business, it got increasingly more difficult, as I’ve described in this book.
But I had it easier than a lot of my counterparts. I was extremely lucky to have started on the Street at a time when there was very little investment banking activity in the telecom industry. The pressures didn’t really intensify until after I had built my reputation and had become ranked on the Institutional Investor magazine’s All-America Research Team. And by then, my job—or at least the pay—was guaranteed under multiyear contracts. So by the time the bankers went into heat, I had financial security from the contracts and a decent amount of job mobility from the high I.I. rankings. That gave me the leverage to resist any pressure to write or say something I didn’t believe.
DESPITE THE INHERENT conflicts of Wall Street, there are a few simple but strong actions that would go a long way toward deterring future misbehavior. Start with the vigorous enforcement of insider-trading laws and regulations. If analysts and others knew they’d go to jail when caught, the laws would deter over-the-Wall analysts from disclosing not-yet-public information. Vigorous enforcement would also deter corporate executives from using misleading or fraudulent accounting to give them time to sell shares when they are aware—but the public is not—that their company’s fortunes are suffering. Aggressive enforcement actions could make a huge difference by deterring would-be criminals.
Second, I propose a new federal law requiring corporate insiders to pay back profits, if those profits have been earned by selling shares during a period of time when the company’s stock price is artificially boosted by fraudulent financial disclosures. Those profits would then be refunded to investors in that company’s stock.
Third, would be to lengthen “restricted” periods. Restricted periods are the period of time after a stock or bond offering or a merger or acquisition when analysts working for the involved banks have to be quiet. That means that they can’t write research reports or give an investment opinion about those companies paying their banks an investment banking fee. Lengthened restricted periods would keep analysts silent and thereby reduce the likelihood that a banker or company would pressure or tempt an analyst to give a favorable rating to the stock of a company paying multimillion dollar fees to that analyst’s firm.
Last and most important, investors need to be aware that they’re playing a loser’s game. No matter what laws or rules are changed, the investment banking and brokerage businesses are fraught with inherent and inevitable conflicts, conflicts that can hurt even the biggest investors. Rather than trusting in the inherent fairness of the markets, individuals buying stocks should assume that they will never receive the same information as the professionals. It’s an insider’s world, and it always will be. Let me explain.
Real estate agents do it. Insurance brokers do it. Headhunters do it. And Wall Street brokerages and investment banks do it. They act as middlemen, trying to match buyers and sellers as often as possible and make as many deals as possible. And they all have inherent conflicts of interest that are simply part of the job. Does the real estate agent always point out the leaky roof to a buyer? Does the insurance broker always direct the customer to the best-priced insurance policy, even if his agency doesn’t represent that company? Does the headhunter know or care whether the individual he has recommended will be a great performer or a Dilbert clone? The answer is no, and no one really expects them to do otherwise.
It’s a similar situation on Wall Street. Securities firms or investment banks are the quintessential middlemen. They match buyers and sellers of securities, and their goal is to get the largest number of bonds, stocks, or some mix of the two bought or sold through their firm. This at first seems to create a built-in conflict, but the market’s laws of supply and demand are supposed to neatly resolve this moral dilemma, since the price paid will be the price customers are willing to pay and sellers are willing to accept. However, if supply or demand is distorted by things like the unfair allocations of IPO shares or selectively disclosing nonpublic information, all of which you’ve read about in this book, it’s a different story.
There is, however, something quite unusual about the securities industry: the role of the analyst. Research analysts are expected—and obligated—to pick a side in this conflict and to change sides whenever circumstances change. If an analyst recommends a stock, he is siding with the corporate issuer, suggesting that investors buy more of that stock and therefore allowing the corporate client to sell more shares at a higher price. But if an analyst advises investors to sell a particular stock, he is working against the corporate issuer because his advice could reduce demand for that stock, thereby lowering the price paid by investors and hurting the company’s ability to raise money.
When I started on Wall Street, I naïvely assumed everyone I dealt with accepted the independence standard. I never really thought about where it came from, why people expected it, or why Wall Street analysts were unique. Eventually, I started to see that the analyst’s obligation to be independent, while ethically imperative, wasn’t economically logical at all, given that he or she works for a firm whose primary purpose is to maximize fees. From the perspective of the cynic—or the economist—it makes sense that every employee of the firm, analyst or not, would work toward that goal.
In the 1990s, this “logical conclusion” became the norm for many analysts. Some of them changed their investment opinions to benefit companies that were paying fees that dwarfed any contribution that the other customers—the investors—were making. Ultimately, the banks and the analysts paid a price for this behavior, but that price was minuscule compared with the losses of the millions of people who trusted the advice they were given.
Can anything be done to restore the role of the analyst as an impartial adviser, or is it simply impossible given the inherent conflicts involved? And have the reforms put in place thus far done anything at all to bring the Ed/Grandma standard back to life? I will first address the simplest and most controversial proposal—the spinning off of research from investment banks altogether. Then I will critique the existing rule changes put in place by Eliot Spitzer and the National Association of Securities Dealers (NASD). Finally, I’ll give my own prescription for the things I think we can—and should—change.
Why Spinning Off Research Won’t Work
After discovering Henry Blodget’s “POS” (piece of shit) e-mails, Eliot Spitzer opened his negotiations with Merrill Lynch by demanding that Merrill disband, sell, or spin off its research department, thereby eliminating any opportunity for conflicted research.1 Though Merrill fought this aggressively and won, I imagine many Wall Street executives agreed with Spitzer. After all, research, once a valuable client service, seemed to have morphed into one huge conflict-of-interest machine with huge legal risks.
In my view, the proposal to spin off research makes no sense, because it’s based on a misunderstanding of how securities are distributed in our markets. The problem is that if an investment bank or brokerage lacks research analysts, it will simply create them anew: inevitably, someone will emerge to describe and evaluate any stock or bond that the firm is selling. It might be a salesperson, broker, banker, or trader, but someone will end up explaining the stock to the firms’ brokers, salespeople, and investor clients.
For example, say Verizon hires Citigroup to sell $1 billion of new stock. Someone has to explain Verizon’s financials, strategic position, competitive position, and a variety of other factors to Citigroup’s institutional salespeople and retail brokers. Normally, a research analyst would do so, as he or she would have the most knowledge of Verizon and the telecom industry. But with no research analysts, someone else would need to write up a “sales memo” and host a “teach-in” explaining the pros and cons of investing in Verizon. If a banker doesn’t do it, someone in the equity syndicate department might. Or a salesperson may volunteer or be assigned to provide some “comps” tables, showing how Verizon at $35 a share compares to the valuations of other stocks and the market overall. That would leave us with a larger problem than we had before: an inexperienced salesperson with no pretense at all of being objective or independent serving as Citigroup’s telecom “expert” even though he doesn’t understand the business in any depth.
Some may argue it’s better simply to call a spade a spade. Since it is sales on some level, why not call it sales and have it performed by a salesperson? Perhaps the fraud was in calling it independent research in the first place. I understand the argument, but in the end, jettisoning the research department simply shifts the burden of “explaining” a public offering to someone less qualified and possibly more conflicted.
The same principle holds if, instead of spinning off research, it is the banking side that is separated. Self-proclaimed “bankers” will emerge, and the same inherent conflicts of mixing banking and research will inevitably arise. The king is dead, long live the king.
A Critique of Actual and Proposed Reforms
In July 2002, roughly a year before Eliot Spitzer’s $1.4 billion settlement with the largest investment banks was finalized in April 2003, the NASD, the industry group governing Wall Street firms, introduced new standards of conduct for research analysts, called Rule 2711.2 The following section analyzes these reforms as well as some others.
1. Analyst Pay Can No Longer Be Tied to Specific Banking Deals
Firms can no longer pay analysts for specific investment banking deals they may have contributed to. Yet analysts can still be paid from the general profits of the firm, including investment banking profits, as long as the bonuses are not tied to any specific deal. Bonuses are determined based on a variety of factors, ranging from stock-picking and buy-side surveys like Institutional Investor magazine’s rankings to the quantity of reports, morning calls, and client contacts to feedback from colleagues.
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.3 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 and 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.4 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.
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.5
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.
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 explicitly 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 bearish 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.