When a frog is just a frog

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					Covington & Burling

When a frog
is just a frog
Caught flat-footed by the stock market’s dizzying fall, hobbled by lame
appreciation for conflicts and hounded by a state prosecutor, Wall Street’s “sell”
side analysts have been trapped in a net of new regulation, says David Martin




Reprinted from ‘The European Lawyer’ July/August 2002 issue 20
ANALYSTS


                                                                                          analysts. Should we have raised at least




When a frog
                                                                                          one eyebrow when the research world
                                                                                          claimed FD would spell its end? Weren’t
                                                                                          we curious to know why analysts never
                                                                                          met a stock they didn’t like?
                                                                                             Perhaps not. What purpose was there in
                                                                                          outing this scene? A rising stock market




is just a frog
                                                                                          has too many willing witnesses. Both
                                                                                          regulators and the public clung to what
                                                                                          now seems the quaint notion of the
                                                                                          Chinese wall. No-one saw it necessary to
                                                                                          probe the personal ownership or pay of the
                                                                                          analysts themselves.




                                          A
                                                                                             But by the late 1990s, as the market
Caught flat-footed by the stock                            s after-shocks from the        cooled, there were misgivings. Former
market’s dizzying fall, hobbled by                         collapse of Enron and the      SEC Chairman Arthur Levitt, Jr.
lame appreciation for conflicts and                        dotcom market send tremors     complained that analysts were “just a bit
                                                           of indignation and distrust    eager to report that what looks like a frog
hounded by a state prosecutor, Wall
                                                           through the capital markets,   is really a prince. Sometimes a frog is just
Street’s “sell” side analysts have been
                                          auditors, executives and directors of public    a frog.” His agency questioned conflicts
trapped in a net of new regulation,       companies brace for broad reforms.              between investment banking and
says David Martin                         Surprisingly, however, the prize for            analysts, and reports of direct links
                                          the earliest victim of post-Enron pique         between analyst compensation and
                                          was awarded months ago to securities            investment banking revenue seeped
                                          research analysts.                              under Wall Street’s doors.
                                              And even now, more may be in the               Mr Levitt, a Democrat, stepped down in
                                          offing. Law suits, investigations and           early 2001 to make way for a new
                                          probable new laws all imperil the               administration. The securities industry
                                          continued coexistence of securities             sighed in relief, assuming that the Bush
                                          research under the same roof with               agenda would have a light hand for Wall
                                          investment banking. That it should have         Street. But Mr Levitt’s acting successor,
                                          come to this for US analysts may bewilder,      Republican Laura Unger, herself a former
                                          if not worry, foreign confreres, who have for   SEC enforcement attorney, would hear
                                          some time seemingly operated in a similar       none of it. Although predisposed to
                                          regulatory environment. But, then too, it       industry self-correction, Ms Unger was
                                          may only be in America that, as one star        determined to get to the necessary facts on
                                          analyst put it, the new economy definition      the table. She also faced an increasingly
                                          of “conflict of interest” was “synergy.”        restive Congress during an appropriation
                                              No-one will benefit if analysts are so      process in which her agency continued to
                                          burdened with regulatory and reputational       pursue pay and budget increases to deal
                                          baggage that the field becomes                  with mounting concerns about staff
                                          unsustainable. Much may be said about the       turnover and capacity. Through inquiries
                                          state of corporate disclosure, but this does    into analyst trading practices and
                                          not diminish the role of analysts in            participation in Congressional hearings,
                                          smoothing informational friction and            the SEC uncovered a troubling record, one
                                          enhancing the efficiency of markets.            that included cosy relationships between
                                          Sidelining analysts would underscore once       analysts and investment banking clients,
                                          again that bad facts make bad law.              threats of unfavourable ratings to obtain
                                              We did not get into this mess without       business, opportunistic trading by analysts
                                          warning. Could we seriously have believed       in securities they covered, ambiguity in
                                          that names such as Meeker, Blodget,             recommendations including a dearth of
                                          Cohen and Grubman took on celebrity             anything resembling “sell,” and opaque
                                          status based on some bottom-line celibacy?      disclosure regarding any of the above.
                                          In 2000, the Securities and Exchange               In June 2001, the Securities Industry
                                          Commission (SEC) adopted Regulation             Association issued a set of best practices to
                                          Fair Disclosure (FD), a simple rule that        guide research activities of member firms.
                                          forbids sharing of material inside              At the same time, the National Association
                                          information selectively with, among others,     of Securities Dealers (NASD) proposed



the European Lawyer                                                                                                    July/August 2002
                                                                                                                         ANALYSTS


new rules to cover analysts. Neither of        regulatory high ground. Historically,            a start and that it was continuing to
these initiatives was particularly strong,     research activities of US broker/dealers,        investigate the area.
and both were palatable to the industry.       which have an inherent conflict when                Only a few weeks after approval of the
The table was set for newly confirmed          opining on firm clients, have been               rules, Mr Spitzer, who had made the
SEC Chairman Harvey Pitt, who had built        covered by a patchwork of general rules          progress of his investigation daily media
a strong reputation as a securities attorney   against market manipulation and                  fare, announced a settlement with Merrill
on structuring back-office deals. The          deceptive practices, along with some             Lynch. The terms of this agreement called
time seemed right for a graceful closure,      requirements for supervision and                 for the firm to pay a $100 million fine,
acceptable to both politicians and             professional qualification. Risk of suit or      sever the link between analysts and
Wall Street.                                   enforcement was managed through the              investment bankers, create a new
   That was until Enron. Some may have         separation of research and banking by            investment review committee responsible
seen the Enron eruption building, but not      internal barriers or “Chinese walls” and         for approving all analyst recommendations,
enough of the analysts. In the days before     generic disclosure. In times past, this          and disclose any termination of research
Enron declared bankruptcy on December          principle-based rules framework may have         coverage on, and compensation from a
2, 2001, after its stock had fallen 99 per     been sufficient. Not, however, in light of the   covered company.
cent and after the SEC had opened its          multiple embarrassing issues surrounding            Mr Spitzer’s settlement has received
investigation, 14 of 16 analysts who           the research activities of investment            much attention and some criticism.
covered the company still recommended          banking firms. Those issues revolved             Republicans have accused him of
that clients buy or hold the stock. This       mainly around ownership and trading of           grandstanding and warned that state
ensured that they would be swept up in the     securities by analysts and the interests of      interference could lead to balkanisation of
outrage that followed.                         financial service firms, particularly            securities regulation. The Economist
   But early on, regulators and                investment banks, in the businesses and          slammed the deal, noting that it failed to
Congressional investigators devoted most       securities covered by their analysts. The        address the relationship between analysts’
of their resources to the immediate victims,   NASD and NYSE wrote rules approved               conflicts and investment banking business,
culprits and solutions. Few specific plans     by the SEC in May of this year that              while aggravating state interference in an
for analysts seemed imminent, until the        targeted these issues directly (see box).        essentially national regulatory problem. To
New York State Attorney General, Eliot            Even as the industry took a dim view of       those who saw the settlement as soft, Mr
Spitzer, announced that he had                 the new rules, the SEC said they were just       Spitzer described it as “a fair one, tailored
commenced an investigation into the
practices of Merrill Lynch and other firms.
His source of authority was an 81-year old       NASD/NYSE rules:
New York securities anti-fraud statute. In a
very real sense, he made analysts his            n Bars on investment bankers supervising analysts and mandatory monitoring of
bigger fish to fry.                                discussions between the two about research reports;
   At first, Wall Street and Washington          n Breaking the link between an analyst's compensation and any specific
were alternatively bemused and                     investment banking transaction;
contemptuous. But this turned to disbelief,      n Restrictions on when and whether analysts and their families can invest in
when Mr Spitzer released a series of               covered companies, including bars on:
internal Merrill Lynch e-mails,                    –investing in companies in sectors covered by the analyst before they go public,
documenting how the firm’s analysts had            –trading in covered securities from 30 days before until five days after a
privately bashed stocks they were publicly           research report, and trading against the analyst's most recent recommendations;
supporting. Suddenly, there was a smoking
gun, one which federal authorities had           n Bars on commissioning favorable research on investment banking business,
either failed to find or reveal.                   including a rule against rating securities of a client within 40 days after taking it
   Spurred by concern about state                  public or within 10 days after a follow-on offering for less actively traded
regulation of Wall Street, the SEC quickly         companies; and
set up a task force involving the New York       n Disclosures in reports and during public appearances, including
Stock Exchange (NYSE), the NASD, Mr                links between an analyst's compensation and general investment banking
Spitzer’s office and that of the attorneys         revenues, payments to the firm for investment banking services in the last 12 or
general of various other states as part of a       next three months:
formal inquiry into analyst trading                –if the analyst has a personal financial interest or the firm has a one per cent or
practices. The federal watchdog said it was          more beneficial interest in a covered company, or either has any other material
pursuing 10 cases involving possible                 conflict of interest, including as a director or officer,
trading by analysts in conflict with their         –the meanings and distributions of various ratings, and
public recommendations.                            –a graphic plot of at least a year of historical stock prices measured at the time
   Also feeling the heat from Mr Spitzer’s           when the firm initiated and changed ratings and price targets for the company.
investigation, the NASD and the NYSE
launched an effort to reclaim the



July/August 2002                                                                                                   the European Lawyer
ANALYSTS


to the abuses we found.” To those              deal with the “flat out conflict of interest”   information about analysts’ conflicts and
who were alarmed that a state prosecutor       between banking and research. “We must          clearer ratings. Perhaps not so many of
conducted the investigation and obtained       prevent analysts from touting weak              these ratings will be favourable.
the settlement, Mr Spitzer took more           companies because they happen to be                The market, a proxy for the public,
umbrage. “As Attorney General of               clients of their own firm...” he said.          continues to exert control and may find
New York, I have a legal duty to               Congress is likely to agree and present the     the most sensible solution of all. Already,
enforce the Martin Act – a law that
predates the federal securities acts –
and that has been integral to protecting
investors for over eighty years, " he said
before a Congressional committee.
Following the Merrill Lynch settlement,        At first, Wall Street and Washington were alternatively
Mr Spitzer announced that he was
expanding his investigation to other           bemused and contemptuous. But this turned to disbelief,
large Wall Street firms.                       when Mr Spitzer released a series of internal Merrill Lynch
   In response to increased scrutiny
and regulation, top Wall Street firms
                                               e-mails, documenting how the firm’s analysts had privately
have announced voluntary reforms of            bashed stocks they were publicly supporting
their internal rules governing research
analysts. Salomon Smith Barney has
adopted changes that mirror the Merrill
Lynch settlement. Goldman Sachs,
Credit Suisse First Boston and Merrill
Lynch have barred analysts from owning         president with legislation that entrenches      public awareness is sorting out the
stocks that they rate. Bank of America         new regulatory measures in statute.             fundamental differences between the
has gone further to prohibit analysts              The legal implications of this new          “buy” and the “sell” sides of the
from owning stocks in industries they          world order for analysts are still in flux.     research house. The stars of pure research
cover. Beyond this, Salomon Smith              Legal and compliance departments of             firms like Sanford Bernstein should rise
Barney has urged that regulators prohibit      investment banking firms now have a new         higher. Public pension plan investors
analysts from attending roadshows and          mandate to police conflicts rules for           are threatening to jerk investment
from helping bankers pitch their services      analysts, including contacts with bankers       banking business from firms that
to public companies.                           and ownership and trading of securities.        cannot demonstrate a more independent
   Regulators now appear fully engaged.        Whether these departments are up to their       approach to research. Part of this
The SEC continues its investigation and        new roles as gatekeepers and whether            re-education may also involve a dose
may have more rules in store. The              enforcement of new rules will congeal           of reality. Coincidence in the qualitative
NASD has announced the formation of            the research process are two very open          judgments of bankers and analysts
several rapid response teams to investigate    questions. As for the analysts themselves,      should not be a cause for moralising.
emerging areas, including conflicts of         personal investing will be more restricted,     There is no incentive for bankers to pick
interest. It recently levied a $300,000 fine   and, without direct links to the revenue-       losers. A different series of concerns
against US Bancorp Piper Jaffray in a          producing side of the business, salaries        would surely attend a firm the research
settled claim involving threats to drop        and incentives for analysts should fall.        and banking decisions of which were
stock coverage if the firm wasn’t awarded      It is also likely that analysts can expect      more than occasionally at variance.
an assignment to manage a stock offering.      more institutional second guessing                 Will a raised legal bar and new
Mr Spitzer’s foray has been joined by at       which may discourage, if not stifle,            public expectation be enough to restore
least 40 more states, and the North            independent thinking.                           the image of a tarnished industry? This
American Securities Administrators                 And what about companies, investors         should be our hope. We cannot afford to
Association has announced that a task          and the public? Many questions remain           vilify or deify analysts. Too much of the
force of state securities regulators is        up for grabs. Companies will presumably         efficient market predicate depends on
targeting conflicts of interest at             have less, or at least more closely             more than retail investors reading and
approximately12 financial services firms.      monitored, access to analysts and their         digesting the disclosures of ever-
   Even President Bush has weighed in.         work product, particularly draft reports.       expanding and increasingly complex
Speaking out about recent turmoil in           This will likely not be a bad thing.            capital markets. n
corporate America and the capital              Companies haven’t always been
markets, the president had choice words        blameless in this area, there having been       David Martin is the head of the securities practice
for analysts: “Stock analysts should be        reports that analysts have been pressured       group at international law firm Covington &
trusted advisors, not salesmen with a          with threats of withholding deals from          Burling and the immediate past director, corporation
hidden agenda.” Going on, he promised          firms if research is other than glowing.        finance division, of the SEC. With thanks to Fuad
aggressive enforcement of new rules to         Investors should receive clearer                Rana for his assistance in preparing this article.



the European Lawyer                                                                                                              July/August 2002

				
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