Why didn’t the regulators act sooner to add more bricks to the wall? “The SEC was underfunded, understaffed, and they had bigger fish to fry,” says Jeffrey Haas, professor of securities law at New York Law School, explaining why it took so long to bring the conflict situation to light. “[Conflict of interest] has been going on forever. It’s been an ongoing joke for years.”
The origins of the “joke” can be traced to May 1, 1975, when the NYSE deregulated fixed commissions on stock trades. “May Day ’75 took the fat out of the commission structure,” says A. Gary Shilling, an investment adviser and economist and a former chief economist at Merrill Lynch. “Analysts started looking for a new trough to feed at, and investment bankers provided it. They’ve been kept men and women ever since.”
Bankers began looking to analysts to help them get a foot into companies, as well as to provide reports to institutional clients that could be counted on to buy large blocks of the underwriter’s new issues. Analysts increasingly became the point men on IPOs, holding veto power over whether an investment bank took on an underwriting client. They worked closely with pre-IPO clients to get them ready to go public, and acted as cheerleaders after road shows with institutional investors to ensure that the company’s message got across.
By the end of the ’90s bull market, analysts almost never issued a “sell” recommendation; even last July, only 3 percent of all ratings were a sell, according to Thomson Financial/First Call. And they weren’t shy about using their increasing clout to “convince” clients to do business with their bank.
It was no surprise that Spitzer’s investigation into such “shocking” analyst conflicts coincided with the advent of the bear market. No one minded those conflicts much while everyone was raking in the dough. But when the money flow stopped, the conflicts provided a convenient misdeed with which shareholders could extract their pound of flesh from the analysts who they claimed knowingly steered them to now-worthless stocks. And, as Haas observes, a more compelling case can be made if a shareholder has lost $100 million than if he has only quadrupled his money rather than quintupled it. Spitzer’s findings have already been used in at least two class-action lawsuits filed against Merrill Lynch and its analysts by investors who bought stock on Merrill analyst recommendations.
On the Front Page
It was only after Spitzer’s legal action against Merrill that the NASD and the SEC announced that they, too, had been conducting investigations into these very same analyst conflicts. In May, the NASD and the NYSE each proposed a new set of nearly identical rules that closely mirror the terms of Spitzer’s agreement with Merrill Lynch.
The new rules, most of which went into effect in July, include a raft of “front page” disclosure requirements. An analyst must disclose in a research report if: (1) his or her bank has received any investment-banking business with a subject company in the past year or expects to receive such business in the next three months; (2) the bank has any financial interest in the company; (3) the analyst has personal or family financial interest in the subject company; (4) the analyst received any compensation based on a broker or dealer’s investment revenues; and (5) any other material conflicts of interest.