American stockmarkets fell at the start of this week, even as the economic outlook grew brighter. The Dow Jones Industrial Average and the technology-heavy Nasdaq touched their lowest levels for months. Investors have had their confidence bashed by a series of revelations of corporate malpractice and number fiddling before the stockmarket bubble burst. The continuing sagas of Enron and its auditor, Andersen, have kept their spirits low. Almost any half-suggestion of impropriety can make them twitch. This week they twitched at the resignation of Dennis Kozlowski, chief executive of Tyco International, a once high-flying agglomeration of ill-fitting businesses, days before he was charged with evading more than $1m in taxes on paintings that he bought last year in New York.
Investors have not only lost patience with corporate America’s greed and its inability to do what it says it is doing; they have also lost confidence in Wall Street’s ability to act as an honest broker between them, the providers of capital, and the corporate users of it. “There is an air of cynicism surrounding every institution that underpins our capital markets,” says Stanley O’Neal, co-head of Merrill Lynch, an investment bank that recently paid $100m to settle a lawsuit over the integrity of its analysts when the Internet hype was at its peak. “This cynicism has gone beyond reasonable questioning, and could easily turn destructive.” What should be done to divert this potentially destructive force?
Although there are important differences, there are also echoes today of the 1930s when, in the aftermath of a stockmarket bubble and the 1929 crash, Wall Street became public enemy number one. Business then went into a severe decline as investors and companies lost faith in the trading and issuance of securities. The Pecora hearings in Congress (named after Ferdinand Pecora, a lawyer who orchestrated the proceedings) provided an outlet for the public’s Depression-era fury and humiliated leading Wall Street figures such as Jack Morgan, the boss of J.P. Morgan. (Famously, during a break in testimony a circus midget climbed on to the financier’s lap and posed for photographs.)
Congress passed several laws that imposed unprecedented regulation on the business of finance, all vigorously opposed by Wall Street at the time. The quality of this legislation was mixed, though the laws that defined the structure of the industry were worse than those that regulated the conduct of the industry’s participants. The Glass-Steagall act, which banned firms from doing both commercial and investment banking, was eventually scrapped in 1999. But the creation of a “cop on the corner” of Wall Street in the shape of the Securities and Exchange Commission (SEC) proved to be a masterstroke, greatly increasing public faith in America’s capital markets.
Today, Wall Street once again faces both a prolonged slump in business and the prospect of punishment and further regulation. Trading in shares by institutional investors, especially hedge funds, continues to accelerate. But many individuals who flocked to the stockmarket during the second half of the 1990s are now giving up en masse. Day traders (so called because they buy and sell stakes within the same trading day, thus producing a rich flow of commissions for brokerage firms) are now yesterday’s traders. And many people who traded only occasionally, or who put their money into mutual funds, are also bailing out of the market.
According to the June issue of Bank Credit Analyst, a newsletter, retail investors have now “lost most of their profits accrued during the bubble years”. The BCA proxy for the average price paid for shares suggests that the cumulative profits of those investing steadily since 1995 are down to less than 10%, compared with a high of 40%. Companies, too, are using Wall Street’s services less. Both mergers-and-acquisition (M&A) activity and initial public offerings of shares (IPOs) are miles below their highs of 2000. The likelihood is that the depression on Wall Street will continue for some time, and that the recent rounds of job-cutting will not be the last. At the very least, firms will have to get used to much lower revenues and slower growth.
Everybody agrees that action is necessary to ensure that America’s capital markets remain the best in the world. But the battle to lead that punishment and reform process promises to be unusually messy. That, in turn, makes the future path of reform highly unpredictable. As well as such assorted congressmen as Paul Sarbanes, Edward Markey, Jon Corzine and Richard Baker, state politicians such as Eliot Spitzer, New York’s attorney-general, are jockeying for a share of the limelight.
Mr Spitzer brought the recent case against Merrill Lynch, which focused on internal e-mails in which Merrill analysts — notably their former Internet guru, Henry Blodget — abused Internet firms as “crap” and “shit” while simultaneously issuing research reports that urged investors to buy their stock. Now Mr Spitzer hopes to repeat his victory — Merrill paid $100m to settle the case, though it did not admit any wrongdoing and was never charged with any specific offence — by obtaining e-mails from Morgan Stanley (home to Mary Meeker, an analyst once known as “the queen of the dotcoms”) and Citigroup, whose telecoms analyst, Jack Grubman, is facing growing public scrutiny.
Worried that action by the states might undermine America’s federal system of securities legislation, Congressman Baker recently wrote to state attorneys-general warning them that he would propose legislation to curb their activities if they continued to go their own way.
Self-regulatory bodies such as the New York Stock Exchange (NYSE) are also competing to show leadership. On June 6th the Big Board introduced new listing requirements for companies that will, among other things, force them to have a majority of independent directors on their boards. The NYSE boasts that these rules are much tougher than those introduced by the National Association of Securities Dealers (NASD) last month.
In an ideal world, the agenda would be set by the SEC, but it remains to be seen if its chairman of nine months, Harvey Pitt, can overcome a series of political embarrassments that have led to criticism from both right and left. Further complicating matters, countless private lawsuits are pending against financial-services firms that seem likely to drag on for years and may result in huge payouts. They are providing plenty of the sort of bad publicity that encourages politicians to turn up the heat on Wall Street more than might be good for its health.
How much punishment does Wall Street deserve, and what reforms does it need? At the most basic level, financial markets stand accused of knowingly selling over-priced shares by claiming they were cheap, and of doing so in ways that benefited some of their customers (and themselves) to the detriment of others. In particular, this boils down to three main concerns. One is about the role of the research that is published by investment banks; a second is about the way in which shares in IPOs are allocated; and the third is about the use of accounting rules to mislead investors.
The focus on research analysts who allegedly advised investors to buy shares at prices they did not really think made sense has intensified since Merrill settled with Mr Spitzer. As well as Mr Spitzer’s pursuit of Morgan Stanley and Citigroup, the SEC this week revealed that it is investigating ten cases of possible conflicts of interest involving analysts, while the NASD and the NYSE are looking into 37 such cases.
Even if these turn up no e-mails as lurid as Merrill’s, there is every chance that firms accused as a result of these investigations will reach a (doubtless expensive) out-of-court settlement. For a financial firm to go to trial over such matters is to risk bankruptcy. The laws in the area are sufficiently untested for them to prefer not to present their case to a judge.
There is no doubt that Wall Street gave investors an unprecedented amount of bad advice; that those dispensing it often had an inkling that the firms they touted were probably overvalued; and that they had strong incentives to err on the bullish side. On the other hand, every piece of advice issuing from a Wall Street firm comes couched in caveats. If the oldest rule of the marketplace, caveat emptor — “buyer beware” — is to apply in such cases, then anybody slavishly following the advice of a Wall Street analyst has only himself to blame for his future losses.
Ominously for Wall Street, however, on June 3rd a Supreme Court ruling — in favour of an SEC action against a broker — stated that the securities markets’ regulations introduced in the 1930s “sought to substitute a philosophy of full disclosure for the philosophy of caveat emptor, and thus to achieve a high standard of business ethics in the securities industry”. Caveat emptor does not go far enough, it seems. Analysts may have a legal duty of care for their retail customers, which means, for example, offering them only such advice as they would give to themselves.
What can be done to make Wall Street fall more into line with this philosophy in future? So far, the focus of reform has been to try to reduce the conflicts of interest that may encourage analysts to feign bullishness. One suggestion is that they should be prevented from owning shares in the companies that they track. But this tackles only one potential conflict. The more powerful arises from the huge rewards that analysts get, directly or indirectly, for promoting their firms’ other services. An alternative (if far-fetched) suggestion is that they should be required to invest according to their own advice, but only after a delay to ensure that they are not able to anticipate their customers’ future purchases.
There is some talk in Washington of drawing up legislation to ban investment banks from publishing research, which would certainly remove that conflict of interest. But there are not many examples of a firm of any scale surviving for long by selling truly independent research. And since the SEC introduced regulation fair disclosure (FD) in 2000, prohibiting firms from disclosing material information to one outsider before the market as a whole, the main source of competitive advantage for analysts — namely, access to privileged information through meetings with the companies’ managers — has supposedly been destroyed. True, it is not yet clear that Regulation FD is being vigorously enforced by the SEC, which has yet to make a single prosecution under it. If it were, though, there would be even less to distinguish the insights of most research analysts from those of an ordinary investor.
In a recent speech, the SEC’s Mr Pitt said that the main issue with the second area of concern, the IPO process, was that “valued brokerage-firm clients are given investment opportunities, but only in return for kickbacks to the brokerage firms that made the opportunity available”. This seems to have happened quite often recently. Indeed, one investment bank, CSFB, paid $100m to settle an investigation into its habit of allocating shares in IPOs to favoured clients who repaid a chunk of any profits that they made by subsequently conducting unnecessary trades with the broker.
Friends of Frank
But this is not the public’s main concern about IPOs. Their worry is that they never get allocated shares in the initial distribution, and that to participate in an IPO they have to buy the shares at an exorbitant mark-up in the after-market. These are problems that the SEC could do something about (though, distressingly, it shows no signs of doing so), notably by ordering investment banks to use auctions to allocate shares in IPOs to the highest bidders. So far, despite the plucky efforts to promote auctions by W&R Hambrecht, a Silicon Valley investment bank, they are used in less than 1% of all issues.
It is not obvious why auctions should be shunned, especially as W&R Hambrecht charges only 4% of the money raised compared with Wall Street’s norm of 7% (a norm so entrenched that it sometimes seems surprising that it has not aroused the interest of antitrust authorities). One possible explanation is that the management of issuing firms may be co-opted into going along with an investment bank’s underpricing of their issue by the promise of “friends of Frank” accounts.
Named after Frank Quattrone, an investment banker who led CSFB’s technology-industry group in the heyday of the dotcom euphoria, these accounts were given to managers as a reward for hiring CSFB. Through them, they received preferential allocations of shares in future IPOs. In effect, this aligned the interests of the company’s managers with those of Wall Street, while putting them in conflict with the interests of their own employer. A solution to this would be to require full disclosure of any other relationships that managers of companies going public have with their underwriter. Jay Ritter, an economist at the University of Florida, says that it would be even better if there were a total ban on dealings between managers and the underwriter until, say, at least two years after their company’s flotation. He expects the next round of lawsuits against Wall Street to target the underpricing of IPOs, especially if (as he thinks likely) the suit recently filed by eToys against Goldman Sachs succeeds.
The erstwhile Internet toyshop claims that it was deprived of cash that could have kept it alive because the investment bank deliberately underpriced its IPO in 1999 so as to gain illegal kickbacks from investors who were allocated shares in it. Given that total IPO underpricing during 1999-2000 amounted to $66 billion (based on the difference between the price at issue and the price at the end of the first trading day), the payouts in such cases could eventually be huge.
There may be trouble too if underwriters are shown to have known more than they let on when selling securities in firms that later stumbled. J.P. Morgan Chase is suing insurers who are refusing to pay up on a $1 billion surety bond tied to Enron, claiming the bank misled them about the risk. And on June 4th it emerged that the SEC is investigating claims that Citigroup underwrote shares in Adelphia, having earlier made undisclosed loans of $3.1 billion to the scandal-hit telecoms firm and its founders, loans which were used to support its share price.
Called to Account
The issue troubling investors more than any other, however, is the third of the three main concerns: the quality of financial information that is provided by companies. This is largely due to failures of accounting and corporate governance that are not, at first glance, really Wall Street’s fault. However, it was the investment banks that supplied much of the financial alchemy that firms have used to hide the truth — such as at Enron, with its various off-balance-sheet financial structures.
It is in responding to this concern that Mr Pitt’s SEC may yet turn out to be revolutionary. Despite criticism over potential conflicts of interest due to his previous employment as a lawyer working for big accounting firms, Mr Pitt is starting to transform the way in which accounting standards are set, and the legal obligations on companies to use accounting data to promote a true picture of their financial condition and risk. He has started to tell the Financial Accounting Standards Board (FASB), America’s main accounting-standards setter, what its agenda should be, and he has ordered firms to make clear the most important assumptions they have made in their choice of accounting treatments (and to show how other choices would have made a difference).
He is also requiring firms to announce material changes in their outlook at the earliest opportunity, and is even taking action against firms which abide by accounting principles but do so in misleading ways. For example, Edison Schools, a school-management company, was recently told to stop booking revenues that never really passed through its coffers, even though this did not technically breach accounting rules.
As for better corporate governance, the NYSE’s new rules are a step in the right direction. Much will depend on how committed the exchange is to ensuring that the rules are honoured in the spirit as well as by the letter. Greater independence of non-executive board directors is certainly desirable. Too many American bosses fill their boardrooms with yes-men who have neither the character nor the financial incentive to challenge the boss’s grandiloquence. Ultimately, however, governance is unlikely to improve much until the institutions that own large chunks of corporate America start acting as real owners, by keeping a sharper eye on their boards and their management.
Joseph Grundfest, a former SEC commissioner, argues that Wall Street firms may be less to blame for the corporate messes currently unfolding than corporate managers and boards, or their auditors. “Wall Street firms,” he says, “clearly have the deepest pockets” at a time when angry investors are looking for any recompense for the sins of the past — which means that they are probably in for a torrid few years, a time in which they will find out how much it costs to lose the trust of investors. It is easy to see why Merrill Lynch’s Mr O’Neal is worried about the destructive possibilities of today’s air of cynicism.