Confessions of a Wall Street Analyst Part 18

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 a.n.a.lysts' 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 a.n.a.lysts.

4. Extend the Post-Issuance "Restricted Periods" During Which a.n.a.lysts 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 a.n.a.lysts must wait after an investment banking client issues securities before discussing or publis.h.i.+ng 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 a.n.a.lysts, flipping the influential research a.n.a.lyst from an a.s.set 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 a.n.a.lyst 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 a.n.a.lysts 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 a.n.a.lyst 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 a.n.a.lyst conflicts of interest. But with this letter, his agency also unleashed one of the most pernicious conflicts in the history of the a.n.a.lyst profession. Before the No-Action Letter, a.n.a.lysts 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 and bullish a.n.a.lyst sometimes lost a deal because the corporations involved knew the a.n.a.lyst couldn't publish any reports while the deal was in process. Companies did not want to lose that a.n.a.lyst's positive influence in the marketplace. bullish a.n.a.lyst sometimes lost a deal because the corporations involved knew the a.n.a.lyst couldn't publish any reports while the deal was in process. Companies did not want to lose that a.n.a.lyst'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 a.n.a.lysts 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 a.n.a.lysts, fostering blatant conflicts of interest.

As suggested in point four, a.n.a.lysts 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 a.n.a.lyzing 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 a.n.a.lyst 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 a.n.a.lysts. And, at worst, companies might intentionally hire bankers whose research a.n.a.lyst is bearish in order to silence that a.n.a.lyst and, conversely, avoid hiring investment banks whose a.n.a.lyst 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 a.n.a.lysts, 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. a.n.a.lyst 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, a.n.a.lysts) often follow the cues and encouragements of their bosses. So, if only the a.n.a.lyst is pursued, the bosses may continue to condone or encourage bad or fraudulent behavior.

7. Tell Individual Investors the Painful Truth Individuals should not 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 compet.i.tors are all juiced up on steroids. 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 compet.i.tors are all juiced up on steroids.

As you've read, a.n.a.lysts were subject to numerous and intense pressures-pressures from bankers, retail brokers, inst.i.tutional money managers, buy-side a.n.a.lysts, 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 a.s.sume 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 inst.i.tutions 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: 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, a.n.a.lysts, bankers, or other groups. 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, a.n.a.lysts, 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 partic.i.p.ants-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.

Notes.

CHAPTER 1 1.

1. Jack Grubman, "United Telecom: Sprint Will Be the 'DEC' of Long Distance" (New York: PaineWebber, March 1, 1988).

2. Morgan Stanley Research doc.u.ment, page 2, date unknown but believed to be 1986 (from author's files).

3. Michael Siconolfi, "Under Pressure: At Morgan Stanley, a.n.a.lysts Were Urged to Soften Harsh Views," Wall Street Journal, Wall Street Journal, July 14, 1992, p. A1. July 14, 1992, p. A1.

4. Morgan Stanley, "The Equity Research Incentive Plan," draft, internal doc.u.ment, (January 23, 1990) p. 3.

CHAPTER 2 2.

1. Michael Siconolfi, "Under Pressure: At Morgan Stanley, a.n.a.lysts Were Urged to Soften Harsh Views," Wall Street Journal, Wall Street Journal, July 14, 1992, p. A1. July 14, 1992, p. A1.

CHAPTER 3 3.

1. United States vs. Jeffrey Sudikoff and Edward Cheramy, United States vs. Jeffrey Sudikoff and Edward Cheramy, case no. CR 97-1176-DDP, June 1996. Grand Jury charges, pp. 813, paragraphs 1828. case no. CR 97-1176-DDP, June 1996. Grand Jury charges, pp. 813, paragraphs 1828.

2. Thomas C. Newkirk and Steven A. Yadegari, "Recent SEC Financial Fraud Reporting Cases and SEC Cases Involving Accountants and Auditors," U.S. Securities & Exchange Commission Division of Enforcement, Jan. 9, 2002, p. 16.

3. U.S. District Court, Central District of California, U.S. vs. Jeffrey Sudikoff and Edward Cheramy. U.S. vs. Jeffrey Sudikoff and Edward Cheramy. Plea Agreement for Jeffrey P. Sudikoff, case no. CR 97-1176-DDP, February 19, 1999. Plea Agreement for Edward Cheramy, same case number and name, May 28, 1999. Plea Agreement for Jeffrey P. Sudikoff, case no. CR 97-1176-DDP, February 19, 1999. Plea Agreement for Edward Cheramy, same case number and name, May 28, 1999.

4. Mark Landler, "The Siskel and Ebert of Telecom Investing," New York Times, New York Times, February 4, 1996, sec. 3, p. 1. February 4, 1996, sec. 3, p. 1.

5. Inst.i.tutional Investor, Inst.i.tutional Investor, "The Cla.s.s of 1972: Where Are They Now?" October 1, 2001, p. 112. "The Cla.s.s of 1972: Where Are They Now?" October 1, 2001, p. 112.

6. Mark Landler, "The Siskel and Ebert of Telecom Investing," New York Times, New York Times, February 4, 1996, sec. 3, p. 1. February 4, 1996, sec. 3, p. 1.

CHAPTER 4 4.

1. Jack Grubman, "Merrill Commentary on Teleport/MFS Comparison Flawed" (New York: Salomon Brothers, June 18, 1996).

2. Stephen E. Frank, "a.n.a.lysts Pay Set a Record Last Year," The Wall Street Journal, The Wall Street Journal, June 29, 1994, p. C2. June 29, 1994, p. C2.

3. Anita Raghavan, "For Salomon, Grubman is the Big Rainmaker," Wall Street Journal, Wall Street Journal, March 25, 1997, p. C1. March 25, 1997, p. C1.

CHAPTER 5 5.

1. Steven Lipin, "British Telecommunications and MCI Unveil $20.88 Billion Merger Agreement," Wall Street Journal, Wall Street Journal, November 4, 1996, p. A1. November 4, 1996, p. A1.

2. Richard Waters, "Curtain Still to Rise on the Concert," Financial Times, Financial Times, July 17, 1997, p. 26. July 17, 1997, p. 26.

3. Gary Weiss with Phillip Zweig, Debra Sparks, and Kerry Capell in New York; Leah Nathans Spiro in Hong Kong; and bureau reports; "Sandy's Triumph," Business Week, Business Week, October 6, 1997, p. 34. October 6, 1997, p. 34.

4. David Faber, Power Lunch, Power Lunch, CNBC, August 21, 1997, 12:302:00 CNBC, August 21, 1997, 12:302:00 PM PM.

5. Jack Grubman, "Ramifications of SBC Announcements: Bell vs. Bell Warfare" (New York: Salomon Smith Barney, May 11, 1998, 10:09 AM AM).

6. Jack Grubman, "CLECs Surpa.s.s Bells in Net Business Line Additions for the First Time" (New York: Salomon Smith Barney, May 6, 1998).

7. Jack Grubman, "Ramifications of SBC Announcements: Bell vs. Bell Warfare" (New York: Salomon Smith Barney, May 11, 1998, 10:09 AM AM).

8. Jack Grubman, "SBC: Upgrade to Buy; SBC Separating Itself From Other Bells" (New York: Salomon Smith Barney, January 7, 1999).

CHAPTER 6 6.

1. Lynn Margherio, (project director), The Emerging Digital Economy, The Emerging Digital Economy, U.S. Department of Commerce, April 1998, p. 2. U.S. Department of Commerce, April 1998, p. 2.

2. Blaise Zerega, "The Next Ma Bell," Red Herring, Red Herring, May 1999, no page number available. May 1999, no page number available.

3. Level 3, "Underwriters Performance Review for Equity Offering," company doc.u.ment, February 23, 1999.

4. Jack Grubman, "Level 3 Communications: Optimizing a Layer of the Telecom Value Chain: The Intel Inside of Telecom" (New York: Salomon Smith Barney, February 22, 1999).

5. Barbara Martinez, "a.n.a.lyst's Report on Level 3 Sparks Questions of Timing," Wall Street Journal, Wall Street Journal, April 3, 1999, p. C1. April 3, 1999, p. C1.

6. Kate O'Sullivan, "Flashbacks: 20 Years of Finance," CFO Magazine, CFO Magazine, March 2005, no page number available. March 2005, no page number available.

7. Linda C. Quinn, (Shearman & Sterling), "Research Reports and Proxy Rules," letter for Merrill Lynch, Pierce, Fenner & Smith Inc., October 21, 1997.

8. U.S. Securities and Exchange Commission, "Response of the Office of Chief Counsel and the Office of Mergers and Acquisitions, Division of Corporation Finance Re: Merrill Lynch, Pierce, Fenner & Smith Incorporated (the 'Company'), Incoming letter dated October 21, 1997," October 24, 1997.

CHAPTER 7 7.

1. "The 1999 All-American Research Team," Inst.i.tutional Investor, Inst.i.tutional Investor, October 1, 1999, p. 120. October 1, 1999, p. 120.

2. Seth Schiesel, "Private Sector: A Tele-Miscommunications Deal," New York Times, New York Times, May 23, 1999, sec. 3, p. 2. May 23, 1999, sec. 3, p. 2.

3. Linda Himelstein, with Steve Hamm and Peter Burrows, "Inside Frank Quattrone's Money Machine," Business Week, Business Week, October 13, 2003, p. 104. October 13, 2003, p. 104.

4. Avital Hahn, "Defections Disrupt Telecom Research at Merrill," Investment Dealer's Digest, Investment Dealer's Digest, December 20, 1999, no page number available. December 20, 1999, no page number available.

5. Rebecca Blumenstein, "AT&T Mulls Wireless IPO to Get Capital," Wall Street Journal, Wall Street Journal, November 26, 1999, p. A3. November 26, 1999, p. A3.

6. Randall Smith and Leslie Cauley, "Will Upgrade of AT&T Stock Help Salomon Smith Barney?" Wall Street Journal, Wall Street Journal, December 6, 1999, p. C1. December 6, 1999, p. C1.

7. Steven Lipin and Rebecca Blumenstein, "Fee Frenzy: Wall Street Heavyweights Feast on AT&T's Offering," The Wall Street Journal, The Wall Street Journal, February 4, 2000, p. C1. February 4, 2000, p. C1.