MAY 13, 2002
COVER STORY
How Corrupt Is Wall
Street?
New revelations have investors baying for blood, and the scandal is widening
When Debases Kanjilal, a Queens (N.Y.)
pediatrician, picked up his phone in early 2001 to call lawyer Jacob H. Zamansky, he had no idea
he would whip up a full-fledged hurricane on Wall Street. Kanjilal claimed he lost $500,000
investing in Infospace Inc., an Internet stock he says his Merrill Lynch & Co. broker urged him
not to sell when it was trading at $60 a share. By the time he sold, it was down to $11.
Zamansky filed a novel arbitration claim against Merrill in March, 2001, in which he argued that
its star Net analyst, Henry Blodget, had misled investors by fraudulently promoting the stocks of
companies with which the firm had investment banking relationships. That lawsuit led directly
to an investigation by New York State Attorney General Eliot Spitzer, who stunned Merrill and its
Wall Street brethren three weeks ago when he made public some shocking e-mail exchanges
between Merrill analysts and bankers.
That was just the start. Now, Spitzer is investigating Salomon Smith Barney, Morgan Stanley
Dean Witter, and at least three others. The Securities & Exchange Commission has launched a
probe into practices at 10 firms, while the Justice Dept. is pondering an inquiry of its own. And
plaintiffs' lawyers are advertising for clients and filing new suits daily.
The widening scandal has plunged Wall Street into crisis. The resulting furor is more
thunderous than the one unleashed by Michael R. Milken's junk-bond schemes in the 1980s, the
Prudential Securities limited-partnership debacle in the early '90s, or price-fixing on the
Nasdaq later in the decade. In part, that's because many more individuals lost money in the
recent market collapse than on earlier scandals.
But uproar over the relationships between analysts and their investment banking colleagues
has also grown because it comes on the heels of several other scandals that raise big questions
about how Wall Street operates. Already, probes are under way into Wall Street's shady initial
public offering allocation practices, as well as its crucial role in setting up and selling the
partnerships that led to Enron Corp.'s collapse. Worse, execs at many firms may have made a
bundle investing in the partnerships, even as those same firms advised clients to hold Enron
stock virtually until it went bankrupt. It all makes Wall Street seem rigged for the benefit of
insiders as never before.
The damage goes way beyond the tattered reputations of the firms and their beleaguered
analysts. The entire economy depends on the financial system to raise and allocate capital. And
that financial system, in turn, is built on the integrity of its information. Should investors lose
confidence in that information, it could deepen and prolong the bear market, as wary investors
hesitate to put money into stocks. And it could easily put a damper on the economy if
companies are less willing--or less able--to raise capital on Wall Street. "One of the precious
things we have is the integrity of the financial markets. If that changes it could have dramatic
repercussions on the dollar, on domestic inflation, on the economy," says Felix G. Rohatyn,
former managing director of Lazard Freres & Co.
Wall Street has always struggled with conflicts of interest. Indeed, an investment bank is a
business built on them. The same institution serves two masters: the companies for which it
sells stock, issues bonds, or executes mergers; and the investors whom it advises. While
companies want high prices for their newly issued stocks and low interest rates on their bonds,
investors want low prices and high rates. In between, the bank gets fees from both and trades
stocks and bonds on its own behalf as well, potentially putting its own interests at odds with
those of all its customers.
But in recent years, those inherent conflicts have grown worse, as the sums to be made by
overlooking them have grown enormous. That's because since the repeal of Depression-era
banking laws, megabanks such as Citigroup and J.P. Morgan Chase are allowed to do everything
from trading stocks to lending money and managing pension funds.
Chinese walls--jargon for the strict separation of the different lines of business conducted
under the same roof--were supposed to keep the bankers honest and free from corruption. But
a series of scandals since the early 1980s has eaten away at those foundations. The final blow,
however, was the tide of money that flooded over Wall Street during the great tech bubble.
Between the last quarter of 1998 and the first quarter of 2000, the tech-heavy Nasdaq market
index soared from 1,500 to more than 5,000. Many investors made out like bandits. So did the
investment banks. During the same period, according to Thomson Financial/First Call, Wall
Street earned $10 billion in fees by raising nearly $245 billion for 1,300 companies, many of
them profitless tech outfits that later blew up. The bubble burst in the spring of 2000, wiping
out more than $4 trillion in investor wealth. "The fact is that a bubble market allowed the
creation of bubble companies, entities designed more with an eye to making money off
investors rather than for them," wrote famed investor Warren E. Buffett in his annual report to
Berkshire Hathaway shareholders last year.
Staking their claim in the gold rush, Wall Street firms ramped up in the late '90s, hiring hordes
of analysts, many of them inexperienced. New investment bankers were hired as well. A
feeding frenzy set in as rivals fought to grab a big share of the market to bring companies
public. At the same time, a new cult of equities came to life, as individuals invested in stocks as
never before. True, many investors ignored common sense. Still, as analysts applauded stocks,
trumpeting their picks on CNBC and other media, investors bought. "Investors took everything at
face value, which was understandable. There wasn't a lot of information, and it was of varying
quality," says Michael E. Kenneally, co-chairman and chief investment officer at Bank of America
Capital Management Inc.
Only now are the ugly details of the conflicts at play being laid bare. In some of the e-mail
turned up by Spitzer, analysts disparage stocks as "crap" and "junk" that they were pushing at
the time. The e-mails are so incendiary that they threaten to thrust Wall Street into the sort of
public-relations nightmare that Philip Morris , Ford , Firestone, and Arthur Andersen have
endured in recent years. All the ingredients are present: publicity-hungry attorneys general,
packs of plaintiffs' lawyers, and potential congressional hearings. "The last thing the industry
wants is...the drip-drip-drip of new stories every week," says Howard Schiffman, a former SEC
Enforcement Div. lawyer now practicing privately in Washington.
More explosive documents may be on the way. Both Spitzer and the SEC are seeking from
more than a dozen firms papers and e-mail related to analysts' recommendations and their
potential conflicts of interest. While nobody knows what evidence will emerge, other firms will
have their own smoking guns. And analyst pay is likely to emerge as a hot-button issue.
Zamansky, for instance, claims that he has seen contracts from investment banks promising
analysts 3% to 7% of all the investment banking revenues that they help to generate.
That would be clear proof that analysts were being paid to help the firms' banking clients,
often at the expense of investors who expected objective advice.
The financial implications of this mess are enormous. Based on the evidence that has already
emerged, Merrill is facing potential fraud claims by every retail investor who purchased any
stock that Blodget & Co. may have insincerely recommended. If analysts covering other
industries at the firm harbored similar doubts about the companies they hawked, the number of
claimants will expand exponentially. Should other financial firms have similarly embarrassing
documents in their files, Wall Street could easily be facing billions in potential liability. In a
report released on Apr. 24, as the fiasco was unfolding, Prudential Financial analyst David Trone
estimated the issue could cost Merrill alone $2 billion.
Heads could roll, too. If prosecutors conclude that firms are guilty of systemic fraud--rather
than harboring a small group of rogues--research directors and other high-ranking execs could
be vulnerable. That's why the way analysts were paid is such an explosive issue. In egregious
cases, criminal prosecutions are possible. Although regulators have never thrown an analyst in
jail for fraudulently recommending a stock, experts say that could happen if public outrage
flames high enough. Spitzer, whose tough New York securities statutes give him unusually
broad power to file criminal suits, says he won't stop short of structural reform. "I'm continuing
to negotiate [with Merrill]," he told BusinessWeek on May 1. "They've been fruitful
discussions, but negotiations can break down over a range of things. At this moment, we have
significant issues that have not been resolved."
Over the long run, a risk bigger than legal penalties could be new restrictions that Spitzer or
others place on the way investment banks do business. On May 8, the SEC is scheduled to
approve new rules forcing analysts to limit and disclose contacts with investment banker
colleagues. But there's good reason to question whether these steps will be enough to satisfy
the industry's critics--some of whom seek a separation between investment banking and
analysis. At the moment, such radical change is a long shot. But if the Democrat-controlled
Senate latches on to the analyst issue, it could trigger embarrassing hearings or proposals for
more stringent rules. "Other shoes will drop," says one securities-industry lobbyist. "If
[Salomon's Jack] Grubman or [Morgan Stanley's] Mary Meeker turns up [in similar evidence], the
sky is the limit" for this issue. "It has big legs."
It was never much of a secret that analysts who work at investment banks often work against
investors. Sell ratings now make up less than 2% of analysts' recommendations, up from around
1% during the bull market, according to First Call. Analysts are under pressure from the
companies they cover, as well as from big institutional clients who may own the stock, to give
positive ratings. Michael Mayo, senior bank analyst at Prudential Financial, recently told the
Senate Banking Committee that he had been exhorted to stay bullish throughout his career,
from both his former employers and the companies he covers. Otherwise, he said, he doesn't
get the same access that others do, which gives him a harder time making nuanced stock calls.
"It's like playing basketball with one hand tied behind your back," says Mayo. Analysts also need
to shine in surveys such as Institutional Investor's annual rankings, in which money managers
vote for their favorite stockpickers, so they spend too much time lobbying clients rather than
crunching numbers. "Analysts get focused on saying what they think the client wants to hear to
win the vote," says Henry J. Herrmann, chief investment officer at Waddell & Reed Inc., a money
manager.
The biggest factor now contaminating the system is compensation. To an ever-increasing
degree, analysts' pay is tied to how much investment banking business they bring in. According
to a Merrill memo released by Spitzer, Blodget detailed how he and his team had been involved
in 52 investment banking transactions from December, 1999, to November, 2000, earning $115
million for the firm. Shortly thereafter, Blodget's pay package shot up from $3 million to $12
million. Charles L. Hill, First Call's director of research, says that when he was a retail analyst 20
years ago, if he helped investment bankers with a new client, he would get a small reward at
year's end: "But it was the frosting on the cake. Now, it is the cake."
It would be an exaggeration to say analysts alone are to blame for Wall Street's woes. There's
a much deeper problem involving everyone from credulous investors to deal-happy investment
bankers and execs looking to fatten their wallets. "It's finally dawning on people that this
incentive system we've given managers based on the value of stock options has encouraged
management to puff up their companies a lot," says Robert J. Shiller, an economics professor at
Yale University and author of the 2000 best-seller Irrational Exuberance.
Even so, experts say a lot of the corruption oozing from Wall Street has to do with an erosion
in investment banking ethics and practices. It goes clear back to 1975, when fixed trading
commissions were ended. Until then, investment banks had been able to make big bucks off
pricey trading commissions. Slashed commissions meant the firms were forced to derive more
revenues from investment banking business. "There's a real sense of sadness over what has
happened in investment banking. It's not about what's right for a client, it's all about jamming a
deal down a client's throat," says an ex-analyst who recently joined a hedge fund.
Consider Enron, which has paid $323 million to Wall Street in underwriting fees since 1986,
according to Thomson. Goldman, Sachs & Co. pocketed $69 million of that, while Salomon
made off with $61 million, and Credit Suisse First Boston took $64 million. Indeed, two of CSFB's
investment bankers, after helping to design Enron's off-the-books partnerships, sat on one of
the partnerships' boards. According to a complaint filed in Houston Federal Court on Apr. 8,
investment bankers generated megaprofits from secretly investing in Enron's hidden
partnerships. Meanwhile, many analysts continued recommending the stock to the bitter end:
11 out of 16 analysts who follow Enron had buys or strong buys less than a month before the
company's bankruptcy filing.
Enron may be an extreme example. Still, in the past, tradition and ethics played a large role in
keeping investment bankers loyal to their corporate clients. Indeed, Wall Street itself used to
have much more of an interest in guarding its reputation. Says Jay Ritter, a finance professor at
the University of Florida: "These days, bankers are far more focused on short-term profits than
on their long-term reputations."
That's likely to get worse as investment banking business continues to dry up. The amount
being raised in initial public offerings is way off its 2000 highs. Now there are far fewer
mergers and follow-on offerings taking place. Because of this, it's unlikely that Wall Street, after
all its hiring during the tech bubble, can sustain its profitability. Goldman Sachs estimates that
five of the top investment banks on Wall Street will have to get by on $2 billion less than the
$16 billion in net revenues they racked up in 1999. If investment banks roll back to 1999
staffing levels, Putnam Lovell Securities estimates that banks will have to shrink their payrolls by
5%--putting over 13,000 out of work.
But no matter how much Wall Street shrinks, its credibility must grow again. Firms have
already taken some steps, such as eliminating direct reporting by analysts to investment
bankers. But the Street and the SEC still must hammer out a solid, enforceable code of conduct.
And if strong reforms in how analysts are compensated aren't pursued, focusing on increased
disclosure will do little to end the abuses. Beyond that, regulators may need to go after the
firms' top brass--the folks who set the procedural as well as ethical tone. And the Street should
take great pains to monitor itself in an effort to restore investors' confidence. "If Wall Street
knows what is good for it and what is good for this country, it will very definitely clean up its
act," says Rohatyn. Adds George H. Boyd III, head of equities at New York's Weiss, Peck & Greer:
"This is an industry of trust; it's one of its key assets. If [Wall Street] loses it, it is going to have
to invest in getting [that trust] back and putting in the controls to rebuild it. Without that trust,
there's nothing."
Merrill Lynch apparently knows this. At its annual shareholder meeting on Apr. 26, Chairman
and CEO David H. Komansky took an unprecedented stand on the analyst debacle, saying: "We
have failed to live up to the high standards that are our tradition, and I want to take this
opportunity to publicly apologize to our clients, our shareholders, and our employees." Other
apologies may follow, as firms desperately try to assuage potentially litigious investors and
unyielding regulators. But for Wall Street, just saying sorry at this stage may prove to be too
little, too late.
By Marcia Vickers and Mike France, with Emily
Thornton, David Henry, and Heather Timmons in New York and Mike McNamee in
Washington
-- Cherri (whatever@who.cares), June 28, 2002