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 one eyebrow when the research world claimed FD would spell its end? Weren’t we curious to know why analysts never When a frog met a stock they didn’t like? Perhaps not. What purpose was there in outing this scene? A rising stock market has too many willing witnesses. Both regulators and the public clung to what now seems the quaint notion of the is just a frog Chinese wall. No-one saw it necessary to probe the personal ownership or pay of the analysts themselves. 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 hounded by a state prosecutor, Wall of indignation and distrust eager to report that what looks like a frog Street’s “sell” side analysts have been through the capital markets, is really a prince. Sometimes a frog is just auditors,A 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.