The Merrill Episode: The myth of market self-governance C.P. Chandrasekhar

On April 26, David Komansky, chief executive of Merrill Lynch, one of the “big players” in world financial markets, apologised for a possible instance of breach of trust in the work of Merrill’s stock research division. “We have failed to live up to the high standards that are our tradition, and I want to take this opportunity to publicly apologise to our clients, our shareholders and our employees,” Mr Komansky said at the annual meeting of America’s largest broker.

Komansky’s apology came in the wake of incessant pressure from Eliot Spitzer, the feisty New York attorney-general, who had launched investigations into possible wilful promotion by Merrill’s stock analysts of shares they privately considered to be duds, in order to help the company earn large fees from its investment banking operations. Mr. Spitzer’s investigations began as far back as July last year, when Merrill chose to settle a suit filed against it by an investor in the internet venture InfoSpace, whose share price collapsed from $132 in March 2000 to $1.46 this April. The complainant, whose case was argued by securities lawyer Jacob Zamansky, held that he had suffered major losses in investments in InfoSpace made on the basis of advice offered by Merril’s investment analysts. In particular, Henry Blodget, Merrill Lynch’s star internet stock analyst, who left the company last year, had backed the stock and recommended it as a wise investment, even when the share was in free fall.

Taking the cue from Merrill’s desire to settle, the attorney general chose to launch an investigation into conflicts of interest between stock analysts and investment bankers in Wall Street firms. He not only subpoenaed the evidence for the Merrill case from Jacob Zamansky, but more than 30,000 intra-office emails, that reveal the potential conflict of interest. While these messages include references to InfoSpace shares as being a “piece of junk”, and others as a “piece of shit”, the research division of the company was promoting those very shares and its investment banking division making large sales of them.

The evidence, which Merrill still claims was being taken out of context, was damaging because, Merrill, as investment banker, earned large commissions from the sale of shares to gullible investors who bought the advice and invested in them. In the long run, investors lost out, because the share prices collapsed, the companies lost out, as they could not back the hype surrounding their shares with performance that spelt profits, but Merrill itself appears to have gained huge amounts by way of investment banking fees. The charge that this was not accidental but wilful carries all the more weight because the analysts whose “advice” generated the investment banking business in shares they themselves privately described as “junk”, were partly paid on the basis of the volume of such business they generated.

It is now clear that neither was InfoSpace an exception for Merrill, nor was Merrill an exception on Wall Street. Salomon Brothers, now the Salomon Smith Barney unit of Citigroup, had a close relationship with the one-time telecom darling WorldCom, whose colourful chief Bernie Ebbers had to quit in ignominy because he drove the company into debt and oversaw a boom and then collapse in the price of the company’s shares. Jack Grubman, a well-known Salomon Smith Barney research analyst, is now accused of helping the shares along on their upward spiral during the 1990s, by hyping up the share. It was only in March 2002 that Grubman changed his advice on WorldCom, when he was left with little option. He had, in fact, maintained his “buy” rating as WorldCom shares collapsed from $60 to less than $6 a piece. Grubman was possibly hoping that his rating would help reverse the decline and cut client losses.

Jacob Zamansky, the securities attorney who focuses on such cases has reportedly argued that “Grubman is at the centre of the WorldCom debacle. His research reports and hyping of the stock led to artificially high levels.” Not surprisingly, Grubman has been the target of a number of lawsuits filed among others by current and former WorldCom employees, who claim that they were given wrong advice by him or that his bullish reports resulted in their clients losing money.

Zamansky has also filed an arbitration case against Salomon Smith Barney and Jack Grubman, claiming that one of his clients lost $455,000 after buying shares in Global Crossing, the bankrupt telecoms group, recommended by Grubman. Global Crossing, as is to be expected, was also a lucrative Salomon banking client. “Jack Grubman was the king of conflicted analysts,” Mr Zamansky says. “He unabashedly promoted investment banking deals for his firm while claiming to be the leading analyst.”

Thus, the matter is not just that of wrong judgement or misplaced enthusiasm of a single analyst. According to the Financial Times, data compiled by Thomson Financial shows that Salomon, which helped manage WorldCom debt issues, generated $106m in fees between 1997 and 2001. Disclosed fees paid by WorldCom to Salomon for merger and acquisition work amounted to another $61m.

These and other instances of misuse of situations of possible conflict of interest have encouraged Spitzer to broaden his inquiry. He has reportedly issued subpoenas to most of Wall Street’s big investment firms – including Credit Suisse First Boston, Salomon Smith Barney, Goldman Sachs, Morgan Stanley, Bear Stearns, UBS Warburg, Lehman Brothers and JP Morgan. All of them have been asked to hand over copies of all communications between their stock analysts, investment bankers and brokers. The rot, Spitzer suspects, seeps right through the system.

Coming in the aftermath of the Enron collapse and Andersen’s role in it, these well-founded allegations make misuse by financial firms of situations of “conflict of interest” for profit a systemic disease. Andersen had suppressed opinions it needed to express as Enron’s auditor, because of the strong relationship that the firm had with Enron as a provider of other consulting services. In 2000, Andersen earned more from non-audit services provided to Enron than from its role as auditor. This meant that even when an internal whistle-blower pointed to what were unacceptable accounting practices that were being adopted by Enron, which helped conceal the financial vulnerability of the company, Andersen chose to ignore, conceal and shred the evidence. This was because Andersen was partly responsible for shaping Enron’s fraudulent financial policies, to the extent where the Securities and Exchange Commission discovered rather belatedly that a significant number of former Andersen employees held top financial jobs at Enron.

There are two ways in which reformers can respond to the evidence that potential conflict of interest can make the system run amok. They could look for and destroy the institutional features that allow for such conflicts. In the case of the financial sector, those features relate to one consequence of a liberalised financial order: the breakdown of the Chinese Walls that separated different financial activities. In the US, the Glass-Steagall Act (1933), which chose to build such a wall between commercial and investment banking, came after the financial crises that led to and accompanied the Depression. It prohibited banks, securities firms and insurance companies from affiliating. Along with the repeal of that Act (by the Gramm-Leach-Billey Act of 1999), financial liberalisation has diluted or done away with a range of other regulatory instruments aimed at segmenting the financial sector in order to pre-empt any situation of conflict of interest. The resulting consolidation in the financial sector that, through diversification activities and mergers and acquisitions brought together hitherto segmented financial activities, was defended on grounds of efficiency and “economies of scale”. As a result, according to one estimate, “a relatively small number of big investment banks – say 15, if you count both the global bulge bracket and the big regional operators – are now part of almost every deal, often playing more than one role.” It is such consolidation combined with the greater freedom from regulation and supervision associated with financial liberalisation that underlies the systemic failure that leads to misuse of situations of conflict of interest. Therefore, it is such consolidation that needs to be reversed.

The fear that the Andersen episode and Spitzer’s pursuit of major Wall Street banks could lead to this conclusion has set off the second of the possible responses, led by Wall Street and its backers in the establishment. The doubts about accounting firms generated by Andersen, which is losing its own independent identity, resulted in cosmetic changes on the part of the other major accounting firms, including the ‘big five’. Price Waterhouse and Coopers and Deloitte Touche Tohamatsu recently announced the separation of their audit and consulting business, imitating KPMG and Ernst and Young, which had earlier spun off their consulting businesses.

Merill’s own initial response was to dismiss Spitzer’s allegations of fraud and refuse to publicly declare the names of companies being prospected for business. However, this initial belligerence has given way to a willingness to go part of the way to accommodate Spitzer, who is threatening penal action varying from criminal cases to imposition of compensation payments, if the firm is found guilty. As a first sign of willingness to soften, Merrill declared that it would make announcements of potential conflicts of interest in its businesses on is website. Subsequently, the apology referred to earlier was tendered. This was because of growing pressure not merely on Merrill but all Wall Street banks, which increased when 11 state securities regulators organised under the North American Securities Administrators Association decided to create a task force to investigate “possible securities law violation by Wall Street firms”.

The scaling down of Merrill’s rhetoric has been accompanied by three other responses aimed at salvaging the reputation and the businesses of the Wall Street majors. First, firms have declared their intention to separate investment banking and research activities, making them accountable to their own boards. Second, there is now a concerted effort to run down Eliot Spitzer, whose actions are being described as a witch-hunt driven by political ambitions. Wall Street bankers have reportedly “gone to pains to point out that the attorney-general is running for re-election in November. And they claim that he is looking for his “Giuliani moment” – a phrase coined when New York’s former mayor won over the public by having suspected inside traders arrested when he was still just an ambitious US attorney.” Interestingly, Merril Lynch has retained Rudolph Giuliani to advise it on settlement talks with Eliot Spitzer.

Finally, the drive to take the “conflicts” case away from Spitzer has begun. After having slept on the growing evidence of such conflict, Harvey Pitt, the Chairman of the US Securities and Exchange Commission has belatedly announced the launch of an investigation into investment banking conflicts of interest. But his newfound enthusiasm carries a caveat. While stating that Spitzer would be “invited to participate” in the SEC’s investigations, Pitt declared that the SEC should lead the national inquiry into analysts’ conflicts of interest. Wall Street has welcomed this, since Pitt is known to be more sympathetic to their cause. Before coming to the SEC, Pitt as a lawyer is known to have worked with all big five accounting firms, and many securities firms, including Merrill Lynch. Not surprisingly Pitt’s initial response to the Merrill Lynch case was that Wall Street firms themselves had started making the necessary “corrections” to deal with conflicts of interest. But forced by the actions of Spitzer and some state securities regulators, Pitt has been forced to accept that there are enforcement as opposed to mere regulatory issues involved.

Soon after Pitt entered into battle, more with Spitzer than with the majors, Richard Baker, chairman of the House sub-committee on capital markets, has called for removing the investigation into conflicts of interest from Spitzer and returning it to federal authorities. In a recent letter sent to Harvey Pitt, the Congressman has expressed “grave concerns” about the attorney- general’s efforts to impose rules on Wall Street.

Meanwhile, the SEC has jumped the gun and approved with minor modifications a set of rules governing analysts that had been proposed earlier this year by the New York Stock Exchange and the National Association of Securities Dealers. These, interestingly, were rules that had been welcomed by large Wall Street firms. But they fall far short of demands for a ban on stock analysts working in areas like mergers or the underwriting of share issues and proposals to protect analysts from internal pressures when they rate the shares of the firms’ investment banking clients as poor. Not surprisingly, many see the SEC’s decision as an effort to pre-empt stronger regulation.

But around that very time news emerged that Pitt had attended a meeting with the chief executive of accounting firm KPMG, which was under investigation for accounting practices that allowed Xerox to inflate its pre-tax earnings over a long period. In an internal memo, the KPMG chief had allegedly claimed that he had requested Pitt to drop the investigation. News of that development led to calls from conservative financial newspapers like the Wall Street Journal and the Financial Times that Pitt should step down.

The likely final outcome of these developments is quite still unclear, but it is bound to involve substantial damage to the reputation, stock values and bond spreads of the Wall Street majors, as well as some compromise on the restructuring of their operations. As late as May 12, Spitzer informed the public on television that he was nowhere near agreement with Merrill in settlement talks. Merrill, in his view, was not willing to go far enough to restore its integrity and regain investor confidence. And the SEC’s newly adopted rules to deal with conflicts of interest were “inadequate”. The attorney general has, it appears, dug his heels in.

Whatever the outcome, the evidence is clear for the disinterested observer. The consolidation created by financial reform the world over has not merely strengthened financial firms, but created structures that substantially increase the likelihood of fraud and financial fragility. Friedrich Hayek, the quintessential apologist for capitalism, had argued, long years back, that markets under capitalism were self-organising systems, which through a process of evolution had created appropriate mechanisms for self-governance. They were therefore best left to themselves. What a range of experiences varying from the breakdown of Long Term Capital Management to the current Merrill Lynch episode (through, of course the Enron and Andersen collapse) show is that such governance is poor. Giant firms operating in unregulated markets spell individual bankruptcy and social chaos. And efforts at tinkering with the discredited regulatory mechanism cannot solve the problem, which is systemic and far-reaching. Resolving it requires breaking down the behemoths that financial deregulation has created, so that a meaningful regulatory structure can be erected.