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.