RESEARCH Business Economy

Conflicts of interest among Wall Street stock gurus under scrutiny

Mark Reutter, Business Editor
(217) 333-0568; mreutter@uiuc.edu

10/29/03

CHAMPAIGN, Ill. — Did the seemingly investor-friendly decision to deregulate brokerage commissions lead to conflicts of interest among Wall Street analysts that, in turn, helped ruin investors caught in the technology-bubble stock market of 2000-2001?

That is one of the questions examined in an article about the rise of Mary Meeker, Jack Grubman, Henry Blodget and other "super-star" stock analysts appearing in the University of Illinois Law Review.

Stock analysts have long been fixtures at investment banks that both broker (that is, sell) stocks and bonds to the public and underwrite new security issues for companies. With deregulation of brokerage commissions in 1975, which ended the practice of fixed-rate minimum commissions, investment banks found their brokerage business dry up, undercut by Charles Schwab & Co. and other discount brokerages.

Trading fees plummeted and analyst reports no longer paid for themselves. As a result, the role of the analyst shifted from providing relatively impartial information for brokers and their clients to boosterish tie-ins with corporate clients, such as using the research reports to hype a company’s prospects and promoting initial public offerings (IPOs) on investor "road shows."

"Year-end performance-based bonuses were offered to analysts for their investment-banking business development skills rather than their analysis," Robert P. Sieland, an editor at the law journal, noted in the law review article. "A clear conflict of interest grew out of this relationship" as "the allure of positive coverage by a well-recognized analyst became a major factor in a company’s choice of underwriter."

Frank Quattrone, whose criminal case of obstruction of justice and witness tampering ended in a mistrial last Friday, was one of the architects of the new business model. As head of Morgan Stanley’s technology-banking team in Silicon Valley, he combined research analysis and underwriting, and in 1991 hired Mary Meeker as his analyst. Meeker replaced Quattrone in 1996 after he left Morgan Stanley to head the technology banking team at Credit Suisse First Boston. (Quattrone’s actions at Credit Suisse were the subject of the trial.)

The hiring and promotion of Meeker by Morgan Stanley reflected two important aspects of the evolving institutional framework to use stock analysts to generate banking and advisory fees, according to Sieland.

"First, an analyst – Meeker – was hired by an investment banker – Quattrone. A clear implication was that an investment banker could also have fired an analyst. Where analysts presumably could assert that their first duty was to offer objective research and that any deal development was only incidental to their reputation, Morgan Stanley’s union of analysts and underwriters under a single group created an inescapable conflict of interest.

"Second, Meeker’s promotion to head of Morgan Stanley’s technology group crystallized the conflict of interest to which she was already subject. Whereas she might have been able to rationalize her conflicting duties as analyst in the technology group, as head of Morgan Stanley’s technology group, she had a clear duty to Morgan Stanley to develop deals and to Morgan Stanley’s underwriting clients."

Meeker’s compensation nearly tripled, to $15 million in 1999, as Morgan Stanley did more Internet underwritings that year than it had done in the four previous years combined.

Another prominent example of an analyst acting as an investment banker was Solomon Smith Barney’s telecommunications analyst Jack Grubman.

Grubman was not only a renowned analyst who could sway the price of a telecom stock, but he was also a telecom dealmaker who advised WorldCom and other high-flying companies he recommended to investors. When subsequently questioned about his dual roles, which netted him $20 million in 1999 alone, Grubman replied, "What used to be a conflict is now a synergy."

Henry Blodget’s career is also studied in the law review article. His career took off after he predicted in 1998 that Amazon.com’s stock price would exceed $400 per share. His role as analyst and stock promoter at Merrill Lynch was blurred as he publicly preached the virtues of Internet companies that he privately disparaged in e-mail messages obtained through subpoenas by New York Attorney General Eliot Spitzer.

The recent wave of reforms on Wall Street only partially addresses the "symbiotic relationship" between investment bankers and analysts, according to the Illinois scholar. The most obvious conflicts – such as letting underwriters review analyst reports before they are issued and prohibiting underwriters from retaliating against analysts who write unfavorable reports on clients – are now banned by Wall Street banks.

But the rules do not cure the problem that analysts are not objective information gatherers, but rather "sell-side" promoters whose compensation and career are linked to their employer’s success at generating underwriting fees.
While the new rules remove analysts from the immediate influence of the underwriters, "they do not, and cannot, change the nature of a sell-side analyst’s function, which is to sell stock," Sieland argued.

He therefore recommends that regulations require investment banks to start labeling reports from analysts as "sales literature" or "marketing material." At the same time, he proposes that the Securities and Exchange Commission certify analysts who are financially and physically separated from all aspects of underwriting to be listed as "independent analysts" who conduct "independent research."

"Such independent analysis would probably cost the private investor because it would no longer be partially funded by the revenues of investment banking activities," Sieland wrote.

"But the regulated distinction between independent analysis and marketing material ensures that investors know what they are getting without destroying the market for research reports. Rather than eliminating the option of free but partial analysis from underwriters, this certification option creates a market for independent research, while preserving the economic incentive for underwriters to procure research. This should expand the availability of research for investors."

Sieland’s article is titled "Caveat Emptor: After All the Regulatory Hoopla, Securities Analysts Remain Conflicted on Wall Street."