Broker Deal May Leave Investors Wondering
For the second time in five years, the nation’s biggest brokerages have agreed to shell out $1 billion of their shareholders’ capital to extricate themselves from a major scandal.
If this happened in another industry it would seem highly likely that shareholders would raise a stink, wondering what kind of managers were running these companies.
But this is Wall Street, where the profits from conduct legal and otherwise have been more than adequate to handle the periodic mega-fine.
In 1996 and 1997, it cost more than two dozen big brokerages and their self-regulatory organization a total of $1 billion to settle government and investor charges that they had long rigged Nasdaq stock trading for their benefit.
This time, the industry is accused of a much more elaborate scheme in which the firms took advantage of an entire nation’s fascination with, and faith in, the stock market.
On Friday, federal and state regulators announced a deal to end their probes of brokerage misconduct during the late 1990s bull market in return for $1.4 billion in fines and other payments and the industry’s acceptance of potentially far-reaching reforms.
Brokerage practices that regulators say were widespread at the height of the bull market -- for example, attempts by fee-driven investment bankers to bias the stock ratings of supposedly objective research analysts at their firms -- will now be explicitly forbidden.
The same goes for “spinning,” the term for brokerages’ awards of shares of hot initial public stock offerings to corporate executives who just might, in turn, award lucrative investment banking business to their benefactors.
The government, led by New York Atty. Gen. Eliot Spitzer and the Securities and Exchange Commission, is making it clear that such blatant conflicts of interest are intolerable in the securities industry.
More to the point, regulators are forcing the industry to step back in time, to re-establish internal walls that were set up long ago to guard against bribery and self-dealing in a business where such risks are always extreme.
Those walls crumbled at many brokerages in the 1990s, regulators’ evidence shows. They must be rebuilt, Spitzer said Friday.
“What used to be a conflict of interest is still a conflict of interest,” he said.
But a weary, and substantially poorer, public may be forgiven for asking why practices that now seem so obviously wrong appeared to attract so little government scrutiny during the bull market.
One answer to that question doesn’t make anyone happy, even though it rings true: In a wildly speculative market where far more players are profiting than are losing money, regulators have little incentive to end the party.
The public may not have known how much it was being cheated by brokerage practices in the late 1990s, but millions of small investors probably wouldn’t have cared anyway, because their portfolios still were ballooning as the market soared.
The media also could be blamed for failing to raise enough red flags about brokerage practices that, at a minimum, smelled bad.
But the media doesn’t have subpoena power, can’t call grand juries and isn’t directly responsible for enforcing the nation’s securities laws.
Was the SEC asleep at the switch? The agency has defended itself by noting that it undertook a host of investor-protection initiatives in the 1990s under former Chairman Arthur Levitt.
David Ruder, who served as SEC chairman from 1987 to 1989 and now is a professor at Northwestern University in Chicago, notes that Levitt championed such issues as auditor independence in corporate accounting and fair handling of small investors’ online stock orders by Wall Street.
“I don’t know how much the commission knew or should have known about pressures being put on analysts by the investment banking side,” Ruder said.
Nonetheless, he said, “They certainly knew about the practice of analysts never having a ‘sell’ recommendation” on the stocks they covered.
But Wall Street had a ready answer about analysts’ unwavering bullishness during the market’s advance: The research wasn’t flawed -- it was reflecting the economy’s new era of unlimited growth potential. Who could measure the true magic of the Internet in terms of what it would mean for the economy, the argument went. And it sounded convincing enough to plenty of investors at the time.
Once the business cycle reasserted itself in 2000 and 2001, and money-losing technology companies began to careen toward insolvency, the incessant “buy” recommendations from major brokerages finally began to ring a bell with regulators.
By then, the damage to many investors’ portfolios was already severe. It got worse by April when Spitzer released internal Merrill Lynch & Co. e-mails showing that some of its analysts privately disparaged Internet stocks while advising the public to continue buying them.
Merrill set the scene for what was to come by agreeing to pay a $100-million fine. That became a basis for the fines that nine of Merrill’s rivals have agreed to pay to settle regulators’ allegations that they too engaged in deceitful practices aimed at keeping fee-generating company clients and executives happy, at the average investors’ expense.
As with Merrill, the rest of the industry isn’t admitting or denying that it did anything wrong. Nor will executives of the major brokerages face removal.
“This deal is going to save a lot of people from being thrown out of the securities industry, which is what should happen,” argues Irving Einhorn, a lawyer and former SEC regional administrator in Los Angeles.
Those concessions by regulators may puzzle or anger small investors. If the scope of the alleged fraud perpetrated was so vast as to merit a $1-billion-plus settlement, shouldn’t some senior executives go to jail, or at least be barred from the securities industry?
Spitzer, however, has made clear he isn’t interested in destroying the brokerage industry in order to save it. Just as some commercial banks clearly are too big to fail because of the effect that could have on the economy, the potential financial ruin of every major brokerage could have dangerous implications for the financial system.
If brokerage managements aren’t going to be reshuffled because of this scandal, and the fines the industry is paying are a relative fraction of what the business can earn at its peak ($16.2 billion in 2000, according to the Securities Industry Assn.), then why should investors believe that the firms will be serious about reform?
Some Wall Street critics say the best hope lies in the structural changes regulators are forcing on brokerages. For example, by demanding that the firms make it more difficult for investment bankers to interact with analysts, the opportunity to compromise analysts’ stock recommendations should be reduced, though certainly not eliminated.
Likewise, if brokerages are forced to supply their investors with stock reports from outside research firms, those investors may at least have an opportunity to see opinions that can put their own brokerage’s views in better perspective.
Even if all of this makes Wall Street a fairer place for investors in the near term, the industry has shown again and again that the potential for abuse is ever present -- a byproduct of capitalism.
In the long run, the only protection is aggressive government oversight, some say.
“There must be an ongoing fear of prosecution,” said Scott Cleland, head of Precursor Group, an independent stock research firm in Washington.
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Key Points of Agreement
Highlights of the agreement between federal and state regulators and 10 major brokerages:
* The firms must insulate research analysts from investment banking pressure that could taint their stock recommendations. They must sever any links between research and banking, including the tying of analyst compensation to banking transactions. Analysts no longer will be permitted to accompany bankers on investor “roadshows” for securities the firms are underwriting or on trips to pitch brokerage work to clients or potential clients.
* For five years, each of the brokerages will be required to contract with at least three independent research firms to provide stock reports to their investors, in addition to in-house research. For each firm, regulators will name an independent monitor with final authority to procure independent research.
* Each firm will make publicly available its stock ratings and price target forecasts for individual shares to allow for evaluation and comparison of analysts’ performance.
* The practice of “spinning” of initial public offering shares will be banned: Brokerages no longer can allocate IPO shares to corporate executives and directors who are in the position to greatly influence awards of investment banking business to the firms.
* When a final agreement is hammered out, regulators will publicly release documents that “will describe the misconduct uncovered in our investigations.” The evidence conceivably could be used in private investor lawsuits against the firms.
* A portion of the fines the industry is paying will be set aside for investor restitution. The amount has not been determined.
* The firms that are party to the agreement are Bear Stearns Cos.; Citigroup Inc., parent of Salomon Smith Barney; Credit Suisse First Boston; Deutsche Bank; Goldman Sachs & Co.; J.P. Morgan Chase & Co.; Lehman Bros.; Merrill Lynch & Co.; Morgan Stanley; and UBS Warburg, the parent of PaineWebber.
Source: Securities and Exchange Commission
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Tom Petruno can be reached at tom.petruno@latimes.com.
