Scandals Pave Way for Wall St. Reforms

The stock market crash of 1929 spurred the creation of the Securities and Exchange Commission.

A rash of insider trading in the 1980s culminated in junk bond king Michael Milken’s guilty pleas to fraud charges in 1990, and in the bankruptcy of Drexel Burnham Lambert.

In 1996, a dramatic clampdown by the federal government put an end to bid-rigging by Nasdaq stock dealers that had inflated investors’ trading costs for decades.

Wall Street’s history has had a certain rhythm: bull market, then bear market, then--almost without exception--scandal.

Many episodes of fraud and chicanery have been so minor that they have come and gone without much effect on the overall financial system. But there are times when the magnitude of the abuses is so large, and investors’ loss of faith in the system so undeniable, that the government steps in to force massive change.

The debate today is whether Wall Street’s intensifying crop of scandals stemming from the 1990s boom years will launch such far-reaching reforms.

Federal and state regulators now are investigating a wide array of alleged Wall Street wrongdoing, ranging from the conduct of stock analysts to the handling of hot stock offerings to the role of investment banks in the collapse of Enron Corp.

And as the list of perceived abuses grows longer, a public that lost trillions of dollars in the stock market’s plunge has grown increasingly agitated, distrustful and hungry for vengeance.

“This is not the kind of once-in-100-year scandal that we saw in the 1930s. But this is the largest crisis in a quarter-century as far as the industry’s reputation for integrity,” said John Coffee, a Columbia University securities law expert.

Some experts say that may lead to genuine change, both in the form of new government regulations as well as heightened internal policing by Wall Street itself, to clean up securities markets and limit the potential for large-scale fraud.

“We have a very good chance that over the next two or three years a broad series of changes will strengthen and improve the markets quite significantly, and hopefully public confidence with it,” said Richard Breeden, a former SEC chairman.

But that sentiment is far from universal, and some doubters worry that only moderate changes will emerge.

Skeptics say regulators were long aware of some institutionalized deceitful practices by the financial industry but failed to corral them.

What’s more, disputes between state and federal regulators, and between Democrats and Republicans in Congress, threaten to slow the reform process.

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Investigators Pursuing Three Main Probes

One of the first major Enron-related reform bills proposed in Congress was panned by some for ordering relatively modest changes in regulatory oversight.

“I don’t think anybody has the stomach, even in a post-Enron environment, for restructuring Wall Street,” said Donald Langevoort, a Georgetown University law professor.

Indeed, regulators’ efforts to effect change so far lack the spectacle of 1987--when accused insider traders at big-name brokerages were led from their offices in handcuffs.

The loss of so many lives on Wall Street on Sept. 11 has almost certainly dimmed prosecutors’ appetite for those kinds of theatrics as well as for the most punitive measures against the financial industry, some experts say.

Nonetheless, government investigators and private plaintiffs’ attorneys are pursuing three main probes of Wall Street conduct that have the potential to generate significant penalties--and reforms--if evidence of fraud is overwhelming:

* The brightest spotlight is trained on brokerage research analysts, as state and federal regulators focus on whether analysts intentionally misled investors with their stock recommendations in recent years.

The key concern is that analysts talked up stocks primarily to flatter the subject companies and lure fee-rich investment banking business to their firms--not because they believed in the companies they touted.

The analyst controversy first surfaced a year ago as Congress began rooting around for villains in the aftermath of the worst stock market decline in a generation. But the issue hit a boiling point only last month, when New York Atty. Gen. Eliot Spitzer released a series of revealing e-mails written by Merrill Lynch Internet-stock analysts in 2000 and 2001.

In the private e-mails Spitzer obtained by subpoena, Merrill analysts brutally criticized stocks they covered--deriding some as “junk” and “crap”--while recommending them to the public.

Many observers view the missives as a smoking gun that provides the strongest proof that serious fraud permeates brokerage practices. Spitzer has broadened his probe of analysts to include other major brokerages, and the SEC has since launched its own formal inquiry.

“If you can establish that the opinions given by these investment banks were not bona fide, that becomes potentially one of the biggest securities frauds in Wall Street history in magnitude,” Langevoort said.

Merrill Lynch initially lashed out at Spitzer and his charges, but became conciliatory as the uproar grew. The firm is attempting to negotiate a settlement with Spitzer, but the attorney general is pushing for a large restitution fund to compensate investors, and the guarantee of reforms that would ensure that analysts are honest and objective in their advice to investors.

* The SEC and National Assn. of Securities Dealers are conducting wide-ranging investigations of Wall Street’s handling of initial public stock offerings in the bull market’s heyday.

Brokerage giant Credit Suisse First Boston agreed in January to pay $100 million to settle twin civil investigations of how it allocated IPO shares to investors. The probes delved into whether the firm charged excessive IPO commissions that amounted to kickbacks.

Now regulators are in a second, and potentially more serious, leg of the investigation: They are examining whether numerous brokerages tied IPO allocations to promises by clients to buy more shares in the open market.

That raises the specter of outright market manipulation, if prearranged buying caused artificial price spikes. If the allegations are borne out, small investors could have a strong case that they were cheated if they bought IPOs on their first trading day, often at exorbitant prices.

The IPO controversy has spawned 310 class-action lawsuits naming about 45 brokerages.

But some Wall Street critics were disappointed last fall when the Justice Department declined to pursue a criminal case against CSFB in the IPO matter.

And many experts say that reforming the IPO-allocation process is one of the most vexing challenges facing regulators.

* Perhaps the biggest wild card for Wall Street is whether its involvement with Enron will be shown to have abetted the company’s alleged frauds in financial reporting.

Congressional investigators and others are studying whether investment banks helped Enron mislead investors by devising its controversial partnerships that hid debt from the company’s investors, work for which the banks earned juicy advisory fees. The House Energy and Commerce committee sent a team of investigators back to New York last week to gather additional data.

Though the probe is not yet done, “some of the transactions under investigation certainly have raised a lot of eyebrows around here,” committee spokesman Ken Johnson said.

Investment banks argue that they were victims of Enron, and several are among Enron’s largest creditors in U.S. Bankruptcy Court. But in court, some rival creditors accuse the banks of contributing to Enron’s downfall. A group of insurance companies has lodged such claims in an almost $1-billion legal dispute against J.P. Morgan Chase & Co. If bankers are shown to have known of the company’s alleged efforts to conceal its true financial condition, they could be held partly responsible for the biggest bankruptcy in U.S. history.

In all three of these investigations, prosecutors and plaintiffs’ attorneys bear the burden of proving wrongdoing in what can be fuzzy areas of securities fraud laws.

But the public’s disgust over the accusations is clearly registering in Wall Street executive suites.

In a rare concession, Merrill Lynch’s chief executive, David Komansky, called the e-mails “embarrassing” and apologized for them.

Komansky defended the firm in a television interview last week as having integrity and following “a very strong set of compliance rules.” But he acknowledged that Merrill and others may have to take significant measures to reestablish good reputations with investors.

“We as a firm and as an industry have to do something to get investor confidence back the way it was,” Komansky said.

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Market Experts Caution Against Overreaction

They’ll have to work hard to reclaim investors such as Marilyn Barrett.

“When an individual investor listens to an expert, you have to appreciate the fact that sometimes they will make an error. But to know that they were not even trying to act in your best interest,” said Barrett, a Los Angeles attorney. “I trust them a lot less than I used to.”

Yet some market experts caution against overreaction.

“Nobody wants to reform anything in a roaring bull market because everybody’s making money,” said Wall Street historian John Steele Gordon. “But then when the bull market suddenly ends, you need scapegoats. People start looking and finding all kinds of things that are wrong.”

He believes that, from as to fairness to investors, “Wall Street is an awful lot better today than it was in the 1970s ... and a whole lot better than it was in the 1920s.”

Even so, the reform process is rolling. Regulators already have proposed some changes to rebuild public confidence.

The NASD and the New York Stock Exchange have proposed banning brokerages from tying research analysts’ compensation to specific investment banking deals. Regulators also want brokerages to boost disclosure of potential conflicts of interests in their stock recommendations.

The SEC will vote on the NASD/NYSE plan Wednesday, even as the agency pursues its investigation of analyst conduct.

But some experts say the proposal doesn’t go far enough. It would “fall short,” Spitzer said.

To some skeptics, the stock analyst controversy shows how tough it will be to achieve real reform: Analyst conflicts were well-known in the financial industry in the 1990s, and were tacitly accepted by regulators, critics say.

The SEC issued a report last year showing that many analysts bought stocks for their personal accounts at low prices before pitching them to investors. Congress held high-profile hearings on the issue last summer.

Yet the SEC launched a full investigation only in the days after Spitzer’s revelations last month.

“Everyone on Wall Street knew there were conflicts of interest involving analysts,” said Coffee of Columbia University. “Even at the SEC, the attitude when these allegations first started surfacing was a little like the French inspector in the film “Casablanca” who was ‘shocked, shocked’ to find there was gambling going on in the casino.”

Spitzer concurs. Before his release of the Merrill e-mails, he said last week, “It was abundantly clear that no serious reforms were occurring.”

The House passed a bill late last month that encompassed analyst-reform issues, but critics blasted it as weak. The Senate Banking, Housing and Urban Affairs Committee is working on a bill that is expected to be much tougher than the House version.

For example, it contains an “anti-retaliatory” provision that would bar brokerages from penalizing analysts whose stock downgrades damage an investment-banking relationship, said one person involved in the process.

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Threat of Prosecution Could Prompt Change

Most observers say some reforms involving analysts’ roles are inevitable. “You can’t support a large stable of analysts who no one believes,” Coffee said. “You’ve got to adopt reforms that make analysts credible.”

The question is whether the reforms would make a practical difference.

For example, analysts are sure to become more upfront in disclosing certain conflicts of interest, such as when they’re writing a report about an investment-banking client. Merrill Lynch, in a partial settlement with Spitzer, has begun to do that.

But “with investment banks regularly seeking business from anybody who has a deal to, [disclosure] is going to become very routine and boilerplate,” Langevoort said.

The most important reforms of Wall Street practices may spring not from new laws, but from market forces--and fear of criminal prosecution, some experts say.

The threat of prosecution could prompt changes in firms’ conduct if executives fear that they or their companies could be criminally liable.

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Investigations Strike Fear Among Analysts

Spitzer has said he could charge Merrill with criminal fraud violations under state law.

The Justice Department, though cautioning that it is not conducting a blanket probe of analysts, also is examining the issue for criminal liability.

“The Department of Justice could have an unprecedented impact on how the financial markets operate in the future,” Washington securities lawyer Jacob Frenkel said.

Beyond any penalties on Wall Street that the government investigations may lead to, “It strikes fear because it raises the hairs on the heads of all the plaintiffs’ class-action lawyers who see this as another way to milk the golden cow,” said one defense attorney involved in stock analyst, IPO and Enron cases.

“They’re [brokerages] terribly exposed with these class-action lawsuits” to high financial costs if government probes prove wrongdoing.

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Times staff writer Kathy M. Kristof contributed to this report.