• SEC Uses $1.4 Billion Crowbar to Separate Analysts and Bankers
  • July 15, 2003 | Author: Benjamin Lehrer
  • Law Firm: Ervin, Cohen & Jessup LLP - Beverly Hills Office
  • On April 28, the Securities and Exchange Commission announced that it had settled enforcement actions against ten prominent Wall Street brokerage firms and two individual analysts over conflicts of interest between the firms' research and investment banking activities. The firms are required to disgorge $387.5 million in profits and pay $487.5 million in penalties, as well as pay $432.5 million to fund independent research and $80 million to promote investor education. The total price tag is roughly $1.4 billion.

    Two former high-flying analysts, Henry Blodget, formerly of Merrill Lynch, and Jack Grubman, formerly with Salomon Smith Barney, were singled out for individual fines of $4 million and $15 million, respectively. They were also barred for life from the securities industry.

    The $387.5 million in profits that is being disgorged will be put in ten distribution funds (one for each of the settling firms other than Merrill Lynch and one for Henry Blodget) to be administered by a court-appointed administrator. The disgorgement process will use the "don't call us, we'll call you" model, where the fund administrator will review the information provided to it by the brokerage houses to identify investors and determine payouts from the funds. The SEC has advised that this process may take up to 18 months after an administrator is appointed. The SEC has also advised that there is no guarantee that everyone who suffered losses will be able to obtain a payment from one of the funds, although the settlements do not preclude investors from bringing their own suits against the brokerages. Further information about how the funds will operate, the requirements investors will need to meet in order to receive a payout from the funds and what investors should do now can be found in a questions and answers press release posted by the SEC at http://www.sec.gov/news/press/globaldistqa.htm.

    The settlement brings to a close claims by the SEC, the New York Attorney General's office and the major national exchanges that leading analysts published research which puffed up moribund stocks in order to funnel more business to their firms' investment banking wings. E-mails and other internal documents revealed that stocks described internally as "turkeys" and "pieces of [expletive]" were being touted to the public as "Buys" and "Strong Buys" in response to pressure from the firms' investment banking wings in order to generate or preserve their underwriting business. In the year 2000, analysts employed by brokerage firms gave 100 "Buy" ratings for every one "Sell" rating--and the Nasdaq dropped 41% that year.

    As part of the settlement, brokerage firms are required to take steps to insulate their analysts from the influence of investment bankers. However, a complete separation, as was required between auditors and consultants in the wake of the Enron and Arthur Anderson scandals, was not mandated.

    The settlement envisions a world that apparently didn't exist before, where analysts will be compensated based on the quality of their analysis rather than their ability to drum up investment banking business. Investment bankers will have no role in reviewing analysts' performance or in choosing which stocks are followed. In addition, the brokerage firms must contract with no fewer than three independent research firms for a five-year period and make the independent research available to the firms' customers. Finally, analysts will not be allowed to participate in bankers' pitches and roadshows.

    The SEC is also attempting to put the kibosh on another shady practice common in the tech-bubble days, where brokerage firms would allocate portions of hot IPOs to executives of other companies in exchange for a chunk of their own underwriting business.

    The settlement is only the beginning, of course. Individual managers and officers are under investigation, and the documents released in the process will be fuel for class action lawsuits and arbitrations brought by disgruntled investors who made investment decisions based on the rose-colored reports analysts churned out at the bankers' behest. Many state regulators, including those in California, also are proposing new regulations to deal with the investment banking community. While many of these proposals will likely mirror those adopted by the SEC, it is possible that the end result may be a hodgepodge of conflicting state regulations.

    Reaffirming the age old adage that you can't always believe what you read, the lesson here for individual investors is to be sure to look beyond the hype and do your own independent investigation before deciding to invest.