css CORPORA NTE ETHICAL GOVERNANCE & ACCOUNTABILITY 353 fow York's attor billion Pa ease asia robe of ten brokerage? qu multitegulator investors ae eect alleged tht hyped stocks during the 90s bays vet, Ben he ks ding the 9s bll market" tip of ake ment BAY represent ony the review the findi Bas aggrieved investors Farce Boing and sve the brokerages {or iss ofthe personal loses estimated n since 2000 Nonetheless, it Promises an overdue start on the reform of Wall Street's awed conflic-of interest lict-of interest ractices. As such, the revisions ultimately adopted will provide a template for invest ‘ment advisors around the world The story behind the probeisalsoan inter- esting one. It shows the capacity ofa state's Attorney-General to force the Securities Exchange Commission (SEC), which hasreg- ulatory authority over U.S. capital markets, to act when they appeared reluctant to take on Wall Street in a direct, public, and serious manner. In fact, Spitzer was able to bring together his office, the SEC, the National Association of Securities Dealers, the New York Stock Exchange, and a group of state regulators, as well as the major brokerages involved, to arrange a settlement. ‘The accepted settlement, while indicat- ing the complicity ofthe ten firms involved, will probably do more to restore lost confi ‘dence in the capital markets than to weaken it, Regulators have been seen to act, bro kerages are on notice thatthe old practices will no longer be tolerated, and the right of investors to have unbiased advice is rein- forced, The resulting sharpening of ethics awareness on the part of advisors, their to Pay Fines of $14 Bi Tewall Street Firms ‘Andrew Ross Sorkin, 2 Alex Berenson and 2003. ed in this ease to signify Wall Street is 0s tered on Wall Street in New York City Randall Smith, “Ten Firms Must Pay S14 December 23, 2002. “Bid. ‘ial Street Fras to Pay Fis of $14 Bll US. Billion lion US." Toronto Star, December 21, 2002, DS “How Wall Steet Was Tamed,” Nev the US. investment advisoryfbrokerage community, which is cen- firms, and the regulators, together with the emergence of mote ethical practices, should assist in the restoration of investor trust in the capital markets The Settlement Ten firms have agreed “to pay $1.435 bil lion, including $900 million in penalties, $450 million for research over the next five years and $85 million for investor ceducation.”' The list of payments, in mil- lions, is shown in Table 1. Two other firms that had been part of the settlement talks didnot participate in the announced settlement. Some observers hailed the settlement and resulting changes to be “the dawn of anew day for Wall Stree.”® Others felt that the fines were a drop in the bucket. “Citi corp, for example, averaged about $65 mil- lion in profit each business day in the third quarter, meaning one good week would cover its payment.”® If the payments turn ‘out to be tax deductible, the impact would certainly be minor in size but would pos- sess a significant signaling value. What Caused Concern? Conflicts of interest have been common practice in the brokerage business since its inception, For example, most brokerages (and brokers) have investments on which they take speculative positions and on Which they make investment recommenda- tions to investors. In the case of the bro- rages, they are usually required to disclose to prospective investors when they are selling shares asa principal, but the pre- sumption of unsuspecting investors has vw York Times, December 22, ‘over Misleading Stock Research,” Wall iret Journal pawT: CORPORATE ETHICAL GOVERNANCE & ACCOUNTABILITY examine ‘his raing_of ted that he helped Grub- man’s children gain admission to eo Slous Manhattan nursery school.”!? In addition to providing investment advice that lacked integrity, Wall Street firms have been playing favorites. They have been offering shares of hot public offerings to the executives of companies Fegarded as good prospects for investment banking deals. This is known as “spi ning,” and due to the pent-up demand for the new offerings, a profit is virtually assured. Proposed Structural Reforms In order to help ensure that “stock recom- mendations are not tainted by efforts obtain investment banking fees"? and other benefits, the settlement pro- poses several changes in the way invest- ment business is done, including the following: + “Each firm’s research unit will reside in a unit separate from the investment banking unit, with its own legal and compliance staff, and which doesn’t report to investment banking... Decisions to terminate [analyst] cover- age must be made by research and not investment bankers, and can’t substitute for a rating downgrade... ‘Analysts can’t be compensated based on investment banking work or input from bankers, and should be paid wid. ‘tid based partly on the accuracy of their stock picks.” Some problems stil exist, and further framework changes will emerge, but a start has been made on cleaning up some of the conflicts of interest facing investors and the brokerage community. On April, 2003, a Joint Release was issued and lodged on the SEC Press website by the five regulatory agencies involved, which had the following headlines: Ten of Nation’s Top Investment Firms Settle Enforcement Actions Involving Conflicts of _ Interest. Between Research and Investment Banking, Historic Settlement Requires Pay- ments of Penalties of $487.5 Million, Disgorgement of $3875 Million to Fund Investor Education and Man- dates Sweeping Structural Reforms Questions 1, Identify and explain the conflicts of interest referred to in this case. What additional rules should the SEC make? . What should be included in the inves- tor education that the settlement funds are earmarked for? Was it appropriate for the New York Attorney General's Office to have become involved in securities regula- tion, or should this have been left to securities regulators? 1 swall Street Firms to Pay Pines of $1.4 Billion US." D3, °S smith, “Ten Firms Must Pay (SPs nding family Glen Grossmith is an outstanding famil man, a frequent coach for his children’s teams, and a dedicated athlete who enjoys ‘SI Billion over Misleading Stock Research.” individual and team sports. One day, his boss at UBS Securities Canada Inc., Zoltan Horcsok, asked him to do a favor for a354 CHAPTER 5 onc eine Tae ‘ ce rT INVESTO! INDEPENDEN EDUCATION FINES RESEARCH Torat eee re 25 a Seman Smith Bamey $300 $75 Ee # Hey Parent, Citigroup inc 50 ee 150 D Creat Suisse First Boston ee 6 25 = o Mere Lyoch 6 50 Morgan Stanley - 50 10 Golsman Sachs - 25 5 z ans 5 7 Deutsche Bank ee By : JP. Morgan Chase eS Bs G a Lehman Brothers ss i UBS Warburg | et = — as $500 $450 $1435 seven months ear i r300n86t0 Spizers orignal haga “"Mernll Lynch agreed to pay an additonal $100 milo been that brokerage employees—analysts and investment advisers—were acting in the best interest of the investors they were advising. How wrong they were! According to Forbes.com, Spitzer’s office found e-mails showing “Merrill Lynch ana- Iysts with their guard down, privately trash- ing the stocks they publicly recommended.”® In addition, “there is the widespread phe- nomenon of research departments com- mencing coverage of companies their (investment) banks recently took public. ‘This coverage is always positive.”® Moreover, “analysts almost never say ‘sell’ According to Thomson Financial/First Call, fewer than 2% of all financial analysts are ‘sell’ or ‘strong sell’... Third, there are cases like Enron that are not recent initial public offerings but companies that do massive and repeat business with Wall Street. The analysts an say they are not swayed by their firm's interests, and they can claim they were defrauded, but how do they explain the uni. formity of their recommendations"! ” Smith, “Ten Fin "Ibid Brokerages have long relied on the notion of the Chinese wall or a fireyal that they claim can stop information known to investment bank personnel wi develop and price independent publi offerings from reaching stock analysts or brokers serving retail clients. However, there are those who doubt that Chinese walls are fully effective. According to Richard Epstein, a law professor at the Uni- versity of Chicago, “The only thing [the analyst] needs to know [about the invest. ment banking client) if he is inclined to swing his recommendation is that it is a client.”"" Since analysts have been remu- nerated partly on the basis of underwriting Tevenues and/or on the basis of retail com- missions or total brokerage revenues, there {8 built-in remuneration motivation for Promoting the stock of known or potential underwriting clients, On other Occasions, the attempts to influence analysts have been quite direct. Pethaps the most startling example came ms Must Pay $1.4 Billion over Misleading Stock Research.” Wall Street Firms to Pay Fines of $1.4 Billion US," pg, 1, Dao Ackman, “Everyone Wants a Shot a the Analysts,” " Thid. Forbes.com, May 1, 2002,