Confessions of a Wall Street Analyst Part 17

Bert Roberts-The former chairman of WorldCom agreed on March 21, 2005, to pay $4.5 million to settle claims against him for his role in WorldCom's downfall. In an unprecedented move, Roberts and the rest of the board of directors paid a total of $24.75 million of their own money to settle a variety of lawsuits, with the board members' insurance policies kicking in another $36 million.18 Usually insurance policies cover any corporate director's liability, but the lead in the cla.s.s-action suits, New York State comptroller Alan Hevesi, wanted to make an example of WorldCom. The directors, according to Hevesi, each paid about 20 percent of their individual net worth. Usually insurance policies cover any corporate director's liability, but the lead in the cla.s.s-action suits, New York State comptroller Alan Hevesi, wanted to make an example of WorldCom. The directors, according to Hevesi, each paid about 20 percent of their individual net worth.

Ivan Seidenberg-Ivan became sole CEO of Verizon in 2002 and was named chairman of the board in 2004.19 In 2005, Verizon agreed to purchase MCI-the former WorldCom. In 2005, Verizon agreed to purchase MCI-the former WorldCom.

Eliot Spitzer-After years of unofficially running for governor of New York, Spitzer made it official in 2005, competing on his record of tackling corporate wrongdoing. Yet most of the cases he pursued were settled. Indeed, after settling with Grubman, he opted not to pursue Weill and other top Wall Street executives in the research scandals. Instead, he pursued high-profile cases against the mutual fund and insurance industries. His office's one Wall Street prosecution involved a mid-level Bank of America broker, Theodore C. Sihpol III, who was accused of late-trading in mutual funds on behalf of some hedge fund clients. Sihpol was acquitted of 29 counts at trial, including a top count of grand larceny, and the jury deadlocked on four others.20 Shortly thereafter, Spitzer decided not to retry Sihpol on the remaining counts. Shortly thereafter, Spitzer decided not to retry Sihpol on the remaining counts.

Scott Sullivan-On Aug. 11, 2005, in exchange for cooperating with the authorities in prosecuting Bernie Ebbers, Sullivan received a five-year federal prison sentence-a fifth of what he could have gotten-for his role in the WorldCom scandal.21 His wife, who is diabetic, and his four-year-old daughter are still living in the same small ranch-style house in a modest neighborhood of Boca Raton, Florida, where they've lived since 1990. Sullivan will likely serve his sentence in a minimum-security federal prison in Pensacola, Florida, 600 miles from his home. In July 2005, Sullivan agreed to forfeit the multimillion-dollar palace he built but never managed to move into, along with his 401 (k) retirement fund, to settle a cla.s.s action lawsuit. His wife, who is diabetic, and his four-year-old daughter are still living in the same small ranch-style house in a modest neighborhood of Boca Raton, Florida, where they've lived since 1990. Sullivan will likely serve his sentence in a minimum-security federal prison in Pensacola, Florida, 600 miles from his home. In July 2005, Sullivan agreed to forfeit the multimillion-dollar palace he built but never managed to move into, along with his 401 (k) retirement fund, to settle a cla.s.s action lawsuit.22 The house sold in August 2005 for $9.7 million, less than half of its original price, while the 401 (k) is only worth $200,000 because most of it was tied up in now-worthless WorldCom stock. The house sold in August 2005 for $9.7 million, less than half of its original price, while the 401 (k) is only worth $200,000 because most of it was tied up in now-worthless WorldCom stock.23

Robin Szeliga-The former Qwest chief financial officer pleaded guilty on July 14, 2005, to one charge of insider trading, and faces up to 10 years in prison and a $1 million fine. Yet the illegal transaction netted her just $125,000-not a good trade. She has also reached a deal with the SEC, and she is widely expected to testify against Joe Nacchio.24

Sol Trujillo-Even though Joe Nacchio edged him out after the Qwest-US West merger, Sol's career didn't grind to a halt. On July 1, 2005, he became the CEO of Telstra, Australia's national phone company, after spending two years as CEO of Orange, the huge European wireless firm and subsidiary of France Telecom.25

Sanford I. "Sandy" Weill-Weill's reputation as the king of financial services took a hit after the Grubman scandal. At the end of 2003, he gave up his post as CEO of Citigroup, handing the day-to-day operations to Charles "Chuck" Prince.26 Nevertheless, Weill remains chairman of Citigroup until April 2006, although in July 2005 he briefly considered stepping down early-on the condition that he continue to have use of the corporate jet and other lifelong perks. Nevertheless, Weill remains chairman of Citigroup until April 2006, although in July 2005 he briefly considered stepping down early-on the condition that he continue to have use of the corporate jet and other lifelong perks.27 Weill also remains heavily involved in charity work, perhaps securing a different kind of legacy by heading the Committee to Encourage Corporate Philanthropy and giving heavily to academic inst.i.tutions and the arts. His name now graces Carnegie Hall's Weill Recital Hall, the Weill Music Inst.i.tute, the Weill Cornell Medical College, and the Weill Cornell Graduate School of Medical Sciences. Weill also remains heavily involved in charity work, perhaps securing a different kind of legacy by heading the Committee to Encourage Corporate Philanthropy and giving heavily to academic inst.i.tutions and the arts. His name now graces Carnegie Hall's Weill Recital Hall, the Weill Music Inst.i.tute, the Weill Cornell Medical College, and the Weill Cornell Graduate School of Medical Sciences.28

Ed Whitacre-Whitacre remains CEO of SBC Communications Inc.29 In a stunning and ironic twist of fate, the former Baby Bell agreed to buy Ma Bell itself, AT&T, in 2005. In a stunning and ironic twist of fate, the former Baby Bell agreed to buy Ma Bell itself, AT&T, in 2005.

Gary Winnick-Despite founding Global Crossing and then selling more than $700 million in stock before it went belly-up, Winnick was never charged in the scandals surrounding the company and remains a multimillionaire, though his name hasn't graced the list of Forbes Forbes's 400 richest Americans since 2003. Although no criminal charges were filed by the government, Winnick did face many civil suits. He paid $55 million to settle a cla.s.s action lawsuit filed by shareholders.30 Winnick continues to operate his investment firm, Pacific Capital Group, and he still maintains his 64-room mansion overlooking the Bel-Air Country Club, with renovations finally finished. Thanks to some big checks, his name can be found on the children's wing at the Los Angeles Zoo, a section of the L.A. Central Library, and a cafeteria at Long Island University, his alma mater. Winnick continues to operate his investment firm, Pacific Capital Group, and he still maintains his 64-room mansion overlooking the Bel-Air Country Club, with renovations finally finished. Thanks to some big checks, his name can be found on the children's wing at the Los Angeles Zoo, a section of the L.A. Central Library, and a cafeteria at Long Island University, his alma mater.31

Afterword.

Back to the Future: Some Policy Prescriptions PLENTY OF LAWS, ethics policies, and regulations have been changed in hopes of cleaning up the Street. But will they make one whit of difference? Sadly, I think that few of them will have much impact in the long run. In part, that's because many create their own set of unintended consequences. I also think that the role of the a.n.a.lyst on Wall Street is filled with inherent conflicts, none of which can be solved by these rule changes. ethics policies, and regulations have been changed in hopes of cleaning up the Street. But will they make one whit of difference? Sadly, I think that few of them will have much impact in the long run. In part, that's because many create their own set of unintended consequences. I also think that the role of the a.n.a.lyst on Wall Street is filled with inherent conflicts, none of which can be solved by these rule changes.

I didn't realize this at first, however. Way back in 1989, when I started as an a.n.a.lyst at Morgan Stanley, I learned everything I needed to know about a.n.a.lyst independence, or so I thought, from Ed Greenberg. Ed was my mentor at Morgan Stanley, the consummate professional, and the guy who talked me into leaving MCI for the Street. His philosophy was simple, and I stuck with it for my entire career: think independently and don't let yourself be influenced by the "noise," as he called it. "Stay focused on a.n.a.lysis and valuation," he said. "The stock picking will flow from that."

It sounded pretty straightforward to me. But Ed warned that all the people around me, from the company executives to the traders, the bankers, and the buy-side clients, had different, and often competing, objectives. Paying too much attention to any of them would only distract me from my job, which was to figure out the future direction of the stocks on my coverage list. There was another reason for staying independent, and it was the most essential one. If I altered my opinions to serve some objective other than giving investors the best possible advice, it would mislead anyone who read my research and acted upon it.

If I ever needed a reality check, I got one every time I spoke to my parents, Muriel and Jack. They were on my mailing list and received all of my reports throughout the years. My father was in many ways a typical individual investor. He watched CNBC constantly and listened to the talking heads as if they were speaking the gospel. He also read virtually every single word I wrote and constantly talked to his friends about my stock picks. Every time I came down to Florida for a visit, I'd be mobbed by my mom's and dad's friends, living on their modest retirement incomes, who would ask me again and again what they should do with various stocks.

"You know, Danny, I own a lot of AT&T," a cheerful Aaron Beckwith would say, as I was still "Danny" with this crowd. "It's my largest stock position. What should I do with it?"

These were real people with real life-savings taking the advice of the supposed pros quite literally. In these cases, my recommendation might make the difference between a comfortable retirement and a miserable one. It was a very big deal. I eventually crystallized my feelings about Aaron and my parents into what I called the "grandma" approach to research: I should never recommend a stock that I wasn't comfortable recommending to my parents, my closest friends, or someone's grandmother.

That didn't mean that I shouldn't consider startups or risky stocks, but rather that I always had to do my homework, seriously investigate all the issues surrounding a stock, and do my best to come up with the right ratings, including the risk level. I wouldn't be right all the time, but I was obligated to do my best. Even though the clients I focused on were primarily large inst.i.tutional investors, those inst.i.tutions were often investing on the part of mutual and pension funds that perhaps managed my parents' or Aaron Beckwith's retirement savings.

Although the pressures from my larger, more powerful const.i.tuencies kept intensifying as the bull market picked up steam, I managed to stick to the Ed/Grandma approach pretty well over the course of my career. It was relatively easy at first, since very few people knew who I was and my calls didn't move stocks. Over time, as my work become more widely read, my rankings rose, and other a.n.a.lysts began to get cozier with the banking side of the business, it got increasingly more difficult, as I've described in this book.

But I had it easier than a lot of my counterparts. I was extremely lucky to have started on the Street at a time when there was very little investment banking activity in the telecom industry. The pressures didn't really intensify until after I had built my reputation and had become ranked on the Inst.i.tutional Investor Inst.i.tutional Investor magazine's All-America Research Team. And by then, my job-or at least the pay-was guaranteed under multiyear contracts. So by the time the bankers went into heat, I had financial security from the contracts and a decent amount of job mobility from the high magazine's All-America Research Team. And by then, my job-or at least the pay-was guaranteed under multiyear contracts. So by the time the bankers went into heat, I had financial security from the contracts and a decent amount of job mobility from the high I.I. I.I. rankings. That gave me the leverage to resist any pressure to write or say something I didn't believe. rankings. That gave me the leverage to resist any pressure to write or say something I didn't believe.

DESPITE THE INHERENT conflicts of Wall Street, there are a few simple but strong actions that would go a long way toward deterring future misbehavior. Start with the vigorous enforcement of insider-trading laws and regulations. If a.n.a.lysts and others knew they'd go to jail when caught, the laws would deter over-the-Wall a.n.a.lysts from disclosing not-yet-public information. Vigorous enforcement would also deter corporate executives from using misleading or fraudulent accounting to give them time to sell shares when they are aware-but the public is not-that their company's fortunes are suffering. Aggressive enforcement actions could make a huge difference by deterring would-be criminals. conflicts of Wall Street, there are a few simple but strong actions that would go a long way toward deterring future misbehavior. Start with the vigorous enforcement of insider-trading laws and regulations. If a.n.a.lysts and others knew they'd go to jail when caught, the laws would deter over-the-Wall a.n.a.lysts from disclosing not-yet-public information. Vigorous enforcement would also deter corporate executives from using misleading or fraudulent accounting to give them time to sell shares when they are aware-but the public is not-that their company's fortunes are suffering. Aggressive enforcement actions could make a huge difference by deterring would-be criminals.

Second, I propose a new federal law requiring corporate insiders to pay back profits, if those profits have been earned by selling shares during a period of time when the company's stock price is artificially boosted by fraudulent financial disclosures. Those profits would then be refunded to investors in that company's stock.

Third, would be to lengthen "restricted" periods. Restricted periods are the period of time after a stock or bond offering or a merger or acquisition when a.n.a.lysts working for the involved banks have to be quiet. That means that they can't write research reports or give an investment opinion about those companies paying their banks an investment banking fee. Lengthened restricted periods would keep a.n.a.lysts silent and thereby reduce the likelihood that a banker or company would pressure or tempt an a.n.a.lyst to give a favorable rating to the stock of a company paying multimillion dollar fees to that a.n.a.lyst's firm.

Last and most important, investors need to be aware that they're playing a loser's game. No matter what laws or rules are changed, the investment banking and brokerage businesses are fraught with inherent and inevitable conflicts, conflicts that can hurt even the biggest investors. Rather than trusting in the inherent fairness of the markets, individuals buying stocks should a.s.sume that they will never receive the same information as the professionals. It's an insider's world, and it always will be. Let me explain.

The Middleman's Dilemma Real estate agents do it. Insurance brokers do it. Headhunters do it. And Wall Street brokerages and investment banks do it. They act as middlemen, trying to match buyers and sellers as often as possible and make as many deals as possible. And they all have inherent conflicts of interest that are simply part of the job. Does the real estate agent always point out the leaky roof to a buyer? Does the insurance broker always direct the customer to the best-priced insurance policy, even if his agency doesn't represent that company? Does the headhunter know or care whether the individual he has recommended will be a great performer or a Dilbert clone? The answer is no, and no one really expects them to do otherwise.

It's a similar situation on Wall Street. Securities firms or investment banks are the quintessential middlemen. They match buyers and sellers of securities, and their goal is to get the largest number of bonds, stocks, or some mix of the two bought or sold through their firm. This at first seems to create a built-in conflict, but the market's laws of supply and demand are supposed to neatly resolve this moral dilemma, since the price paid will be the price customers are willing to pay and sellers are willing to accept. However, if supply or demand is distorted by things like the unfair allocations of IPO shares or selectively disclosing nonpublic information, all of which you've read about in this book, it's a different story.

There is, however, something quite unusual about the securities industry: the role of the a.n.a.lyst. Research a.n.a.lysts are expected-and obligated-to pick a side in this conflict and to change sides whenever circ.u.mstances change. If an a.n.a.lyst recommends a stock, he is siding with the corporate issuer, suggesting that investors buy more of that stock and therefore allowing the corporate client to sell more shares at a higher price. But if an a.n.a.lyst advises investors to sell a particular stock, he is working against the corporate issuer because his advice could reduce demand for that stock, thereby lowering the price paid by investors and hurting the company's ability to raise money.

When I started on Wall Street, I naively a.s.sumed everyone I dealt with accepted the independence standard. I never really thought about where it came from, why people expected it, or why Wall Street a.n.a.lysts were unique. Eventually, I started to see that the a.n.a.lyst's obligation to be independent, while ethically imperative, wasn't economically logical at all, given that he or she works for a firm whose primary purpose is to maximize fees. From the perspective of the cynic-or the economist-it makes sense that every employee of the firm, a.n.a.lyst or not, would work toward that goal.

In the 1990s, this "logical conclusion" became the norm for many a.n.a.lysts. Some of them changed their investment opinions to benefit companies that were paying fees that dwarfed any contribution that the other customers-the investors-were making. Ultimately, the banks and the a.n.a.lysts paid a price for this behavior, but that price was minuscule compared with the losses of the millions of people who trusted the advice they were given.

Can anything be done to restore the role of the a.n.a.lyst as an impartial adviser, or is it simply impossible given the inherent conflicts involved? And have the reforms put in place thus far done anything at all to bring the Ed/Grandma standard back to life? I will first address the simplest and most controversial proposal-the spinning off of research from investment banks altogether. Then I will critique the existing rule changes put in place by Eliot Spitzer and the National a.s.sociation of Securities Dealers (NASD). Finally, I'll give my own prescription for the things I think we can-and should-change.

Why Spinning Off Research Won't Work After discovering Henry Blodget's "POS" (piece of s.h.i.t) e-mails, Eliot Spitzer opened his negotiations with Merrill Lynch by demanding that Merrill disband, sell, or spin off its research department, thereby eliminating any opportunity for conflicted research.1 Though Merrill fought this aggressively and won, I imagine many Wall Street executives agreed with Spitzer. After all, research, once a valuable client service, seemed to have morphed into one huge conflict-of-interest machine with huge legal risks. Though Merrill fought this aggressively and won, I imagine many Wall Street executives agreed with Spitzer. After all, research, once a valuable client service, seemed to have morphed into one huge conflict-of-interest machine with huge legal risks.

In my view, the proposal to spin off research makes no sense, because it's based on a misunderstanding of how securities are distributed in our markets. The problem is that if an investment bank or brokerage lacks research a.n.a.lysts, it will simply create them anew: inevitably, someone will emerge to describe and evaluate any stock or bond that the firm is selling. It might be a salesperson, broker, banker, or trader, but someone will end up explaining the stock to the firms' brokers, salespeople, and investor clients.

For example, say Verizon hires Citigroup to sell $1 billion of new stock. Someone has to explain Verizon's financials, strategic position, compet.i.tive position, and a variety of other factors to Citigroup's inst.i.tutional salespeople and retail brokers. Normally, a research a.n.a.lyst would do so, as he or she would have the most knowledge of Verizon and the telecom industry. But with no research a.n.a.lysts, someone else would need to write up a "sales memo" and host a "teach-in" explaining the pros and cons of investing in Verizon. If a banker doesn't do it, someone in the equity syndicate department might. Or a salesperson may volunteer or be a.s.signed to provide some "comps" tables, showing how Verizon at $35 a share compares to the valuations of other stocks and the market overall. That would leave us with a larger problem than we had before: an inexperienced salesperson with no pretense at all of being objective or independent serving as Citigroup's telecom "expert" even though he doesn't understand the business in any depth.

Some may argue it's better simply to call a spade a spade. Since it is sales on some level, why not call it sales and have it performed by a salesperson? Perhaps the fraud was in calling it independent research in the first place. I understand the argument, but in the end, jettisoning the research department simply shifts the burden of "explaining" a public offering to someone less qualified and possibly more conflicted.

The same principle holds if, instead of spinning off research, it is the banking side that is separated. Self-proclaimed "bankers" will emerge, and the same inherent conflicts of mixing banking and research will inevitably arise. The king is dead, long live the king.

A Critique of Actual and Proposed Reforms In July 2002, roughly a year before Eliot Spitzer's $1.4 billion settlement with the largest investment banks was finalized in April 2003, the NASD, the industry group governing Wall Street firms, introduced new standards of conduct for research a.n.a.lysts, called Rule 2711.2 The following section a.n.a.lyzes these reforms as well as some others. The following section a.n.a.lyzes these reforms as well as some others.

1. a.n.a.lyst Pay Can No Longer Be Tied to Specific Banking Deals Firms can no longer pay a.n.a.lysts for specific investment banking deals they may have contributed to. Yet a.n.a.lysts can still be paid from the general profits of the firm, including investment banking profits, as long as the bonuses are not tied to any specific deal. Bonuses are determined based on a variety of factors, ranging from stock-picking and buy-side surveys like Inst.i.tutional Investor Inst.i.tutional Investor magazine's rankings to the quant.i.ty of reports, morning calls, and client contacts to feedback from colleagues. magazine's rankings to the quant.i.ty of reports, morning calls, and client contacts to feedback from colleagues.

But since many of these factors are subjective, there's still plenty of room for management to reward "banker-friendly" a.n.a.lysts with higher compensation. This means that the a.n.a.lyst can never really stay entirely free of banking as long as the investment banking department still pays many of the bills.

One possible alternative is that firms could pay research from the profits earned by the sales and trading departments, not by investment banking. a.n.a.lysts could be still be evaluated based on a variety of quantifiable factors: stock performance, sales force feedback, survey rankings, quant.i.ties (of reports, morning calls, buy-side client meetings, and phone calls), trading volumes, and trading profits, although this, too, creates a conflict-who gets information from the a.n.a.lyst first, outside investors or internal traders? It might clean up the banking conflict, and a.n.a.lyst pay might fall significantly, but this arrangement might also increase pressures on a.n.a.lysts to put in-house trading interests ahead of those of outside investors.

2. Research Cannot Report to Anyone in Investment Banking Merely redesigning the organization chart does not solve the conflict-of-interest problem, nor remove the temptation for investment banks to put the interests of its corporate clients above those of its investor clients.

Theoretically, research could report directly to the CEO, ostensibly insulating research a.n.a.lysts from business units within the firm. However, it is not practical for a CEO to directly supervise an entire research team given the demands on his time. Even if it were, such an arrangement would not eliminate the basic conflict of interest. The fact remains that the CEO's ultimate goal is to increase profits. Since investment banking generates profits and research doesn't, the CEO and other top executives still have a powerful incentive to reward employees who contribute to the firm's profitability or, at least, to look the other way when bankers are applying pressure on a.n.a.lysts.

This was not my personal experience, however. I worked and traveled with five CEOs and presidents of Wall Street firms: Dan Tully, David Komansky, and Herb Allison at Merrill; Allen Wheat at CSFB; and John Mack at CSFB and Morgan Stanley. None of them ever asked me to alter my research opinions or tone, and none of them ever asked me to take a "fresh look" at any of the stocks I covered, as Sandy Weill admitted asking Jack Grubman to do on AT&T shares. But there is no doubt that each of them served as their firm's consummate banker and supersalesperson. In the end, not allowing research to report to banking prevents some overt conflicts, but it shouldn't be seen as a panacea.

3. "Independent" Research Mandated for Five Years The Spitzer settlement requires each of the major Wall Street firms to offer its clients multiple research reports on each stock it covers, including reports written by "independent research" professionals, that is, firms with no involvement in investment banking activities.3 Each bank is required to pay the independent firms from the $1.4 billion in fees paid in the settlement. So, for example, if you are a client of Merrill Lynch and you are thinking of investing in Google, upon your request your broker must now send you several reports on Google, one written by a Merrill equity a.n.a.lyst and the others by independent research firms hired by Merrill. Each bank is required to pay the independent firms from the $1.4 billion in fees paid in the settlement. So, for example, if you are a client of Merrill Lynch and you are thinking of investing in Google, upon your request your broker must now send you several reports on Google, one written by a Merrill equity a.n.a.lyst and the others by independent research firms hired by Merrill.

I think this "reform" should be ended as soon as possible. It is a waste of money, gives individual investors a false sense of trust, and it is rife with potential conflicts anyway. For starters, I'm not too sure what makes the researchers employed by the "independent" firms so independent. If their firms are competing for contracts with the top investment banks, wouldn't their a.n.a.lyst be tempted to be more bullish in order to help those banks build better relationships with their banking clients?

It's also a safe a.s.sumption that the pay for research a.n.a.lysts at these independent firms will be lower than at the big banks. So won't these "junior" a.n.a.lysts be out to impress the investment banks and then get hired by them? And, in order to counterbalance the bullish bias of the banks, the independent firms may end up with a negative bias. The final problem is that, of course, there is no guarantee that independent research will have much quality. Mostly younger and less experienced a.n.a.lysts will be hired. And since the settlement set a time limit of only five years for the independent-research requirement, the employees will have short-term mind-sets.

4. a.n.a.lysts Can No Longer Partic.i.p.ate in Road Shows or Beauty Contests a.n.a.lysts should be banned from attending "beauty contests," which are compet.i.tions where companies choose underwriters, but I think they should be allowed to attend "road shows," the traveling circus of presentations to large investors where managements pitch their stock.

In the past, a.n.a.lysts played a key role in explaining a new offering, such as an IPO, to investors. They often accompanied the company's management on the "road show." Under pressure from Eliot Spitzer and the SEC, the NASD concluded that a.n.a.lyst partic.i.p.ation in road shows can heighten pressure on the a.n.a.lyst to be bullish on that stock in exchange for the banking business. The NASD's solution was to ban a.n.a.lysts' partic.i.p.ation in and attendance at road shows.

I think the decision is absurd. I don't see how accompanying management to meetings with big investors makes the conflict question any more or less problematic. The rule does, however, constrain an a.n.a.lyst's ability to understand the company and do good research. I attended road-show presentations because I wanted to hear what kinds of questions potential investors were asking and I wanted to hear how management answered those questions. Getting this perspective helped me do my job, which was to know this company, its management, its financials, and its strategy inside and out. What is even more absurd is that under the new rule, a.n.a.lysts from other banks are allowed to attend some of the meetings but an a.n.a.lyst whose firm is managing the offering cannot. If an a.n.a.lyst ends up less informed than he or she otherwise would be, it's a disservice to all investors.

Now let's look at beauty contests, which are the inverse of road shows. Here, a bank, not a company, showcases its services in the hope of winning the right to handle a company's upcoming stock or bond offering. Typically, company management sits on one side of a table while groups of bankers and a.n.a.lysts traipse in, one after another, spreadsheets at the ready, hoping to convince the company that their firm should handle the deal. In my view, banning a.n.a.lysts from attending beauty contests does little to eliminate or even reduce conflicts. If an investment banker wants to pressure an a.n.a.lyst for positive coverage of a company and and if the a.n.a.lyst is willing to bend to that pressure, skipping a beauty contest won't make much difference. That said, unlike at the road show, the a.n.a.lyst doesn't learn much about the company at beauty contests that would improve his research. For that reason, I don't have a problem with prohibiting a.n.a.lyst attendance at these meetings. if the a.n.a.lyst is willing to bend to that pressure, skipping a beauty contest won't make much difference. That said, unlike at the road show, the a.n.a.lyst doesn't learn much about the company at beauty contests that would improve his research. For that reason, I don't have a problem with prohibiting a.n.a.lyst attendance at these meetings.

5. a.n.a.lysts Should Not Attend Board Meetings This is not a formal rule, but it is becoming the de facto way of doing business on Wall Street. I think it is silly. A really good a.n.a.lyst is an expert in his or her industry, which means that members of boards of directors, who often are not not industry experts, could benefit from his or her insights. If a board wants to hear those insights, why can't an a.n.a.lyst make a presentation? industry experts, could benefit from his or her insights. If a board wants to hear those insights, why can't an a.n.a.lyst make a presentation?

The key is to keep a.n.a.lysts and all outsiders away from observing actual board deliberations. That is what creates the potential for a.n.a.lysts revealing inside information.

6. Each a.n.a.lyst Must Have a Certain Percentage of Sell Recommendations in His Portfolio This is not officially part of the NASD's new rules. However, some investment banks have set sell quotas for their a.n.a.lysts, such as my former firm, CSFB, which requires each of its a.n.a.lysts to rate at least 15 percent of his or her coverage list "Underperform" or "Sell." This is true even if the a.n.a.lyst thinks that investors should be overweighted in his sector versus the broader market indices.

The problem with this rule is that mandating sell recommendations only leads to bad stock picking. It is true that sell recommendations were as rare as a blue-footed b.o.o.by during the 1990s and that the inflation of investment recommendation ratings-in effect, grade inflation-was truly out of control.

The problem here is that this is one of those rules that sounds great but is far too easily circ.u.mvented. I, for one, never wasted time writing reports on companies or stocks that looked like bad investments. My job was to find good investments for my clients, which naturally skewed my attention toward companies with better-than-average prospects and, therefore, my ratings to the positive side. With quotas for Sell-or Underperform-rated stocks, a.n.a.lysts will simply add a few bad companies to their coverage lists to meet the quota. It does not necessarily mean that stocks of banking clients will now be rated Sell, nor does it mean the a.n.a.lyst will be free from conflicts or pressures to be bullish.

Moreover, what many people have forgotten is that a Sell recommendation can sometimes be very bad advice. In the 1990s, most Sell ratings would have been the wrong ratings because the bull market, as it turned out, was an extremely powerful one that took on a life of its own.

7. a.n.a.lysts Must Certify That Their Opinions Are Their Own As of April 14, 2003, a.n.a.lysts must sign a form attesting that they believe what they have written in a given report.4 This might be helpful in the sense that it reminds a.n.a.lysts every time they write a report that they are expected to be independent of the bankers and to publish honest research. But in my view, a.n.a.lyst certification does nothing more than that. This might be helpful in the sense that it reminds a.n.a.lysts every time they write a report that they are expected to be independent of the bankers and to publish honest research. But in my view, a.n.a.lyst certification does nothing more than that.

The reality is that liars will be liars, whether they sign a certification form or not. Does anyone really believe that someone who was willing to recommend a stock for reasons other than the merits of the stock would hesitate to lie on the a.n.a.lyst certification form? The same can be said about the Sarbanes-Oxley requirement that CEOs and CFOs of publicly-traded companies must certify in writing the accuracy of the company's accounting and financial statements. Would WorldCom's Scott Sullivan or Enron's Andrew Fastow have been honest CFOs if they were required to certify their company's financial statements? Dishonest a.n.a.lysts will have no trouble signing their names to anything. Honest a.n.a.lysts are already publishing honest research. That said, requiring certification doesn't have a downside, as long as investors don't allow themselves a false sense of comfort.

What Needs to Be Done

1. Stop Making Crime Pay: Vigorously Prosecute Insider Trading Investment banks are sieves when it comes to insider information. Sometimes it is as simple as a driver or corporate security guard overhearing a conversation or noticing that some high-level executives from another company have come in for a sudden visit. Sometimes, it happens when a.n.a.lysts go over the Wall and are tempted to share some of what they've learned so that they seem better-connected in their industry. It's a self-reinforcing, vicious cycle: the more "in the flow" an a.n.a.lyst is perceived to be, the more influential he or she will be, because investors will be more willing to follow his or her advice. The more influential he or she is, the more corporate executives will seek out his or her research support, which of course leads to pressure on the a.n.a.lyst to write positive research. As a result, that a.n.a.lyst can bring in bigger and bigger banking fees.

The only way to put an end to the cycle is to make it clear that insider trading in any form, including knowingly trafficking in inside information, will get you substantial time in the clink. Anyone who acts illegally as a tipper or tippee, including lawyers, secretaries, drivers, delivery services, printers, bankers, or a.n.a.lysts, should be harshly prosecuted with much longer sentences than currently exist. That would have tremendous deterrent impact. As we've seen, the enforcement of insider-trading laws has been spotty at best. The spread of inside information is much more pervasive than people know, and it will continue to flourish until the law is vigorously enforced by securities regulators and government prosecutors.

Wall Street is an extraordinarily tempting place. Money is everywhere, in huge, unfathomable quant.i.ties. Everything there-one's stature, one's self-esteem, one's past, one's future-is defined in terms of money. In view of this, shouldn't we offset those temptations with more vigorous enforcement of insider-trading laws?

2. Force Insiders to Repay Fraud-Inflated Stock Profits Second, I propose a new federal law that requires corporate insiders to repay profits obtained by selling shares that have been artificially boosted by fraudulent financial disclosures. I first became aware of this idea when I stumbled upon a blogger named Mark Pincus.5 His idea is essentially that any insider who sells stock during a time of accounting fraud (and subsequent restatement) must return his or her profits to the extent they are attributable to the fraud, regardless of whether the insider knew about the fraud.

Of course, some constraints would be necessary. For example, "insider" would have to be clearly and quite narrowly defined; government attorneys and private plaintiffs would have to convincingly quantify the degree to which the relevant stock price was inflated; and a statute of limitations must apply.

A law like this could have a profound deterrent effect on corporate accounting fraud. Corporate executives who might not investigate wrongdoing or who might ignore it altogether might, instead, dig deeper to make sure the company's financial reporting and accounting are legitimate.