When Debases Kanjilal, a Queens (N.Y.) pediatrician, picked up his phone in early 2001 to call lawyer Jacob H. Zamansky, he had no idea he would whip up a full-fledged hurricane on Wall Street. Kanjilal claimed he lost $500,000 investing in Infospace Inc. (INSP ), an Internet stock he says his Merrill Lynch & Co. (MER ) broker urged him not to sell when it was trading at $60 a share. By the time he sold, it was down to $11. Zamansky filed a novel arbitration claim against Merrill in March, 2001, in which he argued that its star Net analyst, Henry Blodget, had misled investors by fraudulently promoting the stocks of companies with which the firm had investment banking relationships. That lawsuit led directly to an investigation by New York State Attorney General Eliot Spitzer, who stunned Merrill and its Wall Street brethren three weeks ago when he made public some shocking e-mail exchanges between Merrill analysts and bankers.
That was just the start. Now, Spitzer is investigating Salomon Smith Barney, Morgan Stanley Dean Witter (MWD ), and at least three others. The Securities & Exchange Commission has launched a probe into practices at 10 firms, while the Justice Dept. is pondering an inquiry of its own. And plaintiffs' lawyers are advertising for clients and filing new suits daily.
The widening scandal has plunged Wall Street into crisis. The resulting furor is more thunderous than the one unleashed by Michael R. Milken's junk-bond schemes in the 1980s, the Prudential Securities limited-partnership debacle in the early '90s, or price-fixing on the Nasdaq later in the decade. In part, that's because many more individuals lost money in the recent market collapse than on earlier scandals.
But uproar over the relationships between analysts and their investment banking colleagues has also grown because it comes on the heels of several other scandals that raise big questions about how Wall Street operates. Already, probes are under way into Wall Street's shady initial public offering allocation practices, as well as its crucial role in setting up and selling the partnerships that led to Enron Corp.'s collapse. Worse, execs at many firms may have made a bundle investing in the partnerships, even as those same firms advised clients to hold Enron stock virtually until it went bankrupt. It all makes Wall Street seem rigged for the benefit of insiders as never before.
The damage goes way beyond the tattered reputations of the firms and their beleaguered analysts. The entire economy depends on the financial system to raise and allocate capital. And that financial system, in turn, is built on the integrity of its information. Should investors lose confidence in that information, it could deepen and prolong the bear market, as wary investors hesitate to put money into stocks. And it could easily put a damper on the economy if companies are less willing--or less able--to raise capital on Wall Street. "One of the precious things we have is the integrity of the financial markets. If that changes it could have dramatic repercussions on the dollar, on domestic inflation, on the economy," says Felix G. Rohatyn, former managing director of Lazard Freres & Co.
Wall Street has always struggled with conflicts of interest. Indeed, an investment bank is a business built on them. The same institution serves two masters: the companies for which it sells stock, issues bonds, or executes mergers; and the investors whom it advises. While companies want high prices for their newly issued stocks and low interest rates on their bonds, investors want low prices and high rates. In between, the bank gets fees from both and trades stocks and bonds on its own behalf as well, potentially putting its own interests at odds with those of all its customers.
But in recent years, those inherent conflicts have grown worse, as the sums to be made by overlooking them have grown enormous. That's because since the repeal of Depression-era banking laws, megabanks such as Citigroup (C ) and J.P. Morgan Chase (JPM ) are allowed to do everything from trading stocks to lending money and managing pension funds.
Chinese walls--jargon for the strict separation of the different lines of business conducted under the same roof--were supposed to keep the bankers honest and free from corruption. But a series of scandals since the early 1980s has eaten away at those foundations. The final blow, however, was the tide of money that flooded over Wall Street during the great tech bubble. Between the last quarter of 1998 and the first quarter of 2000, the tech-heavy Nasdaq market index soared from 1,500 to more than 5,000. Many investors made out like bandits. So did the investment banks. During the same period, according to Thomson Financial/First Call, Wall Street earned $10 billion in fees by raising nearly $245 billion for 1,300 companies, many of them profitless tech outfits that later blew up. The bubble burst in the spring of 2000, wiping out more than $4 trillion in investor wealth. "The fact is that a bubble market allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them," wrote famed investor Warren E. Buffett in his annual report to Berkshire Hathaway (BRK.A ) shareholders last year.
Staking their claim in the gold rush, Wall Street firms ramped up in the late '90s, hiring hordes of analysts, many of them inexperienced. New investment bankers were hired as well. A feeding frenzy set in as rivals fought to grab a big share of the market to bring companies public. At the same time, a new cult of equities came to life, as individuals invested in stocks as never before. True, many investors ignored common sense. Still, as analysts applauded stocks, trumpeting their picks on CNBC and other media, investors bought. "Investors took everything at face value, which was understandable. There wasn't a lot of information, and it was of varying quality," says Michael E. Kenneally, co-chairman and chief investment officer at Bank of America Capital Management Inc.
Only now are the ugly details of the conflicts at play being laid bare. In some of the e-mail turned up by Spitzer, analysts disparage stocks as "crap" and "junk" that they were pushing at the time. The e-mails are so incendiary that they threaten to thrust Wall Street into the sort of public-relations nightmare that Philip Morris (MO ), Ford (F ), Firestone, and Arthur Andersen have endured in recent years. All the ingredients are present: publicity-hungry attorneys general, packs of plaintiffs' lawyers, and potential congressional hearings. "The last thing the industry wants is...the drip-drip-drip of new stories every week," says Howard Schiffman, a former SEC Enforcement Div. lawyer now practicing privately in Washington.
More explosive documents may be on the way. Both Spitzer and the SEC are seeking from more than a dozen firms papers and e-mail related to analysts' recommendations and their potential conflicts of interest. While nobody knows what evidence will emerge, other firms will have their own smoking guns. And analyst pay is likely to emerge as a hot-button issue. Zamansky, for instance, claims that he has seen contracts from investment banks promising analysts 3% to 7% of all the investment banking revenues that they help to generate.
That would be clear proof that analysts were being paid to help the firms' banking clients, often at the expense of investors who expected objective advice.
The financial implications of this mess are enormous. Based on the evidence that has already emerged, Merrill is facing potential fraud claims by every retail investor who purchased any stock that Blodget & Co. may have insincerely recommended. If analysts covering other industries at the firm harbored similar doubts about the companies they hawked, the number of claimants will expand exponentially. Should other financial firms have similarly embarrassing documents in their files, Wall Street could easily be facing billions in potential liability. In a report released on Apr. 24, as the fiasco was unfolding, Prudential Financial analyst David Trone estimated the issue could cost Merrill alone $2 billion.
Heads could roll, too. If prosecutors conclude that firms are guilty of systemic fraud--rather than harboring a small group of rogues--research directors and other high-ranking execs could be vulnerable. That's why the way analysts were paid is such an explosive issue. In egregious cases, criminal prosecutions are possible. Although regulators have never thrown an analyst in jail for fraudulently recommending a stock, experts say that could happen if public outrage flames high enough. Spitzer, whose tough New York securities statutes give him unusually broad power to file criminal suits, says he won't stop short of structural reform. "I'm continuing to negotiate [with Merrill]," he told BusinessWeek on May 1. "They've been fruitful discussions, but negotiations can break down over a range of things. At this moment, we have significant issues that have not been resolved."
Over the long run, a risk bigger than legal penalties could be new restrictions that Spitzer or others place on the way investment banks do business. On May 8, the SEC is scheduled to approve new rules forcing analysts to limit and disclose contacts with investment banker colleagues. But there's good reason to question whether these steps will be enough to satisfy the industry's critics--some of whom seek a separation between investment banking and analysis. At the moment, such radical change is a long shot. But if the Democrat-controlled Senate latches on to the analyst issue, it could trigger embarrassing hearings or proposals for more stringent rules. "Other shoes will drop," says one securities-industry lobbyist. "If [Salomon's Jack] Grubman or [Morgan Stanley's] Mary Meeker turns up [in similar evidence], the sky is the limit" for this issue. "It has big legs."
It was never much of a secret that analysts who work at investment banks often work against investors. Sell ratings now make up less than 2% of analysts' recommendations, up from around 1% during the bull market, according to First Call. Analysts are under pressure from the companies they cover, as well as from big institutional clients who may own the stock, to give positive ratings. Michael Mayo, senior bank analyst at Prudential Financial, recently told the Senate Banking Committee that he had been exhorted to stay bullish throughout his career, from both his former employers and the companies he covers. Otherwise, he said, he doesn't get the same access that others do, which gives him a harder time making nuanced stock calls. "It's like playing basketball with one hand tied behind your back," says Mayo. Analysts also need to shine in surveys such as Institutional Investor's annual rankings, in which money managers vote for their favorite stockpickers, so they spend too much time lobbying clients rather than crunching numbers. "Analysts get focused on saying what they think the client wants to hear to win the vote," says Henry J. Herrmann, chief investment officer at Waddell & Reed Inc., a money manager.
The biggest factor now contaminating the system is compensation. To an ever-increasing degree, analysts' pay is tied to how much investment banking business they bring in. According to a Merrill memo released by Spitzer, Blodget detailed how he and his team had been involved in 52 investment banking transactions from December, 1999, to November, 2000, earning $115 million for the firm. Shortly thereafter, Blodget's pay package shot up from $3 million to $12 million. Charles L. Hill, First Call's director of research, says that when he was a retail analyst 20 years ago, if he helped investment bankers with a new client, he would get a small reward at year's end: "But it was the frosting on the cake. Now, it is the cake."
It would be an exaggeration to say analysts alone are to blame for Wall Street's woes. There's a much deeper problem involving everyone from credulous investors to deal-happy investment bankers and execs looking to fatten their wallets. "It's finally dawning on people that this incentive system we've given managers based on the value of stock options has encouraged management to puff up their companies a lot," says Robert J. Shiller, an economics professor at Yale University and author of the 2000 best-seller Irrational Exuberance.
Even so, experts say a lot of the corruption oozing from Wall Street has to do with an erosion in investment banking ethics and practices. It goes clear back to 1975, when fixed trading commissions were ended. Until then, investment banks had been able to make big bucks off pricey trading commissions. Slashed commissions meant the firms were forced to derive more revenues from investment banking business. "There's a real sense of sadness over what has happened in investment banking. It's not about what's right for a client, it's all about jamming a deal down a client's throat," says an ex-analyst who recently joined a hedge fund.
Consider Enron, which has paid $323 million to Wall Street in underwriting fees since 1986, according to Thomson. Goldman, Sachs & Co. (GS ) pocketed $69 million of that, while Salomon made off with $61 million, and Credit Suisse First Boston took $64 million. Indeed, two of CSFB's investment bankers, after helping to design Enron's off-the-books partnerships, sat on one of the partnerships' boards. According to a complaint filed in Houston Federal Court on Apr. 8, investment bankers generated megaprofits from secretly investing in Enron's hidden partnerships. Meanwhile, many analysts continued recommending the stock to the bitter end: 11 out of 16 analysts who follow Enron had buys or strong buys less than a month before the company's bankruptcy filing.
Enron may be an extreme example. Still, in the past, tradition and ethics played a large role in keeping investment bankers loyal to their corporate clients. Indeed, Wall Street itself used to have much more of an interest in guarding its reputation. Says Jay Ritter, a finance professor at the University of Florida: "These days, bankers are far more focused on short-term profits than on their long-term reputations."
That's likely to get worse as investment banking business continues to dry up. The amount being raised in initial public offerings is way off its 2000 highs. Now there are far fewer mergers and follow-on offerings taking place. Because of this, it's unlikely that Wall Street, after all its hiring during the tech bubble, can sustain its profitability. Goldman Sachs estimates that five of the top investment banks on Wall Street will have to get by on $2 billion less than the $16 billion in net revenues they racked up in 1999. If investment banks roll back to 1999 staffing levels, Putnam Lovell Securities estimates that banks will have to shrink their payrolls by 5%--putting over 13,000 out of work.
But no matter how much Wall Street shrinks, its credibility must grow again. Firms have already taken some steps, such as eliminating direct reporting by analysts to investment bankers. But the Street and the SEC still must hammer out a solid, enforceable code of conduct. And if strong reforms in how analysts are compensated aren't pursued, focusing on increased disclosure will do little to end the abuses. Beyond that, regulators may need to go after the firms' top brass--the folks who set the procedural as well as ethical tone. And the Street should take great pains to monitor itself in an effort to restore investors' confidence. "If Wall Street knows what is good for it and what is good for this country, it will very definitely clean up its act," says Rohatyn. Adds George H. Boyd III, head of equities at New York's Weiss, Peck & Greer: "This is an industry of trust; it's one of its key assets. If [Wall Street] loses it, it is going to have to invest in getting [that trust] back and putting in the controls to rebuild it. Without that trust, there's nothing."
Merrill Lynch apparently knows this. At its annual shareholder meeting on Apr. 26, Chairman and CEO David H. Komansky took an unprecedented stand on the analyst debacle, saying: "We have failed to live up to the high standards that are our tradition, and I want to take this opportunity to publicly apologize to our clients, our shareholders, and our employees." Other apologies may follow, as firms desperately try to assuage potentially litigious investors and unyielding regulators. But for Wall Street, just saying sorry at this stage may prove to be too little, too late.
By Marcia Vickers and Mike France, with Emily Thornton, David Henry, and Heather Timmons in New York and Mike McNamee in Washington