"What we are doing is changing the rules of the game."
-- Eliot Spitzer, New York Attorney General
You don't have to read very far into the thousands of pages of damning e-mails and memos that securities regulators released on Apr. 28 to see what the game was about. Up and down Wall Street, analysts and investment bankers, under the watchful eye of management, turned the business of investing into a crass "heads we win, tails you lose" proposition for investors.
To attract corporate underwriting deals, investment bankers pressured analysts to pump out glowing reports they knew were false, and analysts propped up share prices by ignoring flaws in the companies they recommended. Five Wall Street firms even paid rivals to put out puffy research reports on their clients to create the illusion of widespread support. To make sure analysts kept up the ruse, their bosses paid them according to how much new investment-banking business they attracted. And to reward execs for sending them business, bankers "virtually bribed" CEOs, as one regulator put it, with shares of hot initial public offerings.
Such corrupt relationships helped drive the stock market to absurd heights in the late 1990s. And it fueled a vast transfer of wealth from investors to Wall Street bankers and their CEO clients. Retail brokers, whose clients were duped by the dishonest research, complained loudly, but their pleas were ignored all the way up the chain of command. No one did anything because everyone in the game profited. Everyone, that is, but retail investors, who didn't know the rules.
Now they do. The $1.4 billion settlement between state and federal securities regulators and 10 of the largest Wall Street firms is meant to ensure that investors are never again relegated to the bottom of the food chain. Regulators hope to restore the integrity of research by forcing structural reforms on the Terrible Ten. The pact also aims to boost the sophistication of individual investors by requiring the firms to provide free copies of independently produced analysis and to support an investor-education fund. And it hopes to make research more transparent by requiring firms to publish their analysts' stock-picking track records.
How effective will these changes be? Greater transparency, smarter investors, and more honest analysis are all welcome reforms. But what Wall Street really needs is a change in culture, starting at the very top. So far, some key officials seem less than penitent. The day after the settlement, Morgan Stanley CEO Philip J. Purcell said he saw nothing in the agreement "that will concern the retail investor about Morgan Stanley." His remarks left Spitzer furious, sources say, but Purcell's apology the next day reassured him. "We've been told by Morgan Stanley that they acknowledge they have problems and will embrace the reforms," says a Spitzer spokesman.
Real change may depend on regulators making good on promises to bring future cases against the Wall Street executives and managers who oversaw research and banking -- including the CEOs. So far, only two individuals -- former analysts Jack B. Grubman of Salomon Smith Barney (C ) and Henry R. Blodget of Merrill Lynch -- have been punished. Both have been barred for life from the securities industry. Despite plenty of evidence that senior managers knew that retail customers were losing money because of tainted research, none were charged in the settlement. Says Spitzer: "If the responsibility for these improprieties is not directly laid at the feet of senior management, then we will have failed to send a message to the right people."
Stephen M. Cutler, the enforcement director of the Securities & Exchange Commission, says: "Just wait." He won't say who he's reviewing, but other regulators say cases are pending against more than a dozen managers, including Citigroup Chairman and CEO Sanford I. "Sandy" Weill and Michael Carpenter, Citi's former head of investment banking, for failing to supervise Salomon Smith Barney officials. Weill's lawyer, Martin Lipton of Wachtell, Lipton, Rosen & Katz, says that because Weill was not an officer of Salomon Smith Barney, charges against him would be "truly unimaginable." Carpenter could not be reached for comment. Some state securities regulators are also looking into bringing criminal cases against individuals. Still, the Senate Banking Committee, in a hearing set for May 7, is expected to focus on the lack of action taken against top managers.
Even if the top brass does finally get it, the agreement won't end the conflicts of interest that permeate Wall Street. The firms have agreed to rebuild the Chinese walls of years past, but research and investment banking won't be completely separated. The most glaring source of conflict, in fact, remains: Because research produces no revenues, it will need to be indirectly subsidized, most notably by investment banking, which accounts for about 25% of the firms' revenues. "The budgets of research divisions are going to be dependent on whether investment bankers see anything in it for them," says Columbia University law professor John C. Coffee Jr. Knowing where their paychecks come from, analysts will still tend to write reports to please banking clients.
Offsetting such pressure is the settlement stipulation that brokerages inform retail customers every month how in-house analysts ranked the stocks in their portfolios, vs. how independent analysts ranked them. And in-house analysts' compensation must now be based in part on how well they pick stocks. Both moves should go a long way toward encouraging analysts' to pick stocks on their investment merits rather than on their banking prospects.
Some observers also find fault with the independent-research solution. Regulators are likely to find that the $432.5 million fund over five years doesn't buy much. And more work remains to be done, including making the pact permanent through new SEC rules that will take at least a year to write. The restrictions preventing firms from handing out IPO shares to corporate officials especially needs work. It's both too broad and too narrow: too broad because it bans all officers and directors from getting hot IPOs, and too narrow because it lets issuing companies continue directing allocations to select "friends and family," the practice that first opened the door to IPO abuses.
Still, there are signs that Wall Street has, in fact, been shaken to the core. The loss of reputation could take years to recover. Winning back investor confidence may mean complying with the letter of the pact, which requires deep structural reforms. Analysts and investment bankers now must report to different supervisors, and they must be physically separated. Moreover, analysts can no longer join investment bankers on sales pitches to potential corporate clients or on roadshows to help market new shares. And bankers will no longer have a say in analysts' pay.
For some Wall Street leaders, the deal imposes new restrictions that are as humiliating as they are onerous. At Citigroup (C ), Weill and other top managers agreed not to speak to analysts unless a lawyer is present. And Weill had to issue a public statement apologizing for Citi's conduct. Along with Merrill Lynch (MER ) and Credit Suisse First Boston (CSR ), Citi settled charges, without admitting or denying guilt, that some of their research was fraudulent.
Within minutes of the deal's announcement, Goldman Sachs Group Inc. (GS ) Chairman Henry "Hank" Paulson sent out a voice mail to employees saying that, while the firm wasn't charged with fraud, "we could have all done better." Goldman, CSFB, and Morgan Stanley (MWD ) are forcing bankers to sit through training sessions on new rules dictating when they can talk to analysts and what they can say.
The big question is whether reform will stick. Many worry that the changes will last only as long as regulators keep watching. Yet any violations of the pact could result in large new fines on top of the already hefty payments firms have agreed to: $437.5 million in penalties and another $437.5 million in disgorged profits. On top of that, the firms must spend $432.5 million on independent research and $80 million for investor education.
How does it break down? Citigroup will pay $400 million -- the largest portion of the $1.4 billion, followed by $200 million each from Merrill Lynch and CSFB. Morgan Stanley will pay $125 million, and Goldman $100 million. UBS Warburg (UBS ), Bear Stearns (BSC ), Lehman Brothers (LEH ), and J.P. Morgan Chase (JPM ) will put in $80 million apiece, while U.S. Bancorp Piper Jaffray (USB ) will pay $32.5 million.
Even more will be wrung out of the firms as investors make use of the explosive information in the documents to support class actions and arbitration claims that could reach $20 billion, according to Georgetown University law professor Donald C. Langevoort.
But will it really pinch? Probably. Under the deal, it will be difficult, though not impossible, for the firms to pass on the payments to insurers or to claim them as a deduction on taxes owed. And each of the 10 must pay an outside monitor to make sure they are properly distributing independent research that may contradict their own. They must pay another overseer to police the new barriers between analysts and bankers. "If this settlement is a top priority for SEC enforcement [and] if it's backed up by sharp rulemaking on analysts and IPOs, there will be a dramatic impact on how the business is reshaped," says Joel Seligman, dean of Washington University School of Law.
Cleary, the settlement has the potential to shake up Wall Street as radically as the May, 1975, deregulation of commissions did. Back then, it was largely individual investors who paid sky-high fixed commissions while institutional investors secretly negotiated lower ones. Ironically, it was the end of fixed commissions that prompted analysts to make a devil's pact with investment bankers in which they essentially became marketing tools for underwriters.
The pact is meant to make sure that doesn't happen again. But its biggest contribution may not be the structural reforms or the independent research or the investor-education fund. It may be the publication of the e-mails and memos that analysts passed among themselves, which lay bare the conflicts that placed small investors at the bottom of the pile. "Even the most naive investor now realizes this," says University of Texas securities-law professor Henry T.C. Hu. "Maybe this will promote a healthier skepticism among retail investors." If that happens, Eliot Spitzer can rightfully claim to have changed the rules of the game.
By Paula Dwyer, with Mike McNamee, in Washington, and with Emily Thornton and Nanette Byrnes in New York