The Merrill Lynch Settlement: Good for Merrill, Not for InvestorsPublished: June 05, 2002 in Knowledge@Wharton
When brokerage giant Merrill Lynch agreed last month to pay $100 million to settle the analyst bias charge brought by the New York attorney general, it was widely seen as a smart way for the firm to avoid a lengthy, image-tarnishing court case.
But will the settlement, involving a number of changes in the way analysts are paid and supervised, really lead to better, more objective stock analysis on Wall Street?
“I honestly do not think it is a much safer environment for individual investors,” said Wharton finance professor Jeremy Siegel. “You have to realize there are huge risks with the stock market.”
Academics, money managers and savvy investors have long been careful to take analysts’ views with a grain of salt, since “buy” recommendations generally outnumber “sell” recommendations by ratios of 50 to one, and at times by 99 to one. Critics have claimed conflict of interest is the cause, as analysts try to curry favor with corporate clients who can generate lucrative investment banking business.
Then in April, New York Attorney General Eliot L. Spitzer released internal Merrill e-mails in which the firm’s Internet analysts, led by superstar Henry Blodget, derided the very stocks they were urging the firm’s investors to buy during the dot-com craze two years ago. Spitzer is also investigating a number of other big securities firms: Credit Suisse First Boston, Morgan Stanley Dean Witter, Goldman Sachs, Salomon Smith Barney, UBS Paine Webber and Bear Stearns. The Merrill settlement may become the model for changes across Wall Street.
In addition to the fine, the settlement announced May 21 provides for a number of changes within the firm. Most importantly, the firm’s investment bankers will have no direct role in determining analysts’ compensation, as they have in the past. A new committee to review analysts’ stock recommendations will be headed by someone paid on the basis of the recommendations’ performance. Analysts’ reports will disclose whether the firm has earned any fees from the companies covered over the prior 12 months, and Merrill will disclose a company-wide breakdown of the ratio between buy, sell and other recommendations. “From the standpoint of Merrill, it was very sensible,” said Columbia law professor John Coffee. “I think Merrill did avoid problems that otherwise would have become very serious.”
The $100 million fine will have little or no impact on Merrill’s bottom line. More important for the firm is that the settlement may eventually help reverse a more than 20% drop in Merrill’s share price since the e-mails became public. The stock has yet to recover, as Merrill still faces a number of class action suits brought by investors who claim Merrill analysts deliberately misled them.
Coffee, like many other observers, said the Merrill settlement does not resolve investors’ fundamental concern: the inherent conflict produced by analysts’ multiple dual role of serving investors and Merrill’s investment banking business.
Over the years, investment banking – helping public companies raise money by selling new blocks of stocks and bonds – has become one of the largest sources of revenue on Wall Street. Corporate clients are loath to give such business to a firm whose analysts are not trumpeting the stock. In addition to reporting on the investment-banking stocks, analysts participate in efforts to drum up support for new issues, such as conference calls and “road shows” in which the case is presented to professional money managers.
While analysts’ reports are produced for investors, trading commissions and other investor fees are not large enough to cover the cost of analysis. Analysts’ work is therefore heavily subsidized by the investment banking units.
The Merrill settlement means “the allocation of any subsidy provided by investment banking to securities research cannot be administered by investment banking officials,” Coffee said.
That may reduce some of the pressure to support stocks of investment banking clients and potential clients, he said. But so long as analysts have an investment-banking role, they will know that pay and promotions will be affected by their success in that role, he added.
Kent L. Womack , finance professor at Dartmouth’s Amos Tuck School of Business, said it is “inconceivable” that the executives who determine analysts’ pay will ignore their performance in investment banking, even if those executives do not work in investment banking themselves.
“Analysts who drive more profits and business in the door are going to get paid more,” he said, noting that analysts who are successful in investment banking can make millions, while those who are not merely make hundreds of thousands. “That is part of the puzzle that has not changed, and I don’t think it can change,” he said.
Earlier in the Merrill controversy Spitzer indicated that one possible remedy was to sever the analysis and investment banking functions altogether. The settlement did not provide for that, and it is unlikely that will ever happen, said Womack. Investors are not willing to pay the higher commissions and fees it would take to support analysis if it were not being subsidized by investment banking, he said.
Investors may nonetheless have benefited from the Merrill case, since the front-page publicity has made them aware of the problem, he said. Also, a number of other firms have announced similar changes, and the New York Stock Exchange and National Association of Securities Dealers have introduced some new rules. The most important prohibit firms from tying analyst pay to specific investment banking transactions, require that analysts not be supervised by investment bankers and make sure investment bankers do not have veto power of analysts’ reports and recommendations.
The settlement’s requirement for disclosure of past investment-banking fees will help investors spot some potential conflicts, but it does not get at the problem of analysts currying favor with companies that may produce investment banking business in the future, Womack said.
Analysts, he added, can also be influenced by conflicts that the settlement does not address at all. Most significant is the need to stay on corporate executives’ good side to maintain access to people who provide information and insight that is essential to analysts’ work. There is ample evidence, Womack said, of executives freezing out analysts who write critical reports.
“The next big story is the fact that most of the analysts problems are from being held hostage by the company managements – ‘You are going to stay positive on my stock because if you don’t I won’t call you back,’” Womack said. The solution to that, he added, would be “you find a way to penalize management that will not have free and open communication with all interested parties, whether they are positive or negative on the stock.”
To some extent, said Siegel, this problem already has been mitigated by Regulation Full Disclosure, a Securities and Exchange Commission rule imposed in October 2000 that requires companies to quickly make public any information privately disclosed to one or more analysts. “Probably FD had more effect than this” settlement,” Siegel said. “Regulation FD has gone part way,” Coffee agreed. “It would be going much farther to say you’ve got to open all these meetings to all analysts.”
Coffee said the analyst bias problem could be further mitigated if regulators would impose a “strong anti-retaliation rule” prohibiting securities firms from firing, demoting or cutting the pay of analysts who write reports that ruffle the feathers of investment bankers or the companies covered.
Some observers think the marketplace could provide a further remedy if new regulations gave investors the right data. Paul Irvine, finance professor at the Goizueta Business School at Emory University, said the settlement does not go far enough in its requirement for a firm-wide report on the breakdown of buy, sell and other recommendations. Such information, he said, should be made public for each analyst, so investors could see how his or her recommendations have panned out in the past. Each analyst would then have a kind of batting average that would be easy for investors to assess.
“It’s problematical to measure performance, but mutual funds manage to do it,” he said. “It would kind of put a number out there for investors … Then I can see for myself how much weight to put on a recommendation.”
The Merrill settlement is hardly the last word on the analyst bias issue. Merrill could be forced to agree to more stringent remedies as a result of the investor suits. No one knows yet what will result from Spitzer’s investigation of other big firms. Congress, the Securities and Exchange Commission, the stock exchanges and the National Association of Securities Dealers continue to look at the issue.
But it’s unlikely, according to Siegel, that any remedy will resolve one of the fundamental causes of analyst bias – investor’s eagerness to jump on the latest hot stock. It was this, not manipulation by analysts, which caused the Internet bubble a couple of years ago. “The public would have invented Henry Blodget if he didn’t exist,” Siegel said. “They just wanted a cheerleader and he was it.”