When a tentative settlement of the two-year-old investigation of Wall Street analysts was announced last December, not many market watchers thought it would have much effect on stock prices or make the financial markets substantially safer for small investors.
Can investors expect more out of the final deal announced April 28? Regulators crowed that the settlement would help restore confidence in the markets.
So far, the major indexes have not had much reaction. “I don’t think there will be a significant effect of the settlement on stock prices,” said Wharton finance professor Jeremy Siegel. “Earnings growth is the biggest factor driving stock prices today.” And earnings growth has been weak.
As the final settlement was announced, attention focused on the record $1.4 billion in fines to be paid by 10 big securities firms, the banishment of two high-profile analysts and new rules to put distance between analysts and their investment-banking colleagues.
But there was another key element, the importance of which will only be revealed in time – the thousands of pages of internal firm documents that were publicized for the first time. They revealed widespread industry efforts to get analysts to issue glowing reports on risky stocks their firms’ investment bankers were peddling to the public.
The e-mails and other documents could lead to a wave of lawsuits by customers, now armed with hard evidence that analysts deliberately urged them to buy toxic stocks during the dot-com boom. Whether legal actions will lead to big monetary awards and further reform won’t be known for some time.
While the $1.4 billion represents the highest fine ever levied in the securities industry, it will have little effect on the profitability of these enormous firms – and thus little deterrent value, critics say. In the end, only two analysts were fined and disciplined, and the securities firms settled without admitting or denying guilt.
The most immediate effect of the settlements is new rules to attack the conflict of interest that results when analysts work alongside investment bankers who are trying to market new issues of stock for client companies. State and federal investigators found that analysts’ pay was often linked to their willingness to downplay the hazards while issuing “buy” recommendations for such stocks.
Yet regulators were unable to come up with a way to completely eliminate the conflicts inherent in diversified securities firms. “We have this uneasy compromise. That’s what this settlement is,” said John Coffee, law professor at Columbia University and director of the university’s Center on Corporate Governance.
During the 1990s, as analysts increasingly became handmaidens to bankers, the ratio of “buy” to “sell” recommendations soared from 6:1 to more than 100:1.
The 10 companies have agreed that analyst compensation will henceforth be based solely on the quality of their analysis and that analysts would not be supervised by investment bankers or have to submit their reports to the bankers for approval. Data on each firm’s analysts’ performance will be posted on the Internet every quarter, and the firms will better disclose any business dealings with the companies they analyze.
Also, the 10 firms will contribute $432 million to a fund that will pay for outside stock analysis to be distributed to customers alongside the insider’s reports. In theory, this will discourage in-house analysts from issuing biased research.
Many observers note that the reform falls short of those enacted for the accounting profession in last year’s Sarbanes-Oxley Act, which prohibited accounting firms from serving as both auditors and consultants to the same clients. Some industry critics had wanted Wall Street firms to be prohibited from analyzing companies with which they have investment banking deals. But the Securities and Exchange Commission, New York State Attorney General Eliot Spitzer and other regulators concluded this was not practical because analysis is not a moneymaker.
If stock analysis is not in some way subsidized by investment banking and other operations at diversified firms, there will simply be less analysis done, Coffee said. Hence, regulators opted to minimize conflicts of interest rather than eliminate them, and their success will depend on how well regulators police the profession, he noted.
“At the end of the day, any intelligent securities analyst knows that the budget out of which he gets paid his salary is being subsidized by underwriting to a great degree,” Coffee pointed out. “So there’s still a conflict of interest that hangs over analyst research.”
While the settlement provides hundreds of millions to support the work of freestanding analysts, finance professor Andrew Metrick suggests there is little evidence investors are willing to pay enough for stock research to support many freestanding firms after the settlement money dries up. “If people aren’t going to pay for research, they are not going to get good research,” he said.
And according to Coffee, despite their apparent independence, freestanding research firms are not immune from conflicts. In order to get and retain contracts to provide “independent” research, the outside firms may feel they have to stay on the good side of client firms with heavy stakes in underwriting. Criticize a stock the client is peddling and you could jeopardize the next contract renewal.
Indeed, documents released with the final settlement showed that some of the 10 firms had paid outside analysts to provide research that was meant to look objective but was really intended to bolster the firms’ underwriting efforts. The fact that outside analysts look independent makes it possible for them to extract high fees for issuing biased research, Coffee said.
If it is not clear the settlement will produce better, more honest analysis, should investors be worried? Probably not, said Marshall E. Blume, professor of financial management and finance at Wharton. He argues that investors should not pay much attention to the pronouncements of Wall Street analysts, even if they are honest.
“We don’t find individuals, or any large group of investors, making any abnormally high returns when they have access to this stuff,” he noted, adding, “We already know that readily available research has no real value. We know that. So now they’re going to spend $432 million … As far as I can see, that means $432 million is going to be distributed to some people who will make a lot of money on it. And it’s not going to benefit anybody.”
According to Metrick, small investors should not be betting big on individual stocks but spreading their investment money around in diversified portfolios with investments like index funds. By owning hundreds of stocks in this way, the investor deadens the effect of any analyst puffery on a few individual issues. “Who cares what the analysts are saying then?” he asks.