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A Crisis Of Trust on Wall Street

May 4, 2003 | Washington Post Troy Caver is disgusted.

In 1999, the 62-year-old Fairfax engineering management consultant had $5 million to invest. He handed a sizable chunk to two Wall Street brokerage firms. Over four years, he lost $1 million in part, he says, by following advice from his brokers. He has since yanked his money out and put most of it in real estate.

"I don't trust any of the brokerage firms anymore," Caver said last week. "There is not a single one of them that acts in the interest of the individual investor. Given an opportunity to make a choice between the customer and themselves, they will choose themselves every time."

In a Washington Post online discussion last week, other furious investors offered multiple variations on the same theme: Why, in light of all that we now know about the internal workings of Wall Street, should an investor give his money to a Merrill Lynch, a Smith Barney, a Morgan Stanley or any of the other full-service brokerage and investment-banking firms?

Why not just buy stocks through a stripped-down, brokerage-only firm like Charles Schwab, TD Waterhouse or E-Trade?

"Yet another Wall Street scandal, in step with the string of others we now know so well," one angry Ohio investor wrote. "I'm one of the purported 'little investors.' Ten dollars to YOU if you can give me one good reason why I should ever put my money into Wall Street hands again."

The $1.4 billion settlement announced on Monday between regulators and 10 of the nation's largest brokerage firms was intended to close one of the ugliest chapters in Wall Street history, one in which the industry's biggest firms generated vast banking fees for themselves, in part by having their analysts issue enthusiastic reports on companies that the analysts privately disparaged.

Regulators say structural reforms included in the settlement, intended to separate bankers from analysts, will clean up Wall Street and protect investors. But thousands of internal documents released by regulators last week showed that the extent to which Wall Street firms were enriching themselves at the expense of the individual investor was far worse than previously known.

Over and over, analysts admitted that their research calls could be destroying the "little guy's" nest egg. And over and over brokers screamed in internal surveys about how the terrible research calls were costing their clients millions.

In a survey done in 2000 of brokers who worked for Citigroup Inc.'s Salomon Smith Barney, more than 1,000 of them blasted the way its top telecom analyst, Jack Grubman, recommended weak stocks to help the company win banking business, saying it was hurting retail clients. "Jack Grubman is not an analyst he is an investment banker. He sold us a bill of goods and now we're bleeding red in our clients' accounts. How about sharing some of the $25 [million] salary with our clients who bought into his glorified stories?" said one.

Others said they thought the behavior was "unethical" and their clients were better off when they ignored Grubman's advice, raising the question: Just why should anyone go to a full-service broker?

Full-service brokerage firms, led by giants such as Salomon Smith Barney Inc. (now known as Smith Barney), Merrill Lynch & Co. and Morgan Stanley & Co., provide an array of financial services for their clients. In addition to buying and selling stocks for customers' accounts, the firms sell mutual funds, certificates of deposit, bonds and other investment vehicles. They also meet with clients regularly to adjust their investments. These firms tend to charge significant fees and commissions. Clients with large assets, often $1 million or more of investment capital, tend to get the most hands-on treatment.

About half of U.S. households own stocks, although a majority invest in mutual funds rather than individual stocks. At the end of 2001, mutual funds and pension funds held about 61 percent of the outstanding shares, according to the Securities Industry Association. Only 39 percent of the outstanding shares were held by individuals.

Wall Street firms say there are many reasons for their clients to stick around. Officials at several firms said their brokers and financial consultants have strong relationships with their clients that go far beyond any questions about the firm's research.

Brokers for the big firms, who are forbidden by their employers from talking on the record in this supercharged regulatory environment, privately make the same point. A Salomon broker, while acknowledging that he has had to do some hand-holding in recent days, said he wasn't losing clients because he had been honest with them about potential risks of highflying stocks.

Several Wall Street executives said having a full service investment adviser is more important than ever, as the market remains choppy and sources of financial information some reliable, some not continue to proliferate.

"What we are hearing from clients is that the amount of financial information has become overwhelming," said a senior executive in the retail brokerage unit of one of the firms covered by the settlement. "It's information overload, and they are looking for someone to help them peel away the layers of the onion."

He said some clients ask about research and investment-banking conflicts but tend to be satisfied when a financial adviser tells them they will get multiple sources of information on stocks. Lydia Kupersmith, a lawyer for the federal government in Washington, said she is out of the investing game for now. But if she comes back, she said, she will embrace getting more research from Wall Street firms. "Given the lack of independence in the research before, I would definitely look at the independent sources," she said.

Under the settlement, investors will get at least three sources of "independent" stock research. Regulators defined independent research as any coming from firms that do no investment-banking business.

But will it be good enough to help investors make smart investing decisions?

There are several things investors should consider, say critics.

Wall Street firms will pay for the research. That raises concerns that providers might be tempted to write research tailored to please Wall Street and its corporate clients. Critics question whether Wall Street firms will provide top-notch research that might make their own product look bad.

"There may be an incentive there for the firms to hire independent research firms that are not so outstanding," said Henry T.C. Hu, a professor of corporate and securities law at the University of Texas at Austin. Already, some independent research firms have declared their intention not to participate in the settlement for fear of being tainted by Wall Street money.

In addition, retail investors may get the analysts' reports after they have been distributed to large investors. That is especially expected to occur if the reports come from small independent research boutiques that typically serve large institutional investors. Those large clients pay handsomely to get a first look. By the time retail investors get the information, the information could already be absorbed by the market.

The settlement is also supposed to build a wall between research and investment banking so that reports by the brokerage houses' own analysts is more accurate. For instance, investment bankers will no longer have any influence over an analyst's pay. But analysts' pay will still come from overall firm revenue, which includes investment-banking fees.

So should investors stick with full-service firms? Of course, competitors say no and are moving to capitalize on the embarrassing research scandal.

Schwab, which charges lower fees but offers clients less individual attention, has been the most aggressive, running television ads poking fun at Wall Street and showing company founder Charles Schwab leading a pack of investors across a bridge, away from Manhattan's financial district.

"American investors have started to figure out that they are not getting such great advice," Daniel O. Leemon, Schwab's chief strategy officer said. Schwab recently started to offer equity research based on an A-to-F rating system. (The firm already offered clients Goldman Sachs research.)

"Our research is not affected by investment banking and it's not based on anyone's personal opinion. We don't have someone going to see Steve Jobs and then saying, 'I think everything at Apple is going great.' Statistically, that is the kind of research most likely to be wrong," said Leemon.

But Leemon admitted that prying customers away from Wall Street's full-service firms will be tough, despite the fevered outrage of some investors. "Those are pretty strong relationships," he said of clients and their brokers.

Indeed, some brokers at Smith Barney could argue that the investigation shows they moved to protect investors. The survey of their comments showed they complained to management and some moved their clients out of stocks recommended by Grubman.

Revelations that Citigroup chief executive Sanford I. Weill pressured Grubman to upgrade AT&T Corp. stock led the Securities and Exchange Commission to launch a probe into supervisory practices at Citigroup and other firms. Federal law and industry rules require executives to ensure that their subordinates do not defraud investors or to put reasonable structures in place to ensure that this does not happen.

Citigroup, Merrill Lynch and Credit Suisse First Boston Corp. were charged with fraud as part of the settlement. Citigroup declined to make an official comment on the probe. A person familiar with the matter said none of the firm's top management, including Weill, ever saw the brokers' angry comments.

Meanwhile investors say they are wiser and more skeptical of any Wall Street recommendations. Some even acknowledge that they had known about the conflicts but chose to ignore them.

"If I really want to go golfing I'll find a weather report that says partly sunny instead of partly cloudy," said accounting professor Richard Walstra, who has begun dipping his toes back in the market using online trading firms. "I did fear there were some conflicts of interest [in Wall Street research] at the time, but I didn't really focus on it. In clarity of hindsight, it's pretty clear they were saying a lot of things they didn't really mean."

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