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Dot-Bomb Victims Take Aim At The Analysts

Aug 15, 2001 | MSN

It took a while, but the litigation that normally erupts when stocks tumble has finally started to erupt in the aftermath of last year's tech-stock collapse. What do your creditors say about you?

Class-action lawsuits have been filed against the biggest Wall Street firms, charging that their analysts were far more interested in generating business than in offering independent, objective advice for investors.

One case, against Merrill Lynch’s Henry Blodget was settled for a reported $400,000. Blodget is the Internet analyst who, before joining Merrill Lynch, predicted would hit $400 a share. Now, a lot of plaintiff’s attorneys are focusing on Mary Meeker, the star analyst for Morgan Stanley Dean Witter, and Jack Grubman, the well-known telecom analyst from Salomon Smith Barney.

One lawsuit brought by two brothers in Manhattan federal court claimed that their inexperienced Morgan Stanley broker relied extensively on Meeker’s recommendations. That reliance, they claimed, led them to invest heavily on margin in Internet stocks that Meeker rated as “outperform” and resulted in a $19 million loss. (A judge dismissed the suit in August, calling it “abusive litigation.”)

But if you’re an investor burned because you followed analyst recommendations in the last few years, don’t expect to get rich from joining the litigation.

Unlike lawsuits against the tobacco or asbestos industries, legal experts say, new, untested legal theories have to be used, potential damages may be limited and settlements are not likely to be large. For example, investors may have to show that they relied on the analyst’s recommendations, that the analyst’s recommendations altered the stock’s price, and that the analyst intended on misleading investors. “You have to show fraud,” says John Coffee, a securities and corporate litigation specialist at the Columbia University Law School. That’s harder to prove, he added, than showing that a product injured people.

There probably won’t be much action from Congress. The Republican-controlled House is not likely to want to legislate conduct especially because the securities industry is scurrying around trying to cajole its members to implement best-practices policies.

How analysts work

Revelations may show how Wall Street analysts especially stars like Meeker make their money and lose their independence at the same time.

“There’s going to be hot documents coming out of the woodwork,” predicts John Coale, a tobacco plaintiffs lawyer in Washington, D.C. “It will happen. Every transaction is a document, and it’s a felony to destroy them. That’s one area where the companies and analysts should be afraid.”

“There are going to be shocking revelations as a result of these lawsuits against the analysts, just as there was in the tobacco litigation,” predicts Melvyn Weiss, senior partner at Milberg Weiss Bershad Hynes & Lerach, which specializes in filing class-action lawsuits.

Compensation is the issue

Two class action lawsuits against Meeker by investors in, eBay, America Online and AOL Time Warner strike squarely at the compensation issue. The complaints say that Meeker made positive statements about these companies because her overriding interest was to attract and retain the companies as Morgan Stanley banking clients. The suits also allege that her $15 million pay package in 1999 was linked directly to her ability to attract investment-banking fees for her firm. The suits come on the heels of a highly unflattering Fortune magazine cover story on Meeker that appeared at the end of April. (See link at left.)

Meanwhile, the Securities and Exchange Commission has been looking into the independence of analysts and the compensation question, focusing, as then-acting chairman Laura Unger told the House Subcommittee on Capital Markets, on four main questions:

Attracting and retaining clients. Did an analyst participate in a firm’s efforts to win lucrative underwriting business either on initial public offerings or subsequent stock issues? The staff found that analysts provided significant assistance to investment bankers. In addition, the staff found that in 308 of 317 IPOs studied, the firm that underwrote the security also provided research coverage, virtually all of it positive. Some analysts provide investment bankers with prior notice of changes in their recommendations.

Firm profits. Did positive analyst reports trigger higher trading volumes, resulting in greater commissions for the firms? The SEC staff found that some analysts issued “buy” recommendations shortly before the end of the “lock-up” period expired for shares acquired during an IPO. These “booster shot” reports, the SEC claims, may generate buying interest in the stock and “help increase the stock price while the firm, the firm’s clients, or the analysts sell their shares.”

Compensation. Are an analyst’s salary and bonus linked to profitability of the firm’s investment banking business? Yes. At one firm, 90% of an analyst’s bonus was tied to investment banking revenue.

Equity stakes. Are analysts and others allowed to own significant positions in the companies they cover? While some firms prohibited analyst ownership of stocks that they covered, the study showed that about a quarter of the analysts did invest in companies they covered. Some analysts even traded shares counter to their own recommendations.

(Unger did not name names, however.)

No help from Congress

You can expect more hearings on how Wall Street treats investors, but new legislation is unlikely. At a July 31 hearing, Rep. Michael Oxley, the Ohio Republican who chairs the Committee on Financial Services, said “I am loath to legislate in this area. My preference is for industry to clean up this mess.”

The Securities Industry Association (SIA) and the Association for Investment Management and Research, a trade group for analysts, have been pushing plans to improve the quality of analysts' research. The SIA's plan is a series of 14 "Best Practices" recommendations. These include separating research from investment banking. Compensating should not be tied to investment banking. Analysts shouldn't trade against their own recommendations. Analysts should disclose if they're members of teams that are selling securities to the public. Critics say the moves are mostly window-dressing that do little to improve an analyst’s objectivity.

While Harvey Pitt, the new SEC chairman, has not weighed in on this issue, SEC activity will likely be limited to the agency’s work with the National Association of Securities Dealers and the New York Stock Exchange and the SEC’s investor education program.

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