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Time To Clean Up Analysts' Game

Sep 27, 2002 | Montreal Gazette

Financial markets in the U.S. are desperate for a shred of reassurance that the universe will unfold normally from now on. But Wall St.'s credibility gap remains as large as the Grand Canyon. So what will it take to rebuild shattered confidence in the markets?

First, it would help if investors could have at least a smidgen of faith in the buy-and-sell recommendations of securities analysts. Unless earnings forecasts and purchase recommendations are credible, the buyers' strike in the market will continue.

Second, when analysts commit serious securities violations, those responsible must pay a real price.

It's going to take a lot more than the $5-million wrist-slap paid this week by Salomon Smith Barney to settle charges that its star telecom analyst Jack Grubman deliberately misled investors.

Grubman had aggressively touted the stock of Winstar Communications, a telecommunications company that filed for bankruptcy last year.

E-mails showed that early last year he continued to maintain a "buy" rating on the stock, and a $50 target price, when Winstar was running out of cash and its stock was trading for pennies. A few weeks later, it went bust.

There's a lot more to this story. Winstar's stock had been underwritten by Salomon Smith Barney - a conflict of interest that's unfortunately too common on Wall St. The investment bank collected $24 million in fees from its relationship with Winstar. How could its recommendation on the stock be credible?

A civil suit brought by the National Association of Securities Dealers laid out a host of complaints against Grubman: that he failed to adequately disclose the risks of investing in Winstar; that his price target was unrealistic; that he privately urged some investors to bail out at far lower prices; and that he misled investors on the company's liquidity.

Grubman, for his part, blames his employer, saying Salomon's legal department prevented him from downgrading the stock.

In a separate investigation, authorities are looking into whether he allocated hot initial public offerings to clients who gave their underwriting business to Salomon.

The story explains a lot about the technology bubble and why it burst. There was so much money on the table that the traditional Chinese wall between research and underwriting was breached.

Analysts were regarded as big profit generators by their employers, not as legitimate sources of research advice.

That's why the $5-million fine paid by Salomon Smith Barney to settle the civil suit looks ridiculously small. If the shady practices are going to end, there has to be a bigger deterrent.

As U.S. money manager Dan Dreman pointed out, a fine of that size is insignificant for an investment bank that makes hundreds of millions each year underwriting stocks. Even the $100-million fine paid by Merrill Lynch & Co. this spring to settle conflict-of-interest charges against its analysts amounts to spare change for a Wall St. giant.

At least we're seeing some signs of reform. A Securities and Exchange Commission proposal would require analysts to certify that their research reports reflect their true views of the companies they cover.

Big institutional investors like the state of California's retirement fund are now saying they won't deal with investment firms that combine both research and underwriting.

And investment banks like Credit Suisse First Boston and Deutsche Bank have announced new ratings systems on stocks to make them clearer and more comprehensible.

Says Montreal investment dealer Dominik Dlouhy: "The only legitimate reason for research is to identify buy-and-sell opportunities for investors. It's not to get into bed with the underwriting side of the business. Unfortunately, there are a lot of prostitutes around."

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