A letter of acceptance, waiver and consent issued by Lehman Brothers as part of Wall Street’s global settlement paints a grim picture of investment banking’s domination of the firm’s research department during the bubble years.
Lehman acknowledged that it had not only breached National Association of Securities Dealers’ rules by allowing bankers to exercise inappropriate influence over analysts, but also that it had made exaggerated claims in its research and failed to supervise employees to make sure they complied with securities rules.
Specifically, Lehman issued unduly optimistic research about Razorfish, RSL Communications, DDi, RealNetworks and Broadwing in order to cement investment banking relationships. The firm had “buy” or “strong buy” recommendations on all of them, with aggressive price targets.
Since the bubble burst Razorfish has been sold to SDI for $1.70 per share after a long struggle for survival, RSL Comunications has ceased trading and DDi has slumped to 6-7 cents.
RealNetworks and Broadwing have done the best at keeping afloat. RealNetworks now trades at $4.92, while Broadwing stock sells for $4.40. At one time Lehman had a price target of $150 for RealNetworks though it only targeted a more modest $42 for Broadwing.
The letter provides a shocking illustration of how small investors were excluded from the cosy club of bankers and institutional investors.
In a discussion about Razorfish in May 1999 a Lehman analyst acknowledges to an institutional investor that he is not sure how to rate the company, which had increased in price from $16 at the time of its initial public offering to $37.
The institutional investor suggested that the analyst rate the company “neutral”, but the analyst thought that he would have to give the company a buy rating because they were a banking client.
“I understand business is business,” responded the institutional investor. “But I feel bad for those naive investors who assume that sell-side analysts are objective.”
“Ratings and price targets are fairly meaningless,” said the analyst. “But, yes, the ‘little guy’ who isn’t smart about the nuances may get misled.”
Investment banking’s influence over research was reinforced by Lehman’s compensation structure. One analyst was guaranteed a $4.8m bonus if the companies he covered paid the firm less than $50m in banking fees, but based on a rising scale of banking revenues, his bonus could reach $8.8m if Lehman generated more than $125m in fees from his companies.
The pressure on analysts to help out investment banking became incredibly intense. “Enough is enough,” barked the frustrated RSL analyst in August 2000 after bankers had dissuaded him from downgrading the stock three times. “It is hard enough to be right about stocks, it’s even harder to build customer relationships when all your companies blow up, you knew they were going to and you couldn’t say anything.”