Chairman Sarbanes, Senator Gramm, Members of the Committee, thank you for inviting me to testify today about conflicts on Wall Street. I'll cover conflicts among brokerage firms, corporations, and research analysts. I currently work for Prudential Securities, which values independent research, however, I am here today to give my own personal point of view.
It is great to be back near my home in Maryland. I hope that the University of Maryland basketball team advances far in the NCAA basketball tournament. I can guess that the Chairman shares my hopes.
I'm here to talk about what can be analogous to playing basketball with one hand behind your back. Objective analysts, those with negative opinions and/or critical remarks, may have trouble holding corporations accountable. The reason is that companies themselves and their managements are the best source of information, and bullish and conflicted analysts may have the best access to this information.
It is still hard for an analyst to be objective and critical. When an analyst says "Sell.", there can be backlash from investors who own the stock, from the company being scrutinized, and even from individuals inside the analyst's firm. While much attention in Washington is being paid to the pressures related to a firm's investment banking operations, other pressures can be as great or more. The main point: Some companies may intimidate analysts into being bullish. Those who stand up may face less access to company information and perhaps backlashes, too.
I have a few perspectives to support my view:
(a) From personal experience: I've worked at four of the ten largest brokerage firms. I understand how the brokerage industry works;
(b) From my research: I've covered the banking industry since the late 1980s and head the financial research group at Prudential Securities;
(c) From my stock ratings: When the facts support it, I don't shy away from placing Sell ratings on companies I cover. I've probably done so more than almost any other analyst; and
(d) From my current firm Prudential Securities: A year ago, Prudential shed almost all of its investment banking activities.
I will cover three areas in my testimony:
(1) My personal experiences;
(2) The conflict between serving investors versus corporations;
(3) Problems with access by research analysts to corporations.
I. My Experiences
As I prepared for my career, I had all the usual training--financial textbooks, MBA training, professional certification, and even training at the Federal Reserve here in Washington. But playing-by-the-book does not do it on Wall Street. Here are a few personal examples to illustrate my point.
1) After publishing a report with a Hold rating - not a Sell but a Hold rating - the CFO of the subject company had a shouting match with my boss and me. There was a threat of investment banking business getting withdrawn. Luckily, my senior management supported me.
2) I published a report criticizing a merger. One investment banker barked at me, "How do we make money off this research?" I stuck with my opinion.
3) A bank excluded me from an important dinner meeting at which all of the other banking analysts from major firms were in attendance.
4) A CEO called to complain. He didn't like negative comments in a report. He said that he gave investment banking business to my firm due solely to me. He said we had "let him down." I said simply that we are objective with our analysis.
5) I placed a Sell rating on one bank. I was told that the bank's management, in turn, told large investors that we had not done our homework, effectively criticizing our research approach. Within six months, I was proven correct after the stock declined as a result of issues with earnings were publicized.
6) We asked to visit with the management of a company. The response was "No." I finally took a meeting with one company representative. They had said, "Take it or leave it." What choice did I have?
So whether the time was the start of last decade or the start of this decade, whether the firm was UBS, Lehman, Credit Suisse First Boston, or Prudential Securities, the backlash from corporations was similar. Little has changed to help me perform my job better.
This pervasiveness suggests there are larger issues at work. We need to address these issues to ensure that investors get unbiased research.
II. Conflicts At Brokerage Firms: Between Serving Investors Versus Corporations
This statistic is critical: The brokerage industry earns four times as much from serving corporations (i.e., through investment banking and related services) as from serving investors. Two decades ago (1982), this ratio was one to one. (1) In addition, the same firms (the ten largest brokerage firms) that get most of the trading business with investors gain an even greater percentage business of investment banking activities with corporations.
So who is really the client? The degree of conflict between serving corporations and investors--based on where the money is made--is at its highest level in history. If nothing else, this creates an environment ripe for abuse.
For brokerage firms, what does it mean to earn four times more from corporations? First, investment bankers have the leverage. They want research analysts to act as team players. To them, this may mean saying nice things about their major corporate clients or potential future clients. Second, brokerage firms hire people who get along with investment bankers. One manager who hired me said that, in evaluating analysts, the firm placed a lot of weight on what the companies had to say to investment bankers. Can you imagine? This is like judging a food critic based on what the restaurants say!
For analysts, what does it mean that their firms earn four times more from corporations? It means financial incentives, which can taint analysts' opinions, and keeping a job. Its not rocket science: Eighty percent of traditional brokerage profits come from corporations. Help the firm, you do well. Hurt the firm, why get rewarded? Analysts are mainly bullish and conflicted, probably because they do not want to lose their jobs.
My main point: People do what they are incented to do. For brokerage firms, the incentive to serve corporations over investors is stronger than at any other point in history. For analysts, the main incentive is to stay employed.
III. Problems With Access By Research Analysts To Corporations
It takes an objective and critical analyst many times more work to do the job than it does a bullish or conflicted analyst. The main reason: backlash from corporations. Such backlash can take various forms--I have five examples:
(1) Investment Banking: The influence of investment banking on stock research is well documented after the Internet bubble. Per my other examples, sometimes companies pull business from a company after a critical report.
(2) Phone Calls With The Company: Phone contact is part of analysts' day-to-day communication to get more color behind the numbers. Bullish and conflicted analysts can get their calls returned first, and even get senior executives on the line, including the CEO. As for objective and critical analysts, at times their calls are not even returned.
(3) Meetings With Management: Some firms reply to a meeting request, "Why is it a good use of our management's time?" In other words, "Say something positive, we'll let you in."
(4) Conference Calls: Companies hold conference calls for earnings, strategic moves, and other reasons. Conference call systems let you manipulate the order that questions are answered. Last year, on one call, the operator said that my call was in the queue. I then hear, "No more questions." Do the more novice investors listening to the conference calls realize that the order of the questions can be manipulated?
(5) Management Participation In Analyst Events: Institutional investors - my main clients - pay a lot of commissions if you hold good conferences and bring managements in to see them. Guess who gets to do these tasks? Bullish and conflicted analysts, especially those whose firms have investment banking relationships.
For the bullish or conflicted analyst, calls may be returned first, questions may be taken on conference calls, meetings with management may get scheduled earlier, managements help out to visit investors or participate in conferences, and investment banking fees may be better to boot.
Reg FD has not fixed all of the problems. Companies simply make canned presentations on a Webcast, but then may choose to turn off the Webcast during the Q&A and the follow-on breakout sessions. (Also, some firms do not Webcast their presentations, which I find very discouraging.)
Perversely, this poor treatment has helped to make me and my team better analysts. We are forced to better scrutinize accounting footnotes, interact more with impartial third parties, and go out and "kick the tires."
In other words, we are forced to hustle a lot more. To use the analogy, we are still doing the equivalent of playing basketball with one hand behind our back. The issue: I'm not sure how many analysts are willing to accept this handicap, especially the newer ones trying to pay their New York City rents.
To recap the problem:
(1) From my perspective, it's business as usual when it comes to conflicts between companies and research analysts;
(2) People do what they are incented to do. The financial incentives for brokerage firms to serve corporations has never been as high as they are today; and
(3) Objective or critical analysts continue to face backlashes in many ways.
So What Is The Solution? Information And Incentives
From my perspective, speaking solely as an independent analyst, there are a few steps that can be taken to improve the situation:
(1) INFORMATION: Make sure that the access to the information is fair. One idea: Have an avenue for those analysts who feel disadvantaged by the companies they cover to voice concerns and get corrective action. Maybe a clearing house whereby analysts have recourse to voice their concerns? Maybe someone at the SEC? Just give me someone whom I can call when I'm treated unfairly. One caveat: Any solution needs to insure that companies still are incented to maintain the highest level of information flow. I don't believe we need to regulate analysts. Analysts need to have equal access to information and appropriate incentives to provide objective research. Let's address the root of the problem.
(2) INCENTIVES: Take actions to minimize the interference of investment bankers with the job of research analysts. Disclose investment banking relationships to investors. Does the retail investor know that the brokerage firm pitching shares is also earning investment banking fees from the company? A related solution is to eliminate deal-based incentive pay. Also, in terms of carrots and sticks, a lot of attention has focused on making the stick bigger to get the so-called "bad" analyst. The "carrot" needs more attention, to encourage good behavior. I know there is debate about separating research from investment banking. From my personal experience, I can tell you that this is an effective solution.
Conclusion
We have the best capital markets in the world. But let's not grade ourselves on a curve. They can be better. As analysts, we are at the intersection between the interests of corporations and the interests of investors. We provide institutional memory, act skeptically, challenge corporate authority, question assumptions, and speak up if something does not smell right. We are on the front lines of holding corporations accountable. Prudential Securities scaled back its investment banking a year ago. The result is a great environment for me. I have 100% support of management when doing my research. Despite this, the pressures outside the firm are as strong as ever. The result: impediments to conducting full, independent, unbiased investment research on corporations. Actions that can help remove these impediments and reduce the remaining conflicts will help improve our ability to serve clients . . . and when I talk about clients, I'm talking about investors!
1. Based on revenue data from the Securities Industry Association from 1999-2001 and assumed profit margins, earnings (pretax) in investor businesses were $35 billion versus $127 billion from investment banking. In comparison, these amounts in 1982 were $2.1 billion and $2.6 billion, respectively.
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