Infectious Greed (50 page)

Wheat's replacement was John Mack, who had battled with Frank Quattrone years earlier, and who had just lost his own battle for control of Morgan Stanley. Mack captured the culture Allen Wheat had created at CS First Boston when he called an early conference of the firm's managing directors and showed a video clip of John Belushi from the movie
Animal House.
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As Mack put it, “This firm has a history of tolerating cowboys. I don't like cowboys.”
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Not surprisingly, Mack committed to reinforce the firm's compliance and legal departments. He immediately hired Gary Lynch, the former Milken prosecutor who had written the report for Jack Welch about Joseph Jett's losses at Kidder Peabody. Lynch became the general counsel of CS First Boston, and a member of the firm's board of directors. Mack
and Lynch understood that if prosecutors filed criminal charges against CS First Boston for the IPO scheme, the firm probably would not survive (just as criminal charges brought against Arthur Andersen later assured the death of that firm). Lynch was charged with settling the case right away.

After the terrorist attacks of September 11, 2001, and the collapse of Enron, the media coverage of the IPO scheme slipped from the front pages. On October 3, 2001, Mack and Quattrone sat down to have a little chat, over steaks in Kansas City, Missouri. The details of their conversation remain secret, but two conclusions were clear; first, Mack somehow persuaded Quattrone to give up his hefty pay package;
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second, Quattrone and CS First Boston would settle the investigation of the IPO scheme as quickly and quietly as they could. After that, Quattrone could find something else to do at the firm, or elsewhere.

Gary Lynch negotiated the settlement beautifully. The public documents omitted the most serious allegations; instead, CS First Boston was charged with a technical violation of mislabeling the extra payments it had received from clients as “commissions” instead of as “IPO fees,” which they really were. The implication: if CS First Boston had simply disclosed that it was receiving a 65 percent IPO fee, its actions would have been perfectly legal.

Prosecutors dropped the criminal case against CS First Boston. The firm's $100 million fine represented roughly one year of pay for Quattrone, and only a fraction of the fees technology companies paid to CS First Boston the previous year.
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Lynch happily signed the settlement agreement in January 2002.

The media portrayed the case as a significant victory for securities regulators, and any criticism seemed to come from an undistinguished peanut gallery. Even John Gutfreund—the chairman of Salomon Brothers who had been forced to resign during the Paul Mozer scandal—emerged from the shadows to complain about CS First Boston's settlement, saying he was “dismayed” and that the fine was just a “slap on the wrist.”
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(It was less than the fine Salomon paid in 1992, after Gutfreund resigned.)

More than a thousand private lawsuits were filed, by investors in 263 companies.
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Those cases were a thorn in John Mack's side, although CS First Boston would benefit from the legal changes of the mid-1990s that made such lawsuits more difficult. CS First Boston suffered from a decline in IPO fees, which plunged almost 100 percent, but that was primarily due to a widespread decline in the market. During the first six
months of 2002, the firm did just one IPO, for Simplex Solutions, Inc., and made just $3.4 million, barely one week's worth of compensation for Frank Quattrone.

Some commentators have called Frank Quattrone the Michael Milken of the 1990s. There were a few similarities, but in some respects the comparison wasn't fair to Milken. Both men were Wharton grads who quickly rose to the top of their firms and negotiated similar compensation packages. Quattrone symbolized the mania associated with Internet stocks in the same way Milken symbolized the 1980s obsession with corporate raiders and takeovers. Regardless of whether Quattrone “measured up” to Milken, Milken's punishment arguably was too harsh, while Quattrone's treatment arguably was too generous.

 

 

T
he scheme involving securities analysts was closely related to the IPO scheme, but was much simpler to describe. In fact, three words were enough: “pump and dump.” Securities analysts at investment banks pumped up stocks, especially those recently issued in IPOs, with overly optimistic reports. Individual investors believed the hype and stock prices remained high until the 180-day lockup period during which corporate insiders were prohibited from selling shares. After the lockups expired, insiders dumped their shares.

It wasn't always this way. Before 1990, securities analysis was a respected profession, and investors valued the quality of analysts' research and the independence of their opinions. Analysts told investors not only when to buy but, even more important, when to sell. Today, business journalists uncover most financial fraud; ten years ago, that was the job of securities analysts.

As markets became more efficient, and information began flowing more quickly and inexpensively, it became difficult for research analysts to add much value. Investors weren't willing to pay for research reports if the market price of a stock already reflected the information. Consequently, analysts faced pressure to add value in other ways: by helping investment bankers solicit business from the companies they covered.

In 1990, Clayton J. Rohrbach III, a senior officer of Morgan Stanley, suggested in an internal memo that analysts' compensation should be tied to how much business the companies they rated gave to Morgan Stanley. Rohrbach suggested that analysts themselves receive explicit ratings of A to C. Morgan Stanley never formalized this policy, because it presented
obvious conflicts of interest, but analysts at the firm reported that their pay was based on this grading. Most Wall Street firms, including CS First Boston, adopted similar systems of linking investment banking and research.
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These systems remained secret for a decade, until the market finally collapsed and analysts began confessing their sins. In 2002, Gretchen Morgenson of the
New York Times
persuaded several analysts to tell her about their experiences on condition of anonymity. They spoke of being “not so much an analyst as a marketing machine” and said analysts' pay was tied to the investment-banking business they brought in.
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Charles Gasparino of the
Wall Street Journal
uncovered documents that offered analysts “1% to 3% of the firm's net profit per transaction” or 8.5 percent of revenues that “the analyst is clearly instrumental in obtaining,” or that stated “Banking Related Compensation: You will be paid banking related compensation. . . .”
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Bankers and clients also pressured analysts to avoid making negative or controversial comments. For example, when David Korus, an analyst at Kidder Peabody (just before the firm went under after Joseph Jett's losses), questioned some of Dell Computer's currency trading, the company threatened to sue Kidder, and barred Korus from meetings.
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It is not surprising, then, that according to a May 1998 survey by the First Call Corporation, just under two-thirds of analyst recommendations were “buy” or “strong buy,” one-third were “hold,” and just one percent were “sell.” In 1990, there were fifteen times more “sell” recommendations than “buys.”
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It wasn't that analysts had some evil intent; they were simply responding to an incentive system that rewarded them financially for making positive comments, and punished them for making negative ones. Analysts began inflating ratings for the same reason children acquire good manners.

In addition, as financial statements became more complex, analysts—like investors—didn't have time to scrutinize financial statements. By the late 1990s, even an experienced stock analyst would need at least a day to read an annual report carefully. But a typical analyst covered fifteen or more companies, and spent most of the day on the telephone or in meetings with investors and clients. The easy way out was to accept a company's own profit estimates and label it a “buy.”

By 1998, most investment bankers recognized that a high-profile securities analyst could help them get business. After Frank Quattrone arrived at CS First Boston, he noted, “We don't compete against Morgan
Stanley—we compete against Mary Meeker.” Mary Meeker was an Internet analyst who consistently received top rankings from
Institutional Investor
magazine, which rated analysts based on a poll of fund managers, just as
U.S. News
&
World Report
ranked colleges and graduate schools. Experts criticized these rankings, but they were the most credible and simple rankings available, and individuals trusted them. Just as Princeton University attracted students based on its number-one ranking, Mary Meeker attracted investors.

A cozy relationship with a company helped a top analyst, too. Company officials “selectively disclosed” certain information to their favorite analysts, but not to the general public. Companies also prepared their favorite analysts in advance of public announcements, so that they could adjust their expectations and accurately predict corporate-earnings announcements,
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almost like magic.

In short, corporate clients wanted a high-profile analyst to do the “pumping” before they did the “dumping.” This scheme didn't bother investors as long as stock prices continued to increase. When the analysts said “buy,” they generally were giving good advice, at least in the short run.

The key difference was that now it was the analysts who were lying, instead of the companies. Years earlier, analysts had accurately predicted the “numbers” for Cendant, Waste Management, Sunbeam, and Rite Aid, too. But in those cases, companies had lied to both the analysts and to investors. Investors could continue to trust analysts, even if they did not trust the companies.

Now, the greed that earlier had consumed corporate executives was spreading to securities analysts. If CEOs and investment bankers could make tens of millions of dollars per year, why couldn't analysts do the same? All they had to do was rate companies higher than they otherwise would and persuade those companies to do business with their banks. With the links between banking and research, they could then claim the right to a ten-million-dollar-plus bonus. The downside was limited: criminal liability seemed out of the question, and they could always claim they genuinely believed in a company and were surprised—no, shocked—to see a company go under. Besides, federal regulators had shown no interest in pursuing analysts, who were, according to traditional economic theory, providing an important service to financial markets.

The analysts hadn't counted on Eliot Spitzer, the attorney general of New York. Although federal securities regulators had primary jurisdiction
over financial markets, state regulators also had the ability to prosecute financial fraud. Federal and state prosecutors in New York had fought turf battles for decades, and often negotiated parallel investigations, with the U.S. attorney for Manhattan taking one case and the New York district attorney taking another.

This time, there were no negotiations. Spitzer was politically ambitious and the federal regulators—led by Harvey Pitt, the new chairman of the Securities and Exchange Commission—were not aggressively pursuing many cases. Pitt was an able lawyer, but was constrained by perceived conflicts of interest from his previous job representing the major accounting firms and Wall Street banks. That left an opening for Spitzer.

Spitzer issued subpoenas for the e-mail records of analysts at several Wall Street banks, including Merrill Lynch, where Henry Blodget—of Amazon fame—was the top Internet analyst, with a guaranteed annual compensation in 2001 of $12 million.
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Blodget was one of the most popular Internet analysts, and Merrill had done numerous high-profile Internet deals, including eToys, [email protected], InfoSpace, Internet Capital Group, iVillage,
Pets.com
, Quokka Sports, and Webvan. Needless to say, these companies hadn't done very well, and were the subject of numerous lawsuits.

Spitzer uncovered documents confirming that the greed infecting corporate executives had spread to securities analysts. In short, the e-mails were the “smoking gun.”

Spitzer submitted an affidavit to a New York court excerpting some of these e-mails. Investors read edited versions of some of them in the newspapers; others were not fit to print. But, as a whole, the lengthy affidavit was a powerful indictment of how analysts were behaving at Merrill Lynch. If other firms were the same, the system of securities ratings was totally rotten.

Like most banks, Merrill Lynch had a stock-rating system, ranging from 1 to 5. A rating of 1-1 was the highest, then 1-2, 1-3, and so forth. A rating in the general category of 1 or 2 was positive. A 3 was neutral. Merrill's Internet group never ranked companies a 4 or 5; instead, they simply stopped covering the stock.
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The e-mails showed that analysts were publicly issuing high ratings while privately ridiculing the same stocks. For example, analysts privately described stocks with a neutral 3 rating as “crap” or a “dog” or “going a lot lower.”
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Stocks with a positive 2 rating were repeatedly described as a “piece of shit” or “such a piece of crap.”
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Internet Capital
Group, Inc., with a 2-1 rating, was described as “Going to 5.” InfoSpace, which Merrill gave its highest rating of 1-1, was nevertheless described in e-mails as a “piece of junk” and a “powder keg.”
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On April 8, 2002, just after the affidavit was filed, Merrill issued a statement that “E-mails are only one piece of a continuous conversation, isolated at a single point in time—not an end conclusion.” A Merrill spokesperson cautioned investors not to take these e-mails out of context, and disputed Spitzer's allegations.