Now for a cultural change

It was fully a year ago that we were writing about the New York Attorney General’s investigation into investment research at several major U.S. brokerage houses. New York State prosecutors had gone through internal e-mails at Merrill Lynch and found evidence that the firm’s analysts had, in private, very poor opinions of stocks they had rated highly in public. Soon similar evidence was unearthed at other large investment firms.

A year later, the state, along with the U.S. Securities and Exchange Commission, the National Association of Securities Dealers, the North American Securities Administrators Association, and the New York Stock Exchange, has settled enforcement actions with ten large Wall Street houses, and with two high-profile analysts: Jack Grubman, formerly of Salomon Smith Barney, and Henry Blodget, formerly of Merrill. In all, the settlements will cost the firms just short of US$1.4 billion in penalties, disgorgements, and compulsory contributions to funds. Grubman and Blodget are barred from associating with a broker, dealer, or investment advisor; though with the money they made during the boom, chopping old business acquaintances off the guest list at their mansions may not bother them much.

The litany of charges is interesting in itself. Public interest has centred on the breach of the Chinese wall between investment banking and research, but the state and the SEC accused two firms of taking undisclosed payments for research, and five firms (including those two) of paying other firms to cover particular companies. The inference is easy enough to make: the street already was aware that research from some firms had been tainted by investment banking interests, and that those firms needed others to provide “cutouts” for the same message. If that is what happened, then there are implications beyond fair dealing with customers, into anti-competitive practices that fall not far short of market-rigging.

The firms, and Grubman and Blodgett, “neither admit nor deny” the charges. Anyone who has watched securities regulation for any length of time knows there is good reason to believe that the prosecutors would have had immense trouble making many of those charges stick. He’d also know that prosecutors can have immense trouble making even true charges stick. While New York State Attorney General Eliot Spitzer has come in for criticism about the accusations the state levelled against the firms, the firms themselves had deep pockets and good lawyers, and could easily have afforded a defence. That they did not insist on their day in court is significant, though not probative.

The penalties and costs are either severe or a mere slap on the wrist, depending on who’s doing the talking. US$1.4 billion is a sliver of revenue, but for these firms in these times, it’s a large piece of year-end profit. Grubman and Blodget give back part of a large personal fortune, and never work on Wall Street again; which is what large personal fortunes are supposed to let you do, anyway.

Under the settlement, the firms are enjoined from violating the statutes and rules they are alleged to have violated. This little absurdity is a standard formulation in securities enforcement, but we suppose it would mean bigger trouble for a firm that violates the rules in future. The firms have also agreed to new practices that separate research from investment banking. We hope the new practices work.

The last component of the settlement is good old-fashioned shame. There has been perhaps too little of that in the aftermath of the bull market. Seeing Merrill’s chairman, David Komansky, retire, and Sanford Weill, chief executive of Citigroup, openly censured demonstrates that top management cannot dodge its responsibility for the greed culture that has flowered.

Disgorgement money will go into a “distribution fund” to compensate customers of the firms that had bought stock in companies referenced in the authorities’ complaints. There’s a scent of the arbitrary in that, because it’s hard to believe the state and the SEC found all the incidents of impropriety. But the cheques will go to the subset of investors that suffered specifically as a result of the actions the state and the SEC pounced on.

It is wise to note — as did Alan Reynolds in National Review — that the victims of the stock market bubble were investors who “compulsively accepted bad advice from stock analysts.” Another of their compulsions was abandoning their own common sense: instead they placed their faith in tout-TV, breathless business reporting, and rah-rah books like Dow 36,000.

Weaving safety nets for the naive and reckless is not a good use of the money. Investor education probably is, as long as the message of common sense is the lesson that is delivered.

But little will change until the culture changes; it is a fitting irony that one of the firms that has settled with the state and the SEC is Salomon Smith Barney, who used to brag about making money the old-fashioned way: “we earn it.”

They earned this, too.