There wasn't a wet eye in any boardroom after the news that 10 large brokerage houses will pay, collectively, $1.4 billion in fines for (which word from the thesaurus should we use?) dishonest, double-dealing, fraudulent, counterfeit, sham, yes -- sham -- research reports that bilked investors of billions. The only wet eyes may be those of the throttled investors.
The fines are insignificant enough that the day following the news, Standard & Poor's reported that it was not likely to change its ratings on any of the companies charged. Each firm has more than ample cash flow to finance the charges without even a thought to toning down the annual holiday party. Yes, the beat goes on.
You know the charge (Tom Jacobs yesterday covered it in a short Take): Issuance of stock research reports that were disingenuously positive on companies in order to generate and maintain lucrative investment banking business. In other words, earn billions of dollars in banking contracts by misleading individual investors, the very people that full-service firms purported to look out for "one investor at a time."
You know the guilty. You know them very well. They're among the most respected names on Wall Street: Citigroup's (NYSE:C) Salomon Smith Barney unit, Merrill Lynch (NYSE:MER), Credit Suisse Group's (NYSE:CSR) Credit Suisse First Boston, Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MWD), Bear Stearns (NYSE:BSC), J.P. Morgan Chase (NYSE:JPM), Lehman Brothers (NYSE:LEH), UBS Warburg, and U.S. Bancorp's (NYSE:USB) Piper Jaffray.
It should be unbelievable to all of us that each and every one of these giant companies had so little regard for individual investors -- their very clients -- that they wantonly risked clients' life savings for their own corporate gain. So, why are we not up in arms and boycotting these firms? Do we hope that regulators will make things right for us? They won't. The fines imposed by regulators amount to the following (all fines are in millions, all company cash and net income balances are in billions):
Company's...Company Fine Cash* Net Inc.**Citigroup $400m $17.3bn $19.2bn Merrill 200 10.2 5.7Credit S. 200 2.2^ 5.4 Morgan S. 125 67.6 8.5Goldman 110 25.2 5.0Lehman 80 6.5 2.5 J.P. Morgan 80 19.2 8.7Bear S. 80 12.6 1.1U.S. Bancorp 32 10.7 4.3*Cash is cash, equivalents and money due from banks as of the end of 2002.**Net income is from year 2000 before taxes (because we all pay taxes).^Credit Suisse cash is as of 12/01.
You can see that the fines are merely symbolic. They're nowhere near a fraction of cash on hand or one year's net income. In fact, most of these fines can be paid by the little number to the right of the decimal point in each company's cash balance. The fines don't change anything at the companies.
The only good news is that $387 million from the fines will go to wiped-out investors, tens of millions will form an educational fund, and the rest of the money goes to states. But the only changes at the companies themselves will result from the following new regulations, and they're only a small (and largely ineffective) step in the right direction:
- Investment banking and stock research arms must remain separate of one another, with separate reporting and separate management (this was already supposed to be the case, however).
- Stock analysts are barred from meeting with potential investment-banking clients.
- Stock analysts must be compensated based on the performance of their stock picks, rather than on investment-banking contracts.
- Databases must be maintained showing analyst performance.
- Stock reports must indicate any business relationships that an investment house has with companies written about and cite potential conflicts of interest.
That last regulation is the very reason to remain skeptical of research issued by brokerages that have investment banking ties - they must cite potential conflicts of interest, because those conflicts will still exist, writ large. Nobody works in a vacuum.
A stock analyst working one floor below her company's investment-banking arm is going to know pretty darn well which companies have business with her firm. Therefore, being objective will remain a challenge. She'll ponder: "My company has relations with this company. Can I write negatively about it and not suffer any consequences?" That's human nature. That's survival instinct. That's a serious conflict of interest.
Obviously, conflicts remain even as we speak. A majority of research reports continue to proffer positive ratings on companies, and it isn't because most companies are somehow above average.
Past, present, and future
Every time a major bull market has ended, a rolled carpet has effectively unfurled to reveal a gruesome body inside -- a body of corruption. It comes with bull markets. When everybody is gorging, no one bothers to watch the henhouse. Scandal happened in the '20s, '50s, '70s, '80s, and now. It'll happen the next time stocks soar. There will be new scandals and repeats of old.
Some of the very brokerage houses fined this week were fined for fixing Nasdaq stock prices as recently as 1996, and many will likely do wrong again. A Chinese wall between analysts and investment banking will not stop what nobody can stop today: communication. So, research from full-service brokerage houses that are involved in banking has been, and will continue to be, suspect. Period. Disclaimers, Chinese walls and all.
One of the first missions that The Motley Fool undertook in the early 1990s was to expose Wall Street's age-old, bronze-plated, full-service investment houses for what they largely are: made rich on your dollars. Mutual fund bashing aside, we rallied most often against analyst stock ratings, citing that 90% of stocks were rated "buys" and conflicts of interest were behind it.
Yet, like many, we also were too quiet during the late '90s -- perhaps too wrapped up with excitement to write repeatedly about the many questionable activities happening (including giant bonuses paid to research writers that could not have possibly been justified for "writing").
Will we be skeptical enough during the next bull market? Will you be? Or will most investors start buying into the next hot thing again?
Arm yourself now
There are full-service brokers out there who work hard, care about their clients, and do great jobs for reasonable fees. Then there are those who convince their clients to sell a decades-long holding in a retailer in late September 2001 because malls "will likely be bombed soon." And they say to sell it today because "stocks usually rise on Friday." (True quotes.) And then they move the money into an expensive fee-laden investment.
The bottom line is that you need to look out for yourself, know who you're dealing with, and protect your funds. Who do you trust?
Do not trust stock research from brokerage houses that have banking businesses -- that directly conflicts with offering objective stock research. Don't wander from index funds unless you want to work hard to understand individual stocks on your own. And then get independent research from smaller, research-focused organizations that do not have investment-banking arms, including companies such as Morningstar and, right here, The Motley Fool. (We offer unconflicted stock research as well as personal financial advisors with nothing to sell you.)
Get research from firms with nothing to hide -- from ones that, if their stock choices don't do well, their reputations and their very income (their direct and primary income) suffer.
Stay Foolish!
[Speak your mind! What do you think about the $1.4 billion settlement, and how do you make investment decisions? Share your thoughts on the Fool on the Hill board.]
Jeff Fischer is a senior analyst for The Motley Fool. For the Fool's best stock ideas and exclusive analysis, subscribe to our monthly newsletter, The Motley Fool Select . The Motley Fool is investors writing for investors.
