Business

WHEN TRUST IS BREACHED

Some analysts' tech research was compromised, writes KATHERINE MACKLEM

KATHERINE MACKLEM May 19 2003
Business

WHEN TRUST IS BREACHED

Some analysts' tech research was compromised, writes KATHERINE MACKLEM

KATHERINE MACKLEM May 19 2003

WHEN TRUST IS BREACHED

Some analysts' tech research was compromised, writes KATHERINE MACKLEM

KATHERINE MACKLEM

Business

AS TOM MILLS, a former analyst with one of Canada’s largest investment firms, puts it—none too delicately—the job he used to do was “prostitute work, basically.” Mills (not his real name) covered software companies in the days leading up to the tech boom, when investors were pouring money into stocks they couldn’t understand and investment bankers were eager to underwrite even the silliest of dot-com notions. Mills left the business in June 1999, a point when Y2K fears were depressing the value of tech stocks. Even then, many tech stocks were being hyped by overzealous brokers, and early warnings of the monstrously dangerous bubble just around the corner were easy to ignore. Mills left—in fact he was dumped—partly because he contributed to those warnings. But along the way, he encountered what he now describes as a shady business lacking in integrity and trust.

Mills’s job was to study companies and assess whether they would make good investments for his firm’s clients. From 1996 to his departure three years later, Mills researched more than a dozen stocks, rating them as a buy, sell or hold. But he found

NO ONE suggests that the whole industry is tainted. But it’s clear the same pressures were at play in Canada as in the U.S. and abuses did occur.

that rather than basing his recommendations solely on his own objective findings, he was pressured to make his calls more positive. His firm’s corporate finance partners— investment bankers who arrange financing

for companies—pushed for favourable recommendations to bolster their sales pitch to potential clients.

Finally, in April 1999, Mills wrote a 90-page report on a dozen stocks. In earlier sector reports, most recommendations were positive, Mills says. This time, though, it was different. “I decided I was really going to let research drive the recommendations and ignore what corporate finance was saying,” he recalls. “I just focused on how we were going to make money for our clients. I wanted to do things the right way.” He strongly recommended just one stock. Three others he expected to do well. He rated eight either neutral or underperform. Six weeks later, he was let go.

Sound familiar? Last month, U.S. regulators reached a landmark settlement with 10 of the largest and richest Wall Street brokerages, including a payment of US$1.4

billion, following an investigation that uncovered monumental conflicts of interest and abuses (page 36). Four national and 12 state securities agencies focused on analysts who published overly optimistic research reports on companies that were simultaneously being solicited by the analysts’ firms for lucrative investment banking business. Looking through e-mails subpoenaed for the investigation, authorities discovered personal views that clashed dramatically with the analysts’ so-called professional opinions. Henry Blodget, Merrill Lynch & Co.’s superstar tech analyst, for instance, privately called one on-line company a “pos”— e-mail-ese for piece of shit—even though he’d publicly rated it a long-term buy.

What’s frightening for Canadian investors is there’s no way of knowing if similar abuses are occurring here. The Ontario Securities Commission won’t comment on whether it’s investigating Bay Street’s behaviour—at least not publicly. But, adds OSC spokeman Eric Pelletier, “If we had information leading us to believe analysts were aligning their recommendations with corporate finance, we’d potentially launch regulatory action.” No one’s suggesting the whole industry is tainted. The stakes in Canada aren’t quite as high—among other things, analysts here take home less than a tenth of their U.S. counterparts’ income. But it’s clear the same kinds of pressures were at play in Canada as in the U.S., and that abuses did occur. “I have not come across an analyst who participated in such outright two-facedness,” says one tech analyst, who asked not to be identified. Still, the analyst added, scams were there, just in more subtle forms. Mills, for one, recalls being advised to change a hold recommendation to a buy for a company his firm had underwritten. “It wouldn’t look good,” a senior executive told him later, “to initiate coverage on a stock we’d just underwritten with a hold recommendation.” Few market players will speak openly about inflated tech-stock recommendations. But one industry leader did go on the record because he was disgusted by the culture that grew up during the boom. Dominik Dlouhy, a former chairman of the Montreal Exchange and principal founder and chairman of Montreal-based Dlouhy Merchant Group Inc., says conflicts of interest were rampant in Canada during the tech boom, when dealers were underwriting deals “like mad.” Dlouhy blames, among others, corporate

issuers who pushed for positive coverage to go along with an underwriting deal. Corporations, who pay large fees—roughly seven per cent of the amount raised—to invest-

WHAT’S MADE it easy to corrupt analysts is the same reason brokers, dealers, analysts and traders join the investment business. Money.

ment firms for help in raising capital, wouldn’t settle for anything but, and would shop around for the positive write-up. “I haven’t seen a report that is negative,” he laughs, struck by the idea’s absurdity, “by an investment firm trying to get a corporate finance deal. That wouldn’t fly.”

Was his own, independent firm ever put under pressure? “Yup,” he admits freely. “Some issuers wanted us to do issues and do write-ups, and we didn’t. But we had one or two bad deals. You make some mistakes.

We did 30 deals, so that’s not too bad.” Throughout the industry, he suggests, the culture changed and bad deals were driven by “the inexperience of corporate finance guys, analysts, and some management, the lack of knowledge of history and the disdain for history. And, the idea that, boy, this is the way the game is played.”

AN INVESTMENT FIRM is a multi-limbed entity. Its corporate finance—or investment banking—division helps companies raise money in the markets. The bankers are the deal-makers—and the ones making the big bucks. Traders do the actual buying and selling. Each firm also has an institutional sales division where brokers try to capture trading business from mutual funds and pension funds. Retail brokers help small investors.

And then there’s research, where, of course, the analysts reside. Their job, ostensibly, is to provide unbiased opinion on companies that are publicly traded. Their analysis is used by institutional sales people to attract large portfolio trading business, and by re-

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tail brokers to help make their clients more money. If it’s positive, research helps corporate finance, as well, to sell a financing proposition to a company that’s seeking to raise funds and to attract investors.

There’s supposed to be a so-called Chinese wall separating research and corporate finance, but at the same time there’s necessary collaboration between the two. Corporate finance may consult with research when it looks into a potential underwriting deal, and if research advises against the deal, the bankers are expected to back off. But once a deal is in the works, the analysts can’t make recommendations and must step aside.

What’s made it easy to corrupt the analysts is the same reason brokers, dealers, analysts and traders all join the investment business. Money. Traditionally, a firm’s trading business was its cash cow, but commissions have fallen steadily since trading fees were de-regulated in 1986. Now corporate finance is the revenue driver. Research has always been a cost centre, but now its tab is picked up by the investment bankers. Even an analyst’s annual bonus, which can be double his or her salary, is set by the investment bankers.

The tech bubble also played a role in corrupting research. The IT sector, where insiders say most of the bogus reports have been found, was full of companies that were simply ideas with no real assets—and tricky to quantify. Mills ran into trouble on one of the first reports he wrote after joining a major bank-owned Bay Street firm. As he was preparing a draft on a software company that had just gone public (but is no longer around), the firm warned it would fall short of its quarterly forecast. Mills decided to recommend investors hold their stock. Still, he was counselled by a more senior analyst to call the company a “buy.” He did, and afterward was told he would have been “toast” if he hadn’t. “Imagine,” Mills says, “a junior analyst hearing that sort of thing.”

Mills says his workplace performance evaluations were good right up until he was fired in the spring of’99. His director of research told him he was being replaced by a higher-ranked analyst. But a senior tech analyst with his firm had a different story. “I was basically told,” Mills says, “that corporate finance was no longer behind me.”

Today, Mills, who’s in his late 30s, lives in Vancouver. In the mornings, he researches

stocks and invests for himself. “I realized a good analyst can make more money investing for his own account than he can working for an investment firm,” he says. In the afternoons, he’s taking a French cooking course. The one thing from the corporate world he misses, he says, is the expense account and its $400 dinners. “But if I can cook the same dinner for myself and my friends for a hundred bucks, I’m doing it.”

OPINION IS split on how rotten things really are. ‘Are there bad analysts?’ asks one player. ‘Absolutely. Are there bad cops? Bad journalists?’

CANADIAN REGULATORS have long been aware of the temptations for analysts to alter their recommendations. Remember Bre-X? That 1997 fraud, and the bevy of over-eager analysts touting the disastrous mining stock, led to the ultimate Canadian response—a string of committees and commissions and task forces. One of those groups, chaired by Purdy Crawford, former chairman of Imasco Ltd., recommended new rules be drafted for analysts back in November 2001— when Spitzer’s group was roughly halfway

through its investigation of abuses that took place the previous year. As heads roll and Wall Street gets smacked for its sins, the Canadian rules have yet to be put in place.

But they are imminent, officials claim, and will be similar to those imposed in the U.S. The goal is to separate a brokerage’s research and investment banking divisions by creating separate supervisory structures and compensation models. Analysts, for instance, will no longer be paid according to how much investment banking business they help to attract to their firm, but rather by the quality of their research.

Opinion is divided on how rotten things really are. The U.S. investigation is a “witch hunt,” says one Bay Street veteran. “Are there bad analysts?” he asks. “Absolutely. Are there bad cops? Bad doctors? Bad journalists? Biases existed in the ’90s, and investors were fine as long as they were making money. But once the bear market took over, a scapegoat had to be found.” But others say the problems are serious and need fixing. Dlouhy, who started in the investment business in the late-1950s, says the industry has got out of control. “I’ve been in this business for a long time. I’ve never seen the level of greed and corruption that I have in the last three or four years—ever? The worry, though, is that when the bull market returns, investors will happily make their money again, and no one will care. M

kmacklem@macleans.ca