From Behind the Corporate Veil: The Outing of Wall Street's Investment Banking Scandals - Why Recent Regulations May Not Mean the Dawn of a New Day

Article excerpt

It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way.1

INTRODUCTION

It was the dawn of a new millennium, and the infamous Internet tech bubble was about to burst. For years on Wall Street you could practically recommend anything "beginning with 'e-' and see it trade at astronomical prices."2 However, behind the scenes, Wall Street was harboring a dirty little secret. Some of its highest paid investment bankers were handing out hot IPO3 shares in return for kickbacks. Others were offering favorable stock recommendations from their research analysts in order to secure lucrative investment banking contracts. In effect, Wall Street was catering to "two key constituencies: its institutional investors and its corporate clients. If the individual investor wanted to join the party, well, caveat emptor."4

With the advent of the Internet, along with the proliferation of business news rags, and financial TV programs, Wall Street has seen an increase in investor participation in the stock market.5 Unfortunately, quantity of information is no guarantee of quality, and the armchair investor is an easy prey. "Recent investigations into conflicts of interest on Wall Street have shown that in too many cases in the past, investors' interests were compromised for greater investment banking revenues."6 In response, State and Federal regulators have proposed a number of comprehensive reforms in an effort to restore investor confidence and integrity to the capital markets.7

Part I of this note discusses pertinent background information; the role of the research analyst in the capital markets, types of conflicts of interest and early examples of regulation that in the end proved unsuccessful. Part II begins with illustrations of recent high-profile corporate scandals regarding research analysts' conflict of interest, and then moves on to discuss the recent regulatory efforts to curtail such activity. Part III analyzes some of the problems and inconsistencies inherent in some of the new rules and ultimately concludes that a number of them fall short of their intended goals and that the road to restoring investor confidence and market integrity is a long way off.

I. BACKGROUND

A. The Role of the Research Analyst

Research analysts examine companies in light of "economic, industry and business trend information."8 That research is used by broker-dealers to assist their customers in making informed investment decisions,9 and as a marketing device to promote buy and sell recommendations on publicly traded securities.10 In addition, these brokerage firms commonly have investment banking divisions, which underwrite securities.11 "An underwriter acts as intermediary between the company publicly offering securities and investors buying new stock."12

Typically research analysts fall into three categories: "sell-side," "buy-side," and independent.13 Sell-side analysts work for large financial firms with brokerage customers.14 Buy-side analysts, however, typically work for "institutional money managers such as mutual funds, hedge funds or investment advisors."15 Finally, some analysts are unaffiliated, selling their independent research to financial institutions or private investors on an ad hoc or subscription basis.16

B. Types of Conflicts

Following the burst of the Internet bubble, the SEC launched extensive on-site examinations of several full service brokerage firms focusing on buy recommendations made by supposedly independent research analysts to the investing public for technology stocks.17 Investigators wondered how so many analysts could have been wrong. …