Guess who came to dinner

New York State Attorney General Eliot Spitzer sparked controversy last month at Institutional Investor’s All-America Research Team awards dinner by skewering the evening’s honorees in his keynote address.

Spitzer, who is conducting a very public probe of Wall Street analysts’ conflicts of interest, first commended the II-ranked analysts for their awards, then threw water on that praise by unveiling the results of a study he had commissioned, which, he said, showed that the All-America team members often lag their colleagues when it comes to stock picking. His point: Brokerage houses touting their prowess in II’s rankings to make investors think they are good stock pickers is a deceptive practice and has to cease.

He went on to propose a national database of stock recommendations that would allow individuals to check on the performance of particular analysts.

Institutional Investor Editor Michael Carroll took the podium after Spitzer to agree that “brokerage firms should completely and honestly disclose the criteria used in the selection of these awards.” He also pointed out that for the institutional investors who vote in II’s surveys, stock picking is “almost an afterthought.” In 2002 it ranked 11th among the criteria voters used to select the All-America analysts. (Industry knowledge ranked first.)

But Carroll disputed the notion that the II survey is used much by retail investors. Indeed, he said, much of the late-1990s retail boom was about circumventing, not heeding, Wall Street: “I’d welcome the attorney general to take a stroll with me in, say, Washington Heights, where I grew up. If we can find anyone who bought a stock because it was recommended by an II-ranked analyst, I’ll be glad to buy him lunch.”

Spitzer declined to take questions from the audience but agreed to a question-and-answer session with the evening’s master of ceremonies, CNBC television reporter David Faber. An edited version of their exchange follows. (To read the full text of this Q&A, Spitzer’s remarks, Carroll’s introductory comments and his response to the keynote address, as well as a list of all the winners, please go to

Faber: It is extraordinarily hard to be a good stock picker, and even more so over a long period of time. Why not eliminate ratings altogether? Why not protect the individual investor by not having them see a buy, a sell, a hold or a price target at all, by making them read the research and perhaps even try and understand it?

Spitzer: Well, David, I think that there is a powerful argument that can be made that eliminating the buy, sell, hold and the price targets would be a worthwhile way for the industry to run itself. But I don’t think it’s for government to mandate that. What I do believe we have a responsibility to do is permit the transparency, so that those who put a buy, sell or hold or create a price target can then be judged based upon the quality of the work that they produce. If half the entities out here tonight decided they didn’t want to put on a rating, great, good luck, and see if the marketplace absorbs it. But it is not for us to mandate that you do it or not do it.

Faber: The pressures that many analysts are under are not confined to investment bankers. In fact, companies can be extraordinarily vindictive. Money management firms can also be extraordinarily vindictive in terms of directing trading and commissions. Mutual funds for the most part can’t short stocks. They therefore are very vindictive when an analyst comes out and says something negative. Banking is certainly a conflict, but how in the world are you going to go about dealing with those other two, which can be much more significant?

Spitzer: I’m frankly surprised that when these issues began to hit the public’s attention back in April, we didn’t hear more from the investment banking community about the retaliation that they felt and the pressure that they felt from the client companies. I thought that would be a natural way to explain to the world, “Wait a minute, we’re not the bad guys.” That argument was not made.

Faber: Why haven’t we heard more?

Spitzer: Frankly, because I think the evidence was so damaging that it simply didn’t resonate. Having said that, the issue of retaliation is something that we are trying to confront.

Faber: You are the attorney general of the state of New York, which faces an enormous budget deficit. The city of New York is dealing with about a $5 billion budget deficit. You’re attacking an industry that employs a great many people. To what extent do you start to work to the detriment of the citizens of this state by some of the efforts that you’ve undertaken?

Spitzer: I am not attacking the industry. What I am doing is attacking fraud. The industry will be stronger as a result of the confidence in the general public that results from cleaning up its act. I have absolutely no doubt about that. And there is an atrophying effect, a corrosive effect to the sort of problems that we revealed that ultimately would have brought the industry down of its own weight had these problems not been confronted. So, yes, the industry right now is suffering. It is not suffering because of the investigations; it’s suffering because there’s no deal flow. There is no revenue stream there for the industry. Which makes it, I would argue, an especially unique and opportune moment to clean up these structural problems, so that when the economy begins to come back, the industry will be poised to take advantage of the confidence the public should have in it.

Faber: Your efforts may well result in a fundamental and seminal change in the way research is conducted that results in much lower compensation levels for members of this audience and others. And a reduction in employment. Certainly, that has to factor into what you’re thinking as a politician.

Spitzer: It doesn’t factor into what I think. What I would say to the analysts who were getting $20 million a year -- of which $18 million was essentially a percentage of the investment banking revenues -- is: That shouldn’t have been paid to them. If they’re getting $2 million a year because that’s the value of the research they generate, God bless ‘em, that’s what they should get. The incremental $18 million simply is not a legitimate analyst compensation. My guess is that in any global resolution or in any individual company settlement that emerges, you will see outright prohibitions on investment banking revenues being part of the compensation package. That’s as it should be. I have no qualms in saying that, and to folks that are going to say, “Gee, I’m going to be getting a little bit less,” so be it.

Faber: To what extent is there a threat that ultimately the individual investor will be hurt, because you will have less coverage of many stocks?

Spitzer: The problem with orphan stocks, stocks that aren’t covered, is a very real one. We are thinking about ways to ensure broader, deeper coverage of those stocks. But I think that is an issue that is discrete and separate from the issue of how analysts are relating to the investment banking side.

Faber: Is it possible we’re gonna see an industrywide settlement before the end of this year?

Spitzer: Is it possible? Certainly. Do I hope so? Absolutely. Do I think it’s likely? I think there’s a good shot. We are trying very hard to work through these issues. The members of the industry have spoken not always with a unitary voice, which is, of course, what you would expect, and so it is conceivable to me that we will get deals either with the industry or with various members of the industry. We on the government side have a pretty fair and accepted view of what we think the rules should look like. There is an intellectual and philosophical agreement among the government regulators, and I think we are now in the position to say to the industry: “Here it is. If you want it, wonderful; if not, so be it, then we’ll proceed with alternative approaches.”

Faber: What do you think is going to be the response from the industry?

Spitzer: You tell me. We’ll be waiting to find out.

Faber: Sallie Krawcheck is running a new unit at Citigroup, and they have moved to separate it, at least internally. Is that enough?

Spitzer: Is it enough? No. I don’t mean to pick on one company or to look at one paradigm and say why it is sufficient or not sufficient. Clearly, there you have a step that is affirmative, a step that is helpful, but you still have research that is reporting back to the same board of directors, which has theoretically the same concerns, tensions; that looks to the investment banking side; that looks at the revenue stream; and information can go back and forth. There is not the sort of division that would lead to the purity of research that we would aspire to. Does it help? Of course. And so therefore did I and other regulators look at it and say this is a good step? Absolutely.

Faber: You seem to be implying that ultimately the solution would be something that truly separates banking and research, perhaps even through a spin-off of some kind and only through that.

Spitzer: No, I didn’t say that, either. What I said is that it would be a partial solution. There may be other mechanisms that you can put in place to try to craft a resolution that in aggregate gives to retail consumers the type of research that they deserve.

Faber: And are you hearing those kinds of solutions from the people you’re dealing with?

Spitzer: Oh, sure. Does it mean that they’re happy about it? No. Does it mean that they are doing it begrudgingly? Maybe. Does it mean that they will say, “Sure, we have to do it, because we’re at a disadvantage from a negotiating perspective and will bad-mouth it every way we can”? I’ve seen that happen before. But I think we have made some significant progress. And I also step back and put things in a slightly larger time frame. On April 7, the day before we announced the first case against Merrill, I don’t think there was an acceptance that there was a significant structural issue that had to be addressed. We are now here eight, nine months later, and we are debating the various range of solutions. There is now, I think, almost a uniform acceptance that the diagnosis was correct.

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