The mounting price of fame

Wall Street research analysts have become public figures. But they’ve also become targets fire - for angry day traders, fund managers, corporate chieftains and now the SEC.

Wall Street research analysts have become public figures. But they’ve also become targets fire - for angry day traders, fund managers, corporate chieftains and now the SEC.

By Justin Schack
October 2000
Institutional Investor Magazine

Every day one particularly determined individual checks in with Jack Blackstock, head of equity research at Donaldson, Lufkin & Jenrette. Blackstock would rather he didn’t.

The man, who identifies himself as an institutional investor, leaves lengthy, angry voice-mail messages. They are targeted at one DLJ analyst who has yet to issue a buy recommendation on the caller’s favorite stock.

“He leaves voice-mails, two minutes long at the minimum,” says Blackstock, who declines to identify either the stock or the analyst. “He says things like, ‘You need to take action now. I want this man removed. I will hurt your firm if he’s not.’ At first, it was bizarre. Then, it was funny. Now, it’s a little bit worrisome.”

Never before have analysts been so influential, so high-profile - so highly paid. Superstars like Morgan Stanley Dean Witter Internet guru Mary Meeker and Salomon Smith Barney telecom maven Jack Grubman earn an estimated $15 million or more per year. But the newfound stardom carries with it an unexpectedly high price. Just ask Jack Blackstock. Or analysts Dan Niles of Lehman Brothers and Jonathan Joseph of Salomon, who both received death threats earlier this year after downgrading popular technology stocks. Just as the banking and trading masters of the universe in the 1980s metamorphosed into symbols of all that seemed wrong with unfettered markets, so too are analysts fast becoming this era’s easy targets of backlash.

Call it research rage. The pressure certainly is coming from all across the spectrum. Top corporate executives are pressing investment houses more than ever for favorable research if they want to win any banking business; analysts who don’t toe the line can find themselves walking the streets. Institutional investors, who have long griped about analysts’ preoccupation with banking instead of fundamental research, appear more alienated than ever. In a first-ever survey by this magazine, 44 percent of the institutions polled say the overall quality of Wall Street research has declined during the past year (see story, page 57). Meanwhile, retail investors, many new to the market, are as volatile as the Nasdaq index, unleashing harangues and threats by phone and fax and on the Web.

To be sure, investors have plenty to complain about. With the Dow Jones industrial average off more than 7 percent and the Nasdaq composite index down nearly 10 percent, stocks appear poised for their first losing year since 1990. After a tremendous speculative run-up in Internet stocks late last year, many myths of dot-conomics have been exploded. And the pain for many investors has been severe.

But market fluctuations don’t explain the scrutiny coming from another, far more powerful entity - the Securities and Exchange Commission. The agency has begun a crackdown on research practices, which could have far-reaching implications for the way research departments do business. In August, despite widespread industry opposition, the commission passed new fair-disclosure rules, known as Regulation FD, that are designed to make material information about publicly traded companies as accessible to retail investors as it is to well-connected analysts and portfolio managers.

Though the rule doesn’t take effect until October 23, some companies - such as Wells Fargo & Co. and Charles Schwab Corp. - are already curtailing private meetings with individual analysts or small groups in favor of disclosing information more broadly, and fairly, through such measures as Webcasts. Others are considering similar moves. “I think FD will have a great impact on the sell side. In many ways, it seems that they’re selling access to management. That is their real value to the buy side,” says Wells Fargo CFO Ross Kari.

Analysts are feeling the impact of the rule changes already. “We’ve seen companies blacking out slides in presentations. A few have canceled private meetings,” says Kevin McCaffrey, head of U.S. research at Salomon. “The rule hasn’t even taken effect yet. Until they all get more comfortable with exactly what they can and can’t do, there’s going to be a chilling effect. But we hope it will improve over time.”

Coincidence or not, a number of dramatic earnings shortfall announcements at companies from priceline.com to Apple Computer seemed to take analysts by surprise at the end of the third quarter.

For now, the SEC says it has no intention of hunting down corporate violators en masse. “Questions that are at all close are not going to be second-guessed by us,” says David Becker, the agency’s general counsel. “But if we see repeated instances of executives saying, ‘Oh, I had no idea that was material,’ we’re likely to take action. The dog can eat the homework only so many times before the teacher starts to get suspicious.”

More ominously for analysts and their firms, Institutional Investor has learned that the SEC has begun an inquiry into certain compensation and security-ownership practices inside Wall Street research departments. SEC examiners so far have visited a handful of investment banks, including at least one bulge-bracket firm, and plan to gather information from the rest of the industry in coming weeks, according to people familiar with the matter. Though the inquiry is preliminary - and may not lead to any action - the agency is focusing on whether firms have made any direct payments to analysts as compensation for corporate finance transactions they help land. Another point of inquiry is whether firms have allowed analysts to receive pre-IPO shares in companies they later wound up covering, these people say. An SEC spokesman declines comment.

To some extent, Wall Street has only itself to blame for all of this heightened scrutiny. Investment banks have not only fed off the long-running bull market, they’ve also fed it. From saturating the media with advertisements hyping their stock-picking prowess, online and off, to opening their doors to financial television channels, brokers have courted attention for solid commercial reasons. Research may have begun as an institutional business, but the ever-shrinking trading commissions provided by big portfolio managers stopped paying the rent long ago. And investment banking fees have become a far bigger source of funding for already bloated research budgets than ever.

Meanwhile, nearly every major investment bank has a significant retail component (Goldman, Sachs & Co. and Lehman Brothers remain holdouts). Gathering assets and providing advice - ways to add value beyond a $9.95 trading commission - have become strategic necessities. As a result, Wall Street is doing everything it can to push its research to as many people in as many venues as possible, spreading costs across multiple potential revenue sources. And appearing on CNBC is free. “We would like to get our folks as much in the spotlight as possible,” says James Clark, co-head of U.S. research at Credit Suisse First Boston.

All of the largest brokerage firms have installed cameras on their trading floors to facilitate analyst interviews. Some, including Merrill Lynch & Co. and Morgan Stanley, have built studios to handle internal and client Webcasts. Even smaller players, from Jefferies Group to C.E. Unterberg Towbin, have equipped themselves with broadcasting facilities.

“When I began about three years ago, there were only six or seven [in-house cameras],” says Andy Breslau, director of guest booking for CNNfn. “Now there are around 40.”

All over Wall Street, analysts are as busy courting publicity and are polishing their deliveries. Morgan Stanley, Deutsche Bank, Prudential Securities and numerous other investment banks periodically bring in media coaches to prepare analysts for on-air and print interviews. (The basic advice: Stick to the stocks you’re asked about; steer clear of the firm’s internal goings-on; don’t fidget.) Even mere voice-mail messages are scrutinized by specialists hired to help analysts perfect their blast messages to clients. “Until you see yourself on film or hear yourself on a tape, you have no idea that you’re rocking back and forth in your chair or that you’re very long-winded,” says Morgan Stanley global research director Dennis Shea.

Many individual analysts vie for publicity on their own. Several young researchers have tried, with varying degrees of success, to put themselves on the map by making outlandish calls (Amazon 400! Yahoo 600! Qualcomm 1,000!). “For more established analysts, all the attention from the media and from retail adds a tremendous amount of pressure,” says Morgan Stanley’s Meeker. “For the unknowns, it’s nothing but net. It’s nothing but upside.”

Says a financial television staffer: “Especially with some of the younger analysts, they’re looking to make a name for themselves. We’ve had people who didn’t even blink an eye at being picked up as early as 4:00 a.m. in Greenwich, Connecticut, to come to the studio for a 5:00 a.m. appearance.”

With all this tub-thumping, the result is something close to cacophony. Indeed, if E.F. Hutton were talking today, no one would be able to hear it.

“It used to be that we were only accountable to our institutional clients,” says Lise Buyer, who covered Internet stocks for CSFB before leaving in June for venture capital firm Technology Partners. “Now everyone knows what our opinions are, and they’re not shy about letting you know when they disagree. Sometimes it’s a little scary. There’s definitely an up- and a downside to all the publicity.”

Analysts are used to tough criticism from institutional investors and the companies they cover, but retail critics are often anonymous and, occasionally, frightening.

On the morning of June 8, DLJ analyst Jacob Fuller initiated coverage of Cheap Tickets, an online airline ticket seller with a market-perform rating and a near-term price target of 15. Fuller’s research note was hardly a bullish recommendation, since the stock had closed the previous day at 15 7/8, and market-perform is often taken as an analyst euphemism for “not much upside.” Cheap Tickets shares sagged to close below 15, and investors took to Yahoo! message boards. Anonymous posters suggested Fuller or DLJ might have an interest in knocking the stock down. They called him a “hack” who tried to keep the stock’s price low so a takeover bid from rival Expedia would still appear attractive, and threatened legal action. “What Fuller did is illegal!” screamed the headline on one post. “I think this guy tried to slit CTIX’s throat today,” read another. Others posted copies of e-mails to the SEC, requesting an investigation.

“It was clear from the postings that none of these people even read the report,” says DLJ’s Blackstock. “I told Jake to have a good laugh about it and not get involved in the sniping.” DLJ’s lawyers were contacted, but the firm took no action. “You read this stuff,” continues Blackstock, “and it makes you laugh, but it also kind of makes you cry. You almost feel sorry for these people. It’s just like, ‘Get a life!’”

Some boards get even more personal. Morgan Stanley research chief Shea recalls an instance when a message board writer claimed to have been out the previous night with one of firm’s analysts on a bender, during which the analyst decided to downgrade a particular stock. “This analyst is as straight-up-and-down a guy as you’ll come across. It was just ridiculous,” says Shea. “That’s the trouble with the anonymity of the Web.” Morgan Stanley tried unsuccessfully to track down the offender but was able to get Yahoo! to delete the message.

When former CSFB analyst Buyer issued a favorable opinion on online music-sharing service MP3.com, some postings accused her of having more than just a professional relationship with company executives. Buyer shrugs off the nonsense: “I had the most interesting life last year, according to the chat rooms. I just wish I remembered living it.”

Most people don’t take message boards seriously, but at least one firm has decided not to sit still for what it sees as abuse. On July 11 CSFB filed a lawsuit charging Colts Neck, New Jersey, resident Chuan Chang and ten as-yet-unidentified defendants with libeling the firm and its biotechnology analyst David Maris on a Yahoo! Finance message board about Dublin-based biotech company Elan Corp. Two of the messages in question, allegedly written by Chang, have been deleted from the board. Of the 14 still displayed, several suggest that CSFB, Maris and Dallas-based hedge fund Maverick Capital acted in concert to drive down the price of Elan shares. In February, when Maris initiated coverage with a “hold” rating, Elan’s share price fell from $37.50 to $36.16. But it then rebounded to near 40 during the first half of March and flirted with 50 by early April. Elan then declined sharply over the next two months, falling below 37 in early June.

“The Maris/Maverick manipulation continues,” reads an excerpt from one June 12 posting targeted in the suit. The next day another writer suggested the SEC investigate “Maverick’s trades in Elan and compare them to the issuance of a report on Elan . . . by Maris - I would suspect you’ll find a correlation. I’d also look at the commission business done by Maverick and other hedge funds in their circle with CSFB - I’d wager that you’ll find some interesting data points.” CSFB alleges that Chang and the other anonymous posters violated the Federal Telecommunications Act by using the message board to spread defamatory, false statements and seeks compensatory damages of no less than $1 million, according to a copy of the complaint. CSFB and Maverick decline comment. Attempts to reach Chang at home were unsuccessful. Maris maintains his hold rating on Elan shares, which nearly hit 60 in August and now trade in the mid-50s.

Occasionally, the investor feedback is more than worrisome. It can be scary. Earlier this year, after downgrading a number of actively traded tech stocks, from Dell Computer to Rambus, Lehman semiconductor and computer hardware analyst Niles began receiving death threats, which he took seriously enough to unlist his home phone number. “I would go home and check my messages, and there would be at least two or three every day from some investor who thought I was the third coming of the Antichrist,” says Niles, who worked for Robertson Stephens at the time.

In July Niles’s counterpart at Salomon, Jonathan Joseph, received death threats after downgrading the entire semiconductor sector. “As a firm, we’re extremely security conscious. We want to follow up on any potential threat, and in this case we enlisted all potential support, including calling the San Francisco police,” says Salomon U.S. research head McCaffrey. The firm hired security to guard the entrance to the building where Joseph and other Salomon tech analysts work, which was previously unattended. Joseph says that one man continues to leave him harassing voice-mails and that the firm is cooperating with authorities to try and track him down. “We had to have hit a very raw nerve with that call,” says Joseph. “Two months have gone by, and this guy continues to harass me. It’s pretty annoying.”

Other analysts believe this caution is prudent. “You do think about your safety,” says one tech research veteran who used to work out of an office in Silicon Valley. “I sat in an office on the ground floor with a big glass window. I remember coming in one day and thinking to myself, ‘Gosh, I’m pretty exposed here.’”

A veteran recruiter specializing in Wall Street analysts says the research community has to accept this sort of scrutiny: “Isn’t that the price of fame? If [New York Mets All-Star catcher] Mike Piazza strikes out four times in a row with the bases loaded, people are going to boo him. Nobody puts a gun to peoples’ heads and forces them to become analysts, go on CNBC and make obscene amounts of money.”

All this attention from retail investors won’t affect how analysts do their business, but Arthur Levitt Jr. might. The SEC chairman, known for pressing the interests of Main Street investors over financial middlemen, is attacking analysts’ often privileged access to the information that moves stocks.

Regulation FD, first proposed in December, prohibits issuers from disclosing “material nonpublic information” to Wall Street professionals without simultaneously making the same disclosure to the general public. The proposal stirred up a storm of controversy: The SEC received nearly 6,000 comments before modifying and finalizing it on August 15. The regulation that goes into effect October 23 is slightly narrower in scope, specifying that only information a company knows to be “material” must be disclosed to professionals and the public at the same time, and that enforcement actions under the rule will need to prove “knowing or reckless conduct.”

Still, the spirit of the regulation has changed little from proposal to final rule. This should please individual investors, who wrote the SEC in droves, mostly supporting the rule. Brokerage and investment management firms, on the other hand, were just as vociferously opposed.

The SEC’s failure to define “material nonpublic information,” these critics argue, will lead companies, uncertain of where to draw the line, to limit disclosure to only the most innocuous information. Private contact with management, coveted by analysts and portfolio managers, will be severely restricted. All investors, they insist, whether institutional or the small stockholders the SEC wants to protect, will end up with less information.

“We’ve definitely seen a degree of chilling since the rule was passed,” says CSFB’s Clark. “The period just prior to earnings is becoming a much quieter time. You could get a lot more insight from companies as to how their numbers might look, and now that’s disappearing.”

The possibility: Material information that might have been discovered and disseminated by analysts will now remain secret and far more sporadically disclosed, creating the potential for huge swings in stock prices once the market finally finds out. Says Morgan Stanley’s Meeker: “Bottom line, I believe this exacerbates the volatility of stocks. And that’s a bad thing for the very investors it’s trying to protect. I feel very strongly about it.”

Companies are taking the new rules seriously. Wells Fargo earlier this year discontinued the analyst conference calls it held following quarterly earnings reports. Instead, senior management at the San Francisco bank will make recorded statements summarizing the figures available to analysts and investors. The move had been discussed in advance of the SEC proposal and marks a return to the policy followed by Norwest Corp. before its merger with Wells Fargo, but the advent of Reg FD played a part in its timing. Once the new rule was finalized, Wells Fargo took things even further. Says CFO Kari: “It is apparent that the SEC’s current interpretation of materiality probably is a little finer than what we would have expected. So we have taken the step that senior management cannot be speaking about current financial performance. Period.” Analysts may continue to discuss strategy and other qualitative topics with executives, and the company plans to provide more detailed information in earnings releases to compensate for the decrease in access to management. But they no longer will be privy to the level of detail enjoyed before Reg FD, Kari says.

Companies may also go to the opposite extreme - disclosing anything and everything that could possibly be considered material. Last month eBay CEO Margaret Whitman revealed during an analyst conference call that the company has projected annual revenues at $3 billion for 2005 (eBay’s 1999 revenues were $225 million). The company had never projected out that far before. “I think it was a partial response to their confidence in the business but also a reaction to FD,” says Meeker, who took part in the call. “She said, ‘We’re being told we need to be very deliberate in what we disclose. If we’ve made that projection, and if that’s material, let’s say it.’” An eBay spokesman concurs with Meeker’s interpretation and adds that the company is also considering a move to Webcasts instead of conference calls to discuss quarterly results.

The new rule, of course, complements existing prohibitions against insider trading. Possessing the information is fine; passing it along to clients or trading on it is not. Analysts can still get privileged access to material information, as long as they agree to keep it confidential. Of course, that prohibition makes the information merely academic, because they won’t be able to act on it.

Schwab is also making changes to its established practice of holding semiannual conferences for Wall Street analysts, sources say. The conferences traditionally have been “hosted” by a sell-side analyst as a way for the company to reward favored researchers. Goldman Sachs brokerage analyst Richard Strauss, for example, has led Schwab’s spring conference regularly in recent years. Other hosts have included J.P. Morgan Securities’ Michael Freudenstein and Morgan Stanley’s Henry McVey. By hosting these conferences, analysts can curry favor with buy-side clients, who have the power to direct trading business to favored researchers’ firms. But Schwab, in reaction to Reg FD, is nixing the confabs and is holding Webcasts - a more neutral, accessible forum for disclosing information to all investors.

And the Web will only become more compelling as the major forum for public disclosure of material information, as technologies improve and online users proliferate. The SEC admonishes companies to keep up with these developments in the text of its new rule: “Technological limitations no longer provide an excuse for abiding the threats to market integrity that selective disclosure represents.” Drugmaker American Home Products and insurer UnitedHealth Group are just two of the companies considering quarterly earnings Webcasts instead of conference calls.

The Financial Relations Board, which advises 450 publicly traded companies on investor relations policy, is recommending that issuers consider regular, more frequent release of material information to comply with Reg FD. Such “continuous disclosure” can include monthly position papers provided to Wall Street professionals and the larger investing public on company Web sites or in filings to the SEC, rather than the quarterly reports that now predominate. Says Ted Pincus, FRB’s CEO, “Once you do that, you can feel a lot more comfortable when an analyst comes into your office and wants to talk.” The free flow of information, of course, begs the question of what will be left to talk about.

As analysts lose their exclusive access to company executives under Reg FD, they will have little choice but to return to fundamental analysis and original research. “Nobody’s going to have the inside dope. Analysts now will distinguish themselves more on scholarship and analytical ability rather than connections and relationships,” says Pincus. To be sure, many Wall Street analysts already spend their days digging and number-crunching. The best researchers rely on lower-level executives (who are exempted from Reg FD), suppliers, customers, former employees and other outside sources for data on the companies they cover. “There’s a lot of information that can be had from outside the company,” says CSFB research chief Alfred Jackson. “Analysts have other contacts, and they will continue to use them.”

Consider Salomon telecom analyst Grubman, who is renowned for his banking-related connections with top industry executives. Despite the obvious threat Reg FD might present to his franchise, Grubman argues that his strong banking relationships flow from years of deep fundamental research. “What do you think, we got here overnight?” he asks. “We did good research for years and years in the process of cultivating these relationships. I don’t see this as an obstacle at all. I personally like it.”

The new regulation may cause greater pain for institutional investors than for Wall Street. Frustrated with what they see as the declining quality of sell-side research, many large money management complexes in recent years have beefed up their own analytical capabilities. Indeed, some buy-side analysts and portfolio managers, because of the sheer value of the assets their firms manage, enjoy even greater access to senior executives than do analysts at top investment banks. Under Regulation FD, this edge may very well vanish. Moreover, analysts at brokerage firms already disclose almost immediately material information gleaned from executives, by notifying their sales forces and putting out research notes that are disseminated to the larger market by services such as First Call/Thomson Financial. For buy-side analysts and portfolio managers, the whole point of obtaining such information is to keep it to themselves and profit from it. “Reg FD is going to be a far, far bigger issue for the buy side,” says Grubman.

Furthermore, sell-side analysts will continue to enjoy access to management - and to material nonpublic information - while wearing their investment banker hats. Information disclosed to analysts in the context of banking relationships is covered not by Reg FD but rather by existing insider trading rules that prohibit the analysts from acting on it. Most firms also forbid analysts to comment on a stock for a period of time - typically, a month or two - after working with the issuer on a corporate finance transaction such as an IPO or acquisition.

Nevertheless, this kind of continued exposure to management helps analysts assemble a “mosaic” of the company that may give them an advantage over the competition when they are finally freed from banking “blackouts” to publish research and talk to investors about the company. “Obviously, the knowledge one garners from working on deals can be immensely valuable,” says Robert Herz, a partner at PricewaterhouseCoopers. “That is a real question people have - whether there is a real, untenable conflict of interest there.”

Wall Street analysts may very well learn to live with the new SEC rules and perhaps even emerge none the worse for the wear, in the eyes of investors. But short term, they are almost certain to suffer. The bottom line for many researchers is that only the largest institutional clients have the clout to gain private audiences with senior corporate executives. Sell-side analysts thus often win big points by using their own relationships to provide access for money managers. Indeed, institutional investors voting in this magazine’s annual ranking of sell-side analysts consistently say that “access to management” is one of the most valuable things researchers provide.

New rules tend to have unintended consequences. The abolition of fixed commissions in 1975 gave rise to the discount brokerage industry. Order-handling regulations implemented on Nasdaq in 1997 created a new generation of electronic trading systems. How Reg FD plays out remains to be seen. But one thing is certain. Retail investors will be glad to post their opinions.

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