[House Hearing, 107 Congress]
[From the U.S. Government Publishing Office]
ANALYZING THE ANALYSTS
=======================================================================
HEARINGS
BEFORE THE
SUBCOMMITTEE ON
CAPITAL MARKETS, INSURANCE, AND
GOVERNMENT SPONSORED ENTERPRISES
OF THE
COMMITTEE ON
FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED SEVENTH CONGRESS
FIRST SESSION
__________
JUNE 14; JULY 31, 2001
__________
Printed for the use of the Committee on Financial Services
Serial No. 107-25
_______
U.S. GOVERNMENT PRINTING OFFICE
73-368 WASHINGTON : 2001
____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpr.gov Phone: toll free (866) 512-1800; (202) 512�091800
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HOUSE COMMITTEE ON FINANCIAL SERVICES
MICHAEL G. OXLEY, Ohio, Chairman
JAMES A. LEACH, Iowa JOHN J. LaFALCE, New York
MARGE ROUKEMA, New Jersey, Vice BARNEY FRANK, Massachusetts
Chair PAUL E. KANJORSKI, Pennsylvania
DOUG BEREUTER, Nebraska MAXINE WATERS, California
RICHARD H. BAKER, Louisiana CAROLYN B. MALONEY, New York
SPENCER BACHUS, Alabama LUIS V. GUTIERREZ, Illinois
MICHAEL N. CASTLE, Delaware NYDIA M. VELAZQUEZ, New York
PETER T. KING, New York MELVIN L. WATT, North Carolina
EDWARD R. ROYCE, California GARY L. ACKERMAN, New York
FRANK D. LUCAS, Oklahoma KEN BENTSEN, Texas
ROBERT W. NEY, Ohio JAMES H. MALONEY, Connecticut
BOB BARR, Georgia DARLENE HOOLEY, Oregon
SUE W. KELLY, New York JULIA CARSON, Indiana
RON PAUL, Texas BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio MAX SANDLIN, Texas
CHRISTOPHER COX, California GREGORY W. MEEKS, New York
DAVE WELDON, Florida BARBARA LEE, California
JIM RYUN, Kansas FRANK MASCARA, Pennsylvania
BOB RILEY, Alabama JAY INSLEE, Washington
STEVEN C. LaTOURETTE, Ohio JANICE D. SCHAKOWSKY, Illinois
DONALD A. MANZULLO, Illinois DENNIS MOORE, Kansas
WALTER B. JONES, North Carolina CHARLES A. GONZALEZ, Texas
DOUG OSE, California STEPHANIE TUBBS JONES, Ohio
JUDY BIGGERT, Illinois MICHAEL E. CAPUANO, Massachusetts
MARK GREEN, Wisconsin HAROLD E. FORD, Jr., Tennessee
PATRICK J. TOOMEY, Pennsylvania RUBEN HINOJOSA, Texas
CHRISTOPHER SHAYS, Connecticut KEN LUCAS, Kentucky
JOHN B. SHADEGG, Arizona RONNIE SHOWS, Mississippi
VITO FOSELLA, New York JOSEPH CROWLEY, New York
GARY G. MILLER, California WILLIAM LACY CLAY, Missiouri
ERIC CANTOR, Virginia STEVE ISRAEL, New York
FELIX J. GRUCCI, Jr., New York MIKE ROSS, Arizona
MELISSA A. HART, Pennsylvania
SHELLEY MOORE CAPITO, West Virginia BERNARD SANDERS, Vermont
MIKE FERGUSON, New Jersey
MIKE ROGERS, Michigan
PATRICK J. TIBERI, Ohio
Terry Haines, Chief Counsel and Staff Director
Subcommittee on Capital Markets, Insurance, and
Government Sponsored Enterprises
RICHARD H. BAKER, Louisiana, Chairman
ROBERT W. NEY, Ohio, Vice Chairman PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut GARY L. ACKERMAN, New York
CHRISTOPHER COX, California NYDIA M. VELAZQUEZ, New York
PAUL E. GILLMOR, Ohio KEN BENTSEN, Texas
RON PAUL, Texas MAX SANDLIN, Texas
SPENCER BACHUS, Alabama JAMES H. MALONEY, Connecticut
MICHAEL N. CASTLE, Delaware DARLENE HOOLEY, Oregon
EDWARD R. ROYCE, California FRANK MASCARA, Pennsylvania
FRANK D. LUCAS, Oklahoma STEPHANIE TUBBS JONES, Ohio
BOB BARR, Georgia MICHAEL E. CAPUANO, Massachusetts
WALTER B. JONES, North Carolina BRAD SHERMAN, California
STEVEN C. LaTOURETTE, Ohio GREGORY W. MEEKS, New York
JOHN B. SHADEGG, Arizona JAY INSLEE, Washington
DAVE WELDON, Florida DENNIS MOORE, Kansas
JIM RYUN, Kansas CHARLES A. GONZALEZ, Texas
BOB RILEY, Alabama HAROLD E. FORD, Jr., Tennessee
VITO FOSSELLA, New York RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois KEN LUCAS, Kentucky
GARY G. MILLER, California RONNIE SHOWS, Mississippi
DOUG OSE, California JOSEPH CROWLEY, New York
PATRICK J. TOOMEY, Pennsylvania STEVE ISRAEL, New York
MIKE FERGUSON, New Jersey MIKE ROSS, Arizona
MELISSA A. HART, Pennsylvania
MIKE ROGERS, Michigan
C O N T E N T S
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Page
Hearing held on:
June 14, 2001................................................ 1
July 31, 2001................................................ 63
Appendix:
June 14, 2001................................................ 115
July 31, 2001................................................ 208
WITNESSES
Thursday, June 14, 2001
Bowman, Thomas A., CFA President and CEO, The Association for
Investment Management and Research............................. 51
Cleland, Scott C., Chairman and CEO, The Precursor Group......... 49
Cole, Benjamin M., financial journalist and author, ``The Pied
Pipers of Wall Street: How Analysts Sell You Down the River''.. 47
Glassman, James K., Resident Fellow, American Enterprise
Institute, Host, www.TechCentral.com........................... 15
Hymowitz, Gregg S., founding partner, EnTrust Capital............ 12
Lackritz, Marc E., President, Securities Industry Association.... 18
Silvers, Damon A., Associate General Counsel, AFL-CIO............ 53
Tice, David W., Portfolio Manager, Prudent Bear Fund, publisher
of the institutional research service ``Behind the Numbers''... 10
APPENDIX
Prepared statements:
Baker, Hon. Richard H........................................ 116
Oxley, Hon. Michael G........................................ 126
Jones, Hon. Stephanie T...................................... 118
Kanjorski, Hon. Paul......................................... 120
LaFalce, Hon. John J......................................... 122
Ney, Hon. Bob................................................ 124
Bowman, Thomas A............................................. 195
Cleland, Scott C............................................. 184
Cole, Benjamin M............................................. 181
Glassman, James K............................................ 166
Hymowitz, Gregg S............................................ 160
Lackritz, Marc E............................................. 172
Silvers, Damon A............................................. 199
Tice, David W................................................ 128
WITNESSES
Tuesday, July 31, 2001
Page
Byron, Christopher, syndicated radio commentator, columnist,
MSNBC.com...................................................... 90
Glantz, Ronald, former Managing Director, Tiger Management,
former Director of Research and Chief Investment Officer, Paine
Webber......................................................... 87
Hill, Charles, Director of Research, Thomson Financial-First Call 95
Kianpoor, Kei, CEO, Investars.com................................ 100
Lashinsky, Adam, Silicon Valley columnist, The Street.com........ 102
Unger, Hon. Laura S., Acting Chairman, U.S. Securities and
Exchange Commission............................................ 70
Winkler, Matt, Editor-in-Chief, Bloomberg News................... 98
APPENDIX
Prepared statements:
Baker, Hon. Richard H........................................ 209
Oxley, Hon. Michael G........................................ 225
Castle, Hon. Michael N....................................... 211
Hinojosa, Hon. Ruben......................................... 214
Israel, Hon. Steve........................................... 215
Kanjorski, Hon. Paul......................................... 217
LaFalce, Hon. John J......................................... 219
Byron, Christopher........................................... 245
Glantz, Ronald............................................... 241
Hill, Charles L.............................................. 248
Kianpoor, Kei................................................ 261
Lashinsky, Adam.............................................. 266
Unger, Hon. Laura S.......................................... 227
Winkler, Matt................................................ 253
Additional Material Provided for the Record
LaFalce, Hon. John J.:
Letters to Securities and Exchange Commission's Acting
Chairman, Laura S. Unger, July 5, 2001, July 30, 2001...... 221
ANALYZING THE ANALYSTS
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THURSDAY, JUNE 14, 2001
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance,
and Government Sponsored Enterprises,
Committee on Financial Services,
Washington, DC.
The subcommittee met, pursuant to call, at 10:00 a.m., in
room 2128, Rayburn House Office Building, Hon. Richard H.
Baker, [chairman of the subcommittee], presiding.
Present: Chairman Baker; Representatives Oxley, Ney, Shays,
Paul, Castle, Royce, Barr, Weldon, Biggert, Miller, Ose, Hart,
Kanjorski, Bentsen, J. Maloney of Connecticut, Hooley, Mascara,
Jones, LaFalce, Capuano, Sherman, Inslee, Moore, Hinojosa,
Lucas, Shows, Israel and Ross.
Chairman Baker. I would like to call this hearing of the
Capital Markets Subcommittee to order. We're starting promptly
on time this morning. We like to have the ability to start
trading as soon as the opening bell rings around here.
First, by prior agreement with Mr. LaFalce and Mr.
Kanjorski, opening statements today will be limited to Chairman
Oxley, myself, Ranking Member LaFalce, and Mr. Kanjorski, who
is on his way, to expedite the proceedings of the hearing this
morning.
All other Members' statements will be incorporated into the
record.
I am appreciative for the courtesies extended by Mr.
Kanjorski and Mr. LaFalce in facilitating this meeting this
morning.
As we all know, this is an issue of some importance and
volatility. There was a question on a recent magazine cover
that struck me as particularly appropriate: ``Can We Ever Trust
Wall Street Again?''
The simple answer to that question is, we must. That is, we
must find a way. It's simply not a choice. America's
prosperity, as always, is intrinsically bound to the influx of
capital investment that fuels business expansion, job growth
and technology.
To the extent that American consumers have been temporarily
shaken by the recent market downturn, our first goal today here
is to begin a process of rebuilding that confidence, not only
to reaffirm American consumers' faith in the fairness of the
market, but actually to have their trust.
Clearly, I am a pro-market conservative legislator and I am
going to be one of the last on the subcommittee, I think, to
suggest Federal intervention to solve every problem.
However, the foundation of the free market system is based
on the free flow of information which is straightforward and
unbiased. I believe this subcommittee has a very high
responsibility to safeguard this principle.
I am deeply troubled by the evidence of the apparent
erosion by Wall Street of the bedrock of ethical conduct.
It's a new and continually changing marketplace. Since
1995, on-line trading has resulted in enormous growth of
investment by working families, some 800,000 trades a day, I am
told, with a typical demographic profile of a $60,000 annual
income with net worth less than 50.
These individual investors rely on and believe what they
think is objective, professional advice from sophisticated
analysts.
There's a message here. These investors are the future of
the dynamic growth of the market place. They deserve fair
treatment not only for their best interests, but for the growth
of the market.
Folks who work hard to pay the house money, pay their
taxes, and the grocery bill don't have luxury to be able to
speculatively gamble. Over the last few years, Wall Street's
insiders have whispered knowingly about a grade inflation, as
it's called, resulting in what I think is a very coded language
in analysts' recommendations.
A goal of this hearing is to begin speaking openly about
what has apparently been unspoken in the past. I'm amazed. I'm
the chairman of the Capital Market Subcommittee in the United
States Congress. I learned this yesterday. Strong buy does not
mean buy, but actually out-perform.
It really makes you wonder what out-perform or accumulate
must mean. I am concerned not only about the potential for
significant losses by the unwary and misinformed individual
investor, but the possibility of overall market volatility that
results when a more rational view does return.
Today, we are going to inquire into disturbing media and
academic reports about pervasive conflicts of interest, which
appear to be compromising the integrity of current market
practice.
In fact, I want to enter into the record at this time, a
study from the Harvard and Wharton Business School study
entitled ``The Relationship Between Analysts' Forecasts of
Long-Term Earnings Growth and Stock Price Performance Following
Equity Offerings.''
I want to quote from that report one paragraph: ``Our
evidence suggests that the coexistence of brokerage services
and underwriting services in the same institution leads sell-
side analysts to compromise their responsibility to brokerage
clients in order to attract underwriting business. Investment
banks claim to have Chinese walls to prevent such a conflict.
Our evidence raises questions about the reliability of the
Chinese walls. We document that analysts officiated with the
lead underwriter of an offering tend to issue more overly
optimistic growth forecasts than unaffiliated analysts.
Furthermore, the magnitude of the affiliated analysts' growth
forecasts is positively related to the fee basis paid to the
lead underwriter. Finally, equity offerings covered only by
affiliated analysts experience the greatest post-offering under
performance, suggesting that these offerings are the most over-
priced.''
I have to say this in my own words, as I basically
understand it. Maybe there hasn't been a complete erosion in
the Chinese walls that traditionally shield analysts from
investment banking interests. But I have to say that I believe
there are some folks out there manufacturing a lot of Chinese
ladders for people to climb back and forth over those walls as
they deem appropriate.
A market bubble that bursts is the time when people look
for someone to blame. I believe it rather should be an
opportunity for all concerned in the activity to step back,
take a deep breath, and reexamine their own accountability to
make sure it doesn't happen again, and all parties have some
shared responsibility.
Today, we focus on the analysts' conflicts. At some point,
we will take a look at the investment banks and the
institutional investors.
And I must say a word about the financial press. They have
much greater impact than many have given them their allocation
for. It is irresponsible reporting to quote unquestioningly
irresponsible analysts' reports and put them on the cover of
magazines and make them into rock stars.
There is some examination due in this area as well.
Consequently, while I appreciate the effort of the Securities
Industry Association with their best practices proposal, put
forward only 2 days ago, I am not yet convinced we have a
remedy to our problem.
I take the very drafting of them as a positive sign that
the industry accepts that problems may exist and I am naturally
going to take a very careful look at any document that, on its
face, has a disclaimer, which I'm paraphrasing here,
respectfully, we're going to do our best to be honest and
straightforward unless of course circumstances dictate we must
do something different.
Today is not the end of our discussion, but the beginning.
In the next few months, we will access recommendations,
converse with regulators and, at the end of the process, the
subcommittee, I hope, will come to a bipartisan agreement as to
the best practices standard. Make the recommendations to
regulators, and only if necessary, in my view, propose
legislation, particularly for the sake of the growing number of
$200 investors who are out there this morning on the job,
working trying to make the next dollar.
It is far more important to do this very carefully,
thoroughly, rather than do it quickly. Therefore, this hearing
this morning marks the beginning.
It is my intention to have several hearings over the coming
months. At the suggestion of many, we will hear from
regulators, we will hear from academicians, we will hear from
all those concerned who have a financial interest in seeing
trust become the bedrock of our financial marketplace again.
[The prepared statement of Hon. Richard Baker can be found
on page 116 in the appendix.]
Mr. Kanjorski.
Mr. Kanjorski. Thank you very much, Mr. Chairman.
We meet today to consider the issue of analyst
independence, a subject of great significance to our nation's
vibrant capital markets. I congratulate you on your diligence
in convening this very important and well-timed hearing.
I would make, at this point, two observations, however, Mr.
Chairman. As I walked down the hall, it is the first time in my
memory that the line is down to the corner and around the
corner, and down the other hallway. It reminds me that when I
was a little boy, I read the 50 years of the New Yorker cartoon
book, which asked a very pungent question: Where are the
investors' yachts? I think today's crowd brings that cartoon
back into play. Maybe that is why we are meeting here.
The second observation is one of internal process. I do
want to register my great disappointment with the House
leadership in convening a very important bill involving SEC
revenues that is on the floor today at the precise moment we
are having this hearing. As you know, Mr. Chairman, several of
us on this side of the aisle are opposed to the passage of the
bill in its present form, and intended to argue that position
on the floor today, as well as offer amendments in accordance
therewith. And, as a result of the importance of this hearing,
and the conflict with that bill on the floor, we are really put
in an impossible situation either to miss our opportunity here
and the intelligence we can gather, or to have a bill go
through without comment. I hope this scheduling was not
intentional, and I hope it never happens again.
With that said, it is a well-timed hearing. I am not
attempting to be facetious when I say that. Over the last
several years, the perceived immortality of the U.S. economy
and the emergence of the Internet have contributed to
extraordinary interest and growth in our capital markets.
Investors' enhanced access to financial reporting and their
new-found ability to trade electronically also helped to fuel
this dynamic expansion. Unlike some other sources of investment
advice, the vast majority of the general public has usually
considered the research prepared by Wall Street experts as
reliable and valuable. With the burst of the high tech bubble,
however, came rising skepticism among investors concerning the
objectivity of some analysts' overly optimistic
recommendations. Many in the media have also asserted that a
variety of conflicts of interest may have gradually depreciated
analysts' independence during the Internet craze and affected
the quality of their opinions.
We have debated the issues surrounding analysts'
independence for many years. After the deregulation of trading
commissions in 1975, Wall Street firms began using investment
banking as a means to compensate their research departments,
and within the last few years the tying of analysts'
compensation to investment banking activities has become
increasingly popular.
As competition among brokerage firms for IPOs, mergers and
acquisitions grew, so did the potential for large compensation
packages for sell-side analysts. These pay practices, however,
may have also affected analyst independence.
While some brokerage houses suggest that they have erected
an impenetrable Chinese wall, which you mentioned, that divides
analyst research from other firm functions like investment
banking and trading, the truth, as we have learned from many
recent news stories, is that they must initiate a proactive
effort to rebuild their imaginary walls.
The release of some startling statistics has also called
into question the actual independence of analysts. A report by
First Call, for example, found that less than one percent of
28,000 recommendations issued by brokerage analysts during late
1999 and most of 2000 called for investors to sell stocks in
their portfolio. Within the same timeframe, the NASDAQ
composite average fell dramatically. In hindsight, these
recommendations appear dubious. Furthermore, First Call has
determined that the ratio of buy-to-sell recommendations by
brokerage analysts rose from 6-to-1 in the early 1990s, to 100-
to-1 in 2000.
Many parties have consequently suggested that analysts may
have become merely cheerleaders for the investment banking
division of their brokerage houses. I agree. To me, it appears
that we may have obsequious analysts instead of objective
analysts.
Today's hearing will help us better understand the nature
of this growing problem and discover what actions might restore
the public's trust and investors' confidence in analysts. Like
you, Mr. Chairman, I generally favor industry solving its own
problems through the use of self-regulation whenever possible.
But in this instance, the press, regulators, law enforcement
agencies, and spurned investors have also begun their own
examinations into these matters. I suspect that these parties
may demand even greater reforms than those recently proposed by
the Securities Industry Association, including the need for
full and robust disclosure of any and all conflicts of
interest. To address these concerns, the industry may
eventually need to come forward with a way to audit and enforce
the best practices it now proposes. If not, others may seek to
impose their own solutions to resolve this problem.
We will hear today from eight distinguished witnesses
representing a variety of viewpoints. I am, Mr. Chairman,
particularly pleased that you invited a representative from the
AFL-CIO to join in our discussions. I would have also liked to
learn from the concerns of SEC and NASD, among others.
I was, however, heartened to learn yesterday that you plan
to hold additional hearings on this issue in the upcoming
months with the concerned parties.
As we determined last year during our lengthy deliberations
over Government sponsored enterprises, a roundtable discussion
is often the most appropriate forum for us to deliberate over
complex issues. In the future, I urge you to convene a
roundtable over the matters related to analyst independence. A
roundtable discussion would force the participants to challenge
each other's assumptions and assertions in an open environment.
It would also provide us with greater insights than testimony
that has been scrutinized and sterilized through the clearance
process. A roundtable debate would further allow us to more
fully educate our Members about the substantive issues involved
in this debate.
In closing, Mr. Chairman, let me caution all Members of
this subcommittee, and particularly Members on my side. This is
an issue that evidently is somewhat sexy and popular just by
evidence of the amount of television here today. To people in
public office and, quote: ``politicians,'' it may be a great
temptation to be a demagogue.
I join you in urging our fellow Members and others in our
society to hold back their fire and their conclusions. We have
the most successful financial and capital markets in the world.
Because we are in some difficulty economically in the
markets, this is not the time to grab a club and take personal
advantage by playing the role of lead demagogue. We cannot
afford that, and the American economy cannot afford that.
So I look forward to hearing the testimony today. I think
that over the next several months, if we use more open fora, we
may be able to find a solution to a problem that is self-
regulation by the Association and the industry itself. I would
join you in that effort and hopefully, that is the best
conclusion that we could reach.
Thank you, Mr. Chairman.
[The prepared statement of Hon. Paul Kanjorski can be found
on page 120 in the appendix.]
Chairman Baker. Thank you, Mr. Kanjorski.
Just by way of assurance, the subcommittee's hearing date
was established some time ago without knowledge of the floor
consideration. Your point concerning the fee reduction bill on
the floor today and the subcommittee hearing simultaneously is
a matter of concern, but I assure you it was not an intentioned
effort to create difficulty.
I happen to have some interest in the opposite side on that
matter, and would like to be there to watch you on the floor
very carefully.
Mr. Oxley. Thank you, Mr. Chairman. Let me commend you for
holding this hearing.
One of my goals, as the Chairman of this new Committee, is
to help investors by improving the way they get information on
which they base their investment decisions. Due in large part
to the advances in technology that have brought to us the
Internet, we've become not only a Nation of investors, but a
Nation of self-taught investors.
No longer do investors have to rely on the information they
obtain from their broker to make their investment decisions.
Today, there is a veritable smorgasbord of information about
the marketplace available to the public through financial
websites, print publications, television, and virtually every
media outlet.
There is a wealth of data available to investors. I
launched this subcommittee's inquiries into improving the way
stock market quotes are collected and disseminated into the
impact of Regulation FD with an eye toward assuring that
investors have broad access to the highest quality information
about the marketplace.
Today's hearing continues our work toward that goal. I
commend you, Mr. Chairman, for your work on each of these
issues and for holding this important hearing today. I heartily
agree with the Supreme Court's characterization in the Dirks
case of the importance of analysts to investors to the
marketplace.
And I quote: ``The value to the entire market of analysts'
efforts cannot be gainsaid. Market initiatives are
significantly enhanced by their efforts to carry it out and
analyze information. Thus the analysts' work rebounds to the
benefit of all investors.''
Yet the important work of analysts is not to the
marketplace or investors any good at all, if it is compromised
by conflicts of interest. There has been a great deal of
concern raised by the media by regulators and by market
participants about the perception that analysts are not in fact
providing the independent, unbiased research that investors and
the marketplace rely on.
We are here today to learn whether the Chinese wall that is
long cited as the separation between the research and
investment banking arms of securities firms has developed a
crack or is completely crumbling.
I am encouraged that Wall Street has recognized that this
is not a phantom problem, and has proposed industry best
practices guidelines to address these conflicts about which we
will hear today.
But I must emphasize that if that Chinese wall is in need
of repair, wallpaper will not suffice.
While I am a strong proponent of free market solutions, I
and the subcommittee plan to examine these industry guidelines
very closely to ensure that they are tough, they are fair, and
they are effective.
I am distressed by the statistics that as the markets were
crashing last year, less than two percent of analysts'
recommendations were on the sell-side.
It is no wonder there is public outcry about analysts'
independence when the statistics are so stark. But it seems to
me that the problem is not simply biased analysts. The firms
that employ these analysts tie their compensation to the
analysts' success in bringing in investment banking business.
Then the firms are undermining the independence of their
own employees' recommendations.
Similarly, companies that pressure analysts through either
the carrot on the stick or of increased or decreased investment
banking business in turn for favorable reports exacerbates the
problem.
Likewise, institutional investors also exert pressure on
analysts to issue rosy reports about the stocks those
institutional investors hold in their own portfolios.
We intend to examine every angle of this issue in order to
best determine how to resolve it. Our subcommittee's goal here
is to improve industry practices and I call on the industry to
eliminate the conflicts of interest created by compensation
structures and insufficient separation of investment banking
and research, and I call on them also to provide meaningful and
understandable disclosure to investors that will enable
investors to evaluate, for themselves, what weight they should
give the recommendations of any particular analyst.
Mr. Chairman, this hearing is this subcommittee's first
step in a long-term effort to ensure that the Nation's
investors have the best possible information about the stocks
in which they invest. Ensuring that investors could rely on the
expertise of analysts, without any doubt as to their integrity
or independence, could not be more fundamental to that effort.
I yield back the balance of my time.
[The prepared statement of Hon. Michael G. Oxley can be
found on page 126 in the appendix.]
Chairman Baker. Thank you, Mr. Chairman. I certainly
appreciate your leadership on this issue as well.
Mr. LaFalce.
Mr. LaFalce. Thank you very much, Chairman Baker.
Today, our subcommittee confronts the very important
question of whether investors are receiving unbiased research
from Wall Street securities analysts.
I don't think they are, and I commend the Chairman for
holding these hearings. I'm very concerned that investors have
become victims of recommendations of analysts who have apparent
and direct conflicts of interest relating to their investment
advice.
So I think this morning's hearing is extremely important.
It is anomalous that as our subcommittee considers this
extremely important hearing, the bill that was reported out of
our subcommittee is on the floor of the House of
Representatives either now or in a matter of moments, reducing
the fees of the SEC by approximately $14 billion over the next
10 years, without regard to the capacity of the SEC to
effectively enforce the laws and regulations responsible for
investor independence and objectivity, responsible for
accounting independence and objectivity, responsible for so
many of the other problems which are probably just the tip of
the iceberg of problems existing for investors in this multi-
trillion marketplace that the individual citizen is
participating in today in the United States in a manner
unparalleled in American history.
That's very regrettable, but in any event, I'm glad for the
hearing. It's clear that sell-side analysts work for firms that
have business relationships with the companies they follow.
Most analysts are under increased pressure to look for and
attract business and to help the firm keep the business it has.
The analyst is asked to be both banker and stock counselor
and these two goals often live in conflict. The individual
investor is often unaware of the various economic and strategic
interests that the investment bank and the analysts have that
can fundamentally undermine the integrity and quality of
analysts' research.
The disclosure of these conflicts is often general,
inconspicuous, boiler plate, meaningless. In addition, current
conflict disclosure rules do not even reach analysts touting
various stocks.
For example, on CNBC or CNN, as former Chairman of the SEC,
Arthur Levitt noted, I wonder how many investors realize the
professional and financial pressures many analysts face to
dispense recommendations that are more in a company's interest
rather than the public's interest.
I believe it is precisely these pressures that moved many
analysts, during the technology boom over the last several
years, to recommend companies and assign valuations beyond any
relationship to company fundamentals.
In a recent article, a very well-known technology analyst
was quoted as responding to questions concerning the legitimacy
of the valuation of a particular company, and the analyst said,
we have one general response to the word ``valuation'' these
days. Bull market. We believe we have entered a new valuation
zone.
The article to which I refer, and many, many, many others
like it, make the case that these conflicts may have profoundly
undermined analysts' integrity and possibly misled investors. I
think possibly should be almost certainly misled investors as
analysts held fast to companies, as the market eroded out from
under them.
The Securities Industry has suggested new guidelines to
address some of the conflicts we will discuss in today's
hearing. Their initiative is an important first step. I do not
believe, however, that these voluntary guidelines go far enough
to address the problem.
I am pleased therefore that today's hearing will begin a
process whereby our subcommittee and the regulators can begin
to take a hard look at these troubling questions affecting the
American investing public.
I look forward to the hearings where the SEC and the NASD,
amongst others, where academic analysts, where investors,
attorneys, and others can testify on the question of analyst
objectivity.
In my view, the Securities regulators' perspective is
especially critical. We cannot fulfill our oversight
responsibility if the Government and quasi-government entities,
charged by Congress with the protection of investors, have not
been heard.
Not only do the Securities regulators have an important
perspective on the magnitude of the problem, they also have a
view on how the industry is complying with current regulations
on information barriers, so-called Chinese walls and the
disclosure of conflicts.
In sum, I am increasingly concerned that industry self-
regulation may not be sufficient to guard against the problems
and abuses we are seeing, and that more disclosure of these
conflicts, in itself, may not suffice to protect the individual
investor.
So I hope today's hearing is only the first step in
confronting these very troubling issues of securities analysts
conflicts of interest that mean trillions of dollars to people
in neighborhoods across America.
I thank you.
[The prepared statement of Hon. John J. LaFalce can be
found on page 122 in the appendix.]
Chairman Baker. Thank you, Mr. LaFalce.
By prior agreement, we had hoped to limit opening
statements to the Members previously recognized, and I intend
to do so, but I have been requested by Ms. Jones to be
recognized for 30 seconds to explain her necessity for
departing from the hearing this morning.
Ms. Jones.
Mr. Jones. Mr. Chairman, Mr. Ranking Member, Colleagues, I
appreciate the opportunity to submit my statement for the
record.
This morning, the National Institutes of Health will be
naming a building after the Honorable Congressman Louis Stokes,
my predecessor. I must go out there and congratulate them.
Thank you very much. I submit my statement for the record.
[The prepared statement of Hon. Stephanie T. Jones can be
found on page 118 in the appendix.]
Chairman Baker. Thank you very much, Ms. Jones.
At this time, I would like to proceed with the introduction
of our panelists.
Our first to participate this morning, we welcome, is Mr.
David Tice, Portfolio Manager, the Prudent Bear Fund, and
publisher of the institutional research service known as
``Behind the Numbers.''
Welcome, Mr. Tice.
For the record, all witness statements will be made part of
the record. Please feel free to summarize. We will have a
number of questions for the panel during the course of the
morning, and we would like to maximize that time as best we
can.
Please proceed, sir.
STATEMENT OF DAVID W. TICE, PORTFOLIO MANAGER, PRUDENT BEAR
FUND, AND PUBLISHER OF THE INSTITUTIONAL RESEARCH SERVICE
``BEHIND THE NUMBERS''
Mr. Tice. Thank you very much, Mr. Chairman. David W. Tice
& Associates operates two different businesses. We publish
``Behind the Numbers,'' an institutional research service, and
serve as investment advisor to two mutual funds.
I started ``Behind the Numbers'' in 1988 because I realized
institutional investors did not receive independent, unbiased
research from their traditional brokerage firms, which almost
never issued sell recommendations.
To our knowledge, there are now fewer than six other
significant firms that concentrate on only sell
recommendations.
We like to call ourselves ``The Truth Squad'' with regard
to individual Wall Street recommendations. The truth is, this
lack of analyst independence has been great for our business.
Currently, more than 250 institutional investors purchase our
service. Our 15 largest clients manage more than $2.3 trillion.
David W. Tice & Associates, Inc., is a modest-sized
organization of 17 professionals, yet every 2 weeks we butt
heads with the best and brightest from Wall Street's biggest
firms with our assessment of company fundamentals.
Of nearly 900 sell recommendations issued between 1988 and
2001, 67 percent have under performed the market with about
half declining in price in the biggest bull market in this
century.
Usually our analysis makes our research clients
uncomfortable as well as potential mutual fund shareholders
because it differs from the Wall Street consensus.
However, our research has earned respect because of its
quality and because people realize that our conclusions are
free of the biases that affect traditional Wall Street
research.
Our job is not to be pessimistic or optimistic, but to be
realistic and to help protect clients' capital. In this spirit,
and with the benefit of our insight into hundreds of U.S.
companies that we analyze, the U.S. stock market and economy,
we concluded that we had a bubble stock market and a bubble
economy.
So we organized the ``Prudent Bear Fund'' in 1996, the same
year that Alan Greenspan made his famous ``irrational
exuberance'' speech.
We believe the individual investor should be warned and
should have access to a vehicle to hedge himself in a market
decline. Some will question our objectivity since we manage
this bear's fund, and say that I'm just talking ``my book.''
But I believe passionately in every word of my testimony,
and it's all based on fact, rigorous analysis, and solid macro-
economic theory.
There is no question, Mr. Chairman, that Wall Street's
research is riddled with structural conflicts of interest.
Compounding this problem, according to a recent study, those
who closely follow Wall Street's stock recommendations have
suffered abysmal investment performance as this study showed
that from 1997 through May 2001, only 4 out of 19 major Wall
Street firms would have generated positive returns over the
4\1/2\ year period in the biggest bull market in this century.
In our testimony, we've provided many examples of
conflicts. Generally, our perception of this situation today
coincides with the Chief Investment Officer of Asset Allocation
of a multi-billion dollar asset manager who said, and I quote:
``Research analysts have become either touts for their firm's
corporate finance departments or the distribution system for
the party line of the companies they follow. The customer who
follows the analysts' advice is paying the price.''
Today, the power structure of most Wall Street firms is
simply concentrated too much in investment banking; and even
with the supposed Chinese walls, there are still multiple cases
of analysts reporting to investment bankers.
This is an outrage. This conspicuous lack of objectivity in
research is indicative of what we see as a general lack of
responsibility on Wall Street today, one that's having a
corrosive effect on the marketplace.
The main emphasis of our testimony has addressed the
consequences that arise when capital markets lack integrity,
stemming largely from this lack of objectivity. This problem is
much larger, Mr. Chairman, than whether or not individual
investors are disadvantaged or have suffered losses, or if
analysts receive over-sized bonuses.
What's at stake we believe is that a sound and fair
marketplace is at the very foundation of capitalism. It is the
functioning of the market pricing mechanism that determines
which businesses and industries are allocated precious
resources, and it is this very allocation process that's the
critical determining factor for the long-term economic well
being of our nation.
When the marketplace regresses to little more than a
casino, the pricing mechanism falters and the allocation
process becomes dysfunctional. When the marketplace's reward
system so favors the aggressive financier and the speculator
over the prudent businessman and investor, the consequences
will be self-reinforcing booms and busts, a hopeless
misallocation of resources, and an unbalanced economy.
We believe that in an environment of more independent
analysis, it would have led to a more efficient capital
allocation where we would have financed fewer internet
companies less fiber optic bandwidth, and instead perhaps built
more refineries in California power plants.
When credit is made readily available to the speculating
community, failure to rein in the developing speculation risks
ponzi-type investment schemes. Such an environment will also
foster a redistribution of wealth from the unsuspecting to
those most skilled in speculation.
Such an environment creates dangerous instability, what we
refer to as financial and economic fragility.
The financial sector is creating enormous amounts of new
debt that's often being poorly spent. Sophisticated Wall
Street, with its reckless use of leverage, proliferation of
derivatives, and sophisticated instruments, is funding loans
that should not be made.
While such extraordinary availability of credit certainly
does foster an economic boom, it must be recognized that
history provides numerous examples of the precariousness of
booms built on aggressive credit growth that are unsustainable
and dangerous.
Goldman Sachs' Abby Joseph Cohen has used the phrase ``U.S.
Supertanker Economy,'' but the problem is Wall Street has
created a ship that has run terribly off course. Wall Street's
lack of independence has fostered this misdirection and
camouflaged the fact that our U.S. economy is in danger because
of our capital misallocation and credit excess.
This may sound ridiculous to most of you with nearly
uniform optimism among traditional economists. But if you doubt
me, I'll quote ex-Fed Chairman Paul Volker, who more than 2
years ago said, quote: ``The fate of the world economy is now
totally dependent upon the U.S. economy, which is dependent
upon the stock market whose growth is dependent on about 50
stocks, half of which have never reported any earnings.''
If I could go to our potential solutions. We do not pretend
to be experts in the area of Securities Law and Regulation. We
have presented a list of nine solutions in the spirit of
general directions to take, not specific laws to change.
Not included in our list of solutions are proposals that
try to tinker with analysts' compensation schemes or require
some type of peer review. We believe the problems are so
significant and so critically important, bold solutions, not
incremental change, are required.
Tremendous political courage will be needed to effect
change in this area. Those who have benefited from the current
broken system have enormous financial resources.
The raw political power of those who favor the current
system cannot be underestimated.
The voice of those favoring change will be faint, but well
worth listening to. However, we must remember that trust in our
institutions is the cornerstone of a vibrant capitalist
society, and lies at the heart of a healthy democracy.
Chairman Baker. Can you begin to wind it up, sir?
Mr. Tice. Yes. We commend the subcommittee and Chairman for
tackling such a difficult and timely issues. The stakes are
enormous.
Thank you for the honor of appearing before this
subcommittee.
[The prepared statement of David Tice can be found on page
128 in the appendix.]
Chairman Baker. Thank you, Mr. Tice. I appreciate your
courtesy, sir.
Our next witness to appear is Mr. Gregg Hymowitz, founding
partner, EnTrust Capital.
Welcome, sir.
STATEMENT OF GREGG S. HYMOWITZ, FOUNDING PARTNER, EnTRUST
CAPITAL
Mr. Hymowitz. Mr. Chairman Baker, esteemed Members of the
subcommittee, I'm Gregg Hymowitz, a founding partner in EnTrust
Capital. It's a pleasure to share with you this morning my
summarized thoughts and observation.
My comments today represent solely my personal views and
not necessarily the views of EnTrust Capital.
Is there a conflict of interest among sell-side analysts
and the companies they cover? In my opinion, the answer is yes.
But the relationship between analyst, issuer, and the
investing public is a complex network of checks and balances.
Typically, the analyst works for an investment bank whose
bankers are attempting to move business from the issuer, often
in the form of a capital market transaction. Therefore, most
analysts recognize it does not behoove their firm's self-
interest to have a negative view on the issuer.
Additionally, most analysts's compensation at investment
banks has historically been partially determined by the amount
of high margin capital market transaction revenues for which
each analyst was responsible.
The communication between analyst and issuers is symbiotic.
The issuer needs the analyst's coverage to get potential
investors interested in buying, and the analyst's life blood is
an open communication channel to the issuer.
One can surmise that communication is easier and more open
between parties when they are aligned. The pressures and
conflicts on the sell-side analysts during the recent equity
bubble were exaggerated by the compressed period of time the
capital markets were accommodative.
Investment banks, due to the demand from the investing
public, and the supply created by venture capitalists, took
hundreds of companies public that, in historical terms, would
never have made it out the door.
The need for new valuation metrics became apparent. Free
cash flow and earnings metrics were replaced with multiples of
sales, developers, and my favorite, web hits.
Now while many of these metrics have turned out to be just
plain silly and will continue to remain just plain silly, we
need to remember 20 years ago, a now widely recognized metric
called EBITDA was created to analyze certain profitless
companies.
Investment banks have been recommending stocks to their
clients roughly since the 1792 Buttonwood Agreement.
Historically, however, the Morning Call was the province of the
institutional money manager, who understood where this
information was coming from and was able to evaluate its
relative importance.
With the rise of the Internet, Wall Street calls are
everywhere, rich with a frenzy day trading analyst calls took
on exaggerated importance. Often the trading public seized upon
these calls and stocks would move significantly. Remember,
there was little or no public uproar over analysts' rosy
coverage in 1999, when many investors were making in the market
hand-over-fist.
For years, the institutional money manager understood from
where the sell-side research held, and as it became more
dispersed, the individual investor has now caught on.
In this age of information overload, the individual has the
responsibility to perform his or her own due diligence. For
decades now, the institutional investor has been ranking equity
analysts, and today there are dozens and dozens of free
websites, which rank analysts.
These resources are doing an excellent job of informing
those investors who are willing to invest the time on doing due
diligence, and which analysts to follow.
But for the individual who merely sees the stock market as
a craps table, without doing any of his or her own research on
either the issuer or the analyst, does so at one's own peril.
One idea that may coerce analysts to be more thoughtful in
their recommendation is for investment banks to actually urge
analysts to own the stocks they suggest, with proper internal
safeguards to prevent such things as front running in addition
to appropriate disclosure, analysts actually owning the stocks
they recommend actually may help ameliorate the biases that
exist.
The old Wall Street adage to analysts is, don't tell me
what you like, tell me what you own. Many individuals want to
find a causal relationship between the market's crash and the
lack of sell recommendations among sell-side analysts.
I believe no causal relationship exists. While there have
been many buy ratings on the steel, food, and retail stocks,
with little if any sell recommendations, they did not
experience the meteoric rise many tech stocks had over the past
couple of years, incorrectly many believe that there are few
sell recommendations on Wall Street.
There are, however, numerous firms, including Mr. Tice's,
that specialize in providing only sell recommendations.
Unfortunately, much of this research is not widely circulated
to the individual investor because, quite frankly, it is very
costly. There are also many countervailing pressures on
analysts that work toward providing a balanced view, first and
foremost. On Wall Street, reputation and record mean
everything.
The analysts over time who are the most thoughtful,
responsible and correct earn the respect of the investment
community. This institutional pressure for analysts to be
correct is the largest force compelling unbiased work.
Another clear way of holding analysts accountable is for
the investment bank to publish each analyst's performance
record. This will provide more information to the investors and
aid those who are superior stock pickers.
Investment bankers should improve the materiality of
disclosure statements. It is more important from a potential
conflict standpoint to know if the bank is currently engaged by
the issuer or is pitching the firm new business, rather than
the typical historical disclosures.
The disclosure statement should consist of whether the
analyst personally owns the security. Equity ownership by
analysts is a positive occurrence, not something to be shunned.
I will sum up. The new information age, combined with
Regulation FD, Fair Disclosure, is impacting the role of the
analyst, with companies now severely limited to what they can
say to analysts.
Prior to generally released news, the importance and edge
that analysts have over the investing public has significantly
diminished. Unfortunately often, and I know this from personal
experience, the only way to learn this business is from
mistakes. That costs money.
Investors have learned a hard lesson. With huge rewards
come equally huge risks, the bubble has burst. There will be
other manias with new and probably evermore fanciful evaluation
metrics in our future.
Investors should not believe everything they read, hear, or
see. In the new Regulation FD Internet age, the playing field
has been leveled, possibly lowered. And therefore the
responsibility accordingly must be shared.
Thank you, Mr. Chairman.
I'd be honored to attempt to answer any questions the
subcommittee may have.
[The prepared statement of Gregg S. Hymowitz can be found
on page 160 in the appendix.]
Chairman Baker. Thank you very much.
Just by way of notice to Members, we have a 15-minute vote
on the floor pending, followed by two 5-minutes. It would be my
intention to recognize Mr. Glassman for his opening statement,
and then recess the subcommittee at that moment to proceed to
the votes. We'll be out for about 15 minutes. We will try to
get back as quickly as possible.
Mr. LaFalce. Parliamentary inquiry, Mr. Chairman.
I understand what you just articulated. I wonder if we
might consider--I suppose this depends upon the schedule of the
witnesses of panel one and panel two. The bill that we are
considering deals with the SEC and the fees that are being
charged. Section 31, Section 6, Section 13, Section 14, peg to
parity capacity of SEC for enforcement, and so forth.
I'm wondering if we couldn't recess until completion of
debate and passage of that bill, and then return. I suspect it
would be about 2:00 o'clock. But I don't know what the schedule
of the witnesses is.
Right now, we have two responsibilities; one here and one
there. We can't bi-locate, so either we have to give short
shrift to one of our responsibilities and they are both great.
Chairman Baker. I understand the gentleman's point.
Ordinarily, if we had prior notice to try to make arrangements,
we would have just convened at a later hour today, but given
the witnesses' traveling arrangements, I respectfully suggest
we proceed as announced with a brief recess, come back, and we
will do all we can to accommodate appropriate consideration.
I intend to be in the subcommittee most of the day and will
miss most of the debate on the floor myself, which I deeply
regret. But I think in deference to the eight people who've
made arrangements to be here, we need to proceed as we
scheduled.
At this time, I'd like to recognize Mr. James Glassman, no
stranger to the subcommittee, who is a Resident Fellow at
American Enterprise Institute and Host of
TechCentralStation.com.
Welcome, Mr. Glassman.
STATEMENT OF JAMES K. GLASSMAN, RESIDENT FELLOW, AMERICAN
ENTERPRISE INSTITUTE, AND HOST WWW.TECHCENTRALSTATION.COM
Mr. Glassman. Thank you, Mr. Chairman, Members of the
subcommittee.
My name is James K. Glassman. I'm a resident fellow at the
American Enterprise Institute, author of financial books and an
investing columnist for many years. I've devoted much of my
professional life to educating small investors.
This hearing sheds light on an important subject, but I
urge restraint in two ways. First, analysts should not be seen
as scapegoats for the recent market decline.
Second, this subcommittee should resist the urge to pass
legislation in this area.
Analysts and firms have enormous incentives to do their
jobs well. The marketplace weeds out the bad from the good as
long as the public has the information. That is the function of
a hearing like this, and I commend you for holding it.
Many analysts were caught off guard by the recent decline
of the stock market, which represented the first bear market in
a decade. Some of them were accused of allowing personal
financial interests and a desire to cater to the investment
banking side of their firms to distort their judgments.
Let me make three comments about this criticism.
First, conflicts of interest pervade the securities
industry because they pervade life. You Members, yourselves,
cope with conflicts all the time. You have allegiances to
family, to donors, to party, but you try to surmount them.
Or consider journalists. Surveys show that most journalists
lean to the left of the political spectrum. For example, a
study by the Roper Center of 139 Washington bureau chiefs and
correspondents found that in 1992, 89 percent of them voted for
Bill Clinton, 7 percent for George Bush, yet every journalist
to whom I've ever spoken claims that his professionalism
overrides these conflicting political leanings.
Does it?
Well, the answer is that we can judge for ourselves by
reading the articles that they write or the TV segments in
which they appear.
A similar situation prevails for stock analysts, except
that their judgments are clear and more easily accessed by the
public.
The essential problem with a conflict of interest of any
sort is that it leads to poor decisions. In the case of
journalists, bias may suddenly color reporting and be difficult
to discern.
In the case of stock analysts, it could mean that a company
with poor fundamentals is given a high recommendation.
In this case, however, the analysts' judgment is assessed
quickly by the public. An analyst who consistently gives bad
advice will be rejected as not useful, either to investors or
ultimately to the firm that employs her. An analyst cannot hide
for very long.
Second, I favor voluntary and extensive disclosure by
analysts of personal holdings and other affiliations that might
color decisions. But don't exaggerate the benefits of
disclosure. What, for example, should an investor make of the
disclosure that an analyst owns shares of stock that he
recommends?
Is it that the stock may not be all that good, but the
analyst is pushing it for personal gain?
Or is it the opposite. That the stock is particularly good
because the analyst owns it?
I am not really sure that disclosure is all that helpful.
Yet, I do favor it, and I do it myself.
Third, the essential critique is that analysts biased by
conflicts have made poor recommendations. Now we can test that
theory by looking at the actual performance of analysts.
How well do they do? This question has been examined at
length in a study published in the April 2001 issue of the
Journal of Finance, a highly regarded publication for scholars.
In the article, the articles, Brad Barber of the University
of California at Davis and three of his colleagues found that
analysts' recommendations were in fact prescient and
profitable. This research reinforces earlier studies that have
found that professional securities forecasters have acted
rationally, that is, with proper judgment.
The authors of the new study looked at a database of
360,000 pieces of advice from 269 brokerage houses and 4,340
analysts from 1986 to 1996. They found that investors buying
portfolios of the highest rated stocks by these analysts
achieved average annual returns of 18.8 percent to compare with
a stock market benchmark return over this period of 14.5
percent.
The lowest rated stocks by analysts achieved a return of
only 5.8 percent.
These results are truly exceptional. Rare, for example, is
the mutual fund that can beat the Standard & Poor's 500 Stock
Index by four points over 10 years. In fact, the benchmark has
beaten the majority of funds over the past two decades.
I should add that Mr. Tice likes to criticize analysts, but
his own fund, the Prudent Bear Fund, has, according to
Morningstar, produced a total return of minus 47 percent from
its inception in 1996 through April 30th, 2001.
The S&P 500, the benchmark, produced a return of positive
120 percent.
The results of the Barber study suggest that analysts are
truly able to pick winners.
Now last month, the researchers published an unpublished
follow-up for 1997 to 2000. In the first three of those years,
the results were even better than they had been in the previous
10 years. But in the final year, 2000, the results were
terrible. The most highly recommended stocks fell sharply while
the least favored stocks did the best.
Those results of course are at variance with the previous
13 years and certainly we should watch analysts closely, but
the longer term results show that, on the whole, analysts do a
good job for their clients.
Finally, I worry that this hearing could send three wrong
messages to investors, to small investors. The first is that
bad stock picks are the result of corruption and bias. In the
vast majority of cases, they are not.
Poor picks usually happen because the market in the short
term is impossible to predict. No one is right all the time or
even much better than half the time.
The second wrong message is that short-term stock
recommendations are all that important to investors. Again,
they are not. The best advice to investors always is to own a
diversified portfolio for the long term.
Concentrating on the day-to-day judgment of analysts is not
a profitable pastime for small investors, whether those
analysts are pulled by conflicts of interest or not.
And the third wrong message is that the paucity of sell
recommendations is a scandal. To the contrary, smart investors
buy stocks and they keep them; they don't sell.
Despite the past year, as I said earlier, the benchmark is
up 120 percent in 5 years. Investing is a long-term endeavor;
done best, it is boring. If I could change anything that
analysts do, it would be to encourage them to tell us the best
stocks to own unchangingly for the next 5 to 10 years, not the
next 5 to 10 weeks.
However, I congratulate this subcommittee for airing such
an important issue.
Thank you.
[The prepared statement of James K. Glassman can be found
on page 166 in the appendix.]
Chairman Baker. Thank you, Mr. Glassman.
We stand in recess for approximately 15 minutes.
Thank you.
[Recess.]
Chairman Baker. I'd like to begin the effort to reconvene
our hearing. The good news is we only had two votes instead of
three and Members are on their way back. I expect them to be
coming in as we proceed.
In order to facilitate the progress in the hearing, I'd
like to go ahead and recognize our next witness. It's my
expectation that we will have at least another hour before we
get interrupted again unless of course things change.
With that caveat, I would like to, at this time, recognize
Mr. Marc Lackritz, President of the Securities Industries
Association.
Welcome, Mr. Lackritz.
STATEMENT OF MARC E. LACKRITZ, PRESIDENT, SECURITIES INDUSTRY
ASSOCIATION
Mr. Lackritz. Thank you, Mr. Chairman. Mr. Chairman, I'm
really pleased to be here this morning to have this opportunity
to meet with you and the subcommittee.
The subject of today's hearing concerns how this industry
fulfills its obligations to its customers, to the nearly 80
million Americans who directly or indirectly own shares of
stock.
Our most important goal as an industry is to foster the
trust and confidence of America's shareholders in what we do
and how we do it.
And we succeed as an industry only when we put investors'
interests first, period.
I will refer you to my written testimony for a detailed
description of who analysts are and how they help investors and
our markets. The value added by securities analysts has been
widely appreciated.
For example, both the Supreme Court and SEC have said in
the Dirks case, as Chairman Oxley indicated earlier, that the
value to the entire market of analysts' efforts cannot be
gainsaid.
Market efficiency and pricing is significantly enhanced by
their initiatives to ferret out and analyze information. Thus,
the analysts' work redounds to the benefit of all investors.
How good a job you can ask do securities analysts do? As a
group, they do a pretty good job. As my colleague, Mr.
Glassman, said earlier, the recent academic paper that he cited
reviewed approximately 500,000 analysts' recommendations from
1986 to 2000, and concluded that the consensus recommendations
that analysts make on specific stocks prove both prescient and
profitable.
The authors found ``sell-side analysts' stock
recommendations to have significant value.'' Aside from this
comprehensive study, it's quite notable that 71 percent of
recommendations listed in First Call are buys or strong buys.
This seems appropriate, considering that the 12 years from
1988 through 1999 saw the Dow Jones Industrial Average and the
Standard & Poor's 500 Index both post an average gain of 16
percent a year.
Critics of analysts were much less vocal then. To be sure,
in the past year or so as the market declined and the Internet
bubble burst, it seems that securities analysts have a few
bloody noses. They certainly do and they are not alone. Just
about everyone working, reporting on, and commenting about
securities recently has tripped at least a few times.
The question before this subcommittee is whether these
analysts can be subjected to direct or subtle pressure to skirt
objectivity and shade their conclusions one way or another.
It's a very legitimate question. The answer is, yes, they
can. We in the industry, as well as those who regulate us, long
have been aware of this. For this reason, there are strong
legal mandates in the Securities Exchange Act of 1934. And
similar regulations and laws are on the books to ensure
research integrity and objectivity.
These are tough regulations as are the internal safeguards,
yet is clear that some doubts may now be clouding the
perception of how securities analysts operate. That's why we're
meeting today, just to banish these clouds.
The Securities Industries Association has formalized and
bolstered the safeguards by endorsing and releasing earlier
this week, these best practices for research. In these, we
articulate clearly the means to protect the independence and
objectivity of securities research and the securities analysts.
We reaffirm that the securities analyst serves only one
master, the investor, not the issuer nor the potential issuer.
Let me offer some examples from its main points:
One. The integrity of research should be fostered and
respected throughout a securities firm. Each firm should have a
written statement affirming the commitment to the integrity of
research.
Two. The firm research management, analysts and investment
bankers, and other relevant constituencies should together
ensure the integrity of research in both practice and
appearance. Research should not report to investment banking.
The recommendation should be transparent and consistent. A
formal rating system should have clear definitions that are
published in every report or otherwise readily available, and
management should support use of the full rating spectrum.
Three. An analyst should not submit research to investment
banking nor to corporate management for approval of his or her
recommendations or opinions, nor should business producers
promise or propose specific ratings to current or prospective
clients while pursuing business.
Four. A research analyst's pay should not be linked to
specific investment transactions.
Five. Research should clearly communicate the relevant
parameters and practical limits of every investment
recommendation. Analysts should be independent observers of the
industries they follow. Their opinions should be their own, not
determined by those of other business constituencies.
Six. Disclosure should be legible, straightforward and
written in plain English. Disclaimers should include all
material factors that are likely to effect the independence of
specific security recommendations.
Seven. Personal trading and investments should avoid
conflicts of interest and should be disclosed whenever
relevant. Personal trading should be consistent with investment
recommendations.
There are a number of other important points to best
practices, copies of which have been submitted to the
subcommittee.
In addition to these best practices, Mr. Chairman, we will
also continue and renew our efforts to educate investors on the
risks and rewards inherent in the market, as well as basic
investment precepts.
We have a number of publications that we've put out over
the last couple of years. They are available on our website,
and we're renewing our efforts to distribute them through our
own members to investors directly.
Successful investing is a partnership between securities
professionals and the investor. Therefore, just as the
securities industry is renewing its commitment to do its part,
we ask investors to be educated, informed, and prudent in their
investment decisions.
The long-term interests of investors, the securities
analysts and the securities firms for which they work are best
served by analysts using their most skilled powers of research
and best judgment.
The market is a very powerful and unforgiving enforcer.
Flawed projections lose customers.
All of us in this industry know only too well the truth of
the adage that it takes months to win a customer, but only
seconds to lose one.
No securities firm wants to give advice that will hurt a
client. Firms that offer bad investment guidance penalize
themselves.
We believe the best practices endorsed by so many major
firms and continuing throughout our Association demonstrate a
vigorous renewed commitment to the investor. We hope they will
go a long way toward ensuring that the public maintains and
increases its trust and confidence in our markets and our
industry.
Thank you very much, Mr. Chairman.
[The prepared statement of Mark E. Lackritz can be found on
page 172 in the appendix.]
Chairman Baker. Thank you, Mr. Lackritz.
I'll start my questions with you and the recitation of the
best practice summary you just concluded. One element of that
that I believe I understand, and want to clarify, that the
compensation for an analyst should not be tied to a specific
transaction, so that a recommendation that leads to a client is
an example of something, a favorable recommendation would not
be compensated by bringing that client into the bank.
However, I believe this to be accurate, and this is the
reason for the question. Either on a quarterly or on an annual
basis, the bank may declare bonuses for all affected parties
and therefore reimburse or reward the analyst for the year-long
effort, as opposed to the specific transactional activity.
That is correct, is it not?
Mr. Lackritz. Yes. But the specific best practice says that
competition is not to be directly tied to any specific banking
transaction or trading revenue or sales practice, but should be
based on the overall performance of the analyst including the
quality of the recommendations that the analyst has made.
So the notion is to make it a merit-based compensation
system. Of course, if the firm does better, everybody is going
to get some of the rewards from that.
Chairman Baker. I understand that. I'm just reading it
critically from a legislative perspective.
I would seem to me that rather than Fed-Exing the reward,
we're going to send it by bus. That's my problem. There still
is a correlation between the recommendations and bringing
business in, as opposed to doing pure analytical work.
I'm merely making that point to say that the best practices
are indeed an appreciated step and I want to acknowledge that.
As I told you and others, when it was presented, one of the
elements that I believe is missing that we need to figure out
how to resolve is the way to confirm or audit the compliance.
It's one thing to have a nice book and put it on a shelf; it's
another thing for it to actually be utilized.
I think what you have presented there represents the
absolute minimum standard for reasonable professional conduct.
I also understand my criticism about the disclaimer. I've
been provided with information in the interim that was intended
to preclude potential civil cause of action for someone finding
that a particular standard was not complied with and therefore
creating unwarranted legal liability.
I respect that, but I have to honestly say I don't believe
that disclaimer would get you where you want to be. I think in
fact there would be very creative efforts to say that that
means nothing.
If we are going to go that route, I'm simply offering this
today as a matter for later discussion that really would have
to be the subject of legislation to provide for a safe harbor
from civil liability in the event that's where we think we need
to go in order to get the quality of conduct that we think is
required.
Do you have any comment?
Mr. Lackritz. Maybe I could discuss that from two
perspectives. One, your concerned about attracting long-term
business to the firm because of these recommendations, and
second with respect to the footnote.
The goal of these best practices is to raise the quality of
research throughout the industry, not to create a sub-structure
of lots of different rules and regulations, but clear standards
of behavior for what we can control.
In the long run, firms are going to succeed by the quality
of their advice. They will attract business because of the
quality of their advice.
Chairman Baker. I think that's true at a modest growth or
certainly in an environment where people are worried about
losing money. But in a bull market we've just come through,
people are going to throw money without regard.
They're going to watch the evening commentators figure out
who the hot guys are. I mean, I've watched it. I've had yahoo
finance web page and I watch and I say, this is going to be a
real comer.
You can see almost instantaneously the level of volatility
that comes as a result of that guy's hip-shooting, and I can't
say that that's appropriate for the investor to do it, but I'm
saying that's what's happening.
And people don't want to miss out on the opportunity to see
their wealth increase. It's just logic.
So we look to this analyst group to be the guys who really
make sure that we're not being led in the wrong direction.
Mr. Lackritz. I think that's a very good point, and it's
part of the reason we're renewing our efforts toward investor
education, because that's so very important to advise investors
to get a second opinion, to do the research, to not just
immediately buy something.
Chairman Baker. Let me jump, because I've got a couple of
other things I want to try to cover before I run out of my own
time.
I just can't fathom going through the list you read, which
is outstanding, that there would be a circumstance in which any
of those minimal requirements would not always be applicable.
In other words, what circumstances would I not do this,
applying the Louisiana Real Estate Code to my practice?
In all honesty, we've got a way to go here to catch up to
that.
Mr. Glassman, let me address your comment about journalism
and matters in political office and their ethical conflicts. If
you are suggesting that the measure of congressional ethics
ought to be the standard, which I think would shock most people
in America, let me quickly add, we have to disclose every
nickel of public income, every nickel of outside income, which
is also limited. We have to disclose what boards we serve on if
we choose to serve on boards. We have to disclose what
charitable contributions are made to our credit by third
parties. We have to report what trips we take if we're not on
our own time, where we go. Then we are precluded from eating
anything unless we're standing up.
The political contributions, we're limited in what we do.
If you're suggesting we should subject the analyst community to
the same standards of disclosure as the Congressman, I'm on.
Mr. Glassman. In fact, as you may know, Congressman, first
of all, I lived in Louisiana for many years myself, and I know
what you're talking about.
Chairman Baker. Ethics is always the number one concern in
Louisiana. I'm sure you know that.
Mr. Glassman. When I was editor of Roll Call, the newspaper
that so diligently covers Congress, I editorialized many, many
times against these nitpicking kinds of disclosure rules to
which Congress is now subjected.
I think at least there's a certain consistency in my view.
The only thing I can say is that there are many other
conflicts. They have to do with family, and in some cases they
have to do with donors, that really are not covered by any
rules. And the fact is, you surmount them day after day.
For example, it's no secret, and it's not necessarily
terrible that Members of Congress who have Members of their own
families who are suffering from a specific disease will
advocate more research money for that disease.
Chairman Baker. Sure, but that's only subject to getting
219 votes to make it happen.
Mr. Glassman. Exactly right. These conflicts are surmounted
I think in most cases by you, because you have to publicly
vote. And if you take a vote, and people say, oh, well, he did
this because of this donation or because of this conflict or
that conflict, it's out on the table.
That's the analogy that I wanted to draw.
I think with journalists, it's the same thing, but
basically in spades. The journalists lean to the left based on
studies. I think it would be hard to argue with that. And yet
every journalist says that he or she is a professional who
surmounts those conflicts.
Chairman Baker. But if the journalists was writing about a
stock in which he had a financial interest and put it in the
paper, that would be grounds of dismissal, would it not?
Mr. Glassman. It depends on the publication, frankly. I
think that journalists should disclose their holdings, but I
think that's really up to them and to the publication. I don't
think the Congress should pass a law that says that every
journalist must disclose holdings.
When I worked for the The Washington Post, I was not even
allowed to own stocks, and I thought that was a good rule.
Chairman Baker. My point is that you don't have to have a
public disclosure. There is a professional standard which says,
you don't play in this game, period.
Second, if you do play in the game and you write about what
you own, which is self-serving, you're gone. I don't think that
needs to be subject of a rule or regulation. I think that's
professional standards, which is what we are trying to pursue
here today.
And I'm way over my time. I assure you I'm going to be
back.
One caveat that I think, in fairness, I should make an
announcement. After discussion with Mr. LaFalce, Mr. Kanjorski,
and Chairman Oxley, what we do intend to do with the Fair
Practices Standard, not to make a political determination here
today, is to, between now and the next hearing, circulate the
Best Practices Standard for review and comment by regulators,
NASD, the SEC, academic review, to get professional response to
us from appropriate interested parties.
Convene a second hearing, at which time we will receive
those comments, and a second panel. I spoke last night with Ron
Ehsara concerning media concerns was on the air, and he wanted
to know if anybody in the media had been invited, and I said,
yes, we hadn't had anybody take us up, and he wants to come
down.
So we will have a media panel to get their involvement in
this. We cannot shoot specific minnows in the barrel. There are
a number of people who are in the tank who have shared
responsibility.
Before we're done, we're going to look at everybody, and I
just wanted to make that announcement for the subcommittee as
well.
Mr. Bentsen.
Mr. Bentsen. Thank you, Mr. Chairman. Thank you all for
being here. I apologize for missing some of the testimony.
This is an interesting hearing, but I can't think of a time
and I would ask the panel when there was a time that you had a
run up in the market and then you had a correction, that the
fingers didn't start being pointed at one another.
Particularly, it's one thing with retail investors and I
think you have to differentiate between retail and
institutional investors. But I happen to think of institutional
investors as so-called ``big boys'' as being ones who
theoretically and under the law are considered as being
sophisticated and know what they are getting into.
And yet I can't think of an instance where there's a
correction and sophisticated investors don't turn around and
say, why didn't you tell us this? We weren't aware of this.
And yet, there is, under the law, a least in some practice,
there's a great deal of disclosure. I guess from my
perspective, I'm kind of shocked to find out that stock
analysts or equity analysts might well be giving subjective
advice as opposed to objective advice.
I would bet that the retail public would be equally shocked
to find out that somehow that analysts who work for brokerage
houses may well be interested in helping promote some of the
stocks or bonds that are being sold by those houses.
You know, I understand if there is an issue that relates to
manipulation, but on the other hand, I think we might be erring
a little bit in trying to think that analysts employed by firms
which are underwriting stocks and bonds are somehow supposed to
be auditors and not people who give a subjective viewpoint, and
that we don't take this with a grain of salt.
But I would ask anybody, is there a period of time that
there hasn't been a correction where people haven't come back
and said, things were not done fairly.
Mr. Hymowitz raised the issue of EBITDA went on after the
crash of the job market, and people were saying that there
wasn't appropriate disclosure, that these deals were oversold,
and yet you had some very sophisticated investors who were
involved in buying those deals.
Mr. Hymowitz. Unfortunately, I've had the finger pointed at
me by my clients when I lost their money, so your point is
well-taken. Obviously, when the market starts going down,
people start loosing money, you learn very quickly that people
take their money very, very seriously.
This is not a perfect business. In a sense, investing is
not a science. David does an excellent job and we subscribe to
his research, but quite frankly all of our records are mixed.
It is not a science.
I will say one thing to a previous question, Mr. Chairman,
that you asked. We all have to understand that in the
underwriting process, the analyst is extremely important in
that process as it relates to the investment banks decision
whether or not to proceed with taking a particular company
public. It is crucial for the investment banker to get the
input of the firm's supposed expert in a particular industry
sector or, to use a term of art now, space.
If you want to see a public uproar, divorce the analyst
from that role, then have the investment bank take the company
public. Then, after the quiet period, have the analyst issue a
sell recommendation on that stock, and you will see a public
uproar.
It's impossible. I've been in meetings at my previous firm
where the analyst with a private company decided, based upon
the qualities of a particular company, that it would be unwise
to take that company public.
The fact of the matter is, during the most recent bubble,
the pressure on banks, the pressure on investment banks to meet
the demand of the investor for paper of Internet companies was
extreme. That is why, unfortunately, a lot of companies that
should never have made it out the door, went out the door and
in many respects, as I say in my written testimony, the public
equity markets became second-stage venture capital.
And if anyone's ever looked at the venture capital markets,
the risk involved is enormous. And that, in many respects I
believe, is what happened and what ultimately caused the market
correction that we have, besides a whole host of monetary
issues also.
Mr. Glassman. Can I respond to your question, Congressman
Bentsen?
I think we are telling the American public the wrong thing
if the idea they get from this hearing is that the reason that
stocks have gone down, or their own accounts have declined, is
because of some sort of manipulation that's been going on by
analysts.
That's not it at all. The truth is that markets go up and
they go down. And in the history of the stock market, one out
of every 3 or 4 years, the markets go down.
This is an important lesson for people to learn. In fact,
this has not been a particularly rough bear market. The Dow was
down, which I think is a very good reflection of the market as
a whole. The Dow-Jones Industrial Average was down five percent
last year; it's up a little bit this year.
That doesn't mean there's not a lot of pain out there.
There is, and I think a lot of people unfortunately have
learned a tough lesson, and there may well have been and I know
there were some people who exaggerated and led them down the
wrong path.
That's why this hearing is good. But investors have got to
understand that markets go up and markets go down and the way
to smooth them out is by holding diversified portfolios for the
long term.
Mr. Bentsen. My time is up. But investors, I think, also
need to understand that analysts who work for investment firms
are not independent auditors and were never intentioned to be
independent auditors.
And I think Mr. Hymowitz makes a very important point, that
there is another role that applies that analysts play within
the firms for credit concerns, underwriting concerns that
affect the ability of the firm to function in the future and
the risks that it may take.
And I think that all of this needs to be taken into
consideration.
Thank you, Mr. Chairman.
Chairman Baker. Thank you, Mr. Bentsen.
Let me make just one comment.
Mr. Hymowitz, I want to acknowledge your comment. I will
get back to that subject at a later time.
Mr. Paul.
Mr. Paul. Thank you, Mr. Chairman
I want to direct my comments and questions to Mr. Tice and
follow up on his testimony.
This is, to me, a very important subject, but for some
reason I think we are really missing the whole point, because
we are dwelling on the analysts and the advisors.
That's very important, but I think there's a much bigger
problem than the best analysts may be giving the bad advice.
But if you added up all the advice of the analysts and the
advisors last year, I guess they gave pretty good advice. They
told somebody to sell, so I guess more people were selling than
buying. Somebody was giving the correct advice.
But, I'm surprised that people are surprised at what's been
happening for the past year. Free market economists who
understand the business cycle and understand monetary policy
knew this stock market correction was coming and anticipated:
and they anticipate even more problems down the road.
I see this as more of an attempt to scapegoat, find out
who's been causing this problem because people lost some money.
If we had not had a stock market crash, we wouldn't be
here. If the bubble kept growing, you know, we would have been
blissfully nonchalant about what was happening.
But what we don't ask is, why did we have the bubble? Where
did that come from? Was it the analysts that caused the bubble?
They were a participant, but they don't cause bubbles; analysts
can say a lot of things, but credit causes a bubble, excessive
credit, not analysts.
Where does credit come from? Do we go to the bank and
borrow money that someone loaned to the bank? No. Nobody saves
any money. Credit comes out of thin air from the Federal
Reserve System, and we need to concentrate on that.
When the Fed does this, the Fed artificially lowers
interest rates and this causes people to do dumb things. It
causes people who used to save money not to save. It causes
consumers to borrow more money than they should. They cause
investors to invest irrationally. And then all of a sudden, we
have this bubble.
And then, on top of this, this has been around for a long
time, this is nothing new, everybody knows about this, but this
time around, of course, it was different. It was unique,
because we had a ``new era'' economy, just like Japan had in
1980, and just like we had in the 1920s, a ``new era,'' a new
paradigm. And therefore all the rules were thrown out.
And who pumped this up? Who really said the new paradigm
was here? The central bank, the same central bank that created
all the credit. The Fed creates the credit, it created all the
distortion, and then it says, ``Oh, there's so much
productivity increase that it's going to solve all our
problems.''
Therefore, the analysts become the victims. They're victims
of bad information and not good judgment, but they're not the
cause. They are the symptom of the problem.
So my question is, is this not what you were alluding to?
Should we not pay more attention to monetary policy? And is it
not true that just regulating analysts is not the answer,
because they're doing what they see in their own rational self-
interest, under the circumstances. Yes, for 10 years, they made
a lot of money, and they made a lot of money for other people.
It's just when the bubble burst that it happened. But it
seems to me that regulating analysts is not the answer; it is
paying more attention to how we regulate and rein in the power
of the Fed to create money and credit excessively out of thin
air that we should be dealing with.
Mr. Tice.
Mr. Tice. Thank you, Mr. Paul. I agree with you completely.
However, I also do believe that there is a Wall Street problem.
I believe that Wall Street has been a cheerleader for the
bubble.
I share your view that our economy is where it is today due
to excessive credit growth. If you look at the telecom and
Internet mania that occurred, that was really the first stage
of excessive credit growth.
We essentially have financed a number of businesses that
should not have been financed, as I talk about in my written
testimony.
We kept the cost of capital too low. I'm a believer of the
Austrian school of economics, as you are, Dr. Paul, and I
believe that the interest rate has been kept too low and that
we essentially financed a number of CLEC and Internet
companies. We essentially misallocated capital in the Nation
that will have a tragic cost to the country.
Currently, we are over-financing the financial sector. We
are growing MZM at nearly a 20 percent rate over the last 6
months in an attempt to keep the bubble going. We believe that
this bubble is not yet over.
There've been a number of comments as though the bubble has
burst, the decline is over, we can get back to fun and games
again. We don't believe that. The NASDAQ is still selling at
nine times sales. The S&P 500 is still selling at 30 times
earnings.
Mr. Glassman will of course disagree with me. He has a book
out talking about the Dow 36,000. You know, we think that's
absurd. Nobody will pay 100 times earnings for a company like
Bank of America, as he's talked about in his book by assuming
that the discount rate is going to be five-and-a-half percent.
We believe that there's still a great deal of danger in the
economy going forward. It is due to excessive credit growth. If
you look at some of the numbers recently, asset-backed
securities growth is growing at 42 percent. Credit card
securitization is growing at 70 percent. Home equity loans
growing at 63 percent.
So I think it's important to understand that Wall Street is
complicit in this credit growth and essentially seeking out
asset inflation. And they sought out Internet companies and
telecom companies in the first stage.
Now it's the financial companies, but we have an asset
bubble and unfortunately there's more pain ahead.
Chairman Baker. Mr. Paul, your time has expired. We'll come
back for another round.
Mr. Capuano, why don't you be next by time of arrival, sir?
Mr. Capuano. Thank you, Mr. Chairman.
I too want to congratulate you for conducting this hearing.
I think it takes a fair deal of courage to raise these issues
in a public forum.
I'm not a big time investor. I don't really understand some
of the things, the details of how all this works. But I try to
draw analogies.
The analogy I draw is, I don't think there's a big
conspiracy on the part of Wall Street to somehow control the
world. There is certainly not one that I'm aware of in the
Congress to over-regulate anybody. I don't do any of those
things.
All I'm interested in really is transparency. We talk about
it all the time when it comes to financial issues. We did it
last year in the banking bill. We do it on international issues
all the time.
Transparency is honesty and honesty is if you're making
analysis of anything, tell them who you're working for, and
then a reasonable person can make a decision.
Fair enough. I guess, though, I didn't get a chance to look
it up, but a few months ago, I read a pretty interesting story
about a young teenage boy who was dealing on the Internet on
penny stocks, basically giving an analysis of the penny stocks
to lots of people. They would drive up the market, and he would
all of a sudden buy or sell or do whatever he was doing, and
made billions of dollars as a young teenager.
He got caught. He got a slap on the wrist, but it was a
lack of transparency. It has nothing to do with a teenage kid
dealing with penny stocks who cares; that's good. But that's
what I think is missing so far is all this concern about what's
going on. I want honesty, that's all I want, so that investors
can make honest decisions.
I guess I was going through a whole litany of examples, and
I just wonder, what's the difference between what's going on
and the old payola scandals of the radio days when people,
allegedly independent DJs would be on the payroll of a record
company, and all of a sudden, out of nowhere, this record was
going to number one with a rocket. Why? Who knows why? Gee, it
just so happens they're on the payroll of the record company.
What's the difference between this and the S&L scandal?
Don't worry, this company, this investment is stable, it's got
good credit, trust me. Oops. I didn't want to tell you that we
have an investment in that. I didn't want to tell you that my
cousin is the owner.
What's the difference between this and Michael Milken's
situation? Trust me, we don't have any inside information, no
one on Wall Street does that, that is wrong. What's the
difference?
What's the difference between this and the cable
oligopolies who tell me, as a consumer, don't worry, everybody
wants the 14 history channels, and in order to do that, we have
to raise everybody's rates a buck-and-a-half. What's the
difference. And gee, we didn't bother to tell you that we own
all 14 of the history channels.
What's the difference between that and what's going on
right now with our energy oligopolies? I'm not quite sure what
they're doing just yet, but I know one thing. All of a sudden
it is costing us a lot more money and it seems like it's all
going to one group of people who keep telling me that there is
only one problem; that they need to be able to drill.
All I see is a complete and utter--not by everybody--but, a
significant lack of honesty and transparency. If someone is an
analyst who works for somebody who pays them, and then there is
money to be made, so be it. Just tell me what's so hard about
that? What is so difficult about that? Why can't Wall Street
just do it, as opposed to simply coming up with, and again I've
only just gotten them today, but, you know, the best practices.
They sound awfully nice, but I don't see teeth in them, and
I'm sure we'll have further discussions. I do want to talk to
the SEC to see what's going on with it.
I don't believe there is any conspiracy, I really don't,
but I do believe one thing; money makes people do crazy things.
And I'm no different; we all do it.
And if there's money on the table to be made by someone who
holds themselves out, either publicly or by innuendo, as an
independent analyst, simply tell us the truth. Are they
independent or are they not. And I would like to know what the
difference is in any of your minds between any of the analogies
that I just drew and what apparently is going on as apparently
a relatively accepted practice on Wall Street that it's OK to
try to burn both ends.
Mr. Tice. I'd like to respond, Congressman.
I agree with you completely that the system is broken. I do
not see that much difference between what goes on commonplace
on Wall Street versus what happened with this Internet 15-year-
old boy. There's been a lot of discussion so far, as if we can
fix this around the edges.
We think we have a broken system, and I would like to read
you a couple of quotes from our written testimony. This is from
a former research director at Lehman Brothers. He said an
analyst is just a broker who writes reports.
Another gentleman, who was an analyst, said he explained
his reasons for recommending a company. I put a buy on it
because they paid for it. We launched coverage on this company
because they bought it fair and square with two offerings.
Another case, an analyst at Morgan Stanley, who followed
Cisco Systems, analyzed his rationale----
Chairman Baker. Excuse me, Mr. Tice. I would like to have
everybody have an opportunity and my time is running out. I
apologize for interrupting.
Mr. Hymowitz. Congressman, I would add that disclosure is
everything. You are absolutely correct. I think the problem,
one of the problems with current disclosure today is often the
disclosure statements are longer than the actual research
pieces.
You get an early morning note from an investment bank,
it'll be a paragraph long, and the disclosure statement is
three pages long. Disclosure statements need to be, as I guess
the SEC has tried to make prospectuses more in plain English,
disclosure statements need to be more in plain English.
Furthermore, I think that if you really examine this issue,
where the crux lies is that many investment banks, as is the
nature of the business, are constantly trying to get more
investment banking business. So people have grown skeptical of
whether or not the analysts are trying to aid the investment
bank in getting that business.
So one suggestion I have is possibly, as long as it doesn't
interfere with the commercial practicabilities of the
industries, for the investment banks, for issuer to disclose
whether or not they are currently engaging in any publishing
investment banks on them, or whether or not there is the
potential that they are seeking investment banks.
Then you'll know really whether or not--or at least as to
your point--the public will then be informed that possibly if
Investment Bank X is issuing a positive report on Company Y,
well maybe it's due to the fact that there is a beauty contest
going on for capital markets transactions.
The disclosure needs to be more relevant, shorter, more
succinct, and in plain English.
Mr. Glassman. Congressman, I'm definitely in favor of
transparency. I think the question is the role that this
Congress should play. It seems to me that all industries, all
businesses have a tremendous incentive to tell customers what
they're doing, because customers will shun businesses that are
either dishonest with them or opaque.
I also just want to say that I do take exception to a
number of the things you said about energy oligopoly and some
of your comments about Michael Miliken, but in general, I would
also say that the S&L crisis had definitely presented a role
for the Federal Government to play because of insurance.
This area I don't think there's a role for you to play
except to have hearings like this and air these issues
publicly. That's very important.
In general, I want to associate myself with your comments
about the importance of transparency.
Mr. Lackritz. Congressman, I would also associate myself
with those comments and with your comments about transparency.
We have always favored transparency. That's at the crux of the
securities laws in this country.
Where I take issue is when you compare the situation to a
number of other scandals in the past. I think if you take a
longer perspective of what the securities industry has done
over the last decade, the securities industry raised more
capital in 10 years to build plants, to build schools, to
create new jobs, to create new products and services than in
the entire 200 years before that combined.
So we are very proud of what we've accomplished and the
opportunities that we have created for millions and millions of
investors who, if you look at over time, have done extremely
well.
Last year, we had a terrible year. And we could have either
said, well, it was just a bad year and we're going to get back
on track, or we could say, look, let's see if we can fix some
behavior here and assure that going forward, there will be no
questions whatsoever about the independence and objectivity of
analysis.
And that's what we've done with these best practices and
transparency really is at the core of these best practices.
Chairman Baker. Your time has expired, Mr. Capuano.
Mr. Castle, you'd be next.
Mr. Castle. Thank you, Mr. Chairman.
Let me thank you for holding these hearings. Let me
encourage you, although I don't think you need encouragement,
to continue this. This is big time business we're talking
about. It's covered by a lot of national magazines, by national
television every night, by a lot of financially focused
magazines.
It involves the assets of most of America today, and these
questions should be asked and we should get some answers. I'm
not sure that we should legislate in this area, and I'm all for
best practices, I think that's great.
I don't know how much good disclosures do unless somehow
you all are regulating that. I started to get my privacy
notices in the mail recently. I don't even understand what the
heck they mean half the time. And I'm not convinced at all that
either we, as average investors--and that's what I consider
myself to be--would really, truly understand all disclosures
anyhow.
And I would be the first to tell you that stocks are
unpredictable and always will be. And when you get into the
timing of the stock market, it becomes even more unpredictable,
and when you get into the timing of particular sectors, such as
the high tech sector, it becomes even less predictable yet.
Having said that, I am absolutely, totally convinced there
are conflicts out there. I think anyone who dismisses that out
of hand is off base and I do agree with something Mr. Tice
said, something along the lines of Wall Street has been the
cheerleader for the bubble, and I think that is essentially
correct. And I think it really needs to be looked at. I
honestly believe it needs to be looked at, and hopefully you
will all look at yourselves and tell us something so that we
don't have to do something here.
I've been here for most of this hearing and I don't think I
heard this; maybe I did. But I think Mr. Hymowitz, you said
something to this effect, maybe you or Mr. Glassman can help me
with this.
But you stated that many believe there are few sell
recommendations on Wall Street. Maybe you question this fact,
but how do you reconcile that statement with a study by First
Call indicating that the ratio of buy-to-sell recommendations
by brokerage analysts rose from 6-to-1 in the early 1990s to
100-to-1 in the year 2000.
I don't even know what half these expressions mean. Out-
perform, strong buy. I've never seen a sell recommendation on
anything frankly. All I see are these recommendations of a buy
nature, which is part of being the cheerleader for the bubble,
as far as I'm concerned.
I'd be interested in your views on that. I think we have a
problem out there and I think we need to admit that and
determine how we're going to fix it.
But I get the idea that you don't necessarily agree that
there is a problem; maybe you disagree with those facts or
don't think it's relevant or something. I would like to hear
from the two of you on that.
Mr. Hymowitz. Congressman, to answer your question, I'm not
familiar with the First Call Survey. But we utilize First Call
in my firm, and typically First Call covers mainly the well-
known broker/dealers. That's only if, I believe, those
companies submit their research and their analysts' estimates
to First Call.
When I said there's plenty of sell recommendations----
Mr. Castle. I don't mean to interrupt you, I'm sorry, but
let me go on. Maybe that's important. If Merrill Lynch is
giving bad recommendations, if Dean Witter's giving bad
recommendations, instead saying out of 100 securities firms,
which are also analyzing stocks, so many of them gave us bad
recommendations, I think we need to look at the number of
people they are impacting and the total number of dollars
they're impacting.
We might dismiss this on the basis of some three-man shop
doing it incorrectly, but the big boys aren't.
Mr. Hymowitz. I understand that.
My point about the fact that there are as many sell
recommendations on Wall Street as there are is the way I define
Wall Street. As an institutional money manager, we have the
resources due to the fact that we do commission business all
over the street.
To get private research, meaning companies like Mr. Tice's
here and others who specialize in providing a counterbalance to
the sell side research. There are different types of analysts
on Wall Street.
In my written testimony, I define them. One is what we have
mainly been talking about today, the sell side analyst that's
mainly related to a large investment bank.
But there are numerous other kinds of analysts on what I
call Wall Street, and many of them work at research houses
only. And those analysts also provide buy recommendations and
sell recommendations.
Although there has been the creation of a niche business
recently where specifically research analysts look at
accounting issues and sometimes just fundamental business
issues, and recognize that certain companies are possibly
candidates for shorting. So many of the institutional money
managers who subscribe to these services, they tend to be very
costly, you know. I think in the range of some of them cost
roughly $100,000 a year.
And we subscribe to these services and we use these
services to counterbalance the sell side research. Just let me
add one other thing, and I said this in my written testimony.
The most important thing, though, is for the investor to do
their own research.
How many people do we know that spend more time with the
Consumer Reports magazine trying to determine what DVD player
to buy. Then they do in time on due diligence of what stock
they should buy, and ultimately----
Mr. Castle. Let me cut you off, because my time is running
out. I don't know what you expect some of us, as investors, to
do. I imagine most people you're dealing with have other jobs,
have a heck of a lot to do and are dependent upon people who
are supposed to be professionally trained in that job to do it,
which are these analysts. If they're not getting good advice,
they're in a degree of difficulty, and I don't disagree with
you.
I wish I had the time to do it. I wouldn't probably be such
a loser on the stock market.
Mr. Hymowitz. Could I touch on that one last point?
You have to remember the analysts are not buying the
securities. You're right. Many of the individuals do not have
the time to manage money. That is why I'm in business. Without
the fact that you all don't have enough time, I'd be out of
business. So that's why people are very wise to give money to
mutual funds, money managers, hedge funds, index funds. That's
why this business exists, because many people don't have the
time, nor should they spend the time because you're right.
There are professional money managers out there who
understand what sell-side research is all about.
Mr. Castle. Hopefully, individual investors could depend on
those people who have the expertise, without conflict, to have
their good advice.
Mr. Glassman.
Mr. Glassman. I just wanted to comment on selling. There
are 7,000 listed stocks in general. Analysts follow stocks that
have good prospects, because it doesn't make a lot of sense for
them to spend a lot of time on the others, and there are
specialty firms that follow some of these other stocks if they
think there might be a chance to short them.
I just also want to say that the idea that individual
investors should be preoccupying themselves with selling, which
is basically market timing that you talked about earlier I
think is a mistake.
Generally, the way to be a good investor is to buy good
companies and hold onto them for a long time. The paucity of
sell recommendations, as I said earlier, is a reflection, in
part, of what companies' analysts are following, and also the
market itself, which, despite the year 2000, has gone from, if
we just look at the Dow, from 777 in August 1982 to over 10,000
today.
So if you're spending a lot of your time selling, you
weren't doing very well.
Mr. Castle. My final statement, Mr. Chairman, if I may. I
don't disagree with what you've just stated and I don't mind
buy-and-hold as a theory of investing, which I think makes a
lot of sense.
But if you're getting a preponderance of buy
recommendations, the ratio of 99 to one, and a lot of these are
going down as much as 50-, 60-, 70-, or 80 percent of the
course of a year or two, that's a problem as well for the poor
devil who's trying to buy and hold it in that circumstance.
It's not just looking for sell recommendations, it's
knowing what not to buy. And I don't think the average investor
knows, looking at these reports, in many cases what not to buy.
You cited figures earlier. We can't go into them. I'm just
not as optimistic about all those figures.
Chairman Baker. Mr. Castle, if you will, it looks like
we'll be able to do another round and we'll come back to you.
Mr. Kanjorski.
Mr. Kanjorski. Thank you very much, Mr. Chairman.
I think the issue boils down to the fact of whether any of
the alleged conflicts of interest are in real existence, and if
they are, to what percentage they are.
I am sort of disappointed, looking at the analysts'
problem, at a time when the stock market has not reacted well.
Sometimes we get bad law out of responding in times like these.
And, we ruin reputations and injure a lot of people who have
been paid to make estimations that have not got any basis,
other than a lot of their own intuitive senses, once they study
a situation.
But I do think, from my own experience, something I would
like to posit to the panel. Would any of you like to play on a
professional football team where the referees' salaries were
dependent on which team won the game? I think we would have a
tendency to wonder whether every call of the referee was sound.
I will give you an example in Pennsylvania. Up until about
30 years ago, when we reformed our Constitution, the lowest
judicial court in Pennsylvania was the Magistrate's Court. We
saved a lot of money in Pennsylvania because we never paid
magistrates. The way they got paid was by collecting the fees
on the convictions.
It was amazing how many convictions there were in
Magistrate Court, somewhere around 90 percent. When we changed
the Constitution and directly paid Magistrates a set salary
without a fee attachment, suddenly convictions fell
precipitously.
I think in my analysis of this situation, it is somewhat
similar to what happened in the late 1920s and the early 1930s
in the boiler room operations.
There were a lot of people who said, ``No, you do not have
to pass the SEC legislation, we can self-regulate ourselves. I
particularly look at the analysts that appear on the network or
cable programs that are prognosticating 24 hours a day of how
to get instantaneously wealthy.
Investors are 50 percent of the American population, and I
think probably 95 percent of which do not have an MBA from
Harvard or Wharton. So, in a way, they are responding to this
guy in the Brooks Brothers suit, who looks smart, talks smart
and works for a very prestigious named investment house. And
they are relying that these analysts are honest people.
A I mentioned in my opening remarks, the point I want to
make is that we should find whether or not there is any
evidence of actual problems out there.
I would say if we do find literal abuse of position to gain
personally, it is going to be in the smallest percentage of
instances. I think in most instances, the failure to predict
accurately what to do is the exuberance of the market. Who
wants to call contrary to the trends of the market? That is
probably what most analysts did.
This is not necessarily a bad time to raise this problem. I
guess the question I would like to have answered concerning the
best practices as put out by the industry, which are nice, but
are they not a little late and probably fortuitous in timing,
because the hearing was coming up? That is my impression
anyway.
But without any enforcement, do you four witnesses, any one
or all of you, feel that the industry and the private sector
itself cannot only put out standards and have best practices,
but also develop an enforcing mechanism and a mechanism of
disqualification, fines, penalties, and so forth, that will
really work and take the unethical behavior out of the
business, or is that beyond the private industry to do? Does
this matter instead require SEC regulation or acts of Congress
to accomplish that?
Mr. Lackritz. Could I address that first, Congressman? I
think that these best practices that we've come up with are
going to be very effective, and are going to work extremely
well.
The reason for that is because they've been endorsed not
only by the 14 largest firms representing 95 percent of the
underwriting business, but all the CEOs of those firms down
through the directors of research.
In addition, you've got an incredibly powerful and
unforgiving enforcer in the marketplace. These practices are
designed to help improve the quality of research.
To the extent that the quality of research doesn't improve
for clients, they go other places. To the extent that
competitors see that their competitors may not be following
some of these rules, they're going to be quite aggressive.
Already you see a fair amount of competition in the
marketplace.
Mr. Kanjorski. Wait a second. I love the marketplace. I
think it has a lot of regulation to it that is imposed by the
natural forces, but I think to make the argument that the
marketplace itself is going to take care of things is quite
optimistic.
Let me give you an example. Just recently in a fraud case
involving GSEs, as a matter of fact----
Chairman Baker. I am shocked.
Mr. Kanjorski. ----Perhaps thousands of mortgages were
improperly sold at an inflated value. And, when you look at it,
it is alleged that the perpetrators of the fraud were really
two appraisers who were going in and appraising these homes
over their real value.
And in the preliminary investigation, after identifying
something has been maybe millions of dollars of potential
fraud, these two appraisers were fined just $10,000. Woowhee,
big deal.
I mean, if you guys are going to self-regulate by fining
somebody or slapping them on the wrist, and shuffling them off
to Buffalo, if you will, we will not receive any real reform. I
have just met with the State regulators and they tell me that
there are brokers selling intrastate that have been fined and
convicted in three and four and five other states and the State
regulators have no capacity to find out who these people are.
They are just moving around the country, one State by one
State, knocking it off.
And honestly, with the industry coming forward now and
saying, wow, we have got to find a way to make sure this
information gets out to all the regulators so that these
investors are warned that there are these bad actors out there,
it seems questionable.
Look, when you can make millions of dollars by perpetuating
frauds like this one, and you only lose your license, or you
get a penalty of $10,000 on a multi-million dollar fraud, I do
not know any con artists that are going to turn down that deal.
That is a pretty good deal.
Mr. Lackritz. Congressman, I would take issue with that.
Industry has no tolerance for bad actors. We want to do
everything we can to get fraudsters out of the industry.
Mr. Kanjorski. Why, under best practices, do you not have
transparency, enforcement, and penalties that are just like the
Bar Association?
If you have a bad lawyer, you can disbar him and throw him
out.
Mr. Lackritz. We have transparency in these
recommendations. There's mandatory clear language and mandatory
disclosure of holdings of conflicts that go beyond these best
practices, Congressman, go beyond the regulations that are on
the books now.
They take the regulations on the books now and go beyond
that. In fact, part of the reason it took us a while to come to
relesae these was because it was a long process of negotiating
among the firms.
The firms took it quite seriously because they realized in
some cases they might have to change the way they did business
in order to comply with this They took it extremely seriously.
As a result, that's what held this process up a little bit,
but from the standpoint of their effectiveness, I'm quite
confident that they are going to be effective and I think time
is going to be the test. The proof is going to be in the
pudding.
Chairman Baker. Mr. Lackritz, and Members, if I can, we
would like to recognize Mr. Inslee for these questions. We are
nearing the end of debate time on the next vote. I would like
to get him in and perhaps conclude this panel before the vote
starts. You probably would like that idea.
Mr. Inslee.
Mr. Inslee. Thank you, Mr. Chair.
We don't have a rule that we just shoot the analysts here
when the market goes down, if that's any relief to you, but I'm
intrigued by a thought that Mr. Cole, who was an author, I
assume you are familiar with, who has been critical of the
industry in various ways.
Basically as I understand his approach, he believes that
there's been such a radical change in the structure of the
industry toward an investment banking oriented part of the
industry that it's changed dramatically the problems that
analysts have internally in their own structure.
For instance, he quotes a statistic. I don't know if it's
accurate or not, that says that 60 percent of industry revenues
before 1975 were trading commissions. Today, that's less than
16 percent.
As I understand his argument, he's basically saying that
analysts now have this much greater incentive, if you will, to
deal on the investment side, and that's what skewed judgments
perhaps or at least created a concern in the public about that.
And I just want to read--and he's going to testify later--I
want to read something I want to get your comments on, if I
can.
He said, where the role of analysts has changed
dramatically in the last 25 years, the regulatory environment
has little changed from 1975 or even 1945.
Analysts have safe harbor under the law, even to the extent
that they can tell their larger clients that a stock is really
a dog, while keeping the buy signal on for the public. That is
entirely legal.
It is even legal for an analyst to tell their trading
departments that a buy signal will be out on the morrow. If the
analyst is influential, the trading department can bulk up on
the stock and then sell it to retail demand then generated by
the buy signal all legal.
Brokerages call this, quote: ``building inventory to
satisfy demand, just serving our customers.''
Others might call it a license to print money.
I read in your best practices. As I read it, it sounds like
your best practices were designed somewhat to address some of
the issues that he's raising here.
But I guess what I'd like you to do is if you could respond
to his argument that the dominance of the investment side of
the industry has become such that we now need to take another
cut at looking at the regulatory aspects on analysts,
particularly some of the issues that he raised.
I'll leave this open to any of you.
Mr. Lackritz. I would just say, first of all, I disagree
completely with some of the things that you read that he's
written.
Clearly, an analyst that's giving some recommendations to
one side of clients and not to others, that's not currently
appropriate and obviously that's not a good business practice.
Second, the business is changing dramaticaly, but I suggest
that it's changing from a transaction-based business that it's
been historically, to an information and advisory business more
and more and more. This means that the quality of our
information is the most important product that we're offering.
The quality of our advice is the most important product
that we're offering, which is why we put forward these best
practices. We think these will help to continue to improve the
quality of the advice that we are offering and in the long run,
that's what's going to be successful for the business.
Mr. Hymowitz. Congressman, I would also add I would not be
that concerned about the shift in fees investment banks earned
from commissions to advisory fees. I will tell you things have
changed once again back. One would have to wonder what
investment bankers are doing these days. Even the fact that the
capital markets are effectively shut down, there hasn't been,
other than the Kraft IPO yesterday, I don't remember the last
IPO.
It's a natural cycle in the business. When the markets are
going up, the investors are looking for companies to take
public. Therefore, the percentage of revenues in the investment
banking department goes higher, the commission and manaegment
fees goes lower. But the cycle changes.
And today, if you took a snapshot of any investment bank,
I'm sure commissions, asset management fees are gaining in the
preponderance that they represent in the total revenues of the
companies. And in investment banking fees, you can see it by
Wall Street. Look at the layoffs that are occurring. They're
not laying off asset managers, they're laying off investment
bankers, because that portion of he business is suffering due
to hte fact that the capital markets are shut down.
Mr. Glassman. Congressman, I'd like to respond to this
issue of best practices and what the SIA has done. Also, this
addresses something that Congressman Kanjorski asked.
I'm not so sanguine about it, because I think the way to
solve this problem is by individual firms stepping up to the
plate and saying that, at our firm, we have a real Chinese
wall, and if we find anyone breaching it, that person is out.
That's our rules at this firm.
Now another firm will then compete and say ``No, no, we can
top that.'' We can have even more objectivity among analysts.
There are good things about industry groups, but one of the
problems is that they all get together and decide what the rule
is going to be.
That's also the problem, by the way, with legislation. It
takes away the competition, which really ends up giving you the
best kind of rules and the best protections for consumers.
That's what I worry about.
Mr. Inslee. Let me tell you abuot a concern I have.
Obviously what it sounds like, your best practices are designed
to build a Chinese wall. My concern, however, is if you build a
Chinese wall, but you leave it under the control of the Chinese
about where the gates are going to be and how high the wall is
going to be, I'm not sure it gives enough confidence to the
people in this regard.
So let me just ask you this. In contrast to the legal
profession or the accountancy profession, or the physicians'
profession, is there any reason to have Americans trust the
industry to be self-regulatory on this issue as to analysts
where Americans demand some independent source, to some degree,
to control the behavior of lawyers and doctors and accountants.
Mr. Lackritz. Can I address that?
I think, first of all, the quality of our professionals has
never been higher. We in the securities industry have a
mandatory continuing professional education requirement, as I
understand that no other profession even has.
We have to have mandatory retesting your fifth year and
tenth year after receiving a license. So that, in and of
itself, makes it different and the quality has gone up
considerably.
I also think that it is fairly easy for customers to see,
because they get their statements every month how they are
doing.
With other professions, sometimes it's not as clear; it's a
much more subjective kind of judgment.
So we have a real bottom line I think that really serves as
a very effective accuntability mechanism, which is one of the
reasons that the quality of the research is so important. Which
is why our firms have an incentive to give out the best quality
advice they possibly can to their investors.
Mr. Tice. Congressman, if I could just add that I do
believe that you hit a hot button issue as far as the magnitude
of dollars that are involved in the investment banking. And the
fact is that people are people and money motivates people. And
the structure of these firms is that the investment bankers are
still too powerful within these firms, because that's where
money is made.
Now as Gregg said, the IPO and the investment banking
revenues are down currently. However, paying 6 cents a share or
4 cents a share, which is what institutions are paying for
research today, the profitability is much greater in investment
banking, and therefore investment banking drives it.
We don't believe the industry can regulate this from
within. The dollars are just too big.
Another problem is, the industry, in my opinion, has not
even admitted that there's much of a problem. There's talk
about there's a perception of a problem, rather than admitting
that there is a problem.
Mr. Hymowitz. You're not arguing for higher commissions,
are you?
Mr. Tice. I would pay higher commissions, sure.
Mr. Inslee. Thank you, gentlemen.
Chairman Baker. Your time has expired, Mr. Inslee. Thank
you very much.
I want to pick up with a point that I failed to make
accurately perhaps.
Mr. Hymowitz, in your answer to a prior question, talking
about the demand in the market to get paper out, and that as a
result perhaps some of the dot coms move to public offerings
that weren't, in all circumstances, mature for that position.
That is extremely troubling to me.
What is the role of the analyst? Maybe that's where there's
a miscommunication. I want to take you to the days of LTC, and
I'm not making a parallel, I'm not making accusations, merely
to understand my level of concern.
We had 3 years of back-to-back trading without 2 days of
concurrent loss. There were extraordinary levels of
profitability. You had bankers, you had folks in the
international community, literally throwing money at them.
You were told a million dollar minimum, 3 years. Don't pick
up your phone and call me. I'll let you know what's happening.
Extraordinary types of information, lack of exchange.
Now what drove that was the desire by the individual to get
a piece of the action and make a quick buck. I understand that.
In my view of market responsibility, the single person who
should have been in that room when the credit was being
extended by the bank was the credit risk analyst. The little
guy sitting in the corner with the glasses, reading the
complicated sheets. Who says, wait a minute, guys, there may be
something wrong here.
If the management overrides him, I understand, but it's
that analyst who should be the one to have the professional
standard to stand in that door and say, no.
What you're telling me is, because the investor's demand to
get in on the run up of the market, it was almost embarassing
to go to a cocktail party or a birthday party, or you're in the
back row of the church, and people saying, man, have you seen
my 401K lately, and if you weren't in it, there was something
wrong with you.
So the public pressure was to get a piece of it, and within
the firm, deciding what they were going to market and what they
would not, because of the demand for paper.
Because the community was asking for it, the investor
lowered his bar and said, let's put this out, because we've got
to get something for people to buy and keep this moving.
Am I wrong?
Is it not the analysts' obligation to reach a professional
opinion and express it, notwithstanding market conditions and
consumer demand?
Isn't it a professional responsibility to say, no, now is
not the time? People can disagree, but the board can override.
But somewhere in the record, that analyst's view should be
noted. Is that wrong?
Mr. Hymowitz. I don't think it's wrong, but I think the
answer is very complicated. I'm sure we don't have enough time
for it, but let me just make a couple of comments.
The capital markets changed dramatically when companies
like Netscape and Yahoo were able to be taken public without
profits.
Investment bankers realized, unlike years past, the
investor was willing to take the chance, and risk, and look,
that's what investing is about.
Chairman Baker. But on that point, I hate to interrupt, but
it's so critical and pivotal to the understanding.
The investor was willing to take the risk because the
analyst was telling him it was a good risk to take. You're
telling me the analyst was saying, don't invest in this? I
didn't hear that.
Mr. Hymowitz. I didn't say the analysts, I'm not saying
that. But I think it's more complicated than that. A company is
taken public. We all recognize that the Internet was, a few
years back, something completely new.
Let's remember, I see many Congressmen using their
Blackberries. You weren't doing this 3 or 4 years ago. Without
the capital markets financing these companies, we wouldn't be
able to do it.
So there's lots of tremendous positives that have come from
this, thousands and thousands and hundreds of thousands.
Chairman Baker. I agree with you. I think that's great.
What I'm saying to you is, the huge capital flows that
appeared since' 95 to the current day, come from less-than-
sophisticated pension fund managers in some cases, you now,
some school teachers' retirement fund, they are under critical
pressure from their owners of that fund.
Wait a minute. Everybody else is getting 18, 21 percent,
why aren't you? He goes further out on the risk profile. He is
listening to his analyst.
My point, I want to be focused on, I'm not disputing that
the capital markets don't perform a wonderful function. I am
not a regulator. I don't think the Federal Government is the
answer.
But I am suggesting very strongly in terms that I hope are
clearly understood, I believe the sentiment's been expressed in
this subcommittee today, if we don't get this fixed, probably
some session of Congress is going to fix it in a manner the
market won't like.
That's what we are about here, is trying to not have that
occur. And if you're telling me the role of the analyst is not
to be direct and forthright, and to tell people what they don't
want to hear in an environment when it's not popular to say it,
that's a very disturbing thing. We've got to find a way to fix
that.
And I want to say to Mr. Lackritz and the SIA, I appreciate
what you have done, but we have now recognized we have a
problem. We have entered the 12-step process. We are step one,
maybe two. We are all getting in a room together and comforting
one another. We haven't really decided where we're going to
wind up in a few weeks.
We're shaking it a little bit and we are a little bit
worried, but there is a problem. And in my view, although I
fault the media for hyping the stuff, I fault the investment
bank for pushing the analysts, I fault the investor for not
doing the due diligence that they ought to do.
At the end of the day when I get my call from a broker
saying, boy, you don't want to miss this train, it's a sure
bet, who am I to disagree?
I rely on their professional judgment to tell me when it's
advisable. Should they be right a hundred percent of the time?
Heck, no. I'd like them to be, you now, 51/49, but at some
point we have to realize the standard of conduct which a
reasonable man should expect from the Street has not been
utilized, and the formulation of the best practice standard I
think is evidence there was a recognition of a problem. And
we're now about addressing it.
I don't think we need to skirt around it anymore. I think
we've got to figure out what do we do. That's the last piece. I
don't see a lot of recommendations beyond the best practice
standard.
Mr. Tice, you had a few?
Mr. Tice. Yes. If I could respond briefly to Mr. Hymowitz'
point, I don't think it is that complicated and you're exactly
on target that the analysts should be objective. He should not
be looking at what the customers demand for a product or an
investment service.
That's the problem. The analyst most often serves as a
sales person. He's looking at the customers out there and
saying, what can I sell to them; therefore how can I promote
this stock so that he will want to buy it, rather than being
independent and saying, is this good for the customer.
That truly is the problem today.
Chairman Baker. Let me give Mr. Hymowitz equal time,
because we have a couple of more Members who want to come back
with another question.
Mr. Hymowitz. First, I would say if the whole problem was
just analysts had a lot of buy recommendations on stocks, and
that was it then the railroad stocks would have gone to the
moon, the drug stocks would have gone to the moon, the food
stocks would have gone to the moon. That's not what happened.
What happened is the public at large, and I don't know who
is to blame, and I'm not smart enough to figure it out, the
public at large had a very short period of time, 12 months,
maybe 18 months where they got completely enthused with the
Internet and anything dot.com, and that's it.
You know what? Ultimately a lot of these companies will be
good companies. Many companies will employ hundreds of
thousands of people years from now.
The fact is, as I said earlier, for a moment, and I'm not
necessarily saying this is a good thing or a bad thing, but for
a moment, a short period of time, the capital markets that
historically were mature markets, were funding what I have
called and many other people have called ``second stage venture
capital businesses.''
Chairman Baker. I agree with you.
Mr. Hymowitz. There's nothing wrong with that.
Chairman Baker. We don't have a dispute about that. My
point is that there was no public discussion that we were into
venture capital as opposed to long-term investments. When a
dot.com only lost 6 cents instead of seven, they were rewarded.
And when a brick and mortar, who has a 50-year history of
profitability, made 6 cents instead of 7 cents, they were
hammered.
I can't explain that either.
My point is that the rational, calm voice in the midst of
turmoil should be the analyst.
Mr. Hymowitz. Mr. Chairman, could I just comment on that
last thing.
I actually respectfully disagree with you that we weren't
warned. We were of course warned. Any investor should have just
picked up the prospectus and read it, and all you had to do is
look at the financial statements of these companies, and you
would have seen the warnings.
You would have seen that these companies were profitless.
There were plenty of warnings out there that these companies
that were being funded were immature, often very young
companies.
Chairman Baker. I respectfully understand your disclaimer,
but it would take someone fairly committed and fairly clever to
read through the 86 pages of disclaimer. It's the only thing
that I've seen that's more complicated than the first mortgage
loan closing document package. That is not a reasonable man
standard.
What I'm saying to you is the reasonable man, the working
family was providing the capital for all this wonderful
activity. The analysts comfort him and say, yes, I think in the
long haul, you know, don't buy for today, buy for the long
haul. It will be a wise investment. They did.
And when things go south, understandably, the investor is
disturbed.
But if the analysts had done the job at the outset in
saying, look, this is a ten percent shot. If you want to do it,
I'll be happy to service your account, but I would strongly
recommend you get over here with this long record. It'll be
slower growth, it'll be more stable growth, less risk. And I
don't think a lot of those conversations were held is my
concern.
Mr. Castle, I'm sorry I've taken so much time.
Mr. Castle. I'll try to be brief too.
If this was asked, somebody cut me off because I had to be
out of the room for a little bit.
But, Mr. Tice, you apparently in your testimony, according
to our staff, cited the tremendous competitive disadvantages
that independent research firms actually face.
I think a few of them, such as where is the revenue coming
from and whatever, and I can think of a few of them.* But if
people who are investors believe that Wall Street firms are not
giving good advice, then why don't the market forces send more
people to the outside. Why don't the market forces sort of rise
up and say, you're not giving us good advice. We have to look
someplace else for it. And give the independent firms greater
strength than they presently have. What's the marketing problem
there. I don't follow the dynamics of all that.
Mr. Tice. One of the issues there, Congressman, is the fact
that we believe that Wall Street research should be priced.
Currently, Wall Street research is essentially being given away
in order that the big investment managers could have access to
their trading, to their IPOs, and so forth.
Therefore, it's very difficult for a small, independent
firm, such as mine, to be able to garner fees and commissions
in order to get paid. It's very easy to continue to get the
First Boston, the Goldman Sachs, and Merrill Lynch research,
because it's essentially free.
What we would like to see occur, and we've pointed this out
in our solution to a very complicated issue that I can't get
into today, is to have Wall Street price their research.
Mr. Hymowitz. Can I just make one comment?
Wall Street research is priced. You do not get Wall Street
research if you're a client or an institutional money manager
unless you have some relationship with the bank in the form of
commissioned business. There's a price you pay for it.
Mr. Castle. Just a final comment. We are sitting here
talking about analysts and Wall Street firms, and securities
firms, and whatever. But the average person out there is
usually dealing with a broker who is then handing them that
information. They don't know who the analyst is. They don't
even know if the firm that's handing them the information is
the one who did the analysis or whatever it is.
There's sort of a disconnect here between what happens in
public and what we're discussing.
Mr. Glassman. Not only that, Congressman, they are dealing
in many cases with mutual funds. Forty percent of Americans own
mutual funds. Three trillion dollars are in equity funds, and
these are professionals who are getting advice from lots of
sources.
I don't think we need to have laws passed to protect these
professionals.
And also let me just say, I really think it's important to
put in perspective what has happened in the markets over the
last few years.
Over the last 5 years, the stock market as a whole has gone
up 120 percent despite what happened in the year 2000. The
NASDAQ, which is the high tech index, has just about tripled
over the last 10 years.
So the idea of passing legislation, which in fact, if it's
the wrong kind of legislation, will have a devastating effect
on the market itself, because of a problem that has occurred in
stock prices over the last year, I think that may be going a
little bit too far to say the very least.
Mr. Castle. I'll close with this. I don't disagree with you
perhaps, at least at this point, in passing any kind of
regulatory legislation or anything of that nature with respect
to Wall Street research or whatever, but I remain adamantly
convinced that you have not made the case that we have unbiased
research on Wall Street.
I think a lot of the conflicts and problems that have been
mentioned at this hearing do exist, and I think it is up to you
all, meaning the broad securities industry as a whole, to
really take a good look at this.
I think factually that can be demonstrated and I believe
something has to be done, maybe away from Congress, but
something should be done.
I yield back.
Chairman Baker. Thank you, Mr. Castle.
For the record, Mr. Glassman, I don't think anyone today is
suggesting further legislation on the matter. This is an
opportunity to share thoughts and hopefully see some positive
results without legislation.
Mr. Kanjorski.
Mr. Kanjorski. Mr. Hymowitz, you made some interesting
comments about reading the prospectus, the profit-and-loss
statement, and the balance sheet of some of these corporations.
You suggest that people are able to ascertain and make a
judgment on their own.
Unlike Congressmen, you probably spend more time at the
club than you do at the gas station. We are about to decide a
public policy on whether or not Social Security should be
invested in the stock market. The proposal would allow people
to have the voluntary election to do that.
There are about 150 to 160 million workers covered by
Social Security. If you know something about the statistics on
level of education, I think it is more than 20 percent of the
American population that is functionally illiterate. That would
be 35-, 40-million adult Americans that cannot even read and
understand what would be in a business prospectus.
I hope therefore, people are listening to this broadcast
that are going to be deciding whether or not we should open up
Social Security money to go into private accounts managed by
private individuals for investments. In part of your testimony,
I was under the impression that we were going to have a very
high standard of professionalism. You should have taken into
account one out of four people's total incapacity to understand
and comprehend these things. Without the professionals of Wall
Street, they would not have to.
But you are telling me, you are saying to all Americans
now: It is up to you to understand these things, to read these
statements, and to comprehend these statements. So the
Congress, under that argument, should say look, we know there
is more than 20 percent of the population that is functionally
illiterate, who cannot even read and fill out an employment
form, much less read a prospectus.
Should we not protect them and say that is the craziest
issue in the world? Are you not one of the greatest witnesses
against privatizing Social Security?
Mr. Hymowitz. Congressman, let me answer the question. What
I was responding to was Chairman Baker's question about why
wasn't the public informed when the capital markets switched,
in some respects, to start funding secondary venture capital
companies, young, immature enterprises.
And my answer was that prospectuses that this Government
requires companies to file hopefully are meant to be read. And
the individual who does not want to spend time and the effort
to read the prospectus then should do what millions and
millions of Americans do every day, and that is give their
hard-earned investments to mutual fund companies to index
funds, to brokers, to money managers to hedge funds.
Look, I don't know anything about automobiles, so if I go
in and I attempt to figure out what car to buy, I'm going to
get some expert advice on what kind of car I should buy.
Mr. Kanjorski. The average American does not do that. He
does not hire an engineer to evaluate an automobile. I do not
know where the heck you are living, but you are not going to
the gas station to which I go to pump my gas. I talk with
people every day.
I want to give you an anecdote. In a coffee shop 2 weeks
ago, I saw a friend of mine, injured seriously on his job, and
who settled out his Workman's Compensation case at $250,000
about 3 years ago. He got caught up in the hysteria of the
stock market, and made some investments in early IPOs. These
stocks really ran up at first.
He thought Christmas had now arrived 365 days a year. That
$250,000 is, however, now worth less than $19,000. When he told
me what he was doing, I could not believe it. I recommended
against it. I said, ``Don't you ever play this game with this
money. This is your livelihood.'' But he could not resist that
temptation. Everybody else was doing it.
Mr. Baker made the point. Having all my 401(k) in
Government securities, I have to say over these last 5 years,
sometimes I have kicked myself when I look at that bottom line,
and I look at my neighbor's bottom line. But knowing that I
neither have the time nor the expertise, I just cannot. I may
also have a conflict of interest, so I just stay out of it.
But there are an awful lot of American people who are not
capable of doing that. We try to open up hope and opportunity
to everyone, and there is not any question, as I said in my
opening statement, that the American capital markets are the
envy of the world. We are not trying to cast aspersions on all
analysts, even the majority of analysts, and certainly not on
all investments.
I know these people. They are mostly exceptionally
talented, bright, and highly ethical. Do they police everything
or are mistakes made? Yes. But our problem is that we have to
respond and try to protect in some way, even the foolish and
the functionally illiterate. What I think we are asking this
panel to do, and the industry to do, is put your heads together
and come up internally within your industry with standards that
are acceptable, and enforcement that is acceptable. We need
standards that leave us with the belief that the markets are
being handled by people that are credible with integrity, and
not to the disadvantage of the average person.
And if we cannot do that, I agree with my colleagues: there
will be a time when either the regulator, or this Congress,
will act precipitously if conditions continue.
Chairman Baker. Thank you, Mr. Kanjorski.
If no other Member wishes to ask a question of this panel.
Congressman Shays.
Mr. Shays. Mr. Chairman, I consider this a very important
hearing and I was chairing the National Securities Subcommittee
and I just apologize for missing what I was told was an
outstanding dialogue with this panel and the Members and I look
forward to the next panel.
Thank you.
Chairman Baker. Thank you, Congressman Shays.
I want to thank each of you for your perspectives. I assure
you, the subcommittee will move very slowly. We are, hopefully,
not being viewed as demagoguing an important issue. We want to
understand it. We want to know how markets function, the role
of the analyst and all participants.
We would welcome your further comment pursuant to your
appearance here today. If you have answers responsive to any
Members' questions, we would welcome them.
I specifically would like further analysis on if we are to
proceed with the best practices model, in whatever form that
finally is contemplated, I feel it appropriate to have some
confirmation of compliance, whether that is by the Congress,
the regulator or some other activity by contract. But we need
to have some assurances that the standards that are being held
up, as in all other professions, there's some level of
accountability for assuring those practices are being followed.
I don't sense, from the Members of the subcommittee here
today, that we feel like we're near resolution, but that we can
reach an understanding with professional leadership from the
investment community that I think can be acceptable to all
parties, and most importantly, we all fully understand that the
huge growth in our economic ability and our quality of life in
America has been very positively effected by the activities
over this past decade.
We wish to do nothing to impair the efficient flow of
capital markets, but we also have a new political
responsibility. People who are working families that had no
access to the markets to speak of are now on-line, as we hold
this hearing, making investments because they want to have part
of this dynamic growth and that is creating a new level of
responsibility.
As I quoted earlier in the week, I said it may be one thing
for one shark to eat another; it is quite a different matter
for the shark to eat the minnows, and we're about making sure
that everyone who's in the tank has equal access to
opportunity, a free flow of information that's unbiased, that
will result in the restoration of unquestioned truth and faith
in our capital market system.
That really is our purpose and I really do appreciate your
participation. It was not easy to get folks to come and talk
about this and frankly it wasn't easy to call the hearing, but
I think we served an important purpose and I thank you for it.
At this time, I'd like to call our second panel, please.
I'm told, just as an update, we're getting to a point in debate
on the floor where we're expecting a vote within a few minutes.
I'd like to go ahead and proceed. If need be, we will
temporarily suspend. I think it may be only one vote and I can
run over quickly and be back just to give you an advisory.
We will start first with welcoming Mr. Benjamin Mark Cole,
Financial Journalist, author of the ``Pied Pipers of Wall
Street: How Analysts Sell You Down the River.''
Thank you, Mr. Cole.
STATEMENT OF BENJAMIN M. COLE, FINANCIAL JOURNALIST
Mr. Cole. Thank you, Mr. Chairman, for receiving my
testimony today. With the NASDAQ cut in half from 2000 and
Internet stocks trading for pennies on the dollar, many
Americans are asking themselves what happened.
How come no major securities house predicted you might lose
half your dough on the NASDAQ in less than a year, or lose
almost all your money on an E-toys price line, or an I-Village.
It reminds me of that old joke of the 1970s, made fresh
again by recent events. ``How do you end up with a million
bucks on Wall Street? Start off with two million.''
What the public doesn't realize yet, though it is catching
on, is that Wall Street research has become hopelessly corrupt.
Today's so-called analysts are more akin to lawyers in court.
They regard their job as one of advocacy to make the best case
why a stock is a terrific buy.
Ask an analyst if what they are doing is dishonest, and
they will answer that you don't understand their job
description.
What happened to analysis? Why does a sell signal make up
less than one percent of analysts' recommendations?
The answer lies in the way Wall Street makes money today
compared with 1975. Twenty-five years ago, Wall Street made
money in ordinary retail trading commissions which were fixed
by regulation. That environment, something of a cross between
Shangri-La and Fat City, made Wall Street a clubby place of
almost assured profits. The prized customer was a wealthy
individual or family that liked to trade stocks and the prized
employee was a stockbroker with a good book of business.
But the SEC erased fixed trading rates in 1975, an action
then fought tooth and nail by the industry, which wanted no
part of free enterprise and competition.
In the years since, if inflation is taken into account,
retail trading commissions have fallen to a penny on the
dollar.
If you look at a thrifty investor using a discount on long
brokerage for securities firms, the downward plummet of trading
rates raised a serious problem.
How do we make lots of money like we all came to Wall
Street for?
Wall Street, after 1975, had to come up with a new way to
make lots of money and they found it, happily for them in their
own corporate finance departments, also known as investment
banking.
Investment banking is the business of underwriting initial
public offerings of stock, secondary offerings, bond
underwriting, or advising companies on mergers and
acquisitions.
Increasingly, brokerages have moved upstream in the
financing cycle of companies, often providing private equity,
also called venture capital, to a company before they take it
public.
This activity can be extremely lucrative. CIBC Oppenheimer,
now CIBC World Markets, invested $30 million in private equity
into Global Crossing Limited, the Telecom giant. After the
company went public and the stock surged, that stake became
worth $4.3 billion.
Goldman Sachs invested $36 million private equity or stock
in Storage Networks, Inc., pre IPO. That stock became worth
$1.6 billion after Goldman took Storage Networks public.
Some quick numbers illustrate the changed nature of Wall
Street. In 1974, the U.S. securities industry underwrote $42
billion worth of stocks and bonds. In 1999, the industry
underwrote $2.24 trillion of stocks and bonds, more than 50
times the pre-1975 level.
Trading commissions today made up 60 percent of industry
revenues before 1975, but today make up less than 16 percent.
The simple story is this: Wall Street makes its money on
investment banking, not retail trading commissions. With this
change, came a change in who held power within the brokerage.
In days of yore, as quaint as it may seem today, the
stockbroker with his book of business was the power employee
within the brokerage. Sometimes they were referred to as
customers' men.
When an analyst wrote a report, he looked over his shoulder
at the customers' men who would hold him accountable.
Today, things have changed. Today, analysts look over their
shoulders at investment banking and trading departments, the
new profit centers.
The results of this switch in loyalty are obvious to all
within the industry, so much so that brokerage analysts are
referred to often dismissively as sell-side analysts. Perhaps
not surprisingly, numerous industry and academic studies have
found that analysts' recommendations as a group under perform
the market.
Investors would be better off tossing darts at the Wall
Street Journal than following analysts' recommendations.
Although the role of analysts has changed dramatically in
the last 25 years, their regulatory environment is little
changed from 1975 or even 1945. Analysts have safe harbor under
the law even to the extent that they can tell their larger
clients that a stock is really a dog while keeping the buy
signal on for the public. That is entirely legal.
It is even legal for analysts to tell their trading
departments that a buy signal will be out on the morrow. If the
analyst is influential, the trading department can bulk up on
the stock, and then sell into the retail demand generated by
the buy signal, all legal.
Brokerages call this ``building inventory to satisfy
demand.'' Just servicing our customers. Others might call that
a license to print money.
What is disturbing in the last 25 years is to see that many
practices once limited to regional and one-branch brokerage
shops, the so-called schlock shops have become commonplace in
Wall Street proper.
In particular, when a brokerage finances a company before
an IPO and then has an analyst issue a buy recommendation, it
is mimicking practice commonplace off Wall Street for
generations.
Some quick stabs at solutions here.
One, I would increase the budget of the SEC for enforcement
actions and beef up the U.S. Attorneys Office for securities
industry prosecutions.
Two. I would require the brokerages to create a uniform
standard for rating the accuracy of analysts' recommendations
and that analysts' batting averages, if you will, be constantly
published on an industry website maintained by the National
Association of Securities Dealers.
As an aside, I find it somewhat amusing that we know Marc
McGuire's batting average day-by-day, how many home runs he's
hit, but we don't know what the analysts' batting average is
day-by-day, yet we are investing based upon their
recommendations.
In the 1930s, the SEC examined whether brokerages should
even have underwriting and retailing operations under one roof.
It may be time to reexamine that situation.
In care and feeding of short traders, in a nut shell, allow
short traders to have contracts specifying terms for returning
borrowed shares. Short traders can be a tonic on the market.
Lastly, better mandatory disclosure of analysts' conflicts
of interest in both broadcast and print media.
Thank you very much, Mr. Chairman.
[the prepared statement of Benjamin M. Cole can be found on
page 181 in the appendix.]
Chairman Baker. Thank you very much, Mr. Cole.
The next witness is Mr. Scott Cleland, Chief Executive
Officer of the Precursor Group.
Welcome, Mr. Cleland.
STATEMENT OF SCOTT C. CLELAND, CHAIRMAN AND CEO, PRECURSOR
GROUP
Mr. Cleland. Thank you, Mr. Chairman, for the honor of
testifying. I'm Scott Cleland, Founder and CEO of the Precursor
Group.
We provide investment research to institutional investors.
We've aligned our business interests solely with investor
interests so we've avoided the common financial conflicts of
interest. We do no investment banking. We don't manage money.
We trade stocks but we never own them.
And all Precursor researchers may not own individual
stocks. We are a pure research firm because we believe that a
company cannot serve two masters well at the same time. You
can't serve investors and companies together.
We think conflicts undermine research. We think
independence improves research.
We saw a real market opportunity to be a pure research
company.
Our interest in testifying is clear. We are worried that
the powerful investment banking and trading interests that have
suffocated independence within a firm are at work within the
industry at large, and can suffocate the independent research
views at large.
That's because the firms that have conflicts control well
over 90 percent of the market for research commissions,
according to our best estimate.
So what we're calling for is more competition to conflicted
research, not less. The less regulation of pure research and
more disclosure and regulatory oversight of conflicts of
interest, the freest and the most competitive flow of
information is what best serves investors and helps the markets
operate efficiently.
A system that's 90 percent or more dominated by companies
that have inherent conflicts of interest profoundly distorts
the type of information that the market receives. We think that
more competitive research is the answer.
Recently, American shareholders and pension plan
beneficiaries lost over $4 trillion when the NASDAQ fell, and
at that time, there were only one percent of analysts
recommending a sell.
I'm not saying that the problem is the analysts. I think
they are being made the scapegoat.
The problem is the regulatory system that is favoring
companies over investors. The analysts and the firms work
primarily for companies, so it's unrealistic to expect that
they are going to bite the hand that feeds them.
So what are our recommendations for you? We have four.
The first recommendation is, encourage fuller and more
practical useful disclosures of financial conflicts of
interest. Who does a researcher work for? Is it the companies
or is it the investor.
My second recommendation is encourage the alignment of
interests, encourage research that is aligned with investment
and with investor interests.
Let me tell you a little fable in a sense. This is a
classic case of the fox in the hen house. Today, the investment
research assumes that the investor hens will be just fine in
the same hen house with the investment banking fox as long as
the regulator, the farmer, makes sure there's enough chicken
wire to keep the fox away from the hens.
My question to you is: Why not encourage more hens seeking
out hens and why does the system always encourage that a hen
must deal with a fox? It makes no sense, but that's what the
system encourages.
It encourages the hens to live right next to the fox all
the time.
Now what's my third recommendation? Reduce regulatory
barriers to people who want to do pure investment research like
we do. Do you realize that in order to become an independent
research broker/dealer, we had to be licensed and regulated and
audited to do investment banking and all the trading.
There are over 900 pages of regulations that we are
subjected to and only ten apply to research. We essentially in
the regulatory system, why you have so little independent
research is the regulatory system powerfully discourages it. We
have to take a regulatory exam called a Series 24. We took it
and we passed it.
However, it was a very difficult exam. We spent over 150
hours studying for that in order to pass it. And there were
very few questions, a very small percent that applied to what
we are trying to do in our business, which is to provide
investment research to improve investors' performance.So we
think you can do a little bit of deregulating. The last
recommendation I have is ensure a full and diverse competition
for ideas and information in the marketplace.
More specifically, watch the institutional commission
lists, because right now the folks that have 90 percent share
of those research commission lists are trying to get 100
percent. That's the reason why we're testifying here today. If
you want to have more independent research, if you want to fix
the solution, allow the marketplace to compete with conflicted
research.
Thank you for the opportunity to testify today.
[The prepared statement of Scott C. Cleland can be found on
page 184 in the appendix.]
Chairman Baker. Thank you very much, sir. We appreciate
your appearance.
Our next witness is Mr. Thomas Bowman, CFA, President,
Chief Executive Officer, Association for Investment Management
and Research. Welcome, Mr. Bowman.
STATEMENT OF THOMAS A. BOWMAN, CFA, PRESIDENT AND CEO, THE
ASSOCIATION FOR INVESTMENT MANAGEMENT AND RESEARCH
Mr. Bowman. Good afternoon, Mr. Chairman, and other Members
of your subcommittee. My name is Thomas Bowman, President and
Chief Executive Officer of the Association for Investment
Management and Research, a non-profit organization with the
mission of advancing the interests of the global investment
community by establishing and maintaining the highest standards
of professional excellence and integrity.
Thank you for the opportunity to and privilege to speak on
behalf of more than 150,000 investment professionals worldwide
who are members of AIMR or who are candidates for AIMR's
Chartered Financial Analyst designation.
For more than 30 years, CFA charterholders, candidates and
other individuals who are AIMR members have adhered to a
standard of practice that requires them, among other things, to
achieve and maintain independence and objectivity in making
investment recommendations and to always place their clients'
interests before their own.
Although AIMR members are individuals, not firms, AIMR has
succeeded in developing other ethical and professional
standards that require firmwide compliance and have been
globally adopted. Based on our experience, ethical and
professional standards are most effective when voluntarily
embraced rather than externally imposed.
To provide analysts with an environment free of undue or
excessive pressures to bias their work, we must understand that
these pressures come from many sources, not simply investment
banking activities, and not all of them internal to their
firms. None of these pressures is new, but their impact has
escalated in an environment where penny changes in earnings per
share forecasts make dramatic short-term changes in share
price, where profits from investment banking activities outpace
profits from brokerage and research, and where investment
research and recommendations are now prime time news, or as
some would say, entertainment.
Let me elaborate a bit on some of these pressures. Analysts
need to work with their investment banking colleagues to
evaluate prospective clients. Although we do not believe that
this relationship is inherently unethical, firms must have
procedures in place that minimize, effectively manage and
adequately disclose the conflicts to investors.
Firms should foster a corporate culture that supports
independence and objectivity.
They should establish or enforce separate and distinct
reporting structures so that investment banking can never
influence a research report or investment recommendations.
They should have clear policies for analysts' personal
investment and trading.
They should implement compensation arrangements that do not
link analysts' compensation to work on investment banking
assignments; and
Make prominent and specific, rather than marginal and
boilerplate, disclosure of conflicts.
Analysts also have been pressured by companies to issue
favorable recommendations. Companies have been known to take
punitive action against analysts and their firms for negative
coverage.
Some institutional clients also support ratings inflation.
Portfolio managers' compensation may be adversely affected by a
rating downgrade of a security in their portfolio.
Consequently, they may retaliate by shifting brokerage to
another firm.
These and other conflicts are discussed at length in a
position paper that AIMR will soon issue for public comment.
This paper will form the basis for the development of AIMR's
Research Objectivity Standards, which will be specific and
measurable practices addressing each conflict.
Finally, we must address how research recommendations are
communicated. Increasingly, private investors get research
recommendations through brokers, the media and the Internet.
Typical research reports are lengthy, but are often condensed
to earnings forecasts or buy, hold or sell recommendations when
communicated to the investing public. This makes a good sound
bite, but investors should know that headline ratings do not
provide sufficient information for buying or selling a
security.
Investors or their investment managers should study the
entire research report to assess the suitability of the
investment to their own situation, their own investment
objectives, and their constraints.
Although the analysts we are addressing are a small
fraction of AIMR members, and the investment profession at
large for that matter, I would like to impress upon the
subcommittee that AIMR and its members appreciate the
seriousness and also the complexity of this problem. We
recognize that the reputation of the entire investment
profession has been called into question. But a precipitous
solution is not the answer.
AIMR is committed to work with the profession to develop
effective, long-term solutions. I'll be happy to answer any
questions you may have. And again, Mr. Chair, thank you very
much.
[The prepared statement of Thomas A. Bowman can be found on
page 195 in the appendix.]
Chairman Baker. Thank you, Mr. Bowman.
Our final witness today is Mr. Damon Silvers, Associate
General Counsel, AFL-CIO. Welcome, Mr. Silvers.
STATEMENT OF DAMON A. SILVERS, ASSOCIATE GENERAL COUNSEL,
AMERICAN FEDERATION OF LABOR AND CONGRESS OF INDUSTRIAL
ORGANIZATIONS (AFL-CIO)
Mr. Silvers. Thank you, Mr. Chairman. The AFL-CIO and its
member unions--there are 13 million members--believes today's
hearings on investment analyst independence is of vital
importance to working families and their pension funds.
We would like to thank the Subcommittee for its efforts in
this area. In particular, Mr. Chairman, let me express our
appreciation to you for your concern for the interests of
working families as investors.
Defined benefit pension funds that provide benefits to the
AFL-CIO's 13 million members have approximately $5 trillion in
assets. Through 401[k] plans, ESOPs, and union members'
personal savings accounts, there are further extensive
investments in equity markets by America's working families and
union members.
Most of our members and the trustees of our pension funds
rely on a variety of professionals for their information about
the equity markets. America's working families have an enormous
stake in the accuracy of this investment analysis.
In addition, many of the largest pension funds, whose
beneficiaries account for hundreds of thousands of working
families, have placed the majority of their equity investments
in index funds. This decision is driven by index funds' lower
fees and the difficulty of obtaining consistent above-market
returns in active trading.
However, the funds who invest in indexes are placing their
trust in the transparency and honesty of our markets and have
no defense against systematic distortions such as those created
by conflicted analysis.
In that context, what are we to make of the data that's
been cited here frequently today that in December of 2000, 71
percent of all analysts' recommendations were buys and only 2.1
percent were sell?
In the remainder of my testimony, I would like to suggest
that what has happened here is the collapse of what used to be
called the Chinese Wall between investment banking and
analysis, and that only regulatory action can rebuild it.
There is substantial statistical evidence that analysts'
decisions whether or not to recommend that investors buy a
stock are influenced by whether their firm is an underwriter
for that issuer or considering becoming one.
CFO Magazine reported last year that analysts who worked
for full service investment banks have 6 percent higher
earnings forecasts and close to 25 percent more buy
recommendations than analysts at firms without such ties.
And in the last few months, analysts have been quoted by
name in the financial press saying such things as, quote: ``a
hold does not mean it's OK to hold the stock''. And, quote:
``the day you put a sell on a stock is the day you become a
pariah.''
This data is not surprising given the relationships that
have developed between analysts and the investment banking side
of the full service securities firms. It has become a common
practice for analysts to accompany teams from their corporate
finance departments on underwriting roadshows, and most
importantly, analyst compensation has become tied at many firms
to analyst's effectiveness at drawing underwriting business.
In addition, the consolidation of the financial services
industry puts issuers in a position to withhold business from
the firms of critical analysts across a wide array of markets,
including commercial loans and commercial banking services,
pension fund and Treasury money management and insurance
contracts.
For example, the same CFO Magazine article reported last
year that First Union cut off all bond trading business with
Bear Stearns in response to negative comments by Bear Stearns'
analyst, and Bear Stearns then ordered the analyst to be more
positive.
Just yesterday morning there was an account of how an
analyst report critical of the Kraft offering that was
mentioned here today was effectively suppressed by Goldman
Sachs. They had their reasons, they reported in the press. The
fact is, the report was suppressed.
On the eve of this hearing, the Securities Industry
Association announced a voluntary set of principles governing
analysts at their member firms. We would urge the subcommittee
to look closely at this code to see if it leaves room for
continued linkage of analyst compensation to investment banking
activity or continued participation by analysts in marketing
securities underwritten by the analysts' firms.
The problem of conflicted analysts is driven by extremely
powerful financial pressures, and it will not be halted or
reversed by either general statements of a desire to be honest
or subtly crafted principles that on closer examination leave
room for a continuation of business as usual.
Rather, we think Congress ought to assist the Securities
and Exchange Commission, the NASD and the national exchanges in
continuing the course toward greater market transparency and
integrity promoted by the SEC's recent regulatory initiatives.
Already in Regulation FD on selective disclosure, the
subcommittee has taken an important step toward combatting
conflicting analysts' reports. The disclosure targeted by Reg
FD gave issuers power to punish and reward analysts with
information that warped the behavior of those analysts who
actually got the selective disclosure.
Unfortunately, despite the improvements wrought by FD, we
believe that there is a need amply demonstrated by this
morning's hearing for this Subcommittee to work with the
regulatory agencies, including the industry itself, in the NASD
and the SROs to develop new regulatory approaches.
Some measures this subcommittee ought to consider and raise
with the Commission should include bars on any form of linkage
between analyst compensation and investment banking
performance. And in addition, bars on analyst participation in
marketing activities by their firms, most importantly,
underwriting roadshows.
The subcommittee should also consider whether in view of
the pressures at work here a more comprehensive ban on analysts
from issuing reports to the public on companies which their
firms are underwriters for should be appropriate. One thing
that has not come out in this discussion very much this morning
is that analysts and broker-dealers are fiduciaries for their
clients here. And they owe a duty to those people under law
currently. Unfortunately, it seems to be somewhat
unenforceable.
Working with the Commission on these new initiatives,
however, will take time. In the meantime, we think this
subcommittee would do a great deal to protect investors and the
analyst community if at a minimum it used its influence with
the SEC to protect Regulation FD and ensure it continues in its
place in current form.
In conclusion, the AFL-CIO believes the question of analyst
independence is vital for the retirement security of America's
working families. We thank this subcommittee for its work in
this area, and we look forward to working with you in the
future.
[The prepared statement of Damon A. Silvers can be found on
page 199 in the appendix.]
Chairman Baker. Thank you, Mr. Silvers.
Mr. Bowman, I'd like to start my questions with you, sir.
In your capacity representing AIMR and secondarily as to the
content of your statement, I found it most helpful. You
centered on a number of concerns that I have had, and I express
my great interest in the release of the paper, which I assume
will address all of those issues raised.
Have you had occasion to review yet the Best Practices
standard of the SIA?
Mr. Bowman. Very briefly, sir. I think they came out
earlier this week. And I had not had any advance--I had not
discussed that with the SIA prior to their coming out with it.
So I'm vaguely familiar with them, but I have not read them in
depth.
Chairman Baker. And you're not in a position to make a
comment today?
Mr. Bowman. Well, I found one thing very interesting. As I
read through those, in fact I had an e-mail from one of our
members who had seen it, and if you read through those Best
Practices, while we agree with them all, it's very interesting
to see that most of what was included in that report has been
in our Standards of Practice handbook for 35 years--analyst
independence, clients first, you know, conflicts.
Chairman Baker. I was expecting that looking at that manual
for 35 years of practice it would appear to me on first blush
from a distance of about 40 feet, it contains a bit more than
the Best Practices Standard recommended by the SIA. Is that a
fact?
Mr. Bowman. Well, in fairness it does, but there's case
studies in here too. So this is not all the standards.
Chairman Baker. Are there significant elements of its
content which you would deem advisable for the subcommittee to
consider in the application to the Best Practices of the SIA?
Mr. Bowman. Very much, sir.
Chairman Baker. What I will suggest, since I have a
suspicion this will get inordinately complex very quickly, is
to request--and I'll follow up in writing--your organization's
review of those Best Practices as recommended, and particularly
a contrast between your Manual of Best Practice and that which
is proposed to help the subcommittee better understand where
deficiencies might exist or where we find something of value in
the SIA's proposal.
At least my view, and I think the view of most Members of
the subcommittee is there is not a desire to legislate in this
matter, but we certainly want to encourage the best possible
standard to be self-implemented, but to view the best way to
confirm, as Mr. Silvers had pointed out, a way to ensure that
the conformity with the standards is in place. Is there such an
audit or enforcement provision with regard to the AIMR
standards?
Mr. Bowman. Again, sir, as I mentioned in my testimony, we
are an organization of individual professionals. We do not have
corporate membership, and therefore no authority over some of
the firms that we're talking about here this morning.
So we do have enforcement mechanisms over our members.
Chairman Baker. Right. In other words, if you find somebody
not complying with your rules, they're out?
Mr. Bowman. They're out.
Chairman Baker. But my point is that there's accountability
at least within the organization, and where there is evidence
of inappropriate conduct, there are consequences?
Mr. Bowman. Absolutely.
Chairman Baker. Well, see, that's something that's lacking
I think in the SIA proposal. There's not even the beginning
suggestion of a consequence for your failure to act
appropriately.
Mr. Cleland, did you want to jump in there?
Mr. Cleland. Yes, if I could. It's always important to put
things into context. And the SIA Best Practices, everyone
should support. I just would like to put it into context that
there's nothing really new here; that this is boilerplate.
If you look at the National Association of Security Dealers
self-regulatory manual that was first published in the 1950s,
this language would be very similar to what the preamble was
there.
Chairman Baker. So you would characterize this as not a
particularly bold step, in other words?
Mr. Cleland. This is probably a needed refresher course.
But it's been the standard for 45 years.
Chairman Baker. And by the way, just for the record, it was
stated earlier that perhaps the organization was one of the few
that had continuing education. I can confirm from my own
personal experience there. Annual education requirements for
most professional affiliations with annual testing. And I can
speak to that from only the real estate perspective. But it is
not an abnormal activity for a professional organization to
require continuing education and examination, and I think
that's highly appropriate.
Did you wish to jump in, Mr. Silvers?
Mr. Silvers. Yes, Mr. Chairman. I think that you have a way
of avoiding the dichotomy that I think you wish to avoid
between purely voluntary self-policing of the sort that the SIA
code suggests, and legislation. Congress is fortunate that in
its wisdom it created the structures of the self-regulatory
organizations and the NASD, which are industry structures,
controlled by the leaders of the securities industry who have
the authority to enact structures of accountability in this
area.
It's our view that the proper role for this subcommittee
here is to work with those bodies and encourage them to use the
authority they have to address this problem and create the
kinds of accountability, Mr. Chairman, that you are concerned
about.
Chairman Baker. Thank you. I'm going to jump to Mr.
Bentsen. I don't know how soon we'll get to a vote, but I'd
like to try to at least get Mr. Bentsen and Mr. Shays'
questions in before then. Mr. Bentsen?
Mr. Bentsen. Thank you, Mr. Chairman. let me just restate
and make sure it's clear what my opinion is on this so no one
is confused. I think there is some move here to try and treat
financial analysts in the same way that we treat auditors and
to link their positions. And I just continue to believe that
those are two different professions and we ought to be cautious
in our approach.
And in a couple of the testimonies that were given, there
seems to be an extrapolation of not just fiduciary
responsibility--and I agree that analysts, because they have
contact with investors, are required to take their Series 7 and
I don't know whatever series tests they have to take through
the SROs.
But no one yet has shown me in the law where analysts'
reports fall under the same guidelines that offering documents
for securities do in terms of providing objective disclosure.
And second of all, no one has yet fully provided for me some
widespread pattern of manipulation of the market on the part of
the analyst corps that creates some real and present problem
that needs to be addressed through regulation or legislative
action.
Now at the same time, as I said to the earlier panel, and
maybe I'll try and be less subtle, that it comes as no great
surprise to me that analysts who work for investment banking
firms or brokerage firms may well be, particularly on the sell
side, may well be trying to add in the pitch of the sale. And I
think there is a risk to the brokerage firms that they be
cautious in how subjective they want to be, because they are
trading ultimately on trust. And then if they cross that line
into what is manipulation through false disclosure, even though
they are not under the Security Act or other disclosure laws.
I mean, can anybody here give me a pattern that has
occurred? And the other thing I would just add, and I'd ask Mr.
Cole, you talk about the fact that the NASDAQ has been cut in
half from 2000, but this is not the first time we've seen
market corrections in the 20th century. I mean, you had in
1900, in the 1920s, in the 1950s. You had a brief correction in
the 1980s.
And if there's a correlation between analysts saying sell
versus hold versus buy, is it to say--I mean, how did you get
that 50 percent correction in the first place? Had they all
said ``sell,'' would it have been a 100 percent correction in
the market? Or does the market move on information other than
what analysts provide to them?
And finally, I'd just say, in many respects I think there
is a herd mentality that occurs in the market, and I think the
excess capacity of media outlets amplifying what analysts are
saying, which heretofore used to be a subscription-type
business sort of amplifies what their real worth is.
But basically, I'd like to know where is the pattern? Where
is the empirical evidence? Because I don't think that case has
been made today.
Mr. Cleland. If I could jump in, I wouldn't necessarily say
that--I wouldn't try and answer it that way. What I would say
is the entire structure, the economics, the structure, the
regulation, the compensation structures, are all mutually
reinforcing that put company interests ahead of investor
interests.
The SIA's Best Practices said the investor interest comes
first. Well, if you look through the regulation, the structure,
the economics of the industry and the compensation, it all
rewards companies over investors.
Mr. Bentsen. Now Mr. Cleland, do you support Reg FD?
Mr. Cleland. I think that Reg FD is OK. I think what it
means is that most research has to happen in a stadium, and
that generally isn't how research is done. Research is done day
by day, tough, you know, digging and getting different nuggets
at different times.
Mr. Bentsen. But wouldn't it, if we had a Reg FD, isn't
there a school--I think there's a school of thought if we had
Reg FD that when a company tells an analyst that they have a
cozy relationship with they also have to disclose to the rest
of the world. I mean, isn't that what you want to see happen?
Mr. Cleland. I have no problem with that.
Mr. Bentsen. Isn't that what we're saying in part here
today?
Mr. Cleland. Yes. And I don't think there's any--I'm not
quibbling with FD.
Mr. Bentsen. We had a hearing a week ago, or 2 weeks ago,
where some were trashing Reg FD and saying that it was going to
lead to less disclosure and contort the market and all other
sorts of things.
Mr. Cleland. And I'm not quibbling with FD. I'm trying to
tell you that there is a systemic bias toward representing
company interests over investor interests throughout the
system. And you will get biased research, because that's what
the system is geared to do.
Mr. Bentsen. In the laws governing offering documents, I
mean, issues you raise about companies taking positions, the
brokerage houses taking positions in companies that they're
also writing research for, when they are actually pitching a
stock through an offering document is a material item that has
to be disclosed in the document.
And I think what you are arguing is perhaps we need to
apply disclosure standards, legal disclosure standards to
research, which is a pretty far step to take.
Mr. Cleland. No, I'm not saying that. I think the rules as
I know them that research reports are classified as sales
material. So at least that's what the current rules do say.
They treat research as--they call it sales material.
Chairman Baker. If I can, Mr. Bentsen, I'm going to jump to
Mr. Shays, and hopefully we can release our witness panel. Mr.
Shays?
Mr. Shays. Thank you. I'm intrigued with all your
testimony. Mr. Cole, you start out very clearly and say Wall
Street has become hopelessly corrupt. And I'm interested in you
trying to give me the two or three best examples of why you
think it's hopelessly corrupt, and then I'd like a response by
the rest of the panel.
Mr. Cole. Well, when you look at a Planet Hollywood
underwriting or Playboy secondary offering and you see the
quality of research which was released in either of those
companies. Planet Hollywood went bankrupt shortly after it went
public. Or if you consider the role of analysts at a brokerage
where the brokerage actually provides venture capital to a
company, helps create the company, then takes it to an initial
public offering and the company does go public, the brokerage
itself has a stake in the company worth from hundreds of
millions to billions of dollars.
What analyst is going to come out with a sell
recommendation when the brokerage itself owns billions of
dollars of stock in that company? If the analyst's sell
recommendation only knocked 10 percent off the value of that
stock, it could hurt the brokerage to the tune of hundreds of
millions of dollars.
Mr. Shays. I'm struck by the fact, though, I don't know how
a brokerage firm does well if its analysts are constantly
telling people to do something that's not in their best
interest. I see the built-in bias, but in the end, it seems to
me that analysts----
Mr. Cole. The day of reckoning may come, as I said in my
statement. I think the public is catching on. And if you want
to be a little bit dramatic, what happens when the public does
catch on and loses faith in Wall Street?
Mr. Shays. What about all the other analysts who work for
other companies who will express an opinion about a particular
area where one company has a vested interest in? In other
words, doesn't the fact there are so many analysts out there
ultimately modify, provide additional information? So one
brokerage firm says buy and another one says sell.
Mr. Cole. I wish that it did modify it, but it seems to
magnify it since as we've heard, 99 percent of recommendations
are buy, it seems to have a reinforcing effect rather than a
moderating effect.
Mr. Shays. I guess my question is, other firms that don't
have a vested interest in it. Therefore, I don't see where
their bias is.
Mr. Cole. They may seek business in the future. They may be
owned by a commercial bank which has a commercial banking
relationship with the company in question. It never pays to
make enemies.
Mr. Shays. Let me just hear the response of others. Mr.
Cleland, I want to just say, the way you organize your
statement tells me it's based on your training as an analyst.
I'd love to show my staff how clearly you organize your
statement. It's intriguing.
Mr. Cleland. Thank you.
Mr. Shays. But I'd love you all to just respond to Mr.
Cole's comments.
Mr. Cleland. Well, I think I wouldn't use the word
``corrupt''. I would use the word ``conflicted''. I mean,
there's nothing wrong with representing companies. The problem
in the system is, is people think the system represents
investors. And the structure, the economics, the compensation
and the regulation is all biased toward helping company
interests subordinate investor interests. That's the system.
That's the problem is that it's not transparent that the system
is so skewed.
Mr. Shays. Mr. Bowman?
Mr. Bowman. With all due respect, I categorically disagree
with Mr. Cole's statement. As I think Mr. Glassman and the
earlier panel indicated, life has conflicts, as does any
business.
As I mentioned, I represent an organization of 150,000
investment professionals and I deal with thousands of
investment professionals every day, and I can tell you that in
99.99 percent of the cases, all they want is for the investing
public and for us to be able to demonstrate that these people
are honest, forthright and are putting their clients first.
In fact, since this whole issue arose several months ago, I
have probably never been inundated with e-mail, mail and fax
from members about the concern that they have and the black eye
that they're receiving over what is really an isolated set of
conflicts. And that is a relatively few number of sell-side
firms who have these potential conflicts.
So I can tell you that over 30 years of investment
practice, all the investment professionals that I've ever run
into and at least those who are members of our organization,
are honest, forthright and only interested in serving their
clients.
Mr. Shays. Thank you.
Chairman Baker. Thank you, Mr. Shays.
Mr. Royce.
Mr. Royce. Thank you, Mr. Chairman. I missed a little bit
of the testimony here, because the Investor and Capital Market
Relief Act is on the floor and I was speaking to that bill. But
I caught some of the earlier testimony.
And I have yesterday's Wall Street Journal with me here.
And I just want to read for the panel here a comment made in
yesterday's Journal: ``Investors increasingly are blaming
analysts for helping to pump up the dot.com bubble by issuing
favorable research reports in recent years on companies handing
out fat investment banking fees and not warning investors of
the problems at these companies until long after the bubble
burst.''
And what the Journal does is just give a short example
here, which I'd like you to comment on. It says: ``A week ago
Credit Suisse First Boston was appointed lead underwriter on a
new stock deal for GoTo.com, a Pasadena, California Internet
search engine. And Credit Suisse First Boston beat out Merrill
Lynch and Company for the lucrative position. A few hours
later, Merrill's high profile technology stock analyst, Henry
Blodgett, who had been bullish on GoTo.com shares, did a
turnaround on the stock. He downgraded the stock to a neutral
from accumulate.'' And the Wall Street Journal asks the
question, a coincidence? And that's the question I want to ask
you. Is that a coincidence?
Chairman Baker. If I may suggest, gentlemen, respond very
quickly, and here's the incentive. If we get through this round
of questions in time, we will adjourn our hearing. If not,
we'll come back. It's your choice.
[Laughter.]
Mr. Royce. Those types of examples. Are they a coincidence?
Mr. Silvers. Congressman, I think that if you look at the
academic studies in this area which were cited extensively in
my written testimony, you'll see that not only is that not a
coincidence, but that it preceded the bubble. That those people
at the leading business schools of this country who have taken
a look at the relationship between whether or not an analyst's
firm has an investment banking relationship with the company
that analyst is looking at has an effect on their reports, the
answer time and time again has been yes in the 1990s.
It's a matter I think of statistical proof. And in addition
to the academic studies that were done all through the 1990s
that are in my testimony, the Journal had reports yesterday on
a study that showed someone who followed the recommendations of
conflicted analysts would have had a 50 percent grater loss
than one who did not. And furthermore, there was a study in CFO
Magazine that I mentioned earlier. And there is to my knowledge
no contradicting studies.
I think that there is ample data for the proposition that
you're asserting here and that regulators' inaction, frankly,
at this point is inexplicable to me.
Chairman Baker. If I may suggest, we're down to probably a
couple of minutes left, Mr. Royce on the vote.
Mr. Royce. Thank you, Mr. Chairman.
Chairman Baker. Thank you very much. I would enter into the
record, Mr. Silvers, the document you were referring to is the
Investars.com study in which 53.34 percent--investors lost an
average of 53.34 percent when they followed analysts employed
by firms as opposed to independent analysts lost 4.24. Now both
were losing. I mean, there's nothing to brag about in this
message. But the point is that it seems to have been
exacerbated by the affiliation.
To that end, I think the testimony given here today has
been very helpful.
I'm sorry, Mr. Bentsen. Very quickly.
Mr. Bentsen. If I could clarify very quickly, on a point
Mr. Cleland made, talking to counsel, the 33 Act for disclosure
purposes does not cover analysts' reports. And I think we're
again being very confused here that analysts' reports are not
offering documents. And at the end of the day, people who are
buying stocks and bonds should read the offering document where
the disclosure is in and we are now extrapolating that,
expanding that to cover analysts reports. And I think we need
to think long and hard before we make that assumption.
Chairman Baker. We're down to a minute, Mr. Bentsen. And I
don't dispute your point. Investors should have some
responsibility. But this complicated matter, I hate to close
our hearing in this fashion, but I must. We will address the
remaining issues in hearings that are yet to come. I would
welcome your written comments and suggestions, and certainly
Mr. Bowman, I eagerly await the findings of the paper and look
forward to working with each of you toward appropriate
resolution.
Our hearing is adjourned.
[Whereupon, at 1:25 p.m., the hearing was adjourned.]
ANALYZING THE ANALYSTS
----------
TUESDAY, JULY 31, 2001
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance,
and Government Sponsored Enterprises,
Committee on Financial Services,
Washington, DC.
The subcommittee met, pursuant to call, at 2:05 p.m., in
room 2128, Rayburn House Office Building, Hon. Richard H.
Baker, [chairman of the subcommittee], presiding.
Present: Chairman Baker; Representatives Castle, Royce,
Oxley, Fossella, Toomey, Kanjorski, Bentsen, J. Maloney of
Connecticut, LaFalce, Sherman, Inslee, Moore, Gonzalez, Ford,
Hinojosa, Lucas, Shows, Crowley, Israel.
Chairman Baker. I'd like to call this hearing of the
Capital Markets Subcommittee to order. I'm advised Members are
on their way to the subcommittee, but to try and keep our
proceedings on a timely basis, I will open our hearing.
This is the second in a series, and I expect a long series
of hearings over the concerns of market practice and the free
flow of unbiased information to investors.
Many people have expressed concern over the under-
performance of the market over the last few weeks, and
individual investors have seen portfolios shrink rather
dramatically. That is not the basis on which the subcommittee
conducts its review today.
As always, investors have the ultimate responsibility to
make their own determinations based on their own best judgment.
However, it has become increasingly clear that market practices
are not what they used to be, and, in fact, there will be
today, I believe, testimony to indicate that the scope of
concerns the subcommittee has had are fully warranted and, in
fact, may be more pervasive than originally contemplated.
The purpose of the hearing will be to determine the breadth
of those problems and to begin the initial process of assessing
the appropriate steps that are responsive to the problems that
are identified. As everyone is aware, we have appointed a peer
review committee which now has under advisement the best
practices standards as issued by the Securities Investment
Association, (SIA).
It is our hope that with the information provided in the
hearing today, that we can properly assess the effectiveness of
those rules and determine what enforcement mechanisms may be
appropriate in light of the difficulties that have been
determined to date.
I'm particularly grateful for those who are participating
on today's panels. There's pretty clear agreement among all the
witnesses as to the fact that a problem exists. I suspect there
may be some differing opinion as to the remedies that might be
appropriate, but I very carefully reviewed all the witnesses'
testimony and think the hearing today will be very helpful for
the subcommittee in understanding what will be an appropriate
remedy to our concerns.
To put a fine point on that process, the subcommittee will
conduct a hearing in the fall, after the August recess. We will
develop recommendations for the industry to consider, and we
will develop a mechanism by which those recommendations can be
verified as to the level of compliance.
However, I should make it fairly straightforward, at least
in my opinion, that should there not be an appropriate or
adequate response by the industry to the identified public
policy concerns, I am not turning my back on the question of
providing a legislative remedy should we fall short of
achieving the desired goal.
With that, I would like to recognize Mr. Kanjorski, the
Ranking Member, for his opening statement.
[The prepared statement of Hon. Richard H. Baker can be
found on page 209 in the appendix.]
Mr. Kanjorski. Thank you, Mr. Chairman.
We meet today for the second time to consider the issue of
analyst independence, a subject of great significance to our
Nation's capital markets. Increasing the transparency of
analysts' work should make it easier to detect faulty research
and should enable investors to more easily evaluate the
differing views of analysts who cover a particular stock.
Increased transparency should also help restore confidence
in Wall Street's research. Since we last met on this subject in
June, a number of developments directly affecting the subject
of analyst independence have occurred.
Therefore, I will summarize some of these events before we
begin today's hearing. First, the National Association of
Securities Dealers (NASD) recently proposed changes to its
disclosure rules. These amendments propose, among other things,
to include common stock as a financial interest that firms and
analysts must disclose.
More importantly, the proposal would also require
abbreviated disclosures during public appearances on radio and
television shows. When implemented, these changes should help
retail investors to better understand analyst conflicts.
Officials with the NASD have also personally assured me
that this rulemaking is not the last step that their
organization will take to enhance analysts' capabilities. A
number of securities firms have additionally announced
revisions of their existing policies to manage analysts'
conflicts. These changes exceed the recommendations for best
practices announced by the SIA at their last hearing.
For example, Merrill Lynch, Edward Jones, and Credit Suisse
First Boston have announced plans in July to prohibit their
analysts from owning securities in companies they cover in
their research. In the coming weeks, I expect other firms will
follow the lead of these companies by announcing changes in
their own policies and practices designed to increase the
independence of research.
Furthermore, the Nation's largest brokerage firm announced
that it has agreed to pay $400,000 to a pediatrician in Queens,
New York. This doctor claimed that he lost more than one-half
million dollars following the advice of his broker who
regularly cited the bullish research of a prominent Wall Street
analyst.
Although this settlement establishes no legal precedent by
itself, it does raise important ramifications for the brokerage
business, especially if other investors, in the weeks and
months ahead, pursue similar cases.
I predict that just one or two more settlements of this
type will create an incentive for the investment banks to take
further action to improve the quality and trustworthiness of
their research. Although each of these actions demonstrates
that the marketplace has begun to self-regulate on the issue of
analyst objectivity, we must still do more.
Mr. Chairman, in the week since our last hearing, the
debate has intensified about whether we should privatize Social
Security. Social Security presently covers about 160 million
persons. Because more than 20 percent of the adult American
population is functionally illiterate, we can estimate that
about 35 to 40 million Americans cannot read or understand a
business prospectus. Yet, we would be asking these very same
individuals to make decisions about their retirement funds
under Social Security privatization schemes. If they cannot
read and comprehend a business plan or an accounting statement,
it seems likely that many of these individuals would become
reliant on the advice of Wall Street researchers when making
their investment decisions.
Therefore, industry has an obligation and a responsibility
to comprehensively address the issue of analyst conflicts and
resolve all related concerns before we begin any public policy
debate on the future of Social Security.
With that said, Mr. Chairman, today's hearing will further
our understanding of the nature of this growing problem and
help us to discover other actions that might restore the
public's trust in analysts.
As you know, I generally favor industry solving its own
problems through the use of self-regulation whenever possible.
And I was pleased to join you in recent weeks in creating a
review board to assess the adequacy of the industry's reform
proposals. I will also listen carefully to today's testimony
and continue to encourage our subcommittee to move deliberately
on these matters in the months ahead.
As I advised at our last hearing, we should not demagogue
on the issue of analyst objectivity to score political points.
Only cautious action on this subject will help to ensure that
our capital markets remain strong and vibrant.
In closing, analyst independence is an issue of the utmost
importance for maintaining the efficiency of and fairness in
our Nation's capital markets.
Thank you, Mr. Chairman, for having this hearing today and
raising these concerns.
[The prepared statement of Hon. Paul E. Kanjorski can be
found on page 217 in the appendix.]
Chairman Baker. Thank you, Mr. Kanjorski.
Chairman Oxley.
Mr. Oxley. Thank you, Mr. Chairman. I commend you for
holding this important hearing, part of a series of hearings on
issues of Wall Street research practices. These practices have
come under fire in the past year for some good reason. As we
learned at our first hearing on analysts last month, and as
even the trade group for analysts acknowledged, conflicts of
interest do pervade Wall Street's research machine and taint
the recommendations of equity analysts.
There's one reason institutional investors pay little
attention to sell side analysts, relying on their own research
professionals instead.
Robert Sanborn, a former portfolio manager of the Oakmark
Fund says that anyone who follows a recommendation from a sell
side analyst is an absolute fool. Most investment advisors
caution investors to consider analysts' recommendations not as
definitive in any way, but rather as a single factor in making
a buy or sell decision. That is good advice, but even as a
single factor in an investment decision, an analyst's
recommendation should, at the very least, be free from the
taint of bias.
The financial media has played an important role in
elevating the profile of Wall Street analysts. Mary Meeker and
Henry Blodgett are now familiar names to a large number of
American investors. Many have criticized the news media for its
failure to hold analysts accountable for wildly wrong
predictions. I would urge the news media to require sources to
disclose whether they hold any interest in stock, long or
short, and whether their firms have business relationships with
the company. Then let investors weigh that information. Some
news media already take these steps, but it should be
universal.
Having said all that, as a free market Republican, I am
loathe to legislate in this area. My preference is for industry
to clean up its own mess. I'm encouraged by steps that some
companies have taken to address the issue. I will continue to
work with the industry to make sure sufficient steps are being
taken to resolve the problems and to restore confidence in Wall
Street research practices.
This subcommittee has established a peer review board of
industry practitioners, money managers, academics, and
regulators to comment on the industry's proposals for reform.
That group will present its findings to the subcommittee at a
hearing this fall.
I look forward to our distinguished witnesses today who
will provide new perspectives on the issue including
Commissioner Laura Unger, the Acting Chairman, who has done
considerable work on this matter as Acting Chairman of the
Commission, and on our second panel, a variety of esteemed
experts in research and investment banking, and the financial
media.
Welcome, Ms. Unger, it's good to have you back before the
subcommittee.
Mr. Chairman, I yield back the balance of my time.
[The prepared statement of Hon. Michael G. Oxley can be
found on page 225 in the appendix.]
Chairman Baker. Thank you, Mr. Chairman.
Mr. LaFalce.
Mr. LaFalce. Thank you very much, Mr. Chairman. And thank
you, Mr. Kanjorski, for the fine work the two of you have been
doing in the hearings you've had thus far on these very, very
important securities issues. They, along with the many meetings
that I've had with market participants and regulators and
academics have increasingly convinced me that analyst conflicts
have seriously eroded confidence not only in the capital
formation process, but in the way stocks are evaluated by
investors who seek objective advice in a very complex
marketplace.
It's also become clear to me that the analysts have a role
in boosting and supporting the stock price of certain
companies. That is but one piece in a series of activities that
contributed to the market exuberance of the late 1990s and the
early months of this century. We must redress these practices.
The centrality of the market, as both the measure of a
company's success and a fundamental source of wealth creation
for insiders especially, has tilted companies' attention toward
their stock price and away from the fundamentals of their
business.
Executive compensation is now most often intertwined deeply
with the performance of a company's stock. The stock price, in
turn, is very much affected by the expectation of the
securities analysts and the investor community. Companies live
and die by meeting analysts' predictions each and every
quarter. Missing the estimates by as little as a penny can send
a company's stock price plummeting, even when there has been no
substantive change in the firm's condition or prospects.
Since the last hearings, the SIA, in an effort to stem the
public and vocal tide of criticism, released its voluntary
guidelines, and shortly after its release much of the industry
claimed they were already following these guidelines.
In response, Ms. Unger was quoted in the press as saying
that this would, quote: ``Suggest that perhaps the guidelines
need to be enforced more stringently.'' Perhaps so, if you can
enforce guidelines.
In any event, shortly following those remarks, in a very
positive but telling step, Merrill Lynch, Credit Suisse First
Boston, amongst others, barred their analysts from owning the
stocks that they cover. Now I think that was a clear indication
that something was very wrong. I also think it's a clear
indication that the wrong can be righted. As a result, I've
communicated with Ms. Unger, and the NASD on two occasions to
call for a rulemaking that goes beyond the enhanced disclosure
recently proposed by the NASD to amend Rule 2210.
We know that the role of the analyst is both a mechanism to
win business and a voice to speak objectively about the
business fundamentals of the companies they cover. This advice
is relied upon by small investors and by large investors alike.
What is at risk is often a person's entire future, a
person's retirement, a person's financial security, a person's
fortune. Conflicts are not simply facts to be disclosed.
Conflicts of interest undermine the objectivity of the analyst
and the efficacy of the work that they do.
Like any profession that requires trust by the public,
conflicts need to be minimized or eliminated, not simply
disclosed. Therefore, I have suggested to Ms. Unger, and I
invite her to respond today, if not on behalf of the Securities
and Exchange Commission (SEC), on behalf of Laura Unger
personally, to the following recommendations.
First, to affirm through regulation the actions of
companies such as Merrill Lynch and Credit Suisse by banning
securities analysts from owing or having an interest in the
stocks that they cover.
Second, to engage the academic community, the NASD and
market participants to arrive at a workable construct that will
alter the present compensation structure of analysts to
separate analysts' compensation from their investment banking
function, and reward them based on the quality of their
research.
Third, to require securities firms to disclose on each
research report or recommendation, how many issuers they cover,
and an aggregate breakdown by category of the ratings assigned
to these issuers. For example, xyz investment firm covers 200
public companies. Of these companies, 50 are strong buys, 100
are buys, 49 are holds, and one is a sell or two are sells or
three or four or whatever it may be. But that might put the
recommendation in perspective.
I made additional suggestions to the Commission in late
June following this subcommittee's first hearing. Without
objection, I would ask that they also be made a part of the
record.
Chairman Baker. Mr. LaFalce, without objection, but I hate
to ask if you could begin to close.
Mr. LaFalce. Yes, I do support many of the modest changes
supported by the NASD in its proposed rulemaking. But I'm
increasingly concerned that industry self-regulation may not be
sufficient and that more disclosure of these conflicts in
itself will not suffice to protect the American investor.
So I urge the regulators to act quickly to eliminate these
conflicts, because if the regulators do not, Congress must.
[The prepared statement of Hon. John J. LaFalce can be
found on page 219 in the appendix.]
Chairman Baker. Thank you, Mr. LaFalce.
I go next to Mr. Bentsen.
Mr. Bentsen. Thank you, Mr. Chairman.
Ms. Unger, it's good to have you and the rest of our panel.
Mr. Chairman, I appreciate that you are having the second round
of hearings on this important issue, and I think the panel that
you have today, Ms. Unger from the SEC, and our other, broader
panel will be very helpful for both the Congress as well as the
public, who is watching this, to get a better understanding of
both how the process of research analyst works as well as what,
if any, the response from the Federal Government should be.
However, I would caution my colleagues, and I would caution
the Securities and Exchange Commission to be careful in our
attempt to, as we look for a culprit for the collapse--or I
don't want to use the word collapse--but the rapid decline in
the value of certain markets, that we shouldn't try and go and
pin it, in this instance, on the case of the research analyst
and try and sterilize the research business.
I would remind my colleagues that on the books we have
existing securities laws, existing disclosure laws which,
whether or not people are actually looking at what is being
disclosed, is something that we should not ignore.
Second of all, I think we have to be realistic and
understand that this is a problem that the industry not only
has a responsibility to the general public, but has a
responsibility to their own shareholders and their own partners
to fix. I think that any firm which gains a reputation of
irrational research will soon find that reflected in their
bottom line.
So I would hope that we gather as much information as we
can, but that we proceed very cautiously in this approach, and
that we do not try to equate the research business in the same
way as we might equate the auditing business. Because, in this
Member's opinion, those are two very, very different things.
I thank the Chairman for calling this hearing.
Chairman Baker. Thank you, Mr. Bentsen.
Mr. Fossella.
Mr. Fossella. Thank you, Mr. Chairman.
To follow up on my colleague, Mr. Bentsen, it's a great
thing that more Americans have become investors. I think it's a
healthy thing. I think what is important, as well, is to remind
all Americans who want to become investors that it's in their
interest to become educated for their own good.
We acknowledge the critical role I think that research
analysts play in developing the markets and maintaining the
integrity of the markets, and ultimately providing a service
not only to their companies and firms, but to ordinary
investors across this country.
I think that what's happened in the last several weeks is a
positive thing, that is, the industry, I think, has identified
that there seems to be a problem. While the vast majority of
individuals who work for these firms I think are of the utmost
integrity, they have to comply with their own firms' standards,
and deal with the SEC, among other regulatory entities, to
comply with the law, there seems to be a strong belief that
something needs to change.
Some firms I think initially have thought that the best
practices in events recommended by the SIA are necessary. It is
healthy and good that some firms have said, no, I think we need
to make some changes and modifications to our practices.
What's left to be asked, however, is how much time should
the industry have in order to change the way they go about
these practices. There are different firms. Each firm has a
different standard. How is it that the SEC is going to look
upon the implementation of these best practices to ensure that
as many firms as possible, if at all, are going to comply? You
look at a Merrill Lynch, it has a different standard than a
First Boston and a different standard than Salomon.
I think over time it's up to the SEC to put a timeframe on
those, is it 3 months?; is it 6 months?; is it after bonuses
are given in December, to see if these things are working?
I share Mr. Bentsen's views, and I believe my other
colleagues who have said let's not jump to legislative remedies
for this, because ultimately it's up to the investor to beware.
But there is a degree, and a large degree of questions at stake
with those few research analysts who compromise not only
themselves, but their firm's integrity, as well as that of the
individual investor.
There are going to be conflicts always. There's no question
about it. You have the responsibility, and I think you would do
well to ensure that those conflicts and compromises are kept at
a minimum. As the market decreases, it did so rapidly in less
than a year, people are going to start pointing fingers and
looking for someone to blame.
I don't think that's the right thing to do in the long
term. The right thing to do in the long term is to bring all
these firms as close as possible to the best practices as
recommended by the SIA and try to take another snapshot, in say
6 months' time to see what's happened. But the rush to judgment
may just be a big mistake.
I yield back.
Chairman Baker. Thank you, Mr. Fossella.
Does any other Member have an opening statement?
[No response.]
Chairman Baker. If not, it would be my intention to recess
pending the floor, Ms. Unger. I'll come back very quickly. My
best guess is that that will take me about 10 to 12 minutes,
and then we'll get started.
Thank you very much.
[Recess.]
Chairman Baker. I'd like to reconvene our hearing. We had
two votes instead of one so we were detained a little. The
other Members will be returning as soon as possible.
I'd like at this time to recognize our first witness for
today's hearing, The Honorable Laura Unger, Acting Chairman of
the Securities and Exchange Commission, certainly no stranger
to the subcommittee.
Welcome, Ms. Unger.
STATEMENT OF HON. LAURA S. UNGER, ACTING CHAIRMAN, U.S.
SECURITIES AND EXCHANGE COMMISSION
Ms. Unger. Thank you very much, Chairman Baker, and others
who may be returning to the hearing. A lot of what was said
really resonated with me, and I think you'll find that what I
say today will resonate with you.
I thank you for the opportunity to address the subcommittee
today concerning analysts' conflict of interest. The Commission
commends the subcommittee for its continued attention to this
important issue. I thought I would spend my time this afternoon
addressing three issues.
The first is, what conflicts affect analysts and why do
these conflicts exist? The second is, what have we observed
about analyst conflicts as a result of our staff's recent exams
of brokerage firms? The third is, what is being done to address
these conflicts?
Before I turn to these particular questions, I think a
preliminary remark is in order. It is fair to say, as others
have said today, that it has not been a banner year for
analysts. The profession has been the subject of intense public
scrutiny. In many respects, analysts are a victim of their own
success. The longstanding bull market and the record number of
Initial Public Offerings (IPOs) made research--and the positive
impact on stock price that research could have--a basis on
which investment banking firms competed for underwriting
business.
But I think it's important for us not to lose sight of the
important role that analysts play in our securities markets. As
the Commission recently stated, in adopting Regulation Fair
Disclosure (FD), analysts provide a valuable service in sifting
through and extracting information, the significance of which
might not otherwise be apparent to the ordinary investor.
We should also not forget that the overriding majority of
analysts operate on the highest ethical plane. In other words,
the issue of analysts' conflicts is largely structural and not
personal.
With that preface, I will begin by identifying a few of the
more acute conflicts. Most stem from the blurring of the lines
between research and investment banking that I just alluded to.
This blurring can be seen in a number of ways. First, an
analyst's salary and bonus may be linked to the profitability
of the firm's investment banking business, motivating analysts
to produce favorable research that will attract and retain
investment banking clients for the firm.
Second, at some firms, analysts are accountable to
investment banking for their ratings. Third, analysts sometimes
own a piece of a company that they cover, mostly through pre-
IPO share acquisitions.
SEC staff has conducted on-site examinations of several
full service brokerage firms, focusing on analysts' conflicts
of interest. The staff, in its examinations, selected nine
firms that underwrote significant numbers of IPOs, particularly
internet and technology-related IPOs. These examinations
focused on the three areas that I just mentioned: compensation
arrangements; analysts' accountability to investment banking;
and analysts' financial interest in companies they cover.
Today, I will share with you some of the preliminary
observations. The first is that the line between research and
investment banking, has indeed blurred. Seven of the nine firms
inspected reported that investment banking had input into
analysts' bonuses and the analyst hiring process. In at least
one of those firms, 90 percent of the analyst's bonus is based
on investment banking revenue.
The staff inspections found that the investment banking
department does not formally supervise the research department,
but that analysts assist investment banking by consulting on
IPOs, mergers and acquisitions, participating in pre-IPO road
shows, and initiating research of prospective investment
banking clients.
Second, interviews with former analysts revealed that it
was well understood that they were not permitted to issue
negative opinions about investment banking clients.
Third, about one-quarter of the analysts inspected owned
securities in companies they covered.
The staff found that 16 of 57 analysts reviewed made 39
investments in a company they later covered. All of the
investments were pre-IPO. Moreover, the examiners found that
three of these analysts traded contrary to their research
report recommendations. Examiners also found that in 26 of 97
lockups reviewed, research analysts may have issued ``booster
shot'' research reports. These reports reiterated buy
recommendations shortly before or just after the expiration of
the lockup period.
As you know, a lockup is the time period during which
insiders and others who have obtained pre-IPO shares are
prohibited from selling those shares. In each of these
instances, the firms underwrote the IPO of the company in which
the firm's analysts owned stock. So, you may ask what is being
done to address these conflicts?
As has been noted today, the industry, the Self Regulatory
Organizations (SROs), and the Commission have taken action to
improve the objectivity and independence of research analysts.
Both the SIA and the Association for Investment Management and
Research recently issued a set of best practices in this area.
These best practices provide a basis or foundation for on-going
discussions about managing conflicts.
Firms are reviewing their internal policies and procedures.
Several securities firms have already taken some initiatives to
revise their existing policies and procedures to manage
conflicts. As reported in the press, at least three securities
firms have recently adopted policies that prohibit analysts
from owning securities in companies they cover.
The NASD recently proposed for member comment changes to
enhance and harmonize its conflict disclosure rule. The
Commission has two roles in managing analyst conflicts. The
first is making sure that disclosure is adequate and effective.
The second is educating investors.
So far, we have worked with the SROs to improve and more
diligently enforce the disclosure of conflicts of interest. Our
Office of Investor Education and Assistance has also issued an
Investor Alert to explain to investors exactly what conflicts
analysts may face and how investors should interpret
disclosures about these conflicts.
I believe investor education is particularly vital to
managing analyst risk. I say this because we can really only
manage the conflicts. Some conflicts will always exist, such as
pressure from institutional investor clients protecting their
portfolio value, and pressure from issuers who put analysts in
the dog house for downgrading their stock.
It is my hope that with a little help from the regulators,
the industry will resolve these issues. The recent industry
initiatives are a step in the right direction. But I would be
remiss, especially as a former enforcement attorney, if I did
not emphasize that the industry and the SRO initiatives will
only succeed with vigorous enforcement.
The SEC staff inspections revealed that firms had policies
on the books that were virtually ignored and rarely enforced in
practice. For example, one firm approved an analyst's pre-IPO
investment 3 years after the fact. In another example, only one
firm could identify accurately all pre-IPO investments by
analysts. This situation cannot continue. The firms, the SROs,
and the SEC must work together to ensure that we have
information with integrity out in the marketplace.
I look forward to continuing this partnership. Thank you,
Mr. Chairman. I will now be happy to answer any questions.
[The prepared statement of Hon. Laura S. Unger can be found
on page 227 in the appendix.]
Chairman Baker. Thank you very much. I was optimistic that
your testimony would satisfy all the concerns of the
subcommittee and I think you've done an outstanding job of
energizing the subcommittee's concerns.
Ms. Unger. Thank you.
Chairman Baker. There is considerable content to your
testimony that I would like to question you about, but I'm
going to focus on two or three things that I think are
particularly disturbing.
Examiners found that three analysts executed trades for
their personal accounts which were contrary to the
recommendations in their research report. That's from page 6,
footnote 8. It goes on to say, and this is what really got me
concerned, that the analysts' profits generated by acting in
what I think is at least unethical if not a violation of some
rule somewhere, between $100,000 and $3.5 million for each
transaction by selling their shares while continuing to
maintain buy recommendations. One analyst sold securities short
while maintaining a buy recommendation on the subject company.
What was the scope time-wise of your inquiry in the market?
How recent are these examinations that led you to this
discovery?
Ms. Unger. The examinations occurred in 1999 and 2000. What
we saw as far as the scenario you just mentioned in terms of
analysts deriving significant profits from selling activity
contrary to their recommendations is something that we are
taking a very close look at. And in fact, in those cases, it's
possible that the analysts violated not only firm policies, but
also the Federal Securities laws.
Chairman Baker. That really was my next question. Was there
a regulation, a professional standard of conduct, or a statute,
and if not, I would welcome, once your review is finished,
advising the subcommittee as to what, if needed, any steps
might be taken. I find it frankly appalling that someone could
tell me to buy while they're selling in the back room profiting
from my investment.
If that's not a bedrock of necessity to correct, there is
nothing in this marketplace that we can correct. I just found
that very troubling.
The staff found instances in which the analysts' ownership
in stock of the covered company was not disclosed in the
research at all. Now I have trouble with the boilerplate that
says we may have an interest, but to not say it at all is not a
violation of current practice or regulation or is there any
rule that says you have to disclose at least that the firm may
have an interest?
Ms. Unger. Well, this is part of the problem. The New York
Stock Exchange has rules, as does the NASD. There is a
disparity between what each of the SROs require in terms of
disclosure. For example, one SRO requires that the firm
disclose the common stock position, and the other doesn't. One
SRO requires that there be a disclosure of the investment
banking relationship that's more detailed than another.
And so what we really need to do as a first step is
harmonize the existing SRO rules to make it easier for firms to
comply with those rules.
Chairman Baker. I think the subcommittee would be
interested. Again, one of the footnotes, page 8, footnote ten,
despite the language of the rule, the NASD has stated that it
does not interpret the disclosure requirement to apply to media
appearances by analysts. So the SRO doesn't see anything wrong
with someone getting on the television set saying what a great
investment opportunity this is and there are no consequences.
In fact, it doesn't violate the code of conduct.
Again, I commend you for great testimony, but you've just
increased our workload here for the considerable future. If we
don't now have rules sufficient to govern practice from the
SRO, I think we have a long struggle to get the industry to get
where I believe you think they ought to be without significant
encouragement.
Ms. Unger. Well, the Commission, as you know, has been
engaged in a dialogue over at least the last year with the NASD
about their interpretation of what disclosures must be made by
analysts in media appearances.
Chairman Baker. Well, for what it's worth, I'd like to see
a Surgeon General's warning that says, ``Warning. I have an
interest in this thing I'm talking about,'' kind of flashes on
the screen.
Ms. Unger. Well, we have taken the position that the
disclosure requirement applies irrespective of the media.
Chairman Baker. Absolutely. Just because you whisper it
instead of standing up and saying it in public is no different,
you still have to disclose.
Ms. Unger. I think the NASD is coming around to that
viewpoint.
Chairman Baker. Well, for what it's worth, I hope we can
encourage them.
I have one more point I want to make, but my time's coming
to an end, and so I'll do it real quickly. This is a what-if,
and you may not be comfortable to comment today. But let's
assume we had a standard of conduct which we all would
prescribe as being good, and that we were able to get the
industry to voluntarily implement that standard. We don't have
it and we're not there yet. But assume for the moment we had
it.
The other point of your testimony was many of the
organizations have very well written, very well thought out
codes of conduct, but they're also ignored. So we have pretty
books sitting on the shelf that nobody reads.
What we need, no matter what the standard may look like, is
someone to determine compliance and a consequence for not
having compliance. It seems to me there is a great deal of non-
compliance and there's no consequence. For example, the fellows
who are trading against their public position.
What would be the effect of having just a grading system,
A, B, C, for example, real simple. A you comply with
everything, B you're pretty close, but you're not there, and C
you better really get your stuff together or bad things are
going to happen.
Now I don't know whether that would be the role of the SEC,
the NASD, the SRO, but there has to be some measure of
performance of your conduct, because without that, the market
can't act and bring about the discipline we all want.
Can you comment generally on the idea?
Ms. Unger. You are correct. I would like to see the SROs
first make the disclosure requirements crystal clear and
consistent. I would next like to see the firms adopt policies
across the board that would make disclosure with the
requirements an everyday practice, and then I think we need to
ensure a way for firms to enforce those rules.
And what you've described is certainly one way and a
powerful incentive, I'm sure, for the firms to comply with
their own internal policies which in turn comply with the
existing SRO rules, or soon to be existing SRO rules.
I'm not sure what the extent of the SEC's involvement would
be in something like that. I would prefer the Agency not to
have any type of merit review, because we are traditionally not
involved in merit review, and this would be something like
that. I think we could be helpful in the process of developing
standards and certainly we'd like to be engaged in the
dialogue.
Chairman Baker. But do you see merit in the public
disclosure of outcomes? That's really my point, that today
there are--although we all wish for self-discipline in the
market--there is are consequence if you do not, and you can't
make an informed judgment as an investor unless you know how
the company functions. And it appears to be a very difficult
determination to make today.
Ms. Unger. The Commission often uses disclosure as a means
of discipline.
Chairman Baker. Thank you. I've exhausted my time.
Mr. Bentsen.
Mr. Bentsen. Thank you, Mr. Chairman.
Ms. Unger, let me ask you this at the outset, because of
how this is being portrayed and I want to make sure that I
don't dig myself in too deep in the situation, because I'm a
little worried that we're on a little bit of a witch hunt here.
But do you believe that given the current situation and the
concerns about conflicts of interests with analysts, that this
is something akin to--there was a movie called ``Game Show''
about the 1950s and the hearings in Congress, long before you
and I were born.
Ms. Unger. Yes, I know what you're talking about.
Mr. Bentsen. But it was sort of a rigged market. Is that
your perception?
Ms. Unger. No. And I think maybe you missed my opening
comment where I said that, in fact, analysts perform a critical
role in today's market, and in large part, they are victims of
their own success.
I think what's happened is that the market was so strong
for so long and with the huge influx of IPO activity, firms
looked for ways to compete to get that IPO business. Part of
the way they began competing was to include analysts in the
mix. The ability to provide favorable analyst coverage became
part of the mix of services the investment banking firm offered
clients.
Mr. Bentsen. Let me ask you this. I mean, hasn't the
analyst position always been part of the mix of investment
banking and the mix of the trading and underwriting? I mean,
haven't brokerage houses always relied, at least for internal
purposes, for their own internal credit risk purposes, on the
work of their research analysts?
Ms. Unger. Well, I hate to do this, because it always seems
like we point to the deregulation of commissions as the pivotal
point for changes in the industry, but I do think that had some
impact on the underwriting business. Commissions were where
most of the money was being made by Wall Street at that time,
and deregulation changed the focus of that business and how
that business was conducted, and what made it profitable.
I think analysts have probably always been involved in the
deals, but not to the extent that they are now, and not to the
extent that they have become so idolized in some respects.
Mr. Bentsen. Well, they have become the masters of the
universe, I guess, of the 1990s, as opposed to the investment
bankers of the 1980s, at least in the media's eyes.
Let me ask you this. Is there anything under the existing
securities laws that subjects analysts' documents, analysts'
reports or whatever, to the same disclosure requirements that
are required of offering documents. And if not, should there
be?
And furthermore, didn't the Commission, just a few years
ago, pass--I can't remember what the colloquial term was for
this--but a plain English approach to the writing of offering
documents so that they would be more easily understandable and
possibly used by the public?
Ms. Unger. Well, it's interesting, because you raise, I
think, a critical point in the discussion which is not only
have the dynamics of the marketplace changed the role of
analysts, but the role of research reports themselves and the
extent of their availability have also changed. Investors can
now access research reports that they were not able to before,
as a result of the internet.
So what does this mean in terms of how the Commission needs
to educate investors about the conflicts, and what investors
need to know in using these research reports? Yes, there are
the offering documents; yes, they are subject to review by the
Commission, but we don't have the resources, nor would we want
to be engaged in merit review with respect to the contents of a
research report.
Mr. Bentsen. Well then, in fact, the law doesn't cover the
research documents in the same way, I don't think, as it does
the offering documents.
Let me ask you one more question.
Ms. Unger. Well it's slightly different, because Section 11
is strict liability for what is contained in a registration
statement.
Mr. Bentsen. Right.
Ms. Unger. Section 10(b), the anti-fraud provision, applies
to everything.
Mr. Bentsen. Let me ask you this, because my time is up,
but I want to ask you this. Can you be concerned about
conflicts of interest between analysts and companies and be
opposed to Reg FD, and be consistent?
Ms. Unger. I'm sorry, can you repeat that?
Mr. Bentsen. Can you be concerned about potential conflicts
of interest between research analysts and the companies that
they review and the relationship with the investment banks, and
also be opposed to Reg FD and be consistent?
Ms. Unger. Me personally?
Mr. Bentsen. In general.
Ms. Unger. Yes, I think you can, because I think you can
note that the conflicts exist, but I believe that Regulation FD
does not cure the conflicts. Reg FD goes to communications
between an issuer and an analyst and not to insider trading,
which was purported to be the original objective or reasoning
for Reg FD's adoption.
So it depends how far you want to go with the conflicts.
The conflicts are the underpinnings of the discussion on both
Regulation FD and today's hearing, but in a very different way.
Mr. Bentsen. Thank you. Thank you, Mr. Chairman.
Chairman Baker. Thank you, Mr. Bentsen.
Mr. Castle.
Mr. Castle. Thank you, Mr. Chairman. I have an opening
statement which I would like to submit for the record.
Chairman Baker. Without objection.
Mr. Castle. Thank you.
Ms. Unger, I have some questions. I've got to tell you that
this whole practice bothers me a tremendous amount. And I, in
my opening statement that I've just submitted, state that I
don't think we should legislate in this area. But I'm just not
sure anymore. I mean, I'm becoming more and increasingly
concerned. I mean, there could be anything from just bad
analysis which of course should not be punishable by anything
to the classification situation, to the so-called ``hold''
business, which apparently is a red flag to sell which most of
us never understood, except for the analysts owning the stock,
to the firm for which the analyst works owning the stock and
the retirement accounts or otherwise, or other individuals just
having big placements in that particular stock that the analyst
is recommending or the investment banking side of the firm
owning it, or the analysts' compensation being tied to overall
profits of the firm for which the analyst works, or the analyst
being involved in the early IPOs at a lower price than the IPO
is going to come out, and then huckstering it in some way or
another, either verbally or in writing some way or another.
Are there any situations such as that where the SEC does
step in now?
Ms. Unger. Step in and do what?
Mr. Castle. Step in and enforce, do something about it?
Ms. Unger. There are instances----
Mr. Castle. Are any of those things violations of laws or
regulations at this point?
Ms. Unger. I wish you had asked me that before you
enumerated them. None of them jumped out at me as violations of
the law, but I will say that the Commission looks very closely
at what's disclosed, whether there was material information
that was not disclosed by an analyst and the firm's involvement
in recommending and selling. But sometimes you can't just look
at one particular activity--you need to look at the whole
picture to really get a sense of whether it's an area for an
enforcement action or not.
But yes, we brought cases involving analysts.
Mr. Castle. You have brought cases that just involve the
analyst side of it, is that?
Ms. Unger. Well, we've brought cases where an analyst was
making reckless statements----
Mr. Castle. Are these penny stock-type cases or are these
major firms that may have these conflicts in which you've
brought the cases?
Ms. Unger. There's a handful of cases that I could get you
more information about if you're interested.
Mr. Castle. I mean my judgment is there have been billions
of dollars put on the table as a result of a lot of these
practices and which probably occasion losses of a tremendous
amount. Do you trust the industry itself to be able to do this
as a self-regulatory matter, or does the SEC have to get
tougher with its enforcement in order to back that up? Or
should we be passing laws up here which frankly I'm loathe to
do, but is that something we should be considering?
Ms. Unger. Well, I think there are three prongs. One is
compensation, one is the accountability of analysts to
investment banking, and the third is the stock ownership. And I
think you need to look at each one of those individually in
determining whether or not there are issues that need to be
addressed.
I think there are disclosures that apply in each of these
areas and there are existing rules that, as I said earlier,
need to be harmonized and clarified and followed. And I think
we need to do a better job, the industry and the SROs need to
do a better job in inspecting firms to make sure that they
comply with rules that are on the books and rules that are
about to be improved that will be on the books.
I also think that the firms need to do a better job of
ensuring compliance with their existing internal policies and
procedures, most of which exist at the firms that were
inspected, most of which are not being enforced adequately
today.
Mr. Castle. Well, and you're right. I mean, there's a whole
level of enforcement in various ways. But do you believe that
the SEC should change its rules and regulations or specifically
its enforcement mechanisms to address some of the problems
which you have spoken to in your opening statement, which we've
had another hearing, which I'm sure you're familiar with, and
which is going to be continued later today by another panel
involving a number of the different situations that I have set
forth, all of which you're familiar with in terms of different
practices that are at least questionable.
Or do you think the SEC is fine the way it is?
Ms. Unger. The SEC has broad antifraud authority. We have
ample authority to bring cases involving fraud and violations
of Section 10(b) and Rule 10(b)(5). The first line of defense
in this whole discussion about managing analyst conflicts
really are the SROs whose rules deal with this more directly
than the Commission.
Again, I think we all need to do a better job. I think of
course the Commission is doing a great job, but we need to do
more in our oversight of the SROs in making sure that they
conduct the inspections and examinations that are needed to
determine whether the firms have the appropriate policies and
whether the policies are being followed.
I think that's really the first step that we need to take
in this discussion which I think is why the Chairman of this
subcommittee is asking about ways to improve enforcement
efforts and make the firms accountable to the public in terms
of what they're doing internally.
Mr. Castle. Well, my time is up, but I mean, this won't be
a question but, you know, I think it's our job to worry about
the consumer out there. I can't worry about the big firms, I
can't worry about the practice of the SEC, but I think a
consumer should be able to look at an analyst's recommendation
on a stock and it could be wrong, but at least it should be
done with integrity and honesty and they get a pretty good idea
of what they're dealing with.
Until we've gotten to that point, it seems to me we all
haven't done our job. And I yield back the balance of my time.
Chairman Baker. Mr. Castle, just to finish up on your
point, in earlier questions to Ms. Unger, I've made reference
to her footnotes of her own document. In just one transaction,
the fellow profited $3.5 million by selling his interest while
publicly telling his clients to buy. On its face, unless it's
the gentleman's estate--that's the only reason I could see it
would be OK--that in itself is a serious problem, and yet that
is under advisement at the moment for determination as to
whether action is appropriate or not. That is a very large
concern. Your point is right on target.
Mr. Kanjorski.
Mr. Kanjorski. Thank you, Mr. Chairman.
I wanted to follow up. Did I hear you respond to Mr.
Bentsen that you don't have the resources to do some of the
things you'd like to do?
Ms. Unger. We would always like to have more resources, but
I don't think that merit review of analyst research reports is
something that's appropriate for the agency, given our mandate
as it exists today.
Mr. Kanjorski. So in order to have you do something, we
would have to enact statutory law to give you greater authority
or direction to do that?
Ms. Unger. I guess you would, but I also don't think it's a
good idea. With all due deference to this subcommittee, I think
the problem is in managing the conflicts. Whether the
Commission reviews the substance of the research or not, you
still have the issue of the conflicts and managing those
conflicts.
Mr. Kanjorski. Let me direct ourselves to some of those
conflicts. The Chairman and I were talking when we went over to
the vote, particularly about these transactions that you
mention in your testimony. One example is that of pools of
analysts that were investing and giving advice to buy when, in
fact, they were selling, and, in fact, they were making single
transactions in the range of $100,000 to $3.5 million.
I think the Chairman made the observation that if this
activity happened in Louisiana real estate, there'd be somebody
in jail.
Chairman Baker. That's a pretty bad comment too. You know,
when you think about it, when we put anybody in jail in
Louisiana, they've got to really be out of it.
Mr. Kanjorski. And I tend to agree with him. Doesn't that
constitute fraud? Forgetting conflicts, isn't that just out and
out fraud?
Ms. Unger. I did say we were reviewing these particular
transactions.
Mr. Kanjorski. How long ago did these transactions happen,
Ms. Unger?
Ms. Unger. 1999 and 2000.
Mr. Kanjorski. So they are almost 2 years old and we're
still reviewing those transactions? The reason I asked you how
long is because I recall from law school that most of the court
decisions on bills and notes were around 1934, 1935 and 1936.
It seems to happen that we want to find somebody at fault or
responsible when the market crashes.
What I am wondering is why these transactions were going on
when the market was pretty healthy in 1999 and 2000. Are you
intending that we realize that you didn't know at that time?
Did you just found out recently? Or did you know in 1999 and
2000 before the market crashed?
Ms. Unger. Well, no, we did just find out last month, and
in fact, I think it would be highly unlikely that anyone would
be making that kind of money in today's market.
Mr. Kanjorski. OK, but when did you find out about it, I
said?
Ms. Unger. Pardon me?
Mr. Kanjorski. When did you find out?
Ms. Unger. We have just been conducting these reviews about
analyst conflicts.
Mr. Kanjorski. So there isn't any reporting or any way that
you could pick that up without doing these reviews?
Ms. Unger. No. There are inconsistent requirements that
exist currently, SRO requirements, about the firms' disclosure
of stock ownership.
Mr. Kanjorski. Did they make the proper disclosures in a
timely manner?
Ms. Unger. This is what I'm trying to explain to you. Of
the firms we inspected, which were nine firms that account for
the majority of the IPO and technology underwritings, only one
of the firms was able to give us a list of employees who
invested pre-IPO in a company that the firm had as a client.
So in fact, the internal controls at the firms apparently
did not require this information.
Mr. Kanjorski. And you have no regulations that require
that internal information?
Ms. Unger. They are required to make the disclosure.
Mr. Kanjorski. Under your regulations they're required to
make it?
Ms. Unger. No, under the SRO regulations, they're required
to disclose in the research report, depending on which
regulation you're looking at, the firm is required to disclose
certain ownership positions.
Mr. Kanjorski. I understand that. I have limited time, and
I'm trying to rush you along.
What I understand is they didn't make the disclosure, and
they may not have had the internal controls to do that.
However, neither do you have the internal controls to know that
they weren't doing that.
Somebody here is responsible at the end to know whether or
not these SROs are doing what they are supposed to do, or
whether or not you have a requirement to find that out in a
reasonable time: I think 2 years is beyond a reasonable time.
And then for you to tell me you're reviewing these things;
these guys may retire or die before you get all done with those
reviews. And I think the Governor made a good point. You know,
we're not worried about the big, the conflict, quote: ``that
may exist between the analyst and his own company.'' I don't
know if there is a clear conflict with those ten million people
who are watching nightly television and listen to this guy
saying, ``Oh, this is a great buy.'' And I watch them every
night. And I have yet to hear anybody telling me to sell. And
they're still doing it. And every now and then they do say,
``Oh, our company does have stock in them or represent them in
some stock offering.'' I don't understand it.
I want to get to the point. What I'm indicating to you is,
if you don't have the authority to test whether the SROs have
internal controls and are properly reporting or having
transparency back to the SEC, then you should be up here asking
us for that authority.
But second, I'm worried about another thing that I brought
up in my opening statement. You're sitting back here and there
is a public policy decision that's going to be made probably in
the next 6 months or a year, but certainly within the next 18
months, to privatize Social Security. We're going to throw 160
million consumers into the marketplace, 25 to 30 percent of
which are functionally illiterate. That 25 to 30 percent are
going to be guiding their own accounts.
Has the SEC started to enlarge its structure and anticipate
what is about to happen, which could cause massive fraud and
conflict of interest if all these billions of dollars and
millions of people come into the marketplace? Or are you just
going to wait around and have this happen and then come in and
say--2-3 years after the fact, that you have a problem?
Aren't you anticipating that if we, as a matter of public
policy, decide to privatize Social Security, then we are
putting at least another 80 to 100 million people into the
market that have never been there before? And aren't a good
portion of these people not qualified to read financial
statements and understand this information? Many certainly are
not qualified in ``newspeak,'' and I think that is what we are
talking about here. We're in 1984. These people are using terms
that are not standardized. The language that sometimes is only
understood within their own house or within a limited number of
houses, but certainly not by the general public.
And it just seems to me that the SEC ought to be proactive
in anticipating what is about to occur, what may occur. Looking
back at these experiences that you have been reviewing for the
last 2 years and anticipating how they will be compounded if we
put another 50 or 80 million people into the marketplace.
Instead, 2 years after we do that, we are going to have a
hearing within the halls of Congress filled with a lot of
middle-aged and older people that will claim that we led them
down the primrose path. They will say we drove them to take
their 2 percent of Social Security and invest in these
horrendous start-up entities that weren't regulated, weren't
controlled, and didn't have transparency: and they will claim
``people were telling us to buy and we bought, and then some
people who were telling us to buy were selling and cleaning up
and making $3 million per transaction.''
What is your response to that?
Ms. Unger. Are we talking about Social Security or
analysts' conflicts now?
Mr. Kanjorski. I'm talking about looking at what we've
already seen in a hyper market in 1999 and 2000.
Ms. Unger. Just the market generally?
Mr. Kanjorski. With analysts and anticipating what may
happen if we enlarge this market by 80 million more customers?
Ms. Unger. Well, as part of my testimony, I said I thought
the SEC's role in analyst conflicts was disclosure and
educating investors. We have put out a very comprehensive and
well-received ``Investor Alert'' about analysts' conflicts so
that investors would understand exactly what we're talking
about and to highlight for them what analysts' conflicts are
and how they should approach interpreting a research report.
I would never counsel, and I think many people have said
that no investor should rely exclusively on an analyst research
report or recommendation in making an investment decision. The
Commission generally is very proactive in terms of investor
education.
I presume that if Social Security were privatized and there
were special needs presented to the marketplace and to the
Commission, we would attempt to fulfill those special needs by
outreach in further investor education.
With respect to the analysts' conflicts we're talking about
today, it was the SROs' responsibility to supervise and monitor
and inspect for the private investments by the analysts and the
firms at which the analysts work.
Mr. Kanjorski. I love the terminology education and I do
appreciate it and I hope you're very successful in educating
all the people that are in the marketplace today. However, I
doubt that you are going to give them the equivalency of a
working understanding of the marketplace and terminology, but
I'm not talking about those people. I'm talking about knowledge
that there are 20 to 25 percent of the American people that are
functionally illiterate. They cannot even fill out an
application form, let alone read a profit and loss statement or
a balance sheet.
Are you suggesting to me that you're going to put together
an investor educational program that are going to take 25
percent of the American population's functional illiterate and
have them understand what they need to understand to be
privatized and investors in the marketplace and not have to
rely on analysts or security house recommendations?
Ms. Unger. Well, if they are functionally illiterate,
they're not reading research reports either, are they?
Mr. Kanjorski. No, I doubt it. That's why I'm suggesting
that.
Ms. Unger. Just checking.
Mr. Kanjorski. Well, that's the next question. Have you
been asked for, or have you been given by either the Commission
or this Administration, recommendations as to whether or not we
should privatize Social Security and put 160 million more
Americans in the stock market? And are they qualified by basic
learning and education to manage their accounts, or are we
setting them up for a tremendous let-down?
Ms. Unger. Commissioner Carey, who recently passed away,
was the Commission's expert on Social Security privatization
and he did a lot of work on that. And I commend him for that
work. He, however, is no longer with us, and we have not yet
determined who will take on that responsibility at the
Commission.
Mr. Kanjorski. Are you prepared though to make a
recommendation to the Congress?
Ms. Unger. We have not adopted a Commission position yet on
Social Security privatization. There've been numerous different
permutations of how that could occur. We would be happy to
participate in any discussions about Social Security
privatization.
Mr. Kanjorski. Could you succinctly tell me, though, have
you made a recommendation, positive or negative, on that
particular issue? Are we prepared to see 40 million
functionally illiterate Americans put into the market?
Ms. Unger. We have not adopted a Commission position.
Chairman Baker. We'll have to move on.
Mr. Royce.
Mr. Royce. Thank you, Mr. Chairman.
Chairman Unger, one of the things I was going to ask about
is the interviews that we have with people who are analysts,
the information that we've received indicate that one of the
things that's changed on Wall Street is the business model. One
of the things that used to drive profitability was revenues
from research and trading, and as that began to decrease, it
was supplanted instead by enormous revenue gains from initial
public stock offerings. As you saw a 15-fold increase over a
decade in the fees coming into the firms, then the business
models changed.
And the allegation here is that included in that change was
a change in the way the analysts were compensated. In the past,
bonuses were given to analysts based on research quality, or on
the brokerage arm's profitability.
Now it is common for those bonuses instead, and typically
this would be the bulk of their annual compensation at most of
the firms, to be tied to the amount of banking business that
they generate for the firm. And that change in business model
could explain a lot. It certainly could explain the disparity
between positive and negative recommendations. Could it be that
analysts are fearful of offending their banking colleagues and
fearful of those existing underwriting clients or potential
underwriting clients? I mean, why would it be that only two
percent of the stocks covered would have that sell rating? I
mean, that's one of the things I wanted to ask you.
Another question that I had, we have a witness coming on to
the next panel and he submitted his testimony in advance, Chris
Byron. And he calls this an outrageous situation. He says IPOs
are offered to investment bank clients at cheap pre-market
prices even as the bank's analysts engage in non-stop
commentary designed to pump up demand for the stock in the
after-market.
And I wanted to ask you also what is your view of that
practice, OK?
Ms. Unger. OK. I will try to address those questions in
totality.
Mr. Royce. Thank you.
Ms. Unger. I agree that there has been a change in the
business model which has led to a lot of what we're talking
about today. It's not just the investment banking client that
applies the pressure though; it's also the institutional
investors who don't want their investments downgraded. Firms
are competing for underwriting business, and favorable analyst
coverage is part of the package.
No investment banking firm will take a company public that
its analysts couldn't issue favorable research about. Why would
they? Nor would a company want to have an underwriter like
that. So, in a sense, they become intertwined at the very
beginning, which accounts for why you see a large number of
favorable research recommendations. The business itself demands
that, and it makes sense. Many firms do not bring many deals
for that reason.
Mr. Royce. Should we then rename them from analysts to
salesmen?
Ms. Unger. Well, that's sort of the gatekeeper function of
the firms and the analysts that have become part of that. Once
the company goes public, the analyst issues a report, which we
know is going to be favorable, 25 days later. Then the firm
begins putting its clients into that stock, a lot of which are
the institutional investors with sizable portfolios.
As you can imagine, the research is favorable, there may
come a point when the analyst says, ``Gee, this company's not
doing as well as I thought it was going to, I'd like to change
the rating.'' Well, consider all of the pressure that's applied
by the company with the investment banking relationship, the
institutional investors where the firm has a stake in its
commissions and with its relationship, and perhaps stock
ownership on the part of the firm or the analyst.
I don't know that you can ever eliminate these conflicts
and I'm sure there is some good in all of it in terms of
understanding the company and the dynamics and everything else.
What I do think you can do is manage the conflicts, and the
way I think you can manage the conflicts is to have the
investment banking firm disclose the analyst's involvement in
the deal, and to have disclosure if the analyst owns stock in a
particular company that it's issuing research reports about,
and have that all be very clear to the investors, so that the
investor understands any potential conflicts and can take that
into account.
I think we're not even seeing that threshold disclosure at
this particular point. I think we're seeing that stock
ownership exists, that the pre-IPO share allocations exist, and
that there's considerable influence exerted over the analyst by
the investment banking part of the firm, but we are not
managing all of that very well right now, in terms of
disclosure.
Mr. Royce. And I guess for the SEC and for us, one of the
critical questions is, how is that disclosed in a way that the
small investor really comprehends, really sees that disclosure,
as opposed to the institutional investors? How do we do this in
a way that the market really understands?
Ms. Unger. And that question really takes us full circle,
because the reason that this is a discussion that many people
are having now is because of the broad dissemination of
research reports and the fact that they are reaching the
individual investor who may not be as experienced in
interpreting the documents and knowing what the conflicts are.
So that is the challenge of the SEC in terms of educating
investors, and that's what we try to address in our Investor
Alert that we released last month.
Mr. Royce. We have a long way to go.
I thank you, Chairman.
Chairman Baker. Thank you, Mr. Royce.
Mr. Toomey, you're up.
Mr. Toomey. Thank you, Mr. Chairman.
I'd like to first follow up briefly on a line of
questioning that my good friend and colleague from Pennsylvania
made earlier about Social Security accounts and his concern
that 25 percent of the American public is insufficiently
literate to accumulate savings in personal accounts.
I would point out that most of these people have jobs, they
buy homes, they raise their children, they do lots of things in
life, and I think if we suggest that they are not competent to
invest their savings, we may not be giving them the credit they
deserve.
Furthermore, I would observe that any mechanism by which
investments would be made in personal accounts within Social
Security has yet to be defined. It's entirely possible that it
would consist of choosing from a range of funds in which the
individual investor would never have the occasion to actually
attempt individual stocks. So I, for one, hope that you won't
suggest any major new policies and initiatives in anticipation
of what I do hope will be a significant move to allow personal
accounts within a reformed Social Security.
But my first question for you, I'd like to harken back to
an example that's been referred to several times and the
suggestion that an analyst who sells a stock, while
recommending a buy, has prima facie committed fraud and that
this is outrageous. Now I'm not defending any particular
individual or circumstances that I'm not familiar with. But
perhaps you could comment. It seems to me that one could
recommend a buy on a stock while selling it into one's personal
account, and that there might not be anything wrong with that
whatsoever.
There are a lot of reasons a person might choose to sell
stock. It could be the individual simply needs to raise cash
for any number of reasons. It could be that the person's
portfolio is too concentrated in a particular industry or too
concentrated in that particular company. It could be a function
of the profit that's been accumulating in a particular holding,
and the person's own personal investment criteria.
But would you agree that selling a stock while recommending
a buy in that stock is not necessarily evidence prima facie of
fraud or even any nefarious activity on the part of the analyst
by itself?
Ms. Unger. And I'm glad you raised that point, because I
would hate for this subcommittee to walk away today thinking
that it is prima facie evidence of wrongdoing. We would need to
conduct a very fact-intensive review of exactly why the analyst
was acting contrary to the recommendation. There are firm
policies that have very specific times and circumstances under
which an analyst can buy or sell contrary to a recommendation.
I'm not sure that in this case, or these couple of cases
that we're talking about, that was done. If it was so clear and
it was prima facie, we would have brought those cases. So that
I'm sure we are assessing exactly what you are describing and
that is whether there other reasons for the selling in the
account.
I have heard anecdotally that firms have very strict
procedures in terms of looking at the overall portfolio. I'm
confident that firms are able to make and develop internal
policies to make sure that it happens under the proper and
appropriate circumstances.
Mr. Toomey. Thank you. Perhaps you could comment on this
idea, that there are no consequences for firms which would
engage in inappropriate compensation or creating incentives for
analysts that they ought not to have.
I disagree with that. First of all, I think there's a very
competitive marketplace out there. There are a lot of
alternatives for any investor, and we've seen the industry take
many steps already. The securities industry has put forward an
industry best practices guideline, there are rating agencies
that assess the performance of analysts' recommendations,
individual firms disclose their underwritings, and it is public
information what kind of under-writings are going on.
As you pointed out, the SEC has done an alert which strikes
me as the obvious, that investors should not rely solely on the
advice of a particular analyst. And when I look at all this in
a cumulative sense, it strikes me that certainly most
investors, the overwhelming majority, it's going to occur to
them that they ought to have a certain amount of skepticism
about what an analyst recommends, and that that should be one
of various factors that they would include.
But there are alternatives for investors. There are
consequences imposed by the marketplace and we ought not go too
far in trying to impose regulations on this.
Ms. Unger. I think you're right, we ought not go too far,
but I think all we're talking about today or all I'm
recommending today is that we follow the existing rules and
actually improve the existing rules to make clear what the
disclosure obligations are of the firm and the analyst and to
follow those rules. For firms to either follow the best
practices or their own internal procedures that they've already
established and to actually enforce those.
And I think that's the first area that we need to focus on
in terms of managing the conflicts.
Mr. Toomey. Thank you. I yield the balance of my time.
Chairman Baker. Thank you. Just for the record's sake on
whether or not folks trade inappropriately, I think I recall
you making the comment that of the firms you surveyed, only one
could tell you all the positions of every analyst. It would
make it rather difficult, I think, to make the judgment that
the firms are therefore making appropriate disclosure over
these matters when they don't know what the investments are.
That's my point.
And second, the statement that there are perhaps adequate
rules in place, but I believe, in accordance with your own
observation, that they are not being followed, is the core of
the problem. And if we don't bring enough attention and focus
on it, practices are not likely to change.
I do appreciate your appearance here. There are a number of
questions that I would like to follow up with. For my own sake,
and for any of the subcommittee, we'd like to hold the record
open for a few days and perhaps submit additional inquiries for
the record. And we do very much appreciate your courteous
participation today. Thank you, Ms. Unger.
Ms. Unger. Thank you very much.
Chairman Baker. We'd like to have our second panel come
forward, please.
Welcome. I'd like to get started with our panel. I regret
we have so much territory to cover and such a distinguished
panel of witnesses here today. Without further ado, I'd first
like to call Mr. Ron Glantz, former Managing Director, Tiger
Management, former Director of Research and Chief Investment
Officer of Paine Webber. Incidentally, in light of your written
testimony, I think I need to say you're rated by Institutional
Investor for seven consecutive years as the top investor. So I
particularly appreciate your willingness to appear here today,
sir. Welcome.
STATEMENT OF RONALD GLANTZ, FORMER MANAGING DIRECTOR, TIGER
MANAGEMENT, FORMER DIRECTOR OF RESEARCH AND CHIEF INVESTMENT
OFFICER, PAINE WEBBER
Mr. Glantz. Chairman Oxley, Chairman Baker, Ranking Members
LaFalce and Kanjorski, and Members of the subcommittee, thank
you for inviting me to testify on Wall Street's research
practices.
My name is Ronald Glantz. I was in the investment business
for 32 years before retiring last year. I began my career on
Wall Street as an equity research analyst. Money managers
polled by Institutional Investor Magazine selected me the top
analyst in my field for seven consecutive years. I then became
Director of Research, Chief Investment Officer, Director of
Economics and Financial Markets and a member of the Management
Board of Paine Webber, one of the largest brokerage firms in
the United States.
I ended my career as a Managing Director of Tiger
Management, one of the largest hedge funds in the world. This
has given me a good perspective on how the role of analysts has
changed over the last three decades.
When I began in the business, the top-rated equity research
firm was named Laird. Within 5 years it failed. So did most of
the other top-rated firms. What happened? When I began, the
average commission was over 40 cents a share. A few years
later, institutional commissions became negotiated, almost
immediately falling to less than six cents a share. The only
way for research firms to survive was to merge with someone
that could spread research costs over a larger base, usually
brokerage firms whose main clients were individual investors.
Retail commissions had remained fixed and retail brokerage
firms discovered that good research helped them gain retail
clients and stockbrokers. By the end of the 1970s, the largest
number of top analysts were at Paine Webber, which had bought
the top-rated research firm, and Merrill Lynch, which hired
talent from failing research firms.
Meanwhile, as analysts became more influential, companies
increasingly pressured analysts to recommend their stocks,
since a higher price means fewer shares have to be issued when
raising new funds or acquiring another company, they are less
vulnerable to being taken over, executives make more money when
they cash in their options, and shareholders are pleased.
It is easy to reward favored analysts. They are given more
access to management, ``helped'' in making earnings estimates.
They'll even call you up and tell you that your estimates are
too high or too low, and invite you to resorts for
``briefings.'' And most important, their firm receives
lucrative investment banking business.
Companies penalize analysts who aren't sufficiently
enthusiastic. Let me give you a personal example. When I was a
brokerage firm analyst, I downgraded a stock. The company's
chief financial officer called my firm's president to say that
unless I recommended his stock, he would cease doing investment
banking business with my firm, and would order the bank which
managed his company's pension fund to stop doing any business
whatsoever with my firm.
I have seen top analysts removed from company mailing
lists, their telephone calls left unreturned, and even
physically barred from company presentations. Once I was doing
a reference check on an analyst I was considering hiring. A
chief financial officer told me that the analyst was disliked
so much that he was deliberately given misleading information.
In 1980, top analysts made just over $100,000 a year.
Today, top analysts make up to $20 million a year. How is this
possible, considering that institutional commissions have
fallen even further and brokerage firms now discount retail
commissions to avoid losing customers to such firms as Schwab
and e-Trade?
What happened is that brokerage firms discovered that
highly rated research helped them gain investment banking
clients. Soon the largest number of top analysts were at
investment banking goliaths such as Morgan Stanley and Goldman
Sachs. They could pay considerably more because investment
banking transactions were much more lucrative than trading
stocks. The institutional commission on trading $300 million
worth of stock was only $300,000, of which less than $25,000
would go to the research department. This barely paid for
printing and mailing research reports on that company. However,
underwriting a similar dollar value of a new issue would bring
in at least $10 million, and bankers thought nothing of giving
a million dollar fee to the analyst responsible for the
business. A merger or acquisition could bring in even more.
Soon, firms were including anticipated investment banking fees
in the contracts they offered analysts. The huge fees earned by
investment banking gives them the ability to influence and, in
some cases, even control the equity research department. As we
all know, whoever ``pays the piper'' names the tune.
Analysts used to view retail customers and investment
managers as their clients. My first boss told me ``widows and
orphans depend upon you to give good advice.'' Now the job of
analysts is to bring in investment banking clients, not provide
good investment advice. This began in the mid-1980s. The
prostitution of security analysts was completed during the high
tech mania of the last few years. For example, in 1997 a major
investment banking firm offered to triple my pay if I would
join them. They had no interest in the quality of my
recommendations. I was shown a list with 15 names and asked,
``How quickly can you issue buy recommendations on these
potential clients?''
Let me pause here to assure you most analysts still want to
give good advice. Not only is it the right thing to do, it
helps their reputation, which brings in investment banking
business. Nevertheless, the pressures are enormous.
When I was Director of Research, analyst compensation was
based upon the performance of his or her recommendations,
commissions generated, and ratings by institutional clients and
the retail system. Today, name analysts are given guaranteed
contracts, whether or not their recommendations are any good.
Every year, The Wall Street Journal lists the analysts who have
provided the best investment advice. These analysts are rarely
the best paid in their field.
Why is that? Investment banking. It is an open secret that
``strong buy'' now means ``buy,'' ``buy'' means ``hold,''
``hold'' means that the company isn't an investment banking
client, and ``sell'' means that the company is no longer an
investment banking client.
[Laughter.]
Mr. Glantz. Less than one percent of all recommendations
are ``sell.'' Some analysts call their best clients and tell
them that their real opinion differs from their published
opinion, even though this is illegal.
But what about the individual investor? No one told my 86-
year-old widowed aunt that the internet stocks she was buying
in 1999 had no hope of ever earning any money, or that the
analyst recommending purchase was being paid by investment
banking.
Investment banking now dominates equity research. Bankers
often suggest and are usually asked to approve hiring analysts
from other brokerage firms. Investment banking provides the
bulk of proven analysts' pay package. Some analysts report
directly to investment banking. Analysts routinely send reports
to the companies and to bankers for comment before they are
issued.
Three years ago, Tiger was able to hire the top-rated
analyst in his field from a Wall Street firm. This analyst had
consistently been negative on one company, a major source of
investment banking fees, because of its many acquisitions. Then
his firm hired an investment banking team from another
brokerage firm. As reported in the Wall Street Journal, the
analyst was fired so that a more ``compliant'' analyst could be
hired, one who would recommend potential investment banking
clients. Disillusioned, this analyst moved over to money
management where the quality of recommendations was still more
important than the quality of relationships with potential
buyers of investment banking services.
To give one of many personal examples, 4 years ago I came
up with some extremely negative information on a company,
including bribery, defective product, accounting
irregularities, and serious pollution problems. I called the
three most visible analysts recommending the stock, one of them
the top-rated analyst in his field, and gave them my evidence.
Every one of them continued to recommend the stock. Why? This
company was an investment banking client. Incidentally, within
a year, every member of top management was thrown out and, of
course, the stock plummeted.
The genie has been let out of the bottle. As long as
investment banking is the most profitable part of the firm,
then investment bankers will find a way to pay analysts who
bring in business. Money managers can hire their own analysts.
But my elderly aunt will never know whether the advice she is
receiving is unbiased or not. That's not only bad for the
average investor, it undermines one of the primary reasons for
having a stock market--the efficient allocation of investment
dollars.
My proposals can only address part of the problem. At the
least, brokerage firms should list in large type on the first
page of all buy recommendations any investment banking business
they have had with the company over the last 3 years and any
equity ownership by the analyst, members of his or her
immediate family, or the firm.
Second, no buy recommendation should be permitted if the
analyst, members of his or her immediately family, or the
brokerage firm purchased stock or options for their own account
in the month preceding the report, nor should they be permitted
to sell stock until 3 days after a sell recommendation is
issued.
Third, any shares purchased of a new issue by the analyst,
members of his or her immediate family, or a money management
arm of a brokerage firm should be held for a minimum of 1 year.
Thank you, I would be happy to answer any questions.
[The prepared statement of Ronald Glantz can be found on
page 241 in the appendix.]
Chairman Baker. Thank you very much, Mr. Glantz.
Our next participant is Mr. Christopher Byron, Syndicated
Radio Commentator, Columnist for MSNBC.com.
Welcome Mr. Byron.
STATEMENT OF CHRISTOPHER BYRON, SYNDICATED RADIO COMMENTATOR,
COLUMNIST, MSNBC.COM
Mr. Byron. Thank you very much, Chairman Baker,
distinguished Members of the subcommittee.
Chairman Baker. I should make a special notation. As our
MSNBC.com and also our Bloomberg News participant, you are our
first media-related types willing to stand in front of the
subcommittee in a public forum. I welcome you for that reason.
Mr. Byron. Before I go any further, I want to thank the
subcommittee enormously for inviting me to appear before it and
give me this opportunity to do just that. It's an enormous
personal honor and a pleasure to be able to appear before you
and give testimony on a subject that I've written about in one
form or another for a number of years now in various
publications that I write for.
You've asked me for some brief biographical information
about myself, and I'll give you that very quickly. I'm a
magazine, newspaper, and internet columnist and radio
commentator. My columns appear weekly in the New York Observer
newspaper, on MSNBC.com interactive on the internet, where I
host a daily webcast radio show called ``High Noon On Wall
Street.'' I also do a radio show called ``Wall Street Wake Up
with Chris Byron'' that's syndicated on 40 AM radio stations
around the country, and I write a monthly column for Red
Herring magazine as well.
Over the years, I've written for a great number of
newspapers and magazines. They are listed in my submitted
testimony. I won't bother you with them now.
The subject that we are about here today is enormously
important to me personally, because it affects what I do for a
living. The changing role of financial analysis and journalism
on Wall Street is a very important topic for a whole variety of
reasons.
I have a long perspective on this subject. When I came to
Wall Street as a reporter in 1968, the beginning of 1969 was at
the tail end of the go-go 1960s bull market. Three decades
later, I'm still here covering essentially the same material
that I covered then. A lot of the money and equity markets of
America, now the world, a lot has changed in that time. When I
came to Wall Street as a reporter in 1969, not a single person
I knew, including myself, owned a computer. I had never seen a
computer. Today, I know of no one who doesn't work with a
computer.
When I came to Wall Street as a reporter, it took days,
sometimes a week or more, to get my hands on the most single
valuable asset that any writer in this subject area, any
investor, any financial analyst or reporter can have, and
that's an audited financial statement from a company.
Today, that information is instantly available to anybody
with a desktop computer, a telephone connection, and a dial-up
service on the internet. There's also been an enormous
explosion in the public's interest about financial information
itself. When I began covering financial markets at the end of
the 1960s, The Wall Street Journal was generally viewed by
people in my profession as kind of a second tier publication.
There was no CNBC, no CNFM, there was no internet. Now The Wall
Street Journal is regarded as one of the world's premier
newspapers. Electronic media likes CNBC, MSNBC.com on the
internet all have global audiences on every continent.
I'll give you one personal illustration of this, and I
think it is sort of revealing about the kind of thing that
we're talking about here. I do, as I said before, a daily noon
time webcast radio program called High Noon On Wall Street With
Chris Byron. It's carried from my home office in Connecticut
via a distribution system provided by Microsoft in Redland,
Washington to 24 time zones around the world simultaneously. I
must tell you, it is pretty daunting to sit in my den at noon
every day and start to offer opinions and commentary on
whatever happened in the market in the last 3 hours, and
instantly receive back from every continent on the earth,
emails from people listening to what I'm saying and saying
``Byron, that's a great point,'' or ``You're an idiot, you
don't know what you're talking about.''
It's really a very, very large audience that reacts
instantly to financial information all over the world.
There's one thing, however, that hasn't changed in the 30
years that I've been doing this job, and that is fundamentally
Wall Street remains what it has always been: the place you go
to get the money. That's where the money is.
You may hear discussions from time to time about socially
responsible investing and phrases like that. But the reality is
people go to Wall Street to get the money and the promotion of
concepts like socially responsible investing, and phrases like
that are simply another way to enable them to get the money.
The financial markets of Wall Street are, in my personal
opinion, the single most successful self-regulatory arena the
United States has had, at least in my life time. I think that's
because people are, generally speaking, honest by nature and we
have the oversight capacity of the Securities and Exchange
Commission hovering in the wings over the self-regulatory
bodies that we've been talking about this afternoon.
But there's something different now. There's a huge, huge
amplification of voices provided by the digital age. This is
creating what I think are really important new difficult
challenges for the self-regulators and for the SEC. I think you
can make a convincing case that this entire tech sector bubble
that we saw begin in the mid-1990s, swell over the following 4
years, the last two of which the NASDAQ composite index nearly
tripled in value, and then popped like a champagne bubble and
just disappeared in the glass, was caused by, and I think the
responsibility lies directly at the feet of the amplifying
megaphones of the digital age, the internet, the world of cable
television, and the access to them that financial analysts and
compliant journalists have which reaches investors all over the
earth.
This has huge and obvious policy ramifications for
Congress, in my opinion, because the collapse of the market,
the NASDAQ national market is in collapse and we would be
remiss to call it anything other than that. It has lost over 75
percent of its value from its stock. Some of it's come back,
but it is still way, way off.
This has brought an end to the longest running bull market
we've known in this country's history. It now threatens to tip
the entire economy into recession. No one has any clear idea
what to do with it. Trillions of dollars have vanished from the
economy by the implosion of what Federal Reserve Chairman Alan
Greenspan referred to as the ``wealth effect'' created by this
bubble and the dot.com stocks that were in effect the miner's
canary of that bubble.
The Bush Administration and the Federal Reserve are now
engaged in efforts to replace it with a combination of tax
rebates, lowered short term interest rates. No one is entirely
clear whether this is going to work or not. But if prices
hadn't been pumped up to the levels they reached in the first
place, they wouldn't have fallen as far as they have, and we
wouldn't now be groping for a way to pump them back up again.
This bubble was financed largely by individual investors.
And it is the Wall Street analysts and the media voices that
helped turn the analysts into pseudo-celebrities whom I believe
now have to bear the consequences for their actions, the
responsibility for their actions. In some cases, we've seen
what I thought I would never see in my life time in this
business which is the spectacle of professional investors, who
simultaneously wear a hat purporting to be an analyst, an
investor and a journalist simultaneously.
I think is just a circle. You can't square and you can't
put any kind fine line, fancy talk around it. Those three
things don't go together. For nearly 4 years from the Yahoo IPO
in 1996 to the deluge of IPOs that spread across Wall Street in
the first 3 months of 2000, the analyst community, Wall Street,
and the media organizations that covered them engaged in what I
would call nothing less than a massive, shameless, totally
irresponsible free-for-all riot in the pursuit of money.
I have included with this testimony a collection of stories
and columns I wrote during this period that attempted to call
the public's attention to the colossal pocket picking that they
were being subjected to. Most particularly, I wrote repeatedly
about the outrageous situation in which IPOs would be offered
to investment bank clients at cheap, pre-market prices, even as
the bank's analysts and the firms engaged in non-stop public
commentary designed to pump up demand for the stock among
individual investors in the after-market.
There are dozens of billion dollar examples of this in the
public record before us today. Then when the stock would come
public, the insiders would instantly dump their shares into the
waiting and outstretched arms of individual, after-market
investors at four, five and sometimes ten times the price they
paid for them, often within hours.
You can call that what you want, but I call it fraud. You
may review the trading histories of dozens of tech sector IPOs
and dot com IPOs during this period and find precisely this
pattern repeating itself over and over again. To that end, I
would thus respectfully call the subcommittee's attention to
the following IPOs which are simply illustrative of the process
I've described.
VA Linux Systems, Inc. The insider price in this deal was
$30, the first price to an after-market investor in the public
market, $320.
TheGlobe.com, Inc., a deal that failed the first time
around and couldn't even be gotten off, because the underwriter
couldn't even find a market for it. The second time around at a
mark-down, Cy Sims' basic sale price of nine bucks. This deal
got off at $9. First sale to individuals in the after-market,
$97.
WebMethods, Inc., sale price to the insiders, $35; first
sale to the after-market individual investors--everyday
citizens, $336.
All these stocks have since collapsed. There are dozens
more like that. These stocks and countless more were pumped to
wildly supportable prices by impossibly grand claims from
analysts regarding their potential as businesses. We all knew,
as journalists, that these claims were absurd, and we would
constantly talk with each other about that. Not often did our
private opinions about what we were seeing make it into public
print. The fact that these claims echoed through the megaphones
of TV and the internet to reach individual investors from every
corner of the globe simply underscores how much capital can be
raised on Wall Street now that the whole world is watching.
And this is only the first instance of this in which this
unexpected alliance of analysts and the electronic media has
come to bear on the marketplace. Unless efforts are undertaken
to prevent this recurrence, I think we can look for even more
disruptive recurrences of this in the future.
To that end, I would respectfully suggest the following:
Without going into the specific Sections of the 33 and 34
Act, because I'm not entirely certain, in the amount of time
that I had to prepare this testimony, I have the correct
references in my written submission.
Chairman Baker. To that end, please feel free on reflection
to forward that information in writing at a later time. That
will help you in your presentation.
Mr. Byron. I would simply say Section 17(b) of the
Securities and Exchange Act of 1933, which I understand it in
laymen's terms, requires anyone who is paid by an issuer to
circulate, publish, or otherwise disseminate stock
recommendations, be augmented to require, as a matter of law,
that anyone publishing or disseminating that information
disclose on that document in which the dissemination takes
place, any financial interest, either direct or indirect, he or
she holds in the stock in question, and I would wholly endorse
the vivid image that the Chairman offered before of I want to
see the surgeon general's warning stamped across the front of
these things. It says ``Caution! Investing in This Deal May Be
Hazardous To Your Financial Health'' in big red letters.
In this particular area, I think that volunteerism just
hasn't worked. And I don't think that the' 33 Act, I live by
the First Amendment. I say things that anger lots of people so
the First Amendment is very important to me, and I don't feel
that the 1933 Act, as it's written now, violates my First
Amendment rights, and I don't think that the augmentation in
the way I'm saying, you might want to consider augmenting it,
would violate them either.
Second, I think that Section 10(b) of the 1934 Act, which
deals with the general concept of fraud of the market, could be
aggressively enforced by the SEC Enforcement Division. For
example, the black letter law we all know well in my line of
work, the Foster Wynans case. This is a case that the Wall
Street Journal reporter ran afoul of the act by using
information that he had obtained in the course of his work to
trade on stocks before putting it in the paper, in violation of
his agreement that he signed with the Wall Street Journal not
to do that.
I think the essential holding in that case boils down to
this: He promised not to do something that he went ahead and
did anyway. While I think the basic principle there can be
expanded to find an implied covenant, not just with your
publisher, but with the whole world of your consumers,
particularly when you're disseminating financial information
that is offered to the public under the color of impartiality.
Nobody is going to believe what you write if it comes
stamped all over it and says ``I make a buck so long as I get
your money,'' but if it's stamped on the front of it, if it
comes representing itself to be this is unbiased material, in
that case I think when you don't deliver unbiased material, you
ought to be held to account with a sanction that hurts.
I think we shouldn't be looking at the minimum amount of
disclosure necessary to find adequate disclosure, but the
maximum possible disclosure to protect the individual investor,
a completely different orientation.
I've probably run over my time. I thank you for your
patience.
[The prepared statement of Christopher Byron can be found
on page 245 in the appendix.]
Chairman Baker. Thank you very much, sir. We appreciate
your remarks.
Our next witness is Mr. Charles Hill, Director of Research
at Thomson Financial/First Call. Welcome.
STATEMENT OF CHARLES L. HILL, DIRECTOR OF FINANCIAL RESEARCH,
THOMSON FINANCIAL/FIRST CALL
Mr. Hill. Thank you. Good afternoon, Chairman Baker. I
would like to thank you and the Members of the subcommittee for
the opportunity to espouse my views on this important subject.
Let me first mention the usual disclaimers. The views expressed
here today are my personal ones, and are not necessarily those
of my employer, Thomson Financial/First Call, where I'm
Director of Financial Research, or those of the Boston Society
of Securities Analysts, where I'm a Vice President and a
Director.
I'm a chartered financial analyst and proud of it. My only
aim today is to uphold and improve on the quality and integrity
of my profession.
The problems we are talking about today are not new. They
tend to wax and wane with each stockmarket cycle. The only
difference this time is that some of the problems may be worse
than in past cycles. There does to be some secular trend
underway that may have been exacerbated by the cyclical swing
in the market and that needs to be corrected.
Any prolonged corrections in stock prices tend to wring out
some of the excesses we're talking about today. Nevertheless,
some of the underlying secular trends are disturbing and it may
take more than just a market correction to remedy the
situation.
Let me point out that in this market downturn, as in past
ones, investors always look for scapegoats. The broker/analysts
are an easy target. There is no doubt some basis for this, but
it is most probably over done. Let the record show that at the
time of the market's frothiest peaks, there were many broker/
analysts doing very thorough and objective research.
The problem was that there were not enough in this
category. There were too many whose work was shoddy and/or
biased because of naivete, laziness or outside pressures.
But let's not paint all the analysts with the same brush.
As a former sell side analyst for 18 years, I shudder at the
thought of returning to that field and having to compete with
some of the top analysts today with all the technology tools
available. There is no question in my mind that today's stock
research for the top sell side analysts is better than from the
top analysts of 25 years ago.
What we need to improve is the quality and objectivity of
the work from the rest of today's sell side analysts that are
not currently doing their job as well as they should. Before we
turn to the causes of deteriorating stock research quality, it
is worth looking at how the problems of quality and bias can
manifest themselves. There are four data items by which
analysts can distort an investor's perceptions of a company's
stock or leave the investor confused.
The first is recommendations, the second is target prices,
third is earnings estimates, and fourth is earnings basis. On
recommendations, this subcommittee has previously raised this
issue and has cited bar data, first calls data. The rough rule
of thumb is that about one-third of all broker recommendations
are in the positive category, strong buy, or whatever the
broker's equivalent term is.
About one-third are in the second most positive category
buy or whatever the broker's equivalent term is. About one-
third are in the third most positive category, hold or the
equivalent, with only about one percent in the two bottom
categories, sell and strong sell or their equivalents.
The individual investor needs a decoder that would put all
the brokers' various terminology for their recommendations on a
common scale. The brokers are doing a better job of putting in
each research report a definition of what their recommendation
terminology means, making it easier for investors to compare
one broker's recommendation with another. However, not all are
doing this. A better answer might be if the brokers could agree
on a common scale with common terminology.
Let me digress from my printed text for a minute to refer
to something Congressman Kanjorski was talking about. When you
mentioned about the confusion of the terminology, let me just
read you the different terms that the brokers used for the
third category. We've gone to all the brokers and said, you fit
whatever your scale of terminology is to a common scale from
one to five where one's a strong buy, two's a buy, three is a
hold, and so forth.
Here are the terms that are used in category three:
Accumulate, attractive, hold, average, hold/neutral, long-term
accumulate, long-term attractive, maintain, market average,
market perform, neutral, neutral/hold, no action, out perform,
perform in line, speculative buy, trading buy, market out
perform, stock pick.
Now what is the individual investor to do without this
decoder?
But let me go on. Unfortunately, the investor needs a
second level in their decoder to adjust for the over-optimism
of the broker analyst recommendations. Since the better
companies get more analyst coverage than do the weaker
companies, there is a justification for somewhat of a positive
bias to the recommendations. As of the end of July, yesterday,
this data was run. 27.6 percent were in the strong buy
category, 36.9 in the buy, only 1.1 percent were sells and 0.4
percent were strong sells. That means the number of buys of all
kinds were 47 times the number of sells of all kinds. That much
of a positive bias is hard to justify.
Last year when the market was at peak levels, the spring of
2000, and many stocks were substantially overvalued, the ratio
was even worse. On 1 March, it was 92-to-1. As the market crept
up to a bigger peak on May 1st, it was 100-to-1. As the market
began falling, the ratio was still a very high one, 99-to-1 on
the first of August. By October it was 78-to-1. Today, as I
mentioned, it's 47-to-1. It's a bid harder to understand why
the recommendations were even more positively biased than
normal at the market peak.
Second issue, target prices. Target prices are another area
where the analysts have the opportunity to put their naivete or
biases to work. Target prices became the rage of the 1990s, but
their popularity seems to have abated slightly. Many were
unrealistic, but many of the analysts that were providing those
target prices have lost considerable credibility.
Earnings estimates. Most analysts, most of the time, tend
to start out too high with their estimates at the earnings
report time. On average, the analysts start out too high ahead
of the reporting period. They bring the estimates down, but
take them down too far at the end of the period. More than half
of the companies in the S&P 500 beat the final estimates every
quarter.
Whether the analysts have been misled by the company's
guidance or whether they knowingly went along with that
guidance is debatable, but there does seem to be too regular a
pattern of companies beating the estimates, particularly at
some companies.
Now Regulation FD hopefully will diminish that problem. Now
the fourth one is earnings basis. One of the problem areas that
is mushrooming, but is often overlooked is the determination of
the earnings basis used to value the stock. The SEC requires
companies to report earnings on the basis of Generally Accepted
Accounting Principles, (GAAP). Most everyone would agree that
those numbers often need to be adjusted to exclude non-
recurring and/or non-operating earnings.
The problem is that what one person considers non-recurring
or non-operating, another may not. There is no right answer. It
is all in the eyes of the beholder. A big part of the analysts'
job is to determine the appropriate basis for earnings as used
in the price earnings ratio or other earnings-based valuation
yardsticks.
A company's earnings can often be enhanced by excluding
items that normally would not be excluded or by including items
that normally would be excluded. The excesses in this area have
been most common in the technology sector where the use of the
cash earnings or pro forma earnings have taken on a wide
variety of special meanings that have greatly enhanced some
companies' earnings.
Chairman Baker. Mr. Hill, if you can begin to wrap up, I
want to get all of our panelists in before we get interrupted
by a vote. I hate to do it.
Mr. Hill. OK. There's a growing trend for companies to put
out releases that emphasize an earnings number that has been
adjusted to a basis the company espouses, sometimes to the
almost total exclusion of the GAAP results. What this is
amounting to is a way for companies to gild the lily on their
earnings reports, and it's an issue that Lynn Turner did bring
up before his leaving the SEC.
But, let me just quickly say that the four ways that the
analysts are being pressured is first, themselves, in that the
analysts have fallen in love with the industries they cover, or
they'd be covering some other industry. So they start out with
what I call an honest bias, come to the table looking through
rose colored glasses. Second is the investment banking issue
that we've talked quite a bit about today. The third is the
public companies, the companies themselves putting pressure on
the analysts or they'll be cut off communications-wise.
Last, the institutional shareholders who also can pressure
the analysts not to put out a sell when they own the stock.
[The prepared statement of Charles L. Hill can be found on
page 248 in the appendix.]
Chairman Baker. Thank you very much, Mr. Hill. Your
testimony and all the witnesses' testimony will be made a part
of the record in full, and I'm sure--I know I do--we'll have
further questions in writing as well. Pleased don't feel
dispossessed if you don't get through your entire prepared
text.
Our next witness to appear is Mr. Matt Winkler, Editor-In-
Chief of Bloomberg News.
Welcome, Mr. Winkler.
STATEMENT OF MATT WINKLER, EDITOR-IN-CHIEF, BLOOMBERG NEWS
Mr. Winkler. Thank you very much, Mr. Chairman. I'm
delighted to appear before the subcommittee as part of your
continuing discussion of analyzing the analysts. My name is
Matthew Winkler. I am the Editor-In-Chief of Bloomberg News, a
global news service with 1100 reporters and editors and 80
bureaus in 50 countries.
Bloomberg News produces more than 4,000 stories daily on
the economy, companies, governments, financial and commodity
markets, as well as sports, politics, and policy. Many of these
stories are published in more than 350 newspapers including the
New York Times, The Washington Post, Los Angeles Times, Le
Monde, and the Daily Yomiuri.
Since its inception in 1990, Bloomberg News has received
more than 50 awards and citations for the quality of its
journalism, including awards from the Overseas Press Club, the
Gerald Loeb Foundation, the Society of Professional Journalists
and the Society of Professional Business Editors and Writers.
Bloomberg News is the main content provider for Bloomberg print
and broadcast media. These include several magazines, a New
York-based radio station and network, and a 24-hour television
network operating in the U.S. and in a dozen languages in
countries in Europe, Asia, and South America.
Financial stories are both complex and critically
important. As someone who is passionate about providing the
public with the context and analysis necessary to make sound
decisions, I want to salute this subcommittee for its
extraordinary commitment to ensuring that investors have broad
access to the highest quality information about the
marketplace. When this subcommittee greets with skepticism
efforts to create a property right in stock market quotes, or
highlights the question of whether investors are getting
unbiased research from Wall Street, you are taking a step
toward ensuring public access to information. In the
information age, that is no small accomplishment.
It may take a bear market for investors to realize that
many stock analysts have never been anything more than fancy
pitch men for the firms that sell securities. As long as shares
went up, as they did in the 1990s, analysts rarely had to say
``sell.'' In their lingo, the stocks were never ``fully
priced.'' Now that the NASDAQ composite, the symbol of the
greatest bull market ever, is down about 50 percent from a year
ago, it is easy to attack the analysts because the few
occasions when they might have said sell came long after the
damage was done.
Analysts always will have a conflict of interest as long as
the firms that employ them participate in initial public
offerings, arrange stock and bond sales, and use analysts'
research to help win new business. In such circumstances, it's
hard to find any analyst on Wall Street who met a stock he or
she didn't like. Analysts are part of the sales team.
Analyst conflicts of interest are a symptom of something
much more sinister. Until the Securities and Exchange
Commission late last year approved Regulation FD, public
companies routinely invited analysts and some of their
shareholders to private meetings as they discussed sales,
profits and losses. Until adoption of Regulation FD, analysts
were protected under law from insider trading liability and
liability for ``tipping'' if they did not have a special
relationship with the corporate officials that fed them insider
information--a monetary or other quid pro quo.
That protection was designed to shield analysts from
unlimited risks of liability for attempting to ferret out
information. It quickly became perverted, however, as issuers
figured out they could punish analysts that did not give them
good ratings. The punishment came in the form of exclusion from
the inside information gravy train which was provided to their
competitors. Inside information was thus joined with analysts'
recommendations in a troubling form of barter. It was as if a
student could punish the teacher for giving him or her a bad
grade by withholding the teacher's pay.
In short, this practice of selective disclosure
increasingly made the stock market a financial ``Animal Farm''
in which some shareholders were more equal than others. The
sloped playing field created by selective disclosure during the
1990s was so common that many analysts and publicly-traded
companies assumed it was the price of capitalism. Analysts
equipped with inside information, they argued, were needed to
grease the wheels of the market, even if they could trade on
that information before Aunt Betsy and the rest of the
company's shareholders.
The SEC disagreed because in too many instances, trading in
a company's shares turned out to be rigged, undermining the
integrity of the stock market. I believe the SEC got it right.
What precisely does Regulation FD have to do with analyst
conflicts of interest? Everything. Conflicts and bias breed in
the dark. The more information that is available to the public
the greater our collective ability to assess independently
whether the analysis we are receiving is potentially biased.
Does Regulation FD solve the problem of analyst conflicts?
Of course not. I repeat, as long as firms employ them to
participate in initial public offerings, arrange stock and bond
sales, and use analyst research to help win new business,
analysts will always have a potential conflict of interest.
Initiatives that enhance broad dissemination of information to
the public will have a salutary impact.
Justice Brandeis is remembered for observing ``publicity is
justly commended as a remedy for social and industrial
diseases. Sunlight is said to be the best of disinfectants.
Electric light, the most efficient policeman.'' Like seeing a
policeman in the rear view mirror or knowing a Congressional
Oversight Committee is looking over your shoulder, the
availability of information enhances accountability. That
serves as a catalyst that sometimes prods better behavior, and
that is very much in the public interest. Again, I commend you
for your willingness to explore this important issue.
Thank you very much.
[The prepared statement of Matt Winkler can be found on
page 253 in the appendix.]
Chairman Baker. Thank you very much for your remarks.
With apologies, Mr. Kianpoor, Chief Executive Officer for
Investarts.com, also a media panelist of sorts, I have been
informed that I have overlooked as well TheStreet.com also
being an internet site. Thanks to both you gentleman for your
willingness to appear today.
STATEMENT OF KEI KIANPOOR, CHIEF EXECUTIVE OFFICER,
INVESTARS.COM
Mr. Kianpoor. Speaking on behalf of the Investars.com team
and our co-founder, John Eagleton, I'm honored to have the
opportunity to contribute to these hearings. Investars.com was
founded in October 1999 to give investors tools to better
interpret stock recommendations made by Wall Street Analysts.
With the huge growth in the number of individual investors in
the mid-1990s, Investars.com sought to measure the track
records of Wall Street's research providers, thus giving
investors the tools that would allow them to sift through
dozens of stock recommendations made daily. Investars.com
degree of success system calculates the hypothetical return an
investor would have made if he or she had traded based on each
brokerage's recommendations.
Investars currently ranks more than 200 research firms,
based on their overall hypothetical returns for every stock
since January 1997. Hindsight has made it clear that the boom
and bust of the past 4 years did not leave lasting benefits for
anyone. Investors have suffered, businesses built on
unrealistic have collapsed, and the brand equity of many
brokers whose businesses depend on public trust is being eroded
as we speak.
We must join forces to implement common sense reforms that
will benefit all parties. Respectfully, we'd like to propose
three basic reforms.
One, to make historical recommendation and earnings
estimate data public; two, to encourage disclosure of
investment banks relationships with covered companies; three
push for a common recommendation language.
In the interest of saving time I've pared down some of my
testimony on subjects that have been mentioned before. I would
like to focus on some of the more important things. Historical
Wall Street recommendations and earnings data is not available
only to institutional investors. Individual investors suffered
in the recent boom and bust cycle, because they lacked these
key facts. They lacked these facts, because there's a virtual
monopoly on the distribution of analysts' historical data,
namely, financial data distributors who agree with investment
banks not to make historical ratings information available to
the public.
This is the single most important, most absurd, and least
addressed issue affecting the individual investor today, that
investment banks can prevent the release of their historical
recommendations data to the public. Historical recommendations
and earnings estimate data must be made available to all
investors and preserved in the public venue, such as the SEC
database.
Please refer to the statements made by other analysts
ranking sites, such as Validea.com and MarketPerform.com in our
written testimony.
The second issue is the disclosure of investment banking
relationships. Our IPO bias feature compares the track records
of investment banks based on their recommendations for
companies that they underwrote to their track records in
companies that they did not.
Overall, since 1997, the returns in the first case are
approximately 50 percentage points lower than the returns on
the second. Due to the lack of availability of historical
information, the possibility of conflict of interest was not
previously quantifiable for investors.
As their second reform, Investars proposes that investment
banks disclose to an SEC database their historical underwriting
relationship with any company which they cover. I believe
that's been brought up before. Disclosure is not an end in
itself. We call on the media on-line brokers, financial
advisors, research firms, and sites such as Investars, to
educate and protect the people. By placing this information in
context with current technology, we can explore investment
banks' track records and conduct a detailed peer group
analysis, and the media should avail itself of these new tools.
If it proves impossible to obtain full disclosure, the media
should emphasize the implications of its absence.
The third issue we need to address is Wall Street's
language. Again, that has been mentioned before. We need a
common scale. It's just common sense. In that case, our
conclusion is that we cannot lose sight of the average investor
who must be equipped to assess the quality and integrity of
market analysts.
It is common sense when you buy a car, you check consumer
reports. When you buy a house, you have it inspected. To make
such assessment possible, we need to establish a standard
language and break the investment banks' control over factual
historical recommendation data. Investars also suggests that
the media start to delve into more detail when reporting on
analysts' recommendations to the public.
We now possess the technology to refer to analysts' batting
averages and provide play-by-play commentary on their ratings.
We can publicize the good and transparent and underscore the
deficient, heighten investor awareness that will self-enforce
industry compliance with higher standards.
I'd like to end my testimony with a statement. There's a
greater fool theory in the market. It states that no matter
what a stock is worth, investors buy it, because they believe
there will be a greater fool willing to buy the stock from them
at a higher price. As long as brokers and financial data
providers can block the distribution of factually historical
data to the public, the average investor will ever remain as a
greater fool in the market. That's just common sense.
I'm grateful for this opportunity to share our views with
you today.
[The prepared statement of Kei Kianpoor can be found on
page 261 in the appendix.]
Chairman Baker. Thank you very much, sir. I appreciate your
willingness to appear.
Our final witness today is Mr. Adam Lashinsky, a Silicon
Valley columnist, and employed by TheStreet.com.
STATEMENT OF ADAM LASHINSKY, SILICON VALLEY COLUMNIST,
THESTREET.COM
Mr. Lashinsky. Thank you very much, Mr. Baker. I had the
privilege of interviewing you recently for an article that I
was writing, so turn about seems fair play. I'm happy to give
you my thoughts today.
When I first started out as a business reporter, I was
handed a large book called the Nelson's Director of Investment
Research. I was told there are lists of analysts in this book.
Call them if you need comments for the stories you're writing
on public companies.
I knew nothing about what the individual analysts did, the
importance of their firms, whether some were better than
others. All I knew was that the ones who returned my phone
calls were more valuable than the ones who didn't return my
phone calls. If they said something germane on the record, they
were even more valuable because they could go into my articles.
I think that as we entered the bull market, the individual
investor found him or herself in a similar position. They were
told in either the newspaper article or on television that an
analyst had something good to say about a stock. They had no
ability to judge whether or not that analyst was good or bad.
They knew that an expert was speaking and that information was
good enough.
The news media plays a role in this, and I'd like to
address that. The point is that professional investors have
understood the games that have been played on Wall Street all
along. The individual investor didn't understand what the
conflicts were, came into the game cold, if you will, just as
if having been handed a big book.
One thing, Congressman Baker, that I think hasn't been
addressed in the hearings yet is who is entitled to the
information that we're discussing and how they should be using
it. There's been discussion today of research reports being
entered into historical records or indeed being regulated like
a securities offering.
The fact remains that at least for now, these are not
public documents, these are proprietary pieces of research for
which investors pay. So Fidelity understands that it is a
client of Goldman, Sachs, to choose one example.
To the person watching on CNBC, it's not typically a client
of Goldman, Sachs. It they act on the research that Goldman,
Sachs has produced, in a sense, they're taking a shot there on
their own; they're not the client, they didn't pay for it. But
what is the media role here?
TheStreet.com has had a policy since its founding in late
1996 of always stating a conflict of interest that an analyst
has. So if we quoted an analyst whose firm was the underwriter
of the IPO of the company that we're discussing, we simply say
so. It doesn't mean that the analyst is good or bad, it means
that we're cluing our readers in that there's a potential
conflict here.
I would point out that sometimes those analysts are the
best informed because they spend more time with the companies,
but an investor has to have his or her eyes open to the fact
that there may be a conflict here. Thus, Street.com is not
immune from some of the criticism that the financial news media
deserves.
Over the past few years, we had, for example, something
called the ``Red Hot Index'' where we participated fully in the
momentum of the era. However, I'm proud of what TheStreet.com
has done in terms of outlining analysts' conflicts. I don't
think the rest of the media has lived up to the same standard,
in particular the broadcast media has been particularly harmful
in putting analysts or putting fund managers on television
without explaining to the overage viewer at home what the full
story is behind the recommendations that they're making.
I would offer to you several solutions that you're
addressing, not all of which I necessarily endorse, but I offer
them as food for thought.
One, you could write legislation to split investment banks
from brokerages. This would solve the problem. It would be very
painful. It would fly in the face of the last 10 years of
consolidation in the financial services industry, and of course
brokerages wouldn't be able to make much money in that
scenario, because trading is not a particularly profitable
endeavor, but it would solve your problem. Then you could allow
fixed rate minimum commissions again, so that brokerages could
run a profitable business. That flies in the face of Congress'
concerns about price fixing.
You could require, and you are discussing requiring greater
disclosure as the industry itself is discussing. My personal
opinion is that these are palliatives. They will have little
impact on the conflicts. They simply will make people more
aware of what the conflicts are and perhaps make people feel
better.
Lastly, you can rigorously support Regulation FD. There is
an undercurrent that isn't stated loudly that there are
elements with in the SEC and certainly on the Commission and
certainly in the securities industry to diminish the effects of
Regulation FD, because it makes the industry uncomfortable, and
it is requiring the industry, in my opinion, to work harder.
In my reporting, it's my opinion that Regulation FD is one
of the best things that has happened for individual investors
in recent history, and Congress can do its part by standing
firmly behind Regulation FD and not give in to some of the
demands that it be weakened.
Thank you, sir.
[The prepared statement of Adam Lashinsky can be found on
page 266 in the appendix.]
Chairman Baker. Thank you very much, Mr. Lashinsky.
Let me say to the whole panel, thank you very much. This
has been again very informative, but also very troubling. From
the first hearing, when there were some observing, wow,
Congress is looking at the conflicts of interest on Wall
Street, isn't that news?
Obviously we all know that there are conflicts and firms
have assured us of their ability to manage those conflicts. But
the further we have gone in looking at the divergent list of
individuals who have unique perspectives of market actions,
there is no doubt that the character and nature of the market
has changed over the last decade.
Unfortunately, I think there is reason for most investors
to have great concern about the independence of the information
flow when they make such significant investment decisions
coupled with the advent of online trading, and now what many of
us in political life call the working moms and pops investing
on line and, to some extent, using media appearances. Look at
what's happening here in this sector today, the type of
analysis in order to make all those small individual
transactions in the aggregate responsible for the huge inflows
of capital to the market. We have a very volatile circumstance.
In speaking with most members, we are all reticent to act
legislatively. But it would be my intention, based on the
support of the subcommittee, that we would move forward from
this point with some recommendations through the fall and
winter and perhaps come back with the assistance of the NASD,
the SROs and the SEC, and determine whether our actions and
recommendations have not only been implemented, but there is
actual day-to-day practice and consistent following of the
recommendations that appear to be warranted.
Let me make a couple of statements and then kind of get the
consensus, yes or noes. My view is everybody thinks there's a
problem. You all may not see the same problem, but generally
there's a problem that we need to fix. Nobody objects to that?
Second, that it would be better, if possible, for the
industry, itself, to craft the remedy, but have that remedy be
subject to the light of day. For example, additional committee
hearings, SRO insight, that's maybe in the middle of the pack.
Are there those who agree with that sort of general context
that we ought to do something, look to the industry, and then
verify.
The next question is much more difficult. Let's assume
we've gotten through those first two steps. We've prepared a
list, we've gotten the industry to look at it, but there's
still not consistent uniformity in compliance. What should be
the enforcement mechanism? Is it sufficient, as I suggested to
Ms. Unger earlier, to have just a rating mechanism; a, you're
complying with all the rules; b, you're trying, but you're not
quite there; c, you've got a problem. Will the publication of
you being on the c list have a consequence in the market? Is
that a point of discussion?
Yes, sir?
Mr. Winkler. Mr. Chairman, I think the greatest impact on
the market is disclosure and the more disclosure there is, just
as you yourself said earlier today, a warning on a package of
cigarettes is a very powerful way of letting people know that
they are about to use something that's possibly fatal. Reg FD
goes a long way toward that kind of goal.
And I do think that if this subcommittee were active in
doing everything it can to promote and enforce Reg FD, that
would be very helpful.
Chairman Baker. Thank you for that. I do have some concerns
about Reg FD, but not from the perspective of the industry
having a difficult time complying. I just want to make sure it
functions in the intended fashion. And further to the point, it
would have no implication on an analyst making a recommendation
to buy when he's selling his own interest.
I think we have to get not only at the flow of information
but the personal conduct issue of the individuals. For whatever
reason, it makes no difference; are they being pressured by the
firm or is it the opportunity to make four or five million
dollars on a deal. If they do it, it's wrong. That's where we
have to have, I think, significantly more involvement by the
SROs than we have today.
For example, it troubles me greatly that, at least
according to Ms. Unger, the NASD does not look at an analyst or
require disclosure, if he makes a television appearance, if
he's got an interest in the stock which he's talking about. I
find that unfathomable from a regulator's perspective.
Mr. Lashinsky, did you have a comment?
Mr. Lashinsky. Yes, sir. I was going to say that in every
instance I know, the compliance department of any firm would
not allow the type of department that Ms. Unger described
earlier. Without being a lawyer, that strikes me as fraudulent
behavior and bad ethics, so there's a break down in how the
SROs are regulating the compliance departments of their own
members.
Chairman Baker. Ms. Unger also stated that in the short-
term audit they conducted, there was only one firm that could
give her an accurate reporting of all the analysts' interests
within the firm. How could you possibly have any capacity to
govern analysts' practice if you don't know what they own?
There's a fundamental structural problem here that is going
to take more than one hearing and one simple piece of
legislation to fix. To that end, we will get back to each of
you with additional questions and insights for you to give us
your educated opinion on.
But we would very much welcome, over the course of the
August recess, your best thinking along the idea of here are
the elements we think would be important as we have a peer
review group now looking at the SIA's best practices.
By the way, just a show of hands, how many of you think the
SIA's best practices recommendations are sufficient?
[No response.]
Chairman Baker. That's what I thought.
Over the August recess, if you'll give me your insights
into those, as well as additional steps from your various
perspectives, it would be very helpful to us in trying to
construct very carefully a package for us to suggest to the
SROs that they review, and our process would be very slow.
We're not going to rush to judgment. But to take the fall and
winter and come back next spring and make an assessment about
the effect and consequences and recommendations that the
subcommittee may make this fall. It's just by way of process.
I don't want to go on at length because Mr. Kanjorski and
Mr. Crowley have been very patient sitting here.
Mr. Kanjorski.
Mr. Kanjorski. Thank you, Mr. Chairman.
Mr. Kianpoor, you made an observation that the value of a
stock will be whatever the next idiot will pay.
Mr. Kianpoor. That's right. It shouldn't, but it did for
the last 2 years.
Mr. Kanjorski. And after the excellent testimony of the
entire panel, each one of you added a great deal of insight
into some of the problems in analysis on Wall Street.
I don't think any of you are my age, but I'm going to
relate a story. You may remember my favorite program when I was
a young man in the late forties, was Captain Midnight. Captain
Midnight was sponsored by Ovaltine, you'll remember.
I was just about able to read, write, and figure out how to
do things, and I was pressed at 5:00 o'clock every day to
listen to Captain Midnight. And Captain Midnight started this
process of the secret code and secret information, and every
day you would write down the numbers. They were useless to you
if you didn't have a decoding device, but Captain Midnight
offered a decoding ring with ten bottle labels of Ovaltine and
a dollar.
And as a dutiful follower of Captain Midnight, I bugged the
hell out of my mother to get those ten bottles of Ovaltine. By
hook or crook, I got that dollar and I wrote in, and at that
time, nothing was instantaneous like the internet; thus, with
bated breath every day, when I'd come home from school, I'd
look for my package from Captain Midnight. It wasn't there. It
took weeks. But every day at that program at 5:00 o'clock, I
copied down all those numbers so that when my ring came, I'd
know what Captain Midnight was saying to me.
Finally, the day arrived and it came, and I remember it
very well. I tore that box open. I immediately ran in and I
couldn't wait for the program to be over when the message would
be given, and finally it was given. And I took my ring and I
decoded the message. It was probably the best lesson I ever
learned in my life, because the message was----
Mr. Hill. Congressman, that was the information for my
reference. I had my Captain Midnight Decoder.
Mr. Kanjorski. Do you remember what the decoded message
was? ``Buy Ovaltine.''
[Laughter.]
Mr. Kanjorski. Well, it taught me a lesson. We can't
encourage Americans to necessarily buy decoder rings when
they're not available. Somebody's got to do something with this
decoding. We have to move out of the Orwellian world. I think
the Chairman and I both agree we would least like to do it by
Government action. But clearly, I was disappointed. I listened
to the testimony of the SEC today. And I got the feeling that
it's not our fault, it's somebody else's responsibility if they
are not doing something.
It didn't strike me that the proper attention was paid, but
then I thought about listening to all of you six gentlemen
here. I want to compliment you. You are all competent and very
successful in your field, but you have to answer this question
for me.
Why wasn't there anyone that did investigative work in 1998
and 1999 and 2000 to tell the American people and most of us
about these terrible analysts when the market was going up?
Yes?
Mr. Kianpoor. As I said before, the data was not being made
available to individual investors. That means to do this
investigative work, you need to get the historical data for
what these analysts and investment banks have been recommending
for the past 10 years.
Mr. Kanjorski. You mean that there is nobody?
Mr. Kianpoor. The data is being provided by investment
banks to certain financial data providers which will not
allow----
Mr. Kanjorski. Then, we are going then through a fog, is
that it?
Mr. Lashinsky. Mr. Kanjorski, there were plenty of people
during that period who did research and said repeatedly ``this
is madness, this stock is not worth what you say it's worth.
There are ways to fundamentally value this stock, and it's
highly over-valued.'' And those people were laughed at for
roughly 3 years because the stock kept going up and kept going
up and kept going up. That was the period we just came through.
Mr. Kanjorski. Would it have made any difference if we had
the historical knowledge?
Mr. Kianpoor. It would have, Mr. Kanjorski, and it will in
about 4 or 5 years. As early as now, people are looking at our
site and finding out what people's track records are instead of
having a Surgeon General's warning on TV coming up, you could
have the person's track record and see either the guy is a
complete crook or a complete idiot. It's far more effective.
Mr. Kanjorski. It strikes me as something like Monday
morning football reporting, how well we played the game that
was played on Saturday. We are the greatest analyzers of why Al
Gore lost the election. But I don't think anybody could have
told you that or would have told you that beforehand.
And I'm just wondering, are we chasing a phantom?
Chairman Baker. Let me jump in too, because I think Mr.
Byron wanted to make a comment in response to that question.
Mr. Byron. Yes. I would simply say, Congressman Kanjorski,
that the data on which you can base informed judgments with
respect to the value of a stock, given that no one can foresee
the future, at least makes some reasonable guess about the
likely course of a stock's value. It's available to everybody,
whereas 20 years ago, it wasn't. And I mean by that, the
instant access to audited financial statements, balance sheets,
income statements, cash flow statements, shareholder equity
statements from publicly traded companies via the filing system
of the SEC. That stuff is all available and usable by anyone.
Most people have neither the time nor the expertise to dig
into that stuff and understand it. That's where the role of the
media is critically important, because in my respects, we're
the unelected, self-anointed proxies for public understanding
of what these documents are.
Mr. Kanjorski. How am I going to know, though, if I'm
listening to you on the radio, and you're paid for by Exxon or
American Express? How do I know whether or not that's
influencing what you're saying to me?
Mr. Byron. There is an inherent problem in that with
everything in the capitalist system obviously. At some point,
we all need to pay the rent.
The question that I want to get at is when the conflict
becomes gratuitous, particularly in the media, when media
voices begin to have a demonstrable self-interest in the
outcome of their own opinions and their own reporting at the
same time the entire system tends to break down, because
there's no place left for the public to go unless a investor
wants to take the time to learn how to read a 10K statement
from the SEC. Most people don't want to do that.
So in my opinion, a very important part of this equation
has to be the role of the media and financial journalists. When
we start thinking of ourselves as superstars in the same way
that the analysts do, we have a really serious problem on our
hands, because who stands to inform the public when you have a
situation like that?
Chairman Baker. If I can recognize Mr. Crowley, do you have
a comment or question, sir?
Ms. Crowley. I do, Mr. Chairman. Thank you very much.
It's funny. If I close my eyes, I think I'm listening to
election reforms sometimes, some of the comments that are made.
I appreciate that, because there are some analogies I think you
can draw between the two in terms of the sharing of information
by electoral analysts or financial analysts in terms of
expertise dealing with election results or, in this case, maybe
before the bell rings, what they hope would be the market
results for a particular product.
Mr. Glantz, I have a couple of questions, and first of all,
let me thank you for being here. It's good to have, from a
retired analyst, insider information basically on how some of
this may work.
The Henry Blodgett case put the analysts into the forefront
for millions of small investors. While this case was before the
SEC and Mr. Kanjilal--I hope I'm pronouncing that right--of
Queens, my hometown, went to arbitration, and it first looked
like that was going to be the road we were going to be going
down.
This event brought to light a serious issue that when small
time investors, who are the bulk of the American public, set up
a brokered deal, many of these firms require that that
individual agree to arbitration as opposed to going to the
courts to address any wrongdoings down the road.
In your view, do you think the current law should be
overturned or reviewed so that private plaintiffs are provided
with the right of action against analysts?
And with respect to the current arbitration system, do you
believe that the arbiters should be outside the securities
industry and that they rather be from the American Arbitration
Association or some other outside firm to oversee the
arbitration?
Mr. Glantz. Yes. I agree that investors should be able to
sue in courts. I believe that any arbitration should be done by
people outside of the system.
If I can also add a response to a previous question. One of
the problems with the rating systems is that the greatest
excesses are made by people who have no track record. Whoever
heard of Henry Bodgett before the internet stocks went up? It
would have taken until the stocks fell that you would know that
he had been over-enthusiastic. I think the basic problem is not
the analyst, but the pressure on investment banking.
If you tell the investment bankers, ``Gee, I think this is
a terrible company,'' you get fired. If you don't support the
stock, you get fired.
Ms. Crowley. Today, but not in the past.
Mr. Glantz. Right.
Mr. Hill. Back in the days when I was an analyst, I could
put a sell, as I did on investment banking clients, and I did
not hear anything from the investment banking side of the firms
I worked for or from the companies involved. But that's changed
today.
Mr. Kianpoor. Mr. Crowley, that's why we are looking for
historical information on investment bank recommendations. We
don't go by analysts, because we believe that going by analysts
would be like saying that the tail is wagging the dog. We go by
Merrill's recommendations or CFSB's recommendations. Every time
they make one, they put their equity at stake, and the public
should know what their track record in different stocks and
different sectors is when they're making those decisions.
That's a market-based solution to the problem.
Ms. Crowley. In the interest of time, I yield back, but
before I do, I thank the Chairman. I believe this is the second
hearing on this and there are going to be more hearings. I look
forward to it because this is a very interesting issue. The
whole concept of an analyst being rewarded for information that
he or she gives over the mass media is troubling to me. It's
substantial dollars. We're talking in the range of $100,000
plus dollars for every time they give a bump to a product over
the media, the mass media. That's troubling, because it affects
my constituents, the general public that is more involved and
more interested in the market than ever before, those are the
people that we have to look out for.
And that seriously troubles me. So I thank you all for your
testimony today.
Chairman Baker. Thank you, Mr. Crowley, and yes this is
only the second, but it really is the beginning of this
subcommittee's jurisdictional responsibility. I don't see even
the passage of legislation as the end of our responsibility. If
there's anything I've learned from pass excesses, the Long-Term
Capital Management and others, there has to be outside constant
review of business practice in order for the system to work
without distortion.
Ms. Crowley. I agree with you, Mr. Chairman. In fact, I
think the hearings you're holding are doing in many respects
just that.
Chairman Baker. Thank you, sir.
I believe that it's an important responsibility in light of
the way the market has changed, technology has opened up the
world to the small dollar investor, they may even, despite FD,
be flooded by information they can't even understand. So I
don't know that folks today have the confidence that the people
they pay for information are necessarily giving them the
unvarnished truth.
That's what this is all about. I would like to return to
the remedy aspect. I don't think it's that difficult. I think
it's difficult because it may change business practices in
certain areas and cause difficulty in securing the IPO client
for the investment bank. But if you have the research
department not reporting to the investment bank, where their
compensation package may be based on the quality of their work,
is it facetious to be believe that, as a research analyst, that
if you do your work, and go out and say this is a dog and say
this one is so-so, and this one is where we want to put our
money, and based on those recommendations at year end, if you
did identify the dog, you did tell them where to put their
money properly, isn't that a mechanism which could work with
reasonable support from professional management?
Mr. Hill.
Mr. Hill. It could work if the compensation system was
changed. It did work in the past, but the problem is, and this
is where the buy side institutions have to look in the mirror.
They have been one of the big complainers about the
deterioration and the objectivity of quality of sell side
research, but they've driven commissions down to extremely low
rates. There's more of a premium today on trading execution so
it's difficult to get paid the way the brokers used to be able
to for their research.
When I was an analyst, I was incentivized monetarily to do
good fundamental research. Once a quarter, the institution sent
a letter in saying, we did X amount of commissioned business
directed to your firm in return for research services provided
by the following analysts.
If my name appeared on more of those letters than my
compatriots did, I got a bigger share of the research
department bonus pool. In those days, the research department
generated enough commission business to have a bonus pool. If I
did something for investment banking along the way, there may
be a little sweetener in there for that, but it was the
frosting on the cake.
The problem today is it's the cake, because they can't get
paid for research and they've had to return to investment
banking to compensate the analysts.
Chairman Baker. Let's take that point. Let's assume for a
moment that business practice has changed. We can't undo it and
it's a fact of life. The conflict of interest will continue. Is
merely the disclosure of the relationship somehow doing
something about the IPO problem that was referenced, I believe,
by Mr. Glantz in your testimony. Is that going to be sufficient
along with Reg FD-like disclosure requirements sufficient to
bring back or to establish credibility in analysts' work with
the average investor.
If we can't unwrap the investment bank research problem,
where do we go from there?
Mr. Glantz. You have asked two question. One question that
you asked earlier, if I have an investment banker who is making
the firm hundreds of millions of dollars, I don't care what the
formal relationship is, he runs research. The second is to
restore investor credibility. Unfortunately, the investors who
are hurt the most are not paying for the research, they're
trading on AmeriTrade.
Chairman Baker. A network.
Mr. Glantz. They're trading on the internet. Every once in
a while I used to go into one of these chat rooms to find out
what people were saying. I was amazed at the illiteracy, the
lack of knowledge, ``So-and-so's stock is going to go to a
hundred,'' and that's not the analysts' fault.
The criticism I make of analysts is conflict of interest
and I think that should be on the first page. But is that going
to cure the problem of the reputation of analysts? No.
Chairman Baker. Any other comment on the next step?
Mr. Lashinsky. I would just disagree with one thing that
Chuck Hill said to get to Ron Glantz's point. Typically, the
buy side is not particularly upset with the situation. They see
it as an unfortunate situation, but they know that they can't
rely on the sell side for buy and sell recommendations. So they
take the sell side for what it's worth. It's expertise, it's
knowledge, it's analysis, not its recommendations on the
stocks. They have their own research teams for that.
Chairman Baker. Would you like another round, Paul?
Mr. Kanjorski. I was going to confess something. I gave up
holding equities when I got elected to Congress. But I have to
tell you, I gave up going to cocktail parties about 5 years
ago, because I just couldn't stand to go to them and listen to
all my friends making 30 and 40 and 50 percent return on their
investments knowing I'm in Government bonds.
Now I appear absolutely brilliant, but I want to make the
point that what some of you were talking about here goes to the
question of ethics and business. These investment banking
houses are very substantial houses employing very substantial
people. It seems to me they are prostituting, as I think the
word was used, their analysts to help that side of the
business.
Am I to believe that Wall Street is so much different than
say the journalistic area where Katherine Graham stood behind
her investigative reporters even against the President of the
United States. Have we lost that standard of ethics in the
business field? Has capitalism gotten to the level that money
and money alone is the determining level of what ethics exist
in the business?
Mr. Byron. Congressman Kanjorski, I would simply say that
we're at the end, or we were in March of the year 2000, to the
longest sustained bull market in the Nation's history. We saw
levels of premium value attached to stocks that really turned
people's heads around.
I think that it's really possible to lose your moorings
when you can go from $30,000-a-year to $2- or $3-million
dollars a year in 2 years in a job. So, yes, I think that the
correction that you're now seeing in the market is likely to
correct a lot of that.
Nobody was complaining. Nobody ever complains about the
stock market when it goes up. It's only when it stops going up
that people start wondering, well, why didn't you tell me
before. So the ethical question I think is likely to disappear
as values return to their historical norms.
Mr. Kanjorski. With the market coming down, everybody's
going to get ethics and morals?
Mr. Byron. You'll find ethics returning to their mean, yes.
Mr. Kanjorski. I had the one question that I brought up in
my opening statement. Maybe if you could just individually
respond if you have a comment on it. I have a great fear on the
public policy question of privatizing Social Security and
turning those millions of investors and billions and trillions
of dollars over to what you describe as an ``unethical, ethical
or egoistic omen market.''
What are your feelings on this as individuals? Are we
prepared to do that?
Mr. Glantz.
Mr. Glantz. I think this has to be extremely well thought
out or we're going to have a repetition of the S&L problem.
With your constituents saying, ``I just lost half my money,
make me whole.''
Mr. Lashinsky. I work for a website that is committed to
informing the individual investor and I think your concerns are
extremely valid.
Mr. Kanjorski. I just want to congratulate you two. Are you
the last two existing dot com companies?
Mr. Lashinsky. I'm not sure how to respond to that.
Mr. Kanjorski. Going back to what I said before, when I was
growing up in a rather conservative investor home, we used to
think of real estate investments the way you figure out the
value of property was ten times earnings rentals: That was a
pretty good mix of whether the profit was going to be there and
the real estate investment, a maximum of 12 to 20 percent
profits or earnings to price.
Then, of course, I went to these cocktail parties 5 years
ago and I heard 100-to-1. You didn't worry about companies even
making earnings. It was what do we call it, a new market, a new
economy?
Chairman Baker. Stupidity, I think is what it was.
Mr. Kanjorski. We do not want to go into overkill. I, for
one, would like to see more Americans have the capacity to
participate in equities. I think that is a major positive
feature of America today and the world today, but we cannot
allow unrestrained exposure of the fox in the hen house, and
I'm even worried about H.R. 10.
Now we have allowed these securities companies to become
part of huge banks and huge insurance companies. If they are
willing to pollute and prostitute any measure including the
media, maybe we have some fear out there. Unfortunately, maybe
we need Government restraint, even though so many of us would
like to have less regulation. Maybe we are starting down a
trail that we have created our own monster.
How is H.R. 10 treating this? I talked to a banker the
other day and he expects the world to have six multi-trillion
dollar banks in the next 10 to 20 years and that will be it.
The rest will be little mom and pop operations out there.
That's an awful lot of economic power to put in the hands of
single people. The questions are what will they do with it, and
what will the people that work for them do with it, and how
willing will they be to surrender their ethical standards or
morality?
Anyway, Mr. Chairman, again, great panel, great discussion.
I think we can take back to our membership a great transcript.
Thank you.
Chairman Baker. Thank you very much, Mr. Kanjorski. I too,
like Ranking Member Kanjorski, don't have any investments in
the market. Given my responsibilities, I don't think that's
appropriate. But my son asked me some time ago, ``Dad, when
should I get out of the market?'', and I told him ``About 3\1/
2\ years ago.'' This thing can't last. He just started speaking
to me a couple of weeks ago now that things have gone in a
different direction.
There is no doubt that the individual investor shares a
great deal of responsibility in the current market
circumstance. People don't make you put your money in the
market, you have to make a conscious decision to write the
check, to add the debit to your account. But I think our
concern, properly focused, is when you make that decision that
the information you are receiving is unbiased, accurate, and
any interest in the party that is giving you the information
material to your investment decision should be made clear.
There's nothing wrong, and I've used it numerous times in
prior hearings, in Louisiana real estate law, if I'm going to
represent buyer and seller, I must have a written disclosure by
both that that is OK, and then I am not allowed by law to give
any information about the buyer to the seller or conversely
that would prejudice the ability of the other to get full
market value, or for the seller to get the best price.
I become basically a letter carrier at that point, and can
no longer espouse a particular party's interest in that
transaction. We have got to get our standards and the
consequential effects for violating the standards in a position
where I can have the same confidence in the analysts that my
constituents are utilizing that I think my constituents can
have in a Louisiana realtor.
I don't think that is a standard that's too high to
achieve. So from my perspective, with your good help over the
coming months, we hope to be able to encourage the private
market to see the advisability of this effort to be cooperative
and to perhaps lead us in the right direction.
But, as some have indicated, if we are not successful and
the problems do not appear to be remedied, then I certainly
would not at this time rule out the possible further actions of
this subcommittee, given the Members' interest expressed here
today.
With that, I thank you for your courteous and lengthy
participation and we look forward to hearing from you further.
Our hearing is adjourned.
[Whereupon, at 5:15 p.m., the hearing was adjourned.]
A P P E N D I X
June 14, 2001
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