[Senate Hearing 107-385]
[From the U.S. Government Publishing Office]
S. Hrg. 107-385
THE WATCHDOGS DIDN'T BARK: ENRON AND THE WALL STREET ANALYSTS
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HEARING
before the
COMMITTEE ON
GOVERNMENTAL AFFAIRS
UNITED STATES SENATE
ONE HUNDRED SEVENTH CONGRESS
SECOND SESSION
__________
FEBRUARY 27, 2002
__________
Printed for the use of the Committee on Governmental Affairs
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COMMITTEE ON GOVERNMENTAL AFFAIRS
JOSEPH I. LIEBERMAN, Connecticut, Chairman
CARL LEVIN, Michigan FRED THOMPSON, Tennessee
DANIEL K. AKAKA, Hawaii TED STEVENS, Alaska
RICHARD J. DURBIN, Illinois SUSAN M. COLLINS, Maine
ROBERT G. TORRICELLI, New Jersey GEORGE V. VOINOVICH, Ohio
MAX CLELAND, Georgia PETE V. DOMENICI, New Mexico
THOMAS R. CARPER, Delaware THAD COCHRAN, Mississippi
JEAN CARNAHAN, Missouri ROBERT F. BENNETT, Utah
MARK DAYTON, Minnesota JIM BUNNING, Kentucky
Joyce A. Rechtschaffen, Staff Director and Counsel
Cynthia Lesser Gooen, Counsel
John N. Wanat, Congressional Fellow
Hannah S. Sistare, Minority Staff Director and Counsel
William M. Outhier, Minority Investigative Counsel
Jana C. Sinclair, Minority Counsel
Darla D. Cassell, Chief Clerk
C O N T E N T S
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Opening statements:
Page
Senator Lieberman............................................ 1
Senator Thompson............................................. 4
Senator Levin................................................ 6
Senator Collins.............................................. 7
Senator Torricelli........................................... 9
Senator Voinovich............................................ 11
Senator Bunning.............................................. 13
Senator Bennett.............................................. 13
WITNESSES
Wednesday, February 27, 2002
Anatol Feygin, Senior Analyst and Vice President, J.P. Morgan
Securities, Inc................................................ 15
Richard Gross, Analyst, Equity Research Division, Lehman
Brothers, Inc.................................................. 17
Curt N. Launer, Managing Director, Global Utilities Research
Group, Credit Suisse First Boston.............................. 18
Raymond C. Niles, Senior Analyst, Citigroup Salomon Smith Barney. 20
Howard M. Schilit, Ph.D., CPA, President and Founder, Center for
Financial Resarch & Analysis, Inc.............................. 23
Hon. Robert R. Glauber, Chairman and Chief Executive Officer,
National Association of Securities Dealers, Inc................ 50
Thomas A. Bowman, CFA, President and Chief Executive Officer,
Association for Investment Management and Research............. 52
Charles L. Hill, CFA, Director of Research, Thomson Financial/
First Call..................................................... 54
Frank Torres, Legislative Counsel, Consumers Union............... 56
Alphabetical List of Witnesses
Bowman, Thomas A., CFA:
Testimony.................................................... 52
Prepared statement........................................... 100
Feygin, Anatol:
Testimony.................................................... 15
Prepared statement........................................... 67
Glauber, Hon. Robert R.:
Testimony.................................................... 50
Prepared statement with an attachment........................ 90
Gross, Richard:
Testimony.................................................... 17
Prepared statement........................................... 72
Hill, Charles L., CFA:
Testimony.................................................... 54
Prepared statement........................................... 109
Launer, Curt N.:
Testimony.................................................... 18
Prepared statement........................................... 73
Niles, Raymond C.:
Testimony.................................................... 20
Prepared statement........................................... 82
Schilit, Howard M., Ph.D., CPA:
Testimony.................................................... 23
Prepared statement with attachments.......................... 86
Torres, Frank:
Testimony.................................................... 56
Prepared statement with an attachment........................ 111
Appendix
Chart entitled ``Enron Stock Recommendations by Broker''
(submitted for the record by Chairman Lieberman)............... 127
Chart entitled ``S&P 500 Price Index Versus S&P 500 Consensus
Recommendation'' (submitted for the record by Chairman
Lieberman)..................................................... 128
Chart entitled ``Enron Consensus Recommendation Versus Stock
Price'' (submitted for the record by Chairman Lieberman)....... 129
Chart entitled ``Banking Firm'' (submitted for the record by
Senator Levin)................................................. 130
``AIMR Standards of Professional Conduct pertaining to Gifts,''
response to a question by Senator Levin submitted by Mr. Bowman 131
``Association for Investment Management and Research (AIMR)
Survey on Accounting for Stock Options,'' response to a
question by Senator Levin submitted by Mr. Bowman.............. 132
Damon A. Silvers, Associate General Counsel, on behalf of the
American Federation of Labor and Congress of Industrial
Organizations, AFL-CIO, prepared statement with attachments.... 135
THE WATCHDOGS DIDN'T BARK: ENRON AND THE WALL STREET ANALYSTS
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WEDNESDAY, FEBRUARY 27, 2002
U.S. Senate,
Committee on Governmental Affairs,
Washington, DC.
The Committee met, pursuant to notice, at 9:33 a.m., in
room SD-342, Dirksen Senate Office Building, Hon. Joseph I.
Lieberman, Chairman of the Committee, presiding.
Present: Senators Lieberman, Levin, Torricelli, Thompson,
Voinovich, Collins, Bunning, and Bennett.
OPENING STATEMENT OF CHAIRMAN LIEBERMAN
Chairman Lieberman. This hearing will come to order. I
thank you all for being here.
This hearing, which is called ``The Watchdogs Didn't Bark:
Enron and the Wall Street Analysts,'' is the third in a series
of hearings that our Committee is holding on the largest
bankruptcy in American history. It is part of our ongoing
attempt to assess the damage, learn the lessons, and help craft
the solutions to the problems that led to the fall of Enron and
its many connected catastrophes.
Future hearings of the full Committee and our Permanent
Subcommittee on Investigations will look at the role of other
watchdogs, including Federal agencies, auditors, and the board
of directors.
Today, we focus on the private analysts whose warnings
could have, and many say should have, alerted investors to the
fiscal fissures in Enron's foundation before everything
crumbled, but who instead continued to urge investors to buy
Enron stock even after the company began to crumble.
Why were the analysts blinded to the company's deceit and
disintegration? And how can we prevent similar failures in the
future?
Those are the crucial questions we are going to ask today,
and they are crucial because the Enron earthquake has left
millions of Americans worrying that their stocks are standing
on shaky ground. According to a recent Business Week/Ipsos-Reid
poll, 68 percent of investors said they have little or no faith
that the stock market treats average investors fairly, and 54
percent of investors said they are concerned about the honesty
and reliability of the investment information they receive.
According to Business Week, ``The worry is that thousands of
companies have consistently and legally overstated earnings for
the past few years.'' In other words, even when the Enron smoke
clears, people are worried that there may be more accounting
smoke and mirrors lurking. And this is consequential. It is
serious not only for those investors but for our economy.
The average investor today I am afraid feels like a swimmer
who has seen a shark. He or she doesn't know how many more
sharks are in the water and whether there are any lifeguards on
duty who are doing their job.
Making sure those lifeguards are on the lookout is part of
our purpose here, and it is a very important purpose because
this is more than a crisis for a small slice of America's
economy. It really hits at the heart of our recent prosperity.
Spreading 401(k) accounts and a rising market--or rising
markets, really, have spurred a seismic shift in stock
participation over the last 2 decades. From 1930 to 1980, the
number of Americans investing in the markets hovered between 5
and 15 percent. By 1998, that had jumped to more than 50
percent.
It is these middle-class Americans, the new investor class,
who are most shaken today. When equipped with trustworthy, up-
to-date, and independent information on a company and its
competitors, investors, whether professional or amateur, can
choose stocks wisely. But without sound information or, even
worse, with misleading information, they may as well go
gambling.
Average investors I think don't expect Wall Street analysts
to guarantee that they are going to get rich. But they do
expect them and others to filter out the vast and potentially
confusing flow of information about companies and markets to
dissect and decipher the financials of companies, especially
those with hard-to-understand business models, in a way that is
meaningful not only to Wall Street insiders but to investors on
Main Street.
Information, after all, is one of the most precious cargos
in America's economy, and Wall Street analysts are expected to
transport it with maximum care.
This, I think, is the unwritten agreement that has drawn
middle-class investors into the market, and it is what they
rely on as they enter the markets. They know that there is risk
there, that not every stock they invest in will always make
money. But they rely on the watchdogs, both private and public,
to keep the stock markets fair and to give them accurate
information to help them decide where to put their money and
with it their hopes for economic advancement and retirement
security.
The question we ask today is: Have the Wall Street analysts
kept their part of the bargain? And I regret to say that, based
on the investigation our Committee has done, my answer is no,
they have not. Ten out of 15 analysts who follow Enron were
still rating the stock as a ``buy'' or a ``strong buy'' as late
as November 8. This chart \1\--the dark green being ``strong
buy,'' light green ``buy,'' yellow ``hold,'' and red ``strong
sell,'' pink ``sell''--shows you that as of November 8, 10 of
the 15 companies and analysts listed there were still
recommending that Enron was a good buy. And that was 3 weeks
after the initial report of the company's hidden losses
appeared in the Wall Street Journal and about 2 weeks after the
SEC announced an investigation of Enron, and literally months
after the challenging and provocative article by Bethany McLean
that we have all learned so much about, and months after at
least one independent analyst, who I will refer to in a moment,
began to ring alarms about Enron.
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\1\ Chart entitled ``Enron Stock Recommendations by Broker,''
referred to by Senator Lieberman appears in the Appendix on page 127.
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Enron's ad campaign, or one of them, as some may remember,
was: ``Ask Why.'' It now seems clear that too many analysts
failed to ask why before they said buy, and often when they did
ask why but didn't get a straight answer from Enron's
executives, they went right on touting the stock.
At least one analyst did no better. On May 6, 2001, the Off
Wall Street Consulting Group issued a report calling Enron
stock ``extremely overvalued'' and pointing out many of the
problems that would later be revealed in full when the company
collapsed. That was May 6 of last year. Among other things, the
report questioned the fact that the company appeared to be
using accounting tricks to pump up its revenue.
Regrettably, the analysts' performance with Enron that I
have referred to is indicative of a broader problem. Let me
quote David Becker, general counsel of the SEC, who said last
August, ``Let's be plain. Broker-dealers employ analysts
because they help sell securities. There is nothing nefarious
or dishonorable in that, but no one should be under any
illusion that brokers employ analysts simply as a public
service.''
Well, I am afraid that a lot of average investors in the
country are under that illusion, and Mr. Becker's statement is
jarring news to them who have considered ``strong buy'' or
``buy'' or ``hold'' and ``sell'' recommendations to be honest
investment advice.
I must say, in our Committee's investigation, one of the
most stunning facts that has come to my attention is that, no
matter what the market does, analysts seem to just keep saying
``buy.'' According to Thomson Financial, two-thirds of all
analysts' recommendations are ``buy'' and only 1 percent are
``sell.''
If you take a look at this chart,\1\ this is over the last
2 years, and the dotted line is the S&P 500, which, we can see
beginning at January 3, 2000, was up and down, down on February
3, 2002. This straight line is giving a numerical value to
``strong sell,'' ``sell,'' ``hold,'' ``buy,'' and ``strong
buy'' of analysts' recommendations, coming out with an average,
and it is really quite remarkable that the line remains almost
exactly straight at a ``buy'' recommendation no matter what
happens to the market, even as it went down.
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\1\ Chart entitled ``S&P 500 Price Index Versus S&P 500 Consensus
Recommendation,'' referred to by Senator Lieberman appears in the
Appendix on page 128.
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Today we want to ask the analysts: How could that be? Of
course, I fear--and I am not alone in this fear--that one of
the reasons is that the majority of analysts work at Wall
Street firms and banks that are doing business, particularly
investment banking business, with the companies the analysts
are analyzing. In fact, in a general sense, analysts'
compensation is tied directly to their firm's success in
attracting and holding investment banking business. And
analysts usually develop close relationships with the companies
they cover, relationships that are valuable to their firms and
could be endangered by the release of a critical report or
opinion.
All of these influences I am afraid compromise analysts'
objectivity and mean that average investors really ought to use
analysts' recommendations with a great degree of caution.
There is a new set of proposed rules designed to improve
analysts' independence crafted by the National Association of
Securities Dealers, which were submitted to the SEC on February
7. I think these are a very valuable step forward. The rules
would limit compensation that analysts can receive from
investment banking activity, restrict analysts' trading of
stocks they cover, ban them from reporting their firm's
investment banking decisions, and prohibit them from promising
favorable ratings to companies they cover.
In today's hearing, we are going to ask whether more should
be done, and we are going to receive some recommendations, I
believe, about more that could be done, even as we try to
describe today the current system of investment analysis as a
way to provide full disclosure and warning to investors, and
hopefully to push Wall Street, on whose integrity and vitality
so much of our economic strength relies, to clean up this part
of its act.
In 1937, a long time ago, President Franklin Roosevelt
said, ``We have always known that heedless self-interest was
bad morals. We now know that it is bad economics.'' Over the
last few months, because of Enron, too many people individually
and our economy as a whole have painfully discovered the wisdom
of those words. Our job today is to make sure that from this
point forward that wisdom spreads, not through more painful
experiences but through enactment of new ethical and
progressive policies.
I look forward to hearing from our witnesses today, who I
hope and believe can help us do that job.
Senator Thompson.
OPENING STATEMENT OF SENATOR THOMPSON
Senator Thompson. Mr. Chairman, thank you very much. You
have very completely addressed the issues that we are dealing
with here today. I would ask that my statement be made part of
the record and merely reiterate the fact that we are seeing a
loss of investor confidence at a time when there is a
remarkable surge in the number of Americans who invest in our
stock markets. We have seen a growing lack of competence with
regard to financial statements, accounting, and now we are
having to deal with the reliability and objectivity of sell-
side analysts' recommendations, which have also been called
into question.
We have questions with regard to whether or not some of the
things we have seen have been brought about by the obvious
conflicts of interest that are in the system, whether or not
those problems can be solved simply by disclosure. We have
questions as to whether or not analysts really understand some
of the data and the information that they are given, whether or
not they were, in fact, misled.
On the other hand, as you point out, one study, at least,
shows that ``sell'' recommendations account for just 1.4
percent of all analysts' recommendations. That raises the
question as to whether or not there is something more
systematic at issue here beyond Enron's confusing financials.
Of course, the question of analysts' independence is not a
new one. It has had a renewed interest since Enron's collapse.
I am looking forward to hearing the witnesses on our second
panel about rule changes to address at least the perception of
conflicts of so many of these analysts as well as to provide
better ways of public disclosure.
I am also interested in hearing the explanations and
opinions of the analysts testifying on our first panel.
However, I would like for a moment to point out something
concerning the first panel. The companies represented here
today are not the only ones that covered Enron while also
making other business relationships with the company. Merrill
Lynch, Goldman Sachs, UBS Warburg also had investment banking
relationships with Enron or invested in Enron partnerships,
including LJM Partnerships, controlled by Andrew Fastow. So in
a larger sense, there are other banks that may not have covered
Enron that also engaged in this dual role with regard to other
companies. So I sincerely hope that the investing public will
not single out the particular banks represented here today
simply because it is not feasible to call every bank that may
have been similarly situated.
So, Mr. Chairman, I thank you for holding this hearing, and
I believe it is a legitimate concern. At our first hearing we
asked former SEC Chairman Arthur Levitt whether an American
investor today can depend on Wall Street analysts, and his
disturbing answer that Wall Street sell-side analysts have
virtually lost all their credibility. And I hope today we can
learn from our witnesses about the system so the Committee can
contribute toward helping restore the faith of investors in our
capital markets.
Thank you very much.
[The prepared statement of Senator Thompson follows:]
OPENING PREPARED STATEMENT OF SENATOR THOMPSON
Thank you Mr. Chairman. As we all know, one of the major fallouts
of the Enron collapse has been the loss of investor confidence in our
capital markets. Investment of capital is the lifeblood of our economy
and we have seen a remarkable surge in the percentage of Americans that
invest in our equities market over the last several years.
However, the collapse of Enron has shaken the confidence of
investors in the transparency of the capital markets. It has also
brought to the forefront the number of conflicts of interest that
permeate different aspects of our system. Anyone seeking empirical
evidence for the effect of these revelations need look no further than
the recent volatility in the stock market and the constant references
in the press to ``Enronitis.''
Unfortunately, reported problems with financial statements and
accounting are not the only issues that have shaken investor
confidence. The reliability and objectivity of sell-side analyst
recommendations have also been called into question. Reports indicate
that as of early October 2001, there were 16 analysts who covered
Enron, and of them, 15 had a ``buy'' or ``strong buy'' rating, one had
a ``hold,'' and none had a ``sell'' or a ``strong sell.'' Most of these
analysts continued with ``buy'' or ``strong buy'' ratings even after
the resignations of Enron CEO Jeff Skilling and CFO Andrew Fastow and
after the restatement of earnings and reduction of shareholder equity.
I am sure that one of the reasons for these recommendations was the
fact that analysts, like everyone else, were misled by Enron's
financial statements and disclosure. On the other hand, I understand
there is one study that found that sell recommendations account for
just 1.4 percent of analysts' recommendations. That raises the question
whether there is something more systemic at issue here beyond Enron's
confusing financials.
The question of analyst independence is not a new one, but it has
received renewed interest since Enron's collapse. I look forward to
hearing from the witnesses on our second panel about rules changes to
address at least the perception of a conflict for many of these
analysts as well as to provide disclosures for the public.
I am also interested in hearing the explanations and opinions of
the analysts testifying on our first panel. However, I would like to
take a moment to make a point about that first panel. The companies
represented today are not the only ones that covered Enron while also
maintaining other business relationships with the company. Merrill
Lynch, Goldman Sachs, and UBS Warburg also had investment banking
relationships with Enron or invested in Enron's partnerships, including
the LJM partnerships controlled by Andrew Fastow. And in a larger
sense, there are other banks that may not have covered Enron that also
engage in this dual role with regard to other companies. I sincerely
hope that the investing public will not single out the particular banks
represented here today simply because it is not feasible to call every
bank that may be similarly situated.
Mr. Chairman, I thank you for holding this hearing. I believe it is
a legitimate concern. At our first hearing, I asked former SEC Chairman
Arthur Levitt whether an American investor today can depend on Wall
Street analysts. His disturbing answer was that Wall Street sell-side
analysis has lost virtually all credibility. I hope that today we can
learn from our witnesses about the system so that the Committee may
contribute toward restoring the faith of investors in our capital
markets.
Chairman Lieberman. Thank you, Senator Thompson. Thanks for
an excellent statement. And you make a good point. The analysts
that have been asked to come forward here were asked as a
result of our staff's investigation because the staff judged
them to be among the most prominent analysts who were covering
and dealing with Enron. But you are quite right; there were a
number of other firms, as the chart I held up showed, that also
had analysts dealing with Enron and whose recommendations were
really quite similar.
Senator Levin.
OPENING STATEMENT OF SENATOR LEVIN
Senator Levin. Mr. Chairman, first, thank you for convening
this hearing. I think that most Americans who participate in
the stock market--and that is most Americans--don't really
think about or understand the role of the financial analyst in
the investment banking world. We see the faces of analysts on
TV. We read their comments in magazines and online and in
newspapers. And I think most of us just see them as experts.
But we don't think about their place in an investment banking
enterprise and their dual role in facilitating investment
banking deals as well as providing advice to investors. This
hearing will help us hopefully explore that dual role and to
address some of the inherent conflicts later on when we start
legislating.
Most financial analysts wear two hats. One is the allegedly
independent analyst of publicly traded companies providing us
their educated and experienced insight on a company's future
based on publicly available information. The other hat is that
of the sophisticated insider investment banker analyst who
helps his or her company attract and carry out investment
banking business. Moreover, the analyst's compensation is often
tied to the success of the investment banking business, as is
the analyst's standing within the company. That is a problem,
because as long as a company is a client of the analyst's
investment banking firm, the analysts have incentives to
promote the stock of that company.
Mr. Chairman, you have identified some of the suggestions
of the National Association of Securities Dealers to address
these inherent conflicts, and I think we should take a close
look at those. Senator Fitzgerald and I have sponsored
legislation to address the conflicts of interest problem with
respect to analysts. It is in some respects similar to the NASD
proposal. Our bill would require analysts, the investment banks
for which they work, and persons or entities associated with
the analysts to disclose any time the analysts' comments
publicly, either in writing or orally, on a company that the
analyst is covering on the following items: The fees the
analyst or his employer received from the covered company in
the last 3 years; the merger or acquisitions worked on by the
analyst or his employer in the last 3 years relating to the
covered company; and the amount and type of debt or stock owned
by the analyst and his employer in the covered company. We
would also have civil penalties and fines, depending on the
gravity of the violation of those rules.
One out of every two Americans today have a stake in the
stock market so addressing the problems uncovered under the
Enron rock is not a choice but a necessity. And if we are going
to maintain public confidence in our markets, as both you and
Senator Thompson have indicated is such a necessity for us, we
must act in these areas to address these inherent conflicts.
The role of the financial analyst is an important piece of
the Enron puzzle. We know how dependent Enron was on its stock
price, and that it provided significant business to the
investment banking firms on Wall Street, initiating dozens of
investment banking deals every year. So it is not hard perhaps
to understand why the financial analysts waited so long to
issue a ``sell'' recommendation when so much hung in the
balance--indeed why most, perhaps the majority of analysts,
never did issue a ``sell'' recommendation.
Thank you again, Mr. Chairman for convening this important
hearing today.
Chairman Lieberman. Thank you, Senator Levin. Senator
Collins.
OPENING STATEMENT OF SENATOR COLLINS
Senator Collins. Thank you, Mr. Chairman. I want to thank
you for continuing this important investigation.
I ask unanimous consent that my complete statement be
included in the record, and I will just make a few comments.
Chairman Lieberman. Without objection.
[The prepared statement of Senator Collins follows:]
PREPARED OPENING STATEMENT OF SENATOR COLLINS
Mr. Chairman, thank you for calling these hearings to focus on the
role played, or, more accurately, not played by Wall Street analysts in
the events leading up to Enron's bankruptcy.
Individual investors at times know little about the stocks they
purchase. They tend to know what business the company is in and they
might have some familiarity with its product. They may also know
whether their broker's analysts rates the stock a ``buy,'' a ``strong
buy'' or something else. It's unlikely, however, that they will dig
into a company's financial statements. As a consequence, there is a
large reliance by individual investors on professionals whose job it is
to look at one industry, or perhaps even one company, closely and make
a recommendation on the purchase or sale of that company's stock.
Some financial analysts have pointed out that some of the
information Enron gave them was inaccurate or incomplete. Analysts
would ask questions but be brushed off or even lied to. But, why didn't
they press for answers or see the lack of information as warning signs?
After all, top Enron executives were selling substantial positions
in the company. Bad investment after bad investment was being made by
Enron. One analyst says that ``Enron was a `black box' company, where
no one, not the analysts nor any of the institutional or individual
investors, was really sure how the company made money.'' Another called
a lack of transparency and disclosure an ``Enron hallmark.'' Yet, he
continued to keep it on his firm's recommended list, which connotes its
highest ranking. A third noted that Enron's explanations were ``an
inadequate defense of the balance sheet.'' Yet he recommended its stock
be ``bought aggressively.''
Analysts generally work for the same investment houses that seek to
do business with the companies their analysts rate. As a consequence,
do these ``sell side'' analysts, as they are known on Wall Street, come
under pressure to base their conclusions on more than just the numbers?
Many analysts believe that it is better to know the true picture of the
company even if they can't reflect it in their recommendations because
to do so would be lose their contact. As a result, a code develops.
Analysts use terms like ``hold.'' To many of us, Mr. Chairman, ``hold''
would mean that an investor should neither buy nor sell. Wall Street
insiders understand that stocks rated ``hold'' should be gotten rid of
quickly.
We need to determine whether it was such conflicts that led so many
analysts to perform so poorly in their evaluations of Enron. Just weeks
prior to Enron's declaration of bankruptcy, analysts from some of the
best known firms on Wall Street were telling investors that concerns
over Enron's finances were ``very much exaggerated.''
These analysts saw warning signs but ignored them. Common sense
tells us that we should not recommend investments that we cannot
understand. The analysts understood that there was something missing,
something wrong with Enron. But the thing that was missing of most
importance, Mr. Chairman, wasn't information. As one observer noted,
what was missing most was skepticism and a willingness to delve for
answers.
Senator Collins. Mr. Chairman, there is a large reliance by
most individual investors on professionals whose job it is to
examine closely an industry or perhaps even one company and
make a recommendation on the purchase or sale of that company's
stock.
Some financial analysts have pointed out to the Committee
that information provided by Enron was incomplete or
inaccurate. Analysts would ask questions but be brushed off or
even lied to, and that raises the issue of why didn't these
analysts press for answers or see the lack of cooperation and
the lack of information as warning signs. After all, top Enron
executives were selling substantial positions in the company.
Bad investment after bad investment was being made by Enron.
One analyst said that Enron was a black box company where no
one--not the analysts nor any of the institutional and
certainly not the individual investors--were really sure how
the company made its money. Another called the lack of
transparency in disclosure ``an Enron hallmark,'' yet this
analyst continued to keep it on its firm's recommended list,
which connotes its highest ranking. A third analyst noted that
Enron's explanations were ``an inadequate defense of the
balance sheet.'' Yet he, too, kept recommending the stock be
bought aggressively.
Analysts generally work for the same investment houses that
seek to do business with the companies their analysts rate. As
a consequence, the question arises whether or not these sell-
side analysts, as they are known on Wall Street, come under
pressure, either direct or indirect, to base their conclusions
on more than just numbers. Many analysts believe that it is
better to know the true picture of the company, even if they
can't reflect it in their recommendations, because to do so
would jeopardize their contact. As a result, Mr. Chairman, a
code develops. Analysts used terms like ``hold.'' Now, to many
of us, perhaps to the average investors ``hold'' would mean
that an investor should neither buy nor sell. But Wall Street
insiders understand that stocks rated ``hold'' should be dumped
quickly.
We need to determine whether it was such conflicts of
interest that led so many analysts to perform poorly in their
evaluations of Enron. Just weeks prior to Enron's declaration
of bankruptcy, analysts from some of the best-known firms on
Wall Street were telling investors that concerns over the
company's finances were very much exaggerated. These analysts
saw the warning signs but ignored them. Common sense tells us
that we should not recommend investments that we do not
understand. These analysts understood that there was something
missing, something wrong with Enron. But the thing that was
missing of most importance wasn't information. As one observer
noted, what was missing most was skepticism and the willingness
to delve for answers.
I look forward to hearing our witnesses today as we seek to
ensure that there are improvements made in the system.
Thank you, Mr. Chairman.
Chairman Lieberman. Thank you very much, Senator Collins.
Senator Torricelli.
OPENING STATEMENT OF SENATOR TORRICELLI
Senator Torricelli. Thank you, Mr. Chairman, very much.
First, thank you very much for holding these hearings. I
think it is an important contribution, and somewhere on Capitol
Hill there should be some thoughtful analysis going on of this
situation. There has been a great deal of commentary. There has
been a good deal of cross-examination. But there is a need to
have some venue that indeed is looking at some of the
regulatory issues and the roles of the different institutions
in depth, and I am proud that our Committee is doing so.
This is, of course, not entirely a new problem. The
American people may be hearing about some of these issues for
the first time, but it is not a new concern. There is very
little happening here in the concern about the analysis being
offered and the credibility of the profession that some were
not asking during the dot-com fiasco. Companies with enormous
multiples, involving tremendous risk, with conflicting
information coming forward about their prospects, and, as my
colleague noted, 1 percent were receiving ``sell''
recommendations.
There is a belief by most American investors, who may be
unsophisticated but remain a critical part of the Nation's
capital markets, that analysts are somehow on their side. That
an analyst is your advocate. They are impartial. They are
bringing you information as your advocate.
It may not be to the level of a lawyer or a doctor, but
most clients do believe they are in a relationship with the
person that is selling them stock and the analyst that person
is relying upon has some degree of impartiality.
That, of course, was never the case, and perhaps there is
some fault in people ever having been led to rely upon it. But
it has been a reality in the marketplace.
An analyst for a firm who receives a bonus may be involved
in IPOs, may own shares themselves, obviously has inherent
conflicts of all types. The question before the Congress, as we
deal now with these twin fiascos--the dot-com meltdown and now
the Enron problem, different in some respects but having some
of the same core issues--is what we do about it.
As you are answering these questions today and making your
presentations, remember that before this Committee is the issue
of whether this is best dealt with in the marketplace. The best
answer may just be that, based on the experiences of the
technology sector and now Enron, some firms will have
credibility and some will not. Some firms will find the means
of restoring the confidence of their customers, and their
customers will rely upon their analysis. You will provide to
them descriptions of how you are avoiding conflicts, how you
are restoring credibility, and you will succeed, and others
firms that don't will fail. The marketplace may be the best
answer. Or it may be that as a profession or within the
industry, it is to be dealt with yourselves: Set standards as
to what stakes analysts can own themselves, what conflicts will
be tolerated, and what must be disclosed.
Or failing all that, is there a role for the government?
Should we indeed place walls between analysts and brokers?
It is always the belief of most of us here that that is a
role that is reserved for the most extraordinary of
circumstances. But these are extraordinary circumstances. It
may be that many of these people who lost their life savings
were not sophisticated investors. Maybe some believe that is
how the marketplace works.
But this country can't operate that way and maintain the
success of the capital markets. In a society of a quarter of a
billion people and a $10 trillion economy, our reliance upon
average investors with their retirement savings, the little bit
of money they can set aside is not a luxury in this economy. If
it wasn't for our concern for their retirements or their
security, it would still be important because it fuels our
economic growth.
I hope you will remember all those questions. But I do want
to place it in perspective. While I am as critical as any of my
colleagues of how we got in the situation, I also remind my
colleagues that for all the similarities to previous problems,
Enron is distinguished in this: This is also outright fraud. It
may be that all of your analysts should have been more
inquisitive, should have pressed harder. But before you begin
your own testimony, if you will indulge me, Mr. Chairman, I
will quote just two sections from a transcript of Mr. Skilling
and Mr. Lay on August 14 speaking to analysts, which may help
us understand why they perhaps were not more inquisitive but,
nevertheless, were misled:
Mr. Lay: ``In the second quarter, net income was up
40 percent, earnings per share about 32 percent,
operation and physical volume of deliveries are up 60
percent. Again, if anything, in the last 5 years, we
have had a 20 percent per year compound annual growth
in earnings per share.'' Pretty good, pretty
impressive--if true. Yes, analysts are to be faulted,
but they do have to rely upon the information coming
from executives as being truthful.
Finally, Mr. Skilling: ``One of the questions the
analysts''--analysts, parenthetically, I am asking--
``were asking was on the new products. I think we have
gotten really good traction from the new products. The
numbers are looking good. I think in the last quarter,
the second quarter, every one of those products,
whether it was crude and crude products, metal, pulp,
paper, coal, volumes had more than doubled. Every
single one of them in the second quarter of 2001 or the
second quarter of 2000 have all profited, which is a
really good thing. So I am feeling very good, and I
assume that we will continue on into next year. It
looks like we are going to be succeeding very, very
well in the wholesale businesses.''
There is a lot of fault to go around all the way. I am not
going to say that I am not faulting the analysts or the firms,
but I will say if I had been in that conversation and I had
listened to those numbers, frankly I wouldn't have been telling
people to sell either. It was a fraud.
Thank you, Mr. Chairman.
Chairman Lieberman. Thank you, Senator Torricelli. Senator
Voinovich.
OPENING STATEMENT OF SENATOR VOINOVICH
Senator Voinovich. Thank you, Mr. Chairman. I would like to
express my appreciation to you for holding this hearing. As the
Committee gathers information, I hope that it will allow us to
develop real and productive changes, changes that can ideally
prevent another Enron debacle from happening.
One of the things that is a little frustrating to me, Mr.
Chairman, is some of the things that need to be done are not
within the jurisdiction of this Committee.
Today's hearing focuses on the role of Wall Street's
analysts in the financial markets through their ``buy,''
``sell'' and ``hold'' recommendations. We have already heard
the important role that stock analysts play in terms of people
relying on their advice. I suspect that there isn't anybody in
this room that hasn't based a decision to buy or sell stock on
what a group of analysts has said about a particular stock.
Unfortunately, in the Enron situation, in my State
thousands of private investors lost as a result of the bad
information they received. My State's pensions funds lost over
$127 million as a result of the Enron debacle.
Overall, I have been pleased with the steps being taken by
the industry to address some of the issues raised by the
bankruptcy. Two weeks ago, the Securities and Exchange
Commission proposed changes to the corporate disclosure rules
that would require companies to expedite the release of annual
and quarterly reports and require companies to immediately
disclose trading by company executives. In addition, as was
pointed out by one of the other Senators, the National
Association of Securities Dealers announced new rules earlier
this month that would increase the independence of Wall Street
stock analysts, such as prohibiting stock analysts from owning
stock in a company they review.
Investment banking firm Goldman Sachs recently announced
that it is removing its research department from its investment
banking operation and making it a separate independent division
of the firm. I expect that other firms are going to take
similar actions in that regard.
Nevertheless, 40 different legislative proposals have been
introduced to date in Congress in the wake of Enron's collapse.
Each would in some way or another change our Nation's laws
regarding pension plans, financial disclosure or auditor
independence. Close to 30 Enron-related hearings have been held
in the House and Senate since the company's bankruptcy less
than 3 months ago. I think that before Congress acts to
overhaul financial disclosure and accounting rules, we should
proceed cautiously, take into account the non-legislative steps
that have been taken, and make sure we all know all the facts
before we act to overhaul laws governing the strongest
financial markets in the world.
I think we also understand that the private checks and
balances in this country are working as more and more
individuals and entities are being sued for their fraud,
dishonesty, negligence, and lack of due diligence. The Enron
nightmare is going to be around for a long time, and many of
the individuals involved will be taking that nightmare to their
deathbed.
One final area of concern to me--and you won't be
surprised, Mr. Chairman--regards the human capital resources of
the Securities and Exchange Commission. The fact of the matter
is that we have seen an increase of 660 percent in the amount
of activity in the market over the past 10 years. During that
same period of time, the Securities and Exchange Commission has
not increased the people that are capable of dealing with it at
all to put up with that increase in activity.
In addition, I recently found out that one-third of the
people at the Securities and Exchange Commission have left the
Commission because the salary schedule there is not competitive
with other regulatory agencies or with the private sector. And
it seems to me that as we go through these hearings and receive
testimony from witnesses in regard to various aspects of Enron,
it is incumbent on this Committee to make sure that the Federal
agencies that have the responsibility for oversight have the
personnel and the competent people to get the job done. And as
I have observed over the years, too often we have hearings and
lots of TV and newspaper publicity and the rest of it, but
after it is all over with, what have we done to make the
situation better? I think our responsibility in this Committee
is to make darn sure, as part of our oversight, that those
agencies that have responsibility for these markets have the
adequate personnel and the expertise to get the job done to
protect the American people.
Thank you.
Chairman Lieberman. Thank you, Senator Voinovich. Someday
somebody is going to give you the award you deserve for
reminding us constantly about the importance of investing in
the human capital, the people who operate and run our
government.
There is a vote that is going off on the floor. What I
would like to propose is that we go to Senator Bunning and
Senator Bennett. I am going to leave, go and vote, try to get
back real quickly so we don't interrupt the flow of the
hearing. If I am not back, I would ask that the last Senator
standing--or sitting, as it were--just recess the hearing for a
few moments.
Senator Bunning.
OPENING STATEMENT OF SENATOR BUNNING
Senator Bunning. Thank you, Mr. Chairman.
The Enron collapse and that of Global Crossing is
troubling, to say the least, and has shown many weaknesses that
need to be fixed. I was in your business for 25 years prior to
coming to the Congress, so I know how inherent some conflicts
can be, particularly those firms that have an investing, an
equity, an underwriting, and also an advising position.
If you take a position in a stock, an equity position in an
underwriting, and then you become an analyst and are not
independent of that firm, you have a direct conflict of
interest.
I hope at the end of the day all these hearings are not in
vain and that Congress can make some necessary changes,
especially to our pension laws. Today's hearing will focus on
why some analysts continued to recommend stocks to investors
even as the companies were restating its financial earnings and
those stocks were in free fall. Investors' confidence in our
markets without a doubt has been shaken, and many may be more
hesitant--and I see that presently in the market--to trust the
information they receive about a company before investing in
it. I hope that is the case.
As a couple of our witnesses will testify today, there can
be some very direct conflicts of interest and pressures that
analysts face as they rate and recommend stocks. These
conflicts need to be looked at and dealt with as they come up.
However, it is important to remember analysts are only as
good as the information they receive. Any changes that are made
will not make a bit of difference if the companies they are
dealing with are not honest about their financial situations.
The representatives from the National Association of
Securities Dealers and the Association for Investment
Management and Research have some suggestions for us about how
the system can be improved. If you all remember, there used to
be a column in the Wall Street Journal called ``Heard on the
Hill.'' And you know what happened there. The person who was
writing ``Heard on the Hill'' was investing and taking a
position on the stock and then writing columns about how good
this stock was going to be. And on the swing up, they would
unload the stock and make a profit.
Now, you know about that as well as I do if you have been
around the investing business very long. That kind of conflict
of interest is in direct contradiction in what we want to see.
I am looking forward to the hearing today, and the other
witnesses that are going to appear, and I thank you, Mr.
Chairman, for allowing me the time.
Now, Senator Bennett, you are up.
OPENING STATEMENT OF SENATOR BENNETT
Senator Bennett. OK. I get to be the Chairman.
Simply for the record and for the information of the
witnesses that are waiting to testify when we get back from
voting, I want to note that I think the hearings are useful. I
think an airing of this issue in a forum as public as this one
is a salutary thing. But I recognize that human beings being
human beings, we are not going to come to a clear solution that
will pass into law and bring us into the promised land.
I have been involved in IPOs. I have been involved in
presentations to security analysts. I have been the CEO of
publicly traded corporations and have gone through the
experiences. I know about road shows. I know about ``buy'' and
``sell'' recommendations and all the rest of it. I wish my
colleagues were here that I could share with them, but we will
share with the witnesses the experience of seeing analysts make
``buy'' recommendations for the funds that they represent and
seeing the funds purchase stocks that then dropped off the
cliff in the face of which experience the analysts kept saying,
This is a great buy opportunity at the lower price, keep
buying. And they were playing with their own money, that is,
their own firm's money. They were absolutely convinced that
their analysis was correct, and they ended up losing the firm
that they worked for huge sums because they were wrong.
There is no way that the Congress or any other legislative
body in the world can prevent people from being wrong. You
don't have to be dishonest. You don't have to be engaged in
fraud. You can make a mistake. And all of us, all of us have,
and all of us will continue to do that in the future.
I wonder if at some point in your testimony you gentlemen
could address what I would call the Stockholm effect. Those of
you who don't know that term, the Stockholm effect refers to
someone who is taken hostage--I don't know why it happened in
Stockholm or why the term is applied to it, but someone who is
taken hostage and then at the end of his or her incarceration
has fallen in love with or embraced his captors and is more on
the side of the captors than the liberators.
Maybe Patty Hearst is an example of that when she was
kidnapped and ended up, at least for a brief period of time,
joining her kidnappers.
I have seen analysts who have come in very glinty-eyed,
very skeptical, as analytical and as objective as they can
possibly be, examined the company's books, examined the
company's business, fallen in love with what they found, and
then blindly continued to support that first decision and urge
people to buy stock in that company even as the business has
turned. They have become so enamored of the management, which
they thought they were viewing very objectively, so enamored of
the market, which they thought they were looking at in very
glinty-eyed terms, that they really did believe that everything
was going to turn out all right after all. And they continued
to recommend the stock out of complete conviction, no conflict
of interest pushing them, complete conviction that this was the
right thing to do, and they simply made a mistake. They were
simply wrong.
So while it is good for us to air all of these things, I
think these hearings are a wonderful thing to be doing. I think
it is a very good exercise for everybody to go through
periodically. I would just underscore the fact that when it is
all over, we should not kid ourselves into believing that a set
of congressional hearings are going to render every analyst
completely objective and completely wise. And the ability to
make a mistake is programmed into the DNA, and it is still
going to be there for human beings when we are over.
With that, I now have to go save the Republic, so I will
declare this hearing temporarily postponed until the return of
the Chairman.
[Recess.]
Chairman Lieberman. I thank the witnesses and all in
attendance for your understanding. We are just completing a
vote on the Senate floor.
I now go to our first panel. As is the custom of the
Committee, I would like to ask the members of the panel to
stand and please raise your right hands. Thank you. Do you
solemnly swear that the testimony you are about to give this
Committee today is the truth, the whole truth, and nothing but
the truth, so help you, God?
Mr. Feygin. I do.
Mr. Gross. I do.
Mr. Launer. I do.
Mr. Niles. I do.
Mr. Schilit. I do.
Chairman Lieberman. Thank you. Please be seated and let the
record show that all of the witnesses answered in the
affirmative.
I thank you for being here. I want to say for the record--
although perhaps this doesn't have to be said, but it hasn't
been the case in other committees--that all of the witnesses
are here at their own decision and judgment and did not require
a subpoena to ensure their presence. I appreciate that very
much.
We will begin. Obviously you have heard our concerns, which
are deep, and we want to hear you now and then have the
opportunity to question you. We are going to hear first from
Anatol Feygin, senior analyst and vice president at J.P. Morgan
Securities, Incorporated. Mr. Feygin.
TESTIMONY OF ANATOL FEYGIN,\1\ SENIOR ANALYST AND VICE
PRESIDENT, J.P. MORGAN SECURITIES, INC.
Mr. Feygin. Good morning, and thank you, Mr. Chairman.
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\1\ The prepared statement of Mr. Feygin appears in the Appendix on
page 67.
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Mr. Chairman, Members of the Committee, my name is Anatol
Feygin. I am a senior analyst and vice president of the U.S.
Equity Research Department of J.P. Morgan Securities. My area
of coverage is the domestic natural gas industry, and I am
pleased to have the opportunity before you today to discuss my
work as an analyst on Enron Corporation.
At the outset, Mr. Chairman, I would like to make four
important points. As you mentioned in your opening remarks,
absolute integrity is essential in our line of work. Second, I
do not own any stock of the companies I cover and never owned
stock in Enron Corporation; neither has my family at any point
in my tenure at J.P. Morgan. Third, I have complete freedom
with respect to the recommendations that I issue on the
companies that I cover, and my compensation is not tied in any
way to those recommendations. Finally, I have never received
any compensation in any form from any company that I analyze,
including Enron.
Consistent with J.P. Morgan's policies of analyst
independence, in analyzing the companies I follow, I rely on
publicly available information. My sources of information
include the audited financial statements of the companies,
their filings with the Securities and Exchange Commission and
other regulatory bodies, annual reports, and presentations to
analysts. The accuracy of this publicly available information,
as Senators Torricelli and Bunning pointed out, is absolutely
essential to the accuracy of the resulting recommendation.
Let me now turn, as the Committee has requested, to my work
with respect to Enron. I began following Enron in June 1999,
and prior to issuing my report and my initial ``buy''
recommendation on the stock, I conducted extensive research for
nearly a year, tapping all publicly available sources of
information. I also met with senior management at Enron and
other personnel, and I believed that Enron's innovative
business model could be successfully applied in other
industries to generate stable and growing earnings while
assuming minimal risk.
In 2000 and in the 7 months leading up to August 2001, we
saw for the most part very positive developments as they
related to Enron that justified our ``buy'' rating. Enron's
revenue grew from $40 billion to $101 billion in 2000, and its
business model accounted for dramatic successes in various
industries. Enron's outlook did become a little less certain
with the sudden resignation in August of the past year of Mr.
Skilling. We did view that as a negative event. But this did
not lead to a downgrade because one of the things that Enron
brought to the table, in our opinion, was a very deep and very
talented management team and a successful business model.
By mid-October, the picture had deteriorated somewhat, but
still not to the point where we believed that a downgrade was
justified. On October 16, Enron did report a third quarter loss
of $618 million and took a $1.2 billion charge to shareholder
equity I should say. However, at the same time they reported a
35 percent increase in its core business, and even though this
release was made in the morning, the stock closed the day up 2
percent.
Nevertheless, during the next week, we saw a developing
crisis of confidence. It was fueled by negative press coverage,
Enron's disclosure that the SEC had launched an informal
inquiry, and Enron's failure to address the resulting investor
concerns head-on.
On October 24, I downgraded Enron's rating from a ``buy''
to a ``long-term buy'' and removed it from our company's focus
list. Let me just clarify this point. A ``long-term buy'' does
not mean that the stock would be a good investment in the near
term. Instead, the rating tells my institutional clients that
the company is facing near-term challenges that, once resolved,
should allow the stock to outperform its peers.
On November 8, Enron filed documents with the SEC revising
its financial statements for the past 5 years to account for
$586 million previously unrecognized losses. I did not believe
that a second downgrade was justified because Enron's results
for the first three quarters of 2001 were not materially
impacted by this restatement.
On November 9, a proposed merger was publicly announced
between Enron and Dynegy. As the Committee may be aware, J.P.
Morgan was one of the advisers to Enron with respect to this
merger. I, however, was not involved in the transaction and was
only informed of it a few hours before it was publicly
announced. Otherwise, I was not privy to any non-public
information with respect to Enron, Dynegy, or the proposed
transaction. I viewed the proposed merger as a positive event
and believed that if the merger was consummated, the combined
entity would go on to outperform its peers.
The merger was abandoned on November 28 following Enron's
downgrade to below investment grade. And immediately following,
on November 29, we suspended coverage of Enron. As everybody
knows, Enron filed for bankruptcy protection on December 2.
Thank you, Mr. Chairman, and I would be pleased to respond
to any questions that you or other members of the Committee may
have.
Chairman Lieberman. Thank you, Mr. Feygin.
Now we go to Richard Gross, who is an analyst at the Equity
Research Division of Lehman Brothers, Incorporated.
TESTIMONY OF RICHARD GROSS,\1\ ANALYST, EQUITY RESEARCH
DIVISION, LEHMAN BROTHERS, INC.
Mr. Gross. Good morning, Mr. Chairman and Members of the
Committee. My name is Rick Gross. As indicated, I am an analyst
in the Equity Research Division at Lehman Brothers. Lehman
Brothers is a global investment bank and securities firm that
provides research, investment banking, brokerage and other
services to corporations, institutions, governments, and high-
net-worth investors.
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\1\ The prepared statement of Mr. Gross appears in the Appendix on
page 72.
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I have been an equity analyst covering the energy industry
for 27 years. I have been an analyst at Lehman since 1991.
Prior to Lehman, I worked as an analyst at other firms for 16
years. I have a B.S. and M.S. in finance from the University of
Illinois.
At Lehman Brothers, I cover a sector called ``United States
Energy/Power, Natural Gas.'' One of the companies in my
universe of coverage is Enron. As an analyst, I analyze the
publicly available information about a company and its
industry. This information can include: Information made
available to me through SEC filings that the company makes;
press releases and company presentations; materials from the
rating agencies; information about competitors that I can glean
in the marketplace, trade journals, seminars; general
information about the industry as well as whatever public
information is available that I can reasonably obtain. I
compile all of this in a framework for my analysis.
My analysis includes relative valuations arrived at by
reviewing historical and current industry trends, reviewing
market valuations, comparing the company being analyzed to its
peers. Based on this analysis, I develop opinions and make
recommendations, and the factors on which they are based are
reflected in my reports. These reports are available to clients
of Lehman Brothers, which in general are primarily
institutional in nature, although we also serve a high-net-
worth individual group.
I appreciate the opportunity to answer questions before the
Committee.
Chairman Lieberman. Thank you, Mr. Gross. Maybe one of
those shorter opening statements we have had in the history of
the Committee. We will be back to you for questions.
Next, Curt Launer, Managing Director, Equity Research
Group, Credit Suisse First Boston.
TESTIMONY OF CURT N. LAUNER,\1\ MANAGING DIRECTOR, GLOBAL
UTILITIES RESEARCH GROUP, CREDIT SUISSE FIRST BOSTON
Mr. Launer. Good morning, Mr. Chairman. My name is Curt
Launer, and I am a Managing Director at Credit Suisse First
Boston. I head the Global Utilities Research Group of CSFB that
comprises 28 professionals. My specific research coverage is
the natural gas and power sector, and as a research analyst for
the past 18 years, I have followed Enron and its predecessor
companies. I would like to make four main points today.
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\1\ The prepared statement of Mr. Launer appears in the Appendix on
page 73.
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First, the role of an analyst is to make informed judgment
about companies based on publicly available information. We
depend on senior corporate officials and independent
accountants to ensure the accuracy of public disclosures.
Without accurate and complete financial reporting from a
company, I simply do not have the proper tools to do my job.
CSFB's client base is largely comprised of sophisticated,
institutional investors, not individual retail customers. My
clients have their own research staffs. They look to me for
quality information and projections and challenge the
information and analysis that I provide to form their
investment decisions.
My second point is that inaccuracies and lack of
information in Enron's financial reporting affected my
conclusions and ratings on Enron. Each day there are new
allegations in the media concerning Enron about which I was
previously unaware.
Third, I performed my analysis independently and
objectively, and I never felt pressure from Enron or any
investment banker or other employee of my firm to reach any
conclusions other than my own. Not only have I done my work
independently, but, in addition, my firm has strict rules that
prevent me from even having access to the kind of confidential,
non-public information that investment bankers often have. CSFB
has also adopted rules banning stock ownership by analysts in
the companies we cover.
In this regard, I would like to note that before that ban,
my sons each owned 100 shares of Enron that were sold in
December 2001 to comply with new CSFB rules. My family's only
current investments related to Enron are $18,000 I invested in
the NewPower Company and an Enron bond held by my mother, which
is now in default.
Finally, I applaud any effort to craft thoughtful responses
to improve the overall quality of public company disclosures
and restore confidence in our markets. To protect the integrity
of our research, CSFB consistently and without exception
follows Chinese wall procedures. To maintain our independence
and ensure that our research is not influenced improperly, the
Research Group is physically separated from the Investment
Banking Department. We have no access to the confidential files
or data of any other unit of the firm.
In addition, CSFB not only complies with the Securities
Industry Association's best practices for security analysts,
but also has worked with the SEC, the NYSE, and the NASD to
create new rules for analysts and investment banks which, after
months of work, were recently announced.
Enron was unique in its use of off-balance-sheet
financings, off-balance-sheet partnerships, fair value
accounting, and other techniques and vehicles. Any one of these
would not be problematic in and of itself. Many fine companies
use these techniques. However, Enron used all of them in ways
that apparently were not fully disclosed and that we are just
beginning to understand.
It now appears that some critical information on which I
relied for my analysis of Enron was inaccurate or incomplete.
For example, in January 1998, I attended an analyst meeting at
Enron with over 100 analysts. During this meeting we toured a
trading floor of Enron Energy Services. In viewing the activity
in the trading room, I was impressed at the progress Enron had
made in developing this new business. It has now been alleged
in press reports that Enron staged the activity on that trading
floor, and if this allegation is true, the progress of the
business unit was illusory.
In addition, during the August 15, 2001, analyst conference
call following Jeff Skilling's resignation, I specifically
asked him whether his departure suggested that there were
likely to be further disclosures with respect to Enron's
finances. Mr. Skilling responded that there was nothing to
disclose and that the company was in great shape. Furthermore,
Enron never publicly disclosed the alleged use of the Raptor
investment vehicles. It now appears that these entities may
have engaged in trades with Enron simply to establish
artificially higher asset values. Had I known any or all of
these items, the information would have significantly affected
my analyses and recommendations.
I believed as of late November of last year that Enron
could have survived if it had taken the appropriate steps.
These steps would have been a substantial capital infusion
combined at complete disclosure of off-balance-sheet
liabilities and debt levels, plus a decision to slow growth,
all of which could have, in my opinion, resulted in Enron's
survival. Essentially, these are the elements that could have
been provided by the Dynegy merger. Indeed, it appears that
Chevron-Texaco and Dynegy had much the same view of Enron as I
did. Chevron-Texaco was willing to commit $2.5 billion in cash
to its view of Enron, and Dynegy was willing to issue $8.5
billion of additional shares to acquire Enron.
In sum, hindsight allows a view that I as an analyst never
had. I based my views and ratings on the information that was
available every step of the way.
In 2000, the SEC adopted regulation FD in order to promote
equal access by preventing the selective disclosure of
information to some individuals, but not the public at large.
As laudable as that goal is, the regulation can be used as an
excuse by company officials, as it was by Enron, to duck tough
questions from analysts and, thus, thwart full disclosure. The
point, of course, is that these tough questions should be
answered and the answers made available not just to the
questioners but to the public.
The focus of any policy changes should be more complete,
more timely, and more understandable disclosure. We should
consider full disclosure of off-balance-sheet financings and
related-party transactions, more accelerated disclosure of
insider transactions and corporate reports, and enhanced
disclosure of stock option programs. Greater scrutiny of
accountants and other professionals and additional resources
for regulatory agencies like the SEC may be necessary as well.
Thank you again for the opportunity to appear today, and I
look forward to answering any of your questions.
Chairman Lieberman. Thank you, Mr. Launer.
Now we go to Raymond C. Niles, senior analyst, Citigroup
Salomon Smith Barney.
TESTIMONY OF RAYMOND C. NILES,\1\ SENIOR ANALYST, CITIGROUP
SALOMON SMITH BARNEY
Mr. Niles. Thank you, Mr. Chairman and Members of the
Committee.
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\1\ The prepared statement of Mr. Niles appears in the Appendix on
page 82.
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Since March 2000, I have been the senior analyst at Salomon
Smith Barney for the integrated power and natural gas sector.
Before that, and since 1997, I was the senior analyst for the
integrated power and natural gas sector at Schroder. I covered
Enron at both Schroder and at Salomon Smith Barney.
As an analyst, my job is to report to investors about
business and market developments in my industry sector. I also
develop and communicate timely and detailed recommendations
about particular companies in that sector.
In order to do this job, I work with publicly available
information to develop financial models, earnings estimates,
and price targets for the stocks of the companies that I
follow. I also follow and analyze industry trends, such as
power prices, spark spreads, generating capacities, the trend
toward deregulation, and similar items. Part of my job also is
to forecast the impact on individual stock prices of the supply
and demand for electricity and natural gas, the overall health
of the national economy, and even such variables as the
weather. In performing these analyses, I make use of computer
modelings techniques, economic theory, and other tools.
At the heart of my work are the financial statements of the
companies that I follow. I review and analyze a company's
financial statements, press releases, and public filings before
I make a recommendation. I also go beyond the paper record and
participate in regular conference calls held for analysts by
senior and financial management of the companies that I cover.
I visit the companies and call on company personnel in order to
obtain clarification and context regarding the company's
finances and business prospects.
Although I collect and analyze a great deal of information,
I must stress that all of the information I use is and must be
public information. Under Securities and Exchange Commission
rules, a company cannot make selective disclosure of
confidential information only to certain analysts.
Also, investment banks that trade securities establish
information barriers--you have heard those referred to as the
Chinese wall--so that confidential information that may be
known to a company's bankers does not reach the analysts and
salespeople who may be recommending or trading that company's
stock. Therefore, when I issue a report on a company on behalf
of Salomon Smith Barney, I am prevented by rules and
regulations, as well as by the firm's policy, from asking my
banking colleagues about their non-public dealings with the
company that is the subject of my report.
If an analyst is ever brought ``over the Chinese wall'' to
receive non-public information, he is not permitted to make
recommendations with respect to the particular company until
the information learned by the analyst becomes stale or has
been disclosed publicly.
With this background, I would like to summarize for the
Committee my reports concerning Enron.
I initiated coverage of Enron in January 1998, when I
worked at Schroder. I developed my own methodology for
forecasting the company's earnings, and based on my analysis of
the company's reported financial results and business
prospects, I placed Enron on the firm's ``recommended list.''
It was my professional opinion that Enron was well
positioned to take advantage of the deregulation of the
electricity industry. By that time, Enron had already built an
impressive reputation and had achieved dominance in the
competitive natural gas industry, which deregulated about a
decade before.
It was also my professional opinion that Enron's core
merchant energy business model was sound. Under that model,
economies of scale, innovative marketing, and risk management
could allow Enron to offer cheaper and more customized energy-
related services than those provided by its competitors. I
believed that Enron's objective--using risk management products
and long-term contracts to address the needs of wholesale
energy customers in the volatile commodity markets--was a
successful paradigm. The strength of Enron's reported results
appeared to confirm the correctness of this objective and
Enron's success in achieving it.
While I was at Schroder's, Enron's performance in the gas
and electricity commodity markets was impressive. I believed
that Enron's core platform could be applied to other
inefficient markets for commodities that were delivered over a
network, such as bandwidth.
In March 2000, just before our firms merged, I joined
Salomon Smith Barney as a senior analyst. I issued my first
report on Enron at Salomon Smith Barney in April 2000. At that
time I rated Enron as a 1H, which means a ``buy''
recommendation, with high risk attached to it. The high-risk
notation refers to the business risk given that Enron was a
first mover in new markets.
I continued to recommend Enron during the rest of 2000 and
into 2001.
In a report dated August 14, 2001, shortly following an
announcement that Jeff Skilling had resigned, I noted that
although he was an architect of the company's energy merchant
strategy, I believed in the soundness of their business model,
and even though it was a negative factor, barring any further
disclosures from the company, we still felt positive about the
company.
Beginning in October, Enron began to make public disclosure
of the transactions and financial restatements and writeoffs
that eventually led to its bankruptcy. I made timely reports as
the significant facts were announced.
On October 16, I noted Enron's decision to take $2.2
billion in charges, but reported that the charges, as described
by Enron, did not relate to its core merchant energy business.
Accordingly, I continued to rate the company a ``buy'' with a
``high risk'' rating.
On October 19, when the stock was still trading at over $32
per share, I issued a report which noted that the company's
``complex off-balance-sheet vehicles have raised concern,'' and
that there could be further writeoffs, and I was also concerned
that Moody's had put the debt on review for a possible
downgrade, but that we were still evaluating these issues at
that time. Later that day I issued another report, again
raising concern about their off-balance-sheet financing, and
again about the uncertainty and magnitude of potential
writeoffs of the company.
I downgraded my rating to 1S, or ``buy, speculative,'' on
October 25, and lowered it again to ``neutral, speculative,'' a
3S rating, the next day. In my report that day, I noted that
management had to address issues related to credit and
liquidity, particularly the use of off-balance-sheet vehicles.
Given everything that has happened since late October, I
think it is appropriate to ask why the analyst community, at
least the vast majority of its members, missed the mark on
Enron.
The short answer, Mr. Chairman, is that we now know that we
were not provided with accurate and complete information.
A company's public certified financial statements are the
bedrock of any analysis of the value or the prospects of a
company's stock.
It is now common knowledge that Enron's financial
statements, which had been certified by its independent
auditor, did not represent the company's true financial
condition. The analyst community relied on these financial
statements, which were restated. The company restated 3 years'
worth of its earnings in November.
When analysts look at certified financial statements, we
assume that they are accurate and that they fairly and
completely represent the company's financial condition. In
Enron's case, that assumption turned out to be invalid.
As analysts, our reputation and ultimately our livelihood
depends on our making timely and correct calls. I did not want
to get this wrong in terms of Enron. I recommended Enron's
stock because I believed in the company's core business model,
and I trusted the integrity of the company's certified
financial statements and the representations of the company's
management. At all times, I exercised and communicated to
investors my best professional judgments based on the
information that was available to me.
Thank you, Mr. Chairman and members of the Committee.
Chairman Lieberman. Thank you, Mr. Niles.
The last witness on this panel, Dr. Howard Schilit,
president and founder of the Center for Financial Research and
Analysis.
TESTIMONY OF HOWARD M. SCHILIT, PH.D., CPA,\1\ PRESIDENT AND
FOUNDER, CENTER FOR FINANCIAL RESEARCH AND ANALYSIS, INC.
Mr. Schilit. Thank you very much, Senator. I do have a
prepared statement, but I just wanted to interject before I got
into that, at the conclusion of that if you would like me to
comment on what I just heard and also my analysis on Enron that
came out of the public records, I have some interesting
findings in front of me.
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\1\ The prepared statement of Mr. Schilit with attachments appears
in the Appendix on page 86.
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Chairman Lieberman. Fine. Let me ask that you go ahead and
do the opening statement, and during the question and answer
then we will give you an opportunity to offer your reactions.
Mr. Schilit. Senator Lieberman and esteemed colleagues, I
am pleased to appear before this Committee to describe my role
as an independent financial analyst and some of the important
differences between Wall Street research and our independent
boutique.
Before proceeding, I want to emphasize that my comments are
based solely upon personal observations over the last decade
rather than on a comprehensive study of Wall Street or other
independent research boutiques.
My name is Howard Schilit. I am founder and president of
the Center for Financial Research and Analysis, or CFRA, based
in Rockville, Maryland. Prior to that, I was employed for 17
years as an accounting professor at American University. I also
authored a book called ``Financial Shenanigans: How to Detect
Accounting Gimmicks and Fraud in Financial Reports.''
My organization has been writing research reports since
1994, warning institutional investors about companies
experiencing operational deterioration or using unusual
accounting practices. Our reports are published daily and
distributed over our website.
We use a variety of quantitative and qualitative screens to
initially select companies for review. Then an analyst reviews
the financial reports and other public documents to search for
any problems. If any are found, we interview company management
to discuss these issues. If concerns remain, we publish a
report on our website. We make no buy or sell recommendations;
rather, we simply discuss the issues of concern.
Our clients are mainly institutional investors who purchase
the research on a subscription basis. We are paid a fixed fee
based on the number of actual users at the firm, similar to a
license fee on software. Subscribers receive an E-mail each
morning with a notification of the companies profiled, and the
reports are posted on our website at 9 a.m.
All CFRA subscribers receive the information in the same
way and at the same time. In addition, all subscribers have
equal access to discuss issues with our analysts.
CFRA has a variety of strict editorial policies and ethical
guidelines that protect clients' interests and ensure CFRA
employees receive no remuneration based on stock price
performance of companies they profile. I have attached those
policies with my formal statement.
In short, we have no brokerage, investment banking, or
money management operation. We have no conflicts of interest.
We have one client class: Those who make economic decisions
based on financial disclosures. And we have one overarching
goal: To help them make the best decisions.
In contrast, Wall Street research is fraught with real and
potential conflicts of interest.
Wall Street brokerage firms have at least two major client
groups: Those that purchase investment banking services and
institutional investors. Typically, a company needing funding
will hire a brokerage firm to underwrite securities in a public
offering. The brokerage firm receives a fee, generally 6
percent or higher, for this investment banking service. Shortly
thereafter, the successful analyst at the brokerage firm will
begin coverage on this new client with a positive research
report. Generally, future research reports on this investment
banking client will remain positive. Future investment banking
fees on stock or bond offerings depend on a close relationship
with the corporate client.
If CFRA or another critic raises concerns to investors, the
brokerage firm often publishes a rebuttal to show support for
the investment banking client, and in some cases with
disastrous results.
This shows the inherent conflict of interest; the brokerage
firm serves both the underwriting client--the subject of the
report--and the investor, who must be informed when problems
arise.
The method of paying for research also differs
substantially at Wall Street firms. Whereas we receive a cash
payment for selling subscriptions, brokerage firms are paid by
investors in commission dollars. The trading volume affects the
amount, the timeliness of the information, and access to speak
to research professionals. That is, the bigger clients
typically get the first call from institutional brokers and
salesmen, while smaller clients have lesser access.
Moreover, non-institutional investors who generate no
commissions often have no or very limited access to such
research. CFRA, for example, was not permitted to purchase
brokerage research through First Call--the distributor of
brokerage research--because we generate no commission. They
refused our offer to purchase the research for cash.
I have outlined in a chart ten important differences
between the work of our independent boutique and Wall Street
firms, and I will leave that for you to go over, perhaps during
the question and answer period.
In conclusion, as a result of the conflicts of interest and
internal policies, Wall Street research has regularly failed to
warn investors, so not just Enron but regularly failed to warn
investors about problems at companies. I would be happy to
answer any questions at this time.
Chairman Lieberman. Thanks very much, Dr. Schilit.
To the four analysts here, obviously, Dr. Schilit has laid
down a challenge and raised concerns and issued charges that
are very much on the minds of all of us, and I want to ask you
a series of questions, as other Members of the Committee will,
to respond to those.
To one extent or the other, the four analysts who are here
from the firms this morning have defended the fact that jumps
out at us, that you were continuing to recommend Enron long
after it appears that there were warning signs. Some did it
quite specifically, others of you quite generally.
The concern obviously is whether you were influenced in
those favorable recommendations that now seem so wrong by the
fact that your firms were doing business with Enron or perhaps
just because you had become too close to Enron. We have a
syndrome that they sometimes talk about in diplomacy where the
Ambassador we send to a foreign country becomes the advocate
for the foreign country as opposed to the advocate for the
United States. And I wonder about that as I listen to you.
But let me cite the Bethany McLean article in Fortune
Magazine in March 2001, very direct, strong questions about
Enron's viability. At least one analyst, Mark Roberts, of Off
Wall Street Consulting Group, May 2001, which is an independent
research firm, diagnosed the problems with Enron in a research
report that was printed on the Web and talked about shrinking
profit margins, raised questions about Enron's related party
transactions, even identified one dark fiber transaction as
being used to exceed earnings expectations for two quarters in
2000. In additional reports in July and August of last year, he
raised concerns that Enron was relying even more heavily on
related-party transactions and that Enron's cash flow from
recurring operations and return on capital was poor as compared
to its competitors. Finally, he noted that insiders at Enron
were selling like crazy, then put together the growing media
concern during last fall about Enron with some specific
allegations being made in articles and places like the Wall
Street, and the beginning of the SEC investigation. And yet the
four of you--and, in fact, by our calculation, about two-thirds
of the analysts on Wall Street who were really focused on Enron
continued to recommend a ``buy,'' to say the other obvious fact
which I haven't mentioned, the stock price was dropping
significantly over the period of time.
So the obvious question is: Why? And why shouldn't we or
average investors feel that you were not really doing
independent analysis but that you were affected by the fact
that--by either of the factors I mentioned: One, that you got
too close to Enron; or, two, that your firms were benefiting
from ongoing business relationships with Enron? Mr. Feygin.
Mr. Feygin. Thank you, Mr. Chairman. Again, I would like to
go back to something you said in that integrity is absolutely
essential in this line of work, and we focus on the core
operations, the business model, and the publicly available
information.
In the releases from Enron and the conference calls they
had and the financials that were published, the core operations
were doing exceptionally well; as I mentioned, even in the
third quarter with the charge, they were up 35 percent. And as
you mentioned, the stock kept sliding while I believed that the
core operations were continuing to do well. I thought that the
deterioration and all of the issues that were raised were more
than factored into the stock price, and, again, my outlook,
which is what my recommendation is based on, pointed to a solid
core business, the rapid move by Enron to rid itself of some of
these distractions that you mentioned, and I firmly believed
that the stock would go on to outperform until fundamental
issues arose and we downgraded it on October 24 pending the
resolution of those issues.
Chairman Lieberman. Let me ask you more specifically, isn't
there a natural way in which the public's growing skepticism
about the independence of analysts working for firms, as you
do, is justified? In other words, I understand one of you--
perhaps it was you, Mr. Feygin--said you didn't receive any
compensation from Enron. I understand that is true. But I
gather that the income that you make, including bonuses at the
end of the year, is affected by your firm's overall performance
during the year, including its investment banking and other
businesses, which Enron was significantly contributing to.
So weren't there implicit or explicit pressures on you to
continue to recommend a buy for Enron as it slowly collapsed?
Mr. Feygin. The answer to the last part of your question is
no, there were no pressures on me to maintain the rating.
Chairman Lieberman. Mr. Gross, why don't you answer that
question? I understand the defense, notwithstanding the
evidence I have presented, that you are all saying you made a
judgment call. But why should average investors feel that you
and the other analysts working for the firms that were doing
business with Enron were not affected by that, since your
advice seemed to be so counterintuitive? As the stock price
slid, the insiders were selling like crazy, and there were all
sorts of growing--not just speculation but accusations that
something was very rotten at Enron.
Mr. Gross. Well, I think we have all reiterated in one way
or another that the core business, the basic business model, we
believed was very strong, was growing rapidly, was portable
into other commodities, and that this was the strength of
Enron. It materialized when the stock went from $45 to $90, and
we believed that that franchise was portable into broadband in
a context where there was a lot of enthusiasm in general about
broadband.
As the stock fell, it became evident that the broadband
business was not going to pan out as rapidly as most observers
had viewed it. We were back to an energy company. The energy
company still, as we were reporting, they were reporting record
quarters. They were reporting very strong volumes. We could see
the confirmation of the business model in the other companies
that we followed that were also doing very, very well. And so
the core business all along, I think each and every one of us
believed was very, very strong.
As we got toward the end and we got incremental pieces of
information--we would get a piece of information saying that
management was selling stock. The early sales of stocks were
from individuals that in my belief were on their way out of
Enron or retiring. The stock sales of many of the other senior
managers we believed were normal sales. They were programmed
sales. They were very regular.
When it came down to Jeff Skilling quitting, once again,
all of us in our own way interpreted that. My own reports
indicated that this is an issue, but at the end of the day, the
bench is very deep. We had two instances in the 1990's where
senior executives at Jeff's level had quit abruptly, early in
1992-93, an individual named Mick Seidel and an individual
named Rich Kinder. The bench took over and the stock continued
to do well.
It was only toward the very end that it became evident that
the core business, because of lack of management credibility,
because of some rating issues, was going to deteriorate,
possibly to the point where we had significant problems with
that core business. And I think that was the essence of how we
were able to recommend the stock as it----
Chairman Lieberman. We try to keep each of the Senators,
including the Chairman, on a time allotment. I have gone over
mine. I just want to ask, not for a defense of what you did
because you gave it in your opening statement, Mr. Launer and
Mr. Niles, but how do you explain why you missed the signs that
Mr. Roberts of Off Wall Street Consulting Group saw?
Mr. Launer. As an analyst, I worked very hard on Enron, on
all of the publicly available information. I have made it a
practice throughout my career not to use other research reports
written by anybody. I was aware of the Roberts report because
some of the claims in it were brought to my attention by the
institutional investors that I serve.
The questions that came up at that time were relatively
easy to answer analytically through our own work. One of the
main comments in that report dealt with Enron being overvalued
because it was simply a trading business. The analysis that we
have done of the merchant energy business that Enron and other
companies take part in is that the business has substantial
barriers to entry, needs a lot of capital, and has a utility
function to serve and, therefore, justifies a higher multiple
than a trading business.
From the standpoint of the other concerns about dark fiber
sales that you mentioned, we had seen that from Enron and other
companies, and those issues were disclosed and part of our
analysis in terms of the company having included dark fiber
sales in their earnings reports in the year 2000.
In terms of related-party transactions, there simply was
incomplete disclosure, as we now know, of the related-party
transactions. And in terms of the return on capital employed
having come down, that was consistent with Enron's business and
strategy of investing heavily in new start-up businesses that
weren't counted on to provide earnings or returns for the first
couple or 3 years of their existence.
So, overall, from the standpoint of hindsight allowing a
view that we simply did not have, we relied on the information
that was available at the time.
Chairman Lieberman. Mr. Niles, I am going to let my
colleagues question you because time is up. I want to leave you
with a quote, and maybe some of you will respond to it. James
Chanos, a short seller who gained recognition for doubting
Enron's value fairly early on, testified before the House
Energy and Commerce Committee on February 6 that he met
sometime early in 2001 with the analysts covering Enron from CS
First Boston and Salomon Smith Barney. I trust that was the two
of you? Do you remember meeting with Mr. Chanos?
Mr. Launer. Yes, I do.
Mr. Niles. Yes.
Chairman Lieberman. Anyway, he testified that, ``They saw
some troubling signs. They saw some of the same troubling signs
we saw. A year ago, management had very glib answers for why
certain things looked troubling and why one shouldn't be
bothered by them. Basically, that is what we heard from the
sell-side analysts. They sort of shrugged their shoulders. One
analyst said, `Look, this is a trust-me story.' ''
I would like to hear as this morning goes on your response
to that recollection of his to those conversation.
Senator Thompson.
Senator Thompson. Thank you, Mr. Chairman.
Mr. Gross, what did you consider to be Enron's core
business, as you referred to it? You thought the core business
remained strong?
Mr. Gross. Yes, its wholesale energy markets and trading
business.
Senator Thompson. All right. But they were doing quite a
few other things in addition to that, weren't they? They were
trading other things besides----
Mr. Gross. Yes, as they began to migrate the business model
to other commodities, we thought that it would be successful in
the context of the success they had already had and experienced
in natural gas, the experience and success they had in energy,
and the numbers that they were reporting in the way of volumes.
Senator Thompson. Is it fair to say that they made quite a
bit of money with their energy trading but they lost a lot of
money with regard to other trading areas, broadband and a lot
of other things, in addition to losing money on most of their
foreign investments, their base business, their bricks-and-
mortar business or pipeline business and all that? They were
making money in a very speculative area and losing money in
other areas. That is a great generalization, but is that not a
fair generalization?
Mr. Gross. I would say it is a partial characterization. In
general, Enron had invested in international infrastructure,
and a good portion of that historical portfolio, beginning with
some of the investments in the early 1990's, did not generate
high returns.
Senator Thompson. Well, none of it generated a profit, did
it?
Mr. Gross. The way it was reported to us in the audited
statements, it showed that it was making money.
Senator Thompson. Well, we know now that some of the
profits they were showing, if not most of the profits they were
showing, was because they were utilizing these 3,000 or so
partnerships, the Raptors and so forth, and disguising or not
reporting some of the losses and taking credit for some of the
gains generated from self-dealing and all that. We know that
now. The question, I guess, is what did we know back in the
fall?
I don't think we will ever be able to really second-guess
your analysis about what you were thinking at the time. To me,
just because a stock is going down, that doesn't necessarily
mean that you ought to sell it, for sure. Some of the richest
people in the world, most successful people in the world, don't
do that. So we have got to look at it from an objective
standpoint, and the question is: What are the American people
going to think, what is the average investor that our economy
is so dependent upon now going to think?
On the one hand, you have the objective factors that
everybody looks at that have been described here. Mr. Skilling
leaves under questionable circumstances. By September the stock
had lost 60 percent of its value from its high. All these other
things were going on. And then analysts had a conference call
on October 22, in which you were basically told, ``Don't bother
me, I'm busy.'' And then the next day Lehman Brothers came out
and said Enron's conference call began as a methodical review
of current liquidity and deteriorated into an inadequate
defense of the balance sheet; despite this, we affirm our
strong buy recommendation.
So when the public looks at all these objective factors and
then they look at what we now know is a system that is complete
with conflicts of interest where your interests and your firm's
interest is in the stock going up, they have to balance that
over against what you say was basically a reliance on corporate
executives. As I see it, they were telling you everything was
going to be all right.
Let me ask you, in a general sense, I would assume that
that would be a situation you would run into a lot, that a lot
of corporate executives would try to be optimistic with regard
to their own firm. Accounting principles is another issue. But
do you normally rely on just what the public record has got out
there that anybody could look at, plus what the corporate
executives are telling you? Even in light of all these
objective factors and the inherent conflicts of interest with
regard to your job, does the former outweigh the latter?
Mr. Gross. Each of us in our own way go about determining
management credibility in their statements, in that context
where we would be able to confirm or not confirm how Enron was
doing if they are in a market with other competitors. It has
been mentioned earlier that Enron in aggregate generated a
rather poor return on capital. You could see competitors
trading in the marketplace with financials that basically
represented that core business that were earning very high
returns. You could check out the statements of management with
their competitors. Is the market good? Is it bad? Is it
deteriorating? Is it improving?
So there are all kinds of cross-checks at the end of the
day that we have to perform, instead of just taking statements
at face value from the individual companies.
Senator Thompson. Well, I understand that. But let me give
you a cross-check on the other side of the ledger. Mr. Feygin,
I was looking here at a clip from the London Times, March 21,
2001, where it says J.P. Morgan reins in analysts. It says that
the independence of J.P. Morgan's stock research is being
questioned after analysts at the U.S. investment bank were
instructed to seek approval from corporate clients before
publishing recommendations on those stocks. In a memorandum
circulated to J.P. Morgan analysts last week, Peter Houghton,
head of Equity Research, said that he must personally sign off
on all changes in stock recommendations. In addition, the memo
further sets out rules described as mandatory, requiring
analysts to seek out comments from both the companies concerned
and the relevant investment banker, J.P. Morgan, prior to
publishing the research.
He says, ``If the company requests changes to the research
note, the analyst has a responsibility to incorporate the
changes requested or communicate clearly why the changes cannot
be made.''
So it looks to me like J.P. Morgan is telling their
analysts that they have got to get a sign-off from the company
they are analyzing and the mortgage banking side of the
operation before they can make any changes.
As I say, nobody can get in anybody's head and dispute the
fact that there are some factors out there that might lead one
to go in another direction. But over here, you have not only
all of the objective things that were going on out there in the
marketplace that anybody could see, plus the mortgage banking
houses basically letting the companies they are analyzing, it
looks like, call the shots.
What kind of investor confidence comes out of a situation
like that?
Mr. Feygin. Thank you for the question, Senator Thompson. I
have to say that I learned of this memo from the press. Peter
Houghton is the head of our research franchise in London, and
those rules did not apply to my actions. Until the rules were
changed recently, senior analysts were not required to seek
approval for ratings changes, period.
In the initiation process for the companies that we are
about to pick up coverage on, we do send part of the report to
the company, what we call the back of the report, which
factually describes the businesses for fact checking. But after
that point, the recommendations, the evaluation, and our
opinions are not second-guessed by outside or inside people.
Senator Thompson. So this only applies to new businesses as
opposed to companies that you are already doing business with?
Is that----
Mr. Feygin. To my best understanding--and, frankly, since
it didn't apply to me, I didn't study it in great detail, but
that applied to the London research--the department in London,
and it did apply to rating changes broadly, not just to new
initiations.
Senator Thompson. And is it still applicable?
Mr. Feygin. I don't know the answer to that for the London
franchise.
Senator Thompson. My time is up, Mr. Chairman. Thank you.
Chairman Lieberman. Thanks, Senator Thompson. Senator
Levin.
Senator Levin. Thank you, Mr. Chairman.
The Powers Report says, ``There is some evidence that Enron
employees agreed in undocumented side deals to ensure the LJM
partnerships against loss in three transactions.'' Now, one of
the documents that we have identified in the materials that we
have been reviewing at the Permanent Subcommittee on
Investigations confirms this with respect to several deals that
were called the ENA CLO Trust. Enron North America agreed to
buy back accounts receivables that it sold to LJM if these
receivables could not be collected.
Now, three of you, representing Credit Suisse, J.P. Morgan,
and Salomon Smith Barney, were limited partners in LJM. So it
is logical to conclude, I would ask you, that they knew about
these guarantees. And those guarantees were apparently not
reported on Enron's financial statements because that would
have defeated the purpose of the transaction in the first
place. So any of the three of you representing the companies
that I have mentioned, did any of you work on any of the deals
related to LJM or any decisions relating to the LJM
partnership? Let me start with you, Mr. Feygin.
Mr. Feygin. Absolutely not.
Senator Levin. OK. Mr. Launer.
Mr. Launer. I was not over the wall for any of the LJM
activity of our firms.
Senator Levin. Thank you. Mr. Niles.
Mr. Niles. No.
Senator Levin. OK. Now, if you had known about the
guarantees, I assume that you would have considered those
guarantees a liability to Enron, lessening to some degree, at
least, Enron's financial standing. Is that correct?
Mr. Feygin. That is absolutely right.
Senator Levin. Mr. Launer.
Mr. Launer. The same answer would apply here.
Senator Levin. Mr. Niles.
Mr. Niles. I believe so. I might just add, though, if this
was material non-public information, I would have to go to my
attorney, and I wouldn't be able to comment on Enron because of
the Chinese wall restriction.
Senator Levin. But I am asking if that information were
known to you, if it had pierced the wall, it would have
affected Enron's value.
Mr. Niles. Yes.
Senator Levin. OK. Now, the value of the partnership
depends to some extent on the Enron guarantee. The
partnership's value, which is being assessed, touted, sold by
the other part of your firm, depends to some extent on that
guarantee. So should the fact of the guarantee be known to the
analyst since guarantees are significant liabilities? In other
words, you said that it would have affected your judgment had
you known. Part of your firm knew. You didn't because of the
wall.
Should you have that information available to you before
you begin telling the public that this is good stock to buy
since someone else in your firm knows, hey, there is something
that is not appearing on that balance sheet which would affect
that analyst's judgment? Mr. Feygin.
Mr. Feygin. Again, if the question is if this information
is material, it is absolutely incumbent upon the company to
issue and disclose that in its financial statements, at which
point it becomes public information for me----
Senator Levin. It was not in its financial statements,
according to the document.
Mr. Feygin. Correct.
Senator Levin. Now, someone in your company knows something
that is not in the financial statement, because there is
evidence that those guarantees were issued without being
publicly disclosed. Now, does that not create an inherent
problem for your company and for you? Because someone in your
company knows something which affects the value of a stock that
you are analyzing and that you do not know that would affect
that analysis.
Mr. Feygin. The issue of the Chinese wall has been brought
up often in these hearings, and I am sure there is a lot of
information that is on the other side of the wall, the non-
public information that resides within our institution that I
am not privy to. That is not my role, and, regrettably, that is
not something I can incorporate into my analysis.
Senator Levin. So the information that I have just
described, you don't think should be available to the analyst?
Mr. Feygin. If it is material, it should be made available
to me by the company itself.
Senator Levin. All right. And if it is not disclosed by the
company but kept private on the other side of the wall, but it
affects your recommendation, then what?
Mr. Feygin. As the laws are structured today, obviously
that information cannot flow to me from the other side of the
wall.
If inadvertently it did, I would have to report that to our
Compliance Department and action would be taken after that.
Senator Levin. Therefore, on the other side of the wall,
they know that you are giving an analysis which is based on
incomplete information which affects what they are doing
because the more that Enron stock is held to be valuable
because it is not known that that guarantee exists which would
reduce its value, the greater is the partnership interest that
it is selling, the more valuable it is. There is an inherent
conflict right there. How do we solve it?
Mr. Feygin. If it is a material issue, again, the forces at
play should make the company disclose that information openly
and publicly.
Senator Levin. Or your company should itself insist that
that information, that guarantee, be made available on the
financial statement, should it not?
Mr. Feygin. In this case, the company being Enron?
Absolutely.
Senator Levin. No. The company being your company.
Mr. Feygin. Should insist that Enron disclose that
information?
Senator Levin. Yes, that it be on the financial statements.
Mr. Feygin. I can't speak to that call being made on the
other side of the bank.
Senator Levin. Anyone else, just with the three companies,
have a comment on this?
Mr. Launer. The only comment I would make is it is not our
job to disclose material non-public information. It is the
responsibility of the company, meaning Enron, their accountants
and their lawyers.
Senator Levin. Why is it not the responsibility of your
company, on the investment side of your company, to make sure
that something which should be disclosed in that financial
statement which would have an effect on the stock be disclosed?
Mr. Launer. Material non-public information. We are not
over the Chinese wall and do not have possession of that
information.
Senator Levin. By not insisting that it be disclosed, it is
leading the other side of the company to be giving an appraisal
of stock, a valuation of stock which is based on information
which the other side of the company knows to be incomplete. And
it seems to me that creates an inherent conflict that we have
to address and the investment community has to address.
My time is up, and I will pick up later. Thank you.
Chairman Lieberman. Thanks, Senator Levin. That was a very
interesting line of questioning.
Let me just for the purpose of clarity, because there was
something assumed in the line of questioning. There is this so-
called Chinese wall between the research departments, or the
analysts always say, and the rest of the business of the firms
you work for, correct? That is what we are talking about. But,
Mr. Launer, I think you used the term--and we have all heard it
here in these discussions--being ``brought over the wall.'' I
take it--am I correct that there are occasions when you as
analysts are brought over the wall into other parts of your
firm's business? Is that correct?
Mr. Feygin. That is correct.
Mr. Launer. Yes.
Chairman Lieberman. But you were all saying in the specific
instance that Senator Levin was interested in, you were not
brought over the wall.
Mr. Launer. That is correct.
Chairman Lieberman. Were there any occasions, since each of
your firms, the four of you were doing--each of the firms was
doing business with Enron, when you as analysts were brought
over the wall with regard to any deals or business arrangements
with Enron? Mr. Feygin.
Mr. Feygin. Certainly. In the case of Enron, on November 9,
prior to the merger with Enron and Dynegy being announced, a
couple hours prior to that I did receive--I believe I received
the press release of the merger, at which point I was brought
over the wall and was frozen and could not comment on the
stock.
Chairman Lieberman. And you were brought over the wall for
what purpose?
Mr. Feygin. For the purpose of having the information and
being able to respond to investor questions once the deal with
announced.
Chairman Lieberman. So you were no longer giving public
analysis? Is that what I understand you to say?
Mr. Feygin. From the point that I was given that material
non-public information that this merger was about to be
announced and saw the details of that merger, I could not
comment, I could not publish research until it was publicly
announced and disseminated.
Chairman Lieberman. Mr. Gross, were you brought over the
wall in any business transactions related to Enron?
Mr. Gross. Specifically here, we were the adviser to
Dynegy, and I was brought over the wall in late October.
Chairman Lieberman. So to advise your company about Enron--
--
Mr. Gross. My primary role here was to gauge how investors
would react to the merger, to gauge their concerns, and in that
light help formulate but not actually execute due diligence
that Dynegy would do on Enron.
Chairman Lieberman. Did you continue to provide analysis
that was----
Mr. Gross. No. At that point, my ratings, according to
company policy, are frozen.
Chairman Lieberman. Mr. Launer.
Mr. Launer. I was over the wall relative to Enron for 6
weeks in the September-October period of the year 2000 for an
IPO of the NewPower Company.
Chairman Lieberman. Mr. Niles.
Mr. Niles. There was one occasion. In January 2001, I was
brought over the wall for a 24-hour period, I believe, for a
convertible security offering by Salomon Smith Barney for Enron
securities.
Chairman Lieberman. All right. I appreciate your
responsiveness, and I see each of you in one sense or another
presenting evidence that your companies had rules. But you can
see how at least I, as one just sitting here, have doubts
raised in my mind. You have got this expertise, and your
companies have business interests in other dealings, including
with Enron. The public is relying through the media, through
websites, etc., on your analysis of Enron. And yet there is a
feel of a conflict which, no matter how hard you tried with the
freezing of your public analysis and all, still leaves me
feeling that the rules were not adequate, particularly in light
of your continuing recommendation to buy Enron after most
everybody was selling it.
I am going to stop there. Senator Voinovich.
Senator Voinovich. It looks to me like there are a couple
of things we have to be concerned about. Do you guys have a
conflict of interest by owning stock, your family owning stock,
and whether you ought to disclose ownership, or be prevented by
law from owning any stock that you report on. That one is
internal.
External is the Chinese wall. Should we have any Chinese
walls at all? Should you all go into the business that Mr.
Schilit is in, and that is that you are an analyst and you have
got nothing to do with the other side of the business. And,
this gets back to what Senator Lieberman was saying--if you are
in the same outfit, there ought not to be a wall. If you have
got information, inside information, and you are an analyst,
that information should be made available when you do your
reports. So there is no problem of whether you have got a wall
or you don't have a wall. Also, Mr. Launer, you are complaining
about the fact that you didn't have the information that you
needed. What information more do you need to do a better job of
being analysts if you stay in the same kind of outfit that you
are in today? Is there something that we can do in terms of the
law, requiring more information so you can make better
judgments?
Have any of you changed the way you are doing business
because of Enron? Are you doing things the same way as you did
them before? Are you a little bit more cautious? Are there
other things that have changed in terms of your operation?
I would like to hear from all of you. Do you think we ought
to have legislation that says that you can't do any kind of
analyst work on stock that you own? And, do you think that you
should be required to disclose if you are an analyst of the
stock that you own? Yes or no. We will start with you, Mr.
Feygin.
Mr. Feygin. I agree that we should be required to disclose,
which is J.P. Morgan policy, the stocks that we own, as well as
some other disclosures that are standard in our research.
Senator Voinovich. And do you think it should be required
by law that that be the case?
Mr. Feygin. I would like to fall back on something Senator
Torricelli said, and that is the markets do take care of this
issue. And to the extent that firms will be more trusted and
their analysis will be deemed more valuable, the market itself
will impose those disclosures.
Senator Voinovich. So you don't think you need legislation
that requires that?
Mr. Feygin. I can't really comment on that. I know that at
our firm we do disclose that, and hopefully that helps our
product. And I would welcome any changes that would enhance our
product offering. If that is one of them, by all means.
Senator Voinovich. Mr. Gross.
Mr. Gross. No, disclosure I think is a good thing. And, in
general, Lehman Brothers in the past has had outright bans for
analysts owning stocks that they follow.
Senator Voinovich. Legislation or no legislation.
Mr. Gross. That is a difficult call for me to make
because----
Senator Voinovich. Mr. Launer.
Mr. Launer. No legislation, to answer your direct question.
Our firm has adopted the SIA best practices. They effectively
contain provisions which require----
Senator Voinovich. Yes, but before your firm did that, your
family did own--had bought a bond, had stock. Your sons had
stock in Enron. And then the firm changed the rules, and then
you had to transfer stock, except you had to hold a bond that
is not worth anything anymore. But did that color your judgment
when you owned--I mean, you were working on Enron, you or your
family members were buying stock in Enron. Did that color your
judgment in terms of your analysis of Enron stock?
Mr. Launer. No, it did not, and it was fully disclosed each
step of the way.
Senator Voinovich. But right now you don't have to--you
can't deal with any stock that you are an analyst for, right?
Mr. Launer. That is right.
Senator Voinovich. And your family can't, according to the
rules of the firm.
Mr. Launer. That is correct.
Senator Voinovich. And you don't think we need legislation
to require that?
Mr. Launer. No, I don't.
Senator Voinovich. Mr. Niles.
Mr. Niles. Our firm prohibits buying stocks in companies
that we cover, and as far as the policy matter, I haven't
really given it a lot of thought. But I do know our firm
prohibits buying stocks in companies----
Senator Voinovich. OK. How about the Chinese wall? Do you
think that you ought to split off to avoid what Senator
Lieberman and some others have talked about, the issue of
having the same firm being analysts and at the same time being
investment bankers and having all kinds of information on one
side that the people who are doing the analysis can't have
because it is not public? I know what Mr. Schilit is going to
say.
What do you say, Mr. Feygin?
Mr. Feygin. Senator, I believe in your question and in a
lot of the statements there is the presumption that there is a
conflict of interest, and on some levels perhaps it exists. But
the value that I bring to the firm, again, is in my
independence and the credibility I have with my investors. And
that is absolutely key. To the extent that that helps our firm
gain business, that is great and the firm will prosper.
To the extent that it is a ``buy'' recommendation that
helps me build credibility, we have commented--this panel has
commented on numerous occasions that there were multiple buys
on the stock.
Senator Voinovich. I understand the whole thing is trust
and trustworthiness. Enron has destroyed that for a lot of
people in this country. And those of you in the business are
going to have to respond to it because it is really going to
hurt the business, it is already hurting the business.
Let's say, for example, that your firm has a Chinese wall.
Do you disclose to the people that you are analyzing stock for
that there is a Chinese wall and that your firm is doing other
work for the companies that you are analyzing the stock for?
Mr. Feygin. It is company policy to disclose if J.P. Morgan
had a role as an underwriter or was involved in an offering for
the company when we publish any reports.
Senator Voinovich. So that is something that you are
already doing.
Mr. Feygin. Yes. Now, we do not disclose on every report
that there is a Chinese wall because, again, our role focuses
exclusively on publicly available information.
Senator Voinovich. Mr. Gross, how do you feel about it? Do
you think you ought to break it up so you don't have a problem?
Mr. Gross. No, I think that in general that the methods
that we follow to handle potential conflicts are adequate.
Going back to Senator Levin's comment, the investment bankers
periodically have material non-public information. The vast
majority of it is not applicable to what I do. It may be in the
context of Company A wants to buy Company B, never does execute
that transactions. That is material non-public information.
The type of disclosure that Senator Levin was talking about
I think is more appropriately handled in that the rating
agencies see consolidated balance sheets. We have some new
disclosure rules which will allow us on the outside to do so.
The auditors deem what is material or not. We have talked about
in different forms tightening some of those screens.
So there are mechanisms that are out there that would
provide that flow of information to the investment community
without curtailing my role, which is a materially different
role in how I would help the firm with--as I said, my role in
the Dynegy deal was basically to tell the companies the
investor reaction to doing this. So from a standpoint of the
nature of serving multiple clients, I don't think the conflicts
are all that prominent, nor are they that insurmountable when
people----
Senator Voinovich. Well, I will finish because I am out of
time, but you now have a problem of appearances. Before this
you didn't. It is the issue of appearances of conflict of
interest. And what we are trying to do as quickly as possible
is to restore people's faith in the financial markets in this
country so we can get back to business. And I would say to all
of you that are here, the faster you can move internally within
your own organizations to get out and change some of these
things--and I would love to have your recommendations, this
Committee would, on some of the things in terms of legislation
that we need to do so you have better information so that you
can do your job better.
Thank you, Mr. Chairman.
Chairman Lieberman. Thank you, Senator Voinovich. Senator
Torricelli.
Senator Torricelli. Thank you, Mr. Chairman, very much.
What is extraordinary about the Enron matter is the
confluence of failures: Unethical business practices by
executives which could constitute fraud or gross mismanagement;
the failure of a proper accounting to basic standards that
would be acceptable; and now the issue of whether the analysis
was never properly at arm's length or simply failed because of
inadequacy of information.
If any one of these three institutions had actually had the
proper information and acted according to highest expectations,
a great deal of pain would have been saved for a great number
of people.
Our role here is to focus on the third of these functions,
each of your roles in the marketplace. I can only supplement my
colleagues' questions by asking your thoughts on several things
to help me better understand some of these relationships.
First, let me go to this issue of information you were
receiving from Enron. On this conversation of August 14 in
which you received this analysis by Mr. Skilling and Mr. Lay,
characterize for me whether in your judgments this constituted
simply exaggerating information properly available, was just
routinely misleading, or you consider yourself to have been
defrauded by some of this information that was provided by Mr.
Skilling? I go back to the quotes I provided to you earlier,
which I assume you to be familiar with, the numbers, the
projections, and particularly the references to the new
businesses of the crude, the crude products, metal, pulp,
paper, and coal. Some have doubled. Every one of them in the
second quarter or the quarter before, all are profitable.
The characterization then put on the company in August, now
that we know what, in fact, those executives knew about the
company, about the partnerships, about the deteriorating
situation, the warnings they had received from people
internally, as professionals. Looking back on the conversation,
the judgments you made based on it, how do you characterize
this as a business?
Mr. Feygin. Thank you for that question. I will break it up
into two parts. One, the characterization of the businesses'
performance provided by Mr. Skilling. To date, there is no
evidence yet that those new businesses were not performing in
line with what Mr. Skilling said. I think one of the most
impressive aspects was, as the company got into new products
such as pulp and paper when it was about to collapse, the
Scandinavian pulp and paper markets were panicked because of
the size of Enron's presence in that marketplace, or perceived
size of Enron's presence. So it appears today--and we have no
evidence to the contrary--that those businesses were, in fact,
gaining traction and growing.
In hindsight, it certainly seems that, as it relates to the
partnerships and the exposures of Enron, we were misled.
Senator Torricelli. Mr. Gross.
Mr. Gross. I would say obviously, in retrospect, that the
nature of the disclosure was leading with your best foot and
letting the other drag behind. And in the context of the
subsequent information that has come out, there is no question
that we weren't receiving the full story about the health of
the company.
Senator Torricelli. In your mind, as someone who has done
these calls before, is this in keeping with the culture of the
business and the way these disclosures are made? Or do you feel
that you personally and your clients were victims of a fraud?
Mr. Gross. Well, without materially more information, I
can't draw a line between the communications that we received
and outside--outright fraud. I think that will be subject to
further investigations.
Senator Torricelli. Anybody else want to comment on this?
[No response.]
Senator Torricelli. Explain to me further the operation of
the separation of the firms. Apparently each of you are
prohibited from owning positions in the stocks you analyze or
are required to disclose those positions for yourself or family
members. Is that accurate?
Mr. Gross. In our case, I mentioned earlier that at times
we have had that ban. We currently are able to own stocks, and
we have severe restrictions about the nature of how we can own
them and when we can buy or sell those securities.
Senator Torricelli. Now, in the way the separation works,
are you then also not operating with knowledge about the
positions that the firm may be holding on its own account? Or,
for example, if you had done underwriting, the firm had done
underwriting for a company, whether you have future positions
with this firm, or separately whether you are holding large
numbers of bonds for the firm. How knowledgeable are you about
the exposure of the firm itself and its own position in any
particular company, not necessarily this one? Mr. Feygin.
Mr. Feygin. No knowledge whatsoever of actions that are,
again, on the other side of the wall.
Senator Torricelli. You wouldn't indeed know other than
what might be publicly disclosed? I assume if you searched for
it, you could find some public disclosures whether or not the
firm had any of these positions?
Mr. Feygin. Sure. You know, in the case of Enron and our
firm's involvement in particular, all I learned about our
exposure I learned from the press.
Senator Torricelli. Well, we all did. Mr. Niles.
Mr. Niles. I am sorry, Senator. The question was am I aware
of the firm's positions on----
Senator Torricelli. I want to get a feel for how these
walls operate within these firms, whether, in fact, you have
knowledge of the firm's exposure in what position it may have
from doing underwriting for these firms and its future
potential or the bonds that they are holding at the time.
Mr. Niles. I don't have access to that kind of information.
Senator Torricelli. So, in practice, not simply Enron but
any of these firms, you find these absolute?
Mr. Niles. I don't have that information.
Senator Torricelli. Let me ask you finally, in seeking
resolution to this and where this Committee ultimately will be
left is whether to recommend statutory changes or, indeed, as I
suggested earlier, this is worked out in the marketplace or
professionally, is there an argument that, in fact, the
analysis function should be professionalized and separated and
be a product which is individually purchased by the brokerage
firms rather than the investment bankers, the brokerage parts
of this, having it in-house and connected in any case? These
could indeed be separated, much as the accounting industry, we
thought previously, had been separated and made independent. Is
there an argument for taking these out of the same roof at all
to restore public confidence?
Mr. Feygin. Well, Senator, again, these are obviously very
large public policy decisions that we as a firm would be
pleased to work with this Committee on. I firmly believe that
there are plenty of rules and guidelines in place that ensure
our independence and, from a legal framework, ensure our
integrity, as well as the fact that it is, as you pointed out,
paramount in the marketplace, that the marketplace perceive our
product as one of integrity.
Senator Torricelli. Things are not going to be in the
future as they were in the past. The status quo is not an
option. We are either going to take a bright yellow sticker and
put it on the windshield of all of your firms, revealing your
gas mileage and your resale values, much as this Congress did
30 years ago with a different industry, to know what your track
record is, what your rules are about disclosure, and the
holding of equities and your conflicts of interest so the
public can make its judgment in the marketplace, which is my
own preferred solution; or indeed this Congress is going to
write a regulatory framework to impose some of that.
One of the options is to simply separate the functions,
that if Smith Barney wants analysis, buy it from an independent
firm so the customers know that, in fact, they are--what is
happening here is genuinely at arm's length and can have more
than a Chinese wall, we can have a brick wall separating you by
physical location and management.
I want to conclude this by asking your advice. Do you all
favor simply letting this work out in the market: The public
will have confidence in some firms, they won't have confidence
in others? I suspect anybody with a portfolio right now is
scurrying around town trying to figure out who was right, who
was wrong. They are all looking at these sheets. Who came up
with the right answer first to get out? That is one answer, how
our system operates. Or we can go further. Is there anybody
else who wants to add on this in a recommendation? That is,
after all, why you are here. We are trying to figure out how to
make recommendations to our colleagues to proceed with this.
Mr. Schilit. Yes, I have been sitting quietly for a long
time because I am not part of the Wall Street community. There
is a lot wrong, and to answer your specific question, it
absolutely should be expected that the research should be an
independent function, should be set up separately. Customers
should pay a fee for that, and the marketplace decides the
value of that research.
In answer to Senator Voinovich in terms of what steps any
of us have taken in the wake of Enron, sadly we are a tiny
firm. We only had six analysts up until very recently, so one
of the industries we did not cover was the energy group. But we
have hired an additional six analysts, and we are looking at
100 percent of the S&P 500 companies just for these type of
corporate governance problems, a weak control environment.
Also, I did want to--because I have the floor for a few
moments, I did want to comment on were there any signs in any
of the public filings that there were problems at Enron? A very
logical question. Everybody is saying they hid from us, they
lied to us, they committed a fraud. Did you read the public
filings that were published at the SEC? I spent an hour of my
time last night going through every quarterly filing proxy, no
more than an hour, and I have three pages of warnings, words
like ``non-cash sales,'' words like ``$1 billion of related-
party revenue.''
Chairman Lieberman. These were all from last year?
Mr. Schilit. This was beginning in March 2000. Every single
quarter there was a little blurb looking at the reported
profits, for one quarter $338 million, and $264 million of
that, a pretty material amount, represent earnings from
unconsolidated affiliates, more than two-thirds of the
earnings, and it goes on and on.
Senator Torricelli. These corporations we have heard about,
the 3,000 or so Raptors or whatever, they were referred to in
one of those footnotes.
Mr. Schilit. Well, they gave little snippets of
information, but the point is this: I am heartbroken that I was
not covering this company when I could have done some good. But
for any analyst to say there were no warning signs in the
public filings, they could not have read the same public
filings that I did.
Senator Torricelli. Your disappointment is nothing compared
to that of a lot of other people who wish that you were
following it. When you see these footnotes, though, and it is
clear a lot of this is happening off the balance sheets, in
reference to Senator Thompson's question, are there references
only to the gross amounts of these that are happening off the
books? Or is there some indication, some window in the numbers
of these partnerships?
Mr. Schilit. They don't give any clue. I was astounded when
I heard it was 3,500. But just looking at the most basic things
that any investor could understand, if a company reports a
profit of a billion dollars and that same period the company
says we had negative $1.1 billion of cash received from that
operation, there has got to be some warning out there. And
those numbers came right from the June 2001 quarterly report.
Senator Torricelli. Thank you, Mr. Chairman.
Chairman Lieberman. Thank you. Senator Bunning.
Senator Bunning. Thank you, Mr. Chairman.
In regard to some of Senator Torricelli's questioning, I
want to refer to the J.P. Morgan, Lehman Brothers, First
Boston, Citigroup Salomon Smith Barney. Tell me how much your
companies were involved in the selling group or the
underwriting groups or what equity position your company had in
Enron. You can start with the first and go on down, because
from 1961 to 1986, I was in your business. And the same thing
was going on in 1961 that is going on the year 2002. Our
company would take a position in an underwriting group. Then
they would come to the sales force and say: We have an equity
position in this stock. We are recommending it to you to sell.
Now, help me out.
Mr. Feygin. Easy question for us. We are not involved in
any equity underwriting for Enron----
Senator Bunning. Or selling group?
Mr. Feygin. We were not a part of any syndicate on Enron
equity offering.
Senator Bunning. And you own none for your own personal----
Mr. Feygin. Own none for my own personal----
Senator Bunning. Not your personal. The corporation's
personal.
Mr. Feygin. I do not know whether the asset management side
of J.P. Morgan holds or has ever held a position in Enron.
Senator Bunning. That is impossible, sir. I am sorry. That
is impossible for you to tell me that.
Mr. Feygin. Why is that?
Senator Bunning. Because if you know that they weren't in
the selling groups of any type and you know that they weren't
in any underwriting group, you ought to know, if you are in the
business of recommending, whether they are in the equity end of
the--in other words, whose stock are you recommending, the
stock that your company owns or the stock that is owned in the
public market?
Mr. Feygin. The stock that is owned in the public market.
Senator Bunning. Next?
Mr. Gross. We have participated in several offerings that
Enron--most of them were on the fixed-income side. The equity
offerings----
Senator Bunning. Debt instruments?
Mr. Gross. Debt instruments.
Senator Bunning. OK.
Mr. Gross. We were a co-manager in an affiliate called
Northern Border Pipeline in the last year.
Senator Bunning. You were an adviser to them on your----
Mr. Gross. We were a co-manager, which means we did not run
the books.
Senator Bunning. OK.
Mr. Gross. We participate in the sales.
In general, once again, the vast majority of these sales
will take place with companies that are already trading in the
public domain. They will be distributed to institutional
investors.
From a standpoint of our position, yes, the way a syndicate
is formed is they own stock for a brief amount of time. We have
a money management wing where we have a high-net-worth group of
individuals----
Senator Bunning. For which a portion----
Mr. Gross. They may own Enron in that system. It is very
difficult for me to know. But, in general, because it is
investors' money, it is not ours. It is investors' money. The
same thing with J.P. Morgan investment and management company.
It is investors' money, not J.P. Morgan's, that they are
managing. It is an independent wing.
Basically what we will have is in and around, like I say,
an offering, it will be for a brief and limited amount of time.
It is generally in a security that is already publicly traded--
--
Senator Bunning. But you have taken the position so that
you can sell the securities?
Mr. Gross. Yes.
Senator Bunning. OK.
Mr. Launer. Senator, the disclosure on the bottom of our
research report says that our firm may from time to time hold
positions in the securities of the company that is the subject
of the report.
Senator Bunning. Thank you.
Mr. Launer. It does not say anything specifically. For me,
over the wall, the period of time was only the 6-week period in
2000----
Senator Bunning. Over the wall. It is in the Wall Street
Journal who is in the underwriting groups. I mean, that is
public knowledge, who is in the selling group, who is in the
underwriting group. The position that your company might have
in that equity, if you are selling as an owner of or as a
broker for or----
Mr. Launer. The disclosure that needs to be made has been
made relative to those things. Yes, we have been in selling
groups. But it really comes down to the level of our specific
involvement in those when we are over the wall. In 1998, I was
at Donaldson, Lufkin & Jenrette before the acquisition of our
firm by CSFB. I was involved in an equity offering where we
were the lead manager for Enron securities. So for that period
of time that I was over the wall, I was aware of the firm's
position and how we were handling the entire equity offering.
That ends at the time that the prospectus delivery requirement
relative to that offering----
Senator Bunning. You don't feel that inside, supposedly
non-public information, that you got while you were over the
wall would shade your judgment at all in your analysis now of
that same corporation?
Mr. Launer. No.
Senator Bunning. Mr. Niles.
Mr. Niles. Yes, Senator, our firm, it is a large
institution. We have an investment bank, a corporate bank, and
we have been involved in a number of offerings with regard to
Enron. And, I would just say we definitely--that is part of our
practice as a firm. I am not aware of the specific ownership
interest in the securities or how that works or quantities.
Senator Bunning. That blows my mind, because just as an
account executive, I was aware of it. I was aware of whether we
took a position and we were selling stock out of our own
portfolio or if we were just going to the market and buying and
then delivering the stock to a customer. So some of the things
you are telling us are very difficult to believe.
Now, if we are going to solve this problem and we have come
to you for assistance and you are going to testify as you have
testified today, you are asking us to intercede, not by your
suggestions but by our own initiative from what we hear. And
what I hear from you is very difficult for me to believe. And I
know about the walls. But the walls are not impenetrable.
People within your company know just what you are recommending
and are for what you are recommending because they know it is
going to help the other side of the wall. And I think that is
something that we have to look at very closely, Mr. Chairman,
and I am willing to go if you are.
Thank you.
Chairman Lieberman. It is always good to be on the side of
a member of the Hall of Fame. [Laughter.]
He threw some high hard ones in his day.
Senator Levin. Whichever side of the wall he is on, by the
way.
Chairman Lieberman. Well, your questions are right on
target, and, you express the concerns that I certainly have.
And I guess the question is: Each of the four of you have said
at one point or another you went over the wall. You went over
the wall according to the rules of the firms. But, the question
that I have and I think Senator Bunning's and other questions
raised is: If you can go over the wall, was it high enough? In
other words, does it not raise questions in all of our minds
about your ultimate independence or the intermixing of the
different functions of your firm?
Thanks, Senator Bunning. Senator Bennett.
Senator Bennett. Thank you, Mr. Chairman. I won't re-rake
the leaves. I think they have been gone over sufficiently. But
I can't pass the opportunity while you are here to raise
another question that occurs to me. I have not been an account
executive like Senator Bunning, but I have been in the market a
good bit in my career. I have made some fairly substantial
money in the market, and I have lost some fairly substantial
money in the market. And without the education that would be
necessary to be an analyst for pay, I do remember something
that I was taught when I was in my 20's, first getting into the
market, very, very fundamental. Don't buck the trend. And when
I inquired as to my counselor, well, how do you know when the
trend is going on? He said, well, it is very simple. A trend,
once established, continues until it is over.
I turn to your testimony. Here is the Credit Suisse sheet
that says up at the top: ``Recommendation, strong buy.'' And it
is within inches of a chart that makes the trend pretty
obvious. The stock has been going down on a very steady basis
for a year.
My gut reaction is I don't want to buy that unless in the
copy that says ``strong buy'' there is an indication as to why
the trend is over. A trend, once established, continues until
it is over. I want something here that says this is what has
happened different in the firm that shows that there is going
to be a bounce. And I read the copy, and there is nothing here
that shows there is going to be a bounce. Everyone here--and
the copy of the rest of it. I am not just picking this one out.
I picked this one out because it happened to have a chart, and
I like visual aids. But there is nothing in any of the copy of
any of the recommendations that says there is a shift in the
trend.
And so my question to you, which has nothing to do with
what we are talking about, is just interest, the fact that you
are here, and I hope you can educate me. What in your opinion
caused the stock to go down? While analysts were recommending a
buy all the way through, the market was saying this is a dog,
we want out of it.
The uncoordinated decisions of hundreds of thousands of
investors were sending a strong signal, we want out of this
stock. The chart shows that the market says this is a dog.
What did the market see that the analysts didn't? What
caused the stock to go down? Was it people like Mr. Schilit
sitting up at night reading the footnotes? What in your opinion
caused Enron, prior to the disaster--let's say the disaster
didn't occur and we are back on October 24. You have got a
stock that has gone down, according to this chart, index price
has gone down from $100 to $30 in less than a year. It has lost
70 percent of its market value. Why in your opinion did the
market decide this stock was worth only 30 percent of what it
has been worth a year before? Anybody?
Mr. Gross. Principally, the backdrop prior to that is that
the stock had more than doubled to get to $90. And if you look
at the backdrop for emerging market securities, new businesses,
the NASDAQ had gone from 2800 to 5100 and in that same period
had fallen to 1700. So a good portion of what you were seeing
in Enron stock was the entry into emerging businesses which
subsequently didn't work out for the entire industry, not just
of Enron.
Increasingly what you saw was incremental pieces of
information, whether it was the resignation of a chief
executive officer, etc., that took little increments down. But
the stock moving from $40 to $90 back to $40 was principally
broadband bubble.
Senator Bennett. Is there consensus on that?
Mr. Feygin. I think there is also, in addition to what Mr.
Gross has said, which I absolutely agree with, there is also a
period in this country and in investor sentiment of being
extremely bullish on energy and the fact that we had a
shortage, which would be a boon for companies, especially in
the deregulated part of the energy business, and that also came
and went in roughly the same period.
Senator Bennett. Was the consensus in the analyst community
to say ``buy'' during the slide from $100 to $30? Or do we
know?
Mr. Feygin. I think your charts have shown pretty clearly,
with some corrections, but there was a consensus to be
recommending Enron stock throughout most of that period.
Senator Bennett. So there was a ``buy'' when it was at an
index price of $100, and there was a ``buy'' when it was at
$70, and there was a ``buy'' when it was at $50, and there was
a ``buy'' when it was at $40, and then we know there was a
``strong buy'' when it hit $30. Well, OK. I take your point
about NASDAQ. I didn't participate in any of that because I
decided in my own mind this is tulip time. And I don't know at
what point the Dutch are going to wake up and discover that
they can't get much nourishment out of eating the bulbs, and,
therefore, they are not worth the total farm, which is what
they went through. And we went through that with the dot-coms.
And my kids would say, Should I be buying this? As I say, I
said this is tulip time. And I would feel better just staying
out of the market until the tulip bulbs have come back down to
earth.
But as I say, I don't want to re-rake any of the other
leaves. I am just interested in what might be the herd
mentality of some analysts saying, well, everybody else is
recommending it. That is a legitimate question. Is there that?
Do you fear that, gee, all of my fellows who work for big fancy
companies are saying buy this, and if I say sell, I am going to
be embarrassed? Believe me, the herd mentality rules this town.
So it is not an unusual human reaction.
Does anybody have a comment on that? Or should we just go
on?
Mr. Feygin. If I may, I think one of the premises, again,
is that there is a bias to these ``buy'' recommendations. And
to answer your question, as we now know, had somebody been
clairvoyant, had we seen through some of these charades and
some of these financials, nothing would have been more
impactful or valuable for the analysts to have called that
ahead of everyone else. I think I to some extent speak for the
panel that we have very different views and arrive at our
conclusions based on our own independent analysis, obviously.
It happened to be that in this case we didn't have the right
information.
Senator Bennett. Well, I can understand a sense that as
long as the core business is OK, you have shaken it down to
$30, and $30 is the logical place for the core business to be.
So at $30 you can buy it. I had a little problem with the
``buy'' recommendations before that. That is hindsight, and it
is easy for me sitting up here to exercise hindsight. I
appreciate your----
Mr. Schilit. While I am more of an expert on accounting
tricks than on predicting stock prices, where they are going to
stop dropping, very often after we have found problems at a
company and the stock gets cut in half and gets cut in half
again, and people would ask me, well, has this played out? What
I typically tell them, a stock doesn't stop going down because
it gets tired. There usually has to be some type of
interventions as you were showing with your chart. Is there
some change in the business dynamic? Perhaps a new chief
executive comes in. Perhaps they are selling off a money-losing
business. But very often, other than the bubble that we
experienced, when a stock is on a long-term down draft, it
usually doesn't stop going down because it gets tired. There is
usually more problems that will be coming out.
Senator Bennett. A trend, once established, continues until
it is over.
Mr. Schilit. Absolutely.
Senator Bennett. OK. Thank you.
Chairman Lieberman. Thanks, Senator Bennett, for an
interesting line of questions. We are going to have one more
question each, and then we have got to go on to the second
panel.
My question does relate to what Senator Bennett has just
described as the herd mentality, and I am particularly thinking
about what Dr. Schilit said earlier on about the hour he spent
last night looking at reports at the SEC that Enron had filed.
I want to show you two charts and then ask you one question
about the second one.
The first is the Enron consensus recommendation versus the
stock price, and the red line here is the consensus
recommendation, mostly above the ``buy'' until real late; and,
of course, the stock price is here.\1\
---------------------------------------------------------------------------
\1\ The chart entitled ``Enron Consensus Recommdenation Versus
Stock Price,'' referred to by Senator Lieberman appears in the Appendix
on page 129.
---------------------------------------------------------------------------
Chairman Lieberman. But the other chart that I really want
to ask you the question about is the one that I referred to
earlier on, and this is to speak more generally, not just of
Enron but of Wall Street analysts. And here, this is the S&P
500 from January 2000 to February 2002, and you can see it is
up, it is down, it is down, it is down. But the consensus
recommendation on the S&P 500 is almost a straight line at
``buy.''
What you said, I think, Mr. Feygin, earlier, just a few
moments ago about you would think that naturally an analyst
would want to be the first to say that, no, this company is
going down or this market is going down. Something is not
working right here. To state this with the clearest edge that I
can, I will quote David Becker from the SEC again, last year
when he said, August 7, 2001, in a speech to the American Bar
Association: ``Let's be plain. Broker-dealers employ analysts
because they help sell securities.''
So the question is: Have analysts become more salespeople
than analysts? And if not, how can we explain that only 1
percent, slightly more than 1 percent of the recommendations
that analysts made over the period of time studied--that is the
other, the Thomson study--were to sell and two-thirds were buy
and the rest were to hold?
Mr. Feygin. Thank you, Mr. Chairman, for that question.
First, again, I have to go back to the salespeople versus
analysts issue, and especially in the context of this herd. How
much impact can I have--and I believe on this panel I joined
the ranks most recently. But how much of an impact can I have
as an analyst coming into a herd and agreeing with the herd? I
don't believe that that will give my firm any leverage in any
business and will in any way promote my franchise. So I have to
bring something different and something new and something that
will establish my credibility and value to the investment
community, the institutional investment community, my clients.
So at this point, just as a point of reference, in my space
I only have two ``buy'' recommendations on the stocks that I
cover.
Now, I do believe that the natural gas industry overall--
and my ratings are relative to a benchmark. I do believe that
the natural gas industry overall is in a very good position. It
is a limited resource. It is domestic. It does have significant
incremental drivers going forward from gas-fire generation and
so on. So in my industry, I believe that there is a reasonable
bias to be bullish on the performance of those companies, and
yet only two are rated ``buys.''
Chairman Lieberman. OK. Anyone else have different--
obviously you understand that in the public mind, in our mind
now, we are concerned that the pressure may be from the
companies that you are analyzing and who are doing business
with the other divisions of your firm, and that is an even
greater pressure on you to recommend ``buy'' than the kind of
pressure that you describe, which would be to give the most
independent analysis you could.
Mr. Niles, I didn't get to ask you anything on the last
round, so I wonder if you want to respond to that.
Mr. Niles. Well, I would just say this: I do my best to
give the appropriate ratings. In fact, last year I downgraded
an entire group of subsector of stocks I cover. I was actually
the first one on Wall Street to do it. It was controversial.
And, I endeavor to get the call right as often as I can. Right
now not a lot of stocks are rated positively. There are few
that are.
Chairman Lieberman. So let me ask the broader question.
Apart from what each of you may have done in this area, do you
have any explanation for the average investor out there who
goes on to the Internet, checks stocks, watches television when
some of you come on, as to why only 1 percent of the
recommendations during that period studied were to sell and the
rest to buy? Dr. Schilit, maybe you get the last word.
Mr. Schilit. Again, I am not part of the Wall Street
establishment, but every time I have seen an analyst go out on
a limb and go against the conventional wisdom, which is you
have to be very positive on the companies that you are writing
about, that becomes a very controversial analyst. It could be a
very good career step if they want to leave the sell side and
go to work for a hedge fund. In fact, there is a fellow from
Lehman Brothers who wound up with a wonderful job at a hedge
fund. But if you want to move up the hierarchy in the Wall
Street establishment, you don't rock the boat. And that is the
reason why nobody at those firms will say there is a problem at
a company.
Chairman Lieberman. Time is really running. Senator
Thompson.
Senator Thompson. Yes, Mr. Chairman, I was just wondering
whether or not with regard to any of you or anyone on your
research or brokerage sides of your companies, whether or not
your compensation is in any way tied to the profitability of
the investment banking side of your business, salaries, bonus,
anything. Just yes or no, unless you care to elaborate.
Mr. Feygin. No.
Senator Thompson. It is not dependent upon the
profitability of the mortgage banking side of the business in
any way?
Mr. Niles. Yes, I think investment banking profitability,
the profitability of the overall firm factors into my bonus,
but it is a general matter.
Senator Thompson. Anyone else? Is that the case?
Mr. Gross. It is the same issue.
Senator Thompson. Beg your pardon?
Mr. Gross. It is the overall profitability of the firm
where the ultimate pool is drawn from, but there is no direct
link.
Senator Thompson. That the bonus is dependent upon?
Mr. Gross. Overall profitability of the firm, yes, and the
investment bank is part of our firm.
Senator Thompson. Is that the same thing, Mr. Feygin?
Mr. Feygin. That is correct.
Senator Thompson. All right. Thank you very much.
Chairman Lieberman. Thanks, Senator Thompson. Senator
Levin.
Senator Levin. Thank you, Mr. Chairman.
First, a comment, then my question. Mr. Launer, you said
that, relative to Enron, you were on both sides of the wall
relative to one deal, but that the information that you got
when you were here on the investment side of the wall you did
not use when you came back onto the analysis or the brokerage
side of the wall.
I find that just difficult to accept, frankly--that you can
put a wall in your mind between information that you get on one
side and not use it when you go on the other side of the wall.
I don't think the wall can possibly mean that the same person
can be on both sides of the wall. I think it has got to mean
you are either on one side of the wall or the other.
It still has problems because the wall is penetratable, but
in the example you give, it seems to me it defeats the purpose
of the wall for one person to be on both sides of the wall
structuring a deal relative to Enron and then going on the
other side of the wall brokering the stock of Enron, because I
think it is impossible to ignore what you have learned on the
investment side of the wall.
Now, that is a comment, not a question, because I want to
stick to the one-question rule. [Laughter.]
Mr. Launer. May I respond?
Senator Levin. I think in fairness, if you don't mind a
response to----
Chairman Lieberman. Go ahead.
Senator Levin. We get one response, and then I will reserve
my question.
Chairman Lieberman. We have walls here in the Senate that
one is able to go over as well.
Senator Levin. We penetrate walls here.
Chairman Lieberman. Do you want to respond?
Mr. Launer. I thought we set up a wall.
Chairman Lieberman. No.
Mr. Launer. Senator, the circumstances I referred to and
generally circumstances relative to being over the wall are
quite similar. It is when you become in possession of material
non-public information, and that is a decision made by many
others surrounding me at the firm.
Relative to a public offering of securities, as I mentioned
in response to the other question, I was over the wall for a
period of time with my knowledge that that offering of
securities was coming. Enron was doing an $850 million equity
offering. For a period of approximately 3 weeks, that offering
was pending. That offering needed to be filed for at the SEC.
Then that offering needed to be announced.
During the period of the marketing of the offering, I was
also over the wall because I had had the opportunity to have
that material non-public information first. When the offering
was completed and the stock began to trade the next morning and
the syndicate relative to that offering was completed and, as
it said to the SEC, the syndicate is broken, I then am not in
possession of material non-public information anymore and go
back to being an analyst as I had been before I was over the
wall. So it is not a situation that continues beyond.
Senator Levin. My question does relate to IPOs, and let me
ask all of you this question. In July of last year, Laura
Unger, who was then the Acting Chairman of the SEC, reported on
an SEC study of financial analysts that found that 16 of 57
analysts reviewed had made pre-IPO investments in a company
that they later covered. Subsequently, the analysts' firms took
the company public, and the analysts initiated research
coverage with a buy recommendation. That is the SEC study, 16
of 57 analysts reviewed had made these pre-IPO investments in a
company that they later covered.
My question is this: Have any of you personally
participated in an IPO issue or bought stock in the IPO company
before it went public and then recommended the stock? Putting
aside your current company rules because that may have changed
what you are allowed to do now, but at any time during your
career as an analyst, did you recommend a stock where you had
personally participated in the IPO issue or had bought stock in
the IPO company before it went public? Mr. Feygin.
Mr. Feygin. Yes, I participated in an IPO issue, but I
never bought stock in the companies that were brought public.
One of the IPOs that I was involved with never came to
fruition. In another I did end up recommending a buy rating.
Senator Levin. And are you allowed to do that under current
rules?
Mr. Feygin. I am not allowed to own stock.
Senator Levin. Anymore.
Mr. Feygin. Anymore.
Senator Levin. You can still participate in the IPO?
Mr. Feygin. Sorry, participate in the IPO as a firm and
underwriting----
Senator Levin. No. You personally, can you----
Mr. Feygin. No, absolutely not.
Senator Levin. You are not allowed to do that, nor have you
ever done that?
Mr. Gross. No and no.
Senator Levin. Mr. Launer.
Mr. Launer. In one instance, in the NewPower Company IPO, I
was with Donaldson, Lufkin & Jenrette at the time. I referred
to it in my opening statement. I invested $18,000 in NewPower
prior to that IPO.
Senator Levin. And then recommended the stock?
Mr. Launer. Yes, I did.
Senator Levin. And can you do that now?
Mr. Launer. No, I cannot.
Senator Levin. Mr. Niles.
Mr. Niles. No.
Senator Levin. I don't think I have to ask you at all, Mr.
Schilit.
Thank you.
Chairman Lieberman. Thanks, Senator Levin. Thanks to all of
you. The testimony you have given has been very important to us
and I believe--and I hope--very important to the investing
public. Thanks very much.
Could I ask the members of the second panel to please come
and stand by your seats and raise your right hand, if you
would. Thanks. Do you swear that the testimony that you are
about to give to this Committee today is the truth, the whole
truth, and nothing but the truth, so help you, God?
Mr. Glauber. I do.
Mr. Bowman. I do.
Mr. Hill. I do.
Mr. Torres. I do.
Chairman Lieberman. Thanks very much. Please be seated, and
the record will show that each of the witnesses answered the
question in the affirmative.
Let's begin with the Hon. Robert Glauber, chairman and
chief executive officer of the National Association of
Securities Dealers. Thanks to all of you for being here today.
TESTIMONY OF HON. ROBERT R. GLAUBER,\1\ CHAIRMAN AND CHIEF
EXECUTIVE OFFICER, NATIONAL ASSOCIATION OF SECURITIES DEALERS,
INC.
Mr. Glauber. Thank you very much, Mr. Chairman. If I might
just read a brief oral statement and have my entire comments--
--
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Glauber with an atachment appears
in the Appendix on page 90.
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Chairman Lieberman. Please, let me say that the testimony
that you have given, the complete testimony, will be printed in
full in the record.
Mr. Glauber. Thank you very much. Thank you, Mr. Chairman
and Members of the Committee, for the opportunity to testify.
First, let me briefly describe the NASD because who we are
bears directly on both the substance of what I will be saying
and on the usefulness of what we have been doing to strengthen
analyst independence.
The National Association of Securities Dealers is the
world's largest self-regulatory organization, or SRO. Under
Federal law, every one of the roughly 5,500 brokerage firms and
more than 700,000 registered representatives in the U.S.
securities industry comes under our jurisdiction, which also
includes every securities analyst employed by a member firm.
Our mission and our mandate from Congress is clear: To bring
integrity to the markets and confidence to investors.
Employing industry expertise and resources, we license and
register industry participants, write rules to govern the
conduct of brokerage firms, educate our members on legal and
ethical standards, examine them for compliance with NASD and
Federal rules, investigate infractions, and discipline those
who fail to comply. We are staffed by 1,600 professional
regulators and governed by a Board of governors, at least half
of which are unaffiliated with the securities industry.
All of this has given NASD a special responsibility to do
something about the lack of transparency and increasing
conflicts of interest that have eroded public confidence in
securities analysts' recommendations. And, Mr. Chairman it has
given us the means to do something about it as well, for the
NASD is equipped to provide a layer of real private sector
regulation between the industry and the SEC.
In July of last year, well before Enron collapsed, NASD
issued a proposed new rule: To significantly expand analyst
disclosure obligations. And 3 weeks ago, culminating a process
several months in the making, I joined several of your
congressional colleagues and SEC Chairman Pitt in announcing
far-ranging proposed new rules to govern the overall
responsibilities of securities analysts when they recommend
securities.
These tough, comprehensive rules represent a big step
forward, I think, in investor protection. They will provide
disclosure of much more information about analysts' potential
conflicts of interest as when analysts or their brokerage firms
own stock in the company being recommended or their brokerage
firm receives investment banking revenue from the company. And
they will prohibit certain kinds of behavior as simply being
too riddle with such conflicts, such as analysts' receiving
pre-IPO stock--the issue just raised a moment ago--or trading
against their recommendations or promising favorable research
to get underwriting business. The bottom line is not only
enhanced investor protection, but enhanced analyst
independence.
Now, will our analyst rules themselves prevent another
future Enron? I am not going to sit before you and make that
claim, for Enron was a multifaceted disaster, involving
corporate governance that didn't govern and accounting that was
unaccountable, as well as analysts who were far from analytical
in ferreting out the truth. I think there is no doubt that
analysts dropped the ball with Enron.
But I will say this: Under our new rules, the perverse
incentives that may have causes analysts not to want to know or
acknowledge the truth about Enron, because, say, their
investment banks had lucrative client relationships with the
company, those kinds of incentives will be reduced in part
because sunlight is the most effective disinfectant. And if
there is any remaining reason to wonder whether an analyst has
a conflict, he will have to 'fess up to it and disclose why he
has that conflict to the investing public.
Let me make one final point which I believe is critical.
These new rules are a matter of private sector self-regulation,
not self-regulation in name but self-regulation in fact. The
proposed rules were hammered out by the industry's foremost
SROs, acting under the strong oversight of Congress and the
clear vision of SEC Chairman Pitt. They will strengthen the
industry's own business practices and ethical standards, but as
enforceable regulatory rules, not trade association best
practices.
The new rules' impact is already being felt as some firms
hasten to adopt tougher standards. They will be enforced by the
NASD with a full range of disciplinary actions, which this year
alone have included multi-million-dollar fines and expulsions
from the industry. And as detailed in my written testimony,
NASD has not hesitated in the past to use its existing
enforcement authority against analysts whose conduct has
undermined market integrity.
Simply put, Mr. Chairman, these proposed rules will have
teeth because self-regulation in the securities industry does
have teeth. It is what Congress wisely intended more than 60
years ago, and it is what we continue to deliver with these
rules today. Thank you.
Chairman Lieberman. Thank you, Mr. Glauber. I look forward
to questioning you on some of those recommendations, which I
appreciate.
Next we have Thomas Bowman, president and chief executive
officer of the Association for Investment Management and
Research. Thank you for being here.
TESTIMONY OF THOMAS A. BOWMAN, CFA,\1\ PRESIDENT AND CHIEF
EXECUTIVE OFFICER, ASSOCIATION FOR INVESTMENT MANAGEMENT AND
RESEARCH
Mr. Bowman. Good afternoon. My name is Thomas A. Bowman. I
am the president and CEO of the Association for Investment
Management and Research and a holder of the Chartered Financial
Analyst designation.
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\1\ The prepared statement of Mr. Bowman appears in the Appendix on
page 100.
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Thank you, Chairman Lieberman and other Members of the
Committee, for the opportunity to speak on behalf of the
150,000 investment professionals worldwide who are AIMR members
or candidates for the CFA designation.
Allegations that analysts lack independence are
particularly important to us because they cut to the heart of
our core ethical principles and taint a proud profession and
its practitioners.
Most AIMR members are not subject to the majority of
conflicts of interest under discussion today, but all of them
are disadvantaged by companies' exploitation of financial
accounting standards and the important principles of
transparency and disclosure.
Enron's disgrace must primarily be attributed to Enron's
management, who are alleged to have played the most egregious
games with financial reporting rules and misled many of even
the most sophisticated investors.
We are convinced that most companies play such games to a
greater or lesser degree. And until financial reporting
standards are developed and enforced for the benefit of
investors rather than the benefit of issuers, investors will be
disadvantaged. Until auditors renounce their advocacy of
corporate interests, regain independence, and become vigilant
watchdogs for fair disclosure, investors will be disadvantaged.
Until corporate managements put shareholder interests first and
stop retaliating against analysts for unpopular opinions,
investors will be disadvantaged. Until Wall Street firms
recognize that it is in their best interest to reward high-
quality, independent research, investors will be disadvantaged.
And, finally, until all Wall Street analysts adhere tenaciously
to a code of ethics and standards of professional conduct that
place their investing client's interest before their own and
their firm's and require research objectivity and reasonable
basis for recommendations, investors will be disadvantaged.
When Wall Street analysts are assigned companies whose
public disclosures are opaque and for whom transparency is a
dirty word, research reports and recommendations are made with
great uncertainty. There is no obvious point where lack of
transparency and uncertainty about a particular company's
prospects should result in a no recommendation or a sell.
Warren Buffett, one of the most respected investors in the
world, advises that if you don't understand the company, don't
buy it.
What is obvious is that even with the full disclosure
financial analysis is more art than science. No analyst has a
magic formula that accurately and consistently predicts stock
prices. But their firms must reward them for high-quality
research and success of their recommendations. That said, are
Wall Street analysts sometimes pressured to be positive? Yes,
but by many forces and not all internal to their firms. These
forces create an environment replete with conflicts of
interest, one that undermines the ethical principles upon which
AIMR and the CFA program are based, and we condemn all who
foster and sustain it.
These pressures to be positive are intensified in a market
that emphasizes short-term performance, one where investment
recommendations are now prime-time news, often in 30-second
sound bites, and where the serious business of investing
becomes a sport like horseracing where investors are always
looking for the hot tip.
But we don't dispute that the collaboration between
research and investment banking is fraught with ethical
conflicts. But it is critical to a firm's due diligence in
evaluating investment banking clients under the current system.
To effectively manage these conflicts, we believe that
firms must first foster a corporate culture that protects
analysts from undue pressure from issuers or others and
constantly communicate publicly the measures in place to ensure
that this happens;
Second, have reporting structures that prevent investment
banking from approving, modifying, or rejecting reports or
recommendations;
Third, have clear policies for analysts' personal
investment and trading to ensure that investors' interests come
first;
Fourth, not link analyst independence directly to the
success of the investment banking activities; and
Fifth, disclose conflicts in reports and media appearances
that are prominent, specific, plain English, and not marginal
or boilerplate.
At a minimum, analysts should disclose their personal
investments, the compensation to their firm from the subject
company, and material gifts received from the subject company.
Finally, security ratings systems must be concise, clear,
and easily understood by the average investor. In addition to
the recommendation itself, ratings should include a risk
measure and a time horizon to provide investors better
information to judge the suitability of the investment to their
own unique circumstances and constraints.
In closing, I would like to impress upon the Committee that
we appreciate the seriousness of the problems facing Wall
Street analysts but also their complexity. A precipitous
solution that addresses only one aspect of the problem is not
the answer.
I will be happy to answer any questions later. Thank you
very much.
Chairman Lieberman. Thank you, Mr. Bowman, for a very
strong statement. You are absolutely right, and just to make
clear what I said at the outset, the analysts weren't the only
watchdogs that didn't bark here. There were a lot of others who
let the investing public down. Also, I think you have made some
excellent recommendations, which I look forward to talking to
you about in the question and answer period.
The next witness is Charles Hill, who is the director of
financial research at Thomson Financial/First Call, which is
one of the groups that we have cited with appreciation here
today. Thanks, Mr. Hill.
TESTIMONY OF CHARLES L. HILL, CFA,\1\ DIRECTOR OF RESEARCH,
THOMSON FINANCIAL/FIRST CALL
Mr. Hill. Thank you. Chairman Lieberman, Ranking Member
Thompson, and Members of the Governmental Affairs Committee, I
am Charles L. Hill, director of research at Thomson/First Call.
I appreciate the opportunity to testify in front of this
Committee today. I believe the issue of analyst conflicts is an
important issue that needs to be addressed. It is one of
several investment issues that needed to be addressed before
the Enron debacle, and now even more so. It is important not
only to the future health of the investment community, but it
is of greater importance to the public's perception of and
confidence in the overall capitalist system.
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\1\ The prepared statement of Mr. Hill appears in the Appendix on
page 109.
---------------------------------------------------------------------------
Given the importance of these hearings, I appreciate the
attendance at this hearing by the two Committee members that
are still here today. Thank you.
The most obvious symptom of the analyst conflict problem is
the positive bias of analyst recommendations in general, as
well as the extreme positive bias of their recommendations on
Enron in particular.
For at least the last several years, roughly one-third of
all broker analyst recommendations were strong buys--or
whatever their equivalent terminology was for the top category;
similarly, one-third were buys and one-third were holds. The
total of both sells and strong sells was always less than 2
percent. This is still true today despite the severe criticism
analyst recommendations have been increasingly subject to in
recent months. It is interesting that the analyst
recommendations were at their most positive levels at the peak
of the market in the spring of 2000.
That means that if an individual investor--oops, I have
left something out.
The above normal positive bias persisted until early 2001,
even though the stock market indices were in decline from the
spring 2000 highs. The shift that did occur was fairly minimal,
roughly 6 percentage points shifted from strong buy to buy, and
above 5 percent from buy to hold, and about 1 percent from hold
to sell.
In the specific case of Enron, the analysts were in a
different position. Enron had morphed into what was essentially
a hedge fund. As a result there was very little transparency in
recent years as to where earnings were coming from. Analysts
were virtually limited to Enron's historical earnings record
and to the company's guidance for future earnings.
Therefore, it was not surprising that on the eve of Enron's
third quarter 2001 earnings report, 13 broker analysts had a
strong buy--or their equivalent terminology--three had a buy,
and none had a hold, sell, or strong sell.
However, despite a number of red flags from October 16,
2001 on, the analysts dallied in lowering or discontinuing
their recommendations in the face of increasing risk. By
November 12, almost a month after Enron had announced a $1.2
billion write-off that Ken Lay could not explain on a
conference call, almost a month after the Wall Street Journal
reported Enron executives stood to make millions from Enron
partnerships, 3 weeks after the CFO was fired, 2 weeks after
Enron announced it was being investigated by the SEC, and 4
days after Enron announced that it had overstated 4 years of
earnings by $600 million--after all these red flags, there were
still eight analysts with a strong buy, three with a buy, one
with a hold, and one with a strong sell. At that point, none
had dropped their recommendations.
The new proposals from NASD go a long way toward addressing
some aspects of the bias problems. They provide for better
disclosure of the firm's investment banking relationships with
the company, and of the firm's and the analyst's holdings. They
provide for some standardization of recommendations across the
brokerage industry. The requirement for analyst reports to show
the recommendation distribution of all the firm's
recommendations hopefully will lead to less of a positive bias
in analyst recommendations.
Unfortunately, the new NASD rules do not sufficiently
address the key issue of analyst compensation. It is the old
story: Follow the money. Until the so-called Chinese wall
between research and investment banking is restored at the
brokerage houses, there will continue to be a problem with
analyst objectivity.
In the interest of full disclosure, before coming to
Thomson/First Call, I spent 4 years as a buy-side analyst and
16 years--or 18 years as a sell-side analyst. As a sell-side
analyst, I did put sells--and not holds that meant sell--on
investment clients, investment banking clients. But my monetary
incentives in those days were heavily tied to doing objective,
incisive research rather than what I did for investment
banking. We need to try to return to those days of yesteryear.
Also, in the interest of full disclosure and in view of Mr.
Skilling's being pilloried in yesterday's Senate hearing for
being a Harvard Business School MBA, I also have to admit to
being a Harvard MBA.
Chairman Lieberman. Now you are in trouble. [Laughter.]
Mr. Hill. Harvard's motto is ``Veritas''--truth. Hopefully
I can do a better job of upholding that motto than Mr. Skilling
did.
On the assumption that all of you have heard my earlier
testimony in front of the House subcommittees, I have purposely
kept my testimony short, although I guess I did run over
slightly, so we can focus on the questions. I look forward to
responding to those questions.
Chairman Lieberman. Thanks, Mr. Hill. Thanks for all you
have done. I don't know whether you will take this as a
compliment from me as a Yale graduate, but I think you have not
only upheld the ``veritas,'' you have upheld the ``lux'' in the
Yale motto. Light and truth. So I thank you.
Next, and last, is Frank Torres, legislative counsel of the
Consumers Union. Thanks, Mr. Torres, for being here. Thanks for
your patience.
TESTIMONY OF FRANK TORRES,\1\ LEGISLATIVE COUNSEL, CONSUMERS
UNION
Mr. Torres. Mr. Chairman, Senator Levin, thank you for the
invitation to be here today. We are here because the
marketplace has failed. Market forces failed to discipline
market participants. The watchdogs didn't just fail to bark;
they let in the crooks and led them to the cash. And there is
enough blame to go around. We are here today talking about the
analysts, but we could be talking about the auditors or even
the regulators and their failure to fully oversee the industry.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Torres with an attachment appears
in the Appendix on page 111.
---------------------------------------------------------------------------
No one seems to be able to answer confidently, I don't
think, given the testimony here today, that there are not more
Enrons out there. In the end, that uncertainty is a problem not
just for investors, institutional and individual, but also for
the marketplace and the economy as a whole.
Today over half of American families invest, and I think we
as a society encourage that. Companies benefit, the economy
benefits. And it is a good thing. And they rely on the
expertise of the analysts to digest raw data, to talk to
insiders, to put together the recommendations. Analysts'
research is likely to be the most detailed information some
investors have. Unfortunately, too many securities analysts
have become cheerleaders for the companies their firms are
doing business with. Investors don't need more cheerleaders.
They need critical evaluations and analysis.
It is apparent that the analysts aren't asking the tough
questions. They believed the Enron sales pitch and got duped
just like the Enron employees who were told by Ken Lay and
others to buy and to hold on to their stock. But aren't
analysts supposed to be the experts? We expect them to be more
skeptical of sell jobs by company executives.
We are not saying that Congress needs to protect against
bad advice. But how can investors have confidence in such an
environment? And what value, then, are analysts
recommendations? And how is this any different from the SEC
going after the New Jersey teenager who was offering stock tips
over the Internet? In fact, he might have been better off
because he wasn't privy to all the inside information that
apparently was leading all the analysts astray.
Now, no one has denied the pressures created by the
conflicts in this industry. In fact, firms and analysts
sometimes get punished for negative reports about companies,
and there is enough evidence of that. Expert analysts are
expected or should be expected to overcome those pressures.
This situation is amazing. No one seems to know anything
about what these companies do or how things operate. Analysts
point to the auditors. The auditors say Enron wasn't
forthcoming. I am waiting for Enron to blame the investors for
investing in their own company's stock. Where is this going to
end? Who is going to be accountable and who is going to be the
watchdog for investors?
We are pleased with the NASD proposed rule and will work on
submitting comments to that. But the rule has some shortcomings
and has some very good things.
The rule seems to be focused on disclosure. However, no
disclosure will create a Chinese wall big enough to prevent
some of these conflicts from occurring in the first place.
Analyst ownership of stock and the restrictions on that are
a good step, but as was pointed out by others here on this
panel, the analysts know where their paycheck is coming from.
Just because you are prohibiting the sale of stock and
restricting some things around the IPO issuance isn't going to
prevent the conflicts. And we heard from the earlier panel that
profitability of the company plays a role in that.
When you have got companies--and somewhere on the earlier
panel that I won't mention--having multi-hundreds of millions
of dollars of investments in companies like Enron, how can the
analyst not recognize that and not work to protect that in some
way, if not directly then indirectly? If not intentionally, how
can you not picture that in the back of their minds as
influencing their decisions?
We have some recommendations on the NASD proposal that I
would like to go over now very briefly. One is: Why don't we
give a boost to the independent analyst? Why not create some
sort of certification system for them so that investors reading
a report from an independent analyst or listening to one on TV
would know right away that that analyst is conflict-free?
Investors could choose to disregard advice by analysts without
this independent designation.
Second, why don't we require analysts and firms to publish
their research quality ratings, a step that would likely
encourage them to produce more reliable recommendations? Better
yet, develop standardized measurements of the success of
analyst recommendations, publish the good ones, let people know
who are the bad ones are, too. I think the NASD rules get us
halfway there. We need to take the next step.
Disclosing conflicts is important, but it won't get rid of
the underlying bias. They are important, though. They are
important, but we think that they should not just simply say
that there are conflicts that exist, but extend that to include
both the nature and extent of the conflicts. How much money
does a firm have invested in a particular company that they are
developing a report on?
Finally, uniform language should be developed that all
firms should be required to use about their recommendations. It
is kind of weird English that ``hold'' really means ``sell.''
What is up with that? A lot of investors I think are confused
about this. It is great for the insiders who know what is going
on, but the analysts knew full well that people will make--
investors were making decisions based upon those types of
advice.
One firm has proposed using the terms ``overweight'' and
``underweight'' to describe those recommendations. While this
sounds like more appropriate for junk food labels, I think that
is a promising start.
And, finally, I would like to commend this Committee for
taking a look beyond some of the villains in the company
themselves, and I think it is important to take a look at some
of those players, but in looking beyond that and in trying to
get to some ideas that will help the investors and the
consumers in this country.
Thank you very much.
Chairman Lieberman. Thanks, Mr. Torres, for very
constructive testimony.
It is true that this Committee is trying to more broadly
focus on the lessons we learned from Enron, not just from
within Enron, and in this case we were drawn to the analysts
and the fact, as you have all indicated, that they continued to
recommend buying Enron stock long after, it seems to the casual
observer, there should have been reason to do so, and then that
led to the larger concern about the independence of analysts,
which I want to get to in a moment.
Senator Levin has to leave in a few moments, and I am going
to yield to him to ask the first questions, and then I will
wrap up.
Senator Levin. Thank you so much, Mr. Chairman. I
appreciate your yielding. As always, you are courteous, and it
is most appreciated. Three questions of Mr. Bowman and that is
it.
One, you indicate in your prepared testimony--and you also
said something about this in your oral testimony--that firms
should implement compensation arrangements that do not link
analyst compensation directly to their work on investment
banking assignments or the success of the investment banking
activities. Then under that formulation, they could continue to
receive compensation based on the overall firm--the overall
well-being of the firm or how well the firm did in a particular
year. Would you leave that open?
Mr. Bowman. Yes, that is being left open as it currently
exists, Senator. We have had a research objectivity standards
task force in place now for about 18 months, and as you can
imagine, this has been the subject of great debate within that
council.
Certainly, I think Senator Lieberman is the one that
referred to it, the implicit risk that is inherent in any
situation where, directly or indirectly, analyst compensation
is tied to success of the overall firm, which means primarily
in many cases the investment banking side. And certainly, the
implicit risk would, in effect, go away with regard to that
aspect of it if analyst compensation had nothing to do with the
success of the investment banking side. I don't think anybody
could argue with that point.
The issue, however, is that once--what seems like a very
reasonable and simplistic change could have implications that
really need to be discussed and debated.
For example--you could argue both sides of this, but, for
example, Wall Street firms will make the claim that they need
to be able to attract the top-quality analysts to their firms,
and in order to do that, they have got to pay for it. And in
order for them to pay for it, they have got to go to the place
where most of the money is made, and that is investment
banking. And their bonuses are heavily dependent upon the
investment banking success.
Wall Street firms will then tell you that if they can't do
that, they are not going to be able to afford these high-
quality analysts because they will be attracted to other
firms----
Senator Levin. Well, the other firms are bound by the same
rules.
Mr. Bowman. Well, no, other non-sell-side firms who don't
have this conflict.
Senator Levin. Which may not be all bad.
Mr. Bowman. And their argument is--I am the messenger here,
but their argument is that in the end, therefore, investors who
are relying on Wall Street research will be hurt.
I think, frankly, Senator, speaking as an individual
investment person and one who grew up on the buy side, it would
certainly be more appropriate if they could find--if the sell-
side group could find some way to compensate their analysts in
a way that would attract and keep them and keep them out of
this conflict that we are all concerned about, it would be all
to the good.
Mr. Hill. Senator, could I respond to that as well?
Senator Levin. Sure.
Mr. Hill. As I mentioned, I was on the sell side for 18
years. In those days, we got paid for doing research. The way
the system worked was that every quarter the institutions sent
a letter in to the firms saying we did X amount of commission
business with your firm in return for services provided by the
following analysts. If my name was on those lists more than
anybody else, I got the biggest piece of the Research
Department bonus pool. In those days, there was a meaningful
Research Department bonus pool because the commissions were
more meaningful. Since then, they have brought them down to
almost nothing. The institutions need to look in the mirror.
They are complaining that their research isn't as good a
quality or as objective as it used to be. It is the old story:
You get what you pay for. It is the same with the individual
investors that are paying almost nothing today in commissions.
We have to do something about changing the way the
brokerage firms can get compensated for research. We probably
can't put the fixed commission rate genie back in the bottle.
Whether the institutions would be willing to pay hard dollars
for research instead of just commissions remains to be seen. We
know that that is anathema to institutions. They try to soft-
dollar everything. If they could soft-dollar the janitor
service, they would.
Senator Levin. Thank you. The second question I am just
going to put in for the record, if, Mr. Glauber, both you and
Mr. Bowman would answer this for the record.Tell us what the
current rules are relative to gifts from companies that are
being analyzed to those analysts--just for the record, what
current rules exist? Mr. Bowman, you made reference to the need
for disclosure of material gifts received by the analysts from
either the subject company or the Wall Street firms' investment
banking department. If you would for our record give us the
detail of what you are recommending on that, I would appreciate
it.\1\
---------------------------------------------------------------------------
\1\ The information requested entitled ``AIMR Standards of
Professional Conduct pertaining to Gifts,'' from Mr. Bowman appears in
the Appendix on page 131.
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Senator Levin. This would be the last question, and it
would be for Mr. Bowman. Your association has surveyed your
members relative to stock options and whether they ought to be
reported or not. And here is what a release of yours says back
in November 2001: ``More than 80 percent of the financial
analysts and portfolio managers around the world who responded
to a survey believe that any stock options granted to employees
are compensation and should be recognized as an expense in the
income statements of the companies that grant them.'' As you
know, that is a position that I have espoused personally, but
can you give us----
Chairman Lieberman. Your time is up, Senator Levin.
Senator Levin. Right. [Laughter.]
Taking advantage of your good nature----
Chairman Lieberman. Go right ahead.
Senator Levin. Can you tell us, if you would, why you
believe that such a large percentage of your members take that
position?
Mr. Bowman. With regard to gifts, Senator----
Senator Levin. No, not gifts. Skip the gifts. Give us that
for the record. Just respond to the press release saying that
80 percent of financial analysts and portfolio managers believe
stock options should be expensed.
Mr. Bowman. Well, for many, many years, AIMR has taken the
position that stock options should indeed be reflected on the
income statement, the balance sheet. And I think the reason why
80 percent of our members have indicated that they believe that
should be the case is that they tell us they believe that it is
a form of compensation and, therefore, an expense to the firm
and, therefore, should, like any other expense, be included on
the income statement. That is the reason that they give us,
and, frankly, we have made a very strong position that that
should be the case.
Senator Levin. Would you submit for the record the way the
question was asked that was responded to by the 80 percent?
Could you give us the questionnaire's question? For the record,
just submit it later.\2\
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\2\ The information requested entitled ``Association for Investment
Management and Research (AIMR) Survey on Accounting for Stock
Options,'' from Mr. Bowman appears in the Appendix on page 132.
---------------------------------------------------------------------------
Mr. Bowman. Let's see----
Senator Levin. If you could give it to us after the hearing
is over, that would be good.
Chairman Lieberman. You don't have to do that now, Mr.
Bowman.
Senator Levin. I am trying to save time.
Chairman Lieberman. Thanks, Senator Levin. I have a feeling
this topic will come up on other occasions, in other places, I
am sure. [Laughter.]
Senator Levin. Thank you.
Chairman Lieberman. Not at all.
Let me ask a final series of questions. First, Mr. Hill,
the research that Mr. Hill's firm did on the recommendations of
analysts over a period of time was, as I mentioned in my
opening statement, one of the more stunning facts that I
learned in preparing for this hearing, this business that less
than 2 percent of the recommendations were to sell, when the
market was going up and down, and even as the S&P 500, as our
chart showed, was going down.
I just want to ask--and so that raises in me and others
this concern, suspicion, conclusion in some that there can't be
any rational basis for that, it has to be that for one reason
or another, either at one extreme that the analysts have become
salespeople, or in another sense that they have just gotten so
swept off their feet by the companies they are analyzing that
they are on longer independent. Each of you has thought about
this and worked in this area to one degree or another. Is there
any other explanation for why, as the S&P 500 went up, and
particularly went down, the consensus recommendation continued
to be buy, buy, buy? Mr. Glauber.?
Mr. Glauber. Sure. I think the points you have made are
clearly part of the answer to the puzzle. I think investors
also are looking to invest, and so they are looking for
companies to buy. Most investors want to buy stocks rather than
sell them short. So I suppose there is going to be some kind of
bias.
I think one good way to deal with this--and, clearly, it is
a form of grade inflation or bias--is to give investors
information. One of our rules that we have proposed is that
each firm publish the distribution of buy, hold, sell
recommendations----
Chairman Lieberman. Yes, that was, I thought, a very
important recommendation because that information itself may
have an effect on the analysts. Certainly it will have an
effect on the consumers of their analysis.
Mr. Glauber. I think so. And, of course, related to that is
a rule that is in our proposal to require a price chart to
accompany each research report in which the price of the stock
is shown together with the analyst's ``buy'' and ``sell''
recommendations during that historical period. Again, I think
it is going to alert investors to just how good--Mr. Torres
said he would like some more information on just how good the
analyst's record is.
Chairman Lieberman. Right.
Mr. Glauber. That is going to be that kind of information.
Chairman Lieberman. Mr. Bowman.
Mr. Bowman. Yes, Senator, I spent 17 years as an analyst
and a portfolio manager before joining AIMR, and I can give you
a little personal perspective about some other forces that
might be in place here besides the conflict issue that we have
talked about earlier. That is, when an analyst, especially in a
smaller firm, is assigned two or three different industries to
follow, that individual, if he were to follow or she were to
follow every publicly trade company in each of those
industries, would literally be responsible for following and
giving due diligence to hundreds of companies, which is just--
there is not enough hours in the day or the week or the month
in order to do that.
So when I was practicing, in my firm what we did was we had
certain screens, basic criteria and characteristics that we
wanted to look for in a company before we even look at it and
do research on it. And a lot of the companies fell out of those
screens because they didn't meet the minimum criteria that we
had in place to look at the company.
So right away the analysts are looking at a biased group of
stocks before they begin research, so what would traditionally
have been sells, had they been covering them all, are filtered
out.
So I think that is one of the things that is going, that
since analysts can't follow every company there is to follow,
some screens, screen out some of the inferior companies, and so
they end up following an upwardly biased select group of
companies.
So I am not really surprised that there are significantly
more buys than sells out there, just because an analyst can't
cover every stock in the universe. I think that is one thing.
And I think the other thing--and you called it the
ambassador effect earlier, of who is the ambassador advocating,
and I believe Senator Bennett mentioned something about the
Stockholm effect, which has to do with not seeing--you get so
close to something that you can't see the forest for the trees.
I think there is some of that that goes on, too. I think that
analysts can get very close to their companies, fall in love
with the companies, but a very important point is you can be in
love with a company but not necessarily be in love with the
stock because the stock fluctuates in price. So what might be a
wonderful company, if it is too rich and the PE is too high or
whatever else you are looking at, you shouldn't be in love with
the stock as well.
So I think those are a couple of things----
Chairman Lieberman. I hear you. We talked about this as we
were preparing for the hearing, about the first point you made
and the filtering-out effect in terms of how many stocks are
evaluated. But I do think that the chart with the straight red
line at ``buy'' was a consensus of the S&P 500. So I think we
were measuring apples and apples there.
Mr. Hill. That is the average of the consensus
recommendation for each of the 500 companies.
Chairman Lieberman. Right. I don't know whether either of
you want to add anything, because you----
Mr. Hill. I do.
Chairman Lieberman. Go ahead.
Mr. Hill. I agree on this filtering-out process, but let's
put it into perspective. If you go back to the peak of the
market in the spring of 2001--or spring of 2000, I guess it
was, the ratio of buys and strong buys to sells and strong
sells was over 100 to 1. Now, filtering out doesn't get you to
that.
Chairman Lieberman. I agree.
Mr. Hill. The other thing, too, is that the analysts are
only recommending buy, where is the money coming from to buy
those stocks? You have got to sell something. So, if they want
to generate business, they ought to be putting some sells out
there, too. But I think it is part of the Lake Wobegon problem.
All the children are above average.
Mr. Torres. Senator, we would attribute the problem
directly to some of the conflicts of interest that I think will
only grow worse in the future as the Gramm-Leach-Bliley act
comes into play, where you have bigger consolidation in the
financial services industry. The thing that I am surprised at,
if the analyst doesn't have enough resources to cover all that
they are supposed to cover, why are the buy recommendations
left hanging out there? Why isn't there another designation,
need to be updated, need more information, instead of having a
recommendation out there that you might not be solid on?
Chairman Lieberman. Mr. Bowman, I was going to ask you, you
made a very interesting point, which I guess others may have
made along the way, though not today, that part of what we are
dealing with at Enron is a good system gone to extreme, gone
bad, and the pressure of companies to continue to generate more
quarterly earnings, leading people to make--leading what I
might say are good people to make bad decisions, leading people
to lose sight of their ethical bearing. And you make a proposal
about attaching ethical standards, if I understand, to either
CFA certification or maybe to the conduct of analysts
generally. And, you do wonder whether if they were under some
explicit series of standards personally--I know the analysts
now, some of them I guess are certified, but a lot of them are
accountable through their companies that come under the NASD.
If they had a clearly articulated standard that their
responsibility, like a fiduciary, was to serve their clientele,
the public, that they were to be purely independent, and you
wonder at some point whether if any of them were under
pressure. There has been testimony here on the Hill that Mr.
Lay and Mr. Skilling were pressuring analysts, or perhaps even
under pressure from the investment banking side of the
business, they could say at those points, hey, wait a second,
pal, I would like to help you but I am about to lose my
certificate if I do this.
Is this kind of ethical standard that Mr. Bowman proposes
capable of being administered and enforced?
Mr. Glauber. Well, it is an interesting idea. We think of
our rules as embodying a set of principles of proper behavior,
if you want to call it ethical standards. And we think the
articulation of these specific rules is the enforcement of
those standards. So I agree with you that in the end, so much
of what we are discussing here is not an issue of fraud. It is
not an issue of violation of the 1933 or 1934 act. It is an
issue of proper behavior for professionals.
Chairman Lieberman. Right.
Mr. Glauber. We think that can be embodied in private
sector regulatory rules, like our rules, which in essence set
what you would call an ethical standard. Your idea of going to
an explicit ethical standard is an interesting one, I think.
Chairman Lieberman. Mr. Bowman, did you want to add
something?
Mr. Bowman. Yes, I do, Senator. We as chartered financial
analysts and members of AIMR, some 55,000 of us, as a condition
for retaining the right to use that designation, have got to
annually sign a statement that says we comply with our code and
our standards. And AIMR regulates its members. And if there are
violation, AIMR has the processes to investigate them, and if
those violations are deemed to be egregious enough, we have
every right to basically prevent that person from continuing to
use the CFA designation.
And all of these individual codes of ethics and standards
of professional conduct embody everything we have talked about
here today: Reasonableness of recommendation, objectivity,
everything.
Chairman Lieberman. Am I right--excuse me a second--that a
lot of the Wall Street analysts are not chartered?
Mr. Bowman. They are not. A very small percentage of Wall
Street analysts are chartered financial analysts.
Chairman Lieberman. Is one possibility that we require or
that NASD require that they be chartered?
Mr. Bowman. I think that is a definite possibility, and we
would be more than happy to work with you on that.
Mr. Glauber. The point I would make is that the standards
embodied in our rules are imposed upon all security analysts.
You cannot be a member of a broker-dealer if you don't meet our
rules, because violations of them, we toss you out.
Chairman Lieberman. Mr. Hill.
Mr. Hill. I agree that I think at least one of the analysts
covering a company should be a CFA. I am a CFA even though my
sign doesn't say it, like Mr. Bowman's.
Chairman Lieberman. It is implicit.
Mr. Hill. But in my career as a sell-side analyst, I was a
CFA during that time.
It is interesting, if we bring that down to Enron, the
analysts that moved soonest and most aggressively in lowering
their recommendations and actually going to strong sells, I
mean, first to a hold and then to a strong sell, one was a CFA,
the other was a CFA candidate. And out of the 16 analysts that
covered Enron, only four were CFAs, plus the one that was a
candidate in the midst of taking the exams.
Chairman Lieberman. Very interesting.
Let me ask a final question. You have been very generous
with your time. Senator Torricelli raised a good point earlier,
and it is the point that all of us are considering, which is:
How can we act on the lessons we have learned from the Enron
scandal and collapse? And how can we be constructive and
restore confidence in the capital markets and, particularly, to
give some greater confidence to these millions of middle-class
families that have come into the market in the last two
decades? I would like to think that the hearings that are being
held on Capitol Hill and, I must say, the investigative work
being done by journalists, people in the media, has given some
warning and information, if you will to the investing public
about where to put their confidence and where not to put their
confidence. But now we also have to try to restore confidence.
Some of it will come by natural forces of the market. There is
a way in which I think Enron's experience--perhaps even the
analysts who were here today and others analysts may not want
to be called before a congressional committee. Certainly Enron
and executives of other companies presumably don't want to be
the targets of investigative journalists, etc.
So there is a way in which the process going on now will
have some effect, at least for a period of time, but then the
question is what follows that beyond the natural forces of the
marketplace. And the question is some things can be done within
industry and professional groups to raise standards, as we have
talked about. The question for us ultimately is: Is there any
area--I know there are some areas where we should legislate in
response to Enron. But in the specific case of the analysts, is
there a proper place that any of you see for legislation?
Mr. Glauber. Mr. Chairman, I think that the question of
getting the balance right between legislation and SEC
rulemaking and self-regulatory rulemaking is a very difficult
one. The one place that you have discussed frequently during
these hearings today is the question of structural separation
between investment banking and security research.
I would prefer to see if we can't make that work through
private sector and SEC rulemaking rather than going to that
kind of structural separation because I think it runs a risk of
seriously reducing the amount of information available to
investors.
Chairman Lieberman. But you would keep the option open?
Mr. Glauber. I surely would keep the option open. I think
it is one you should discuss. It is a completely debatable
issue. In my view, I think we can do it--that is, we, the SEC,
the SROs can do it--through rulemaking, but I think the issue
has to be kept on the table.
Chairman Lieberman. Mr. Bowman, any place for lawmaking
here?
Mr. Bowman. Well, as I said during my comments, Senator--
and I would agree with Mr. Glauber--we would very much prefer
to see the industry itself resolve these problems. It has been
our experience, anyway, through establishing the CFA program
and others, setting other standards, that if it comes from the
business, it is probably more apt to be embraced and obeyed
than if it comes from outside sources.
But certainly I would agree that in the absence of the
industry being able to handle this on their own, it should be
kept on the table.
I think that one--there are two things, I think, that
legislation cannot do, but I think we all really need to be
aware of it in terms of protecting the public. The first one is
that the FASB and the SEC have got to be allowed to act
independently and set rules on behalf of investors rather than
on behalf of issuers of financial statements. There has been
way too much money being spent by the issuers of financial
statements to lobby against accounting rules and accounting
proposals that will actually favor investors but will cause
companies, or whatever, to not be able to manage their earnings
as effectively. And I think that the SEC and the FASB have got
to be given the independence to do that, and the money,
frankly.
The other thing is that individual investors--we are in a
very early stage of individual investors becoming involved in
the stock market. Before 1990--I can't remember what the
percentages are, but the percentage of individual investors who
had investment in the stock market was infinitely smaller than
it is today. And I think individual investors are still going
through an educational process here. What is investment? And
what am I listening to on the TV?
And I think that we need to be able to educate investors to
understand that this is serious business. They are not going to
treat their own medical problems without going to a doctor, and
they are not going to represent themselves in a court of law
without hiring an attorney. And I would like to see some of the
same mentality be there on the part of individual investors
that this is something that they can't do alone and they should
rely on professional help to save their precious retirement
accounts and their assets.
Chairman Lieberman. And, of course, that is the problem.
Right now there is a lack of confidence in the professional
help, and that is what we have got to restore. Mr. Hill.
Mr. Hill. I strongly echo Mr. Bowman's comments about the
FASB and the SEC. As a matter of fact I spent all day yesterday
at FASB as part of a financial performance reporting task force
where hopefully we will make some changes that will alleviate
some of these problems.
But it is the money, again. FASB needs more money and needs
to be treated independently, as was mentioned. The SEC, I think
Arthur Levitt as chairman, set a new standard there. Hopefully
that tradition can be carried on. But, again, they are
understaffed because of not getting enough money.
Chairman Lieberman. But right now you wouldn't propose any
legislating regarding analysts?
Mr. Hill. I think we have to move carefully there. Like the
others, I wouldn't rule it out. As I said before, you have got
to follow the money, and until we do something about changing
analyst compensation, the problem is going to continue because,
either consciously or subconsciously, it is likely to creep
into the analyst's thinking. So if there was a way that you
could solve the problem of the firms getting paid again for
research so we could get it back to where it was, that would be
helpful.
I don't have a good answer myself, but that is the issue.
Chairman Lieberman. It is a pretty good one. Mr. Torres.
Mr. Torres. Mr. Chairman, I think there is a very
appropriate role for Congress to make sure that there is
accountability in this industry and that there is an
appropriate watchdog group set up to oversee it.
I would go back to the lessons that we learned when Arthur
Levitt was chairman of the SEC. He tried to push for strong
rules on the accounting industry, and those got pushed back.
When Chairman Pitt took over, there was talk that he was going
to dismantle the fair disclosure rules that were passed. And,
of course, in light of Enron, all that has changed.
Congress needs to--should step in to ensure that the right
rules are put into place and give some direction to both the
industry and the regulators on how to handle this. The best way
to restore the confidence in the marketplace for consumers and
investors is for Congress to take a leading role here.
Chairman Lieberman. I thank all of you for your time. You
have made a substantial contribution to this Committee's effort
to constructively respond to the Enron collapse and scandal.
I am going to leave the record of the hearing open for an
additional 2 weeks, if any of you or the other witnesses have
any additional testimony you would like to submit, and to allow
my colleagues on the Committee to submit questions to you in
writing. But for now I thank you, and the hearing is adjourned.
[Whereupon, at 1:22 p.m., the Committee was adjourned.]
A P P E N D I X
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