[Senate Hearing 107-1026]
[From the U.S. Government Publishing Office]
S. Hrg. 107-1026
ISSUES AND PERSPECTIVES IN ENFORCING
CORPORATE GOVERNANCE: THE EXPERIENCE OF THE STATE OF NEW YORK
=======================================================================
HEARING
before the
SUBCOMMITTEE ON CONSUMER AFFAIRS, FOREIGN COMMERCE AND TOURISM
OF THE
COMMITTEE ON COMMERCE,
SCIENCE, AND TRANSPORTATION
UNITED STATES SENATE
ONE HUNDRED SEVENTH CONGRESS
SECOND SESSION
__________
JUNE 26, 2002
__________
Printed for the use of the Committee on Commerce, Science, and
Transportation
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91-441 PDF WASHINGTON : 2006
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SENATE COMMITTEE ON COMMERCE, SCIENCE, AND TRANSPORTATION
ONE HUNDRED SEVENTH CONGRESS
SECOND SESSION
ERNEST F. HOLLINGS, South Carolina, Chairman
DANIEL K. INOUYE, Hawaii JOHN McCAIN, Arizona
JOHN D. ROCKEFELLER IV, West TED STEVENS, Alaska
Virginia CONRAD BURNS, Montana
JOHN F. KERRY, Massachusetts TRENT LOTT, Mississippi
JOHN B. BREAUX, Louisiana KAY BAILEY HUTCHISON, Texas
BYRON L. DORGAN, North Dakota OLYMPIA J. SNOWE, Maine
RON WYDEN, Oregon SAM BROWNBACK, Kansas
MAX CLELAND, Georgia GORDON SMITH, Oregon
BARBARA BOXER, California PETER G. FITZGERALD, Illinois
JOHN EDWARDS, North Carolina JOHN ENSIGN, Nevada
JEAN CARNAHAN, Missouri GEORGE ALLEN, Virginia
BILL NELSON, Florida
Kevin D. Kayes, Democratic Staff Director
Moses Boyd, Democratic Chief Counsel
Jeanne Bumpus, Republican Staff Director and General Counsel
------
Subcommittee on Consumer Affairs, Foreign Commerce and Tourism
BYRON L. DORGAN, North Dakota, Chairman
JOHN D. ROCKEFELLER IV, West PETER G. FITZGERALD, Illinois
Virginia CONRAD BURNS, Montana
RON WYDEN, Oregon SAM BROWNBACK, Kansas
BARBARA BOXER, California GORDON SMITH, Oregon
JOHN EDWARDS, North Carolina JOHN ENSIGN, Nevada
JEAN CARNAHAN, Missouri GEORGE ALLEN, Virginia
BILL NELSON, Florida
C O N T E N T S
----------
Page
Hearing held on June 26, 2002.................................... 1
Statement of Senator Boxer....................................... 5
Statement of Senator Dorgan...................................... 1
Prepared statement........................................... 3
Statement of Senator Edwards..................................... 19
Statement of Senator Fitzgerald.................................. 17
Statement of Senator McCain...................................... 16
Statement of Senator Nelson...................................... 20
Statement of Senator Wyden....................................... 4
Witnesses
Spitzer, Hon. Eliot, Attorney General of the State of New York... 6
Prepared statement........................................... 12
ISSUES AND PERSPECTIVES IN ENFORCING
CORPORATE GOVERNANCE: THE
EXPERIENCE OF THE STATE OF NEW YORK
----------
WEDNESDAY, JUNE 26, 2002
U.S. Senate,
Subcommittee on Consumer Affairs, Foreign Commerce and
Tourism,
Committee on Commerce, Science, and Transportation,
Washington, DC.
The Subcommittee met, pursuant to notice, at 9:30 a.m. in
room SR-253, Russell Senate Office Building, Hon. Byron L.
Dorgan, Chairman of the Subcommittee, presiding.
OPENING STATEMENT OF HON. BYRON L. DORGAN,
U.S. SENATOR FROM NORTH DAKOTA
Senator Dorgan. I will call the hearing to order. This is a
hearing of a Subcommittee of the Commerce Committee. We are
meeting today to hear from the Attorney General, Eliot Spitzer
from the State of New York. I am constrained to make a few
comments at the start of this hearing.
There are matters in this morning's newspaper that relate
to a series of hearings we have been holding in this
Subcommittee. This Subcommittee has heard over recent months
from executives of the Enron Corporation and others on the
issue of corporate governance, and especially issues that
affect the Enron Corporation and investors and employees of the
Enron Corporation.
This morning's news on the front page of the Washington
Post about another company, World Com (the headlines say its
books are off by $3.8 billion) raises once again, as has been
raised nearly every day in recent months, the issue of
corporate governance. What can investors rely upon? What is
happening in corporate business in this country? We see
restatements of earnings every day now. Seldom do we see
statements of $3.8 billion, but the table where Mr. Spitzer
sits, the person who did the Powers report, which on behalf of
the board of directors looked inside the Enron Corporation,
said that what the board of directors found inside the Enron
Corporation was, ``appalling.''
In a rather short period of time they said that that
corporation reported $1 billion of earnings that it did not
have, and it kept off the books debt that existed as a
liability to the corporation. These are the kinds of things
that are going on all too often in this country now, and we see
reports on them virtually every day: restatements of earnings,
in some cases massive restatements of earnings, inversions
where corporations have decided to renounce their citizenship
and become citizens of another country so they can save on
their tax bill in this country--which I think is fundamentally
unpatriotic, I might say--the question of the behavior of
corporate CEO's, boards of directors, the question of the
accounting firms who were supposed to be involved in oversight
and the enforcement of standards, and the spectacle of the
people at the top of these companies getting rich while people
at the bottom are losing everything.
I said some months ago that with respect to the Enron
Corporation what I saw was a culture of corruption, and Mr. Lay
took great umbrage at that. These stories, and especially the
information unearthed by Attorney General Spitzer about
security analysts who were pumping stocks that they knew to be
dogs, they knew to be not of sound value, but who nonetheless
were pushing these stocks and marketing these stocks to unaware
consumers, show us that it was even more than a culture of
corruption.
We have heard a lot about the bursting of the speculative
bubble in this super-turbocharged economy of the 1990's,
especially the bubble over technology firms, but we see that
this was more than just a bubble whose bursting was inevitable.
There was more than that. There was greed and dishonesty, and
what we are reading about daily and what this Subcommittee has
learned over recent months is appalling.
There must be some accountability here, and in this
Subcommittee we are trying to get to that. The method by which
we accumulate capital in this country requires that people have
confidence, that they can rely on the people who run our
corporations, that they can rely on the representations of
accountants, and that they can rely on security analysts. We
have learned that in many cases the fact is they cannot rely on
any of those people.
Accountability and responsibility do not just apply to poor
people, and they do not just apply to the bottom of the
economic ladder. Let some one go buy a six-pack of beer on food
stamps and you have people jumping off the buildings here
trying to proclaim how awful that is. Well, let us see if the
same people are willing to stand up at this point and talk
about stealing in the corporate suite, or talk about
misrepresentation or criminal behavior in accounting firms, or
misrepresentation by security analysts. Let us see if the same
people care as much about accountability and responsibility at
the top as they do about accountability and responsibility
among poor people.
So let me make one final point. I think all of this,
including this morning's information, ought to persuade some of
the regulators in the regulatory agencies to hang their head in
shame. They have been AWOL, gone fishing for a long, long time.
All of this has happened at a time when regulators have sat on
their hands, and those who have been critical of Mr. Spitzer
for using his authorities as a state regulator to do that which
federal regulators should have been involved in the first place
have no cause to be critical of anyone. I suggest to all of
those who have been critical of Mr. Spitzer for using the reins
of state government to take effective action that they spend a
little more time asking hard questions of the Securities &
Exchange Commission and others. Where was the SEC ? Where were
these regulators? We paid them. Why didn't they do their job? I
suggest they spend a little more time worrying about that, and
a little less time worrying about State regulators who are in
many cases digging into these issues with an aggressive
approach and a vigor that I commend.
Well, I have more to say, but I will put my entire
statement in the record. This morning's news is once again
unnerving to this country's economy. It is simply one more
piece of evidence that there is an avarice and a corruption and
a greed that exists in some areas in this country that
desperately cries out for effective regulatory oversight. The
American people--who rely on the representations of those who
run corporations, those who run accounting firms, those who are
involved in security analysis--have to be able to trust those
folks, and when that trust is broken (and it is) it has
dramatic consequences for the methods by which we accumulate
capital in our country, and will have a dramatic impact on this
country's economy.
I want this economy to do well. I want it to succeed. I
want it to grow again. We have the capacity to do that, but we
must address these questions. These questions are basic, and
very troubling to all the American people. Many of the American
people have now become investors in their 401(k) program, which
they now refer to as a 201(k) or a 101(k) program, as it
shrinks and shrinks and shrinks virtually every single day.
Then they read the stories that suggest they have lost money
not because they made a bad investment, but because someone
misrepresented stocks to them, or because someone in the
corporate boardroom stole money, or because accountants who
were paid a lot of money to look over the shoulder of the
corporations that were reporting income and expenditures were
enablers, enabling the corporation to misrepresent its books to
the ultimate investors.
Well, I spoke longer than I intended. Let me say welcome,
Mr. Spitzer, to the Committee. We have been reading of your
work and want to ask some questions about it and have you
testify, and then have the opportunity to ask questions.
Let me call on my colleague, Senator Wyden.
[The prepared statement of Senator Dorgan follows:]
Prepared Statement of Hon. Byron L. Dorgan,
U.S. Senator from North Dakota
We are in the middle of a crisis in corporate responsibility.
Almost every day we see more reports in the news media about
companies restating their earnings. Sometimes these restatements go
back 2, 3, 4 years and cover billions of dollars.
Not only are ordinary investors understandably outraged as they
watch their life's savings disappear; they feel deceived because they
know that their losses are the fault of poor corporate behavior, and a
lack of oversight by federal regulators.
The ability to accumulate capital for public corporations in our
economic system requires trust--trust in accounting firms, corporate
financial statements, security analysts, and confidence in those who
run our public corporations.
My concern is that with all that has gone on in corporate America
in the past few months that this trust has been broken by a complete
breakdown in corporate responsibility.
It is no wonder then that the investing public is having a hard
time putting its trust in corporate America when:
Consumers now know that some of the ``books were cooked'' with
the help of the accountants and boards of directors that were
willing to look the other way;
Consumers now know that many of the so called ``independent''
analysts who pushed individual stocks on TV were sometimes
anything but ``independent'' as they pumped stocks in which
their firms had a financial stake, and
They have a sense that those at the top made off with millions
while the ordinary investor has been taken for a ride.
The question that has to be asked is where were the public and
private watch dogs that are supposed to ensure that these things do not
happen? Where were the ``independent'' analysts? And most importantly
where was the Securities and Exchange Commission (SEC) while all of
this was occurring?
Today, we are going to hear from one man who has actually done
something to address the problems surrounding conflicts of interest
with investor analysts.
He is New York's Attorney General Eliot Spitzer. Last month, Mr.
Spitzer announced a $100 million settlement with Merrill Lynch
following allegations that the company's advice was tainted by
conflicts of interest.
Mr. Spitzer's investigation revealed that Merrill Lynch analysts
reportedly inflated their ratings on certain stocks to boost the firm's
related investment banking business. He showed that even as analysts
pushed individual stocks, behind the scenes they were secretly
referring to some as ``junk'' and ``dogs.''
As with many industries, the regulation of securities has been a
shared federal-state responsibility. Mr. Spitzer's extraordinary
efforts have shown the valuable role that state authorities can play in
protecting consumers.
It also shows that the fed regulators have been paper tigers in
recent years, and it demonstrates how important it is for us to have
federal regulators that are aggressively engaged in protecting
consumers from this kind of chicanery.
While I recognize the desire for uniformity I think the solution
lies in having the State Attorneys General work together with the SEC.
Reliable analysis based on a sound ethical and legal foundation is
the key to a stable marketplace. Attorney General Spitzer has set the
example, and it is up to the SEC to follow his lead.
I look forward to hearing from Mr. Spitzer on these important
issues.
STATEMENT OF HON. RON WYDEN,
U.S. SENATOR FROM OREGON
Senator Wyden. Thank you, Mr. Chairman. Let me commend you
for being willing to stay at this task. We have had a number of
hearings on Enron, and I think what often happens in this town,
somebody does one hearing and then just moves on, and you have
been willing to be persistent and stay at it, and that is what
it really takes and, of course, that is what Mr. Spitzer has
done in the State of New York. He has been a pioneer and it is
so good to know that somebody on the front lines is actually
out digging and excavating the critical materials that are
needed to make these cases. We are very glad that he is here,
and look forward to his remarks.
Mr. Chairman, let me pick up on something that you touched
on. Today, the stock market is no longer the exclusive province
of the wealthy. We have got millions of working families whose
hopes and aspirations are tied to the stock market, to their
retirement accounts and others, and it will be devastating if
the American people walk away and say, this is a rigged game,
that the rules are fixed, and our country cannot afford that.
We have got to make sure that there are rules on the books and
that they are enforced, and that in a number of areas that the
rules are strengthened.
I want to bring to the Committee's attention Fortune
Magazine, not exactly a radical left-wing rag, ran a cover
story just recently entitled, ``In Search of the Last Honest
Analyst,'' and it seems to me this cover story is a clear
indictment of the problem and why this hearing is important as
anything else.
What we have seen in recent days is what amounts to a
spectacle, a spectacle of analysts snickering behind the backs
of American investors as they sell them lemons, and I think
that what people thought the analyst industry was all about was
being an expert observer, and much of its behavior seems more
typical of used car salesmen. They do an aggressive sales job,
then go into the back room and snicker about how they just sold
an investor a lemon, and I think we do need to examine a number
of these key issues, and particularly one that I want Attorney
General Spitzer to review with us is the conflict of interest
laws, or lack thereof, that are on the books today.
For example, attorneys are subject to conflict of interest
rules, they have to disclose conflicts, and it seems that there
is little, if anything, that would in effect ensure that an
investor goes into these kinds of transactions with full
disclosure and a full array of the facts.
Let me wrap up by commenting on the overall business
picture, Mr. Chairman, because I was going to talk about the
World Com situation as well. I do not subscribe to the notion
that the majority of people in this business, in American
business are crooks. I just do not buy that notion. I think the
majority of people are honest and sincere in their views, but
what we have seen too often, as the chairman has pointed out,
is what amounts to a triangle of deception involving corporate
executives, audit firms, and investment analysts.
What Chairman Dorgan is doing is ensuring that today we
take a look at the third leg of the triangle, the analysts. I
think it is high time. I am looking forward to Mr. Spitzer,
commend him for his good work on the front lines of New York
State, and thank you again, Mr. Chairman, for being willing to
stay at it. This is not the typical sort of approach to
hearings, where you sort of do one and you hit and run. You
have been willing to stay at it, and that is what it is going
to take.
Senator Dorgan. Senator Wyden, thank you very much. Senator
Boxer.
STATEMENT OF HON. BARBARA BOXER,
U.S. SENATOR FROM CALIFORNIA
Senator Boxer. Thank you, Mr. Chairman. Thank you for
inviting Attorney General Spitzer here to testify on corporate
governance and investment counseling practices at Wall Street
firms.
Mr. Chairman, it takes courage to do what the Attorney
General is doing on a daily basis, and that is trying to weed
out the corruption on Wall Street, and the reason it takes
courage is, these people are very powerful and they are very
wealthy, and they have a lot of people around them to protect
them from the law, and so it takes courage. It also takes
courage, Mr. Chairman, for you to do a lot of the things you do
in this Subcommittee. I have been wanting to say that publicly
for a long time. It means a great deal to me that you are
willing to take on these issues, because we rub people the
wrong way, and I am glad we do because they cannot get away
with it, because what happens on Wall Street impacts Main
Street, and we represent Main Street, or we should. We should.
Mr. Spitzer, I wanted you to know that I was a broker on
Wall Street many, many years ago, when 12 million share days
were overwhelmingly exciting. It was such a low volume of
trades in those days, and I just want to speak to you as
someone who went into that business because I wanted to help
people do well, and I was quite young, and I could tell you
this, we counted on the work that the people in the firms did
to analyze those stocks. I felt so good, so comfortable with
it, and I could tell my clients who were not very wealthy, who
were just saving for their retirement, that this was real. I
also counted on the big four at that time, the big four
accounting firms. Boy, if they stamped their approval on it,
you knew it was real.
I long for those days, and if anything good comes out of
this it would be, maybe we can get back to those days where
being honest and being true and being sincere, and as Senator
Wyden believes a majority of the people are, if those are the
people that would take the leadership we will not have
headlines like this in search of the last honest analyst.
Let me close in this way. Just today's headline in the
Washington Post, ``Corporate Scandals Taking Toll on Markets,''
and it shows how the scandals track with the prices of stocks,
and then even a broader statement on the next page, a headline,
``Scandal's Impact Felt on Dollar and the Economy,'' so what we
are doing here today with your leadership, Mr. Chairman, is
trying to get to the bottom of why we are in such shaky times,
and I think you have invited someone here today who has shown
his courage, his conviction, his leadership, and it is
wonderful that you are really honoring him with this invitation
to come before the Senator. I thank you very much.
Senator Dorgan. Senator Boxer, thank you very much.
Attorney General Spitzer, again we welcome you to the
Committee. We have followed your work with interest. We think
it is important work done at a very important time, and you
know and I know and my colleagues know that your work has been
lauded by some and criticized very significantly by others. I
must say to you that I also invited Congressman Baker to be
present today, who has been critical of having an Attorney
General involved in the things you are involved in, and he
elected not to be here. I wanted to also give him the
opportunity to make a statement, but in any event, we are
delighted to have you, and why don't you proceed. Your entire
statement will be made a part of the permanent record; you may
summarize as you wish, and then we would like to pursue some
questions.
STATEMENT OF HON. ELIOT SPITZER, ATTORNEY GENERAL OF THE STATE
OF NEW YORK
Mr. Spitzer. Chairman Dorgan, Senators Wyden and Boxer,
thank you for your kind words. Senator Dorgan, let me simply
begin by saying I am aware of the praise, and I am thankful for
that and your kind words, especially this morning. I also have
noted the criticism in passing over the past weeks and months,
and I appreciate your commenting on it.
Thank you for the invitation to be here this morning. This
morning the stock market has taken another hit. At my last beep
from back home the market was down 180 points at the opening.
This is because the credibility of another major corporation
has been shattered. The investing public's confidence in
corporate governance is dropping precipitously, and throughout
this crisis of accountability there has been a void, a vacuum
in leadership from federal regulators. It is time for the SEC
to wake up. It is time for Congress to pass fundamental reform,
and it is time for our blind faith in Wall Street's capacity to
regulate itself to come to an end.
Several months ago, my office announced the results of an
investigation that showed the degree to which the investing
public had been fundamentally misled by one of the largest
institutions on Wall Street. Unfortunately, several ongoing
investigations that I am conducting have revealed similar
problems in other major investment houses. It is absolutely
essential that we now take steps to restore investor confidence
in the marketplace. The way to do so is through true industry-
wide reform that changes the way business is done at investment
banks and assures individual investors that their interests are
protected and that the information they are receiving is
truthful.
My office's continuing investigation and my testimony today
are aimed at achieving reforms that are necessary to achieve
that goal. I would like to start with a very brief description
of my office's findings with respect to Merrill Lynch, simply
to demonstrate the nature of the infractions and the
protections that are necessary to prevent similar wrongdoing in
the future.
First, the evidence showed that Merrill Lynch's publicly
stated assessment of stocks was often false, and did not
represent the privately stated opinions of the firm's analysts.
For instance, Merrill Lynch was urging customers to buy
Lifeminders while Merrill Lynch's analysts were referring to
the company as, `` POS.'' Let me simply say that POS is a
euphemism for an extremely poor investment.
Second, the evidence revealed that the analysts writing
stock reports at times functioned essentially as sales
representatives for the firm's investment bankers, using
promises of positive research coverage to bring in new clients
and stock offerings. Favorite investment banking clients
received advance viewings of analysts' reports, and were
offered an opportunity to change those reports themselves. In
one revealing e-mail exchange, an investment banker said to an
analyst, ``we should aggressively link coverage with banking.''
That is what we did with go2net. If you are very bullish, they
will love you.
Research could also be used to punish companies. In one
instance, a company was downgraded when Merrill Lynch did not
get the company's investment banking business, and in another,
a stock was downgraded to please a competitor who was a client
of Merrill Lynch.
Third, the evidence demonstrated that a key element of
research analysts' compensations was the success of the
investment banking activities they pursued, rather than the
accuracy of their buy-sell recommendations to the public.
These problems were well-recognized within Merrill Lynch.
Management itself acknowledged the problem, saying, ``we are
off-base on how we rate stocks and how much we bend backward to
accommodate banking,'' but nothing meaningful was done. Henry
Blodget, the senior Internet analyst, described the conflict in
one particularly damming e-mail. Blodget, frustrated by the
lack of guidance about how to handle certain investment banking
situations, threatened to do the unthinkable, render an
unbiased evaluation. His words are shocking, ``If there is no
new e-mail forthcoming on how ratings should be applied to
sensitive banking clients, we are just going to start calling
the stocks like we see them, no matter what the ancillary
business consequences are.''
Because of the conflict of interest I have described, the
company's investment advice was tainted. Companies that were
poor investments, companies that were disparaged internally,
still received strong ratings. Even as stocks plummeted, the
buy recommendations on investment banking clients remained
firm. Individual investors who depended on Merrill Lynch's
stock analysis and investment advice were misled, and left to
rely on stock ratings skewed to please investment banking
clients. In short, a major Wall Street firm exploited its
massive retail client base as a tool for bringing in new
business. There is no telling how much individual investors
lost as a result.
On April 8, 2002, my office obtained an order in state
supreme court putting in place temporary remedies to largely
deal with the abuses we found. Thereafter, on May 21 of this
year, we and Merrill Lynch reached a settlement involving
monetary payment and permanent remedial changes in Merrill
Lynch procedures. The terms of the settlement have been widely
reported, and I will not burden the record by repeating them
here. It included serious structural reforms in Merrill Lynch's
operations, as well as the penalty of $100 million intended to
emphasize to the management and shareholders of Merrill Lynch
the gravity of the company's infractions.
I should add that it is to Merrill Lynch's credit that they
have acknowledged the problem and implemented certain necessary
reforms. We believe the settlement was a fair one, tailored to
the abuses we found at Merrill Lynch, but the settlement dealt
only with Merrill Lynch. We believe that the problem extends
beyond Merrill, and it is our job, under New York State law, to
respond to fraud in the marketplace. Further investigations and
enforcement proceedings are necessary, as is industry-wide
reform.
Remarkably, throughout our investigation, which has now led
us to examine the documents of a significant number of
companies, there is absolutely no evidence that any compliance
department ever took any action to stop behavior that clearly
violated internal rules, state and federal law. The failure of
the industry's much-vaunted compliance structure is appalling.
A few critics, however, as the Chairman mentioned, are
alarmed that a state prosecutor conducted the investigation and
obtained the settlement. For example, Congressman Baker, in a
letter to each of the 50 State Attorneys General, criticized
the action of New York, saying it would produce confusion in
the market, and harm the interests of investors. Congressman
Oxley, Chairman of the House Financial Services Committee, went
further, writing in a May 31 letter to the New York Times that
the settlement with Merrill was, ``a State regulatory coup.''
These allegations are wholly without basis, and reflect a
flawed understanding of the necessary role that the states have
played in protecting the integrity of the securities markets.
The Merrill investigation and settlement was not a state
excursion into rulemaking. My office became aware of possible
fraud by Merrill. We investigated it. We exposed Merrill's
practices to public view. We commenced a proceeding, and we
reached a settlement with Merrill which provided for both a
monetary penalty and substantive relief.
As Attorney General of New York, I have legal duty to
enforce the Martin Act, a law that predates the federal
securities acts, and that has been integral to protecting
investors for over 80 years. Unlike rulemaking, which is the
province of the SEC and the securities SRO's, the settlement we
reached with Merrill was a resolution of an enforcement
proceeding against the firm. It imposed no rule on the
securities industry as a whole. Indeed, it imposed no change on
a firm other than the firm investigated, Merrill Lynch.
The settlement required specific remedial actions to be
undertaken by Merrill and no one else. It was tailored to deal
with the specific abuses we had evidence of at Merrill. It was
negotiated with Merrill, and it is binding on Merrill and
Merrill alone.
It is quite true that after we reached our settlement with
Merrill Lynch, I said I hoped the industry as a whole would
adopt the reforms Merrill Lynch was undertaking. That is
because that I believed then, and believe now, that the reforms
represented good practices that could well be adopted by other
firms or imposed by the SEC. I am gratified that several large
Wall Street firms apparently agree, and have voluntarily
adopted the Merrill reforms. I hope other firms follow their
lead, and that they do even more to address the potential
conflict of interest that exists.
Critics of state action overlook the absence of federal
action that made the Merrill investigation and reforms
necessary. The analysts' conflict of interest we investigated
had been widely reported in the press for years, but until we
published the Merrill Lynch e-mails, virtually nothing had been
done about it. There was no meaningful new SEC regulation to
address the problem, no legislation to correct the abuses, no
serious enforcement actions against those who were defrauding
the public. During the period of this federal enforcement
vacuum, untold millions of individual investors lost vast sums
of money.
Congressman Baker held hearings on the issue of analysts'
conflict of interest, but those hearings utterly failed to
uncover the damning evidence revealed by our investigation.
Indeed, those hearings failed to include testimony from
industry insiders, even though those are the individuals with
the most extensive knowledge of the conflicts, and his hearings
produced no proposal for reform, even though such reforms were
desperately needed.
The NASD proposed new regulations on analysts which were
accepted by the SEC at its June 8 meeting, but those
regulations are simply inadequate. Indeed, if those rules had
been in effect, the abuses we discovered at Merrill Lynch all
would have been perfectly within the bounds of federal
regulations. With respect to analysts' compensation, the only
restriction imposed by the new regulations is a ban on
compensating an analyst on a per-transaction basis, i.e., a
flat fee per transaction, or percentage of the investment
banking fee from each transaction. All other methodologies and
procedures to compensate analysts for generating investment
banking revenue, including those ended at Merrill by the
settlement, are permitted to continue.
The new regulations disclosure requirements are also
inadequate in several respects. They totally fail to address
clear disclosure upon termination of coverage, serious abuse we
found at Merrill, and also failed to require firms to disclose
whether analysts authoring research reports solicited
investment banking business in the past year, something we feel
strongly investors should be told.
In considering the attacks made by critics of state action,
one must consider the alternatives they support. A case in
point is H.R. 3763, a bill that originated in Chairman Oxley's
and Representative Baker's committee, which on the issue of
analyst conflicts requires absolutely no action from anyone.
Its sole directive is to the SEC to study and report back to
Congress on any final rules a self-regulatory organization may
in the future deliver to the SEC. It is difficult to conceive
of a more passive or inadequate response to the problem.
The Merrill investigation and settlement has spawned
another movement, one that is very dangerous to investors. I am
referring here to the behind-the-scenes effort to pass
legislation that would eviscerate the ability of states to
effectively prosecute securities fraud. The threat is very
real. Representative Baker, in a letter to all of the Nation's
Attorneys General, has threatened that he would introduce
legislation which would supersede state efforts in this area.
Two weeks ago, an amendment to the Sarbanes bill was
circulated. It would have stripped state prosecutors of their
power to obtain substantive relief from analysts who have
conflicts of interest.
This is no time to curtail the powers of state regulators
to pursue securities fraud. Continued state enforcement is
essential if individual investors are to receive the continued
protection they need and deserve. The state security regulators
are the cops on the beat to ensure that the investing public is
protected from fraud, whether that fraud is perpetrated by a
small bucket shop or one of the biggest investment institutions
in the world.
For years, many in Congress have aggressively promoted the
concept of increased federalism, a belief that the Federal
Government should scale back its involvement in our Nation's
affairs. I opposed that effort when it began, and I still
oppose it now. However, I believe that the Congress and the
Federal Government cannot have it both ways. If Congress and
the Executive Branch decide to curtail federal oversight of
areas such as securities, they must recognize it is the
responsibility of state securities regulators such as myself to
step in to protect the investing public.
Several Members of Congress and some leaders of the
financial industry have said that what is truly needed is a
uniform national standard. Let me be very clear. I agree it
would be best for the SEC to use its powers to impose nation-
wide rules to regulate analysts to prevent the sort of abuses
we discovered in the Merrill Lynch cases, but so far that has
not happened, and when and if it does, the enforcement of those
regulations and actions to curtail abuses will be of paramount
importance. It will be incumbent on federal and state
regulators to continue our efforts to vigorously pursue
enforcement actions and obtain significant relief when it is
necessary to protect the investing public.
Finally, I want to be very clear what this case is about.
Wall Street spends millions of dollars each year to convince
individual investors to put their life savings in the hands of
the large investment houses and the brokers. What they have not
told investors is that their investment advice has been
compromised by a desire to win investment banking clients.
Regular people, not Wall Street professionals, have lost a
collective fortune by relying on the tainted advice of the
biggest and most trusted names in the world of finance.
Do not take it from me. Listen to the words of one
investment analysts at Merrill Lynch who wrote, ``we are losing
people's money and I do not like it. John and Mary Smith are
losing their retirement because we do not want an investment
banking client to be mad at us.''
I do not like it either, and neither should anyone who has
the power and responsibility to regulate or prosecute this
industry. As I said at the beginning of my testimony, one of my
primary goals is to restore the confidence of the investing
public in Wall Street. Unfortunately, as a result of the abuses
that have occurred, including those we see on the front pages
of the papers today, the American people simply do not believe
the advice they are being given by the Wall Street securities
firms. We need to change that perception, and let me list
quickly several of the reforms that are absolutely necessary.
First, we need to rebuild the wall between research
analysts and investment bankers, to eliminate pressure from the
investment bankers for more favorable research reports. This
must include careful thought to the precise aspects of every
interaction with investment banking clients that analysts are
permitted to participate in.
Second, we need to ensure that analysts' compensation is
not based on investment banking revenue so that analysts are
considering the interests of the investing public and not their
own wallets.
Third, we need to provide greater disclosure to the public.
For example, investors should be told how frequently a firm
issues buy or sell recommendations on stocks in particular
sectors. All research reports should reveal whether the
investment banking firm has received compensation from the
subject company, and firms must state when and why they have
discontinued research coverage of a company.
Finally, every firm should have an independent committee
that reviews all research recommendations to confirm that the
research recommendations are based upon sound objective
analysis.
Implementation of these four fundamental reforms will give
confidence to the Mr. and Mrs. Smith mentioned in the Merrill
Lynch e-mail that the recommendations provided by Wall Street
firms are objective and honest.
I thank you for giving me the opportunity to testify today,
and I look forward to answering your questions.
[The prepared statement of Mr. Spitzer follows:]
Prepared Statement of Hon. Eliot Spitzer,
Attorney General of the State of New York
Chairman Dorgan and distinguished Members of the Subcommittee,
thank you for inviting me to testify before you today on the important
issue of investment banking reform.
There is no question that the investing public has diminished faith
in Wall Street. We have seen that not only in public opinion polls, but
also in the performance of the stock market over the past year. Several
months ago, my office announced the results of an investigation that
showed the degree to which the investing public had been misled by one
of the largest institutions on Wall Street. Unfortunately, several
ongoing investigations have revealed similar problems elsewhere. Those
deceptions--Enron, Global Crossing, and other scandals--have led many
small investors to withdraw from the markets. It is absolutely
essential that we now take steps to restore investor confidence in the
marketplace. The way to do so is through true industry-wide reform that
changes the way business is done at investment banks and assures
individual investors that their interests are protected and that the
information they are receiving is truthful. My office's continuing
investigation and my testimony today are aimed at achieving reforms
that are necessary to achieve that goal.
I would like to start with a brief description of my office's
findings with respect to Merrill Lynch, simply to demonstrate the
nature of the infractions and the protections that are necessary to
prevent similar wrongdoing in the future.
First, the evidence showed that Merrill Lynch's publicly stated
assessment of stocks was often false, and did not represent the
privately stated opinions of the firm's analysts.
For example, while Merrill Lynch publicly was giving the company
Infospace its highest rating in the fall of 2000, the firm's analysts
privately were branding said InfoSpace ``a powder keg'' and ``a piece
of junk.'' This particular stock remained on Merrill Lynch's list of
highest recommended stocks for many months even after these internal
warnings. In the same vein, Merrill Lynch was urging customers to buy
``Lifeminders'' while Merrill Lynch analysts privately were referring
to the company as a ``POS'' Let me simply say that POS is a euphemism
for an extremely poor investment.
Second, the evidence revealed that the analysts writing stock
reports at times functioned essentially as sales representatives for
the firm's investment bankers, using promises of positive research
coverage to bring in new clients and stock offerings.
Individual mandates for investment banking services are worth
millions of dollars, and are the major income stream of a securities
firm. As a result, there is incredible pressure to win investment
banking deals and to secure and retain investment banking clients.
Because of the risk that research conclusions relied upon by the
general public could be manipulated to assist in obtaining investment
banking clients, the two realms must remain independent. Merrill
Lynch's internal policy manual stated ``opinions expressed by analysts
must be objective. Any indication that a research opinion is less than
totally objective, or that it may have been influenced by a business
relationship of the firm, could seriously damage the firm's reputation
and lead to potential legal liability.''
Yet the reality was very different. Research was openly and largely
used as a sales hook for investment banking clients. Indeed, the
internet unit never recommended that investors sell any stock and
rather than recommend a ``sell'' on a given stock Merrill Lynch would
simply drop coverage. Favored investment banking clients received
advanced viewings of analyst reports and were offered an opportunity to
offer changes. In one revealing e-mail exchange, an investment banker
said to an analyst: ``we should aggressively link coverage with
banking--that is what we did with go2net . . . if you are very bullish
they will love you . . . '' This was a situation in which Merrill Lynch
was trying to win a new client. In another example, an institutional
investor e-mailed Henry Blodget asking, ``What's so interesting about
GOTO except banking fees???'' Blodget responded, ``nothin.'' Blodget's
candid opinion was not reflected in the initiation research report, nor
did the report disclose that Merrill Lynch had promised research
coverage in exchange for GoTo's investment banking business.
Research could also be used to punish companies. In one instance a
company was downgraded when Merrill Lynch did not get the company's
investment banking business and, in another example, a stock was
downgraded to please a competitor.
Third, the evidence demonstrated that a key element of research
analyst's compensation was the success of the investment banking
activities rather than the accuracy of their buy-sell recommendations
to the public. For example, the head of equity research wrote to
analysts soliciting information on their involvement in investment
banking so compensation could be calculated: He said:
We are once again surveying your contributions to investment
banking during the year . . . please complete details on your
involvement in the transaction, paying particular attention to
the degree your research coverage played a role in origination,
execution and follow-up. Please note as well, your involvement
in advisory work on mergers or acquisitions, especially where
your coverage played a role in securing the assignment and you
made follow up marketing calls to clients. Please indicate
where your research coverage was pivotal in securing
participation in high yield offerings.
These problems were well recognized within Merrill Lynch.
Management itself acknowledged the problem--saying ``we are off base on
how we rate stocks and how much we bend backwards to accommodate
banking.'' But nothing meaningful was done. Henry Blodget, the senior
internet analyst, described the conflict in one particularly damning e-
mail. Blodget, frustrated by the lack of guidance about how to handle
investment banking situations, threatened to do the unthinkable--render
an unbiased evaluation. His words are shocking: ``If there is no new e-
mail forthcoming on how `ratings' should be applied to sensitive
banking clients, we are just going to start calling the stocks like we
see them, no matter what the ancillary business consequences are''.
Because of the conflict of interest I have described, the company's
investment advice was tainted. Companies that were poor investments--
companies that were disparaged internally--still received strong buy
ratings. Even as stocks plummeted, the buy recommendations on
investment banking clients remained firm. Individual investors who
depended on Merrill Lynch's stock analysis and investment advice were
misled, and left to rely on stock ratings skewed to please investment
banking clients. In short, a major Wall Street firm exploited its
massive retail client base as a tool for bringing in new business.
There is no telling how much individual investors lost as a result.
On April 8, 2002 my office obtained an order in State Supreme Court
putting in place temporary remedies to partially deal with the abuses
we had found. Thereafter, on May 21, 2002, we and Merrill Lynch reached
a settlement involving a monetary payment and permanent remedial
changes in Merrill Lynch procedures.
The terms of the settlement have been widely reported, and I will
not burden the record by repeating them here. It included very serious
structural reforms in Merrill Lynch's operation, as well as a penalty
of $100 million, intended to emphasize to the management and
shareholders of Merrill Lynch the gravity of the company's infractions.
I should add that it is to Merrill Lynch's credit that they have
acknowledged the problem and implemented necessary reforms. We believe
the settlement was a fair one, tailored to the abuses we found at
Merrill Lynch. But the settlement dealt only with Merrill Lynch. We
believe that the problem extends beyond Merrill Lynch, and it is our
job under New York State law to respond to fraud in the marketplace.
Further investigations and enforcement proceedings are necessary as is
industry-wide reform.
Remarkably, throughout our investigation, which has now led us to
examine the documents of a significant number of companies, there is
absolutely no evidence that any compliance department ever took action
to stop behavior that clearly violated internal rules and state and
federal law. The failure of the industry's much vaunted compliance
structure is appalling.
Beyond Merrill Lynch
A few critics, however, are alarmed that a state prosecutor
conducted the investigation and obtained the settlement.
For example, Congressman Richard Baker (Chairman of the House
Subcommittee on Capital Markets, Insurance and Government Sponsored
Enterprises) in a letter to each of the 50 state attorneys general,
criticized the action New York took as an improper attempt to impose
state rules on a national marketplace which, if emulated by other
states, would produce confusion in the market and harm the interests of
investors. Congressman Michael Oxley, Chairman of the House Financial
Services Committee, went further, writing in a May 31 letter to the New
York Times that the settlement with Merrill was a state ``regulatory
coup'' which would lead to a ``balkanization'' of rulemaking and
oversight.
These allegations are wholly without basis and reflect a flawed
understanding of the necessary role the states have historically played
in protecting the integrity of the securities markets. The Merrill
investigation and settlement was not a state excursion into rulemaking.
My office became aware of possible fraud by Merrill; we investigated
it; we exposed Merrill's practices to public view; we commenced a
proceeding; and we reached a settlement with Merrill which provided for
both a monetary penalty and substantive relief. As Attorney General of
New York, I have a legal duty to enforce the Martin Act--a law that
predates the federal securities acts--and that has been integral to
protecting investors for over eighty years.
Unlike rulemaking, which is the province of the SEC and the
securities SROs, the settlement we reached with Merrill was a
resolution of an enforcement proceeding against a firm. It imposed no
rule on the securities industry as a whole. Indeed, it imposed no
change on any firm other than the firm investigated, Merrill Lynch. The
settlement required specific remedial actions to be undertaken by
Merrill and no one else. It was tailored to deal with the specific
abuses we had evidence of at Merrill, it was negotiated with Merrill,
and it is binding on Merrill and Merrill alone.
It is quite true that after we reached our settlement with Merrill
I said I hoped the industry as a whole would adopt the reforms Merrill
was undertaking. That is because I believed then, and believe now, that
the reforms represented good practices that could well be adopted by
other firms or imposed by SEC rule. I am gratified that several large
Wall Street firms apparently agree, and have voluntarily adopted the
Merrill reforms. I hope other firms follow their lead, and that they do
even more to address the potential conflicts of interest that exist.
Critics of state action overlook the absence of federal action that
made the Merrill investigation and reforms necessary. The analyst
conflicts of interest we investigated had been widely reported in the
press for years. But until we published the Merrill Lynch e-mails
virtually nothing had been done about it--there were no meaningful new
SEC regulations to address the problem, no legislation to correct
abuses, and no serious enforcement actions against those who defrauded
the public. During the period of this federal enforcement vacuum,
untold millions of individual investors lost vast sums of money.
Congressman Baker held hearings on the issue of analyst conflicts
of interest but those hearings utterly failed to uncover the damning
evidence revealed by our investigation. Indeed, those hearings failed
to include testimony from industry insiders--even though those are the
individuals with the most extensive knowledge of the conflicts--and his
hearings produced no proposals for reform, even though such reforms
were desperately needed.
The NASD proposed new regulations on analysts, which were accepted
by the SEC at its June 8th meeting, but those regulations are simply
inadequate. Indeed if those rules had been in effect, the abuses we
discovered at Merrill Lynch all would have been perfectly within the
bounds of federal regulations. With respect to analyst compensation,
the only restriction imposed by the new regulations is a ban on
compensating an analyst on a per transaction basis--i.e., a flat fee
per transaction or a percentage of the investment banking fee from each
transaction. All other methodologies and procedures to compensate
analysts for generating investment banking revenue, including those
ended at Merrill by the settlement, are permitted to continue. The new
regulations' disclosure requirements are also inadequate in several
respects. They totally fail to address clearer disclosure upon
termination of coverage, a serious abuse we found at Merrill, and also
fail to require firms to disclose whether analysts authoring research
reports solicited investment banking business in the past year,
something we feel strongly investors should be told.
In considering the attacks made by critics of state action, one
must consider the alternatives they support. A case in point is HR
3763, a bill that originated in Chairman Oxley's and Representative
Baker's committee, which on the issue of analyst conflicts requires
absolutely no action from anyone. Its sole directive is to the SEC to
study and report back to Congress on any final rules a self-regulatory
organization may in the future deliver to the SEC. It is difficult to
conceive of a more passive--or inadequate--response to the problem.
The Merrill investigation and settlement has spawned another
movement, that is very dangerous to investors. I am referring here to
the behind-the-scenes effort to pass legislation that would eviscerate
the ability of the states to effectively prosecute securities fraud.
The threat is very real. Representative Baker--in a letter to all
of the nation's attorneys general--has threatened that he would
``introduce legislation which would supercede'' state efforts in this
area. Two weeks ago, an amendment to the Sarbanes bill was circulated.
It would have stripped state prosecutors of their power to obtain
substantive relief from analysts who have conflicts of interest.
This is no time to curtail the powers of state regulators to pursue
securities fraud. Continued state enforcement is essential if
individual investors are to receive the protection they need and
deserve. The state security regulators are the ``cops on the beat'' who
insure that the investing public is protected from fraud--whether that
fraud is perpetrated by a small bucket shop or by one of the biggest
investment institutions in the world.
For years, many in Congress have aggressively promoted the concept
of increased federalism--a belief that the Federal Government should
scale back its involvement in our nation's affairs. I opposed that
effort when it began and I still oppose it now.
However, I believe that the Congress and the Federal Government
cannot have it both ways. If Congress and the Executive Branch decide
to curtail federal oversight of areas such as securities, they must
recognize it is the responsibility of state securities regulators such
as myself to step in to protect the investing public.
Several Members of Congress and some leaders of the financial
industry have said that what truly is needed is a uniform national
standard. Let me say very clearly here: I agree. It would be best for
the SEC to use its power to impose nationwide rules to regulate
analysts to prevent the sort of abuses we discovered in the Merrill
Lynch case. But so far that has not happened, and when and if it does,
the enforcement of those regulations and actions to curtail abuses will
be of paramount importance. It will be incumbent on federal and state
regulators to continue our efforts to vigorously pursue enforcement
actions and obtain significant relief where such relief is necessary to
protect the investing public from continued abuses.
Finally, I want to be very clear what this case is about. Wall
Street spends millions of dollars each year to convince individual
investors to put their life savings in the hands of the large
investment houses and their brokers. What they have not told investors
is that their investment advice has been compromised by a desire to win
investment banking clients. Regular people--not Wall Street
professionals--have lost a collective fortune by relying on the tainted
advice of the biggest and most trusted names in the world of finance.
Don't take it from me. Listen to the words of one investment analyst of
Merrill Lynch who wrote, ``We are losing people's money and I don't
like it. John and Mary Smith are losing their retirement because we
don't want . . . [an investment banking client--the cfo of goto.com] to
be mad at us.'' I don't like it either, and neither should anyone who
has the power and responsibility to regulate or prosecute this
industry.
As I said at the beginning of my testimony, one of my primary goals
is to restore the confidence of the investing public in Wall Street.
Unfortunately, as a result of the abuses that have occurred, the
American people simply do not believe the advice that they are being
given by the Wall Street firms. We need to change that perception, and
here are the reforms that need to be implemented:
First, we need to rebuild the wall between research analysts and
investment bankers, to eliminate pressure from the investment bankers
for more favorable research reports. This must include careful thought
to the precise aspects of every interaction with investment banking
clients that analysts are permitted to participate in.
Second, we need to ensure that analyst compensation is not based on
investment banking revenue, so that analysts are considering the
interests of the investing public, and not their own wallets.
Third, we need to provide greater disclosure to the public. For
example, investors should be told how frequently a firm issues ``buy''
or ``sell'' recommendations on stocks in particular sectors; all
research reports should reveal whether the investment banking firm has
received compensation from the subject company; and firms must state
when and why they have discontinued research coverage of a company.
Finally, every firm should have an independent committee that
reviews all research recommendations, to confirm that the research
recommendations are based upon sound, objective analysis.
Implementation of these four fundamental reforms will give
confidence to the Mr. and Mrs. Smith mentioned in the Merrill Lynch e-
mail that the recommendations provided by Wall Street firms are
objective, honest, and can be relied upon as they decide how to invest
their life savings.
Again, I thank you for giving me this opportunity to address you
today on these important issues. If you have any questions I would be
happy to answer them.
Senator Dorgan. Attorney General Spitzer, thank you very
much. We have been joined by the Ranking Member of the Full
Committee and the Ranking Member of the Subcommittee, as well
as Senator Edwards. Let me call on Senator McCain for an
opening statement.
STATEMENT OF HON. JOHN McCAIN,
U.S. SENATOR FROM ARIZONA
Senator McCain. Thank you. I will be brief. Thank you, Mr.
Spitzer. Mr. Chairman, I was just informed by staff that
Congressman Baker called over and said he was never formally
asked to testify. We can rectify that, I am sure, in the
future.
Mr. Spitzer, I applaud what you have done. The only
encounter I ever had with Attorney General Spitzer was an
effort to clean up boxing, so far, at which we have been
significant failures, but I still appreciate your effort
enormously. Anybody who says that you should not have done what
you did does not have the interest of the investors all over
the country as their primary motive. I do not believe that we
would be finding out the things we are finding out today in
light of a $3.8 billion misstatement on the part of WorldCom. I
think Enron was only $1.-something billion. So Mr. Spitzer, I
applaud your efforts, and I believe a majority of the United
States Senate would oppose any endeavor to curtail your efforts
on behalf of the average citizens of this country. Mr. Spitzer,
I hope you will do more, and I wish you would put somebody in
jail. I will tell you, Mr. Spitzer, until somebody goes to jail
I am not sure that these people are going to get the message. I
hope that the next time, and obviously there will be a next
time, that criminal charges are referred, because I do not
think that a $100 million fee is that big. I mean, it is a
pretty big deal in most places in America, but I am not sure
how big a deal it is with Merrill Lynch.
So Congressmen and Senators are free to write letters to
anybody they want to, and I applaud that right, but I believe a
majority of the United States Senate would oppose curtailing
your investigatory activities, which I think are carried out on
behalf not only of the people of New York but the people of
Arizona and every other state in America.
Why did you decide not to refer criminal charges?
Mr. Spitzer. Senator, let me explain it this way. The
objective number one for me was to reform the industry and to
articulate a new set of rules that desperately needed to be
articulated so that others who have the power to mandate
industry-wide reform could do so.
As we proceeded with the Merrill Lynch investigation, I
have stated this publicly, we could have indicted and convicted
Merrill Lynch. That would have destroyed 60,000 jobs. It would
have destroyed an entity, but it would not have led to the sort
of reforms that we believe are necessary to protect the
American public.
Senator McCain. Is not there some individual
responsibility?
Mr. Spitzer. Absolutely, Senator, and there are individuals
who still face the possibility of criminal charges, not from my
office but from other offices, and indeed, let me explain this
in the context of timing. I believed it was critical for Wall
Street, the investment world to see what the parameters were of
the Merrill Lynch deal to be awakened quickly to the realities
of what was there, and to protect the investing public, and we
took a first step at that.
I have spoken to the leadership on Wall Street and said to
them, it is now incumbent upon you to step into this breach,
because as I said in my opening statement, we have had an
absolute void at the SEC. There has been absolutely no
meaningful----
Senator McCain. An absolute void, and the fox is guarding
the hen house.
Mr. Spitzer. And that is why I said to the industry,
gentlemen and ladies, it is up to you now to work with me and
with others who have the interest of the investing public at
heart.
Senator McCain. What do you think of what the SEC has
proposed so far?
Mr. Spitzer. Inadequate, and I have said that privately and
publicly, and I have made it very clear to the SEC that
although I am proud to be in a partnership with them to
continue to investigate the underlying abuses, they are indeed
the primary regulator of this industry. Their actions so far
have been inadequate for a year now. It has been a year now,
Senator, that this has been brewing. We have seen nothing
meaningful from them.
Senator McCain. For the record, and soon, would you provide
this Committee and me with your recommendations as to what they
should be doing?
Mr. Spitzer. Yes, sir, I will do that.
Senator McCain. I appreciate the generosity of the Chairman
here. I was supposed to be making an opening statement, but I
think all Americans are terribly disturbed, particularly in
light of today's news. People's life savings are being wiped
out today as we speak. The last time I looked, the market was
down 140 points. By the way, we do have a banking expert here
to my right who will probably be able to ask much more coherent
and temperate questions than I am asking.
I thank you, Mr. Chairman.
Senator Dorgan. Senator McCain, thank you. Let me ask
Senator Fitzgerald for an opening statement, then Senator
Edwards, and then we will get to the questions. As always,
Senator McCain got right to the bull's eye of the target.
Senator McCain. I thank you for your forbearance, Mr.
Chairman.
Senator Dorgan. Senator Fitzgerald. Before you start, let
me just make this point. When we announced this hearing,
Senator McCain, Congressman Baker's staff called and asked
about the opportunity to testify. I told our staff to call them
back and say he was invited to testify. They then said he was
unavailable, so that is the way that worked. I do not want to
misrepresent it, but they did inquire. I said, ``you are
welcome, we would love to have you,'' and then they indicated
he was not able to, so just for the record.
STATEMENT OF HON. PETER G. FITZGERALD,
U.S. SENATOR FROM ILLINOIS
Senator Fitzgerald. Thank you, Mr. Chairman, and Mr.
Attorney General, thank you for being here, and I want to
compliment the Chairman for the series of hearings we did. I
think it was back in December when we first had a bunch of
employees from Enron testify right where you are today, and
these were the folks who lost most or all of their life savings
in their Enron 401(k) account. At that time I asked all of
those employees if they had seen any of the research reports
coming out on Enron stock from some of the analysts and the
Wall Street investment banking houses, and every member at that
panel raised their hand, and I said, did you rely on that
research, did you think that was good, independent, objective
advice, and they said, oh, yes. That is why we kept holding
onto our stock, buying more of it in some cases.
This Committee later looked into what the analysts had been
doing with respect to Enron. We found that there were 17
analysts following Enron stock, and up through September of
last year, 16 of them had a buy or strong buy recommendation on
the stock, and of those, half kept a buy recommendation on
Enron right up to the time they filed bankruptcy on December 2,
and there have been empirical studies that have looked into
this before.
As you know, the prior Chairman of the SEC, Arthur Levitt,
was very interested in this issue, and I think he attempted a
reform but either got bludgeoned back by Congress or the
investment banks or both, but there was a study of stock
analyst recommendations from 1996 through 2000 conducted by
Dartmouth Professor Kent Womack that found that 71 percent of
all analysts' recommendations were buy or strong buy, while
less than 2 percent were sell or strong sell recommendations.
It is very clear that there is an overwhelmingly optimistic
bias on the part of analysts, and when you combine that with
concerns about the influence of the enormous investment banking
fees that are often generated by the clients that are being
analyzed, you really have the worry about the independence of
analysts' judgment.
Now, I have myself concluded that analysts' reports are
merely advertisements in most cases for the firms being
analyzed. They are paying for that advertising via their
investment banking fees. That is what was going on in the case
of Enron. They paid hundreds of millions of dollars to Wall
Street investment banks, and I think there are two ways we can
deal with it.
We could seek to stamp out the conflicts of interest, and I
applaud you for your efforts with respect to the Merrill Lynch
settlement, or we could simply require disclosure of those
conflicts of interest, and I think with disclosure of those
conflicts of interest, most average investors would then have a
better idea that when they are reading one of these analyst
reports it really does not have much more credibility, in most
cases, than an advertisement for diapers, or cereal, or
something they see on TV.
I introduced a bill that would require disclosure of all
the investment banking fees, any positions that companies, the
investment houses, have in the company being analyzed. I think
that would help in clearing up people's understanding that they
may have an agenda, but on the other hand, to stamp out the
conflicts entirely, or to have complete disclosure of them, is
very, very difficult when you are dealing with sell-side
analysts, so I will be interested in your perspective on how we
should go about handling this situation.
I do commend you for what you have done in New York, and I
will have some more questions when we get to the question and
answer session.
Senator Dorgan. Senator Fitzgerald, thank you very much.
Next, we will call on Senator Edwards.
STATEMENT OF HON. JOHN EDWARDS,
U.S. SENATOR FROM NORTH CAROLINA
Senator Edwards. Good morning, Mr. Attorney General, very
good to see you again, and thank you for what you are doing on
behalf of the people of North Carolina, because I think you are
protecting investors not only in the State of New York but all
over this country, including people I represent in North
Carolina.
As others have said, this hearing could not be more timely,
given the news on WorldCom. This I think has been focused on
businesses and investors and employees, but the reality is, as
the Washington Post reported today, it is also about the
economy as a whole, because there is no question that what is
happening with these various firms is having a real impact on
slowing down the recovery that all of us need, and the key, I
think, to restoring investor confidence, which I think is a
huge component of what we are trying to accomplish here, is to
have aggressive watch-dogs like you, and the truth of the
matter is that while the federal regulators have been sitting
on their hands and fiddling around, you have actually been
doing something, so thank you for what you are doing.
To those who would say that what you are doing should be
stopped, they are wrong. What you are doing is important, and
instead of trying to stand in your way, what we ought to be
doing is applauding you for what you are doing and pushing you
forward.
I want to change subjects, though, just briefly. There has
been a lot of focus on the investment firms, which you have
been focused on, on the accounting firms, on the actions of the
top-level executives at these various companies. I also think
there is another component that has gotten little attention
thus far, which is the role of the lawyers in these various
problems.
I have many years of experience as a lawyer, as I know you
do, and you are the top lawyer in the State of New York, but
the truth of the matter is, a lot of these things could not
have happened without some lawyer either allowing it to happen,
or giving an opinion that it was okay, and one of the problems
that I think happens is, the lawyers develop relationships with
the people they deal with on a day-to-day basis, the CEOs. You
know, they go to lunch with them, they play golf with them,
they are their friends, but that is not who the lawyers work
for.
They work for the corporation. They work for the investors.
They work for the shareholders, and it is my belief that they
have, we, as lawyers, have a responsibility to those
shareholders first of all. If they see something about to
happen that is wrong/illegal, they have a responsibility to say
it and to stop it.
Number two, if it goes forward over their objection, I
think they also have a responsibility to go up the chain, to go
to the chairman of the board, to go to the board of directors,
because oftentimes they are in a position to actually stop this
stuff, as you well know, and I have written a letter to Harvey
Pitt asking him whether he agrees with this, and whether this
is something we can do something about. For years, this sort of
regulation occurred, but unfortunately it stopped over the
course of the last decade or so, and it is my belief that we
need to reinstate it at the national level.
I have also written a letter to the ABA, and unfortunately
the ABA, even though they agree with the substance of what I
have just said, is taking somewhat of a hands-off approach to
this, which I think is wrong. I think we have to be willing to
police our own profession, and I just wanted to get--Senator
Corzine and I are working on a bill to do something about this
issue, because I think it is another place where we can have a
really meaningful and positive impact in restoring investor
confidence, and I do not want to ask you questions now, but let
me just ask you briefly, is that something you would agree
with?
Mr. Spitzer. Absolutely, Senator, and I will be brief in my
answer. I know this is not the Q&A.
I referred to Enron as the perfect storm of corporate
governance failure, by which I mean, you not only had a failure
on the part of the board, the audit committee, the outside
auditors, the peer review, which is an area I think has gotten
insufficient attention, but also, as per your point, the
outside lawyers.
I think the outside lawyers and the lawyers who work within
a company have an ethical obligation to report those actions,
those steps that they believe are wrong, violate law, and as
you suggest, because their fiduciary duty goes to the
shareholders, not to the CEO, not to the executive, it goes to
the shareholders, they have to report up the chain to the board
when their advice is not followed on ethical matters.
Senator Edwards. Thank you for your leadership, Mr.
Attorney General. I look forward to working with you, and thank
you, Mr. Chairman.
Senator Dorgan. Senator Nelson.
STATEMENT OF HON. BILL NELSON,
U.S. SENATOR FROM FLORIDA
Senator Nelson. Mr. Chairman, I was somewhat jolted into
reality in a conversation with the Chairman of the Banking
Committee last evening, the very distinguished Senator from
Maryland, Senator Sarbanes. When asking him about the reform
legislation, which is the part that Senator Carnahan and I have
added to that particular bill on corporate reform, and on
accounting reform, Senator Sarbanes said that there was an all-
out effort, and they may succeed in defeating his bill. If this
environment that we have just witnessed of corporate greed and
skullduggery and accounting firms being in bed with the
corporate managers, if this environment cannot create the
political environment in which we can move legislation, that is
a sad commentary, and I hope that further exposing to the clear
light of day what you are doing in this hearing will help give
us the momentum to try to be able to be successful in passing
legislation for corporate reform.
Thank you, Mr. Chairman.
Senator Dorgan. Senator Nelson, thank you very much.
Mr. Spitzer, again thank you for being here, and thank you
for your testimony. I want to ask you about the Securities and
Exchange Commission just a bit.
The Securities and Exchange Commission was appropriated
$514 million last year. The President's budget request suggests
a cut to $466 million this year, a rather strange
recommendation at this point in time, of course, but I said
when I started that the SEC ought to hang its head in shame,
because this has gone on around them. It is as if there is this
carnival of greed and they have a front-row seat, and they are
eating popcorn, and nothing is happening there.
Can you tell me--and again, in your investigation, you
investigated one piece of this. You are not investigating the
things I referred to in the newspaper this morning that deal
with restatements and so on, but tell me about the Securities
and Exchange Commission and your contacts with them. What were
they doing? Were they active in this area?
Mr. Spitzer. I will try to be deft but make my point
persuasively, and I will try to be deft because I have a
partnership with the SEC and look forward to working with them
as we march forward. Having said that, I have been sorely
disappointed in what we have seen from the SEC over the past
year. In an environment, as Senator Nelson said, when the
public and all investors are crying out for leadership we have
not seen it.
It is not merely a matter of the budget. I hate to say this
publicly, because some may get comfort from it. We have only 15
lawyers in my Investor Protection Bureau, although I am
constantly asked for more by the Bureau Chief, and we have
managed rather easily, I should say, to reveal the evidence
that verified an underlying theory that had been floating out
there for years, and so it is not that the SEC lacks resources.
I think they need more resources so they can be more
affirmative and more aggressive, but it is a matter of will, it
is a matter of desire, it is a matter of aggressiveness, it is
a matter of leadership, and I think it is very clear that after
a year this SEC is not where it should be.
Senator Dorgan. Well, in your judgment, what has failed? Is
it, you say a lack of will at the top of the SEC? For how long,
and is there a culture here at the SEC that says, well, we have
got $\1/2\ billion so let us decide what to do with it, let us
sit around and do nothing?
Mr. Spitzer. Senator, I do not wish to personalize this
with respect to Chairman Pitt. Having said that, there are many
professionals at the SEC who wish to be vigorous. I think that
I will without recounting the details of my first meeting with
the SEC, I would say that when I first sat down with senior
lawyers at the SEC and proposed some of the ideas that I
thought they could embody, since they have rulemaking authority
that would begin to address the analysts' problems, they were
dismissive of the ideas.
The SEC and the SIA were the same. The SEC and the
Securities Industries Association saw eye-to-eye. It was
absolutely a failure on the part of the SEC to be inquisitive,
to be aggressive, to understand that as the evidence was
unfolding the much-vaunted self-regulatory world that had been
relied upon was failing the public, and I think that is what is
clear, whether it is Senator Edward's comments about lawyers,
where self-regulation there also has been insufficient, or more
palpably, as the American public has seen on the front page of
every newspaper and every business page for the past year, in
the context of our financial reporting systems, there has been
a failure of self-governance, and hence, it was obligatory upon
the SEC to step in, and they have not.
Senator Dorgan. Mr. Spitzer, Senator McCain made the point
that a lot of folks out there have just lost their shirts, lost
their life savings. You turn on television, and if you have
cable television you have 100 channels, and you go through the
channels and you see all kinds of programs these days with
investor analysts talking about this stock or that stock. They
seem authoritative, they sound informed, and they are making
recommendations here and there, but what you have discovered is
that in many cases these recommendations are not objective at
all. In some cases, recommendations are made by security
analysts or stock analysts who privately are telling their
firm, ``this is a dog, this stock is worthless,'' and yet they
are saying to the public, ``buy this stock, buy this stock,''
and it has to do with money, does it not?
Now, let me ask the question. Some say that there ought to
be some kind of federal standard governing independence of
investor analysis, or investor analysts. Even if we develop a
federal standard, something, incidentally, I support, that does
not mean that there is not going to be a role for Attorneys
General in enforcing state and federal laws, is that not
correct?
Mr. Spitzer. Absolutely, Senator. I could not agree with
you more. I said in my testimony and I said it for months, I am
in favor of the SEC articulating a standard. They are the
rulemaking entity that is supposed to define the behavior in
the securities environment. I have been encouraging them to do
so, to do it aggressively. Once they do so, there still will be
a need for state enforcement.
I have the Martin Act, which has generalized antifraud
provisions. It will be obligatory and important for the
investing public that we continue to enforce those provisions
as we do from the smallest Ponzi scheme and bucket shop up to
the Merrill Lynch inquiry. Those two work together.
Senator Dorgan. Mr. Spitzer, what led you to the
investigation? The reason I ask that question is that today in
the Wall Street Journal--I suspect it is coincidence that it
appears today. It is a two-page advertisement by Merrill Lynch
with a picture of the president and CEO and chairman and CEO,
and it says, ``lately you have been hearing a lot about Merrill
Lynch, now you are going to hear from us,'' and it describes
the reforms and so on.
Look this is not, to me, about this company. It is about
the people inside this company and other companies that have
not been honest with analysts or with the American public, and
as a result people have lost a fortune. Tell me what led you to
this investigation? Were there whistleblowers some place? Where
did you find the hints and the information to go forward?
Mr. Spitzer. There were, Senator, over time there were
people who came forward and spoke to us, but the instigation
for this was very simple, and this is what is, I think, most
unfortunate about it. Everybody on Wall Street knew. In the
past year I have spoken to hundreds of investment bankers.
Everybody agrees with the premise of our investigation.
Everybody agrees that there was a fundamental tension and
conflict, and yet nobody was doing anything about it. It was
because of the void in enforcement that I felt there was an
obligation to protect the investor.
We stepped in precisely because every investment banker,
every analyst understood what was going on. Mr. and Mrs. Smith
were losing their shirts and nobody was doing anything.
Senator Dorgan. Is there a connection, in your judgment--
this is my last question, and it kind of goes far afield in
terms of what you have done--with the Enron hearings? We saw a
string from the law firms, high-paid, big law firms that were
enablers, to accounting firms that were enablers, to CEOs who
in this turbocharged economy think you ought to make hundreds
of millions of dollars and perhaps even get hundreds of
millions of dollars as you exit, to stock analysts whose
connection to the firm and to the investment bank that they
serve relates to the fees, and therefore the requirement that
they give good reports on the company. Is there a thread that
connects all of this with respect to a culture, do you think?
Mr. Spitzer. Senator, I think it is a harder question to
answer, but I do think there is a thread there, and there has
been I think a crisis of accountability that has gripped Wall
Street, perhaps other sectors of our society as well, but there
has been a more generalized dissipation of standards, a
dissipation of the recognition on Wall Street to abide by the
ethics that the investment bankers and lawyers and accountants
understand. Not a failure of understanding. There is a failure
of will in terms of their willingness to abide by their
standards.
Senator Dorgan. Just one final point. Do you have other
cases underway?
Mr. Spitzer. Unfortunately we do, and unfortunately, as I
have said, the evidence at other houses replicates what we have
seen at Merrill, and I say unfortunately because I wish this
were isolated, but it is not, and that is a problem.
Senator Dorgan. Senator McCain.
Senator McCain. Mr. Spitzer, what is it that motivated you
to begin your investigation?
Mr. Spitzer. Senator, we have in New York a statute, the
Martin Act, that has been on the books since 1921, it predates
the federal securities laws, that obligates the State Attorneys
General to enforce the antifraud provisions of the statute to
ensure integrity on Wall Street. We have had historically
through Attorneys General of both parties, I am proud to say,
aggressive enforcement with respect to fraud on Wall Street.
Most often the cases do not receive the notoriety of our
investigation of Merrill, of course, because they relate to
Ponzi schemes, bucket shops, fraud that does not go to the core
of what has gone on, but our Merrill Lynch investigation is the
same kind of inquiry that we conduct day-in and day-out, where
we get evidence, or have a theory of wrongdoing on Wall Street,
where investors are the losers, and we then pursue it.
Senator McCain. Did you work with Mr. Morganthal?
Mr. Spitzer. Yes, sir. I am proud to say I was in his
office as an Assistant DA for 6 years, and I am glad you raised
him, because I think the BCCI inquiry is another example of--it
was the largest bank fraud in history--another example where
state prosecutors stepped in to make an important case.
Senator McCain. The agreement you reached with Merrill
Lynch includes an enforcement provision which allows the firm
to appoint its own monitor, subject to your approval.
Mr. Spitzer. Yes, sir.
Senator McCain. When will this appointment occur?
Mr. Spitzer. It will occur shortly, and I have every
confidence that Merrill now understands the problem and will
act appropriately, if only out of a sense of self-preservation.
Senator McCain. Well, I want to ask you one question that
is pretty tough, and that is, under its present leadership, do
you believe the SEC can be effective?
Mr. Spitzer. I believe that Chairman Pitt understands the
problems. I look forward to the evidence that the SEC is
willing to take the steps that are needed. I have not seen that
evidence yet. I have seen them proffer proposed rules with
respect to accounting, with respect to analysts, that are
insufficient, that do not reflect an understanding of the
vacuum that exists and, quite frankly, Senator, in a year in
which there has been a crisis of corporate governance unlike
any we have ever seen we have seen a failure of leadership at
the SEC.
Senator McCain. The hour grows late. I thank you, Mr.
Spitzer, and I congratulate you for your singular public
service.
Mr. Spitzer. Thank you, sir.
Senator Dorgan. Senator Wyden.
Senator Wyden. Thank you, Mr. Chairman.
Mr. Spitzer, one of the things I did in preparation for
this hearing is, I went out and picked up all the financial
magazines, the money magazines, Kiplinger's and the like, and
they are just filled with articles about this, and particularly
the need for more independence at the various firms, and as I
go through these my sense is that even now, after your good
work, the firms still do not get it. They do not get it in
terms of how serious these conflicts are.
For example, in Money Magazine of this month, where there
was considerable discussion about the need for firewalls that
would separate, for example, investment banking from research,
the Merrill CEO told Money Magazine that research plays a
critical role in the capital-raising process.
Now, when I hear a statement like that, that suggests again
that they still do not see how important these firewalls are
that separate out these various kinds of functions. Tell me
what your sense is. Is this message now finally starting to
sink in, because to see these kinds of quotes after all of this
attention suggests to me there is still a long way to go.
Mr. Spitzer. Senator, I agree with you there is a long way
to go. I think there are different camps within the investment
banking world, and I think that we saw from Hank Paulson, the
chairman of Goldman, a very important speech, now 2 weeks ago,
in which he addressed these issues. I have spoken with many of
the leaders in the investment banking world, the business
community, who understand what is at stake, who understand the
revenues that are needed. They understand the magnitude of what
is at issue here.
I think that the precise parsing of where the analysts, and
as I said in my testimony, how the analysts interact with each
aspect of the investment banking function of the firms and the
houses that are full-service investment houses need to be
parsed very carefully, and that is where we need leadership
from the SEC.
Early on in our inquiry, I floated publicly the notion that
theoretically one could remove the research function entirely
from the investment banking side, the capital formation side,
because they serve different customers, one the retail public
that was buying, the other the capital formation side with
investment banking fees. It was an idea that garnered
absolutely no support. It is not a concept I can impose
unilaterally. It is not a concept that can be the product of a
settlement with one company. It is a concept that could result
only from an SEC directive, or legislation, and as a
consequence, I think that is why, as I said in my testimony,
this issue of how the analysts interact with investment banking
needs to be carefully thought through, carefully parsed. That
has not yet happened sufficiently.
Senator Wyden. Is it your sense that there are no rules on
conflicts of interest, or is it a problem that the rules are
not being enforced?
Mr. Spitzer. The rules are not being enforced. There are
platitudinous statements in most of the manuals that are issued
to analysts by the investment houses. Merrill Lynch had some
wonderful language in its firm manual, but there was absolutely
no effort to enforce. As I have said, there was absolutely no
evidence of compliance ever raising a hand, compliance sending
a letter to the chairman, to the director of research, to
anybody, to signal that there was a problem, and this was in a
context where the abuses were brazen and not subtle, a context
where, for instance, an analyst would send a report to an
outside company to get the company's approval before it was
issued. That is inconceivable, and yet compliance never did
anything.
Senator Wyden. Let me ask you about this matter of buy and
sell recommendations. John Coffey of the Columbia Law School
makes the point that in 1990 analysts issued six buy
recommendations for every sell, and by the year 2000 the ratio
was nearly 100 to 1. You get the sense as you look at this that
for some analysts--and again, I want to make clear I think
there are many, many honest people in this field, but for some
analysts it seems that the word sell is a four-letter word, and
I would like to have you give us your sense about whether you
examined whether the percentage with respect to these issues
varied greatly on whether or not a company was a client in the
analyst's firm for banking purposes.
Obviously, to have this information on something resembling
a firm-by-firm basis would be helpful. Did you look at that?
Mr. Spitzer. Yes, Senator. As a matter of fact, we have
obligated Merrill as part of our settlement to disclose that
very information to investors. What we have required is that
each analyst statement include not only an array within the
sector of buy-sell recommendations that Merrill has issued, but
also then a second chart that says, with respect to those
companies that are clients of Merrill Lynch, what is the
distribution of buy-sell recommendations, and that will permit
us, and we have begun to do this, to examine any skew, any
differentiation there may be between the distribution of buy-
sells across a sector where people are not clients, and then
buy-sell recommendations when you do have a client
relationship, and the evidence so far is that there is a skew,
so we have been focusing precisely on that issue.
Senator Wyden. If nothing was done, what do you think would
happen in 5 years? Would we just be back to business as usual,
because again, as I talk to someone on Wall Street, and I want
to stress that I think there are many honest people there, I
get the sense that people think conflicts are just inevitable.
They say, you know, we are going to have this attention
now, and Spitzer is out there digging up our e-mails, and they
are running around in Washington all lathered up about this,
but conflicts are always going to be with us. We are always
going to have these, and I am interested in your judgment about
what would happen 5 years from now if this is just allowed to
go by the boards after a few more hearings.
Mr. Spitzer. I think you are correct that--whether it is 5
years, 4 years, or 10 years I, of course, do not know, but your
point that there will be a cycle that will bring us back to
this problem is absolutely correct, I think, which is precisely
why we need vigilance on the part of the SEC, on the part of
the state regulators to ensure that the attention that now has
properly shone the light on the abuses, that that attention
continues.
If this is spasmodic, if this is not a continuing effort to
ensure that those on Wall Street abide by the ethical rules
that they understand, then we will see a dissipation of
standards once again, and we have seen this historically. There
was a period where insider trading cases were made about 10
years ago. For a period, people on the street believed that the
ethic changed, but now here we are a number of years later, and
again we are seeing the same sorts of problems, so I think you
are correct, Senator, we need continuing attention to this
issue.
Senator Wyden. My time is up, Mr. Chairman. I just wanted
to wrap up with one point. This morning's story about WorldCom
10, 15 years ago would be a big deal at the typical country
club in America, because that is where you would have so many
people concerned, and they would be anxious about their
stockholdings. Today's story, though, is of tremendous interest
to millions of working families, because the stock market is no
longer just the province of the wealthy, and I think there is
no more important issue in this Congress at this point, and no
more important domestic issue in this Congress than making sure
that working families see that the rules are not rigged against
them, and that is what is important about continuing these
hearings.
I look forward to working with you, and the willingness of
Senator McCain and Senator Fitzgerald to constantly come to
these hearings and to make sure that these issues with respect
to corporate governance are going to be bipartisan, Senator
McCain, Senator Fitzgerald, I think you do a great service by
being so extensively involved, and I look forward to working
with you and them.
Senator Dorgan. Senator Wyden, thank you very much. Senator
Fitzgerald.
Senator Fitzgerald. Mr. Spitzer, I wanted to ask you some
questions about the Martin Act. It is my understanding the
Martin law is kind of a strict liability statute, and you said
you have had it on the books since 1921, that it only requires
evidence of a conflict of interest that hurt investors, but it
does not require proof of criminal intent. Is that correct?
Mr. Spitzer. It is correct, Senator, that to establish
certain types of violations, that it is not necessary to
establish intent, that is correct.
Senator Fitzgerald. In the case of your use of the Martin
law against Merrill Lynch, was proof of criminal intent
required?
Mr. Spitzer. Well, we did not reach that point, and I think
that--let me say this, since I have said this before. We could
have established intent had we needed to.
Senator Fitzgerald. But it sounds to me that that statute
is stronger than any statutory tool that the SEC may have at
its disposal, is that not correct, because the SEC would have
to show criminal intent?
Mr. Spitzer. I believe it is correct, Senator, that for the
SEC to enforce most of its provisions, other than bookkeeping
provisions, certainly in the criminal context the SEC would
have to establish intent, that is correct. I should indicate,
it is only in the context of misdemeanors, the criminal
context, that the Martin Act does not require a demonstration
of intent.
Senator Fitzgerald. Say that again.
Mr. Spitzer. In other words, if you want to indict somebody
for a felony as opposed to charge him or her with a
misdemeanor, then it is obligatory that you demonstrate intent
under the Martin Act.
Senator Fitzgerald. Okay, and that comports with what I
learned in law school. You have to have criminal intent for a
felony.
Mr. Spitzer. We usually believe that.
Senator Dorgan. Senator Fitzgerald, would you yield on that
point just for a moment, so I can understand this? You are not
saying, however, that the SEC lacks the authority to issue some
kind of cease-and-desist orders if they see practices in a
company by which security analysts are providing information
that is at odds with information the company has because there
is a conflict. You are not saying they do not have the
authority to be active and involved and engaged, right?
Senator Fitzgerald. By no means am I saying that.
Senator Dorgan. I think that is important, because you were
asking, I think, Senator Fitzgerald, what authority does the
SEC have, or what do they not have. My view has been that they
have had the authority to do certain things but largely have
been----
Senator Fitzgerald. Well, what could the SEC do in the case
of analysts giving overly optimistic research reports that
misled investors? Say they could not establish, they could not
show criminal intent, what could the SEC do?
Mr. Spitzer. Senator, there is absolutely nothing we have
done that the SEC could not have done, absolutely nothing.
Senator Fitzgerald. So it is not the difference in the
Martin law.
Mr. Spitzer. No, sir. I think many people have focused on
this, and it is an intriguing, perhaps, issue for a law school
law review article, but I think in terms of its practical
import as we have pursued this investigation, there is
absolutely nothing we did the SEC could not have done under the
myriad of statutory powers they have.
Senator Fitzgerald. Now, both the National Association of
Securities Dealers, the NASD, and the SEC have proposed rules
to force disclosure of some conflicts such as whether a firm or
its affiliate owned 1 percent of more of the examined company's
securities, whether the firm had a banking relationship with
the issuer over the past 12 months. I notice that you did not
require specific disclosure along these lines in the agreement
that you made with Merrill Lynch. Was there a particular reason
for that, and is it your opinion that making information of
this type available to potential investors is important?
Mr. Spitzer. We actually did require that disclosure. We
did require disclosure of an investment banking relationship
that generated any revenues in the past 12 months, because we
thought that was an absolutely critical piece.
Senator Fitzgerald. How about ownership?
Mr. Spitzer. Ownership, I do not believe we got to the
issue of ownership, because I think that was already covered
elsewhere, but let me say this. We even tried to be more
expansive than that, because it is the pitch, and this is why
there is so much work to be done. It is really at the point
where the solicitation is being made that there is the moment
of greatest vulnerability.
It is even prior to the existence of the investment banking
relationship, when the analyst and the investment bankers are
going to the prospective client, where the real nefarious deals
are cut, where the statements are made either explicitly or
implicitly, if you bring your business to us, we will give you
a strong buy, and I have heard from CEOs and analysts from both
sides of this.
Senator Fitzgerald. So it is really hard to cover that
situation with disclosure, is it not?
Mr. Spitzer. It is hard to craft it properly, and we have
been struggling on how one might do it, but it can be done,
because it gets into the area of where there is an ongoing
effort to solicit business, which is, of course, then an area
where there is some interaction.
Senator Fitzgerald. Well, do you think that our government
should try to cover all those potential conflicts with
disclosures, or should we try to educate the public that hey,
these are just advertisements, like as you see on TV? People
are conditioned to know that an ad that they see on TV, they do
not necessarily believe that it is true, but I believe the way
analysts' reports come out, people think that they are credible
and objective.
Mr. Spitzer. Senator, I suppose--first of all I have to
say, I was intrigued by your metaphor, your comparison of
diapers to analysts' reports. I thought, there is probably some
work we could do with that metaphor, but I am not sure we
should pursue it too much here, but I think there is a utility
to having the public rely upon analysts' reports, so I do not
want to be so dismissive that we say that the capital formation
purpose that results from dissemination of information to the
public should be discarded and we should remove these and
relieve these.
Senator Fitzgerald. But can we ever require disclosure of
all the potential conflicts? Don't you think that is really
hard? For example, Citibank, they loaned $1.5 billion to Enron.
I am not sure that the disclosures that the NASD and the SEC
want to require would have required Citibank to disclose the
indebtedness owed to them, because it is not an ownership
interest, they were a creditor. Citibank actually wound up
losing nothing, even though they had lent $1.5 billion to Enron
because they sold securities to the general public, or maybe in
a private placement, that had the effect of hedging their
position. They did not have to pay back the securities if Enron
did not pay back its debt to Enron. They ended up losing
nothing.
Mr. Spitzer. Senator, I agree with you that the complexity
of the web of interrelationships among the full service
entities and their client, Citigroup, perhaps being the largest
of them, makes it difficult to figure out how to do it, but we
must try, because if we throw up our hands in despair and say
there is no possibility, there is no mechanism, then we will be
dooming the capital markets to the increasing decline of
participation by the American public.
And as Senator Wyden said, and has observed several times,
the increasing participation by the American public in capital
formation is critical. It has been one of the great successes
of our economy over the past 15 years, and I am concerned that
if we do not make every reasoned effort to ensure disclosure,
to ensure that the conflicts--you drew a dichotomy, I am not
sure it is real, between disclosure versus eliminating the
conflict.
I think we can do both. I think we can attack this from
several angles. If we do not address this problem from each of
these perspectives, then I think the public confidence will
continue to dissipate, and we will see the public exiting the
capital markets.
Senator Fitzgerald. I know my time is up. Can I do one or
two followups here? Just, if you really extend that far, we
cannot limit our disclosure requirements to analysts. There
were apparently members of the news media that appear to have
been on Enron's payroll, some of whom were out writing puff
pieces in various publications, pumping Enron. They would not
be subject to these regulations. People are conditioned to
believe that everything they read in the newspaper is
independent and objective, but there are, in fact, no
disclosure requirements for members in the news media. It gets
very hard to stamp all that out. I just want to make that
comment.
One other thing is, there is a whole industry of buy-side
analysts who do emphasize that they are representing just the
buyers, that they do not work for investment banks, that are
trying to sell stock for issuers, and you can pay them for
their research. A lot of the big institutional investors like
TIAA-CREF will buy some of this research. The problem is that
research costs money. It is more objective.
Our system in this country is that the investment banking
fees pay for research at the investment banking houses, but
then it is just so intermingled with conflicts that I wonder
how we can ever really change it.
Mr. Spitzer. Senator, let me pick up on one of the things
you said. I agree with you, there are the other houses, Sanford
Bernstein, others--I do not mean to promote any one--which are
merely--are not involved in the sell side, they are merely buy-
side, and they are advertising these days. If you turn on the
TV, you will see advertising that focuses on the fact that they
do not participate on the sell side, and therefore their
research should have more credibility.
You are correct, unfortunately it has been TIA-CREF, the
major pension funds, the sophisticated investors who have been
able historically to draw these distinctions to tap into that
research. It has been the small investors, the Mr. and Mrs.
Smith referred to in the e-mails, who have been brought into
the retail network of the sell-side houses, the Merrill Lynch,
Salomon Smith Barney retail networks that are out there who
have been, then, the recipients of this research, and hence I
would argue the victims of the conflicts and the tainted
advice.
Senator Fitzgerald. Thank you very much.
Mr. Spitzer. Thank you, sir.
Senator Dorgan. Senator Fitzgerald, thank you very much.
Senator Nelson.
Senator Nelson. Mr. Chairman, I want to thank you and
Senator McCain for just like a pit bull hanging onto this,
because it is a responsibility. It is a unique constitutional
responsibility that we have in the Senate, when something is
out of kilter, when something is wrong, when something is out
of balance, as it clearly was in the decade of the nineties,
and it starts coming to light, that we bore in and we keep
boring.
I appreciate the witness. I am curious, when you found out
about the Merrill Lynch analysts who were promoting the
technology stock based upon decisions on the investment banking
side instead of on the research side, how did you get tipped to
this?
Mr. Spitzer. Well, Senator, it was an unfortunately easy
investigation to conduct. We served a few subpoenas. Merrill
Lynch, to its credit, did not destroy any documents. They
turned over all of their material, and it was there clear as
day. We did not have at that moment anybody who directed us to
a particular stock or a particular transaction. It was a matter
of good, diligent work by the lawyers in my bureau, and I am
enormously proud of them.
I say it was unfortunately easy, because it shows how
brazen this behavior was.
Senator Nelson. Why would Merrill Lynch agree in a
settlement not to admit guilt?
Mr. Spitzer. Well, Senator, there is the entire issue of
the restitution. They paid $100 million as a penalty, or fine.
They are subject, and there have been a significant number of
class action and individual lawsuits filed on behalf of
individual investors who are seeking restitution.
I have no individual opinion about the magnitude of the
settlements or verdicts that will result from those
litigations, but analysts, if we can rely upon them, have
suggested that could range over a billion to $2 billion, and so
they did not want to make a statement that would then, from a
lawyer's perspective, be an admission of liability that would
necessarily lead to that payment. They wanted to put the
individual plaintiffs to the proof, and that is what I think
will happen in the hundreds if not thousands of lawsuits that
are now pending.
Senator Nelson. Well, thank you for you work. I appreciate
it. In my former life as the elected State Insurance
Commissioner, I had to go after a number of big companies, and
if you do not go with--as we say in the south, put your head
down and go forward with an intention that you are going to
prevail you will get thrown off-course by the dilatory tactics
and the nuanced answers and the incredible resources that are
at a number of these companies, and we just need to ferret it
out and get people on the straight and narrow, and get people
heading in the right direction as to what they are supposed to
be, which is protecting their customers and their stockholders.
Let me summarize here portions of the bill that Senator
Carnahan and I have filed, and which have been incorporated in
the Banking Committee bill, the Banking Committee bill to which
I referred earlier that I was shocked last night when Senator
Sarbanes thought it is going to be very difficult to pass this
bill. It sounds like motherhood and apple pie to me, but for
the record, I wish you would comment on portions of this bill
prohibiting auditors from providing any nonaudit services to
their audit clients, the separation of the auditing function
from the consulting function. That is in our bill and in the
banking bill as well.
Mr. Spitzer. I am firmly in support of that. What I have
referred to, I apologize, until now the Sarbanes bill. I will
now call it the Sarbanes-Nelson-Carnahan bill.
[Laughter.]
Senator Nelson. No, around here you give all kinds of
deference to the senior Senators. You bow and scrape to the
chairmen of committees, the Ranking Members of committees, and
I do that with great deference. It is the Sarbanes bill.
[Laughter.]
Mr. Spitzer. Yes, sir. I think the Sarbanes bill is an
absolutely essential step. I think it is a wonderful beginning
at clarifying not only in the context of accountants, which is
not the area we have investigated, but I am familiar with those
provisions, but also in the contexts of analysts and other
areas where Congress should be moving.
I have spoken to Senator Sarbanes, and am fully supportive
of his bill.
Senator Nelson. All right. A comment about closing the
revolving door, where accountants that have been performing the
audit function and all of a sudden get hired in by the company.
Mr. Spitzer. I think that is highly problematic. Just as we
have revolving door concerns in government, because of the
conflicts that emerge and the concerns about the independence
of decisionmaking that results, likewise we have to have that
concern in that context as well.
Senator Nelson. Mr. Chairman, oh boy, is the revolving door
a problem that I see, for example, in the regulation of the
insurance industry, for most of the insurance commissioners in
the country are appointed instead of being elected, and as such
they are appointed out of the insurance industry. They are
appointed Insurance Commissioner by the governor, or whatever
the appointing authority in the state is, and usually they are
less than a year in office, and the revolving door continues,
and they go right back out, back into the industry that they
are supposed to be regulating.
All right, here is another component. Requiring the
rotation of auditors every 7 years, and what the Sarbanes bill
did was require the leading auditor partner to be rotated every
5 years.
Mr. Spitzer. I think that makes perfect sense, and I have
spoken to not only Senator Sarbanes to this and his staff, but
also to Arthur Levitt, the prior Chair of the SEC, with whom I
have had a number of conversations about the issues we are
discussing this morning, and I think that is a very important
proposal.
Senator Nelson. Another component is that the board of
directors must disclose with every filing any director
relationships, such as familial, professional, or financial, to
the company. The banking bill did not go quite that far. It did
require enhanced disclosure, particularly of loans from the
companies to directors and transactions between the management
and the principal stockholders. What do you think about that?
Mr. Spitzer. Absolutely essential, and I would also add
that I think that Dick Grasso's and the New York Stock
Exchange's recommendations about board independence have been
critically important, and I think were a powerful and useful
reaffirmation of how independence should be defined, and how we
need a much more sophisticated interaction between independent
board members and CEOs.
Senator Nelson. All right, here is another interesting
component, that the audit and compensation committee members
must be independent directors instead of inside directors. The
banking bill did not go that far. They did it for--the audit
committee would have to be an independent director. It did not
address the compensation committees.
Mr. Spitzer. I think we need to do more in the area of
compensation. I think one of the things we saw during the
Roaring Nineties was the explosion of option packages that,
while one can theoretically argue in favor of options as an
incentive device for CEOs, they grew so wildly disproportionate
to the return to shareholders that one wonders what was going
on, and there were also options that were, heads I win, tails
you lose, from a shareholder's perspective, so I think a
critical reevaluation of compensation decisionmaking is also
necessary as Dick Grasso argued, and as the Sarbanes bill and
as your proposal called for.
Senator Nelson. Boy, we sure learned that in the Enron
case, and then there is the sense of the Senate that the
commission should take a tough enforcement approach. The actual
committee bill ends up having, the commission has the authority
to take legal, administrative, or disciplinary action. It does
not specifically encourage the tough enforcement approach.
Mr. Spitzer. Well, Senator, as I have said, I think we
would all benefit from a strengthening of the resolve at the
SEC.
Senator Nelson. Well, Mr. Chairman, thank you for indulging
me as I got the expert testimony of our expert witness, which
is all the more testimony that corroborates why a bill that has
been produced by Senator Sarbanes ought not to be heavy
lifting. I mean, we ought to pass this, and yet the hard
reality is, it is going to be difficult to do it. With my
Chairman's help, we are certainly going to try to help the
other Chairman, Senator Sarbanes.
Senator Dorgan. Senator Nelson, thank you. Those were
interesting observations, and I agree with you with respect to
the Sarbanes bill. Let me make a couple of additional comments
and ask a couple of additional questions, Mr. Spitzer, and then
we will adjourn the hearing.
The point that was made by my colleague, Senator
Fitzgerald, is an important one. I think this is complex; it is
difficult to root out all conflicts, there is no question about
that. The issue of advertising, for example, consumers beware.
Advertising that is patently deceptive is illegal, and we have
a Federal Trade Commission that is supposed to be taking action
against it.
If someone is advertising a product that they in their
internal memorandum are saying this product does not work, but
we are out here on TV advertising that it works to cure
hiccoughs or the gout or acne, but internally they are saying
it does not work, that is perpetrating a fraud on the public.
The same is true with respect to securities analysts
working for a firm who are receiving fees from their investment
banking activities, who are internally saying this stock is a
dog, it is not worth anything, but who are on television or in
print saying, ``We recommend as a matter of course, our firm
recommends that this stock has high earnings potential, has
high upside potential, we recommend you buy it.'' That also is
perpetrating a fraud, and so I wanted to make the point that I
think, while this is a difficult area, it is an important area
to be involved in.
I want to go back to testimony last December that was
received by our Subcommittee by Scott Cleland, the CEO of The
Precursor Group, some of the most interesting testimony we have
received. This was last December. I want to read to you what he
says. The Precursor Group is an independent research broker-
dealer which provides investment research to institutional
investors. That is essentially what they are doing, so they are
in a different position than perpetrating sales, but here is
what he says.
``Systemic conflicts of interest are more pervasive and
corrosive than either Congress, regulators, investors, or the
press appreciate. Conflicts of interest are eroding the
integrity and resilience of our capital markets because they
undermine the objectivity, integrity, and accountability of the
watch dogs and the early warning systems that markets depend on
to prevent Enron-type situations from escalating into
disasters.
Millions of trusting American investors have lost big in
the markets in recent years in part because the system has
become so conflict-ridden that the system no longer effectively
serves investor interests but primarily serves company
interests. It appears that the oversight mood has now
shifted,'' and ``more than ever,'' he says, ``we need the
internal controls capital markets rely on--auditors, research
analysts, and boards of directors--to function with integrity
to ensure the protections of investors' financial security.''
When Mr. Cleland testified, I thought it was pretty
remarkable testimony. With 6-months age it appears to be even
more prescient, and I wanted to make that point.
Let me also say again that accountability and
responsibility does not just apply to poor people in America.
We have seen a decade or two here in Congress where people
point fingers at something that has happened that is ugly on
the side of someone who did not have anything, who was abusing
the system. Well, we ought to point fingers at that, but it
does not just apply to poor people when you talk about
accountability and responsibility. It also applies to people at
the top, and there was an insider trading issue that has
arisen.
I mean, we are so surrounded by issues of corporate
governance and swashbuckling behavior in these financial areas
that it is hard to know where to start. I was reading the other
day about an inside trading scandal--I shall not mention the
participants in this, but it is under active investigation--but
this is a case where a large investor is on a private jet to a
foreign land to take a vacation, stops for fuel some place, and
calls the broker back in New York.
Well, you know my point. People take a look at that and
say, well, is this how the system works, and the answer is no,
it does not work for everybody that way. The broad bulk of
people in this country who invest and have a 401(k) think that
everything is on the up-and-up. Everything is honest.
Everything is something they can rely on.
I think it is important to say that there are wonderful
companies out there, wonderful CEO's that run these companies
that produce great products, do a great service to our country
and to the stockholders and shareholders, and we should not
tarnish all of them with these hearings. By the same token,
there are some that are greedy, that take advantage of people,
that are committing criminal acts, that are replete with
conflicts of interest, and we have a responsibility, all of us,
to do something about it.
I want to make one point clear at this hearing. There ought
not be a conflict between federal and state regulators. We have
enough work for both to do, and both ought to work in harmony
and together. I said when I started I feel terrible that I
think our regulators at the federal level have let the American
people down, and to some extent the Congress as well, but we
spend a lot of money creating regulatory systems and funding
agencies, and it is very hard to see that they have been
aggressive or interested or active in what is going on.
As the souped up, turbocharged economy surged forward and
we began to read about the excesses, we have some of these
agencies that are on the sidelines, and I regret that. I think
that is shameful. Let me just ask two additional questions, and
then we will let you go.
In the standards you have suggested, you talk about a wall
between the analysts and the investment bank side. Can you
describe how could one construct that wall? What are the
developments that would lead you to create that?
Mr. Spitzer. There are several issues that one has to think
about in constructing that wall. As I said, it is a subtle
issue that is difficult and has to be parsed, but first and
foremost is compensation. We have promoted and have encouraged
Merrill and the other firms with whom we have been talking to
devise a compensation system for the analyst that disengages
analysts from investment banking, that absolutely prohibits any
factor in the compensation of analysts from being dependent on
deal flow, from the ability of an analyst to get a client in
the door, or any favorable treatment of that client. That is
the rigid, absolute rule that must be followed.
We have also had discussions with the investment banks
about the necessity of ensuring that investment bankers do not
in any way, shape, or form call or excerpt pressure upon the
analysts in any subtle or overt way to change or alter an
evaluation that the analyst might render because the client has
perhaps a conflicting interest, and we also, of course, have
had lengthy conversations about the degree to which the analyst
can in any way, or should interact with the potential client or
an ongoing client in an effort to solicit business from the
outside entity. That is an area where I think, quite frankly, I
wish we could do more.
What we did with Merrill was a first shot at articulating
that boundary line. There is discussion, I believe, amongst
some of those who were thoughtful in this area about
prohibiting analysts from in any way participating in what they
call the pitch, the effort to generate new clients. I think
that would be a very important and positive step forward. It
was not something that we could unilaterally do, but I think it
would be an important step forward.
Senator Dorgan. And finally, in the investigations that you
have been doing, does the culture you describe, the development
of the conflicts that have occurred over time, extend to the
top of these companies, in your judgment? Where does the
knowledge of this practice reach in a corporation, in your
judgment?
Mr. Spitzer. That is a hard question to answer in a
sweeping manner. Part of the problem is that the documentary
evidence does not always establish that information flows to
the very top, but as I have said, I have spoken to hundreds,
literally hundreds of investment bankers, from CEOs down to
line analysts who are straight out of college or B school, and
at every point, every individual, man or woman, has
acknowledged an understanding of this problem, and so yes, I
think there was an understanding to the very top that this was
a problem that was festering, but it was a problem that led to
enormous fee-generations, and as a consequence there was a
failure of will to address it in the ways that leadership
understood that they should have been pursuing.
Senator Dorgan. Mr. Spitzer, let me say for the record that
we also invited the Securities Industry Association to testify
today, but those who would testify on their behalf were not
available today so they declined. I think, had the schedule
been such that we were able to match yours and theirs, they
would have testified. Let me again go back to the question of
Congressman Baker.
It is not my intention at all to cast aspersions here. He
certainly has a right to his opinion. He is a thoughtful
legislator. I would disagree with the publicly stated opinions
of his with respect to what has happened in New York, but his
office did call and inquire of the Subcommittee of the
opportunity to testify. We then called back and indicated we
would invite him to do so, and then apparently his schedule did
not allow him to do that, but I wanted to make clear for the
record that was the case.
Let me again say I think your work is very helpful. I, for
one, appreciate the work you do. Having served in a state
capital for a good number of years, I think much of what goes
on in state government is refreshing and interesting, and you
were able to take effective action where in some cases federal
agencies with far greater resources than you had available to
you either refused to or failed to. I do not know which at this
point, but I commend you for your work, and we will have
additional hearings on this general subject.
Attorney General Spitzer, thank you for being here. This
hearing is adjourned.
[Whereupon, at 11:10 a.m., the Subcommittee adjourned.]