Segment 2 Of 2 Previous Hearing Segment(1)
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ANALYZING THE ANALYSTS
TUESDAY, JULY 31, 2001
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises,
Committee on Financial Services,
Washington, DC.
The subcommittee met, pursuant to call, at 2:05 p.m., in room 2128, Rayburn House Office Building, Hon. Richard H. Baker, [chairman of the subcommittee], presiding.
Present: Chairman Baker; Representatives Castle, Royce, Oxley, Fossella, Toomey, Kanjorski, Bentsen, J. Maloney of Connecticut, LaFalce, Sherman, Inslee, Moore, Gonzalez, Ford, Hinojosa, Lucas, Shows, Crowley, Israel.
Chairman BAKER. I'd like to call this hearing of the Capital Markets Subcommittee to order. I'm advised Members are on their way to the subcommittee, but to try and keep our proceedings on a timely basis, I will open our hearing.
This is the second in a series, and I expect a long series of hearings over the concerns of market practice and the free flow of unbiased information to investors.
Many people have expressed concern over the under-performance of the market over the last few weeks, and individual investors have seen portfolios shrink rather dramatically. That is not the basis on which the subcommittee conducts its review today.
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As always, investors have the ultimate responsibility to make their own determinations based on their own best judgment. However, it has become increasingly clear that market practices are not what they used to be, and, in fact, there will be today, I believe, testimony to indicate that the scope of concerns the subcommittee has had are fully warranted and, in fact, may be more pervasive than originally contemplated.
The purpose of the hearing will be to determine the breadth of those problems and to begin the initial process of assessing the appropriate steps that are responsive to the problems that are identified. As everyone is aware, we have appointed a peer review committee which now has under advisement the best practices standards as issued by the Securities Investment Association, (SIA).
It is our hope that with the information provided in the hearing today, that we can properly assess the effectiveness of those rules and determine what enforcement mechanisms may be appropriate in light of the difficulties that have been determined to date.
I'm particularly grateful for those who are participating on today's panels. There's pretty clear agreement among all the witnesses as to the fact that a problem exists. I suspect there may be some differing opinion as to the remedies that might be appropriate, but I very carefully reviewed all the witnesses' testimony and think the hearing today will be very helpful for the subcommittee in understanding what will be an appropriate remedy to our concerns.
To put a fine point on that process, the subcommittee will conduct a hearing in the fall, after the August recess. We will develop recommendations for the industry to consider, and we will develop a mechanism by which those recommendations can be verified as to the level of compliance.
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However, I should make it fairly straightforward, at least in my opinion, that should there not be an appropriate or adequate response by the industry to the identified public policy concerns, I am not turning my back on the question of providing a legislative remedy should we fall short of achieving the desired goal.
With that, I would like to recognize Mr. Kanjorski, the Ranking Member, for his opening statement.
Mr. KANJORSKI. Thank you, Mr. Chairman.
We meet today for the second time to consider the issue of analyst independence, a subject of great significance to our Nation's capital markets. Increasing the transparency of analysts' work should make it easier to detect faulty research and should enable investors to more easily evaluate the differing views of analysts who cover a particular stock.
Increased transparency should also help restore confidence in Wall Street's research. Since we last met on this subject in June, a number of developments directly affecting the subject of analyst independence have occurred.
Therefore, I will summarize some of these events before we begin today's hearing. First, the National Association of Securities Dealers (NASD) recently proposed changes to its disclosure rules. These amendments propose, among other things, to include common stock as a financial interest that firms and analysts must disclose.
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More importantly, the proposal would also require abbreviated disclosures during public appearances on radio and television shows. When implemented, these changes should help retail investors to better understand analyst conflicts.
Officials with the NASD have also personally assured me that this rulemaking is not the last step that their organization will take to enhance analysts' capabilities. A number of securities firms have additionally announced revisions of their existing policies to manage analysts' conflicts. These changes exceed the recommendations for best practices announced by the SIA at their last hearing.
For example, Merrill Lynch, Edward Jones, and Credit Suisse First Boston have announced plans in July to prohibit their analysts from owning securities in companies they cover in their research. In the coming weeks, I expect other firms will follow the lead of these companies by announcing changes in their own policies and practices designed to increase the independence of research.
Furthermore, the Nation's largest brokerage firm announced that it has agreed to pay $400,000 to a pediatrician in Queens, New York. This doctor claimed that he lost more than one-half million dollars following the advice of his broker who regularly cited the bullish research of a prominent Wall Street analyst.
Although this settlement establishes no legal precedent by itself, it does raise important ramifications for the brokerage business, especially if other investors, in the weeks and months ahead, pursue similar cases.
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I predict that just one or two more settlements of this type will create an incentive for the investment banks to take further action to improve the quality and trustworthiness of their research. Although each of these actions demonstrates that the marketplace has begun to self-regulate on the issue of analyst objectivity, we must still do more.
Mr. Chairman, in the week since our last hearing, the debate has intensified about whether we should privatize Social Security. Social Security presently covers about 160 million persons. Because more than 20 percent of the adult American population is functionally illiterate, we can estimate that about 35 to 40 million Americans cannot read or understand a business prospectus. Yet, we would be asking these very same individuals to make decisions about their retirement funds under Social Security privatization schemes. If they cannot read and comprehend a business plan or an accounting statement, it seems likely that many of these individuals would become reliant on the advice of Wall Street researchers when making their investment decisions.
Therefore, industry has an obligation and a responsibility to comprehensively address the issue of analyst conflicts and resolve all related concerns before we begin any public policy debate on the future of Social Security.
With that said, Mr. Chairman, today's hearing will further our understanding of the nature of this growing problem and help us to discover other actions that might restore the public's trust in analysts.
As you know, I generally favor industry solving its own problems through the use of self-regulation whenever possible. And I was pleased to join you in recent weeks in creating a review board to assess the adequacy of the industry's reform proposals. I will also listen carefully to today's testimony and continue to encourage our subcommittee to move deliberately on these matters in the months ahead.
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As I advised at our last hearing, we should not demagogue on the issue of analyst objectivity to score political points. Only cautious action on this subject will help to ensure that our capital markets remain strong and vibrant.
In closing, analyst independence is an issue of the utmost importance for maintaining the efficiency of and fairness in our Nation's capital markets.
Thank you, Mr. Chairman, for having this hearing today and raising these concerns.
Chairman BAKER. Thank you, Mr. Kanjorski.
Chairman Oxley.
Mr. OXLEY. Thank you, Mr. Chairman. I commend you for holding this important hearing, part of a series of hearings on issues of Wall Street research practices. These practices have come under fire in the past year for some good reason. As we learned at our first hearing on analysts last month, and as even the trade group for analysts acknowledged, conflicts of interest do pervade Wall Street's research machine and taint the recommendations of equity analysts.
There's one reason institutional investors pay little attention to sell side analysts, relying on their own research professionals instead.
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Robert Sanborn, a former portfolio manager of the Oakmark Fund says that anyone who follows a recommendation from a sell side analyst is an absolute fool. Most investment advisors caution investors to consider analysts' recommendations not as definitive in any way, but rather as a single factor in making a buy or sell decision. That is good advice, but even as a single factor in an investment decision, an analyst's recommendation should, at the very least, be free from the taint of bias.
The financial media has played an important role in elevating the profile of Wall Street analysts. Mary Meeker and Henry Blodgett are now familiar names to a large number of American investors. Many have criticized the news media for its failure to hold analysts accountable for wildly wrong predictions. I would urge the news media to require sources to disclose whether they hold any interest in stock, long or short, and whether their firms have business relationships with the company. Then let investors weigh that information. Some news media already take these steps, but it should be universal.
Having said all that, as a free market Republican, I am loathe to legislate in this area. My preference is for industry to clean up its own mess. I'm encouraged by steps that some companies have taken to address the issue. I will continue to work with the industry to make sure sufficient steps are being taken to resolve the problems and to restore confidence in Wall Street research practices.
This subcommittee has established a peer review board of industry practitioners, money managers, academics, and regulators to comment on the industry's proposals for reform. That group will present its findings to the subcommittee at a hearing this fall.
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I look forward to our distinguished witnesses today who will provide new perspectives on the issue including Commissioner Laura Unger, the Acting Chairman, who has done considerable work on this matter as Acting Chairman of the Commission, and on our second panel, a variety of esteemed experts in research and investment banking, and the financial media.
Welcome, Ms. Unger, it's good to have you back before the subcommittee.
Mr. Chairman, I yield back the balance of my time.
Chairman BAKER. Thank you, Mr. Chairman.
Mr. LaFalce.
Mr. LAFALCE. Thank you very much, Mr. Chairman. And thank you, Mr. Kanjorski, for the fine work the two of you have been doing in the hearings you've had thus far on these very, very important securities issues. They, along with the many meetings that I've had with market participants and regulators and academics have increasingly convinced me that analyst conflicts have seriously eroded confidence not only in the capital formation process, but in the way stocks are evaluated by investors who seek objective advice in a very complex marketplace.
It's also become clear to me that the analysts have a role in boosting and supporting the stock price of certain companies. That is but one piece in a series of activities that contributed to the market exuberance of the late 1990s and the early months of this century. We must redress these practices.
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The centrality of the market, as both the measure of a company's success and a fundamental source of wealth creation for insiders especially, has tilted companies' attention toward their stock price and away from the fundamentals of their business.
Executive compensation is now most often intertwined deeply with the performance of a company's stock. The stock price, in turn, is very much affected by the expectation of the securities analysts and the investor community. Companies live and die by meeting analysts' predictions each and every quarter. Missing the estimates by as little as a penny can send a company's stock price plummeting, even when there has been no substantive change in the firm's condition or prospects.
Since the last hearings, the SIA, in an effort to stem the public and vocal tide of criticism, released its voluntary guidelines, and shortly after its release much of the industry claimed they were already following these guidelines.
In response, Ms. Unger was quoted in the press as saying that this would, quote: ''Suggest that perhaps the guidelines need to be enforced more stringently.'' Perhaps so, if you can enforce guidelines.
In any event, shortly following those remarks, in a very positive but telling step, Merrill Lynch, Credit Suisse First Boston, amongst others, barred their analysts from owning the stocks that they cover. Now I think that was a clear indication that something was very wrong. I also think it's a clear indication that the wrong can be righted. As a result, I've communicated with Ms. Unger, and the NASD on two occasions to call for a rulemaking that goes beyond the enhanced disclosure recently proposed by the NASD to amend Rule 2210.
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We know that the role of the analyst is both a mechanism to win business and a voice to speak objectively about the business fundamentals of the companies they cover. This advice is relied upon by small investors and by large investors alike.
What is at risk is often a person's entire future, a person's retirement, a person's financial security, a person's fortune. Conflicts are not simply facts to be disclosed. Conflicts of interest undermine the objectivity of the analyst and the efficacy of the work that they do.
Like any profession that requires trust by the public, conflicts need to be minimized or eliminated, not simply disclosed. Therefore, I have suggested to Ms. Unger, and I invite her to respond today, if not on behalf of the Securities and Exchange Commission (SEC), on behalf of Laura Unger personally, to the following recommendations.
First, to affirm through regulation the actions of companies such as Merrill Lynch and Credit Suisse by banning securities analysts from owing or having an interest in the stocks that they cover.
Second, to engage the academic community, the NASD and market participants to arrive at a workable construct that will alter the present compensation structure of analysts to separate analysts' compensation from their investment banking function, and reward them based on the quality of their research.
Third, to require securities firms to disclose on each research report or recommendation, how many issuers they cover, and an aggregate breakdown by category of the ratings assigned to these issuers. For example, xyz investment firm covers 200 public companies. Of these companies, 50 are strong buys, 100 are buys, 49 are holds, and one is a sell or two are sells or three or four or whatever it may be. But that might put the recommendation in perspective.
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I made additional suggestions to the Commission in late June following this subcommittee's first hearing. Without objection, I would ask that they also be made a part of the record.
Chairman BAKER. Mr. LaFalce, without objection, but I hate to ask if you could begin to close.
Mr. LAFALCE. Yes, I do support many of the modest changes supported by the NASD in its proposed rulemaking. But I'm increasingly concerned that industry self-regulation may not be sufficient and that more disclosure of these conflicts in itself will not suffice to protect the American investor.
So I urge the regulators to act quickly to eliminate these conflicts, because if the regulators do not, Congress must.
Chairman BAKER. Thank you, Mr. LaFalce.
I go next to Mr. Bentsen.
Mr. BENTSEN. Thank you, Mr. Chairman.
Ms. Unger, it's good to have you and the rest of our panel. Mr. Chairman, I appreciate that you are having the second round of hearings on this important issue, and I think the panel that you have today, Ms. Unger from the SEC, and our other, broader panel will be very helpful for both the Congress as well as the public, who is watching this, to get a better understanding of both how the process of research analyst works as well as what, if any, the response from the Federal Government should be.
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However, I would caution my colleagues, and I would caution the Securities and Exchange Commission to be careful in our attempt to, as we look for a culprit for the collapse—or I don't want to use the word collapse—but the rapid decline in the value of certain markets, that we shouldn't try and go and pin it, in this instance, on the case of the research analyst and try and sterilize the research business.
I would remind my colleagues that on the books we have existing securities laws, existing disclosure laws which, whether or not people are actually looking at what is being disclosed, is something that we should not ignore.
Second of all, I think we have to be realistic and understand that this is a problem that the industry not only has a responsibility to the general public, but has a responsibility to their own shareholders and their own partners to fix. I think that any firm which gains a reputation of irrational research will soon find that reflected in their bottom line.
So I would hope that we gather as much information as we can, but that we proceed very cautiously in this approach, and that we do not try to equate the research business in the same way as we might equate the auditing business. Because, in this Member's opinion, those are two very, very different things.
I thank the Chairman for calling this hearing.
Chairman BAKER. Thank you, Mr. Bentsen.
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Mr. Fossella.
Mr. FOSSELLA. Thank you, Mr. Chairman.
To follow up on my colleague, Mr. Bentsen, it's a great thing that more Americans have become investors. I think it's a healthy thing. I think what is important, as well, is to remind all Americans who want to become investors that it's in their interest to become educated for their own good.
We acknowledge the critical role I think that research analysts play in developing the markets and maintaining the integrity of the markets, and ultimately providing a service not only to their companies and firms, but to ordinary investors across this country.
I think that what's happened in the last several weeks is a positive thing, that is, the industry, I think, has identified that there seems to be a problem. While the vast majority of individuals who work for these firms I think are of the utmost integrity, they have to comply with their own firms' standards, and deal with the SEC, among other regulatory entities, to comply with the law, there seems to be a strong belief that something needs to change.
Some firms I think initially have thought that the best practices in events recommended by the SIA are necessary. It is healthy and good that some firms have said, no, I think we need to make some changes and modifications to our practices.
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What's left to be asked, however, is how much time should the industry have in order to change the way they go about these practices. There are different firms. Each firm has a different standard. How is it that the SEC is going to look upon the implementation of these best practices to ensure that as many firms as possible, if at all, are going to comply? You look at a Merrill Lynch, it has a different standard than a First Boston and a different standard than Salomon.
I think over time it's up to the SEC to put a timeframe on those, is it 3 months?; is it 6 months?; is it after bonuses are given in December, to see if these things are working?
I share Mr. Bentsen's views, and I believe my other colleagues who have said let's not jump to legislative remedies for this, because ultimately it's up to the investor to beware. But there is a degree, and a large degree of questions at stake with those few research analysts who compromise not only themselves, but their firm's integrity, as well as that of the individual investor.
There are going to be conflicts always. There's no question about it. You have the responsibility, and I think you would do well to ensure that those conflicts and compromises are kept at a minimum. As the market decreases, it did so rapidly in less than a year, people are going to start pointing fingers and looking for someone to blame.
I don't think that's the right thing to do in the long term. The right thing to do in the long term is to bring all these firms as close as possible to the best practices as recommended by the SIA and try to take another snapshot, in say 6 months' time to see what's happened. But the rush to judgment may just be a big mistake.
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I yield back.
Chairman BAKER. Thank you, Mr. Fossella.
Does any other Member have an opening statement?
[No response.]
Chairman BAKER. If not, it would be my intention to recess pending the floor, Ms. Unger. I'll come back very quickly. My best guess is that that will take me about 10 to 12 minutes, and then we'll get started.
Thank you very much.
[Recess.]
Chairman BAKER. I'd like to reconvene our hearing. We had two votes instead of one so we were detained a little. The other Members will be returning as soon as possible.
I'd like at this time to recognize our first witness for today's hearing, The Honorable Laura Unger, Acting Chairman of the Securities and Exchange Commission, certainly no stranger to the subcommittee.
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Welcome, Ms. Unger.
STATEMENT OF HON. LAURA S. UNGER, ACTING CHAIRMAN, U.S. SECURITIES AND EXCHANGE COMMISSION
Ms. UNGER. Thank you very much, Chairman Baker, and others who may be returning to the hearing. A lot of what was said really resonated with me, and I think you'll find that what I say today will resonate with you.
I thank you for the opportunity to address the subcommittee today concerning analysts' conflict of interest. The Commission commends the subcommittee for its continued attention to this important issue. I thought I would spend my time this afternoon addressing three issues.
The first is, what conflicts affect analysts and why do these conflicts exist? The second is, what have we observed about analyst conflicts as a result of our staff's recent exams of brokerage firms? The third is, what is being done to address these conflicts?
Before I turn to these particular questions, I think a preliminary remark is in order. It is fair to say, as others have said today, that it has not been a banner year for analysts. The profession has been the subject of intense public scrutiny. In many respects, analysts are a victim of their own success. The longstanding bull market and the record number of Initial Public Offerings (IPOs) made research—and the positive impact on stock price that research could have—a basis on which investment banking firms competed for underwriting business.
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But I think it's important for us not to lose sight of the important role that analysts play in our securities markets. As the Commission recently stated, in adopting Regulation Fair Disclosure (FD), analysts provide a valuable service in sifting through and extracting information, the significance of which might not otherwise be apparent to the ordinary investor.
We should also not forget that the overriding majority of analysts operate on the highest ethical plane. In other words, the issue of analysts' conflicts is largely structural and not personal.
With that preface, I will begin by identifying a few of the more acute conflicts. Most stem from the blurring of the lines between research and investment banking that I just alluded to. This blurring can be seen in a number of ways. First, an analyst's salary and bonus may be linked to the profitability of the firm's investment banking business, motivating analysts to produce favorable research that will attract and retain investment banking clients for the firm.
Second, at some firms, analysts are accountable to investment banking for their ratings. Third, analysts sometimes own a piece of a company that they cover, mostly through pre-IPO share acquisitions.
SEC staff has conducted on-site examinations of several full service brokerage firms, focusing on analysts' conflicts of interest. The staff, in its examinations, selected nine firms that underwrote significant numbers of IPOs, particularly internet and technology-related IPOs. These examinations focused on the three areas that I just mentioned: compensation arrangements; analysts' accountability to investment banking; and analysts' financial interest in companies they cover.
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Today, I will share with you some of the preliminary observations. The first is that the line between research and investment banking, has indeed blurred. Seven of the nine firms inspected reported that investment banking had input into analysts' bonuses and the analyst hiring process. In at least one of those firms, 90 percent of the analyst's bonus is based on investment banking revenue.
The staff inspections found that the investment banking department does not formally supervise the research department, but that analysts assist investment banking by consulting on IPOs, mergers and acquisitions, participating in pre-IPO road shows, and initiating research of prospective investment banking clients.
Second, interviews with former analysts revealed that it was well understood that they were not permitted to issue negative opinions about investment banking clients.
Third, about one-quarter of the analysts inspected owned securities in companies they covered.
The staff found that 16 of 57 analysts reviewed made 39 investments in a company they later covered. All of the investments were pre-IPO. Moreover, the examiners found that three of these analysts traded contrary to their research report recommendations. Examiners also found that in 26 of 97 lockups reviewed, research analysts may have issued ''booster shot'' research reports. These reports reiterated buy recommendations shortly before or just after the expiration of the lockup period.
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As you know, a lockup is the time period during which insiders and others who have obtained pre-IPO shares are prohibited from selling those shares. In each of these instances, the firms underwrote the IPO of the company in which the firm's analysts owned stock. So, you may ask what is being done to address these conflicts?
As has been noted today, the industry, the Self Regulatory Organizations (SROs), and the Commission have taken action to improve the objectivity and independence of research analysts. Both the SIA and the Association for Investment Management and Research recently issued a set of best practices in this area. These best practices provide a basis or foundation for on-going discussions about managing conflicts.
Firms are reviewing their internal policies and procedures. Several securities firms have already taken some initiatives to revise their existing policies and procedures to manage conflicts. As reported in the press, at least three securities firms have recently adopted policies that prohibit analysts from owning securities in companies they cover.
The NASD recently proposed for member comment changes to enhance and harmonize its conflict disclosure rule. The Commission has two roles in managing analyst conflicts. The first is making sure that disclosure is adequate and effective. The second is educating investors.
So far, we have worked with the SROs to improve and more diligently enforce the disclosure of conflicts of interest. Our Office of Investor Education and Assistance has also issued an Investor Alert to explain to investors exactly what conflicts analysts may face and how investors should interpret disclosures about these conflicts.
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I believe investor education is particularly vital to managing analyst risk. I say this because we can really only manage the conflicts. Some conflicts will always exist, such as pressure from institutional investor clients protecting their portfolio value, and pressure from issuers who put analysts in the dog house for downgrading their stock.
It is my hope that with a little help from the regulators, the industry will resolve these issues. The recent industry initiatives are a step in the right direction. But I would be remiss, especially as a former enforcement attorney, if I did not emphasize that the industry and the SRO initiatives will only succeed with vigorous enforcement.
The SEC staff inspections revealed that firms had policies on the books that were virtually ignored and rarely enforced in practice. For example, one firm approved an analyst's pre-IPO investment 3 years after the fact. In another example, only one firm could identify accurately all pre-IPO investments by analysts. This situation cannot continue. The firms, the SROs, and the SEC must work together to ensure that we have information with integrity out in the marketplace.
I look forward to continuing this partnership. Thank you, Mr. Chairman. I will now be happy to answer any questions.
Chairman BAKER. Thank you very much. I was optimistic that your testimony would satisfy all the concerns of the subcommittee and I think you've done an outstanding job of energizing the subcommittee's concerns.
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Ms. UNGER. Thank you.
Chairman BAKER. There is considerable content to your testimony that I would like to question you about, but I'm going to focus on two or three things that I think are particularly disturbing.
Examiners found that three analysts executed trades for their personal accounts which were contrary to the recommendations in their research report. That's from page 6, footnote 8. It goes on to say, and this is what really got me concerned, that the analysts' profits generated by acting in what I think is at least unethical if not a violation of some rule somewhere, between $100,000 and $3.5 million for each transaction by selling their shares while continuing to maintain buy recommendations. One analyst sold securities short while maintaining a buy recommendation on the subject company.
What was the scope time-wise of your inquiry in the market? How recent are these examinations that led you to this discovery?
Ms. UNGER. The examinations occurred in 1999 and 2000. What we saw as far as the scenario you just mentioned in terms of analysts deriving significant profits from selling activity contrary to their recommendations is something that we are taking a very close look at. And in fact, in those cases, it's possible that the analysts violated not only firm policies, but also the Federal Securities laws.
Chairman BAKER. That really was my next question. Was there a regulation, a professional standard of conduct, or a statute, and if not, I would welcome, once your review is finished, advising the subcommittee as to what, if needed, any steps might be taken. I find it frankly appalling that someone could tell me to buy while they're selling in the back room profiting from my investment.
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If that's not a bedrock of necessity to correct, there is nothing in this marketplace that we can correct. I just found that very troubling.
The staff found instances in which the analysts' ownership in stock of the covered company was not disclosed in the research at all. Now I have trouble with the boilerplate that says we may have an interest, but to not say it at all is not a violation of current practice or regulation or is there any rule that says you have to disclose at least that the firm may have an interest?
Ms. UNGER. Well, this is part of the problem. The New York Stock Exchange has rules, as does the NASD. There is a disparity between what each of the SROs require in terms of disclosure. For example, one SRO requires that the firm disclose the common stock position, and the other doesn't. One SRO requires that there be a disclosure of the investment banking relationship that's more detailed than another.
And so what we really need to do as a first step is harmonize the existing SRO rules to make it easier for firms to comply with those rules.
Chairman BAKER. I think the subcommittee would be interested. Again, one of the footnotes, page 8, footnote ten, despite the language of the rule, the NASD has stated that it does not interpret the disclosure requirement to apply to media appearances by analysts. So the SRO doesn't see anything wrong with someone getting on the television set saying what a great investment opportunity this is and there are no consequences. In fact, it doesn't violate the code of conduct.
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Again, I commend you for great testimony, but you've just increased our workload here for the considerable future. If we don't now have rules sufficient to govern practice from the SRO, I think we have a long struggle to get the industry to get where I believe you think they ought to be without significant encouragement.
Ms. UNGER. Well, the Commission, as you know, has been engaged in a dialogue over at least the last year with the NASD about their interpretation of what disclosures must be made by analysts in media appearances.
Chairman BAKER. Well, for what it's worth, I'd like to see a Surgeon General's warning that says, ''Warning. I have an interest in this thing I'm talking about,'' kind of flashes on the screen.
Ms. UNGER. Well, we have taken the position that the disclosure requirement applies irrespective of the media.
Chairman BAKER. Absolutely. Just because you whisper it instead of standing up and saying it in public is no different, you still have to disclose.
Ms. UNGER. I think the NASD is coming around to that viewpoint.
Chairman BAKER. Well, for what it's worth, I hope we can encourage them.
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I have one more point I want to make, but my time's coming to an end, and so I'll do it real quickly. This is a what-if, and you may not be comfortable to comment today. But let's assume we had a standard of conduct which we all would prescribe as being good, and that we were able to get the industry to voluntarily implement that standard. We don't have it and we're not there yet. But assume for the moment we had it.
The other point of your testimony was many of the organizations have very well written, very well thought out codes of conduct, but they're also ignored. So we have pretty books sitting on the shelf that nobody reads.
What we need, no matter what the standard may look like, is someone to determine compliance and a consequence for not having compliance. It seems to me there is a great deal of non-compliance and there's no consequence. For example, the fellows who are trading against their public position.
What would be the effect of having just a grading system, A, B, C, for example, real simple. A you comply with everything, B you're pretty close, but you're not there, and C you better really get your stuff together or bad things are going to happen.
Now I don't know whether that would be the role of the SEC, the NASD, the SRO, but there has to be some measure of performance of your conduct, because without that, the market can't act and bring about the discipline we all want.
Can you comment generally on the idea?
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Ms. UNGER. You are correct. I would like to see the SROs first make the disclosure requirements crystal clear and consistent. I would next like to see the firms adopt policies across the board that would make disclosure with the requirements an everyday practice, and then I think we need to ensure a way for firms to enforce those rules.
And what you've described is certainly one way and a powerful incentive, I'm sure, for the firms to comply with their own internal policies which in turn comply with the existing SRO rules, or soon to be existing SRO rules.
I'm not sure what the extent of the SEC's involvement would be in something like that. I would prefer the Agency not to have any type of merit review, because we are traditionally not involved in merit review, and this would be something like that. I think we could be helpful in the process of developing standards and certainly we'd like to be engaged in the dialogue.
Chairman BAKER. But do you see merit in the public disclosure of outcomes? That's really my point, that today there are—although we all wish for self-discipline in the market—there is are consequence if you do not, and you can't make an informed judgment as an investor unless you know how the company functions. And it appears to be a very difficult determination to make today.
Ms. UNGER. The Commission often uses disclosure as a means of discipline.
Chairman BAKER. Thank you. I've exhausted my time.
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Mr. Bentsen.
Mr. BENTSEN. Thank you, Mr. Chairman.
Ms. Unger, let me ask you this at the outset, because of how this is being portrayed and I want to make sure that I don't dig myself in too deep in the situation, because I'm a little worried that we're on a little bit of a witch hunt here.
But do you believe that given the current situation and the concerns about conflicts of interests with analysts, that this is something akin to—there was a movie called ''Game Show'' about the 1950s and the hearings in Congress, long before you and I were born.
Ms. UNGER. Yes, I know what you're talking about.
Mr. BENTSEN. But it was sort of a rigged market. Is that your perception?
Ms. UNGER. No. And I think maybe you missed my opening comment where I said that, in fact, analysts perform a critical role in today's market, and in large part, they are victims of their own success.
I think what's happened is that the market was so strong for so long and with the huge influx of IPO activity, firms looked for ways to compete to get that IPO business. Part of the way they began competing was to include analysts in the mix. The ability to provide favorable analyst coverage became part of the mix of services the investment banking firm offered clients.
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Mr. BENTSEN. Let me ask you this. I mean, hasn't the analyst position always been part of the mix of investment banking and the mix of the trading and underwriting? I mean, haven't brokerage houses always relied, at least for internal purposes, for their own internal credit risk purposes, on the work of their research analysts?
Ms. UNGER. Well, I hate to do this, because it always seems like we point to the deregulation of commissions as the pivotal point for changes in the industry, but I do think that had some impact on the underwriting business. Commissions were where most of the money was being made by Wall Street at that time, and deregulation changed the focus of that business and how that business was conducted, and what made it profitable.
I think analysts have probably always been involved in the deals, but not to the extent that they are now, and not to the extent that they have become so idolized in some respects.
Mr. BENTSEN. Well, they have become the masters of the universe, I guess, of the 1990s, as opposed to the investment bankers of the 1980s, at least in the media's eyes.
Let me ask you this. Is there anything under the existing securities laws that subjects analysts' documents, analysts' reports or whatever, to the same disclosure requirements that are required of offering documents. And if not, should there be?
And furthermore, didn't the Commission, just a few years ago, pass—I can't remember what the colloquial term was for this—but a plain English approach to the writing of offering documents so that they would be more easily understandable and possibly used by the public?
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Ms. UNGER. Well, it's interesting, because you raise, I think, a critical point in the discussion which is not only have the dynamics of the marketplace changed the role of analysts, but the role of research reports themselves and the extent of their availability have also changed. Investors can now access research reports that they were not able to before, as a result of the internet.
So what does this mean in terms of how the Commission needs to educate investors about the conflicts, and what investors need to know in using these research reports? Yes, there are the offering documents; yes, they are subject to review by the Commission, but we don't have the resources, nor would we want to be engaged in merit review with respect to the contents of a research report.
Mr. BENTSEN. Well then, in fact, the law doesn't cover the research documents in the same way, I don't think, as it does the offering documents.
Let me ask you one more question.
Ms. UNGER. Well it's slightly different, because Section 11 is strict liability for what is contained in a registration statement.
Mr. BENTSEN. Right.
Ms. UNGER. Section 10(b), the anti-fraud provision, applies to everything.
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Mr. BENTSEN. Let me ask you this, because my time is up, but I want to ask you this. Can you be concerned about conflicts of interest between analysts and companies and be opposed to Reg FD, and be consistent?
Ms. UNGER. I'm sorry, can you repeat that?
Mr. BENTSEN. Can you be concerned about potential conflicts of interest between research analysts and the companies that they review and the relationship with the investment banks, and also be opposed to Reg FD and be consistent?
Ms. UNGER. Me personally?
Mr. BENTSEN. In general.
Ms. UNGER. Yes, I think you can, because I think you can note that the conflicts exist, but I believe that Regulation FD does not cure the conflicts. Reg FD goes to communications between an issuer and an analyst and not to insider trading, which was purported to be the original objective or reasoning for Reg FD's adoption.
So it depends how far you want to go with the conflicts. The conflicts are the underpinnings of the discussion on both Regulation FD and today's hearing, but in a very different way.
Mr. BENTSEN. Thank you. Thank you, Mr. Chairman.
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Chairman BAKER. Thank you, Mr. Bentsen.
Mr. Castle.
Mr. CASTLE. Thank you, Mr. Chairman. I have an opening statement which I would like to submit for the record.
Chairman BAKER. Without objection.
Mr. CASTLE. Thank you.
Ms. Unger, I have some questions. I've got to tell you that this whole practice bothers me a tremendous amount. And I, in my opening statement that I've just submitted, state that I don't think we should legislate in this area. But I'm just not sure anymore. I mean, I'm becoming more and increasingly concerned. I mean, there could be anything from just bad analysis which of course should not be punishable by anything to the classification situation, to the so-called ''hold'' business, which apparently is a red flag to sell which most of us never understood, except for the analysts owning the stock, to the firm for which the analyst works owning the stock and the retirement accounts or otherwise, or other individuals just having big placements in that particular stock that the analyst is recommending or the investment banking side of the firm owning it, or the analysts' compensation being tied to overall profits of the firm for which the analyst works, or the analyst being involved in the early IPOs at a lower price than the IPO is going to come out, and then huckstering it in some way or another, either verbally or in writing some way or another.
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Are there any situations such as that where the SEC does step in now?
Ms. UNGER. Step in and do what?
Mr. CASTLE. Step in and enforce, do something about it?
Ms. UNGER. There are instances——
Mr. CASTLE. Are any of those things violations of laws or regulations at this point?
Ms. UNGER. I wish you had asked me that before you enumerated them. None of them jumped out at me as violations of the law, but I will say that the Commission looks very closely at what's disclosed, whether there was material information that was not disclosed by an analyst and the firm's involvement in recommending and selling. But sometimes you can't just look at one particular activity—you need to look at the whole picture to really get a sense of whether it's an area for an enforcement action or not.
But yes, we brought cases involving analysts.
Mr. CASTLE. You have brought cases that just involve the analyst side of it, is that?
Ms. UNGER. Well, we've brought cases where an analyst was making reckless statements——
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Mr. CASTLE. Are these penny stock-type cases or are these major firms that may have these conflicts in which you've brought the cases?
Ms. UNGER. There's a handful of cases that I could get you more information about if you're interested.
Mr. CASTLE. I mean my judgment is there have been billions of dollars put on the table as a result of a lot of these practices and which probably occasion losses of a tremendous amount. Do you trust the industry itself to be able to do this as a self-regulatory matter, or does the SEC have to get tougher with its enforcement in order to back that up? Or should we be passing laws up here which frankly I'm loathe to do, but is that something we should be considering?
Ms. UNGER. Well, I think there are three prongs. One is compensation, one is the accountability of analysts to investment banking, and the third is the stock ownership. And I think you need to look at each one of those individually in determining whether or not there are issues that need to be addressed.
I think there are disclosures that apply in each of these areas and there are existing rules that, as I said earlier, need to be harmonized and clarified and followed. And I think we need to do a better job, the industry and the SROs need to do a better job in inspecting firms to make sure that they comply with rules that are on the books and rules that are about to be improved that will be on the books.
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I also think that the firms need to do a better job of ensuring compliance with their existing internal policies and procedures, most of which exist at the firms that were inspected, most of which are not being enforced adequately today.
Mr. CASTLE. Well, and you're right. I mean, there's a whole level of enforcement in various ways. But do you believe that the SEC should change its rules and regulations or specifically its enforcement mechanisms to address some of the problems which you have spoken to in your opening statement, which we've had another hearing, which I'm sure you're familiar with, and which is going to be continued later today by another panel involving a number of the different situations that I have set forth, all of which you're familiar with in terms of different practices that are at least questionable.
Or do you think the SEC is fine the way it is?
Ms. UNGER. The SEC has broad antifraud authority. We have ample authority to bring cases involving fraud and violations of Section 10(b) and Rule 10(b)(5). The first line of defense in this whole discussion about managing analyst conflicts really are the SROs whose rules deal with this more directly than the Commission.
Again, I think we all need to do a better job. I think of course the Commission is doing a great job, but we need to do more in our oversight of the SROs in making sure that they conduct the inspections and examinations that are needed to determine whether the firms have the appropriate policies and whether the policies are being followed.
I think that's really the first step that we need to take in this discussion which I think is why the Chairman of this subcommittee is asking about ways to improve enforcement efforts and make the firms accountable to the public in terms of what they're doing internally.
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Mr. CASTLE. Well, my time is up, but I mean, this won't be a question but, you know, I think it's our job to worry about the consumer out there. I can't worry about the big firms, I can't worry about the practice of the SEC, but I think a consumer should be able to look at an analyst's recommendation on a stock and it could be wrong, but at least it should be done with integrity and honesty and they get a pretty good idea of what they're dealing with.
Until we've gotten to that point, it seems to me we all haven't done our job. And I yield back the balance of my time.
Chairman BAKER. Mr. Castle, just to finish up on your point, in earlier questions to Ms. Unger, I've made reference to her footnotes of her own document. In just one transaction, the fellow profited $3.5 million by selling his interest while publicly telling his clients to buy. On its face, unless it's the gentleman's estate—that's the only reason I could see it would be OK—that in itself is a serious problem, and yet that is under advisement at the moment for determination as to whether action is appropriate or not. That is a very large concern. Your point is right on target.
Mr. Kanjorski.
Mr. KANJORSKI. Thank you, Mr. Chairman.
I wanted to follow up. Did I hear you respond to Mr. Bentsen that you don't have the resources to do some of the things you'd like to do?
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Ms. UNGER. We would always like to have more resources, but I don't think that merit review of analyst research reports is something that's appropriate for the agency, given our mandate as it exists today.
Mr. KANJORSKI. So in order to have you do something, we would have to enact statutory law to give you greater authority or direction to do that?
Ms. UNGER. I guess you would, but I also don't think it's a good idea. With all due deference to this subcommittee, I think the problem is in managing the conflicts. Whether the Commission reviews the substance of the research or not, you still have the issue of the conflicts and managing those conflicts.
Mr. KANJORSKI. Let me direct ourselves to some of those conflicts. The Chairman and I were talking when we went over to the vote, particularly about these transactions that you mention in your testimony. One example is that of pools of analysts that were investing and giving advice to buy when, in fact, they were selling, and, in fact, they were making single transactions in the range of $100,000 to $3.5 million.
I think the Chairman made the observation that if this activity happened in Louisiana real estate, there'd be somebody in jail.
Chairman BAKER. That's a pretty bad comment too. You know, when you think about it, when we put anybody in jail in Louisiana, they've got to really be out of it.
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Mr. KANJORSKI. And I tend to agree with him. Doesn't that constitute fraud? Forgetting conflicts, isn't that just out and out fraud?
Ms. UNGER. I did say we were reviewing these particular transactions.
Mr. KANJORSKI. How long ago did these transactions happen, Ms. Unger?
Ms. UNGER. 1999 and 2000.
Mr. KANJORSKI. So they are almost 2 years old and we're still reviewing those transactions? The reason I asked you how long is because I recall from law school that most of the court decisions on bills and notes were around 1934, 1935 and 1936. It seems to happen that we want to find somebody at fault or responsible when the market crashes.
What I am wondering is why these transactions were going on when the market was pretty healthy in 1999 and 2000. Are you intending that we realize that you didn't know at that time? Did you just found out recently? Or did you know in 1999 and 2000 before the market crashed?
Ms. UNGER. Well, no, we did just find out last month, and in fact, I think it would be highly unlikely that anyone would be making that kind of money in today's market.
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Mr. KANJORSKI. OK, but when did you find out about it, I said?
Ms. UNGER. Pardon me?
Mr. KANJORSKI. When did you find out?
Ms. UNGER. We have just been conducting these reviews about analyst conflicts.
Mr. KANJORSKI. So there isn't any reporting or any way that you could pick that up without doing these reviews?
Ms. UNGER. No. There are inconsistent requirements that exist currently, SRO requirements, about the firms' disclosure of stock ownership.
Mr. KANJORSKI. Did they make the proper disclosures in a timely manner?
Ms. UNGER. This is what I'm trying to explain to you. Of the firms we inspected, which were nine firms that account for the majority of the IPO and technology underwritings, only one of the firms was able to give us a list of employees who invested pre-IPO in a company that the firm had as a client.
So in fact, the internal controls at the firms apparently did not require this information.
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Mr. KANJORSKI. And you have no regulations that require that internal information?
Ms. UNGER. They are required to make the disclosure.
Mr. KANJORSKI. Under your regulations they're required to make it?
Ms. UNGER. No, under the SRO regulations, they're required to disclose in the research report, depending on which regulation you're looking at, the firm is required to disclose certain ownership positions.
Mr. KANJORSKI. I understand that. I have limited time, and I'm trying to rush you along.
What I understand is they didn't make the disclosure, and they may not have had the internal controls to do that. However, neither do you have the internal controls to know that they weren't doing that.
Somebody here is responsible at the end to know whether or not these SROs are doing what they are supposed to do, or whether or not you have a requirement to find that out in a reasonable time: I think 2 years is beyond a reasonable time.
And then for you to tell me you're reviewing these things; these guys may retire or die before you get all done with those reviews. And I think the Governor made a good point. You know, we're not worried about the big, the conflict, quote: ''that may exist between the analyst and his own company.'' I don't know if there is a clear conflict with those ten million people who are watching nightly television and listen to this guy saying, ''Oh, this is a great buy.'' And I watch them every night. And I have yet to hear anybody telling me to sell. And they're still doing it. And every now and then they do say, ''Oh, our company does have stock in them or represent them in some stock offering.'' I don't understand it.
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I want to get to the point. What I'm indicating to you is, if you don't have the authority to test whether the SROs have internal controls and are properly reporting or having transparency back to the SEC, then you should be up here asking us for that authority.
But second, I'm worried about another thing that I brought up in my opening statement. You're sitting back here and there is a public policy decision that's going to be made probably in the next 6 months or a year, but certainly within the next 18 months, to privatize Social Security. We're going to throw 160 million consumers into the marketplace, 25 to 30 percent of which are functionally illiterate. That 25 to 30 percent are going to be guiding their own accounts.
Has the SEC started to enlarge its structure and anticipate what is about to happen, which could cause massive fraud and conflict of interest if all these billions of dollars and millions of people come into the marketplace? Or are you just going to wait around and have this happen and then come in and say—2-3 years after the fact, that you have a problem?
Aren't you anticipating that if we, as a matter of public policy, decide to privatize Social Security, then we are putting at least another 80 to 100 million people into the market that have never been there before? And aren't a good portion of these people not qualified to read financial statements and understand this information? Many certainly are not qualified in ''newspeak,'' and I think that is what we are talking about here. We're in 1984. These people are using terms that are not standardized. The language that sometimes is only understood within their own house or within a limited number of houses, but certainly not by the general public.
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And it just seems to me that the SEC ought to be proactive in anticipating what is about to occur, what may occur. Looking back at these experiences that you have been reviewing for the last 2 years and anticipating how they will be compounded if we put another 50 or 80 million people into the marketplace.
Instead, 2 years after we do that, we are going to have a hearing within the halls of Congress filled with a lot of middle-aged and older people that will claim that we led them down the primrose path. They will say we drove them to take their 2 percent of Social Security and invest in these horrendous start-up entities that weren't regulated, weren't controlled, and didn't have transparency: and they will claim ''people were telling us to buy and we bought, and then some people who were telling us to buy were selling and cleaning up and making $3 million per transaction.''
What is your response to that?
Ms. UNGER. Are we talking about Social Security or analysts' conflicts now?
Mr. KANJORSKI. I'm talking about looking at what we've already seen in a hyper market in 1999 and 2000.
Ms. UNGER. Just the market generally?
Mr. KANJORSKI. With analysts and anticipating what may happen if we enlarge this market by 80 million more customers?
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Ms. UNGER. Well, as part of my testimony, I said I thought the SEC's role in analyst conflicts was disclosure and educating investors. We have put out a very comprehensive and well-received ''Investor Alert'' about analysts' conflicts so that investors would understand exactly what we're talking about and to highlight for them what analysts' conflicts are and how they should approach interpreting a research report.
I would never counsel, and I think many people have said that no investor should rely exclusively on an analyst research report or recommendation in making an investment decision. The Commission generally is very proactive in terms of investor education.
I presume that if Social Security were privatized and there were special needs presented to the marketplace and to the Commission, we would attempt to fulfill those special needs by outreach in further investor education.
With respect to the analysts' conflicts we're talking about today, it was the SROs' responsibility to supervise and monitor and inspect for the private investments by the analysts and the firms at which the analysts work.
Mr. KANJORSKI. I love the terminology education and I do appreciate it and I hope you're very successful in educating all the people that are in the marketplace today. However, I doubt that you are going to give them the equivalency of a working understanding of the marketplace and terminology, but I'm not talking about those people. I'm talking about knowledge that there are 20 to 25 percent of the American people that are functionally illiterate. They cannot even fill out an application form, let alone read a profit and loss statement or a balance sheet.
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Are you suggesting to me that you're going to put together an investor educational program that are going to take 25 percent of the American population's functional illiterate and have them understand what they need to understand to be privatized and investors in the marketplace and not have to rely on analysts or security house recommendations?
Ms. UNGER. Well, if they are functionally illiterate, they're not reading research reports either, are they?
Mr. KANJORSKI. No, I doubt it. That's why I'm suggesting that.
Ms. UNGER. Just checking.
Mr. KANJORSKI. Well, that's the next question. Have you been asked for, or have you been given by either the Commission or this Administration, recommendations as to whether or not we should privatize Social Security and put 160 million more Americans in the stock market? And are they qualified by basic learning and education to manage their accounts, or are we setting them up for a tremendous let-down?
Ms. UNGER. Commissioner Carey, who recently passed away, was the Commission's expert on Social Security privatization and he did a lot of work on that. And I commend him for that work. He, however, is no longer with us, and we have not yet determined who will take on that responsibility at the Commission.
Mr. KANJORSKI. Are you prepared though to make a recommendation to the Congress?
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Ms. UNGER. We have not adopted a Commission position yet on Social Security privatization. There've been numerous different permutations of how that could occur. We would be happy to participate in any discussions about Social Security privatization.
Mr. KANJORSKI. Could you succinctly tell me, though, have you made a recommendation, positive or negative, on that particular issue? Are we prepared to see 40 million functionally illiterate Americans put into the market?
Ms. UNGER. We have not adopted a Commission position.
Chairman BAKER. We'll have to move on.
Mr. Royce.
Mr. ROYCE. Thank you, Mr. Chairman.
Chairman Unger, one of the things I was going to ask about is the interviews that we have with people who are analysts, the information that we've received indicate that one of the things that's changed on Wall Street is the business model. One of the things that used to drive profitability was revenues from research and trading, and as that began to decrease, it was supplanted instead by enormous revenue gains from initial public stock offerings. As you saw a 15-fold increase over a decade in the fees coming into the firms, then the business models changed.
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And the allegation here is that included in that change was a change in the way the analysts were compensated. In the past, bonuses were given to analysts based on research quality, or on the brokerage arm's profitability.
Now it is common for those bonuses instead, and typically this would be the bulk of their annual compensation at most of the firms, to be tied to the amount of banking business that they generate for the firm. And that change in business model could explain a lot. It certainly could explain the disparity between positive and negative recommendations. Could it be that analysts are fearful of offending their banking colleagues and fearful of those existing underwriting clients or potential underwriting clients? I mean, why would it be that only two percent of the stocks covered would have that sell rating? I mean, that's one of the things I wanted to ask you.
Another question that I had, we have a witness coming on to the next panel and he submitted his testimony in advance, Chris Byron. And he calls this an outrageous situation. He says IPOs are offered to investment bank clients at cheap pre-market prices even as the bank's analysts engage in non-stop commentary designed to pump up demand for the stock in the after-market.
And I wanted to ask you also what is your view of that practice, OK?
Ms. UNGER. OK. I will try to address those questions in totality.
Mr. ROYCE. Thank you.
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Ms. UNGER. I agree that there has been a change in the business model which has led to a lot of what we're talking about today. It's not just the investment banking client that applies the pressure though; it's also the institutional investors who don't want their investments downgraded. Firms are competing for underwriting business, and favorable analyst coverage is part of the package.
No investment banking firm will take a company public that its analysts couldn't issue favorable research about. Why would they? Nor would a company want to have an underwriter like that. So, in a sense, they become intertwined at the very beginning, which accounts for why you see a large number of favorable research recommendations. The business itself demands that, and it makes sense. Many firms do not bring many deals for that reason.
Mr. ROYCE. Should we then rename them from analysts to salesmen?
Ms. UNGER. Well, that's sort of the gatekeeper function of the firms and the analysts that have become part of that. Once the company goes public, the analyst issues a report, which we know is going to be favorable, 25 days later. Then the firm begins putting its clients into that stock, a lot of which are the institutional investors with sizable portfolios.
As you can imagine, the research is favorable, there may come a point when the analyst says, ''Gee, this company's not doing as well as I thought it was going to, I'd like to change the rating.'' Well, consider all of the pressure that's applied by the company with the investment banking relationship, the institutional investors where the firm has a stake in its commissions and with its relationship, and perhaps stock ownership on the part of the firm or the analyst.
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I don't know that you can ever eliminate these conflicts and I'm sure there is some good in all of it in terms of understanding the company and the dynamics and everything else.
What I do think you can do is manage the conflicts, and the way I think you can manage the conflicts is to have the investment banking firm disclose the analyst's involvement in the deal, and to have disclosure if the analyst owns stock in a particular company that it's issuing research reports about, and have that all be very clear to the investors, so that the investor understands any potential conflicts and can take that into account.
I think we're not even seeing that threshold disclosure at this particular point. I think we're seeing that stock ownership exists, that the pre-IPO share allocations exist, and that there's considerable influence exerted over the analyst by the investment banking part of the firm, but we are not managing all of that very well right now, in terms of disclosure.
Mr. ROYCE. And I guess for the SEC and for us, one of the critical questions is, how is that disclosed in a way that the small investor really comprehends, really sees that disclosure, as opposed to the institutional investors? How do we do this in a way that the market really understands?
Ms. UNGER. And that question really takes us full circle, because the reason that this is a discussion that many people are having now is because of the broad dissemination of research reports and the fact that they are reaching the individual investor who may not be as experienced in interpreting the documents and knowing what the conflicts are.
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So that is the challenge of the SEC in terms of educating investors, and that's what we try to address in our Investor Alert that we released last month.
Mr. ROYCE. We have a long way to go.
I thank you, Chairman.
Chairman BAKER. Thank you, Mr. Royce.
Mr. Toomey, you're up.
Mr. TOOMEY. Thank you, Mr. Chairman.
I'd like to first follow up briefly on a line of questioning that my good friend and colleague from Pennsylvania made earlier about Social Security accounts and his concern that 25 percent of the American public is insufficiently literate to accumulate savings in personal accounts.
I would point out that most of these people have jobs, they buy homes, they raise their children, they do lots of things in life, and I think if we suggest that they are not competent to invest their savings, we may not be giving them the credit they deserve.
Furthermore, I would observe that any mechanism by which investments would be made in personal accounts within Social Security has yet to be defined. It's entirely possible that it would consist of choosing from a range of funds in which the individual investor would never have the occasion to actually attempt individual stocks. So I, for one, hope that you won't suggest any major new policies and initiatives in anticipation of what I do hope will be a significant move to allow personal accounts within a reformed Social Security.
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But my first question for you, I'd like to harken back to an example that's been referred to several times and the suggestion that an analyst who sells a stock, while recommending a buy, has prima facie committed fraud and that this is outrageous. Now I'm not defending any particular individual or circumstances that I'm not familiar with. But perhaps you could comment. It seems to me that one could recommend a buy on a stock while selling it into one's personal account, and that there might not be anything wrong with that whatsoever.
There are a lot of reasons a person might choose to sell stock. It could be the individual simply needs to raise cash for any number of reasons. It could be that the person's portfolio is too concentrated in a particular industry or too concentrated in that particular company. It could be a function of the profit that's been accumulating in a particular holding, and the person's own personal investment criteria.
But would you agree that selling a stock while recommending a buy in that stock is not necessarily evidence prima facie of fraud or even any nefarious activity on the part of the analyst by itself?
Ms. UNGER. And I'm glad you raised that point, because I would hate for this subcommittee to walk away today thinking that it is prima facie evidence of wrongdoing. We would need to conduct a very fact-intensive review of exactly why the analyst was acting contrary to the recommendation. There are firm policies that have very specific times and circumstances under which an analyst can buy or sell contrary to a recommendation.
I'm not sure that in this case, or these couple of cases that we're talking about, that was done. If it was so clear and it was prima facie, we would have brought those cases. So that I'm sure we are assessing exactly what you are describing and that is whether there other reasons for the selling in the account.
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I have heard anecdotally that firms have very strict procedures in terms of looking at the overall portfolio. I'm confident that firms are able to make and develop internal policies to make sure that it happens under the proper and appropriate circumstances.
Mr. TOOMEY. Thank you. Perhaps you could comment on this idea, that there are no consequences for firms which would engage in inappropriate compensation or creating incentives for analysts that they ought not to have.
I disagree with that. First of all, I think there's a very competitive marketplace out there. There are a lot of alternatives for any investor, and we've seen the industry take many steps already. The securities industry has put forward an industry best practices guideline, there are rating agencies that assess the performance of analysts' recommendations, individual firms disclose their underwritings, and it is public information what kind of under-writings are going on.
As you pointed out, the SEC has done an alert which strikes me as the obvious, that investors should not rely solely on the advice of a particular analyst. And when I look at all this in a cumulative sense, it strikes me that certainly most investors, the overwhelming majority, it's going to occur to them that they ought to have a certain amount of skepticism about what an analyst recommends, and that that should be one of various factors that they would include.
But there are alternatives for investors. There are consequences imposed by the marketplace and we ought not go too far in trying to impose regulations on this.
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Ms. UNGER. I think you're right, we ought not go too far, but I think all we're talking about today or all I'm recommending today is that we follow the existing rules and actually improve the existing rules to make clear what the disclosure obligations are of the firm and the analyst and to follow those rules. For firms to either follow the best practices or their own internal procedures that they've already established and to actually enforce those.
And I think that's the first area that we need to focus on in terms of managing the conflicts.
Mr. TOOMEY. Thank you. I yield the balance of my time.
Chairman BAKER. Thank you. Just for the record's sake on whether or not folks trade inappropriately, I think I recall you making the comment that of the firms you surveyed, only one could tell you all the positions of every analyst. It would make it rather difficult, I think, to make the judgment that the firms are therefore making appropriate disclosure over these matters when they don't know what the investments are. That's my point.
And second, the statement that there are perhaps adequate rules in place, but I believe, in accordance with your own observation, that they are not being followed, is the core of the problem. And if we don't bring enough attention and focus on it, practices are not likely to change.
I do appreciate your appearance here. There are a number of questions that I would like to follow up with. For my own sake, and for any of the subcommittee, we'd like to hold the record open for a few days and perhaps submit additional inquiries for the record. And we do very much appreciate your courteous participation today. Thank you, Ms. Unger.
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Ms. UNGER. Thank you very much.
Chairman BAKER. We'd like to have our second panel come forward, please.
Welcome. I'd like to get started with our panel. I regret we have so much territory to cover and such a distinguished panel of witnesses here today. Without further ado, I'd first like to call Mr. Ron Glantz, former Managing Director, Tiger Management, former Director of Research and Chief Investment Officer of Paine Webber. Incidentally, in light of your written testimony, I think I need to say you're rated by Institutional Investor for seven consecutive years as the top investor. So I particularly appreciate your willingness to appear here today, sir. Welcome.
STATEMENT OF RONALD GLANTZ, FORMER MANAGING DIRECTOR, TIGER MANAGEMENT, FORMER DIRECTOR OF RESEARCH AND CHIEF INVESTMENT OFFICER, PAINE WEBBER
Mr. GLANTZ. Chairman Oxley, Chairman Baker, Ranking Members LaFalce and Kanjorski, and Members of the subcommittee, thank you for inviting me to testify on Wall Street's research practices.
My name is Ronald Glantz. I was in the investment business for 32 years before retiring last year. I began my career on Wall Street as an equity research analyst. Money managers polled by Institutional Investor Magazine selected me the top analyst in my field for seven consecutive years. I then became Director of Research, Chief Investment Officer, Director of Economics and Financial Markets and a member of the Management Board of Paine Webber, one of the largest brokerage firms in the United States.
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I ended my career as a Managing Director of Tiger Management, one of the largest hedge funds in the world. This has given me a good perspective on how the role of analysts has changed over the last three decades.
When I began in the business, the top-rated equity research firm was named Laird. Within 5 years it failed. So did most of the other top-rated firms. What happened? When I began, the average commission was over 40 cents a share. A few years later, institutional commissions became negotiated, almost immediately falling to less than six cents a share. The only way for research firms to survive was to merge with someone that could spread research costs over a larger base, usually brokerage firms whose main clients were individual investors.
Retail commissions had remained fixed and retail brokerage firms discovered that good research helped them gain retail clients and stockbrokers. By the end of the 1970s, the largest number of top analysts were at Paine Webber, which had bought the top-rated research firm, and Merrill Lynch, which hired talent from failing research firms.
Meanwhile, as analysts became more influential, companies increasingly pressured analysts to recommend their stocks, since a higher price means fewer shares have to be issued when raising new funds or acquiring another company, they are less vulnerable to being taken over, executives make more money when they cash in their options, and shareholders are pleased.
It is easy to reward favored analysts. They are given more access to management, ''helped'' in making earnings estimates. They'll even call you up and tell you that your estimates are too high or too low, and invite you to resorts for ''briefings.'' And most important, their firm receives lucrative investment banking business.
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Companies penalize analysts who aren't sufficiently enthusiastic. Let me give you a personal example. When I was a brokerage firm analyst, I downgraded a stock. The company's chief financial officer called my firm's president to say that unless I recommended his stock, he would cease doing investment banking business with my firm, and would order the bank which managed his company's pension fund to stop doing any business whatsoever with my firm.
I have seen top analysts removed from company mailing lists, their telephone calls left unreturned, and even physically barred from company presentations. Once I was doing a reference check on an analyst I was considering hiring. A chief financial officer told me that the analyst was disliked so much that he was deliberately given misleading information.
In 1980, top analysts made just over $100,000 a year. Today, top analysts make up to $20 million a year. How is this possible, considering that institutional commissions have fallen even further and brokerage firms now discount retail commissions to avoid losing customers to such firms as Schwab and e-Trade?
What happened is that brokerage firms discovered that highly rated research helped them gain investment banking clients. Soon the largest number of top analysts were at investment banking goliaths such as Morgan Stanley and Goldman Sachs. They could pay considerably more because investment banking transactions were much more lucrative than trading stocks. The institutional commission on trading $300 million worth of stock was only $300,000, of which less than $25,000 would go to the research department. This barely paid for printing and mailing research reports on that company. However, underwriting a similar dollar value of a new issue would bring in at least $10 million, and bankers thought nothing of giving a million dollar fee to the analyst responsible for the business. A merger or acquisition could bring in even more. Soon, firms were including anticipated investment banking fees in the contracts they offered analysts. The huge fees earned by investment banking gives them the ability to influence and, in some cases, even control the equity research department. As we all know, whoever ''pays the piper'' names the tune.
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Analysts used to view retail customers and investment managers as their clients. My first boss told me ''widows and orphans depend upon you to give good advice.'' Now the job of analysts is to bring in investment banking clients, not provide good investment advice. This began in the mid-1980s. The prostitution of security analysts was completed during the high tech mania of the last few years. For example, in 1997 a major investment banking firm offered to triple my pay if I would join them. They had no interest in the quality of my recommendations. I was shown a list with 15 names and asked, ''How quickly can you issue buy recommendations on these potential clients?''
Let me pause here to assure you most analysts still want to give good advice. Not only is it the right thing to do, it helps their reputation, which brings in investment banking business. Nevertheless, the pressures are enormous.
When I was Director of Research, analyst compensation was based upon the performance of his or her recommendations, commissions generated, and ratings by institutional clients and the retail system. Today, name analysts are given guaranteed contracts, whether or not their recommendations are any good. Every year, The Wall Street Journal lists the analysts who have provided the best investment advice. These analysts are rarely the best paid in their field.
Why is that? Investment banking. It is an open secret that ''strong buy'' now means ''buy,'' ''buy'' means ''hold,'' ''hold'' means that the company isn't an investment banking client, and ''sell'' means that the company is no longer an investment banking client.
[Laughter.]
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Mr. GLANTZ. Less than one percent of all recommendations are ''sell.'' Some analysts call their best clients and tell them that their real opinion differs from their published opinion, even though this is illegal.
But what about the individual investor? No one told my 86-year-old widowed aunt that the internet stocks she was buying in 1999 had no hope of ever earning any money, or that the analyst recommending purchase was being paid by investment banking.
Investment banking now dominates equity research. Bankers often suggest and are usually asked to approve hiring analysts from other brokerage firms. Investment banking provides the bulk of proven analysts' pay package. Some analysts report directly to investment banking. Analysts routinely send reports to the companies and to bankers for comment before they are issued.
Three years ago, Tiger was able to hire the top-rated analyst in his field from a Wall Street firm. This analyst had consistently been negative on one company, a major source of investment banking fees, because of its many acquisitions. Then his firm hired an investment banking team from another brokerage firm. As reported in the Wall Street Journal, the analyst was fired so that a more ''compliant'' analyst could be hired, one who would recommend potential investment banking clients. Disillusioned, this analyst moved over to money management where the quality of recommendations was still more important than the quality of relationships with potential buyers of investment banking services.
To give one of many personal examples, 4 years ago I came up with some extremely negative information on a company, including bribery, defective product, accounting irregularities, and serious pollution problems. I called the three most visible analysts recommending the stock, one of them the top-rated analyst in his field, and gave them my evidence. Every one of them continued to recommend the stock. Why? This company was an investment banking client. Incidentally, within a year, every member of top management was thrown out and, of course, the stock plummeted.
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The genie has been let out of the bottle. As long as investment banking is the most profitable part of the firm, then investment bankers will find a way to pay analysts who bring in business. Money managers can hire their own analysts. But my elderly aunt will never know whether the advice she is receiving is unbiased or not. That's not only bad for the average investor, it undermines one of the primary reasons for having a stock market—the efficient allocation of investment dollars.
My proposals can only address part of the problem. At the least, brokerage firms should list in large type on the first page of all buy recommendations any investment banking business they have had with the company over the last 3 years and any equity ownership by the analyst, members of his or her immediate family, or the firm.
Second, no buy recommendation should be permitted if the analyst, members of his or her immediately family, or the brokerage firm purchased stock or options for their own account in the month preceding the report, nor should they be permitted to sell stock until 3 days after a sell recommendation is issued.
Third, any shares purchased of a new issue by the analyst, members of his or her immediate family, or a money management arm of a brokerage firm should be held for a minimum of 1 year.
Thank you, I would be happy to answer any questions.
Chairman BAKER. Thank you very much, Mr. Glantz.
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Our next participant is Mr. Christopher Byron, Syndicated Radio Commentator, Columnist for MSNBC.com.
Welcome Mr. Byron.
STATEMENT OF CHRISTOPHER BYRON, SYNDICATED RADIO COMMENTATOR, COLUMNIST, MSNBC.COM
Mr. BYRON. Thank you very much, Chairman Baker, distinguished Members of the subcommittee.
Chairman BAKER. I should make a special notation. As our MSNBC.com and also our Bloomberg News participant, you are our first media-related types willing to stand in front of the subcommittee in a public forum. I welcome you for that reason.
Mr. BYRON. Before I go any further, I want to thank the subcommittee enormously for inviting me to appear before it and give me this opportunity to do just that. It's an enormous personal honor and a pleasure to be able to appear before you and give testimony on a subject that I've written about in one form or another for a number of years now in various publications that I write for.
You've asked me for some brief biographical information about myself, and I'll give you that very quickly. I'm a magazine, newspaper, and internet columnist and radio commentator. My columns appear weekly in the New York Observer newspaper, on MSNBC.com interactive on the internet, where I host a daily webcast radio show called ''High Noon On Wall Street.'' I also do a radio show called ''Wall Street Wake Up with Chris Byron'' that's syndicated on 40 AM radio stations around the country, and I write a monthly column for Red Herring magazine as well.
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Over the years, I've written for a great number of newspapers and magazines. They are listed in my submitted testimony. I won't bother you with them now.
The subject that we are about here today is enormously important to me personally, because it affects what I do for a living. The changing role of financial analysis and journalism on Wall Street is a very important topic for a whole variety of reasons.
I have a long perspective on this subject. When I came to Wall Street as a reporter in 1968, the beginning of 1969 was at the tail end of the go-go 1960s bull market. Three decades later, I'm still here covering essentially the same material that I covered then. A lot of the money and equity markets of America, now the world, a lot has changed in that time. When I came to Wall Street as a reporter in 1969, not a single person I knew, including myself, owned a computer. I had never seen a computer. Today, I know of no one who doesn't work with a computer.
When I came to Wall Street as a reporter, it took days, sometimes a week or more, to get my hands on the most single valuable asset that any writer in this subject area, any investor, any financial analyst or reporter can have, and that's an audited financial statement from a company.
Today, that information is instantly available to anybody with a desktop computer, a telephone connection, and a dial-up service on the internet. There's also been an enormous explosion in the public's interest about financial information itself. When I began covering financial markets at the end of the 1960s, The Wall Street Journal was generally viewed by people in my profession as kind of a second tier publication. There was no CNBC, no CNFM, there was no internet. Now The Wall Street Journal is regarded as one of the world's premier newspapers. Electronic media likes CNBC, MSNBC.com on the internet all have global audiences on every continent.
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I'll give you one personal illustration of this, and I think it is sort of revealing about the kind of thing that we're talking about here. I do, as I said before, a daily noon time webcast radio program called High Noon On Wall Street With Chris Byron. It's carried from my home office in Connecticut via a distribution system provided by Microsoft in Redland, Washington to 24 time zones around the world simultaneously. I must tell you, it is pretty daunting to sit in my den at noon every day and start to offer opinions and commentary on whatever happened in the market in the last 3 hours, and instantly receive back from every continent on the earth, emails from people listening to what I'm saying and saying ''Byron, that's a great point,'' or ''You're an idiot, you don't know what you're talking about.''
It's really a very, very large audience that reacts instantly to financial information all over the world.
There's one thing, however, that hasn't changed in the 30 years that I've been doing this job, and that is fundamentally Wall Street remains what it has always been: the place you go to get the money. That's where the money is.
You may hear discussions from time to time about socially responsible investing and phrases like that. But the reality is people go to Wall Street to get the money and the promotion of concepts like socially responsible investing, and phrases like that are simply another way to enable them to get the money.
The financial markets of Wall Street are, in my personal opinion, the single most successful self-regulatory arena the United States has had, at least in my life time. I think that's because people are, generally speaking, honest by nature and we have the oversight capacity of the Securities and Exchange Commission hovering in the wings over the self-regulatory bodies that we've been talking about this afternoon.
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But there's something different now. There's a huge, huge amplification of voices provided by the digital age. This is creating what I think are really important new difficult challenges for the self-regulators and for the SEC. I think you can make a convincing case that this entire tech sector bubble that we saw begin in the mid-1990s, swell over the following 4 years, the last two of which the NASDAQ composite index nearly tripled in value, and then popped like a champagne bubble and just disappeared in the glass, was caused by, and I think the responsibility lies directly at the feet of the amplifying megaphones of the digital age, the internet, the world of cable television, and the access to them that financial analysts and compliant journalists have which reaches investors all over the earth.
This has huge and obvious policy ramifications for Congress, in my opinion, because the collapse of the market, the NASDAQ national market is in collapse and we would be remiss to call it anything other than that. It has lost over 75 percent of its value from its stock. Some of it's come back, but it is still way, way off.
This has brought an end to the longest running bull market we've known in this country's history. It now threatens to tip the entire economy into recession. No one has any clear idea what to do with it. Trillions of dollars have vanished from the economy by the implosion of what Federal Reserve Chairman Alan Greenspan referred to as the ''wealth effect'' created by this bubble and the dot.com stocks that were in effect the miner's canary of that bubble.
The Bush Administration and the Federal Reserve are now engaged in efforts to replace it with a combination of tax rebates, lowered short term interest rates. No one is entirely clear whether this is going to work or not. But if prices hadn't been pumped up to the levels they reached in the first place, they wouldn't have fallen as far as they have, and we wouldn't now be groping for a way to pump them back up again.
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This bubble was financed largely by individual investors. And it is the Wall Street analysts and the media voices that helped turn the analysts into pseudo-celebrities whom I believe now have to bear the consequences for their actions, the responsibility for their actions. In some cases, we've seen what I thought I would never see in my life time in this business which is the spectacle of professional investors, who simultaneously wear a hat purporting to be an analyst, an investor and a journalist simultaneously.
I think is just a circle. You can't square and you can't put any kind fine line, fancy talk around it. Those three things don't go together. For nearly 4 years from the Yahoo IPO in 1996 to the deluge of IPOs that spread across Wall Street in the first 3 months of 2000, the analyst community, Wall Street, and the media organizations that covered them engaged in what I would call nothing less than a massive, shameless, totally irresponsible free-for-all riot in the pursuit of money.
I have included with this testimony a collection of stories and columns I wrote during this period that attempted to call the public's attention to the colossal pocket picking that they were being subjected to. Most particularly, I wrote repeatedly about the outrageous situation in which IPOs would be offered to investment bank clients at cheap, pre-market prices, even as the bank's analysts and the firms engaged in non-stop public commentary designed to pump up demand for the stock among individual investors in the after-market.
There are dozens of billion dollar examples of this in the public record before us today. Then when the stock would come public, the insiders would instantly dump their shares into the waiting and outstretched arms of individual, after-market investors at four, five and sometimes ten times the price they paid for them, often within hours.
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You can call that what you want, but I call it fraud. You may review the trading histories of dozens of tech sector IPOs and dot com IPOs during this period and find precisely this pattern repeating itself over and over again. To that end, I would thus respectfully call the subcommittee's attention to the following IPOs which are simply illustrative of the process I've described.
VA Linux Systems, Inc. The insider price in this deal was $30, the first price to an after-market investor in the public market, $320.
TheGlobe.com, Inc., a deal that failed the first time around and couldn't even be gotten off, because the underwriter couldn't even find a market for it. The second time around at a mark-down, Cy Sims' basic sale price of nine bucks. This deal got off at $9. First sale to individuals in the after-market, $97.
WebMethods, Inc., sale price to the insiders, $35; first sale to the after-market individual investors—everyday citizens, $336.
All these stocks have since collapsed. There are dozens more like that. These stocks and countless more were pumped to wildly supportable prices by impossibly grand claims from analysts regarding their potential as businesses. We all knew, as journalists, that these claims were absurd, and we would constantly talk with each other about that. Not often did our private opinions about what we were seeing make it into public print. The fact that these claims echoed through the megaphones of TV and the internet to reach individual investors from every corner of the globe simply underscores how much capital can be raised on Wall Street now that the whole world is watching.
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And this is only the first instance of this in which this unexpected alliance of analysts and the electronic media has come to bear on the marketplace. Unless efforts are undertaken to prevent this recurrence, I think we can look for even more disruptive recurrences of this in the future.
To that end, I would respectfully suggest the following:
Without going into the specific Sections of the 33 and 34 Act, because I'm not entirely certain, in the amount of time that I had to prepare this testimony, I have the correct references in my written submission.
Chairman BAKER. To that end, please feel free on reflection to forward that information in writing at a later time. That will help you in your presentation.
Mr. BYRON. I would simply say Section 17(b) of the Securities and Exchange Act of 1933, which I understand it in laymen's terms, requires anyone who is paid by an issuer to circulate, publish, or otherwise disseminate stock recommendations, be augmented to require, as a matter of law, that anyone publishing or disseminating that information disclose on that document in which the dissemination takes place, any financial interest, either direct or indirect, he or she holds in the stock in question, and I would wholly endorse the vivid image that the Chairman offered before of I want to see the surgeon general's warning stamped across the front of these things. It says ''Caution! Investing in This Deal May Be Hazardous To Your Financial Health'' in big red letters.
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In this particular area, I think that volunteerism just hasn't worked. And I don't think that the' 33 Act, I live by the First Amendment. I say things that anger lots of people so the First Amendment is very important to me, and I don't feel that the 1933 Act, as it's written now, violates my First Amendment rights, and I don't think that the augmentation in the way I'm saying, you might want to consider augmenting it, would violate them either.
Second, I think that Section 10(b) of the 1934 Act, which deals with the general concept of fraud of the market, could be aggressively enforced by the SEC Enforcement Division. For example, the black letter law we all know well in my line of work, the Foster Wynans case. This is a case that the Wall Street Journal reporter ran afoul of the act by using information that he had obtained in the course of his work to trade on stocks before putting it in the paper, in violation of his agreement that he signed with the Wall Street Journal not to do that.
I think the essential holding in that case boils down to this: He promised not to do something that he went ahead and did anyway. While I think the basic principle there can be expanded to find an implied covenant, not just with your publisher, but with the whole world of your consumers, particularly when you're disseminating financial information that is offered to the public under the color of impartiality.
Nobody is going to believe what you write if it comes stamped all over it and says ''I make a buck so long as I get your money,'' but if it's stamped on the front of it, if it comes representing itself to be this is unbiased material, in that case I think when you don't deliver unbiased material, you ought to be held to account with a sanction that hurts.
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I think we shouldn't be looking at the minimum amount of disclosure necessary to find adequate disclosure, but the maximum possible disclosure to protect the individual investor, a completely different orientation.
I've probably run over my time. I thank you for your patience.
Chairman BAKER. Thank you very much, sir. We appreciate your remarks.
Our next witness is Mr. Charles Hill, Director of Research at Thomson Financial/First Call. Welcome.
STATEMENT OF CHARLES L. HILL, DIRECTOR OF FINANCIAL RESEARCH, THOMSON FINANCIAL/FIRST CALL
Mr. HILL. Thank you. Good afternoon, Chairman Baker. I would like to thank you and the Members of the subcommittee for the opportunity to espouse my views on this important subject. Let me first mention the usual disclaimers. The views expressed here today are my personal ones, and are not necessarily those of my employer, Thomson Financial/First Call, where I'm Director of Financial Research, or those of the Boston Society of Securities Analysts, where I'm a Vice President and a Director.
I'm a chartered financial analyst and proud of it. My only aim today is to uphold and improve on the quality and integrity of my profession.
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The problems we are talking about today are not new. They tend to wax and wane with each stockmarket cycle. The only difference this time is that some of the problems may be worse than in past cycles. There does to be some secular trend underway that may have been exacerbated by the cyclical swing in the market and that needs to be corrected.
Any prolonged corrections in stock prices tend to wring out some of the excesses we're talking about today. Nevertheless, some of the underlying secular trends are disturbing and it may take more than just a market correction to remedy the situation.
Let me point out that in this market downturn, as in past ones, investors always look for scapegoats. The broker/analysts are an easy target. There is no doubt some basis for this, but it is most probably over done. Let the record show that at the time of the market's frothiest peaks, there were many broker/analysts doing very thorough and objective research.
The problem was that there were not enough in this category. There were too many whose work was shoddy and/or biased because of naivete, laziness or outside pressures.
But let's not paint all the analysts with the same brush. As a former sell side analyst for 18 years, I shudder at the thought of returning to that field and having to compete with some of the top analysts today with all the technology tools available. There is no question in my mind that today's stock research for the top sell side analysts is better than from the top analysts of 25 years ago.
What we need to improve is the quality and objectivity of the work from the rest of today's sell side analysts that are not currently doing their job as well as they should. Before we turn to the causes of deteriorating stock research quality, it is worth looking at how the problems of quality and bias can manifest themselves. There are four data items by which analysts can distort an investor's perceptions of a company's stock or leave the investor confused.
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The first is recommendations, the second is target prices, third is earnings estimates, and fourth is earnings basis. On recommendations, this subcommittee has previously raised this issue and has cited bar data, first calls data. The rough rule of thumb is that about one-third of all broker recommendations are in the positive category, strong buy, or whatever the broker's equivalent term is.
About one-third are in the second most positive category buy or whatever the broker's equivalent term is. About one-third are in the third most positive category, hold or the equivalent, with only about one percent in the two bottom categories, sell and strong sell or their equivalents.
The individual investor needs a decoder that would put all the brokers' various terminology for their recommendations on a common scale. The brokers are doing a better job of putting in each research report a definition of what their recommendation terminology means, making it easier for investors to compare one broker's recommendation with another. However, not all are doing this. A better answer might be if the brokers could agree on a common scale with common terminology.
Let me digress from my printed text for a minute to refer to something Congressman Kanjorski was talking about. When you mentioned about the confusion of the terminology, let me just read you the different terms that the brokers used for the third category. We've gone to all the brokers and said, you fit whatever your scale of terminology is to a common scale from one to five where one's a strong buy, two's a buy, three is a hold, and so forth.
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Here are the terms that are used in category three: Accumulate, attractive, hold, average, hold/neutral, long-term accumulate, long-term attractive, maintain, market average, market perform, neutral, neutral/hold, no action, out perform, perform in line, speculative buy, trading buy, market out perform, stock pick.
Now what is the individual investor to do without this decoder?
But let me go on. Unfortunately, the investor needs a second level in their decoder to adjust for the over-optimism of the broker analyst recommendations. Since the better companies get more analyst coverage than do the weaker companies, there is a justification for somewhat of a positive bias to the recommendations. As of the end of July, yesterday, this data was run. 27.6 percent were in the strong buy category, 36.9 in the buy, only 1.1 percent were sells and 0.4 percent were strong sells. That means the number of buys of all kinds were 47 times the number of sells of all kinds. That much of a positive bias is hard to justify.
Last year when the market was at peak levels, the spring of 2000, and many stocks were substantially overvalued, the ratio was even worse. On 1 March, it was 92-to-1. As the market crept up to a bigger peak on May 1st, it was 100-to-1. As the market began falling, the ratio was still a very high one, 99-to-1 on the first of August. By October it was 78-to-1. Today, as I mentioned, it's 47-to-1. It's a bid harder to understand why the recommendations were even more positively biased than normal at the market peak.
Second issue, target prices. Target prices are another area where the analysts have the opportunity to put their naivete or biases to work. Target prices became the rage of the 1990s, but their popularity seems to have abated slightly. Many were unrealistic, but many of the analysts that were providing those target prices have lost considerable credibility.
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Earnings estimates. Most analysts, most of the time, tend to start out too high with their estimates at the earnings report time. On average, the analysts start out too high ahead of the reporting period. They bring the estimates down, but take them down too far at the end of the period. More than half of the companies in the S&P 500 beat the final estimates every quarter.
Whether the analysts have been misled by the company's guidance or whether they knowingly went along with that guidance is debatable, but there does seem to be too regular a pattern of companies beating the estimates, particularly at some companies.
Now Regulation FD hopefully will diminish that problem. Now the fourth one is earnings basis. One of the problem areas that is mushrooming, but is often overlooked is the determination of the earnings basis used to value the stock. The SEC requires companies to report earnings on the basis of Generally Accepted Accounting Principles, (GAAP). Most everyone would agree that those numbers often need to be adjusted to exclude non-recurring and/or non-operating earnings.
The problem is that what one person considers non-recurring or non-operating, another may not. There is no right answer. It is all in the eyes of the beholder. A big part of the analysts' job is to determine the appropriate basis for earnings as used in the price earnings ratio or other earnings-based valuation yardsticks.
A company's earnings can often be enhanced by excluding items that normally would not be excluded or by including items that normally would be excluded. The excesses in this area have been most common in the technology sector where the use of the cash earnings or pro forma earnings have taken on a wide variety of special meanings that have greatly enhanced some companies' earnings.
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Chairman BAKER. Mr. Hill, if you can begin to wrap up, I want to get all of our panelists in before we get interrupted by a vote. I hate to do it.
Mr. HILL. OK. There's a growing trend for companies to put out releases that emphasize an earnings number that has been adjusted to a basis the company espouses, sometimes to the almost total exclusion of the GAAP results. What this is amounting to is a way for companies to gild the lily on their earnings reports, and it's an issue that Lynn Turner did bring up before his leaving the SEC.
But, let me just quickly say that the four ways that the analysts are being pressured is first, themselves, in that the analysts have fallen in love with the industries they cover, or they'd be covering some other industry. So they start out with what I call an honest bias, come to the table looking through rose colored glasses. Second is the investment banking issue that we've talked quite a bit about today. The third is the public companies, the companies themselves putting pressure on the analysts or they'll be cut off communications-wise.
Last, the institutional shareholders who also can pressure the analysts not to put out a sell when they own the stock.
Chairman BAKER. Thank you very much, Mr. Hill. Your testimony and all the witnesses' testimony will be made a part of the record in full, and I'm sure—I know I do—we'll have further questions in writing as well. Pleased don't feel dispossessed if you don't get through your entire prepared text.
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Our next witness to appear is Mr. Matt Winkler, Editor-In-Chief of Bloomberg News.
Welcome, Mr. Winkler.
STATEMENT OF MATT WINKLER, EDITOR-IN-CHIEF, BLOOMBERG NEWS
Mr. WINKLER. Thank you very much, Mr. Chairman. I'm delighted to appear before the subcommittee as part of your continuing discussion of analyzing the analysts. My name is Matthew Winkler. I am the Editor-In-Chief of Bloomberg News, a global news service with 1100 reporters and editors and 80 bureaus in 50 countries.
Bloomberg News produces more than 4,000 stories daily on the economy, companies, governments, financial and commodity markets, as well as sports, politics, and policy. Many of these stories are published in more than 350 newspapers including the New York Times, The Washington Post, Los Angeles Times, Le Monde, and the Daily Yomiuri.
Since its inception in 1990, Bloomberg News has received more than 50 awards and citations for the quality of its journalism, including awards from the Overseas Press Club, the Gerald Loeb Foundation, the Society of Professional Journalists and the Society of Professional Business Editors and Writers. Bloomberg News is the main content provider for Bloomberg print and broadcast media. These include several magazines, a New York-based radio station and network, and a 24-hour television network operating in the U.S. and in a dozen languages in countries in Europe, Asia, and South America.
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Financial stories are both complex and critically important. As someone who is passionate about providing the public with the context and analysis necessary to make sound decisions, I want to salute this subcommittee for its extraordinary commitment to ensuring that investors have broad access to the highest quality information about the marketplace. When this subcommittee greets with skepticism efforts to create a property right in stock market quotes, or highlights the question of whether investors are getting unbiased research from Wall Street, you are taking a step toward ensuring public access to information. In the information age, that is no small accomplishment.
It may take a bear market for investors to realize that many stock analysts have never been anything more than fancy pitch men for the firms that sell securities. As long as shares went up, as they did in the 1990s, analysts rarely had to say ''sell.'' In their lingo, the stocks were never ''fully priced.'' Now that the NASDAQ composite, the symbol of the greatest bull market ever, is down about 50 percent from a year ago, it is easy to attack the analysts because the few occasions when they might have said sell came long after the damage was done.
Analysts always will have a conflict of interest as long as the firms that employ them participate in initial public offerings, arrange stock and bond sales, and use analysts' research to help win new business. In such circumstances, it's hard to find any analyst on Wall Street who met a stock he or she didn't like. Analysts are part of the sales team.
Analyst conflicts of interest are a symptom of something much more sinister. Until the Securities and Exchange Commission late last year approved Regulation FD, public companies routinely invited analysts and some of their shareholders to private meetings as they discussed sales, profits and losses. Until adoption of Regulation FD, analysts were protected under law from insider trading liability and liability for ''tipping'' if they did not have a special relationship with the corporate officials that fed them insider information—a monetary or other quid pro quo.
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That protection was designed to shield analysts from unlimited risks of liability for attempting to ferret out information. It quickly became perverted, however, as issuers figured out they could punish analysts that did not give them good ratings. The punishment came in the form of exclusion from the inside information gravy train which was provided to their competitors. Inside information was thus joined with analysts' recommendations in a troubling form of barter. It was as if a student could punish the teacher for giving him or her a bad grade by withholding the teacher's pay.
In short, this practice of selective disclosure increasingly made the stock market a financial ''Animal Farm'' in which some shareholders were more equal than others. The sloped playing field created by selective disclosure during the 1990s was so common that many analysts and publicly-traded companies assumed it was the price of capitalism. Analysts equipped with inside information, they argued, were needed to grease the wheels of the market, even if they could trade on that information before Aunt Betsy and the rest of the company's shareholders.
The SEC disagreed because in too many instances, trading in a company's shares turned out to be rigged, undermining the integrity of the stock market. I believe the SEC got it right. What precisely does Regulation FD have to do with analyst conflicts of interest? Everything. Conflicts and bias breed in the dark. The more information that is available to the public the greater our collective ability to assess independently whether the analysis we are receiving is potentially biased.
Does Regulation FD solve the problem of analyst conflicts? Of course not. I repeat, as long as firms employ them to participate in initial public offerings, arrange stock and bond sales, and use analyst research to help win new business, analysts will always have a potential conflict of interest. Initiatives that enhance broad dissemination of information to the public will have a salutary impact.
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Justice Brandeis is remembered for observing ''publicity is justly commended as a remedy for social and industrial diseases. Sunlight is said to be the best of disinfectants. Electric light, the most efficient policeman.'' Like seeing a policeman in the rear view mirror or knowing a Congressional Oversight Committee is looking over your shoulder, the availability of information enhances accountability. That serves as a catalyst that sometimes prods better behavior, and that is very much in the public interest. Again, I commend you for your willingness to explore this important issue.
Thank you very much.
Chairman BAKER. Thank you very much for your remarks.
With apologies, Mr. Kianpoor, Chief Executive Officer for Investarts.com, also a media panelist of sorts, I have been informed that I have overlooked as well TheStreet.com also being an internet site. Thanks to both you gentleman for your willingness to appear today.
STATEMENT OF KEI KIANPOOR, CHIEF EXECUTIVE OFFICER, INVESTARS.COM
Mr. KIANPOOR. Speaking on behalf of the Investars.com team and our co-founder, John Eagleton, I'm honored to have the opportunity to contribute to these hearings. Investars.com was founded in October 1999 to give investors tools to better interpret stock recommendations made by Wall Street Analysts. With the huge growth in the number of individual investors in the mid-1990s, Investars.com sought to measure the track records of Wall Street's research providers, thus giving investors the tools that would allow them to sift through dozens of stock recommendations made daily. Investars.com degree of success system calculates the hypothetical return an investor would have made if he or she had traded based on each brokerage's recommendations.
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Investars currently ranks more than 200 research firms, based on their overall hypothetical returns for every stock since January 1997. Hindsight has made it clear that the boom and bust of the past 4 years did not leave lasting benefits for anyone. Investors have suffered, businesses built on unrealistic have collapsed, and the brand equity of many brokers whose businesses depend on public trust is being eroded as we speak.
We must join forces to implement common sense reforms that will benefit all parties. Respectfully, we'd like to propose three basic reforms.
One, to make historical recommendation and earnings estimate data public; two, to encourage disclosure of investment banks relationships with covered companies; three push for a common recommendation language.
In the interest of saving time I've pared down some of my testimony on subjects that have been mentioned before. I would like to focus on some of the more important things. Historical Wall Street recommendations and earnings data is not available only to institutional investors. Individual investors suffered in the recent boom and bust cycle, because they lacked these key facts. They lacked these facts, because there's a virtual monopoly on the distribution of analysts' historical data, namely, financial data distributors who agree with investment banks not to make historical ratings information available to the public.
This is the single most important, most absurd, and least addressed issue affecting the individual investor today, that investment banks can prevent the release of their historical recommendations data to the public. Historical recommendations and earnings estimate data must be made available to all investors and preserved in the public venue, such as the SEC database.
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Please refer to the statements made by other analysts ranking sites, such as Validea.com and MarketPerform.com in our written testimony.
The second issue is the disclosure of investment banking relationships. Our IPO bias feature compares the track records of investment banks based on their recommendations for companies that they underwrote to their track records in companies that they did not.
Overall, since 1997, the returns in the first case are approximately 50 percentage points lower than the returns on the second. Due to the lack of availability of historical information, the possibility of conflict of interest was not previously quantifiable for investors.
As their second reform, Investars proposes that investment banks disclose to an SEC database their historical underwriting relationship with any company which they cover. I believe that's been brought up before. Disclosure is not an end in itself. We call on the media on-line brokers, financial advisors, research firms, and sites such as Investars, to educate and protect the people. By placing this information in context with current technology, we can explore investment banks' track records and conduct a detailed peer group analysis, and the media should avail itself of these new tools. If it proves impossible to obtain full disclosure, the media should emphasize the implications of its absence.
The third issue we need to address is Wall Street's language. Again, that has been mentioned before. We need a common scale. It's just common sense. In that case, our conclusion is that we cannot lose sight of the average investor who must be equipped to assess the quality and integrity of market analysts.
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It is common sense when you buy a car, you check consumer reports. When you buy a house, you have it inspected. To make such assessment possible, we need to establish a standard language and break the investment banks' control over factual historical recommendation data. Investars also suggests that the media start to delve into more detail when reporting on analysts' recommendations to the public.
We now possess the technology to refer to analysts' batting averages and provide play-by-play commentary on their ratings. We can publicize the good and transparent and underscore the deficient, heighten investor awareness that will self-enforce industry compliance with higher standards.
I'd like to end my testimony with a statement. There's a greater fool theory in the market. It states that no matter what a stock is worth, investors buy it, because they believe there will be a greater fool willing to buy the stock from them at a higher price. As long as brokers and financial data providers can block the distribution of factually historical data to the public, the average investor will ever remain as a greater fool in the market. That's just common sense.
I'm grateful for this opportunity to share our views with you today.
Chairman BAKER. Thank you very much, sir. I appreciate your willingness to appear.
Our final witness today is Mr. Adam Lashinsky, a Silicon Valley columnist, and employed by TheStreet.com.
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STATEMENT OF ADAM LASHINSKY, SILICON VALLEY COLUMNIST, THESTREET.COM
Mr. LASHINSKY. Thank you very much, Mr. Baker. I had the privilege of interviewing you recently for an article that I was writing, so turn about seems fair play. I'm happy to give you my thoughts today.
When I first started out as a business reporter, I was handed a large book called the Nelson's Director of Investment Research. I was told there are lists of analysts in this book. Call them if you need comments for the stories you're writing on public companies.
I knew nothing about what the individual analysts did, the importance of their firms, whether some were better than others. All I knew was that the ones who returned my phone calls were more valuable than the ones who didn't return my phone calls. If they said something germane on the record, they were even more valuable because they could go into my articles.
I think that as we entered the bull market, the individual investor found him or herself in a similar position. They were told in either the newspaper article or on television that an analyst had something good to say about a stock. They had no ability to judge whether or not that analyst was good or bad. They knew that an expert was speaking and that information was good enough.
The news media plays a role in this, and I'd like to address that. The point is that professional investors have understood the games that have been played on Wall Street all along. The individual investor didn't understand what the conflicts were, came into the game cold, if you will, just as if having been handed a big book.
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One thing, Congressman Baker, that I think hasn't been addressed in the hearings yet is who is entitled to the information that we're discussing and how they should be using it. There's been discussion today of research reports being entered into historical records or indeed being regulated like a securities offering.
The fact remains that at least for now, these are not public documents, these are proprietary pieces of research for which investors pay. So Fidelity understands that it is a client of Goldman, Sachs, to choose one example.
To the person watching on CNBC, it's not typically a client of Goldman, Sachs. It they act on the research that Goldman, Sachs has produced, in a sense, they're taking a shot there on their own; they're not the client, they didn't pay for it. But what is the media role here?
TheStreet.com has had a policy since its founding in late 1996 of always stating a conflict of interest that an analyst has. So if we quoted an analyst whose firm was the underwriter of the IPO of the company that we're discussing, we simply say so. It doesn't mean that the analyst is good or bad, it means that we're cluing our readers in that there's a potential conflict here.
I would point out that sometimes those analysts are the best informed because they spend more time with the companies, but an investor has to have his or her eyes open to the fact that there may be a conflict here. Thus, Street.com is not immune from some of the criticism that the financial news media deserves.
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Over the past few years, we had, for example, something called the ''Red Hot Index'' where we participated fully in the momentum of the era. However, I'm proud of what TheStreet.com has done in terms of outlining analysts' conflicts. I don't think the rest of the media has lived up to the same standard, in particular the broadcast media has been particularly harmful in putting analysts or putting fund managers on television without explaining to the overage viewer at home what the full story is behind the recommendations that they're making.
I would offer to you several solutions that you're addressing, not all of which I necessarily endorse, but I offer them as food for thought.
One, you could write legislation to split investment banks from brokerages. This would solve the problem. It would be very painful. It would fly in the face of the last 10 years of consolidation in the financial services industry, and of course brokerages wouldn't be able to make much money in that scenario, because trading is not a particularly profitable endeavor, but it would solve your problem. Then you could allow fixed rate minimum commissions again, so that brokerages could run a profitable business. That flies in the face of Congress' concerns about price fixing.
You could require, and you are discussing requiring greater disclosure as the industry itself is discussing. My personal opinion is that these are palliatives. They will have little impact on the conflicts. They simply will make people more aware of what the conflicts are and perhaps make people feel better.
Lastly, you can rigorously support Regulation FD. There is an undercurrent that isn't stated loudly that there are elements with in the SEC and certainly on the Commission and certainly in the securities industry to diminish the effects of Regulation FD, because it makes the industry uncomfortable, and it is requiring the industry, in my opinion, to work harder.
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In my reporting, it's my opinion that Regulation FD is one of the best things that has happened for individual investors in recent history, and Congress can do its part by standing firmly behind Regulation FD and not give in to some of the demands that it be weakened.
Thank you, sir.
Chairman BAKER. Thank you very much, Mr. Lashinsky.
Let me say to the whole panel, thank you very much. This has been again very informative, but also very troubling. From the first hearing, when there were some observing, wow, Congress is looking at the conflicts of interest on Wall Street, isn't that news?
Obviously we all know that there are conflicts and firms have assured us of their ability to manage those conflicts. But the further we have gone in looking at the divergent list of individuals who have unique perspectives of market actions, there is no doubt that the character and nature of the market has changed over the last decade.
Unfortunately, I think there is reason for most investors to have great concern about the independence of the information flow when they make such significant investment decisions coupled with the advent of online trading, and now what many of us in political life call the working moms and pops investing on line and, to some extent, using media appearances. Look at what's happening here in this sector today, the type of analysis in order to make all those small individual transactions in the aggregate responsible for the huge inflows of capital to the market. We have a very volatile circumstance.
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In speaking with most members, we are all reticent to act legislatively. But it would be my intention, based on the support of the subcommittee, that we would move forward from this point with some recommendations through the fall and winter and perhaps come back with the assistance of the NASD, the SROs and the SEC, and determine whether our actions and recommendations have not only been implemented, but there is actual day-to-day practice and consistent following of the recommendations that appear to be warranted.
Let me make a couple of statements and then kind of get the consensus, yes or noes. My view is everybody thinks there's a problem. You all may not see the same problem, but generally there's a problem that we need to fix. Nobody objects to that?
Second, that it would be better, if possible, for the industry, itself, to craft the remedy, but have that remedy be subject to the light of day. For example, additional committee hearings, SRO insight, that's maybe in the middle of the pack.
Are there those who agree with that sort of general context that we ought to do something, look to the industry, and then verify.
The next question is much more difficult. Let's assume we've gotten through those first two steps. We've prepared a list, we've gotten the industry to look at it, but there's still not consistent uniformity in compliance. What should be the enforcement mechanism? Is it sufficient, as I suggested to Ms. Unger earlier, to have just a rating mechanism; a, you're complying with all the rules; b, you're trying, but you're not quite there; c, you've got a problem. Will the publication of you being on the c list have a consequence in the market? Is that a point of discussion?
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Yes, sir?
Mr. WINKLER. Mr. Chairman, I think the greatest impact on the market is disclosure and the more disclosure there is, just as you yourself said earlier today, a warning on a package of cigarettes is a very powerful way of letting people know that they are about to use something that's possibly fatal. Reg FD goes a long way toward that kind of goal.
And I do think that if this subcommittee were active in doing everything it can to promote and enforce Reg FD, that would be very helpful.
Chairman BAKER. Thank you for that. I do have some concerns about Reg FD, but not from the perspective of the industry having a difficult time complying. I just want to make sure it functions in the intended fashion. And further to the point, it would have no implication on an analyst making a recommendation to buy when he's selling his own interest.
I think we have to get not only at the flow of information but the personal conduct issue of the individuals. For whatever reason, it makes no difference; are they being pressured by the firm or is it the opportunity to make four or five million dollars on a deal. If they do it, it's wrong. That's where we have to have, I think, significantly more involvement by the SROs than we have today.
For example, it troubles me greatly that, at least according to Ms. Unger, the NASD does not look at an analyst or require disclosure, if he makes a television appearance, if he's got an interest in the stock which he's talking about. I find that unfathomable from a regulator's perspective.
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Mr. Lashinsky, did you have a comment?
Mr. LASHINSKY. Yes, sir. I was going to say that in every instance I know, the compliance department of any firm would not allow the type of department that Ms. Unger described earlier. Without being a lawyer, that strikes me as fraudulent behavior and bad ethics, so there's a break down in how the SROs are regulating the compliance departments of their own members.
Chairman BAKER. Ms. Unger also stated that in the short-term audit they conducted, there was only one firm that could give her an accurate reporting of all the analysts' interests within the firm. How could you possibly have any capacity to govern analysts' practice if you don't know what they own?
There's a fundamental structural problem here that is going to take more than one hearing and one simple piece of legislation to fix. To that end, we will get back to each of you with additional questions and insights for you to give us your educated opinion on.
But we would very much welcome, over the course of the August recess, your best thinking along the idea of here are the elements we think would be important as we have a peer review group now looking at the SIA's best practices.
By the way, just a show of hands, how many of you think the SIA's best practices recommendations are sufficient?
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[No response.]
Chairman BAKER. That's what I thought.
Over the August recess, if you'll give me your insights into those, as well as additional steps from your various perspectives, it would be very helpful to us in trying to construct very carefully a package for us to suggest to the SROs that they review, and our process would be very slow. We're not going to rush to judgment. But to take the fall and winter and come back next spring and make an assessment about the effect and consequences and recommendations that the subcommittee may make this fall. It's just by way of process.
I don't want to go on at length because Mr. Kanjorski and Mr. Crowley have been very patient sitting here.
Mr. Kanjorski.
Mr. KANJORSKI. Thank you, Mr. Chairman.
Mr. Kianpoor, you made an observation that the value of a stock will be whatever the next idiot will pay.
Mr. KIANPOOR. That's right. It shouldn't, but it did for the last 2 years.
Mr. KANJORSKI. And after the excellent testimony of the entire panel, each one of you added a great deal of insight into some of the problems in analysis on Wall Street.
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I don't think any of you are my age, but I'm going to relate a story. You may remember my favorite program when I was a young man in the late forties, was Captain Midnight. Captain Midnight was sponsored by Ovaltine, you'll remember.
I was just about able to read, write, and figure out how to do things, and I was pressed at 5:00 o'clock every day to listen to Captain Midnight. And Captain Midnight started this process of the secret code and secret information, and every day you would write down the numbers. They were useless to you if you didn't have a decoding device, but Captain Midnight offered a decoding ring with ten bottle labels of Ovaltine and a dollar.
And as a dutiful follower of Captain Midnight, I bugged the hell out of my mother to get those ten bottles of Ovaltine. By hook or crook, I got that dollar and I wrote in, and at that time, nothing was instantaneous like the internet; thus, with bated breath every day, when I'd come home from school, I'd look for my package from Captain Midnight. It wasn't there. It took weeks. But every day at that program at 5:00 o'clock, I copied down all those numbers so that when my ring came, I'd know what Captain Midnight was saying to me.
Finally, the day arrived and it came, and I remember it very well. I tore that box open. I immediately ran in and I couldn't wait for the program to be over when the message would be given, and finally it was given. And I took my ring and I decoded the message. It was probably the best lesson I ever learned in my life, because the message was——
Mr. HILL. Congressman, that was the information for my reference. I had my Captain Midnight Decoder.
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Mr. KANJORSKI. Do you remember what the decoded message was? ''Buy Ovaltine.''
[Laughter.]
Mr. KANJORSKI. Well, it taught me a lesson. We can't encourage Americans to necessarily buy decoder rings when they're not available. Somebody's got to do something with this decoding. We have to move out of the Orwellian world. I think the Chairman and I both agree we would least like to do it by Government action. But clearly, I was disappointed. I listened to the testimony of the SEC today. And I got the feeling that it's not our fault, it's somebody else's responsibility if they are not doing something.
It didn't strike me that the proper attention was paid, but then I thought about listening to all of you six gentlemen here. I want to compliment you. You are all competent and very successful in your field, but you have to answer this question for me.
Why wasn't there anyone that did investigative work in 1998 and 1999 and 2000 to tell the American people and most of us about these terrible analysts when the market was going up?
Yes?
Mr. KIANPOOR. As I said before, the data was not being made available to individual investors. That means to do this investigative work, you need to get the historical data for what these analysts and investment banks have been recommending for the past 10 years.
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Mr. KANJORSKI. You mean that there is nobody?
Mr. KIANPOOR. The data is being provided by investment banks to certain financial data providers which will not allow——
Mr. KANJORSKI. Then, we are going then through a fog, is that it?
Mr. LASHINSKY. Mr. Kanjorski, there were plenty of people during that period who did research and said repeatedly ''this is madness, this stock is not worth what you say it's worth. There are ways to fundamentally value this stock, and it's highly over-valued.'' And those people were laughed at for roughly 3 years because the stock kept going up and kept going up and kept going up. That was the period we just came through.
Mr. KANJORSKI. Would it have made any difference if we had the historical knowledge?
Mr. KIANPOOR. It would have, Mr. Kanjorski, and it will in about 4 or 5 years. As early as now, people are looking at our site and finding out what people's track records are instead of having a Surgeon General's warning on TV coming up, you could have the person's track record and see either the guy is a complete crook or a complete idiot. It's far more effective.
Mr. KANJORSKI. It strikes me as something like Monday morning football reporting, how well we played the game that was played on Saturday. We are the greatest analyzers of why Al Gore lost the election. But I don't think anybody could have told you that or would have told you that beforehand.
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And I'm just wondering, are we chasing a phantom?
Chairman BAKER. Let me jump in too, because I think Mr. Byron wanted to make a comment in response to that question.
Mr. BYRON. Yes. I would simply say, Congressman Kanjorski, that the data on which you can base informed judgments with respect to the value of a stock, given that no one can foresee the future, at least makes some reasonable guess about the likely course of a stock's value. It's available to everybody, whereas 20 years ago, it wasn't. And I mean by that, the instant access to audited financial statements, balance sheets, income statements, cash flow statements, shareholder equity statements from publicly traded companies via the filing system of the SEC. That stuff is all available and usable by anyone.
Most people have neither the time nor the expertise to dig into that stuff and understand it. That's where the role of the media is critically important, because in my respects, we're the unelected, self-anointed proxies for public understanding of what these documents are.
Mr. KANJORSKI. How am I going to know, though, if I'm listening to you on the radio, and you're paid for by Exxon or American Express? How do I know whether or not that's influencing what you're saying to me?
Mr. BYRON. There is an inherent problem in that with everything in the capitalist system obviously. At some point, we all need to pay the rent.
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The question that I want to get at is when the conflict becomes gratuitous, particularly in the media, when media voices begin to have a demonstrable self-interest in the outcome of their own opinions and their own reporting at the same time the entire system tends to break down, because there's no place left for the public to go unless a investor wants to take the time to learn how to read a 10K statement from the SEC. Most people don't want to do that.
So in my opinion, a very important part of this equation has to be the role of the media and financial journalists. When we start thinking of ourselves as superstars in the same way that the analysts do, we have a really serious problem on our hands, because who stands to inform the public when you have a situation like that?
Chairman BAKER. If I can recognize Mr. Crowley, do you have a comment or question, sir?
Ms. CROWLEY. I do, Mr. Chairman. Thank you very much.
It's funny. If I close my eyes, I think I'm listening to election reforms sometimes, some of the comments that are made. I appreciate that, because there are some analogies I think you can draw between the two in terms of the sharing of information by electoral analysts or financial analysts in terms of expertise dealing with election results or, in this case, maybe before the bell rings, what they hope would be the market results for a particular product.
Mr. Glantz, I have a couple of questions, and first of all, let me thank you for being here. It's good to have, from a retired analyst, insider information basically on how some of this may work.
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The Henry Blodgett case put the analysts into the forefront for millions of small investors. While this case was before the SEC and Mr. Kanjilal—I hope I'm pronouncing that right—of Queens, my hometown, went to arbitration, and it first looked like that was going to be the road we were going to be going down.
This event brought to light a serious issue that when small time investors, who are the bulk of the American public, set up a brokered deal, many of these firms require that that individual agree to arbitration as opposed to going to the courts to address any wrongdoings down the road.
In your view, do you think the current law should be overturned or reviewed so that private plaintiffs are provided with the right of action against analysts?
And with respect to the current arbitration system, do you believe that the arbiters should be outside the securities industry and that they rather be from the American Arbitration Association or some other outside firm to oversee the arbitration?
Mr. GLANTZ. Yes. I agree that investors should be able to sue in courts. I believe that any arbitration should be done by people outside of the system.
If I can also add a response to a previous question. One of the problems with the rating systems is that the greatest excesses are made by people who have no track record. Whoever heard of Henry Bodgett before the internet stocks went up? It would have taken until the stocks fell that you would know that he had been over-enthusiastic. I think the basic problem is not the analyst, but the pressure on investment banking.
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If you tell the investment bankers, ''Gee, I think this is a terrible company,'' you get fired. If you don't support the stock, you get fired.
Ms. CROWLEY. Today, but not in the past.
Mr. GLANTZ. Right.
Mr. HILL. Back in the days when I was an analyst, I could put a sell, as I did on investment banking clients, and I did not hear anything from the investment banking side of the firms I worked for or from the companies involved. But that's changed today.
Mr. KIANPOOR. Mr. Crowley, that's why we are looking for historical information on investment bank recommendations. We don't go by analysts, because we believe that going by analysts would be like saying that the tail is wagging the dog. We go by Merrill's recommendations or CFSB's recommendations. Every time they make one, they put their equity at stake, and the public should know what their track record in different stocks and different sectors is when they're making those decisions. That's a market-based solution to the problem.
Ms. CROWLEY. In the interest of time, I yield back, but before I do, I thank the Chairman. I believe this is the second hearing on this and there are going to be more hearings. I look forward to it because this is a very interesting issue. The whole concept of an analyst being rewarded for information that he or she gives over the mass media is troubling to me. It's substantial dollars. We're talking in the range of $100,000 plus dollars for every time they give a bump to a product over the media, the mass media. That's troubling, because it affects my constituents, the general public that is more involved and more interested in the market than ever before, those are the people that we have to look out for.
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And that seriously troubles me. So I thank you all for your testimony today.
Chairman BAKER. Thank you, Mr. Crowley, and yes this is only the second, but it really is the beginning of this subcommittee's jurisdictional responsibility. I don't see even the passage of legislation as the end of our responsibility. If there's anything I've learned from pass excesses, the Long-Term Capital Management and others, there has to be outside constant review of business practice in order for the system to work without distortion.
Ms. CROWLEY. I agree with you, Mr. Chairman. In fact, I think the hearings you're holding are doing in many respects just that.
Chairman BAKER. Thank you, sir.
I believe that it's an important responsibility in light of the way the market has changed, technology has opened up the world to the small dollar investor, they may even, despite FD, be flooded by information they can't even understand. So I don't know that folks today have the confidence that the people they pay for information are necessarily giving them the unvarnished truth.
That's what this is all about. I would like to return to the remedy aspect. I don't think it's that difficult. I think it's difficult because it may change business practices in certain areas and cause difficulty in securing the IPO client for the investment bank. But if you have the research department not reporting to the investment bank, where their compensation package may be based on the quality of their work, is it facetious to be believe that, as a research analyst, that if you do your work, and go out and say this is a dog and say this one is so-so, and this one is where we want to put our money, and based on those recommendations at year end, if you did identify the dog, you did tell them where to put their money properly, isn't that a mechanism which could work with reasonable support from professional management?
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Mr. Hill.
Mr. HILL. It could work if the compensation system was changed. It did work in the past, but the problem is, and this is where the buy side institutions have to look in the mirror. They have been one of the big complainers about the deterioration and the objectivity of quality of sell side research, but they've driven commissions down to extremely low rates. There's more of a premium today on trading execution so it's difficult to get paid the way the brokers used to be able to for their research.
When I was an analyst, I was incentivized monetarily to do good fundamental research. Once a quarter, the institution sent a letter in saying, we did X amount of commissioned business directed to your firm in return for research services provided by the following analysts.
If my name appeared on more of those letters than my compatriots did, I got a bigger share of the research department bonus pool. In those days, the research department generated enough commission business to have a bonus pool. If I did something for investment banking along the way, there may be a little sweetener in there for that, but it was the frosting on the cake.
The problem today is it's the cake, because they can't get paid for research and they've had to return to investment banking to compensate the analysts.
Chairman BAKER. Let's take that point. Let's assume for a moment that business practice has changed. We can't undo it and it's a fact of life. The conflict of interest will continue. Is merely the disclosure of the relationship somehow doing something about the IPO problem that was referenced, I believe, by Mr. Glantz in your testimony. Is that going to be sufficient along with Reg FD-like disclosure requirements sufficient to bring back or to establish credibility in analysts' work with the average investor.
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If we can't unwrap the investment bank research problem, where do we go from there?
Mr. GLANTZ. You have asked two question. One question that you asked earlier, if I have an investment banker who is making the firm hundreds of millions of dollars, I don't care what the formal relationship is, he runs research. The second is to restore investor credibility. Unfortunately, the investors who are hurt the most are not paying for the research, they're trading on AmeriTrade.
Chairman BAKER. A network.
Mr. GLANTZ. They're trading on the internet. Every once in a while I used to go into one of these chat rooms to find out what people were saying. I was amazed at the illiteracy, the lack of knowledge, ''So-and-so's stock is going to go to a hundred,'' and that's not the analysts' fault.
The criticism I make of analysts is conflict of interest and I think that should be on the first page. But is that going to cure the problem of the reputation of analysts? No.
Chairman BAKER. Any other comment on the next step?
Mr. LASHINSKY. I would just disagree with one thing that Chuck Hill said to get to Ron Glantz's point. Typically, the buy side is not particularly upset with the situation. They see it as an unfortunate situation, but they know that they can't rely on the sell side for buy and sell recommendations. So they take the sell side for what it's worth. It's expertise, it's knowledge, it's analysis, not its recommendations on the stocks. They have their own research teams for that.
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Chairman BAKER. Would you like another round, Paul?
Mr. KANJORSKI. I was going to confess something. I gave up holding equities when I got elected to Congress. But I have to tell you, I gave up going to cocktail parties about 5 years ago, because I just couldn't stand to go to them and listen to all my friends making 30 and 40 and 50 percent return on their investments knowing I'm in Government bonds.
Now I appear absolutely brilliant, but I want to make the point that what some of you were talking about here goes to the question of ethics and business. These investment banking houses are very substantial houses employing very substantial people. It seems to me they are prostituting, as I think the word was used, their analysts to help that side of the business.
Am I to believe that Wall Street is so much different than say the journalistic area where Katherine Graham stood behind her investigative reporters even against the President of the United States. Have we lost that standard of ethics in the business field? Has capitalism gotten to the level that money and money alone is the determining level of what ethics exist in the business?
Mr. BYRON. Congressman Kanjorski, I would simply say that we're at the end, or we were in March of the year 2000, to the longest sustained bull market in the Nation's history. We saw levels of premium value attached to stocks that really turned people's heads around.
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I think that it's really possible to lose your moorings when you can go from $30,000-a-year to $2- or $3-million dollars a year in 2 years in a job. So, yes, I think that the correction that you're now seeing in the market is likely to correct a lot of that.
Nobody was complaining. Nobody ever complains about the stock market when it goes up. It's only when it stops going up that people start wondering, well, why didn't you tell me before. So the ethical question I think is likely to disappear as values return to their historical norms.
Mr. KANJORSKI. With the market coming down, everybody's going to get ethics and morals?
Mr. BYRON. You'll find ethics returning to their mean, yes.
Mr. KANJORSKI. I had the one question that I brought up in my opening statement. Maybe if you could just individually respond if you have a comment on it. I have a great fear on the public policy question of privatizing Social Security and turning those millions of investors and billions and trillions of dollars over to what you describe as an ''unethical, ethical or egoistic omen market.''
What are your feelings on this as individuals? Are we prepared to do that?
Mr. Glantz.
Mr. GLANTZ. I think this has to be extremely well thought out or we're going to have a repetition of the S&L problem. With your constituents saying, ''I just lost half my money, make me whole.''
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Mr. LASHINSKY. I work for a website that is committed to informing the individual investor and I think your concerns are extremely valid.
Mr. KANJORSKI. I just want to congratulate you two. Are you the last two existing dot com companies?
Mr. LASHINSKY. I'm not sure how to respond to that.
Mr. KANJORSKI. Going back to what I said before, when I was growing up in a rather conservative investor home, we used to think of real estate investments the way you figure out the value of property was ten times earnings rentals: That was a pretty good mix of whether the profit was going to be there and the real estate investment, a maximum of 12 to 20 percent profits or earnings to price.
Then, of course, I went to these cocktail parties 5 years ago and I heard 100-to-1. You didn't worry about companies even making earnings. It was what do we call it, a new market, a new economy?
Chairman BAKER. Stupidity, I think is what it was.
Mr. KANJORSKI. We do not want to go into overkill. I, for one, would like to see more Americans have the capacity to participate in equities. I think that is a major positive feature of America today and the world today, but we cannot allow unrestrained exposure of the fox in the hen house, and I'm even worried about H.R. 10.
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Now we have allowed these securities companies to become part of huge banks and huge insurance companies. If they are willing to pollute and prostitute any measure including the media, maybe we have some fear out there. Unfortunately, maybe we need Government restraint, even though so many of us would like to have less regulation. Maybe we are starting down a trail that we have created our own monster.
How is H.R. 10 treating this? I talked to a banker the other day and he expects the world to have six multi-trillion dollar banks in the next 10 to 20 years and that will be it. The rest will be little mom and pop operations out there. That's an awful lot of economic power to put in the hands of single people. The questions are what will they do with it, and what will the people that work for them do with it, and how willing will they be to surrender their ethical standards or morality?
Anyway, Mr. Chairman, again, great panel, great discussion. I think we can take back to our membership a great transcript. Thank you.
Chairman BAKER. Thank you very much, Mr. Kanjorski. I too, like Ranking Member Kanjorski, don't have any investments in the market. Given my responsibilities, I don't think that's appropriate. But my son asked me some time ago, ''Dad, when should I get out of the market?'', and I told him ''About 3 1/2 years ago.'' This thing can't last. He just started speaking to me a couple of weeks ago now that things have gone in a different direction.
There is no doubt that the individual investor shares a great deal of responsibility in the current market circumstance. People don't make you put your money in the market, you have to make a conscious decision to write the check, to add the debit to your account. But I think our concern, properly focused, is when you make that decision that the information you are receiving is unbiased, accurate, and any interest in the party that is giving you the information material to your investment decision should be made clear.
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There's nothing wrong, and I've used it numerous times in prior hearings, in Louisiana real estate law, if I'm going to represent buyer and seller, I must have a written disclosure by both that that is OK, and then I am not allowed by law to give any information about the buyer to the seller or conversely that would prejudice the ability of the other to get full market value, or for the seller to get the best price.
I become basically a letter carrier at that point, and can no longer espouse a particular party's interest in that transaction. We have got to get our standards and the consequential effects for violating the standards in a position where I can have the same confidence in the analysts that my constituents are utilizing that I think my constituents can have in a Louisiana realtor.
I don't think that is a standard that's too high to achieve. So from my perspective, with your good help over the coming months, we hope to be able to encourage the private market to see the advisability of this effort to be cooperative and to perhaps lead us in the right direction.
But, as some have indicated, if we are not successful and the problems do not appear to be remedied, then I certainly would not at this time rule out the possible further actions of this subcommittee, given the Members' interest expressed here today.
With that, I thank you for your courteous and lengthy participation and we look forward to hearing from you further.
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Our hearing is adjourned.
[Whereupon, at 5:15 p.m., the hearing was adjourned.]