Buy! (I Need the Bonus)

By Daniel Kadlec

Inside Salomon Smith Barney, analysts date the cultural shift in the research department to 1997, when parent company Travelers Group bought Salomon Brothers and married that firm with its focus on institutions and investment banking to retail-driven Smith Barney, which Travelers (now Citigroup) also owned. Suddenly, "earning money the old-fashioned way" made a far better ad campaign than corporate game plan. "The Salomon guys were a little faster with the rules and more focused on investment banking," says a longtime member of Smith Barney's research team. That's when big money started flying toward analysts at the firm who could help reel in underwriting deals by promising to "cover" the stock--which often meant that the analysts would praise the stock and recommend it to investors.

Salomon and other big brokerages profited nicely from this approach during the '90s boom, when a rising tide lifted all kinds of leaky stocks. Investment-banking divisions became huge profit centers for brokerage firms, which in addition to garnering lucrative advisory fees made 20 times as much in commissions on IPOs as they did on simple stock trades. Companies choosing which brokerage firm would handle their new stock issues increasingly went with those that had a star analyst willing to recommend their stock.

Such was the climate that led to the now famous e-mails written in 1999 and 2000 by Henry Blodget and other Merrill Lynch analysts privately calling stocks "a piece of junk" or "crap" or "a dog," while advising clients to buy them. The e-mails, subpoenaed and made public last month by New York State attorney general Eliot Spitzer, have created an uproar among investors who feel they have been defrauded by brokerage firms whom they had trusted--and often paid--for honest advice. The Securities and Exchange Commission last week approved new rules meant to moderate the collaboration of bankers and analysts within brokerage firms. But some lawmakers and investor advocates view the rules as too little, too late and are calling for the resignation of SEC chairman Harvey Pitt.

Spitzer clearly hopes to ride the outrage against Wall Street to political gain, much as Rudolph Giuliani exploited the Street's insider-trading scandals as a federal prosecutor in New York City 15 years ago. And make no mistake: Spitzer is on to what has become an emotional issue for investors who want to see someone on their side. Long before he arrived, several institutions--the SEC, Congress, the New York Stock Exchange and the National Association of Securities Dealers--had looked for but failed to turn up hard evidence of what Spitzer asserts is criminal fraud. Few expect that anyone will go to jail. More likely, Merrill, which says the e-mails were taken out of context, will settle with Spitzer--perhaps this week--by agreeing to some kind of fine as well as curbs that would extend to other brokerage firms.

Merrill has said it is critical that any analyst practices forced on it be applied Streetwide to keep the firm from being at a competitive disadvantage, underscoring the pivotal role of analysts in the prevailing business model for investment banking. A recognizable analyst is often what distinguishes one underwriter from another. But even if underwriters were told they could not use analysts to win deals, they would still pull in plenty of business, says Samuel Hayes, professor of investment banking at Harvard University. Someone has to do the deals, he notes, and the large firms still have the critical sales, trading and advisory capability to trump boutique banking firms. What the Street fears most is having to duplicate the analytical staff on its banking side (while calling the analysts something else). That would drive up costs dramatically.

The Street also dreads a lengthy process to resolve the analyst flap, which, layered on top of the accounting concerns springing from the Enron scandal, is driving investors away. To help regain their confidence, brokerage firms are making a show of efforts to reform. Last week UBS Warburg initiated its coverage of JetBlue Airways--a firm whose IPO it co-managed last month--by advising investors to "reduce" their holdings. It was apparently a pre-emptive move, to show regulators that UBS Warburg is indeed capable of using the word sell.

Meanwhile, the industry absorbed a new set of SEC rules approved last week, which order that analysts' pay not be tied to specific transactions, that analysts not be permitted to share draft research reports with clients or prospective clients, and that analysts more visibly disclose conflicts of interest. There wasn't a peep of dissent on Wall Street, which, unhappy with Spitzer's bare-knuckled approach to reform, is openly begging for remedies from the industry-friendly SEC. Indeed, the big brokerages uniformly embraced a follow-up investigation the SEC announced two weeks ago, in hopes that Spitzer's state office would yield to a federal authority. But Spitzer isn't backing down. "I'm not going to go away just because the SEC is involved," he says. "I want to make sure the remedies we get ensure that analysts can honestly evaluate stocks."

That hasn't been the case for a decade. As early as 1991, analysts at Furman Selz (now part of ING) recall having to pass muster with investment bankers during job interviews. Bankers, who held veto power over analyst hires, pressed applicants on their willingness to work with bankers. "You had to be willing to compromise, or you were out," says a former Furman Selz employee. By 1996 analysts at some large firms were going on new-business pitches with investment bankers, crossing the line dividing salespeople and bankers, which had been sacrosanct. By then star analysts were getting as much as 75% of their compensation from the banking side of the firm. One can well imagine they cared more about wooing banking clients than about putting Grandpa in a winning stock.

In a 1999 memo, Merrill's Blodget outlined a weekly schedule that had him spending 85% of his time on banking and 15% on stock research. Many analysts had investment-banking bonuses written into their contracts. In an interview with FORTUNE last year, Mary Meeker, the analyst at Morgan Stanley who was dubbed "queen of the Net" for her connections in Silicon Valley, spoke freely of her interest in IPOs and investment banking. A 1999 Wall Street Journal article reported that star technology banker Frank Quattrone at Credit Suisse First Boston enjoyed "unusual autonomy," which included tech analysts' reporting directly to him. CSFB has since removed that autonomy and any investment-banking kickers from analyst contracts.

The real crime, securities lawyers say, is that while the problems were well documented, regulators did nothing until investors had lost billions of dollars. Only since Spitzer's investigation turned up blunt double-dealing by analysts has the SEC intensified its efforts, currently looking at other firms too, like Salomon, where telecom analyst Jack Grubman earned more than $10 million a year reeling in underwriting clients. That princely pay had nothing to do with his stock advice. Grubman rated the disastrous stock WorldCom a strong buy until mid-March, although it was down 88% from its June 1999 peak. Salomon--which has told Spitzer it did not save e-mails between analysts and bankers, as required by the SEC--says Grubman acted out of conviction, not self-interest.

Spitzer's sudden celebrity and his refusal to let go even now that the SEC has begun its investigation are an embarrassment for Pitt. Just nine months on the job, Pitt has had to reverse himself more often than a new driver learning to parallel park. A former lawyer for big accounting firms and brokerages, he started out on the permissive side of debates over whether accounting and auditing functions should coexist, whether the accounting industry needs its own watchdog group and whether measures are needed to rein in stock-option abuse. In each case, he relented only after a public outcry. Now he says tougher action is needed to protect investors from bum analyst recommendations--action that goes beyond the rules the SEC approved just last week, rules that Pitt at one time regarded as sufficient.

The latest black eye for Pitt came with the revelation that on April 26 he met secretly with Eugene O'Kelly, the new chairman of accounting firm KPMG, which is under SEC investigation for its audits of Xerox. The accounting firm was Pitt's legal client for years, and the meeting prompted the Wall Street Journal and the Financial Times to run editorials saying Pitt may have to go. In an interview on CNBC last Friday, Pitt called his critics "misguided" and said, "I will serve as long as the President has confidence in me."

Pitt came to the job with a goal of regulating through consensus and self-policing, a stark change from his predecessor, Arthur Levitt, who was an outspoken ally of the small investor. In the wake of Enron, Pitt hasn't had a chance to test his style, and the hard-charging Spitzer is now making many wonder if Pitt isn't plain soft. "The SEC under Harvey Pitt has been something of a reluctant regulator," says John Coffee, professor of securities law at Columbia University. Damon Silvers, associate general counsel at the AFL-CIO, which has been carping about analyst abuses for a year, says, "The SEC was a little late to this party." In the end, Pitt's survival doesn't mean much to investors. What they need is evidence that the game isn't rigged.