July 1999-July 2001 Goldman Sachs
Goldman Sachs listed World.com as one of the stocks to buy yet they knew the stock was not a good buy. In a private conversation with a hedge fund manager, the Business Unit Leader of Goldman's U.S. Telecommunications told the manager that the stock is a sell. The investment bank received fees from World.com and other clients thus influencing it to give misleading information. Goldman Sachs was valuing the company and providing other investment banking services. Conflict of interest led to investor losses since they purchased World.com due to Goldman's valuation. The firm's executives fraudulently manipulated earnings by creating illusionary profits to match analysts' valuations (Atlas, 2002). World.com filed for bankruptcy in July 2002, one month after it revealed that it had improperly accounted for expenses amounting to $3.8 billion.
May 1999 Lehman Brothers (Analysts) and Razorfish:
Razorfish was Lehman Brothers' banking client. It gave Razorfish a 2-Buy rating and a target price of $48 despite the institutional investor's rating of Neutral. Lehman Brothers Inc. was valuing Razorfish, yet the later was its client for other banking services. Giving valuations favorable to Razorfish helped the bank to secure other banking services. This conflict of interest compromised the independence of Lehman Brothers. Analysts at Lehman Brothers had to exaggerate Razorfish's rating to increase their earnings on fees from other banking services offered to Razorfish.
October 2000 Merrill Lynch -Top Internet Analyst:
Merrill Lynch rated InfoSpace stock as a long-term buy yet its top internet analyst disclosed to an institutional investor than the stock was a piece of junk. Merrill Lynch provided investment banking services to InfoSpace. Thus, it had a conflict of interest in its valuation of the company. Despite its analysts indicating to an institutional investor that InfoSpace was a 'short,' Merrill Lynch gave a 'buy' recommendation. Merrill Lynch overstated InfoSpace's potential. The company became popular at the Wall Street and was at one time worth more than Boeing (Heath & Chan, 2005). However, since Merrill Lynch's valuations were misleading, the company collapsed as its stock fell from $1000 in March 2000 to less than $3 by June 2002 (Heath & Chan, 2005).
April 2001 Salomon Smith Barney Inc. this case involved Jack Grubman Salomon's top telecommunications analyst. Grubman listed six stocks that "must not remain buys" yet Salomon maintained buy ratings for the stocks. Salomon offered investment banking services to these six companies. The head of Salomon's investment banking instructed Grubman not to downgrade the six stocks to avoid hurting the investment banking business. The head noted that such downgrades would 'anger' the companies and lead to losses to the bank. Due to the conflict of interest, Salomon maintained the buy recommendation on these stocks, some as late as November yet they ought to have been downgraded as early as April. This misled investors into buying such shares that were collapsing.
1999 to 2001 Bear Stearns:
It was involved in several transactions leading to conflicts of interest. When negotiating for an IB mandate, the bank sent its analysts to persuade the client to select it as one of the investment bankers. It also initiated coverage on companies that engaged it and promised the companies an improved future financing. The investment bank offered valuation services to clients while lobbying for other banking services to the clients. This compromised its independence. The bank pressured its analysts to give independent valuations but also be sensitive to the interests of its clients. This followed complaints from some clients that the bank's analysts were not responsive to the interests of its clients. Giving independent valuations and being sensitive to the client's interests are mutually exclusive objectives. Companies would want their stocks to get positive recommendations. Thus, an investment banker being 'sensitive' to the interests of such companies would give favorable ratings even when such is inaccurate.
1999 to 2000 Morgan Stanley:
The bank promised coverage to most of its clients. Several issuers sought the coverage believing that the coverage would improve their credibility and increase stock prices.
By promising coverage on the stocks of issuers, Morgan Stanley jeopardized its independence. The coverage itself was considered a positive rating on a stock and a conflict of interest since the bank could not give a negative valuation and provide coverage. There were instances when Morgan Stanley won investment banking engagements by promising coverage to clients. Inaccurate valuations by Morgan Stanley and other banks misled investors and created a bubble in the stock market. It eventually led to the dot.com crash which affected most tech stocks.
1999 to 2001 Executives of banks and analysts. This involved almost all investment banks.
Most investment banks paid their securities analysts based on banking revenues earned. Executives of investment bankers, as well as covered companies, also pressured the analysts to issue buy recommendations. The firms encouraged included being a partner with banking as part of the job description of analysts. Banking revenues was a significant factor in the determination of the compensation of analysts with some banks giving it weight as high as a third. Jack Grubman (Bear Stearns), for instance, attended several board meetings of World.com yet he was the company's independent securities analyst. Another analyst, Mary Meeker (Morgan Stanley) trained Priceline.com presenters on how to handle pre-IPO appearances.
SEC studies indicated that most analysts were involved with startup companies and invested in those firms well before their IPOs. The same analysts would be contracted to value the stocks of these firms. Some analysts participated in roadshows and preparing pitches for the companies being valued. Analysts offering other services and attending board meetings jeopardized their independence. Securities valuation should be an independent process to guarantee objective valuations. During this time, most analysts issued reports with buy recommendations even to companies that did not qualify. It was in the interest of analysts and their firms to give favorable ratings and valuations to maximize their earnings. These conflicts of interest led to inaccurate security valuations which exposed investors to losses.
2000 UBS Warburg - analysts
The analyst warned his sales staff about putting customers into Interspeed and advised an institutional investor than the stock was a 'short.' This happened during at the time when UBS Warburg had a 'buy' recommendation on the stock. This illustrates the conflict of interest where analysts conduct personal trades contradicting the recommendation given by their firms on the same stock. Where analysts own shares of a firm, they are tempted to issue a buy rating if they want to dispose of the securities. Some analysts mislead investors, yet they inform their friends and family and other investors that stock is 'short.'
The above cases of conflicts of interest led to inaccurate and misleading valuations by analysts to the detriment of the interests of investors. The cases were due to several flaws in the regulation and operation of research analysts and investment bankers. Firstly, no law prohibited analysts from owning stocks in the companies they covered or that their firms took public. As such, an analyst would be contracted to value the share of a company in which he or she is a shareholder. This compromised the independence of the analysts since giving an unfavorable valuation would hurt the analysts' self-interests (Sanderson, 2003). Studies indicated that these analysts always issued buy recommendations on companies they owned shares. In some cases, analysts undertook personal trades contrary to the recommendation in the research report (Overton, 2018). Secondly, most research analysts were involved with startup companies before their initial public offering. Such analysts offered advisory services that jeopardize their independence thus making it difficult to issue unfavorable valuations on the securities (Shen & Chih, 2009). There were no regulations requiring firms and analysts to disclose their ownership in the securities they have valued and given recommendations (De Jonghe, Diepstraten & Schepens, 2014). The interaction between investment banking personnel and research analysts was one of the primary causes of conflict interests in the valuation of companies (Guan, Lu & Wong, 2011). Most firms integrated the two units and involved analysts in sourcing for investment banking services. In most firms, research analysts' compensation was based on banking revenue associated with the analyst. It pressured the analysts always to issue favorable ratings that were sensitive to the interests of clients (Ke & Yu, 2006). Section 501 of the Sarbanes-Oxley Act of 2002 introduced provisions to regulate the investment banking industry (Jaiswal, 2017). In April 2003, the SEC imposed actions against the top US investment banks and introduced reforms in the investment research industry, popularly known as the Global Settlement (Bathala, 2010). The changes to address the conflicts of interests are discussed below.
The Association between Investment Banking and Research Analysts
The reforms limit communication between the investment banking and research departments (Sec.gov, 2018). Besides, investment banking staff are barred from evaluating the performance of research analysts. The rules also prohibit research analysts from discussing or sharing research reports with the investment baking personnel. Investment banks are also required to physically separate the research analysts and investment banking departments. Firms cannot involve research analysts in pitching for clients or soliciting investment banking services from clients (Spindler, 2004). This provision protects the independence of the research department thereby improving the accuracy of valuations and recommendations.
Compensation of Analysts
The rules prohibit firms from tying the remuneration of a research analyst to investment banking transactions (Stowell & Stowell, 2013). This eliminates the conflict of interest where analysts provided favorable recommendations to increase their earnings (Arand & Kerl, 2012). Besides, where the income of an analyst is based on some investment banking revenues, that fact must be disclosed in the report (Stowell & Stowell, 2013). This provision also improves transparency in securities analysis and valuation.
Promises of Favorable Research
Analysts are now prohibited from promising companies favorable recommendations or threatening to issue adverse recommendations to secure investment business (Bartos, 2006). Besides, a firm acting as a co-manager of the company offering the securities cannot issue a report on the company's stock within 40 days after the IPO (Groysberg & Healy, 2013). This regulation makes promising favorable ratings unattractive. Even if a firm promises and gives a favorable rating, other analysts will issue a report, which may conflict with the favorable recommendations.
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