Wall Street Prophets

Do Some Analysts Have Conflicts Of Interest?

If you're like a lot of people you probably lost a bundle when the bull market went bust. Billions of dollars were wiped out in stocks and in retirement accounts and a lot of that was lost following the advice of Wall Street stock analysts. Think of these analysts as the prophets of Wall Street—researchers who look into the future, predict the success of a company and tell investors whether to buy the stock.

Most investors believed their advice was unbiased, based on what the analysts really thought. But now it is clear that in many cases, analysts were hawking stocks that they believed were losers—because selling those stocks would make their brokerage houses rich—not you.

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But when 60 Minutes II first brought you this story last year, the largest brokerage, Merrill Lynch, told us that its analysts always "make independent recommendations based on their best judgments." But it turns out that, privately, Merrill's analysts were telling a different story, that has now been exposed in the company's own email.

"The emails were stark, they were dramatic," says Elliot Spitzer, Attorney General of the State of New York. "And they laid bare the tension and the conflict of interest that had driven the false advice that was being given by the analysts."

Last year Spitzer launched an investigation of Merrill Lynch research analysts. He subpoenaed 30,000 pages of internal emails, and found that what the analysts were telling each other privately was profoundly different than what they were telling the public.

For example: Look at what the Merrill Lynch emails said about some Internet companies at the same time Merrill was recommending them to the public. Merrill gave Infospace its highest "buy" rating. But, privately, Merrill's analysts called Infospace a "piece of junk." Merrill gave its second highest buy rating to Internet Capital Group while the analyst wrote "no hopeful news to relate. We see nothing that will turn this around in the near term." Merrill also gave its second highest buy rating to a company called Lifeminders. But the analyst called it a "POS" short for piece of ___.

"I was outraged. I reacted the way any investor would," says Spitzer. "Because I knew that there were people who were listening to the advice that was being given. Who didn't understand what was really going on. People who were losing a vast sum of money. People who were losing their kids' college tuition, their savings."

Investors may be shocked by this, but former analyst Tom Brown isn't.

"I don't know frankly how some of these analysts live with themselves," he says. "I couldn't get up in the morning and look in the mirror and know that I just caused somebody to lose 50 percent of their retirement money because I exaggerated and lied. And that's exactly what I saw at DLJ.

Brown worked at the Wall Street firm DLJ - Donaldson, Lufkin and Jenrette-for 7 years. He was a top banking analyst with a reputation for blunt honesty. Brown says he recalls a DLJ meeting where an analyst explained to the group that their job was to make the stocks they represented, look good.

"The line was, 'you have to understand, forgive me father for I have sinned.'" Brown recalls. "The point of that was that you were gonna have to go back to the sales force after having lied to 'em and tell 'em that you were wrong."

If there is pressure to lie, it stems from a very simple conflict of interest. Wall Street's major brokerage houses make about 70 percent of their profits from what's called "investment banking" – simply put, that's raising money for companies that need cash. Here's an example, when Pets.com needed money, it went to one of its bankers, Merrill Lynch. Merrill Lynch offered Pets.com stock for sale to the public and the higher the price of the stock, the more money the brokerage would make. Now, imagine what that analyst is going to tell the public about a stock his firm is trying to sell.

"They really are cheerleaders because even if... this company that you're working on is not a client of the firm, every company is a potential client so the investment banking group wants you to be wildly bullish about everybody," says Brown.

Meaning that if there's bad news about a stock, you're not likely to hear it from the analysts. One example is Priceline.com. The brokerage firm Morgan Stanley made millions of dollars in fees raising money for Priceline. Morgan's analyst, Mary Meeker, seen here on CNBC, recommended buying Priceline's stock at $134 a share. When it fell to $78, she repeated her buy recommendation. And she kept on recommending Priceline as it fell to less than three dollars in 2000.

Are analysts free to be critical of clients of the firm? "I don't think analysts are so free, since I was fired for being critical of, not only clients, but potential clients of the firm," says Brown.

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How did he come to be fired? "I was very critical in the 1995 to 1998 time frame of the mergers and acquisitions activity that was taking place among the largest banks. I frankly thought they were paying too much and that they were using unrealistic assumptions and that shareholders were going to be hurt," says Brown.

Brown says he was fired because the banks he criticized stopped doing business with DLJ. The company told us that Brown was fired because of quote "his persistent inability to operate effectively within a team infrastructure." DLJ insisted that there is a separation between investment banking and analysts and it says that its analysts are encouraged to be candid.

Brown says that he thinks that the average investor was hoodwinked in all of this.

The Merrill-Lynch e-mails show that other analysts felt the same way—privately at least. One wrote, "We are losing people money and I don't like it. John and Mary Smith are losing their retirement because we don't want [our clients] to be mad at us." She added, "The whole idea that we are independent from [investment] banking is a big lie."

In fact, Spitzer says, far from independent, the analyst's pay was linked to investment banking.

"Compensation is the key to this. The analysts were told every year, tell us, the people who will determine your bonus, how much you helped the investment bankers," says Spitzer. "What deals did you help promote? What revenue did you generate? So the analysts were told your compensation depends upon your helping the investment bankers and that they understood, the analysts understood was the key to getting the big bonuses. And not the integrity of their research. Not being right or wrong in their stock picks. How much they helped the investment bankers was the key."

One of those raking in the big bonuses was Henry Blodget, the former head of Internet research at Merrill Lynch. He was taking in a reported $15 million a year for advice on companies like Infospace. Early in 2000, Infospace was trading above $130 a share. Publicly, Blodget's research department said it should be trading at $200. But privately, Blodget wrote that he had "enormous skepticism" about the stock. Even so, Merrill continued to tell investors to buy Infospace as it fell all the way down to $11 a share. It's an example of one of the analysts' unwritten rules—never say sell.

"You rarely see sell," says Lise Buyer, a former Internet stock analyst. "It angers management, it doesn't help institutional investing clients and it makes a lot of people very hostile at you. So what you say instead is 'we're downgrading this to a hold and believe it promising for those with a three to five year investment horizon.' Which for those in the know means-'See ya.'"

In the roaring 90's, thousands of people, watching from their kitchens, tuned in to analysts who appeared on TV like sports commentators. New investors were taking it all down with no idea about the conflict of interest.

"One of the problems is when CNBC started 10 years ago it had a relatively small audience that was almost entirely professional," says Mark Haines, the host of Squawk Box on CNBC. "There was no need to point out these relationships because our viewers knew about them."

"The pros knew. As time went by, the so-called democratization of the market occurred and as the audience broadened, more and more and more people were coming to this not knowing the rules."

Haines says the analysts can't be blamed alone—he says that many investors chose to ignore warnings that should have been obvious.

Says Haines: "We would invite on the CEOs and we would interview them and we would say do you have any patents? And they would say no. Well, would it be hard for me to go into business to compete with you? And they'd say no…. Do you have any cash? No. And I'd look down and the stock would be up $40. It didn't make any difference to people. You would point out the risks, you would point out how crazy it was. There was a mania going on out there where people were just throwing money. And you would, if you would grab them by the lapels and shake them and point out the risks and it didn't make any difference."

There were subtleties to the market, says Buyer: "Should the individual feel badly about some of that? Yes. On the other hand, no one ever said anywhere that stocks were a risk free game."

Neither Mary Meeker nor Henry Blodget would agree to do an interview for this story. But Meeker did send a statement saying in part, "We maintain a strict separation of the (investment) banking and research functions within the firm. Our research is objective and has a long term focus." Henry Blodget left Merrill Lynch last year and is now writing a book.

Last week Merrill settled the case brought by the New York Attorney General. The firm did not admit wrongdoing but it did agree to pay a $100 million fine and separate research analysts from investment banking. Merrill wrote to us saying, "We believe strongly in the integrity of our research. The new policies we are implementing will ensure that analysts are compensated only for activities intended to benefit investors."

As for Brown, he started his own investment company. He left the analyst game because he says there's too much pressure to be dishonest. DlJ offered him the usual severance deal when it fired him but he refused because it required him to keep quiet.

"I have no regrets. DLJ offered me $400,000 to not say anything… And I decided in August of '98 that it was worth more for my pride to be able to shout it from the mountaintop that something was wrong and tell them to keep the $400000."
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