Spitzer Picks Nits

The faulty premise of the state corporate scandal investigations.

In Salt Lake City, temporary legal workers and law students are trolling through some 100,000 e-mails sent by employees of Goldman Sachs, seeking evidence that its analysts skewed stock recommendations to curry favor with investment bankers and companies. (The researchers may not find evidence of conflicts of interest, but they will surely hit a mother lode of off-color jokes.)

Ever since New York State Attorney General Eliot Spitzer single-handedly wrung a $100 million settlement out of Merrill Lynch in May, his fellow state AGs have been sifting through Wall Street internal communications like forty-niners in search of gold nuggets. California has staked out Deutsche Bank, Massachusetts is digging dirt on Credit Suisse First Boston, and Alabama is looking into Lehman Brothers.

The connections between the states and their Wall Street targets are tenuous. Lehman does trace its origins to a dry-goods store in Montgomery, Ala. But the states really claim jurisdiction because large investment banks all conduct business in every state and because investors in their state were theoretically harmed by the corrupt recommendations these banks’ analysts made.

There is some historical precedent for this state activity. In the early 20th century, securities salesmen traipsedfrom town to town like Harold Hill, promising the investments they sold would grow as high as the sky. And so sensible Progressives (the muscular early 20th-century kind) passed “Blue Sky” laws, which empowered states to regulate securities and punish hucksters.

Since the creation of the Securities and Exchange Commission in 1934, federal law enforcers have generally taken the lead in securities cases. But with the SEC run by Harvey Pitt, a man not known for his reformist tendencies, the state AGs, who possess both vast ambition and the power to litigate, have stepped into the vacuum. What better way to get free media exposure, and hence set the stage for a gubernatorial run, than by crusading against an ill-reputed industry? Even now, the Spitzer 2006 buttons are likely being printed. (In 1998, Jacob Weisberg explained why state AGs have suddenly become so litigious.)

Still, the premise of these state cases is troubling. The theory seems to be that by failing to disclose that their recommendations (and compensation packages) were influenced by their firms’ investment-banking business, analysts corruptly gulled people into buying stock and then into holding that stock as it crashed.

The problem with the theory is that it confuses analysts’ responsibility to clients (enormous) with their responsibility to all the people who watched them on CNN (nonexistent). What fiduciary duty to the residents of Provo, Utah, did Jack Grubman violate when he flogged stocks on CNBC? What commercial relationship between Lehman Brothers and the denizens of Birmingham, Ala., was compromised when a Lehman analyst told a Dow Jones reporter that she had upgraded a stock to a strong buy?

The vast majority of the people who consumed these recommendations—on television, through the Internet, in newspapers, at the water cooler—and then acted upon them weren’t clients of the investment banks.

When most people buy stocks traded on the New York Stock Exchange, they buy them from other investors. Specialists on the floor of the NYSE stand there all day and match up buyers and sellers. The person who sold you those 200 shares of Enron at $80 could have been a mutual-fund company like Janus or your neighbor. When you sold AOL at $50 just before it plunged, you made a few bucks off your buyer’s misjudgment.

Now, if you were a Merrill account holder, and your Merrill broker, acting on Merrill analyst Henry Blodget’s suggestion, strongly suggested that you buy a stock of one of Merrill’s investment-banking clients, and thus induced you to conduct a revenue-generating transaction with Merrill, that would be plainly actionable. Indeed, last year Merrill paid $400,000 to a brokerage client who lost bucket-loads of cash after taking Blodget’s advice to buy InfoSpace, a Merrill investment-banking client. Even as the stock tanked, the Merrill broker urged the client not to sell, citing Blodget’s positive recommendation. Investors and lawyers have filed several arbitration claims or lawsuits involving similar situations.

(In that case, Merrill didn’t merely give its own client poor advice in order to safeguard its profitable InfoSpace relationship. It also violated one of the basic premises of its relationship with individual investors. Investors pay high commissions to trade with large firms like Merrill so that they can get exclusive access to their stock research.)

But simply watching Blodget on television doesn’t make you a Merrill Lynch customer. And if you didn’t have an account at the firm or didn’t rely on the advice of a firm’s brokers when you conducted a trade, how can you prove that you bought on the recommendation of one conflicted analyst, rather than on the equally wrong advice of another, unconflicted analyst? Virtually all the analysts—including the independent ones—were wrong about Amazon, Cisco, Enron, and a multitude of other stocks.

I’m not defending equity analysts. As a group they have underperformed. And there’s no doubt that people who took their advice lost money. But the vast majority of these people weren’t their customers.

Ah, but wasn’t concealing the influence that investment-banking relationships had on their stock recommendations a crime? Didn’t they have an obligation to tell CNBC viewers about their conflicts of interest? I’m no lawyer, but I’m not sure. There’s a difference—some may think it too fine—between not volunteering information that you’re under no legal duty to disclose and lying about it.

The problem was, as The Music Man author Meredith Willson might have put it, that the small investors didn’t know the territory. And sadly, neither did their guides, financial journalists. Throughout the boom years, CNBC and the vast majority of financial news outlets lacked either the understanding of the markets or the inclination to ask pointed questions of analysts. Had Grubman been asked point-blank: “Does your firm do investment banking for WorldCom?” or “Isn’t your compensation partially tied to Salomon’s investment banking business?” he likely would have fessed up, and viewers could have drawn their own conclusions. The pervasive policy, however, was don’t ask, don’t tell.

While there are a few damning episodes of two-faced analysts praising a stock in public and dumping on it in private, by and large the multitude of crappy stock recommendations turned out to be predictions that failed to pan out. Stock analysts weren’t public officials, who had sworn some legally binding vow to provide the public with unstintingly accurate advice. They were, and are, essentially salesman for stocks and for the stock market in general. It’s our mistake to listen to them.

Spitzer was able to extract a settlement from Merrill in part because he was armed with New York’s Depression-era Martin Act, under which state prosecutors don’t have to prove intent to commit securities fraud. Instead, they can say that fraud occurred if investors were not given all the information necessary make informed decisions.

The premise behind Spitzer’s case against Merrill—and all these other potential state cases—is that all of us buyers were too ignorant to ask questions. But of course, the truth was out there. It just wasn’t on CNBC or in other free media. Throughout the late 1990s, made a habit of pointing out investment-banking relationships when it quoted analysts. But you had to pay $160 per year to subscribe to that publication, and only a tiny sliver of the investing population did.

Of all the delusions rampant in the late bull market, perhaps the notion that you could get great investment advice for free on television was the biggest. But did that make the TV analysts crooks for offering that advice? Or did it make us fools for heeding it?