Here’s a doozy of a business ethics problem:
In May, Morningstar, the Chicago-based company that rates the performance of mutual funds, filed to go public. Founded in 1984 by former securities analyst Joe Mansueto, Morningstar has parlayed a quarterly publication, Mutual Fund Sourcebook, into an international research-based company that now serves “more than 3 million investors, 100,000 professional financial advisors, and 500 institutional clients around the world.” In 2003, Morningstar had revenues of $139.5 million, although profits have been meager.
Morningstar, a sort of Consumer Reportsfor mutual-fund investors, has thrived because the data it provides is useful and comprehensive and because of its strong tradition of independence. With headquarters a time zone away from Wall Street, ownership concentrated in the hands of Mansueto and a Japanese venture capital firm, and a historic orientation toward individual investors, Morningstar has been insulated from the pressures that corrupted Wall Street research in the 1990s. Its preliminary IPO prospectus is filled with references to the firm’s “strong reputation for independence and objectivity” and its “trusted name.”
In 20 years as a privately held company, Morningstar has given investors little reason to question its integrity. But once Morningstar is public, it will, by necessity, have to forge new relationships, answer to different constituencies, and pursue new lines of business. Hello, conflicts of interest! (Don’t just take it from me. Take it from Morningstar.)
Let’s count the ways Morningstar could be compromised. First, a public offering will create a new relationship between the company and several investment banks. As the prospectus notes, Morgan Stanley will run the underwriting process, with Deutsche Bank Securities and William Blair & Co. as co-managers. A successful public offering requires underwriters’ support—before and after the IPO. Occasionally, underwriters intervene in the market to keep the price from falling below the offering price, for example. What’s more, it’s likely the same bankers will be tapped for future financing. All of these firms have mutual-fund units or operations whose products Morningstar ranks.
Second, as a public company, Morningstar will face pressure to expand its business further beyond the core of ranking mutual funds. And Morningstar hopes to grow in part by providing stock research. As part of the $1.4 billion research-corruption settlement, 10 firms will spend $432.5 million over five years to purchase independent research from companies that are not linked to investment banking. To get in on this business, Morningstar plans “to increase the number of stocks rated by our analysts from approximately 700 to 1,350 in 2004.” The prospectus notes that Morningstar is “currently in discussions with several of the 10 firms” involved in the settlement. In the space of a few years, companies in this group—which includes Lehman Brothers, Citigroup, Merrill Lynch, and UBS—could become Morningstar’s largest clients for stock research. Yet virtually all the firms in the group have mutual-fund operations rated by Morningstar.
Third—and most tricky—it is likely that a large chunk of Morningstar’s publicly held shares will wind up in the hands of mutual funds. And since Morningstar isn’t a huge company, it would be relatively easy for a single mutual fund, or for several funds in the same family, to acquire a big stake. That would naturally raise questions about Morningstar’s independence. Of course, it would be remarkably destructive for Morningstar to skew its ratings to favor a shareholder or a client, or for a mutual fund that owns a big chunk of Morningstar to push it to treat its funds with favor. Still, self-destructiveness is hardly unknown on Wall Street.
Sure, thanks in part to the recent scandals, certain conflicts of interest have been legislated out of existence. But when there are public companies, and when there is money to be made from advice, new conflicts are likely to spring up. Will Morningstar stoutly protect itself against them, or will it fail? Check the Harvard Business School case study in 2014.