The NYT almost gets it about SEC fines

Michael Pollak mpollak at
Thu Dec 26 23:56:49 PST 2002

[Not as good as Nomi, but better than anything else in the Times. Of course this is from a visitor, admitted for the sake of balance.]

New York Times December 27, 2002

Settling for Less



One week ago regulators and the nation's top investment firms

announced what they described as a historic settlement. To settle

government claims that they misled investors, the country's 10 largest

securities firms will pay $1.4 billion and will make certain changes

in how they operate. Industry regulators said the settlement

represents "the dawn of a new day on Wall Street" and is a "vital step

in restoring investor confidence."

It might be more accurate to regard the settlement, announced by

federal, state and industry regulators, as a slap on the wrist. By any

standard measure its punitive value, its deterrence effect or the

extent to which it will bring about structural change on Wall Street

the settlement is rather modest.

One goal of regulatory action is to provide deterrence by imposing

costs for past misdeeds. For deterrence to be effective, players must

anticipate penalties that would exceed any gains they would make from

the misbehavior. While more than $1.4 billion in fines and future

payments is hardly trivial, it is not large given what is at stake and

the potential gains to the firms from this type of misconduct.

Consider Citigroup, on which much of the recent investigation has

focused. Jack Grubman, its star analyst, is alleged to have painted an

excessively rosy picture of telecommunications firms in order to help

Citigroup get underwriting business. The total cost of the settlement

to Citigroup will be $400 million. Is this price steep enough to

discourage thoughts of similar misdeeds in the future? Hardly.

According to a complaint filed by New York Attorney General Eliot

Spitzer against five telecom executives who received shares in

companies brought public by Citigroup's investment banking unit, the

unit has underwritten $190 billion in the telecom sector alone since

1996, pocketing hundreds of millions in underwriting fees. Moreover,

according to its 2001 annual report Citigroup made $4 billion from

underwriting fees in 2000 and 2001 10 times the cost of its part of

the settlement.

Aside from monetary penalties, another way to discourage corporate

misconduct is the threat of criminal sanctions for corporate

executives. Thus far, however, regulators have not announced any plans

to indict any of the individuals involved in the scandals over

analysts' research and banks' conflicts of interest.

Perhaps the value of the settlement lies in neither its punitive

effect nor its deterrence value but in the structural changes it will

bring to Wall Street. The terms of the settlement require the firms to

sever direct ties between their research divisions and their

investment banking businesses. By preventing analysts from

accompanying investment bankers when they make sales calls, for

example, and by prohibiting any linking of analysts' compensation to

the investment banking business they bring in, the settlement tries to

ensure that analysts will render objective investment advice.

But even without such direct links, analysts will still be influenced

by how their actions affect their firm's other profit centers, like

investment banking. The settlement does not permit the fate of

analysts to be directly determined by the investment banking unit. But

the success and compensation of analysts will continue to depend on

the management and decisions of the firm's top executives, for whom

investment banking fees remain an important source of profits.

There is strong empirical evidence that analysts tend to issue more

favorable reports about companies with which their firms have an

underwriting relationship. There is little reason to expect that the

settlement will eliminate this pattern.

Analysts have substantial discretion in choosing which recommendation

to issue. We might expect their recommendation to be influenced if,

for example, their firm brought public the company they are covering.

And we might expect the head of the research department to try to

please the firm's executives with a department that makes "buy"

recommendations rather than "sell" recommendations for the companies

the firm underwrites.

In fairness to the regulators, they had to take into account other

considerations in fashioning the settlement. Tougher action on the

nation's top investment firms could have dealt a terrible blow to

important institutions at a difficult time for the capital markets. It

is also true that the reputational costs and public embarrassment

caused by the scandals, coupled with the private suits many investors

are bringing, will provide some measure of deterrence. And perhaps

there are no realistic structural reforms that would work better than

the moderate ones adopted.

Still, the settlement is better characterized as "business as usual"

than as "the dawn of a new day." We should not exaggerate the extent

to which the settlement will restore investor confidence.

Lucian Bebchuk is a professor at Harvard Law School and a research

associate of the National Bureau of Economic Research.

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