East West Ends Squabble Over Research Deal

By ANTHONY PALAZZO and CONOR DOUGHERTY

Staff Reporters

First Union Securities has quietly settled a lawsuit accusing it of making, and then breaking, a promise to provide research coverage to East West Bancorp in exchange for receiving $10 million in investment banking business.

The case, filed in L.A. Superior Court and settled in early August, sheds additional light on the close ties between brokerage firms’ investment banking and research departments. It also raises the question of whether recently adopted rules, which prohibit only promises of favorable research coverage in exchange for investment banking business, go far enough.

“The investment bank’s retail clients are expecting the honest advice of the analysts, as opposed to advice that is intended to benefit the investment banking business,” said Stephen Bainbridge, a law professor at UCLA. When research coverage is promised at all as part of an investment banking deal, “it seems to me that that’s just fraught with conflicts of interest,” he said.

First Union promotes its research as “objective.” But testimony arising from the case points otherwise.

Research analyst Bradley Vander Ploeg acknowledged in an internal memo that his choices of research targets weren’t based on merit.

“Many of the smaller companies on our coverage list were being followed in order to support investment banking relationships, and were of only limited interest to a select few institutional clients,” the memo said.

The memo was issued on July 24, 2000, around the time that First Union dropped coverage of a number of small banks and failed to initiate the research the firm allegedly promised to East West. The memo was read into a deposition in the case.

In the same deposition, a director in First Union’s debt capital markets group, Amy Kabatznick, is asked whether First Union targets certain companies for coverage in order to support “desirable” investment banking relationships with those clients.

“Not being an equity market professional, and not being in the equity capital markets group, that is my perception from where I stand in the bond group,” Kabatznick answered.

Retail heft

First Union Securities changed its name to Wachovia Securities after the September 2001 merger of First Union with Wachovia Corp. Charlotte, N.C.-based Wachovia is the nation’s fourth largest bank, with assets of $325 billion. It operates the fifth-largest retail brokerage operation.

Citing the litigation, Wachovia Securities spokesman Jim Pierpoint declined to comment beyond a prepared statement: “Wachovia Securities has clear policies and procedures in place to ensure the integrity and independence of our equity research in keeping with SEC regulations.”

Vander Ploeg, now a senior vice president with Raymond James Financial Inc., did not return calls. He left First Union in March 2001.

Kabatznick could not be reached.

Critics have periodically assailed the perceived ties between the research and investment banking arms of brokerage firms. The firms maintain that a “Chinese wall” between the two arms keeps their research coverage independent. But a number of events have turned up the heat on perceived conflicts.

Merrill Lynch & Co. has undertaken numerous reforms of its equity research department in the wake of a $100 million settlement following New York Attorney General Eliot Spitzer’s investigation into its analysts’ practices. E-mails sent by Merrill analysts belied their public proclamations of support for Internet companies with snide dismissals.

In June, U.S. Bancorp’s Piper Jaffray unit agreed to pay $300,000 to settle an investigation into whether it revoked its research coverage when a client, Antigenics Inc., chose another firm to lead a follow-on offering.

And Salomon Smith Barney telecommunications analyst Jack Grubman recently admitted in Congressional testimony that his views probably brought investment banking business to the Citigroup unit. He is reportedly facing regulatory action from the National Association of Securities Dealers over his research on Winstar Communications Inc.

“(Investment) banks have long maintained that the two operations should be separate,” said Charles Elson, director of the Center for Corporate Governance at the University of Delaware. “The controversy that’s swirling has revolved around coverage being influenced by underwriting activities.”

Promised coverage

The East West lawsuit only fuels those concerns. Filed in August 2001, it addresses events starting in late 1999, when First Union sent a Chicago-based investment banker, Dennis Klaeser, to meet with East West’s chief financial officer, Julia Gouw, according to the complaint filed by East West.

In the complaint, East West claimed Klaeser, who was a managing director of First Union’s Wheat First Securities investment banking division, repeatedly promised research coverage to Gouw and East West Chairman and Chief Executive Dominic Ng, if East West would participate in an offering of trust preferred securities to be managed by First Union.

Klaeser even brought Vander Ploeg to L.A. to help pitch First Union’s research capabilities, according to the complaint. Vander Ploeg and an assistant conducted on-site research in preparation of an initiation, the complaint said, but First Union never initiated research coverage.

Letters sent from Klaeser to Ng and Gouw that were filed in the case appear to support East West’s allegations. In one, Klaeser indicates he “would be willing to discuss making a commitment to initiate equity research coverage.” Another states: “You can expect a call from Brad Vander Ploeg within the next couple of weeks to discuss research coverage ”

The first attempt at a First Union-led offering in early 2000 fell through. East West raised the $10.4 million it needed through another firm, but continued to seek research coverage from First Union. Klaeser told Gouw that First Union would only initiate coverage if it were chosen to manage an additional offering of at least $10 million in size, according to the complaint.

Ultimately, East West complied despite the fact that its capital objectives had been met. Obtaining research coverage was “one of the principal business factors” in the decision to raise another $10 million of trust preferred securities as part of a larger pool, at a cost to East West of more than $300,000, the complaint said.

East West committed to the deal on July 12, 2000, and it closed on July 26, according to the complaint. East West alleged that shortly after the deal closed, First Union breached its oral agreement by “refusing and failing to ever initiate or provide” coverage of its common stock.

Around the time the East West deal was going through, First Union dropped coverage of a number of small-cap banks. It couldn’t be determined whether Vander Ploeg’s July 24 memo was meant to address the dropped coverage.

East West sought $2 million in damages.

First Union initially fought the lawsuit, filing a motion to dismiss it as recently as July 19.

Case settled

In that filing, First Union said there are “numerous factual disputes whether First Union representatives ever orally agreed or promised to provide equity research coverage.” However, the document did not detail those disputes.

But with a trial date of Sept. 17 approaching, the firm opted to settle.

“If I had this sort of dispute right now I would not want to be getting into litigation that would put things in the public record that might then attract the regulators’ attention,” Bainbridge said.

The case has been resolved and a settlement agreement signed by both parties, said East West’s attorney, Michael J. Maloney. Under the final settlement agreement, First Union has required that specific terms of the settlement be confidential. Maloney declined to comment on negotiations that led to the settlement.

Both sides agreed to an earlier stipulation to keep discovery information confidential as well, Maloney said. The material found in the deposition was filed in support of First Union’s dismissal motion.

Klaeser couldn’t be reached, and Wachovia’s Pierpoint declined to say whether he still worked for the firm. Klaeser was listed elsewhere in November 2001 as a member of the global structured finance and leasing group at Arthur Andersen LLP. An Arthur Andersen spokesman did not return a phone call.

Through their lawyer, East West’s Gouw and Ng declined to comment.

New rules

The East West case illustrates potential loopholes in recently developed rules governing analyst conflicts. The rules, approved by the Securities and Exchange Commission in May, were developed by the securities industry. NASD Chairman and Chief Executive Robert R. Glauber praised them as “comprehensive” in addressing potential analyst conflicts of interest.

The rules ban promises of favorable coverage, or the threat of its withdrawal as inducement to investment banking deals. But they don’t take the extra step of banning any commitment to coverage.

“What’s appropriate is that there be no tie. Brokerage firms should provide research coverage on companies that they believe would be attractive investments for their retail or institutional clients. Period,” said Lloyd Greif, chief executive of L.A. investment banker Greif & Co. His firm has no research department.

Less discussed in the Merrill inquiry and elsewhere in the analyst debate is the role the covered companies play in treating equity research coverage as a marketing tool.

Gouw, for example, testified that each time she spoke with Klaeser she made sure he understood that “we will not do any transaction with First Union if we are not getting analyst coverage.” She also said she asked him to put his assurances into writing, although the pledge apparently wasn’t included in the transaction contracts.

Executives at small companies are well aware that research coverage is a key to getting the stock price higher.

Indeed, research done by Paul Irvine, assistant professor at the Goizueta Business School at Emory University in Atlanta, shows the initiation of new research coverage provides a boost to the prices of lightly covered stocks, because additional trading volume increases their liquidity.

The so-called “liquidity premium” existed even with “hold” ratings, Irvine said, although the price improvement was not as high.

“What you have is a company fully recognizing that they are paying for a research report. And they’re paying for it not by writing a check to the analyst, not by writing a check to the firm, but by throwing business to the firm,” Greif said.