Probe of Analysts Withering From Sept. 11 Distractions
By BENJAMIN MARK COLE
Just a few months ago stock analysts were under fire.
Then came Sept. 11.
The issue of analyst duplicity in handing out “buy” recommendations was blasted off the radar screen before any significant reforms were considered. If anything, the prospect for bolstered Securities and Exchange Commission oversight appears slimmer than before Congress and others focused on the subject.
Questions about the objectivity of analysts are hardly new. The charge: that analysts, nearly by rote, issue “buy” recommendations to help their investment banking departments gain lucrative corporate finance work, and to not offend institutional owners of any particular stock.
In addition, analysts and brokerages have been taking “pre-IPO” stock in companies they later take public, running up enormous profits as the stock rises.
But on Sept. 26, SEC Chairman Harvey Pitt said that the problems surrounding analyst “buy” recommendations were “ethical issues, not legal issues,” and thus the SEC would not move for new regulations.
Pitt said he would defer to the National Association of Securities Dealers, an industry-financed self-regulatory body. The NASD has taken no action, but is studying the problem.
It is still legal for analysts to go on television, or issue reports advising investors to buy a stock, while telling institutional investors or brokerage trading departments that it’s time to sell. Analysts can personally sell, or even sell short, stocks they have advised investors to buy.
Need for change?
So little has changed on Wall Street, although some say that little needs to change. “I have never been in the camp that analyst recommendations are all just smoke and mirrors to help deals get done,” said Byron Roth, chairman and co-owner of Newport Beach-based brokerage Roth Capital Partners.
“I went to business school with Mary Ann Meeker (the Morgan Stanley Dean Witter Internet analyst), and what people have never really understood is that before Morgan Stanley would take on a deal, they had to get Meeker’s say-so. It is analyst driven,” he said.
Perhaps so, but analyst pay in the 1990s was heavily boosted by bonuses that were tied to investment banking deals, as SEC Acting Chairwoman Laura Unger testified to Congress.
Furthermore, analysts sometimes get fired. In November, after Laura Martin downgraded a slew of entertainment stocks, Credit Suisse First Boston coincidentally shut down the Pasadena office in which Martin worked. But CSFB did not ask Martin to move to any other CSFB office.
The problem of objective analyst coverage can be especially vexing for small and mid-cap companies, which make up a large part of L.A.’s corporate population. Usually there is only slim analyst coverage of these firms and that often by an analyst with a banking connection to the company.
Last month Roth Capital Partners handled a $20 million private placement of stock for Hawthorne-based OSI Systems Inc., a maker of airport security systems. On Nov. 26, a Roth analyst put out a “buy” recommendation. On Dec. 10, Roth handled another $40 million private placement. (The stock has performed well since the buy recommendation).
Byron Roth insists that the buy recommendation came from the analyst, and then the brokerage went ahead with the private placements. “In some cases, we have dropped out of syndication even after the cover of prospectus was printed,” said Roth.
Some critics say that on thinly traded stocks, a brokerage’s decision to back a stock is a self-fulfilling prophecy for a while. As the brokerage moves clients into a small-cap, the demand boosts the price. More clients jump in, inspired by the price run-up, and perhaps a well-written research report that touts the stock.
Steering clear of conflicts
A few securities firms are growing precisely because they do not have investment banking conflicts.
We don’t do any banking,” said Bryant Riley, founder of West Los Angeles brokerage B. Riley & Co. Unable to make money by handling investment banking work, B. Riley handles stock trades for institutional clients, who in turn get research from its six analysts.
Michael Pachter, who heads up research for downtown Los Angeles-based Wedbush Morgan Securities, says limited investment banking business at his brokerage leaves his 11 analysts free to draw their own conclusions.
Pachter has dispensed with old “strong buy” and “buy” labels, and now has analysts issue only “buy,” “hold,” or “sell” signals. A “hold” is issued when a stock has hit a target price and there is no justification for raising that target, said Pachter. “But our ‘hold’ really means hold. It is not a closet ‘sell’ signal,” said Pachter.
He also said that Wedbush Morgan forbids analysts from owning stock in any company that is covered by the research department.
Rep. Richard Baker, R.-La., chairman of the House subcommittee on capital markets that held hearings on analysts’ conflicts this summer, recently told reporters the issue may be revived next year.