In the firing line
    Oct 4th 2002 
    From The Economist Global Agenda
    &&&
    
    In a week when prosecutors have finally charged the former chief financial
   officer of Enron, New York’s feisty attorney-general, Eliot Spitzer, is
   joining forces with the Securities and Exchange Commission to root out
   corporate wrongdoing in America. Investment banks beware
    AP  
        
        
    Spitzer sues again
    
        
    THE might of Wall Street is under attack from all sides. In filing charges
   alleging fraud, money laundering and conspiracy against Andrew Fastow, the
   former chief financial officer of Enron and the first of the company’s
   “inner circle” of senior executives to be indicted, federal prosecutors
   have also pointed the finger at Merrill Lynch. A criminal complaint, filed
   in a Houston court on October 2nd, alleges that the investment bank helped
   Enron to conceal debt and hide its true financial position. One of the
   charges against Mr Fastow, who was given bail of $5m, involves a Nigerian
   company which Enron is said to have sold to Merrill and then repurchased in
   order, it is claimed, to inflate Enron’s earnings. The transaction was a
   “sham”, say prosecutors, in which Merrill assumed no risk. 
    
    Such allegations, which have been vehemently denied by Merrill, are an
   example of the whirlwind of claim and counterclaim that is engulfing Wall
   Street’s finest and many of its former clients. On the day that Mr Fastow
   gave himself up to FBI agents, a Congessional committee was chipping away
   at the reputations of Goldman Sachs and two other investment banks. The
   House Financial Services Committee accused Goldman, Credit Suisse First
   Boston and Salomon Smith Barney, part of Citigroup, of making preferential
   allocations of shares in sought-after initial public offerings (IPOs) to
   their favoured clients, so that the latter could make a quick profit by
   selling the shares on. In return, the banks are said to have received
   lucrative banking mandates. Among the executives named was Kenneth Lay, the
   former chief executive of Enron. The committee concluded that the practice,
   known as “spinning”, had not only led to the false pricing of IPOs but
   had harmed ordinary investors. “There is no equity in the equities
   market,” lamented the committee’s chairman, Michael Oxley, the
   Republican member for Ohio.
    
    Congress is not the only body making accusations about the cosy
   relationship between investment banks and their clients. On September 30th,
   Eliot Spitzer, New York's attorney-general, filed a lawsuit seeking that
   once high-flying telecoms executives return over $1.5 billion in profits
   allegedly obtained illegally thanks to their links with bankers at Salomon
   Smith Barney. Most of the money was made when the executives sold stock in
   their own companies that was inflated by overly optimistic reports from
   Salomon’s recently departed star analyst, Jack Grubman. The executives
   also pocketed some $28m when they sold shares they were allocated in IPOs
   of “hot” technology clients of Salomon's, allegedly as a payback for
   giving investment-banking business to Salomon.
    
    The executives involved include Bernie Ebbers, the disgraced former boss
   of WorldCom, which filed for bankruptcy in July and which has admitted
   overstating profits by $4 billion; Philip Anschutz, former chairman and
   founder of Qwest Communications; and Joseph Nacchio, Qwest’s former chief
   executive. Neither Salomon nor Mr Grubman were named, but correspondence
   that embarrasses them has been included in the evidence. In one e-mail, Mr
   Grubman wrote to the head of research, explaining why certain stocks had
   not been downgraded: “Most of our [investment] banking clients are going
   to zero and you know I wanted to downgrade them months ago but got huge
   pushback from banking."
    
    &&&T and United Technologies, “as part of our continuing effort to
   assure that our corporate governance reflects best practices.” On the
   same day, Citigroup announced that Michael Masin, currently vice-chairman
   of Verizon, a regional telecoms firm in the north-eastern United States and
   a Citigroup director, would become chief operating officer. Mr Masin is to
   chair a committee reviewing Citigroup's business practices.
    
    Citigroup is also in negotiation with both Mr Spitzer and the Securities
   and Exchange Commission (SEC) over new arrangements that would remove
   conflicts of interest inherent in having analysts and investment bankers
   under the same roof. The SEC worries in particular that analysts are being
   rewarded on the basis of investment-banking mandates they help their bank
   to win rather than the quality of their research.
    
        
        
        
    
    
        
    
    Citigroup is reported to have already offered to create a separate company
   to house its investment-banking research, though this would still be within
   the Citigroup empire. The spin-off would serve mainly institutional
   investors as well as the small number of retail investors who trade through
   Salomon. Its analysts would no longer be allowed to attend “pitch”
   meetings with investment bankers. Citigroup has resisted making any changes
   unless and until they can be imposed on other Wall Street firms as well.
   CSFB, which is under scrutiny itself over the alleged allocation of shares
   to “friends of Frank”--Frank Quattrone, its star technology
   banker--is known to be willing to go along with such changes. Merrill
   Lynch, which has already made some changes to the way its analysts are
   organised and paid, and which has paid a $100m fine following an earlier
   investigation by Mr Spitzer, is opposed to further reform. 
    
    In bringing his latest charges, Mr Spitzer has not only upset Wall
   Street’s big banks. He has also upstaged the SEC and its chairman, Harvey
   Pitt, a former securities lawyer who stands accused of being too soft on
   the big firms that used to count among his clients. The SEC, along with the
   New York Stock Exchange and the National Association of Securities Dealers,
   Wall Street’s self-regulatory organisation, have been looking into IPO
   spinning for years, but have yet to bring any actions. This may now change.
   Messrs Pitt and Spitzer have patched up their differences and are joining
   forces to press for changes in the way investment banks go about their
   business. Egged on by Mr Spitzer, his opposite numbers in other states have
   also divided up their investigations into the big investment banks: Utah is
   looking into Goldman Sachs, Texas J. P. Morgan Chase, and Alabama Lehman
   Brothers, for instance. This will not please those who believe that the
   zest for re-regulation is getting out of hand. Siren voices including that
   of Bill Harrison, chief executive of J. P. Morgan Chase, are beginning to
   warn that a raft of new regulations and moves to break up the industry
   could shackle investment banks at a time when their profits are already
   under strain. 
    
    Nevertheless, reform of how research is conducted by investment banks now
   seems inevitable. There are few examples on Wall Street--Sanford Bernstein
   is one--of truly independent research houses. It is notoriously difficult
   to get investors to pay for research, especially since academic studies
   suggest that it is extremely difficult to beat the market consistently.
   Still, observers increasingly believe that the collapse of the bull market
   will lead to the break-up of financial “one-stop-shops” such as
   Citigroup, because no firm will want to risk the sort of
   conflict-of-interest lawsuits to which it is now being subjected.
    
    Quite apart from any fine, Citigroup’s share price has fallen by nearly
   40% this year, despite healthy operating profits. Even if it does not come
   to break-ups, it is hard to see analysts retaining the status they enjoyed
   in the late 1990s. Briefly masters of the universe, they will return to
   being the backroom geeks they once were.