Business Page – May 5th, 2002

Introduction

Even as the Enron saga continues, taking down with it one of the world’s Blue Chip accounting firms, the centre of American capitalism is faced with yet another crisis involving securities firms and very specifically prestigious financial giant Merrill Lynch, one of America’s oldest and largest such firms. In an action initiated by Eliot Spitzer, Attorney General of New York under that state’s General Business Law, Merrill Lynch is accused of serious conflict of interest following an investigation by Spitzer which found that the firm's supposedly independent and objective investment advice was tainted and biased by the desire to aid its investment banking business.

Merrill Lynch is not the only securities firm which is under suspicion or investigation but it is the one where the investigation is furthest advanced and which has found it necessary to negotiate with the regulator with a view to avoiding legal action being taken against it. It has retained the popular former New York City mayor Rudolph Guiliani (Time’s Man of the Year 2001) to negotiate with Spitzer in what can only be described at this stage as damage control and which can cost the firm as much as US$2Bn.

Close to a dozen Wall Street firms including Morgan Stanley and Salomon Smith Barney have had approaches from the Securities and Exchange Commission (SEC), according to the prestigious Wall Street Journal.

The publicity surrounding Enron and its auditors Andersen has caused many in the investment community to become a little more careful and the financial statements of once-revered companies like GE and Xerox have come under intense scrutiny. There is now more than enough evidence that greed drives the capital market and that for all their high profits and glossy annual reports, these companies treat their unsuspecting investors as easy prey, ripe for exploitation by the big players and manipulation by the combined efforts of those who produce and deliver the financial results. Once again, it is the size and reputation of the parties involved that is causing the greatest unease among those in the financial and investment world. 

The Chinese Wall

As firms increase in size and complexity to meet the one-stop needs of corporate giant clients across sectors and borders, the range of their services are forced to expand covering different skills and professions. Naturally, the potential for overlap increases with the growing likelihood of what is perhaps euphemistically called conflict of interest. At a securities firm, this tension is usually addressed by the establishment of a “Chinese Wall” – an internal barrier by which investment bankers are prevented from sharing with other employees material, non-public information received by the bankers from their company clients. In other words, the banker is not allowed to discuss such inside information with his research analyst counterpart who is providing information to the public on the same company.

The Practices

Merrill Lynch is no small fish struggling for survival although this episode can have severe consequences for its reputation and pocket. In financial practices, confidence is everything and that has certainly been eroded. After all, how can the firm explain the regular practice of deliberately disseminating misleading information about its corporate clients to help its banking arm? Or explain why it has practically abandoned its own rating system which included designating some stocks as “reduce” or “sell”? Or explain its failure to devise effective policies to address the inherent conflicts between its investment advice arm and its banking arm?

The Big Lie

With the benefit of access to internal communications, Mr. Spitzer was able to establish that all along some of  Merrill’s staff were aware that all was not well and had been saying so for some time within the firm. One of the analysts actually described as not right a “buy rating to a poor investment” as a result of which “John and Mary Smith are losing their retirement because we don’t want a client’s CEO to be mad at us”. And another analyst obviously fed up about pressure from the investment banking division wrote: "the whole idea that we are independent of (the) banking (division) is a big lie."

Other internal communications show analysts privately disparaging companies while publicly recommending their stocks. For example, one analyst made highly critical remarks about the management of an internet company and called the company's stock 'a piece of junk', yet gave the company, which was a major investment banking client, the firm's highest stock rating."

When the issue first surfaced Merrill responded with the usual self- righteous indignation but with the weight of evidence going heavily against it, its position has shifted to conciliation and contriteness.

Structural Defects

At issue is the nature and structure of an industry which drive analysts to promote companies they do not believe in while their banks earn fees selling the shares of and offering advice to those very companies. The evidence suggests that the “Chinese Wall” is often made of paper which comes down at the whiff of strong fees or the unfavourable stare of the client CEO. In January last year, an investor asked a Merrill Lynch analyst why the investment bank had suddenly started rating the stock of a little-known internet company and pointedly questioned “what’s so interesting about the company except banking fees?” The short and honest response: “Nothing.”

It is interesting to note that the Chinese Wall explanation is often offered by accounting firms accused of conflicts between their audit and consulting arms and which were at the centre of the Enron/Andersen affair.

Legal Action

This issue could not have come at a worse time for Merrill Lynch. The stock market has lost billions and some of this would have been borne by those who followed the firm’s “buy” advice. Merrill Lynch can therefore expect that in a litigious society as the USA with over-zealous attorneys, legal action is almost inevitable. One commentator has already suggested that the threat of criminal action is likely to be the most effective catalyst for change although Spitzer would like to see institutional regulatory reforms as well.

Any lessons for Guyana?

Given the state of our financial and investment architecture  which places us light years behind the USA, we may not be in any danger of this type of practice, certainly on any scale worth noticing. We are however finally about to launch the Stock Exchange and we do have some conglomerates which include banking, trust and commercial businesses. At the moment, the trading in shares that does take place is well outside of the public eye and appears to lack transparency. Not too long ago we witnessed an attempt by one company to block its shares being sold to a member of such a conglomerate.

Some argue that it is the very practices and mindset of those who control our public companies which are retarding real progress in the development of a capital market. Those who own and control our commercial banks whose operations bear all the hallmarks of cartels may consider the development of a competitive capital market inimical to their banking interest. We are painfully aware of the resistance by some of our public companies to provide shareholders and prospective investors with the quality and flow of information necessary for the purpose of informed investment decisions. Meanwhile, those with the responsibility for ensuring that such information is made available seem unwilling, unable or just too scared of vested interest to take decisive action.

Conclusion

As with Enron/Andersen, the case of Merrill Lynch is likely to resonate around the world and hopefully we in Guyana will take note of the dangers of conflicts of interest and take appropriate action to prevent them. We explain our own conflicts by the small size of our population but then exacerbate the situation by limiting our choice to those with whom we are “comfortable”. What is even clearer however, is the danger posed by those determined to manipulate and mislead the public, by greed and the possibility that dangerous practices are most prevalent in circumstances where the likelihood of sanction is least. In this regard, we have a fairly clean slate and we can avoid some of the pitfalls which seem so common in the more developed countries. Enron, Andersen and now Merrill Lynch are wonderful examples of how we should not conduct financial and fiduciary relationships.