Financial Daily from THE HINDU group of publications
Monday, Dec 30, 2002
Corporate - Accounting Standards
Columns - American Periscope
Reforming corrupt practices on Wall Street
IN an interview on a television channel about two weeks ago, Mr Jack Welch, the former CEO of GE was asked for his reactions to the scandals in corporate America. Mr Welch replied that we should not judge the corporate world based on the revelations of about 10 companies out of about 17,000 in the US. True, but the real question is whether the problems are confined to those 10 or so companies. The Chairman of the Federal Reserve System (that is, the US central bank) commented some time ago that the problem is one of "infectious greed."
That greed permeated and corrupted many layers of the private enterprise system as practised here. Another layer of the onion was peeled last week when 10 major US securities firms entered into a settlement with regulators of about a dozen States to reform their practices.
This was the culmination of a year-long investigation by these States, led by the Attorney General of New York, and the firms have agreed to pay fines amounting to about $ 1.45 billion (Rs 6,960 crore), apart from making changes in the way they operate.
Some leading names that are a part of this settlement include Salomon Smith Barney (a unit of Citigroup), Credit Suisse First Boston, Merrill Lynch, Morgan Stanley, UBS Warburg, and Goldman Sachs. The fine amount is small, and a fraction of the earnings of not just these firms but their top management. Yet, it is hoped that the new restrictions on the way they do business will help build trust back into the system.
When Enron first imploded, and the experts started examining the virus, they found that it had spread to the external auditors, the commercial lenders, investment bankers, and analysts in brokerage houses. One by one, efforts are being initiated to treat them all. An accounting oversight board is being set up to examine accounting rules and practices.
The Sarbanes-Oxley Act aims to reform governance and responsibilities of the board of directors of companies. And now, this settlement between the securities firms and state regulators aims at reforming the structure and behaviour of how the securities firms operate.
Revelations suggest that many of their practices are what would be called corruption if it was in the Third World. But that is not a term used in the First World. Take, for example, what is called "spinning". When a company wishes to issue a public offering of shares, it would retain the services of a securities firm to organise the process.
The bankers, as per existing practice, get to allot a certain percentage of shares to their "friends". During the boom times in the stock market this meant instant wealth since the market price of the stock would multiply several fold the same day. The bankers found this to be a useful method to bribe senior executives of major firms. So, banker Z helping to issue stock in company A would allot some of it to the top management of company B so that when Company B was looking for banking advice, it would pick banker Z.
Mr Quattrone, a banker at Credit Suisse First Boston and Mr Grubman, a former senior officer at Salomon Smith Barney, were both stars charged with allocating stock to several senior telecom industry executives in return for business.
The CEO of EBay Inc., Ms Margaret Whitman, resigned from her position on the board of Goldman Sachs recently on disclosure that she had receive shares in more than 100 initial public offerings (IPOs) and quickly resold many (spinning) at a profit. Of course, she denies that had any connection with the fact that her company gave significant business to Goldman Sachs.
It is estimated that out of 22 Goldman-led IPOs given to executives, eight gained at least 173 per cent on the first day of trading. Several members of Congress (that is, the US Parliament) belonging to both parties were also beneficiaries of these IPO allocations. This spinning has now been banned.
A major factor that helped keep the stock market up and booming is the positively rave recommendations provided by analysts. The problem in many of the big name firms on Wall Street is that they operate both brokerages and investment banking business. And in these firms, the analysts were pressured to maintain strong buy recommendations on stocks that the firm, internally, believed were trash.
This was done using a stick (subtle threats) or a carrot (compensating the analysts with investment banking funds). Merrill Lynch paid a fine to settle charges that its analyst defrauded many small investors by hyping stocks of technology companies that were also clients of Merrill investment banking. Salomon also stands accused of publishing positive research and pumping up the stock of telecom companies in an effort to win banking business from them.
Credit Suisse First Boston stands charged of demanding kickbacks from clients in return for allocating them stock in hot IPOs. Other stories that have been reported in the papers include Mr Grubman issuing a positive report on AT&T in return for his boss, Mr Weill, the head of Citigroup, getting Mr Grubman's children into an exclusive private school in New York.
Mr Weill apparently wanted to secure the support of AT&T's Chairman who was a member of his board of directors. The depths to which these leaders of highly reputed firms seem to have fallen have no limits.
Apart from the ban on spinning, other changes have been initiated by the agreement. Research analysts would be separated from investment bankers with a so-called Chinese wall. That is, the bankers would not be allowed to influence the recommendation of the analysts in the same firm.
Analysts cannot be compensated with investment banking funds and cannot accompany the bankers on their sales calls. Moreover, for the next five years, brokerage firms must enter into contracts with at least three independent research firms so that their clients can have an independent opinion.
Nobody thinks these terms of agreement will fix the system, but at least they are a beginning. Some firms, such as US Bancorp Piper Jaffray, against whom there are charges, are not a part of the settlement. Moreover, specific civil charges against each of the firms are yet to be filed.
Sure, you would argue that no system is perfect, and that includes our free market economy. But for the market system to work, there are several players who participate and serve to check and balance. The odd story of corruption and influence peddling would leak out now and then but there was no suspicion of a system-wide fraud and deceit as it has now been revealed based on several investigations.
Over time, a few individuals had usurped for themselves the power to make markets. Mr Grubman was one individual who is reported to have strongly influenced all that went on in the telecom sector. Since the days of President Reagan, and followed up by both Mr Bush (the elder), and Mr Clinton, the dominant political ideology has been that the US free market system is perfect and regulators get in the way of honest businessmen creating jobs and building a powerful US economy. The budgets of regulating agencies were cut, or less zealous individuals were put in charge of those agencies.
President Bush (the younger), as a Republican, is now in the ironical position of expanding regulation and oversight of the private sector which is antithesis to his party's basic beliefs.
Thanks to the fallout from Enron, various agencies that participate in the system are now getting closer scrutiny.
The small number of financial services companies that deal with securities, market analysis, or act as investment bankers had the power to make or break firms. They will think twice before misusing that power again. What we need next is a similar investigation into the practices of credit rating agencies whose manner of revising country ratings, although not linked to personal greed, has given rise to similar concerns of poor integrity.
(The author is a professor of international business and strategic management at Suffolk University, Boston, US. His Internet address is firstname.lastname@example.org)
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