Of Spitzer, Merrill, NASDR, and Hoisting Petards

Regulatory Sanctions in the Aftermath of Spitzer/Merrill

By Bill Singer,
 

e-mail:  bsinger@rrbdlaw.com

http://www.rrbdlaw.com

On April 8, 2002, New York State Attorney General Eliot Spitzer obtained a court order requiring immediate reforms in investment counseling by Merrill Lynch.¹ Spitzer alleged that the "firm's supposedly independent and objective investment advice was tainted and biased by the desire to aid Merrill Lynch’s investment banking business." Citing findings of its investigations, the AG’s office claimed that Merrill’s "stock ratings were biased and distorted in an attempt to secure and maintain lucrative contracts for investment banking services. As a result, the firm often disseminated misleading information that helped its corporate clients but harmed individual investors." In fairly frank, if not caustic language, Spitzer described the matter as a "shocking betrayal of trust by one of Wall Street’s most trusted names [and the] case must be a catalyst for reform throughout the entire industry."

Following Spitzer’s announcement, the House Financial Services Committee/Capital Markets Subcommittee Chairman Richard H. Baker (LA) sent a letter to SEC Chairman Harvey.² Baker, advocating for uniformity in our national securities markets, expressed "grave concerns about reports involving the NYAG’s unprecedented efforts to propose and impose its own rules on the marketplace. First, it strikes me as strange that throughout last year’s entirely open and public process of congressional efforts toward reform, when the Capital Markets subcommittee specifically invited input from anyone concerned, not a single substantive contribution to the dialogue was received from the NYAG."

But the ensuing debate between the Democrat New York AG and his Republican Congressional critics has remained anything but tepid. During a CNBC appearance on May 3, 2002, Representative Baker criticized Spitzer for "taking his prosecutorial authority and turning it into a legislative platform . . ."³The Congressman further warned against resorting to "backroom negotiation based on a judicial authority to force changes in the structure of the marketplace. That’s not good business planning, it’s not good for our marketplace and it’s not good for the economy.

Yet another salvo aimed at Spitzer was issued forth when House Financial Services Committee Chairman Michael G. Oxley (OH) and. Baker mutually applauded the NASD and NYSE’s rulemaking to "require additional disclosures and crack down on conflicts of interest in Wall Street research. The proposed changes went through an extensive and public vetting process. The outcome is a common sense solution which will significantly improve Wall Street research practices."⁴ In contradistinction to Spitzer, the Representatives viewed the research shortcomings as essentially addressed and resolved by the commonsense rulemaking of the self-regulators.

Still, the political infighting and sniping continued. Spitzer agreed that nationwide uniformity in securities regulation was important; however, he added the caveat that "although it is a good start, the proposed regulations by the NASD and the NYSE fall short of what should be legislated in this area. While the proposed rules make progress on disclosure obligations, it should be noted that the proposed structural changes were already largely in effect at Merrill Lynch, while Merrill's analysts were issuing manipulated ratings."⁵ As such, the NYAG is now clearly on record as rejecting any suggestion that the NYSE and NASD’s recently approved rules have eradicated the problems inherent in the role of research analysts on Wall Street. As such we have clear-cut battlelines:  the NYAG does not believe that the SEC-approved and SRO-proposed regulations fully and satisfactorily address the analyst conflicts.  All of which goes to the heart of Congressman Baker's concern:  who's in charge of securities regulation in the United States?  Of course, AG Spitzer would likely retort that he is if everyone else has fallen asleep at the switch.

Contemporaneously with the SEC’s announcement of its approval of the NYSE and NASD’s rule proposals to redress the conflicts of interest between analysts and their employing BDs, NASD Chairman and CEO Robert Glauber commented that the "new rules will greatly strengthen NASD's hand in bringing cases in this area. But as demonstrated by our enforcement record in this area, NASD has not hesitated to use its existing enforcement tools against analysts whose conduct has undermined market integrity. And we will not hesitate to enforce these demanding new rules with a full range of disciplinary options - ranging from stiff monetary penalties to suspension from the industry."⁶ Typically, the NASD falls back upon its shotgun in the closet --- its ability to threaten Wall Street with prosecutions and sanctions.

On May 21, 2002, AG Spitzer announced a settlement with Merrill Lynch. Merrill Lynch agreed to:

• Sever the link between compensation for analysts and investment banking.
• Prohibit investment banking input into analysts’ compensation.
• Create a new investment review committee responsible for approving all research recommendations with strict standards and independence from investment banking and the analysts themselves;
• Establish a monitor to ensure compliance with the agreement.
• Require that upon discontinuation of research coverage of a company, Merrill Lynch will issue a report disclosing the termination of coverage and the rationale for such termination, and will notify investors that the last rating should no longer be relied upon;
• Disclose in Merrill Lynch’s research reports whether it has received or is entitled to receive any compensation from a covered company over the past 12 months;
• Pay a $100 million penalty; and
• Issue a statement of contrition on the part of Merrill Lynch for failing to address conflicts of interest.⁷

I remain left with an uneasy feeling about this entire episode. On the one hand, to some degree, kudos to AG Spitzer. It seems beyond dispute that his staff clearly uncovered a problem, one with far reaching implications. Similarly, Representative Baker has raised a legitimate concern as to the issue of the primacy of federalism versus states’ rights in the sphere of securities regulation. Accordingly, as any veteran litigator has often similarly stated, the Congressman states a valid concern when he criticizes efforts to legislate through litigation. His counsel against rushing into such serious business as rewriting Wall Street's rules and regulations resonates well with those of us who earn a living by following the circus parade of politicians and regulators with brooms and garbage cans. After all the publicity, there’s often a lot of waste byproduct to clean up from the roadway.

Carefully consider NASD Regulation’s recent action involving Hornblower & Weeks, Inc. and its President. On May 7, 2002, NASDR announced that it had entered into a settlement with member firm Hornblower & Weeks, Inc. and its President, John Rooney.⁸ NASD Regulation found that the firm and Rooney issued a research report recommending the common stock of MyTurn.com as a "strong buy" when, in fact, the report contained what NASDR has characterized as baseless projections, misleading and exaggerated statements and omitted important facts, in violation of NASD antifraud and advertising rules, as well as the antifraud provisions of the federal securities laws. I find it somewhat coincidental that this settlement was announced on the NASD’s website the day before the SEC approved the SRO’s proposed rules for analyst regulation, but, maybe I’ve just become too cynical after 20 years on the Street.

In settling, Hornblower (without admitting or denying the findings) agreed to a

• Censure,
• $100,000 fine,
• a suspension of its research activities for six months and,
• before resuming research reports, to retain an outside consultant to review and make recommendations concerning the firm's procedures relating to research reports.

Hornblower’s, CEO Rooney (without admitting or denying the findings) agreed to a

• $85,000 fine,
• a suspension from associating with any NASD member firm for three months in all capacities, and for an additional four months in a supervisory or principal capacity,
• requalification through examination as a principal before again serving in that capacity.

In commenting on Hornblower/Rooneysanction, NASDR President Mary Schapiro admonished that the SRO " will aggressively use our existing rules to discipline both firms and individuals that issue research that contains misleading or exaggerated statements." As if the weight of the fines and suspensions weren’t enough, NASDR warns that in "addition to a number of other pending investigations involving research analysts, NASD is conducting a joint inquiry with the Securities and Exchange Commission and the New York Stock Exchange and state securities regulators into market practices concerning research analysts and potential conflicts that can arise from the relationship between research and investment banking."

Now that AG Spitzer has extracted significant and painful concessions from Merrill, one must wonder whether NASDR realizes the tight corner into which it has painted itself with the Hornblower decision. Assuming that other broker-dealers are ensnared in NASDR’s traps (and in those now so cunningly being set by the SEC, NYSE, and the states), will the regulatory community dilute the potency of its sanctions? NASDR President Schapiro talks of the aggressive use of the SRO’s rules? Similarly, NASD President Glauber warned, "we will not hesitate to enforce these demanding new rules with a full range of disciplinary options - ranging from stiff monetary penalties to suspension from the industry." Okay, so it’s brass knuckles time.

Now, here’s my question. Assuming that NASDR is now privy, or will become privy, to the AG’s findings against Merrill --- or even assuming that NASDR may reach some independent findings of its own --- what then? Having suspended member firm Hornblower & Weeks and its CEO in varying capacities, how will the SRO justify imposing any lesser sanction upon any other member firm within the near future? Should we expect to read that David Komansky or Stanley O’Neal will be suspended for up to seven months? Should we expect to read that Merrill Lynch’s research facility will be suspended for six months? Forgetting for the moment whether such sanctions are even appropriate, how can the NASD sanction Merrill to any lesser degree than Hornblower? And assuming other major firms will soon be named as violating the research protocols set forth by the various regulators cited above, will there be a wholesale shutdown of Wall Street's research functions for six months?

Ultimately, Wall Street, its regulators, and the investing public are faced with a crisis. A weakened industry cannot support the markets. Investors, disenchanted with the lack of ethics on Wall Street, have not come back to the markets. Ineffective regulators are toothless tigers, of no use to the industry nor the public. But there are other parts to this equation. Excessive bloodletting by regulators is counterproductive. Unbalanced regulation in which larger firms get relatively lighter sanctions than smaller firms is unfair.

At the end of the day, the regulatory community would be well served to reference the 1996 resolution of the United States Department of Justice/Antitrust Division investigation of the major NASDAQ market makers of what was so euphemistically described as the "pricing convention." One should also consider the SEC’s 1996 investigation of NASDAQ/NASD’s marketplace and regulatory misconduct. The regulatory sanctions were largely limited to implementing remedial measures, some fines, and a select few suspensions. As to the NASD itself, it was sanctioned by the SEC. But what of that sanction? No fine. No suspension. Simply a Censure and a series of undertakings. How does one reconcile that response with the hammer and tongs now flashed? Perhaps the Bard put it all too well: ‘Tis the sport to have the engineer Hoist with his own petard."⁹