Move Over Merrill Lynch: Salomon Smith Barney Alleged To Have Deceived Investors By Issuing Misleading Research Reports and Stock Ratings
he second shoe has dropped. New York Attorney General Eliot Spitzer now has set his sights on Salomon Smith Barney and corporate executives from some of the companies for which the brokerage firm provided investment banking and stock research coverage.
The lawsuit, filed September 30, 2002, alleges that Salomon Smith Barney engaged in a practice called "spinning", whereby it allocated nearly risk-free shares of stock to executives of companies who chose Salomon Smith Barney to act as the companies' investment banker for initial public offerings (IPOs). The lawsuit names executives at Qwest Communications, WorldCom, Metromedia Fiber Networks and McLeod USA, and alleges that they wrongfully reaped millions of dollars in IPO stock profits. According to the lawsuit, Salomon Smith Barney and its analysts (such as Jack Grubman) allegedly reaped millions of dollars in investment banking fees, "by covering the defendants' companies with unduly optimistic research reports and buy recommendations".
How did investors fare? The lawsuit alleges that investors were stuck "holding the bag", losing "hundreds of millions of dollars when the stock in the defendants' companies crashed", because they never were informed of the arrangement between Salomon Smith Barney and the companies for which it provided investment banking and stock research coverage.
Particularly disturbing is the degree to which Salomon Smith Barney allegedly encouraged its research analysts to, in effect, defraud investors. Specifically, the attorney general's lawsuit (which may be viewed at
http://www.oag.state.ny.us/press/2002/sep/sep30c_02_complaint.pdf)
makes several unsettling allegations, as detailed below, against Salomon Smith Barney ("SSB").
SSB Research's Ratings Were Not Independent, Objective or on the Merits
SSB issued research and ratings on over 1,000 U.S. stocks. SSB rated stocks as follows: Buy, Outperform, Neutral, Underperform, and Sell. Nonetheless, SSB had not one Sell rating, and only 15 (1.4%) Underperform ratings, according to the complaint.
SSB executives internally criticized SSB's research coverage and ratings. For example, the attorney general alleges that the head of SSB's Global Equity Research Management, John Hoffmann, described SSB's ratings as the "worst" and "ridiculous on face". He acknowledged that institutional and sophisticated investors knew that SSB's "Neutral" rating did not mean Neutral but instead meant Sell. Hoffmann wrote in his "2000 Performance Review" that there was "legitimate concern about the objectivity of our analysts which we must allay in 2001".
Hoffmann's sentiments were echoed by the global head of SSB's retail stock-selling division, Jay Mandelbaum, who told Hoffman that SSB's "research was basically worthless".
Investment Bankers and Investment Banking Fees Influenced The Ratings
Investment bankers and stock research analysts must be separated and not influence each other. However, at SSB, the complaint alleges that:
Investment bankers wanted the highest research rating for their banking clients or potential clients to enhance their ability to garner additional banking fees in the future. SSB's structure and compensation procedures encouraged investment banking to exercise its influence over analysts and their research ratings.
Indeed, the attorney general cites and quotes from several pieces of correspondence from John Hoffmann and others which demonstrates not only that SSB knew of the close relationship between investment banking and research analysts but also encouraged even closer ties, especially through fee sharing.
At a "Best Practices Seminar", hosted by SSB's head of U.S. Research Management, Kevin McCaffrey, and by Jeffrey Waters, SSB's Associate Director of U.S. Equity Research, research analysts learned "how to manipulate their financial models to support underwriting by SSB's investment banking division"! The reason? Money:
And its clear…that Research is driving a lot of this [investment banking revenues] increasingly. And therefore, as a [research] department our goal has to be, to be a really effective partner in terms of helping drive initiation, execution and everything else. Because there is a lot of money on the table for this company [SSB]. And we'll all benefit from it. (Emphasis added).
In fact, the attorney general alleges that in 1997, SSB paid what it called "Helper's Fees" to analysts of $11 million. To ensure accuracy, "scorecards for analyst performance included as a specific metric the amount of investment banking fees SSB earned in each analyst's sector of coverage and, for recent years, also included the SSB investment bankers' evaluation of the analysts", according to the complaint.
SSB "Research Analyst' Jack Grubman
The complaint alleges that Jack Grubman was not a legitimate research analyst but, instead, was "in reality an investment banker". Grubman was paid an average of $20 million per year in compensation from 1998 to 2001. That compensation was not based upon his performance as a research analyst. In 2000 and 2001, Grubman had the dubious distinction of being chosen the worst of SSB's more than 100 research analysts, as rated by SSB's retail sales force.
The attorney general alleges that Grubman's compensation was based upon his misleading actions and his philosophy of how the "new" research analyst should operate:
Consistent with his view that 'what used to be a conflict [between investment bankers and research analysts] is now a synergy', Grubman issued misleading ratings of stocks in favor of investment banking clients, including defendants' companies.
* * * *
Because Grubman's compensation was determined by his participation in investment banking, the ratings Grubman issued were not independent, objective or on the merits.
* * * *
Grubman failed to timely downgrade stocks on investment banking clients.
Overall, the allegations previously made against Merrill Lynch pale in comparison to the systematic deception occurring and encouraged at Salomon Smith Barney. The fallout from Spitzer's allegations surely will shatter what little trust and respect remains for Wall Street brokerage firms, especially Salomon Smith Barney. Undoubtedly, arbitration claims and class actions will surge to redress the wrongs that investors have suffered.
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