When Interests Collide
Why Wall Street analysts love companies on the verge of failure
by Bruce Barry
A farcical sideshow of the Enron circus is the role of financial analysts at major brokerage houses, who last fall continued to promote Enron stock as a good investment even as the company was starting its free fall toward bankruptcy. The actions of these analysts, which brought a few of them a scornful reception at a Senate committee hearing last week, raised new questions about an old problem in the financial markets: flagrant conflicts of interest that corrupt the objectivity of the investment “research” produced by Wall Street firms. The analyst imbroglio also hints more broadly at disturbing trends in how we manage conflicts of interest in public and professional life.
Congress first became interested in the conflicted life of Wall Street analysts almost a year ago. As the 1990s stock market boom went bust, many analysts remained stubbornly persistent in their enthusiasm for technology companies, continuing to recommend many stocks even as balance sheets were deteriorating and the technology sector as a whole was crashing. Analysts were called to account (and publicly chided) by a House committee last June. Fearing a congressional itch to regulate, several Wall Street firms endorsed a set of voluntary measures aimed at restoring investor confidence in their research operations. Their analysts' undying affection for the investment potential of an imploding Enron several months later is sufficient evidence of how well that worked.
So the analysts were back for more public flogging at last week's Senate committee hearing, where they defended their “buy” ratings on a collapsing Enron as legitimate, given deceptive financials the company provided. But some experts, like Howard Schilit of the Maryland-based Center for Financial Research & Analysis, say the warning signs were there in public filings for analysts to see, if only they had looked. They didn't. Even when it became known in late October that accounting problems related to the firm's ill-fated partnerships would mean eliminating over a billion dollars in shareholder equity, several prominent analysts were still rating Enron as a “buy.” One at Lehman Brothers advised investors to “rustle up a little courage and aggressively buy the stock.”
At the heart of the matter is a web of conflicts of interest that compromise the integrity of the research departments within big investment banks. In theory, analysts develop authentic evaluations of investment potential based on unbiased research, but the reality is that analysts have clear incentives to skew positive in their evaluations. Their firms make the real money on the investment banking side—mergers, acquisitions, underwriting and so forth—and the clients (and potential clients) for these services are the same firms that analysts are “independently” evaluating. Weak or diminishing analyst ratings for a client company's stock may induce that company to take its lucrative business elsewhere. Some firms even link analyst pay directly to earnings on the investment banking side, and many firms allow analysts to own stock in the companies they review. The inevitable result: analysts who are terminally bullish in a world of investment research that feels fundamentally corrupt.
Individual analysts may well be nice people who love children and pets and don't cheat on their taxes, and they may honestly believe that the apparent conflicts of interest in their work are not tainting their investment research. Such beliefs, while admirable, are beside the point. In generic terms, a conflict of interest exists when independent judgment about one thing (one's work or organization) is potentially compromised by interests in some other transaction that may work at cross purposes with the first. Notice the qualifiers in that sentence: “potentially” compromised; “may” work at cross purposes. Conflicts of interest are arrangements that entice corrupt judgment, or invite observers to suspect corrupt judgment after the fact, not necessarily the existence of corruption itself.
And they seem to be proliferating, or at least becoming more noticeable. According to Andrew Stark of the University of Toronto, author of a recent book about conflict of interest in public life, “we are paying ever more attention to conflicts that originate inside an individual's professional role.” That's a good thing, as long as we put as much energy into resolving them as noticing them. But to judge by recent events, business leaders seem more inclined to deny the existence of conflicts, or deny that their own pure selves can be corrupted by them, than to restructure the underlying arrangements that create conflicts in the first place.
And so we marvel with disgust at former Enron executives who see no conflict in personal profits from off-the-books transactions that bring the firm to ruin; or at accounting firms that see no problem with doing both audit and consulting work for the same clients; or at Wall Street analysts who with a straight face dismiss the manifest taint of their enthusiasm for failing companies. If the Enron saga teaches us anything, it's that conflicts of interest should be aggressively exposed and assertively resolved, not sold as somehow acceptable or dismissed as gratuitous moralizing.
Comments (0)