Ian Fraser reports on the race in America to find the most draconian measure to tackle financial corruption
Two years after the irrational exuberance of the dotcom era subsided, a new mood is prevailing on Wall Street. Legislators from both the Republican and Democratic parties are closing ranks with the Securities and Exchange Commission’s Harvey Pitt to introduce new laws which are likely to cramp capitalism’s style. Some market participants fear that the current witch-hunt will jeopardise Wall Street’s pre-eminence in global capital markets, leaving it over-burdened with legislation and fuelling the rise of a European capital market.
America has an estimated 79 million private shareholders — more than the entire UK population — many of whom hold their shares in so-called 401K retirement plans. But that bubble has burst and the corporate tide has gone out to reveal the extent of the scandals by which a privileged few benefited at the expense of the many and retail shareholders are now determined to get even.
Many ordinary Americans have had to downshift their lifestyles and even postpone their retirements because of the slump in the value of their 401K. They are determined to see some scalps taken, and politicians and regulators seem increasingly willing to oblige.
Another more pressing goal is the introduction of structural reforms aimed at eradicating the conflicts of interest that prompted the world’s leading investment banks to issue misleading research during the technology boom.
The Securities and Exchange Commission (SEC), Congress and the White House are now trying to outgun each other to see who can implement the most draconian measures to tackle white collar crime. In some cases they are picking up and running with initiatives started by one of the rival agencies.
Eliot Spitzer, the feisty New York State attorney general, has become the hero of the hour.
Spitzer has already humiliated the world’s mightiest stockbroking firm, Merrill Lynch. He forced it to pay out $100m (£64m) to settle charges that its analysts had been pumping the stock of companies that they had labelled as ‘dogs’ in private e-mails.
Thanks to that action, Merrill Lynch and all the other big investment banks have been forced to take steps to separate their research and investment banking arms to make sure such manipulation does not occur in future.
Earlier this month Spitzer launched proceedings against five telecoms executives, including Bernie Ebbers, the disgraced former boss of WorldCom, and Philip Anschutz, the former chairman and founder of Qwest Communications.
Each was alleged to have been given preferential access to initial public offerings (IPOs) staged by Citigroup’s subsidiary Salomon Smith Barney (SSB), which permitted them to make personal gains of more than $28m. In exchange, the five individuals handed SSB investment banking contracts worth $241m in fees.
Spitzer says he will be looking into the “degree to which stock options and executive packages that were given to chief executives were either illegal or improper”.
He is already investigating Sanford Weill, Citigroup’s chairman, over allegations that Weill put pressure on his star telecoms analyst, Jack Grubman, to reconsider his negative rating of AT&T, of which Weill is also a director. Weill allegedly did this in order to secure SSB the role of lead underwriter on the flotation of AT&T Broadband.
The New York State attorney-general has said he might get some of the loot carried off by the corporate cowboys returned to the shareholders who were taken for a ride. If he achieves that, his political star will shine very brightly indeed.
Meanwhile, Michael Oxley, the Republican chairman of the House of Representatives’ financial services committee, has revealed that investment bank Goldman Sachs gave investment banking clients (including Dennis Kozlowski, former chief executive of Tyco and Kenneth Lay, former chief executive of Enron) privileged access to hot IPOs.
This is one of a number of allegations that, during the dotcom bubble years, the top investment banks essentially bribed the wealthy CEOs and finance directors of client companies to ensure that these individuals kept steering work their way. The kickbacks often came in the shape of privileged access to technology company initial public offerings — a practice dubbed ‘spinning’.
The banks made it easier for their favoured clients to make a fast buck by deliberately underpricing the IPOs concerned. This enabled the individuals concerned to ‘flip’, or sell on, their allocated tranches of shares, often at massive profits. During 1999 and 2000 IPOs were on average experiencing first-day share price rises of 65%.
The investment banks’ research departments eased the process by fuelling the first-day surges with frequently very partisan research reports. Each bank had a prominent technology analyst — for example Mary Meeker at Morgan Stanley, Henry Blodget at Merrill Lynch and Jack Grubman at Salomon Smith Barney. During TV appearances on investment shows these analysts were able to drum up interest, persuading naive retail investors to fill their boots with overvalued stock even after it was ‘flipped’.
The private investors had no a rogues’ gallery of corporate villains was being offered preferential treatment by the analysts’ own employers. But it was they who were left holding worthless pieces of paper when the stuffing fell out of the market.
As the famous Merrill Lynch email saga of April 2002 has demonstrated, the analysts had few qualms about talking up stocks which they personally knew to be ‘dogs’. It was all part of the job.
Institutional investors were, of course, savvier and more attuned to the rules of the game. They recognised that people like Grubman were not being paid to pass objective judgement on stocks, but merely to keep their investment banking clients sweet.
“The whole equities research establishment was inherently corrupt — we’ll write nice things about your company so long as you keep channelling those juicy investment banking contracts our way,” said one New York-based banker.
Oxley, who is facing re-election next month, said: “People are willing to take a risk with their money, but they’re not willing to gamble when the system seems rigged against them.”
It now seems possible that the investment banks will be forcibly broken up, with parallels to what happened after the 1933 Glass-Steagall Act which broke up the banks after the Wall Street Crash of October 1929. Many, including Citigroup and CSFB, have been prepared to go with the flow, attempting to pre-empt legislation by volunteering to spin-off their research departments and ensure analysts are not pressured into writing unduly rosy reports. Merrill Lynch, however, is opposed to further reform.
The burning question is whether their research arms could survive as standalone profit centres. Buyside clients, such as fund managers, are happy to receive their investment research when it comes free as part of a wider package. After all, it does bring the occasional insight. But there is little evidence they would be prepared to fork out separately for it.
The worry for auditors, corporate governance experts and FTSE-100 companies in the UK is that competition between the various arms of US government to see who can deliver the most hardline measure will mean that companies outside the US find themselves in the crossfire.
The SEC’s initial proposal for new regulations in May was rapidly superseded by a legislative onslaught from Washington in the shape of the hurriedly assembled Sarbanes-Oxley Act.
“This could have a dramatic effect on British business, and we are very concerned about the extra-territorial jurisdiction involved,” warned Judith Mayhew, chairman of the Corporation of London’s policy and resources committee.
The Sarbanes-Oxley Act, masterminded by Paul Sarbanes, the Democratic chairman of the Senate banking committee and by congressman Michael Oxley, was signed off by President George W. Bush on 30 July. Bush described it as “the most far-reaching reform of American business practice since the time of Franklin D. Roosevelt”.
The Act’s core clause requires chief executives and finance directors to provide sworn statements that their accounts are fair and honest, with the risk of up to 20 years in jail and fines of $5m should they mis-certify. It also requires fully independent audit committees with new responsibilities and bans companies from making loans to their directors, as well as threatening 20-year jail terms for anyone shredding documents that could aid an investigation.
GlaxoSmithKline, the UK’s biggest drugs company, last week became one of the first non-US companies to introduce changes to comply with the new legislation. It said that Dr Lucy Shapiro, a non-executive director, had stepped down from its audit committee to bring it in line with the Act.
But ScottishPower, which acquired US-based PacifiCorp for £4.5 billion in 1998, does not foresee any need for significant change. A spokesman said: “Our compliance and controls are such that we are virtually there anyway.”
However, other non-US companies complain that the Act is unwarranted, time-consuming and a costly interference in their affairs when they believe there are adequate investor safeguards in place already.
Last week, the SEC seemed to be listening, indicating that foreign groups with US listings might be granted concessions. Pitt, who is facing calls to resign because of a row over who should lead the US’s new accountancy oversight body, last week denied that America is forcing other countries to adopt a US response to a domestic problem.
He said: “I don’t think it is solely a US problem. We may be feeling the brunt right now but I think many of the same underlying problems exist elsewhere in the world.”
This is probably not too encouraging for Patricia Hewitt, the UK’s trade and industry secretary, who last week told British finance directors it would be wrong for business to face duplicate regulation. A source close to Hewitt said the government supported the US in its bid to restore investor confidence but criticised the rushed nature of the Sarbanes-Oxley Act. They described it as “an example of legislating in haste and repenting at leisure.”
Even if it does not directly effect UK companies, the fear is that Sarbanes-Oxley will become the benchmark against which every other jurisdictions’ corporate governance rules will, in future, be tested.
But the real fear on Wall Street is that over-zealous post-bubble legislation is going to kill their “golden goose”.
Bill Harrison, chief executive of JP Morgan Chase, warned that attempts to reform Wall Street might even undermine America itself. “I just hope we don’t go too far with these things [so] that we damage what’s made Wall Street great and what’s made this country great.”
This article was published in the Sunday Herald on 13 October 2002