Yet More Corruption in Banks

The Broken Firewall

Several years ago, in my therapy, practice I saw a financial analyst with a major bank who agonized about the appearance of wrong-doing should he talk to a salesman about a pending stock offering. The problem was, some of the people in sales had information that could be useful to him.

But the rule was strict. There was a firewall between analysis and sales — for good reason. The part of the bank that sold financial products to its customers had a duty to be rigorous and fair to them about the value of those products, while the part of the bank that generated new offerings was committed to promoting the companies they underwrote. If the bank did not keep those two parts separate, there would be an unmistakable conflict of interest, and my analyst would run the risk of being called to task by the compliance department.

Turns out that he worried in vain. As Gretchen Morgenson pointed out in The New York Times yesterday in reporting on a fine levied on 10 firms for violations of this very principle.

“The rules are not a great mystery here,” Brad Bennett, chief of enforcement at the Financial Industry Regulatory Authority, said in an interview last week. “You cannot use the analyst to solicit investment banking business.” The reason for that is the same as it always was, notes Morgeson, adding that this “takes us back to the financial scandal of the early 2000s involving corrupt Wall Street research.
Remember that mess? Firms whose analysts were supposed to be impartial instead used their bullish stock recommendations to attract investment-banking business. The losers in the situation were investors who didn’t know that the analysts were biased and who heeded their calls to buy the shares.”

In the new case, according to Morgenson, analysts went all out to assist their banks to get the deal, one offering in an email to “crawl on broken glass” naked to get the deal. “Right now, my whole life is about posturing for the Toys R Us IPO,” he wrote in a subsequent message according to The Times.

Since crawling on broken glass is not illegal, this probably reflected the analyst’s youthful enthusiasm and desperation. More importantly, the client who put pressure on the banks making the public offering was hardly free of blame. According to The Times, “It required any firm wishing to underwrite its initial public offering to submit an investment banking pitch and company valuation that included deep involvement and support from the firm’s retailing analyst. The retailer went so far as to tell Merrill Lynch that its analyst’s view could influence what underwriting role it might receive in the deal.”

One of the company’s officials said, “Such pitches were intended to protect [the client], “from being ‘burned’ by an analyst’s decision to adopt a negative view” of the retailer after winning the investment banking business. But that’s just the point. To be true to his clients, the analyst has to be free to arrive at a “negative view.”

I’m not a lawyer, so I am not sure what rules or regulations the client’s action violated – whether they were co-conspirators or accessories – but it is hard to imagine that they were guiltless.

The stench is the sign of a corrupt system, and picking off individuals to prosecute will hardly fix that.