Worried that action by the states might undermine America's federal system of securities legislation, Congressman Baker recently wrote to state attorneys-general warning them that he would propose legislation to curb their activities if they continued to go their own way.
Self-regulatory bodies such as the New York Stock Exchange (NYSE) are also competing to show leadership. On June 6th the Big Board introduced new listing requirements for companies that will, among other things, force them to have a majority of independent directors on their boards. The NYSE boasts that these rules are much tougher than those introduced by the National Association of Securities Dealers (NASD) last month.
In an ideal world, the agenda would be set by the SEC, but it remains to be seen if its chairman of nine months, Harvey Pitt, can overcome a series of political embarrassments that have led to criticism from both right and left. Further complicating matters, countless private lawsuits are pending against financial-services firms that seem likely to drag on for years and may result in huge payouts. They are providing plenty of the sort of bad publicity that encourages politicians to turn up the heat on Wall Street more than might be good for its health.
Shaky Analysis
How much punishment does Wall Street deserve, and what reforms does it need? At the most basic level, financial markets stand accused of knowingly selling over-priced shares by claiming they were cheap, and of doing so in ways that benefited some of their customers (and themselves) to the detriment of others. In particular, this boils down to three main concerns. One is about the role of the research that is published by investment banks; a second is about the way in which shares in IPOs are allocated; and the third is about the use of accounting rules to mislead investors.
The focus on research analysts who allegedly advised investors to buy shares at prices they did not really think made sense has intensified since Merrill settled with Mr Spitzer. As well as Mr Spitzer's pursuit of Morgan Stanley and Citigroup, the SEC this week revealed that it is investigating ten cases of possible conflicts of interest involving analysts, while the NASD and the NYSE are looking into 37 such cases.
Even if these turn up no e-mails as lurid as Merrill's, there is every chance that firms accused as a result of these investigations will reach a (doubtless expensive) out-of-court settlement. For a financial firm to go to trial over such matters is to risk bankruptcy. The laws in the area are sufficiently untested for them to prefer not to present their case to a judge.
There is no doubt that Wall Street gave investors an unprecedented amount of bad advice; that those dispensing it often had an inkling that the firms they touted were probably overvalued; and that they had strong incentives to err on the bullish side. On the other hand, every piece of advice issuing from a Wall Street firm comes couched in caveats. If the oldest rule of the marketplace, caveat emptor — "buyer beware" — is to apply in such cases, then anybody slavishly following the advice of a Wall Street analyst has only himself to blame for his future losses.
Ominously for Wall Street, however, on June 3rd a Supreme Court ruling — in favour of an SEC action against a broker — stated that the securities markets' regulations introduced in the 1930s "sought to substitute a philosophy of full disclosure for the philosophy of caveat emptor, and thus to achieve a high standard of business ethics in the securities industry". Caveat emptor does not go far enough, it seems. Analysts may have a legal duty of care for their retail customers, which means, for example, offering them only such advice as they would give to themselves.
What can be done to make Wall Street fall more into line with this philosophy in future? So far, the focus of reform has been to try to reduce the conflicts of interest that may encourage analysts to feign bullishness. One suggestion is that they should be prevented from owning shares in the companies that they track. But this tackles only one potential conflict. The more powerful arises from the huge rewards that analysts get, directly or indirectly, for promoting their firms' other services. An alternative (if far-fetched) suggestion is that they should be required to invest according to their own advice, but only after a delay to ensure that they are not able to anticipate their customers' future purchases.
There is some talk in Washington of drawing up legislation to ban investment banks from publishing research, which would certainly remove that conflict of interest. But there are not many examples of a firm of any scale surviving for long by selling truly independent research. And since the SEC introduced regulation fair disclosure (FD) in 2000, prohibiting firms from disclosing material information to one outsider before the market as a whole, the main source of competitive advantage for analysts — namely, access to privileged information through meetings with the companies' managers — has supposedly been destroyed. True, it is not yet clear that Regulation FD is being vigorously enforced by the SEC, which has yet to make a single prosecution under it. If it were, though, there would be even less to distinguish the insights of most research analysts from those of an ordinary investor.
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