Conflicts of Interest – The Wall Street Plague
Investment Analysis and Portfolio Management
By: Marc Mills
For: Prof. Valsan
Due: Week 2
January 24, 2003
Table of Contents
Brokerage Division – Sell-side Analyst…………………………………………….…..3
Corporate Finance Division………………………………………………………….…4
Investment Analysis & Portfolio Management 2
Conflicts of Interest in the Investment Industry – When Money Interferes with
Independence and Objectivity
As we enter into 2003 we are still feeling the effects of the corporate scandals and
other wrongdoings that have helped bring, and also keep, the economy in a near state of
recession. The end of 2002 marked the third consecutive year of negative market
indices, something that hasn’t occurred since the 1940’s. Over the past year the TSX
was down 13.5%, the S&P500 was off 24% and the NASDAQ lost 30.5%. This
economic downturn is the result of several things including weakening fundamentals in
the economy such as increasing unemployment, low business spending and recently
decreased consumer confidence from a consumer that can be held responsible for
keeping the economy afloat over the last year thanks to their resilience. Furthermore,
acts of terrorism and other geo-political tensions such as the recent developments with
Iraq have further depressed the economy. One thing that has not been mentioned yet,
but has played a large part in adding to the weakened economy and contributing to
uncertainty in the market are the scandals that have emerged from the corporate world.
These scandals are wide spread and range from insider trading to fraudulent accounting
practices to conflicts of interest between underwriting firms and financial analysts who
make security recommendations. Who can you trust now? Everybody seems to be in it
for themselves trying to make the fast buck. “Nobody wants to work for it anymore, the
honor’s in the dollar” (Todd, 2000).
This paper will be exploring this latter part involving the conflict of interest that
has been present for so long but only now has really began to catch the attention of the
investment world. It will look at how the industry works, who is involved and finally
what is being done to prevent this from reoccurring in the future.
Within an investment firm you may find a brokerage division as well as a
corporate finance division. While both of these divisions provide a source of income for
the firm, the combination of the two can lead to potentially higher income for the firm.
The problem however, is that the combination of these two branches of the firm can lead
to a conflict of interest which goes against most standards of practice in regards to
proper disclosure and fair dealing, which will be explored later. First I will look at the
brokerage division and their sell-side analysts and then it will look at the corporate
finance division of the firm, which is involved in completing IPO transactions, mergers
and acquisitions, and equity offerings for its clients. With an understanding of how both
of these areas of the firm work, you will get a better understanding of how the conflict of
interest issues arises and what it entails.
Brokerage Division – Sell-side Analyst
What exactly is a sell-side analyst and what role do they play at an investment
firm? The analyst does just that, they analyze. Most analysts specialize in a specific
sector of the economy such as the Telecommunication sector, Consumer Discretionary
sector or the Information Technology sector to name a few. These analysts gather
information on securities within their sector, including the company’s financial position,
Investment Analysis & Portfolio Management 3
management, and product base and so on. Analysts will often visit the companies that
they are initiating coverage on and they will meet with the management team and tour
the plant or facilities. In doing so they attempt to obtain an accurate overall picture of
the company in question so that that they can eventually make a recommendation based
on their findings. The research reports that are produced by these analysts are then sold
to investors through the firms brokers (Dunn, 2000). These analysts also maintain
ratings on the stocks that they cover usually in the form of “buy”, “sell” or “hold”
ratings. Note that the ratings systems vary from firm to firm and can often be very
confusing or misleading. There has been an effort however, to make these rating
systems more understandable and clear for investors. On its own it seems like there is
nothing wrong with what the analyst is doing and in most cases there is nothing wrong
as long as the analyst is using independence and objectivity when doing their research.
Corporate Finance Division
If a private company was interested in going public, they would first find an
investment bank that would price and issue their initial public offering (IPO). IPO’s are
an important source of income for the firm and these firms are always looking for new
deals. Once they have done the IPO for a firm they are often used to issue a secondary
offering which will generate substantial commissions. Furthermore, the corporate
finance division also does merger and acquisition (M&A) transactions for their clients.
Overall, these transactions provide a large amount of income for the firm, which means
the more transactions completed the better. They cannot always get all of their business
on their own however, and this is where the analysts come into the picture.
Now that you have an idea of what each division of the investment firm does you
may have an idea of how a conflict of interest may arise between the two. The corporate
finance department sees these analysts as a “marketing tool”, and a valuable one at that.
They see the analyst as someone with influence on the market and their ratings can make
or break a company. Given the right circumstances and monetary incentive, an analyst
can produce a report that makes the investment look very favorable and help push the
new issue of a company’s stock. This will attract companies to their firm in order to
issue an IPO because they believe they will get good coverage. This of course relates to
more investment banking fees for the firm (a portion of which goes to the analyst who
helped out) and everybody is happy.
In the past the analyst was the watchdog for the shareholder and made an effort to
make timely and accurate reports that would be in the best interest of the investor. As a
result they were compensated for their services. The problem today however, is that
analysts are getting paid based on fees received when the investment bank secures an
IPO client. Basically a large portion of their pay is derived from investment banking
transactions. Here is where the problem arises. The analyst wants to provide research
reports that are independent and objective to the investor, but they also want to receive
good compensation from giving a strong rating on a potential investment banking client.
A stock rating that may help secure that client and generate large fees. In many cases
their analysis of the potential company is not thorough or complete and may be
Investment Analysis & Portfolio Management 4
fabricated to make the company appear better than it really is. This of course is not in
the best interest of the investor and as a result there is a conflict of interest. John Coffee
Jr., a law professor at Columbia Law School and a visiting professor at Harvard Law
School explains what a conflict of interest in business is. He states that as an employee
“you owe a duty of loyalty to your employer, and you should not accept other kinds of
interest or payments that could give you a reason to act contrary to the best interest of
your employer or the persons to whom you owe a duty [shareholders]” (Coffee, 2001).
Therefore, based on this definition the analyst is clearly in a conflict of interest situation.
First of all, the analyst should be loyal to his employer, which is the brokerage firm, not
the investment banking firm. Secondly, he is receiving payment from the investment
banking division that will most likely cause him to act in the best interest of the
underwriters and not the best interest of the brokerage firm or the investors.
This conflict of interest is not a new phenomenon on the streets. It has probably
been around for quite a long time, but now someone is finally stepping up and taking
action. The attorney general of New York State, Eliot Spitzer, is making a lot of noise
on Wall Street these days and he has quickly become one of the most feared people on
Wall Street (Gimein, 2002). Mr. Spitzer has been pushing a campaign against
corruption in the financial world and has begun to expose the corruption taking place.
Although he and his team have not actually prosecuted any firm or individual yet, they
certainly have investment banks and their executives running for cover.
Although Merrill Lynch never admitted to or denied allegations against them for
misbehavior, the efforts of Spitzer made Merrill Lynch pay a $100 million dollar fine
(Gimein, 2002). Regulators believed that analysts at Merrill Lynch were “tailoring their
stock picks to win investment banking business by recommending the stocks of Merrill’s
banking clients” (Gimein, 2002, p. 82). This is a clear example of a case of a conflict in
interest as described above. Henry Blodget, a well-known Internet analyst with Merrill
Lynch, made headlines for his actions and especially for e-mails that were written by
him to co-workers describing the stock picks and ratings that he had made. For
example, Blodget wrote an e-mail about a company named GoTo.net (now called
Overture Services), saying that there was “nuthin” to it (Mann, 2002). This was a
security that he was promoting to the public as a good buy, but behind closed doors he
obviously had different feelings about the stock. Why was he doing this and what was
his motivation behind these lies? Money. By promoting the stock he was helping the
underwriters get potential investment banking fees. According to Roni Michaely and
Kent Womack (2001), it is common for a significant portion of the analyst’s
compensation to be determined by their “helpfulness” to the corporate finance division.
What kind of figures are we looking at? Henry Blodget’s salary jumped from $3 million
in 1999 to $12 million in 2001. This increase was apparently due to his ability to “bring
home the bacon” (Coursey, 2002). In other words, he was very “helpful” to the
investment banking division.
Investment Analysis & Portfolio Management 5
An e-mail from another Merrill Lynch analyst, Kristen Campbell explains it clearly:
“if [this rating] means that we are putting half of Merrill retail into this stock because
they are out accumulating it then I don’t think that’s the right thing to do. We are
losing people money and I don’t like it. John and Mary Smith are losing their
retirement because we don’t want [the CFO] of GoTo to be mad at us” (Mann, 2002).
This e-mail demonstrates that they were just pushing the stock in question in order to
satisfy the potential client in order to obtain their business and amass large fees. There
is no duty to the investor here. In fact by giving these companies high ratings they are
misleading the investors and causing these investors large financial losses in the process.
The evidence appears to be quite clear that there was something going on and
Spitzer believes that there was definitely enough evidence for prosecution. He felt
however, that “to indict Merrill for misbehavior that was endemic throughout the
investment banking world would have been a mistake” (Gimein, 2002, p. 82). He feels
that just that fact that all of this has been exposed is a victory in itself as it will open the
door to other similar cases and will get the ball rolling for future regulation changes.
Another notable for Mr. Spitzer includes Salomon Smith Barney analyst Jack B.
Grubman and some of his co-workers who publicly recommended several telecom
companies and kept “strong buy” or “buy” ratings on the stocks even as then plunged,
some even into bankruptcy (1). Some of the companies that Grubman recommended
and went bankrupt include Global Crossing, Teligent and FLAG Telecom. Mr. Spitzer
is also targeting other major firms on Wall Street including Morgan Stanley, Credit
Suisse First Boston and Goldman Sachs.
As we have seen from the Blodget case or the Grubman investigation a sell
recommendation is not a common or popular practice. According to a 2001 study
conducted by Reuters (2), 88% of analysts surveyed said that if they issued a sell rating
for a stock, the underlying company would retaliate. Retaliation methods would include
“minimizing the analyst’s access to the company and the executives, cutting the
analyst’s employer out of future investment banking deals, suing the analyst and/or the
firm, or trying to get the analyst fired” (2, p. vii). It is no wonder then that you see very
few “sell” ratings from analysts. According to Brian Bruce (October 2002), analysts
claim that they are under a lot of pressure to issue favorable ratings for the investment
banks clients or potential clients.
In order to see the effect of this conflict of interest it is worthwhile to examine
that number and types of recommendations that analysts are giving and then exploring
the results of these stock picks. Thompson Financial/First Call compiled a list of
recommendations in July 2001 and discovered that almost 50% of all recommendations
were “buy” recommendations while less than 1% were “sell” (Bruce, May 2002).
Considering the current state of the economy and the position of many companies, it is
hard to believe that these recommendations were justified.
Investment Analysis & Portfolio Management 6
Roni Michaely of Cornell University and Kent Womack of Dartmouth did a study on the
“Conflict of Interest and the Credibility of Underwriter Analyst Recommendations”. In
their study they came up with several interesting findings. In one of their studies they
compared a sample of IPO stocks given “buy” recommendations by analysts at lead
underwriting firms with a sample given “buy” recommendations by non-underwriting
analysts. The results of the study show a clear conflict of interest. Two years after the
recommendations, the stocks’ relative performance was compared to other similar-sized
stocks. Stocks that were recommended by non-underwriting-firm analysts out-
performed similar stocks by almost 50%. On the other hand stocks that were
recommended by underwriting-firm analysts under-performed by almost 20% (Foerster,
2001). What does this show? Well, it shows that the “buy” ratings from the
underwriting-firm analysts were most likely just to promote the stock and secure
investment banking business. The non-underwriting-firm analysts were not trying to
make the stocks look better than they actually were and as a result presented a more
accurate picture of the company. These are the kind of things that are probably going on
in most investment firms and it will take a while before this can be stopped for good.
Whether it is through the Association for Investment Management and Research
(AIMR), or through another regulatory body, all individuals in the investment industry
have some form of ethical guidelines or a code of practice to which they must adhere to.
Despite this fact however, we are seeing more and more corruption and unethical
practice take place and this is undermining the nature of these regulatory bodies. The
following is “The Code of Ethics” that must be followed by members of AIMR:
Members of the Association for Investment Management and Research shall:
• Act with integrity, competence, dignity, and in an ethical manner when dealing with public, clients,
prospects, employees, and fellow members.
• Practice and encourage others to practice in a professional and ethical manner that will reflect credit
on members and their profession.
• Strive to maintain and improve their competence and the competence of others in the profession.
• Use reasonable care and exercise independent professional judgment.
If you read through each one of these points and think of the events that have
taken place over the last few years you can see that there is a lot of discrepancy between
what has been happening and what is ethical. The events that have been described
above that deal with conflicts of interest go against all of these points relating to ethics.
If we look further into AIMR’s Standards of Professional Conduct we can
address some specific points that have been in violation.
Standard IV. Relationships with and Responsibilities to Clients and Prospects
A.3 Independence and Objectivity. Members shall use reasonable care and judgment
to achieve and maintain independence and objectivity in making investment
recommendation or taking investment action.
Clearly this has been broken in all of the cases that have been mentioned thus far. By
making investment recommendations in order to try and win investment banking
Investment Analysis & Portfolio Management 7
contracts regardless of the actual performance of the underlying security the analyst is
failing to act independently and the objectivity is lost. We must have analysts who are
not compensated based on the transactions of the corporate finance division and this
way they will not push a stock just for the sake of the money, but rather because it is a
B.1 Fiduciary Duties. In relationships with clients, members shall use particular care in
determining applicable fiduciary duty and shall comply with such duty as to those
persons and interests to whom the duty is owed. Members must act for the benefit of
their clients and place their clients’ interest before their own.
I think that this is the major problem with the analysts. They are simply not putting the
clients interest before their own. They owe a duty to the client to provide independent
and objective research in a timely manner. However, the analyst also wants to “help”
the investment banking division secure some potential contracts and this will cloud their
judgment and make them issue recommendations that would not otherwise be issued.
This is definitely against the best interest of the client.
B.7 Disclosure of Conflicts to Clients and Prospects. Members shall disclose to their
clients and prospects all matters, including beneficial ownership of securities or other
investments, that reasonably could be expected to impair the member’s ability to make
unbiased and objective recommendations.
The fact that the analyst will be compensated well (in the case of Henry Blodget) for
placing a “buy” rating on a “crappy” stock is most certainly a conflict and it will impair
the analysts ability to make unbiased and objective recommendations.
These are just a few examples showing how analysts and members of the
investment community are practicing unethical investing and it is more often than not at
the expense of the client. As a result investors have come to lose confidence in these
analysts. In order to regain their confidence regulations must be put in place and
With the help of people like Eliot Spitzer and other regulatory groups such as the
Securities and Exchange Commission and the Association for Investment Management
and Research, Wall Street is beginning to crack down on such practices and is trying to
build a wall between brokers and bankers.
There are certain disclosure rules put in place by the NYSE and the NASD
dealing with certain conflicts of interest for analysts when recommending the purchase
or sale of specific securities. There have been recent rule changes put in place to try and
increase the analysts’ independence and decrease future conflicts of interest. The SEC
approved these rule changes (that will be outlined below) on May 10, 2002. There is an
implementation period of between 60 and 180 calendar days for the new rules to be
Investment Analysis & Portfolio Management 8
enforced in order to given sufficient time for firms to develop and implement the new
Here are some of the rules that will be put in place (Source: U.S. Securities and
Exchange Commission Investor Alert):
• No promises of favorable research – analysts will not be allowed to
offer favorable research ratings or price targets with the goal of attracting
investment banking opportunities. There is also a “quiet period” put in
place that will prevent the underwriting firm from issuing reports on the
company within 40 days after an IPO or within 10 days after a secondary
• Limitations on Relationships and Communications – this rule change
prevents the analyst from being supervised by the investment banking
department. This will protect the analyst from influences that could
impair their objectivity and independence.
• Analyst Compensation – you cannot tie an analyst’s compensation to
specific investment banking transactions. Also if the compensation is
based on the firm’s general investment banking revenue it must be
• Firm Compensation – the firm must disclose if it managed or co-
managed a public offering for a company in the last 12 months. This will
alert investors to potential biases in their recommendations
• Restrictions on Personal Trading by Analysts – by preventing the
analyst from trading around the time they issue their reports the conflict
arising from their personal financial interests should be reduced.
• Disclosures of Financial Interests in Covered Companies – analysts
must disclose if they own shares of recommended companies. The firm
must also disclose if they own more than 1% of the companies equity.
• Disclosure in Research Reports Regarding the Firm’s Ratings – they
must clearly explain in the research reports the meaning of all ratings
terms they use. This will assist the investor in deciding what value to
place on the securities.
• Disclosures During Public Appearances by Analysts – when on
television or radio or other media forms, analysts must disclose if they or
their firm have a position in the stock, if the company is an investment
banking client of the firm and other material conflicts.
The rules above will be put into place over the next year and if successful, they
may help regain the confidence of the investors that have been let down in the past.
Investment Analysis & Portfolio Management 9
I think that it is fair to say that the reputation of the business world and the
investment community have been severely tarnished over the last few years and there is
a lot of work that must be done in order to correct this. With the help of new rules and
regulations investment firms can begin to rebuild this trust with investors. I believe
however, not all of these changes will be in everyone’s best interest. Take the private
firm wishing to go public for example. The analyst was a very valuable asset to these
companies as their exposure to the investment world depended on them. They got the
names of these companies out into the papers and in the media. With the regulations in
place the small companies are going to get very little help and will have little exposure
because the analyst will have no interest or incentive in pushing the stock. Even though
a lot of the research that analysts did on these small companies wasn’t exactly
independent and objective research, it was still research and it gave the small company a
name. This will no longer happen under the new rules.
Another issue is that everybody is putting all of the blame on the analyst. I think
that the analysts and the investment banking departments should take the majority of the
blame, but there is someone else that should also take part of the blame and that is the
media. During good times they push the same stocks that the analysts do and publish
articles about them giving them full exposure. They often fail to do their own research
on the companies that they are publishing and in the end they are just as wrong as the
analysts and are in fact helping them help the investment bankers get new deals. When
the economy turn sour, they are the first to criticize these analysts. So I think that the
media should take some responsibility.
It will be interesting to see what will come next in this fiasco and what rules we
will have to play by as we enter into the job markets. Will analysts regain their
independence and objectivity? As long there is more money to be made and lucrative
deals around every corner I don’t know if we will every see a squeaky clean Wall Street.
Investment Analysis & Portfolio Management 10
1. (2002, April 29). Trying to Build a Wall on Wall Street: Will Investment Bankers
Have to Keep Their Analysts Separate? Business Week. [Online].
2. What Analysts and Investors Want. Investor Relations Magazine. Guide no. 6.
Sponsored by Association for Investment Management and Research (A.I.M.R.).
Bruce, B.R. (2002, October). The Analyst Conflict of Interest. PanAgora Asset
Management. [Online]. Available: HTTP: http://www.panagora.com/index.asp?mode-
=intl_eq [2003, January 20].
Bruce, B.R. (2002, September). The Analyst Cycle. PanAgora Asset Management.
[Online]. Available: HTTP: http://www.panagora.com/index.asp?mode=intl_eq [2003,
Bruce, B.R. (2002, May). The Role of Analysts. PanAgora Asset Management.
[Online]. Available: HTTP: http://www.panagora.com/index.asp?mode=intl_eq [2003,
Borrus, A., McNamee, M. (2002, October 7). Commentary: How Bankers and Brokers
Could Get Bruised. Business Week [Online].
Coffee Jr., J. (2001, August 23). The Conflict-of-Interest Minefield. Business Week
Coursey, D. (2002, April 17). Was Merrill Lynch Full of Bull? Looks That Way.
ZDNet. [Online]. Available: HTTP:
Dunn, B. (2000). What in the World is a Buy-Side/Sell-Side Analyst? [Online].
Available: HTTP: http://www.bankrate.com/brm/news/investing/20000126k.asp [2003,
Foerster, S. (2001, December). Do Analysts Have a Conflict of Interest? R.O.B.
Gimein, M. (2002, September 16). Eliot Spitzer – The Enforcer. Fortune. pp. 77-84.
Kahn, J. (2002, October 28). Splitting Up the Street. Fortune. p. 31.
Mann, B. (2002, April 19). How Do Analysts Sleep? The Motley Fool [Online].
Available: HTTP: http://www.fool.com/server/foolprint.asp?
file=/news/foth/2002-/foth020419.htm [2003, January 22].
Investment Analysis & Portfolio Management 11
Michaely, R., Womack, K. L. (1999). Conflict of Interest and the Credibility of
Underwriter Analyst Recommendations. The Review of Financial Studies. Vol.12.
Nichols, C. (2002, May 31). Pitt Says Analyst Probes Rising. TheStreet.com [Online].
Available: HTTP: http://www.thestreet.com/markets/marketfeatures/10025084.html
[2003, January 21].
Standards of Practice Handbook: The Code of Ethics and The Standards or
Professional Conduct. (8th ed.). (1999). Association for Investment Management and
Todd, S., & Todd, J. (Producers). (2000). Boiler Room. [Film]. New Line Cinema.
Investment Analysis & Portfolio Management 12