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Dotcom investors turn on analysts following losses

"The writing is so coded that only sophisticated investors understand that you would have to be an idiot to own the stock."

US Congressman Richard Baker

It happened in the 1880s, again in 1929 and even more famously in 1987. After every stock market party, the police arrive to pick through the morning-after rubbish and find something ugly.

The Wall Street party was no different this time. Among the burst dotcom balloons and empty champagne bottles left on the street in 2001, US regulators found some allegedly criminal acts as well as questionable behavior among the financial sector's biggest firms.

Two grubby areas have come to light. The first is the behavior of analysts, and the second, the methods used to underwrite new shares. The latter, investigated by the securities and exchange commission, the US attorney's office and the National Association of Securities Dealers, could lead to criminal charges.

The fallout from these inquiries has already been felt in the UK. Several private investors have contacted Jacob Zamansky, head of US law firm Zamansky & Associates, about filing complaints against analysts. Zamansky, who is acting on behalf of almost 20 investors in the US, could file these cases imminently.

In the US, more than 20 claims have already been filed against Wall Street firms and their analysts. Zamansky filed the first of these for a client against Henry Blodget, one of the street's best-known internet analysts, and Merrill Lynch, his firm.

Blodget and Merrill stand accused of "systematic fraud ... on an industry-wide basis" for touting shares in internet stocks without revealing the extent of their financial reliance on the company. Dr Debases Kanjilal, a New York pediatrician, is claiming the US US$600,000 he lost from an investment in one online directory company and US$10 million in punitive damages. Merrill has described the charges as meritless.

Most Wall Street banks reward analysts using client review and banking fees. Few chart the success of an analyst's recommendations.

This means that high profile analysts such as Blodget, Mary Meeker at Morgan Stanley and Jack Grubman at Salomon Smith Barney can be rewarded by winning more business for their firms.

Complaints of bias have long dogged analysts. The frenzy of recent years, when high-tech analysts used newly minted valuation tools to justify huge premiums, simply opened up the practice to a wider audience. "The analysts pumped up this tech bubble and left investors holding the bag," says Zamansky.

Spurred on by constituents' complaints, some politicians have started to echo this view. On June 14, investment bankers are expected to be hauled in front of Congress to discuss their behavior. Republican Congressman Richard Baker, who chairs Washington's capital markets sub-committee, believes the coded language used on Wall Street "penalized" ordinary investors.

A year ago, analysts believed that just 206 US companies -- or 0.8 percent of all those rated -- should be sold, according to research by Thomson Financial-First Call. At a time when most US shares were trading at all-time highs, nearly 74 percent were rated either "strong buy" or "buy". Only those institutional investors lucky enough to receive a call from the investment bank would know which of the "accumulate" or "hold" stocks should be dumped forthwith.

"The writing is so coded that only sophisticated investors understand that you would have to be an idiot to own the stock," said Baker this week. "Mom and Pop investors are not getting the same treatment."

This "buy" bias increased during the boom, when analysts simply chased what went up rather than try to understand why it did so. In 1992, says Baker, the buy-sell split was about 50:50.

Washington is now considering changes to the laws governing securities advice to make it more transparent. "Clearly the status quo is not acceptable," says Baker.

The threat of legislation, combined with horror at their star analysts appearing in a dotcom show trial, has already prompted Wall Street firms to begin addressing the problem.

The Securities Industry Association, a trade body, and senior bankers are working on a code of conduct that is expected to call for more disclosure. Baker says he is "optimistic" that the code will be presented at this month's hearing. Some firms, such as Prudential Securities, are also banning vague recommendations for straightforward buys or sells.

There is little evidence that banks are as willing to issue a mea culpa over how they award shares in newly listed companies. A grand jury is reviewing evidence that several of Wall Street's biggest banks effectively demanded kickbacks from institutional clients in return for giving them lucrative shares in initial public offerings.

The investigations have so far focused on CSFB, where several employees have been told they face possible regulatory action by the NASD. Two have been sent on administrative leave. The bank has said it is cooperating with the government inquiries but has denied any wrongdoing alleged in the class action lawsuits.

CSFB also issued a statement saying that Frank Quattrone, the head of its high-tech group, was "not responsible for overseeing brokerage accounts or commissions, nor is he or was he responsible for IPO allocations to clients". Insiders privately fear regulators could be looking for a high profile scapegoat -- a Michael Milken for the internet age.

Sirota & Sirota, a New York law firm, has filed a class action complaint for at least 15 individuals against seven banks: CSFB, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley, Bancboston Robertson Stephens and Salomon Smith Barney. The banks are all expected to defend themselves vigorously.

This lawsuit and others claim that hedge funds and other institutional investors were awarded large chunks of IPO shares in return for a promise that the bank would receive a certain percentage of it back in commission fees. Asking for kickbacks and "laddering" a stock, by making an investor pay for more shares at higher prices later, is illegal.

Yet such practices were hugely lucrative during the dotcom boom, when investors clamored to buy shares that gained more than several hundred per cent in a day.

Research by Jay Ritter, Cordell professor of finance at the University of Florida, found that the average first day increase of American IPOs during the last two years of the millennium was 65 per cent. This compares with 6 per cent during the whole of the 1980s.

The SEC is understood to have subpoenaed trading records for VA Linux, which achieved a record-breaking first day gain of 700 per cent in November 1999, to see how much banks made from its IPO in underwriting and subsequent commission fees.

Some analysts wonder why regulators and investors are only now asking questions about the behavior of banks, more than a year after the stock market peaked. Professor Ritter says: "With 20:20 hindsight, a case could be made that the SEC and NASD should have started raising questions earlier. On the other hand, there weren't a lot of complaints coming in."

There is also the old adage that generals fight the last war. After the get rich quick railroad schemes blew up, regulators clamped down on pyramid schemes, only to be hurt again by the 1929 crash.
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