The much-ballyhooed Wall Street settlement is supposed to punish the perps and fix research, but it will probably do neither. The settlement will most likely decrease market efficiencies and thus increase costs of both issuers and investors. However, some good will come from the harsh glare of publicity that accompanied the process: here are the good, the bad and the ugly sides of the settlement.
The Good: Tough Love on Wall Street
The good thing about Mr. Spitzer's efforts is that it undoubtedly accelerated a necessary examination of Wall Street practices. While these practices themselves have been around since the first traders gathered, excesses served as a function of the last bubble, leading to the corruption of research staffs, the demolition of the Chinese Wall and, most importantly, the loss of investors' trust.
If left ignored, Wall Street might have never underwent this cleansing process. Wall Street has always been a closed club whose oversight actions are implemented at glacier speed, and often with a wink. Generally, it is an outside force that encourages change, and this time it was New York State Attorney General, Mr. Spitzer, who forced the issue into the glare of public scrutiny. There may be differing opinions about why he chose this issue and how efficient the results may be, but Wall Street will be better off because investors are now more informed about how Wall Street works.
The Bad: Ineffective Effort and Wasted Money
The settlement will more than likely increase costs for both sides of the Street (issuers and investors). The need to comply with all the new regulations arising from the dotcom crash (including Sarbanes-Oxley) is increasing corporate expenses across the board, which will reduce earnings and raise the cost of products and services. Investors will interpret these costs as increased brokerage fees and other hidden charges in banking and insurance rates.
If you think that is bad, just wait until you see what the lawyers do! The documents released with the settlement will provide a cornucopia of material for class action lawsuits that will do more to line lawyers' pockets than to redress past wrongs. The cost of director and officer insurance rates will therefore rise, which in turn will further erode corporate earnings.
The Ugly: The Street Remains Broken
It is hard to believe that $1.4 billion is about to be wasted on ineffective provisions. Many may think that this money will provide restitution, objective research and protection for investors, but it will probably do none of the above. Here is a summary of the SEC's press release and some comments on how we see the potential end results:
|•$775 million will be paid as "restitution" to investors hurt by tainted research - Half will go the SEC, NYSE and NASD while the remainder will go to the states. The amount is a joke compared to the trillions lost by investors and the billions in fees that the brokerages earned. It is also doubtful that individual investors will see much, if any, of this money, because it will be held by regulators to recoup their costs and by states to help offset budget deficits.
• $432.5 million earmarked for independent research - While the intent is noble, this is not likely to result in more objective information for investors. From what I have discerned, each brokerage firm will have an employee in charge of finding an independent firm to publish research on the stocks the firm follows. This addition of independent will not add any new information; adding ten analysts to the current crop of 38 analysts covering, say, Cisco will not uncover anything new.
• $80 million will go to a yet undefined investor education program - While this has potential to do some good, its success will be determined only by those who administer the funds.
• The above settlements amount to a total of $1.288 million, leaving about $112 million unaccounted for. Most of this amount appears to involve the separate $100 million settlement reached with Merrill Lynch and may be in addition to the other restitution fines, but the use of the funds was not clear in the SEC\'s release.
I think the most unfortunate thing is that funds earmarked for research will do little to bridge the information gap on Wall Street - this plan's weakness is that it will increase the number of analysts following companies that already have too many analysts! How much new information can be provided by adding more reports on big-cap stocks?
The plan instead should call for an independent administrator or committee of practitioners and regulators to establish an analyst cooperative. The coop would select qualified analysts to provide one new report for each of the firms currently covered by Wall Street, thus reducing redundancy and wasted effort. In addition, the analysts, who would be independent contractors, would be incented to provide research on orphaned stocks, which have little or no analyst coverage. If these analysts then provided good investment ideas, meaning these stocks appreciated, and were accurate with their EPS forecasts, these analysts would receive a bonus on top of a standard report fee.
The Bottom Line
In every post-bubble market, it is deemed necessary to fix the system with new regulations and to punish the wrong doers. Whether regulations actually fix the system or just present temporary obstacles to creative financiers remains to be seen. The key fact is that Mr. Spitzer helped to accelerate efforts and educate investors. It is unlikely, however, that there are any innocents left on Wall Street, at least in this generation of investors.