INDEPENDENT DUE DILIGENCE

ANALYST'S CONFLICTS

NETTING OUT THEORY

A. PART OF THE SELLING GROUP

Credit report checks - Individuals & entities

FBI checks through NASD personal files

Corporate legal counsel review of offering materials

Internal analysis of projections/forecasts

Utilization of outside legal & special consultants

Sponsor & asset verification

Visit to headquarters
- Write-up and analysis of sponsors accounting, compliance & organization procedures. Interviews with key mgmt. personnel.

Property verification

Program monitoring (with a min. of $300,000 raised)

B.  PLACEMENT AGENT OR UNDERWRITER:      

*  Management

(a)  Individual interviews with all senior officers

(b) Verification of background - College, previous employment, criminal record, credit history (bankruptcy?)

(c)  Objectives

(d)  Business Plan

*  Previous History of Corporation

(a)  Profit & Loss Analysis-dependence upon key supplier or customer

(b)  Cause for need for Capital

(c)  Product line, mix, marketing

(d)  Patents or trademarks

*Physical Inspection of Facilities

(a) Capabilities of equipment - Serviceability, Potential for breakdown and effects

(b) Building or Property - Sufficient for needs?  Length of lease, flexible for growth or lack thereof

(c) Process of production - Follow chain of supply-(potential for raw material shortages).  Key personnel or employees.  Unusual expertise required. 

*  Legal Organization

(a)  Inspection of legal documents - By-laws, Minutes, Corporate powers.

(b)  License or regulatory restrictions - Determine city, state, and federal restrictions on proposed business activities.  Cost of compliance.

*  References

(a)  Independent verification - Auditors, accountants, banks & credit bureaus, attorneys, suppliers & customers

(b)  Competition (most important)

(c)  Use outside experts, where possible, for analysis of business plan

*  Financial Review

(a)  Balance sheet review (before + pro-forma)

(b)  Use of Proceeds

(c)  Organizer's investment - are they at risk?

(d)  Potential for profit - P/E analysis, Units-market potential realistic, Gross revenues

(e)  Revenue needed to obtain 5/10/20% return on shareholder's equity

(f)  Management commitment to profitability

C.  Advertising and Communications -

     All advertisements that refer to specific recommendations, including research reports, shall contain all proper disclosures of the NASD Conduct Rule 2210 (d) (2) (B).  The following must be disclosed when applicable:

          1.  That the member usually makes a market in the securities being recommended, or in the underlying security if the recommended security is an option, and/or that the member or associated persons will sell to or buy from customers on a principal basis. 

          2.  That the member and/or its officers or partners own options, rights or warrants to purchase any of the securities of the issuer whose securities are recommended, unless the extent of such ownership is nominal. 

          3.  That the member was manager or co-manager of a public offering of any securities of the recommended issuer within the last three years.  

                                                 ANALYST'S CONFLICTS

     In the Wall Street Journal, March 1, 2005, it was reported that arbitrators in Florida ordered Merrill Lynch & Co. to pay $731,000 in compensatory damages and $300,000 in punitive damages to Gary Friedman, a medical-malpractice lawyer in Coral Gables, Fla. and his wife.  The award was predicated on Merrill's failure to disclose that its analysts had conflicts of interest in recommending stocks.  

     An NASD panel ruled last month that Merrill analysts "were guilty of intentional misconduct" in using a rating system that overvalued stocks they were covering.  The case is one of the first in which an investor won punitive damages against a Wall street firm for conflicted stock research.  It also is significant because Mr. Friedman relied on Merrill analysts to buy or hold 39 stocks that weren't involved in a $1.5 billion research settlement that Merrill and other Wall Street companies made in 2003 and 2004, said the Freidman's lawyer Robert W. Pearce.  He said Merrill did investment-banking work for about two-thirds of the companies in his client's portfolio at Merrill.  

    New York Attorney General Eliot Spitzer and other regulators charged the firms with recommending stocks that they privately disparaged in order to get investment-banking assignments from the companies.  The three-person NASD panel said it reviewed "clear and convincing evidence" of analyst misconduct.

     An SEC  alert titled "Analyzing Analyst Recommendations" issued by the SEC in June 2002, points out that "[W]hile analysts provide an important source of information in today's markets, investors should understand the potential conflicts of interest analysts might face.  Examples given by the SEC are analysts who work for firms that underwrite or own the securities of companies the analysts cover, or analysts who themselves own stocks in the companies they cover, either directly or indirectly, such as stock-purchase pools in which they and their colleagues participate.  They may have participated in "venture investing" where the analyst, the analyst's firm and the analyst's colleagues acquire a stake in a start-up company by obtaining discounted, pre-IPO shares.      

     The SEC alert states: "[Many] analysts work in a world with built-in conflicts of interest and competing pressures ... [which] can create pressure on an analyst's independence and objectivity."  some of the pressures identified by the SEC are investment banking relationships, brokerage commissions, analyst compensation, and ownership interests in the company who is the subject of the research rating.  

     Underwriting a company's securities offerings and providing other investment banking services can bring in more money for firms than from brokerage operations or research reports.  The SEC alert points out what an investment banking relationship may mean:  The analyst's firm may be underwriting the offering which means the firm has a substantial interest, both financial and with respect to its reputation, in assuring the offer is successful.  Upbeat research reports and positive recommendations published after the offering is completed may "support" new stock issued by a firm's investment banking clients.  Unfavorable reports may hurt the firm's efforts to nurture a lucrative, long term investment banking relationship because the reports may alienate a client or potential client and cause the company to look elsewhere for its investment banking services.  It is no secret that brokerage firms are in intense competition with each other for investment banking business.  Favorable reports and positive recommendations may induce the company to hire the firm to underwrite a securities offering where an unfavorable report makes it less likely the company will hire the firm as an underwriter to sell its stock.  

     Positive-sounding reports can help the analyst's firm make money indirectly by generating more purchases and sales of covered securities which, in turn, result in additional brokerage commissions.  analyst compensation can put pressure on analysts to issue positive research reports and recommendations.  Until recently, most firms linked compensation and bonuses, directly or indirectly, to the number of investment banking deals the analyst landed or to the profitability of the firm's investment banking division.  

     In June and July, 2001. Wharton finance professor Andrew Metrick told the House Committee on Financial Services Subcommittee on Capital Markets:  "Its not unreasonable to say that if these analyst's were truly independent we would not have had the bubble and crash that we did have."  Professor Metrick pointed out that "there were tons of companies that were going public without profits, while, historically, only biotech firms had done this".  Other academics and Wall Street observers pointed out that many analyst's continued to recommend internet stocks long after it was clear that the bubble had burst, leading investors who followed those buy recommendations to suffer deep losses.  Business Week Online (March 5, 2001 issue) reported that investors lost $3 trillion in the stock market between March 2000 and March 2001.  

     Benjamin Mark Cole, author of the book "The Pied Pipers of Wall street - How Analyst's Sell You Down the River," provided the subcommittee with research studies showing that, in the early 1970's, brokerage commissions supplied 60% of industry revenues.  But commissions fell after the federal government deregulated them in 1975, and commissions today provide less than 16% of  brokerage firm revenues.  To replace this loss, the industry turned to investment banking.  In 1974, Cole pointed out "the U.S. securities industry underwrote $42 billion worth of stocks and bonds.  In 1999, the industry underwrote 2.24 trillion, more than 50 times the pre-1975 level."

     The subcommittee considered a 1999 research study by Kent Womack, finance professor at Dartmouth's Amos Tuck School of Business Administration, and Roni Michaely, a professor at Cornell University, titled "conflict of Interest and the Credibility of Underwriter Analyst Recommendations."   The Womack and Michaely study found analyst's to be more optimistic about stocks underwritten by their own firms than they were about stocks underwritten by others.  But those optimistic forecasts tended to be wrong:  in the 24 months following IPO's, stocks recommended by analysts associated with the underwriting firms trailed stocks recommended by non-underwriters by 15.5 percentage points.  The underwriting analysts did much better when they recommended stocks their firms had not underwritten.  Womack and Michaely also found that analysts' "buy" recommendations outnumbered "sell" recommendations about six to one early in the early 90's.  By 1999, the study reported that the ratio had soared to as much as 100 to 1.  They concluded that buy recommendations by analyst's from brokerage firms which had recently brought out offerings of the stock in question "do show significant evidence of bias and potential conflict of interest."

     Investars.com, a company that tracks analysts' stock-picking performance, performed a study that encompassed the period that included the dot-com meltdown.  The Investars study found that the investment-banking conflict can have devastating effects on investor returns.  In a look at 19 major investment banks from January 1, 1997 through June 12, 2001, the study found that a portfolio of stocks recommended by analysts whose firms had "IPO relations" lost 51% of its value.  At the same time, the stocks recommended by analyst's without IPO relations fell by only 1%.   

     New York Attorney General Spitzer began a probe into possible analyst conflicts in early 2001.  Spitzer accused the major brokerage firms of using upbeat stock research and positive recommendations during the 1990's bull market to lure investment banking business to the detriment of the small investors who relied upon the tainted research.  A settlement agreement, announced in December, 2002, required 12 major brokerage and investment banking firms to pay multimillion-dollar fines totaling about $1.5 billion and separate their stock research from their investment business.  The firms neither admitted nor denied the Attorney General's charge that they had duped investors.  

     Salomon Smith Barney's former star telecom analyst, Jack Grubman, hyped many of the telecom stocks, most notably maintaining "buy" ratings on AT&T, Global Crossing and WorldCom while the stock values dropped precipitously.  Grubman's and Salomon's conflicts of interest did not go entirely unnoticed by the Salomon retail sales force, with scathing comments like, 

     -  "Grubman's analysis and recommendations to buy (1 Ranking) WCOM [Worldcom], GX [Global Crossing], Q [Quest] is/was careless";

     -  "His ridiculously bullish calls on WCOM and GX cost our clients a lot of money";

    -  "How can an analyst be so wrong and still keep his job?  RTHM [Rhythm NetConnections], WCOM, etc.etc.";

    -  "Downgrading a stock at $1/sh. is useless to us";

    -  "How many bombs do we tolerate before we totally lose credibility with clients?"

Source - SEC v. Grubman Complaint, at #27, and see also # 22 - 26.

Yet, Grubman and his boss at Salomon, Sandy Weill, did not care one whit for the retail customers whose accounts were devastated by their fraud.  In its civil complaint filed against Grubman April 8, 2003, the SEC quotes a January 2001 email in which he states, 

     "I never much worry about review.  for example, this year I was rated last by retail (actually had a negative score) thanks to T [AT&T] and carnage in new names.  As the global head of research was haranguing me about this, I asked him if he thought Sandy [Weill] liked $300 million in trading commission and $400 million [only my direct credit not counting things like NTT [Nippon Telecom] or KPN [KPN Quest] our total telecom was over $600 million in banking revenues.  So, grin and bear it..." SEC v. Grubman Complaint at #28.

At about the same time, Grubman emailed another friend admitting that he had upgraded AT&T only to obtain Weill's help in getting his children into an exclusive pre-school.

     "You know everyone thinks I upgraded T [AT&T] to get lead for AWE [AT&T Wireless Tracker].  Nope.  I used Sandy to get my kids into 92nd St. Y pre-school (which is harder than Harvard) and Sandy needed [the AT&T's CEO's] vote on our board to nuke [John] Reed in showdown.  Once coast was clear for both of us (i.e. Sandy clear victor and my kids confirmed) I went back to my normal negative self on T. [AT&T's CEO] never knew that we both (Sandy and I) played him like a fiddle".  SEC v. Grubman Complaint at #99.  The next day, Grubman emailed the same friend to say, "I always viewed T [AT&T] as a business deal between me and Sandy." Id at #100.

Salomon's complicity in this conduct, among other things, resulted in the filing of a separate SEC complaint against Salomon itself.  These Salomon conflicts of interest resulted in investment decisions based on tainted research, damaging the firms retail clients, immeasurably.  Grubman's illegal and fraudulent conduct was so egregious that he has been banned for life from the securities industry and fired by Salomon.   

Salomon 's research department, in effect, was little more than a marketing division for the firm's investment bankers.  Instead of placing the financial interests of their small retail clients in the fore, as they had a fiduciary duty to do, Salomon placed its investment banking profits and its relationships with its investment banking clients ahead of its retail clients.  Citigroup (SSB) paid approximately $400,000,000 to the U.S. Government in a settlement over its tainted research.     

                                                      HOW IT HAPPENED

     To understand how the present day relationship between investment banking and equity research evolved, we must take a trip back in time.  We will examine the industry over two very specific periods.  The first period begins at the end of World War II (1945) and continues through the end of fixed commission rates (1975).  The second period stretches from 1975 to the end of the 1990's "Bull" market in early 2000.  Unfortunately, as investors now know with the benefit of perfect 20/20 hindsight, the tremendous stock market price gains of the 1990's were an unsustainable bubble that has since burst.  Measured against the market's all-time highs, through the end of 2002, the Dow Jones Industrials were down 32%, the S&P 500 had fallen 49% , while the NASDAQ Composite Index was down a staggering 74%.  

     Over the 1945 - 1975 period, a symbiotic relationship developed among research, sales, and trading at the large U.S. brokerage firms.  The system essentially worked in the following way....Working in the brokerage firm's equity research department, "Sell" side analysts sought out the stocks of the very best companies in their respective industry area to recommend.  At most firms, each industry group (such as aerospace, automotive, construction, electrical equipment, retail, semiconductors, telecommunications, etc.) had its own analyst.  After conducting a thorough review and analysis of all the firm's in their particular area of expertise, the analyst wrote a detailed research report that recommended certain stocks for purchase.  The finished research report, which was distributed to clients (via mailing lists during this era), also explained the rationale behind the analysts recommendation, usually in considerable detail.  Once the research report on any given stock was published, the analyst basically had to market his/her research to three audiences.

     *     The first audience was the analyst's own internal institutional sales force.

     *     The second audience was the firms highest producing retail brokers (if the firm had a retail business).  At most firms with a retail client base, only a certain select number of the biggest  commission-producing brokers were allowed to directly call and /or otherwise directly interact with the equity research analyst.  

     *     Third, the analyst marketed his or her research to counterpart "Buy" side institutional analysts and/or money managers at large financial institutions such as Fidelity, Allstate, Alliance Capital and Vanguard, among many others.  

     It was only by building a positive track record of "correct" research calls over a period of time, that the analyst was able to build his or her professional reputation, and win the confidence of the audiences discussed above.  Normally, all three audiences were skeptical of any new analyst, and simply would not use any analyst that they did not know or were not comfortable with.  From the ongoing interplay among and between this three sided relationship of equity research, sales and trading, the brokerage firm would receive financial remuneration as the following sequence of events occurred.  the analyst would put out a "buy" recommendation on a certain stock, the institutional sales force and the firm's retail brokers would believe the veracity of the analyst's story, and would then attempt to sell this investment recommendation to their clients (either institutional or retail).  If institutional and/or retail sales were successful in selling this particular research recommendation, the brokerage firms' trading department would execute the trade(s).  The commissions generated from the trade(s) would pay the salaries of the analyst and the salesperson/broker, with any residual monies going to the brokerage firm as profit.  During this era, before the end of fixed commission rates, and under this business model, equity research was a "profit" center even after substantial five and six-digit analyst salaries were factored in.  

     With the end of fixed commissions in 1975, the U.S. brokerage industry entered an entirely new era with increased levels of competition occurring between and among the various firms as they pursued new clients and new business opportunities.  It was over this 1975-2000 time frame that the following events took place:

     1.  In this much more competitive post 1975 world, commission rates charged to the brokerage client fell dramatically, in many cases falling to only pennies per share traded.  In this environment and under changed operating conditions, it was no longer possible for research and/or trading to directly earn a profit.  

     2.  Thus, the equity research department went from being a "profit" center to being a "cost" center.  Moreover, it was because of these changed economic dynamics in the brokerage industry that the new equity research/investment banking relationship was born.  

     3.  Despite dramatic market fluctuations in recent years, basic Initial Public Offering (IPO) investment banking fees have changed little, and remain at the 7% level where they have been for a number of years.  In other words, a $100 million IPO (which was generally viewed as a "small" deal) would generate about $7 million in gross fees for the lead underwriting firm, with the net gain usually being in the $4 to $5 million range, after expenses.  Working with investment banking, equity research could once again "pay the bills" while continuing to pay analysts large salaries. 

     4.  In the new highly competitive economic environment that arose in the U.S. brokerage industry after the demise of fixed commissions, equity research analysts became much more involved in looking for, soliciting and supporting investment clients.  As a result of this relationship with investment banking, the average New York based equity research analyst could earn a six-digit salary, while analysts who were highly ranked in the Institutional Investor research poll could take home annual paychecks that stretched out to seven, and in some cases even eight digits.  

     5.  To manage the inherent conflict between the underwriting of new securities (investment banking) and the publication of research about an existing company's future business prospects (equity research) the SEC promulgated rules and regulations that required a "Chinese Wall" to be established between the two functions.  

     6.  Conceptually, the "Chinese Wall" was erected by the regulatory authorities to prevent the direct flow of information between investment bankers (whose access to information in discussions with company management often made them "insiders") and equity research, where information about any particular company was supposed to be independently gathered, compiled and analyzed.  In the early years after the end of the fixed commission era, the required "Chinese Wall" separation between investment banking and equity research was rigorously enforced.  However, as practiced by the U.S. brokerage industry in the 1990's (with the de facto consent of the SEC, which did little to enforce the "Chinese Wall" separation as originally envisioned), the separation between investment banking and equity research became less and less formal.  

     The old adage of "follow the money" will highlight what has happened to brokerage firm equity research departments and equity research analysts since 1975.  During the fixed commission era, equity research analysts could absolutely focus on making the best "stock market" investment recommendations because that is how they built their professional reputations and got paid.  In those days, if an analyst recommended a certain stock, successfully sold it to all the necessary target audiences, and the price of that stock went up, the analyst was rewarded in two ways:

     *     First, the research analyst's professional reputation was enhanced, as he or she became perceived as an industry expert and a good stock-picker.  

     *     Second, the analyst and the analyst's firm both got paid because the business of recommending stocks and trading stocks, particularly if the analyst's investment calls were timely and accurate, was quite profitable.  

     In the brokerage industry environment of the late 1990's equity research and trading were no longer profitable in and of themselves, while investment banking remained highly profitable.  In this setting, the research analyst could potentially be faced with diverse situations that often resulted in very different outcomes:  

     1.  In the first case, and in what would be an ideal situation for the equity research analyst, he or she would be able to recommend the stock of an investment banking client based on that company's strong business fundamentals.  Next, when that firm's sales, earnings and stock price all increased in line with stated forecasts, the analyst's professional reputation was enhanced.  In this situation, the investment banking client was happy, and the analyst and his/her firm both got paid through the investment banking side of the business.  

     2.  However, the second situation we will examine is not nearly as positive.  What would happen if an investment banking client's fundamental business story was not good, and would not normally merit a positive investment recommendation?  Then, assume that the investment banking relationship with this particular firm remained highly profitable for the brokerage firm.  Would the research analyst write a negative, but honest, assessment based on the company's underlying business fundamentals, or would the analyst write a positive business review knowing that it simply was not true?

     3.   If there were no threats against the analyst's job security and/or income, most professional research analysts would write an accurate assessment of a high profile investment banking client's business outlook, even if it upset the management of the outside client firm.  However, if the analyst perceived that his or her job and/or income were at risk if the high profile investment banking client were offended, then many analysts would likely choose to be less than honest in their public commentary (either written or oral).  

     4.  Simply put, the "conflict of interest" situation discussed above was quite prevalent in the U.S. brokerage industry of the late 1990's.  Unfortunately, it now appears that many analysts were looking more to their own perceived self-interest (keeping their high paying job), rather than clearly and honestly stating what they truly believed to be the fundamental business outlook for any given investment banking client. 

     5.  In addition, given the increased focus on investment banking that was keyed by the high level of profit generated  by this activity in the 1990's, many industry research analysts began actively searching for private companies that could be taken public via an Initial Public Offering (IPO).  Often, these firms were small and not well known, and would give the research analyst an ownership stake as compensation for setting up the investment banking relationship.  

     6.  If and when the IPO did occur, these analyst ownership positions usually became quite valuable.  However, if the analyst then uncovered "bad news" about a company in which he or she had an ownership stake, how likely were they to write a negative (but honest) report that would negatively impact their personal wealth?  Analysts having a "vested interest" in the companies that they covered and then write about it, is the second major "conflict of interest" that occurred during the bubble market of the late 1990's. 

     This examination of the U.S. brokerage industry has highlighted how the equity research department moved from being a "profit" center during the fixed-commission era, to a "cost" center by the time the "Bull" market of the 1990's rolled around.  While this change in internal industry dynamics certainly can explain some of the increased pressure that was faced by the "Sell" side equity research analyst over the 1975 through 2000 period, it does not explain why brokerage firm legal and compliance departments allowed the "Chinese Wall" separation between equity research and investment banking to become meaningless.  In fact, as highlighted in a number of Wall Street Journal articles, at least one large brokerage firm had a number of equity research analysts report directly to senior investment bankers.  Neither, in  spite of structural dynamics, is there a satisfactory explanation for the reason that the U.S. brokerage industry was left to its own devices by regulators during the latter part of the 1990's.  Nor does the change in industry dynamics explain why senior management and/or senior investment bankers allowed highly inflated business forecasts to go unchallenged to the investing public as if these projections were derived through truly independent research.    

     Did a number of large U.S. brokerage firms simply have their senior management and investment banking leadership positions filled by dishonest people, or was there some other dynamic at work here?  Between 1982 and 1992, the three large brokerage firms did not combine the efforts of different departments into a single-minded pursuit of new business opportunities.  In other words, a research analyst would initiate coverage on stocks he or she believed had the most upside price potential, without looking at the underlying company for commercial banking, investment banking, mergers/acquisitions, and/or other related new business opportunities.  After 1992, this began to change rapidly as a number of large brokerage firms merged with commercial banks, investment management companies, and insurance companies who were searching for distribution of "other" financial products.  Research analysts now began to get calls from senior persons in other departments of the firm who were looking to leverage the research relationship in an effort to win new business in both traditional and non-traditional areas.  If you were senior to the person calling with the request, you could readily say "no" if you did not like what was being proposed.  However, if the person calling was senior to you, then it became much more difficult to say "no".  In other words, the "separation of powers" that allowed research analysts a great deal of autonomy to pick and choose which stocks to cover and which not to cover began to be usurped, primarily by investment bankers, from the mid-1990's on.  Also frowned upon by investment bankers was the publication of any research report that expressed anything but the most glowing opinion about an investment banking client.   

     During the 1990's, the traditional brokerage firm changed from a company primarily focused on client services (institutional and/or retail) into a "financial supermarket".  Once in the "financial supermarket" mode, brokerage firms were looking to offer clients a wide array of services ranging from traditional brokerage services like research and trading to commercial banking, investment banking, merger/acquisition advisory, and asset management, among others.  The concept of being a "team player" was widely heralded, with the expectation being that each person involved would bring all of their particular experience and expertise to bear, with the primary focus being to get a particular piece of business done.  What an individual research analyst thought about any particular business transaction was not important.  All that was important was that everyone totally supported the "team effort" and got the deal done. 

     In retrospect, it is not surprising that the U.S. brokerage industry now labors under a cloud of scandal and controversy.  Particularly egregious examples of questionable industry behavior were the low-quality IPO deals that were brought public during the bubble market of the 1990's.  Under the new "team concept" once a decision had been made at the upper levels of management to pursue a particular business opportunity, everyone at the firm was expected to march in unquestioning lockstep until the transaction was completed.  Anyone who questioned a less than "top-flight" transaction was accused of not being a "team player".  Then, in a number of cases, analysts who persisted in attempting to write factual research reports or resisted supporting the "low grade" transactions that became common during the latter part of the 1990's were fired.  While all brokerage firm employees who supported these questionable business transactions must share in the blame for what happened, analysts are being particularly singled out because what they said about any particular stock or transaction was "on the record".  Obviously, a published research report can be dissected and examined word-by-word and sentence-by-sentence long after all other traces of a "deal gone bad" have long since vanished.  

     On the other hand, in many instances, analysts deserve to be blamed for much of the shoddy research that occurred during the late 1990's.  It was analysts who thought up new and novel valuation measures like backlog to sales/book to bill ratios, times sales ratios, times operating cash flow ratios, times free cash flow ratios, and economic value added measures using unrealistic growth and discount rates when a company's stock price no longer appeared attractive using established measures like times earnings per share (the old P/E ratio).  It was also analysts who came up with even more bizarre valuation parameters like market share of an undefined or unprofitable market, mouse clicks (hits) per web site, and the number of incremental new subscribers per month regardless of customer cancellation rates and/or other true cash and profitability measures.  

     Although there appears to be enough blame to go around, it is clear that the "team player" or "team concept" mode of doing business that was espoused by U.S. brokerage firms during the 1990's made it easy to silence critics and suppress dissent.  It became hard to individually oppose a large number of "team" members when the analyst did not have perfect information and foresight, particularly if billions of dollars were at stake, and if the market was taking the price of a security well above what the analyst believed was reasonable.  Keep in mind that no analyst could predict with 100% certainty what would happen to the price of any stock over any given period of time.  Finally, when the market price of a security went against an analyst's deeply held convictions and expectations in a major way for a prolonged period of time, that analyst would almost always be plagued by doubts.  He or she would keep asking, "What does the market know that I don't know?"  If this went on long enough, even the most convinced analyst might waver and change his or her investment opinion, because the belief was that the millions and millions of people whose combined input went into the making of any given stock's market price was collectively in possession of more information than the individual analyst.  

     Placing blame after any negative occurrence has taken place, particularly if backed by major fines and/or prison time, will normally prevent the same thing from happening for some period of time going forward.  However, people forget over time, and the human emotions of fear and greed will once again lead to market excesses.  However, the blame for the extreme market excesses of the late 1990's should be placed primarily with senior management persons and brokerage firm legal and compliance departments along with those individual analysts who acted in a less than professional manner, and who essentially "sold their soul" to the highest bidder.  Keep in mind that senior management is responsible for all that happens or fails to happen at their firms.  During the decade of the 1990's, they established the culture that put profit and the "team player" concept of doing business above ethics, client service, and individual employee dissent.  It was senior management who rewarded "rogue" analysts and investment bankers with enormous seven and eight-digit salaries.  It was senior management who reined in their firm's legal and compliance departments, and who turned a blind eye to the excesses that occurred at their firms during the latter part of the 1990's.  It was even senior management, with the help of their compliance and legal departments, that convinced regulators, during inspections and audits, that the "Chinese Wall" was firmly standing and that there was no need to interfere with the raging "bull market", which at the time, seemed to be making everyone rich.  

     Finally, individual investment bankers, analysts, traders, and brokers all have to look in the mirror and judge whether they honestly performed their jobs to the best of their ability.  Can they honestly say that they put their clients' interests ahead of their own.  Until the investing public perceives that client interests are once again paramount, we should not expect a major sustainable stock market recovery to occur.    

Note:  Attorney Ken Wood contributed to this material and portions of an article by Peter L. Aseritis were included.

                                                          NETTING OUT THEORY

     Also known as the Total Return Theory, this method of reducing losses is often used by respondent's in arbitration cases.  To do otherwise, states respondent, and to just to consider losses in one of several accounts is tantamount to "cherrypicking".  Further, defense counsel often attempts to garner gains of long past years to offset losses in recent periods.  Remember the NASD has a six year eligibility rule and wouldn't respondent be the first one to cut off "losses" if they occurred more than six years prior to the filing of the statement of claim.  

     There is another problem with this netting out theory.  Logically, it follows that claimant doesn't have to complain about an account that is handled suitably.  In other words, you don't give the broker or brokerage firm accolades or brownie points for doing what they were supposed to do.  They are expected to follow the rules and recommend suitable trades.  That is what a full service broker is paid to do.  Claimants in arbitration then have the right to isolate the unsuitable portion of an account relationship if significant, and deal with it separately.  This is especially true if that unsuitable portion is in excess of 10 - 15% of the total entire account relationship.  In other words, as Merrill Lynch properly states, in a moderate account, you would not be surprised to find 10% to 15% in speculative securities for complete portfolio diversification.  

     There is well settled case law regarding the netting of an account's profits against losses.  In Kane v. Shearson, 916 F.2d 643, 646 (11th Cir. 1990), the appellate court affirmed the trial court's reversal of an arbitration decision that offset the claimant's losses by his gains from the same unsuitable stock.  The court concluded that "[t]here is no indication that other transactions are relevant to this calculation at all."  the Court further observed the perverse incentives of such a "netting" theory stating:  "[T]here is no support to be found under federal...law for the "netting " theory Shearson argues for here...As the district judge noted, "If the ...methodology espoused by [Shearson] were adopted, it could serve as a license for broker-dealers to defraud their customers with impunity up to the point where losses equaled prior gains."  

    In Randall v. Loftsgarden, 106 S.CT.3143, 3153 (1986), the United States Supreme Court rejected a netting analysis based on the deterrent purpose of the securities laws: "This deterrent purpose is ill-served by too rigid insistence on limiting plaintiff's to recovery of their net economic loss."  In a case in the appellant circuit in California, Nesbit v. McNeil, 896 F.2d 380, 385, 386 (9th Cir,1990) the appeals court affirmed the trial court's rejection of the netting argument, stating that "there is no reason to find that [plaintiffs] should be denied a recovery because their portfolio increased in value, either because of or in spite of the activities of the defendants, "and that "gains in portfolio will not offset losses...."

     Again in Davis v. Merrill Lynch, 906 F.2d 1206, 1218 (8th Cir. 1990), the federal appeals court, interpreting both state common law and federal statutory claims, rejected the netting argument: We disagree with Merrill Lynch's argument that no actual damages were sustained....The implications of this argument are disturbing.  If we were to adopt Merrill Lynch's view. securities brokers would be free to churn their customers' accounts with impunithy so long as the net value of the account did not fall below the amount originally invested.  Finally, in Levine v. Futra, the court similarly rejected a "netting" defense, stating that "this court holds that plaintiffs suffered damages even though the investment portfolios incurred a net gain."  In short, no netting may occur.  Respondent's misconduct cannot be rewarded or mitigated by the mere fortuity that prior transactions may have been profitable.  

     The above analysis carries significant weight when the total account relationship while at the subject broker dealer, substantially under-performed the market.  Further, one account or securities position, in relation to the total account relationship, may be so egregiously unsuitable, it may rise to the level of rescission as the proper measure of damages.  

FEND - Securities Expert Witness
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