As a cautionary tale, let me relate the sad stories of Henry Blodget at Mer- rill Lynch, Jack B. Grubman at Salomon Smith Barney, and Chung Wu at PaineWebber. The incident that kicked off Attorney General Spitzer’s inves- tigation of Merrill Lynch in the first place was an arbitration claim filed with the NYSE in March 2001. At that time, a Merrill Lynch investor claimed to have lost $500,000 when following Blodget’s advice about Info- Space—the mobile Internet company mentioned earlier.6Merrill Lynch’s ace broker had maintained the stock’s 1–1 rating while the stock price was plummeting—all the way from $261 to $13.69.
The court order documented the context of that highly visible case in these terms:
Merrill Lynch maintained a list of its highest recommended stocks, selected from all of the stocks Merrill Lynch covered—not just Internet stocks. To be selected for this list (the “Favored 15”), to which retail bro- kers and the public had access, a stock had to have a 1–1 rating. . . . Info- Space was on the “Favored 15” list from at least August 2000 until December 5, 2000, even though Blodget had acknowledged as early as July 2000 that the stock was a “powder keg” and that “many institutions”
had raised “bad smell comments” about it, and in October had referred to it as a “piece of junk.” . . . Oddly enough, Blodget was unaware that the
stock he had been covering for months carried the imprimatur of the
“Favored 15.” . . . When a broker eventually complained on October 20, 2000, about Blodget’s price objective and rating of the stock, Blodget con- tacted a fellow analyst: “Can we please reset this stupid price target and rip this piece of junk off whatever list it’s on. If you have to downgrade it, downgrade it.” . . . InfoSpace however, was not removed from the “Favored 15” until December 5, 2000 . . . and was not downgraded until December 11, 2000.7
What had happened to the Merrill Lynch investor was that he had purchased InfoSpace shares for prices between $122 and $135. When a few months later the stock dropped to $60, he expressed to his broker his desire to sell his shares. At that point, his broker said to him, “No, stay in it because Blod- get will issue a research report and the stock will go up based on that.”
Notwithstanding Blodget releasing his report in July, the stock went on falling. The investor finally sold his stock in December with the price down to $11 a share. Later on he found out that Merrill Lynch had been hired by InfoSpace to advise it on a deal with a gain for Merrill Lynch worth $17 million.8
In July 2001, Merrill Lynch settled the disagreement by paying the investor $400,000. At the time, a spokesman for Merrill Lynch declared that the “matter was resolved to avoid the expense and distraction of protracted litigation.”
What happened at Salomon Smith Barney (Citigroup) in the case of Jack B. Grubman was different—involving as it did a dispute within the same firm between two brokers and one of its prominent analysts—but no less disheartening. Grubman, Salomon’s star telecommunications analyst, was sued by two former brokers for having persisted in recommending WorldCom stock while its price was plummeting, leading to substantial losses in their customers’ portfolios. Philip L. Spartis, one of the plaintiffs, was head of the WorldCom stock-option plan for Salomon; he had joined the firm in 1984 and had held WorldCom’s account for Salomon since 1997.
Spartis was helped in his task by Amy Jean Elias, a former insurance agent.
Both were terminated by Salomon on March 1 for having abandoned their job.
In the lawsuit they initiated against Salomon, they claimed that Grub- man’s upbeat rating of WorldCom stock had persuaded them to recommend to their clients that they hold onto their shares while the stock price was falling. They maintained that their accounts had suffered mainly because of their own firm’s flawed research.
READING(ORIGNORING) ANALYSTS’ RECOMMENDATIONS 173
Grubman is known to have continued recommending stock that had lost over 90 percent of its value. Why? Well, you cannot ignore the fact that over the years WorldCom had been a treasured client for Salomon in its invest- ment banking activity. Since 1997, in fact, Salomon managed or coman- aged all 16 offerings of public debt by WorldCom. Those deals, which raised
$25 billion for the telecommunications giant, resulted in $75 million in fees for Salomon.
In the days that followed Spitzer’s court order, Jacob Zamansky, the lawyer who had successfully sued Blodget, filed a similar suit against Grub- man. This time the case involved a CBS video editor who had filed for per- sonal bankruptcy after having lost about $455,000 in his investment portfolio. Zamansky was seeking $10 million in redress for his client.
I do not intend to pass judgment on the individuals in these two cases, who have been or will be judged in other venues. What seems clear and con- sistent across these two very different situations is that individuals making recommendations to investors are under intense pressures—at least some of which are not exerted in ways that help the investor. In fact, the investor is very likely to get hurt under circumstances like these.
The demise of Enron brought to light an even more extreme case of pressure being applied. In this case, as the New York Timesreported, the pressure was applied in a different direction:
The broker, Chung Wu, of PaineWebber’s Houston office, sent a message to clients early on Aug. 21 [2001] warning that Enron’s “financial situa- tion is deteriorating” and that they should “take some money off the table.”
That afternoon, an Enron executive in charge of its stock option program sent a stern message to PaineWebber executives, including the Houston branch office manager. “Please handle this situation,” the newly released message stated. “This is extremely disturbing to me.” PaineWebber fired Mr. Wu less than three hours later. That evening, the firm retracted Mr.
Wu’s assessment of Enron’s stock—then about $36—by sending his clients an optimistic report that Enron was “likely heading higher than lower from here on out.” A few months later, the stock was worthless, and the com- pany was in bankruptcy court.9
Analysts report that companies routinely stop communicating with them if they issue a sell recommendation. What can we conclude from all this? Well, to put it bluntly, we have to conclude that most research analysts are con- sidered to be salespersons for the investment banking activity of their firm.
If and when they depart from that role, they are punished, cut adrift, or both.