August 7, 2008
By Susan Antilla
If you have been perusing recent news reports that chronicle Wall Street’s latest crop of outrageous, investors-be-damned e-mails and wondering where the regulators were, I’ve got news for you.
The regulators were there. The problem is it just didn’t make any difference.
Massachusetts Secretary of State William Galvin brought an administrative action on Aug. 1 against Merrill Lynch & Co., releasing e-mail gems that included a doozey written Aug. 16, 2007. “Come on down and visit us in the vomitorium!” wrote Frances Constable, a managing director, to a Merrill colleague. Constable’s aptly named locale was the Merrill Lynch auction-rate securities desk, which Constable ran, and which by this time last year must have been a sickening sight.
The auction-rate market may have been in crisis mode. But that didn’t stop Merrill from selling the securities for months after, with Constable even pushing a bond analyst to tone down a negative report lest it scare away customers, according to the state action.
Tone down a negative report? Didn’t we already watch this show?
It was five years ago when 10 securities firms reached a $1.4 billion settlement with regulators that was supposed to wipe out the conflicts of interest that infected Wall Street research. A little caveat: The global research-analyst settlement, as it was called, didn’t apply to fixed-income research. Nor to any other research — technical, commodities or quantitative — for that matter. Just stocks.
Saw It Coming
William Donaldson, who was chairman of the Securities and Exchange Commission at the time, anticipated problems in the fixed-income market nonetheless. He made it clear to bond-market players that he expected them to address conflict-of-interest issues, such as situations where analysts risked retaliation for writing honest, but negative, reports.
In an April 2005 speech, Donaldson suggested they learn from the mistakes that led to the embarrassing equity-market settlement. “Rather than conclude that they could never happen here,” he said, “ask yourselves what sorts of practices in the bond market might implicate the same fundamental concerns.”
The audience must have been dozing. Only three months after Donaldson’s speech, a trail of e-mails began at the major bond rating companies showing that research staffs were sometimes involved in fee negotiations with issuers, and that personnel were straining to keep up amid troubles in the subprime market. The e-mails became public when the SEC released a report on Moody’s Investors Service, Fitch Ratings Ltd. and Standard & Poor’s on July 8.
NASD and the New York Stock Exchange, meanwhile, were also hot on the trail of problems in bond research in the years before the credit crisis erupted. In July 2006, the self-regulatory organizations jointly released a notice to members that described fixed-income analysts making public appearances without a supervisor’s approval and fixed-income research reports going out without any disclosure about conflicts of interest. Some fixed- income analysts were even keeping personal-investment accounts outside of their own firms in violation of company policy.
The premiere regulatory gotcha of the bond market, though, already had happened two months before.
On May 31, 2006, 15 brokerage firms had signed a consent order with the SEC related to violations in the auction-rate market.
Some of the firms were making their own bids in auctions “to ensure that all of the securities would be purchased to avoid failed auctions,” the agency said. The firms didn’t properly disclose what they were doing, according to the SEC, and “since the firms were under no obligation to guarantee against a failed auction, investors may not have been aware of the liquidity and credit risks associated with certain securities.”
“The remedies were appropriate to the firms’ failures to disclose their role as participants in the auctions,” said John Heine, a spokesman for the SEC. “No findings were made concerning sales practices.”
It’s to the SEC’s credit that it discovered the disclosure violations in 2006, says Steven D. Toskes, a lawyer at Klayman & Toskes PA in Boca Raton, Florida, who is representing investors suing brokerage firms over their auction-rate securities investments. He says the agency didn’t do proper follow-up, which resulted in investors making auction-rate investments without understanding how easily the auctions could fail.
“There doesn’t seem to have been active oversight” from the time of the 2006 case to the time that the auction-rate market shut down this February, Toskes says. “Our clients had no idea that their investments were at risk to the level they were.”
The SEC said the 15 firms helped the SEC “conserve resources” by being good citizens and disclosing their practices without a fight. And it paid off for the firms.
“This case signals that the commission is willing to take measured sanctions when broker-dealers are cooperative with the SEC in curing industrywide violations and there is relatively modest investor harm,” agency Enforcement Director Linda Chatman Thomsen said at the time.
Whoops. Well, they almost got it right. Now if we could just fix that glitch with the “investor harm” business.