Zamansky & Associates

This article examines the question of whether major securities’ brokerage firms analysts can be held liable for securities fraud as a result of stock recommendations they make which fail todisclose conflicts of interest and are premised upon the use of baseless “valuation” criteria. The issue is of great importance as the U.S. Congress and securities regulators are currently examining the role and potential liability of stock analysts. As shown below, existing securities law does, in fact, hold analysts liable for misleading statements or failure to disclose conflicts.

The fall of the NASDAQ market (Internet/high technology) stocks from its high of 5,000 in March 2000 to 2,000 in March 2001 has been largely attributed by many financial market observers to false and misleading “buy” recommendations issued by major brokerages’ “superstar” Internet analysts such as Henry Blodget of Merrill Lynch and Mary Meeker of Morgan Stanley. These analysts have been criticized for failure to disclose material conflicts of interest, namely, their firms’ financial interest in the stocks they were touting and the use of newly minted “valuation criteria” to justify their buy recommendations and high stock price targets.

During the 1998-2000 Internet stock market frenzy, major brokerage firms such as Merrill Lynch and Morgan Stanley created media “superstar” Internet analysts as a means of enticing the investing public (who watch CNBC and other financial shows) to purchase Internet and high technology stocks. The superstar analysts were also used to generate investment banking business for their firms. Critics argue that the research “analysts” no longer perform objective unbiased analytical functions (as required by Industry Standards) but, instead, are mere “touters” or “cheerleaders” for the companies they cover.

The “newly minted” valuation criteria used by these analysts do not appear to comport with Industry Standards such as the standards of the Association for Investment Management and Research (AIMR) which requires that analysts use “objective” and “unbiased” research backed by proper and adequate due diligence.2 Instead, the Internet analysts have moved from the Industry Standard of “price to earnings” valuation methodology to price to “revenue multiples” to justify their valuations.3 In fact, many analysts have moved “off the charts” to value stocks based on “visits to websites”, “mouse clicks” and other “statistics” which may bear no basis in reality and are not consistent with Industry Standards.4 Lastly, research analysts and investment bankers are by regulation required to be separate and to maintain a “wall” between their functions. In reality, the “wall” no longer exists and analysts have been criticized for becoming mere tools for their investment banking departments to generate underwriting and other business.5

The failure to disclose a material conflict of interest (a firm’s financial interest in the stock it is recommending —such as investment banking fees) may serve as the basis for a securities fraud claim. The use of baseless valuation criteria which are inconsistent with Industry Standards may constitute fraud and/or gross negligence on the part of an analyst or a violation of New York Stock Exchange (NYSE) Rule 405 which requires a broker or analyst to have a “reasonable basis” for making a recommendation.

SEC Rule 10b-5 provides that it is unlawful for any person to make an untrue statement of a material fact or to omit to state a material fact necessary in order to make the statement made, in the light of the circumstances under which it was made, not misleading, or to engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person in connection with the purchase or sale of any security.6 In the leading case on point, Credit Suisse First Boston Corp. Securities Litigation,7 the Court held that an analyst’s research report, could, in fact, serve as the basis for a securities fraud complaint where the report made false or misleading statements in connection with stocks and that the firm which issued the research report failed to disclose that it had a “short” position in the securities which were being analyzed.

In that case, a CSFB analyst issued a report entitled “Trading Notes, The Year 2000 Bubble,” which recommended the sale of Data Dimensions and Viasoft stock, two companies involved in attempting to solve the Year 2000 computer problem. The report stated that the software companies highlighted in the report could not fix the problem and had no possibility of earning close to what the market capitalization indicated. The report, however, failed to disclose that CSFB had a significant “short” position in the stock of the two companies and stood to profit if the stocks’ price fell as a result of the report.

The defendants moved to dismiss the complaint claiming that the alleged misstatements in the report were merely “statements of opinion” that are not verifiably false and are thus not actionable. In denying the motion to dismiss, the court held that projections and opinions could provide the basis for liability under Section 10(b) and Rule 10b-5 and that forward looking statements or predictions can be considered “facts” within the meaning of the rule’s proscription of fraud. The court also observed that the failure to disclose the firm’s short position in the stocks could constitute a material omission sufficient to support a securities fraud claim.
After the “tech stock” crash, the following significant regulatory and industry events regarding analysts occurred. The following is a summary of these key events.
• December 2000 — Prudential
Securities’ Chairman announced that the
firm’s analysts should use “sell” when they
mean sell and not hide behind typical
Wall Street euphemisms like “market
perform” or “neutral.”
• June 7, 2001 — The New York
Attorney General’s Office announced that
it has begun an investigation into Wall
Street’s stock-research practices, including
whether analysts are presenting unbiased
information to investors.
• June 12, 2001 — the Securities
Industry Association adopted a set of
“Best Practices” guidelines aimed at
increasing the independence of analysts
and eliminating undue influence from
investment-banking pressures.
• June 14, 2001 — the United States
House of Representatives’ Subcommittee
on Capital Markets held the first of
several hearings entitled “Analyzing the
Analysts: Are Investors Getting Unbiased
Research from Wall Street”. The
Subcommittee heard testimony from
critics and industry supporters regarding
analysts’ conflicts of interests.
• July 2, 2001 — the NASD proposed
new rules mandating, among other things,
that analysts and brokerage houses
definitively disclose ownership in or
investment banking business with
companies under coverage.
• July 9, 2001 — the SEC issued an
“Alert” entitled “Analyzing Analysts
Recommendations.” The SEC cautioned
investors about analysts’ recommendations
advising investors that analysts have
“potential conflicts of interest” and that
“investors should not rely solely on an
analyst’s recommendation on deciding
whether to buy, hold or sell a stock.”
• July 10, 2001 — Merrill Lynch, the
nation’s largest brokerage firm, announced
a new policy prohibiting analysts from
buying shares in companies they cover.

The following proposals from the author
are designed to eliminate analyst conflicts
of interest.
(1) Analysts should make specific
disclosures of conflicts of interest or
the financial interest of their firm in
stocks that are being recommended.
For example, if an analyst is recommending
a stock for which his or her
firm was the underwriter or the financial
advisor, that specific relationship
and the amount of compensation must
be disclosed at the beginning of the
analyst’s report. The fine print generic
“boilerplate” disclosures at the end of a
report are meaningless and are not
designed to alert investors to specific
conflicts of interest.
(2) A clear wall must separate
investment banking and research —
the days of analysts promoting an
investment banking deal which the
Research Department is covering
must end.

(3) Analysts’ compensation must not
be based on investment banking
revenues and the amount of compensation
and the formula for determining
compensation must be disclosed in
public filings and made available to
the public on the firm’s or the NASD
and SEC Web sites.
(4) Analysts’ recommendations must
be in “plain English” — “buy”, “hold”,
and “sell” are plain English terms
which the public understands. Using
terminology to reference a sell recommendation
such as “accumulate” and
“hold” are misleading to the public.
(5) Analysts must disclose in their
reports the specific “valuation criteria”
used to value a stock and such criteria
must be consistent with Industry
Standards such as those set forth by
the AIMR.