IN THIS CHAPTER
Getting an understanding for the goals of financial regulation
Finding out how the rules have evolved through time
Coming to terms with the common rules imposed on investment banks
Seeing how investment banking regulation changed after the financial crisis
Finding out about the rules on investment analysts
Finding out why regulation may be ineffective
Some people would say investment banking is a highly regulated industry, while others would contend that it isn’t regulated nearly enough, and more government oversight is warranted. The financial crisis of 2007 and 2008 refocused debate on the role of regulation and the perceived failure of oversight to prevent the near meltdown of the financial system and subsequent global recession. But memories are short and many of the laws passed in the wake of the crisis are being reassessed and weakened. Trying to strike the proper balance between free market forces and the protection of investors is a difficult task that lawmakers have wrestled with through time. In this chapter, we will fill you in on the current state of financial regulation and how we got to where we are.
As is the case with most industries, the regulation of the investment banking industry has evolved through time. Unlike most fields, however, major changes in legislation have come in clusters and have been precipitated by seminal crises in the markets.
According to the primary U.S. regulator, the Securities and Exchange Commission (SEC), “The mission of the U.S. Securities and Exchange Commission is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.” The SEC attempts to accomplish this by requiring full disclosure of all relevant information related to specific securities and financial advisors. The goal is not to prevent losses by investors, but to allow investors to make informed investment decisions by requiring the disclosure of audited financial and other information.
American historian James A. Field, Jr., a professor at Swarthmore College, was quoted as saying that “It is proverbial that generals always prepare for the last war.” The same can be said of regulators with respect to the investment banking industry. Sweeping regulatory changes generally come out of market crises, and the recent past is certainly no different. The two biggest crisis periods of the last 100 years — the market crash of 1929 (and subsequent Great Depression) and the financial crisis that began in 2007 — both resulted in major legislation affecting the financial markets. To say that financial regulation is reactive rather than proactive is a gross understatement. Regulators, it seems, have looked to prevent the last crisis instead of trying to avoid the next one.
To understand today’s securities regulation, you need to know how it developed. Rules passed decades ago are still binding today. The history of regulation of the investment banking industry begins during the Great Depression with the passage of the Glass-Steagall Act of 1933. The main purpose of this act was to separate investment banking activities (primarily securities underwriting and trading) from commercial banking activities (taking deposits and making loans). This was done because many people felt that commercial bank participation in the stock market was too risky an endeavor and that depositors’ funds shouldn’t be used to speculate in the stock market (sound familiar?). It was widely believed that the combination of commercial and investment banking activities within the same firms contributed to the crash of 1929 and the subsequent Great Depression.
The year 1933, the height of the Great Depression, witnessed another seminal regulatory act with the Security Act of 1933, which guides the industry’s behavior to this day. The main purpose of this act was to regulate the primary securities market — that is, the new issue or IPO market. This piece of legislation required that firms issuing securities must fully disclose all material information concerning the new issue. It also required that investment banking firms provide investors with a prospectus (a formal legal document that contains all relevant information — including audited financial statements and other disclosures) on all new issues.
The very next year witnessed the passage of the Securities Exchange Act of 1934. The primary purpose of this act was to regulate the secondary market (the market where already existing securities are traded). The main points of this act involved setting margin requirements, audit requirements, registration requirements for stocks listed on exchanges, and disclosure requirements. The act also created the SEC as the primary enforcement agency for securities laws.
The final two pieces of major legislation that had its genesis in the stock market crash of 1929 were the Investment Advisors Act of 1940 and the Investment Company Act of 1940. The Investment Advisors Act and subsequent amendments required investment advisors with a minimum asset size under management to register with the SEC. It also provided guidelines regarding the fees and commissions they may collect and detailed the liability of advisors. The Investment Company Act of 1940 detailed requirements for mutual funds (both open- and closed-end) and exchange traded funds (ETFs).
Investment banks are governed by a myriad of complex legislation that is enforced by several government agencies and self-regulatory organizations, most notably the SEC, the Financial Industry Regulatory Authority (FINRA), and the various securities exchanges including the New York Stock Exchange (NYSE) and the Commodities Futures Trading Commission (CFTC), among others. One of the problems with regulating the financial markets has been a difficulty in coordination by the various regulators.
Investment banks are subject to many rules that govern their activities, but the primary focus of regulation is on information flow — ensuring that all investors have equal access to information and one group is not disadvantaged relative to another.
Under certain limitations, insiders are allowed to trade in the securities of the firm that they’re involved in. The SEC defines illegal insider trading as “buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.” Information is material if its disclosure would likely have an impact on the price of a security; that is, if investors would want to know the information before making an investment decision. Information is nonpublic if the investing public has not been made aware of it. For instance, potential mergers and acquisitions, unreleased company earnings numbers, upcoming changes in management, and any regulatory approval or rejection of a patent would all be considered material information.
In addition to trading for one’s own benefit, it is illegal to pass along that information to others who trade on it. Investment bankers have access to much more and better information than the typical investor. In order to maintain a level playing field for all investors, those individuals in possession of inside information are strictly prohibited from trading on that information unless and until it is released to the public through proper channels like a press release or required filings.
There are instances, however, where individuals break these rules and have been brought to justice. For instance, in a high-profile case in 2012, former Goldman Sachs board member Rajat Gupta was convicted of leaking confidential information from Goldman Sachs board meetings to Galleon hedge fund tycoon Raj Rajaratnam. Gupta was fined $5 million and sentenced to two years in prison.
Another high profile insider trading case involved former U.S. House of Representative member Chris Collins. He pled guilty to conspiracy to commit securities fraud and lying to federal investigators after passing along private information about Innate Immunotherapeutics to his son to help him avoid financial losses. Collins was a member of the firm’s board of directors, and the scandal forced him to resign his House seat.
Market manipulation occurs when market participants conspire to distort prices and trading volumes in order to mislead the markets. A classic example of market manipulation is a pump-and-dump strategy in which a firm or individual acquires a position in a company, releases positive (and often false or very misleading) information about that company, and then dumps the stock at a profit when the price increases. Pump-and-dump occurrences tend to be concentrated in the micro-cap or penny stock market — markets for small, thinly traded stocks — because these markets are much easier to manipulate.
The traditional image of pump-and-dump purveyors was that of the so-called boiler room where individuals would cold-call unsuspecting investors and promote a specific stock or stocks. The advent of the Internet and social media made it much easier to accomplish a pump-and-dump strategy. All it takes is a few strategically placed comments or false rumors to get gullible investors to fall prey to unscrupulous operators. One of the most famous pump-and-dump cases involved 15-year-old high school student Jonathan Lebed, who made hundreds of thousands of dollars by posting on Internet message boards and using social media to promote stocks that he owned. Lebed eventually settled with the SEC and paid a fine of nearly $300,000 but was allowed to keep some of the profit from the strategy.
Market manipulation can also be done by people who take a short position in a security — that is, bet on the stock price falling by short-selling or buying put options — and then denigrate the stock by spreading (often false and misleading) information. Once the stock price falls, these “stock bashers” close out their positions at a profit. Although it certainly isn’t illegal for market participants to point out the weaknesses of particular stocks, it is illegal to spread false and misleading rumors. As you may suspect, cases of stock bashing are very difficult to prove.
Not all market manipulation is meant to distort prices in the market. Another form of market manipulation is churning, in which market makers collude to make it appear that the buying and selling in a security is much more active than it actually is. A market maker is a firm that is a dealer in a particular security, standing ready to buy and sell, hoping to profit on the bid-ask spread, which is the difference between the quoted buy price and sell price.
For instance, a market maker may quote a buy price of $20.25 per share and be willing to sell the security for $20.50 per share. A successful market maker doesn’t care as much if the price of the securities that it makes a market in rises. The market maker is concerned with the ability to match buyers and sellers and profit on the spread between the prices. Investors prefer to invest in securities that have a deep and liquid market and often look to the volume of shares traded in a day or a week as an indication of how deep the market is. Market-making firms could manipulate volume by simultaneously buying and selling the stock or colluding with others to do so.
Because information is the lifeblood of the investment banking industry, regulations govern what information is required and how that information is released. The information that is required is explained in Chapter 6. How information is released is an area that can be characterized as in flux due to the changing ways in which individuals communicate.
Before the adoption of Reg FD, companies often practiced selective disclosure — alerting professional analysts covering the company to developments prior to disseminating the information to the larger public. Oftentimes, these disclosures took place on quarterly conference calls between the company and firm analysts. Because information is the valuable commodity in the investment business, providing information to one group prior to more widespread dissemination was viewed as creating an unlevel playing field. Essentially, the firms receiving selective disclosure could front-run the other firms, trading first on that information.
Reg FD has taken an interesting turn in the era of social media. The case that really brought attention to this issue was that of Netflix CEO Reed Hastings, who posted on his Facebook page in July 2012 that Netflix monthly viewing hours had exceeded one billion for the first time. Netflix did not simultaneously release the information in the more standard press release or Form 8-K filing. Despite the Facebook page having over 200,000 followers, including analysts and reporters, the SEC originally charged Hastings with a violation of Reg FD. The SEC has subsequently changed its stance and said that companies can use social media to disseminate information if certain requirements are met. It doesn’t strain credulity to believe that many more people saw the Facebook posting than would have seen the standard disclosure. Welcome to the 21st century!
Securities laws continue to evolve, and investment bankers need to keep up. In 2010, President Obama signed into law the omnibus Dodd–Frank legislation. The law expanded to a mind-numbing 9,000-plus pages in length, affecting nearly every aspect of the financial markets. Studies have found that while the legislation has improved financial stability and consumer protection, the jury is still out on its influence on the global economy. And as the political winds change, many of the provisions of the original law are being debated and weakened.
For investment banks some of the most important provisions of the legislation include the following:
More intense scrutiny and reform of the credit-rating agencies: Credit-rating agencies such as Moody’s, Standard & Poor’s, and Fitch Ratings provide ratings on a variety of financial securities — from government bonds to corporate bonds and mortgage-backed securities. These ratings are meant to provide investors with a sense of the likelihood that an issuer will default on a particular security. Rating agencies played a central role in the financial crisis, as many securities — particularly mortgage-backed securities — that had been given very high or the highest credit quality ratings defaulted as homeowners defaulted on their residential mortgages. Investment banks are major users of the services of these rating agencies, because it’s much easier to sell highly rated securities to investors because the buyers believe them to be relatively safe. Investment banking firms are the lifeblood of these rating agencies, because investment banks pay the rating agencies to rate the securities.
There is an obvious conflict of interest with issuer-paid ratings — investment banks want high ratings for the securities they’re putting together, and rating agencies want the continued business of these investment banks. High ratings make both parties happy but can mislead investors who rely on these ratings as part of their investment decision-making process. The Dodd–Frank legislation provides for increased scrutiny of credit-rating agencies.
The game has changed dramatically for Wall Street analysts over the past 20 years. Many of the changes were brought about as the result of abuses triggered by conflicts of interest described in this section. The problems were exacerbated as the compensation of analysts soared and the financial rewards for bending and breaking the rules were astronomical.
Investors and potential investors look to security analysts to provide them with professional, unbiased opinions on the investment potential of a stock. After all, the analyst is assumed to have the knowledge and skills to investigate and form a recommendation — generally “buy,” “sell,” or “hold” — on a stock’s future potential. Many analysts are highly trained individuals who went to the top business schools and were taught various state-of-the-art valuation techniques. Professional certifications (such as the Chartered Financial Analyst [CFA] designation) train analysts on the ins and outs of analyzing companies, and these qualifications signal to investors that these individuals have the skill set to provide sound advice.
Given all this training, what could possibly go wrong? Why around the turn of the recent century did stock analysts earn reputations that rivaled used-car salesmen or elected officials? It all centered on behavior that resulted from conflicts of interest that were inherent in the role of analysts at investment banking firms and led to changes in regulation meant to curb abuses and mitigate these conflicts.
During the time of the Internet boom, many analysts — like Jack Grubman, Mary Meeker, and Henry Blodget — became media darlings and commanded multimillion-dollar annual compensation packages. A positive report on a company, or an upgrade of the company’s stock to a “buy” or a “strong buy” by one of these rock-star analysts, could result in significant increases in the price of that company’s stock. Although few and far between (more about that later), a negative report or the downgrade of a company’s stock to a “sell” recommendation or even from a “sell” to a “hold” could result in the price plunging as investors sell their holdings.
Stock analysts are employed by investment banking firms that do more than simply issue buy, sell, and hold recommendations on individual stocks to investors. Investment banking firms are paid to bring companies public by underwriting IPOs. These firms advise corporate client firms on strategies to increase firm value such as during mergers and acquisitions or in leveraged buyouts.
Without clients, investment banking firms wouldn’t exist. Like any company in any industry, the lifeblood of an investment banking firm are clients or customers. Customers want to be happy and investment banking firms want them to be happy. What makes investment banking customers really happy is when their company stock price increases. Stock prices generally don’t rise when analysts issue negative or neutral recommendations on stocks. Perhaps that explains why analysts are overwhelmingly bullish, and the ratio of buy to sell recommendations by Wall Street firms is typically in the area of 10-to-1. By the way, this isn’t an issue that is isolated to U.S. markets. In the Chinese and Korean markets, buy-sell recommendation ratios can approach 20-to-1. In fact, rather than issue a negative recommendation, it’s common for some investment banking firms to simply drop coverage of a firm.
Corporate firms want a relationship with an investment banking firm that will continue to increase demand for the company’s stock even well after the IPO. Corporations are less likely to maintain a relationship with an investment banking firm that doesn’t provide favorable coverage on its stock. Thus, there is pressure on analysts to issue favorable recommendations on the firms with which they have investment banking relationships. Perhaps this explains why, for instance, Henry Blodget allegedly referred to Internet search company InfoSpace as a “piece of junk” and a “powder keg” in internal e-mails, while simultaneously recommending the stock to investors.
As we note earlier, a change in analyst recommendation — particularly from a prominent analyst — from a “hold” to a “buy” or from a “buy” to a “hold,” for instance, can lead to dramatic stock price changes following the release of the recommendation. A pending recommendation change is valuable information that is coveted by market participants. Investment banking firms have large clients who would benefit from advance notice of any recommendation changes. Suffice it to say, the investment banking side of the business is very interested in developments from analysts.
If the conflict of interests outlined here weren’t enough, there may be other incentives that have driven analysts to make certain recommendations on stocks that are not driven by the fundamentals of the company. In a widely reported scandal, Salomon Smith Barney telecommunications analyst Jack Grubman raised his rating on AT&T from a “neutral” to a “buy” rating in 1999. Grubman later admitted in an internal e-mail that his decision was motivated, at least in part, by a desire to get his children placed in an exclusive NYC preschool program. Conflicts, it seems, like ice cream, come in a variety of flavors.
The result of the conflicts outlined earlier and the belief that analysts don’t always operate independently but can be influenced by factors other than the desire to make an objective determination of an investment’s prospects, resulted in a call for increased regulation of the analyst profession. Former Supreme Court Justice Louis Brandeis once said, “Sunlight is said to be the best of disinfectants; electric light the most effective policeman.” In the spirit of Brandeis, a series of regulatory changes — including both disclosure of conflicts of interests and prohibitions of actions — has transformed the analyst profession.
As an indication of the seriousness of the problem, in April 2003, ten of the largest investment banks agreed to pay a pretty steep price — $1.4 billion in total — and were forced to abide by a series of regulations governing their behavior.
There is recognition by the regulatory authorities and the industry that while not all these conflicts of interest can be completely eliminated via stricter regulations, they need to be properly disclosed. The following represents a synopsis of the major changes to regulations and required disclosures governing analysts:
If all these rules are in place, why do crooks like Bernie Madoff and others get away with bilking millions and billions of dollars from investors? How does such a highly regulated industry have systemic problems such as those exemplified by the concept of “too big to fail”? Besides having the proper laws on the books, two elements are necessary to achieve successful regulation of the financial markets:
The best and the brightest in the field — including master’s and PhD graduates from the top business schools — work for investment banking firms and hedge funds and command multimillion-dollar pay packages. The average SEC employee, not trained in finance but in the law, makes a fraction of that. As an aside, there is a revolving door at the SEC between the agency and the industry that it regulates. Specifically, many SEC employees leave the agency and are hired by investment banking firms who pay them multiples of their SEC salaries to help them navigate the regulatory landscape.
In 2020, the SEC budget was $1.75 billion, which sounds like a lot of money until you realize that it’s responsible for ensuring the proper functioning of U.S. financial markets worth at least $97 trillion. To put this in perspective, the SEC budget is equal to approximately $1 for every $55,429 that it is charged with protecting. Another way to look at the size of the SEC budget in relation to the financial markets is that, in 2018, the combined one-year earnings of three individuals — Ray Dalio of Bridgewater Associates, Ken Griffin of Citadel, and James Simons of Renaissance Technologies — were more than double the entire SEC budget. And 2018 wasn’t even a good year in the financial markets! Suffice it to say, the investing public can’t expect a filet-mignon regulator on a macaroni-and-cheese budget.