Conflicts of interest raise ethical dilemmas for those engaged in the financial service business by generating incentives for financial service firms or their employees to conceal or provide misleading information, thereby hurting the customers for whom they work. The growing economies of scope in the financial industry that have led financial

institutions to offer more services under one roof have increased conflicts of interest and, not surprisingly, led to more unethical behavior. One way to limit unethical behavior is to make those working in the financial industry aware of the ethical issues that arise when they exploit conflicts of interest; with this awareness, employees are less likely to engage in unethical behavior. To address this need to limit unethical behavior, business schools are now bringing the discussion of ethics into the classroom and firms are establishing policies (discussed later in this chapter) that make it harder for individuals to exploit conflicts of interest.


Four areas of financial service activities harbor the greatest potential for generating conflicts of interest that ultimately reduce the amount of information available in financial markets:

• Underwriting and research in investment banking

• Auditing and consulting in accounting firms

•Credit assessment and consulting in credit-rating agencies

• Universal banking

Und rewriting and Research in Investment Banking

Investment banks perform two tasks: They research corporations issuing securities, and they underwrite these securities by selling them to the public on behalf of the issuing corporation. Investment banks often combine research and underwriting because the information synergies created may lead to economies of scope. In other words, information that is produced for one task is also useful for another task. A conflict of interest arises between research and underwriting because the investment bank attempts to serve the needs of two client groups—the firms for which it is issuing the securities and the investors to whom it sells these securities.

These client groups have different information needs: Issuers benefit from optimistic research, whereas investors desire unbiased research. Due to economies of scope, however, both groups will receive the same information. When the potential revenues from underwriting greatly exceed brokerage commissions, the investment bank has a strong incentive to alter the information provided to both types of clients so as to favor the issuing firms' needs. If the information provided is not favorable to the issuing firm, it might take its business to a competitor that is willing to put out more positive information and thereby entice more people to buy the newly issued stock. For example, an internal Morgan Stanley memo excerpted in the Wall Street Journal on July 14, 1992, stated: "Our objective . . . is to adopt a policy, fully understood by the entire firm, including the Research Department, that we do not make negative or controversial comments about our clients as a matter of sound business practice."

Because of directives like this one, analysts in investment banks might be persuaded to distort their research to please the underwriting department of their bank and the corporations issuing the securities. Of course, such actions undermine the reliability of the information that investors use to make their financial decisions and, as a result, diminish the efficiency of securities markets. A similar chain of events precipitated the tech boom of the 1990s (see the Conflicts of Interest box, "The King, Queen, and Jack of the Internet").

Conflicts of Interest. The King, Queen, and Jack of the Internet

The King, Queen, and Jack of the Internet are the nicknames of a trio of bullish technology analysts who were very influential during the tech boom of the late 1990s: Henry Blodgett at Merrill Lynch, Jack Grub-man at Salomon Smith Barney (Citigroup), and Mary Meeker at Morgan Stanley. Their stories reveal a lot about how conflicts of interest may have influenced analysts' recommendations during this heady period. In late 1998, Henry Blodgett, then at Oppenheimer and Company, recommended a price target of $400 per share for At the time, most analysts believed that was overvalued at $240 per share. In particular, Jonathan Cole of Merrill Lynch indicated that $50 was a more reasonable price. When the price of stock rose above $400 per share, Blodgett was hailed as a guru and hired by Merrill Lynch, while Cole left the firm. Clearly, Blodgett saw that he could reap benefits by hyping tech stocks. A subsequent investigation by the New York Attorney General's office found that Blodgett issued very positive reports on certain Internet stocks while privately deriding them in e-mails. Blodgett was accused of issuing favorable research reports for Info Space because he knew that it was planning to buy Go2Net, one of Merrill Lynch's clients. Similarly, Blodgett was alleged to have maintained a positive recommendation for, even though it was not doing well, at a time when Merrill Lynch was competing to manage a new stock issue for the company. He downgraded's rating only after it chose Credit Suisse First Boston as its underwriter instead.

The New York Attorney General's office accused Jack Grubman of engaging in similarly questionable behavior. Although he expressed doubts in private, Grubman made wildly bullish recommendations about several telecom companies—including WorldCom, Global Crossing, and Winstar Communications—that were spiraling toward bankruptcy. In 1999, he upgraded his rating of AT&T when Salomon Smith Barney was competing for a new issue of AT&T's spin-off of its cellular division. Six months after his firm, along with Goldman Sachs and Merrill Lynch, was awarded AT&T's business, Grubman downgraded AT&T's rating.

Blodgett and Grubman have faced criminal charges for their actions, whereas Mary Meeker has not. Like Blodgett and Grubman, Mary Meeker kept her ratings of tech stocks high after their prices plummeted. However, unlike Blodgett and Grubman, there was no evidence that Meeker did not believe her ratings, and she did discourage many Internet issues when the companies had poor outlooks. Morgan Stanley argued on her behalf that "research analysts helped screen out IPO candidates such that Morgan Stanley rejected five Internet IPOs for every one the firm underwrote. Mary Meeker was an integral part of this screening process, which benefited the firm's investor clients." Despite the New York Attorney General's office's criticisms of some of Morgan Stanley practices, Mary Meeker was not subjected to criminal charges because she did provide some screening and no exploitation of conflicts of interest was evident.

Another practice that exploits conflicts of interest is spinning. Spinning occurs when investment banks allocate hot, but underpriced, initial public offerings (IPOs), shares of newly issued stock, to executives of other companies that may potentially have business with the investment bank (see the Conflicts of Interest box, "Frank Quattrone and Spinning"). Because hot IPOs typically rise immediately in price after they are first purchased by investors, spinning is a form of kickback to other firms' executives, luring them to use that investment bank. When the executive's company plans to issue its own securities, he or she will be more likely to use as an underwriter the investment

Conflicts of Interest. Frank Quattrone and Spinning

Frank Quattrone of Credit Suisse First Boston was a highly regarded investment banker specializing in technology companies. But his reputation took a big hit in March 2003, when the National Association of Securities Dealers (NASD) filed a complaint against him for improperly pressuring his analysts to provide favorable coverage in an effort to solicit customers for his firm. Allegedly, Quattrone linked his analysts' bonuses to their investment banking work and permitted executives of companies whose stock he handled to make changes in his staff's draft research reports.

NASD also accused Quattrone of spinning because he maintained more than 300 "Friends of Frank" accounts for executives of technology companies that were active or prospective clients of the bank. These "friends" were allocated hot shares at his discretion.

Spinning was not isolated to Quattrone's firm; it was actually quite common on Wall Street. Salomon Smith Barney also allocated hard-to-get IPO shares to a number of executives, including Bernard Ebbers of WorldCom, Philip Anshutz and Joe Nacchio of Qwest, Stephen Garfalo of Metromedia, and Clark McLeod of McLeodUSA. The bank claimed that it issued shares to these executives because they were among the firm's best individual customers and not because it wanted to persuade these executives to channel their companies' investment banking business to Salomon Smith Barney. This claim was deemed dubious, at best. Quattrone was convicted in 2004 (but later overturned) of obstructing the investigation into his activities and was sentenced to eighteen months in prison.

bank that gave the executive the hot IPO shares, which is not necessarily the investment bank that could get the highest price for the firm's securities This action may raise the cost of capital for the firm, and therefore hinder the efficiency of the capital market.

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