Lock up the analysts and throw away the key

An investor who followed expert advice lost $100,000. He wants vengeance, but history suggests he's not likely to get it.

By Damien Cave
May 20, 2002 11:30PM (UTC)
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A couple moves to Hawaii and after a lifetime of work saves $400,000 for retirement. It's 1999, so they put their money in stocks and ask their son to take charge of the portfolio. He's only 22, having just graduated from Carnegie Mellon University, but he's a tech-savvy math wizard who's considering a career in finance. They figure he's got what it takes to make millions.

But things don't go according to plan. Using an account at Charles Schwab, the son -- let's call him Sunil -- follows analysts' recommendations. He buys 1,000 shares of the wireless high-flyer Qualcomm when it's at $150, trusting the advice of supposed experts like Merrill Lynch analyst Mike Ching, who declared in early 2000 that the stock's price-to-earnings ratio of 100 -- five times the historical market average -- "fairly values" Qualcomm's prospects.


Then the market deflates. But Sunil holds on to the stock even as he begins to notice news stories about how analyst "buy" orders seem to uncannily favor precisely those companies whom their employers wish to attract as investment banking customers. He can hardly believe what he's reading. By the time the SEC gets actively involved in early 2002, his Qualcomm stock is trading at about $30 a share. Sunil has lost $100,000. Now, two years after his first investment, he's convinced that Wall Street analysts deserve some of the blame for his losses. And he's calling out for their punishment.

"Is there anyone else out there as irate as me?" he asks, in a message posted in mid-May on Craig's List, a San Francisco community Web site. "Wall Street & venture capitalists can go to hell. A slap on the wrist ain't going to fix the problem."

Banning bad analysts from the industry -- the most common form of white-collar punishment -- isn't enough, he says in a phone interview, while asking to remain anonymous because he now works in the finance sector and fears for his job. Instead, analysts need to be held personally responsible. "The first thing they should do is return the money they earned to the people, the mom-and-pop investors," he says. "Then they should go to jail."


Sunil isn't the only investor boiling over with rage. Other victims of plunging stock prices are also calling for analysts to trade in their pinstripes for prison stripes. News reports generated by New York Attorney General Eliot Spitzer's release of damning e-mails from Merrill Lynch, which revealed how analysts boosted stocks in public while slamming them in private, have fanned the flames.

But will individual analysts take a fall? History suggests they won't. White-collar criminals almost never pay out of pocket or go to jail. The reasons go deeper than just the ability of analysts to hire the best lawyers. According to experts, American capitalism at the turn of the 20th century does a great job of encouraging entrepreneurship and risk taking but lacks an effective mechanism for punishing those who go too far. The two predominant legal responses -- the criminal prosecution and civil class-action suit -- continually fail to do the job.

Federal prosecutors, for example, rarely pursue finance-related cases, preferring to focus their resources on easier targets. Meanwhile, the civil system is dominated by class-action lawyers who fixate on obtaining the largest possible settlement, and not on pushing for the kind of personal accountability that might actually keep future criminals from committing similar crimes. As a result, bad behavior is rewarded: Executives, analysts and other Wall Street players who take part in fraudulent financial schemes usually get to keep their winnings. Not even Spitzer's surprisingly effective campaign against Merrill Lynch, critics argue, will be enough to buck historical trends.


"The long and the short of it is that no one will do time for this," says Ben Cole, the author of "The Pied Pipers of Wall Street: How Analysts Sell You Down the River." "Merrill will pay fines. The SEC will ban the direct payment to analysts of investment banking fees, while the indirect payment will stay in effect. Nothing will change."

Some white-collar criminals do go to jail. Charles Ponzi, master of the pyramid scheme, went to prison in 1920 for defrauding 40,000 people out of $15 million. Billy Sol Estes, a Texan who raised capital in the '60s by mortgaging nonexistent farm equipment, also spent time in the slammer, as did the king of junk bonds, Michael Milken.


But those men are exceptions. Study after study shows that white-collar criminals, particularly those who work on Wall Street, regularly receive kid-glove treatment. Jail time is extremely rare. According to TRAC, a crime database at Syracuse University, the SEC referred 609 cases to the Justice Department between 1992 and 2001. The U.S. attorneys declined to prosecute on all but 187 of the cases, and though they earned guilty verdicts in 142 of those, only 87 people spent time in jail.

And if they do go to jail, they don't get a chance to get comfortable. The financiers behind the '80s savings-and-loan scandal -- one of the costliest financial crimes of the century -- spent an average of 36.4 months behind bars. Milken, arguably the best known of the convicts, logged only 22 months in prison. Meanwhile, according to a study conducted by Henry Pontell, a criminologist at the University of California at Irvine, a burglar who steals $300 or less goes to jail for 55.6 months, and first-time drug offenders are locked up for an average of 64.9 months.

Sunil explains the disparity in treatment as a result of class background and access to power. Wall Street's alleged criminals "are at the highest realms of society," he says. "They went to Harvard or Stanford. They belong to country clubs. They're rich old white men who know how to work the system."


But its not just a matter of knowing how to maneuver through the system; the system itself encourages such behavior. According to legal experts and former regulators, the legal system has over the past 25 years shifted in favor of those who commit complex financial crimes. The deck is stacked in favor of future Ponzis.

Prosecutors, for example, are now required to prove intent before they can win a criminal conviction for financial crimes. In other words, they have to convince a jury that an analyst intentionally defrauded customers while knowing that he was committing a crime. This is an extremely high legal standard, and it's relatively new, says Michael Greenberger, a University of Maryland law professor and the former head of trading and markets at the Commodities Futures Trading Commission (CFTC).

"You used to be able to find fraud if there was recklessness [aggressive disregard for the law], but now they have to have knowledge of the fraud," he says. "Through a combination of Supreme Court decisions in the '80s and early '90s and the 1995 Private Securities Litigation Reform Act, you have to demonstrate that the analyst is not just an aider and abettor to the fraud but also a primary actor. It's a much higher standard."


Congress is also to blame, says James Cox, a securities law professor at Duke. Funding for enforcement is not adequate to the task.

"The SEC is managing a restricted budget in a multitrillion-dollar economy," Cox says. "It's very difficult for them to go to the mat in these cases."

Prosecuting white-collar crime also tends to require more work, notes U.C. Irvine's Pontell. Prosecutors must have a firm grasp not just of the law but also of high finance, and they must be willing to fight a well-heeled defendant who can drag out the case. So when a U.S. attorney can bust, say, three prostitution rings in the same time it takes to prosecute one person accused of insider trading, it shouldn't come as a surprise that many prosecutors decide not to bother with the latter.

"[They] only go after the biggest and best cases," Pontell says. "Why else would a prosecutor waste their scarce resources on something with an uncertain outcome? They have to show convictions."


Could high-watt public outrage alter this legal landscape? Don't hold your breath, Cox says. "It's highly unlikely that the [conflict of interest] cases will pique the interest of the U.S. attorney," he says. "It's possible that there will be a criminal investigation, but it looks like there will be some kind of restitution instead."

But even if the SEC or state attorneys general exact some kind of fine, the restitution probably won't come from the culprits. Henry Blodget, Merrill Lynch's biggest dot-com booster and a central subject of the Spitzer investigation, reportedly earned more than $10 million a year during the '90s Internet boom. But in all likelihood he'll get to keep most of his earnings.

"It's going to be very hard to go after Blodget," says law professor Cox. "It's like playing Old Maid, the card game, where you pass off the card you don't want. Here, the costs will be passed off to an insurance policy or the firm itself."

Spitzer's office insists that it's still considering a financial penalty that would be paid by analysts. "We have not ruled out criminal or civil penalties at this point," says Juanita Scarlett, a spokeswoman. "We are addressing the issue of a fine."


And some argue that if Spitzer actually fights for a fine, he has a good chance of winning. The e-mails could tip the scales; this is the best chance in years of hanging Wall Street crooks out to dry, says Greenberger, who served at the CFTC in the late '90s.

"Normally a case against an analyst or law firm is extremely hard to bring, but the facts that have been outlined here by these e-mails really put the plaintiff and the government in a much stronger position to go after them," he says. "The evidence is so dramatic. The analysts really have to defend themselves from the charge of being primary actors in the fraud."

To the skeptics who say it will never happen, Greenberger says, "Look what's happened so far. Eight weeks ago, everyone said they'd never get enough evidence to go after the analysts. But now they have it."

Still, the hurdles look overwhelming. The analysts and their firms can easily push the burden of responsibility back to investors like Sunil, who admits that he should have been smarter with his parents' money. Wall Street and its defenders are already trotting out this line of thinking.


"People need to understand the business of an investment bank," says Adam Pritchard, a research fellow at the Cato Institute and a law professor at the University of Michigan. "If Blodget knew enough about a particularly good company, why would he share it with you? The idea that the analyst is going to provide you with some inside scoop is something that you can believe only if you've been blinded by greed."

Not even Spitzer's office is dead set on criminal prosecution. "We're insisting that the company admit wrongdoing, and that would open up the door for civil actions," says Scarlett, when pressed about Spitzer's strategy. "It's been our experience that the best way to get restitution is through these private class-action lawsuits."

But class-action lawyers aren't interested in going after individuals. They have their sights set on bigger game: huge cash settlements from the deepest pockets they can find.

Their motivation is understandable, another product of how the system is wired. Class-action lawyers front the cost of litigation and earn back up to a third of whatever is gained. Thus they have no incentive to get the money from the officers, who may have hidden their assets in offshore accounts or spent the money they earned illegally. They want the corporation as a whole to pay the price.

To many, this makes little sense: "The real problem with class actions is that they sanction the wrong entity," Pritchard says. "They sanction the corporation, not the people in charge."

Settlements also tend to please judges, who want to clear their dockets, and defendants, who prefer to hold their assets while hiding behind the corporate veil.

"There's a famous quote from a federal district court judge that sums up the conventional wisdom," says Cox: "A bad settlement is much better than a good trial."

And why not, say class-action lawyers. Settlements benefit investors. "The reality is that you're charged with recovering money," says Darren Robbins, a partner at Milberg Weiss, the nation's largest class-action firm. "You're not charged with putting people in jail. You have a job to recover damages."

But the so-called deep-pockets theory of justice has proved costly in at least one critical domain: deterrence. Experts argue that those who defend the system of class-action settlements are essentially encouraging fraud. When only corporations pay, often with large insurance policies, there's no incentive to obey the law, says Cole, the "Pied Pipers" author.

"The more you make it look like a cost of business, the more it just appears in an insurance policy," he says.

This is how the present system works. These days, "the crooks have a good idea that they have a high likelihood of getting away with fraud," Pontell says. And so the crimes continue.

"If we decided to go after the people, they would have a much larger incentive not to cheat," Pritchard says.

And if the analysts and their ilk continue to get off scot-free, investors will remain angry and skittish.

Ultimately, Sunil says, "something has to happen. This can't go on."

Damien Cave

Damien Cave is an associate editor at Rolling Stone and a contributing writer at Salon.

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