Investors have always been perplexed by the fact that while the ace analyst of a reputed broking house publicly recommends the buy of a stock, the broking house does not act on the advice. On the contrary it does the reverse and dumps the stock.
There are at least two occasions where we have seen this happen.
One explanation for this peculiar state of affairs is that there is a “Chinese wall” between the research wing and the proprietary trading wing of the broking house. The trading wing is not aware of, or is not in agreement with, the public advice offered by the research wing.
The other explanation is that the whole scheme is carefully orchestrated to get the public interested in the stock and to get the price to move upwards, while giving the broking house and its chosen clients an opportunity to exit at higher prices.
The surprising part is that this nefarious practice is not limited to fly-by-night research houses. Instead, even highly reputed research houses like Deutsche Bank, Merrilyn Lynch and others are party to it.
MarketWatch has referred to a few high profile cases in its latest article “The SEC says analyst secretly told hedge funds ‘sell’ while officially saying ‘buy’”.
In the first case, Charles P. Grom, the former Managing Director and senior equity research analyst at Deutsche Bank Securities, issued a research report on Big Lots, Inc, a retail company, in which he recommended a buy of the stock. However, Grom privately advised a few hedge funds, which were his firm’s clients, that Grom had a bleak outlook and that they should sell the stock.
SEC’s order sets out in graphic detail how Grom was on the phone, or otherwise in contact, with the hedge funds, and minutely advised them to dump the stock even though he knew that the public would be thronging to buy the stock, based on his public recommendation.
It is evident from the details in the SEC’s order that the hedge funds profited to the extent of several millions as a result of the devious practice.
The second case cited by Marketwatch is that of Henry Blodget, a managing director at Merrill Lynch. Blodget’s alleged modus operandi was to issue “fraudulent research under Merrill Lynch’s name, as well as research in which he expressed views that were inconsistent with privately expressed negative views”. Blodget is also alleged to have prepared reports “that were not based on principles of fair dealing and good faith and did not provide a sound basis for evaluating facts regarding those companies, contained exaggerated or unwarranted claims about those companies, and/or contained opinions for which there was no reasonable basis.”
The third case is that of Jack Benjamin Grubman, the former managing director of Salomon Smith Barney. Jack Grubman was “the hottest telecom analyst on Wall Street” in the 1990s.
SEC’s charge sheet describes Grubman as “the linchpin for SSB’s investment banking efforts in the telecom sector” and calls him “the preeminent telecom analyst in the industry”. It also points out that telecom was of critical importance to SSB and that it earned earned more than $790 million in investment banking revenue during the relevant period from telecom companies Grubman covered. Grubman was one of the most highly paid research analysts at SSB and on Wall Street and his total compensation exceeded $67.5 million, including his multi-million dollar severance package.
SEC alleges that Grubman “published fraudulent research reports” on certain telecom companies which were “contrary to the true views Grubman and another analyst on his team privately expressed, presented an optimistic picture that overlooked and minimized the risk of investing in these companies, predicted substantial growth in the companies’ revenues and earnings without a reasonable basis, did not disclose material facts about these companies, and contained material misstatements about the companies.”
In an interview to CNBC, Grubman defended himself on the basis that “Lightning doesn’t strike the short trees”, implying that he was targeted by the SEC because he was a high profile analyst.
Grubman also admitted that there is a “co-mingling” between the analysts and all the stakeholders with a view to “maximize the profitability” and that the research reports are not really “independent”. He said:
“Unfortunately, part of what was going on then was you had a commingling in the investment banks between research, banking, sales, trading” … “Everybody was working for the same enterprise, trying to maximize the profitability.”
He added “I don’t know if anything was right or wrong … It was just what it was at the time.”
The worrying part is that Jack Grubman emphasized that “Wall Street has changed in form but not in substance” implying that the same nefarious tactics are continuing even today, albeit in a more refined manner which makes detection by the regulators more difficult.
The more worrying aspect is that if this can happen so frequently in a sophisticated and highly regulated market like the USA where the SEC has strict control, imagine the level of pump n’ dump in a scenario like ours where unscrupulous market men rule the roost and call the shots and where SEBI is no better than a toothless tiger.
Now, the million dollar question is where does this sorry state of affairs leave novice investors like you and me, who treat research reports like the gospel truth and invest our hard-earned savings in the recommended stocks?