The New York Times

December 27, 2002

Settling for Less

By LUCIAN BEBCHUK


CAMBRIDGE, Mass.
One week ago regulators and the nation's top investment firms announced what they described as a historic settlement. To settle government claims that they misled investors, the country's 10 largest securities firms will pay $1.4 billion and will make certain changes in how they operate. Industry regulators said the settlement represents "the dawn of a new day on Wall Street" and is a "vital step in restoring investor confidence."

It might be more accurate to regard the settlement, announced by federal, state and industry regulators, as a slap on the wrist. By any standard measure its punitive value, its deterrence effect or the extent to which it will bring about structural change on Wall Street the settlement is rather modest.

One goal of regulatory action is to provide deterrence by imposing costs for past misdeeds. For deterrence to be effective, players must anticipate penalties that would exceed any gains they would make from the misbehavior. While more than $1.4 billion in fines and future payments is hardly trivial, it is not large given what is at stake and the potential gains to the firms from this type of misconduct.

Consider Citigroup, on which much of the recent investigation has focused. Jack Grubman, its star analyst, is alleged to have painted an excessively rosy picture of telecommunications firms in order to help Citigroup get underwriting business. The total cost of the settlement to Citigroup will be $400 million. Is this price steep enough to discourage thoughts of similar misdeeds in the future? Hardly.

According to a complaint filed by New York Attorney General Eliot Spitzer against five telecom executives who received shares in companies brought public by Citigroup's investment banking unit, the unit has underwritten $190 billion in the telecom sector alone since 1996, pocketing hundreds of millions in underwriting fees. Moreover, according to its 2001 annual report Citigroup made $4 billion from underwriting fees in 2000 and 2001 10 times the cost of its part of the settlement.

Aside from monetary penalties, another way to discourage corporate misconduct is the threat of criminal sanctions for corporate executives. Thus far, however, regulators have not announced any plans to indict any of the individuals involved in the scandals over analysts' research and banks' conflicts of interest.

Perhaps the value of the settlement lies in neither its punitive effect nor its deterrence value but in the structural changes it will bring to Wall Street. The terms of the settlement require the firms to sever direct ties between their research divisions and their investment banking businesses. By preventing analysts from accompanying investment bankers when they make sales calls, for example, and by prohibiting any linking of analysts' compensation to the investment banking business they bring in, the settlement tries to ensure that analysts will render objective investment advice.

But even without such direct links, analysts will still be influenced by how their actions affect their firm's other profit centers, like investment banking. The settlement does not permit the fate of analysts to be directly determined by the investment banking unit. But the success and compensation of analysts will continue to depend on the management and decisions of the firm's top executives, for whom investment banking fees remain an important source of profits.

There is strong empirical evidence that analysts tend to issue more favorable reports about companies with which their firms have an underwriting relationship. There is little reason to expect that the settlement will eliminate this pattern.

Analysts have substantial discretion in choosing which recommendation to issue. We might expect their recommendation to be influenced if, for example, their firm brought public the company they are covering. And we might expect the head of the research department to try to please the firm's executives with a department that makes "buy" recommendations rather than "sell" recommendations for the companies the firm underwrites.

In fairness to the regulators, they had to take into account other considerations in fashioning the settlement. Tougher action on the nation's top investment firms could have dealt a terrible blow to important institutions at a difficult time for the capital markets. It is also true that the reputational costs and public embarrassment caused by the scandals, coupled with the private suits many investors are bringing, will provide some measure of deterrence. And perhaps there are no realistic structural reforms that would work better than the moderate ones adopted.

Still, the settlement is better characterized as "business as usual" than as "the dawn of a new day." We should not exaggerate the extent to which the settlement will restore investor confidence.

Lucian Bebchuk is a professor at Harvard Law School and a research associate of the National Bureau of Economic Research.


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