Investors have long depended on Wall Street's research analysts for independent analysis of company performance. But recent disclosures of conflicts of interest have tarnished these pros' reputation. In particularly damaging testimony before Congress in July, acting Securities & Exchange Commission Chairwoman Laura S. Unger said her staff had examined nine major brokerage houses and found that all of them had questionable practices, such as analysts assisting investment bankers in marketing efforts. "It is," wrote one commentator, "a little like letting Dan Rather or Tom Brokaw do a commercial in the middle of the national news."
That analysis appeared in an article written by John C. Coffee Jr. in the New York Law Journal. Coffee is the Adolf A. Berle professor of law at Columbia Law School and a visiting professor this year at Harvard Law School. He's an expert in corporate and securities law, as well as white-collar crime. And while he's a close observer of the securities industry, Coffee is also an expert on conflicts of interest in other professions.
Recently, BusinessWeek Online writer Pamela Mendels spoke with Coffee about workplace conflict of interest -- what it is, where it can be found, and how it can be avoided. Following are edited excerpts of that conversation:
Q: What is a conflict of interest in business?
A: Essentially, the law says that there are times when you owe a duty of loyalty to your employer, and you should not accept other kinds of interests or payments that could give you a reason to act contrary to the best interest of your employer or the person to whom you owe a duty.
Q: Are modern business practices giving rise to new types of conflicts?
A: I think we're seeing new conflicts arising today. A publicly held
corporation usually has several intermediaries between it and the public. It has lawyers, investment bankers, securities analysts, and most of all, accountants or auditors.
All of those people are in separate firms, and their role has historically been that of watchdogs who have their own reputations pledged to make sure that shareholders are informed both as to accurate results of the company's financial history and a fair evaluation of the company's future prospects. That's what a securities analyst does.
Q: So where do the conflicts arise?
A: I think more recently, we've seen that these outside gatekeepers are
getting increasingly enmeshed in a web of relationships [with each other]. For example, the SEC was very concerned last year, and continues to be concerned, that accounting firms no longer are serving simply as auditors for the company but also as consultants -- consultants on electronic data processing, e-business, or simply as management consultants.
Those consulting relationships often produce fees that dwarf the payments that the accountants receive for serving as auditors. In that world, there's an economic interest to subordinate your responsibility as an auditor to receive lucrative fees as a consultant. That could cause the auditors to be less loyal to the shareholders because they have a greater interest in attempting to receive consulting fees from the firm.
That's an example of the outside watchdog which, because of a variety of increasingly complicated relationships, is no longer a simple watchdog.
Q: You've written about the conflicts facing Wall Street research analysts. You seem to be more concerned about the pressure -- whether it's direct or indirect -- being put upon them by having a relationship with their investment-banking department. Can you assess that?
A: Traditionally, the securities analyst was a watchdog for shareholders and investors, and was compensated by the users of their reports. Institutional investors, for example, would direct brokerage business to the firm that employed the analyst if they thought they received a useful or insightful report by that analyst. So you were paid by the people who used your services. Today that has shifted. Because the market for brokerage commissions has been so competitive, it has eroded away those commissions, and they don't really pay for the analysts' services anymore.
Instead, an analyst tends to be compensated based on the fees that the underwriting operation of his employer receives for securing an IPO client or sometimes for doing very lucrative merger-and-acquisition deals. In other words, the analyst is now being paid based on transactions -- and by the fees that those transactions generate. That makes the analyst much more interested in pleasing the person paying those transaction fees, namely the issuer, as opposed to the long-term user of his services, the investor.
Q: What's the solution to that?
A: One is greater disclosure. I don't believe that it's simple to purge this industry of its conflicts of interest, which are inevitable and recurring as death and taxes. Independent analysts are analysts for whom there's no business relationship between their employer and the firm [on which the analyst is passing judgment].
For example, in any public offering, some firms will serve as underwriters, and other firms are not participating in the underwriting syndicate. Analysts employed by those nonparticipating firms can be much more objective and much more willing to point out the potential flaws. Even those analysts may have a conflict to the extent they hope to get future underwriting business or other consulting business. But the possibilities of their being biased are far less.
I think the public has to be educated to look to the views of independent analysts and to be very skeptical of analysts who are essentially being compensated by the issuer.
Q: How have corporate mergers and the emergence of megacorporations introduced the possibility of more conflict of interest in business?
A: Obviously, mergers produce fees for investment-banking firms. And those are the source of revenues out of which analysts are increasingly compensated. One is not being cynical to note that whoever pays the piper is likely to get the attention of the piper.
So to the extent that underwriting firms are heavily dependent on IPOs and merger-and-acquisition business, that's the revenue out of which they are paying analysts. Analysts are important to these firms as a way of securing clients.
Q: How about conflicts of interest within huge corporations?
A: Corporations have always had the problem of conflicts of interest. For that reason, they often have policies requiring complete disclosure from employees as to whether they have any financial interest in transactions the company is about to engage in. If the company was buying land, it would like to know that some officer with responsibility for that transaction owns interest in the land. Generally, that's the kind of oversight the audit committee exercises.
Q: Do you see any evidence that executives are becoming more aware of the possibility for conflicts of interest within their business?
A: I don't know that recent developments have changed the position of corporate executives. They're probably much more conscious today of stock options and the impact of the share price upon their stock options. That can give them a reason for trying to delay the release of adverse information until they have first exercised and sold any stock they have under option. But I'm not aware that there has been a major change in the behavior of executives. I think the new impact has been on people who are the agents of the corporation -- law firms representing corporations, investment-banking firms, securities analysts, and auditors.
Lawyers, for example, over the past couple of years have been increasingly paid in the stock of the corporate client. That can change the amount of distance and objectivity the law firm has, if it has several million dollars worth of the corporation's stock in its investment portfolio. Now this year, of course, as the stock market has fallen, law firms are a little bit less interested in receiving stock as compensation for their services.
Q: Is there a rule of thumb for the manager or executive who wants to avoid a conflict of interest? Is there a smell test?
A: Any employee should not look to a simple rule of thumb. If you have a personal financial interest or if your family has a personal financial interest in a transaction with a corporation, I think you have a very clear obligation to disclose that to the people who are negotiating the transaction for the corporation.