At first glance, New York Attorney General Eliot Spitzer's main target with his latest civil suit on Sept. 30 appears to be the five telecom executives named in the filing. After all, the defendants -- former WorldCom CEO Bernard J. Ebbers, ex-McLeod USA CEO Clark E. McLeod, former Quest Communications Chairman Philip F. Anschutz, Metromedia Fiber Networks founder Stephen A. Garofalo, and ex-Qwest CEO Joseph P. Nacchio -- are being called upon to "disgorge," or give back, some $28 million in profits from selling shares in initial public offerings and some $1.5 billion in profits from sales of their own stock.
Look closer, however, and the focus shifts to another entity -- Salomon Smith Barney, Citigroup's investment-banking unit. The 29-page suit provides damning detail about its research department, which over a four-year period went from investor-friendly to investment-banker-friendly in pursuit of profits. The suit paints a picture of intense pressure on the firm's analysts -- including Jack Grubman, the telecom rainmaker -- to bring in business as soon as Salomon's merger with Smith Barney went through. As the pressure rose, even those inside the bank started to balk, wondering if what they had created was legal, ethical, or moral.
Travelers Group merged with Citibank in 1997, bringing its newly formed Salomon Smith Barney unit in touch with Citi's commercial bankers and its private-banking clients. A year of strife followed, as the merged divisions battled over clients and wrestled with compensation issues, while heads rolled in the executive suite. Salomon's notoriously aggressive bankers struggled to get along with Smith Barney's much more retail-focused, small-town brokers.
"A KEY ELEMENT." By late 1998, however, Citigroup's business model was ascendant. A big part of that, the Spitzer suit posits, was driven by the changing nature of research. In January, 1998, SSB's head of equity research, John Hoffman, said in a presentation to Travelers executives, "there is a continuing shift in the realization that the analyst is a key element to investment-banking success."
The hunt was on. From 1999 to 2001, analysts were encouraged to get feedback from their investment-banking counterparts and develop a list of potential clients. Once the investment banker obtained the lead underwriting position on a deal, the analyst had to take "ownership" of the relationship and sell the deal to institutional buyers. The company also developed a list of "Platinum Accounts" -- private-banking clients who were also company heads and therefore should be cultivated for corporate banking business.
Nowhere was this model pushed harder than in the telecom industry, where Grubman, a former AT&T employee, became both counsel and supporter for many of the companies that the new Citigroup advised. Citi dominated the sector, raising a total of $190 billion in equity and bonds for telecom companies. Grubman alone claimed he brought in $166 million in investment-banking revenues in 2001.
HANDSOME REWARDS. In his 2000 performance review, SSB's Hoffman patted himself on the back, saying "we have become much more closely linked to investment banking this year, as a result of participating in their much-improved franchise review process." He added: "There has been a year-end cross review of senior analysts and bankers particularly in the U.S. and Europe, and with the development of the Platinum Program in the investment bank, the analyst's understanding of the relative importance of clients for investment banking and global relationship banking is much improved."
Along the way, analysts were rewarded handsomely for their work. According to the Spitzer suit, at a January, 2000, "Best Practices Seminar," research management head Jeffrey Waters told analysts that if SSB could grab more market share from competitors, there is "roughly a billion dollars of investment banking revenue on the table for this firm...and we'll all benefit from it."
As early as 1997, Smith Barney analysts were paid $11 million in "helpers fees" for working on investment-banking transactions. In 1999, Hoffman reiterated his belief in the system, saying that it "makes the analysts more responsive to the investment bank." Following his recommendation, SSB generated scorecards for analyst performance that included the amount of fees they had generated and the investment bankers' evaluation of the analyst who covered their sector. Grubman earned $25 million in 2000 and 2001.
LOSING FAITH. No doubt, the business model was lucrative. Citigroup's Global Corporate & Investment Bank group brought in nearly 40% of the bank's profits in 1999 and 2000. Revenues for the unit rose $5 billion per year from 1998 to 2000.
However, once the markets started to sag, cracks appeared in the system. Smith Barney's retail brokers, who had been using the company's pumped-up advice to sell stocks to long-time clients, were losing customers -- and losing faith in their employer, according to Spitzer's suit. "Jack Grubman...sold us a bill of goods on WCOM [WorldCom]...and now we're bleeding red in our clients accounts," complained one broker. "How about sharing some of [Grubman's] $25MM salary with our clients who bought into his glorified stories?" Added another: "In my 16 years in the brokerage business, NEVER have I received such misguided, horrific recommendations from an analyst."
Even Hoffman -- one of the biggest proponents of the analyst-linked system -- started to realize it was a problem. In late 2000, he wrote in a memo to SSB CEO Michael Carpenter: "There is legitimate concern about the objectivity of our analysts that we must allay in 2001." One month later, Hoffman made a presentation to Citigroup's senior management, revealing that out of 1,179 stock ratings, there were zero sells and one underperform. Message: Our ratings look askew. Right around the same time, Jay Mandelbaum, the global head of SSB's retail stock-selling division, told Hoffman that the firm's research was "basically worthless," Spitzer's suit says.
"GOING TO ZERO." Grubman himself was starting to balk under the pressure. In February, 2001, the exalted telecom guru issued a research note on Focal reiterating a buy but noting some concerns. When bankers told Grubman that Focal's executives complained, he e-mailed the bankers: "If I so much as hear one more f-ing peep out of them, we will put the proper rating in this stock.... We lost credibility on MCLD [McLeod USA, an Iowa-based telecom provider] and XO [bankrupt telecom XO Communications] because we support pigs like Focal." In an e-mail with his 2001 performance review, Grubman wrote, "Most of our banking clients are going to zero and you know I wanted to downgrade them months ago, but got huge pushback from banking."
No one, of course, is going to feel sorry for Grubman, who took home a $30 million severance package when he left SSB in August as scrutiny of his stock recommendations rose. But in the end, even he, the poster child for the conflicted, overpaid analyst, had stared to rethink the model that Citigroup had built. Citigroup declined to comment on the suit for this story but said in a statement: "We are moving aggressively to resolve questions about past practices and to institute far-reaching reforms. We are committed to being a leader in raising the standards of our industry."
By providing details about how conflicts arose and were ignored at Salomon Smith Barney, Spitzer is challenging Citigroup CEO Sandford I. Weill to come up with a swift and dramatic resolution. By Heather Timmons in New York