Centre for Economic Policy Research

Street Journal (14 July 1992, quoted in Michaely and Womack, 1999, p. 654) report-
ed an internal Morgan Stanley memo: ‘Our objective…is to adopt a policy, fully
understood by the entire firm, including the Research Department, that we do not
make negative or controversial comments about our clients as a matter of sound
business practice’. While the conflicts may have existed before, there is a general
belief among observers that during the stock market boom of the late 1990s,
research departments were co-opted and induced to provide overoptimistic
reports.
11
The scandals emerging from the collapse of stock market give the
impression that conflicts appeared at most major investment banks.
A trio of bullish technology analysts who gained enormous investor followings
– Henry Blodget at Merrill Lynch, Mary Meeker at Morgan Stanley and Jack
Grubman at Salomon Smith Barney (Citigroup) – were dubbed the King, Queen,

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and Jack of the internet. Although they all came under scrutiny, only Blodget and
Grubman currently face charges. Differences in how they operated and the 
environment of their banks reveal a considerable divergence in how potential
conflicts were and were not exploited.
The New York Attorney General’s investigation found that Blodget often issued
very positive reports on internet stocks, while he privately derided them in emails
(New York Times, 22 November 2002, p. C1). It is alleged that he issued bullish
research reports for InfoSpace, even though its price had fallen to a tenth of its
peak, because the firm was planning to buy Go2Net which was one of Merrill
Lynch’s investment bank clients. In spite of continuing complaints from brokers
with unhappy clients, Blodget only downgraded InfoSpace after it had completed
its purchase of Go2Net. Similarly, while Merrill Lynch was seeking to manage a
new stock issue for GoTo.com, Blodget maintained a positive recommendation for
this troubled company, only to immediately downgrade it when the firm chose
Credit Suisse First Boston (Cassidy, 2003). 
Grubman’s behaviour at Salomon Smith Barney appears to have been similar to
Blodget’s at Merrill Lynch. Spitzer accused Grubman of being wildly bullish on
telecom companies, including WorldCom Inc., Global Crossing Ltd and Winstar
Communications, even when these now bankrupt companies began to get into
serious trouble and he dismissed them in private (Wall Street Journal, 3 September
2002, p. C1). In 1999, Grubman upgraded his rating on the stock of AT&T, a 
surprising move given that he had criticized the company for years. At the time,
AT&T was planning to spin off its cellular division in a huge stock offering.
Salomon Smith Barney was competing for this new issue, and its chances of 
winning AT&T business would have been poor if its analysts offered negative
assessments. Six months after the bank won the contract with Goldman Sachs and
Merrill Lynch, Grubman downgraded AT&T (Cassidy, 2003).
At Morgan Stanley, Meeker was the star internet analyst. Like others, she kept
her ratings high after stocks plummeted. Morgan Stanley’s research department
was criticized by the Attorney General and regulators for issuing faulty reports
that misled investors and for keeping track of analysts’ work on investment 
banking deals when conducting reviews of analysts’ performance to set 
compensation. Unlike Blodget and Grubman, however, there was no evidence
that she did not believe in her ratings and recommendations; and she discouraged
many internet issues when she did not believe that the companies would fare
well. Morgan Stanley argued that ‘research analysts helped screen out IPO 
candidates such that Morgan Stanley rejected five internet IPOs for every one the
firm underwrote. Mary Meeker was an integral part of this screening process,
which benefited the firm’s investor clients’ (Gasparino and Craig, 2003; Cassidy,
2003). While Meeker might be accused of undue enthusiasm for internet stocks,
there was no evident exploitation of conflicts, and there may have been some
benefit to investors from the screening that was provided. 
Complaints were not limited to these three banks. At Donaldson, Lufkin &
Jenrette, analyst Kevin A McCarthy complained to the head of equity research
that investment bankers had pressured him to write positively about Lantronix
Inc, a network device server company, even though its IPO had done extremely
poorly, and its price was plummeting. In an email McCarthy stated that the
bankers had acted as a proxy for the management of Lantronix and had blocked
his attempts to do an in-depth analysis of the financial statements. He wrote ‘I put
my reputation on the line to sell this piece’ of junk ‘calling favors from very
important clients’ (New York Times, 12 September 2002, pp. C5 and 12).
In another important case, Frank Quattrone of Credit Suisse First Boston, a 
formerly highly regarded investment banker specializing in technology 
20 Conflicts of Interest in the Financial Services Industry

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Investment Banking: Conflicts of Interest in Underwriting and Research 21
companies, had a complaint filed against him by NASD for improperly pressuring
his analysts (Thomas, 2003). He was accused of soliciting banking business by
promising favourable coverage, breaking the ‘firewall’ barrier between research
and investment banking. He engaged his analysts by linking their bonuses to their
investment banking work and apparently permitted executives of companies
whose stock he handled to make changes in his staff’s draft research reports.
NASD also alleged that Quattrone was heavily involved in spinning, maintaining
more than 300 ‘Friends of Frank’ accounts of executives at technology companies
that were active or prospective clients of the bank. These ‘friends’ were allocated
hot shares at his discretion (Thomas, 2003). Salomon Smith Barney also allocated
hard-to-get IPO shares to executives like Bernard Ebbers of WorldCom, Philip
Anshutz and Joe Nacchio of Qwest, Stephen Garfalo of Metromedia and Clark
McLeod of McLeodUSA (The Economist, 5 October 2002). The bank claimed that
they were issued shares because they were among the firm’s best individual 
customers not because Salomon Smith Barney wanted investment banking 
business.
It is generally conceded that while this alleged exploitation of conflicts had
been practised for a long time, it has only received much attention since the 
collapse of the stock market. Michaely and Womack (1999) find some indications,
however, that the potential conflicts of interest increased during the 1990s.
Previously an investment bank’s corporate finance department typically used its
own staff to perform due diligence for an issue it was underwriting. After the 
offering was completed, the bank assigned an equity research analyst to cover the
stock. More recently, equity research analysts have been used directly for due 
diligence process and marketing issues. While duplication of expertise may have
been reduced, the ‘wall’ between the two departments potentially became much
thinner (McLauglin, 1994 and Dickey, 1995). The SEC reported that research 
analysts were heavily involved with start-up companies well before they had
established an investment banking relationship. They often established the initial
relationship with the company, reviewed its operations and provided strategic
advice. It also found that banks even allowed analysts to invest privately in firms
before shares were available to the public. Furthermore, after an IPO the manage-
ment of companies often applied pressure on analysts for favourable reports and
recommendations. Analyst ownership of stocks that they cover creates a personal
conflict of interest. Although current regulations do not prohibit this practice,
some firms limit or prohibit it (Boni and Womack, 2002).
Analysts’ ‘excessive’ optimism and spinning became lightening rods for angry
investors after the collapse of the stock market.
12
While the individual cases 
highlighted in the media reveal some exploitation of conflicts for considerable
gain, they also show that there were differences in how firms and analysts 
grappled with the problem. Whether these practices were characteristic of the
industry and whether the market acted to discount biased information is 
important for determining what specific remedies are required.