Commentary

Calling the Dogs off on Wall Street

This article was published in the Washington Times, December 1, 2002.
The Washington Post reports that New York State Attorney General Eliot Spitzer plans to stop his “investigations” of Wall Street firms in a few weeks. “Sources close to Spitzer said he believes that the investigation is rapidly approaching a point where continuing it — with its slow drip of damaging revelations — could further erode investor confidence.”

That cannot be the real reason Mr. Spitzer is suddenly so eager to retreat from battle. It could not have taken him this long to notice that stocks crash every time he attacks another brokerage house or bank.

A subsequent article in the same paper offered a better explanation — namely, that “Spitzer has come under rising criticism lately.” Office vacancies in Lower Manhattan are approaching 15 percent, and Mr. Spitzer’s raid on Wall Street can only drive more business away. Even an editorial in The Washington Post described Mr. Spitzer’s proposals as “wacky.”

Besides, the election is over, and local papers are sure Mr. Spitzer is running for governor in 2006, so his self-promoting publicity blitz has served its purpose. And much of the fun of collecting ransom money for Albany is now threatened by federal legislators who are pushing Mr. Spitzer to share the loot with unidentifiable investors (which really means trial lawyers).

Before he drops the subject entirely, though, Mr. Spitzer is still trying to squeeze about a billion dollars from a few New York companies that won’t roll over on his command. His counterparts in Massachusetts and elsewhere are playing a similar game of high-stakes poker, where they alone have nothing to lose. The same news report that mentioned criticism of Mr. Spitzer’s tactics nonetheless noted that “regulators will inform several Wall Street firms how much they will be expected to pay to end multiple investigations by state regulators and the Securities and Exchange Commission.” If you cough up enough money, says the Spitzer gang, then we’ll leave you alone. That’s not regulation, it’s extortion — not protection of investors, but a protection racket.

The article adds that “officials in Spitzer’s office have publicly warned Citigroup Inc. that civil or criminal charges remain a possibility if the firm does not agree to pay a large fine, as much as half a billion dollars.” The key phrases were “publicly warned” and “large fine.”

The Spitzer gang shuns the courtroom and instead abuses the press to make vague accusations and blackmail threats. “A Spitzer official said investigators continue to find ‘interesting things,’” the article explains, “an apparent attempt to increase the pressure on Citigroup.” There is no crime called “interesting things.” But Mr. Spitzer and company have always relied on highly publicized gossip and insinuation, never the sort of evidence that would stand a chance in court.

The closest those anonymous “officials in Spitzer’s office” ever came to specific charges of illegality was an affidavit in April by Eric R. Dinallo, counsel to Mr. Spitzer. That document launched the famed accusations about a Merrill Lynch team of Internet analysts headed by Henry Blodget. The affidavit noted that an ancient New York law allows almost anything to be labeled deceptive, since “unlike the federal securities laws, no purchase or sale of stock is required, nor are intent, reliance or damages required elements of a violation.” In New York, anyone can be accused of deceptive practices even if nobody intentionally deceived anyone and no investors have been damaged. It is almost enough to make one wish for a new head of the SEC who is manly enough to spoil Mr. Spitzer’s adventures.

The Spitzer-Dinallo affidavit relied heavily on an illogical argument about analysts’ ratings and a selection of misleading quotations from e-mails. Merrill Lynch used five ratings, just like the way schools grade children, except that the highest grade (A) is shown by number 1 and the lowest (F) by a 5. Failing grades are rare at school, but there is special reason why they are rare among analysts. If a stock is not worth buying or holding, then it is also not worth paying an analyst to cover that company.

The Spitzer-Dinallo affidavit complained that “as previously covered stocks such as Pets.com plummeted, sometimes all the way to zero, retail customers and the investing public were never advised to sell. The reason for this failure is at least in part the substantial unrevealed conflict of interest” between research and investment banking.

That was typically illogical. Analysts could not possibly advise anyone to sell a “previously covered” stock. And it was equally impossible for Merrill to have a conflict of interest with a “previously covered” stock.

The affidavit contained a chart contrasting the company’s published ratings with brief quotes from e-mails, intended to imply that analysts were denigrating stocks in private while praising them in public. The press seized on these comments uncritically. But those carefully edited e-mails have been shown to be extremely misleading by John J. McConnell, a professor of management at Purdue.

A piece by Gretchen Morgenson in the New York Times on May 5 opened with a short excerpt from an e-mail from Mr. Blodget that ends with: “It is hugely ironic to me that we are invested for potential conflict of interest over a stock we put a ” The carefully suppressed ending to that comment was this: “It is hugely ironic to me that we are being investigated for potential conflict of interest over a stock we put a Neutral on (and that after we upgraded, doubled, and after we downgraded dropped 40 percent — if there ever was a better example of independent, high-quality research, I don’t know what it is.” The actual statement was obviously inconsistent with the Spitzer-dominated story.

In the end, Merrill Lynch paid $100 million in hush money, without admitting guilt, just to get out of the headlines. Mr. Spitzer reneged on the deal by claiming it must have been guilty, or it wouldn’t have paid. In fact, there were plenty of reasons to settle that had nothing to do with guilt. The bad press alone had already knocked $10 billion off the value of Merrill Lynch stock, so $100 million might look like a cheap payoff.

Then there is the inevitable flood of “class action” lawsuits that follow any excuse to sue. Louis Vuitton Moet Hennessy (LVMH) just sued Merrill Lynch for a $100 million for saying nicer things about a competitor, Gucci. According to the Financial Times, “LVMH believes its suit should be seen in the context of Mr. Spitzer’s attempt to purge Wall Street of the conflicts of interest that have undermined investor trust.” If the Spitzer media-bombing raid had continued much longer, there would have been dozens more frivolous suits like that, and juries that have awarded millions just because of spilled coffee are capable of costly surprises.

In a fairer world, stockholders in Merrill Lynch might have been allowed to launch a class-action suit against the State of New York or the New York Times for maliciously plotting to sink the value of their shares and expose them to frivolous lawsuits. In the real world, it often seems easier to keep your mouth shut and pay the ransom. As more and more companies have felt Mr. Spitzer’s hand reaching deep into their pockets, however, a few have actually began to resist. At that point, Mr. Spitzer the politician finally noticed that “the investigation — could further erode investor confidence.” Indeed it has.

Alan Reynolds is a senior fellow with the Cato Institute and a nationally syndicated columnist.