Yesterday, I described how Morgan Stanley was holding firm-wide conference calls to explain the Facebook disclosure scandal to its angry financial advisors and clients…and how, on at least one of those calls, my name had come up repeatedly.
The Facebook disclosure scandal, you will recall, is about how Morgan Stanley and the other IPO underwriters verbally relayed bad news to their big clients about Facebook having a crappy quarter…but didn’t tell their financial advisors and individual clients about this.
As a result of this selective disclosure, in the days leading up to the Facebook IPO pricing, institutions had much better information about Facebook’s current business than individuals did. And that may be one reason why the stock tanked after the IPO: Because there’s nothing like finding out a company is having a lousy quarter to cause people to dump stock.
I also described how it has recently become a convention on Wall Street to blame me for everything. Bank of America blamed me for its cratering stock price last summer. Morgan Stanley is blaming me for the Facebook disclosure scandal. And so on.
(I am relieved to report that JP Morgan hasn’t blamed me for its ~$5 billion trading loss yet. I’ve always thought that Jamie Dimon was a class act!)
The word I got yesterday was that Morgan Stanley was blaming the Facebook scandal on me because I have recently written articles about how outrageous it was that institutions were told about Facebook’s lousy quarter and individuals weren’t. In other words, because I had hyped up the scandal and gotten Morgan Stanley’s clients all hot under the collar about it.
I tried to discuss this with Morgan Stanley yesterday, but their approach to dealing with me right now is to ignore my emails and calls. So I didn’t get very far.
Instead, last night, I talked to someone familiar with Morgan Stanley’s view of the situation.
And I discovered that the firm really is blaming the whole Facebook IPO disclosure scandal on me…and not just because of the recent articles I’ve been writing!
Explaining this story will require a lot of background, so grab a cup of coffee and settle in. Otherwise, the short version is this:
Morgan Stanley is saying that the regulations put in place after the research-banking scandal of the 1990s—in which I was Exhibit A—caused this new disclosure scandal.
The Origins Of The Ridiculous Rules That Just Hosed Morgan Stanley Clients
You will unfortunately no doubt recall that, a decade ago, I was a famous Wall Street analyst.
Specifically, I was one of the top-ranked Wall Street Internet analysts during the dotcom bubble. One of the reasons I was famous was that I had been very right about the Internet stocks for 3 or so years in the late 1990s, when some other analysts were wrong. But then, like a lot of other analysts, I made the mistake of trying to perfectly time the bursting of what looked like a bubble—and I waited too long to downgrade the stocks. And then I was disastrously wrong.
That was a searing lesson for me—one I will never forget. I had actually put a lot of money where my mouth was—on a handful of the top Internet stocks—and I lost most of that money. I also missed the chance to save my clients a lot of money by getting them out before the collapse. I will forever regret that.(In my defence, it really wasn’t just me who waited too long. Pretty much everyone waited too long. If you go back and read articles from the summer of 2000, you will find almost every big money manager quoted as saying the recent pullback in the NASDAQ was a fantastic buying opportunity. It wasn’t until that fall, after I had downgraded the stocks, that the world ended.)
Anyway, part of every analyst’s job in those days was to work with their firms’ bankers to take companies public. Analysts were involved in evaluating IPO candidates, pitching IPO candidates, positioning IPOs, marketing IPOs, and then providing research on IPOs after the companies went public. This was a longstanding industry practice, one that had been around since long before I got into the industry. It had also been described frequently in the press: The top analysts were said to have to “wear two hats,” banker and analyst, and have to help investors while also maintaining great relationships with companies. At some firms, analysts were even paid directly for banking deals, though that wasn’t the case at my firm (Merrill Lynch).
This involvement of analysts in the IPO process, not surprisingly, occasionally created pressure and friction between bankers and analysts, as well as between analysts and companies. The banks made more money from banking than they did from trading, and there were many stories of analysts getting fired after annoying banking clients with negative reports. Companies, meanwhile, gave detailed information to friendly analysts and shut out negative analysts, so if you didn’t maintain good relationships with companies, you often were unable to add much value for your investor clients. And this friction only increased as the bull market roared on, because negative analysts were not only annoying—they were also usually wrong.
After the market crashed, a new New York Attorney General named Eliot Spitzer decided to look into the research-banking conflict. And, thanks to my visibility, he started with me. My research team and I had had a penchant for writing really colourful emails to each other—I famously dissed a stock that we were covering that had collapsed as a “piece of junk”—and these emails provided spectacular ammunition. In the spring of 2002, Spitzer alleged that the reason I had been slow to downgrade the dotcom stocks was because of the banking conflict.
That latter conclusion was not, in fact, true. (My firm categorically denied that part of the allegations at the time). The reason I had been slow to downgrade the stocks was that, like thousands of other investors and analysts, I had thought that the bull market had longer to run.
Photo: Michael Seto
But Spitzer was certainly right that the banking conflict had created friction and stress for us and that we had not wanted to recklessly damage the firm’s banking business—or, for that matter, companies’ businesses—by recklessly downgrading stocks. (After an 18-year bull market, downgrades were highly unusual).After extending his investigation to many other firms, Spitzer forced an industry-wide settlement in which the involvement of research analysts in IPOs was pared back and the “Chinese Wall” between research and banking was strengthened.
This industry reform had several consequences, some of which were positive and some of which were negative.
On the positive side, the reforms removed some stress for analysts. Once analysts were no longer evaluated in part on banking business, they focused more on serving institutional investor clients and researching already public companies. And that’s unequivocally a good thing.
On the negative side, it became harder for companies to go public…because it turned out that having analysts involved in the screening, positioning, and marketing of deals and then providing follow-on research coverage of small companies made the whole IPO process work better. So that, arguably, was a bad thing.
And that brings us to today…
When the Facebook IPO disclosure scandal was revealed a few days ago, Morgan Stanley immediately protested that it had followed all the rules.
And that may, in fact, be true.
The problem is that, as Facebook has illustrated, the rules themselves are grossly unfair.
The story that Morgan Stanley is telling people is that Spitzer’s research reforms actually exacerbated the Facebook IPO disclosure problem, in the following ways.
Before Facebook, the assumption was that every communication from an underwriter’s research analyst about an IPO candidate would be positive. Whatever the analyst had to say, in other words, could be construed as “hyping” the stock and making it easier to sell.
In their desire to protect unsophisticated investors from this “hyping” of IPOs, regulators decreed that underwriter research analysts would not be allowed to publish any research on an IPO—or publish anything in print—until a certain amount of time after the deal.Back in the 1990s, this “quiet period” was 25 days. After the Spitzer reforms, it was lengthened to 40 days.
But, more importantly, the underwriter research analysts were still allowed to do three things to help the firm’s big institutional investors:
- Talk to company management about the business
- Generate estimates for IPO companies with management’s help
- Discuss these estimates and their opinions verbally with big institutional investors
The idea was that institutional investors would be sophisticated enough to evaluate the analysts’ estimates and opinions, instead of just regarding them as “hype” and mindlessly placing orders.
In the view of the regulators, in other words, the institutions did not need to be “protected” from the enthusiasm of research analysts. So they could talk to the analysts and learn all they could from them (which in most cases was a lot). Individual investors, meanwhile, were assumed to be clueless and gullible and therefore in need of protection from analyst enthusiasm.
So now you can begin to see the irony of all this…
Most of the rules in the IPO process are designed to protect individual investors from getting too much good news about companies.
But the important news on the Facebook IPO was bad news.
When Facebook realised it was having a crappy second quarter, it called up the analysts at all the underwriters and told them to cut their estimates. And the analysts did as they were told. And then the analysts and their firms got on the phones with big institutional investors and told these investors about the crappy quarter and estimate cuts.
Meanwhile, the financial advisors and individual clients of the underwriters, who were thought to be in need of protection from good news, not bad news, were kept in the dark. Because that’s what the regulators had wanted… to restrict communications from analysts to individual investors on IPOs, on the theory that anything analysts had to say about IPOs would be positive and, therefore, hype-y.
So that’s the other way that Morgan Stanley is now blaming me for Facebook IPO disclosure scandal.The research reforms that Spitzer’s settlement brought about restricted the already limited level of communication between analysts and individual investors on IPOs. Because, after the dotcom bubble, it apparently never occurred to anyone that analysts would have anything negative to say.
So, in other words, we’ve just seen another vicious example of the Law of Unintended Consequences.
So, That’s The Problem… What Is The Solution?
So, what’s the answer?
Here’s the answer:
We need to stop treating individual investors like babies.
We need to stop pretending that it can be smart and safe for individual investors to “play IPOs” and start being forthright about how investing in stocks is speculative and risky and that even expert analysts are often wrong.
We need to start educating the public about how hard it is even for the most well-trained and experienced professionals to consistently make money trading stocks. (Most pros lag index funds.)
And then, we need to make exactly the same information available to individuals as we do to institutions.
In this case, we can do this in one of two ways.
First, we can change our pre-IPO disclosure rules to match those in the UK. The analysts at the underwriters could write full research reports on the pre-IPO companies and then publish them BEFORE the IPO marketing process, thus sharing their insights and estimates with everyone.
If regulators are terrified that this might induce some innocent individual investors to start speculating, we should remind the regulators that the individuals are adults and, as such, should take responsibility for their own decisions.
Alternatively, we should eliminate analyst involvement in the IPO process entirely. No talks with company management, no phone calls with institutional investors, no estimates, no nothing.
Either of these solutions would be better than the current system.
Because, as the Facebook IPO just revealed, the current system is grossly unfair.
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