You buy a stock and the price goes down. Who accepts the liability for losses? The purchaser of stock, of course, who must always bear in mind that stocks are never foreordained to go up or down. Even so, regulators and politicians have been using the great bubble and bust of the late 90s to extract billions from securities companies, under the implied assumption that the mere fact of losses is evidence of fraud.
“The record of Merrill Lynch’s fraud is overwhelming,” said New York state attorney general Eliot Spitzer. “That is the record I established in an affidavit admitted to court on April 8 of last year…The issue of the fraudulent advice is beyond dispute.”
At least, two federal court judges have correctly disputed Spitzer’s bold contentions. New York federal judge Milton Pollack rejected two suits against Merrill Lynch, with prejudice. Separately, Judge Harold Baer Jr., rejected similar claims against Goldman Sachs, Credit Suisse First Boston, and Morgan Stanley. In these suits, Spitzer’s affidavit had been submitted as evidence of securities fraud.
The rulings came after a regulatory settlement of Wall Street conflicts of interest, conceived by Spitzer and federal regulators. In that settlement, the securities industry was fined $1.4 billion and forced to further separate stock research and investment banking business segments. A portion of the money was slated to subsidize independent research firms.
In light of the courts’ findings that a bursting Internet bubble was solely responsible for investor losses in the stock market, it is time for the government to return that money and repeal the settlement. There is no justification for maintaining legal penalties against businesses whose conduct was not illegal.
In the federal suits, Merrill Lynch and other firms were faulted for recommending the shares of investment banking client companies whose share prices later declined in value. Investment banking relationships were posited as evidence of a sinister conflict of interest that impaired published opinions on stocks. Had the brokerage firms disclosed their banking relationships, investors would not have lost money in the tech bubble, or so the plaintiff’s attorneys alleged.
In line with Spitzer’s widely publicized accusations, plaintiffs obliquely asserted that “some, and perhaps much, of the Internet bubble was a classic stock market manipulation engineered by Wall Street’s investment bankers and research analysts.”
Judge Pollack responded that federal securities laws only fault those who intend to defraud by misrepresenting or omitting material facts, thus causing a plaintiff’s losses. But the circumstances surrounding the case clearly showed that brokerage firms were not defrauding anyone. The stock market was “in the throes of a colossal bubble of panic proportions,” the judge observed, in which “speculators abounded to capitalize on the opportunities presented.” The plaintiffs got caught up in the general euphoria over the Internet that gripped so many people at the time.
The brokerage firms’ investment advice and target price forecasts “were both correct and incorrect,” points out Pollack, “depending on the timing of the mercury level in the market thermometer.” Investors who acted on such prognostications were either rewarded with outsized returns or disappointed during the collapse of the fever, depending on the timing of their actions as the bubble ran its course. Regardless, none of the plaintiffs to the class action ever admitted to having seen or read an analyst research report before making a purchase or sale of stock.
The judge’s conclusions were devastating to the entire conspiracy theory dreamt up by Spitzer:
The record clearly reveals that plaintiffs were among the high risk speculators who, knowing full well or being properly chargeable with appreciation of the unjustifiable risks they were undertaking in the extremely volatile and highly untested stocks at issue, now hope to twist the federal securities laws into a scheme of cost-free speculators’ insurance. Seeking to lay the blame for the enormous Internet Bubble solely at the feet of a single actor, Merrill Lynch, plaintiffs would have this Court conclude that the federal securities laws were meant to underwrite, subsidize, and encourage their rash speculation in joining a freewheeling casino that lured thousands obsessed with the fantasy of Olympian riches, but which delivered such riches to only a scant handful of lucky winners. Those few lucky winners, who are not before the Court, now hold the monies that the unlucky plaintiffs have lost—fair and square—and they will never return those monies to plaintiffs. Had plaintiffs themselves won the game instead of losing, they would have owed not a single penny of their winnings to those they left to hold the bag (or to defendants).
Investment banking considerations, a possible factor in a firm’s general market outlook, were adequately disclosed to the market. Merrill Lynch’s role as lead underwriter in initial public offerings for Internet companies was fully disclosed on the cover of the prospectus for each IPO, as well as in research reports on the companies. Moreover, Judge Pollack cited numerous press reports as early as 1995 cautioning investors about possible banking conflicts. The issue of conflict of interest, said Judge Pollack, “was a matter of public knowledge for years before the amazing boom of the market initially rewarded those who disregarded such caveats.”
Judge Pollack found that Merrill Lynch and its Internet analyst, Henry Blodget, did not trick investors into placing bets on risky Internet companies. Mr. Blodget’s research opinions on stocks were replete with risk warnings about price volatility, and included detailed explanations for why stock prices could disappoint. Had the investors actually read Blodget’s reports, they would have been fully apprised of the potential for declining share price performance.
The unavoidable implication of these court findings is that the Spitzer regulatory settlement was a sham. All the hype about Wall Street conflict of interest was a politically convenient excuse to take money from Wall Street investment houses.
The $1.4 billion in fines were funneled improperly into the coffers of state and federal governments. They must be returned.
The continued existence of the Wall Street research settlement, and its fallacious public verdict that biased research caused stock market losses, is a moral hazard to the investing public. The legal reprimand of brokerage houses misleads investors into thinking that investment losses are somebody else’s fault. In addition, it promotes the harmful perception of cost free investment insurance via government intervention. This makes investors likely to take on more investment risk than they would otherwise be willing to tolerate, leaving them more vulnerable to share price declines. The same phenomenon would accompany a government plan to give away magic hangover pills. Drinkers would tend to become more intoxicated on the assumption that the next day’s pain would be anesthetized.
Kudos to federal judges Pollack and Baer for not bending to the victimology and sentimentalism of the times. The entire basis for a market system of finance is undermined if investors are not forced to realize losses that are the consequence of their own failed investment strategies.
As painful as they are, investment losses are necessary to work off the excesses of a bubble, and to re-allocate capital to more promising business ventures. In addition, steep post-bubble investor losses engender a healthy skepticism that prevents new market bubbles from forming. In this era of unprecedented monetary turmoil under Federal Reserve chairman Alan Greenspan, investor caution is more critical than ever.
