24 December 2002

The Wall Street Journal, December 23, 2002

The Dark Side of Wall Street: Why Scandals Continue to Erupt


Why do Wall Street scandals recur with the grim regularity of earthquakes and forest fires? The obvious answer, of course, is that Wall Street is where the money is. Beyond the inevitable appeal of billions of dollars changing hands daily, however, lie more peculiar reasons why knavery on a grand scale periodically racks the securities industry.

The $1.4 billion settlement of the Wall Street stock-research scandal marks the resolution of only the latest in a chain of scandals since the late 1980s. To mention just a salient few: the junk-bond scandals of Drexel Burnham Lambert; Salomon Bros.' fake bids for Treasury bonds; Prudential Securities' sales of worthless limited-partnership interests to tens of thousands of small investors; and the Nasdaq scandal, involving dozens of brokerage firms colluding to rig spreads at investors' expense.

While scandals are nothing new, the pain they cause is being felt more deeply. Ordinary Joes and Janes have flooded into the stock market, with an estimated 84 million individuals owning stock this year, double the number in 1983, according to the Securities Industry Association. The problem is that most lack the ability to easily detect flim-flam in balance sheets and earnings statements.

The analysts' scandal highlights one reason some Wall Street firms in modern times can't resist treating men and women of Main Street as chickens to be plucked. With the end of fixed commissions on stock trades in 1975, individual investors -- while remaining an important source of revenue -- became progressively less important for most firms than the huge fees to be earned from underwriting and investment banking for big corporations. Over time, taking advantage of the naiveté of individual investors became a convenient way to gain and keep big corporate clients. In the analysts' case, firms disseminated falsely rosey reports to induce unwitting investors into boosting the stock price of the firms' investment-banking clients.

Indeed, the language Wall Street traders and brokers use sometimes betrays disdain toward individual investors. Nasdaq market makers commonly refer to buy and sell orders from individuals as "dumb order flow," meaning their orders are almost certain to be profitable for the market makers because small investors typically trade without any hard information that could give them an advantage over these dealers.

While people don't like to be deceived, and usually won't do business again with someone who ripped them off, that doesn't apply if they are unaware that they have been hoodwinked. Brokerage firms can count on this phenomenon, especially in up markets. Gains from rising prices mask losses from questionable practices, at least for a while.

Says David Becker, a former general counsel at the Securities and Exchange, "We're talking about types of behavior where if you misbehave, there's no bang. It's not like Grand Theft Auto 3, where you see blood splattered all over the place." He adds, "To the contrary, when markets are going up, everyone's life seems good."

In addition, the risks of serious consequences if firms get caught are small compared with huge profits from flouting the rules. True, getting caught is occasionally fatal: Drexel folded in 1990, about a year after pleading guilty to criminal charges, and accounting firm Arthur LLP collapsed this year when it was convicted of obstruction-of-justice charges. Other firms, however, thrive despite repeated major scandals. Prudential Insurance Co. of America, now called Prudential Financial Inc., paid $1.5 billion between 1993 and 1995 to settle the limited-partnership scandal involving its securities unit. Then, by late 1999, allegations that Prudential's life-insurance units had made deceptive sales cost it more than $2 billion. Prudential not only survived but had no trouble converting from a mutual company owned by policyholders into a publicly traded company in 2001, with assets now of about $293 billion.

One reason the risk of getting caught is small is that the securities industry's main regulator, the SEC, is overtaxed and chronically underfunded. Congress, under the influence of campaign contributions from Wall Street, consistently has resisted giving the SEC any sizable increase in funding. Lynn Turner, a former SEC chief accountant, likens the situation to having only two cops to chase speeders on the interstate between New York and Boston. "Frankly, you can go 94 [miles per hour] without being too worried about getting caught," he says.

For nearly all the major financial scandals of the past decade, the SEC didn't start looking into them until after longstanding problems were publicized. In the Nasdaq case, the SEC didn't jump in until well after the press prominently reported on an obscure study by two business-school professors, who noted the seemingly obvious fact that most Nasdaq stocks never traded with less than a quarter-point spread, a phenomenon which had no apparent explanation other than collusion to ensure big profits for Nasdaq market makers. The analysts inquiry likewise didn't get under way until after months of prominent newspaper coverage of the issue.

When cases are brought, they invariably are settled. One result is that the penalties typically pale next to the amount of profits gained from the wrongdoing. Settlement numbers in the analysts' case seem large. But securities expert John C. Coffee Jr., a Columbia University law professor, contends they are only a small fraction of investors' losses from stocks that were excessively hyped by analysts.

And because the top executives at the firms are the ones who negotiate the settlements, the terms seldom cost them their jobs, even when they appear to bear some responsibility for the wrongdoing. As has been widely noted, the analysts settlement called for no action against Citigroup Inc. Chairman and Chief Executive Sanford I. Weill, even though he acknowledged asking analyst Jack B. Grubman to reconsider his rating of AT&T Corp. stock in 1999. Mr. Weill denies wrongdoing and disputes some of Mr. Grubman's account, and regulators indicated Friday that they hadn't found enough evidence to warrant accusing him.

Revelation of scandal typically prompts a flurry of new laws and regulations. But things often swing back toward the way they were before as soon as the spotlight moves on. In response to the recent accounting scandals, Congress called for creation of a tough new board to oversee audit practices. But as public attention waned, the accounting industry beat back plans to appoint a tough chairman to the new board, which currently remains headless.

Of course not everyone on Wall Street is engaged in improper activity and sometimes investors believe they have been defrauded when in fact the market simply moved against them.

And, of course, many argue that firms can take advantage of individual investors only because greed, excessive optimism and failure to heed warnings make many of them all too easy targets. Mr. Turner argues against passing off too much blame on the victims, though, and insists that tight regulation and more enforcement are the only way to ensure that ordinary people can rely on what they are told by investment houses. Referring to the legion cab drivers, sales clerks and others who have become investors, Mr. Turner asks, "Is there any hope we'll turn those people into sophisticated people who can read financial statements? The answer is absolutely not."

Write to Scot J. Paltrow at scot.paltrow@wsj.com

Updated December 23, 2002