The argument that a conflict of interest at Wall Street investment houses harmed individual investors during the stock market bubble is rapidly losing steam. In the wake of the stock market collapse, investment banks such as Merrill Lynch and Citigroup were accused of touting shaky Internet companies, tricking unwitting investors into making losing investments. In hindsight, it is becoming clear that the investment banks were themselves taken in by the great tech bubble of the late 1990s. Though their recommendations to buy Internet stocks were not intentionally fraudulent, the securities firms have become convenient scapegoats for the generalized collapse of the bubble. Last year, Wall Street firms reached a settlement with New York Attorney General Eliot Spitzer and federal regulators regarding an investigation into potential conflict of interest. Spitzer had led the charge, accusing brokerage firm analysts of issuing misleading research reports on hot Internet companies in order to win lucrative investment banking business. In that regulatory settlement, the nation’s securities industry was fined $1.4 billion collectively, and forced to separate internal stock research and investment banking activities.
The regulators made out very well in the settlement. The Securities and Exchange Comission (SEC) and various state governments shared the fine monies. Eliot Spitzer won re-election as state attorney general, and achieved fame and media adoration for “cleaning up” Wall Street. Spitzer’s deputy, Eric Dinallo, won a high-salaried job at Morgan Stanley to navigate the bank around the tangle of new regulatory restrictions that he helped create.
Since the Wall Street settlement, however, a number of developments on the legal front have called into question whether Wall Street firms really committed any misdeeds at all.
First, New York federal judge Milton Pollack dismissed two class-action lawsuits against Merrill Lynch for bubble-related investor losses in Internet stocks. The dismissed lawsuit alleged that thousands of investors lost money in stocks because of overly positive Merrill Lynch research. Lawyers in the lawsuit had introduced evidence gathered by Spitzer.
Second, another New York federal judge, Harold Baer Jr., dismissed similar class-action suits against Goldman Sachs, Credit Suisse First Boston, and Morgan Stanley.
And third, an arbitration panel of the National Association of Securities Dealers (NASD) threw out a $30 million claim against Merrill Lynch. In this claim, a founder of Internet start-up Infospace blamed his investment losses on Merrill’s bullish opinion of the company. The NASD panel found no wrongdoing on the part of Merrill Lynch.
These legal developments show that the case against the investment houses first brought by Eliot Spitzer was not very solid. Spitzer did not have enough evidence to bring a single criminal charge. He tried the investment banks mostly in the press via leaks and inflammatory comments.
Judge Pollack had a much different view. He cited numerous press reports starting in 1995 cautioning investors to take the stock calls of Wall Street analysts with a grain of salt. The facts, wrote Judge Pollack, “show beyond doubt that plaintiffs brought their own losses upon themselves when they knowingly spun an extremely high-risk, high-stakes wheel of fortune.” Investors lost their monies “fair and square.”
A generalized market crash — not bad investment advice — caused the shares of Internet companies to fall in 2000-02. As far as the law is concerned, investors alone were responsible for making risky bets, and for the consequences. The unavoidable implication is that last year’s Wall Street regulatory settlement was a rush to judgment. All the hype about Wall Street “conflict of interest” was simply a politically convenient explanation for the bursting bubble.
No fraud was committed by the securities firms, who were themselves caught up in the historic stock market mania. Perhaps since the bubble burst, the government has decided to set stricter rules for the securities industry. But any new rules put in place to regulate the investment banks should apply from 2003 forward. In the interest of fairness, the $1.4 billion in fines and restitution paid collectively by the securities industry should be refunded.
The real victims of the Wall Street research settlement are ordinary investors, who do not understand the real risks associated with speculation. The settlement perpetuates the myth that greedy Wall Street firms caused average investors to lose money in the stock market. Investors must not be absolved of the responsibility to research investments diligently, and to diversify their holdings to minimize risk. Unless this baseless regulatory settlement is reversed, investors may continue to believe falsely that government regulations will protect them against losses from unsound investment strategies.
— James M. Sheehan is an adjunct scholar of the Competitive Enterprise Institute.