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June 30, 2001

The Blame Season

By Harold Bradley

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  • The Blame Season

The endless drone of economists is not required to identify the comings and goings of "the bear." Traders need look only to the business pages and to Congress for such evidence. The blame season shines a bright light on Street practices and identifies possible culprits who "duped" an unsuspecting public into paying ridiculous prices for business start-ups.

This theatre is as old as the traditional business cycle - the same cycle declared dead by many of the new economy mavens. When excesses give way to corrections, human behavior dictates that we look for someone to blame. As long as IPO "flips" generated overnight double-digit institutional returns and new issue participants profited directly from biased hawking of stocks in a circus-like atmosphere, then old ideas like Chinese walls just got in the way.

New Economy

All investors acted as eager accomplices to the new economy mania. It is very difficult to lay blame solely at the doors of investment banks.

Yet moneymakers in Manhattan did work overtime to expand the boundaries of acceptable business practice much as they have during countless other cycles of bull market overconfidence.

Numerous stories document ongoing investigations of IPO allocation processes, including possible commission kickbacks. Academic studies examine the "buy rating" bias of investment bank analysts.

The SEC pronounces new best execution guidelines that examine whether commissions are used to "maximize the value of the investment decision" and asks managers to keep records of IPO indications and allotments. The noose appears to be tightening around long-standing practices that "bundle" into commissions a host of unrelated services paid by investment managers.

Mounting pressure to unbundle commissions has new urgency. But it is not a new idea. Sellside firms prevailed upon Congress for a "safe harbor" allowing institutions to pay up for research when commissions were deregulated in 1975.

Research providers worried more than 25 years ago that the buyside might choose to forego such "value added" services if the costs were specific and visible - a curious argument indeed.

The Council of Institutional Investors in 1999 recommended "the full unbundling of pricing for investment management, brokerage and research services, so that institutional investors can purchase and budget for these services as they do any other expense of the plan."

One cannot easily reconcile institutional complacency with Street practices, including obvious conflicts of interest, unless one sufficiently examines buyside incentives.

While there is no evidence that institutional firms put pressure on sellside analysts to issue favorable reports, there can be little doubt that institutional firms appreciate and cheer on Street "hype" when the security is held in portfolio.

A recent paper on institutional trading costs by two leading experts in market structure, Professor Robert Schwartz of Baruch College, and Benn Steil, senior fellow at the Council on Foreign Relations, pointedly states that "fund managers are hardly passive victims of sellside structures and practices. If the buyside's goal was truly to minimize trading costs, then they would appear to be their own worst enemy."