An unfair dismissal suit triggers an important SEC investigation.

In April 2003, ten of Wall Street’s largest firms agreed to pay a US$1.4 billion penalty for issuing biased research to promote their new issues. It was the largest fine in investment history and deservedly so. Investors, bilked of millions of dollars and disgusted with all the deceit, were leaving the market in droves. The government was in full cry and the supposedly humbled investment bankers were going to clean house and separate research from investment banking. We were promised a fresh start and totally objective, independent advice. We should have known better! The new Securities Exchange Commission (SEC) probe into Wachovia Corp. suggests that nothing really changed.

The investigation itself is relatively straight-forward. Arturo Cifuentes, a Wachovia fixed-income analyst, was fired last April because he refused to certify that his income was not directly geared to his recommendations (certification is an SEC requirement). Mr. Cifuentes, in testimony to the SEC and in his suit for unfair termination filed with the U.S. Labour Department, asserts that he was unwilling to sign because the company’s investment bankers repeatedly tried to influence his reports. When he refused to comply, Wachovia reduced his compensation. The company says the charges are without merit. So the battle lines are drawn in the first real test of the SEC’s conflict of interest rules imposed after the major scandals. The new system is on trial.

Enquiries are at an early stage but there are already several things about the case that should concern us all. First, the SEC must have felt that there were grounds for an enquiry before proceeding. The Commission is not a sounding board for disgruntled ex-employees. Second, Mr. Cifuentes cites too many specific instances of pressure for this to be shrugged off as just a row over fine-tuning. Moreover, he claims Wachovia takes the position that the April 2003 agreement addressed equities and was vague about fixed-income research. In other words, never mind the public, there is legal wriggle room to slant some reports. Finally, and most important, new SEC chairman, Christopher Cox, has said he is concerned about growing signs in the industry that analysts are under pressure to compromise their research.

You have to keep in mind that Wachovia is not some small marginal operation where a little rule-bending might be expected. This is the fourth-largest bank in the U.S., a major player in wealth management. It is fully aware of the need to reassure investors still carrying scars from Enron and WorldCom. Yet, according to Mr. Cifuentes, Wachovia’s investment bankers contacted him on nine occasions during one year asking that he enhance reports concerning products they were trying to promote. They also wanted him to withdraw reports that upset some clients. In this respect, the bank’s legal department told Mr. Cifuentes that the SEC rules do not deal with withholding opinions, a fine point that certainly evades the spirit and intent of Wall Street’s deal in 2003.

Equally troublesome, Arturo Cifuentes is not a rookie analyst. The Treasury Department has invited him to address its regulators. His immediate boss praised some of the work the bankers disliked. Of course, Wachovia will have its day in court but the whole affair already smacks of tainted research and conflict of interest. Analysts have to be totally independent, otherwise they are on a slippery slope.

Does the name Jack Grubman ring a bell? It should. Mr. Grubman, eventually banned for life from the securities business, became notorious for blurring the walls between research and investment banking during the telecom boom. Churning out supposedly objective reports, he was in the pocket of the bankers and corporations. Jack is famous for his remark: “The notion that keeping your distance makes you objective is absurd. Objective? The other word for it is uninformed.” That attitude plus his complete lack of ethics cost investors millions of dollars. Hopefully we are not going down the same path again.

It could happen. The Wall Street firms never acknowledged any wrongdoing in the April 2003 agreement. One even issued a belligerent denial and was reprimanded by the SEC. The Consumer Confederation of America cautioned investors not to “rush to bestow renewed trust on Wall Street firms”. There was no contrition, just grudging acceptance of some new rules.

Keep in mind as well that this is a cut-throat business, everybody is trying to get an edge, and the research community is surprisingly close knit. Analysts monitor the opposition and if Wachovia is ignoring the rules other firms will quickly follow suit. That is why there were so many Wall Street bankers involved in the major scandals.

What to do? I think that for now we should weigh U.S. fixed-income recommendations more carefully, at least until the SEC gives the green light.

Because the Wachovia case pivots on fixed income as opposed to the normal common stock research, it’s perhaps worthwhile taking a quick look at how these reports differ. Sometimes they provide almost opposite opinions about the same company at the same time. For example, on Sept. 8, Nesbitt Burns issued a gung-ho buy recommendation on CIBC stock, then trading at $71. Enron apart, the analyst thought loan losses were low, costs had been reduced, and the stock was oversold. It was a good call and CIBC moved up smartly. Then, 15 days later, using exactly the same numbers, a Nesbitt Burns fixed-income analyst issued what was in effect a warning about the bank. Pointing to the Enron charge, he said that CIBC had a much weaker capital position than its peers and that the Dominion Bond Rating Services downgrade of the credit to A (High) from AA (Low) was deserved. In fact, he thought that the other rating services should have also downgraded the bank and advised investors to avoid the CIBC’s debt because of the poor fundamentals.

When you think about it, the reports are not only easily reconcilable but form two parts of the same analysis. They recommended that people shopping for fixed-income securities, where safety is paramount, should look at other bank debt. On the other hand, CIBC shares represented good value for investors willing and able to assume some risk in the stock market. There is no contradiction. However, I suspect that Wachovia is going to argue that fixed-income and equity research are totally unrelated disciplines, and therefore the work done by Mr. Cifuentes is not governed by the 2003 agreement. If that is the defense, which is in effect sophistry, I hope the SEC comes down hard. Investment bankers and analysts are bad chemistry. Keep them apart.