The $1.4 billion "global settlement" between 10 Wall Street banks and regulators, following a two-year investigation spearheaded by New York State Attorney General Eliot Spitzer, may have closed a particularly sordid chapter of Wall Street's history. But many observers question whether the much-touted "structural reforms" required by the settlement -- including measures to insulate research analysts from their investment banking colleagues -- go far enough, and most importantly, whether they'll do much to change the culture of Wall Street.

What really has been learned from this episode? Is there any way to prevent these kinds of abuses in the future? Or is Wall Street -- and the investing public -- destined to repeat the mistakes of the past? Taking up these questions are Eliot Spitzer, former SEC Chairman Arthur Levitt, financial historian Charles Geisst, Precursor Group CEO Scott Cleland, and former Federal Reserve Board member and former presidential adviser Alan Blinder.

Spitzer is the attorney general of New York. He spearheaded the investigations into Wall Street practices that led to the historic $1.4 billion settlement announced on April 28, 2003.

What's the big question in your mind about whether or not this [settlement and the reforms it requires] will work?

The marketplace is dynamic, and the marketplace is impossible to predict. I think that at the core of what we have done in the settlement is the separation of analytical work from investment banking. Our firm belief is that the analytical work that people rely on for their investment decisions will improve in its quality, because it will not be tainted by the underwriting desires and the desires of investment bankers to generate revenue streams. So I have every reason to believe that analytical work will be better, investment decisions will be sounder, investors won't be led astray. All of that will be great.

But you're not sure?

Well, you never know. ...

But you're dealing with ingrained practices, you're dealing with institutional inertia, and you're also dealing with high financial incentive. So when you say you're not sure it will work, if you were looking for the danger areas, what are you looking at?

I want to see the analysts at the major houses begin to say critical things about companies with whom the bank has an investment banking relationship. I want to see them admit to the company for whom they did an underwriting six months, a year ago, that the business model of that company hasn't worked, and see the analyst put out a "sell" recommendation on a stock that they brought into the marketplace. When that begins to happen, then I will know that the cultural effort -- that is, the effort to create a different culture for the analyst -- has succeeded. ...

Citigroup, CSFB, and Merrill Lynch have been charged with fraud. Let's just take Citigroup. What's the fraud, in simple terms? ...

At its core, the wrongdoing was as simple as one can imagine. The bank recommended a stock when it knew that stock was a bad deal. You can't go to an investor and say, "Buy this stock because I trust it, it's good," when you know it isn't, and when the reason for that mistake is that you have a conflict of interest, and you are being paid by the company [whose] stock you recommended. That, in our view, is a fraud, and that is what underlies this entire set of relationships. ...

Is the evidence so clear that you could have brought criminal cases against somebody in the Citigroup/Salomon Smith Barney hierarchy, and others?

... These are very difficult criminal cases. The reason for that is that you're dealing with subjective beliefs. Proving a subjective belief beyond a reasonable doubt, even when you have these e-mails, is very, very difficult. I'll give you an example.

Somebody says this stock is no good, but has put out a buy recommendation. You charge somebody with criminal fraud. You have to prove beyond a reasonable doubt that that was fraudulent advice. The defendant could take the stand and say, "I knew that at a pure equity level, in terms of the value invested for a five-year period, that stock was a dog. But I'm riding a wave, and I know that stock is going to go up for some period of time. As long as I get my guys out before that wave crests, I've made them money. The reason I said 'Buy the stock' is not because I think that the valuation long-term is sound, but because I know there's market momentum." ... That's why these are difficult, difficult cases to prove at a criminal level. ...

What do you say to people who say we have had the rules on the books for years. The real problem has been that self-policing hasn't worked, that enforcement hasn't worked, and if we're ever going to make rules work, to be taken seriously, the real test is to give them bite -- and that means criminal prosecution?

I agree with some of that. I agree that self-regulation failed. I agree that the rules were on the books, but not enforced. What we did over the last year, I believe, was begin to enforce those rules and then change the rules. The problem wasn't just that there were rules that were inadequate; there was an absence of rules in certain areas. We have created those rules through this global resolution. So that is what we have been trying to do. [But] I don't disagree -- criminal cases ultimately will have the greatest bite. ...

I've had a trilogy of objectives throughout. First, it was structural reform. Second, restitution. Third, individual cases demonstrating individual liability. ... But first and foremost, it was important to get structural reform. ...

From the standpoint of the banks and the analysts, what do you think is the most serious deterrent to future misbehavior, abuse, corruption, and fraud?

The next time there will be absolutely no inhibition to bringing criminal cases. ...

The next time, you'll throw the book at them. Why give the banks a second chance?

Because the harm to our economy that would result from eliminating a Citigroup or a Merrill Lynch is enormous, and it's disproportionate to the remedy that we want. What we want to do is clean up the system and hold the individuals accountable, and that is what we have tried to do. There will be people who disagree, who say we were too tough, and some who are going to say we should have indicted the company and hold the company accountable and eliminate it. I understand that, and I've heard both perspectives. ...

But did you push for, and find that the banks were not buying in with you on structural reforms if you proceeded down the criminal path?

There was a concern on the part of the banks that structural reform would end up being meaningless if criminal sanctions were sought, against either the institutions, or the most senior individuals, because that would be tantamount to destroying those institutions.

A former investment banker and chairman of the American Stock Exchange, he served as chairman of the Securities and Exchange Commission from 1993 to 2001.

We just had a settlement between the regulators and the big Wall Street banks. Did that settlement regulate things? Has that fixed the problem of analyst conflicts and bank conflicts?

I don't think so. I think that settlement was arrived at by a very creative and determined attorney general of the state of New York, Eliot Spitzer, but it didn't complete the job by any means. The firms were fined, to be sure. Various protections were put in. Additional sources of research were provided for. The solution that we've seen is companies are walling off their analysts from their investment banking, but they are still under the same corporate umbrella. In my judgment, that makes the problem a little bit better, but it doesn't cure it. The perceptual image of a firm that is conflicted is still there, and whether it is perceptual or real is questionable. I don't believe in Chinese walls. I don't care if you build them higher or thicker. The only answer to this is total separation of research and investment banking, and we don't yet have that. ...

[With this settlement] we've moved the ball somewhat, but the problem is still very much there. We need to continue to be wary.

I think the best answer to this ... is full disclosure. ... Have we heard from the firms precisely what they did? Have the firms told the world, told investors, "Yes, we compromised your interest in favor of our corporate clients' interests. Yes, we tried to promote the interests of WorldCom, we tried to promote the interests of AT&T, at the expense of investors?"

Unless we hear that, the settlement doesn't do all that it could do, and that is ultimately a far better solution than any amount of money you can extract from the firms. The money is relatively meaningless.

How tough are these fines for these firms?

I think the fines are symbolic, and no amount of money will ultimately be judged to be satisfactory. The best response to all of this would be the confession of the firms to what they did wrong.

So what you're saying is Sandy Weill [of Citigroup] and Bill Harrison [of J.P. Morgan Chase] and the heads of these groups, should have come forward and admitted to the public what they did wrong?

I think that a satisfactory settlement of this issue would involve a public revelation and public admission, by all parties across the board, of what went wrong. ...

Ivan Boesky and Michael Milken went to jail [in the 1980s]. I haven't seen anybody in the Wall Street part of this scandal go to jail. Will it take that to really get the serious attention of Wall Street?

I don't think so. I think Wall Street's serious attention is very much focused on this. I think that the actions of the Conference Board Commission on corporate ethics is something that couldn't possibly have taken place two years ago, in that an establishment group has come up with recommendations that I think will be largely accepted by the corporate community, that would have been laughed at two years ago. So I think change is already taking place, and the change is cultural, which has far greater impact than legislative or regulatory change. ...

Do you think the regulators were deterred in their investigation of the current Wall Street scandals by a fear that, if they really nailed the top executive or major figures in any of the big firms like Citigroup or Merrill Lynch or J.P. Morgan Chase, that once again the markets would collapse?

Absolutely not. I have seen in my years at the Commission the appeals of companies, of banking regulators, of politicians, who said, "If you bring this case, it will jeopardize the interests of the country." When we went after the over-the-counter firms, when we went after Bankers Trust, those arguments were raised. That didn't impress us one single bit. ...

Well, Eliot Spitzer [has said] that he was worried that if he indicted the top executive at Merrill Lynch, it would bring Merrill Lynch down. He didn't want to do that.

Well, I can only speak for the SEC. I think the SEC goes where it believes wrongdoing has been done. Certainly not at any time in my recollection has the Commission been deterred because of fear of consequences to the market. Not once.

A professor of finance at Manhattan College, he is the author of numerous books on Wall Street and financial history.

What do you make of the settlement that Eliot Spitzer and the regulators have made with Wall Street?

I think that the settlements that Spitzer made are a step in the right direction, in that he clearly stole the thunder of the SEC, which was proceeding much too slowly.

The actual fines themselves are not substantial enough. They're literally slaps on the wrist. It may be argued that Merrill Lynch paid 100 million dollars for their transgressions. But as it turns out, 100 million dollars isn't worth very much in the post-1990s environment. If the fine had been more like a billion for one of them, they might have taken more notice. A hundred million dollars is pocket change.

But in terms of the really big problems that came up -- the conflicts of interest, guys like Jack Grubman, and the IPOs -- have the structural problems been resolved? Is Wall Street fixed?

No, hardly. I mean, Wall Street's problems are now better known than they were. ... But the structural problems are still there. ...

The separation of analysts from investment bankers now is recognized as something which is necessary. But I don't think there's anything in place so far which is going to actually prohibit someone from the research side who wants to influence investment banking from doing so. ...

I guess the critical question about the settlement is, has the settlement restored public trust in the marketplace?

No, I don't think so. Public trust is usually earned by a long period of time, when the public feels that they can invest, deposit money without repercussion. We haven't had that. The new laws which have been put in place to separate analysts from the investment bankers, the fines which have been leveled, are just not substantial enough.

It's doubtful that the public would take time to understand it, which is the other side of it. What the public generally recognizes is imprisonments and very stiff fines, which of course may work, but it wouldn't make Wall Street very happy.

So is one of the problems that there hasn't been a serious criminal prosecution?

Yes. I think that probably if someone were actually dragged, if you will, in handcuffs, as Richard Whitney was in the late 1930s, president of the New York Stock Exchange, and put in prison -- he was put in Sing Sing for embezzlement at the time -- that's the sort of thing which catches the public's attention, not simply the 100-million-dollar fines. ...

Eliot Spitzer calls it a corrupt business model. Do you agree?

On the basis of the 1990s experience, yes. I mean, the business model from the very beginning was to portray companies, which probably weren't as strong as they were portrayed to be, as good investments.

There was obviously some manipulation of stock prices along the way to make those companies perform well in the marketplace. Then obviously a lot of executives and Wall Street people were getting out of those stocks when they hit their highs. That's a corrupt business model from beginning to end.

A top telecom strategist, Cleland is the founder and CEO of the Precursor Group, a research boutique for institutional investors.

What do you make of the settlement that Eliot Spitzer and the regulators have made with the Wall Street banks? Is that settlement going to fix the problem for us ordinary investors?

Well, let's put the global settlement on Wall Street research in perspective. One of the reasons the bubble occurred is, for 10 years, the government didn't enforce the law, allowed a lot of misrepresentation and didn't do the appropriate oversight. Now, I applaud the government for coming in and now reaching a global settlement, and they're making a serious effort. But whether it's going to work will depend on the next 10 years of whether they diligently oversee it, and make sure that it occurs, because there were great rules on the books the last 10 years, but nobody enforced them. ... We've had good rules for a long time. The only thing that's going to make the situation get better is if those rules are enforced and they have bite.

What does that mean? Somebody's got to go to jail?

If there is misrepresentation and fraud, people should go to jail. ...

Are regulators like Eliot Spitzer pulling their punches? Should they be hitting harder?

Wall Street is a very powerful entity, and I think they deserve a lot of credit for taking Wall Street on. But the proof will be, are they diligent overseers in the years ahead? Because the only way this market is not going to return to where it was is if it's constantly overseen, with a fear that it might return to where it was. ...

The real concern many of us have is, when the market comes back and the economy comes back, memories will be short. So that's the time when the government needs to make sure that people are not misrepresenting companies and also looking for fraud.

We've heard for years about the "Chinese wall." ... We have lived through a period where that wall was obviously very porous, if it existed at all. Can there be a real separation between analysts and investment banking? ...

The Chinese wall was a joke. It turned out to be a Chinese shower curtain. That is because you have people that are literally in the same room, or one or two walls apart, who are trying to keep things separate, when the financial incentive is to bring them together.

So there is a question whether or not investment banking or research can be done in the same house. I think as long as everybody is well aware of who the investment banking analysts are working for -- that they're working for the company and not the investor -- then it's the investor beware.

The problem in this instance was the investment banking analyst was able to convince the investor that they were working for them, and not the company. That was the real fraud.

So now we all know we're OK?

No. I think there needs to be an ongoing effort to educate investors about who Wall Street really works for, because there's all sorts of entities that they can go to to get straight advice that are aligned with investor interests. ...

Professor of economics at Princeton, former vice chairman of the Federal Reserve Board, and former member of the Council of Economic Advisors under President Bill Clinton.

From what you know of Wall Street, do you think the problems of the abuses we saw in the 1990s have been solved by this settlement?

No, I don't think it's solved. You'll never solve it, I think. What you try to do is mitigate it. My view of this, and many things in the regulatory and legal realm, is that you see a problem, you try to make a patch or repair. You fix the exact problem -- or you mostly fix it -- but then right next to it, there'll be some other kind of a problem that arises. ...

I think the way you want to think about this is, in the lexicon there's supposed to be a kind of a "Chinese wall" between the analysts on the one side and the investment bankers on the other side. To put it crudely, the analysts are not supposed to act as shills for the investment bankers. The accusation is that, to much too great an extent, they were acting as shills. So what do you do about that?

An idealist might say you put up a perfectly, completely impregnable Chinese wall between the two. I don't think that's possible. I think what you do is thicken the wall, and you make it higher. You make it harder to either go through it or around it and, therefore, quantitatively you reduce the amount of abuse. You never can reduce it to zero, I don't think.

To me, the most amazing thing was that anybody was listening to the Wall Street analysts to begin with. I know some people were; it's still amazing to me. I think there are fewer such people now. ...

There are those who say that all the rules that have been put forward as part of the Wall Street settlement were essentially on the books before ... and that, in fact, the culture of Wall Street isn't going to change. As soon as this has blown over in a few years, we'll be back in the same mess again.

I think there's probably some truth to that, but I think we'll be back in some kind of a different mess. It changes things, and it moves things. ... They've signed a legal agreement. They're going to be in specific sorts of hot water, being in breach -- I might say "material breach" -- of those agreements, if they violate them. That's a little bit of a change from the status quo ante, before they had signed that agreement.

But if what you're basically saying is these kinds of blatant conflicts of interest were against the rules before, and they're still against the rules, that's basically right.

Self-policing, which this heavily depends on -- can that work?

Well, only so far. I believe you have to have policemen. You rely to some extent on self-policing, and then you have to have policemen. ...

But if the securities cop doesn't send anybody to jail, the way Rudy Giuliani sent Michael Milken and Ivan Boesky to jail [in the 1980s], then what's the message? "Lay low for a while, but it's OK"?

The message, I guess, is you can lose in many, many ways, but probably not go to jail.

How would you do it? If you had a chance to try to fix the problems that we saw on Wall Street in the last five or 10 years, what do you think are the most essential things that need to be done?

I don't have a simple answer to that, because I think the real root cause in this is something that we can't get rid of -- which is that there have been manias and speculative fevers since the beginning of markets. We're never going to get rid of them.

When those things happen, there are going to be con men and con women of various sorts. They're going to take advantage of people. So what you can do is try to tighten the rules every time you see someone's figured out a way to get around the rules. Make sure you have cops on the beat. Try to give people warning. Have lots of disclosure. ...

But I think that to think that we're going to make financial markets free of excesses is an illusion. It's never going to happen. People have amazingly short memories. You'd like to think this is a searing memory, that something like this will now not happen again for 35 years. I don't believe that. People forget faster than that. ...

[So] you try to put in consumer protections every place you can -- transparency, rules, laws and otherwise -- that limit conflicts of interest where you can find them. Then you hope for the best, and then you come in and clean up the mess after the mess happens. And you learn, so that the next time, the mess is at least different. You don't screw up the same way twice.

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published may 8, 2003

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