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| Spitzer's next crusade
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He's taken on Wall Street, insurance brokers and the mutual fund industry. Now for the big time. (Full story)
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NEW YORK (FORTUNE) - A recently unearthed "highly confidential"
Citigroup memo openly discussed the "pressures" keeping research
analysts from providing investors with honest research.
In the 2002 memo, John Hoffman, then global research chief for
Citi's Salomon Smith Barney division, advised Salomon Smith Barney CEO
Michael Carpenter of the internal view that "implementation and
enforcement of clearer and more accurate ratings is in conflict with
certain paramount goals of our firm"—namely, maximizing underwriting
fees. (The memo was made public in ongoing litigation filed by a
Florida law firm, Babbitt Johnson Osborne & LeClainche.)
"When I read it my blood began to boil again," says New York
attorney general Eliot Spitzer. "It drove home how crass that whole
system was."
As a participant in the 2002 global Wall Street settlement resulting
from Spitzer's investigation, Citi has since reformed its research
practices.
The memo
To: Michael A Carpenter
From: John Hoffman
Re: Revision of the Ratings System
Date: March 22, 2002
HIGHLY CONFIDENTIAL
In an extensive discussion of stock ratings and a revised rating
system by the Equity Research Directors last week, several general
points were made which deserve your consideration and probably
discussion at the Operating Committee level.
First, the equity research directors agreed that the clearest, most
understandable system for our sales force and investors would be a
simple Buy/Hold/Sell categorization. However, that simple system is
unlikely to produce the balance in ratings sought by the regulators and
the investing public. Pressures on the analysts by corporate
management, by investment bankers and by selected institutional
accounts cause the analyst to steer away from negative ratings.
Most of the research directors felt that they could overcome or at
least lean against this positive bias with a more structured and more
forceful review process. While none would expect total balance, they
would expect the number of negative ratings to rise to a reasonable
level (Jeff Waters pointed out that if one were to retranslate the
current 1/2/3 ratings from Buy/Outperform/Neutral to Buy/Hold/Sell as
they are interpreted by many of the users, the distribution is close to
one-third each).
However, the research directors feel strongly that implementation
and enforcement of clearer and more accurate ratings standards is in
conflict with certain paramount goals of the firm. Research analysts
have been told repeatedly that the primary goal of the firm is to get
our equity underwriting market share ranking up into the top three.
This message is reinforced in the investment banking weekly meetings
and planning offsites to which research management and analysts are
invited. The success of the Platinum Account program and the Equity
Task Force initiatives are very dependant on the corporates' positive
view of equity research and there is no mystery that this positive view
hinges on a favorable stock rating. In contrast, seldom does research
management hear from top management about the damage that a confusing
or biased rating system has done to our sizable retail business in the
form of depreciated assets and lost accounts. And seldom in recent
years does research management participate in any retail business
sessions.
The scope of this conflict is obvious when we compare the Investment
Banking initiatives with our research coverage. The Investment Bank has
designated 400 corporations as Platinum Accounts and another 1,700 as
"Core" accounts. Each the corporations so designated is expected to
produce $20+ million or $5+ million respectively in fees to Citigroup.
Equity Research covers about 3000 companies, and since these also tend
to be the leading corporations in the world, the overlap with these ID
priority account lists is substantial. To have even 20% of these stocks
with a negative rating (probably the minimum to satisfy the demands for
balance) means that a lot of Platinum and Core accounts will carry some
kind of negative equity rating.
The equity research directors question the Investment Bank's ability
to accept stricter rating standards at the expense of revenues. We
discussed extensively whether we could do this with a "revenue neutral"
impact on Investment Banking and the answer was clearly "no". In fact,
it is more likely that the new ratings standards if enforced could
competitively disadvantage our Investment Bank given that historically
it has been more dependant on equity research support than its leading
competitors.
Given this last point, there was concern about franchise risk if we
should attempt to lead the industry in setting new rating standards.
These doubts were increased with the release this week of the details
of the Morgan Stanley system, which at first glance looked like it
might answer some of these conflicts and received a lot of publicity,
but which in practice is anything but clear and understandable.
Before we institute a new, more disciplined and more balanced rating
system, we need complete support from you and from all of the division
heads of the firm. Are we all agreed that we want to be a leader on the
topic of more accurate and more balanced ratings, recognizing that this
could increase conflict with our major corporate clients, could put our
bankers at a disadvantage to those who moves slowly or not at all, and
will almost certainly dampen the Investment Banking momentum towards a
leadership market share in our industry?
The design of a new rating system is partially dependant on your
answer to this final question. I think you and I should discuss this
issue privately before we get any of the business heads group involved.
You have the only hard copy of this memo.
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