<i>Caveat Emptor</i> Isn't Enough

In the 1990s, Janet Reno’s Department of Justice and the Federal Trade Commission (FTC) took an active role in policing large mergers, in the name of protecting consumer interest. Under their watch, the mergers of Sprint and Worldcom, Office Depot and Staples, and United Air Lines and U.S. Air were all blocked. The FTC even blocked the merger of Meade and Celestron, two hobbyist telescope manufacturers who competed in a market totaling a few million dollars in sales per year. Retrospectively, it’s unclear what benefit, if any, the public received from these blocked mergers since most mergers of large, competing companies fail. For proof, look at the fates of MCI Worldcom and AOL Time Warner, two companies whose plans for world domination through merger have failed of late. AOL just recorded the largest quarterly loss—$54 billion—in corporate history, and Worldcom’s CEO Bernie Ebbers has just resigned under pressure from his board for his poor management.

Contrast the Clinton era trustbusting to the current business reforms initiated in the wake of Enron’s collapse. While Congress is busy focusing on the accounting industry, the rest of the business world is closely watching the efforts of New York Attorney General Eliot Spitzer, a 1984 graduate of Harvard Law Sschool, who is investigating the stock analysts on Wall Street for fraud. Unlike companies that, however foolishly, want to merge in order to grow, the analysts on Wall Street have been consciously deceiving the public for years. Spitzer’s investigation, and the dirt he has dug up on prominent analysts like Jack Grubman of Salomon Smith Barney and Henry Blodget of Merrill Lynch, has finally prodded the rest of the regulatory agencies into action. Both the Securities and Exchange Commission and the National Association of Securities Dealers are currently investigating Wall Street, fearful of losing control over the brokerage industry to 50 state AGs if Spitzer proves successful. As Businessweek states in this week’s issue, the current scrutiny on American business is the most intense since the initial regulations imposed after the Gilded Age, during the height of Teddy Roosevelt’s trustbusting.

Merrill’s Henry Blodget, whose excesses have been uncovered by the Spitzer investigation, is emblematic of the current problems on Wall Street. Blodget, a man whose career mirrored the Internet bubble, was an Internet stock analyst at the second-tier firm CIBC Oppenheimer when he made a now famous prediction. Blodget correctly forecast in 1998 that the stock of Amazon.com, then trading at around $225, would hit $400 within 12 months. When the stock hit that target within months, a star was born and Blodget soon jumped to the more prestigious Merrill Lynch. By the time the Internet bubble burst in April 2000, Blodget had become one of the most influential people in the technology business, able to move markets with his predictions.

Spitzer has discovered that Blodget, who remained publicly optimistic about Internet stocks, nevertheless harbored significant private doubts about the companies he was touting. InfoSpace, a company that retained Merrill Lynch as its banker, received a favorable rating from Blodget even as its stock fell from a high of $80 in early 2000 to under $13 by the end of that year. In e-mails uncovered by Spitzer, Blodget describes the company as a “powder keg” and a “piece of junk,” expressing serious doubts about the company’s management, all while advising Merrill clients to continue buying the stock.

Now, Blodget is “retired” from Merrill, which realized that his continued presence at the firm was an invitation to class action lawsuits. Blodget’s case illustrates the power of greed to erode the barriers of self-interest that are supposed to police capitalism. When bankers and research analysts work at the same firm, the fee-generating bankers put enormous pressure on the research analysts to issue favorable ratings. They know companies that receive less than stellar ratings from an analyst will not take their banking business to that analyst’s firm. The same problem plagues the accounting business, where Enron’s auditors at Anderson were also consultants to the company, a role that generated more in fees for Anderson than Enron’s auditing business. Corruption, in these cases, resulted from an inadequate separation of self-interests, and restoring a favorable balance of self-interest should be a focus of the regulatory attention now being paid to these firms.

A total separation of business activities with contrasting self-interests would do the most good, and will likely be the outcome (at least in the case of auditing and consulting firms, since those companies have the taint of Enron). Such will likely not be the case for Wall Street analysts and bankers, since those firms are less exposed and can always cry caveat emptor, effectively saying that investors must take responsibility for their own losses. On that note, they have a point, but the presumed skepticism of his readers does not excuse Blodget of fraud in publicly praising stocks that he privately felt unworthy. Whatever the outcome of the ongoing investigations, the reforms that they are likely to generate will be far better for the public than any of the blocked mergers were during the Clinton administration. Breaking up companies whose divisions have divergent self- interests will always be more effective than blocking the mergers of companies that are simply trying to sell the same class of products.

Alex F. Rubalcava ’02 is a government concentrator in Eliot House. His column appears on alternate Wednesdays.