Nearly a decade ago, Eliot Spitzer, then the New York attorney general, had to force major Wall Street firms to build a Chinese wall between research and investment banking. Now, the same banks are fretting over a breach in that wall.
Lawyers and bankers at major Wall Street firms are worrying that provisions in the newly passed Jobs Act will compromise the independence of their research and leave them open to investor lawsuits around initial public offerings they underwrite, adding a new headache in managing potential conflicts of interest among different divisions.
At the heart of the debate is a measure in the Jobs Act that will allow analysts to write research reports ahead of an IPO being marketed by their investment banking colleagues. Analysts will also be allowed to write research immediately after an IPO, instead of waiting for a 40-day blackout period as current rules require.
The provision applies to so-called emerging growth companies with less than $1 billion in annual revenue. Bankers estimate the new rule would actually cover as much as 90 percent of companies looking to go public. That would have included some of the recent high-profile IPOs such as LinkedIn Corp, Zynga Inc and Pandora Media Inc.
Supporters of the act, who include venture capitalists and buyout firms backing start-up companies, argue that small companies typically are not covered by research and therefore need investor attention.
But Wall Street bankers and lawyers fear that the act leaves research analysts vulnerable to pressure to write biased reports about companies before IPOs to help their investment banking counterparts land a role in those deals. That could open up the door to a flood of investor lawsuits when the stocks do not perform as expected.
They are also concerned that pre-IPO research may make the job tougher for underwriters, who have to balance competing interests of companies wanting to achieve a high IPO price and investors wanting to buy in cheaply.
This takes us back to the bad old days when analysts were cheerleaders for their underwriting brethren, said Amy Burrow, deputy director of the Council of Institutional Investors, a watchdog agency for investors. Just think back 10 years ago, the scandals of the dotcom era when investment banks got business by promising upbeat research reports.
In 2003, these practices led to what is known as the Global Analyst Research Settlements, under which banks were required to separate research and investment banking activities to prohibit improper communications between the two.
The settlement with regulators covered 10 Wall Street firms, including Credit Suisse, Goldman Sachs Group Inc, JPMorgan Chase & Co, Merrill Lynch, Morgan Stanley, Citigroup Inc and UBS AG.
The $64,000 question is, in the longer term, when hot companies say, ‘If you want to be in my deal, (pre-IPO research) is what it takes,' will big banks be forced to take on this liability because of competitive reasons? said Richard Truesdell, co-head of the global capital markets group at law firm Davis Polk & Wardwell.
The Jobs Act, signed into law by President Barack Obama on April 5, is intended to make it easier for young companies to raise money.
Other provisions of the Jobs Act could also make banks more vulnerable to liabilities. The law reduces the regulatory barriers for firms seeking to launch IPOs by exempting them from some accounting and audit standards for up to five years, making research all the more important for investors.
Imagine what's going to happen when deal economics is getting decided by how good an underwriter's pre-deal research is, said a senior lawyer at a Wall Street bank who asked not to be named.
In making it easier for companies to go public, the biggest thing that's missing is investor protection, he said. IPOs will be measured by how they trade in the aftermarket. If investors go unprotected and they get burned in the process as a result, confidence in IPOs will diminish and the result will be less IPOs, not more IPOs.
Glowing pre-IPO reports could also lead to increased market volatility — already present in sectors such as software and Internet — if investors are told a certain security is worth significantly more than its IPO price.
If the company misses numbers and stock tumbles after the IPO, investors could sue the banks and the companies, saying, 'I relied on this research as part of my investment decision and the research estimates didn't come true,' said a senior source involved in implementing the act at another Wall Street firm.
Do the underwriters write it and concede to the demands of the issuers, or do they just say no because of the preservation of the volatility in the aftermarket and the liability risk?
The debate comes at a time when banks have come under intense scrutiny around their conflict of interest policies. In a recent court ruling, Goldman Sachs was criticized for advising El Paso Corp on its $21 billion sale to Kinder Morgan even though Goldman's private equity firm had a multibillion-dollar stake and its banker held a personal stake in the acquirer.
Banks are now scrambling to understand the implications of the Jobs Act, while remaining wary of changing any of their IPO practices as they await guidance from the Financial Industry Regulatory Authority and the U.S. Securities and Exchanges Commission on how the law will be interpreted.
Many Wall Street firms have already reached out to law firms, financial regulators and industry groups like the Securities Industry and Financial Markets Association for guidance, according to people familiar with the discussions.
For now, banks are being advised by outside counsel not to make a major change to their IPO practices, these sources said.
But experts worry that competition for winning underwriting mandates may eventually get in the way, especially for mid-tier and smaller banks, which are not part of the 2003 settlement and are trying aggressively to get into the underwriting market.
Banks will remain cautious in the short term but recognize it's a game-changer for everyone, said Andrew Fabens, a New York-based partner at Gibson, Dunn & Crutcher. Some may look to take advantage of it as soon as they can while maintaining safeguards to help protect themselves against investor suits.
(Reporting by Soyoung Kim and Olivia Oran in New York, Editing by Paritosh Bansal and Matthew Lewis)