Investment Industry
Who Really Profits: The Investor or The Investment Firm?
Investment Industry
Who Really Profits: The Investor or The Investment Firm?
Some say, ‘where there is lots of money to be made, there are just as many ethical
decisions to ponder.’ One place where this seems to hold true is Wall Street. The following is a
simplified look into the ethical actions of the big players in the investment industry. Conflicts of
interest arise in large investment firms due to their anomalous business interests. This discussion
will explain what the functions and goals are of an investment firm and the key players involved.
Each player’s roles and responsibilities will be examined, including factors that may encourage
unethical behavior. This will include a discussion of previously found unethical practices and
then lead into some reforms set forth to abate them. A brief conclusion will follow of possible
reasons why these behaviors exist in the investment industry and why the current reforms may
not be enough to control them effectively.
Securities are mainly bought and sold through a brokerage or investment firm. There are
generally two types of brokerage firms: discount brokers and full-service brokers. Discount
brokers tend to offer few services but charge a relatively low commission. Full-service brokerage
or investment firms, on the other hand, offer a wide range of service, including personal
investment plans and underwriting public offerings. They also market stocks, bonds, and other
financial products. The investment firm services everyone from the individual to the corporation
and allows the investor to find the proper investment for them.8 Simply put, an investment firm is
“a financial institution that sells shares to individuals and invests in securities issued by other
companies.”17
The key players in an investment firm include market specialists, underwriters, brokers,
customers, and analysts. Each plays an important role for the success of the investment firm.
Over time, these roles have been scrutinized for their apparent unethical overlap and the conflict
of interests that have risen due to them. To find the source of these conflicts of interest and to
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obtain a better understanding of the industry, a detailed examination of each key player follows. I
am fully aware many of these conflicts of interest have been identified by the Security Exchange
Committee (the governing body of the investment industry), and reform has been ordered
throughout the industry. However, I believe it is important to note that the conflicts of interest
that have been addressed are still very important to understand, since the reforms in place are
quite questionable as to their effectiveness.
The role of the marketing department in large investment firms is publicly noted to have
several roles. One role consists of targeting current and prospective customers and discovering
their needs. According to eFinancialCareers Staff, “Once they know what customers want,
marketing specialists design, price, and promote products and services to match customers’
requirements.” The second role of the marketing department in an investment firm is to promote
the firm as a whole. They work on developing an image and brand name for the firm. Plus, they
are often in charge of public relations. The third role of the marketing department has them
teamed with the sales division of the investment firm. Together they focus on specific investment
banking product areas. 9
According to PEI Job Futures, an underwriter at an investment firm, “underwrites new
issues of stocks and bonds, negotiates with corporations and governments to determine the type
and terms of new securities issued and prepare offering prospectus.” 16 Underwriters work
closely with the marketing and research departments.
Brokers are the players within the investment firm that ‘broker’ between the investor and
the security opportunities. First, brokers must develop a client base. This is an on-going task for
most brokers to increase his/her performance levels. Brokers then meet with clients, either the
individual or an institution, to find out their short and long-term goals, and their risk-levels to
create the correct portfolio for them. The broker then assists with portfolio management, which
consists of buying and/or selling stocks, bonds, commodities, and options. To be effective, the
broker must maintain many skills to correctly analyze past, current, and future market conditions.
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Most brokers also do some research on the individual securities they push to their clients,
although this is not always the case.6
According to a retired financial advisor from one prestigious investment firm, the brokers
attended seminars put on by the marketing department of their own firm, which pushed certain
stocks to sell. This practice is not publicized and may still continue today. Another practice,
which has been made illegal since the 90’s, involves sales contests. For years, the investment
firms held sales contests for specific securities they wanted to push. Perks, such as fishing trips,
ski trips, free lodging, executive skyboxes for sporting events, and $100 pens were doled out for
compensation. Another illegal practice brokers have been found guilty of is called ‘churning.’
Brokers get a commission on every trade they perform for a client. The legal way to success is to
have a large customer base to increase the number of trades a broker is likely to perform. Instead,
some brokers would ‘churn’ by trading a lot of stocks for just a few clients. In the past, many
investment firms did not have a large number of monitors, so this ‘churning’ would go
unnoticed.2
The role of the customer of an investment firm is very important. There are three main
customers: the individual investor, the businesses being brought public, and less known are the
owners of the securities suggested by the investment firm. The individual investor may be better
mentioned for what they give up rather than what they bring to the firm. Each investor must sign
a contract giving up their legal right to sue the broker or investment firm for any wrongdoing.2
Instead, if an occasion arose for the individual investor to want to sue the firm, they would have
to go through an arbitration process, which must be approved by the SEC.21 Mark E. Lackritz,
president of the Security Industry Association claims, “arbitration continues to be a far more
efficient and cost-effective dispute resolution mechanism than traditional court-based
litigation.”12 An arbitration panel typically consists of one ‘industry’ arbitrator and two ‘public’
arbitrators. In the past, arbitrators have been known to represent the firm’s interests, because
either the firm or the companies that issued the stock in question is a key investor in one or more
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of the arbitrators law firms. In addition, there is no legal educational or experience requirement
to be an arbitrator. The arbitration system is commonly known by many to be flawed.21
In the past few years, analysts for investment firms have been under the most scrutiny for
the conflict of interests that rest in their daily activities. Analysts mainly conduct research for the
investment firm and then make recommendations upon their research. They research publicly
traded securities, privately held companies and entire industries.3
In addition to issuing reports, analysts also give presentations to new investors on the
companies they find promising.5 Research analysts were often involved with and compensated
for investment banking work and participating in sales meetings and public presentations.
Although, most analysts possessed a post-graduate degree, only a select few jurisdictions required
analysts to pass an exam to prove their knowledge of the investment industry and regulatory laws.
This is interesting because the vast number of investors commonly base their investment
decisions on the research and advice of analysts.14
The job of an analyst sounds simple and straightforward, but many conflicts of interest
present themselves. The Association for Investment Management and Research (AIMR) believe,
“that conflicts of interest abound in the investment industry and are inherent to the role of
research analysts in the securities industry. The issue is not whether conflicts exist, but rather
how the conflicts are dealt with.” The AIMR has identified what they believe to be the four main
conflicts of interest that are present in the job of an analyst:

An analyst may play a dual role within a firm: making recommendations regarding
investments for the firm’s clients while at the same time assisting the firm with trading,
investment banking, or other interests.

Firm compensation arrangements for analyst may encourage an analyst or his supervisor to
favor one such role over the other.

An analyst or his or her firm may have a position with an issuer that is the subject to the
analyst’s investment recommendations.
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
An analyst or another member of his or her firm may be a director of an issuer’s firm or may
be receiving perks or other benefits from an issuer 7
Benchmarkalert.com went as far as to plainly state, “research provided by investors is not really
research at all. It is promotional material related to moving the firm’s inventory of securities or
strengthening the firm’s investment banking franchise.”3 In this case, someone else seemed to
come to similar conclusions, the SEC.
In May 2002, Lori Richards, representing the Security Exchange Committee (SEC), gave
a speech that added to the list created by the AIMR. Richards stated common conflicts of
interest the SEC has found since the summer of 1999 in many analysts’ dealings. The first
discovery noted that many research analysts were involved with private companies long before
they went public. The analyst would research the company, which seems to part of their job
description, but in this case the analysts are offered a share in the company before it goes public.
The SEC also found that if the analyst’s own company underwrote the IPO (initial public
offering), the analyst would in every case give the company a good rating. In addition, analysts
were also found to recommend a ‘buy’ rating, while in private the analyst would sell their own
personal shares. The SEC also noted that throughout the history of the investment industry, there
were no set policies or laws that prohibited analysts from owning stock that the company
represented.19
The SEC also found that investment firms were not complying with the Self-Regulatory
Organization’s (SRO) rules. The SRO rules set forth to require each investment firm to monitor
the security holdings of each of their employee. Most of the firms examined by the SEC were
not aware of the securities their employees held in the companies that they brought public. In
addition, the SEC also noted many occurrences where analysts would announce publicly (on
television, radio, and other media sources) their recommendations with absolutely no mention of
any conflicts of interest that may be present. The recommendations the analysts made also
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alarmed the SEC. They found that the ratings analysts used (“buy,” “sell,” “strong buy,”
“outperform,” etc.) were confusing to those they were intended to guide, the investors.19
Another finding by the SEC was attributed to holes in the SRO rules. There was not a
consistent rule across the investment industry for firms to disclose publicly whether their
employees held securities in those they recommended. Instead, most firms gave a blanket
statement informing clients that employees may or may not hold those securities in the
companies they recommend. 19
The SEC also found that many analysts were compensated according to the profitability
of the investment banking division of the firm. Since the analysts often wrote reports on the
companies that the investment unit of the firm underwrote, this set forth yet another conflict of
interest. 19
To address these issues, the SEC and congress pressured the NASD and NYSE (SROs) to
set forth a new set of rules governing the investment industry that were put into affect May 8,
2002. The first rule limited the relationship between analysts and investment banking divisions.
This was to allow for independent research and to secure the objectivity of the analyst. 19
The second rule banned analysts from being compensated for investment banking
transactions. This was also enacted to encourage the objectivity of the analyst. 19
The third rule enforced disclosure of any other involvement with or compensation from a
company for which the investment firm brought public. This rule was meant to inform the public
of any possible biases the investment firm may have in its recommendations. 19
The fourth rule targeted unfavorable recourse from analysts towards companies that may
choose to go elsewhere for their investment banking. In turn, this also prohibits analysts from
promising good ratings to companies to entice their investment banking business. This rule
stated that analyst could not offer a rating for companies their firm brought public until after 40
days of the initial public offering. This would allow for uninterested parties (i.e. analysts from
other firms) to report unbiased recommendation at the outset of the offering. 19
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The fifth rule prohibited employees or their families from purchasing securities from a
company before they ‘go’ public. This rule also restricts the personal trading by an analyst to
outside the bounds of 30 days prior or five days after they issue a report on a particular stock.
This rule was meant to eliminate the conflict of the analyst’s own financial interests. 19
The sixth rule requires both the employee and the firm to publicly disclose any holdings
they have in a company’s security of which they are making a recommendation. This rule allows
investors to come to their own conclusions on whether the recommendation may be bias.19
The seventh rule commands investment firms to make clear all ratings terms used in their
recommendations. Plus, all firms must make public the percentage of buy –sell –hold ratings
that their analysts recommend. Included in this is the percentage of each rating given to their
own investment banking clients. In addition, the firm must provide graphs on each
recommended holding that plots the movement of the security’s historical pricing, including the
ratings, which the investment firm offered, related to each point on the graph. This rule is
intended to help the investor have a clear picture of how the investment firm’s ratings compare to
the actual performance of the securities. 19
The last and eighth rule set forth requires analysts that appear in public media sources, to
clearly state if themselves or their firm holds any securities in the company or if the company is
an investment client of the firm. This rule is meant to alert the investor of any potential conflicts
of interest, who may otherwise not have access to this information. Overall, these rules were
meant to alleviate conflicts of interest among analysts, and to help regain the publics trust in
investment firms.19
So, did these new rules reform the investment banking industry and eliminate the
conflicts of interest? Nearly one year after the rules were put in place, April 8, 2003, the largest
investment industry fraud case in history was settled, which included 10 of the industries largest
investment firms. According to Carrie Johnson of the Washington post, the “brokerage firms
agreed to pay $1.4 billion …to settle charges that their investment banking divisions exerted
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improper influence on securities research reports - - with analysts praising companies publicly
that they derided privately.”11 Although the brokerage firms agreed to pay the $1.4 billion, they
did not admit to the allegations brought against them.21
Merrill Lynch was one of the investment giants that was found to be making positive
recommendations based on research done by their own analysts, while badmouthing the stock
behind closed doors.20
Other giants, such as Arlington’s Friedman, Billings, and Ramsey Group, Inc. were
included in the seven investment banking firms that settled with the SEC for $3.65 million. The
main count brought against them was for publishing research reports on companies that were
paying them and not publicly disclosing the information. Charges were also brought against
these firms for not saving records, emails, and research reports.18
The prevalence of conflicts of interest is evident in the investment banking industry. The
reforms issued in May 2002 were clearly targeted to alleviate these conflicts of interest. Not
even a year after the SEC put forth the new regulations, numerous large investment firms were
found guilty of several violations. It may be beneficial to look at possible root causes of these
unethical and serious charges. The following discussion includes several postulations of how and
why these conflicts of interest have arisen in the investment banking industry.
Robert Weiss, an attorney representing middle-class investors, clearly addresses what he
believes to be the driving force behind the conflicts of interest in the investment industry, in an
interview with NewsMax, in May 2003. He begins in 1974 when the securities industry was deregulated. To stay competitive, firms reduced their fees many times over. When competition
increased even further due to online brokers, in the 90’s, large firms had to find alternate revenue
sources. They found new, big revenue sources in fees from investment banking deals with large
corporations, such as Enron. Weiss notes that “hundreds of billions of dollars in fees” were
collected. Suddenly, investment banking became the most profitable division of an investment
firm. Weiss claims “the new emphasis on investment banking meant that brokerage firms were
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no longer working for stock purchasers but now were working for stock sellers.” He goes on to
state, “All of the incentives were to sell stocks, never mind whether they were sound or not.”21
Weiss also believes that the reforms in place will not be enough to rid the industry of
unethical dealings. He points out that the fines charged to large investment firms are such a small
portion of their total income, it does not act as a deterrent. According to a Safe Money Report in
April 2003, “they [investment firms] can pay the entire fine with the revenues from just one
business day.” Weiss says this is the fault of the SEC, claiming the governing agency itself is
controlled by the investment industry.21
Finally, Weiss gets down to the bottom line. He believes the system will not change due
to how the investment banks earn their money. As long as the same investment firm ‘researches’
and makes recommendation about the same companies that produce their main revenue source,
there will continue to be illegal and unethical behavior. 21
Scot J. Paltrow, a staff reporter for the Wall Street Journal purposes yet another idea of
why illegal and unethical behavior is so prevalent in the industry. He believes investment firms
can’t help but take advantage of the individual investor, “Wall Street firms in modern times can’t
resist treating men and women of Main Street as chickens to be plucked.” Paltrow attributes this
to the same reason as Weiss; he believes individual investors became less important as the main
revenue source switched from individual broker sales to underwriting and investment banking
deals.15
Paltrow goes on to state, “Over time, taking advantage of the naivete of individual
investors became a convenient way to gain and keep big corporate clients.” In addition, he
claims, “many argue that firms can take advantage of individual investors only because greed,
excessive optimism and failure to heed warnings make many of them all too easy targets.” He is
basically claiming that the investment industry justifies their unethical behavior because he/she
thinks the average investor is so dumb that they will never be the wiser and they may even
deserve it. Paltrow says this is especially easy to do in a bull market; everyone is making some
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money, so no red flags are raised. Maybe they were right, but did those firms question the
consequences in a bear market? The problem with this reasoning became clear in the dot.com
crash when everybody lost and red flags triggered the largest fraud settlement in the investment
banking history. 15
Paltrow again follows Weiss and points to the SEC as a cause for the continuing behavior
of the investment industry. Paltrow states, “the SEC is overtaxed and chronically underfunded.”
In addition he quotes Lynn Turner, a former SEC chief accountant, “[he] likens the situation to
having only two cops to chase speeders on the interstate between New York and Boston.
“Frankly, you can go 94 [miles per hour] without being too worried about getting caught.”” He
claims the reason the SEC is underfunded is due to Wall Street’s campaign contributions to
Congress. 15
In contrast to Weiss and Paltrow, researchers Don A Moore, Phillip E. Tetlock, Lloyd
Tanlu, and Max H. Baserman purpose two theoretical arguments: “moral seduction” and “issuecycle” theory. First, they realize the potential conflicts of interest that lie in the investment
industry as noted in the above discussion. To even further show the obvious unethical actions
that prevail in the industry they cite a survey performed by the SEC in 2000. “A period during
which the stock market was in broad decline (the Dow Jones Industrial Average dropped 6
percent, the Standard & Poors 500 index dropped 10 percent, and the NASDAQ dropped 41
percent), 99 percent of brokerage analysts’ recommendations to their clients remained “Strong
Buy,” “Buy,” “Hold” (Unger, 2001).”13
The researchers claim their first theoretical argument, “moral seduction” is due to fact
that “the majority of professionals are unaware of the gradual accumulation of pressures on them
to slant their conclusions...” They allege that investors honestly feel that outsiders claims against
them are unfounded and unjust. The researchers say these behaviors are obvious human traits
including, “motivated reasoning and self-serving biases.” In addition, they say the unethical
behaviors are only intensified by the incentives put forth on these individuals. 13
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The second theoretical argument “issue-cycle” theory purposes that society encourages
the current system in which the investment industry functions. The researchers suggest that
“issue-cycle” theory “accounts for four recurring patterns in the real world: (1) many
organizations aggressively and successfully promote legislative and regulatory changes that work
to their advantage; (2) these organizations manage to create sufficient attributional ambiguity
about their rent-seeking behavior and thus stay below the radar screens of potentially
countervailing interest groups; (3) some of these organizations over-reach in these efforts and end
up inflicting tangible losses (not just opportunity costs) on well-defined, influential
constituencies, thus becoming the targets of political backlash; and (4) organizations often
recover surprisingly quickly after outrage fades and reconcentrate their lobbying efforts against
the diffuse sources of countervailing power.” The researchers imply that these patterns are
responsible for the continuing unethical behavior that is prevalent in the investing industry.13
The investment banking business seems to have been riddled with unethical behavior
since it began. In the past seven years, many new reforms have been put in place (many of which
were not included in the discussion due to limited space) to try and control the unethical behavior
of the investment industry players. Since the market began to decline and the reforms have been
established, more and more scandals have surfaced. To this day the anomalous business interest
still remain in the industry, there is still lots of money to be made, and ethical questions continue
to be pondered.
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Case Questions
1. What is in the best interest of the broker? The research analyst? The underwriter?
The marketing specialist? The investment firm?
2.
What is in the best interest for the client? The individual investor? The IPO? The
revenue producing corporate client?
3. What are all of the main conflicts of interest that arise from these self-interests?
4. How will we know when the investment industries conflicts of interest have been
remedied?
5. Today, do you believe the monitoring system is ‘fixed,’ honest, and effective?
6. What are questionable activities within the investment industry that are still legal?
7. Do you believe analysts release honest research results or do you see it as
promotional material?
8. How much financial damage do you think has been incurred from the proposed
conflicts of interest? To the investor? To the investment firms? Which is higher?
Who pays a ‘higher price?’
9. What minimum standards do you believe should be set forth by the SEC?
10. Do you see the SEC as an effective governing body? Why?
11. Do you believe there should be additional governance over the investment industry?
If so, what solution would you propose?
12. Do you believe the new addition of the Sarbanes-Oxley governance will be more
effective than the previous reforms put forth by the SEC? Why?
13. Do you believe the arbitration process currently used to settle disputes between
private parties and investment firms is fair? Why?
14. Do you think the conflicts of interest present in the investment industry today can
ever be overcome? Do you think the actions are part of human nature?
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References
1
About.com Investment Banking Resources. Retrieved March 21, 2005;
http://beginnersinvest.about.com/od/investmentbanking/
2
Anonymous. Former financial advisor for a large investment firm. Interviewed February
23, 2005.
3
Benchmarkalert.com. Retrieved March 20, 2005;
http://www.benchmarkalert.com/library/alerts/0801.html
4
Benchmarkalert.com. Retrieved March 20, 2005;
http://www.benchmarkalert.com/advisory/
5
Bureau of Labor and Statistics. Financial Analysts and Personal Financial Advisors.
Retrieved March 21, 2005; http://www.bls.gov/oco/ocos259.htm
6
California Occupational Guide Number 252. Labor Market Information: Securities
Brokers. 1996. Retrieved March 20, 2005;
http://www.calmis.cahwnet.gov/file/occguide/SECBRKRS.htm
7
CFA Institute. Retrieved March 20, 2005;
http://cfainstitute.org/advocacy/99commltr/99anstan.html
8
Datek.smartmoney.com. Web definitions for Brokerage firm. Retrieved March 21, 2005;
http://datek.smartmoney.com/glossary/index.cfm
9
eFinancialCareers Staff. Marketing and PR. Nov. 1, 2004. Retrieved March 20, 2005;
http://efinancialcareers.com/SECTOR_PROFILE_ITEM/newsItemId-18500000000018542
10
Iseek.org. Career: Securities Salespeople. Work Activities. Retrieved March 21, 2005;
http://www.iseek.org/sv/13000.jsp?id=100444
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11
Johnson, Carrie. 7 Firms Settle SEC Disclosure Charges. Washington Post.
Wednesday, August 25, 2004. P E01 Retrieved March 21, 2005; http://washingtonpost.com/wpdyn/articles/A30330-2004Aug24.html
12
Lackritz, Mark E. Testimony before the Committee on Financial Services U.S. House
of Representatives. March 17, 2005. Retrieved March 30, 2005.
http://www.sia.com/testimony/html/sec-arbitration3-17-05.html
13
Moore, A. D., Tetlock, P. E., Tanlu, L., Bazerman, M. H. Conflicts of Interest and the
Case of Auditor Independence: Moral Seduction and Strategic Issue Cycling. Working Paper
#03-115. Rev. 09/04.
14
OICV-IOSCO. A report of the technical Committee of the International Organization of
Securities Commissions. September, 2003. Retrieved March 21, 2005;
www.iosco.org/pubdocs/pdf/IOSCOPD152.pdf
15
Paltrow, Scot. J. The Dark Side of Wall Street: Why Scandals Continue to Erupt. The
Wall Street Journal. December 23, 2002. Retrieved March 20, 2005; http://www.hermespress.com/WS_dark_side.htm
16
PEI Job Futures. Underwriters. Retrieved March 20, 2005;
http://www.pei.jobfutures.org/profiles/profile.cfm?noc=en&site=graphic
17
Princeton University. Web definition for investment firm. Retrieved March 21, 2005;
www.cogsci.princeton.edu/cgi-bin/webwn
18
Reuters. Brokers settle with SEC over research payments. USA Today. August 25,
2004. Retrieved March 22, 2005. http://www.usatoday.com/money/perfi/funds/2004-08-25-secbrokers-research_x.htm?POE=MONISVA
19
Richards, Lori. Speech: Analysts Conflicts of Interest: Taking Steps to Remove Bias.
New York, New York. May 8, 2002. Retrieved March 22, 2005;
http://www.sec.gov/news/speech/spch559.htm
15
20
SecuritiesfraudFYI. How Did Merrill Lynch Defraud Investors? Retreived March 21,
2005. http://securitiesfraudfyi.com/merrill_lynch.html
21
Wollstein, Jarret. How to Get Your Money Back From Wall Street’s Crooks. Interview
with Robert Weiss. NewMax. Wednesday, May 28, 2003. Retrieved March 20, 2005;
www.stockmarketfraud.com
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