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North Korea Comes To Wall Street

Try to imagine this:  Your e-mail and phone calls are constantly monitored by a group of people who can at any time block your communications for any reason they see fit.  Everything you write is closely reviewed and liberally edited by people whose sole job is to make sure that you are in strict compliance with government policies.  You can not speak to many outsiders, especially members of the press, without having an official “minder” present.  You can not even speak to many of your own co-workers without first getting official permission and even when you get that permission you must still have an official “minder” present to oversee the conversation.  Worse yet, if you do speak or write publicly, the government reserves the right closely parse whatever you say and charge with your serious crimes if they believe your speech has even slightly deviated from the government declared orthodoxy.

No, you are not a North Korean diplomat or Cuban baseball player, you are a Wall Street analyst.  That’s right, in the name of “protecting” investors, the government, in conjunction with the major investment banks, has conspired to create an Orwellian regulatory “regime” on Wall Street that Kim Jong-Il himself would be proud of.   While the regime differs somewhat by firms, today most Wall Street analysts have all of their communications monitored and often have e-mails, both inbound and outbound, “bounced” without explanation by their compliance departments.  Analysts must get official approval just to talk to their colleagues in their investment banking department and face severe reprimands for having even a simple “Hi, How are you?” conversation with a banker in the elevator lobby.  Even if they do get permission to meet with one of their investment banking colleagues, a member of the compliance department must mediate and oversee the meeting in order to insure that no inappropriate speech is uttered.   Some firms have gone so far as to require analysts to have “minders” present when they speak to the press or even when they visit a private company. One has to wonder: how has a country that prizes the freedom of speech and association as two of its most essential freedoms let those freedoms become so blatantly infringed upon?

The government justifies such infringements on the basis of “protecting” investors from potential conflicts of interest between the research and corporate finance arms of an investment bank.  The basic gist is that unscrupulous research analysts may only say positive things about a bank’s corporate finance clients because they stand to get a cut of the investment banking fees.  Such “false” advice constitutes fraud and therefore opens the door for the government to step in and regulate things.

But this logic has a very, very slippery slope.  If the government is trying to eliminate conflicts of interests in commercial relationships why are they stopping with investment banks?  There are obviously lots of other commercial relationships where consumers are “advised” by parties that have clear conflicts of interest such as:

  1. Realtors:  For many, if not most Americans the biggest investment decision they will make is not some Wall Street stock, but buying their home.   In conjunction with this transaction, most people must deal with realtors.  Realtors clearly do not have compliance departments looking over their writings or else classified listings such as “cozy, vintage, bungalow near mass transit” would read “small old shack next to railroad tracks”.  In addition, realtors can have huge conflicts of interest.  Not only do most realtors simultaneously represent both buy side and sell side clients, but if an agent works at Realtor XYZ they often have a vested incentive to show their clients mostly properties from Realtor XYZ and refer clients to their in-house mortgage banker.  Given this, as anyone who has ever shopped for a house will tell you, you should always be careful when dealing with a realtor because you never know when they are only looking out for their own interests.  That’s why word of mouth and reputation are so important in the realty business.  Sure, just like investment banks, realtors must deal with a fair amount of regulation and disclosure, but unlike investment banks realtors are not subject to draconian restrictions on what they write or who they can associate with.
  2. Car Salesmen:  Perhaps the second biggest financial decision that most people make after buying a house is what car to buy.  Car salesmen are of course notorious for being less than honest about the cars they are selling and for having lots of conflicts of interests such as dealer-rebates, in-house financing, etc.    However you don’t see the government threatening to throw them in jail every time they lie and say “this model is selling like hotcakes, but I might be able to reserve one for you if you can act today” when they know that their manager told them that morning “get this dog off the lot before the end of the month and I’ll pay you a special bonus.”
  3. Waiters:  Many diners often ask waiters “What’s good on the menu?”  This question presents a classic conflict of interest.  Waiters (in the US) receive most of their compensation in tips and thus have a strong incentive to recommend the most expensive item on the menu.  In fact, some restaurant managers are known to instruct waiters to recommend to diners the most expensive meals on the menu.  Applying the government’s security industry rationale to restaurants, any waiter that recommended the filet mignon when they actually felt that the cheaper pasta special was a better dish would be throw in jail.  Of course most consumers know that if a waiter immediately recommends the most expensive item on the menu, they probably don’t have the diner’s best interests at heart.

The point is that almost every commercial relationship in the world is subject to some potential conflicts of interest and the average sentient consumer is already well aware of this.  If consumers feel like they are being taken advantage of, they take their business elsewhere and the reputations of those service providers ultimately suffer.  Those service providers that are known to provide good service despite the inherent conflicts build good reputations which ultimately translate into brands which help build long term franchise value.  Wall Street analysts are no different.  Analysts who screw their clients by advocating bad deals get bad reputations.  Analysts that get a reputation for putting the interests of their clients first, even at the expense of their firm’s financial interests, ultimately have the best reputations.

The only difference with Wall Street analysts is that the government somehow feels that because their commercial relationship involves stocks and not houses or cars, that they have the right to intervene and impose draconian restrictions on freedom of speech and freedom of association.  Given that in the wake of the Internet bubble everyone pretty much hates Wall Street and Wall Street analysts in particular it’s easy to see how the government has gotten away with this (and the mainstream media, supposed defenders of free speech, have acquiesced to this) but it’s also important to contemplate the very slippery and inconsistent slope we are now on in terms of some of our most fundamental freedoms.

As some of you know, I was at one time a Wall Street analyst, so that is why this subject is near and dear to my heart.  This should not be read an attempt to rationalize or legitimize investment banking conflicts of interest.  I actually am a big supporter of full, clear and prominent disclosure of any potential conflicts and I think that government regulation is this regard is actually a good thing.  However I am opposed to the government either directly or indirectly imposing restrictions on our basic freedoms, especially when it’s crystal clear that the free market ultimately does a much better job punishing those who abuse conflicts of interest and rewarding those who don’t.  The government’s current posture towards Wall Street research represents one of the worst and most mis-guided examples of how the “nanny” state ultimately opens the door to unbridled authoritarianism in the trying to protect supposedly clueless citizens.

April 19, 2005 in Wall Street | Permalink

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The thoughts and opinions on this blog are mine and mine alone and not affiliated in any way with Inductive Capital LP, San Andreas Capital LLC, or any other company I am involved with. Nothing written in this blog should be considered investment, tax, legal,financial or any other kind of advice. These writings, misinformed as they may be, are just my personal opinions.