Analysts and lawyers plaguing tech companies

On the west coast this week, VA Linux, our parent company,
will announce its most recent quarterly earnings. That announcement
will have followed months of sober re-assessment of where the money
is in the Linux business. It has been a tough stretch. The mood hasn’t
been helped by dozens of legal sharks circling the both the company and
the investment banks that helped it go public.

It is no secret that
the wild run-up of VA Linux’s stock following its IPO has been cited as
the most extreme example of the “irrational exuberance” that
characterized the Linux and Internet speculative bubble. Its subsequent fall-off
attracted suspicion and lots of lawsuits.

Whatever the merits of the particular legal claims in the VA Linux
case, there’s blood in the water, and lawsuits are mounting against a host of
Linux companies and dot-coms. As of last week there were nearly seven
hundred lawsuits pending just in the U.S. District Court for the Southern
District of New York. Lawsuits are being filed at the rate of over 50 a week.
Suits typically name both investment houses and the firms they
promoted, although in many cases companies were taken along for the ride, right
along with stockholders.

Much of those stock run ups were driven by hilariously inaccurate
“recommendations” generated by analysts who worked for investment banking companies underwriting stock or holding it in speculation. Toward the end of the stock
bubble these recommendations had become an industry in of themselves.
Analysts dominated cable shows. Services like First Call, which featured analyst
speculation, became required reading among investors. Unfortunately,
the advice these analysts gave was worse than valueless. Earlier this
summer, four professors from the University of California’s Haas School
of Business studied “buy” and “sell” recommendations by analysts
attached to U.S. investment banks like Goldman Sachs and Merrill Lynch . Their
report, titled “Prophets and Losses,” found that the average stock recommended
by analysts fell over 30% below the market average. Stocks with sell or similarly
negative recommendations outperformed the market by nearly 50%.

One major reason for these inaccuracies has been blatant conflict
of interest. In a statement before the U.S. House, Rep. Edward
Royce (R-Calif.) cited the example of Merrill Lynch’s high profile
“analyst” Henry Blodget. Blodget is best known for his nearly tireless promotion
of Amazon.com, which sent the company’s stock price soaring toward $400
per share until reality sunk in. According to Royce, Blodget should be better
known for what he did to GoTo.com. During the period when Merrill Lynch
and Credit Suisse First Boston (CSFB) were competing to be the chief
underwriter of GoTo’s stock, Blodget couldn’t say enough good things about the
company. Within two hours of CSFB winning the business instead of Merrill, Blodget
downgraded the stock.

Is this ethical? American courts are deciding if its
legally actionable. This week, U.S. District Judge Milton Pollack threw out
lawsuit aimed at Morgan Stanley Dean Witter and its star analyst Mary
Meeker. The lawsuit, one of several, alleged that Meeker issued impossibly
optimistic “analysis” concerning Amazon.com with one objective — to generate fees
for her employer and hike her own salary. Pollack dismissed the suit
without a hearing, saying that the allegations were repetitive and in
“bad taste.”

Bad taste or not, the entire investment industry has been tarnished.
The Association for Investment
Management & Research (AIMR) and its chair, Thomas Bowman,
suggested that the analyst community ‘fess up to the fact that ”
firms pressure their analysts to issue favorable research on current or
prospective investment banking clients,” including IPO candidates, and warned
that that not fixing the problem will result in “… deteriorating
investor confidence in the independence and objectivity of … research reports
and recommendations.” Bowman warned that this “does NOT advance the
interests of the global investment community.” Strong language for a trade group,
but the AIMR consists of more than just analysts. The organization
caters to portfolio managers, fund managers and a variety of other
investment specialists.

AIMR has embarked on an aggressive revamp of its own regulations.
The organization’s Board of Governors has generated an Issues
Paper on Analyst Independence. (PDF file). The paper is remarkably frank,
suggesting that “the perception that research reports and recommendations are
biased threatens the reputation of the entire profession.”

Self-regulation may require government assistance, and,
remarkably, many North American regulators don’t seem to want to address the issue
head on. During discussions with Canadian regulators, the AIMR had to
protest that a set of proposed regulationsweren’t strong enough. In response to questions, the AIMR suggested that proposed regulations, like forcing disclosure when an analyst’s company owned over 10 percent of a company, was far too lax. The AIMR suggested that “investment positions below the 10 percent threshold pose significant conflicts of interest.” It further
suggested that a proposed requirement that analysts not serve on the boards of
firms they review be extended to an analyst’s employees and associates. The
AIMR suggested that the common practice of basing analyst pay on the
revenues generated by the investment bank was an obvious conflict of interest.
(Surprisingly few analysts are compensated according to their
accuracy.)

The AIMR also suggested that analysts post a history of their
recommendations so that consumers could judge for themselves if a given “analyst” had
any credibility.

U.S. regulators and politicians seem even less eager to take on the
investment bankers and support a clean up of the analyst community.
Under pressure, the U.S. House of Representatives Subcommittee on Capital
Markets recently held hearings concerning alleged abuses by stock analysts.
Committee Chair, Rep.
Richard Baker, (R-La.) suggested that public concerns about analyst
integrity and independence were
“fully warranted”. However, the majority of the committee
seemed inclined to stay out of the issue.

Other congressmen were simply embarrassing. Throughout the hearing,
Connecticut Rep. Christopher Shays seemed to be having trouble
understanding what analysts had done wrong. Texas Democrat Ken
Bentsen suggested that investors were to blame — they simply didn’t
read the boilerplate in the average stock offering. Rep. Michael
Oxley (R-Ohio) spent much of his time during the first day of
hearings speculating that the “media” was somehow responsible for the problem.

Under such circumstances, the most that the AIMR can expect is lip-service
support for industry self regulation. But until some sort of internal or
external regulation takes hold, the complaints and the lawsuits are likely to
continue to plague dot-coms and Linux pioneers for some time to come.