Sin Citi
November 25, 2014

Sin Citi

Wall Street was supposed to have cleaned up its act following the excesses of the late 1990s. But the latest enforcement action from FINRA against Citi indicates the stench from the Street is still as foul as ever.

“These are the old days man, the bad days, the all-or-nothing days. They’re back!”  Merv, Sin City

The FINRA letter runs to 13 pages, and contains a wealth of salacious details that have got the whole industry talking. The “sins” cited by the regulator against Citi focus on two key areas: Selective Disclosure and Chinese Walls.

Selective Disclosure

The most colorful evidence raised in the enforcement letter comes out of the “ideas dinners” held by Citi analysts, where the ideas touted were inconsistent with published research.

“at an idea dinner that occurred in July 2011, a CGMI equity research analyst [identified by the WSJ as Deane Drey] identified a stock as a “short” pick. Before the dinner, however, the analyst had upgraded that stock from Sell to Hold and reiterated his Hold rating on the company in the last report that he published prior to the dinner. Moreover, the analyst identified other companies, on which he had Hold or Neutral ratings, as “short” picks at six subsequent idea dinners between October 2011 and June 2013”

Let’s for a moment suspend disbelief and assume that the views of Citi analysts are worth something to somebody. As a fund manager I’ve certainly come across situations like this in my career. Often this occurs because an analyst assumes “Neutral” is code for “Sell” (they just don’t want to be impolite in front of management). Sometimes it’s because they see a short-term opportunity to buy or sell, but don’t want to change their official rating for a “low-quality” reason. In either case this is clearly bad practice and it’s right that the regulator punishes this.

However these transgressions distract us from the more sinister practice of pure “front-running”, where an analyst discloses a rating change to a favored client ahead of publication.   FINRA does not cite any examples of this, I imagine because it’s much harder to unearth (both analyst and fund manager have an interest in keeping the information private and are unlikely to communicate such content by email or over a recorded line).

Regardless, FINRA are going after what they can see. And they come to the conclusion that much of the problem stems from a flawed compensation structure and a lack of oversight. In the letter they go on to state:

“Approximately half of each equity research analyst’s “scorecard” rating was related to interactions and feedback with both internal and external clients…This compensation structure, while not inconsistent with the regulatory framework…created an incentive for CGMI equity research analysts to engage in inappropriate communications with clients…GGMI did not adequately supervise interactions between its equity research analysts and clients to deter improper communications in light of this incentive”

Perhaps the most damning evidence from the report relates to the lack of sanctions imposed on the offending analysts. If the firm itself is unprepared to punish the bad behavior of its analysts, then it’s no wonder that these transgressions are so rampant – it certainly reflects poorly on the (undoubtedly overstaffed) compliance department. The following paragraph is great [my emphasis]:

GGMI disciplined an equity research analyst four times for conduct that violated various CGMI policies regarding research reports and client communications. The firm imposed some of the discipline long after the analyst’s prohibited conduct and did not impose and any enhanced discipline for the analyst’s repeat violations. The analyst’s repeated policy violations were never mentioned in any of the analyst’s performance reviews

Failure of Chinese Walls

The evidence from FINRA focuses on a senior equity analyst [identified by the WSJ as Mark Mahoney], who provided feedback and advice to company management during an IPO roadshow. The analyst participated in a practice session, received draft road show presentation slides and sent an email to company representatives in which he suggested that the company should “amp up” discussions of certain topics.

This may not sound like the worst thing to ever happen on Wall Street, and I’m sure it’s not. But again, it probably represents the tip of the iceberg. If the analyst is so blasé about breaching the Chinese Wall in this manner over a medium he knows is monitored, you wonder about what else is going on behind closed doors. The relationship here is rife with potential conflicts of interest.

A Citi in Decline

Time and time again the regulators have come down on the banks, yet the violations continue. The paltry $15m fine associated with this settlement is unlikely to prove much of a deterrent.   Apart from some mild embarrassment, I imagine Citi will get over this one quite rapidly.

But while many see this defiance as a sign of strength, I see it as a sign of desperation. The model of Wall Street research has been broken for some time and the function has always struggled to pay for itself. The long-term trend is towards declining commissions as clients vote with their feet, while compliance costs rise ever higher.

To my mind the model is so thoroughly broken that it is pointless to try to fix it now. By the time the regulator cracks down, there may not be much left to regulate. Other models have been rapidly stepping in to fill the void previously occupied by the banks. I believe online research platforms, including StockViews, will have a much larger role to play in the future due to two obvious advantages: Firstly ratings which are completely transparent (and performance track records associated with those ratings). Secondly analysts who are incentivized to create alpha, not commissions. As the veil comes down on the seedy world of Wall Street and the corruption becomes ever more apparent, the attractions of the alternatives will become ever more obvious.

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