Search the Internet          Tips  Sites: Finance, Investment

Transparency, anyone?

Jamal Mecklai

Merrill Lynch recently acknowledged, in a $ 100 million settlement with the New York State Attorney General's office, that some of its equity analysts had recommended certain stocks even though their research suggested that these companies were "dogs".

This hustling of small investor clients was to ensure that Merrill Lynch could bag juicy investment banking contracts from these companies. The practice became so institutionalised that analyst compensation was (at least partly) determined by the impact their "analyses" had on investment banking revenues.

Of course, lest Merrill Lynch is singled out as the villain of financial markets, I must hasten to point out that virtually every investment bank on Wall Street (and in India?) had similar policies. Now, most of them are hurriedly revamping their approach to analyst compensation and are co-operating with the State Attorney General and so on to clean up their act.

While this analyst/investment banker conflict of interest is hardly a new issue, the timing of this substantial indictment of the system, coming, as it does, on the heels of that other great conflict of interest story (the Enron/ Arthur Andersen case) suggests that the Great Romantic Internet Era, spanning the last decade of the twentieth century, like other great romantic eras before it, has already had an irrevocable influence on human expectations and will lead to permanent changes in behaviour patterns.

The promise of the Internet was that, according to one of its denizens, it would no longer be possible to make money merely by leveraging whom you knew or by holding back or manipulating "price-sensitive" information.

Knowledge had come into its own. Welcome to the new world, where God was around the corner, technologically speaking. And as knowledge continued to increase its dominance, God would appear. And all of us - from the now-starving villager in sub-Saharan Africa to the trendy socialite sipping Evian in her 52nd Street penthouse - will become happy.

Clearly, even though the highest kites flown by the New Economy extrapreneurs have long since fluttered away, the essence of their vision remains a key driver of value.

Transparency - also called honesty, in lay terms - is becoming more and more commercially valuable. Certainly, the perceived lack of transparency - circa Enron, General Electric, Tyco, WorldCom - is sufficient to push market value substantially lower.

Scrutinising accounting practices has suddenly become sexy: we may soon see T-shirts reading, "Accountants do it in the blinding light of congressional hearings". Chief Financial Officers are suddenly waking up to the obvious: stock options are a cost, just like rent and electricity and need to be reflected in the account books.

And while there will be some resistance - large companies like GE and Cisco have quickly criticised a new "core earnings" measure being promoted by Standard & Poor's that tries to identify some of the more egregious within-the-rules accounting lapses of the past several decades - there is little doubt that transparency is here to stay.

Other equally within-the-rules conflict of interest structures are also coming under attack. Credit rating agencies get paid by companies to tell the investing world how worthy those companies are. In my experience, he who writes the cheque gets to call the shots. So, it is hard to see how long rating agencies (many of whom also provide consultancy services to business and industry) can retain their credibility in the face of the new "tell it like it is" demand from investors and markets.

Unfortunately, this conflict is substantially complicated. Rating agencies lead a charmed existence in that regulators and trustees use rating cut-offs to define capital requirements and investment policy.

Thus, in a sense, regulators subsidise (at no cash cost to the regulator, of course) the ratings business. However, the cost of this subsidy is ultimately borne by investors when the market drastically devalues bonds before the ratings are changed.

The emerging reality is that cross-subsidising service offerings - a wonderful way to create dense clouds of non-transparency - is no longer a viable business model. Knowledge vendors will, once again, sell products and services independently, rather than having them bundled apparently free with easier-to-sell services (like brokerage) or statutory requirements (like audit).

"Full service" financial companies (like the Big Four audit and consulting firms) will resist this for a while. There is considerable inertia in the system and genuine concerns that costs will rise. For example, mutual funds "pay" for the equity research that is embedded in brokerage fees since brokerage is counted as part of the fund's returns. So they do not discount the fees earned by the fund manager.

Thus, if mutual funds had to pay for research separately, they would either have to change the way they were structured or charge higher fees, thereby increasing the cost of buying equity through mutual funds.

However, the reality is that with greater transparency, some costs will rise and some costs will decrease; if the net effect of all this is that a particular cost (say, buying stocks) rises, it will simply reflect the true cost of that service or product.

In other words, there is no free lunch. If someone includes research recommendations and stock picks for free as part of the "full service" they offer, you can be sure that you will pay for it - and probably at a much higher price - in some other way. If a bank or a broker offers you "free" advice on foreign exchange or bonds or government securities, you can be sure that you will pay for it - probably at a much higher price - in some other way.

And if the management of a company that you want to invest in pays for a certification (audit report) that you use to make your investment decision without investing any of your own effort or money, you can be sure that you will pay for it - and, again, probably at a much higher price - some other way. Isn't it time for lunch?

Powered by

ALSO READ:
More Specials
More Money Headlines