Date:    05/19/2000  1:12 PM

Subject: RE: Proposed Regulation FD: File No. S7-31-99

The Myth of Analysts' Best Practices 
     
By Bill Barker (TMF Max) 
May 18, 2000 
     
Here in the Fool on the Hill space, we've been keeping our eyes on a new 
rule proposed by the Securities and Exchange Commission (SEC) regarding the 
fair disclosure of material information by publicly owned companies. As you 
may know, public companies are allowed to give material information to Wall 
Street analysts before they make it known to the public. Wall Street, of 
course, loves the status quo, and is fighting mightily, though I would say 
far from valiantly, to stop the SEC from enacting the rule that would erase 
Wall Street's special privileges and level the playing field. There are now 
about 4,000 public comments up on the SEC's website, by my estimate nearly 
3,000 or so coming from readers of this site.
     
One that doesn't come from our readers, though, is Merrill Lynch's public 
comments. Let's take a look at the argument that this Wall Street leader 
puts forward and the rather persuasive evidence that Merrill Lynch is 
knowingly misrepresenting the truth of the matter.
     
In a May 5 letter to the SEC on behalf of Merrill Lynch, Carlos Morales 
argues that there is really no problem with the current system of companies 
giving material information to analysts, though there might possibly be some 
people who are not as highly principled in their actions as the fine, fine 
employees of Merrill Lynch. What the SEC should really be thinking about, 
writes Morales, is getting everybody else to act more like the employees of 
Merrill Lynch:
     
"We believe that the Commission should give greater thought to identifying 
best practices with regard to the dissemination of material information and 
should encourage [companies] and analysts voluntarily to follow these 
practices. For example, Merrill Lynch requires its analysts uniformly to 
disseminate their comments to both retail and institutional investors 
simultaneously. Analysts are not permitted to convey information, or their 
opinion of that information, to any Merrill Lynch trader, institutional 
investor or any specific person until the analyst has made such information 
available to all of Merrill Lynch's clients."
     
Oh, really?
     
In an outstanding must-read Washington Post article entitled "Analyst With a 
Knack for Shaking Up Net Stocks," writer David Steitfeld followed well-known 
Merrill Internet analyst Henry Blodget around on February 2 -- the day 
Amazon.com (Nasdaq: AMZN) reported its fourth-quarter earnings for 1999. We 
learn a number of things about the way analysts operate, among them being 
that Merrill's analysts do communicate with individual clients before making 
their comments known publicly. In this particular case, Blodget received a 
private call from Amazon execs (after the conference call) to update him 
personally on what his revenue estimates for the next quarter should be. 
Blodget was then on the phone with a number of clients informing them of his 
latest thoughts on Amazon, all prior to going public with his comments -- 
including a raised price target and upgrade -- the next day. As Blodget 
eloquently noted regarding his upgrade of Amazon.com, he wanted "to 
differentiate it from all the pieces of [expletive] we have buys on."
     
I don't really care about Blodget's private discussions when he was 
apparently under house orders to be quiet, or about his cynical comments 
regarding his role in a profession that deserves cynical treatment. I don't 
expect analysts to withhold their thoughts from their richest clients until 
they can be known to the lumpenproletariat, and if Merrill Lynch wants to 
misrepresent how the system really works to the SEC, I've no doubt that the 
SEC commissioners aren't as gullible as Merrill seems to think. The broader 
issue, which is demonstrated magnificently in the Post article, is that the 
entire method of analyst conversations with companies is designed to 
purposefully hide the truth from the public, rather than help reveal it.
     
In his letter to the SEC, Merrill's Morales states, "Although we applaud the 
Commission's goal of promoting broad disclosure of material information, we 
are concerned that the practical effect of Regulation FD will be exactly the 
opposite: it will discourage many [companies] from disclosing much of the 
information that now enters the marketplace." The argument here is that the 
current unfettered interplay between analysts and companies results in a 
near-perfect distribution of information into the marketplace -- but you 
simply can't come to a similar conclusion from reading the Post piece. It is 
quite evident that analysts aren't talking to companies simply to ferret out 
the most useful information for their clients and convey it to the 
marketplace -- there's something else at work.
     
In a particularly telling moment that discusses Blodget's private 
conversation with Amazon's execs, the article notes: 
     
"The Amazon folks know exactly what Blodget is thinking because he's 
e-mailed them his financial model -- an extensive breakdown of Amazon's past 
results and future expectations. 'Feedback is valuable,' the analyst says. 
'It's become so important for a company to beat expectations that they want 
to make sure they don't get out of hand.' Investors also like a company to 
beat forecasts. As a result, there's a tendency in models to keep 
expectations modest -- to say that Company X will increase profits by 10 
percent. Then the earnings come in, as usual, 20 percent higher. The stock 
jumps, and everyone but the short sellers are happy. So on stocks such as 
Amazon, Blodget keeps a private model, too. This one doesn't incorporate 
feedback from the company. It's more speculative. It's also probably closer 
to the truth...." (Emphasis added.)
     
So Blodget is willing to admit that he alters his publicly made comments to 
serve the companies he covers. He's also willing to admit to one of the most 
widely read papers in the country that he's perfectly capable of producing 
an estimate that is closer to the truth with no input from the company than 
what he actually does produce with guidance from the company.
     
If this example is representative of the way that analysts work -- and I 
believe that it is -- then it is not persuasive for Merrill, or any of the 
other of Wall Street's many, many conflicted brokerages, to argue that their 
being cut off from special information is a harm to investors. It isn't. 
Analysts are perfectly capable of producing better analysis without special 
information from companies than what they choose to produce with the 
"benefit" of their private communications. In fact, analysts are apparently 
so cocky about their place in society that they admit on the record that 
they produce less-than-honest analysis as a more or less mandated part of 
their job. 
     
As Blodget admits in the article, "There's certainly a tendency to give the 
company the benefit of the doubt, [but] the best analysts find a way of 
balancing the needs and wants of their constituencies. It's like being a 
good politician." 
     
Is that what we really want from analysts? To be like politicians? Is that 
why we need to preserve their special access to companies -- so that they 
can agree to change their analysis from the truth to something that the 
company wants disseminated? Is this the best that Merrill can offer?
     
Apparently so. It's sad, it's selfish, and it's an intellectually dishonest 
story that Merrill is putting on the public record. 
     
It's also perfectly predictable.
     

     
     
Chand Ramlakhan