U.S. GOVERNMENT PRINTING OFFICE

WASHINGTON : 

For sale by the Superintendent of Documents, U.S. Government Printing Office

Internet: bookstore.gpo.gov Phone: toll free (866) 512–1800; DC area (202) 512–1800

Fax: (202) 512–2250 Mail: Stop SSOP, Washington, DC 20402–0001

78–622 PDF 2002

S. Hrg. 107–385

THE WATCHDOGS DIDN’T BARK: ENRON AND

THE WALL STREET ANALYSTS

HEARING

BEFORE THE

COMMITTEE ON

GOVERNMENTAL AFFAIRS

UNITED STATES SENATE

ONE HUNDRED SEVENTH CONGRESS

SECOND SESSION

FEBRUARY 27, 2002

Printed for the use of the Committee on Governmental Affairs

(

(II)

COMMITTEE ON GOVERNMENTAL AFFAIRS

JOSEPH I. LIEBERMAN, Connecticut, Chairman

CARL LEVIN, Michigan

DANIEL K. AKAKA, Hawaii

RICHARD J. DURBIN, Illinois

ROBERT G. TORRICELLI, New Jersey

MAX CLELAND, Georgia

THOMAS R. CARPER, Delaware

JEAN CARNAHAN, Missouri

MARK DAYTON, Minnesota

FRED THOMPSON, Tennessee

TED STEVENS, Alaska

SUSAN M. COLLINS, Maine

GEORGE V. VOINOVICH, Ohio

PETE V. DOMENICI, New Mexico

THAD COCHRAN, Mississippi

ROBERT F. BENNETT, Utah

JIM BUNNING, Kentucky

JOYCE A. RECHTSCHAFFEN, Staff Director and Counsel

CYNTHIA LESSER GOOEN, Counsel

JOHN N. WANAT, Congressional Fellow

HANNAH S. SISTARE, Minority Staff Director and Counsel

WILLIAM M. OUTHIER, Minority Investigative Counsel

JANA C. SINCLAIR, Minority Counsel

DARLA D. CASSELL, Chief Clerk

(III)

C O N T E N T S

Opening statements: Page

Senator Lieberman ........................................................................................... 1

Senator Thompson ............................................................................................ 4

Senator Levin .................................................................................................... 6

Senator Collins ................................................................................................. 7

Senator Torricelli .............................................................................................. 9

Senator Voinovich ............................................................................................. 11

Senator Bunning ............................................................................................... 13

Senator Bennett ................................................................................................ 13

WITNESSES

WEDNESDAY, FEBRUARY 27, 2002

Anatol Feygin, Senior Analyst and Vice President, J.P. Morgan Securities,

Inc. ......................................................................................................................... 15

Richard Gross, Analyst, Equity Research Division, Lehman Brothers, Inc. ...... 17

Curt N. Launer, Managing Director, Global Utilities Research Group, Credit

Suisse First Boston .............................................................................................. 18

Raymond C. Niles, Senior Analyst, Citigroup Salomon Smith Barney ............... 20

Howard M. Schilit, Ph.D., CPA, President and Founder, Center for Financial

Resarch & Analysis, Inc. ..................................................................................... 23

Hon. Robert R. Glauber, Chairman and Chief Executive Officer, National

Association of Securities Dealers, Inc. ................................................................ 50

Thomas A. Bowman, CFA, President and Chief Executive Officer, Association

for Investment Management and Research ....................................................... 52

Charles L. Hill, CFA, Director of Research, Thomson Financial/First Call ....... 54

Frank Torres, Legislative Counsel, Consumers Union ......................................... 56

ALPHABETICAL LIST OF WITNESSES

Bowman, Thomas A., CFA:

Testimony .......................................................................................................... 52

Prepared statement .......................................................................................... 100

Feygin, Anatol:

Testimony .......................................................................................................... 15

Prepared statement .......................................................................................... 67

Glauber, Hon. Robert R.:

Testimony .......................................................................................................... 50

Prepared statement with an attachment ....................................................... 90

Gross, Richard:

Testimony .......................................................................................................... 17

Prepared statement .......................................................................................... 72

Hill, Charles L., CFA:

Testimony .......................................................................................................... 54

Prepared statement .......................................................................................... 109

Launer, Curt N.:

Testimony .......................................................................................................... 18

Prepared statement .......................................................................................... 73

Niles, Raymond C.:

Testimony .......................................................................................................... 20

Prepared statement .......................................................................................... 82

Schilit, Howard M., Ph.D., CPA:

Testimony .......................................................................................................... 23

Prepared statement with attachments ........................................................... 86

Page

IV

Torres, Frank:

Testimony .......................................................................................................... 56

Prepared statement with an attachment ....................................................... 111

APPENDIX

Chart entitled ‘‘Enron Stock Recommendations by Broker’’ (submitted for

the record by Chairman Lieberman) .................................................................. 127

Chart entitled ‘‘S&P 500 Price Index Versus S&P 500 Consensus Recommendation’’ (submitted for the record by Chairman Lieberman) ................ 128

Chart entitled ‘‘Enron Consensus Recommendation Versus Stock Price’’ (submitted for the record by Chairman Lieberman) ................................................ 129

Chart entitled ‘‘Banking Firm’’ (submitted for the record by Senator Levin) .... 130

‘‘AIMR Standards of Professional Conduct pertaining to Gifts,’’ response to

a question by Senator Levin submitted by Mr. Bowman ................................. 131

‘‘Association for Investment Management and Research (AIMR) Survey on

Accounting for Stock Options,’’ response to a question by Senator Levin

submitted by Mr. Bowman .................................................................................. 132

Damon A. Silvers, Associate General Counsel, on behalf of the American

Federation of Labor and Congress of Industrial Organizations, AFL–CIO,

prepared statement with attachments ............................................................... 135

(1)

THE WATCHDOGS DIDN’T BARK: ENRON AND

THE WALL STREET ANALYSTS

WEDNESDAY, FEBRUARY 27, 2002

U.S. SENATE, COMMITTEE ON GOVERNMENTAL AFFAIRS, Washington, DC.

The Committee met, pursuant to notice, at 9:33 a.m., in room

SD–342, Dirksen Senate Office Building, Hon. Joseph I. Lieberman, Chairman of the Committee, presiding.

Present: Senators Lieberman, Levin, Torricelli, Thompson, Voinovich, Collins, Bunning, and Bennett.

OPENING STATEMENT OF CHAIRMAN LIEBERMAN

Chairman LIEBERMAN. This hearing will come to order. I thank

you all for being here.

This hearing, which is called ‘‘The Watchdogs Didn’t Bark: Enron

and the Wall Street Analysts,’’ is the third in a series of hearings

that our Committee is holding on the largest bankruptcy in American history. It is part of our ongoing attempt to assess the damage, learn the lessons, and help craft the solutions to the problems

that led to the fall of Enron and its many connected catastrophes.

Future hearings of the full Committee and our Permanent Subcommittee on Investigations will look at the role of other watchdogs, including Federal agencies, auditors, and the board of directors.

Today, we focus on the private analysts whose warnings could

have, and many say should have, alerted investors to the fiscal fissures in Enron’s foundation before everything crumbled, but who

instead continued to urge investors to buy Enron stock even after

the company began to crumble.

Why were the analysts blinded to the company’s deceit and disintegration? And how can we prevent similar failures in the future?

Those are the crucial questions we are going to ask today, and

they are crucial because the Enron earthquake has left millions of

Americans worrying that their stocks are standing on shaky

ground. According to a recent Business Week/Ipsos-Reid poll, 68

percent of investors said they have little or no faith that the stock

market treats average investors fairly, and 54 percent of investors

said they are concerned about the honesty and reliability of the investment information they receive. According to Business Week, ‘‘The worry is that thousands of companies have consistently and

legally overstated earnings for the past few years.’’ In other words,

even when the Enron smoke clears, people are worried that there

may be more accounting smoke and mirrors lurking. And this is

2

1 Chart entitled ‘‘Enron Stock Recommendations by Broker,’’ referred to by Senator Lieberman

appears in the Appendix on page 127.

consequential. It is serious not only for those investors but for our

economy.

The average investor today I am afraid feels like a swimmer who

has seen a shark. He or she doesn’t know how many more sharks

are in the water and whether there are any lifeguards on duty who

are doing their job.

Making sure those lifeguards are on the lookout is part of our

purpose here, and it is a very important purpose because this is

more than a crisis for a small slice of America’s economy. It really

hits at the heart of our recent prosperity.

Spreading 401(k) accounts and a rising market—or rising markets, really, have spurred a seismic shift in stock participation over

the last 2 decades. From 1930 to 1980, the number of Americans

investing in the markets hovered between 5 and 15 percent. By

1998, that had jumped to more than 50 percent.

It is these middle-class Americans, the new investor class, who

are most shaken today. When equipped with trustworthy, up-todate, and independent information on a company and its competitors, investors, whether professional or amateur, can choose stocks

wisely. But without sound information or, even worse, with misleading information, they may as well go gambling.

Average investors I think don’t expect Wall Street analysts to

guarantee that they are going to get rich. But they do expect them

and others to filter out the vast and potentially confusing flow of

information about companies and markets to dissect and decipher

the financials of companies, especially those with hard-to-understand business models, in a way that is meaningful not only to

Wall Street insiders but to investors on Main Street.

Information, after all, is one of the most precious cargos in America’s economy, and Wall Street analysts are expected to transport

it with maximum care.

This, I think, is the unwritten agreement that has drawn middleclass investors into the market, and it is what they rely on as they

enter the markets. They know that there is risk there, that not

every stock they invest in will always make money. But they rely

on the watchdogs, both private and public, to keep the stock markets fair and to give them accurate information to help them decide

where to put their money and with it their hopes for economic advancement and retirement security.

The question we ask today is: Have the Wall Street analysts kept

their part of the bargain? And I regret to say that, based on the

investigation our Committee has done, my answer is no, they have

not. Ten out of 15 analysts who follow Enron were still rating the

stock as a ‘‘buy’’ or a ‘‘strong buy’’ as late as November 8. This

chart 1—the dark green being ‘‘strong buy,’’ light green ‘‘buy,’’ yellow ‘‘hold,’’ and red ‘‘strong sell,’’ pink ‘‘sell’’—shows you that as of

November 8, 10 of the 15 companies and analysts listed there were

still recommending that Enron was a good buy. And that was 3

weeks after the initial report of the company’s hidden losses appeared in the Wall Street Journal and about 2 weeks after the SEC

announced an investigation of Enron, and literally months after the

3

1 Chart entitled ‘‘S&P 500 Price Index Versus S&P 500 Consensus Recommendation,’’ referred

to by Senator Lieberman appears in the Appendix on page 128.

challenging and provocative article by Bethany McLean that we

have all learned so much about, and months after at least one independent analyst, who I will refer to in a moment, began to ring

alarms about Enron.

Enron’s ad campaign, or one of them, as some may remember,

was: ‘‘Ask Why.’’ It now seems clear that too many analysts failed

to ask why before they said buy, and often when they did ask why

but didn’t get a straight answer from Enron’s executives, they went

right on touting the stock.

At least one analyst did no better. On May 6, 2001, the Off Wall

Street Consulting Group issued a report calling Enron stock ‘‘extremely overvalued’’ and pointing out many of the problems that

would later be revealed in full when the company collapsed. That

was May 6 of last year. Among other things, the report questioned

the fact that the company appeared to be using accounting tricks

to pump up its revenue.

Regrettably, the analysts’ performance with Enron that I have

referred to is indicative of a broader problem. Let me quote David

Becker, general counsel of the SEC, who said last August, ‘‘Let’s be

plain. Broker-dealers employ analysts because they help sell securities. There is nothing nefarious or dishonorable in that, but no one

should be under any illusion that brokers employ analysts simply

as a public service.’’ Well, I am afraid that a lot of average investors in the country

are under that illusion, and Mr. Becker’s statement is jarring news

to them who have considered ‘‘strong buy’’ or ‘‘buy’’ or ‘‘hold’’ and

‘‘sell’’ recommendations to be honest investment advice.

I must say, in our Committee’s investigation, one of the most

stunning facts that has come to my attention is that, no matter

what the market does, analysts seem to just keep saying ‘‘buy.’’ According to Thomson Financial, two-thirds of all analysts’ recommendations are ‘‘buy’’ and only 1 percent are ‘‘sell.’’

If you take a look at this chart,1 this is over the last 2 years, and

the dotted line is the S&P 500, which, we can see beginning at January 3, 2000, was up and down, down on February 3, 2002. This

straight line is giving a numerical value to ‘‘strong sell,’’ ‘‘sell,’’

‘‘hold,’’ ‘‘buy,’’ and ‘‘strong buy’’ of analysts’ recommendations, coming out with an average, and it is really quite remarkable that the

line remains almost exactly straight at a ‘‘buy’’ recommendation no

matter what happens to the market, even as it went down.

Today we want to ask the analysts: How could that be? Of

course, I fear—and I am not alone in this fear—that one of the reasons is that the majority of analysts work at Wall Street firms and

banks that are doing business, particularly investment banking

business, with the companies the analysts are analyzing. In fact,

in a general sense, analysts’ compensation is tied directly to their

firm’s success in attracting and holding investment banking business. And analysts usually develop close relationships with the

companies they cover, relationships that are valuable to their firms

and could be endangered by the release of a critical report or opinion.

4

All of these influences I am afraid compromise analysts’ objectivity and mean that average investors really ought to use analysts’ recommendations with a great degree of caution.

There is a new set of proposed rules designed to improve analysts’ independence crafted by the National Association of Securities Dealers, which were submitted to the SEC on February 7. I

think these are a very valuable step forward. The rules would limit

compensation that analysts can receive from investment banking

activity, restrict analysts’ trading of stocks they cover, ban them

from reporting their firm’s investment banking decisions, and prohibit them from promising favorable ratings to companies they

cover.

In today’s hearing, we are going to ask whether more should be

done, and we are going to receive some recommendations, I believe,

about more that could be done, even as we try to describe today

the current system of investment analysis as a way to provide full

disclosure and warning to investors, and hopefully to push Wall

Street, on whose integrity and vitality so much of our economic

strength relies, to clean up this part of its act.

In 1937, a long time ago, President Franklin Roosevelt said, ‘‘We

have always known that heedless self-interest was bad morals. We

now know that it is bad economics.’’ Over the last few months, because of Enron, too many people individually and our economy as

a whole have painfully discovered the wisdom of those words. Our

job today is to make sure that from this point forward that wisdom

spreads, not through more painful experiences but through enactment of new ethical and progressive policies.

I look forward to hearing from our witnesses today, who I hope

and believe can help us do that job.

Senator Thompson.

OPENING STATEMENT OF SENATOR THOMPSON

Senator THOMPSON. Mr. Chairman, thank you very much. You

have very completely addressed the issues that we are dealing with

here today. I would ask that my statement be made part of the

record and merely reiterate the fact that we are seeing a loss of investor confidence at a time when there is a remarkable surge in

the number of Americans who invest in our stock markets. We

have seen a growing lack of competence with regard to financial

statements, accounting, and now we are having to deal with the reliability and objectivity of sell-side analysts’ recommendations,

which have also been called into question.

We have questions with regard to whether or not some of the

things we have seen have been brought about by the obvious conflicts of interest that are in the system, whether or not those problems can be solved simply by disclosure. We have questions as to

whether or not analysts really understand some of the data and the

information that they are given, whether or not they were, in fact,

misled.

On the other hand, as you point out, one study, at least, shows

that ‘‘sell’’ recommendations account for just 1.4 percent of all analysts’ recommendations. That raises the question as to whether or

not there is something more systematic at issue here beyond

Enron’s confusing financials.

5

Of course, the question of analysts’ independence is not a new

one. It has had a renewed interest since Enron’s collapse. I am

looking forward to hearing the witnesses on our second panel about

rule changes to address at least the perception of conflicts of so

many of these analysts as well as to provide better ways of public

disclosure.

I am also interested in hearing the explanations and opinions of

the analysts testifying on our first panel. However, I would like for

a moment to point out something concerning the first panel. The

companies represented here today are not the only ones that covered Enron while also making other business relationships with

the company. Merrill Lynch, Goldman Sachs, UBS Warburg also

had investment banking relationships with Enron or invested in

Enron partnerships, including LJM Partnerships, controlled by Andrew Fastow. So in a larger sense, there are other banks that may

not have covered Enron that also engaged in this dual role with regard to other companies. So I sincerely hope that the investing

public will not single out the particular banks represented here

today simply because it is not feasible to call every bank that may

have been similarly situated.

So, Mr. Chairman, I thank you for holding this hearing, and I

believe it is a legitimate concern. At our first hearing we asked

former SEC Chairman Arthur Levitt whether an American investor

today can depend on Wall Street analysts, and his disturbing answer that Wall Street sell-side analysts have virtually lost all their

credibility. And I hope today we can learn from our witnesses about

the system so the Committee can contribute toward helping restore

the faith of investors in our capital markets.

Thank you very much.

[The prepared statement of Senator Thompson follows:]

OPENING PREPARED STATEMENT OF SENATOR THOMPSON

Thank you Mr. Chairman. As we all know, one of the major fallouts of the Enron

collapse has been the loss of investor confidence in our capital markets. Investment

of capital is the lifeblood of our economy and we have seen a remarkable surge in

the percentage of Americans that invest in our equities market over the last several

years.

However, the collapse of Enron has shaken the confidence of investors in the

transparency of the capital markets. It has also brought to the forefront the number

of conflicts of interest that permeate different aspects of our system. Anyone seeking

empirical evidence for the effect of these revelations need look no further than the

recent volatility in the stock market and the constant references in the press to

‘‘Enronitis.’’

Unfortunately, reported problems with financial statements and accounting are

not the only issues that have shaken investor confidence. The reliability and objectivity of sell-side analyst recommendations have also been called into question. Reports indicate that as of early October 2001, there were 16 analysts who covered

Enron, and of them, 15 had a ‘‘buy’’ or ‘‘strong buy’’ rating, one had a ‘‘hold,’’ and

none had a ‘‘sell’’ or a ‘‘strong sell.’’ Most of these analysts continued with ‘‘buy’’ or

‘‘strong buy’’ ratings even after the resignations of Enron CEO Jeff Skilling and

CFO Andrew Fastow and after the restatement of earnings and reduction of shareholder equity.

I am sure that one of the reasons for these recommendations was the fact that

analysts, like everyone else, were misled by Enron’s financial statements and disclosure. On the other hand, I understand there is one study that found that sell recommendations account for just 1.4 percent of analysts’ recommendations. That

raises the question whether there is something more systemic at issue here beyond

Enron’s confusing financials.

6

The question of analyst independence is not a new one, but it has received renewed interest since Enron’s collapse. I look forward to hearing from the witnesses

on our second panel about rules changes to address at least the perception of a conflict for many of these analysts as well as to provide disclosures for the public.

I am also interested in hearing the explanations and opinions of the analysts testifying on our first panel. However, I would like to take a moment to make a point

about that first panel. The companies represented today are not the only ones that

covered Enron while also maintaining other business relationships with the company. Merrill Lynch, Goldman Sachs, and UBS Warburg also had investment banking relationships with Enron or invested in Enron’s partnerships, including the LJM

partnerships controlled by Andrew Fastow. And in a larger sense, there are other

banks that may not have covered Enron that also engage in this dual role with regard to other companies. I sincerely hope that the investing public will not single

out the particular banks represented here today simply because it is not feasible to

call every bank that may be similarly situated.

Mr. Chairman, I thank you for holding this hearing. I believe it is a legitimate

concern. At our first hearing, I asked former SEC Chairman Arthur Levitt whether

an American investor today can depend on Wall Street analysts. His disturbing answer was that Wall Street sell-side analysis has lost virtually all credibility. I hope

that today we can learn from our witnesses about the system so that the Committee

may contribute toward restoring the faith of investors in our capital markets.

Chairman LIEBERMAN. Thank you, Senator Thompson. Thanks

for an excellent statement. And you make a good point. The analysts that have been asked to come forward here were asked as a

result of our staff’s investigation because the staff judged them to

be among the most prominent analysts who were covering and

dealing with Enron. But you are quite right; there were a number

of other firms, as the chart I held up showed, that also had analysts dealing with Enron and whose recommendations were really

quite similar.

Senator Levin.

OPENING STATEMENT OF SENATOR LEVIN

Senator LEVIN. Mr. Chairman, first, thank you for convening this

hearing. I think that most Americans who participate in the stock

market—and that is most Americans—don’t really think about or

understand the role of the financial analyst in the investment

banking world. We see the faces of analysts on TV. We read their

comments in magazines and online and in newspapers. And I think

most of us just see them as experts. But we don’t think about their

place in an investment banking enterprise and their dual role in

facilitating investment banking deals as well as providing advice to

investors. This hearing will help us hopefully explore that dual role

and to address some of the inherent conflicts later on when we

start legislating.

Most financial analysts wear two hats. One is the allegedly independent analyst of publicly traded companies providing us their

educated and experienced insight on a company’s future based on

publicly available information. The other hat is that of the sophisticated insider investment banker analyst who helps his or her company attract and carry out investment banking business. Moreover,

the analyst’s compensation is often tied to the success of the investment banking business, as is the analyst’s standing within the

company. That is a problem, because as long as a company is a client of the analyst’s investment banking firm, the analysts have incentives to promote the stock of that company.

Mr. Chairman, you have identified some of the suggestions of the

National Association of Securities Dealers to address these inVerDate 11-MAY-2000 10:36 Aug 16, 2002 Jkt 000000 PO 00000 Frm 00010 Fmt 6633 Sfmt 6601 78622.TXT SAFFAIRS PsN: SAFFAIRS
7

herent conflicts, and I think we should take a close look at those.

Senator Fitzgerald and I have sponsored legislation to address the

conflicts of interest problem with respect to analysts. It is in some

respects similar to the NASD proposal. Our bill would require analysts, the investment banks for which they work, and persons or

entities associated with the analysts to disclose any time the analysts’ comments publicly, either in writing or orally, on a company

that the analyst is covering on the following items: The fees the analyst or his employer received from the covered company in the last

3 years; the merger or acquisitions worked on by the analyst or his

employer in the last 3 years relating to the covered company; and

the amount and type of debt or stock owned by the analyst and his

employer in the covered company. We would also have civil penalties and fines, depending on the gravity of the violation of those

rules.

One out of every two Americans today have a stake in the stock

market so addressing the problems uncovered under the Enron

rock is not a choice but a necessity. And if we are going to maintain public confidence in our markets, as both you and Senator

Thompson have indicated is such a necessity for us, we must act

in these areas to address these inherent conflicts.

The role of the financial analyst is an important piece of the

Enron puzzle. We know how dependent Enron was on its stock

price, and that it provided significant business to the investment

banking firms on Wall Street, initiating dozens of investment banking deals every year. So it is not hard perhaps to understand why

the financial analysts waited so long to issue a ‘‘sell’’ recommendation when so much hung in the balance—indeed why most, perhaps

the majority of analysts, never did issue a ‘‘sell’’ recommendation.

Thank you again, Mr. Chairman for convening this important

hearing today.

Chairman LIEBERMAN. Thank you, Senator Levin. Senator Collins.

OPENING STATEMENT OF SENATOR COLLINS

Senator COLLINS. Thank you, Mr. Chairman. I want to thank you

for continuing this important investigation.

I ask unanimous consent that my complete statement be included in the record, and I will just make a few comments.

Chairman LIEBERMAN. Without objection.

[The prepared statement of Senator Collins follows:]

PREPARED OPENING STATEMENT OF SENATOR COLLINS

Mr. Chairman, thank you for calling these hearings to focus on the role played,

or, more accurately, not played by Wall Street analysts in the events leading up to

Enron’s bankruptcy.

Individual investors at times know little about the stocks they purchase. They

tend to know what business the company is in and they might have some familiarity

with its product. They may also know whether their broker’s analysts rates the

stock a ‘‘buy,’’ a ‘‘strong buy’’ or something else. It’s unlikely, however, that they will

dig into a company’s financial statements. As a consequence, there is a large reliance by individual investors on professionals whose job it is to look at one industry,

or perhaps even one company, closely and make a recommendation on the purchase

or sale of that company’s stock.

Some financial analysts have pointed out that some of the information Enron gave

them was inaccurate or incomplete. Analysts would ask questions but be brushed

8

off or even lied to. But, why didn’t they press for answers or see the lack of information as warning signs?

After all, top Enron executives were selling substantial positions in the company.

Bad investment after bad investment was being made by Enron. One analyst says

that ‘‘Enron was a ‘black box’ company, where no one, not the analysts nor any of

the institutional or individual investors, was really sure how the company made

money.’’ Another called a lack of transparency and disclosure an ‘‘Enron hallmark.’’ Yet, he continued to keep it on his firm’s recommended list, which connotes its highest ranking. A third noted that Enron’s explanations were ‘‘an inadequate defense

of the balance sheet.’’ Yet he recommended its stock be ‘‘bought aggressively.’’ Analysts generally work for the same investment houses that seek to do business

with the companies their analysts rate. As a consequence, do these ‘‘sell side’’ ana- lysts, as they are known on Wall Street, come under pressure to base their conclusions on more than just the numbers? Many analysts believe that it is better to

know the true picture of the company even if they can’t reflect it in their recommendations because to do so would be lose their contact. As a result, a code develops. Analysts use terms like ‘‘hold.’’ To many of us, Mr. Chairman, ‘‘hold’’ would

mean that an investor should neither buy nor sell. Wall Street insiders understand

that stocks rated ‘‘hold’’ should be gotten rid of quickly.

We need to determine whether it was such conflicts that led so many analysts

to perform so poorly in their evaluations of Enron. Just weeks prior to Enron’s declaration of bankruptcy, analysts from some of the best known firms on Wall Street

were telling investors that concerns over Enron’s finances were ‘‘very much exaggerated.’’ These analysts saw warning signs but ignored them. Common sense tells us that

we should not recommend investments that we cannot understand. The analysts understood that there was something missing, something wrong with Enron. But the

thing that was missing of most importance, Mr. Chairman, wasn’t information. As

one observer noted, what was missing most was skepticism and a willingness to

delve for answers.

Senator COLLINS. Mr. Chairman, there is a large reliance by

most individual investors on professionals whose job it is to examine closely an industry or perhaps even one company and make a

recommendation on the purchase or sale of that company’s stock.

Some financial analysts have pointed out to the Committee that

information provided by Enron was incomplete or inaccurate. Analysts would ask questions but be brushed off or even lied to, and

that raises the issue of why didn’t these analysts press for answers

or see the lack of cooperation and the lack of information as warning signs. After all, top Enron executives were selling substantial

positions in the company. Bad investment after bad investment

was being made by Enron. One analyst said that Enron was a

black box company where no one—not the analysts nor any of the

institutional and certainly not the individual investors—were really

sure how the company made its money. Another called the lack of

transparency in disclosure ‘‘an Enron hallmark,’’ yet this analyst

continued to keep it on its firm’s recommended list, which connotes

its highest ranking. A third analyst noted that Enron’s explanations were ‘‘an inadequate defense of the balance sheet.’’ Yet he,

too, kept recommending the stock be bought aggressively.

Analysts generally work for the same investment houses that

seek to do business with the companies their analysts rate. As a

consequence, the question arises whether or not these sell-side analysts, as they are known on Wall Street, come under pressure, either direct or indirect, to base their conclusions on more than just

numbers. Many analysts believe that it is better to know the true

picture of the company, even if they can’t reflect it in their recommendations, because to do so would jeopardize their contact. As

a result, Mr. Chairman, a code develops. Analysts used terms like

‘‘hold.’’ Now, to many of us, perhaps to the average investors ‘‘hold’’

9

would mean that an investor should neither buy nor sell. But Wall

Street insiders understand that stocks rated ‘‘hold’’ should be

dumped quickly.

We need to determine whether it was such conflicts of interest

that led so many analysts to perform poorly in their evaluations of

Enron. Just weeks prior to Enron’s declaration of bankruptcy, analysts from some of the best-known firms on Wall Street were telling

investors that concerns over the company’s finances were very

much exaggerated. These analysts saw the warning signs but ignored them. Common sense tells us that we should not recommend

investments that we do not understand. These analysts understood

that there was something missing, something wrong with Enron.

But the thing that was missing of most importance wasn’t information. As one observer noted, what was missing most was skepticism

and the willingness to delve for answers.

I look forward to hearing our witnesses today as we seek to ensure that there are improvements made in the system.

Thank you, Mr. Chairman.

Chairman LIEBERMAN. Thank you very much, Senator Collins.

Senator Torricelli.

OPENING STATEMENT OF SENATOR TORRICELLI

Senator TORRICELLI. Thank you, Mr. Chairman, very much.

First, thank you very much for holding these hearings. I think

it is an important contribution, and somewhere on Capitol Hill

there should be some thoughtful analysis going on of this situation.

There has been a great deal of commentary. There has been a good

deal of cross-examination. But there is a need to have some venue

that indeed is looking at some of the regulatory issues and the

roles of the different institutions in depth, and I am proud that our

Committee is doing so.

This is, of course, not entirely a new problem. The American people may be hearing about some of these issues for the first time,

but it is not a new concern. There is very little happening here in

the concern about the analysis being offered and the credibility of

the profession that some were not asking during the dot-com fiasco.

Companies with enormous multiples, involving tremendous risk,

with conflicting information coming forward about their prospects,

and, as my colleague noted, 1 percent were receiving ‘‘sell’’ recommendations.

There is a belief by most American investors, who may be unsophisticated but remain a critical part of the Nation’s capital markets, that analysts are somehow on their side. That an analyst is

your advocate. They are impartial. They are bringing you information as your advocate.

It may not be to the level of a lawyer or a doctor, but most clients do believe they are in a relationship with the person that is

selling them stock and the analyst that person is relying upon has

some degree of impartiality.

That, of course, was never the case, and perhaps there is some

fault in people ever having been led to rely upon it. But it has been

a reality in the marketplace.

An analyst for a firm who receives a bonus may be involved in

IPOs, may own shares themselves, obviously has inherent conflicts

10

of all types. The question before the Congress, as we deal now with

these twin fiascos—the dot-com meltdown and now the Enron problem, different in some respects but having some of the same core

issues—is what we do about it.

As you are answering these questions today and making your

presentations, remember that before this Committee is the issue of

whether this is best dealt with in the marketplace. The best answer may just be that, based on the experiences of the technology

sector and now Enron, some firms will have credibility and some

will not. Some firms will find the means of restoring the confidence

of their customers, and their customers will rely upon their analysis. You will provide to them descriptions of how you are avoiding

conflicts, how you are restoring credibility, and you will succeed,

and others firms that don’t will fail. The marketplace may be the

best answer. Or it may be that as a profession or within the industry, it is to be dealt with yourselves: Set standards as to what

stakes analysts can own themselves, what conflicts will be tolerated, and what must be disclosed.

Or failing all that, is there a role for the government? Should we

indeed place walls between analysts and brokers?

It is always the belief of most of us here that that is a role that

is reserved for the most extraordinary of circumstances. But these

are extraordinary circumstances. It may be that many of these people who lost their life savings were not sophisticated investors.

Maybe some believe that is how the marketplace works.

But this country can’t operate that way and maintain the success

of the capital markets. In a society of a quarter of a billion people

and a $10 trillion economy, our reliance upon average investors

with their retirement savings, the little bit of money they can set

aside is not a luxury in this economy. If it wasn’t for our concern

for their retirements or their security, it would still be important

because it fuels our economic growth.

I hope you will remember all those questions. But I do want to

place it in perspective. While I am as critical as any of my colleagues of how we got in the situation, I also remind my colleagues

that for all the similarities to previous problems, Enron is distinguished in this: This is also outright fraud. It may be that all of

your analysts should have been more inquisitive, should have

pressed harder. But before you begin your own testimony, if you

will indulge me, Mr. Chairman, I will quote just two sections from

a transcript of Mr. Skilling and Mr. Lay on August 14 speaking to

analysts, which may help us understand why they perhaps were

not more inquisitive but, nevertheless, were misled:

Mr. Lay: ‘‘In the second quarter, net income was up 40

percent, earnings per share about 32 percent, operation

and physical volume of deliveries are up 60 percent. Again,

if anything, in the last 5 years, we have had a 20 percent

per year compound annual growth in earnings per share.’’

Pretty good, pretty impressive—if true. Yes, analysts are

to be faulted, but they do have to rely upon the information coming from executives as being truthful.

Finally, Mr. Skilling: ‘‘One of the questions the analysts’’—analysts, parenthetically, I am asking—‘‘were askVerDate 11-MAY-2000 10:36 Aug 16, 2002 Jkt 000000 PO 00000 Frm 00014 Fmt 6633 Sfmt 6601 78622.TXT SAFFAIRS PsN: SAFFAIRS
11

ing was on the new products. I think we have gotten really

good traction from the new products. The numbers are

looking good. I think in the last quarter, the second quarter, every one of those products, whether it was crude and

crude products, metal, pulp, paper, coal, volumes had more

than doubled. Every single one of them in the second quarter of 2001 or the second quarter of 2000 have all profited,

which is a really good thing. So I am feeling very good,

and I assume that we will continue on into next year. It

looks like we are going to be succeeding very, very well in

the wholesale businesses.’’

There is a lot of fault to go around all the way. I am not going

to say that I am not faulting the analysts or the firms, but I will

say if I had been in that conversation and I had listened to those

numbers, frankly I wouldn’t have been telling people to sell either.

It was a fraud.

Thank you, Mr. Chairman.

Chairman LIEBERMAN. Thank you, Senator Torricelli. Senator

Voinovich.

OPENING STATEMENT OF SENATOR VOINOVICH

Senator VOINOVICH. Thank you, Mr. Chairman. I would like to

express my appreciation to you for holding this hearing. As the

Committee gathers information, I hope that it will allow us to develop real and productive changes, changes that can ideally prevent

another Enron debacle from happening.

One of the things that is a little frustrating to me, Mr. Chairman, is some of the things that need to be done are not within the

jurisdiction of this Committee.

Today’s hearing focuses on the role of Wall Street’s analysts in

the financial markets through their ‘‘buy,’’ ‘‘sell’’ and ‘‘hold’’ recommendations. We have already heard the important role that

stock analysts play in terms of people relying on their advice. I suspect that there isn’t anybody in this room that hasn’t based a decision to buy or sell stock on what a group of analysts has said about

a particular stock.

Unfortunately, in the Enron situation, in my State thousands of

private investors lost as a result of the bad information they received. My State’s pensions funds lost over $127 million as a result

of the Enron debacle.

Overall, I have been pleased with the steps being taken by the

industry to address some of the issues raised by the bankruptcy.

Two weeks ago, the Securities and Exchange Commission proposed

changes to the corporate disclosure rules that would require companies to expedite the release of annual and quarterly reports and require companies to immediately disclose trading by company executives. In addition, as was pointed out by one of the other Senators,

the National Association of Securities Dealers announced new rules

earlier this month that would increase the independence of Wall

Street stock analysts, such as prohibiting stock analysts from owning stock in a company they review.

Investment banking firm Goldman Sachs recently announced

that it is removing its research department from its investment

banking operation and making it a separate independent division

12

of the firm. I expect that other firms are going to take similar actions in that regard.

Nevertheless, 40 different legislative proposals have been introduced to date in Congress in the wake of Enron’s collapse. Each

would in some way or another change our Nation’s laws regarding

pension plans, financial disclosure or auditor independence. Close

to 30 Enron-related hearings have been held in the House and Senate since the company’s bankruptcy less than 3 months ago. I think

that before Congress acts to overhaul financial disclosure and accounting rules, we should proceed cautiously, take into account the

non-legislative steps that have been taken, and make sure we all

know all the facts before we act to overhaul laws governing the

strongest financial markets in the world.

I think we also understand that the private checks and balances

in this country are working as more and more individuals and entities are being sued for their fraud, dishonesty, negligence, and lack

of due diligence. The Enron nightmare is going to be around for a

long time, and many of the individuals involved will be taking that

nightmare to their deathbed.

One final area of concern to me—and you won’t be surprised, Mr.

Chairman—regards the human capital resources of the Securities

and Exchange Commission. The fact of the matter is that we have

seen an increase of 660 percent in the amount of activity in the

market over the past 10 years. During that same period of time,

the Securities and Exchange Commission has not increased the

people that are capable of dealing with it at all to put up with that

increase in activity.

In addition, I recently found out that one-third of the people at

the Securities and Exchange Commission have left the Commission

because the salary schedule there is not competitive with other regulatory agencies or with the private sector. And it seems to me that

as we go through these hearings and receive testimony from witnesses in regard to various aspects of Enron, it is incumbent on

this Committee to make sure that the Federal agencies that have

the responsibility for oversight have the personnel and the competent people to get the job done. And as I have observed over the

years, too often we have hearings and lots of TV and newspaper

publicity and the rest of it, but after it is all over with, what have

we done to make the situation better? I think our responsibility in

this Committee is to make darn sure, as part of our oversight, that

those agencies that have responsibility for these markets have the

adequate personnel and the expertise to get the job done to protect

the American people.

Thank you.

Chairman LIEBERMAN. Thank you, Senator Voinovich. Someday

somebody is going to give you the award you deserve for reminding

us constantly about the importance of investing in the human capital, the people who operate and run our government.

There is a vote that is going off on the floor. What I would like

to propose is that we go to Senator Bunning and Senator Bennett.

I am going to leave, go and vote, try to get back real quickly so we

don’t interrupt the flow of the hearing. If I am not back, I would

ask that the last Senator standing—or sitting, as it were—just recess the hearing for a few moments.

13

Senator Bunning.

OPENING STATEMENT OF SENATOR BUNNING

Senator BUNNING. Thank you, Mr. Chairman.

The Enron collapse and that of Global Crossing is troubling, to

say the least, and has shown many weaknesses that need to be

fixed. I was in your business for 25 years prior to coming to the

Congress, so I know how inherent some conflicts can be, particularly those firms that have an investing, an equity, an underwriting, and also an advising position.

If you take a position in a stock, an equity position in an underwriting, and then you become an analyst and are not independent

of that firm, you have a direct conflict of interest.

I hope at the end of the day all these hearings are not in vain

and that Congress can make some necessary changes, especially to

our pension laws. Today’s hearing will focus on why some analysts

continued to recommend stocks to investors even as the companies

were restating its financial earnings and those stocks were in free

fall. Investors’ confidence in our markets without a doubt has been

shaken, and many may be more hesitant—and I see that presently

in the market—to trust the information they receive about a company before investing in it. I hope that is the case.

As a couple of our witnesses will testify today, there can be some

very direct conflicts of interest and pressures that analysts face as

they rate and recommend stocks. These conflicts need to be looked

at and dealt with as they come up.

However, it is important to remember analysts are only as good

as the information they receive. Any changes that are made will

not make a bit of difference if the companies they are dealing with

are not honest about their financial situations.

The representatives from the National Association of Securities

Dealers and the Association for Investment Management and Research have some suggestions for us about how the system can be

improved. If you all remember, there used to be a column in the

Wall Street Journal called ‘‘Heard on the Hill.’’ And you know what

happened there. The person who was writing ‘‘Heard on the Hill’’

was investing and taking a position on the stock and then writing

columns about how good this stock was going to be. And on the

swing up, they would unload the stock and make a profit.

Now, you know about that as well as I do if you have been

around the investing business very long. That kind of conflict of interest is in direct contradiction in what we want to see.

I am looking forward to the hearing today, and the other witnesses that are going to appear, and I thank you, Mr. Chairman,

for allowing me the time.

Now, Senator Bennett, you are up.

OPENING STATEMENT OF SENATOR BENNETT

Senator BENNETT. OK. I get to be the Chairman.

Simply for the record and for the information of the witnesses

that are waiting to testify when we get back from voting, I want

to note that I think the hearings are useful. I think an airing of

this issue in a forum as public as this one is a salutary thing. But

I recognize that human beings being human beings, we are not

14

going to come to a clear solution that will pass into law and bring

us into the promised land.

I have been involved in IPOs. I have been involved in presentations to security analysts. I have been the CEO of publicly traded

corporations and have gone through the experiences. I know about

road shows. I know about ‘‘buy’’ and ‘‘sell’’ recommendations and all

the rest of it. I wish my colleagues were here that I could share

with them, but we will share with the witnesses the experience of

seeing analysts make ‘‘buy’’ recommendations for the funds that

they represent and seeing the funds purchase stocks that then

dropped off the cliff in the face of which experience the analysts

kept saying, This is a great buy opportunity at the lower price,

keep buying. And they were playing with their own money, that is,

their own firm’s money. They were absolutely convinced that their

analysis was correct, and they ended up losing the firm that they

worked for huge sums because they were wrong.

There is no way that the Congress or any other legislative body

in the world can prevent people from being wrong. You don’t have

to be dishonest. You don’t have to be engaged in fraud. You can

make a mistake. And all of us, all of us have, and all of us will

continue to do that in the future.

I wonder if at some point in your testimony you gentlemen could

address what I would call the Stockholm effect. Those of you who

don’t know that term, the Stockholm effect refers to someone who

is taken hostage—I don’t know why it happened in Stockholm or

why the term is applied to it, but someone who is taken hostage

and then at the end of his or her incarceration has fallen in love

with or embraced his captors and is more on the side of the captors

than the liberators.

Maybe Patty Hearst is an example of that when she was kidnapped and ended up, at least for a brief period of time, joining her

kidnappers.

I have seen analysts who have come in very glinty-eyed, very

skeptical, as analytical and as objective as they can possibly be, examined the company’s books, examined the company’s business,

fallen in love with what they found, and then blindly continued to

support that first decision and urge people to buy stock in that

company even as the business has turned. They have become so enamored of the management, which they thought they were viewing

very objectively, so enamored of the market, which they thought

they were looking at in very glinty-eyed terms, that they really did

believe that everything was going to turn out all right after all.

And they continued to recommend the stock out of complete conviction, no conflict of interest pushing them, complete conviction that

this was the right thing to do, and they simply made a mistake.

They were simply wrong.

So while it is good for us to air all of these things, I think these

hearings are a wonderful thing to be doing. I think it is a very good

exercise for everybody to go through periodically. I would just underscore the fact that when it is all over, we should not kid ourselves into believing that a set of congressional hearings are going

to render every analyst completely objective and completely wise.

And the ability to make a mistake is programmed into the DNA,

and it is still going to be there for human beings when we are over.

15

1The prepared statement of Mr. Feygin appears in the Appendix on page 67.

With that, I now have to go save the Republic, so I will declare

this hearing temporarily postponed until the return of the Chairman.

[Recess.]

Chairman LIEBERMAN. I thank the witnesses and all in attendance for your understanding. We are just completing a vote on the

Senate floor.

I now go to our first panel. As is the custom of the Committee,

I would like to ask the members of the panel to stand and please

raise your right hands. Thank you. Do you solemnly swear that the

testimony you are about to give this Committee today is the truth,

the whole truth, and nothing but the truth, so help you, God?

Mr. FEYGIN. I do.

Mr. GROSS. I do.

Mr. LAUNER. I do.

Mr. NILES. I do.

Mr. SCHILIT. I do.

Chairman LIEBERMAN. Thank you. Please be seated and let the

record show that all of the witnesses answered in the affirmative.

I thank you for being here. I want to say for the record—although perhaps this doesn’t have to be said, but it hasn’t been the

case in other committees—that all of the witnesses are here at

their own decision and judgment and did not require a subpoena

to ensure their presence. I appreciate that very much.

We will begin. Obviously you have heard our concerns, which are

deep, and we want to hear you now and then have the opportunity

to question you. We are going to hear first from Anatol Feygin, senior analyst and vice president at J.P. Morgan Securities, Incorporated. Mr. Feygin.

TESTIMONY OF ANATOL FEYGIN,1 SENIOR ANALYST AND VICE

PRESIDENT, J.P. MORGAN SECURITIES, INC.

Mr. FEYGIN. Good morning, and thank you, Mr. Chairman.

Mr. Chairman, Members of the Committee, my name is Anatol

Feygin. I am a senior analyst and vice president of the U.S. Equity

Research Department of J.P. Morgan Securities. My area of coverage is the domestic natural gas industry, and I am pleased to

have the opportunity before you today to discuss my work as an analyst on Enron Corporation.

At the outset, Mr. Chairman, I would like to make four important points. As you mentioned in your opening remarks, absolute

integrity is essential in our line of work. Second, I do not own any

stock of the companies I cover and never owned stock in Enron

Corporation; neither has my family at any point in my tenure at

J.P. Morgan. Third, I have complete freedom with respect to the

recommendations that I issue on the companies that I cover, and

my compensation is not tied in any way to those recommendations.

Finally, I have never received any compensation in any form from

any company that I analyze, including Enron.

Consistent with J.P. Morgan’s policies of analyst independence,

in analyzing the companies I follow, I rely on publicly available information. My sources of information include the audited financial

16

statements of the companies, their filings with the Securities and

Exchange Commission and other regulatory bodies, annual reports,

and presentations to analysts. The accuracy of this publicly available information, as Senators Torricelli and Bunning pointed out,

is absolutely essential to the accuracy of the resulting recommendation.

Let me now turn, as the Committee has requested, to my work

with respect to Enron. I began following Enron in June 1999, and

prior to issuing my report and my initial ‘‘buy’’ recommendation on

the stock, I conducted extensive research for nearly a year, tapping

all publicly available sources of information. I also met with senior

management at Enron and other personnel, and I believed that

Enron’s innovative business model could be successfully applied in

other industries to generate stable and growing earnings while assuming minimal risk.

In 2000 and in the 7 months leading up to August 2001, we saw

for the most part very positive developments as they related to

Enron that justified our ‘‘buy’’ rating. Enron’s revenue grew from $40 billion to $101 billion in 2000, and its business model accounted for dramatic successes in various industries. Enron’s outlook did become a little less certain with the sudden resignation in

August of the past year of Mr. Skilling. We did view that as a negative event. But this did not lead to a downgrade because one of

the things that Enron brought to the table, in our opinion, was a

very deep and very talented management team and a successful

business model.

By mid-October, the picture had deteriorated somewhat, but still

not to the point where we believed that a downgrade was justified.

On October 16, Enron did report a third quarter loss of $618 million and took a $1.2 billion charge to shareholder equity I should

say. However, at the same time they reported a 35 percent increase

in its core business, and even though this release was made in the

morning, the stock closed the day up 2 percent.

Nevertheless, during the next week, we saw a developing crisis

of confidence. It was fueled by negative press coverage, Enron’s disclosure that the SEC had launched an informal inquiry, and

Enron’s failure to address the resulting investor concerns head-on.

On October 24, I downgraded Enron’s rating from a ‘‘buy’’ to a

‘‘long-term buy’’ and removed it from our company’s focus list. Let

me just clarify this point. A ‘‘long-term buy’’ does not mean that the

stock would be a good investment in the near term. Instead, the

rating tells my institutional clients that the company is facing

near-term challenges that, once resolved, should allow the stock to

outperform its peers.

On November 8, Enron filed documents with the SEC revising its

financial statements for the past 5 years to account for $586 million previously unrecognized losses. I did not believe that a second

downgrade was justified because Enron’s results for the first three

quarters of 2001 were not materially impacted by this restatement.

On November 9, a proposed merger was publicly announced between Enron and Dynegy. As the Committee may be aware, J.P.

Morgan was one of the advisers to Enron with respect to this merger. I, however, was not involved in the transaction and was only

informed of it a few hours before it was publicly announced. OtherVerDate 11-MAY-2000 10:36 Aug 16, 2002 Jkt 000000 PO 00000 Frm 00020 Fmt 6633 Sfmt 6601 78622.TXT SAFFAIRS PsN: SAFFAIRS
17

1The prepared statement of Mr. Gross appears in the Appendix on page 72.

wise, I was not privy to any non-public information with respect to

Enron, Dynegy, or the proposed transaction. I viewed the proposed

merger as a positive event and believed that if the merger was consummated, the combined entity would go on to outperform its

peers.

The merger was abandoned on November 28 following Enron’s

downgrade to below investment grade. And immediately following,

on November 29, we suspended coverage of Enron. As everybody

knows, Enron filed for bankruptcy protection on December 2.

Thank you, Mr. Chairman, and I would be pleased to respond to

any questions that you or other members of the Committee may

have.

Chairman LIEBERMAN. Thank you, Mr. Feygin.

Now we go to Richard Gross, who is an analyst at the Equity Research Division of Lehman Brothers, Incorporated.

TESTIMONY OF RICHARD GROSS,1 ANALYST, EQUITY

RESEARCH DIVISION, LEHMAN BROTHERS, INC.

Mr. GROSS. Good morning, Mr. Chairman and Members of the

Committee. My name is Rick Gross. As indicated, I am an analyst

in the Equity Research Division at Lehman Brothers. Lehman

Brothers is a global investment bank and securities firm that provides research, investment banking, brokerage and other services

to corporations, institutions, governments, and high-net-worth investors.

I have been an equity analyst covering the energy industry for

27 years. I have been an analyst at Lehman since 1991. Prior to

Lehman, I worked as an analyst at other firms for 16 years. I have

a B.S. and M.S. in finance from the University of Illinois.

At Lehman Brothers, I cover a sector called ‘‘United States Energy/Power, Natural Gas.’’ One of the companies in my universe of

coverage is Enron. As an analyst, I analyze the publicly available

information about a company and its industry. This information

can include: Information made available to me through SEC filings

that the company makes; press releases and company presentations; materials from the rating agencies; information about competitors that I can glean in the marketplace, trade journals, seminars; general information about the industry as well as whatever

public information is available that I can reasonably obtain. I compile all of this in a framework for my analysis.

My analysis includes relative valuations arrived at by reviewing

historical and current industry trends, reviewing market valuations, comparing the company being analyzed to its peers. Based

on this analysis, I develop opinions and make recommendations,

and the factors on which they are based are reflected in my reports. These reports are available to clients of Lehman Brothers,

which in general are primarily institutional in nature, although we

also serve a high-net-worth individual group.

I appreciate the opportunity to answer questions before the Committee.

18

1The prepared statement of Mr. Launer appears in the Appendix on page 73.

Chairman LIEBERMAN. Thank you, Mr. Gross. Maybe one of those

shorter opening statements we have had in the history of the Committee. We will be back to you for questions.

Next, Curt Launer, Managing Director, Equity Research Group,

Credit Suisse First Boston.

TESTIMONY OF CURT N. LAUNER,1 MANAGING DIRECTOR,

GLOBAL UTILITIES RESEARCH GROUP, CREDIT SUISSE

FIRST BOSTON

Mr. LAUNER. Good morning, Mr. Chairman. My name is Curt

Launer, and I am a Managing Director at Credit Suisse First Boston. I head the Global Utilities Research Group of CSFB that comprises 28 professionals. My specific research coverage is the natural

gas and power sector, and as a research analyst for the past 18

years, I have followed Enron and its predecessor companies. I

would like to make four main points today.

First, the role of an analyst is to make informed judgment about

companies based on publicly available information. We depend on

senior corporate officials and independent accountants to ensure

the accuracy of public disclosures. Without accurate and complete

financial reporting from a company, I simply do not have the proper tools to do my job.

CSFB’s client base is largely comprised of sophisticated, institutional investors, not individual retail customers. My clients have

their own research staffs. They look to me for quality information

and projections and challenge the information and analysis that I

provide to form their investment decisions.

My second point is that inaccuracies and lack of information in

Enron’s financial reporting affected my conclusions and ratings on

Enron. Each day there are new allegations in the media concerning

Enron about which I was previously unaware.

Third, I performed my analysis independently and objectively,

and I never felt pressure from Enron or any investment banker or

other employee of my firm to reach any conclusions other than my

own. Not only have I done my work independently, but, in addition,

my firm has strict rules that prevent me from even having access

to the kind of confidential, non-public information that investment

bankers often have. CSFB has also adopted rules banning stock

ownership by analysts in the companies we cover.

In this regard, I would like to note that before that ban, my sons

each owned 100 shares of Enron that were sold in December 2001

to comply with new CSFB rules. My family’s only current investments related to Enron are $18,000 I invested in the NewPower

Company and an Enron bond held by my mother, which is now in

default.

Finally, I applaud any effort to craft thoughtful responses to improve the overall quality of public company disclosures and restore

confidence in our markets. To protect the integrity of our research,

CSFB consistently and without exception follows Chinese wall procedures. To maintain our independence and ensure that our research is not influenced improperly, the Research Group is physically separated from the Investment Banking Department. We

19

have no access to the confidential files or data of any other unit

of the firm.

In addition, CSFB not only complies with the Securities Industry

Association’s best practices for security analysts, but also has

worked with the SEC, the NYSE, and the NASD to create new

rules for analysts and investment banks which, after months of

work, were recently announced.

Enron was unique in its use of off-balance-sheet financings, offbalance-sheet partnerships, fair value accounting, and other techniques and vehicles. Any one of these would not be problematic in

and of itself. Many fine companies use these techniques. However,

Enron used all of them in ways that apparently were not fully disclosed and that we are just beginning to understand.

It now appears that some critical information on which I relied

for my analysis of Enron was inaccurate or incomplete. For example, in January 1998, I attended an analyst meeting at Enron with

over 100 analysts. During this meeting we toured a trading floor

of Enron Energy Services. In viewing the activity in the trading

room, I was impressed at the progress Enron had made in developing this new business. It has now been alleged in press reports

that Enron staged the activity on that trading floor, and if this allegation is true, the progress of the business unit was illusory.

In addition, during the August 15, 2001, analyst conference call

following Jeff Skilling’s resignation, I specifically asked him whether his departure suggested that there were likely to be further disclosures with respect to Enron’s finances. Mr. Skilling responded

that there was nothing to disclose and that the company was in

great shape. Furthermore, Enron never publicly disclosed the alleged use of the Raptor investment vehicles. It now appears that

these entities may have engaged in trades with Enron simply to establish artificially higher asset values. Had I known any or all of

these items, the information would have significantly affected my

analyses and recommendations.

I believed as of late November of last year that Enron could have

survived if it had taken the appropriate steps. These steps would

have been a substantial capital infusion combined at complete disclosure of off-balance-sheet liabilities and debt levels, plus a decision to slow growth, all of which could have, in my opinion, resulted in Enron’s survival. Essentially, these are the elements that

could have been provided by the Dynegy merger. Indeed, it appears

that Chevron-Texaco and Dynegy had much the same view of

Enron as I did. Chevron-Texaco was willing to commit $2.5 billion

in cash to its view of Enron, and Dynegy was willing to issue $8.5

billion of additional shares to acquire Enron.

In sum, hindsight allows a view that I as an analyst never had.

I based my views and ratings on the information that was available

every step of the way.

In 2000, the SEC adopted regulation FD in order to promote

equal access by preventing the selective disclosure of information

to some individuals, but not the public at large. As laudable as that

goal is, the regulation can be used as an excuse by company officials, as it was by Enron, to duck tough questions from analysts

and, thus, thwart full disclosure. The point, of course, is that these

20

1The prepared statement of Mr. Niles appears in the Appendix on page 82.

tough questions should be answered and the answers made available not just to the questioners but to the public.

The focus of any policy changes should be more complete, more

timely, and more understandable disclosure. We should consider

full disclosure of off-balance-sheet financings and related-party

transactions, more accelerated disclosure of insider transactions

and corporate reports, and enhanced disclosure of stock option programs. Greater scrutiny of accountants and other professionals and

additional resources for regulatory agencies like the SEC may be

necessary as well.

Thank you again for the opportunity to appear today, and I look

forward to answering any of your questions.

Chairman LIEBERMAN. Thank you, Mr. Launer.

Now we go to Raymond C. Niles, senior analyst, Citigroup

Salomon Smith Barney.

TESTIMONY OF RAYMOND C. NILES,1 SENIOR ANALYST,

CITIGROUP SALOMON SMITH BARNEY

Mr. NILES. Thank you, Mr. Chairman and Members of the Committee.

Since March 2000, I have been the senior analyst at Salomon

Smith Barney for the integrated power and natural gas sector. Before that, and since 1997, I was the senior analyst for the integrated power and natural gas sector at Schroder. I covered Enron

at both Schroder and at Salomon Smith Barney.

As an analyst, my job is to report to investors about business and

market developments in my industry sector. I also develop and

communicate timely and detailed recommendations about particular companies in that sector.

In order to do this job, I work with publicly available information

to develop financial models, earnings estimates, and price targets

for the stocks of the companies that I follow. I also follow and analyze industry trends, such as power prices, spark spreads, generating capacities, the trend toward deregulation, and similar items.

Part of my job also is to forecast the impact on individual stock

prices of the supply and demand for electricity and natural gas, the

overall health of the national economy, and even such variables as

the weather. In performing these analyses, I make use of computer

modelings techniques, economic theory, and other tools.

At the heart of my work are the financial statements of the companies that I follow. I review and analyze a company’s financial

statements, press releases, and public filings before I make a recommendation. I also go beyond the paper record and participate in

regular conference calls held for analysts by senior and financial

management of the companies that I cover. I visit the companies

and call on company personnel in order to obtain clarification and

context regarding the company’s finances and business prospects.

Although I collect and analyze a great deal of information, I must

stress that all of the information I use is and must be public information. Under Securities and Exchange Commission rules, a company cannot make selective disclosure of confidential information

only to certain analysts.

21

Also, investment banks that trade securities establish information barriers—you have heard those referred to as the Chinese

wall—so that confidential information that may be known to a company’s bankers does not reach the analysts and salespeople who

may be recommending or trading that company’s stock. Therefore,

when I issue a report on a company on behalf of Salomon Smith

Barney, I am prevented by rules and regulations, as well as by the

firm’s policy, from asking my banking colleagues about their nonpublic dealings with the company that is the subject of my report.

If an analyst is ever brought ‘‘over the Chinese wall’’ to receive

non-public information, he is not permitted to make recommendations with respect to the particular company until the information

learned by the analyst becomes stale or has been disclosed publicly.

With this background, I would like to summarize for the Committee my reports concerning Enron.

I initiated coverage of Enron in January 1998, when I worked at

Schroder. I developed my own methodology for forecasting the company’s earnings, and based on my analysis of the company’s reported financial results and business prospects, I placed Enron on

the firm’s ‘‘recommended list.’’ It was my professional opinion that Enron was well positioned to

take advantage of the deregulation of the electricity industry. By

that time, Enron had already built an impressive reputation and

had achieved dominance in the competitive natural gas industry,

which deregulated about a decade before.

It was also my professional opinion that Enron’s core merchant

energy business model was sound. Under that model, economies of

scale, innovative marketing, and risk management could allow

Enron to offer cheaper and more customized energy-related services

than those provided by its competitors. I believed that Enron’s objective—using risk management products and long-term contracts

to address the needs of wholesale energy customers in the volatile

commodity markets—was a successful paradigm. The strength of

Enron’s reported results appeared to confirm the correctness of this

objective and Enron’s success in achieving it.

While I was at Schroder’s, Enron’s performance in the gas and

electricity commodity markets was impressive. I believed that

Enron’s core platform could be applied to other inefficient markets

for commodities that were delivered over a network, such as bandwidth.

In March 2000, just before our firms merged, I joined Salomon

Smith Barney as a senior analyst. I issued my first report on

Enron at Salomon Smith Barney in April 2000. At that time I

rated Enron as a 1H, which means a ‘‘buy’’ recommendation, with

high risk attached to it. The high-risk notation refers to the business risk given that Enron was a first mover in new markets.

I continued to recommend Enron during the rest of 2000 and into

2001.

In a report dated August 14, 2001, shortly following an announcement that Jeff Skilling had resigned, I noted that although

he was an architect of the company’s energy merchant strategy, I

believed in the soundness of their business model, and even though

it was a negative factor, barring any further disclosures from the

company, we still felt positive about the company.

22

Beginning in October, Enron began to make public disclosure of

the transactions and financial restatements and writeoffs that

eventually led to its bankruptcy. I made timely reports as the significant facts were announced.

On October 16, I noted Enron’s decision to take $2.2 billion in

charges, but reported that the charges, as described by Enron, did

not relate to its core merchant energy business. Accordingly, I continued to rate the company a ‘‘buy’’ with a ‘‘high risk’’ rating.

On October 19, when the stock was still trading at over $32 per

share, I issued a report which noted that the company’s ‘‘complex

off-balance-sheet vehicles have raised concern,’’ and that there

could be further writeoffs, and I was also concerned that Moody’s

had put the debt on review for a possible downgrade, but that we

were still evaluating these issues at that time. Later that day I

issued another report, again raising concern about their off-balance-sheet financing, and again about the uncertainty and magnitude of potential writeoffs of the company.

I downgraded my rating to 1S, or ‘‘buy, speculative,’’ on October

25, and lowered it again to ‘‘neutral, speculative,’’ a 3S rating, the

next day. In my report that day, I noted that management had to

address issues related to credit and liquidity, particularly the use

of off-balance-sheet vehicles.

Given everything that has happened since late October, I think

it is appropriate to ask why the analyst community, at least the

vast majority of its members, missed the mark on Enron.

The short answer, Mr. Chairman, is that we now know that we

were not provided with accurate and complete information.

A company’s public certified financial statements are the bedrock

of any analysis of the value or the prospects of a company’s stock.

It is now common knowledge that Enron’s financial statements,

which had been certified by its independent auditor, did not represent the company’s true financial condition. The analyst community relied on these financial statements, which were restated. The

company restated 3 years’ worth of its earnings in November.

When analysts look at certified financial statements, we assume

that they are accurate and that they fairly and completely represent the company’s financial condition. In Enron’s case, that assumption turned out to be invalid.

As analysts, our reputation and ultimately our livelihood depends on our making timely and correct calls. I did not want to get

this wrong in terms of Enron. I recommended Enron’s stock because I believed in the company’s core business model, and I trusted the integrity of the company’s certified financial statements and

the representations of the company’s management. At all times, I

exercised and communicated to investors my best professional judgments based on the information that was available to me.

Thank you, Mr. Chairman and members of the Committee.

Chairman LIEBERMAN. Thank you, Mr. Niles.

The last witness on this panel, Dr. Howard Schilit, president and

founder of the Center for Financial Research and Analysis.

23

1The prepared statement of Mr. Schilit with attachments appears in the Appendix on page

86.

TESTIMONY OF HOWARD M. SCHILIT, PH.D., CPA,1 PRESIDENT

AND FOUNDER, CENTER FOR FINANCIAL RESEARCH AND

ANALYSIS, INC.

Mr. SCHILIT. Thank you very much, Senator. I do have a prepared statement, but I just wanted to interject before I got into

that, at the conclusion of that if you would like me to comment on

what I just heard and also my analysis on Enron that came out of

the public records, I have some interesting findings in front of me.

Chairman LIEBERMAN. Fine. Let me ask that you go ahead and

do the opening statement, and during the question and answer

then we will give you an opportunity to offer your reactions.

Mr. SCHILIT. Senator Lieberman and esteemed colleagues, I am

pleased to appear before this Committee to describe my role as an

independent financial analyst and some of the important differences between Wall Street research and our independent boutique.

Before proceeding, I want to emphasize that my comments are

based solely upon personal observations over the last decade rather

than on a comprehensive study of Wall Street or other independent

research boutiques.

My name is Howard Schilit. I am founder and president of the

Center for Financial Research and Analysis, or CFRA, based in

Rockville, Maryland. Prior to that, I was employed for 17 years as

an accounting professor at American University. I also authored a

book called ‘‘Financial Shenanigans: How to Detect Accounting

Gimmicks and Fraud in Financial Reports.’’

My organization has been writing research reports since 1994,

warning institutional investors about companies experiencing operational deterioration or using unusual accounting practices. Our reports are published daily and distributed over our website.

We use a variety of quantitative and qualitative screens to

initially select companies for review. Then an analyst reviews the

financial reports and other public documents to search for any

problems. If any are found, we interview company management to

discuss these issues. If concerns remain, we publish a report on our

website. We make no buy or sell recommendations; rather, we simply discuss the issues of concern.

Our clients are mainly institutional investors who purchase the

research on a subscription basis. We are paid a fixed fee based on

the number of actual users at the firm, similar to a license fee on

software. Subscribers receive an E-mail each morning with a notification of the companies profiled, and the reports are posted on our

website at 9 a.m.

All CFRA subscribers receive the information in the same way

and at the same time. In addition, all subscribers have equal access

to discuss issues with our analysts.

CFRA has a variety of strict editorial policies and ethical guidelines that protect clients’ interests and ensure CFRA employees receive no remuneration based on stock price performance of companies they profile. I have attached those policies with my formal

statement.

24

In short, we have no brokerage, investment banking, or money

management operation. We have no conflicts of interest. We have

one client class: Those who make economic decisions based on financial disclosures. And we have one overarching goal: To help

them make the best decisions.

In contrast, Wall Street research is fraught with real and potential conflicts of interest.

Wall Street brokerage firms have at least two major client

groups: Those that purchase investment banking services and institutional investors. Typically, a company needing funding will hire

a brokerage firm to underwrite securities in a public offering. The

brokerage firm receives a fee, generally 6 percent or higher, for this

investment banking service. Shortly thereafter, the successful analyst at the brokerage firm will begin coverage on this new client

with a positive research report. Generally, future research reports

on this investment banking client will remain positive. Future investment banking fees on stock or bond offerings depend on a close

relationship with the corporate client.

If CFRA or another critic raises concerns to investors, the brokerage firm often publishes a rebuttal to show support for the investment banking client, and in some cases with disastrous results.

This shows the inherent conflict of interest; the brokerage firm

serves both the underwriting client—the subject of the report—and

the investor, who must be informed when problems arise.

The method of paying for research also differs substantially at

Wall Street firms. Whereas we receive a cash payment for selling

subscriptions, brokerage firms are paid by investors in commission

dollars. The trading volume affects the amount, the timeliness of

the information, and access to speak to research professionals. That

is, the bigger clients typically get the first call from institutional

brokers and salesmen, while smaller clients have lesser access.

Moreover, non-institutional investors who generate no commissions often have no or very limited access to such research. CFRA,

for example, was not permitted to purchase brokerage research

through First Call—the distributor of brokerage research—because

we generate no commission. They refused our offer to purchase the

research for cash.

I have outlined in a chart ten important differences between the

work of our independent boutique and Wall Street firms, and I will

leave that for you to go over, perhaps during the question and answer period.

In conclusion, as a result of the conflicts of interest and internal

policies, Wall Street research has regularly failed to warn investors, so not just Enron but regularly failed to warn investors about

problems at companies. I would be happy to answer any questions

at this time.

Chairman LIEBERMAN. Thanks very much, Dr. Schilit.

To the four analysts here, obviously, Dr. Schilit has laid down a

challenge and raised concerns and issued charges that are very

much on the minds of all of us, and I want to ask you a series of

questions, as other Members of the Committee will, to respond to

those.

To one extent or the other, the four analysts who are here from

the firms this morning have defended the fact that jumps out at

25

us, that you were continuing to recommend Enron long after it appears that there were warning signs. Some did it quite specifically,

others of you quite generally.

The concern obviously is whether you were influenced in those

favorable recommendations that now seem so wrong by the fact

that your firms were doing business with Enron or perhaps just because you had become too close to Enron. We have a syndrome that

they sometimes talk about in diplomacy where the Ambassador we

send to a foreign country becomes the advocate for the foreign

country as opposed to the advocate for the United States. And I

wonder about that as I listen to you.

But let me cite the Bethany McLean article in Fortune Magazine

in March 2001, very direct, strong questions about Enron’s viability. At least one analyst, Mark Roberts, of Off Wall Street Consulting Group, May 2001, which is an independent research firm,

diagnosed the problems with Enron in a research report that was

printed on the Web and talked about shrinking profit margins,

raised questions about Enron’s related party transactions, even

identified one dark fiber transaction as being used to exceed earnings expectations for two quarters in 2000. In additional reports in

July and August of last year, he raised concerns that Enron was

relying even more heavily on related-party transactions and that

Enron’s cash flow from recurring operations and return on capital

was poor as compared to its competitors. Finally, he noted that insiders at Enron were selling like crazy, then put together the growing media concern during last fall about Enron with some specific

allegations being made in articles and places like the Wall Street,

and the beginning of the SEC investigation. And yet the four of

you—and, in fact, by our calculation, about two-thirds of the analysts on Wall Street who were really focused on Enron continued

to recommend a ‘‘buy,’’ to say the other obvious fact which I haven’t

mentioned, the stock price was dropping significantly over the period of time.

So the obvious question is: Why? And why shouldn’t we or average investors feel that you were not really doing independent analysis but that you were affected by the fact that—by either of the

factors I mentioned: One, that you got too close to Enron; or, two,

that your firms were benefiting from ongoing business relationships with Enron? Mr. Feygin.

Mr. FEYGIN. Thank you, Mr. Chairman. Again, I would like to go

back to something you said in that integrity is absolutely essential

in this line of work, and we focus on the core operations, the business model, and the publicly available information.

In the releases from Enron and the conference calls they had and

the financials that were published, the core operations were doing

exceptionally well; as I mentioned, even in the third quarter with

the charge, they were up 35 percent. And as you mentioned, the

stock kept sliding while I believed that the core operations were

continuing to do well. I thought that the deterioration and all of

the issues that were raised were more than factored into the stock

price, and, again, my outlook, which is what my recommendation

is based on, pointed to a solid core business, the rapid move by

Enron to rid itself of some of these distractions that you mentioned,

and I firmly believed that the stock would go on to outperform

26

until fundamental issues arose and we downgraded it on October

24 pending the resolution of those issues.

Chairman LIEBERMAN. Let me ask you more specifically, isn’t

there a natural way in which the public’s growing skepticism about

the independence of analysts working for firms, as you do, is justified? In other words, I understand one of you—perhaps it was you,

Mr. Feygin—said you didn’t receive any compensation from Enron.

I understand that is true. But I gather that the income that you

make, including bonuses at the end of the year, is affected by your

firm’s overall performance during the year, including its investment banking and other businesses, which Enron was significantly

contributing to.

So weren’t there implicit or explicit pressures on you to continue

to recommend a buy for Enron as it slowly collapsed?

Mr. FEYGIN. The answer to the last part of your question is no,

there were no pressures on me to maintain the rating.

Chairman LIEBERMAN. Mr. Gross, why don’t you answer that

question? I understand the defense, notwithstanding the evidence

I have presented, that you are all saying you made a judgment call.

But why should average investors feel that you and the other analysts working for the firms that were doing business with Enron

were not affected by that, since your advice seemed to be so

counterintuitive? As the stock price slid, the insiders were selling

like crazy, and there were all sorts of growing—not just speculation

but accusations that something was very rotten at Enron.

Mr. GROSS. Well, I think we have all reiterated in one way or another that the core business, the basic business model, we believed

was very strong, was growing rapidly, was portable into other commodities, and that this was the strength of Enron. It materialized

when the stock went from $45 to $90, and we believed that that

franchise was portable into broadband in a context where there

was a lot of enthusiasm in general about broadband.

As the stock fell, it became evident that the broadband business

was not going to pan out as rapidly as most observers had viewed

it. We were back to an energy company. The energy company still,

as we were reporting, they were reporting record quarters. They

were reporting very strong volumes. We could see the confirmation

of the business model in the other companies that we followed that

were also doing very, very well. And so the core business all along,

I think each and every one of us believed was very, very strong.

As we got toward the end and we got incremental pieces of information—we would get a piece of information saying that management was selling stock. The early sales of stocks were from individuals that in my belief were on their way out of Enron or retiring.

The stock sales of many of the other senior managers we believed

were normal sales. They were programmed sales. They were very

regular.

When it came down to Jeff Skilling quitting, once again, all of

us in our own way interpreted that. My own reports indicated that

this is an issue, but at the end of the day, the bench is very deep.

We had two instances in the 1990’s where senior executives at

Jeff’s level had quit abruptly, early in 1992–93, an individual

named Mick Seidel and an individual named Rich Kinder. The

bench took over and the stock continued to do well.

27

It was only toward the very end that it became evident that the

core business, because of lack of management credibility, because

of some rating issues, was going to deteriorate, possibly to the

point where we had significant problems with that core business.

And I think that was the essence of how we were able to recommend the stock as it—— Chairman LIEBERMAN. We try to keep each of the Senators, including the Chairman, on a time allotment. I have gone over mine.

I just want to ask, not for a defense of what you did because you

gave it in your opening statement, Mr. Launer and Mr. Niles, but

how do you explain why you missed the signs that Mr. Roberts of

Off Wall Street Consulting Group saw?

Mr. LAUNER. As an analyst, I worked very hard on Enron, on all

of the publicly available information. I have made it a practice

throughout my career not to use other research reports written by

anybody. I was aware of the Roberts report because some of the

claims in it were brought to my attention by the institutional investors that I serve.

The questions that came up at that time were relatively easy to

answer analytically through our own work. One of the main comments in that report dealt with Enron being overvalued because it

was simply a trading business. The analysis that we have done of

the merchant energy business that Enron and other companies

take part in is that the business has substantial barriers to entry,

needs a lot of capital, and has a utility function to serve and, therefore, justifies a higher multiple than a trading business.

From the standpoint of the other concerns about dark fiber sales

that you mentioned, we had seen that from Enron and other companies, and those issues were disclosed and part of our analysis in

terms of the company having included dark fiber sales in their

earnings reports in the year 2000.

In terms of related-party transactions, there simply was incomplete disclosure, as we now know, of the related-party transactions.

And in terms of the return on capital employed having come down,

that was consistent with Enron’s business and strategy of investing

heavily in new start-up businesses that weren’t counted on to provide earnings or returns for the first couple or 3 years of their existence.

So, overall, from the standpoint of hindsight allowing a view that

we simply did not have, we relied on the information that was

available at the time.

Chairman LIEBERMAN. Mr. Niles, I am going to let my colleagues

question you because time is up. I want to leave you with a quote,

and maybe some of you will respond to it. James Chanos, a short

seller who gained recognition for doubting Enron’s value fairly

early on, testified before the House Energy and Commerce Committee on February 6 that he met sometime early in 2001 with the

analysts covering Enron from CS First Boston and Salomon Smith

Barney. I trust that was the two of you? Do you remember meeting

with Mr. Chanos?

Mr. LAUNER. Yes, I do.

Mr. NILES. Yes.

Chairman LIEBERMAN. Anyway, he testified that, ‘‘They saw

some troubling signs. They saw some of the same troubling signs

28

we saw. A year ago, management had very glib answers for why

certain things looked troubling and why one shouldn’t be bothered

by them. Basically, that is what we heard from the sell-side analysts. They sort of shrugged their shoulders. One analyst said,

‘Look, this is a trust-me story.’ ’’ I would like to hear as this morning goes on your response to

that recollection of his to those conversation.

Senator Thompson.

Senator THOMPSON. Thank you, Mr. Chairman.

Mr. Gross, what did you consider to be Enron’s core business, as

you referred to it? You thought the core business remained strong?

Mr. GROSS. Yes, its wholesale energy markets and trading business.

Senator THOMPSON. All right. But they were doing quite a few

other things in addition to that, weren’t they? They were trading

other things besides——

Mr. GROSS. Yes, as they began to migrate the business model to

other commodities, we thought that it would be successful in the

context of the success they had already had and experienced in natural gas, the experience and success they had in energy, and the

numbers that they were reporting in the way of volumes.

Senator THOMPSON. Is it fair to say that they made quite a bit

of money with their energy trading but they lost a lot of money

with regard to other trading areas, broadband and a lot of other

things, in addition to losing money on most of their foreign investments, their base business, their bricks-and-mortar business or

pipeline business and all that? They were making money in a very

speculative area and losing money in other areas. That is a great

generalization, but is that not a fair generalization?

Mr. GROSS. I would say it is a partial characterization. In general, Enron had invested in international infrastructure, and a

good portion of that historical portfolio, beginning with some of the

investments in the early 1990’s, did not generate high returns.

Senator THOMPSON. Well, none of it generated a profit, did it?

Mr. GROSS. The way it was reported to us in the audited statements, it showed that it was making money.

Senator THOMPSON. Well, we know now that some of the profits

they were showing, if not most of the profits they were showing,

was because they were utilizing these 3,000 or so partnerships, the

Raptors and so forth, and disguising or not reporting some of the

losses and taking credit for some of the gains generated from selfdealing and all that. We know that now. The question, I guess, is

what did we know back in the fall?

I don’t think we will ever be able to really second-guess your

analysis about what you were thinking at the time. To me, just because a stock is going down, that doesn’t necessarily mean that you

ought to sell it, for sure. Some of the richest people in the world,

most successful people in the world, don’t do that. So we have got

to look at it from an objective standpoint, and the question is:

What are the American people going to think, what is the average

investor that our economy is so dependent upon now going to

think?

On the one hand, you have the objective factors that everybody

looks at that have been described here. Mr. Skilling leaves under

29

questionable circumstances. By September the stock had lost 60

percent of its value from its high. All these other things were going

on. And then analysts had a conference call on October 22, in

which you were basically told, ‘‘Don’t bother me, I’m busy.’’ And

then the next day Lehman Brothers came out and said Enron’s

conference call began as a methodical review of current liquidity

and deteriorated into an inadequate defense of the balance sheet;

despite this, we affirm our strong buy recommendation.

So when the public looks at all these objective factors and then

they look at what we now know is a system that is complete with

conflicts of interest where your interests and your firm’s interest is

in the stock going up, they have to balance that over against what

you say was basically a reliance on corporate executives. As I see

it, they were telling you everything was going to be all right.

Let me ask you, in a general sense, I would assume that that

would be a situation you would run into a lot, that a lot of corporate executives would try to be optimistic with regard to their

own firm. Accounting principles is another issue. But do you normally rely on just what the public record has got out there that

anybody could look at, plus what the corporate executives are telling you? Even in light of all these objective factors and the inherent conflicts of interest with regard to your job, does the former

outweigh the latter?

Mr. GROSS. Each of us in our own way go about determining

management credibility in their statements, in that context where

we would be able to confirm or not confirm how Enron was doing

if they are in a market with other competitors. It has been mentioned earlier that Enron in aggregate generated a rather poor return on capital. You could see competitors trading in the marketplace with financials that basically represented that core business

that were earning very high returns. You could check out the statements of management with their competitors. Is the market good?

Is it bad? Is it deteriorating? Is it improving?

So there are all kinds of cross-checks at the end of the day that

we have to perform, instead of just taking statements at face value

from the individual companies.

Senator THOMPSON. Well, I understand that. But let me give you

a cross-check on the other side of the ledger. Mr. Feygin, I was

looking here at a clip from the London Times, March 21, 2001,

where it says J.P. Morgan reins in analysts. It says that the independence of J.P. Morgan’s stock research is being questioned after

analysts at the U.S. investment bank were instructed to seek approval from corporate clients before publishing recommendations

on those stocks. In a memorandum circulated to J.P. Morgan analysts last week, Peter Houghton, head of Equity Research, said that

he must personally sign off on all changes in stock recommendations. In addition, the memo further sets out rules described as

mandatory, requiring analysts to seek out comments from both the

companies concerned and the relevant investment banker, J.P.

Morgan, prior to publishing the research.

He says, ‘‘If the company requests changes to the research note,

the analyst has a responsibility to incorporate the changes requested or communicate clearly why the changes cannot be made.’’

30

So it looks to me like J.P. Morgan is telling their analysts that

they have got to get a sign-off from the company they are analyzing

and the mortgage banking side of the operation before they can

make any changes.

As I say, nobody can get in anybody’s head and dispute the fact

that there are some factors out there that might lead one to go in

another direction. But over here, you have not only all of the objective things that were going on out there in the marketplace that

anybody could see, plus the mortgage banking houses basically letting the companies they are analyzing, it looks like, call the shots.

What kind of investor confidence comes out of a situation like

that?

Mr. FEYGIN. Thank you for the question, Senator Thompson. I

have to say that I learned of this memo from the press. Peter

Houghton is the head of our research franchise in London, and

those rules did not apply to my actions. Until the rules were

changed recently, senior analysts were not required to seek approval for ratings changes, period.

In the initiation process for the companies that we are about to

pick up coverage on, we do send part of the report to the company,

what we call the back of the report, which factually describes the

businesses for fact checking. But after that point, the recommendations, the evaluation, and our opinions are not second-guessed by

outside or inside people.

Senator THOMPSON. So this only applies to new businesses as opposed to companies that you are already doing business with? Is

that——

Mr. FEYGIN. To my best understanding—and, frankly, since it

didn’t apply to me, I didn’t study it in great detail, but that applied

to the London research—the department in London, and it did

apply to rating changes broadly, not just to new initiations.

Senator THOMPSON. And is it still applicable?

Mr. FEYGIN. I don’t know the answer to that for the London franchise.

Senator THOMPSON. My time is up, Mr. Chairman. Thank you.

Chairman LIEBERMAN. Thanks, Senator Thompson. Senator

Levin.

Senator LEVIN. Thank you, Mr. Chairman.

The Powers Report says, ‘‘There is some evidence that Enron employees agreed in undocumented side deals to ensure the LJM partnerships against loss in three transactions.’’ Now, one of the documents that we have identified in the materials that we have been

reviewing at the Permanent Subcommittee on Investigations confirms this with respect to several deals that were called the ENA

CLO Trust. Enron North America agreed to buy back accounts receivables that it sold to LJM if these receivables could not be collected.

Now, three of you, representing Credit Suisse, J.P. Morgan, and

Salomon Smith Barney, were limited partners in LJM. So it is logical to conclude, I would ask you, that they knew about these guarantees. And those guarantees were apparently not reported on

Enron’s financial statements because that would have defeated the

purpose of the transaction in the first place. So any of the three

of you representing the companies that I have mentioned, did any

31

of you work on any of the deals related to LJM or any decisions

relating to the LJM partnership? Let me start with you, Mr.

Feygin.

Mr. FEYGIN. Absolutely not.

Senator LEVIN. OK. Mr. Launer.

Mr. LAUNER. I was not over the wall for any of the LJM activity

of our firms.

Senator LEVIN. Thank you. Mr. Niles.

Mr. NILES. No.

Senator LEVIN. OK. Now, if you had known about the guarantees, I assume that you would have considered those guarantees a

liability to Enron, lessening to some degree, at least, Enron’s financial standing. Is that correct?

Mr. FEYGIN. That is absolutely right.

Senator LEVIN. Mr. Launer.

Mr. LAUNER. The same answer would apply here.

Senator LEVIN. Mr. Niles.

Mr. NILES. I believe so. I might just add, though, if this was material non-public information, I would have to go to my attorney,

and I wouldn’t be able to comment on Enron because of the Chinese wall restriction.

Senator LEVIN. But I am asking if that information were known

to you, if it had pierced the wall, it would have affected Enron’s

value.

Mr. NILES. Yes.

Senator LEVIN. OK. Now, the value of the partnership depends

to some extent on the Enron guarantee. The partnership’s value,

which is being assessed, touted, sold by the other part of your firm,

depends to some extent on that guarantee. So should the fact of the

guarantee be known to the analyst since guarantees are significant

liabilities? In other words, you said that it would have affected

your judgment had you known. Part of your firm knew. You didn’t

because of the wall.

Should you have that information available to you before you

begin telling the public that this is good stock to buy since someone

else in your firm knows, hey, there is something that is not appearing on that balance sheet which would affect that analyst’s judgment? Mr. Feygin.

Mr. FEYGIN. Again, if the question is if this information is material, it is absolutely incumbent upon the company to issue and disclose that in its financial statements, at which point it becomes

public information for me—— Senator LEVIN. It was not in its financial statements, according

to the document.

Mr. FEYGIN. Correct.

Senator LEVIN. Now, someone in your company knows something

that is not in the financial statement, because there is evidence

that those guarantees were issued without being publicly disclosed.

Now, does that not create an inherent problem for your company

and for you? Because someone in your company knows something

which affects the value of a stock that you are analyzing and that

you do not know that would affect that analysis.

Mr. FEYGIN. The issue of the Chinese wall has been brought up

often in these hearings, and I am sure there is a lot of information

32

that is on the other side of the wall, the non-public information

that resides within our institution that I am not privy to. That is

not my role, and, regrettably, that is not something I can incorporate into my analysis.

Senator LEVIN. So the information that I have just described, you

don’t think should be available to the analyst?

Mr. FEYGIN. If it is material, it should be made available to me

by the company itself.

Senator LEVIN. All right. And if it is not disclosed by the company but kept private on the other side of the wall, but it affects

your recommendation, then what?

Mr. FEYGIN. As the laws are structured today, obviously that information cannot flow to me from the other side of the wall.

If inadvertently it did, I would have to report that to our Compliance Department and action would be taken after that.

Senator LEVIN. Therefore, on the other side of the wall, they

know that you are giving an analysis which is based on incomplete

information which affects what they are doing because the more

that Enron stock is held to be valuable because it is not known

that that guarantee exists which would reduce its value, the greater is the partnership interest that it is selling, the more valuable

it is. There is an inherent conflict right there. How do we solve it?

Mr. FEYGIN. If it is a material issue, again, the forces at play

should make the company disclose that information openly and

publicly.

Senator LEVIN. Or your company should itself insist that that information, that guarantee, be made available on the financial statement, should it not?

Mr. FEYGIN. In this case, the company being Enron? Absolutely.

Senator LEVIN. No. The company being your company.

Mr. FEYGIN. Should insist that Enron disclose that information?

Senator LEVIN. Yes, that it be on the financial statements.

Mr. FEYGIN. I can’t speak to that call being made on the other

side of the bank.

Senator LEVIN. Anyone else, just with the three companies, have

a comment on this?

Mr. LAUNER. The only comment I would make is it is not our job

to disclose material non-public information. It is the responsibility

of the company, meaning Enron, their accountants and their lawyers.

Senator LEVIN. Why is it not the responsibility of your company,

on the investment side of your company, to make sure that something which should be disclosed in that financial statement which

would have an effect on the stock be disclosed?

Mr. LAUNER. Material non-public information. We are not over

the Chinese wall and do not have possession of that information.

Senator LEVIN. By not insisting that it be disclosed, it is leading

the other side of the company to be giving an appraisal of stock,

a valuation of stock which is based on information which the other

side of the company knows to be incomplete. And it seems to me

that creates an inherent conflict that we have to address and the

investment community has to address.

My time is up, and I will pick up later. Thank you.

33

Chairman LIEBERMAN. Thanks, Senator Levin. That was a very

interesting line of questioning.

Let me just for the purpose of clarity, because there was something assumed in the line of questioning. There is this so-called

Chinese wall between the research departments, or the analysts always say, and the rest of the business of the firms you work for,

correct? That is what we are talking about. But, Mr. Launer, I

think you used the term—and we have all heard it here in these

discussions—being ‘‘brought over the wall.’’ I take it—am I correct

that there are occasions when you as analysts are brought over the

wall into other parts of your firm’s business? Is that correct?

Mr. FEYGIN. That is correct.

Mr. LAUNER. Yes.

Chairman LIEBERMAN. But you were all saying in the specific instance that Senator Levin was interested in, you were not brought

over the wall.

Mr. LAUNER. That is correct.

Chairman LIEBERMAN. Were there any occasions, since each of

your firms, the four of you were doing—each of the firms was doing

business with Enron, when you as analysts were brought over the

wall with regard to any deals or business arrangements with

Enron? Mr. Feygin.

Mr. FEYGIN. Certainly. In the case of Enron, on November 9,

prior to the merger with Enron and Dynegy being announced, a

couple hours prior to that I did receive—I believe I received the

press release of the merger, at which point I was brought over the

wall and was frozen and could not comment on the stock.

Chairman LIEBERMAN. And you were brought over the wall for

what purpose?

Mr. FEYGIN. For the purpose of having the information and being

able to respond to investor questions once the deal with announced.

Chairman LIEBERMAN. So you were no longer giving public analysis? Is that what I understand you to say?

Mr. FEYGIN. From the point that I was given that material nonpublic information that this merger was about to be announced and

saw the details of that merger, I could not comment, I could not

publish research until it was publicly announced and disseminated.

Chairman LIEBERMAN. Mr. Gross, were you brought over the wall

in any business transactions related to Enron?

Mr. GROSS. Specifically here, we were the adviser to Dynegy, and

I was brought over the wall in late October.

Chairman LIEBERMAN. So to advise your company about

Enron——

Mr. GROSS. My primary role here was to gauge how investors

would react to the merger, to gauge their concerns, and in that

light help formulate but not actually execute due diligence that

Dynegy would do on Enron.

Chairman LIEBERMAN. Did you continue to provide analysis that

was——

Mr. GROSS. No. At that point, my ratings, according to company

policy, are frozen.

Chairman LIEBERMAN. Mr. Launer.

34

Mr. LAUNER. I was over the wall relative to Enron for 6 weeks

in the September-October period of the year 2000 for an IPO of the

NewPower Company.

Chairman LIEBERMAN. Mr. Niles.

Mr. NILES. There was one occasion. In January 2001, I was

brought over the wall for a 24-hour period, I believe, for a convertible security offering by Salomon Smith Barney for Enron securities.

Chairman LIEBERMAN. All right. I appreciate your responsiveness, and I see each of you in one sense or another presenting evidence that your companies had rules. But you can see how at least

I, as one just sitting here, have doubts raised in my mind. You

have got this expertise, and your companies have business interests in other dealings, including with Enron. The public is relying

through the media, through websites, etc., on your analysis of

Enron. And yet there is a feel of a conflict which, no matter how

hard you tried with the freezing of your public analysis and all,

still leaves me feeling that the rules were not adequate, particularly in light of your continuing recommendation to buy Enron

after most everybody was selling it.

I am going to stop there. Senator Voinovich.

Senator VOINOVICH. It looks to me like there are a couple of

things we have to be concerned about. Do you guys have a conflict

of interest by owning stock, your family owning stock, and whether

you ought to disclose ownership, or be prevented by law from owning any stock that you report on. That one is internal.

External is the Chinese wall. Should we have any Chinese walls

at all? Should you all go into the business that Mr. Schilit is in,

and that is that you are an analyst and you have got nothing to

do with the other side of the business. And, this gets back to what

Senator Lieberman was saying—if you are in the same outfit, there

ought not to be a wall. If you have got information, inside information, and you are an analyst, that information should be made

available when you do your reports. So there is no problem of

whether you have got a wall or you don’t have a wall. Also, Mr.

Launer, you are complaining about the fact that you didn’t have

the information that you needed. What information more do you

need to do a better job of being analysts if you stay in the same

kind of outfit that you are in today? Is there something that we can

do in terms of the law, requiring more information so you can make

better judgments?

Have any of you changed the way you are doing business because

of Enron? Are you doing things the same way as you did them before? Are you a little bit more cautious? Are there other things that

have changed in terms of your operation?

I would like to hear from all of you. Do you think we ought to

have legislation that says that you can’t do any kind of analyst

work on stock that you own? And, do you think that you should be

required to disclose if you are an analyst of the stock that you own?

Yes or no. We will start with you, Mr. Feygin.

Mr. FEYGIN. I agree that we should be required to disclose, which

is J.P. Morgan policy, the stocks that we own, as well as some

other disclosures that are standard in our research.

35

Senator VOINOVICH. And do you think it should be required by

law that that be the case?

Mr. FEYGIN. I would like to fall back on something Senator

Torricelli said, and that is the markets do take care of this issue.

And to the extent that firms will be more trusted and their analysis will be deemed more valuable, the market itself will impose

those disclosures.

Senator VOINOVICH. So you don’t think you need legislation that

requires that?

Mr. FEYGIN. I can’t really comment on that. I know that at our

firm we do disclose that, and hopefully that helps our product. And

I would welcome any changes that would enhance our product offering. If that is one of them, by all means.

Senator VOINOVICH. Mr. Gross.

Mr. GROSS. No, disclosure I think is a good thing. And, in general, Lehman Brothers in the past has had outright bans for analysts owning stocks that they follow.

Senator VOINOVICH. Legislation or no legislation.

Mr. GROSS. That is a difficult call for me to make because——

Senator VOINOVICH. Mr. Launer.

Mr. LAUNER. No legislation, to answer your direct question. Our

firm has adopted the SIA best practices. They effectively contain

provisions which require—— Senator VOINOVICH. Yes, but before your firm did that, your family did own—had bought a bond, had stock. Your sons had stock in

Enron. And then the firm changed the rules, and then you had to

transfer stock, except you had to hold a bond that is not worth anything anymore. But did that color your judgment when you

owned—I mean, you were working on Enron, you or your family

members were buying stock in Enron. Did that color your judgment

in terms of your analysis of Enron stock?

Mr. LAUNER. No, it did not, and it was fully disclosed each step

of the way.

Senator VOINOVICH. But right now you don’t have to—you can’t

deal with any stock that you are an analyst for, right?

Mr. LAUNER. That is right.

Senator VOINOVICH. And your family can’t, according to the rules

of the firm.

Mr. LAUNER. That is correct.

Senator VOINOVICH. And you don’t think we need legislation to

require that?

Mr. LAUNER. No, I don’t.

Senator VOINOVICH. Mr. Niles.

Mr. NILES. Our firm prohibits buying stocks in companies that

we cover, and as far as the policy matter, I haven’t really given it

a lot of thought. But I do know our firm prohibits buying stocks

in companies——

Senator VOINOVICH. OK. How about the Chinese wall? Do you

think that you ought to split off to avoid what Senator Lieberman

and some others have talked about, the issue of having the same

firm being analysts and at the same time being investment bankers and having all kinds of information on one side that the people

who are doing the analysis can’t have because it is not public? I

know what Mr. Schilit is going to say.

36

What do you say, Mr. Feygin?

Mr. FEYGIN. Senator, I believe in your question and in a lot of

the statements there is the presumption that there is a conflict of

interest, and on some levels perhaps it exists. But the value that

I bring to the firm, again, is in my independence and the credibility

I have with my investors. And that is absolutely key. To the extent

that that helps our firm gain business, that is great and the firm

will prosper.

To the extent that it is a ‘‘buy’’ recommendation that helps me

build credibility, we have commented—this panel has commented

on numerous occasions that there were multiple buys on the stock.

Senator VOINOVICH. I understand the whole thing is trust and

trustworthiness. Enron has destroyed that for a lot of people in this

country. And those of you in the business are going to have to respond to it because it is really going to hurt the business, it is already hurting the business.

Let’s say, for example, that your firm has a Chinese wall. Do you

disclose to the people that you are analyzing stock for that there

is a Chinese wall and that your firm is doing other work for the

companies that you are analyzing the stock for?

Mr. FEYGIN. It is company policy to disclose if J.P. Morgan had

a role as an underwriter or was involved in an offering for the company when we publish any reports.

Senator VOINOVICH. So that is something that you are already

doing.

Mr. FEYGIN. Yes. Now, we do not disclose on every report that

there is a Chinese wall because, again, our role focuses exclusively

on publicly available information.

Senator VOINOVICH. Mr. Gross, how do you feel about it? Do you

think you ought to break it up so you don’t have a problem?

Mr. GROSS. No, I think that in general that the methods that we

follow to handle potential conflicts are adequate. Going back to

Senator Levin’s comment, the investment bankers periodically have

material non-public information. The vast majority of it is not applicable to what I do. It may be in the context of Company A wants

to buy Company B, never does execute that transactions. That is

material non-public information.

The type of disclosure that Senator Levin was talking about I

think is more appropriately handled in that the rating agencies see

consolidated balance sheets. We have some new disclosure rules

which will allow us on the outside to do so. The auditors deem

what is material or not. We have talked about in different forms

tightening some of those screens.

So there are mechanisms that are out there that would provide

that flow of information to the investment community without curtailing my role, which is a materially different role in how I would

help the firm with—as I said, my role in the Dynegy deal was basically to tell the companies the investor reaction to doing this. So

from a standpoint of the nature of serving multiple clients, I don’t

think the conflicts are all that prominent, nor are they that insurmountable when people——

Senator VOINOVICH. Well, I will finish because I am out of time,

but you now have a problem of appearances. Before this you didn’t.

It is the issue of appearances of conflict of interest. And what we

37

are trying to do as quickly as possible is to restore people’s faith

in the financial markets in this country so we can get back to business. And I would say to all of you that are here, the faster you

can move internally within your own organizations to get out and

change some of these things—and I would love to have your recommendations, this Committee would, on some of the things in

terms of legislation that we need to do so you have better information so that you can do your job better.

Thank you, Mr. Chairman.

Chairman LIEBERMAN. Thank you, Senator Voinovich. Senator

Torricelli.

Senator TORRICELLI. Thank you, Mr. Chairman, very much.

What is extraordinary about the Enron matter is the confluence

of failures: Unethical business practices by executives which could

constitute fraud or gross mismanagement; the failure of a proper

accounting to basic standards that would be acceptable; and now

the issue of whether the analysis was never properly at arm’s

length or simply failed because of inadequacy of information.

If any one of these three institutions had actually had the proper

information and acted according to highest expectations, a great

deal of pain would have been saved for a great number of people.

Our role here is to focus on the third of these functions, each of

your roles in the marketplace. I can only supplement my colleagues’ questions by asking your thoughts on several things to

help me better understand some of these relationships.

First, let me go to this issue of information you were receiving

from Enron. On this conversation of August 14 in which you received this analysis by Mr. Skilling and Mr. Lay, characterize for

me whether in your judgments this constituted simply exaggerating information properly available, was just routinely misleading, or you consider yourself to have been defrauded by some

of this information that was provided by Mr. Skilling? I go back to

the quotes I provided to you earlier, which I assume you to be familiar with, the numbers, the projections, and particularly the references to the new businesses of the crude, the crude products,

metal, pulp, paper, and coal. Some have doubled. Every one of

them in the second quarter or the quarter before, all are profitable.

The characterization then put on the company in August, now

that we know what, in fact, those executives knew about the company, about the partnerships, about the deteriorating situation, the

warnings they had received from people internally, as professionals. Looking back on the conversation, the judgments you made

based on it, how do you characterize this as a business?

Mr. FEYGIN. Thank you for that question. I will break it up into

two parts. One, the characterization of the businesses’ performance

provided by Mr. Skilling. To date, there is no evidence yet that

those new businesses were not performing in line with what Mr.

Skilling said. I think one of the most impressive aspects was, as

the company got into new products such as pulp and paper when

it was about to collapse, the Scandinavian pulp and paper markets

were panicked because of the size of Enron’s presence in that marketplace, or perceived size of Enron’s presence. So it appears

today—and we have no evidence to the contrary—that those businesses were, in fact, gaining traction and growing.

38

In hindsight, it certainly seems that, as it relates to the partnerships and the exposures of Enron, we were misled.

Senator TORRICELLI. Mr. Gross.

Mr. GROSS. I would say obviously, in retrospect, that the nature

of the disclosure was leading with your best foot and letting the

other drag behind. And in the context of the subsequent information that has come out, there is no question that we weren’t receiving the full story about the health of the company.

Senator TORRICELLI. In your mind, as someone who has done

these calls before, is this in keeping with the culture of the business and the way these disclosures are made? Or do you feel that

you personally and your clients were victims of a fraud?

Mr. GROSS. Well, without materially more information, I can’t

draw a line between the communications that we received and outside—outright fraud. I think that will be subject to further investigations.

Senator TORRICELLI. Anybody else want to comment on this?

[No response.]

Senator TORRICELLI. Explain to me further the operation of the

separation of the firms. Apparently each of you are prohibited from

owning positions in the stocks you analyze or are required to disclose those positions for yourself or family members. Is that accurate?

Mr. GROSS. In our case, I mentioned earlier that at times we

have had that ban. We currently are able to own stocks, and we

have severe restrictions about the nature of how we can own them

and when we can buy or sell those securities.

Senator TORRICELLI. Now, in the way the separation works, are

you then also not operating with knowledge about the positions

that the firm may be holding on its own account? Or, for example,

if you had done underwriting, the firm had done underwriting for

a company, whether you have future positions with this firm, or

separately whether you are holding large numbers of bonds for the

firm. How knowledgeable are you about the exposure of the firm

itself and its own position in any particular company, not necessarily this one? Mr. Feygin.

Mr. FEYGIN. No knowledge whatsoever of actions that are, again,

on the other side of the wall.

Senator TORRICELLI. You wouldn’t indeed know other than what

might be publicly disclosed? I assume if you searched for it, you

could find some public disclosures whether or not the firm had any

of these positions?

Mr. FEYGIN. Sure. You know, in the case of Enron and our firm’s

involvement in particular, all I learned about our exposure I

learned from the press.

Senator TORRICELLI. Well, we all did. Mr. Niles.

Mr. NILES. I am sorry, Senator. The question was am I aware of

the firm’s positions on——

Senator TORRICELLI. I want to get a feel for how these walls operate within these firms, whether, in fact, you have knowledge of

the firm’s exposure in what position it may have from doing underwriting for these firms and its future potential or the bonds that

they are holding at the time.

Mr. NILES. I don’t have access to that kind of information.

39

Senator TORRICELLI. So, in practice, not simply Enron but any of

these firms, you find these absolute?

Mr. NILES. I don’t have that information.

Senator TORRICELLI. Let me ask you finally, in seeking resolution

to this and where this Committee ultimately will be left is whether

to recommend statutory changes or, indeed, as I suggested earlier,

this is worked out in the marketplace or professionally, is there an

argument that, in fact, the analysis function should be professionalized and separated and be a product which is individually

purchased by the brokerage firms rather than the investment

bankers, the brokerage parts of this, having it in-house and connected in any case? These could indeed be separated, much as the

accounting industry, we thought previously, had been separated

and made independent. Is there an argument for taking these out

of the same roof at all to restore public confidence?

Mr. FEYGIN. Well, Senator, again, these are obviously very large

public policy decisions that we as a firm would be pleased to work

with this Committee on. I firmly believe that there are plenty of

rules and guidelines in place that ensure our independence and,

from a legal framework, ensure our integrity, as well as the fact

that it is, as you pointed out, paramount in the marketplace, that

the marketplace perceive our product as one of integrity.

Senator TORRICELLI. Things are not going to be in the future as

they were in the past. The status quo is not an option. We are either going to take a bright yellow sticker and put it on the windshield of all of your firms, revealing your gas mileage and your resale values, much as this Congress did 30 years ago with a different industry, to know what your track record is, what your rules

are about disclosure, and the holding of equities and your conflicts

of interest so the public can make its judgment in the marketplace,

which is my own preferred solution; or indeed this Congress is

going to write a regulatory framework to impose some of that.

One of the options is to simply separate the functions, that if

Smith Barney wants analysis, buy it from an independent firm so

the customers know that, in fact, they are—what is happening here

is genuinely at arm’s length and can have more than a Chinese

wall, we can have a brick wall separating you by physical location

and management.

I want to conclude this by asking your advice. Do you all favor

simply letting this work out in the market: The public will have

confidence in some firms, they won’t have confidence in others? I

suspect anybody with a portfolio right now is scurrying around

town trying to figure out who was right, who was wrong. They are

all looking at these sheets. Who came up with the right answer

first to get out? That is one answer, how our system operates. Or

we can go further. Is there anybody else who wants to add on this

in a recommendation? That is, after all, why you are here. We are

trying to figure out how to make recommendations to our colleagues to proceed with this.

Mr. SCHILIT. Yes, I have been sitting quietly for a long time because I am not part of the Wall Street community. There is a lot

wrong, and to answer your specific question, it absolutely should be

expected that the research should be an independent function,

40

should be set up separately. Customers should pay a fee for that,

and the marketplace decides the value of that research.

In answer to Senator Voinovich in terms of what steps any of us

have taken in the wake of Enron, sadly we are a tiny firm. We only

had six analysts up until very recently, so one of the industries we

did not cover was the energy group. But we have hired an additional six analysts, and we are looking at 100 percent of the S&P

500 companies just for these type of corporate governance problems, a weak control environment.

Also, I did want to—because I have the floor for a few moments,

I did want to comment on were there any signs in any of the public

filings that there were problems at Enron? A very logical question.

Everybody is saying they hid from us, they lied to us, they committed a fraud. Did you read the public filings that were published

at the SEC? I spent an hour of my time last night going through

every quarterly filing proxy, no more than an hour, and I have

three pages of warnings, words like ‘‘non-cash sales,’’ words like ‘‘$1

billion of related-party revenue.’’ Chairman LIEBERMAN. These were all from last year?

Mr. SCHILIT. This was beginning in March 2000. Every single

quarter there was a little blurb looking at the reported profits, for

one quarter $338 million, and $264 million of that, a pretty material amount, represent earnings from unconsolidated affiliates,

more than two-thirds of the earnings, and it goes on and on.

Senator TORRICELLI. These corporations we have heard about,

the 3,000 or so Raptors or whatever, they were referred to in one

of those footnotes.

Mr. SCHILIT. Well, they gave little snippets of information, but

the point is this: I am heartbroken that I was not covering this

company when I could have done some good. But for any analyst

to say there were no warning signs in the public filings, they could

not have read the same public filings that I did.

Senator TORRICELLI. Your disappointment is nothing compared to

that of a lot of other people who wish that you were following it.

When you see these footnotes, though, and it is clear a lot of this

is happening off the balance sheets, in reference to Senator Thompson’s question, are there references only to the gross amounts of

these that are happening off the books? Or is there some indication, some window in the numbers of these partnerships?

Mr. SCHILIT. They don’t give any clue. I was astounded when I

heard it was 3,500. But just looking at the most basic things that

any investor could understand, if a company reports a profit of a

billion dollars and that same period the company says we had negative $1.1 billion of cash received from that operation, there has got

to be some warning out there. And those numbers came right from

the June 2001 quarterly report.

Senator TORRICELLI. Thank you, Mr. Chairman.

Chairman LIEBERMAN. Thank you. Senator Bunning.

Senator BUNNING. Thank you, Mr. Chairman.

In regard to some of Senator Torricelli’s questioning, I want to

refer to the J.P. Morgan, Lehman Brothers, First Boston, Citigroup

Salomon Smith Barney. Tell me how much your companies were

involved in the selling group or the underwriting groups or what

equity position your company had in Enron. You can start with the

41

first and go on down, because from 1961 to 1986, I was in your

business. And the same thing was going on in 1961 that is going

on the year 2002. Our company would take a position in an underwriting group. Then they would come to the sales force and say: We

have an equity position in this stock. We are recommending it to

you to sell.

Now, help me out.

Mr. FEYGIN. Easy question for us. We are not involved in any

equity underwriting for Enron—— Senator BUNNING. Or selling group?

Mr. FEYGIN. We were not a part of any syndicate on Enron

equity offering.

Senator BUNNING. And you own none for your own personal——

Mr. FEYGIN. Own none for my own personal——

Senator BUNNING. Not your personal. The corporation’s personal.

Mr. FEYGIN. I do not know whether the asset management side

of J.P. Morgan holds or has ever held a position in Enron.

Senator BUNNING. That is impossible, sir. I am sorry. That is impossible for you to tell me that.

Mr. FEYGIN. Why is that?

Senator BUNNING. Because if you know that they weren’t in the

selling groups of any type and you know that they weren’t in any

underwriting group, you ought to know, if you are in the business

of recommending, whether they are in the equity end of the—in

other words, whose stock are you recommending, the stock that

your company owns or the stock that is owned in the public market?

Mr. FEYGIN. The stock that is owned in the public market.

Senator BUNNING. Next?

Mr. GROSS. We have participated in several offerings that

Enron—most of them were on the fixed-income side. The equity

offerings——

Senator BUNNING. Debt instruments?

Mr. GROSS. Debt instruments.

Senator BUNNING. OK.

Mr. GROSS. We were a co-manager in an affiliate called Northern

Border Pipeline in the last year.

Senator BUNNING. You were an adviser to them on your—— Mr. GROSS. We were a co-manager, which means we did not run

the books.

Senator BUNNING. OK.

Mr. GROSS. We participate in the sales.

In general, once again, the vast majority of these sales will take

place with companies that are already trading in the public domain. They will be distributed to institutional investors.

From a standpoint of our position, yes, the way a syndicate is

formed is they own stock for a brief amount of time. We have a

money management wing where we have a high-net-worth group of

individuals—— Senator BUNNING. For which a portion—— Mr. GROSS. They may own Enron in that system. It is very difficult for me to know. But, in general, because it is investors’ money, it is not ours. It is investors’ money. The same thing with

J.P. Morgan investment and management company. It is investors’

42

money, not J.P. Morgan’s, that they are managing. It is an independent wing.

Basically what we will have is in and around, like I say, an offering, it will be for a brief and limited amount of time. It is generally

in a security that is already publicly traded—— Senator BUNNING. But you have taken the position so that you

can sell the securities?

Mr. GROSS. Yes.

Senator BUNNING. OK.

Mr. LAUNER. Senator, the disclosure on the bottom of our research report says that our firm may from time to time hold positions in the securities of the company that is the subject of the report.

Senator BUNNING. Thank you.

Mr. LAUNER. It does not say anything specifically. For me, over

the wall, the period of time was only the 6-week period in 2000——

Senator BUNNING. Over the wall. It is in the Wall Street Journal

who is in the underwriting groups. I mean, that is public knowledge, who is in the selling group, who is in the underwriting group.

The position that your company might have in that equity, if you

are selling as an owner of or as a broker for or——

Mr. LAUNER. The disclosure that needs to be made has been

made relative to those things. Yes, we have been in selling groups.

But it really comes down to the level of our specific involvement

in those when we are over the wall. In 1998, I was at Donaldson,

Lufkin & Jenrette before the acquisition of our firm by CSFB. I

was involved in an equity offering where we were the lead manager

for Enron securities. So for that period of time that I was over the

wall, I was aware of the firm’s position and how we were handling

the entire equity offering. That ends at the time that the prospectus delivery requirement relative to that offering—— Senator BUNNING. You don’t feel that inside, supposedly nonpublic information, that you got while you were over the wall

would shade your judgment at all in your analysis now of that

same corporation?

Mr. LAUNER. No.

Senator BUNNING. Mr. Niles.

Mr. NILES. Yes, Senator, our firm, it is a large institution. We

have an investment bank, a corporate bank, and we have been involved in a number of offerings with regard to Enron. And, I would

just say we definitely—that is part of our practice as a firm. I am

not aware of the specific ownership interest in the securities or how

that works or quantities.

Senator BUNNING. That blows my mind, because just as an account executive, I was aware of it. I was aware of whether we took

a position and we were selling stock out of our own portfolio or if

we were just going to the market and buying and then delivering

the stock to a customer. So some of the things you are telling us

are very difficult to believe.

Now, if we are going to solve this problem and we have come to

you for assistance and you are going to testify as you have testified

today, you are asking us to intercede, not by your suggestions but

by our own initiative from what we hear. And what I hear from

you is very difficult for me to believe. And I know about the walls.

43

But the walls are not impenetrable. People within your company

know just what you are recommending and are for what you are

recommending because they know it is going to help the other side

of the wall. And I think that is something that we have to look at

very closely, Mr. Chairman, and I am willing to go if you are.

Thank you.

Chairman LIEBERMAN. It is always good to be on the side of a

member of the Hall of Fame. [Laughter.]

He threw some high hard ones in his day.

Senator LEVIN. Whichever side of the wall he is on, by the way.

Chairman LIEBERMAN. Well, your questions are right on target,

and, you express the concerns that I certainly have. And I guess

the question is: Each of the four of you have said at one point or

another you went over the wall. You went over the wall according

to the rules of the firms. But, the question that I have and I think

Senator Bunning’s and other questions raised is: If you can go over

the wall, was it high enough? In other words, does it not raise

questions in all of our minds about your ultimate independence or

the intermixing of the different functions of your firm?

Thanks, Senator Bunning. Senator Bennett.

Senator BENNETT. Thank you, Mr. Chairman. I won’t re-rake the

leaves. I think they have been gone over sufficiently. But I can’t

pass the opportunity while you are here to raise another question

that occurs to me. I have not been an account executive like Senator Bunning, but I have been in the market a good bit in my career. I have made some fairly substantial money in the market,

and I have lost some fairly substantial money in the market. And

without the education that would be necessary to be an analyst for

pay, I do remember something that I was taught when I was in my

20’s, first getting into the market, very, very fundamental. Don’t

buck the trend. And when I inquired as to my counselor, well, how

do you know when the trend is going on? He said, well, it is very

simple. A trend, once established, continues until it is over.

I turn to your testimony. Here is the Credit Suisse sheet that

says up at the top: ‘‘Recommendation, strong buy.’’ And it is within

inches of a chart that makes the trend pretty obvious. The stock

has been going down on a very steady basis for a year.

My gut reaction is I don’t want to buy that unless in the copy

that says ‘‘strong buy’’ there is an indication as to why the trend

is over. A trend, once established, continues until it is over. I want

something here that says this is what has happened different in

the firm that shows that there is going to be a bounce. And I read

the copy, and there is nothing here that shows there is going to be

a bounce. Everyone here—and the copy of the rest of it. I am not

just picking this one out. I picked this one out because it happened

to have a chart, and I like visual aids. But there is nothing in any

of the copy of any of the recommendations that says there is a shift

in the trend.

And so my question to you, which has nothing to do with what

we are talking about, is just interest, the fact that you are here,

and I hope you can educate me. What in your opinion caused the

stock to go down? While analysts were recommending a buy all the

way through, the market was saying this is a dog, we want out of

it.

44

The uncoordinated decisions of hundreds of thousands of investors were sending a strong signal, we want out of this stock. The

chart shows that the market says this is a dog.

What did the market see that the analysts didn’t? What caused

the stock to go down? Was it people like Mr. Schilit sitting up at

night reading the footnotes? What in your opinion caused Enron,

prior to the disaster—let’s say the disaster didn’t occur and we are

back on October 24. You have got a stock that has gone down, according to this chart, index price has gone down from $100 to $30

in less than a year. It has lost 70 percent of its market value. Why

in your opinion did the market decide this stock was worth only 30

percent of what it has been worth a year before? Anybody?

Mr. GROSS. Principally, the backdrop prior to that is that the

stock had more than doubled to get to $90. And if you look at the

backdrop for emerging market securities, new businesses, the

NASDAQ had gone from 2800 to 5100 and in that same period had

fallen to 1700. So a good portion of what you were seeing in Enron

stock was the entry into emerging businesses which subsequently

didn’t work out for the entire industry, not just of Enron.

Increasingly what you saw was incremental pieces of information, whether it was the resignation of a chief executive officer, etc.,

that took little increments down. But the stock moving from $40

to $90 back to $40 was principally broadband bubble.

Senator BENNETT. Is there consensus on that?

Mr. FEYGIN. I think there is also, in addition to what Mr. Gross

has said, which I absolutely agree with, there is also a period in

this country and in investor sentiment of being extremely bullish

on energy and the fact that we had a shortage, which would be a

boon for companies, especially in the deregulated part of the energy

business, and that also came and went in roughly the same period.

Senator BENNETT. Was the consensus in the analyst community

to say ‘‘buy’’ during the slide from $100 to $30? Or do we know?

Mr. FEYGIN. I think your charts have shown pretty clearly, with

some corrections, but there was a consensus to be recommending

Enron stock throughout most of that period.

Senator BENNETT. So there was a ‘‘buy’’ when it was at an index

price of $100, and there was a ‘‘buy’’ when it was at $70, and there

was a ‘‘buy’’ when it was at $50, and there was a ‘‘buy’’ when it

was at $40, and then we know there was a ‘‘strong buy’’ when it

hit $30. Well, OK. I take your point about NASDAQ. I didn’t participate in any of that because I decided in my own mind this is

tulip time. And I don’t know at what point the Dutch are going to

wake up and discover that they can’t get much nourishment out of

eating the bulbs, and, therefore, they are not worth the total farm,

which is what they went through. And we went through that with

the dot-coms. And my kids would say, Should I be buying this? As

I say, I said this is tulip time. And I would feel better just staying

out of the market until the tulip bulbs have come back down to

earth.

But as I say, I don’t want to re-rake any of the other leaves. I

am just interested in what might be the herd mentality of some analysts saying, well, everybody else is recommending it. That is a legitimate question. Is there that? Do you fear that, gee, all of my

fellows who work for big fancy companies are saying buy this, and

45

1The chart entitled ‘‘Enron Consensus Recommdenation Versus Stock Price,’’ referred to by

Senator Lieberman appears in the Appendix on page 129.

if I say sell, I am going to be embarrassed? Believe me, the herd

mentality rules this town. So it is not an unusual human reaction.

Does anybody have a comment on that? Or should we just go on?

Mr. FEYGIN. If I may, I think one of the premises, again, is that

there is a bias to these ‘‘buy’’ recommendations. And to answer

your question, as we now know, had somebody been clairvoyant,

had we seen through some of these charades and some of these financials, nothing would have been more impactful or valuable for

the analysts to have called that ahead of everyone else. I think I

to some extent speak for the panel that we have very different

views and arrive at our conclusions based on our own independent

analysis, obviously. It happened to be that in this case we didn’t

have the right information.

Senator BENNETT. Well, I can understand a sense that as long

as the core business is OK, you have shaken it down to $30, and

$30 is the logical place for the core business to be. So at $30 you

can buy it. I had a little problem with the ‘‘buy’’ recommendations

before that. That is hindsight, and it is easy for me sitting up here

to exercise hindsight. I appreciate your——

Mr. SCHILIT. While I am more of an expert on accounting tricks

than on predicting stock prices, where they are going to stop dropping, very often after we have found problems at a company and

the stock gets cut in half and gets cut in half again, and people

would ask me, well, has this played out? What I typically tell them,

a stock doesn’t stop going down because it gets tired. There usually

has to be some type of interventions as you were showing with your

chart. Is there some change in the business dynamic? Perhaps a

new chief executive comes in. Perhaps they are selling off a moneylosing business. But very often, other than the bubble that we experienced, when a stock is on a long-term down draft, it usually

doesn’t stop going down because it gets tired. There is usually more

problems that will be coming out.

Senator BENNETT. A trend, once established, continues until it is

over.

Mr. SCHILIT. Absolutely.

Senator BENNETT. OK. Thank you.

Chairman LIEBERMAN. Thanks, Senator Bennett, for an interesting line of questions. We are going to have one more question

each, and then we have got to go on to the second panel.

My question does relate to what Senator Bennett has just described as the herd mentality, and I am particularly thinking about

what Dr. Schilit said earlier on about the hour he spent last night

looking at reports at the SEC that Enron had filed. I want to show

you two charts and then ask you one question about the second

one.

The first is the Enron consensus recommendation versus the

stock price, and the red line here is the consensus recommendation,

mostly above the ‘‘buy’’ until real late; and, of course, the stock

price is here.1

Chairman LIEBERMAN. But the other chart that I really want to

ask you the question about is the one that I referred to earlier on,

46

and this is to speak more generally, not just of Enron but of Wall

Street analysts. And here, this is the S&P 500 from January 2000

to February 2002, and you can see it is up, it is down, it is down,

it is down. But the consensus recommendation on the S&P 500 is

almost a straight line at ‘‘buy.’’ What you said, I think, Mr. Feygin, earlier, just a few moments

ago about you would think that naturally an analyst would want

to be the first to say that, no, this company is going down or this

market is going down. Something is not working right here. To

state this with the clearest edge that I can, I will quote David

Becker from the SEC again, last year when he said, August 7,

2001, in a speech to the American Bar Association: ‘‘Let’s be plain.

Broker-dealers employ analysts because they help sell securities.’’ So the question is: Have analysts become more salespeople than

analysts? And if not, how can we explain that only 1 percent,

slightly more than 1 percent of the recommendations that analysts

made over the period of time studied—that is the other, the Thomson study—were to sell and two-thirds were buy and the rest were

to hold?

Mr. FEYGIN. Thank you, Mr. Chairman, for that question. First,

again, I have to go back to the salespeople versus analysts issue,

and especially in the context of this herd. How much impact can

I have—and I believe on this panel I joined the ranks most recently. But how much of an impact can I have as an analyst coming into a herd and agreeing with the herd? I don’t believe that

that will give my firm any leverage in any business and will in any

way promote my franchise. So I have to bring something different

and something new and something that will establish my credibility and value to the investment community, the institutional investment community, my clients.

So at this point, just as a point of reference, in my space I only

have two ‘‘buy’’ recommendations on the stocks that I cover.

Now, I do believe that the natural gas industry overall—and my

ratings are relative to a benchmark. I do believe that the natural

gas industry overall is in a very good position. It is a limited resource. It is domestic. It does have significant incremental drivers

going forward from gas-fire generation and so on. So in my industry, I believe that there is a reasonable bias to be bullish on the

performance of those companies, and yet only two are rated ‘‘buys.’’ Chairman LIEBERMAN. OK. Anyone else have different—obviously you understand that in the public mind, in our mind now, we

are concerned that the pressure may be from the companies that

you are analyzing and who are doing business with the other divisions of your firm, and that is an even greater pressure on you to

recommend ‘‘buy’’ than the kind of pressure that you describe,

which would be to give the most independent analysis you could.

Mr. Niles, I didn’t get to ask you anything on the last round, so

I wonder if you want to respond to that.

Mr. NILES. Well, I would just say this: I do my best to give the

appropriate ratings. In fact, last year I downgraded an entire group

of subsector of stocks I cover. I was actually the first one on Wall

Street to do it. It was controversial. And, I endeavor to get the call

right as often as I can. Right now not a lot of stocks are rated positively. There are few that are.

47

Chairman LIEBERMAN. So let me ask the broader question. Apart

from what each of you may have done in this area, do you have

any explanation for the average investor out there who goes on to

the Internet, checks stocks, watches television when some of you

come on, as to why only 1 percent of the recommendations during

that period studied were to sell and the rest to buy? Dr. Schilit,

maybe you get the last word.

Mr. SCHILIT. Again, I am not part of the Wall Street establishment, but every time I have seen an analyst go out on a limb and

go against the conventional wisdom, which is you have to be very

positive on the companies that you are writing about, that becomes

a very controversial analyst. It could be a very good career step if

they want to leave the sell side and go to work for a hedge fund.

In fact, there is a fellow from Lehman Brothers who wound up

with a wonderful job at a hedge fund. But if you want to move up

the hierarchy in the Wall Street establishment, you don’t rock the

boat. And that is the reason why nobody at those firms will say

there is a problem at a company.

Chairman LIEBERMAN. Time is really running. Senator Thompson.

Senator THOMPSON. Yes, Mr. Chairman, I was just wondering

whether or not with regard to any of you or anyone on your research or brokerage sides of your companies, whether or not your

compensation is in any way tied to the profitability of the investment banking side of your business, salaries, bonus, anything. Just

yes or no, unless you care to elaborate.

Mr. FEYGIN. No.

Senator THOMPSON. It is not dependent upon the profitability of

the mortgage banking side of the business in any way?

Mr. NILES. Yes, I think investment banking profitability, the

profitability of the overall firm factors into my bonus, but it is a

general matter.

Senator THOMPSON. Anyone else? Is that the case?

Mr. GROSS. It is the same issue.

Senator THOMPSON. Beg your pardon?

Mr. GROSS. It is the overall profitability of the firm where the ultimate pool is drawn from, but there is no direct link.

Senator THOMPSON. That the bonus is dependent upon?

Mr. GROSS. Overall profitability of the firm, yes, and the investment bank is part of our firm.

Senator THOMPSON. Is that the same thing, Mr. Feygin?

Mr. FEYGIN. That is correct.

Senator THOMPSON. All right. Thank you very much.

Chairman LIEBERMAN. Thanks, Senator Thompson. Senator

Levin.

Senator LEVIN. Thank you, Mr. Chairman.

First, a comment, then my question. Mr. Launer, you said that,

relative to Enron, you were on both sides of the wall relative to one

deal, but that the information that you got when you were here on

the investment side of the wall you did not use when you came

back onto the analysis or the brokerage side of the wall.

I find that just difficult to accept, frankly—that you can put a

wall in your mind between information that you get on one side

and not use it when you go on the other side of the wall. I don’t

48

think the wall can possibly mean that the same person can be on

both sides of the wall. I think it has got to mean you are either

on one side of the wall or the other.

It still has problems because the wall is penetratable, but in the

example you give, it seems to me it defeats the purpose of the wall

for one person to be on both sides of the wall structuring a deal

relative to Enron and then going on the other side of the wall

brokering the stock of Enron, because I think it is impossible to ignore what you have learned on the investment side of the wall.

Now, that is a comment, not a question, because I want to stick

to the one-question rule. [Laughter.]

Mr. LAUNER. May I respond?

Senator LEVIN. I think in fairness, if you don’t mind a response

to——

Chairman LIEBERMAN. Go ahead.

Senator LEVIN. We get one response, and then I will reserve my

question.

Chairman LIEBERMAN. We have walls here in the Senate that

one is able to go over as well.

Senator LEVIN. We penetrate walls here.

Chairman LIEBERMAN. Do you want to respond?

Mr. LAUNER. I thought we set up a wall.

Chairman LIEBERMAN. No.

Mr. LAUNER. Senator, the circumstances I referred to and generally circumstances relative to being over the wall are quite similar. It is when you become in possession of material non-public information, and that is a decision made by many others surrounding

me at the firm.

Relative to a public offering of securities, as I mentioned in response to the other question, I was over the wall for a period of

time with my knowledge that that offering of securities was coming. Enron was doing an $850 million equity offering. For a period

of approximately 3 weeks, that offering was pending. That offering

needed to be filed for at the SEC. Then that offering needed to be

announced.

During the period of the marketing of the offering, I was also

over the wall because I had had the opportunity to have that material non-public information first. When the offering was completed

and the stock began to trade the next morning and the syndicate

relative to that offering was completed and, as it said to the SEC,

the syndicate is broken, I then am not in possession of material

non-public information anymore and go back to being an analyst as

I had been before I was over the wall. So it is not a situation that

continues beyond.

Senator LEVIN. My question does relate to IPOs, and let me ask

all of you this question. In July of last year, Laura Unger, who was

then the Acting Chairman of the SEC, reported on an SEC study

of financial analysts that found that 16 of 57 analysts reviewed had

made pre-IPO investments in a company that they later covered.

Subsequently, the analysts’ firms took the company public, and the

analysts initiated research coverage with a buy recommendation.

That is the SEC study, 16 of 57 analysts reviewed had made these

pre-IPO investments in a company that they later covered.

49

My question is this: Have any of you personally participated in

an IPO issue or bought stock in the IPO company before it went

public and then recommended the stock? Putting aside your current company rules because that may have changed what you are

allowed to do now, but at any time during your career as an analyst, did you recommend a stock where you had personally participated in the IPO issue or had bought stock in the IPO company

before it went public? Mr. Feygin.

Mr. FEYGIN. Yes, I participated in an IPO issue, but I never

bought stock in the companies that were brought public. One of the

IPOs that I was involved with never came to fruition. In another

I did end up recommending a buy rating.

Senator LEVIN. And are you allowed to do that under current

rules?

Mr. FEYGIN. I am not allowed to own stock.

Senator LEVIN. Anymore.

Mr. FEYGIN. Anymore.

Senator LEVIN. You can still participate in the IPO?

Mr. FEYGIN. Sorry, participate in the IPO as a firm and

underwriting——

Senator LEVIN. No. You personally, can you—— Mr. FEYGIN. No, absolutely not.

Senator LEVIN. You are not allowed to do that, nor have you ever

done that?

Mr. GROSS. No and no.

Senator LEVIN. Mr. Launer.

Mr. LAUNER. In one instance, in the NewPower Company IPO,

I was with Donaldson, Lufkin & Jenrette at the time. I referred to

it in my opening statement. I invested $18,000 in NewPower prior

to that IPO.

Senator LEVIN. And then recommended the stock?

Mr. LAUNER. Yes, I did.

Senator LEVIN. And can you do that now?

Mr. LAUNER. No, I cannot.

Senator LEVIN. Mr. Niles.

Mr. NILES. No.

Senator LEVIN. I don’t think I have to ask you at all, Mr. Schilit.

Thank you.

Chairman LIEBERMAN. Thanks, Senator Levin. Thanks to all of

you. The testimony you have given has been very important to us

and I believe—and I hope—very important to the investing public.

Thanks very much.

Could I ask the members of the second panel to please come and

stand by your seats and raise your right hand, if you would.

Thanks. Do you swear that the testimony that you are about to

give to this Committee today is the truth, the whole truth, and

nothing but the truth, so help you, God?

Mr. GLAUBER. I do.

Mr. BOWMAN. I do.

Mr. HILL. I do.

Mr. TORRES. I do.

Chairman LIEBERMAN. Thanks very much. Please be seated, and

the record will show that each of the witnesses answered the question in the affirmative.

50

1The prepared statement of Mr. Glauber with an atachment appears in the Appendix on page

90.

Let’s begin with the Hon. Robert Glauber, chairman and chief executive officer of the National Association of Securities Dealers.

Thanks to all of you for being here today.

TESTIMONY OF HON. ROBERT R. GLAUBER,1 CHAIRMAN AND

CHIEF EXECUTIVE OFFICER, NATIONAL ASSOCIATION OF

SECURITIES DEALERS, INC.

Mr. GLAUBER. Thank you very much, Mr. Chairman. If I might

just read a brief oral statement and have my entire comments——

Chairman LIEBERMAN. Please, let me say that the testimony that

you have given, the complete testimony, will be printed in full in

the record.

Mr. GLAUBER. Thank you very much. Thank you, Mr. Chairman

and Members of the Committee, for the opportunity to testify.

First, let me briefly describe the NASD because who we are

bears directly on both the substance of what I will be saying and

on the usefulness of what we have been doing to strengthen analyst independence.

The National Association of Securities Dealers is the world’s

largest self-regulatory organization, or SRO. Under Federal law,

every one of the roughly 5,500 brokerage firms and more than

700,000 registered representatives in the U.S. securities industry

comes under our jurisdiction, which also includes every securities

analyst employed by a member firm. Our mission and our mandate

from Congress is clear: To bring integrity to the markets and confidence to investors.

Employing industry expertise and resources, we license and register industry participants, write rules to govern the conduct of brokerage firms, educate our members on legal and ethical standards,

examine them for compliance with NASD and Federal rules, investigate infractions, and discipline those who fail to comply. We are

staffed by 1,600 professional regulators and governed by a Board

of governors, at least half of which are unaffiliated with the securities industry.

All of this has given NASD a special responsibility to do something about the lack of transparency and increasing conflicts of interest that have eroded public confidence in securities analysts’ recommendations. And, Mr. Chairman it has given us the means to

do something about it as well, for the NASD is equipped to provide

a layer of real private sector regulation between the industry and

the SEC.

In July of last year, well before Enron collapsed, NASD issued

a proposed new rule: To significantly expand analyst disclosure obligations. And 3 weeks ago, culminating a process several months

in the making, I joined several of your congressional colleagues and

SEC Chairman Pitt in announcing far-ranging proposed new rules

to govern the overall responsibilities of securities analysts when

they recommend securities.

These tough, comprehensive rules represent a big step forward,

I think, in investor protection. They will provide disclosure of much

more information about analysts’ potential conflicts of interest as

51

when analysts or their brokerage firms own stock in the company

being recommended or their brokerage firm receives investment

banking revenue from the company. And they will prohibit certain

kinds of behavior as simply being too riddle with such conflicts,

such as analysts’ receiving pre-IPO stock—the issue just raised a

moment ago—or trading against their recommendations or promising favorable research to get underwriting business. The bottom

line is not only enhanced investor protection, but enhanced analyst

independence.

Now, will our analyst rules themselves prevent another future

Enron? I am not going to sit before you and make that claim, for

Enron was a multifaceted disaster, involving corporate governance

that didn’t govern and accounting that was unaccountable, as well

as analysts who were far from analytical in ferreting out the truth.

I think there is no doubt that analysts dropped the ball with

Enron.

But I will say this: Under our new rules, the perverse incentives

that may have causes analysts not to want to know or acknowledge

the truth about Enron, because, say, their investment banks had

lucrative client relationships with the company, those kinds of incentives will be reduced in part because sunlight is the most effective disinfectant. And if there is any remaining reason to wonder

whether an analyst has a conflict, he will have to ’fess up to it and

disclose why he has that conflict to the investing public.

Let me make one final point which I believe is critical. These

new rules are a matter of private sector self-regulation, not selfregulation in name but self-regulation in fact. The proposed rules

were hammered out by the industry’s foremost SROs, acting under

the strong oversight of Congress and the clear vision of SEC Chairman Pitt. They will strengthen the industry’s own business practices and ethical standards, but as enforceable regulatory rules, not

trade association best practices.

The new rules’ impact is already being felt as some firms hasten

to adopt tougher standards. They will be enforced by the NASD

with a full range of disciplinary actions, which this year alone have

included multi-million-dollar fines and expulsions from the industry. And as detailed in my written testimony, NASD has not hesitated in the past to use its existing enforcement authority against

analysts whose conduct has undermined market integrity.

Simply put, Mr. Chairman, these proposed rules will have teeth

because self-regulation in the securities industry does have teeth.

It is what Congress wisely intended more than 60 years ago, and

it is what we continue to deliver with these rules today. Thank you.

Chairman LIEBERMAN. Thank you, Mr. Glauber. I look forward

to questioning you on some of those recommendations, which I appreciate.

Next we have Thomas Bowman, president and chief executive officer of the Association for Investment Management and Research.

Thank you for being here.

52

1The prepared statement of Mr. Bowman appears in the Appendix on page 100.

TESTIMONY OF THOMAS A. BOWMAN, CFA,1 PRESIDENT AND

CHIEF EXECUTIVE OFFICER, ASSOCIATION FOR INVESTMENT MANAGEMENT AND RESEARCH

Mr. BOWMAN. Good afternoon. My name is Thomas A. Bowman.

I am the president and CEO of the Association for Investment

Management and Research and a holder of the Chartered Financial

Analyst designation.

Thank you, Chairman Lieberman and other Members of the

Committee, for the opportunity to speak on behalf of the 150,000

investment professionals worldwide who are AIMR members or

candidates for the CFA designation.

Allegations that analysts lack independence are particularly important to us because they cut to the heart of our core ethical principles and taint a proud profession and its practitioners.

Most AIMR members are not subject to the majority of conflicts

of interest under discussion today, but all of them are disadvantaged by companies’ exploitation of financial accounting standards

and the important principles of transparency and disclosure.

Enron’s disgrace must primarily be attributed to Enron’s management, who are alleged to have played the most egregious games

with financial reporting rules and misled many of even the most

sophisticated investors.

We are convinced that most companies play such games to a

greater or lesser degree. And until financial reporting standards

are developed and enforced for the benefit of investors rather than

the benefit of issuers, investors will be disadvantaged. Until auditors renounce their advocacy of corporate interests, regain independence, and become vigilant watchdogs for fair disclosure, investors will be disadvantaged. Until corporate managements put

shareholder interests first and stop retaliating against analysts for

unpopular opinions, investors will be disadvantaged. Until Wall

Street firms recognize that it is in their best interest to reward

high-quality, independent research, investors will be disadvantaged. And, finally, until all Wall Street analysts adhere tenaciously to a code of ethics and standards of professional conduct

that place their investing client’s interest before their own and

their firm’s and require research objectivity and reasonable basis

for recommendations, investors will be disadvantaged.

When Wall Street analysts are assigned companies whose public

disclosures are opaque and for whom transparency is a dirty word,

research reports and recommendations are made with great uncertainty. There is no obvious point where lack of transparency and

uncertainty about a particular company’s prospects should result in

a no recommendation or a sell. Warren Buffett, one of the most respected investors in the world, advises that if you don’t understand

the company, don’t buy it.

What is obvious is that even with the full disclosure financial

analysis is more art than science. No analyst has a magic formula

that accurately and consistently predicts stock prices. But their

firms must reward them for high-quality research and success of

their recommendations. That said, are Wall Street analysts sometimes pressured to be positive? Yes, but by many forces and not all

53

internal to their firms. These forces create an environment replete

with conflicts of interest, one that undermines the ethical principles upon which AIMR and the CFA program are based, and we

condemn all who foster and sustain it.

These pressures to be positive are intensified in a market that

emphasizes short-term performance, one where investment recommendations are now prime-time news, often in 30-second sound

bites, and where the serious business of investing becomes a sport

like horseracing where investors are always looking for the hot tip.

But we don’t dispute that the collaboration between research and

investment banking is fraught with ethical conflicts. But it is critical to a firm’s due diligence in evaluating investment banking clients under the current system.

To effectively manage these conflicts, we believe that firms must

first foster a corporate culture that protects analysts from undue

pressure from issuers or others and constantly communicate publicly the measures in place to ensure that this happens;

Second, have reporting structures that prevent investment banking from approving, modifying, or rejecting reports or recommendations;

Third, have clear policies for analysts’ personal investment and

trading to ensure that investors’ interests come first;

Fourth, not link analyst independence directly to the success of

the investment banking activities; and

Fifth, disclose conflicts in reports and media appearances that

are prominent, specific, plain English, and not marginal or

boilerplate.

At a minimum, analysts should disclose their personal investments, the compensation to their firm from the subject company,

and material gifts received from the subject company.

Finally, security ratings systems must be concise, clear, and easily understood by the average investor. In addition to the recommendation itself, ratings should include a risk measure and a

time horizon to provide investors better information to judge the

suitability of the investment to their own unique circumstances

and constraints.

In closing, I would like to impress upon the Committee that we

appreciate the seriousness of the problems facing Wall Street analysts but also their complexity. A precipitous solution that addresses only one aspect of the problem is not the answer.

I will be happy to answer any questions later. Thank you very

much.

Chairman LIEBERMAN. Thank you, Mr. Bowman, for a very

strong statement. You are absolutely right, and just to make clear

what I said at the outset, the analysts weren’t the only watchdogs

that didn’t bark here. There were a lot of others who let the investing public down. Also, I think you have made some excellent recommendations, which I look forward to talking to you about in the

question and answer period.

The next witness is Charles Hill, who is the director of financial

research at Thomson Financial/First Call, which is one of the

groups that we have cited with appreciation here today. Thanks,

Mr. Hill.

54

1The prepared statement of Mr. Hill appears in the Appendix on page 109.

TESTIMONY OF CHARLES L. HILL, CFA,1 DIRECTOR OF

RESEARCH, THOMSON FINANCIAL/FIRST CALL

Mr. HILL. Thank you. Chairman Lieberman, Ranking Member

Thompson, and Members of the Governmental Affairs Committee,

I am Charles L. Hill, director of research at Thomson/First Call. I

appreciate the opportunity to testify in front of this Committee

today. I believe the issue of analyst conflicts is an important issue

that needs to be addressed. It is one of several investment issues

that needed to be addressed before the Enron debacle, and now

even more so. It is important not only to the future health of the

investment community, but it is of greater importance to the

public’s perception of and confidence in the overall capitalist system.

Given the importance of these hearings, I appreciate the attendance at this hearing by the two Committee members that are still

here today. Thank you.

The most obvious symptom of the analyst conflict problem is the

positive bias of analyst recommendations in general, as well as the

extreme positive bias of their recommendations on Enron in particular.

For at least the last several years, roughly one-third of all broker

analyst recommendations were strong buys—or whatever their

equivalent terminology was for the top category; similarly, onethird were buys and one-third were holds. The total of both sells

and strong sells was always less than 2 percent. This is still true

today despite the severe criticism analyst recommendations have

been increasingly subject to in recent months. It is interesting that

the analyst recommendations were at their most positive levels at

the peak of the market in the spring of 2000.

That means that if an individual investor—oops, I have left

something out.

The above normal positive bias persisted until early 2001, even

though the stock market indices were in decline from the spring

2000 highs. The shift that did occur was fairly minimal, roughly 6

percentage points shifted from strong buy to buy, and above 5 percent from buy to hold, and about 1 percent from hold to sell.

In the specific case of Enron, the analysts were in a different position. Enron had morphed into what was essentially a hedge fund.

As a result there was very little transparency in recent years as

to where earnings were coming from. Analysts were virtually limited to Enron’s historical earnings record and to the company’s

guidance for future earnings.

Therefore, it was not surprising that on the eve of Enron’s third

quarter 2001 earnings report, 13 broker analysts had a strong

buy—or their equivalent terminology—three had a buy, and none

had a hold, sell, or strong sell.

However, despite a number of red flags from October 16, 2001

on, the analysts dallied in lowering or discontinuing their recommendations in the face of increasing risk. By November 12, almost a month after Enron had announced a $1.2 billion write-off

that Ken Lay could not explain on a conference call, almost a

month after the Wall Street Journal reported Enron executives

55

stood to make millions from Enron partnerships, 3 weeks after the

CFO was fired, 2 weeks after Enron announced it was being investigated by the SEC, and 4 days after Enron announced that it had

overstated 4 years of earnings by $600 million—after all these red

flags, there were still eight analysts with a strong buy, three with

a buy, one with a hold, and one with a strong sell. At that point,

none had dropped their recommendations.

The new proposals from NASD go a long way toward addressing

some aspects of the bias problems. They provide for better disclosure of the firm’s investment banking relationships with the company, and of the firm’s and the analyst’s holdings. They provide for

some standardization of recommendations across the brokerage industry. The requirement for analyst reports to show the recommendation distribution of all the firm’s recommendations hopefully will lead to less of a positive bias in analyst recommendations.

Unfortunately, the new NASD rules do not sufficiently address

the key issue of analyst compensation. It is the old story: Follow

the money. Until the so-called Chinese wall between research and

investment banking is restored at the brokerage houses, there will

continue to be a problem with analyst objectivity.

In the interest of full disclosure, before coming to Thomson/First

Call, I spent 4 years as a buy-side analyst and 16 years—or 18

years as a sell-side analyst. As a sell-side analyst, I did put sells—

and not holds that meant sell—on investment clients, investment

banking clients. But my monetary incentives in those days were

heavily tied to doing objective, incisive research rather than what

I did for investment banking. We need to try to return to those

days of yesteryear.

Also, in the interest of full disclosure and in view of Mr.

Skilling’s being pilloried in yesterday’s Senate hearing for being a

Harvard Business School MBA, I also have to admit to being a

Harvard MBA.

Chairman LIEBERMAN. Now you are in trouble. [Laughter.]

Mr. HILL. Harvard’s motto is ‘‘Veritas’’—truth. Hopefully I can do

a better job of upholding that motto than Mr. Skilling did.

On the assumption that all of you have heard my earlier testimony in front of the House subcommittees, I have purposely kept

my testimony short, although I guess I did run over slightly, so we

can focus on the questions. I look forward to responding to those

questions.

Chairman LIEBERMAN. Thanks, Mr. Hill. Thanks for all you have

done. I don’t know whether you will take this as a compliment from

me as a Yale graduate, but I think you have not only upheld the

‘‘veritas,’’ you have upheld the ‘‘lux’’ in the Yale motto. Light and

truth. So I thank you.

Next, and last, is Frank Torres, legislative counsel of the Consumers Union. Thanks, Mr. Torres, for being here. Thanks for your

patience.

56

1The prepared statement of Mr. Torres with an attachment appears in the Appendix on page

111.

TESTIMONY OF FRANK TORRES,1 LEGISLATIVE COUNSEL,

CONSUMERS UNION

Mr. TORRES. Mr. Chairman, Senator Levin, thank you for the invitation to be here today. We are here because the marketplace has

failed. Market forces failed to discipline market participants. The

watchdogs didn’t just fail to bark; they let in the crooks and led

them to the cash. And there is enough blame to go around. We are

here today talking about the analysts, but we could be talking

about the auditors or even the regulators and their failure to fully

oversee the industry.

No one seems to be able to answer confidently, I don’t think,

given the testimony here today, that there are not more Enrons out

there. In the end, that uncertainty is a problem not just for investors, institutional and individual, but also for the marketplace and

the economy as a whole.

Today over half of American families invest, and I think we as

a society encourage that. Companies benefit, the economy benefits.

And it is a good thing. And they rely on the expertise of the analysts to digest raw data, to talk to insiders, to put together the recommendations. Analysts’ research is likely to be the most detailed

information some investors have. Unfortunately, too many securities analysts have become cheerleaders for the companies their

firms are doing business with. Investors don’t need more cheerleaders. They need critical evaluations and analysis.

It is apparent that the analysts aren’t asking the tough questions. They believed the Enron sales pitch and got duped just like

the Enron employees who were told by Ken Lay and others to buy

and to hold on to their stock. But aren’t analysts supposed to be

the experts? We expect them to be more skeptical of sell jobs by

company executives.

We are not saying that Congress needs to protect against bad advice. But how can investors have confidence in such an environment? And what value, then, are analysts recommendations? And

how is this any different from the SEC going after the New Jersey

teenager who was offering stock tips over the Internet? In fact, he

might have been better off because he wasn’t privy to all the inside

information that apparently was leading all the analysts astray.

Now, no one has denied the pressures created by the conflicts in

this industry. In fact, firms and analysts sometimes get punished

for negative reports about companies, and there is enough evidence

of that. Expert analysts are expected or should be expected to overcome those pressures.

This situation is amazing. No one seems to know anything about

what these companies do or how things operate. Analysts point to

the auditors. The auditors say Enron wasn’t forthcoming. I am

waiting for Enron to blame the investors for investing in their own

company’s stock. Where is this going to end? Who is going to be accountable and who is going to be the watchdog for investors?

We are pleased with the NASD proposed rule and will work on

submitting comments to that. But the rule has some shortcomings

and has some very good things.

57

The rule seems to be focused on disclosure. However, no disclosure will create a Chinese wall big enough to prevent some of these

conflicts from occurring in the first place.

Analyst ownership of stock and the restrictions on that are a

good step, but as was pointed out by others here on this panel, the

analysts know where their paycheck is coming from. Just because

you are prohibiting the sale of stock and restricting some things

around the IPO issuance isn’t going to prevent the conflicts. And

we heard from the earlier panel that profitability of the company

plays a role in that.

When you have got companies—and somewhere on the earlier

panel that I won’t mention—having multi-hundreds of millions of

dollars of investments in companies like Enron, how can the analyst not recognize that and not work to protect that in some way,

if not directly then indirectly? If not intentionally, how can you not

picture that in the back of their minds as influencing their decisions?

We have some recommendations on the NASD proposal that I

would like to go over now very briefly. One is: Why don’t we give

a boost to the independent analyst? Why not create some sort of

certification system for them so that investors reading a report

from an independent analyst or listening to one on TV would know

right away that that analyst is conflict-free? Investors could choose

to disregard advice by analysts without this independent designation.

Second, why don’t we require analysts and firms to publish their

research quality ratings, a step that would likely encourage them

to produce more reliable recommendations? Better yet, develop

standardized measurements of the success of analyst recommendations, publish the good ones, let people know who are the bad ones

are, too. I think the NASD rules get us halfway there. We need to

take the next step.

Disclosing conflicts is important, but it won’t get rid of the underlying bias. They are important, though. They are important, but

we think that they should not just simply say that there are conflicts that exist, but extend that to include both the nature and extent of the conflicts. How much money does a firm have invested

in a particular company that they are developing a report on?

Finally, uniform language should be developed that all firms

should be required to use about their recommendations. It is kind

of weird English that ‘‘hold’’ really means ‘‘sell.’’ What is up with

that? A lot of investors I think are confused about this. It is great

for the insiders who know what is going on, but the analysts knew

full well that people will make—investors were making decisions

based upon those types of advice.

One firm has proposed using the terms ‘‘overweight’’ and ‘‘underweight’’ to describe those recommendations. While this sounds like

more appropriate for junk food labels, I think that is a promising

start.

And, finally, I would like to commend this Committee for taking

a look beyond some of the villains in the company themselves, and

I think it is important to take a look at some of those players, but

in looking beyond that and in trying to get to some ideas that will

help the investors and the consumers in this country.

58

Thank you very much.

Chairman LIEBERMAN. Thanks, Mr. Torres, for very constructive

testimony.

It is true that this Committee is trying to more broadly focus on

the lessons we learned from Enron, not just from within Enron,

and in this case we were drawn to the analysts and the fact, as

you have all indicated, that they continued to recommend buying

Enron stock long after, it seems to the casual observer, there

should have been reason to do so, and then that led to the larger

concern about the independence of analysts, which I want to get to

in a moment.

Senator Levin has to leave in a few moments, and I am going

to yield to him to ask the first questions, and then I will wrap up.

Senator LEVIN. Thank you so much, Mr. Chairman. I appreciate

your yielding. As always, you are courteous, and it is most appreciated. Three questions of Mr. Bowman and that is it.

One, you indicate in your prepared testimony—and you also said

something about this in your oral testimony—that firms should implement compensation arrangements that do not link analyst compensation directly to their work on investment banking assignments or the success of the investment banking activities. Then

under that formulation, they could continue to receive compensation based on the overall firm—the overall well-being of the firm

or how well the firm did in a particular year. Would you leave that

open?

Mr. BOWMAN. Yes, that is being left open as it currently exists,

Senator. We have had a research objectivity standards task force

in place now for about 18 months, and as you can imagine, this has

been the subject of great debate within that council.

Certainly, I think Senator Lieberman is the one that referred to

it, the implicit risk that is inherent in any situation where, directly

or indirectly, analyst compensation is tied to success of the overall

firm, which means primarily in many cases the investment banking side. And certainly, the implicit risk would, in effect, go away

with regard to that aspect of it if analyst compensation had nothing to do with the success of the investment banking side. I don’t

think anybody could argue with that point.

The issue, however, is that once—what seems like a very reasonable and simplistic change could have implications that really need

to be discussed and debated.

For example—you could argue both sides of this, but, for example, Wall Street firms will make the claim that they need to be able

to attract the top-quality analysts to their firms, and in order to

do that, they have got to pay for it. And in order for them to pay

for it, they have got to go to the place where most of the money

is made, and that is investment banking. And their bonuses are

heavily dependent upon the investment banking success.

Wall Street firms will then tell you that if they can’t do that,

they are not going to be able to afford these high-quality analysts

because they will be attracted to other firms——

Senator LEVIN. Well, the other firms are bound by the same

rules.

Mr. BOWMAN. Well, no, other non-sell-side firms who don’t have

this conflict.

59

1The information requested entitled ‘‘AIMR Standards of Professional Conduct pertaining to

Gifts,’’ from Mr. Bowman appears in the Appendix on page 131.

Senator LEVIN. Which may not be all bad.

Mr. BOWMAN. And their argument is—I am the messenger here,

but their argument is that in the end, therefore, investors who are

relying on Wall Street research will be hurt.

I think, frankly, Senator, speaking as an individual investment

person and one who grew up on the buy side, it would certainly be

more appropriate if they could find—if the sell-side group could

find some way to compensate their analysts in a way that would

attract and keep them and keep them out of this conflict that we

are all concerned about, it would be all to the good.

Mr. HILL. Senator, could I respond to that as well?

Senator LEVIN. Sure.

Mr. HILL. As I mentioned, I was on the sell side for 18 years. In

those days, we got paid for doing research. The way the system

worked was that every quarter the institutions sent a letter in to

the firms saying we did X amount of commission business with

your firm in return for services provided by the following analysts.

If my name was on those lists more than anybody else, I got the

biggest piece of the Research Department bonus pool. In those

days, there was a meaningful Research Department bonus pool because the commissions were more meaningful. Since then, they

have brought them down to almost nothing. The institutions need

to look in the mirror. They are complaining that their research isn’t

as good a quality or as objective as it used to be. It is the old story:

You get what you pay for. It is the same with the individual investors that are paying almost nothing today in commissions.

We have to do something about changing the way the brokerage

firms can get compensated for research. We probably can’t put the

fixed commission rate genie back in the bottle. Whether the institutions would be willing to pay hard dollars for research instead of

just commissions remains to be seen. We know that that is anathema to institutions. They try to soft-dollar everything. If they could

soft-dollar the janitor service, they would.

Senator LEVIN. Thank you. The second question I am just going

to put in for the record, if, Mr. Glauber, both you and Mr. Bowman

would answer this for the record.Tell us what the current rules are

relative to gifts from companies that are being analyzed to those

analysts—just for the record, what current rules exist? Mr. Bowman, you made reference to the need for disclosure of material gifts

received by the analysts from either the subject company or the

Wall Street firms’ investment banking department. If you would for

our record give us the detail of what you are recommending on

that, I would appreciate it.1

Senator LEVIN. This would be the last question, and it would be

for Mr. Bowman. Your association has surveyed your members relative to stock options and whether they ought to be reported or not.

And here is what a release of yours says back in November 2001:

‘‘More than 80 percent of the financial analysts and portfolio managers around the world who responded to a survey believe that any

stock options granted to employees are compensation and should be

recognized as an expense in the income statements of the compaVerDate 11-MAY-2000 10:36 Aug 16, 2002 Jkt 000000 PO 00000 Frm 00063 Fmt 6633 Sfmt 6601 78622.TXT SAFFAIRS PsN: SAFFAIRS
60

2The information requested entitled ‘‘Association for Investment Management and Research

(AIMR) Survey on Accounting for Stock Options,’’ from Mr. Bowman appears in the Appendix

on page 132.

nies that grant them.’’ As you know, that is a position that I have

espoused personally, but can you give us—— Chairman LIEBERMAN. Your time is up, Senator Levin.

Senator LEVIN. Right. [Laughter.]

Taking advantage of your good nature—— Chairman LIEBERMAN. Go right ahead.

Senator LEVIN. Can you tell us, if you would, why you believe

that such a large percentage of your members take that position?

Mr. BOWMAN. With regard to gifts, Senator—— Senator LEVIN. No, not gifts. Skip the gifts. Give us that for the

record. Just respond to the press release saying that 80 percent of

financial analysts and portfolio managers believe stock options

should be expensed.

Mr. BOWMAN. Well, for many, many years, AIMR has taken the

position that stock options should indeed be reflected on the income

statement, the balance sheet. And I think the reason why 80 percent of our members have indicated that they believe that should

be the case is that they tell us they believe that it is a form of compensation and, therefore, an expense to the firm and, therefore,

should, like any other expense, be included on the income statement. That is the reason that they give us, and, frankly, we have

made a very strong position that that should be the case.

Senator LEVIN. Would you submit for the record the way the

question was asked that was responded to by the 80 percent? Could

you give us the questionnaire’s question? For the record, just submit it later.2

Mr. BOWMAN. Let’s see—— Senator LEVIN. If you could give it to us after the hearing is over,

that would be good.

Chairman LIEBERMAN. You don’t have to do that now, Mr. Bowman.

Senator LEVIN. I am trying to save time.

Chairman LIEBERMAN. Thanks, Senator Levin. I have a feeling

this topic will come up on other occasions, in other places, I am

sure. [Laughter.]

Senator LEVIN. Thank you.

Chairman LIEBERMAN. Not at all.

Let me ask a final series of questions. First, Mr. Hill, the research that Mr. Hill’s firm did on the recommendations of analysts

over a period of time was, as I mentioned in my opening statement,

one of the more stunning facts that I learned in preparing for this

hearing, this business that less than 2 percent of the recommendations were to sell, when the market was going up and down, and

even as the S&P 500, as our chart showed, was going down.

I just want to ask—and so that raises in me and others this concern, suspicion, conclusion in some that there can’t be any rational

basis for that, it has to be that for one reason or another, either

at one extreme that the analysts have become salespeople, or in another sense that they have just gotten so swept off their feet by the

companies they are analyzing that they are on longer independent.

Each of you has thought about this and worked in this area to one

61

degree or another. Is there any other explanation for why, as the

S&P 500 went up, and particularly went down, the consensus recommendation continued to be buy, buy, buy? Mr. Glauber.?

Mr. GLAUBER. Sure. I think the points you have made are clearly

part of the answer to the puzzle. I think investors also are looking

to invest, and so they are looking for companies to buy. Most investors want to buy stocks rather than sell them short. So I suppose

there is going to be some kind of bias.

I think one good way to deal with this—and, clearly, it is a form

of grade inflation or bias—is to give investors information. One of

our rules that we have proposed is that each firm publish the distribution of buy, hold, sell recommendations——

Chairman LIEBERMAN. Yes, that was, I thought, a very important

recommendation because that information itself may have an effect

on the analysts. Certainly it will have an effect on the consumers

of their analysis.

Mr. GLAUBER. I think so. And, of course, related to that is a rule

that is in our proposal to require a price chart to accompany each

research report in which the price of the stock is shown together

with the analyst’s ‘‘buy’’ and ‘‘sell’’ recommendations during that

historical period. Again, I think it is going to alert investors to just

how good—Mr. Torres said he would like some more information on

just how good the analyst’s record is.

Chairman LIEBERMAN. Right.

Mr. GLAUBER. That is going to be that kind of information.

Chairman LIEBERMAN. Mr. Bowman.

Mr. BOWMAN. Yes, Senator, I spent 17 years as an analyst and

a portfolio manager before joining AIMR, and I can give you a little

personal perspective about some other forces that might be in place

here besides the conflict issue that we have talked about earlier.

That is, when an analyst, especially in a smaller firm, is assigned

two or three different industries to follow, that individual, if he

were to follow or she were to follow every publicly trade company

in each of those industries, would literally be responsible for following and giving due diligence to hundreds of companies, which

is just—there is not enough hours in the day or the week or the

month in order to do that.

So when I was practicing, in my firm what we did was we had

certain screens, basic criteria and characteristics that we wanted to

look for in a company before we even look at it and do research on

it. And a lot of the companies fell out of those screens because they

didn’t meet the minimum criteria that we had in place to look at

the company.

So right away the analysts are looking at a biased group of

stocks before they begin research, so what would traditionally have

been sells, had they been covering them all, are filtered out.

So I think that is one of the things that is going, that since analysts can’t follow every company there is to follow, some screens,

screen out some of the inferior companies, and so they end up following an upwardly biased select group of companies.

So I am not really surprised that there are significantly more

buys than sells out there, just because an analyst can’t cover every

stock in the universe. I think that is one thing.

62

And I think the other thing—and you called it the ambassador

effect earlier, of who is the ambassador advocating, and I believe

Senator Bennett mentioned something about the Stockholm effect,

which has to do with not seeing—you get so close to something that

you can’t see the forest for the trees. I think there is some of that

that goes on, too. I think that analysts can get very close to their

companies, fall in love with the companies, but a very important

point is you can be in love with a company but not necessarily be

in love with the stock because the stock fluctuates in price. So what

might be a wonderful company, if it is too rich and the PE is too

high or whatever else you are looking at, you shouldn’t be in love

with the stock as well.

So I think those are a couple of things—— Chairman LIEBERMAN. I hear you. We talked about this as we

were preparing for the hearing, about the first point you made and

the filtering-out effect in terms of how many stocks are evaluated.

But I do think that the chart with the straight red line at ‘‘buy’’

was a consensus of the S&P 500. So I think we were measuring

apples and apples there.

Mr. HILL. That is the average of the consensus recommendation

for each of the 500 companies.

Chairman LIEBERMAN. Right. I don’t know whether either of you

want to add anything, because you—— Mr. HILL. I do.

Chairman LIEBERMAN. Go ahead.

Mr. HILL. I agree on this filtering-out process, but let’s put it into

perspective. If you go back to the peak of the market in the spring

of 2001—or spring of 2000, I guess it was, the ratio of buys and

strong buys to sells and strong sells was over 100 to 1. Now, filtering out doesn’t get you to that.

Chairman LIEBERMAN. I agree.

Mr. HILL. The other thing, too, is that the analysts are only recommending buy, where is the money coming from to buy those

stocks? You have got to sell something. So, if they want to generate

business, they ought to be putting some sells out there, too. But I

think it is part of the Lake Wobegon problem. All the children are

above average.

Mr. TORRES. Senator, we would attribute the problem directly to

some of the conflicts of interest that I think will only grow worse

in the future as the Gramm-Leach-Bliley act comes into play,

where you have bigger consolidation in the financial services industry. The thing that I am surprised at, if the analyst doesn’t have

enough resources to cover all that they are supposed to cover, why

are the buy recommendations left hanging out there? Why isn’t

there another designation, need to be updated, need more information, instead of having a recommendation out there that you might

not be solid on?

Chairman LIEBERMAN. Mr. Bowman, I was going to ask you, you

made a very interesting point, which I guess others may have

made along the way, though not today, that part of what we are

dealing with at Enron is a good system gone to extreme, gone bad,

and the pressure of companies to continue to generate more quarterly earnings, leading people to make—leading what I might say

are good people to make bad decisions, leading people to lose sight

63

of their ethical bearing. And you make a proposal about attaching

ethical standards, if I understand, to either CFA certification or

maybe to the conduct of analysts generally. And, you do wonder

whether if they were under some explicit series of standards personally—I know the analysts now, some of them I guess are certified, but a lot of them are accountable through their companies

that come under the NASD.

If they had a clearly articulated standard that their responsibility, like a fiduciary, was to serve their clientele, the public, that

they were to be purely independent, and you wonder at some point

whether if any of them were under pressure. There has been testimony here on the Hill that Mr. Lay and Mr. Skilling were pressuring analysts, or perhaps even under pressure from the investment banking side of the business, they could say at those points,

hey, wait a second, pal, I would like to help you but I am about

to lose my certificate if I do this.

Is this kind of ethical standard that Mr. Bowman proposes capable of being administered and enforced?

Mr. GLAUBER. Well, it is an interesting idea. We think of our

rules as embodying a set of principles of proper behavior, if you

want to call it ethical standards. And we think the articulation of

these specific rules is the enforcement of those standards. So I

agree with you that in the end, so much of what we are discussing

here is not an issue of fraud. It is not an issue of violation of the

1933 or 1934 act. It is an issue of proper behavior for professionals.

Chairman LIEBERMAN. Right.

Mr. GLAUBER. We think that can be embodied in private sector

regulatory rules, like our rules, which in essence set what you

would call an ethical standard. Your idea of going to an explicit

ethical standard is an interesting one, I think.

Chairman LIEBERMAN. Mr. Bowman, did you want to add something?

Mr. BOWMAN. Yes, I do, Senator. We as chartered financial analysts and members of AIMR, some 55,000 of us, as a condition for

retaining the right to use that designation, have got to annually

sign a statement that says we comply with our code and our standards. And AIMR regulates its members. And if there are violation,

AIMR has the processes to investigate them, and if those violations

are deemed to be egregious enough, we have every right to basically prevent that person from continuing to use the CFA designation.

And all of these individual codes of ethics and standards of professional conduct embody everything we have talked about here

today: Reasonableness of recommendation, objectivity, everything.

Chairman LIEBERMAN. Am I right—excuse me a second—that a

lot of the Wall Street analysts are not chartered?

Mr. BOWMAN. They are not. A very small percentage of Wall

Street analysts are chartered financial analysts.

Chairman LIEBERMAN. Is one possibility that we require or that

NASD require that they be chartered?

Mr. BOWMAN. I think that is a definite possibility, and we would

be more than happy to work with you on that.

Mr. GLAUBER. The point I would make is that the standards embodied in our rules are imposed upon all security analysts. You

64

cannot be a member of a broker-dealer if you don’t meet our rules,

because violations of them, we toss you out.

Chairman LIEBERMAN. Mr. Hill.

Mr. HILL. I agree that I think at least one of the analysts covering a company should be a CFA. I am a CFA even though my

sign doesn’t say it, like Mr. Bowman’s.

Chairman LIEBERMAN. It is implicit.

Mr. HILL. But in my career as a sell-side analyst, I was a CFA

during that time.

It is interesting, if we bring that down to Enron, the analysts

that moved soonest and most aggressively in lowering their recommendations and actually going to strong sells, I mean, first to

a hold and then to a strong sell, one was a CFA, the other was a

CFA candidate. And out of the 16 analysts that covered Enron,

only four were CFAs, plus the one that was a candidate in the

midst of taking the exams.

Chairman LIEBERMAN. Very interesting.

Let me ask a final question. You have been very generous with

your time. Senator Torricelli raised a good point earlier, and it is

the point that all of us are considering, which is: How can we act

on the lessons we have learned from the Enron scandal and collapse? And how can we be constructive and restore confidence in

the capital markets and, particularly, to give some greater confidence to these millions of middle-class families that have come

into the market in the last two decades? I would like to think that

the hearings that are being held on Capitol Hill and, I must say,

the investigative work being done by journalists, people in the

media, has given some warning and information, if you will to the

investing public about where to put their confidence and where not

to put their confidence. But now we also have to try to restore confidence. Some of it will come by natural forces of the market. There

is a way in which I think Enron’s experience—perhaps even the analysts who were here today and others analysts may not want to

be called before a congressional committee. Certainly Enron and

executives of other companies presumably don’t want to be the targets of investigative journalists, etc.

So there is a way in which the process going on now will have

some effect, at least for a period of time, but then the question is

what follows that beyond the natural forces of the marketplace.

And the question is some things can be done within industry and

professional groups to raise standards, as we have talked about.

The question for us ultimately is: Is there any area—I know there

are some areas where we should legislate in response to Enron.

But in the specific case of the analysts, is there a proper place that

any of you see for legislation?

Mr. GLAUBER. Mr. Chairman, I think that the question of getting

the balance right between legislation and SEC rulemaking and

self-regulatory rulemaking is a very difficult one. The one place

that you have discussed frequently during these hearings today is

the question of structural separation between investment banking

and security research.

I would prefer to see if we can’t make that work through private

sector and SEC rulemaking rather than going to that kind of strucVerDate 11-MAY-2000 10:36 Aug 16, 2002 Jkt 000000 PO 00000 Frm 00068 Fmt 6633 Sfmt 6601 78622.TXT SAFFAIRS PsN: SAFFAIRS
65

tural separation because I think it runs a risk of seriously reducing

the amount of information available to investors.

Chairman LIEBERMAN. But you would keep the option open?

Mr. GLAUBER. I surely would keep the option open. I think it is

one you should discuss. It is a completely debatable issue. In my

view, I think we can do it—that is, we, the SEC, the SROs can do

it—through rulemaking, but I think the issue has to be kept on the

table.

Chairman LIEBERMAN. Mr. Bowman, any place for lawmaking

here?

Mr. BOWMAN. Well, as I said during my comments, Senator—and

I would agree with Mr. Glauber—we would very much prefer to see

the industry itself resolve these problems. It has been our experience, anyway, through establishing the CFA program and others,

setting other standards, that if it comes from the business, it is

probably more apt to be embraced and obeyed than if it comes from

outside sources.

But certainly I would agree that in the absence of the industry

being able to handle this on their own, it should be kept on the

table.

I think that one—there are two things, I think, that legislation

cannot do, but I think we all really need to be aware of it in terms

of protecting the public. The first one is that the FASB and the

SEC have got to be allowed to act independently and set rules on

behalf of investors rather than on behalf of issuers of financial

statements. There has been way too much money being spent by

the issuers of financial statements to lobby against accounting

rules and accounting proposals that will actually favor investors

but will cause companies, or whatever, to not be able to manage

their earnings as effectively. And I think that the SEC and the

FASB have got to be given the independence to do that, and the

money, frankly.

The other thing is that individual investors—we are in a very

early stage of individual investors becoming involved in the stock

market. Before 1990—I can’t remember what the percentages are,

but the percentage of individual investors who had investment in

the stock market was infinitely smaller than it is today. And I

think individual investors are still going through an educational

process here. What is investment? And what am I listening to on

the TV?

And I think that we need to be able to educate investors to understand that this is serious business. They are not going to treat

their own medical problems without going to a doctor, and they are

not going to represent themselves in a court of law without hiring

an attorney. And I would like to see some of the same mentality

be there on the part of individual investors that this is something

that they can’t do alone and they should rely on professional help

to save their precious retirement accounts and their assets.

Chairman LIEBERMAN. And, of course, that is the problem. Right

now there is a lack of confidence in the professional help, and that

is what we have got to restore. Mr. Hill.

Mr. HILL. I strongly echo Mr. Bowman’s comments about the

FASB and the SEC. As a matter of fact I spent all day yesterday

at FASB as part of a financial performance reporting task force

66

where hopefully we will make some changes that will alleviate

some of these problems.

But it is the money, again. FASB needs more money and needs

to be treated independently, as was mentioned. The SEC, I think

Arthur Levitt as chairman, set a new standard there. Hopefully

that tradition can be carried on. But, again, they are understaffed

because of not getting enough money.

Chairman LIEBERMAN. But right now you wouldn’t propose any

legislating regarding analysts?

Mr. HILL. I think we have to move carefully there. Like the others, I wouldn’t rule it out. As I said before, you have got to follow

the money, and until we do something about changing analyst compensation, the problem is going to continue because, either consciously or subconsciously, it is likely to creep into the analyst’s

thinking. So if there was a way that you could solve the problem

of the firms getting paid again for research so we could get it back

to where it was, that would be helpful.

I don’t have a good answer myself, but that is the issue.

Chairman LIEBERMAN. It is a pretty good one. Mr. Torres.

Mr. TORRES. Mr. Chairman, I think there is a very appropriate

role for Congress to make sure that there is accountability in this

industry and that there is an appropriate watchdog group set up

to oversee it.

I would go back to the lessons that we learned when Arthur

Levitt was chairman of the SEC. He tried to push for strong rules

on the accounting industry, and those got pushed back. When

Chairman Pitt took over, there was talk that he was going to dismantle the fair disclosure rules that were passed. And, of course,

in light of Enron, all that has changed.

Congress needs to—should step in to ensure that the right rules

are put into place and give some direction to both the industry and

the regulators on how to handle this. The best way to restore the

confidence in the marketplace for consumers and investors is for

Congress to take a leading role here.

Chairman LIEBERMAN. I thank all of you for your time. You have

made a substantial contribution to this Committee’s effort to constructively respond to the Enron collapse and scandal.

I am going to leave the record of the hearing open for an additional 2 weeks, if any of you or the other witnesses have any additional testimony you would like to submit, and to allow my colleagues on the Committee to submit questions to you in writing.

But for now I thank you, and the hearing is adjourned.

[Whereupon, at 1:22 p.m., the Committee was adjourned.]

(67)

A P P E N D I X

68

69

70

71

72

73

74

75

76

77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

98

99

100

101

102

103

104

105

106

107

108

109

110

111

112

113

114

115

116

117

118

119

120

121

122

123

124

125

126

127

128

129

130

131

132

133

134

135

136

137

138

139

140

141

142

143

144

145

146

147

148

149

150

151

152

153

154

155

156

157

158

159

160

161

162

163

164

165

166

167

168

169

170

Æ