Asymmetrical Information

From the desk of Mindles H. Dreck:

UNINTENDED CONSEQUENCES

I have little sympathy for the brokerage industry. Nonetheless, I find it interesting that efforts for reform inspired by imprudent internet-inspired speculation and fraudulent accounting by large companies are focused primarily on restructuring the brokerage industry. I'm surprised that most analysts fail to consider the following:

• There has been a truly massive increase in regulation of the brokerage industry over the last 15 years, roughly tripling the compliance burden of being a broker or money manager. Most of it focused on areas that would seem to be relevant to the industry's shortcomings in the bubble.
• Not only did this huge increase in regulation not prevent Enron and the sale of hyper-inflated dotcoms to hapless investors, it very well may have reinforced the trend and suckered many more investors into it.

Yes folks, regulation (self and official) played a role in both the bubble and the crappy value delivered by the brokerage industry in the 1990s. I kid you not. It's a travesty. Allow me to provide a breezy history of some of the changes in brokerage regulation over the last two decades.

There was a time when a stock broker made recommendations based on his/her own judgement. Brokers were free to use or not use their firm's research, and even to conduct their own. Most brokers bought blue chip stocks and relatively risk-free bonds for their clients. Some learned to manage against the market and generated outstanding results for their clients, garnering recommendations and developing hard-earned trust from their clients. Others churned and burned, shrinking accounts through excessive trading, or just made crappy recommendations that sounded exciting. In other words, client results were widely distributed, but clients, quite rightly, associated those results with individuals, not necessarily the firms in which they were employed.

On the institutional side of the business, commissions were fixed by regulation (prior to May 1, 1975). Given commission sizes relative to the actual (falling) cost of executing a trade, institutional customers demanded additional value from their brokers. Brokers achieved that two ways:

1) "soft dollar" and brokerage recapture: brokers will pay for a variety of the market data and analysis systems used by their large customers, subject to minimum brokerage volume amounts. Through today, there are a variety of mechanisms by which institutional customers can recapture the excess profits brokers would otherwise earn through the large commissions they generate.

2) Research: Given that prices were the same everywhere, brokers competed on the basis of information provided. In exchange for a certain amount of volume, institutions were given greater access to "sell-side" analysts. Sell-side analysts were paid primarily on their ability to get institutions to funnel commissions to their employers.

Institutions never really looked at sell-side recommendations. It was the analysts ability to provide fresh company information that made their commissions worthwhile. Institutions (pension funds, money managers, mutual funds, banks, insurance companies) have a fiduciary duty to their investors and generally do their own research or hire a discretionary manager. So the numbers and the industry color were useful, the ratings were ignored.

Sell-side analysts had little or nothing to do with the retail investor. That was the broker's territory. You could say this was the still the dominant state of the industry in the 1970s and even early 1980s.

Naturally, many individuals, and a few firms, were egregiously dishonest and sloppy, and the industry's regulatory structure adapted in an attempt to rid society of the lower end of the distribution. Regulation intensity increased in the following areas:

1. Suitability - the idea that recommendations should be appropriate to the investor. Brokers are required to collect voluminous information on investors and their risk profiles, and branch managers were made to supervise the suitability of recommendations to clients
2. Research and recommendations: firms were encouraged to centralize "buy list" type policies and maintain files and due diligence on recommendations. The stock-picker broker was discouraged, and brokers were increasingly required to sell product that had been "vetted" by a centralized research organization.
3. Elimination of insider advantage best represented by Regulation FD ("Fair Disclosure") mandating that anything companies told analysts had to be advertised to the entire investor community.
4. Training and testing for securities registration: The Series 7 (and 3, 7,8, 24 etc.) came to focus less on the mechanics of financial instruments and more on suitability, content of marketing materials and customer interaction and conflicts of interest.
5. Use of soft dollars exclusively for the benefit of clients.

Notice that items 1 and 2 above are focused entirely on developing practices designed to prevent brokers from foisting speculative or poorly-researched securities on investors interested in preservation of principal. The documentation and supervision of these policies includes:

• both compliance and sales supervision must monitor every piece of hardcopy and electronic correspondence, and maintain records of doing so;
• representatives must attend continuing education classes, both in firm and through NASD testing;
• all personnel servicing clients must be registered;
• detailed histories of registered reps and all customer complaints must be maintained separately by compliance
• detailed "customer information documents" must be maintained centrally and updated on every client, documenting risk appetite, source of funds, identification and reference checks on customers, etc. (this develops even further after the Patriot Act this year).
• branch managers and compliance must monitor accounts for excessive trading patterns and suitability - the regulatory standard evolving to the point of requiring software to perform these screens for large institutions.
• detailed policies must be developed and documented in public filings on soft-dollar and related conflicts of interest;
• supervision of all employee trading, including restricting employees from trading stocks on which the firm may have insider information, a recent research opinion, a substantial position, etc. "Control Persons" are subject to even tighter restraints which may force them to unwind any trades if the firm makes a related trade or recommendation within up to 7 days before or up to 30 days after the employee trades. Compliance must maintain detailed records of employee trading centrally.

Glancing over the above incomplete list gives you an idea of why brokerage firms have increased the staffing of their compliance departments by a factor of at least three over the last ten years, and have created massive budgets for transaction tracking and correspondence filtering software.

Let's focus for a moment on the suitability and research requirements. Essentially, what this has meant to brokers is that they are no longer free agents when it comes to recommendations in their accounts. Anything eligible for recommendation to a client must be researched and, more important to regulators, documented in various files with manager approvals, data reports and all that great "file stuff". This tends to be a legalistic requirement, sort of like the "file" you have to build on someone you are going to terminate for cause.

So the brokerage industry sees this regulatory trend and thinks "hmm, where are we going to get this handy file stuff? Oh, wait a minute, we have a sell-side research department! We can "leverage" that to create this centralized retail brokerage policy that never existed before." Just in time, too, as the sell-side analysts are becoming irrelevant to institutions because of Reg FD. Most of them are making money by leveraging their industry expertise to pitch large M&A assignments (which often involves convincing big companies that more spreadsheets and industry data will magically make an ill-considered but bonus-padding acquisition a future bonanza for shareholders).

Of course, brokers continue to want to recommend whatever they want plus, more importantly, whatever their clients' want. Seriously, over my career I have literally heard otherwise rational-seeming people say, basically, "my client wants a portfolio with the following stocks in the following proportions, and they want it to outperform and never produce a negative return." The role the advisor plays in such a scenario, other than sprinkling the magic fairy dust that makes the pre-ordained portfolio perform like Berkshire Hathaway in its early years, is unclear. When these requests come, they express either the preferences of the broker or the client, not any centralized research or policy.

In fact, it gets worse than that, because brokers can make a lot more money selling mutual funds and wrap accounts, so they rarely recommend stocks at all. Clients did come in noticing the performance of Qualcomm and Amazon and Priceline (in 1999-2000 for instance) wanting to buy those stocks. The analyst better have a buyable position. Between the need for a broad buy list for the retail brokers, and the desire to flatter potential M&A clients, it is no small wonder that sell-side analysts were generous with their ratings.

The worst part remains, however. Markets work best when information is decentralized and decision-making is likewise decentralized. The Invisible Hand requires many nerves to function. To the extent that brokers were now making recommendations off of eight or nine centralized buy lists rather than exercising thousands of independent judgements, the herding instinct is emphasized as opposed to mitigated. Brokers exaggerated the bubble by selling homogeneous opinions buttressed by mindless file-building. The regulatory trends above re-centralized decision-making. Worse, the current proposal for reform creates a central "independent" research bureau for all the major brokers to use! (UPDATE: thankfully, Spitzer and the industry appear to be backing off this idea).

Despite the failure of this incredible regulatory buildup to materially slow the flow of complaints about brokers and conflicts of interest, the only solution we can come up with is to keep adding to the pile. Don't even think about asking the buyer to bear some responsibility for their decisions! Regulatory agencies resemble public schools in this regard. No matter how much they fail, the solution is always more of the same with a bigger budget.

I don't mind so much that we try a new regulatory approach, but how about taking a critical eye and an axe to what's come before? Unlikely, I'm afraid, because reducing regulation provides ample risk and no reward to the regulators themselves.

Posted by Mindles H. Dreck at November 12, 2002 09:37 PM | Technorati inbound links