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Jubak's Journal
Recent articles:
• Don't be fooled by earnings headlines, 7/16/2003
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| | Jubak's Journal
Judge lets Wall Street off the hook
The big brokerages may have won a legal victory with a judge's recent decision to dismiss a shareholder suit against Merrill Lynch. But they're losing the war to win back the confidence of small investors.
By Jim Jubak
So why arent individual investors flocking back to Wall Street even though the stock market is rallying? Merrill Lynch (MER, news, msgs), commission revenue, for example, fell 14% in the just-completed second quarter from the already low levels of 2002.
I dont think you need to look any further than the logic in the opinion of Senior United States District Judge Milton Pollack when he handed a Pyrrhic victory to Merrill Lynch in a securities fraud case. Wall Street cheered the judges ruling, but a few more hollow victories like this and the brokerage firms that hand out advice can just send all their business over to the stock market indexers at Vanguard.
Boil Judge Pollacks elegant decision down to its core and youre left with this logic:- Investors have a choice of who to believe on stocks and if they pick the wrong advice, well, thats just too bad. Wall Street analysts do not have a fiduciary duty to investors in general.
- Cause and effect is very complicated in the stock market, and Wall Street analysts dont have any more of a clue than anyone else of what causes a stock to go up or down.
- Everyone knows that Wall Street firms and analysts are so horribly conflicted that their advice can be worthless, so investors who rely on that advice deserve everything they get.
(Follow the link at left for Judge Pollacks entire 43-page decision.)
I dont know about you, but that logic is hardy a ringing endorsement of the securities industry. And it certainly does nothing to restore my faith in how the financial markets operate.
The decision is a useful reminder of the brutal truth of investing: youre out there alone, baby, and you cant count on anyone to care about your money but you.
Judge Pollacks decision to dismiss the suits brought by investors in the Internet stocks 24/7 Real Media (TFSM, news, msgs) and Interliant (INIT, news, msgs) hangs on the legal definition of causation. The investors who brought the suit claimed that their losses were the result of fraud. The plaintiffs allege that Merrill Lynch and its analyst Henry Blodget (yes, that tech analyst Henry Blodget) drove the prices of these two stocks up to unsustainable levels -- $64.63 for 24/7 Real Media and $54.44 for Interliant -- in January and February 2000, respectively, by issuing knowingly false optimistic research, ratings and price targets. The plaintiffs claimed they bought the stocks near those levels and then lost money when the market collapsed in March 2000.
Pollack begins the logic of his decision by noting that none of the investors in this class action suit were clients of Merrill Lynch. As such they cant claim that Merrill Lynch or its employees, including its analysts, had any fiduciary duty to protect their assets.
Instead, Judge Pollack notes, the plaintiffs in this suit must allege what is called a fraud on the market. To make that case, the plaintiffs would have to prove that Merrill Lynch and its analysts wrote favorable opinions about the Internet stocks in question even though they knew those reports were in error, and that Merrills actions inflated stock prices and helped create a bubble in the market.
And Judge Pollack isnt buying that fraud on the market theory, for oh so many reasons.
Its not enough just to be wrong
First, and by no means least, there are the technical objections to the plaintiffs arguments. The plaintiffs brief doesnt adhere to proper form, its overly vague, and its disorganized, Judge Pollack lectures. Although the plaintiffs have scavenged lots of examples of analysts saying one thing publicly and quite another thing privately, theyve been unable to come up with examples pertinent to the stocks in question. And they certainly dont succeed in linking any of these examples of analyst perfidy to the performance of these specific stocks on specific days.
Second, Pollack writes that to prove fraud the plaintiffs have to show that Merrill Lynch and its analysts made a material misrepresentation or omission of fact (not opinion) that caused the plaintiffs losses.
In other words it isnt enough for Merrill Lynch and its analysts to have been wrong in their opinions about a stock. Getting it wrong, in itself, says Judge Pollack, isnt enough to prove fraud.
And it isnt enough for the plaintiffs to argue that Merrill Lynch and its analysts inflated stock prices with their optimistic opinions of these stocks. That inflation, in Pollacks judgment, didnt cause their losses. It was the breaking of the bubble that caused these investors to lose money, and the plaintiffs cant show that Merrill Lynch or anyone on Wall Street caused the bubble to burst -- or had an interest in seeing it burst.
It was, in fact, in the self-interest of Merrill Lynch and other Wall Street firms to keep the bubble inflated. They didnt earn a cent by seeing it break.
Following this theory, Pollack bores in on one of the biggest weaknesses in the fraud-on- the-market argument. Merrill Lynch and its analysts continued to write glowing reports on these stocks even as their prices started to plunge and those favorable opinions did not prevent the fall in prices or reverse it. Its hard to argue that analyst opinions were powerful enough to cause the bubble but powerless to prevent its deflation.
The investors should have known better
And, third, the plaintiffs in this case were sophisticated investors -- Pollack calls them high-risk speculators, who knew full well the risks they were taking and how the Wall Street game worked. It was certainly common knowledge before the bubble burst, Pollack writes, that Wall Street research was tainted by investment banking relationships and the hunt for big fees. These investors cant now claim that they invested without knowing about these conflicts of interest and that these conflicts of interest themselves constitute fraud.
In essence, Pollack writes, these plaintiffs arent really suing because Merrill Lynch inflated stock prices and created a bubble that burst. They're suing because Merrill Lynch didnt keep the bubble inflated long enough for them to get their profits out of these stocks as other speculators and investors had done.
This point generates some of Pollacks best prose:
The record clearly reveals that plaintiffs were among the high-risk speculators who, knowing full well or being properly chargeable with appreciation of the unjustifiable risks they were undertaking in the extremely volatile and highly untested stocks at issue, now hope to twist the federal securities laws into a scheme of cost-free speculators insurance. Seeking to lay the blame for the enormous Internet bubble solely at the feet of a single actor, Merrill Lynch, plaintiffs would have this Court conclude that the federal securities laws were meant to underwrite, subsidize and encourage their rash speculation in joining a freewheeling casino that lured thousands obsessed with the fantasy of Olympian riches, but which delivered such riches to only a scant handful of lucky winners. Those few lucky winners, who are not before the Court, now hold the monies that the unlucky plaintiffs have lost -- fair and square -- and they will never return those monies to plaintiffs. Had plaintiffs themselves won the game instead of losing, they would have owed not a single penny of their winnings to those they left to hold the bag.
Might as well sue the lottery when your ticket doesnt win, Pollack argues.
Pollacks decision, in my reading, hangs on the nature of the plaintiffs -- speculators -- and the stocks they bought -- extremely volatile and highly untested.
Getting away with it
I think the decision does damage to Wall Streets already-tattered reputation among individual investors because the decision seems to be just one more indication that They are going to get away with it. Courts arent designed to provide the kind of psychological healing that investors need after the crashits not their purpose. But no one on Wall Street seems to recognize the need to woo investors back with demonstrations of contrition, believable reform, and an acknowledgment that yes, Wall Street let individual investors down. Wall Street has treated Judge Pollacks decision as a victory instead of recognizing that it contributes to the Streets institutional problem.
That problem will grow to truly immense proportions if other courts and other judges apply Judge Pollacks logic to other kinds of investors and other kinds of stocks. (And given that the 96-year-old Judge Pollack is one of the most senior judges likely to rule on these cases, this is possible.)
Its one thing to say that speculators in 24/7 or Interliant should have known better. I think most individual investors actually have some sympathy with that view.
But its a very different thing to argue that investors in AT&T (T, news, msgs) were speculators who should have known the game was rigged. This classic widows-and-orphans stock, also the subject of a pending class action suit, is one of the most widely held in the United States. It will be hard for the investing public to swallow the argument that this was an extremely volatile and highly untested stock.
Same goes for stocks such as WorldCom, now MCI (MCWEQ, news, msgs), and Qwest Communications (Q, news, msgs). These stocks werent supposed to be highly volatile -- thats why people bought them -- and they werent held by sophisticated speculators.
If the courts say that even investors like these in stocks of this sort got what was coming to them, then Wall Street will win these class action cases and avoid millions and perhaps billions in damages.
But investors who follow the logic of decisions like that will rightly conclude that Wall Street is fit only for gamblers and speculators. And that its certainly no fit place to put money that anyone might actually need for college, a house, or retirement.
Wall Street brokerages cant afford victories like those.
New developments on past columns
Can the rally survive earnings season?
Ive repeatedly pointed to IBMs (IBM, news, msgs) July 16 earnings report as a key to the current rally. Well, the company reported and the news wasnt good. IBM indeed matched Wall Street earnings estimates of 98 cents a share for the quarter, but revenue growth was tepid, at best. The reported revenue growth rate was 10%, but all of that and more came from gains from a weak dollar and the added sales that came with IBMs recent pig acquisitions. Correct for those effects and IBMs sales actually fell about 3%. The picture for the upcoming third quarter wasnt much prettier: new-business contracts for the service business were below expectations and IBMs overall backlog fell to $112 billion from $113 billion. IBMs CFO John Joyce confirmed that the company remains on track to meet Wall Street earnings and revenue projections for all of 2003. But any investor who hoped that IBM would say business was improving was certainly disappointed by the results.
Join forces to build a list of stocks to trust
I received 60 e-mails in the two days since I launched an effort to build a list of the stocks of clean companies. Please keep those cards and letters coming in. Critique my first set of three nominees -- so far readers have found fault with all three -- and nominate your own candidates for the next round of vetting. The point of this exercise is to use our collective wisdom to gradually put together a list of stocks with clean accounting, reasonable executive compensation, and sold corporate governance -- and that also have solid potential for long-term price appreciation. To read more about the effort, see my July 15 column. Ill be reporting on the results in my Aug. 1 column.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. At the time of publication, Jim Jubak did not own or control shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
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