‘Let the Buyer Beware’ Doesn’t Protect Investors

"Let the buyer beware" is a poor warning for investors, says HBS professor D. Quinn Mills. In this excerpt from his new book, Buy, Lie, and Sell High: How Investors Lost Out on Enron and the Internet Bubble, he offers a way to shape up the system. Plus: Author Q&A.
by D. Quinn Mills

The American regulatory agencies, described by Henry Kaufmann as "...less than robust... Understaffed, under-funded, and badly fragmented," have been, in his words, "slow to recognize some of the more serious abuses" in the financial markets.70

Among the biggest abuses—now recognized as a result of the bubble—have been those of the analysts who worked in the investment banks. The banks employ two kinds of analysts: Those who issue recommendations about individual firms, and those who try to get investors to buy the stocks. For an investor to have any confidence in a bank's analysts, he or she must believe that an analyst's report is something more than a disguised sales pitch. So banks have ordinarily insisted that analysis and sales were separated by a so-called Chinese wall which left analysts free to make honest appraisals. But during the bubble, it became clear that the Chinese wall was no protection at all for the independence of the analysts. Trying to sell IPOs, analysts gave glowing recommendations to firms which collapsed within months. Trying to support the stocks of firms previously sold to the public, analysts issued buy recommendations as the company's share price plummeted. Trying to justify dozens of mistaken recommendations, analysts insisted that the New Economy was real, and then defended the notion by pointing to analysts at other banks who were making similar erroneous forecasts.

We met Frank Quattrone in a previous section; he was a leading investment banker during the bubble. About him Forbes wrote: "...in Quattrone's shop research was expected to serve the bankers' interests. The Internet craze had led analysts at every investment bank to issue glowing reports on Internet companies that were little more than an idea and some PowerPoint slides—a process that Bill Burnham, a former CSFB Internet analyst, calls 'the competitive devaluation of underwriting standards.' But nowhere did the wall between research and banking fall so completely as in Quattrone's group—both at DMG and at CSFB.

The prospectus is full of language originally intended to inform an investor, which now protects the offerers.
—D. Quinn Mills

"While some analysts insist that Quattrone believed in honest research, others say he tried to bully them. `I'll have you out of here Monday morning if you say that, one former DMG managing director recalls Quattrone telling an analyst who wanted to issue a less than flattering report about a client. `Do you want to work in this firm? Do you want to be a team player? When it comes time for bonus review, all this will be remembered.' The managing director says Quattrone would even demand that he raise his earnings estimates. `I don't think you understand the business,' he recalls Quattrone telling him. `I've been doing this for twenty-five years, and I think this company's going to make a shitload of money."71

It ought to be perfectly clear, and it isn't right now, whether an investment bank has a real interest in a company in some fashion; but this information tends to be buried in very small print in the back of the materials provided by investment bankers rather than up front.

This is a failure of the regulatory system because few people read the prospectuses. Investors rarely do; they get them with the confirmation of a purchase rather than ahead of time. Were there a five-day waiting period before an order could be placed, the current system would perform better. But people want to act quickly, and in markets which are as volatile as today's financial markets, that makes sense. So disclosure is a very important part of a better system, but it has to be more timely and apparent than in the current form of a prospectus.

It was a poor performance by the banks; one that revealed a basic conflict of interest between giving honest advice to buyers and making fees by selling shares. But the banks weren't alone in this conflict of interest—it existed in the mutual funds as well. In the funds, brokerage—the sell side of the financial market, and mutual funds—the buy side of the market, had a potential conflict. Brokerage was trying to sell dot-coms to investors, and for credibility, needed for the mutual funds themselves to load up on Internet stocks. But the funds are supposed to keep away from too speculative investments. In the end, the funds bought the dot-coms and left owners of the funds, investors, with huge losses.

The conflict of interest was only part of a larger problem from the point of view of a potential investor. The regulatory system no longer helps the investor evaluate an IPO candidate. It may still protect against some abuses, even though large ones, like the perversion of the analysts' function slip through untouched, but it doesn't provide investors with confidence in what they hear from investment banks.

The prospectus presents everything legally. It is the document that sets forth the terms of the sale of shares to the investor. It takes precedence over any verbal representations made by the bank or executives of the company going public, except in unusual circumstances.

The prospectus is full of language originally intended to inform an investor, but which now protects the offerers. This is a well-known dynamic of regulation, in which those regulated adapt themselves to the regulations so thoroughly that the regulations become protection for them against legal liability. This occurs in two ways: (1) those actions not proscribed by law are presumably legal, and ways to mislead buyers are continually being developed, and updating of law is slow and uncertain; and (2) boilerplate warnings protect the offerers from liability for failure for all but the most glaring fraud or embezzlement.

The real problems for a potential investor are not those warned of in a prospectus in such general terms as to apply to virtually any company; they are specific matters not revealed in the prospectus. The investor is pitched by bank salespeople, who expect their customers to disregard the boilerplate language of a prospectus. What the salespeople say can be summarized as follows: "All prospectuses say there are potential problems, and we know that many offerings have been huge financial successes, so there's no information in the boilerplate of interest to an investor."

In the end, an investment bank is a sales organization not much different from an auction house that sells used furniture.
—D. Quinn Mills

In the end, an investment bank is a sales organization not much different from an auction house that sells used furniture. The bank, like the auction house, prepares sales documents which are intended to do two things: first, to persuade the potential buyer to buy by putting forward positive information while suppressing negative data; and second, to protect the seller from any recourse from the buyer when the item turns out to be junk. Thus, an auction catalogue describes an eighteenth century desk/bookcase without mentioning that the two pieces are thought to be married—not originally together—and includes a page of small print in which the auction house disclaims any responsibility for representations about any item it sells. Similarly, the prospectus for a dot-com described the firm and its promise, without mentioning that there'd been a serious debate in the bank about whether or not the company had any value and should be taken public, without mentioning that it was very likely to need substantial additional financing before ever becoming profitable. But the prospectus certainly included pages of disclaimers, reviewed and approved by a law firm, that were intended to protect the bank from any recourse by a furious investor after the company had collapsed.

In both cases, the principle is "buyer beware." The dynamics of the financial markets are the attempt of the bank to sell to suspicious investors. In bubbles, the professionals in the Financial Value Chain get too successful at fooling the retail investor, and the balance needs to be restored. One way it gets restored is for the investor to quit buying—but that puts the brakes on both corporate investment and technological innovation for an extended period. A better method is to update regulation to restore a modicum of honesty to the relationship between investors and banks.

About the Author

D. Quinn Mills is the Alfred J. Weatherhead Jr. Professor of Business Administration at Harvard Business School.