It is impossible for major investment banking firms to avoid conflicts of interest.
What counts, according to Wall Street executives, is not avoiding these conflicts, but managing them carefully. Over the past year, The Washington Post has interviewed investment bankers at many of the leading firms to identify some of the most significant conflicts.
"If an investment banker shed himself of all conflicts, he wouldn't have any business," said Deputy Secretary of State John Whitehead, who formerly served as the codirector of Goldman, Sachs & Co. "It is how you weave your way through these mine fields of conflicts that determines whether you are conducting yourself in a proper way, not whether you can find some pristine snow-white-pure environment in which to live."
Investment bankers serve the classic matchmaking function in financial markets: They bring together buyers and sellers of stocks, buyers and sellers of businesses and sources of financing with businesses that need capital. In the roaring merger-and-acquisition boom of the 1980s, investment bankers have profited handsomely, especially through the multimillion-dollar fees earned by arranging and negotiating corporate takeovers.
Conflicts of interest in investment banking are caused by the dual roles the firms frequently play. The most glaring conflict results from the firms' role as both an adviser to corporations and an investor in stocks. The firms erect barriers between the investment banking and stock trading departments -- known as Chinese Walls -- to control the flow of confidential information from investment bankers to stock traders.
First Boston Corp. failed to control the flow of such confidential information last January, according to allegations made by the Securities and Exchange Commission. In that instance, First Boston's investment bankers, who were serving as the financial adviser to Cigna Corp., were informed in confidence by Cigna officials that the company was going to announce some negative financial news. That information was passed along to a stock analyst at the firm, who then informed First Boston's head stock trader. The stock trader immediately acted on the information to make stock trading profits for the firm in advance of the public announcement by Cigna.
While it is not clear whether the stock trader knew he was acting on inside information the firm had learned in its confidential relationship with Cigna, it is clear that the firm's Chinese Wall system failed to block the flow of information. Another mechanism used by First Boston to prevent such conflicts from occurring is a "restricted list" of stocks that the firm is not allowed to trade while it is serving as a financial adviser to a company. Although Cigna was on its restricted list, First Boston said that its chief stock trader failed to check the list before trading.
There are other conflicts that occur within investment banking firms. For example, the major firms employ research analysts who try to bring in stock-trading business by recommending the purchase of various stocks. The analysts frequently write research reports upgrading and downgrading various stocks in the industry they follow. The conflict arises when the firm is hired to serve as an investment banker to one of the companies an analyst has been following.
Wall Street sources say that, at some firms, analysts are encouraged to write favorable research reports about clients and even may write favorable research reports to get new investment banking clients. An even larger group of sources agrees that negative research reports about investment banking clients are strongly discouraged.
Another conflict of interest that occurs is in the fee letters that investment bankers often insist that their corporate clients sign. Companies that fear they are going to be the target of unwanted takeover bids often retain investment banking firms in an "antiraid" capacity, to help them fight for their independence. However, the financial agreements between the investment banking firms and their corporate clients typically award investment bankers a fixed fee for serving as an adviser, and a much larger fee, stated as a percentage of the total purchase price, if the company is sold. Even though the company may wish to remain independent, its investment banker has a strong financial incentive, sooner or later, to preside over the sale of the company.
Another problem that occurs within investment banking firms involves the use of a "restricted list" of stocks. When the firm has been hired by a corporation to serve as its financial adviser, it often will place that company on its restricted list so that neither the firm nor any of its employes trades the stock while in possession of material, nonpublic information. However, by placing a stock on its restricted list, which is distributed to thousands of employes, an investment banking firm may be sending a signal to some sophisticated investors that a deal is about to occur. This problem can be especially troublesome when a corporation is secretly planning a takeover. Some firms try to get around this dilemma by having two lists -- one restricted list that is distributed throughout the firm, and another, with limited distribution, that is seen only by a few people. When two lists are used, stock trades must be closely monitored by those with the limited-distribution list.
The most common conflict in investment banking firms occurs in underwritings, when the firms raise money for corporate clients by selling new stock or bonds to investors. While the firm's corporate client wants the price of the securities to be set high in order to raise the largest amount of capital, its investor clients want the price to be as low as possible.