In today's prosecutorial, legislative and regulatory war on capitalism, the battle on this particular front was a victory for capitalism. But now to another battlefront in the same war -- the attack on the securities industry led by New York attorney general Eliot Spitzer. We can only hope that some of Kollar-Kottely's intellectual ammunition can be aimed at Spitzer, before he carpet-bombs the firms that are at the very center of free global capitalism.

Kollar-Kettely told the hold-out states attorneys general in the Microsoft case that it was unjust for them to drag in "all existing allegations … which have not been proven or for which liability has not been ascribed." Yet it is exactly this that Spitzer and other states attorneys general are doing to the securities industry, as they ransack the dirty laundry bins for internal e-mail messages that could be interpreted as evidence of fraud -- the slightest hint of which is treated as though it were an open-and-shut guilty verdict.

And Kollar-Kettely wisely cautioned that remedies must not …"adopt overly regulatory requirements which involve the judiciary in the intricacies of business management." Yet the settlement contemplated by Spitzer, as described in numerous press reports, is just that. Spitzer has proposed that the biggest Wall Street firms split their investment banking and research functions, and that they pay up to a billion dollars to fund a "consortium" of unaffiliated stock research companies, whose work they would be obliged to distribute free to their clients. It doesn't get much more "overly regulatory" than that without calling in both houses of congress.

Spitzer's proposed solution is all risk and no return -- it's as silly and as pointless as breaking up the Microsoft monopoly into several smaller monopolies. In seeking to remove any possible conflict of interest from Wall Street stock research, Spitzer is risking the destruction of the very thing that allows Wall Street to function -- the capacity to act as a middleman, representing both buyer and seller. Conflicts of interest -- divided loyalties -- are an unavoidable aspect of any middleman role. But acting as a middleman is what makes Wall Street the gearbox of the engine of capitalism.

Think of Wall Street investment banks as retailers, like Walmart or Bloomingdales. They are distribution networks who take in merchandise from a small number of manufacturers and sell them to a large number of customers. To do that they have to advertise -- and that's exactly what Wall Street research is: the advertising function of the securities industry.

Walmart and Bloomingdales advertise for two reasons. First, advertising alerts customers to particular merchandise that Walmart and Bloomingdales think will be particularly attractive at a moment in time -- a sale on potato chips, or the introduction of a sexy new cut of ladies' blue-jeans. When Wall Street research supports an initial public offering or secondary offering, that's exactly what it's doing: advertising the merchandise. Second, advertising helps differentiate Walmart and Bloomingdales from all the other stores who all distribute the same products at the same prices most of the time. When a Wall Street firm provides stock research to its institutional and retail trading customers, it is creating an incentive to have a trading account with that firm -- even though trading is a completely undifferentiated, generic commodity function, essentially the same at all firms.

When Walmart and Bloomingdales advertise, they must be careful not to commit fraud. They cannot make unfactual claims that customers might detrimentally rely upon -- for instance, Walmart cannot claim that potato chips help you lose weight. But they can and do make abstract claims for their products that, by their very nature, can never really be true or false -- and on which only a foolish buyer would rely. For instance, Bloomingdales might claim that a particular brand of blue jeans will make a woman more popular with men.

Wall Street stock research is exactly the same. It is fraud if the analyst makes deliberately untrue statements about objective facts, and there are clear regulatory and legal remedies for this that work quite well. It is not so clear that it is fraud to simply express an opinion that turns out later to have been wrong -- for example, to put a "buy" rating on stock that subsequently goes down. It's not clear to me that this is fraud in the fullest sense even if the analyst privately believes that the stock is not a good buy. It may be unprincipled, but is it fraudulent for Merrill Lynch analyst Henry Blodgett to have written an internal e-mail privately calling a company a "piece of s--t" when he publicly had a buy recommendation on it? It's just a matter of opinion, and any reasonable customer should realize that. Does the advertising copywriter from Bloomingdales have to really believe that the blue jeans will get a girl more boyfriends?

But these business realities, and these subtleties, are completely assumed away in Spitzer's proposals. He wishes to eradicate Wall Street's essential role as a middleman between securities issuers and securities investors, in which stock research is the medium of communication between the two. According to Spitzer, any such research is inherently "tainted" simply by virtue of the position as middleman, whether or not there is fraud committed. Spitzer wants Wall Street to act as what amounts to a trustee -- a designated guardian that owes a duty of completely undivided loyalty only to the securities buyers. But then who will connect capital to firms who need capital -- when connections by their very nature are forbidden as "tainted"?

Spitzer's proposal to have big Wall Street firms finance "independent research" firms and distribute their work to their customers is less harmful to the operating structure of our free capital markets, but it is remarkable for its sheer silliness. What is "independent research," anyway? Does the producer of "independent research" have to certify that no portion of his information or judgment came from exposure to Wall Street sources that might be "tainted"?

And can it be "independent" when it is paid for and distributed by Wall Street to begin with, under the very terms of Spitzer's proposed structure. It surely will not be if the Wall Street firms get to pick the "independent research" providers. And if they don't pick them, some government board will -- and we can be sure that the research will be provided by minorities, women, Vietnam-era vets, the disabled, and others qualified to do stock research by nothing more than that they were lucky enough to be unlucky. Even if it is completely independent and carefully selected -- won't it be "tainted" for Wall Street firms to distribute to their trusting customers any research that they themselves have not selected or approved?

And what's the point of all that independent research anyway? By flooding Wall Street's customers with it, are the supposed sins of Wall Street supposed to be diminished by sheer dilution?

By understanding Wall Street's role as a middleman, and by understanding stock research as advertising, the issues become quite simple and clear. It's all a question of fraud. There are laws against fraud. There are criminal and civil recourses and remedies. They should simply be enforced -- and then there's no reason to even consider "overly regulatory" solutions.

It may very well be that the big Wall Street firms very much want to avoid the real issue of fraud. They may fear that they have so much unbounded liability spread across so many cases that it is in their best interest to agree to a compromise even as draconian and silly as Spitzer's proposals. But if Spitzer wants to serve the public interest, and if he really thinks that the Wall Street firms have committed fraud, then he shouldn't let them get away with that -- he should prosecute the fraud, and get out of the industrial restructuring business.

That was the message of Colleen Kollar-Kettely's Microsoft decision on Friday -- that corporate wrongdoing is simply crime, to be dealt with as such, on the merits. Hopefully it will send a signal to Elliot Spitzer and other state attorneys general that investing the taxpayers' money in a scorched-earth war on capitalism isn't riskless. That war is a stock that a lot of attorneys general have a buy rating on. Kollar-Kettely just said it's a "piece of s--t."

Posted by Donald L. Luskin at 12:28 PM | link