Ashes to Ashes, Dust to Dust (Except Where Prohibited by Law)
Submitted by Marla Singer on 03/22/2010 03:56 -0500
* Allied Capital
* Barclays
* Bear Stearns
* Citigroup
* Credit Suisse
* David Einhorn
* Digital Millennium Copyright Act
* Fail
* Federal Deposit Insurance Corporation
* Finance Industry
* Goldman Sachs
* Henry Blodget
* Lehman
* Lehman Brothers
* Merrill Lynch
* Morgan Stanley
* New York Stock Exchange
* ratings
* Ratings Agencies
* The Economist
In April of 1994, Bill Clinton nominated to the federal bench one Denise Cote, formerly an editor of the Columbia Law Review, and the first woman to serve in the U.S. Attorney's Office as the Chief of the Southern District of New York Criminal Division. Cote pulled the federal securities case against WorldCom's officers and directors. And on March 18th of this year, Cote issued an opinion and order baring Zero Hedge partner TheFlyOnTheWall.com from reporting immediately on equity research reports from the big banks, not to mention awarding damages and attorney's fees in an amount to be determined later. It seems (brace yourself) that TheFlyOnTheWall.com had been something of an authority on equity research recommendations from Wall Street and regularly reported to its active newsfeed the 10,000 foot versions thereof with characteristic Super Fly speed.
We at Zero Hedge are highly suspicious of any effort to reduce the amount of information available to the marketplace. Or the citizenry, for that matter. For example, when someone writes:
...a State that is one of the 50 States or the District of Columbia, for which, at any time during the preceding 7 fiscal years, the President has declared a major disaster under section 401 of the Robert T. Stafford Disaster Relief and Emergency Assistance Act and determined as a result of such disaster that every county or parish in the State warrant individual and public assistance or public assistance from the Federal Government under such Act and for which— "(A) in the case of the first fiscal year (or part of a fiscal year) for which this subsection applies to the State, the Federal medical assistance percentage determined for the State for the fiscal year without regard to this subsection and subsection (y), is less than the Federal medical assistance percentage determined for the State for the preceding fiscal year after the application of only subsection (a) of section 5001 of Public Law 111–5 (if applicable to the preceding fiscal year) and without regard to this subsection, subsection (y), and subsections (b) and (c) of section 5001 of Public Law 111–5, by at least 3 percentage points; and "(B) in the case of the second or any succeeding fiscal year for which this subsection applies to the State, the Federal medical assistance percentage determined for the State for the fiscal year without regard to this subsection and subsection (y), is less than the Federal medical assistance percentage determined for the State for the preceding fiscal year under this subsection by at least 3 percentage points.
...when they actually mean "Louisiana" or:
(1) a bank, the deposits of which are guaranteed by a State;
(2) owned by the State in which the lender is located;
(3) under the control of a board of directors that includes the Governor of the State....
...when they actually mean "The Bank of North Dakota" we check to make sure our pocket watches are still with us. By the same token, we are fairly certain that Zero Hedge readers are not particularly impressed with the abolition of mark-to-market accounting in favor of deeply opaque mark-to-myth coated balance sheets. While looking the other way when it comes to a technically insolvent institution is bad, coy FDIC lies like "we cannot ever run out of money" are just the next step from concealment to obfuscation. (Does anyone know what is actually in the health care bill, by the way?)
A number of forces now conspire to prevent the free dissemination of information to unapproved parties (read: the little guy) in the United States. Ironically, the more truthful and damaging the data, the more cause seems available to those wishing to oppress it. Truthful data about the insolvency of a financial institution, for instance, has far more power to (correctly) shake the confidence in the stability of the institution than fabrications. Though vindicated by the truth of his conclusions, David Einhorn was mercilessly investigated and scrutinized for having the temerity to suggest that Lehman Brothers and Allied Capital were bits of burnt toast.
In the United States, tools like the Digital Millennium Copyright Act (and Julius Genachowski) give third parties the ability to preemptively, and without showing cause, force service providers to remove content they would prefer to see suppressed, even in the absence of any legitimate copyright claim. Long time readers may remember Zero Hedge's experience in such matters.
Libel law in the United States has become an excuse to attack the author who suggests (perhaps with some reason) that you might be a skank. And now, apparently, if you commit the crime of reposting an unclassified and already widely public airport notice sent from the TSA to tens of thousands of recipients including some in Nigeria and Islamabad (not exactly super-secret stuff) you can expect to be visited by TSA agents and threatened with arrest, a HUAC-like blacklist, and foster care for your children- yet somehow the President of the United States can call you an obscene, greedy, fat cat banker to a national television audience of millions without repercussion.
In this context, it is more than ironic that while, on the one hand the judicial, executive and legislative branches of the United States have embarked on a pressing anti-finance campaign, at the same time the infrastructure, both legal and technical, supporting, for example, citizen journalism has been eviscerated with the surgical instruments of libel law, copyright law, and anesthetized with the thick, vein-burning serum of injunctive relief.
This is easier to understand when you realize that a number of players stand to benefit from opacity. Yes, those seeking to create a consensus for favored policy reforms that could never gain favor if their true nature were known, but most particularly those who purport to clear away the fog and cut peepholes in the frosted glass- for a nominal fee, obviously. We refer to equity research teams, as the astute reader has no doubt already guessed.
It takes only a brief skimming to discover that Judge Cote is quite taken with the import and power of the large equity research houses and the potential for their research to move markets. Her assessment of the case, it will be seen, borders on the terminally naive. To wit:
This litigation confronts the phenomenon of the rapid and widespread dissemination of financial services firms’ equity research recommendations through unauthorized channels of electronic distribution. This dissemination frequently occurs before the firms have an opportunity to share these recommendations with their clients -- for whom the research is intended -- and to encourage the clients to trade on those recommendations.
Recommendations may move the market price of a stock significantly, particularly when a well-respected analyst makes a strong Recommendation. Such market movement usually happens quickly, often within hours of the market opening following the Recommendation’s release to clients. Thus, timely access to Recommendations is a valuable benefit to each Firm’s clients, because the Recommendations can provide them an early informational advantage.
[...]
As Lynch explained at trial, a client who learns of a Recommendation from a telephone call from Merrill Lynch often will decide to initiate a trade on the spot.
Oh, well if Merrill Lynch says so....
Quite the contrary, it isn't difficult to find reason to doubt the value of equity research. In fact, it is more difficult to find reason not to doubt it. Consider "Target Price Accuracy in Equity Research," research by Stefano Bonini et al.:
Our analysis shows that forecasting accuracy is very limited: prediction errors are consistent, auto-correlated, non-mean reverting and large (up to 46%). The size of forecasting errors increases with the predicted growth in the stock price, the size of the company and for loss making firms. Additionally, the intensity of research and the market momentum negatively affect accuracy. These results suggest that analysts research is systematically biased which supports theoretical predictions by Ottaviani and Sorensen (2006). Since stock price forecasting is largely an unmonitored activity, market participants may fail in fully understanding this behavior thus not arbitraging away these inefficiencies.
Ottaviani and Sorensen, for their part, opined:
We develop and compare two theories of professional forecasters’ strategic behavior. The ?rst theory, reputational cheap talk, posits that forecasters aim at convincing the market that they are well informed. The market evaluates their forecasting talent on the basis of the forecasts and the realized state. If the market expects the forecasters to report their posterior expectations honestly, then forecasts are shaded toward the prior mean. With correct market expectations, equilibrium forecasts are imprecise but not shaded.
A footnote points out:
Ironically, The Economist (“Dustmen as Economic Gurus,” 3 June 1995) reports the surprisingly good performance of a sample of London garbagemen in forecasting key economic variables.
Cote, however, obviously limited by the evidence the parties presented to the court, considers matters much weightier than all that:
The unauthorized redistribution of research reports and Recommendations has had another impact on the Firms. The Firms have cut their analyst staff and budgets significantly in the last five years because of their perception that equity research is no longer driving commission revenue as forcefully or consistently as it once had. With clients able to review the Firms’ Recommendations and even research reports through other sources, the research departments have been handicapped in their ability to argue for their historical share of the Firms’ overall budgets. Thus, with the decline in exclusivity of their research, the resources that the Firms have devoted to research production have declined. (Emphasis ours).
The "exclusivity of their research," you see, is so critical and so fragile that the likes of Fly is prone to cause massive research layoffs daily with the publication of each new morning recommendation summary update. How glorious must it be to walk along the sweet gumdrop shores under the big, purple skies of planet Cote, where the savaging of the finance industry in general in recent years and the 2003 global analyst research settlements (forbidding compensation to research linked to trading or investment banking volumes) specifically have no impact whatsoever on the staffing levels of research groups much less the growing insignificance of sell-side research on every level.1
Barclays Capital Inc, et al. v. TheFlyOnTheWall.com might be a straightforward case if the only issue were limited to copyright. Fly fielded cease and desist letters on a number of occasions and apparently modified its behavior with respect to the collection of recommendations data to avoid outright copyright violations. The case notes that:
When it comes to the plaintiff Firms, however, [Fly President and majority shareholder Ron] Etergino professes that he no longer feels free to look at the research reports, even if someone should send them to him. Instead, Etergino asserted at trial that he is usually the only employee who posts the Firms’ Recommendations, and by 2009, he was engaging in a ritualistic and labor-intensive process of “confirming” each Firm’s Recommendations from at least two and sometimes three independent sources before publishing them, still typically before the market opening.
On reading this account we could imagine virtually no circumstance in which a citizen reporter, a blogger, or any other author could reasonably be restricted from publishing information gleaned, via the methods described above. Clearly, the ability to confirm the information from multiple sources would at least suggest that the material had seen wide distribution. This brings up a particular point.
Much is made in the present case of the allegation that Fly routinely published recommendations before the client of the bank received them. To our way of thinking this is primarily the result of sloppy thinking on the part of the court, not least by equating access with actual consumption. No serious institutional client would make substantive trades based solely on Fly's reporting as a substitute for the full text of an actual research report.
To draw the conclusion that the sorts of clients that would drive material fractions of trading revenue for the bank developing equity research would use recommendations in such a fashion and without the support of detailed financial models and internal research would not only require a vanishingly small estimate of the client's intelligence, but would mandate a highly permissive, or perhaps non-existent investment committee process at the client as well.
It is extremely difficult to see how timeliness of access to these reports relative to the market's opening bell is some kind of critical, world-shaking concern in this context. This is, however, a key component of the court's rationale. This, in turn, leads to another question:
If snap-trading on recommendations is a trading tactic inconsistent with the sorts of clients that might throw around enough trading commissions to make a bank grovel, how does one argue that the value of such reports to a bank's clients just after release is so high as to warrant notice (much less special judicial protection under "hot-news misappropriation" theory)?2
We actually think it much more likely that, to the extent they have any value at all, and we do not consider this even remotely self-evident, recommendations have become a recursive end unto themselves, with short term investors chasing the crowd, which is itself chasing the crowd and trying to jump the recommendation bump before the rest of the country gets in on the action.
Of course, this sort of self-referential paradox of recursive hype makes it somewhat difficult to call recommendations "hot news" with a straight face. Unfortunately, as Fly did not seek to present any of these facts to the court as evidence and, in fact, Judge Cote does not seem to have taken much of a shine to Fly, the court is quite deaf to them. For example:
Ultimately, as the facts are in dispute. It should be observed, however, that Etergino was not a reliable reporter of facts. He frequently contradicted himself. His unreliability appeared attributable to both his lack of attention and care in making statements, which tended to be rushed, and his motive to escape liability.
Then there is this:
Fly’s complaint in its suit against TTN also heavily borrowed language, structure, and argument from the complaint in this action.
Ouch.
But on a moment's reflection, this is a bizarre complaint. Given the amount of boilerplate and reuse of material in complaints and motion filings throughout the practice of law in the United States it seems almost petty and trite for an individual sitting on the federal bench to sink to this level. To our way of thinking, no argument has endured such a severe mismatch of station since Milburn Drysdale sucked up to Jedediah Clampett once weekly on CBS.
On the face of it, most of the case would seem to be wrapped up in copyright issues, which should be easily disposed of by resort to the Fair Use Doctrine, provided Fly had taken even the most casual editorial liberties by injecting sufficient commentary and original content into quoted material. Oddly, Fly abandoned that defense quickly and apparently on its own initiative:
In its defense, Fly asserted that its copying was a fair use of the Copyright Plaintiffs’ reports under 17 U.S.C. § 107, and Fly maintained this defense through summary judgment. Fly no longer disputes, however, that it infringed the copyrights in these seventeen reports. As such, judgment shall be entered for the Copyright Plaintiffs on their claims of copyright infringement.
This leaves only the misappropriation of "hot news" to deal with, surely a trivial matter once the "hot news" (an analyst recommendation in this case) is widely disseminated. Truly, what value can information have as "hot news" if you can confirm it independently from two, three or more different sources? What legal theory could be offered to warrant granting a property right in such information? Cote jumps right into misappropriation:
Similarly, even if true, it is not a defense to misappropriation that a Recommendation is already in the public domain by the time Fly reports it.
[...]
Since it does not matter whether Fly has taken its headlines directly from the Firms’ research reports or elsewhere, it is not necessary to decide the credibility of Fly’s description of its current methodology for researching the Firms’ Recommendations, nor to decide which of the putative sources for its headlines could properly be considered “public” in nature. (Emphasis ours).
For those of us not on planet Cote: "'Hot news' is neither hot, nor news. Discuss." Or, perhaps, just try to follow this reasoning:
The value of "Hot News" is its exclusivity to the possessor, and;
Its timely distribution, and;
The unique and costly research and analysis that goes into its production, yet;
For the purposes of enforcing misappropriation it need not be:
Valuable (see Stefano Bonini et al.), or;
Exclusive, or;
Accurate, and;
It can be saturating the public domain in four different mediums, and;
You're still fucked if you distribute summaries of it.
But really what sends us screaming off into the darkness in the end can be found towards the end of the opinion:
This final element also helps to align the tort with the overriding public interest, so that it serves to protect socially valuable products or services in danger of being under-produced.
[...]
It was undisputed at this trial, and explicitly conceded by Fly, that the production of equity research in general, and its production by the plaintiff Firms specifically, is a valuable social good.
Read: We're doomed, at least while defendants concede this kind of fact without dispute.
In essence, one need only know that a number of forces align themselves against the free dissemination of information in the name (whether they realize it or not) of protecting old business models that depend for their existence on slow, antiquated distribution channels or the fact that all financial data is molding away in a file cabinet somewhere in Fresno, CA. Moreover, a sort of "new dark ages" movement, closely tied to the hard swing towards state owned and command and control economies that now dominates the political landscape, increasingly makes a mockery of "free speech" ideals in the United States. Don't worry though, the Dustman Forecasters, Pipefitter Fortunetellers, and Iron Workers Clairvoyants Union Local #255 is accepting new members. With a little palm greasing Local #255 is certain to be gifted a majority stake in one of the soon-to-be-bankrupt ratings agencies via a little bankruptcy priority modification by their executive branch patron. I hear salaries are on a 14 monthly payment cycle and their pension pays 135% of salary after 12 years of loyal service. Yeah, it is hard to get in past the waiting list but I hear cheap scotch gets the taste right out of your mouth.
1. 1. The settlement, which also smacked Henry Blodget with $4 million in fines and "disgorgements," was between the SEC, NASD Inc., the New York Stock Exchange, Inc., the New York Attorney General, and other state regulators and Bear, Stearns & Co. Inc. (Bear Stearns), Credit Suisse First Boston LLC (CSFB), Goldman, Sachs & Co. (Goldman), Lehman Brothers Inc. (Lehman), J.P. Morgan Securities Inc. (J.P. Morgan), Merrill Lynch, Pierce, Fenner & Smith, Incorporated (Merrill Lynch), Morgan Stanley & Co. Incorporated (Morgan Stanley), Citigroup Global Markets Inc., f/k/a Salomon Smith Barney Inc. (SSB), UBS Warburg LLC (UBS Warburg), and U.S. Bancorp Piper Jaffray Inc. (Piper Jaffray).
2. 2. See e.g., International News Service v. Associated Press, 248 U.S. 215 (1918) (Ruling that "hot-news" is a form of “quasi-property.”)
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