Modern capitalism does not, as a general matter, demand that workers believe in their work in their inmost souls. Teetotalers can be bartenders, doctors can smoke, Ford salesmen can drive Hondas, or bicycles, in their private lives. Mental reservations are allowed. There are a few careers that are exceptions to this general rule of laissez faire.1 A loss of faith is, I gather, disqualifying for the priesthood.
Sell-side equity research is like the priesthood. If you are a sell-side research analyst in the U.S., you are required by the Securities and Exchange Commission to conform your work to your inmost beliefs. “When research analysts tell clients to buy or sell a particular security, the rules require them to actually mean what they say,” says the SEC’s head of enforcement.2
It is a weird state of affairs. How can the SEC know what you actually think?
Here is a beautiful SEC case against Charles P. Grom, a former research analyst at Deutsche Bank Securities, Inc. Grom covered, among other companies, Big Lots, Inc. He initiated his coverage with a Buy recommendation in September 2011. Big Lots announced earnings on March 2, 2012, and Grom published a report reiterating his Buy rating. He also called four hedge fund clients — the SEC calls them “Hedge Fund A, Hedge Fund B, Hedge Fund C, and Hedge Fund D” — and told them that he meant what he wrote.3 There is no reason to doubt that he meant what he wrote, in his heart of hearts, though of course you can’t prove that he did either. Perhaps in his heart of hearts Grom is a Humean radical skeptic and believes that all knowledge, including knowledge about Big Lots’ comparable-store sales, is impossible.4 Perhaps he writes research reports anyway, because it pays well, and in the face of an unknowable universe, what else is there to do? The SEC does not inquire.
In any case, Grom soon enough stopped meaning what he wrote. You can pinpoint — the SEC did pinpoint — the exact moment, or at least the day, when Grom had his crisis of faith. It was March 28, 2012, sometime before lunch:
On March 28, 2012, Grom and DBSI hosted Big Lots’ Chief Executive Officer and Senior Vice President of Finance at a non-deal roadshow (“NDR”) at DBSI’s Boston office. Beginning at about 7:30 a.m. and continuing until about 3:15 p.m., the Big Lots executives held private meetings with DBSI clients. Grom attended all of these meetings.
Before the NDR, Grom was bullish on Big Lots: he believed the company’s first quarter financial performance, particularly its first quarter comparable store sales, would be strong, with comparable store sales “up four or five, maybe six percent.” At some point early during the NDR, Grom’s view changed and he ultimately concluded that Big Lots’ first quarter comparable stores sales would increase by only two to three percent, a significant shift in Grom’s view.
It might at first seem difficult to believe that the SEC would have such penetrating insight into Grom’s personal beliefs. It turns out to be very easy to believe, though, as Grom left a weirdly comprehensive electronic record of the change in his beliefs. Starting with:
At 8:51 a.m. on March 28, 2012, shortly after the first NDR meeting had ended, Grom called the DBSI trader responsible for trading Big Lots’ stock. At 9:31 a.m., within a minute of the market opening, the trader placed an order to sell 25,000 shares of Big Lots’ stock, which he had purchased the day before in a firm proprietary account.
Hedge funds A through D also got calls from Grom that day, and also dumped stock shortly thereafter. Inferring a person’s state of mind from his actions is notoriously difficult, and inferring them from other people’s actions is even more difficult, but it doesn’t look great. We don’t have to rely on those sales, though, because “Grom stated on multiple occasions that he told certain DBSI clients to sell Big Lots stock,” including on a conference call, in an e-mail to a salesperson and even, incredibly, in an e-mail to himself:5
In an email to himself on April 24, 2012, Grom wrote an outline of his comments regarding Big Lots for the DBSI morning conference call that day, in which he noted that he had “told most to take profits @ $46,” which was the price of Big Lots stock on March 28, 2012.
So Grom recorded his change of heart about Big Lots in almost every possible venue. Except one. Unfortunately that was the only one where sincerity is required by SEC rules:6
On March 29, 2012, Grom issued a research report on Big Lots entitled “Not All Is Good In Buckeye Land,” in which he reiterated his BUY rating.
I mean that title doesn’t sound bullish? But, sure, don’t call up your hedge-fund buddies, tell them to sell the stock, and then issue a Buy recommendation the next day. Why would you do that? Again, Grom was weirdly helpful in documenting his thought process, saying on a (presumably recorded) conference call with sales that “we just had them in town so it’s not kosher to downgrade on the heels of something like that.”
But, no, not all was good in Buckeye Land,7 and less than a month later Big Lots “issued an unexpected press release forecasting negative first quarter comparable store sales, which resulted in the company’s stock losing almost one-quarter of its value in one day.” Grom again dictated his internal monologue straight into a recorded conference call:
[F]ortunately we told many clients a few weeks back to sell the stock. . . . I think the writing was on the wall [that] we were getting concerned about it, but I was trying to maintain, you know, my relationship with them. So, that’s why we didn’t downgrade it a couple of weeks back.
For this, the SEC looked deep into Grom’s soul, fined him $100,000 and suspended him from the industry for a year.8
One question you could ask here is, was Grom being a good analyst by doing this, or a bad analyst? I mean, he was clearly doing bad stuff according to SEC rules. But if you are a Deutsche Bank research client — or if you are, like, the dollar-weighted average of all Deutsche Bank research clients — the answer is not so clear. It seems to me that Grom’s job had at least three components. One component was writing research reports about Big Lots, with a big “BUY” or “HOLD” or “SELL” at the top. Let us concede that, by telling clients to Buy when he thought they should Sell, Grom did this part of his job poorly.9
Another component was giving better clients better service. Hedge Funds A through D expected personalized service, not just the research reports that were available to everyone:
Grom knew that these four hedge funds were particularly valuable clients to the firm. Hedge Fund A, Hedge Fund B, and Hedge Fund D were all designated as top priority “Global Research Service Level 1” accounts that received the highest level of service from the firm’s research and sales personnel.
Obviously one way to give better clients better service is to take them golfing and buy them fancy dinners. But the main way to do it is to call them up sometimes and say things that aren’t in the research reports. Telling them to sell, when the written research says Buy, is kind of a lazy way to do that. The more normal approach is to give them, you know, “color” or whatever around the written research. But the difference is one of degree: The written research has to be anaccurate reflection of the analyst’s mind, but it doesn’t have to be a complete reflection. It’s legitimate for the research analyst to be more helpful to some clients than to others — and since all clients get the written research, that means it’s legitimate for the analyst to give the favored clients information that is better than what’s in the reports.
The last component of Grom’s job was to get clients access to corporate management:
DBSI’s performance evaluation system for equity research analysts, including Grom, assigned significant weight to an analyst’s access to and relationships with the senior management of the companies they covered and the feedback that the firm received from its clients. Nearly ten percent of an analyst’s internal performance rating was based on the frequency and level of contact that the analyst was able to arrange for firm clients with management from the companies they covered. An analyst earned additional credit for arranging contact with chief executive officers and chief financial officers.
To be clear, when Grom told anyone who would listen that he held off on downgrading Big Lots to maintain his Big Lots relationship, that wasn’t about maintaining an investment banking relationship, like it would have been in 2000. It was about maintaining a relationship in which Grom could introduce investing clients to Big Lots, and those clients could hear what Big Lots had to say. Grom wasn’t protecting a relationship that was profitable for Deutsche Bank by lying to his investing customers. He was protecting a relationship that was profitable for his investing customers — some of them, anyway — by lying to his investing customers. Customers who made decisions based on research reports got let us say not a completely sincere research report. Customers who made decisions based on management meetings got to keep having management meetings. The Deutsche Bank customers who went to that March 28 non-deal roadshow heard the same stuff that Grom heard, the stuff that turned him bearish on Big Lots. Hedge Fund A heard from Grom at 3:18 p.m. that day; Hedge Funds B through D got calls later. The customers who were actually in the meetings presumably got the bad news long before those guys.10
Obviously the SEC’s job is to some extent to push for a level playing field, to make sure that little retail clients aren’t getting dishonest research reports in order to make sure that big institutional clients keep getting management meetings. But there is at least a hint in this case that, for big institutional clients, the management meetings were much more valuable than the headline recommendations on the written research. Given the choice of Buy/Sell/Hold recommendations that Grom believed in his heart of hearts and no management meetings, or garbage spammy universal Buy recommendations and lots of management access, it would be totally reasonable for Deutsche Bank’s investing customers to choose access over honesty.
Also this is obvious but: Those meetings seem to have been super material!11 Whatever was said or not said, whatever was implied by Big Lots’ CEO’s body language, one of its leading analysts came into the meetings bullish and came out bearish. And then his trader and his customers went and dumped Big Lots stock. And then a few weeks later Big Lots announced bad news and the stock went down. If Big Lots’ CEO had told his brother-in-law on the golf course whatever he told these investors at a non-deal roadshow, we might well be talking about insider trading instead of a research analyst’s crisis of faith.
- One that I wonder about is Internet columnizing.
- The particular rule is Regulation AC, which requires an analyst to certify ”that all of the views expressed in the research report accurately reflect the research analyst’s personal views about any and all of the subject securities or issuers.”
Grom told the hedge funds, along with other firm clients, that Big Lots’ management “sounded great” and expressed positive views about the company’s stock.
- Perhaps he follows Quine in thinking:
Physical objects are postulated entities which round out and simplify our account of the flux of experience, just as the introduction of irrational numbers simplifies laws of arithmetic. From the point of view of the conceptual scheme of the elementary arithmetic of rational numbers alone, the broader arithmetic of rational and irrational numbers would have the status of a convenient myth, simpler than the literal truth (namely, the arithmetic of rationals) and yet containing that literal truth as a scattered part.
Similarly, from a phenomenalistic point of view, the conceptual scheme of physical objects is a convenient myth, simpler than the literal truth and yet containing that literal truth as a scattered part.Thus he might deny the literal existence of Big Lots stores, never mind Big Lots comparable-store sales, while still believing that those stores and those sales are a convenient enough myth to feed to his research customers.
- We sometimes talk, around here, about the financial-industry imperative not to put incriminating things in writing. But this conflicts with another obvious imperative, which is that putting things in writing is often the easiest way to communicate with colleagues spread out around the world. But, you know. Don’t put incriminating things in writing to yourself. What is the purpose of that?
- Again, nothing here is legal advice, but if I were defending Grom I might have argued that the research report reflected his true beliefs, and that what he told all those clients and salespeople and himself and so forth was insincere. It doesn’t help that the stock went down though.
- Big Lots is headquartered in Columbus, Ohio, home of the Ohio State Buckeyes, which I guess is the point here?
- Grom neither admitted nor denied the SEC’s findings.”
- I haven’t read that report, but again the title might have at least hinted that, you know, not all was good in Buckeye Land. You could have a model in which the rating is to appease management, and the text of the report — or even just the headline! — is to communicate the analyst’s real views to investors.
- Except weirdly that Hedge Fund A actually met with Big Lots at a conference the day before (March 27) and thought everything was great:Analyst A, an analyst at Hedge Fund A, attended this conference and met with Big Lots’ management during one of the private meetings. At 11:57 a.m., shortly after his meeting ended, Analyst A sent an email to a portfolio manager at Hedge Fund A, recommending that they buy Big Lots’ stock: “Believe we should add some Big Lots. They sound good and Chuck Grom is taking them for dinner tonight so I suspect he will be on the horn tomorrow. Q1 comp will be strong and then the street has modeled [gross margins] down in Q2 while they are saying up.”
Within a minute of receiving Analyst A’s email, the portfolio manager placed an order to buy almost 100,000 shares of Big Lots’ stock, increasing the portfolio’s existing position in the stock.
Later that day, Analyst A spoke by phone with Grom. While that call was in progress, the same portfolio manager placed an order to purchase an additional 110,583 shares of Big Lots’ stock.Hedge Fund A dumped all that stock and more the next day, after hearing from Grom. I don’t quite know what changed in Big Lots’ body language overnight.
- For previous discussions of this sort of thing, consider this post, or this one, or this one.