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.”