The "irrational exuberance" cited by Federal Reserve Board Chairman Alan Greenspan was, in fact, "rational manipulation." That's the provocative charge made by Scott Cleland, chief executive officer of the Precursor Group, an independent research firm based in Washington.
This irrational exuberance was based on a "trillion-dollar fib," Mr. Cleland says. This fib was the conventional wisdom, repeated by almost everyone in the telecom industry, that data traffic was doubling every three to four months, or 800% to 1,600% per year.
In reality, data traffic was growing only 100% to 200% per year, as the Precursor Group reported early in 2001. That's still healthy growth, but not enough to power the demand for bandwidth that drove the business plans, or at least the proclaimed business plans, of Global Crossing Ltd. and similar companies.
The fact that so many top executives of companies such as Global Crossing sold out most of their company stock holdings at or near the top of the market for those stocks suggests to Mr. Cleland that they knew the higher figures were false.
And, Mr. Cleland says, the fact that Wall Street security analysts weren't able to starkly expose the "trillion-dollar fib" showed the weaknesses of Wall Street research. The failure of these analysts to expose this fib and others involving the telecom and Internet sectors cost U.S. investors at least $1 trillion, according to Mr. Cleland.
The basic problem, as almost everyone now recognizes, he says, is the conflict of interests inherent when research is housed inside an investment banking firm.
Mr. Cleland believes the conflicts will remain as long as investment banking and research are conducted by the same company. The current system makes it difficult for investors to use research that is free of the conflicts, he says. That's because most research is paid for through directed commissions, which, as required by regulation, can be collected only by broker-dealers.
Regulation also requires all broker-dealers to be licensed to handle the complexities of investment banking, even if they do no investment banking. "This is a serious barrier to entry for pure research firms," he says. Before the Precursor Group could accept directed commissions, Mr. Cleland and his partner, William Whyman, had to pass the Series 24 exam. That involved studying 900 pages of regulations, only about 10 of which dealt with simple brokerage. The remainder dealt with investment banking activities, "which we never intend to do."
Mr. Cleland has started an association of independent research firms, the InvestorSide Research Association, one objective of which is helping investors find sources of research that are free of the investment banking taint. It also will lobby for better investor education, better payment practices and revised regulation.
The association has three founding member firms: The Precursor Group, Argus Research Corp. and Eagan-Jones Rating Co.; Mr. Cleland is recruiting additional members. To become members, research firms must be without investment banking operations.
Mr. Cleland and others now are working on the association's bylaws to spell out eligibility and determine how to certify the members are conflict free. The aim of the group is the continued development of a vibrant independent research community that will provide a loud, unconflicted alternative voice to Wall Street research. Such a community might have been able to head off the excesses and losses caused by the "trillion-dollar fib."