Consumer Party

by Noam Scheiber | December 2, 2002

George Zicarelli is the kind of voter that must give his party fits. A longtime resident of New York City's Upper East Side, he is a self-described "conservative Democrat" who has now voted for Republican Governor George Pataki in two successive elections--in 1998 and again this November. "I like Pataki on a fiscal level," Zicarelli explains.But Zicarelli did vote for at least one Democrat on the statewide ballot this year: Attorney General Eliot Spitzer. Zicarelli, it turns out, lost several hundred thousand dollars in the stock market after his broker at Salomon Smith Barney encouraged him to invest in stocks recommended by the firm's star telecom analyst, Jack Grubman. As a result, Zicarelli has derived no small amount of satisfaction from watching Spitzer investigate analysts such as Grubman and Merrill Lynch's Henry Blodget for promoting stocks they didn't believe in. In fact, Zicarelli is so grateful for Spitzer's activism on behalf of investors that when I asked him who his favorite politician is, he hesitated briefly before conceding that, "to be honest, if it was between Pataki and Spitzer, I'd have to vote for Spitzer." Zicarelli, in short, is the sort of middle-of-the-road voter many Democrats failed to impress on Election Day but whom Spitzer won in droves en route to racking up 66 percent of the vote in his reelection campaign. Spitzer won 2.5 million votes in all--over one million more than the state's Democratic candidate for governor, Carl McCall, and almost half a million more than Pataki. As Democratic political consultant Richard Schrader told The New York Times two weeks ago, Spitzer "is the one politician nationally who has been able to capitalize on the issue of corporate misconduct." It's not as though other politicians didn't try. National Democrats responded to the collapse of Enron and WorldCom by condemning the corporate world as greedy and corrupt, and then assailing Republicans for their corporate ties. In late June, Majority Leader Tom Daschle declared on the Senate floor that "it is as if the line between right and wrong ... was so little enforced that it became blurred. Bringing it back into focus--as Enron's collapse did-- revealed more than a few businesses standing on the wrong side." One week later, on "Face the Nation," he made the connection to the Bush administration: "We've even seen [a permissive atmosphere] in relationships that some of the members of the administration have had with their own corporate roles and the responsibilities they had in the corporate sector." Daschle's Democratic counterpart in the House, Dick Gephardt, went even further. "I think we're in a world of George Orwell, only Big Brother is not the government, Big Brother is corporate America," Gephardt alleged at a press conference shortly after WorldCom's collapse in July. "This is a Republican majority in the House that is of, by, and for corporate America." Unfortunately for the Democrats, most Americans simply didn't agree with Gephardt's analysis. In June, on the eve of WorldCom's collapse, 38 percent of respondents to a USA Today/Gallup poll viewed "big business" as the greatest threat to the future of the country. But 47 percent gave that distinction to "big government." One reason is that, although Americans were outraged by the corporate scandals, more than half of them--and two-thirds of voters--own stock in some form. Any attack on business that seemed to hint at excessive fines or burdensome new regulations could therefore be seen as an attack on their personal financial interests. That helps explain why a poll released by the Pew Research Center in early September showed registered voters giving Republicans a five-point edge when it came to "dealing with corporate corruption." And it helps explain why, according to a Pew poll the following month, investors who by their own description "lost a lot of money recently"--the George Zicarellis of the world--planned to vote Republican by a six-point margin. Spitzer grasps this problem intuitively. "I think there is some anger," he told me in a recent interview. "But nobody wants the marketplace to crumble and to see their 401(k) drop even more." Spitzer's solution hasn't been to do nothing; it has been to focus more narrowly on the harm done to investors--who, after all, were the people hurt by the scandals in the first place. Spitzer argued, in effect, that buying stock is in a fundamental way like buying any other product: The buyer needs quality information in order to decide among numerous options. If for some reason investors had been getting misleading information, they couldn't possibly have made intelligent decisions. Like other Democrats, Spitzer advocated reform. But, unlike other Democrats, Spitzer's reforms weren't designed to punish or rein in inherently corrupt executives. They were designed to give essentially amoral corporations incentives to better serve their customers. Spitzer, in other words, wasn't anti-business so much as pro-consumer. And that made all the difference in the world. Spitzer's reluctance to demonize business follows from his biography. The youngest child of a New York City real estate magnate, Spitzer--after Harvard Law School and a stint in the Manhattan District Attorney's office--spent two years working on mergers and acquisitions at the corporate behemoth Skadden Arps. In many ways, he resembles the young, Harvard-trained corporate lawyers who wrote many of the federal statutes that govern the financial markets today. New Dealers like Tommy Corcoran and Benjamin Cohen had lost money in the market crash of 1929, but, in the words of one contemporary, "They want[ed] to reform the system, not take revenge on it." Spitzer, likewise, is a reformer with a large personal stake in preserving "the system." He is fond of joking that "[h]alf his friends are investment bankers, and the other half are lawyers who represent investment bankers," as Fortune magazine recently put it. Spitzer's friend, the hedge-fund manager and financial commentator Jim Cramer, points out that "he's really one of them. He could have been general counsel of Merrill." In our interview, Spitzer confided that he'd seriously considered a career in business himself. "There's always been a piece of me that wants to be in the private sector. There is an element of dynamism and risk-taking that is very appealing, to actually be out there in the business world." So, when Spitzer squeaked into office by fewer than 30,000 votes in 1998 (out of nearly 4.5 million cast), it was only natural that he'd look for an uncontroversial way to pursue his reform agenda. He found it in consumer protection. Some of his early cases were downright middling--one investigation focused on whether Pfizer overstated the effectiveness of its lice-treatment products--but others were bolder. Spitzer took the lead, for example, in a multistate price-fixing suit alleging that CD manufacturers had colluded with retailers to bilk consumers out of nearly $500 million. Whatever the size of the case, though, Spitzer's approach was reliably pragmatic. He staked out an aggressive position among the 18 state attorneys general suing Microsoft for anti-competitive behavior shortly after entering office. But, when the Bush Justice Department reached an agreement with the company after its court-ordered breakup had been overturned, Spitzer led a group of attorneys general who signed on over the bitter objections of their more hard-line colleagues. "I stood to gain more by negotiating with Microsoft if I could get something from them; whereas the other argument was to litigate and ask for more and get nothing," Spitzer says. "That's what happened to the litigating states." Spitzer's centrist approach earned him the affection of conservative editorial pages around the country. The Orange County Register even held him up as an example to California Attorney General Bill Lockyer, who, it complained, was "continuing his quixotic antitrust attack on Microsoft Corp., with taxpayers picking up the legal tab." But Spitzer's real innovation was to extend his pragmatic, consumer-oriented approach beyond conventional consumer issues. "I hear the derisive comments that somehow a consumer case is less intellectually stimulating," he told me. "But I think we have expanded the mandate of the office beyond that traditional image." Perhaps the most significant of these cases involved General Electric (G.E.). In the 1940s, two of the company's upstate facilities began dumping a class of compound called polychlorinated biphenyls, or PCBs, into the Hudson River. The federal government finally banned PCBs in 1976, after research demonstrated that they could be cancer causing in sufficient quantities. But by this point there were already one million pounds of PCBs lying at the bottom of the Hudson. Despite periodic prodding from environmental activists and state and federal officials, G.E. never did anything about them. Enter Spitzer. In November 1999, he announced that the state was suing G.E. over the PCBs. The move was fraught with risk. At the time, the company stood at the very top of the business world, its CEO, Jack Welch, held up as a hero of American enterprise. In this context, few believed Spitzer would be able to paint G.E. as an evil colossus out to harm the residents of upstate New York (particularly since many of those residents actually worked for G.E.). But, given the tenuous scientific evidence surrounding the case, winning a claim based on the harm done to wildlife and human beings would have required just that. So Spitzer took another route altogether. He argued only that the accumulation of PCB sediment in the Hudson had rendered parts of the river impossible to navigate. Spitzer didn't even threaten the company with a massive damage award. He simply asked G.E. to cover the costs of the dredging. The strategy proved to be inspired. Spitzer tapped a reservoir of public support by casting the despoiling of the river as essentially a consumer issue: Upstate businesses that depended on the river were being deprived of its use. According to his pollster, Jef Pollock, "[Spitzer's] numbers shot up upstate, where it's really hard for a New York City person to become known." That gave Spitzer a mandate to press on even after a federal judge ruled that the suit couldn't go forward before the Environmental Protection Agency (EPA) had studied the matter. And many observers feel that Spitzer's pressure helped build momentum for the dredging, which the EPA eventually ruled in favor of. "Some people don't buy the health issue and the contamination-of-fish issue," says Rich Schiafo, a spokesman for the environmental group Scenic Hudson. "Some of those same people said, `Yeah, part of the economic engine of the Hudson has been damaged.'" Given Spitzer's pro-consumer agenda, it's not surprising that he suspected his office might have a role to play after the spectacular meltdown of companies like Enron helped bleed investors of billions of dollars. He found that role in July 2001, when a Queens pediatrician named Debases Kanjilal won a surprising concession from Merrill Lynch. In January 2000, Kanjilal had instructed Michael Healy, his Merrill Lynch broker, to take his daughter's college savings out of name-brand stocks like America Online and Microsoft and invest them in the speculative telecom sector. But, by May, the telecom stocks had begun to tank. So Kanjilal did what any panicky investor would: He called Healy and asked him to sell. That didn't happen. Instead, Kanjilal said in an arbitration claim, Healy encouraged him to ride out the dip. According to Kanjilal, Healy would cite the bullish buy recommendation that Henry Blodget, Merrill's star telecom analyst, had placed on the stocks. Kanjilal also said that Healy once even claimed Blodget had personally assured him that one stock, for a company called InfoSpace, would recover to $100 per share from its then-price of $60. (Merrill Lynch denies that Healy made these statements.) By the time Kanjilal finally sold the InfoSpace stock in December, its share price had plummeted to $11. His overall portfolio, once worth $1.2 million, stood at a meager $95,000. Not surprisingly, Kanjilal blamed Healy and Blodget for the losses he racked up between May and December. "He felt he had been misled by the top analyst at Merrill," says Kanjilal's lawyer, Jake Zamansky. So Zamansky filed a $500,000 claim against Merrill with the New York Stock Exchange, alleging that Blodget had been pressured to talk up a loser like InfoSpace because Merrill's investment-banking arm counted the company's parent as a client. Merrill quickly caved and agreed to a $400,000 settlement before the case even entered the arbitration phase.; "'Spitzer is a wild man,' one Wall Street veteran recently complained to me. 'He can do enormous damage.'" The settlement sent tremors up and down Wall Street. According to Brad Hintz, a longtime brokerage analyst at Sanford Bernstein, it was not the $400,000 figure itself that was particularly eye-opening. "The issue was the eighty cents on the dollar," he says. Most settlements between clients and firms tend to hover at somewhere between 40 and 60 percent of the reported loss. That Merrill was paying 80 percent so early in the process seemed to indicate the company had something to hide. Or, as Spitzer put it to me, "There are two risks that a company faces in that negotiation. One is the risk of not settling and going to trial and having it all come out. The other is the risk of settling and having the settlement amount be noticed. They took the latter approach, hoping that it would disappear into the ether." It didn't. Spitzer had already launched a preliminary investigation into the way companies like Merrill were promoting stocks. But the Kanjilal deal was like a bolt of lightening: By focusing on the analyst/investment-banking relationship, Spitzer could highlight the bill of goods investors had been sold without risking a much cruder attack on Wall Street as a whole. Of course, given Merrill's sterling reputation and vast legal apparatus, the company wasn't about to roll over-- particularly in the face of a challenge from a state official like Spitzer, whom Wall Street considered out of his league. The main regulator of financial markets, after all, is the federal Securities and Exchange Commission (SEC). And, over the years, Wall Street firms have developed a fairly cushy relationship with the commission. At the very least, says Jacob Frenkel, a securities litigator and former SEC enforcement lawyer, "Firms know where they stand with the agency." For the first six months of the investigation, Merrill's confidence seemed well-placed: Spitzer made little progress, and the SEC was nowhere to be found. But, in January 2002, Spitzer's investigators stumbled onto e-mails in which Merrill's analysts privately derided the very same stocks they were hyping to clients. Spitzer couldn't believe his eyes when he saw the documents himself. "Get me the damn e-mails! All of them," Spitzer told a top aide, according to The Wall Street Journal. Before long, Spitzer's office had subpoenaed 30,000 e- mails, which his lawyers spent the next several months poring through. They'd amassed a damning pile of evidence by the time they'd finished. In perhaps the most infamous message, Blodget referred to one stock as "a piece of junk." Another e-mail documented an exchange between an analyst and an institutional investor who asked, "What's so interesting about [the Internet company] GoTo except banking fees?" "Nothing," the analyst replied. Merrill Lynch now had a real problem, and it wasted little time responding. The company brought in a partner from Skadden Arps, Spitzer's one-time employer, to handle its negotiations with the attorney general's office. It subsequently lobbied New York Senator Chuck Schumer to intervene on its behalf. Merrill even hired former New York Mayor Rudy Giuliani to remind Spitzer that the firm was a vital part of the local economy and that it had returned to its Wall Street headquarters as soon as possible after the September 11 attacks. Or, as Giuliani put it to the Journal, "Merrill is an enormously important player in New York in the right sense." But Merrill's lobbying campaign had almost no effect. For one thing, Spitzer has little patience for special pleaders. Cramer, a friend of Spitzer's from law school, is fond of telling a story about an abortive plan to send a proxy to their third-year criminal procedure class. "Eliot shamed me into going," Cramer recalls. "He hates system gamers." Last year, Spitzer nearly came to blows with California's Lockyer over $50 million left over from the states' tobacco settlement, which he accused Lockyer of wasting on various pet projects. (According to an article in The American Lawyer, Spitzer, who preferred sending the money back to the states for tobacco-related health initiatives, bellowed, "You want to step outside, that's fine! I grew up in the Bronx!") More importantly, though, Giuliani didn't need to remind Spitzer that bringing Merrill to its knees would deal a blow to the city's economy: Spitzer never intended to bring Merrill to its knees. Far from seeing his investigation of Merrill as an assault on the firm, Spitzer saw it as a way to save Merrill from itself, since investors who repeatedly get bad information will eventually lose confidence in the market and stop providing capital to businesses altogether. This is a point Spitzer stresses repeatedly. In our interview, he used the phrase "capital formation" at least four times--as in, "ensuring that the investment banks continue their function of facilitating capital formation, " and, "This is an effort to improve upon the capital-formation structure to see that it works." But to do that Spitzer had to first convince Merrill that the alternative to negotiating with him could be disastrous. So, on April 8, Spitzer decided to play his hand, releasing the e-mails and putting Merrill unambiguously on notice. "We are revealing today evidence that demonstrates that Merrill Lynch's advice to the investing public was fundamentally flawed and skewed," Spitzer told a group of reporters. "The desire to generate more investment-banking clients overwhelmed the obligation to provide straightforward, honest analysis to the investing public, and the internal e-mails from Merrill Lynch demonstrate that." As it happened, Merrill was the perfect foil for Spitzer. Whereas other Wall Street firms almost exclusively serve large, institutional clients who don't rely on the firms' research anyway, Merrill owes much of its reputation to its services for small-time investors--the real consumers of analysts' research. Over the years, Merrill has built one of the largest retail (i.e., small- investor) businesses on Wall Street--about 30 percent of its revenues, compared with about 15 percent for a higher-end firm like Morgan Stanley. And, as participation in the market shot up during the '90s--stock and mutual-fund ownership (excluding pension funds) rose from 23 percent in 1990 to 46 percent by the end of the decade--Merrill became a symbol of middle-class investing. Commercials featured middle-class parents coaching their children's soccer games while an announcer explained that their college savings were safe and sound with Merrill Lynch. Wall Street analysts even dubbed the firm "Mother Merrill." All of which convinced Spitzer that the firm was particularly vulnerable to evidence that it had misled its customers. "That's the critical factor," he says. "An entity such as Merrill ... that has a more expansive retail operation, that reaches farther out to Main Street, is a different type of entity with a more vulnerable consumer." It's also why the Merrill brass knew Spitzer had the company dead to rights when he produced his evidence. Merrill's chief executive, David Komansky, later acknowledged to The New York Times that he "found it quite embarrassing" when he learned of Spitzer's documents. He subsequently conceded to employees that the firm's reputation had suffered and even apologized at a shareholders' meeting a few weeks later. By late May, Merrill had agreed to a $100 million settlement. More significantly, the settlement forced the company to become a kind of laboratory for reform. Spitzer argued that the reason Merrill's research analysts spent so much time talking up lousy companies was that they were compensated--like most analysts on Wall Street--partly according to how many of these companies did business with the company's investment-banking arm. So, as a condition of the settlement, he insisted that the link between analysts' compensation and investment-banking business be severed. The most common criticism you hear from Wall Street is that Spitzer, who's now wrapping up a similar investigation of Salomon Smith Barney (a division of the financial conglomerate Citigroup), doesn't know what he's doing. "Spitzer is a wild man," one Wall Street veteran recently complained to me. "He can do enormous damage." But the more you know about Spitzer, the more you realize that what such critics mean isn't so much "damage" as "change." In fact, Spitzer knows exactly what he's doing. A former law review editor, he has a voracious appetite for detail--he frequently tries his own cases, something unusual for a state attorney general--and a hyperrational approach to reform. As Spitzer explained the analyst/investment-banker issue to me, "It's difficult because it poses theoretical issues about who needs research, how it's used, how you pay for it, how the marketplace will get access to it. Good people sharing common objectives could still disagree about what the best formulation on that one is." In the next couple of weeks, Spitzer and SEC enforcement chief Stephen Cutler are expected to announce a "global settlement" that will apply to all the major Wall Street firms and will, once and for all, resolve those theoretical issues. Though the details are still subject to negotiation, early reports suggest it will require companies to subsidize independent research for their retail customers--something that could cost as much as $1 billion over five years--and to hire an internal "ombudsman" to see to it that the research is distributed properly. The agreement will also use the Merrill settlement as a benchmark for levying fines, which could run into the hundreds of millions of dollars for firms like Citigroup and Credit Suisse First Boston. Increasingly, even people on Wall Street are grudgingly conceding that Spitzer's efforts have been largely on target. There is ready acknowledgement, for example, that analysts at Merrill and Salomon breached the so-called "Chinese Wall" that's supposed to separate research and investment banking. "The impression I have is that, in their eagerness to increase market share, Blodget and, to a larger extent, Grubman threw the rule book out," says one longtime Wall Street lawyer. Perhaps the more biting criticism comes from those who argue that Spitzer has actually been too easy on companies like Merrill, which he never forced to compensate investors. (There have been reports that the global settlement being negotiated will require a modest restitution fund for investors.) And, while Spitzer's $100 million settlement with Merrill seems large, it is mostly symbolic, little more than a pinprick for a company that earned $2.4 billion in profits last year and will have no trouble withstanding even the $4 billion some estimate it will have to shell out in arbitration claims and class-action suits over the next couple of years. "I think $100 million is chump change for Merrill Lynch, and it's almost a sign that the attorney general of the state of New York is settling this much too easily," Boston University economist Allen J. Michel told The Boston Globe in May. But, however morally satisfying it might be to punish corporate evildoers, there's little evidence that this is what the public wants--particularly as a greater and greater percentage of that public owns stocks. In recent years, a number of commentators, mostly on the right, have written extensively about the political implications of this phenomenon. The basic assumption is that investors have a shared political philosophy that leads them to favor limited government and deference to business. Since more and more people are becoming investors, the argument goes, reflecting that philosophy is becoming increasingly important for successful politicians. In some sense, the results of this month's elections confirm that theory. In races where the Democrats' approach to the corporate scandals was seen as retributive, the investing public--which is increasingly the public itself-- largely favored their opponents. In one Indiana swing district, for example, congressional candidate Jill Long Thompson flatly accused her opponent, the chairman of a local farm-equipment manufacturer, of epitomizing "corporate greed" in a widely publicized campaign mailing. She lost by four percentage points. Democrat Ronnie Shows fared no better in the Mississippi district that WorldCom calls home. Shows spent much of his campaign emphasizing WorldCom's shenanigans and scolding his opponent for refusing to return the outsized campaign contributions he'd received from the company. Voters would have none of it, going so far as to boo Shows when he suggested in a public debate that the election was about "jobs, greed, and trade." Shows lost by 29 points. But Spitzer's victory suggests that investors do have some interests--their interests as consumers--which only government can protect. And, while it's true that the range of projects that can be justified under the banner of consumer protection is less ambitious than the range that can be justified in the service of grander objectives, such as economic justice, many of those more ambitious projects may not be politically feasible. When I asked Spitzer whether he regretted not pressing Merrill Lynch for large, punitive-damage awards, he was basically unapologetic. "This is not a Robin Hood effort," he told me. Democrats who don't want the growth of the investor class to mean the end of government activism would be wise to learn that lesson.

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