Friday, June 09, 2006

What Would Michael Corleone Say?

Mr. Cummins said in a telephone interview that all the options had been legally priced, properly reported and approved by the company’s auditors and lawyers.

—New York Times

And so it is that the CEO and Chairman of the Board of Cyberonics, a medical device maker, defends the granting of options on 150,000 shares of Cyberonics stock at a special board meeting hours after an FDA panel had approved the company’s device for treatment of chronic depression, in February 2005.

The options were priced based on the company's stock price earlier that day—$19.58 a share. Of course, given the great news from the FDA, the stock was fifteen bucks higher the next day. Hey, it is a wonderful life.

The issue of Mr. Cummins’ wonderful option grant was raised—surprisingly, perhaps, to those of us accustomed to the ‘see no evil’ qualities of fee-hungry Wall Street types—not by a disgruntled shareholder or an investigative reporter (the Wall Street Journal has led all media in breaking the issue of back-dating option abuse), but by a medical device analyst for a mainstream brokerage firm.

The analyst in question, Amit Hazan, may not have done himself any favors by saying something less than fawning about the CEO of one of the very companies on which his career depends, but at least we can say this: one of Wall Street’s Finest is calling it as he sees it.

Now, in case you’re asking yourself “Why did it take so long for an analyst to raise this issue?” let me provide a cynical answer: Wall Street’s Finest routinely practice the same sort of artificial pricing of which Mr. Cummins is accused.

The way it works is this: when a major event occurs overnight that substantially increases the expected value of a stock—such as Cyberonics’ FDA event—the analysts covering that stock are allowed to upgrade the stock before the market opens, and the price at which they are deemed to have upgraded the stock is, just like Mr. Cummins’ option grant, the price at which the stock previously closed. Even if the stock is going to open up, like Cyberonics, fifteen bucks when trading resumes.

In other words, they do exactly what Mr. Cummins is accused of doing.

And it wouldn't surprise me if more than one analyst upgraded shares of Cyberonics itself the morning following the FDA's action, at a price of $19.58 a share instead of the price everybody would have to pay when the stock would open for trading a few short hours later.

Now, analysts upgrading (or downgrading, in the case of a company with bad after-hours news) a stock in this way do not make money when the stock goes up or down once trading is resumed, as in the case of a CEO who gets a favorable stock option grant. But they look a heck of a lot better than they would if their upgrade (or downgrade) was priced at the same price the public would be able to buy (or sell) the stock.

In response to the analyst’s report, Mr. Cummins—as quoted above from today’s account of the dust-up in the New York Times—has resorted to what looks and sounds a lot like the defense used (unsuccessfully) by former Enron COO Jeff Skilling in his recent trial on fraud and insider trading charges.

In essence, Skilling said that since everything at Enron had been vetted by the lawyers and the auditors, not to mention the Board of Directors, there had been no crime.

As we know, it didn’t work.

Now, I have no idea how far the Cyberonics controversy will go, nor am I going to sound off here on what Mr. Cummins may or may not have done, rightly or wrongly, when it comes to his wonderful option grant.

But I’d bet dollars to donuts that one reason Wall Street’s Finest have been slow to document the systemic abuse of the options gravy train is that Wall Street’s Finest frequently resort to precisely the same type of behavior highlighted by one of their own.

As Michael Corleone said, “We’re both part of the same hypocrisy, Senator.”

Jeff Matthews
I Am Not Making This Up

© 2006 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.


Gone to the blogs said...

I'm fairly certain that most, if not all brokerage analysts get the next day's opening price (for the purposes of performance measurement) after an overnight upgrade or downgrade, not the prior closing price as you suggest. In fact, analysts are frequently criticized both within and outside of their firms for these types of rating changes, because the analyst is effectively making an investment recommendation without knowing the price of the security (i.e. the price won't be determined until the next day's market open). I've seen countless instances where devasting news is announced after the close, and several analysts pile in with downgrades to Hold or Sell. The trouble, of course, is that the stock will gap down the following morning, and the analyst has therefore gone on record with a neutral or negative recommendation on a stock that may have just reached a new low.

Ask anybody who's been on the sell side and I'm sure they'll concur.

bubbles said...

While Mr. Cummins may not have broken any laws, just because it’s legal doesn’t make it right. Don’t these people have any morals and ethics?

In my world I consider this illegal insider trading and this guy and everyone who went along with this scheme are crooks.

As for the analysts that play the same game, I don’t think much of them either, but at least they are not screwing over shareholders for their own monetary gain.

bgthej said...

I worked on the sell-side as "one of Wall Street's finest" as you refer to them less than a year ago. The firm I worked for only gave you credit for the day's price at the close if there was news that impacted the stock price. So if a major deal was signed and the stock was up 40%, the upgrade (for performance purposes) counted after the stock closed up 40% that day. While I am not one to defend the practices of Wall Street analysts, I have to say I think your analysis here is factually inaccurate based upon the system that was in place at the firm I worked for. Maybe other firms are different, as I only worked for one firm. However, if I had to guess why the analyst brought this up now, I'd say it is more likely because the issue is in the spotlight and was largely being dismissed as commonplace prior to a month ago.

Jeff Matthews said...

Au Contraire.

I have in my hand (well, on my computer) a research piece from a brokerage firm dated 2/3/05 in which the analyst is upgrading his rating on Cyberonics at a stated price of $27.48.

The shares never traded below $35 that day.

It's a wonderful life!

Regret said...

I was formerly employeed by a major sell side firm and found the practice was the same as described by "gone to the blogs." Analyst picks were credited (when measuring their track record) at the close of business the following day.

Regret said...

Jeff - The price on the published research report is not necessarily the price at which the firm "credits" the analyst when they review his/her performance track record. The report is probably published with the most recent close of business price filled in by the computer, but this publishing convention isn't the same as the analyst claiming clairvoyance.

Obviously, some firms could attempt what you are suggesting, but the large wirehouse for which I worked did not do it this way. Even slightly sophisticated consumers of Wall Street research would not be fooled by the purported practice.

CheddahYetti said...


You might want to check the report from the same analyst, dated May 23, 2005. Go look at page 4.

You'll see he was credited with the upgrade to outperform (and $37) at the price of $40.

The stuff you talked about used to happen all the time, but the rules were changed after the analyst scandals of the late 90's caused the legal troubles of the early 2000's. The sell side pulls plenty of weasel-moves, but this one they haven't been allowed to for about four years.

Gone to the blogs said...

Au contraire, indeed...let's use our heads. The research editorial staff at a sell side firm processes the analyst's note at night (or very early in the morning), and typically the pricing data on the note is automatically fed from Factset or similar. Now unless that editorial staff (or their instance of Factset) has the use of a time machine, the note prepared for release in the morning will have the prior night's close. So naturally, if the stock gaps up on the open, the pricing data in the note will appear stale. That's just the way it is, and there's no getting around it unless the note is published without pricing data. QED.

Buddy Larsen said...

Nice appearance on Kudlow, just now, Mr. Matthews.

Can you tell me why I'm holding 33 different stocks right now and am down two years worth of living expenses in the last 3 weeks, and why didn't I sell, and what the heck's the matter with my brain?

Jeff Matthews said...

"CheddahYetti" is correct: the Reg SRO-required disclosures in the Cyberonics report in question (and subsequent reports by the same analyst) show he received the next-day price for his upgrade.

Indeed, the cosmetic magic by which analysts used to get internal credit for out-dated prices has indeed gone the way of the pre-earnings tip-off from the CFO to the favored analyst, and other pre-REG FD abuses--a good thing all around.

But the use of out-of-date prices on the front cover of the research reports--Factset or no Factset--is disingenuous as best.