Dotcom Déjà Vu as Citi Fires Star Internet Analyst

It’s been a number of years now since the first time Internet analysts ran into a firestorm of controversy. That was in the aftermath of the dotcom bubble, when investigations by then-New York State Attorney General Eliot Spitzer uncovered that star analysts had been custom-tailoring their views of particular stocks to the needs of their banks’ investment banking divisions, or otherwise failing to disclose their real opinions of the companies they covered. That kind of misleading of investors got analysts Jack Grubman (of Salomon Smith Barney) and Henry Blodget (of Merrill Lynch) permanently banned from the securities industry.

These days, both Grubman and Blodget are doing quite nicely in their second careers – and another analyst has run afoul of regulators and his employer. This time, it’s Mark Mahaney, the Citigroup analyst who got the axe on Friday after Massachusetts regulators fined the bank $2 million for failing to supervise Mahaney and one of the junior analysts on his team (who also has lost his job). The regulatory verdict doesn’t mention Mahaney by name, but his identity can be easily deduced from the description of him as a top-rated Internet analyst.

But this isn’t another Grubman/Blodget snafu. The Citigroup analyst isn’t in trouble for seeking to curry favor with a few big clients, whether underwriting clients or hedge funds, while keeping less important clients in the dark. Rather, Mahaney and his minion got the sack for sharing their real views with the world as a whole, via outside reporters. The problem was, in the case of Mahaney, that he hadn’t confined his comments on Google’s YouTube to what he had already published in a report and that he didn’t route his comments through the proper channels, and in the case of the junior analyst, that he provided insight into Facebook that had been acquired from what regulators described as confidential IPO documents.

The regulators decided to crack down on Citi because its two employees violated internal bank rules about how and when they could conduct “media appearances” and what information could be publicly shared. But let’s be clear on one part of this: While ethically those employees certainly had an obligation to their employer to abide by those rules and any other confidentiality provisions, this is not an instance where an analyst has damaged the integrity of the research process or affected investors’ ability to trust their institution or the financial markets in general. On the contrary, Citigroup’s solution will probably have just that kind of impact.

When banks and investment banks adopted new standards after the Spitzer-led probe for how they would share their research reports with the world, it was in order to prevent abuses of investors. If an analyst rated a stock a “buy” simply in order to help his bank win a big fat underwriting fee, or shared his latest insights with a select group of his favorite traders first, that’s clearly a violation not only of rules but of basic principles of the kind that were behind the passage in 2000 of Reg FD (Regulation Fair Disclosure) by the Securities & Exchange Commission. The intent of that rule was to ensure that investors of all kinds had access to material information at the same time.

The rule was directed at companies and sought to ensure that whenever executives decided to talk openly about a particular problem – anxiety about the outcome of a patent suit, say, or the bankruptcy filing by a large client – they had to disclose that information publicly, not just confide in a handful of chosen insiders.

The same spirit – that there should be a level playing field for all investors – underpinned Spitzer’s probe. Analysts, he reasoned, shouldn’t be allowed to mislead the general public by claiming the outlook for a particular stock is bullish when privately they believe the contrary or may, indeed, be suggesting to some of their best clients that it’s time to walk away.

The Massachusetts regulators appear to have stumbled over Mahaney’s faux pas while investigating a related issue that certainly would have fallen into the same general category as the Grubman and Blodget affairs. In the aftermath of Facebook’s bungled IPO earlier this year, Secretary of the Commonwealth William Galvin announced he had subpoenaed e-mails and other communications involving Morgan Stanley to see what kind of discussions Internet analysts there had had with institutional investors about Facebook’s revenue outlook. So, at the start, the inquiry centered on the question of whether analysts were once again playing favorites.

But this doesn’t appear to be what happened in the case of Mahaney. Based on the contents of the consent order made public by the regulators, Mahaney and his junior analysts weren’t chatting with favored clients and sneaking them information to give them an edge in the market. Rather, they were talking to the press – a conduit to the general public and investors of all kinds – without having jumped through all the hoops. (Mahaney, by the way, had initiated hisCoverage of Facebook with a “neutral” rating and upgraded the stock to a “buy” last week.)

I’m not suggesting that what Mahaney and his colleague did was appropriate, merely that there is an order of magnitude of difference in the nature of the two offenses, one that I would have hoped both Citigroup and the regulators could recognize.

In fact, what is likely to happen going forward is that there will be less information, and that what information there is will be less widely available than was the case before this kerfuffle. Already, The Wall Street Journal’s report on Mahaney’s departure cites Citi as stating that it plans to stop publishing any research on about 30 companies that Mahaney once covered. Others will now be followed by another Citi analyst who has yet to achieve Mahaney’s credibility with investors.

And then there is the “chilling” effect resulting from recent events not only at Citigroup but at other Wall Street institutions. It has become significantly more difficult over the last decade to get these banks to provide reporters with both research and insightful commentary that goes beyond carefully scripted comments. Odds are high that this is simply going to get more difficult still given that open communication with the media on fairly straightforward questions – Mahaney’s responses to a French reporter were said by regulators to have been a series of “yes” answers to the reporter’s queries – has had such dramatic consequences.

Abiding by the letter of rules and regulations governing how and when disclosure takes place is great – and certainly it’s up to the Commonwealth of Massachusetts to decide when and how to bring enforcement actions and to Citigroup to determine who it wants to remain it the bank’s employ. But abiding by the spirit behind those rules and regulations can be even more important, as this chain of events seems to demonstrate.