The National Assn. of Securities Dealers has targeted one of Wall Street's most high-profile research analysts for enforcement proceedings after concluding he recommended a stock with too flimsy a rationale.
Star telecommunications analyst Jack Grubman of Salomon Smith Barney has a few weeks to defend himself to the self-regulating agency for securities brokers, which could initiate a civil process leading to a massive fine or a ban from the business.
The NASD's enforcement staff reached a "preliminary determination" last month that Grubman's reports touting telecommunications upstart Winstar Communications Inc. violated NASD regulations, according to the agency's public records.
The evidence against Grubman doesn't involve any special deals between Salomon and Winstar, such as the allocation of shares in hot initial public offerings to executives, according to someone familiar with the proceedings. If Grubman is found to have broken the rules simply by making unreasonable recommendations, the move could set a tough new standard for analysts everywhere.
The planned action highlights the extent to which the stock market meltdown has prompted authorities to reexamine what had been common during the boom years of the late 1990s.
The NASD has rarely sought to discipline analysts for unreasonable optimism, and it has taken on fewer big-name Wall Street professionals than the Securities and Exchange Commission, federal prosecutors or, more recently, New York's attorney general.
"Clearly, there is a lot more regulatory and judicial scrutiny today, and given the crisis we've just been through, it's appropriate," said David Hilder, who tracks the stocks of investment banks for Bear Stearns & Co.
During the boom, many analysts shifted from predictions based on such traditional guidelines as the ratios of share price to earnings and share price to book value, moving instead to looser measurements including tallies of Internet visits. Few have been punished for that.
"Through disciplinary actions, the NASD could provide a more specific working definition of having a reasonable basis for an analyst recommendation," Hilder said. "If that happened, it could certainly affect the way analysts do their work in potentially a very positive way."
The most serious enforcement actions to date have concerned conflicts of interest, such as the tying of lucrative investment banking business to positive analyst reports. New York Atty. Gen. Eliot Spitzer reached a $100-million settlement with Merrill Lynch in May after finding that analysts there were hyping stocks that they criticized internally. Spitzer also is investigating Grubman and other Salomon analysts, a person close to the inquiry said.
In the NASD case, Winstar provided a very small amount of investment banking income to Salomon, now owned by Citigroup Inc. Winstar's stock collapsed as Grubman was still defending it against a growing chorus of critics, and the company filed for bankruptcy reorganization in April 2001.
Unless evidence emerges that Grubman himself didn't believe what he was writing, it could be hard for the NASD to hold him accountable, some experts said.
"If I just recommend this thing because my bosses want some investment banking business, that's wrong," said Junius Peake, a former NASD vice chairman now teaching at the University of Northern Colorado. "But if he believed in it, that's a very subjective thing, unless there's a smoking gun there."
Salomon, which has paid Grubman as much as $20 million a year, said his backing of Winstar fit into an overall sector strategy.
"Mr. Grubman's calls on Winstar were part of a consistent and reasonable investment thesis developed and held in good faith for many years," a firm spokeswoman said.
The NASD declined to comment.
Numerous investors have begun arbitration proceedings against Grubman or filed lawsuits over his recommending other stocks, including WorldCom Inc. and Global Crossing Ltd.