UNITED STATES DISTRICT COURT
Plaintiff, Securities and Exchange Commission (the "Commission"), alleges the following against Lehman Brothers Inc. ("Lehman"):
1. From at least July 1999 through at least June 2001, Lehman held out its equity research as providing independent stock recommendations and independent analysis of stocks based on the investment merits of the stocks being evaluated. In fact, Lehman's research analysts were, at times, confronted with pressures and conflicts of interest stemming from Lehman's desire to obtain investment banking business from covered companies.
2. Lehman used research to obtain investment banking business from covered companies. Specifically, Lehman tied the financial compensation of analysts directly and indirectly to the analyst's success in generating investment banking revenue from covered companies. In addition, Lehman also used the promise of future research coverage to obtain valuable IPO underwriting business and marketed to companies the ability of Lehman analysts to move the market for a stock. Lehman analysts were subject to conflicts of interest that, at times, adversely impacted the independence of Lehman's research product.
3. In certain instances, the financial incentives and pressure on analysts to assist in obtaining investment banking deals and to maintain banking relationships adversely affected the integrity of the analysts' ratings, price targets, and research reports, and caused analysts to issue more positive reports or ratings, and to avoid downgrades or negative reports regarding companies that were investment banking clients.
4. As a result of the conduct alleged herein, Lehman violated several rules of conduct of the National Association of Securities Dealers, Inc. ("NASD") and the New York Stock Exchange, Inc. ("NYSE").
NATURE OF THE PROCEEDINGS AND THE RELIEF SOUGHT
5. The Commission brings this action pursuant to authority conferred upon it by Sections 21(d) and 21(f) of the Securities Exchange Act of 1934 ("Exchange Act"), 15 U.S.C. §§ 78u(e) and 78u(f), to enjoin Lehman from violating provisions of the NASD Conduct Rules and the Rules of the Board of the NYSE. In addition, the Commission seeks other relief, including, but not limited to, disgorgement and civil penalties, and certain ancillary and further relief as is necessary and appropriate.
JURISDICTION AND VENUE
6. This Court has jurisdiction over this action pursuant to Sections 21(d), (e) and (f), and 27 of the Exchange Act, 15 U.S.C. §§ 78u (d), (e) and (f) and 78aa.
7. Venue lies in this Court pursuant to Section 27 of the Exchange Act, 15 U.S.C. § 78aa. Certain of the transactions, acts, practices, and courses of business alleged herein occurred within the Southern District of New York, where Lehman's headquarters is located.
STATUTES AND RULES ALLEGED TO HAVE BEEN VIOLATED
8. Lehman has engaged in, and unless enjoined, will continue to engage, directly or indirectly, in transactions, acts, practices, and courses of business that constitute violations of Rules 2110, 2210 and 3010 of the NASD Rules of Conduct and NYSE Rules 342, 401, 472 and 476.
9. Lehman Brothers Inc. is a broker-dealer registered with the Commission pursuant to Section 15 of the Exchange Act, 15 U.S.C. § 78o. Lehman has been registered with the Commission since March 1965, and is a wholly owned subsidiary of Lehman Brothers Holdings Inc., a Delaware corporation. The firm is a member of all principal securities and commodity exchanges, including NYSE, as well as NASD. Lehman's principal offices are located at 745 Seventh Avenue, New York, New York. Lehman provides the full range of services offered by a multi-purpose investment bank, including equity and fixed income sales, trading and research, investment banking, private equity and private client sales.
A. The Investment Banking Function at Lehman
10. Lehman is a global investment bank providing financial advisory, capital markets and underwriting services, among other services, to its clients. From at least July 1999 through at least June 2001, Lehman's investment banking department ("Investment Banking"), among other activities, engaged in securities offerings, including initial public offerings ("IPOs"), secondary offerings and debt financings, and provided merger and acquisition and other advisory services for its clients.
11. From at least July 1999 through at least June 2001, Lehman competed vigorously with other investment banks to be selected as the lead manager for securities offerings, in part because of the financial rewards associated with that role. In addition, Lehman hoped to gain ongoing transactional and advisory work from existing and potential clients, including secondary offerings and financial advisory arrangements. In 2001, Lehman served as lead manager for sixty-six equity deals, and earned approximately $1.3 billion from underwriting services.
B. Lehman's Global Equity Research Department
12. During 1999 and 2000, Lehman's Equity Research Department ("Research") employed approximately 400 people and expanded to 600 employees in 2001, including approximately 100 senior research analysts and 200 junior research analysts. During 2001, Research covered approximately 80 industries and approximately 900 U.S. companies. Senior research analysts in the United States reported to the Director of U.S. Equity Research, who reported to the Managing Director of Global Equity Research.
13. Research analysts collect financial and other information about a company and its industry, analyze that information, and develop recommendations and ratings regarding a company's securities. In addition, research analysts also examine the financial condition of selected publicly traded companies that are believed to be of potential investment value. Lehman analysts also make evaluations of companies' expected earnings, revenue and cash flow, operating and financial strengths and weaknesses, and long term viability and dividend potential. Lehman analysts produced written research materials including research reports and First Call notes regarding companies and industry sectors.
14. Lehman's research was distributed to both institutional clients and retail investors. Lehman distributed its research product directly to its own client base, comprised of institutional investors and high net worth individual retail investors. In June 1999, Lehman entered into a "strategic alliance" with Fidelity Investments. Among other things, the "strategic alliance" provided Fidelity's retail customers with access to Lehman's research, along with other independent research. Lehman also sold its research product to other broker-dealers that in turn provided the research to their retail customers. Lehman also made its research available to the public through services such as Thomson Financial/First Call and Multex.com, Inc. Ratings of Lehman's analysts were freely and publicly available to retail clients through a number of media outlets.
15. At the top of its research reports that were devoted to specific stocks, Lehman assigned to the stock a "rank" according to a 5-point scale reflecting how the analyst believed the stock would perform relative to the market generally. During the period June 1999 through December 2000, Research used the following ratings: 1-Buy (expected to outperform the market by 15 or more percentage points), 2 - Outperform (expected to outperform the market by 5 -15 percentage points), 3 - Neutral (expected to perform in line with the market, plus or minus 5 percentage points), 4 - Underperform (expected to underperform the market by 5 -15 percentage points), 5 - Sell (expected to underperform the market by 15 or more percentage points). In January 2001, Lehman changed the names of these ratings to 1-Strong Buy, 2-Buy, 3-Market Perform, 4-Market Underperform and 5-Sell. The definitions remained the same. The definitions for the ratings were provided to Lehman clients on a monthly basis. Commencing in March 2001, the definitions appeared on all of Lehman's research reports.
16. Although Lehman purported to rank stocks according to a 5-point scale, in fact, during the relevant period Lehman analysts never assigned a 5-Sell rating to a domestic company and almost never assigned a 4-Underperform to a stock.
17. Lehman's research reports also assigned to the stock a price target designed to reflect the price at which the analyst believed the stock would trade within a time period that was identified in some reports and unidentified in others. Commencing in March 2001, the relevant time period for the price target appeared in all of Lehman's research reports.
II. LEHMAN'S RESEARCH ANALYSTS WERE SUBJECTED TO
18. Lehman held out its research analysts as providing independent recommendations and analysis of companies and stocks upon which investors could rely in reaching investment decisions. Lehman promoted its research for the "quality and timeliness of its investment recommendations."
19. In fact, Lehman's research analysts were, at times, subjected to conflicts of interest arising from the close relationship between Research and Investment Banking. Such conflicts of interest, at times, adversely impacted the independence of Lehman's public stock recommendations.
A. Lehman Used Research To Obtain Investment Banking Business
20. Analysts worked closely with members of Investment Banking and other departments to generate business for Lehman. Analysts often worked with Investment Banking to identify corporate finance opportunities and to win corporate finance business for Lehman, including identifying private companies appropriate for an IPO as well as identifying possible transactions, such as secondary offerings or debt financings, once a company had completed an IPO. To this end, analysts were expected to have yearly target and alignment meetings with their Investment Banking counterparts.
21. Lehman aligned its analysts with an Investment Banking team. Analysts' responsibilities included providing research to their Investment Banking counterparts so that the bankers could leverage the research product into a full service relationship with a company.
22. Recognizing the strategic importance of this alignment, on August 5, 1999, Lehman's Managing Director of Global Equity Research circulated a memorandum to Global Research Directors (the "August 5 Memorandum"), which detailed key areas of "strategic importance." The memorandum concluded that in order for Lehman to be more profitable, Investment Banking and Research should work together to increase Lehman's number of equity originations, stating:
23. The August 5 Memorandum also set forth a "new paradigm" for Lehman's investment banking relationships, stating:
24. The August 5 Memorandum emphasized the research analyst's role in identifying potential banking business for Lehman stating: "global research must drive the banking targeting efforts, consistent with the `new paradigm.'" The August 5 Memorandum stated further: "to ensure we have proper recognition of analysts' impact on banking, we have to closely track every dollar of IBD revenue (equity, M&A, and debt) by analyst."
25. On September 14, 1999, the Managing Director of Global Equity Research again emphasized the importance of the Investment Banking/Research partnership in a memo directed to "Coverage Analysts." "Coverage Analysts" were provided with an attachment dated September 13, 1999 entitled "1 + 1 = $" (the "September 13 Attachment") that advised them that the successful partnership of Research and Investment Banking was a key to Lehman's growth as a firm. The first page of the September 13 Attachment contained a chart reflecting that an "enhanced Banking/Research partnership" would strengthen brand perception, increase origination fee share and ultimately lead to a higher Lehman stock price.
26. The September 13 Attachment explained numerous ways in which Lehman Research and Investment Banking could be beneficial to each other and stated that "seamless Banking/Research coverage" was critical to all Investment Banking products. The attachment also contained a chart captioned "Secret to Success -- Lehman Wins Business When Banking And Research Are Aligned." The September 13 Attachment explained that the Research/Investment Banking partnership at Lehman would be institutionalized through executive committee support, targeting and alignment, full partnership accountability between bankers and research analysts, and reinforced through compensation.
27. The September 13 Attachment also instructed that bankers and research analysts would be required to complete performance reviews of their counterparts. Research analysts would be evaluated on, among other things, "the extent to which the analyst places origination as [a] priority" and "adds value in building banking business," and the analyst's "effectiveness in [the] pitching process."
28. Finally, the September 13 Attachment explained that Lehman would reinforce the partnership of Research and Banking through compensation. Analyst compensation would be "impacted by contribution to banking" and "reviewed with appropriate banking group heads." The primary criterion in evaluating analyst compensation would be Investment Banking Revenue.
29. As part of the relationship between Investment Banking and Research, analysts often communicated with their Investment Banking counterparts several times a week, or even daily. These communications included identifying banking opportunities for Lehman. For example, on July 7, 2000 one senior analyst wrote the following email to members of Investment Banking:
30. In another instance, on September 21, 2000 that same analyst wrote an email to a company to offer research coverage in exchange for naming Lehman as a co-manager on a deal stating:
31. Investment bankers at times suggested that analysts issue positive research coverage on a company to help the bankers win business. Investment bankers would sometimes recommend potential banking clients to Lehman's research analysts. Lehman's investment bankers understood that if Lehman's research department would cover a potential banking client, this could strengthen Lehman's chances to obtain banking business from that client. For example, on October 4, 2000 a banker sent the following email to an analyst:
32. Another banker wrote the following email to investment bankers and analysts on June 29, 2000:
33. Investment bankers also routinely reviewed drafts of analysts' research reports before publication for several purposes including to insure that the reports were consistent with generating investment banking revenue from the covered company.
B. Lehman Gave Its Analysts Financial Incentives To
34. Lehman tied the compensation of senior research analysts to the amount of Investment Banking revenue the analyst helped to generate. Lehman analysts typically received relatively small base salaries and considerably larger bonuses. Bonuses were determined by, among other factors, the amount of Investment Banking revenue generated by companies the analysts covered. The bonuses Lehman paid to analysts dwarfed their base salaries and gave the analysts a strong personal financial incentive to obtain Investment Banking business. This compensation structure, which in part linked analyst compensation to investment banking business, created conflicts of interest.
35. Six of Lehman's approximately 100 senior research analysts had employment contracts that linked their bonuses directly to Investment Banking revenue generated by companies they covered. Depending on the contract, the analyst's entire bonus or an additional Investment Banking Department ("IBD") bonus was paid based on the aggregate IBD net revenues and fees generated by companies covered by the analyst or by companies where the analyst significantly contributed to the Investment Banking business.
36. For example, one analyst's contract provided for an annual salary of $200,000, and a minimum bonus of $4.8 million. The minimum bonus could increase in $1 million increments, based on the Aggregate IBD Net Revenues and Fees for the performance year as follows:
Aggregate IBD Net Revenues and Fees were defined as revenues and fees booked or received by Lehman from companies covered by the analyst or from companies whose award of business to Lehman was attributable to the analyst's "significant contribution."
37. Another analyst's contract provided for the payment of a yearly salary of $200,000, a minimum bonus of $3.3 million and an additional bonus equal to 5% of Investment Banking revenues and fees generated by companies covered by the analyst or companies where the analyst substantially contributed to the award of Investment Banking business.
38. Analysts who did not have specific clauses in their contracts related to Investment Banking revenue were nevertheless compensated financially if companies they covered generated Investment Banking revenue.
39. The Director of U.S. Equity Research applauded analysts for generating Investment Banking business. In an email dated January 21, 2001 an analyst described that he had arranged a meeting between Lehman analysts and investment bankers and a large blue chip company. The analyst explained that his relationship with the company resulted in Investment Banking receiving ten potential projects for the company. The Director of U.S. Equity Research congratulated the analyst in an email dated January 22, 2001 stating "well done, we need senior bankers to see who (the analysts) have the real relationships with the big companies. This is how we justify big comp. packages."
40. Lehman also monitored the Investment Banking revenue that analysts generated. For example, Lehman maintained a document titled "Performance Review" that, among other information, kept track of the Investment Banking and trading revenue attributable to each senior analyst. Senior analysts were shown the Performance Review during their reviews.
41. For each analyst, Investment Banking also generated a spreadsheet known as a "Project Review" that identified Investment Banking projects with revenue booked for the year and projects expected to generate revenue in the next year. The Director of U.S. Equity Research used the Project Reviews in conducting both mid-year and year-end evaluations for senior analysts.
42. Senior analysts also frequently provided lists of the Investment Banking deals they had worked on during the year to the Director of U.S. Equity Research in connection with consideration of their year-end bonuses. For example, in December 1999 one senior analyst (who did not have an Investment Banking revenue clause in his contract) wrote in an email to the Director of U.S. Equity Research that his research accomplishments and banking revenue were relevant to his compensation. In describing his research accomplishments, the analyst noted that he had written frequently on a company and the company had raised $430 million in equity and high yield financing through Lehman. The analyst also noted that he had written frequently about another company and, as a result, Lehman was going to appear "out of order" on the cover of a convertible deal and had a "good shot" at leading an upcoming equity deal. With respect to banking revenue, the analyst wrote:
43. One senior analyst sent an email on February 9, 2000 to Lehman's Managing Director of Global Research and the Director of U.S. Equity Research requesting a promotion to vice president. In support of this request, the analyst wrote, among other things, that the analyst's estimated Investment Banking revenue for the year 2000 was greater than $5 million and added "1999 Banking Revenue $1.2M solely due to research relationship."
44. In addition, senior analysts were required to complete business plans each year. The business plan included an entire section devoted to banking and asked analysts to identify the transactions they are working on or foresee for the coming year. The business plans asked senior analysts to report:
45. Investment bankers participated in analyst evaluations by providing written comments on a form titled "Year End Performance Review for Analysts (to be completed by Bankers)" to the heads of Research. Bankers were asked to evaluate:
46. The bankers' comments were relayed to analysts during their reviews. For example, one senior analyst's review stated the analyst "cares a great deal about competing for business and winning." Another senior analyst's review stated "strong originator/rainmaker," "strong pitchman" and "very supportive of banking effort; coordinate with banking team on targeting major clients."
47. Analysts were also criticized at times if they failed to work closely with Investment Banking. For example, in one instance, a senior analyst was encouraged to have more frequent contact with her Investment Banking counterpart.
48. One analyst sent a memorandum dated December 22, 1999 to the Managing Director of Global Equity Research and the Director of U.S. Equity Research stating that he was "`surprised'" by the review he received from an investment banker (the "December 22 Memorandum"). As a result, the analyst met with the investment banker in order to receive feedback and "improve the relationship between research and investment banking."
49. The analyst described his meeting with the banker in the December 22 Memorandum stating:
50. The analyst also commented that the bankers told him "that the analysts need to be available at extremely short notice to assist in pitch meetings." The analyst defended himself, in part, by commenting that he spent an "inordinate" amount of time on other banking prospects.
51. Finally, the analyst listed several steps for the future to improve his relationship with Investment Banking and stated:
C. Lehman Used The Promise Of Future Research Coverage To Obtain Investment Banking Business
52. Lehman used the promise of future research coverage to obtain Investment Banking business. Implicit in Lehman's marketing efforts was the assurance that Lehman's research would be favorable and that Lehman's research would raise the price of the issuer's stock.
53. Lehman competed with other investment banks for selection as lead underwriter for securities offerings, including IPOs, secondary offerings and debt offerings. As part of this competition, Lehman met with companies to present its qualifications. Research analysts sometimes attended these meetings, often referred to as "pitch" meetings, with members of Investment Banking in an effort to win Investment Banking business for Lehman. Lehman research analysts typically advised companies how best to position and market the company's story to investors.
54. At such meetings, Lehman often presented companies with marketing materials known as pitchbooks that touted Lehman's underwriting qualifications. The pitchbooks typically featured the Lehman analyst who would be covering the company after a banking transaction and stated that the analyst would issue research on the company as soon as the "quiet period" (a period of time after an offering during which the underwriting firms cannot publish research) ended. The pitchbooks on occasion provided examples of how coverage by the analyst had been viewed favorably by the market and had a positive impact on a company's stock price.
55. For example, a pitchbook for the Zymogenetics potential IPO promised that the analyst would issue a comprehensive report on the company twenty-five days after pricing (at the end of the quiet period), would regularly educate investors on the company's story and would publish reports and notes on the company on a timely basis. The pitchbook also promised that Lehman would provide "pricing, trading and aftermarket support" by, among other things, providing on-going research coverage. Under the heading "Preliminary Terms and Marketing Conditions," the pitchbook stated that the analyst would provide "high quality research support critical to a strong aftermarket."
56. A pitchbook for a Dyax PIPE offering described Lehman's prior research support of the company following its IPO, noting that Lehman had issued "8 notes and one extremely comprehensive report on [company], as compared to 5 notes and 1 report by [co-manager], and 2 notes and 1 report by [co-manager]." The pitchbook also noted that "Lehman's Equity Analysts . . . have been strong supporters of the stock," adding that since the analysts published their research report the stock had increased twenty percent.
57. The pitchbooks often noted the analyst's role in marketing the offering. Some pitchbooks listed research as a term of the underwriting and stated that the "[analyst] will lead a powerful marketing campaign." The Zymogenetics pitchbook described the analyst as the "preeminent force" in the biotechnology sector and stated that the analyst has "outsold other analysts in previous equity offerings," and "outsold the other co-managers." Other pitchbooks described the analyst as the "axe" in the industry and provided numerous examples of how the analyst's positive coverage had positively impacted a company's stock price.
58. For example, a pitchbook for Yadayada dated November 10, 2000 contained a section entitled "[Analyst] Moves Markets" and contained graphs for two companies, Triton and Alamosa, covered by the analyst. The graph subtitled "[Analyst] Moves Triton" demonstrated a decrease in stock price following the analyst's downgrade of Triton and an increase in the stock price following an upgrade by the analyst. Similarly, the graph subtitled "[Analyst] Upgrades Alamosa" shows an increase in Alamosa's stock price following a voicemail blast by the analyst to clients reiterating the analyst's buy recommendation.
59. Similarly, a pitchbook for Texas Instruments dated June 2000 included a graph of Micron Technology's stock price demonstrating that the stock price increased after the analyst re-initiated coverage and rose again when the analyst raised earnings per share ("EPS") targets. The pitchbook also contained a graph of Intel's stock reflecting price increases after the analyst re-initiated coverage and again when the analyst raised the EPS target. Other pitchbooks contained similar statements about the manner in which the market received Lehman's research.
60. The decision whether Lehman would initiate research coverage of a company was often tied to the opportunity for Lehman to earn Investment Banking fees from the covered company. For example, in February 2000, Lehman bankers questioned a delay in Lehman initiating research on Curagen Corporation following Lehman's participation in a convertible bond offering by Curagen. The analyst had explained he needed more time and more meetings with the company before issuing a report. The bankers then questioned the delay in an email to the Director of U.S. Equity Research who responded that the analyst was doing a great job given his many responsibilities, and asked the bankers:
One of the bankers responded to the question, stating:
61. On other occasions, the Director of U.S. Equity Research received inquiries from Lehman employees on behalf of officers of public companies seeking to have Lehman initiate research coverage of their company. The Director of U.S. Equity Research responded by directing such inquiries to Investment Banking. For example, in February 2000, the Director of U.S. Equity Research advised a Lehman employee in an email:
62. Similarly, in October 1999 the Director of U.S. Equity Research advised another Lehman employee in an email:
63. In another email in March 2000, an analyst explained to his product manager his reason for initiating coverage on a stock listed only in Mexico that will be of "little interest to our US institutional salesforce." The analyst wrote:
III. CONFLICTS OF INTEREST, AT TIMES, RESULTED IN THE
64. The relationship between Investment Banking and Research as alleged herein at times created conflicts of interest for Lehman's research analysts. At times, the financial incentives and pressure on analysts to assist in obtaining investment banking deals and to maintain banking relationships adversely affected the integrity of the analysts' ratings, price targets, and research reports. As the following examples demonstrate, these conflicts of interest caused analysts, at times, to issue more positive research reports or ratings, and to avoid downgrades or negative reports regarding companies that were investment banking clients.
A. Razorfish, Inc.
65. Lehman co-managed the IPO for Razorfish, Inc. ("Razorfish") in April 1999. The Razorfish IPO was priced on April 26, 1999 at $16 per share and opened for trading on April 27, 1999 at $56 per share but ended the day at $35 per share. On May 3, 1999, with Razorfish trading at $37 per share, the Lehman analyst confided to an institutional investor in emails that he was not sure of the rating and price to assign to the company when he initiated coverage. The institutional investor replied:
The analyst responded:
66. The institutional investor and the analyst discussed the effect of the conflict of interest on the analyst's research in the following exchange:
67. On May 24, 1999, with Razorfish trading at $36, Lehman initiated coverage of Razorfish with a 2-Buy rating and a price target of $48.
B. RSL Communications, Inc.
68. Lehman had a substantial Investment Banking relationship with RSL Communications, Inc. ("RSL"). Lehman was a joint lead underwriter in a high yield note placement by RSL in December 1998, provided advisory services in October 1999, was the lead underwriter when RSL spun off Delta Three Communications, Inc. in an IPO in November 1999 and co-managed two debt offerings for RSL in February 2000. On at least three occasions during 1999-2000, the Lehman analyst covering RSL was "held off" from downgrading his analysis of RSL for "banking reasons." One of these instances occurred in February 2000.
69. On November 1, 1999, with RSL trading at $21 5/16, the Lehman analyst covering RSL had rated RSL a 1-Buy with a price target of $40. In February 2000, with RSL trading at $17, the analyst drafted a new report which lowered his revenue projections for RSL and lowered the price target to $35. The first sentence of the text of the draft report read "we are revising our Revenue and EBITDA estimates for RSL to reflect declining revenue from U.S. prepaid and wholesale and a more moderate ramp in European retail revenue." Based on his prior experience, the analyst knew that his attempt to express his more negative view of RSL would be resisted by Investment Banking within Lehman. On February 24, 2000, the analyst sent an email to his supervisor captioned "RSL Note - Bankers are going to resist" in which he enclosed his draft report and stated:
70. The Lehman investment banker for RSL prevailed on the analyst not to issue the report and instead to meet with RSL management and to reconsider his analysis. As a result, on March 2, 2000, the analyst issued a report that maintained the $40 price target. The first sentence of the text of the report touted that "RSL's European unit posted strong sequential revenue growth in Q4 . . .." The analyst issued additional reports on RSL on March 9 and March 10, 2000, in which he raised the price target to $50.
71. On March 16, 2000, the investment banker for RSL sent an email to the analyst's supervisor praising the analyst's "open-mindedness" and crediting the analyst with raising RSL's stock price stating:
The supervisor forwarded the email to the analyst and wrote "good job & congratulations."
72. In May 2000 the analyst issued another report reiterating the 1-Buy rating on the stock and retaining the $50 price target despite the fact that the stock price had declined to $15.50 per share and the company had missed its revenue estimates.
73. By August 14, 2000 RSL's stock price had declined to approximately $4. In an August 14, 2000 email, the analyst candidly complained to his supervisor about the influence Investment Banking had exerted over his research during the preceding year:
74. The analyst voiced particular concerns about RSL stating "for the record, I have attempted to downgrade RSLC THREE times over the last year, but have been held off for banking reasons each time." (Emphasis in original.)
75. Even after this complaint, the analyst did not downgrade RSL but rather simply was permitted to drop coverage in September 2000, devoting a few short sentences to the company in a sector report.
C. DDi Corporation
76. A pitchbook for the DDi Corporation ("DDi") IPO offering described Lehman's highly regarded research team, listed the analysts' combined years of experience and strong research qualifications and promised research coverage for DDi after the IPO.
77. The pitchbook contained an example of the mock research report that the two Lehman analysts who covered DDi's industry sector would write for DDi, including a graphic of the research report's cover page with a 1-Buy rating.
78. DDi opened for trading on April 10, 2000. On June 28, 2000, the analyst whose name appeared on the mock research report sent an email to the Director of U.S. Equity Research stating that Lehman was a "co" on the DDi IPO and that the analyst should have initiated coverage when the company went public in April but did not due to other demands on his time including the need to cover two banking deals where Lehman was the lead. The analyst complained that both DDi and Lehman bankers were pushing the analyst to initiate coverage with a 1-Buy rating. The analyst wrote:
79. Despite his misgivings, the analyst initiated coverage of DDi on June 30, 2000 with a 1-Buy rating and a price target of $36. DDi closed on June 30, 2000 at $28 1/2. On July 31, 2000 DDi closed at $22.
D. RealNetworks, Inc.
80. In June 1999, Lehman served as a co-managing underwriter for a secondary offering of common stock by RealNetworks, Inc. Lehman maintained a 1-Strong Buy rating on the stock from July 1999 through June 2001 despite the fact that the stock lost approximately 90% of its value falling from a high of $78.59 per share in February 2000 to a low of $7.06 in April 2001.
81. In the first few days of July 2000, RealNetworks' stock price dropped from $52 per share on July 3, 2000 to $38 per share on July 11, 2000. Lehman issued a research report on July 11, 2000 responding to what the report described as a weakness in the stock price caused by investor concern over RealNetworks' exposure to online advertising revenue. The report sought to calm investors' fears by stating that online advertising figures would have "minimal" impact on RealNetworks overall revenue. The report reiterated the 1-Buy rating assigned to the stock and maintained the $150 price target. The report further advised investors that the price weakness presented a buying opportunity and that Lehman remained "bullish" on the stock.
82. By July 18, 2000, the stock price had climbed to $56 per share. The analyst issued another research report that again advised investors to ignore concerns about RealNetworks' exposure to online advertising revenue stating "we believe recent articles about reductions in online spending is (sic) completely over-hyped - in terms of its overall impact on RealNetworks." The report also reiterated the 1-Buy rating assigned to the stock and maintained the $150 price target for the stock.
83. On July 19, 2000 the analyst issued a third report commenting on RealNetworks' second quarter earnings release. The report described the second quarter results as "stellar" and reiterated the 1-Buy rating assigned to the stock and maintained the $150 price target for the stock.
84. Despite the analyst's support for RealNetworks, on July 18, 2000, the analyst advised an institutional investor to short the stock stating "RNWK has to be a short big time." The next morning the institutional investor emailed the analyst "nice call on rnwk . . . I mean all the upside from crappy ad business . . . why aren't people jumping up and down and saying this sucked??? . . . nice call on your part anyhow."
85. The analyst replied: "we bank these guys so I always have to cut the benefit of the doubt."
86. RealNetworks' stock price continued to fall throughout July 2000, and its price continued to drop through the end of 2000. By December 2000, RealNetworks had fallen to approximately $12 per share having fallen from its February 2000 high of $78 per share.
87. In January 2001, that same analyst wrote to an institutional investor, "if it's in my group it's a short" despite the fact that the analyst maintained 1-Strong Buy ratings on all of his stocks.
E. Broadwing, Inc.
88. In January 2001, an analyst was about to initiate coverage of Broadwing, Inc. ("Broadwing"). On January 24, 2001 an investment banker sent an email to the analyst asking him if Broadwing's numbers were good. The analyst responded that the numbers were "very much in line." The banker asked the analyst to raise the price target. When the analyst questioned the rationale, the banker explained that the increase was necessary to help Lehman win Investment Banking business.
The next day the analyst issued a research report initiating coverage of Broadwing with a $42 price target.
IV. LEHMAN FAILED ADEQUATELY TO SUPERVISE RESEARCH ANALYSTS
89. Lehman failed to supervise sufficiently research analysts or establish adequate policies and procedures to ensure their proper conduct at all times. Lehman had insufficient written procedures to protect the independence of its research analysts and failed to enforce fully the written procedures it did have.
90. Research did not review the propriety of the ratings issued by analysts. For example, Lehman purportedly vetted most of the written research produced by analysts through the Investment Policy Committee ("IPC") comprised of six people including the Director of U.S. Equity Research. Written procedures required that an IPC meeting be held to review initiation of coverage or change of a rating. In fact, at times, reports were reviewed by a single IPC member, who received reports shortly before a meeting.
91. Lehman also had inadequate procedures to protect analysts from the pressures and conflicts of interest resulting from the interaction between research analysts and investment bankers. As alleged above, Lehman permitted pre-publication review of draft research reports by Investment Banking and by the companies covered in the reports. The Chairman of the IPC and other senior managers in Research also encouraged analysts to check with banking before changing ratings, downgrading or dropping coverage of a stock.
FIRST CLAIM FOR RELIEF
[Violation of NASD and NYSE Conduct Rules Due to Conflicts of Interest Resulting from Investment Banking Influence over Research Analysts]
92. Paragraphs 1-91 are realleged and incorporated by reference.
93. NASD Conduct Rule 2110 requires members to observe high standards of commercial honor and just and equitable principles of trade.
94. NYSE Rule 401 states that "[e]very member, allied member and member organization shall at all times adhere to the principles of good business practice in the conduct of his or its business affairs."
95. NYSE Rule 476(a)(6) prohibits member organizations, among other things, from engaging in practices that constitute conduct inconsistent with just and equitable principles of trade.
96. During the relevant period, Lehman engaged in the acts and practices described above that created and/or maintained inappropriate influence by investment banking over research analysts and therefore imposed conflicts of interest on its research analysts. Lehman failed to manage these conflicts in an adequate or appropriate manner.
97. By reason of the foregoing, Lehman violated NASD Conduct Rule 2110 and NYSE Rules 401 and 476(a)(6).
SECOND CLAIM FOR RELIEF
[Violation of NASD and NYSE Rules by Publishing Research
98. Paragraphs 1-91 and 93-95 are realleged and incorporated by reference herein.
99. NASD Conduct Rules 2210(d)(1) and 2210(d)(2) prohibits members from making exaggerated or unwarranted claims in public communications and requires members to have a reasonable basis for all recommendations made in advertisements and sales literature.
100. NYSE Rule 472 prohibits members from issuing communications that contain exaggerated or unwarranted claims or opinions that lack a reasonable basis.
101. As alleged above, during the relevant time period, Lehman issued research reports, including those for Razorfish, Inc., RSL Communications, Inc., DDi Corp., RealNetworks, Inc., and Broadwing, Inc., that were not based on principles of fair dealing and good faith and did not provide a sound basis for evaluating facts, contained exaggerated or unwarranted claims, and/or contained opinions for which there was no reasonable basis in violation of NASD Conduct Rules 2110, 2210(d)(1) and 2210(d)(2) , and NYSE Rules 401, 472 and 476(a)(6).
THIRD CLAIM FOR RELIEF
[Violation of NASD and NYSE Rules by Failing to Supervise]
102. Paragraphs 1-91 are realleged and incorporated by reference herein.
103. NASD Conduct Rule 3010(a) requires members, among other things, to "establish and maintain a system to supervise the activities of each registered representative and associated person that is reasonably designed to achieve compliance with applicable securities laws and regulations, and with" NASD's own Rules.
104. NYSE Rule 342 requires members, among other things, to maintain "appropriate supervisory control" over all business activities to ensure compliance with securities laws and regulations, including providing a "separate system of follow-up and review to determine that the delegated authority and responsibility is being properly exercised."
105. During the relevant time period, Lehman failed to establish and maintain adequate procedures to protect research analysts from conflicts of interest. Despite knowledge of research analysts' complex responsibilities and conflicts of interest, Lehman failed to implement a system to detect and insulate its research analysts from improper influence and pressure by Investment Banking personnel. To the contrary, Lehman's business practices motivated research analysts to issue research that would attract and retain Investment Banking business.
106. By reason of the foregoing, Lehman violated NASD Rule 3010 and NYSE Rule 342.
PRAYER FOR RELIEF
WHEREFORE, the Commission respectfully requests that this Court enter final judgment: