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Experts' Independence: A Question of Trust

They provide daily recommendations to thousands of investors and offer colorful voices of authority that liven up business news -- and they are supposed to provide independent analyses of companies for investors.

But sell-side analysts, at least in the West, are coming under increasing fire for sweetening their commentary to keep and win clients for the securities side of their investment banking firms.

In America, for example, "buy" recommendations on Enron, now known as the largest bankruptcy in U.S. history, kept coming even as the company's share price plummeted and news broke that it had, to put it mildly, unorthodox accounting practices.

One bond analyst who spoke out against the company, Daniel Scotto, claims he was punished for doing so. Scotto accused his former employer, BNP Paribas, of firing him for downgrading Enron from "buy" to "neutral" and later telling clients to sell as the company's margins began to decline.

With all things Enron now in fashion in Russia -- both the Audit Chamber and the Federal Securities Commission are currently looking at the possible domestic ramifications of the scandal -- the question arises: Do analysts in Russia face similar pressures as their American colleagues like Scotto? The answer is yes, according to analysts and investors interviewed for this story -- and it is a problem with enough upside to rate it a "buy" if it were a stock.

One of Moscow's most colorful analysts, Eric Kraus, says he was fired by NIKoil, a leading brokerage, for making critical remarks about Sibneft -- a top oil company that was controversially carved out of the old Rosneft in the mid-1990s by exiled tycoon Boris Berezovsky and oil and aluminum magnate-turned-politician Roman Abramovich.

NIKoil denies this, but Kraus insists that his comments in a Moscow Times story last year, headlined "'Bandit' Sibneft Blasted for Sell Off," got him fired.

"Several weeks ago we termed Sibneft 'former bandits.' ... We think that a rectification is called for -- the term 'former' is now open to serious challenge," Kraus said in response to learning of the closed-door sale of a blocking stake in Sibneft by management to "core shareholders," known to be a euphemism for Abramovich.

The incident illustrates the risk inherent in any capitalist system, in which information rules and opinions -- right or wrong -- move markets. But whatever the truth of Kraus' firing, there is a general consensus that the practice of putting undue pressure on opinion-makers is more of a problem in the West than in the small and illiquid Russian market, whose total capitalization is dwarfed by many companies in the West.

The more blatant type of manipulation -- such as when an investment firm buys cheap securities to resell and has analysts rate them up -- was more common before the 1998 financial crash, said an analyst at a major Moscow-based investment bank who asked not to be named.

During the Russian stock boomlet years of 1996 and 1997, most domestic companies cared little about their image, while many investors were happy to buy into the next big thing, leaping without looking carefully. Since the crash, many second-tier stocks have either been consolidated by Russian holding companies or have been ignored, with the same result: illiquidity.

Investors, once burned, have also become more critical, and investment banks cannot afford to lose face.

Bernard Black, a corporate and securities law professor at Stanford University who has written about Russia, said that analysts here are more likely to rate companies a "sell" than their U.S. counterparts, who give the lowest rating to less than 1 percent of all companies.

"The environment here is much more caveat emptor," said oil and gas analyst Steven Dashevsky of Aton Capital. "Judging by what is going on in the States, the quality and independence of Russian analysts matches or exceeds that of their counterparts. ... Things missed in the States by analysts raise questions of conflict of interest as well as competency."

Another issue for investment houses is the available volume of corporate finance work, such as mergers and acquisitions, initial public offerings and restructurings, which is far lower than in the West. Although some say the relative scarcity may only whet investment bankers' appetites, others say trading activity still carries more weight in making an investment bank's reputation.

"In Russia, the volume of corporate finance work is minimal. Companies like Enron, which engage nearly all market participants in their equity and bond deals, spread fees all over the table," Dashevsky said.

For that reason, there has been substantially less pressure on analysts here than elsewhere, said Peter Boone, head of research at Brunswick UBS Warburg in Moscow.

In the West, pressures come from all sides -- investment bankers angling for corporate finance work, issuers who want a good rating and even institutional investors, who fear being blindsided by a downgrade -- said Patricia Walters, senior vice president of professional standards and advocacy at the Association for Investment Management and Research in a telephone interview from the United States.



The pressures on analysts and the impact they have on the Russian economy is far less significant than in the West, because the market is still not integrated into the real economy, said Ivan Lazarko, head of the National Association of Market Participants, or NAUFOR.

As the market matures, Boone said, major companies become more image conscious, and this could mean more pressure on analysts.

"The situation is becoming more like Wall Street, where analysts are no longer paid to protect the interests of clients but rather to keep potential issuers happy," said Kraus, whose firing did nothing to quell his outspoken nature. "Any criticism of a potential issuer may be very badly received by the investment banking department at the analysts' securities firms."

It is true that Sibneft vice president Alexander Korsik called NIKoil president Nikolai Tsvetkov to complain about Kraus' comments, according to Cormac Lynch, head of investment banking at NIKoil.

And NIKoil and core Sibneft shareholders, through Sibneft's new London-based holding company Millhouse, are believed to have been negotiating a business deal when Kraus was fired. In January, local media reported that NIKoil had agreed to buy Avtobank -- one of the few major retail banks to survive the 1998 crisis -- for $15 million from Millhouse. Neither NIKoil nor Millhouse nor Avtobank have officially confirmed the sale. NIKoil has announced it will invest $10 million in Avtobank to develop a joint sales system.

Lynch, however, said the deal played no part in Kraus's dismissal.

"There were a variety of reasons Eric was fired and this wasn't one of them," Lynch said. He would not discuss the reasons but said the company was building a new research team with a new style.

Sibneft refused to comment, saying it was "an internal matter for NIKoil."

Nonetheless, the day after the "bandit" article appeared on Oct. 24, the investment community began speculating that Kraus had been fired on the spot at Sibneft's behest. He stayed away from his office for a week. Two days after the article appeared, Sibneft e-mailed a statement prepared by NIKoil to investment firms in Moscow.

The statement began: "NIKoil today refutes comments made by the company's chief strategist Eric Kraus and published in The Moscow Times."

The statement continued, "'The comments made by Mr. Kraus were irresponsible and do not in any way represent NIKoil's view of Sibneft. This kind of unsubstantiated allegation risks inflicting grave damage on NIKoil's reputation as a source of independent and unbiased analysis,' said Cormac Lynch, head of investment banking at NIKoil."

The statement then went on to praise Sibneft for setting "a new benchmark for sound corporate governance in Russia when it published the country's first corporate governance charter in 1998."

The statement ended, perhaps not unexpectedly, with a reiteration of NIKoil's "buy" recommendation on Sibneft shares.

Kraus said he was given three months' notice as soon as the article was published.

"NIKoil's comments tax the credibility of anyone who has followed the story. They're being parsimonious with the truth. Their statement speaks for itself," Kraus said.

A darling of journalists for his flamboyant research notes, under titles such as "Against Human Stupidity ... the Gods Themselves Struggle in Vain," and, "Whipping a Dead Oil Company," Kraus also earned detractors who criticized him for his style and for his insufficient microeconomic analysis.

In his own defense, Kraus said he had been singled out for excellence more than once in the prestigious annual awards presented by Institutional Investor magazine. He said he was also the first Western analyst to correctly call a number of market moves, including putting out a "buy" recommendation on Yukos about two years ago when the stock was trading at 72 cents. It now sells for almost $7.

Kraus, who is currently focusing on editing an e-mail list called "Truth and Beauty [and Russian Equities]," would not comment on Sibneft's role, saying only that it is good when companies are concerned with their image.

"I regret the use of the term 'bandit,' which was inappropriate. But I stand by the substance of the article, which was that I was disappointed by the corporate governance aspect of the transaction," Kraus said.

Although many of Kraus' colleagues said using the term "bandit" was a potentially libelous act, he is not alone in his assessment of Sibneft.

Paul Klebnikov, an editor at Forbes magazine and author of the controversial book, "Godfather of the Kremlin: Boris Berezovsky and the Looting of Russia," said using the term in the case of Sibneft was not inappropriate.

"Sibneft is an example of bandit capitalism in the way it developed and the way it has been operated," Klebnikov said in a telephone interview from New York on Tuesday.

There is no clear way to insulate analysts and ensure their objectivity.

Vladimir Milovidov, deputy head of the Federal Securities Commission, said proving impropriety is impossible.

"Denying it is also impossible," he said. "Investment banks tend to be vertically integrated; the head has lots of power and determines things at all levels." He said the FSC demands reports on interdepartmental information sharing from market participants as a way of trying to prevent insider trading and ensure the independence of analysts.

"People would be disappointed, to say the least, if it turned out that a potential investment banking client had pressured the sell-side analysts. But it is an inherent contradiction that has existed for a long time and it is not clear what a practical solution may be. One does rely on individuals' ethics," said Michael Khlebnikov, managing director of Hypovereinsbank Capital Market's Financial Advisory Group in New York.

"It is extremely important for investment professionals and their firms to develop strict codes of ethics and conduct and publish them, so the public can judge," AIMR's Walters said.

Most leading investment houses have codes, said NAUFOR's Lazarko.

Others find the whole system so tarnished that the opinions of research analysts mean nothing.

"Companies complain to investment banks all the time, and always have. ... Almost all the investment banks in Moscow and elsewhere are interested in corporate finance work and so almost all analysis is suspect," said William Browder, a long-time investor in Russia and managing director of Hermitage Capital Management.

"If I had made my investments based on brokers' recommendation, I'd be out of business by now," Browder said.

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