BlueLake News:

BlueLake Partners is pleased to announce that William Luke and Peter Miller have both joined the firm.

William Luke
Bill brings to BlueLake over 25 years of senior financial management experience. He has served as a CFO for over 19 years, including 14 years with Autotote Corporation (now Scientific Games - Nasdaq: SGMS) and Nashua Corporation (NYSE: NSH). During his career, Mr. Luke has successfully led five restructuring efforts as a senior financial officer, and raised capital in both the equity and debt capital markets. He received a BS in Management summa cum laude from Boston College and an MBA from the Amos Tuck School at Dartmouth. Bill's title will be Managing Director.

Peter Miller
Peter brings to BlueLake Partners, LLC over 30 years of senior operational and strategic management expertise. Mr. Miller was a co-founder and COO of Abt Associates, a $180 million software and services firm, and COO of SNAP Software which was sold to Dunn & Bradstreet. Mr. Miller has also served as the Chairman of the International MIT Enterprise Forum and is active with the Launchpad angel group. He received an SB from the Massachusetts Institute of Technology followed by the MIT Sloan School masters program. Peter's title will be Managing Director, Strategic Services.

With these two valuable additions, BlueLake continues to differentiate itself from other investment banks through the combination of senior operational experience and transactional expertise.

Sincerely,

BlueLake Partners, LLC

The Wall Street Settlement has far reaching implications beyond the $1.4 billion fines:

• The firms will physically separate their research and investment banking departments to physically build the infamous “Chinese Wall,” including the regulation of communications between research and investment banking units;
  
• The firms’ senior management will determine the research department’s budget without input from investment banking and without regard to specific revenues derived from investment banking;
  
• Research analysts’ compensation may not be based, directly or indirectly, on investment banking revenues or input from investment banking personnel;
  
• For the next five years, brokerage firms will be required to supplement their own analysts’ reports by hiring at least three independent research firms to provide independent research for individual investors;
  
• Disclosure of historical ratings of research analysts, enabling investors to evaluate and compare the performance of analysts; and
  
• Voluntary agreement restricting allocations of securities in hot IPOs to clients or potential clients.
  

The immediate impact of Sarbanes-Oxley is to make being a publicly owned company much more expensive and to increase the demands on executive management and the board. We predict an industry will be created around providing compliance tools for the Sarbanes Oxley Act. Companies like eRoom/Documentum, PeopleSoft and Oracle are currently positioning their products as compliance tools for Sarbanes-Oxley.

The lawyers and accountants have recognized a handsome new revenue source and are actively soliciting business. Law firms are busy publishing papers and advising clients as to how to comply with the Act. The law firms are rendering a valuable service, as the law is vague and not yet finalized on various points. The accounting firms are working with companies to input and strengthen the internal controls and sign-offs deemed to be necessary to comply with the Act.

CEO and CFO Sign-off
Several CEO’s have pointed out that the sign-off on the financial statements is nothing new. It has always been required for 10-Ks and 10-Qs. What is new is the introduction of felony charges for fraudulent, false or misleading statements.

One of the somewhat comical effects of the sign-off is that some large corporations are requiring CFO’s of their small divisions and subsidiaries to formally sign-off on their division’s/subsidiary’s financial statements and procedures. These CFO’s cynically remarked that it seemed “the CEO didn’t want to go to jail alone.” Yes, it certainly does flow downhill.

Internal Audit
When we speak with corporate CEO’s they seem immediately concerned with the provisions of the Act with respect to strengthening internal controls. We had overlooked the importance of the CEO and CFO signing off on the quality of internal controls and procedures. The bar for internal controls is much higher now. The framework recommended is called the COSO Internal Control framework (Committee of Sponsoring Organizations of the Treadway Commission in 1992). The COSO framework provides a standard and criteria against which companies can design and test their own control systems. In the COSO framework, a matrix is developed between business units for monitoring information and communications, control activities, risk assessment and control environment. These factors are viewed in conjunction with operations, financial reporting and compliance.

The cost of implementing these procedures will have profound impact on the financial markets. In order to go public, a company must have these processes and controls in place before a public offering; these are not a “use of proceeds.” One Chairman of an Audit Committee of a small, public, technology company estimated that the annual cost of the internal audit will be 1.5X that of the external audit, and the cost of putting the controls in place will be $3.5 million (we are hoping this is high). The earnings impact of compliance is substantial for smaller companies and requires a significant revenue base, upwards of $100 million, to afford public ownership. The installation of these same procedures and controls will also impact mergers and acquisitions of private companies, and potentially make them much more costly with respect to integration. Further, we have been told by many sources that the costs and expenses of complying with the Sarbanes-Oxley Act has had a dampening effect on the current IPO market, although it is certainly not the only issue in today's IPO market.

Audit Committee
The Audit Committee is now comprised solely of outside directors, responsible for hiring the Auditors and is the group to which the Auditors report directly. While these may seem to be small changes, they are not. The thought is that outside directors are concerned with their integrity and have more to lose than an insider, especially since these directors are not responsible for the operating results. Outside directors will be more likely to go the extra mile in disclosure to ensure the results are clear and unquestionable. We believe that in 99% of the companies, the disclosures will be the same regardless of the auditor reporting chain. However, the flavor and method of those disclosures may change. We also believe that the potential conflict of interest between the CFO and auditor will be eased. To be sure, the audit committee will require a serious time commitment for whoever is involved.

Board Member Compensation
In a dramatic change, board members will receive compensation solely for their work as a board member and they (and their family members) will be unable to generate additional "consulting" or other fees from a company where they sit on the Board of Directors. Traditionally, board members are hired as respected advisors, where the board members’ services and contacts are also valued in their own right. The ability to "broker" relationships may be limited. Some board members may see it to their economic advantage to resign from board seats.

Further, according to Richard Grasso, President of the NYSE, the work of a board member is estimated to increase from approximately 150 hours per year to an estimated 250 hours per year (this is the equivalent of 6.3 weeks of 9-5 work, for those without an HP 12C handy). Board members will want to be, and should be, compensated for the additional responsibilities and workload.

Research Analyst Independence
Sarbanes-Oxley calls for independence of the research analyst from the investment banking (corporate finance) function. In investment banking, deals are the bank’s profit center. Most investment bankers will tell you that research is a cost center and sales and trading are breakeven activities at best. Separating research from investment banking will not change the economics of investment banking, but may force Corporate Finance investment bankers to become more than simply deal processors.

Sarbanes-Oxley does not address an issue rarely discussed - the Blacklisting of research analysts. Blacklisting is the process of “freezing out” a research analyst by a management team due to negative or contrary remarks made with respect to the Company in question. This especially occurs when the analyst’s remarks have had a negative impact on stock price. We have personally seen research analysts black-listed from anywhere between several quarters to several years. Given recent events, (WorldCom), perhaps the more distance between a research analyst and management the better.

Wall Street Settlement

All of this leads us to The Wall Street Settlement, which addresses the distribution of stock in IPOs, research analyst independence and the provision of independent research to brokerage firms’ clients.

The Dynamic Duo
In the settlement, Jack Grubman and Henry Blodget were singled out as the ‘bad’ poster boys by Eliot Spitzer. Both were fined significant sums and barred from the NYSE and NASD for life. While it is hard to feel sorry for someone who made so much money, it is in a sense unfair, as the practices were and still are widespread. While there were clearly some excesses, Jack and Henry have been singled out due to the success they enjoyed rather than their "behavior," in relation to other research analysts.

The Retail Investor
When we first heard about the investigation into Wall Street practices, we were amused, and believed it was much ado about nothing. “Everyone Knew” that a research rating of Strong Buy meant ‘probably a good company’ and a Hold meant ‘dead money.’ In fact, we have only seen a Sell recommendation once or twice in the last 20 years, and that was when there was fraud or when management had blatantly lied to the analyst. The Sell rating had much less to do with the value of the stock than the ethical behavior of management. Unfortunately, the basis of the assumption was incorrect; only the institutional investors knew, not the retail investors. Retail investors were severely and negatively affected by this Wall Street game.

Separation of Church and State — Part Deux
The Settlement also attempts to address the "Chinese Wall" between research and the corporate finance departments within an investment bank. Topics addressed include creating physical separation, regulating interaction (verbal and other) and compensation for research analysts. All would agree that by not actively regulating the interaction between these two departments, problems can and have been created. Perhaps in this post-bubble era the pendulum has swung a little too far in the other direction.

Recently a research analyst at Bear Stearns was sanctioned for appearing in a roadshow for the iPayment IPO. In a webcast supporting the offering, the analyst vouched for the potential investment and endorsed the IPO. While we understand why the analyst is being sanctioned, we wonder if the regulators aren’t going a bit far. Presumably Bear Stearns would not bring the IPO to market if their analyst did not believe in the Company and endorse the IPO. Further, is speaking with investors, apart from the roadshow, really any different from endorsing the investment in a roadshow?

Further, Lehman Brothers was planning a golf outing in Scotland with research analysts, corporate finance bankers and corporate clients. The analysts were withdrawn from the outing, as Lehman Brothers believed that the SEC would view this form of fraternization negatively.

Currently, certain investment banks not only prohibit email communication between research and banking, but also prohibit corporate finance professionals and investment research analysts from socializing outside the office. While we had heard the investment banks had cut back on the office Christmas parties recently, we think this might be a tad zealous.

Independent Research
The most intriguing part of the Wall Street Settlement is the requirement by the ten firms in the settlement to each hire three independent research firms to provide unbiased coverage to supplement their own analysts for five years at a total cost of $432.5 million. Additionally, each bank must hire an external research consultant to manage the outsourced research. To date, none of the ten firms in the Settlement have announced the hiring of an outside research consultant, who is to oversee these programs. The firms have up to 30 days after the final judgment to hire the consultant, and 270 days after the final judgment to make the independent research publicly available.

Walking around Boston, we have been told that several opportunistic securities sales professionals have recently set up research boutiques to take advantage of these new requirements. Other more established firms, such as 12-year old Renaissance Partners, which focuses on unbiased reporting in IPOs, should be well positioned for this opportunity. Given that many transgressions occurred in the technology sector, technology market analysts such as Judith Hurwitz of Judith Hurwitz & Associates, or Forrester Research, could seize the opportunity to form divisions to provide investment research to the larger Wall Street firms.

As a result, we believe the Wall Street that exists in five years will be markedly different from today’s Wall Street. In addition to the disaggregation of research and banking, Wall Street is dealing with the impact of the ECN’s on trading economics, major industry consolidation and a three year old bear market. Currently 30 % of Nasdaq trades are done through ECN’s. In fact, we are told that 60 % of Fidelity’s trades are accounted for by ECN’s. Could we see deal houses, separate from research houses, separate from trading?

Conclusion

It is fascinating, but not accidental, that major reform is occurring in both Corporate America and Wall Street concurrently. We view much of the change as positive. It is easier to predict scenarios and ask more questions rather than reach a final conclusion. While the fallout from Sarbanes-Oxley is relatively certain, the fallout from the Settlement is much more nebulous, and will play itself out over the next few years.

• The value of the research analyst as a rainmaker is much diminished. With the separation of research from corporate finance, investment bankers must be much more knowledgeable about the industries they serve, rather than relying on the research analysts. Is the investment banking world moving to the BlueLake model?
  
• The cost of being a publicly owned company has dramatically increased. Proportionally, the institution of the additional controls will be much more expensive for the small and medium-sized publicly owned company. It may become prohibitively expensive for smaller technology companies to go public.
  
• Board compensation will increase to account for the increased workload. The average workload has increased to six weeks, for which directors should be compensated.
  
• More data and time is required to determine if the now current ‘theoretical’ separation of research from investment banking benefits the customer. We have seen the negative side of a close banking and research relationship. Net-Net, is the inverse better for the investor?
  
• The traditional investment banking business model is being tested, particularly with respect to the research-sales/trading-corporate finance relationships. For example: Is it necessary for research and corporate finance to work closely together in order to generate business and have a profitable investment banking enterprise, as has been assumed in the past?
  

— Margaret Johns, Ron Rossetti

If you have any comments or observations, we are very intereseted in hearing from you at Newsletter@BlueLakePartners.com.