VideoTo hear Eliot Spitzer tell it, he was "shocked" by E-mails recovered earlier this year from Merrill Lynch & Co. in which analysts at the giant brokerage firm privately called stocks they recommended to the public "crap" and "junk." But Spitzer, attorney general for the state of New York, can't have been very surprised to discover plentiful evidence of conflicts of interest in Merrill's research operation. After all, what he found there, and is currently investigating at Salomon Smith Barney, may be the worst-kept secret on Wall Street. There may be a few investors left who don't know that analysts may issue overly optimistic recommendations about companies that do investment-banking business with their firms--but only a few.
Still, if almost everyone knew about it, nobody did anything until Spitzer came along. Merrill Lynch caved under the pressure last May, agreeing to pay $100 million in fines and make reforms, such as separating analyst compensation from investment-banking activity. Meanwhile, Spitzer's investigations have galvanized (if not shamed) the regulatory community into action. In recent months, new rules intended to erect a meaningful barrier between analysts and investment bankers have been announced by the National Association of Securities Dealers, the New York Stock Exchange, the Securities and Exchange Commission, and the Senate Committee on Commerce, Science, and Technology.
Trouble is, some of those rules may end up making it harder for companies to raise capital. At the same time, the new rules leave the problem relatively untouched--in fact, they practically hand the banks a get-out-of-jail-almost-free card and a chance to redeem their still-impaired credibility. And according to an NASD spokesperson, more rules could be forthcoming.
"I might argue that [the rules] hurt CFOs more than the banks," says David Lavallee, a partner in boutique investment-banking firm Revolution Partners and a former banker at Credit Suisse First Boston. "[CFOs] are going to be getting a lot less for their money. The rules may be good for investors, but they're bad for CFOs." Gone, for example, is the finance chief's ability to leverage his company's investment banking dollar for more favorable research coverage. Gone also is the presumption of analyst support during an initial public offering, as well as the heads-up from your investment banker if an analyst is planning to downgrade a stock.
For their part, finance executives can't be too happy about the prospect of more regulation. But they are concerned about restoring confidence in the capital markets, judging by the results of a new CFO magazine survey, and part of that involves cleaning up the analysts' act. In fact, nearly three out of four respondents say that investment banks should be required to make their research arms completely, and legally, separate from the rest of the business (see "Quid Pro Quos," below).
"An Ongoing Joke"
Today, the so-called Chinese wall that is supposed to prevent conflicts of interest between the two sides of an investment bank is hopelessly porous--no surprise there, as it is based almost entirely on the honor system. Most banks, like Merrill Lynch, have internal policies that demand that analysts be impartial, but then compensate those analysts based on specific investment banking deals in which they have been involved. What's more, a supervising analyst with a Section 16 certification, not the compliance department, is responsible for reviewing all analyst reports to make sure they comply with conflict-of-interest policies and NASD disclosure rules. The problem is that the supervisory analyst has the same incentives to overlook conflict as the analysts he or she supervises.
Why didn't the regulators act sooner to add more bricks to the wall? "The SEC was underfunded, understaffed, and they had bigger fish to fry," says Jeffrey Haas, professor of securities law at New York Law School, explaining why it took so long to bring the conflict situation to light. "[Conflict of interest] has been going on forever. It's been an ongoing joke for years."
The origins of the "joke" can be traced to May 1, 1975, when the NYSE deregulated fixed commissions on stock trades. "May Day '75 took the fat out of the commission structure," says A. Gary Shilling, an investment adviser and economist and a former chief economist at Merrill Lynch. "Analysts started looking for a new trough to feed at, and investment bankers provided it. They've been kept men and women ever since."
Bankers began looking to analysts to help them get a foot into companies, as well as to provide reports to institutional clients that could be counted on to buy large blocks of the underwriter's new issues. Analysts increasingly became the point men on IPOs, holding veto power over whether an investment bank took on an underwriting client. They worked closely with pre-IPO clients to get them ready to go public, and acted as cheerleaders after road shows with institutional investors to ensure that the company's message got across.
By the end of the '90s bull market, analysts almost never issued a "sell" recommendation; even last July, only 3 percent of all ratings were a sell, according to Thomson Financial/First Call. And they weren't shy about using their increasing clout to "convince" clients to do business with their bank.
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