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What Chinese Wall?

The SEC hopes curbing selective disclosures makes analysts more honest.
Stephen Barr, CFO Magazine
March 1, 2000

Do the research  and underwriting arms of securities firms collude to generate corporate finance business? Do analysts pull their punches to foster and preserve investment banking deals? After all, 70 percent of analyst reports carry a buy rating, but only 1 percent a sell. Or consider that analysts at firms with investment banking ties have 6 percent higher earnings forecasts and nearly 25 percent more buy recommendations than analysts at firms without such ties.

Concern about such collusion has reached the point where institutional investors now feel they need to beef up their own research capabilities. "All of us feel differently today about most analyst recommendations," says Art Zimmer, a portfolio manager at Denver's OppenheimerFunds and a former sell- sider. One finance executive who requested anonymity says he gets many more calls directly from the buy-side, because today "they're having difficulty determining whether a recommendation is the result of a deal or of bona fide research."

The complaints are often directed at such all-star analysts as Salomon Smith Barney's Jack Grubman, a telecommunications specialist with an annual pay package reportedly worth as much as $25 million, much of it based on the amount of underwriting business his research helps generate from companies he covers. But the sniping is also aimed at executives who seek kid-glove treatment by making selective disclosures to favored analysts and who blackball the bearish analysts.

"The day you put a sell on a stock is the day you become a pariah," says Stephen Jacobs, an analyst at U.S. Bancorp Piper Jaffray, who would not name the company that recently retaliated against him. "The CFO called me and said what I was writing was unfair and inaccurate. The next time there was a press release, it took a few weeks of constant effort to get a call back." Last year, Sunrise Technologies International retaliated with a defamation lawsuit against two firms that put out negative reports.

"The CFOs themselves are part of the problem," says A. Gary Shilling, an economic consultant who was once fired as chief economist at Merrill Lynch for his downbeat forecasts. "Freezing analysts out of the game is standard practice." Shilling cites more than a dozen recent instances in which companies froze out analysts who issued negative reports.

As for CFOs, many may have reason to believe that Wall Street is reneging on a deal by turning bearish on their stocks. "I've seen banking-side guys say, 'We'll assign one of our top analysts to follow you and start to put out reports,' when we didn't have someone doing that before," recalls one executive who asked not to be identified. "That's pretty blatant. They were trying to get our business. I'd like to see more people follow us, but under those conditions it's crazy. The implication was that I would get positive research, and then I'd be party to a collusion to press our stock up."

Four years ago, says Washington Post Co. CFO John Morse, one top analyst told him point-blank that he was going to stop following the media company because his firm saw no opportunities for investment banking business.

Another executive suggests that the collusion is often subtler. Soon after a brokerage house picked up coverage on the company, the broker's bankers approached the treasurer with a new financing vehicle. The overture was spurned. "Most bankers are smart and mannerly, and they don't come in and hit you over the head," the executive observes. "I'm waiting to see if the coverage declines."

The Securities and Exchange Commission is also waiting. In a speech last October, SEC chairman Arthur Levitt cited such collusion as part of the "web of dysfunctional relationships" that undermines the quality of U.S. financial markets. "In many respects," Levitt intoned, "analysts' employers expect them to act more like promoters and marketers [for the corporate finance division] than unbiased and dispassionate analysts."

But Levitt had no concrete solutions such as those the SEC issued in December to combat selective disclosure. He did, however, call on the stock exchanges to develop more-effective disclaimers than the ones that now appear in small type on analyst research reports. He also asked that the Wall Street firms consider whether their analyst pay packages "ensure unbiased and quality information."

Neither the exchanges nor brokerage houses have taken up Levitt's challenge. "We haven't seen anything that warrants any concern," says James Spellman, a spokesman for the Securities Industry Association.

But Harvey Goldschmid, former SEC general counsel and now special senior adviser to the chairman, contends that the new selective disclosure regulations, which he wrote, will encourage greater independence and objectivity by analysts. "Companies would no longer be able to use material information as a means of buying less rigorous analysis or tempering critical evaluation," he says.

He concedes that the rules would not stop brokerage houses from using analyst coverage to market corporate finance transactions, nor would it prevent leaks of inside information between the research and banking ends of the business. But bringing more openness to the disclosure system, he says hopefully, might prove contagious.

Not everyone is as optimistic. "The rules are in place that there should be a Chinese Wall; it's a matter of the SEC enforcing them," says Sam Jones, a portfolio manager at Trillium Asset Management in Boston. "But so much money is at work here that it ain't going to happen."




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