Capital Markets

Near the Corner of Church and State (Update)

Efforts to insulate sell-side analysts from investment bankers will hurt some capital-raisers, but help others.
Jennifer CaplanJuly 22, 2002


In a speech given in 1999, Arthur Levitt, then chairman of the Securities and Exchange Commission, spoke eloquently about a “web of dysfunctional relationships” which was inexorably undermining confidence in U.S. financial markets. During the speech, Levitt roundly criticized, among other things, the close ties between Wall Street investment bankers and their research analyst colleagues.

Since everybody on Wall Street — and Main Street — was making a killing in the market at the time, nobody much listened to Levitt. In fact, the issue barely made it onto the radar screens of market regulators

Three years later, the incestuous relationship between investment bankers and sell-side analysts has become fodder for supermarket tabloids, let alone market regulators.

In April, for example, New York State Attorney General Eliot Spitzer made national headlines when he charged that rain-makers at Merrill Lynch, Wall Street’s largest firm, had urged the bank’s research analysts to issue buy recommendations on potential banking clients.

Then, late last month, the National Association of Securities Dealers fined U.S. Bancorp Piper Jaffray $250,000 and managing director Scott Beardsley $50,000. The reason? The NASD claimed bankers at the firm threatened to drop coverage of Antigenics Inc. unless the biotech company hired U.S. Bancorp to underwrite a stock offering.

NASD’s dramatic actions came just weeks after the SEC had greenlighted Nasdaq’s new rules governing analyst independence. Those rules, which are now in force at the New York Stock Exchange as well, strictly prohibit sell-side analysts from promising favorable corporate coverage in exchange for investment banking business. The rules also bar investment bankers from overseeing sell-side analysts.

While the new prohibitions may help restore a sense of church-and-state in investment banking circles, the rules may not be greeted warmly by some finance chiefs. Wall Street, observers point out, is a two-way street, and corporate capital raisers often have benefited from investment bankers’ sway over analysts.

In fact, some observers say it’s not uncommon for a company’s CEO or CFO to demand positive stock coverage in exchange for the company’s banking business. The larger the prospective client, the greater the clout.

Says Sam Miller, a partner and chair of the market-regulation group at law firm, Orrick, Herrington & Sutcliffe: “There is no question that there has been a history of issuers strong-arming analysts and their firms.”

Off the Guest List

Take the case of BellSouth. According to information gathered by economic consultants A. Gary Shilling & Co. and published in CFO magazine, management at the Baby Bell apparently excluded Salomon Brothers from a $300 million bond issue in 1994 after analyst Jack Grubman criticized the company’s inefficiency. (Last month, Grubman appeared before the House Financial Services Committee to explain why he touted WorldCom two days before the telecom giant announced a $3.8 billion restatement.).

Another example: insurance company Conseco reportedly fired Merrill Lynch as the lead underwriter for the company’s $325 million debt offering after Merrill analyst Edward Spehar downgraded his stock rating for Conseco.

Remarkably, finance-watchers say some CFOs have actually barred bearish analysts from conference calls, or kept them out of lavish corporate gatherings. Executives at America Online, for instance, are said to have once excluded Jeff Goverman of S.G. Cowen from a party after Goverman published a negative report about AOL.

Some companies have gone so far as filing lawsuits against investment firms that issued negative reports. In 1999, for example, Sunrise Technologies International slapped defamation suits on two Wall Street firms because of less-than-enthusiastic coverage.

Nevertheless, a number of finance chiefs defend much of the behavior. They argue that it’s only natural for CFOs to develop strong ties to banks that have faith in their companies’ business models.

It’s also understandable, they assert, if corporate executives gravitate to banks that will help them raise capital on the most favorable terms. “Why would a CFO hire an investment banker whose analysts find something wrong with the company, when others don’t,” asks Raghanvan Rajaji, CFO of software vendor Manugistics.

Albert Meyer, a short seller at David Tice & Associates, agrees. “If you’re a CFO trying to raise capital, and you need the highest P/E you can get,” he states, “you’re going to go to the investment bank whose analysts will write a compelling story about your business.”

In part, this may explain why, at the peak of the Nineties stock market boom, a mere 1 per cent of stock recommendations from Wall Street analysts were a “sell.”

Another Brick in the Wall

Once the stock markets started to plunge last year, competition among investment banks turned noticeably fierce — particularly for lucrative equity underwritings. Given the white-hot competition, it’s possible that some Wall Street firms began applying even more pressure to analysts to help scare up business.

Certainly, it appears that some bankers at Merrill Lynch were applying the screws to analysts. Communications retrieved by Spitzer’s office were nothing short of disturbing. A senior analyst, for example, wrote: “The whole idea that we are independent (of the banking division) is a big lie.”

Still, Manugistics CFO Rajaji thinks the Merrill case was the exception rather than the rule. “Most investment bankers respect the Chinese Wall and are very cautious about even insinuating that they will produce positive coverage,” says Rajaji. He adds: “My feeling is this is a case of a few bad apples. I don’t think it is as widespread as people are making it seem.”

Possibly. But Spitzer uncovered evidence that the problems at Merrill may have gone beyond a single analyst or research unit.

For example, the head of the equity division wrote to analysts: “We are once again surveying your contribution to investment banking … please provide complete details on your involvement…paying particular attention to the degree your research played a role in originating ….banking business.”

Although Merrill Lynch never admitted any wrongdoing in the $100 million settlement with New York state, the bank’s management agreed to make substantial reforms to insulate research analysts from the firm’s investment banking divisions.

The changes are wide-ranging. For instance, Merrill agreed to create a new investment review committee responsible for approving all research recommendations. That committee will be shielded from both investment bankers and analysts.

Merrill also agreed to indicate if a company in a research report is also an investment-banking client. Upon discontinuation of research coverage of a company, Merrill will also issue a report disclosing the termination of coverage and the rationale for dropping a company.

But perhaps the biggest change: Merrill agreed to end the practice of tying analyst compensation to business origination. Instead, the bank will reward analysts’ for the accuracy of their forecasts and stock recommendations.

It’s likely that other Wall Street banks will ape many of these changes. Indeed, Salomon Smith Barney, the brokerage subsidiary of Citigroup, has already announced that it will overhaul the structure of its equity research department to mirror the changes at Merrill.

It remains to be seen, however, whether these curatives will truly remedy the problem, or merely heal Wall Street’s PR problem. “I’m not sure that the way they have settled the compensation issue yet is going to totally avoid conflicts,” says Louis Thompson, president of the National Investor Relations Institute. “But it will help get the wall back up.”

Coddled, Egged On

Some CFOs may actually benefit from the construction work started by Spitzer.

For one thing, a number of observers believe the attempt to shield sell-side analysts from in-house pressuring may actually lead to more financial discipline in boardrooms.

“In our opinion, one the most serious consequences of excessive bullishness (on Wall Street) is the incorrect signal sent to corporate managers,” notes David Tice, president of David Tice & Associates, an investment research and management firm, in a recent report.

In fact, when analysts indiscriminately touted stocks, pushing market caps through the roof, some executives suddenly stood to make millions by selling stock options. Such a scenario hardly fostered an evangelical fervor for financial discipline. In that frenzied environment, it paid for companies to pursue reckless acquisitions, expand into strange new businesses, and cleave to risky growth strategies.

What’s more, the lure of getting rich quick led many investors to pour money into highly speculative areas of the economy — sectors like technology and telecommunications. CFOs at less glamorous companies — traditional businesses with more normal earnings growth — found it difficult to be heard above the new economy din.

“The coddling of companies by analysts,” claims Tice, “fueled the massive over-investment in technology and diverted capital from other valuable sectors of the economy.”

Brutally frank research will benefit the best businesses. “Companies will no longer be able to count on guaranteed positive ratings,” says Roger Ibbotson, a professor at Yale’s School of Management. “And because they will no longer get false advertising, capital will flow where it is more deserved.”

Others also believe that, if research becomes more independent, CFOs will feel less pressure to meet what are often overly ambitious consensus estimates. “I think there is going to be a very different attitude among CFOs,” says A. Gary Shilling, head of the eponymously named research company. “They will be able to tell analysts ‘read the quarterly reports and come to the annual meetings. Otherwise don’t bother me.’”


The prospect would probably have some CFOs skipping rope and making large donations to charitable institutions.

The fact is, although buy-side analysts have largely discounted Wall Street’s recommendations (and their expected earnings numbers), individual investors have typically relied on the Street’s information when picking stocks.

Indeed, Wall Street forecasts still set the market’s expectations on earnings. “If the majority of skeptical investors begin to discount Wall Street’s earnings expectations,” asserts Shilling, “then whether EPS comes in at $1.20 or $1.30 won’t make much difference.”

Reduced pressure to meet earnings projections, in turn, may lessen the temptation to resort to accounting gimmicks. “Behind the penny-miss notion, was the perception that companies should have enough reserves or be able to manipulate the numbers enough to make up a penny,” notes Thompson. “If they couldn’t, it meant they had serious problems.”

Wall Street analysts may still have serious problems. If analyst coverage becomes less valuable to investment banks, critics say non-tied research firms (such as Sanford Bernstein) could emerge as forces in the capital markets.

“There are already indications that the buy-side is willing to finance independent research,” notes Thompson, “and individual investors might very well be willing to pay a few more cents in commissions to get unbiased information.”

At that point, managers at Wall Street investment houses might begin to wonder why they’re even in the research game. “I don’t know if the firms will get out of the research business altogether,” says Thompson. “But there will be some serious cutbacks.”


According to a published account, the National Association of Securities Dealing (NASD) is preparing to take regulatory action against Salomon Smith Barney and its star telecom analyst, Jack Grubman.

Apparently, officials at NASD believe Grubman may have helped Salomon Smith Barney win business from Winstar Communications Inc. by recommending that investors buy shares of the telco, which filed for bankruptcy in April 2001. A Salomon Smith Barney spokeswomen denies that Grubman ever intended to mislead investors.