To 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.

It was no surprise that Spitzer’s investigation into such “shocking” analyst conflicts coincided with the advent of the bear market. No one minded those conflicts much while everyone was raking in the dough. But when the money flow stopped, the conflicts provided a convenient misdeed with which shareholders could extract their pound of flesh from the analysts who they claimed knowingly steered them to now-worthless stocks. And, as Haas observes, a more compelling case can be made if a shareholder has lost $100 million than if he has only quadrupled his money rather than quintupled it. Spitzer’s findings have already been used in at least two class-action lawsuits filed against Merrill Lynch and its analysts by investors who bought stock on Merrill analyst recommendations.

On the Front Page

It was only after Spitzer’s legal action against Merrill that the NASD and the SEC announced that they, too, had been conducting investigations into these very same analyst conflicts. In May, the NASD and the NYSE each proposed a new set of nearly identical rules that closely mirror the terms of Spitzer’s agreement with Merrill Lynch.

The new rules, most of which went into effect in July, include a raft of “front page” disclosure requirements. An analyst must disclose in a research report if: (1) his or her bank has received any investment-banking business with a subject company in the past year or expects to receive such business in the next three months; (2) the bank has any financial interest in the company; (3) the analyst has personal or family financial interest in the subject company; (4) the analyst received any compensation based on a broker or dealer’s investment revenues; and (5) any other material conflicts of interest.

The rules say that analysts must make these disclosures in public appearances (such as on television) as well. They also require them to put a chart in each research report showing the subject company’s stock price and the rating assigned to the company over the same time period, as well as a chart showing what percentage of the firm’s covered companies fall into each of the firm’s rating categories.

The SEC’s Regulation Analyst Certification, proposed in July, would require analysts to certify that the opinions in their research reports are their personal opinions. Analysts would further be obliged to certify whether or not their compensation is tied to the specific recommendations or views expressed in the research report. That’s not to imply that analysts could no longer be paid for covering companies or writing reports, adds the SEC. (The text of the proposed regulation is available at the SEC Web site.)

Seemingly more onerous are the NASD’s rules governing communications between analysts and investment bankers. The rules prohibit bankers from reviewing or approving a research report prior to publication, except to verify factual accuracy. Any written or oral communication between bankers and analysts regarding a research report must be made through a legal or compliance officer. Any draft reports that are shared must omit the research summary, rating, or price target. Analysts may not be compensated based on specific investment banking deals. Nor may they offer a company favorable research or ratings, or threaten to change research or ratings, as a consideration of inducement for business or compensation.

This last provision would affect not just analysts but some companies, too. No longer would CFOs be able to convince an analyst to adjust ratings based on the amount of investment-banking business their companies do with the analyst’s firm. Although just 9 percent of survey respondents admit to pressuring analysts in this way in the past five years, 71 percent of those who have say they plan to do so again in the next 12 months.

“If you asked 100 CFOs, they would say they liked the idea of being able to buy or influence coverage,” says Lavallee of Revolution Partners. “It was a nice arrow to have in their quiver. These rules make it a lot harder for them to pick up coverage.”

Losing Perks

But corporate finance executives will find the rules governing analyst involvement in IPOs the most disturbing. As an NASD spokesperson acknowledges, there is an expectation of an investment bank’s analyst involvement and coverage during the IPO process. And indeed, the CFO survey reveals that more than 23 percent of respondents expect a firm’s analyst to recommend the company’s stock in exchange for underwriting business. But the NASD’s rules bar a lead or co-managing underwriter from publishing a research report on a public company for 40 days following an IPO, or 10 days following a secondary offering (compared with the previous rules blocking reports for 25 days after an IPO). Such reports have long been one of the valuable perks that CFOs of newly public companies received when they selected an underwriter.

In addition, new internal policies adopted by Citigroup, and expected to be adopted by other banks, would bar analysts from attending road shows, traditionally another large perk in selling an IPO. Although some CFOs don’t think that losing these perks are a big deal, they do protest the intent of the changes–cutting analysts out of the IPO process.

“To exclude them from the process is a fundamental mistake,” says Ken Goldman, CFO of Siebel Systems. “It’s good for analysts to get involved in these deals. It’s the one time they can really get inside a company and understand what’s going on internally, because it’s still private. They can get information they couldn’t otherwise obtain.”

“This one was a tough pill for the analysts to swallow,” admits the NASD spokesperson. “It was one of the more controversial rules.” However, the new rules would do nothing to change the standard practice of underwriters offering to initiate analyst coverage as part of an underwriting deal. So why is one prohibited while the other is allowed? “If they didn’t have coverage [being initiated], it would be harder to sell the deal,” says the spokesperson. “But if the analyst hated the company, they wouldn’t take them on in the first place.”

Some experts say that the new rules would continue to allow clear conflicts of interest, while minimally affecting the investment banker­analyst relationship. By agreeing to comply with the rules, investment-banking firms can crow that they have taken positive steps to ensure their analysts’ credibility.

Will analysts who have green-lighted an IPO suddenly become impartial once the offering is complete? It’s doubtful; analysts will still draw their salaries from investment-banking revenues, although bonuses for specific deals will be prohibited. “As long as research exists on the same P&L as banking, you’ll never get rid of this problem,” says Lavallee. Most of the corporate financial executives polled in the CFO survey would like to get rid of it: 71 percent say that the regulators should mandate a complete, legal separation between analysts and investment banking.

Capital Costs

One can only speculate on what effect the new rules will have on the capital-raising process. “It’s possible that [the cost of capital] will go up,” says Jay Morse, CFO of The Washington Post Co., “but I think it will be very small.” Almost half of the survey respondents think a legal separation wouldn’t increase the cost of capital at all, but 29 percent think it would increase the cost. Meanwhile, the NASD and the SEC have both made it clear that they aren’t finished tinkering with the investment banker­analyst relationship. While it’s hard to make predictions, some outcomes are less likely than others. For example, even though most respondents in the CFO survey think that analysts should be legally separate from banking, that probably won’t happen anytime soon, say experts.

“Lopping off research from the rest of investment banking firms is not a good idea, either in theory or in practice,” comments Dwight Crane, a professor at Harvard Business School and co-author of Doing Deals: Investment Banks at Work. “A full-service bank has a corporate finance department, a trading department, an institutional sales force, and a retail sales force. One analyst team serves all of those groups. They screen investment-bank deals, they provide content and ideas to the institutional and retail sides. We can imagine efforts to make the research team 100 percent credible with the public through a complete separation, but it would make it less useful to the rest of the bank.”

Merrill Lynch vehemently opposed Spitzer’s proposal that its analysts be separated from the rest of the firm, and the attorney general dropped the request. “Merrill Lynch decided it was willing to give up something on the credibility side to hold on to those analysts,” says Crane.

Rise of the Buy Side

Investment adviser Shilling believes that institutional investors will continue to beef up their buy-side analyst teams and start ignoring the sell side entirely. “Eventually, you’ll have a very clear separation between truly independent analysts and the in-house shills who are basically touting the corporate finance list,” he says. He also predicts that sell-side analyst departments will begin to shrink, but not because of analyst conflicts. “Corporate- financing activity is going to continue to go down, creative financing is out, there’s going to be very few corporate deals being done,” says Shilling. “Do you think the investment banking guys are going to eat beans while the analysts are living high? Hell, no. Pay for analysts is going to shrink tremendously, and I predict that a lot of them are going to go to the buy side as a safe haven.”

Crane thinks this is an extreme view and argues that there is still a role for sell-side research, albeit a limited one.

“There are various degrees of credibility,” says Crane. “If you want to know what’s going on with a company’s capital structure or sales growth, get an analyst’s report and you can learn a lot. Often they provide information that [investors] never heard before about a company or an industry. But I’m not going to put 100 percent faith in the fact that that person rated the company a buy. I think we should regard analysts as helpful but, like salespeople, everything they say has a point of view.”

Others foresee the rise of paid-for research, in which investors subscribe to research reports from independent or buy-side analysts, who are widely considered to be far more impartial because they have a vested interest only in predicting the accurate movement of a stock, not touting it. Many hold up the example of money managers Sanford Bernstein as the face of the future for analysis. In fact, paid-research firms and Web sites have proliferated in the past six months.

Goldman says that whereas Siebel was once covered by 10 analysts, it’s now covered by 30–many from new boutique research firms–who often aren’t as knowledgeable as their predecessors at the big firms. “The challenge for CFOs will be dealing with all these analysts,” he says. “The average company’s analyst group is being splintered as investment banks let go of people. Small boutiques are springing up. They have low overhead. The analyst pay is low. These analysts are perceived to be more objective, but a lot of the information that will come out won’t be factual, and it’s much more time-consuming to deal with them.”

Smaller companies may have fewer analysts following them once their ability to bargain for coverage is taken away. As a result, more issuers may commission analyst coverage from specialty investment advisers such as BlueFire Research, which provides equity research for small- and midcap companies. A recent survey by the National Investor Relations Institute found that 10 percent of the respondents had commissioned research, and it wasn’t just small-cap companies that did so; 8 percent of companies valued at $10 billion or higher had commissioned research.

On the whole, the future CFOs fear most is one with even more regulation in the research arena. “My main concern is the overreaction and the overregulation to solve a problem that the marketplace can solve on its own,” says Goldman. “It will be self-correcting.” The NASD and the SEC seem unwilling to wait to see if that’s true.

Kris Frieswick is a staff writer at CFO.

Quid Pro Quos

The CFO Survey of Investment-Banking Relationships

This survey, our third in a series of four on corporate-finance practices, focuses on investment-banking and research-analyst relationships. A questionnaire was E-mailed to senior financial executives; 142 responded, and their answers are presented here. Seventy-five respondents work at publicly traded companies. The respondents represent a broad range of company sizes and industries. Most are from companies with at least $100 million in revenues, and the most-represented industries were financial services and technology.

Some highlights of the survey results: Most financial executives say they don’t expect an analyst’s recommendation in return for underwriting business, nor do they ask analysts to change recommendations. Also, a third of respondents are giving more guidance to analysts than they did a year ago. And 9 out of 10 think that analysts should be paid independently of their firm’s investment-banking revenues.

The first two surveys in this series, on financial reporting and auditor-client relationships, respectively, appeared in the August and September issues of CFO. The final survey will focus on corporate-governance issues.

1. Have you purchased investment banking services in the past two years?

• Yes: 47.6%
• No: 52.4%

2. Does your investment bank require you to buy other products or services in return for underwriting your securities?

• Yes: 12.2%
• No: 87.8%

3. Have you ever asked that the bank charge less than 7 percent of investment-banking proceeds in return for underwriting business?

• Yes: 25%
• No: 75%

4. If your answer to Question 3 was yes, did the bank agree to lower the underwriting fee?

• Yes: 90%
• No: 10%

5. How much did you pay?

• 5 ­- 6.99%: 66.7%
• 3 – ­4.99%: 33.3%
• < 3%: 0%

6. Will you ask that your investment bank charge less than 7 percent for underwriting securities during the next 12 months?

• Yes: 43.6%
• No: 56.4%

7. Have you ever received an allocation of IPO stock in exchange for current or promised business with the underwriter’s bank?

• Yes: 2.1%
• No: 97.9%

8. How much earnings guidance are you giving analysts now compared with a year ago?

• More: 32.4%
• Less: 13.2%
• Same: 54.4%

9. Do you expect an investment bank’s analysts to recommend your stock in return for your underwriting business?

• Yes: 23.2%
• No: 76.8%

10. How often in the past five years have you asked that an underwriter’s analyst change his or her recommendation about your company’s stock?

• Never: 91.3%
• Once: 2.9%
• Twice: 2.9%
• More than twice: 2.9%

11. How many analysts currently cover your company?

• 0: 20%
• 1: 1.2%
• 2­4: 17.6%
• 5­7: 24.7%
• 8+: 36.5%

12. Has an analyst ever stated or implied that coverage of your company was contingent on your buying of services at the analyst’s bank?

• Yes: 8.7%
• No: 91.3%

13. Do you think analysts should be paid independently of their firm’s investment-banking revenues?

• Yes: 90.6%
• No: 9.4%

14. Do you think research operations should be legally separated from investment banks?

• Yes: 71.4%
• No: 28.6%