The bubble burst, and the recriminations came next.

In the 18 months leading up to September 11, some $6 trillion in U.S. equity investments evaporated. Shares in technology and Internet companies that once traded for hundreds of dollars dipped to a few bucks, or worse. As the Dow sank, bankruptcies, layoffs, and restructurings rose.

At the uncertain beginning of the new war on terrorism, it’s easy to forget that until two months ago, angry investors sought to blame others for their stock market losses. Chief among their targets was the Wall Street research community. “Analysts are the sacrificial lamb,” said A. Gary Shilling, an economic consultant and money manager, in an interview last August. Little wonder, given their track record of irrationally optimistic reports and their bias for touting companies that deliver handsome investment-banking fees.

While concern over the credibility of analysts has understandably receded, it hasn’t gone away. Shareholders are still suing Wall Street firms for too- bullish calls. Congress has held two hearings this year on the deterioration of the so-called Chinese walls that are supposed to eliminate conflicts of interest among analysts and bankers, and plans to hold more. Regulators have made troubling discoveries, such as analysts executing trades in their own accounts that ran contrary to the advice they gave the public.

One party, though, remains to be heard from: chief financial officers. They have not been asked to testify in Washington, nor have they been quoted much, if at all, in the press. Yet perhaps no one knows better about Wall Street’s questionable conduct than CFOs. Although not privy to details about a brokerage firm’s internal reporting relationships and compensation schemes, they have a unique vantage point–that of an outsider who nevertheless sees what goes on behind the scenes through regular dealings with analysts and investment bankers.

“The illusion that there is some kind of Chinese wall between those two [research and banking] organizations is laughable at best, illegal at worst,” says one CFO, who, like most of the 20 or so we contacted for this story, agreed to be interviewed only on condition of anonymity. Another, the former CFO of a now-defunct Internet company, indicated that saying anything was “a no-win situation,” then hung up.

But others were willing to reveal stories of a dysfunctional relationship. Like the CFO who took a call last summer from an analyst who griped that because his firm wasn’t chosen for the company’s latest underwriting assignment, his bosses thought he wasn’t doing a good job. Or the CFO who says that last year, within weeks of an analyst initiating coverage, the bankers came calling to peddle their services. Or the one who in recent years has been told by “two dozen” brokerage firms that their analysts won’t follow the company–until there are better prospects for corporate finance or M&A advisory fees.

These are examples of the pressures that many CFOs face when dealing with analysts. They are evidence of a credibility gap, one that raises worries over biased coverage (or no coverage at all). The problem isn’t nearly as glaring as that of superstar analysts flogging sky-high price targets for unprofitable dot-coms, but it’s corrosive of confidence all the same, and perhaps harder to solve.

Of course, CFOs cannot claim to be naive victims of analysts’ bad behavior. More than a handful have been known to blackball bearish analysts and seek kid- glove treatment from favored ones by making selective disclosures. And cynics could argue that companies benefit from collusion in which, say, an underwriter delivers positive analyst coverage in exchange for a piece of a transaction–an accusation that has been made in some shareholder lawsuits.

Nevertheless, few people deny the continuing influence of analysts. “They still matter,” says Siebel Systems Inc. CFO Ken Goldman. Even at a time when the flow of corporate information to investors is more direct–and when those investors have more reason than ever to mistrust analysts–the Wall Street research community plays a pivotal role when it comes to expanding a company’s shareholder base and keeping the markets up-to-date.

What remains in doubt is what can be done to make brokerage-firm analysts more trustworthy, especially as long as analysts get a portion of their pay based on deal-related activities or bankers’ assessments of their contribution to underwriting relationships. “If you say that an analyst is not allowed to benefit in any way from corporate finance work,” says the CFO of a medical-related business, “only then are you removing the possibility of any conflicts.”

Root of the Problem

The root of these conflicts goes back to the mid-1970s, when the securities business was threatened with price-fixing charges. That brought about the end of fixed-rate minimum commissions, and as a result, trading fees plummeted and analyst research reports no longer paid for themselves. The big money would be made generating banking and advisory fees, and analysts increasingly became part of that effort–coming “over the wall” to attract new corporate finance clients, to promote initial public offerings on road shows, and to use their research reports to hype companies’ prospects.

This was no secret to institutional investors, who in the past decade have beefed up their own research capabilities when it comes to making buy/sell decisions. 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 [sell-side] recommendation is the result of a deal or of bona fide research.”

This situation intensified with the bull market of the 1990s and the mania for technology stocks, as Wall Street analysts like Mary Meeker of Morgan Stanley and Henry Blodget of Merrill Lynch began to assume celebrity status. New issues soared on their first day of trading and continued to climb to analyst price targets that far exceeded conventional valuation methods. By the end of the decade, 70 percent of stocks carried a buy rating and only 1 percent carried a sell. Similarly, analysts at firms with investment banking ties were found to have 6 percent higher earnings forecasts and nearly 25 percent more buy recommendations than analysts at firms without such ties.

For the most part, the CFOs we contacted say that in their experience, the Chinese wall remained intact in one respect: confidential information that bankers shared with analysts on upcoming deals was not leaked. “It’s always been very clear when you bring an analyst ‘over the wall’ that they can’t write on the company until the information they’re privy to is disclosed,” says Siebel’s Goldman.

“That’s Pretty Blatant”

Rather, the problems stem from the increasing use of analysts to foster or further investment-banking relationships. Five years ago, recalls one software CFO, an analyst interested in initiating coverage would offer to drop by for a meeting and arrive with several bankers in tow. Once the CFO explained the company’s minimal capital needs and limited acquisition opportunities, he says, “the interest went away fairly quickly and the coverage never came.” More recently, analysts have simply come out and told him that there’s no chance of coverage unless there’s banking business.

“I’ve seen banking-side guys say, ‘We’ll assign one of our top analysts to follow you and start to put out reports,'” says another CFO. “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 collusion to press our stock up.”

Several years ago, says Washington Post Co. CFO Jay 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.”

CFOs of widely covered companies are not confronted with the same predicament of making a quid pro quo, but see the conflicts between analysts and bankers from a different perspective. One, for instance, has confronted analysts who have sugarcoated bad news from his company and from his competitors in a deliberate effort not to alienate the executives. “They’ve said to me,” the CFO recalls, “‘When I meet investors one-on-one, I give them a much more accurate portrayal.'”

Such hypocrisy is also evident when well-known firms plan their next transaction. One CFO says he received about a dozen proposals from bankers at firms that follow the company when it became clear that financing was required for a planned acquisition. Of course, he was able to select only a few brokerage houses to help underwrite the deal, and representatives from every firm that was not picked called to express their disappointment, some more strongly than others.

“One analyst called investor relations very, very annoyed, feeling very much at risk within his firm,” the CFO notes. “In another case, the CEO [of the securities firm] called and said, ‘It looks like our analyst was not on top of things. I thought he was doing a better job.’ It’s tough if analysts have to prove their worth by generating investment-banking business. [The CEO] was almost holding the analyst responsible for his firm not getting the business.”

The Regulators Step In

Ironically, this brouhaha over analyst-banking conflicts comes at a time when they surely have abated, thanks to the weak market for new equity issues and corporate mergers. That hasn’t stopped government regulators and elected officials from scrutinizing Wall Street conduct, and it hasn’t stopped the securities firms from taking steps to polish their image. But will there be substantial change the next time the market heats up?

In June, the House Subcommittee on Capital Markets, which oversees securities regulation, held the first of three planned hearings to “analyze the analysts,” as Richard Baker (R-La.), the subcommittee chairman, put it. “I am deeply troubled by evidence of Wall Street’s erosion of the bedrock of ethical conduct,” the congressman stated in his opening remarks.

Lobbying hard for self-regulation, on the eve of the June hearing, the Securities Industry Association released a set of 14 “best practices” to increase the independence of analysts and restrict the undue influence of investment bankers. These include a rebuke of any bonus system that links analyst pay to specific banking transactions or sales, but the 13 Wall Street firms that agreed upon them went on to say that their analysts already adhere to virtually all of them.

The guidelines “won’t change anything,” predicts Shilling. “They’re an attempt to placate Congress and the plaintiffs’ bar. They’re more an admission of a problem than a plan of action.” And in his remarks, Baker expressed concern that the industry’s proposals were voluntary and did not “go far enough to insure accountability and enforcement.”

The SEC has also weighed in on analyst behavior, but has not taken regulatory action. In June, it cautioned investors against relying solely on analyst reports when deciding to buy or sell stocks. A month later, at a second hearing of Baker’s subcommittee, Laura Unger, then the SEC’s acting chair, released the results of an agency survey of the research departments at nine major securities firms, which confirmed that Wall Street was rife with conflicts.

“There may be legitimate business reasons for communications between analysts and underwriters,” Unger told CFO, “but how do you manage the process to minimize the conflicts? The firms need to examine how they use analysts to attract underwriting business. They need to make sure the analysts are not being unduly influenced by the bankers; that their research objectives are not based on the bankers’ business objectives.”

Appeasing the Critics

Independently, numerous brokerage houses have taken various steps to appease their critics. Merrill Lynch and Credit Suisse First Boston have said that their analysts can no longer buy stock in the companies they cover. The policy affects about 120 of the firms’ 600 stock analysts. Several CFOs were dismissive of the move. For one thing, owning the stock meant putting their money where their mouths were; for another, the holdings were likely minuscule compared with analysts’ net worth.

Still, one CFO says it makes sense for the securities firms to take steps to eliminate even the hint of a conflict related to stock ownership. “Some argue that owning a stock you recommend is a strong endorsement,” he says, “but if you own shares, that has to influence what you will write, what you will say, and how you think. They make enough money that they don’t need to make more trading in the stocks they follow.”

Precisely how they make their money is, of course, the nub of the issue. Many observers note that prohibitions on stock ownership are irrelevant to the real conflicts of interest at firms, where investment bankers not only rely on analysts to push their underwriting relationship but also in many instances have a say in an analyst’s pay package. “I’ve had analysts tell me they do get a portion of the fees that the bankers bring in,” says the same CFO who commented on stock ownership. “This is not on Merrill’s radar screen.”

In her House testimony last summer, Unger reported on evidence compiled by the SEC indicating that bankers at most firms have input in analysts’ bonuses and evaluate analysts to determine their compensation. Specifically, the head of investment banking at one firm doles out bonuses from an aggregate pool for the research department. At another firm, some senior analysts have contracts to receive bonuses based on the amount of investment banking revenue generated by the business sectors they cover.

But Unger, who will step down as a commissioner in December, would be inclined to push for better disclosure practices that might bring potential analyst biases to the surface, and she does not believe that the agency should not dictate internal business practices at securities firms.

“I would be reluctant to tell a firm how to compensate its employees, and I don’t think that’s necessary,” she explains. “The culture on Wall Street has been to pay based on the firm’s banking success, so you can’t deprive analysts of the firm’s largesse. But you should do it so they benefit without tying [their pay] to specific companies the analysts follow.”

Sidebar: Two-Way Street

If analysts have pressured CFOs to steer business toward their firms, CFOs have returned the favor in the past, by using selective disclosures to curry favor with doting analysts and shut out overly critical ones. Now, the Securities and Exchange Commission’s Regulation FD, which requires greater openness, limits a company’s ability to punish its critics. “FD gives Wall Street a license to be more honest,” says SEC commissioner Laura Unger.

Money manager A. Gary Shilling, who was once fired as chief economist at Merrill Lynch for his downbeat forecasts, acknowledges that analysts cannot be completely frozen out, as they once were, from receiving mailings and attending conference calls. But, he argues, now that they also can no longer depend on direct pipelines to management, they may still be inclined to be bullish to preserve banking opportunities. “CFOs can rip out the corporate finance business,” he says, “even though they can’t withhold information.”

“I know many CFOs,” avers one chief financial officer, “who say that if an analyst writes a negative report, they won’t speak at [the brokerage firm’s] next conference” for investors. “It’s a small jump to go from that to saying that they won’t use [the firm] for their next underwriting.”

Yet even CFOs who consider themselves ethical to a fault concede that they would be reluctant to bring a deal to a brokerage firm whose analyst has a sell on the company or whose research reports are pessimistic about the company’s outlook. But they see this tendency as having less to do with inspiring positive coverage or punishing negative coverage, and more to do with the quality of the analyst’s work.

“Clearly, if you have an analyst who is not constructive on your story, you’re less likely to do business with that firm,” says Siebel Systems Inc. CFO Ken Goldman.

But some finance executives may soon have to defend their choices of whom they do business with, in connection with lawsuits brought by investors looking to recoup losses. Many of these suits are related to analysts’ exuberance; several implicate executives, including the CFO, of dozens of companies that went public in recent years.

One lawsuit that’s seeking class-action status alleges that analysts at six securities firms were required to issue buy recommendations on companies with dubious prospects because of corporate finance imperatives. “It was not in the interest of the investment banking departments to have sell recommendations, even while the [share] prices plunged,” argues Russel Beatie of Beatie & Osborn LLP, one of the three law firms that filed the suit, “because they used the coverage to further the underwriting relationship with individual companies and to recruit new banking clients.” Beatie, who may depose corporate officers if the case reaches discovery, wonders further whether these executives had a duty to ensure that analysts put an honest recommendation on the company when the business was struggling.

Not surprisingly, CFOs find the notion that they should publicly denounce an analysts’ assessment of their company’s prospects to be preposterous. “We have a responsibility to provide reasonable guidance and be sure analyst reports are accurate regarding facts about the company,” says Gene Godick, CFO of VerticalNet Inc., an Internet company that reached $278 per share in March 2000 and has traded under $1 since mid-August. “But the two things we never talk about are an analyst’s rating and price target.” (Editor’s note: Godick resigned from VerticalNet as this issue went to press.)

Sidebar: What Chinese Wall?

On July 31, Laura Unger, then-acting chair of the Securities and Exchange Commission, testified before the House Subcommittee on Capital Markets and told of an SEC review of research and investment banking practices at nine major Wall Street firms. Among the agency’s discoveries:

Analysts at all nine firms consulted with investment bankers on possible mergers and corporate finance deals, participated in road shows, and initiated coverage on prospective investment banking clients. Bankers at seven firms had input into research analysts’ bonuses.

Three analysts sold shares in companies they had a buy rating on, generating profits of $100,000 to $3.5 million.

Of 57 analysts reviewed, 16 made pre-IPO investments in a company they later covered. Subsequently, the analysts’ firm took the company public, and the analyst initiated research coverage with a buy recommendation.

In 308 of 317 IPOs examined, the firm that underwrote the security also provided research coverage.

Six firms stated that at times analysts provide investment bankers with advance notice of recommendation changes, though none of the firms reported that the bankers had the authority to stop an analyst from issuing a downgrade.

Some research analysts issued “booster-shot” reports to generate interest in a stock. In 26 of 97 new issues reviewed by the SEC, the analyst of the lead underwriting firm issued a buy recommendation within a week of the expiration of the lockup period.