Will Merrill's Deal Reshape the Street?


By Amey Stone Today I'm one very ambivalent columnist pondering the news that Merrill Lynch and New York Attorney General Eliot Spitzer have settled their case over conflicts of interest between the firm's research and investment-banking departments. Plenty of good news here. Merrill Lynch (MER), one of the financial world's most important firms, wasn't dealt a crippling blow. And it's unlikely that many other brokerages will suffer collateral damage and be forced into the $100 million fine and public apology that Merrill agreed to for its mistakes.

Indeed, everyone on Wall Street is breathing a huge sigh of relief. After all, for weeks following Spitzer's Apr. 8 announcement of the Merrill investigation, there was the potential -- especially if criminal charges had been filed -- for the industry, already beset by a wobbly stock market and sluggish economy, to buckle under pressure from the public and regulators.

Merrill's settlement, while more than a slap on the wrist, is hardly enough to destroy the firm. Likewise, rules recently passed by the Securities & Exchange Commission, Nasdaq, and the New York Stock Exchange don't require firms to split off their research arms from their banking divisions, allowing Wall Street to maintain the status quo in many ways.

LOTS OF LOOPHOLES. All well and good. But what about the thousands of individuals who lost money in Wall Street's late-'90s hype machine? The settlement also leaves some reformers questioning whether the changes being implemented will eliminate future conflicts of interest. "When people aren't looking, they are going to start doing it again," predicts economist and Nobel laureate Joseph Stiglitz.

The basic business model of these firms remains the same. They give research away practically for free and hope to make their money on trading commissions. But those commissions have fallen dramatically. The upshot? Analysts' pay checks will remain tied to investment-banking business, says a skeptical Chuck Hill, research director at First Call. And as for requirements that new firewalls go up between the divisions, he says, "There are a zillion ways to get around that."

Most brokerage stocks slipped on May 21, but investors seemed to shrug off news of the Merrill settlement, turning their worries instead to more fundamental problems for the Wall Street firms: low trading volume and weak investment-banking business. Legally, the brokerage industry isn't out of the woods, and potential civil liabilities running into the billions of dollars could dog the firms.

So what will change for the better -- and the worse? Let's take a look:

Conflicts of interest will be prominently disclosed.

Wall Street research will soon, uniformly, include prominent mention of investment-banking ties (real or potential) in research reports. It's an easy measure for firms to adopt, and it has important consequences.

One of the conclusions of Stiglitz' Nobel-winning research is that it doesn't matter if conflicts of interest exist as long as everyone knows what they are -- a thesis Stiglitz laid out again at a recent speech at Columbia University's business school. That explains why research produced by brokerage houses continues to be of value to professional investors, even though they know analysts are conflicted. Now that individual investors will be similarly informed, they can read through the conflicts and find value in the information supplied in the reports.

The competitive landscape between firms will shift.

Now, those with the most brokers will have an edge. This is one of the outcomes foreseen by Bernstein Research analyst Brand Hintz. He predicts that as the promise of research coverage becomes less of a lure, a firm's "distribution" arm (brokers in the field who can sell stocks and bonds) will become increasingly important in gaining new investment-banking business.

This would give an edge to Merrill Lynch, (somewhat ironically, given that its Internet stock research was the focus of the analyst controversy), since Merrill employs more brokers than any other firm and does the biggest volume of trades on the New York Stock Exchange. Salomon Smith Barney is a close second. Underwriting giants Goldman Sachs (GS) and Morgan Stanley (MS), the firms ranked first and second in proceeds from domestic initial public offerings in 2001 and 2000, stand to lose under this scenario.

Analysts will make less money.

Because they'll no longer be able to play such a direct role in marketing investment-banking deals, they'll probably get a smaller piece of the revenue pie. "In the end, Wall Street's investment-banking divisions will be much less willing to pay for research they cannot use for marketing," Hintz wrote in a May 8 report.

Over time, the decreased opportunity to make a fortune doing research could change the profession. Compensation experts might argue that lower pay would mean a lower caliber of analysts. But it's also possible that smart people less driven by financial gain will enter the business and that the quality and objectivity of securities analysis will improve.

Wall Street research will have less power to make the markets gyrate.

With a new grasp of the way research works, individual investors will learn to use analysts' reports the way professional investors do -- as contrary indicators. David Kern, portfolio manager of Fremont U.S. Small-Cap, says he buys stocks before Wall Street gets on board, expecting initiations of coverage to be a catalyst to propel the share price. If the stock reaches his price target as a result of a new buy recommendation, he sells.

Likewise, a weak quarterly earnings report that triggers analyst downgrades is often a trigger for professional money managers to buy a stock at a cheap price. As more individual investors learn these techniques, new coverage initiations, upgrades, and downgrades should have less of an effect on share prices.

More independent research boutiques will spring up.

The kind of individual investors -- and lots of them are out there -- who want an analyst to tell them which stocks to buy and sell are now more likely to reject brokerage-house research and turn to the products of independent firms. New outfits are already sprouting up that promise unbiased, objective advice. Some of these analysts will be very talented -- but not all. "It's hard to support a completely independent research industry," says Ken Broad, a portfolio manager with Transamerica Investment Management.

In fact, one downside of the scrutiny of Wall Street's failings in research is that firms that blur the line between stock promotion and objective analysis could attract new business. Boiler rooms, as they're known on Wall Street, could be encouraged to increase their fraudulent activities. Likewise, the opportunity for less-than-ethical public companies to buy positive research coverage could increase.

Concern over conflicts of interest will increasingly focus on executive compensation.

In the '90s, investment-banking divisions weren't the only ones putting pressure on analysts to come out with positive reports. CEOs and other managers at the companies analysts cover were part of the problem. The issue is that executives' pay is now closely tied to their stocks' short-term movement, says First Call's Hill. "As long as you have that much money on the table, managers are going to find some way to get their message across to analysts," he says. "You have to change the money situation in both areas."

Conflicts of interest on Wall Street aren't going away. Indeed, the business models of today's huge, integrated financial services firms in many ways rely on them. But skeptical investors who pay attention to changes in the industry will be better served by the new rules. "It will get better, but never get to perfect," says Broad. "That's too difficult to get to." Like I said, I'm feeling very ambivalent. Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column


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