A Clean Break for the Street?


The era of stock analysts working with -- and sometimes serving as shills for -- their investment banker colleagues is drawing to a close. A powerful group of big players -- including Citigroup, Goldman Sachs, and Securities & Exchange Commission Chairman Harvey L. Pitt -- is pressing for a clean break between research and banking to end the mushrooming investigations that are embarrassing Wall Street. But the closure won't be quick or clean.

After talks on Oct. 1 and 2, Pitt and New York Attorney General Eliot Spitzer announced on Oct. 3 an agreement to jointly develop reforms for investment banking, research, and initial public offerings. Their pact is likely to lead to a clear separation between dealmaking bankers and the stock analysts who cover the bankers' client companies. Working with the New York Stock Exchange and the NASD, the pair also plans to come up with tighter rules on how banks hand out shares in initial public offerings to reward top corporate execs. The deal "is a foundation for a global settlement" of probes into Wall Street's boom-time practices, says an official involved in the agreement.

Both Citi and Goldman are working with the regulators to get new rules in place quickly. Citi -- on the hot seat for alleged analyst and IPO abuses at its Salomon Smith Barney unit -- opened the way to a deal on Sept. 27 by offering to split its research and banking units. Citi's main condition: Pitt had to bring along the rest of Wall Street so Salomon would not be at a competitive disadvantage. And Goldman Chief Executive Henry M. Paulson Jr., eager to remove the cloud over the industry, is working with other CEOs to unveil a separate set of proposals on analysts and IPOs that will dovetail with regulators' plans, sources say.

THE TAINT SPREADS. But even an entente between Pitt and Spitzer -- ideological opposites at odds for months -- may not bring quick relief from the embarrassment that Wall Street is suffering over analysts' behavior and banks' IPO allocations during the Internet boom. Investigators have discovered that analysts issued "buy" ratings for stocks they privately disparaged, while bankers allocated shares in hot IPOs to executives at client companies who could steer more business to the banks.

The three banks hit hardest so far are Merrill Lynch, Credit Suisse First Boston, and Citi. Now Goldman, too, has been tainted: On Oct. 2, House Financial Services Committee investigators revealed that top executives at 21 companies that were Goldman clients received hot IPO shares from the firm. Recipients included former Enron CEO Kenneth L. Lay and eBay CEO Meg Whitman, a Goldman director. Goldman says the allocations were not improper.

The proposed deal isn't the last word for other banks under investigation. Spitzer will still seek huge penalties to

settle his charges against Citi. Other banks -- which maintain they're not as guilty as Citi or Merrill -- can't yet gauge how much they'll have to pay to put their charges behind them. And state regulators won't easily give up probes into abuses suffered by Main Street investors -- meaning that leaked e-mails and new allegations could continue to drag down the Street's battered credibility.

UPSTAGED BY LOCALS. Bankers and securities lawyers also note that separating research from banking isn't a magic solution to Wall Street's conflicts of interest. Even if analysts work in a separate subsidiary -- as Citi has proposed -- the bankers whose profits support the parent firm can still exercise strong influence over their ratings. "The heavy lifting will come in rules dictating in detail what analysts can and can't do," says a former SEC lawyer. "Until you have those, separation may just be cosmetic."

Still, it might be just the makeover that Pitt needs. The SEC chief, President Bush's point man on fighting corporate crime, has been repeatedly upstaged by low-budget state regulators with their lurid revelations of Wall Street chicanery. The latest: Spitzer's charges on Sept. 30 that former WorldCom CEO Bernard J. Ebbers and four other telecom executives reaped more than $1.5 billion in illicit profits from IPO shares and from gains in their own stocks helped by glowing research reports from Salomon (see BW Online, 10/2/02, "Spitzer Raises the Heat on Citigroup").

Pitt's sudden decision to back Citi's proposal and push for wider changes is aimed at putting the SEC back in control on an issue that has infuriated investors -- and many voters. "Harvey Pitt has to look like he's being tough by Election Day," says Adam C. Pritchard, assistant law professor at the University of Michigan.

"PIGS AT THE FEAST." But in his haste, Pitt is racing ahead of his fellow commissioners and much of his senior staff, including Democratic Commissioner Harvey J. Goldschmid. While Goldschmid has been charged with drafting comprehensive analyst and IPO rules for the industry's 7,000 firms, Pitt's push to lay down markers for the biggest firms will sharply limit Goldschmid's running room.

The Street knows an overhaul of investment banking is inevitable. But most of its players aren't as desperate as Citi to close the issue. Most of the other banks being probed -- including Goldman, Lehman Brothers, and Morgan Stanley -- say their e-mail won't reveal the same degree of two-faced behavior alleged at Merrill, Salomon, and CSFB. Banks don't want a rush to judgment with one-size-fits-all penalties. Firms that got smaller slices of the boom in Internet IPOs object to paying for abuses by what one Wall Street executive calls "the pigs at the feast."

Splitting research from banking also would require major firms to accept a new business model -- and neither Wall Street nor the SEC yet has a clue about how that would work. Analysts became closely allied with investment bankers because research doesn't generate revenue on its own. If investment banking isn't allowed to support research, big banks will have to return to the days when investors -- whether big institutions or individuals -- somehow subsidize analysts.

NOT-SO-NEAT CLOSURE? It isn't clear how much of a rise in trading costs investors will accept to pay for a product that now is tainted. At the least, analysts' salaries will plummet, and research departments will shrink. SEC officials fret that investors will get information that's less biased -- but also far less complete.

State regulators, too, could complicate the neat closure Pitt is seeking. While Citi is negotiating with Spitzer and Pitt, other state securities chiefs say they have only belatedly been invited to participate. Nor are they inclined to shut down their ongoing probes. Spitzer is their unofficial leader, thanks to his revelations about Merrill and his power to use New York's sweeping securities fraud laws to bring cases that other states can't.

But his acceptance of a deal wouldn't bind the other states. And future reforms wouldn't redress the wrongs that investors suffered in the '90s. State officials want the banks to pay up -- and heavily -- for those abuses.

HASTENING THE ENDGAME. Unlike Pitt, the state regulators don't place any premium on ending Wall Street's embarrassment. If banks want a quick end to states' probes, "they should come forward with their problems," says Alabama securities chief Joseph P. Borg. That's not likely, and any deal that forces firms to concede more wrongdoing won't fly.

Even if it doesn't settle all the details, the likely Pitt-Spitzer pact will hasten the endgame in Washington and New York. And Citi is moving to bolster its credibility: On Oct. 1, it named Verizon Communications President Michael T. Masin as chief operating officer and head of a new business-practices committee that will "assure that Citigroup is embracing the industry's highest standards."

If Pitt and Spitzer succeed in seriously raising those standards, investors might finally have reason to begin trusting Wall Street again. By Mike McNamee, with Amy Borrus, in Washington, and Heather Timmons and Emily Thornton in New York


Silicon Valley State of Mind
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