By Mike McNamee How many regulators does it take to make Wall Street's analysts honest? No, that's not a joke. As one federal agency, two industry regulators, 50 states, and even a local district attorney or two pile on, finding a solution to ending the conflicts of interest between investment banking and stock research is only getting tougher.
Regulators are getting together at the Securities & Exchange Commission on Oct. 24 to try to get back on track for a "global settlement" of charges that as many as a dozen investment banks issued glowing reports on stocks that analysts actually thought were bad bets. The SEC and state securities commissioners agreed to pursue such a deal on Oct. 3 -- but haven't made much headway. Even the once-unified states are splintering: Massachusetts authorities preempted the grand compromise to file their own civil charges against Credit Suisse First Boston on Oct. 21, and other states are expected to follow.
There's no simple way to make sure analysts give investors their honest opinions. As long as investment houses represent both companies that sell stocks and the investors who buy them, analysts will be tempted to turn their research into sales literature. To ensure that they don't yield to temptation, regulators need to address at least three areas: legal separation of research from investment banking, detailed proscriptions to keep analysts from morphing into salespeople, and public exposure of analysts' track records to show whose stock picks hold up. Only a carefully balanced package of all three reforms will ensure that investors get unbiased advice that they can trust.
INDEPENDENT VOICE. Striking that balance in the current climate is a tall order. Armed with smoking e-mail, state regulators want to reap the rewards of their expensive probes of the big Wall Street houses. The states don't trust SEC Chairman Harvey Pitt to force needed reforms on his former Wall Street clients -- but they're at odds with one another, too. New York State Attorney General Eliot Spitzer, author of the global pact, asked Massachusetts Secretary of State William Galvin to hold off on charging CSFB with securities fraud for using upbeat research to woo banking clients. But Galvin, just two weeks from a reelection vote, went ahead. Other state regulators, upset that Spitzer negotiates with the SEC without consulting them, are privately cheering.
Undeterred, Spitzer has taken a new tack. At the Oct. 24 meeting, he's expected to propose that Wall Street create a new board that would sponsor research for individual investors. Under Spitzer's plan, an investment bank underwriting a stock issue would be required to hire the new board to give small investors an independent assessment of the stock's prospects. The board, essentially a co-op funded by an annual levy on investment banks, would use its own analysts or contract with research boutiques.
Wall Street is leaping at the idea -- which might be a sign the plan doesn't go far enough. Spitzer's proposal would sponsor an independent voice, but it would leave superstar analysts free to issue their own reports and possibly drown out the new voice with their cheerleading. The research board might help individuals, but it's not enough.
SUSPICIOUS BEHAVIOR. A better solution would start by requiring the banks to create separate subsidiaries for research. A clear legal break would give regulators a handle on who's funding the research -- investors or banking clients -- and make it easier to police rules prohibiting bankers from controlling analysts' salaries or work.
Separation on paper isn't adequate, though. "People from separate subsidiaries work side by side all the time," notes a senior SEC official. There's no substitute for tough rules and strict enforcement. So regulators have to figure out just what actions might compromise an analyst's independence -- such as helping to make pitches to new banking clients or accompanying the sales team on road shows -- and prohibit such behavior. That's a job for the SEC, together with the New York Stock Exchange and the NASD, which can write the needed rules and keep tabs on whether the banks follow them.
The strongest proof of independence, though, will be in the results. The track records of analysts' stock recommendations and the accuracy of their earnings estimates should be compiled and published in a uniform, easy-to-follow scorecard. It should be a cinch for investors to judge who truly did a good job proffering investment advice.
KEEPING SCORE. David Pottruck, co-chief executive of Charles Schwab, which doesn't do company research, takes that idea a step further: Banks should be rated on all their analysts' picks, with separate scores for stocks that a bank underwrites and those that aren't clients. "Do the stocks of investment-banking clients get better grades, and are those grades less reliable? That's important to know," says Pottruck.
Such a three-pronged attack on analyst bias doesn't make for good sound bites. But the conflicts revealed by Spitzer's and Galvin's aggressive digging -- and those still to be unveiled by other states -- require reforms that are thoughtful and comprehensive. A race to settle cases won't get the job done.
With Paula Dwyer in Washington and Heather Timmons in New York McNamee is a senior correspondent for BusinessWeek in Washington, D.C.