Settling for nothing

Nearly three years after Eliot Spitzer pronounced an end to tainted Wall Street research, his $1.5 billion settlement with big brokerages has done little to help aggrieved investors.

On December 20, 2002, state and federal regulators gathered at the New York Stock Exchange to proclaim an end to one of the biggest scandals in U.S. financial history. Big Wall Street brokerage firms had agreed to settle charges that they had misled investors on a grand scale by publishing glowing research reports on dubious companies from which they hoped to win investment banking business.

None of the officials was more triumphant than Eliot Spitzer. And rightly so: The crusading New York State attorney general had uncovered the most damning evidence in the case -- private e-mails in which analysts bashed the very stocks they had publicly praised. He also was the most zealous about prosecuting the miscreants, hunting down offenders while other regulators, such as the New York Stock Exchange and the Securities and Exchange Commission, were caught napping.

“Our objective throughout the investigation and negotiations has been to protect the small investor and restore integrity to the marketplace,” declared Spitzer. “We are confident that the rules embodied in this agreement will do so.”

So have they?

Spitzer is not very forthcoming about the impact of his historic accord these days. “The implementation of the settlement is being handled by the SEC,” was the terse reply Institutional Investor received late last month from Spitzer spokesman Brad Maione when we asked to talk with the attorney general about the deal’s aftermath. Later, Maione said that Spitzer’s schedule -- among other commitments, he has been busy running for governor of the Empire State since December -- would not permit him to sit for an interview.

The attorney general’s reticence is understandable: Almost three years after his made-for-TV announcement of the deal, the settlement has proved in many ways to be as much of a bust as the dot-com Internet companies that Wall Street analysts eagerly touted in the late 1990s. Consider:

* The settlement called for compensating investors who lost money because of allegedly duplicitous research. Of the $942.5 million paid by the firms for that purpose, not one cent has yet been paid in restitution. But hundreds of millions have been spent by politicians to plug state budget gaps;

* The pact’s acclaimed $55 million federal investor education foundation didn’t hold a meeting until eight months after a federal court approved its creation, and it disbanded four months later without spending a dime on education. Its executive director, who planned to let employees of settling firms sit on a foundation advisory board, was pushed out by the SEC. Now the federal education money is being turned over to the NASD, a self-regulatory body owned by the brokerage industry;

* The 12 Wall Street firms that are party to the settlement must pay $460 million over five years to provide “independent” research to their clients. But it’s impossible for investors to assess the reliability of this research. That’s because the settlement’s much-trumpeted requirement that firms publicly disclose their recommendations and ratings histories quarterly applies only to their own research, not to the independent analysis;

* The settlement may have reduced the amount of research available to individual investors. Big firms have slashed research budgets, analyst head count and the number of companies they cover. That means less-efficient markets for many stocks, giving sophisticated pros a leg up on average Joes -- the exact opposite of the regulators’ intent.

To be sure, the research settlement has had some salutary effects, not least in setting a tone of intolerance for illicit activity. It banned, for example, analysts from working on or getting paid from banking deals. That has left researchers freer to criticize their firms’ corporate clients. Last month Goldman, Sachs & Co. and Piper Jaffray initiated coverage of Chinese Internet company -- which their bankers had just taken public -- with underperform ratings. Such an occurrence would have been unimaginable in 2001.

But the settlement’s failures, shortcomings and unintended consequences outnumber its benefits. Meanwhile, Spitzer’s staff appears no more vigilant about following through on the agreement than the attorney general himself. During quarterly meetings between regulators and the defendant firms to monitor implementation of the independent research portion of the agreement, for instance, “there is a different lawyer there every time from the AG’s office, and they don’t say a word,” says one person who has attended the sessions. (Susan Mathews, the SEC official charged with overseeing the settlement, declines to comment.)

“Spitzer got his photo opportunity, he declared victory, and he moved on,” says Jacob Zamansky, a securities fraud attorney who in July 2001 won a $400,000 settlement from Merrill Lynch & Co. in a suit charging that a Queens pediatrician lost half a million dollars by following the recommendations of Internet analyst Henry Blodget. Zamansky’s case helped turn Spitzer on to the analyst scandal.

“A lot of this stuff sounded good in the beginning,” Zamansky says of the settlement’s remedies, “but I don’t think it has made much of a difference for individual investors. And now he’s out there fund-raising for his election.”

THE “GLOBAL RESEARCH ANALYST Settlement” is 14 separate agreements: one for each of the defendants -- Bear, Stearns & Co.; Citigroup; Credit Suisse First Boston; Deutsche Bank; Goldman; J.P. Morgan Chase & Co.; Lehman Brothers; Merrill Lynch; Morgan Stanley; Piper Jaffray; UBS; and Thomas Weisel Partners -- plus one each for Merrill’s Blodget and Citi telecommunications analyst Jack Grubman, who were fined separately and barred from the securities industry for allegedly writing misleading research reports. The complaints were brought and settled jointly by Spitzer’s office, the SEC, the NYSE, the NASD and the North American Securities Administrators Association, which represents state regulators.

The deal, finalized in April 2003 and approved by a federal court six months later, imposed a series of reforms on Wall Street firms. Among other measures designed to insulate analysts from investment banking pressure, it was stipulated that firms can no longer allow analysts and bankers to communicate without compliance officials present. Firms also are prohibited from paying analysts with banking revenues. The settlement called for the 12 firms to pay $1.5 billion, which is earmarked to fund restitution efforts, investor education and, humiliatingly, “independent” research that the settling firms are required to give to clients alongside their own work.

Spitzer began investigating Wall Street research in early 2001, but its objectivity had been debated for years. Institutional investors had traditionally paid for research with trading commissions. But after Congress deregulated brokerage commission rates in 1975, profit margins in that business plummeted. Over time it became clear to Wall Street that serving corporate clients was more important -- and more lucrative -- than catering to investors, a fact that led many institutions to question the value of the work Wall Street did, particularly its stock picking. Many retail investors, flocking to the bull market, weren’t as savvy. When the bubble burst analysts became the perfect scapegoats for the huge losses some of these individuals suffered.

To pursue these malefactors, Spitzer creatively interpreted a little-known 1921 state law called the Martin Act, which requires neither proof of intent nor actual evidence that a fraud was committed to establish wrongdoing, as giving him the authority to right financial wrongs that, though perpetrated by mostly New Yorkbased firms, affected consumers across the country. Stealing a sleepy SEC’s thunder, he became the driving force behind research reform nationally.

ONE OF THE MOST HERALDED of Spitzer’s fixes requires the 12 firms to collectively spend $460 million, roughly one third of the total cost of the deal, over five years to provide independent research to their clients. The individual bills range from a low of $2.5 million for Thomas Weisel Partners, to $75 million for Citi, Merrill and Morgan Stanley.

Each firm must buy research from at least three outside providers (known in settlement-ese as independent research providers, or IRPs) and make at least one independent report available to clients for every stock covered by one of its own analysts. They must provide the research on their Web sites or through brokers. The firms are further required to hire independent consultants to oversee the selection of this research and to ensure its quality. The consultants meet quarterly with the regulators who negotiated the settlement to report on progress and receive interpretive guidance about implementing the independent research plan.

Unlike most of the money earmarked for restitution and investor education, these funds are actually being spent. But it’s far from clear how much that’s helping investors.

First, there are basic philosophical questions: If the corrective measures in the settlement have truly insulated research by the likes of Merrill and Citi from banking conflicts, then what is the need for independent research to be handed out alongside it? And if it’s really needed, then why is it mandated for just five years?

Another concern: A huge swath of the intended recipients of these reports appear to be paying no attention whatsoever to them. A survey released in May by Standard & Poor’s found that a stunning 40 percent of individual investors were completely unaware of the global settlement. Only six in ten clients of the settling firms surveyed said that they get research from their brokers, and of this group, just 62 percent reported using the independent research. (Several of the independent consultants overseeing this provision of the deal for the defendant firms say that the research is being read but decline to provide statistics to back up their claims.)

And research deemed free from banking pressure can still be conflicted. The CFA Institute, a professional organization for analysts, has identified pressure to provide positive ratings from both institutional investors and publicly traded companies as conflicts that its members must still battle even as banking pressure has abated. Institutions sometimes punish negative analysts by not trading with their firms, thus depriving them of commission revenue. Companies have been known to retaliate for sell ratings by cutting analysts off from earnings conference calls or management meetings.

“The big question is, how good is the research that’s being selected by the independent consultants,” says Michael Mayhew, chief executive officer of Integrity Research Associates, a Boston consulting firm that assesses independent research for institutional investors. “Based on the universe of providers that I’ve studied, I think we’ve got a mixed bag. Some is quite good and some is, frankly, bad. But it is very difficult for a retail investor to make that kind of judgment.”

Difficult, indeed. That’s because the settlement, inexplicably, treats the firms it’s punishing and the IRPs differently when it comes to disclosing ratings information. According to a clause in the settlement titled “Transparency of Analysts’ Performance,” the 12 firms must publish within 90 days of the end of each quarter a list of every report, ratings change, price target and earnings-per-share forecast issued by every analyst it employs. This information allows investors and third-party performance-measurement services, such as Investars and StarMine, to track the accuracy of recommendations.

But read on a few lines, and it becomes clear that the $460 million in independent research is specifically exempted from this and other disclosure requirements. Additionally, rules passed by the NASD and NYSE a year before the settlement was finalized, which require each research report to include a graph plotting the subject company’s three-year price history along with every ratings change by the author, do not apply to most IRPs because they are not registered broker-dealers and thus fall outside the self-regulatory organizations’ jurisdiction.

This creates a perverse situation. Clients of firms like Citi, Merrill, Morgan Stanley and UBS can refer to performance information and decide whether the research that those firms produce is worth paying attention to, based on the accuracy of ratings. But they can’t assess the quality of the third-party analysis that’s also provided -- research they are led to believe is better than the brokerages’ because it bears the “independent” label.

Spitzer had quite a different vision three years ago.

“The data necessary for investors to objectively measure an analyst’s stock-picking performance is being withheld from the market,” said the AG on November 12, 2002, in an address at an IIsponsored dinner honoring the winners of that year’s All-America Research Team. “The solution is to require all recommendations to be provided to a publicly available database maintained by the SEC or another regulatory authority 90 days after they are issued.” He further advised analysts not to fight such transparency, warning, “If you don’t want to stand behind your recommendations, don’t make them available to retail investors.”

But the settlement’s independent research is being offered to retail clients without adequate disclosure. There’s no way, for example, to even make a simple comparison between the distribution of buys, sells and holds for a given brokerage firm and for the independent research it provides. Performance measurement ser-vices like Investars have convinced a handful of the independent firms to give up their data, but the majority of IRPs getting settlement money -- Lehman alone is using 34 firms, according to its independent consultant, Mark Fichtel -- are not.

“We’re very disappointed at the way this part of the settlement has been implemented,” says Barbara Roper, director of investor protection at the Consumer Federation of America. “The firms should have to provide a track record for the independent recommendations in addition to their own. Just because research is labeled independent doesn’t mean it’s good. Investors have a right to see this information and judge for themselves.”

Kei Kianpoor, CEO of Investars, concurs: “We think the regulators should make the firms publish that data. That would be the fairest thing for investors. The rules should apply to everyone.”

Beyond disclosure, another problem with independent research under the settlement is that some firms are only providing one recommendation per stock. This is particularly true of firms that are required to spend less money than their peers but still cover a similar number of stocks. Lehman and UBS, for example, each must spend $25 million over five years on independent research, even though they are global investment banks that cover roughly the same universe as Citi, Merrill and Morgan Stanley, which are each required to spend $75 million. Lehman consultant Fichtel, for instance, has turned to a novel system developed two years ago by the Bank of New York’s Jaywalk unit, dubbed the Independent Research Meritocracy, to handle most of his research selection. Other firms, including Bear Stearns, CSFB, Merrill and UBS, are also using Jaywalk to cover some stocks.

Jaywalk acts as a clearinghouse for some 200 independent research firms. It rates the track records of analysts at these firms continuously, stock by stock, based on their recommendations’ performance and other factors that brokerage clients can preselect, such as the readability of reports. It then picks one IRP for every stock a firm needs to cover -- the best according to its grading system. Selections are constantly monitored and updated. Fichtel uses Jaywalk to cover all of the 1,280 stocks that Lehman analysts follow. Bear Stearns takes a similar approach, according to its independent consultant, Michael Downey. CSFB, Merrill and UBS provide a second or third recommendation where available from other providers, but many stocks are assigned just one.

The system is perfect for consultants who need to cover a wide array of companies without the hassle of dealing separately with dozens of providers.

“It provides me and the research providers with absolute flexibility,” says Fichtel. “With the $5 million a year that I have to spend, and knowing the amounts of money that people are asking for in direct deals, I wouldn’t have been able to use more than four or five firms.”

Yet it also may be causing problems. Because Jaywalk emphasizes ratings performance when selecting IRPs, some critics say, it may contribute a short-term bias that actually hurts investors more than it helps them. Consider the following hypothetical situation: Stock XYZ surged 20 percent in 2002 but then plunged 30 percent over the next two years. An analyst at Firm A had a buy on the stock all the way up and maintained that rating throughout its decline. At Firm B an analyst advised investors to sell the shares in 2002 and continued to do so while they plunged. An investor looking for a recommendation on the stock at the beginning of 2003 could receive Firm A’s report from Jaywalk, because its analyst’s ratings on the company were the most accurate during XYZ’s run-up in 2002. But by following Firm A’s advice, investors wind up with a loss of 30 percent after two more years. Even though Firm B’s performance was terrible in 2002, and thus would not have much of a chance of being selected and distributed by Jaywalk, its recommendation in 2003 to avoid the stock was a much better long-term call.

Rather than picking the best buy-and-hold plays, Jaywalk could be advising investors to buy high and sell low. Such a system certainly wouldn’t have done a better job than conflicted Wall Street analysts during the bubble.

These effects are magnified when firms issue just one independent report per stock and by the fact that investors are unable to see the ratings histories of the independent analysts and judge the quality of the research for themselves. Jaywalk doesn’t make this information public, but does provide it to the independent consultants. However, data are available only for the amount of time that an IRP has been part of the Jaywalk platform. In some cases this is two to three years. In other instances it’s a year or less.

“The problem is selecting research based on one to two years’ worth of data,” says Integrity Research’s Mayhew. “That kind of track record typically is not sufficient to pick a long-term winner as a money manager, and it’s also not a sufficient way to pick research.”

That doesn’t bother Fichtel, who says he is providing his independent recommendations to professors at Columbia Business School and Northwestern University’s Kellogg School of Management, who grade his performance quarterly. He says these reports so far show the research he selects using Jaywalk to be producing returns of 25 to 30 percent on an annualized basis. That compares with a 4.4 percent gain for the S&P 500 index for the 12 months ended June 30, which was the first year that independent research was distributed to investors under the settlement. But he won’t make the reports or the data behind them public.

“Investors have to make the assumption that I’m doing my job and looking out for their interests,” he says.

(All 12 independent consultants are required to file their first annual progress reports with U.S. District Court Judge William Pauley III, who approved the settlement, by October 31. It isn’t clear whether these reports will be made public, but one consultant who spoke with II says, “We are operating with the presumption that once they are filed they will make their way into the public domain, one way or another.”)

The Jaywalk system also may be contributing to rapid changes in ratings. Lehman turned over one third of its stock assignments in the first year of the independent research program, meaning that a different firm is covering a stock today than on day one, according to Fichtel. He and other consultants using the system say they’re also emphasizing nonperformance criteria, such as the readability of research reports and an IRP’s responsiveness to news and earnings reports.

An abundance of ratings changes is something that worries Patricia Chadwick, a former chief investment officer for money management firm Invesco and currently CSFB’s independent research consultant. “What’s concerning me most,” she says, “is that there’s a lot of turnover in recommendations on the part of the IRPs.” Rapid-fire trading may be fine for hedge funds and other sophisticated professionals, but for retail investors the transaction costs and capital gains taxes involved may make such a strategy pointless, she explains. “I see that and I ask myself, ‘How can this be value-added for the retail client?’”

John Meserve, Jaywalk’s president, agrees that moving quickly in and out of stocks isn’t advisable for most individual investors. But he contends that ratings turnover in the Jaywalk system has been limited. “Enormous swings in the ratings wouldn’t be good for the clients or the brokers at the firms” in the settlement, he tells II. “But that’s not our intention, and based on what we’ve seen so far, it’s not happening.” On the issue of making ratings histories public so clients can judge the reliability of independent research for themselves, he argues that ratings are the intellectual property of the firms that produce and get paid for them, not a public good. “The settlement firms are disclosing it to some extent, but no one is really paying attention to the track records. It’s not an issue that people are following.”

A MORE DIRECT WAY TO EXACT justice for investors who have been hurt by dishonest research, of course, is to require the firms responsible to make clients whole for their losses. The settlement attempted to do this by mandating total payments of $942.5 million for “penalties and disgorgement” -- $521.25 million for the states and $421.25 million for a federal restitution fund. (The state total is bigger because it includes $100 million that Merrill agreed to pay to the states in an earlier agreement.)

The restitution fund is composed of 12 smaller funds. The idea is to enable investors to submit claims for losses they incurred as a result of buying stocks on which settlement firms allegedly issued biased ratings. Each firm is liable for claims related to a handful of stocks, covering periods when their research was deemed to be misleading. About 50 stocks, mostly technology and telecom plays, are covered. Piper Jaffray clients who bought shares of JDS Uniphase Corp. through the firm between July 27, 1999, and October 25, 1999, for example, are eligible to make claims for losses in that stock. And investors needn’t have sold their shares to qualify: Unrealized losses also count. But investors who picked up on analyst recommendations in the media and bought the stocks in question through other means, such as online brokerages, are not eligible.

The final judgments issued against the firms further stipulate that if there isn’t enough money in a particular fund to pay all claimants, investors will be compensated according to the timing of their stock purchases and the sizes of their positions. Those who bought close to an allegedly dishonest buy recommendation get preference over those who waited longer. And although institutions may make claims, retail investors will get paid first. It’s possible that some firms’ entire funds will be exhausted and others won’t, depending on who files for restitution. It’s also possible that some investors will be compensated for all losses, while others will get just pennies on the dollar.

Investors have received nothing so far. The deadline to submit claims was July 29. Late claims were being accepted through September 30 but will be paid only if there’s enough money left in the funds after the on-time filers get their checks. Payments are required to be made no later than January 22, 2006, nine months after the U.S. District Court for the Southern District of New York’s approval of the distribution plan.(The settlement does not prohibit aggrieved investors from pursuing private litigation against the firms.)

Perhaps the biggest problem with the restitution fund is, quite simply, that it’s too small. If every eligible investor received an equal share, for example, the payments would come to about $5,700 each. That’s certainly better than nothing. But the losses investors sustained from heeding conflicted analyst recommendations could be far higher.

Consider JDS Uniphase. It closed at $34.26 per share, adjusted for splits, on October 25, 1999, the last day that investors could have bought it through Piper Jaffray and been eligible to make a claim. On July 29 of this year, the filing deadline, it closed at $1.51. An investor who bought and held just 200 shares throughout that period would have been sitting on a $6,550 loss. Any investors who owned more than such a relatively small stake, or owned more than one of the covered stocks, likely would have sustained losses equaling many multiples of the paltry sums the fund is capable of paying.

“The restitution money is really insignificant,” says plaintiff lawyer Zamansky. “Each person’s average share will be enough for them to get a cup of coffee at Starbucks or a hamburger at McDonald’s.”

Many investors appear to have figured this out and concluded that applying to the fund is more trouble than it’s worth. Francis McGovern, a law professor at Duke University who is serving as court-appointed administrator of the restitution funds, told the Los Angeles Times in late July that less than 50 percent of eligible investors had submitted claims. Contacted by II in early October, he declined to update that estimate, noting that he would be submitting to Judge Pauley by midmonth a full report on the level of claims filed.

But at least the federal money should eventually find its way into investors’ hands. Contrast that with what has happened to the $521.25 million paid by the settlement firms to the 50 states, which were represented in the deal by NASAA, the state regulatory group. This money was divided among the states according to population. In announcing the pact at the NYSE almost three years ago, Spitzer said that the fines paid by the defendants “can be -- and, we hope, will be -- returned to the investing public.” Hardly.

Most of the penalties paid to the states have instead been funneled directly into their general funds, helping fill budget gaps, or into projects that have nothing to do with justice for wronged investors. Why? Despite Spitzer’s press conference rhetoric, the final judgments against the firms do not specify how the state money is to be spent. Two years ago the SEC moved to put the state money into a dedicated restitution fund, but NASAA resisted the overture, arguing at the time that it would be too labor-intensive to identify all the wronged parties and that none would receive enough of a restitution payment.

Patricia Struck, Wisconsin’s state securities administrator and president of NASAA, referred inquiries about the settlement to Christine Bruenn, Maine’s commissioner of professional and financial regulation, who headed NASAA in 2002 and helped negotiate the pact. Bruenn did not respond to phone calls and e-mails seeking comment about what happened to the state disgorgement money. NASAA spokesman Robert Webster says that “how states spend this money really is dictated by state law within each jurisdiction. In some cases it has gone into the general fund for general state use. In others it has not.” California, Maine and Maryland are among the majority of states that put the money into their general funds. In the minority are North Carolina, which started its own investor education fund, and Mississippi, which hired more securities fraud investigators. One source involved in the settlement negotiations says that only a handful of states elected to spend the money on investor-related projects rather than funnel it into state general funds.

UNDERSTANDABLY, INVESTORS might hope for a better chance of reaping benefits from the settlement’s program of financial education. Unfortunately, they’re not getting much of a return on this money, either.

The final judgments against the firms call for eight of them to pay a total of $85 million for investor education. Of that, $55 million was designated to start a federal education fund. The SEC was to nominate a chairman and executive director for this nonprofit organization and oversee its operations. The $30 million in state money was given over to the Washington-based Investor Protection Trust, an education group founded in 1993 with funds from a previous securities misconduct settlement. The rationale behind this element of the pact, according to settlement documents, is “to equip Americans with the knowledge and skills necessary to make informed investment decisions.”

One curiosity of the education program, however, is that four of the settlement firms are exempted from contributing to it. One of these, Morgan Stanley, operates the country’s third-biggest retail brokerage, with more than 10,000 sales representatives around the country. Yet other firms with little or no retail business, such as Goldman and Lehman, are contributing to the fund.

The implementation of the education program has thus far been mostly an embarrassing failure. The federal effort, in particular, has been plagued by poor communication among the authorities responsible for it, a slow-moving bureaucracy and a good measure of questionable judgment.

After Judge Pauley approved the settlement on October 31, 2003, nomination of a chairman for the federal investor education foundation fell to the SEC. William Donaldson, then the agency’s chairman, turned to a close friend of nearly four decades, Charles Ellis, who had been a partner in the late 1960s at Donaldson, Lufkin & Jenrette, the investment bank Donaldson co-founded. Ellis left in 1972 to start consulting firm Greenwich Associates and has taught at the Yale School of Management, which Donaldson founded in 1976. Ellis gladly accepted. “Bill said, ‘I think you’d be a perfect fit,’” he recalls. “To me, it was a chance to say, ‘Thank you, America,’ for the good fortune I’ve had in my career.”

Things went downhill, however. On Ellis’s recommendation, the SEC nominated George Daly, then dean of New York University’s Stern School of Business, as executive director of the foundation. After being confirmed by Judge Pauley on March 24, 2004, Ellis and Daly were charged with establishing the nonprofit foundation that would put the $55 million to work. But the pair’s initial picks for directors of the entity -- including senior executives from big mutual fund houses the Capital Group, Fidelity Investments and Vanguard Group -- didn’t sit well with SEC officials, who feared bias in the education program toward those firms’ products. Also controversial were Ellis and Daly’s picks for an advisory board. Among these were Abby Joseph Cohen, a veteran portfolio strategist at Goldman, and Martin Liebowitz, longtime investments chief for retirement fund TIAA-CREF, who had just joined Morgan Stanley as a strategist. SEC officials, including thenenforcement director Stephen Cutler, who had negotiated the settlement alongside Spitzer, objected strongly to employees of defendant firms being involved.

Three months passed before Ellis and Daly could line up six directors who passed SEC muster, including former McGraw-Hill CEO Joseph Dionne, veteran financial journalist Carol Loomis and University of Massachusetts professor Sheila Bair, a former SEC attorney and Commodity Futures Trading Commission chairwoman. But the group didn’t hold its first meeting for another four months, a delay that Ellis attributes to vacations in July and August and scheduling snafus during September and October. And to the dismay of many of the directors, that first meeting was little more than an organizational session, during which lawyers from the firm of Wilkie Farr & Gallagher had the board slog through a raft of resolutions authorizing the hiring of staff, leasing of office space, contracting for professional services and other start-up functions. With a mandate for only four meetings per year, some directors were peeved that this work had not been done in advance and approved in one fell swoop so that the foundation could get on to making specific plans for educating investors.

“They hadn’t even put together a budget yet,” says one person who attended the meeting. “We thought we would be discussing ideas and making some recommendations about how to put this money to work for investors. Instead it was all housekeeping. It was very frustrating.”

Things got worse when Ellis and Daly began dealing directly with the court on implementing the education plan, rather than vetting things with the SEC first, as called for by the settlement. Ellis says that Donaldson indicated to him early on that the commission would take a hands-off role following the appointment of a board. (Donaldson declines comment, though one source familiar with his thinking denies that he gave Ellis such freedom.)

The lack of communication between the foundation and the SEC ultimately led to the group’s demise. Commission officials learned, to their dismay, that Daly had not been filing required quarterly financial reports to the court. There was also a kerfuffle over Daly’s compensation. The exact figures are not public, but people familiar with the matter say that he was earning in excess of $150,000 per year. That was less than his NYU salary but still more than regulatory officials deemed appropriate for the head of a nonprofit foundation whose primary mission was serving unsophisticated investors. (Ellis and the other directors were unpaid.)

The directors never met again. Instead, Donaldson asked that they huddle with him, Cutler and a third SEC official in New York, without Daly present. “It was made clear to us that it was important to the SEC that George step down,” says a person who attended the tense January meeting. Daly, who didn’t return calls seeking comment, announced his resignation in February. Frustrated at their lack of effectiveness, the remaining directors quit a month later.

Ellis and Daly had formulated ideas for the fund, which involved concentrating the $55 million in only a few programs to maximize its impact. They wanted to focus particularly on helping people take full advantage of defined-contribution retirement plans. But not one dime of the $55 million fund has gone toward educating even one investor.

Last month, Judge Pauley approved an SEC plan to transfer the money to the NASD Investor Education Foundation, a two-year-old organization formed in response to the collapse of the bull market and the ensuing wave of corporate scandals. Some investor advocates -- including the Investor Protection Trust -- objected to the plan, arguing that NASD, a self-regulatory organization that is owned and funded by its brokerage-industry member firms, can’t provide unbiased advice about the full array of investment options.

Elisse Walter, executive vice president for regulatory and policy programs at NASD and a director of the Investor Education Foundation, says that it has had strict standards regarding its grant recipients since its founding in 2003. “No one who has any affiliation with the securities industry or the foundation board can get any of the money, and grant recipients have to be nonprofit organizations,” she says. The foundation is also in the process of expanding its board from five to seven members so that a majority will not be affiliated with NASD or the brokerage business.

The IPT has been more successful, doling out some $1.7 million since last November on projects in 20 states, such as estate-planning conferences in Alabama and antifraud education targeted at Florida retirees, according to its Web site. (Through July 31 it had collected $11.5 million of the $30 million the settlement firms must pay it through 2008). But the trust also switched investment managers in April, after seeing the value of the securities in its portfolio decline by some $80,000 during the first quarter of 2005. Don Blandin, the IPT’s president, notes that the trust’s net investment loss during the quarter was just $28,000 when including gains from interest and dividends. The IPT’s new money manager, Trusco Capital Management, has trimmed the capital losses to $46,000 and boosted interest and dividend gains, resulting in a net investment gain for the year of $216,450 through July 31.

ALL OF THE PROBLEMS AND deficiencies of the settlement as it has been implemented can be traced back to one simple premise underlying its creation: that individual investors can and should buy individual stocks. Spitzer and other regulators promised “unconflicted” ratings so the little guy could breathe easy while following them. They pledged to educate the unsophisticated masses so they could tell good ideas from bad. And they said they would pay investors back for the dishonest advice that contributed to their postbubble losses.

But retail investors who buy and sell individual stocks often ignore widely accepted principles for building wealth in the stock market: diversification, the minimization of transaction costs and -- most important -- patience. Buying and holding a collection of low-cost index funds is often the best way to adhere to all three. That’s something that the brokerage and mutual fund industries, understandably, don’t like to talk about. Even professionals, who have much more capital, specialized training and lots of time to devote to investing, frequently fail to beat the market. Dentists, lawyers, plumbers, secretaries and cab drivers who, despite this fact, plunge into stocks anyway do so at their own peril.

Veteran Judge Milton Pollack, a colleague of Pauley’s on the U.S. District Court for the Southern District of New York, in 2003 cited these very sentiments in tossing out two class-action lawsuits alleging that Merrill analysts were responsible for retail investors’ losses. In one opinion Pollack -- who passed away at the age of 97 last year -- scolded the plaintiffs for trying “to twist the federal securities laws into a scheme of cost-free speculators’ insurance.” The facts presented in the case, he added, “show beyond doubt that plaintiffs brought their own losses upon themselves when they knowingly spun an extremely high-risk, high-stakes wheel of fortune.”

Even investor advocates like the Consumer Federation’s Roper are skeptical that research plays a big role in the investment decisions of individuals. “We think the number of individuals who actually read research reports and use them as a basis for buying and selling individual stocks is very small,” she says.

But assuming that some did pay attention and were hurt by misleading research, the best way to address such a situation would be to make them whole for their losses. Instead, the settlement money that could have been used for restitution either has been frittered away by the states or could return just pennies on the dollar through the federal fund. Spitzer and the other regulators could have more than tripled the size of the federal fund by adding in the $521 million in state money, plus the $545 million earmarked for independent research and investor education.

Investors have been asked instead to accept a deal that not only has failed to deliver most of what it promised but also has caused collateral damage to the capital markets. One particularly perverse unintended consequence appears to be less research for all investors. After the settlement banned firms from funding research departments with banking dollars, the firms instituted massive budget cuts. With compensation declining, experienced analysts quit. Today coverage is spread thinner, among fewer, younger and greener fill-ins. In 2000, 45 percent of U.S. public companies were covered by sell-side analysts, according to Reuters Estimates. That number dipped to 41 percent in 2003. It has rebounded to 46 percent today. An encouraging sign? Not at all: Research professionals say that much of the resurgence in coverage is coming from tiny independent research houses and boutique investment banks that cater almost exclusively to institutions like high-powered hedge funds, not to individuals.

And there is simply less research being done on the smallest public companies. Big Wall Street firms, forced to fund research out of slim institutional brokerage profits, are focusing on only the most widely held stocks. Coverage of companies with market capitalizations of less than $500 million -- almost 6,000 of the U.S.'s 8,780 public companies -- dipped from 30 percent in 2000 to 25 percent in 2003 and stands at just 27 percent today, according to Reuters. That’s not only a disadvantage for those retail investors who choose to pick their own stocks; it’s also hurting the ability of small companies, long a key driver of the U.S. economy, to raise capital, innovate and grow.

The attorney general cannot excuse his lack of follow-through by claiming that he’s merely a prosecutor. In the process of investigating, negotiating and announcing the settlement, he claimed a national regulatory mantle like few state-level enforcers before him, one that significantly heightened his political profile as he eyed the governor’s mansion in New York. To be fair, the SEC, NYSE and other regulators with broader authority were less than zealous about pursuing what was wrong with research.

But the settlement exists because of Spitzer, a fact that he was not shy about broadcasting three years ago. True, all of the law enforcement entities involved in the deal agreed that oversight of it would be best left to the SEC, as the nation’s securities regulator. But many of its terms were directly dictated or influenced by Spitzer. To turn around and disclaim responsibility for its implementation, particularly in light of how badly so many aspects of it are going, is asking investors -- and maybe voters -- to settle for less than they deserve.