A lot of people are paying very close attention to Wall Street research these days -- congressional investigators, state attorneys general, federal prosecutors, plaintiffs’ lawyers. Not to mention investors. Having pumped up the technology stock bubble, missed signs of corporate skulduggery and gotten caught up in scandals of their own for being duplicitous and too cozy with investment bankers, securities analysts, the erstwhile stars of the bull market, now find themselves in disrepute, even disgrace.
Their misdeeds are all too well chronicled. Telecommunications specialist Jack Grubman, the poster boy for the analyst-as-investment-banker, resigned from Citigroup/Salomon Smith Barney in August, just before regulators charged him with producing misleading research about the now-bankrupt Winstar Communications. Former Merrill Lynch & Co. analyst Henry Blodget’s private disparaging of the very Internet stocks he rated positively led to the landmark $100 million settlement between Merrill and New York State Attorney General Eliot Spitzer. Then, after Merrill fired highly respected conglomerates analyst Phua Young in April for allegedly leaking research before it was published, news reports revealed that Young had exchanged gifts with disgraced former Tyco International CEO L. Dennis Kozlowski, who, the reports said, had influenced Merrill to hire Young in 1999 because of his favorable outlook on Tyco. Young has denied any wrongdoing.
“This is clearly the most significant scrutiny that Wall Street research has ever been under during my tenure on the Street,” says Morgan Stanley & Co. research chief Dennis Shea, a 17-year industry veteran. “There were a lot of bad practices out there, and they needed to be corrected.”
Much of the abuse and bad behavior is being corrected, as a host of changes, minor and major, are demanded by investors, required by regulators or offered as a sop to an outraged public by reeling investment banking firms. But will any of this help Wall Street research restore its good name? Or is its reputation too far gone to bother?
“The caricature of research that has been created is of research analysts sitting in their offices dreaming up ways to deceive the retail investor -- that’s just not true,” insists Lehman Brothers global research chief Joseph Amato. “Sure, there are conflicts, and there have been some abuses. But the reality is, what we do is vitally important to the efficient allocation of capital in the economy. Our research adds a tremendous amount to the collective knowledge of the investors who are making the decisions about which companies get funded and which don’t.”
Amato is right. For better or worse, Wall Street research is critical to the smooth functioning of the capital markets, which in turn underpin the economy. Much more is at stake than the reputations (and bonuses) of a few thousand anxious analysts or those of the firms that employ them.
Begin with the structure of the markets themselves and the vanishing investor faith in them. “The objective is to restore investor confidence,” says Goldman Sachs Group CEO Henry Paulson Jr. “And we think there is real value in constructive discussions with our regulators.”
The most extreme of the reforms proposed would completely separate research from banking. As part of its settlement talks with regulators, including the NASD, the Securities and Exchange Commission and Spitzer, Salomon has reportedly offered to do this, as long as the rest of the Street follows suit. SEC chairman Harvey Pitt reportedly has decided to push for such an industrywide separation. This situation may well be politically necessary.
“When I first broached the idea, soon after the Merrill Lynch affidavit, people reacted with shock, saying it was naive and impossible,” Spitzer says. “Now the spectrum has shifted.”
But such a split could easily backfire. It’s unquestionable that much of Wall Street research was deeply flawed and sometimes intentionally deceptive during the last stages of the bull market. But the fact remains that since fixed brokerage commissions were outlawed in 1975, no investor, retail or institutional, has been willing to pay enough to make research profitable on its own. Inevitably, removing investment banking support, directly or indirectly, will lead to drastic cost-cutting. That will mean that far fewer companies will be covered and far fewer analysts will be around to cover them. In the long run, will this be better for investors?
“Everyone is going to halve their budgets for research this year,” says the head of investment banking at a major Wall Street firm, grimly. “And if markets don’t change, it’s not unreasonable to think that you just shut it down.”
Some observers worry that separating banking and research could represent the first stage of a reversal of a four-decade process in which scores of tiny firms that specialized in one niche or another of finance were assembled to form today’s efficient global powerhouses. Consider Morgan Stanley, which barely 30 years ago had 200 employees and no capital markets or research business to speak of. If conflicts of interest are the problems that regulators want to solve, worry some, why not take disaggregation a step further and once again separate corporate advisory work and underwriting from the distribution of securities? Clearly, the interests of sellers and buyers are at odds. But putting the two sides together is the fundamental intermediary role of Wall Street.
“Look, we sit between the buyers and the sellers,” says the head of research at a large firm. “Without the product, there’s nothing for investors to buy and sell.”
HOW DID ONCE-RESPECTED Wall Street researchers get themselves into this mess in the first place? History provides an illuminating perspective.
Modern Wall Street research started in 1959 with the birth of Donaldson, Lufkin & Jenrette, which offered in-depth reports about specific stocks to the investment management companies and corporate pension funds that were beginning to dominate the market. DLJ’s analysts focused on only a handful of companies in specific industries, enabling them to provide a level of depth and insight that buy-side customers could not attain themselves while managing diverse portfolios. The firm more than offset the costs of producing such research by asking customers to pay them back with orders sent to their trading desk -- for any stocks, not necessarily the ones it reported on. Because most institutions were looking for stocks that were going to rise, not fall, research even during this otherwise golden era was almost always positive, though not blindly so (Institutional Investor, October 2001).
DLJ quickly spawned countless imitators eager to turn the giant institutions’ appetite for stocks into commissions and profits. But life changed on May 1, 1975, when the government deregulated brokerage commission rates, which plunged from 25 cents or more per share to about a nickel per share today. Research became a money loser; the silver lining was that the discounted rates only increased retail investors’ hunger for securities. That helped drive a boom in underwriting. Soon research departments were cooperating more closely with corporate finance -- on mergers and acquisitions, IPO road shows and deal pitches -- which picked up one third to one half of the high-priced research budgets at major securities firms. At the biggest houses it costs from $500 million to $1 billion to run a global operation, according to Wall Street research managers. That’s easily 25 percent of many firms’ annual profits.
Research soon became as much a promotional tool for bankers and their corporate clients as it was a source of unbiased intelligence for investors. Compensation schemes for researchers -- bonuses based on banking work, permission to invest in pre-IPO shares of companies they covered -- further tainted their analytical rigor.
Sophisticated institutional investors understood many of these conflicts and largely disregarded ratings and price targets, looking instead for nuggets of value and analysis in long written reports or in private conversations with analysts. But what worked for savvy investors was lost on the throngs of individual investors who bought stocks on their own -- many for the first time -- during the tech boom. Their losses, disenchantment and withdrawal are a major factor in the current paralysis in the capital markets.
“The No. 1 goal of Wall Street right now is to restore the confidence and trust of investors,” says Alfred Jackson, head of global research at Credit Suisse First Boston. “I think everything you see happening right now, and there’s certainly a lot of activity, is directed at that one goal.”
Until this year little in the way of reform was happening, despite investor anger. Wall Street dug in its heels when the backlash against research first began early last year. Following an April 2001 story by Institutional Investor on analysts’ stock ownership and trading practices, several sell-side firms either barred or severely restricted analysts from owning stocks that they cover. But further reforms were slow in coming. Some firms made cosmetic changes to their multitiered, often opaque, ratings systems. On the eve of June 2001 congressional hearings about analyst conflicts, the Securities Industry Association, the Street’s main trade group, offered up tepid, voluntary “best practices for research” that largely codified the status quo and failed to placate lawmakers. But the attacks of September 11 and the beginning of the war on terrorism eclipsed the ills wrought by overpaid stock pickers, and the outrage over research subsided.
The wave of corporate scandals and damning indications of alleged analyst misconduct brought to light by Spitzer changed all that in a hurry. Regulators and Congress -- poring over literally millions of internal e-mails, analyst employment contracts and other documents provided by brokerage houses -- have imposed new strictures on the industry as they pursue investigations into potential criminal wrongdoing.
As government queries intensified and the threat of criminal charges grew more real, individual firms acted on their own initiative. Credit Suisse First Boston, J.P. Morgan and Salomon Smith Barney voluntarily adopted reforms called for under the Merrill settlement. Among these measures: evaluating and determining the compensation of analysts must be conducted independently of the firm’s investment banking business; analysts must notify investors when discontinuing coverage of a company and explain why coverage is being dropped; each firm promised to create an investment review committee to ensure that all research recommendations are independent from banking concerns.
In April Morgan Stanley replaced a four-tiered rating system that was weighted heavily toward positive recommendations to a simpler, three-tiered one. Analysts now rate stocks as “overweight,” “equal weight” or “underweight” in relation to other stocks in the same sector, roughly equivalent to buy, hold and sell ratings. The change was more than mere euphemism. After the shift 22 percent of Morgan Stanley’s recommendations fell into the underweight category. Overweight made up 33 percent, and 45 percent were equal weight. Most major investment banks, including CSFB, Goldman Sachs, Lehman and Salomon, have followed Morgan Stanley’s lead and adopted similar systems.
Goldman, borrowing from journalism’s toolbox, appointed an ombudsman, longtime firm executive and former head of the Federal Reserve Bank of New York, E. Gerald Corrigan, to monitor the research department and root out behavior that conflicts with the interests of the firm’s investor clients.
“We’ve set up a hotline for him so that the analysts can contact him independent of research management if necessary,” says Andrew Melnick, Goldman’s co-head of global research. At the same time, Goldman elevated Melnick and co-head Suzanne Nora-Johnson -- a former investment banker -- to its management committee in an attempt to foster independence. The pair have asked Goldman board members who sit on the firm’s compensation committee to review both individual analysts’ pay packages and the process used to determine them.
In August, before it proposed totally separating its research and banking operations, Salomon Smith Barney appointed former chief technology officer Robert Druskin as president of the firm, a move designed in part to better wall off research from banking, by putting an extra layer of management between Salomon’s top research officials and its CEO, Michael Carpenter (who was subsequently pushed aside). Druskin is responsible for research, risk management, finance, legal and other divisions, but not investment banking. Salomon now prohibits its analysts from accompanying bankers to pitch underwriting or advisory business to public companies -- though not to private enterprises seeking to go public -- and bans researchers from taking part in road shows designed to market public offerings to investors.
The entire Street has been busy hiring additional legal and compliance professionals to help enforce provisions in new regulations that require the monitoring of virtually any research-related communication between bankers and analysts. Many research departments are holding intensive training for analysts to ensure that they comply with all aspects of the new regulations. Lehman Brothers, for example, requires analysts to sit through daylong seminars explaining the ins and outs of the new rules. Lehman global research chief Amato says he has contacted every company his analysts cover to make sure that they understand that analysts can no longer provide them with draft research reports that include a rating and a price target.
Even the tiniest violations are putting analysts on the unemployment line. In addition to canning Young this spring for allegedly distributing unapproved research, a charge he denies, Merrill fired Peter Caruso in August. Caruso got the ax for musing during a conference call about the possibility that he might downgrade Home Depot. He declines to comment but has publicly contended that that he did nothing wrong when he downgraded the company from strong buy to neutral the next day.
Regulators have also imposed reforms. After Congress and the SEC pressed Wall Street to go beyond its anemic “best practices” proposal, the New York Stock Exchange and NASD, the industry’s main self-regulatory organizations, proffered a package of rules requiring more prominent, detailed disclosure of conflicts and limiting the influence of investment bankers on research. Approved by the SEC in May, the rules became fully effective on September 9. An important provision requires firms to display, on the first page of research reports, their firmwide distribution of buy, hold and sell ratings. That lead page must also have a graph showing the recent performance of the stock being discussed, correlated with the analyst’s past recommendations. Compliance officials must monitor and document any communication between bankers and analysts related to research reports. The rules also prohibit bankers from supervising analysts, bar anyone in a firm from promising positive research to companies in exchange for banking business and ban firms from linking analyst compensation to specific investment banking deals that researchers may have helped to land.
Last month the NASD added bite to its bark when it sued Salomon, Jack Grubman -- the firm’s former star telecommunications analyst -- and an assistant, Christine Gochuico, for allegedly producing misleading research about now-bankrupt local exchange carrier Winstar Communications. Salomon settled the NASD suit without admitting or denying guilt, but paid a $5 million fine, the third-largest levy in NASD history. Grubman and Gochuico are contesting the charges.
Still more rules, regulations and settlements are all but certain. Despite voluntarily adopting the “Spitzer principles,” for example, firms like Salomon and CSFB remain targets of the investigations the New York AG is coordinating with several other state regulators. Last month Massachusetts Secretary of State William Galvin, whose office is handling the probe of CSFB, recommended that Spitzer bring criminal charges against CSFB for issuing misleading research.
The SEC, not to be outdone, has stepped up compliance examinations of research departments and intends to propose a set of comprehensive rules that will create uniform standards from the various reforms imposed by the stock exchanges, state regulators and individual firms. “Chairman Pitt and I have recommended to our colleagues that we undertake a comprehensive rulemaking to establish rigorous, uniform national standards,” says newly confirmed SEC commissioner Harvey Goldschmid. “This would create certainty and fairness, and everyone will understand the rules of the game. The basic rules for how broker-dealers ought to operate in this area should be made on a national level by, or at the direction of, the SEC.”
The SEC has proposed Regulation AC (Analyst Certification), which would require analysts to certify in their research reports and public appearances that the opinions they express to investors about companies are consistent with their personal views. The proposal is still open for public comment and subject to final approval by the commission, but Salomon and CSFB have voluntarily adopted it. Goldschmid won’t speculate about what else the SEC might propose, but people familiar with the agency’s thinking say that barring analysts from banking pitches and road shows is high on the list. Last month The Wall Street Journal reported that Pitt was considering requiring Wall Street to sever all connections between investment banking and research.
INDEED, REGULATORS AND research officials alike now speak of the complete separation of research and banking as a foregone conclusion, though it remains far from certain what form such a split will take. The possibilities include spinning research departments off as separate companies. It is more likely, however, that they will become distinct subsidiaries of Wall Street firms, which will continue to own them and distribute the reports they generate to investor clients.
The effects of such a structure would be pervasive. For one, the freestanding research units will probably be left with two options for funding themselves: direct contributions of revenue from the brokerage operations they support -- that is, a cut of the commissions -- or annual budget allocations from a parent company. In the first case, the lack of funds from investment banking will mean dramatically smaller research budgets. In the second, research managers will face annual battles for money with no clear-cut method for demonstrating the value of research to their firms.
Either way, research is going to have to cost a lot less to produce. That means fewer and far lower-paid analysts -- and less research. Assuming that the regulatory framework takes several more months to firm up, say research officials, the impact won’t be felt until the 2003'04 bonus season, a little over one year from now. But hit it will.
Many expect that large numbers of analysts will decamp, probably to the buy side, which continues to expand its research ranks, partly in response to the declining quality of sell-side research during the late 1990s. Hedge funds, voracious consumers of research, are likely takers of top talent.
All of this portends serious competitive implications for Wall Street. On the face of it, firms like Salomon, Merrill and Morgan Stanley may be able to better cope with the new economics of research, thanks to their retail brokerage operations, which will supplement institutional commission revenue. Firms like Lehman Brothers and Goldman Sachs that primarily serve institutional brokerage clients may have a tougher time competing in the new environment. “We have an economic model that can afford equity research with just two revenue streams -- retail and institutional equities,” says the head of research at one major diversified firm. “If you’re an institutional-only firm, the new economics of this business are probably going to be more painful for you.”
That may be looking at a debased coin from only one side, however. The flip side is that leading research firms, unable to leverage their top analysts to pitch for underwriting business, may find it harder to compete with a Goldman and its long-standing, powerful banking relationships.
THIS FLURRY OF CHANGES already is having a positive effect. It has encouraged a return to in-depth, kick-the-tires research. After years of taking CEOs and CFOs at their word, more analysts are conducting independent surveys and consulting other sources to corroborate the truth about the companies they cover.
“After the market broke the buy side didn’t want to get calls telling them about new stocks to buy,” says Kevin McCaffrey, Salomon’s head of U.S. research. “They wanted to know more about existing positions. They wanted analysts to dig deeper and give them the full picture on how risky those stocks were.”
Late last month, for example, analysts from Merrill and Banc of America Securities simultaneously exposed the use of derivatives contracts by Electronic Data Systems Corp. Those contracts, exercised over the past several months, obligated the company to purchase millions of its own shares at above-market prices. Puzzled by the company’s warning of a massive quarterly profit shortfall, the analysts pulled apart EDS’s financial statements and learned of the obligations. EDS’s share price promptly fell from near 20 to the low teens.
“People are getting back to basics,” says Margo Vignola, associate director of research at BofA. “You still hear people on the morning call saying, ‘XYZ changed their guidance,’ but now you hear them also say, ‘This dovetails with what we hear from suppliers.’ They’re trying to make sure they verify whether what the company says is true or not. That may seem simple, but a lot of people were not doing it during the bull market.”
To hear the buy side tell it, that’s all it ever wanted. “We rely on Wall Street research for its information, not its judgments,” says James McDonald, head of research at $327 billion-in-assets money manager Northern Trust Corp. “Sell-side analysts do a tremendous amount of work. They have huge staffs that can do a lot of industry research and number-crunching.”
Normally, lower pay attracts less talent. But some believe that by reducing compensation and lowering profiles, Wall Street may attract a more committed, less purely money- and publicity-hungry sort to the research profession.
“The importance of sales and marketing skills will be less, and you’ll need to be hiring more of the green-eyeshade types,” says Leslie Peyton-Gordon, a recruiter for executive search firm Korn/Ferry International. “You don’t have to pay people $5 million or $25 million a year to analyze balance sheets and income statements.”
Adds Morgan Stanley research chief Shea: “Now you’re getting down to the people who really have the passion and the talent for the business. If you can remove the emotion from it, it’s always more interesting to be an analyst in a bear market than in a bull market.”
Recent changes to firms’ ratings systems have created far more balance in the distribution of positive and negative recommendations. During the boom years “sell” ratings and their equivalents were all but unheard of, as analysts either sought to please current and potential investment banking clients or suspended disbelief in an ebullient market. As recently as April sells were still scarce: Only 3 percent of ratings fell into that category, while 62 percent had a buy or equivalent rating and 35 percent were in the hold category (Institutional Investor, May 2002). But by mid-September 7.3 percent of all stock ratings fell into the sell category, a tenfold increase from the nadir of 0.7 percent in May 2000, according to First Call/Thomson Financial. Still, a majority of ratings, 54.2 percent, remain buys.
“These numbers are only an indication of the direction we’re moving in and not where we’re going to end up,” says First Call research director Charles Hill. “I wouldn’t be surprised to eventually see the percentage of sells in the low teens.”
Investors, after fuming for years at the deterioration in the quality of analysis coming from big brokerage houses, notice the change. “The firms are all trying to distinguish their research abilities from everyone else,” says one portfolio manager for a state investment system. “They are more conscious of quality and separation from corporate finance.”
BUT HOW MUCH OF THIS IS merely good behavior while the cops are looking? And does it really make a difference? Securities firms were supposed to have erected a wall between research and investment banking long ago. But the abuses of the 1990s showed that wall to be porous. Are corrective actions all that is necessary, or is a fundamental restructuring of research the only way to restore investor confidence?
The ultimate solution requires cooperation not just from securities firms but also from investors. As long as analysts’ paychecks are funded in part with banking revenue, the potential for conflict, and the appearance of conflict, will persist.
“I’m still concerned that research can’t stand on its own two feet economically,” says First Call research director Hill. “If you put enough barriers up, the conflicts aren’t going to be as direct as they used to be, but I still think you have a problem if the analyst knows that ultimately investment banking is important to his paycheck. You can put all the rules and regulations in place, but let’s face it, people are going to be having conversations down the hall and behind closed doors about who should get more and who should get less.”
Adds Patricia Walters, director of professional standards for the Association of Investment Management and Research, a group of primarily buy-side analysts: “There are loopholes in the Ten Commandments. Thou shalt not kill -- but it’s okay in self-defense. When you’re talking about rules based on ethical principles, people will always look to get around them.”
Still, those willing to pay full freight for research, like hedge funds, will be served better. Wall Street has tried to capitalize on this phenomenon by creating customized research. That, of course, only introduces another kind of conflict: Should different classes of investors, or customers, be given different kinds of analyses? The obvious economic answer is yes -- some folks can afford to buy a Mercedes, some a Hyundai -- but it may not be one regulators want to hear, and it may not be one that suits an industry with an image problem.
No one pretends that bringing back artificially high fixed commissions is the answer. But the buy side can no longer expect a free ride on research. To get quality, it must find a way to pay for it. One possibility is unbundling the various services that the sell side provides to institutional investors -- research, trade execution and fund distribution -- all currently paid for with ever-shrinking brokerage commissions.
Some investors see a cluster of independent research boutiques -- essentially, the second coming of what DLJ and the first research firms were in the early 1960s -- as a new paradigm (see story). But these small shops will ultimately face the same economic limitations that forced the original research boutiques to spread their costs over a wider revenue base.
If the traditional model of research provided by investment banks is to have a future, the companies analysts cover will also have to do their part to minimize conflicts. Corporations are always likely to push for positive coverage regardless of whether investment banking is separated from research. AIMR, the analysts’ professional organization, has released “research objectivity standards” that not only focus on sell-side analysts and firms but also call upon corporations to end the retaliation that so often follows negative ratings by an analyst. Among the more infamous examples of such blackballing: ThenFirst Union Corp. CEO Edward Crutchfield in 1996 banned DLJ analyst Thomas Brown from setting foot in company headquarters after Brown criticized the bank. Brown was later fired after clashing with DLJ bankers over his bearishness on the industry. Last year Qwest Communications International’s then-CEO, Joseph Nacchio, held a special conference call to rail at a downgrade of the company by Morgan Stanley analyst Simon Flannery, who was subsequently prohibited from asking questions on Qwest earnings calls (see People).
But without any enforcement power, AIMR can only hope to shame and cajole companies into changing their ways. “It really is in companies’ best interest to have independent research,” says professional standards director Walters. “Investors are more likely to believe the good news if they think it’s an independent opinion.” AIMR is soliciting comments on its proposed standards through October 17.
The most likely path to radical reform is for Congress or the SEC to draft a blue-ribbon panel of sell-side, buy-side and corporate executives, along with other interested parties, to try and create a new system for producing, delivering and paying for the kind of in-depth research that Wall Street created more than four decades ago, when the financial rewards for doing so were greater. “That’s the only way I see to really fix the fundamental problem,” says First Call’s Hill, who began his career as a sell-side analyst more than two decades ago.
Without such a solution, Wall Street research may survive, but its integrity will be forever in doubt.
“Clearly, we’re looking for a new model,” says famed investor and former sell-side analyst Mario Gabelli, CEO of Gabelli Asset Management. “The problem is, you don’t have a payment mechanism, because the nickel a share isn’t going to carry it. For now, it’s a work in progress.”
For recent articles on Wall Street research, its history and conflicts, please go to www.institutionalinvestor.com/research .
