Near the Corner of Church and State (Update)

Efforts to insulate sell-side analysts from investment bankers will hurt some capital-raisers, but help others.

The changes are wide-ranging. For instance, Merrill agreed to create a new investment review committee responsible for approving all research recommendations. That committee will be shielded from both investment bankers and analysts.

Merrill also agreed to indicate if a company in a research report is also an investment-banking client. Upon discontinuation of research coverage of a company, Merrill will also issue a report disclosing the termination of coverage and the rationale for dropping a company.

But perhaps the biggest change: Merrill agreed to end the practice of tying analyst compensation to business origination. Instead, the bank will reward analysts’ for the accuracy of their forecasts and stock recommendations.

It’s likely that other Wall Street banks will ape many of these changes. Indeed, Salomon Smith Barney, the brokerage subsidiary of Citigroup, has already announced that it will overhaul the structure of its equity research department to mirror the changes at Merrill.

It remains to be seen, however, whether these curatives will truly remedy the problem, or merely heal Wall Street’s PR problem. “I’m not sure that the way they have settled the compensation issue yet is going to totally avoid conflicts,” says Louis Thompson, president of the National Investor Relations Institute. “But it will help get the wall back up.”

Coddled, Egged On

Some CFOs may actually benefit from the construction work started by Spitzer.

For one thing, a number of observers believe the attempt to shield sell-side analysts from in-house pressuring may actually lead to more financial discipline in boardrooms.

“In our opinion, one the most serious consequences of excessive bullishness (on Wall Street) is the incorrect signal sent to corporate managers,” notes David Tice, president of David Tice & Associates, an investment research and management firm, in a recent report.

In fact, when analysts indiscriminately touted stocks, pushing market caps through the roof, some executives suddenly stood to make millions by selling stock options. Such a scenario hardly fostered an evangelical fervor for financial discipline. In that frenzied environment, it paid for companies to pursue reckless acquisitions, expand into strange new businesses, and cleave to risky growth strategies.

What’s more, the lure of getting rich quick led many investors to pour money into highly speculative areas of the economy — sectors like technology and telecommunications. CFOs at less glamorous companies — traditional businesses with more normal earnings growth — found it difficult to be heard above the new economy din.

“The coddling of companies by analysts,” claims Tice, “fueled the massive over-investment in technology and diverted capital from other valuable sectors of the economy.”

Brutally frank research will benefit the best businesses. “Companies will no longer be able to count on guaranteed positive ratings,” says Roger Ibbotson, a professor at Yale’s School of Management. “And because they will no longer get false advertising, capital will flow where it is more deserved.”


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