On Closer Examination

Reform of sell-side research is creating a variety of new headaches for corporations.

In the spring of 2000, Bernie Ebbers, president and CEO of WorldCom Inc., called Scott Cleland “the idiot Washington analyst” because Cleland predicted that WorldCom’s proposed merger with Sprint would fail. The reference to Washington, D.C., was meant to disparage the analyst by pointing out that he wasn’t part of a big Wall Street firm. Today, Cleland wears the insult as a badge of honor.

Now founder and CEO of independent equity research firm Precursor Group Inc., Cleland says it was his distance from Wall Street that enabled him to see WorldCom for the troubled company it was. He was right about the merger, of course, and he was right again in early 2002, when he became the first analyst to predict the downfall of the company, which he called a “dead model walking.” “[Precursor] was one of the few to see it, because we didn’t have any investment-banking relationship with [WorldCom],” says Cleland, who cofounded the Investorside Research Association, an organization of independent research firms.

Not surprisingly, Cleland has no sympathy for the Wall Street research system he left behind after 10 years as an analyst with, among others, Legg Mason. He says the system has failed investors. “There should be no tears over reforming the false advertising and misrepresentation that has passed for sell-side research for so long.”

Right now, sell-side research hovers on the verge of real reform, triggered by New York Attorney General Eliot Spitzer’s crusade. Reform proposals are intended to eliminate the conflicts of interest that led sell-side analysts to grant “buy” recommendations and other favors to investment-banking clients they privately derided. As part of a more than $1.4 billion settlement Spitzer brokered with the investment banks over various misdeeds, 10 Wall Street firms, including Merrill Lynch, Credit Suisse First Boston, Smith Barney, and Morgan Stanley, will be required to pay $900 million in “retrospective relief” for investors, $450 million over five years to fund research from independent companies, and another $85 million for educating investors.

The settlement, as well as new rules from the National Association of Securities Dealers, the New York Stock Exchange, and the Securities and Exchange Commission, will also prohibit investment banks from subsidizing their research arms or influencing analysts’ pay, and require analysts to disclose relationships with the companies they follow. An additional directive from the SEC will require analysts to certify that their reports reflect their true personal views.

All of this is sure to improve the overall quality and integrity of research, which in the broader scheme is a very good thing for the U.S. financial markets. Yet the blow to the economics of research is real, and at least in the short-term, this means that companies will have to struggle with coverage that is less available, more critical, and sometimes confusing to investors.

Part of the problem is that research just doesn’t generate investment-banking-scale revenues, so many firms are cutting back on analyst staff. In fact, the number of analysts had been dropping since the end of the boom, when much of the investment-banking business dried up. In the spring of 2000, Thomson First Call, which publishes analysts’ earnings estimates and research, carried 28,500 total individual analyst recommendations. Today that number has dropped to 24,500.

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