Commentary: Clean Up, Wall Street--or the Feds May Do It for You

By Mike McNamee

Whom do Wall Street analysts serve? If you say "investors," you probably think a "hold" rating means you should hang on to your shares. The fact is, for most big firms, research is just salesmanship, and stock ratings are tools to court investment-banking business. During the Internet boom, analysts out to win hot initial public offerings for the likes of (AMZN ) and (PCLN ) competed to set sky-high price targets and buried the stocks' risks--giving investors no warning of the huge losses that lay just ahead. And it wasn't just tech analysts who blew it: While the Standard & Poor's 500-stock index was falling 14% during 2000, 99% of analysts' ratings were "buy" or "hold."

WHAT WALL? Increasingly, investors are on to analysts. And so are the Securities & Exchange Commission and Congress. To head off mounting political heat, the Securities Industry Assn. has sped up work on a voluntary code of conduct for analysts. The code, due just before congressional hearings in mid-June, will urge firms to rebuild the thin "Chinese walls" that are supposed to separate research and investment banking. It could also recommend that firms quit paying analysts bonuses based on the success of IPOs.

But a code drawn up in secret by industry insiders is hardly enough. The issue is credibility--in short supply on Wall Street these days. Investors and regulators should insist on a tougher code drawn up by outside experts and verified by outside auditors. That code should include detailed disclosures that say which analysts have helped sell the stocks they're covering. And it should ban analysts from doing research on stocks they own. Otherwise, Wall Street leaves itself wide open to an investor backlash that could fuel stiffer regulation.

Analysts have always been prone to conflicts. Research costs money, and firms expect analysts to pay their way by helping to sell stocks. But the Net IPO boom worsened what ex-SEC Chairman Arthur Levitt Jr. decried as "a web of dysfunctional relationships." As Net stocks hit the stratosphere, analysts turned into cheerleaders to help investment bankers win IPOs. Many even issued favorable reports--known within the industry as "booster shots"--around the time company managers became eligible to sell shares.

ACTION. Now, Acting SEC Chairman Laura S. Unger warns that analysts' "blatant conflicts" are undermining confidence. And the House Financial Services Committee will hold hearings on whether analysts "are crossing the fine line between research and merchandising," says Representative Richard H. Baker (R-La.).

The SIA's response: Push for release of Wall Street's code. The panel is likely to recommend that research departments report only to top management and that analysts' bonuses be based on firms' overall profits, not on the business they help bring in. But those steps, while worthy, aren't enough. Merrill Lynch & Co. already separates its analysts' pay and supervision from its banking arm. Yet its Internet analyst, Henry Blodget, is the poster boy for bulls who sent IPOs skyrocketing.

A better code is likely to come later this year from the Association for Investment Management & Research, a professional society that trains and sets ethical standards for analysts. Its task force on "research objectivity standards" includes institutions and individual investors with a stake in getting unbiased analysis. It is likely to argue for stricter rules on stock ownership, pay, and disclosure. And brokerages that claim to follow the code would have to submit to outside audits to prove that their analysts are above sales pressure.

Burned investors have learned not to trust analysts' recommendations. So they're hardly likely to take Wall Street's word that it's cleaning up its analysts' act. Regaining credibility is the name of the game--and an insiders' code of ethics isn't the way to make that happen.

McNamee covers investing from Washington.

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