Commentary: Wall Street's Chinese Walls Aren't Strong Enough

By Emily Thornton

Fighting off lawsuits and arbitration cases filed by disgruntled investors is becoming routine for Wall Street. On Aug. 7, investors in AOL Time Warner Inc. (AOL ) alleged in a suit that Morgan Stanley's star Internet analyst, Mary Meeker, issued misleading positive stock recommendations to land lucrative investment-banking deals. The suit follows similar ones against Meeker involving Inc. (AMZN ) and eBay Inc. (EBAY ) Morgan Stanley Dean Witter & Co. dismisses the suits as publicity stunts. "Ms. Meeker, whose integrity is beyond reproach, is one of the most respected analysts on Wall Street," it stated.

Already, the litigation is hitting investment banks' bottom lines. In early summer, Merrill Lynch & Co. agreed to shell out $400,000 to settle an arbitration complaint seeking $10.8 million against star Internet guru Henry Blodget on similar grounds. All claims against Blodget were dropped. And now, investment banks are facing 137 class actions charging them with allocating initial public offering shares unfairly and manipulating stock prices. Research outfit Securities Class Action Services LLC figures they could cost Wall Street as much as $1 billion.

The cases highlight that investment banking is a business built on inherent conflicts of interest. The banks have always walked a thin line between raising capital for companies, advising investors, and trading stocks for their own accounts--activities often in direct conflict. The 1999 repeal of the Glass-Steagall Act, which separated commercial and investment banking, makes the balancing act even more delicate.

Indeed, there has been a dangerous thinning of so-called Chinese walls within investment banks to which even regulators have paid scant attention until lately. Originally designed to stop insider trading, the walls are lousy at keeping those in the business of landing investment-banking deals separate from those who are supposed to issue objective research. "There needs to be a firm delineation between the role of a security analyst and the role of a new business proponent for an investment bank," says Samuel Hayes, member of a review board of the House Financial Services subcommittee on capital markets.

LOSS-LEADER. A new code of conduct, issued in June by the Securities Industry Assn., is an attempt to rebuild those walls. It states that research analysts should not report directly to bankers. It also lays down that bankers should not determine analysts' bonuses. So far, 13 brokers have signed on to the new rules. And while some firms have now banned analysts from owning stocks they cover, on Aug. 8, Goldman, Sachs & Co. refused to go that far: It will simply require disclosure.

Such efforts are far from enough. No one, for example, is considering stopping analysts from promoting deals at sales road shows. Indeed, Wall Street hates that idea. Analysts make excellent salespeople, since they often know CEOs better than the bankers. That's crucial to the bottom line: Investment banking accounted for about 68% of the top five brokerages' $28 billion in 2000 earnings. Research is a loss-leader, says Putnam Lovell Securities Inc.

With so much at stake, rules already on the books must be enforced. SEC acting Chairwoman Laura S. Unger told Congress on July 31 that though investment banks are required to monitor employees' shareholdings, most couldn't identify analysts' holdings in companies their banks took public. The SEC or the National Association of Securities Dealers must discipline analysts who short stocks while telling investors to buy.

Regulators should also insist that conflicts of interest be clearly disclosed. And strict guidelines are needed to end analysts' "booster shots"--glowing research reports--six months after an IPO. "That's a form of commercial prostitution," says John C. Coffee Jr., professor at Columbia Law School.

But investors still need to be on their guard. "Analyst conflicts are as inevitable as death and taxes," says Coffee. The only sure way to avoid them: Seek out independent research.

Thornton covers investment banks in New York.

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