Trying to Build a Wall on Wall Street

Will investment bankers have to keep their analysts separate?

Here's some good news for investors: The war on bad Wall Street research is picking up steam. New York State Attorney General Eliot Spitzer has convinced Merrill Lynch & Co. and securities industry regulators that they must do more to clean up stock analysts' acts. As a result, America's No. 1 brokerage plans to go substantially beyond rules drafted by the National Association of Securities Dealers and the New York Stock Exchange to rein in its analysts.

Spitzer is just getting warmed up. BusinessWeek has learned that Salomon Smith Barney star analyst Jack B. Grubman and several other employees have received subpoenas requesting documents related to Grubman's recommendations of troubled telecom companies. In particular, the attorney general is examining whether Grubman said anything negative in private about the telecom companies that he recommended publicly. Several have gone bankrupt, including Global Crossing, Teligent, FLAG Telecom, and Rhythms Net-Connections. Grubman did not return calls, and Salomon declined to comment.

Now, in addition to Salomon, Spitzer is targeting half a dozen other major Wall Street firms including Morgan Stanley, Credit Suisse First Boston, and Goldman Sachs. And his crusade against the Street is winning allies. The NASD, which has long been investigating analyst conflicts, is stepping up its cooperation. The Securities & Exchange Commission is following both probes closely. "It's possible they may bring their own proceeding," says Columbia University securities law professor John Coffee. The North American Securities Administration Assn., which represents state regulators of securities firms, may also follow in his footsteps. "There are some states that will consider joining the attorney general or bringing their own actions [against securities firms]," says NASAA President Joseph P. Borg. "This could be one of the biggest investigations in broker-dealer history."

Spitzer is gaining enormous leverage because industry insiders expect that if he cracks the code in managing analysts' conflicts in a deal with Merrill, he will try to apply the same model to the rest of the securities industry. He's likely to stop short of forcing investment banks to spin off research departments to prevent analysts from hyping stocks--one of his early proposals. And he may accept much less than the $250 million fine he sought initially from Merrill, according to sources close to the deal.

Merrill hopes to settle quickly, even though its former star Internet analyst Henry Blodget may still face criminal charges. For starters, it is offering to disclose any deal in the past three years with a company that's the subject of a research report. The NYSE and NASD--the industry's self-regulatory organizations (SROs)-- suggested only one year. It may also offer to disclose any deals in the works beyond the three months proposed by the SROs. Merrill wants to establish a separate board for its research department and give outside directors the final say on how its research is managed. The firm will also base its research analysts' pay partly on the performance of their stock picks--an idea Wall Streeters consider heretical.

That still may not satisfy Spitzer. He is pushing for a far greater degree of separation between analysts and investment bankers than the NYSE and NASD have proposed. He doesn't want analysts to get a dime from any investment banking deals; the SROs just want to stop bonuses for specific transactions. Likewise, the SROs would allow bankers and analysts to discuss the accuracy of research reports--provided they are monitored by lawyers. Spitzer could propose that communications between bankers and analysts be banned extensively.

State regulators in NASAA have their own ideas. They are considering suggesting to the SEC that bankers be prohibited from bringing analysts on road shows to sell companies to institutional investors. They also want the SEC to encourage analysts to stick to their guns by adopting a rule that forbids companies from retaliating against analysts who criticize them.

Breaking investment banks apart, as Spitzer first suggested, may not be the answer. But the banks can no longer afford to resist the growing pressure for real change. Investors won't follow advice unless they're convinced that analysts have changed their ways. And if brokers want a reminder of the high price of resisting, they need only consider the estimated $4 billion in class-action damages burned clients are now seeking from them.

By Emily Thornton, with Peter Elstrom in New York, and Mike McNamee in Washington

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