Commentary: The Overhaul Wall Street Really Needs

By Amy Borrus and Mike McNamee

The Bush Administration never tires of extolling the virtues of the Investor Class. Putting information in the hands of investors, a favorite Administration mantra goes, empowers them to make smart financial investments that ultimately enrich the U.S. economy. But what if the sources of the information are so enmeshed in conflicts of interest that the advice they give is tainted?

That concern is at the heart of the widening scandal over the cozy relationships between Wall Street analysts and their investment banking colleagues. Revelations that analysts knowingly misled investors in order to pump up banking fees have already unleashed the fury of New York State Attorney General Eliot Spitzer upon Merrill Lynch & Co. (MER ) The two sides are now trying to hammer out a settlement that would impose changes on the way Merrill's analysts do their jobs, and other big-name firms may be next.

Now, Securities & Exchange Commission Chairman Harvey L. Pitt, under increasing political pressure to crack down on Wall Street, is stepping up the SEC's efforts. On May 8, the SEC imposed rule changes that force analysts to limit and disclose contacts with investment banks.

The SEC action couldn't come soon enough for Pitt. His ties to former clients have put his credibility on the line. The latest revelations haven't helped: Pitt met with the chairman of KPMG International (KCIN ), an ex-client now under SEC investigation for its audits of Xerox Corp. (XRX ) Pitt denies discussing Xerox with KPMG, but the incident has revived doubts about his independence and grit.

So how hard-hitting are the SEC rule changes? Brokerages must reveal whether companies they rate are or are likely to be banking clients. Any communication between bankers and analysts prior to a research report's distribution must go through the firm's lawyers. Brokerages must also tell investors how their analysts' stock ratings correlated with changes in stock prices. The new rules also stop the practice of paying analysts bonuses for help on specific investment banking deals.

That's a nice start--but it's hardly enough. As the ugly e-mail exchanges between Merrill Lynch analysts and bankers make clear, Wall Street needs higher walls and tougher policing to ensure the advice investors get is free from banking pressure. Moreover, the rules were drawn up before Spitzer's revelations. If current probes by New York and the SEC uncover deeper corruption, pressure for tougher action will grow.

How so? For starters, the SEC should do more to prod brokerages to sever, not just trim, the link between analysts' pay and banking fees. The Association for Investment and Management Research (AIMR), which runs the Chartered Financial Analyst examinations, thinks research quality should determine pay. "Until Wall Street firms totally disengage the way analysts are paid from the success of the investment banking side, there will continue to be conflicts," says CEO Thomas A. Bowman of the AIMR.

To buttress the Chinese Wall that is supposed to separate analysts from their banking co-workers, firms could bar analysts from the "road shows" that underwriters use to sell new stock issues. An anti-retaliation rule to prevent analysts from being penalized for issuing negative reports on a banking client would also help, according to John C. Coffee Jr., a law professor at Columbia University.

The rating system needs overhaul, too. The current "buy," "hold," or "sell" ratings don't tell investors much, especially since analysts rate only 2.5% of stocks a "sell" or "strong sell." Adding time-horizon and risk elements would provide more guidance. AIMR also says analysts should issue final reports when they stop following a company, rather than simply dropping coverage to avoid a "sell" rating.

Protecting investors must be Pitt's prime goal. He tells critics to judge him by his actions. What he does next to halt the collusion that has tainted analysts' reports will be key.

Borrus and McNamee cover finance from Washington.

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