Commentary: How Bankers and Brokers Could Get Bruised

By Amy Borrus and Mike McNamee

Regulators slap a $5 million fine on Salomon Smith Barney, charging that its star analyst privately questioned a telecom stock he publicly boosted. Lawmakers grill J.P. Morgan Chase & Co. (JPM ) execs as to whether they helped Enron Corp. deceive investors. The Securities & Exchange Commission vows to curb investment banks' lucrative but abusive practice of earmarking shares in new offerings for favored clients.

No matter where investment bankers turn these days, there's no escaping the heat. With each congressional hearing and release of embarrassing e-mails, the ground shifts beneath Wall Street. Regulators step up punishments for firms that cross the line into illegal behavior, while long-acceptable practices now are derided as unseemly quid pro quos. "People have lost faith, just like with the Catholic church," says Wall Street guru and former Lazard Frères managing director Felix G. Rohatyn.

Inevitably, the accumulating evidence of conflicts of interest is driving reforms by Congress and federal and state regulators. "No one thinks this is going to blow over," says Richard Walker, a former SEC enforcement director, now general counsel at Deutsche Bank. "A low-pressure system has arrived, and it's stationary over Wall Street."

Capitol Hill and state regulators are gunning for Citigroup (C ), Merrill Lynch (MER ), Credit Suisse First Boston (CSFB ), J.P. Morgan Chase, and Goldman Sachs. The SEC, stung by charges that it has moved too slowly, is likely to force changes. The outlook:

-- ANALYSTS' CONFLICTS: New York Attorney General Eliot Spitzer wrung a $100 million penalty from Merrill Lynch & Co. after revealing internal e-mails in which analysts privately disparaged as "junk" and "crap" stocks they were pushing at the time. Merrill promised changes, including delinking analyst compensation and investment banking.

The Merrill deal could become the floor for future settlements that state regulators win from banks they are probing. Facing pressure to restore investor trust, the SEC has vowed to adopt uniform national standards for analysts that could further curtail contacts between research and banking divisions. One worrisome sign for the Street: SEC Commissioner Harvey J. Goldschmid, who championed "fair disclosure" rules limiting analysts' special access to company executives, is leading the effort. The rules could prove so onerous--and the e-mail revelations so embarrassing--that banks figure they're better off getting out of the unprofitable research business.

-- IPOs: Raising cash for new companies through initial public offerings is rife with conflicts. Investment banks push their analysts to give IPO clients sky-high ratings. And banks routinely underprice IPOs--a practice that became more pronounced during the boom years--so they can use shares in a hot new stock to reward friends and woo potential banking clients.

The National Association of Securities Dealers is cracking down on unsavory allocation practices. A stronger attack is coming from the SEC, which wants to reduce the underpricing that makes IPOs so ripe for abuse. By next year, the SEC could require bankers to open up their IPO order books to more scrutiny and to allocate more shares to high bidders--not to cronies.

-- TYING: Representative John D. Dingell (D-Mich.), ranking Democrat on the House Energy & Commerce Committee, is leaning on regulators to investigate "tying" by commercial banks--the illegal practice of granting loans only if customers sign on for other services. The Federal Reserve and Treasury Dept. say they've found no evidence of unlawful tying but have launched special queries to make sure.

Regulators will severely punish any bank they find linking credit to securities underwriting. But Democrats want more: They see tying as a lever to reopen the 1999 Gramm-Leach-Bliley Act, which blessed the merger of commercial and investment banking. After the bill's author, Senator Phil Gramm (R-Tex.), retires at yearend, Hill aides expect Democrats to examine whether the resulting financial conglomerates abuse their clout. But Congress is unlikely to reverse the law, especially if the GOP keeps control of the House.

Shell-shocked Street lobbyists are counting the days until Congress goes home. With no more documents flowing from the Hill and mid-term election rhetoric cooled, financiers figure the relentless pressure will end. That's a pipe dream. By spotlighting Wall Street's seamier side, Congress has uncorked a reform drive that won't stop anytime soon.

Borrus and McNamee cover finance from Washington.

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