Commentary: What It Will Take to Police the Street

So much for radical solutions to the conflicts that have tainted Wall Street research reports and the analysts who write them. Law enforcers and regulators may shelve the much criticized $1 billion plan, pushed by New York State Attorney General Eliot Spitzer, to create an independent oversight board to force banks to distribute independent research. Instead, Spitzer and Securities & Exchange Commission enforcement head Stephen M. Cutler are considering having each bank employ an "outsider" to buy independent research to give to clients along with their own reports.

And forget about forcing all banks to hive off research into separate subsidiaries. Now, the goal is to beef up the Chinese walls between bankers and analysts. The new plan has brought the convoluted research saga one step closer to resolution. But some bankers say in private that its real impact will be "marginal" at best, and much work remains to be done.

Certainly, Spitzer and Cutler face a tough balancing act. If they want to convince the public that they have fixed Wall Street, they need to punish wrongdoers for past misconduct and roll out truly prophylactic remedies that root out the offending banks' conflicts of interest. Yet they have to ensure that measures enacted now don't clash with structural reforms for the industry, such as making initial public offering allocations fair and compliance effective, that SEC commissioner Harvey J. Goldschmid is working on.

As negotiations hurl forward, some law enforcers fear they'll run out of time to uncover all of Wall Street's abuses. That might undermine the momentum for reform. Top regulators, including the SEC's Cutler, want to settle quickly. But some state regulators prefer to finish their own investigations first. "I still have a lot of work to do," says one. In return for giving up their chance to find a smoking gun, they want some payback, such as imposing far stiffer penalties than the $100 million Merrill Lynch & Co. (MER ) paid to settle with Spitzer in May. That way, some of the 12 banks now being investigated could end up paying as much as $250 million to settle.

Yet even if the banks agree to buy independent research and pay hefty fines, other big issues remain to be resolved. Disagreements about how best to seal off analysts from bankers are still widespread. Most banks have conceded that analysts should not be allowed to go on "road shows" or "pitches" for banking business. However, on Nov. 18, banks' legal counsels are expected to argue once again that analysts must assist bankers in pricing deals. Even if the enforcers were to agree, a skeptical public probably wouldn't--and that could undercut the settlement's credibility.

To restore public confidence in the markets, negotiators also must decide how analysts should be paid. Alas, no firm has figured out how to do that. Citigroup's (C ) plan to completely separate its research operations from banking might work as long as controls are strict and banking doesn't simply end up paying the bill, as before. Yet even if Citi's approach works, for now, no other firm has announced plans to follow it.

The real key to keeping Wall Street honest is compliance--enforcing rules designed to protect investors inside brokerage houses and banks. During the '90s bull market, failure by the Street's top dogs to make compliance a priority fostered many of the practices that have brought them to shame. Banks agree that their heads of compliance should have a direct line to the CEO and that research should have its own legal department. But the SEC may have to insist that compliance officers blow the whistle if their bosses don't act. Without a realistic threat of exposure and punishment, reform efforts will remain marginal.

By Emily Thornton

With Mike McNamee in Washington and Heather Timmons in New York

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