Buying Wall Street's Attention

Paid-for research is a questionable, barely regulated practice--and likely to keep growing

On Jan. 6, the financial newswires reported rare good news for Hartmarx Corp.: A securities analyst had finally acknowledged that the company exists. Chicago-based Hartmarx, whose stock trades on the New York Stock Exchange, is very much a presence in men's clothing stores, with its product lines including Hart Schaffner & Marx and Hickey-Freeman suits. But lagging sales and falling share prices had turned it into the Wall Street version of an unperson since early 2001--the last time Hartmarx had analyst coverage. All that abruptly changed with an 18-page research report and "speculative buy" recommendation from the New York brokerage firm Taglich Brothers Inc.

Why the sudden interest? After all, this staid garment manufacturer had done nothing that would ordinarily pique analyst interest. It wasn't generating investment-banking revenues and hadn't produced any particularly sexy news in quite a while. The reason for the newfound attention can be found in a footnote on page 12 of the report: "The company pays Taglich Brothers Inc. a monthly fee for the creation and dissemination of research reports." For Hartmarx, the decision to buy the report was a no-brainer. "The traditional investment-banking firms are not interested in small, micro-cap situations such as ourselves," says Glenn R. Morgan, Hartmarx' chief financial officer.

Hartmarx' predicament is at the heart of a troubling issue. Increasingly, analyst-bereft companies have been reduced to buying investment research--a controversial practice that is commonplace in the fringes of the over-the-counter market, where paid reports often do little more than shill for companies. The spread of paid research has received remarkably little regulatory attention despite the recent debate over analyst conflicts of interest.

The few statistics on the subject are startling. A February, 2002, survey by the National Investor Relations Institute, the professional association of investor relations execs, found that 10% of all companies surveyed--ranging from micro-caps to large-cap companies--had commissioned stock research during the preceding two years. Among the companies engaged in this practice is EasyLink Services Corp., an Edison (N.J.)-based company in which William H. Donaldson, nominated to become chairman of the Securities & Exchange Commission, served as a director. He won't say if he knew about, or approved, the paid research (BW--Jan. 13).

EasyLink is in good company. The ranks of companies paying for research include growing numbers of established, even name-brand companies with products ranging from catchers' mitts (Rawlings Sporting Goods Co.) to pickled herring (Vita Food Products Inc.), and include dozens of regional banks that have trouble generating analyst interest in the best of times. And the issue is not likely to come back to haunt Donaldson--at the SEC, at least--if he wins confirmation. An SEC spokesperson says that, apart from continued active enforcement of the laws requiring proper fee disclosure, no rulemaking is planned to deal with this issue.

With regulatory attention diverted, the climate for paid research is likely to remain favorable, as traditional research declines because of the bear market and downsizing by brokerage houses. According to First Call, which tracks analyst research, the total number of analyst stock recommendations has fallen 18% over the past three years, from 28,500 to 23,500 (chart). Still, paid research has an obstacle to overcome: an awful reputation. That is conceded even by its staunchest defenders, who admit that this breed of research, though legal if disclosed to investors, has been hurt by its association with pump-and-dump stock schemes and a reputation for puffery even by analyst standards. "One of our members commented, `Paying for research is like paying for a date with a good-looking person. You might enjoy it and you might turn a few heads, but you'd never want to admit that you had paid for it,"' says NIRI President Louis M. Thompson Jr.

The people who produce company-compensated research--research boutiques and small brokerages--feel that the bad rap is unjust. They note that companies "pay" for traditional analyst coverage, indirectly, mainly by investment-banking fees. Their brand of research, they maintain, is equally ethical. "The idea that such a thing as independent research exists, that is not compensated in some way, is a fallacy," says Francisco Clough, Taglich's vice-president for corporate development.

Proponents of paid research contend that, even though the companies foot the bill, there is no understanding that favorable research will result. Fees, they note, are often nominal, with Hartmarx paying an up-front fee of $5,000 plus $1,750 a month. "The whole thing comes down to the integrity of the person who's writing the research, and you can say that for traditional research or paid research," says John A. Howard, president of Equity Research Services Inc., a Raleigh (N.C.) firm that produces paid research for small regional banks.

Paid-report writers also point out that one form of issuer-commissioned research--credit ratings--has a long and reputable history. John M. Dutton, whose J.M. Dutton & Associates research firm produced the EasyLink report, compares his firm's business model with the one employed by agencies such as Standard & Poor's, which like BusinessWeek is owned by The McGraw-Hill Companies. That argument is rejected by Kenneth Shea, S&P's equity research director, who notes that ratings are narrow assessments of company creditworthiness, do not involve buy or sell recommendations, and are a far cry from the much broader analysis required in equity research. "The company pays us to give a credit evaluation," says Shea. "We're not telling you to buy it. There are some AAA bonds that may be terrible investments because of their price--we don't make any statement about that."

Still, it's certainly true that a good deal of paid research fills a gap that Wall Street firms don't even attempt to bridge. Regional banks are a prime example. Howard founded Equity Research in 1989, after his firm, Thompson McKinnon Securities, was taken over by Prudential Securities Inc., which proceeded to drop its coverage of the small Southeastern banks Howard had followed. The reports generated by Equity Research don't contain buy or sell recommendations--a major issue for NIRI, whose guidelines, adopted early in 2002, allow paid reports only if they don't contain purchase recommendations and don't resemble ordinary analyst reports.

The NIRI guidelines are voluntary and are widely ignored by paid-research firms. And the disclosures contained in these reports are sometimes ambiguous at best in describing payment arrangements. Until last fall, a Minneapolis firm called BlueFire Research said in its reports that the subjects of the reports "paid no direct compensation." But the reports didn't say that virtually all of the companies covered by BlueFire paid $60,000 a year to an affiliated company. William Bartkowski, BlueFire's chief executive, says the disclosures now say that a BlueFire entity does business with the companies. But his firm's reports otherwise disregard the NIRI guidelines--because of the view, widely held by paid-report writers, that their output is genuine analysis, not investor relations.

That's a dubious argument. But for now, they have the last word. So long as the few guidelines governing paid research are given short shrift and regulators are focused on other issues, paid research is likely to remain the Wild West of the analyst business.

By Gary Weiss in New York

    Before it's here, it's on the Bloomberg Terminal.