Still Outside Looking In

Independent stock analysts hoped to cash in on the Spitzer pact. What went wrong?

For independent stock-research firms, these were supposed to be the best of times. Under the landmark conflict-of-interest settlement finalized in 2003, the biggest Wall Street banks would be funneling millions of dollars to dozens of independent shops, giving what was little more than a cottage industry credibility and market power overnight.

But the independents are a pretty frustrated bunch these days. Ten months after the money started to flow, the settlement is not giving them anywhere near the lift they expected. Big banks are making the independents' stock reports available along with their own, as required, but they're downplaying them as much as possible, the research firms argue. "This should be an opportunity [for Wall Street firms] to turn lemons into lemonade and show what a great job they're doing for their clients, but instead they really want to keep this quiet," says Martin Weiss, chairman of Weiss Ratings Inc., an independent providing research for six of the 12 banks in the settlement. Indeed, the early results of a poll of 1,000 retail investors by Standard & Poor's (MHP ) "indicate that a great many [investors] are unaware of the settlement and don't feel an immediate impact from it," says Michael Privitera, a spokesman for S&P, which provides stock research. (Like BusinessWeek, S&P is a unit of The McGraw-Hill Companies Inc. (MHP )).

Worse, many of the independents are suffering collateral damage from the mutual-fund scandal. As part of the effort to reform the fund industry, regulators are mulling whether to limit "soft dollars," rebates of their stock-trading commissions that fund companies use to buy research and other services. Trouble is, fully 80% of independent research is paid for with soft dollars, says Michael W. Mayhew, chief executive of consulting firm Integrity Research Associates LLC in Darien, Conn. Already, some fund companies are reining in their use of soft dollars and buying less independent research.

Meanwhile, the rivalry among independents has become cutthroat. Spitzer's settlement set off a gold rush. Many new players jumped in, but the research pie hasn't grown. In fact, the settlement money -- nearly $90 million a year for five years -- is apparently not enough to replace the lost soft dollars, according to industry calculations. That has left many newly beefed-up firms disappointed and freshly minted research boutiques struggling. Mayhew says there were about 40 independent firms five years ago; today there are 350 to 400, including the roughly 65 that won settlement contracts to supply research to big banks. "We absolutely believe there is going to be a huge shakeout," he says.

All this has some independents scrambling for a new business model. A growing number of independents are trying to get listed companies -- particularly small ones that lost analyst coverage as Wall Street retrenched -- to pay for their own research coverage. Many independents frown on this, saying it sets up a conflict of interest and tarnishes the squeaky-clean image they try to project. While the Investorside Research Assn., the trade group for independents, has banned members from accepting company payments for research, its conference last month included a discussion of how to create credible reports paid for by companies that are covered. Mayhew believes that can be done, pointing to credit-rating agencies that charge bond issuers for their ratings.

Most firms aren't offering company-paid research. Instead some are asking existing customers to pay them directly, and not with soft dollars. And some are chopping staff: 65% of firms responding to a survey by Investorside released in September said they had recently laid off workers or put off hiring them.


This isn't at all what New York Attorney General Eliot Spitzer and the Securities & Exchange Commission thought they were engineering with their settlement. The aim was to have investors both large and small embrace outside research free of Wall Street's conflicts. Spitzer, speaking at a recent Investorside conference, said he believes that independent research is gaining traction. He points to discount brokerage firms not included in the settlement, such as Fidelity Investments, that are voluntarily providing outside research to their customers.

In fact, big brand-name independents such as S&P and Morningstar have done well. S&P says it is capturing 15% to 20% of the settlement money and Morningstar declined to comment.

For the upstart firms, though, the settlement is a different story. Consider NuFact Inc., based in Naperville, Ill., and launched by Anil Joshi in November, 2003. Joshi hoped the settlement would create demand for independent research like his that focuses on earnings quality. But he didn't snag contracts, and then the shrinking pot of soft dollars hurt his ability to sign up customers such as funds or banks. In some cases, "the message we've gotten is, 'We like [the research], but we just don't have the soft dollars to pay for it,"' he says. Laura S. Unger, the consultant picking outside research for JPMorgan Chase & Co., says smaller firms often don't cover a broad enough range of companies to match the vast number followed by JPMorgan.

The settlement isn't that stringent. Wall Street firms need only to make the independent research available on their Web sites, and in print by request, and must include independents' ratings alongside those of in-house analysts on trade confirmations and statements. Brokers are also required to inform clients that independent research is available when they recommend a trade.

The result: Clients must take the initiative to get the research. This is something investors who hire brokers to manage their investments don't normally do. "It seems [Wall Street firms] are fulfilling their requirements," says Mark Fichtel, the consultant hired by Lehman Brothers Inc. (LEH ) to monitor its compliance with the settlement. "Should the settlement have required more? That's a different issue."

Indeed, there's no evidence that the big Wall Street houses are doing anything worse than sticking to the letter of the law. "Every effort is being made to ensure that banks are in full compliance with the settlement," says Stanley "Bud" Morten, a consultant working with Citigroup (C ). Merrill Lynch & Co. (MER ) says its customers are happy with the outside offerings. While it doesn't advertise the research, "it would be virtually impossible to be a client and not notice it," says Merrill spokesman Mark Herr. In October, an outside monitor will report to the SEC on how well Wall Street is complying.


While the settlement may be a missed opportunity, the cloud over soft dollars threatens actual damage. An SEC task force is expected this summer to recommend greater disclosure and limits on what kinds of services can be paid for with soft dollars. Some fund companies already are pulling back. More than a year ago, Janus Capital Group and MFS Investment Management (SLF ) stopped using soft dollars entirely. That led MFS to trim the amount of independent research it buys, says spokesman John Reilly. MFS expects to pay $10 million to $15 million a year in cash for the research and data services it finds most valuable. Federated Investors Inc. (FII ), too, has cut back on the research it pays for with soft dollars, says Uri Landesman, director of global equity research.

Despite all the uncertainty, the independents still have four more years to prove their worth to retail investors they rarely reached before. "If clients react positively to the research, it will be tougher for firms to drop it when the five years are over," says Lehman's Fichtel. And given how much cheaper it is for a Wall Street bank to buy research than to do it in-house, some firms may end up outsourcing a chunk of coverage, he says.

But many independents will probably not last that long. "They are going through a major transition, and everybody is suffering as we work that out," says Landesman. So at least for now, the payoff -- for all the good intentions behind the settlement -- still seems far off.

By Amey Stone in New York, with Amy Borrus in Washington and Aaron Pressman in Boston

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