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Memo to Mr. Pitt: Target analyst conflicts

I received a phone call this week from a registered representative with a major Wall Street firm who…

I received a phone call this week from a registered representative with a major Wall Street firm who was troubled about the conflicts of interest he has seen, not only at his firm, but on the Street in general.

His call was prompted by a discussion he had with one of his firm’s analysts about the prospects of a particular technology stock. The analyst put a “hold” rating on the stock, but when the rep called, the analyst admitted that he didn’t expect the company to survive.

Why, the rep wondered, did the analyst not come out and say publicly that the stock should be sold? Perhaps it was because his firm had had an investment banking relationship with the company. “What if I’d had clients in the stock?” the rep said.

A “hold” clearly means the analyst is not excited about the company’s prospects, and one might take it as a sign to think about getting out. But it’s ambiguous. It doesn’t even hint that the company might not survive.

A “sell” rating would give investors fair warning. Why did the analyst not have such a rating on the stock, given his opinion the company might not make it?

On another occasion, when he asked why no analyst covered a particular company that he was interested in for his clients, the rep was told it was because there was no investment banking relationship. It was not that the company was not worthy of coverage, just that there was no immediate payoff for the investment banking arm.

Both of those situations troubled the rep because he felt his ability to provide quality investment advice to his clients was compromised. Where, he wondered, could he go to get honest research for his clients? He suspected his firm was no different than other Wall Street firms.

He also wondered if anyone was looking out for such conflicts of interest on the part of Wall Street analysts and investment bankers, and if anyone was planning to take action.

His call came only a few days after I read Fortune magazine’s excellent article about Morgan Stanley’s star Internet analyst, Mary Meeker, and her dual, conflict-laden role as analyst and investment banking rainmaker, titled, “Can we ever trust Wall Street again?”

The flip answer might be: What do you mean “again”? When could Wall Street research ever be trusted? But in fact, through much of the 1970s and 1980s, most Wall Street analysts tried to provide unbiased research.

The proverbial wall between research and investment banking, if not brick, was at least plasterboard rather than the Swiss cheese it has become. And thanks to the Association for Investment Management and Research, the technical competence of analysts has improved steadily through the Certified Financial Analyst program.

But now where does an investment adviser or an individual investor turn for unbiased research? What can be done to correct the situation, to build true walls between research and investment banking?

First, here is an obvious job for the Securities and Exchange Commission’s chairman-designate, Harvey Pitt, though given his industry background, it might not fire up his interest. Nevertheless, if he really wants to make the investment world fairer for individual investors, and even institutions, this is an issue to which he should give high priority.

Second, the AIMR should crack down on analysts found to be serving also as investment bankers. The association should rescind the CFA designation of any analyst who receives compensation tied to the firm’s investment banking revenues.

Third, users of research should be prepared to pay for it directly, not simply through directed commissions. Using directed commissions is akin to getting it for free, and we all know just how good free advice is usually.

Paying cash for research might spark a larger independent research industry or perhaps might encourage investment institutions that have their own staffs, such as mutual fund companies, money managers and pension funds, to sell their proprietary research. Either of those developments would provide more competition for the big Wall Street firms.

The registered rep who called me would like to be able to give his clients investment advice that he, and they, can trust. So would all investment advisers.

Mike Clowes is the editorial director of InvestmentNews.