One on One: "Research practices were going to change before this investigation ever came forward"

While politicians worry about the skeletons in their closets, unscrupulous sell-side analysts may fret over the e-mail on their hard drives.

E-mail uncovered by New York state Attorney General Eliot L. Spitzer showed the true colors of some Merrill Lynch & Co. analysts, who privately derided some stocks – as “dogs” or worse – while they publicly urged investors to buy them. The investigation resulted last week in a $100 million settlement by the company, although Merrill neither admitted nor denied guilt.

Prudential Securities Inc. senior brokerage-industry analyst David M. Trone knows firsthand the pressure from investment bankers to push certain stocks. But he and his partner, the well-known and outspoken Prudential bank analyst Michael L. Mayo, have never shied away from telling investors to sell.

In 2000, Prudential downsized its investment bank so as not to influence its research.

“It does seem like Dave and the whole group that works there has really tried to make a point of saying, `Look, we are going to come straight out [and give a “buy” or “sell” recommendation],”‘ says Lisa Welch, a buy-side analyst with John Hancock Funds LLC in Boston.

In Mr. Trone’s view, brokerage stocks are no dogs.

Q What’s your reaction to the settlement reached between Merrill and Mr. Spitzer?

A I think it’s a win-win situation in that Merrill came away with a pretty manageable fine and the New York state attorney general has motivated Merrill to agree to make some changes to the research practice, which I think are pretty relevant to getting objectivity back for the investor.

Q What’s the long-term impact for Merrill?

A With a $100 million state settlement with tens of millions in costs, upfront and ongoing, for research-practice changes, and then a few hundred million for assumed client attrition and lost profits, you simply come up with a total impact that’s fairly trivial in aggregate, given the context of what was uncovered.

This financial payment and these research-practice concessions are very manageable, so it doesn’t weaken the firm really in any way, shape or form.

Q How about the cost of investor lawsuits?

A With regard to civil litigation, certainly, things are not altered by this settlement because Merrill did not admit wrongdoing. Even if it had, there’s still such a challenging legal path for plaintiffs to have to follow, the primary issue being just how much did investors rely on the allegedly fraudulent stock recommendations.

Class-action suits continue to be a long shot because you’re going to have to not only prove that fraud was committed but also there was a strong connection between that recommendation and the inflation of the stock price.

Q Will other Wall Street firms aside from Merrill be targeted?

A I’m really starting to think that Merrill will be the only one, because at the end of the day, the only reason why Spitzer is able to get action out of Merrill is because he has a smoking gun. And if he doesn’t find problematic e-mails at these other firms, then he has no leverage over the firms. He can’t force them to do anything.

Q Will Mr. Spitzer’s investigation result in a separation of research from investment banking?

A Research practices were going to change before this investigation ever came forward. I think the disclosure of the e-mails only magnifies and sensationalizes the issue to the point where the changes will probably end up being a little bit more robust than they would have in the absence of Spitzer’s disclosure.

In terms of separating research and banking, the only way you really do that 100% is by legally severing the two institutions into legally separate companies, so there is literally no link whatsoever. But that’s not going to happen, because research can’t stand on its own.

What’s probably more rational and more realistic [is that] there will be tactics put in place and policies and procedures whereby the influence of banking over research will be much less direct and probably so indirect that the average research analyst will be more motivated to focus on the investor’s needs first and the business needs a distant second.

For example, pay. Getting paid directly for deals, that will almost certainly be abolished.

Q Do you expect to see the large banks acquiring brokerage firms?

A The big driver of brokerage firms selling is because they fail to have the global investment banking platform, and that driver will still be there. The stronger firms on the investment banking side continue to get stronger, and the globalization of industries play into their strengths. Goldman Sachs, Merrill and Morgan Stanley, we strongly believe, will remain independent for the foreseeable future, but the midsize firms – Lehman Brothers, Bear Stearns, Lazard in Europe – will be incrementally disadvantaged and probably will link up with larger institutions, whether that be a bank or an insurance company or even one of the bigger brokerage houses.

Q Does the IPO scandal involving Credit Suisse First Boston, which paid $100 million to settle charges that it extorted huge commissions, reverberate in the industry?

A I think there was a certain bubble-induced euphoria, and things got a little out of hand. I don’t think that it really has any meaningful impact on the IPO business. Scandals in this industry will happen forever, and that’s just one that certainly the firm was penalized for, but that doesn’t mean it is going to stop people from choosing CSFB for doing their IPOs.

Q You have “buy” recommendations on the major firms, The Goldman Sachs Group Inc. (GS), Merrill (MER) and Morgan Stanley Dean Witter & Co. (MWD). Why?

A The great franchises have unparalleled global distribution, trading and investment banking. They have superior skill in advisement, both on the investor and on the corporate side. They simply are in the driver’s seat. These companies are selling at deep discounts, which simply does not reflect the franchise value. We are in a deep cyclical downturn, but I think the worst of that is over.

Q Of the big three, which offers the greatest upside potential?

A Certainly Merrill Lynch because they are the ones who took the brunt of the sell-off, and over time the market will realize the legal realities are pretty benign for Merrill. What’s gotten lost is they are going through a historic restructuring, and this is a firm that we are not going to recognize in another year or two.

Q Do you carry “hold” or “sell” ratings?

A We do have a “hold” on Lehman and Bear Stearns for really the antithesis. They don’t have the broad global strength that we think you need going forward. They, generally speaking, are not cheap. They’re trading above their average price-to-books. And they have benefited from a very historically strong fixed-income cycle, which of course continues to do well, but again the incremental change is away from fixed-income and to the benefit of equities. So they would be less advantaged than the big three.

Q As an analyst, have higher-ups ever pressured you to change your ratings?

A We don’t have investment banking here, but in previous times in my career … I think the reality for most analysts is that there was a general unwritten rule that you don’t do anything generally that makes the investment bankers’ job harder. There was never any explicit rule, even verbally given, that `Hey, you have to put a buy on this stock.’ But it was a cleverly delivered message in a very general way that analysts who make the investment bankers’ life easier will have greater employment likelihood, if you will. There were performance reviews where input was provided by the investment banker, so if your work made their life more difficult, they could conceivably give you a negative review, and that would make your employment unstable

I never let the pressure alter my recommendations.

SNAPSHOT

David M. Trone, 38, senior brokerage analyst, Prudential Securities Inc. in New York, since 2001

Career: 1997-2000, banking and mortgage-finance analyst at Credit Suisse First Boston Corp. in New York; 1995-97, credit card executive at The Bank of New York Co. Inc.; before business school, worked as a software product manager

Education: bachelor’s degree in computer science (1987) and master’s in business administration (1995) from the University of Maryland