Taking Sides: SEC lets fox guard analyst henhouse

Wall Street analysts have a long way to go before they restore their credibility with institutional and individual investors, not to mention financial advisers.

But regulators are taking the wrong track to get the industry there.

Rick Miller and Joel Chernoff, reporters for InvestmentNews and sister publication Pensions & Investments, respectively, contacted more than 30 money managers and investment advisers last month to gauge the credibility of Wall Street analysis in the wake of the tech stock crash.

Their findings were not surprising. By an overwhelming margin, the people they interviewed held most Wall Street analysis in very low esteem. As the story in last week’s issue noted, analysts no longer have to prove that they’re stupid; they have to prove that they’re smart.

To institutional money managers, such analysis was little more than a starting point. Advisers, meanwhile, said they were turning more to independent sources for stock recommendations. As for many retail investors, it’s a safe bet judging from chat-room postings that most are fed up with Wall Street analysts altogether.

In the months since the tech stock crash, lawmakers on Capitol Hill have held hearings to examine allegations that many analysts were entangled in conflicts of interest or were held captive by the investment-banking arms of the companies they worked for. The findings aren’t pretty.

At one of three hearings held by a House Financial Services subcommittee, the Securities and Exchange Commission revealed that 30% of the researchers it surveyed had bought stock in companies before they went public. Then they wrote glowing reports about the companies after their initial public offerings.

The agency also disclosed that at least three analysts pocketed profits ranging from $100,000 to $3.5 million by selling stock they owned at the same time that they had issued “buy” recommendations for those companies. And at least one analyst short-sold stock on which he had a “buy” rating.

The SEC survey included the nine firms that had handled most of the IPOs involving technology and Internet stocks during the bull market in 1999 and 2000. Although it did not release any names, it’s safe to assume that Merrill Lynch & Co. Inc. and Goldman Sachs Group Inc. were among the culprits.

Aside from uncovering those conflicts of interest, the SEC also discovered that analysts routinely played a role in mergers, acquisitions and corporate-finance deals. And they often went on the road to help sell IPOs.

The pay of many analysts was tied to the profitability of the investment-banking unit, and at seven of the nine securities firms, investment bankers even had a say in how much analysts got paid.

Last June as public outcry was reaching a crescendo, the Securities Industry Association, the industry’s leading trade group, issued a new set of “best practices” guidelines to address the problems.

Among other things, they recommended severing ties, including pay considerations, between analysts and investment-banking operations, and broader public disclosure by analysts of their stock holdings.

The guidelines also suggested that analysts should be prohibited from selling a stock when they had a “buy” recommendation on it.

In all, 14 brokerage firms agreed to abide by the SIA’s guidelines.

At the time, critics said the effort was largely an attempt to ward off new SEC regulations and possible legislation on Capitol Hill.

If so, the industry appears to have been successful.

In an apparent reversal of direction, new SEC chairman Harvey Pitt two weeks ago said that his agency would let the industry fix the problem.

Essentially, Mr. Pitt is counting on the National Association of Securities Dealers, the industry’s self-policing organization, to play watchdog.

Ordinarily we’d favor self-regulation over government regulation any day. But this situation is different.

That means it’s up to Congress to pick up the ball. Given everything that’s happened over the past few weeks, lawmakers might be reluctant to tamper with the already weakened securities industry.

But given Wall Street’s track record and the competitive pressures firms face, not only to make money but to land IPO deals, allowing the industry to regulate itself is too much like letting the fox guard the henhouse.