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Analyst Inquiry May Cost Wall Street up To $2 Billion

Plan Would Yield Fines, Civil Liabilities, And Payments For Independent Research

Oct 28, 2002 | Wall Street Journal

The investigations into stock-research conflicts on Wall Street, now reaching a head, are likely to trigger the largest settlement cost ever for the securities industry.

The overall price tag including fines, civil-litigation liability, and payments to finance independent stock research for small investors could total as much as $2 billion, according to regulators and others. It is still unclear how much aggrieved investors would see, but what is clear is that total payment will top the $1 billion cost of a civil settlement a large group of firms paid in the late 1990s to resolve charges of price-fixing on dealers' price spreads for stocks traded on the Nasdaq Stock Market.

The cost to Wall Street became clearer late last week, when the New York state attorney general and federal securities regulators agreed on a broad plan to overhaul the way securities firms provide research on stocks to small investors. The plan would create a panel to oversee independent stock research that brokerage firms would be required to provide to individual investors in addition to their own analyst recommendations.

Funding the independent research would cost a dozen or more Wall Street firms $50 million to $100 million apiece, for a total of as much as $1 billion, spread out over five years. Under the plan, each firm would be expected to adopt the new rules as part of separate enforcement actions to settle investigations by the attorney general's office and regulators that are examining whether brokerage firms misled small investors with overly optimistic research on investment-banking clients during the stock-market bubble of the 1990s. These actions, plus any civil-litigation liability, could total as much as an additional $1 billion, securities lawyers say.

All this comes at a bad time for the securities industry. Brokerage firms are struggling through the third year of a bear market, sending profits down and layoffs up. Yet some industry analysts say the cost, though steep, won't significantly harm the bottom lines of most big firms, which earned far more than that in underwriting fees during the boom years.

"We do not view the plan as onerous," said David Trone, who follows the securities industry for the Prudential Securities unit of Prudential Financial Inc. He issued a report Friday calling the plan "quite manageable." In an interview, he said the $1 billion possible price tag for the new research panel isn't trivial, but noted that considering the cost for 10 major firms is spread out over five years, "in the grand scheme of things we're talking about [an earnings impact of] a few cents a share."

Such costs "aren't going to break the bank at these companies," said Brad Hintz, a securities-industry analyst at the Sanford Bernstein unit of Alliance Capital Management Holding LP. He noted that Wall Street research budgets reached a peak of $2.9 billion in the year 2000. Even within a 1997 level of research spending, which he estimated at $1.4 billion, Mr. Hintz said firms could absorb the annual cost of the new requirements without much discomfort.

The cost is also dwarfed by the profits Wall Street rang up during the salad days of the late 1990s. Annual pretax profit for the securities industry in the U.S. totaled $16.3 billion in 1999 and $21 billion in 2000, according to the Securities Industry Association. Even in the current bear-market climate, the trade group says Wall Street earned $10.4 billion in 2001, and is on track to earn $8.1 billion this year.

In a report Friday, Judah Kraushaar, an analyst who follows financial-services stocks at Merrill Lynch & Co., called the independent research subsidy requirement "relatively modest vs. overall profits." Another analyst noted that firms that contributed to the $1 billion Nasdaq civil settlement did so at a time when trading in Nasdaq stocks was booming, easing the sting of the cost.

Executives at several major Wall Street firms appear resigned to some form of the independent-research proposal, which was presented to the firms' general counsels Thursday at a meeting at the Washington headquarters of the Securities and Exchange Commission by regulators led by the New York attorney general, Eliot Spitzer, and Stephen Cutler, the SEC's enforcement chief. The firms realize they have little choice in the matter.

Several uncertainties remain under the plan. The first is how much each firm will be required to pay to fund the panel, which will negotiate contracts with about 20 independent research providers, whose stock reports would be made available to individual investors through the securities firms' Web sites. Regulators proposed that all firms pay the same amount. But some Wall Street executives have argued that the payments should vary according to the different firms' size, amount of business with individual investors, and degree of misconduct alleged by regulators.

And though the proposal would resolve most of the pending investigations by the SEC and other regulators into alleged analyst conflicts, some states such as Massachusetts and Utah still seem to be pursuing their own cases against firms such as the Credit Suisse First Boston unit of Credit Suisse Group and Goldman Sachs Group Inc., respectively.

Merrill Lynch has already agreed to pay a $100 million fine to settle a probe by Mr. Spitzer, and other firms-most prominently the Salomon Smith Barney unit of Citigroup Inc. are likely to have to pay big fines as well. People with knowledge of the Citigroup investigation, for example, say the firm could pay several hundred million to settle the case. Meanwhile, Massachusetts is seeking $100 million from CSFB. Merrill's Mr. Kraushaar said the proposal "seems to leave the door ajar for open-ended enforcement actions."

At the moment, it is unclear if the fines will go directly to government coffers, split between the federal treasury and the various states investigating the analyst issue, or if investigators will create a "restitution fund" to repay investors who lost money from hyped research. One person with knowledge of the investigations says regulators and Mr. Spitzer haven't decided on the restitution issue just yet. The firms must also separately reckon with civil-court claims by investors who are suing to recover market losses they incurred by relying on tainted Wall Street research.

There is one aspect of the plan that should make it more palatable to many major Wall Street firms. While it strengthens some fire walls between research and investment banking, the proposal doesn't require a complete separation between the two, a more radical step that had been discussed but resisted by some firms.

It appears, for example, that research analysts still would be able to provide input to investment bankers on companies the bankers are considering for financing assignments. And it appears that despite the criticism of analysts who received seven-figure annual pay during the boom if they could influence the award of underwriting assignments to their firms, those "rainmaker" paychecks would still be possible because analysts could still be paid from the general revenue of their firms.

Thus, some critics say, there still could be incentive for research analysts to be less than truly independent. For relationships with institutional investors, "the current structure is really left in place," said Reilly Tierney, an analyst who follows securities firms at the Fox-Pitt, Kelton unit of Swiss Re. "If you can come back to the idea of paying analysts out of the general revenues of the firm, you can continue to pay analysts for bringing in deals." That will remain so, he said, "until you de-couple analyst compensation and investment banking."

Meanwhile, Wall Street firms will still be able to fund their existing research for institutional investors through general corporate funds, which Merrill's Mr. Kraushaar called "a silver lining." This tack, he added, "should allow for serious sustained investment for in-depth research."

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