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Does Settlement Do Enough?

Many Conflicts Of Interest Extend Beyond Investment Banking

Dec 24, 2002 | Wall Street Journal

A regulatory overhaul will put more stock research in the hands of small investors, but it won't necessarily be better.

For years, individual investors have been spoon-fed research reports from big Wall Street firms more concerned about winning investment-banking business than delivering unbiased analysis. Under the regulatory settlement Friday, the nation's largest securities firms will be required to pay $450 million over five years to buy stock reports from independent-research firms that don't do investment-banking business. The firms also will set up a restitution fund for aggrieved investors. The size and mechanism of the fund have not yet been set.

The result: Investors will have access to at least one independent research report in addition to the stock research published by their brokerage firms. Customers will be able to view that research online whenever they wish. And Wall Street firms will be required to put stock ratings from various sources on brokerage statements they send investors after they buy a stock.

Yet the shift, while significant, won't guarantee superior stock analysis. "We may end up getting a system that is better than the old one, but sadly investment-banking conflicts are just one of the many on Wall Street, and there is no saying independent research is better," said Mike Corasaniti, director of research at Keefe, Bruyette & Woods Inc., which has investment-banking operations but doesn't cater to individual investors. "You really do have to wonder how much further this moves us along."

Here is how the new system will work.

Securities regulators will designate as many as 10 independent-research firms that will provide stock reports to brokerage firms. Specific firms haven't been named. Regulators will appoint an independent monitor at each brokerage firm who will have the authority to buy research from these independent outfits.

Each firm monitor will select at least three independent firms to work with. They will be required to provide at least one research report from these firms, in addition to their own research on the stock. So an investor at Merrill Lynch & Co. who wants to buy, say, General Electric Co. stock, will receive Merrill's GE report, as well as one from an outside research outfit. Investors then could have another opinion before buying.

Many details have yet to be worked out. It isn't clear when the process will take effect, or what will happen after five years. And it isn't entirely clear how exactly the government will define what research outfits are "independent."

New York Attorney General Eliot Spitzer said any firm that does investment banking, or has a financial relationship with the companies it covers, won't be deemed independent. However, many of the so-called independent firms have conflicts that extend beyond investment banking.

For example, Sanford C. Bernstein & Co., often cited as an independent research house, is a unit of big mutual-fund group Alliance Capital Management Holding LP. Prudential Financial Inc., which sold most of its investment-banking unit in late 2000, also is a big mutual-fund operator. Bernstein and Prudential maintain that the firewall between the businesses is thick, but it still raises at least the potential for conflict. Mr. Spitzer didn't immediately know if these companies would be considered independent under the new rules.

In many ways, $450 million is a drop in the bucket when weighed against the hundreds of millions of dollars each of the big Wall Street firms individually pumps into its own research. And some of the more-established independent firms say they want no part of the settlement, saying it will weaken their own work, which they sell for top dollar to select clients.

"Our research is not geared toward individual investors," said Michael Margolies, chief executive officer of Avalon Research Group, Inc., a well-regarded research firm in Boca Raton, Fla. The firm is one of many independent research firms that have balked at participating in the settlement.

For investors like Robert Quist, all these issues make him skeptical of the potential for real change. The 74-year-old retiree from Juneau, Alaska, a member of the Chicago-based American Association of Individual Investors, said he has always been suspicious of Wall Street research.

"They are just swapping one conflict for another," said Quist, who has two brokerage accounts, at Charles Schwab Corp. and Edward D. Jones & Co., and has about $100,000 invested in the stock market. He said he relies on his own digging, with some help from statistics provided by ValueLine.com, when making his stock picks, and that won't change now.

The settlement also requires firms to disclose to investors their rating and price-target forecasts to allow them to evaluate and compare them with independent research. Those targets will have to be posted for all investors within 90 days. Spitzer declined to put an exact timetable on when the changes will kick in, but said that it will be complete "well before" the end of next year.

Meanwhile, investors shouldn't hold their breath for big money from the restitution fund. If history is any guide, it is unlikely that most investors who lost money during the last few years will benefit from the fund.

Over the past decade, there have been a handful of restitution funds that rival the one announced Friday. For instance, several major Wall Street firms paid a total of about $1 billion to settle price-fixing allegations madein the mid-1990s against securities firms that act as market makers for Nasdaq Stock Market stocks.

And in 1993, Prudential Securities agreed to an open-ended restitution fund to refund investors for various misdeeds, which the company initially believed would cost about $300 million but grew to about $1.5 billion.

Boyd Page, a lawyer in Atlanta who represented a number of investors with claims against Prudential, said because it was an open-ended fund, investors fared better with Prudential than they likely will with this latest fund.

"I fear the fund will fall far short of even coming close to compensating the victims of this abuse," said Page.

Spitzer said the fund is capped, and he expects most claims against the firms will go through arbitration, a process that promises to end up costing brokerage firms millions of dollars more than the current fines as investors either settle or win arbitration claims.

In January, regulators are expected to release details of their case against the firms, which will help investors determine whether they are eligible for compensation.


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