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Research is still a vital tool for banks and companies, despite recent scandals. perhaps the securities industries should now consider forming a cooperative.
This story first appeared in the August 19, 2002 issue of WWD. Subscribe Today.
The use of stock research by investment banks to gain lucrative underwriting and merger fees is not a shock to anyone.
The practice began to flower that day in May 1975 when the Securities and Exchange Commission eliminated fixed commissions. Almost immediately, commissions on stock fell 75 percent and securities research became unprofitable.
Fixed commissions, it turned out, supported the securities research published by Wall Street. The SEC followed up with a ruling saying commissions could not be “directed” to a third party for any reason such as providing research. The law of Unintended Consequences was in full swing; research immediately became even more unprofitable.
Research is necessary for an efficient market. Broad and deep research is one of the reasons the markets grow and become global.
But how do you pay for it?
Beginning in the early Eighties, the larger Wall Street firms realized that their investment banking clients would subsidize research. A favorable research opinion on a corporate client would bring more banking fees. At first, the firms may have tried to maintain standards, but big money eventually knocked down whatever remained of a “Chinese Wall.” Jack Grubman of Salomon Smith Barney is simply one of the best known security analysts to get caught in the money web, but he isn’t alone. Smoking guns binding analysts’ pay to investment banking fees could be found in every firm, in every research category and for many years.
What is amazing is not that the research became corrupted, but how long it took for public outrage to explode over a practice prevalent for a generation.
Corporate chief executive officers share some of the blame. CEOs welcomed the Street’s research compensation scheme and, in fact, lobbied the securities firms to reward analysts. Their colleagues — chief financial officers — eagerly completed the analysts’ earnings models and led them to “buy” recommendations, often settling for indifferent investment banking advice as long as the analysts’ favorable coverage kept coming.
Sophisticated institutional buyers, such as the large mutual funds and trust companies, understood the system and long ago developed their own “buy” side research, regarding the “sell” side recommendations as tainted by self-interest.
The public, however, didn’t have access to the same information. It was not an insider. It didn’t understand the game.
It’s easy to state the problem and it’s even easier to criticize the process. This is not to dismiss the positive action of the President, the Sarbanes-Oxley Act of 2002, the New York Stock Exchange, NASD, the SEC and New York Attorney General Eliot Spitzer.
Rules and regulations may curb excesses but they will not create good, independent research widely available to institutions and the general public alike.
Why won’t the rules create a better research environment for our capital markets? Because the subsidies from investment banking will not be available, securities firms will, over time, do less research on fewer companies. Equity research will be limited to a small number of widely owned stocks.
It is in the public interest to know as much as possible about the publicly traded stocks of companies traded. Public policy supports timely and broad disclosure and transparency.
So, given the fact that good research is doable but may not be affordable, how might we solve this problem?
There are models in many industries. Competitors frequently have banded together to form cooperatives for common purchases that they support. Retailers and vendors are familiar with a number of these efforts. Buying offices, such as Associated Merchandising Corporation, represented the leading department stores throughout the country for 86 years. The advertising industry supports BPA International which provides audited marketing data. Uniform Code Council, Inc., the organization which oversees the assignment of ID numbers and bar coding, covers virtually every industry.
The model may become a profit-making business. First Call, a reporting service providing Wall Street’s earnings per share estimates on 18,000 common stocks, has until recently been owned by eight securities firms and is a business, not a cooperative. Standard & Poor’s and Moody’s are also examples of independent businesses providing respected analysis.
The securities industry should think along these lines and create an independent research organization. It will undoubtedly require subsidies by them, but it might accomplish the goal of creating an entity that has a chance to provide independent and quality research. The securities firms themselves may go back to the type of serious research, costly as it may be, on industries or companies where they can distinguish the quality of their work and of their brains.
A model exists to solve one problem. The other systemic failing in the capital markets, however, is the practice by larger banks and securities firms of using their balance sheets to muscle into merger and underwriting fees. It’s not bad enough to corrupt research but we have, over the last decade, compromised balance sheets through looser credit extensions. Enron, WorldCom and Adelphia Communications are the tip of the iceberg, exemplifying the meltdown of credit standards.
The excesses are being exposed. Investors are alerted. Regulators are poised to indict. Top management is fearful. But unless we permanently restructure the relationships amongst research, credit and their providers, our capital markets on which the global economy has flourished will be a lot less trustworthy.