The potential conflict of interest inherent in auditor relationships will never be eradicated until legislation cleanly separates the consulting business from the auditing function.In securities research, the rules must go two steps further than the proposals. Many of us know that, on one hand, the tar and feathering of the entire investment analyst profession for the abuses of a few is overreaching.
(If the myth were true about research recommendations only being "traded
for the hostage of investment-banking business, then the only reports ever published would be those issued by the underwriter. This is nonsense considering the five, eight, or 10 reports often in circulation on a single stock, based purely on independent judgment.) On the other hand, I suggest that the rules must stipulate that membership in the AIMR (Association for Investment Management & Research) would prohibit stock ownership by any analyst or member of his family in any security on which he has a published recommendation. Moreover, the SEC should decree that every investment research report plainly state on page one in 12-point type the investment-banking relationship between the firm and the subject company.
In investor relations, the exchanges should insist that listed companies have their IR directors and consultants report directly to the board, as the CPA firms must do. This "chief credibility officer
responsibility would enable the IR professional to more freely provide the investor feedback, cautionary counsel, and persistent prodding for open disclosure policy that can truly bring to reality the corporate transparency everyone seeks, and rarely finds.
Why is going this extra mile so vital? Because the real root cause of this era of crumbled credibility is spinelessness among today's generation of corporate advisors. With the bull market of the '90s and heightened competition for clients, the stakes changed for lawyers, accountants, investment bankers and IR professionals. A yellow streak began to infect the ranks. Clients were more often told what they wanted to hear. Fortitude in consulting became a scarce commodity. Advice became devalued. And in the end, corporate America suffered.
Vastly tighter regulations and forced disclosure policies are the price that now must be paid to bring back the kind of unshakable faith that kindled the '90s. The reward? A renewal of a true watchdog/advisor role for the consultants. A renewal of spirit within the business community.
And a renewal of the kind of stock market valuations that helped to fuel the longest peacetime prosperity our economy has ever known. The trade-off would be a bargain.
- Ted Pincus is chairman emeritus of FRB/Weber Shandwick, a columnist for The Chicago Sun-Times and an independent consultant. This text includes excerpts from his remarks in accepting the PR Professional of the Year award from the PRSA at its annual dinner in Chicago this month.
"Can we please reset the stupid price target and rip this piece of junk off whatever list it's on."
So reads an October 2000 e-mail sent by fallen internet analyst Henry Blodget to a research colleague. The message was in response to a plea by a Merrill Lynch broker for the research department to reassess its opinion of web advertiser Infospace. The stock was sporting Merrill's highest buy rating, and was listed as one of its "Favored 15
stocks, despite the fact that it had been spiraling downward since January.
The e-mail represents just one of scores of internal messages that New York Attorney General Eliot Spitzer released in April when he charged Merrill with using its sell-side research to intentionally mislead investors.
Spitzer's probe ended any hope of Merrill and its counterpart firms quietly restoring the image of their research departments, which had already suffered a series of credibility hits. The firms' analysts had been repeatedly slammed in the media for being far too slow to change their bullish outlook as the 1990s stock market euphoria turned into full-scale bear market.
This relentlessly sanguine outlook led many pundits to conjecture that conflicts of interest were affecting the quality of Wall Street's sell-side research.
The basic allegations leveled against the firms have remained unchanged for years. The investment banks stand accused of using their "independent
sell-side research departments to cheerlead for shares of the firms' investment banking clients.
Critics charge that when investment-banking firms pitched their services - IPO underwriting, merger-and-acquisition advisory services, etc. - they offered clients consistently bullish research analysis. Spitzer's probe seemed to confirm years of speculation.
The scandal has dealt Wall Street's research a serious reputation setback.
"There is strong evidence that they have suffered serious damage, and it may be irreparable in some respects,
says Alan Siegel, CEO of branding consultancy Siegel & Gale. "It will be very difficult to overcome the negative perceptions that this scandal has developed in the minds of the public."
So how can firms begin the reputation reclamation?
"The only way the firms can restore credibility in their research is to put in place concrete polices that shield research from the conflict of interest inherent in the current structure,
says Ted Pincus, founder of the Financial Relations Board.
Yet addressing the conflicts of interest alone may not be enough.
"They have to be more transparent, and demonstrate that they have made the changes,
says Siegel. "They should use the media to show how they have walled off their analysts from the influence of investment banking."
For years, Wall Street has operated under what is referred to as the "Chinese Wall
system - a metaphor for the supposed limited interaction between the firm's investment-banking unit and other business segments.
It was assumed that the wall also insulated analysts from the influence of bankers eager to get client companies favorable stock recommendations.
Nevertheless, while research alone has always had limited revenue-generating potential for Wall Street, investment banking is the industry's revenue locomotive. So using research to attract banking clients becomes an attractive, if ethically tenuous, proposition.
"The conflict is similar to the one accounting firms are now grappling with between auditing and consulting,
says Jeff Corbin, managing partner at IR firm KCSA. "You have two parts of the same firm, with a tremendous potential conflict of interest."
A big problem for firms is that issuing honest research on banking clients can undercut the bankers' ability to drum up business. A potential client is less likely to consider banking with a firm whose research analyst has been critical of management, or pessimistic about the company's outlook.
"It's going to be hard, because investment banking is the firms' bread and butter,
says Pincus. "It's difficult for analysts to say negative things about the people who pay the bills."
This conflict has led sell-side analysts to be incredibly bullish on the stocks they cover. In March, only 1.8% of all analyst recommendations were sell recommendations, according to First Call/Thomson Financial.
At times, this failure to turn bearish on stocks has bordered on the absurd.
For instance, Lehman Brothers did not drop its "strong buy
rating on Enron until December 6, five days after the company filed for bankruptcy.
While IR pros and other experts agree that sell-side-research credibility is on life support, analysts do not seem to be in danger of falling completely off the Wall Street radar. This appears at least partly because the financial press continues to be addicted to quotes and commentary from the analyst community. Analysts are also very influential in setting expectations for things like quarterly earnings releases.
When a company makes news, the coverage is always rife with quotes from the analysts covering the stock. The reliance by financial journalists on analysts for instant insight provides analysts with a unique platform.
The profession is populated with garrulous and often charismatic figures who make for good copy and sound bites, and analysts have become the public face for some firms.
"It's the easy way out for journalists to quote analysts,
says Lou Thompson, president and CEO of the National Investor Relations Institute (NIRI).
"And it affects an analyst's standing on Wall Street whether he is regularly quoted by the major media."
While acknowledging that analysts retain some influence, most experts agree that their sway with the all-important institutional investor has waned considerably.
"I was on a discussion panel two years ago with a portfolio manager and a high-profile tech analyst from a major firm,
says Elizabeth Saunders, cofounder of IR firm Ashton Partners.
"A CEO asked the money manager who he listened to when he made investment decisions. He turned to the analyst and said, 'Well, I don't listen to these goons.'"
Because institutional investors regularly deal with both the investment banking and brokerage sides of the major firms, they have been familiar with conflict of interest, and wary of sell-side research for a long time.
Some believe that this may help the banks quickly rehabilitate their image.
"For the most part, the people who deal with sell-side research analysts on a consistent basis have known about these conflicts for years, and have factored them into the market,
says Davia Temin, founder of Temin & Co., a marketing and communications firm. "The general public wasn't aware of the conflicts. And now as public attention is drawn away by the numerous corporate scandals that break almost daily, I think this scandal might fade quickly."
IR pros say they have been helping clients reach out directly to institutional investors and circumvent sell-side analysts, who for years had been an important channel to institutional investors.
"IR people have relied on sell-side analysts too much as a conduit to institutions,
says Al Bellenchia, senior partner for financial communications at Fleishman-Hillard. "Most major institutions are doing their own research these days, and we are also seeing more and more targeting and a lot more companies talking directly to their institutional investors."
Still, demand for reliable research continues to pervade Wall Street.
The big firms' loss may end up being the small firms' gain. Independent research firms and smaller brokerage houses that do not do investment banking have been marketing themselves as alternatives to the high-profile firms. Indeed, Prudential Securities - which officially exited the investment banking business - has been trumpeting the fact that its research comes with no strings attached.
"There's a real opportunity for independent research houses,
says Thompson. "There's still a great need for good, fundamental research."
RENEWAL OF INVESTOR CONFIDENCE WON'T HAPPEN BY LIP SERVICE
In this post-Enronian era, we're witnessing a frenetic scene, with scurrying by the SEC, Congress, Justice, and the IR industry to plug a leaky dike. But lip service won't do much to renew investor confidence.
Few of the proposed cures go far enough. Not Senate Banking Committee chairman Paul Sarbanes' new prescription of tighter rules and oversight for public accounting and Wall Street research. Not SEC chairman Harvey Pitt's bold new mandate for investment analysts and investment bankers.
And not the IR industry's new ethics code certification.