Can Outside Research Clean Up the Street?

Stock research by major Wall Street brokerages has been shown to be tainted by inherent conflicts of interest. So securities regulators have come up with a novel plan for reform: Force the brokerages to give their investors the research of outside firms that don’t face the same kinds of conflicts.

Backers say the idea would benefit individual investors by making available to them a range of opinions on stocks -- specifically, the opinions of analysts whose firms aren’t also pursuing fee-rich investment banking work from companies the analysts are covering.

Many so-called independent research firms are small, little-known operations that now primarily provide their work to institutional investors.

Critics say the idea would just create a new conflict of interest by aligning the independent research boutiques with the scandal-tainted brokerage giants.

“We’re kind of scratching our heads,” said Scott Cleland, chief executive of Precursor Group, a Washington-based independent research firm. “The word ‘independent’ means ‘not of Wall Street,’ and now the government’s solution is to have Wall Street be a distributor of independent research. We don’t see how you remain independent.”

The Securities and Exchange Commission and New York Atty. Gen. Eliot Spitzer, along with other state regulators, have been negotiating with the big brokerages in recent weeks, seeking a “global” settlement of allegations of widespread misconduct by analysts during the late-1990s bull market.

Probes by New York, Massachusetts and congressional committees this year have shown that some analysts touted stocks of even the most fundamentally weak companies to help their firms win lucrative banking work, such as underwriting stock offerings.

As part of a settlement, it’s expected that regulators would demand that the 10 to 12 biggest brokerages shell out $1 billion over five years to fund the work of independent research firms and make that research available to their clients in addition to in-house research.

The brokerages have endorsed the accord in concept, but they reportedly are bickering about how much each should pay. A deal could be struck any time in the next few weeks.

Under the plan, an oversight panel would set standards for independent research and decide which research firms would get contracts to supply the brokerages.

The panel would be expected to pick the “most accurate” research firms for different stock sectors, say people familiar with the negotiations. But the question of how to judge accuracy could become contentious.

For example, three firms might be picked to cover energy, so if a Merrill Lynch & Co. client sought information on Duke Energy Corp., his broker would have to make available reports from those firms along with reports by Merrill’s in-house analyst, according to people who have been part of the discussions.

To be included, independent firms would have to swear they have no investment banking ties and would have to meet other standards yet to be determined.

“We hope this will put integrity back into the [Wall Street] research business and stimulate competition,” said Darren Dopp, a spokesman for Spitzer.

Paul A. Volcker, a former Federal Reserve chairman, and John Biggs, former head of the pension giant TIAA-CREF, have been mentioned as possible nominees for the research panel.

Yet critics question the idea of government-appointed bureaucrats directing the process.

Said Cleland: “Does anybody think a quasi-government body would be good at picking stock pickers?”

“Why not give investors everything and let the marketplace decide?” said Samantha Topping, spokeswoman for Multex Inc., a New York company that provides research, for fees, from more than 250 independent firms as well as from the big brokerages.

Cleland said Precursor, for one, wouldn’t compete for any of the contracts. “It’s temporary money and it’s tainted money. It would undermine our integrity,” he said.

Dopp called the critics misguided. “It would not be the government doing anything. This would be an independent panel and the money would be escrowed,” he said. “This is not going to be ‘Eliot Spitzer-sanctioned’ research.”

Some independent firms concur, saying they don’t believe distribution of their reports through brokerages would taint their work.

“Our research already is being distributed through brokerage Web sites as well as [financial] advisors and our investor newsletter,” said Sandy Bragg, executive managing director at the Standard & Poor’s Corp. investment services group in New York. “Wall Street firms license our research today -- it’s part of how we’ve built a successful business model. We don’t have any qualms about that.”

Other firms are taking a wait-and-see approach, saying key questions need to be answered.

“I understand they will pick the research firms based on accuracy, but how do you define ‘accuracy’?” asked John Eade, president of Argus Research Co. in New York.

What’s more, “It will be interesting to see how they define ‘independent.’ It’s hard to be totally conflict-free,” said Eade, who noted that his firm -- along with other such independents as Value Line Inc. and Sanford C. Bernstein & Co. -- also operates a money management business.

Jean Buttner, chief executive of Value Line in New York, said, “No government body has contacted us, so we don’t know what they’re proposing. One thing is certain: People should have independent research. It’s badly needed, as you can see from all the scandals.”

Still, independent research is not necessarily superior, experts caution.

“Analysts can be independent but horrible stock pickers,” said Kei Kianpoor, CEO of Investars.com in Hoboken, N.J., which ranks analysts’ picks. “The folks at Morgan Stanley might provide far better research despite their investment banking business.”

Kianpoor also noted that much of the research that boutique firms provide has been tailored for institutional investors’ specific needs, which could make it difficult for small investors to digest or use.

For example, some research firms have thrived in a tough stock market because hedge funds and other institutional clients need “short-sale” candidates -- stocks to bet against, not on.

Regardless, the plan would at least “give investors a stronger sense of the diversity of opinion,” said John Coffee, a Columbia University law professor. “More information is always better than less.”

Coffee said analysts and brokers at the big Wall Street firms might be shamed into providing more thoughtful work.

“It may create a certain embarrassment cost: If a Merrill customer sees that others are saying something different about a stock, that might make [the broker] a little more modest in recommending it,” he said.