On April 25, 2002, the SEC announced that it had commenced a formal inquiry into market practices concerning research analysts and the conflicts that may arise from the relationship between research and investment banking.43 On April 30, 2002, the SEC stepped up its probe by issuing formal requests for documents from ten Wall Street firms.44 The SEC is also continuing to forge ahead with its investigation into Wall Street’s allocation of IPO shares.45 

Elliott Spitzer is now heading a multi-state task force, with attorneys general from California and New Jersey, to investigate analyst objectivity. The head of the criminal division of the Department of Justice has recently indicated that analyst reports may need a closer look.46

In an era when firms such as Credit Suisse First Boston pay $100 million to settle SRO disciplinary investigations involving improper IPO allocations, the multi-million and perhaps even billion dollar investor ramifications resulting from analyst practices require greater scrutiny, examination and reform. 

It has been estimated that several hundred or more arbitration claims are likely to follow in the wake of the New York State Attorney General’s investigation. In a report released on April 24, 2002, a Prudential Financial analyst estimated the cost to Merrill Lynch alone may be two billion dollars.47 Class action litigation cases continue to be filed on issues ranging from IPO allocations to analyst independence. In an unprecedented move at its annual shareholder meeting on April 26, 2002, Merrill Lynch Chairman and CEO David Komansky told his shareholders “[w]e have failed to live up to the high standards that are our tradition, and I want to take this opportunity to publicly apologize to our clients, shareholders and employees.”48 It is likely that severe financial fallout and other apologies will follow. 

The SRO rule changes approved by the SEC recently will greatly assist investors in being able to read and understand research reports and will begin the process for firms to start creating some bona fide separations of its investment banking and research business. It should be noted that the SRO rules do not apply to third party non-member research reports which may be issued or reprinted by member firms. The NASD has indicated that it intends to address those issues more thoroughly at a later time.

It is likely that in a post-Enron environment, the public debate and resultant liability to brokerage firms over research analyst conflict of interest, will not abate in the near future. It is also possible that before this controversy is over, one or more brokerage firms may be subject to the same kind of regulatory scrutiny and private litigation exposure that have befallen Arthur Andersen over the Enron imbroglio. 

Until such time as research and investment banking are completely separated from one another, conflicts of interest will continue to arise. If additional reforms are not made in the manner in which analysts are compensated and perhaps how much they are compensated, these authors believes that focusing primarily on increased disclosure may do little to end some of the alleged abuses. There are recommendations to modify the analyst compensation rules to pay analysts only on the basis of how well their stock picks have performed. The current rules still permit analysts to be paid out of a money pool derived by the firm’s investment banking fees.49 New York State Attorney General Elliott Spitzer has described “. . . as ‘insufficient’ pending rules designed to protect analysts’ independence.”50 Mr. Spitzer has also opined that regulations recently proposed by the NASD and NYSE do not go far enough towards eliminating what he called an incentive structure on Wall Street that encourages analysts to write reports that please corporate clients rather than inform investors.51 “The odds continue to grow that the issue of analyst conflicts will now require a radical structural revision at “sell-side” firms before it goes away.”52 “A full split between analysis and what the rest of the broker-dealer firm does looks less fanciful everyday.”53 

43   See Securities and Exchange Commission Release 2002-56, SEC Launches Inquiry into Research Analysts Conflicts, April 25, 2002, at 1.

44   See Charles Gasparino, SEC -2:Looking At New Rules For Securities Industry, WSJ, Dow Jones News Service, April 30, 2002.

45   See Vickers and France et al, supra note 15 at 36.

46   See Per Jebsen and Brian Kelleher, USA: Feature - Science fiction shows future for stock research, Reuters, May 5, 2002.

47   See Vickers and France et al., supra note 15 at 37.

48   Id. 

49   The Association for Investment Management and Research (“AIMR”) submitted a comment letter to the SEC in late April. Among other things, the AIMR report suggested that analyst compensation should be based only on the merits of the work, not in bonuses from bringing in investment banking business. Other AIMR recommendations include: (1) the proposal be broadened to cover research reports in recommendations for all investment types, not just stocks; (2) if analysts received compensation from the investment banking revenue of the firm they should disclose that and also the percentage of their compensation that was based on that revenue; (3) Any employers who permit their research analysts to give media interviews and make other public appearances should be required to provide the relevant research reports to those audience for free or for a nominal fee. Analysts who do media interviews should also have to disclose their conflicts and should not be allowed to participate if media analysts do not support those disclosures.

50   See Ben White, 12 States Join N.Y. Probe of Wall Street; Prosecutor Spitzer Says He Has Enough Evidence to File Charges Against Merrill, The Washington Post, April 25, 2002, at E06.

51   Id.

52   See Neal Lipschutz, Point of View: Analyst Mess Goes To Front Burner, Dow Jones Newswire Column, April 24, 2002.

53   Id.