Merrill Rules Skirt the Chinese Wall Issue

Merrill Lynch (MER Quote) analysts: Be bullish, but tell us about it.

The brokerage giant said Tuesday it will restrict stock analysts' ownership of shares in companies they cover, as part of an effort to ensure objective research. The company said analysts who continue to hold shares will have to disclose their positions on their reports. The moves come as regulators and legislators cast an increasingly wary eye on potential conflicts on Wall Street, where buy ratings are the norm.

But disclosure aside, some industry experts say the real issue is the lucrative investment banking business that is the bread and butter of Wall Street firms. Until Wall Street firms' research and banking functions are truly independent of one another, investors won't have confidence in the analysis they see, no matter how much disclosure the firms offer, analysts say.

"It's ridiculous," says Tom Brown, CEO of Second Curve Capital, a hedge fund that invests almost exclusively in financial stocks. "What you need to see more of is the walls that are already supposed to exist between investment banking and research. The Chinese wall needs to be strengthened, and enforcement action needs to take place."

In the past few months, investors, trade groups and regulators have studied the issue, trying to figure out how to make these relationships more transparent. In June, for instance, the Securities Industry Association trade group issued guidelines to ensure the integrity of analyst research. The group, made up of Wall Street firms, suggested not linking analyst pay to specific investment banking transactions or sales, disclosing ownership positions and explicitly discussing valuations and risks. Subsequently, a House subcommittee set plans to examine the guidelines.

"This is an issue that is not going to go away," says Prudential financial services analyst Mike Mayo. "I think it is important for firms to show they provide a platform for objective research."

Frank Barkocy, director of research at hedge fund Keefe Managers who spent 25 years as a Merrill analyst, favors the new rule, saying it "removes a layer of concern the investor might have." Still, he agrees there is much more to be done: "Only time and stricter imposition of controls will alleviate investment banking concerns."

Brown, for his part, says he would just as soon see analysts own the stocks they recommend. "If they really believe it's a buy, I want to know that an analyst has put his own capital behind it," he says. "This whole issue of prohibiting analysts from owning stock in the institutions they cover is just a red herring."