Telling Congress About the Rigged Research Game (Cont'd)

Editor's note: TheStreet.com columnist Adam Lashinsky is testifying today before the House of Representatives Subcommittee on Capital Markets, Insurance, and Government-Sponsored Enterprises. The committee is investigating the quality of equity research and reporting available to the average U.S. investor. We are running Lashinsky's testimony in full and in three parts. This is the third and final part.

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This committee is better off hearing from analysts about the pressures analysts face. But I talk to analysts and their clients every day, and I can give you some insight. One prominent analyst I know once described his job as having to be willing to come into work each day and get clobbered repeatedly by a two-by-four. Who's delivering the punishment? By turns: Retail brokerage clients unhappy with a recommendation that didn't work out, companies bothered by unfavorable commentary, institutional brokerage clients displeased at not getting the early word, investment banking colleagues peeved that some report hurt a deal. And so on.

This isn't to make you feel sorry for analysts. It's just that one begins to understand how a profession so badly conflicted could try so hard to please so many and end up pleasing so few.

And it's important to point out here, again, who's complaining about rotten research and who isn't. The primary audience for Wall Street research is the institutional investors who are trading clients of the firm -- the ones who understand best what the research is worth. They aren't typically disappointed by the quality of the work, at least not enough to complain about it. If they are disappointed, they hire their own researchers to investigate companies. All the best investors conduct their own research and use the sell side to supplement their data and test their conclusions. Who's left? The individual, who typically is not paying for the research but is reacting to things he or she heard on television. Let me state that a different way: The people complaining loudest about the quality of Wall Street research generally are the people who aren't paying for it.

Some Obvious and Not-So-Obvious Solutions

This committee seems to be taking the approach that its best role is to use its bully pulpit to get the market's participants to clean up their act rather than to propose structural reform. As a columnist and observer of the capital markets, I support that approach. Analysts should be encouraged to disclose their conflicts of interest. Reporters should be urged to be critical. Investors should be admonished to do their homework before buying securities. Investment banks should be embarrassed at the way they have misled the general public.

But there are other, more radical, approaches Congress, together with the SEC, could take.

• Split investment banks from brokerages. This step flies in the face of the last decade of financial services reforms intended to allow consolidation of the industry. But if the government feels that the public is being hurt by the system as it exists today, take apart the system. Brokerages that didn't have investment banking arms no longer would be conflicted by investment banking pressures. Investment banks could distribute research to whomever they liked, but it would be clearer whose interests they serve. Brokerages, of course, would find it difficult to make money under such a scenario. Conversely, perhaps all that's needed is a semantic shift. Perhaps if investment banks somehow were more honest about the fact that their research arms already lack independence then the charade would be over and everyone would be happier.

• Allow fixed-rate minimum commissions. When Congress threatened the exchanges with price-fixing charges, it began the end to institutional investors paying for research. If trading isn't profitable, the brokerages will find other ways to make money. But if they could charge some clients more, those clients likely would be willing to pay for the privilege of receiving independent research. Research, after all, isn't public information the way the public filings of listed companies are. The way the system works today, however, brokerages don't try to make money on research, essentially because they are not allowed to.

• Require greater disclosure. This process is under way, led by a series of best practices suggested by the Securities Industry Association. These are guaranteed to be little more than palliatives. It will help a paying client to know the conflicts of an author of a report, but only so much. Similarly, firms restricting stock ownership by analysts will have little impact. The big money is in investment banking, not trading for one's personal account. These are matters properly addressed by a firm's own compliance department, not Congress.

• Support Regulation FD. The job of being a research analyst has become more difficult since October 2000, when the SEC promulgated Regulation FD, for "fair disclosure." Because public companies must disclose all material information simultaneously, analysts with good social skills or financial muscle with senior management no longer have an edge. This is a good thing. In order to be effective, analysts must analyze again. An analyst recently wrote me an email complaining that companies had to be allowed to supply him with a financial model. Otherwise, how could investors know what to expect? I reminded him that it is his job to build a model based on his research. Good modelers will make good money for their clients; bad ones will not. A dangerous move is afoot by the securities industry and some elements within the SEC to weaken FD. If Congress wants to do right by the individual investor and force analysts to analyze, it should throw its support behind Reg FD.

Wall Street research during and after the stock-market bubble has become something of a joke. Analysts went from unknowns to superstars to goats in the span of five years. Fortunately, the market has a wonderful self-correcting mechanism. To restore its credibility, Wall Street is trying to promote the appearance of objectivity and independence in its research departments. Individual analysts are struggling to keep up in a Reg FD world and one where most of the participants now have the fabled decoder ring that lets them understand what analysts mean when they say buy, accumulate and hold, but rarely sell. As well, my sense is that the financial news media generally is embarrassed by its role and is correcting the situation by embracing its natural skepticism again.

For the time being, the investment-banking conflict will diminish because there is so little investment banking being committed. The key for this committee is to determine what regulatory oversight will be needed, if any, when the investment-banking machine cranks itself up again.

To return to the first part of Lashinsky's testimony, click here, and for the second part, click here.