Brokerages Swoon on SEC Probe

Updated from 5:26 p.m. EDT

It's sinking in on Wall Street that the growing scrutiny of its clubby procedures represents more than a passing annoyance that can be chalked up to lousy markets.

The urgency of the matter was underscored Thursday when brokerage stocks tumbled on news the

Securities and Exchange Commission

launched a formal investigation into analysts' conflicts of interest. The probe, which follows a high-profile investigation of

Merrill Lynch

(MER)

by New York Attorney General Eliot Spitzer, could result in new laws governing the profession, according to SEC Chairman Harvey Pitt.

Pitt's announcement came the same day as news that embattled Salomon analyst Jack Grubman has been subpoenaed in Spitzer's widening investigation. Spitzer has asked for documents dating back to January 1998 relating to 54 telecom companies, according to published reports.

Changing Times

"Conflict of interest has been an issue in the brokerage industry and other industries for a long time, and there are early industry codes that made an effort to deal with such conflicts," said Paul Maco, a securities lawyer with Vinson & Elkins, itself no stranger to controversy. "But markets change and circumstances change over time. Obviously one of the objects of inquiry is whether circumstances have in fact changed with such a degree of significance that regulators need to change the framework."

Fearing the framework won't hold, investors sent brokerage shares lower. Merrill Lynch ended down $2.15, or 4.8%, to $42.50.

Bear Stearns

(BSC)

lost $1.42, or 2.3%, to $61.18, and

Goldman Sachs

(GS) - Get Report

fell $2.28, or 2.9%, to $77.21.

J.P. Morgan Chase

(JPM) - Get Report

was down 86 cents, or 2.4%, to $35.03,

Lehman Brothers

(LEH)

closed down $2.24, or 4%, to $57.91, and

Morgan Stanley

(MWD)

was falling $2.86, or 5.6%, to $48.13.

Pitt's announcement is the latest and potentially darkest cloud to gather around the brokerages, which already were coping with disaffected investors and a barren climate for new underwriting and advising. Thursday's big moves reflect the increasing seriousness with which investors are taking the matter.

One of the Street's worst-kept secrets for years, the role of equity research in soliciting other business for investment banks has come under a harsh light as the stock market has bottomed. Spitzer and now Pitt risk little political capital in going after investment banks but on Wall Street their venom is starting to look more like a structural threat than an irritation.

"It will be very difficult for new players to win market share in the world of IPOs," said one analyst who spoke on condition of anonymity. "For those investment banks that don't already have market share, equity research is the principal tool for winning mandates to do an IPO. They'll say, 'Oh, I have the No. 1-rated optical switch analyst.'

"If they can't do that anymore, that means the people that do have the market share, the Goldman Sachs, Merrills and Morgan Stanleys, will be the winners. The losers are those that don't have the market share -- the Lehman Brothers and the J.P. Morgans," the analyst said.

In the Merrill probe, analysts were criticized for orienting their buy-and-sell recommendations to the goals of the company's investment banking operations. Spitzer cited emails in which analysts derided companies privately while publicly telling clients to buy their stock.

In the Works

Pitt, who met with Spitzer on Tuesday, will oversee a meeting May 8 in which various new proposals for rules governing research are weighed. Those proposals would generally increase analysts' independence by prohibiting the tying of compensation to investment banking transactions.

"The kind of things they're talking about, more disclosure, are par for the course. As far as a complete separation

between investment banking and research, it's effect on companies ability to raise capital -- you have to be a little careful on how far they should take this," said Greg Smith, a former analyst at J.P. Morgan. "There would be no incentive on smaller companies to publish the research."

The inquiry will be conducted jointly with Spitzer, the

New York Stock Exchange

, the

National Association of Securities Dealers

, the North American Securities Administrators Association and state authorities, Pitt said.

Despite its quick response to the crisis of confidence in accounting that followed the

Enron

collapse, the SEC had been criticized for dropping the ball on analysts prior to Spitzer's investigation.

"This is the next step -- and a critical one -- in the commission's year-long review of analyst practices," Pitt said. "The recent disclosures that resulted from the investigation by the New York State Attorney General, as well as the practices uncovered by the staff of the SEC, the NYSE and NASD, reinforced the commission's conclusion that further inquiry is warranted."