Executive Summary

Millions of individual investors are marking the third anniversary of the U.S. bear market with both quiet outrage and hope.

Their outrage stems from $10.5 trillion in lost stock market value from peak to trough, along with smoking-gun evidence of widespread Wall Street corruption that helped entrap them into the losing investments; their hope stems from the global settlement with 10 large firms and a wide range of reforms that promise to restore fairness on Wall Street.

While the global settlement and new rules are a welcome change and important steps to restoring investor confidence in Wall Street, there is a real danger that this opportunity will be wasted in a plethora of overlapping and confusing rulemaking initiatives. Currently, there are adopted and proposed rules by the SEC, NASD, and NYSE, additional rules that will be required by the Sarbanes-Oxley Act, plus expectations that the SEC, NASD, and NYSE may extend reforms that are imposed as a result of the settlement.

Each set of rules seeks to address serious conflicts of interest underlying Wall Street research reports and recommendations. However, as we shall demonstrate in this paper, the piecemeal process of rulemaking has left us with regulations that are often weak, confusing, and incomplete--leaving serious gaps and failing to protect investors adequately.

To keep track of which reforms have been approved and proposed, and which are missing, we have compiled a scorecard, entitled Analyst Reform Progress Report, attached to this paper as Appendix A.

Part 1 of this paper provides detail on our scorecard, showing that, in the final tally of proposed and adopted rules, investors could still be the losers in each of the following areas:

• the continuing influence of investment banking and other conflicts of interest on research analysts,
• how analysts get paid and solicitation of banking business,
• disclosure and notification to investors of changes in ratings, and
• oversight of analysts.

Legislators and regulators have decided not to require divestiture in order to bring about a clean separation between research and profit centers that can bias analysts. Thus, instead of seeking to eliminate the conflicts, they have decided they will try to manage the conflicts. In Part 2 of this paper, we demonstrate that this approach is deficient inasmuch as the rules:

• do not address the fact that a firm's other profit centers can also cause serious conflicts of interest for research analysts;
  
  
• do not adequately recognize informal pathways of communication and influence; and
  
  
• do not take into consideration Wall Street's two-tier system for the distribution of information that favors a privileged class of investors.

Despite all the rules, we have identified both strong motives and easy pathways that can lead back to business as usual on Wall Street. Indeed, it could be very difficult for most firms to maintain research independence while continuing to pursue their primary goals-promoting the sale of equity and debt securities, trading many of those same securities in their house account, servicing top corporate clients with mergers and acquisitions, and generating larger commission revenues.

As we demonstrate in this paper, while many of the rules are steps in the right direction, there are also many that leave loopholes that may be very difficult to close. Part 3 of this paper contains our specific recommendations for improving the effectiveness of analyst regulation. We believe regulators should:

• Centralize the rule-making function under the SEC. Currently, the convergence and overlapping of adopted and proposed rules by the SEC, the NASD, the NYSE, and the global settlement is causing significant market and industry confusion. In addition, it is unclear as to how the settlement among a limited number of large firms is going to be applied to the many firms that are not party to the settlement. We propose that the rulemaking functions be centralized under one committee or rulemaking body.
  
  
• Seriously reconsider divestiture. Regulators and legislators have decided not to force the separation of research from other operations. However, given the difficulty of regulating and enforcing behavior that goes against the grain of the profit motive in each firm, this would be the cleanest solution and should be seriously reconsidered.
  
  
• Base analysts' incentive compensation exclusively on the accuracy of their research and ratings. If divestiture is impossible, there is a fall-back solution: To better align the interests of analysts with those of investors, we propose that 600 of the analysts' incentive compensation be based on the relative accuracy and quality of the analyst's research and ratings, measured by a standard methodology; and that the incentive compensation be targeted to represent at least 50% of the analysts' total compensation.
  
  
• Create a comprehensive Stock Ratings Database (SRD) and make it widely available to the public. The SRD would provide individual investors with a user-friendly database on the current and historical stock ratings issued by Wall Street analysts and firms, empowering investors to make informed decisions regarding the value of the advice. (See Appendix B.)
  
  
• Require firms to update their stock ratings on a regular basis and following any event that could materially impact a rated company. Firms should be required to update ratings following any event-such as a debt downgrade-that could materially impact a rated company. At a minimum, ratings should be reviewed annually.
  
  
• Require that all research reports be written in plain English. Research and disclosures must not only reach individual investors, but they must also be clearly understandable to those investors.
  
  
• Require firms and their brokers to provide disclosures to investors when recommendations are communicated orally or to inform customers when ratings change or coverage is dropped. When brokers relay an analyst's recommendations orally, they should be required to provide investors with the disclosures contained in the research report and a brief review of the accuracy of the analyst's past recommendations.
  
  
• Extend rulemaking to analysts issuing bond and credit ratings. Investors should be able to rely upon the same degree of disclosure and research ethics regardless of whether they are investing in stocks or bonds.

Part 1. The Patchwork of New Rules and Regulations

In 2002, we demonstrated that the ratings publicly available from 94% of 50 major brokerage and investment banking firms continued to recommend that investors buy or hold shares in failing companies right up to the day those companies filed for bankruptcy.¹ Further, in two follow-up studies, we revealed that despite widespread investigations by regulators, publicly available ratings from the majority of Wall Street firms continued to recommend companies going bankrupt.² (See Appendix C.)

These findings support and expand upon the evidence revealed in the global settlement and by the earlier complaint against Merrill Lynch, illustrating how analysts continued to recommend stocks to the public, while deriding those same stocks in private communications.

Overall, a widespread pattern of deceit was an integral element in the pattern of devastating losses suffered by investors. In contrast, the response from legislators and regulators has been fragmented, with multiple rulemaking processes, including:

• SEC and SRO rules by the NASD and NYSE already in place;
• proposed rules by the NASD and NYSE that have yet to be approved by the SEC;
• additional rules that have not yet been proposed, but will be required in the near future by the Sarbanes-Oxley Act of 2002;
• conjecture that the SEC may take over the rulemaking process from the NASD and NYSE to effect a national standard for the regulation of analysts; and
• the requirements of the settlement, along with expectations that the SEC, NASD, and the NYSE may extend reforms that are imposed as a result of the global settlement on all analysts through additional rulemaking.

A Landmark Decision With Widespread Consequences

It is widely agreed by consumer and investor advocacy groups that a clean separation between investment banking and research through divestiture is the best vehicle to bring about a true break with the past, revive investor confidence, and pave the way for stronger equity markets in the future.

However, legislators and regulators have decided not to require divestiture. Instead of seeking to eliminate the conflicts, they will try to manage the conflicts. Toward that end, they are building a complex patchwork of rules designed to modify some of the formal pathways through which they believe the conflicts flow from investment banking departments to research departments.

We examine below how these reforms change the way Wall Street conducts research, along with their shortcomings and what remains to be done to restore investor confidence in four major areas: (1) investment banking and other outside influences on research analysts; (2) how analysts get paid; (3) disclosure and notification to investors; and (4) oversight of analysts.

(1) Investment Banking and Other Outside Influences on Research Analysts

• Research from independent firms. As part of the terms of global settlement with the largest brokerage firms, the firms will be required to contract with at least three independent firms to provide research for five years, using an independent consultant chosen by regulators to procure the research at each firm. In addition, the ratings from the independent research firms will appear on each brokerage statement and confirmation.
  
  Our view: This is a strong step in the right direction. However, it is unclear how balanced presentations can be enforced in the context of oral communications between brokers and clients. For instance, if the firm's rating is a buy and the independent research analysts are all rating the stock a sell, how will the broker explain to the client why there is a difference and how that might affect the decision to buy?
  
  
• Participation of research analysts in investment banking sales. The NASD and NYSE have proposed (but not yet approved) rules that state, in essence: If a research analyst helps obtain investment banking business or is involved in road shows, he must not issue research reports or make public statements about the company. At the same time, the global settlement prohibits analysts from participating in any road shows at all.
  
  Our view: The NASD/NYSE rules are weak, since they would not prohibit such analysts from sharing any information or opinions with colleagues in the same or related research departments. Nor is there any rule that would prevent those colleagues from using the same or similar material in their own public reports and statements. The global settlement's total prohibition of analyst participation in road shows is a more appropriate response although it remains to be seen if this will be enacted industry-wide.
  
  
• Supervision of research analysts. The NASD and NYSE have approved rules prohibiting research analysts from being supervised or controlled by a firm's investment banking department. The settlement reaffirms this rule and, in addition, it stipulates that firms will adopt and implement policies and procedures reasonably designed to ensure that its associated persons cannot and do not seek to influence the contents of a research report or the activities of research personnel for the purposes of obtaining or retaining investment banking business.
  
  Our view: There are no rules, policies or procedures that can effectively prevent the investment banking department, by its sheer presence and by virtue of its large revenues, from exercising broad indirect impact on research. Analysts know where the money is coming from. Moreover, it is not possible to micro-manage personal interactions and informal communications in any modern organization.
  
  
• Separation of research from investment banking. The global settlement requires that research and investment banking be managed in two separate units, with separate legal and reporting structures, in physically separate locations. In addition, the settlement strengthens the firewalls between the two functions, further restricting communications between investment banking and analysts.
  
  Our view: Managerial and physical separation will help manage the potential for conflict. However, regardless of the degree of separation, analysts will still have the overall success of the firm as a common goal, continuing to potentially bias the research.
  
  
• Discussing research with investment bankers. The NASD and NYSE have approved rules forbidding investment banking personnel from discussing a research report with the analyst unless the firm's legal/compliance staff is present.
  
  Our view: Same comments as above.
  
  
• Fact-checking by companies. In conjunction with the above rule, the NASD and NYSE have approved a rule that forbids the rated company from reviewing a research report except to check factual accuracy.
  
  Our view: There is no discrete line that separates fact from analysis, or that distinguishes analysis from opinion. Thus, any prepublication review by the companies can open the door to continuing influence from the companies. We propose that:
  
  
  • researchers, themselves, be fully responsible for fact-checking;
  • their reports should not be seen by the rated companies until after they are released to the public;
  • the companies should submit any suggestions for corrections after publication; and
  • such corrections should be handled in a manner that conforms to journalistic standards.
  
  
• Booster shots. The widespread practice of issuing "booster shots" -follow-up reports released to coincide with the expiration of lock-up agreements that free shareholders to sell their stock-is prohibited under a proposed rule by the NASD and NYSE. Instead, there would be a blackout period during which new reports or public appearances are not allowed 15 days before and after the expiration of a lock-up agreement.
  
  Our view: If the analyst had a strong incentive to produce accurate reports at all times, as we propose, this rule would not be needed. Conversely, if there is an incentive to produce reports to boost share prices for favored companies and investors, the prohibition period is inadequate.
  
  
• Retaliation against analysts. The Sarbanes-Oxley Act of 2002 requires that the SEC, the NYSE, or the NASD adopt rules by July 2003 to prohibit retaliation by companies against analysts for issuing unfavorable research. However, no rule has been proposed to date.

(2) How Analysts Get Paid and Solicitation of Banking Business

Regulators have proposed a series of rules governing how analysts get paid, as follows:

• Analyst compensation based on quality of research. According to the settlement terms, a significant portion of the compensation of anyone principally engaged in the preparation of research reports must be based on quantifiable measures of the quality and accuracy of the lead analyst's research and analysis, including his or her ratings and price targets, if any.
  
  Our view: This is a welcome step in that it lays the groundwork for putting the analyst on the side of the investor. However, the settlement does not spell out a definition of "significant portion," while also allowing for five other factors, unrelated to the quality of research, that could impact an analyst's compensation. Therefore, this requirement needs to be spelled out more clearly. As demonstrated elsewhere in this section, despite the many regulations that seek to erect a firewall between investment banking and research, there are bound to be continuing pressures and influences on the analyst to be a team player for the firm by supporting the firm's corporate clients, and there are bound to be continuing opportunities for investment bankers to communicate with, and influence, analysts informally. To counter these pressures and influences, the incentive for the analyst to strive for accuracy must be stronger and more specifically delineated.
  
  
• Analyst compensation tied to banking transactions. The settlement terms disallow any compensation based directly or indirectly on investment banking revenues or results; provided, however, that compensation may relate to the revenues or results of the firm as a whole. Meanwhile, the NASD and NYSE have approved rules that disallow any analyst compensation that is tied to specific investment banking transactions.
  
  Our view: Since investment banking revenues can often represent a large share of firm's overall revenues, and since nearly all analysts would likely be well aware of this fact, many analysts who wish to see their firm prosper are bound to be motivated to support the firm's investment banking efforts with positive research and to avoid undermining the effort with negative research. (See more on this topic below.)
  
  
• Disclosure of investment banking compensation. The SEC, NASD and NYSE have approved rules that explicitly allow compensation to analysts based on general investment banking revenues. They merely require that such compensation be disclosed in the analyst's research reports.
  
  Our view: Such standard disclosures are often (a) buried in reports and/or (b) become so ubiquitous that they lose most or all meaning. Moreover, the mere disclosure of factors that are likely to cause a bias does not reduce or excuse that bias. The disclosure must connect the dots for investors. A generic statement that analysts receive compensation based on general investment banking revenues-without an explanation as to why that could create problems-will not give investors adequate information to weigh the real significance of the issue.
  
  
• Compensation Committee to review compensation process. In the settlement, and in a rule proposed (but not yet approved) by the NASD and NYSE, a committee reporting to the board of directors must review and approve analysts' compensation at least annually.
  
  Our view: This is an appropriate mechanism, provided the above three issues are resolved.
  
  
• Promising positive ratings to generate banking business. Based on rules approved by the NASD and NYSE, firms may not offer a rating or price target to a company in order to get its investment banking business or other compensation.
  
  Our view: While addressing quid pro quo transactions, this rule does not prevent firms from establishing a reputation for glowing research reports and high price targets in order to attract the business of companies in the future.
  
  
• Quiet periods. The NASD and NYSE have approved a rule mandating a 40-day quiet period with no new research reports or public pronouncements on a particular company after an IPO, as well as a 10-day quiet period after a secondary offering. In addition, the NASD and NYSE have approved a 15-day quiet period before and after the expiration of a lock-up agreement for a securities offering.
  
  Our view: These rules represent a tacit recognition that the body of rules as a whole may not adequately prevent research from continuing to influence-and be influenced by-investment banking transactions.
  
  
• IPO shares to analysts. The NASD and NYSE have approved a rule forbidding any analyst or family member from receiving securities prior to an IPO.
  
  Our view: This is an adequate response to this practice.
  
  
• Personal securities transactions. The NASD and NYSE have approved a rule forbidding analysts from trading in a stock 30 days prior to the issuance of a report on that company, and ending five days after.
  
  Our view: There are two fallacies in this and other securities transactions rules: First, front running and conflicts of interest related to personal transactions are not restricted to a particular time frame. The analyst can easily buy up shares 31 days or more before issuing a recommendation. Second, an analyst can be biased by any positions held in the securities covered, despite the absence of any new transactions to buy or sell. Thus, with the exception of exempt securities, such as Treasury securities and mutual funds, we recommend that analysts not be allowed to invest in or hold any securities that they cover.
  
  
• Contrary trading. The NASD and NYSE have approved a rule that analysts cannot trade contrary to their most recent recommendations on a company.
  
  Our view: While this rule is a step in the right direction, we believe that analysts should be prohibited from trading in the stocks they cover.
  
  

(3) Disclosure and Notification to Investors

• Analyst certification. According to the SEC's Regulation Analyst Certification adopted on February 20, 2003, analysts must certify that the views expressed in their research reports and public appearances are their own. They must also state that no part of their compensation was related to specific recommendations or views; and if that isn't true, they must provide details on their compensation. (This rule applies to both equity and debt securities, while similar rules adopted by the NYSE and NASD apply strictly to equities.)
  
  Our view: There is nothing to prevent individuals from (a) formulating their views under pressure of bias, and then (b) incorporating those views into their own body of opinions as if they were their own from the outset. Indeed, the powerful principle of cognitive dissonance implies that this is the normal behavioral pattern in almost any context. This principle can greatly weaken the efficacy of the analyst certification rules. Separately, there is no mechanism for isolating investment banking revenues from other company revenues as a prime driver of compensation.³
  
  
• Plain English. In order for any ratings, reports, recommendations, disclosures or notifications to investors to be effective, they must be written in plain English. However, no rules have been adopted or formally proposed to address this critical issue. In addition, there is no requirement that the reports or model disclosure formulations be tested on investors to see if they are actually understood and effective in educating and warning investors.
  
  
• Oral communications. When brokers relay recommendations orally, they should be required to provide investors with the disclosures contained in research reports and information regarding the accuracy of the analyst's past recommendations. However, with the exception of the settlement terms requiring brokers to inform customers regarding the availability of independent research reports, no clear rules governing oral communications between brokers and their clients have been adopted or formally proposed. This is a deficiency that can lead to significant investor losses. For example, when a broker recommends a stock based on its rating by the firm's analysts, the broker should seek to inform the client when the rating has changed.
  
  
• Disclosure of public offerings. According to rules approved by the NASD and NYSE, research reports must disclose if the analyst's firm has handled a public offering of equity securities for the company, received investment banking compensation within the last 12 months, or anticipates revenues within the next three months.
  
  Our view: Regardless of when investment banking revenues have been received or are anticipated, firms vying for the highly competitive and lucrative investment banking business may seek to establish a positive reputation for their research departments to entice companies to use their services. Conversely, any firm issuing a preponderance of negative reports may develop a stigma for being "too negative," thus damaging the firm's chances of developing new investment banking relationships in the future. The proposed rule does not address this greater, underlying concern. Nor does it cover the offerings of debt securities, which can also bias research.
  
  
• Disclosure in public appearances. The analyst must also disclose if a company is a client in public appearances mentioning the company, according to a rule adopted by the NASD and NYSE.
  
  Our view: The disclosure of bias does not correct the bias.
  
  
• Disclosure of ownership. The NASD and NYSE have adopted a rule requiring analysts to disclose if they or family members own any of the securities covered in their research reports or public appearances.
  
  Our view: For the reasons expressed above, analysts should not hold or invest in the securities they cover.
  
  
• Disclosure of percentage of ratings assigned to each category. The NASD and NYSE have adopted a rule requiring firms to disclose the percentage of ratings assigned to buy/hold/sell categories; and in each category, the percentage involving investment banking services within the last 12 months.
  
  Our view: This is a positive step that can only help investors better evaluate the impact of investment banking on each firm's research.
  
  
• Disclosure of price chart. The NASD and NYSE have also adopted a rule requiring that research reports contain a chart showing historical price movements along with notations as to when ratings or price targets were assigned or changed.
  
  Our view: This is another positive step that will help investors evaluate each analyst's track record. In addition, it could be enhanced with a record of any upgrades or downgrades to the company's public debt as a reference point for assessing the analyst's response to changing public information.
  
  
• Transparency of analysts' performance. The settlement stipulates that, if contained in their research reports, the firms will make the following information public via their websites within 90 days after the end of each quarter: subject company, names of analysts, date of report, rating, price target, period within which the price target is to be achieved, earnings per share forecasts, periods for which such forecasts are applicable, and a definition or explanation of the ratings used by the firm.
  
  Our view: This is a welcome step that will also help investors learn more about the ratings. However, it will still be very difficult for investors to compare the research and ratings from multiple firms and various independent research organizations. Furthermore, the rule implies that, by the time the information is made available on the brokerage firm websites, the ratings issued in the beginning of a quarter could be as much as six months old. The investor will need information that is more current in order to make informed decisions.
  
  
• Notification to investors on termination of coverage. The global settlement and the NASD and NYSE proposed rules require firms to notify investors when an analyst's coverage is dropped, with the notice including a final rating or recommendation. The rules and the settlement specifically call for notice to be made in the same manner as when research coverage was first initiated.
  
  Our view: Under the terms of the settlement, investors who own the shares with the firm will get notification through their statements. However, for the sake of investors who currently do not own the shares, or do not own them with the firm, these requirements place no responsibility on any entity for passing that notification on to the public. This could be a serious deficiency as explained below. In addition, it does not require notification of other rating changes-only when coverage is dropped.
  
  As documented in the next section, there have been many instances in which (a) the notification of buy ratings reached the public immediately, but (b) the notification of coverage termination, although disseminated through ordinary channels, never reached the public. Therefore there is an urgent need to review and reform dissemination channels in order to make this rule effective.
  
  
• Standards for dissemination of ratings. With the exception of dropped coverage notifications, clearer standards are needed for dissemination of ratings and updates, via major public sources.
  
  
• Updating ratings. Firms should update or affirm their analysts' ratings following any event that could materially impact a rated company, such as a major credit rating downgrade or, at a minimum, once annually. Otherwise, there is a strong possibility that outdated ratings will languish in the public domain, misleading investors.

(4) Oversight of Analysts

• Registration and continuing education. The NASD and NYSE have proposed a rule to establish requirements for registration, qualification, and continuing education for analysts to ensure they receive ethics and professional responsibility training.
  
  Our view: This is a positive step. However, if ethics training is not fully supported by-or is in conflict with-the financial incentives of each analyst, it is likely to be undermined by the day-to-day realities of Wall Street.
  
  
• Review committee. The global settlement requires the firm to establish a committee to review analyst ratings and reports for objectivity, integrity, and quality.
  
  Our view: It remains to be seen whether or not regulators will adopt similar rules for other firms. This is not an onerous requirement and should be required for all firms.
  
  

Part 2. Why Many of the Rules are Inadequate to Protect Investors

Overall, we believe there are three fundamental flaws in rules adopted and proposed to date, as follows:

First fundamental flaw:

The firewall built under the new rules and the settlement is exclusively between equity underwriting and research, failing to recognize that a firm's other profit centers can also cause serious conflicts of interest for research analysts.

Table 1 summarizes the breakdown of revenues among the investment banking firms that have participated in the global settlement, based on their most recent filings with the SEC. Among the various revenue sources, there are three that have not been addressed by the rules proposed and approved to date:

Underwriting of debt securities. Other than the SEC rule requiring analyst certification, the rules address issues related strictly to the underwriting of equity issues. There are no new rules that specifically address the underwriting of debt securities. Negative research reports on a company can easily become the fly in the ointment for these operations, while positive research reports inevitably help support them.

Commissions. Among the 10 firms involved in the settlement discussions, the aggregate percentage of revenues from commissions (9%) is larger than the percentage from all investment banking activities (8.4% including M&A), according to the firms' recent SEC filings.

Brokers can typically use a buy rating on a stock to pitch it to all customers and generate large commissions. In contrast, with a sell rating, their target market is much smaller, limited strictly to customers who already have shares to sell. Moreover, most brokers fear too many sell ratings will chase customers away - the more their customers sell, the more likely they are to close their accounts. Therefore, we believe the firm's desire for more commission revenues can easily bias research.

Trading and investments. Except for other revenues largely unrelated to this discussion, trading and investment revenues from house accounts (proprietary trading) represent the single largest source of revenues (10.8%) among the ten firms that participated in the global settlement discussions. This can bias research in several ways. For example:

• If a firm's traders decide to unload a few stocks from their house account, it's likely that a downgrade or a "sell" on those same companies from their own analysts would make it more difficult for the firm to sell at a favorable price.
  
  
• Conversely, there is a financial incentive for trading department managers to pressure analysts to issue upgrades and "buys" to help them unload their shares to more willing buyers.

Table 1. Revenue Breakdown of Investment Banking Firms In Settlement

Company Name Total Revenues Under- writing M & A* Commis- sions Trading and Investing Asset Mgmt. Interest, Dividends, and Other Bear Stearns & Co. LLC 8,699 378 394 1,116 2,282   4,529 Credit Suisse First Boston 7,548 2,779 588 1,479 1,255   1,447 Deutsche Bank 78,409 1,912 3,095 3,856 7,819 2,831 58,896 Goldman Sachs Group 34,412 1,766 2,070 3,020 6,349 4,587 16,620 J.P. Morgan Chase & Co. 50,429 2,364 1,248 9,208 4,551   33,058 Lehman Brothers 17,555 1,103 381 848 903   14,320 Merrill Lynch & Co. 38,757 2,438 1,101 5,266 3,930 5,351 20,671 Morgan Stanley 43,674 1,942 1,420 3,153 5,185 7,327 24,647 Salomon Smith Barney 21,483 3,879   3,619 576 3,147 10,262 UBS AG 62,084 1,595   930 6,504 14,010 39,045 Total 363,050 20,156 10,297 32,495 39,354 37,253 223,495 Percent 100 5.6 2.8 9 10.8 10.3 61.6 M & A includes mergers and acquisition advisory fees and other investment banking advisory fees

Second fundamental flaw:

The rules fail to adequately recognize informal pathways of communication and influence through which conflicts and deceptions can easily continue despite even the most elaborate regulations.

The global settlement prohibits analysts from participating in investment banking road shows. At the same time, the NASD and NYSE have proposed a rule that permits analysts to assist in investment banking sales and road shows but prohibits those same analysts from issuing reports or making public statements on the client companies. It remains to be seen whether or not the more rigid restrictions from the global settlement will be applied universally.

In the meantime, however, there is nothing in the NASD/NYSE proposed rules to prevent those analysts from sharing information or opinions with colleagues in the same company who do issue the reports.

Similarly, the NASD, NYSE, and global settlement have instituted rules prohibiting research analysts from being supervised by a firm's investment banking department. However, the investment banking department can continue to exercise broad impact on research through a myriad of informal pathways of authority and influence.

They have also approved a rule forbidding investment banking personnel from discussing a research report with the analysts unless the firm's legal/compliance staff is present, but without a mechanism to clearly control informal communications in and outside the workplace. They have approved a rule mandating quiet periods during which reports cannot be issued, but with no mechanism for enforcing private or informal communications of research results during that period. And, they have proposed or approved numerous rules governing the disclosure of conflicts of interest to clients in written reports and communications, but without rules governing oral communications by analysts or brokers to clients.

At best, these rules underestimate the relative ease with which they can be circumvented. At worst, the rules tacitly endorse the conflicts, providing a veneer of propriety behind which many investment bankers, analysts, and brokers can pursue business as usual.

Third fundamental flaw:

The rules fail to recognize that Wall Street has established a two-tier system for the distribution of information, and that this system often favors a privileged class of investors.

As we have seen, there are several rules that seek to regulate the manner in which information is disclosed and transmitted to the public. The SEC's global settlement will require the settling firms to distribute independent research to investors. The settlement contains-and the NASD and NYSE have approved-rules requiring that investors be notified when an analyst's coverage is dropped. And the SEC has adopted a rule requiring analysts to certify that their views are their own.

However, these rules do not take into consideration the fact that there are two communication networks on Wall Street-one for an elite group of customers that receive complete research and stock ratings data, and another for all other investors who often receive incomplete and outdated information.

Currently, many firms fail to adequately inform the public when coverage is dropped, even for companies going bankrupt. Thus, among the firms covering companies that filed for Chapter 11 in 2002, many dropped coverage on the failing companies, but neglected to inform major public sources. Investors seeking an opinion would not have learned that the coverage was dropped. They would only see the usually-positive, outdated rating.

For example, in early 2003, the leading private information source, First Call, posted the terms "dropped coverage," "suspending coverage," or "not rated" with respect to the companies listed in Table 2. However, at the same time, three leading public information sources, Briefing.com, Bloomberg, and Yahoo.com, continued to display "buy" or "hold" ratings on these same bankrupt companies.

Rules proposed in the settlement and by the NYSE and NASD require that firms notify investors when coverage is dropped. However, if the existing flawed communication system is used, these rules will be largely ineffective.

In the final analysis, individual investors will be the losers if investors are not informed that their shares have been abandoned by the same analysts who had recommended their purchase earlier. Moreover, if key research reports continue to be circulated strictly through private channels, any disclosures they contain will also not see the light of day. At best, their distribution to the public could be unduly delayed.

Overall, unless all three of these fundamental flaws in the new rules-informal pathways of influence, other revenue sources that can bias ratings, and Wall Street's two-tiered communication network-are more fully recognized and addressed, the new regulations are bound to leave most investors unprotected from many of the offenses.

Table 2. "Dropped Coverage" Ratings Reported to First Call but Not Available to the Public

Investment Banking Firm Failed Company McDonald Investments Adelphia Business Solutions Buckingham Research Adelphia Communications Corp. CIBC World Markets Adelphia Communications Corp. McDonald Investments Budget Group, Inc. Credit Suisse First Boston Conseco, Inc. UBS Warburg Conseco, Inc. Bear Stearns Covanta Energy Corp Wachovia Securities Encompass Services Corp Lehman Brothers Exide Technologies Salomon Smith Barney Exide Technologies Credit Lyonnais Global Crossing Ltd Credit Suisse First Boston Global Crossing Ltd Deutsche Bank Global Crossing Ltd First Union Global Crossing Ltd Buckingham Research Globix Corp Janney Montgomery Scott Globix Corp Deutsche Bank Kaiser Aluminum Corp Ladenburg Thalmann KMart McDonald Investments Mcleod USA Salomon Smith Barney Metromedia Fiber Network, Inc. CIBC World Markets NewPower Holdings, Inc. Salomon Smith Barney NewPower Holdings, Inc. Bear Stearns Peregrine Systems, Inc. CIBC World Markets Peregrine Systems, Inc. McDonald Investments Peregrine Systems, Inc. Bear Stearns Pinnacle Holdings, Inc. Credit Suisse First Boston Pinnacle Holdings, Inc. Raymond James Pinnacle Holdings, Inc. U.S. Bancorp Piper Jaffray Repeater Technologies, Inc. CIBC World Markets SpectraSite Holdings Inc. Credit Suisse First Boston SpectraSite Holdings Inc. Janney Montgomery Scott Suprema Specialties Inc CIBC World Markets U.S. Airways, Inc. JP Morgan UAL Corp. Schroder Salomon Smith Versatel Telecom International, NV Prudential Securities Williams Communications Lehman Brothers WorldCom,Inc. Pacific Crest Securities WorldCom,Inc. Prudential Securities WorldCom,Inc. CIBC World Markets XO Communications, Inc.

Part 3. Weiss Ratings' Recommendations

If securities regulators are truly committed to protecting investors from the widespread abuse to which they are being subjected, the following reforms must be addressed, either in the context of the proposed rules or in subsequent rulemaking:

1.	Centralize the rule-making function. Currently, the convergence and overlapping of adopted and proposed rules by the SEC, the NASD, the NYSE and settlements with the state attorneys general is causing significant market and industry confusion. In addition, it is unclear as to how the settlement with the ten large firms is going to be applied to the many firms that are not party to the settlement. We propose that the rule-making functions be centralized under the SEC.
2.	Seriously reconsider divestiture. Regulators and legislators have decided not to force the separation of research from other operations. However, given the difficulty of regulating and enforcing behavior that goes against the grain of the profit motive in each firm, this would be the cleanest solution and should be seriously reconsidered.
3.	Base analysts' incentive compensation exclusively on the accuracy of their research and ratings. If divestiture is impossible, this is a fall-back solution: In order to better align the interests of analysts with those of investors, we propose that at least 50% of each analyst's compensation be derived from incentive bonuses, and that 100% of the bonuses be based strictly on the relative accuracy of the analyst's ratings, measured by a standard methodology. Compared to the terms of the settlement, this will provide analysts with a stronger and clearer incentive to voluntarily shun outside influences, helping to allay our concerns regarding the many ways the new rules can be circumvented. We feel this is essential in order to establish a firm counterweight to the conflicts of interest that are bound to persist on a corporate level as long as research and investment banking are under the same roof.
4.	Create a comprehensive Stock Ratings Database (SRD), making it widely available to the public. The global settlement requires each participating firm to publish its analyst ratings and targets on a quarterly basis via the firm's own website. While this public dissemination is a positive step, this measure stops far short of providing investors with an easy-to-use means for assessing and comparing the latest ratings on a stock. Our proposed SRD (see Appendix B) would provide individual investors with a user-friendly database on the current and historical stock ratings issued by Wall Street analysts and firms, empowering investors to make informed decisions regarding the value of the advice. In addition, it would give third-party researchers the ability to develop comparative studies and commentary regarding the value of the advice to investors. The aggregation of information on one Web site would allow the public to compare and measure the performance of analysts. This, in turn, would provide market-based incentives for analysts to compete based on the quality of their research. Investors would be able to view or compare the current ratings of each stock by various analysts, the track records of each analyst, and the performance of various analysts and firms over time. As such, the SRD would circumvent and overcome Wall Street's two-tiered communication network, which has left most investors with outdated information. We recommend that regulators place the primary burden for the creation and maintenance of the database on the individual brokerage firms by requiring them to submit all of their analysts' stock recommendations in a standard format and via an automated upload. The procedure would populate the database with the relevant information. Firms supplying incomplete or erroneous information should be subject to penalties that would then go toward covering the cost of monitoring that firm's submissions in the ensuing year. Until such time as this system is in place, changes in ratings, including notification of dropped coverage, must be disseminated in such a way as to ensure that the public receives effective notice.
5.	Require firms to update their stock ratings on a regular basis and following any event that could materially impact a rated company. As discussed above, many firms fail to update their ratings despite significant changes affecting the rated company. We propose that firms be required to update ratings following any event-such as a debt downgrade-that could materially impact a rated company. At a minimum, ratings should be reviewed annually.
6.	Require that all research reports be written in plain English. This requirement should include disclosures regarding the nature of any remaining conflicts, explicitly pointing out how such conflicts could bias the research. Research and disclosures of any remaining conflicts must not only reach individual investors, but they must also be clearly understandable to those investors. Disclosures should not only state the required facts, they should also inform investors why the facts are important and how they could bias the opinion of the researcher. All too often, opaque disclosures become standard, leading investors to dismiss them and the firms free to go about business as usual. Or, sometimes industry leaders consent to broader, jargon-filled disclosures, but then overwhelm investors with reams of unintelligible information. These roadblocks can only be overcome with very specific, plain English disclosures (tested on actual investors) regarding the actual relationships and potential conflicts between each firm and its clients.
7.	Require firms and their brokers to provide similar disclosures to investors when recommendations are communicated orally and to inform customers when ratings change or coverage is dropped. It is especially important that individual investors understand the analysis in the report, the nature of any conflicts, and how such conflicts could bias the analysis. When brokers relay an analyst's recommendations orally, they should be required to provide investors with the disclosures contained in the research report and a brief review of the accuracy of the analyst's past recommendations. Further, when ratings change, brokers should be required to inform their clients that bought the stock on their recommendation. Once the SRD is in place, brokers should educate their customers regarding its goals, usage, and contents.
8.	Extend rulemaking to analysts issuing bond and credit ratings. The final and proposed rules of the NYSE and the NASD focus almost exclusively on the buy, sell, and hold ratings issued on stocks, failing to address widespread conflicts with respect to the issuance of bond and credit ratings.4 Investors should be able to rely upon the same degree of disclosure and research ethics regardless of whether they are investing in stocks or bonds.

Without these additional steps, it is very possible that the settlement and the ongoing rulemaking process will fall short. With them, it is far more likely that the goal of truly protecting investors can be achieved.

 

Appendix A. Analysts Reform Progress Report

Major Reforms	Rules Approved	Rules Proposed	Not Done	Weiss Commentary
Investment Banking and Other Outside Influence on Research Analysts
Separation of investment banking and research through divestiture. Proposed by consumer and investor advocates as the only way to eliminate conflicts of interest.			Ö	Legislators and regulators have decided not to force divestiture. As a result, instead of eliminating serious conflicts of interest, they are seeking to manage the conflicts through the patchwork of regulations and the global settlement summarized below.
Research from independent firms. Brokerage firms must contract with at least three independent research firms to provide research for five years. Independent ratings must appear in brokerage statements and confirms.	Ö Global Settlement			Strong step in the right direction. However, it is unclear how balanced presentations can be enforced in the context of oral communications between brokers and clients.
Prohibition on research analysts in investment banking sales. NASD/NYSE: Those who participate in obtaining inv. banking business or road shows must not issue reports or make public statements about the company. Global settlement: Prohibits analyst participation in road shows.	Ö Global Settlement	Ö NASD NYSE		There is nothing restricting the prohibited analyst from sharing information or opinions with colleagues, who may use the same or similar material in their own reports or statements. The global settlement's total prohibition of analyst participation in road shows is a more appropriate response.
Supervision of research analysts. Research analyst may not be supervised or controlled by a firm's investment banking department.	Ö NASD NYSE Settlement			Inv. banking could continue to impact research through informal pathways of authority and influence.
Separation of research from investment banking. Research and inv. banking must be managed in two units, with separate legal and reporting structures, in physically separate locations, and with a firewall between them restricting communications.	Ö Global Settlement			Managerial and physical separation will help manage the potential for conflict.  However, analysts will still have the overall success of the firm as a common goal, continuing to potentially bias the research.
Discussing research. Investment banking personnel cannot discuss a research report with the analyst unless the firm's legal/compliance staff is present.	Ö NASD NYSE Global Settlement			This is an artificial firewall that cannot be effectively enforced. It is very difficult to control private communication among employees.
Fact-checking by companies. The company may not review the research report except to check factual accuracy.	Ö NASD NYSE			There is no discrete line that separates fact from analysis. Any prepublication review can open the door to continuing influence.
Booster shots. Research reports cannot be published or public appearances made 15 days before or after the expiration of a “lock-up” agreement.		Ö NASD NYSE		If the analyst has a strong incentive to produce accurate reports, this rule would not be needed. Conversely, if there is an incentive to boost share prices for favored companies and investors, the prohibition period is inadequate.
Retaliation against analysts. Companies must not retaliate for issuing unfavorable research.			Ö	The Sarbanes-Oxley Act of 2002 requires the SEC or the NYSE/NASD to adopt rules by July 2003 to prohibit retaliation.
How Analysts Get Paid And Solicitation of Banking Business
Analysts compensation to be based on quality of research. A significant portion of compensation must be based on quality and accuracy.	Ö Global Settlement			A welcome step to lay the groundwork for putting the analyst on the side of the investor. However, it is vital that “significant” be spelled out more clearly.
Analyst compensation tied to banking. NASD and NYSE: Direct ties not allowed to specific transactions. Global settlement: Neither direct or indirect ties allowed, but compensation may relate to overall firm revenues.	Ö NASD NYSE Global Settlement			Overall firm revenues, if largely driven by investment banking and other profit centers that create a conflict, may continue to bias research.
Disclosure of banking-related compensation. If analyst compensation is based on general investment banking revenues, it must be disclosed in the analyst's research reports.	Ö SEC NASD NYSE