Investment research crackdown: The real costs
By Kevin Phillips and John Berthelsen

The final terms of the settlement being forced on New York's major investment banks as a result of New York Attorney General Eliot Spitzer's war on Wall Street are expected to be announced soon. And, because global financial markets are now so interwoven, effects of the settlement are certain to be felt far outside the United States.

For the investor, it probably means somewhat reduced service from stockbrokers, fewer choices in research, and increased unit costs for research production. These costs will have to be passed on to the consumer. Consequently, equity markets will probably become a less attractive investment option, and reduced investor interest will slow the recovery in stock-market values.

Nor will the settlement produce more unbiased, independent research, most financial industry sources feel.

The US banks agreed weeks ago to pay US$1.4 billion in fines and damages and to adhere domestically to strict conflict-of-interest provisions designed to break up the incestuous relationships between financing of corporate deals and what should be independent research. However, last week most of them balked at agreeing to the same conflict provisions for their overseas operations, pleading that to do so would place them at a disadvantage to their overseas counterparts. It appears that the US authorities will agree to the exemption.

Nonetheless, whether they win that argument or not, their foreign operations inevitably will be affected, and so will the foreign operations against which they compete. Local banks, including those in Asia, will likely be forced to adopt similar standards, if for no other reason than because the long reach of shareholder suits is eventually going to be felt well beyond US shores.

These changes have been widely praised. But don't bet that they will produce more accurate or timely stock recommendations. When the broad terms of settlement were first announced with Merrill Lynch in New York last September, one Credit Suisse First Boston (CSFB) analyst described them in an e-mail later made public as equivalent to "giving up turpentine for Lent".

To understand how effective those conflict provisions will or will not be, it isn't necessary to look much farther than one European investment bank's experience in Hong Kong in the late 1990s.

The bank made a fateful decision. It would be the only multinational to put a Sell recommendation atop a voluminous report on what was then one of Asia's most glamorous companies - Pacific Century CyberWorks, headed by Richard Li Tzar-kai. PCCW, as it is known, was at that point preparing for a rights issue to cover the massive debt that PCCW had incurred in swallowing Hong Kong Telecom, one of the territory's biggest companies. Richard Li is the son of Li Ka-Shing, Hong Kong's most prominent citizen and a man whose every business move seemed golden until the territory's current economic disaster. At that time, his son's decisions had similar cachet. Every investment bank in Hong Kong was vying for a chunk of the underwriting operations.

Never mind that the European multinational's head of research made the Sell decision because his corporate finance department had been frozen out of helping to underwrite PCCW's rights issue and he felt there was nothing to lose. Despite the fact that PCCW was one of Hong Kong's biggest local companies, its situation dictated that its share price was inexorably going to fall. Despite its aura of glamour, PCCW had been formed from the remains of Hong Kong Telecom with a few dotcom bits and bobs attached, and it was beset on all sides by young, lean, fast telecoms companies. The price did fall shortly after, and dramatically, with or without the bank's recommendation. Today the shares are worth perhaps a tenth of what they sold for at their zenith. (For more on the PCCW saga, see Hong Kong phone giant gets static, February 14.)

However, as far as is known, PCCW's management never again spoke to the analysts who had written the negative report. It was certain that, should Richard Li ever come to the market again, it would be without the services of the European investment bank. That will remain true today. Nor is PCCW alone. Generally a negative report on any company means communication with that company is going to cease, or be severely constrained. Analysts have received death threats for negative recommendations. Companies will continue to exclude the analysts they don't like. That threat of lack of access is going to continue to intimidate analysts and affect their recommendations.

The terms of Spitzer's settlement include substantially tighter restrictions on any type of communication between research analysts and investment bankers (the suits behind the corporate transactions). Independent research must be funded that investors can use as an alternative to that generated by the investment banks. Those who receive allocations in "hot" initial public offerings (IPOs) will be closely monitored.

The regulatory changes also include requirements for clearer and more simplified stock recommendations, historical data relating to previous recommendations and subsequent performance, and price (rather than relative performance) charts.

However, the changes affect the appearance and structure of investment banking rather than substance. There are matters that absolutely no one in the financial community really wants raised, including the relationships between investment banks and corporations, and brokers and fund managers. It is significant that there was a distinct undercurrent to the negotiations between Spitzer and the banks that suggested the banks were looking for a quick solution.

The fact that the banks were happy to settle for $1.4 billion in fines seems a clear indication that the real prize is somewhat larger. None of the banks involved were forced to admit guilt, which helps to insure them against civil suits.

There will be plenty of window-dressing. For US investment banks, this means setting in place procedures that satisfy the most stringent legal requirements - in other words, those of the United States itself. That will affect the principal investment banks in Asia, which are predominantly American, with the second tier mostly populated by a range of European firms. This increasing globalization of all markets means groups will need to protect themselves well beyond their own borders with appropriate standards of internal regulation. Compliance departments in all investment banks are certain to grow even beyond their current bloated size and expense.

Unfortunately, the investment banks' dirty little secret is that the stringent observation of the so-called "Chinese Wall" between research and corporate finance that compliance departments enforce is basically irrelevant. Compliance departments slow up the process, sometimes by days, while they ensure that all the legal t's are crossed and i's are dotted. But these suffocating legalities have almost nothing to do with the real relationships between corporate finance departments and their clients. The process of shepherding an IPO to market is one in which the investment bank basically coaches the eager company to evade the real scrutiny of those who want to buy the newly issued shares.

"In the end, for an industry so intensely relationship-driven as Wall Street, it may be a fool's errand to attempt to banish altogether conflicts of interest, real or perceived, by way of restructuring or re-regulation," writes Kevin Keogh of the New York law firm of White & Case. "Rules requiring disclosure of investment banking and customer relationships in securities analysts' reports would shine a bright light on conflicts of interest and do more to produce independent analysis than costly structural walls."

And are any of these changes going to improve the accuracy or timeliness of analysts' recommendations? Probably not. Owning a Calloway golf club doesn't automatically make one a better golfer. A supposedly independent analyst in the new, separated research arm probably won't know much more about the company than the investor in the street. Analysts by and large sit in front of screens and look at numbers - all day long. Few of them know anything about the corporate dynamics that make companies tick.

They are far more fallible than the general public knows, even absent intimidation from their superiors or the companies they cover. Analysts will continue to underestimate or overestimate company profitability and revenue targets, sometimes badly.

Equity research has always been deemed a loss leader, although this is somewhat at odds with the idea that research and development for manufacturing companies is always deemed an investment. Falling market volumes and lower profitability for investment banks overall means budgets for research teams will duly fall.

These factors, taken together with the enforced increase in the cost of production as a result of the settlement agreed in New York, will probably mean fewer analysts employed and consequently fewer companies monitored. Compliance department personnel will inevitably replace some of the departing analysts.

As the US investment banks fear, while private American investors will find research on mid-sized and smaller companies more difficult to acquire, regional brokering houses with no US exposure should continue to flourish. However, that's until the regulations in the local markets are more closely aligned with those in the United States. Eventually, they too will be forced by common industry practices to add to their compliance departments, cut the numbers of analysts and provide fewer services.

Meanwhile, the Asian retail investor tends more toward being a trading animal than a long-term shareholder. With the demise of the IPO market in the region, the perceived opportunities for profits have diminished and private customer brokers are now recommending more guaranteed products. Retail investors can be expected to look to other areas for investment.

The new rules can be expected to impact fund management as well, giving fund managers less to work with in making investment decisions. The leading professional fund-management companies have their own teams of buy-side research analysts responsible for distilling the information gathered and distributed by sell-side broking analysts. These individuals reward analysts who provide insights into industry dynamics and gather basic data. Fund managers are ultimately responsible for each investment decision.

With banking departments no longer able to subsidize research teams, the buy-side fund-management business will be seeking to reduce its own cost of doing business after the drop in the value of funds managed.

Falling markets have an immediate and direct impact on the revenues of fund-management businesses, as fees are usually determined by the level of funds under management, exacerbated by the liquidation of holdings by investors.

Therefore, 2003 could be characterized as the year when not only do we see a marked increase in the already considerable number of mutual funds being closed as they fall below economically viable levels. Buy-side research teams can also be expected to shrivel. In turn, this will mean a greater reliance upon the shrinking sell-side teams. This does not appear to be an environment where we can expect a short-term improvement in investment performance by the fund-management houses. Investors beware.

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