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Merrill Puts a Brick Back in the Chinese Wall

Merrill Lynch's settlement—without an admission of wrongdoing—purports to slam the door on the research department's conflict-of-interest case. If only it were true.

Please disperse. Nothing to see here.

That's essentially the message Merrill Lynch is sending after announcing it paid $100 million to settle the conflict-of-interest scandal with New York State Attorney General Eliot Spitzer. In a statement, Chairman David Komansky and COO Stanley O'Neal mentioned — twice — the importance of putting this behind the firm. “We are pleased to put the matter behind us in a way that seriously addresses investor concerns,” Komansky and O'Neal said in a joint May 21 statement.

Clearly, Merrill management wants to quickly move on, but this is not the last word on the subject. A number of lawsuits have already been filed, and Spitzer's investigation into other firms continues. However, the settlement with Spitzer does take significant steps to keep research and investment banking departments more separate. That's obviously a benefit to brokers, whose reputations have been tarnished by the apparent conflict of interest.

“It's good,” says one broker. “Because in the last couple months, you get someone on the phone, and they say, ‘Oh, I know all about Merrill,’ and you have to tell them they don't need to get sidetracked, you just want to talk about the financial plan … but you can't convey that over the phone.”

The firm plans on creating a research recommendation committee to review coverage and rating changes, which will be “headed by an individual paid primarily based on the performance of research recommendations for investors.”

Ultimately, the hope for brokers is that they'll be able to trust sell-side research more, instead of having to guess what was the analyst's real opinion. One West Coast-based veteran rep was optimistic, saying: “Because they're under greater scrutiny, they're more likely to say what they think nowadays.”

But it's unclear how impervious the improved Chinese wall will be. For sure, it's improved. Under the new plan, investment bankers will not have any input on analyst compensation. Instead, Merrill brass will solicit opinions on its analysts' performance from its own institutional sales force, its institutional clients and its retail arm. But compensation will continue to be defined in some part based on analyst contributions to bringing deals to market.

“There is a process that analysts are involved in, which is important to bringing new issues to market,” said Merrill's O'Neal on a May 21 conference call. “It's a legitimate function in the capital formation process. That activity will continue to be a part of what analysts do, and therefore a part of what they must be compensated for.”

So there will continue to be analyst-banker interaction, which means it'll be up to Merrill's review board to enforce research's independence from the investment banking department. Komansky hoped this process wouldn't become a “bureaucratic morass.”

Komansky added, “The investment banking part of the firm has no input as to analyst compensation.” But, “at the same time, analysts are expected to fulfill their rule as it pertains to supporting activities on the behalf of investors, and that includes due diligence, the availability to participate in pitches and to participate in road shows.”

Chuck Hill, research director of First Call, doesn't think this is the magic bullet cure. “Brokerage firms still can't get paid for research in a meaningful way anymore,” says Hill. “The conflict issues are going to be present, and this does nothing to solve that. It's a help, because it's not tied to a deal anymore.”

For brokers, meanwhile, the tactic of phoning clients to let them know about a new upgrade to generate a trade is probably still dead — the research conflict isn't likely to be forgotten so easily. Of the new protocol, a Merrill vet says, “That's not going to hold as much weight because the client is going to think, ‘Hey, analysts are just pushing this thing.’”

Brokers might still be inclined to take a skeptical view of their own research, although in their words, they came around to this understanding years ago. They'll also continue to swap research with colleagues at other firms to round out their analysis. “We try not to rely on any one opinion, and temper research a bit with telling people to diversify,” one Merrill broker says.

Now that Merrill has settled, there is speculation that it will lead to settlement agreements with other firms the attorney general is investigating, such as Morgan Stanley, Salomon Smith Barney, UBS PaineWebber, Credit Suisse First Boston and Goldman Sachs. In fact, on the day of Merrill's announcement, Goldman Sachs also said it would reevaluate how it was paying its analysts and appointed an ombudsman to scrutinize its research analysts. Other firms are likely to take similar steps to rebuild the so-called “Chinese Wall.”

As for brokers, the best way to handle this is to continue to migrate to fee-based advisory services. “I haven't done a stock order in two months,” one broker says. Rather than relying on their firms to help pick individual stocks, brokers will increasingly count on money managers, and restrict themselves to a financial planning/consultative approach.

That's certainly where the management teams of the various wirehouses are pushing their brokers. At Merrill, fee-based business represented 16.8 percent of private client business, up from 14.4 percent at the end of 2000 (some of that attributable to the decline in transaction revenue). But that leaves many Merrill brokers doing business the old-fashioned way — selling individual stocks and bonds.

Under statement (of the Year)

“Clearly, we have been wrong on the stock.”
— Jack Grubman,
Salomon Smith Barney analyst on WorldCom, after downgrading the stock to “neutral” from “strong buy,” with the stock trading around $6.

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