This is it--the high tide of financial reform. It should be payback time for shareholders who have lost trillions of dollars partly because of greedy executives, crony accountants, conflicted research analysts, and duplicitous investment bankers. It is the moment when legislators and regulators should be restoring confidence in Corporate America by punishing the crooked and building bulletproof systems to prevent the same thing from happening again.
So why does it feel as if the moment is slipping away? After almost a year of crusading against corrupt corporate practices, regulators are throwing together oversight boards to cure the ills that ailed corporate ethics during the heady bull market of the 1990s. But the boards' effectiveness looks highly questionable even before they start.
The Securities & Exchange Commission has appointed a new accounting watchdog made up mostly of people with no track record in accounting. Meanwhile, New York Attorney General Eliot Spitzer, along with the SEC and other regulators, is fine-tuning a plan to resolve Wall Street's research woes by insulating analysts from pushy bankers. It would also create an independent oversight board with a five-year, $1 billion budget funded by investment banks. The board would force banks to give retail investors reports from 20 independent research outfits alongside their own. But as critics get a closer look at Spitzer's plan, it, too, looks increasingly unwieldy.
So far, only the regulators fully embrace it. Even before Spitzer and SEC Enforcement Director Stephen M. Cutler put the final touches on their proposal, investors, independent researchers, and industry veterans are dumping on it. Investors doubt that forcing big banks to hand out independent research will shame in-house analysts into honest recommendations. Independents complain that their own research may become biased if they accept money from big banks. And industry veterans think the reforms don't go far enough. On Oct. 29, Charles R. Schwab, chairman and co-CEO of discount brokerage Charles Schwab & Co. (SCH
) branded Spitzer's latest proposal "ludicrous." He told financial advisers in Washington: "It looks like one more thing done by a couple of crafty investment bankers."
Indeed, the bankers are now stealing regulators' thunder. On Oct. 30, Citigroup (C
) announced it will separate research from its investment-banking unit, pair it with its retail brokerage business, and hire 37-year-old research hotshot Sallie L. Krawcheck, CEO of independent researcher Sanford C. Bernstein & Co., to run the new unit, to be called Smith Barney. "There is going to be major change in the way this business is going to be conducted in the future, and we accept that, and we applaud that," Citi Chairman and CEO Sanford I. Weill told BusinessWeek. "It is very important that people have confidence in this system."
Citi's proposal doesn't undermine regulators' new roadmap. Weill says he plans to go along with regulators' recommendations. But Citi's announcement has put some of their noses out of joint. "It would be better if the banks' responses came through the negotiating room, not the press," says one.
Some rival bankers consider Citi's proposal more form than substance. They say Citi, like all banks, will stop analysts from consulting with bankers on deals only if regulators order them to. They also think Citi's plan is designed to help Weill, who is being questioned as part of Spitzer's probe of Citi. Weill told BusinessWeek: "If our competitors think [our plan] is nothing, God bless them!"
Curiously, regulators abandoned the idea of spinning off research because banks convinced them it would be a nightmare, bringing massive layoffs, and less choice for investors. Now, they believe clear rules to give research separate compensation, supervision, evaluation, and compliance structures can solve the problem. John C. Coffee Jr., professor of securities law at Columbia University, says the trick will be to "get independent views into the hands of investors without coming up with a reform that is so prophylactic that it starves the field of securities research."
As of Oct. 30, banks and regulators remained at odds on several issues. Banks are bickering over how to split the $1 billion bill for Spitzer's plan. Says one source close to the talks: "Firms will be unwilling to pay hundreds of millions of dollars if they don't know what other penalties the SEC has in mind or what the states plan to do."
No wonder retail investor groups are skeptical. They fear the net result of the flurry of reform proposals will be same old, same old. "What's going to happen is that [brokers will say], `Here's this plain-vanilla, unbiased report I have to give you. But then there's this other one that really says what I mean,"' says John D. Markese, president of the American Association of Individual Investors in Chicago. "I don't think we're changing anything, frankly."
Surprisingly, independent research firms are even more critical. In theory the biggest beneficiaries of Spitzer's plan, many are skeptical--especially since they weren't consulted. They worry that if investment banks subsidize their research, they, too, could become contaminated. "It's a system that might eventually taint independent research," says Scott C. Cleland, chairman of the Investorside Research Assn.
It's even unclear if there are 20 firms that cover enough stocks well enough to fit the bill. Most focus on a couple of hundred U.S. companies, while major firms cover thousands of them globally. Worse, independents that line up for funds may not be the best qualified. Under the plan, the oversight board can pay an average of just $10 million a year to 20 firms. That's unlikely to tempt the best, who charge as much as $40,000 a year for their reports. "I don't think you're going to get any of the upper-echelon firms," says Steve Leuthold, chairman of Minneapolis-based Leuthold Group.
Some firms want to keep their focus on money managers, not retail investors. Recently, BNY JayWalk Inc., a Bank of New York subsidiary that resells independent research, yanked 35 firms from a Web site for retail investors. President John D. Meserve said it was too time-consuming to explain repeatedly to clients that they couldn't afford the expensive research.
The makeup of the oversight board proposed by regulators might bring some clarity. Sources close to the talks say names such as Paul A. Volcker, the ex-Federal Reserve chairman, and Felix Rohatyn, ex-managing partner of Lazard Freres & Co., are being floated as candidates to head the board. For now, Rohatyn, who has not been contacted, has reservations. "I'm still not clear in my own mind how this structure would work," he says. Rohatyn thinks it will still take draconian measures, such as spinning off research, to truly rid Wall Street of its conflicts. "You can set up all sorts of internal controls and safeguards, but I just don't believe that Chinese walls work," he says. Volcker couldn't be reached for comment.
Ironically, Spitzer's plan may benefit investment banks--by cutting their costs sharply. Research costs big Wall Street houses $800 million a year each. By paying the likes of Salomon Smith Barney telecom analyst Jack Grubman $20 million a year to help bankers win deals, banks "created for themselves a new cost of doing business," says David Trone, a securities-industry analyst at Prudential Securities Inc. "It will be good for the industry if regulators force the cost out of the system." But it won't be if they fail to bring investors back and a quick fix proves popular only with regulators and banks.
By Emily Thornton, with Heather Timmons and Mara Der Hovanesian in New York, and Geoffrey Smith in Boston
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