One Really New Rule For Analysts

Take a look at some of the "new" rules for stock analysts approved Wednesday by the U.S. Securities and Exchange Commission.

The rules would ban offering favorable research in exchange for banking business. This is new? If this isn't illegal already then why do the banks uniformly deny they would ever consider doing anything of the kind?

The rules would bar securities firms from tying an analyst's compensation to specific investment banking transactions. Another fine idea--but not even the analysts' worst critics suggest any Wall Street firm would do anything as ham-handed as that.

More new rules floated by the SEC and its old-school chairman, Harvey Pitt: bar analysts from investing in a company's securities prior to its initial public offering and then covering that company or its sector. Prohibit analysts from trading against their most recent recommendations. Even

Ivan Boesky Ivan Boesky

Other rules would restrict, but not ban, collaboration on research reports between analysts and investment banking employees. Most usefully--and this really is new--the rules would require banks to clearly explain their stock rating systems and disclose historic data about ratings assigned, including what percentage of stocks the bank rates a "buy" versus the percentage it rates a "sell" or "hold." This rule might prevent Wall Street firms from saying "buy" to everything because they'd soon look ridiculous.

Most of the new rules, though, appear very much like the old rules, perhaps slightly warmed over.

Now there is a fair case to be made that analysts are being scapegoated for their clients' own greed or simple foolishness. Steve Forbes, for one, has made it. James Grant compares New York Attorney General Eliot Spitzer's uncovering of analyst bias to learning the truth about professional wrestling. Certainly there are plenty of rules already--perhaps too many--including blanket prohibitions against fraud, which can include any manner of wrongdoing.

But many rules are hard to enforce--whether by the SEC itself, individual investors, or criminal prosecutors. No one doubts that most people on Wall Street try to follow the rules, just as no one doubts that many violations go undetected. Spitzer's study might have proved what savvy pros knew already--and therefore have discounted when making their own investment decisions. But the e-mails containing specific statements indicating duplicity would be hard for individual investors or lawyers to uncover, even after the fact. They wouldn't know where to look.

The real problem is not so much that rules are broken, it's that corruption of a sort can easily occur with all the rules intact. Most conflict of interest rules are variations on the Chinese Wall idea--separating the analysts from the bankers. But this idea can't work, explains University of Chicago law professor Richard Epstein Richard Epstein , because the one bit of information the analyst needs to know to be tainted is simply if his bank works for the company whose stock he is recommending (or not recommending). This information is normally public and flies right over even the highest and strongest wall.

If there is to be a new rule, here is one that's simpler and more comprehensive: No analyst shall recommend the stock of any company with whom his firm has an investment banking relationship. Just a flat prohibition.

This rule would end all the questions about disclosure or sharing information. Of course, it would immediately bar what many analysts spend most of their time doing and it would be especially hard on the biggest firms like Merrill Lynch , Morgan Stanley , Citigroup , J.P. Morgan Chase and Goldman Sachs , who have widespread banking relationships.

The rule, however, would put no analyst out of business. It would simply force him to change his focus to companies his mother firm is not in business with. He would have no reason not to be honest. If anything, he'd be "too" honest--having an incentive to trash offerings of companies doing business with the other guy.

Would this rule put Merrill Lynch's analysts out of business? Maybe it would. But that result might actually help Merrill Lynch since it, like other firms, has long noted that it makes no money directly on research. That the banks "give away" what the analysts provide means they have to subsidize the research department with fees earned elsewhere, whether in brokerage or investment banking.

This situation, of course, is what creates the possibility of corruption in the first place. By not covering companies they are in business with, the banks could abandon a money-losing proposition. If they chose to stay in research, they'd also benefit from their product losing its stink.

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