When Chinese Walls Come Crumbling Down

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It's been ten years since prosecutors announced a $1.4 billion settlement with the Wall Street's biggest investment banks and two individual stock analysts over accusations that the firms and analysts had duped investors to curry favor with corporate clients. Under the terms of the settlement, twelve investment banks agreed to separate their securities analysis from their investment banking business.

One of the key reforms put in place in the settlement was the bar on basing the compensation of stock analysts on their contribution to investment banking revenue. This was meant to prevent analysts from becoming shills for the corporate clients that were paying fees to the investment banks for stock and bond underwriting deals.

A new study suggests that this part of the settlement may have fallen by the wayside.

Four researchers—Lawrence Brown of Temple University, Andrew Call of Arizona State University, Michael B. Clement of the University of Texas at Austin and Nathan Y. Sharp of Texas A&M University—surveyed 365 sell-side analysts to see how the business of stock analysis is conducted these days. Startlingly, they found that 44 percent of the analysts indicated that their success at generating underwriting business or trading commissions is "very important" to their compensation.

Only 20 percent indicated that underwriting and commissions were "not important" to their compensation. Which means that another 36 percent said these things—supposedly walled off ten years ago—were somewhat important. That's a total of 80 percent who said that generating underwriting business and trading commissions play some role in their compensation.

In other words, the so-called Chinese walls between analysis and investment banking appear to have come crashing down—and almost no one has noticed.

There's little room for doubt that at least some of the analysts indicating that their compensation depends on investment banking business and trading commissions work inside some of the biggest Wall Street firms. Although the researchers cannot say which ones, because they promised anonymity to the respondents, there's really no way to get to the 60 percent without including analysts from the bigger firms.

For example, over fifty percent of the respondents work for firms that have 26 or more research analysts. And, in any case, the smallest research firms tend to be independent and not connected with investment banks.

The firms that originally signed onto the 2003 settlement were Citigroup's Salomon Smith Barney (now run by Morgan Stanley), Merrill Lynch (now owned by Bank of America), Credit Suisse First Boston (now simply Credit Suisse), Morgan Stanley, Bear Stearns (acquired by JPMorgan Chase), Goldman Sachs, Lehman Brothers (which declared bankruptcy in 2008, Piper Jaffray, J.P. Morgan (now part of JPMorgan Chase) and UBS Warburg (rebranded as UBS Investment Bank).

Credit Suisse, Morgan Stanley and JPMorgan declined to comment. Bank of America Merrill Lynch said it was unable to comment immediately. Goldman Sachs, UBS and Piper Jaffray did not respond to inquiries.

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The researchers themselves were surprised by how many of the research analysts indicated their pay was tied to the investment banking and trading sides of the business.

"I thought it was quite surprising," said Texas A&M's Sharp. "When we presented it to an audience at another university, one person who has done a lot of research into the analyst field told us it was the most surprising finding in the whole study."

The survey results may actually undercount the number of analysts who believe their pay is tied to underwriting and trading.

"These guys are well aware of the Chinese Wall rules. Several of them specifically brought it up in individual interviews we conducted. So the fact that 44 percent say what they said, it could be taken as a lower bound of what's really going on," Call said.

In addition to the survey, the researchers also conducted 18 detailed follow-up interviews. They discovered a disconnect between what analysts would say when individually interviewed and the survey responses.

"They were adamant that the Chinese walls were consistent and working, when interviewed individually,"said Arizona State's Call.

A person at one of the firms involved in the settlement said that the survey question was flawed because it combined generating underwriting business with trading commissions. (This person requested anonymity because he was not authorized to speak on the matter.) Tying the former to analyst compensation is barred by the 2003 agreement and SEC guidelines, while tying the latter is not, the person said. Nonetheless, tying research to sales commissions creates a conflict of interest for analysts since it makes them part of the securities sales force for the firm.

"Asking about both these things in one question is bound to produce misleading results. One is legal, another is not," a person at a different firm involved with the settlement said.

As a legal matter, this is correct. While the 2003 settlement required firms to separate research and investment banking, they left open this important loophole. Analyst compensation can still be tied to trading commissions, which puts implicit pressure on analysts to craft ratings to generate high levels of client trading. Think of it as the new form of that old Wall Street swindle known as "churning."

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The researchers distributed surveys to all 3,341 analysts whose research appeared in the Investext database in the 12 month period from October 1, 2011 to September 30, 2012. They received full survey responses from 365 analysts, or 10 .9 percent of the survey pool. That's considered a very favorable response rate in academic circles. Their report, titled "Inside the Black Box of Sell-Side Financial Analysts," was published in March 2013.

The study seems to vindicate some of the early criticisms of the attempt to liberate analysts from compromising financial ties at their firms.

"Clearly, brokerage and investment firms have a conflict of interest. Since investment activities (such as initial public offerings and secondary market issues) are highly profitable and research and analysis lose money, the former will eventually compromise the latter. Chinese walls will mask rather than preclude abuses, and even the most conscientious analysts will in the end surrender to the rainmakers' dictates," law professor Michael Greve wrote in an article for the American Enterprise Institute even before the settlement was finalized.

''I am not convinced that the global settlement has done enough to change attitudes at the top of these banks,'' said Senator Richard Shelby, then chairman of the banking committee, said in 2003.

Not everyone is surprised that at the results of the study. Barbara Roper, director of investor protection at the Consumer Federation of America, said, "Sadly I'm not surprised. The analyst settlement never did as much as it could or should have done to bring real analyst independence. The SEC never fully embraced it, didn't adopt rules to enforce its principles, and didn't implement it in a way that really changed practices."

She added, "The best thing the settlement did was to undermine confidence in stock analysts. It put people on alert not to trust these guys."

(Full disclosure: one of the individuals who participated in the 2003 settlement was Henry Blodget. He paid millions to a restitution fund and agreed to a lifetime ban from the securities industry. I worked for Blodget at Business Insider from 2008 to 2010.)

_By CNBC's John Carney. Follow him on Twitter at @carney.