Critics have complained for years that Wall Street analysts don’t provide the honest “buy” and “sell” recommendations their customers expect. But now the controversy appears headed for a legal showdown that could force change at big securities firms, thanks to a set of startling e-mails recently made public in an investigation of brokerage giant Merrill Lynch. The notes showed some Merrill Lynch analysts denigrating stocks among one another even as they urged customers to buy. “That is a smoking gun,” according to Wharton finance professor Jeremy Siegel.


And yet, the most radical remedy – forcing securities firms to sever ties between investment banking and analysis – is sure to face intense opposition, not only from the firms but from many money managers who use analysts’ reports. When the smoke clears, the most likely changes will be a set of new disclosure requirements to discourage biased advice. Says Wharton finance professor Marshall Blume, “I don’t think we need any more regulation, except perhaps to indicate conflicts of interest.”


Wall Street watchers have long noted a striking imbalance that pointed to bias, with analysts offering many more buy recommendations than sell recommendations. During the Internet boom of the late 1990s, that ratio leapt to an estimated 100 to one, from an historical average of around six to one. Academics and other observers pointed out that many analysts continued to recommend Internet stocks long after it was clear that the bubble had burst, leading investors who followed those buy recommendations to suffer deep losses.


Analysts, said critics, are reluctant to criticize the companies they cover for fear of losing access to corporate managers who supply them with vital information and insight. More importantly, securities firms have come to rely heavily on investment banking fees, and analysts have been given a key role in landing this business. To curry favor with current and prospective investment-banking clients, analysts pull their punches when they see problems with the company’s stock, critics say. The rewards can be enormous. Former Merrill Lynch Internet analyst Henry Blodget, one of the most controversial analysts, made $12 million last year, according to court documents.


Basically, the long-standing complaints about analysts have been built on statistical evidence. If an analyst were truly looking for gems, one would expect few buy recommendations among the stocks he covers. The fact that buys vastly outnumber sells shows that something is wrong. But it does not prove a specific analyst is biased in a specific case. Conceivably, many analysts are less than competent, or they may simply be overly optimistic. Indeed, during the boom of the mid- and late-1990s, defenders argued that since the average stock was going up, it made sense for there to be a preponderance of buy recommendations.


That picture changed dramatically, however, when New York’s attorney general, Eliot L. Spitzer, released an affidavit earlier this month containing a string of excerpts from internal Merrill Lynch e-mails. The affidavit included evidence gathered in a 10-month investigation that grew out of the post-Internet-bust controversy over analysts’ recommendations.


“We see nothing to turn this around, near-term,” a Merrill Lynch analyst said of a stock he had given a positive rating. Other stocks that were publicly graced with buy or accumulate ratings were called “horrible”, “a piece of crap”, or a “powder keg” in internal communications. In fact, Merrill Lynch’s Internet analysts had never issued a sell recommendation, Spitzer reported.


In response, Merrill Lynch was generally defiant, labeling Spitzer’s complaint about bias “just plain wrong.” The e-mails had been taken out of context, the company said, and showed nothing more than the normal give and take of healthy internal debate.


But by the end of the week, Merrill Lynch had agreed to make public more detail about its investment banking relationships, so customers can assess potential conflicts that could taint analysts’ research. The firm will also make public a running tally of stock ratings, allowing outsiders to see the ratio between buy and sell recommendations. The list will be broken down by industry, and it will disclose the recommendations made on stocks of companies from which Merrill Lynch has received investment-banking fees versus those for which it has not.


But Spitzer said he still was negotiating with Merrill Lynch over a monetary penalty and his demand that the firm change its operations to remove analysts from the investment banking process. In addition, he wants Congress to prohibit any compensation to analysts based on their contributions to investment banking. But Republicans have strongly opposed this move and currently there seems to be little chance such a regulation will be enacted.


Nonetheless, the controversy could grow, forcing Congress and regulators to take more extreme steps. Spitzer has subpoened records from Credit Suisse First Boston, Morgan Stanley Dean Witter, Goldman Sachs, Salomon Smith Barney, UBS Paine Webber and Bear Stearns.


Conceivably, some analysts and some of their bosses could be subject to criminal prosecution and prison terms under an 81-year-old New York law, the Martin Act, which allows criminal convictions without proof of criminal intent or examples of securities transactions that defrauded specific investors.


By contrast, federal criminal cases must satisfy a much higher level of proof. Hence, most federal cases are civil matters brought by the Securities and Exchange Commission, which typically settles out of court with the defendant neither admitting nor denying guilt.


Now, the smoking-gun e-mails open the door to shareholder suits that could compel change, says Paul Irvine, finance professor at the Goizueta Business School at Emory University. “What I find crucial is that in the past this kind of thing has not been actionable because, who’s to say? So your opinion is wrong. You cannot sue someone for having the wrong opinion on a stock.” The e-mails, he said, show duplicity – analysts deliberately giving advice they knew to be bad.


In fact, on April 22, two lawsuits were filed against Merrill Lynch by people who said they had invested in Excite@Home and Internet Capital Group on the basis of the investment firm’s positive recommendations. “The analysts publicly hyped but privately disparaged numerous companies in their pursuit of securing and maintaining lucrative investment banking engagements for Merrill Lynch from those companies and increasing the compensation of research analysts,” one of the suits stated.


While these are apparently the first suits against Merrill Lynch to cite the e-mail evidence produced by Spitzer, many legal experts think a flood may follow. Indeed, the threat of expensive civil suits ultimately could do more to curtail analyst bias than new regulation. Insurance companies that will be forced to help Wall Street firms pay any awards in such cases may demand change as well.


Some critics would like to see the government force securities firms to completely separate the investment banking and analysis functions, perhaps by putting banking and retail brokerage operations into separate entities.


But there would be enormous opposition to this on Wall Street. Stock analysis is crucial to investment banking – not just to peddle shares to the public but in pricing new issues and, in fact, in determining whether a company should go public or make a secondary offering. And investment banking is one of Wall Street’s biggest moneymakers. Who would want to be stranded in a separate entity that could not share in the investment-banking pie?


“That would be a radical, radical solution,” Siegel said, “because we know how much these brokerage firms depend on those IPO fees. To break them apart…I don’t think you need something this radical. But you do need disclosure.”


Severing analysis from investment banking would likely force mutual fund companies, pension funds, money managers and the other key users of analysts’ reports to pay for them, adding to money-management fees, said Irvine. Currently, professional money managers get reports free, in exchange for allowing the brokerage to handle the manager’s trades. Hence, opposition to severing analysis from investment banking could come from many quarters beyond the securities firms themselves.


To some extent, the marketplace is already compensating for analyst bias as investors grow more savvy, Siegel said. “I think there’s definitely more skepticism.” Analysts’ buy recommendations on growth stocks don’t seem to be creating the price jumps they did in the late ‘90s, he noted, nor are investors as thrilled as they once were when corporate earnings beat analysts’ expectations.


Siegel also believes that controversy over analysts in the past year has made many small investors somewhat leery of individual stocks, pushing them to invest in mutual funds instead. But regulators, he added, could still have a useful role. He suggested that it might be wise to impose a rule prohibiting analysts from making recommendations on stocks their firms have underwritten until a number of months after the offering. That would remove the incentive for the most egregious cases of bias – the “booster shot” buy recommendation meant to gain the highest possible IPO or secondary-issue price for the client.


Regulators should also consider requiring detailed disclosure of individual analysts’ performance, just as mutual funds must disclose their performance relative to standard benchmarks, said Irvine. This would allow investors to easily see whether an analyst’s buy recommendations were better than average or worse.


Wharton’s Blume said money managers and other sophisticated investors have long understood that terms like “hold” – indeed, anything other than the strongest “buy” – were code for “sell.” Given the recent controversy, more small investors are aware of this as well, mitigating the bias problem to some degree. “If you know what they actually mean, you’re not going to be fooled,” he said.


With regulators investigating and potential litigants lining up to seek monetary awards, it’s impossible to predict how the analyst-bias controversy will unfold. But with so many spotlights turned their way, it seems a safe bet that the renegade analyst of the late-1990s is a creature of the past.