Edmond Warner: Merrill lynched by conflict of interest

Now that Enron has destroyed Andersen, could the fallout from the dotcom boom destroy Merrill Lynch? Wall Street's greatest stockbroker is under assault from the New York state attorney general, who has armed himself with sheaves of emails that raise severe doubts about the integrity of its advice.

The American public has been shocked to discover that Merrill's analysts produced positive investment recommendations on a number of hi-tech stocks, while referring to them disparagingly in internal communications. How could a stock be crap to an internal audience but a worthy investment to a client?

It is unlikely that professional investors will be at all surprised to learn of this apparently confused recommendation system. The conflict of interest inherent within investment banks - in which corporate financiers draw on the expertise of the same analysts that advise investors - has been widely recognised for years.

Many major investors choose to ignore the headline recommendations on broking research. They use brokers' analysts to give them insights into the financial dynamics of companies and to keep them abreast of corporate developments, but then employ their own valuation models to determine their buy and sell decisions.

Only a small fraction of investment recommendations on Wall Street - or on the London market for that matter - are sells (or some euphemistic equivalent such as "reduce"). Since by definition half the stocks (by capitalisation) in the market must underperform the index, investors cannot rely on brokers to steer their portfolios clear of the rocks.

The investment banks mount a very weak defence when confronted with their unbalanced recommendation lists. We only research those companies we believe have inherent value, they say. And anyway, what we tell our clients over the phone might differ from our published advice. After all, if we offend a company with a sell conclusion, they'll never talk to our analyst again.

There is some truth in this defence. Corporates are notoriously badly behaved when they see a sell recommendation in print. Even if they have no banking or advisory relationship with the investment bank concerned, this does not stop them jumping on the phone to a senior executive in an attempt to bring pressure to bear on the analyst concerned.

When an advisory relationship does exist, a sell recommendation, or often even a neutral hold, can prove incendiary. Few analysts feel empowered to speak their minds in public on companies that their bank advises. In many banks mechanisms exist to ensure that corporate financiers see research on the companies they advise before it is published. They can then prove formidable barriers to it ever seeing the light of day.

Before you start to feel sorry for the poor, put-upon analyst, remember that they are the stars in the investment banking firmament. Their pay is determined by their ability to build a reputation among investors for giving timely, profitable advice, and then to leverage that reputation to win lucrative work for their banks. They might squeal when their independence is compromised, but that does not stop them spending the bonuses that corporate fees generate.

Professional investors tolerate the conflict of interest ingrained within the current investment banking structure for broadly two reasons. First, they value the ability to tap the minds of bright analysts who have privileged access to companies and to pay little in the way of commissions in return. Secondly, they want priority treatment when an investment bank is distributing shares in a hot new issue.

Private investors, by contrast, have all of the downside and none of the upside from the flaws in the analytical system. The major investment banks servicing institutional and retail investors typically send condensed versions of their institutional research to their private clients. Caveat emptor does not seem to be sufficient in these circumstances.

This problem is greater in the US than over here, for America has an investment culture that runs deep. Thus Henry Blodget, the former Merrill analyst whose emails have been laid bare for public scrutiny, is something of a national celebrity, having made his reputation in the dotcom boom. It is almost impossible to conceive of a financial researcher achieving similar status in the UK.

Merrill is fighting to hold back a tide of reform of its working practices. Each of the other major banks is watching with fear. The only thing unique about Merrill's case is that it is first in the queue before the beak.

If they are lucky, the banks will escape with an agreement to tighten up their disclosure procedures. If they are unlucky, structural change will be forced on them. Either way, there is likely to be a substantial diminution in the size and cost of research departments. The best analysts will be absorbed into corporate finance teams entirely, or will jump the fence and join the investment management industry.

Private clients will probably end up paying more for advice, but this in turn should ensure an improvement in its quality.

One final thought: what company or industry could stomach the publication of its staff's private views of its products? There is a warning in the Merrill affair for all businesses.

Edmond Warner is chief executive of Old Mutual Financial Services