While the regulatory world is wagging its collective finger at Wall Street and corporate America clucks its tongue, the fact is that the shady practice of promoting and issuing favorable opinions on questionable investment deals is just as much a reflection of the companies looking to do those deals as it is of the investment banks trying to sell them. When Wall Street research departments give the thumbs-up to a deal or company, corporate executives at the enterprise in question know whether favorable opinions are close to their company's financial reality, but choose to accept and promote them even if they are not. It is not too dissimilar to the problems that have cropped up in the relationship between accounting firms and their corporate clients. It's in everyone's interest for companies to look good–except, of course, for the investor, who needs to know the true picture.

Unfortunately, without a fix, the very credibility and viability of U.S. financial markets may be threatened. Investor confidence has certainly gone through a tender period in recent weeks in the wake of relentless revelations about erstwhile superstar stocks that now appear to have been products of smoke and mirrors rather than financial analysis. As of mid-May, the Nasdaq is off 15% since the beginning of the year, while the S&P 500 Index has fallen 6%. The Dow Jones index has held steady.

Up until the recent scandals, the U.S. business community depended on the so-called Chinese Wall–the separation of church, the research department, from state, investment bankers–to defend the integrity of Wall Street's dialogue on the health of companies and industry sectors. In early May, the Securities and Exchange Commission, in concert with the New York Stock Exchange and the National Association of Securities Dealers, announced new rules aimed at rebuilding this protective dividing line. Under these new rules, analysts will no longer be compensated for bringing in specific deals and will have to publicly disclose it if their compensation is pegged to overall investment banking revenues. Analysts will also be banned from writing research reports on a company for 40 days following an IPO or for 10 days following a secondary offering. Finally, analysts will be barred from trading on their most recent recommendations or from trading in a stock around the time that they are issuing a company research report.

But even as the rules were issued, the presumption of many, including SEC Chairman Harvey Pitt, was that these initial efforts would prove insufficient. They are a "first step toward educating investors of, and protecting them from, potential conflicts analysts face, realigning the motivations of analysts and preventing and detecting misconduct," Pitt said that day.

What then must regulators demand in order to be successful? Inevitably, it seems to point in the direction of removing all need for a Chinese Wall, which, just like the one facing Genghis Khan, the barbarian conqueror of 13th Century China, was too easy to go through with a little help from friends on the other side. That would seem to translate into a total severing of investment banking from research. "Erecting a Chinese Wall will never be a real solution," argues Lawrence White, a professor of economics at New York University's Leonard N. Stern School of Business. "Consider that a Merrill Lynch or Goldman Sachs will always want research for its own portfolio, and once you have that research, why not make it public?" Sarah Teslik, executive director of the Council of Institutional Investors, is more blunt. Unless there is a complete separation of analysts from investment bankers, she says "all reforms will fall short."

Analysts as Stars

That may seem like a drastic solution, but the whole edifice of the capital markets depends upon investors being willing to put up their money, and investors will only do that if they have confidence that the system isn't rigged against them. Although they may scoff at the notion now, it would seem to be in the long-term interest of all players that investors have that confidence.

So how can this be accomplished without throwing Wall Street's businesses into a tailspin? It's a difficult predicament. In the old days of fixed commissions, brokerage operations were so lucrative that they were able to fund a bank's research operation. This arrangement left analysts free to do "honest" research since the firm made as much on "buy" transactions as it did on "sells." Once commission revenues got squeezed, though, the source of funding for research shifted from the brokerage side to the investment banking side. And with that shift came a natural shift in allegiance.

As a partner to investment banking, analysts–and every other party involved–were quick to realize that negative opinions on the prospects of companies hurt the bank's ability to do business. How could a company with too much debt on the books be rewarded for buying new enterprises and increasing that debt load? And how could you sell an initial public offering of a young technology startup, with no profits in the immediate future, unless you argued that the traditional business model did not apply and revenue growth was the key benchmark?

Suddenly, analysts were part of the investment banking team as it went out on road shows to sell its wares. In the high-flying days–really only three years ago–of Silicon Valley, the stars of the analyst community, such as tech queen Mary Meeker of Morgan Stanley, would be trotted out both before potential clients and investors on the obvious merits of the latest IPO or M&A deal being contemplated or sold. Analysts began to market companies, not research them. No surprise then, that the research eventually began to read more like ad copy and that the collapse of this symbiotic feeding frenzy would result in investigations by the Securities and Exchange Commission, the New York State Attorney General and various congressional committees.

Now, with each passing day, the volume of horror stories mounts, with among the most disturbing being reports that the other tech darling of the analyst community, Merrill Lynch & Co.'s Henry Blodget, had actually disparaged companies as "junk" in e-mails to Merrill Lynch colleagues as he simultaneously touted their stock to investors. Actions like that make it hard to argue that there was not a premeditated desire to deceive.

Who Will Pay?

New York Attorney General Eliot Spitzer, who supports a solution that would sever all links between research and investment banking divisions, has been aggressively pursuing a settlement, including a hefty fine and an admission of wrongdoing from Merrill Lynch. He is also publicly urging investors to sue if they think they lost money on investments because of poor advice from analysts. In fact, his investigation was triggered when one investor, a physician, won a $400,000 settlement from Merrill Lynch–a sum that may be a drop in the bucket if disgruntled investors who lost billions when the tech bubble burst take Spitzer's advice.

The problem with trying to bring integrity back to Wall Street research, say experts, is that nobody wants to pay for it. If the investment banks don't pay the analysts, who will? "The value of pure research analysis is pretty low," says Andrew Metrick, a finance professor at the University of Pennsylvania's Wharton School. "Investors don't want to pay for it. They want it for free. And the analysts, if they're good, are going to want to make more money, so they'll become money managers. It's hard to see how independent research operations are going to make it."

Investors, however, may feel differently about paying if the research is less tilted toward the interests of the financial services company that issues it. And of course, the changed stock market environment may also alter investor attitudes regarding the value of research. When the only direction the market was going was up, as was largely the case for the last decade, who needed research?

Meanwhile, the crisis in research analysis at the investment banks complicates things for corporate finance offices and treasuries, where there is always a need to get information out to investors in some way short of telegraphing it in a press release. "In the old days," says Metrick, "if a company wanted to get the word out ahead of time that they were not going to meet their earnings target, they'd whisper it to a favored analyst and then the word would spread around. SEC Regulation [Fair Disclosure] did away with that, but companies still had a way of telegraphing things to analysts." That, however, was back when investors still believed analysts.

"Now everyone knows that analysts are just touts," says Metrick. "Nobody believes what they say. In fact, if an analyst says something these days you do the opposite. So companies don't have an easy way to communicate anymore. To the extent that that makes things more opaque, it's bad for capital markets in general, and that's not a good thing."