Does Prudential have the solution to sleazy stock analysts?

Last week, it was reported that Citigroup is considering formally separating the investment bankers from the analysts at its Salomon Smith Barney unit. Such a move would undoubtedly help the megabank reach a settlement with New York State Attorney General Eliot Spitzer, who has been looking into the web of conflict-of-interest and corruption issues at Salomon.

Wall Street goo-goos have long advocated a formal separation of the two functions. Insiders have always known, and Spitzer's investigations have virtually proved, that stock analysts help drum up investment banking business by relentlessly pushing the stocks of their clients on a gullible public. Frequently, their compensation is tied to investment banking revenues rather than to the performance of the stocks they recommend. As a result of all the revelations, Wall Street analysts have seen their credibility sink about as far as the Nasdaq. So instead of merely rebuilding the Chinese Wall that was supposed to separate analysts and investment bankers, the argument goes, we should send the analysts to Formosa.

There's a bit less than meets the eye to the Citigroup proposal. Most notably, CEO Sanford Weill will only take the bold step if all his major competitors agree to do the same. But there's a larger question here. Would a complete divorce between analysts and investment bankers serve investors better? Unshackled from their investment banking clients, will independent analysts be more likely to call a sell a sell? And will they be more likely to be accurate than their conflicted counterparts?

Judging by the experience of a major Wall Street firm that voluntarily tried this reform a couple of years ago, the answer is a qualified yes.

In late 2000, before analysts fell into such disrepute, Prudential Securities moved to decouple its investment banking and analyst functions. The move by the unit of the giant Prudential insurance/financial-services conglomerate was more a recognition of market realities than a bid for virtue. Prudential Securities had long been an also-ran in the great Wall Street underwriting game of the 1990s. Its 1999 move to acquire Volpe, Brown, a San Francisco-based boutique company that specialized in technology IPOs, came about four years too late to do any good.

Unable and unwilling to compete for the dwindling share of business with the likes of Merrill Lynch and Goldman, Sachs, Prudential decided to jettison its high-priced investment bankers and keep its lower-priced analysts on board. After all, Prudential had a vast consumer and retail brokerage business. The move would both slash costs and send a message to individual investors that the analysts were there to serve them.

The theory, of course, was that Prudential's analysts would spend more time researching stocks and less time schmoozing on the golf course with potential clients. They would function more like reporters than bankers. They'd also get paid more like reporters, too, since the revenues supporting them would come from asset management and brokerage fees and not from the more lucrative underwriting fees. There would be no Grubmanesque $20 million paydays for Prudential analysts.

Next, Prudential moved to simplify its ratings. Most brokerages used five ratings, ranging from the redundant (strong buy), to the amorphous (accumulate and hold), to the seldom-used and hence meaningless (sell). Starting in May 2001, Prudential began to rate stocks buy, sell, or hold. Without the investment bankers looking over the shoulders, Prudential analysts felt more comfortable urging clients to dump certain stocks. Indeed, they were encouraged to rate any stock that they believed might fall by one-fifth as a sell.

Even after the market meltdown of March 2000, only about 2 percent of the stocks covered on Wall Street were rated as sells. At Prudential, the rate was significantly higher. "Their sell ratings got up to 7 percent or 8 percent of the stocks covered at times," said Chuck Hill, director of research at First Call.

Throughout 2001, Pru's analysts distinguished themselves by making some noteworthy calls—especially sell calls. The Wall Street Journal dubbed Prudential Internet analyst Mark Rowen the No. 2 stock-picker on its Home Run Hitters Team for telling people to dump Amazon in February 2001, and to go long Digital River. Prudential downgraded Enron to a sell in October 2001, when the stock was still at 20, and analysts at the major investment banks that had done so much business with Enron were still suffering from ratings-lock. Last November, it put a sell sign out in front of Homestore.com after it warned about fourth-quarter results. Within three months, the company's shares were halted amid allegations of fraud.