Investors have long expected the research they get from energy industry analysts to be many things: educational, accurate, truthful, complete. Now-in the wake of Wall Street scandals illustrating the influence investment banking can have on research-users of this research wonder about the independence of the commentary. Does independence guarantee quality? Of course not. "I can throw a dart at a stock table and that's a completely independent act, and completely worthless as far as adding any kind of value," says Rich Wyler, a spokesman for the Association for Investment Management and Research (AIMR). However, regulators believe independence is a critical first step to the credibility of financial analysis. Long lists of rules have been devised to make the big Wall Street investment-banking firms more independent within themselves-strengthening the walls between their banking and research departments. And, in an especially intriguing step, 10 of the major Wall Street houses soon will be required to offer their clients research from independent firms-those that do not offer investment-banking services at all-alongside their own analyses. That requirement was part of the April 28 settlement between regulators-including the Securities and Exchange Commission, New York Attorney General Eliot Spitzer, the National Association of Securities Dealers, the New York Stock Exchange and state securities regulators-and 10 of the nation's top investment firms: Bear Stearns & Co.; Credit Suisse First Boston; Goldman, Sachs & Co.; Lehman Brothers; J.P. Morgan Securities; Merrill Lynch; Morgan Stanley & Co.; Citigroup Global Markets; UBS Warburg and U.S. Bancorp Piper Jaffray. The $1.4-billion settlement says that, from about mid-1999 through mid-2001 or later, the 10 firms "engaged in acts and practices that created or maintained inappropriate influence by investment banking over research analysts, thereby imposing conflicts of interest on research analysts that the firms failed to manage in an adequate or appropriate manner." The firms will be required to separate their investment-banking and research arms. This includes a physical separation; a separate management chain of command; and separate legal staffs, compliance staffs and budgeting processes. Research analysts may not help solicit investment-banking business, and their compensation may not be based directly or indirectly on investment-banking revenues. The firms will pay $875 million in penalties and disgorgement of proceeds, $80 million for investor education and $432.5 million to fund independent research. For five years, each of the firms will be required to contract with at least three independent research firms that will make their research available to the firm's customers. An outside consultant for each firm will have final authority to buy that research. A consultant for each firm must be named within 30 days from when U.S. District Judge William Pauley enters his final judgement on the settlement, which, as of press time, had not been done. The firms have 270 days after the final judgement to make the independent research available. "I think [the independent-research requirement] is the component of that settlement that is the most mystifying to everyone, and perhaps the most cutting-edge," says Wyler. AIMR currently has 60,000 members, including investment managers, securities analysts and investment advisors. He estimates big-name independent firms with a focus on individual investors-such as Standard & Poor's, Value Line and Multex-will be the main contenders for a piece of the estimated $432.5-million pie. "I've heard secondhand a lot of independent firms that serve institutional clients are not interested in pursuing that business because they don't want the big firms to give away their research," Wyler says. "Also, they don't want to be beholden to these big firms. Does it compromise their interest if they have a huge contract with a big-name firm?" Energy research In addition to receiving independent research reports via the Wall Street firms, investors can seek opinions from an increasing number of energy-specific, boutique research firms. These often are backed by analysts with years of experience at the large Wall Street firms. Stephen Smith is one of those entrepreneurs. After working at Dain Rauscher Wessels (now RBC Capital Markets) and Bear Stearns for a total of about 15 years, he formed his own firm, Stephen Smith Energy Associates, in November 2001. "I did so to really have the kind of freedom to pursue some ideas that I had had for a long time in terms of what a research product should look like," he says. "And I was ready to try something on my own." Smith works from his home in Natchez, Mississippi, with one part-time assistant. His web site advertises annual subscription fees from several hundred to several thousand dollars. He said his business has been helped some by the recent Wall Street scandals, but it can be tough to operate without a team of salespeople promoting the products. "You do have to convince people that what you're doing is better enough than what they're getting for free, so they should make the investment," he says. "...Let's put it this way: The Wall Street research is free, unless you want to count the loss you suffered by owning Enron [stock]." The stipulation that some Wall Street firms must offer their clients research from independent firms is a good trend, Smith says. But he doubts that the investment-banking business and research could ever be truly separated in these organizations, despite regulators' best efforts or intentions. "I still find it hard to believe that a company can actually set up a research company within itself and have it be unaware that there's another part of the firm that does a substantial amount of money in investment banking. They know who they're doing investment banking with, and how it could not somehow be viewed as being in the researcher's interests to foster that...to assume that somehow or another that intrinsic motivation has been severed is maybe wishful thinking." Did Smith feel those pressures when he was a Wall Street analyst? "Everybody felt them. Sure. Absolutely." Donato J. Eassey, a former Merrill Lynch research analyst, launched his Houston-based independent firm, Royalist Independent Equity Research, in February. He is joined by three additional analysts. "Basically, I felt there was a need for independent equity research, just from a perception standpoint. It doesn't matter what reality was," Eassey says. "I felt when I was at Merrill that our research was independent of any pressures from any direction, irrespective of what one reads in the press. But it doesn't smell that way and it doesn't taste that way to the investor. So if you can create a firm or an entity that does have total independence, both from an appearance standpoint and a factual standpoint, that should be a welcome venue for the market." Eassey says his opinions reach the market more quickly through Royalist than they did through Merrill. "We don't have to manage our opinions by a large committee. We're much more timely than the Street can be, because they're hamstrung. They have to go through a lot of hoops to make a recommendation change." Royalist does not make Buy, Sell or Hold recommendations per se on stocks. "We analyze 41 names, and we come up with the three distinct model portfolios-conservative income, moderate growth and income, and aggressive growth and income." A master limited partnership (MLP) income portfolio is also available; it's segregated from the other three because tax implications are different for MLPs. Investors can get Royalist's research for a $130 fee. "Over the past few years, mom-and-pop [investors] have been left in the dust," Eassey says. Investors who want access to Royalist's detailed models pay a higher price. "We charge a considerable amount for those types of services. People are very interested in our detailed models." Support services The trend toward independent-research boutiques has created somewhat of a cottage industry among firms that are creating new services to help investors, corporations and even analysts navigate the new landscape. For example, Soleil Securities Group launched an "outsourced sales platform" for independent-research boutiques in June. Soleil does not generate any research. Rather, it markets the reports of 11 research boutiques that employ 35 analysts. Talks are ongoing with additional firms. "What we have figured out is that even the best analysts require the support of experienced and knowledgeable sales people who have access to buyside portfolio managers and trading desks," says Andrew Klein, co-founder and executive chairman of Soleil. "By bringing together a solid sales team and making it available to independent analysts on an outsourced basis, Soleil represents a new model that will open opportunities for a new generation of research boutiques." Helping smaller companies get attention from investors and from research analysts is investor relations firm Dennard Rupp Gray & Easterly LLC. The Houston-based firm has hired a number of former sellside analysts-including Carl Kirst, who covered energy for Merrill Lynch-who help companies present their stories to the market, using data points that analysts like to see, but which may not be included in traditional company literature such as annual reports. The firm helps the companies put together a report that has the look and feel of a sellside analyst report. The companies file these reports as a Form 8-K with the Securities and Exchange Commission, which shows the market that company executives are willing to back up everything said in the report, that it's not just fluff, says Kenneth Dennard, managing partner. The idea is that with Wall Street firms paring down their research staffs, smaller companies are losing coverage from analysts, and they must take control over their own message, Kirst says. Ironically, among the companies that have released such reports to the market so far, some of them have found that time-strapped analysts are more willing to cover them, since management has shown a commitment to transparency and open communications, he says. "You're doing a good chunk of a sellside analyst's work for them. We make it as easy as possible for them to be comfortable with their own analysis and pick up coverage." The separation Simply cutting all ties to investment banking doesn't guarantee that a research analyst won't feel any pressure to give companies good ratings, says AIMR. The companies under coverage often exert pressure on analysts, and that's something that can affect Wall Street and boutique firms alike. In May, AIMR and the National Investor Relations Institute (NIRI) formed a joint task force on corporate issuer and analyst relations. The two professional associations hope to identify guidelines for companies to support independence and objectivity among the analysts who cover them, and advance a relationship that is in the best interests of investors. "A Reuters survey indicated that 88% of analysts said they feared negative consequences from the companies they covered, if they were to issue negative opinions on those companies," says Thomas A. Bowman, AIMR president and chief executive officer. "Whether that fear is justified or not, the perception alone can inhibit candor in a way that ultimately disadvantages the investor." Those fears range from a corporation cutting off the flow of information to an analyst to actually bringing legal action against him or her. Conversely, corporate issuers have concerns about analyst practices as well, which the task force hopes to address. For example, some analysts may grill investor relations officers for confidential and material information that has not yet been publicly and broadly disclosed. "We believe analysts must respect the regulatory issues facing investor-relations officers to insure fair disclosure to all interested parties and not request special access and information that might be in violation of those regulations," says Louis M. Thompson Jr., NIRI president and CEO. AIMR first published draft standards for corporate/analyst relations in July 2002. Among its suggestions: Prohibit retaliation against research analysts who issue undesirable recommendations or ratings on corporate issuers; require public companies to establish formal written policies supporting independent and objective analyst research; and require that a senior corporate officer publicly attest at least annually that the company is adhering to the policy. Also, the draft standards included best-practice guidelines stating that corporate issuers should not file legal suits against research analysts nor make defamatory accusations against them in the media. According to the Wall Street Journal, the Securities and Exchange Commission is weighing in on this issue as well. In April, the SEC sent a letter to the New York, Nasdaq and American stock exchanges asking them to consider creating new standards to prevent corporate pressure on analysts. Bowman says, "I know it's a difficult area to regulate-you can't force a positive working relationship. But if a company blacklists an analyst, then he or she is working at a disadvantage in producing a high-quality research report. And that, as we have seen, ultimately disadvantages the investor."