Editor’s note: This is the third in a five-part series examining the fallout of the corporate scandals from Enron to WorldCom. Not just giant firms are getting hit.When Merrill Lynch Internet analyst Henry Blodget wrote glowing reports on stocks he was saying internally were terrible, he didn’t just shine a light on age-old practice of analyst’s fibbing on their research to get investment bank business.

He may have inadvertently — at least temporarily — made life harder for hundreds of small cap companies who can only get analyst coverage because, maybe, one day they might need an investment bank to prepare a secondary offering or some other service.

Companies like Morrisville’s SciQuest or RTP’s Embrex don’t have enough stock in the marketplace to gather a throng of analysts watching their every move. Firms that might be able to go public one day, like Raleigh’s Nitronex, don’t stand much of a chance unless they can garner analyst interest and market makers.

So while the SEC studies stricter regulations, Congress calls hearings, the New York State Attorney General’s office continues its investigations, and brokers even file suit against analysts at their former firm (two former Salomon brokers based in Atlanta — Phillip Spartis and Amy Elias – are suing Salomon and its now resigned telecomm analyst Jack Grubman over bullish recommendations they claim cost their clients millions), lawyers and investor relations professionals in the Southeast hope the ultimate effect isn’t to make it impossible for companies to interest investors in their small cap stocks.

When a company is looking to go public, it will often do business with the firm whose analyst they would like to be covered by, explains Jim Verdonik, a lawyer with Kilpatrick, Stockton in Raleigh who works with high-tech firms. Forbiding a firm from covering a company it brought public would make it hard to even bring a company public since ongoing analyst coverage is what sustains interest in the stock.

“It is already very hard for small companies to get coverage, it could be harder,” Verdonik says.

Others share his concern.

“This is certainly on the radar screen of investor relations professionals,” says Jenny Kobin, Morrisville-based SciQuest’s IR director and the president of the Triangle chapter of the National Investor Relations Institute. If restrictions are particular stiff large Wall Street firms might abandon coverage on small companies. “There are only so many resources to go around. They’ll put resources where they can make money.”

Not only are small publicly traded companies affected, but also companies looking to sell out to a small, publicly traded company could find it tougher.

“A company being acquired is looking at the potential liquidity of the firm acquiring them,” says Walter Daniels a securities lawyer with Daniels & Daniels in Durham. The sellers want to find some buyers for the stock they acquire in the transaction without driving the price of the stock down. It’s generally believed that the more analyst coverage the less volatile the stock.

A change in a publicly traded company’s liquidity affects the whole capitalistic food chain right down to the venture capital firms considering funding a start-up. Those firms want to know they can cash out at some point in a liquid way. “For every one company that goes public, there are 10 that are sold,” Daniels says.

Needs of companies vs. public good

No one thinks dishonest analysis is a good thing.

One North Carolina investment banker — who says he can’t be quoted — thinks the free market would do a better job of policing the situation than myriad rules. “People looking for sell-side advice would buy from the firms who provide good research.”

But in case you don’t want the fox guarding the hen house, Daniels says at least full disclosure needs to be made. “It’s not wrong for an analyst to cover a company their firm has an interest in as long as it is disclosed.”

Most of the analysts quoted in publications and chatting on CNBC come from what’s known as the “sell-side” portion of the business. They research companies and provide their stockbrokers with information that helps them pitch a stock to their clients.

The sell-side analysts’ ratings are tracked by companies like First Call, who average the ratings giving investors a “snapshot” of the what Wall Street thinks of a firm’s stock. Their reports are easy to access — sometimes free or for a small fee. They are almost always happy to be quoted — after all, getting their company’s name out there is about bringing in business.

They also appear to be terminal optimists. Only about 7.3 percent of Wall Street ratings are “sells” according to First Call. On Sept. 1, 2001, less than one percent were listed as “sells”.

As the investigations are revealing, the rosy outlooks are a product of their status as a cost center. It’s the investment bankers who pay the bills with the services they sell and they get awfully antsy when a research analyst puts a sell rating on a company who might have provided some business.

Analysts with tough reputations — even if their analysis proves correct — have been fired.

One of the reforms suggested by New York Attorney General Eliot Spitzer was restricting communications between analysts and the investment side. Citibank’s Salomon Smith Barney adopted those reforms earlier in the summer but then garnered headlines in August after firing a junior analyst who claims he got canned for refusing Salomon investment bankers request to make a report on office furniture companies more positive. Salomon claims he was fired for performance reasons.

Monday: Why shoddy analysis didn’t matter during the boom and why it does now.

THE SERIES:

Part One: Want To Be a CEO? Your Feet Will Be Closer to Fire in Hot Scandal Climate – www.localtechwire.com/article.cfm?u=1970&k=22&I=10

Part Two: New Rules, Regulations Mean Tougher Scrutiny for CEOs – and Boards – www.localtechwire.com/article.cfm?u=1986