New research businesses bloom.

The independent research business, buoyed by a recent settlement that provided it with tens of millions of dollars, is hoping the advisor community will see it as a new source of unbiased information.

But will it? And will the independent research houses, most of which have been in business for a relatively short period, survive and establish credibility with advisors?

Those are the questions facing the reborn research industry. Some advisors believe they have a stake in these firms surviving. They say that advisors need to turn to them for unbiased research because they lack the in-house modeling capabilities required for sophisticated portfolios and for analysis of alternative investments that clients increasingly request.

A handful of firms led by Standard & Poor's, Value Line and, more recently, Morningstar and Argus Research, have traditionally dominated the independent research business. They, along with the newer upstarts, are believed to generate over $500 million in annual revenues, with the larger firms controlling the lion's share of the total.

Given the widespread discrediting of Wall Street research, some think independent research could experience a wave of continued growth. "We are also using it (independent research) to challenge or validate research that we have already done in-house," says Joe Birkofer, a certified financial planner and a principal of Legal Asset Management in Houston. Birkofer says his firm, which works with high-net-worth individuals, runs value portfolios. The research provided by independents is important, he explains.

"We're seeing independent research firms shifting their focus from the buy side to the sell side," said John Meserve, president of BNY Jaywalk, an independent equity research consultancy. He said that the independents, which have generally concentrated on institutional business, are starting to reorient services toward retail institutions, including individual investors and financial planners.

These independent research businesses seek to help advisors assure their clients that they have accounted for every possible bad thing that can happen to their plans, according to John Grace, an advisor in Westlake Village, Calif., and the president of his own firm, Investors Advantage.

Many don't believe that new regulations will ensure objective advice from Wall Street's sell-side institutions. "We need unbiased buy-side research and, despite all that has happened, I don't believe that Wall Street can provide that," declares Rick Kaplan, a chartered financial analyst and Birkofer's partner.

Kaplan describes himself as a value manager who has his own in-house investment model. Using independent research gives him a chance to test many of his assumptions, Kaplan says. He also argues that many advisors need outside research because they don't have the in-house modeling capabilities.

Many advisors agree with Birkofer, Kaplan and Grace. They say that they have an interest in the growth of this relatively new business. Some are beginning to use it as more research firms become available. Nevertheless, independents face regulatory and historical hurdles, officials of these research firms complain.

"I don't know that advisors or retail investors are ready to pay for independent research. I'm not sure that they see it as something valuable," worries Peter Sidoti, chief executive officer of the Sidoti & Company LLC, a research firm in New York.

The problem, Sidoti adds, is that many people view research as a commodity. He says investors often think they can easily obtain research from the Internet. Therefore, Sidoti asks, how can their advisors persuade them to pay for something that they believe is free?

The growth of the independent research movement comes at a time when Morningstar, for years a big player in rating mutual funds, is now expanding its ratings of individual stocks. Given its expertise in funds and its huge data bank, the Chicago-based Morningstar, which is in the process of going public, is expected to be a big player as the independent research business expands. A spokeswoman for Morningstar declined to comment, saying the company could not comment because its IPO is before the public.

The 75-member Investorside Research Association is a trade group representing new independent research businesses. Investorside officials estimate that there are now some 200 independents offering research services. For the near future, Investorside is not concentrating on attracting new members, but on helping current ones with what they say is a sometimes-hostile regulatory climate.

"Regulators, for years, have taken a one-size-fits-all approach to research," says Investorside Chairman Scott Cleland. But independents now are benefiting from last year's global settlement, which requires Wall Street's biggest firms to ante up some $1.5 billion to help fund the independents. The payment was, in part, a penalty for the large firms' conflicts of interest.

The regulators contended that "from approximately mid-1999 through mid-2001 or later, all of the firms engaged in acts or practices that created or maintained inappropriate influence by investment banking over research analysts, thereby imposing conflicts of interests on research analysts that the firms failed to manage in an adequate or appropriate manner," according to the Securities and Exchange Commission settlement.

Some of the firms cited and forced to pony up were Credit Suisse First Boston, Merrill Lynch, Goldman Sachs, Bear Stearns and Piper Jaffray, among others. Nevertheless, despite some $430 million of the settlement money going to fund independent research businesses, Investorside officials say independents still have many hurdles ahead of them.

Sidoti, who is also a member of Investorside, says he is surprised that the regulators have not taken some simple steps that would help independents. "They could suggest to pension funds that they get a periodic evaluation of how the funds are invested," Sidoti says.

He also is surprised that the regulators haven't opposed those in the fund industry who want to curtail or eliminate the use of soft dollars. Supporters of a bill in Congress to ban soft dollars have argued that the use of soft dollars drives up execution costs and results in high fund expense fund ratios.

"If they ban soft dollars, that would really hurt many independent firms," Sidoti warns. Cleland also contends that unfair government regulation is retarding the growth of independents. He says that is because regulators don't understand the nature of how these firms function.

For example, Cleland says securities rules now require a broker-dealer to be licensed to offer investment banking if the firm is collecting research commissions from funds and investors. And that, he complains, discourages new independents because a broker-dealer licensing exam requires the knowledge of some 900 pages of investment banking rules.

"Those regulations are mostly irrelevant and unnecessary to the provision of pure research," Cleland contends. He runs his own Washington-based research business called The Precursor Group. Cleland's suggestion is that there should be research-only broker-dealers that would be exempted from many of the regs of other broker-dealers.

Regulators enforce such rules, he adds, because they usually don't understand the independent research firm. Even their definition of what constitutes independent research is slightly different from Investorside's.

The SEC, as part of the global settlement, defines independent research as simply "having no association with investment banking activities." Investorside's standard appears to be more stringent. It requires would-be members to stipulate that "they are not in the business of providing investment banking services; they are primarily paid by a client base of investors, not issuers of securities who are the subject of research; and they have no regulatory problems."

SEC officials said they had no comment on the complaints of Investorside members. The global settlement also requires that the independent advisor, seeking third-party research services, must take into consideration "whether and to what extent the independent research provider is engaged in activities or has a business that may conflict with the preparation and publication of the independent research."

Investorside generally agrees with that requirement, but also stipulates that independent research must be "primarily paid by a client base of investors, not by companies who are the subject of the applicant's research." Further, there is disagreement between the SEC and Investorside over the role of soft dollars.

The SEC generally has been trying to discourage the practice. It has hinted that it wants to narrow the safe harbor by which soft dollars are used. The soft dollar practice originates in the famous 1975 Section 28(e) of the securities code.

However, Investorside has been a fierce proponent of any narrowing of Section 28(e), a possible move now under review. Some members of Congress, with the support of John Bogle, the founder of the Vanguard Group, have called for the reduction or the elimination of the soft dollars. Investorside, in letters to the SEC, has warned that reducing or eliminating soft dollars through the repeal of Section 28(e) would destroy some of the nascent independents.

That would "defund the independent research industry almost completely, and perversely grant a de-facto government preference for conflicted, company subsidized, investment banking research," declares a letter sent by Investorside officials to the SEC. "Just talk of eliminating the primary source of independent research has had the unintended destructive and chilling effect on the use of and investment in independent research," the letter warned.

So why the misunderstanding, even when regulators are now seeking to nurture an independent research industry? It is because independent research remains a little-understood niche business, Cleland says. And that's even though these independents are supposedly going to become the solution to the problems of biased research and the resulting scandals of the past few years. These independents are not yet a huge factor. They are now only generating about $500 million in annual revenues, Investorside estimates.

Still, they have become a useful service for some advisors.

Mindy Ying, an advisor with her own firm, PacWest Financial Management in San Marino, Calif., says she chooses from an expanding menu of independent research firms.

"We now depend on these firms to back up the models we are creating in house," she says. "We started using them some years ago and now we have become dependent on them, although we are constantly evaluating them and will often switch services," says Ying. She works with high-net-worth individuals, endowments and offshore accounts.

Grace, who has used an independent firm for the last three years, calls upon the independents to investigate the macroeconomic implication of the recommendations that his firm makes. "Some clients think their planning goals are the only thing they have to worry about. I used a research service to explain to them that there are other things that we need to consider in our plan," Grace says.

"The research firm is more adept than we are at questioning and figuring out where the economy is going. We need to know if the wind is at our backs. This is a way of reassuring clients that every relevant question has been asked and answered about a plan. It is also an important element in getting people to stay with a plan," Grace adds.

Soft Dollars Defined

What are soft dollars? According to The Barron's Finance and Investment Handbook, they are "the paying of brokerage firms for their services through commission revenue, rather than through direct payments, known as hard dollar fees."

Ted Aronson, a principal of Aronson+Johnson+ Oritz, a Philadelphia institutional investment advisor, offers a simple definition. "Soft dollars are any commissions that are not used to achieve best execution." Nevertheless, there is a Catch 22 to Aronson's explanation. "No one knows how to define best execution," he concedes.

Whatever soft dollar arrangements are-and there are more than a few professionals who would disagree with Barron's or Aronson's definition-they have a considerable history. Soft dollars were legally created by Congress and regulators in the wake of May Day 1975. That's when commission rates were deregulated. The SEC enacted Section 28(e), an amendment to the Securities Act of 1934. Investment advisors using soft dollars, under the section, must use the credit to provide "lawful and appropriate assistance" to the account manager carrying out responsibilities, the SEC said. Ultimately, this critical section was put on the books because of fears that the unfixing of commissions-bringing competition to something that had never had competition before-would lead to dirt-cheap prices. Without this safe harbor, managers who passed up the brokerage 99-cent store could be accused of breaching their fiduciary obligations. Still, the key goal was giving the retail broker and investor a better deal.