By Jonathan Boersma, CFA
10/01/2005
We are now nearly halfway through the five-year provisions of the Global Analyst Research Settlement that the New York District Attorney’s office announced in April 2003, designed to reduce equity analysts’ conflicts of interest by separating investment banking from research. Yet there are still any number of opportunities for conflicts of interest to distort the reports and recommendations that research analysts produce.
In addition to the separation of investment banking and research, the investment banks involved in the settlement are required to provide clients with a report produced by an independent research firm for every stock they cover in-house. The district attorney hoped that this practice would create a permanent demand among investors for independent research. In a strange turn of events, some investment banks are now advertising that they “offer” this independent research as a service to their clients. Turning a punishment into a marketing tool—now that is innovative.
However, many of the groups that generate this “independent” research are, in fact, still part of institutions that do business with the companies that the research analysts follow. For example, a sell-side research firm might be part of an institution that has an asset management division that manages the pension fund assets of a company followed by one its analysts. If an analyst issues a negative report, the company could threaten to take its pension fund business elsewhere. There are also cases in which the investment management divisions may pressure an analyst to issue positive research. Since an investment manager’s pay is typically determined by the performance of his or her portfolio—which can benefit from positive research reports—the manager may bring pressure to bear on the research analysts.
One distressing precedent for those who hope analysts will remain able to speak freely was a 2004 decision in the French courts that forced Morgan Stanley to pay around v30 million ($38.5 million) to Moët Hennessy Louis Vuitton (LVMH), based on allegations that the firm issued negative reports on LVMH and positive ones on Gucci because the latter was a client. While this would certainly be unethical if proved true, ultimately analysts need to be free to state their own opinions regardless of which companies the firm has as clients.
Some companies may lobby for favorable reports, especially because so many now tie executive compensation to the performance of company stock. More often, companies employ the subtle practice of denying access to those who have written negative reports or who are known for asking tough questions in meetings. Such analysts frequently find they have mysteriously been blocked out of a conference call or have not received notice of the meeting at all. We have also heard of cases of companies attempting to pressure analysts by refusing to trade through their firms’ brokerage divisions.
Wall Street Orphans
One of the unintended consequences of the global
settlement was the general downsizing of the research departments at many of the
large sell-side firms—which has led to fewer analysts covering fewer companies
and not enough hiring at independent firms to compensate. As a result, many
small- to midsize companies have lost analyst coverage to the point that
approximately 35 percent of all U.S. public companies are without any research
coverage at all. Some of these Wall Street orphans have hired analysts directly
to issue reports, resulting in clear conflicts of interest.
Also, investors
should be aware that the global settlement only addressed conflicts of interests
pertaining to equity research. The same types of conflicts also exist in the
fixed income markets. Because the disclosures required by the global settlement
do not carry over to the fixed income sector, investors need to be keenly aware
of any potential conflicts that may exist in those markets.
The global
settlement has changed the nature of the investment research industry for both
the long and short terms, but we continue to wonder if investors will truly
place a premium on independent research. Independence alone does not guarantee
high-quality research, which is a function of the analysts’ own capabilities.
But a prerequisite for quality research is a thorough and reasonable analysis,
which is usually impossible when an analyst is subject to pressures or to the
possibility of personal gain from his recommendations.
 | Jonathan Boersma is director of standards of practice at the CFA Centre for Financial Market Integrity in Charlottesville, Va. |