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Aug 31, 2001

The bull market

Standards of practice for analysts and why investors are crying out for them

Most sell-side analysts are either shameless liars or shamefully incompetent. That would be the opinion of pretty much any investor who got wiped out by listening to one of the countless analysts who stuck to their strong-buy, buy or hold recommendations throughout the long stock market swan dive. Multiply that opinion by millions and you can begin to measure the crisis of confidence facing Wall Street.

The situation is disturbingly reminiscent of another bubble that burst some 70 years ago. Then, lots of suddenly-skinny citizens began asking questions about how fairly they were treated by the fat cats of the US securities markets. Congress swiftly enacted a series of disclosure-oriented laws designed to prevent conflicts of interest and shoo away skepticism. We have yet to see legions of ex-dot-commers on the street with ‘will compute for food’ signs on their chest. But investing is now a national sport, and any tremble in investor confidence is bound to cause aftershocks on Wall Street and Capitol Hill.

And that’s just what has happened. With investor cynicism growing, Congress and regulators along with industry and professional associations are all questioning whether Wall Street analysts can produce trustworthy research on public companies; and, if not, what to do about it. At issue is whether potential conflicts of interest affect the integrity of reports. In particular, many fear brokerage research has been corrupted by analysts’ eagerness to pen enthusiastic reports to help their firms attract profitable investment banking business.

That is not an idle anxiety. Data gathered by analyst performance appraiser StarMine shows that lead underwriters issue and maintain relatively optimistic recommendations on their clients. ‘It is clear evidence that analysts at firms with investment banking relationships with the companies they follow tend to be biased,’ says Joe Gatto, president of StarMine.

The parade of inquisitors (and respondents) is long. For their part, Congress and the SEC are scrutinizing how securities analysts are paid and supervised and whether regulations need to be beefed up or better enforced.

The Securities Industry Association (SIA) has issued voluntary best practice guidelines. The Association of Investment Management and Research (AIMR) has launched its own effort to investigate the pressures analysts face and to help shape new guidelines. The NASD wants analysts to prominently disclose whether they or their firm own a security being publicly recommended. Merrill Lynch and Credit Suisse First Boston went one step further by barring their analysts from buying the shares they cover. (Days after its announcement, Merrill paid a disgruntled investor $400,000 to settle allegations that he was misled by overly bullish research.)

Nor is the issue being ignored north of the border, with a blue-ribbon committee enumerating steps to ensure analyst independence and integrity in Canada.

Trust me,
I’m from Wall Street

But will all these efforts to polish up analysts’ tarnished image be enough? The securities industry hopes to stave off regulation with an ‘industry solution’, but so far its efforts at damage control have been largely underwhelming. The SIA’s best practices guide, for example, simply crystalizes the practices most brokers say they already adhere to. Mark Lackritz, president of the SIA, was quoted as saying the goal is to ‘try to get back the public perception that analysts are independent and call stocks as they see them.’ While changing perceptions is a necessary step, it is unlikely a sufficient one. Moreover, skeptics note the SIA has no authority to sanction rogue brokers; thus, the guidelines are toothless.

Meanwhile, Harvey Pitt, newly nominated as SEC chairman, echoed Lackritz’s comments, saying, ‘Everyone has to work together to change the popular perception.’ However, he said he didn’t yet know whether legislation was needed to watch over analysts. So far, the SEC has relied on education, issuing an ‘investor alert’ urging investors not to rely solely on sell-side research.

Indeed, ‘sell-side’ analysts aren’t called that for nothing, and it isn’t as if the issue of their independence is a new one. Institutions and other ‘sophisticated’ investors have long known to take what brokerage analysts say with a grain of salt. ‘Portfolio managers know that dropping a stock from a buy to a hold really means sell,’ says StarMine’s Gatto. ‘They have developed these elaborate codes and signaling methods, but it is confusing for the rest of the world.’

The secret ‘codes’ also confuse Congressman Richard Baker, chairman of a House subcommittee looking into the matter. ‘I’m amazed to have learned just yesterday that strong buy doesn’t really mean buy, but actually means outperform,’ said Baker during hearings on June 14. ‘Makes you wonder what an outperform recommendation really means.’

While Baker favors an industry solution, he is concerned the SIA’s guidelines are inadequate because they don’t provide for oversight by an impartial party such as the SEC. ‘You trust, but you also verify,’ Baker said, quoting former president Reagan.

New relationships

So far, the spotlight has been on how conflicts are disclosed or internally managed between brokerage houses’ research and investment banking divisions. These efforts are laudable. But one step behind the investment bankers are issuers themselves.

SEC acting chairman Laura Unger remarked in an April speech, ‘If the brokerage firm wants to develop a business relationship with an issuer, and it offers research coverage of the issuer, by necessity the brokerage firm compromises its objectivity. The tension arises because the firm’s research analyst typically becomes part of the investment banking team formed to promote the offering for the issuer... How can analysts provide independent research when they are part of the marketing team?’

How, indeed. But it wasn’t always that way. Issuers’ relationships with sell-side analysts have changed considerably in recent years.

‘In the early 1980s, analysts were much more removed from corporate finance,’ says Susan Herman, executive vice president for IR at Stylus Strategic Communications, and a former stockbroker and portfolio manager. ‘But by the mid-1980s, during a bull market, the Chinese wall was crumbling.’

Some analysts released what were then termed ‘investment banking research reports’. These made little pretense of objectivity and were not as credible to buy-side groups.

Inevitably, the buy side began relying on its own research. ‘Sell-side analysts were thought to be prostitutes of the investment banking arms of all major firms,’ adds Herman. More and more buy-side analysts were brought into company conference calls and results meetings.

With the rise of discount brokers in the 1990s, securities firms turned to investment banking as their number-one cash cow; and analysts, if keen on job security, went along for the ride as part of the merchandising team. Anecdotal evidence suggests issuers chose investment banks not for their expertise in the mechanics of an IPO, but rather according to the ‘star’ quality of their analysts – an image that was, in turn, willingly burnished by many journalists. Meanwhile, as corporate lawyers turned a blind eye, ‘positive’ analysts were granted access to senior management offices, and sometimes received non-public material information. It was a cozy situation.

Then along came Regulation FD, which radically altered the relationship between sell-side analysts and corporate issuers. ‘Today, if an analyst asks a question, the IRO can’t answer it unless they have something to point to – page x in the prospectus, for example,’ says Herman. ‘Analysts cover many more companies than they used to, and it is tough to get an analyst to follow your company if you can’t make their job easier. Some companies are speaking less with individual analysts and are trying to have more large-scale webcast meetings.’

Under pressure

At any rate, now it seems the relationship between issuers and sell-side analysts is going to be further attenuated. What the precise parameters will be remains unclear. What is clear, however, is that public companies must also play a role in restoring confidence to the market.

That is because besides pressures within their firms, analysts can also be pressured to issue favorable reports by the companies they follow. One reason is that management compensation is often tied to stock performance. According to the AIMR’s issue paper, ‘Research analysts may justifiably fear that companies will limit an analyst’s ability to conduct thorough research by denying negative analysts direct access to company management and/or barring them from conference calls and other communication venues.’

‘Theoretically, the ability to blackball an analyst doesn’t exist under Regulation FD,’ says Jessica Mann, a CFA and vice president for standard setting at the AIMR. ‘But there remains the fear of reprisals.’

Such fear appears well founded. A survey conducted by Tempest Consultants shows that 31 percent of public companies acknowledge having retaliated against ‘negative’ analysts. Retaliatory practices could include suing analysts personally and/or their firms. And, of course, further investment banking relationships could be denied.

‘Companies want favorable analyst coverage and use the fact they are clients to get it,’ says Roger Pondel, president of Pondel Wilkinson MS&L. ‘The credible analyst will report problems at companies, but the problem is that some analysts have not been allowed to report them because of the client relationship.’

Legislating in the area of issuer/analyst/ investment banker might be difficult, but it seems a change in both corporate culture and governance practice is in the cards. Says Mann, ‘Just to pick on investment bankers isn’t enough. You have to look at the issue holistically. It might be optimistic, but we want corporate executives to be committed to ethics and morals and not use the investment banking relationship as a manipulative and sometimes retaliatory [weapon]. It’s in everybody’s best interest to take steps to remedy the situation.’

Purdy Crawford, chairman of Canada’s Securities Industry Committee on Analyst Standards (Sicas), agrees. ‘It is not in an issuer’s long-term interest to be putting pressure on an analyst – subtle or otherwise,’ he says. ‘The long term catches up to you pretty quick.’ Crawford suggests part of the solution lies in companies practicing good corporate governance. ‘The problems disappear if the leaders at both issuers and investment dealers want them to go away,’ he says. ‘If the company’s board and CEO monitor the communications program and make it clear the company won’t pressure analysts, then the CFO and IRO will respond to that. Those companies whose senior management have demonstrated integrity – and can understand that analysts sometimes disagree with them – will be treated well in the market if they perform.’

Besides issuers, institutional investors also have a key role to play. The AIMR’s Mann notes that because portfolio managers may have large positions in a company under review, they could support sell-side ratings inflation or retaliate against analysts they see as ‘negative’ by shifting business to another firm. They may also squeal on those analysts to the company in question, thus precipitating corporate retaliation.

The attention focused on the issue of improving stock market predictions means that analyst performance ratings will now take on greater importance for all market sectors. ‘If the buy side awarded trading business based upon analyst performance, that could change the dynamics in terms of the sell side wanting to secure competitive advantage,’ says Purdy. StarMine’s Joe Gatto confirms there is more interest among sell-side research directors to objectively track their analysts’ performance (and presumably reward them accordingly).

Sell-side analysts are keeping an especially low profile on this issue these days. But their feelings are not unknown. ‘The investment bank heads of research I have spoken with feel it a bit unfair that their analysts are getting the chop in the neck from the media at the moment,’ says Sohal Shah, senior vice president at securities industry advisor Tempest Consultants. ‘They believe an undue amount of pressure is being placed on them by the companies themselves.’ Shah points to the Reuters survey. ‘There is a disconnect,’ he says.

‘Most companies say their reaction to a sell recommendation would be to increase communication and extend access. That might be lip service. Analysts, on the other hand, would expect their firm to be excluded from financing. The reality probably lies somewhere in the middle.’ [see chart]

‘It is in everybody’s interest that there is a fair and open market and that no undue influence is taking place in that market,’ says John Rogers, director of investor relations at Suncor Energy. ‘To that end, issuers must continue to deal with both the sell and buy sides at arm’s length, as opposed to creating a clubby sort of relationship.’

For now, governments and regulators know a problem exists and something must change. Yet to be determined is the level of intervention needed. ‘The focus is clearly on what the industry can do – particularly brokerage firms and investment bankers,’ says an SEC spokesman. ‘That’s not to say we aren’t thinking about the issuer side. But for the moment, there’s not much we have to say.’

An easy solution to the problem, of course, would be to legislate a Glass-Steagall sort of act that would separate the investment bankers from sell-side analysts, right down to terms of payment. Another unlikely, but effective, fix would be to prohibit analysts from covering the companies their firms are underwriting.

One way or another, the investment banks will have to change the way they do business, by both increasing disclosure and improving the management of conflicts. Certainly an opportunity is opening up for independent analysts not associated with investment banks. Brokers could also gain more credibility for their research by paying analysts based on the accuracy of their predictions rather than the investment banking business they help win. Restoring confidence will take time. But it must happen: Brokers’ franchises depend on it.

Do companies react to a sell recommendation?
If yes, how do companies react?
Increase communication/extend access
Exclude from financing
Reduce communication/reduce access
Complain to analyst’s head of research
Temporarily exclude analyst from briefings, visits, etc.
Do analysts expect companies to react to a sell recommendation?
If yes, how do analysts perceive the companies will react?
Exclude from financing
Reduce communication/reduce access
Complain to analyst’s head of research
Temporarily exclude analyst from briefings, visits, etc
Increase communication/extend access


Source: Tempest Consultants, 2001 Reuters Survey of US Larger Companies