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U.S. Securities and Exchange Commission

Public Statement by SEC Commissioner:
Comment & Analysis — Let Issuers Pay for Analysts' Research


Roel Campos

U.S. Securities and Exchange Commission

"Op-Ed" for the Financial Times, London Edition 1

The problem of research analysts' conflicts of interest captured public attention this year when Merrill Lynch agreed to pay $100m in its settlement with the New York State attorney-general and other parties. The allegations stemmed from smoking-gun e-mails that showed analysts deriding certain stocks as "dogs" in private while extolling their virtues in public research reports. Most recently, reports have emerged that Jack Grubman, Citibank's star analyst, issued positive research in order to induce his chief executive to help him gain admission to pre-school for his children.

Conflicts of interest permeate the investment banking industry, mostly because investment bankers and research analysts reside under one corporate roof. Recent disclosures suggest that for years analysts' research has been improperly influenced by pressure to issue positive research to attract underwriting and investment banking business. Small retail investors understandably consider these past practices to be outrageous. Sadly, they have now come to the view that Wall Street has rigged the system against them.

Last month the Securities and Exchange Commission, together with state authorities and stock exchanges, announced a joint effort to co-ordinate investigations into analysts' conflicts and to reach a comprehensive settlement with 12 investment banks. I am not involved in the ongoing discussions. I have not formed a judgment as to whether I would favour a settlement if one were presented to the SEC.

Whether or not there is a settlement, the SEC may need to consider whether new rules would help create a permanent, industry-wide solution. But first we must decide how important it is to have more widely available "independent" research.

If you do not believe that more independent research is necessary, you presumably will favour a solution that leaves the industry mostly as it exists today, with the additional protections mandated under the Sarbanes-Oxley legislation and now proposed by the exchanges. The new rules will require analysts to certify the integrity of their research and will prevent them from being compensated for attracting underwriting and other banking business for their employer banks.

Many people also support an additional requirement that all sell-side research be prominently labelled as "marketing materials". Supporters of this status quo approach argue that this is enough to protect investors. Others argue that no set of conflict rules or firewalls will ever eliminate the appearance that analysts will be more favourable to the bank's clients. They believe it would be better to ensure that independent research is generated outside the banks.

This approach raises two fundamental questions: who, ultimately, will pay for the independent research; and who will select the research providers?

One answer would be to require all listed equity securities to be rated by an independent analyst. The meaning of "independent" would be defined by SEC rules and enforced by the stock exchanges. Under this scheme, independent research would be funded by the exchanges, which would pass on those costs to the issuers as part of their listing fees. Since issuers are benefiting from access to capital markets it is appropriate that they should carry the costs. Over time, however, those costs might be shared by the investment banks through lower underwriting and banking fees in exchange for the issuers' business.

Any proceeds from a settlement with the banks could subsidise the costs of this type of "outside the bank" solution for a period - say, for five years - after which the issuers would be fully responsible, through their exchange listing fees.

An "outside the bank" solution along these lines would not discriminate among exchanges since the rules would apply to all of them. Ideally, the exchanges would compete to provide the highest quality research. Consideration also would have to be given to whether independent research would be provided to smaller companies not on national securities exchanges or a part of the national market system.

If the SEC decides to seek a long-term, market-wide solution through new rules, it would be wise to consider this "outside the bank" solution. There is much to be gained from eliminating potential conflicts of interest in a way that restores credibility among small retail investors.



Modified: 12/03/2002