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Speech by SEC Staff:
Analysts Conflicts of Interest: Taking Steps to Remove Bias


Lori Richards

Director, Office of Compliance Inspections and Examinations
U.S. Securities and Exchange Commission

Financial Women's Association

New York, New York
May 8, 2002

The SEC, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author's colleagues upon the staff of the Commission.

Good Evening. I'm so glad to be here with you tonight.

I'd like to thank all of you for coming today, especially those of you who heard I would be substituting for Chairman Pitt and who came anyway.

The bad news is that Chairman Pitt couldn't be here tonight. The good news is that we still have a lot of interesting things to talk about. I thought it would be worthwhile to talk to you about research analysts. At an Open Meeting this morning, the SEC approved rule changes proposed by the National Association of Securities Dealers, Inc. and the New York Stock Exchange, Inc. regarding analyst conflicts of interest. These rules reflect a dramatic change in the way analysts are regulated. I thought it would be timely and interesting to talk with you tonight about the issues affecting research analysts in our securities markets.

Over the last several years there has been increased concern regarding the changing role of research analysts. Certainly this issue has garnered national attention and Attorney General Spitzer has brought this issue into sharp focus. While sell-side analysts used to be perceived as objective forecasters of corporate prospects and providers of opinions, they have increasingly become involved in marketing the broker's investment banking services. As markets have declined and with the downfall of Enron, there is increased public concern about research analyst conflicts of interest. Some of the key questions raised by Congress, regulators, the media, and the public surrounding the relationship between research and investment banking include:

  • Do investment banking interests drive ratings?
  • Do the personal financial positions of analysts and the securities ownership positions of their firms impair analysts' objectivity?
  • Why are there so few sell ratings?
  • Why don't analysts change recommendations when there are material financial problems affecting the issuer?

I. Conflicts of Interest for Research Analysts at Full Service Firms: Commission and Congressional Initiatives

Recent press articles make it sound as though the SEC has only just started examining analyst conflict of interest issues. In fact, the SEC began to examine this issue in 1999. We were concerned that analysts, who had became veritable media stars, appearing ubiquitously on television financial programs, did not disclose their own conflicts of interest so that investors could evaluate their recommendations against their possible biases. We were particularly concerned that many investors who rely on analysts' recommendations may not know, among other things, that: the issuer may be an investment banking client of the analyst's firm; the promise of favorable research can be an important component of the marketing of investment banking services; the analyst's compensation may significantly be based on generating investment banking business; the analyst may have personally purchased pre-IPO shares of the issuer; or the issuer may have reviewed and approved a draft of the research report before its publication.

In the summer of 1999, staff from the SEC's Division of Market Regulation began a review of industry practices regarding disclosure of research analyst's conflicts of interest. Then, staff from my office, the Office of Compliance Inspections and Examinations, conducted examinations of the largest full-service firms on the Street. We focused on analysts' financial interests in companies they covered, as well as analyst compensation arrangements and reporting structures, in particular whether analysts reported to investment banking personnel. The SEC reported our findings in Congressional testimony last summer, which were the following:

  • Many research analysts were significantly involved with start-up companies well before the companies had established an investment banking relationship with a broker-dealer. This involvement typically included establishing an initial relationship with the company, reviewing the company's operations, and providing informal strategic advice. Many times, these analysts were invited to invest in these companies' private placements, which were not available to the public generally. The staff also found that if the company went public and the analyst's firm underwrote the IPO, the analyst always issued positive research on the company.
  • It was commonplace for research analysts to provide research reports on companies that the analysts' employer firm underwrote. Many firms paid their analysts largely based upon the profitability of their investment banking unit, and investment bankers at some firms were involved in evaluating the firm's research analysts to determine their compensation.
  • Some research analysts owned securities in companies they covered. These analysts sometimes acquired their shares in private placements prior to the initial public offering for a fraction of the IPO price. Subsequently, the analysts' firms took the company public and the analyst initiated research coverage with a "buy" recommendation. Examiners found that some of these analysts executed trades for their personal accounts that were contrary to their recommendations in their research reports. In these instances, examination findings were referred to the SEC's enforcement staff.
  • The regulations existing at the time did not prohibit analysts from owning stock in companies their employer firms took public or that the analysts covered, but some firms maintained policies prohibiting analysts from owning stock in companies they covered. Other firms permitted analysts to own stock in companies they covered but prohibited them to execute personal trades that were contrary to the analysts' outstanding recommendations.
  • At the firms examined, compliance with SRO rules that require firms to monitor the private equity investments of employees (including analysts) was found to be poor. Nearly all firms examined were unable to identify accurately all private equity investments by their employees in companies the firms took public. Consequently, firms did not always know whether their research analysts owned stock in companies they underwrote and upon which their analysts then issued research reports.
  • Disclosure of analysts' and firms' ownership in recommended securities varied widely, which may have been due to gaps and inconsistencies between SRO rules. As a result, some firms' analysts' reports affirmatively stated that they or their employees held positions in recommended securities, while other firms used boilerplate noting, "the firm or employees may have positions in the recommended issuer." We found some instances in which the analysts' ownership in stock of the covered company was not disclosed in the research report at all.
  • Sell-side analysts routinely recommended securities during public appearances in the media (such as on financial television and radio programs), but rarely revealed any conflicts of interest to investors.
  • The ratings terminology may have been be unclear to investors. The variety of undefined terms to describe investment recommendations, included: "buy," "sell," "strong buy," "hold," "neutral," "accumulate," "near-term accumulate," "long-term buy," "outperform," "market perform," and "market under-perform," could confuse investors.

We were concerned that investors were simply not aware of these conflicts of interest. Last summer, the Commission issued an Investor Alert highlighting the numerous biases that may affect analyst recommendations. The Alert, called "Analyzing Analyst Recommendations," is available on the SEC's website, www.sec.gov, and explains to investors the relationships between securities analysts and the investment banking and brokerage firms that employ them, and educates investors about potential conflicts of interest analysts may face.

Congress also has focused on the independence of research analysis. The House Subcommittee on Capital Markets, Chaired by Richard Baker, held hearings last summer entitled, "Analyzing the Analysts: Are Investors Getting Unbiased Research from Wall Street?" The SEC provided testimony at the hearing concerning the preliminary results of the OCIE exams. The Congressional landscape has also recently included proposals covering research analysts. House Financial Services Chairman Oxley's bill (HR 3763) would require the SEC to examine the implementation and effectiveness of any new rules adopted by the SROs and to report to Congress, including making recommendations as to what further action may be necessary. There have been other legislative proposals in Congress that would enact structural reforms in the securities industry and/or require SEC rulemaking.

Given the serious concerns about the conflicts of interest analysts face that may taint or bias their advice, last fall the NASD and NYSE, following a call from the SEC and Congress, began to work together to craft new rules that would aim to restore investor confidence in the analysts' work. These rules were designed to address the conflicts of interest identified by the SEC. They were first proposed and aired for public comment in February and after reviewing and addressing various commenters' concerns, they were adopted today. Before I describe the rules, it's important to note that the Commission was very clear in saying that these rules are a first step in addressing analysts' conflicts, and that additional rules may be appropriate.

II. New Rules Governing Research Analysts

The new rules include the following provisions, among others:

  • Limitations on Relationships and Communications Between Investment Banking and Research Analysts. The rules prohibit research analysts from being supervised by the investment banking department. In addition, investment banking personnel will be prohibited from discussing research reports with analysts prior to distribution, unless staff from the firm's legal/compliance department monitor those communications. Analysts will also be prohibited from sharing draft research reports with the target companies, other than to check facts after approval from the firm's legal/compliance department. This provision helps protect research analysts from influences that could impair their objectivity and independence.
  • Analyst Compensation Prohibitions.The rules bar securities firms from tying an analyst's compensation to specific investment banking transactions. Furthermore, if an analyst's compensation is based on the firm's general investment banking revenues, that fact will have to be disclosed in the firm's research reports. Prohibiting compensation from specific investment banking transactions significantly curtails a potentially major influence on research analysts' objectivity.
  • Firm Compensation. The rules require a securities firm to disclose in a research report if it managed or co-managed a public offering of equity securities for the company, or if it received any compensation for investment banking services from the company in the past 12 months. A firm also will be required to disclose if it expects to receive or intends to seek compensation for investment banking services from the company during the next 3 months. Requiring securities firms to disclose compensation from investment banking clients can alert investors to potential biases in their recommendations.
  • Promises of Favorable Research are Prohibited. The rules prohibit analysts from offering or threatening to withhold a favorable research rating or specific price target to induce investment banking business from companies. The rule changes also impose "quiet periods" that bar a firm that is acting as manager or co-manager of a securities offering from issuing a report on a company within 40 days after an initial public offering or within 10 days after a secondary offering for an inactively traded company. Promising favorable research coverage to a company would not be as attractive if the research will follow research issued by other analysts.
  • Restrictions on Personal Trading by Analysts. The rules bar analysts and members of their households from investing in a company's securities prior to its initial public offering if the company is in the business sector that the analyst covers. In addition, the rules require "blackout periods" that prohibit analysts from trading securities of the companies they follow for 30 days before and 5 days after they issue a research report about the company. Analysts also will be prohibited from trading against their most recent recommendations. Removing analysts' incentives to trade around the time they issue research reports should reduce conflicts arising from personal financial interests.
  • Disclosures of Financial Interests in Covered Companies. The rules require analysts to disclose if they own shares of recommended companies. Firms also will be required to disclose if they own 1% or more of a company's equity securities as of the previous month end. Requiring analysts and securities firms to disclose financial interests can alert investors to potential biases in their recommendations.
  • Disclosures in Research Reports Regarding the Firm's Ratings. The rules require firms to clearly explain in research reports the meaning of all ratings terms they use, and this terminology must be consistent with its plain meaning. Additionally, firms will have to provide the percentage of all the ratings that they have assigned to buy / hold / sell categories and the percentage of investment banking clients in each category. Firms will also be required to provide a graph or chart that plots the historical price movements of the security and indicates those points at which the firm initiated and changed ratings and price targets for the company. These disclosures will assist investors in deciding what value to place on a securities firm's ratings and provide them with better information to assess its research.
  • Disclosures During Public Appearances by Analysts. The rules require disclosures from analysts during public appearances, such as television or radio interviews. Guest analysts will have to disclose if they or their firm have a position in the stock and also if the company is an investment banking client of the firm. This disclosure will inform investors who learn of analyst opinions and ratings through the media, rather than in written research reports, of analyst conflicts.

As you can see, these new rules are quite significant, and in my view, will certainly help to address the significant conflicts of interests that we saw in our examinations last summer. These new rules impose major changes in the way research is conducted. But the costs of implementation are minimal when compared to the need to restore integrity and investor confidence in research analysts' work.

III. Next Steps

What's next? The rules will be implemented by the firms, and provisions of the new rules have different kick-in dates to allow firms to make systems and other changes to become compliant. The SROs are committed to providing any interpretive guidance that is needed, and to ensure uniformity and consistency in interpretation. Both SROs will provide members with guidance notices to their members about the new rules, and they will work with smaller firms to ensure that the rules can be implemented in their environment. The SEC also requested that the NASD and NYSE report within a year of implementing the rules on their operation and effectiveness, and whether any changes or additions should be made to the rules.

Several weeks ago, the SEC announced that it had commenced a formal inquiry into market practices concerning analysts. We are conducting the inquiry jointly with the NYSE and NASDR, and with NASAA, and numerous state securities regulators. We are focusing in this review on several things — First, have analysts issued ratings that are fraudulent? The recent information revealed by the New York Attorney General's Office is very troubling. I note that existing anti-fraud rules prohibit making statements that the speaker knows not to be true — that would be fraud, plain and simple. Second, are the firms complying with the new rules? We'll be looking to see compliance with the new rules as they go effective. Finally, we'll be reviewing whether additional rules may be appropriate. I am very pleased that we will be partnering with all securities regulators in this effort.

IV. Conclusion

This is a time of change for research analysts. In some quarters, they have been villified. It's important to remember that they perform an important service — and they need to do their work in an environment free from conflicts and biases. Investor trust is too critical to their work to allow them to be compromised. The new SRO rules approved by the SEC today, and the other steps we are taking, go a long way to helping analysts regain their independence.

I have often said that, what's in investors' best interest is also in the best interest of firms doing business with investors. That's certainly true with respect to firms that have analysts who communicate with public investors. It's in these firms' interest to make sure that their analysts are in fact independent. Literal compliance with the rules is one thing, but firms can take steps, above and beyond the rules, to ensure that they create a culture and an environment that enforces and holds analyst objectivity paramount. Today's news that one firm that helped underwrite an IPO, also issued an unfavorable recommendation on that very issue, is a good sign that objectivity is possible.

Thank you for your attention. If you enjoyed my talk this evening, please remember my name is Lori Richards. And if you didn't enjoy my talk, my name is Harvey Pitt.



Modified: 05/09/2002