DRAFT Comments on the proposed Research Analyst Conflict of Interest Rules

Rob Tholemeier
Senior Equity Analyst
Wells Fargo Securities
(formerly Wells Fargo Van Kasper)

The new proposed NASD rules are supposed to re-establish independence of research activities and improve reliability of analyst opinions by removing analyst conflict of interests. Fantastic goals but these regulations will not help.

The new rules restrict analysts from actively buying and selling shares of the companies they follow, and the rules attempt to re-build the `Chinese wall' between investment banking and research. We are not sure these are actually good ideas and the rules as they are currently written will be completely ineffective.

Instead of giving investors more information these regulations simply make the relationship between corporate finance and research more opaque and reduce incentives for analysts to improve congruency between their public rating and their real opinion on a security - the latter, by the way, they frequently share privately only with their best customers.

The new proposed rules will have a chilling effect on free and open distribution of investment information. These rules clearly benefit the large brokerages and their best clients. These rules need to be rejected as proposed. New rules are needed but the rule makers need more input from analysts and the investment community.

This is my analysis of the proposed rules and some suggestions for improvement.

First let's deal with analysts holding or trading shares in the companies they follow. The new rules prohibit analysts from buying or selling stocks for 30 days prior to a research report and for five days after. In effect most firms will take a more restrictive position and will completely eliminate analyst ownership of stocks in their research universe.

This is a really dumb idea. It will not reduce the practice of analysts maintaining Buy ratings on stocks even if the analyst knows there is reason for concern. Buy ratings are influenced by several factors: 1) what the analyst actually thinks about the company; 2) avoidance of being "blacklisted" by companies for a downgrade, Neutral or Sell rating; 3) pressure from corporate finance to have a favorable rating on corporate finance clients; 4) pressure from the institutional sales force to have `Buy ideas' they can sell; 5) laziness; and 6) the excuse that everybody else has a Buy rating so why rock the boat.

In many cases analysts have nothing to lose by sticking to Buy ratings and verbally communicate concerns to their best clients. We do not think that these regulations will motivate analysts to be more circumspect or more forthcoming.

The result is that analyst recommendations are overwhelmingly "Buys". What is needed is an additional incentive for analysts to be more skeptical and more explicit in sharing negative information on stocks. Restricting share ownership will not help.

What would help is more disclosure and more incentive for analysts to reflect publicly their real assessment of the companies they follow.

What would help is if analysts were MORE active buying and selling shares of companies they follow with total and instantaneous disclosure.

To that end we suggest that regulations should TIGHTEN the window in which analysts can buy and sell securities. There should be a rule that requires analysts to buy or sell stocks WITHIN 48 hours of issuing a research report and force complete disclosure of ALL trading activity.

Investors could then see if the analyst puts their money where their mouth is. Analyst personal ownership of securities can be an important signal of the analyst's commitment to their Buy rating. Investors will be able to immediately smell a rat if analysts establish or repeat Buy ratings but they do not hold or add shares to their own account. An analyst selling shares would say a lot more about the research opinion than any words on paper.

Second, analysts should ONLY be compensated DIRECTLY for banking deals and this should also be disclosed. Investors can then make their own judgement on deal influence of analysts' opinions. It is a cruel joke to assume that analysts are not influenced by deal flow even if there is no direct compensation. It is a hoax to assume that the elimination of direct compensation removes or reduces banking influence on analysts opinions. Analysts will still be paid if they bring in revenue and generate profits. Corporate finance is still the most profitable arm of institutional brokerage. Corporate finance deals presume Buy ratings. Nothing in these rules breaks this chain.

There is no doubt that compensating analysts directly for deals will fling open the research kimono. Analyst should be encouraged to participate in deals and subsequently communicate their findings to investors. This will level the playing field and allow individual investors to learn more about what is inside the deals.

Of course, analysts should not be able to trade in or share non-public insider information - the current regulation - but working closely with bankers to produce the most complete information is the best way to inform investors.

Keeping analyst out of the deal flow information is simply impractical. In the real world many corporate finance transactions flow from analyst research. It would be oxymoronic for analysts to not look favorably on deals they initiate.

What is not appropriate is for analyst to be compensated for deals indirectly. This is the opposite of full disclosure and against the basic principle of open markets.

In summary, instead of opening up the research process these rules push it further into the shadows. Analyst should be encouraged to trade in the names they recommend and should be paid for corporate finance in a very specific, accountable and open way.

The new rules are a sham and in no way assist individual investors who would like to rely on professional analyst reports for investment information. All the new regulations do is insulate the large brokerage companies from the appearance of corruption and provide institutional defense for malfeasance law suites. They actually shift the analyst compensation to the brokerage managers who can use this power to further pressure analysts to look out for the brokerage's interest. I strongly suggest that these rules not be adopted.

(Since I have been working as an equity analyst I have never bought or sold a single share in a company I have ever followed, nor have I received direct compensation from deals, so far.)

DRAFT Comments on the proposed Research Analyst Conflict of Interest Rules