Speech by SEC Acting Chairman:
How Can Analysts Maintain Their Independence?
Acting Chairman Laura S. Unger
U.S. Securities & Exchange Commission
At the Ray Garrett Jr. Corporate and Securities Law Institute
Northwestern University School of Law
April 19, 2001
In today's markets, investors are closely monitoring their investment portfolios. Thanks to today's technology, they have at their fingertips a wealth of information to accomplish this. Never before have investors had more choices in terms of sources of investment information. Of course, quantity does not necessarily equate to quality. A number of investors have learned some pretty hard lessons by relying on information they read in chat rooms, on message boards and on the many investment-oriented websites.
As you know, the Commission has cracked down on individuals who have exploited investors' hunger for financial information through the dissemination of false and misleading statements. And we've also spearheaded aggressive investor education efforts to help investors use, not misuse, the wealth of information available to them.
One of the most important sources of information has always been analysts. Unlike others, they put their name on their work-product and their professional reputations are at stake. But, for a variety of reasons, including recent market events, there is skepticism of the objectivity of analysts' recommendations lately. One survey showed that in 2000, 99.1% of brokerage-house analysts' recommendations were "strong buy," "buy" or "hold" recommendations.
Investors are also becoming circumspect about research emanating from brokerage firms where analysts don't change their recommendations until after a stock begins to slide or after an accounting problem surfaces. Last year, while the Nasdaq composite index was dropping 60%, less than 1% of analyst recommendations were "sell" or "strong sell" recommendations.
So just as investors are taking a second look at their portfolios as a result of our changed market conditions, it may also be the perfect time for analysts and the brokerage firms they work for to take a hard look at whether conflicting duties to investment banking and other clients stand in the way of truly independent analysis.
The "Fencing Match" Between Analysts and Corporate Officials
Although the Commission has recognized the critical role analysts play in ferreting out and evaluating complex financial information, it has struggled with the flow of information from issuers to analysts for over thirty years. Part of this comes from the fact that analysts have historically had unique access to confidential issuer information and a relationship with - but no duty to - that issuer.
The Commission's early cases against analysts were pursued under a "parity of information" theory, a theory that required all traders to have equal access to information before trading. But in 1980, the Supreme Court soundly rejected this theory in Chiarella, holding that a duty to disclose arises from a relationship of trust and confidence between parties, "not merely from one's ability to acquire information because of his position in the market."
More directly on point to today's discussion, the Supreme Court concluded in Dirks in 1983 that the corporate insider who passed material nonpublic information to Dirks did not breach a relationship of trust and confidence with the company or its shareholders. As a result, Dirks had no duty to disclose or abstain from trading, and did not run afoul of the federal securities laws by passing the information on to others who traded.
It is clear from reading these decisions that the Court and the Commission share a healthy respect for analysts and their role in the marketplace. In Chiarella, the Court noted that analysts "contribute to a fair and orderly marketplace," and in the Dirks case, the Court referred approvingly to the language of an earlier Commission decision: "[T]he value to the entire market of [analysts'] efforts cannot be gainsaid; market efficiency in pricing is significantly enhanced by [their] initiatives to ferret out and analyze information, and thus the analyst's work redounds to the benefit of all investors."
Backdrop to Regulation FD
In the 1990's, investors surged into a bull market that seemed to have no upper limit. The demand for financial analysis skyrocketed. The growing equity culture transformed the stereotype of the analyst from numbers-crunchers in green eyeshades to the "talking heads" of the financial media.
With the increased stature of analysts came increased scrutiny by the media and others. Before long, the spotlight on analysts focused on allegations of insider trading following issuers' selectively disclosing earnings and sales figures in conference calls or meetings open only to analysts and institutional investors.
In December 1999, the Commission proposed a cure to end the practice of selective disclosure, Regulation Fair Disclosure ("FD").
Acknowledging the limits of Dirks on our ability to pursue insider trading by analysts, Regulation FD attempted to tackle the problem from another angle. Rather than reading a duty into the analyst/issuer relationship, Regulation FD returns to the "parity of information" theory issuers may not disclose material nonpublic information to analysts (absent a confidentiality agreement) without disclosing it simultaneously to the rest of the world.
The proposing release also described the problem of selective disclosure in terms of analyst conflicts. The release stated: "[I]f selective disclosure were to go unchecked, opportunities for analyst conflicts of interest would flourish. We are greatly concerned by reports indicating a trend toward less independent research and analysis as a basis for analysts' advice, and a correspondingly greater dependence by analysts on access to corporate insiders to provide guidance and "comfort" for their earnings forecasts."
Conflicts Beyond Regulation FD
Commenters disagree on whether Regulation FD will serve to minimize the conflicts that arise as analysts "walk the tightrope" with corporate officials.
When I dissented from the vote adopting Regulation FD, it was because I took issue with the solution not the problem. At the time, I said that brokerage firms could do more to address the problem that Regulation FD was intended to cure, namely, trading by firm clients prior to a company's public disclosure of material information.
Although Regulation FD reaches far, it does not really address many of the inherent conflicts that analysts, particularly sell-side analysts who work for investment banking firms, face in performing their job. I worry that as investors seek an explanation about why so many stock market experts could have been so wrong about so many companies, they will conclude that analyst conflicts of interests are a big part of the answer. And I worry even more about those investors who are unaware of these conflicts and who remain confident in analyst recommendations. To reinvigorate public confidence, the brokerage industry needs to start thinking about resolving some of the more blatant conflicts facing this part of the industry.
Analysts on the Investment Banking Team
The most frequently discussed potential conflict involves the blurring of the line between research and investment banking. When a brokerage firm underwrites a company's public offering, the brokerage firm has a number of financial interests in seeing that the offering performs well. It also has a reputational interest; better performance will improve its competitive standing.
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 a brokerage firm manage those two competing interests? Unfavorable analyst reports are bad for sales and a bad way to nurture a lucrative long-term investment banking relationship. The natural incentive, therefore, is to avoid releasing an unfavorable report that might alienate the company and impact its future investment banking business.
This is not an irrational fear, either. In a recent survey of 3,000 CFOs, 1 out of 5 CFOs acknowledged that they have withheld business from brokerage firms whose analysts issued unfavorable research on the company.1
What happens when an issuer, its investment firm, and the firm's analysts all have a common financial interest in seeing that the company performs well? How can analysts provide independent research when they are part of the marketing team? A memo recently leaked to the press described a practice at one firm that required its analysts to give advance notice to both the company and the firm's investment banking division whenever they planned to change their opinion on a company. Although there is nothing improper or inappropriate about correcting factual inaccuracies, it would be troubling if issuers turned into editors of analysts' reports.
The conflicts between the firms' investment banking and research arms become even more apparent in the "venture investing" area. In venture investing, investment banking firms acquire a stake in a start-up by obtaining shares in exchange for financing services. Often, the firm's shares, and in certain cases, the analyst's shares, are subject to a lock-up period after the issuer's initial public offering. After the lock-up period expires, the firm can sell the stock. Press reports indicate that, in some cases, just a few days prior to the expiration of the lock-up period, the analyst issues a favorable research report, a so-called "booster shot" report. Shares of the company rise in value and the brokerage firm reaps a huge profit by selling its shares into an inflated market.
Profiting from "booster shot" reports may not simply be a conflict, but a violation of the antifraud provisions. Legalities aside, this practice does not reflect well on brokerage firms.
Compensation schemes within brokerage firms also present conflicts when they further align the interests of analysts with the revenues of the brokerage firm. Some firms tie analyst compensation and bonuses to investment banking division revenues overall. Other firms tie analyst compensation to the amount of business done by the firm with a particular issuer, giving the analyst an incentive in seeing the company continue its investment banking relationship with the brokerage firm. And in some cases, analysts receive discounted, pre-IPO shares in a company they cover.
Owning Shares in Covered Companies
The conflict involving individual analysts owning shares, including pre-IPO shares, in the companies they follow is one that is easily curable by disclosure. While many firms prohibit analysts from owning stock in companies they cover, in an effort to protect them from conflicts of interest, it seems to be becoming more common for firms to allow analysts to own pre-IPO stakes. Recent examples indicate that when analysts and firms disclose their ownership positions in the security being recommended, the disclosure language is just boilerplate, stating only that the firm and the analyst may have a position in the security being recommended.
So what is the solution?
My message today is that brokerage firms need to deal with the problem of analysts' conflicts. As they focus on the broader challenge of providing more value to investors and the marketplace, the firms can bolster the credibility and usefulness of analysts' work product - research reports - by addressing these conflicts.
Above all, they should make adequate disclosure. Both the New York Stock Exchange and the NASD have rules that address the disclosures that should be included in research reports. These rules generally require the disclosure of a firm's financial relationships with the companies recommended, including ownership positions, market making and investment banking services. We need to ask whether these rules are adequate to address the conflicts analysts now face.
To the extent undisclosed conflicts raise issues under existing law, broker-dealers would do well to remember that the NYSE and the NASD have supervision requirements, and the Commission requires that firms maintain information barriers under Section 15(f) of the Securities Exchange Act of 1934. Sell-side analysts are employees of brokerage firms subject to firm supervision.
Brokerage firms profess to rely on "Chinese walls" to minimize conflicts between their research, trading and underwriting departments and to prevent insider trading, but these procedures may well need to either be upgraded or enforced more effectively.
Even where complying with the "letter" of these procedures may protect a firm from liability, it may not be enough to satisfy a firm's ethical obligations to the investing public. To comply with the "spirit" of the "Chinese walls," firms may need to rethink both their disclosure practices and their compensation structures to ensure that they aren't undermining the necessary separation between research and underwriting.
Current market changes may impact analyst conflicts in other ways. Shrinkage in the IPO market means that more firms will compete for fewer underwriting opportunities. This could result in firms' competing even more aggressively, but it could also encourage more independent research. One brokerage firm has already shed most of its underwriting business and is using conflict-free research as a selling point. Many institutions are beginning to rely more on their own research teams and independent research firms. They believe that independent research produces more original ideas and is more valuable than the research of an analyst that is just trying to please the company. Some research groups have split off from investment banking firms because they believed their independence and objectivity were impaired by the firms' investment banking interests.
But despite these trends, addressing analysts' conflicts is critical to promoting fair and efficient markets. The necessary rules and tools are in place to deal with these conflicts. I believe now is the time for the firms themselves to take the lead in addressing this issue.
As the Supreme Court has stated, analysts have a crucial role to play by providing investors with objective and independent analysis of a company's prospects. Our markets will remain strong and vibrant only so long as investors have confidence in them. Thus, it can only follow that the integrity of our markets relies fundamentally on the integrity of market information available to investors. To the extent that firms can ameliorate analysts' conflicts and better ensure objectivity and independence, all of the investing community will be better served.
1 Subsequent to delivery of this speech, it was noted that the source for information about this survey was in error. The number of CFOs canvassed was 300.