Speech by SEC Staff:
|General Counsel, U.S. Securities and Exchange Commission. The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed in this paper do not necessarily represent the view of the Commission, or the members of the staff of the Commission.|
Thank you, Stan, for that kind introduction. I'm delighted and semi-flattered to be here. I'm semi-flattered since Stan was quite clever when he asked me several months ago if I would be willing to speak. I told him I would and thanked him for the honor. He answered, in effect, "Not so fast. Now that I've got you committed I want to let you know that, if Harvey is confirmed in time, we'd like to have him speak." Well, the process took longer than we all hoped, and our new Chairman could not take office until last Friday, so the Committee's loss is my gain; and, as I said, thank you, Stan, for that kind introduction.
I'd like to bring a little less clarity to the current public discussion on securities analysts and their conflicts of interest. I mentioned this to Brandon Becker, who responded that if less clarity was the goal, I was just the one to achieve it. Before I say anything, however, I must stress that the views I am about to express are mine alone and are not necessarily those of the Commission, of any individual Commissioner or indeed of any member of the SEC staff other than myself. I especially wouldn't try to commit anyone to any particular course in any event, since I'm not at all sure what the Commission's response should be to these issues.
As the securities markets have gone through their convulsions of the last year, and so many investors have gotten so badly hurt, there has been an understandable search for reasons. It is in this context that attention has come to be focused on analysts, particularly sell-side analysts. During the recent bull market, many analysts took on a certain celebrity mystique. They were the wizards, the keepers of the secrets of the next hot stock. And all the financial news shows and financial websites made them seem more familiar and accessible to the individual investor. It was no longer just your broker passing on some filtered advice from his firm's faceless research department, now the superstar analyst talked directly to you. With the bull market validating the analysts' advice, the public began to pay a lot more attention to the analytical wizards. For analysts, that was the good news then; it's the bad news now.
The investor who lost a significant amount of money, the public at large, even Congress, now want to know "how could so many analysts be so wrong?" It's an unfair question in a way. For years, there had been unheeded warnings that the market was overvalued. As the market went up, and up, and up, those who warned that the bubble was about to burst got clobbered. Remember value investing, how that came to be derided and abandoned? Remember earnings, how they came to be dismissed as an outdated benchmark for value in the New Economy? The efficient market, that agglomeration of the conventional wisdom of the moment, seemed to confirm many versions of a new paradigm for investing. So it's useful to remember that before sell-side analysts were very, very wrong, they were for a time very, very right. Looking back at a time when we were all foolish - and where those who warned us about our irrational exuberance were largely ignored - we all have to take our measure of responsibility for believing, in our heart of hearts, that what went up would never come down.
In the end, many investors lost lots of money on some very bad investments. They did so, in part, by relying on people who should have known better and who claimed that they did. We all may have taken leave of our senses for a time, but it is appropriate that we reserve a special place in our hearts for those who encouraged us to do so.
Any useful discussion of these matters should start with a description of what analysts actually do. Let's be plain: broker-dealers employ analysts because they help sell securities. There's nothing nefarious or dishonorable in that; but no one should be under any illusion that brokers employ analysts simply as a public service. Analysts help sell securities by guiding investors and registered representatives among the myriad of investment opportunities to the best investments. When they do their job well - and they usually do - analysts and their research departments provide a tremendous public benefit while serving their own interests in developing large and loyal client bases for their firms.
Those large and loyal client bases generate commission revenue, but commission revenue is not what it used to be and has declined over many years as a percentage of firm income. That large and loyal client base, then, is used mainly to bring investment banking clients in the door. Issuers want to expose their product to all those investors who believe in and follow the analyst, but only, of course, if the analyst will be enthusiastic about the securities. To be most attractive to a prospective underwriting client, an analyst has to convince the client that he is enthusiastic about the issuer's prospects and that he can sow his enthusiasm among potential investors. So long as the issuer has a choice about its future banking business, it will chose the banker with an analyst whose influence and enthusiasm won't dim shortly after the offering is completed.
How does an analyst remain influential? First, be an analyst in a bull market. When everyone is making money, it's hard to be wrong. Second, distinguish yourself. Get some name recognition. Visibility helps sell. Third, show your following that you're good, that investors make money by following your advice. It's good, very good, for business to be voted as one of the top 100 analysts in America.
Over the long run, the best way to be well regarded by customers is to put them in winners and advise them to minimize their losses quickly on the losers. Underwriters have similar long-term interests. But, as we all know, the seductions and the terrors of the moment have their way of crowding out detached calculation about the long term. The quick bonanza can be enormously attractive. And, again, a bull market, particularly a long one, helps concentrate the mind more on the bird in hand than on the skunk in the bush.
Analysts also know the simple truth that no one but a short-seller likes a sell recommendation. Issuer's hate sell recommendations, and why shouldn't they? And they have a variety of ways, which they will not hesitate to use, to punish the analyst recommends that investors sell. Falling stock prices also are bad news for a firm's investment bankers. Investment bankers who consistently underwrite stocks that fall in price face unhappy banking clients, who wonder whether someone else might do a better job on the next deal. An analyst who, within weeks or months of an underwriting, advises his large and loyal client base to sell surely does not need to be told about the potential impact his firm's investment banking revenue and on the reputation and pockets of the analyst's colleagues.
Investors rarely treat a sell recommendation as such good news either. The reaction is not so much "thank goodness you kept an open mind and took me out of a bad situation quickly." It's more of "how did you get me into this mess in the first place! You'll get my vote for America's Most Wanted before you get it for America's Top Analyst."
There's also the very human dynamic that no one wants to explain away an earlier pronouncement, even when the facts have changed. The natural human tendency is to avoid looking foolish. So of course an analyst's first impulse is to say, "I was right yesterday, and I'm still right today."
The point here is to acknowledge that, under any circumstances, analysts have enormous incentives to generate investment enthusiasm and are under enormous pressures to maintain it. These pressures are inherent in the job. It must be hard for anyone to be utterly objective under those circumstances. I say this in neither criticism nor praise, but to raise the question whether complete analyst independence -- by which I mean sell-side analysts free from interests that may produce bias - is an attainable public policy goal, however desirable. While we may be able to lessen some of these pressures, I'm not sure that we can realistically expect complete disinterest from analysts employed by firms whose principal source of income comes from investment banking fees and other activities dependent on the sale of securities.
In my view there is an open question - the answer to which I simply don't know - whether it is possible to achieve complete analyst objectivity without cocooning analysts from the rest of a firm's business. And there is the further question whether a firm whose analysts are so cocooned would find them worth having at all.
It's also an open question in my mind whether the public wants to pay what it costs to get analysts whose bias is beyond question. Some independent research firms are thriving. Still, I would be interested in finding out whether truly independent analysis is a bit like legroom in an airplane. Everyone likes it; people complain about the lack of it; but when push comes to shove there aren't that many people willing to pay for it. With commission income dropping and spreads narrowing, it may be that a firm that cloisters its analysts has no way of recovering their cost.
But, while a firm might be find it too expensive to cut off its analysts from forces that might undermine their objectivity, it's considerably less expensive to maintain the analyst's reputation for objectivity. I don't think one can always assume that reputation mirrors reality - even over the long term. We all know of people in every profession - except ours of course - whose reputation for wisdom seems untethered to anything real and persists for years for no apparent reason.
In my view, the public, the Congress, and the Commission have raised appropriate concerns about whether investors have been led to believe that analysts are more objective than they, in fact, are. That, I think, was the point of Acting Chairman Unger's speech last April about analyst conflicts, and it has been the point of two Congressional hearings held on the issue under the able leadership of Chairman Richard Baker. The essential issue is whether too many investors wrongly believe they are getting objective financial analysis from persons who in fact have more complicated agendas.
The problem, of course, is exacerbated where financial interests that are personal to the analyst and peculiar to a particular recommendation enhance inherent structural conflicts. We are right to be concerned about the output from an analyst who can literally count the dollars that turn on his success as a salesman. In particular circumstances where the incentives and pressures go from subtle to overt, from episodic to constant, from significant to huge, and where the public is unaware of them, there is reason to question whether the public is getting a fair opportunity to evaluate what it is being told by the purported experts.
I've been told that "everybody" knows about the pressures upon analysts that are inherent in their job and in the fundamental economic dynamics at large, multi-service broker-dealer firms. My guess is that indeed "everybody" does know - except for those who don't. I remember a brief summer job experience I had over 35 years ago when I was young but old enough to have known better. I was a cold-caller for a firm selling advertising space in some sort of service directory, and I was instructed to tell prospective clients they had been "recommended" for inclusion in the directory. No one believed me of course, except for one couple running a small family business. They were thrilled by the recognition accorded them by this so-called "recommendation." I am still embarrassed that I took their money. It paid for some advertising that I hope was useful to them. It also paid for a valuable lesson I've carried with me ever since: there are people out there who are not cynical about everyone's motives and take at face value plausible explanations they hear from pleasant - sounding people. Not everyone is jaded, and not everyone knows the ins and outs of the securities business.
I guarantee that billions of dollars of investments come from investors who aren't part of the "everybody" who knows the biases that are an inevitable part of the business of sell-side analysts. And I guarantee the circle of "everybody" who knows is far smaller when it comes to knowing that the analyst writing a particular report is getting paid by the investment banking department for his success in selling the deal, that he owns cheap stock that he got before the issuer went public, or that, before the issuer even went public, it reviewed and approved the draft of the report the analyst published weeks later.
As always the question is what should be done? To some extent, existing law may cover these issues. Some conduct may involve out-and-out fraud. Where there is fraud, the Commission will enforce the law. I note also that already private litigants have filed numerous class actions lawsuits related to these issues. I have no view about the merits of these cases, but they will tee up some of these issues for the courts.
Those legal issues may be close. There is question whether silence about a conflict of interest is fraudulent where there has been no representation about the absence of conflicts, unless there is some duty to disclose. I'm not sure whether there is such a duty or to whom it would run. In particular, I'm not sure that such a duty would run to readers of broadly distributed reports. I'm also not sure that courts would find some of the facts I previously discussed to be material in all instances. Generally, the courts have held that information about motive is not material to investors. I'm not sure that undisclosed bias would be regarded as a material fact. I can imagine some of the arguments either way. I also would expect, as a general matter, that an intention to defraud could be difficult to prove, though the presence of motive makes it easier to allege.
There may also be cases where arrangements between an issuer, the underwriter, and the analyst raise legal issues under Section 17(b) of the Securities Act, the anti-touting provision. That provision makes it unlawful for anyone to make any communication that describes a security, where the person communicating is getting paid to do so by an issuer or an underwriter, unless the person discloses the consideration received and its amount. The Commission in the recent past has interpreted this provision broadly. But again, there will be issues about who is paying the analyst and what it is that an analyst is getting paid to do. Disclosure could be the cure of choice. I should note that on July 2, the NASD proposed amendments to its conflicts disclosure rule, Rule 2210, to require more specific disclosure of the economic arrangements between an analyst, his firm, and the issuer. Similarly, the SIA's "Best Practices for Research" includes certain disclosure standards. Some in Congress and elsewhere have called for the SROs and the SEC to require more disclosure in connection with research reports.
To state the obvious, the efficacy of any disclosure remedy turns on what will be required to be disclosed. Here again, there are multiple considerations. As I mentioned at the outset, it may well be that much of the stress on analysts is structural and may not be unique to any particular transaction or any particular recommendation. How much about the general biases of an analyst needs to be disclosed to avoid misleading investors, and does it really make sense to have a brief essay at the end of every analyst's report? But how useful are particularized disclosures without this context? At the same time, I'm not sure whether even some of the more particularized disclosures that have been discussed will suggest inferences that are inevitably correct.
Similar considerations are raised by possible measures that would attack the problem by requiring the analyst to avoid situations that may give rise to bias. I would hope we don't place any unnecessary burdens on businesses and the capital raising process. But I would also hope that we don't gravitate towards the quick fix that is only modestly helpful and then move on. To take one example, public attention has focused on analysts whose compensation is determined in all or part by a firm's investment banking department. In response, the SIA's Best Practices call on firms to eliminate the role of investment bankers in compensating analysts. If firms adopt this recommendation, will the pressures on analysts change materially? Will this be a development of substantial significance? Or will firms find other ways to pass on to analysts the economic incentives for the firm as a whole. Again, I don't know.
Here's what I do know. First, the SEC has no monopoly on wisdom in this area. The industry, the SROs, investors, and a Congress that has been engaged and constructive, have experiences and views here that should inform the Commission's view as to what, if anything, the it should do. The Commission works best when it knows most. I would urge the Commission to find mechanisms to tap into the experience, expertise, and good will of all concerned. There may be a particular role here for self-regulation, where attention may be broadened from purely legal principles to considerations of professional standards and just and equitable principles of trade.
Second, the public needs to be educated. I'm not here to suggest any particular mechanism - already our Commissioners, our investor alerts, Congressional hearings, the financial press, and the industry itself have been effective. It may well be that all these parties, as well as the Commission and the SROs, should do more. There's a lot of context here that investors and the public at large should understand.
Finally, over the long term nothing is as necessary or as effective as internalized professional values. We need to be the most unsparing critics of our own conduct. We should judge ourselves not just by what the market encourages or what the law allows. Whether legal or not, whether consistent with market incentives or not, professionals who act as the proverbial gatekeepers need to ask themselves about whether the public has been helped or harmed by what they have let pass through the gates. Defenses, justifications, and excuses aside, we all need to look at the economic, legal, and ethical bottom line. If we do, and if we ask both the complex and the simple questions with our minds open about the answers, we will serve ourselves, our clients, and the public.
Thank you very much.
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