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U.S. Securities and Exchange Commission

Testimony Concerning
Conflicts of Interest Faced by Brokerage Firms and Their Research Analysts

By: Laura S. Unger Acting Chair, U.S. Securities & Exchange Commission

Before the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, Committee on Financial Services
United States House of Representatives

July 31, 2001

Chairman Baker, Ranking Member Kanjorski, and Members of the Subcommittee:

Thank you for the opportunity to address the Subcommittee concerning analysts' conflicts of interest. The Commission commends the Subcommittee for its continuing attention to this important issue.

I would like to use my time this afternoon to address three issues:

    One, what conflicts affect analysts and why do they exist?

    Two, what have we observed about analyst conflicts as a result of our recent exams of brokerage firms conducted by SEC staff?

    And, three, what is being done to address these conflicts?

Before I get to these questions, a preliminary remark is in order. It is fair to say that it has not been a banner few months for analysts. To put it mildly, the profession has been the subject of rather intense public scrutiny. In many respects, analysts are a victim of their own success. The long-standing bull market and record number of IPOs made research - and the positive stock price impact research could have - a basis on which investment banking firms competed for underwriting business.

We must not lose sight, however, of the important role analysts play in our securities markets. As the Commission recently stated when adopting Reg. FD, "Analysts provide a valuable service in sifting through and extracting information that would not be material to the ordinary investor." We should also not forget that the overriding majority of analysts operate on the highest ethical plane. In other words, the issue of analyst conflict of interests is largely structural, not personal.

With that preface in mind, I begin by identifying a few of the more acute conflicts. Most stem from the blurring of the lines between research and investment banking I just alluded to. This blurring can be seen in a number of ways. First, an analyst's salary and bonus may be linked to the profitability of the firm's investment banking business, motivating analysts to attract and retain investment banking clients for the firm. Second, at some firms, analysts are accountable to investment banking for their ratings. Third, analysts sometimes own a piece of the company they analyze, mostly through pre-IPO share acquisitions.

SEC staff has been conducting on-site examinations of full service brokerage firms, focusing on analyst conflicts of interests. The staff selected for examination nine firms that underwrote significant numbers of IPOs, particularly internet and technology related IPOs. These examinations focused on the three areas I just mentioned: (1) compensation arrangements; (2) analyst accountability to investment banking; and (3) financial interests in companies they cover.

Today, I share with you some preliminary observations:

  • The lines between research and investment banking have indeed blurred. Seven of the nine firms inspected reported that investment banking had input into analysts' bonuses and the analyst hiring process. At at least one of those firms, 90 percent of an analysts' bonus is based on investment banking revenue.

  • The staff inspections found that investment banking did not formally supervise analysts. However, analysts assist investment banking by consulting on IPOs, mergers and acquisitions, participating in pre-IPO roadshows, and initiating research of prospective investment banking clients. Interviews with former analysts revealed that it was well understood by all of these analysts that they were not permitted to issue negative opinions about investment banking clients.

  • About one quarter of the analysts inspected own securities in companies they cover. The staff found that 16 of 57 analysts reviewed made 39 investments in a company they later covered. All of the investments were pre-IPO. Most significantly, examiners found that three of these analysts traded contrary to their research report recommendations.

  • Examiners also found that in 26 of 97 lock-ups reviewed, research analysts may have issued "booster-shot" research reports. These reports reiterated "buy" recommendations shortly before, or just after, the expiration of the "lock-up" period. ("Lock-ups" are the time period preventing insiders and others obtaining pre-IPO shares from selling the shares.) In each of these instances, the firm underwrote the IPO, or the firm's analysts owned stock in the company.

What, you may ask, is being done to address these conflicts?

The industry, the SROs, and the Commission have taken action to improve the objectivity and independence of research analysis:

  • Both the SIA and the Association for Investment Management and Research recently issued a set of best practices in this area. These best practices provide a foundation for ongoing discussions about managing conflicts.

  • Firms are reviewing their internal policies and procedures. Several securities firms have already taken some initiatives to revise their existing policies and procedures to manage conflicts. As reported in the press, at least three securities firms have recently adopted policies prohibiting analysts from owning securities in companies they cover in research.

  • The NASD recently proposed for member comment changes to enhance and harmonize its conflict disclosure rule.

The Commission has two roles in managing analyst conflicts. The first is making sure that disclosure is adequate and effective. The second is educating investors. So far, we have worked with the SROs to improve and more diligently enforce the disclosure of conflicts of interest. Our Office of Investor Education and Assistance has also issued an Investor Alert to explain to investors exactly what conflicts analysts might face and how investors should interpret disclosures about these conflicts.

I believe investor education is particularly vital to managing analyst risk. I say this because we can really only manage the conflicts. Some conflicts will always exist - such as pressure from institutional investor clients protecting their portfolio value and pressure from issuers who put analysts in the "dog house" for downgrading their stock.

It is my hope that - with a little help from the regulators -- the industry will resolve these issues. The recent industry initiatives are a step in the right direction.

I would be remiss if I did not emphasize that industry and SRO initiatives will only succeed with vigorous enforcement. Much of the SEC staff inspections revealed that firms had policies that were virtually ignored and rarely enforced. For example, one firm only approved of an analyst pre-IPO investment three years after the fact. In another example, only one firm could identify accurately all pre-IPO investments by analysts.

This cannot continue. The firms, the SRO's and the SEC must work together to ensure that we have information with integrity out in the marketplace. I look forward to continuing this partnership.

Thank you, Mr. Chairman. I will now be happy to answer any questions.


Modified: 08/01/2001