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Tomments #9:
What can be done to eliminate conflicts of interest in analyst research?[1 page, 06/21/01]

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A House subcommittee convened last week to begin investigating whether analysts are giving biased advice to their clients due to conflicts of interest. The issue is that the brokerage firms at which the analysts work often generate significant investment banking business from the companies they recommend, creating a strong financial incentive to paint an overly optimistic picture of those companies. Rep. Richard Baker (R-La.), chairman of the House Financial Services subcommittee on capital markets, said at the hearing Thursday, June 14th: "I must say I am deeply troubled by evidence of Wall Street's erosion of the bedrock of ethical conduct." In addition to the congressional hearing, the New York state attorney general's office is conducting a similar investigation.

The evidence presented to the subcommittee overwhelmingly supports the claim that the problem deserves attention. For example, at the Nasdaq's peak last year, less than 2% of all analyst recommendations were "sell". In addition, internal memos and numerous other pieces of evidence were presented indicating that implicit or explicit collaboration between the underwriting business and the research business is commonplace at some firms. Furthermore, a study by Kent Womack, associate professor of finance at Dartmouth's Tuck School of Business and a former Goldman Sachs VP, found that analysts whose employers were the lead underwriters of a stock gave out 50% more "buy" ratings than analysts from other brokerages.

The problem has grown over the years. In the not-too-distant past, the research department was funded by brokerage commissions, but once that commission revenue tapered off, the investment banking arm began picking up the tab, leading to the potential conflict of interest. Additionally, analysts have more power than they used to. Previously only their clients read their research, but now their audience has grown by orders of magnitude as the internet, TV and other media have made their pronouncements accessible to millions of individual investors. Although it's not only a bear market problem, the Nasdaq's collapse has brought the issue to the forefront, as analysts continued making rosy projections even as the markets fell apart.

Just a few days before the subcommittee investigation (and perhaps not coincidentally), Wall Street's largest trade group, the Securities Industry Association, issued a set of "Best Practices for Research". The guidelines were agreed to by 14 major investment banks which together represent 95% of Wall Street's underwriting activity. Rather than listing all the guidelines here, I'll make some general observations about them (I encourage you to read them yourself at http://www.sia.com/pdf/BestPractices_F.pdf).

First, there is nothing new or unexpected in the guidelines. It is essentially a description of behavior analysts already know they should be conforming to, and many of the practices are already covered by existing regulations. Even more importantly, the guidelines describe recommended rather than required behavior, "best practices" rather than standard practices. Indeed, the word "should" appears fifty times in the document, but the word "must" appears only once (in the sufficiently vague "investors' interests must come first"). Additionally, they do not provide any enforcement provisions or monitoring by an impartial outside party. As the document says: "These best practices... provide general guidance and do not create legally enforceable obligations or duties. Adherence to these practices is voluntary, and specific situations may require appropriate modifications. Given the differences among firms, each firm may need to adapt these practices to its particular circumstances."

For these reasons, I am confident that the SIA's Best Practices initiative will have no effect on analyst behavior. Granted, some analysts don't cave in to conflicts of interest, and some firms discourage such caving in. But those analysts and firms which have been putting money ahead of ethics will continue to do so, because they haven't been given any reason to stop. Even if the initiative were to change the behavior of a few firms and a few analysts, there would be no effect, because companies that wanted positive coverage in exchange for their underwriting business would simply go elsewhere. In reality, the intended audience appears to be not the analysts but the House subcommittee, with the intent of persuading the panel that no outside intervention is necessary because self-regulation is working just fine.

So what should be done? I usually trust the market's invisible hand more than I trust the government's all-too-visible one, but some amount of government regulation might be warranted. Hopefully the subcommittee will see through the Best Practices guidelines and disregard them. Or perhaps they should have the Securities and Exchange Commission modify the document by replacing all the instances of "should" with "must", require compliance, and provide appropriate penalties for rule violations. A less stringent measure would be to require, as some other self-regulating organizations do, that the analysts sign a "professional conduct statement" affirming that they are complying with the guidelines and will self-report any violations. The subcommittee might also regulate the current practice of permitting analysts to invest in the companies they cover, which the guidelines don't address sufficiently. More extreme solutions have been suggested by some; Security Analysis on Wall Street author Jeffrey Hooke has said: "Any analyst whose firm does major investment banking work--and nearly all of them do--is suspect. I don't know why the SEC doesn't ask these firms to spin off their research operations." However, SIA member firms have significant clout, so Congress would face an uphill (and probably losing) battle trying to enact any change this radical. I do expect to see increased disclosure requirements, some SEC supervision and at least a slight regulatory tightening to come out of this. And while these steps may mitigate the problem, it won't go away. There will still be many firms whose analysts are incentivized to maintain overly optimistic coverage of companies for which they do (or want to do) underwriting business.

But I'd prefer to focus not on what the government should do but what you as an individual investor should do. And the good news is, although the government might face an uphill battle, you don't, because you have the power. It may appear that analysts have the power, because their research has the ability to move stock prices. But the ultimate source of that power is you, the individual investor. Analysts can move markets only because people listen to them. If you ignore analyst recommendations, you take their power away from them, and in doing so, you eliminate the conflict of interest.

So what should you do?

You've already taken the first step, by realizing that these conflicts of interest exist. In fact, the subcommittee investigation and the Best Practices initiative have already had an impact in that they have raised the level of investor awareness of analyst integrity issues. If the extensive media coverage these two events continues, investors may not need government protection from analysts, because they'll know enough to protect themselves.
Don't believe that the "Best Practices" initiative will resolve these conflicts of interest.
As I mentioned, one option is to completely ignore all analysts. (For the most part, this is what I do.) The downside is that a few analysts do have interesting things to say. The upside is that your overall performance probably would not be negatively impacted, as several recent studies indicate that analyst recommendations underperform the market. For example, according to Investars.com, 16 of the 19 largest U.S. brokerages have issued advice which, on average, would have lost you money. (If I find sufficient additional data to support this, I might even consider using analyst recommendations as a contrary indicator.)
If you already follow one or more analysts who you believe offer insight worthy of your attention, continue to listen to them. If you don't, but if you believe that some analysts might be worth listening to, visit a site that rates analysts, such as Validea.com or BulldogResearch.com. When I wrote Tomments 2 last year I had hoped that these and similar sites would grow so much in popularity that analysts who gave in to conflicts of interest would be revealed by their underperformance; in other words, that transparency and accountability would eliminate the need for either a Best Practices initiative or governmental regulation. The internet meltdown has slowed the overall progress toward this eventual goal, but I'm still confident that it's only a matter of time.
When you do listen to what a given analyst says, find out whether they or their firm gains any financial benefit from your interest in the stock. (Some such disclosure is already required, and you can usually find more with a little digging.) If they do, you can either ignore the recommendation completely or take it with a grain of salt. Another option is to pay attention to only the hard facts in the research, and ignore the recommendations, projections or anything that might be biased.
Don't count on the analyst or the government to protect your best interests. Each sometimes might, but neither is a safe bet. Instead, do it yourself.
Whatever you do, don't blindly follow any specific analyst, and don't assume that they're all created equal and choose stocks based on how many analysts recommend them.

If you follow this advice, it almost doesn't matter what the government does. In fact, you should prefer less regulation. Here's why: with tighter regulation, the overall quality of analyst research would likely increase, but that information and insight would be accessible to everyone. With the current lack of regulation, more conflicts of interest occur and more individual investors fall prey to the biased advice. However, you will know enough not to, but the person on the other side of your trade might not, enabling you to profit from their folly. Although our mission at InvestorGuide.com is to enable everyone to invest better, you should prefer to have us help only you, because as all investors get better, it raises the bar and eliminates investment opportunities that might otherwise have been more profitable for you. back to top
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