Around the time the global settlement with major Wall Street firms was being finalized, New York Attorney General Eliot Spitzer suggested reading Bonfire of the Vanities to understand what was happening in New York. Tom Wolfe’s classic 1987 novel tells the story of a high-flying Wall Street bond salesman brought to his knees by an upstart assistant district attorney after he is found to have left the scene of a hit-and-run in the South Bronx.
When Spitzer made his recommendation at a Conference Board event in April, the audience laughed at the analogy. Spitzer, a politically ambitious attorney general, first started rattling Wall Street’s powerbrokers in the late 1990s. His joint investigation with securities regulators into analyst conflicts of interest brought down two former star analysts – Jack Grubman and Henry Blodget – and forced ten major sell-side firms to cough up $1.4 bn in a global settlement. As we go to press, securities regulators in the US are continuing to investigate whether CEOs, research executives or investment bankers at sell-side firms were aware that investment banking relationships tainted analyst research reports.
The combined probe into Wall Street showed that investment banking was influencing equities research and that analysts were publicly touting stocks they privately criticized. The ensuing bonfire of the vanities is creating a ripple effect that will transform the way the sell side functions internationally.
This high-profile investigation into analysts’ conduct coupled with major corporate failures in the US have motivated regulators around the world to tackle sell-side regulation in their own markets. Currently the Financial Services Authority (FSA) in the UK and the Investment Dealers Association of Canada (IDA) are finalizing principles that are similar in tone and intent to the global settlement.
While specific measures vary by region, most regulators are effectively setting up internal controls that reinforce Chinese walls between investment banking and research (in the US these literally are walls) and external disclosure to notify investors of any potential conflicts of interest. The ultimate goal is to prevent analysts from being unduly influenced by investment banking and to provide retail investors with information on the relationship (if any) between the sell-side firm and the company the analyst is rating.
Sell-side shrinkage
Sell-siders agree the global settlement has changed the world of investment research. Speaking at the annual Canadian Investor Relations Institute (Ciri) conference in May, Stephen Walker, director of Canadian equity research for RBC Capital Markets, noted that new rules create more red tape which may hamper research and set up road blocks for analysts. There will be ‘a tremendous amount of dialogue between compliance officers and analysts – double or triple the paperwork – making management’s responsibility onerous,’ he said.
In the current environment, ‘Research becomes a commodity and small companies will find it harder to get coverage,’ Walker added. New rules for securities firms stipulate that investment banking fees cannot be used to compensate analysts, essentially cutting off much of the old revenue stream. It also means investment banking will have to win business without the promise of favorable sell-side coverage.
One immediate effect is on analysts’ own wallets as their salaries have taken a hit. This is because, as Raymond James analyst James Kumpel notes, ‘Investment banking and research are not part of an integrated, competitive situation anymore.’ As a result some sell-side analysts will likely jump to the buy side or even take up investment banking – where the real money is made. Others are crossing over to IR.
Indeed, many brokerage firms have already laid off a number of analysts. Thus the sell side is shrinking and companies are losing coverage. ‘A lot of my peers are no longer in their positions, which may have been eliminated or merged into other sectors or segments,’ confirms Kumpel. According to the Los Angeles Times, the number of publicly traded companies getting Wall Street coverage has dropped by 25 percent since 1999.
It’s different for Europe
While sell-side regulation is estimated to have a damaging effect on North American research departments, things may be different in Europe, notes ABN Amro analyst Sandy Morris. ‘We have never seen a hint [of what went on in US firms],’ says Morris. European banks like ABN Amro typically have well-established Chinese walls between banking and research, he adds. ‘If you bump into people [on the banking side], you might not know who they are, even if they work in the same building.’
Morris observes that analysts at European banks don’t get paid the lucrative salaries that are lavished on their US counterparts. As a result they are not under the same pressure to please clients of the investment banking arm. ‘Working for an American house over here is seen as something you do for the money, not for the pleasure,’ he maintains.
The effect of regulation depends on ‘how you behave personally and whether the people you work with day-to-day have similar professional standards,’ Morris continues. Because his firm already separates banking and research, Morris says the FSA’s principles governing conflicts of interest will not have a major effect on the way he does his job. ‘It’s going to change disclaimers and disclosure, but I don’t own any stocks anyway.’
For IR professionals, the effect of sell-side regulation varies depending on how much coverage your company has and how reliant management is on the sell side to get to the buy side. It is widely presumed that small and mid-cap companies that already struggle for coverage will have an even harder time getting sell-side attention (see Sell-side suspects, March 2003).
Companies with adequate sell-side coverage worry that top-notch analysts will leave the field. ‘The only drawback [from an IR standpoint] would be if you start losing quality coverage,’ says Paul Gifford, vice president of IR for North Carolina-based Goodrich Corp. Currently around 13 analysts cover the aerospace company, many of whom have been covering the industry for a long time. With budget cuts to research, Gifford says his ‘biggest worry is losing experienced analysts – regardless of what rating they have.’
‘Our central role for communicating will not change; it just may be different target audiences,’ says Andy Mann, IR manager at BAE Systems (formerly British Aerospace). The major impact of the FSA’s proposals is that everyone is more aware of the potential for conflicts of interest. There is also a trend for the buy side to appoint its own analysts and Mann says newly hired buy-side analysts are proactively making contact with IROs.
In the US, the global settlement clears up at least one confusing decision for IROs: whether or not to review analysts’ reports. As part of their compliance, analysts cannot solicit outside views on research reports prior to publication. For his part, Gifford has not been asked to review an analyst report for several months.
Winning coverage
While the role of sell-side research is changing, winning coverage will remain an essential part of IR. ‘One sell-side report is seen by more folks on the buy side than any one of us [IR officers] could contact in six months,’ says Brian Arsenault, senior vice president of investor relations at Banknorth Group. A lot of IR contact with the buy side is initiated because a portfolio manager happens to see someone from the sell side quoted in Barron’s, he adds. With sell-side distribution and visibility key to investor relations, Arsenault says brokerage research will continue to play a pivotal role.
Still, with sell-side research departments shrinking, the buy side is going to have to decide where to get its research. ‘In the end, the business models [for the buy and sell side] are interrelated,’ says Pat Walters, senior VP in charge of advocacy at the Association for Investment Management and Research (AIMR). ‘The buy side will have to decide whether it wants to do more research in-house or get information externally.’
The buy side’s decision will ultimately affect what type of research is available for purchase. The traditional revenue model for sell-side research was through trading commissions – the better the research, the more trading action a firm got. But since the end of fixed commissions equities research has been largely a loss-leader – a lure for companies bringing investment banking business. Now brokerages might want to sell their research to the buy side for hard dollars. The question is, will the buy side buy?
In the UK, trading commissions are higher but the buy side gets a tangible return for its soft pound when it sends trading to one sell-side firm or another. According to the FSA, an estimated 40 percent of brokerage commissions paid by UK fund managers comes back to them in the form of investment research or market information technology like Bloomberg or Reuters terminals.
Currently the FSA has a proposal that would require fund managers to unbundle the cost of trades and additional services like sell-side research. ‘It’s not that you wouldn’t get soft commissions, but as a buy-side firm, you would have to put a price on research and you would have to go back to the [client] investor and ask them if it would be okay to use soft dollars to purchase sell-side research,’ notes Walters. Investors are unenthusiastic about the proposal. If it passes, Walters adds, the requirement will undoubtedly have a huge effect on global firms that practice in the UK.
In the US, the SEC is under intense political pressure to reform the mutual fund industry, including putting limits on the services mutual funds can get through soft-dollar arrangements.
As regulators worldwide focus on the sell side, the question of the issuer’s role in ensuring analyst objectivity has come up. A recent Reuters survey of sell-side analysts finds that 88 percent fear negative consequences from companies they cover if they issue negative opinions. That perception has led regulators and industry associations to address the issue of companies’ treatment of analysts.
The FSA proposal specifically states that it is improper for a company to seek to influence an analyst’s judgment. Meanwhile, Canada’s new IDA proposals will place more focus on companies penalizing analysts for negative views. More recently, AIMR and the National Investor Relations Institute (Niri) formed a joint task force to work on guidelines for companies and analysts that help foster and support analyst independence and objectivity.
‘It’s incumbent on IROs to hold the analyst rating independently of overall banking relationships,’ notes Goodrich’s Gifford. Interestingly, when Goodrich did an equity offering last fall, an analyst from Citigroup, one of the banks involved in the offering, had an underperform rating on the stock. ‘We had a very successful equity offering even though this analyst was part of the roadshow,’ Gifford comments.
While most IROs fully understand their responsibility in ensuring analysts provide objective research, it is increasingly clear that all market participants – from fund managers to senior management – will play a crucial role in supporting analysts’ objectivity in the future. Indeed, the bonfire of the vanities has affected boardrooms far beyond the hallowed halls of Wall Street’s investment banks.
Independent research
Under the global settlement, Wall Street firms have to pay out around $400 mn to fund independent research. Brokerage firms must appoint independent monitors to oversee independent research, which most firms have already done. The settlement also specifies that a sell-side firm must contract a minimum of three independent research firms with the intent of having at least one independent opinion complement their internal research.
Who will provide this independent research? Look at Value Line and Standard & Poor’s, for example, which are in discussions with the ten firms affected by the settlement to make their research available. Many of the firms already subscribe to data from these independent research providers but do not have a formal arrangement to distribute the research to investors. ‘Our reports [on companies] are published four times a year and we have supplementary reports when there is news that warrants it,’ says Stephen Sanborn, head of research at Value Line.
However, there is speculation over whether independent research will help investors make more informed decisions – the intent of the settlement. As one IRO says, ‘In nine years as an IR professional, I have yet to receive a call from these independent research providers, so I don’t believe they capture the entire story.’
Both S&P and Value Line have a relatively small number of analysts covering a broad spectrum of stocks. S&P currently has around 80 analysts covering about 1,400 stocks globally while Value Line has about 70 analysts covering 1,700 stocks. Recently S&P has increased its global coverage and will be hiring more analysts, notes Sandy Bragg, executive managing director at S&P. ‘We follow all the US sectors and have the broadest coverage,’ Bragg adds. ‘So we have already demonstrated we can deliver good quality research across a very large universe.’
The elephant in the room
Everyone is still ignoring the sell side’s mammoth problem, says Tom Franco
The Wall Street settlement has garnered much publicity for securities regulators and many suggestions from commentators on how investment banks can improve the value of their research and better serve their clients. These suggestions have included moving from a star system to a team-oriented approach, producing research more tailored to clients’ specific needs, providing analysis as opposed to information and even outsourcing data collection. However, regulators, commentators and banks have all ignored the elephant in the room – the fact that sell-side analysis may be permanently impaired.
The basic issue is that the best fund managers in the US long ago determined that brokerage firm equities research was fundamentally lacking. So these sophisticated market participants have invested huge amounts of money over the past 20 years to build internal, proprietary and unbiased research capabilities. Today, for example, there are approximately 6,000 US institutional fund management analysts specializing in specific industry sectors, many with years of experience conducting the kind of research proposed by commentators.
A recent survey by Broadgate suggests that individual investors are also looking elsewhere for unbiased insights. Only 2 percent of 7,000 retail brokers surveyed say small investors value the stock research produced by their firms.
How can sell-side analysts recover from the usurpation of their role by buy-side analysts? How can the sell side survive the loss of its credibility among investors and continue to make money? It doesn’t matter at this point. Brokerage firms will probably spend time and resources trying to develop more relevant, objective or cost-effective research, but it could be that such firms will not find much of a paying audience. Ironically, this is the reason analysts were forced to shill for their corporate finance departments in the first place.
For the IRO, the decreasing importance of sell-side analysts means they should refocus their principal efforts – as many have already done – on communicating directly with portfolio managers and buy-side analysts.
Navigating this shift will require broadening capital markets communications themes well beyond an explanation of quarterly earnings blips. Most investors don’t really care about one or two cents of earnings per share. They do, however, care about the long-term dynamics of a business, about management evaluating operating performance realistically, and they care about the right actions, however painful, being taken to ensure long-term success.
IROs should become champions of a balanced performance ‘scorecard’ that encourages management to address broader issues such as recruiting and developing great people, innovating better products and improving core processes, risk oversight and governance policies.
By telling the whole story in their own words – good, bad and ugly – companies ultimately will attract the shareholders they deserve and avoid those inflicted on them as a result of over-exuberant sell-side research reports.
Thomas Franco is chairman and chief executive of Broadgate Consultants
Does the sell side take this seriously?
Vanessa Theiss reports on post-settlement gaffes by Wall Street firms
Just after the global settlement with major Wall Street firms, Morgan Stanley’s CEO, Phil Purcell, made the New York Times headlines with a rash comment to a group of institutional investors. After coughing up $125 mn to settle conflict of interest charges, Purcell was quoted as saying, ‘I don’t see anything in the settlement that will concern the retail investor about Morgan Stanley, not one thing.’
Purcell’s behavior demonstrated that he did not take the global settlement seriously.
‘To most people, including regulators, it just shows that they didn’t get it, that they weren’t contrite – that they really didn’t understand they did anything wrong,’ says TJ Walker, president of Media Training Worldwide, a New York-based firm. ‘Now he is being taken to the woodshed by the regulators,’ he adds.
Sure enough, SEC chairman William Donaldson wrote a stern response to Purcell. ‘The allegations in the Commission’s complaint against Morgan Stanley are extremely serious,’ Donaldson wrote.
Donaldson also questioned the CEO’s commitment to investors and reminded him of the terms of the settlement which forbid Morgan Stanley representatives from denying the Commission’s charges, something which Purcell had come awfully close to doing.
Purcell changed his tune in a letter to Donaldson. ‘I deeply regret any public impression that the Commission’s complaint was not a matter of concern to retail investors,’ he wrote. Purcell also affirmed that Morgan Stanley ‘fully endorses the settlement’ and assured that ‘no-one at Morgan Stanley will violate the settlement.’
Bear Stearns also showed signs of failing to live up to the spirit of the global settlement. On May 2 the firm sent an e-mail to institutional investors with a link to a web-based roadshow video that included comments from one of the firm’s analysts.
In a shameful infringement of the settlement’s terms, the Bear Stearns analyst, who was identified by the Wall Street Journal as James Kissane, was seen in the video giving financial projections for iPayment, a credit-card processing company which has a banking relationship with Bear Stearns.
The global settlement had not officially entered into court – technically saving Bear Stearns from an actual violation of the condition forbidding analysts from participating in roadshows. However, it aroused concern among SEC officials.
Bear Stearns spokesman Russell Sherman told newspapers the firm fully supports the letter and, more importantly, the spirit of the recent settlement agreement, adding that Bear Stearns is ‘taking precautions to ensure that it will not occur again.’
