NIBM - Investing Help - 5 rules for analysts

Five rules for analysts to follow if they want credibility

August 3, 2001 David D. Miller, President, NIBM

Top of the fold business news lately has focused on the conflict of interest in the analyst, investment banking, and brokerage business. Merrill Lynch recently settled a $500,000 claim against its prominent internet analyst, Henry Blodgett. Merrill then issued rules prohibiting analysts from owning shares in the companies they cover. CSFB, Edward Jones, and Prudential Securities followed suit. The Securities Industry Association (SIA) put forth a set of guidelines for behavior in an effort to stave off regulatory or Congressional action.

This past week saw disturbing testimony in Congress on this issue. Perhaps the most disturbing came from acting SEC Chairperson Laura Unger. In her testimony (click here to view her entire transcript), she disclosed a series of findings from a recent inquiry that should trouble everyone involved in the stock market.

One analyst even shorted the company he/she recommended as a buy to clients

Analysts routinely participated in the IPO road shows designed to convince investors to buy pre-IPO shares

Analysts initiated coverage to assist investment bankers' efforts to capture clients

Analysts were involved in IPO companies before the companies were public. Analysts recommended these companies to investors without disclosing this fact. Sixteen of 57 interviewed analysts received pre-IPO shares as compensation. Three of the 16 then sold shares contrary to their buy recommendations, generating personal profits between $100,000 and $3.5M. One analyst even shorted the company he or she was recommending to clients as a buy!

In 26 of 97 studied instances, the analyst re-issued a buy recommendation prior to the expiration of a lock-up period in order to boost prices just prior to when his or her firm, the analyst, and company insiders were allowed to sell shares.

The SEC is on the record saying they are not interested in issuing new regulations to combat this problem. It would rather the industry solve matters internally. Congress seems content, for now, to follow that line of thought, too. While I don't find either "stand" surprising, it doesn't make a lot of sense in the face of the facts presented by Ms. Unger: Only one of the nine firms interviewed by the SEC had records on hand about share ownership by their analysts. That does not bode well for self-regulation.

Many of you are probably saying to yourself: "Aw, c'mon. Everyone knows that's how the game is played. Anyone who actually paid attention to the analysts got what they deserved." Perhaps you are right. However, as TheStreet.com's Adam Lashinsky pointed out in his testimony (click here to view) most of the people entering the market in the last few years knew nothing of this unwritten rule.

Investment bank research analysts have an important role. More on point, their opinions move the market day in and day out. Because of this, lack of disclosure and conflicts of interest are everyone's problem whether you read the research or not. We should demand analysts be covered by a code of conduct.

What the rules should be is an emerging debate. Here is my offering:

Lack of disclosure is everyone's problem whether you read the research or not.

1. Analysts must disclose if they have personal holdings in the company they are covering. They must declare whether their holdings are net long or short. Any changes in their personal holdings should be updated on a daily basis on the web site of the analyst's firm and made available to the general public.

This, not coincidentally, has been our policy at our company since we were founded in 1999. While some would argue daily disclosure of positions is onerous, we can say for certain it is not that bad. For a much larger firm, a couple weeks of time by a competent IT staff could link the personal portfolio of the analyst to a disclosure web page with little trouble. I would not prohibit analysts from owning shares since there is a good argument to be made for analysts eating their own cooking, so to speak.

2. Firms must disclose whether they are market makers in the company's stock. They must disclose if they have an investment banking relationship with the company or are currently pursuing a relationship. If the firm secures an investment banking relationship with a company within six months after issuing a report, and there was no disclosure on the report, the firm must issue an update to the original report disclosing the banking relationship.

This is straightforward. Again, companies might complain about the work involved in reissuing a report or even about secrecy issues. I believe the greater good requires such disclosures and outweighs these concerns. The six-month rule would obviate questions as to when the pursuit of the banking relationship began in relation to the issuance of coverage. Blanket disclosures would not be allowed. The goal is to exactly communication potential conflicts of interest on a subject-by-subject basis.

3. The SEC must clarify Regulation FD by providing guidance as to the difference between material and mosaic (background) information. The recent trend towards companies not providing advance notice of web casts of analyst conferences -- or providing no real-time access to comments made at those conferences at all -- should be specifically addressed.

Mr. Lashinsky eloquently addressed the need for Reg. FD and its role in this debate in his testimony. In our own series of articles and interviews on Reg. FD, one common theme was the difficulty legal advisors and IR professionals have in determining where the gray line between material and mosaic information. That line needs to be brightened even if the SEC has to start making a list of examples. At the least, the SEC should move more quickly to release decisions from ongoing Reg. FD investigations so companies have a better idea of the boundaries of the rule. Brightening the line would dramatically increase acceptance of the rule in the legal community, causing a broader acceptance of the rule among companies.

4. Analysts should disclose whether their pay scheme is directly tied to the performance of the stocks they recommend. If their pay is tied to returns from the investment banking side of the business, or other funds coming from the company covered, that should be disclosed as well.

I would view it as a big plus if the analyst was paid according to how well their picks performed. Disclosing if the analyst could benefit financially in other ways from the company is also important in determining the objectivity of the analyst.

5. For firms other than investment banks, any compensation or expected compensation from the company covered must be prominently disclosed.

I see a great number of "research reports" cross my desk that are nothing other than PR pieces in disguise. The authoring firm is paid by the subject company in either cash or shares to say nice things. The product is designed to resemble an objective research report. More insidious are the firms who write research reports and then make significant sums of money holding company-sponsored investment conferences. The covered companies often pay large appearance fees. That is a potential conflict of interest since firms receiving bad ratings are unlikely to attend these conferences, and should therefore be disclosed.

These five rules should go a long way to making analyst research more credible -- or at least making readers of the research more cognizant of potential biases. I would consider the latter at least as important.

You'll note I've included no prohibition against an analyst taking the opposite side of his or her recommendation -- for example, shorting a stock he or she has recommended as a buy. If the analyst wants to take that position, that's fine by me. Remember that under Rule 1, such action will be available for all to see. Let the analyst explain their rationale once the disclosure hits the fan.

I also did not seek to separate the research department from the investment side of the business. While it would certainly be good for my company if the big houses started charging huge sums of money for their research, the fact is their research makes them no money. Mr. Lashinsky points out in his testimony most people who saw this research got it for free. In my opinion, the two can never be truly separated at the large firms so disclosure is the best solution.

The five rules should go a long way to making analyst research more credible

These five simple rules with some enforcement teeth behind them would go a long way to cleaning up the research industry. Pointing out conflicts of interest should also make for better-educated investors as well. Peeling back one more layer of the wink-wink, nudge-nudge tradition permeating the analyst community on Wall Street is a good thing. Let's hope someone in Congress, the SEC, the NYSE, and/or the NASD has the courage to do something about it.