Credibility crisis by Martin Budd and Shawn Wooden
Updated 02:40 PM EST, May-1-2002
When the U.S. Securities and Exchange Commission announced in late April that it would launch its own formal investigation into the practices of Wall Street's research analysts, the 800-pound gorilla finally stepped into the ring.
This, along with the proposed new rules of the National Association of Securities Dealers and the New York Stock Exchange, will ensure that the already shifting landscape of analysts' disclosure will change even more dramatically in the near future.
As a result of the technology, telecommunications and Internet boom of the 1990s — and the sudden bubble bursting in these sectors — sell-side analysts have been put in the hot seat by those assessing blame for investors losing millions of dollars. The claim is that analysts' institutional and personal conflicts of interest have been so rampant that they produced biased research reports that seriously misled the public and adversely affected the efficiency of our securities markets.
The spotlight initially focused on this arena in 1999, when Arthur Levitt, then chairman of the SEC, accused analysts of compromising their research to win investment-banking business. In the euphoria of the dot-com hype, Levitt's steady stream of warnings went largely unheeded.
However, the changing fortunes of the economy, the accompanying lawsuits against investment banks and their analysts, and the Enron bankruptcy combined to produce a glare too bright to ignore.
In an attempt to right the ship, salvage the industry's tinged credibility and possibly avert governmental intervention, industry trade groups, individual securities firms and self-regulatory organizations began to formulate their own responses to the mounting crises of credibility.
In June 2001, the Securities Industry Association issued "Best Practices for Research," a series of recommendations to voluntarily foster the integrity of research in securities firms.
It called for a greater separation between investing banking and research departments, and it stressed the importance of objective and independent evaluations by analysts, as well as the avoidance and disclosure of personal conflicts of analysts.
Similarly, last July, the Association for Investment Manager Research released its proposed issues paper titled "Preserving The Integrity of Research" and sought comments on it. As with those of the SIA, the standards of the AIMR would be voluntary.
To date, the most significant developments in the changing analysts' disclosure landscape have come in the advancement of proposals by the NASD and the NYSE. The rules of these self-regulatory organizations have teeth that those of the other organizations do not.
On Feb. 13, the securities-dealers association submitted its proposed NASD Rule 2711 ("Research Analysts and Research Reports") to the SEC.
In addition to including a set of outright restrictions focused on reducing the systemic institutional factors contributing to conflicts of interests, the proposed NASD rule would require:
• Disclosure of any relationship between an analyst's firm and the company being evaluated if an analyst makes a "buy" recommendation on a security;
• Disclosure of ownership, material conflicts of interest, certain sources of compensation and the percentage of each kind of recommendation made;
• That research reports contain a price chart on equity securities that the analyst has covered for more than one year in the form of a line graph of the security's daily closing price for a period of up to three years and an indication on the graph of the point at which the analyst made or changed a recommendation and what the recommendation was;
• And that research reports disclose the valuation methods that are used to determine a price target, which must have a reasonable basis, and contain a disclosure of risks that may hinder the price target being met.
On Feb. 27, the NYSE filed a proposal amending its Rule 472 ("Communications with the Public") and creating a new NYSE Rule 351 ("Reporting Requirements") with the SEC.
If amended, NYSE Rule 472 would impose the same disclosure requirements on the exchange's member organizations as the NASD is proposing. And NYSE Rule 351 would require that exchange members make an annual filing attesting that they have "established and implemented written procedures reasonably designed to comply with the provisions of NYSE Rule 472."
However, to the extent that the industry has been motivated to address the conflicts-of-interest issue to avert greater governmental intervention, recent activity certainly suggests that this objective will not be met.
New York State Attorney General Eliot Spitzer has launched his own investigation into Merrill Lynch & Co. And after Spitzer obtained a court order forcing the company to make certain disclosures, he and Merrill Lynch reached a temporary settlement.
Merrill Lynch agreed to provide more disclosures in its research reports about its investment-banking relationships with companies its analysts cover and information on the number of buy and sell recommendations it has made.
All indications suggest that Spitzer's engagement on this issue is only beginning.
It has been reported that the Empire State attorney general will launch a more widespread investigation into Wall Street analysts that will very likely lead to even greater disclosure arrangements with securities firms.
And it is likely that Spitzer's investigation and actions motivated the SEC to institute its own investigation.
So with the actions to date of individual securities firms, the expected rules of the self-regulatory organizations and the investigations of the New York attorney general and the SEC, the landscape of analysts' disclosure has been changing — and it is likely to continue to do so, probably even more dramatically.
— Martin Budd is a partner in the Stamford, Conn., office of Day Berry & Howard llp and chairs the firm's securities law practice. Shawn Wooden is an associate in the firm's office in Greenwich, Conn. |
