New York, NY – At the end of July of this year, the bulk of the independent research that was distributed free of charge to individual investors as a part of the 2003 Global Research Analyst Settlement will disappear. As you might expect, various viewpoints have emerged about whether the GRAS was successful in achieving its goal, with many independent research firms supporting it, while sell-side analysts have cited the settlement as a failure. Even academics have produced conflicting research about the efficacy of the GRAS. In the following blog, Integrity will try and provide some clarity on whether the settlement was successful in achieving its goals.
What did the GRAS mandate?
In April 2003, the Securities and Exchange Commission, NASD Inc. (NASD), the New York Stock Exchange, Inc. (NYSE), the New York Attorney General (NYAG), and other state regulators reached an agreement with ten of the largest investment banks in the world. Initially, these banks included Bear Stearns, Credit Suisse, Goldman Sachs, Lehman Brothers, J.P. Morgan, Merrill Lynch, Morgan Stanley, Citigroup (Salomon Smith Barney), UBS, and Piper Jaffray. Eventually Deutsche Bank and Thomas Weisel also reached an agreement with the regulators to be included in the settlement.
The GRAS was a far reaching agreement which included $875 million in penalties and monetary relief, numerous structural reforms, enhanced research disclosures, the purchase and distribution of $432 million in independent research to investors, and setting aside $80 million to develop an investor education program. The remainder of this blog will focus on the GRAS requirement to distribute independent research.
Did the GRAS directly benefit investors?
One of the obvious goals of the Global Research Analyst Settlement was to provide investors who received research from the investment banks discussed above with another “more objective” source of investment research to help them make better investment decisions. The settlement required that an independent consultant be hired for each of the banks involved in the GRAS, who would purchase independent research coverage for each of the stocks covered by the investment banks they represented. Consequently, these consultants purchased research coverage from between 60 and 70 independent research firms under the terms of the settlement.
Unfortunately, retail investors really didn’t get too much direct benefit from the $432 million in independent research provided by the various participating investment banks. This conclusion is supported by the rather anemic usage statistics collected by the banks and their independent consultants. Probably one of the primary reasons for the poor investor demand was the fact that the investment banks were not required to advertise the availability of this research. Consequently, the banks had little incentive to market the availability of the third-party research very aggressively.
It is interesting to note that some of the independent consultants have suggested that while individual investors did not use much of the independent research, the firms’ own retail stock brokers did consume this research. This would lead us to believe that retail clients might have benefited from this independent research indirectly, rather than directly.
And while most of the investment banks involved in the GRAS have not seen significant investor demand for the independent research, a few of the participating banks have decided to continue providing third-party research after the settlement ends.
Did the GRAS reduce bias in Sell-Side research? Another rationale for the GRAS was that the provision of third-party research alongside the investment banks own research, plus the numerous structural reforms included in the settlement, would promote less biased research from the participating sell-side firms. A few of the reforms associated with the GRAS include (the description of these reforms was excerpted from http://www.sec.gov/news/speech/factsheet.htm):
- Separation of research and investment banking. This includes a physical separation, completely separate reporting lines, separate legal and compliance staffs, and separate budgeting processes.
- Analysts’ compensation cannot be based, either directly or indirectly upon investment banking revenues or input from investment banking personnel.
- Investment bankers cannot evaluate analysts.
- An analyst’s compensation will be based in significant part on the quality and accuracy of the analyst’s research.
- Decisions concerning compensation of analysts will be documented.
- Investment bankers will have no role in determining what companies are covered by the analysts.
- Research analysts will be prohibited from participating in efforts to solicit investment banking business, including pitches and roadshows.
- Firms will implement policies and procedures reasonably designed to assure that their personnel do not seek to influence the contents of research reports for purposes of obtaining or retaining investment banking business.
- Firms will create and enforce firewalls between research and investment banking reasonably designed to prohibit improper communications between the two. Communications should be limited to those enabling research analysts to fulfill a “gatekeeper” role.
- Each firm will retain, at its own expense, an Independent Monitor to conduct a review to provide reasonable assurance that the firm is complying with the structural reforms. This review will be conducted eighteen months after the date of the entry of the Final Judgment, and the Independent Monitor will submit a written report of his or her findings to the SEC, NASD, and NYSE within six months after the review begins.
A number of academic studies suggest that sell-side research has become less optimistic and biased (based on a number of measures) during the first few years of the GRAS. Unfortunately, few studies have yet been able to measure the trends throughout the entire settlement period. In addition, no formal studies we have seen have been able to net out the impact of a poor IPO market and the overall weakness in the stock market in recent years. We suspect that the sell-side would naturally tend to be less optimistic when the overall stock market was falling. In addition, the lack of a strong IPO market would eliminate the incentive to be overly optimistic.
Despite the lack of this research, we would not be surprised if sell-side research has actually become less biased in response to the GRAS, as well as other regulations targeting sell-side research (N.A.S.D. Regulation 2711 and other research disclosure rules). Certainly, compensating analysts based on the quality and performance of their research should also help reduce an optimistic bias.
Did the GRAS subsidize the development of a vibrant independent research industry? Some of the people involved with the GRAS suggest that the regulators were interested in promoting the development of a vibrant independent research industry in the US – a trend they felt would benefit individual investors in the long run.
Based on data we have collected, the number of independent research firms in the US has grown significantly since the settlement was reached in 2003. In fact, we estimate that close to 110 new research firms have been birthed over this period (approximately 20% growth).
However, it would be extremely misleading to conclude that the GRAS alone promoted this growth. The first reason we believe this is because very few of the new firms that have started up in recent years have been targeted at serving retail investors (the key users of the GRAS research). Second, the growth in independent research started significantly before the GRAS did. In fact, between 1999 and 2002, 82 new independent research firms started up in the US.
We believe that this growth has been encouraged by three factors. One has been the growth in the number of buy-side firms (particularly hedge funds) over this period. The second has been the declining value of sell-side research caused, in large part, by the passage of Regulation Fair Disclosure in August 2000. The third has been the significant innovation that has taken place in the independent research industry as many new types of research firms have been created and marketed to fill the buy-side’s appetite for proprietary research.
What will happen once the GRAS ends?
So, what will happen in August 2009 once the GRAS comes to an end? We think the two groups that will feel the greatest impact will be independent research firms and retail investors.
The impact on the independent research industry is obvious as close to $90 million per year in revenue will disappear. However, this impact will be restricted to less than 10% of the independent research industry (or 70 research firms) who were paid as part of the settlement. In fact, the real impact will be felt by fewer than 6 firms that garnered the bulk of this revenue, including firms like S&P, Morningstar and Argus Research. As a result, we suspect that the impact on the independent research industry, while painful for some, will be limited.
The impact on retail investors is less obvious. Of course, retail investors will have, either directly or indirectly, access to less investment research once the GRAS ends. Unfortunately, many of the independent firms will stop publishing research for retail investors because it doesn’t pay – instead focusing their business on serving institutional investors. We suspect this trend will be exacerbated by the squeeze that is currently being felt within sell-side research departments as commission volumes shrink. Consequently, we fear that retail investors could lose out as their access to high quality investment research shrinks.
Another concern we have is how the sell-side will respond once the GRAS ends. Will the research published by these investment banks become increasingly more biased in an effort to win potential investment banking deals once IPOs pick up again? Certainly the financial pressure to do this is likely to grow at these banks given the weakness in their commission businesses in 2009. It remains to be seen whether the gains experienced from the GRAS will be maintained in the years ahead.Subscribe to Integrity ResearchWatch by Email or in an RSS/XML reader