The following is a guest article by Stanley (Bud) Morten, C.F.A., who was appointed by the regulators to be an independent consultant overseeing Citigroup’s spending on independent research under the S.E.C.’s Global Research Analyst Settlement (2003-2009). The following is an excerpt from a presentation during a panel discussion on the impact of regulation on competitiveness.
Having recently participated on a panel addressing the question of whether excessive and/or bad regulation is damaging one of America’s most important competitive advantages (i.e., access to capital for promising, small, entrepreneurial companies), I thought it opportune to consider the arguments in favor of rescinding the most onerous restrictions of the Global Research Analyst Settlement — particularly the separation of research and investment banking.
One manifestation of excessive and/or bad regulation is the collapse in the U.S. IPO market at a time when there could and should be record numbers of start-ups seeking public financing. Attached are a couple of relevant slides from Renaissance Capital, the first of which shows a slide in the U.S. share of IPOs to 21% in 2010 from a peak of 55% in 2002, and a surge in Asia Pacific’s share to 56% in 2010 (excluding China A shares, which would raise AP’s share in 2010 by another 10 percentage points) from a low of only 11% in 2001.
The following are excerpts from my responses to the questions posed by the Regulators to the Independent Consultants about the effects of the Settlement, which outlines my perspective on the Global Research Analyst Settlement.
Question: How did the Settlement impact equity research in the U.S.?
Response: The Settlement damaged equity research in the U.S., which hurt U.S. capital markets, which hurt U.S. companies and U.S. exchanges, which hurts us all.
The mandated separation of investment banking and investment research reduced substantially the resources available to support sell-side research at a time when those resources were already declining due to industry consolidation and a downward trend in commission rates (driven in recent years by a shift to electronic trading, decimalization, and by increasing regulatory scrutiny of how investment managers were using their clients’ commission [a.k.a. “soft”] dollars). The result has been a significant reduction in both the quantity and quality of sell-side research.
The quality of sell-side research is down because, having been excluded from the professional challenges and economic rewards of successful investment banking (“IB”) activities, many of the best and brightest analysts have defected: (a) to the buy side, particularly to hedge funds and private equity firms where they can now obtain a much higher return on their knowledge, skills and judgment, and where, ironically, the opportunities are greatest to exploit the very market inefficiencies that are attributable in part to their defections; and (b) to set up their own specialty research firms serving a limited number of institutional clients.
The reduced quantity and quality of sell-side research means that U.S. capital markets are less efficient, which means greater market volatility and a higher cost of capital, making U.S. companies and U.S. exchanges less competitive in world markets, and diminishing their overall benefit to our country and the world. Market efficiency is reduced simply because fewer analysts, less experienced analysts, lower quality analysts, no analysts on road shows to respond to questions, less effective research departments and fewer companies under coverage means that market participants are not as well informed as they would have been without the Settlement – which in turn means that the markets cannot adjust as quickly or as accurately to the continuous stream of developments that every day can change the growth, profitability and risk characteristics of companies, industries and the overall economy.
Market efficiency is also reduced because the quality of the market’s amorphous but critically important analytical framework is not as good as it would otherwise be, to the detriment of investors, business managers, creditors and other interested parties who must constantly evaluate the significance of changing economic and market conditions. Sell-side analysts have always been among the most important contributors to the quality of this intellectual framework of understanding about the myriad causal and coincidental relationships within which market participants collectively and constantly re-price capital assets.
Finally and paradoxically, market efficiency is also reduced to the extent that the Settlement actually succeeded at reducing investment banking bias in sell-side research. All markets function best when the broadest range of plausible expectations is well defined and well advocated, and the best way to do this is to tolerate and even embrace bias. A specific example of constructive investment banking bias is the identification and sponsorship of promising IPO candidates, which was an important and socially valuable function of sell-side analysts in the past that has been greatly suppressed by the Settlement, thereby contributing to the dearth of IPOs in the U.S. in recent years.
Question: What will happen to the Independent Research industry following the Settlement?
Response: After the Settlement, the Independent Research industry will probably remain as insignificant as it was before and during the Settlement.
There are hundreds of independent equity research providers (“IRPs”), the vast majority of which are specialty firms of some kind, many of them small, one- or two-person “boutiques” established by former sell-side analysts who had enough strong client, corporate and media relationships to strike off on their own and sustain a modest freelance research business without the support of the investment banks that provided the platforms upon which their reputations were originally built.
Some of these spin-off boutiques can be quite influential (e.g., banking analyst Meredith Whitney recently left Oppenheimer to create her own firm) for as long as their relationships last without the sponsorship of a major firm and the power of its sales forces to establish new ones. But with very few exceptions, these small firms do not survive beyond the professional lives of their founders. Because they were not, in general, major beneficiaries of the Settlement, the end of the Settlement will have little or no effect on these small, specialty firms.
The biggest obstacle to competing head-to-head with sell-side firms is the need to build what is, in effect, a complementary product called “an institutional sales force.” In the institutional market, research is sold, not bought. This simply means that institutional portfolio managers do not have time to filter all the research distributed by all research firms looking for actionable advice. The research for which they are willing to pay is usually delivered by an institutional salesperson who has demonstrated an ability to provide inputs that directly address their specific needs. The problem for IRPs is that providing this complementary “product” would roughly double their existing costs, and it generally takes years to develop the client relationships that generate sufficient revenues to cover those incremental costs.
Question: Comments on other aspects of the Settlement, its implementation, or its termination.
Response: The Settlement should be a mandatory case study of unnecessary structural change and unintended consequences for all business- and law-school students. Major new regulations should never be imposed in the heat of the moment, with inadequate analysis, or under the threat of criminal prosecution.
Based on the stupid actions or inactions of: (a) a few prominent analysts, (b) the people who were supposed to be supervising those analysts, and (c) the senior executives who failed to set the proper tone at the top of their firms, the regulators argued that major structural change (i.e., a complete separation of investment banking and investment research) was necessary “to restore faith in the system” and “to protect the small investor.”
Although all sell-side analysts have been wrong from time to time, the vast majority of them have never been guilty of publishing willfully dishonest ratings or opinions. The majority adheres to very high ethical standards, like those promulgated by the CFA Institute, because they are professionals and because they know that failing to do so would jeopardize their reputations and their careers.
For most analysts, investment banking bias is not nearly as big a problem as “confirmation bias,” which is the tendency of all human beings (even regulators) to ignore or minimize arguments and evidence that contradict their adopted opinions. This explains why even analysts at firms with no investment banking operations are inclined to believe that a stock they recommended at a higher price must be even more attractive at a lower price, particularly if the market has been rising.
The problem of deliberately misleading research is self-correcting because no analyst who produces bad research can escape the harsh and unforgiving discipline of the market, and no firm can long survive that does not serve its investor clients well. The analytical judgments of sell-side analysts are challenged rigorously every day by: (a) extremely demanding buy-side analysts and portfolio managers, none of whom suffer fools gladly; (b) by various “internal” constituencies, particularly their firms’ highly sophisticated and highly cynical institutional and retail salespeople who must answer to their clients; and (c) many others, including competitors, research colleagues, financial journalists, and financial bloggers.
A far better response from the regulators would have been to punish the transgressors, publicly embarrass and fine their firms, require better disclosure, and impose greater regulatory oversight of potential bias in investment research, as they did as part of the Settlement by strictly enforcing the rules on undisclosed payments for research, and by enforcing and tightening the rules on “spinning” hot IPOs.
The most important lesson we should draw from the Settlement is perhaps that, just as one today cannot construct a major new building without a comprehensive Environmental Impact Study, regulators should not seek to impose major new rules or requirements, let alone major structural changes, without having first completed a dispassionate, comprehensive and painstaking study of the direct and indirect costs and benefits of their proposed actions.
At the end of the day, the Settlement’s scorecard reads as follows:
- The separation of investment banking and research damaged our capital markets, the effects of which U.S. companies, investors, workers, and everyone else will bear until the separation of IB and research is either rescinded or until the twelve Settlement banks are supplanted by others (perhaps from China, India, Brazil, etc.) to which these overzealous and dysfunctional restrictions do not apply.
- The independent research provided at a cost of $460 million (plus an estimated $30 million in implementation costs) was basically ignored by 98% of the clients it was supposed to benefit.
- The $85 million education funds seem to have accomplished nothing. In the words of Judge Pauley, “While the plan to create a new grant making investor education entity was worthwhile . . . bureaucratic inertia led to the SEC’s proposal to . . . transfer the funds to the NASD Foundation . . . [and] to put it mildly, the . . . Foundation’s performance has been disappointing.”
- The Administrator of the $432.75 million in restitution funds could not find enough victims. In the words of Judge Pauley, “Six years after the Securities and Exchange Commission’s (“SEC”) much-heralded announcement of the “Global Research Analyst Settlement,” more than $79 million intended for aggrieved investors cannot be distributed and continues to accrue interest. The quandary of what to do with undisbursable funds presents cautionary lessons for regulators, courts, and all other participants in securities fraud litigation.”
Bud Morton spent most of his career at Wertheim & Co., where he began as a security analyst covering technology and growth stocks and was recognized on Institutional Investor magazine’s All-America Research Team for ten consecutive years, four of them as the number-one analyst in his sector. He also served as Director of Research and head of Equities at Wertheim.