How did it come to this? How is it that independent research, once the beneficiary of regulatory largesse, is now viewed with suspicion and concern? A decade ago, being independent from investment banks was a positive in the eyes of regulators and investors. Now independents are viewed as unregulated entities that generate risk. It is tempting to blame Primary Global for the current state of affairs, but that is too simple. The reality is that the causes are much deeper, and they aren’t going away.
2003 was a heady time to be an independent research provider. Regulators were requiring investment banks to separate their equity research departments from investment banking–cutting a major source of internal funding for research, isolating analysts from their banking brethren, and imposing many new compliance obligations. Many senior analysts left investment banks, some going to the buy side, some to independents. Best of all, regulators were forcing twelve investment banks to set aside $90 million a year for five years—nearly half a billion dollars—for the purchase of independent research.
No wonder there was a mad scramble to start up new independent firms. In 2003, 112 new independent firms were founded, a record number that is unlikely to be topped anytime soon. The dewy-eyed new IRPs quickly learned that you needed to be in business for at least three years to be eligible for the Global Research Analyst Settlement monies, and even then most of the money was going to a handful of firms (Morningstar, S&P, Argus).
Nevertheless, being independent had cachet. Institutional investors, though aloof from the Settlement, were open to independents. Hedge funds in particular developed an appetite for niche boutiques whose research was not widely disseminated. Hedge funds also savored the diverse approaches offered by independents, ranging from forensic research to channel checks to expert networks.
For a time, it seemed like regulators were going to level the equity research playing field even further, forcing greater transparency and unbundling of equity commissions. In 2005, the Financial Services Authority (FSA) developed a regime requiring greater commission disclosure of execution and research payments, which went into effect the following year. The Securities and Exchange Commission (SEC) published new ‘soft dollar’ guidelines in 2006, clarifying that bundled payments to investment banks for research is a form of soft dollars. The SEC promised to develop commission disclosure guidelines in the following year, but never got around to it.
Regulatory interest in reforming equity research petered out after 2006. In early 2008, the FSA commissioned a study of the effectiveness of its commission disclosure guidelines, and though the response was mixed, decided to declare victory and move on. The U.S. Department of Labor did not get the memo that reform was passé and proposed some FSA-like commission transparency guidelines in 2006, but neutered the regulation by the time it was implemented last year.
In this gradual way, the tide floating independent research began to recede, but most of us were too busy to notice. By the time Lehman went bankrupt in September 2008, the nails were in the coffin of equity research reform. Less predictable was the direction that regulators would take after the crisis.
There was a certain regulatory logic to the Global Research Analyst Settlement, irrespective of how you might feel about its specific provisions. Analysts had hyped dubious technology stocks during the dot.com bubble, and banking relationships had played a role. Nobody has explained how insider trading contributed to the 2008 financial crisis. That’s because the regulatory effort is focused on recapturing regulatory mojo, rather than fixing the root causes of the crisis.
It would be a mistake, however, to dismiss the current regulatory actions. Don’t get too hung up on Primary Global or expert networks. The central issue here is that independent research firms are for the most part unregulated entities. And this issue is not going to pass. Look around you. Everything in the financial sector is getting more regulated: banks, investment banks, hedge funds. You think independent research is exempt? Think again.
No, there is not a pending bill or regulation which will require independent research firms to get regulated. But in the context in which your clients are living, you are increasingly an anomaly. That is why you are getting more questions from clients, why there is more red tape, why you have more questionnaires to fill out, why it is harder to get prospects to return calls, why it is excruciatingly difficult to grow business.
We are in a new era. Most of the independent research industry grew up in an environment where conflict management was the regulatory topic de jour. We now live in an environment where it is all about information control. The regulatory goal posts have shifted. This has implications for how you do your research and how you run your firm. Not every firm is affected the same, so how you address it will depend on the way you do your analysis, how you are organized, your clients and a variety of other factors.
Information control is the specific manifestation of the new era, but the larger aspect is increasing oversight, either through self-regulation or by registering as an investment advisor or broker dealer. Not every firm will need to become a registered entity, but every firm will need to recognize the new reality. The reality is more regulation, and the sooner you are attuned to it, the better.