New York, NY – For a number of years, politicians, regulators, and industry executives have been struggling to address the numerous conflicts of interest and market pressures that hamper the production of objective unbiased investment research by the world’s largest investment banks and brokerage firms.
Unfortunately, the lack of transparency in the commercial relationships between the buy-side and the sell-side around paying specific fees for the various services they offer, including investment research, trade execution, new issues, and product distribution has limited any real progress to mitigate the conflicts of interest surrounding these relationships.
In response, a number of regulatory and market led initiatives have sprung up to address these issues including the Global Research Analyst Settlement in the U.S., the Enhanced Analytics Initiative in Europe, and various unbundling efforts around the world. Most would agree that these initiatives have fallen short for one reason or another.
The following is an excerpt from a draft white paper written by Michael Mainelli, Jamie Stevenson & Raj Thamotheram entitled SELL-SIDE RESEARCH: THREE MODEST REFORM PROPOSALS, The reasons why sell-side research has failed to deliver on its analytical promise and the measures needed to release that potential. This paper analyzes the sell-side research industry, the conflicts endemic in this business, the market forces which have led to these conflicts, and presents three conservative recommendations to start reducing these conflicts.
The authors are participants of the Network for Sustainable Financial Markets and are writing in their private capacity. To request the entire 19 page paper, or to make comments, please contact jamieroger.stevenson@virgin.net.
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1. Executive Summary
Investment banks (“sell-side”) spend at least $10billion[1] per annum globally on equity research sold to investment clients (“buy-side”). Even after cutbacks in recent years, sell-side equity research remains a well-funded and high-profile activity. It ought therefore to be adding significant value to investors’ understanding of quoted companies. And, since sell-side analysts disseminate their research widely, it should also improve the all-round quality of market information. Yet despite these sizable resources and high rewards (unmatched in any other field of analytical research) and powerful advantages, sell-side research has been clearly and consistently shown to:
- Miss most of the major insights or turning points in company analysis[2]
- Err persistently towards Buy recommendations and stances supportive and uncritical of current company management policies and or management fads[3]
- Follow consensus (and company guidance) forecasts and views, rather than construct independent earnings models and opinions
- Prioritise daily client marketing contact over long term development of fundamental research
- As a consequence, focus on short to medium term valuation formulae at the expense of examining in depth the extra-financial and operating issues which impact the long term sustainability of business models and company performance.
The reason for these failures can be traced to the lack of transparency in commercial relationships between sell-side and buy-side. This lack of transparency arises because:
- Buy-side institutions are loath to make open, direct and significant payments for specified research services
- Instead, they opt for a maze of commercial contracts – across the corporate, new issue and market-making functions as well as commission – which mask their true dealing costs whilst providing broad research cover to defend their decisions
- This reluctance to pay full dealing and research costs has shifted focus and power within investment banks towards corporate fee and proprietary trading income
- Which in turn has exacerbated the conflicts for equity analysts between research for clients and making a contribution to corporate and trading income
There have been three very different attempts to address these weaknesses. Each has had some positive impact but none have significantly altered the status quo.
The Spitzer settlement in December 2002[4] aimed to eliminate these conflicts of interest and create a level playing field in which buy-side could access sell-side research on a transparent basis. It has improved the system of research disclosures (to the displeasure of many analysts who complain about ‘red tape’) but failed to alter the preponderance of Buy recommendations and favourable research on each bank’s own corporate clients.
The launch of the Enhanced Analytics Initiative (EAI) in Europe in mid-2004 sought to encourage research beyond the limits of short term financials. Its radical idea of linking income (5% of participating institutions’ annual commission total) with a public ranking of sell-side competency in this new type of research started to attract significant research efforts from a dozen or more bulge bracket and other leading banks. But the project struggled against the domination of fully bundled corporate, trading and commission packages and in late 2008, it merged into the Principles of Responsible Investment initiative leaving unanswered questions about how to keep pushing for change.[5] Ironically, the banking crisis of 2008 (itself a classic example of a fundamental event which ESG research would have better placed to identify) has led to retrenchment by investment banks from research in general and from ESG research in particular.[6]
A similar fate awaits post-Spitzer initiatives in ‘unbundled’ research from non (or less) conflicted boutique broker-banks. The logic of quality research standing apart from corporate client and proprietary trading pressures is flawless. It has to be the logical way to raise equity research quality and independence. Yet few firms offering earmarked, unbundled research services have succeeded beyond the specialist boutique level.
The weight of existing relationships between buy-side and sell-side militates against such initiatives. It is arguable that only legally enforced separation of corporate, trading and broking functions (i.e. break-up of integrated investment banks) could achieve full transparency and independence in the supply of equity research. In the absence of political support for radical reform, the following three manageable steps would improve research quality:
- Full disclosure by sell-side and buy-side of all commission contracts
- Compulsory publication by sell-side of their recommendation balance (Buy/Hold/Sell) for (a) all covered stocks, and (b) corporate client stocks
- Naming and shaming of corporate managements who deny access to non-favourable analysts (‘analyst freeze-out’)
These are modest steps and simple to implement. They would not eradicate the failings of sell-side research at a stroke but they would at least make it harder for corporates and investment banks to conspire in neutering the analytical edge of equity research. And they might encourage the buy-side to see their long term advantages in paying directly for less conflicted and more deeply questioning sell-side research. Given the persistent failures of the voluntary approach, such measures need to be supported by regulation or at least the imminent threat of it, in the absence of industry proposals with teeth.
[1] Estimate based on 10% of reported $83bn global investment banking revenues in 2007
[2] Examples of significant missed turning points include widescale earnings manipulation in the 1980s, dotcom bubble in the 1990s, Enron and other off-balance sheet scams, BP’s safety exposure, dividend cuts in the early 1990s and now again in 2008/9, bank balance sheet failures etc
[3] Are security analysts fashion victims? The Core Competence Case, Ann-Christine Schulz and Alexander Nicolai, University of Oldenburg, 2008
[4] New York State Attorney General Eliot Spitzer agreed to drop cases against major Wall Street banks for fraudulent research in return for $1.5bn fines and agreements to separate research functions more clearly from trading and corporate, and to make more transparent statements about conflicts of interest
[5] What’s the future for ESG broker research, Hugh Wheelan, responsible-investor.com, 22/12/08
[6] Sell side firms who closed their ESG units in 2008 include Citi, Deutsch Bank and JP Morgan.