New York—”For individual investors, it is a whole new world when it comes to stock research,” proclaimed The Wall Street Journal on July 27, 2004, the first day of the Global Research Settlement. Three years on, the Journal‘s prediction rings hollow. If the measure of success for the Settlement is transforming equity research for retail investors, the Settlement has been a failure. The Settlement’s most significant impact has been on institutional research, not retail-oriented research. Whether the impact endures is increasingly under pressure, as the Street looks for ways to restructure research, bringing research more in line with its other capital markets activities.
The $1.5 billion Global Research Settlement consisted of three components: 1) punitive damages; 2) rules separating research from investment banking; and 3) a requirement to provide independent research in addition to proprietary research. Unfortunately, investors harmed by tainted research did not receive the full amount of punitive damages from the Settlement. Half of the $900 million in punitive damages went to the states who participated in negotiating terms with the twelve investment banks in the settlement. For the most part the states spent the windfalls on budget shortfalls, rather than reimbursing investors. The SEC set up a distribution fund with the remainder and has been paying investors.
The Settlement also set aside $87 million earmarked for investor education. $22 million disappeared into state budgets. The SEC set up a $55 million fund for investor education, but after a series of false starts, this was dissolved and the $53 million remaining was sent to the NASD to become part of what is now FINRA Investor Education Foundation, which provides grants to academics and non-profits relating to investor education.
Subsidizing Independent Research
The part of the Settlement which received the greatest fanfare was the provision requiring the twelve settlement banks to provide independent research. An explicit regulatory goal was to stimulate the market for independent research with a subsidy of $460 million to be paid over 5 years. This caught the attention of independent research providers, which mobbed the independent consultants administering the research budgets. Although hundreds competed, approximately fifty were selected, with the largest share of the spending going to a handful of firms. The top five beneficiaries—Standard & Poor’s, Morningstar, Argus, Renaissance Capital and the Street.com (formerly Weiss Ratings)—garnered almost 60% of the spending by the independent consultants.
Jaywalk, now part of BNY Convergex, was chosen as a distribution platform by seven of the twelve independent consultants. Through Jaywalk, consultants could choose from 175 research providers, with some selecting as many as thirty-five or forty research providers. This had the effect of diluting the payments to the research providers, with many independent research firms dejected at receiving five figure and low six figure checks. A number of research firms concluded it was not worth it, and the number of research firms available through the Jaywalk platform shrank from 175 to 150.
Not all the monies set aside for independent research were spent. In the first year, there was $86.5 million available for spending, of which only $75 million was spent, based on reports that the independent consultants made to regulators. The reason for this is that some independent consultants wanted a reserve in case they had to purchase additional research in future years. Also, consultants for the firms with the biggest allocations to independent research—Merrill, Citi, Morgan Stanley, Goldman and CSFB—had difficulty spending the money. $10 million buys a lot of independent research.
Now, with the end of the Settlement less than two years away, those who did well which are beginning to sweat. Of the twelve banks in the Settlement, there are only four with significant retail business—Merrill, Citi, Morgan Stanley and UBS. The remaining eight firms have little retail business so dropping the independent research will be a no-brainer. Merrill, Citi, and Morgan Stanley are each allocating $15 million per year for the procurement of independent research (although their independent consultants may not spend it all). It is a safe bet that they will reduce this budget significantly after July 2009, perhaps by as much as 80%. The annual spending is likely to go from $80-85 million a year to $10-15 million a year.
In anticipation of the end of the Settlement, Jaywalk has been beefing up its institutional sales force to increase its institutional business. Argus Research is also targeting institutional investors, with its second institutional conference scheduled for November. Standard & Poor’s reportedly laid of fifty employees in its equity area, apparently in anticipation of the end of the Settlement in 2009. Investorside, the trade association for independent research, announced an initiative to try to persuade regulators to extend the Settlement. This may be a difficult task since regulators seem to have moved on to other topics. When Banc of America settled in March of 2007, it got off with a fine of $26 million with no obligation to provide independent research.
The track record of the Settlement is mixed, at best. Investors are being paid, but only half the original damages assessed. The independent research being purchased so expensively through the Settlement is little used by investors. The independent consultant for Citigroup reported that total investor usage of its most popular research provider (S&P) was only 54,000 hits over the first 12 months, or approximately 200 per day.
Independent research is flourishing, but not because of the Settlement. Or, at least not because of the subsidy that regulators set aside. The subsidy largely went to a few firms which provide retail-oriented equity research. The Settlement has helped independent research (or alternative research as we prefer to call it) through the separation of proprietary research from investment banking. This created a more level playing field between proprietary and alternative research by keeping Street analysts from being “pulled over the wall.” It has also focused proprietary research on its P&L, starting a more market-centered process that commission transparency is accelerating.
However, this legacy is not assured. Banks continue to chafe at the separation of banking from research. Last week, the Financial Times reported that Citigroup has considered moving its stock research analysts back to its institutional securities business. This move makes sense since research is now part of Citi’s retail business, whereas research’s P&L is largely dependent on its institutional business. On paper, such a move also brings research closer to banking. In August, Goldman Sachs CEO Lloyd Blankfein apologized to a banking client, Russian company VTB Group, for an analyst’s sell rating on the company’s stock, highlighting that banking still drives the bottom line.