Power and conflicts of interest in professional firms: evidence from investment banking

Administrative Science Quarterly, March, 1998 by Mathew L.A. Hayward, Warren Boeker

We sit on opposite sides of the table, like a law firm representing both sides of a divorce. When corporate finance and research clash, it's a real problem.

- Paul Leming, a former equity analyst

Conflicts of interest arise in two main ways in organizations (Carson, 1994). First, self-interested agents may not properly perform their duties for their clients (Kesner, Shapiro, and Sharma, 1994) or their firms (e.g., Kosnik, 1987). Second, conflicts, such as that in the above quote about an investment bank, arise when intraorganizational groups perform duties for at least two parties who each have conflicting goals or objectives (Perrow, 1986; Poser, 1988). This study examines the resolution of this second, highly pervasive but relatively unexplored conflict.

Professional firms that provide multiple services are well suited to exploring this intergroup conflict (Tomasic, 1991). These firms commonly possess skills, information, or relationships with one client that compromise their ability to serve another. Lawyers in a litigation department may be hired by one client to provide advice prejudicial to another client (Tomasic, 1991). Consultants or accountants often decide whether to work with a firm that competes with an existing client (Lindsay, 1989). Journalists may consider whether to pursue a story damaging to an advertiser. And as professional service firms expand and diversify their range of services and their client base, such conflicts become more pervasive.

The above illustrates cases in which the ability of one department to affect the client relationships of another can be a source of conflict. We use theories of power to explore the nature and resolution of these conflicts in professional firms (Lukes, 1974; Giddens, 1979). Power becomes an issue when party A seeks to get party B to do what party B would not otherwise do or when such an outcome becomes entrenched in the interactions between the parties. In this context, the resource positions of those in potential conflict can substantially determine who gains from them (Pfeffer, 1981). Actors can transform dominant outcomes when they have the motivation and resources and may use numerous tactics, including coercion, co-optation, and politics to do so (Oliver, 1991). These practices distract members from organizational objectives and disrupt intrafirm relationships, information sharing, and, ultimately, performance (Eisenhardt and Bourgeois, 1988). But conflicts are forestalled when they have pre-existing and implicitly accepted forms of resolution.

Within professional firms, we examine the importance of analysts and their departments' reputation to identify such conditions.

While many professional firms have conflicting interests, we study equity analysts ("analysts") in investment banks ("banks"). Because banks have numerous departments that offer multiple services, they are well suited to studying intraorganizational conflict (Eccles and Crane, 1988). Within banks, analysts purport to provide objective and independent advice to investors (individuals and institutions) by rating firm securities a "buy, hold, or sell." Concurrently, the corporate finance department within the same bank competes to undertake capital offerings and mergers and acquisitions (M&A) for many of these same firms. Analysts issue ratings of firms that may themselves be current or prospective clients of the corporate finance department. Conflicts arise because, whereas corporate finance seeks to promote its clients' deals (issuance of debt and equity securities and M&A deals) through favorable ratings, analysts seek to rate corporate finance clients independently and objectively (i.e., not necessarily favorably; Morley, 1988). Therefore, analysts must decide whether to issue ratings helpful to corporate finance deals. While doing so may support corporate finance relationships and revenue, it undermines analysts' ability to serve investors independently and objectively. Because we did not observe actual conflict in banks, we limit our discussion to the potential for conflict between analysts and corporate finance that arises from their interdependence and conflicting goals. In particular, we explain and predict how the conditions underlying such conflicts affect analysts' ratings.

CONFLICTS OF INTEREST IN INVESTMENT BANKING

There are many models of power in organizations. By describing organizations as systems of coalitions with different and often conflicting interests, Cyert and March (1963) underscored the endemic nature of organizational conflict. Pfeffer (1981) noted that action and outcomes result more from bargaining and compromise than from an organization's mission or objectives. Common to these models is that the most powerful normally prevail in important contests over firm resources.

One manifestation of power is strategic conduct initiated to attain contested resources; here discrete action determines who gets such resources (Bacharach and Baratz, 1962; Lukes, 1974). Studies that investigate contests over key organizational resources, including leadership and capital, have found that such contests surface as coercion, co-optation, and politics (Pfeffer and Salancik, 1978). These studies often explore either weakly institutionalized settings, in which decisions follow individual discretion rather than past practices, or do not explore pre-existing institutionalized practices (e.g., Eisenhardt and Bourgeois's 1988 study of leadership contests in microcomputer firms undergoing rapid and discontinuous change).