Analyst conflicts of interests: Are the NASD and NYSE rules enough?

Fordham Journal of Corporate & Financial Law, 2003 by Contoudis, Karen

NOTES

INTRODUCTION

In recent years, a recurring trend has emerged in the United States financial markets: following a period of seemingly unprecedented market prosperity, a select group of perceived heroes has been transformed almost overnight from being celebrated trendsetters into reviled scapegoats.1 In the 1980s Michael Milken was the revolutionary junk bond king.2 Milken was an innovator,3 but faced his demise with his infamous cohort Ivan Boesky after being jailed for using insider information.4 Thereafter, in the early 1990s, Long-Term Capital Management and its partners, considered geniuses on Wall Street, suffered their downfall when interest rates took a turn for the worst and the company that seemed foolproof faced financial disaster.5 Today there is a new breed of evil genius on Wall Street, the financial analyst. Financial analysts are so called because the demise of both the Internet stocks and Enron came with little or no warning from these "experts." The result being that the integrity of "name" financial analysts was undermined in the eyes of the public,6 which in turn made Congress take action by initiating investigations into Wall Street's financial analysts.7

In an attempt to mitigate damages the industry responded with self-regulation.8 Broker-dealers instituted internal procedures that placed restrictions on analysts whom they employ, and the Securities Industry Association ("SIA") published a guide for analysts and broker-dealers alike.9 However, after the Internet bust left many asking questions,10 the colossal collapse of Enron, when again analysts failed to recognize problems, provoked the industry regulators to take action. In February 2002, the Self Regulatory Organizations ("SROs")11 entered the fray,12 making regulatory rule proposals to the Securities and Exchange Commission ("SEC"). The National Association of Securities Dealers ("NASD") proposed a new rule, 2711, and the New York Stock Exchange ("NYSE") proposed amendments to its Rule 472 (Communications with the Public).13

To put some realism into the severity of the situation, , more than ten articles relating to the SRO proposals appeared in the Wall Street Journal alone in the month following the publication of the proposals.14 Moreover, shareholders have brought suits against analysts, which until now have been dismissed.15 The culmination of the backlash occurred on April 9, 2002, when Eliot Spitzer, the attorney general for New York State, won a court order, "forcing Merrill Lynch & Co. to overhaul its research [procedures] . . . ."16 Spitzer's inquiry has already moved beyond Merrill Lynch.17

This Note will respond to the SROs' proposed rules. Part I will review the traditional role of securities analysts. Part II will provide a review of the many conflicts these analysts face. Part III will provide a review of the new rules and their attempt to address each of the conflicts analysts face. Finally, Part IV will analyze these proposed rules, for better or worse.

I. THE TRADITIONAL ROLE OF THE SECURITIES ANALYST

Generally, a financial analyst is a "person in a brokerage house, bank trust department, or mutual fund group who studies a number of companies and makes buy or sell recommendations on the securities of particular companies and industry groups."18 Basically, analysts review public information in order to make buy or sell recommendations.19 An analyst will also "actively seek out bits and pieces of corporate information not generally known to the market for the express purpose of analyzing that information . . . ."20

More specifically, the analyst will review financial information, and gather both qualitative and quantitative information.21 An analyst will collect earnings data, information about federal actions, interest rates and social and economic trends.22 Analysts must review this information for current and future expectations, compare it to the industry and then make future predictions while balancing these predictions against future risks like market risk or cyclical factors.23 Thereafter, a report is put together which balances all of these factors, including the analyst's opinion and predictions, which are based on experience and logic.24 Thus, "as you can see the role of the analyst is multifaceted."25 Given the complexity of the job it seems obvious why most analysts specialize in either a few companies or one industry or sector.26

In the U.S. markets, analysts are said to play a key role in promoting efficient market pricing by gathering available information and sorting it out.27 Indeed the United States Supreme Court recognized this proposition in Dirks v. SEC, explaining that the analyst is key to healthy markets because they provide objective evaluations of companies.28 They do this by, "evaluating, verifying, and researching corporate disclosures required by the securities laws, and in disseminating company-specific information to the market as a whole."29

The role of the analyst to broker-dealers is centered on generating revenue; they are not employed as a public service.30 An analyst's recommendation sells securities and makes the company money.31 Moreover, as will be discussed later, certain recommendations can assist in bringing in investment banking business for a broker-dealer.32 Other companies, like mutual funds, use analysts internally to assist in the purchase and sale of securities in their own account.33 These distinctions are extremely important in the current debate, because the only groups of analysts under fire are the ones working for broker-dealers.34