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

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

An analyst's employer is an important distinction in understanding the proposed NASD and NYSE rules because most of the conflicts a broker-dealer's analyst faces is as a result of their employer. The three general types of analysts are buy-side, sell-side and independent.35 The sell-side analysts are the ones at issue in the SROs proposed rules. Typically the sell-side analysts work for a full service broker-dealer.36 "Many of the more popular sellside analysts work for prominent brokerage firms that also provide investment banking services for corporate clients-including companies whose securities the analysts cover."37 This is the root of many conflicts.38 The buy-side analyst, "typically work[s] for institutional money managers-such as mutual funds, hedge funds, or investment advisors-that purchase securities for their own accounts. They counsel their employers on which securities to buy, hold, or sell and stand to make money when they make good calls."39 Finally, independent research analysts typically do their research and publish it on a subscription or other basis.40

II. CONFLICTS OF INTEREST FACED BY SECURITIES ANALYSTS

Sell-side analyst conflicts are not a new phenomenon; they are almost "as old as Wall Street."41 For instance, complaints can be traced to the 1929 crash when again analysts failed to recognize the problems and predict the changing tide of the market in the pre crash economy.42 However, in recent years there has been an increased amount of conflicts spotlighted. This change is due in large part to three main occurrences. First, the growth in investment banking revenues to broker-dealers has caused an increase in conflicts when an analyst attempts to provide quality research about clients or potential clients of their firm.43 Second, during the recent bull market, analysts were treated as media stars, getting them lots of exposure, which is good on the upside but when the market suffers a downturn their mistakes are even more pronounced.44 Finally, there was an explosion in stock market participation by the individual investor and these customers had more access to the information analysts provided.45

Recent studies have illustrated the effect of the abovementioned conflicts of interest. For instance it has been said that in recent years one-third of all recommendations were strong buys or some variation of that top recommendation (since analysts' terminology varies by broker-dealer), one-third buys, and one-third holds.46 Thus, the sell recommendations represented less than 2% of all recommendations.47 Another study indicated that sell-side analysts, whose firms have investment banking activities, have 6% higher earnings forecasts and 25% more buy recommendations then do analysts who do not have ties to underwriting activities.48 Other studies state that recently the buy sell ratio was 66:1 from 6:1 a decade ago.49 Due to the scarcity of sell recommendations, the industry has come to regard a hold recommendation as a sign to sell, something that many retail customers do not know.50