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

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

Thus, in an attempt to eliminate these conflicts, the SROs have proposed their rules.51 The conflicts these rules address can be broken up into three categories, conflicts as a result of investment banking,52 conflicts resulting from the desire to provide more investment profits for a broker-dealer,53 and finally, personal conflicts of analysts, their employers, and its institutional customers.54

A. Conflicts As a Result of Broker-Dealer Investment Banking Activities

The conflicts resulting from investment banking activities are "in large part [due] to a blurring of the lines between research" analysts and a firm's investment banking department.55 In this category two major conflicts arise. One is when an analyst helps to attract and retain clients of the investment banking department.56 Second, conflicts are created when an analyst's salary and/or bonus is connected to the success of the investment banking department.57 It is this conflict that drew the attention of the attorney general, Eliot Spitzer, in his crusade to prosecute broker-dealers for allowing investment banking revenues to conflict with the integrity of the broker-dealer's research departments.58

1. Analyst Conflicts Resulting From Drawing and Maintaining Investment Banking Clients.

In the first instance, conflicts present themselves when a broker-dealer either: (1) has an investment banking client who the broker-dealer has already provided underwriting services to and wants to continue the relationship; or (2) the broker-dealer wants to attract new investment banking clients.59 First, a conflict can simply arise if the analyst participated on the underwriting team that brought the existing client's securities to market.60 An sec examination found that there was a significant amount of assistance rendered by analysts to investment banking teams in the underwriting process.6' In the past, "Chinese Walls" were erected between the investment banking and research departments.62 However, recently there has been a trend to bring the analyst over this wall and involve them in the due diligence and marketing of a new offering, making the line between the firm's analyst as a provider of information for the retail customer and as a participant in the investment banking department a very gray area.63

It is important to understand the pressures placed on an analyst, from both their employers and its investment banking clients to provide positive recommendations about the clients. The outcome of these pressures has been shown in recent studies providing evidence that recommendations by an analyst whose company underwrote an offering was positively biased as compared to those not involved in the offering.64 Why are these recommendations skewed? Because the investment banking side of a broker-dealer can provide significant revenues for a broker-dealer and, as such, an analyst would not want to jeopardize an investment banking relationship.65

It is most evident when reviewing the IPO process. The investment banking department must attract the new customer. In one study, 20% of CFOs acknowledged that if an analyst issued bad press on the CFO's company, the company would not use the services of that analyst's employer.66 Furthermore, other studies have shown that the quality of the research department was taken into account by 75% of CEOs and CFOs when choosing a brokerdealer.67 One reason this is important is because the management will face a lock-up prohibiting them from selling the company's stock for a certain amount of time after it is offered.68 A good research department will support the stock so that it will maintain a good price in the aftermarket and therefore profit management.69 Thus, "implicit in the underwriter-issuer relationship is the underwriter's intention to follow the newly issued security in the aftermarket: that is, to provide (presumably positive) analyst coverage."70