Analyst Conflicts – Problems? Solutions?

securities lawyer

 The SEC Releases an Investor Alert on Analyst Conflicts and Suggests that Investors do their Own Research.

By Mark J. Astarita, Esq.

June 30, 2001

The SEC has posted an Investor Alert on Analyst Recommendations and Conflicts Tilted “Analyzing Analyst Recommendations”. According to the Commission, the Alert is intended to warn investors of what the Commission terms the “inherent conflicts” in analysts reports. The Commission’s Investor Alerts typically deal with fraud issues. Recent releases have been “Stock Market Fraud “Survivor” Checklist, “The Fleecing of Foreign Investors: Avoid Getting Burned by “Hot” U.S. Stocks”, “Prime Bank Fraud Information Center”, “Broken Promises: Promissory Note Fraud”, “Identity Theft: Learn How To Protect Yourself”, “Affinity Fraud: How To Avoid Investment Scams That Target Groups”; well, you get the idea.

The inclusion of this topic with such fraud topics is a bit troublesome, but the education of the investing public is an important function of the Commission, and the Alert does an excellent job of describing the various types of analysts (Sell Side, Buy Side and Independent) and of addressing the potential conflicts which face analysts. However, in doing so, the Alert emphasizes the obvious and offers suggestions to investors which simply are not practical, and which in fact may be harmful to their long-term investment objectives.

The Alert also demonstrates the Commission’s view of the investing public and its own conflicts. Once again, the Commission has taken a position which has as its basic premise that the investing public is uneducated, simple and in need of the assistance of the government in order to live his life. At the same time, and in the same breathe, the Commission urges these “simpletons” to do their own research, to thrash through EDGAR filings, to ignore the research and advice of market professions, and instead to do their own research and to make their own investment decisions.

Lets be clear – analyst conflicts exist. The existence of potential conflicts is well known, and painfully obvious. So obvious that common sense discloses same to the investing public, and current rules and regulations require that the conflicts, when they exist, be disclosed.

For example, the classic example is the potential conflict when the analyst’s firm has an investment banking relationship with the issuer. As the SEC points out, the potential conflicts in that situation include:

1) The analyst’s firm may be underwriting the offering, and the firm has a interest a successful offering. An upbeat research report and positive recommendations published after the offering is completed may “support” new stock issued by a firm’s investment banking clients.

2) Issuer clients prefer favorable research reports – and unfavorable ones may harm the investment banking relationship. “An unfavorable report might alienate the firm’s client or a potential client and could cause a company to look elsewhere for future investment banking services. Positive reports attract new clients”

3) Positive reports attract new clients — Favorable analyst coverage of a company may induce that company to hire the firm to underwrite a securities offering.

The Commission also points out two other potential conflicts of interest:

1) Analyst Compensation — Brokerage firms’ compensation arrangements can put pressure on analysts to issue positive research reports and recommendations. For example, some firms link compensation and bonuses — directly or indirectly — to the number of investment banking deals the analyst lands or to the profitability of the firm’s investment banking division.

2) Ownership Interests in the Company — An analyst, or the firm may own significant positions in the companies an analyst covers. Analysts may also participate in employee stock-purchase pools that invest in companies they cover. And in a growing trend called “venture investing,” firms and analysts may acquire a stake in a startup by obtaining discounted, pre-IPO shares.

While these concerns are all legitimate, they are also theoretical. More to the point, if an analyst wrote a research report for purposes of helping the investment banking side of his business, or his own compensation, to the detriment of the retail side, he would not only be impuning his own integrity, he might very well be committing a fraud.

The SEC also points out a conflict they label “Brokerage Commissions”, stating “a positive-sounding analyst report can help firms make money indirectly by generating more purchases and sales of covered securities — which, in turn, result in additional brokerage commissions.” While I am sure it is true that a positive report will generate purchases of covered securities, the “conflict” has a severe lapse of logic. For this to be a conflict, it would have to be true that the analyst wrote a positive report, on a company which did not deserve the report, in order to generate commissions. If the generation of commissions were the goal, wouldn’t it be more effective to make a recommendation on a stock which deserved a positive report? With nearly 3,000 companies listed on the NYSE and an additional 4,000 on the NASDAQ NMS system, does an analyst really need to write a positive research report about a poorly performing company in order to generate commissions?

The solution? While I suppose that there may be an investor or two who did not appreciate the existence of these potential conflicts, the reality is that the solution is already in the regulations and rules which govern the securities industry. Since the dawn of the securities laws in the 1930s, the primary focus of the securities laws, and its primary objective has been disclosure. Plain and simple – disclosure.

And the disclosure rules are already in place. The rules of the NASD and the NYSE already require analysts to disclose certain conflicts of interest when recommending the purchase or sale of a specific security. For example, analysts generally must disclose if they or their firm owns stock in the covered issuer. They must disclose if the firm is a market maker in the security, or in certain circumstances, if there was an investment banking relationship.

Clearly, there are potential conflicts in the world of the research analyst. Depending on the particular circumstances, some analysts on the Sell Side (those who work for the brokerage firms and underwriters) have the interests of the issuer, who may be a client of the firm, to consider, as well as the interests of the firm’s retail and institutional customers. The analyst in this situation wants to keep both sets of clients (the issuer and the retail customers) happy. So he discloses that there is a relationship with the issuer. The investing public knows of the conflict, and can read and digest the analyst’s comments in that light.

While I can hardly claim to be an expert on research analysts, I have dealt with a number of them over the years, and have read thousands of research reports. The overriding concern, it seems to me, that all analysts have is to be correct – to present a correct view of the company. They want to be right, they want to be known as being intelligent, insightful and knowledgeable, and value their reputations. Heck, they live by their reputations. This idea is in fact mentioned by the SEC in the Alert “[a] well-respected investment research team is an important service to customers” but it is buried in a ton of discussion about the conflicts, and suggestions for online research. It seems to me that the potential conflicts that an analyst has are readily apparent to anyone who invests, and that the reputation aspect of their recommendations more than offsets any real or imagined conflicts.

Is there anyone who misunderstands the following disclosure when it is contained in a research report?

“The firm and/or affiliates and employees have or may have a long or short position or holding in the securities, options on securities, or other related investments of issuers mentioned herein.”

It says “We have a position in the stock”. Does anyone who reads this not understand that the analyst might have an interest, aside from his reputation, in recommending the stock? The SEC apparently thinks so, as it goes through the possible meanings of this sentence in its Alert.

The remaining problem that I have with the Alert is the Commissions proposed solution to this theoretical problem – investors should do their own research. Yes, the Commission has again taken the position that the same naive public which requires the protection of the Commission, should be conducting their own financial research and analysis of companies.

Where have we heard this before? This is becoming a theme in SEC statements – forget your broker, forget your financial advisor, do your research. Last year, SEC Chairman Levitt urged investors to be diligent, and do research. He urged investors to review the prospectuses of mutual funds, to determine the reasons for past performance and to “scrutinize the fund’s fees and expenses.” He also urged investors to investigate securities at EDGAR, by simply typing in a company’s name and retrieving every report the company has filed with the SEC in the past five years.

As I wrote back then, in April 2000, the concept that an investor should be doing his own detailed analysis of securities, financials, and mutual fund performance figures is pure folly. I have been investing for nearly 20 years, and have a pretty good understanding of a financial statement and a mutual fund prospectus. But, am I a research analyst? Can I make an accurate determination of the projected cash flow of a company? or of the intrinsic value of a share of common stock? Of course not, and I rely on a research analyst to make those determinations for me.

Does he have a conflict in making the recommendation? I assume he does, but I also do not assume that he has fudged the numbers, or lied in his report to earn a commission dollar, or to promote an investment banking relationship.

Rather, I assume that he is a professional, that he is competent and honest.

It is a shame that our regulators do not start their own analysis with the same proposition.


Securities Attorney at Sallah Astarita & Cox | 212-509-6544 | | Website | + posts

Mark Astarita is a nationally recognized securities attorney, who represents investors, financial professionals and firms in securities litigation, arbitration and regulatory matters, including SEC and FINRA investigations and enforcement proceedings.

He is a partner in the national securities law firm Sallah Astarita & Cox, LLC, and the founder of The Securities Law Home Page -, which was one of the first legal topic sites on the Internet. It went online in 1995 and is updated daily with news, commentary and securities law related links.