New York, NY – On April 23, 2003 the SEC, NASD, NYSE, and the New York State Attorney General Eliot Spitzer reached a historic $1.4 billion settlement with ten of the world's largest investment banks to address accusations that conflicts of interest between these firms' investment banking and equity research divisions were causing these banks to issue overly optimistic research recommendations.
As part of this settlement the ten investment banks agreed to pay $432.5 million over five years to purchase and distribute independent research reports alongside their brokerage research to give retail investors an objective "second opinion". With the end of the independent research program now little more than one year away, it makes sense to look back and evaluate the success or failure of the Settlement, and assess who loses when the Settlement ends in the Summer of 2009.
The Goals of the Settlement
The stated overall goal of the Global Research Analyst Settlement was to eliminate "undue influence of investment banking interests on securities research at brokerage firms", whereas the goal of the independent research program itself was "to ensure that individual investors get access to objective investment advice".
However, various participants in the Settlement admitted they were unsure how to measure whether the Settlement was a success or not. In a speech at the annual Investorside conference in April of 2005, New York Attorney General noted that two metrics that might be used to judge the efficacy of the Settlement, included "Were investors using the independent research?", and "Was sell-side research better as a result?" A few of the independent consultants hired to oversee the Settlement's independent research program have also noted that another measure of the Settlement's success could be "Did the Settlement promote a vigorous independent research industry which would provide investors with objective second opinions?"
How Well Did The Settlement Work?
So, based on these metrics, was the Settlement successful? We think the results are mixed at best. First, the usage of the independent research provided under the terms of the Settlement by retail investors has been quite poor. In an article written in 2005, two of the independent consultants who took part in the Settlement explained that the amount of independent research used by retail investors was 10% to 25% of the number of sell-side research reports requested by retail investors. However, it is interesting to note that these statistics do not reflect the number of independent research reports downloaded by retail brokers. It is likely that many of the research reports requested by stock brokers indirectly benefited retail investors.
It should be noted that one of the greatest weaknesses of the Settlement was that the participating investment banks were not required to advertise or market the independent research to their retail clients. In fact, a study conducted by S&P in 2005 showed that 40% of 1000 retail investors surveyed were "unaware of the settlement" and the research that was available as a result.
If we judge the Settlement on whether sell-side research improved as a result, we get more mixed results. One study published in February 2008 by Kadan, Madureira, Wang, and Zach revealed that the Settlement "had some success in curbing conflicts of interest." This study found that after the Settlement, affiliated analysts (those who work for the Settlement banks) are no longer more likely to issue optimistic recommendations. However, they are still less likely to issue pessimistic recommendations compared to unaffiliated analysts.
Another study published in March 2008 by Woolridge and Cusatis examined analysts' long-term (three to five years) and one-year ahead annual growth rate estimates for all companies from 1984 to 2006. Their findings showed that, for both types of forecasts, analysts consistently project EPS growth rates much higher than actual growth and that firms rarely meet or exceed their projected EPS growth rates. These authors explained that excessive optimism reflected in this study could reflect career concerns, a loss of objectivity resulting from becoming "attached" to the companies they follow, or conflicts of interest.
A study conducted in March 2008 by analysts at eFinancial News showed that the optimism of the ten investment banks involved in the Global Research Analyst Settlement has now risen close to the level seen right after the Settlement went into effect, while the pessimism continues to decline. The study reveals that at the end of 2007, the percentage of BUY recommendations totaled 44.8% of all recommendations, just below the 45.8% level seen in January 2003, but considerably higher than the 41.6% ratio seen in October 2006. The study also revealed that the percentage of SELL recommendations made by analysts at the 10 Settlement banks fell from 18% of all recommendations in January 2003 to 12.5% in October 2006 to 10.6% at the end of last year.
However, if we measure the success of the Settlement on whether it helped create a robust independent research industry to provide "objective second opinions" for retail investors, then the evidence is somewhat more encouraging. Since the initial announcement of the Settlement in December 2002, forty-two (42) new independent research firms were formed. However, only 22 of these firms produce fundamental or quantitative research and therefore would actually be eligible to participate in the Settlement.
At the peak, between 60 and 70 independent research firms were paid between $80 million and $90 million per year to provide research reports that would be redistributed by the twelve investment banks involved in the Settlement (Deutsche Bank and Thomas Weisel Partners joined after the initial Settlement was announced). However, it must be noted that the lion's share of the Settlement payments were made to a small number of research firms including the likes of S&P, Morningstar, and Argus Research.
Who Loses When Settlement Ends?
Despite the fact that the Global Research Analyst Settlement posted mixed results, it is also clear that the end of the Settlement will create a few losers, including a number of independent research providers and most retail investors. And while the team at Integrity Research Associates is sensitive to the impact the end of the Settlement will have on a number of boutique research providers, we are considerably more concerned about how retail investors will be affected.
In recent years, the deteriorating economics of the sell-side research industry has prompted many firms to slash the number of analysts they employ. TABB Group, a financial services consultancy, anticipates that sell-side analyst hiring will plunge in the coming years -- falling from 16,200 analysts in 2000 to 9,300 in 2006, to 6,000 analysts in 2008.
This plunge in the number of sell-side analysts is consistent with a significant drop in the number of public companies under coverage. According to Reuters, from the period 2002 to 2006, close to 690 companies lost research coverage in the United States as investment banks have been forced to scale back their research operations. Of course, this means that retail investors have lost access to all investment research on these firms. Unfortunately, most retail investors cannot afford to do their own research, unlike the institutional investor community.
However, in a little over twelve months, retail investors will also lose access to independent research on close to 2800 stocks that are currently covered by the Global Research Analyst Settlement. Of course, many will argue that these investors will still receive the equity research reports produced by Wall Street analysts. However, given the likelihood that continued industry pressures will lead to additional declines in research coverage, we suspect that retail investors will get even less and less sell-side research in the coming years. In addition, retail investors will also lose access to the "objective second opinion" provided by independent research – a development that does not bode well given the increased optimism (and reduced pessimism) seen in Wall Street research in recent years.
Consequently, it is clear to us that retail investors are likely to be the biggest losers once the Global Research Analyst Settlement comes to an end in the summer of 2009.
Possible Next Steps?
This does not mean that Integrity is advocating that the Regulators or Courts should step in to officially extend the Settlement. However, we do think that given both the industry trends discussed above, and the excessive optimism that continues to plague sell-side research, the Regulators need to consider how they might be able to encourage the industry to continue providing retail investors with "objective investment advice".
We should make it clear that we have heard some heartening news on this score. A few of the investment banks involved in the Settlement are actively investigating what type of independent research program they might continue in the second half of 2009 and beyond.
However, we suspect that left to their own devices, most of the Settlement banks will shutter their third-party research offerings as soon as they are able. As a result, we would humbly recommend that the Regulators start a discussion with all the participants involved in the Global Research Analyst Settlement to see if a market-led solution might be possible.
