Conflicts of interest and stock recommendations
From the Briefcase: Research produced by America's Best Business Schools
Authors: Ohad Kadan, Rong Wang, Tzachi Zach (Olin School of Business, Washington University in St. Louis), and Leonardo Madureira (Weatherhead School of Management, Case Western Reserve University)
Status: Working paper
Summary: After the dot-com bust revealed the flimsiness of the "Chinese wall" separating investment and analysis divisions in Wall Street's biggest banks, the New York Stock Exchange enacted regulations to stop the behind-the-scenes meetings of finance's most influential minds. According to a new paper, though, they may not have had the desired effect.
When New York Attorney General Eliot Spitzer launched an investigation into allegations of misconduct by security analysts, scholars took note, following with particular interest the enactment, in 2003, of the Global Analyst Research Settlement, which aimed to resolve conflicts of interest between research and investment banking.
The final terms of the settlement demanded that 10 of the country's top investment firms pay $1.4 billion in penalties and fines. The firms also were required to reform business practices that inappropriately influenced the output of research analysts. Such practices included tying analysts' salaries and bonuses to the success of a deal.
Did the global settlement eradicate analyst bias? Researchers at the Olin School of Business at Washington University in St. Louis decided to find out. Profs. Tzachi Zach and Ohad Kadan, together with Rong Wang, a doctoral student, analyzed data on firms during three different time periods: from 1995 to September 2000, before Regulation Fair Disclosure; from September 2000 to December 2002, when the global settlement was announced; and from April 2003 to September 2004, the first phase of implementation.
They obtained information from both affiliated analysts, those employed by underwriting firms, and unaffiliated analysts on earnings forecasts, long-term growth forecasts, and stock recommendations.
Then they evaluated bias in analysts' research by examining the differences between the two groups. "Anecdotal evidence from analysts told us that their behavior changed after the settlement," said Zach. "Whether this would be reflected in a large-scale study was the issue."
In the period following the global settlement, recommendations by affiliated analysts–those working at the 10 firms that were part of the deal–are no longer more optimistic than those stated by unaffiliated analysts, the research revealed. "In fact, analysts' optimism in general has declined since the global settlement," said Kadan. The study shows, though, that affiliated analysts are still reluctant to issue pessimistic recommendations about the firms their banks have underwritten.
Research results also showed that investors perceive analysts' recommendations differently post-settlement and react differently to buy, hold, and sell recommendations.
"Before, if an analyst issued a hold recommendation, it was almost like a sell," said Zach. "We see a differential response to the same recommendation today."
The researchers also examined the implication of Regulation Fair Disclosure. "We show that Regulation FD doesn't have an effect on this particular aspect of analysts' behavior," Zach said.
"Hopefully, the settlement achieved its goal," said Zach. "Based on our results, we believe that analysts, in general, have become more cautious in issuing forecasts and recommendations."
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