A conflict of interest for analysts?

United Kingdom
Those involved in the production and consumption of research notes issued by analysts at investment banks will have followed with interest the recent investigations by the New York Attorney General into certain research notes published by Merrill Lynch. These focused on the apparent discrepancy between analysts' public investment recommendations and their private views expressed in internal emails.

They resulted in Merrill Lynch making a payment (without any admission of wrongdoing or liability) of USD100 million and agreeing to implement a number of changes to the way in which its analysts operate. These include:

  • a complete separation of the evaluation and determination of research analyst remuneration from investment banking - in future business research analysts will be compensated only for those activities and services intended to benefit Merrill Lynch's investor clients (and not its corporate finance clients); and

  • an agreement that future equity research reports will include:

    • disclosure of whether Merrill Lynch has received, or is entitled to receive, from the covered company any fees over the previous 12 months from publicly announced equity underwriting and merger and acquisition transactions;

    • specific disclosure, on a percentage basis, of the distribution of "strong buy", "buy", "neutral" and "reduce/sell" recommendations for stocks in a number of different categories.

What are the implications of this investigation and settlement in New York for practice in London? Shortly after the Merrill Lynch settlement was concluded, the FSA announced a review of how investment banks in London run their research departments, the results of which were published on 31 July in the form of a Discussion Paper (DP 15). This identified significant differences between the New York and London markets which would tend to reduce the risk of abuses here. For example: London does not have the "star analyst" culture which is so strong in New York; and there are many more retail investors trading in New York (who rely particularly on analysts' recommendations). The FSA also reported that it had not identified any specific examples of bias and corrupted advice.

The FSA did, however, find some evidence that analysts' recommendations have been systematically more positive than market performance would justify and also, more seriously, that analysts' recommendations in relation to companies with which their parent house has a relationship are systematically more positive than the average. The proportion of "buy" recommendations made by firms acting as corporate brokers/advisers to the subject company is, at 80 per cent, almost twice as high as the proportion of "buys" where the analyst does not work for the corporate broker. In addition, although the proportion of "underperform"/"sell" recommendations in recent months has been almost four times as high in London as in New York, they still account for only approximately 16 per cent of the total number.

Having identified these issues, DP 15 contains a wide ranging and discursive discussion of the possible explanations. This includes: a description of the function of research analysts; an analysis of the different ways in which their remuneration may be calculated; the conflicts of interest inherent in the position of analysts and the pressures which may be brought to bear on them; and whether there is any confusion over the precise meaning of the terms used (e.g. "underperform") in analysts' notes. DP 15 also summarises the way in which the regulatory regime in the UK applies to analysts.

In case the FSA is persuaded, as a result of the consultation, that a significant problem exists and that action is required, DP 15 canvasses a range of options, including:

  • consumer education;

  • greater disclosure (possibly along the lines of the Merrill Lynch model);

  • constraints on firms' organisational and operational arrangements; and

  • controls on the financial analysts themselves (i.e. some more specific form of regulation).

In any event, it seems to us that the bias in favour of "buy" recommendations cannot, in normal market conditions, be justified on any objective ground and that the conclusion of the FSA's consultation is likely to be that reform of some kind is required. We also believe, however, that market practice is likely to move fairly quickly in the direction of current US practice - not least because the same US-based investment banks now dominate London as well as New York. If these banks follow the Merrill Lynch example (which, in any event, is now partially enshrined in revised rules of the NYSE and NASDAQ), it is an easy step for them to insist on the same practice being applied within their organisations on a worldwide basis. Whether these, and other, changes will be sufficiently widespread and far-reaching to dissuade the FSA from taking action remains to be seen.

For further information, please contact:

Michael Draper
Corporate Partner
michael.draper@cms-cmck.com
+44 (0)207 367 2068