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