Analyst compensation is indirectly based on revenues that investment banks earn, and clients of banks invariably overlap with the companies that analysts cover. Therein lies all the brouhaha — an obvious conflict of interest at the heart of the financial industry. One analyst, who declined to be named, protests that the media has unfairly targeted his profession.
He points out, “In certain sectors — Internet, software, optical networking — the vast majority of the companies that analysts followed over the last couple of years were companies they had brought public.” He adds, “The fact is that none of these companies would ever have gone public or have received the valuations they did, if institutional investors had not been extremely interested in them. Once the bubble burst, analysts were unfairly painted as the ones responsible while clearly the whole finance industry including VC’s, institutional investors and investment bankers fueled the tremendous increase in capital flowing to these companies.”
It is clear that since institutional investors cannot short stocks, they dislike downgrades. This partially explains why analysts are overwhelmingly bullish on the companies they cover.
Conflict of Interest
Calling the analyst-banking nexus “incestuous and horribly conflicted,” one mutual fund manager who did not want his identity revealed, denies that institutional investors are to be blamed.
explains, “Some firms like Lehman Brothers, for example, don’t have an asset management business and so they couldn’t care less what institutional investors are saying.” He argues that research firms like ValueLine, which don’t have any banking business, are the only credible sources of information.
Arnab Chanda, of Lehman Brothers, responds that at Lehman, banking, research and sales are separate entities. Analysts report to the head of research and not to the banking chief. They respect the “chinese walls,” which make it illegal for analysts, bankers and sales representatives to share mutually beneficial information.
Sources say that although pressures on analysts in large investment banks may be less, that is not true of smaller investment banks that have a high percentage of IPO business. The only way to reduce this conflict is if the profits of investment banks are evenly split between profits from banking deals, and from sales and trading commissions. Currently revenues are skewed toward the former.
“The point here is to acknowledge that, under any circumstances, analysts have enormous incentives to generate investment enthusiasm and are under enormous pressures to maintain it,” said David M. Becker, General Counsel at the SEC, in a speech before the Committee on Federal Regulation of Securities of the American Bar Association on Aug. 7.
Saying that such pressures are inherent, Becker raised the question of whether complete independence of sell-side analysts is an attainable goal, however desirable. He suggested that naïve, individual investors can protect themselves by understanding that the system makes it impossible for analysts to be totally objective.
Yet, rules have started to become strict and analysts say that the SEC is watching very closely. Merrill Lynch has recently instituted a policy forbidding analysts from owning stock in the companies they cover. But Michael Parekh of Goldman Sachs, a twenty-year veteran, dismisses the entire controversy in one sweeping statement, insisting that, “Issues of conflict always come up in every up cycle and down cycle.”
Farrokh Billimoria, former Wall Street Journal All Star Analyst with Hambrecht & Quist, now a VC, disagrees, saying the current scrutiny was not warranted a few years ago. He suggests, “In the last two to three years, there were so many deals out there that you had to chase, and so much money to be made, that you started to see procedural systems fall apart.”
“Reg FD”
In an attempt to make the system more equitable, the SEC adopted Regulation Fair Disclosure (Reg FD) in October 2000, making issuers of “material non-public information” disseminate it to securities market professionals and shareholders simultaneously. In other words, CEOs or company management cannot provide one single analyst, trader or a single company shareholder any information that may unfairly influence the stock’s movement. They need to inform everyone at the same time.
Kash Rangan of Dain Rauscher Wessels feels that Reg FD has had virtually no effect on the way he interacts with CEOs. In the software business, a company’s quarter typically concludes in the last couple of weeks, when there are 30 to 100 different transactions that the direct sales representatives close and company management is unaware of. Thus he depends on systems integrators, who possess data points regarding potential deals, for information about companies. Partners and competitors can also have relevant data.
“There’s no way that even company management will know until the last day of the quarter how business has gone,” says Rangan. “Even prior to Reg FD, the best answer you got when you talked to management was ‘I don’t know.’”
Billimoria believes that although Reg FD gives analysts the chance to use their analytical abilities, it makes interactions between them and companies “unnecessarily stilted,” because management is not sure how to respond to questions.
The Way Ahead
Reg FD may be a step forward, but the system is far from clean. The self-serving nature of the business seems to be fundamental to the way capital is created and channeled. As it is, it seems that despite SEC scrutiny and shareholder outrage, the status quo hasn’t really shifted. Public memory is short and in 10 years another wrinkle in the American stock market is bound to rehash the same issues. Analysts will still be around, and investors will likely still not fully understand the conflicts of interest inherent in the system. si
