January 25th, 2012
Econintersect: Almost nine years ago rules were implemented that required stock analysts to be separated by “firewall” from investment bankers when the two worked for the same employer. (Details later.) The reason for the firewall rules was the incredibly misleading “analysis” that occurred during the dot.com bubble. Analysts were producing incredibly (in fact unbelievable) glowing reports about the future business prospects for companies that had no income and investors were pouring money into these “incredible opportunities.” Not long after many investors learned that “credible” and “believable” (and “incredible” and “unbelievable”) are synonyms.
Why did these problems arise? As we have learned again and again through hard experience, a significant factor was compensation incentives. When an analyst is compensated based even partially on the performance of the investment banker a serious problem arises. The investment banker makes money by successfully launching the stock of a client company. If the analyst receives compensation based on how well a stock is received by investors, what influence will that have on his analysis?
Alan Greenspan had an answer for why regulation was not needed in the financial sector. He maintained that reputation was a primary driver of ethical behavior and regulatory enforcement was redundant (and inefficient, as it encumbered free enterprise). The ridiculous nature of the Greenspan logic was detailed recently by William K. Black (GEI Opinion). The behavior of some stock analysts in the late 20th century is a case in point.
Telis Demos has an article in the January 24, 2012 Financial Times that tells of action undertaken by FINRA (Financial Industry Regulatory Authority) “at the urging of the SEC (Securities and Exchange Commission)” that would create rules for bond analysts similar to those for stock analysts. Demos gives details of some examples of conflict of interest cases where bond analysts had been pressured to write favorable reports of credit securities ahead of auctions for those securities.
Some of the scandals of the housing and credit bubble related to representations being made by banking firms, such as Goldman Sachs in the Abacus case (see Seeking Alpha), where the divisions between securities sales and advice to clients were not just fuzzy, but virtually did not exist. While it is not clear that the proposed FINRA rules would apply to private placement deals with investment banks, such blatant disregard for client interests should be also brought under examination.
For reference, here are the specific firewall requirements for stock analysts from an April 28, 2003 SEC Fact Sheet:
- The firms will separate research and investment banking, including physical separation, completely separate reporting lines, separate legal and compliance staffs, and separate budgeting processes.
- Analysts' compensation cannot be based directly or indirectly upon investment banking revenues or input from investment banking personnel.
- Investment bankers cannot evaluate analysts.
- An analyst's compensation will be based in significant part on the quality and accuracy of the analyst's research.
- Decisions concerning compensation of analysts will be documented.
- Investment bankers will have no role in determining what companies are covered by the analysts.
- Research analysts will be prohibited from participating in efforts to solicit investment banking business, including pitches and roadshows.
- Firms will implement policies and procedures reasonably designed to assure that their personnel do not seek to influence the contents of research reports for purposes of obtaining or retaining investment banking business.
- Firms will create and enforce firewalls between research and investment banking reasonably designed to prohibit improper communications between the two.
- Communications should be limited to those enabling research analysts to fulfill a "gatekeeper" role.
- Each firm will retain, at its own expense, an Independent Monitor to conduct a review to provide reasonable assurance that the firm is complying with the structural reforms. This review will be conducted eighteen months after the date of the entry of the Final Judgment, and the Independent Monitor will submit a written report of his or her findings to the SEC, NASD, and NYSE within six months after the review begins.
Demos (Financial Times) says there is considerable political pressure to revisit these firewall provisions. There is opposition because they “hampered small companies’ ability to raise capital and create jobs.” On the other hand, Demos also mentions a recent report by the GAO which highlighted that potential loopholes still exist in the equity analyst rules.