The year that changed research analyst coverage

Author: | Published: 30 Nov 2012
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Glen Rae Jim Tanenbaum Anna Pinedo
In a period of just 12 months, three crucial developments changed the future of research analyst regulation. Bank of America Merrill Lynch's Glen Rae, and Morrison & Foerster's Anna Pinedo and Jim Tanenbaum, explain how

In 2003, as a result of legal and regulatory developments, the business of research coverage changed quickly and fundamentally. It is only now that policymakers are contemplating how to encourage research analyst coverage, especially for emerging growth companies. Promoting research analyst coverage will require a more comprehensive approach than the modest reforms brought about by the last year's Jumpstart Our Business Startups Act (JOBS Act).

In hindsight, it is plain to see that a number of 2003 developments would have a lasting impact in this area: changes arising from the finalised Global Research Analyst Settlement (Global Settlement); adoption of self regulatory organisation (SRO) rules relating to research; and the Securities and Exchange Commission's (SEC) promulgation of Regulation AC.

The Global Settlement addressed the most serious perceived conflicts between investment banking and research departments during the dotcom boom, and prompted implementation of various prophylactic measures. These included the structural and physical separation of banking and research, the requirement for a chaperone to monitor communications between the two, and the requirement for analyst compensation be determined independently and not be based on banking revenues. Regulation AC was designed to ensure research analyst independence and integrity by requiring research analysts to certify the truthfulness of the views expressed in research reports and public appearances. The rules adopted by the National Association of Securities Dealers (the Financial Industry Regulatory Authority's predecessor) and NYSE followed the same lines, and also addressed the timing of research reports in connection with offerings. It is difficult to find fault with the premise underlying these measures – that is, restoring integrity to research – however, taken together, they required that investment banks undertake very significant changes very rapidly. These changes had widespread effects, as many were implemented in other jurisdictions as well.

For many, the overriding effects were compliance burdens, regulatory risks associated with establishing, maintaining and monitoring complex policies and procedures designed to prevent actual conflicts, and costs of defending litigation involving conflicts of interest. But if one could set these factors aside, it is worth focusing solely on the cultural and business model shifts brought about by the Global Settlement, SRO rules and Regulation AC.

Experiments relating to third-party research firms (not connected to sell-side firms) established in the immediate aftermath of the Global Settlement revealed that viewing research coverage as a so-called utility is, for the most part, a failed and therefore misguided undertaking. The collective experience since 2003, as supported by substantial economic analysis, reveals that research coverage is essential to a thriving capital market. Recognising research coverage's contribution to the market for emerging companies, the JOBS Act attempted to address some logistical issues. However, it did not supersede the Global Settlement. The JOBS Act also eliminated certain so-called quiet period restrictions on publication of research reports in offerings by emerging growth companies. However, the Act does little to address the business model questions that stymy the return of more vibrant research coverage. Perhaps, it would be worth stepping back and considering all of the components of the capital markets ecosystem, and finding ways, over time, to return balance to the banking/research system. Perhaps then, a broader array of promising companies may find research support.

For more of IFLR's 30th anniversary coverage see http://www.iflr.com/30th-anniversary

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