The Global Settlement of Research Conflicts of Interest-Back to the Future for the Research Analyst

In late April 2003, 10 Wall Street firms, the SEC, NYSE, NASD and state securities regulators announced a long-awaited settlement of enforcement actions surrounding allegedly abusive research practices that had emerged in the '90s. The settlement addresses only government enforcement actions and not private litigation. Along with the settlement, regulators released a large quantity of supporting documents that could be used in private actions against the settling defendants. The settlement is intended to return the research analyst to his pre-Bubble role of full-time company analysis and away from pitchman for investment banking business.

The settlement was preliminarily reached in December 2002, but negotiations over its terms became protracted by concerns over contingent liabilities that might arise out of private litigation. The brokerage firms collectively will pay $387.5 million in disgorgement, $487.5 million in penalties and $432.5 million to fund independent research. An additional $80.0 million is earmarked for investor education. Two high profile research analysts, Henry Blodgett and Jack Grubman, were named individually and subjected to almost $20 million in fines. The settlement is still under court review and is not yet final.

Among the evidence released were indications that analysts published biased research in order to curry lucrative investment banking business from companies they follow, or promised to follow, favorably. Further, brokerage firms allegedly used the threat of termination of research as a means to hold on to investment banking business. These questionable practices were the product of a system, which had become well established, that compensated research analysts for their role in winning investment banking business rather than publishing accurate research, allowed investment bankers to supervise and participate in compensation decisions concerning research analysts and generally made the research analysts the centerpiece of a brokerage firm's capital markets relationship with its public company clients.

Certain firms were also alleged to have improperly engaged in "spinning." Spinning involves the allocation of hot issues to executives of existing or prospective investment banking clients in order to win investment banking business. The SROs proposed rules in October 2002 barring spinning.

To combat these problem behaviors, the settlement imposes requirements on the settling defendants relating to:

• internal and external reporting and compliance;
• analyst compensation;
• research and investment banking interaction; and
• investor disclosure.

Internal and External Reporting and Compliance

• Research and investment banking must report through entirely separate lines within the firm. Research may not report to any person having direct responsibility for investment banking.
• Research must have its own dedicated legal and compliance staff.
• Research and investment banking will be physically separate.
• The firm's budget for research must be set without regard to specific revenues or results derived from investment banking.
• An oversight committee comprised of research personnel is required to review changes on ratings and price targets, conduct periodic reviews of research reports to determine the need for changes in ratings or price targets, and monitor the overall quality and accuracy of research.
• The firm must adopt policies and procedures reasonably designed to ensure its personnel do not unduly influence research and report attempts by others to do so.
• Firms will be required to retain an independent monitor to review implementation and effectiveness of firm policies regarding compliance, to follow recommendations made, and in five years to certify compliance with the terms of the settlement.

Analyst Compensation

• Compensation of analysts must be determined exclusively by research management and senior management.
• Investment banking must have no input in compensation decisions concerning or evaluation of analysts.
• Compensation may not be based on investment banking revenues.
• Compensation must be based in principal part on quantifiable measures of quality and accuracy of research.
• Compensation criteria must be set in writing in advance and the basis for decisions must be documented.
• Annually, a properly constituted compensation committee must review the compensation process for research.

Research and Investment Banking Interaction

• Investment banking will have no input into company specific coverage decisions and investment banking revenues will not be considered in such decisions.
• Except as set forth below, all business communication between research and investment banking personnel is prohibited:
  • Through research management or a chaperoned communication with research personnel, investment banking may solicit views about the merits of a proposed transaction, or market or industry trends or developments. Likewise, research may initiate communications regarding market and industry trends or developments.
  • Research may participate in commitment committee deliberations regarding a proposed transaction and in the presence of investment banking, but research must have an opportunity to express their views to the committee outside the presence of investment banking personnel.
  • Research may confirm the adequacy of disclosure in an offering document, but to the extent communicated to investment banking, it must be through underwriters' counsel or a compliance chaperone.
  • After receiving an investment banking mandate, research may communicate views on structuring and pricing to personnel in the firm's equity capital markets group and provide other information obtained from investing customers relevant to pricing and structuring.
  • Joint attendance at widely attended conferences is permitted for investment banking and research, whether for clients or for internal purposes, provided all other prohibitions are observed.
  • Research may not participate in efforts to solicit investment banking business.
  • Research may not participate in offering or similar road shows, and investment banking may not direct research personnel to engage in marketing or selling efforts to investors.

• The first page of a research report must
  • disclose the firm's interest in doing business with a subject company and the possibility that may affect the firm's objectivity;
  • the availability of third party research; and
  • the report is only a single factor in making an investment decision
• The firm will make available on a quarterly basis via its website selected published research data.
• Upon termination of coverage, research must publish a final report disclosing the termination of coverage and its rationale for termination.

Other Matters Covered by the Settlement

Third party research. For five years, defendant firms must contract to provide customers reports from no fewer than three other independent research firms, although not each subject company covered by the firm must be covered by independent research. Third party research firms are to be selected by an independent consultant acceptable to regulators. Certain other requirements apply to assure investors are advised of the availability of third party research.

Spinning. The settlement bars allocation of securities in a hot IPO to an executive or director of a U.S. public company or a public company for which a U.S. market is the principal equity trading market. If there have been such allocations in the past, the firm is required to notify its client company of such fact prior to acting as a managing underwriter. Investment banking is barred from having any input in allocation decisions to individual investors. In general, allocations can not be made in exchange for investment banking business.

SRO/SEC Rules. The SROs have proposed rules regarding similar topics. The SEC may also propose additional rules relating to research and spinning pursuant to Sarbanes-Oxley. These rules will have marketwide application and will expressly supersede the settlement.

Looking Forward

We can expect firms not subject to the settlement to give careful consideration to this new paradigm for research and investment banking. Private litigation, which has already begun against the settling defendants, will accelerate this trend. The NASD has said it expects 3,000 to 4,000 arbitration claims as a result of the settlement. There will be a period of difficult adjustment as research, investment banking and issuers understand and accept the changes swept in by the settlement terms.

The settlement is a first step in a broader effort to revamp the IPO process. The NASD and NYSE have proposed rules dealing with spinning and other questionable IPO practices. A blue ribbon committee established by the SEC and the SROs recently published 20 recommendations for improving the IPO process.

Regulators have also signaled that their probe will extend to supervisors and executives. In late May, the SEC sent subpoenas to the chief executives of Goldman Sachs, Citigroup and other firms to produce documents concerning supervision of securities analysts. Regulators have said they are considering criminal actions against bankers and analysts as well.

While not yet final, the settlement is already generating interpretive questions. For example, whether any role remains for an analyst in the road show process is unclear. Does prohibited road show "participation" include an analyst responding to institutional investor calls about an issuer made during the road show period? To date, firms have gone different directions on this. A form of road show participation that seems clearly improper is Bear Stearns' recent circulation of a prerecorded net road show for iPayment in which a top Bear Stearns computer services industry analyst called it "his pleasure" to introduce three top executives of iPayment and said the company was a smart investment.

What about giving out orally the analyst's future revenue and earnings estimates for the IPO issuer? The practice is often touted as essential to the willingness of investors to participate in a new issue. Does it matter whether the analyst does it in response to an investor call or an investment banker delivers it during a road show?

These and other issues will undoubtedly vex investment bankers, issuers and institutional investors as the pace of offering activity picks up.