Wall Street Research: Will New Rules Change Its Usefulness?

Differences in how retail and institutional investors use analyst research cloud the future usefulness of recent reforms. Virtually anyone with an opinion on the controversies surrounding Wall Street analysts has chimed in with criticisms, complaints, and anecdotes about analyst conflicts and misjudgments. And not without cause. Clearly, two decades of ebullient bull markets leading up to the year 2000 highs created “opportunities” for sell-side analysts and their firms to engage in questionable and objectionable behavior.The clamor about analyst lack of objectivity has resulted in a number of changes. The U.S. Congress held hearings in the summer of 2001, Merrill Lynch and Company agreed in a $100 million settlement with the state of New York to make changes in the monitoring and compensation of its analysts, and by the summer of 2002, the U.S. SEC had approved new NASD and NYSE rules for sell-side analysts. These rules mandate the separation of research and investment banking; prohibit the compensation of analysts from specific investment banking deals; prohibit the managers of a company covered in an analyst's report from reviewing, approving, or changing the sell-side analyst's final judgments; prohibit banks from offering favorable research to companies in exchange for investment banking business; and require increased disclosures in such areas as analysts' personal trading positions. In addition, a $1.4 billion “global research settlement” has been reached between the SEC, the New York attorney general, and the largest U.S. investment firms to resolve issues of conflict of interest, produce reform in the industry, and shore up the integrity of equity research.Many of the new requirements are clear attempts to disclose and potentially remove biases associated with the capital-raising pressures on analysts. Other changes are intended to educate retail investors. Will the recent efforts to “fix” sell-side research make investors better off in the long run? What value does Wall Street research have for investors—retail and institutional—and how will that value change in the future?Retail investors and institutional investors use analyst reports differently. Retail investors are prone to rely on the level of a recommendation, whereas institutional investors are likely to focus on the direction of change relative to the analyst's previous recommendation.We discuss how, in light of the differences in these perspectives, the rule changes and negotiated settlements will affect sell-side research in the future. We conclude as follows:The cost of research is likely to rise. A bundled service, such as investment research, which is usually paid for through trading commissions, is not really a free good. If the cost of research is unbundled, the price must be paid in the form of either increased trading or higher fees.The scope of research is likely to narrow. Brokerage firms have already been announcing cuts in their research departments, reductions in the number of staff analysts, and discontinuations of coverage of some companies and industries.Bias may not decrease. One source of strong pressure for “optimism bias” in analyst recommendations is the need to keep access to the managers of the companies they cover. Whether this pressure will be reduced by the rule changes is unclear. In addition, if allowed, brokerage firms could choose to fund the most positively biased independent research firms.The cost of issuing IPOs could rise on average while the quality of IPOs declines. The elimination of sell-side analysts from the IPO process could result in more unprofitable deals reaching the market and greater uncertainty in expected returns from IPOs in general, creating a classic “lemons” problem.The quality of analyst research may not improve, on average, because of reduction in the funding of research.In summary, institutional investors will continue to be in a better position than retail investors to observe and understand the subtleties of sell-side research. Although partly designed to improve the lot of retail investors, the new rules and settlements are not likely to render them better able to compete against institutional investors when attempting to use Wall Street research.