Remarks at the SIA Research and Regulation Conference
President, NASD Regulation, Inc.
Sheraton New York Hotel & Towers
New York City
Thank you so much. It's a pleasure to be here. Having reviewed today's agenda, I can see that you are in for an excellent conference, with distinguished panelists from the securities industry, the SEC and the SROs. I'm delighted to have the opportunity to present the opening remarks for this program.
Today's conference is entitled, "Research and Regulation: Analyst Objectivity and Related Issues." Given the events of the past year, this conference could not be more timely or relevant to what is happening in our industry.
How Did We Get Here?
Before I discuss the recent NASD rule proposal on analyst conflicts, it is useful to ask, "How did we get here?"
Not long ago, most Americans had any idea what a securities analyst was, much less who populated the profession. Securities analysts mostly toiled in relative obscurity, known only to their clients, which consisted principally of institutional investors. Analysts had the job of researching companies to determine which ones offered the most promising investment opportunities for their firm's clients.
In those "good old days," industrial companies were taken public. These were coal companies or utilities, consumer products or manufacturing enterprises with an earnings history and an established name and reputation. In the '80s, however, dramatically more high-tech and other entrepreneurial enterprises were brought to the public markets. These were companies that engaged in specialized businesses, often with little earnings history or reputation. Investment bankers had to increasingly rely upon research analysts who followed those sectors to evaluate these start-up companies.
As analysts became more involved in the investment banking process, they also became more involved in marketing their firms' products and services through "road shows" and other sales events. They faced an increasingly dangerous conflict, between their loyalty to the investment banking department and their responsibilities to the public investor. The need to support their investment banking clients created conflicts of interest that had the potential to interfere with the objectivity and accuracy of their research.
The next stage in this history was the rise of the analyst as celebrity. With the dot-com boom of the late 1990s and the simultaneous increase in the popularity of cable financial networks, previously unknown securities analysts entered America's living rooms and became overnight stars. Some analysts became hotly sought-after guests on financial news shows, and millions of investors hung on their every word. A good word about a supposedly hot stock could send its price soaring upward. Similarly, a downgrade in a rating or price target-rare as they might have been in the 1990's-could substantially deflate a stock's price.
These analyst forecasts often became self-fulfilling prophecies. If a well-known analyst reported a stock was a good buy, it often became a good buy, at least in the short term. The analyst's remarks could influence the market almost completely without regard to the actual condition or prospects of the issuer.
Instead of doing their homework, some retail investors concluded that if their favorite analyst said a stock was a strong buy, that was all they needed to know. Buy the stock, sit back, and let the riches pour in. Notwithstanding a century of cyclical returns in the stock market, some believed that in the "new economy," financial losses were a thing of the past.
This kind of thinking started to come to an end, of course, as stock prices began falling in early 2000. Many growth stocks, particularly those in the technology sector, fell tremendously, and the word "over-valued" was heard repeatedly. Suddenly, retail investors began to ask, "How could I be losing money on my investments when four out of the six analysts who covered this stock rated it a strong buy!"
Retail investors who worshiped securities analysts as heroes suddenly viewed them as less than heroic, and in some cases, even villainous. They blamed the analysts for their losses. Media articles soon described research analysts, particularly those that worked for large securities firms, as nothing more than cheerleaders for investment banking clients. The bloom was off the vine.
In the late 1990's, the NASD began to examine whether our existing rules were adequate, and whether investors received sufficient disclosure regarding the potential conflicts of interest that can arise when a research analyst recommends a particular stock. The SIA issued its own best practices for securities firms and their research analysts. Intense Congressional interest developed in the issues surrounding analyst behavior. In examining these issues, their focus centered on whether new legislation was needed to address these problems. Many in Congress felt that it was-and some still do.
Initially we felt that any proposed rule that imposed new requirements on broker/dealers should be accompanied by similar requirements on investment advisers. However, we ultimately concluded that our industry had to take the lead on this issue. Accordingly, in July 2001, we issued a rule proposal that would require many new disclosures by research analysts that recommend securities in reports or public appearances.
Our proposal touched a hot button: we received over 850 comments to this proposal, many from retail investors-more than any other rule proposal in the NASD's history. Although some members of the securities industry had qualms about particular provisions of our proposal, the comments largely supported our efforts. Many of the most supportive letters came from rank-and-file securities representatives who rely on securities research reports to guide their retail clients.
The seminal event had yet to occur: Enron. The largest bankruptcy in our nation's history took on a life of its own, and securities analysts were viewed as contributors to this debacle because they had maintained strong buy ratings for Enron's stock. Suddenly, analysts were called before Congress to explain why they did not either foresee or report on this disaster. Despite the likely fact that analysts were mislead about Enron, as they testified, the public and Congress remain skeptical and believe that they were acting as little more than cheerleaders because of entangling relationships between their firms and Enron.
The Analyst Profession Today
After all this, where is the analyst profession today? Despite all the bad press that our industry has received, it is still the greatest capital raising mechanism in the world, and is largely responsible for our nation's prosperity and success. Securities analysts have contributed to that success, and deserve some credit for helping drive our nation's financial engine.
Even with this success, some things clearly need fixing. And it is more than just an image problem. I think all of us recognize that conflicts in fact do exist, and changes need to be made.
I applaud the SIA for issuing its best practices last year, well before the Enron debacle had occurred. I encourage the industry to follow them. Nevertheless, it is clear that voluntary standards are not enough. With voluntary standards alone, the good guys in our industry would continue to do the right thing, while some would continue to besmirch the whole industry's reputation. Moreover, Congress and the SEC would consider the lack of mandatory standards to represent a failure in securities self-regulation. After all, the essence of self-regulation is finding and fixing our problems before the government is forced to do it for us. So, while we will carefully consider all of the comment letters-and we expect many to raise very difficult operational and other issues-you need to understand that within Washington and really throughout the country, as I can attest from our town hall meetings, there is little sympathy for the burdens these new rules will place on our industry.
Mandatory standards must improve the information that investors receive regarding securities recommendations, and must bring about reforms that change the public's perception of the sell-side analyst culture. Not only must there be more disclosure so that investors can properly evaluate the information that they receive from research analysts. We also need corporate change to ensure that an analyst remains objective and is not swayed by improper influences.
Our goal is to address the conflicts that research analysts face in a forthright and effective manner in order to restore investor confidence in the objectivity and value of securities research. This goal has driven the comprehensive proposal that we filed with the SEC on February 8th. I am proud of our efforts in this area, particularly in how Congress, the SEC, the SROs and the industry have worked together in seeking a common goal of a stronger, more objective securities research analyst profession.
Highlights of the Analyst Conflicts Proposal
Today's panels will discuss the NASD and NYSE analyst proposals in great detail, and so I don't want to spend too much time talking about our proposal. Nevertheless, I did want to highlight some of its provisions.
The industry has received a great deal of criticism that research analysts lack independence because they are beholden to their firm's investment bankers. If we are to restore the public's trust in the securities markets, both the industry and the public's perception of the industry must change. This is a very comprehensive set of reforms and each provision was designed to address specific and real problems. We haven't eliminated all conflicts in what the NYSE and we have proposed. Indeed, even a Glass-Steagall type separation of investment banking and research would not do that, because analysts can also be conflicted in their relationships with investors, especially large institutions. In most instances, we have sought to use disclosure of the conflicts as our remedy. But in some areas, where the conflicts pervade the situation, even full disclosure is not enough and outright prohibitions are called for.
Accordingly, our proposal would not allow research analysts to be subject to the supervision or control of a firm's investment banking department. We also would limit the extent to which an investment banking department or an issuer could review a research report and the purpose of such a review. An analyst can provide objective advice to investors only if his firm's corporate structure allows him to maintain his independence. These gatekeeper provisions inject new process and place a burden on the legal and compliance department of firms. One of the criticisms I have heard since we released our proposal is that these rules will "change the way firms work". Yes, exactly.
Analysts also have taken a lot of heat for trading in the stocks that they cover. Stories have emerged of analysts giving securities they cover a "booster shot" to increase share prices, and then selling their holdings at a tidy profit. Analysts also have been accused of trading against their recommendations, such as selling shares of a stock to which the analyst has assigned a "strong buy" rating.
Many members of the industry already prohibit their research analysts from owning stock in the companies they cover. We applaud these actions. Nevertheless, we determined to address the personal trading conflicts in a less restrictive manner, by imposing blackouts and other measures.
Because analysts may in the future recommend the securities of other companies in the sectors that they cover, we believe that other trading restrictions are necessary to prevent future conflicts of interest. Accordingly, our proposal would ban analysts from purchasing "cheap," pre-IPO shares of companies in the industries they cover. We also would prohibit analysts from trading against their recommendations.
As every securities lawyer and compliance officer knows, sunlight is the best disinfectant. For this reason, we would require more disclosure regarding compensation and investment banking activities. A firm would have to disclose holdings of one percent of any class of an issuer's equity securities and an analyst would have to disclose any financial interest in the issuer's securities.
Analysts also would have to disclose if their compensation is based in part on the firm's investment banking revenues. A firm would have to disclose if it or its affiliates received any compensation from the issuer within the last 12 months, or expected to receive compensation in the next three months following publication of a research report or a public appearance. We recognize the important issues and concerns with the potential for signaling non-public information through this forward-looking disclosure. We will work through the comments we have received on this issue with great care. But the essence of this disclosure is so important-that investment banks have or will receive compensation from the issuer. While it is hard for many of us in this room to imagine, it is absolutely clear that many investors simply did not understand this reality.
Our proposal also would require firms to break down the percentages of ratings assigned to particular securities. While there may be good reasons why a firm has assigned a buy or strong buy to 80 percent of the companies it covers, investors have a right to know this information. It suggests a bias in the firm's coverage that investors should take into account in evaluating ratings. They also have a right to know what percentage of companies in each ratings category are investment-banking clients of the firm. Our proposal would require firms to disclose this information.
The proposed price chart also should help investors follow a firm's track record on a particular stock. Research reports would be required to be accompanied by a chart showing the changes in a stock's price over time and indicating the points at which the firm assigned or changed a rating or price target for the stock. Such disclosure allows an investor to develop of a pretty good sense of the analyst's track record.
These proposed rules are tough-we understand that. They are not perfect-we understand that, too. But it is clear that a response to these issues is overdue.
Thank you all for your attention. I look forward to working with each of you on this and future initiatives.