8/10/2019 Who Should Pay for Independent Research

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Who Should Pay For Independent Research?

The crisis of the conflicts of interest faced by research analysts came to the notice of the outsideworld last year when Merrill Lynch decided to pay a fine of $100m to the attorney-general of NewYork State and others. The accusations stemmed from the incriminating e-mails that revealedanalysts privately ridiculing certain stocks as "dogs" while publicly commending their virtues intheir research reports. Of late, information has come to light that Jack Grubman, Citibank's staranalyst, released positive research so as to persuade his chief executive to lend him a hand ingaining admission to pre-school for his kids.

Conflicts of interest pervade investment banking, mainly because investment bankers andresearch analysts stay under the same corporate ceiling. Fresh revelations imply that for yearsanalysts' research has been influenced by demands to give out positive research to drawinvestment banking and underwriting business. Understandably, retail investors consider thesepast practices to be despicable and have been outrage. Unfortunately, they have now comearound to the outlook that Wall Street has manipulated the system against them.

In October, the Securities and Exchange Commission, along with state authorities and stockexchanges, declared a combined effort to harmonize investigations into the conflicts of interestsfaced by analysts and to arrive at a wide-ranging resolution with 12 investment banks.Irrespective of the results of this effort, the SEC may need to contemplate if new regulationswould assist in creating an enduring, industry-wide answer. However, we must decide first howimperative it is to have more extensively accessible "independent" research.

If you do not think that more impartial research is required, you presumably will support aresolution that leaves it more-or-less in the same state as it is today, with the supplementarydefenses directed under the Sarbanes-Oxley Act and now planned by the exchanges. The newsystem will entail analysts to confirm the honesty of their research and will preclude them frombeing remunerated for drawing underwriting and other investment banking business for theiremployers.

Many also espouse an extra obligation that all sell-side research should be clearly andprominently labeled as " promotion materials ". Supporters of this status quo style contend that thisis enough to protect investors. Others maintain that no set of policies or firewalls will ever get ridof the facade that analysts will favor the investment bank's clients. They think it would behealthier to ensure that independent research is done outside the banks.

This method raises two primary questions:

Who, eventually, will have to shell out money for the impartial research? Who will choose the research sources?

One remedy would be to compel all listed stocks to be evaluated by an impartial analyst. Themeaning of " impartial " would be defined by the SEC and implemented by the stock exchanges.

Under this proposal, independent research would be financed by the exchanges, which wouldpass on these expenses to the issuers of stocks as a component of their listing fees. Since theissuers are gaining from access to the capital markets, it is fitting that they should bear the costs.In due course, the investment banks may split these costs through reduced underwriting andother investment banking charges in return for the issuers business.

Any income from an arrangement with the investment banks could sponsor the costs of this typeof "external " remedy for a period - say, for three years - after which the issuers would becompletely responsible for them, through their exchange listing fees.

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An "external " remedy along this outline would not differentiate among exchanges since thesystem would pertain to all of them. In an ideal world, the exchanges would vie to provide thehighest quality research. Thought also would have to be given to if autonomous research wouldbe offered to smaller companies not on national exchanges or a part of the national marketstructure.

If the SEC decides to seek an enduring, market-wide solution through new regulations, it wouldbe wise to contemplate this " external " solution. There is a lot to be gained from eradicatingpossible conflicts of interest in a manner that reinstates trustworthiness among small retailinvestors.

Aayamtathaghat Banerjee