Currently, Australia has no specific legal or regulatory requirements for research analysts; however, regulation relating to research analysts and conflicts of interest relating to their work is developing. Under the Corporations Act, S912A (1), a financial services licensee must do all things necessary to ensure that the financial services covered by the licence are provided efficiently, honestly and fairly. Furthermore, there are a number of interconnected provisions which deal with false, misleading, and deceptive conduct in Part 10.2, Division 2 of Corporations Act 2001 (Corporations Act). These include:
Section 1041E(1) ‘A person must not (whether in this jurisdiction or elsewhere) make a statement, or disseminate information, if: (a) the statement or information is false in a material particular or is materially misleading; and (b) the statement or information is likely: (i) to induce persons in this jurisdiction to apply for financial products; or (ii) to induce persons in this jurisdiction to dispose of or acquire financial products; or (iii) to have the effect of increasing, reducing, maintaining or stabilising the price for trading in financial products on a financial market operated in this jurisdiction; and (c) when the person makes the statement, or disseminates the information: (i) the person does not care whether the statement or information is true or false; or (ii) the person knows, or ought reasonably to have known, that the statement or information is false in a material particular or is materially misleading.’
Section 1041F ‘(1)A person must not, in this jurisdiction, induce another person to deal in financial products: (a) by making or publishing a statement, promise or forecast if the person knows, or is reckless as to whether, the statement is misleading, false or deceptive; or (b) by a dishonest concealment of material facts; or (c) by recording or storing information that the person knows to be false or misleading in a material particular or materially misleading if: (i) the information is recorded or stored in, or by means of, a mechanical, electronic or other device; and (ii) when the information was so recorded or stored, the person had reasonable grounds for expecting that it would be available to the other person, or a class of persons that includes the other person.’
Section 1041G(1) ‘A person must not, in the course of carrying on a financial services business in this jurisdiction, engage in dishonest conduct in relation to a financial product or financial service.’
Section 1041H(1) ‘A person must not, in this jurisdiction, engage in conduct, in relation to a financial product or a financial service, that is misleading or deceptive or is likely to mislead or deceive.’
In order to address the recent international developments on research analysts and related conflicts of interest, in addition to the requirements of the Corporations Act, the Securities Institute of Australia (SIA) and the Securities and Derivatives Industry Association (SDIA) issued best practice guidelines for research analysts in November 20017. Following the lead of the SIA and the SDIA, The Australian Stock Exchange (ASX) and ASIC have begun investigations into the need for specific rules related to conflicts of interest. This paper now looks at what developments have occurred in Australia in terms of dealing with conflicts of interest.
In September 2002, the ASX began work on a new regulatory framework for research related conflicts of interest after they released a Draft Guidance Note that called for various restrictions on research reports issued by financial services firms. At the same time, the commonwealth government issued a policy paper suggesting that certain changes to the Corporations Act would be forthcoming in the areas of corporate disclosure and the management of conflicts of interest. Additionally, the government requested that ASIC prepare a Policy Statement regarding research related to conflicts of interest to complement their expected revisions to the Corporations Act. The introduction of these actions followed the US Securities and Exchange Commission (SEC) national inquiry that commenced in April 2002 into market practices and the efficacy of existing mechanisms. In February 2003, the ASX issued a revised Draft Guidance Note following extensive comments from market participants.
In the August 2003 ASIC surveillance report on research analyst independence, identified a number of concerns including: whether conflicts of interest were being adequately managed and whether current disclosure levels were adequate. Initial interviews, in early 2001, with a number of investment banks, found that a number of conflicts of interest existed but there was a degree of uncertainty about the extent to which the conflicts were impacting on retail consumers and market fairness. The report identified a number of problematic areas: (1) pressure from companies and institutional clients; (2) inadequate separation of investment banking from equities and research functions; (3) analysts’ remuneration; (4) analyst trading; (5) disclosure of conflicts of interest; and (6) research dissemination.
Following ASIC’s surveillance report, the Commonwealth Government published, October 8th 2003, a draft of the Exposure Draft Corporate Law Economic Reform Program (Audit Reform and Corporate Disclosure) Bill 2003 (Draft CLERP Bill)8. This Bill sought to amend the Corporations Act and impose an obligation on licensees to have adequate arrangements to manage conflicts of interest under s912A (1) (aa). Furthermore, the ASIC policy proposal paper, also released in October, entitled Licensing: Managing Conflicts of Interest offered specific guidance for providers of research reports. The key suggestions put forward by ASIC, were that for licensees to comply with the conflict provisions, it was imperative to disclose and avoid conflicts of interest. Moreover, they should have measures, processes and procedures to identify conflicts of interest; assess and evaluate those conflicts; appropriately respond to those conflicts; and ensure that, regardless of any conflicts, the quality of the financial services they provide is not significantly compromised.
Schedule two of the Licensing: Managing Conflicts of Interest paper offers guidance that is more detailed on ASIC’s expectations for research report providers, following their consideration of international and domestic developments. The ASIC proposals on analyst research reports cover:
Structure and general practices
Monitoring and supervision
Benefits and remuneration
Other steps to prevent inappropriate conduct
Other disclosure issues
On 30 August 2004, ASIC released the Policy Proposal Statement 181, Licensing: Managing conflicts of interest with the aim of ensuring that financial service licensees manage conflicts in a way that enhances consumer confidence, fairness, honesty, professionalism and market integrity. While the policy statement did not offer any additional guidance for research report providers above that provided in original policy proposal paper, it set out to reinforce three key mechanisms (1) controlling conflicts; (2) disclosing conflicts; and (3) avoiding conflicts to ensure the prior mentioned outcomes. This obligation came into effect on 1 January 2005.
4. International regulation of Research ANalysts
Undoubtedly, the regulation of research analysts has been most prolific in the United States of America, although there has been a resilient global effort. This came about because of a numerous serious allegations regarding the conduct of several investment banks and their employees. In particular, that Merrill Lynch tarnished its investment recommendations as a result of undisclosed conflicts of interest, namely that research analysts were acting as quasi-investment bankers for corporate issuers, regularly initiating, continuing, and/or manipulating research coverage with the intent of attracting and maintaining investment-banking clients. This meant that the research analysts became involved in producing misleading ratings/investment recommendations that were neither objective nor independent, as they professed to be.
For example, the research analyst would publicly tout stocks as ‘accumulate’ although they internally disparaged them as a ‘piece of shit’ and ‘such a piece of crap’. Even though Merrill Lynch policies reflected an understanding that a separation between the banking and research departments (‘Chinese Wall’) is critical for maintaining the integrity of recommendations, investigations revealed that their Chinese Wall had broken down. Contributing to the breakdown between the research and the investment department were revelations that investment-banking work determined analyst compensation.
During 1999, the SEC the United States Congress and the New York State Attorney-General began to examine research analysts’ conflicts of interest. Of primary concern in their investigation was that investors who rely on analyst recommendations might not know that favourable research coverage assists in the marketing of the analyst firm’s investment banking services, and that they might be unaware that analyst compensation may depend on the investment banking business they generate9.
In response to the investigations and the concerns about potential misconduct, the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) introduced detailed and prescriptive rules, dealing with operational practices and procedures, remuneration, disclosure obligations and trading restrictions to regulate the behaviour of analysts. Nevertheless, these rules are restricted to analysts that are members of the NYSE and NASD10. Concurrently, the largest trade association for the securities industry in the United States of America, the Securities Industry Association (SIA), convened a committee composing of the heads of research of the major investment banks to develop a set of ‘best practices’ for research analyst and investment banks. This set of ‘best practices’ subsequently has served as a template for regulatory authorities around the world.
During 2002, the New York Attorney General and a number of U.S. state and federal agencies reached an ‘in principle’ settlement of allegations against Bear Stearns & Co LLC, Credit Suisse First Boston Corp, Deutsche Bank, Goldman Sachs, J.P. Morgan Chase & Co, Lehman Brothers Inc, Merrill Lynch & Co Inc, Morgan Stanley, Salomon Smith Barney Inc and Warburg LLC. The provisions of the settlement included:
The firms will physically separate their research and investment banking departments to prevent the flow of information between the two groups
The firms’ senior management will determine the research department’s budget without input from investment banking and without regard to specific revenues derived from investment banking
Research analysts’ compensation may not be based, directly or indirectly, on investment banking revenues or input from investment banking personnel, and investment bankers will have no role in evaluating analysts’ job performance.
Research management will make all company-specific decisions to terminate coverage, and investment bankers will have no role in company specific coverage decisions.
Research analysts will be prohibited from participating in efforts to solicit investment-banking business, including pitches and roadshows. During the offering period for an investment banking transaction, research analysts may not participate in roadshows or other efforts to market the transaction.
The firms will create and enforce firewalls restricting interaction between investment banking and research except in specifically designated circumstances.
To ensure that individual investors get access to objective investment advice, the firms will be obligated to furnish independent research. For a five-year period, each of the firms will be required to contract with no fewer than three independent research firms that will make available independent research to the firm’s customers. An independent consultant for each firm will have the final authority to procure independent research.
To enable investor to evaluate and compare the performance of analysts, research analysts’ historical rating and price target forecasts publicly available.
The ten firms have collectively entered into a voluntary agreement restricting allocations of securities in hot IPOs – offering that begin trading at a premium – to certain company executives officers and directors, a practice known as ‘spinning’. This will promote fairness in the allocation of IPO shares and prevent firms from using these shares to attract investment-banking business.
In the United States of America, the CFA Institute11 (formerly the Association for Investment Management and Research (AIMR)), which is a non-profit professional association of 75,000 securities analysts, fund managers and other investment professional in 120 countries has also taken a hard line on research analyst conduct. In their draft Research Objectivity Standards for brokerage and sell-side research firms, they accepted the following SEC requirements:
Aligning analyst compensation to the quality of research and the accuracy of analyst recommendations over time;
Segregating research from investment banking in ways that ensure that investment banking does not influence research or the resulting recommendations;
Establishing rating systems that help investors assess the suitability of a security to their own unique circumstances and constraints, rather than taking a "one size fits all" approach that treats all investors alike; and
Fully disclose all conflicts of interest of both the analyst and the firm, especially whenever analysts discuss their research and recommendations in public settings.
Additionally the CFA Institute proposed the following practices and guidance for sell-side firms.
When discontinuing coverage, brokerage firms should issue a "final" research report and recommendation, explaining the reason for doing so, rather than quietly discontinuing coverage to avoid putting a negative rating on a stock.
Firms should prohibit research analysts from participating in marketing activities, including "road-shows," for corporate clients issuing new shares of stock.
Sell-side firms should adopt a "three-dimensional" rating system that communicates risk and a time horizon in addition to the "buy-hold-sell" recommendation itself.
Sell-side analysts who give media interviews or make other public appearances discussing their research recommendations should make the full research report available to the public at a reasonable price.
More recently in November 2004, the CFA Institute launched the CFA Centre for Market Integrity to continue their crusade on the key issues affect the integrity of capital markets around the world, including amongst others, ethical standards, research objectivity, market fairness, openness, transparency, competent, fair and efficient investment practice. The core guiding principle of the CFA Centre is that all market participants have an ethical responsibility to place the interests of investors first. Moreover, the CFA Institute will aim to enforce the obligations on all their charterholders.
In step with the SEC in the United States and ASIC in Australia, the Financial Services Authority (FSA) in the United Kingdom took a considerable interest in conduct of research analysts. Their interest resulted in the production of Consultation Paper 171 Conflicts of Interest: Investment Research and Issues of Securities (CP 171) following site visits and surveillance of investment banks. The FSA CP 171 proposed comprehensive rules regulating analyst conduct, including trading restrictions, restrictions on ownership of securities covered, conflicts disclosure, quiet periods around securities issues and controls on dissemination of research. They also suggested that it might be appropriate for analysts to be restricted from covering securities that they own. Their suggestions are almost identical to those made in the United States and Australia.
Additionally, to deal in part with research related conflicts of interest, the European Union established two directives and appointed a Forum Group on Research Analysts to examine the need for new regulations and/or best practices for research analysts in the European context.
At the international level, IOSCO commenced a Project Team, in early 2001, on Securities Analysts to examine how the securities regulator could address the conflicts of interest faced by sell-side research analysts. IOSCO Statement of Principles on Security Analyst Conflicts of Interest sought to deal with the standards of disclosure of conflicts of interest, limitation or management of such conflicts, reporting and compensation systems, elimination of outside influences and the integrity and competence of research analysts. Their development of high-level principles were proclaimed to be used as the basis for new regulations regarding research analysts and research related conflicts of interest in all IOSCO jurisdictions.
5. Conflicts of Interest and Research ANalysts
The ASIC surveillance report, in addition to similar international investigations, identified a number of problematic areas with respect to conflicts of interest with analysts and their investment research. In the following, this paper investigates each of these areas and offers arguments for increased regulation.
Inadequate separation of investment banking from equities and research functions
The importance of income from investment banking to the profitability of an investment bank has been critical to offset the decline in brokerage. Consequently, allegations have been made to the effect that investment firms pressured analysts to issue highly favourable research on current and prospective investment banking clients. There is no problem with research analysts releasing favourable research, so long as the company rightfully deserves it.
Furthermore, the trouble arose as analysts participated in ‘road shows’ and other marketing activities without conflicts being adequately or effectively managed or disclosed. The traditional approach for dealing with potential conflicts of interests is the erection of ‘firewalls’ or ‘Chinese walls’ which separate the two functions of investment banks: investment banking and investment research. Furthermore, it is critical that the investment bank instils a culture that facilitates and encourages independence and objectivity and protects their analyst from the pressure of their investment banking colleagues.
Critical to the success of separation of investment banking from the research function is independent reporting structures for personnel within the investment banking and research functions. Under no circumstance should investment-banking personnel have authority to approve, disapprove or make changes to research reports or recommendations. Furthermore, it would be appropriate for the investment bank to review their policies and procedures regularly to ascertain whether conflicts are minimised and disclosures are transparent.
Pressure from Companies and Institutional Clients
Research analysts do not only receive pressure from their firm’s investment-banking division to issue favourable investment research. It can come from the corporate issuers who are averse to downgrading of their company’s securities and additionally from institutional clients of the research and brokerage divisions (i.e. fund managers) who are also averse to downgrades of stocks that they hold in their portfolio. Furthermore, a 2001 Reuters survey12 found that 88 percent of U.S. research analysts feared company executives would ‘retaliate’ if they issued a negative recommendation. Retaliatory practices reported in the study included companies bringing legal suit against analysts personally and/or their firms seeking monetary damages for the economic effects of negative reports and recommendations. Even though not all companies engage in such behaviour, the discernment that a reprisal is possible is a realistic concern for analysts.
When analyst remuneration is determined by investment banking relationships, then it is evident that the research analysts have a motive to ensure that current or prospective investment banking clients receive supportive research. As a solution, analyst compensation should not be linked either directly or indirectly to investment banking relationships. This solution would minimise the pressures on research analysts to issue biased research and if the compensation plan is well structured it should reward research objectivity and the accuracy of the analyst’s research.
Disclosure of Conflicts of Interest
Transparency and disclosure are critical for investors to identify whether conflicts of interest may affect the research-analyst investment recommendations they receive. As mentioned previously the actions of the investment-banking department have played a role in determining investment recommendations. Thus, research analysts are encouraged to disclose the investment-banking relationships that their organisation has with the company they are covering, so that current or potential investors are alert to a potential bias. Additionally, the objectivity of investment research could result from the personal investments of research analysts (or their immediate families). Personal investments could adversely affect a research analyst’s ability to issue independent and objective research and recommendations.
The question is should a research analyst be allowed to hold investments in companies they follow? Most investment professionals would believe that research analysts should own the securities of the companies they follow and recommend as it displays their confidence and that it is their right. Although, there is nothing inherently unethical in research analysts owning stock in the companies they cover, the problem is whether the analyst can hold their clients’ interest foremost.
To ensure that analysts maintain their fiduciary duty to clients, investment firms should implement clear policies for personal investment and trading by research analysts. These policies should enforce disclosure of an analyst’s investments, and include a review and approval of procedures for research reports and recommendations. Effective policies and procedures should eliminate the potential for analysts to manipulate ratings and recommendations for their own benefit. Investment firms must regularly monitor their policies and employees to ensure compliance, and specifically disclose both firm policies and analyst personal investments to investors. Personal investments should be permitted although subject to constraints.
In recent times, sell-side research has increasingly become available to all investors, mainly through brokers, the media and the Internet. Previously, the predominant users of research were institutional investors. Institutional investors are aware of and understand the difficult conflicts of interest that affect research analysts and can factor this knowledge into the assessment of the quality and objectivity of research.
The typical investor is not ‘sophisticated’ and is unable to discern facts from opinions and reasonable judgements about the quality of any research as well the suitability of investment recommendations. Analyst research reports commonly are many pages in length however often they are reduced by brokers and the media to one-word ratings (i.e. ‘Buy’, ‘Hold’, ‘Sell’) or recommendations that do not provide sufficient information to justify buying and selling a security. Furthermore, research analysts should clearly disclose any conflicts of interests (such as conflicts stemming from personal or firm holdings or investment banking relationships) to journalists and make reasonable efforts to ensure that journalists make such disclosures public.
Rating systems are often criticised13 for being ambiguous and complicated. In addition, the differences between the rating systems of various investment banks can be significant and often confusing for the investing public. In response, either the investment firms should be required to explain their rating systems or alternatively it may be appropriate to establish standards to ensure that there are consistent rating systems. Nonetheless, another solution would be to abolish ratings system altogether and rely strictly on the content of the research report. However, with no ‘BUY’ or ‘SELL’ signals, it would be necessary to assume investors could interpret the content and import of financial research product. Furthermore, the tone of the research would have to remain objective such it does not offer recommendations intuitively. In this situation, the effects from conflicts of interests from investment banking relationships would be minimised.
6. Australian Investment Banks And Conflicts Of Interest
Following the U.S. scandals, Australian investments banks have receive heightened media attention regarding the potential conflicts of interests that stand between the research analyst recommendations and investment banking business. Ian Ramsey, Professor of Corporate Law and Director of the Centre of Corporate Law at Melbourne University, expressed the view that14 ‘There can be a real conflict between the financial imperatives, which is certainly driven by corporate finance and the ethics of independence…Chinese walls don’t always work and sometimes they’ve been found to be low and not sufficiently rigorous’. In the same article, Peter Morgan, the [now former] head of equities at Perpetual Funds Management, opines that there is a clear conflict of interest for analysts: ‘The fact that none of these analysts have any accountability for their calls in the first quarter of 2000 is a disgrace’
In response to the outrage of the media and the public about analyst conduct, a key objective of the research project reported in this paper was to investigate what major investment banks in Australia have done to address the new Corporate Law requirements following the Financial Services Reform Act and ASIC’s recommendations. For the purposes of this study, a number of investment banks operating in Australia (several of which had been part of the settlement with the New York Attorney General) were contacted, and questions put to their representatives about the issues of interest in the context of the research. An inspection was also made of publicly available documentation on the websites of these organisations.
The objective was to ascertain a policy statement or comments that address how the investment firm deals with conflicts of interests and analyst conduct and the secondly observe how they present their investment research and recommendations in light of concerns regarding its ambiguity. This task was relatively difficult, especially given the reticence of a number of the organisations to make available their policy statements on this issue. In all, eight organisations were contacted and the results of the review of their policies and research recommendations is set out below.
At Bank 1, the Executive Director Corporate Communications questioned the motive for requesting this information then said that ‘after checking with the relevant people that they were unable to assist with the request’. Furthermore, he said that while ‘Bank 1 has extensive and detailed policies governing every aspect of analyst conduct and behaviour, these policies are internal references and therefore cannot be distributed externally’. Nevertheless, on their website they detail their ‘Client First Policy’. Part of this policy is to ensure each of [their] client's best interests are upheld without compromise and that our investment recommendations are made with absolute objectivity.
In doing so, Bank 1 maintains several internal policies with which all employees must comply: First, ‘Client Focus’, the first obligation of every Bank 1 adviser is to understand each client's investment objectives. By understanding the goals of each client, they aim to make appropriate recommendations that help realise our client's goals. Second, ‘Sector Prohibition’, means that the research analysts (and members of their immediate families) are prohibited from transacting in shares in the sectors they research — the prohibition extends beyond the particular companies the analyst researches and is applied to the entire sector(s). These measures are imposed to avoid the possibility of conflicts of interest.
Third, ‘New Issues’, requires Bank 1 staff members to not receive preferential access to placements or company floats. Staff members are not allowed to apply for new issues until access has been made available to the general public. Last, ‘Staff Purchases’, requires each Bank 1 staff member who transacts in shares to have each transaction authorised by approved representatives of the firm. In addition, staff members who purchase shares are not permitted to sell the shares within three months of the date of purchase.
The form of the research recommendations published by Bank 1 is unique in the sense that the bank uses ratings definitions that are dependent on time period. For example, for short term investments, they use Underperform (UP) (Stock is expected to underperform the S&P/ASX 200 on a 0-6 month timeframe), Marketperform (MP), Stock is expected to perform in line with the S&P/ASX 200 on a 0-6 month timeframe and Outperform (OP) Stock is expected to outperform the S&P/ASX 200 on a 0-6 month timeframe and for long term investments they use Sell (S) (Stock is expected to underperform the S&P/ASX 200 for beyond 6 months), Hold (H), (Stock is expected to perform in line with the S&P/ASX 200 for beyond 6 months) and Buy (B), (Stock is expected to outperform the S&P/ASX 200 for beyond 6 months). No specific policy addressing conflicts of interest policy could be found.
Bank 2 was also uncooperative in providing information about their policy for dealing with conflicts of interest. However, an email from one of their compliance officers contained the following disclosure:
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