Preserving Market Integrity

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Analyst Certification: The views expressed in this research accurately reflect the personal views of the analyst(s) about the subject securities or issuers and no part of the compensation of the analyst(s) was, is, or will be directly or indirectly related to the inclusion of specific recommendations or views in this research. The analyst principally responsible for the preparation of this research receives compensation based on overall revenues, including investment banking revenues, of Bank 2 and its wholly owned subsidiaries (“the Bank 2 group”) and has taken reasonable care to achieve and maintain independence and objectivity in making any recommendations.
An analysis of this disclosure statement reveals that there is the potential for conflicts of interest to influence analyst reports. The fact that analysts responsible for the preparation of research receive compensation-based investment banking revenues of Bank 2 provides a clear incentive for all analysts within the bank to provide favourable research and subsequently maximise investment banking revenues and their compensation.
Following the scandals in the U.S. and worldwide public concern regarding the analyst research, it appears that Macquarie Bank has decided to changed their recommendation definitions which were previously, sell, hold and buy to underperform (return >5% in excess of benchmark return), neutral (return within 5% of benchmark return) and outperform (return >5% below benchmark return), respectively. Additionally, Bank 2, since 2002, has started to include information about the risk of the particular stock for which they have released recommendations. The risk of individual stocks is now measured by Bank 2 using a ‘Volatility Index’ with five definition classifications that have been calculated from the volatility of historic price movements: Very High - Highest Risk, where the stock should be expected to move up or down 60-100% in a year. Investors should be aware that this stock could be highly speculative. High Risk, where the stock should be expected to move up or down at least 40-60% in a year. Investors should be aware that this stock could be speculative, Medium Risk, where the stock should be expected to move up or down at least 30-40% in a year, Low/Medium Risk, where the stock should be expected to move up or down at least 25-30% in a year. Low Risk, where the stock should be expected to move up or down at least 15-25% in a year.
At Bank 3, the Director of Compliance contended that he would not provide any information about how they deal with conflicts of interests within his firm. However, the in discussion with the researcher, the director highlighted the intense scrutiny the media has ‘unfairly’ put on investment banks in Australia. He stated that the events that occurred in the United States were definitely not replicated in Australia. Australia, he claimed, does not have the same tight knit investment banks, where the investment banking division and research analysts work together in promoting deals.
Furthermore, he mentioned an internal paper that he had written attacking the myth of bias in investment banking research. He said that his paper argued that preponderance of ‘buy’ over ‘sell’ recommendations is due to the larger appeal of ‘buy’ recommendations than ‘sell’ recommendations and that investors prefer to see ‘buys’. Moreover, the audience of a ‘sell’ recommendation is limited to those who already hold the stock or may wish to short-sell the stock as opposed to a ‘buy’ which every investor can potentially act upon. Also as a result of limited resources investment banks prefer to look for buy recommendations which they can provide their clients and that research analysts are interested in covering.
Upon queering the reasons as to why research analysts continue to promote stocks as ‘buys’ even though there was public criticism of their recommendations, the Director of Compliance responded that ‘market exuberance’ or the ‘tech boom’ was almost non-existent in the Australia during the 1990s and 2000. In support of the research analysts’ failure to predict the market reversal, he said that financial analysis is not a science and that predictions are not perfect. Moreover, he stated that generally research analysts are independent, comprehensive and objective in the production of research and that ASIC’s recent efforts to regulate the investment banking industry was publicly excessively strict even though privately they had been in support of the investment banks conduct in dealing with conflicts of interest over the last 5 years. Lastly, all attempts to source Bank 3’s policy regarding their issuance of investment recommendations were unsuccessful.
On the international website (which serves as the homepage for the Australian branch) for Bank 4, a highly detailed six-page document entitled ‘Managing Conflicts of Interest’ appears. This document clearly presents the Bank 4 policies for managing conflicts of interest in connection with investment research. In summary, the document concerns: (1) Investment Research; (2) Integrity; (3) Identification of Conflicts; (4) Supervision and Remuneration of Analysts; (5) Analysts’ Activities; (6) Inducements and Inappropriate Influences; (7) Method and Timing of Publication; (8) Disclosure of Interests and Personal Account Dealing.
The policy states that Bank 4 will only publish investment research that is impartial, independent, clear, fair and not misleading. Their analysts are required to ensure that they have a reasonable basis for their analysis and recommendations. Bank 4 analysts are restricted from roles that could prejudice, or appear to prejudice the independence of their research or conflict with their duties to the recipients of their research, but are otherwise free to use their expertise for the benefit of Bank 4’s clients.
Bank 4’s policy on managing conflicts of interests required that research reports contain disclosures as required by various legal and regulatory requirements. Such as:

    • An explanation of the rating system used by Bank 4;

    • Whether Bank 4 holds 1% or more of the securities of companies referred to in research reports;

    • Whether Bank 4 acts as a market maker in the securities of companies referred to in research reports;

    • Information regarding any directorships or other material relationships of individual officers of Bank 4 with companies referred to in research reports;

    • Any personal interest of the analyst or close relations of the analyst in securities of companies referred to in research reports;

    • Past significant relationships of Bank 4 with companies referred to in research reports, including investment banking or other advisory assignments or relationships; and

    • Subject to legal and confidentiality constraints on disclosure, current or perspective relationships between Bank 4 and companies referred to in research reports, or the fact that such relationship may exist.

In a similar vein the practice of Bank 4, Bank 5 publishes a ‘Code of Business Conduct and Ethics of the UBS Group’ which specifies the policies and practices that are expected, such as standards of fairness, honesty and integrity. Additionally, their Code of Business Conduct specifies that the firm is required to disclose information fully, fairly, accurately, timely and understandably in reports and documents.

At Bank 6 all that could be found were their latest definitions for their rating system: Overweight - Over the next six to twelve months, we expect this stock will outperform the average total return of the stocks in the analyst's (or the analyst's team's) coverage universe. Neutral - Over the next six to twelve months, we expect this stock will perform in line with the average total return of the stocks in the analyst's (or the analyst's team's) coverage universe. Underweight - Over the next six to twelve months, we expect this stock will underperform the average total return of the stocks in the analyst's (or the analyst's team's) coverage universe. Bank 6’s decision has also been to move away from the buy, hold and sell recommendations that caused so much controversy.
Intriguingly, at Bank 7 the current rating system still resembles that which other investment banks have attempted to do away with, namely, the Buy, Hold and Sell categories. While prior to September 9, 2002 Bank 7 had Strong Buy, Buy, Market Perform, Under Perform, Not Rated, Suspended Ratings classifications their more recent rating are as follows: Buy - Total return expected to appreciate 10% or more over a 12-month period, Hold - Total return expected to be between 10% to -10% over a 12-month period, Sell - Total return expected to be between 10% to -10% over a 12-month period, Not Rated - There is no investment rating and target price for this security, and Suspended - The investment rating and price target, if any, for this security, have been suspended. The previous investment rating and price target, if any, are no longer in effect for this security and should not be relied upon.
Consistent with the majority of the investment banks that operate in Australia, Bank 8 failed to provide any information on their research analyst policy. However, on their website they state that they maintain the highest professional standards and principles in publishing research and to ensure that all our clients are fully informed, Bank 8 has established a special website that contains important disclosures relating to its research on companies. Additionally, stock recommendations at Bank 8 include a risk rating and an investment rating. First, the Risk rating, takes into account both price volatility and fundamental criteria, are: Low (L), Medium (M), High (H), and Speculative (S). Investment ratings - Buy (1), Hold (2), and Sell (3) - are based upon Bank 8's expectation of total return (price appreciation plus forecast dividend yield) within the next 12 months, and take into account the risk rating and second the investment rating represents the opinion of the analyst and thus should not be construed as guarantees of quality and/or performance.
Furthermore, for securities in developed markets (US, UK, Europe, Japan, and Australia/New Zealand), their investment ratings are: Buy [1] (expected total return of 10% or more for Low Risk stocks, 15% or more for Medium Risk stocks, 20% or more for High Risk stocks, and 35% or more for Speculative stocks); Hold [2] (0% 10% for Low Risk stocks, 0% 15% for Medium Risk stocks, 0% 20% for High Risk stocks, and 0% 35% for Speculative stocks); and Sell [3] (negative total return).
Bank 8 also adds that Investment ratings are determined by the ranges described above at the time of initiation of coverage, a change in risk rating, or a change in target price. At other times, the expected total returns may fall outside of these ranges because of price movement and/or volatility. Such interim deviations from specified ranges will be permitted but will become subject to review by research management. Lastly, Bank 8, consistent with all banks reviewed, alerts its clients that their decision to buy or sell a security should be based upon your personal investment objectives and should be made only after evaluating the stock's expected performance and risk.

A comprehensive stock rating system introduced by Bank 8 on September 12, 2003 aims to differentiate their research and demonstrate their commitment to providing research of the highest quality. Moreover, the new methodology is more rigorous and robust, also aims to expose the underlying components of the rating within the research. This transparency hopefully will allow the investor to quickly assess the various risks and expected returns that go into the rating and apply these factors to your own investment criteria.

The rating system is a significant departure from its predecessor where stocks were rated on a relative basis. This means that stocks will no longer be rated relative to others in their industry or to the analyst's universe of coverage. In contrast, the rating system will be absolute in nature. Investment ratings are determined based on expected total return and risk rating. Ratings are independent of relative performance to other stocks.

In addition to an improved rating system, Bank 8 has also constructed a ‘Conflicts Policy – Equity Investment Research’ paper addressing their policies in relation to the ‘Identification of Conflicts’, ‘Structural Separation’, ‘Supervision and Remuneration of Equity Analysts’, ‘Involvement of analysts in other activities’, ‘Avoiding Inappropriate Influences’, ‘Means and Timing of Publication’ and ‘Disclosures’. In light of this, Bank 8 could be argued to have established a benchmark for all Australian investment banks to follow to ensure that investment research and recommendations are unbiased and independent and that clients are aware of their companies’ policies for dealing with conflicts of interests.

In summary, the failure of a number of the major investment banks in Australia to produce open policy documentation regarding their methods of dealing with conflicts of interest and analyst conduct is extremely concerning. It does little to alleviate the concerns of particularly the many first time investors that suffered dearly in the collapse of the prior tech bubble. Establishing clear and rigid policy documentation would be highly reassuring to any current or potential client of these investment banks. Additionally, it could work towards alleviating the perception that investment banks issue subjective and biased research.
Only the NYSE and NASD rules on analyst conflicts of interest and the Global Research Settlement that has required their Member Firms to disclose in their research reports any conflicting relationships that analysts and/or the Firm may have regarding individual companies. These disclosures require detailed information on company ratings as well as a description of the firm's rating system and ratings distribution. This includes discussion on the valuation technique and a supporting rating and price target (if any), and a discussion of risks to the rating and price target (if any). Without the structured rules and guidelines, it would appear unlikely that the investment firms, as evidence by Australian investment banks, would disclose this necessary information.
Ultimately, the federal government, ASIC, other regulatory bodies and shareholder groups have a role in requiring that all Australian investment banks involved in production of analyst research and carrying out investment banking produce and present policy statements regarding conflicts of interest and analyst conduct to the public rather then just offering relatively loose guidelines. Formalised and consistent policy statements could also prove useful in reducing future investor apprehension about the affects of lax monitoring of potential conflicts of interest.

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