Jonathan Boersma is vice president, professional standards at the CFA Institute (formerly AIMR), based in Virginia in the US. On a recent trip to Asia he discussed the new pressures building up in the world of equity research. Paramount among these are the pressures companies are putting on analysts to produce positive reports and the retaliation they wage when reports are negative. He also touches on the aftermath of the Spitzer 'global settlement' and the small advances made by independent research. Finally he asks the $10 billion question: how much is research actually worth?
Has the standard of equity research improved in the last two years?
Boersma: It is maybe a bit early to tell how much it's improved since all the new regulations and the global settlement. But we've seen some changes in the industry. A lot of the large sell side firms have downsized their research staff so there are fewer analysts covering fewer companies.
One of the things that has come up is that some small and mid sized companies now have no analyst coverage whatsoever. So they have to go out and hire analysts to write reports on their companies. We think that's a big problem. There are some fairly significant conflicts on interest there. So we're working on developing some guidelines around that issue.
We're also developing some guidelines in general on the relationship between analysts and the companies they cover. One of the things that the global settlement has done is to refortify the Chinese wall between investment banking and research. Now though, instead of going through the investment banking relationship, companies are trying to pressure analysts directly for positive coverage. They are threatening to sue them, or cutting them off from the quarterly conference calls and not allowing them to see the CEO.
So is the new front in the battle between analysts and the rest of the world?
It's one of the areas we're concerned about it. We've formed a joint task force with the National Investor Relations Institute (NIRI) in the US to try to bring both sides of the equation together and come up with some draft guidelines about the relationship.
Ultimately what can anyone do? It's a relationship driven by the companies.
It is and that's why we're working jointly with NIRI. If they think that is best practice for their members then we will follow them. Some of these things you cannot eliminate, but you can try to shine some light on it and let people know what are best practices and what we expect of them.
Are there any mechanisms for naming and shaming those companies that are withdrawing access or cutting off analysts for negative reports and stopping this retaliation?
It's difficult. We've seen a lot more of this played out in the press and we don't think that is the best way to be handled. It turns out to be a very unprofessional type of discussion.
It is good for the media though...
Yes, they are spicy stories. But we've talked about whether there should be an ombudsman type role played by a regulator. But right now there isn't a function to do that. The positive is a better way to do it. Having awards for companies with good IR functions or for those providing good investor services, as opposed to pointing out the bad guys, which is not very pleasant.
To be honest, companies cannot spend all their time talking to investors. They need to run the company. They have no real responsibility to make themselves available to investors. But if they are to provide access to management and provide more information than is in their annual reports, then they need to do that consistently and not play favorites. We want them to develop an access policy, determining who they get access to and what types of people are allowed to have access.
If we can get a few companies to take the lead and let all this be known, then they will have a competitive advantage over those that don't and that hopefully will build some market pressure on those companies that don't do it.
What else has the CFA Institute done over the past few years to improve the quality of equity research?
Our main thrust is looking out for investors and protecting their interests. That means the research they read needs to be unbiased. We've developed research objectivity standards, which we started five years ago before everything blew up. We brought people from the sell side and buy side together with some regulators sitting in to see how we could improve things.
While we were doing that everything blew up. But a lot of the regulations that came out had ties to a lot of the work we were doing. We continued with that and came out with our research objectivity standards.
These dealt with anything from the separation of investment banking and research to making sure that when analysts and portfolio managers make public appearances they disclose their personal or firm holdings in the company they're talking about. It is really about making sure that when conflicts cannot be eliminated then they are managed and disclosed.
We feel the media has an important role to play here in asking for these disclosures and we've seen a lot of improvement in that. It seems the media has been really sensitive to that in the last few years.
Our CFA programme is active across the board in educating analysts of the future to give them the discipline and skills that they need to do rigourous analysis. The very nature of who we are as an organization is to try to improve the integrity of research.
Do you get the feeling that standards of equity research are more lax in Asia than they are in the US?
I think we have more regulation in the US surrounding these aspects. But we are seeing that change. Nine months ago, the Hong Kong Securities and Futures Commission came out with a proposal on analyst's independence. Maybe they didn't have quite the same meltdown we had in the US. Not just in Asia, but across the world, people were looking at these issues and saying 'we don't have these problems. That doesn't affect our market'. But then they sit and think about it for a while and think 'hmm maybe we do'. So they want to put the safeguards in place to prevent such a destructive event.
But they have been very slow. As you say it was nine months ago that the SFC issued a proposal but nothing concrete has happened as yet. In Singapore they have done a few things. In Japan you have strange actions of the FSA, which don't give anyone any clear guidelines.
We didn't have any rules on the books [before the meltdown] but when you have this large event, it is a catalyst after which everything comes out. Our hope is that if our guidelines take hold and people adopt them, then there is no real need for some of this regulation. You cannot force people to do the right thing, but you can lead them in the right direction.
A lot of the banks I speak to, which are a part of the global settlement complain that those banks and brokerages which are not part of the global settlement are still behaving as they did before. Do you agree with that?
If you're running a business and think that if you don't have to do certain things that will cost you money, then why would you? The flip side of that is that there is a liability there. As there is so much regulatory focus on this issue, even some of the firms that were not part of the settlement are certainly very sensitive to these issues. So I am not sure there is that much truth to that comment. Sure they are not required to include an independent report with their own report when they send it out to investors...
...But you can still see analysts from certain firms on road shows and doing deals, which US banks generally are not allowed to do.
There is still room for improvement there. But they are not completely pushing the settlement issues away.
Do you think the global settlement is a tax on US banks doing business, making them adhere to one strict and expensive set rules that others don't have to?
Well, yes. But part of it is that they were breaking the rules and they had to pay up for that. Another interesting aspect to the global settlement is that a lot of the thrust of this was to protect retail investors who have been hurt. But we contacted all the ten firms that were part of the settlement as well as some others and asked what their account minimum size was to enable retail investors to get their research reports; they don't give it to everybody. For some of the firms it as a few thousand dollars: for some it was tens of thousands. You get up to Goldman Sachs and it was two million dollars. That eliminates any retail investors whatsoever. There is a question as to how effective [the settlement] is going to be to [protect] retail investors. What they were getting was the recommendations and so they would see on CNBC that some firm had downgraded Microsoft, for instance. We really feel strongly that investors should not be making judgments based solely on one word recommendation.
So have the banks been made scapegoats?
That's tough. They were breaking the rules and got caught and are now being punished for that. I think it is appropriate but it is tough to say if it should be wider or not. They were definitely made an example of. If other firms are caught subsequently doing similar things, look out. They will be treated very harshly.
It is a very hard thing to police. How do you actually ensure that someone's view is independent and is what they say it is?
Unless you have the e-mail saying that this company is terrible, it is. That is why you try to set up the framework so that at least there aren't the pressures from investment banking to act that way.
We want to ensure that analysts' compensation is based solely on the quality of their research. It is a difficult thing to assess, as it is qualitative assessment. You can look at ratings by the buy side and that is a decent way of assessing it somewhat. But there are still these huge investment banking revenues that are the source of bonuses for the analysts. And that is still a problem, which the industry needs to resolve.
The main problem appears to be that the buy side still doesn't want to pay for research.
That is part of it. This whole ordeal has really raised the question that no one wants to deal with which is how much is this stuff actually worth. The sell side firms are very scared to set a price to this. A lot of the larger buy side firms have beefed up their own in house research department so they are not as reliant on the sell side reports. It is also tied into the soft commission issue. In the US, UK and Australia, there are significant problems with this. Not only are they trying to determine how much the research is worth, but also how to pay for it.
Much of the new, independent research that has apparently come out in the last few years, has actually only been paid for out of the $450 million pot that the Spitzer settlement set up. The investors are not paying it for. It is again being subsidized by the banks, but just through a different avenue. It seems a false victory.
It is and it is a temporary victory. It is for five years and after that the money goes away and then what is left? Hopefully it sets the stage and allows some of these firms to get a foothold and for investors to see that there is some value in this independent research. But just because it is independent, it doesn't mean it is any good. It removes the potential for bias but analysts are still going to be wrong some of the times.
