Aiming to Elevate the Conduct of Analysts
Stung by the conflict-of-interest controversies tainting Wall Street’s stock analysts, an association of financial professionals is pushing for new rules of conduct that it believes go far beyond the reforms recently adopted by major brokerages.
The Assn. for Investment Management and Research has issued a series of proposals it hopes will become the industry standard for analyst practices worldwide.
The group, which has 59,000 members and is the largest investment analyst association, issued its plan July 17 and asked for public comment for three months.
AIMR, which may be best known as the keeper of the chartered financial analyst, or CFA, designation, said it supports the brokerage industry reforms recently approved by the Securities and Exchange Commission in the wake of a host of scandals involving Wall Street research practices over the last two years.
Those reforms are meant to guarantee analysts’ objectivity in their stock recommendations by strengthening the wall between research and investment banking activities.
But AIMR suggests additional changes in how analysts recommend stocks. The group’s ideas also target the conduct of mutual fund managers and other portfolio managers and the conduct of corporate executives in terms of how they interact with analysts.
Unlike the SEC, however, AIMR is not a regulatory agency. It has no enforcement power over Wall Street brokerages. Still, about 18% of its members work for brokerages--the “sell side,” in industry parlance--including well-known names such as investment strategist Abby Joseph Cohen of Goldman Sachs. The bulk of AIMR’s members work for institutional investors such as mutual funds and banks, the so-called buy side.
AIMR hopes not only brokerages but also money managers, public companies and the news media will follow its guidelines on stock research.
The Times spoke recently with Patricia Doran Walters, AIMR’s senior vice president for professional standards and advocacy, about the group’s proposals and Wall Street’s credibility crisis.
Question: Is this the worst crisis of confidence you’ve seen in the investment business?
Answer: I do think it is probably the worst ethical crisis in the industry. The general public doesn’t really understand the difference between a research analyst and a portfolio manager and an investment advisor. The vast majority of our members believe that the whole profession is being tainted by a few people on the sell side, a subset of the profession. Most investment professionals are ethical and put their clients’ interests first.
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Q: How do you feel about the reforms the brokerage industry adopted in the wake of the conflict-of-interest charges brought by the New York attorney general against Merrill Lynch & Co. in April?
A: Basically, we would like everybody to adopt that standard--that [an analyst] is compensated based on the quality of the job that you’re hired to do, not on investment banking deals.
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Q: Are the highest-profile, most controversial analysts in the brokerage business AIMR members? For example, Jack Grubman, formerly of Citigroup’s Salomon Smith Barney; Henry Blodget, formerly of Merrill; and Mary Meeker of Morgan Stanley?
A: They are not AIMR members.
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Q: If they and other prominent brokerage analysts aren’t members, how would your proposed standards be enforced?
A: The idea is that you put what you consider to be the highest-quality set of standards on the table, and you expect that industry participants would voluntarily adopt these standards. The New York Stock Exchange and National Assn. of Securities Dealers can enforce their standards on their members because they’re regulatory organizations and you can’t practice unless you’re one of their members.
But you can certainly be a securities analyst or a portfolio manager and not be an AIMR member. We just believe that our code of ethics and standards of practice differentiate our members.
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Q: How does AIMR enforce its rules with its own members?
A: We have sanctions anywhere from cautionary letters to public sanctions to time suspensions of AIMR membership to revocation of membership and the right to use the CFA designation.
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Q: Explain your analyst reform proposals, starting with how you would change stock ratings.
A: Rating systems should include a risk dimension and a time horizon as well as the traditional “buy,” “hold,” “sell” or “market outperform” or “underperform” dimension. Companies would certainly have the flexibility to design the rating system they want; it’s just that they would need to communicate all three of those elements.
So, you wouldn’t go on TV and say, “I think this is a ‘buy.’ ” You might say, “I think this is a ‘buy’ but it’s high-risk security and I don’t think we’ll reach the price target for five years.”
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Q: Your proposals also address the conduct of analysts and portfolio managers on the buy side, and practices you think should be banned. Can you give examples?
A: If portfolio managers have a major position in a company, they don’t want to be blindsided by a change in [a brokerage] recommendation, and therefore they can put pressure on research analysts not to do that by threatening to redirect brokerage business [from the analyst’s firm].
Or they’ve been known to basically call a company and say, “This particular analyst is changing his or her mind about you--please do something about it.”
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Q: You’re also hoping to change the conduct of corporate executives, in terms of how companies deal with brokerages and analysts?
A: Right. The corporate issuers have other ways of pressuring analysts besides threatening not to give investment banking business to a firm, and we address these areas.
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Q: How does that pressure manifest itself?
A: Issuers can avoid taking particular analysts’ questions on quarterly conference calls. Some analysts may never get to ask a question because the person being interviewed doesn’t think they’re on “their side.” Investment relations people might not call you back if you have questions.
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Q: You also propose standards for the media.
A: If the media truly believe that [analyst] conflicts of interests should be disclosed to the public, then they need to facilitate those disclosures. Whether you’re having someone speak on TV about their recommendations or writing an article about it, you should do something to make sure that the appropriate disclosures, even if abbreviated, reach their intended audience. If you’re going to interview somebody about their recommendations, you should at least direct people in the article to where they can go to find out about any potential conflicts.
We also believe that when investment professionals appear in a public forum, whether it’s on TV or at a conference, that there be some arrangement by the firm so that members of the audience can purchase the research report for a reasonable fee. It’s extremely difficult for average investors to get research reports now.
If we don’t expect investment pros to make valuation decisions based on earnings alone, we shouldn’t expect the average investor to make a decision based only on a recommendation--even if it’s the expanded rating system that we’re calling for.
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Q: What’s a “reasonable” price for a research report?
A: AIMR doesn’t have a particular view on that. I certainly think under a couple of hundred dollars would be reasonable. Now, you wouldn’t be able to get it at all.
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Q: Unless you’re a customer of the brokerage.
A: A fairly substantial customer. If you’re a small retail customer, you’re not going to be able to get the reports. I’m personally a customer of CS [Credit Suisse] First Boston and I don’t have a big enough account to get the reports.
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Q: You propose prohibiting analysts from taking part in brokerage marketing activities such as “road shows” for corporate clients’ stock or bond offerings. But you also believe that brokerage research units don’t have to be completely separated from the investment banking business, as some Wall Street critics have suggested.
A: We don’t think it’s realistic, particularly because investment banking is going to need a research analyst to do due diligence: “Is this a deal we should do or not do?” The firm has a reputation that ultimately depends on whether or not the deals are good ones for investors.
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Q: Even after more than a year of criticism of analysts’ practices, the vast majority of stock recommendations on Wall Street still are “buy.” The number of “sells” has increased modestly, but shouldn’t there be a more even distribution of analysts’ ratings?
A: The analyst’s job is to go find companies to recommend to their clients to buy, unless you happen to be a “short” seller. In terms of “sell,” well, you can avoid buying if you’ve heard a sell rating, but the only people who can act on that rating are the people who already own the stock. Also, most firms don’t cover every company in an industry. So I’m not sure you really ever expect a normal distribution of “buy,” “hold” and “sell” ratings.
We do think the AIMR proposal to have a final report [in cases where brokerages drop coverage of stocks] would throw a few more “sell” recommendations in there. We think firms should be a little more forthcoming--when you discontinue coverage, basically you think this stock is a dog now and nobody should be buying it.
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Q: In what other ways do AIMR’s proposals go beyond what the SEC has approved?
A: An important distinction is that our standards are meant for firms globally.
The NYSE and NASD rules cover firms that are listed only on those two exchanges. Currently, 25% to 30% of our individual members are outside the U.S., and by 2011 they will probably make up the majority.
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Q: Have any brokerages promised to implement your standards when they become final?
A: No. People are going to comment, and I’m sure they will wait and see what the final standards are before they decide.
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Q: What is the gist of the industry’s comments so far?
A: It’s way too early to say. If you’ve ever been part of a comment process, you know what I mean: We expect that the vast majority will come in Oct. 18--and the deadline is Oct. 17.
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For more information on AIMR’s proposals, visit www.aimr.org/pdf/standards/aimr-ros.pdfll-side; for details of the SEC’s new analyst conduct rules, see www.sec.gov/news/press/2002-63.htm.
