Modifications to Global Research Analyst Settlement

By Cydney Posner

Now, going back to the last scandal we had (you know, the one about the dot-com bust and the analysts who were allegedly recommending stocks they privately acknowledged were, to put it politely, garbage), you might remember that, in 2003, 12 firms entered into the Global Research Analyst Settlement, which was designed, among other things, to prevent recurrences of that scandal. (See the article from 2003 attached below). The Settlement contained an extensive Addendum with provisions mandating structural and other reforms that addressed potential conflicts of interest between equity research analysts and investment banking. Apparently, it was expected that those "reforms" need not continue forever, and the various firms (or at least those that remain standing) subject to the Settlement decided that now was an especially good time to seek to terminate all of those uncomfortable restrictions. While the SEC did not agree with that proposal, it did not object to removal of some of the limitations, and those changes are reflected in a recent court order. 

Specifically, the following restrictions remain in place under the Settlement:

• Investment banking input into the research budget is prohibited;
• The physical separation of research analysts and investment banking is required;
• Investment banking is prohibited from having input into company-specific coverage decisions;
• Research oversight committees are required to ensure the integrity and independence of equity research; <
• Communications between investment banking personnel and research analysts regarding the merits of a proposed transaction or a potential candidate for a transaction are prohibited unless a chaperone from the firm's legal and compliance department is present;
• Research analysts and investment bankers are prohibited from having any communications for the purpose of having research personnel identify specific potential investment banking transactions; and
• Research analysts must be able to express their views to a commitment committee about a proposed transaction outside the presence of investment bankers working on the deal.

A proposed modification that would have allowed investment banking to seek the views of research analysts regarding market or industry trends, conditions, or developments without the requirement of a chaperone, subject to certain limitations, was not approved by the court.

A number of provisions were eliminated, however, in light of protections that were considered comparable under the NASD or NYSE rules, including the prohibitions against investment banking input into research analyst compensation and the bar against research analysts participating in efforts to solicit investment banking business, among other things. These firms, along with the rest of the industry, also remain subject to NASD Rule 2711, NYSE Rule 472, and the SEC's Reg AC that address research analyst conflicts of interest.

Article Exerpt from April 28, 2003

The SEC, New York Attorney General, NASAA, NASD, NYSE and state securities regulators have announced that 10 of the top investment banking firms have settled enforcement actions involving conflicts of interest between research and investment banking. The enforcement actions track the provisions of the December global settlement in principle. According to the release, the individual penalties include some of the highest ever imposed in civil enforcement actions under the securities laws.

The 10 firms are: Bear, Stearns; CSFB; Goldman, Sachs; Lehman Brothers; J.P. Morgan; Merrill Lynch; Morgan Stanley; Citigroup Global Markets (f/k/a Salomon Smith Barney); UBS Warburg; and Piper Jaffray.

The firms will pay a total of $875 million in penalties and disgorgement, consisting of $387.5 million in disgorgement and $487.5 million in penalties (which includes Merrill Lynch's previous payment of $100 million in connection with its prior settlement with the states relating to research analyst conflicts of interest). Under the settlement agreements, half of the $775 million payment by the firms other than Merrill Lynch will be paid in resolution of actions brought by the SEC, NYSE and NASD and will be put into a fund to benefit customers of the firms. The remainder of the funds will be paid to the states. In addition, the firms will make payments totaling $432.5 million to fund independent research and payments of $80 million from seven of the firms will fund and promote investor education. The total of all payments is roughly $1.4 billion. Under the terms of the settlement, the firms will not seek reimbursement or indemnification for any penalties that they pay. In addition, the firms will not seek a tax deduction or tax credit with regard to any federal, state or local tax for any penalty amounts that they pay under the settlement.

The enforcement actions alleged that, beginning approximately mid-1999, all of the firms engaged in acts and practices that involved inappropriate influence by investment banking over research analysts, creating conflicts of interest that the firms failed to manage in an adequate or appropriate manner. In addition, the regulators found supervisory deficiencies at every firm. Other specific charges included issuance of fraudulent research reports; issuance of research reports that were not based on principles of fair dealing and good faith and did not provide a sound basis for evaluating facts, contained exaggerated or unwarranted claims about the covered companies, and/or contained opinions for which there were no reasonable bases; receipt and making of payments for research without disclosing the payments; inappropriate spinning of "hot" IPO allocations; and books and records violations. These allegations were neither admitted nor denied by the firms. Under the terms of the settlement, each of the firms will be enjoined from violating the statutes and rules that it is alleged to have violated.

In addition to the monetary payments, the firms are also required to comply with significant reform requirements that relate to separation of the research and investment banking departments at the firms, how research is reviewed and supervised and making independent research available to investors. These reforms include the following:

• To ensure that stock recommendations are not tainted by efforts to obtain investment banking fees, research analysts will be insulated from investment banking pressure. The firms will be required to sever the links between research and investment banking, including prohibiting analysts from receiving compensation for investment banking activities and prohibiting analysts' involvement in investment banking "pitches" and "roadshows." Specifically:
  • 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. Decisions concerning compensation of analysts must be documented and reviewed by an independent committee within the firm.
  • 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. Each firm will retain an independent research monitor, in consultation with the regulators, who will oversee this process to insure the research is independent, of high quality and useful to the firms' various customer bases. Each independent research monitor also will report periodically to the regulators on his or her firm's compliance with this requirement.

To enable investors to evaluate and compare the performance of analysts, each firm will make its analysts' historical ratings, EPS and price target forecasts publicly available. The SEC Chairman expects that these disclosures will fuel development of private services to transform this raw data into investor-friendly report cards on the accuracy of the firms' research.

To provide investors with better information concerning the limitations of research: <br>• Firms must include on the first page of research reports a "warning notice" making clear that the reports are produced by firms that do investment banking business with the companies they cover and that this may affect the objectivity of the firms' research reports.

The disclosure must further state that "investors should consider the report as only a single factor in making their investment decision."

In addition, the firms have collectively entered into a "voluntary" agreement restricting allocations of securities in hot IPOs to certain company executive officers and directors, a practice known as "spinning." The SEC expects to bolster this temporary measure with future rulemaking.

A link to SEC Chairman Donaldson's statement and the SEC's fact sheet can be found online or you can access the more detailed SEC litigation releases. 

Finally, two of the more infamous players have been censured, permanently barred and required to pay penalties: Jack Grubman ($15 million)  and Henry Blodgett ($4 million). (Do you think these amounts are equal to even one year's bonus for these guys?)

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