Security analysts and regulatory reform

Robert Marquez

FRBSF Economic Letter, 2006, issue apr14

Abstract: Just a few years ago, Wall Street was rocked by scandals about conflicts of interest involving stock analysts' reports. In response, the U.S. Securities and Exchange Commission (SEC) undertook investigations and filed a number of complaints against some major securities firms and analysts. These complaints cited evidence to suggest that some analysts' research was not designed to give investors an objective assessment of a company and its prospects, but rather was designed to attract and retain investment banking clients by giving "buy" or "hold" recommendations for that firm whether the recommendations were fully warranted or not (see, for example, the SEC's Litigation Releases Nos. 18115 and 18111). ; To attempt to restore public confidence in the objectivity of analyst research, the SEC, other regulatory agencies, and industry associations introduced reforms for the conduct of equity research, with a focus on making analysts more independent and on requiring securities firms to increase their disclosures. But these reforms have not been without their detractors. For example, some market participants have argued that making analysts more independent of investment banking will entail burdensome costs that could lead these firms to devote fewer resources to equity research; see, for instance, the comments by Marc E. Lackritz, president of the Securities Industry Association, regarding Rule 2711 of the National Association of Securities Dealers (NASD) on "Research Conflicts of Interest," in Money, February 7, 2002. ; This Economic Letter summarizes recent research by Chen and Marquez (2005) that addresses the question of whether such regulatory efforts are likely to improve the objectivity of analysts' research reports and aid investors in their investment decisions. One message from the analysis is that an understanding of the nature of the information production process within securities firms is necessary to assess the likely effectiveness of the regulatory initiatives.

Date: 2006
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