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CRISIL YOUNG THOUGHT

LEADER 2005

EQUITY RESEARCH
ENVIRONMENT IN LIGHT
OF THE
GLOBAL SETTLEMENT

A DISSERTATION

MANOJ UPADHAYAY

SYMBIOSIS INSTITTE OF BUSINESS MANAGEMENT


MBA II ~ FINANCE ~ manoj.upadhayay06@sibm.net
Mobile: 9890893724

Word Count: 2499 Words

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EXECUTIVE SUMMARY

In April 2003 the Securities and Exchange Commission, US (SEC) and the New York

Attorney general Eliot Spitzer reached a significant agreement with major Wall Street

investment banking and brokerage houses. Termed the global settlement the settlements

aimed at the separation of research function from investment banking and trading

functions and at reassuring investors of untainted, unbiased, objective and independent

research from the ten major Wall Street firms. The settlements donned a new era for

equity research in general and for equity research in investment banking in particular.

This paper initially discusses the global settlement, its terms and the new regulations in

place and what it all implies for the future of equity research. The subsequent sections

bring out the current state of, and also make projections for future of, research at

investment banks as well as at independent equity research houses with an analysis of

their relative strengths and weaknesses. The last section provides a comparative analysis

of independent equity research and research divisions at investment banks and delves on

the question of how the independent equity research houses will impact the investment

banking research divisions.

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SECTION I:

THE GLOBAL SETTLEMENT

The settlement finalized implements far-reaching reforms that will radically change

behavior on Wall Street- New York Attorney General Eliot Spitzer 2003

The global settlement referred to the settlement, which the major Wall Street

investment banking and brokerages arrived at with the Securities and Exchange

Commission (SEC), and the New York Attorney General Eliot Spitzer in April 2003. The

settlements aimed at settling the issue of separating the research function from investment

banking and trading activities and reassuring investors that they could rely on the

"independent" research to be offered in the future by the ten firms (Salomon smith

Barney, Merrill Lynch, Morgan Stanley, Goldman Sachs etc) involved in the settlement.

It was hoped that the $1.4 billion global agreement effected by prosecutors and regulators

would bring major reforms in the ways that all financial analysts do their work, publish

results, insulate themselves from banking and brokerage, and are compensated. New

York State Attorney General Eliot Spitzer began the probe into analyst behavior in June

2001 with an investigation into the rating practices of just one firmMerrill Lynch. The

continuing (and expanding) investigations led to the enactment of the comprehensive

package of measures known as the Sarbanes-Oxley Act by the Congress In July 2002.

The Sarbanes- Oxley Act contained additional measures intended to reform certain

practices in financial analysis. Also, in December 2002, the National Association of

Securities Dealers (NASD) and the New York Stock Exchange (NYSE) proposed

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additional analyst rules to further insulate analyst compensation from investment bank

pressures, prevent the issuance of "booster shot" research reports, and require a final

research report be issued when an analyst terminates coverage of an issuer.

Among the terms of the global settlement were:

Investment bankers were prohibited from setting analyst compensation and

analyst pay was to be based on quality and accuracy

A ban on IPO spinning investment firms no longer allowed to allocate to

officers or directors of public companies preferential access to valuable IPO

shares of corporations from which they had sought or obtained investment

banking business

Each of the 10 firms were to pay to publish every one of their analysts' ratings

on every stock covered; reports were to be published within 90 days of the end

of each quarter

Each of the firms to provide three "independent" research opinions for any

research that is provided to a customer ($432 million was earmarked for this)

Analysts were not allowed to participate in road shows or sales

This "independent research" was to be monitored by an SEC-approved consultant

to the Banking or trading firm; and

Each firm was to have its monitor report on Compliance with the agreement

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SECTION II:

BRINGING TRANSPARENCY

While the terms under the Global Settlement inherently bring about a fair degree of

transparency and protect the integrity of equity research, analysts must now also abide by

a much more detailed set of regulations of their professional conduct issued by the SEC

and NASD. Regulation Analyst Certification (Regulation AC) which became effective

in April 2003, incorporated the following main elements:

Required research analyst compensation to be independent of investment banking

relationships

Prohibited submitting the research report to the subject company for approval

Restricted publishing reports and public appearances during designated public

offering quiet periods

Prohibited publishing reports during bake-off period when banking deals were

being negotiated; and

Required registration, a qualification exam and continuing education for research

analysts

At the same time, AIMR (Association of Investment Management and Research) and

NIRI (National Investor Relations Institute) have also introduced guidelines that extend

to buy-side research, corporate issuers, investor relations executives and related

professionals and seek to significantly reduce a companys ability to influence sell-side

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research reports. All these measures have greatly fostered a climate of integrity,

objectivity and fairness in equity research. This fact is amply supported by a Report

released in early 2005 prepared by professors Tzachi Zach, Ohad Kadan and Rong Wong

at the Washington University in St Louis Olin School of Business which indicates that

the gap in bias between affiliated and unaffiliated reports as well as the level of bias in

analyst reports has decreased significantly after the implementation of Global Settlement.

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SECTION III:

EQUITY RESEARCH AT INVESTMENT BANKS

The sweeping changes post the Global Settlement has had profound consequences on

established processes at the research departments of investment banks for analyzing

stocks, disseminating material information to investors, and capital formation. Among the

most important effects of the global settlement and the newer regulations on investment

banking research have been:

The number of sell-side analysts working at major brokerage firms has declined

sharply, with fewer star analysts and outsized compensation packages. This has

happened because analyst salaries must now be paid out of funds generated from

retail brokerage accounts and institutional trading, neither of which is nearly as

lucrative as investment banking fees.

Research by bulge-bracket firms is becoming concentrated on large-cap names

that trade millions of shares each day. As the commission margins are decreasing

and conducting fundamental research is a time consuming process, the analysts

have no economic incentive to follow companies that cannot support their trading

desks. This has in turn lead to many small- and mid-cap companies becoming

Wall Street orphans with limited or no research coverage.

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Years

There has been a corresponding increase in the number of independent or

boutique research shops attempting to fill the void for high-quality, unbiased

research.

Investment banking assignments are no longer a guarantee to a firm establishing

or maintaining research coverage.

In an effort to restore their tarnished credibility and comply with new rating

system standards, many sell-side analysts have been more prone to issue

downgrades and sell recommendations on under performing stocks.

Investment banks are looking at innovative ways to cut costs, especially for junior

analyst work by outsourcing the research function to offshore destinations like

India, Philippines etc and by rationalizing technology.

Some issuers have responded to this skeptical climate by cutting off access to

analysts with an unfavorable view of their prospects.

Although sell-side research has become cost-prohibitive and the settlement terms and

regulations have had adverse consequences for it there are still some factors, which will

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ensure its survival. For Investment banks high grade qualitative company and industry

research is a source of competitive advantage and thus it cannot do without it. Besides the

sell side research community plays a valuable role in the asset allocation process and

keeps management teams honest. Add to this the fact that the Big Buy side institutions

will continue to use sell side research, in addition to their own analysts and their is no

doubt that sell side research will survive.

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SECTION IV:

INDEPENDENT EQUITY RESEARCH

Under the terms of the global settlement, $450 million was to be paid out over five years

for independent research and each of the firms involved in the settlement were to be

responsible for selecting as many as three additional reports from independent third

party research analysts. There was thus a scramble for the settlement dollars, which led

to the emergence of a plethora of independent equity research houses but with only few

with high quality like Bernstein, Argus etc. This high on quantity but low on quality

phenomena basically occurred due to the reasons as below:

Successful independent analyst shops generate their revenues by selling

proprietary research to Institutional clients. Having these reports widely

circulated through broker-dealer networks would dilute the value of their insights

and destroy their business models.

Bulk of the research money will fund reports on the most liquid, large-cap names

that already have extensive research coverage and not the Small- and Mid-cap

companies.

A SWOT analysis of the sector is presented below which clearly shows the

opportunities that the global settlement has created for this industry.

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Strengths Weaknesses

Better relative performance vis-- Inability to tap quality analytical

vis sell-side research. talent

Better funding of independent Wide circulation of research post

research global settlement makes business

model unsustainable.

Opportunities Threats

Erosion of investor confidence in Heightened expectations

sell-side research Elimination of soft dollars.

Reduced coverage by sell-side Industry consolidation.

firms

Increasing number of hedge funds

and institutional investors turning

up for research requirements.

The exposure from the global settlement and unprecedented investor interest in

independent viewpoints has propelled this sector into new prominence. According to

projections made by the equity research ratings and consulting firm Integrity Research

Associates the Independent equity research industry is set to grow at a torrid pace from its

current level of approx $1 billion in annual sales to between $2 billion and $3 billion by

2008.

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SECTION V:

INDEPENDENT EQUITY RESEARCH

VERSUS RESEARCH AT INVESTMENT BANKS

Encouraging competition to investment banking research should be on everyones short

list of common sense solutions to restore investor trust Former SEC chairman Arthur

Levitt, July2002.

Going forward the independent equity research houses will get a major boost on account

of an increasing number of hedge funds and institutional investors turning to them for

objective, unbiased and innovative investment ideas as well as because of their Better

relative performance vis--vis sell-side research and Erosion of investor confidence in

sell-side research. On the other hand the increasing efforts of the institutional investors

towards cutting costs will surely undermine the profitability of investment banking

research .As a survey by The Greenwich Associates points out, in the wake of budgetary

constraints institutional investors are realigning their priorities and cutting costs in a

number of ways, including directing more business to electronic brokerage systems,

hiring more in-house analysts and employing cost-benefit ratios for research and trading

expertise. What also tilts the scales in favour of independent equity research is the current

unsustainable underlying cost structure of investment banking research. In the post global

settlement era separation from investment banking departments is resulting in serious

cost pressure on sell side departments and companies are being forced to cut costs. As the

exhibit below shows it will not be possible for the investment banks to sustain the huge

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amount of expenditure that they have been incurring on their research divisions in the

past:

In the context of the Comparison between Investment banking research and Independent

equity research, the findings of the Greenwich Associates Equity Analyst Research 2005

are significant. Some of them are:

Institutional investors are diverting equity commission dollars from Wall Streets

traditional research offerings in favor of face-to-face meetings with company

management. Between the first quarter of 2004 and Q1 2005, U.S. institutions

paid their brokers approximately US$1.4 billion in commission dollars for the

facilitation of meetings with company management, Greenwich reports which was

about 36% of all U.S. equity commission dollars allocated by institutions for sell-

side research.

Institutions are turning more often to specialized and independent research firms

now. As recently as 2003, the 15 or so so-called bulge bracket firms earned

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more than 82% of the equity commissions paid out by U.S. institutions. In 2005,

the proportion claimed by this group fell to about 75%. Over the same period, the

30-odd firms generally regarded as the leading independent research brokers

increased their share of the commission pool from 1.8% to 4.4%.

The increase in commission flows to independent research providers has cost

bulge-bracket firms some $25 million over the past two years.

However many investment managers are also beginning to understand the need to

concentrate their commissions with their important brokers as they are

discovering the connection between commission flows and research, sales

coverage, and other services

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CONCLUSION

The terms of settlement under the global settlement and the regulations pertaining to

analysts professional conduct Regulation AC issued by the SEC and NASD have

produced an environment in which equity research has become more transparent,

unbiased, objective and independent. With the settlement terms making research

departments at investment banks uneconomic, these divisions are experiencing major

changes in the form of reduced coverage of mid cap and small cap stocks, significant cost

cutting measures and a sharp decline in the number of analysts employed. What would

continue to let sell side research survive though is it being a source of competitive

advantage for investment banks and the continued reliance of big buy side institutions on

sell side research.

The global settlement and the newer regulations also created a big opportunity for

independent research houses though not in the same degree as was widely believed at the

time of the settlement as the wide circulation of research reports through broker dealer

networks diluted the value of the insights of independent research houses which

generated their revenues by selling proprietary research to Institutional clients. The

independent research industry though is set to soar by all estimates and reach revenues

between $2 billion and $3 billion by 2008. It is also evident that Independent research

houses are gaining at the expense of investment banking research houses as shown by the

figures in the Greenwich Associates Equity Analyst Research 2005 on account of several

factors as discussed above in the paper though investment banking research would

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survive owing to it being a source of competitive advantage for investment banks and the

continued reliance of big buy side institutions on sell side research.

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REFERENCES

Coffin Communications Group report June 2003

The Delloite Consulting Report titled Right Sizing Research

Securities advisor Vol 4,No 3 Winter/Spring 2004 authored by Grant Thornton

Securities Regulation Law Journal - Vol. 31, No. 4, Pgs. 427-495

Wall Streets Credibility Problem: Misaligned Incentives and Dubious Fixes?

by Leslie Boni and Kent L. Womack, February 2004 published by the Wharton

School University of Pennsylvania

www.investorside.org

www.investopedia.com

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