Analyst independence under scrutiny

ANALYSIS: The possibility of criminal charges against investment banks and stockbroking analysts in the US for giving misleading or biased investment advice to private clients has drawn attention again to the issue of analyst independence and, therefore, the reliability of their share recommendations.

The long-time concern, which has intensified with the discovery of documents in the US investigation into Merrill Lynch, has been that some analysts have been giving positive stock recommendations so that the banking arms of their companies can generate fees from selling the stock or providing corporate finance or other services to the company concerned.

In the US, New York attorney-general Mr Eliot Spitzer has now widened his investigation into possible conflicts of interest between analysts and investment bankers at Merrill Lynch by ordering a number of other investment banks to disclose documents. Mr Spitzer has said he believes conflicts of interest are endemic in the industry.

In his ongoing investigation of Merrill Lynch, which began last July following complaints from investors about stock recommendations, Mr Spitzer subpoenaed more than 30,000 internal e-mails. These disclosed stark differences between analyst recommendations to clients and their private opinions on shares. Some shares given "buy" recommendations were privately described as "piece of junk" (InfoSpace), "piece of shit" (Media and Lifeminders) and "we see nothing that will turn this around near-term" (Internet Capital).

Mr Spitzer has accused Merrill of privately disparaging companies while publicly telling investors to buy the shares, and of paying its research analysts to recruit new customers for its investment banking operation. Merrill has rejected the allegations of wrongdoing and said the attorney-general's conclusions were wrong.

Mr Spitzer is now working with the powerful US financial regulator the Securities and Exchange Commission (SEC). Last year, an SEC investigation found the required "Chinese walls" between the corporate finance and research divisions of investment banks were full of holes.

The conflict of interest issue became most obvious at the time of the technology, media and technology bubble, when analysts were putting "buy" recommendations on shares their banks were promoting in flotation offers or were advising. These share prices were hyped by bullish comment and subsequently fell sharply.

High-profile internet analyst Mr Henry Blodget, who left Merrill last year, was advising investors to buy InfoSpace even after they had passed their peak of $132 in March 2000, while privately describing the stock as "a powder keg". The shares are now trading around $1.46.

Reacting to regulator disquiet, some banks started to reorganise their research divisions by, for example, either restricting analysts from holding the shares they cover or requiring disclosure of any holdings in their reports on the companies. But most regulators and customers feel these actions do not go far enough to protect investors from conflicts of interest.

Suggestions have included the spinning off of research divisions into separate companies, banning direct payments by the investment side to analysts and restrictions on issuing recommendations on shares where the public offer was being managed by the bank.

Analyst pay and compensation has emerged as another area of concern in the US, where there have been calls to ensure that it is not linked in any way to the performance of the investment-banking side of the business. Typically, analysts are paid a basic salary based on their qualifications, seniority and the going market price for their skills. But they often get a bonus as well, which may be linked to the overall performance of the firm, including its corporate finance arm.

In the Irish market, stock exchange rules require the same sort of "Chinese Walls" between the research divisions of investment firms and their investment banking and corporate finance operations, as in the US. On the contentious area of personal ownership of stock, Irish analysts are not obliged to declare in their research if they hold shares in the company but some companies have implemented internal rules requiring disclosure of analyst holdings in research documents.

Mr Brian Healy is director of trading and regulation at the Irish Stock Exchange, which is in the process of updating its membership rules. He said that, while there was no regulatory order on analyst disclosure, any problems could be dealt with under the cornerstone membership rule of "client best advantage". Under this rule, if a broker or an individual is found to have given inappropriate advice, the stock exchange can order financial restitution for the injured client/clients and a range of punitive actions against the firm or individual involved, from fining to the cancellation of its trading licence.

The Irish Stock Exchange has established complaints and appeals procedures, which are free to the clients of member firms. However, the outcome of these procedures are not disclosed publicly by the exchange.