Investment research became an issue three years ago when it was revealed that a number of leading US investment banks had breached the ‘Chinese walls’ between their research divisions and the sales side of their investment banking business.
This clearly affected the quality of their equity analysts’ stock recommendations. Famously, internet stock analyst Henry Blodget described one of the internet companies he recommended as ‘a piece of junk’.
Organisations providing investment research fall into two main categories: buy-side and sell-side films. In general sell-side firms are brokerage firms and buy-side firms are asset management firms.
Research generated by buy-side firms is used exclusively for the firm’s trading. Research generated by sell-side is distributed to the firm’s clients. Thus the problem of conflicts of interest is principally a sell-side problem.
Goaded by the New York attorney general, Eliot Spitzer, US regulators have acted swiftly to resolve these conflicts of interest. In 2002 the Securities and Exchange Commission (SEC) proposed a regulation that requires any analyst’s research report to include ‘certifications’ as to whether the report accurately reflects the analyst’s personal views, and whether the analyst received payment in connection with his or her recommendations.
International and European regulators have followed suit, though in a rather different style. Crucially, they have adopted a ‘principles-based’ approach rather than the prescriptive, ‘rules-based’ approach of the US. They have for example, avoided the legal separation of research from investment banking and concentrated instead on ensuring that the relationship between research and investment is properly managed, in particular by ensuring that the investment banking side of a firm cannot influence the research side.
At the international level, the technical committee of the International Organisation of Securities Commissions’ (IOSCO), representing 168 members in 100 jurisdictions, has drawn up a ‘Statement of Principles for Addressing Sell-Side Securities Analyst Conflicts of Interest.’
Among the principles is the requirement that there should be mechanisms to ensure that analysts’ trading activities or financial interests do not prejudice their research and recommendations, and that their reporting lines and pay arrangements should be structured to limit conflicts of interest.
A key principle is that firms that employ research analysts should establish written internal procedures or controls to identify and manage analyst conflicts of interest. Managing conflicts of interest means essentially keeping analysts at arm’s length from investment banking departments.
At the pan-European level, the European Commission’s Forum Group, a group of 21 people drawn from leading European investment banks and other market players, has looked at investment research as an important component of the single market in financial services and has attempted to draw up Community-wide standards of ethics and reliability for financial analysts.
Like IOSCO, the Forum Group focused on how conflicts of interest can best be managed to ensure analyst objectivity; how research is paid for, and by whom, and the role of best practice codes and regulation in delivering investor protection. And like IOSCO, it has taken a principles-based approach. One of the reasons, it said, was that prescriptive legislation “might cause markets to function less efficiently, stifling analytical efforts and disadvantaging Europe in the global marketplace.”
However, Ian Mackintosh, the chairman of the Forum Group, warned that detailed rules might be needed if principles-based regulation failed. “ While European investment research may not currently stand in need of detailed prescriptive rules such as have prevailed in other jurisdictions, it is clear that more detailed rules should be considered in the future if a principles-based approach does not avert or properly control any market failures.
“The EU absolutely cannot and should not be complacent with respect to recent or current practice in the industry.”
The Forum Group has drawn up a set of five overarching principles for the European investment research industry. (See box) These principles, and the 31 recommendations that go with them, have been framed so that they could be implemented across Europe, either through EC legislation or by cooperation among regulators and supervisors in the member states.
Another option is for the principles to be implemented through industry codes of conduct. The most likely candidate would be the code of ethics of the Association for Investment Management and Research (AIMR), which represents more than 67,000 investment professionals.
There are currently two pieces of EC legislation that have something to say about investment research and conflicts of interest. One is the EU Market Abuse Directive (MAD), which was adopted in January 2003 and became effective October 2004. The other is the revised Investment Services Directive (ISD), which is yet to be adopted.
The broad aim of the MAD is to prevent insider dealing and manipulation of the market. It also lays down rules for investment research. Article 6(5) of MAD requires investment research to be ‘fairly presented’ and relevant conflicts of interest to be disclosed.
Disclosure is also required as to whether the pay of anyone involved in preparing a stock recommendation is linked to investment banking transactions performed by the firm.
The upgraded ISD includes for the first time financial analysis and research as an ancillary investment service. This means that firms that combine research and analysis with other investment business will be subject to the new directive.
The ISD includes proposals requiring member states to introduce measures obliging firms to introduce arrangements so that conflicts of interest that may arise in the provision of investment services are identified, managed and/or disclosed.
In particular, the directive contains a provision that investment firms are organised so that client interests are not adversely affected by conflicts of interest between the brokerage and dealing business of the firm.
Specifically, Article 16 of the directive makes it a requirement to manage conflicts of interest that could jeopardise research objectivity.
New rules about investment research are also being drafted at a national level. Within the EU, member states are required to implement the measures provided by MAD. Some EU countries may use the implementation as an opportunity to draft their own legislation.
Denmark, for example, is introducing its own set of regulations on investment analysis and conflicts of interest. Iceland’s financial supervisor body, the FME, has drafted its own directive on disclosure in investment research.
In Portugal, the securities regulator CMVM is looking at options for controlling conflicts of interest facing research analysts, which could range from simple disclosure to limitations on trading during certain periods. And in Austria, the Austrian Association of Financial Analysis and Asset Management has produced a new code of ethics, which could provide a framework for new regulations.
The UK’s Financial Services Authority (FSA) has arguably taken the lead among European regulators on the issue of investment research and conflicts of interests. In March 2003 it stated its case for new regulation.“ It has become clear to us and other regulators around the world that the marketing of research to clients as being objective did not match reality.
“In particular senior managers of firms did not, as they should have done, ensure that analysts producing this research were free from the influence of conflicting business interests in the production of research. This was a serious matter.”
The FSA, in line with the EC Forum Group and IOSCO, sticks to the principles-based approach but acknowledges the need to give clear guidance to market practitioners. It has expanded its conduct of business rules to include clear standards on the management and control of conflicts of interest in investment research.
The new FSA rules say that it is the responsibility of each firm’s senior management to put in place appropriate system and controls to ensure that their analysts are as free as possible from conflicts o interest that could improperly influence the content of their work and impair their ability to produce objective research.
The rules say that firms should avoid reward structures that create direct incentives for analysts to act in ways that would compromise their judgment. While it would be acceptable to link the analyst’s pay to the general profits of the firm, it would be unacceptable to link it to specific investment banking deals.
One way for institutional investors to avoid the conflicts of interest inherent in sell-side research is to go to independent research firms whose main business is selling research.
Independent firms are currently under represented in investment research. In the US, for example, buy-side firms, 25% by sell-side firms while independent firms produce only 5%, produce 70% of research.
Last year, Instinet Europe, an electronic securities broker, launched an independent research consultancy, which aimed to put institutional investors and hedge funds in touch with independent research firms.
Daniela Meyers, head of independent research, Instinet Europe said there was a demand for independent research as an alternative or complement to the sell-side brokerage research investors currently receive. “ As European regulators increase their scrutiny of conflicts of interest, our clients are anticipating potential regulatory changes by investigating independent research and we are seeing a growth in this area right across Europe.”
The consultancy assesses a client’s research requirements and provides a list of suitable independent research providers. Meyers says the service is designed to save time and money. “The number of independent research providers is continually expanding, and meeting each provider and assessing their relevance and quality would involve a significant amount of resource by clients.”
In general, asset managers are demanding more and better quality sell-side research. However In-house equity research is now coming under increasing pressure because of tighter margins, tougher regulatory developments and lower credibility. One leading institutional investor has decided that it can do without it altogether.
In a deal announced earlier this year, the Nordea financial services group announced it was outsourcing its entire Nordic equity research to Standard & Poor’s (S&P). Nordea’s head of equities, Frans Lindelow, explained: “The Nordic market is a microcosm of the dilemma facing the wider equity research industry. There are over 650 analysts worldwide following Nordic stocks, all of them essentially producing the same sort of research and not all of them adding value for clients.
“Transferring the function to an independent provider improves the credibility of our company research, makes the economics of the research function more transparent, and enables us to focus on generating strong investment ideas for our clients.”
S&P will set up a 20-strong equity research team in Stockholm specialising in Nordic companies and will provide Nordea with research and recommendations on 200 Nordic stocks.
Julien Hardwick, European head of equity operations at S&P, believes that this move could set the pattern for other financial institutions. “We expect others to follow Nordea’s path. Many banks are taking a long hard look at their research function. They realise there is a gap between what investors are looking for and what the sell-side is offering, The market for equity research is labouring with over-capacity, continuing questions about quality, increasing regulatory constraints and declining margins.”
Conflicts of interest may be one reason for the low credibility of current investment research. Conservatism may be another equally important reason. Increasingly, institutional investors are becoming irritated by the refusal of brokers to include ‘non-traditional” issues of corporate performance on issues such as overall strategy, corporate governance, human capital management and environmental management in their mainstream analysis of companies.
One reason for this reluctance is that non-traditional issues like SRI tend to have a long-term impact on corporate performance and analysts are more interested in short term performance such as quarterly earnings.
Another reason is that is that the way in which institutional investors allocate commission income does not encourage coverage of these issues. As a result, brokers say there is no money in it. A group of leading institutional investors, including Dutch pension fund PGGM and French asset manager BNP Paribas Asset Management, have set up the Enhanced Analytics Initiative (EAI), an effort to encourage brokers to incorporate intangibles in their research. (See page 32)
The EAI may be pushing at an open door. Some sell-side analysts have already put their weight behind initiatives to incorporate a consideration of ‘intangibles’ into equity research - principally the research reports sponsored by the United Nations Environment Programme Finance Initiative (UNEPFI) Asset Management Working Group (AMWG). The report written by Anthony Ling of Goldman Sachs received particular praise.
In one of these reports, ‘The Materiality of Social, Environmental, and Corporate Governance Issues to Equity Pricing’, a group of 12 fund managers including such heavyweights as Goldman Sachs, call on investors, government and business leaders to incorporate environmental, social, and governance their best practice. Brokers involved in this initiative believe that sell-side equity research has an important part to play in this process. If this is so, it could help to raise the standing of investment research from its current low level.

Five key principles
After the scandals in sell-side research, the investment industry is re-thinking its approach to buying and using sell-side research. The Forum Group, which was set up in 2002 by the European Commission to draw up a code of conduct for financial analysts has established five overarching principles for the European investment research industry. These principles are:

q Clarity - research should be fair, clear and not misleading.

q Competence, conduct and personal integrity - research should be produced by competent analysts with skill, care diligence and integrity and it should reflect the opinion of its authors.

q Suitability and market integrity – research should be distributed
taking into account the different categories of its intended recipients and the need to maintain market integrity.

q Conflict avoidance, prevention and management - analysts’ firms should have in place systems and controls to identify and avoid, prevent or manage personal and corporate conflicts of interest.

q Disclosure – conflicts of interest, whether corporate or personal, should be prominently disclosed.

Widening the agenda
A group of leading European institutional investors plans to direct 5% of commissions to brokers who integrate ‘ intangibles ‘ such as corporate governance and socially responsible investment (SRI) into their research.
The group, which includes the Dutch pension fund PGGM, the Universities Superannuation Scheme (USS), BNP Paribas Asset Management; RCM, part of Allianz Dresdner Asset Management, and the boutique Generation Investment Management, has named its project the Enhanced Analytics Initiative. (EAI).
“We feel research on extra-financial areas such as governance and labour relations is one of the keys to understanding the performance of a business in the long term. We think that if you look five years ahead these issues will eventually be part of mainstream financial research,” says Philippe Lespinard, chief investment officer at BNP Paribas Asset Management.
“ We thought about just doing this project but ourselves but although we are a big client we concluded we would still have bigger impact by doing this jointly. Probably the biggest factor was hearing from brokers that the more we could send co-ordinated signals about our priorities, the more likely it was they would gear up in the short term. It is in our interests that we put this their development plans on a secure footing because we are in this for the long term.”
EAI members have already agreed on some of the criteria that they will use to evaluate the performance of the brokers taking part in the initiative. These will include the comprehensiveness of the range of extra-financial issues analysed and the ability of the brokers to draw company specific conclusions, which could be used to contrast different companies performances.
Other factors will include the integration of extra-financial into financial analysis, coverage of a broad universe, and responsiveness of service.
Members of the group say they expect to allocate between €4m and €5m during to 2005 to brokers “who excel at integrating extra-financial analysis into their mainstream research process”.

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