Conflicts of Interest and Stock Recommendations: The Effects of the Global Settlement and Related Regulations

Abstract

This paper studies the effect of regulations on sell-side analysts' research. These regulations - NASD Rule 2711, NYSE Rule 472, and the Global Analyst Research Settlement - attempted to mitigate the interdependence between research and investment bank departments of U.S. brokerage houses. We document that since the regulations have been in place, many brokerage houses have migrated from the traditional five-tier rating system to a coarser three-tier system. In addition, optimistic recommendations have become less frequent and more informative, whereas neutral and pessimistic recommendations have become more frequent and less informative. Importantly, the overall informativeness of recommendations has declined. The likelihood of issuing optimistic recommendations no longer depends on whether analysts are affiliated with the covered firm, although affiliated analysts are still reluctant to issue pessimistic recommendations. An analysis of price reactions to recommendations provides mixed evidence on whether investors discount affiliated recommendations to a lesser extent than they did before the regulations.