Global Research Analyst Settlement Research Articles

Independent analyst research: Does it matter who pays?

On April 28, 2003, ten of the largest investment banks reached an agreement with the Securities and Exchange Commission and other regulatory bodies regarding alleged misconduct of security analysts. This agreement, called the Global Research Analyst Settlement, allocated $460 million to source independent analyst research. Unlike other forms of analyst research, this research was not financed through investment banking or trading commissions and was theoretically “unbiased research”. We compare independent research funded by the Global Settlement to research provided by the same firms that was not funded by the Global Settlement. Research funded by the Global Settlement appears to be of lower quality than non-funded research produced by the same set of firms, suggesting that unbiased research does not necessarily generate higher quality research. More specifically, we find that quality declined in the later years of the Global Settlement period when there was no expectation of future funding for this research, commonly referred to as the horizon effect.

Analyst independence and earnings management

AbstractWe examine whether analyst independence contributes to analysts’ monitoring role in deterring accruals earnings management. We first report a negative association between earnings management and the ratio of independent analysts to brokerage analysts covering a firm. Next, through the lens of the promotion of independent sell‐side research institutions by the 2003 Global Research Analyst Settlement, we document a significant decrease in earnings management on firms affected by the Global Settlement's mandate for time‐limited support to back independent research institutions. Additionally, we find that, as the aforementioned support ended, the extent of monitoring effectiveness reverted to a level indistinguishable from that before the Global Settlement. Finally, using closures and mergers of independent research institutions as a quasi‐natural experiment, we provide corroborating evidence consistent with analyst independence leading to more effective monitoring.

Analyst rounding of EPS forecasts and stock recommendations

We examine the association between analysts' stock recommendations and their tendency to round annual EPS forecasts to nickel intervals (i.e. placing a zero or five in the penny location of the forecast). We find that prior to Regulation Fair Disclosure (Reg FD), analysts were more likely to provide rounded EPS forecasts in association with unfavorable (underperform and sell) recommendations. However, after Reg FD, we find no significant association between rounded forecasts and unfavorable stock recommendations. Further, other regulations (NASD 2711, NYSE 472, and Global Research Analyst Settlement) have no impact on analyst rounding behavior. The findings in this study suggest that analyst rounding behavior is a particular form of forecasting optimism motivated, at least in part, by management relations incentives. Further, Reg FD appears partially successful at curbing the influence of management relations incentives on analysts' research.

The Integrity of Financial Analysts: Evidence from Asymmetric Responses to Earnings Surprises

This paper investigates the integrity of financial analysts by examining their recommendation responses to large quarterly earnings surprises. Although there is no significant difference in recommendation changes between affiliated and unaffiliated analysts in response to positive earnings surprises, affiliated analysts are more reluctant than unaffiliated analysts to downgrade stock recommendations in response to negative earnings surprises. The evidence implies that conflicts of interest undermine the integrity of financial analysts. We further examine the effects of reputation concern and the Global Research Analyst Settlement as informal and formal mechanisms, on restoring analysts’ integrity. The results show that the positive bias in recommendations remains prevalent for affiliated analysts from reputable investment banks and for the postreform period. Finally, evidence from market reactions suggests that investors fail to notice that analysts’ integrity is compromised by conflicts of interest and are misled by affiliated analysts.

The Global Settlement, All-Star Analyst Departures and Their Impact on the Capital Markets

The Global Research Analyst Settlement prohibited twelve large investment banks from tying equity analysts’ compensation to investment banking revenues, causing a large number of Institutional Investor “all-star” analysts to exit the sell-side industry. Using a difference-in-differences specification, I find that the departure of all-stars caused their bank-industry underwriting groups to lose equity issuance market share. Market share losses were more severe for IPOs than for IPOs and follow-on underwritings combined. The higher the average quality of all-stars in a bank-industry, the more severe were the bank-industry’s losses. Additionally, the departure of all-stars raised the cost of equity capital for IPOs underwritten by their bank-industry groups, particularly for IPOs that were more difficult to value. Ultimately, the loss of sell-side research talent, an unintended consequence of regulation, forced issuers to accept research coverage of inferior quality, raising the cost of obtaining public capital.

Was the Global Settlement Effective in Mitigating Systematic Bias in Affiliated Analyst Recommendations?

Regulators have recently relaxed some provisions of the Global Research Analyst Settlement of 2003 (the “Global Settlement”) and associated reforms, which arose from charges that conflicts of interest within investment banks had induced the issuance of fraudulent or otherwise misleading analyst research reports. We examine the effectiveness of the Global Settlement in reducing the systematic optimism observed in stock recommendations of analysts whose employer is a merger and acquisition (“M&A”) advisor for the covered firm (“affiliated analysts”), by comparing the optimism exhibited in stock recommendations issued by these analysts and by unaffiliated analysts before and after the Global Settlement. To control for the impact on analyst optimism of other time varying factors, our sample includes cases from the US and from other countries in which the Global Settlement had no direct impact. We argue that if the Global Settlement was effective, there should be a reduction in the relative optimism of affiliated analysts following this reform, and that reduction in the relative optimism should be greater for affiliated US analysts, than for affiliated analysts from non-US countries. When optimism is measured over a 180-day period surrounding the M&A announcement, we find a significantly greater reduction in US affiliated analysts’ optimism than occurs outside the US. However, evidence regarding analysts’ optimism in the 90-day period prior to the announcement of an M&A deal is mixed.

A Lesson Learned or Business as Usual? The Global Research Analyst Settlement and Analyst Research Quality

We examine the impact of a specific facet of the Global Research Analyst Settlement (Global Settlement) - the $460 million spent to procure independent analyst research. We compare independent research funded by the Global Settlement to that of the sanctioned investment banks as well as that of independent research firms not receiving such funding. Our results suggest that funded research is of lower quality than that of the sanctioned banks and non-funded independent research based on future performance of recommendations and the market reaction to the recommendations. Additional tests reveal that the main reason for this lack of quality is associated with industry inexperience on the part of independent research analysts; independent analysts tend to have less industry experience, and recommendations of inexperienced analysts were generally of lower quality.

Sleeping with the Enemy: Should Investment Banks Be Allowed to Engage in Prop Trading?

This paper investigates whether conflicts of interest exist between the research and proprietary trading departments of full-service investment banks. Using a data set of 11,590 analyst stock recommendations over the period 1999-2007, we find that in the period preceding the Global Research Analyst Settlement (GRAS) sanctioned banks traded ahead of their research reports. Results in the post-GRAS period indicate that sanctioned banks continue to trade ahead of their research reports as institutional ownership in the stock increases and as return volatility increases. The latter result holds only if they also intend to trade against their recommendations after their release. We also find that banks trade against their recommendations for affiliated stocks. Finally, we do not find that the recommendation revision is related to changes in holdings of other investment banks, alleviating concerns that the observed relation is related to common information available to both departments and not to information leakages. Overall, the evidence supports the recent concerns of regulators regarding conflicts of interest that can arise between bank proprietary trading and research departments, highlighting the need for stricter regulation; it is not yet clear whether the Volcker Rule will be successful in addressing this issue.

Conflicts of Interest and Analyst Behavior: Evidence from Recent Changes in Regulation

Regulation FD made analysts less dependent on insider information and diminished analysts’ motives to inflate their forecasts. The Global Research Analyst Settlement had an even bigger impact on analyst behavior: The mean forecast bias declined significantly, whereas the median forecast bias essentially disappeared. These results are similar for all analysts.

Financial Regulation, Information Uncertainty, and Stock Returns

We examine the joint impact of six financial regulations on the information efficiency of US stock markets. Following the decline of investor confidence in financial information as a result of biased sell-side analyst research in the years leading up to the market peak of 2000 as well as corporate scandals such as Enron and WorldCom, a series of regulations curbing abusive analyst and financial reporting behavior were enacted between 2000 and 2003 to strengthen the information environment of US capital markets. These regulations included Regulation Fair Disclosure, NASD Rule 2711, NYSE Rule 472, the Sarbanes-Oxley Act, the Global Research Analyst Settlement, and Regulation Analyst Certification. Merton (1987) suggests that incomplete information can cause asset pricing predictabilities to arise even if the capital market is dominated by rational agents. Existing literature confirms this assertion using cross-sectional evidence (e.g., Zhang, 2006). We provide time-series evidence by comparing price continuation effects following news before and after the regulations to determine whether their enactment improved the information environment. If the stock price response to news increased as a result of an improved information environment, we expect to find a greater impact among stocks of firms with higher information uncertainty (proxied by size, firm age, analyst coverage, cash flow volatility, and return volatility). We find empirical evidence consistent with this prediction, which is robust to controlling for risk, a time trend, and the recent financial crisis. Unlike existing studies that largely attribute evidence of market inefficiency to investors, i.e. to the demand-side of information, our findings bring the focus back to the supply-side of information, i.e. to financial information intermediaries and providers.

Did Small Traders Benefit from the Global Settlement and Related Regulations?

Responding to the allegedly biased research reports issued by large investment banks, the Global Research Analyst Settlement and related regulations went to great lengths to weaken the investment banking tie and mitigate the conflicts of interest faced by investment bank analysts. The primary objectives of these regulations are to improve investor confidence and protect small investors. In this study I test the effect of the regulations on small and large trader trading activity. Comparing abnormal trading volume across time periods, I find that abnormal trading volume upon investment bank recommendations increased in the Post-Reg. period, for both types of traders, at any level of recommendations (revisions), suggesting that investors are relying more on i-bank recommendations. Moreover, small trader trading profit following these recommendations has increased since the regulations while large trader trading profit has decreased. The wealth-transfer from small traders to large traders has been largely reduced. I conclude that small traders benefited from the Settlement and related regulations.

The effects of regulation on industry structure and trade generation in the US securities industry

This study investigates the effects of Regulation FD and the Global Research Analyst Settlement on market share within the US securities industry as well as the determinants of market share during 1996–2004. We find that these regulations did not cause top brokers to lose market share in spite of their reduction of information asymmetries existing within the brokerage industry. They did, however, significantly reduce the quarterly variability in market share changes. We find that Regulation FD and the Global Research Analyst Settlement reduce the importance of an all-star analyst, issuer affiliation, and analyst optimism for gaining brokerage market share. We further discover that the Global Research Analyst Settlement increases the importance of coverage as a market share determinant while reducing the value of analyst experience for non-top brokers. We find that our results remain robust even when we limit our analysis to a set of pure brokerage firms.

Comparing the stock recommendation performance of investment banks and independent research firms

From January 1996 through June 2003, the average daily abnormal return to independent research firm buy recommendations exceeds that of investment bank buy recommendations by 3.1 basis points (almost 8 percentage points annualized). Investment bank buy recommendation underperformance is more pronounced following the NASDAQ market peak (March 10, 2000) and strikingly so for buy recommendations on firms that recently conducted equity offerings. In contrast, investment bank hold and sell recommendations outperform those of independent research firms by 1.8 basis points daily ( 4 1 2 percentage points annualized). These results suggest reluctance by investment banks to downgrade stocks whose prospects dimmed during the bear market of the early 2000s, as claimed in the SEC's Global Research Analyst Settlement.

Comparing the Stock Recommendation Performance of Investment Banks and Independent Research Firms

This study compares the profitability of security recommendations issued by investment banks and independent research firms. During the 1996 through mid-2003 time period, the average daily abnormal return to independent research firm buy recommendations exceeds that of the investment banks by 3.1 basis points, or almost 8 percentage points annualized. In contrast, investment bank hold and sell recommendations outperform those of independent research firms by -1.8 basis points daily, or -4½ percentage points annualized. Investment bank buy recommendation underperformance is concentrated in the subperiod subsequent to the NASDAQ market peak (March 10, 2000), where it averages 6.9 basis points per day, or slightly more than 17 percent annualized. More strikingly, during this period those investment bank buy recommendations outstanding subsequent to equity offerings underperform those of independent research firms by 8.7 basis points (almost 22 percent annualized). Taken as a whole, these results suggest that at least part of the underperformance of investment bank buy recommendations is due to a reluctance to downgrade stocks whose prospects dimmed during the early 2000's bear market, as claimed in the SEC's Global Research Analyst Settlement. Additional analyses find that the underperformance of investment bank buy recommendations extends not only to the ten investment banks sanctioned in the research settlement but to the non-sanctioned investment banks as well.

Buys, Holds, and Sells: The Distribution of Investment Banks' Stock Ratings and the Implications for the Profitability of Analysts' Recommendations

This paper analyzes the distribution of stock ratings at investment banks and brokerage firms and examines whether these distributions can be used to predict the profitability of analysts' recommendations. Consistent with prior work, we find that the percentage of buy recommendations increased substantially from 1996-2000. Starting in mid-2000, however, the percentage of buys decreased steadily. Our analysis strongly suggests that this is due, at least in part, to the implementation of NASD Rule 2711, which requires brokers' ratings distributions to be made public. Notably, over our sample period the difference between the percentage of buy recommendations of the large investment banks singled out for sanction in the Global Research Analyst Settlement and that of the non-sanctioned brokers is economically quite small. Additionally, we find that a broker's stock ratings distribution can predict the profitability of its recommendations. Upgrades to buy issued by brokers with the smallest percentage of buy recommendations significantly outperformed those of brokers with the greatest percentage of buys, by an average of 50 basis points per month. Further, downgrades to hold or sell coming from brokers issuing the most buy recommendations significantly outperformed those of brokers issuing the fewest, by an average of 46 basis points per month.