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LEADER 2005
EQUITY RESEARCH
ENVIRONMENT IN LIGHT
OF THE
GLOBAL SETTLEMENT
A DISSERTATION
MANOJ UPADHAYAY
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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
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
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
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SECTION I:
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
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
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
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)
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
relationships
Prohibited submitting the research report to the subject company for approval
Prohibited publishing reports during bake-off period when banking deals were
analysts
At the same time, AIMR (Association of Investment Management and Research) and
NIRI (National Investor Relations Institute) have also introduced guidelines that extend
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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:
The sweeping changes post the Global Settlement has had profound consequences on
stocks, disseminating material information to investors, and capital formation. Among the
most important effects of the global settlement and the newer regulations on investment
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
that trade millions of shares each day. As the commission margins are decreasing
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
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Years
boutique research shops attempting to fill the void for high-quality, unbiased
research.
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
Investment banks are looking at innovative ways to cut costs, especially for junior
Some issuers have responded to this skeptical climate by cutting off access to
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
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SECTION IV:
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
circulated through broker-dealer networks would dilute the value of their insights
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
model unsustainable.
Opportunities Threats
firms
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:
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
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
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
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
Institutional investors are diverting equity commission dollars from Wall Streets
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
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
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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
bulge-bracket firms some $25 million over the past two years.
However many investment managers are also beginning to understand the need to
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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
unbiased, objective and independent. With the settlement terms making research
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
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
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
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REFERENCES
by Leslie Boni and Kent L. Womack, February 2004 published by the Wharton
www.investorside.org
www.investopedia.com
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