Merrill Lynch, the largest US brokerage, is facing possible criminal charges because it is alleged that several of its analysts issued misleading stock ratings in order to please the firm’s investment banking clients.
In this country, such an issue would probably not spill over from the business pages. But, in the US, the case has acquired so high a public profile that Merrill Lynch has retained former New York mayor Rudolph Giuliani to negotiate with state attorney general Eliot Spitzer. More embarrassingly for the bank, its chief executive officer David Komansky recently took the unprecedented step of publicly apologising for “having failed to live up to the high standards that are our tradition”.
For the moment, London-based banks can rejoice in the fact that the regulatory apparatus here is a good deal more benign than in the US. City watchdog the Financial Services Authority (FSA) recently carried out a review of equity research and found no evidence of significant shortcomings. “The level of concern and complaints is higher in the US, but that does not mean we are complacent,” says an FSA spokesman.
The FSA can send in a team of investigators if it feels there has been a breach of the regulatory rules. The findings go to the Regulatory Decisions Committee, which can impose fines or issue a public reprimand. But the FSA is only empowered to prosecute for insider trading or market manipulation.
Graham Field, editor of the securities industry intelligence quarterly AQ, says: “Here, the internet boom (the sector in which the US allegations have surfaced) was not as dramatic and it was not associated with particular analysts. There is also less of a retail culture in Britain and individual punters don’t feel that they’ve been caught out.” Nevertheless, only 3% of the stock recommendations issued by the big London-based investment bank analysts are “sells”.
Some houses have begun to take preventive action. HSBC, for instance, which has a team of 130 pan-European analysts covering 25 sectors, took the view that it needed to balance the number of buy and sell recommendations it made. Guy Ashton, the bank’s joint head of European research, says the idea was first mooted in November 2000, and hence pre-dates events in the US. “The idea is to balance the recommendations by market capitalisation so that buy and add equal reduce and sell,” he says. “The sum should come to zero, or within 10 or 20 percentage points of that.”
Ashton says the bank wanted to stimulate analysts to think of clients.
“We have also stopped our analysts putting out holds, as we want them to take a view. We feel this strengthens our research franchise and the response from clients has been tremendous. They are saying that at last someone is doing it right.”
Of course, one could take the cynical view that HSBC can take radical steps such as this because it has little investment banking business and does not have to worry about alienating clients. But other investment banks in London are believed to be considering similar shake-ups.
The US allegations reinforce the role of small houses, which can afford to be independent in their research. The big houses may have begun to pay lip service to independent research, but this is largely because the mega IPO deals of the past have vanished in the current climate. Once that market comes back, much of the fuss about conflicts of interest will melt away.
“Niche brokers like ourselves can continue with an independent non-consensus view,” says Michael Drozd, head of research at London broker Teather & Greenwood. “Research has become so much of a commodity that you’ve got to provide fund managers with something different. Our analysts give an independent view, and of the large- and mid-cap stocks we cover, 30% to 35% of our recommendations are sells. We have no corporate finance axe to grind in the large- and mid-cap arena.”
The large investment banks are waking up to the fact that the credibility gap is widening and they are tightening up on compliance questions, meaning there is more pressure on analysts to publish their interests. So far, no one has taken the view that equity research is not worth the trouble and expense, despite the fact that it only brings income when it generates corporate finance deals. In fact, the recent trend has been to recruit more analysts, simply because this year’s wave of investment bank lay-offs has dumped cheap talent into the market.