Spitzer’s research settlement at 20

Craig Coben is a former global head of equity capital markets at Bank of America and now a managing director at Seda Experts, an expert witness firm specialising in financial services.

Today is the 20th anniversary of the “Global Settlement of Conflicts of Interest Between Research and Investment Banking”. Heralded at the time as a landmark reform to clean up Wall Street, it will be a cause for no celebration today.

In April 2003, ten investment banks signed a $1.4bn settlement with a panoply of US regulators, led by then-New York attorney-general Eliot Spitzer, and agreed to major structural reforms to separate equity research from investment banking.

In a nutshell, the global settlement . . . 

● prohibited interactions between investment bankers and equity research analysts, except under narrow, controlled circumstances;

● barred investment banking from having a say in research analyst compensation;

● outlawed promises of favourable research; and

● prohibited research analysts from attending IPO pitches or roadshows with investment bankers.

Spitzer lost his moral halo after scandal forced him to resign as New York State governor in 2008. But it’s worth remembering that his crusade had commanded overwhelming public support two decades ago, earning him the moniker “The Sheriff of Wall Street” well before he was outed as Emperors Club VIP Client Number 9.

The NYAG investigation concluded that research analysts were touting stocks, not out of genuine conviction, but rather to appease investment bankers and their corporate clients. This narrative resonated strongly following the dotcom bubble collapse. Investors were nursing huge losses, and it was more expedient politically to blame compromised analysts than to acknowledge that most people just aren’t very good investors.

So has the global settlement made research better?

Nuclear plant safety inspector Homer Jay Simpson once described alcohol as “the cause of, and solution to, all of life’s problems.” The same could be said about Spitzer’s reforms and the problems with equity research.

It’s hard to argue that investors value research more now than pre-2003. Today as before, asset managers might use research forecasts or models to save time but mostly disregard the buy/sell/hold recommendations and do their own work to decide on an investment. The experience in Europe — where Mifid II rules force research to be unbundled from trade execution — suggests that fund managers don’t value sellside research enough to pay much for it.

Opinion is sharply divided on whether research has at all improved. Many agree with tech investment banker Frank Quattrone that the best analysts have forsaken banks for more lucrative work on the investing side:

And most institutional investors perform their own research and don’t rely on sellside research any more.

— Frank Quattrone (@FrankQuattrone) October 2, 2019

Quattrone’s tweet is a huge generalisation, but it is true that by severing the link between investment banking fees and analyst compensation, the global settlement squeezed research departments at a time when fund manager consolidation and lower commission rates were already putting pressure on resources available to support broker research.

Equity research today may not conspicuously be better, but it may at least be more sincere. NYAG investigators had unearthed emails of analysts apparently disparaging stocks they were recommending in public, calling them such epithets as “POS [piece of shit]”, “powder keg” and “piece of junk”. These inflammatory email excerpts were arguably taken out of context, but the impression of intellectual dishonesty stuck. Just the possibility that analysts might think one thing and say another discredited the business model.

But in trying to restore research integrity, the global settlement birthed a new conflict which practitioners and clients would soon find intolerable: that the same bank could have sharply different opinions within it on the same company. This is the last thing that clients want.

A company hires an investment bank to do its bidding — to tell its story to investors. No client wants to hire a bank, only to discover later that the research analyst has a more negative view of the company than the investment bankers. Companies tend to steer M&A and capital markets mandates away from banks whose analysts are “nattering nabobs of negativism”, even if they like the investment banking coverage team.

So the last twenty years have involved elaborate, convoluted attempts to align investment banking and research — without violating the Spitzer settlement.

As a general matter, investment bankers can speak to an analyst only with a compliance chaperone present. They can (politely) query and probe the analyst’s views, but the chaperone will halt the discussion if the bankers say anything to try to influence the analyst. The chaperone’s job is to protect the Little Red Riding Hood of equity research from the Big Bad Wolf of investment banking, and every chaperone I’ve ever dealt with has taken this role very seriously.

Companies have meanwhile looked for a workaround. For a while they would interview (or ask their “independent IPO adviser” to interview) analysts away from the investment banker presentation to learn what the research view would be.

Regulators, however, worried that these interviews put undue pressure on analysts. So Finra put a stop to this practice in the US, banning analyst interviews during the “solicitation period” and fining the banks pitching for the Toys “R” Us IPO for allowing their analysts to be interviewed by the company and its private equity owners.

Undeterred, clients have sought new ways of assessing analysts, for example by requesting sector briefings prior to any pitch process. Investment bankers also discuss companies early on with analysts so that they’re on notice of the analyst’s approach. (They have to be careful not to tell the client what the analyst’s views are, lest it be construed as promising positive research coverage.)

There are also stories of analysts contacting companies to ingratiate themselves because they had read a media report about an upcoming IPO. Companies have also been rumoured to initiate contact with highly-ranked analysts. In other words, other players have filled the vacuum left by keeping investment bankers away from analysts.

Do these end-arounds run against the spirit of Spitzer’s diktat?

Back in 2003, regulators considered — and rejected as too disruptive — the option of forcing investment banks to hive off their research units. With research and investment banking sitting under one roof (even if separated by a Chinese wall), it seems bizarre for a company to hire a bank to market its shares without knowing what that bank’s analyst thinks. No one is asking for a guarantee of favourable research coverage; rather, deal participants want to make sure the analyst understands the sector and is keen to work on the offering.

This distinction — between influencing an analyst and assessing viewpoint alignment — is a fine one. Maybe too fine for some, but it has been crucial for enabling broker research to play a role in investment banking transactions in the post-settlement era.

Twenty years later, banks are still trying to safeguard research independence and ensure that research and investment banking don’t contradict each other. That tension isn’t going away anytime soon.

Further reading:

— Sellside toil and trouble (FTAV)

— Buy? Sell? Hold? Delete! (FTAV, 2007)