Required Disclosure and Compliance Rules for Investment Banking Analysts

By Matt Krantz, Robert R. Johnson

The belief that investment banking analysts don’t always operate independently but can be influenced by factors other than the desire to make an objective determination of an investment’s prospects, resulted in a call for increased regulation of the analyst profession. Former Supreme Court Justice Louis Brandeis once said, “Sunlight is said to be the best of disinfectants; electric light the most effective policeman.”

In the spirit of Brandeis, a series of regulatory changes — including both disclosure of conflicts of interests and prohibitions of actions — has transformed the analyst profession.

As an indication of the seriousness of the problem, in April 2003, ten of the largest investment banks agreed to pay a pretty steep price — $1.4 billion in total — and were forced to abide by a series of regulations governing their behavior.

There is recognition by the regulatory authorities and the industry that while not all these conflicts of interest can be completely eliminated via stricter regulations, they need to be properly disclosed. The following represents a synopsis of the major changes to regulations and required disclosures governing analysts:

  • A prohibition on analysts receiving compensation for investment banking activities: Analyst compensation cannot be tied directly to a specific investment banking activity. Going even further, if any part of the compensation of analysts is tied to general investment banking activity at the firm, that must be disclosed in the firm’s research report. The intent is to tie an analyst’s compensation solely to the quality of his research.

  • A prohibition on promises of favorable research: Investment banking firms cannot promise a favorable research rating or a specific price target to secure investment banking business. Firms are also prohibited from issuing a report on a company within 40 days after an IPO.

  • A prohibition on analysts being involved in soliciting investment banking business: Prior to the change in regulations, star analysts often accompanied investment bankers on their recruiting trips when seeking new or maintaining existing investment banking clients.

  • A prohibition on influence by investment bankers: Analysts are prohibited from being supervised by the investment banking departments of their firms. In addition, analysts cannot discuss research reports with investment bankers prior to distribution.

  • A requirement to certify analyst reports: Specifically, Regulation Analyst Certfication (Reg AC) requires analysts to certify that their views accurately reflect their beliefs about the future performance of the subject company. This is similar to the requirement that CEOs and CFOs certify the accuracy of their financial statements.

  • A requirement to disclose firm compensation: Investment banks issuing research reports must disclose in the report if they managed or co-managed a public offering or received any compensation for investment banking services in the past year. Such a disclosure signals to investors that the firm may have a vested interested in the performance of the company.

  • A requirement to disclose holdings or investment banking ties during public appearances: How often have you wondered if the analysts appearing on TV touting a stock hold positions in that stock? Analysts must now disclose if they or their firms have a position in the stock or if the company is an investment-banking client. This helps the viewer form her own opinion about the validity of the recommendation.

  • A requirement to disclose financial interests on reports: On research reports, analysts must disclose if they own shares of the companies.

  • A requirement to disclose what the firm’s ratings mean: Firms must fully explain — in plain English — what any ratings terms like buy, sell, or hold mean. Firms must also disclose the percentage of the ratings that they have in each category, and also disclose the percentage of investment banking clients that they have in each category.

  • Limitations of personal trading by analysts: Analysts are investors too. But, they aren’t allowed to trade on the companies they follow during blackout periods. Specifically, analysts can’t trade for 30 days before and 5 days after they issue a research report. They’re also prohibited from trading against their most recent recommendation.