Analysts conflict of interest potential - underwriting, clients, commissions, compensation, ownership

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This page discusses potential conflicts of interest as it applies to analysts, analyst firms, and underwriters of securities.

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POTENTIAL CONFLICTS OF INTEREST

Many analysts work in a world with built-in conflicts of interest and competing pressures. On the one hand, sell-side firms want their individual investor clients to be successful over time because satisfied long-term investors are a key to a firm's long-term reputation and success. A well-respected investment research team is an important service to customers.

At the same time, however, several factors can create pressure on an analyst's independence and objectivity. The existence of these factors does not necessarily mean that the research analyst is biased. But investors should take them into account before making an investment decision.

Investment Banking Relationships
When companies issue new securities, they hire investment bankers for advice on structuring the deal and for help with the actual offering. Underwriting a company's securities offerings and providing other investment banking services can bring in more money for firms than revenues from brokerage operations or research reports. Here's what an investment banking relationship may mean:

The analyst's firm may be underwriting the offering
The firm has a substantial interest in assuring that the offering is successful. Analysts are often an integral part of the investment banking team for initial public offerings assisting with due diligence, research into the company, participating in investor road shows, and helping to shape the deal. Positive recommendations published after the offering may support new stock issued by a firm's investment banking clients.
Client companies prefer favorable research reports
Unfavorable analyst reports may hurt the firm's efforts to nurture a lucrative, long-term investment banking relationship. An unfavorable report might alienate the firm's client or a potential client and could cause a company to look elsewhere for future investment banking services.
Positive reports attract new clients
Firms must compete with one another for investment banking business. Favorable analyst coverage of a company may induce that company to hire the firm to underwrite a securities offering. A company might be unlikely to hire an underwriter to sell its stock if the analyst has a negative view of the stock.

Brokerage Commissions
Brokerage firms usually don't charge for their research. A positive-sounding analyst report can help firms make money indirectly by generating more sales of covered securities which result in additional brokerage commissions.

Analyst Compensation
Brokerage firms' compensation arrangements can put pressure on analysts to issue positive research reports and recommendations. For example, some firms link compensation and bonuses to the number of investment banking deals the analyst lands or to the profitability of the firm's investment banking division.

Ownership Interests in the Company
An analyst and the firm itself may own significant positions in the companies an analyst covers. Analysts may also participate in employee stock-purchase pools that invest in companies they cover. In venture investing, an analyst's firm or colleagues may acquire a stake by obtaining discounted, pre-IPO shares. These practices allow an analyst or the firm to profit from owning securities in companies the analyst covers.

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