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Research and "independence" in post-Spitzer world


Personal opinion alert!


A comment on independent research in Toddo's missive earlier in the week prodded me to write a column I've been meaning to write for a long time.

I think I'm qualified to write about independent research since our company was founded in 1999 as a reaction to widespread research conflicts present at the time. We've retained our independence in the intervening 6 years. It hasn't been easy and it is still a work in progress, largely because we have a commitment to remain affordable to the individual investor.

Before I go any further, I need to define independent research as I see it. It's a term a number of firms throw around, but very few actually achieve. True independence is only achieved through the following commitments:

1. No investment banking arm
2. No market making or other income from trading volume
3. No hedge or mutual fund
4. 100% subscription fee supported
5. No consulting for special clients - uniform offerings to all clients
6. No consideration from companies covered
7. No ownership of shares by staff members in companies covered

Our firm does pretty well in this list, "violating" only the last rule. We overcompensate by an industry-best disclosure policy (any trade by a staff member is disclosed in detail (direction, instrument) within 24 hours of execution) and overly-restrictive blackout periods. We also survey our Subscribers to determine their thoughts on the issue. Thus far, they would rather we have "skin in the game" than not.

Over the last six years, the industry has changed dramatically. I point to the initiation of Regulation Fair disclosure (Reg. FD) as the genesis of the independent research movement. Some shops existed before then, but Reg. FD was an official reminder to industry that most of the then-accepted communications between company and analyst were tantamount to insider trading. I remind those who denigrate Reg. FD that it introduced no new rules. It only emphasized rules that were already on the books. Without Reg. FD, independent research teams could not get the management access they needed because they couldn't buy their way in.

The Spitzer Crusade against the investment banking/analyst relationship is clearly the next biggest influence on the business. It drew attention to the existence or independent research, particularly among individual investors. Every professional (and, truth be told, most individuals) were aware of the Swiss cheese Chinese wall between research and banking. We all considered it when reading the research. Spitzer's Crusade took it to the level of household familiarity.

The restrictions put in place in the Spitzer settlement were broadly adopted across the industry. While bankers and analysts still work towards the same goals, the relationship is nowhere near as lucrative as it once was. Analysts were fired in droves in a movement that was largely attributed to "business model problems." Not so much. When the sales aspect of research was eliminated, the salespeople who were wearing analyst hats were lost. This exacerbated the problems exposed by Reg. FD where close relationships with management could allow a salesperson to effectively wear the analyst hat.

Once both crutches were gone, those who were not natural analysts quickly became outmatched by the job. Their pay decreased, their stature decreased, and they left (or were moved out) to greener pastures.

Research muddled along for a couple of years. Research was this huge cost center (even a small sector-specific team probably costs a firm $1M annually to cover less than two dozen stocks). There was nothing obviously on the other side of the T-account to balance that cost.

When banking revenues coincidentally died off as the market collapsed into 2002, the light shone on the trading desk. Look back at the articles from 2001-2003 outlining what sections of the banking world were making good bonuses. It became clear the new kings on the block - especially at the small and mid-tier firms - were the traders.

At some point in late 2003 or 2004, the light bulb went on over someone's head. Trading desks make money off volatility and volume. Analyst notes inherently create volatility and volume. There is a whole industry (, FirstCall, STAR Analyst, Thomsons, CNBC, WSJ, Multex, Bloomberg, Reuters, etc.) centered around communicating analyst opinions to the market as quickly as possible.

It was a match made in heaven.

Increasingly, analysts are working for the trading desk. Prior to the Spitzer Crusade, an analyst's job was to issue research that supported the investment bankers' ability to land deals. Now the analyst's job is to issue research that supports the trading desks' thirst for trading volume. Research is used to win the favor of a hedge fund's volume. Say the right things in your research, an analyst is told, and we'll reward you with volume. Say the wrong things and we'll go do business with someone else.

Business Week last year had an article quoting unnamed analysts who were pressured by a fund on one side and trading desks on the other to alter their research to fit the book of large clients. In discussing changes to my own business model with the professional community, this linkage was reinforced. "We make sure to spread our trading around to reward those researchers we find particularly useful."

I can hear the objections now, mostly because I've heard them all. Most people see "useful" as synonymous with "accurate." Naïve. In a business where performance is king, it is exceptionally naïve to assume "useful" is synonymous with anything other than "supports our position." Now don't get me wrong, not all funds act that way just like not all analysts were tools of their banking arm and not all analysts are tools of their trading desk. It happens each and every day, however, and few on Wall Street have figured it out. Main Street America is completely clueless.

Those of us who recoil at this arrangement know there will be no Spitzer Crusade on this one. The relationship between order flow and research is essentially impossible to prove without the mother of all subpoena processes - or some whistleblower developing a conscience. The relationship between investment banking and research was obvious enough - anyone with access to the WSJ and FirstCall could see it. Not so with the relationship between analysts and the trading desk.

This is a perfect example of unintended consequences. I submit Mr. Spitzer's cure has created an affliction far worse than the disease. Honestly, I don't see how anything short of complete divestiture of the research arm will solve the problem. We can't take the genie out of the bottle, so reforming the rules about analyst's linkage with investment banking won't fix it.

So what's to be done? Recognition of the problem is a good start. Supporting your friendly neighborhood independent research team is another. And yes, I'm well aware that's self-serving for me and the precious few others who run truly independent shops. Ultimately, the best research is the one that makes you the most money as an investor. Most people don't care if that research has horrible conflicts as long as it makes them money.

I submit, however, those conflicts will bite you in the back sooner rather than later. At the very least, every time you read a piece of research from a firm with one or more of the seven conflicts I noted above, you have to stop and take the time necessary to determine what the motivation behind the piece is, if any. This business is complicated enough without having that extra work to do every time you get a new piece of research.

Before I close, I want to be perfectly clear about something: You can be an independent voice as an analyst and still "violate" one or more of those seven conflicts. I firmly believe we're independent despite violating number seven. As we explore alternative revenue models for the future - including revenue from order flows via secondary distribution of our research - I expect to be able to retain our independence. The more tick marks on the conflict list, however, the tougher it is.

The research industry is being turned upside down by this new trend. Our clients complain about it more frequently. Companies we speak with are noticing the trend. Hopefully this article has helped you recognize the problem if you haven't already.

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