The expiration of the Global Research Analyst Settlement with major brokerage firms ends a troubled chapter in Wall Street history. The settlement, reached in 2002, concluded a joint investigation by the Securities and Exchange Commission, then-New York Attorney General Eliot Spitzer and other regulators into conflicts of interest and undue influence of investment banking interests on securities research.
The expiration of the settlement forces us to ask: How will investors find reliable, independent information on securities and the companies that issue them?
The settlement provided that 12 major firms would pay more than $430 million and provide independent research reports to their clients in response to charges that their research was biased toward their own investment banking clients.
The settlement required the firms to pay fines totaling $1.435 billion to their investors to fund investor education and to pay for independent third-party market research. About a third of the fines went to paying for independent research. With the expiration of the settlement last July 31, the firms do not have to continue paying for and distributing third-party research.
It's crucial that independent research continues — and the private sector must lead the way. Why? One key reason is market liquidity. The private sector should look for new ways to promote growth by ensuring that more information is available to help reduce the cost of capital. Research by Roger Ibbotson and Zhiwu Chen suggests that a company's cost of capital increases significantly if its stock is illiquid — and higher costs for capital can diminish valuations, as noted in the 2009 Ibbotson SBBI Classic Yearbook, published by Morningstar Inc. (Mr. Ibbotson, professor in the practice of management at Yale University's School of Management, is chairman and chief investment officer of Zebra Capital Management LLC, Milford, Conn. Mr. Chen is Zebra's director of research.)
Institutional investors spend nearly $2 billion a year on research services. With the expiration of the settlement, there's a real danger that the research industry's focus on large institutional investors and hedge funds will only grow. But how can smaller, individual investors gain access to independent stock research? They too need insightful and trustworthy information to make investment decisions. Without their participation, the market is less liquid than it should be, and companies can lose early opportunities for growth simply because information about them is not readily accessible.
For public companies, research coverage tends to be either a feast or a famine.
Even before the economic downturn, investment banks were eliminating their analyst staffs. According to Integrity Research Associates LLC, which tracks the investment research industry, from 2001 to 2006 - during the market boom - the number of analysts fell to about 9,000 from 16,000. Currently about 1,000 public companies have no research coverage at all, and 2,000 have two or fewer research analysts covering them. Investment banks and broker-dealers have less reason to cover smaller companies and fewer analysts to do the work. All this concentrates more research attention on large, well-capitalized companies, while most others lose out.
As much as some CEOs may privately grumble about research on their companies, the benefits of analyst coverage are well proven. Investors become more aware of companies, their products, and their financial situation. This generates a virtuous cycle of greater investor interest and potentially greater liquidity in the company's shares.
It's time to fill the void left by the expiration of the global settlement to provide all types of investors with the information they need to make better decisions. There are solutions today that help address the market's need for independent research at no cost to the issuer. However, all public companies and investors alike deserve openness, visibility and credible research coverage. Just because the Global Analyst Research Settlement ended doesn't mean that independent research should not matter. The need for transparency is more important now than ever.
Bruce Aust is executive vice president of NASDAQ OMX Group, New York.
