Analysts need access. Analysts may be better than the rest of us at assessing the quality of a firm, but they also need to be better than the next analyst. To do this, analysts will try to get their hands on as much information as possible. Of course, the best source of a firm's information is from the firm itself. As mentioned earlier, analysts want to be able to have frank discussions with a firm's management. This represents an obvious conflict of interest. How can an analyst who needs to be chummy with management turn around and give it a bad rating, and then expect to be able to get access again? One analyst said that without access, it becomes difficult to make quality stock assessments, akin to playing basketball with one hand tied behind your back.  In addition, since analysts typically specialize in a particular industry or two, they get to know the managers in the field. That is, they may even develop friendships.
Specializing in a particular industry or sector allows the analyst to become an expert in the different influences and nuances of the industry. However, it is human nature for analysts to be optimistic about the firms they follow so closely. This makes it hard to be objective about the industry in general. Consider the predicament of an analyst following the airlines industry after the September 11, 2001, terrorist attacks. It would be hard for an analyst to recommend selling all the firms in the industry. Yet, it was clear that the airlines were going to experience both lower passenger demand and higher costs due to new regulations. Analysts rarely recommend selling stock in all firms in an industry. Instead, they recommend buying stock in the few companies that they think will hold up the best in a problematic industry. Therefore, investors may misinterpret a "buy" rating on a firm in a troubled industry.
These conflicts of interest certainly jeopardize an analyst's ability to be completely honest when he or she is pessimistic. For example, analyst Daniel Peris was bearish on AOL Time Warner. As a result, he charges that his attempts to gain more access to AOL Time Warner were met with roadblocks from management.  Incidentally, how is it that Peris feels free to be bearish on AOL Time Warner while other analysts are hesitant to be? Perhaps it's because Peris works for an independent research firm that doesn't trade and isn't involved in investment banking. In other words, he doesn't have to be a salesperson, and he doesn't have to worry about angering investment banking clients . This latter fact touches on an important issue with regard to a potential conflict of interest. Would an analyst who works for an investment bank be objective?
Analysts at Investment Banks
Analysts can work for an independent research firm, for a brokerage firm, or for the brokerage operation of an investment bank. Most of the high-profile analysts who many investors follow are analysts who work for investment banks. Why is this? The cost of collecting, analyzing, and disseminating information is enormous . The high cost is less burdensome for an investment bank.
Consider that investment banks have corporate clients with firms that one of their analysts follows . The fees for investment banking services can easily run into the tens of millions of dollars. Do you think that these analysts will feel free to publicly make honest assessments if they would jeopardize those banking fees? If analysts came out with a negative rating, wouldn't the investment bankers get mad? Also, if a non-client firm received a negative assessment from an analyst, do you think it would ever give the analyst's firm any investment banking business? This conflict of interest is similar to the one that occurs when a firm is both a consultant and an auditor to a public company, as described in Chapter 5. No matter how you cut it, analysts who work at investment banks may feel the need to compromise their integrity for the good of their employer.
According to an article in Time magazine, when brokerage firm Smith Barney merged with Salomon Brothers in 1997, there was a cultural shift among the Smith Barney analysts.  There was now big money to be made. Before, analysts had primarily relied on brokerage commissions, but now they were trying to help lure investment banking clients by promising to "cover" (i.e., promote) the stock to investors. One academic study provides evidence that is consistent with this allegation.  The study finds that stocks of firms that are promoted by analysts at investment banks (in cases in which the bank recently provided services for the firms) performed worse than stocks that are promoted by unaffiliated analysts. Also, according to a commentary in BusinessWeek , the stock-picking performance of independent shops such as Callard Asset Management and Alpha Equity Research outperformed the stock-picking performance of powerhouse investment banks such as Goldman Sachs, Salomon Smith Barney, Morgan Stanley, and Merrill Lynch.  Is this because independent analysts are harder working and smarter ? Or is it because their assessments are uncompromised?
Some analysts go so far as to become actively and directly involved in the investment banking side of their employer. For example, telecom analyst Jack Grubman calls himself "banking- intensive ."  He claims that being active in both the analyst function and the banking function leads to a synergy. He has a good point. By working on investment banking deals, one can become better acquainted with the health of the firm, which, in turn, could lead to superior insights into making assessments and assigning ratings. However, despite his intimate relationships with telecom firms, he did not publicly come out against them as their stocks were plummeting in value. Since the summer of 2002, he has been under investigation by New York State Attorney General Eliot Spitzer for his role in WorldCom's fall. Whether or not he compromised his stock recommendations because of his banking ties is also a question. This may not be the worst of it. According to one lawsuit, Grubman may have allocated hot IPOs to telecom executives as bribes to win investment banking business. (Recall that these types of activities were discussed in detail in the prior chapter.) If true, it is an explicit violation of securities regulation and an explicit portrayal of how a conflict of interest may play itself out.
It became common in the late 1990s for analysts to be a part of an investment banking team. When bankers were pitching their services to a firm that wanted to issue securities, an analyst would be there. After the bankers were hired to underwrite the security, they took the analyst on the road show to help market the issue to institutional investors. In this capacity, analysts become salespeople and promoters of a firm instead of objective analyzers of financial performance.
The name Spitzer may also ring a bell. Eliot Spitzer is the person who went after Blodget and his employer Merrill Lynch. Blodget was accused of misleading investors by promoting the stocks of Merrill Lynch's investment banking clients ”even though he knew that they were bad stocks. Normally, this would be hard to prove . However, in subpoenaed e- mails , it was discovered that Blodget had criticized stocks to his colleagues that he was publicly trumpeting. For example, he called some stocks "junk" and "crap," but he was still recommending a "buy" because these firms had investment banking business with Merrill Lynch. Blodget also had a direct vested interest in seeing happy investment banking clients instead of happy investors who followed his recommendations. Apparently, he spent 85 percent of his time on banking and only 15 percent on stock research.  From December, 1999 to November, 2000 ”less than one year ”he worked on 52 investment banking transactions that generated $115 million in fees for Merrill Lynch.  Blodget subsequently received a raise ”from $3 million to $12 million.
Merrill Lynch has also been criticized for two apparent incidents in which one analyst with a bearish recommendation on a firm was replaced with another analyst who was bullish in order to obtain investment-banking business from the firm. In one incident, an analyst covering Enron was replaced with a more optimistic analyst in order to gain favor with Enron executives. Early in 1998, analyst John Olson recommended Enron stock with a "neutral" rating. Olson's negative rating and his personal style rubbed Enron executives Skilling and Lay the wrong way. So Merrill Lynch bankers complained to their CEO about the analyst. The complaint was that Merrill Lynch could not gain any investment banking business with Enron while Olson rated the firm so poorly. The investment banking business kept going to banks that employed analysts who rated Enron as a "buy" or better. In August 1998, Olson left Merrill Lynch for another company. Merrill Lynch then hired Donato Eassey to be its analyst covering Enron. Eassey quickly upgraded Enron to "accumulate." By the end of 1998, Merrill Lynch was participating in investment banking services with Enron that would generate $45 million in fees.  Olson, Eassey, and Merrill Lynch all deny that anything inappropriate occurred. Indeed, Eassey was one of the few analysts to downgrade Enron when its troubles began to become public. Regardless, the story illustrates the strong power companies have over analysts who work at investment banks and the motivation of banks to be optimistic in order to gain business.
In 1999, Merrill Lynch replaced analyst Jeanne Terrile (who covered Tyco International) after Tyco CEO Dennis Kozlowski complained to Merrill Lynch CEO David Komansky about her.  The new analyst, Phua Young, promptly upgraded Tyco to a "buy" rating. The next year, Merrill Lynch underwrote Tyco's $3 billion stock issue.
Internet stock analyst Mary Meeker may be viewed as more of an investment banker than as an analyst. One former banker at Deutsche Morgan Grenfell stated that Meeker (an analyst) was talked about as being one of the best investment bankers on the planet.  When going after investment banking clients, one rival banker considered that he was not competing with Morgan Stanley at all. He was competing with Mary Meeker.  Eventually, Internet firms started chasing after Morgan Stanley to take their firms public, instead of the other way around, because it would mean, they felt, having Meeker give their stock her seal of approval. It appears that Meeker started to feel more loyalty to the stocks that she helped take public than to the investors who relied on her advice. She was being protective. She even privately referred to Netscape as "her baby," so that when one analyst downgraded Netscape stock, she quickly responded by upgrading her rating on it. Now, however, investors are hopping mad. The betrayal has been exposed.
Just Who Is the Client?
From the point of view of the sell-side analyst, the public investor is not the client. The analyst's clients are those institutional or individual investors who trade through the brokerage arm of a firm or buy new security issues from the banking arm. In addition, analysts don't really consider the published ratings and earnings estimates to be the whole of their research product either. Indeed, analysts don't just write a report and consider themselves done. They constantly reevaluate their opinions and advise their biggest institutional clients. The public investor is not included in this process.
While this is the traditional role and duty of the analyst, we believe that things have substantially changed. If analysts just kept to their paying clients, the public investor would not know about their recommendations. But this is not the case. Analysts market themselves and their firms precisely where the public investor is tuned in. Analysts commonly appear on TV networks like CNBC and CNNfn and on TV shows with Lou Dobbs and Louis Rukeyser. When they make changes in their ratings, they alert the media. They also promote themselves and their ratings through numerous financial websites . Since analysts use the public to promote their own agendas , they must also be responsible to those investors. For an analogy, consider that a private company does not have to jump through all the hoops of the SEC regulations because public investors are not the owners and, thus, do not need to be protected. Alternatively, if a private company wants the benefits of accessing the capital of public investors, it must become a public company and succumb to being fully regulated . Likewise, if analysts want the benefits of interacting with the public, they must also take on the duty of protecting the public.
The days of analysts aspiring for a piece of the investment banking action may be over. Merrill Lynch settled its case with Spitzer for $100 million, and its chairman and CEO David H. Komansky publicly apologized to clients, shareholders, and employees by saying that the firm had failed to live up to its traditionally high standards.  Merrill Lynch has adopted a new policy that will not compensate analysts for generating investment banking business.
In fact, the NASD and the NYSE both put forth new or amended rules that would address the conflict of interest problem. The SEC approved these new regulations on May 10, 2002. Under the new rules, sell-side research analysts cannot (1) be subject to supervision from investment banking operations, (2) have their compensation tied to investment banking deals, or (3) promise favorable ratings to lure investment banking deals. Time will tell whether the new rules will help.
There are also different kinds of analysts other than the sell-side analysts who work for brokers or bankers. Institutional investors like pension funds and mutual funds hire analysts to help decide which stocks the funds should buy. Therefore, they are referred to as buy-side analysts. The recommendations of these analysts are not public. Indeed, they are only used within the institution. According to one survey of buy-side professionals, the new rules are not likely to help resolve sell-side analyst problems. Survey respondents doubted that regulations aimed at separating research activities from banking activities could be credibly enforced. 
They may have a point. The SEC told analysts to simplify their ratings to just three categories (like "buy," "hold," and "sell") in May 2002. By September, the rating system hadn't changed much. Sure, the ratings were in only three categories. However, only 7.5 percent were listed as "sell." Not only that, analysts from investment banking firms were still not giving "sell" ratings on firms that were also investment banking clients. For example, for every 25 firms that Merrill Lynch had listed as a "sell," only one was a Merrill Lynch client.  On the other hand, 60 percent of the companies that received a "buy" rating were clients. It doesn't appear that a separation between analysts and banking had effectively occurred by this time.