Regulators responded to the analyst scandals of the late 1990s by imposing extensive new rules on the research industry. These rules include a requirement forcing financial firms to separate investment banking operations from research. Regulators argued, with questionable empirical support, that the reforms were necessary to eliminate analyst conflicts of interest and ensure the integrity of sell-side research.
By eliminating investment banking revenues as a source for funding research, the reforms have had substantial effects. Research coverage of small issuers has been dramatically reduced—the vast majority of small capitalization firms now have no coverage at all. The market for research has become increasingly segmented; institutional investors have access to highly sophisticated and costly information sources, while retail investors are receiving less information than ever.
This Article argues that these consequences were predictable. Because research is a public good, and quality research cannot be produced at low cost, the basic business model of the research industry requires firms to subsidize their research operations—especially research that is widely distributed to retail investors—with other services. Analysts traditionally used investment banking revenues, trading commissions, and proprietary trading to fund their research. These services, in turn, created incentives for analyst optimism. Mandated independence does not change this market structure, and high-quality research cannot be provided to public investors on a cost-effective basis absent a source of funding.
This Article proposes an alternative to mandated independence: a disclosure-based mechanism to manage analyst conflicts of interest. The Article argues that the recent reforms should be replaced by a combination of analyst registration and a new model of analyst disclosure through a Securities and Exchange Commission Analyst Website (SECAW). SECAW would enable firms to subsidize research while providing the information necessary to allow researchers and investors to evaluate the quality of that research. At the same time, SECAW would respond to concerns about segmentation, information access, and non-investment-banking conflicts that have not been addressed by the Global Research Settlement or other regulatory efforts.55-1-2