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Research Analyst Reforms and the Settlement
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First fundamental flaw: |
The firewall built under the new rules and the settlement is exclusively between equity underwriting and research, failing to recognize that a firm's other profit centers can also cause serious conflicts of interest for research analysts. |
Table 1 summarizes the breakdown of revenues among the investment banking firms that have participated in the global settlement, based on their most recent filings with the SEC. Among the various revenue sources, there are three that have not been addressed by the rules proposed and approved to date:
Underwriting of debt securities. Other than the SEC rule requiring analyst certification, the rules address issues related strictly to the underwriting of equity issues. There are no new rules that specifically address the underwriting of debt securities. Negative research reports on a company can easily become the fly in the ointment for these operations, while positive research reports inevitably help support them.
Commissions. Among the 10 firms involved in the settlement discussions, the aggregate percentage of revenues from commissions (9%) is larger than the percentage from all investment banking activities (8.4% including M&A), according to the firms' recent SEC filings.
Brokers can typically use a buy rating on a stock to pitch it to all customers and generate large commissions. In contrast, with a sell rating, their target market is much smaller, limited strictly to customers who already have shares to sell. Moreover, most brokers fear too many sell ratings will chase customers away - the more their customers sell, the more likely they are to close their accounts. Therefore, we believe the firm's desire for more commission revenues can easily bias research.
Trading and investments. Except for other revenues largely unrelated to this discussion, trading and investment revenues from house accounts (proprietary trading) represent the single largest source of revenues (10.8%) among the ten firms that participated in the global settlement discussions. This can bias research in several ways. For example:
- If a firm's traders decide to unload a few stocks from
their house account, it's likely that a downgrade or a "sell"
on those same companies from their own analysts would make it
more difficult for the firm to sell at a favorable price.
- Conversely, there is a financial incentive for trading department managers to pressure analysts to issue upgrades and "buys" to help them unload their shares to more willing buyers.
| Table 1. Revenue Breakdown of Investment Banking Firms In Settlement | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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Second fundamental flaw: |
The rules fail to adequately recognize informal pathways of communication and influence through which conflicts and deceptions can easily continue despite even the most elaborate regulations. |
The global settlement prohibits analysts from participating in investment banking road shows. At the same time, the NASD and NYSE have proposed a rule that permits analysts to assist in investment banking sales and road shows but prohibits those same analysts from issuing reports or making public statements on the client companies. It remains to be seen whether or not the more rigid restrictions from the global settlement will be applied universally.
In the meantime, however, there is nothing in the NASD/NYSE proposed rules to prevent those analysts from sharing information or opinions with colleagues in the same company who do issue the reports.
Similarly, the NASD, NYSE, and global settlement have instituted rules prohibiting research analysts from being supervised by a firm's investment banking department. However, the investment banking department can continue to exercise broad impact on research through a myriad of informal pathways of authority and influence.
They have also approved a rule forbidding investment banking personnel from discussing a research report with the analysts unless the firm's legal/compliance staff is present, but without a mechanism to clearly control informal communications in and outside the workplace. They have approved a rule mandating quiet periods during which reports cannot be issued, but with no mechanism for enforcing private or informal communications of research results during that period. And, they have proposed or approved numerous rules governing the disclosure of conflicts of interest to clients in written reports and communications, but without rules governing oral communications by analysts or brokers to clients.
At best, these rules underestimate the relative ease with which they can be circumvented. At worst, the rules tacitly endorse the conflicts, providing a veneer of propriety behind which many investment bankers, analysts, and brokers can pursue business as usual.
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Third fundamental flaw: |
The rules fail to recognize that Wall Street has established a two-tier system for the distribution of information, and that this system often favors a privileged class of investors. |
As we have seen, there are several rules that seek to regulate the manner in which information is disclosed and transmitted to the public. The SEC's global settlement will require the settling firms to distribute independent research to investors. The settlement contains-and the NASD and NYSE have approved-rules requiring that investors be notified when an analyst's coverage is dropped. And the SEC has adopted a rule requiring analysts to certify that their views are their own.
However, these rules do not take into consideration the fact that there are two communication networks on Wall Street-one for an elite group of customers that receive complete research and stock ratings data, and another for all other investors who often receive incomplete and outdated information.
Currently, many firms fail to adequately inform the public when coverage is dropped, even for companies going bankrupt. Thus, among the firms covering companies that filed for Chapter 11 in 2002, many dropped coverage on the failing companies, but neglected to inform major public sources. Investors seeking an opinion would not have learned that the coverage was dropped. They would only see the usually-positive, outdated rating.
For example, in early 2003, the leading private information source, First Call, posted the terms "dropped coverage," "suspending coverage," or "not rated" with respect to the companies listed in Table 2. However, at the same time, three leading public information sources, Briefing.com, Bloomberg, and Yahoo.com, continued to display "buy" or "hold" ratings on these same bankrupt companies.
Rules proposed in the settlement and by the NYSE and NASD require that firms notify investors when coverage is dropped. However, if the existing flawed communication system is used, these rules will be largely ineffective.
In the final analysis, individual investors will be the losers if investors are not informed that their shares have been abandoned by the same analysts who had recommended their purchase earlier. Moreover, if key research reports continue to be circulated strictly through private channels, any disclosures they contain will also not see the light of day. At best, their distribution to the public could be unduly delayed.
Overall, unless all three of these fundamental flaws in the new rules-informal pathways of influence, other revenue sources that can bias ratings, and Wall Street's two-tiered communication network-are more fully recognized and addressed, the new regulations are bound to leave most investors unprotected from many of the offenses.
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Table 2. "Dropped Coverage" Ratings Reported to First
Call but Not Available to the Public |
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Part 3. Weiss Ratings' Recommendations
If securities regulators are truly committed to protecting investors from the widespread abuse to which they are being subjected, the following reforms must be addressed, either in the context of the proposed rules or in subsequent rulemaking:
| 1. | Centralize the
rule-making function. Currently, the convergence
and overlapping of adopted and proposed rules by the SEC,
the NASD, the NYSE and settlements with the state attorneys
general is causing significant market and industry
confusion. In addition, it is unclear as to how the
settlement with the ten large firms is going to be applied
to the many firms that are not party to the settlement. We
propose that the rule-making functions be centralized under
the SEC. |
| 2. | Seriously reconsider
divestiture. Regulators and legislators have
decided not to force the separation of research from other
operations. However, given the difficulty of regulating and
enforcing behavior that goes against the grain of the
profit motive in each firm, this would be the cleanest
solution and should be seriously reconsidered. |
| 3. | Base analysts' incentive
compensation exclusively on the accuracy of their research
and ratings. If divestiture is impossible, this is
a fall-back solution: In order to better align the
interests of analysts with those of investors, we propose
that at least 50% of each analyst's compensation be derived
from incentive bonuses, and that 100% of the bonuses be
based strictly on the relative accuracy of the analyst's
ratings, measured by a standard methodology. Compared to
the terms of the settlement, this will provide analysts
with a stronger and clearer incentive to voluntarily shun
outside influences, helping to allay our concerns regarding
the many ways the new rules can be circumvented. We feel this is essential in order to establish a firm counterweight to the conflicts of interest that are bound to persist on a corporate level as long as research and investment banking are under the same roof. |
| 4. | Create a comprehensive
Stock Ratings Database (SRD), making it widely available to
the public. The global settlement requires each
participating firm to publish its analyst ratings and
targets on a quarterly basis via the firm's own website.
While this public dissemination is a positive step, this
measure stops far short of providing investors with an
easy-to-use means for assessing and comparing the latest
ratings on a stock. Our proposed SRD (see Appendix B) would provide individual investors with a user-friendly database on the current and historical stock ratings issued by Wall Street analysts and firms, empowering investors to make informed decisions regarding the value of the advice. In addition, it would give third-party researchers the ability to develop comparative studies and commentary regarding the value of the advice to investors. The aggregation of information on one Web site would allow the public to compare and measure the performance of analysts. This, in turn, would provide market-based incentives for analysts to compete based on the quality of their research. Investors would be able to view or compare the current ratings of each stock by various analysts, the track records of each analyst, and the performance of various analysts and firms over time. As such, the SRD would circumvent and overcome Wall Street's two-tiered communication network, which has left most investors with outdated information. We recommend that regulators place the primary burden for the creation and maintenance of the database on the individual brokerage firms by requiring them to submit all of their analysts' stock recommendations in a standard format and via an automated upload. The procedure would populate the database with the relevant information. Firms supplying incomplete or erroneous information should be subject to penalties that would then go toward covering the cost of monitoring that firm's submissions in the ensuing year. Until such time as this system is in place, changes in ratings, including notification of dropped coverage, must be disseminated in such a way as to ensure that the public receives effective notice. |
| 5. | Require firms to update
their stock ratings on a regular basis and following any
event that could materially impact a rated company.
As discussed above, many firms fail to update their ratings
despite significant changes affecting the rated company. We
propose that firms be required to update ratings following
any event-such as a debt downgrade-that could materially
impact a rated company. At a minimum, ratings should be
reviewed annually. |
| 6. | Require that all research
reports be written in plain English. This
requirement should include disclosures regarding the nature
of any remaining conflicts, explicitly pointing out how
such conflicts could bias the research. Research and
disclosures of any remaining conflicts must not only reach
individual investors, but they must also be clearly
understandable to those investors. Disclosures should not
only state the required facts, they should also inform
investors why the facts are important and how they could
bias the opinion of the researcher. All too often, opaque disclosures become standard, leading investors to dismiss them and the firms free to go about business as usual. Or, sometimes industry leaders consent to broader, jargon-filled disclosures, but then overwhelm investors with reams of unintelligible information. These roadblocks can only be overcome with very specific, plain English disclosures (tested on actual investors) regarding the actual relationships and potential conflicts between each firm and its clients. |
| 7. | Require firms and their
brokers to provide similar disclosures to investors when
recommendations are communicated orally and to inform
customers when ratings change or coverage is
dropped. It is especially important that individual
investors understand the analysis in the report, the nature
of any conflicts, and how such conflicts could bias the
analysis. When brokers relay an analyst's recommendations
orally, they should be required to provide investors with
the disclosures contained in the research report and a
brief review of the accuracy of the analyst's past
recommendations. Further, when ratings change, brokers should be required to inform their clients that bought the stock on their recommendation. Once the SRD is in place, brokers should educate their customers regarding its goals, usage, and contents. |
| 8. | Extend rulemaking to analysts issuing bond and credit ratings. The final and proposed rules of the NYSE and the NASD focus almost exclusively on the buy, sell, and hold ratings issued on stocks, failing to address widespread conflicts with respect to the issuance of bond and credit ratings.4 Investors should be able to rely upon the same degree of disclosure and research ethics regardless of whether they are investing in stocks or bonds. |
Without these additional steps, it is very possible that the settlement and the ongoing rulemaking process will fall short. With them, it is far more likely that the goal of truly protecting investors can be achieved.
Appendix A. Analysts Reform Progress Report
| Major Reforms | Rules Approved | Rules Proposed | Not Done | Weiss Commentary |
|
Investment Banking and Other Outside Influence on Research Analysts |
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Separation of investment banking and research through divestiture. Proposed by consumer and investor advocates as the only way to eliminate conflicts of interest. |
Ö |
Legislators and regulators have decided not to force divestiture. As a result, instead of eliminating serious conflicts of interest, they are seeking to manage the conflicts through the patchwork of regulations and the global settlement summarized below. |
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Research from independent firms. Brokerage firms must contract with at least three independent research firms to provide research for five years. Independent ratings must appear in brokerage statements and confirms. |
Ö |
Strong step in the right direction. However, it is unclear how balanced presentations can be enforced in the context of oral communications between brokers and clients. |
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Prohibition on research analysts in investment banking sales. NASD/NYSE: Those who participate in obtaining inv. banking business or road shows must not issue reports or make public statements about the company. Global settlement: Prohibits analyst participation in road shows. |
Ö |
Ö |
There is nothing restricting the prohibited analyst from sharing information or opinions with colleagues, who may use the same or similar material in their own reports or statements. The global settlement's total prohibition of analyst participation in road shows is a more appropriate response. |
|
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Supervision of research analysts. Research analyst may not be supervised or controlled by a firm's investment banking department. |
Ö |
Inv. banking could continue to impact research through informal pathways of authority and influence. |
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Separation of research from investment banking. Research and inv. banking must be managed in two units, with separate legal and reporting structures, in physically separate locations, and with a firewall between them restricting communications. |
Ö |
Managerial and physical separation will help manage the potential for conflict. However, analysts will still have the overall success of the firm as a common goal, continuing to potentially bias the research. |
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Discussing research. Investment banking personnel cannot discuss a research report with the analyst unless the firm's legal/compliance staff is present. |
Ö |
This is an artificial firewall that cannot be effectively enforced. It is very difficult to control private communication among employees. |
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Fact-checking by companies. The company may not review the research report except to check factual accuracy. |
Ö |
There is no discrete line that separates fact from analysis. Any prepublication review can open the door to continuing influence. |
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Booster shots. Research reports cannot be published or public appearances made 15 days before or after the expiration of a “lock-up” agreement. |
Ö |
If the analyst has a strong incentive to produce accurate reports, this rule would not be needed. Conversely, if there is an incentive to boost share prices for favored companies and investors, the prohibition period is inadequate. |
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Retaliation against analysts. Companies must not retaliate for issuing unfavorable research. |
Ö |
The Sarbanes-Oxley Act of 2002 requires the SEC or the NYSE/NASD to adopt rules by July 2003 to prohibit retaliation. |
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How Analysts Get Paid And Solicitation of Banking Business |
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Analysts compensation to be based on quality of research. A significant portion of compensation must be based on quality and accuracy. |
Ö |
A welcome step to lay the groundwork for putting the analyst on the side of the investor. However, it is vital that “significant” be spelled out more clearly. |
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Analyst compensation tied to banking. NASD and NYSE: Direct ties not allowed to specific transactions. Global settlement: Neither direct or indirect ties allowed, but compensation may relate to overall firm revenues. |
Ö |
Overall firm revenues, if largely driven by investment banking and other profit centers that create a conflict, may continue to bias research. |
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Disclosure of banking-related compensation. If analyst compensation is based on general investment banking revenues, it must be disclosed in the analyst's research reports. |
Ö |
Such standard disclosures are often (a) buried in reports and/or (b) become so ubiquitous that they lose most or all meaning. Moreover, the mere disclosure of factors that are likely to cause a bias does not reduce or excuse that bias. |
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Compensation Committee. A committee reporting to the Board of Directors must review and approve analyst compensation at least annually. |
Ö |
Ö |
|
This is an appropriate mechanism, provided the above three issues are resolved. |
|
Promising positive ratings to generate banking business. Firms may not offer a rating or price target to a company to get its banking business or other compensation. |
Ö |
Does not prevent firms from establishing a reputation for glowing research reports and high price targets in order to attract the business of companies in the future. |
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Quiet periods.. 40-day quiet period after an IPO; 10 day quiet period after a secondary offering; 15 day quiet period before and after the expiration of a lock up agreement for a securities offering |
Ö |
These rules represent a tacit recognition that the body of rules as a whole may not adequately prevent research from continuing to influence—and be influenced by—investment banking transactions. |
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IPO shares to analysts. No analyst or family member may receive securities prior to an IPO. |
Ö |
This is an adequate response to this practice. |
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Personal securities transactions. Analysts cannot trade in a stock 30 days prior to the issuance of a report on that company, and ending 5 days after. |
Ö |
Front running and conflicts of interest related to personal transactions are not restricted to a particular time frame. Weiss recommends that analysts should not be allowed to invest in or hold any securities that they cover. |
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Contrary trading. Analysts cannot trade contrary to their most recent recommendations on a company. |
Ö |
This is a step in the right direction. However, Weiss believes that analysts should not be allowed to trade at all in the stocks they cover. |
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Disclosure and Notification to Investors |
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Analyst certification. Analysts must certify that the views expressed in their research reports and public appearances are their own. |
Ö |
|
There is nothing to prevent individuals from (a) formulating their views under pressure of bias, and then (b) incorporating those views into their own body of opinions as if they were their own from the outset. |
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Plain English. Analyst reports and disclosures must be in plain English. |
Ö |
No rules have been adopted or formally proposed to address this critical issue. |
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Oral communications. When brokers relay recommendations orally, they should be required to provide investors with disclosures contained in the research report and the accuracy of the analyst's past recommendations. |
Ö |
With the exception of a settlement stipulation that brokers must inform clients of the availability of independent research, rules governing oral communications between brokers and their clients regarding research have not been adopted or formally proposed. |
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Disclosure of public offerings. Research reports must disclose if the analyst's firm handled a public offering of equity securities for the company or received investment banking compensation within last 12 months or anticipates revenues within next 3 months. |
Ö |
Regardless of when investment banking revenues have been received or are anticipated, firms vying for banking business may seek to establish a reputation for their research departments to entice companies to use their services. The proposed rule does not address this concern, nor does it cover the offerings of debt securities. |
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Disclosure of public appearances. Analysts must disclose if the company is a client in their public appearances. |
Ö |
The disclosure of bias does not correct the bias. |
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Disclosure of ownership. Analysts must disclose any ownership of securities by themselves and their family members in their research reports and public appearances. |
Ö |
Weiss believes analysts should not own the securities they cover. |
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Disclosure of percentage of ratings in each category. Firms must disclose percent of ratings assigned to buy/hold/sell categories and the percentage within each category of companies for whom the firm has provided investment banking services within the last 12 months. |
Ö |
This is a positive step that will help investors evaluate the impact of investment banking on a firm's research. |
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Disclosure of price charts. Research reports must contain a price chart that shows historical price movements and indicates points in time when ratings or price targets were assigned or changed. |
Ö |
This is a positive step that will help investors evaluate an analyst's track record. In addition, it could be enhanced with a record of any upgrades or downgrades to the company's public debt as a reference point for assessing the analyst's response to changing public information. |
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Transparency of analyst's performance. Firms must make data on their ratings available on their website within 90 days after end of each quarter. |
Ö |
This is a welcome step. However, it will be very difficult for investors to compare the data among firms, and most of the data may be outdated. Weiss proposes the creation of an Internet-based comprehensive analyst ratings database to track all analyst recommendations and ensure unequivocal access to all investors |
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Notification of termination of coverage. Investors must be notified when an analyst drops coverage. Proposed NASD/NYSE rules require that this notice must also include a final rating or recommendation while the global settlement makes no such requirement. |
Ö |
Weiss believes this notification provision is deficient. It calls for “notice to be made in the same manner as when research coverage was first initiated” but places no responsibility on any entity for passing that notification on to the public. |
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Standard for dissemination of ratings. These are needed regarding the issuance and updating of ratings, including dropped coverage, via major public sources. |
Ö |
In order for rating change notifications to be effective, the notifications must get into the hands of investors, including dissemination via major public sources that are currently not being kept up to date. |
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Updating ratings. Firms should update or affirm their analysts' ratings following any event that could materially impact a rated company, with annual updates at a minimum. |
Ö |
There is a strong possibility that ratings will languish and become outdated unless there is an onus on the firms to update them. |
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Oversight of Analysts |
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Registration and continuing education. Establish registration, qualification, and continuing education requirements for analysts to ensure they receive ethics and professional responsibility training. |
Ö |
|
This is a positive step. However, if ethics training is not fully supported by – or is in conflict with – the financial incentives of the analyst, it is likely to be undermined. |
|
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Review Committee. The global settlement requires firms to establish a committee to review analyst ratings and reports for changes, accuracy, and overall quality. |
Ö |
|
Weiss believes this approach should be adopted industry-wide. |
|
Appendix B. Stock Ratings Database
In order to ensure accurate and timely dissemination of analyst stock ratings, Weiss Ratings recommends the creation and maintenance of a free website that provides investors with a comprehensive stock ratings database (SRD).
Goals of the SRD:
1. To provide individual investors with a user-friendly database on the current and historical stock ratings issued by Wall Street analysts and firms, empowering investors to make informed decisions regarding the value of the advice.
2. To provide third-party researchers the ability to freely download a relational database in its entirety, enabling them to develop comparative studies and commentary regarding the value of the advice to investors.
The aggregation of information on one website will allow the public to compare and measure the performance of analysts. This, in turn will provide market incentives for analysts to compete on the quality of their research. This service should be "free" so that it is widely used and its benefits flow to the very investors who have been harmed by past abuses.
Creation and Maintenance of the SRD:
Weiss Ratings recommends that regulators put the majority of the burden for creating and maintaining the database on the individual brokerage firms by requiring them to submit all of their analysts' stock recommendations in a standard format and via an automated upload.
The procedure would populate the database with the relevant information. Firms supplying incomplete or erroneous information should be subject to penalties that would then go toward covering the cost of monitoring that firm's submissions in the ensuing year. Weiss Ratings recommends regulatory action to encourage and possibly compel the participation of all analysts so that the website becomes a truly comprehensive resource for the public.
Contents of the SRD:
Weiss Ratings recommends that the SRD be made available through its internet website, with fields such as:
- Brokerage firm name
- Research analyst name
- An indication as to whether the firm or the analyst is independent or has conflicting business relationships
- Company name and ticker symbol of stock being rated
- A chronology of all ratings on this company:
- by the same firm
- by the same analyst
- with dates and closing stock prices at time of each rating change - Current rating, using standard classifications:
- Buy
- Sell
- Hold
- Dropped coverage
Note: For the purpose of tracking performance, dropped coverage is considered identical to a "sell" rating. - Date of first "buy" rating, if any
- Closing stock price on date of first "buy" rating
- Position Open/Closed, wherein
- the position is defined as "open" if no "sell" or dropped coverage rating has been issued
- the position is defined as "closed" as soon as a "sell" or dropped coverage rating has been issued
On open positions:
- Most recent closing price
- Price appreciation or depreciation of the stock to date
- Total hypothetical accumulated dividends to date (assuming investors bought and sold at the closing prices)
- Total hypothetical return to date
- Number of calendar days from first "buy" recommendation to date
- Annualized total hypothetical return to date
On closed positions:
- Date position closed
- Closing price on date position was closed
- Price appreciation or depreciation on recommendation
- Total hypothetical accumulated dividends to date (assuming investors bought and sold at the closing prices)
- Total hypothetical return
- Number of calendar days from first "buy" recommendation to date position closed
- Annualized total hypothetical return
Application of the SRD:
The stock ratings database would allow each investor to sort
or select the data by:
- Stock,
- Firm, or
- Analyst.
Sorting or selecting by stock, the investor would be able to review and compare:
1. The current rating for the stock by multiple
firms.
2. The current rating for the stock by multiple analysts.
3. The annualized total hypothetical returns achieved for the
stock by multiple firms.
4. The annualized total hypothetical returns achieved for the
stock by multiple analysts.
Sorting or selecting by analyst, the investor would be able to review and compare:
1. Current ratings issued by the analyst on
multiple stocks.
2. Historical ratings issued by the analyst on multiple
stocks, with total returns for each.
3. Overall total returns achievable by following the analyst's
advice from inception.
4. Total returns achieved by various analysts.
Sorting or selecting by firm, the investor would be able to review and compare:
1. Current ratings issued by the firm on multiple
stocks.
2. Historical ratings issued by the firm on multiple stocks,
with total returns for each.
3. Overall total returns achievable by following the firm's
advice from inception.
4. Total returns achieved by various firms.
Appendix C. Brokerage Firm Ratings on Bankrupt Companies
In order to better quantify the bias in Wall Street's research and ratings, several approaches have been considered by regulators and analysts:
One approach is to determine the percentage of buy, sell, and hold ratings, with the assumption that there should be some balance in the distribution among them. However, in a bull market, it might be appropriate for the majority of ratings to be "buy," while in a bear market, even a relatively smaller number of "buy" ratings may be indicative of an inappropriate bias. Thus, there is no fixed standard to evaluate the accuracy-let alone the bias-in the ratings with this method.
Others have suggested examining the track record of each analyst or firm to determine whether recommended stocks have gone up or down in value subsequent to the publication of the recommendations. However, bad calls on stocks are no indication of bad intentions; and favorable results alone do not preclude bias as a factor. Thus, although this approach can help measure the accuracy of research, it does not capture factors that might bias the research.
Weiss Ratings' approach has been to focus on Wall Street ratings issued to companies filing for Chapter 11 that are available to the public on the date of the Chapter 11 filing.
In the weeks and days prior to a bankruptcy, research analysts are rarely oblivious to impending troubles. They almost always see it coming, based on numerous public warnings from credit rating agencies or from the companies themselves. Therefore the failure to downgrade the company's stock to a "sell" or to inform investors of a rating change, generally implies a serious lapse that cannot be attributed to research error.
Moreover, as soon as a company goes bankrupt, nearly all shareholder equity is wiped out, and there is scant hope for recouping the original investment. Thus, there can be little debate that a continuing "buy" or "hold" rating in the public domain is (a) obviously wrong and (b) probably the result of bias in the ratings process.
Therefore, Weiss Ratings surveyed the publicly available ratings on all publicly traded companies filing for Chapter 11 in 2002 that were covered by research analysts. Further, in order to evaluate any changes over time, the survey was repeated during three periods, as detailed in Table 3.
| Table 3. Summary of Weiss Ratings' Surveys of Ratings on Failed Companies | ||||||||||||||||
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We analyzed the data from three perspectives:
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Perspective 1. |
What percentage of the Wall Street firms continued to maintain at least one buy or hold rating in the public domain for the bankrupt companies until the day they filed for Chapter 11? (See Table 4.) |
| Table 4. Percentage of Firms Recommending Bankrupt Companies | |||||||||||||||||||||||||
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Survey #1: Among 50 brokerage firms covering companies that went bankrupt between January 1 and April 30, 2002, the publicly available ratings available from 94%, or 47 firms, continued to issue a buy or hold rating on at least one failing company even as they filed for Chapter 11.
Examples: There were six "buy" ratings from Lehman Brothers on failing companies and eight "hold" ratings from Salomon Smith Barney through the date the companies filed for bankruptcy. "Buy" ratings until the day of Chapter 11 filing were also available from Bank of America Securities, Bear Stearns, CIBC World Markets, Dresdner Kleinwort Wasserstein, Goldman Sachs, and Prudential Securities.
Survey #2: Among 62 brokerage firms covering companies filing for bankruptcy between May 1 and August 31, 2002, the publicly available ratings from 46 firms, or 74 percent, continued to recommend that investors buy or hold shares in the failing companies even as they were filing for Chapter 11.
Examples: CIBC World Markets maintained three "buy" ratings and two "hold" ratings in the public domain on failing companies, while Thomas Weisel Partners maintained three "buy" ratings and one "hold" rating up through the date the rated companies filed for bankruptcy. In addition, Goldman Sachs and Credit Suisse First Boston each maintained five "hold" ratings on failed companies in the public domain at the date of bankruptcy.
Also maintaining "buy" ratings until the very end were ABN Amro, Argentina Research, Banc of America, Buckingham Research, Commerzbank Securities, Dresdner Kleinwort Wasserstein, Jesup & Lamont Securities, JP Morgan, Kaufman Brothers, Pacific Crest Securities, Performaxx AG, Raymond James, RBC Dain Rauscher, Robertson Stephens, Sanford C. Bernstein, SG Cowen, SoundView Technology, and USB Piper Jaffray.
Survey #3: Among 30 brokerage firms covering companies filing for bankruptcy between September 1 and December 31, 2002, the publicly available ratings from 20 firms, or 66 percent, continued to recommend that investors buy or hold shares in the failing companies right up to the day they filed for Chapter 11.
Examples: Credit Lyonnais, Punk, Ziegel & Company, and SCO Financial Group each maintained a "buy" rating in the public domain on one failing company, while Bear Stearns maintained a "buy" rating and a "hold" rating through the date the companies filed for bankruptcy. Credit Suisse First Boston maintained four "hold" ratings and CIBC World Markets maintained two "hold" ratings up through the date the companies filed for bankruptcy. In addition, the following firms each maintained one "hold" rating on a failing company: Banc of America Securities, Barrington Research, JP Morgan, McDonald Investments, Morgan Stanley Dean Witter, Pacific Crest Securities, Raymond James, RBC Capital Markets, Soundview Technology Group, U.S. Bancorp Piper Jaffray, UBS Warburg, Wachovia Securities, and WR Hambrect & Co.
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Perspective 2. |
What portion of the failing companies received exclusively buy and hold ratings from the firms that covered them? (See Table 5.) |
| Table 5. Failing Companies Receiving Exclusively Buy And Hold Ratings | |||||||||||||||||||||||||
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Survey #1. Of the 19 failing companies rated by brokerage firms, the publicly available ratings on 12, or 63.2% of the companies continued to be unanimously "buy" or "hold" ratings on the date of bankruptcy filing. For example, on the day they filed for Chapter 11, Global Crossing received five "buys," nine "holds" and no "sells," while Adelphia Business Solutions received two "buys," three "holds" and no "sells."
Survey #2. Of the 19 failing companies rated by brokerage firms, publicly available ratings on nine, or 47.4% continued to receive unanimously "buy" or "hold" ratings on the date of their bankruptcy filing. For example, on the day they filed for Chapter 11, APW Ltd. received two "buys" and five "holds," New Power Holdings, Inc. received one "buy" and two "holds," and Budget Group, Inc. received two "holds."
Survey #3. Of the 18 failing companies rated by brokerage firms, publicly available ratings on seven, or 38.9%, continued to receive unanimously "buy" or "hold" ratings on the day of bankruptcy filing. For example, Peregrine Systems, Inc. received seven "hold" ratings and Advanced Tissue Sciences continued to receive a "buy" rating.
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Perspective 3. |
What percentage of the ratings issued to bankrupt companies were buy, sell or hold? |
| Table 6. Percentage of Buy, Sell, Hold and Dropped Ratings Issued to Bankrupt Companies | ||||||||||||||||||||||||
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Overall, we note an improvement during the course of the year, apparently due to the intensified regulatory scrutiny and to increasingly vocal investors. Yet, there should be virtually no buy or hold recommendations on failing companies. Even just a few such cases denote a serious problem -- a continuing bias in the process.
We repeat: These are the ratings available to investors on bankrupt companies on the very day they filed for Chapter 11. As such, any reasonable person would agree that continuing recommendations to buy or hold are clear indications of serious, systemic flaws in the ratings process. We doubt that these can be adequately addressed with the new patchwork of rules.
