Tag: Analysts

New FINRA Equity and Debt Research Rules

Annette L. Nazareth is a partner in the Financial Institutions Group at Davis Polk & Wardwell LLP, and a former commissioner at the U.S. Securities and Exchange Commission. The following post is based on a Davis Polk client memorandum by Ms. Nazareth, Lanny A. SchwartzHilary S. Seo, and Zachary J. Zweihorn. The complete publication, including appendices, is available here.

The Financial Industry Regulatory Authority (“FINRA”) has adopted amendments to its equity research rules and an entirely new debt research rule. Member firms should review and revise their policies, procedures and processes to reflect the new rules, and analyze what organizational structure and business process changes will be necessary.

The main differences between FINRA’s Current Equity Rules and the New Equity and Debt Rules (as defined below) are outlined in the original publication, available here. Highlights include:


FINRA Settles with Banks; Provides Views on Analyst Communications During “Solicitation Period”

Richard J. Sandler is a partner at Davis Polk & Wardwell LLP and co-head of the firm’s global corporate governance group. This post is based on a Davis Polk client memorandum.

In December, the Financial Industry Regulatory Authority entered into settlement agreements with a number of the major banking firms in response to allegations that their equity research analysts were involved in impermissibly soliciting investment banking business by offering their views during the pitch for the Toys “R” Us IPO (which was never actually completed). FINRA rules generally prohibit analysts from attending pitch meetings [1] and prospective underwriters from promising favorable research to obtain a mandate. [2] In this situation, no research analyst attended the pitch meetings with the investment bankers and none explicitly promised favorable research in exchange for the business. However, FINRA announced an interpretation of its rules that took a broad view of a “pitch” and the “promise of favorable research.” FINRA identified a so-called “solicitation period” as the period after a company makes it known that it intends to conduct an investment banking transaction, such as an IPO, but prior to awarding the mandate. In the settlement agreements, FINRA stated its view that research analyst communications with a company during the solicitation period must be limited to due diligence activities, and that any additional communications by the analyst, even as to his or her general views on valuation or comparable company valuation, will rise to the level of impermissible activity. The settlements further suggested that these restrictions apply not only to research analysts, but also to investment bankers that are conveying the views of their research departments to the company. The practical result of these settlements will be to dramatically reduce the interaction between research analysts and companies prior to the award of a mandate.


The Dark Side of Analyst Coverage

The following post comes to us from Jie (Jack) He of the Department of Finance at the University of Georgia and Xuan Tian of the Department of Finance at Indiana University.

In our paper, The Dark Side of Analyst Coverage: The Case of Innovation, forthcoming in the Journal of Financial Economics, we examine the effect of analyst coverage on firm innovation and test two competing hypotheses. We find that firms covered by a larger number of analysts generate fewer patents and patents with lower impact. To establish causality, we use a difference-in-differences approach and an instrumental variable approach. Our identification tests suggest a causal effect of analyst coverage on firm innovation. The evidence is consistent with the hypothesis that analysts exert too much pressure on managers to meet short-term goals, impeding firms’ investment in long-term innovative projects. Finally, we discuss possible underlying mechanisms through which analysts impede innovation and show a residual effect of analyst coverage on firm innovation even after controlling for such mechanisms. Overall, our study offers novel evidence of a previously under-explored adverse consequence of analyst coverage, namely, its hindrance to firm innovation.


Bias and Efficiency: Comparison of Analyst Forecasts and Management Forecasts

The following post comes to us from Urooj Khan, Oded Rozenbaum, and Gil Sadka, all of the Accounting Division at Columbia Business School.

In our paper, Bias and Efficiency: A Comparison of Analyst Forecasts and Management Forecasts, we compare the forecast characteristics of analyst forecasts and management forecasts. Frequently, analysts and managers provide similar type of information to investors, namely forecasts. Since managers and analysts have different incentives and different information sets, we empirically test whether those differences are manifested in their forecast characteristics. Specifically, we compare the bias, a systematic deviation of management and analyst EPS forecasts from the actual realized EPS, and efficiency, the ability of managers and analysts to incorporate prior publicly available information in their forecasts.

When comparing management forecasts and analyst forecasts, it is important to consider the implications of the difference in incentives and information available to analysts and managers. Since prior literature documents an optimistic bias in analyst forecasts, we expect that, given management incentives and cognitive biases, management forecasts will be at least as biased as analyst forecasts. In addition, since companies’ managers are exposed to private information, we expect management forecasts to better incorporate prior available information.

We find several striking results. First, we find that prior stock returns do not predict management forecast errors while they predict analyst forecast errors. Furthermore, while we find an optimistic bias in a broad sample of both management forecasts and analyst forecasts, the optimistic bias in analyst forecasts disappears in months in which management forecasts are issued. The bias is still apparent for these firms when managers do not provide forecasts.


The Expanded Role of Economists in SEC Rulemaking

Editor’s Note: The following post comes to us from Craig M. Lewis, chief economist and director of the Division of Risk, Strategy, and Financial Innovation at the U.S. Securities and Exchange Commission. This post is based on Mr. Lewis’s remarks at the SIFMA Compliance & Legal Society Luncheon, available here. The views expressed in this post are those of Mr. Lewis and do not necessarily reflect those of the Securities and Exchange Commission, the RSFI division, or the Staff.

I would like to talk about economic analysis in support of Commission rulemakings, and, in particular, the role of economists from the Division of Risk, Strategy, and Financial Innovation (or “RSFI”) and the recently issued guidance on economic analysis.

Background on the Division of Risk, Strategy, and Financial Innovation

Without going into a description of the history of RSFI — which would not take long in any event, as the Division is only three years old — it may be useful to set the stage for how, in my mind, the Division fits into the overall structure of the Commission.

First, who are we? Often referred to as the SEC’s “think tank,” RSFI consists of highly trained staff from a variety of academic disciplines with a deep knowledge of the financial industry and markets. For example, we currently have over 35 PhD financial economists on staff, and hope to hire more this fall. We also have statisticians, financial engineers, programmers, MBAs, and other experts, including individuals with decades of relevant industry experience.


Private Interaction Between Firm Management and Sell-Side Analysts

The following post comes to us from Eugene Soltes of the Accounting and Management Unit at Harvard Business School.

In the paper, Private Interaction Between Firm Management and Sell-Side Analysts, which was recently made publicly available on SSRN, I investigate private interaction between sell‐side analysts and senior management by examining a set of internal records compiled by a large‐cap NYSE traded firm. Thousands of hours of senior management time are consumed speaking with sell‐side analysts annually at publicly traded firms. Despite this significant use of time, there is little academic evidence that directly examines these interactions. The analysis in this paper seeks to begin a dialogue to fill this gap.

I find that analysts who privately meet with management cover fewer firms, have less experience, and cover the sample firm for a longer period of time. These individual analyst characteristics dominate attributes of the firms they work for in explaining which analysts privately interact with management.

Evidence indicates that analysts who interact privately are more likely to create reports. I do not find that private interaction significantly improves the accuracy of analysts’ earnings estimates. Evidence also suggests that private interaction with management largely complements, rather than substitutes for, other means of public interaction such as quarterly conference calls.


The Effectiveness of Institutional Investors in Evaluating Analysts

The following post comes to us from Lily Fang of the Department of Finance at INSEAD and Ayako Yasuda of the Graduate School of Management at UC Davis.

In the paper, The Effectiveness of Institutional Investors in Evaluating Analysts, which was recently made publicly available on SSRN, we examine the effectiveness of institutional investors in evaluating analysts by comparing the performance of recommendations made by AAs—star analysts elected by institutional investors—with those made by other analysts.

We ask four related questions. First, does the AA status at least partially reflect analyst skill? That is, if AAs make more valuable recommendations, is it because of skill, or other factors such as luck, market influence, or access to management? If investors are effective in evaluating analysts, we expect the AA status to be indicative of skill. Second and closely related to the first question, does the AA status contain information about the analyst that is not entirely captured by other observable characteristics? The answer should be affirmative if institutional investors uncover unique information about analysts. Third, can institutional investors and the AA election process adapt to major changes brought to the industry by regulations and labor market movements? And finally, who benefits the most from the elected star analysts’ views?


The Timeliness of Bad Earnings News and Litigation Risk

The following post comes to us from Dain Donelson of the Department of Business, Government, and Society at the University of Texas at Austin, John McInnis of the Department of Accounting at the University of Texas at Austin, Richard Mergenthaler of the Department of Accounting at the University of Iowa, and Yong Yu of the Department of Accounting at the University of Texas at Austin.

In our paper, The Timeliness of Bad Earnings News and Litigation Risk, which was recently made publicly available on SSRN, we examine the relation between the timeliness of bad earnings news and the incidence of securities litigation. Skinner (1994) proposes that the earlier revelation of bad news reduces the expected costs of litigation because earlier revelation diminishes the perception that management “hid the truth” and reduces damages by shortening the class period. This litigation reduction hypothesis predicts that timelier revelation of bad earnings news should reduce the likelihood of being sued and/or the costs of resolving lawsuits that do occur.


The Perils of Implied Messages for Reg FD

Annette Nazareth is a partner in the Financial Institutions Group at Davis Polk & Wardwell LLP. This post is based on a Davis Polk client memorandum by Michael Kaplan, William M. Kelly, Linda Chatman Thomsen and Janice Brunner.

The SEC recently announced settled Reg FD charges against Office Depot and its CEO and former CFO related to “signals” that Office Depot made in one-on-one conversations with analysts implying that it would not meet future earnings expectations. The Office Depot settlement, which is the SEC’s third Reg FD action in a little over a year after an approximately four-year hiatus, is distinctive because the challenged statements appear to have been crafted—unsuccessfully, as it turned out—to walk the FD compliance line by avoiding express references to changes in the company’s business.


To Guide or Not to Guide? Causes and Consequences of Stopping Quarterly Earnings Guidance

This post is from Baruch Lev of NYU Stern School of Business.

In “To Guide or Not to Guide? Causes and Consequences of Stopping Quarterly Earnings Guidance”, which I co-wrote with Joel F. Houston and Jennifer W. Tucker, and which was recently accepted for publication in Contemporary Accounting Research, we investigate the importance of quarterly earnings guidance. Quarterly earnings guidance—managers’ public forecasts of forthcoming earnings—is widespread yet highly controversial. Arguments for ending the practice of guidance are made by purists, who claim that managers should tend to their business and leave securities valuation and the underlying forecasts of future performance to investors and analysts, and by pragmatists, lawyers in particular, who caution managers that guidance increases litigation exposure. Regulators and commentators are often concerned that a previously issued forecast will motivate managers to meet the guidance even if doing so would require costly changes in real activities, such as cutting capital expenditures or R&D, and sometimes induce them to manage earnings toward the forecast. On the pro-guidance side, managers often claim that the practice is necessary to keep analysts’ earnings forecasts—issued with or without corporate guidance—within a reasonable range to avoid large earnings surprises and the consequent high stock price volatility and investors’ heightened risk perceptions.

We empirically examine in this study a sample of 222 U.S. firms that ceased to provide quarterly earnings guidance during 2002 through the first quarter of 2005, after having routinely done so. Only a few of these “stoppers” publicly announced and rationalized their decision, whereas the majority just ceased to provide guidance. We first examine the determinants of the stopping decision with particular reference to the pro and con arguments made by challengers and supporters of the practice. Although managers often cite reducing short-termism as the motive for stopping guidance, an unstated reason could be poor performance and repeated consensus misses. We then examine the post-stoppage changes in the stoppers’ long-term investments, in their complementary disclosures, and in their information environment. Using a control sample of 676 guidance “maintainers,” along with the 222 stoppers, we find that poor performance is the main reason for guidance cessation. Our stoppers are characterized by (1) a decline in earnings before stopping, (2) a poor record of meeting or beating analyst consensus forecast, and (3) a deterioration of anticipated earnings. Additionally, we document that guidance cessation is associated with (1) a change in top management, likely ushering in new management philosophy, (2) a relatively low frequency of guidance by industry peers, and (3) past as well as anticipated difficulties in predicting earnings. In addition, we do not find that stoppers enhance investment in capital expenditure and research and development after guidance cessation. Contrary to the claim that firms would provide more alternative, forward-looking disclosures in lieu of the guidance, we find that such disclosures are curtailed. We also find a deterioration in the information environment of guidance stoppers in the form of increased analyst forecast errors and forecast dispersion and a decrease in analyst coverage. Taken together, our evidence indicates that guidance stoppers are primarily troubled firms and stopping guidance does not benefit either the stoppers or their investors.

The full paper is available for download here.