Investors, Research Firms Brace For Settlement's End
May 12 2009 - 12:06PM
Dow Jones News
Five years after the largest Wall Street firms agreed to supply
independent analyst reports to their clients as part of a massive
regulatory settlement, the arrangement is coming to an end -
something that could hurt both research shops and individual
investors.
The majority of the banks involved in the 2003 case involving
allegations of tainted analyst recommendations are scheduled to
wind down the settlement's research obligations at the end of July.
That means the spigot of mandated money - $460 million total - that
financed alternative research reports will dry up.
Although every independent research company that benefited from
that funding stream knew the end would come one day, they won't be
able to immediately replace the drop in revenue beginning Aug. 1.
Public companies that have struggled to attract analyst coverage
will also lose out when some brokerage firms drop the extra
research. For the individual investors who took advantage of the
free reports, independent research will once again revert to its
original audience: large institutions such as hedge funds and
mutual funds.
There's considerable debate about whether individual investors
will directly suffer from the end of the settlement-funded
research. Many investment banks maintain it wasn't widely used by
customers, and in any case, two of the largest brokerage firms -
Citigroup Inc.'s (C) Smith Barney unit and Morgan Stanley (MS) -
plan to continue paying for it after the settlement period ends.
UBS AG (UBS) is the only bank so far that has said it doesn't plan
to do so; others have remained noncommittal.
Of secondary concern to individual investors is whether offering
independent research caused the banks' own research reports to
become less biased; there was some evidence in the early years that
the level of "sell" recommendations by banks rose, said Michael
Mayhew, chairman of Integrity Research Associates LLC, which
evaluates research services for asset managers.
"During the settlement period, I think the (Wall Street) sell
side worked hard to try to make their research more objective. The
big question is, without that competition will we start to see a
slide back to pre-settlement "sell" levels? I'm not suggesting we
will or not; I just don't know," said Mayhew.
The settlement's end coincides with a trend toward less research
in general being available to individuals, thanks to unrelated
market forces. Many brokerage firms have cut back on their stock
analysts in the post-settlement environment because investment
banking fees can no longer be used to finance it, and the economic
slowdown has prompted further cuts.
"There are easily 1,400 companies in the U.S. markets with no
analyst coverage at all. Fifty percent of all companies have two or
fewer analysts covering them," said Bruce Aust, executive vice
president of Nasdaq OMX Group Inc.'s (NDAQ) corporate client group.
"We'll see if the number of under-covered companies goes up
dramatically after the settlement dollars go away."
For independent research shops themselves, there's no getting
around the fact that the settlement money - in some cases in the
tens of millions - will disappear for the most part in August.
Morningstar Inc. (MORN) has warned investors that it expects its
post-settlement revenue to be "significantly lower" beginning in
the second half of the year. Morningstar received $21 million in
settlement monies in 2008 - about 4% of its consolidated revenue
last year.
But executives at Morningstar and other independent research
firms - including heavy-hitters Standard & Poor's and Argus
Research - say that they are optimistic that the many of the Wall
Street banks will continue to hire them for research after the
settlement ends.
At the same time, settlement money has helped firms build up
their business and target more clients outside the original banks
involved.
"Even though the settlement revenue will go away, we think we're
emerging stronger than we were going into" the contracts five years
ago, said John Eade, president of Argus Research.
While the traditional "buy, hold, sell" research used by retail
investors has been in decline during the settlement period, an
alternative research industry has flourished by creating exclusive
research for institutional investors with deep pockets. The
research spans a wide range of services, from collecting field data
and surveys to providing specialized forensic accounting services.
Integrity Research estimates the revenue spent on such research
services in North America last year reached nearly $2 billion, or
nearly half the amount of commissions spent on traditional Wall
Street research.
-By Lynn Cowan, Dow Jones Newswires; 301-270-0323;
lynn.cowan@dowjones.com
-By Ed Welsch, Dow Jones Newswires; 201-938-5244;
edward.welsch@dowjones.com