Term Paper on "Securities Law and Ethics"

Term Paper 6 pages (1952 words) Sources: 1+

[EXCERPT] . . . .

Securities Law and Ethics

After the stock market collapsed in 2002, more than seven trillion dollars vanished from the U.S. stock market and from the brokerage accounts and retirement funds of ninety million Americans, a vanishing act helped along by greed and corporate fraud (60 Minutes - the sheriff of Wall Street). The public, whose money was being used, whose interests the financial institutions were committed to serve, and who should have benefited from the financial proceeds of the stock market advances were systematically lied to and defrauded. In one instance a securities research analyst told an institutional investor in an email, "well, ratings and price targets are fairly meaningless anyway . . . but, yes, the 'little guy' who isn't smart about the nuances may get misled, such is the nature of my business" (Securities and Exchange Commission Litigation Release No. 18116). This paper describes how such a cavalier attitude was allowed as the norm during the stock market bubble and assesses current efforts to stop future occurrences. The prognosis is grim. Too much effort is placed on disclosure rather than eliminating unethical conduct.

Throughout the 1990s, laws to protect investors that have been on the books since the 1930s were severely eroded (Rayburn, 2004). Congress replaced them with new laws backed by business interests that made it more difficult for investors, their lawyers and government to sue or regulate companies engaged in alleged wrongdoing, including releasing false earnings statements. Examples include the Private Securities Litigation Reform Act of 1995, the National Securities Market Improvement Act of 1996 and the Securities Litigation Uniform Standards Act of 1998, each making it harder for investor plaintiffs to pursue legal or regulatory actions against companies. As a result, analysts were freer to pursue their own or their employers interests at the expense of the investing public.

Analysts, particularly sell-side analysts, work in an environment with many inherent conflicts of interest that create pressure on an analyst's objectivity. One major source of conflict is created by full-service investment firms and proprietary trading (Report on analyst conflicts of interest, 2003). Providing investment banking services, such as underwriting an initial public offering or advising clients on mergers or acquisitions, can be a lucrative source of revenue for full-service investment firms. Sell-side analysts at these firms may be inhibited from making statements or publishing research reports that could jeopardize existing or potential client relationships. With regards to proprietary trading, conflicts of interest may arise where a firm trades, for its own account or for clients, securities of companies covered by the firm's analysts. Because research recommendations often have the ability to impact the price of a company's securities, analysts may produce favorable reports and recommendations in an attempt to maintain or boost the value of the securities held by the firm, or its clients. And, in brokerage services, an analyst's report can help his firm make money indirectly by generating the buying and selling of covered securities -- which result in commission revenue for the firm.

Relationships, compensation and reporting arrangements can also result in substantial conflicts of interest (Report on analyst conflicts of interest, 2003). Often a firm or analyst may own significant positions in the companies the firm's analysts cover or the firm may have a commercial relationship with the company such as a significant loan. Analysts also may participate in employee stock-purchase pools that invest in companies they cover. These practices create a huge incentive to issue favorable research. Significant firm clients also may pressure analysts to issue favorable research or refrain from issuing negative research about securities in which they hold large positions. Further, many firms significantly link the compensation of their research analysts to investment banking revenue generated by the analyst. Even in firms that do not make the link between analyst compensation and investment banking deals explicit, it is still often perceived to be significant.

On May 10, 2002, in response to conflicts of interest issues, the Securities and Exchange Commission (SEC) approved amendments to a series of self-regulatory organization (SRO) rules regarding securities research (Richards, 2002). SEC issued Release No. 34-45908 approving changes proposed by the NASD and NYSE to their rules governing research analysts, approving new NASD Rule 2711 and changes to NYSE Rules 472 and 351. These Amendments represent ongoing SEC and SRO rulemaking activity regarding securities research, and in particular regarding conflicts of interest between research analysts and the securities firms with which they work. Key provisions of the new NASD and NYSE rules include:

Limitations on Relationships and Communications Between Investment Banking and Research Analysts. The rules prohibit research analysts from being supervised by the investment banking department. In addition, investment banking personnel will be prohibited from discussing research reports with analysts prior to distribution, unless staff from the firm's legal/compliance department monitor those communications.

Analyst Compensation Prohibitions. The rules bar securities firms from tying an analyst's compensation to specific investment banking transactions. Furthermore, if an analyst's compensation is based on the firm's general investment banking revenues, that fact must be disclosed in the firm's research reports.

Firm Compensation. The rules require a securities firm to disclose in a research report if it managed or co-managed a public offering of equity securities for the company, or if it received any compensation for investment banking services from the company in the past 12 months. A firm must disclose if it expects to receive or intends to seek compensation for investment banking services from the company during the next 3 months.

Promises of Favorable Research are Prohibited. The rules prohibit analysts from offering or threatening to withhold a favorable research rating or specific price target to induce investment banking business from companies. The rule changes also impose "quiet periods" that bar a firm that is acting as manager or co-manager of a securities offering from issuing a report on a company within 40 days after an initial public offering or within 10 days after a secondary offering for an inactively traded company.

Restrictions on Personal Trading by Analysts. The rules bar analysts and members of their households from investing in a company's securities prior to its initial public offering if the company is in the business sector that the analyst covers. In addition, the rules require "blackout periods" that prohibit analysts from trading securities of the companies they follow for 30 days before and 5 days after they issue a research report about the company. Analysts are prohibited from trading against their most recent recommendations.

Disclosures of Financial Interests in Covered Companies. The rules require analysts to disclose if they own shares of recommended companies. Firms are also required to disclose if they own 1% or more of a company's equity securities as of the previous month end.

Disclosures During Public Appearances by Analysts. The rules require disclosures from analysts during public appearances, such as television or radio interviews. Guest analysts will have to disclose if they or their firm have a position in the stock and also if the company is an investment banking client of the firm.

On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002 which contains additional provisions intended to address analyst conflicts of interest (Fleischman. 2003). Although most of the provisions set forth in the Sarbanes-Oxley Act had already been addressed by the previously adopted NASD/NYSE analyst conflicts rules discussed above, a new provision was added that requires the adoption of rules prohibiting retaliation against an analyst who issues a research report that may have an unfavorable impact on a firm's investment banking relationship with a client.

In addition to new laws, investment firms have faced significant penalties for their roles in defrauding the public (Fleischman, 2003). In 2002, the Attorney General of the State of New York (NYAG) entered into a settlement agreement with Merrill Lynch requiring the company to pay a fine of $100 million and to comply with certain disclosure and other requirements, some of which differ in certain respects from the NASD/NYSE analyst conflicts rules. Later in the same year, NYAG, SEC, NASD, NYSE and North American Securities Administrators Association settled with ten of the largest investment banking firms (Bear Stearns, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, JP Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, Salomon Smith Barney, and UBS Warburg) to resolve their participation in research analyst conflicts of interest. The firms agreed to pay approximately $1.5 billion in fines and to adopt additional internal structural and operational reforms to further ensure research analyst independence and promote investor confidence.

Despite efforts to reduce analyst conflicts of interest, some believe there's still more work to do. On the extreme side, critics recommend that Wall Street analysts should give up explicit stock recommendations or earnings in favor of providing basic information (Whalen, 2003). They feel that forecasts based on a company's current and past performance and industry trends are little more that "crystal-ball gazing." To support this argument, critics charge that stock analysts aren't in possession of material, nonpublic information and, therefore,… READ MORE

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