Centre for Economic Policy Research

2.6
Remedies for the underwriter/analyst conflict of interest
The extraordinary disclosures about the exploitation of conflicts of interest have
elicited a wide range of proposed remedies. Proposals fall into one of five 
categories discussed in the first chapter: let the market resolve conflicts of 
interest; require increased disclosure; increase supervisory oversight; separate
activities; and socialize information production.
Having removed much of the New Deal banking regulation in the past decade,
there was initially little interest in broad new regulations. In September 2001, SEC
Chairman, Harvey Pitt stated that he would prefer that the securities industry set
its own rules for dealing with analysts’ conflicts rather than have the SEC create
more regulations. In fact, after the crash of the market, some firms with damaged
reputations responded with internal reforms and some ‘overly’ optimistic analysts
departed. 
For the market to solve the conflicts of interest, investors need to be able to
identify and respond to inaccurate, biased information.
15
Boni and Womack
(2002) conducted a survey and found that 86% of the professional money 

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Investment Banking: Conflicts of Interest in Underwriting and Research 25
managers and buy-side analysts said that they discount the recommendations and
reports of analysts when there is an investment banking relationship between the
bank and the company analysed. Looking at data for 1990-91, Michaely and
Womack (1999) found that the market slightly discounted post-IPO recommen-
dations of underwriting analysts, but their recommendations were not entirely 
discounted, perhaps reflecting some value to their information advantage. Boni
and Womack conjecture that this result arises because institutional investors and
money managers understand the bias, but less sophisticated individuals do not.
Institutional investors are aware of the conflicts of interest, but they make 
adjustments to the biases of analysts’ reports because they have their own 
in-house research staffs and buy independent research. To the degree that they
focus on fundamentals, the individual investors, who lack the funds or skills to
judge brokerage research analysts, would be the most affected.
If the market does not provide sufficient disclosure, regulation may be 
necessary to coerce firms to permit investors to observe whether there are any
conflicts of interest behind the information provided by analysts. Mandatory 
disclosure of the relationship between the bank and its employees and the issuing
firms is the minimum information required. Such information would include
whether the firm was a client of the bank’s underwriting or other departments,
and any conflicts of interest for individual analysts. Disclosure is more difficult
when banks are assisting mergers and acquisitions. Disclosure of a relationship
with corporate clients or a change in ownership stakes would provide private
information about impending mergers and acquisitions to the market (Anderson
and Schack, 2002). The problem here is that there is a trade-off between disclosure
and the loss of proprietary information. The appropriate solution to this problem
is to substitute disclosure with supervisory oversight by regulators when 
appropriate.
16
Another solution is to increase the distance between analysis and underwriting
by either strengthening firewalls within investment banks or forcing a complete
separation.
17
The difficulty here is that although the potential conflicts of interest
are reduced by this approach, the greater the degree of separation, the more
potential synergies in information collection and use are lost. There is no simple
guide to striking the right balance of costs and benefits. The SIA Best Practices for
Research 2001 report recommended a reinforcement of the firewalls by ensuring
the following: that analysts do not report to investment banking; that analysts’
pay is not directly linked to specific investment banking transactions; and that
their reports are not submitted to corporate finance or company management 
for approval (Securities Industry Association, 2001). Having separate analysts –
analysts in underwriting and in brokerage – could lead to the embarrassing and
probably intolerable situation where they issue conflicting recommendations at
the same time as synergies are lost.
While a public debate on the appropriate mix of disclosure, separation and pru-
dential supervision was possible, it was foreclosed by the global settlement
reached on 20 December 2002 by the SEC, the New York Attorney General, NASD,
NASAA, NYSE and state regulators with the ten largest investment 
banks.
18 
The five key terms of the agreement were:
1. Firms are required to sever the links between research and investment 
banking, including analyst compensation for equity research and the 
practice of analysts accompanying investment banking personnel on road 
shows and pitches.
2. The practice of spinning is banned.
3. Each firm is required to make public its analyst recommendations, 

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26 Conflicts of Interest in the Financial Services Industry
including its ratings and price target forecasts.
4. For a five-year period, each of the brokerage firms will be required to 
contract with no less than three independent research firms to provide 
research to the brokerage firm’s customers. An independent consultant 
‘monitor’ for each firm will be chosen by regulators to procure 
independent research from independent providers to ensure that investors
get objective investment advice.
5. Each firm in the settlement will pay a fine, which is partly retrospective 
relief, independent research and investor education. The total is more than
$1.4 billion. 
While it remains to be seen how the terms of this agreement are implemented,
there are some good and some alarming features. Overall, it seems as though the
Act aims at making analyst information a purely public good. By effectively 
socializing research, firms no longer compete for customers by the quality of their
research if it is all made public. By taxing the firms to fund independent research,
there will be an incentive to decrease their own internal analysis. What will be
produced will probably be of lower quality. There is less incentive for quality
information, as the banks do not control the information that they are being
forced to acquire. Fortunately this is only for a five-year period, but it should not
be renewed.
The stock market boom produced enormous opportunities for exploiting con-
flicts. Without a new spectacular rise in the market, there will be few incentives
to favour issuing customers at the expense of investor clients. Banning spinning
will, however, ensure that insiders do not take advantage of outsider investors.
Although the executives did not always profit, they benefited by the underpricing
of issues in the booming market. Banning spinning, which exploited the lack of
information about how shares were distributed, will not affect the efficiency of
the market.
Although it is appropriate for some separation between analysts and under-
writers with firewalls, complete separation is mistaken. In light of the failed
attempts to separate commercial and investment banking under the Glass-Steagall
Act (described in Chapter 5), this remedy is extreme. Given that the market
already discounted lead underwriter analysts’ recommendations, firms were 
subject to some market discipline. Separation means that firms will have to have
a separate staff for underwriting to perform the analysis, raising costs and thereby
losing some economies of scope. Failing to let firms be disciplined by loss of 
reputation and litigation where conflicts were exploited by individual firms, may
weaken the competitiveness of investment banks. 
To overcome the information asymmetries, the New York Attorney-General-
SEC’s global settlement relies on separation and the socialization of research as
remedies. The alternative approach would be to allow the market to discipline
firms that have been required to provide increased disclosure to investors of the
firm’s underwriting relationships, complementing this with supervisory oversight
where disclosure would result in the loss of proprietary information.

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