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University of Iowa News Release

Aug. 28, 2003

(Photo: Hillary Sale, UI professor of law)

UI Law Professor Thinks Stock Analysts Need More Regulation

A UI law professor says it's time for the law and for investors to see stock analysts for what they are: sales reps.

Sort of.

In an article in the most recent issue of the Iowa Law Review, law professor Hillary Sale argues that the Wall Street fiascoes of the late 1990s demonstrated that too many stock analysts have too many conflicts of interest to offer truly independent and objective advice.

"It's a reasonable question to ask how independent stock analysts really are, and we don't think they're the independent information gatherers the courts and other academics have purported them to be," said Sale, who co-wrote the article with Jill Fisch, a professor of law at Fordham University in New York City. "Instead, they are subject to a variety of conflicts of interest that compromise their independence and the advice they offer."

Part of the problem is the lack of regulations over the financial services industry to offer sufficient protection to investors, and investors who suffer as a result of fraudulent advice have little legal recourse, Sale said. Redefining analysts as quasi-sales agents of companies in business to sell securities, rather than as independent intermediaries in the information chain, is the first step in making it easier to monitor them and any conflict of interest in their advice.

These conflicts of interest are at the crux of many of the Wall Street scandals that unfolded during the last few years. Shortly after the collapse of the dot-coms and Enron brought public scrutiny to the securities industry, investors learned that many investment houses had an ownership stake in the companies about which their analysts were reporting. The investment houses frequently pressured analysts not to issue negative reports so those companies' stock prices continued to rise. Analysts also felt pressure not to issue negative reports on companies with which their employers had investment banking or other business relationship.

Sale points out numerous examples of such conflicts, including Jack Grubman, the Salomon Smith Barney analyst who made millions of dollars a year recommending the stocks of telecommunications companies that were, in fact, struggling. Many of his star picks eventually filed for bankruptcy, and investors lost billions of dollars as a result.

Despite this, Sale said analysts are bound by surprisingly little federal regulation because they do not have a "fiduciary relationship" with the client. That is, they do not directly manage a client's money or provide personalized investment advice, and so are free to recommend whatever they wish. In addition, courts have given analysts wide berth in holding them legally accountable for their recommendations, for fear too much accountability may have a chilling effect on that allegedly "independent" research and investors will have less information they can make investment decisions with.

The resulting government regulation over the investment industry was so weak that analysts were not required to even disclose any conflicts of interest they may have, and Sale said any requirements that did exist were not enforced.

Several initiatives were taken in the wake of the Wall Street meltdown in order to boost investor confidence, including a renewed commitment to self-regulation by the securities industry and by the Sarbanes-Oxley Act, passed by Congress to provide additional regulation, including a provision that analysts reveal all conflicts of interest. However, Sale and Fisch argue that these measures simply will not work because, among other reasons, they fail to take into account the fact that the investment companies that employ the analysts need to sell securities so they can make money, some of which is used to pay the analysts. Indeed, Sale said those firms have proved themselves to be unwilling to engage in the serious level of self-monitoring necessary to disclose and eliminate the conflicts.

Ultimately, Sale says analysts are simply asked to serve too many masters -- their employers, their clients, investors and themselves -- and those masters have too many competing interests. But Sale recognizes that a traditional sales rep-client relationship would not work, either, because those relationships are generally dictated by contracts, and contracts would not work for all the relationships inherent in the analyst's role.

So she and Fisch propose in their article a new way of considering the legal roles of analysts that takes into account their dual roles as someone who is offering advice while, at the same time, working for a company that sells securities. Their proposal is a concept called "duty of reliability," and simply put, requires analysts to act as a reasonable person would if they did not have a conflict of interest. Analysts who fail this test could open themselves for lawsuits by investors who lost money as a result of their unreliable advice. Their employers would also be liable.

"By framing the analysts' obligation in terms of a duty of reliability, the analyst is given greater freedom to cross-subsidize research ... than under current regulatory reforms," Sale and Fisch write. But, a key part of the duty of reliability would be an understanding that analysts are basing their opinions on actual research, Sale said, so investors can be assured the advice is based on sound reasoning.

STORY SOURCE: University of Iowa News Service, 300 Plaza Centre One, Iowa City, Iowa 52242-2500.

CONTACT(S): Tom Snee, 319-384-0010, tom-snee@uiowa.edu.