Research
departments of banks are an excellent place to look at if you want to
understand conflicts of interest in a bank. A recent example is a
FINRA case in which ten banks accepted to pay a total of 43.5 MUSD in
fines.
What
do securities research analysts do?
First
the obvious: They research on securities – How did they perform in
the past? How will they perform tomorrow? What are they worth today?
The more formal definition says that research departments of banks
provide economic research about financial securities to clients and
formulate investment recommendations.
For
example, Citigroup writes that “the
breadth, depth and strength of our sales and trading, distribution
and research capabilities span a broad range of asset classes”
and that “through our web, mobile and trading
applications, clients can find Citi research and commentary and
proprietary data and analytics”.
In
banks, research departments usually constitute profit centers or, at
least, are part of them. For example, Wells Fargo’s economics group
is part of the bank’s “Investment Banking / Securities &
Markets” unit.
The
above description suggests that research analysts are exclusively
working for clients to whom the bank wants to sell financial
securities.
But
what happens if the bank also participates in generating the same
securities which are, later on, sold to clients? Let’s be more
specific: The investment banking department helps a client listing
his shares and the financial markets department then helps selling
them to investors. In this case, the bank builds a Chinese Wall
(which is, knowingly, so huge that you can see it from the moon)
between both departments. On which side sits the research analysts?
A
research analyst is not an investment banker.
In
the U.S., the situation is, on paper, clear. FINRA (the Financial
Industry Regulatory Authority) Rules say:
- A member of an investment banking department cannot supervise a research analyst (Art. 2711.(b).(1))
- A member of an investment banking department cannot approve a research analyst report (Art. 2711.(b).(2)).
- In principle, a research analyst cannot participate in the investment banking business (Art. 2711.(c).(4) to (7). The opposite is also true (Art. 2711.(f)).
- A bank cannot offer favorable research on a client to induce or compensate for business (Art. 2711.(e).
- A research analyst is limited in how he can trade shares of a company he covers (Art. 27.11.(g)).
- A research analyst must disclose conflicts of interest, for example if he holds shares in the covered company, receives remuneration from the company, or participates in the company’s management (Art. 27.11.(h)).
Toys
R Us IPO – Playing with the research analyst?
In
April 2010, Toys R Us invited several banks to pitch for
broker-dealer roles in its planned IPO. In the request to banks, the
company asked the banks’ research analysts to make presentations
about their view on Toys R Us and its valuation to the company’s
management.
“TRU
[Toys R Us] would consider each analyst’s views of the company and
whether the analyst’s valuation was consistent with the firm’s
investment bankers’ valuation.”
In
addition, the IPO candidate sent templates to the banks for
signature. This was to “prevent TRU [Toys R
Us from being “burned” by an analyst’s decision to adopt a
negative view of TRU after the company had awarded its investment
banking business to the analyst’s firm.”
All
pitching investment banks accepted to make their research analyst
participate in their pitch. The facts vary slightly. Deutsche Bank
can serve as an example:
“By
providing TRU [Toys R Us] the unified valuation it sought, DBSI
[Deutsche Bank] indicated to TRU that post-IPO research coverage
would be positive and aligned with investment banking.”
Goldman
Sachs’ analyst, in addition, sold his investment banking
experience:
“The
analyst told TRU [Toys R Us] and the Sponsors that he was “very
excited” to be speaking with them and noted his “extensive
transactional experience,” noting that he had “worked on more
than a dozen retail IPOs.”
Merryl
Lynch’s analyst did not speak but helped investment bankers by his
mere presence:
“I
am sorry that I was not permitted to speak about many specifics
today, but I hope that my enthusiasm surrounding the Toys R Us story
was evident.”
It
is pretty obvious that the story contradicts the FINRA rules. More
surprising are the varying amounts of the fines: The implication and
the roles which were offered to the banks varied substantially but
seem to be disconnected from the amount of the fines.
Furthermore,
I wonder who is at fault here – the banks or Toys R Us, asking
banks to make research analysts work.
A
final note on the file: Toys R Us ultimately abandoned the IPO…
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