Securities Analysts’ Undisclosed Conflicts of Interest: Unfair Dealing or Securities Fraud?

Tuesday, January 1st, 2002 at 12:00 am by Jill I. Gross
Jill I. Gross, Securities Analysts’ Undisclosed Conflicts of Interest: Unfair Dealing or Securities Fraud?, 2002 Colum. Bus. L. Rev. 631

Following the burst of the Internet bubble, securities industry participants and observers have focused on ‘buy‘ recommendations made by purportedly independent research analysts to the investing public for technology and Internet stocks. Questions have been raised as to how all of those analysts could have been so wrong in their recommendations. Subsequently, their motivations and methods have been scrutinized. Critics have focused on the apparent conflict of interest certain analysts faced: they recommended the purchase of securities to the investing public and to customers of their own firms without disclosing the fact that they owned those very securities, that their compensation was tied to their recommendations, or, even more significantly, that their firms received compensation–typically in the form of investment banking business–from the issuer.

In light of the media attention and public criticism lavished on brokerage firms’ analysts and their undisclosed conflicts of interest, the industry has implemented many changes. Many financial services firms have altered their company policy precluding or limiting the ownership by analysts of stocks they follow and securities self-regulatory organizations (‘SROs‘) have enacted rules requiring heightened disclosure of any potential conflicts of interest.

Most significantly, regulators have begun enforcement investigations and proceedings. As one striking example of sweeping regulatory action, on April 8, 2002, New York State’s Attorney General brought an enforcement action in state court under New York’s state securities statute, the Martin Act, seeking a preliminary injunction directing Merrill Lynch and some of its research analysts to refrain from misleading disclosures in their research reports and seeking judicial intervention in the continuing investigation. The affidavit that the Attorney General filed in support of that application for relief was replete with egregious examples of conflicts faced by Merrill Lynch analysts– including the allegation that the analysts themselves had different opinions of the issuers than those disseminated publicly in their supposedly independent research reports. The Supreme Court of New York granted the requested relief and, pending completion of the Attorney General’s investigation, issued an order temporarily restraining the respondents from violating the Martin Act and specifically from preparing or disseminating any research report on an issuer without disclosing Merrill Lynch’s investment banking relationships with that issuer. Not long after, Merrill Lynch settled with the Attorney General before it even filed formal charges–agreeing to pay a $100 million penalty and to restructure its research department to insulate analysts from many of these conflicts.

Outside of the regulatory landscape, investors increasingly have brought lawsuits and arbitrations against analysts for damages resulting from recommendations tainted by conflicts of interest. For example, in July 2001, Merrill Lynch settled an arbitration proceeding brought by a former customer before an arbitration panel of the New York Stock Exchange. Merrill Lynch agreed to pay $400,000 to the customer who alleged that he was misled by a favorable research report issued by Merrill Lynch technology-stock analyst, Henry Blodget (the analyst whose e-mails played a significant role in the New York State Attorney General’s investigation), on a company whose securities the customer purchased. Both the customer’s broker and Merrill Lynch’s report failed to disclose that Merrill Lynch had an investment banking relationship with the issuer. Due to the settlement, however, the legal theory underlying the claimant’s case against Merrill Lynch and Blodget has not been tested.

Securities research analysts provide securities recommendations for institutional and individual investors, and hold themselves out as providers of independent objective analyses of issuers. Analysts generally divide themselves into three types: ‘sell-side,‘ ‘buy-side,‘ or independent. Sell-side analysts are those analysts who work for large brokerage firms with brokerage customers. The brokers use the research to recommend and sell securities to their customers. These firms also typically have investment banking divisions that underwrite securities, and the investment banks use the analyst research to serve an important due diligence function for the underwriters. In contrast, buy-side analysts ‘typically work for institutional money managers–such as mutual funds, hedge funds, or investment advisers.‘ Buy-side analysts work for firms that manage portfolios of others and make investment decisions directly on their behalf. Finally, independent analysts are not affiliated with either the sell-side or the buy-side and ‘sell their research reports on a subscription or other basis.‘

Analysts’ conflicts of interest are troubling to investors, who rely on the integrity of these industry professionals. Under the shingle theory, broker-dealers, including their sell-side analyst employees, have a duty to deal fairly with their customers. This duty of fair dealing encompasses the duty to give customers their undivided loyalty. If an analyst serves two competing masters–his firm’s customers to whom he recommends the purchase of a security, on the one hand, and the investment banking department of the firm, which stands to lose lucrative investment banking fees from an issuer if the firm does not maintain a ‘buy‘ recommendation on the issuer’s stock, on the other hand, then the analyst has violated this duty of loyalty. By failing to disclose these divided loyalties in research reports, analysts have deceived the customers who rely on these reports to reflect an unbiased, objective analysis of the strengths, weaknesses, and market value of the securities.

However, there appears to be scant precedent supporting an investor’s right to civil damages for undisclosed conflicts of interest by analysts. The federal securities laws, as currently interpreted by the Supreme Court, do not clearly provide investors with a right of action against a broker-dealer or its employees merely for a breach of their professional duties. Indeed, numerous scholars have questioned the validity of the shingle theory as a basis for imposing federal securities fraud liability. Furthermore, enhanced industry regulation does not necessarily translate into additional private rights of action for the investing public.

Historically, the courts have imposed liability on industry participants for failure to disclose their intent to trade on the short-term market effect of their recommendations–a practice known as ‘scalping.‘ However, beyond scalping, what legal duties do analysts have to customers to disclose their conflicts of interest in the securities they recommend?

Part II of this article addresses recent regulatory efforts to proscribe undisclosed conflicts of interest beyond mere scalping, including ownership interests in recommended securities, and the compensation connection between analysts and investment bankers within a firm. Part III of this article traces the history of prior cases imposing liability on industry participants, including investment advisers, analysts and others, for failing to disclose their conflicts of interest when recommending securities. Part IV of this article then examines the question of whether analysts have any civil liability to those relying on their recommendations for failure to disclose actual or potential conflicts of interest. Finally, the author concludes that, in light of the new regulations, analysts should be liable to investors for their undisclosed conflicts of interest.

Author Information

Visiting Professor of Law at Pace University School of Law and Co-Director of its Securities Arbitration Clinic