In The News

Making Research Litigation Proof

Investment Dealers' Digest
by Avital Louria Hahn

Monday, February 09, 2004 - Some research analysts, still smarting from the conflicts-of-interest scandal and the bear market that led to it, are throwing in the towel and declining to make recommendations on the stocks they cover.

That may provide these analysts, and the firms that hire them, some legal protection down the road. But the small firms, like America's Growth Capital and Researchstock.com, that have gone this route say there are other reasons they're making the move. These firms argue that ratings can make it more cumbersome for analysts to change their views of a company, that ratings are meaningless and that institutional investors don't pay attention to them anyway.

Moreover, what may be the right recommendation for one investor may not be right for another, said Rick Wayman, senior analyst and president of Researchstock.com, an independent research provider that has no investment banking or trading businesses. "To give one analysis for a diverse audience is ridiculous."

The small boutiques say their analysts provide quantitative analysis and intelligence on the company without a buy or a sell, using numbers to demonstrate where the stock may be heading.

Some investors seem to agree. "I have never placed much value in the sell-side buy, sell and hold ratings," said Will Muggia, president and chief investment officer at Westfield Capital Management. "We tend to use some of the research boutiques for information, but we tend to do most of the work ourselves and make our own decisions on buys and sells."

Still, the legal issues seem even more critical these days. Dropping recommendations and letting investors make their own decisions based on quantitative analysis can provide investment banks with a measure of "legal safety," said Dr. Roger Edelen, managing director in charge of research at ReFlow Management, an institutional service provider to mutual funds.

While the big bulge-bracket firms with the most potential for investment banking conflicts and a higher risk of litigation seem a natural for abandoning ratings, so far none has done so. However, some may be tinkering with the idea. Sources said that SG Cowen Securities Corp., which is owned by Societe Generale, has floated several "trial balloons" of research without ratings. SG Cowen denied it has considered getting rid of ratings, however.

Edelman noted that smaller firms, especially those that have some investment banking business, are more likely to worry about the legal costs.

For analysts, who have been constrained by a mountain of new regulations, removing the rating straightjacket certainly makes life easier. When an analyst has a buy or a sell on a stock, and a new piece of information comes that may be in conflict with the rating, an analyst's first inclination is to defend the rating, said Maria Lewis Kussmaul, who is a founding partner and director of investment research at America's Growth Capital, a Boston-based boutique investment bank. "We wanted to avoid the tendency to encourage the analysts to become advocates or the enemies of the company," she said, adding that by providing the research without the rating, analysts have more freedom to express their thoughts about a company.

A former sell-side analyst who is now a portfolio manager agrees. "Buys and sells hamper a free thought process," he said. Even before the bubble and the scandals, when he was a sell-side analyst, changing a rating "always was a big deal," he recalled. Now, the analyst's job has become so encumbered that "a lot of the guys are leaving the bigger firms because of the hassle."

The big firms, especially those that cater to retail investors, can't get rid of recommendations easily. Unlike institutional investors, who are considered sophisticated enough to make up their own minds, retail investors need an analyst to connect the dots.

And even firms that do an institutional business are finding that some investors want ratings. Susquehanna Financial Group, an institutional brokerage firm that launched its research unit a year ago, started out with no ratings in 2003 but added them in 2004. Clients asked for them, said Eric Noll, director of research. "Some of the feedback was, I really appreciate the unbiased research, but ultimately I want your analyst's opinion on what it means,'" he said. "We are in a good position to do that. We have no other relationships with our covered companies."

Susquehanna rates stocks net positive,' net neutral' and net negative,' Noll said. It does not, however, provide any price targets, saying asset managers typically use them, preferring to reach their own conclusions.

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