Emerging from the Storm

Journal Issue

Nov 2002

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Toiling as a research analyst for an investment bank isn't what it used to be.
Treated like rock stars during the stock market "bubble" years, research analysts have
become an easy and frequent target for criticism from all quarters. By now you have
heard allegations from the New York State Attorney General, the Securities and
Exchange Commission and U.S. legislators that a lack of independent research duped
many individual investors into collectively losing billions of dollars during the most
recent bear market.

Serious reform efforts have accompanied the criticism, some beginning in early
2001. The National Association of Securities Dealers Board of Governors, for
instance, recommended for the first time in July 2001 that research reports
include disclosure on conflicts of interest. The New York Stock Exchange implemented
new rules governing research analysts in July 2002 after its board of directors
approved sweeping changes in February 2002. More recently, Eliot Spitzer, the
New York State Attorney General, has taken several high-profile actions to force
investment banks to clearly separate research from the rest of the institution. In
addition, investment banks have responded by making their own proposals for restructuring
research.

This issue is not a narrow, esoteric governance debate. It is one piece of the
country's current attention to corporate governance in general, spurred in part by the
downfall of corporate giants such as Enron, Global Crossing and WorldCom. To some
extent, sheer numbers explain why it has captured the average American's attention.

The individual investor plays a prominent role in the U.S. equity markets, both
through mutual fund holdings and direct equity investments. Based on a recently issued
report by the Securities Industry Association, the total value of individual stocks
held directly by retail investors is approximately $3.7 trillion, down from a total
value of approximately $4.1 trillion in 1999. Despite the decline, individual
stockholders remain a significant force in the U.S. equity markets, and they have
seen hundreds of billions of dollars of wealth evaporate in the last several years.
It is little wonder that the analyst-independence issue has gained such traction
among a wide swath of the U.S. investing public.

Critics say that while investors seek unbiased, independent coverage of companies
to assist in investment decisions, analysts instead may issue research reflecting a
positive bias due to personal or structural conflicts. A research analyst who receives
a significant portion of his or her compensation in a bonus tied to investment-banking
revenues may have a meaningful economic incentive to look on the bright side when
judging a company's prospects. Critics claim to have data supporting this assertion,
not the least of which is the preponderance of "strong-buy" recommendations as
reported by Thompson First Call.

<blockquote><blockquote>
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Have analysts been as positive about companies
that ultimately file for bankruptcy as they have
been about successful companies?
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</blockquote></blockquote>

Naturally, we are interested in the analyst independence issue from a bankruptcy
angle. Have analysts been as positive about companies that ultimately file for
bankruptcy as they have been about successful companies? Perhaps more importantly, has
there been any tempering of analyst optimism given the reform efforts and exposure
concerning research independence?

We try to answer these two questions by taking a look at the data from a
bankruptcy perspective. First, we assembled a group of bankruptcies involving public
companies with at least $500 million of assets during the 1999 to mid-2002
period. Our search criteria led to a sample size of 55 companies ranging from ANC
Rental Corp. to Metromedia Fiber Network to Williams Communications Group. Next,
we surveyed Thompson First Call for all research analyst reports on these 55
companies, tracking analyst recommendations during a two-year period leading up to
bankruptcy.

We then converted each research analyst's rating system to a numerical scale and
calculated averages. Prior to conducting the analysis, we generally expected our sample
companies to be rated between a "buy" and a "strong buy" at two years prior to a
bankruptcy filing declining to something approaching a "sell" at some point prior to
bankruptcy.

Analysis results show that research has been very optimistic even in the case of
future bankruptcies. The adjacent chart shows the average rating for our sample. Two
years prior to bankruptcy, the average analyst rating is slightly above a "buy"
recommendation. The average rating declines slightly over the next 18 months, but
even at six months prior to failure, research analysts maintain an average rating well
above "neutral." For the smaller sample that enjoy analyst coverage up to bankruptcy,
the average rating declines to a negative bias below "neutral," but remains above
"underperform." Even in the weeks and days leading up to a chapter 11 filing,
research analysts have not reduced a failing company's rating to a "sell," as shown
in Chart 1.

The data also points out that a large number of analysts simply stop writing on
companies prior to bankruptcy. There were 159 analyst ratings of our sample companies
at six months prior to a chapter 11 filing. The number of ratings fell to 90
in the period immediately preceding bankruptcy, and only 15 analysts actually chose
to inform the market that they had discontinued coverage. The remainder appeared to
stop publishing without public notification.

As stated above, critics say that analysts are beholden to investment banking clients
and the future fees they may bring. This theory has been evident in e-mails disclosed
by Spitzer in his inquiries. Yet in instances where management and accounting fraud is
involved, it could very well be that research analysts are just as shocked as the
average individual investor upon its disclosure. The same might be true of businesses
subject to sudden liquidity challenges such as losing access to the commercial paper
market. The point is that it is not reasonable to expect research analysts to anticipate
failure in every instance. On the other hand, most bankruptcies arise from fundamental
and honest missteps that should be apparent to those that monitor companies as closely
as research analysts are supposed to do.

There are emerging signs that all of the attention, regulatory and otherwise, is
bringing about the desired result—greater research analyst freedom to rate companies
without worrying about investment banking relationships. Chart 2 shows the average
rating for companies filing bankruptcy in 1999, 2000, 2001 and the first
part of 2002. The various dashed lines display the average rating of companies that
filed for bankruptcy in 1999-2001 respectively, while the solid line shows the
same statistic for companies that have filed in 2002. Note that the more recent
bankruptcies have carried lower average analyst ratings than those that filed in
1999-2001 during most of the two-year period leading up to failure. Certainly
one explanation for the lower ratings for more recent bankruptcies could be the reform
efforts and public backlash discussed above.

Admittedly, the 2002 bankruptcies are a small sample, and the reforms and
rhetoric have only existed for a short period. Nonetheless, given the negative economic
incentives associated with retaining the old research model, we are inclined to believe
that this trend will continue.

It is a great American tradition to identify victims in a situation such as this.
Institutional investors (including managers of 401(k)s and pension funds) typically
maintain their own research capability and supposedly knew that a "buy" rather than a
"strong buy" used to be a signal to sell. On the other hand, a research report in
the hands of an experienced retail broker can be a very convincing sales tool,
particularly if the individual investor has abdicated responsibility because of a lack
of knowledge, experience or time.

While the retail investor has been labeled as the primary victim of overly optimistic
research, it is their responsibility to read what gets published rather than rely
solely on a broker's recommendation. One recent study conducted by two finance
professors at Boston University provided an in-depth look at research reports published
on future bankrupt companies and concluded that the text of the reports often
contradicted the analyst rating on the cover. One can only speculate that the retail
investor or broker never bothered to make it past the cover to read the more detailed
analysis that could have changed an investment decision. This is not to say that
research analysts are above the charges of irresponsible ebullience, but this is not
the one-dimensional problem that some in the press might make it.

The point is that there is plenty of blame for everyone to share. With the
exception of your next door neighbor who announces proudly that she sold all of her
investments in March 2000, no one who participates in the equity markets is
absolved of at least a little responsibility. That's what makes a bubble a bubble.

Journal Authors

Montgomery W. Cornell

Journal Date

Friday, November 1, 2002 - 12:00

Bankruptcy Rule

2002