1. Financial analysts
Financial analysts deliver information about issuers and their financial instruments to current and future investors. Their analyses directly or indirectly contain recommendations for a certain investment decision, ie to buy, sell or hold a certain financial instrument. The services of financial analysts differ from those of investment consultants in that they do not cater to individual investment objectives or risk preferences. Investors or their consultants make use of financial analyses, however, when drafting a coherent investment strategy. Sell-side financial analysis is mainly provided by banks or other financial services institutions with an interest in the distribution of financial products. Sell-side analysis is only to a small extent provided by independent analysts. Conversely, the overall less frequent buy-side analysis is normally commissioned by institutional investors and their research departments.
2. Purpose and concept of financial analysis
Financial analysis is an information service which supports financial intermediation (financial intermediary). Financial analysts can hence be categorized as financial intermediaries in the broader sense. Financial intermediation serves to match supply of and demand for financial funds in a wide range of economic relations especially between private households and commercial entities. In essence, they compensate for differences in batch sizes, maturity, liquidity and risks by transforming assets or liabilities into different forms of assets and liabilities (transformation function). Financial intermediaries in the narrow sense of the word include, in particular, banks (European banking market). Financial analysts and other financial intermediaries in the broader sense support this process by providing information services. Other information intermediaries are auditors and rating agencies. Together with financial analysts they are regarded as the most important information intermediaries in financial markets.
The overall purpose of information intermediation is to verify available information, supply missing information and evaluate it in line with macroeconomic developments. The services of the information intermediaries in financial markets complement one another and directly or indirectly draw from each other. However, they each follow their own methodology. Financial analysts emphasize future-oriented evaluation of a company’s data in connection with the development of financial markets. In particular, they analyse the issuer’s market position vis-à-vis competitors, possible foreign exchange risks and global economic developments.
The existence of financial analysts—like the existence of financial intermediaries in general—can be explained by agency theory and transaction cost economics (economic analysis of European private law). Financial analysts serve to overcome or minimize information asymmetries between issuers and investors at reasonable costs. Information asymmetries are especially severe in capital markets because financial products exhibit strong characteristics of credence goods. Their adequacy to fulfil individual investment objectives can only be evaluated with the help of reliable, ie sufficiently objective, information. The European legal framework concerning issuers’ disclosure ranges from continuing to ad hoc disclosure obligations and lays the foundation for investor information. The information to be published by the management of an issuer, however, is subject to unavoidable biases; it may be inaccurate or deliberately untrue. Together with the services of other information intermediaries, financial analysts provide an indispensable contribution towards overcoming the uncertainties of investors and enabling transactions in the financial market.
3. State of European legal harmonization
Financial information permeates national borders. The cross-border dimension of capital market transactions explains why European legal harmonization is far advanced concerning financial intermediaries in general. Banks have a high market share in providing sell-side analysis. Thus, regulation focuses, in particular, on due handling of conflicts of interest, which inevitably result from the combination of financial analyses with the distribution of financial instruments. In its Communication to the European Parliament and to the Council of 2006 (COM 789 final) the European Commission took the view that the harmonized rules on financial services adequately covered the issues relating to financial analysis and that at that time no further legislation was needed in Europe.
With a view to financial analysis, the acquis communautaire consists of Dir 2003/6 on insider dealing and market manipulation (market abuse) whose Art 6(5) included rules of conduct for financial analysts for the first time. It stipulates that persons who produce or disseminate research or information recommending or suggesting investment strategy shall disclose their interests or indicate possible conflicts of interest. The directive does not only apply to investment firms but also to independent financial analysts. The implementing Dir 2003/125 substantiates the disclosure obligations concerning conflicts of interest.
More generally, Dir 2004/39 on markets in financial instruments (MiFID), which is commonly perceived as a constitution for capital markets, stipulates a general authorization requirement for financial services as well as numerous standards of good conduct. These rules are applicable to financial analysts as they provide so-called ‘ancillary services’. Implementing directive (Dir 2006/73) adds to the general stipulations of the MiFID on conflicts of interest. For financial analysts, it requires organizational measures to avoid conflicts with purposes or interests that collide with the interests of the target group of financial analysts.
One of these measures is the separation of services in connection with different interests of business clients and the analyst’s own business interests. Chinese walls are the internationally accepted means to disrupt information flows between the financial research and the sale departments of banks. Additionally, the individual employees are subject to dealing prohibitions if they have knowledge of the publication date or the content of an unpublished analysis. This prevents the exploitation of information advantages vis-à-vis other potential investors and especially clients of the bank (front running). Concurrently, the dealing prohibition avoids the generation of artificial facts leading to a price change of a certain financial instrument in which the analyst might have invested (scalping). The prohibition extends to dealings which run contrary to an analyst’s recommendation. The overall purpose is to counter the possibility of personal profits by disseminating untrue information. This is also the underlying reason for the ban on accepting greater remuneration in exchange for advantageous analyses, which applies also to individuals reviewing draft recommendations. Finally, there are restrictions regarding the degree to which analyses may be revised after publication.
In general, the development of European private law on the subject of financial analyses as well as on the wider area of financial intermediaries is influenced by the International Organization of Securities Commissions (IOSCO). The IOSCO Statement of Principles on Analyst Conflicts of Interest of 2003 proposes detailed measures to prevent conflicts of interest of financial analysts. Further, they apply to issuers and investment service providers and state that they shall, for example, refrain from a selective circulation of information or from influencing the results of an analysis.
4. Regulatory structure and issues
In essence, the law on financial analysis faces two challenges: on the one hand it has to encourage appropriate analysis processes and, on the other hand it has to ensure the sufficient objectivity of the analysts. As a general rule, regulatory intervention is only necessary if market forces are inapt to tackle the issue. With a view to the credibility argument, some scholars in the United States have proposed to refrain completely from statutory measures or at least to limit them to disclosure obligations. They argue that the credibility of financial analysis clearly stems from success rates. Only analysts whose recommendations have repeatedly come true can build up lasting credibility. The resulting reputation is seen as a long-term investment which the entities in question would not compromise for short-term benefits.
This has been questioned in academia and the EU has not followed this approach. Potential doubts relate, in particular, to the behaviour of financial analysts in market bubbles. Investment choices in overheated markets are rarely caused by the services of financial intermediaries. Thus, the demand for such services drops when markets overheat. The lessened demand theoretically leads to a higher readiness of analysts to euphemize their recommendations. It has been observed in many cases that numerous analysts publish similar recommendations which are not justifiable by the sheer facts (herd behaviour). Performance-based remuneration schemes are a possible source of such behaviour. Badly structured remuneration schemes can encourage short-term behaviour and cause analysts to inflate the bubble causing it to burst.
The European and international regulatory approach towards financial analysts was strengthened vigorously by the unexpected downfall in 2001 of Enron, the second largest US electricity supplier. Both investors and employees were heavily affected. The latter did not only lose their jobs but also substantial parts of their pensions. The downfall of Enron was at least in part caused by intentional accounting irregularities that were not reported by the statutory auditor. Ignoring warning signs, even a few days before Enron filed for insolvency a majority of financial analysts published buy recommendations.
In the United States, the Enron case led to the Sarbanes-Oxley-Act which lays down strict regulatory measures against malpractice of auditors. The European Commission feared comparable weaknesses in the corporate governance of financial intermediaries and constituted the Financial Analysts Forum. Its final report 2003 had a weaker impact than the IOSCO principles which were published almost concurrently. Nonetheless, it raised awareness in the European Union of inevitable conflicts of interest of financial intermediaries in the case of a single entity providing services for issuers as well as financial analysis. This development explains the aforementioned increase of statutory intervention in the EU concerning conflicts of interest with regards to sell-side financial analysis.
A yet unresolved issue concerns the enabling of a continuous supply of financial analyses in relation to small and medium-sized issuers. The most pertinent question concerns the funding of financial analysts. It is apparent that the cross-subsidization through the sale departments of banks results in inevitable conflicts of interest where banks simultaneously engage in investment services. It seems that some banks completely refrain from analysing small issuers. Independent analysis may provide the information supply vital for both issuers and investors. Its funding by issuers, however, entails conflicts of interest similar to the analysis by banks. The 2003 US Global Settlement sets forth an alternative. The Global Settlement was effected between the New York Attorney General and the leading investment banks. The latter were obliged to provide a sum amounting to more than $10 million over five years for independent financial analyses. It remains open whether this form of cross-subsidization is a viable method of bringing sustainable funding to the industry of financial analysis.
5. Prospects of harmonization
In its communication of 2006 (COM 789 final) the European Commission considers four regulatory issues in light of the IOSCO principles. First, the possibility of an obligatory register for analysts combined with professional qualification requirements; secondly, the regulatory and competitive role of independent analysts vis-à-vis analysts in investment banks; thirdly, possible additional corporate governance rules for analysts as well as codes of conduct for the relationship between issuers and analysts; and fourthly, the education of investors in recognizing and evaluating conflicts of interest in the area of financial analysis.
The sustainability of future efforts will depend on a more comprehensive understanding of information intermediation in general and the role of financial analysis within a system of private market access control (gatekeeping). This is a basic regulatory issue that encompasses not only financial analysts but all financial intermediaries in the broader sense.
Charles Hollander and Simon Salzedo, Conflicts of Interest and Chinese Walls (2000); Hanno Merkt, Unternehmenspublizität (2001); International Organization of Securities Commissions, Statement of Principles for Addressing Sell-Side Securities Analyst Conflicts of Interest (September 2003); Jill E Fisch and Hillary A Sale, ‘The Securities Analyst as Agent’ (2003) 88 Iowa Law Review 1035; Stephen J Choi and Jill E Fisch, ‘How to Fix Wall Street’ (2003) 113 Yale Law Journal 269; Jennifer Francis and others, Security Analyst Independence (2004); Christoph H Seibt, ‘Finanzanalysten im Blickfeld von Aktien- und Kapitalmarktrecht’  ZGR 501; John C Coffee, Gatekeepers (2006); Jan von Hein, Die Rezeption US-amerikanischen Gesellschaftsrechts (2008); Patrick C Leyens, ‘Intermediary Independence: Auditors, Financial Analysts and Rating-Agencies’ (2011) 11 Journal of Corporate Law Studies 33, earlier version in German: ‘Unabhängigkeit der Informationsintermediäre zwischen Vertrag und Markt’ in Harald Baum and others (eds) Perspektiven des Wirtschaftsrechts—Beiträge für Klaus J Hopt (2008) 423.