Effect of 2002/3 Reforms on the Extent to Which Analyst Optimism

Anecdotal evidence shows that analysts might be pressured to issue overly optimistic reports to their clients with a view to influencing banks’ future deal flow (i.e., market shares of investment banking mandates). For example, in 1999, Tyco rewarded Merrill Lynch the lead management of a $2.1bn bond offering in exchange for favourable research coverage from Merrill Lynch hiring a pro-Tyco analyst (Bowe & Silverman, 2004). Analysts can contribute to retaining or attracting investment banking business for their employers by providing optimistically biased reports.

There is mixed evidence in the literature regarding whether analyst optimism positively affects the market share of analysts’ employers’ future investment banking transactions. Findings reported by Ljungqvist, Marston and Wilhelm (2006) suggest that aggressive analyst optimism may cause a reduction in employing banks’ opportunities to win future underwriting mandates because such behaviour may damage the banks’ reputation. The authors find that although analyst optimism adds value to the covered issuers, it is not the dominant consideration when issuing firms select an underwriter for equity and debt issues. Clarke, Khorana, Patel and Rau (2007) study a sample of analysts who switched employment between 1988 and 1999 and examine whether their optimistic forecasts or recommendations affected their new bank’s chance of winning future market shares of investment banking deals. They consider both capital-raising and corporate control transactions to develop a comprehensive understanding of the relations between analyst optimism, analyst reputation, investment bank reputation and deal flow. Consistent with Ljungqvist et al. (2006), they find no evidence that issuing optimistic reports (i.e., forecast bias and aggressive recommendations) increases a bank’s chance of winning future near- term lead investment banking deals. While Ljungqvist et al. (2006) find no evidence that optimistic coverage of an issuing firm improved a bank’s likelihood of winning the

immediate lead underwriting mandate, Ljungqvist, Marston and Wilhelm (2009) show that, during the pre-reform period (before June 2002), optimistic coverage increased the chance of securing co-management appointments, which in turn increased the bank’s likelihood of winning long-term future lead-management mandates. Moreover, Ellis, Michaely and O’Hara (2011) find that investment banks compete for SEOs by intentionally providing optimistic recommendations before the offerings, suggesting a positive relation between analysts’ favourable coverage of issuing firms and underwriting mandates. Research also considers the effect of optimism in other analyst outputs. For instance, Boudry, Kallberg and Liu (2011) find that analyst optimism reflected in target prices significantly increased an underwriter’s likelihood of attracting equity and debt underwriting business for real estate investment trusts between 1996 and 2004. Overall, optimistic research may help banks gain a competitive advantage in winning or retaining advisory/underwriting mandates in the long run.

3.2.4.1 Hypothesis 7: Effect of the 2002/3 Reforms on the Extent to Which Analyst Optimism Affects Brokers’ Deal Flow

Prior studies also examine the effect of regulatory changes on deal flows. Ljungqvist et al. (2006) observe that the repeal of the Glass–Steagall Act in the late 1990s expanded the range of investment banking transactions with which commercial banks can become involved, which changed the existing equilibrium between reputational capital and conflicts of interest between investment banking and research. Ljungqvist et al. (2006) argue that analysts’ aggressive optimism may increase the likelihood of banks being awarded underwriting mandates, but that this behaviour is also regarded by the market as a liquidation of reputation capital, and taken together, this does not systematically influence banks’ market shares. Boudry et al. (2011) also contend that the enhanced scrutiny of analysts’ potential conflicts of interest by the 2002/3 reforms is associated

with a reduction in the extent to which analyst optimism has affected firms’ underwriting choices since the 2002/3 reforms.

H7 focuses on whether the 2002/3 reforms and the prominent provision therein (i.e., NASD 2711) affect the extent to which analyst optimism influences brokers’ deal flows. The objective of the 2002/3 reforms is to curb analysts’ potential conflicts of interest arising from their employers’ attempts to win future underwriting or advisory mandates. Before the reforms, both affiliated and unaffiliated analysts had incentives to issue optimistic reports of the covered firms surrounding the investment banking deals. If the 2002/3 reforms at least partially achieved their goal, I expect this to lead to a reduction in aggressive analyst optimism. Following the 2002/3 reforms, analysts may have less incentive to provide overly optimistic coverage to lure lead management or advisory mandates for their employing banks because their compensation and status are no longer determined by investment banking revenues. Of course, at any point in time, some analysts will be more optimistic than others. However, I argue that in the post-reform period, observed abnormal optimism will more likely reflect genuinely held beliefs rather than opportunistic behaviour intended to help brokers win future deals. From the perspective of potential clients, if they believe that inducing analysts to be optimistic became more difficult after the reforms, then observed (historical) optimism should have a smaller effect on their choice of future underwriters or advisors. Therefore, I propose that the extent to which analysts’ aggressive optimism affects their employers’ deal flow decreases following the 2002/3 reforms. H7 is formally stated as follows:

H7: The sensitivity of the annual change in the market share of investment banking

3.2.4.2 Hypothesis 8: Effect of Changing Tiers on the Extent to Which Analyst Optimism Affects Brokers’ Deal Flow

H8 examines the effect of the implementation of the three-tier ratings system induced by NASD 2711 on the extent to which analyst optimism affects brokers’ deal flow.

Before the 2002/3 reforms, favourable analyst recommendations potentially benefited employers’ investment banking business. This study argues that, following the disclosure requirements of NASD 2711, any reduction in excess analyst optimism attributable to the effect of the 2002/3 reforms will be stronger among analysts who changed their ratings system relative to those who did not. Thus, if the extent to which analysts’ intentional optimism affects their employers’ deal flow decreased following the 2002/3 reforms, I expect that this reduction will also be greater among analysts whose employers implemented the three-tier ratings system induced by NASD 2711. H8 examines a stronger effect for those analysts changing to the three-tier ratings system after the NASD 2711. The hypothesis is formally stated as follows:

H8: The decrease in sensitivity of the change in the market share of investment banking

business to the annual change in analyst optimism after the 2002/3 reforms is greater for brokerage firms whose analysts changed to the three-tier recommendation ratings system after the 2002/3 reforms than for other brokerage firms.

To test H7 and H8, I focus on brokers’ market shares in investment banking business such as M&A advisory and new equity (IPO/SEO deals) underwriting mandates to develop hypotheses.

This completes the development of the hypotheses relating to changes of behaviour around the 2002/3 reforms. The next section develops hypotheses concerning the expiration of the mandatory procurement of independent research.

Effect of the Five-Year Funding of Independent Research and its Expiration