Many homeowners in Cambridge, England, have a “Wattson” device in their homes, which answers their questions about energy consumption. For example, it can tell them exactly how much electricity a fan would consume if left on for a year (£3,000 or more). Such simple feedback or nudges have had a much greater impact on energy consumption than pious admonitions to conserve.

This is the premise of a recent book entitled Nudge, authored by Cass Sunstein (a law professor and head of the Office of Information and Regulatory Affairs in the administration of U.S. President Barak Obama) and Richard Thaler (a professor of behavioural science and economics.) They suggest that the way information and choices are presented — what they call “choice architecture” — can be a powerful tool for changing behaviour.

Such approaches merit careful consideration as we face the daunting challenge of reforming financial regulatory frameworks. One set of issues that, while not at the forefront of public attention, cries out for some nudges are those relating to investment research. Michael Mainelli, Jamie Stevenson and Raj Thamotheram of the Network for Sustainable Financial Markets recently posted a paper that merits careful consideration.

Financial institutions (the “sell side”) spend at least $10 billion a year on equities research sold to “buy-side” clients (mutual and pension funds and other institutional investors). Despite the sizable resources and high rewards (unparalleled in any other field of analytical research), sell-side research has been consistently demonstrated to miss most of the major insights in company analysis and to err toward “buy” recommendations. Moreover, the tendency to follow company guidance and to focus on immediate client marketing has led to a conspicuous dearth of critical analysis concerning the long-term sustainability of business models and individual company performance.

These failures derive, in large measure, from the lack of transparency in the commercial relationships between sell-side and buy-side institutions. Buy-side firms are reluctant to pay directly for research. As a result, the sell-side firms bundle a range of services (investment banking, market-making and research) in a way that masks costs and generates conflicts of interest.

There have been many attempts to address these concerns, none of which have significantly altered the status quo. To take a recent example, then New York State Attorney General Eliot Spitzer settled allegations of fraudulent research made against major Wall Street banks in return for fines and agreements to separate research functions and make statements about conflicts of interest more transparent. While transparency was improved, there has been no demonstrable impact on the preponderance of “buy” recommendations and the tendency to generate favourable research in respect of a bank’s corporate clients.

The NSFM is an international, non-partisan network of finance-sector professionals, academics and others focused on reform to ensure that financial markets can better serve their core purpose of creating long-term, sustainable value. In addressing investment research, the recent NSFM paper advances three modest proposals for reform, each of which should impose more discipline on both buy-side and sell-side conduct. Each proposal is designed to frame choices to help reduce the scope for undermining the independence and integrity of sell-side research.

The first proposal entails full and standardized disclosure by the “buy” side to its clients of financial relationships with the “sell” side. Put simply, end-users should know how their money is spent. This should be achieved by requiring all buy-side firms to report to their clients the full details of business arrangements with sell-side firms.

The second proposal builds upon a consequence of the Spitzer settlement, whereby sell-side firms in the U.S. now report on the independence of their recommendations. Most simply give the percentage of investment-banking clients in each of the categories they monitor (i.e., buy, hold and sell). Compulsory publication by sell-side institutions of their current (and historical) recommendation balance with respect to all issuers they cover (or covered), as compared with their corporate clients, could be voluntarily embraced or required. A starting point would be an agreement to, or imposition of, an acceptable reporting framework.

Finally, former Securities and Exchange Commission chairman Christopher Cox made a commitment that his agency would tackle the problem of companies “freezing out” analysts that wrote negatively about them. A former NASDAQ official had characterized such “freeze-outs” as “the rule rather than the exception.” The NSFM paper proposes that regulators impose on research firms, as a licensing condition, the obligation to report such “freeze-outs.”

@page_break@Historically, the average buy/hold/sell ratio has been about 49/39/12. It isn’t clear why any single financial services institution should think there are more buying opportunities than selling. It is even less evident why all financial services institutions would take a similar view!

If encouraging long-term investment is a primary purpose of capital markets, one would think the ratio should adjust to more “holds” and roughly equivalent numbers of “buy” and “sell” recommendations. Hence, the NSFM and the recommendations advanced in its paper. Well-crafted regulation should result in behaviour and culture change through transparency and competition.



Edward Waitzer holds the Jarislowsky Dimma Mooney Chair in Corporate Governance at Osgoode Hall Law School and the Schulich School of Business in Toronto, and is a senior partner with Stikeman Elliott LLP. He is a NSFM participant.