Sell-Side Analyst Bias When Investment Banks Have Privileged Access to the Board

Article excerpt

Research on analyst bias typically identifies affiliation with reference to a subset of the mandates that could give rise to incentives for bias in a multifunction investment bank. This paper develops a new measure of affiliation based upon the UK practice of corporate broking. An advantage of this approach is that affiliation is no longer restricted to isolated equity issuance events as it is an ongoing activity. This research shows that prior US evidence regarding the "Global Settlement" is robust to this new measure and application in the United Kingdom rather than solely the United States. The paper uses a hazard rate methodology focusing on the timeliness of revisions to address selection bias concerns.

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Earlier research on sell-side analysts looking at how affiliation may induce bias has typically used observed underwriting mandates for initial public offering (IPO) or seasoned equity offering (SEO) fundraising as the way to identify affiliation (Lin and McNichols, 1998; Michaely and Womack, 1999). Here, the bias inducement contention is that since fundraising for corporate clients can be very profitable for investment banks, sell-side analysts may bias recommendations to try and curry favor with companies that are considering an IPO or SEO. Unfortunately, since IPO firms in particular are ones in which relatively little information is known, any claimed bias results might potentially be driven by an omitted variable related to the lack of market knowledge about the firm that may not apply to established firms not seeking new or additional finance. To address this specific concern, this research examines, in detail, UK data as historically, all primary listed firms in the United Kingdom have been required to employ a "corporate broker" that is formally referred to as the "sponsor," to perform an independent self-regulatory advisor function to insure that corporate boards understand and implement the London Stock Exchange (LSE) disclosure requirements (please refer to the Appendix for a more detailed description of the role of corporate brokers). That is, using UK data, this study is able to move away from a measure of affiliation based upon the relatively isolated events of IPO or SEO fundraising and, instead, uses a measure of affiliation that applies to all primary listed firms.

It is important to recognize that the UK situation not only facilitates a more robust research measure of affiliation, but also changes the type of information flows between companies and specific operating entities of investment banks. Specifically, in order to perform their regulatory sponsor duties, UK corporate brokers meet regularly with the board members of firms to discuss their strategic plans including potential financing requirements and market disclosure timings. The nature of this ongoing sponsorship relationship has led some to say that "in the UK, companies tend to choose the bank that handled their IPOs as their corporate brokers and they then tend to give most of any subsequent capital raising business to the [multi-function investment bank owning the] retained [corporate] broker" (Koh, 2004; brackets added by authors, p. 173). According to Koh (2004), there is a large correlation between the top 10 corporate brokers and the top 10 UK bookrunners (excluding IPOs) from 1999 to 2003, in light of a 90% overlap. Moreover, corporate broking is vital for achieving not only equity and bond deals but also mergers and acquisitions (M&A) business. Koh (2004) estimates that about 50% of all UK M&A deals are won on the back of corporate broking relationships. Chinese Wall regulatory structures exist in the United Kingdom that are intended to maintain independence for both corporate brokers and sell-side analysts from the rest of a multi function investment bank. However, given that the sell-side Chinese Walls broke down in the United States, with sell-side analysts allegedly "promoting stocks" of IPO and SEO clients, it is conceivable that corporate brokers in the United Kingdom give advance knowledge to their parent investment bank about the strategic financing plans of UK companies. …