The impact of regulations, salutary or otherwise, on the behavior of affected agents is of special interest to financial economists. Since the turn of the century, the regulatory environment for sell-side research has changed as a reaction to the considerable evidence that sell-side analysts face significant conflicts of interest. The charge was that analysts, affiliated with institutions which also offered investment banking (IB) services, issue biased forecasts.

The objective of the new regulations has been to sever the ties between investment banking and  the sell-side research departments of these institutions. In the United States, changes in the regulatory environment began in July 2002, when the SROs (Self-Regulatory Organizations) NASD and NYSE issued NASD Rule 2711 and the amended NYSE Rule 472. The Global Settlement, following soon after, closely mirrored the SROs’ new regulation, but also imposed penalties exceeding $1.4 billion on the affected institutions. In a similar change in the regulatory environment in the European Union (EU), the first directive dealt with insider dealing and market manipulation (Market Abuse Directive - MAD 2003). The second, Markets in Financial Instruments Directive, (MiFID 2004) aimed at preventing issuers from influencing the research produced by investment firms. These directives also banned analysts from disclosing information likely to influence prices selectively, before disclosing such information to all market participants. The 2003 IOSCO report also aimed at managing conflicts of interest in financial institutions. These new regulations have collectively formed a watershed event for how the sell-side research industry operates, both in US and EU markets.

In our study, we examine the collective impact of regulatory changes on prevalent practices of analysts exposed to conflicts of interest. We do so by examining analysts’ advice produced for firms in the first year after their initial public offering (IPO). As a proxy for conflicts of interest, we measure whether the analyst’s employer participates in the IPO syndicate.

We determine that the regulations are instrumental in altering the behavior of conflicted analysts. Moreover, the pattern of change in behavior is similar across both US and EU markets. In the period before the new regulations were adopted, affiliated analysts—the ones whose brokers acted as lead underwriters or co-managers in the IPO process—issued more optimistic recommendations and target prices, compared to advice from unaffiliated analysts. We find that pursuant to the regulations, both lead and co-managers are no more optimistic than their unaffiliated counterparts. We also find that investors tend to discount optimistic outputs, both recommendations and target prices, less in the post-regulatory period. These findings suggest that the credibility of analysts’ advice has improved and the market is less skeptical of the analysts’ outputs, in the presence of conflicts of interest.

Another rich dimension of our study is that we compare the behavior of US brokers operating in EU IPOs. It is unclear whether brokers and their affiliated analysts would respond to strict local regulations even when they are operating in international arenas with relatively lax restrictions. We focus on the period following the new regulations in the US and before the staggered implementation of MAD across various EU countries. This period offers an interesting window to examine the behavior of US brokers in a foreign market that had lax rules, relative to the stricter rules that had already been put in place in the US. Examining the behavior of investment banks in this unique interval, we find that analysts affiliated with US brokers followed the stricter US based regulations and restrained themselves from being overly optimistic, even though the contemporaneous regulations in Europe did not compel them to do so. Not surprisingly, the EU brokers continued with their optimistic projections until the implementation of the local regulations.

It is possible that the impact of a regulation on analysts’ behavior, and how investors interpret analysts’ advice in the new regulatory framework, depends on the threat and the severity of legal sanctions in the new regulation. In our paper, we examine the role played by severity of sanctions on the relative effectiveness of regulatory changes by classifying each broker as having been sanctioned by the Global Settlement or not. We observe a differential pattern of change in optimism emanating from regulations depending on whether a broker has been part of the Global Settlement.


Romain Boissin is Associate professor of Finance at the University of Montpellier

Leonardo Madureira is Deborah and David Daberko Fellow, Associate Dean for Research and Associate Professor in Banking and Finance at the Weatherhead School of Management, Case Western Reserve University

Ajai K. Singh is Professor of Finance and Director of the Dr. P. Phillips School of Real Estate, University of Central Florida