This “mistake” has at least two real economic consequences: First it
damages the integrity of the market in that some (private) investors feel
that they are not privileged to the same information others had. Institu-
tional investors may know when a buy recommendation means a buy and
when it does not. But individual investors potentially do not. Second, and
even more important from a policy perspective, the gap between investors’
perspectives of the role of analysts and what they really do may erode in-
vestors’ confidence in the integrity of financial markets with the end result
that capital is scarcer and cost of capital is increased for those firms that
can raise capital.
Presently, in 2002, there is considerable foment among politicians, regu-
lators, and, investors to increase the disclosure by analysts and their firms
about the affiliations they have with the firm being recommended. Almost
surely, this is a good thing, and it would appear to be an important research
agenda to analyze which reforms are most valuable. The solutions to these
problems are not trivial. The first and most obvious step that has been
adopted is to force analysts to explicitly and prominently state their con-
nections to the firms they recommend. Just as the Surgeon General forces
the tobacco companies to label cigarettes as posing a danger to health, the
NASDAQ or the SEC has asked analysts to display in their reports, and in
public appearances, the nature of their personal and the corporate relation-
ships to the firms they recommend. The recent increased disclosures give in-
vestors the some tools they need to “debias” analysts’ potentially optimistic
or misleading reports.
Since many of the abuses are related to IPO firms, as part of an effort “to
reassure investors and build investor confidence,” the NASDAQ is propos-
ing new rules that would bar any association between IPO allocations and
future business with the investment bank that serves as the underwriter that
would result in excessive compensation.^13
A more significant change in the industry structure is a separation of in-
vestment banking from research, suggested for example by New York State
Attorney General Spitzer.^14 Given the current structure of the industry, it is
not clear that there is a demand (i.e., clients that are willing to pay) for inde-
pendent equity research: Investment banks claim that institutional and espe-
cially private investors do not pay the full cost of investment research through
their trading commissions. Recall that brokerage research is a bundled good,
meaning that investors do not pay “hard” dollars for it, they instead pay for
the research through trading commissions and taking investment banking
MARKET EFFICIENCY AND BIASES 411(^13) The Wall Street Journal, “NASD proposes tougher rules on IPO abuses—Agency would
bar brokers from allocating hot issues to curry favor with clients,” July 29, 2002, p. A1. The
proposed rule states that it “would prohibit the allocation if IPO shares in exchange for exces-
sive compensation relative to the services provided by the underwriter.”
(^14) The Wall Street Journal, “Merrill Lynch Will Negotiate With Spitzer,” April 15, 2002,
p. C1.