Banks May Have Trouble Taking Full Advantage Of JOBS Act's New Opportunities For Deceiving Clients

My time in the financial industry entirely postdated the global research settlement, which means that I have a different view of sell-side research from some of the olds. As far as I can make out, there are people who think that investment bank research was once a demonic scheme in which research analysts - larger-than-life figures whose recommendations were irresistible to the retail investors who in this vision bought all of every pre-2003 stock offering - swindled those besotted retail investors into buying crap stocks at inflated prices so that the banks could get gigantic investment banking fees. Whereas I always thought that investment bank research was a sort of cute endeavor of unclear commercial purpose, taken skeptically by the institutional investors who buy most of every post-2003 offering, made fun of by bankers, and conducted by people whom we never saw because, among other things, our network was set up to prevent them from emailing us and vice versa. Perhaps before the settlement giants roamed the halls of research divisions, defrauding investors with abandon, but once their email was cut off from the bankers' email they retreated into mousy irrelevance? Unclear. In any case THEY'RE BACK BABY, sort of:
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My time in the financial industry entirely postdated the global research settlement, which means that I have a different view of sell-side research from some of the olds. As far as I can make out, there are people who think that investment bank research was once a demonic scheme in which research analysts - larger-than-life figures whose recommendations were irresistible to the retail investors who in this vision bought all of every pre-2003 stock offering - swindled those besotted retail investors into buying crap stocks at inflated prices so that the banks could get gigantic investment banking fees. Whereas I always thought that investment bank research was a sort of cute endeavor of unclear commercial purpose, taken skeptically by the institutional investors who buy most of every post-2003 offering, made fun of by bankers, and conducted by people whom we never saw because, among other things, our network was set up to prevent them from emailing us and vice versa.

Perhaps before the settlement giants roamed the halls of research divisions, defrauding investors with abandon, but once their email was cut off from the bankers' email they retreated into mousy irrelevance? Unclear. In any case THEY'RE BACK BABY, sort of:

One measure in the [JOBS Act], passed by Congress March 22 to ease securities rules for closely held firms, would restore communication between bank research and underwriting arms. Those links were restricted in 2003 by regulators and by a separate settlement between then-New York Attorney General Eliot Spitzer and 10 firms including Goldman Sachs Group Inc. and JPMorgan Chase & Co. ...

When it becomes law, regulators will no longer be able to write or maintain rules that restrict investment bankers from arranging communications between analysts and investors when dealing with firms with less than $1 billion in gross annual revenue. Analysts also will be able to join investment bankers on meetings with the management of qualified firms, as well as have the freedom to publish research reports on firms immediately after an initial public offering instead of waiting for a blackout period to end.

Would it surprise you to learn that some people think this is a bad idea, and that one of them is this guy?

“It is a bad sequel to a bad movie,” said Eliot Spitzer, the former New York attorney general. “It shouldn’t be called the JOBS Act, it should be called the Bring Fraud Back to Wall Street Act.”

If you take this seriously you might ask questions like: is this in fact a bad idea? Well, lots of people (not just Spitzer!) think so. And if you think (reasonably) that research should be walled off from banking, then I guess you might ask why those walls should be lowered for "emerging growth companies" in particular. On the one hand, you can understand why emerging growth companies, who lack a track record of consistent financial results and are bought and sold based on subjective perceptions of "story" and potential rather than on actual performance, would be particularly well served by sympathetic research crafted in consultation with management and the bankers who know the company best. On the other hand, that sentence is self-refuting.

But I wonder how seriously you should take it. Maybe start not by asking "what will research analysts do in reaction to this?" or "what will capital markets bankers do?" or even "what will investors do?" but - "what will the IT department do?" Like, do you change the email system? Do you have some sort of filter where analysts can't email bankers unless the subject line is the name of a sub-$1bn-revenue company, in which case, HAVE AT IT?

The global settlement imposed a range of hurdles on banker-analyst communications, which now, when they occur, are monitored by chaperones* so that no one can do anything untoward. And more broadly the culture of research is, at least in theory, now supposed to be about helping buy-side clients invest rather than helping bankers win sell-side business - as promoted not only through things like walls between the divisions but also by comp structures that don't allow research analysts to be paid out of banking fees. Perhaps the analysts who only cover pre-IPO emerging growth companies will over time develop a view of themselves as adjuncts to banking, but how many of those are there?

Davis Polk's client memo on the topic is pretty balanced:

It is not clear that investment banks will take advantage of this flexibility, at least for now. While pre-deal research is common outside the United States, the U.S. litigation environment is unique. After the late 1990’s “dot-com craze,” investment banks paid sizable amounts to settle Rule 10b-5 claims where the research in question allegedly contained misstatements. ...

[T]he JOBS Act would not eliminate all restrictions on research related to EGCs. For example, research analysts would still need to comply with the unaffected provisions of FINRA’s research rules, including the prohibition on participating in efforts to solicit investment banking business, and with Regulation AC, which requires research analysts to certify that the views they express in their research reports accurately reflect their personal views. It is unclear what the ongoing status of the Global Research Settlement will be in light of the JOBS Act’s mandated changes to SEC and FINRA research rules. To the extent that the Global Research Settlement is still applicable, it includes restrictions, such as a prohibition on research analysts participating in pre-marketing, that could limit the ability of firms that are party to the Global Research Settlement to take advantage of some of the flexibility contained in the JOBS Act.

They also point out something pretty compelling, which is (1) the SEC haaaaaaaates this and (2) they still have a lot of ability to make trouble by "impos[ing] rules around research on matters that are not addressed by the JOBS Act."

My basic view remains that the JOBS Act is weird and kind of dumb for having one set of rules for most of the securities market and another, more fraud-friendly set of rules for one medium-sized corner of that market. In some places, though, it may be saved from its own dumbness by the difficulty in adjusting background rules, and bank systems and behaviors, to take advantage of the more fraud-friendly JOBS Act rules.

The JOBS Act: Implications for Capital Markets Professionals, Pre-IPO Companies and Private Offerings [Davis Polk]
Analyst-Banker Firewall Weakened in Bill on Obama’s Desk [Bloomberg]
Wall Street Examines Fine Print in a Bill for Start-Ups [DealBook]

* Are they called that elsewhere? They are at GS. It's so demure.

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