Company-Sponsored Equity Research Reduces Conflict of Interest

In reference to company-sponsored equity research – the company that the research is profiling pays for writing the research – the perception may be the exact opposite of the headline of this article. To be clear, we’re not talking about Public Relations, propaganda-pieces commissioned by the subject company, we’re talking about the kind of research that institutional investors have relied on for decades. Research that’s produced and distributed by analysts from SEC-regulated and FINRA licensed broker-dealers. When it’s this level of research, the fact that the company is paying the broker-dealer is irrelevant as it relates to the opinion of the analyst. There’s far too much on the line for a broker-dealer to compromise its integrity in exchange for a few thousand dollars a month. But if a broker-dealer is leveraging its research, in exchange for the engagement of lucrative investment banking deals, that could net millions for the BD, the motivation to produce a more favorable report is much more apparent. And that’s a clear conflict of interest that could taint the equity research reporting process.

So why, seemingly all-of-a-sudden, has the popularity of company-sponsored research risen so dramatically? As the saying goes; “Necessity is the mother of invention.” The broker-dealers issuing research, particularly research written on small and micro-cap companies, were no longer getting paid through trading commissions or direct payment from institutional investors. It was either shut it down or approach the companies themselves to help offset their costs. According to Peter Sidoti, CEO at Sidoti & Company, a company that has adopted the company-sponsored model, “Clearly, broker-dealers are continuing to find it less profitable, and even unprofitable, to provide securities research to companies whose coverage several years ago was economically viable.” ‘With passively managed funds [ETFs] becoming a greater factor in the investing landscape every day, active money managers simply do not have the same repository of funds to pay research providers for their services. We continue to see good companies lose coverage and all the benefits associated with such coverage as a result.’

In a recent article in the Boston Herald, Dr. Rainford Knight, who is the founder and Director of the FAU Financial Analyst Program, a member of the CFA Institute, and who teaches an Executive MBA program at the University, cites regulatory hurdles as another reason for the advent of company-sponsored research. “Those who are not directly involved in the financial industry may brush over articles with headlines like “Regs Are Killing Small Broker-Dealers,” which was recently in Barron’s,” he said. “But executives of small public companies, investors at all levels of sophistication, and those who are simply interested in the survival of our economy’s lifeblood should take notice.”

Sophisticated investors point to very clear parameters for company-sponsored research. At a conference this year sponsored by OTC Markets and IR Magazine, Jim Harvey, CFA® a portfolio manager and principal of The Royce Funds – one of the oldest and most respected small and micro-cap funds in the country with billions of AUM – was asked where he stands on company-sponsored research and his reply was simple: “I’m not biased against company-sponsored research when its written by qualified, FINRA-licensed analysts.”

Dr. Knight agrees with Harvey adding “Financial Industry Regulatory Authority (FINRA) sets strict rules for analysts and broker-dealers regarding the issuance of equity research. These analysts must take courses, tests, and certified and licensed by FINRA. Both the broker-dealer and the analyst face stiff fines and even the loss of licenses for breaking the rules.” Here are some of those rules:

• The decision to initiate coverage must originate from the research department (not from investment banking, for example)
• The analyst must certify if he or she is getting direct compensation for rendering his or her opinion
• Compensation from the subject company to the broker-dealer must be disclosed in the research report
• The analyst may not share his or her price target, market rating, or fundamental analysis before publishing the report

On both sides of the equation – issuer and investor – there seems to be an agreement on the importance of equity research. Investors rely on third-party research to make more informed investment decisions. According to Bloomberg’s Justina Lee, “For investors, the concern is that shrinking analyst coverage, especially in small and mid-caps, will make the market less efficient, with lower liquidity. Already smaller companies are feeling the pressure to beef up investor relations resources, as they can no longer count on analysts alone to tell their story.”

Before small issuers jump up and down with excitement because company-sponsored research now offers a credible option to tell their stories, they should be cautioned that gaining company-sponsored research coverage (from FINRA licensed analysts) is not necessarily any easier than it was in the past. Just because you’re willing to pay does not mean you’ll be covered. Broker-dealer research departments are no less careful in the adjudication of a company in terms of its worthiness of coverage. But if you are fortunate enough to be on the list of an established broker-dealer offering to initiate coverage, there are a few more things that should be considered:

• Look for licensed analysts who have “Street” accreditations form WSJ and other analysts ranking services and who have many years of experience, particularly in your industry sector
• Make sure that the research contains all the analytical elements that institutions demand – market rating, 12-month price-target, fundamental analysis, investment model and thesis, and analysts’ certifications
• Verify how the research is distributed and if there are barriers to access – research should be readily accessible (and at no cost) through aggregators such as Bloomberg, FactSet, Cap IQ, and Reuters
• These services are designed more for institutional investors, so investigate the channels of distribution to advisors, family offices and self-directed investors – investors like these are less likely to have access to a Bloomberg terminal, for example
• Find out the regularity of the issuance of reports – make sure that all important corporate events are reported on and not just the provision of quarterly updates

For investors who are looking for more information on these smaller companies, Dr. Knight suggests a new portal that lists 6,000 “emerging growth” companies and does not charge users to use the platform. In addition to research (yes, by FINRA licensed analysts), www.channelchek.com provides advanced market data, small and micro-cap news, video webcasts from issuers, and a popular success-story podcast series.

For issuers that have gone through an extended “quiet period,” there’s a new way to regain your voice. And it goes by the name of company-sponsored research. When done well, this can be a gamechanger.

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