Conflicts of Interest, Regulations, and Stock Recommendations

This paper examines how sell-side equity research companies (brokerage houses) responded to the increased scrutiny of their equity research business regarding conflicts of interest driven by investment bank relationships. This scrutiny materialized in new regulations adopted by the Self-Regulatory Organizations NASD and NYSE, affecting all brokerage houses, and in the Global Settlement, affecting the big 10 brokerage houses. I find evidence of an overall change in the distribution of recommendations issued by brokerage houses after the new regulations took effect, in which they leaned towards less optimistic ratings. However, the big change is cross-sectional, with the big 10 brokerage houses that were part of the Global Settlement aggressively downgrading recommendations, to the point where the distribution of their consensus recommendations after the regulations took effect became fairly symmetrical between optimistic and pessimistic ratings. More importantly, the results suggest that the regulations achieved their goal of curbing effects of conflicts of interest in how recommendations are issued. While in the pre-regulatory period underwriter recommendations were more likely to be optimistic, and this bias was only partially recognized by the market, after the regulations were adopted the underwriter status is no longer a determinant of optimism in recommendations. * Ph.D. Candidate, Department of Finance, The Wharton School. Please address correspondence to: Leonardo Madureira, Department of Finance, The Wharton School, University of Pennsylvania, 2300 Steinberg Hall – Dietrich Hall, 3620 Locust Walk, Philadelphia, PA, 19104-6367. E-mail: [email protected]. I would like to thank Philip Bond, Richard Evans, Ben Esty, Rüdiger Fahlenbrach, Bulent Gultekin, Paul Irvine, Armando Gomes, Gary Gorton, Christian Leuz, Craig MacKinlay, Andrew Metrick, Günter Strobl, and seminar participants at the Wharton School, the London Business School 2004 Doctoral Conference and the 2004 FMA Annual Meeting for their helpful comments and suggestions.