30 October 2002 Mr Usman Butt Business Standards Department by leader6


									                                                                                 Arete Research Limited
                                                                                    117 Farringdon Road
                                                                                      London EC1R 3BX
                                                                              Tel: +44 (0)20 7959 1300
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30 October 2002

Mr. Usman Butt
Business Standards Department
Conduct of Business Standards Division
The Financial Services Authority
25 The North Colonnade
Canary Wharf
London E14 5HS

Dear Mr. Butt

DP15 – Investment Research: Conflicts and Other Issues

Arete Research was founded on the core values of integrity, exclusivity and independence.
Registered at Companies House in January 2000, it was approved by IMRO to provide investment
advice in April 2000. The founders include former top-rated sell-side analysts from a large
investment bank, who fled the pervasive conflicts of interest inherent in the mixed "broking/banking"
structure of all major banks. Discussions with clients revealed a distinct need for wholly independent
research, unfettered by the wide range of hidden agendas. The company now comprises nine
analysts, servicing a restricted client base, affording them time to conduct thorough research and
tailor their work to individual clients' needs. At the heart of its model is that fact that Arete
takes no money from any of the many companies it covers, nor does it compete in any way
with its clients via trading or money management. Only firms which meet these two criteria
can be considered genuinely "independent". Furthermore, Arete is remunerated by its clients on a
perceived-value basis, subsequently holding true to the company's and the FSA's stated principles of

At its inception, Arete faced many sceptics. Some suggested Arete would be denied access to
companies; others thought clients were unwilling to pay for research. Time proved them wrong.
Arete's analysts speak with or meet 60-75 companies per month, generating an in-depth exchange
of ideas with key decision makers. These discussions form the basis of its research, focussed on
long-term industry themes, unlike the brief earnings reviews/forecasts published by average sell-
side analysts which often simply parrot company statements. The sceptics were right about one
aspect: the onerous rules governing compensation mean few institutions actively seek out
independent research.

Recognising the value our work adds to theirs, clients have leaned on internal compliance
departments to work closely with IMRO/the FSA to reach a solution to secure our service. Acting as
an Introducing Broker enables Arete to share commissions with a panel of brokers, nominated by
clients for good execution and liquidity. How much clients choose to compensate for ideas generated
is left to their discretion. This arrangement would suit Arete's and clients' needs perfectly – and
encourage others to provide similarly unbiased research – but for the fact that such "commission
sharing" is still considered "softing" by some. The FSA must join US regulators to devise a
global solution which revises the view of "soft commission" to encourage trustworthy
research providers to emerge. Until then, sell-side research will continue to be subsidised at
most major banks by their Investment Banking operations, its objectivity compromised.

Registered in England: number 3909374
Registered Office: Southampton House, 317 High Holborn, London W1V 7NL
Regulated by the FSA
                                                  -2 -

Analysts are ofte n thought of as falling into two camps – buy-side and sell-side. Another way to look
at it might be to divide them between "company-side" - i.e., publishing promotional material which
advertises trading or banking services - and "investor-side", i.e., writing objective research for
consideration by investors. In boom times, most sell-side analysts focus on promoting corporate
deals, endless marketing rounds, and talking to sales forces. Research is largely not done. The
rapid and dramatic expansion of r     esearch departments in the late 1990s saw many analysts of
limited experience assigned to cover sectors where deals were forthcoming. The result? A dilution
of quality research. There remains no reliable professional qualification for analysts. Knowing an
industry does not ensure good stock picking, nor do insights into accountancy explain the vagaries of
different business models. This is a complex blend most analysts fail to master. The vast majority
would certainly fail the ultimate test - being hired to work for the companies they cover
for their understanding of its strategies, strengths and weaknesses.

Today, analysts' reputations are badly tarnished; those who put their names to over-hyped tech
deals in the Internet bubble generated short-term profits, but brought the wider profession into
longer-term disrepute. Most face an unpleasant choice in explaining their behaviour: either they
were incompetent – they failed to spot obvious flaws in companies – or they were pathological liars –
they knew companies were deeply flawed, but nonetheless kept recommending "buy". This is why
institutional investors have so little respect for sell-side recommendations, and retail investors, who
bore much of the cost, have lost confidence in the stock market. Objective research has a
critical role to play in restoring trust in an efficient market; efforts by the SEC to rush
through solutions which involve brokering back-room deals with banks will only erode this
already thinly stretched trust further.

So, what are these conflicts? DP15 identifies some which are systemic across integrated banks: it
however overlooks many glaring and obvious abuses of "research" designed to promote investment
banking deals, unwind proprietary trading positions, or churn equity trades to generate commissions.
All these are regular practices within leading banks, especially as research costs are largely borne by
bankers or traders. The FSA's paper merely skims the surface of conflicts, innocently assuming
matters in the US are more exaggerated than in the UK. This is naïve in the extreme. The US,
UK and European markets are dominated by the exact same small number of investment
banks. They adopt common misleading practices worldwide in the service of their best clients: large
corporates. How many collapses of high-flying tech IPOs, led by global banks, must the UK endure
before it admits practices are no different here than in the US? The FSA is glossing over, ostrich-
like, the pervasiveness of conflicts in the UK market, where leading global banks' business
practices are precisely the same as those in the US. Does the FSA fear taking on those
banks whose fees sustain their budget?

The report fails to address the style and nature of bankers in relation to analysts. Bankers are
transaction-driven. Diminishing an analyst's reputation to secure a one-time deal is considered a
normal trade-off. Analysts realise banking generates far more lucrative fees than stock broking at a
penny a share in commissions. Seduced by the compensation accompanying these fees, analysts
routinely attach their names to reports prepared by, or in conjunction with investment banking
departments. They time recommendations to coincide with key decisions about underwriting or
advisory work. Buy-side investors often remark that a deal is coming when a sheaf of buy notes or
upgrades on an otherwise troubled company hits the market.

To imagine research published by any integrated investment bank can be independent is to live in a
fantasy world. The same goes for any suggestion that we have had no cases of misleading or
tainted research in the UK. It is an endemic feature of the market. We could cite numerous
examples, ranging across all sectors, not just technology. Prospectuses routinely give short shrift to,
                                                 -3 -

or fail to disclose material information, partly a function of hurried due diligence. One of our
analysts had frequent battles with compliance and bankers over the specific wording of reports -
bankers regularly tried to influence, if not actually write the reports analysts claim to publish. One
situation saw a note re-issued simply to remove a reference to "vapourware" in describing an optical
networking product announced as "available" in 1998 by Lucent which to this day has not been
produced.    Another saw an entire sector research piece written by the investment banking
department to "help an overworked analyst".

Investment banks are often heard complaining that their client companies want boosters, not critics,
and pressure them to issue flattering research. Never is it suggested that they should be selective
about who their advisory clients might be! Troubled companies need advice just as much as high-
quality ones, yet we rarely see the even distribution of buys, holds and sells that might be expected
in any normal market. One leading bank even published their distribution of buys, holds and sells,
stating which percentage in each category are banking clients. No surprise that 63% of notes are
buys, of which 91% are banking clients, yet of the 6% of sell notes, only 58% are about banking
clients. The very same bank's high-minded CEO blamed his own bankers – of which he was one –
for unduly pressuring his poor, beleaguered analysts. This would be amusing were it not to mask
such serious issues. If genuinely concerned about compromising the integrity of their research, why
do banks offer so many sweeteners (e.g., corporate loans, share allocations, spinning, promises of
favourable coverage and other well-documented abuses) in return for advisory client business? Why
do banks write page-long, small-font disclaimers and bury them in the back of their research notes
while claiming the pretence of objectivity? The link is clear enough, and no bank denies it: the
FSA should mandate that integrated banks' analysts' work be marketed only as
promotional material or advertising on behalf of companies paying investment banking
fees. Much research is published only to solicit such fees.

One might forgive some of these offences if they did not lead to gross distortions of market
information. Changes in recommendations are reported as fact before it is determined whether they
are fiction, spurred by trading positions at big banks. In-house analysts are incentivised to favour
certain trading clients over others and become conduits for rumours, again at the expense of retail
investors. Amazingly, any "analyst" might be quoted on Bloomberg, Reuters, national TV or in tip
sheets, making headline recommendations that actually "move" the market on any given day. While
still regarded as investment advice, these so-called analysts may be poorly qualified. Few retail
investors are likely to appreciate or benefit from recent cosmetic changes to banks' disclaimers.
They are more likely to have increased scepticism from reading the popular press than from banks
admitting they were deliberately misleading clients.

The solution? Spinning out banks' research departments would "protect" analysts from investment
banking conflicts but under their current structure (and with compensation largely derived from
banking fees), most would find it uneconomic. Competition has dramatically reduced commission
levels, formerly one of the two sources covering research costs; given leading investment banks'
different business models and legal situations, it may prove difficult to achieve. That said, most of
the halfway house measures proposed are so toothless as to be risible. For example. the notion that
compensation decisions should be split within a firm is totally unworkable , as is having armies of
compliance lawyers pore over analysts' notes before publication. The idea that US investment banks
should finance independent research companies is equally foolish: who will criticise those banks'
clients when ultimately they are still paying the bills? This would also serve to create some sort of
"monopoly" on so-called "independent" research, and very clearly leave the fox guarding the hen
                                                   -4 -

At the heart of the matter is a need for greater transparency and disclosure globally. We
must avoid additional regulatory measures which simply cloud issues and encourage the finding of
loopholes. Banks will surely resist this as intrusive; clients may be keener to break out research (in-
house and external), trading, and settlement costs. Surely investors have a right to know how their
commissions are spent. Transparency is an essential component of any solution; "remedies"
dictating how compensation is determined must be avoided. Full disclosure of any conflicts should
appear as headlines on the front page, not buried in lengthy back-page disclaimers. Trading desks
should be rewarded for best execution; sell-side analysts for objective research, generating
performance -enhancing ideas; corporate finance teams for their dogged advocacy. Enforced
unbundling (or unravelling) of research, trading and banking services might resolve this. It might
also change others' mindset, familiarising them with the idea of paying for research, ultimately
intended to improve performance. This tallies with global cries for improved corporate governance.
But it requires taking on the investment banks whose fees support the FSA, and mandating that they
fully unbundle – if not separate - their conflicting lines of business which put ordinary investors at
such an unfair disadvantage.

Ultimately however, it is up to investors to take precautions. Sadly, the trust that was once placed
in the stock market, painstakingly built through public participations like BT and British Gas has now
been all but lost. Greater transparency and disclosure is essential to restoring faith in a system
which is integral to UK society. Trustworthy research, free from hidden agendas is equally an
essential component of an efficient market. We look to the FSA to take action and propose
solutions, standing up to those who have disgraced the industry, not simply to hope, with
astonishing naivety, that the UK somehow stands aside from a clear global trend.

Please do not hesitate to call if you would like to discuss any of the issues raised in more detail.

Yours sincerely,

Richard Kramer
Managing Director, Arete Research

Harriet Tory
Compliance Officer, Arete Research

cc.     Mr. Eliot Spitzer, Attorney General, State of New York
        Mr. Harvey Pitt, Chairman, SEC
        Mr. Robert Glauber, Chairman, NASD

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