A couple of days ago, the SEC announced that it had filed a settled administrative action against former Deutsche Bank research analyst Charles Grom. The administrative order is interesting because it gives a little glimpse into the lives of sell-side research analysts in the wake of early 2000s reforms. It also serves as an object lesson in the failures of attempts to “level the playing field” regarding access to inside information.
[More under the cut]
Sell-side analyst research has always been an odd duck because its purpose isn’t actually to help investors make better decisions; its purpose is to attract clients to an investment bank/brokerage. That function may be served by simply providing the best/most accurate research, but not always, or at least not exclusively, which is what sets up the conflict.
In the wake of the post-dot-com reforms, investment banks are no longer permitted to compensate analysts specifically for their ability to attract new deals, but analysts’ essential function as a marketing tool for brokerage clients remains. This is made clear in the facts of In the Matter of Charles P. Grom, which explain that analysts at DBSI are evaluated based mainly on their ability to arrange meetings between brokerage clients and the management of companies covered by the analyst’s research, and clients’ evaluations of the analyst’s value. The evaluation of particularly important clients carries extra weight, and these clients accordingly receive concierge service.
The conflicting incentives are on full display in the Grom case. Charles Grom regularly covered a company called Big Lots, and had extensive access to Big Lots management. He had a history of being (genuinely) more bullish on Big Lots than the market, which allowed his clients to earn extra profits when his optimism was proven correct.
DBSI then hosted a series of conferences between Big Lots management and brokerage clients, during which Grom became disillusioned about Big Lots prospects. Rather than publicly downgrade his buy rating – which he openly acknowledged would damage his relationship with the company – he instead privately counseled DBSI’s in-house trader, and a few important institutional clients, to sell.
This conduct violated the SEC’s post-dot-com requirement that analyst recommendations truthfully reflect their personal views, and resulted in Grom being barred from the industry for a year, and paying a $100K fine.
There are several aspects of this saga that strike me as significant.
First, DBSI – and, I assume, other broker-dealers – may be complying with prohibitions on tying analyst evaluations to their ability to win investment banking deals, but they obviously continue to reward analysts for their ability to ingratiate themselves with corporate management, which will necessarily skew research. That’s not exactly new; we’ve always known that analysts have an interest in maintaining access to executives of the companies they cover (with potentially dire consequences if they do not), but the Grom case is a particularly plain illustration of the phenomenon.
Second, Grom was so open and notorious about his willingness to skew his research that I have to assume his attitude was common within the firm. To be fair, DBSI eventually fired Grom, but that did not occur until a year later, and the SEC doesn’t claim the firing was related to his Big Lots coverage. So I’m guessing that it’s understood – both within DBSI and in other brokerages – that analysts pull their punches to maintain access to management. And it is particularly ironic that these attitudes are being made public just as FINRA has initiated a new program to assess how well brokerages develop and maintain cultures of compliance.
Third, the Tale of Charles Grom is a neat, straightforward demonstration of the value that comes from access to corporate management, even with Regulation FD in place. The SEC does not allege that Big Lots management communicated nonpublic material information, but it is plain that Big Lots communicated something – if only via body language and hesitancy – that allowed Grom’s favored clients to profit while other investors did not. And Big Lots management knew it – the CEO even called Grom after their meetings to ask if the company would be downgraded. Frankly, the whole issue of access to corporate management – available to some, but not to others, and highly valued by those who can get it – highlights the theoretical tensions inherent in current insider trading prohibitions.
In sum, there’s a certain banality to the l’affaire du Grom. Anyone engaged in public reporting is caught between the desire to issue ahead-of-the-pack reports, and the desire to maintain relationships with sources. It’s a common complaint in journalism that members of the press avoid reporting on certain sensitive topics in order to curry favor with insiders. Research analysts, though – unlike journalists – have the option (and are, in some ways, encouraged) to create a two-tiered system whereby favored investors receive the genuine scoop, and everyone else gets the pablum. That way, the analyst has the best of both worlds: s/he can reap the benefits of offering unique insights, and simultaneously please his/her sources of information.