The Integrity of Financial Analysts: Evidence from Asymmetric Responses to Earnings Surprises

Rui Lu
Zhongshan University Lingnan (University) College

Wenxuan Hou
University of Edinburgh Business School

Henry R. Oppenheimer
University of Rhode Island Area of Finance and Insurance

Ting Zhang
University of Dayton School of Business Administration

June 16, 2016

Journal of Business Ethics, 2016

This paper investigates the integrity of financial analysts by examining their recommendation responses to large quarterly earnings surprises. Although there is no significant difference in recommendation changes between affiliated and unaffiliated analysts in response to positive earnings surprises, affiliated analysts are more reluctant than unaffiliated analysts to downgrade stock recommendations in response to negative earnings surprises. The evidence implies that conflicts of interest undermine the integrity of financial analysts. We further examine the effects of reputation concern and the Global Research Analyst Settlement as informal and formal mechanisms, on restoring analysts' integrity. The results show that the positive bias in recommendations remains prevalent for affiliated analysts from reputable investment banks and for the post-reform period. Finally, evidence from market reactions suggests that investors fail to notice that analysts' integrity is compromised by conflicts of interest and are misled by affiliated analysts.

The Integrity Of Financial Analysts: Evidence From Asymmetric Responses To Earnings Surprises Introduction

Financial analysts provide professional expertise and communication channels for both managers and investors. Their role in protecting investors and ensuring investor well-being in capital markets has received increasing attention from investors, regulators, and researchers. As important participants in the stock market, analysts collect and analyze firm financial information and other publicly available information, forecast revenues and earnings, and issue stock recommendations. The information and recommendations contained in analyst reports help investors to identify investment opportunities and risks. Previous studies have generally concluded that analysts provide valuable information that enhances market efficiency (eg, Schipper, 1991; Brown, 2000). They also serve as whistleblowers on corporate fraud, accounting for 16.9% of fraud detection (Dyck et al., 2010), and deter managers from engaging in opportunistic behavior, thereby decreasing earnings management, corporate fraud, and the modification of audit opinions (Yu, 2008; Chen et al., 2014 and 2015ab).

However, a number of studies have raised concerns about the integrity of financial analysts in capital markets. Jensen (2011) defines analysts with integrity as those who keep their word, ie, honor their commitments and fulfil their promises on time, and who are honest and straightforward. Using data collected by a mail survey of security analysts, Veit and Murphy (1996) document that approximately 25% of the analysts in the sample had experienced or observed unethical behavior by a colleague, such as a lack of diligence and thoroughness in making recommendations, or writing reports with predetermined conclusions. Cote and Goodstein (1999) question the ethics of analysts' practice of withholding their private opinions, and argue that analysts' herding behavior has long-term ramifications for the efficient pricing of securities and the preservation of public trust in the financial services industry. Other studies show that conflicts of interest reduce analysts' integrity, as reflected in biased recommendations (Lin and McNichols, 1998; Michaely and Womack, 1999; O'Brien et al., 2005; Palazzo and Rethel, 2008; Kolasinski and Kothari, 2008; Wu et al., 2015). In the Financial Market Integrity Outlook Survey conducted by the CFA Institute in 2011, financial advisors in the global markets received a score of only 3 out of a possible 5 for integrity. Financial advisory services are considered to have the most serious ethical issues.

The aim of this study is to shed further light on the topical yet under-researched issue of the integrity of financial analysts by taking earnings surprises into account to investigate how conflicts of interest determine analysts' recommendation responses. We also examine the effectiveness of informal (reputation concern) and formal mechanisms (the Global Research Analyst Settlement of 2003, hereafter the Global Settlement) in restoring their integrity, and explore whether the market recognizes the systematic bias caused by the reduced integrity of financial analysts.

Conflicts of interest may arise when sell-side analysts, who are employed by investment banks or brokerage firms,2 are under pressure from their employers (ie, investment banks) to produce favorable research reports either to maintain relationships with current investment banking clients or to attract such clients. Underwriting equity or bond offerings is an important revenue source for investment banks, and optimistic reports may encourage clients to buy securities and increase brokerage commissions (eg, Cowen et al., 2006). Analysts also have an incentive to maintain good relationships with the managers of the firms they follow, as management provides an important information source (eg, Francis et al., 1997; Das et al., 1998). Analysts employed by a merger and acquisition (Mamp;A) advisor also tend to make optimistic recommendation revisions over a 180-day period surrounding the Mamp;A announcement (eg Kolasinski and Kothari, 2008; Wu et al., 2015). Sell-side analysts, regarded as affiliated analysts, are subject to more conflicts of interest than unaffiliated analysts whose employers have no investment banking relationships with the firms they follow.

We extend the studies of analyst optimism by focusing on analysts' responses to earnings surprises, which represent important new information released to the market.3 We argue that conflicts of interest may impede affiliated analysts from incorporating negative earnings surprises in their recommendations. Large negative earnings surprises usually indicate a firm's unexpected financial deterioration, and are a red flag to investors, alerting observant analysts to the need to revise their earnings forecasts and recommendations (Brown and Rozzeff, 1979; Stickel, 1989). 4 A set of firms with earnings surprises thus provides an interesting context in which to investigate analysts' recommendation changes and any possible bias involved in these changes. While large positive earnings surprises represent good news for the market and for both affiliated and unaffiliated analysts, large negative earnings surprises make conflicts of interest more severe for affiliated analysts than for unaffiliated analysts.

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Financial advisor Hamid Biglari left Iran for the United States in 1977 - two years before the 1979 Islamic Revolution - when his native country produced nearly 6 million barrels of oil per day. In the following decades, Iran's economy collapsed due to sanctions by the west, and more recently, falling oil prices.

"It turns out that Iran has lost about $135 billion just from the fact that it wasn't able to produce as much as it did post-sanctions," Biglari told KGOU's World Views. But it's going to lose, over the next five years, about $180 billion. It will lose even more than what it lost during sanctions. So it's a double-whammy deal."

Biglari serves as a managing partner at the TGG Group, a Manhattan-based financial advisory firm for Fortune 100 companies. He's also worked with Citibank, and last year Bloomberg News called him Iranian President Hassan Rouhani's "go-to guy" in New York financial circles.

Although some sanctions have been lifted following a nuclear deal with the five permanent members of the United Nations' Security Council and Russia (the so-called "P5-plus-1"), Biglari says Iran still has problems that have to be solved before the country can generate more foreign investment and rebuild its economy.

"If you look at the various elements of what makes it difficult to do business in Iran, one of the most challenging is corruption," Biglari said. "You need to feed a lot of different hands in terms of getting something done."

Watch Joshua Landis extended interview with Hamid Biglari

Sensible investors will be seeking to cash in on the weak pound, affirms the Head of FX at one of the world's largest independent financial advisory organizations.

The observation from James Stanton, deVere Group's Head of Foreign Exchange, comments as sterling fell to a three decade low in the wake of Britain's decision to leave the European Union.

Mr Stanton explains: "The Brexit victory has dragged the pound down, as was expected.  But the scale of the drop has been a shock - it plummeted to its lowest level since 1985.

"However, moving forward as the dust settles, it can be expected that GBP/USD resistance could be found at 1.35 with support levels found above 1.38.  Similarly, I believe that GBP/EUR will soon test levels at 1.20.

"In the longer term, I think that the Euro will be fundamentally weakened by Brexit, as it could serve as catalyst for full EU break up as other member countries calling for referendums."

He goes on to say:" This news was always going to create a huge panic sell-off and bearing in mind the wider impact this will have on the Euro, many sensible investors will be seeking to look to cash in on a Brexit-battered pound.

"UK banks are stress-tested to deal with this kind of news, as Mark Carney, the Governor of the Bank of England has said this morning, and will offer a lot of support during these testing times.

"We can expect the pound to begin to stabilize over the next week, thereby creating better selling opportunities for investors and, indeed, the wider public.

"I strongly believe GBP/EUR will recover back nearer to the 1.30 mark and GBP/USD to 1.45 by the year's end."

Mr Stanton concludes: "Investors will be using the plummeting pound to their long term financial advantage."

Unwinding 42 years of economic cooperation and trade deals will not be easy, though, and EU leaders will be in no mood to give an inch to a leaving Britain. Otherwise, the Union will lose more members.

There cannot be any special treatment for the United Kingdom, said Manfred Weber, leader of the European Peoples Party, the largest bloc in the EU parliament. Leave means leave. The times of cherry-picking are over.

Leave negotiations will suppress any hope for economic growth from the EU until the deal is made, and the uncertainty around those talks may very well cause a recession in the EU, which has an economy about the same size as that of the US

Add in trouble with Chinas economy, Japans flirtation with recession, Africas recession due to commodity prices and big problems in Latin America, and who does that leave to power the global economy? Only North America, and neither Canada nor Mexico can help because of depressed oil prices.

That leaves the United States, and guess what? Our economy is not healthy enough to drive the world economy forward. In fact, we are at risk of the global economy dragging us down as the value of the dollar skyrockets and our trade deficit balloons.

US markets are down, but the drop isnt out of the range of what investors have endured before. Thats because so many listings on the Dow and Samp;P 500 are domestic companies without exposure to Europe. But the multinationals are taking it on the chin, and that will trickle down to domestic companies in time.

Due to the far-reaching impact of this vote, Brexit will inevitably affect the British and the European economies and the wider global financial markets, said Nigel Green, founder and CEO of deVere Group, a London-based financial advisory firm. The decision may have been taken in the UK, but it will impact the rest of the world too.

The UKs decision has already sparked talk of Scotland and Northern Ireland leaving the UK to remain in the EU. Then there are the leavers who want similar votes in France, the Netherlands and Greece. Every one of those votes will further destabilize the global economy.

Angry voters in the UK may have set off a global recession with their fit of pride. Do they know what they have wrought?