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 (e.g., 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, i.e., 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.

Financial Analysts, Earnings Surprises, Asymmetric Responses

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 (i.e., 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 (e.g., 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 (e.g., Francis et al., 1997; Das et al., 1998). Analysts employed by a merger and acquisition (M&A) advisor also tend to make optimistic recommendation revisions over a 180-day period surrounding the M&A announcement (e.g. 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.

Financial Analysts, Earnings Surprises, Asymmetric Responses

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