Changes in Recommendation Rating Systems, Analyst Optimism, and Investor Response
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ORIGINAL PAPER
Changes in Recommendation Rating Systems, Analyst Optimism, and Investor Response Yen‑Jung Tseng1 · Mark Wilson2 Received: 10 December 2017 / Accepted: 28 February 2019 © Springer Nature B.V. 2019
Abstract We study whether changes in analyst recommendation ratings systems encouraged by the implementation of NASD 2711 in 2002 are associated with improved objectivity and independence in analyst recommendations. Using recommendations issued during windows surrounding major investment banking events (M&A transactions, IPOs and SEOs), we show that reductions in analyst optimism following the reforms concentrate in the recommendations of analysts whose employer adopted a three-tier rating system at the time of the reforms, and that this effect is generally stronger for analysts whom the underlying incentives to engage in unethical behaviour is greatest. We also find evidence that adoption of the three-tier system improved the market’s perception of the objectivity of analyst recommendations issued after SEOs, and that for hold and sell-type recommendations this effect was stronger for analysts subject to the greatest potential ethical conflicts. While we find some evidence of a general post-reform increase in the profitability of recommendations issued following equity transactions, this improvement was only conditioned by changes to the rating system in our IPO sample. Keywords Analyst optimism · Analyst conflicts of interest · Analyst regulation
Introduction Securities analysts play an important role in capital markets, providing informed advice regarding the investability of the stocks they cover. However, these intermediaries face conflicts of interest that may induce them to issue recommendations that misrepresent their true beliefs about the covered stock (Veit and Murphy 1996; Lin and McNicholls 1998). One such conflict of interest derives from the existence of connections between analyst compensation and their employers’ investment banking revenues (Kadan et al. 2009), which may result in significant economic harm if less-sophisticated investors are unable to recognise the ethical challenges facing analysts and to adjust their investment * Yen‑Jung Tseng [email protected] Mark Wilson [email protected] 1
Accounting Department, Auckland University of Technology, Auckland, New Zealand
Research School of Accounting, College of Business and Economics, Australian National University, Canberra, Australia
2
decisions accordingly (Naffziger and Fox 2004; New York Attorney General 2002; Malmendier and Shanthikumar 2007). The consequences of analysts’ pursuit of self-interest were brought into focus following the dot-com crash of 2000. Prior to the crash, analysts had frequently ‘hyped’ stocks which they privately considered uninvestable (New York Attorney General 2002, p. 13; Forbes 2013). Investors who followed the advice of analysts that engaged in such unethical behaviour suffered significant losses when the NASDAQ suddenly lost more than 50% of its value, and this inspired a series
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