In the winter of 2015, the CEO and two directors of a big brokerage firm were arrested and sent to jail by the Federal Investigation Agency (FIA).

The National Accountability Bureau (NAB) was napping at the time. Charges against the three men were that they wrote a research report on a textile company that went wrong and caused a loss of several hundred million rupees to a public institution.

The FIA suspected “violation of investment rules” and “conflict of interest”. The market did not get wind of how things were finally settled. Investors soon forgot all about it and moved on as they have done after every market crisis and crash over the past decade.

But the incident did put fear in the hearts of analysts and brokerage houses. The frequent releases of research reports, which would be in dozens every day, came to a screeching halt. The Securities and Exchange Commission of Pakistan (SECP) released the Research Analysts Regulations, 2015, which prescribe the minimum professional qualification for a research analyst. They require that a person must obtain the mandatory certification to become a research analyst as specified by the commission.

The law also stipulates that any actual or potential conflict of interest arising from dealings in securities of the company on which research is conducted by the analyst, company and its officials be addressed.

There are a host of other requirements such as an adequate documentary basis supported by research for preparing a report. “The analysts shall base (their) report on reliable information and source of such information would have to be disclosed,” the law stipulated.

Brokerages avoid quoting a ‘target price’ post-Research Analysts Regulations, 2015

It was like swinging from one extreme to the other — no regulation to the most stringent regulations. The law prescribed punishments for brokerage and research analysts who contravened any regulatory provisions. Despite protests by the researchers’ fraternity, the regulations got many things in order. Analysts did put the ‘disclaimer’ in a footnote in fine print at the bottom of their voluminous research reports even before the 2015 regulations became effective. But that was not regarded sufficient.

Most research reports before the regulations signalled a ‘buy’ and almost never a ‘sell’. That was possibly because the brokers’ livelihood depends on selling optimism. But in doing so, investors were at times misguided. Analysts would quote the ‘target price’ of a stock so high that it seemed preposterous to anyone who did minimal due diligence on the company.

The incarceration of the head of a big brokerage on a misleading research report did a few things that are to be appreciated. Brokerages that are unable to hire qualified analysts have stopped issuing clumsy reports. Besides the positive and negative themes, a couple of responsible and reputed brokerages now clearly enumerate the “key risks to the stocks” even when issuing a one-page, simple analytical report. A major change in research reports is that brokerages now avoid quoting a “target price”.

But there are still some unanswered questions. Many believe that unless criminal offence is proved, the onus for a research report that goes wrong is not on the writer of the report, but on those who made the wrong decision to invest. “Does the regulator reward analysts for releasing research reports that fill the investors’ pockets with profits?” asked an equity researcher. He affirmed that unless sufficient evidence exists of a deliberate misleading report, arrests and sentencing were unfair. “These individuals are analysts, not stock market gods. If they could accurately predict the future, trust me that most would own their own islands,” he said.

A man who has made fortunes by investing in markets from Wall Street to the Colombo Stock Exchange says that research reports provide fundamental information. He claims that he delves deeply into the technical and fundamental analyses of a stock before taking a plunge. The man shrugged his shoulders when asked if analysts could be apprehended for research reports that were prepared in good faith but without much hard work.

Many analysts refer to the Enron scandal in 2001. In addition to being the largest bankruptcy in American history at that time, Enron was cited as the biggest audit failure. The company’s stock price, which peaked at $90.75 per share in mid-2000, plummeted to less than $1 by the end of November 2001. However, analysts following the company continued to be optimistic. Even after Enron announced a $1.2 billion reduction in the shareholders’ equity, all 15 of the analysts employed by the largest investment banking firms rated Enron as a ‘strong buy’ or ‘buy’.

When Enron filed for bankruptcy protection, only two analysts recommended the sale of its shares. Seven rated it as a ‘hold’ and one still listed it as a ‘buy’. Richard Gross of Lehman Brothers wrote: “We think investors should rustle up some courage and aggressively buy the stock.” None of those analysts were brought to book. Meanwhile, in the local market, as the stream of company reports coming out of brokerage houses is drying up, small investors have now gone back to depend on the old-fashioned ‘tips’ and rumours.

Published in Dawn, The Business and Finance Weekly, September 30th, 2019