A couple of years ago, I wrote an article which discussed how the European Union financial regulators tackled the problem of conflicts of interest when payment for investment research and trade execution was combined in a single commission charge. Their intent was to force equity analysts to justify their value-added and the buyers of investment research to put a separate price on the value of the product delivered. This policy of “unbundling” was introduced in January, 2018, in a directive known as MiFID II.
My interest in the topic was triggered several years later by an article in the Financial Analysts Journal (Fourth Quarter 2022) in which two finance professors and a PhD candidate, Yihan Li, Xin Liu and Vesa Pursiainen, looked at the consequences of this new policy. Their assumption was that the result should be a reduction in the number of analysts following European firms and an improvement in the quality of research. Their study found that there was in fact a 22-per-cent reduction in the number of analysts covering European stocks in the two-year period 2017-2018, so that consequence came to pass. The quality improvement was tougher to assess, but based on correlation analysis, they claimed to identify a “statistically-significant and economically large” improvement in the quality of the remaining research output. In other words, fewer analysts were providing better quality information.
This may have been true in the aggregate, but the passage of time showed that the shrinkage in research coverage was largely focused in the smaller company sector where poor quality research was often replaced by no research at all. To address this situation, the U.K. ended the ban on bundling following Brexit, although it did introduce some measures to minimize conflicts of interest, while Europe eased the protocol for some small caps.
These remedies do not appear to have completely resolved the problem of a lack of research on certain issuers because the European Securities and Markets Authority (ESMA) this month put out a call for comments on a code of conduct for issuer-sponsored research. Their proposed solution to the lack of research on your company? Pay for it yourself, as long as the third-party reports meet certain minimum standards regarding conflicts of interest.
Specifically, the ESMA proposals will require:
Issuers and research providers should only enter into an agreement where the minimal initial term of the contract is two years and where, at a minimum, 50 per cent of the annual remuneration is paid up front.
Research providers should establish, implement and maintain an effective conflict-of-interest policy
Research that is fully paid for by the issuer should be made public immediately.
These proposals are open for comment until March 18, 2025, so this is far from a done deal, but what ESMA has in mind is clearly something more than the existing role of an Investor Relations firm which essentially packages management presentations without editorial control. Depending on the price point, these reports could range from a simple one-pager on the latest quarterly earnings to a full-blown industry overview and the company’s competitive position.
If the securities regulators of Canada could be persuaded to adopt a similar mindset to ESMA, they could single-handedly create a whole new employment opportunity for retired investment professionals, research analysts looking for a side-hustle and amateur investors hoping to establish industry credentials. As I see it, there are minimal barriers to entry as an issuer-sponsored research writer: you can work from home, you get paid 50 per cent up front and you simply have to adhere to a conflict-of-interest code. The final piece of the puzzle will require those neglected small-cap companies to send out a request for proposals and a whole new industry will be born.
I won’t be polishing up my resume, though, because with 11,000 members in the Toronto CFA Society alone, I suspect the competition will be fierce. There may be a race to the bottom in bidding for the business and the winners will be the issuers and not the analysts.
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.