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3- What are the limitations of the paper? Conflict of Interest and the Credibility of
Underwriter Analyst Recommendations
Roni Michaely
Cornell University and Tel-Aviv University

Kent L. Womack
Dartmouth College

Brokerage analysts frequently comment on and sometimes recommend compa-
nies that their firms have recently taken public. We show that stocks that under-
writer analysts recommend perform more poorly than “buy” recommendations
by unaffiliated brokers prior to, at the time of, and subsequent to the recommen-
dation date. We conclude that the recommendations by underwriter analysts show
significant evidence of bias. We show also that the market does not recognize the
full extent of this bias. The results suggest a potential conflict of interest inherent
in the different functions that investment bankers perform.

Investment banks traditionally have had three main sources of income:
(1) corporate financing, the issuance of securities, and merger advisory
services; (2) brokerage services; and (3) proprietary trading. These three
income sources may create conflicts of interest within the bank and with
its clients. A firm’s proprietary trading activities, for example, can con-
flict with its fiduciary responsibility to obtain “best execution” for
clients.

A more frequent and more observable conflict occurs between a bank’s
corporate finance arm and its brokerage operation. The corporate finance
division of the bank is responsible primarily for completing transactions
such as initial public offerings (IPOs), seasoned equity offerings, and merg-
ers for new and current clients. The brokerage operation and its equity
research department, on the other hand, are motivated to maximize com-

The authors thank seminar participants at the University of Arizona, Boston College, New York Univer-
sity, University of Utah, Yale University, the NBER Corporate Finance and Behavioral Finance Groups,
and the WFA; Franklin Allen, Stephen Brown, John Elliott, Bob Gibbons, Les Gorman, Marty Gruber,
Gustavo Grullon, William Gruver, Susan Helfrick, Jeff Hubbard, Paul Irvine, Charles Lee, Bob Libby,
Avner Kalay, Abbott Keller, Dan Myers, Maureen O’Hara, Meir Statman, Jeremy Stein, David Stierman,
Sheridan Titman, and Ingo Walter offered helpful comments. Special thanks to Jay Ritter for extensive
comments and suggestions throughout this project. We also gratefully acknowledge data provided by
First Call Corporation and the expert research assistance of Roger Lynch, Paul Davey, and Louis Crosier.
Finally, we would like to thank Scott Appleby, Donal Casey, Amaury Rzad, and Robert Yasuda (all 1993
Johnson School MBA graduates) for helping us conduct a pilot study in 1993. We are solely responsible
for any remaining errors. Address correspondence to Roni Michaely, Department of Finance, Johnson
Graduate School of Management, Cornell University, 431 Sage Hall, Ithaca, NY 14853-6201, or e-mail:
rm34@cornell.edu.

The Review of Financial StudiesSpecial 1999 Vol. 12, No. 4, pp. 653–686
c© 1999 The Society for Financial Studies

The Review of Financial Studies / v 12 n 41999

missions and spreads by providing timely, high-quality (and presumably
unbiased) information for their clients. These two objectives may
conflict.

Many reports in the financial press also suggest that conflict of interest
in the investment banking industry may be an important issue.1 One source
of conflict lies in the compensation structure for equity research analysts. It
is common for a significant portion of the research analyst’s compensation
to be determined by the analyst’s “helpfulness” to the corporate finance
professionals and their financing efforts (see, for example, theWall Street
Journal, June 19, 1997, “All Star Analysts 1997 Survey”). At the same time,
analysts’ external reputations depend at least partially on the quality of their
recommendations. And this external reputation is the other significant factor
in their compensation. When analysts issue opinions and recommendations
about firms that have business dealings with their corporate finance divi-
sions, this conflict may result in recommendations and opinions that are
positively biased. A Morgan Stanley internal memo (Wall Street Journal,
July 14, 1992), for example, indicates that the company takes a dim view
of an analyst’s negative report on one of its clients: “Our objective. . . is to
adopt a policy, fully understood by the entire firm, including the Research
Department, that we do not make negative or controversial comments about
our clients as a matter of sound business practice.” Another possible out-
come of this conflict of interest is pressure on analysts to follow specific
companies. There is implicit pressure on analysts to issue and maintain pos-
itive recommendations on a firm that is either an investment banking client
or a potential client.

Conflicts between the desire of corporate finance to complete transactions
and the need of brokerage analysts to protect and enhance their reputations
are likely to be particularly acute during the IPO process. First, this market
is a lucrative one for the investment banking industry. Second, implicit in
the underwriter-issuer relationship is the underwriter’s intention to follow
the newly issued security in the aftermarket: that is, to provide (presumably
positive) analyst coverage. This coverage is important to most new firms
because they are not known in the marketplace and they believe that their
value will be enhanced when investors, especially institutional investors,
hear about them. For example, Galant (1992) and Krigman, Shaw, and
Womack (1999) report surveys of CEOs and CFOs doing IPOs in the 1990s.
About 75% of these decision makers indicated that the quality of the research
department and the reputation of the underwriter’s security analyst in their

1 For example, Paine Webber allegedly forced one of its top analysts to start covering Ivax Corp., a stock
that it had taken public and sold to its clients. According to theWall Street Journal(July 13, 1995), the
“stock was reeling and needed to be covered.” On February 1, 1996, theWSJreported that the attitude of
the investment bank analysts toward AT&T was a major factor in AT&T’s choice of the lead underwriter
of the Lucent Technologies IPO.

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Conflict of Interest and the Credibility of Underwriter Analyst Recommendations

industry were key factors in choosing a lead underwriter. Hence a well-
known analyst who follows a potential new client’s industry represents an
important marketing tool for the underwriters.

Finally, a positive recommendation after an IPO may enhance the like-
lihood that the underwriter will be chosen to lead the firm’s next security
offering. Consequently there may be substantial pressure on analysts to
produce positive reports.

These potential conflicts of interest may have been exacerbated in the
last decade with changes in the marketing and underwriting strategies of
investment banks. In the past the corporate finance arm of the investment
bank was more likely to perform due diligence on an issuer using its own staff
and not analysts in the equity research department. Only after an offering was
completed would the underwriting firm assign an equity research analyst
to cover the stock. The trend in the last two decades, however, has been
to use equity research analysts directly in the marketing and due diligence
processes [see McLaughlin (1994)]. While there are several good reasons
that can explain this trend (less duplication of expertise, improved marketing
efforts), it is likely that the “walls” between departments have become less
clear. Consequently the analyst has become more dependent on the corporate
finance group.2

The potential conflict of interest between a research analyst’s fiduciary
responsibility to investing clients and the analyst’s responsibility to corpo-
rate finance clients suggests several testable implications. First, underwriter
analysts may issue recommendations that are overly optimistic (or positively
biased) than recommendations made by their nonunderwriter competitors.
Second, these analysts may be compelled to issue more positive recommen-
dations (than nonunderwriter analysts) on firms that have traded poorly in
the IPO aftermarket, since these are exactly the firms that need a “booster
shot” (a positive recommendation when the stock is falling). The implication
is that rational market participants should, at the time of a recommendation,
discount underwriters’ recommendations compared to those of nonunder-
writers.

There is little empirical evidence relating the performance of investment
bankers’ recommendations to their affiliation with issuing firms. There are
some studies that examine the nature of the relation between the investment
banker association with the issuing firm and how this relation affects the
investment banker’s earnings forecasts and types of recommendations [see
Dugar and Nathan (1995) and Lin and McNichols (1997)]. They find that
around seasoned equity issues, underwriters’ earnings forecasts and rec-

2 See Dickey (1995). Several conversations with investment bankers confirm this conclusion. It should
be noted that, while the transmission of information and the close links between the corporate finance
division and the equity research division may result in biased recommendations, they do not constitute a
violation of the “Chinese wall.”

655

The Review of Financial Studies / v 12 n 41999

ommendation ratings are more positive (but not in a statistically significant
way) than those of nonunderwriters.

Lin and McNichols (1997) report that recommendation classifications
are more positive for underwriters’ recommendations. Dugar and Nathan
(1995) find, despite the fact that affiliated analysts are more optimistic,
that their earnings forecasts “are, on average, as accurate as those of non-
investment banker analysts.” More recently, however, Dechow, Hutton, and
Sloan (1997) conclude that the earnings estimates of underwriters’ analysts
are significantly more optimistic than those of unaffiliated analysts, and that
stocks are most overpriced when they are covered by affiliated underwriters.

A credible alternative theory is that underwriters’ recommendations will
be not only unbiased but also more accurate than those of nonaffiliated
equity analysts. Several authors, including Allen and Faulhaber (1989),
suggest that investment bankers will have superior information on firms
they have underwritten. Underwriter analysts will have an informational
advantage gained during the marketing and due diligence processes; they
may thus be more knowledgeable than their competitors and produce more
accurate forecasts. At the beginning of an IPO firm’s public life, information
asymmetry is at its greatest, which could lead to differing forecasts. It is also
plausible that the IPO firm will continue to provide the underwriter analyst
more and better information to maintain a healthy agency relationship.

If this superior information story is the dominant effect, the market should
greet underwriters’ better information with a more pronounced immediate
response. Ex post, if their information is superior, their recommendations
should be more predictive of future prices and provide investors with su-
perior investment results. (The superior information idea suggests no clear
price behavior differences in the prerecommendation period.)

We analyze three issues. Does an underwriting relationship bias analysts’
recommendations, or does it result in more accurate recommendations? Do
underwriter analysts tend to be overly optimistic about stock prices of firms
they underwrite? Does the market correctly discount the overly positive
recommendations of affiliated underwriters?

The regulatory environment provides a convenient testing ground for this
question. Twenty-five calendar days after the IPO is an important date for
a new company. It is only then that underwriters (and all syndicate mem-
bers) can comment on the valuation and provide earnings estimates on the
new company.3 And although nonunderwriters technically can express their

3 See Rule 174 of the Securities Act of 1933; Rule 15c2-8 of the Securities Exchange Act of 1934; and the
1988 revision to Rule 174 by the Securities and Exchange Commission. The revision to Rule 174 reduces
the “quiet period” to 25 calendar days for any equity security that is listed on a national securities exchange.
It does not apply to securities for which quotations are listed solely by the National Quotation Bureau
in the “pink sheets.” SEC release #5180 (August 16, 1971) explicitly states that the issuers (i.e., the firm
and its investment bankers) should avoid issuance of forecasts, projections, or predictions related to but
not limited to revenues, income, or earnings per share,and refrain from publishing opinions concerning
value, as long as the firm is in registration and in the posteffective period (i.e., the quiet period).

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Conflict of Interest and the Credibility of Underwriter Analyst Recommendations

opinions before that time, typically they do not. Thus the end of the Secu-
rities and Exchange Commission (SEC) “quiet period” marks a transition.
Before that time, investors must rely solely on the prospectus and audited
financial information (disclosures regulated under security laws). After that
time research analysts can interpret the factual information and disseminate
estimates, predictions, and recommendations as to valuation of the new firm
relative to its competitors.

We examine the information — particularly the “buy” recommendations
disseminated by brokerage analysts in the period after the end of the quiet
period. Our findings indicate, first, that in the month after the quiet pe-
riod lead underwriter analysts issue 50% more buy recommendations on
the IPO than do analysts from other brokerage firms. Second, there is a
significant difference in the prerecommendation price patterns of under-
writer and nonunderwriter analysts’. Stock prices of firms recommended
by lead underwriters fall, on average, in the 30 days before a recommen-
dation is issued, while prices of those recommended by nonunderwriters
rise.

Third, the market responds differently to the announcement of buy rec-
ommendations by underwriters and nonunderwriters. The size-adjusted ex-
cess return at the event date is 2.7% for underwriter analyst recommen-
dations (significantly different from zero) versus 4.4% for nonunderwriter
recommendations.

Finally, the long-run postrecommendation performance of firms that are
recommended by their underwriters is significantly worse than the perfor-
mance of firms recommended by other brokerage houses. The difference in
mean and median size-adjusted buy-and-hold returns between the under-
writer and nonunderwriter groups is more than 50% for a two-year holding
period beginning on the IPO day.

These results are consistent across the major brokers making buy rec-
ommendations for both their underwriting clients and nonclients. The mean
long-run return of buy recommendations made on nonclients is more posi-
tive than those made on clients for 12 of 14 brokerage firms. In other words,
it is not the difference in the investment banks’ ability to analyze firms that
drive our results, but a bias directly related to whether the recommending
broker is the underwriter of the IPO.

1. The Sell-Side Security Analyst

1.1 The Delivery of Financial Information and Recommendations to
Customers

Brokerage analysts (“sell-side” analysts) are responsible for distributing
reports such as “buy” recommendations to investors. They provide exter-
nal (“buy-side”) customers with information on and insight into particular
companies they follow. Most analysts focus on a specific industry, although

657

The Review of Financial Studies / v 12 n 41999

some are generalists, covering multiple industries or stocks that do not easily
fit into industry groupings.4

The analyst’s specific information dissemination tasks can be catego-
rized as (1) gathering new information on the industry or individual stock
from customers, suppliers, and firm managers; (2) analyzing these data and
forming earnings estimates and recommendations; and (3) presenting rec-
ommendations and financial models to buy-side customers in presentations
and written reports.

The analyst’s dissemination of information to investment customers oc-
curs in three different time circumstances: urgent, timely, and routine. The
result is the main “information merchandise” that is transmitted to cus-
tomers on a given day. An urgent communication may be made following
a surprising quarterly earnings announcement or some type of other cor-
porate announcement while the market is open for trading. In this case the
analyst immediately notifies the salespeople at the brokerage firm, who in
turn call customers who they believe might care (and potentially transact)
on the basis of the change. Once the sales force is notified, the analyst may
directly call, fax, or send e-mail to the firm’s largest customers if the analyst
knows of their interest in the particular stock.

Less urgent but timely information is usually disseminated through a
morning research conference call. Such conference calls are held at most
brokerage firms about two hours before the stock market opens for trading
in New York. Analysts and portfolio strategists speak about, interpret, and
possibly change opinions on firms or sectors they follow. Both institutional
and retail salespeople at the brokerage firm listen to this call, take notes,
and ask questions.

After the call, and usually before the market opens, the salespeople will
call and update their larger or transaction-oriented customers (professional
buy-side traders) with the important news and recommendation changes of
the day. The news from the morning call is duplicated in written notes and
released for distribution to internal and external sources such asFirst Call.
Important institutional clients may receive facsimile transmissions of the
highlights of the morning call.

Thus the “daily news” from all brokerage firms is available to most buy-
side customers, usually well before the opening of the market at 9:30A.M.
The information is sometimes retransmitted via the Dow Jones News Ser-
vice, Reuters, CNNfn, or other news sources when the price response in the
market is significant.

The importance and timeliness of the “daily news” varies widely. One
type of announcement is a change of opinion by an analyst on a stock.

4 We thank managing directors and vice presidents in the equity research and M&A departments of BT
Alex Brown, Goldman Sachs, Lehman Brothers, Morgan Stanley, and Salomon Brothers for extensive
discussions on this topic.

658

Conflict of Interest and the Credibility of Underwriter Analyst Recommendations

New “buy” recommendations are usually scrutinized by a research over-
sight committee or the legal department of the brokerage firm before re-
lease. Thus a new added-to-buy recommendation may have been in the
planning stage for several days or weeks before an announcement. Sudden
changes in recommendations (especially, removals of “buy” recommenda-
tions) may occur in response to new and significant information about the
company. Womack (1996) shows that new recommendation changes, par-
ticularly “added to the buy list” and “removed from the buy list,” create
significant price and volume changes in the market. For example, on the
day that a new buy recommendation is issued, the target stock typically
appreciates 3%, and its trading volume doubles.

For routine news or reports, most of the items are compiled in written
reports and mailed to customers. At some firms, a printed report is dated sev-
eral days after the brokerage firm first disseminates the news. Thus smaller
customers of the brokerage firm who are not called immediately may not
learn of the earnings estimate or recommendation changes until they receive
the mailed report.

More extensive research reports, whether an industry or a company anal-
ysis, are often written over several weeks or months. Given the length of
time necessary to prepare an extensive report, the content is typically less
urgent and transaction oriented. These analyst reports are primarily deliv-
ered to customers by mail, and less often cause significant price and volume
reactions.

1.2 Sell-side security analysts’ compensation
An important aspect of our analysis is related to sell-side security analyst
compensation, since a significant portion of it is based on their ability to gen-
erate revenue through service to the corporate finance arm of the investment
bank.

At most brokerage firms, analyst compensation is based on two major
factors. The first is the analyst’s perceived (external) reputation. The an-
nual Institutional InvestorAll-American Research Teams poll is perhaps
the most significant external influence driving analyst compensation [see
Stickel (1992)]. All-American rankings are based on a questionnaire asking
more than 750 money managers and institutions to rank analysts in several
categories: stock picking, earnings estimates, written reports, and overall
service. Note that only the first two criteria are directly related to accurate
forecasts and recommendations.

The top analysts in each industry are ranked as first, second, or third place
winners or (sometimes several) runners-up. Directors of equity research at
brokerage firms refer to these results when they set compensation levels
for analysts. Polls indicate that analysts’ being “up to date” is of paramount
importance. The timely production of earnings estimates, buy and sell opin-
ions, and written reports on companies followed are also key factors. Polls

659

The Review of Financial Studies / v 12 n 41999

also indicate that initiation of timely calls on relevant information is a valu-
able characteristic in a successful (and hence, well-compensated) analyst.

An analyst’s ability to generate revenues and profits is the second signif-
icant factor in compensation. An analyst’s most measurable profit contribu-
tion comes from involvement in underwriting deals. Articles in the popular
financial press describe the competition for deal-making analysts as intense.
Analysts who help to attract underwriting for clients may receive a portion
of the fees or, more likely, bonuses that are two to four times those of
analysts without underwriting contributions. The distinction between vice
president and managing director (or partner) for analysts at the largest in-
vestment banks is highly correlated with contributions to underwriting fees
[see Dorfman (1991), Galant (1992), and Raghavan (1997)].

Another potential source of revenues, commissions generated by trans-
actions in the stock of the companies the analyst follows, may also be
a factor in the analyst’s compensation. It is difficult, however, to define
an analyst’s precise contribution to trading volume. There are many other
factors, including the trading “presence” of the investment bank, that af-
fect it. Moreover, customers regularly use the ideas of one firm’s analysts,
but transact through another firm. For institutional customers, this is the
rule rather than the exception. In the short run, institutional “buy-side”
customers seek out the most attractive bids and offers independently of
analysts’ research helpfulness. Over a quarter or a year, the allocation of
commission dollars among brokerage firms is more closely tied to research
value-added.

2. Data, Sample Selection, and Sample Description

2.1 Return Data for IPOs
The data we examine come from two sources. First, we identify firms that
conducted IPOs in 1990 and 1991 usingInvestment Dealers Digest (IDD).
A total of 391 IPOs are included in the sample. We collected relevant in-
formation on each offering, including the lead underwriter, offering price,
size, and date. Stock returns are then collected from the Center for Research
in Securities Prices (CRSP) NYSE/AMEX/Nasdaq data tape.

Table 1 describes the IPO sample in terms of offering month, market
capitalization, and industry distribution. We limit the sample to firm com-
mitment offerings of equity only (no warrants or bonds attached) and an
offering size of $5 million or more. The sample includes almost all un-
derwritings by the major well-known underwriters in the United States.
Most underwriters make their recommendation comments available on
First Call.

As in previous studies [e.g., Ibbotson, Sindelar, and Ritter (1994)], the
number of IPOs is positively correlated with the lagged changes in the
level of the market (panel A). Fifty-two percent of the firms in the IPO

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Conflict of Interest and the Credibility of Underwriter Analyst Recommendations

Table 1
Description of IPO sample

Panel A: Distribution of firms conducting initial public offerings by
month in 1990–1991 (with offering size (flotation) greater than or equal
to $5 million) and the month-end Nasdaq price index

Month and year Number of IPOs Nasdaq price index

Jan 1990 8 415.81
Feb 6 425.83
Mar 14 435.54
Apr 16 420.07
May 13 458.97
Jun 19 462.29
Jul 17 438.23
Aug 10 381.21
Sep 5 344.51
Oct 1 329.84
Nov 1 359.06
Dec 2 373.84
Jan 1991 3 414.20
Feb 5 453.04
Mar 15 482.29
Apr 21 484.72
May 22 506.11
Jun 36 475.92
Jul 31 502.04
Aug 26 525.67
Sep 18 526.88
Oct 35 542.97
Nov 37 523.90
Dec 1991 30 586.34
Total 391

sample have market capitalizations between $50 million and $200 million
(panel B). (Market capitalization is calculated as the number of shares out-
standing, as reported on the CRSP tapes, multiplied by share price at the
end of the SEC quiet period, 25 days after the IPO.) Twenty-six percent of
the offerings have a capitalization of less than $50 million. The industry
composition of the sample is well balanced; business services (including
computer software), chemicals, health services, and high-tech equipment
(including computer hardware) are the most frequent SIC code designations
(panel C).

Table 2 reports the number, size, first-day return, and two-year excess
return of IPOs by underwriter. Seventy-two different underwriters acted as
lead managers in our sample of 391 IPOs. Fourteen underwriters managed
246 or 63% of the IPOs. Because of an insufficient number of observations,
we assign all the remaining underwriters to a single group.

We find a general pattern of substantial underpricing at the offering
date (10.8% mean excess return on the first day) and modest positive size-
adjusted returns (relative to CRSP size-decile return) in the next five months.
Thereafter the mean and median size-adjusted returns for the entire IPO sam-
ple are mostly negative, averaging about−5% per year. These returns are

661

The Review of Financial Studies / v 12 n 41999

Table 1
(continued)

Panel B: IPO firms differentiated by market capitalization in millions

Market capitalization Percent of IPOs Number of IPOs

Less than $50 26 100
$50–$99.9 27 105
$100–$199.9 25 98
$200–$400 15 58
Greater than $400 7 30
All IPO firms 100 391

Panel C: Distribution of IPO firms across industry groups (by two-digit SIC
code)

SIC code Percent of IPOs Number of IPOs

Business services (73) 10.0 39
Chemicals and allied products (28) 9.5 37
Health services (80) 7.7 30
Electronic equipment (36) 6.9 27
Industrial equipment (35) 5.6 22
Instruments (38) 5.6 22
Insurance (63) 4.1 16
Banks and investment firms (67) 4.1 16
Oil and gas (13) 3.8 15
Durable goods (50) 3.1 12
Other industries (Various) 39.6 155
All IPO firms 100.0 391

All firms conducting IPOs in 1990 and 1991 with offering proceeds of $5 million
or greater (with details available inInvestment Dealers Digest) are included in the
sample. Panel A shows the time series of IPO dates across months in 1990–1991.
Panel B shows the market capitalization of IPO firms, which is calculated as shares
outstanding times market price as of the end of the 25-day SEC quiet period after the
issue date. Panel C describes the sample by industry (two-digit SIC codes).

consistent with Ritter’s (1991) and Michaely and Shaw’s (1994) findings
of positive early term and negative longer-run performance of IPO firms.
Because we eliminate smaller IPOs, which have the most negative long-run
returns in Ritter’s study, our mean and median long-term returns are not as
negative as his.

The finding of a positive first-day excess return is not unique to a partic-
ular underwriter, but holds for all the 14 major underwriters in the sample
(it varies between 18.6% and 2.1%), as well as for the combined group of
nonmajor underwriters. The two-year excess return is negative for 9 of the
15 underwriter categories, and it varies between−45.8% and+21.3%.

2.2 Analysts’ recommendation data
Information on analysts’ recommendations of companies that completed
IPOs was obtained fromFirst Call. First Call Corporation collects the daily
commentary of portfolio strategists, economists, and security analysts at
major U.S. and international brokerage firms and sells it to professional
investors through an on-line PC-based system. As brokerage firms report
electronically from their “morning calls,” First …

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