Favors on Wall Street help ensure good stock ratings

Updated 11:00 AM August 13, 2007

Favors on Wall Street help ensure good stock ratings

By Bernie DeGroat
News Service

Favors given by executives to Wall Street analysts to secure better stock ratings is all in a day's work for corporate leaders, says a U-M business professor.

A new study by James Westphal, professor of strategy at the Stephen M. Ross School of Business, and colleague Michael Clement of the University of Texas found that 63 percent of analysts—especially if they had All-America status or worked for large brokerage firms—received favors from chief executive officers, chief financial officers and investment relations officers.

"What we're talking about here is certainly not as blatant as bribery, nor does it have an instant payoff, like getting a piece of privileged information," Westphal says. "But it is more than just socializing."

Based on a survey of thousands of stock analysts and corporate executives between 2001-03, the study shows that the more a company missed its earnings forecast, the more favors executives tended to provide analysts covering the firm.

Analysts who received at least two favors were half as likely as colleagues who did not receive favors to downgrade a company after poor results. Moreover, in the wake of a diversifying acquisition—a move generally frowned upon by Wall Street because it moves a company away from its core markets—favor-rendering reduced the likelihood of a downgrade by 65 percent.

Favors included putting an analyst in touch with a top manager of another company, relaying industry information, offering to meet with an analyst's clients, offering career advice, recommending an analyst for a job, providing advice on a personal matter and helping an analyst gain access to a private club or nonprofessional organization.

Westphal and Clement say withholding favors or singling out analysts for disfavor, such as limiting or cutting off personal contact with an analyst who recently downgraded the company's stock, is as effective as granting favors. Further, analysts were less likely to downgrade a firm's stock in response to relatively low earnings to the extent they were aware of another analyst's loss of favors or access after issuing a downgrade.

"Given that downgrades have a variety of negative consequences for firms and their leaders—damaging firm reputation, market value and access to capital, and harming the reputation and career prospects of the firm's leaders—they have the potential to incite retaliatory behavior by top executives," Westphal says.

In all, the researchers say their findings have important implications for corporate control and the efficiency of capital markets.

"Security analysts, by issuing negative recommendations in response to poor firm performance or strategic actions that appear to serve management interests at the expense of shareholders, can direct capital and other resources away from under-performing firms and self-interested managers toward more productive uses," Westphal says. "In this way, analysts can serve an important role in controlling agency costs and maintaining allocative efficiency of financial markets."

They add that favor-rendering, on the other hand, can compromise the value of the guidance analysts provide to investors.

"While there may be no simple solution to the problem, our findings certainly suggest that it deserves to be taken seriously, whether by the securities industry or by government," Clement says.

The study, "Sociopolitical Dynamics in Relations between Top Managers and Security Analysts: Favor Rendering, Reciprocity and Analyst Stock Recommendations," was presented at the Academy of Management meeting in Philadelphia Aug. 5-8.

Favors on Wall Street help ensure good stock ratings

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