US Analyst Regulation and the Earnings Forecast Bias around the World

Date01 June 2014
Published date01 June 2014
European Financial Management, Vol. 20, No. 3, 2014, 435–461
doi: 10.1111/j.1468-036X.2012.00653.x
US Analyst Regulation and the
Earnings Forecast Bias around
the World
Armen Hovakimian
Zicklin School of Business, Baruch College, New York, NY 10010, USA
Ekkachai Saenyasiri
School of Business, Providence College,Providence, RI 02918, USA
We examine the spillover effects of the Global Analyst Research Settlement (or
Global Settlement) on analysts’ earnings forecasts in 40 developed and emerging
markets. Prior to the Global Settlement, analysts generally made overly optimistic
forecasts, this bias tending to be higher in countries with less investor protection.
This forecast bias declined significantly after passage of the Global Settlement,
the spillover effect being strongerfor countries with lower investor protection. The
spillover effect is also stronger for countries with a more significant presence of
the analysts of the 12 banks directly involved in the Global Settlement.
Keywords: analyst regulation,investor protection,cross-country spillover,analyst
forecast bias,analyst conflicts of interest
JEL classification: G15, G24, G28, G29, G38
1. Introduction
We present evidence that recent changes in research analyst regulation in the USA
have led to legal spillovers affecting analyst behaviour in 40 developed and emerging
markets around the world. We further document the role of investor protection and the
12 banks directly involved in the Global Analyst Research Settlement (hereafter Global
Settlement) in the spillover effect.
A vast literature on finance, accounting, and law documents how the extent of investor
protection and financial disclosure in a country affect its financial market development
We would like to thank John Doukas (the editor of this issue) and an anonymous referee
for valuable suggestions. We also thank Donal Byard, Terrence Martell, Oghenovo Obrimah,
Joseph Weintrop, and seminar participants at Baruch College for helpful comments.
2012 Blackwell Publishing Ltd
© 2012 John Wiley & Sons Ltd
Armen Hovakimian and Ekkachai Saenyasiri
and the behaviour of market participants (e.g., La Porta et al., henceforth LLSV, 1998).
The literature finds that in countries with legal environments that are protective of outside
investors’ rights, financial markets are characterised by higher analyst coverage, higher
forecast accuracy,and higher f irm valuations (Bushman et al., 2005; Hope, 2003; Kwag,
2006; LLSV, 2002). The literature also finds that higher accounting disclosure levels
lead to higher analyst forecast accuracy and lower the optimistic bias (Higgins, 1998).
Another strand of the literature examines how private transactions allow f irms from
countries with poor investor protection and less transparent accounting disclosure to
overcome the shortcomings of their home markets. For example, Stulz (1999) argues
that firms that choose to be subjected to more stringent US regulations via cross-listing
can improvetheir informational environment and reduce their cost of capital. Foerster and
Karolyi (1999) and Miller (1999) provide evidenceconsistent with these arguments, and
Lang et al. (2003) report that cross-listings in the USA lead to greater analyst coverage
and increased forecast accuracy. Similarly, cross-border mergers and acquisitions have
been shown to result in governance and legalspillovers affecting shareholder value (e.g.,
Bris et al., 2008; Goergen and Renneboog, 2004).
Despite the abundance of research, little attention has been devoted to the analysis
of a related issue: how regulatory changes in one country can influence the financial
markets and market participants in others. This paper provides evidence that fills this
gap. Wespecif ically focus on the optimistic bias in analystforecasts that has been linked
by earlier research to conflicts of interest. These conflicts of interest arise when sell-
side analyst compensation is tied to profits generated from investment banking business
and brokerage commissions, giving analysts incentives to generate research reports
and inflated earnings forecasts that do not reflect their true opinions (e.g., Bessler and
Stanzel, 2009; Carleton et al., 1998; Lin and McNichols, 1998).
In late 2002 to early 2003, US regulators introduced severalnew rules and regulations,
prosecuted analysts whose research reports weretainted by conflicts of interest, and f ined
banks that failed to adequately address their research analysts’ conflicts of interest. One
of the main regulatory developments during this period was the Global Settlement, an
enforcement agreement between US regulators and 12 large investmentbanks (hereafter
referred to as the Big 12 banks) designed to eliminate research analysts’ conflicts of
interest. We use the term Global Settlement to refer to this and other contemporaneous
regulatory actions aimed at curtailing such conflicts of interest.1
While the main motivation for these regulatory efforts wasto restore public conf idence
in the US capital markets, the main objective of this paper is to document their impact
on the forecasts of analysts operating outside the USA.2These US rules and regulations
can influence analyst behaviour in foreign capital markets through several mechanisms.
1The Global Settlement was announced on 20 December, 2002. Provisions of the National
Association of Securities Dealers (NASD) Rule 2711 and NewYork Stock Exchange (NYSE)
Rule 472 went into effectin July 2002, whereas Regulation Analyst Certification was adopted
by the US Securities and Exchange Commission (SEC) in February 2003. Because these
regulatory actions were introduced overa relatively short period, it is not possibleto deter mine
their independent impacts. Importantly, however, all of these rules and regulations share the
same goal of reducing analysts’ conflicts of interest.
2Hovakimian and Saenyasiri (2010) examine the impact of the Global Settlement on US
analysts’ forecast bias and find that the bias practically disappears following its passage. The
authors conclude that the Global Settlement has significantly mitigated analysts’ conflicts of
interest in the USA.
2012 Blackwell Publishin
© 2012 John Wiley & Sons Ltd

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