Analysis of a complex loss-making company that is seeking to compromise analyst objectivity

Entry for CFA UK ethics case study 2017 by Marietta Miemietz, CFA

 

Notes & disclaimers

  1. The purpose of this Professional Ethics Case Study is educational: to help Members of the CFA Society and the UK to consider their duties arising under the CFA Institute’s Code of Ethics (“Code”) and Standards of Professional Conduct (“Standards”) in a hypothetical scenario; and to encourage Members to reflect more generally on ethical issues in the financial services industry.
  2. This case study was inspired by ethical and analytical dilemmas faced by sell-side research analysts on a regular basis, particularly those who conduct research on extremely early-stage companies that are clients of their employers’ investment banking or other departments. Affected analysts typically face two ethical challenges that are interlinked with analytical problems: often, these companies are at a stage of immaturity where the interpretation of “reasonable basis” for the analysis is not straightforward as potential outcomes include an extremely broad range of scenarios, the likelihood of success is very low and robust data or statistics on the basis of which analysts could assign a success probability are lacking. Since banks and brokers typically only initiate coverage of these stocks if coverage (likely) results in substantial revenues beyond those arising from institutional investor interest; consequently, the issuers typically exert substantial pressure on analysts to set generous price targets and to issue Buy ratings at all times.     
  3. This case study does not constitute, and is not to be interpreted as, advice as to how conduct similar in nature to its hypothetical scenario might be viewed by the CFA Institute, the CFA Society UK, any regulatory authority, or any court of law. Persons seeking legal or other advice concerning specific facts should always consult an appropriate professional adviser.
  4. In reading the case members should consider all of their obligations under CFA Institute’s Code & Standards, with particular reference to the following Standards: 

I.B.: Professionalism – Independence and Objectivity
Members and Candidates must use reasonable care and judgment to achieve and maintain independence and objectivity in their professional activities. Members and Candidates must not offer, solicit, or accept any gift, benefit, compensation, or consideration that reasonably could be expected to compromise their own or another’s independence and objectivity.

I.C.: Professionalism - Misrepresentation
Members and Candidates must not knowingly make any misrepresentations relating to investment analysis, recommendations, actions, or other professional activities.

II.B.: Integrity of Capital Markets – Market Manipulation
Members and Candidates must not engage in practices that distort prices or artificially inflate trading volume with the intent to mislead market participants.

III.B.: Duties to Clients – Fair Dealings
Members and Candidates must deal fairly and objectively with all clients when providing investment analysis, making investment recommendations, taking investment action, or engaging in other professional activities.

V.A.: Investment Analysis, Recommendations and Actions – Diligence & Reasonable Basis
Members and Candidates must:

  1. Exercise diligence, independence, and thoroughness in analyzing investments, making investment recommendations, and taking investment actions.
  2. Have a reasonable and adequate basis, supported by appropriate research and investigation, for any investment analysis, recommendation, or action.

 

SECTION I: SCENARIO

Sarah is a senior pharmaceutical analyst with BoutiqueCo, a small investment bank. She mainly covers Blue Chips; however, since BoutiqueCo does not have a dedicated biotechnology analyst, she is asked to write the research when her firm decides to pick up coverage on the small start-up biotechnology company DreamOn. DreamOn has only one drug candidate, which it is developing in a rare disease setting exclusively for the European market. The company has sought advice from the European Medicines Agency and has reflected this advice in the clinical trial design. As there are no data in humans to date, Sarah assumes a mere 10% success probability, in line with industry statistics. Even so, her fair value estimate exceeds the share price and the DreamOn management team is happy with her high-quality research.  

 

After a year with no news-flow (NB: clinical trials typically take years to complete), the CEO of DreamOn resigns to pursue other opportunities and is replaced by a new CEO who has less experience, but is more adept at talking up share prices. After a massive investor roadshow, which was partly organized by BoutiqueCo, DreamOn’s share price exceeds Sarah’s price target. The investor relations (IR) officer at DreamCo calls Sarah and makes the following statements: 

  • DreamOn’s business relationship with BoutiqueCo only makes sense for as long as her research is “useful” to DreamOn – which is not the case if her price target is below the current share price
  • Whilst she might consider herself independent of the company, the reality is that DreamOn is effectively paying BoutiqueCo for her research and therefore, DreamOn considers her research as a marketing tool
  • Her research is replaceable; other banks have signaled an interest in winning DreamOn’s lucrative business from BoutiqueCo
  • DreamOn is concerned that its share price might gradually decline during a long period with no news-flow and relies on Sarah to keep up investor interest in the stock
  • To this effect, they are giving Sarah 4 weeks to publish a new piece of research with a higher price target; otherwise, they would terminate the relationship with BoutiqueCo. 

Sarah explains to him that she has no basis for changing her assumptions in the absence of any new data, that she is bound by regulations as well as her CFA charter to write independent research and that the company’s view of her research as a marketing tool does not alter her obligations in this regard. The IR officer replies that he is sympathetic if she is unable to comply with DreamOn’s request, but that in that case, they would terminate the relationship with BoutiqueCo. Sarah points out that she is not authorized to negotiate with DreamOn on behalf of BoutiqueCo and that it is in effect highly inappropriate for her to get involved in the commercial aspects of the companies’ business relationship. She refers DreamOn to their appropriate contacts within BoutiqueCo, clarifying once again that it is up to BoutiqueCo to decide on the coverage of DreamOn and up to her to write objective research on DreamOn if BoutiqueCo wishes to cover the name. 

After the call, Sarah submits a summary of the key points in writing to her Head of Research Tom and the Compliance department, requesting instructions on how to proceed. She never receives a written response; several days later, Tom tells her verbally that the Compliance officer has told him verbally that the research department is free to proceed as it sees fit, with the caveat that Sarah is not allowed to write biased research in an effort to appease the company. 

DreamOn subsequently arranges a conference call attended by the DreamOn CEO and IR officer as well as BoutiqueCo’s Head of Research Tom, and Sarah. Sarah states at the beginning of the call that she does not wish to be part of any commercial discussions between BoutiqueCo and DreamOn, that the earlier call with IR (which she summarizes briefly) has put her in a difficult position since his ultimatum has created a suspicion that any research she would write going forward might be tainted and that in her opinion, DreamOn is not doing itself a favor by effectively “auctioning off” its business to the bank that promises the highest price target. The CEO immediately backs off, expressing the hope that his IR officer has not actually issued an ultimatum or worded any of his commentary as sharply as Sarah has indicated; the CEO merely wants to offer her a one-on-one meeting to review DreamOn’s business case as he feels that her research does not reflect the value of DreamOn given “where the company is at”. Sarah’s assessment that nothing has changed since her last major update is wrong, in his view, as the company has since announced plans to file its main asset in the US in addition to Europe, while she continues to carry zero in her price target for the US opportunity. 

Sarah replies that there has been no formal “announcement”, that the company has merely added the words “potential to file in the US or other jurisdictions” in small font underneath one of many the bullets points in its investor slide deck and that she is unaware that the company is conducting a US study or that it has discussed its filing plans with the US FDA. The CEO replies that it is looking to file in the US based on the study it had designed for the European market and that there is no legal requirement to hold discussions with the US FDA prior to the submission of a dossier. In addition to a slightly technical discussion about FDA’s requirements, Sarah asks the CEO why he had not pointed out the omission of the US opportunity from her research earlier; he replies that during his initial months as CEO, he was too busy to worry about analysts and that in any case, it had been a moot issue for him for as long as the DreamOn share price was below her price target.  

After the call, Tom points out to Sarah that DreamOn’s CEO has a point: the company can submit its European data in the US at marginal incremental cost; the value of this optionality is bound to be higher than zero and really should have been reflected in her price target all along, notwithstanding the old management team’s initial focus on Europe. 

Sarah disagrees; she argues that it is customary for analysts in the pharmaceutical sector to exclude “pie-in-the-sky” from forecasts and valuations; specifically, analysts typically exclude any jurisdictions where company management does not have any filing plans, and that throughout her 25-year career, she has modeled her Blue Chip companies using that formula. She also notes that the highly professional management teams of her Blue Chip companies like to stress the importance of engaging with the US FDA early on, as the agency makes approval decisions on the basis of the totality of the evidence and failure to address any of the FDA’s concerns due to sub-optimal study design or execution against the backdrop of the specific treatment paradigms and patient characteristics prevailing in the US market could preclude approval. She adds that Blue Chip companies never announce US filing plans before speaking to the FDA, that reading the FDA’s mind is an impossible task, and that DreamOn should do its homework and have a discussion with the agency prior to bullying analysts into including “optionality” related to the US in their price target – she is not going to “reward” a management team for not doing their homework by giving them a higher price target due to the fact that the FDA has not been given an option to say “no”. 

In any case, her assumed success probability for the European market is only 10%, by definition, the probability in the US is even lower, but there are no statistics available as to the probability of the FDA approving drugs based on dossiers based exclusively on European studies and without prior discussion, since only dodgy companies like DreamOn would even dream of doing such a thing. If she includes this optionality in her valuation, she has to provide arguments supporting whatever success probability she chooses and she has no reasonable basis for determining the success probability.       

Tom replies that Sarah is able to get away with excluding “pie-in-the-sky” from her Blue Chip company forecasts because they have so many products that this optionality is likely to be immaterial to her share price target, but for a biotechnology company that has almost nothing, she has to take into account every “optionality”. Based on her comments, the US success probability is clearly lower than the European probability, ie lower than 10%, but so long as the FDA hasn’t opined at all, it is higher than 0%, and she will simply have to make her “best effort” to come up with a success probability in between 0% and 10%. While she might not have a truly “reasonable basis” for whatever success probability she assumes, it will be more reasonable than assuming zero.  

BoutiqueCo has not yet decided on a course of action when a couple of weeks later, DreamOn sends written notice of the termination of its business relationship with BoutiqueCo. The CEO of DreamOn simultaneously sends an e-mail to Tom and Sarah, also cc’ing a BoutiqueCo salesman who had been instrumental in setting up the earlier roadshow, to the effect that DreamOn had sent notice of termination, but that it was hoping to continue working with BoutiqueCo and to sign a new agreement during the relatively long notice period, adding that they valued Sarah’s research, but that her price target currently didn’t make sense. He asks Tom and Sarah for their availability for a meeting in the coming weeks.     

SECTION 2: DISCUSSION

 

What are some of the ethical issues Sarah faces in relation to the Code and Standards?

1. Interpretation of “reasonable basis” in the context of very early stage opportunities that are hard to gauge 
This set of questions primarily relates to standard V.A. 

  • Reasonable basis for a research report vs. formal price target:  In general, how should analysts go about valuing an income stream that has a very low probability of materializing in the absence of any statistics on standard success probabilities compiled over a large number of comparable cases? Should they include the NPV on a very heavily risk-adjusted basis in their forecasts and valuation because it is more reasonable than assuming zero (e.g. 2% US success probability in the above case study) and explain in the report that they have randomly picked a very low success probability in lack of better alternatives? Or would it be more reasonable to exclude this optionality from their valuation and simply flag it in the report as non-quantifiable upside? 
  • Does the answer to a) differ depending on whether the success probability is truly unknowable, or whether it is in the issuer’s power to greatly reduce this uncertainty (e.g. by speaking to the FDA)? 
  • Irrespective of the “text book” answer to a), should standard analyst practice in an industry (in this case: customary exclusion of ill-defined opportunities from models) have a bearing on Sarah’s approach to valuing the US opportunity?    
  • Are analysts required to apply their approaches to forecasting and valuation consistently, or does Sarah have a reasonable basis for modifying her Big Pharma approach to valuing drug candidates when analyzing a biotechnology firm, as suggested by Tom?

Q2.: Managing conflicts of interest and guarding against charges of manipulation and misrepresentation
This set of questions refers to the other standards referenced at the beginning of the case study. 

  • How do the answers to Q1 change if an analyst is conflicted? With regard to the specific example, how do DreamOn’s obvious and well-documented efforts to influence Sarah’s price target affect her flexibility to vary her analytical methods and her burden of proof that she had a reasonable basis for her assumptions?
  • Does the Compliance officer’s view that Sarah can continue to produce research on DreamOn, including revisiting any and all of her previous assumptions, so long as she herself is satisfied that she has been objective, still stand at the end of the case study, or has the clearly documented link between BoutiqueCo’s financial interests and Sarah’s price target created a situation where she is too conflicted to continue covering the stock? And fi so, what should determine the duration of the “cool-off” period before she can come off the restricted list (or re-initiate coverage, if it was dropped)?     
  • What, if any, consequences arise from the fact that the DreamOn CEO cc’ed a BoutiqueCo sales representative on his e-mail?
  • Should Sarah refuse to attend the meeting proposed by the CEO at the end of the case study, given that it is likely to compromise her objectivity further, and/or refuse to cover the stock going forward, even if she is ordered to attend/to write a research report by her Head of Research?
  • Assuming that BoutiqueCo finds a way to adequately manage the conflict of interest, what safeguards should Sarah consider with respect to the content and timing of her next publication on the company to avoid any potential allegations of misrepresentation or manipulation under Standards I.B. and II.C., respectively?  

Key Points

Under Standard V.A., analysts must exercise thoroughness in their analysis and have a reasonable and adequate basis for their conclusions; however, there are limitations to the thoroughness analysts can apply and by implication, the robustness of their conclusions, when there are no hard facts or industry statistics available that the analyst could consider. 

Standard I.B. clearly states that not only must members strive to maintain and achieve objectivity, but they must also stay clear of any situation that could reasonably be expected to compromise their independence and objectivity. 
DreamOn raised the specific (and potentially valid) point that the US remained excluded from Sarah’s forecasts only after she refused to raise her price target in line with the company’s expectations. 
Sarah is not privy to the exact commercial arrangements between DreamOn and BoutiqueCo. However, based on BoutiqueCo’s overall approach to small cap research and structure of client relationships, as well as the bank’s overall profitability, it is a fair assumption that the main reason for BoutiqueCo’s research coverage is ongoing and/or future expected payments from DreamOn, rather than demand from institutional investors, and that BoutiqueCo cannot afford to lose much business from companies like DreamOn. It is also obvious to any senior drug analyst that DreamOn will be looking to do a rights issue soon.  
Furthermore, Sarah is DreamOn’s only analyst with the expertise and skill set necessary to cover DreamOn; expanding BoutiqueCo’s pharma/biotech team is out of the question from a business perspective and even if BoutiqueCo was willing to hiere, it would be difficult to find a suitable analyst. 
Sarah has not sought independent legal advice on how to protect herself against any potential allegations that her objectivity has been compromised while adhering to her employment contract from a legal perspective. However, since her employer generally has the right to direct her, there is a risk that if she refuses to attend a meeting that her Head of Research has ordered her to attend, or to write a research report she has ben ordered to produce, she may be terminated for cause and lose all of her deferred compensation in the process. 
  
In general, analysts are considered to be relatively safe from any allegations of Market Manipulation (Standard II.B.), since they don’t intervene directly in the price setting and trading process. However, Sarah is the only analyst covering the stock and DreamOn want her to publish a glowing report during a period when a share price decline is to be expected, and DreamOn has effectively stated its belief that Sarah’s research will have a direct impact on the share price. Since her last research update, the only change at DreamOn relates to company’s business plan and related communication: management has made a unilateral decision to submit a clinical trial to the US FDA upon completion. The company’s communication in this regard as well as the recent share price movement that forces Sarah to reconsider her price target and recommendation are thus the only triggers for a potential research update; none of the hard facts in relation to the company have changed. Moreover, there was no mandatory disclosure requirement for the company to update the market on its US filing plans, and many investors are likely to consider the company’s plans premature as the study results are not yet available and the company has not yet had any discussions with the FDA.  

With respect to the risk of misrepresentation under standard I.B., please bear in mind the following circumstances, which are fairly representative of the real world where sell-side analysts operate. 
BoutiqueCo’s research is available exclusively to sophisticated institutional investors; the company does not distribute its research to retail investors and DreamOn is not legally allowed to distribute Sarah’s research to any investors (although this is known to happen with fair regularity where research is paid for by the issuer and/or there is little analyst coverage). Most of BoutiqueCo’s clients are generalist fund managers with little expertise in biotechnology; on the rare occasions that they buy or sell a biotech stock covered by BoutiqueCo, they rely heavily on Sarah (who is highly regarded and has won numerous industry awards in relation to her pharmaceutical and biotechnology research) to help them navigate the complexity of the science and regulations. They are familiar and comfortable with her style, which includes erring on the side of conservatism and clearly delineating opportunities and risks. Of course, they always take any research on small companies or illiquid stocks with a grain of salt, as they either know of (from the disclaimer) suspect a business relationship between the bank and the company in the background.   

At the same time, BoutiqueCo is trying to discourage analysts from writing long research pieces for various commercial reasons, including its institutional investor clients’ time constraints that would likely prevent them from reading a lengthy piece, and has a policy of blocking analyst research notes that exceed 12 pages unless an internal research committee has given sign-off on a longer note, which is rarely granted. The factors that the FDA would likely consider in its deliberations of whether to accept DreamOn’s file are extremely complex; to lay them all out in a note and to explain them in layman’s terms that generalist investors (who may not be aware of the extent to which the FDA’s requirements and review process differs from other regulatory processes) could understand would require Sarah to write a report that is multiple times longer than BoutiqueCo’s average research reports and that may not even be decision-useful due to its inconclusiveness. Also, being BoutiqueCo’s only analyst in a complex sector with a lot of news-flow, Sarah already works extremely long hours on a regular basis and would be physically unable to write such a detailed report without jeopardizing the quality of her other stock coverage.