Regulating the Financial Analysis Industry: Is the European Directive Effective?

New regulations aimed at curbing conflicts of interests in the financial analysts’ profession have been adopted both in the US (Sarbanes-Oxley Act, Section 501) and in the European Union (Market Abuse Directive and CD2003/125). While more than 60% of the US recommendations have been shown to be potentially biased because of investment banking relationships, this proportion is as low as 2% to 8% for recommendations issued on EC firms. These figures raise the following question: Was the EU regulation really useful? To answer this question we first provide evidence showing that the European regulation had only a weak negative impact on the proportion of buy (strong buy) recommendations. It did not affect the proportion of sell (strong sell) recommendations. Then, using an event study methodology, we show that the European law had no impact on stock returns associated with recommendations issued by financial institutions with investment banking business. However, investors perceive upgrades issued after the adoption of the European law as more reliable than those issued before: stock returns associated with upgrades are higher since the new law has been adopted. The introduction of the law had no impact on investors' reaction to downgrades. As the US regulation devoted to analysts' forecasts and recommendations was adopted before the European one, we examine whether the US regulation spilled over into the European Union, making the European regulations less relevant, or even useless. We show that the Market Abuse Directive and CD2003/125 have their own legitimacy. Regulation spill-over did not materialize for the Sarbanes-Oxley Act.