Analyst Affiliation, Stock Recommendation Optimism, and the Implementation of NASD Rule 2711 : Evidence from Financially Distressed Firms

This study examines whether recommendation optimism by affiliated analysts exists for financially distressed firms and how the implementation of NASD Rule 2711 has affected the relationship between analyst affiliation and recommendation optimism. To examine the issue, I classify recommendation optimism based on 1) the likelihood of issuing negative recommendation and 2) the timing of issuing negative recommendation. Using stock recommendations issued in the U.S. during 1993-2012, I find that affiliated analysts are less likely to issue negative recommendations for financially distressed firms than unaffiliated analysts. However, such bias disappears after the implementation of NASD Rule 2711. Similarly, affiliated analysts generally tend to defer the delivery of bad news of bankrupt firms, whereas the tendency also disappears after the passage of the rule. My findings suggest that analyst affiliation generates conflicts of interest even for financially distressed firms. However, the implementation of NASD Rule 2711 has severed the relationship between analyst affiliation and recommendation optimism, implying that the rule has increased the costs of recommendation optimism by affiliated analysts, and thereby improved the usefulness of stock recommendations for financially distressed firms. Recently, although a regulation similar to the provision in Rule 2711, which requires disclosing the distribution of stock ratings issued by brokerage firms, was introduced in Korea, the proportion of negative recommendations is still very low. Future research about the differential effect of the regulation between Korea and the U.S. is requested.