Joe Klein is an analyst for an investment banking firm that offers both underwriting and brokerage services. Joe sends you a highly favorable report on a stock that his firm recently helped go public and for which it currently makes the market. What are the potential advantages and disadvantages in relying on Joe's report in deciding whether to buy the stock?
The combination of brokerage and underwriting activities adds several advantages and disadvantages that should be considered separately from those discussed in Question 6 . These additional advantages and disadvantages come from the information gathered by and the revenues generated by the underwriting part of the firm.
Advantage
Better knowledge of the firm. If Mr. Klein has better knowledge of the firm than other analysts, then his recommendation should be better as well. As part of the public offering process, underwriters will conduct due diligence on the firm, gaining considerable knowledge and insight about its current operations and future prospects. The firm's management may also have a better relationship with Mr. Klein than other analysts from other brokerages because of an overall level of comfort developed between management and Mr. Klein's firm during the public offering process. As a result of this relationship, management may be responsive to Mr. Klein's questions about the firm. In addition, to the extent that knowledge moves from the underwriting side to the brokerage side, Mr. Klein may have access to additional information about the firm. It is important to note two mitigating factors in the United States. First, firms like Mr. Klein's are required to maintain a "Chinese Wall" between their brokerage and underwriting businesses to eliminate the transfer of any private information from the latter to the former. Second, firms are supposed to provide the same access to information to all of their analysts, eliminating selective disclosure to specific analysts.
Disadvantages
Need for consistency between investment banking and brokerage operations. Since underwriters are selling the stock, it is unlikely that they will provide negative reports on their clients. The investment banking side of the business may therefore pressure Mr. Klein to make recommendations that are generally supportive of the firm's underwriting decisions.
Desire for future investment banking business with the firm. Investment banking is likely a significant source of revenue for Mr. Klein's firm. Firms whose brokerage operations issue negative recommendations about a particular company are less likely to provide investment banking services for that company than those that issue positive recommendations. Thus, Mr. Klein's positive recommendation may be related either to his firm's desire to keep the company's future investment banking business or to the fact that its historical optimism made it initially an attractive underwriter for the client.
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