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. Last Updated: 07/27/2016

Drawing a Line Between Research and Investment

Joining the global effort to improve market practices and inspired by the high appraisal of Russia's new corporate governance code, the local investment community is now going one step further by developing ethical standards for brokerages and investment banks.

The Guild of Investment and Financial Analysts, or GIFA, has teamed up with the Federal Securities Commission, market players, and a number of government organizations and international experts to draft a code of ethics. It seeks to prevent conflicts of interest, avoid insider trading and increase public awareness of bad practices in the market.

The draft code, which has been offered to market participants for discussion, is addressing the same problem that investment banks are facing worldwide: conflicts of interest between the investment and research arms of companies working in the sector.

"The text of the code is under discussion and is expected to get approval from the local investment community by the end of 2002," GIFA president Alexander Idrissov said in an interview.

The Russian market has learned a lot from the 1998 financial crisis and the recent conflicts involving analysts in the United States. Russian brokerages say they care much more about their own reputations now than several years ago. Some already meet international standards, but there is still room for improvement at others.

Eric Kraus, chief strategist and head of equities with Sovlink investment bank, said the situation in Russia is perhaps better than it was, at least until recently, in the United States.

"We see more 'sell' recommendations than one did in New York, largely because there is rather little corporate finance business here," Kraus said.

Nevertheless, he said, "given the lack of effective regulatory oversight, the investor must ask himself whether a given broker has a strong personal interest in a given asset."

Roland Nash, head of research with Renaissance Capital, said separating investment banking and research is even more important in Russia than in the United States. "There is a lot of suspicion in the market, given that it is still quite risky and given what happened in 1998," he said.

What is so important about the code, analysts say, is that its existence means another stage has been reached in the market's development.

"The code itself brings nothing new, as it sets basic ethical standards that are the same in all countries, including the United States, Britain or any other developed country," said Denis Rodionov, deputy head of research with Brunswick Warburg and a member of the working group responsible for the code. "But the most important thing about it is that it will finally exist in Russia."

Idrissov said GIFA would enforce the code according to the same principles as other international bodies with similar roles. Violators of ethical standards may be subject to either private warning or public reprimand, depending on the degree of the offense; the facts are to be made public to the members of association; and in the worst cases offenders may be stripped of their qualifications as chartered financial analysts.

According to local analysts, the problem here is fundamentally different from that in the United States, where the major conflict of interest is between investment and research departments during IPOs. Here, the potential for conflicts of interest can arise due to major companies controlling brokerages. Another cause is the trading activity of brokerages that are heavily invested on their own accounts. In this case, analysts can come under pressure to talk positively about companies their brokerage holds, or, conversely, negatively about stocks they are trying to buy.

"I think there is a general problem in some [brokerage] companies, when there are investment deals that affect the research ranking of the [traded] company," said James Fenkner, chief strategist with Troika Dialog.

"In this case, this is a real conflict, as the research ranking should be independent of other business."

All these issues are addressed in the draft code. For example, it recommends that market participants avoid situations in which an analyst or his or her relatives hold the stock the analyst is covering; in which a brokerage company is invested in the stock covered by its analytical department; or in which a company or an analyst has other motivations to influence the price of the stock.

Fenkner said that to ensure high standards, every analyst with Troika Dialog's research team is either a member of the U.S.-based Association of Investment Management and Research or is qualified as a chartered financial analyst and must abide by their ethical guidelines.

Nash said the most important attribute of a research team in Russia is now its credibility because this is the only way to make money and attract clients. Most big brokerage houses in Moscow are serious about maintaining the independence of their research and investment banking operations, he said.

"Of course it's not possible to isolate one part of the bank from another, but the risk for us to lose our credibility is much more significant than the possible benefits," Nash said.

One of the solutions is simply to make investment deals public. For example, Aton brokerage was the lead manager for RosBusinessConsulting's initial public offering on the domestic market in May this year and, although Aton initiated its analytical coverage of the stock with a "buy" recommendation, it made public its investment and consulting business with the issuer.

"We always disclose information regarding our relations with the company we are covering, in order to meet international disclosure standards," said Steven Dashevsky, Aton's head of research.

He said another way to solve ethical issues is to cease coverage of the stock in question, but this is difficult to do in Russia given the very small number of public companies.

Chris Weafer, chief strategist with Alfa Bank, said the bank's policy is to address possible conflicts openly and publicly. For example, he said, since Alfa Bank is an adviser to Unified Energy Systems on its restructuring, the bank is not making a stock-specific recommendation nor publishing any financial forecasts on any Russian energy companies, including UES itself.

Slava Rabinovich, head of MDM Asset Management, said MDM is also trying to address the issue.

"MDM Bank, recognizing possible conflicts of interest, is doing its best either to eliminate them or minimize them to an acceptable level," he said. "If you still do have a conflict of interest, which is minimized but impossible to eliminate, that is also fine as long as it is properly disclosed to the public."

Self-discipline and enforcement of the rules are key to improving ethical standards, analysts said.

"Russians seem to love new codes. But the only thing that will have an effect is pressure from the investor community," Kraus said.

Rabinovich said it will take some time for Russian organizations to fully appreciate the notion of self-regulation, but in time, everybody will get there. "Those who won't will just disappear, driven out by the market itself, if not by law," he said.

The FSC in November approved several concrete steps to further boost the transparency of publicly traded companies and make the market more attractive to institutional and foreign investors, including new legislation on insider trading it expects the State Duma to approve in 2003. Also, in line with global efforts, the government has approved an FSC initiative under which local companies would be barred from working with the same auditor for more than five years. An auditor's income from one client would not be allowed to exceed 10 percent of total earnings.