The Securities & Exchange Commission (SEC) recently released a new regulation that is meant to increase the level of honesty in research reports. Many think the law will have little impact because it does not go far enough. This article will define Reg AC and discuss its potential impact on the market and investors.

Reg AC Defined
On Feb 6, 2003, the SEC issued Reg AC (the "AC" stands for analyst certification) which requires analysts to "certify the truthfulness of the views they express in research reports and public appearances, and disclose whether they have received any compensation related to the specific recommendations or views expressed in those reports and appearances." The goal is similar to the regulation that requires CEOs and CFOs to certify the truthfulness of the financial statements they publish.

What Does It Accomplish?
At the very least, Reg AC will increase disclosure and hold analysts more accountable, much like CEOs and CFOs are now more accountable for the financial statements they issue. How much of an impact Reg AC will have is open to debate. Some claim the law does not go far enough. Others feel that existing laws already provide enough protection.

I originally thought this would be a non-event because there are already regulations and policies that require disclosures. Pre-existing SEC regulations require disclosures of the nature of the relationship between the brokerage firm and the subject company. For example, the brokerage firm must disclose if it has been involved in an investment banking deal or if it has acted as an underwriter within the last three years. Independent fee-based research firms must also disclose if and how much the subject company has paid them. And if an analyst is a CFA charter holder, CFA Institute's Code of Ethics and Standards of Professional Conduct currently require the analyst to state his or her true opinions in the research report.

The new twist that Reg AC will introduce is that it requires the disclosure of whether the analyst received any compensation "related to the specific recommendation or views expressed". I interpret this to mean that analysts must report whether or not the subject company has paid for a "buy" rating ("specific recommendation") or a favorable report ("views expressed").

The Potential Impact
I think the main contribution of Reg AC will be that it requires analysts to disclose whether the subject company paid for an objective research report or a rating. In order to discuss how this will impact the market, we need to review how Wall Street has changed.

At one time, brokerage firms researched most publicly-traded companies; however, the number of companies that receive research coverage declined significantly over the last 10 years due to industry consolidation and, more recently, due to staff reductions at Wall Street firms. Today, the remaining brokerage firms cover a relatively small number of stocks. This minority consists of stocks with the largest market capitalization and highest liquidity.

The majority of publicly traded firms (about 65%, based upon our research) has been "orphaned" by Wall Street and has little or no research coverage. We have found that most of these orphaned companies have good fundamentals and represent long-term value investments. The challenge facing these companies is reaching investors who are looking for good long-term investments.

Independent research firms are attempting to bridge this information gap. As with any industry, some are more legitimate than others, and a good way to differentiate the good from the bad is to read disclosure statements. And this is where Reg AC may have its greatest impact.

Contracting for objective research coverage is very different from paying for a rating. In my opinion, legitimate fee-based research involves both parties committing to objective research coverage for at least one year. This provides investors with the ability to read about and evaluate a company's progress for four quarters. One-time reports do not help investors track a company's progress, nor do they indicate a company's commitment to providing investors with necessary information.

To provide the market with objective research for a period spanning several quarters, companies who want to maintain their credibility will contract only with legitimate independent research firms. These research firms will provide Reg AC disclosures because they want to abide by the laws and have nothing to hide.

Other times, companies will hire a firm to write a one-time favorable report with a "buy" recommendation. These types of reports will not contain the Reg AC disclosure. The absence of the disclosure should serve as a red flag to investors, who should then ignore the report. (For more information on how to read research reports, see Six Signs of an Objective Research Report.)

Time Will Tell
It may take some time to determine the real impact of Reg AC, but I think the end result may be surprising. Today, not much is expected to change with the implementation of Reg AC. People had the same opinion when CEOs and CFOs were first required to certify their financial statements, but these regulations did bring about many changes. CEOs and CFOs implemented new reporting procedures and made their subordinates more accountable, which appears to have eliminated some of the abuses that were made famous by Enron and others.

What is certain is that this reiterates the importance of reading disclosure statements and gives investors another indicator of the legitimacy of a report. Investors must read disclosure statements so that they understand the nature of the relationship between the research firm and the subject company. Investors should not put much faith in reports that do not contain the Reg AC disclosure.

Related Articles
  1. Options & Futures

    Pick 401(k) Assets Like A Pro

    Professionals choose the options available to you in your plan, making your decisions easier.
  2. Economics

    The 5 Countries That Produce the Most Carbon Dioxide (CO2)

    Learn about the top five countries, China, the United States, India, Russia and Japan, that are the largest contributors to carbon dioxide emissions.
  3. Investing Basics

    Explaining the 10-K

    A 10-K is an annual comprehensive report that thoroughly recaps a company’s performance.
  4. Economics

    Explaining the Tier 1 Leverage Ratio

    The Tier 1 leverage ratio measures a bank’s core capital against its total assets.
  5. Investing Basics

    What Is Schedule 13G Used For?

    Schedule 13G is an SEC form an investor must file upon taking ownership of 5% or more of a company’s outstanding shares.
  6. Investing News

    Understand the SEC Rules on Equity Crowdfunding

    The SEC's adoption of equity crowdfunding rules, initiated under the JOBS Act, enables small investors to invest in companies that show early potential.
  7. Insurance

    Airbnb Insurance: Will It Cover Enough?

    If a paying guest trips over a rug in your home, breaks an ankle and sues for damages, here's how to make sure your coverage protects you.
  8. Insurance

    5 (Possibly) Costly Risks of Being an Airbnb Host

    Guests who get injured or damage your neighbor’s property are just a couple of examples of what can go wrong. Here’s how to protect yourself.
  9. Investing News

    Mexican Energy, Telecom Reforms Please Foreign Investors

    Two years into his first term, Mexican President Enrique Peña Nieto is following through on radical campaign promises he made to Mexican citizens for sweeping multi-industry reform.
  10. Investing

    Top Cities Where Airbnb Is Legal Or Illegal

    Thinking of subletting your apartment on Airbnb? Make sure that you meet your city's regulations first.
  1. Is a financial advisor allowed to pay a referral fee?

    A financial advisor is allowed to pay a referral fee to a third party for soliciting clients. However, the Securities and ... Read Full Answer >>
  2. How often do mutual funds report their holdings?

    The Securities and Exchange Commission (SEC) requires mutual funds to report complete lists of their holdings on a quarterly ... Read Full Answer >>
  3. Do financial advisors need to be approved by FINRA?

    The term "financial advisor" can refer to a couple of different roles. It most often refers to a broker-dealer or an investment ... Read Full Answer >>
  4. What are the disclosure requirements for a private placement?

    The U.S. Securities and Exchange Commission (SEC) has set forth disclosure requirements for private placements, including ... Read Full Answer >>
  5. What role does the Inspector General play with the Securities and Exchange Commission?

    The inspector general of the U.S. Securities and Exchange Commission (SEC) oversees, audits and conducts investigations of ... Read Full Answer >>
  6. How long does it take to execute an M&A deal?

    Even the simplest merger and acquisition (M&A) deals are challenging. It takes a lot for two previously independent enterprises ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  2. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  3. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  4. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  5. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  6. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!