The Use of Broker Votes to Reward Brokerage Firms’ and Their Analysts’ Research Activities
Executive Summary — Broker votes are one of the most pervasive yet least understood reporting practices on Wall Street. The votes are essentially ratings of the value of brokers' investment research services. These ratings are produced by institutional investors (the "buy side") and solicited by broker dealers (the "sell side"). Little research to date, however, has examined the determinants of broker votes, their consequences, and their economic function. In this paper the authors use data gathered from a mid-sized investment bank for the years 2004 to 2007 in order to study how broker votes are related to institutional investors' commission payments and analysts' client services and compensation. Results overall suggest that broker votes help to facilitate implicit contractual relationships between sell-side brokers, their affiliated analysts, and their buy-side clients. Broker votes are neither mere popularity contests nor a simple reflection of trading in analysts' covered stocks. Instead, they appear to be a key component of the investment research industry's contracting technology, acting as the nexus for a set of relationships between sell-side brokers, their affiliated analysts, and their buy-side clients. The findings thus deepen our understanding of how information is exchanged on Wall Street and help to explain why the practice of collecting and aggregating client votes—a costly internal reporting procedure—has stood the test of time and has been replicated across countless sell-side research departments. Key concepts include:
- Broker votes facilitate a set of implicit contractual relationships between sell-side brokers, their affiliated analysts, and their buy-side clients.
- These voluntary contracting arrangements help to resolve inter- and intra-firm coordination problems.
- Broker votes may represent real efforts by buy-side clients to reward analysts for providing information that is difficult to reward through contemporaneous trading in analysts' covered stocks.
- Broker votes influence resource allocation within brokerage divisions, aligning analysts' incentives with their clients' objectives and hence the brokerage firm.
In traditional markets, the price mechanism directs the flow of resources and governs the process through which supply and demand are brought into equilibrium. In the investment-research industry, broker votes perform these functions. Using detailed clinical data from a midsized investment bank for the years 2004 to 2007, we present evidence that institutional investors use broker votes to budget future aggregate commission payments across brokerage firms; that these votes are responsive to actions that brokerage-house analysts take to communicate with client investors; and that brokerage firms use client-supplied votes as a quasi allocation base to indirectly reward individual analysts for contributions to brokerage-wide commission payments. Overall, our results suggest that broker votes function as the nexus for a set of implicit contractual relationships between sell-side brokers, their affiliated analysts, and their buy-side clients.