Laura Unger, acting chair of the U.S. Securities & Exchange Commission, testified yesterday before a U.S. Congressional subcommittee about security analyst conflicts of interest, revealing the results of recent SEC investigations into the issue. Although she applauded efforts to minimize conflicts, she admitted they may never be eliminated.

Unger addressed the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises of the Committee on Financial Services. She suggested that the industry is doing the right things to mitigate conflicts of interest, “I recently called on the industry to take an active role in dealing with these and other problems surrounding analysts’ conflicts of interest. It is fair to say, that the industry, as well as the self-regulatory organizations have heard this call to action.”

Unger testified that SEC staff have conducted on-site examinations of full-service broker-dealers focusing on analysts’ conflicts of interests. SEC staff have reviewed firms’ written disclosures and have examined nine firms that underwrote significant numbers of IPOs, particularly Internet and technology-related IPOs.

Commission staff reviewed documentation and interviewed senior management of firms’ research and investment banking departments and research analysts. These examinations focused on analysts’ financial interests in companies they cover, reporting structures, and compensation arrangements.

The SEC’s preliminary observations shed some light on the extent of the conflict of interest conundrum. All firms examined confirmed that research analysts were not formally supervised by investment bankers. Nevertheless, all firms reported that research analysts provided assistance to investment banking, and many firms pay their analysts largely based upon the profitability of their investment banking unit. Seven firms reported that investment banking had input into research analysts’ bonuses.

Many research analysts were significantly involved with start-up companies well before the companies had established an investment banking relationship with a broker-dealer. “Many times, these analysts were invited to invest in these companies’ private placements, which were not available to the public generally. The staff also found that if the company went public and the analyst’s firm underwrote the IPO, the analyst always issued positive research on the company,” Unger testified.

SEC staff found that disclosure of analysts’ and firms’ ownership in recommended securities varies widely. Disclosure in analysts’ reports of whether the firm has an investment banking or other relationship with the company covered is limited to disclosure of whether the firm has recently acted as underwriter or market maker, as required by existing SRO rules.

Sell-side analysts routinely recommend securities during public appearances in the media, but rarely reveal any conflicts of interest to investors. Examiners found indications that some research analysts issued “booster-shot” research reports.

Unger noted that the industry, the SROs, and the SEC have recently taken action to improve the objectivity and independence of research analysis. She pointed out that the Securities Industry Association recently set forth “Best Practices for Research.”

Unger told the subcommittee that the SEC plans to work with the SROs to improve and more diligently enforce their existing rules governing the disclosure of conflicts of interest, but she warned that some conflicts may always exist.

“At a minimum,” she said, “the commission should continue to promote both clear, meaningful, and prominent disclosure, as well as effective investor education, so that investors may weigh for themselves the significance of any conflicts.”

“The role of investor education is particularly important because there are other pressures originating outside the firms that may affect research analysis and recommendations. Since these pressures are largely outside the control of the firm, arguably they are more difficult for the firm to address.” These pressures include the interests of institutional investors and issuers.