The influence of NASD rule 2711 on the usefulness of analyst stock recommendation prior to corporate bankruptcy

Abstract

This study investigates whether NASD Rule 2711 has improved the usefulness of analysts’ stock recommendations for firms prior to bankruptcy filings. To examine the issue, I analyze the usefulness of stock recommendations for ex post bankrupt firms in terms of 1) the negativity of the recommendations for bankrupt firms relative to comparable non-bankrupt firms and 2) recommendation profitability. I document that the stock recommendations for bankrupt firms are more negative than those for non-bankrupt firms and the difference in the recommendations between the two groups is more pronounced and timely in post-Rule 2711 period. In addition, for bankrupt firms, analysts at investment banks with better reputation issue more negative recommendations in post-Rule 2711 period. I also find that while the recommendation profitability of bankrupt firms is lower than that of non-bankrupt firms in pre-Rule 2711 period, it outperforms in post-Rule 2711 period. Aggregately, I provide evidence on the improvement in the usefulness of the stock recommendations for firms prior to bankruptcy filings after the implementation of NASD Rule 2711 suggesting that analysts have become more attentive to the risk of bankruptcy. I argue that the results are driven by analysts’ efforts to optimize the net benefit from issuing recommendations for ex post bankrupt firms in NASD Rule 2711 regime rather than by enhanced independence of analyst research.