| Studies have shown that reputation helps financial intermediaries earn higher fees. Like other financial intermediaries, financial analysts want to build their reputation, which generates favorable career outcomes like better pay (Stickel, 1992) and moving up to a high-status brokerage house job (Hong & Kubik, 2003). Therefore it is puzzling to see analysts providing biased research that hurts their reputation. Fang and Yasuda (2009) point out that two distinct facets of the analyst compensation structure produce two opposing incentives. While reputational compensation is an incentive to provide accurate research, other kinds of compensation (access to private information, and underwriting and M&A advising business steered to the analyst’s employer) are related to conflict of interest and furnish incentives for analysts to bias their recommendations. Therefore, analysts strike a balance between their own reputation and revenues for themselves and their investment banking departments (Ljungqvist, Marston, Starks, Wei, & Yan, 2007). We propose that an external factor, corporate governance, affects analysts’ compensation structure by changing that balance. More specifically, we ask a question that would improve our understanding of analysts’ conflict of interest: Do entrenched managers of firms with weaker corporate governance demand more favorable recommendations from analysts? We suggest that, as managers get more entrenched, they engage in more value-destroying actions and seek cooperation from analysts to cover their actions (Tirole, 2005). Entrenched managers may hire analysts’ investment banks and may provide non-public company information to analysts and by using these as indirect channels to punish and reward analysts, managers can pressure analysts to bias their research. Managers can reward (punish) analysts by increasing (cutting) the disclosure of non-public information and investment banking business when analysts provide optimistic research (do not cooperate with entrenched managers). This reward and punishment system can force analysts cater to entrenched managers. Furthermore, in firms with dysfunctional governance lack of transparency shields analysts from reputational cost. |