On November 18, 2014, the Securities and Exchange Commission (SEC) issued Release No. 34-73623 requesting comment on proposed Financial Industry Regulatory Authority (FINRA) Rule 2242 addressing conflicts of interest and disclosure obligations relating to the publication and distribution of debt research reports. The purpose of the proposed rule is to provide retail recipients of debt research with conflict of interest protections and disclosures generally similar to those mandated for equity research under current and proposed FINRA rules. Debt research is presently excluded from FINRA’s research rule. The SEC concurrently published for comment proposed amendments to FINRA’s equity research rules. See our related post.
FINRA determined to proceed with these rules, in part, because of
- examination results indicating a significant number of instances of inadequate procedures in managing debt research conflicts or failure to disclose conflicts,
- misconduct in the sale of auction rate securities in cases in which traders allegedly pressured research analysts to issue unwarranted optimistic research,
- The fact that the reliability of credit agency ratings was brought into question in the aftermath of the financial crisis, and
- A desire for consistency in light of Dodd-Frank mandated CFTC actions to address conflicts of interest regarding non-security-based swaps and commodities research and comparable SEC proposals regarding security-based swaps and research.
FINRA was also influenced by the growing direct retail participation in the debt markets. FINRA transaction reporting data showed a 97% increase in retail-sized transactions in corporate bonds to an average of about 16,000 daily transactions between 2007 and 2013.
The proposed rules recognize significant differences in the role of debt research and analysts from their equity counterparts. First, the proposed rules would delineate the prohibited and permissible communications between debt research analysts and principal trading and sales and trading personnel, and not only with investment banking personnel. Second, many of the proposed changes are not required to apply to debt research provided solely to institutional investors, although the ability of institutional investors to elect to only receive fully compliant debt research is also provided for. Third, there are exemptions from the review, supervision, budget and compensation provisions of the proposed rule for firms engaged in limited principal trading, in addition to limited investment banking, activities.
The proposed rules define “debt research report” as “any written (including electronic) communication that includes an analysis of a debt security or an issuer of a debt security and that provides information reasonably sufficient upon which to base an investment decision.” Exceptions apply to more general communications that do not address individual securities or issuers as well as statistical summaries of financial data that include ratings.
An analysis prepared for a specific person or a limited group of fewer than 15 persons is excluded from the definition.
Debt securities exclude equity securities, municipal securities, security-based swaps and U.S. Treasury securities.
Similar to FINRA’s equity research rules, as proposed to be amended, the proposed rules contain an over-arching principle requiring:
members to establish, maintain and enforce written policies and procedures reasonably designed to identify and effectively manage conflicts of interest related to the preparation, content and distribution of debt research reports, public appearances by debt research analysts and the interaction between debt research analysts and persons outside of the research department, including investment banking, sales and trading and principal trading personnel, subject companies and customers.
These policies and procedures must:
be reasonably designed to promote objective and reliable debt research that reflects the truly held opinions of debt research analysts and to prevent the use of debt research reports or debt research analysts to manipulate or condition the market or favor the interests of the firm or current or prospective customers or class of customers.
The proposed rules also establishes the minimum requirements to apply these principles:
- Prepublication Review: Prepublication review restrictions, prohibiting investment banking, sales and trading, principal trading personnel and, generally, other non-research firm personnel, other than compliance, from reviewing, clearing or approving research prior to publication and subject company involvement from reviewing research prior to publication, except to verify facts.
- Coverage Decisions: Procedures must restrict or limit input on coverage decisions by investment banking, sales and trading and principal trading personnel. This does not preclude personnel outside the research department from conveying customer interests and needs, as long as the final coverage decisions is made by research management.
- Solicitation and Marketing of Investment Banking Transactions: Procedures must restrict or limit activities that may compromise an analyst’s objectivity, including participation in pitches, soliciting investment banking transactions and roadshows, and the inclusion of statements in pitch materials that may imply a promise of future coverage.
- Supervision: Procedures must limit the supervision of debt research analysts to persons not engaged in investment banking, sales or trading or principal trading activities, including the establishment of information barriers to insulate debt research analysts from pressures from these departments.
- Budget and Compensation: Procedures must limit the determination of a firm’s debt research department budget to senior management, excluding senior management engaged in investment banking or principal trading activities, and without regard to investment banking revenues or results. These groups may provide input to senior management “regarding the demand for and quality of debt research, including product trends and customer interests.” Debt research analyst compensation decisions must similarly be insulated and must be reviewed and approved annually by a committee that excludes investment banking or principal trading, which generally reports to the member’s board of directors. This committee is required to consider enumerated factors related to productivity and quality of research.
- Personal Trading Restrictions: Procedures must prevent personal trading in a “debt research analyst account” in securities and instruments where the performance is materially dependent on the performance of securities covered by the debt analyst. Trading that is inconsistent with published recommendations is also prohibited subject to a hardship exception.
- Retaliation and Promises of Favorable Research: Procedures must prohibit “direct or indirect retaliation or threat of retaliation against debt research analysts by an employee of the firm for publishing research or making a public appearance that may adversely affect the member’s current or prospective business interests.”
- Joint Due Diligence with Investment banking Personnel: Joint investment banking/debt research due diligence involving debt analysts in the presence of investment banking personnel is prohibited prior to the selection of underwriters for an investment banking transaction.
- Communications Between Debt Research Analysts and Trading Personnel: The proposed rules restrict communications between debt research analysts and trading desk personnel that may influence a debt analyst’s opinions or views in order to benefit the trading position of the firm or customers. However, given the large number of debt securities that could potentially be covered and the need for analysts to obtain valuation information, certain communications are allowed:
- customers’ interests may be communicated as long as the analyst does not respond by publishing research for the purpose of benefiting the trading position of the firm, a customer or a class of customers.
- customized analysis, recommendations or trade ideas can be provided to the firm’s trading personnel and customers, provided that it is not inconsistent with published research, and any subsequently published research is not for the purpose of benefiting trading positions of the firm or customers.
- debt research analysts can be consulted regarding the creditworthiness of issuers, provided that the response of the analyst is consistent with published research and consistent in nature with communications.
- debt research analysts may seek information from trading personnel “regarding a particular debt instrument, current prices, spreads, liquidity and similar market information relevant to the debt research analyst’s valuation of a particular debt security.”
- Restrictions on Communications with Customers and Internal Sales Personnel — The proposed rules provide that oral communications by debt analysts with current or prospective customers, or internal personnel, related to an investment banking transaction must be fair, balanced and not misleading. These communications cannot be made in the presence of investment banking personnel or company management.
The proposed rules also include content and disclosure requirements for debt research reports that are generally similar to those applicable under existing and proposed FINRA rules to equity research reports.
Unlike the proposed amendments to the equity research rules, debt research need not include a statement regarding firm and firm-affiliated ownership above a stated percentage of a class, but instead require disclosure in research reports or a public appearance “to the extent those holdings constitute a material conflict of interest.”
The proposed rules regarding public appearances closely parallel the equity research rules.
Like the equity research rules, procedures must be in place to prevent selective disclosure to internal personnel or favored customers that may afford a timing advantage in trading decisions.
The rules applicable to the review and disclosure obligations applicable to the distribution of third-party research for equity research are proposed to be extended to debt research. These review requirements are not applicable to independent third party debt research – i.e., independent research providers that are free of any influence by the distributing firm. Members can also establish procedures for the distribution of independent third party debt research without regard to the conflict disclosure requirements in defined circumstances.
Comments on this proposal are due on December 15, 2014 unless the SEC extends this deadline. If adopted, these rules are expected to enter into effect 12 to 18 months after SEC approval.
See the proposing release.