On November 18, 2014, the Securities and Exchange Commission (SEC) issued Release No. 34-73622 requesting comment on amendments to NASD Rule 2711 governing equity research analysts and research reports.
The proposal creates a new section entitled “Identifying and Managing Conflicts of Interest” containing an overarching provision that:
requires 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 research reports and public appearances by research analysts and the interaction between research analysts and persons outside of the research department, including investment banking and sales and trading personnel, the subject companies and customers.
These policies and procedures must:
be reasonably designed to promote objective and reliable research that reflects the truly held opinions of research analysts and to prevent the use of research reports or research analysts to manipulate or condition the market or favor the interests of the member or a current or prospective customer or class of customers.
This rule maintains similar structural protections to those currently in effect, but in the form of mandated written policies and procedures with enumerated baseline requirements consisting of:
- Prepublication review restrictions reasonably designed to prohibit review, clearance or approval of research reports by investment banking personnel and others not involved in the research process, with the exception of compliance personnel. Prepublication review by subject issuers is also prohibited except for the purpose of verifying facts.
- Procedures restricting input on coverage decisions.
- The procedures must generally restrict or limit activities that may compromise an analyst’s objectivity, including barring participation in pitches, soliciting investment banking transactions and roadshows, and the inclusion of statements in pitch materials that may imply a premise of future coverage. The current prohibition against promises of favorable research, a particular research recommendation, rating or specific content as inducement for business or compensation is maintained. Pursuant to the recent amendments implementing the Jumpstart Our Business Startups Act (the “JOBS Act”), the prohibition on participation in pitch meetings does not apply to research analysts attending a pitch meeting in connection with an IPO of an Emerging Growth Company (as defined in the JOBS Act) that is also attended by investment banking personnel. However, research analysts still are prohibited from soliciting an investment banking transaction or promising favorable research during permissible attendance at those pitch meetings.
- The procedures must limit the supervision of research analysts to supervision by persons not engaged in investment banking activities.
- The procedures must limit the determination of a firm’s research department budget to senior management, excluding senior management engaged in investment banking activities, and without regard to investment banking revenues or results.
- The procedures must prevent personal trading in a “research analyst account” in securities, any derivatives of such securities and funds where the performance is materially dependent on the performance of securities covered by the analyst, thus eliminating specific black-out periods included in the present rules. The prohibitions on receiving pre-IPO shares in sectors covered by an analyst and trading against recommendations (subject to a hardship exception) are continued.
- Information barriers or other institutional safeguards must be established to ensure that research analysts are insulated from the review, pressure or oversight by persons engaged in investment banking services activities or other persons, including sales and trading department personnel, who might be biased in their judgment or supervision.
- The 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.”
- In a significant shortening of quiet periods, the proposed rules would require that quiet periods of a minimum of 10 days after an initial public offering (presently 40 days for a managing underwriter and 25 days for other underwriters or dealers), and a minimum of three days after a secondary offering must be established (presently 10 days for managers and co-managers), during which the member must not publish or otherwise distribute research reports, and research analysts must not make public appearances, relating to the issuer if the member has participated as an underwriter or dealer in the initial public offering or, with respect to the quiet periods after a secondary offering, as a manager or co-manager of that offering. As a result of the JOBS Act, offerings of Emerging Growth Companies are exempt from these quiet periods.
- In another significant change, the proposed rule eliminates the current quiet periods 15 days before and after the expiration, waiver or termination of a lock-up agreement. The JOBS Act similarly exempted Emerging Growth Companies.
- In a new measure, joint investment banking/debt research due diligence conducted by debt analysts in the presence of investment banking personnel is prohibited prior to the selection of underwriters for a transaction.
With certain modifications, the proposed rule change generally maintains the current equity research disclosure requirements. The principal changes are:
- A member must establish, maintain and enforce written policies and procedures reasonably designed to ensure that purported facts in its research reports are based on reliable information.
- The proposed rules also expand upon the current “catch all” disclosure, which mandates disclosure of any unspecified material conflicts of interest of the research analyst or member that the research analyst knows or has reason to know of at the time of the publication or distribution of a research report or public appearance by requiring disclosure of material conflicts known not only by the research analyst, but also by any “associated person of the member with the ability to influence the content of a research report.”
- The requirement to disclose when a member or its affiliates own securities of the subject company is proposed to be modified to include any “significant financial interest in the debt or equity of the subject company,” including, at a minimum, as under the prior rule, beneficial ownership of 1% or more of any class of common equity securities of the subject company.
The proposed rule change amends the definition of “research analyst” for the purposes of FINRA’s research analyst registration and qualification requirements to limit the scope to persons who produce “research reports” and whose primary job function is to provide investment research. The revised definition is intended to provide relief for those who produce research reports only on an occasional basis.
The proposal deletes the requirement to separately attest annually that the firm has in place written supervisory policies and procedures reasonably designed to achieve compliance with FINRA’s research rules since FINRA regards this requirement as redundant in light of other FINRA requirements.
Comments are due on December 15, 2014, unless the SEC extends this deadline If adopted, these rules are stated to enter into effect not later than 180 days following approval.
See the proposing release.