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OVERVIEW OF NEW SRO ANALYST CONFLICTS OF INTEREST RULES
Summary of SRO Rules
Research Reports
The NASD and NYSE have substantially identical provisions. They apply to "research reports," the persons who prepare them, and their firms.
The term "research report" is defined as "a written or electronic communication which includes an analysis of equity securities of the individual companies or industries, and which provides information reasonably sufficient upon which to base an investment decision and includes a recommendation."
The definition does not apply to non-equities research, such as research on fixed income securities, currencies or commodities. In addition, compendiums of research that cover six or more companies need not contain the required disclosures, but instead can refer prominently to a place(such as a web site) where the current disclosures can be found. The NASD and NYSE have indicated that they will soon issue written interpretive guidance on the application of the definition to abstracts, updates, industry or market sector reports, quantitative and technical analyses, trading and portfolio strategies and general market commentary.
Where a member firm distributes research in the U.S. prepared by a nonmember affiliate, the disclosures apply only to the member firm. The disclosure requirement does not apply to independently-produced research.
Restrictions on Investment Banking Department Relationship with Research Department
The new rules prohibit investment banking from exercising supervision or control over research analysts. In particular, investment bankers cannot review or approve a research report prior to publication, except to verify factual accuracy or to review for any potential conflict of interest.
Any written communications between a research analyst and investment banking personnel regarding a draft research report must be made through a legal or compliance official, or such an official must be copied on the document. Any oral communication must be "documented and made through" a legal or compliance official acting as intermediary, or in the presence of such an official.
Restrictions on Contacts between Research Analyst and the Subject Company
The rules permit analysts to share draft research reports with the subject company, but only as necessary to verify factual accuracy. Any draft that is shared must omit the research summary, rating or price target. In addition, a complete draft must be sent to the legal or compliance department prior to submission to the subject company.
If the analyst proposes to change a rating or price target after submitting the report to the subject company, the research department must provide a written justification for the change to the legal or compliance department, and the legal or compliance department must provide written authorization for the change. The draft and final version of a research report that is changed in this manner must be retained for three years following publication.
A subject company can only be notified of a change in its rating after the close of trading in its principal market on the business day prior to publication of the change.
Prohibitions and Restrictions on Analysts
- Compensation - Broker-dealers cannot pay any bonus, salary or other form of compensation to a research analyst that is based on a specific investment banking services transaction.
- Promises of Favorable Research - A broker-dealer cannot directly or indirectly offer to a company favorable research, a specific rating or price target, or threaten to change research, a rating or a price target, as consideration or inducement for business or compensation.
- Restrictions on Personal Trading - These restrictions apply to "research analyst accounts," which are defined to include any account over which a member of the analyst's household has a financial interest or over which the analyst has discretion or control, other than a registered investment company.
Research analyst accounts are barred from selling any securities (including options or derivatives) of a company that the analyst follows during the 30 calendar days prior to publishing a research report or changing a rating or price target on the company, and for 5 calendar days after such a report or change. Exceptions are provided for sales within 30 days of beginning coverage of a company, or for research or ratings or price target changes due to significant news or events, if the legal or compliance department pre-approves the report or change.
Analysts must not purchase or sell securities in a manner inconsistent with the analyst's most recent published recommendation.
Trades can be excepted from the restrictions described above if they are based on an unanticipated significant change in the analyst's personal financial circumstances, if pre-approved by the legal or compliance department.
An analyst cannot receive any pre-IPO securities of an issuer that is principally engaged in the same type of business as companies that the analyst follows.
None of these restrictions on analyst accounts apply to purchases or sales of securities of a registered diversified investment company. They also do not apply to purchases or sales of securities of any other investment fund not controlled by the analyst or a member of the analyst's household, provided that the analyst owns less than 1 per cent of the fund assets, the fund invests no more than 20 per cent of its assets in issuers principally engaged in the businesses of companies covered by the analyst, and if the fund distributes securities in kind to the analyst or a household member prior to an IPO, the analyst either divests them immediately or refrains from preparing research on that company.
Disclosure Requirements
A broker-dealer must disclose in research reports:
- Whether the analyst or a household member has a financial interest in the securities of a subject company, and the nature of that interest (i.e., option, right, warrant, future, long or short position);
- If, as of the month immediately preceding the of publication of the report (or the end of the second most recent month if the date is less than 10 calendar days after the end of the most recent calendar month) the broker-dealer or its affiliates own more than 1 per cent of any class of common equity securities of the subject company. Computation of ownership is to be made using the same standards as under Section 13(d) of the Exchange Act;
- Whether the analyst principally responsible for preparing the report received compensation that is based in part upon the broker-dealer's investment banking revenues;
- Whether the broker-dealer or its affiliates managed or co-managed a public offering of the securities of the subject company in the past 12 months, received compensation for investment banking services from the subject company in the past 12 months, or expects to receive or intends to seek compensation for investment banking services from the subject company in the next three months;
- Whether the analyst or a member of the analyst's household serves as an officer, director or advisory board member of the subject company;
- Any other actual, material conflict of interest of the analyst of which the analyst or broker-dealer knows or has reason to know, and any other actual material conflict of interest of the broker-dealer of which the broker-dealer has reason to know at the time of publication of the report.
The analyst must also make the above disclosures in public appearances, except that, instead of disclosing information about investment banking compensation, the analyst must disclose whether the subject company is an investment banking services client of the broker-dealer or its affiliates1. The NASD staff has indicated that analysts are only responsible for providing this material to a broadcaster when the analyst makes a television appearance, and will not be held accountable if the broadcaster cuts out the disclosure.
Regardless of the ratings system that a firm uses, the rules require the firm to disclose in each research report the percentage of all securities rated by the firm to which it would assign a "buy," "hold/neutral," or "sell" rating. The firm must also disclose the percentage of companies in each category for whom the firm has provided investment banking services in the past 12 months.
Research reports on equity securities that have been covered for at least one year must also contain a line graph of the security's daily closing price for the period in which it has assigned a rating, up to 3 years. The graph must indicate the dates when ratings or price targets changed, "depict" each rating and price target on those dates, and be current as of the most recent calendar quarter (or the second most recent quarter if the report is issued within 15 days of the end of the most recent quarter). Here is an example of what the NASD envisions the price chart to be:
http://www.nasd.com/web/groups/corp_comm/documents/speech/nasdw_ 011656.pdf
Research reports on equity securities must also disclose the valuation method used to determine any price target. The price target must have a reasonable basis and must be accompanied by a list of risk factors that may impede achievement of the target.
Firms must also disclose in research reports if they make a market in the securities of the subject company. In addition, firms must induce any other disclosures required by other NASD or NYSE rules, or by the antifraud provisions of the federal securities laws.
The disclosures required under the new rules must be presented on the front page of the research report, or the front page must refer to the page on which disclosures are found. Disclosures "must be clear, comprehensive and prominent."
Imposition of Quiet Periods
The rules bar a lead or co-managing underwriter from publishing a research report regarding a public company for 40 calendar days following an initial public offering, or from10 calendar days following a secondary offering. The rule provides two exceptions: (i) research can be published during these periods concerning the effects of "significant news or a significant event" on the subject company, if given prior authorization by the legal or compliance department; and (ii) research can be published regarding a secondary offering pursuant to Rule 139 of the Securities Act of 1933 if the company has "actively-traded securities" as defined in Regulation M under the Securities Exchange Act of 1934.
Supervisory Procedures
The rules require every firm subject to the rules to adopt and implement written supervisory procedures reasonably designed to ensure compliance. In addition, a senior member of the firm must attest annually to the NASD and/or NYSE (whichever it is a member of) that it has adopted and implemented those procedures.
Implementation Period
The provision on disclosure of 1 per cent positions will take effect on November 6, 2002.
The provisions concerning communications between research and investment banking or subject companies will take effect on September 9, 2002.
All other provisions of the rules will take effect on July 9, 2002.
Next Steps
SIA understands that the NASD and NYSE plan to issue written guidance on many aspects of the rules prior to the initial July 9, 2002 implementation date.
SIA will hold a conference on the analyst rules in the late fall. Information on the conference should be on this web site by mid-September.
Footnotes:
1.The NASD rule diverges from the NYSE rule on this provision. The NASD rule requires that the analyst disclose whether the subject company is a "client" of the broker-dealer of its affiliates.
