The development of US regulation of broker-dealer research

The Authors

Charles S. Gittleman, Counsel at Shearman & Sterling LLP, New York, New York, USA

Russell D. Sacks, Counsel at Shearman & Sterling LLP, New York, New York, USA

Abstract

Purpose – The purpose of this paper is to describe regulatory activities since the initial regulatory actions between 2001 and 2003 in response to securities firm research analyst conflicts of interest that were identified after the “internet bubble.”

Design/methodology/approach – The paper describes a number of important regulatory activities, including: interpretive activities, such as the 2004 Second Joint Research Memorandum; establishment of a new licensing requirement for research analysts; additional rulemaking, in the form of 2005 changes to the SRO Rules that are meant to tighten those rules; the December 2005 report of the NASD and NYSE studying the operation and effectiveness of prior regulatory actions, including the SRO Rules; enforcement actions against both firms' and research analysts' behavior; industry sweeps gathering information regarding industry practices in respect of debt research; and rulemaking for purposes of implementing interpretive guidance and Joint Report.

Findings – Following extraordinary and sweeping regulatory actions between 2001 and 2003, securities regulators have continued a high level of activity with respect to securities research. Research regulation stands as a hallmark for the current era of securities regulation for at least three reasons: it has displayed a wide range of regulatory tools including rulemaking, publication of interpretive guidance, “sweep” examinations, licensing, and enforcement, and has been largely “principles-based” rather than prescriptive in nature; it is marked by complexity: a web of SEC, SRO, and informal or “best practices” regulation now exists covering every aspect of securities research; and it is a cornerstone of an emerging regulatory theme of heightened and more detailed compliance for investment banking operations.

Originality/value – This is a valuable summary and analysis of seven years of regulatory activity on a complex issue by experienced securities lawyers

Article Type:

Technical paper

Keyword(s):

Regulation; United States of America; Securities markets.

Journal:

Journal of Investment Compliance

Volume:

9

Number:

2

Year:

2008

pp:

12-25

Copyright ©

Emerald Group Publishing Limited

ISSN:

1528-5812

I. Introduction

After the collapse of the “internet bubble” in 2000, certain activities of securities firms' research analysts were impugned as being permeated with conflicts of interest. Regulators acted, at first quickly, through their litigation and enforcement powers, and then thoroughly, through regulation. The period from 2001 through 2003 saw a series of extraordinary and sweeping regulatory actions. During that period, the regulation of securities firms' research reports and of the research analysts preparing those reports was the subject of:

  1. Major enforcement actions by the Securities and Exchange Commission (SEC), the National Association of Securities Dealers (NASD), the New York Stock Exchange (NYSE), and state regulators, including New York's then Attorney General, Elliot Spitzer.
  2. The “global research settlement” among ten of the largest US broker-dealers, the SEC, the NASD and the NYSE, and state regulators consenting to, among other things:
    • near complete separation of investment banking and research departments within the settling financial institutions;
    • appointment of independent monitors to review the implementation of the global research settlement; and
    • provision to customers by the settling firms of independent, third-party research.
  3. Major SEC regulation in the form of Regulation AC, which requires certain research analysts to make disclosures certifying that the views expressed in each research report and public appearance are their own[1].
  4. The 2002 adoption and substantial revision in 2003 of NASD Conduct Rule 2711 and NYSE Rule 472 (together, the “SRO Rules”[2]) relating to research reports and research analysts, including detailed rules restricting and/or regulating:
    • communications with the subject company;
    • certain relationships between research and investment banking activities;
    • research analyst compensation;
    • prohibition on the promise of favorable research;
    • publication of research close in time to underwriting activity;
    • termination of coverage;
    • personal trading by research analysts; and
    • detailed disclosures that are required on all research reports and in public appearances[3].

Following this period, important questions arose as to the interpretation and implementation of various provisions of Regulation AC, the SRO Rules, and the global research settlement.

In recent years, securities regulators in the USA have continued a high level of activity in respect of securities research. This activity has seen interpretive, rulemaking, and enforcement activities. The sum total of the activity is a complex and comprehensive set of regulation and best practice relating to securities research, which stands as a hallmark of the current regulatory environment. This note describes a number of important regulatory activities, including:

Each of these activities is described below, following which some conclusory thoughts are shared. Note that the discussions of the various regulatory activities are not meant to be comprehensive descriptions or discussions.

II. The Second Joint Memorandum (2004)

In July 2002, at the time of SEC approval of the SRO Rules, NASD and the NYSE (the “SROs”) published a Joint Memorandum[5] (the “First Joint Memorandum”) providing interpretive guidance relating to various issues under the SRO Rules. The First Joint Memorandum was important both in its content and inasmuch as it signaled the continuing intention of the SROs to cooperate in the regulation of securities research. The First Joint Memorandum provides interpretive guidance regarding:

Following the 2003 amendment of the SRO Rules[7], the SROs, in March 2004, published the Second Joint Memorandum, which provided additional guidance relating to the SRO Rules. Unlike the First Joint Memorandum, which was published concurrent with the adoption of the SRO Rules themselves in order to provide additional color to the provisions of that (newly adopted) regulation, the Second Joint Memorandum commenced the process of providing official interpretation in response to the SROs' experiences with firms' compliance. The Second Joint Memorandum provides interpretive guidance regarding:

The Second Joint Memorandum signaled the willingness of the SROs to use interpretive guidance in addition to the rulemaking process as a means of influencing firms' activities in respect of securities research. The Second Joint Memorandum also continued the cooperation of the SROs in respect of regulation of research.

III. Licensing of research analysts

Another important initiative implemented by the SROs in the regulation of securities research was the adoption of a requirement that research analysts be specially licensed. NASD Rule 1050, which was approved concurrent with the 2003 amendments to the SRO Rules, requires qualification, registration, examination and continuing education of research analysts[9].

In 2005, the SROs amended the research analyst licensing requirement to provide an exception from the Series 7, Series 86 and Series 87 examinations for research analysts of non-US affiliates of US securities firms[10]. In April of 2008, FINRA modified the exemption for non-US research analysts, permitting any research analyst residing outside the USA to be exempt from the Series 7, 86 and 87 examinations, provided that the other provisions of the exemption are met[11]. This important exception is subject to certain criteria, including:

The 2005 amendments to the licensing rule contained certain requirements that limited the practical utility of the exception. The most burdensome of these criteria would appear to have been eliminated with the 2008 changes to the exception[14]. These amendments to NASD Rule 1050, together with the Second Joint Memorandum's guidance regarding third party research, are an important acknowledgment by the SROs of the global nature of financial institutions and of their research activities[15].

IV. Prohibitions on research analyst participation in road shows

In April 2005, the SROs again amended the SRO Rules, this time to prohibit research analyst activity in the solicitation of investment banking transactions. The amendments to the SRO Rules specifically prohibit research analysts from participating in “road shows” related to an investment banking transaction, and from engaging in any communication with current or prospective customers in the presence of either company management or investment banking personnel regarding the investment banking transaction. The 2005 amendments also prohibit investment banking personnel from directing research analysts to engage in any sales or marketing efforts, or other communications, with customers in relation to investment banking transactions. The SRO Rules' 2005 amendments expressly permit research analysts to prepare written information for purposes of educating customers and internal personnel (such as sales personnel) regarding an investment banking transaction, with the express proviso that such communications must be “fair, balanced and not misleading”[16].

The NASD Notice to Members announcing these amendments did not provide an empirical rationale for the new, stricter standards, but stated that the general purpose of the amendments was fortification of the separation between firms' research and investment banking activities:

During the past few years, NASD has implemented a series of rules to increase the objectivity and reliability of research. While the rules generally foster objectivity through extensive conflict of interest disclosure requirements, they also prohibit certain conduct to minimize the primary source of biased research: the influences of investment banking … The new rule fortifies the wall between investment banking and research by prohibiting research analysts from participating in a road show related to an investment banking services transaction and from communicating with current or prospective customers in the presence of investment banking department personnel … (emphasis added)[17].

The 2005 amendments to the SRO Rules represent an evaluation that additional tightening of the regulation of conflicts of interest in respect of research by securities firms was warranted at the time. While it is unclear whether this action represents a generalized view that the SRO Rules were not strict enough, the statement noted above suggests a regulatory view that additional fortification of the “wall” between research and investment banking was required.

V. The Joint Report (December 2005)

In December 2005, the SROs published the Joint Report, which summarized prior regulatory activity, evaluated the effect of the SRO Rules, and made a series of recommendations relating to the SRO Rules.

V.1. Review of the effect of the SRO Rules

Following their review of prior regulatory activity, the SROs summarize academic studies and media reports suggesting that the SRO Rules had been successful in meeting the goals of separating research and investment banking and reducing conflicts of interest between research and investment banking. Specifically, the Joint Report summarizes others' conclusions that the SRO Rules:

The Joint Report also summarized some of the views presented by academic research and media reports regarding the manner in which the research industry had changed following the implementation of the SRO Rules[23].

V.2. Recommendations of the Joint Report

The Joint Report followed its review of the effect of the SRO Rules with a provision-by-provision review of the SRO Rules and a series of recommendations for changes to the SRO Rules.

The recommendations in the Joint Report follow a provision-by-provision analysis of the SRO Rules. Among the important recommendations of the Joint Report include:

The recommendations found in the Joint Report were important as a signal of continued cooperation between the SROs in relation to research reports, and because of certain recommendations relating to the easing of the SRO Rules in order to permit more efficient operation of the SRO Rules. With the creation of FINRA, the Joint Report – and particularly the expression of differences between the SROs in the Joint Report – remains important as a signal of the manner and challenges facing FINRA as it seeks to consolidate the SROs' rulebooks in 2008.

VI. Enforcement actions: watching research analyst and firm behavior

In 2005, 2006, and 2007 NASD issued News Releases regarding a number of enforcement actions relating to publication of research and the actions of research analysts. While several of the releases deal with relatively simple failures on the part of firms to comply with basic aspects of regulation[28], a number of the enforcement actions involve monitoring and sanctioning the actions of firms or individual research analysts.

In July 2006, NASD fined three major broker-dealers for compliance failures relating to research reports[29]. The sanctioned activities included:

In addition, NASD published News Releases relating to NASD sanctions against individual research analysts for trading contrary to their recommendations. In one case, NASD details what appear to be sales by a firm's research analyst (in a firm account held by that research analyst) against the “buy” or “strong buy” recommendations of his research[30].

In a second case, a research analyst temporarily terminated coverage in part in order to sell options that he had received while employed by companies that he subsequently covered as research analyst. The options were set to expire. The research analyst issued “outperform” and “market perform” ratings on the equity securities in question and specifically disclosed that he was terminating coverage in order to exercise the options. NASD stated that in this regard the firm had (unsuccessfully) sought relief from the SRO Rules in 2004. In its News Release, NASD disputes that termination was an appropriate option, stating that the research analyst “did not have to sell his holdings and could have continued to hold his … securities, using other funds to pay for the costs of exercising his … options.” NASD concludes that “Inconvenience or expense does not excuse non-compliance with NASD's rules against analysts trading contrary to their research recommendations”[31].

In June 2007, NASD censured and fined Wells Fargo Securities, LLC and imposed a fine and 60-day supervisory suspension against its former Director of Research for failing to disclose in a research report that the lead analyst on the report had accepted a job at a company that was the subject of the report. According to the NASD Press Release, the analyst failed to disclose in a series of three research reports that she was pursuing employment and then had accepted a job with the subject of all three reports[32].

In November 2007, FINRA censured and fined Wachovia Capital Markets, LLC (“Wachovia”) for “deficient disclosures in research reports”[33]. Generally, FINRA found that Wachovia failed in some cases to disclose compensation received from the subject company for investment banking services, and also failed in certain cases to disclose that it owned an interest or was making a market in the equity securities of the subject company. Further, FINRA found that Wachovia was in certain cases using a generalized disclosure relating to ownership of subject company securities by the firm, rather than a specific disclosure regarding firm ownership of subject company securities.

These enforcement actions highlight the monitoring of the industry that has followed the imposition of the SRO Rules, and also the breadth of that monitoring: both firms and research analysts have been subject to substantial – and publicly disclosed – actions.

VII. Principle-based guidance regarding firm governance of debt research

Following the publication of the Joint Report, the SROs engaged in “sweep” style examinations of member firms in order to determine how firms have addressed conflicts of interest with respect to research on fixed income securities[34]. The SROs concluded that firms were deficient in three principal areas:

  1. The supervision of fixed income research was lacking, both because firms failed to have written supervisory procedures in respect of fixed income research and because firms were not following written supervisory procedures as written.
  2. Fixed income research did not contain disclosures sufficient to warn readers regarding conflicts of interest that may arise in respect of the research, such as conflicts of interest relating to analyst compensation, or to firm and/or analyst relationships (both commercial and affiliation) with subject companies.
  3. Disclosures required by SEC Regulation AC were not universally present[35].

The SROs also sought to evaluate whether firms had policies and procedures that were meant to address industry initiatives, such as the Bond Markets Association's “Guiding Principles” for fixed income research. In doing so, the SROs expressly noted that the existence of “trade association conduct standards [is] not the equivalent of sanctionable rules. As such, the SROs maintain the right to promulgate rules in the fixed income research area that may be different from, or analogous or additive to, the Guiding Principles”[36].

The SROs' conclusions in respect of fixed income research link two important modern regulatory concepts: research analyst conflicts of interest and broker-dealer supervisory controls. These have been, independently, areas of significant activity for the SROs in recent years, with supervisory control of firm activity being a major focus of rulemaking, examination and enforcement[37]. In doing so, the SROs have underscored the importance of maintaining policies, procedures and supervisory controls designed not only to ensure compliance with existing regulation, but to anticipate and address conflicts of interest that exist in otherwise unregulated, lightly regulated, or generally regulated aspects of a broker-dealer's business.

VIII. Implementing the Joint Memoranda and the Joint Report

In September 2006, NASD and the NYSE concurrently proposed rule changes in response to the Joint Report[38]. The changes were proposed by the SROs in two separate phases: in the first phase, certain SRO rule amendments were proposed implementing changes that track prior interpretive guidance, generally that found in the Joint Memoranda. Those changes became effective upon the September 27, 2006 filing of the proposal with the SEC.

In the second phase, a series of proposals were made to change provisions that NASD believed required SEC approval prior to implementation. Those proposals would become effective on a date to be announced by NASD in a Notice to Members that would be published not less than 60 days following SEC approval. NASD and NYSE jointly published an amendment to this “second phase” proposal on January 9, 2007[39].

VIII.1. 2006 rule change implementing the Joint Memoranda

Certain of the SROs' rule changes were designed to implement joint guidance, generally that found in the First Joint Memorandum and Second Joint Memorandum. As noted above, those changes were filed with the SEC and became effective upon filing in September 2006. Some of the major changes that were implemented by the SROs include:

VIII.2. 2006 rule change proposal implementing the Joint Report

Certain of the changes proposed by the SROs are currently subject to comment prior to their approval by the SEC[42]. In short, the SROs propose the following amendments to the SRO Rules:

FINRA has stated that it will seek to consolidate the SROs' rulebooks in 2008. As part of this consolidation, FINRA will be forced to reconcile the differences between NASD Rule 2711 and NYSE Rule 472, and will also be required to reconcile the differences between the rule change proposals described above.

IX. Conclusion

Initial changes made to regulation of research and research analysts from 2000 through 2003 were large, implementing prohibitive regulation that was at once highly detailed and principle-based. Investment banks were instructed by regulatory authorities that certain ways of doing business were no longer acceptable, and major institutional change was dictated by regulators.

Since that time, regulators have continued aggressive regulation, and have not been afraid to do so in a manner that responds in detail to complex issues.

Research regulation stands as a hallmark for the current era of regulation for at least three reasons. First, the current period displays a wide variety of regulatory tools that are being used to keep up with – and in some cases curb – practices in a business as complex and fast-paced as securities. As described above, these tools have included rulemaking, publication of interpretive guidance, “sweep” examinations, licensing, and enforcement. Most recently, regulation of research has involved the implementation of regulation that is designed to be “principles-based” rather than prescriptive in nature. Second, the current period is marked by complexity: a web of SEC, SRO, and informal or “best practices” regulation now exists covering every aspect of securities research. Finally, the regulation of research is one of the cornerstones of an emerging regulatory theme of heightened and more detailed compliance for investment banking operations. Once thought to be largely devoid of compliance requirements, investment banking is increasingly being scrutinized in respect of conflicts of interest, supervision, maintenance of stringent policies and procedures, insider trading and information management, solicitation practices, and recordkeeping. Separation of research and investment banking – a principal focus of research and research analyst regulation – is a leading trend in that area.

The result, which has been both publicized and touted by the SROs, is a comprehensive approach to regulation that requires firms to pay attention not only to rulemaking, but to the entire web of regulatory tools used to signal regulatory expectations. Consequently, firms are expected to manage their businesses – and in particular conflicts of interest – in a manner that is sensitive not only to existing regulation, but to principles underlying that regulation.

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Corresponding author

Charles S. Gittleman can be contacted at: cgittleman@shearman.com