September 23, 2002
Mr. Jonathan G. Katz
Re: File No. S7-30-02
Dear Mr. Katz:
The Bond Market Association ("Association")1 is pleased to comment on proposed Regulation AC, concerning certifications by research analysts, as recently proposed by the Commission,2 and related issues. The Association is committed to maintaining the highest standards of conduct in the fixed income markets, including standards of conduct as they relate to the publication of research.
Summary of Comments
The Association supports the adoption of Regulation AC and its application to fixed income research. Further, we believe that it would be appropriate to explore whether some of the requirements recently adopted by the National Association of Securities Dealers, Inc. and the New York Stock Exchange (the "SROs") for equity research (the "SRO Rules") should be applied, with modifications, to some types of fixed income research. In general, fixed income research differs from equity research in a number of important respects, and potential conflicts are significantly less than exist in the equity arena. Accordingly, analyst conflicts rules that have been developed to respond to equity market concerns should be individually reviewed to determine whether it would be sensible or practical to apply them in the fixed income area, and whether and how they should be modified for that purpose.
Distinctions between Equity and Fixed Income Research
In considering possible regulation of fixed income research, it is important to understand how it differs from equity research, in terms of the market context in which it exists, the types of research that is produced, how it is used, and the clients to whom it is directed.
Public concerns involving equity research, and the rules that have been adopted or proposed to respond to these concerns, derive from the potential conflict that exists when a broker-dealer maintains or is seeking to establish an investment banking relationship with a particular company, and at the same time, publishes recommendations to its public customers concerning equity securities of the same company. Concerns also have been raised with regard to connections between investment banking revenue and analyst compensation.3 These concerns have been raised particularly in the context in which a company issues stock in an initial public offering. In that circumstance, the importance to the issuer of maintaining a high share price in the aftermarket (and the importance of the investment bank's relationship to the issuer) may conflict with the objective of producing fully objective research on the issuer and its stock.
The impact of equity research on share price may be affected by the broad distribution of research to retail customers. Nearly universal Internet access by investors, coupled with the increased availability of firm proprietary research through electronic channels, has substantially increased the potential audience for such research. Retail investors generally do not have the kind of experience or access to independent sources of information that is possessed by money managers and other institutional clients and so may rely more heavily on research in making investment decisions than do institutions. Therefore, for example, in the context of an initial public offering, favorable research may contribute to the types of substantial price gains following the offering that have been witnessed in recent years.
The bond markets encompass an extremely broad range of fixed income securities, including U.S. Treasury securities, agency instruments, taxable (corporate) bonds, structured securities (including mortgage and other asset securitizations), preferred securities, and securities issued by tax-exempt entities. Bond prices usually do not experience the degree of price fluctuations in response to research that is typical of many equities, particularly those traded in the immediate aftermarket. This is true both because the audience for such research is generally more limited, as discussed below, and because for many bonds, prices are mainly driven by changes in interest rates and other macroeconomic factors, rather than factors that are unique to the issuer.
Bonds usually are priced in relation to standard benchmark securities (for example, at a specified spread to Treasury securities of like maturity). Further, in those cases in which the issuer's credit is a significant element in determining price, investors rely to a significant degree on ratings assigned by nationally recognized rating agencies. In addition, a debt issuer may issue a variety of different types of fixed income securities (e.g., secured, unsecured, preference), each with its own structural dynamics and the prices of which are likely to respond differently to interest rate-related or credit-related information.
Accordingly, much of the research that is relevant to fixed income investors, particularly in the government, sovereign debt, and mortgage and asset-backed markets, is macroeconomic in nature, i.e., it analyzes trends in general interest rate barometers, spreads between different types of investments, and similar data, rather than focusing on a single issuer or bond. Institutional investors use this type of research to help manage the composition of their portfolios in terms of average maturity, yield, credit quality, and other factors. In some other cases, research focuses on industry sectors and mentions individual companies in the context of identifying benchmark issuers within a sector, rather than recommending the purchase or sale of particular bonds. Because research of this type is not focused on or issued in connection with individual bond issues, it is unlikely to benefit or harm the market position of individual issuers, nor would it affect the ability of the issuing firm to obtain investment banking business.
Further, when fixed income research does focus on individual credits and securities, it sometimes is oriented around a "relative value" analysis that considers the price or value of an instrument relative to other bonds issued by entities of similar or different credit standing or that are within the same industry. Depending on the language used, this category of research may or may not involve a "recommendation" as we understand that term to be used in proposed Regulation AC.
For all of these reasons, bond research and bond analysts have significantly less potential to influence the price of particular bonds, in comparison to the potential impact of equity research on stock prices.
Moreover, the various categories of debt securities, as described above, should be considered separately in considering the potential for conflicts between investment banking and research functions. For example, in the case of government securities, the nature of the individual markets for such securities negates the potential for such conflicts (in the case of Treasuries, because there is no investment banking relationship between dealers and the Treasury, and in the case of government agency debt, because the volume and liquidity of the trading market limits the potential market impact of any particular research report). A categorical review by type of fixed income security would be especially relevant in considering whether to extend the SRO Rules to the fixed income area, as suggested by the Proposing Release. Because of the factors and distinctions described in this section, in considering whether to apply any of the SRO rules to fixed income securities, the Commission and SROs should focus on those instruments as to which price is strongly tied to evaluations of the issuer's credit.
Finally, it is important to consider that the great bulk of fixed income research is directed and disseminated to institutional investors, who view it as one of many sources of information to consider in making investment decisions. For example, based on the flow of funds data published by the Federal Reserve Board, as of March 31 of this year, direct holdings by "households" accounted for approximately 7.8% of marketable U.S. Treasury debt outstanding, 1% of agency debt, 12% of corporate and foreign bonds, and 33.8% of municipal securities. Further, retail investors who do purchase fixed income securities tend to do so on a "buy and hold" basis in order to obtain current income or favorable tax treatment, rather than capital gains. It is precisely because of the fact that fixed income research is primarily directed to institutional investors that it often does not contain recommendations of individual securities, but tends to concentrate on market data and detail that institutional investors can add to the other information sources available to them.
We believe that these distinctions sharply reduce the potential conflicts presented by fixed income research and should be considered by the Commission and the SROs in considering further regulation.
In general, Regulation AC would require that research reports disseminated by broker-dealers include a certification by the research analyst that the views expressed accurately reflect the analyst's personal views and whether the analyst received compensation connected to the recommendations or views contained in the report. In addition, broker-dealers would be required to keep copies of similar certifications on a quarterly basis by analysts who make public appearances.
For purposes of the rules, "research report" is defined to mean "a written communication that includes an analysis of the securities of an issuer or issuers, provides information reasonably sufficient upon which to base an investment decision, and includes a recommendation." Accordingly, the rules would reach fixed income as well as equity securities research that contains a recommendation. In contrast, the same term in the SRO Rules is expressly limited to research involving equity securities.4 In the Proposing Release, the Commission indicated that it intentionally sought to include fixed income research, stating that "[w]e believe that some of the same concerns regarding analyst conflicts also pertain to debt securities."5 The Commission specifically solicited comment on this issue.
In essence, Regulation AC asks that analysts certify for public consumption that they stand behind what they write, and that they have not been paid to express a particular viewpoint or make a particular recommendation. Although, for the reasons described above, we believe that fixed income research poses significantly less potential to create conflicts of the type addressed by the proposed regulation, the Association also believes that Regulation AC establishes a reasonable benchmark standard to which analysts of all types should be able to subscribe. The proposal also would appear to impose relatively little in the way of additional costs to firms. Accordingly, the Association supports the adoption of Regulation AC and its application to fixed income research.
Proposed Rule 502(b)(1) would require that research reports include a statement that "no part of the research analyst's compensation was, is, or will be directly or indirectly, related to the specific recommendations or views expressed by the research analyst in the research report." It is our understanding that this provision is meant to address compensation that is paid in connection with and that is intended to influence a particular recommendation or view (for example, a payment that is made to induce a change in a recommendation from "hold" to "buy"), and not compensation paid to the analyst for preparing the report or the quality of the work performed (for example, tying compensation to how well recommendations track subsequent performance of the securities that are reviewed). This is consistent with the expressed purpose of the proposal, although the use of the term "indirectly" in this part of the proposed rule may cause confusion about its meaning. Therefore, we request that the Commission clarify that this requirement is meant only to address payments that are made to influence specific recommendations or views before they are published.
In the Proposing Release, the Commission indicated that "the SROs are considering expanding the coverage of their rules regarding analyst research reports to cover debt securities."6 Those rules prescribe a comprehensive set of new requirements for equity research including, among others, requirements concerning the separation of investment banking functions, compensation of analysts, personal trading by analysts, and a variety of new disclosures in research reports.
The Association will await further specific proposals before providing detailed comments. However, based on a preliminary review, and in view of the considerations described above, we believe that it would be appropriate to explore whether some of the requirements of the SRO Rules should be applied, with modifications, to some types of fixed income research. Some of these requirements clearly would be impractical to so apply. For example, the requirement that research reports include a line graph showing daily closing prices for a defined period would not be practical, given that there is no single accepted "closing price" for most debt securities.
Any effort to extend the SRO Rules to fixed income research should include a detailed review of the usefulness and practicality of imposing each specific requirement to research on the various categories of fixed income instruments, bearing in mind the differences among those categories, as well as between fixed income and equity research generally. We would welcome the opportunity to work with the Commission and the SROs in conducting this analysis. We also look forward to discussing all of the issues raised in this letter with the staff of the Commission. Please contact Paul Saltzman, Executive Vice President and General Counsel, or the undersigned, at 212.440.9400.
/sgd./ John M. Ramsay
John M. Ramsay
cc: Securities and Exchange Commission
New York Stock Exchange
Edward A. Kwalwasser, Group Executive Vice President, Regulation
The Bond Market Association
Micah S. Green, President