Via Electronic Delivery and Overnight Mail
April 18, 2002
Jonathan G. Katz
Secretary, U. S. Securities and Exchange Commission
450 Fifth Street NW
Washington, D.C. 20549-0609
Re: Proposals Relating to Research Analyst Conflicts of Interest,
File Nos. SR-NASD-2002-21 and SR-NYSE-2002-09
Dear Mr. Katz:
The Charles Schwab Corporation ("Schwab") appreciates the opportunity to submit this comment on the above-referenced proposals. Schwab, a financial holding company under the Gramm-Leach-Bliley Act, is one of the five largest financial services companies in the United States, with $858 billion in client assets at the end of the first quarter of 2002. Schwab serves its broker-dealer clients through its Charles Schwab & Co., Inc., Schwab Capital Markets L.P., CyberTrader, Inc. and U.S. Trust Securities subsidiaries. Charles Schwab & Co., Inc. is a New York Stock Exchange ("NYSE") and National Association of Securities Dealers, Inc. ("NASD") member firm, and Schwab Capital Markets L.P., CyberTrader, Inc. and U.S. Trust Securities are NASD members.
Schwab concurs with the premise of these proposals. As the NASD puts it in its proposing release: "[t]here exists a potential conflict between a firm's responsibility to provide fair, objective and unbiased research and its interest in obtaining or retaining investment banking business from a company that is the subject of a research report[.]" We applaud the Commission, the NYSE and the NASD for this constructive initiative to restore confidence in the securities markets. We support the overall approach of the NYSE and NASD proposed rules as a significant first step to preventing (or at least disclosing) conflicts of interest. Schwab urges the SEC, the NYSE and NASD to continue to seek out and address conflicts of interest in our industry, particularly those in the distribution and sale of institutional clients' securities to retail investors.
We do, however, have some questions about the application of certain parts of the proposals, and some suggestions about ways in which we believe the proposals might be improved. With the hope of enhancing the NYSE's and NASD's efforts to address research analyst conflicts of interest, we offer the following comments.
I. Background: Research at Schwab.
Schwab's advice and guidance are central to the brokerage services we offer to retail clients. Schwab offers its clients proprietary research, most notably our Schwab Equity Research group (described in some detail below) and other market information and educational tools. Schwab also offers its clients third party research from sources such as S&P, Morningstar, Argus, First Call and Goldman Sachs.1 By providing its clients with this information, Schwab strives to empower clients so that they can make better and more informed investment decisions.
Schwab currently offers three types of proprietary research: model-driven quantitative research, technical analysis, and "public policy" research. These three types of research (collectively referred to in this letter as "Schwab Research") cover a broad cross-section of publicly traded equities. Schwab Research is based on objective criteria rather than on subjective judgments about the prospects of individual companies. Schwab does not engage in traditional investment banking. Schwab participates in equity underwriting only as a selling group member. We currently provide the following types of Schwab Research:
II. Restrictions on Personal Trading by Research Analysts.
Proposed NASD Rule 2711(g) and Proposed NYSE Rule 472(e) as currently drafted are unclear as to how they apply to most Schwab Research. The proposals appear to assume the traditional research model in which a sector of companies is assigned to a particular, named research analyst. As discussed above, Schwab's model-driven research is not attributed to any specific person and for that research, no specific person follows a particular stock. As the proposals are currently drafted, it is unclear who, if anyone, would be deemed the "research analyst" responsible for Schwab's model-driven research. We have similar questions with respect to technical research, because technical analysts do not have any ongoing responsibility for particular securities or sectors; rather, they look for technical patterns they believe are significant from a large universe of securities. Schwab suggests that the NYSE and NASD provide guidance on how the proposals' personal trading restrictions apply in the case of research reports that solely reflect model-driven or technical research or market commentary.
We agree with SIA that, for quantitative research not attributed to any individual analyst, as well for technical analysis, these personal trading rules should not apply. The contrary result would effectively bar the individuals responsible for Schwab's systematic model (as well as some people who report to them) from owning equities, because the model rates over 3,000 stocks.2 We believe that for model-driven or technical research, this is an unnecessary result; these types of research do not have the same potential for conflict of interest as does traditional, sector-based research attributed to individual research analysts. One suggestion would be that the NYSE and NASD consider incorporating a new definition into the proposals, that of a "covered research analyst." A covered research analyst would be a research analyst that is subject to all of the proposals' personal trading restrictions. Specifically, a covered research analyst would include any research analyst other than those associated persons who are principally responsible for the preparation of research reports that solely reflect quantitative, technical research or market commentary. Should this concept be incorporated into the proposals, the NYSE and NASD would have greater flexibility in determining which provisions of the proposals would apply only to covered research analysts.
III. Prominence of Disclosure in Electronic Communications.
Schwab urges the NYSE and NASD to provide more guidance concerning the prominence of disclosure requirements under Proposed NASD Rule 2711(h)(10) and Proposed NYSE Rule 472(k)(2), particularly in the context of electronic communications with clients. Rapid and clear dissemination of a rating change, for example, should be encouraged. Certain of the prominence requirements could have the unintended impact of impairing or even preventing the electronic dissemination of such research. Electronic delivery of research reports via e-mail alerts or conveyed through wireless products and services may not be practical if all of the proposed disclosures are required to be included. We believe that the benefits of including the proposed disclosures in every electronic communication should be weighed against the practical impact they would have on any impairment to the quick and broad electronic dissemination, and access to, research reports currently available to investors. This is particularly true for reports that mention several subject companies (including those in the same sector). We believe it should be permissible for such electronically delivered research to contain some of the required disclosures, while making others available on the firm's web site (perhaps with a hyperlink). Therefore, Schwab requests that the NYSE and NASD provide written guidance that would not unduly hinder the use, for example, of e-mail and wireless technology to transmit or make available research reports.
Similarly, Schwab would appreciate guidance concerning the prominence of disclosure requirement in the context of web pages. We would hope that disclosure using a hyperlink, or disclosure that required the user to scroll to the bottom of a web page, would not be deemed to be insufficiently prominent. Schwab requests that the NYSE and NASD provide written guidance regarding how the prominence of disclosure requirement should be interpreted when research reports are made available via the web. 3
IV. Discrepancies between Proposed NASD Rule 2711 and the Proposed NYSE Amendments to NYSE Rule 472.
Both the NASD's and the NYSE's proposals are designed to enhance investor protection. As such, Schwab strongly believes that there should not be any substantive differences between the two sets of proposals. Investor protection should not vary based on the happenstance of which self-regulatory organization the client's brokerage firm is a member. Therefore, we urge the Commission to require that the NASD and the NYSE resolve any and all substantive discrepancies between the proposals. We are particularly concerned that the NASD and NYSE definitions of "research report" are significantly different from each other. Under the NYSE's proposed amendments to Rule 472, "research reports are generally defined as, but not limited to, an analysis of equity securities of individual companies, or industries, which provide information reasonably sufficient upon which to base an investment decision." Under proposed NASD Rule 2711, research report means "a written or electronic communication that the member has distributed or will distribute with reasonable regularity to its customers or the general public, which presents an opinion or recommendation concerning an equity security." We believe that the NASD's proposed definition is preferable to the NYSE's proposed definition. The NYSE's use of the phrase "but not limited to" unnecessarily raises potential interpretive issues and adds ambiguity. For instance, the NYSE definition could arguably include an analysis of fixed-income or other securities in addition to the explicitly stated equity securities. The NYSE's proposed definition is also not explicitly limited to written or electronic communications, or communications distributed with reasonable regularity, and therefore could be interpreted to apply to telephone or other conversations between an associated person of a firm and any other individual.4
V. Role of Legal or Compliance Official as Intermediary for Communications between the Research Department and the Investment Banking Department or the Subject Company
As discussed above, Schwab supports the NYSE's and NASD's intention to ensure that research is shielded from the influence of a firm's investment banking department's relationships and to protect against any attempt by a subject company to influence the opinions in a research report. And as discussed above, Schwab does not engage in what would commonly be considered investment banking, so the issue of legal or compliance department intermediation does not directly affect us. Nonetheless, we are concerned with the precedent that would be set by Proposed NASD Rules 2711(b)(3) and 2711(c)(2)(C) and Proposed NYSE Rules 472(b)(2) and 472(b)(3) as they would require that compliance or legal department personnel play a supervisory or "gate-keeping" function. Requiring that compliance or legal personnel act as an intermediary for communications between research department personnel and investment banking department personnel and that compliance and legal personnel authorize certain changes to research reports may create unintended and undesirable results. This aspect of the proposals could serve to effectively undercut, if not eliminate, the responsibility of business-side supervisors to oversee the activities of their subordinates. Moreover, business-side supervisors are more likely to understand better the overall business and financial issues that impact investment banking activities.
The Commission and the SROs have spent years building a supervisory structure that requires business-side managers to be responsible for the activities of their subordinates. The proper role of legal and compliance personnel is to monitor that structure, make sure it is working, and advise the line supervisors when the structure may be failing. To shift direct supervisory responsibility to the legal and compliance staff, in our view, will be counter-productive and harmful. We suggest that better alternatives are to either build on the existing supervisory analyst research review process or require firms to designate the personnel who will be responsible for handling the proposals' supervisory tasks.
* * *
Schwab supports the goal of the NYSE and NASD in proposing these rules: to have member firms disclose and (to the extent possible) prevent the conflict of interest between research analysis for retail clients and investment banking activities for issuers. We believe these rules are a constructive first step to addressing conflicts of interest that have long affected the securities markets. Our comments are intended to assist the NYSE and NASD in making these regulations as effective as possible in meeting that goal. We urge the SEC, the NYSE and the NASD to continue to examine other conflicts of interest that can harm retail investors, particularly those relating to the distribution and sales process. If you have any questions regarding this letter, please contact me. Thank you for providing us this opportunity to comment on the proposals.
W. Hardy Callcott
SVP & General Counsel
Charles Schwab & Co., Inc.
|1||Schwab concurs with the Securities Industry Association (SIA) that the rule proposals should clarify that for third-party research, the party producing the research should have responsibility for complying with these rules. To hold otherwise would provide a strong disincentive against providing third-party research at all - a result that would diminish the utility and objectivity of the information made available to retail investors.|
|2||Schwab proposes that our public policy research, which is sector-based and attributed to individual analysts, be subject to Proposed NASD Rule 2711(g) and Proposed NYSE Rule 472(e), even though that research does not rate or recommend securities.|
|3||Schwab concurs with the SIA that the disclosures of firm and affiliate positions under proposed NASD Rule 2711(h)(1)(B) and proposed NYSE Rule 472(k)(1)(i) should occur quarterly. This would be consistent with the analogous federal securities position reporting requirement, Rule 13f-1 of the Exchange Act, which addresses position reporting by institutional investment managers. By making these disclosure requirements consistent with the timing requirements under analogous federal securities law, firm implementation should be less costly while still meeting the goal of providing clients with important disclosure information. Schwab would suggest a six-month implementation period for these requirements, and a twelve-month implementation period for firms to build and implement the systems necessary to track the information and create the price charts required under Proposed NASD Rule 2711(h)(6) and Proposed NYSE Rule 472(k)(2).|
|4||Ensuring consistent application of investor-protection rules to all clients at all brokerage firms is one of the reasons why Schwab supports the SIA's idea of a single SRO, as set forth the white papers "Reinventing Self-Regulation, White Paper for the Securities Industry Association's Ad Hoc Committee on Regulatory Implications of De-Mutualization" (January 5, 2000), and "Recommendations Regarding Self-Regulatory Structure" (March 23, 2000). See www.sia.com/demutualization.|