April 18, 2002
Jonathan G. Katz
Secretary, United States Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Dear Mr. Katz:
Wachovia Securities1 appreciates the opportunity to comment on proposed rules of the National Association of Securities Dealers, Inc. ("NASD") and the New York Stock Exchange ("NYSE") (the NASD and the NYSE, collectively, the "SROs") relating to research analyst conflicts of interest (the "Proposals"). Wachovia Securities supports the spirit and purpose of the Proposals, which is to "improve the objectivity of research and provide to investors more useful and reliable information when making investment decisions." Wachovia Securities believes that each provision of the Proposals should be analyzed to ensure that the provision accomplishes this intended purpose without imposing a burden on the member that is disproportionate to the benefit achieved.
As a general proposition, Wachovia Securities believes that the SROs should focus their regulatory efforts on creating rules that prohibit, or require disclosure of, specific drivers that may bias analysts' and their objectivity. Wachovia Securities recognizes that certain structures may have evolved at some firms, which create incentives contrary to the analysts' primary responsibility: serving the needs of the investor. Clearly, conflicts created by (i) reporting structure, (ii) analyst compensation and (iii) the personal, material financial interests of the analyst, are the main drivers against objectivity, and should be addressed by SRO Rules. If effective controls minimize or eliminate improper influences in these areas, and mandate disclosure of material conflicts that otherwise arise, analysts will be able to maintain their objectivity and better serve the interests of the investor. Finally, as with all rules and regulations, the rules must be clear and consistent in order to maximize their effectiveness and minimize their unintended consequences.
Against this background, we offer the following specific comments on several provisions of the Proposals:
Wachovia Securities agrees with the Proposals to the extent that they require disclosure of compensation received by a member firm or its affiliates for publicly announced investment banking transactions. We believe, however, that the nature and scope of compensation captured by the Proposals is too broad to provide meaningful information to investors and would impose a significant financial and administrative burden on member firms and their affiliates. We strongly disagree with the requirement for specific disclosure of expected compensation.
The Proposals would require a member to disclose in its research reports the fact that "the member or its affiliates received compensation from the Subject Company during the preceding 12 months or expects to receive compensation in the three months following publication of a report." The disclosure requirement would be triggered irrespective of the nature and scope of the relationship with the Subject Company or the materiality of compensation to the financial institution. A member would also be required to make the disclosure even if it is unlikely that the analyst knows about the compensation. For example, an affiliate of a member could provide trust services to the Subject Company that generated only nominal annual revenue. This compensation would be immaterial and the analyst would be unlikely to know about the compensation given the traditional separation between the trust department and other business units. Rather than provide the investor with reliable or meaningful information, the proposed disclosure may well mislead the investor because it does not distinguish situations in which the consideration received presents a real conflict from those that do not. Moreover, this broad requirement could have the perverse effect of influencing the analyst by putting the analyst on notice of the importance (or a lack thereof) of a Subject Company to the financial institution as a whole.
Although the disclosure provides little, if any, additional value to investors, compliance would place a tremendous administrative burden on member firms, particularly those that are a part of a diversified financial institution. In order to make an accurate disclosure, a financial institution would have to implement sophisticated systems to track, by customer, all forms of consideration received across its many businesses and product lines. Since the disclosure requirement triggers upon receipt of any compensation, regardless of form and amount, in a large financial institution the diligence and new technology involved in giving an accurate disclosure would be excessively costly and burdensome. Yet, as set forth above, the compensation that the diligence would uncover could be immaterial and unknown to the analyst. Given the breadth of many customer relationships at diversified financial institutions and the requirement to disclose any consideration, we believe that the disclosure would be given for most, if not all, Subject Companies. In effect, the disclosure would become "boilerplate" that provides the investor with no more useful or reliable information about the institution's relationship with the Subject Company than the investor would have without the disclosure. The benefit of the disclosure simply does not justify the cost of compliance.
If the disclosure requirement is to be meaningful, the SROs should limit the disclosure to compensation received for traditional investment banking services-merger and acquisition services and underwriting. The specific disclosure should be limited to investment banking services for publicly announced transactions. By limiting the disclosure to publicly announced transactions, there is no danger of tipping investors with nonpublic information or prematurely bringing the analyst "over the wall." The disclosure is limited to compensation about which the analyst knows and, accordingly, to situations where there is a reasonable possibility of bias. Limiting the definition in this way significantly reduces the cost of complying with the disclosure requirement and, more importantly, provides the investor with a disclosure that might be meaningful.
Mandatory disclosure of expected compensation from an issuer would contradict requirements to maintain a Chinese Wall between the research and investment banking departments. Expected compensation may include compensation for a nonpublic transaction for which the analyst has not yet been brought "over the wall". If a firm has received no other compensation in the last twelve months, the expected compensation would require a new disclosure in a research report thereby alerting the research department and the investing public of a pending non-public transaction. This requirement would work exactly contrary to the purpose underlying the Proposals by providing the analyst with information that could bias his or her opinion. Worse yet, the disclosure could generate rumors with resulting negative effects on the market.
Wachovia Securities recognizes that there may be a benefit in disclosing material financial interests but (i) the 13(d) standard of "beneficial ownership," a control standard, is not the relevant measure and (ii) the proposed 1% threshold is too low. Instead, the NASD Rule 2720 definition of beneficial ownership, a conflicts standard, and its 10% threshold should apply.
The Proposals require members to disclose in research reports and analyst public appearances if, in the five business days before the publication of the research report or public appearance, the member or its affiliates beneficially own 1% or more of any class of common equity securities of the Subject Company. "Beneficial Ownership," as defined pursuant to Section 13(d) and Section 13(g) of the Securities Exchange Act of 1934, as amended, is not the most appropriate standard to trigger a disclosure and would be misleading to investors.
If the purpose of the disclosure is to put the investor on notice of the financial institution's financial interest, using "beneficial ownership" as defined pursuant to the Act does not accomplish this purpose. Consistent with the purposes of Section 13(d) and (g), beneficial ownership under the Act focuses on voting control and discretion over disposition rather than economic interest. Accordingly, nonvoting securities are not "equity securities" under the Act even if the nonvoting securities represent a significant economic stake.
Using beneficial ownership as defined in Section 13(d) will sweep in trust and other managed accounts where the interest of the financial institution is generally limited to fee income from its customer. The institution generally has no financial interest in the issuer of securities held by those accounts. Using this standard does not distinguish, as we believe it should, a financial interest from other aspects of ownership. As a result, a disclosure by an institution with beneficial ownership of securities of a Subject Company solely by virtue of holdings of managed accounts and a disclosure by a member with beneficial ownership by virtue of direct holdings of equity securities of the Subject Company would be identical.
If the purpose of the disclosure is to show an institution's financial interest that may indicate a conflict of interest with research, then the NASD Rule 2720 standard should apply. NASD Rule 2720 defines beneficial ownership as: "the right to the economic benefits of a security." Rule 2720, like the Proposals, is focused on conflicts of interest rather than voting control. For clarity, as in Rule 2720, the definition should be contained, or incorporated by reference, in the text of the rule rather than in the accompanying commentary.
Whatever definition of beneficial ownership the SROs adopt, we respectfully suggest that a threshold higher than one percent is appropriate in order to address potentially material conflicts. One percent ownership is not a financial interest from which an investor could reasonably infer potential bias and, as a result, does not provide the investor with more useful or reliable information.
Complying with a one percent disclosure requirement would impose a tremendous administrative burden on a diversified financial institution. Members and their affiliates track beneficial ownership to determine whether 13D filings are required, triggered upon acquisition of 5%. Most members and their affiliates, however, will qualify for 13G filings. They will compute their beneficial holdings at the end of each month to determine whether holdings exceed 10% and at the end of each year in order to file Schedule 13G. Similarly, NASD Rule 2720, using its own definition of beneficial ownership, requires a snapshot of beneficial ownership in order to determine whether participation in a transaction is permissible. Rule 2720 relies on a 10% beneficial ownership level. We suggest that, consistent with other rules governing conflicts of interest, the appropriate trigger for disclosure is 10%. Member firms and their affiliates are already focused on this level of beneficial ownership for a variety of purposes and could provide this information without incurring substantial technology costs.
We also suggest that member firms be permitted to disclose ownership as of the end of the month immediately preceding the report or public appearance. Ownership levels can and do change daily. A report as of five business days prior to an appearance or report is no more likely to be an accurate reflection of ownership than a report as of the end of a month yet the former would require significant expenditures for systems and personnel.
Price Chart Disclosures
The price chart disclosure requirement is unworkable because charts often exceed server size limits. Research reports containing such charts could not be effectively transmitted via e-mail or other electronic means to many vendors and customers.
Wachovia Securities has been notified by many market participants that market data services and e-mail users often cannot electronically accept transmissions that exceed server size limitations. Price charts or other graphics within a research report often cause documents to exceed server size limitations, so the report cannot be open by an e-mail recipient. The proposed mandatory price charts would exceed many market participants' server size limitations and would render the research unreadable when transmitted via e-mail. Since electronic delivery is increasingly the investor's preferred method of delivery of research reports, the Proposals should not require the inclusion of price charts that cannot be viewed by the investor.
Analyst Supervision and Control
Wachovia Securities believes that the definitions of the above-referenced key terms are overly broad and ambiguous. In order to facilitate compliance, the definitions should be clear and concise and consistent between the rules of the SROs.
We agree with the proposition that research departments must operate independently of investment banking departments in order to ensure greater reliability in research reports. The Proposals correctly focus on organizational structure as a possible source of improper influence on the research department. Accordingly, under the Proposals, no research analyst may be subject to the supervision and control of any employee of the member's investment banking department. In order to determine whether control exists, however, a member firm must be able to draw a line between what is in investment banking and what is not. These key terms simply must have some degree of specificity.
The Proposals define "investment banking department" as "any department...that performs investment banking services on behalf of the member." It is unclear whether this definition is intended to capture affiliates that may be providing investment banking services. The definition of "investment banking services" includes, but is not limited to, the services listed in the definition. Clearly, the scope of this inclusion was not intended as it could draw in every service provided by a member firm, regardless of whether it relates to what is customarily known as investment banking. We recommend limiting the definition to its traditional scope - underwriting and merger and acquisition advisory services-the type of services that typically have been the source of analyst conflicts of interest.
The Proposals contain different definitions of "research" and appear to sweep in all communications regardless of whether they are generated by the equity research department or contain an opinion (as opposed to quantitative analysis). Given the common objectives of the two Proposals, there is no reason why the two definitions should be different. The costs and inefficiencies associated with interpreting and complying with two separate rules would be substantial. The SEC should not approve the two sets of rules unless, at a minimum, they use the identical definitions of "Research."
Wachovia Securities believes that the investment banking department should not be permitted to review research for conflicts of interest.
We believe that the investment banking department should not be permitted to review research for conflicts of interest, and we would not be opposed to a complete prohibition of investment banking reviews specifically of research reports. The compliance and legal departments should be aware of potential conflicts of interest that might require the need for disclosure as outlined in the Proposals. The compliance and legal departments may need to confer with investment banking to ensure that all conflicts are properly vetted in clearing research for distribution. We believe that permitting review by the investment banking department, specifically for conflicts of interest, opens the door for the investment banking department to attempt to influence the content of the report in a way that favors, its client, the Subject Company. By empowering the investment banking department to review research for conflicts, the Proposals would provide oversight functions to the very department that the Proposals otherwise seek to distance from the research department. We believe that the better approach is to allow the legal or compliance departments, or alternatively, a supervisory analyst to review research reports for conflicts, as those reviewers will predictably take a more balanced approach following the identification of a conflict.
Wachovia Securities believes the gatekeeper aspect of the Proposals would contradict the traditional and appropriate approach for supervision and place an undue burden on the legal and compliance staffs.
As noted above, we agree that there are few, if any, reasons for a member of the investment banking department to review a research report prior to publication. Nonetheless, the research department and the investment banking department often confer on industry matters. Provided that communications do not involve forthcoming research or the member's investment banking initiatives, there are many appropriate synergies to be gained (both in-house, and ultimately by the market and investing public) by sharing information on sector trends and even issuer-specific business initiatives. These types of communications are appropriate and encouraged. In attempting to control the influence of the investment banking department over the research department, the Proposals should not sweep so broadly as to chill appropriate communication.
The Proposals attempt to control communications by placing the legal or compliance department in the middle of communications concerning a research report. This effectively requires legal and compliance to monitor all communications between the research and compliance department as most communications, even appropriate communications concerning industry, "concern" a research report. Much improper communication is already controlled through Chinese Wall procedures that members have in place. Implementing this type of additional Chinese Wall procedure would place a significant administrative and financial burden on member firms.
We believe that, rather than requiring a gatekeeper for communications, it is more effective to simply prohibit prior review of all research reports by the investment banking department. As set forth above, the compliance and legal departments should know of potential and actual conflicts of interest and can provide this information for any mandatory disclosures. The research department has access to the companies it covers and has the means of verifying factual accuracy without the involvement of the investment banking department. A prohibition on prior review coupled with other effective controls on the prime sources of analyst bias--compensation, supervision and control and financial interest-will minimize or eliminate the need for a gatekeeper. Assuming that these controls are in place, an analyst would have little to gain and much to lose if he or she violated the prohibition on prior review. The analyst simply will not be motivated to serve any interest other than the investor's interest.
If the SROs maintain a "gatekeeper function," they should recognize that it is simply another name for supervision, which is best left to properly licensed and registered supervisors who are fully empowered and paid for taking corrective action against employees who violate policies and procedures in place at member firms. These supervisory principals are legally responsible for all other aspects of the research analysts' day-to-day activities. They are responsible for compensation, role definition and development. Removing responsibility for regulatory supervision from the principal is contrary to the SROs' traditional approach to supervision.
Moreover, the Proposals do not make clear what is prohibited or intended once the gate-keeper becomes aware of an improper communication. In fact the rule does not define what is an improper communication. Simply knowing and recording communications would add nothing to improve conflicts. Instead, the rules should identify improper conduct, and conduct that requires disclosure, require supervisors to supervise, allow legal departments to advise, and expect compliance departments to surveil. Blurring these lines as proposed without clearly defined prohibitions or requirements would only add costs and lack of clarity, putting the legal and compliance departments potentially at odds with the research department with no regulatory benefit.
Imposition of 40-day and 10-day "quiet period"
Wachovia Securities believes that the proposed quiet periods would impede the flow of information and, as such, would be a disservice to the investor. At a minimum, any quiet period must be defined clearly and consistently in both the NASD and NYSE rules.
Wachovia Securities believes that the bedrock of efficient markets is information. Rather increase access to information, the Proposals work against that objective. We see no benefit to investors of a "40-day" versus the current "25-day" quiet period for initial public offerings that is implicit in Rule 174. Indeed, while the SROs contend that the extension is necessary, neither SRO offers a justifying benefit.
We support utilization of the 138, 139 safe harbors for making a determination as to whether a firm can publish research following their role as a manager or co-manager for a secondary offering. Issuers meeting the requirements of the safe-harbors are mature and seasoned with ample available publicly available information should investors wish to seek it. The publication of research is intended to benefit investors. Depriving the investor of valuable analysis when all selling efforts have ended is counterproductive. We do support a 10-day quiet period for secondary offerings if the manager or co-manager intends to initiate research coverage or in cases where the issuer does not meet the requirements for the safe harbors.
If the SROs adopt new quiet periods, we urge the SROs or SEC, at a minimum, to establish one starting date for the quiet period. Since many broker dealers are subject to both NYSE and NASD regulation, we suggest that the rules of the SROs be identical. We note that the NASD initial public offering quiet period commences on the date of the offering. In the commentary, the NASD defines the date of an initial public offering as the effective date of the registration statement and the date of a secondary offering as the date on which sales begin pursuant to an underwriting or similar agreement. The NYSE quiet period commences on the effective date of the initial public offering or the secondary offering. It is unclear whether the NYSE is referring to the effective date of the registration statement or the date on which the offering commences. The commentary accompanying both Proposals, however, makes it clear that quiet periods are intended to reduce a manager's ability to improperly reward a Subject Company for its underwriting business by publishing favorable research after the completion of an offering. If this is the purpose of the quiet period, it is unclear that a quiet period commencing on the effective date of the registration statement, or any time prior to pricing accomplishes the stated purpose.
It is unclear how the SROs intend to treat shelf registrations. A blackout of research for 10 days after all shelf issuances would be very disruptive of the flow of information. Under the Proposals, however, it is not clear when the registration date would be and how that would relate to research or the pricing of an individual shelf distribution.
Wachovia Securities strongly believes that research analysts' compensation should contain no formulaic component related to investment banking but the regulations should expressly permit compensation related to overall advisory services that an analyst has provided to the investment banking department.
The Proposals appropriately recognize that research departments provide important services to the investment banking and other business units of the member firm and its affiliates. The commentary accompanying the NASD Proposal notes:
"Since research analysts, as part of their job responsibilities, advise investment banking departments concerning such matters as whether a potential underwriting client is financially or operationally prepared for an initial public offering, the NASD's proposed rule change would permit a member to compensate its research analysts based on their overall performance, which may include these services to the investment banking department."
Wachovia Securities agrees that it is appropriate to compensate analysts based on their overall performance, including their performance of these important services to the investment banking department. We also agree that analyst compensation should have no formulaic component that reflects investment banking revenues. Given the importance of compensation schemes to encouraging appropriate behavior, we believe that the text of the rule itself, rather than the commentary, should prescribe the proper approach for compensation. We believe that these clarifications, within the rule itself, are necessary to ensure that analysts may be compensated for the application of their expertise to the investment banking business in general, but that their judgement is not influenced by transaction-specific revenues.
Wachovia Securities again appreciates the opportunity to comment on the Proposals and would welcome the opportunity to discuss our comments with you in more detail.
|1||Wachovia Securities is the trade name under which Wachovia Corporation conducts its investment banking, capital markets and institutional securities business through First Union Securities, Inc. ("FUSI"), Member NYSE, NASD, SIPC, and through other bank and non-bank and broker-dealer subsidiaries of Wachovia Corporation.|