March 10, 2003
Mr. Jonathan G. Katz
Re: File No. NYSE-2002-49
Dear Mr. Katz:
The undersigned brokerage firms, Adams, Harkness & Hill, Inc., AG Edwards, Keefe, Bruyette & Woods, Inc., Pacific Growth Equities, LLC, RBC Capital Markets,1 Stephens, Inc., Stifel Nicolaus & Company, and William Blair & Company (together, the "Firms"), are integrated financial services firms that provide both investment banking and research services. We are commenting on the proposed amendments submitted by the New York Stock Exchange, Inc. (the "NYSE") and the National Association of Securities Dealers, Inc. (the "NASD") to NYSE Rule 472 and NASD Rule 2711 (collectively, the "Proposed Rules") regarding research analysts' conflicts of interest. We appreciate this opportunity to provide comments on the Proposed Rules.
The Firms provide a wide range of investment banking services to corporate clients, including both public and non-public companies, as well as brokerage and trading services to both institutional and retail investors. The Firms are also a primary source for their investor clients of objective quality research on public companies, with a focus on middle market and growth companies in certain geographic and industry sectors.
The investment banking services the Firms provide to their corporate clients include serving as advisors and underwriters in initial public offerings for middle market and emerging growth companies. In order to understand completely a private company and its chances for future success as a public company, broker-dealers must have the flexibility to employ their intellectual capital in the most productive manner. The interests of a company and its potential investors are best served when research analysts understand fully the company and its industry sector well before any time-constrained formal due diligence process that occurs in the context of an initial public offering. In many cases, this means having research analysts perform ongoing due diligence of a company for an extended period prior to any determination by the company to go public.
The Firms recognize and endorse the efforts of securities regulators to re-establish confidence in the U.S. equity markets. For this reason, the Firms generally support the NYSE and NASD Proposed Rules. The Firms are concerned, however, that the Proposed Rules may have unforeseen negative consequences, especially with regard to the ability of U.S. middle market and emerging growth companies to raise capital and the ability of their underwriters to perform ongoing and meaningful due diligence for the protection of investors and the markets. The protection of investors requires that underwriters be able to acquire a comprehensive and fully informed understanding of a private company prior to committing to act as an underwriter in such company's initial public offering. However, the Proposed Rules would likely significantly restrict an underwriter's ability to acquire this knowledge by imposing restrictions on the ability of any research analyst associated with the underwriter to communicate with the company prior to its initial public offering.
The Firms are focusing their comments on two specific aspects of the Proposed Rules:
Proposed New Paragraphs NYSE Rule 472(b)(4) and NASD Rule 2711(c)(4)
Both the NYSE and the NASD propose to add the following paragraph to their existing rules:
This proposed addition to the NYSE and NASD rules concerns the Firms for several reasons. First, the Firms believe that some of the terms used in the rules are overly broad and may cause the bar to apply in situations that were unintended. Second, the Firms believe that a complete, permanent bar is an overly draconian remedy.
1. "In furtherance of obtaining investment banking business"
In the Firms' view, the phrase "in furtherance of obtaining investment banking business" can be interpreted to include almost any contact between a research analyst and a potential issuer. The Commission's release requesting comments on the Proposed Rules uses the terms "pitch" and "bake-off" to describe activities "in furtherance of obtaining investment banking business."2 Neither "pitch" nor "bake-off" are technical terms or terms of art. Therefore, these terms may mean different things to different people.
The NYSE states that "the rule is intended to segregate legitimate research analyst duties/functions traditionally associated with their profession, from the sales/marketing duties that they may have been called upon recently to do by their firms."3 While this distinction sounds logical on paper, in reality the distinction is much harder to define. For example, research analysts regularly visit private companies to learn more about them and to better understand their particular industries and industry sectors. During the course of these meetings, an analyst may be asked about his or her firm's investment banking practice or about the feasibility of an initial public offering by the company. Similarly, a private company may want to familiarize itself with the personnel at a firm, and to meet all relevant personnel, including research analysts and investment bankers, at one meeting. Company representatives at such meetings may ask specifically whether the analyst's firm is interested in underwriting an initial public offering by the company. Under any of these circumstances, the analyst's mere presence at meetings, even if the analyst's sole purpose is to gather information concerning the company and its industry or to provide the company with meaningful analysis of its business and its industry sector, could be deemed to have been "in furtherance of obtaining investment banking business."
Furthermore, the "in furtherance of obtaining investment banking business" language could be construed to apply to an analyst who does nothing to pitch a firm's investment banking capabilities, but nevertheless is a significant factor in the issuer's choice of investment bankers, either because of the analyst's reputation or because of prior contacts between the analyst and the company. Thus, under the language of the Proposed Rules, a company's determination to choose an investment bank based in part on an earlier meeting with a research analyst could be enough to trigger a permanent writing bar against the analyst with regard to that company.
The Firms strongly urge the NYSE and NASD to redraft the proposed language in NYSE Rule 472(b)(4) and NASD Rule 2711(c)(4) with greater specificity and clarity with regard to those contacts by research analysts that will be considered "in furtherance of obtaining investment banking business." Without clearer guidance, a reasonable person could conclude, after reviewing the proposed language, that a research analyst may no longer contact a private company at any time before the company becomes public without running a significant risk that the contact will be construed as a "pitch" or other communication in "furtherance of obtaining investment banking business." As currently worded, the Proposed Rules may result in a reduction in the breadth and quality of fundamental research, and may limit the ability of research analysts to commence meaningful and value-added research on newly public companies because they have not been able to gather baseline information about the company prior to the company's initial public offering.
The Firms believe that the Proposed Rules should identify more clearly those communications that will trigger the writing and public appearance prohibition as being "in furtherance of obtaining investment banking business." Specifically, the Firms believe that the Proposed Rules should bar an analyst from writing or otherwise providing research coverage of a company only where: (i) the analyst has communicated with a private company for the purpose of inducing the company to select the analyst's firm as a managing or co-managing underwriter of the company's initial public offering and the communication occurs in the 12 months prior to the filing of a registration statement for the company's initial public offering,4 and (ii) the analyst continues to be an employee or other person associated with such firm.5
The Proposed Rules by their terms would apply only to contacts in furtherance of possible retention as an "underwriter of an initial public offering" by the company contacted. The Firms encourage the NYSE and the NASD to identify in the text of any adopted rule amendments, or in contemporaneous interpretive material, those transactions that are covered by "initial public offering." Specifically, the Firms request that the NYSE and NASD confirm that this reference is only to initial public offerings by the subject company, and not to transactions such as mergers in which a non-public company is acquired by a public company, or in which a division of the subject company is spun off solely to existing shareholders.
The Proposed Rules would permit due diligence meetings, but the language permitting such meetings presupposes an anticipated underwriting. In the release soliciting comments on the Proposed Rules, the NYSE acknowledges that due diligence communications are necessary "during the period an issuer is preparing to engage in a securities offering with the public" so that research analysts can perform "critical financial analysis of the subject company."6 This limited window for due diligence meetings should extend retroactively to protect ongoing analyst due diligence that may have commenced before the company determined to proceed with an initial public offering. It is often this ongoing due diligence, not the due diligence during the period just before a company's initial public offering, that allows analysts to gain an extensive level of knowledge about a private company's business strategy as well as the capabilities of the company's management to execute that strategy.
Analysts with this extensive understanding of a company and its management are far better equipped to provide investors with insightful views of a company and its likely future prospects. In addition, analysts with this extensive understanding are better equipped to veto any initiative by their firms to recommend to such a company that it proceed with an initial public offering or participate in such an initial public offering.
2. Permanent Bar
As mentioned above, proposed NYSE Rule 472(b)(4) and proposed NASD Rule 2711(c)(4) would bar a research analyst permanently from issuing research reports or making public appearances with regard to a company if the analyst is determined to have been in contact with the company in "furtherance of obtaining investment banking business." Moreover, the permanent bar would attach to the analyst, not to his or her firm. The Proposed Rules provide no basis on which an analyst can seek to have the permanent bar lifted.
The Firms are aware of the recent revelations that certain research analysts may have issued research on subject companies that did not reflect their true opinions of those companies in an effort to assist their firms to obtain investment banking business. The Firms also understand and support regulatory efforts to articulate stricter, clearer standards to ensure that research about newly public companies is not being provided by compromised analysts whose duty it is to provide the best possible research to investors. The Firms strongly support these efforts and believe that the adoption of Regulation AC, in conjunction with NYSE Rule 472 and NASD Rule 2711 as already in effect, will significantly improve public trust in analyst reports. However, for the reasons discussed below, the Firms strongly urge the NYSE and NASD to reconsider whether the proposed permanent bar will add to these efforts.
Generally, over a relatively short period following an initial public offering, factors beyond an individual analyst's research materially diminish the influence of any single analyst's views on the secondary market for a company's stock. As the secondary market develops, and additional analysts follow a newly public company, a market "consensus" of analyst ratings and estimates develops. Ratings and estimates that differ from such consensus without clearly defined reasons are not likely to have a significant effect. Subsequent periodic or current reports, press releases and industry and general economic factors ultimately are likely to have a far greater impact on stock prices, especially after a market consensus of analysts develops.
The Firms believe that, if adopted as proposed, the amendments to NYSE Rule 472(b) and NASD Rule 2711(c) will lead to an industry practice of prohibiting research analysts from meeting with private companies except under very limited circumstances. Larger integrated financial services firms may be in a position to take competitive advantage of this practice by hiring two sets of analysts, one to provide research coverage to investing clients and the other to provide internal research and analysis to these firms' investment banking departments. Whether or not this duplication makes sense, smaller integrated firms simply do not have these resources.7 As a result, the Firms believe that the small to medium sized companies traditionally serviced by the Firms will suffer by having less research coverage and less access to the public equity markets. Most importantly, the Firms also believe that a regulatory structure that in effect encourages the best research analysts to move from a firm's research department (where their duty is to serve investors) to its investment banking department is not in the best interest of these companies or investors.
To the extent that there is a risk that an analyst will be barred from writing about specific companies or industries (when the industry is dominated by a company that is the subject of a writing bar), prospective issuers may assign a significant weight to this risk and may affirmatively choose NOT to use the analyst's firm as its underwriter or investment banker because it perceives there to be a risk that the firm's research will be less than thorough. This will substantially narrow the choices available to small and medium market companies seeking the best advice as they contemplate initial public offerings.
The NYSE and NASD now restrict all analysts in a firm that is a manager or co-manager of an initial public offering from publishing a research report or making a public appearance for 40 calendar days after the offering,8 and the Proposed Rules would prohibit all analysts in that firm from publishing a research report or making a public appearance in the 15 days before and after the expiration of a lock-up agreement or other agreement restricting or prohibiting the sale of shares by the company or its shareholders.9
If the NYSE and NASD consider a further bar necessary to deter analysts and their firms from inappropriate contact with non-public companies, the Firms believe that a finite prohibition on writing and public appearances with regard to a subject company should be sufficient to achieve the stated goals of the NYSE and NASD, without creating professional havoc for research analysts.
Specifically, the Firms would support an extended bar of one year, following the completion of a company's initial public offering, on writing or public appearances, by an analyst where: (i) the analyst had communicated with the company for the purpose of inducing the company to select the analyst's firm as a managing or co-managing underwriter of the company's initial public offering and the communication occurs in the 12 months preceding the filing of the registration statement for the company's initial public offering, and (ii) the analyst continues to be an employee or other person associated with such firm.10
The Firms question whether any bar should continue to apply after an analyst leaves the tainted firm. If a company is significant to the analyst's sector, having a rule that bars the analyst from covering that company effectively bars the analyst from covering in a meaningful way his or her industry sector. This result seems draconian in its impact.11 Rather, the bar should apply to the firm and the analyst only while the offending firm continues to employ the analyst, and as described in the paragraph above, only for one year from the completion of the company's initial public offering. The Firms also seek assurance that the Proposed Rules, if adopted, will not apply retroactively to any analyst contacts that pre-date the effective date of the Proposed Rules.
Proposed amendments to NYSE Rule 472(h)(1) and (2) and NASD Rule 2711(d)(2)
Both the NYSE and the NASD propose to amend their rules to clarify that research analysts cannot receive compensation based on the analyst's "contributions to a firm's investment banking business." The NYSE would further amend its rule to clarify that an analyst may receive compensation based on the firm's overall performance, including the performance of its investment banking department. The NASD rule at present and as proposed for amendment does not include this clarifying language.
The Firms understand that the principle underlying the proposed amendments to NYSE Rule 472 (h) and NASD Rule 2711(d)(2) is that an analyst should never receive compensation based on the analyst's interaction, directly or indirectly, with a firm's investment banking department where that interaction takes place in the context of specific investment banking assignments or transactions.12 The Firms support this concept in principle. However, the Proposed Rules are both inconsistent as between the NYSE and NASD proposals, and ambiguous in their scope.
The clarifying language in the proposed amendments to NYSE Rule 472(h)(2) acknowledges that if a substantial amount of revenue at a firm comes from investment banking an analyst's compensation may to a substantial degree be based on revenue the firm has received through investment banking services, although not based on any direct or indirect efforts by the analyst on behalf of the investment banking department. The proposed amendment to NASD Rule 2711(d)(2) does not.
The Firms seek clarification that the proposed amendments to NASD Rule 2711(d) are intended to parallel the proposed amendments to NYSE Rule 472(h)(2).
The Firms also seek clarification that under the Proposed Rules, it will be permissible for a firm to pay its research analysts based on: (1) the firm's overall profitability, (2) the profitability of the firm's capital markets division, (3) the profitability of the firm's investment banking department, and (4) the profitability of specific industry and/or product groups within the firm's investment banking department. 13
The Firms appreciate this opportunity to comment on the proposed amendments to NYSE Rule 472 and NASD Rule 2711. These comments reflect very real concerns that the Firms have about the likely negative impact on U.S. middle market and emerging growth companies and on investors in these companies should NYSE Rule 472 and NASD Rule 2711 be amended as proposed. To avoid the uncertainty inherent in the language described above, and the negative consequences that are likely to flow from such uncertainty - namely, diminution in the quality of due diligence currently performed on private companies and diminution in value-added research following a company's initial public offering - and to maximize the utility and impact of NYSE Rule 472 and NASD Rule 2711, the Firms strongly encourage the NYSE and NASD to consider these comments and to change the proposed amendments to NYSE Rule 472 and NASD Rule 2711 as suggested in this letter.
If the Commission staff would like to discuss these issues, please feel free to contact the Firms' counsel on this matter, George Simon (312-755-2536) or Amy Kroll (202-295-4157).
cc: William H. Donaldson, Chairman, U.S. Securities and Exchange Commission
Cynthia A. Glassman, Commissioner, U.S. Securities and Exchange Commission
Harvey J. Goldschmid, Commissioner, U.S. Securities and Exchange Commission
Paul S. Atkins, Commissioner, U.S. Securities and Exchange Commission
Roel C. Campos, Commissioner, U.S. Securities and Exchange Commission