Charles Schwab & Co., Inc.
Via Electronic Delivery
March 20, 2003
Jonathan G. Katz
Secretary, United States Securities and Exchange Commission
450 Fifth Street NW
Washington, D.C. 20549-0609
Re: Proposed Rule Changes of New York Stock Exchange and National Association of Securities Dealers, Inc. Relating to Research Analyst Conflicts, File Nos. SR-NASD-2002-154 and SR-NYSE-2002-49
Dear Mr. Katz:
The Charles Schwab Corporation ("Schwab") appreciates the opportunity to comment on the above-referenced proposed amendments to the New York Stock Exchange ("NYSE") and National Association of Securities Dealers, Inc. ("NASD") rules relating to research analyst conflicts of interest ("SRO Proposed Amendments"). Schwab serves its broker-dealer clients through its subsidiaries, Charles Schwab & Co., Inc., Schwab Capital Markets L.P., CyberTrader, Inc. and U.S. Trust Securities. Charles Schwab & Co., Inc. is a NYSE and NASD member firm, and Schwab Capital Markets L.P., CyberTrader, Inc. and U.S. Trust Securities are NASD members.
Schwab strongly supports the ongoing efforts of the NYSE and the NASD (collectively, the "SROs") to put in place, as noted in the SRO Proposed Amendments release,1 additional safeguards intended to protect investors and restore integrity to the public equity markets. We also applaud the ongoing efforts of the Securities and Exchange Commission (the "Commission" or "SEC") in this area, as evidenced most recently by its adoption of Regulation Analyst Certification.
With the hope of enhancing the SRO's ongoing efforts to address research analyst conflicts of interest, we offer below the following comments. Specifically, in section II below we have some specific suggestions regarding how we believe certain of the NYSE's proposed amendments could be modified so that substantive differences between the NYSE's and the NASD's proposals could be best addressed. In sections III, IV and V we have some recommendations and suggestions regarding both the NYSE's and the NASD's proposals relating to personal trading restrictions (as well as the impact of the current SRO research analyst personal trading restrictions on certain research analysts), withdrawal of research coverage of a subject company and the qualification and registration of research analysts, respectively.
I. Background: Research at Schwab.
As noted most recently in our comments to then proposed Regulation Analyst Certification,2 Schwab offers its clients proprietary research, including our Schwab Equity Ratings and other market information and educational tools. Schwab also offers its clients third party equity-related research from sources such as S&P, Argus, First Call and Goldman Sachs. By providing our clients with this information, Schwab strives to empower clients so that they can make better and more informed investment decisions.
Schwab currently offers four types of proprietary research: quantitative research, technical analysis, "public policy" research and fundamental research. These four types of research (collectively referred to in this letter as "Schwab Research") cover a broad cross-section of publicly traded equities. Schwab does not engage in traditional investment banking in equity securities. For example, Schwab participates in the underwriting of common stocks only as a selling group member for which we are not compensated. We currently provide the following types of Schwab Research:
- Quantitative Research. Schwab provides clients with stock ratings based on a systematic quantitative research model containing carefully selected, fixed-weight investment criteria ("Schwab Equity Ratings"). These Schwab Equity Ratings, which are based on objective criteria rather than on subjective judgments about the prospects of individual companies, seek to identify stocks that are undervalued or overvalued. Over 3,000 stocks receive a composite score based on the application of the model. The scores are force ranked and then are assigned a Schwab Equity Rating grade of A, B, C, D or F based on a fixed distribution pattern of approximately 10%, 20%, 40%, 20% and 10%, respectively. Schwab Equity Ratings, which are generally updated weekly, are currently not attributed to individual research analysts, and no research analyst "follows," or "covers" a security, group of securities or sector of the equity market for the purpose of the research model. Additionally, Schwab provides quantitative research to institutional clients.
- Technical Analysis Research. Schwab also provides clients with technical analysis through daily, weekly and monthly market reports that seek to highlight market trends based on certain technical indicators. These reports also may contain proprietary views on specific industry groups and individual issuers and a summary of a particular Schwab technical research analyst's overall view of a sector of the market, or the overall market, from a technical research perspective. While this research is attributed to an individual research analyst, the analyst does not follow or cover particular securities, group of securities or sector of the equity market; rather, the analyst looks for certain technical patterns in the trading of a large universe of securities.
- Public Policy Research. Schwab provides clients with information and insights on the policies and actions of the federal government and other policymakers. This research provides perspectives on policy initiatives that Schwab believes will affect the market generally or specific sectors of the market. Individual issuers may be referenced in parts of this research. While this research is attributed to an individual research analyst and the analyst may follow a particular segment of the market, the analyst does not provide a comprehensive financial analysis of industry sectors or issuers, nor does the analyst make specific recommendations concerning a security. Rather, the research provides information and forecasts about how specific public policy developments may affect sectors or individual securities.
- Fundamental Research. In close association with its public policy research, Schwab also provides clients with research on some industry sectors and issuers. Using a top-down perspective, this research provides more detailed examination of underlying business issues and financial data that may impact a sector or an individual security, and may include analysis of the relative valuation of a particular security within a sector. In these instances, an analyst may follow a particular industry sector.
II. Reconciling Differences between the NYSE Proposals and the NASD Proposals.
Both the NASD's and the NYSE's proposals are designed to enhance investor protection. As such, Schwab strongly believes that there should be no substantive differences between the two sets of proposals. If the NASD's and the NYSE's proposals are adopted as proposed, investors would be accorded different levels of protection, and have access to different disclosure information, based solely upon the SRO membership of the brokerage firm they choose to do business with. We believe that investor protection rules are among the types of rules that should not vary based on which SRO regulates the client's brokerage firm. Similarly, rules governing how a firm must conduct its business activities (in this case its research activities) should not depend on the fortuity of whether it is a member of the NASD or the NYSE or, as in the case of Charles Schwab & Co., Inc., dually registered with both SROs. For such dually registered firms, there is significant cost involved in reconciling substantive differences among SRO rules. We recognize that the SROs and the Commission have made significant efforts to resolve, and in many cases have in fact resolved, many substantive differences in both the current SRO research analyst conflict rules as well as the SRO Proposed Amendments. We do, however, urge the SROs and the Commission to continue with their efforts so that there are workable solutions for eliminating any and all remaining substantive differences between the NASD and NYSE research analyst conflict rules and any accompanying joint SRO interpretive guidance.
We are particularly concerned about the following remaining differences:
- Definition of "Research Analyst." Under the NYSE's proposed amendment to NYSE Rule 472.40, research analysts are defined in relevant part as those individuals who are responsible for one or more of the following tasks: (i) the preparation of research reports; (ii) making recommendations or offering opinions in public appearances; or (iii) establishing a rating or price target of a subject company's equity securities. The NASD defines research analysts as the individuals principally responsible for the preparation of the substance of a research report.3
Under the NYSE's proposed amendment, an associated person making recommendations or offering opinions in public appearances (apparently whether or not they mention a particular subject company's equity securities or even a particular industry, or have ever prepared or contributed to a research report) could be deemed a research analyst. We believe that the NYSE's use of the phrase "making recommendations or offering opinions in public appearances" unnecessarily raises potential interpretive issues and adds ambiguity. For example, the NYSE definition could arguably apply to an associated person's public appearances in which the associated person offers opinions on the economy, the markets generally, investment and stock selection processes and related methodologies, public policy issues or fixed-income securities.
We believe that the NASD's current definition of research analyst is preferable to the NYSE's proposed definition and should, therefore, be adopted by the NYSE. Alternatively, we suggest that the NYSE amend their proposed definition so that it explicitly covers individuals "making recommendations or offering opinions in public appearances regarding a subject company's equity securities." We believe that such modification would address the potential ambiguity that could arise if the NYSE's proposed definition is adopted as proposed.
- Public Appearances With Media Outlets. In the Proposing Release, the NASD modified guidance that the SROs had previously provided concerning the making of required disclosures in public appearances with media outlets.4 Specifically, the NASD indicated in the Proposing Release that a research analyst would not violate the public appearance disclosure rule if the analyst makes the required disclosures to the media in good faith, even if the media outlet does not print or broadcast the disclosure information. Absent similar explicit guidance from the NYSE, it appears that the NYSE is standing by its guidance in the Joint Memorandum. Therefore, for NYSE member firms only, when the firm or the analyst is aware that a media outlet has previously edited out the required disclosures, the expectation is that the analyst will decline subsequent appearances with the particular media outlet unless assurances are provided that applicable disclosures will not be edited out.
Schwab requests that the NYSE adopt the NASD's view that compliance with the rule requires the research analyst to make the required disclosures to the media outlet and that inclusion of those disclosures in a particular public appearance with a media outlet will be subject to the media outlet's editorial discretion.
- Public Appearance Disclosures. Currently, research analysts making public appearances are required to make subject company specific disclosures when they make a recommendation or offer an opinion concerning an equity security.5 The NYSE has proposed an amendment to its Rule 472.50 definition of the term "public appearance," while the NASD has not made a corresponding proposal to amend its definition of the term. If the NYSE proposal is adopted, research analysts associated with NYSE member firms will be required to make applicable public appearance disclosures when they make a recommendation or offer an opinion "concerning any equity securities and/or industries." Research analysts associated with an NASD member firm, however, will continue to be required to make applicable public appearance disclosures when they make a recommendation or offer an opinion "concerning an equity security."
Schwab believes that if the NYSE's proposed amendment is adopted, it will add uncertainty to what is now a straight forward disclosure obligation. We are particularly concerned that, absent guidance to the contrary, a research analyst offering an opinion about an industry would be required to make all of the applicable public appearance disclosures for each subject company within the industry mentioned (which in some instances could be in the hundreds). This situation is likely to be exacerbated due to the NYSE Rule 472(l) proposal regarding "other communication activities,"6 which is discussed in some detail below.
Schwab suggests that the NYSE keep its definition of "public appearance" consistent with the NASD's current definition of the term. Alternatively, Schwab seeks guidance regarding what specific disclosures would be required when a research analyst, or other NYSE member firm employee under proposed NYSE Rule 472(l), recommends or offers an opinion concerning an industry during a public appearance or other communication activity.
- Other Communication Activities. As noted above, the NYSE proposed amendments to NYSE Rule 472(l) specifically address certain "other communication activities" engaged in by NYSE member firms and their employees. The NASD has not proposed an analogous amendment to its rules. Under the proposed amendment, NYSE member firms would be required to establish specific written supervisory procedures relating to such communication activities. The written supervisory procedures would have to include provisions that require "prior approval of such activity" by a designated supervisor.7 Additionally, as noted above, to the extent that these activities include a discussion of specific securities and/or industries, the proposed amendment requires that certain disclosures be made during the communication activity. Schwab has the following additional suggestion regarding this proposed amendment:
Schwab believes that, as proposed, the "prior approval" requirement could prove to be extremely burdensome without adding much benefit in the way of increased investor protections. In certain instances, firm employees, such as those involved in corporate communications, may be involved in numerous such "other communication activities" in a single day or over several days. As proposed, the NYSE Rule 472(l) amendment would appear to require supervisory approval before each and every such communication activity. This requirement may have the unintended result of making it more difficult for key employees to communicate with the news media and others in a timely manner. Schwab suggests that the NYSE provide guidance that firms may, but are not required to, include a prior approval provision in their other communication activity written supervisory procedures or, alternatively, that supervisors can grant prior approval of such activities on a more global basis to employees so that those employees can have their other communication activities approved generally, but not necessarily on an activity-by-activity basis.
III. Restrictions on Personal Trading by Research Analysts and Others.
Under NASD Rule 2711(g) and NYSE Rule 472(e), the SRO research analyst personal trading restriction rules currently apply to research analysts and members of their households. Under the SRO Proposed Amendments, "other persons," such as directors of research, supervisory analysts or members of committees who have direct influence or control with respect to: (i) the preparation of research reports; or (ii) establishing or changing a rating would be subject to the SRO personal trading restrictions. In particular, we share the concern of the Securities Industry Association ("SIA") regarding the proposed extension of the current restriction on research analysts' and their household members' accounts to supervisory personnel and committee members.8 These supervisory personnel and committee members may supervise or oversee numerous research analysts who collectively follow hundreds or thousands of subject companies. Similarly, they may supervise or oversee quantitative research or technical analysis that covers hundreds or thousands of subject companies. In either instance, an extension of the current SRO personal trading restrictions to these supervisory personnel and committee members would effectively bar these individuals from owning individual equities. Such onerous trading restrictions could discourage experienced and qualified people from serving in these important supervisory and oversight roles (which are designed to enhance investor protections).
Therefore, we recommend that the proposal to extend the current SRO personal trading restrictions to supervisory personnel and committee members be replaced by a requirement that firms implement policies and procedures reasonably designed to ensure that the applicable transactions of such supervisory personnel and committee members do not create a conflict of interest between the professional responsibilities and the personal trading activities of the supervisory personnel and committee members.9 We believe that by doing so, the SROs would address any concerns the proposed personal trading restrictions are designed to address (such as trading ahead of research reports), while not putting in place such onerous personal trading restrictions that will likely result in key personnel not wanting to serve in important supervisory and oversight positions or committee membership roles. Schwab also seeks guidance from the SROs on the following issues raised by the current SRO research analyst personal trading restrictions:
- Impact on Quantitative and Technical Analysts. The current SRO research analyst personal trading restrictions appear to contemplate the traditional research model in which a fundamental research analyst follows or covers a particular group of stocks or sector of the market. The impact of those rules on such fundamental research analysts, in most instances, is that the research analyst's personal trading is only restricted with regard to the securities of subject companies they follow or cover. We note, however, that (as similarly discussed in the SIA Letter) for research analysts who are principally responsible for the preparation of research reports based on quantitative models or certain technical analysis10 (both of which can cover and/or rate hundreds or thousands of subject companies), the impact of the personal trading rules can be much greater. These quantitative and technical research analysts (who generally do not follow or cover a particular group of securities or sector of the equity market) can, in some instances, be effectively barred (as well as members of their households and certain people who report to them for purposes of this work) from owning equity securities, because the universe of subject companies that their firm's quantitative research model or technical analysis rates can run into the hundreds or thousands. We believe that in the context of quantitative research or technical analysis, this is an unnecessary and onerous 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. Unlike traditional research reports based on fundamental research, research reports based on a quantitative model are derived from objective criteria rather than on subjective judgments about the prospects of individual companies. Similarly, research reports based on technical analysis are based on the research analyst looking for certain technical patterns in the trading of a large universe of securities rather than subjective judgments about the prospects of individual companies.
Therefore, as similarly noted above regarding supervisory personnel and committee members, Schwab seeks guidance that in cases where a research analyst is principally responsible for the preparation of research reports based on a firm's quantitative model or technical analysis (and where the research analyst does not cover or follow a security, group of securities or sector of the equity market), the firm be required to implement policies and procedures reasonably designed to ensure that transactions in applicable research analyst accounts do not create a conflict of interest between the professional responsibilities and the personal trading activities of the research analyst.
- Managed Accounts. Additionally, Schwab believes that the NASD should clarify that, under the current NASD research analyst trading restrictions, managed accounts that are not controlled by the owner of the account are excepted from the research analyst personal trading restrictions.11
IV. Withdrawal of Research Coverage of a Subject Company.
Under the NYSE's proposed amendment to NYSE Rule 472(f), firms that "withdraw" research coverage of a subject company would be required to provide notice of the withdrawal. Under the proposed NYSE amendment, this notice would have to be made in the same manner as when research coverage was first initiated by the firm and must include the firm's final recommendation or rating. Similarly, under the NASD's proposed amendment to NASD Rule 2711(f), if a firm "intends to discontinue" its research coverage of a subject company, it must provide notice of the withdrawal in the same manner as when the research coverage was first initiated by the firm and must also include the firm's final recommendation or rating.
Schwab generally supports the SROs' proposed amendments in this area and the SROs' stated intention to address situations in which research analysts have discontinued following subject companies without changing their ratings, even though ratings changes may, in certain instances, have been warranted or the practice of dropping coverage of a subject company rather than lowering a rating or a recommendation. We are, however, concerned with how the SROs' proposed amendments would apply to several situations. Specifically, we are concerned about situations in which a firm temporarily withholds a research report or coverage of a subject company: (i) while it assesses, based on significant news or events impacting the subject company, whether to continue offering research on the subject company; (ii) due to the firm's belief that one or more critical data elements concerning the subject company is unavailable; or (iii) because a subject company, at a particular point in time, does not meet certain rating "eligibility" criteria (e.g., a subject company's market capitalization has dropped below a certain minimum level required to be included in the firm's universe of rated subject companies). Each of the situations described above can be temporary in nature. For example, a firm may rate a particular subject company for a long period of time and then, due to one or more of the situations described above, temporarily cease rating the subject company. Shortly thereafter, the firm may, as a result of a change to or resolution of a temporary situation, resume rating the particular subject company. Therefore, Schwab suggests that the SROs include guidance that the term "withdrawal" in the context of their respective amendments is a decision by the firm or the firm's head of research that the firm's applicable research service (e.g., its research based on a quantitative model) will no longer provide research coverage of the issuer's equity securities. By doing so, the SRO rules in this area would distinguish between situations in which a firm withdraws research and the types of temporary situations noted above.
V. Qualification and Registration of Research Analysts.
Schwab supports the SRO Proposed Amendments to require research analysts to be registered with, and subject to a qualification examination by, their SRO.12 However, Schwab has the following suggestions, or seeks clarification, regarding the proposed requirements:
- CFA Level I Exam and Professional Experience. Schwab believes that the SROs should exempt from the qualification examination requirement those research analysts who have passed the CFA Level I examination and/or have, as of the effective date of the amended SRO research analyst conflict rules, been principally responsible for the preparation of the substance of research reports for a minimum of three years.
- "Junior" Analysts. As noted above in section II of this letter, under the current SRO research analyst rules, research analysts generally include those persons who are responsible for the preparation of research reports, as well as individuals who report directly or indirectly to such research analysts in connection with such work. The SRO Proposed Amendments, however, appear to require only those persons who are directly responsible for the preparation of research reports to register with the applicable SRO and be required to pass the qualification exam. Schwab requests clarification as to whether the registration and qualification examination requirements apply only to the research analysts directly responsible for the preparation of the research report (and not to junior analysts).13
* * *
Thank you for providing us with this opportunity to comment on the SRO Proposed Amendments.
Bruce W. Maisel
VP & Senior Corporate Counsel
Charles Schwab & Co., Inc.
|1|| Specifically, SEC Release No. 34-47110 (December 31, 2002) (the "Proposing Release").
|2|| See Schwab's letter to Jonathan G. Katz, Secretary SEC, dated September 23, 2002.
|3|| The NASD's definition is consistent with the analogous definition in the Sarbanes-Oxley Act of 2002, which defines the term "securities analyst" in relevant part as the individuals principally responsible for the preparation of the substance of a research report.
|4|| The SROs had previously provided guidance on this topic in the Joint Memorandum of the NASD and the NYSE. NASD NTM 02-39, July 2002 (the "Joint Memorandum").
|5|| See NASD Rules 2711(a)(4) and 2711(h) and NYSE Rules 472(k)(1) and 472.50.
|6|| Under proposed NYSE Rule 472(l), NYSE member firm employees engaged in such other communication activities (e.g., conducting interviews with the media, writing books, making radio/TV appearances or conducting seminars) will, to the extent the activity includes discussion of specific securities and/or industries, be required to make the public appearance disclosures that are currently only applicable to research analysts during their public appearances.
|7|| Specifically, the proposed amendment requires prior approval of such other communication activity by a person designated under the provisions of NYSE Rule 342(b)(1).
|8|| See the SIA's letter relating to the SRO Proposed Amendments to Margaret H. McFarland, Deputy Secretary SEC, dated March 10, 2003 (the "SIA Letter").
|9|| We note that the NASD has already adopted a similar standard, under current NASD Rule 2711(g)(4)(B), in which a firm's legal or compliance department may authorize certain research analyst transactions that are otherwise prohibited, provided that, among other things, the exception is granted in compliance with policies and procedures that are reasonably designed to ensure that the transactions do not create a conflict of interest between the professional responsibilities and the personal trading activities of the research analyst.
|10|| Excluding technical analysis concerning the supply for a sector, index or industry based on trading volume and price which the SROs, based on guidance provided in the Joint Memorandum, would generally not consider to be a research report.
|11|| Currently, it appears that NYSE Rule 472(e)(4)(v) exempts transactions in these type of managed accounts from the research analyst personal trading restrictions.
|12|| See proposed NASD Rule 1050 and proposed NYSE Rule 344.
|13|| As you know, the SEC recently indicated that under Regulation Analyst Certification, the certification requirements apply only to the analyst or analysts primarily responsible for the content of a research report while junior analysts are not required to certify. SEC Release Nos. 33-8193; 34-47384 (February 20, 2003).