Association for Investment Management and Research
6 March 2003
Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street, N.W., Stop 6-9
Washington, D.C. 20459
Re: NASD and NYSE Rulemakings: Proposed Rule Changes Relating to Exchange Rules 344, 345A, 351 and 472 and the National Association of Securities Dealers, Inc.-File Nos. SR-NYSE-2002-49; SR-NASD-2002-154
Dear Mr. Katz:
The U.S. Advocacy Committee (USAC) of the Association for Investment Management and Research (AIMR)1 appreciates the opportunity to respond to proposals by the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) (collectively referred to as SROs) to revise their respective analyst conflict of interest rules. The USAC is a standing committee of AIMR charged with responding to new regulatory, legislative, and other developments in the United States affecting the investment profession, the practice of investment analysis and management, and the efficiency of financial markets.
We appreciate the renewed effort by NASD and NYSE, through these proposed rule amendments, to strengthen the ability of research analysts to provide unbiased and sound research reports and recommendations without undue influence from their employers. AIMR has been a strong proponent of shoring up safeguards to ensure the integrity of analyst research. In 2002, it issued proposed Research Objectivity Standards (ROS) for managing some of the major conflicts confronting analysts today. The ROS track both in spirit and principle many of the amendments offered through these Proposals.
We therefore support many of the provisions of both the NYSE and NASD proposals, as discussed in detail below. In particular, we offer comments on provisions of the Proposals that address analyst compensation, termination of coverage by analysts, and the proposed registration and qualification requirements for research analysts.
I. Analyst Compensation (NYSE Rule 472; NASD Rule 2711)
We strongly support provisions of the SRO proposals that separate the analyst research function from the investment banking arm of a firm. We believe that research must stand on its own, uninfluenced by explicit or implicit promises of compensation.
A central tenet of AIMR's proposed Research Objectivity Standards (ROS) is that collaboration between the research and investment banking activities of a firm creates severe conflicts of interest for research analysts. Consequently, investment banking firms must segregate research analysts from the investment banking department and ensure that the research or recommendations are not influenced by the investment banking arm.
AIMR's ROS thus not only align themselves with the approach proposed by the SROs in their rule proposals, but also require additional safeguards to ensure the continued integrity of the research reports. Section 4 of the ROS provides that
Firms that engage in, or collaborate on, investment banking activities must:
(a) Establish and implement effective policies and procedures that:
i. Segregate research analysts from the investment banking department; and
ii. Ensure that investment banking objectives or employees do not have the ability to influence or affect research or recommendations;
(b) Implement reporting structures and review procedures that ensure that research analysts do not report to, and are not supervised or controlled by, investment banking or another department of the firm that could compromise the independence of the analyst; and
(c) Implement procedures that prevent investment banking or corporate finance departments form reviewing, modifying, approving or rejecting research reports and recommendations on their authority.
The AIMR ROS also specifically address research analyst compensation. Section 5 provides that
Firms must establish and implement salary, bonus, and other compensation for research analysts that:
(a) Align compensation with the quality of the research and the accuracy of the recommendations over time; and
(b) Do not link compensation to investment banking or other corporate finance activities on which the analyst collaborated (either individually or in the aggregate).
This section of the ROS encourages firms to develop measurable criteria for assessing the quality of research, including the reasonableness and adequacy of the basis for any recommendation and the accuracy of recommendations over time. Firms should also implement compensation arrangements that depend on these measurable criteria and that are applied consistently to all research analysts.
II. Notice of Final Rating (NYSE Rule 472; NASD Rule 2711)
As proposed, SRO rule amendments would require a member to publish notice of its withdrawal from/termination of research coverage of a company. In addition, the member must publish the final rating or recommendation. As noted by the NASD, this amendment is intended to eliminate the practice of simply dropping the coverage of a company, rather than lowering the rating or recommendation.
We support this approach. We believe that investors are entitled to receive a direct statement of termination of coverage and to receive information related to this termination.
AIMR's ROS specifically address this area. Section 8.2 states that
Firms should not quietly and unobtrusively discontinue coverage of a subject
company. When coverage of a subject company is being discontinued, firms
should require the research analyst to issue a "final" research report that
includes a recommendation. The final report should clearly explain the
reason for discontinuing coverage.
III. Registration and Qualification of Research Analysts (NYSE Rule 344; NASD Rule 1050)
Under current rules, the NYSE exempts those who have passed Level I of the Chartered Financial Analysts examination from its qualification requirements for supervisory analysts. We strongly urge that this exemption be extended by the NYSE to "securities analysts" and by the NASD to "research analysts."
NYSE Rule 344-Securities Analysts and Supervisory Analysts
Proposed amendments to NYSE Rule 344 require securities analysts and supervisory analysts to be registered with, qualified by, and approved by the Exchange. As explicitly provided for under this rule, supervisory analysts may meet this requirement by passing "a specified level of the Chartered Financial Analysts Examination prescribed by the Exchange and pass only that portion of the Exchange Supervisory Analysts Examination dealing with Exchange rules on research standards and related matters."
Under definitions proposed under this rule, "securities analyst" includes a "member, allied member or employees who is directly responsible for the preparation of research reports" while "supervisory analyst" includes a "member, allied member or employee who is responsible for approving research reports under Rule 472(a)(2)." If those responsible for approving research reports qualify by passing a level of the CFA exam, it is tautological that the same approach should apply to those preparing the report for review and approval. We thus urge the NYSE to apply the same approach taken with respect to the qualification of supervisory analysts to research analysts for purposes of amendments to Rule 344.
NASD Rule 1050-Research Analysts
NASD proposes to create a new rule that would require all persons that are associated with a member that function as research analysts to register with the NASD, which includes passing a qualification exam for research analysts specified by the NASD. "Research analyst" is defined as any associated person who is directly responsible for the preparation of research reports.
In their proposals, neither the NASD, nor the NYSE addresses the basis for these proposals to require qualification exams for securities analysts (NYSE) or research analysts (NASD). If these changes are to address competence, the CFA designation represents the pinnacle of professional competence throughout the industry. If the qualification process is being required out of a desire to address situations where analysts failed to act professionally, or in the best interests of their clients, attainment of the CFA designation also meets that challenge.
AIMR administers and maintains the CFA examination program and designation. This designation is widely accepted throughout the world as the globally recognized standard for measuring the competence and integrity of financial analysts. Three levels of examination measure a candidate's ability to apply the fundamental knowledge of investment principles at a professional level.
Even after passing all levels of the CFA exam, an individual must meet certain experience requirements and agree to comply with a strict code of ethics and standards, in order to receive the CFA designation. To maintain the right to use the CFA designation, CFA charterholders must adhere to the AIMR Code of Ethics and Standards of Professional Conduct (Code and Standards) in their day-to-day practice in the investment industry, attest annually in writing to compliance with this strict code of ethics and standards of practice, and self-report any violations or complaints about their professional competence. Failure to make this attestation can result in summary suspension of the right to use the CFA designation and membership in AIMR. In addition, AIMR enforces the Code and Standards. Sanctions for violations range from private censure up to revocation of the AIMR membership and the right to use the CFA designation.
As discussed in detail in Attachment A to this letter, the CFA designation-replete with its rigorous exam, and the Code of Ethics and Standards of Professional Conduct, with which all CFA charterholders must comply-in spirit and substance meets the objectives for which these qualification exams would appear to be designed. We therefore respectfully urge the NASD to exempt those who have passed the CFA exam from this qualification exam.
As discussed in the Attachment, the CFA Program tests on a broad spectrum of substantive areas. In addition, high ethical and professional standards are the cornerstone of the CFA Program. Accordingly, they are tested at each level of the CFA examination. The Ethical and Professional Standards section of the CBOK in each Study Guide sets forth four separate topics that the candidate must master. In addition, each Study Guide for the Level II and Level III exams devotes two study sessions solely to ethical and professional standards.
To reflect the importance that the CFA Program places on high ethical and professional standards, the Level I exam allocates 15% to Ethical and Professional Standards; and Level II and III exams each allocate 10%. In addition, candidate responses to the ethics questions are a material factor in the review of marginal examinations.
In addition, prior to receiving the CFA designation, each candidate must:
- sign and submit a professional conduct statement;
- sign and submit a certification form agreeing to comply with AIMR's rules and regulations, and acknowledging the authority of AIMR's Professional Conduct Program to enforce the Code and Standards; and
- exhibit a high degree of ethical and professional conduct.
In order to retain the right to use the CFA designation, each CFA charterholder and, to continue in the CFA program, each candidate must file a Professional Conduct Statement annually in which they renew their pledge to comply with the Code and Standards and voluntarily disclose any ethics-related complaints that may have been lodged against them. Each disclosure is reviewed independently and may result in an investigation by the AIMR Professional Conduct Program. Sanctions entered against those candidates found to have violated the Code and Standards may include suspension or permanent dismissal from the CFA program.
The AIMR Code and Standards address many areas of practice, all with the focus on maintaining the highest ethical standards in the investment management profession. We believe that it is noteworthy that several specific standards speak to the heart of the commitment that appear to have been lacking in publicized cases of analyst behavior, and that may account, in part, for the SROs' decision to require a qualification exam.
For example, Standard IV (B.1)-Fiduciary Duties expressly provides that "Members must act for the benefit of their clients and place their clients' interests before their own." As noted in the text accompanying this standard, "the duty required in fiduciary exceeds that which is acceptable in many other business relationships because the fiduciary is in a position of trust. Fiduciaries owe undivided loyalty to their clients and must place client interests before their own."
Standard IV (A.1)-Reasonable Basis and Representations requires members to
- Exercise diligence and thoroughness in making investment recommendations or in taking investment actions;
- Have a reasonable and adequate basis, supported by appropriate research and investigation, for such recommendations or actions;
- Make reasonable and diligent efforts to avoid any material misrepresentation in any research report or investment recommendation; and
- Maintain appropriate records to support the reasonableness of such recommendations or actions.
Standard IV (B.2)-Portfolio Investment Recommendations and Actions, among other things, requires members to
- Consider the appropriateness and suitability of investment recommendations or actions for each portfolio or client... Members shall not make a recommendation unless they reasonably determine that the recommendation is suitable to the client's financial situation, investment experience, and investment objectives; and
- Distinguish between facts and opinions in the presentation of investment recommendations.
Taken together, these standards effectively mandate that (1) if compensation is received by an analyst, it does not unduly influence recommendations provided a client so as to place the analyst's interests before its client's; (2) that recommendations provided by analysts in any forum are thorough, reasonable, have an adequate basis, and are suitable for a particular client; and (3) that investors receive investment recommendations that distinguish fact from an opinion.
As discussed above, we believe that CFA charterholders-through their knowledge of the substantive areas tested by the three levels of the CFA examination, and the experience they must have to be awarded the charter-amply demonstrate that they are fully qualified industry professionals. CFA charterholders also bring with them an additional, vital characteristic: an abiding commitment to high ethical standards. We submit that this demonstrated commitment is central to addressing some of the issues that contributed to the current question about the integrity of the markets, and will serve over time to bolster the confidence of investors as companies set out to implement new oversight procedures.
Continuing Education Requirement
Through their rule amendments, both the NYSE and NASD seek to impose continuing education requirements on securities analysts/supervisory analysts, and research analysts, respectively. Without providing much detail, they speak of training in rules, regulations, ethics and professional responsibility.
As noted above, CFA charterholders are committed to promoting and maintaining the highest ethical and professional standards in the industry--a commitment that is first ignited through the CFA Exam Program, and continued throughout the charterholder's career. In addition to the AIMR Standards of Practice, AIMR offers charterholders and members hundreds of hours of continuing education opportunities each year. With its emphasis on ethics, AIMR's continuing education program covers a broad spectrum of industry issues through in-person meetings, seminars and conferences; web-based programs; and publications, including the highly-regarded Financial Analysts Journal, which each AIMR member receives quarterly. In addition, AIMR Societies and Chapters throughout the country offer a variety of continuing education opportunities on their own, including conferences and seminars on timely industry developments, speaker series, and web casts.
We applaud the SROs for their efforts to address certain conflicts that have faced analysts in the industry over the years, and generally support the approaches taken in these proposals. We do, however, strongly urge both the NYSE and NASD to provide CFA charterholders a waiver from the qualification exams that are being proposed. We believe that as discussed above, the CFA Examination Program not only tests for high levels of competence in a wide variety of specific areas, but also is responsive to the ethics and professional responsibility components that are of concern to the NYSE and NASD.
If we can provide additional information, please do not hesitate to contact Deborah Lamb at 770.971.7010, firstname.lastname@example.org or Linda Rittenhouse at 434.951.5333, email@example.com.
|/s/ Deborah A. Lamb
Deborah A. Lamb
Chair, U.S. Advocacy Committee
|| /s/ Linda L. Rittenhouse|
Linda L. Rittenhouse
Staff, AIMR Advocacy
Cc: Members of the U.S. Advocacy Committee
Rebecca T. McEnally, CFA, PhD.,
Vice President-AIMR Professional Standards and Advocacy
|1 || With headquarters in Charlottesville, VA and regional offices in Hong Kong and London, the Association for Investment Management and Research® is a non-profit professional association of over 62,,000 financial analysts, portfolio managers, and other investment professionals in 114 countries of which 49,700 are holders of the Chartered Financial Analyst® (CFA®) designation. AIMR's membership also includes 122 affiliated societies and chapters in 40 countries. AIMR is internationally renowned for its rigorous CFA curriculum and examination program, which has more than 98,000 candidates from 148 nations enrolled for the June 2003 exam.
Attachment A to AIMR Letter to SEC
Re: NYSE/NASD Proposals-File No. SR-NYSE-2002-49; SR-NASD-2002-154
Discussion of CFA Examination Program
A. Overview of the CFA Program
The CFA Program, which is developed and administered by AIMR, seeks to represent to the investing public, employers, and fellow investment professionals that a holder of the CFA designation possesses the fundamental knowledge and commits to adhere to ethical standards necessary to practice in the investment and securities profession. Accordingly, in order to obtain the CFA designation, a candidate must pass a rigorous series of exams designed to test the CFA candidate on a broad spectrum of subjects that are essential to the competent and ethical practice of investment management activities. These subjects include:
- Ethical and professional standards;
- Financial statement analysis;
- Analysis of equity investments;
- Analysis of debt investments;
- Portfolio management;
- Analysis of derivatives;
- Quantitative methods;
- Corporate finance; and
- Analysis of alternative investments.
Today, the CFA designation is a credential recognized throughout the world as signifying the highest achievement in the investment profession. Since the first CFA designation was awarded in 1963, more than 56,000 professionals have become CFA charterholders.
Each year, the number of candidates who take the CFA exams continues to grow. Over 100,000 candidates from 148 countries enrolled for the 2002 CFA Exam, and over 98,000 to date have enrolled for the June 2003 Exam. In the United States alone, over 31,900 individuals have received the CFA designation. The dramatic growth in the number of candidates pays tribute to the value investment professionals place on the CFA Program and their desire to achieve and maintain the highest standards of professional excellence and integrity.
In order to be awarded the CFA designation, a candidate must fully satisfy the program's requirements in three primary areas. First, a candidate must demonstrate comprehensive knowledge of securities analysis and valuation, and investment and portfolio management by sequentially passing a series of rigorous examinations that are administered over a minimum of three years-the Level I, Level II and Level III examinations. Second, the candidate must have accrued at least three years of acceptable professional experience in financial analysis, investment management, securities analysis and other similar professions. Third, a candidate must agree to comply with a stringent code of ethical and professional standards-the AIMR Code of Ethics and Standards of Professional Conduct.
B. CFA Examinations
The CFA program is designed so that, by the time a charter is awarded, the CFA charterholder has not only mastered the basic competency areas, but has a substantial breadth of investment knowledge. Unlike other designations, the CFA program is not solely academic. A candidate will not receive the CFA designation until he/she has at least three years of relevant experience in the investment profession. The exam's focus on practical applications of investment management and financial analysis, coupled with practical experience in these fields, allows the CFA charterholder to apply his/her education in a meaningful manner. Thus, the process of becoming a CFA charterholder demands a candidate demonstrate broad, substantive knowledge and understanding of all aspects of the investment profession.
(b) Requirements of the CFA Examination Program
To be awarded the CFA designation, a candidate must pass three comprehensive examinations - Level I, Level II and Level III. Each Level exam is administered once a year. Given the degree of difficulty of the exams, candidates do not always pass the exams in successive years. Examination pass rates have varied over time and across exam levels. For example, over the entire history of the examinations, the average pass rate has been 54% for Level I, 56% for Level II, and 69% for Level III. In 2002, the pass rate was 44% for Level I candidates, 47% for Level II candidates, and 58% for Level III candidates.
(i) Sitting for the Exam
To enroll and sit for the CFA exam, an applicant must, in addition to other requirements: (i) have a bachelor's degree or the equivalent in qualified investment work experience; and (ii) complete an AIMR professional-conduct inquiry form demonstrating that the individual understands, maintains, and adheres to the AIMR Code and Standards and that he/she has not been convicted of any felony or, within the last ten years, a misdemeanor for a crime of moral turpitude (e.g., lying, cheating, stealing).
Each exam is prepared at AIMR in conformity with industry testing standards. Exams are printed under secure conditions, sealed prior to delivery, and stored in a locked and access-controlled storage area until distributed to candidates at the exam. Exam site supervisors and proctors ensure the integrity of the testing process in accordance with the AIMR "Security Controls and Procedures" manual specifically prepared for the AIMR CFA Program by security experts.
(ii) Content - The Candidate's "Body of Knowledge"
All three levels of the CFA exam require the candidate to demonstrate a thorough understanding of, and the ability to apply, a substantial amount of information on a broad range of topics. Since the CFA curriculum is grounded in the practice of investment analysis, valuation, and management, AIMR periodically conducts a "job analysis" by surveying CFA charterholders throughout the world on the "elements of the body of investment knowledge" that are most important in their practice. These surveys contribute to the development and maintenance of the CFA "Candidate Body of Knowledge" ("CBOK®") and help determine the appropriate emphasis each subject matter receives on the examination.
The CBOK is the basis of the CFA exam curriculum. Each of the three levels of the exam tests candidates on their knowledge of specific subjects contained within the CBOK. It is organized along functional lines to track changes in the investment decision-making process and is updated regularly.
The major functional areas of the CBOK are:
- ethical and professional standards;
- tools and inputs for investment valuation and management (investment tools);
- asset valuation; and
- portfolio management.
(iii) Selection of Questions
Questions for each CFA Level exam are written by an AIMR standing committee called the "Council of Examiners" (COE). The COE consists of prominent practitioners and academicians, all CFA charterholders. In writing questions, the COE uses learning outcome statements ("LOS") developed by another AIMR standing committee, the "Candidate Curriculum Committee" (CCC). The CCC, also composed of CFA charterholders, selects the appropriate texts and readings to address the topics in the CBOK, which the candidate will use in studying for the exam. LOS are provided for each assigned reading and indicate the specificity and level of knowledge that is expected for each topic area. The COE writes the exam questions to test the specific "learning outcomes" designed for each reading.
(iv) Exam Preparation
In order to prepare for each level of the CFA exam, a candidate receives a Study Guide that provides basic information on the CFA program, organizes the assigned readings into separate "study sessions", and provides the required reading list for the relevant level exam. Primary Readings are the core of the study program and form the basis for exam questions. For the 2003 exams, the required textbook readings consist of nine sources for Level I, ten sources for Level II, and eight sources for Level III; these textbooks are supplemented at all three levels by a variety of articles, readings, monographs, and selected textbook chapters. In addition, the Study Guides provide lists of suggested Preliminary Readings and Supplementary Readings on specific study topics. As noted above, each Study Guide also provides LOS or "expected learning outcomes," which indicate the level of knowledge a candidate should demonstrate with respect to each reading, as well as the relevant CBOK that the candidate is expected to master. Each level exam requires an average of over 250 hours of individual study time.
The CFA Level I exam is a multiple-choice exam and is scored by computer. The format of both the Level II and Level III CFA exams consists of 50% "item set" questions and 50% essay/short answer questions that are assigned maximum point values based on the number of minutes allocated to the question. Item set questions are also scored by computer. The essay/short answer questions on both Level II and Level III exams are graded by a carefully selected group of approximately 650 CFA charterholders from around the world who are practitioners or academics. Each grader is assigned to a grading team that grades a single question which helps to ensure consistency in grading and allows each grader a greater degree of specialization.
Each exam question is graded in accordance with a guideline answer and grading key that are developed by the Council of Examiners and members of AIMR senior professional staff. Each grading team captain receives statistical reports during grading about the work of his/her team to ensure that grading is done consistently and in accordance with the grading key. Senior graders re-grade marginal exams in their entirety during the second week of grading.
The AIMR Board of Governors determines the "minimum passing score" (MPS) for each level of the exam. The goal of the Board of Governors in determining the appropriate MPS for each level is to maintain the integrity of the CFA charter. With that goal in mind, the Board considers, among other factors
- The top-scoring exam responses as an indication of the difficulty of the examinations;
- Recommendations from a panel of CFA charterholders who review the examinations and the quality of candidate responses (Level I only)
- Feedback from those involved in the grading process on the examinations and the quality of candidate responses; and
- Actual candidate responses in papers above and below the minimum passing scores (Levels II and III only).
Level I Examination - Knowledge and Comprehension
The CFA Level I exam is the foundation for the CFA program, focusing on ethical practices and the tools and concepts that apply to investment valuation and management. It also provides an overview of asset valuation and portfolio management. This six-hour exam concentrates on:
- ethical and professional standards;
- investment tools;
- financial statement analysis
- quantitative analysis/techniques
- macro- and micro-economics
- corporate finance;
- asset valuation (equity, fixed income, derivatives, and alternative investments); and
- portfolio management.
Level II Examination - Financial Analysis and Application
The Level II CFA exam builds on the breadth of knowledge obtained from the Level I exam and emphasizes asset valuation, including applications of the tools and inputs (economics, financial statement analysis and quantitative techniques) to the practice of asset valuation. Specifically, the Level II CFA exam tests a candidate's ability to:
- analyze and value debt, equity, and derivative securities and recommend those with the most (or least) attractive expected return/risk characteristics for purchase (or sale);
- apply a top-down valuation approach based on global trends, national economies, industry- and company-specific factors and individual assets characteristics;
- apply an alternative (bottom-up) valuation approach based on the identification of those companies and industries/sectors that are undervalued regardless of the macroeconomics forecast;
- use a variety of valuation techniques and the duPont approach to financial analysis;
- incorporate international factors in asset valuations; and
- apply a knowledge of applicable laws and regulations and the AIMR Code and Standards to recognize and avoid unprofessional practices and violations of standards where issues are not clear (e.g., conflicts of interest, compensation, inside information, corporate governance, proxies, and the "prudent expert rule").
Level III Examination - Synthesis and Evaluation
The Level III CFA exam emphasizes portfolio management, including strategies for applying the tools and inputs in managing equity and fixed-income securities. Specifically, the Level III CFA exam tests a candidate's ability to:
- develop suitable investment policies that meet the specific requirements and circumstances of different types of individual and institutional investors;
- incorporate domestic and international economic forecasts and market conditions into portfolio investment strategies;
- determine asset allocations that are consistent with investment policies and strategies;
- implement portfolio strategies that take into consideration the costs and benefits of timely execution of trades;
- monitor and evaluate portfolio performance and respond to change; and
- design and administer a program of professional and ethical standards within an organization.
Critical regulatory topics, such as fiduciary duty, misrepresentation, disclosure of conflicts, personal trading, insider trading, performance presentation, use of soft dollars, suitability of investments, supervisory responsibility and trade allocation are all tested repeatedly at each level of the CFA exam.
A Level I candidate is expected to demonstrate a thorough knowledge of these topics. Candidates at Level II are expected to differentiate between acceptable behavior in these subject areas and conduct that violates best practices. At Level III, candidates are expected to be able to critique and revise compliance guidelines and policy statements with regard to these subjects. By the time the candidate has completed the CFA Program, he or she is well versed in those subject areas and professional practices involved in the investment-decision making process that are subject to intense regulatory scrutiny.
C. Relevant Work Experience
Successfully completing all three levels of the CFA exam is a major part of achieving the CFA designation. However, to become a CFA charterholder, a candidate must also have three years of acceptable professional work experience in financial analysis, investment management, securities analysis, or similar areas. This work may be accrued before or during the study and examination period or after completion of all three level exams. Moreover, work experience that will qualify for the eventual award of the CFA charter must consist of activities substantially related to the investment decision-making process, the supervision of those who engage in such activities, or the teaching of such activities.