Sullivan & Cromwell LLP
125 Broad Street
New York, New York 10004-2498
June 19, 2003
Via e-mail: firstname.lastname@example.org
Jonathan G. Katz, Secretary,
Securities and Exchange Commission,
450 Fifth Street, N.W.,
Washington, D.C. 20549.
Re: Proposed Rules Regarding Research Analyst Conflicts of Interest - File Nos. SR-NASD-2002-154 and SR-NYSE-2002-49
Dear Mr. Katz:
We are pleased to submit this letter in response to the Commission's request for comments on the proposals by the National Association of Securities Dealers, Inc. ("NASD") to adopt new NASD Rule 1050 and amend NASD Rules 1120 and 2711, and by the New York Stock Exchange (the "NYSE") to amend NYSE Rules 344, 345A, 351 and 472, as contained in Release Nos. 34-47110 and 34-47912 (the "Releases"), and how those proposals relate to the settlement with a number of leading investment banking firms, announced April 28, 2003 (the "Global Settlement").
We have set forth below our comments on specific aspects of the proposals that we believe, based on our review of the proposals and discussions with our clients, can be improved or clarified in a manner consistent with the purpose of the proposals. In general, we believe that, to the extent practicable, NASD and NYSE rules should be consistent with each other, with other applicable rules of the Commission, including Regulation AC, and the terms of Addendum A to the Global Settlement ("Addendum A"). Most broker-dealers will be subject to both sets of SRO rules as well as to the SEC rules, and some will be subject to the terms of Addendum A (which various members of the Commission's staff and the SROs have suggested may form the basis of future rulemaking). In most cases, compliance efforts will be easier for firms to the extent that the applicable rules are uniform when addressing the same matters.
Definition of Research Report
We note that the term "research report" is defined differently in the SRO rules, Regulation AC and Addendum A. Putting aside minor drafting differences and the expansion of the term under Regulation AC to cover debt as well as equity securities (which we recognize is the Commission's policy choice, driven by the more limited focus of Regulation AC on core standards of integrity), we believe that there are two important concepts in the Addendum A definition of "research report" that should be reflected in the corresponding definition in the SRO rules.1
U.S. Customers Only. First, Addendum A expressly limits "research report" to a communication that is "furnished by the firm to investors in the U.S." We believe the SRO definition should be similarly limited. In addition to the compliance benefit that would result from more uniform standards, we believe that this limitation is appropriate as a matter of comity and makes it less likely that SRO-regulated entities would have to operate at a competitive disadvantage in foreign markets relative to non-U.S. firms that are not subject to similar restrictions. We also note that Regulation AC contains a similar limitation. Rule 501 (with respect to research reports) and Rule 502 (with respect to public appearances) make clear that the respective certification requirements apply only to research reports that are published, circulated or provided, and only to public appearances by research analysts whose research reports are published, circulated or provided, to a "U.S. person" in the "United States" (as those terms are defined in Regulation S).
U.S. Issuers and U.S.-Traded Issuers Only. Second, although not expressly contained in the definition of "research report," the provisions of Addendum A make clear that the restrictions on, and requirements in respect of, research activities contained therein apply only in respect of a research report that relates to "either (A) a U.S. company or (B) a non-U.S. company for which a U.S. market is the principal equity trading market." We believe that the SRO rules should be similarly limited.
Exceptions to the Definition of Research Report
The SROs have provided a list of communications that they generally would not consider to be a "research report" for purposes of their rules. 2 The Regulation AC adopting release3 and Addendum A contain similar lists, but those lists include several important exceptions that the SROs' list does not. We believe that these additional exceptions reflect a recognition that broadly worded definitions of research can interfere with a variety of legitimate communications that do not raise the kinds of regulatory concerns that are the focus of rules relating to research analyst conflicts of interest.
We believe that the list of exceptions in the SRO rules should be modified to include all of the exceptions that are provided in Regulation AC and Addendum A. Specifically, the SROs should add the following communications identified in Regulation AC and/or Addendum A:
- Periodic reports, solicitations or other communications prepared for current or prospective investment company shareholders (or similar beneficial owners of trusts and limited partnerships) or discretionary investment account clients, provided that such communications discuss past performance or the basis for previously made discretionary investment decisions (even if they include information reasonably sufficient upon which to base an investment decision or a recommendation or rating of individual securities or companies).
- An analysis prepared for a current or prospective investing customer or group of current or prospective investing customers by a registered salesperson or trader who is (or group of registered salespersons or traders who are) not principally engaged in the preparation or publication of research reports (even if it includes information reasonably sufficient upon which to base an investment decision or recommends or rates individual securities or companies).
- An analysis prepared for a limited group of fewer than 15 persons (even if it recommends or rates individual securities or companies).
- Reports commenting on market (including trading) conditions (if they do not include an analysis of, or recommend or rate, individual securities or companies).
- Reports that recommend increasing or decreasing holdings in particular types of securities (if they do not include an analysis of, or recommend or rate, individual securities or companies).
- Broad-based summaries or listings of recommendations or ratings contained in previously issued research reports (if they do not include any analysis of individual companies).
Definition of Research Analyst
As drafted, the current SRO rules are confusing in respect of who is covered by the rules, and appear to apply more broadly than the SROs may have intended. One source of confusion is the use of different terms by NASD and the NYSE to define the category of covered research personnel. The NASD rules use the term "research analysts" while the NYSE rules use the term "associated persons." Although the SROs apparently intend the two terms to have substantially identical meanings, it is not clear that this is in fact the case.
NASD Rule 2711(a)(5) defines "research analyst" to mean "the associated person who is principally responsible for, and any associated person who reports directly or indirectly to such a research analyst in connection with, preparation of the substance of a research report, whether or not any such person has the job title of `research analyst.'"4 NYSE Rule 472.40, as it would be modified by the pending NYSE proposal, defines "associated person" to include "a member, allied member, or employee of a member or member organization responsible for, and any person who reports directly or indirectly to such associated person in connection with the preparation of research reports, or making recommendations or offering opinions in public appearances or establishing a rating or price target of a subject company's equity securities."
The NASD definition of "research analyst" appears to be limited to natural persons while the NYSE's definition, by its use of the terms "member" and "allied member," appears to include entities as well as natural persons.5 Moreover, the proposed amendments to NYSE Rule 472.40, which would expand its definition of "associated persons" to include anyone "making recommendations or offering opinions in public appearances," would appear to cover, for example, brokers who participate generally at a seminar and other firm personnel that do not fit the generally understood meaning of research personnel.
We believe that the NYSE's definition of "associated person" should be modified to conform exactly to NASD's definition of "research analyst." The NASD's definition is easier to understand, faithful to Section 15D(c)(1) of the Exchange Act and more consistent with Regulation AC and Addendum A.
More important, we believe that concepts similar to the concepts of "exempt investment adviser affiliate," as contained in Addendum A, and "covered person," as contained in Regulation AC, be incorporated into the SRO rules for the reasons described by the Commission in the Regulation AC adopting release, i.e., that entities, departments or divisions that have a sufficient level of independence from the member firm are not as likely to be subject to pressures, such as those to generate investment banking business, that might compromise the integrity of their research and therefore should not be subject to research-related regulations. To qualify for the exception, the entity, department or division should have no officers (or persons performing similar functions) or employees in common with the firm who can influence the activities of the firm's research personnel or the content of the firm's research reports, and the firm should be required to maintain and enforce written policies and procedures reasonably designed to prevent the firm and any of its controlling persons, officers (or persons performing similar functions) or employees from influencing or seeking to influence the activities of research personnel of, or the content of research reports prepared by, the entity, department or division. We believe that the SRO rules should make clear that they do not apply to "exempt investment adviser affiliates."
Expansion of Persons Subject to the Personal Trading Restrictions
Among other things, "research analysts" and "associated persons" are subject to limits on their personal trading in securities under the SRO rules. NASD's proposed amendment to its Rule 2711(a)(5) would expand the definition of "research analyst" to include "such other persons as the director of research, supervisory analyst, or member of a committee who have direct influence or control with respect to (A) the preparation of research reports, or (B) establishing or changing a rating or price target of a subject company's equity securities," but it would do so "[s]olely for the purposes" of the restrictions on personal trading by research analysts.
The NYSE has proposed a similar amendment to its Rule 472.40 and its definition of "associated person." While it appears that the NYSE intends that research directors, supervisory analysts and committee members similarly would be included in the definition of "associated person" solely for purposes of the NYSE's restrictions on personal trading by associated persons, the language of the NYSE's proposed amendment (and its discussion of the amendment in the proposing release) can be read more broadly. Specifically, the NYSE merely states that such persons "are subject to" the NYSE's personal trading restrictions. Without limiting language similar to the NASD's "solely for the purposes of," the proposed amendment can be interpreted to mean that these persons are subject to all of the NYSE's rules applicable to "associated persons," not only the personal trading restrictions. We trust this is unintentional and recommend that the NYSE proposal be modified to make it clear that this broader coverage is solely for the purpose of the NYSE's personal trading restrictions.
Research Blackout When "Lock-ups" Expire
The current analyst rules of the NASD and the NYSE impose certain research blackout periods on member firms. The rules prohibit a member firm that manages or co-manages an equity IPO from issuing research reports on the issuer within 40 days after the effective date of the offering. A 10-day blackout applies to managers and any co-managers of follow-on offerings unless the research complies with Rule 139 under the Securities Act of 1933 and the subject company's securities are "actively traded" within the meaning of Rule 101(c)(1) of Regulation M.
The proposals of both the NASD and the NYSE would extend their blackout periods to prohibit the manager and any co-manager of a securities offering from issuing research reports for 15 days before or after the expiration of any "lock-up" or other agreement that the member firm has entered into with the subject company and its shareholders and that restricts or prohibits the sale of the subject company's securities after the completion of a securities offering. However, neither SRO proposal would provide an exception from the lock-up blackout for research issued pursuant to Rule 139 on a company with actively traded securities; under both proposals, that exception would apply only to the 10-day blackout after follow-on offerings.
We believe that the Rule 139/actively traded exception is appropriate and necessary in the context of a lock-up blackout. This is especially true if the lock-up agreement relates to an offering other than an IPO, since in that context the blackout is more likely to interfere with the normal course of established research coverage.
Research Blackout for Participating Underwriters or Dealers
As noted above, the current SRO rules impose a 40-day blackout period from the effective date of the offering during which a member firm that manages or co-manages an IPO may not publish research on the issuer.6 The SRO amendments would prohibit a member firm "that has agreed to participate or is participating as an underwriter or dealer (other than as manager or co-manager)" in an IPO from publishing research on the issuer within 25 calendar days after the offering date.
We are mindful that the SROs have proposed extending the research blackout in connection with IPOs to participating underwriters and dealers in an effort to comply with Section 15D(a)(2) of the Exchange Act and to "eliminate any possible or potential competitive disadvantage that managers and co-managers are subject to under the current . . . provisions." We do not believe, however, that the statutory language requires the SROs to apply the blackout to every dealer that participates in the offering in any manner, even if the dealer has no agreement with the issuer or any underwriter to distribute the securities or to provide research about the issuer. As proposed, the scope of the blackout is so broad and open-ended as to be indeterminable. For example, when is a dealer that is not a member of the syndicate deemed to be participating in the offering? Is a dealer that purchases securities from an underwriter and resells them for a normal commission participating in the offering for purposes of the research blackout? We believe the blackout should apply only to a dealer that is in privity of contract with the issuer, or with another dealer that is in privity of contract with the issuer, with regard to the distribution of the securities or of research covering the issuer.
Pre-Publication Review of Research Reports
Under current SRO rules, investment banking personnel may review research reports before publication only to verify factual accuracy or to identify potential conflicts of interest, and all communications between investment banking and research personnel concerning a report must be documented and made either through or in the presence of an authorized legal or compliance official.7 Under the proposed SRO amendments, the restrictions on pre-publication review would be extended beyond investment banking personnel to all "non-research personnel," meaning all persons at the firm who are not directly responsible for investment research, other than legal and compliance personnel.
Firms subject to Addendum A will be required to establish an oversight and monitoring committee or committees, comprised of representatives of research management and others as the firm believes appropriate (but not investment banking personnel) (a "Committee"). A Committee would be responsible for reviewing changes in ratings and material changes in price targets contained in the firm's research reports. It is possible that a firm might choose to have persons fitting within the SROs' definition of "non-research personnel" serve on a Committee for good reasons. We believe that the SROs' proposals should be clarified to allow pre-publication review by any person that serves on a Committee or similar body with oversight and monitoring responsibilities for research. We note that allowing such persons would enhance, not detract from, the overriding goal of Section 15D(a)(1) of the Exchange Act, which is "to foster greater public confidence in securities research, and to protect the objectivity and independence of securities analysts."
Restrictions on Research Analyst Compensation
The current SRO rules prohibit a research analyst from being compensated on the basis of a specific investment banking transaction. The pending SRO rule proposals would add additional restrictions requiring, among other things, that a research analyst's compensation be reviewed and approved annually by a committee without investment banking division personnel representation that reports to the member's board of directors or senior executive officer. The committee would be required to evaluate certain performance-based criteria and would not be permitted to consider an analyst's contribution to the firm's investment banking business.
Addendum A restricts research analyst compensation in a similar manner. We believe that Addendum A provides useful guidance on three aspects of the compensation issue that should be incorporated into the SRO rules.
First, like the SROs' compensation rules, Addendum A provides that compensation for professional research personnel may not be based directly or indirectly on investment banking revenues or results. Addendum A, however, further makes clear that compensation may relate to the revenues or results of the firm as a whole. The NYSE's compensation rule similarly provides that the overall results of the firm may be considered, but the NASD's rule is silent on this point.
Second, in light of the definitions of "research analyst" and "associated person" under the NASD and NYSE rules, respectively, which each include personnel that are not principally responsible for the research product, an interpretive question arises as to how the firm's compensation committee should apply the listed performance measures to such persons. Addendum A clarifies that such measures must be employed only to calculate a significant portion of a "lead analyst's" compensation. The term "lead analyst" is defined as those persons principally engaged in the preparation of research reports such that they are required to certify under Regulation AC. We recognize that the SRO rules only require consideration of a listed factor to the extent that it is applicable, but we believe that the SROs should adopt similar guidance in order to eliminate interpretive issues.
Third, Addendum A specifically permits consideration of several factors not referenced in the SRO rules, including: (i) market capitalization of, and the potential interest of the firm's investing clients in research with respect to, the industry covered by the analyst; (ii) research management's assessment of the analyst's overall performance of job duties, abilities and leadership; (iii) the analyst's seniority and experience; (iv) the analyst's productivity; and (v) the market for the hiring and retention of analysts. While we recognize that the list of permissible factors in the SRO rules is not meant to be exclusive, we believe that it would be helpful to firms for the SRO rules to recognize these additional factors explicitly.
* * *
We appreciate this opportunity to comment on the proposed amendments to the NASD and NYSE rules, and we would be happy to discuss any questions the Commission or its staff may have with respect to this letter. Questions may be directed to David B. Harms (212-558-3882) or John T. Bostelman (212-558-3840) in our New York office or to Eric J. Kadel, Jr. (202-956-7640) in our Washington office.
Very truly yours,
SULLIVAN & CROMWELL LLP
|1|| Although Addendum A does not specifically employ the term "public appearances," we believe that, for similar reasons and where appropriate, the modifications we describe below should also be applied to the SROs' definition of "public appearances."
|2|| The list is contained in the Joint Memorandum of NASD and the NYSE interpreting their rules governing research analysts. See NASD Notice to Members 02-39 (July 2002) and NYSE Information Memo No. 02-26 (June 26, 2002) (the "Joint Memorandum").
|3|| See Final Rule: Regulation Analyst Certification, Rel. No. 34-47384 (Feb. 20, 2003), 68 Fed. Reg. 9482 (Feb. 27, 2003), at 68 Fed. Reg. 9485.
|4|| The definition of "research analyst" in the NASD's rules is essentially the same as the definition of "securities analyst" in new Section 15D(c)(1) of the Exchange Act, as added by the Sarbanes-Oxley Act of 2002.
|5|| The definition of "research analyst" under Regulation AC is also limited to "any natural person."
|6|| See NASD Rule 2711(f); NYSE Rule 472(f).
|7|| See NASD Rule 2711(b); NYSE Rule 472(b).