June 25, 2003
By Electronic Delivery
Jonathan G. Katz, Secretary
Re: Amendment No. 2 to Proposed Rule Changes by the New York Stock Exchange, Inc. and the National Association of Securities Dealers, Inc. Relating to Research Analyst Conflicts of Interest, File Nos. SR-NYSE-2002-49, SR-NASD-2002-154
Dear Mr. Katz:
We submit this letter on behalf of Banc of America Securities LLC; Citigroup Global Markets Inc.; Credit Suisse First Boston LLC; Goldman, Sachs & Co.; JPMorgan Securities Inc.; Lehman Brothers Inc.; Merrill Lynch, Pierce, Fenner & Smith Incorporated; Morgan Stanley & Co. Incorporated; and UBS Securities LLC, in response to a request by the Securities and Exchange Commission ("SEC" or the "Commission") for comments regarding Amendment No. 2 to the above-referenced proposed rules by the New York Stock Exchange, Inc. ("NYSE") and the National Association of Securities Dealers, Inc. ("NASD"), collectively, the self-regulatory organizations ("SROs").1
As an initial matter, we strongly support the objectives of the SROs' proposed rule changes, which the SEC initially published for comment on December 31, 2002 ("Proposed Rules") and republished, with amendments, on May 22, 2003.2 In addition, we appreciate the SROs' efforts, through Amendment No. 2, to harmonize certain provisions of NYSE Rule 472 and NASD Rule 2711.3 That being said, we continue to have significant concerns relating to the Proposed Rules, which we expressed in our letter dated March 11, 2003.4 Amendment No. 2 does not address those concerns and, in some cases, exacerbates them by imposing a series of new requirements on research analysts and firms. We urge the Commission to consider and address these concerns prior to taking any final action on the Proposed Rules. For purposes of this letter, we have limited our comments to the matters raised in Amendment No. 2 and certain other areas about which the SEC specifically has requested comment. This letter is intended to supplement, and not supplant, the concerns and comments raised in our March 11 letter.
I. Comments Relating to Amendment No. 2
A. The Proposed Compensation Disclosure Requirement Is Neither Consistent with the Sarbanes-Oxley Act Nor Technologically Practicable.
Amendment No. 2 proposes to require broker-dealers to disclose in research reports whether the broker-dealer and/or its affiliates have received "any compensation" other than for investment banking services from the subject company in the past twelve months.5 According to their Notice of Filing, the SROs have proposed this rule change in order to conform their respective rules to Title V of the Sarbanes-Oxley Act of 2002 (the "SOA")6 and, in particular, Section 15D(b) of the Securities Exchange Act of 1934.
This new requirement, however, goes beyond the mandate of the SOA and is not only inconsistent with the plain language of Section 15D(b), but also with its purpose. Moreover, we believe that the breadth of this new disclosure requirement would create a technological nightmare for broker-dealers, impose onerous costs and burdens, and require a substantial commitment of technology resources, while the disclosure itself would be of marginal benefit to public investors. We set forth our specific concerns and suggestions more fully below.7
1. The Proposed Compensation Disclosure Requirement Is Inconsistent with the Plain Language of Section 15D(b) and the Sarbanes-Oxley Act.
We believe that Amendment No. 2's proposed requirement that broker-dealers disclose any and all compensation received from a subject company by the broker-dealer and its affiliates is inconsistent with the plain language of Section 15D(b) and the SOA. Unlike the SROs' proposed rules, Section 15D(b) and the SOA do not require broker-dealers to track and disclose every dollar that they and/or any of their affiliates may have received from a subject company in any capacity -- without regard to the magnitude of such compensation, and/or the extent to which the persons preparing the research had reason to know about such compensation. Instead, Section 15D(b) requires the SEC, or the SROs upon the authorization and direction of the SEC, to adopt rules reasonably designed:
In drafting Section 15D(b), Congress purposely qualified the compensation disclosure to require disclosure of only compensation that rises to the level of and presents a "conflict of interest" and was "known or should have been known" by the broker-dealer or analyst to exist at the time of the publication of the research report or the public appearance. By requiring disclosure of any and all compensation, the SROs' proposed disclosure requirement disregards the plain language of Section 15D(b).
2. The Breadth of the Proposed Compensation Disclosure Requirement Does Not Serve the Purposes of Section 15D(b) and Title V of the Sarbanes-Oxley Act.
Title V of the SOA is intended to "provide disclosure to investors of certain conflicts of interest that can also influence the objectivity of the analyst in preparing a research report"9 and "to enable the investor to assess whether the relationship is likely to influence the objectivity of the subjective portions of the research report."10 By requiring firms to disclose any and all compensation -- not just compensation that may present a conflict of interest -- the SROs' proposed rules do not serve these goals nor the goal of Section 15D to "provide investors with more useful and reliable information."11
Indeed, the SROs themselves have previously acknowledged that overly-broad disclosures, such as those required in the proposed rules, do not contribute to investors' ability to make judgments about the objectivity of research. In their initial proposals regarding Rule 472 and Rule 2711, respectively, the NYSE and NASD would have required broker-dealers to disclose if they or their affiliates received "any compensation" from a subject company.12 Recognizing that "disclosure of all forms of compensation is too broad," however, the SROs decided to limit their rules to require disclosure of only those particular forms of compensation that could present a real conflict of interest, i.e., compensation received for investment banking services.13
Not only is the utility of a sweeping disclosure obligation questionable, but by requiring broker-dealers to seek out, track, and compile data on any compensation received by themselves and their affiliates, the SROs' proposed disclosure requirements may give rise to the knowledge that creates a potential conflict of interest where no such conflict previously existed. Such a result is hardly consistent with Title V's broader goal of mitigating or eliminating conflicts of interest.
3. The Proposed Compensation Disclosure Requirement Would Impose Extraordinary Financial and Technological Burdens on Firms.
The SROs' proposed requirement that broker-dealers provide real-time disclosures regarding any and all compensation received by them and/or their affiliates from subject companies will impose substantial costs and burdens, require a substantial commitment of technology resources, and create a technological quagmire for firms. For global firms with a multitude of affiliates engaging in a diverse range of activities, implementation of this requirement will be so complex that even if they expend substantial financial resources and personnel to implement the proposed rules, they will never be confident that all of the information they have collected, compiled and disclosed is accurate and complete.
Even within a single broker-dealer, there may be multiple lines of business that utilize different systems for capturing and measuring compensation. While broker-dealers have procedures in place to aggregate revenue data from these systems, they may have to make significant modifications to these systems in order to identify and consolidate payer-specific data on a real-time basis. For some systems, the modifications will cost millions of dollars and hundreds of hours; for other systems (particularly older or foreign systems), technology modifications may not be available at any cost or effort. Reaching out to multiple affiliates increases exponentially the complexity of the task because many affiliates operate on different and/or legacy systems and platforms that do not interrelate to the broker-dealer's systems and platforms. We understand that it is not unusual for global broker-dealers to have several hundred direct subsidiaries and affiliates in as many as 50 different countries: one of our broker-dealer clients has over 1,700 affiliates; another has over 800; a third has over 600; and three others have over 300. These numbers do not include the hundreds of other entities that are affiliated directly or indirectly with these broker-dealers through joint ventures and portfolio investments.14
Costs aside, some firms have told us that such requirements would be impossible to comply with because of the nature of their particular global organizations and systems infrastructure. One firm whose compliance technology group conducted a preliminary assessment regarding the feasibility and cost/personnel impact of complying with the proposed rules told us that 100% accuracy is impossible due to, among other things, the difficulty of properly coding, tracking and compiling payments received by far-flung affiliates engaged in a diverse range of services and legal restrictions relating to the transmission of customer data to the United States.
In addition, the efforts required to compile real-time information could lead to delays in issuing research reports. For example, any corporate transaction or change in business line (e.g., the acquisition of a new company by the broker-dealer or an affiliate) would mean that before any research report could be issued, the broker-dealer would have to take steps to review all compensation received by that business line or new affiliate in the past twelve months. Unless the systems of the new business line or affiliate are designed to provide such information to the broker-dealer's research department on a real-time basis, every research report would have to be delayed until information from the new business or affiliate could be verified manually.
4. The SROs Should Therefore Consider More Reasonable Alternatives to the Proposed Compensation Disclosure Requirement.
For these reasons, we urge the SROs to consider alternatives that are more "reasonably designed" to disclose "conflicts of interest" relating to compensation that are "known, or should have been known," by the broker-dealer or research analyst.15 In particular, rather than requiring broker-dealers to disclose any and all compensation received from subject companies (which is not required by Section 15D(b)), the SROs might require them to disclose that type of compensation that is most likely to present an actual or potential "conflict of interest." To that end, the SRO rules already require broker-dealers to make specific disclosures with respect to any compensation that they or their affiliates have received for investment banking services.16 These disclosures are updated on a current basis. The SRO rules also require broker-dealers to provide updated disclosures regarding any other compensation that may present a "conflict of interest" because of its magnitude and because the associated persons involved in the preparation of the research knew, or had reason to know, of such compensation at the time of the publication of the research report.17
For all other non-investment banking types of compensation that broker-dealers and their affiliates may have received, the SROs should limit their rules to disclosures that are updated on an annual basis. The SROs should require broker-dealers to adopt policies and procedures reasonably designed to identify such compensation. The timing of the periodic updates/due diligence process could be linked to the release of the broker-dealer's annual audited financial statements, the firm's 10-K, or other periodic compilations by the broker-dealer of financial data containing compensation information. Combined with the existing requirements to disclose investment banking compensation and any other material conflicts of interest, this approach would be consistent with Section 15D(b) without requiring broker-dealers to continuously seek out, track and compile information regarding other compensation that was not previously known to the persons preparing the research and, thus, could not have presented a "conflict of interest."
The SROs also should limit this non-investment banking compensation disclosure to compensation received only by the broker-dealer or by an affiliate that is a "covered person" of the broker-dealer under Regulation Analyst Certification ("Reg AC").18 Presumably, affiliates that are not "covered persons" for purposes of Reg AC are sufficiently independent from the broker-dealer and should not be viewed as having the ability to influence the activities of the analysts or the contents of research reports. As such, compensation that these non-covered persons have received should not raise the types of "conflicts of interest" that the SOA was designed to address. Moreover, disclosures regarding such compensation would only weaken the significance of legitimate compensation disclosures and could undermine the information barriers between the non-covered person and the broker-dealer. For non-covered person affiliates, the SROs could require a more general disclosure designed to put investors on notice regarding non-investment banking related compensation that may have been received by those affiliates. To that end, this disclosure could resemble the advisory-type disclosure endorsed by the SEC, SROs and a number of state authorities in connection with their recent settlement with ten major broker-dealers ("Research Settlement").19
In sum, we believe that the compensation disclosure alternative described above better serves the purposes of Section 15D(b) and Title V of the SOA because it targets that type of compensation that may present a "conflict of interest," instead of requiring broker-dealers to provide disclosures regarding any and all compensation that they or any of their affiliates have received from a subject company. This alternative would provide investors with more meaningful information while recognizing the legitimacy of information barriers created for U.S. regulatory, foreign law, or other purposes that firms have implemented between broker-dealers and their affiliates. Finally, this alternative would better satisfy Section 15D(b)'s mandate to adopt rules that are "reasonably designed" to disclose "conflicts of interest" that are "known, or should have been known" by the broker-dealer or research analyst.20 We encourage the SROs to consider this alternative or other options that would be consistent with the language and purpose of Section 15D(b) and more technologically feasible for broker-dealers to implement. We would be happy to schedule a meeting with the SROs or the SEC to discuss such matters.
5. The SROs Also Should Consider More Reasonable Alternatives to the Proposed Client Services Disclosure Requirement.
Although the above discussion focuses on the SROs' proposed compensation disclosure requirements, we believe that the same concerns apply to the proposed disclosure requirements regarding client services.21 For the reasons set forth above, the SROs should require broker-dealers to disclose those types of services that are most likely to present an actual or potential "conflict of interest," instead of requiring them to disclose any and all services provided to subject companies. To that end, the SRO rules already require broker-dealers to make specific disclosures regarding investment banking services, which are updated on a current basis. For disclosures regarding other services, the SROs should require broker-dealers to provide disclosures that are updated on an annual basis and that are tied to the receipt of compensation from the subject company for such non-investment banking, securities-related services or for non-securities services. Such an approach would be consistent with Section 15D(b) because it would not require broker-dealers to continuously seek out, track and compile information regarding other services that was not previously known to the persons preparing the research and, thus, could not have presented a "conflict of interest."
B. The SROs Should Provide Firms with Greater Flexibility To Document Compliance with the Public Appearance Disclosure Requirements.
We appreciate the NYSE's proposal to modify its June 2002 guidance that analysts must refrain from further interviews, articles or broadcasts if a media outlet fails to publish or broadcast the required public appearance disclosures.22 However, we are concerned that the new recordkeeping requirements for public appearances in the NYSE's proposed interpretation to Rule 472(k)(1) are impractical and fail to take into consideration the realities of analysts' business and travel schedules. In that regard, the NYSE's proposal would require the individual analyst (as opposed to the analyst's delegate) to prepare a record before the opening of business on the next business day (regardless of the time or location of the public appearance) and record, at a minimum: (1) the name of the analyst; (2) the name of the publication; (3) the date of the interview, article, or broadcast; (4) the name of the interviewer; (5) the name(s) of the securities recommended; and (6) the specific disclosures provided to the print or broadcast media source and/or interviewer. This very specific "one size fits all" approach contrasts sharply with the more practical guidance set forth in NYSE Rule 472(c) that provides firms with flexibility in developing written procedures that are "reasonably designed to ensure that members, member organizations and their associated persons are in compliance with this Rule."23 Presumably, under a "reasonably designed" standard, firms should have the flexibility to maintain records of public appearances "that are sufficient to record the statements made by the research analyst."24
We are concerned that the procedures proposed by the NYSE would result in a dramatic reduction in the number of public appearances and interviews that firms permit analysts to make. Due to the impracticability of complying with every aspect (in particular, the timing) of the NYSE's prescribed recordkeeping requirements, analysts would also decline requests for comments by media outlets. As a result, the proposed recordkeeping requirements would chill important speech, depriving public investors of valuable market information. For these reasons, we encourage the NYSE and the NASD to adopt recordkeeping requirements that provide firms with flexibility in devising procedures to demonstrate an analyst's compliance with the disclosure requirements. For example, the NYSE could permit analysts to delegate their obligation to create records of public appearances and revise its proposal so that the six categories of information enumerated above represent guidelines, as opposed to information that analysts "must record at a minimum." In addition, we urge the NYSE to avoid imposing rigid timing requirements for when such records are created. Finally, we assume that the SROs will clarify that member firms of both the NYSE and NASD need not comply with two sets of recordkeeping requirements for public appearances.25
II. Comments Relating to the Overlapping Provisions in Addendum A
In addition to requesting comment on Amendment No. 2, the SEC specifically solicited comment on those aspects of the Proposed Rules that overlap, but are inconsistent with, elements of the Research Settlement. As part of the Research Settlement, each of the settling broker-dealers agreed to comply with a set of undertakings ("Addendum A") relating, among other things, to the activities of research analysts and required disclosures for research reports.26 We believe that the fundamental overlapping, but inconsistent, area in the Proposed Rules and Addendum A that should be addressed relates to their respective definitions of "research report" and persons who qualify as "research analysts" or "Research" personnel.27 For the reasons discussed below, we believe that the SROs should adopt the definitional approach in Addendum A that they, along with the SEC, specifically endorsed in connection with that settlement.
A. The SROs Should Revise the Definition of "Research Report" To Be Consistent with Addendum A.
As we noted in our March 11 letter, we are concerned that the open-ended definition of "research report" in the Proposed Rules will turn on its head traditional and common-sense understandings of what constitutes a research report.28 Although the SROs have provided some examples of the types of communications that generally would not constitute a "research report," this guidance is extremely limited.29 Even with this guidance, communications that traditionally never have been considered "research reports" could fall under the SROs' broad definitions despite the fact that there is little or no opportunity for these types of communications to be tainted by an analyst's or firm's conflict of interest bias. In addition, under the SROs' definitions of "research report" and "research analyst" (which we discuss below), written or electronic communications of persons who are not research personnel, such as investment bankers, salespeople, and traders, could just as easily constitute "research reports" as the written or electronic communications of traditional research analysts.
In contrast to the Proposed Rules, Addendum A defines "research report" in a manner that more appropriately targets the types of communications that we believe Congress intended to address in Title V of the SOA -- i.e., written or electronic analyses of companies or securities by traditional research analysts whose principal responsibility is to publish research reports that are regularly issued to public investors and who typically cover companies in a certain sector or industry.30 For example, Section I.1.e.ii of Addendum A specifically excludes from the definition of "research report" two important categories of communications by non-research personnel: (1) 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; and (2) 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.
We urge the SROs to modify their rules to reflect these excluded categories and also to consider expanding the first category to cover communications by any other non-research personnel, in particular investment banking personnel. Such modifications would not only provide a more workable definition of "research report," but also would be consistent with the SROs' proposed amendments to restrict non-research personnel (other than legal or compliance personnel) from reviewing research reports prior to their publication.31 In this regard, the SROs' proposed restrictions on pre-publication review of research reports by non-research department personnel would make sense only if the term "research report" presumptively excludes communications that are prepared by non-research personnel.
In addition, we encourage the SROs to expand upon the guidance in their Joint Memorandum regarding the types of communications that generally will not be considered to be "research reports"32 and reflect the following additional categories of communications by research and non-research personnel that are excluded from the definition of "research report" in Section I.1.e.i of Addendum A:
As we emphasized in our March 11 comment letter, it is critical that the SROs provide greater clarity regarding the meaning of the term "research report." While the above modifications would not resolve all of the vagaries in the SROs' definition of "research report," we believe that they would alleviate many of the problems associated with that overly-broad definition.34
In addition, such modifications are necessary to prevent the patchwork, contradictory regulatory scheme that inevitably would flow from the overlapping, but inconsistent, provisions in the Proposed Rules and Addendum A. As the SEC and the SROs are well aware, it is critical from both a regulatory and industry perspective to implement a set of coherent, uniform rules. Although Addendum A, on its face, only applies to the broker-dealers that are parties to the settlement, as a practical matter, state regulators and other third parties will impose those terms on other broker-dealers.35
B. The SROs Should Revise the Definition of "Research Analyst" To Be Consistent with Addendum A.
Under the Proposed Rules, an individual's job title and actual responsibilities are irrelevant for purposes of determining his or her status as a "research analyst."36 To this end, an investment banker, salesperson, or trader would be deemed to be a "research analyst" if he or she prepares a single communication that falls under the open-ended definition of "research report." As "research analysts," their communications, personal trading, supervision and even compensation would be restricted to the same extent as those of traditional Research Department analysts. We believe that these extraordinary consequences do not serve the interests of the public and, ultimately, would harm investors by disrupting the flow of information to the marketplace from non-research market professionals. Moreover, as noted above, the SROs' current expansive definition of "research analyst" is inconsistent with Section 15D(a)(1)(A)'s requirement that the SROs restrict "the pre-publication review or approval of research reports by persons employed by the broker or dealer who are engaged in investment banking activities, or persons not directly responsible for investment research, other than legal or compliance staff," as well as the SROs' proposed restrictions on pre-publication review by non-research personnel.37
To avoid these unintended and unworkable consequences, the SROs should adopt the definitional approach in Addendum A, which defines "Research" personnel as "all firm personnel engaged principally in the preparation and/or publication of research reports . . ."38 We believe that the definitional approach in Addendum A more accurately addresses the SOA's emphasis on persons whose primary job responsibility is to cover companies and the conflicts of interest that may arise in a full-service brokerage firm where a research analyst "covers" and writes research reports about a company.39 In addition, it is more consistent with a description of the term "research analyst" provided by the SEC as "persons who study publicly traded companies and make recommendations on the securities of those companies."40
III. The Effective Dates Are Not Feasible and Should Be Extended
Amendment No. 2 would impose a series of new requirements on broker-dealers. While many of these requirements relate to behavioral changes and can be implemented within the proposed timeframes, certain requirements will necessitate substantial systems and information technology changes, as well as significant capital expenditures and personnel adjustments. In particular, it will be extremely difficult for firms to comply with the compensation and services disclosure requirements even if the SROs revise the proposed disclosure requirements as we suggest, above.
We urge the SROs to extend the effective dates of the new compensation and services disclosure requirements to allow firms to comply with the new rules within a reasonable and realistic timeframe. The proposed implementation schedule provides firms with only four months to develop and implement procedures and systems necessary to comply with these requirements. We understand, however, that these new disclosures will necessitate far greater technological adjustments and the diversion of more firm resources than the disclosures regarding receipt of investment banking compensation by foreign affiliates and disclosures regarding firm ownership, which went into effect approximately six months after the SEC entered its approval order in May 2002.41 If the SROs adopt the compensation and disclosure requirements in their current forms, they should provide firms with an eighteen month timeframe in which to comply.42 To fail to do so would place firms in an impossible position by requiring them to comply with timeframes that are not technologically feasible.
Thank you for providing us with the opportunity to comment on the SROs' proposed rule changes regarding research analyst conflicts of interest. If you have any questions, or if we can provide any further information, please contact the undersigned at 202-663-6720.
cc: Chairman William H. Donaldson, U.S. Securities and Exchange Commission
Commissioner Paul S. Atkins, U.S. Securities and Exchange Commission
Commissioner Roel C. Campos, U.S. Securities and Exchange Commission
Commissioner Cynthia A. Glassman, U.S. Securities and Exchange Commission
Commissioner Harvey J. Goldschmid, U.S. Securities and Exchange Commission
Robert R. Glauber, Chairman and Chief Executive Officer, NASD, Inc.
Mary L. Schapiro, Vice Chairman and President, Regulatory Policy and Oversight, NASD Inc.
Elisse B. Walter, Executive Vice President, Regulatory Policy and Programs, NASD, Inc.
Thomas M. Selman, Senior Vice President, NASD, Inc.
Richard Grasso, Chairman and Chief Executive Officer, New York Stock Exchange, Inc.
Edward A. Kwalwasser, Group Executive Vice President, Regulation, New York Stock Exchange, Inc.
Donald van Weezel, Vice President, Regulatory Affairs, New York Stock Exchange, Inc.
Annette L. Nazareth, Director, Division of Market Regulation, U.S. Securities and Exchange Commission
Stephen M. Cutler, Director, Division of Enforcement, U.S. Securities and Exchange Commission
Giovanni P. Prezioso, General Counsel, U.S. Securities and Exchange Commission
Robert L.D. Colby, Deputy Director, Division of Market Regulation, U.S. Securities and Exchange Commission
Larry E. Bergmann, Senior Associate Director, Division of Market Regulation, U.S. Securities and Exchange Commission
James A. Brigagliano, Assistant Director, Trading Practices, Division of Market Regulation, U.S. Securities and Exchange Commission
Attachment: March 11, 2003 comment letter