Pacific Growth Equities, Inc.
Four Maritime Plaza
San Francisco, California 94111

April 18, 2002

Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609


NASD Rule Proposal Regarding Research Analyst Conflicts of Interest
(File No. SR-NASD 2002-21)                                                              

Dear Mr. Katz:

           This letter responds to the request of the Securities and Exchange Commission for comments on the proposal by the National Association of Securities Dealers, Inc. ("NASD") to adopt Rule 2711 regarding research analysts and research reports (the "Proposal") as described in Release No. 34-45526 (the "Release").

           Pacific Growth Equities, Inc. ("PGE") is a small firm located solely in San Francisco. It is registered as a broker-dealer under the Securities Exchange Act of 1934 and various states' laws. It is a member of the NASD and no exchanges.

           PGE's brokerage business is focussed on research-driven brokerage in smaller-capitalization growth stocks, particularly in the biotechnology, pharmaceutical, medical technology and technology sectors. Our investment banking activities focus on capital-raising for companies in the same sectors as our brokerage and research activities.

           Our brokerage clients (the audience for which our research reports are written) are almost exclusively institutional and other professional investors.

           We have detailed below specific comments about several specific elements of the Proposal. However, certain general observations underly or inform many of those specific comments.

Impact on smaller firms and competition.

           If adopted as proposed, Rule 2711 would have very significant adverse effects on smaller brokerage firms - effects that are much more keenly felt by those firms than by larger firms. These effects may result not only from significantly increased compliance costs but also from substantive constraints on functions that individual personnel may perform and on smaller firms' ability to attract talented research personnel.

           For example, the Proposal would require legal or compliance personnel to act as intermediaries in many communications between investment banking and research departments. It would also increase the involvement by legal or compliance personnel in reviewing research analysts' personal transactions and research-related activities following analysts' transactions (e.g., updates that respond to news or developments if they occur within 30 days after an analyst effects a personal transaction). The Release acknowledges that imposing "gatekeeping" and other new burdens could require the hiring of additional personnel and commitment of additional resources. The magnitude of the impact of these additional burdens on smaller firms should not be underestimated. Many small firms do not have an in-house legal department or a separate compliance department. Those firms' compliance activities are performed by personnel who are actively involved in other aspects of the firms' business. The Proposal could well, in effect, require these firms to add new personnel who are not able to participate in investment banking or research functions. The impact on a 20-person firm of adding one new employee is almost incomparably greater than the impact on a 200- or 300-person firm of adding two or three new employees. Further, the changes required by the Proposal for a small firm may be structural: the firm may need to reorganize and create a new department, while larger firms may be able to redeploy existing personnel and avoid direct increases in costs.

           These impacts are notable not simply because of the potential unfairness of the impact on the owners and employees of smaller firms, but because of their adverse impact on competition in the delivery of quality research services. The Release states that the NASD does not believe the proposed changes will result in any burden on competition that is not necessary or appropriate. We respectfully disagree with this assessment. The costs of engaging in both research and investment banking will go up and the number of firms that would otherwise compete - not only for investment banking business, but also, on the basis of the quality of their research, for brokerage business - will go down. Particularly with respect to small-capitalization, growth stocks, which have been a tremendous source of vitality and growth in the U.S. economy, this will undoubtedly have an adverse effect on investors. Further, excessive constraints on research personnel's personal investment activities, particularly when accompanied by restraints on compensation techniques, will reduce the number of high-quality analysts willing to build careers working for brokerage firms. Again, this cannot be good for investors or for capital formation activities on behalf of smaller issuers.

Disclosure versus Substantive Restriction.

           The proposed rule imposes significant new disclosure requirements. While we are not necessarily convinced that the level and particular types of disclosure proposed are, in all their particulars, fully warranted, we do believe that full and effective disclosure is the best way to provide substantial additional protection for investors. We strongly believe the proposed disclosure requirements are more than adequate to address the issues that have received so much public attention recently; the proposed substantive restrictions on members' and analysts' activities for the most part are unnecessary and will have little beneficial effect.

           Research reports are opinions. They are not facts and they are not presented as facts. Furthermore, analysts are not portfolio managers. They do not make investment decisions with other peoples' money on the basis their opinions. (1)

           It is impossible to eliminate all conflicts of interest that an analyst may face in formulating his or her opinions. In fact, despite the severe substantive constraints the Proposal would impose, it certainly will not and cannot not eliminate the potential conflict to which it is most expressly directed-pressure on analysts to cause the research they publish to be structured in a way that will help an analyst's employer obtain and keep investment banking business. That conflict is endemic. In fact, the Proposal does not even purport to truly eliminate the potential for an analyst to feel such pressure. It only restricts some of the ways in which the pressure. can be applied. We submit that the most effective substantive check on this potential conflict of interest is the need, particularly for smaller firms serving institutional clients, to preserve their credibility. Over the long run, no regulatory constraint will be as effective as this need.

           Disclosure is at the heart of the U.S. securities laws. As a tool for addressing conflicts of interest it has a long history. In a free market it respects investors' abilities to evaluate information and the circumstances in which information is presented, and is (and should be) generally preferable to prohibitions on particular activities or speech. If a firm discloses fully that its opinions may be influenced by certain activities (either the firm's or its analyst's), if it discloses information sufficient to allow a reader to understand the potential impact of those influences, we do not believe it or its analysts should be prohibited from engaging in particular activities that are otherwise lawful.

Institutional and Other Professional Investors

           Disclosure is more obviously the appropriate remedy when the recipients of research reports are professional investors. Those investors are fully capable of evaluating the factors that inform the opinions they receive.

           Those customers are demanding and critical. They tend to understand implicitly the incentives and forces that influence brokerage firms' opinions. They often consider it a sign of conviction that an analyst owns a stock he or she has written about and ask questions about analyst ownership. Imposing limits that would, as a practical matter, significantly reduce analysts' investment in securities in the industries they cover, would not protect these investors or the retail investors with whom we do not do business. Nor would the proposed restrictions on internal firm structure, compensation and communication. They would only increase the costs involved in producing quality research.

           PGE is smaller than many NASD members specifically because we have chosen to serve only professional investors. We have found that we can provide high quality investment banking and research services with respect to smaller, growth-oriented companies largely because of our "lean," efficient staffing, composed of talented, focussed personnel who understand the needs of the investment professionals that make up our customer base. We think this is beneficial for capital formation for small, growth companies.

           We suggest that, if the NASD determines to adopt the substantive restrictions in the Proposal, an exemption should be available where research is disseminated only to institutional and professional investors and is clearly marked as intended for those types of investor. Qualifying investors could be defined as those whose accounts with the member settle on a "delivery versus payment" basis. The disclosure could include a statement that the report was prepared under conditions that do not comply with certain restrictions imposed by Rule 2711 and that its preparers therefore may have conflicts of interest that they would not have if those conditions were not present.

1. Definitions.

           Many of the prohibitions (and exceptions) in paragraph (g) of the Proposal apply to transactions in a "research analyst account." That term includes any account in which a member of the analyst's "household" has a beneficial interest or over which such a household member has discretion or control. The term "member of a research analyst's household" means any individual with the same principal residence as the analyst. This is a broad formulation that could include potentially inappropriate persons such as roommates, boarders or landlords who are otherwise unrelated to an analyst. We suggest including as a condition that the household member contributes materially to the analyst's support, or that the analyst contributes materially to the household member's support, similar to the tests in NASD's IM-2110-1 and proposed Rule 2790.

2. Rule 2711(b) -- Restrictions on Investment Banking Department Relationship with Research Department:

      a.   Paragraph (b)(1) of the Proposal prohibits a NASD member to allow any research analyst to be "subject to the supervision or control of any employee of the member's investment banking department." PGE's chief executive officer is the supervisor in charge of, and is actively involved in, the firm's investment banking activities. He is on the firm's board of directors and executive committee. We suspect this is not uncommon among smaller firms.

            The rule is not clear what is meant by "supervision or control." We are concerned that the term could be interpreted to mean that the chief executive officer, or any member of the firm's governing body such as a board of directors or executive committee, is considered to supervise or control all of the firm's employees, including research analysts.

            We also note that in many smaller firms, research analysts, including supervisors in research departments, are often involved in investment banking transactions, particularly initial public offerings. They participate in due diligence and specific comment as actively as full-time investment bankers on disclosure documents and transaction structure and pricing. They may also participate in "roadshows" and other meetings with potential investors.(2) These activities are appropriate and salutary. However, under the definitions in the Proposal, they could make research analysts "employees of the investment banking department" and therefore ineligible to supervise or control any other person in the research department. This ineligibility would be extremely and inappropriately onerous for small firms.

            We suggest that disclosure in research reports that members of the investment banking department may be in control positions within the firm and may therefore, at least indirectly, supervise or control research personnel should be adequate to serve the purposes intended by the Proposal.

            Alternatively, we suggest that the concepts of supervision and control be clarified to exclude supervision or control that may be implicit in an investment banking employee's status as an officer or member of a governing board. The Rule should also provide that the prohibition does not apply to supervision and control by employees who are employees of the research department regardless of whether they may also be deemed to be employees of the investment banking department by virtue of the kinds of activities described above.

       b.  Paragraph (b)(2) of the Proposal prohibits review or approval of a research report by investment banking personnel. We do not believe that, as a practical matter, the prohibition is workable.

            First, although the prohibition is on "review and approval" of a research report by investment banking personnel, both the practicalities of communication and the text of subparagraphs (b)(3)(A) and (b)(3)(B) suggest it is really a prohibition on any communication "concerning" a research report. There are many circumstances in which communication between research and investment banking personnel are appropriate and important to both the investment banking and research functions. Further, particularly in smaller firms, investment banking and research personnel may be in frequent contact both in business dealings and socially. Determining when communications may "concern" a research report will inevitably be difficult and good faith judgments could easily subject a firm and its personnel to "second guessing" with hindsight.

            Prohibitions on communications are inherently difficult to implement, enforce, and supervise. In the "insider trading" context at least the prohibition is somewhat objective: one may not communicate material nonpublic information. Further, in that context the types of events that might suggest violations are relatively objective: particular trading activity by the purported recipient of the information can suggest he or she has been "tipped." The prohibitions in the Proposal are nowhere near so objective. Determining whether the content of a communication indirectly "concerns" a report is inherently ambiguous. And the kind of activity from which a non-participant might infer that a communication concerning a research report occurred is even more so. We are concerned that, if a firm publishes favorable research reports about an investment banking client that subsequently experiences difficulties, regulators or investors may infer that violative communications must have taken place and costly investigations and enforcement activity may ensue, all with no real investor protection benefit.

            We also note, as above, that under the Proposal's definitions, research personnel could be considered members of a firm's investment banking department by virtue of their activities relating to particular transactions. If the prohibition in paragraph (b)(2) is imposed, it should be clarified to exclude review or approval by personnel who are also employees of the research department.

       c.  Paragraph (b)(3) creates an exception to paragraph (b)(2)'s prohibition if a review by investment banking personnel is solely to verify factual accuracy or to identify conflicts of interest, but only if certain "gatekeeping" functions are performed by an "authorized legal or compliance official of the member."

            The Proposal is unclear about the role a "gatekeeper" should play in communications. Presumably he or she should ensure that the communications are limited to what is necessary to verify factual accuracy or identifying potential conflicts of interest, particularly with a view to ensuring that investment banking personnel do not influence research analysts to improve the recommendations they would otherwise make or to "spin" presentations in a particular way. This involves subjective judgments about subtle elements of communication and can put the "gatekeeper" in a difficult, if not untenable position. If the substance of a research report and disappointing subsequent results lead regulators or investors to suspect that an analyst was influenced by an investment banker, any gatekeeper who was involved in any communications will be exposed in any ensuing investigations and allegations.

            Even if the gatekeeping activities suggested in the proposed rule were otherwise substantively workable in a large firm context, they may be impractical for a small firm that does not have a dedicated legal or compliance department. A firm may have many compliance functions performed by employees who have other business duties such as sales or trading. Involving such people as intermediaries in investment banking-research communications can result in the transmission of potentially sensitive information to personnel who would not and should not otherwise have access to it. That is, there may be circumstances where it is appropriate and necessary for a research employee to be brought over the wall or an investment banking employee to be consulted about facts related to a research report, but it would not be appropriate for sales or trading employees to be involved in the communications. It may be possible to address these staffing and logistical challenges by allowing research personnel who are not involved in the particular research report to serve as gatekeepers -- make them "authorized compliance officials" for these purposes. But the complexities of characterizing different employee's roles or an interaction-by-interaction basis are significant and the "independence" of the gatekeeper can always be questioned. The firms that will probably have the most communication between research department employees and investment banking department employees are the ones that will have the hardest time taking advantage of the "gatekeeper" exception for communications.

           In the end, we suspect that, because of the difficulties of implementation, the "gatekeeper" exception will be relatively little used and firms will, at least formally, discourage communications of all kinds between investment banking and research personnel. This could prevent or impair beneficial, often critical communications, particularly in small firms.

3. Paragraph (d) - Prohibition of Certain Forms of Research Analyst Compensation.

           This paragraph prohibits a firm to "pay any bonus, salary or other form of compensation to a research analyst that is based upon a specific investment banking services transaction." However, it does not prohibit, and the Release notes that the proposed rule would permit, compensating research analysts based on their overall performance, which may include services to, and presumably also the performance (revenues or profitability) of the investment banking department. This is appropriate and necessary -- it could hardly be prohibited. However, we believe that as long as those factors may be considered in compensating analysts, prohibiting compensation that is related to particular transactions will do little if anything to eliminate the targeted conflict of interest.

           What it will do is reduce the value of any disclosure regarding an analyst's compensation. Disclosure that an analyst's compensation may be influenced by, among other factors, contributions to or performance of the firm's investment banking department will become standard "boilerplate" and will provide little information of value to investors.

           As a result, we suggest paragraph (d) should be deleted.

4. Paragraph (f) - Imposition of Quiet Periods.

           This paragraph would prohibit a firm from distributing research for 40 days after an initial public offering in which it acts as a manager or co-manager and for 10 days after a secondary offering in which it acts in those capacities. We do not believe the risk of a firm "rewarding" an issuer for investment banking business, as described in the Release, warrants imposing quiet periods beyond those already, in effect, imposed under existing securities laws.

           First, the fact that a firm has recently acted as a manager or co-manager in an offering is one of the easiest, most objective facts for a firm to disclose prominently in its research reports. That disclosure can be more straightforward and more easily understood than much of the disclosure currently provided and proposed. We contend that such straightforward disclosure is the best approach to addressing the concern expressed in the Release.

           Second, the rule provides an exception to the prohibition for reports discussing the effects of "significant news or a significant event." But the rule does not provide any guidance as to the meaning of those terms A firm's subjective judgments on this score, both as to the significance of the relevant event and to whether the information in the publication is truly limited to the effects of the event, will be subject to second guessing. The requirement that a legal or compliance gatekeeper "authorize" the publication involves all the difficulties discussed above in connection with other gatekeeping functions; it will increases the number of people subject to such second guessing. The impact of the prohibition will be to decrease the amount of information published during "quiet periods," even in response to developments We believe this is disadvantageous for investors.

5. Paragraph (g) - Restrictions on Personal Trading by Research Analysts.

      a.   Pre-public Company Investments. Subparagraph (1) of this paragraph prohibits research analysts from purchasing or receiving any securities of an issuer before that issuer's initial public offering if the issuer is principally engaged in the same types of business as companies that the analyst follows. The Proposal acknowledges that it is not appropriate to prohibit analysts from acquiring shares of public companies in their areas of coverage. But it effectively bars participation in any "venture capital" type investment in an analyst's industry or sector of coverage, other than through certain limited types of diversified funds in which the analyst has no control or significant economic participation. The reason expressed for the difference in treatment of venture capital type investing and public company investing is to "prevent a research analyst from receiving 'cheap stock' before the initial public offering of a company that the analyst may subsequently cover."

           We believe this prohibition is somewhat extreme and is not justified by the risk of "bribery" of the kind suggested by the Release. As with other prohibitions, we believe the more appropriate prescription is disclosure: allow investors to evaluate the impact that acquisitions of stock within a relatively short period before a company files a registration statement for its initial public offering may have on an analyst's opinion.

           Alternatively, we suggest that, if an analyst has acquired securities of a company within the six month period before the filing of such a registration statement, the analyst can be precluded from publishing a research report on a company, or being the supervisor with responsibility for approving the publication of such a research report, unless the analyst agrees not to sell, transfer, assign, pledge or hypothecate those securities for a period of 180 days following the effective date of the registration statement for the issuer's initial public offering. This is consistent in principle with the NASD's approach in Rule 2710 to prohibiting excessive compensation in connection with public offerings.

           In any event, if the prohibition is imposed, we think it is appropriate to clarify either in the rule or in the adopting release that the prohibition does not affect investments made before the effective time of the proposed rule and does not affect a firm's hiring or continued employment of an analyst to cover industries in which he or she has previously made venture capital investments.

      b.  Blackout Periods. Subparagraph (g)(2) imposes "blackout" periods on analysts' purchases or sales of securities issued by companies they follow. While expressed as a prohibition on analyst transactions, the Proposal actually restricts a firm's ability to publish research on a company, regardless of the content of that research, for thirty days after the relevant analyst has bought or sold the company's stock. It does provide an exception for publications that are "due to significant news or a significant event concerning the subject company." However, it requires that the firm's legal or compliance department preapprove the publication.

           We believe that many of the reasons that the proposed "quiet periods" are inappropriate and unworkable also apply to the proposed blackout periods. The "significant event" standard will be unnecessarily difficult to implement and supervise. The "gatekeeper" function will unnecessarily complicate the application of that standard. And these difficulties will be more burdensome for smaller firms than larger firms. We believe the result, particularly for smaller firms, would likely be a prohibition on investment by analysts in companies they cover. For years there has been a vigorous debate about the appropriateness of such investment, both in the brokerage and the investment management context, with credible arguments being made for encouraging such investment rather than restricting or discouraging it.

           We believe that disclosure of an analyst's ownership of securities is adequate to address the perceived conflict of interest this provision is intended to address.

      c.  Transactions Inconsistent with Most Recent Report. Subparagraph (g)(3) prohibits analysts to buy or sell securities "in a manner inconsistent with the research analyst's recommendation as reflected in the most recent research report published by the member."

           We believe the risks arising out of the conflicts of interest involved in this type of transactions do not justify the broad proscription imposed by the rule. We believe at disclosure of the potential for transactions of this kind should be sufficient to allow investors to evaluate an analyst's objectivity. If more is required, we believe disclosure of recent historical transactions of this kind, rather than prohibition, is more appropriate.

           If a prohibition of this type is to be imposed, we suggest that the exceptions provided in subparagraph (g)(4) be broadened beyond only transactions based on "significant personal financial circumstances of the beneficial owner of the research analyst account." In addition, we believe the requirement that the procedures pursuant to which exceptions may be granted be designed to ensure that transactions "do not create a conflict of interest between the professional responsibilities and the personal trading activities" of the analyst is not the appropriate formulation. It is ambiguous and refers to responsibilities that are not well identified or defined. We suggest it would be more appropriate for a firm's procedures to be designed to prevent the transactions from inappropriately affecting the firm's discharge of its responsibilities to make recommendations for which it has a reasonable basis.

           d.  Technical Comments. In addition to the fundamental, substantive comments on paragraph (g) described above, we have the following, more technical comments:

           (1)  In a number of places, particularly in paragraph (g), the Proposal refers to the publication of a research report or change in the rating or price target of the subject company's securities. The publication date of such a communication may be unclear if it is a communication sent separately to multiple sources over a period of several days. We suggest the concept of publication be clarified to refer to the date of first transmission to a customer or member of the general public.

           (2)  Subparagraph (g)(3) does not refer to the exception in subparagraph (g)(2)(A) for sales by an analyst of all of his or securities issued by a subject company within 30 days after the analyst began covering the company. In many instances, an analyst will begin covering a company with a favorable recommendation. Therefore, in order for the exception in subparagraph (g)(2)(A) to be effective, it must provide an exception from not only the prohibition in subparagraph (g)(2), but also the prohibition in subparagraph (g)(3).

6. Disclosure Requirements.

           a.  Disclosure Regarding Compensation from Issuers. Subparagraph (h)(2) requires disclosure in research reports if the member or an affiliate expects to receive compensation from the subject company within the three months following publication of the report. This could alert the public, the analyst or other market participants that the subject company may have engaged the firm or its affiliates in connection with a transaction that has not yet been made public. The Release indicates that NASD believes the required disclosure is sufficiently general to eliminate this as a risk. We believe the required disclosure could still generate speculation about pending or prospective transactions that have not been publicly announced. We believe this risk outweighs the benefit intended to be provided by the proposed disclosure requirement.

           We suggest that historical disclosure, plus a statement that the firm may seek additional business in the future, would be sufficient and would avoid the risk of stimulating inappropriate speculation.

           Subparagraph (h)(2)(B) requires disclosure by an analyst in public appearances if he or she "has reason to know" that the subject company is a client of the member (or an affiliate). We believe the "has reason to know" test is too subjective and vague and could require an analyst to speculate or disclose information from which one might infer the possibility of an engagement. We suggest deleting the phrase.

      b.  Disclosure of Beneficial Ownership. The Proposal requires disclosure in research reports and public appearances if a firm (or its affiliates) beneficially owns more than one percent of a company's common equity securities. The Proposed Rules refer to Sections 13(d) and 13(g) of the Exchange Act to determine what constitutes "beneficial ownership." The disclosure requirement in the Proposal is triggered by a significantly lower threshold than the five percent threshold required by Schedules 13D and 13G under the Exchange Act. We believe the 5% threshold is more appropriate.

           In addition, the Proposal requires firms to calculate their holdings as of the date of each report or public appearance, rather than at the times specified for filing Schedule 13D or 13G. This requirement will likely add significant cost and compliance burdens to firms, as they may be forced to modify or create new systems to track such information. The disclosure of information beyond that required in publicly available SEC filings may also result in unfair treatment among market participants, as only those receiving the research reports or attending (or hearing a broadcast of) the public appearance would receive the additional information. We believe that the beneficial ownership disclosure requirement should be limited to the information (and reference the time periods) required by Schedules 13D and 13G.

           We appreciate the opportunity to comment on the proposed rule. We would be pleased to respond to any inquiries regarding this letter. Please contact the undersigned at 415.274.6800.

Yours very truly,

Stephen J. Massocca

1 We recognize that many firms have discretion over some customer accounts and that registered representatives who exercise that discretion may rely on the firm's research. PGE does not exercise such discretion. If the Proposal may be intended to address conflicts of interest in making investment decisions on a discretionary basis, we believe it should focus directly on that issue and the activities of the registered representatives, rather than on the activities of the research personnel.
2 These activities are subject to compliance with information-barrier procedures intended to prevent the misuse of material nonpublic information.