Charles Schwab Corporation
Via Electronic Delivery
June 30, 2003
Margaret H. McFarland
Deputy Secretary, United States Securities and Exchange Commission
450 Fifth Street NW
Washington, D.C. 20549-0609
Re: Amendment No. 2 to Proposed Rule Changes by the New York Stock Exchange, Inc. and National Association of Securities Dealers, Inc. Relating to Research Analyst Conflicts, File Nos. SR-NYSE-2002-49 and SR-NASD-2002-154
Dear Ms. McFarland:
The Charles Schwab Corporation ("Schwab") appreciates the opportunity to comment on the above-referenced Amendment No. 2 to proposed rule changes by the New York Stock Exchange ("NYSE") and National Association of Securities Dealers, Inc. ("NASD") relating to research analyst conflicts of interest.1 Schwab provided comments2 in response to the NYSE's and NASD's Original Notice of proposed rule changes to their respective rules in this area.3
In response to the Original Notice, we urged that investor protection rules should not vary based on which self-regulatory organization regulates a client's brokerage firm. Restoring investor confidence in securities industry research requires that all clients receive the same level of protection by self-regulatory organization rules. We offered specific suggestions, which we reiterate here, regarding how some of the NYSE's initial proposed amendments could be modified so that substantive differences between the NYSE's and the NASD's (collectively, the "SROs") proposals could be best addressed. We also made suggestions regarding both the SROs' proposed amendments relating to personal trading restrictions (as well as the impact of the current SRO research analyst personal trading restrictions on certain research analysts), withdrawal of research coverage of a subject company and the qualification and registration of research analysts. We offer in Sections II and III of this letter below comments relating to personal trading restrictions, the withdrawal of research coverage and substantive differences that need to be reconciled between the NYSE's and the NASD's proposals.
We note that the SROs have indicated that comments received by the SEC in response to the Original Notice will be addressed together with comments received in response to the Amendment No. 2 Proposing Release. With the hope of enhancing the SEC's and the SROs' ongoing efforts to address research analyst conflict of interests, we offer below the following comments.
I. Disclosure of Receipt of Compensation and Client Relationships.
We agree with the Securities Industry Association ("SIA")4 that the proposals that would require disclosure in research reports and public appearances as to whether any compensation was received by the firm or its affiliates other than for investment banking services, as well whether the subject company currently is, or was, a client of the firm during the prior 12 months (and, if so, the types of services provided)5 raise the most important issues should the SROs' Amendment No. 2 be adopted as proposed. While these disclosure requirements would require firms to build, test and maintain vast and complex new systems and data bases that would be designed to attempt to track and report such compensation on a real-time basis, we believe the disclosures would provide investors with information of little, if any, benefit. As similarly noted in the SIA Letter, these proposed disclosures would require firms and those individuals principally responsible for the preparation of the substance of research reports, their supervisors and other research personnel to search for firm and affiliate compensation and client relationships (on a real-time basis) with current and potential future subject companies of which the research analysts, supervisors and research personnel would otherwise not have knowledge.6 Absent such knowledge by those principally responsible for, or involved with, a firm's research reports, we fail to see what actual conflict of interest is posed by a firm's or its affiliates' receipt of compensation or the existence of client relationships.
Therefore, we urge the SROs to adopt one of the two alternative approaches described in the SIA Letter. We agree with the SIA that those two alternatives are reasonably designed to disclose conflicts of interest as contemplated by the standards included in Title V of the Sarbanes-Oxley Act of 2002 (the "Act"). Specifically, the Act requires that rules be adopted that are reasonably designed to address conflicts of interest that can arise when research analysts recommend equity securities in research reports and public appearances in order to improve the objectivity of research and provide investors with more useful and reliable information. Furthermore, the Act requires disclosure, in research reports and public appearances, of conflicts that are known or should have been known by the research analyst or the firm at the time of the public appearance or date of distribution of the research report. Accordingly, the SROs' disclosure rules in this area should not require blanket disclosure of far flung firm (and affiliate) compensation and client relationships that do not influence the objectivity of research analysts (or firms) in the course of the preparation of research reports. In fact, we believe that such overbroad disclosures would be contrary to the Act's standard of providing investors with more useful and reliable information in that it would often require disclosure of compensation and client relationships that have had no impact on the objectivity of the research analysts or the firm's research reports.
We also note that if the NYSE's Other Communication Activities7 proposal is adopted as proposed the concerns noted above and in the SIA Letter about the proposed compensation and client relationship disclosures will be exacerbated by the requirement that member firm employees engaged in such other communication activities will also be required, along with research analysts, to make disclosures in public appearances that we believe will be of dubious value to investors.
Finally, as noted in the SIA Letter, due to the substantial challenge posed by attempting to build, test and maintain complex new systems and data bases that would need to be built it will be necessary to have substantially more than 120 days to create these systems and data bases. If the SROs' disclosure is adopted as proposed we urge the SROs to adopt the SIA's more realistic proposed implementation dates.
II. Elements of the "Global Settlement" Addressed by the SROs' Initial Proposed Rule Changes.
In the Amendment No. 2 Proposing Release, the SEC noted that although certain elements of the settlement8 cover areas addressed by the SROs in the Original Notice, the requirements are not identical. The Commission has indicated that in light of the settlement, it is soliciting additional comment on the SRO rule changes that were proposed in the Original Notice. Schwab offers the following additional comments:
- Personal Trading Restrictions on Quantitative and Technical Research Analysts. Several of the terms of the settlement include "carve-outs" for, or exceptions from, certain settlement term sheet requirements for research reports limited to purely quantitative analysis. For example, Part I (8) of the term sheet includes an exception to the termination of research coverage requirement for situations in which the prior coverage has been limited to purely quantitative analysis. Similarly, Part I (12) requires that an oversight/monitoring committee be created to perform certain specific research oversight tasks, while stating that certain of the committee's tasks will not be required with respect to research reports limited to purely quantitative analysis. Finally, Part II (2) describes the transparency of research analysts' performance obligations and states that the requirement that research analyst performance information be made publicly available will not apply if the applicable information is included in reports limited to purely quantitative analysis. Additionally, the SEC's adopting release regarding Regulation Analyst Certification9 states that in certain cases where there is no identified research analyst because the research report is based on the firm's quantitative or technical model, the firm itself may provide the applicable certification.
Both the settlement and Regulation Analyst Certification treat research reports limited to purely quantitative analysis differently from other types of research. By contrast, the current SRO research analyst personal trading restrictions only appear to contemplate the traditional research model in which a fundamental research analyst follows or covers a particular group of stocks or sector of the market. The SRO research analyst personal trading restrictions do not give full consideration to the disparate impact that those restrictions have on those research analysts who are responsible for research reports limited to purely quantitative or technical analysis. The impact of the personal trading restriction rules on a fundamental research analyst, in most instances, is that the research analyst's personal trading is only restricted with regard to the securities of subject companies they follow or cover. However, for research analysts who are principally responsible for the preparation of research reports limited to purely quantitative or certain technical analysis,10 the impact of the personal trading rules can be much greater. For example, Schwab's quantitative research models produce ratings on over 3,000 securities - virtually all significant U.S. equity securities listed on the NYSE or Nasdaq. Quantitative and technical research analysts (who generally do not follow or cover a particular group of securities or sector of the equity market) can be effectively barred (as well as members of their households and certain people who report to them) from owning any equity securities, because the universe of subject companies that their firm's quantitative research model or technical analysis covers can run into the hundreds or thousands.11 We believe that in the context of quantitative research or technical analysis this is also an unnecessary and onerous result.
In the Joint Memorandum, the SROs stated that the research analyst personal trading restrictions "impose a number of restrictions on the personal trading of securities in accounts in which a research analyst or a member of his or her household has a financial interest or over which the analyst has discretion or control." The application of these same personal trading restrictions, however, on quantitative and technical research analysts results in much more than "a number of restrictions" being imposed on personal trading in their (and their household member's) accounts. In many instances, the restriction effectively bars such research analysts from owning equity securities at all.
Therefore, Schwab requests that the SROs (as they similarly did as part of the global settlement and as the SEC did in Regulation Analyst Certification) structure their research analyst personal trading rules in a way that takes into account the substantive differences between research reports based on fundamental analysis and research reports based on a firm's quantitative models or technical analysis. Accordingly, Schwab seeks guidance that in cases where a research analyst is principally responsible for the preparation of research reports based on a firm's quantitative models or technical analysis (and where the research analyst does not cover or follow a security, group of securities or sector of the equity market), the firm be required only to implement policies and procedures reasonably designed to ensure that transactions in research analyst accounts do not create a conflict of interest between the professional responsibilities and the personal trading activities of the research analyst.12
- Withdrawal of Research Coverage. Under the NYSE's proposed amendment to NYSE Rule 472(f), firms that "withdraw" research coverage of a subject company would be required to provide notice of the withdrawal. Under the proposed NYSE amendment, this notice would have to be made in the same manner as when research coverage was first initiated by the firm and must include the firm's final recommendation or rating. Similarly, under the NASD's proposed amendment to NASD Rule 2711(f), if a firm "intends to discontinue" its research coverage of a subject company, it must provide notice of the withdrawal in the same manner as when the research coverage was first initiated by the firm and must also include the firm's final rating or recommendation. As noted above in this Section II, the settlement term sheet also addresses the termination of research coverage. Specifically, the settlement term sheet indicates in relevant part that "when a decision is made to terminate coverage of a particular company in the firm's research reports (whether as a result of a company-specific or category-by-category decision), the firm will make available a final research report on the company using the means of dissemination equivalent to those it ordinarily uses, provided, however that no final report is required for any company as to which the firm's prior coverage has been limited to purely quantitative analysis."
Schwab has concerns regarding how the SROs' proposed amendments in this area would apply to several situations. In these situations, the Commission should not seek to discourage temporary discontinuations of research, and it may be misleading to include a former research rating.13 In response to the SEC's solicitation of additional comments in light of the settlement, Schwab seeks guidance from the SROs that their respective "withdrawal of research coverage" rules, as noted in the settlement term sheet, do not require notice of withdrawal of research coverage of a particular covered company if the firm's applicable research service's prior coverage has been limited to purely quantitative analysis. Alternatively, as suggested in our letter on the Original Notice, Schwab seeks guidance from the SROs that the term "withdrawal" in the context of their respective rules is a decision by the firm or the firm's head of research that the firm's applicable research service will no longer provide research coverage of the issuer's equity securities.
- Definition of "Research Analyst." As noted in our comments in response to the Original Notice, under the NYSE's proposed amendment to NYSE Rule 472.40, research analysts are defined in relevant part as those individuals who are responsible for one or more of the following tasks: (i) the preparation of research reports; (ii) making recommendations or offering opinions in public appearances; or (iii) establishing a rating or price target of a subject company's equity securities. As we also noted in those comments, the NASD defines research analysts as the individuals principally responsible for the preparation of the substance of a research report.14 The settlement also covers this definition15 by defining the term "Research" in relevant part as including "all firm personnel engaged principally in the preparation and/or publication of research reports."
In addition to the comments that we provided in response to the Original Notice regarding the NYSE's proposed definition of the term "research analyst," we agree with the SIA that the approach adopted in the settlement term sheet focuses regulatory requirements on the correct type of personnel (meaning those individuals principally responsible for the preparation of the substance of a research report) and, therefore, should be incorporated in the SROs' definitions of the types of personnel covered by their respective research rules. By doing so (or alternatively, adopting the suggestions we made in our comments in response to the Original Notice), it would avoid a situation under the NYSE proposed definition in which an associated person making recommendations or offering opinions in public appearances (apparently whether or not they mention a particular subject company's securities or even a particular industry, or have ever prepared or contributed to a research report) could be deemed a research analyst.
- Exclusion from the Definition of "Research Report." As noted in the SIA's letter to the SEC in light of the settlement,16 Part I (1)(e)(i) of the term sheet broadens the scope of the types of communications that would not be considered research reports to include in relevant part those communications that: comment on trading conditions; recommend increasing or decreasing holdings in particular types of securities; and broad based summaries or listings of recommendations or ratings contained in previously issued research reports. We request that the SROs provide guidance that these types of communications generally would not be considered to be research reports.17
III. NYSE Proposed Interpretation on Public Appearances and Print Media.
Schwab agrees with the SIA that the portion of the NYSE's proposed interpretation that would not require a research analyst to refrain from continued contacts with media outlets that have edited out or failed to publish required disclosures, provided that the research analyst provides the required disclosures to the media source is helpful. As noted in the SIA's Letter, the NASD made a similar statement in the Original Notice and there seems to be no remaining substantive differences between the two SROs on this point.
We offer the following in response to the SEC's request for comment on whether the proposed NYSE requirement that would require NYSE-member firms to make and keep records of detailed information relating to public appearances is appropriate. We agree with the SIA that the NYSE's record-keeping requirement, as proposed, is problematic in that it specifically requires the research analyst (and not for example, other research personnel at the research analyst's direction) to actually prepare the record. As similarly noted by the SIA, we also question the specific "timing" requirement in that, as proposed, the record must be prepared by the research analyst before the opening of business on the next business day.18 We agree with the SIA that it should be sufficient to require that the research analyst who makes a particular public appearance, should be permitted to prepare the required record or cause such a record to be prepared by other research personnel at the earliest practicable time. We do not believe that any investor protections covered by the NYSE's proposed rule would be diminished by the modifications we suggest here.
We do note, however, that the proposed NYSE research analyst public appearance record-keeping requirement is significantly different than the NASD's current analogous record-keeping rule. Therefore, we reiterate our strong belief that because both the NASD's and the NYSE's rules relating to research analyst conflicts are designed to enhance investor protection, there should be no substantive differences between the SROs' respective research analyst rules. If the NASD's and the NYSE's respective amendments are adopted as proposed in the Original Notice (and for the NYSE's proposed record-keeping rule on research analyst public appearances), investors would be accorded different levels of protection, and in some instances have access to different disclosure information (e.g., the NYSE's proposed "other communication activities" rule),19 based solely upon the SRO membership of the brokerage firm with which they do business. We believe that investor protection rules should not vary based on the SRO of which a client's brokerage firm is a member. Accordingly, we again urge the SROs and the Commission to continue with their efforts so that there are workable solutions for eliminating all remaining substantive differences between the NASD and NYSE research analyst conflict rules and the accompanying joint SRO interpretive guidance.
* * *
Thank you for providing us with this opportunity to comment on Amendment No. 2 to the proposed rule changes by the SROs relating to the SRO research analyst conflicts.
Bruce W. Maisel
VP & Senior Corporate Counsel
Charles Schwab & Co., Inc.
|1|| See SEC Release No. 34-47912 (May 22, 2003) (the "Amendment No. 2 Proposing Release").
|2|| See Schwab's letter to Jonathan G. Katz, Secretary, United States Securities and Exchange Commission ("the "Commission" or "SEC"), dated March 20, 2003.
|3|| See SEC Release No. 34-47110 (December 31, 2002).
|4|| See the SIA's letter regarding the SRO Amendment No. 2 Proposing Release to Margaret H. McFarland, Deputy Secretary SEC, dated June 26th, 2003 (the "SIA Letter").
|5|| See proposed NYSE Rules 472(k)(1)(i)(c), (k)(1)(ii) and (k)(1)(iii) and proposed NASD Rules 2711(h)(2)(C), (h)(2)(E) and (h)(2)(F).
|6|| For example, if the rule is adopted as proposed, Schwab research analysts responsible for our systematic quantitative research models would likely be required to, or direct other research personnel to, interact with other Schwab business units and affiliates (e.g. Schwab Corporate Services, which manages 401(k) and stock option services for corporations, Schwab Capital Markets L.P., which provides institutional trading services for corporate pension plans and treasury departments, and U.S. Trust Corporation, which similarly offers investment services to clients including corporations) in order to learn of client relationships of, and compensation paid to, such business units or affiliates of which they would otherwise be unaware.
|7|| As discussed in our comments on the Original Notice, under proposed NYSE Rule 472(l), NYSE member firm employees engaged in "other communication activities" (e.g., conducting interviews with the media, writing books, making radio/TV appearances or conducting seminars) will, to the extent the activity includes discussion of specific securities and/or industries, be required to make the public appearance disclosures that are currently only applicable to research analysts during their public appearances.
|8|| The global settlement term sheet is available at the SEC's Website at http://www.sec.gov/litigation/litreleases/finaljudgadda.pdf.
|9|| See SEC Release No. 34-47384 (February 20, 2003).
|10|| Excluding technical analysis concerning the supply for a sector, index or industry based on trading volume and price which the SROs, based on guidance provided in the Joint Memorandum of the NASD and the NYSE, NASD Notice to Members 02-39 (dated July 2002) (the "Joint Memorandum"), would generally not consider to be a research report.
|11|| As we discussed in our comments on the Original Notice, the proposal to extend the research analyst personal trading restrictions to "other persons" such as Directors of Research, Supervisory Analysts or members of a committee who have direct influence and/or control with respect to preparing research reports or establishing or changing a rating or price target of a subject company's equity securities also would result in effectively barring those individuals from owning individual equities. We believe this result is unnecessary and onerous.
|12|| The NASD has adopted a similar standard, under current NASD Rule 2711(g)(4)(B), in which a firm's legal or compliance department may authorize certain research analyst transactions that are otherwise prohibited, provided that, among other things, the exception is granted in compliance with policies and procedures that are reasonably designed to ensure that the transactions do not create a conflict of interest between the professional responsibilities and the personal trading activities of the research analyst.
|13|| Specifically, as discussed in our comments on the Original Notice, we are particularly concerned about situations in which a firm temporarily withholds a research report or coverage of a subject company: (i) while it assesses, based on significant news or events impacting the subject company, whether to continue offering research on the subject company; (ii) due to the firm's belief that one or more critical data elements concerning the subject company is unavailable or inaccurate; or (iii) because a subject company, at a particular point in time, does not meet rating "eligibility" criteria (e.g., a subject company's market capitalization has dropped below a minimum level required to be included in the firm's universe of rated subject companies).
|14|| The NASD's definition is consistent with the analogous definition in the Act, which defines the term "securities analyst" in relevant part as the individuals principally responsible for the preparation of the substance of a research report.
|15|| See Part I (1)(d) of the global settlement term sheet.
|16|| See the SIA's letter to Margaret H. McFarland, Deputy Secretary, SEC, dated May 9, 2003.
|17|| The current types of communications that the SROs generally would not consider to be research reports is contained in the Joint Memorandum.
|18|| Similar to the SIA's view, we believe that the proposed timing requirement would be extremely difficult for a research analyst to personally meet in several situations, including situations in which a research analyst is preparing a research report due to breaking "significant news or a significant event" relating to a subject company or when the research analyst is in transit on a business trip.
|19|| See Section I above of this letter and Schwab's letter on the Original Notice for a further discussion of, and our comments on, the NYSE's proposed other communication activities rule.