Banc of America Securities LLC
Credit Suisse First Boston LLC
Goldman, Sachs & Co.
JPMorgan Securities Inc.
Lehman Brothers Inc.
Merrill Lynch, Pierce, Fenner & Smith Incorporated
Morgan Stanley & Co. Incorporated
UBS Warburg LLC
March 11, 2003
By Electronic Delivery
Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: Proposed Rule Changes of New York Stock Exchange and National Association of Securities Dealers 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; 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 Warburg LLC, in response to a request by the Securities and Exchange Commission ("SEC" or the "Commission") for comments regarding proposed rule changes by the New York Stock Exchange ("NYSE") and the National Association of Securities Dealers ("NASD"), collectively, the self-regulatory organizations ("SROs"), relating to research analyst conflicts of interest.1 We appreciate the opportunity to comment on the matters raised in the proposed rule changes ("Proposed Rules").
As an initial matter, we strongly support the objectives of the Proposed Rules and commend the NYSE and NASD for their efforts in seeking to rebuild public trust and confidence in this area. However, we believe that the Proposed Rules, as submitted, are inconsistent with the Securities Exchange Act of 1934, as amended ("Exchange Act") because they will hurt investors by depriving them of significant market information and thereby impeding the efficient pricing of securities.2 We believe that the Proposed Rules will limit the dissemination of important information to the public because the potential, unintended effects of certain of their provisions will upset longstanding sales and trading information flows whose legitimacy has not been questioned. In particular, we are concerned that the open-ended definitions of "research report" and "research analyst" in NYSE Rule 472 and NASD Rule 2711 (the "SRO Rules") could turn on their heads traditional and common-sense understandings of what constitutes a research report and who constitutes a research analyst. The Proposed Rules will exacerbate this problem by expanding those definitions.
In addition, we are concerned that the SROs' incremental approach to adopting rules regarding research analyst independence will result in a patchwork, contradictory regulatory scheme. The Proposed Rules represent the latest initiatives in a series of significant changes in the regulation of analysts, which have been imposed by various regulators over the past year.3 As the SROs have acknowledged, the Proposed Rules do not even represent the last in this series because further amendments "will also be required to comply with the mandate of the Sarbanes-Oxley Act of 2002" (the "SOA").4 Instead of hastening to adopt the Proposed Rules only to alter them further with new rule changes, the SROs should work with the SEC to review and consolidate all impending regulatory changes into a single set of coherent rules.
As a general matter, we believe public interest would be best served if the Proposed Rules were significantly amended and re-proposed for public comment as a comprehensive set of rules that are consistent with and enhance the existing regulatory framework and Title V of the SOA. We comment below on those aspects of the Proposed Rules that raise the most significant concerns and make a number of suggestions to address those concerns.
I. The Proposed Rules Should Complement the Existing Regulatory Framework and the Purpose of the SOA.
Ultimately, the Proposed Rules should complement the existing regulatory framework and the purpose of the SOA. To achieve these overarching goals, it is critical to place the latest round of rule proposals in context. As you know, broker-dealers are highly-regulated entities, and the entire structure of their communications with the public is already subject to an elaborate regulatory regime. At its most basic level, all communications by broker-dealers in connection with the purchase and sale of securities are subject to the far-reaching antifraud standards of the federal securities laws, and in particular Rule 10b-5 under the Exchange Act. As interpreted by courts and the SEC, Rule 10b-5 broadly applies to any form of deceit or fraud in connection with the purchase or sale of securities and potentially subjects alleged violators to both criminal and civil liability.
In addition, the NASD and NYSE impose on their members strict requirements designed to ensure that a broker-dealer's written and electronic communications with the public occur within a framework that will enhance investor protection.5 The SROs have created a carefully textured supervisory structure to ensure that these communications comply with all applicable SEC and SRO standards, including observing just and equitable principles of trade. To this end, any written or electronic communications related to the business of the broker-dealer as such, including e-mails, must be retained and subject to review processes by the broker-dealer. The NASD also requires its member firms to pre-approve certain advertising and sales literature and file certain of these communications with the NASD. Beyond these supervisory and recordkeeping requirements, the SROs have established certain standards that apply to communications with the public. NASD Rule 2210(d)(1) and NYSE Rule 472(i) explicitly prohibit misstatements, omissions of material facts, and exaggerated or misleading facts with regard to all communications with the public. Further, when providing recommendations to customers, broker-dealers must have a reasonable basis for concluding that recommendations for the purchase, sale, or exchange of a security are suitable for that customer.
The SEC and SRO rules outlined above cover a diverse range of broker-dealer communications, including communications by research analysts, salespeople, traders, and other persons employed by a broker-dealer. Recently, regulatory and media attention has focused on one particular type of broker-dealer communication- research reports- and the role of the persons who create those reports- research analysts. In 1999, Congress and the SEC began to examine issues relating to research analyst conflicts of interest. In particular, they were concerned that investors relying on analysts' recommendations may not know that favorable research coverage could be used to market a firm's investment banking services, or that an analyst's compensation could be based on generating investment banking business for the firm, for companies or industries covered by the analyst.6 During this timeframe, news reports also surfaced that some research analysts issued research reports and stock ratings regarding the companies that they covered to assist their firms in obtaining and retaining investment banking business.
In June and July 2001, the House Committee on Financial Service's Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises held hearings on the sources and ramifications of research analysts' conflicts of interest. Thereafter, in early 2002, the Senate Committee on Banking, Housing, and Urban Affairs ("Senate Committee") conducted hearings regarding research analyst conflicts of interest. Throughout the 2001 and 2002 Congressional hearings and testimony, it was widely accepted and understood that the phrase "research analyst" meant a professional in a "research department" whose full-time job was to "cover" companies in a certain sector or industry and, on a regular basis, to prepare "research reports" analyzing those companies, their economic prospects, and investment potential. Congressional concern regarding these persons stemmed from the fact that public investors were encouraged to rely on them as stock "experts." Investors also were encouraged to rely on the recommendations in their "research reports," which were held out to the public as objective, in-depth analyses, and qualitatively different from discussions of companies or industries that investors might receive from salespeople or traders.
It was in this context that Congress adopted Title V of the SOA, which governs analyst conflicts of interest. In adopting Title V, Congress intended to address the specific conflicts of interest that may arise between "stock analysts and their employing brokerage firms, on the one hand, and the public companies that the stock analysts cover, on the other hand."7 In its Report, the Senate Committee cited concerns about recent investigations of analyst recommendations, which revealed that "research reports and stock ratings of companies that were potential banking clients of [a major broker-dealer] were often distorted to assist the firm in obtaining and retaining investment banking business."8 To address these concerns and "protect the objectivity and independence of securities analysts," Title V mandates, among other things, measures to separate investment banking employees from employees in a firm's research department.9
II. The Proposed Rules Exceed the Scope of the SOA and Disregard the Validity of the Existing Framework for Communications.
A. The Overly-broad Definitions of "Research Report" and "Research Analyst" Capture Communications and People Beyond the Scope of the SOA and Lead to Unworkable Consequences.
1. The Definition of "Research Report"
Although the SRO Rules are intended to address the same concerns that motivated the adoption of Title V of the SOA, the SROs have proposed a framework that goes far beyond the SOA and disregards the existing regulatory framework for communications. Specifically, the definitions of "research report" in the current and proposed rules are open-ended and, absent clarification by the SROs, can capture communications that traditionally have not been regarded as "research reports" and that are already extensively regulated under the existing framework for communications. The proposed definition of "research report" would significantly exacerbate the situation by eliminating what is a key element of traditional research reports- the recommendation or subjective views of the research analyst. The Proposed Rules would define a "research report" as any "written or electronic communication which includes an analysis of equity securities of individual companies or industries, and provides information reasonably sufficient upon which to base an investment decision."10
Under this proposed definition, the following communications might constitute a research report: company prospectuses; summaries of a company's financial data; factual information about specific companies or industries provided to clients at their request; reports written by portfolio analysts; trader commentary; company profiles and data summaries generated through computer models; and industry data compilations that contain no subjective conclusions or recommendations. Each communication between salespeople and their clients or between traders and counterparties would have to be reviewed and assessed to determine whether that communication might constitute a research report. Similarly, every response to a customer's request for information about a security or company or industry would have to be reviewed and assessed to determine whether that response might constitute a research report. Because the definition of research report is so ambiguous, each determination would require a subjective analysis to determine whether the particular communication at issue might contain "sufficient information upon which to base an investment decision."
The application of the Proposed Rules to these types of communications- which clearly are not "research reports" under traditional and common-sense principles- is not only unnecessary but also will impose counterproductive costs on the free flow of information to the investing public. These types of communications are already covered by a rigorous regulatory framework, and fraudulent or misleading information is already prohibited by the federal securities laws and SRO rules. Here, the only question is whether the open-ended definition of "research report" will chill the flow of sales and trading information to the public by imposing additional costs on the provision of that information. This flow of information is critical to the U.S. securities markets and to an efficient marketplace. Nothing in the Congressional hearings regarding research analyst conflicts of interest nor the legislative history of the SOA suggests that such a broad application of the term "research report" to these communications by non-research department personnel is warranted.
2. The Definition of "Research Analyst"
Further, because the universe of "research report" determines the universe of persons who are "research analysts" under the SROs' definitions of "research analyst,"11 a sweeping definition of "research report" would transform into "research analysts" numerous non-research personnel beyond the scope of the SOA, such as salespeople, traders, marketing personnel, computer programmers, and even investment bankers. 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. Unlike Research Department analysts whose primary responsibility is to write research reports, these other persons (and their supervisors) would not know whether they were subject to these restrictions until one of their communications is deemed to be a research report because it crossed some unseen line to provide "sufficient information upon which to base an investment decision."
For example, if a salesperson sends her clients descriptions and analyses of multiple companies and their financial data, this communication could be deemed to be a "research report" under the SROs' definition of that term, thus transforming the salesperson into a "research analyst." As a research analyst, the salesperson's communications would have to contain the extensive disclosures required by the SROs' rules, such as the disclosures regarding her and her household members' financial interests, the firm's equity ownership and investment banking compensation, price charts, and distribution of ratings charts. Moreover, because the salesperson's communication contained summaries of multiple companies, the firm would be required to make all of the disclosure requirements with respect to each company for which a summary was provided. This communication as well as her future communications could also be subject to the "quiet period" restrictions in the research analyst rules, including the proposed new restriction for lock-up agreements. Under these restrictions, the salesperson would not be allowed to provide her clients with factual information and analyses regarding companies if the firm had managed or co-managed the company's primary or secondary offering within certain specified periods of time.12
Further, if the salesperson's communication is deemed to be a "research report," the salesperson's compensation could be subject to the new restrictions on compensation in the Proposed Rules, including the requirement that a special committee, which does not include representation from the firm's investment banking department, review and document her compensation on an annual basis. Finally, the salesperson and her household members would be subject to the personal trading restrictions on research analysts. Under the Proposed Rules, the salesperson's supervisors and their household members also would become subject to the research analyst personal trading restrictions. Thus, in the case of a branch manager who supervises an office of 50 brokers, the manager's personal trading and his or her household members' personal trading could be subject to the research analyst personal trading restrictions at any given time, depending on whether one or more of the 50 salespersons under the manager's supervision sent a communication that could be deemed to be a "research report." Because the SRO Rules do not provide for the termination or lapsing of a person's status as a research analyst, these salespeople and their manager may be subject to the research analyst rules indefinitely as a result of isolated communications that are deemed to be a research report. These persons even may be required to register and qualify as a "securities analyst" and "supervisory analyst," respectively, under the SROs' new registration and qualification requirements in the Proposed Rules.
Because the status of someone as a "research analyst" depends entirely on the particular analysis that he or she has written regardless of the individual's position within the firm or the audience, it is critical that the definition of "research report" provide sufficient guidance so firms can identify when someone has become a "research analyst" and, under the Proposed Rules, when that person's supervisor also has become a "research analyst." Without such clarification, firms face a Hobson's choice: (1) they can treat all written and electronic communications discussing an equity security as a "research report," thereby incurring tremendous costs, which could result in a drastic reduction of information provided to investors; or (2) they can try to limit the scope of "research report" on the basis of common sense and custom and thereby risk second-guessing and significant regulatory penalties. Either way, investors will be the ultimate losers because the Proposed Rules will impede the distribution of important information to the marketplace and the efficient functioning of the securities markets.
B. The SROs Should Clarify the Meanings of the Terms "Research Analyst" and "Research Report."
1. Clarification of the Term "Research Analyst"
To avoid the unintended and unworkable consequences described above, the SROs should clarify the meanings of the terms "research analyst" and "research report" so that they comport with the purpose of the SOA and complement the existing framework for regulated communications. We agree with 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.13 We also agree with the SEC's definition of the term "research analyst" as "persons who study publicly traded companies and make recommendations on the securities of those companies."14 Consistent with this guidance, the SROs should clarify that the term "research analyst" applies to persons whose primary job responsibility is to cover companies and issue research reports about those companies. Such common-sense clarification would alleviate some of the problems described above.
2. Clarification of the Term "Research Report"
The SROs also should clarify the term "research report" by providing guidance regarding the meaning of the phrase "analysis of equity securities of individual companies or industries . . . which provides information reasonably sufficient upon which to base an investment decision." In particular, the SEC or SROs should clarify that this phrase:
- Presumptively excludes communications by certain persons never intended to be swept under the definition of "research analyst" or "securities analyst," such as salespersons, traders, and investment bankers.15
- Excludes summaries of or references to research reports, provided that such summaries or references direct the recipient to where he or she may obtain a complete copy of the research report, with required disclosures.
- Requires a subjective view or conclusion regarding an issuer or its securities that is supported by an analysis of the equity securities that is reasonably sufficient upon which to base an investment decision. Thus, factual discussions and quantitative or technical analyses that do not advocate a view should not constitute "research reports" because they contain no subjective view. Similarly, "pull down" material regarding issuers or industries, which a client generates through a firm's Website, should not constitute "research reports" because they are generated by a computer algorithm or program, and do not contain a subjective view of any analyst.
- Requires an "analysis" to include a narrative discussion of the basis of the subjective view or conclusion set forth in the report.
With regard to the third point, it is important to note that the definition of "research report" in the SOA presumes that the report will contain a recommendation to buy, sell, or hold securities, whether or not this recommendation is separately labeled as such. To this end, the phrase "analysis of equity securities . . . sufficient upon which to base an investment decision" in effect describes a "recommendation."16 The wording of Title V, itself, underscores this point, by requiring the SEC to adopt rules "reasonably designed to address conflicts of interest that can arise when securities analysts recommend equity securities in research reports and public appearances . . ."17 Potential conflicts of interest raised by analysts' recommendations in research reports are also at the core of the SRO Rules. According to the SEC's May 2002 order approving the SRO rules regarding research analyst conflicts of interest, the SROs "proposed to amend their rules to address conflicts of interest that are raised when research analysts recommend securities in public communications. These conflicts of interest can arise when analysts work for firms that have investment banking or other business relationships with issuers of the recommended securities, or when the analyst or firm owns securities of the recommended issuer."18 It is difficult to see how communications that are factual or objective and do not contain an analyst's subjective view or recommendation could raise the potential "conflicts of interest" issues and concern with analyst objectivity that prompted the adoption of Title V of the SOA and the SRO Rules.19
With regard to the last point, we believe that clarification of the term "analysis" as requiring a narrative description is consistent not only with the traditional understanding of the types of communications that rise to the level of a "research report," but also with the definition of "research report" in the SOA, which requires "an analysis of equity securities of individual companies or industries, and that provides information reasonably sufficient upon which to base an investment decision."20 As a practical matter, unless research provides a narrative discussion that explains the basis for the analyst's particular views concerning companies or industries and their economic prospects, the research would not contain information "reasonably sufficient" upon which a public investor could base an investment decision. In adopting Regulation AC, the SEC observed that: "Research reports generally contain an analyst's summary rating of the security based on his or her particular firm's rating system, as well as an analysis. The summary rating or recommendation is often one word (e.g., buy, sell, overweight), while the analysis may be very detailed and lengthy. Generally, the analysis explains the basis for the rating and provides extensive supplementary information, which, in some instances, significantly qualifies or conditions the stated rating."21
As a general matter, we note that many of the provisions of the current SRO Rules and the Proposed Rules would not make sense (and the SRO Rules would be internally inconsistent) unless the definition of "research report" is clarified as set forth above. For example, the focus on ratings and price chart disclosures presumes that ratings and price targets reflect an analyst's recommendation or subjective view or conclusion about the equity securities of a particular company or industry. Similarly, the personal trading restriction on analysts' trading in a manner inconsistent with their views presumes that research reports will contain views or subjective conclusions. The price chart disclosures and the termination of coverage provision also presume that the author is "covering" a company or industry. Presumably, "company coverage" must mean something more than trader commentary and a person who "covers" companies must be someone more than a broker or trader who creates such trader commentary or a person who provides merely objective facts.
3. Reaffirming the General Exclusions from the Definition of "Research Report"
The SROs should take into account the above points of clarification and expand upon the guidance in the Joint Memorandum regarding the types of communications that generally will not be considered to be "research reports."22 The SROs' general exclusions of certain types of communications from the definition of "research report" are based on well-established understandings of what constitutes a research report. It is only logical that the SROs reaffirm the validity of their guidance and expand it as set forth above, confirming that traditional principles and common sense still hold and the SROs will not, overnight, regard certain types of communications as "research reports" that never before have been regarded as research reports by regulators, firms, or investors.
The SROs also should affirm that the exclusions in Regulation AC are valid for purposes of the Proposed Rules. As a general matter, we note that the definition of "research report" in Regulation AC is much broader than the SROs' existing definition.23 We believe that a broader definition of "research report" is appropriate for Regulation AC purposes but not for purposes of the Proposed Rules because, as the SEC has acknowledged, the Regulation AC requirements are much narrower than the SRO rules.24 In this respect, Regulation AC, by the SEC's own admission, reaffirms existing obligations (i.e., core standards of integrity) to which firms and their associated persons were already subject. The Proposed Rules, in contrast, create a whole new regulatory framework for dealing with research reports and impose significant new burdens and requirements on firms and their associated persons.
III. Other Provisions of the Proposed Rules Raise Concerns and Should Be Clarified or Revised.
A. The Proposed "Pitch" Restrictions in NYSE Rule 472(b)(4) and NASD Rule 2711(c)(4) Should Be Clarified.
The Proposed Rules would prohibit analysts from issuing reports or making a public appearance about a subject company if the analyst "engaged in any communication with the subject company in furtherance of obtaining investment banking business prior to the time the subject company entered into a letter of intent or other written agreement with the member or member organization as an underwriter of an initial public offering by the subject company."25 As written, this proposed "pitch" restriction is ambiguous as to what types of activities the SROs intend to prohibit. The open-ended phrase "in furtherance of obtaining investment banking business" could cover a vast range of activities that are not related to solicitations for initial public offering ("IPO") business and interfere with valid and important research activities.26 For example, this phrase could cover communications between an analyst and a private company that are conducted for purely research purposes and with no particular investment banking relationship in mind, but which may be followed years later by the firm's receiving an IPO mandate. A key practice of research analysts is to seek out and meet private companies as a means of understanding developments in their industries. Such visits are part of an analyst's information-gathering and education process and occur at the initiative of the analyst in the course of his research coverage activities. The breadth of the language of the Proposed Rules regarding pitch restrictions, however, could have a chilling effect on such visits, for fear that they might be regarded in retrospect as "pitches" by a regulator.
To address these concerns, the SROs should revise this language to make clear that the pitch restrictions apply to analysts "participating in any solicitation of an IPO mandate with the subject company." The SROs also should state the types of prohibited activities that would constitute a "pitch," such as any meetings attended by analysts, bankers and private company representatives where the firm's underwriting capabilities are discussed or where the meeting is designed to influence the issuer to choose the analyst's employer as a managing underwriter of its IPO. Further, the SROs should, in consultation with the industry, clarify the phrase "due diligence" communications, which they do not define, and provide guidelines with respect to the types of communications that constitute "due diligence communications." The SROs also should confirm that "due diligence" communications may include analyst participation in screening and vetting IPO deals, prior to the time that a firm is awarded an IPO mandate. In this regard, analyst participation in screening deals is an important investor protection function. The legitimacy of this practice was confirmed recently by the announced terms of the Global Settlement between certain investment banking firms and regulators, including the SROs.27
Further, the SROs should consider revising the measurement point from which the pitch provisions are triggered. We understand that the signing of a letter of intent or similar document is not a realistic proxy for when a firm becomes an underwriter in an IPO. For some IPOs, there may be no written agreement evidencing the mandate other than the underwriting agreement, which typically is executed long after the firm has begun to act as an underwriter. Instead of focusing on these artificial measurements of when a firm becomes an underwriter, we suggest that the Proposed Rules limit the bar on research to situations where the analyst was involved in a solicitation of an IPO underwriting engagement during the period which is 180 days prior to the filing of the IPO. We believe that this 180-day "blackout" period is consistent with the view taken (and already being applied) by the NASD in its proposed amendments to Rule 2710, in which acquisitions of equity securities of an issuer (or receipt of other items of value) by an underwriter prior to the 180-day period preceding the filing date of an IPO are not considered to be underwriting compensation. Applying this rationale to the Proposed Rules, then, an analyst should not be viewed as "participating in the solicitation of an IPO mandate" if he or she visits a company before the 180-day period preceding the IPO filing date.
Finally, the SROs should make clear that the pitch restrictions are not retroactive and do not apply to the following persons: (1) analysts who participated in a company pitch while employed at a different firm; and (2) analysts who participated in a company pitch while they were employed in a different capacity (e.g., as an investment banker). As written, the pitch restrictions are very broad and do not carve out specific exceptions for these persons or for activities that were not covered prior to the adoption of the Proposed Rules.
B. The Application of the Personal Trading Provisions to Persons Who "Have Direct Influence and/or Control" with Respect to the Preparation of Research Reports Is Overly Broad.
The Proposed Rules extend the personal trading restrictions to "such `other persons,' e.g., Director of Research, Supervisory Analyst, or member of a committee, who have direct influence and/or control with respect to (1) preparing research reports, or (2) establishing or changing a rating or price target of a subject company's equity securities."28 As an initial matter, we are perplexed by the need for such a drastic measure. To our knowledge, there have been no findings or even allegations that the personal financial interests of research directors, research managers, supervisory analysts, members of research review committees, and others who could be covered by this proposed personal trading provision have been a factor in influencing the views expressed in research reports.
In addition, we are concerned that the breadth of this new provision would have the de facto effect of preventing any members of research review committees, research managers, research directors, or supervisory analysts from owning investments that are not excluded from the personal trading restrictions. As a general matter, these individuals review research concerning multiple, if not all, companies and industries for which a firm provides coverage. As such, the personal trading restrictions, including the trading "blackouts," would apply to virtually all, if not all, of the securities covered by the firm. Under the blackout restrictions, trading in a security is prohibited within thirty days before and five days after a "research report" is published concerning the company's equity securities or a change in rating or price target of the company's securities. Because of the difficulty of administering such restrictions to all of these individuals and their household members, firms would have to prohibit them from trading all equity and debt securities of corporate issuers covered by the firm's research department(s). Such a de facto ban on securities ownership would make it difficult, if not impossible, for firms to enlist qualified individuals to serve as members of research review committees, research managers, or research directors.
This proposed expansion of the personal trading restrictions is even more troubling in light of the universe of non-research personnel and their supervisors who would be subject to these restrictions as a result of the proposed expansion of the definition of "research report." For example, in the case of a branch manager who supervises a large office of brokers, the manager's personal trading and his or her household members' personal trading could be subject to the research analyst personal trading restrictions at any given time, depending on whether one or more of the salespersons in the office has issued a written or electronic communication to clients that could be deemed to be a "research report" under the open-ended definition of that term.
In light of the potential draconian results of the Proposed Rules and the lack of evidence that these individuals face the same, unique conflicts of interests that research analysts face, the SROs should consider using less restrictive means to achieve the same purpose of preventing any single person with an interest in an issuer or security from controlling or influencing research reports about that issuer or security. In this regard, the SROs should adopt a two-prong approach. First, they should limit the personal trading restrictions to persons who have direct control and/or influence over the substance of an analyst's recommendation, opinion, price target, or rating. These restrictions should not cover persons who have merely an editorial role with respect to the substance of a research report. Second, the SROs should eschew a "one size fits all" approach and instead require firms to adopt specific procedures designed to address conflicts of interest that may arise when certain persons have direct control and/or influence over a research analyst's recommendation, opinion, price target, or rating. Such a flexible approach would take into consideration the diverse managerial approaches and sizes of brokerage firms and enable them to address potential conflicts where they are most likely to occur, based on their unique organizational structures.
For example, firms might require these people to disclose to legal and/or compliance personnel their holdings on an ongoing basis, so that legal and/or compliance could determine whether such ownership presents a material financial conflict with respect to a covered security. Alternatively, firms might require research management or members of research review committees to recuse themselves from decisions regarding changes in research opinions, recommendations, price target and/or rating changes if they or their household members have material ownership interests in the subject company's securities. To ensure compliance, firms could require such managers or committee members to certify that they have disclosed all personal holdings to legal and/or compliance, or have recused themselves from decisions concerning issuers in which they hold material ownership interests.
C. The SROs Should Clarify the Term "Public Appearances" Before Extending the "Quiet Period" Restrictions to Them.
The SROs have proposed to extend the "quiet period" restrictions in NYSE Rule 472(f) and NASD Rule 2711(f) to "public appearances" by research analysts. Before applying these restrictions to public appearances, however, the SROs should provide clear guidance regarding the status of password-protected and restricted conference calls and Webcasts. Although the SRO rules define the phrase "public appearance," the SROs have not clarified whether this phrase applies to conference calls or Webcasts that are password protected, and not open to the general public.
We believe the better view is that a conference call or Webcast would not fall under the definition of a "public appearance" if it is password-protected and restricted to a firm's clients, regardless of number, on an invitation-only basis.29 Extension of the quiet period requirements to these types of conference calls and Webcasts ultimately would harm investors and undermine transparency because firms would be forced to curtail their practice of hosting such calls and Webcasts, or eliminate this service altogether.30
IV. The SROs Should Resolve Certain Differences between their Respective Rule Proposals.
A. The Certification Requirements Are Inconsistent and Should Be Revised.
NYSE Rule 351(f) and NASD Rule 2711(i) require members to provide annual certifications regarding their compliance with the SRO Rules. The SROs should provide guidance that firms should submit these certifications only to their respective designated examining authority, and not to both SROs. If the SROs disagree with this approach, at the very least, they should coordinate their certification filing deadlines. Currently, the NASD requires firms to file certifications by December 31, while the NYSE has set an April 1 filing date. Requiring firms to undergo the certification process twice each year is unnecessary and a waste of important compliance resources.
B. The SROs Should Coordinate their New Registration Requirements.
Proposed NYSE Rule 344.10 and NASD Rule 1050 will establish a new registration category for associated persons who are directly responsible for the preparation of research reports. The NYSE's proposed rule will require these persons to register with the NYSE and pass a "qualification examination acceptable to the Exchange." The NASD's proposed rule also will require these persons to "pass a Qualifications Examination for Research Analysts" and register with the NASD. We encourage the SROs, as they have done in the past, to avoid unnecessary regulatory overlap by coordinating these new registration and qualification requirements so that research analysts at firms with dual memberships are not subject to two separate categories of registration and two separate examination requirements.
C. The NYSE Should Adopt the NASD's Approach Regarding Public Appearance Disclosures.
We support the NASD's statement in the proposing release that it will modify its current guidance regarding the making of the required disclosures in public appearances with media outlets. Under the modified guidance, an analyst would not violate the disclosure requirements if the analyst makes the required disclosures to the print, radio or television media in good faith, even if the media outlet does not print or broadcast the information. We believe that the NYSE should adopt the NASD's approach with regard to disclosures in public appearances. To fail to do so would make the NASD's guidance meaningless for many firms, which are members of both the NASD and NYSE. Fundamental notions of fairness dictate that analysts and firms should not be held accountable for violations if the analyst makes the required disclosures to the print, radio or television media in good faith, and the media outlet does not print or broadcast the information. Further, as the NASD has acknowledged, such an approach is consistent with and recognizes "the independent editorial discretions of the print, radio and television media."31
V. The SEC Should Provide the SROs with Exemptive Authority.
The SEC should provide the SROs with exemptive authority in administering the SRO Rules because they are extremely complex and, in certain circumstances, may lead to draconian, unintended results. As the SEC well knows, the power to provide exemptive or no-action relief is critical to the effective administration of a broad regulatory program with justice and fairness in a manner appropriately textured to particular facts. Of course, we recognize that such power can be abused in a manner that violates the basic objective of a regulatory scheme, for example, if the exemptions "swallow the rule."
Nevertheless, the fact that the power to grant an exemption can be abused does not mean that the power should not exist. While we respect the mutual concerns of the SEC and the SROs, it is not fair to leave individual firms twisting in the wind because the SROs lack the authority to address individual circumstances. The logical resolution, then, is for the SROs to have exemptive authority, appropriately circumscribed by a standard tied to the purposes of the SRO Rules and the protection of investors, coupled with a rigorous recordkeeping requirement regarding the exercise of such power by the SROs. In this manner, the SROs would retain the necessary power to be used as needed, and the SEC would maintain an effective oversight mechanism.
In particular, the SROs need exemptive authority to provide formal guidance regarding the personal trading provisions. Many of the personal trading restrictions, as written, would apply in certain cases where there appears to be no logical reason for such application. For example:
- As written, the personal trading blackout restrictions could apply to automatic dividend reinvestment plan ("DRIPs"). There appears to be no logical reason for extending the restrictions to automatic DRIPs because the research analyst has no control over the timing of the company's declaration of a dividend, or the amount of such dividend. In addition, the amount of shares purchased through a DRIP at any given time is typically insignificant, in contrast to the significant administrative burden and cost of requiring firms to track the timing of every share purchased through a DRIP for an analyst account or the account of a household member.
Further, the personal trading restrictions, as written, would apply to all managed accounts and other accounts in which the analyst or a member of the analyst's household holds a financial interest but has no discretion or control. A restriction on these types of accounts is unnecessary because neither the analyst nor the analyst's household member has any discretion, control, or knowledge of prospective investments.
Thank you for providing us with the opportunity to comment on the NYSE and NASD proposed rule changes regarding research analyst conflicts of interest. As noted above, we support the stated goals of the Proposed Rules. Nevertheless, we believe that the Proposed Rules, as submitted, are likely to have unintended, unworkable consequences. Instead of hastening to adopt these Proposed Rules as part of a series of incomplete rule changes, we urge the SROs to work with the SEC to review and consolidate all impending regulatory changes into a single set of coherent rules. Failing that, the SROs, at a minimum, should clarify and modify the Proposed Rules as set forth above. Such clarifications and modifications are necessary to make the Proposed Rules consistent with the Exchange Act, the purpose of the SOA, and the existing regulatory scheme, and ultimately would inure to the benefit of investors. 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
|1|| Exchange Act Release No. 47110 (Dec. 31, 2002), 68 Fed. Reg. 826 (Jan. 7, 2003) ("Notice of Filing of Proposed Rule Changes by the NYSE and NASD").
|2|| Sections 6 and 15A of the Exchange Act require national securities exchanges and registered securities associations, respectively, to adopt rules designed to "remove impediments to and perfect the mechanism of a free and open market and a national market system, and, in general, to protect investors and the public interest." See 15 U.S.C. §§ 78f(b)(5), 78o-3(b)(6).
|3|| In March 2002, the SROs proposed the first round of rules relating to research analyst conflicts of interest, which the SEC approved in May 2002. See Exchange Act Release No. 45908 (May 10, 2002), 67 Fed. Reg. 34969 (May 16, 2002) ("Order Approving Proposed Rule Changes by the NASD and NYSE"). In June 2002, the SROs issued guidance regarding these rules. See NASD Notice to Members 02-39 (June 26, 2002); NYSE Information Memo No. 02-26 (June 26, 2002). In August 2002, the SEC proposed Regulation Analyst Certification ("Regulation AC"), which was adopted last month. See Exchange Act Release No. 47384 (Feb. 20, 2003), 68 Fed. Reg. 9482 (Feb. 27, 2003) ("Regulation AC Adopting Release"). In May 2002, the settlement of a state enforcement action against Merrill Lynch was followed by an initiative by various state treasurers to impose the principles of that settlement on securities firms. See Spitzer, Moore, McCall and Angelides Announce Landmark Initiative to Eliminate Wall Street Conflicts of Interest, Office of New York State Attorney General Eliot Spitzer Press Release (July 1, 2002), available at http://www.oag.state.ny.us/press/2002/jul/jul01a_02.html.
|4|| Notice of Filing of Proposed Rule Changes by the NYSE and NASD, 68 Fed. Reg. at 833.
|5|| The SROs also have adopted specific rules regarding trading ahead of customer orders (i.e., front running) and trading ahead of research reports. See, e.g., NASD IM-2110-3 (front running policy) and IM-2110-4 (trading ahead of research reports); NYSE Rules 105(g) (prohibition against front-running of blocks -- specialists' interest in pools and options) and 112.20(d) (prohibition against front-running of blocks -- restrictions on competitive traders); NYSE Information Memo No. 89-53 (Nov. 27, 1989) (NYSE front-running interpretations).
|6|| See Regulation AC Adopting Release, 68 Fed. Reg. at 9482.
|7|| S. Rep. No. 107-205, 2002 WL 1443523, at *32 (2002) ("Senate Report").
|8|| Senate Report, 2002 WL 1443523, at *32 (quoting from a letter to Paul S. Sarbanes, Chairman, Committee on Banking, Housing, and Urban Affairs by Eliot Spitzer, Attorney General of the State of New York).
|9|| 15 U.S.C. § 78o-6(a)(1).
|10|| NYSE Proposed Rule 472.10(2). The NASD's proposed definition is substantially identical: "a written or electronic communication which includes an analysis of equity securities or individual companies or industries, and which provides information reasonably sufficient upon which to base an investment decision." NASD Proposed Rule 2711(a)(8).
|11|| NASD Rule 2711(a)(5) defines the term "research analyst" as "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.'" The NYSE's definition is substantially identical, although the NYSE uses the term "associated person," instead of "research analyst." See NYSE Rule 472.40.
|12|| For example, if, after an IPO, a client requests information from a broker regarding the company, the broker might be precluded from sending background information and factual, financial summaries regarding the company to the client for 40 days under the SRO Rules (a period that unnecessarily exceeds the restrictions on information following an IPO imposed by the Securities Act of 1933, as amended) because such information might be deemed to be a "research report."
|13|| Senate Report, 2002 WL 1443523, at *32.
|14|| Analyzing Analyst Recommendations, available at http://www.sec.gov/investor/pubs/analysts.htm.
|15|| The presumption of an exclusion, as opposed to an automatic exclusion, would address regulatory concern that a firm might use traders and salespeople to cover companies and issue "research reports" to avoid the application of the SRO Rules.
|16|| 15 U.S.C. § 78o-6(c)(2) (emphasis added).
|17|| 15 U.S.C. § 78o-6(a) (emphasis added).
|18|| Order Approving Proposed Rule Changes by the NASD and NYSE, 67 Fed. Reg. at 34969 (emphasis added). Regulation AC further underscores the notion that a subjective view or conclusion is inherent in the definition of "research report" by requiring a research analyst to certify that "the views expressed in the report accurately reflect his or her personal views." Regulation AC Adopting Release, 68 Fed. Reg. at 9482.
|19|| According to the Report of the Senate Committee on Banking, Housing, and Urban Affairs: "The bill is intended to prevent certain pressures on analysts which could compromise their objectivity and to provide disclosure to investors of certain conflicts of interest that can also influence the objectivity of the analyst in preparing a research report." Senate Report, 2002 WL 1443523, at *33.
|20|| 15 U.S.C. § 78o-6(c)(2) (emphasis added).
|21|| Regulation AC Adopting Release, 68 Fed. Reg. at 9483 (emphasis added).
|22|| See NASD Notice to Members 02-39 (June 26, 2002); NYSE Information Memo No. 02-26 (June 26, 2002).
|23|| Regulation AC defines a "research report" as a "written communication (including an electronic communication) that includes an analysis of a security or an issuer and provides information reasonably sufficient upon which to base an investment decision." 17 C.F.R. § 242.500.
|24|| Regulation AC Adopting Release, 68 Fed. Reg. at 9484.
|25|| NYSE Proposed Rule 472(b)(4). The NASD's proposal is substantively identical: "[n]o research analyst may issue a research report or make a public appearance concerning a subject company if the research analyst engaged in any communication with the subject company in furtherance of obtaining investment banking business prior to the time the subject company entered into a letter of intent or other written agreement with the member designating the member as an underwriter of an initial public offering by the subject company." NASD Rule 2711(c)(4).
|26|| Concerns relating to the ambiguous scope of the pitch restrictions are exacerbated by the broad definitions of "research analyst" and "research report, which potentially could transform investment bankers into research analysts. Would investment bankers then be prohibited from participating in pitches for IPO business?
|27|| See SEC, NY Attorney General, NASD, NASAA, NYSE and State Regulators Announce Historic Agreement To Reform Investment Practices, SEC Press Release No. 2002-179 (Dec. 20, 2002), available at http://www.sec.gov /news/press/2002-179.htm. In their Joint Memorandum, the SROs stated that the SRO Rules "are not intended to prevent a member's investment banking department from obtaining a research analyst's view of a prospective client before committing to undertake an investment banking transaction." NASD Notice to Members 02-39 (June 26, 2002); NYSE Information Memo No. 02-26 (June 26, 2002).
|28|| NYSE Proposed Rule 472.40. The NASD's proposal is substantially identical to the NYSE's proposal. See NASD Proposed Rule 2711(a)(5).
|29|| We understand that these passwords and invitations are distributed to a targeted group of the firm's clients, which typically number in excess of 15.
|30|| If the SROs do not agree with this proposed clarification, at the very least, they should consider excluding from the definition of "public appearance" conference calls or Webcasts that are restricted to institutional investors. Indeed, in other contexts, the NASD has recognized that institutional investors and retail investors are fundamentally different and that different communications standards should apply to them. For example, in December 2001, the NASD proposed rule changes that would exclude all communications to institutional investors from member pre-use approval and NASD filing requirements. See Exchange Act Release No. 45181 (Dec. 20, 2001), 66 Fed. Reg. 67586 (Dec. 31, 2001). The NASD also imposes different suitability obligations for retail and institutional investors. Compare NASD Rule 2310 with IM-2310-3.
|31|| Notice of Filing of Proposed Rule Changes by the NYSE and NASD, 68 Fed. Reg. at 836.