On July 29, 2003, the Securities and Exchange Commission ("SEC") approved the proposed rule changes by the National Association of Securities Dealers, Inc. ("NASD") and the New York Stock Exchange, Inc. ("NYSE") (together with other self-regulatory organizations, the "SROs") that further address research analyst conflicts of interest in connection with equity research reports, and are designed to achieve full compliance with the mandates of section 501 of the Sarbanes-Oxley Act of 2002 ("SOA").[1]
The approval of the SRO rule changes represent the latest in a series of regulatory actions taken during the last year to promote the integrity of research. Most recently, on April 28, 2003, the SEC, the NASD, the NYSE, and the States announced the settlement of enforcement actions against ten of the nation's top securities firms alleging undue influence by investment banking interests on the firms' research. This Global Settlement includes substantial monetary relief and imposes structural reforms that seek to promote analyst independence. Earlier, the SEC approved a series of SRO rule changes addressing analyst conflicts of interest and adopted Regulation AC (Analyst Certification), which requires analysts to certify that their research reports accurately reflect their personal views and disclose whether they received compensation for their specific recommendations.
The SEC Order approving the proposed SRO rule changes relating to research analyst conflicts of interest can be found a: http://www.sec.gov/rules/sro/34-48252.htm
The approved rule amendments were proposed as two different sets of SRO rule proposals; one set conceived as improvements to the May 2002 SRO rule changes and another set to comply with the mandate in section 501 of the SOA. The following sets forth an overview of SRO rule amendments:
Definitions
In an effort to conform to the definition contained in the SOA, the term "research report" has been amended to eliminate the current definitional requirement that a research report contain a "recommendation." The SROs have substantially similar amended definitions, defining the term as a 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.
In addition, the term "public appearance" has been amended by the SROs to include print media interviews and the writing of print media articles.
Separation of Research Analyst Compensation from Investment Banking Influence
The rule changes reinforce the separation of research analyst compensation from investment banking influence by requiring firms to establish a compensation committee to review and approve the compensation of its research analysts who are primarily responsible for the preparation of the substance of research reports. The committee is required to report to the Board of Directors or a senior executive of the broker-dealer and may not have representation from the firm's investment banking department. At a minimum, the committee must consider the analyst's individual performance (e.g., quality of research product); correlation between a research analyst's recommendations and stock prices; and overall ratings from various internal or external parties exclusive of the firm's investment banking personnel. The committee may not consider a research analyst's contribution to the firm's overall investment banking business. In addition, in order to comply with the SOA, the rule changes prohibit investment banking personnel influence or control over compensation evaluationsof research analysts.
Booster Shot Research Reports
The rule changes prohibit analysts from issuing positive research reports or reiterating a "buy" recommendation around the expiration of a lock-up agreement (sometimes called "booster shot" research reports). The proposals accomplish this by prohibiting the issuance of research reports by the manager or co-manager of a securities offering for 15 days prior to and after the expiration of lock-up agreements.
Quiet Periods
The SOA requires the establishment of periods during which broker-dealers who have participated or are to participate in a securities offering as underwriters or dealers may not publish or otherwise distribute research reports related to such securities. In order to comply with the SOA, the SRO rule changes extend the current ten and forty-day quite periods for the issuance of written research reports imposed on managing underwriters and co-managers following public offerings to communications in public appearances by managers and co-managers of initial and secondary offerings. The amendments also establish a 25-day quiet period during which broker-dealers who have agreed to participate as underwriters or dealers (other than as a manager or co-manager) of an issuer's initial public offering would be prohibited from publishing research reports and analysts would be prohibiting from making public appearances regarding that issuer.
Pitch Meeting
The amended rules further insulate research analysts from investment banking interests by prohibiting analysts from participating in "pitches" or other communications for the purpose of soliciting investment banking business. This prohibition on analysts' involvement in the solicitation of investment banking business is intended to support the prohibition on promising favorable research as a marketing tool to prospective investment banking clients.
Termination of Coverage
The amended rules require that firms provide notice of termination of research coverage to its customers.[2] Specifically, firms are required to disclose to its customers in a final report that it is terminating research coverage of an issuer that is the subject of a research report. The final report must include a final recommendation or rating unless it is impracticable to do so.
Prepublication Review of Research Reports and Approval of Securities Transactions by Legal or Compliance Staff
The SRO rule changes restrict the prepublication review and approval of research reports by persons not directly responsible for research. The rules also require that prepublication communications about a research report between all non-research personnel and the research department be intermediated by legal or compliance staff. Furthermore, the rules require that legal or compliance personnel pre-approve all securities transactions of persons who oversee research analysts, including any persons or members of committees that may have direct influence or control with respect to the preparation of research reports or establishing or changing a rating or price target of a subject company's equity securities, to the extent that the transactions involve securities of subject companies covered by research analysts that they oversee.
Anti-Retaliation
Pursuant to the SOA mandate, the rule amendments prohibit firms engaged in investment banking activities from directly or indirectly retaliating, or threatening to retaliate, against a research analyst who publishes a research report or makes a public appearance that may adversely affect the member's present or prospective investment banking relationships. However, the anti-retaliation provision would not preclude termination of a research analyst, in accordance with the member's policies and procedures, for causes unrelated to issuing or distributing such adverse research or for making an unfavorable public appearance . (Please note that the SROs have suggested that this proposed rule change be made effective immediately.)
Disclosure of any Compensation from the Issuer
The rule amendments expand on the current SRO compensation disclosure requirements by requiring disclosure by a member in research reports, to the extent the member knows or has reason to know, and by a research analyst in public appearances, to the extent the analyst knows or has reason to know, of whether the member, or any affiliate thereof (including the research analyst), received any compensation during the past twelve months from the issuer that is the subject of the report or public appearance. The rule changes further require disclosure of whether the subject company is, or has been during the previous year, a client of the member, and if so, the types of services provided to the issuer. The types of services provided to the subject company must be described as: (i) investment banking services, (ii) non-investment banking securities-related services, or (iii) non-securities services. Both the compensation disclosure and the client services disclosure provisions provide for an exception in order to prevent the disclosure of material non-public information regarding specific potential future investment banking transactions of the issuer.
Gatekeeper Exceptions
The SRO rule changes create an exception from the existing "gatekeeper" provisions of the SRO rules for certain members that engage in limited underwriting activity. The gatekeeper provisions prohibit a research analyst from being subject to the supervision or control of any employee of a member's investment banking department, and further require legal or compliance personnel to intermediate certain communications between research and investment banking personnel.
Research Analyst Registration and Qualification
The rules impose additional registration, qualification, and continuing education requirements on research analysts. The rule amendments establish a new registration category and require a qualification examination for research analysts. The rules also impose requirements regarding the continuing education of certain registered persons consisting of a Regulatory Element and a Firm Element to address applicable rules and regulations, ethics, and professional responsibility.
Implementation
Implementation of the various rule amendments is being phased in to allow broker-dealers time to develop and implement policies, procedures and systems to comply with the new requirements. Some elements of the rule amendments are effective immediately, while others take effect in 60, 90 or 180 days from the time of the SEC's approval. See Exhibit A attached hereto for details regarding the implementation schedule for the rule amendments.
Please do not hesitate to contact the following members of our Broker-Dealer Practice Group if we can be of assistance to you in explaining the rule amendments, and/or developing written supervisory procedures that comply with the new rules.
D. Grant Vingoe
(416) 367-7370
Benjamin J. Catalano
(212) 415-9346
Barri L. Bogner
(212) 735-0798
Fola Adamolekun
(212) 415-9377
EXHIBIT A
NYSE IMPLEMENTATION SCHEDULE
NYSE Rule(s) | Subject Matter | Suggested Effective Date |
Rules472(k)(1)(i)d.2. and (k)(1)(iii)a. | Firm and affiliate compensation disclosure provisions | January 26, 2004 except upon written request to the NYSE for an extension of up to 90 days thereafter |
Rules 472(k)(1)(ii)a., (k)(1)(iii)a., (k)(2)(i)c.2. and f. | Analyst and firm compensation disclosure provisions | January 26, 2004 except upon written request to the NYSE for an extension of up to 90 days thereafter |
Rules 472(k)(1)(i)d.1., (k)(1)(ii)b.1., and (k)(2)(1)c.1. | Client disclosure provisions | January 26, 2004 except upon written request to the NYSE for an extension of up to 90 days thereafter |
Rule 472(k)(3)(1) | Exceptions to disclosures as applied under Rules 472 (k)(1)(i)a.2 and 3. | Effective immediately |
Rule 472(k)(3)(1) | Exceptions to disclosures as applied under Rules 472(k)(1)(i)d.1, (k)(1)(ii)b.1 and (k)(2)(i)c. | January 26, 2004 |
Rule 345A | Continuing education requirements for research analysts | January 26, 2004 |
Rule 344 | Qualification, examination and registration requirements for research analysts | 365 days after the completion of the Qualification Examination. January 26, 2004 for the development and implementation of the examination |
Rule 472(h)(2) | Compensation committee review/procedures | October 27, 2003 |
Rules 472(g)(2) and 472(m) | Anti-retaliation and small firm exemption provisions | Effective immediately |
All other Rule provisions will become effective September 27, 2003 | ||
NASD IMPLEMENTATION SCHEDULE
NASD Rule(s) | Subject Matter | Suggested Effective Date |
Proposed Rule 1050 and amendments to Rule 1120 | Qualification, examination, registration and continuing education requirements for research analysts | January 26, 2004 or such later date as determined by the NASD |
Proposed Rule 2711(h)(2) | New compensation and client disclosure provisions | January 26, 2004 with an extension of up to an additional 90 days as deemed appropriate on a case-by-case basis |
Proposed Rule 2711(h)(2)(C) | Exemptions from disclosure requirements as applied under Rules 2711(h)(2)(a)(ii)(a) and (b) | Effective immediately |
Proposed Rule 2711(h)(2)(C) | Exemptions from disclosure requirements as applied under Rules 2711(h)(2)(a)(iii)(b), (h)(2)(b)(i) and (iii) | January 26, 2004 |
Proposed Rule 2711(d)(2) | Research analyst compensation review procedures | October 27, 2003 |
Proposed Rule 2711(j) | Prohibition against retaliation against research analysts | Effective immediately |
Proposed Rule 2711(k) | Exceptions for small firms | Effective immediately |
All other proposed rule changes will be implemented within 60 days of approval | ||
[1] On October 25, 2002, the NASD submitted proposed new NASD Rule 1050 and amendments to NASD Rules 2711 and 1120 for approval by the SEC, and the NYSE submitted a similar proposal to amend NYSE Rule 472 on October 9, 2002.
[2] The NASD intends to provide general guidance as to what constitutes "termination," and will also consider such scenarios on a case-by-case basis.
Disclaimer
If you have any questions, please do not hesitate to contact Charles L. Potuznik at 612-340-2914 or potuznik.charles@dorseylaw.com; D. Grant Vingoe at 416-367-7377 or vingoe.d.grant@dorseylaw.com; or Benjamin Catalano at 212-415-9346 or catalano.benjamin@dorseylaw.com.
This memorandum is intended for general information purposes only and should not be construed as legal advice or legal opinions on specific facts or circumstances. Members of the Dorsey & Whitney LLP Broker-Dealer Practice Group listed above will be pleased to provide further information with regard to the matters discussed above.