What Are Investment Banks Doing to Avoid Analyst Conflicts?
What Are Investment Banks Doing to Avoid Analyst Conflicts?
Compliance Director Equity Research and Investment Banking
Lehman Brothers Inc.
Mark E. Kaplan
Charles F. Ughetta
Gerard Klauer Mattison & Co
John V. Ayanian
Morgan, Lewis & Bockius LLP
Institutional Investor Seminars
The Future of Investment Research Summit
Regulations, Standards & Managing Expectations
New York, NY
November 14, 2002
II. SRO RESEARCH ANALYST CONFLICT OF INTEREST RULES
1. In May 2002, the SEC approved proposals by the NASD and the NYSE to
beef up disclosure of research analyst conflicts and to establish substantive
restrictions governing research analyst practices. 4 NASD Rule 2711
(Research Analysts and Research Reports) and amendments to NYSE
Rule 472 (Communications with the Public), among other things, impose
limits on how a firm’s investment banking and research departments may
interact, require disclosure of financial interests held by the firm and its
analysts in covered companies, and require firms to describe their rating
systems and price target methodology. The Rules were phased-in
incrementally on July 9, 2002, September 9, 2002, and November 6, 2002.
B. Independence of Research
1. The Rules prohibit a firm’s investment banking department from
supervising or controlling the firm’s research department and from
reviewing or approving research reports before publication. NYSE Rule
2. Investment banking personnel can communicate with research personnel
on a pre-publication basis to “ensure the report’s factual accuracy and to
screen for conflicts of interest.” NYSE Rule 472(b)(2). The firm’s legal
or compliance department is required to serve as “gatekeeper” for such
3. No pre-publication review of a research report by the subject company is
permitted, except to ensure that the report is factually accurate. NYSE
Rule 472(b)(3). Again, the firm’s legal or compliance department is
required to serve as “gatekeeper” for such communications.
a. Draft reports submitted to a company cannot contain a research
summary, the rating, or the price target.
b. A member may notify a subject company that the member will
change a rating after the close of trading in the principal market
one business day prior to the announcement of the change. NYSE
4 The SEC approval order is available at <http://www.sec.gov/rules/sro/34-45908.htm>.
4. Member firms are prohibited from:
a. issuing research reports (provided the firm was an underwriting
“manager” or “co-manager”) during two “quiet periods”: (1) 40
calendar days following the date of an IPO, and (2) 10 calendar
days following the commencement of sales in a secondary
offering. NYSE Rule 472(f)
(i) Firms may permit exceptions for research reports issued
due to significant news or events, provided reports are pre-
approved in writing by legal/compliance.
NOTE: Firms must still comply with Section 5 of the Securities
(ii) The 10 day “quiet period” will not prevent a member from
publishing a research report pursuant to SEC Rule 139
regarding a subject company with “actively-traded
securities,” as defined in Regulation M under the Exchange
b. offering or threatening to change research, ratings, or price targets
to attain business or compensation. NYSE Rule 472(g)
c. tying analyst compensation to specific investment banking
transactions. NYSE Rule 472(h)
C. Research Analyst Personal Trading Restrictions
1. Any account of an analyst or member of the analyst’s household, and any
account over which the analyst has a financial interest, or exercises
discretion or control (see NYSE Rule 472.40) are prohibited from:
a. purchasing or receiving pre-IPO shares of an issuer in the industry
the analyst covers. NYSE Rule 472(e)(1)
b. trading a subject company’s securities (or derivatives overlying
those securities) during a “blackout” period beginning 30 calendar
days before, and ending 5 days after, the issuance of a research
report or change in the research rating or price target. NYSE Rule
c. trading against the firm’s most current recommendation
concerning a security. NYSE Rule 472(e)(3)
NOTE: The NYSE rule appears to prohibit trading against all firm
recommendations, while the NASD rule prohibits trading by an analyst
against that particular analyst’s recommendation. We understand that the
NYSE recognizes the difference, and intends to apply the rule consistent
with the plain meaning of the NASD rule.
2. Exceptions (NYSE Rule 472(e)(4))
a. personal financial circumstances
b. significant news or events
c. sales transactions if the purchase was before:
(i) date of employment
(ii) initiation of coverage
d. passive investor in investment fund where interest in fund is no
greater than 1% of funds assets and fund does not invest more than
20% of assets in securities of issuers in same business as
companies analyst usually covers
e. transactions in registered diversified investment companies
3. Legal/compliance department must review trading and distribution of
research reports that rely on these exceptions.
a. For example, legal or compliance must pre-approve a research
report prepared in response to significant news or events (and
within 30 days following an analyst trade), and consider whether
the research analyst knew or had a reason to know of the
significant news or events leading to the new research report or
change in the rating or price target.
D. Disclosure of Relationships and Financial Interests
1. The following rules apply if the firm or its affiliates:
a. managed/co-managed a public offering of a subject company’s
securities in the last 12 months
b. received compensation for investment banking services from the
company within the last 12 months
c. expects to receive or intends to seek compensation for investment
banking services from the company within the next 3 months.
NYSE Rule 472(k)(1)(ii)
2. Research analysts have to disclose in public appearances if they know or
have reason to know that the subject company is an investment banking
3. Research analysts (public appearances) and firms (research reports) must
a. the firm or its affiliates beneficially owned = >1 percent of any
class of the subject company’s equity securities as of the end of the
month immediately preceding the date of publication of the
research report or the public appearance (or the end of the 2nd
most recent month if the publication date is less than 10 calendar
days after the end of the most recent month) – NYSE Rule
b. a research analyst account has a financial interest in the subject
company – NYSE Rule 472(k)(1)(i)(b);
c. there is any other actual, material conflict of interest – NYSE Rule
E. Disclosure of Analyst Compensation
1. Firms must disclose in research reports if the analyst received
compensation that is “based upon (among other factors) the [firm’s]
overall investment banking revenues.” NYSE Rule 472(k)(2)
F. Rules Regarding Disclosure of Ratings/Price Targets/Price Charts (NYSE Rule
Members must disclose in research reports:
1. the meaning of all ratings in the firm’s rating system;
2. the percentage of all securities rated by the firm to which the firm would
assign a “buy,” “hold/neutral,” or “sell” rating;
3. the percentage of subject companies within each of the three rating
categories for which the firm has, within the previous 12 months, provided
investment banking services;
4. if the firm has rated a security for at least one year, provide a price chart
(current as of end of most recent calendar quarter) that maps the historical
daily closing price movements of the security and indicates those points at
which the firm assigned or changed a research rating or price target (chart
need not extend more than 3 years prior to date of report); and
5. the valuation method used in developing price targets and risks that may
impede achievement of price target.
G. Other Disclosures
1. whether the firm makes a market in the security. NYSE Rule 472(k)(2)(i)
2. whether a research analyst (or household member) is an officer, director or
advisory board member of the subject company (also required in public
appearances). NYSE Rule 472(k)(1)(iii)
H. Disclosures in Compendium Reports
1. If a report covers 6 or more companies, the firm may direct the reader in a
clear and prominent manner as to where they may obtain applicable
current paragraph (k) disclosures in written or electronic format.
I. SRO Interpretive Guidance 5
1. What is a Public Appearance?
a. Definition is broad, and includes: seminars, forums,
radio/television interviews, or other public speaking activity in
which a research analyst makes a recommendation or offers an
opinion concerning an equity security.
b. Interpretive Memo suggests that conference calls and Web casts
that are open to the public are also public appearances.
2. Who is a Research Analyst?
a. NASD/NYSE state that the term does not include every registered
person who may express an opinion on an equity security. The
term does not include:
(i) RRs who recommend securities to their customers, so long
as they do not prepare the substance of research reports and
do not report to persons who do prepare research reports.
(ii) Investment advisers, such as mutual fund portfolio
managers, who are not principally responsible for preparing
the substance of a research report, even if they are
registered persons of members.
5 The NASD and NYSE published a joint memorandum in June 2002 that provides interpretive guidance on several
issues relating to the new SRO Research Analyst Rules. The text of the joint memorandum is available at
b. This guidance is helpful, but still requires firm’s to determine
whether written or electronic communications prepared by such
persons constitute a “research report.”
3. What is a Research Analyst Account?
a. Financial interest; or
b. Discretion or control
c. NOT portfolio investments of registered investment companies.
4. What is a Research Report?
a. Four-Part Test:
(i) written or electronic communication;
(ii) that includes an analysis of equity securities of individual
companies or industries;
(iii) that provides information reasonably sufficient upon which
to base an investment decision; and
(iv) that includes a recommendation.
5. What is not a Research Report?
a. Reports discussing broad-based indices; or economic, political, or
b. Technical analysis of demand/supply of sector/index/industry
based on trading volume and prices.
c. Statistical summaries of multiple companies’ financial data
(including listings of current ratings) without narrative discussions
or analysis of individual companies’ data.
d. Reports that recommend increasing or decreasing holdings in
particular industries or sectors but that do not recommend or rate
e. Notices of ratings/price target changes with no discussion of
company (with reference to current disclosures).
f. Analysis by RR for specific customer’s account.
g. Internal Use Only.
6. Third-Party Research
a. If report produced by independent third party, in accordance with
soft-dollar arrangement, the distributing firm’s disclosure
requirements do not apply.
b. If independent third-party source is a NASD or NYSE member,
then that firm (and not the distributing firm) must comply with the
c. If report produced by non-member affiliate, or independent third
party other than through a soft-dollar arrangement, then
distributing member must make following disclosures, if
(i) one-percent beneficial ownership;
(ii) certain disclosures regarding underwriting activities or
compensation for investment banking services generally
(see delaying amendment with respect to foreign affiliates);
(iii) if member is a market maker in the security; and
(iv) other actual, material conflicts of interest of the member.
d. Third-party research will not be deemed to be “distributed” if:
(i) a customer independently requests or accesses the report
from the member; or
(ii) the member makes research available to customers through
its Web site or a third party’s Web site and customers select
their own research.
7. Quiet Periods
a. Significant News or Events Exceptions to SRO Quiet Periods
(i) any news or events that are expected to have a material
impact on, or that is expected to cause a material change to,
the subject company’s operations, earnings or financial
(ii) NOTE: This exception from the SRO rules is not an
exemption from Section 5 of the Securities Act.
b. When Does the “Quiet Period” Begin?
(i) IPOs -- effective date of the registration statement
(ii) Secondary -- date secondary shares are first offered to the
c. Applies to convertible debt offerings.
d. Applies to offerings that commenced on or after July 9, 2002.
J. Legal/Compliance Department Challenges
1. Requiring legal/compliance personnel to serve as “gatekeepers” marks a
significant expansion of their traditional role and greatly expands their
2. Designated legal/compliance personnel who serve as “gatekeepers” should
have expertise similar to a supervisory analyst to be in a position to
evaluate the bases for a research analysts’ conclusions.
K. Supervision and Internal Controls
1. Identify Legal and Compliance personnel to serve as “gatekeepers”
a. Such personnel should work closely with firm’s registered
supervisory analyst to develop skills necessary to perform this
2. Monitor personal trading of analysts and their “household members”
3. Monitor electronic communications between research and investment
4. Determine policy for customer-directed materials prepared outside of the
III. AGREEMENT BETWEEN THE ATTORNEY GENERAL OF THE STATE OF
NEW YORK AND MERRILL LYNCH, PIERCE, FENNER & SMITH, INC.,
DATED MAY 21, 2002
1. Research Reports
a. Cover Legend – “Investors should assume that the Firm is seeking
or will seek investment banking or other business from the covered
b. Ratings disclosure on a percentage basis, the aggregate
distribution, calculated quarterly, of the intermediate-term rating
category used by the Firm, for:
• all stocks in the applicable sector/industry; and
• all stocks covered by the research department.
2. Solicitations of Public Equity Underwrtings – Solicitation materials will
include a written disclosure that:
• “The Firm prohibits employees from, directly or indirectly, offering a
favorable research rating or specific price target, or offering to change
a rating or price target to a subject company as consideration or
inducement for the receipt of business or for compensation”; and
• “The Firm prohibits research analysts from being compensated for
involvement in investment banking transactions except to the extent
that such participation is intended to benefit investor clients.”
3. Termination of Coverage -- When terminating coverage, the Firm must
disclose in the research report:
• that the Firm is terminating coverage;
• the rationale for the decision to terminate coverage; and
• that, effective upon the termination of coverage, the last
recommendation issued for the particular stock should not be relied
upon going forward.
B. Analyst Compensation
a. Compensated for only those activities and services intended to
benefit the Firm’s investor clients, which include:
• formulating recommendations and preparing research reports;
• communicating investment information to investor clients;
• cooperation, accessibility and responsiveness consistent with serving
• identifying and evaluating potential investment opportunities,
including whether appropriate for the Firm’s investor clients.
b. Research Department managers and more senior executives
determine compensation, based primarily upon:
• quality of research and performance of recommendations;
• competitive compensation factors;
• investor client surveys;
• input from institutional sales, equity trading, and private client
2. Executive management may discuss with Research management overall
costs, budgets, resource allocation and retention and recruitment of
3. Conditions To Reference in Employment Contracts
Persons responsible for determining analyst compensation are prohibited from
soliciting from analyst, or considering, either:
• investment banking revenue from clients covered by analyst;
• analyst’s participation in investment banking transactions, except to
the extent such activities intended to benefit investors.
4. Investment banking department personnel may not evaluate analysts’ help
with generating investment banking business.
5. Research management may not communicate with investment bankers to
calculate or influence an analyst’s compensation.
C. Research Recommendation Committee (“RRC”)
Monitor and supervise research recommendations for “objectivity, integrity, and a
rigorous analytical framework in development of all recommendations”
Institutional and private client sales management, research management, and
a. Reports to research director
b. Fixed salary, plus a bonus based primarily on recommendation
performance (based on absolute price performance, against rating
definitions, and relative to industry and market benchmarks).
4. Initiation/Change of Recommendation
a. Requires RRC approval (or approval by RRC member and ratified
b. Analyst must disclose to RRC any participation in investment
banking transactions for subject company in last 12 months.
D. Compliance Monitor
1. The Firm designates a Compliance Monitor whose assignment is to
“ensure compliance with the policies required by [the] Agreement.”
2. The Compliance Monitor will be available to research analysts to address
issues of actual or perceived undue influence or pressure from investment
banking or any other source.
3. The Compliance Monitor will report directly to the General Counsel.
IV. PROPOSED CHANGES TO SRO RESEARCH ANALYST RULES
On October 8, 2002 and October 25, 2002, the NYSE6 and NASD, 7 respectively, filed with the
SEC proposals to expand the existing SRO research analyst rules. As of the date of this outline,
these proposals have not been published in the Federal Register for notice and comment. The
proposals primarily address issues involving: analyst compensation, SRO-imposed “quiet
periods,” termination of research coverage, participation in “bake-offs,” and registration,
qualification and continuing education of research analysts. Both proposals expand the scope of
the definition of research analyst and public appearance, while the NYSE revised its definition of
research report. The following discussion briefly outlines the proposals.
A. Analyst Compensation – Formation of Compensation Committee
1. Firms would be required to employ a compensation committee that:
a. reports to the Board of Directors (or if the member does not have a
Board, a senior executive officer of the member);
b. is responsible for reviewing and approving analyst compensation at
c. does not have representation from the investment banking
d. documents the basis for establishing the analyst’s compensation.
2. The committee would have to consider:
a. the analyst’s individual performance;
b. the analyst’s productivity and research quality;
c. the correlation between analyst’s recommendations and stock price
d. overall ratings of clients, sales force, and peers independent of the
member’s investment banking department.
3. The committee could not consider the analyst’s contributions to the
member’s investment banking business.
4. The member would have to attest annually to its SRO that the committee
reviewed and approved each analyst’s compensation and documented the
basis upon which the compensation was established.
6 The text of the NYSE rule filing is available at <http://www.nyse.com/pdfs/2002-49fil.pdf>.
7 The text of the NASD rule filing is available at <http://www.nasdr.com/pdf-text/rf02_154.pdf>.
B. “Quiet Periods”
1. Existing (see Section II.B.4) and newly proposed (see below) “quiet
periods” would apply to recommendations made in public appearances by
research analysts as well as to the issuance of research reports.
a. The definition of “public appearance” would be revised to include
interviews with print media and the writing of a print media article.
b. Similar to the guidance set forth in the Joint Memorandum
published in June 2002, an analyst would not violate the rule if,
after making all the required disclosures in a public appearance,
the media outlet edits out the disclosures before final publication.
c. If the analyst becomes aware that the disclosures are being edited
out, the analyst would be expected to decline further interviews
with that media outlet, absent assurances that the disclosures would
not be edited out.
2. Newly proposed “quiet period” would prohibit a research analyst of a
member acting as manager or co-manager of a subject company’s
securities offering from publishing a research report or recommending a
the company’s securities in a public appearance for 15-days prior to or
after the expiration, waiver or termination of a lock-up agreement.
NOTE: The significant news or events exception also would apply to this
C. Termination of Coverage
1. Members would be required to publish a notice of termination in the same
manner as when research coverage was first initiated by the member; and
2. Publish a final rating or recommendation of the subject company’s
1. Research analysts would be prohibited from issuing a research report or
making 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.
NOTE: The NYSE states in the description of its proposal that the
changes “will prohibit research analysts from participating in solicitation
or ‘pitch’ meetings with prospective investment banking clients.” The
NYSE’s proposed rule text – similar to that of the NASD – states,
however, that the analyst simply would be prohibited from covering the
subject company in a research report or public appearance if he or she
participated in the solicitation.
2. The provision would not apply to any due diligence communication
between the research analyst and the subject company, the sole purpose of
which was to analyze the financial condition and business operations of
the subject company.
E. Registration, Qualification and Continuing Education
1. Research analysts would have to register with each SRO, as applicable.
2. Prior to the registration becoming effective, research analysts would have
to pass a qualification examination.
3. Research analysts (and supervisory analysts for NYSE members) would
be required to participate in the regulatory element and firm element of the
member’s continuing education program.
4. Firm element would have to include research analysts’ training and
education in ethics, professional responsibility and applicable rules and
F. Research Analyst Trading Restrictions – For the purposes of the research analyst
personal trading restrictions only, the definition of “research analyst” would
include supervisors of research analysts, including directors of research and
members of supervisory committees who have direct influence or control with
respect to the preparation of research reports, or establishing or changing ratings
or price targets.
G. NYSE Proposed Revisions to Definition of Research Report
1. The NYSE proposes to delete the criterion of providing a recommendation
from the criteria that determines what constitutes a “research report.”
2. It is unclear whether the newly proposed definition would pull
publications satisfying the remaining three components of the definition of
“research report” within the scope of the rule’s disclosure requirements
and substantive prohibitions.
3. Alternatively, the rules could continue to apply only in situations where
analysts make recommendations of equity securities in research reports –
consistent with the mandate of Sarbanes-Oxley.
4. Sarbanes-Oxley requires the SEC, either directly or indirectly through
SROs, to adopt “rules reasonably designed to address conflicts of interests
that can arise when securities analysts recommend equity securities in
research reports….” (Emphasis added).
5. The NASD did not propose to amend its definition of “research report” in
its companion rule filing.