What Are Investment Banks Doing to Avoid Analyst Conflicts?


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What Are Investment Banks Doing to Avoid Analyst Conflicts?

  1. 1. What Are Investment Banks Doing to Avoid Analyst Conflicts? Panelists Pamela Gannon Compliance Director Equity Research and Investment Banking Lehman Brothers Inc. Mark E. Kaplan General Counsel Societe Generale Charles F. Ughetta Secretary/Treasurer Gerard Klauer Mattison & Co John V. Ayanian Partner Morgan, Lewis & Bockius LLP Institutional Investor Seminars The Future of Investment Research Summit Regulations, Standards & Managing Expectations New York, NY November 14, 2002
  2. 2. What Are Investment Banks Doing to Avoid Analyst Conflicts? I. INTRODUCTION 1 Broker-dealers with research departments have been working diligently this year to respond to new NYSE and NASD rules, ongoing SEC, SRO, and state investigations, and congressional inquiries relating to perceived research analyst conflicts of interest. In addition, firms have been asked as a condition of receiving investment banking business by various state comptroller’s and treasurer’s offices, and money management firms that advise state pension funds, to adopt the so- called “Investment Protection Principles” derived from the Merrill Lynch settlement with the New York Attorney General’s Office. The Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”) was signed by President Bush and became law on July 30, 2002. Sarbanes-Oxley created new Section 15D of the Securities Exchange Act of 1934, as amended, which requires the SEC to adopt, or cause SROs 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….” 2 That same week, the SEC proposed Regulation Analyst Certification (“Regulation AC”), which would require research analysts to certify the truthfulness of their views in research reports and public appearances and disclose whether they were compensated for the specific research recommendation. 3 Finally, the SEC and various state officials are reportedly negotiating a global settlement with a number of firms that may result in the creation of an independent research entity funded by those under investigation to provide research to retail investors. With all of these moving targets as a backdrop, firms are reviewing their supervisory structures and internal controls to avoid potential research analyst conflicts. The panelists intend to describe various potential analyst conflicts and how firms are addressing them. For background purposes, this outline describes the SRO research analyst rules governing conflicts of interest, the details of the Merrill Lynch settlement, and newly proposed changes to the SRO research analyst rules. 1 Copyright © 2002 Morgan, Lewis & Bockius LLP. All rights reserved. This outline provides general information on the subject matter discussed and should not be relied upon for legal advice on any matter. The views expressed are those of the panelists and do not necessarily reflect those of their employers, clients or colleagues. This outline has been updated and is current as of November 6, 2002, when submitted to Institutional Investor Seminars. 2 15 U.S.C. § 78o-6. 3 The proposing release for Regulation AC is available at <http://www.sec.gov/rules/proposed/33-8119.htm>. 1
  3. 3. II. SRO RESEARCH ANALYST CONFLICT OF INTEREST RULES A. Background 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 472(b)(1) 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 communications. 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 Rule 472(b)(3)(iii) 4 The SEC approval order is available at <http://www.sec.gov/rules/sro/34-45908.htm>. 2
  4. 4. 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 Act. (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 Act. 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 472(e)(2) 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 3
  5. 5. 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) 4
  6. 6. 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 services client. 3. Research analysts (public appearances) and firms (research reports) must disclose if: 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 472(k)(1)(i)(a); 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 472(k)(1)(i)(c). 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 472(k)(2)(ii)-(v)) 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
  7. 7. 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 <http://www.nasdr.com/pdf-text/0239ntm.pdf>. 6
  8. 8. 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 market conditions. 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 individual securities. 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. 7
  9. 9. 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 rules. 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 applicable: (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 condition. (ii) NOTE: This exception from the SRO rules is not an exemption from Section 5 of the Securities Act. 8
  10. 10. 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 public. 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 responsibilities. 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 function 2. Monitor personal trading of analysts and their “household members” 3. Monitor electronic communications between research and investment banking personnel 4. Determine policy for customer-directed materials prepared outside of the research department 9
  11. 11. III. AGREEMENT BETWEEN THE ATTORNEY GENERAL OF THE STATE OF NEW YORK AND MERRILL LYNCH, PIERCE, FENNER & SMITH, INC., DATED MAY 21, 2002 A. Disclosures 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 company.” 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. 10
  12. 12. B. Analyst Compensation 1. Factors 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 investor clients; • 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 divisions. 2. Executive management may discuss with Research management overall costs, budgets, resource allocation and retention and recruitment of research analysts. 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. 11
  13. 13. C. Research Recommendation Committee (“RRC”) 1. Duties Monitor and supervise research recommendations for “objectivity, integrity, and a rigorous analytical framework in development of all recommendations” 2. Representation Institutional and private client sales management, research management, and research strategists 3. Chair 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 by RRC). 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. 12
  14. 14. 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 least annually; c. does not have representation from the investment banking department; and 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 performance; and 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>. 13
  15. 15. 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 prohibition. 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 securities. D. “Bake-Offs” 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. 14
  16. 16. 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 regulations. 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. 15
  17. 17. 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. 16