In March 2011, FINRA issued Regulatory Notice 11-11 requesting comments on a concept proposal to apply objectivity safeguards and disclosure requirements to the publication and distribution of debt research reports. The proposal would provide retail debt research recipients with most of the same protections provided to recipients of equity research, while exempting research provided solely to institutional investors from many of the provisions.
Comments must be received by April 25, 2011
FINRA is concerned over firms’ management of conflicts of interest related to the publication and distribution of debt research, including certain cases where firms lacked any policies and procedures to manage debt research conflicts to ensure compliance with applicable SRO ethical and anti-fraud rules and recent allegations of misconduct in the sale of auction rate securities (ARS). Currently, FINRA’s research rules apply only to “equity securities” as defined under the Securities Exchange Act of 1934, subject to certain exemptions.
In response, FINRA developed this concept debt research rule that would recognize a bifurcated debt research regulatory approach – the proposed rule extends protections similar to equity research to retail investors, while research distributed solely to institutional investors would require a more general “health warning,” but would allow such institutional investors to choose to receive the full protections accorded to retail investors.
Standards Applicable to Retail Debt Research
The majority of NASD Rule 2711 would apply to debt research with the proposed addition addressing conflicts between debt research and sales and trading personnel. Thus, the rule would:
- Require member firms to establish, maintain and enforce policies and procedures reasonably designed to identify and effectively manage conflicts of interest
- Prohibit prepublication review, clearance or approval by investment banking and sales and trading, as well as restrict (or prohibit) such by a subject company (except for fact checking)
- Prohibit input by investment banking and sales and trading into the determination of the research department budget.
- Limit the supervision and compensatory evaluation of debt analysts to persons not engaged in investment banking services or sales and trading.
- Require similar compensation rules and review as equity analysts
- Restrict or limit debt analyst account trading in the securities, derivatives and funds related to the securities covered by the debt analyst
- Prohibit promises of favorable debt research coverage.
- Prohibit retaliation against debt analysts by investment banking personnel or other employees as the result of an unfavorable research
- Restrict or limit activities by debt analysts that can reasonably be expected to compromise objectivity
- Prohibit investment banking from directing debt analysts to engage in sales or marketing efforts
Further, FINRA envisions disclosures applicable to equity research largely should apply to debt, including:
- personal and firm financial interests;
- receipt of investment banking services compensation from the subject company; and
- the meaning of each rating employed in any rating system used by the member firm in the research report.
Institutional Investor Exemption
The general exemption is based on the assumption that institutional investors are aware of the types of potential conflicts that may exist between a member’s recommendations and trading interests, and are capable of exercising independent judgment in evaluating such recommendations (and instead incorporate the research as a data point in their own analytics) and reaching pricing decisions. However, the institution-only exemption, if not opted out by the institution, requires a “health warning” disclosure on the first page, including:
- the research is intended for institutional investors only and is not subject to all of the independence and disclosure standards applicable to research provided to retail investors;
- if applicable, that the firm trades the securities covered in the research for its own account and on behalf of certain clients; such trading interests may be contrary to the recommendations offered in the research and the research may not be independent of the firm’s proprietary interests; and
- if applicable, that the research may be inconsistent with recommendations offered in the firm’s research that is disseminated to retail investors.
In addition, specific prohibitions and restrictions are placed on:
- promises of favorable research;
- debt research analyst involvement in pitches, road shows and other marketing;
- certain three-way meetings with analysts, investment banking and issuer management
- input into research coverage by investment banking personnel;
- retaliation against debt research analysts for unfavorable research;
- review of research by the subject company (beyond fact-checking) or investment banking personnel; and
- FINRA rules would continue to apply to member conduct, including Rules 2010 and 2020
Communication Firewalls Unique to Debt
While certain communications between debt analysts and sales and trading personnel are necessary to allow each to perform their primary functions, the following are expressly prohibited:
- Sales and trading personnel attempting to influence a debt analyst’s opinion
- Debt analysts identifying or recommending specific potential trading transactions to sales and trading personnel not contained in such debt analyst’s published reports; disclosing the timing of, or material investment conclusions in, a pending debt research report; or otherwise having any communication for the purpose of determining the profile of a customer
Assuming the rules are approved, broker-dealers will need to significantly alter policies and procedures regarding debt research to ensure and monitor compliance Please contact our firm if you need experienced legal representation and advice if you need assistance updating your written supervisory procedures, providing comments to FINRA, or any other regulatory or arbitration related legal assistance at firstname.lastname@example.org.