On November 14, 2014, FINRA published two proposed rule changes, covering debt and equity research reports and research analysts. FINRA proposed to adopt current NASD Rule 2711 (Research Analysts and Research Reports) as FINRA Rule 2241, with several modifications. FINRA also proposed adopting new Rule 2242 (Debt Research Analysts and Debt Research Reports), which is designed to address conflicts of interest relating to the publication and distribution of debt research reports.

The current rules covering equity research, NASD Rule 2711 and Incorporated NYSE Rule 472, set forth requirements to foster objectivity and transparency in equity research, and provide investors with more reliable and useful information to make investment decisions. The proposed rule change would retain the core provisions of the current rules and, among other objectives, broaden members’ obligations to identify and manage research-related conflicts of interest. Rule 2242 would provide retail debt research recipients with extensive protections similar to those provided to recipients of equity research, but modified to reflect differences in the trading of debt securities.

The text of the proposed equity research rule changes can be found at:

http://www.finra.org/web/groups/industry/@ip/@reg/@rulfil/documents/rulefilings/p601676.pdf

The text of the proposed debt research rule can be found at:

http://www.finra.org/web/groups/industry/@ip/@reg/@rulfil/documents/rulefilings/p601678.pdf

Communications that include analyses of proprietary indices and baskets of equity securities are within the definition of “research report” in Rule 2241, as they are in the current equity research rules. A communication including an analysis of a broad-based index, such as the S&P 500, is not within the definition of “research report.” Any communication including an analysis of a debt security, such as a structured note, would be a “research report” under proposed Rule 2242. Like Rule 2241, Rule 2242 provides that a communication including an analysis of a broad-based index is not a “research report,” provided that the communication does not include an analysis of, or recommend or rate, individual debt securities or issuers. In each case, in order to constitute a research report, the communication must also provide information reasonably sufficient upon which to base an investment decision.

Rule 2241 – Key Changes From the Current Rules

Identifying and Managing Conflicts of Interest

The rule requires FINRA member firms to establish, maintain and enforce written policies and procedures reasonably designed to:

  • Identify and effectively manage conflicts of interest related to the preparation, content and distribution of research reports, public appearances by research analysts and the interaction between research analysts and those outside of the research department, including investment banking personnel and sales and trading personnel; and
  • Promote objective and reliable research and prevent the use of research reports or research analysts to manipulate or condition the market by, for example, prohibiting prepublication review, clearance or approval of debt research reports by persons engaged in investment banking services activities, and other individuals aside from legal and compliance personnel, or by a subject company, other than for verification of facts.

These provisions would, among other things, help insulate research analysts from structured products personnel seeking to influence the content of a research report relating to a proprietary index or a basket of equity securities, or a debt security linked to either type of underlying asset.

These policies and procedures must also, at a minimum, include the following:

  • Establish information barriers or other institutional safeguards to ensure that research analysts are insulated from the review, pressure or oversight by persons engaged in investment banking services activities or other persons, including sales and trading department personnel, who might be biased in their judgment or supervision;
  • Restrict or limit activities by research analysts that can reasonably be expected to compromise their objectivity, such as participation in pitches, road shows and other marketing on behalf of issuers;
  • Limit the determination of a firm’s research department budget to senior management, excluding senior management engaged in investment banking services activities, and without regard to specific revenues or results derived from investment banking;
  • Prohibit compensation based upon specific investment banking services transactions or contributions to a member’s investment banking services activities;
  • Require that the compensation of a research analyst who is primarily responsible for preparation of the substance of a research report be reviewed at least annually by a committee that reports to a member’s board of directors or, if the member has no board of directors, a senior executive officer of the member;
  • Prohibit investment banking personnel from directing research analysts to engage in sales or marketing efforts related to an investment banking services transaction or any communication with a current or prospective customer about an investment banking services transaction;
  • Restrict or limit trading by a research analyst account in securities, derivatives and funds whose performance is materially dependent upon the performance of securities covered by the research analyst:
    • For example, a research analyst would be prohibited from trading in a structured note that is linked to a single stock, proprietary index or equity basket that, in each case, is covered by that research analyst;
  • Prohibit direct or indirect retaliation or threat of retaliation against any research analyst by any employee of the member or its affiliates as the result of an adverse, negative or otherwise unfavorable research report or public appearance written or made by the research analyst that may adversely affect the member’s present or prospective business interests;
  • Prohibit joint due diligence activities — i.e., due diligence by the research analyst in the presence of investment banking personnel — prior to the selection of underwriters for the investment banking services transaction;
  • Prohibit explicit or implicit promises of favorable research, a particular research rating, or recommendation or specific research content, as inducement for the receipt of business or compensation; and
  • Define “quiet periods” of a minimum of 10 days after an initial public offering, and a minimum of three days after a secondary offering, during which a member must not publish or otherwise distribute research reports, and research analysts must not make public appearances, relating to the issuer if the member has participated as an underwriter or dealer in the initial public offering, or, with respect to secondary offerings, as a member or co-manager of that offering.11

Content and Disclosure in Research Reports

The rule covers the content of research reports, particularly with respect to the use of ratings.

FINRA members must establish, maintain and enforce written policies reasonably designed to ensure that purported facts in its research reports are based on reliable information, and that any recommendation or rating has a reasonable basis and is accompanied by a clear explanation of any valuation method used and a fair presentation of the risks that may impede achievement of the recommendation, rating or price target. If a rating system is employed, the member must define in each research report the meaning of each rating in the system, including the time horizon and any benchmarks on which a rating is based.

Potential conflicts of interest relating to a research report must be disclosed, including:

  • If the research analyst or a member of his or her household has a financial interest in the debt or equity securities of the subject company, and the nature of such interest;
  • Any compensation received by the research analyst based upon the FINRA member’s investment banking, sales and trading or principal trading revenues;
  • If the member or any of its affiliates managed or co-managed a public offering of securities for the subject company in the past year, or received compensation for investment banking services from the subject company in the past year;
  • If the member or its affiliates maintain a significant financial interest in the debt or equity securities of the subject company, including, at a minimum, if the member or any of its affiliates beneficially owns 1% or more of any class of common equity securities of the subject company;
  • If the member was making a market in the securities of the subject company at the time of publication or distribution of the research report; or
  • Any other material conflict of interest of the research analyst or member that the research analyst or an associated person of the member with the ability to influence the content of the research report knows of or has reason to know of at the time of the publication or distribution of the research report.

Similar disclosures must be made in a public appearance by a research analyst.12

Timing of Research Reports

Members must establish, maintain and enforce written policies and procedures reasonably designed to ensure that a research report is not distributed selectively to trading personnel or a particular customer or class of customers in advance of other customers that the member has previously determined are entitled to receive the research report.

Unique Features of Rule 2242

Rule 2242 (debt research) differs from the current equity research rules in three respects:

  • The rule delineates the prohibited and permissible communications between debt research analysts and principal trading and sales and trading personnel;
  • The rule adopts a tiered approach by exempting debt research provided solely to institutional investors from many of the structural protections and prescriptive disclosure requirements that apply to research reports distributed to retail investors; and
  • The rule has exemptions from certain of its provisions for members that engage in limited principal trading activity.13

Exemption for Debt Research Reports Provided to Institutional Investors

Debt research distributed solely to eligible institutional investors is exempted from most of the provisions regarding supervision, coverage determinations, budget and compensation determinations and all of the disclosure requirements applicable to debt research reports distributed to retail investors. A “retail investor” means any person other than an institutional investor.

The rule allows firms to distribute institutional debt research by negative consent to a person who meets the definition of a “qualified institutional buyer” (QIB) as defined in Rule 144A under the Securities Act of 1933 and where, under FINRA Rule 2111(b) (Suitability):

  • The member or associated person has a reasonable basis to believe that the QIB is capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies involving a debt security or debt securities; and
  • The QIB has affirmatively indicated that it is exercising independent judgment in evaluating the member’s recommendations under Rule 2111 and the affirmation is broad enough to encompass transactions in debt securities.

The rule requires written disclosure to the QIB that the member may provide debt research reports that are intended for institutional investors and are not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. If the QIB does not contact the member and request, to receive only retail debt research reports, the member may reasonably conclude that the QIB has consented to receiving institutional debt research reports. Institutional accounts that meet the definition of FINRA Rule 4512(c) but do not satisfy the higher requirements described above may still affirmatively elect in writing to receive institutional debt research.