The research analyst conflict of interest issue is back. This month, FINRA warned:  

It has come to FINRA’s attention that certain issuers may be attempting to extract implicit promises of favorable research by suggesting publicly or directly to potential deal participants in advance of an anticipated offering that positive research coverage will be an implicit or explicit condition to selection as an underwriter or selling group member.1

This issue famously reared its head in the early 2000’s, culminating in the 2003 Global Research Analyst Settlement (GRAS) involving the SEC, self regulatory organizations, state securities regulators and a dozen investment banks. Alleging that investment banks were providing positive research coverage in order to obtain banking business from issuers, the regulators secured settlements involving over a billion dollars in sanctions and restitution payments, and undertakings to revise firm procedures and to provide independent research for a five-year period. Rule changes occurred, and both the banks and the issuer community emerged with a general recognition that research and investment banking were two areas of a firm’s business that needed to operate separately to avoid potential conflicts of interest that might impact the research product. Apparently sensing that a reminder would be timely, FINRA recently published Regulatory Notice 11-41 to caution banks not to be induced by issuers to provide favorable research in order to gain investment banking business.  

Research and Banking Must Continue to Operate Separately

The FINRA notice starts with the premise that its NASD Rule 2711 already requires member firms to maintain separate research and investment banking activities to protect the objectivity of the research. Thus, the rules overtly disallow firms from directly or indirectly offering favorable research, ratings or price targets in order to receive banking business,2 and they prohibit analysts from participating in pitches or solicitations for the investment banking business.3

As a reaction to the notion that issuers might be trying to condition their awards of banking business to firms based on the promise of future positive research coverage, FINRA reiterates that such a tie-in between research and banking assignments would violate its research rules. In this notice, FINRA warns that it views “hints, insinuations or other subtle references [that] are intended to condition the award of investment banking business on the nature of research attendant to the deal” as “attempts to create an expectation that a firm chosen to participate in a subsequent offering will maintain favorable research on the issuer’s stock, irrespective of the stock price or the company’s ongoing performance.” Although this may be more subtle than some of the allegations in the GRAS, the FINRA message remains the same: even a member firm’s implicit or tacit acquiescence to an issuer’s overtures seeking ongoing favorable research coverage would be improper.

How Does FINRA Reach This Conduct?

Since FINRA does not have jurisdiction over the issuers allegedly pressuring the investment banks, FINRA comes at the conduct another way. It reminds broker-dealers that FINRA has the ability to “closely scrutinize offering participants’ research and other deal-related activities for compliance with, among others, NASD Rule 2711 and SEC Regulation Analyst Certification.” The regulatory notice advises firms that, if they decide to compete for investment banking business when there has been an attempt to extract positive research as a condition to getting the deal, they must do four specific things:

  1. Tell the issuer expressly that it can have no expectation regarding the content of the firm’s research coverage;  
  2. Document that repudiation (and, of course, retain the documentation for future FINRA examinations or inquiries);  
  3. Implement heightened supervision of solicitation activities “including pitch meetings and other communications with the issuer, to ensure there is no express or implied acknowledgement or accedence to the research expectation,” and  
  4. Increase oversight of the preparation and content of the research on that company, including oversight of “permissible communications” between research and investment banking personnel before and after the deal participants are chosen.  

What Does this All Mean for FINRA Member Firms?

While the notice prescribes a specific path for member firms to cure an issuer’s improper hint, insinuation or other subtle reference, it also provides a good reminder that firms should remain vigilant in adopting, implementing and training employees about procedures and controls designed to detect an issuer’s hint, suggestion or insinuation and promptly trigger the curative procedures. Broker-dealers may consider reviewing their engagement letters and other documentation to address this issue, whether or not a problem arises. It may be helpful to remind bank employees to promptly notify the compliance officer or other appropriate person upon observing any issuer’s hints, insinuations or tacit references to research content, even if the recipient bank employee believes them to be in jest and totally unrelated to investment banking work. An early report would enable the bank to evaluate whether the curative path should be implemented. Finally, the notice provides member firms with the impetus to adopt and implement procedures to address this situation, and then to train bank employees about the heightened supervision and oversight procedures. This will enable quick implementation of the curative path if an unfortunate incident occurs.

The notice serves as a good reminder that firms must remain vigilant in protecting the objectivity and integrity of their research, even if that means running the risk of not being selected for banking business FINRA will be looking for indications that the independence of a member’s research program may have been compromised. In short, the research analyst conflict of interest issue is back.