Securities and Futures Regulatory Update
A federal court in New York approved on March 15, 2010 significant changes to the securities research rules that twelve investment banking firms agreed to follow in 2003 and 2004 as part of the “global research settlement.” One of the changes will facilitate the participation of research analysts in a firm’s due diligence deliberations.
Origin of the global settlement
Together with the payment of civil penalties and other amounts totaling $1.5 billion, the global research settlement resolved civil complaints filed against the twelve firms by the SEC and other federal and state regulatory and law enforcement authorities. The complaints grew out of investigations of the research that the firms had published during the “Internet Bubble.”
The global settlement technically applies only to the settling firms and their successors. As a practical matter, however, it has much broader application since many state pension funds and other institutional investors have required non-settling securities firms to agree to follow its provisions. Also, some non-settling firms and some non-U.S. securities regulators have come to regard the global settlement as embodying “best practices” in this area.1
The operative portion of the global settlement is reflected in substantially identical “addenda” attached to the final judgments. The addenda include agreements by the settling firms (1) to establish “firewalls” between their research and investment banking functions, (2) to make disclosures in research reports for the purpose of promoting transparency and identifying conflicts of interest and (3) to provide customers with independent third-party research.2
By their terms, the addenda were subject to being superseded by any rule of the Securities and Exchange Commission (SEC), the National Association of Securities Dealers (NASD) or the New York Stock Exchange (NYSE) that expressly purported to supersede any provision of the addenda. Subsequent to 2004, both the NASD and NYSE adopted rules that covered many of the disclosure and conflict of interest provisions of the addenda but that did not purport to supersede any of their provisions.3
The addenda also held out the parties’ “expectation” that the SEC would agree at the end of five years to amend any non-superseded provision of the addendum, subject to court approval.
The SEC could have taken the expiration of the five-year period in 2008 and 2009 as an opportunity to adopt (or encourage FINRA to adopt) uniform rules for the industry that would address the complete subject matter of the addenda. Instead, it acquiesced in a lengthy closed-door negotiation with the settling firms to develop changes to the addenda with a view to submitting these to the court.
The settling firms stated that they believed that the addenda should be dropped in their entirety, but the SEC refused to agree to this. The firms and the SEC in August 2009 submitted a package of changes to Judge William H. Pauley III of the Southern District of New York, and Judge Pauley approved all but one of these changes on March 15, 2010.
The surviving provisions of the addenda are to be reconsidered by the SEC, subject to Judge Pauley’s approval, at the earlier of March 15, 2011 or the effective date of FINRA’s pending proposals to amend its research rule.4
Addenda provisions deleted with the court’s approval, either as substantially covered by SRO rules or where deletion was otherwise determined to be in the public interest
Judge Pauley approved the request of the SEC and the settling firms to delete provisions of the addenda that required:
- separate reporting lines for research and investment banking
- a dedicated research legal and compliance staff
- annual review by the firm’s audit committee of the research budget
- no investment banking influence over research compensation
- no investment banking influence over evaluations of research personnel
- mandatory announcements when coverage of a stock is terminated
- no research participation in efforts to solicit investment banking business
- no research participation in road shows
- no investment banking direction to research to engage in marketing or selling efforts for investment banking transactions
- disclosure of analyst performance information
Of course, many of these requirements are now imposed by NASD and NYSE rules and would continue to be imposed by FINRA’s proposed Rule 2240. Where not covered by rules, the SEC and the settling firms simply stated their joint view that elimination of these requirements would be consistent with the public interest.
Modifications approved by court to facilitate research participation in due diligence deliberations
The most restrictive of the addenda provisions are those that require “firewalls” between a firm’s investment banking and research functions. The intent of the separation is, of course, to minimize the possibility that investment banking personnel will seek to influence research recommendations as a means of obtaining mandates from potential investment banking clients. On the other hand, the mandated separation also makes it harder to achieve another important policy objective, which is to remove obstacles to effective due diligence in advance of securities offerings and to educate a firm’s sales force and customers about securities offerings.
The addenda had to be amended in the fall of 2004 to facilitate research participation in due diligence and educational efforts, but the process was still inefficient. The SEC and the settling firms therefore recommended that Judge Pauley approve (and he did approve) a change that permits joint research and investment banking communications for due diligence purposes under either of two circumstances:
- The first is where an investment banking mandate has already been received and the joint communications take place in the presence of internal legal or compliance staff “or underwriters’ or other counsel on the transaction who are knowledgeable regarding Research and Investment Banking conflicts and the terms of the Addendum.”
- The second is in connection with a request to the firm from a company or selling shareholder to submit a proposal for a block bid, competitive secondary or follow-on offering or “similar transaction” (but apparently not an IPO) and where the joint communications take place in the presence of internal legal or compliance staff who have concluded that time is too short to permit separate communications. (The omission here of any reference to chaperoning by underwriters’ or other transaction counsel is presumably based on the assumption that such counsel has not been retained at the proposal stage, but this overlooks the fact that shelf takedowns often take place with the assistance of designated underwriters’ counsel where due diligence discussions may take place before a mandate is issued.)
Other provisions approved by Judge Pauley include a relaxation of conditions on research personnel’s communications with a firm’s sales force, so that it is no longer necessary for these communications to be chaperoned or pre-reviewed by legal or compliance personnel or to be subject to written log requirements.
There is also a slight relaxation of the conditions on research and investment banking joint participation in “widely-attended events.”
Addendum provisions retained at the SEC’s insistence
As noted above, the SEC insisted on the retention of a number of provisions that the settling firms would have preferred to drop. These retained restrictions include the continuation of:
- a physical separation of research and investment banking
- a prohibition on investment banking input into company-specific research coverage decisions
- a requirement that research be given the opportunity to express its views on a proposed transaction to the firm’s commitment committee outside the presence of investment banking personnel
- the requirement that communications to the sales force (or to ten or more investors) be “fair and balanced” and that the views expressed have reasonable basis
- the research oversight committee’s review or ratings, targets and the overall quality of research
- disclosure that conflicts of interest may exist
Addendum provisions agreed to be amended but rejected by the court
The SEC and the settling firms were willing to permit communications between research and investment banking, if consistent in nature with types of communications that an analyst might have with investing customers:
- outside the presence of legal or compliance staff, if regarding “market or industry trends, conditions or developments,” or
- in the presence of legal or compliance staff, for the purpose of “learn[ing] more about a particular company.”
Judge Pauley criticized these proposals as “counterintuitive,” as undermining the separation between research and investment banking, as “deconstructive” of the firewall and as contrary to the public interest. One can understand an investment banker’s frustration, however, at his or her being unable to obtain from a research colleague the information that would be available to any customer of the firm.
As noted above, FINRA published in October 2008 a proposed Rule 2240 that would combine the current NASD and NYSE research rules. Like the current rules, Rule 2240 would focus on disclosures for the purpose of promoting transparency and identifying conflicts of interest.5 It would not expressly mandate firewalls, but it does require in (b)(2)(E) that member firms “establish informational barriers and other institutional safeguards to ensure that research analysts are insulated from the review, pressure or oversight” by investment banking personnel or “other persons who might be biased in their judgment or supervision.” FINRA would thus leave to its member firms to develop policies and procedures that would be reasonable in the light of their particular size and mix of business.
Senate Banking Committee bill
The financial regulatory reform bill that the Senate Banking Committee approved in March 2009 by a vote of 13-10 instructs the Comptroller General to deliver a report to the relevant Congressional committees within 18 months of the enactment of the bill. The report is to identify and examine the conflicts of interest between research and investment banking and to consider the “nature and benefits” of the undertakings contained in the global settlement, including whether any such undertakings “should be codified and applied permanently to securities firms.” Enactment of this provision of the bill could affect the timing of any further changes to the global settlement or any rulemaking action by FINRA.
1 With certain exceptions, the global settlement applies to the settling firms and their affiliates but only in respect of research reports that are prepared by the firms or their affiliates, that are furnished to investors in the United States and that relate to U.S. companies (or non-U.S. companies for which the United States is the principal trading market).
2 The obligation to provide independent third-party research expired in mid-2009.
3 FINRA’s most recent proposal to adopt Rule 2240 in lieu of the existing NASD and NYSE rules was published in Regulatory Notice 08-55 (October 2008).
4 The regulatory functions of the NASD and the NYSE are now carried out by the Financial Industry Regulatory Authority (“FINRA”), which is consolidating the rulebooks of its predecessor organizations.
5 One important proposed change would eliminate all “quiet periods” except for a 10-day period following an IPO.
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