FINRA Proposes to Adopt FINRA Rule 2241 on Research Analysts and Research Reports

Practical Law Legal Update 0-588-7428 (Approx. 8 pages)

FINRA Proposes to Adopt FINRA Rule 2241 on Research Analysts and Research Reports

by Practical Law Corporate & Securities

Overview of Proposal

The proposal would retain the core provisions of current NASD Rule 2711 and Incorporated NYSE Rule 472 while making certain modifications to broaden member firms' obligations in some areas and reduce burdens in others. According to FINRA's proposing release, many of the changes reflect input from advisory committees, market participants and a 2005 joint report by NASD and the NYSE on the operation of the research rules.

NASD Rule 2711 and Incorporated NYSE Rule 472 are designed to foster objectivity and transparency in equity research and to provide investors with more reliable and useful information with which to make investment decisions. The rules were intended to restore public confidence in the objectivity of research and the veracity of research analysts after certain conflicts of interest involving research analysts came to light in the early 2000s. Portions of the rules implement provisions of the Sarbanes-Oxley Act of 2002. Generally, Rule 2711 and Rule 472 mirror each other. Generally speaking, among other things, these rules:

Mandate the separation of the research and investment banking departments of securities firms and prohibit analysts from being under the supervision or control of investment bankers.
Prohibit research analysts from certain involvement with investment banking services.
Require disclosure in research reports about conflicts of interest.

For a further discussion of Rule 2711 and Rule 472, see Practice Note, Research Analysts and Research Reports.

NASD Rule 1050 and Incorporated NYSE Rule 344 define the term "research analyst" and, with certain exceptions, require these individuals to be registered and to pass the Series 86 and 87 exams.

Identifying and Managing Conflicts of Interest

Proposed FINRA Rule 2241 would include a new provision requiring 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 and public appearances by research analysts.
The interaction between research analysts and persons outside the research department, including investment banking and sales and trading personnel, subject companies and customers.

This approach is intended to require member firms to be more proactive in identifying and managing conflicts of interest, while providing flexibility for them to do so consistent with their particular size and structure. Policies and procedures would be required to:

Promote objective and reliable research that reflects the truly held opinions of analysts.
Prevent the use of research analysts to manipulate or condition the market or favor the interests of the member firm or its current or prospective customers.

The policies and procedures would need to be reasonably designed to:

Pre-publication review of research. Prohibit prepublication review, clearance or approval of research reports by investment bankers and restrict prepublication review by other non-research personnel. Notably, this would eliminate the exception in Rule 2711(b)(3) permitting pre-publication review of a research report by investment bankers to verify its factual accuracy.
Research coverage decisions. Restrict or limit input by member firms' investment banking departments into research coverage decisions.
Supervision of analysts. Prohibit persons engaged in investment banking activities from supervision or control of research analysts, including their evaluation and compensation.
Research budget. Limit determination of research department budget to senior management, excluding investment banking personnel.
Analyst compensation. Prohibit compensation based on specific investment banking services activities or contributions to investment banking services activities. The policies and procedures would need to require a committee that reports to the member firm's board of directors to review and approve the compensation of any analysts primarily responsible for preparation of the substance of research reports.
Research department separation. Establish information barriers or other institutional safeguards to ensure research analysts are insulated from review, pressure or oversight by investment bankers or other personnel, such as sales and trading department personnel, who might be biased. The expansion of this requirement to non-investment banking personnel is notable.
No retaliation. Prohibit retaliation against research analysts by investment bankers or others as a result of an unfavorable research report or appearance by an analyst that may adversely affect the member firm's business interest. Again, the expansion of this requirement to non-investment banking personnel is notable.
Quiet periods. Define "quiet periods" (periods in which a member firm may not publish research reports) of at least 10 days after an IPO in which the member firm has acted as an underwriter or dealer, and three days after a follow-on offering in which the member firm has acted as a manager or co-manager. This represents a significant change from the current rule, which, subject to certain exceptions (including for certain emerging growth company (EGC) offerings) imposes a quiet period of 40, 25 and 10 days depending on the circumstances. The proposed rule would also eliminate the 15-day quiet period before and after the expiration, waiver and termination of a lock-up agreement.
Analyst conflicts. Restrict or limit activities by research analysts that can reasonably be expected to compromise their objectivity. This includes the existing prohibitions on analyst participation in pitches and other solicitations of investment banking services transactions and road shows and other marketing on behalf of issuers related to these transactions (although analysts could still view road shows or sales presentations from a remote location or separate room). Naturally, the existing JOBS Act exception for analyst participation in pitch meetings attended by investment bankers for EGC IPOs would continue to apply.

The proposal also would:

Joint due diligence. Establish a new proscription on due diligence by research analysts in the presence of investment banking department personnel during a specified time period. The proposal would add Supplementary Material .02 which states that FINRA believes the logic of the rule prohibits the performance of joint due diligence before underwriters are selected in an investment banking services transaction. The proposal would continue to prohibit investment banking department personnel from directly or indirectly directing a research analyst to engage in sales or marketing efforts related to an investment banking services transaction, and directing a research analyst to engage in any communication with a current or prospective customer about an investment banking services transaction. Supplementary Material .03 would:
- clarify that three-way meetings between research analysts and a current or prospective customer in the presence of investment banking department personnel or company management about an investment banking services transaction are prohibited; and
- retain the current requirement that any written or oral communication by a research analyst with a current or prospective customer or internal personnel related to an investment banking services transaction must be fair, balanced and not misleading, taking into consideration the overall context in which the communication is made.
No promises of favorable research. Maintain the current prohibition against promises of favorable research, a particular research recommendation or rating, or specific content as inducement for receipt of business or compensation. It would also prohibit prepublication review of a research report by a subject company for any reason other than the verification of facts. Supplementary Material .05 would maintain the current guidance that applies to the prepublication submission of a research report to a subject company.
Analyst personal trading. The proposed rule would provide for a more encompassing and flexible supervisory approach with respect to research analyst account trading in securities of companies the research analyst covers.

Content and Disclosure in Research Reports

The proposal would maintain the current disclosure requirements for research reports, with a few changes. The proposal would:

Add a requirement that a member establish, maintain and enforce written policies and procedures reasonably designed to ensure that purported facts in its research reports are based on reliable information.
Expand the current "catch-all" disclosure to require disclosure of material conflicts known not only by the research analyst, but also by any "associated person of the member with the ability to influence the content of a research report."
Modify the requirement to disclose when a member or its affiliates own securities of the subject company to include any "significant financial interest in the debt or equity of the subject company," including, at a minimum, beneficial ownership of 1% or more of any class of common equity securities of the subject company. This effectively adds a new requirement to disclose significant debt holdings.

The proposal also would group in a separate provision the disclosures required when a research analyst makes a public appearance. The required disclosures would remain substantively the same as under the current rules, with one exception. The proposal would also retain, with non-substantive changes, the current provision requiring a member firm to notify its customers if it intends to terminate coverage of a subject company.

Distribution of Member Research Reports

The proposal would codify an existing interpretation of FINRA Rule 2010 and provide additional guidance on selective, or tiered, dissemination of a firm's research reports. It would require firms to establish, maintain and enforce written policies and procedures reasonably designed to ensure that a research report is not distributed selectively to internal trading personnel or a particular customer or class of customers in advance of other customers that the firm has previously determined are entitled to receive the research report. The proposal also would provide guidance explaining that firms may provide different research products and services to different classes of customers, provided the products are not differentiated based on the timing of receipt of potentially market moving information and the firm discloses its research dissemination practices to all customers that receive a research product. A member that provides different research products and services for certain customers would be required to inform its other customers that the alternative products and services may reach different conclusions or recommendations that could impact the price of the security. Members would not be permitted to design or implement a distribution system intended to give a timing advantage to select customers.

Distribution of Third-party Research Reports

The proposal would expand on the third-party research report distribution requirements while generally maintaining the current requirements. Under the proposal:

A distributing member would be required to disclose 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 its affiliates beneficially own 1% or more of any class of common equity securities of the subject company.
Members would be required to disclose any other potential conflict of interest that can reasonably be expected to have influenced the member's choice of a third-party research provider or the subject company of a third-party research report.
Members would be required to ensure that a third-party research report is clearly labeled as one and that there is no confusion on the part of the recipient as to the person or entity who prepared the report.

Other Matters

The proposal would also:

Expand on the current exemptions for firms with limited investment banking activity from the provisions that prohibit a research analyst from being subject to the supervision or control of an investment banking department employee.
Remove the requirement that firms annually attest they have written supervisory policies and procedures in place reasonably designed to achieve compliance with the applicable provisions of the rules.
Clarify the obligations of each associated person under the provisions of the proposal that require a member to restrict or prohibit certain conduct by establishing, maintaining and enforcing particular written policies and procedures.
Provide FINRA, under the NYSE Rule 9600 Series, with the authority to conditionally or unconditionally grant, in exceptional and unusual circumstances, an exemption from any requirement of the proposed rule for good cause shown, after taking into account all relevant factors, provided the exemption is consistent with the purposes of the rule, the protection of investors and the public interest.
Modify certain of the rule's definitions, including by:
- changing the definition of "investment banking services" to clarify that these services include all acts in furtherance of a public or private offering on behalf of an issuer;
- clarifying in the definition of "research analyst account" that the definition does not apply to a registered investment company over which a research analyst has discretion or control, provided that the research analyst or a member of that research analyst's household has no financial interest in the investment company, other than a performance or management fee;
- excluding communications regarding mutual funds from the definition of "research report;" and
- transferring into the definition section of the definitions of "third-party research report" and "independent third-party research report," which are now in a separate provision of the rules.

Effective Date

The effective date of the proposed rule change will be announced in a regulatory notice to be published no later than 60 days following SEC approval. The effective date will be no later than 180 days following publication of the regulatory notice.

FINRA's Rulebook Consolidation Process

FINRA is the successor organization to NASD and the member regulation, enforcement and arbitration functions of the NYSE, which consolidated operations in 2007. FINRA's current rulebook consists of FINRA rules as well as NASD Rules and certain NYSE Rules that FINRA has incorporated, known as the Incorporated NYSE Rules. FINRA is in the process of consolidating the NASD and Incorporated NYSE Rules into a single set of FINRA rules. For more information on the rulebook consolidation process, see FINRA's website.

Update: On February 20, 2015, the SEC instituted proceedings to determine whether to approve or disapprove the proposed rule change. The SEC is accepting comments until March 19, 2015. Any person who wishes to file a rebuttal to any other person's submission must file that rebuttal by April 2, 2015. To learn more, see Legal Update, SEC Delays Consideration of Proposed FINRA Research Rules.

Update: On March 12, 2015, FINRA filed an amendment to the proposed rule change with the SEC. The amendment included the following changes, among others:

To exclude from the definition of "research report" private placement memoranda and similar offering-related documents prepared in connection with investment banking services transactions, other than those that purport to be research.
To delete language from the original proposal stating that a violation of a firm's policies and procedures would constitute a violation of the rule itself.
To retain the exceptions in NASD Rule 2711(f) to the prohibition on publishing or distributing research or making a public appearance during the quiet periods following a broker-dealer's participation in an offering to permit:
- research or public appearances concerning significant news or a significant news event concerning the issuer that is the subject of the research report during the quiet period; and
- research reports issued under Rule 139 of the Securities Act.

The amended proposal also maintained the proposed rule change's hybrid approach by requiring that a firm's procedures contain certain minimum elements.

Update: On May 20, 2015, the SEC extended the period it has to approve or disapprove of the proposed rule change until July 22, 2015. The deadline was previously May 23, 2015.

FINRA Proposes to Adopt FINRA Rule 2241 on Research Analysts and Research Reports | Practical Law