SEC Approves FINRA Rule 2241 on Research Analysts and Research Reports | Practical Law

SEC Approves FINRA Rule 2241 on Research Analysts and Research Reports | Practical Law

The SEC approved the Financial Industry Regulatory Authority's (FINRA) proposal to adopt NASD Rule 2711 (Research Analysts and Research Reports) as a FINRA rule with several modifications and to eliminate NYSE Rule 472 from the FINRA Rulebook.

SEC Approves FINRA Rule 2241 on Research Analysts and Research Reports

Practical Law Legal Update w-000-4753 (Approx. 8 pages)

SEC Approves FINRA Rule 2241 on Research Analysts and Research Reports

by Practical Law Corporate & Securities
Published on 17 Jul 2015USA (National/Federal)
The SEC approved the Financial Industry Regulatory Authority's (FINRA) proposal to adopt NASD Rule 2711 (Research Analysts and Research Reports) as a FINRA rule with several modifications and to eliminate NYSE Rule 472 from the FINRA Rulebook.
On July 16, 2015, the SEC approved FINRA's proposed rule change to adopt NASD Rule 2711 (Research Analysts and Research Reports), with certain modifications, as new FINRA Rule 2241. FINRA Rule 2241 eliminates New York Stock Exchange (NYSE) Rule 472 from the FINRA rulebook. It also amends NASD Rule 1050 (Registration of Research Analysts) and Incorporated NYSE Rule 344 (Research Analysts and Supervisory Analysts) to create an exception from the research analyst qualification requirement. These changes are part of FINRA's rulebook consolidation process (see FINRA's Rulebook Consolidation Process).
The effective date of the rule will be announced in a regulatory notice to be published no later than 60 days following the SEC's approval. The effective date will be no later than 180 days following publication of the regulatory notice.
On July 16, the SEC also approved a FINRA proposal to adopt new FINRA Rule 2242 (Debt Research Analysts and Debt Research Reports) (to learn more, see Legal Update, SEC Approves FINRA Rule 2242 on Debt Research Analysts and Debt Research Reports).

Overview of FINRA Rule 2241

FINRA Rule 2241 retains 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 were 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. Rule 2711 and Rule 472 mirror each other in large part. 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

FINRA Rule 2241 includes 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 will 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 will need to be reasonably designed to address, at a minimum:
  • Pre-publication review of research. The policies and procedures must prohibit prepublication review, clearance or approval of research reports by investment bankers and restrict prepublication review by other non-research personnel. Notably, this will 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. The policies and procedures must restrict or limit input by member firms' investment banking departments into research coverage decisions.
  • Supervision of analysts. The policies and procedures must prohibit persons engaged in investment banking activities from supervision or control of research analysts, including their evaluation and compensation.
  • Research budget. The policies and procedures must limit determination of research department budget to senior management, excluding investment banking personnel.
  • Analyst compensation. The policies and procedures must prohibit compensation based on specific investment banking services activities or contributions to investment banking services activities. The policies and procedures will 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. The policies and procedures must 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. The policies and procedures must 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. The policies and procedures must 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 rule will also eliminate the 15-day quiet period before and after the expiration, waiver and termination of a lock-up agreement.
  • Solicitation and Marketing. The policies and procedures must 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 may still view road shows or sales presentations from a remote location or separate room). The existing JOBS Act exception for analyst participation in pitch meetings attended by investment bankers for EGC IPOs will continue to apply.
FINRA Rule 2241 also includes requirements on:
  • Joint due diligence. Rule 2241 establishes a new proscription on due diligence by research analysts in the presence of investment banking department personnel during a specified time period. The rule adds 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 rule clarifies that this provision will not apply when it is contrary to the JOBS Act, such as when due diligence activities involve a communication with the management of an EGC that is attended by both the research analyst and an investment banker. The rule continues 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:
    • clarifies 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
    • retains 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. Rule 2241maintains 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 also prohibits prepublication review of a research report by a subject company for any reason other than the verification of facts. Supplementary Material .05 maintains the current guidance that applies to the prepublication submission of a research report to a subject company.
  • Analyst personal trading. Rule 2241provides for a more encompassing and flexible supervisory approach with respect to research analyst account trading in securities of companies the research analyst covers. The rule maintains the current prohibitions on research analysts receiving pre-IPO shares in the sector they cover and trading against their most recent recommendations. However, members may define financial hardship circumstances, if any, in which research analysts would be permitted to trade against their most recent recommendations. Supplementary Material .10 provides that FINRA will not consider a research analyst account to have traded in a manner inconsistent with a research analyst's recommendation where a member has instituted a policy prohibiting any research analyst from holding securities of the companies in the research analyst's coverage universe, as long as the member establishes a reasonable plan to liquidate the holdings and the plan is approved by the member's legal or compliance department.

Content and Disclosure in Research Reports

FINRA Rule 2241 maintains the current disclosure requirements for research reports, with a few changes. The rule:
  • Adds 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.
  • Expands 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."
  • Modifies the requirement to disclose when a member or its affiliates own securities of the subject company to include any significant financial interest in the 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. The rule implicitly requires disclosure of a firm's debt holdings of a subject company where the holdings rise to an actual material conflict of interest.
The rule also groups in a separate provision the disclosures required when a research analyst makes a public appearance. The required disclosures will remain substantively the same as under the current rules, except that the "catch all" disclosure requirement in public appearances would apply only to a conflict of interest of the research analyst or member that the research analyst knows or has reason to know at the time of the public appearance. The rule also retains, 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 rule codifies an existing interpretation of FINRA Rule 2010 and provides additional guidance on selective, or tiered, dissemination of a firm's research reports. It requires 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 rule also provides 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 will 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 will 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

FINRA Rule 2241 expands on the third-party research report distribution requirements while generally maintaining the current requirements. Under the rule:
  • A distributing member will be required to disclose if the member or its affiliates maintain a significant financial interest in the 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 will 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 will 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

FINRA Rule 2241 also:
  • Expands 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.
  • Removes 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.
  • Clarifies 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.
  • Provides FINRA, under the 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.
  • Modifies 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 the definitions of "third-party research report" and "independent third-party research report," which are now in a separate provision of the rules.

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.