FINRA Issues New FAQs on Its Equity and Debt Research Rules

Practical Law Legal Update w-001-5002 (Approx. 4 pages)

FINRA Issues New FAQs on Its Equity and Debt Research Rules

by Practical Law Corporate & Securities

Registration Requirements

The FAQs state that NASD Rule 1050 (Registration of Research Analysts) applies only to research analysts who are primarily responsible for the preparation of the substance of an equity research report, or whose names appear on an equity research report. Debt research analysts are not required to register as research analysts or take a qualifying examination under this rule. However, FINRA is considering whether a similar requirement should apply to debt research analysts.

Separation Requirements

The FAQs state that FINRA Rule 2242 (Debt Research Analysts and Debt Research Reports) does not require physical separation between the debt research department and the investment banking, sales and trading, and principal trading departments when operating under the rule's institutional debt research exemption. However, FINRA does expect physical separation except in extraordinary circumstances where the costs are unreasonable due to a firm's size and resource limitations. In these circumstances, a firm must implement written policies and procedures, including information barriers, to effectively achieve and monitor separation between debt research and investment banking, sales and trading, and principal trading personnel.

Disclosure Requirements

The FAQs clarify that:

FINRA Rules 2241(c)(4)(I) and 2242(c)(4)(H) require disclosure of the material conflicts of interest of the research analyst or member that a person with the ability to influence the content of an equity or debt research report knows or has reason to know. Therefore, a research report must include disclosure of a material conflict that, for example, a supervisory analyst or research principal knows of and that the research analyst is not aware of. However, a research report would not need to include disclosure of a personal conflict of interest of the supervisory analyst or research principal, unless it rises to the level of a conflict of the member. FINRA notes, however, that other provisions in the rules may require management of those personal conflicts. For example:
- Rules 2241(b) and 2242(b) contain overarching requirements to establish, maintain, and enforce policies and procedures reasonably designed to identify and effectively manage conflicts of interest related to the preparation, content, and distribution of research reports; and
- Rules 2241(b)(2)(J)(i) and 2242(b)(2)(J)(i) require that a member's policies and procedures be reasonably designed to ensure that associated persons with the ability to influence the content of equity and debt research reports do not benefit in their trading from knowledge of the content or timing of a research report before the intended recipients of the research have had a reasonable opportunity to act on the information in the research report.
A member must disclose in an equity or debt research report if the subject company has paid the member to prepare and distribute the report (issuer paid research). FINRA considers issuer paid research to be an actual material conflict of interest that must specifically be disclosed by the member under Rules 2241(c)(4)(I) and 2242(c)(4)(H). In this circumstance, a member will not have satisfied its disclosure obligations simply by complying with the disclosure requirements under Rule 2241(c)(4)(D) or (E) or Rule 2242(c)(4)(D) or (E), which are intended to provide more general disclosure of conflicts with less direct potential impact on the objectivity of a research report.

Exemption for Institutional Debt Research

The FAQs clarify that:

The exemption for institutional debt research does not apply to the public appearance provisions of Rule 2242. It would be inconsistent with the rationale of the institutional exemption (that all recipients of the debt research have sufficient sophistication to understand the conflicts of interest without the specific disclosures and other protections afforded retail debt research) to allow debt research analysts to make public appearances before an audience that could include retail investors.
Although it is not required to do so, a firm may rely on certifications obtained directly, or through third-party vendors, to establish elements of consent required by either Rule 2242(j)(1)(A) or (B) to distribute institutional debt research to an institutional investor. FINRA has not approved or endorsed any particular certification or third-party vendors that might create these certifications. Rule 2242(j)(1)(A) incorporates and modifies elements of the institutional customer exemption in FINRA Rule 2111 (Suitability). If a firm intends to obtain negative consent under Rule 2242(j)(1)(A), it may wish to reference Questions 24-26 in Notice 12-25 (May 2012) related to the Rule 2111 institutional customer exemption. Rule 2242(j)(1)(A)(ii) requires a qualified institutional buyer to affirmatively indicate that it is exercising independent judgment in evaluating the member's recommendations under Rule 2111 and that the affirmation cover transactions in debt securities. Therefore, any certification that is obtained or may have previously been used for the purposes of Rule 2111 must be broad enough to fairly encompass transactions in debt securities.

Applicability of Rule 5280 (Trading Ahead of Research Reports)

The FAQs indicate that the provisions of Rule 5280 (Trading Ahead of Research Reports) do not apply to research reports that are produced outside of the research department, such as trading desk research. In filings in connection with the proposal to establish Rule 5280, FINRA stated that the rule applies only to debt and equity research reports that are produced by personnel in the research department. The reference to "other persons with the knowledge of the content or timing of a research report" in Rule 5280(b) is not intended to capture persons outside of the research department, such as sales and trading personnel, who may produce research reports. Rather, that language is intended to refer to persons who may become aware of the content or timing of a research report coming from the research department (for example, a committee that reviews initiations of coverage or changes in ratings or price targets).

FINRA also noted in its filings that, because of the differing objective of Rule 5280, the definition of research report in the rule is intended to be broader than the definition of research report in Rule 2241 and, by extension, new Rule 2242. Instead, it captures any written information from the research department that a reasonable person would expect to result in a transaction based on that information. For example, whereas Rules 2241 and 2242 exclude research reports distributed to fewer than 15 persons, those communications would be covered by Rule 5280.

However, trading ahead of customers based on non-public advance knowledge of research originating outside of the research department may raise issues under FINRA Rule 2010 (Standards of Commercial Honor and Principles of Trade), particularly where the trading is to the detriment of customers to which that research is ultimately directed. FINRA also notes that the SEC has charged violations of Section 15(g) of the Exchange Act where a broker-dealer failed to establish, maintain and enforce written policies and procedures reasonably designed to prevent the misuse of material, nonpublic information concerning its research analysts' published research.

To learn more about FINRA's equity and debt research rules, see Practice Notes, Equity Research Analysts and Equity Research Reports and Debt Research and Debt Research Analysts.

FINRA Issues New FAQs on Its Equity and Debt Research Rules | Practical Law