On July 30, 2002, the Sarbanes-Oxley Act of 2002 was signed by President Bush and became law. Sarbanes-Oxley comes after a series of recent initiatives by the Securities and Exchange Commission, the National Association of Securities Dealers, and the New York Stock Exchange regarding conflicts of interests that may arise when research analysts recommend securities in public communications. These conflicts can arise, for example, when an analyst works for a firm that has an investment banking relationship with the issuers of securities that the analyst recommends, or when the analyst or firm owns securities of a recommended issuer.

Among other things, Sarbanes-Oxley adds another layer of federal regulation regarding research analysts by creating new Section 15D of the Securities Exchange Act of 1934,¹ which mandates that the SEC adopt, or direct the self-regulatory organizations to adopt, rules “reasonably designed to address conflicts of interest that can arise when securities analysts recommend equity securities in research reports and public appearances.…”² In addition, Section 15D sets forth specific areas that the SEC, or the SROs at the SEC’s direction, must address, including:

• Disclosures relating to an analyst’s securities holdings in an issuer that is the subject of a research report or public appearance, analyst compensation, services provided by the analyst’s firm to the issuer, and compensation received by the firm from the issuer;³
• Restrictions on pre-publication approval or clearance of research reports by investment bankers or persons not directly responsible for investment research, other than legal or compliance staff;⁴
• Limitations on persons who may supervise and provide compensatory evaluations of analysts;⁵
• Prohibitions on retaliations against analysts by their broker-dealer employers as a result of adverse, negative, or unfavorable research reports that may damage the relationship between the broker-dealer and the subject issuer;⁶ and
• Defined periods during which broker-dealers that have participated, or are to participate, in a public offering of securities as underwriters or dealers should not publish or distribute research reports relating to those securities or such issuer.⁷

Although the SEC, NASD, and NYSE have addressed some of these areas in recent rulemaking, their respective rules contain inconsistencies that likely will be exacerbated by Sarbanes-Oxley’s latest layer of regulation. This article first summarizes the rules regarding analyst conflicts of interest recently adopted by the SROs and proposed by the SEC. Next, we examine some of the inconsistencies among these rules and the rules contemplated by new Section 15D. Finally, this article briefly discusses recent initiatives by other groups to reduce or eliminate research analyst conflicts of interest.

NASD, NYSE, and SEC Rules

NASD Rule 2711 and NYSE Rule 472

On May 10, 2002, the SEC approved new NASD Rule 2711 and changes to NYSE Rule 472, both of which address certain conflicts of interest that arise when research analysts recommend equity securities in research reports or public appearances.⁸ These rules address the following issues, among others.

Promises of favorable research. NASD Rule 2711 and NYSE Rule 472 prohibit analysts from offering or threatening to withhold a favorable research rating or specific price target to generate investment banking business from issuers.

Quiet periods. These rules impose “quiet periods” that generally bar a securities firm that is acting as manager or co-manager of a securities offering from issuing a research report on the issuer within 40 days after an initial public offering or ten days after a secondary offering.⁹

Limitations on relationships and communications. The rules prohibit the investment banking department from supervising research analysts. In addition, investment banking personnel may not review or approve an analyst’s research report prior to distribution unless staff from the firm’s legal and compliance department monitors those communications. The rules also prohibit a firm from sharing draft research reports with subject issuers other than to check facts and only if the issuer receives a redacted version that excludes the recommendation, price target, and research summary. Such communications also are subject to oversight by the firm’s legal and compliance department.

Analyst compensation. The rules prohibit securities firms from tying an analyst’s compensation to specific investment banking transactions. Also, if the analyst principally responsible for the preparation of the report received compensation that is based, even in part, on the firm’s general investment banking revenues, that fact must be disclosed in the analyst’s reports.

Restrictions on personal trading by analysts. The rules bar analysts and members of their households from investing in a company’s securities prior to its initial public offering if the issuer is in the business sector the analyst covers, and from trading against the issuer’s securities in a manner contrary to the analyst’s most recent recommendations (e.g., selling after issuing a “buy” recommendation). In addition, the rules impose “blackout periods” that prohibit analysts and their household members from trading securities of issuers that they follow for 30 days before and five days after they issue a research report about that issuer.¹⁰

Firm compensation. Firms must disclose in research reports whether they or their affiliates: (1) have managed or co-managed a public offering of securities for the subject issuer in the past 12 months; (2) have received any compensation for investment banking services from that issuer in the past 12 months; or (3) expect to receive or intend to seek compensation for investment banking services from that issuer during the next three months. In addition, analysts must disclose in public appearances if they know or “have reason to know” that the subject company is an investment banking client of the analyst’s firm. Public appearances may include television or radio interviews, conference calls or web casts that are open to the public, and any other public speaking activity.

Disclosures of financial interests in covered issuers. The rules require disclosures in research reports where the analyst or a household member has a financial interest in the securities of a subject issuer, or where the analyst’s firm and its affiliates beneficially own 1% or more of an issuer’s equity securities.¹¹ Analysts also must make these disclosures, as relevant, in public appearances when making a recommendation or offering an opinion concerning an equity security.

Disclosures regarding the firm’s ratings. The rules require firms to explain clearly in research reports the meaning of all ratings terms they use, and this terminology must be consistent with its plain meaning. Additionally, firms must disclose the percentage of all the ratings that they have assigned to “buy/hold/sell” categories and the percentage of investment banking clients in each category.¹² They also must provide a graph or chart that plots the historical price movements of the subject security and indicates those points at which the firm initiated and changed ratings and price targets for the issuer.

The SEC’s proposed Regulation Analyst Certification

Two months after approving NASD Rule 2711 and NYSE Rule 472, the SEC voted to propose its own rules regarding research analyst conflicts of interest. Under Regulation Analyst Certification (“Regulation AC”),¹³ research analysts would be required to certify the truthfulness of their views in research reports and public appearances and disclose whether they have received any compensation related to the specific recommendations provided in those reports and appearances. To that end, proposed Regulation AC includes the following provisions.

Research reports. Firms would be required to include in research reports a statement by the research analyst certifying that the report accurately reflects the analyst’s personal views at that time about any and all of the subject securities or issuers. If there is any relation between the analyst’s compensation and the specific recommendations or views expressed in the report, that fact must be disclosed along with the amount of the compensation received, its source, and its purpose.

Public appearances. On a quarterly basis, research analysts would be required to attest that any recommendations and views provided in public appearances during the prior quarter accurately reflected their personal views and were not related to any compensation that they received or will receive. Any analyst who is unable to make these written certifications would be required to provide his or her firm with a statement regarding this failure to certify, which the firm would provide to its designated examining authority (e.g., the NYSE or NASD). The firm then would have to disclose in all research reports prepared by that analyst for the next 120 days that the analyst did not provide the certifications and the reasons for the failure to certify.

Inconsistencies Among the SRO Rules, Regulation AC, and Section 15D

A careful reading of the various rules and proposals designed to reduce analyst conflicts of interest reveals many inconsistencies. We describe several of these variations below, and summarize some of them in the chart that accompanies this article. For the most part, the discrepancies among the various rules are not significant. Still, any firm that wishes to comply meticulously with all of the current requirements must be alert to the differences.

NASD Rule 2711 v. NYSE Rule 472

Notwithstanding the SROs’ efforts to harmonize NASD Rule 2711 and NYSE Rule 472, inconsistencies between these rules remain. For example, there are still inconsistencies regarding disclosures of analysts’ financial interests in a company that is the subject of a research report or public appearance. While the NYSE rule requires firms and analysts to disclose simply whether a financial interest exists, the NASD rule also requires disclosure of the nature of that interest (e.g., whether it is an option, right, warrant, future, long or short position).¹⁴ In addition, the SRO rules differ with regard to disclosures in research reports relating to firm compensation. While the NYSE rule requires specific disclosure of public offerings of equity securities within the past 12 months, the NASD rule requires disclosure of public offerings generally—not just equity offerings—within the past 12 months.¹⁵

Definition of “research report”

The SRO rules define a “research report” as a written or electronic communication that includes an analysis of equity securities of individual companies or industries and that provides information reasonably sufficient to support an investment decision and includes a recommendation.¹⁶ In contrast, the SEC’s proposed definition is not limited to equity research reports; it broadly applies to reports that analyze the “securities of an issuer or issuers.” Thus, Regulation AC would apply to analysts who prepare non-equity research reports as well as to equity analysts.¹⁷

Significantly, the SEC’s proposed definition in Regulation AC is inconsistent not only with the SRO rules but also with the definition of “research report” under new Section 15D(c)(2), which limits the term “research report” to reports analyzing the equity securities of a company. Unfortunately, the inconsistencies among the various definitions do not end there. While the SEC and SRO rules require that a communication include a recommendation to constitute a “research report,” the definition in Section 15D(c)(2) contains no such requirement.

Definition of “public appearance”

The SROs define a “public appearance” as any “participation in a seminar, forum…or other public speaking activity in which a research analyst makes a recommendation or offers an opinion concerning an equity security.”¹⁸ In contrast, the SEC’s proposed definition is not limited to recommendations concerning equity securities. Like the SEC’s definition of “research report,” the “public appearance” definition more broadly applies to specific recommendations or opinions concerning a “security or an issuer.”¹⁹ Section 15D, on the other hand, uses the term “public appearance,” but does not define it.

Definition of “research analyst”

NASD Rule 2711(a)(5) and Section 15D(c)(1) define the terms “research analyst” and “securities analyst,” respectively, to mean the associated person who is principally responsible for the preparation of the substance of a research report and any associated person who reports, directly or indirectly, to that person in connection with such preparation. In contrast, NYSE Rule 472 does not contain a separate definition of the term “research analyst.” Instead, NYSE Rule 472 defines the term “associated person,” for purposes of that rule, to mean “a member, allied member, or employee of a member or member organization responsible for, and any person who reports directly or indirectly to such associated person in connection with the making of the recommendation to purchase, sell or hold an equity security in research reports or public appearances or establish a rating or price target of a subject company’s equity securities.”²⁰ The SEC’s proposed definition of a “research analyst,” in turn, is different from all of these definitions: “any natural person who is principally responsible for the analysis of any security or issuer included in a research report.”²¹

Differences in disclosure requirements

In addition to the inconsistencies noted above, Section 15D and the SRO rules contain different disclosure requirements. For example, Section 15D(b)(1) requires the SEC, or the SROs at the SEC’s direction, to adopt rules that would require disclosure of the “extent to which the securities analyst has debt or equity investments” in an issuer that is the subject of a public appearance or research report. This provision is different from the SRO rules, which do not require disclosure of the extent or amount of the analyst’s financial interest, but rather disclosure of the fact that a financial interest exists and, in the case of the NASD rules, the nature of such interest.²²

Another difference between the SRO rules and Section 15D relates to disclosure of compensation received by broker-dealers. Section 15D(b)(2) requires disclosures in research reports and public appearances where a broker-dealer or its affiliates, including the research analyst, has received any compensation from an issuer that is the subject of the research report or public appearance. Although Section 15D(b)(2) allows the SEC to provide certain exemptions from this requirement, such exemptions are limited to situations where it is necessary to prevent the disclosure of material nonpublic information regarding specific potential future investment banking transactions.

In some respects, Section 15D(b)(2) is significantly broader than the SRO rules on the issue of disclosure. The SRO rules only require disclosures in research reports, and only require disclosure of investment banking compensation. Indeed, the SROs specifically amended their rules to address commenters’ concerns about over-broad disclosures of firm compensation. Initially, the SROs had proposed to require firms to disclose if they or their affiliates received any compensation from the subject company within the 12 months before, or reasonably expected to receive compensation within the three months following, the publication of the report. In response to comments that such a broad requirement would provide a large volume of meaningless disclosures to investors and prove difficult to implement, the SROs amended their rules to address specifically the receipt of investment banking compensation.²³

Unfortunately, Section 15D’s broad disclosure requirements regarding firm compensation do not reflect these considerations. By the same token, however, Section 15D(b)(2) seems more limited than the SRO rules because it only relates to compensation that “has been received” by a firm, whereas the SRO rules also cover prospective compensation.

A third difference between the SRO rules and Section 15D relates to disclosures of client status. Section 15D(b)(3) requires the SEC, or the SROs at the SEC’s direction, to adopt rules requiring disclosures in research reports and public appearances if the issuer whose securities are recommended is currently or was a client of the broker-dealer within the past year. In those circumstances, the broker-dealer must describe the types of services provided to the issuer. In contrast, the SRO rules require disclosure only if the research analyst (or associated person, in the case of NYSE Rule 472) knows or has reason to know that the recommended company is an investment banking client of the broker-dealer or its affiliates.²⁴ In this regard, the SRO rules are more narrowly tailored to address the specific conflict of interest concerns that arise when an analyst recommends securities of a company that is also an investment banking client.

Differences in “quiet period” requirements

Yet another difference between the SRO rules and Section 15D relates to the “quiet period” restrictions. As stated above, the SRO rules generally prohibit members from publishing research reports during certain time periods after the date of an initial public offering or secondary offering if they have acted as a manager or co-manager in the offering.²⁵ Section 15D, in contrast, is worded more broadly and seems to apply to situations where the broker-dealer has participated, or will participate, in a public offering of securities as an underwriter or dealer even if the broker-dealer was not a manager or co-manager.²⁶

Other Initiatives Regarding Research Analyst Conflicts of Interest

In addition to the SEC and SRO rulemaking discussed above, securities firms should take note of recent initiatives by certain states and the Association for Investment Management and Research (“AIMR”). To the extent these initiatives are inconsistent with SEC or SRO rules, they also add to firms’ burden of compliance. For example, on July 1, 2002, New York, California, and North Carolina embraced certain “Investment Protection Principles,” and have asked firms that conduct business with them to adopt these principles.²⁷ The disclosure requirements in the Investment Protection Principles are inconsistent with certain provisions in the SRO rules: while the SRO rules require firms to disclose in research reports if they have received investment banking compensation from a subject company within the past 12 months, the states seek broader disclosure of any compensation received from a subject company.

Similarly, AIMR’s draft research objectivity standards, issued on July 17, 2002,²⁸ are inconsistent with certain provisions of the SRO rules. For example, in contrast to the SRO rules, the definition of a “research report” in AIMR’s proposal is not limited to a report that recommends the equity securities of a company, but is defined more broadly as a written or electronic document that “presents information about a corporate issuer and expresses an opinion or makes a recommendation about the investment potential of the corporate issuer’s equity securities, fixed income securities, or derivatives of such securities.”²⁹

Conclusion

Increasingly, regulators have thrust issues involving research analyst conflicts of interest into the spotlight, and it is likely that the recent initiatives by the SEC, NASD, NYSE and other groups represent the latest, but not the last, efforts in this area. Before regulators hasten to propose additional rules, however, they should harmonize existing and pending ones. Otherwise, firms will struggle not only with the frustrations and expense of complying with extensive new requirements, but also with the burdens of complying with a patchwork, and in some cases inconsistent, regulatory scheme.

Notes

1§ 15 U.S.C. 78o-6 (hereinafter “Section 15D”).
2Section 15D(a). Section 15D(b) also mandates that the SEC, or the SROs at the SEC’s direction, adopt rules reasonably designed to require each securities analyst to disclose in public appearances, and each registered broker-dealer to disclose in research reports, conflicts of interest that are known or should have been known to exist at the time of the appearance or the date of the distribution of the research report.
3See Section 15D(b)(1)-(4).
4See Section 15D(a)(1)(A).
5See Section 15D(a)(1)(B).
6See Section 15D(a)(1)(C). This prohibition would not limit the ability of a firm to discipline a securities analyst for other causes.
7See Section 15D(a)(2).
8See Exchange Act Release No. 45908 (May 10, 2002). Most of the provisions of NASD Rule 2711 and NYSE Rule 472 were effective July 9, 2002 or September 9, 2002, but certain provisions will not be effective until November 6, 2002.
9There are limited exceptions to this general bar: (1) members may publish a research report concerning the effects of significant news or a significant event on the issuer within such periods, provided that the legal and compliance department authorizes publication of the research report, and (2) members may publish a research report pursuant to SEC Rule 139 regarding an issuer with “actively-traded securities.”
10The prohibitions on trading against recommendations and trading during “blackout periods” are subject to limited exceptions.
11The analyst disclosure requirement became effective July 9, 2002; the firm disclosure requirement is effective November 6, 2002. The 1% ownership is measured as of the end of the previous month, or the end of the second most recent month if the publication date is less than ten calendar days into a month.
12Firms that use a ratings system other than “buy/hold/sell” still must apply a “buy/hold/sell” structure for purposes of making this disclosure.
13Proposed Rule: Regulation Analyst Certification, Exchange Act Release No. 46301 (Aug. 2, 2002).
14See NASD Rule 2711(h)(1)(A); NYSE Rule 472(k)(1)(i)(b).
15See NASD Rule 2711(h)(2)(ii)(a); NYSE Rule 472(k)(1)(ii)(a).
16See NASD Rule 2711(a)(8) (emphasis added); NYSE Rule 472.10(2) (emphasis added).
17Indeed, in its proposing release, the SEC stated that the “scope of Proposed Regulation AC is broader than the scope of the current SRO rules in that the proposed regulation covers debt as well as equity securities. We believe that some of the same concerns regarding analyst conflicts also pertain to debt securities…. In addition, we understand that the SROs are considering expanding the coverage of their rules regarding analyst research reports to cover debt securities.” Release No. 34-46301, supra note 13.
18NASD Rule 2711(a)(4) (emphasis added). NYSE Rule 472.50 contains a substantially identical definition, but uses the term “associated person” instead of “research analyst.”
19Release 34-46301, supra note 13.
20NYSE Rule 472.40 (emphasis added).
21Release 34-46301, supra note 13 (emphasis added).
22See NASD Rule 2711(h)(1)(A); NYSE Rule 472(k)(1)(i)(b). An additional difference is that the SRO rules require disclosures if financial interests are held by the analyst or a member of the analyst’s household, whereas Section 15D(b)(1) only applies to the analyst.
23The cover letter transmitting the amendments to NASD Rule 2711 explains: “we agree with commenters who believe that disclosure of all forms of compensation is too broad and should therefore be limited to compensation that the member or its affiliates received, or expected to receive, for investment banking services.” Letter from Philip A. Shaikun, Esq., Assistant General Counsel, NASD Regulation, Inc., to James A. Brigagliano, Esq., Assistant Director, Division of Market Regulation, Securities and Exchange Commission (May 2, 2002) (emphasis added).
24NASD Rule 2711(h)(2)(B); NYSE Rule 472(k)(1)(ii). See also Joint Memorandum of the NASD and NYSE, NYSE Information Memo No. 02-26 (June 26, 2002), at 13 (stating that the “term ‘client’ is intended to include those clients from whom the member received revenues from investment banking services within the last 12 months, or for whom the member expects to provide investment banking services in the next 3 months, as disclosed in the most recent research report.”)
25NASD Rule 2711(f); NYSE Rule 472(f).
26Section 15D(a)(2).
27See Office of the New York State Attorney General, Press Releases, “Spitzer, Moore, McCall and Angelides Announce Landmark Initiative To Eliminate Wall Street Conflicts of Interest” (July 1, 2002), available at www.oag.state.ny.us/press/20002/jul/jul01a_02.htm. The Investment Protection Principles are based on the conflict of interest principles set forth in the agreement that New York State Attorney General Spitzer reached with Merrill Lynch in May.
28Association for Investment Management and Research Proposed Objectivity Standards. AIMR’s draft standards would apply to broker-dealers and other firms that sell research (“sell-side” firms), investment management firms, other firms that take investment actions (“buy-side” firms), corporate issuers, and the media. Although AIMR has no regulatory authority to compel firms to adopt its standards, many firms adopt AIMR’s standards and recommended practices voluntarily.
29Id. Although it is inconsistent with the SRO rules, AIMR’s broader definition of a “research report” is consistent with definitions recently adopted by certain foreign regulators, such as the Korean Securities Dealers Association and the Committee on European Securities Regulators.

This article was originally published in the September 2002 issue of the Wall Street Lawyer