FINRA Proposes to Adopt FINRA Rule 2242 on Debt Research Analysts and Debt Research Reports | Practical Law

FINRA Proposes to Adopt FINRA Rule 2242 on Debt Research Analysts and Debt Research Reports | Practical Law

The Financial Industry Regulatory Authority (FINRA) issued a proposed rule change to adopt new FINRA Rule 2242 (Debt Research Analysts and Debt Research Reports) to address conflicts of interest relating to the publication and distribution of debt research reports.

FINRA Proposes to Adopt FINRA Rule 2242 on Debt Research Analysts and Debt Research Reports

by Practical Law Corporate & Securities
Published on 19 Nov 2014 • USA (National/Federal)
The Financial Industry Regulatory Authority (FINRA) issued a proposed rule change to adopt new FINRA Rule 2242 (Debt Research Analysts and Debt Research Reports) to address conflicts of interest relating to the publication and distribution of debt research reports.
On November 14, 2014, FINRA issued a proposed rule change that would adopt new FINRA Rule 2242 (Debt Research Analysts and Debt Research Reports). Like FINRA's equity research rules, proposed Rule 2242 is intended to foster objectivity and transparency in debt research and to provide investors with more reliable and useful information with which to make investment decisions. The proposal sets out a tiered approach in that, in the retail context, it imposes similar protections to those provided to recipients of equity research under current and proposed FINRA rules, while providing broad exemptions for debt research distributed only to institutional investors.
Currently, the principal rules administered by FINRA regulating research analysts and research reports, NASD Rule 2711 (Research Analysts and Research Reports) and Incorporated NYSE Rule 472 (Communications with the Public), apply only to research reports that include analysis of equity securities. On the same day as the debt research rules proposal, FINRA proposed to adopt NASD Rule 2711, with certain modifications, as new FINRA Rule 2241, and to eliminate Incorporated NYSE Rule 472 from the FINRA rulebook (see Legal Update, FINRA Proposes to Adopt FINRA Rule 2241 on Research Analysts and Research Reports).

Conflicts of Interest

Proposed Rule 2242 would impose requirements and restrictions on member firms, debt research analysts and debt research reports similar to those that would apply in the equity context under Proposed Rule 2241. Among other requirements, member firms would be required 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 debt research reports and public appearances by debt research analysts.
  • The interaction between debt research analysts and persons outside the research department, including investment banking, sales and trading and principal trading personnel, subject companies and 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, sales and trading and principal trading personnel, restrict or prohibit review by other non-research personnel (other than legal or compliance), and limit review by subject companies to matters of factual accuracy.
  • Research coverage decisions. Restrict or limit input by a member firm's investment banking, sales and trading and principal trading personnel into research coverage decisions.
  • Debt analyst conflicts. Restrict or limit activities by debt research analysts that can reasonably be expected to compromise their objectivity. The policies and procedures would be required to prohibit:
    • 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 view road shows or sales presentations from a remote location or separate room);
    • investment banking personnel from directing debt research analysts to engage in sales or marketing efforts related to an investment banking services transaction or any communication with a current or prospective customer about an investment banking services transaction; and
    • debt analysts from engaging in any communication with a current or prospective customer in the presence of investment banking department personnel or company management about an investment banking services transaction.
  • Supervision and separation of debt research analysts. Limit the supervision of debt research analysts to persons not engaged in investment banking, sales and trading or principal trading activities. In addition, member firms would be required to establish information barriers or other institutional safeguards to ensure debt research analysts are insulated from review, pressure or oversight by investment bankers, sales and trading or principal trading personnel who might be biased.
  • Research budget and compensation. Limit determination of a member firm's debt research department budget to senior management, excluding senior investment banking, sales and trading or principal trading personnel, and without regard to specific revenues or results derived from investment banking (however, input from all personnel on certain indicators could be provided). The policies and procedures would need to specify that debt analyst compensation could not be based on specific investment banking or principal trading activities and must prohibit investment banking and principal trading personnel from input into debt research analyst compensation.
  • Personal trading. Limit or restrict debt research analysts from trading in securities, derivatives and funds if the performance of those is materially dependent on the performance of securities covered by the research analyst, and impose other safeguards related to personal trading.
  • No retaliation. Prohibit retaliation against debt research analysts by any employee of the firm for publishing a report that may adversely affect the firm's business interest, and prohibit promises of favorable debt research, specific research content or a specific rating or recommendation as inducement for the receipt of business or compensation.
The proposal would also:
  • Proscribe "joint due diligence" by debt research analysts in the presence of investment banking department personnel during the time period before underwriters are selected in an investment banking services transaction.
  • Require members to establish, maintain and enforce written policies and procedures reasonably designed to prohibit sales and trading and principal trading personnel from attempting to influence a debt research analyst's opinion or views for the purpose of benefiting the trading position of the firm, a customer or a class of customers.
  • Prohibit debt research analysts from identifying or recommending specific potential trading transactions to sales and trading or principal trading personnel that are inconsistent with the debt research analyst's currently published debt research reports, or from disclosing the timing of, or material investment conclusions in, a pending debt research report. Certain exceptions would apply to facilitate legitimate exchanges of information.

Content and Disclosure in Debt Research Reports

Proposed Rule 2242 would, in general, adopt disclosure requirements in the equity research rule for retail debt research with certain modifications.

Exemptions

The proposal would:
  • Institutional Investor Exemption. Exempt debt research provided solely to institutional investors from many of the structural protections and prescriptive disclosure requirements that apply to debt research reports distributed to retail investors. The proposing release states that this tiered approach is appropriate because of the needs of institutional market participants who rely on timely market color, trading strategies and other communications from the trading desk. Specifically, the proposal would allow firms to distribute institutional debt research by negative consent to a person that meets the definition of a QIB, subject to certain conditions, and other institutional investors upon affirmative consent.
  • Limited Investment Banking and Trading Activities Exemptions. Similar to the equity research rules, exempt members that engage in limited investment banking activity from certain restrictions, including those dealing with prepublication review by investment banking personnel, and the involvement of investment banking personnel in coverage decisions, supervision, budget, compensation and information barriers. However, these members would still be subject to safeguards designed to insulate debt research analysts from pressure by investment banking personnel. An analogous exemption would be available to members with limited trading activity.

Effective Date

The proposed rule change must be approved by the SEC. FINRA will announce the effective date of the proposal 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.
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 "debt 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.
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.