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SEC Approves FINRA Rule 2242 on Debt Research Analysts and Debt Research Reports
Practical Law Legal Update w-000-4748 (Approx. 6 pages)
SEC Approves FINRA Rule 2242 on Debt Research Analysts and Debt Research Reports
by Practical Law Corporate & Securities
| Published on 20 Jul 2015 • USA (National/Federal) |
The SEC approved the Financial Industry Regulatory Authority's (FINRA) proposal 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 July 16, 2015, the SEC approved FINRA's proposed rule change to adopt new FINRA Rule 2242 (Debt Research Analysts and Debt Research Reports). Like FINRA's equity research rules, 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 rule 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 approved FINRA rules, while providing broad exemptions for debt research distributed only to institutional investors and for firms with limited investment banking and principal trading activities.
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 July 16, 2015, the SEC approved a FINRA proposal 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, SEC Approves FINRA Rule 2241 on Research Analysts and Research Reports).
FINRA will announce the effective date of Rule 2242 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.
Conflicts of Interest
Rule 2242 will impose requirements and restrictions on member firms, debt research analysts and debt research reports similar to those that will apply in the equity context under Rule 2241 when distributing debt research reports to retail investors. Among other requirements, member firms will 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 will need to be reasonably designed to provide for, 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, 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. The policies and procedures must restrict or limit input by a member firm's investment banking, sales and trading and principal trading personnel into research coverage decisions.
- Solicitation and Marketing. The policies and procedures must restrict or limit activities by debt research analysts that can reasonably be expected to compromise their objectivity. The policies and procedures will be required to prohibit:
- analyst participation in pitches and other solicitations of investment banking services transactions and road shows and other marketing activities on behalf of issuers related to these transactions (although analysts could view road shows or sales presentations from a remote location or separate room);
- information in pitch materials about a member's debt research capacity in a manner that suggests, directly or indirectly, that the member might provide favorable debt research coverage;
- 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 customers in the presence of investment banking department personnel or company management about an investment banking services transaction.
- Supervision and separation of debt research analysts. The policies and procedures must limit the supervision of debt research analysts to persons not engaged in investment banking, and 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. The policies and procedures must 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 will need to specify that debt analyst compensation cannot 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. The policies and procedures must 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. However:
- members may define financial hardship circumstances, if any, in which debt research analysts would be permitted to trade against their most recent recommendations; and
- 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.
- No retaliation. The policies and procedures must 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.
- Restrictions on Communications. Any written or oral communication by a debt 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. Debt research analysts will not be permitted to engage 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.
The rule also:
- Proscribes "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.
- Requires 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.
- Prohibits 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 apply to facilitate legitimate exchanges of information.
- Requires firms to establish, maintain and enforce written policies and procedures reasonably designed to ensure that a debt research report is not distributed selectively to internal trading personnel or a particular customer or class of customers before other customers that the member has previously determined are entitled to receive the debt research report.
- Prohibits a member from distributing third-party debt research if it knows or has reason to know that the research is not objective or reliable. Members must establish, maintain and enforce written policies and procedures reasonably designed to ensure that any third-party debt research report it distributes contains no untrue statements of material fact and is otherwise not false or misleading. With any third-party research report it distributes, a member must provide, or provide a web address that directs a recipient to, disclosure of any material conflict of interest that can reasonably be expected to have influenced the choice of a third-party debt research report provider or the subject company of a third-party debt research report.
Content and Disclosure in Debt Research Reports
In general, Rule 2242 adopts the disclosure requirements of the equity research rules for retail debt research and public appearances with certain modifications that rely on the distinctions between the debt and equity markets.
Exemptions
The rule provides:
- Institutional Investor Exemption. The rule exempts 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 stated 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 rule will allow firms to distribute institutional debt research by negative consent to a person that meets the definition of a QIB and where, under FINRA Rule 2111(b):
- the member or associated person has a reasonable basis to believe that the QIB is capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies involving a debt security or debt securities; and
- the QIB affirmatively indicates that it is exercising independent judgment in evaluating the member's recommendations under Rule 2111 and that affirmation is broad enough to encompass transactions in debt securities.
- The rule will allow firms to distribute institutional debt research to other institutional investors upon affirmative consent. To avoid a disruption in the receipt of institutional debt research, the rule allows firms to send institutional debt research:
- to any FINRA Rule 4512(c) account, except a natural person, without affirmative or negative consent for up to one year after the SEC's approval while they obtain the necessary consents; and
- to natural persons that qualify as an institutional account under FINRA Rule 4512(c), provided they provide affirmative consent to receive institutional debt research during and after the transition period.
- Limited Investment Banking and Trading Activities Exemptions. Similar to the equity research rules, the rule exempts 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 will still be subject to safeguards designed to insulate debt research analysts from pressure by investment banking personnel. An analogous exemption will be available to members with limited trading activity.