,
Jackson B.R. Galloway and
Elizabeth Shea Fries 
.
FINRA has issued a request for comment (FRN 12-09) on a revised proposal for a rule to identify and manage conflicts of interest involving the preparation and distribution of debt research reports to retail and institutional investors. The proposed rule in large part parallels the requirements of NASD Rule 2711 for equity research reports, with some important differences. The revised proposal maintains a tiered approach, adopted in a concept proposal (FRN 11-11) released in March 2011, based on whether the debt research is distributed to retail or institutional investors. The revised proposal also incorporates some changes based on comments submitted regarding the concept proposal.
Identifying and Managing Conflicts of Interest
The revised proposal includes most of the provisions contemplated by the concept proposal. In that regard, the revised proposal requires member firms to establish, maintain and enforce policies and procedures reasonably designed to identify and manage conflicts of interest related to debt research reports.
Prepublication Review. The policies and procedures would be required to prohibit prepublication review, clearance or approval of debt research reports by persons involved in investment banking or sales and trading as well as generally prohibit prepublication review by a subject company. Unlike the current rule on equity research reports, the proposed rule includes a firm's sales and trading departments as possible sources of conflicts of interest for the research department.
Coverage. With respect to coverage determinations, the policies and procedures would be required to restrict input by investment banking or sales and trading personnel to ensure that the final decisions are made independently by research management.
Solicitation and Marketing of Investment Banking Transactions. The proposed rule would require firms to prohibit debt research analysts from participating in the solicitation of investment banking services and other marketing on behalf of issuers and to prohibit banking personnel from directing a debt research analyst to engage in sales and marketing efforts or communication with current or prospective customers related to an investment banking deal.
Supervision. The proposed rule would require firms to implement policies and procedures to limit the supervision of debt research analysts to persons not engaged in investment banking or sales and trading. Firms would have to erect information barriers between debt research analysts and persons engaged in investment banking or principal trading activities.
Budget and Compensation. The proposed rule would limit determination of a firm's debt research department budget to senior management, other than persons engaged in investment banking or principal trading activities, and would prohibit compensation determinations based on non-research activities or transactions. The proposed rule would, however, permit persons making budget and compensation decisions to consider the revenues and results of the firm as a whole, and would permit any person to provide input to senior management regarding the demand for and quality of debt research.
Personal Trading. The proposed rule would require firms to implement policies and procedures to limit trading by a debt research analyst in securities whose performance is materially dependent upon the performance of securities covered by the research analyst.
Retaliation and Promises of Favorable Research. The proposed rule would require firms to prevent retaliation against debt research analysts by any employee of the member as the result of an adverse, negative or otherwise unfavorable debt research report or public appearance by the debt research analyst and to prohibit promises to a subject company by employees of the member of favorable debt research as inducement for the receipt of business compensation.
Content and Disclosure in Debt Research Reports
For purposes of some disclosure requirements, the proposed rule would distinguish between institutional investors and retail investors. Institutional investor would have the same meaning as "institutional account" in FINRA Rule 4512(c) and would include banks, insurance companies, registered investment companies, registered investment advisers and any individual or entity with total assets of at least $50 million. A retail investor would be any person other than an institutional investor.
With respect to debt research distributed to retail investors (retail debt research), the proposed rule would impose most of the same disclosure requirements that apply in the equity research context, with a few modifications to account for the difference between debt and equity markets. The revised proposal requires firms to include certain disclosures with respect to facts, recommendations or ratings in debt research reports, including any valuation methods used or risks involved in achieving the recommendation or rating. In addition, firms must include disclosures regarding historical ratings or recommendations by the member firm as well as whether the firm has provided investment banking services in the past 12 months with respect to subject companies.
The proposed rule would require firms to disclose in debt research reports all conflicts that reasonably could be expected to influence the objectivity of the debt research report and that are known or should have been known by the firm or the debt research analyst on the date of publication or distribution, including, among other disclosures, if the firm received any non-investment banking compensation from the subject company in the past 12 months or if the debt research analyst has any financial interest in the debt or equity securities of the subject company.
Standards Applicable to Research Distributed to Institutional Investors
The proposed rule would exempt research distributed solely to eligible institutional investors (institutional debt research) from most of the provisions regarding supervision, coverage determination, budget and compensation determination and all of the disclosure requirements applicable to debt research reports distributed to retail investors. The concept proposal contemplated that institutional investors could be treated as institutional investors unless they elected to be treated as a retail investor for the purposes of this rule. FINRA is now proposing that member firms would be required to treat otherwise eligible institutional investors the same way they treat retail investors unless the institutional investor affirmatively notifies the firm that it wishes to forego treatment as a retail investor and receive the more limited protections afforded to debt research distributed only to institutional customers.
Certain provisions would still apply to debt research distributed to eligible institutional investors, including the prohibitions on: (i) prepublication review of debt research reports; (ii) debt research analysts participating in the solicitation and marketing; and (iii) investment banking personnel directing a debt research analyst to engage in sales and marketing efforts. The provisions prohibiting retaliation against debt research analysts and promises of favorable debt research would also apply to institutional debt research. While the revised proposal would not require institutional debt research to carry the specific disclosures applicable to retail debt research, it would require that such research carry general disclosures prominently on the first page, including that the report is intended solely for institutional investors.
Additionally, the revised proposal would require firms to implement policies reasonably designed to ensure that institutional debt research is made available only to eligible institutional investors. A firm may not rely on the exemptions for institutional debt research if it has reason to believe that the research will be redistributed to retail investors. Thus, if despite having in place reasonably designed policies and procedures, a firm learns that a party has been routinely redistributing institutional debt research to retail investors, the firm must discontinue distribution of institutional debt research to that party until it reasonably concludes that measures have been taken to prevent future improper redistribution.
Communications Between Debt Research Analysts and Trading Desk Personnel
The revised proposal maintains the general prohibition against sales and trading personnel attempting to influence the content of a debt research report. In supplementary materials, FINRA would offer guidance with respect to permissible interactions between debt research and sales and trading and principal transactions personnel. Specifically, the proposed supplementary material would state that (i) sales and trading personnel may communicate customers' interests to debt research personnel, so long as debt research analysts do not respond by publishing research that is intended to benefit a trading position of the firm, a customer or a class of customers and (ii) debt research analysts may provide custom analysis to sales and trading customers, provided such communications are not inconsistent with the analyst's currently published or pending research and any subsequent research that is not for the purpose of benefiting any firm or customer positions.
Distribution of Member Research Reports
The proposed rule would require firms to establish, maintain and enforce policies and procedures reasonably designed to ensure that a firm does not selectively distribute a debt research report to trading personnel or a particular class of customers in advance of other customers. In supplementary materials, FINRA explained that this would not prohibit member firms from offering different research products to different classes of customers. For example, a firm could provide one kind of research to customers with a long-term investment horizon and another to customers with a short-term investment horizon.
Prohibitions on Information in Pitch Materials
The proposed supplementary materials would state that FINRA interprets the proposed rule to prohibit the use in pitch materials of any information about a member's debt research capacity in a manner that suggests that the member might provide favorable research coverage.
No Imposition of Quiet Period
Unlike NASD Rule 2711, which applies to equity research reports, the revised proposal does not impose quiet periods around the issuance of debt research reports.
Request For Comments
Comments are due by April 2, 2012.
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