United States: SEC Approves Long-Anticipated FINRA Research Rules

Last Updated: July 24 2015
Article by Amy Natterson Kroll and John V. Ayanian

New FINRA Rule 2241 consolidates and expands upon legacy NASD and NYSE rules to address equity research analyst activities, equity research reports, and conflicts of interest relating to equity research analysts. New FINRA Rule 2242 for the first time regulates debt research analyst activities, debt research reports, and related conflicts of interest.

On July 16, the Securities and Exchange Commission (SEC) approved two Financial Industry Regulatory Authority (FINRA) proposed rule changes pertaining to research analysts and research reports.1 The first rule change amends and consolidates into new FINRA Rule 2241 existing legacy NASD Rule 2711 and NYSE Rule 472 with regard to equity research activities (the SRO Rules). The second results in new FINRA Rule 2242, which for the first time imposes SRO regulation on debt research reports and debt research analysts. FINRA has not announced when these changes will take effect.

The approved rule changes follow years of consideration of amendments to FINRA's original proposal for a new debt research rule2 (first presented in a concept release in 2011) and almost a year of consideration by the SEC Staff of both the new debt research Rule 2242 and the proposed amendments to the SRO Rules and their consolidation into new FINRA Rule 2241.3

While the two FINRA rules track each other in many areas, there are differences. This LawFlash provides a high-level overview focusing primarily on the changes to the SRO Rules reflected in FINRA Rule 2241 that pertain to equity research activities. In addition, this LawFlash discusses the changes to the licensing requirements for equity research analysts that the SEC approved in conjunction with the approval of FINRA Rule 2241. We will publish a subsequent LawFlash with detailed information about new Rule 2242 pertaining to debt research activities, however, we note in this LawFlash those changes with regard to equity research activities that also will apply to debt research activities.

New FINRA Rule 2241—Equity Research Analysts and Equity Research Reports

Joint Due Diligence

The Supplemental Material section of FINRA Rule 2241 expressly prohibits joint due diligence by research analysts and investment banking department personnel prior to the selection by the issuer of the underwriters for an investment banking services transaction, to the extent that such joint due diligence prohibition does not run contrary to the Jumpstart Our Business Startups (JOBS) Act. FINRA has informed the SEC that it would not interpret the joint due diligence prohibition to apply where the activities involve a communication with the management of an Emerging Growth Company (EGC)4 that is attended by both the research analyst and an investment banker.5  This is a significant (though not surprising) change, especially in light of recent FINRA enforcement actions and FAQs from FINRA regarding research analysts and investment banking activities stating this position.6

  • New FINRA Rule 2242 includes the same limitations on joint due diligence by debt research analysts and investment bankers.

Identifying and Managing Conflicts of Interest

New FINRA Rule 2241 includes a section titled "Identifying and Managing Conflicts of Interest."7 This section is, in FINRA's view, a prudential approach to regulation of equity research activities. It incorporates many elements of the SRO Rules that require member firms to establish, maintain, and enforce written policies and procedures reasonably designed to identify and effectively manage conflicts of interest related to research analysts' interactions amongst themselves and with others, including "investment banking and sales and trading personnel, subject companies and customers." 

This new section addresses practices related to the preparation, content, and distribution of research reports; public appearances by research analysts; and the interactions among research analysts and investment banking, sales, and trading personnel, subject companies, and customers.

  • The express inclusion of potential conflicts between research activities and sales and trading personnel raises a number of issues beyond the information barriers and limitations FINRA already imposes through its Rule 5280. We will provide a more detailed analysis of these issues in our next LawFlash.

New FINRA Rule 2241 also requires that policies and procedures be reasonably designed to promote "objective and reliable research reflecting truly held opinions of research analysts" and to "prevent the use of research or research analysts to manipulate or condition the market or favor the interests of the member firm, or of particular current or prospective customers."

New FINRA Rule 2241 also imposes significantly reduced quiet periods when compared to the SRO Rules. Quiet periods during which member firms cannot publish and distribute research are now:

  • 10 days after completion of an IPO for underwriters and dealers, and
  • 3 days after the completion of a secondary offering for managers and co-managers of the offering.

New FINRA Rule 2241 retains the exceptions to the quiet periods noted above to allow for significant news or events about a subject company, and the three-day quiet period is lifted after secondary offering for issues that are actively traded as defined in Regulation M if the research is issued in reliance on the safe harbor in Rule 139 under the Securities Act of 1933.  New FINRA Rule 2241 does not include any quiet periods before or after expiration, waiver, or termination of a lock-up agreement.

  • New FINRA Rule 2242 includes many of the above-described provisions regarding managing conflicts of interest, particularly with regard to debt research that will be distributed to retail investors.

Disclosures 

New FINRA Rule 2241 retains the required disclosures found in the SRO Rules and also adds a new disclosure requirement that is triggered "if a member or its affiliates maintain a significant financial interest in the debt or equity securities of the subject company,"8 including, at a minimum, as required in the SRO Rules if the member or its affiliates beneficially own 1% or more of any class of common equity of the subject company.

Furthermore, member firms will now be required to disclose in research reports any other material conflicts of interest of the research analyst or the member firm known "by any associated person of the member with the ability to influence the content of a research report" or that such person has "reason to know,"9 in addition to the requirement in the SRO Rules that calls for disclosure if the analyst had such knowledge. An "associated person" with such ability is defined as any person (other than legal and compliance personnel) who reviews the content of a report or has exercised authority to review or change the research report prior to publication or distribution.10

  • The provisions described above can also be found in new FINRA Rule 2242.

Distribution of Equity Research Reports to Different Groups

The Supplemental Material to New FINRA Rule 2241 incorporates a concept introduced when FINRA Rule 2242 regarding debt research was first proposed, specifically, that research products and services may be provided to different classes of customers provided that:

    • the products are consistent with the meaning of the member's rating system for each respective product (for example, research regarding products with long-term investment horizons should have ratings that correspond to the long-term investment horizons and research about products with short-term investment horizons should have ratings systems that correspond to the short-term horizons);
    • the products are not differentiated based on the timing of receipt of a recommendation, rating, or other potentially market-moving information, or to allow certain customers to trade in advance of other customers; and
    • there is disclosure in the case that alternative research products and services may reach different conclusions or recommendations that could impact the price of the equity security.11

  • The above-described concept remains in new FINRA Rule 2242's Supplemental Material with regard to distribution of debt research reports.

Definitions

  • "Sales and Trading Personnel" is a new term not previously defined in connection with equity research activities. New FINRA Rule 2241 defines "sales and trading personnel" as "persons in any department or division, whether or not identified as such, who perform any sales or trading service on behalf of a member."
  • "Research Report" is amended to expressly exclude communications pertaining to open-end registered investment companies that are not listed or traded on an exchange, as well as private placement memoranda and comparable offering related documents prepared in connection with investment banking services transactions.12
  • "Research Analyst Account" is amended to clarify that the term does not include a registered investment company over which a research analyst or a member of the research analyst's household has discretion or control, provided that the research analyst or member of the household has no financial interest in the investment company other than a performance or management fee.13 

Personal Trading by Research Analysts

  • New FINRA Rule 2241 expressly allows a research analyst to trade against a recommendation in the face of "financial hardship" as defined in the member firm's policies and procedures managing conflicts of interest.14
  • Supplemental Material to new FINRA Rule 2241 also allows a firm that has a policy prohibiting the research analyst accounts from holding securities, or options on or derivatives of such securities, of the companies in the research analyst's coverage universe, to permit the research analysts' accounts to trade in a manner inconsistent with his or her recommendation, provided that the trades are pursuant to a "reasonable plan to liquidate the holdings and that plan is approved by the firm's legal or compliance department.15
  • The above-described concepts also are included in new FINRA Rule 2242.

Registration Requirements

In addition to New FINRA Rule 2411, the SEC approved amendments to legacy NASD Rule 1050 and incorporated NYSE Rule 344.

For purposes of NASD Rule 1050 and NYSE Rule 344 (which require specific licenses for research analysts), the definition of "research analyst" has been amended to mean those associated persons of member firms "whose primary job function is to provide investment research . . . " This amendment provides leeway for such persons—often sales and trading or other personnel within a firm—who may from time to time produce equity research reports, but whose primary job is not to provide investment research. The SEC recognizes that the amended definition would exclude general registered representatives and traders in an effort to "provide relief for those who produce research reports on an occasional basis."16 

We will continue to evaluate these new rules and will be issuing additional LawFlashes in the coming weeks.

Footnotes

1 SEC Release No. 34-75471 (July 16, 2015) ("SEC Rel. No. 34-75471"); SEC Release No. 34-75472 (July 16, 2015) ("SEC Rel. No. 34-75472").

2 Debt Research Reports, FINRA Regulatory Notice 11-11 (March 2011)

3 See, SR-FINRA-2014-047 (Nov. 14, 2014) and SR-FINRA-2014-048 (Nov. 14, 2015)

4 See FINRA Rule 2241(a)(1).

5 SEC Rel. No. 34-75471 at 11.

6 See, FINRA Publishes Guidance on Research Conflict of Interest Rules, Morgan, Lewis & Bockius LLP (June 3, 2015)

7 FINRA Rule 2241(b).

8 FINRA Rule 2241(c)(4)(A).

9 FINRA has informed the SEC that "reason to know" does not impose a duty of inquiry. See, SEC Rel. No. 34-75471 at 16-17.

10 FINRA Rule 2241(c)(4)(I).

11 Supplemental Material .07.

12 FINRA Rule 2241 (a)(11). "Investment banking services" transactions continued to be defined as transactions where a member firm acts as a underwriter or participates in a selling group in an offering for an issuer; acts as a financial adviser in a merger or acquisition, provides venture capital equity lines of credit, private investment, public equity transactions or similar investments, or serves as placement agent for an issuer.  FINRA Rule 2241(a)(5).

13 FINRA Rule 2241(a)(9).

14 FINRA Rule 2241(b)(2)(J)(ii).

15 Supplemental Material .10.

16 SEC Rel. No. 34-75471 at 23.

This article is provided as a general informational service and it should not be construed as imparting legal advice on any specific matter.

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