Editor's Note: Richard J. Sandler is a partner at Davis Polk & Wardwell LLP and co-head of the firm’s global corporate governance group. This post is based on a Davis Polk client memorandum.

In December, the Financial Industry Regulatory Authority entered into settlement agreements with a number of the major banking firms in response to allegations that their equity research analysts were involved in impermissibly soliciting investment banking business by offering their views during the pitch for the Toys “R” Us IPO (which was never actually completed). FINRA rules generally prohibit analysts from attending pitch meetings [1] and prospective underwriters from promising favorable research to obtain a mandate. [2] In this situation, no research analyst attended the pitch meetings with the investment bankers and none explicitly promised favorable research in exchange for the business. However, FINRA announced an interpretation of its rules that took a broad view of a “pitch” and the “promise of favorable research.” FINRA identified a so-called “solicitation period” as the period after a company makes it known that it intends to conduct an investment banking transaction, such as an IPO, but prior to awarding the mandate. In the settlement agreements, FINRA stated its view that research analyst communications with a company during the solicitation period must be limited to due diligence activities, and that any additional communications by the analyst, even as to his or her general views on valuation or comparable company valuation, will rise to the level of impermissible activity. The settlements further suggested that these restrictions apply not only to research analysts, but also to investment bankers that are conveying the views of their research departments to the company. The practical result of these settlements will be to dramatically reduce the interaction between research analysts and companies prior to the award of a mandate.

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FINRA Settles with Banks; Provides Views on Analyst Communications During “Solicitation Period”

Richard J. Sandler is a partner at Davis Polk & Wardwell LLP and co-head of the firm’s global corporate governance group. This post is based on a Davis Polk client memorandum.

In December, the Financial Industry Regulatory Authority entered into settlement agreements with a number of the major banking firms in response to allegations that their equity research analysts were involved in impermissibly soliciting investment banking business by offering their views during the pitch for the Toys “R” Us IPO (which was never actually completed). FINRA rules generally prohibit analysts from attending pitch meetings [1] and prospective underwriters from promising favorable research to obtain a mandate. [2] In this situation, no research analyst attended the pitch meetings with the investment bankers and none explicitly promised favorable research in exchange for the business. However, FINRA announced an interpretation of its rules that took a broad view of a “pitch” and the “promise of favorable research.” FINRA identified a so-called “solicitation period” as the period after a company makes it known that it intends to conduct an investment banking transaction, such as an IPO, but prior to awarding the mandate. In the settlement agreements, FINRA stated its view that research analyst communications with a company during the solicitation period must be limited to due diligence activities, and that any additional communications by the analyst, even as to his or her general views on valuation or comparable company valuation, will rise to the level of impermissible activity. The settlements further suggested that these restrictions apply not only to research analysts, but also to investment bankers that are conveying the views of their research departments to the company. The practical result of these settlements will be to dramatically reduce the interaction between research analysts and companies prior to the award of a mandate.

Toys “R” Us IPO

The settlements stem from a proposed IPO by Toys “R” Us, where the firms were invited to compete for roles in the offering. Toys “R” Us and its private equity owners (hereafter, Toys “R” Us or the company) scheduled pitch meetings with each firm’s investment bankers as part of the bid process. The company also notified the firms that they wanted to hear the views of the firms’ equity research analysts and provided a list of topics that the analysts should cover, including the retail industry outlook, valuation and comparables. The company informed the firms that the analyst presentations would be considered as part of the selection process. No firm’s equity research analyst attended the pitch meetings, but each did separately present his or her views to the company. The analyst presentations varied: some covered the topics requested by the company, including information specific to it; others declined to do so and presented information in general terms without references to the company. The company also asked all but one of the firms to complete a valuation template that was to reflect the firms’ unified view, that is, investment banking and research’s, as to valuation. According to the settlement documents, the company stated “that if a firm was selected as an underwriter, the firm, including its analyst, would be expected to stand behind the valuation provided in the template.” Communications between the firms’ investment bankers and research analysts regarding the presentations and valuation were detailed in the settlement documents. All but the one firm that was not asked returned the requested valuation template. FINRA viewed the analyst presentations and the valuation confirmations as impermissible solicitation activity in furtherance of investment banking business. In addition, FINRA viewed the analysts’ favorable views of Toys “R” Us in their presentations and the valuation confirmations as promises of positive post-IPO research coverage. In the case of the one firm that did not provide a valuation confirmation, the analyst presentation alone rose to the level of impermissible activity for both violations. Toys “R” Us offered the firms various roles in the IPO, but ultimately decided not to proceed with the offering.

Through the settlements, FINRA offered new interpretations of its conflicts of interest rules that prohibit research analysts from communicating with prospective issuers during a newly created “solicitation period,” except as part of due diligence. Any communications that do not pertain to due diligence during the solicitation period, defined as “the period after a company has made known that it intends to proceed with a prospective investment banking services transaction, such as an IPO, and before the company has made a bona fide award of a mandate for the transaction” would be viewed as soliciting activity on behalf of the firm in violation of FINRA rules. FINRA stated that “[i]n the context of a meeting requested by an issuer during the solicitation period for the purpose of obtaining an analyst’s views as part of the underwriter selection process, as occurred in the [Toys “R” Us] IPO, an analyst from a soliciting investment bank may not communicate to the issuer his views about the issuer or the issuer’s industry, such as his views about valuation or comparable companies.” The settlements also extended this to indirect communications: “a firm cannot indicate to a prospective investment banking client its analyst’s positive views of the company or the company’s prospects, even if honestly held, or the positive prospective valuation the analyst may give the company.” The settlement agreements further hold that the communication of a research analyst’s view of a company, whether directly or indirectly, such as through the unified valuation, is an impermissible offer of favorable research for the purpose of obtaining investment banking business, even if the view is subject to change due to market conditions and diligence, and even if the view is the analyst’s honestly held belief that was not modified to obtain the mandate.

In connection with these allegations, and in the case of some firms, additional related activity, FINRA fined the settling firms a total of $43.5 million, ranging from $2.5 to $5 million per firm.

Implications to Current Practice

The facts in this case go beyond what we have seen as customary practice. However, the restrictions imposed by FINRA’s new interpretations go far beyond the activity in the Toys “R” Us IPO. Despite the reforms over the last decade, research analysts remain integral to an IPO, as investors respect, and rely in part upon, their views in making investment decisions. Accordingly, prospective issuers who are looking at selecting underwriters often choose to interview the analysts—not to secure a guarantee of favorable coverage but in an attempt to ensure that the hired bank will have an analyst that understands the sector and will be interested in the offering. Those practices will now be eliminated. While the pressure from companies inviting firms to compete for roles in their investment banking transactions will invariably continue, investment banks will impose heightened restrictions on their research analysts during the solicitation period for a particular transaction that will eliminate any conversations other than for diligence purposes. Such restrictions will also likely include a blanket prohibition on communicating, directly or through investment bankers, a research department’s views.

One remaining question is when the “solicitation period” ends in situations where issuers grant mandates with exact roles or economics to be determined. Assuming that the determination is not explicitly or implicitly based on research views, we believe that awarding of the mandate, without a specific role or economics, will end the solicitation period. In situations where roles are linked directly to research views, the solicitation period could last much longer.

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The settlements are a general reminder of the continued scrutiny by FINRA on equity research practices and conflicts of interest since the high-profile Global Research Equity Settlement in 2003, which resulted in the settling firms collectively paying $1.5 billion in fines and agreeing to significant structural and operational reforms. They also come on the heels of FINRA’s recent proposal to amend existing equity research rules (and a proposal to establish a new debt research rule) as part of its ongoing rulebook consolidation process and efforts to relax elements that have been deemed unnecessarily burdensome (discussed in our client memorandum FINRA Proposes to Amend Equity Research Rules and Establish New Debt Research Rule). To be sure, FINRA’s focus on conflicts of interest remains strong and firms will need to be vigilant that they are not running afoul of these rules.

Endnotes:

[1] NASD Rule 2711(c)(4) (prohibiting research analysts from participating in pitch meetings except in limited circumstances in connection with the IPO of an emerging growth company).
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[2] NASD Rule 2711(e) (prohibiting FINRA members from directly or indirectly offering favorable research in exchange for business or compensation).
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