New FINRA Equity and Debt Research Rules

Annette L. Nazareth is a partner in the Financial Institutions Group at Davis Polk & Wardwell LLP, and a former commissioner at the U.S. Securities and Exchange Commission. The following post is based on a Davis Polk client memorandum by Ms. Nazareth, Lanny A. SchwartzHilary S. Seo, and Zachary J. Zweihorn. The complete publication, including appendices, is available here.

The Financial Industry Regulatory Authority (“FINRA”) has adopted amendments to its equity research rules and an entirely new debt research rule. Member firms should review and revise their policies, procedures and processes to reflect the new rules, and analyze what organizational structure and business process changes will be necessary.

The main differences between FINRA’s Current Equity Rules and the New Equity and Debt Rules (as defined below) are outlined in the original publication, available here. Highlights include:

  • Blackout Periods. The blackout periods during which firms may not publish or distribute equity research reports and equity analysts may not make public appearances relating to the issuer will be significantly shortened: the current 40-day blackout period for IPOs will be reduced to a minimum of 10 days after the completion of the offering for any firm that participated as an underwriter or dealer; the current 10-day blackout period for secondary offerings in which a firm participated as a manager or co-manager will be reduced to a minimum of three days after the completion of the offering; and the blackout period around the time of lock-up expiration will be eliminated. [1] The Debt Rule does not provide for any research or public appearance blackout periods for debt research;
  • “Policies and Procedures” Approach. The rules require firms to adopt written policies and procedures incorporating specific elements. It will be deemed a violation of the rules if an associated person engages in conduct that is prohibited or restricted under a firm’s required policies and procedures;
  • Exemption for Institutional Debt Research. Debt research provided solely to certain eligible institutional investors will be exempted from many provisions of the Debt Rule, provided that certain disclosure and other requirements are met;
  • Prepublication Review. Investment Banking (“IB”) personnel will no longer be able to conduct prepublication review for factual verification for either equity or debt research;
  • Compensation. Both rules will extend the Current Equity Rules’ prohibition on basing analyst compensation on specific IB transactions or contributions to the firm’s IB business; the Debt Rule will also prohibit the consideration of specific trading transactions or contributions to the firm’s principal trading activities;
  • Disclosure. Both rules will require firms to establish policies and procedures to ensure that purported facts in research reports are based on reliable information and expand the current “catch all” disclosure to cover material conflicts of interest known by any associated person of the firm with the ability to influence the contents of a research report;
  • Information Barriers. Both rules will explicitly require firms to maintain information barriers or other safeguards reasonably designed to ensure research analysts are insulated from the review, pressure or oversight by persons who might be biased in their judgment or supervision, including IB and sales and trading personnel, and, in the case of the Debt Rule, principal trading personnel;
  • Annual Attestation. The current research-specific annual attestation requirement will be eliminated;
  • Retaliation. Both rules will extend the current anti-retaliation prohibition to employees other than IB personnel; and
  • Exemptive Authority. FINRA will have the authority to exempt firms from any of the requirements for “good cause.”

Background

FINRA’s current research rules, NASD Rule 2711 and Incorporated NYSE Rule 472 (together, the “Current Equity Rules”) apply only to member firms’ equity research reports and activities. As part of its ongoing rulebook consolidation project, FINRA has combined its Current Equity Rules into a single rule and also codified several existing FINRA interpretations in new FINRA Rule 2241 (the “New Equity Rule”). In doing so, FINRA has taken the opportunity to make the rule somewhat less prescriptive by utilizing a “policies and procedures” approach, and to relax some elements that have come to be viewed as unnecessarily burdensome.

FINRA has also achieved its long-stated objective of establishing a debt research rule. New FINRA Rule 2242 (the “Debt Rule”) carries over most requirements in the Current Equity Rules, but with modifications. Notably, the Debt Rule will apply a tiered approach to certain requirements. Debt research provided solely to certain eligible institutional investors will be exempted from most of the provisions regarding supervision, coverage determinations, budget and compensation determinations and all of the disclosure requirements, provided that the research reports contain a front page “health warning” disclosure and the firm establishes policies and procedures to ensure that such research is available only to eligible institutional investors who agree (or, in some cases, are deemed to agree) to receive reports that are prepared without these safeguards. The Debt Rule will supplant the Securities Industry and Financial Markets Association’s voluntary “guiding principles” concerning fixed income research, which firms have adopted to varying degrees.

Both the New Equity Rule and the Debt Rule, which were approved by the SEC on July 16, 2015 (approval orders available here and here), codify certain existing guidance under the Current Equity Rules. The new rules do not supersede the “Global Research Settlement,” which imposes on many of the largest broker-dealers a structural separation between IB and equity research units. Nor do the new rules impact the obligations of firms under SEC Regulation AC, which, among other things, requires securities research analysts to certify the truthfulness of the views they express in research reports and public appearances.

Registration of Research Analysts

As part of the rule changes, FINRA has modified the definition of “research analyst” in FINRA’s research analyst registration rules (NASD Rule 1050 and Incorporated NYSE Rule 344, Supplementary Material .10) to limit it to associated persons whose primary job function is to provide investment research and who are primarily responsible for the preparation of the substance of a research report or whose name appears on a research report. This provides relief for persons who prepare equity research reports only on an occasional basis. The Debt Rule does not include any specific qualification requirements for debt research analysts, but FINRA notes that it is considering the issue.

Effective Dates

The Debt Rule becomes effective on February 22, 2016.

Most of the provisions of the New Equity Rule become effective on December 24, 2015. However, certain provisions of the New Equity Rule become effective on September 25, 2015, including:

  • the new, shorter blackout periods;
  • the elimination of the research-specific annual attestation requirement; and
  • the modification of the “research analyst” definition in FINRA’s research analyst registration rules.

Impact of New Rules

The new rules will have a significant impact on those member firms that produce research, particularly multiservice banks. For example:

  • Those firms that produce debt research and distribute it to retail and nonconsenting institutional investors (and thus are not able to avail themselves of the Debt Rule’s exemption for institutional debt research) will need to design and implement new compliance policies, procedures, processes and written supervisory procedures and training and education programs, and in some cases, reengineer certain reporting lines—all of which will have implications for their research, IB, principal trading (“PT”), sales and trading (“S&T”) and compliance departments and personnel. The Debt Rule distinguishes PT personnel from S&T personnel and imposes stricter restrictions on the former due to a perception of a greater potential for conflicts of interest between those persons and debt research analysts;
  • Those firms that produce debt research but limit its distribution to eligible institutional investors will be subject to a lighter touch set of requirements, but will still need to establish a number of new policies and procedures and written supervisory procedures and potentially modify reporting lines and organizational structures—both to ensure that such research is available only to eligible and consenting (or deemed consenting) institutional investors and to address certain aspects of the Debt Rule, such as a general prohibition on prepublication review by IB, PT and S&T personnel and a requirement that firms have barriers between research and IB, PT and S&T personnel, that apply regardless of the institutional debt research exemption; and
  • Firms that produce equity research will need to analyze and modify their existing policies, procedures and processes and their written supervisory procedures and also establish new training and education programs.

The new rules, and their important differences from the Current Equity Rules, are summarized in a chart attached to the full publication, available here.

Endnotes:

[1] Under both the Current and New Equity Rules, the blackout periods do not apply following the IPO or secondary offering of the securities of an emerging growth company (“EGC”).
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