• Reforming Research
  • May 1, 2003 | Author: Sam Scott Miller
  • Law Firm: Orrick, Herrington & Sutcliffe LLP - New York Office
  • The litany goes on. The New York Attorney General charges that Wall Street research is "a fundamental deception of the public. The self-regulators rush out rules to address conflicts of interest. The Sarbanes-Oxley Act of 2002 establishes standards for research analysts. The Commission commences a formal inquiry into market practices concerning research analysts and the conflicts that can arise from the relationship between research and investment banking, at the same time moving forward with enforcement actions against analysts who sold stocks in their personal accounts while recommending them to investors. Meanwhile, a spate of class-action lawsuits allege that investment banks' analysts issued misleadingly rosy recommendations of stocks to facilitate profitable deals between the banks and the issuers or to affect the price of the stock. Finally, hundreds of arbitrations are being filed against firms alleging failure to disclose that their analysts issued rosy research to get investment-banking assignments for their firms.

    The North American Securities Administrators Association has piled on, announcing a task force to join the NYAG's investigation. The NYAG suggests the possibility of bringing criminal charges, and the Justice Department is looking into whether to start a criminal investigation of analysts' conduct.

    The uproar is not confined to the U.S. markets: Deutsche Bank came under investigation by German regulators for jettisoning a forty-four-million-share chunk of Deutsche Telekom a day after publicly reiterating its "buy" advice on the stock. The United Kingdom's Financial Services Authority has also proposed rules designed to ensure that analysts are independent of the investment banking side of their own firms as well as the companies they cover. The FSA said it may require disclosure of the meanings of stock ratings and the percentage of buy, hold, and sell ratings. The proposal suggests analysts may be required to provide full details of their relationship with the companies they research and to label their reports either as advice, promotion, or marketing material.

    While the outcome cannot be definitively predicted, what is clear is that research and its preparers will require much closer supervision and that more specific disclosure of conflicts will be required.

    Settlements

    Settlements of proceedings involving major firms provide some guidance to those reviewing and restructuring their research functions.

    A court order requiring immediate reforms by Merrill Lynch followed an investigation by the New York Attorney General which concluded that the firm's investment advice was tainted by the desire to aid its investment-banking business. The NYAG alleged that the firm's stock ratings were biased in an attempt to secure and maintain lucrative investment-banking contracts. Specifically, analysts at Merrill Lynch helped recruit new investment-banking clients and were paid to do so. As part of a quid pro quo between the firm and its investment banking clients, Merrill Lynch analysts skewed stock ratings, giving favorable coverage to preferred clients, even when those stocks were dubious investments.

    Merrill Lynch agreed to pay $100 million dollars and

    • Severe any link between compensation for equity-research analysts and investment-banking business;
    • Prohibit investment-banking input into analyst's compensation;
    • Create an investment-review committee, independent of investment banking and research, to review and prove all stock recommendations;
    • Establish a monitor to ensure compliance with the settlement agreement;
    • Upon discontinuation of research coverage, disclose the termination and the reason for the termination;
    • Disclose in its research reports whether or not it received any compensation from a covered company over the past 12 months; and
    • Issue a statement of contrition for failing to address conflicts of interest

    The NASD subsequently fined Salomon Smith Barney $5 million for issuing materially misleading research reports on Winstar Communications, Inc. Separately, the NASD filed a complaint against Jack Grubman, formerly the Managing Director of the firm's Equity Research Department, and an assistant to Grubman, concerning the same conduct. NASD found Salomon's reports failed adequately to disclose the risk of investing in Winstar, including important risks relating to funding and bankruptcy. The reports contained repeated strong praise for Winstar, while belittling other analysts who were critical of the company. Some of the rebuttals were false and misleading. The complaint against Grubman and his assistant charged that e-mails and other internal Salomon documents demonstrate that, while they were publicly recommending Winstar to investors, they expressed contrary views in private. In various private communications, both Grubman and his assistant highlighted risks of investing in Winstar and expressed doubts about Winstar's ability to obtain funds. Those risks and doubts were never disclosed to the investing public.

    A global settlement, announced December 20, 2002, by the SEC, the New York Attorney General, the securities regulators of other states, the NASD and the NYSE, and by Bear Stearns, CSFB, Deutsch Bank, Goldman Sachs, J.P. Morgan Chase, Lehman Bros., Merrill Lynch, Morgan Stanley, Salomon Smith Barney and UBS Warburg requires that each investment bank:

    1. Insulate research analysts from investment-banking pressure by severing the link between investment banking and analyst compensation and prohibiting analysts from traveling on investment banking pitches and road shows;
    2. Contract with at least three outside research firms to provide analysis to the firm's customers, monitored by an independent consultant chosen by regulators;
    3. Publicly disclose its analyst recommendations, including ratings and price targets, so as to permit the public to compare and evaluate analysts' performance; and
    4. Cease allocating desirable IPO shares to executives of corporations in a position to influence those corporations' decisions concerning the retention of investment banking firms.

    The settling firms will pay an aggregate of $1.4 billion, ranging from $400 million (for Salomon Smith Barney) to $80 million. The payments are divided among three pools: $900 million towards "investor restitution"; $450 million to pay for the independent research contemplated by the settlement, and $85 million towards investor education. Merrill Lynch's previous payment of $100 million is counted in the $1.4 million, along with an additional $100 million paid toward research and investor education.

    Analyst Independence

    The broad issue of analyst independence breaks down into three primary aspects:

    • Analysts' direct financial interest in securities they cover;
    • Broker-dealers' financial interest in securities covered by their analysts; and
    • Broker-dealers' financial interest in stimulating new or continued business with issuers covered by their analysts, both in underwriting and in trading.

    Thus the issue for financial-services firms is not simply whether analysts have a personal stake in the securities they cover and fail to disclose this fact, but more broadly whether their firms maintain sufficiently strong internal barriers between the analysts and other business activities. Ideally, such barriers will prevent an analyst from overrating a stock. For instance, a strong barrier would entirely de-link analyst compensation from investment bankers' successful completion of transactions with the stock's issuer, thus removing any direct incentive for analysts to create a positive or negative "buzz" around a stock.

    Regulation of Analyst Conflicts

    Regulations against market manipulation and deceptive practices have for some time dealt with improper analyst activities. For example, SEC rule 10b-5 forbids any person to omit to state a material fact, or engage in any fraudulent or deceptive action, in connection with the purchase or sale of any security. Thus an analyst's "buy" recommendation without disclosure of his personal stake in a security, followed by his sale of the stock to profit by its run-up in price, is prohibited by this rule, and a violation might trigger SEC enforcement action or a lawsuit by an injured investor.

    The anti-fraud provisions of section 15(c)(1) of the Exchange Act have also been used to address research abuses. When a broker-dealer recommends a security to a customer, it impliedly represents that it has conducted a reasonable investigation and that a reasonable basis underlies the recommendation. Those facts known to the broker-dealer as well as those reasonably ascertainable must be disclosed. This responsibility is enhanced by "red flags" or "warning signals" such as projections that fail to materialize. Red flags should impel further inquiry and investigation. The affirmative obligation to supervise properly the business of broker-dealers may also be implicated.

    At the self-regulatory organization ("SRO") level, and prior to implementing new rules to be discussed below,

    • NYSE rule 472 establishes standards governing member and member organization communications with the public. In particular, NYSE rule 472.40(2) requires disclosure by member organizations as to certain relationships with recommended issuers, e.g., if the member organization participates in a public offering, makes a market or has positions in the securities of a company that is recommended in a communication to the public.

    • NYSE rule 472(b) requires that research reports issued by member firms be prepared or approved by a supervisory analyst meeting the requirements of NYSE rule 344, which include a minimum level of experience, NYSE investigation of the individual's character and conduct, and the passing of relevant parts of either the NYSE's supervisory analysts' examination or the Chartered Financial Analysts' examination.

    • NYSE rule 472.30 prohibits member firms' communications with the public that omit material facts.

    • NYSE rule 472.40 requires a recommendation (even though not labeled as a recommendation) to have a basis "which can be substantiated as reasonable" and prescribes that specified sources of potential bias be disclosed.

    • An interpretation of the NYSE rule states that the foregoing requirements are illustrative and not exclusive. In other words, disclosure of the required information may not suffice if additional facts would be material to the customer or reader.

    • Similarly, NASD rule 2210 requires that research reports be approved by a registered principal of the member firm or in some cases by a supervisory analyst. Similar to the NYSE, NASD rule 2210(d)(1)(A) requires that all "member communications with the public ... should provide a sound basis for evaluating the facts in regard to any particular security or securities or type of security, industry discussed, or service offered." NASD rule 2210(d)(2)(B)(i) requires a reasonable basis for any security recommendation in an advertisement or sales literature.

    The foregoing would appear to cover many if not all of the abuses being alleged in Congressional hearings, by the N.Y.A.G. and presumably in the private lawsuits. Violators risk the gamut of sanctions from censure and fine to suspension and expulsion as well as civil liability.

    None of these regulatory measures, however, specifically addressed the broader issue whether broker-dealers maintain sufficiently effective internal barriers between their analysts and their investment bankers.

    New NYSE/NASD Rules

    Responding to congressional scrutiny of research practices, the New York Stock Exchange and the National Association of Securities Dealers proposed rules that are intended to diminish conflicts affecting analysts. These rules were approved by the SEC in slightly modified form on May 10, 2002.

    NASD rule 2711 (Research Analysts and Research Reports) addresses analysts' conflicts by lessening any influence of an investment-banking department over its research counterpart. In addition, the rule restricts analysts' personal trading and requires disclosure of financial interests held by the firm, the analyst and the analyst's household. Member firms also have to clarify their research ratings and provide historical data that will assist investors to evaluate the research.

    Amendments to NYSE rule 472 (Communications with the Public) similarly restricts relationships and communications among investment banking and research departments and subject companies. Likewise, the amendments add disclosure requirements for research reports and public appearances. Finally, amendments to NYSE rule 351 (Reporting Requirements) require annual attestation of procedures for compliance with rule 472.

    The rules are similar in most respects, and the following discussion lumps them together for the most part. Our discussion omits many details of the rules, although we believe it captures the core features. The proposed rules had some apparent inconsistencies, but the amended rules are "substantially identical and are intended to operate identically."

    The Commission will request the NASD and NYSE to report within a year of implementing these rules on their operation and effectiveness and whether they recommend any changes or additions to the rules. A second round of rule-making is already underway (see below).

    Research Reports and Public Appearances

    The NASD and the NYSE revised their proposals to have a common definition of the term "research report." "Research report" is now defined as "a written or electronic communication which includes an analysis of equity securities of individual companies or industries, and which provides information reasonably sufficient upon which to base an investment decision and includes a recommendation."

    The NYSE retained its required disclosure when the firm has managed or co-managed a public offering of the securities of the subject company but the time period has been reduced from three years to 12 months.

    Analysts are required to make certain disclosures in the event of a public appearance in which a research analyst makes a recommendation or offers an opinion concerning an equity security. A guest analyst must disclose if the analyst or a member of the analyst's household has a financial interest in the securities of the subject company and any other actual, material conflict of interest of the firm which the analyst knows, or has reason to know, at the time the research report is issued or at the time the public appearance is made. When an analyst recommends securities in a public appearance, the analyst must disclose if the subject company is an investment-banking client of the firm or one of its affiliates, when the analyst knows or has reason to know of this relationship. A firm must disclose in research reports and an analyst must disclose in public appearances whether the analyst or member of the analyst's household is an officer, director or advisory board member of the recommended issuer. In public appearances, a research analyst has to disclose that the issuer of a recommended security is a client of the member or its affiliates so long as "the analyst knows or has reason to know this fact." SEC Chairman Pitt at the meeting approving the rules urged analysts to get advance commitments from TV producers to make these disclosures, possibly as printed statements that flash on the screen as the analyst speaks.

    Most firms have established ground rules that are followed by their corporate-communications staff in setting up public appearances.

    Gatekeeper Provisions

    No research analyst may be supervised or controlled by a firm's investment banking department.

    The investment-banking department is prohibited from supervising or controlling the research department, including reviewing or approving research reports before publication. Nonetheless, investment-banking personnel can review a report for factual accuracy and to screen for conflicts so long as an authorized legal or compliance official acts as intermediary for all communications. Similarly, sections of the report can only be submitted to the subject issuer for accuracy after written approval from the member firm's legal and compliance department. Even then, the research summary, rating and price target cannot be shown to the issuer.

    Analyst Compensation

    The rules prohibit tying analysts' compensation to specific investment-banking transactions. Nevertheless, an analyst might be compensated on overall performance, including services to investment banking such as advice whether a company is prepared for an IPO. If an analyst's compensation is based on the firm's general investment-banking revenues, however, that fact will have to be disclosed in the firm's research reports.

    Promising or Threatening to Change Favorable Research

    Although the NASD says that offering, or threatening to change, favorable research as an inducement for business is already a violation of just and equitable principles of trade (rule 2110), its rule change makes the prohibition explicit. The NYSE rule change prohibits offering favorable research or a specific rating or price target. Threatening to change research negatively would undoubtedly constitute a violation of just and equitable principles of trade.

    Application of this proscription raises some thorny issues, for example, how and to what extent may analysts become involved in presentations to issuers and investors. These issues for better or worse may be resolved in proposed new rules, which we discuss below.

    Quiet Periods

    An underwriting manager or co-manager cannot issue a research report about the issuer for 40 days following an IPO and 10 days after a secondary offering. Nevertheless, an event that is expected to impact materially the issuer's earnings, operations or financial condition can be reported if authorized by the firm's legal and compliance department. Moreover, the prohibition does not apply to research reports issued under rule 139 of the Securities Act regarding issuers whose securities are actively traded, as defined in Regulation M under the Exchange Act.

    Personal Trading by Research Analysts

    In order to prevent an analyst from receiving "cheap stock" before an IPO of a company that the analyst might subsequently follow, any account of the analyst or member of the analyst's household or account controlled by any of them cannot purchase or receive securities of such a company. Neither can a research analyst trade an issuer's securities during a period beginning 30 days before and ending five days after publication of a research report or change in the company's research rating or price target. Moreover, the analyst cannot make a trade inconsistent with the analyst's most current recommendation.

    Exceptions are provided for the purchase or sale of securities of a registered, diversified investment company or any other investment fund in respect of which neither the analyst nor a member of the analyst's household has investment discretion or control so long as the research analyst accounts collectively own interests representing no more than one percent of the assets of the fund; the fund invests no more than twenty percent, of its assets in securities of issuers principally engaged in the same types of business as companies that the research analyst follows; and, if the investment fund distributes securities in kind to the research analyst or household member before the issuer's initial public offering, the research analyst or household member divests those securities immediately or refrains from participating in the preparation of research reports regarding that issuer. Other limited exceptions are available, most of which will require approval by legal and compliance.

    Disclosure of Financial Interests and Price Chart

    Member firms and research analysts must disclose in research reports and public appearances any financial interest of the analyst (or a household member) in the subject company. The rules require disclosure if, as of five business days before publication of a research report or a public appearance, the firm or its affiliates beneficially own one percent or more of any class of common equity securities of the subject company. The time period for disclosure of one percent ownership is as of the month-end prior to issuance of the research report or public appearance, with an additional ten calendar days after the month-end to make this calculation. In the event the research report or public appearance is made less then ten calendar days from the end of the previous month, the disclosure may be as of the end of the second most recent month.

    The rules require disclosure in research reports and public appearances if the firm received compensation from the subject company within the past 12 months, or reasonably expects to receive compensation from the subject company within three months following the publication of the research report or the public appearance. The disclosure requirement is limited to compensation for "investment banking services." The rules, in addition, require disclosure whether an analyst or member of the analyst's household is an officer, director or member of an advisory board of the subject company as well as any "other actual, material conflict of interest known to the analyst or of which the analyst has reason to know."

    Disclosure of Rating System and Price Chart

    Research reports are required to include an explanation of the meaning of their ratings. Moreover, the reports have to include statistical data breaking down the securities rated by the member into three categories: buy, hold/neutral and sell; then the report has to reflect the percentage of ratings falling into each category for the previous 12 months. The report also has to break down the percentage of companies that are investment-banking clients for these categories for the previous 12 months. For securities assigned a rating for at least one year, a chart mapping the price movements of recommended securities and indicating points at which the member assigned a research rating or price target for the period during which the securities had been rated or three years, whichever is less, has to be included.

    The rules require disclosure of valuation methods for price targets, which must have a reasonable basis and be accompanied by disclosure of risks that might impede reaching the price target.

    Role of Legal and Compliance

    The rules require not only that legal and compliance personal devise extensive systems as well as implement and monitor them, but also that they play a supervisory role. The latter requirement places these personnel in a role for which they may not be trained and which may carry with it regulatory exposure as supervisors (notwithstanding the SRO's protestations). Moreover the dynamics of interjecting legal and compliance into the research process will retard and, perhaps sometimes, render obsolete research.

    Implementing Compliance Systems

    The NYSE/NASD rules and other regulatory actions will require modification in existing compliances and supervisory procedures. It is possible that legislation will force other changes. In the meantime, given the scrutiny of the research functions, lawyers and compliance personnel should review their procedures to insure that they at least cover existing requirements and, moreover, are consistent with industry standards. For most firms this will entail incorporating the new NYSE/NASD rules into their compliance systems. The SIA's best-practices guidelines are consistent with these rules and helpful in filling in the interstices.

    NYSE/NASD: New Proposals

    The NYSE and the NASD put forth a second round of proposals to strengthen the rules concerning research analysts and initial public offerings, and the SEC has published these for comment. The proposed rules would:

    • Require compensation-committee review and approval of research analysts' compensation;
    • Prohibit the compensation committee from considering a research analyst's contribution to the firm's overall investment-banking business;
    • Require the basis for compensation to be documented and certified by an annual attestation to the exchange;
    • Prohibit research analysts from participating in solicitation or "pitch" meetings with prospective investment-banking clients; and
    • Include as research analysts directors and supervisory analysts or others who supervise, influence or control the preparation of research reports and establishment or change in ratings or price targets.

    The proposals would also provide a new registration category and qualification exam as well as continuing education for research analysts. Firms would be required to notify customers when they terminate research coverage of a company and publish a final rating or recommendation (if a rating or recommendation has been issued) in the same manner as when research was initiated.

    The rule proposals as originally filed would have amended the definition of "public appearance" to apply restrictions to research analysts making a recommendation in a newspaper article or similar public medium. Under an amendment to the NASD (but not the NYSE) proposal, however, an analyst would not violate the proposed rule if the analyst makes the required disclosures in good faith, even if the media outlet does not print the disclosures. This position applies not only with respect to disclosure to the print media, but to disclosure to the radio and television media as well. The NYSE, on the other hand, requires that analysts disclose to print journalists stock holdings or other personal affiliations that might pose a conflict with the stock advice they give. Analysts whose conflicts weren't disclosed by print journalists who interviewed them would be expected to avoid future interviews with those journalists.

    The rule proposals would also extend the 10-day and 40-day quiet periods for research reports of managers and co-managers of initial and secondary offerings to making recommendations or offering opinions in public appearances. In addition, a quiet period of 15 days before and after termination of a lock-up agreement would apply to such research reports and public appearances.

    The proposals would drop the requirement of a recommendation from the definition of a "research report" in order to conform with Sarbanes-Oxley. The release announcing these proposals cautioned that additional rule amendments will be required to comply with the Sarbanes-Oxley Act of 2002.

    The NASD has proposed to extend the effective date of provisions dealing with supervision and control and the intermediation of communications for small firms, i.e., those that have over the past three years, on average per year, participated in ten as fewer investment-banking transactions as manager or co-manager and generated no more than $5 million in gross investment-banking revenue from those transactions.

    Sarbanes-Oxley

    This legislation adds to the Exchange Act section 15D, which instructs the SEC, either directly or indirectly through an SRO, to adopt rules governing secured analysts and research reports that would:

    • Restrict investment-banking employees from clearing or approving research;
    • Preclude supervision and compensation evaluation of analysts by persons engaged in investment banking;
    • Prohibit retaliation by a broker-dealer or its associated persons for negative research that negatively impacts investment banking;
    • Establish black-out periods for publishing research at the time of public offerings; and
    • Establish barriers to protect analysts from investment-banking influence that might bias their judgment or supervision.

    In addition, disclosure rules should address conflicts of interest, ownership of securities,, analyst compensation, and banking relationship.

    The Sarbanes-Oxley Act differs in certain respects from provisions in NASD rule 2711 and NYSE rule 472. Moreover, the Act imposes several requirements that are not already covered by SRO rules:

    Public Appearances

    Unlike the recently approved SRO rules, an analyst making a recommendation during a television interview must include all the same disclosures required in written research reports.

    Research Report

    The Act's definition of "research report" does not require that the research report contain a recommendation. (The new proposals of the NYSE and NASD would also eliminate this requirement.)

    Compensatory Evaluation

    The Act requires that rules be adopted that limit research analyst supervision and compensatory evaluation to non-investment banking officials. The SRO rules prohibit the supervision and control of research analysts by investment-banking personnel, but do not address compensation evaluation.

    Retaliation

    Sarbanes-Oxley requires that rules address retaliation against analysts by investment-banking staff.

    Quiet Periods

    The Act requires that quiet periods on the issuance of research reports apply to "brokers or dealers who have participated, or are to participate, in a public offering of securities as underwriters or dealers," not just managers and co-managers.

    Compensation Disclosure

    The Act requires disclosure of any compensation received from the subject company (by the registered broker or dealer, or any affiliate thereof, including the securities analyst), whereas SRO rules limit compensation disclosure to investment banking services compensation from the subject company by the firm or its affiliates during the past 12 months.

    Disclosure of Client Status

    The Act requires that firms disclose in research reports and public appearances whether the subject company currently is a client of the firm, and going beyond the SRO rules, requires that the firm disclose the types of services provided to the issuer.

    Proposed Regulation AC

    The SEC has proposed Regulation Analyst Certification ("Regulation AC"). (SEC Chairman Pitt asked research analysts to start complying with the proposed rules.) Research analysts would be required to certify the truthfulness of their views in research reports and public appearances, and to disclose whether they have received any compensation related to specific recommendations provided in those reports and in appearances.

    Unlike NYSE rule 2711 and NASD rule 472 that are limited to equities, Regulation AC covers debt as well as equity securities. Broker┬┐dealers would be required to include the following "clear and prominent" statements by research analysts in their research reports certifying that:

    • The research report accurately reflects the analyst's personal views about the subject securities and issuers;
    • None of the analyst's compensation was, is, or will be directly or indirectly related to the views or recommendations contained in the research report. If the analyst did receive such related compensation, then the statement must include the source and amount of the compensation and the purpose of the compensation, and further disclose that the compensation may influence the recommendation in the research report.

    Moreover, broker-dealers would be required to obtain quarterly certifications by the analyst that his or her views expressed in public appearances accurately reflect the analyst's personal views and whether any related compensation was received.

    The comment period expired September 23, 2002. Most commentators were concerned that the regulation would reach non-relevant persons and that it was inconsistent in places with the SRO rules and Sarbanes-Oxley.

    SIA Best Practices Guidelines

    The Securities Industry Association in June 2001 issued a set of best practices to guide its member firms in thinking about their research operations and how best to structure these to avoid potential analyst conflicts of interest. The practices fall under three main rubrics: Integrity of Research; the Research Process; and Conflicts of Interest.

    Integrity of Research

    The firm, research management, analysts, and investment bankers should together ensure the integrity of research, in practice and in appearance:

    • Research should not report to investment banking or to any other unit so as to compromise its integrity;
    • Reports as issued should be consistent with the analyst's own view of the security;
    • Analysts should be encouraged to issue both "buy" and "sell" recommendations, and to peg issues at all points on the ratings spectrum (i.e., rate an issue poorly if it so deserves);
    • Management should at least annually review analysts' rationale for and overall distribution of their ratings;
    • Analysts' pay should not be directly linked to specific investment-banking deals, sales and trading revenues, or asset-management fees, but should reflect, among other factors, the performance of analysts' recommendations;
    • Outside approval of analyst recommendations should be prohibited, and draft reports should be shown an issuer only to verify facts (and have the recommendation itself removed);
    • Investment banking and other non-research units should not guarantee specific ratings to current or prospective issuer clients; and
    • Firms should erect and carefully maintain internal barriers between research and investment-banking personnel.

    The Research Process

    Research should clearly state the relevant parameters and practical limits of each analyst's recommendation:

    • Analysts should form their own, objective opinions, using their best judgment to choose relevant issues on which to focus in analyzing an issuer;
    • Analysts should identify the major assumptions from which they proceed in a report, and distinguish between fact and opinion;
    • Earnings estimates should represent an analyst's best judgment and never solely reflect issuer predictions;
    • Reports should outline valuation methods and, in cases when a "buy" is issued, specify a price objective with a reasonable basis; and
    • Disclaimers should be straightforward, comprehensive and in plain English as well as include all material factors likely to affect the objectivity of the recommendation.

    Conflicts of Interest

    Personal trades and holdings of analysts should avoid conflicts of interest and should be disclosed whenever relevant:

    • Analysts should not trade a stock within a reasonable time of issuing research on it, nor should they communicate material non-public information about it to colleagues;
    • Analysts should not be allowed to trade against their own recommendations, except for appropriate reasons and after approval by research management or legal and compliance personnel;
    • Reports should contain information on direct ownership stakes in the issue by the analyst or members of his/her household;
    • If the firm is taking an issuer public and an analyst holds a stake in the stock, this fact should be disclosed, along with other private investments or outside business interests if these will likely cause conflicts of interest; and
    • Analysts should not cover stocks of companies of which they or members of their households are officers or directors.

    Conclusion

    According to the Economist,

    [A] ... sensible course is to allow the market itself to find the solution ┬┐ as it has already. The many analysts who maintained buy recommendations all last year on such companies as Enron or Global Crossing have lost any remaining shreds of credibility. Investors who lost money on dotcom shares are today more skeptical of analysts who puff companies with unintelligible business models that never make profits. Fund managers who find research from investment banks unreliable or tainted are relying more on their own work. Above all, investors should remember those old principles of commerce. Besides caveat emptor stands another: he who pays the piper calls the tune. Whatever the rules or the internal walls, the recommendations of any analyst who is paid a small fortune by his bank should always be regarded with suspicion. No amount of structural changes, lawsuits or compensation funds can beat this simple advice.

    Neither regulatory authorities nor financial services firms can hermetically seal off analysts and their research from the rest of the firm, given the role analysts play in supplying investment data and advice to their employing firms and clients. This reality suggests that, rather than requiring broker-dealers to root out and forestall all possible analysts' conflicts of interest, regulators instead require them to set out clear, firm procedures to manage, minimize and disclose such conflicts. Commissioner Paul S. Atkins recently commented,

    It is perhaps all too easy to ask in retrospect, but why is it too much to expect investment banks to have recognized the inherent conflicts? Why could they not have established compliance programs to detect and correct these structural flaws? Should the compliance and legal groups of brokerage firms have been aware that this use of compromised research reports tainted their overall sales effort? The duty of an attorney is to take the initiative to raise possible issues and design reasonable solutions. This duty will become increasingly important in the future due to the implementation of the attorney conduct rules provided for under Sarbanes-Oxley.