FINRA Proposes Debt Research Rule: FINRA Regulatory Notice 12-09

February 24, 2012

FINRA has published Regulatory Notice 12-09 and Attachment A — the text of an unnumbered proposed debt research rule — for comment (together the “debt research rule proposal”).1 The proposed debt research rule tracks the current equity research rules (NASD Rule 2711 and NYSE Rule 472) in many respects, but diverges from the equity research rules in others, and likely anticipates the direction that FINRA ultimately will take with regard to the regulation of research generally. The influence of SEC staff views and of the recent GAO report 2 on integration of global settlement terms into the SRO and SEC rules are evident in the debt research rule proposal.

Any FINRA member firm that publishes debt or equity research should read the debt research rule proposal closely. FINRA will receive comments on the debt research rule proposal and then likely will contemporaneously file with the SEC both the debt research rule and a consolidated equity rule to replace NASD Rule 2711 and NYSE Rule 472. It seems likely that the consolidated equity research rule will, to the extent possible, mirror many aspects of the debt research rule ultimately filed with the SEC. Therefore, any significant concerns with the proposed debt research rule should be raised now, in the current FINRA comment process.

A summary of the debt research rule proposal is below. This alert first lays out the key definitions used in, then addresses the specific terms of, the proposed debt research rule. The alert also highlights the significant policy issues that the debt research rule proposal raises. The FINRA comment period expires on April 2, 2012.

I. Definitions

Any rule is shaped by the terms used in that rule. Paragraph (a) of the proposed debt research rule defines its significant terms.

A “debt research report” is a written communication that includes an analysis of debt securities and provides information reasonably sufficient upon which to base an investment decision. Excluded from debt research reports are any communications that are excepted from the definition of “research report” in NASD Rule 2711. FINRA explicitly rejects a proposal from a commenter that FINRA exclude from the definition “trader commentary” or other analytic communication prepared by non-research personnel, and states that it “believes it is more appropriate to tier the rule based on the sophisticate of the recipient rather than the department of origin of the communication.”

A “debt research analyst,” like an equity research analyst as defined in Rule 2711, is an associated person primarily responsible for, and any associated person who reports directly or indirectly to a debt research analyst in connection with, the preparation of the substance of a debt research report, whether or not the person has the job title of “research analyst.”

A “debt security” is any “security” as defined in Section 3(a)(10) of the Securities Exchange Act of 1934 (“Exchange Act”), but would exclude equity securities, municipal securities, security-based swaps (all based on Exchange Act statutory definitions) and U.S. Treasury Securities (as defined in FINRA Rule 6710). FINRA explicitly rejects earlier comments requesting that certain foreign sovereign debt, agency securities and other securities identified as “analogous to municipals” also be excluded from the definition of “debt security.”

A “research department” would be any department or division, whether or not identified as such, which is principally responsible for preparing the substance of a debt research report on behalf of a member.

An “institutional investor” would be any person described in FINRA Rule 4512(c), and a “retail investor” is any person “other than an institutional investor.”

II. Rule Requirements Generally

The proposed debt research rule in paragraph (b) would require FINRA members to:

  • Establish, maintain and enforce policies and procedures reasonably designed to identify and effectively manage conflicts of interest related to preparation, content and distribution of research reports, public appearances by debt research analysts, and interactions between debt research analysts and others.
  • At a minimum, the policies and procedures would have to:
    • Prohibit prepublication review, clearance and approval by investment banking, sales, and trading and principal trading personnel, and restrict or prohibit such activities by all other persons not directly responsible for the debt research, other than legal and compliance personnel;
    • Restrict or limit activities by debt research analysts that could reasonably be expected to compromise objectivity, including prohibiting participation in pitches or other solicitation of investment banking transactions and participation in road shows and other marketing on behalf of issuers;
    • Prohibit investment banking personnel from directing debt research analysts to engage in sales or marketing efforts related to investment banking transactions and from directing analysts to engage in any communication with current or prospective customers about an investment banking transaction;
    • Require that research management independently make final decisions about research coverage by restricting or limiting input by a firm’s investment banking department, sales and trading personnel on debt research coverage decisions; and
    • Prohibit prepublication review of debt research reports by a subject company other than to verify facts.
  • The policies also must be reasonably designed to promote objective and reliable debt research reflecting the truly held opinions of debt research analysts and prevent the use of reports or analysts to manipulate or condition the market or favor the interest of the FINRA member or a current or prospective customer or class of customers. Therefore, the proposed debt research rule also states that the policies and procedures must:
    • Limit supervision of the debt research analysts to persons who are not engaged in investment banking or sales and trading;
    • Limit budget determinations to senior management exclusive of investment banking or trading personnel and without regard to specific revenues or results from investment banking and trading activities;
    • Prohibit compensation based on specific investment banking or trading transactions or contributions to such activities;
    • Require that a debt research analyst’s compensation be reviewed at least annually by a committee that reports to the board of directors (or to a senior executive officer) that does not include investment banking personnel or persons engaged in trading activities;
    • Establish information barriers or other institutional safeguards to insulate debt research analysts from review, pressure or oversight by investment banking or trading personnel or others who may be biased in their judgment or supervision;
    • Restrict or limit trading in accounts of debt research analysts and their households, supervisors of debt research analysts, and associated persons with the ability to influence the content of research;
    • Prevent direct retaliation or threats of retaliation against debt research analysts by other employees as a result of unfavorable research reports or public appearances; and
    • Prohibit explicit or implicit promises of favorable debt research, specific research ratings or content as an inducement for business or compensation.

The proposed debt research rule in paragraphs (c) and (d) outlines the required content standards for debt research reports and also the disclosures that are required to be included in debt research reports and public appearances by debt research analysts. Generally, the disclosures track those that are required in the equity research rules.

One significant difference FINRA proposes for debt research disclosure is to omit disclosure of "significant financial interest in the debt or equity of the subject company” maintained by the firm or its affiliates, which would be at a minimum the 1 percent beneficial interest in common equity securities that is required to be disclosed in equity research reports. Rather, debt research reports would disclose debt or equity positions of subject companies only when the positions “amount to a material conflict of interest” that the research analyst or a person with the ability to influence the content of a research report knows or has reason to know about at the time of publication or distribution of the report. FINRA further clarifies that walling off research analysts and other persons with the ability to influence the content of research reports would address this proposed disclosure requirement, even if there is an ownership interest, because this disclosure would be based on an analyst’s knowing or having reason to know of a material conflict of interest.

The proposed debt research rule addresses numerous other areas, including, among others, a proposed prohibition on joint due diligence by research analysts and investment banking personnel in Supplemental Material .02.

III. Significant Policy Issues Raised in the Proposed Debt Research Rule

The core proposed debt research rule anticipates that all of its requirements will apply to all research reports a FINRA member firm produces and distributes regarding debt securities. Although the core proposed debt research rule would track many components of the current equity research rules, there are a number of features in the proposed debt research rule that are different from the current equity research rules and that likely will be incorporated into a consolidated equity research rule. Therefore, firms should closely consider the following issues, even if they do not publish or distribute debt research reports.

A. Opt-In for Institutional Investors

The debt research rule proposal contemplates that all debt research reports would have to satisfy the requirements of the proposed debt research rule, unless an exception or exemption is satisfied.

Paragraph (f) of the proposed research rule would allow member firms to offer institutional investors, as defined in FINRA Rule 4512(c),3 debt research reports that do not comply with some of the provisions of the proposed debt research rule. This would only be true if the institutional investors “have, prior to receipt of a debt research report, affirmatively notified the member in writing that they wish to forego treatment as a retail investor for the purposes of this Rule” — that is “opted-in” to institutional only research.

FINRA, in Regulatory Notice 11-11, had proposed the concept of an opt-out for institutional investors who could instead opt to receive debt research intended for retail investors. Reversing course, FINRA now proposes to require affirmative consent from each institutional investor receiving a firm’s institutional-only research and affirmative acknowledgement that the debt research received is not compliant with all aspects of the proposed debt research rule.

The proposed exemption for institutional debt research is not comprehensive, however. Rather, FINRA proposes that for debt research reports provided exclusively to institutional investors, firms must still establish, maintain and enforce policies and procedures reasonably designed to identify and effectively manage conflicts of interest.

Specifically, the debt research rule proposal would require, among other things, that institutional-only research reports be subject to procedures on prepublication review, clearance and approval by investment banking and sales and trading personnel. Debt research analysts also would be subject to restrictions on participating in pitches for investment banking transactions, road shows or other marketing on behalf of issuers. Investment banking personnel would be prohibited from directing debt research analysts to market banking transactions or direct analysts to communicate with customers about such transactions. The firm’s policies would have to prevent retaliation or threats of retaliation against debt research analysts by firm employees for adverse or otherwise unfavorable reports or public appearances. And finally, a firm’s policies would also have to prohibit explicit or implicit promises of favorable debt research, particular research ratings or recommendations, or specific content to induce business or compensation.

Also, FINRA would require that the research reports include a prominent disclosure on the first page about the nature of the research (that it is institutional, and thus not subject to all the rule’s safeguards) and, if applicable, the lack of independence of the debt research from the firm’s proprietary interests.

In Notice 12-09 FINRA recognizes that “no firm would be obligated to create or maintain a retail debt research product — a firm may choose to offer debt research only to those eligible persons that opt in to the institutional framework.” But FINRA cautions both in the Regulatory Notice, and in the text of the proposed debt research rule itself, that the exemption will not be available for debt research reports that the firm has reason to believe will be redistributed to a retail investor.

B. Trade Research vs. Investment Research; Interactions With Sales and Trading Personnel as Distinguished From Proprietary Trading Personnel

As described above, the definition of “debt research report” is quite broad, and FINRA is clear that it intends to capture analytic communications prepared by non-research department personnel as well as the products produced by research departments. FINRA recognizes in the Regulatory Notice, however, that there are many communications between debt research analysts and trading desk personnel and/or customers that should not be subject to all of the limits it imposes in the proposed debt research rule.

Supplementary Material .07 to the proposed research rule clarifies that a FINRA member may provide different debt research products and services to different classes of customers. In the Supplemental Material, FINRA acknowledges that a firm may produce trading research for customers with short-term investment horizons and investor research for customers with long-term investment horizons, and that these products may have different recommendations or ratings. In the Supplemental Material FINRA proposes parameters for firms that produce different debt research products; for instance, products cannot be differentiated solely based on timing of receipt of a recommendation or other potentially market moving information, or to allow certain customers to trade in advance of others entitled to the same debt research product. Specific disclosure would be required regarding the existence of other, potentially conflicting research products.

In the debt research rule proposal FINRA also recognizes that certain communications with sales and trading personnel are essential to allow both debt research analysts and sales and trading personnel to discharge their primary functions. In Regulatory Notice 11-11 FINRA had listed certain communications that it would have prohibited because of a concern about the potential of undue influence on debt analysts to conform research to a firm’s proprietary trading interests or the interests of particular customers. In response to comments that Regulatory Notice 11-11 was too restrictive, and in particular that sales and trading personnel should be permitted to communicate customer interests to debt research analysts and debt research analysts should be permitted to generate trading ideas and strategies not already in published research, FINRA has included in the new proposed Supplemental Material permitted communications between sales and trading personnel and debt research analysts. These include (i) communications of customer interests, provided that the analyst does not respond by publishing debt research to benefit the trading position of the firm, a customer or a class of customers; (ii) customized analysis, recommendations and trading ideas from debt research analysts to sales and trading personnel and customers that are consistent with published or pending debt research, provided that subsequently published debt research is not for the purpose of benefiting the trading position of the firm, a customer or a class of customers; (iii) communication of views regarding issues reasonably related to the price/performance of a debt security, provided that the information is consistent with published debt research reports and consistent with the types of communications that a debt research analyst might have with customers; and (iv) information from sales and trading personnel to research analysts regarding specific bonds, current prices, spreads, and similar market information relevant to the analyst’s valuation of particular debt securities.

In the Supplemental Material, FINRA also proposes to clarify that all communications not related to sales and trading or debt research activities are permissible without any restriction, unless otherwise prohibited.

IV. Third Party Research

The proposed debt research rule would incorporate the approach to third party research currently found in equity research rules. The rule would require a firm that distributes third-party debt research to implement review procedures and disclosures, unless the debt research reports are independent third party research. FINRA clarifies that the review for third-party debt research reports would be risk-based, and that prior approval of third-party debt research reports would not be required.

V. Exemption for Members With Limited Investment Banking Activity

The proposed debt research rule would exempt from certain provisions FINRA members that over the previous three years, on average per year, have participated in fewer than 11 investment banking transactions as manager or co-manager and generated $5 million or less in gross investment banking revenues.4 Information barriers or other safeguards would still be required to insulate debt research analysts from pressure by investment bankers. The proposed rule would exclude, when calculating the thresholds for this exemption, revenue from municipal securities underwriting.

VI. Comments Are Essential

The proposed debt research rule itself encompasses a complex set of regulatory requirements that are only summarized above. FINRA members should read both the proposed rule and the Regulatory Notice carefully to understand fully the scope of the debt research rule proposal. FINRA will be adopting a debt research rule. Therefore, FINRA members should comment, both individually or as part of groups, on areas in which they believe FINRA has it right, and also on areas where FINRA has it wrong. Only if FINRA receives comments on the proposed debt research rule will the rule — that FINRA files with the SEC reflect the thoughts of those most impacted by the rule — FINRA members firms that publish and distribute debt research reports.


If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:


1 FINRA previously published a concept proposal for a debt research rule in “Debt Research Reports” Regulatory Notice 11-11 (March 2011).

2 Securities Research: Additional Actions Could Improve Regulatory Oversight of Analyst Conflicts of Interest (Jan. 2012)

3 An “institutional investor” is defined as:

(1) a bank, savings and loan association, insurance company or registered investment company;

(2) an SEC or state registered investment adviser; or

(3) any other person (whether a natural person, corporation, partnership, trust, or otherwise) with assets of at least $50 million.

Among those provisions that would not apply would be the prohibition on review and approval of research by investment banking personnel, and restrictions on review and approval by other personnel at the firm, limits on supervision of debt research analysts by investment banking personnel, and other provisions that would otherwise insulate debt research analysts from investment banking personnel.

This article was originally published by Bingham McCutchen LLP.