The Financial Industry Regulatory Authority (“FINRA”) has re-proposed its debt research rule, which will for the first time impose formal SRO regulation on broker-dealers that publish or distribute debt research (the “Re-proposed Debt Research Rule”). The re-proposal in Regulatory Notice 12-42 is a direct response to comments FINRA received after first proposing a debt research rule in Regulatory Notice 12-09 in February 2012. The significant changes from the rule as originally proposed are: (1) a greatly refined and clarified definition of “debt research report” that incorporates explicitly the exceptions from the definition of “research report” that are available under the Security and Exchange Commission’s Regulation AC;1 (2) an exemption to allow member firms to provide institutional debt research (a new category under the proposed rule) to Qualified Institutional Buyers as defined in Rule 144A under the Securities Act of 1933 (the “Securities Act”) without obtaining affirmative consent; and (3) a new exception from the rule’s coverage for firms with limited principal debt trading activities. FINRA members should comment on the Re-proposed Debt Research Rule and recommend any additional refinements that would make this an even more workable and effective rule when it becomes effective and FINRA member firms implement procedures to comply with the rule’s requirements.
1. The Re-proposed Definition of Debt Research Report
The re-proposed definition of “debt research report” reflects concerns that were highlighted in comment letters to FINRA.2 Specifically, comment letters argued that the original proposed debt research rule definition was excessively broad and conflicted with the SEC’s definition in Regulation AC, which already applies to both equity and debt research reports. As a result, FINRA’s re-proposed definition has both been refined to specify that it covers “an analysis of a debt security or an issuer of a debt security and that provides information reasonably sufficient upon which to base an investment decision.” The re-proposed definition also incorporates the categories of communications that the SEC carved out from the definition of “research report” in its Regulation AC Adopting Release,3 as well as an additional category of reports that will be excluded (for ratings notices), specifically:
Questions for FINRA on this much-improved definition remain, however. In particular, there are several small grammatical variations between the Regulation AC definition and exclusion and the FINRA rule proposal definition, which, not surprisingly, would result in interpretive differences between a FINRA debt research rule and Regulation AC. FINRA members that produce materials that may be debt research reports under this revised definition should ask FINRA for clarity regarding the reasons for the differences between the Re-proposed Debt Research Rule’s definition and Regulation AC to ensure that member firms understand the applicable requirements.
2. Re-proposed Institutional Debt Research Exemption
As FINRA has begun to consider adopting rules to regulate the issuance and distribution of debt research reports, it has recognized that debt research reports may be produced in a variety of contexts for a range of clients of member firms. However, the original debt research rule proposal would have required affirmative consent from any institutional investor — even the most sophisticated institutional investor — that the institution did not wish to be treated as a retail investor in order to receive a debt research report under the “institutional debt research exemption.” FINRA proposed that exemption to permit desk analysts and strategists to continue their activities without the limitations that the proposed rule would otherwise have imposed on them. Commenters and others expressed concern that an affirmative-consent requirement could have the effect of inhibiting the flow of information to many institutional investors.
The Re-proposed Debt Research Rule would permit member firms to provide institutional debt research to certain “higher tier” institutional investors without receiving affirmative written consent. FINRA is proposing that these higher-tier institutional investors: (1) meet the Qualified Institutional Buyer definition in Rule 144A under the Securities Act, and (2) satisfy the new FINRA Rule 2111 institutional suitability standards with regard to the member firm providing the institutional debt research.
FINRA has retained in the Re-proposed Debt Research Rule the ability of other investors to be considered “institutional” for the purposes of continuing to receive institutional debt research. However, these other institutional investors would have to provide affirmative consent that they do not wish to be treated as retail investors.
FINRA clearly is working to respond to concerns expressed by commenters, although further comment should be provided to help refine this re-proposal. For instance, it is possible that Qualified Purchasers, excluding natural persons, are a more workable group (given the realities of the marketplace) than Qualified Institutional Buyers to be eligible to receive “institutional” debt research without affirmative consent. Nevertheless, FINRA’s receptivity to the concerns commenters and others voiced is to be lauded; member firms should continue commenting on this aspect of the re-proposed rule.
3. Exemption for Limited Dealer Activities
As noted earlier, FINRA has incorporated into the Re-proposed Debt Research Rule a new exemption from many of the rule’s requirements for member firms that engage in limited debt-trading activity as measured in two ways. A member firm would be eligible for this exemption: (1) if it does not have trading gains or losses in absolute value on an annual basis from principal trades in debt securities of more than $15 million on average per year over the previous three years, and (2) the member employs fewer than 10 debt traders.4 If a member firm is relying on this exemption, it would nevertheless have to insulate debt research analysts from pressure by persons engaged in principal trading or others who may be biased in judgment or supervision by establishing information barriers or other institutional safeguards appropriate to the firm. A member firm relying on this exemption would be required to maintain records to establish eligibility for the exemption and also maintain for at least three years any communication that, but for the exemption, would be subject to the conflict of interest rules that the exemption eliminates. FINRA member firms potentially eligible to rely on this exemption should considering commenting on the details of the proposal to ensure that it ultimately is workable when it is implemented.
4. Disclosure Revisions
Under both the original and the Re-proposed Debt Research Rules, FINRA would require its member firms to disclose material conflicts of interest. The Re-proposed Debt Research Rule includes a revised and clearer standard for such disclosure than the original rule. The requirement under the re-proposed rule is that disclosure will be required of material conflicts that are known or should have been known by the member firm or debt analyst at the time of publication or distribution of the research report. This is a much clearer standard for firms seeking to comply than the standard articulated in the original proposal, which would have required firms to disclose “all conflicts that reasonably could be expected to influence the objectivity of the debt research report.”
5. Foreign Sovereign Debt Compensation
A new provision in the re-proposal permits FINRA member firms that produce debt research reports that are not exempt as institutional debt research to implement information barriers between their debt-research departments and non-U.S. affiliates that receive investment banking compensation from foreign sovereigns. The purpose of the information barrier is to prevent research analysts from direct or indirect receipt of information about such compensation. This would be in lieu of the requirement that such compensation would have to be disclosed as investment banking compensation from the foreign sovereign. Note, however, that if the FINRA member firm debt analyst has actual knowledge of receipt of investment banking compensation by the non-U.S. affiliate, then disclosure is required.
6. Road Show Prohibition
The re-proposed rule clarifies that the prohibition on road show participation only applies to those road shows and other marketing activities on behalf of an issuer “related to an investment banking services transaction.”
7. Prohibition on Joint Due Diligence
The prohibition on research analysts participating in due diligence that was in the original rule proposal is eliminated in the Re-proposed Debt Research Rule. This change makes this rule consistent with the equity research rules found in NASD Rule 2711 and NYSE Rule 472, as well as for Global Settlement firms, amendments to the Global Settlement.5
8. Research Analyst Interactions With Sales and Trading
The Re-proposed Debt Research Rule includes Supplemental Materials, which, like the original rule proposal, clarify that certain communications between debt research analysts who prepare retail debt research and sales and trading must be limited through the imposition of information barriers. The Supplemental Materials also state, however, that permitted communications include communications regarding creditworthiness of an issuer and other information that is reasonably related to the price/performance of the debt security, so long as the information is consistent with the analyst’s published debt research report and other factors. The Re-proposed Debt Research Rule further clarifies that a member may consider the context, including that the investment objectives or time horizons being discussed differ from those underlying the debt research analyst’s published views in determining what is consistent with the debt research analyst’s published debt research.
9. Comments Solicited, Due by Dec. 9, 2012
FINRA has once again invited comments on its proposal. Given FINRA’s reception to the comments provided to the original proposal, we strongly encourage thoughtful comments on the re-proposal.
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This article was originally published by Bingham McCutchen LLP.