In September, the Financial Industry Regulatory Authority (FINRA) issued a Regulatory Notice reminding member firms of the need for heightened supervision over solicitation and research activities in circumstances where an issuer has communicated an expectation of favorable research as a condition of participating in an offering.
It was thought that this issue was put to rest in 2003 with the Global Research Analyst Settlement (GRAS) involving the SEC, self regulatory organizations, state securities regulators and a number of investment banks. Alleging that investment banks were providing positive research coverage in order to obtain banking business from issuers, the regulators secured settlements involving over a billion dollars in sanctions and restitution payments, and undertakings to revise firm procedures and to provide independent research for a five-year period. Rule changes occurred, and both the banks and the issuer community emerged with a general recognition that research and investment banking were two areas of a firm’s business that needed to operate separately to avoid potential conflicts of interest that might impact the research product.
From the notice:
It has come to FINRA’s attention that certain issuers may be attempting to extract implicit promises of favorable research by suggesting publicly or directly to potential deal participants in advance of an anticipated offering that positive research coverage will be an implicit or explicit condition to selection as an underwriter or selling group member. The suggestions may take the form of hints, insinuations or other subtle references, but are intended to condition the award of investment banking business on the nature of research attendant to the deal. For example, the CEO of an issuer recently stated in an interview that he was dissatisfied with the tone of research coverage of his company by certain firms that previously served as underwriters for the company. As a result, the CEO reportedly intends to require candidates for the company’s next offering to demonstrate “a clear understanding of who [the company] is and our trajectory, and why [the company] is a stock that investors should own.” He further is quoted as saying, “If I’m confident they can articulate that well, they will have a chance” at being selected as an offering participant.
FINRA views these and similar advance statements as attempts to create an expectation that a firm chosen to participate in a subsequent offering will maintain favorable research on the issuer’s stock, irrespective of the stock price or the company’s ongoing performance. FINRA views even tacit acquiescence to such overtures to be a violation of NASD Rule 2711(e), and under certain facts and circumstances, potentially a violation of NASD Rule 2711(c).
Under NASD Rule 2711 member firms are required to maintain separate research and investment banking activities to protect the objectivity of the research. Thus, the rules overtly disallow firms from directly or indirectly offering favorable research, ratings or price targets in order to receive banking business, and they prohibit analysts from participating in pitches or solicitations for the investment banking business.
As a reaction to the idea that issuers might be trying to condition their awards of banking business to firms based on the promise of future positive research coverage, FINRA reiterates that such a tie-in between research and banking assignments would violate its research rules. In its notice, FINRA warns that it views “hints, insinuations or other subtle references [that] are intended to condition the award of investment banking business on the nature of research attendant to the deal” as “attempts to create an expectation that a firm chosen to participate in a subsequent offering will maintain favorable research on the issuer’s stock, irrespective of the stock price or the company’s ongoing performance.” Although this may be more subtle than some of the allegations in the GRAS, the FINRA message remains the same: even a member firm’s implicit or tacit acquiescence to an issuer’s overtures seeking ongoing favorable research coverage would be improper.
In its notice FINRA states that member firms that choose to compete for or participate in offerings under such circumstances must expressly repudiate to the issuer any expectation with respect to the content of research coverage and document such repudiation. In addition, the firms must implement heightened supervision of their solicitation activities, including pitch meetings and other communications with the issuer, to ensure there is no express or implied acknowledgement or accedence to the research expectation. Finally, members must increase oversight of the preparation and content of their research on the subject company—both before and after deal participants are chosen—including any permissible communications between research and investment banking personnel.
The notice serves as a reminder that firms must remain vigilant in protecting the objectivity and integrity of their research, even if that means running the risk of not being selected for banking business. It also serves notice that FINRA will be looking for indications that the independence of a member’s research program may have been compromised.