a. the next era of research regulation and enforcement

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NOVEMBER 12, 2015

SIDLEY UPDATE

FINRA’s New Debt and Equity Research Rules Herald Wide-Ranging Changes for Firms Following approval by the Securities and Exchange Commission (SEC) this summer, the Financial Industry Regulatory Authority, Inc.’s (FINRA) new rules governing equity and debt research are being implemented over the course of the coming months.1 The new consolidated rule governing equity research, FINRA Rule 2241 (New Equity Research Rule), represents modifications to a scheme that has been in place since 2003 following the Global Research Settlement and the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley) directive to the SEC to oversee the implementation of rules designed to manage and mitigate conflicts of interest between research and investment banking. The new rule governing debt research, FINRA Rule 2242 (New Debt Research Rule), represents the first time FINRA rules will regulate communications regarding debt securities as research.

The New Equity Research Rule becomes effective in two stages with an initial tranche implemented on September 25, 2015 and the remainder going into effect on December 24, 2015.2 The New Debt Research Rule becomes effective on February 22, 2016.3

This Sidley Update provides an in-depth look at the new rules and highlights some of the key differences between the new and outgoing requirements that firms should consider in evaluating their policies and procedures. Section A discusses the broader implications of the new rules in the evolution of research regulation. Section B highlights key concepts and provisions of the rules, followed by comprehensive assessments of the provisions of the New Equity Research Rule and New Debt Research Rule in Sections B.1 and B.2, respectively.

A. The Next Era of Research Regulation and Enforcement Since the flurry of regulatory activity in the early 2000s—a period marked by the development of the modern regulatory structure for research and the concurrent enforcement actions that led to the Global Research Settlement—the last decade has until recently seen relative quiescence among regulators. The new research rules, along with a marked uptick in significant enforcement actions and active examinations, signals that research is once again at the forefront of regulatory focus. 1 See Order Approving a Proposed Rule Change, as Modified by Amendment No. 1 Thereto, To Adopt FINRA Rule 2241 (Research Analysts and

Research Reports) in the Consolidated FINRA Rulebook, Release No. 34-75471 (July 22, 2015) (Equity Adopting Release); Order Approving a Proposed Rule Change, as Modified by Amendment No. 1 Thereto, To Adopt FINRA Rule 2242 (Debt Research Analysts and Debt Research Reports), Release No. 34-75472 (July 22, 2015) (Debt Adopting Release).

2 FINRA Regulatory Notice 15-30, SEC Approves Consolidated Rule to Address Conflicts of Interest Relating to the Publication and Distribution of Equity Research Reports (Aug. 2015).

3 FINRA Regulatory Notice 15-31, SEC Approves Consolidated Rule to Address Conflicts of Interest Relating to the Publication and Distribution of Debt Research Reports (Aug. 2015).

In restructuring the current regulatory scheme, FINRA pursued a multi-year rulemaking process for revising the New Equity Research Rule and formulating the New Debt Research Rule. This process featured substantial outreach to the industry, including two notices to members before filing the proposal.4 FINRA’s rulemaking particularly attempted to address the conflicts unique to debt research and endeavored to calibrate the New Debt Research Rule to the institutional nature of the debt market.

That said, it is still an open question whether certain of FINRA’s calibrations will prove workable, mostly with respect to the institutional exemption. The recently approved rules, moreover, coincide with a revival of enforcement interest in research. For example, FINRA has pursued enforcement as a remedy for what it views to be analyst involvement in procuring investment banking business5 and selective dissemination to key clients,6 among other enforcement and examination activities. As further discussed below, the new rules themselves, especially their new policies and procedures approach, are ripe for examination and enforcement attention. Thus, even while implementing a new compliance regime for debt research, firms need to batten down compliance hatches while concurrently engaging FINRA in a dialogue to promote the application of the research rules so that they are consistent with the robust and efficient functioning of the equity and debt markets.

B. Overview of the New Debt and Equity Research Rules The New Equity Research Rule, FINRA Rule 2241, incorporates discrete but significant changes from the current rule, NASD Rule 2711. For the most part, the new provisions allow additional flexibility, such as the small firm exception and personal trading restrictions with respect to quiet periods. In a few instances, the provisions have been tightened. For example, investment banking personnel are no longer permitted to “fact check” a research report. Moreover, the anti-retaliation provisions have been expanded to cover all firm personnel, rather than just investment banking staff. The new rule also codifies certain existing interpretations, notably including FINRA’s prior guidance that firms may issue different research products for different classes of customers, provided they are not inconsistent with published research and the products are not differentiated based on timing of their release. Given the focus on so-called selective dissemination, these codifications are both helpful and timely.

Both the New Equity Research Rule and New Debt Research Rule, FINRA Rule 2242, employ a policies and procedures approach for the identification and management of equity research-related conflicts. Yet while the New Debt Research Rule requires conflicts management procedures and disclosures similar to those required for the New Equity Research Rule, the rule also reflects FINRA’s recognition that the market for debt research is in many cases institutional and that analysts play a key role in advising traders. As such, the New Debt Research Rule focuses to a greater extent on conflicts with sales and trading and also contains an institutional exemption that allows institutions to opt out of full disclosures, or opt in if they are sufficiently large.

4 FINRA Regulatory Notice 12-09, FINRA Requests Comment on a Proposal to Identify and Manage Conflicts Involving the Preparation and Distribution of

Debt Research Reports (Feb. 2012); FINRA Regulatory Notice 12-42, FINRA Requests Comment on a Revised Proposal to Identify and Manage Conflicts Involving the Preparation and Distribution of Debt Research Reports (Oct. 2012).

5 See infra note 24 (discussing Toys “R” Us IPO settlement). 6 See infra note 25 (discussing FINRA AWC No. 2013036054901).

Implementation Dates

For Rule 2242 (New Debt Research Rule), the implementation date will be: February 22, 2016. 7 For Rule 2241 (New Equity Research Rule), implementation will occur in two stages:

Effective on September 25, 2015:

• Amendments to NASD Rule 1050 and Incorporated NYSE Rule 344.10 (registration of research analysts)

• Rule 2241(b)(2)(I) and corresponding deletion of NASD Rules 2711(f)(1) through (5) and Incorporated NYSE Rules 472(f)(1) through (6) (quiet periods with respect to IPOs and secondary offerings for non-EGCs)

• Rule 2241(j) (exemption for good cause) • Rule 2241.10 (divesting research analyst holdings) • Deletion of NASD Rule 2711(i) and Incorporated NYSE Rule 351 (annual attestation

requirement) Effective on December 24, 2015: All other provisions

1. FINRA Rule 2241 – the New Equity Research Rule Consolidated FINRA Rule 2241 is replacing NASD Rule 2711 and NYSE Rule 472, but retains the core provisions of such rules with various modifications. Among other things, the New Equity Research Rule:

• Reconfigures much of the current rule provisions into a set of policies and procedures requirements for identifying and managing equity research-related conflicts;

• Significantly reduces the current quiet periods in connection with an initial public offering (IPO) and secondary offerings but presents the shortened periods as “minimums”;

• Eliminates the annual attestation requirement, including the compensation committee review provision; and

• Expands the exemption for firms with limited investment banking activity.

These and other modifications are discussed in more detail below. We also briefly touch on the core provisions that have been retained, albeit relocated within the rule or incorporated as a policies and procedures requirement.

a. Definitions (Rule 2241(a))

The New Equity Research Rule maintains most of the definitional provisions in NASD Rule 2711, with a few modifications and one notable addition. In particular, FINRA has added a definition for “sales and trading personnel,” which the rule defines as “includ[ing] persons in any department or division, whether or not

7 FINRA Rule 2242.11 (supplementary material) permits a firm to distribute institutional debt research during a transition period lasting until July

22, 2016 for non-natural persons meeting the definition of “institutional account” in Rule 4512(c). Natural persons that qualify as institutional accounts under Rule 4512(c) must provide affirmative written consent to receive institutional debt research during the transition period.

identified as such, who perform any sales or trading services on behalf of a member.”8 As worded, this new definition would appear susceptible to expansive construction by FINRA. The definition is important because it bears upon the scope and application of various aspects of the new rule’s policies and procedures provisions, as further discussed below. Firms will want to pay close attention to how they manage the roles and responsibilities of personnel in other departments in an effort to mitigate the risk that other (non-sales and trading) department personnel will be captured by this definition.

The New Equity Research Rule also modifies several of the historical definitions, as follows:

• The definition of “investment banking services” clarifies that such services include all acts in furtherance of a public or private offering on behalf of an issuer, even if the member is not acting as an underwriter or selling group participant or private placement agent, as the case may be;

• The definition of “research analyst account” clarifies that the definition does not apply to a registered investment company over which a research analyst has discretion or control, provided that the research analyst or a member of that research analyst’s household has no financial interest in the investment company other than a performance or management fee but, presumably, this would include a performance or management fee in a non-registered hedge fund or private equity fund;

• The definition of “research report” has been revised to expressly exclude communications that concern open-end registered investment companies that are not listed or traded on an exchange, as well as communications that constitute private placement memoranda and comparable offering-related documents prepared in connection with investment banking services transactions, other than those that purport to be research; and

• The definitions of “third-party research report” and “independent third-party research report” have been moved into the definitional section of the rule.

b. Identifying and Managing Conflicts of Interest (Rule 2241(b)) The New Equity Research Rule employs a policies and procedures approach to identifying and managing equity

research-related conflicts. Under this approach, members are required to establish, maintain and enforce

written policies and procedures reasonably designed to identify and effectively manage conflicts of interest

related to the preparation, content and distribution of research reports and public appearances by research

analysts and the interaction between research analysts and persons outside of the research department,

including investment banking, sales and trading personnel, the subject companies and customers.9 In addition, a

member’s written policies and procedures must also be reasonably designed to promote objective and reliable

research that reflects the truly held opinions of research analysts and to prevent the use of research reports or

research analysts to manipulate or condition the market, or favor the interests of the member or a current or

prospective customer or class of customers. Unlike the prior rule proposals, the final version of the New Equity

8 FINRA Rule 2241(a)(12) (emphasis added).

9 FINRA Rule 2241(b)(1)(A)-(C). With regard to interactions between research analysts and other personnel outside of the research department, it is FINRA’s position that any written or oral communication by a research analyst with a current or prospective customer or internal personnel related to an investment banking services transaction must be fair, balanced and not misleading, taking into consideration the overall context in which the communication is made. FINRA Rule 2241.03 (supplementary material).

Research Rule generally does not formally present the rule requirements as “minimum” procedural elements.

Nonetheless, it remains to be seen whether FINRA will enforce the rule in a manner that treats the requirements

as mere minimums, and will expect more from firms on a regular basis. FINRA has certainly emphasized that it

“intends for firms to proactively identify and manage . . . conflicts with appropriately designed policies and

procedures.”10

While many of the provisions of FINRA Rule 2241(b) are substantially comparable to the requirements of NASD Rule 2711 (albeit reformulated in a policies and procedures format), others substantively diverge from the current requirements and may necessitate some significant adjustment to firms’ internal systems, policies and procedures. The provisions are summarized below, with key differences from the current requirements bolded.

Prepublication Review, Clearance or Approval of Reports. A member’s policies and procedures must (i) prohibit prepublication review, clearance or approval of research reports by investment banking personnel and (ii) either restrict or prohibit such review, clearance or approval by other personnel not directly responsible for the preparation, content and distribution of research reports, other than legal and compliance personnel.11 The New Equity Research Rule thus eliminates the current provisions that allow investment banking personnel, at the request of a research analyst, to review sections of a report for factual accuracy. Consistent with NASD Rule 2711, the New Equity Research Rule also requires policies and procedures to prohibit prepublication review by a subject company, other than for purposes of verifying facts.12 The supplementary material provides details as to the circumstances under which sections of a research report may be provided to non-investment banking personnel or the subject company for factual review.13

Coverage Decisions. A member’s policies and procedures must restrict or limit the investment banking department’s input into research coverage decisions in order to ensure that research management independently makes all final decisions regarding the research coverage plan.14 The New Equity Research Rule does not, however, preclude investment banking personnel from conveying customer interests or providing input into coverage considerations so long as final decisions regarding coverage are made solely by research management.

Supervision and Control of Research Analysts. A member’s policies and procedures must prohibit persons engaged in investment banking activities from supervising or controlling research analysts, including influencing or controlling research analyst compensation evaluations and determinations.15

Research Budget. A member’s policies and procedures must restrict research department budget determinations to senior management, excluding senior management engaged in investment banking activities.16

10 See Notice of Filing of Amendment No. 1 to a Proposed Rule Change to Adopt FINRA Rule 2241 (Research Analysts and Research Reports) in

the Consolidated FINRA Rulebook, Release No. 34-74488 (March 12, 2015) (in which the SEC published Amendment No. 1 to proposed FINRA Rule 2241 for comment) (the March Rule 2241 Release).

11 FINRA Rule 2241(b)(2)(A). Under FINRA Rule 2241.08 (supplementary material), legal or compliance personnel may review a research report for compliance purposes, but are not authorized to dictate a particular recommendation, rating or price target.

12 FINRA Rule 2241(b)(2)(N).

13 FINRA Rule 2241.05 (supplementary material). These provisions generally track the requirements of current NASD Rule 2711(c)(2). 14 FINRA Rule 2241(b)(2)(B).

15 FINRA Rule 2241(b)(2)(C). 16 FINRA Rule 2241(b)(2)(D).

Compensation of Research Analysts. The policies and procedures must (i) prohibit compensation of research analysts based upon specific investment banking transactions or contributions to a member’s investment banking activities and (ii) require that the compensation of research analysts primarily responsible for the preparation of the substance of a research report be reviewed and approved at least annually by a compensation committee that does not include any representatives from the firm’s investment banking department.17 This compensation committee must consider various specific factors when reviewing an analyst’s compensation and must document the basis upon which each analyst’s compensation was established. Careful consideration may be prudent for boutique firms with dominant investment banking departments.

Information Barriers. The policies and procedures must establish information barriers or other institutional safeguards reasonably designed to ensure that research analysts are insulated from review, pressure or oversight not only by persons engaged in investment banking activities but also by other persons including sales and trading personnel who might be biased in their judgment or supervision.18 In this regard, we wish to draw firms’ attention to the new definition of “sales and trading personnel” as set forth in Rule 2241(a) (discussed above). Although the rule does not explicitly mandate physical separation between research and investment banking personnel (or with other personnel who might be able to influence research analysts), both the SEC and FINRA have expressed the view that physical separation is expected except in extraordinary circumstances “where the costs are unreasonable due to a firm’s size and resource limitations.”19

Anti-Retaliation. The New Equity Research Rule extends the rule’s current anti-retaliation provisions to all firm personnel by requiring that a member’s policies and procedures prohibit investment bankers and other employees from directly or indirectly retaliating or threatening to retaliate against the firm’s (or its affiliates’) research analysts as the result of any adverse, negative, or otherwise unfavorable research report or public appearance that may adversely affect the member’s present or prospective business interests.20

Research “Quiet Periods.” The New Equity Research Rule requires policies and procedures that define quiet periods of a minimum of 10 days after an IPO,21 and a minimum of three days after a secondary offering, during which the member must not publish or otherwise distribute research reports. Research analysts also must not make public appearances relating to the issuer if the member has participated as an underwriter or dealer in the IPO or, with respect to the quiet

17 FINRA Rule 2241(b)(2)(E)-(F).

18 FINRA Rule 2241(b)(2)(G). 19 See Equity Adopting Release at n.196 and text preceding n.200. See also Notice of Filing of a Proposed Rule Change To Adopt FINRA Rule 2241

(Research Analysts and Research Reports) in the Consolidated FINRA Rulebook, Release No. 34-73622 (Nov. 18, 2014) (in which the SEC originally published proposed FINRA Rule 2241 for comment).

20 FINRA Rule 2241(b)(2)(H).

21 Although the term “initial public offering” is not defined in the rule, such term is defined in current NYSE Rule 472.100 with respect to research reports to “refer[] to the initial registered equity security offering by an issuer, regardless of whether such issuer is subject to the reporting requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, prior to the time of the filing of such issuer’s registration statement.” NYSE Rule 472, however, is being rescinded in connection with the adoption of FINRA Rule 2241. Using the current definition of “initial public offering” in NYSE Rule 472.100, which is conditioned on there being a “registered” equity security offering, such term would not apply to a Regulation A+ offering, which provides an exemption from registration under the Securities Act of 1933 for certain issuer offerings up to $50 million.

periods after a secondary offering, as a manager or co-manager of that offering.22 Thus, under the New Equity Research Rule, the minimum quiet period for IPOs will be the same for all underwriter and dealer participants. The New Equity Research Rule retains the current exception for research reports relating to emerging growth companies (EGCs).23 Also remaining are the current exceptions for:

• Research reports and public appearances concerning the effects of “significant news or a significant event” in the case of an IPO or secondary/follow-on offering, but provided that legal or compliance personnel authorize publication of the research report before it is issued or authorize the public appearance before it is made (even if a type of news/event has been previously determined to be “significant” for these purposes) and

• A research report issued pursuant to Rule 139 under the Securities Act of 1933 regarding a subject company with “actively traded securities,” as defined in Regulation M under the Exchange Act, in the case of a secondary/follow-on offering, as well as a public appearance concerning such a company.

In addition, the rule eliminates (for all offerings, not just EGCs) the quiet period requirements surrounding the expiration, termination or waiver of a lock-up agreement or any other agreement that the member has entered into with a subject company or its shareholders that restricts or prohibits the sale of securities held by the subject company or its shareholders after the completion of a securities offering (currently a 15-day period). Members should review and consider revising their current templates for underwriting agreements accordingly.

The new minimum quiet period provisions represent a significant liberalization of the quiet periods imposed by NASD Rule 2711. It is worth noting, however, that the rule presents the shortened quiet periods as “minimums,” thereby, perhaps suggesting that a longer quiet period might be warranted based on the facts and circumstances of a given situation (although FINRA does not provide any guidance as to when a longer period might be so warranted).

FINRA had previously sought to eliminate all quiet periods in light of Regulation AC analyst certification requirements and investment banking/research separation requirements (thereby conceding that there is no good policy reason for maintaining quiet periods for any offerings). In this regard, FINRA Rule 2241(b)(2) requires that a member’s written supervisory policies and procedures must be reasonably designed to promote objective and reliable research that reflects the “truly held opinions of research analysts and to prevent the use of research reports or research analysts to manipulate or condition the market or favor the interests of the member or a current or prospective customer or class of customers.” Ultimately, regulators concluded that some minimum level of quiet periods was required for both IPOs and secondary offerings under Sarbanes-Oxley, except with respect to offerings by EGCs in light of the JOBS Act. Unfortunately, this maintains a dubious distinction for less “seasoned” EGC issuers that are potentially subject to greater price influence through the issuance of a research report. For these issuers, there are no quiet periods for either IPO or secondary/follow-on offerings. For more seasoned/non-EGC issuers, minimum quiet periods are still required.

22 FINRA Rule 2241(b)(2)(I).

23 An emerging growth company is generally defined under Title I of the Jumpstart Our Business Startups Act (JOBS Act) as domestic or foreign issuers with less than $1 billion of “total annual gross revenues” for their most recent fiscal year. 15 U.S.C. § 77b(a)(19).

Solicitation and Marketing. The New Equity Research Rule requires policies and procedures to restrict or limit research analyst activities that can be reasonably expected to compromise objectivity. This includes but is not limited to preserving the existing prohibition on participating in pitches and other solicitation of investment banking business, as well as the prohibition on participating in road shows related to an investment banking services transaction.24 However, as in the case of the treatment of quiet periods as described above, the new rule continues to maintain a distinction between prospective offerings involving EGC and non-EGC issuers in that it allows research analysts to “participate” (i.e., attend) pitch meetings with investment banking personnel in connection with an IPO of an EGC, provided the research analysts do not participate in the solicitation of investment banking business (but where a research analyst could presumably discuss the member’s approach to the conduct of research).25 Moreover, FINRA has noted that, consistent with existing guidance, research analysts may listen to or view a live webcast of a road show or other widely attended presentation by investment banking personnel to investors or the sales force from a remote location or another room if at the same location.26

In addition, the supplementary material codifies a current interpretation that pitch materials may not include any information about the firm’s research capacity in a manner that suggests the member might provide favorable research coverage. In this regard, “FINRA would consider the inclusion of an analyst’s industry ranking to imply the outcome of future research because of the manner in which such rankings are compiled.”27

The New Equity Research Rule also retains the current prohibition against investment banking personnel directing a research analyst to engage in (i) sales or marketing efforts related to an investment banking services transaction or (ii) any communication with a current or prospective customer about an investment banking services transaction.28 The supplementary material emphasizes that this prohibits a research analyst from engaging in any communication with a current or prospective customer in the presence of investment banking department personnel or company management regarding an investment banking services transaction.29

Joint Due Diligence and Other Interactions with Investment Banking. The New Equity Research Rule establishes a new proscription with respect to joint due diligence activities. More specifically, FINRA interprets the new rule as prohibiting a research analyst from performing due diligence in the

24 FINRA Rule 2241(b)(2)(L). Lest there be any doubt about the vitality of the prohibition on analysts soliciting business, FINRA announced on

December 11, 2014 that it had settled an action with 10 major securities firms for an aggregate of $43 million in connection with the selection process for prospective underwriters for a prospective IPO by Toys “R” Us. FINRA, News Release, FINRA Fines 10 Firms a Total of $43.5 Million for Allowing Equity Research Analysts to Solicit Investment Banking Business and for Offering Favorable Research Coverage in Connection With Toys "R" Us IPO (Dec. 11, 2014), available at https://www.finra.org/newsroom/2014/finra-fines-10-firms-total-435-million. FINRA alleged that the analysts were soliciting investment banking business when they met with the issuer, admittedly as part of the underwriter selection process. See, e.g., FINRA AWC No. 2011030683801. Moreover, in providing the issuer with valuations, the analysts were alleged to have promised favorable research, which is also a violation of FINRA rules. Id.

25 See FINRA Rule 2241.01(b) (supplementary material). See also a recent FINRA action against a major securities firm whereby FINRA concluded that although research analysts did not physically participate in a road show, research analysts were involved “indirectly” in the preparation of the firm’s presentations for the road show. See FINRA AWC No. 2013036054901.

26 See Equity Adopting Release at text accompanying n.36; see also the March Rule 2241 Release cited supra note 10. 27 FINRA Rule 2241.01(a) (supplementary material).

28 FINRA Rule 2241(b)(2)(M). 29 FINRA Rule 2241.03(a) (supplementary material).

https://www.finra.org/newsroom/2014/finra-fines-10-firms-total-435-million

presence of investment banking personnel, prior to the selection of underwriters for the investment banking transaction.30

Promises of Favorable Research. The New Equity Research Rule maintains the current prohibition against promises of favorable research, a particular research recommendation or rating or specific content as inducement for receipt of business or compensation.31 We note that FINRA has taken a broad interpretation of this concept in enforcement matters.32

Personal Trading. The New Equity Research Rule requires written policies and procedures that restrict or limit research analyst account trading in securities covered by the research analyst, as well as any derivatives of such securities and funds whose performance is materially dependent upon the performance of such securities. This includes ensuring that research analyst accounts, supervisors of research analysts and associated persons “with the ability to influence the content of a research report”33 do not benefit in their trading from knowledge of the content or timing of a report before the intended recipients have had a reasonable opportunity to act on the information in the report.34

The New Equity Research Rule’s treatment of personal trading differs materially from the current rule, in that it provides additional flexibility but also additional expansiveness in approach, both as to securities (e.g., with regard to derivatives and certain fund securities) and persons covered (e.g., by extending certain of the provisions to research analyst supervisors and other persons with the ability to influence the content of research reports), subject to a financial “hardship” exception that permits a research analyst to trade against his or her most recent recommendation(s). With regard to the considerable expansion in the scope of financial instruments covered, we note that additional guidance may be needed with respect to when a fund’s performance may be deemed “materially dependent” upon a security.

c. Content and Disclosure in Research Reports (Rule 2241(c))

The New Equity Research Rule generally retains the current disclosure requirements but also incorporates certain additional requirements. For example, it requires a member to (i) establish, maintain and enforce written policies and procedures reasonably designed to ensure that purported facts in its research reports are based on reliable information and (ii) disclose in research reports any material conflicts known not only by the research analyst but also by any associated person with the ability to influence the content of the report.35 The rule also now requires that paper-based compendium reports provide either a toll free number to call or postal address to request the

30 FINRA Rule 2241.02 (supplementary material). 31 FINRA Rule 2241(b)(2)(K). 32 See, e.g., FINRA AWC No. 2011030683801; see also supra note 24.

33 The supplementary material provides that the “ability to influence the content of a research report” refers to an associated person who is required to review the content of the research report or who has exercised authority to review or change the research report prior to publication or review. It also expressly excludes legal or compliance personnel who may review a research report for compliance purposes but who are not authorized to dictate a particular recommendation, rating or price target. FINRA Rule 2241.08 (supplementary material).

34 FINRA Rule 2241(b)(2)(J).

35 FINRA Rule 2241(c)(1)(A) and (c)(4)(I). See supra note 33 regarding persons deemed to have the ability to influence the content of a research report.

required disclosures. The ability under NASD Rule 2711(h)(2)(A)(v) to disclose in research reports a member’s affiliates’ receipt of compensation or services from a subject company within 30 days after completion of the last calendar quarter has been eliminated. Members must now disclose all required information “at the time of publication or distribution of report.”36 In addition, the rule retains the exception for situations in which disclosure would reveal material non-public information (MNPI) regarding specific potential future investment banking transactions but no longer confines the exception to investment banking transactions “of the subject company.”37

With respect to the distribution of ratings in a research report, FINRA Rule 2241(c)(2) preserves the general requirements set forth in NASD Rule 2711(h)(5). A member that employs a rating system must still clearly define in each research report the meaning of each rating in the rating system, including the time horizon and any benchmarks on which a rating is based. The required disclosures/information must be current as of the end of the most recent calendar quarter or the second most recent quarter if the publication date of the research report is less than 15 calendar days after the most recent calendar quarter, but no longer must necessarily reflect the distribution of the most recent ratings issued by the member for all subject companies where the most recent rating was issued more than 12 months prior.

d. Disclosure in Public Appearances (Rule 2241(d))

The New Equity Research Rule’s public appearance provisions retain the substance of the current rule requirements, including the exception for situations in which disclosure would reveal MNPI regarding specific potential future investment banking transactions of the subject company.38 Thus, unlike the counterpart exception for research reports, the wording of the MNPI exception for public appearances could be interpreted as continuing to confine the exception to investment banking transactions “of the subject company.” This appears to be an inadvertent oversight rather than intentional; indeed, we note that neither of the counterpart MNPI exceptions in the New Debt Research Rule confine their application to investment banking transactions “of the subject company.”

e. Disclosure Required by Other Provisions (Rule 2241(e))

This provision of the New Equity Research Rule emphasizes that in addition to the specific disclosures required by the rule, members and research analysts must continue to comply with the applicable disclosure provisions of FINRA Rule 2210 (communications with the public) and the federal securities laws.

f. Termination of Coverage (Rule 2241(f))

The New Equity Research Rule retains the current requirement that a member notify its customers if it intends to terminate coverage of a subject company.

36 FINRA Rule 2241(c)(4). 37 Compare FINRA Rule 2241(c)(5) (exempting requisite disclosures “to the extent such disclosure would reveal material non-public information

regarding specific potential future investment banking transactions”) with NASD Rule 2711(h)(2)(C) (exempting requisite disclosures “to the extent such disclosure would reveal material non-public information regarding specific potential future investment banking transactions of the subject company”).

38 FINRA Rule 2241(d)(2).

g. Distribution of Member Reports (Rule 2241(g))

The New Equity Research Rule requires a member to establish, maintain and enforce written policies and procedures reasonably designed to ensure that a research report is not distributed selectively to internal trading personnel or certain customers “in advance of other customers that the firm has previously determined are entitled to receive the research report.”39 The New Equity Research Rule does not prohibit a firm from providing different research products and services to different customers so long as the differentiation is not based upon the timing of dissemination of market sensitive information and the firm discloses its dissemination practices to all customers who receive research products.40 Thus, short-term and long-term horizon research are permitted. To the extent a firm offers different or alternate research products, the rule would require the firm to disclose the possibility of a different recommendation or conclusion being contained in other research products and that such different recommendation or conclusion could affect the market price of the security.

h. Distribution of Third-Party Research Reports (Rule 2241(h))

In addition to largely retaining the current rule’s third-party research provisions, the New Equity Research Rule requires a member to establish, maintain and enforce written policies and procedures reasonably designed to ensure that any third-party research it distributes contains no untrue statement of material fact and is not otherwise false or misleading.41 In addition, a member is required to disclose any other material conflict that can reasonably be expected to have influenced the member’s choice of a third-party research provider or the subject company of a third-party report, including but not limited to certain of the disclosures required by Rule 2241(c).

In contrast to NASD Rule 2711, the New Equity Research Rule now appears to obligate members to review independent third-party research reports (ITPRR) for whether they know or have reason to know an ITPRR is not “objective or reliable,”42 unless a member can qualify under Rule 2241(h)(6) for “non-distribution” status. This review requirement exists notwithstanding provisions (h)(5) and (h)(3) which excuse members from establishing, maintaining, and enforcing written policies and procedures designed to ensure that an ITPRR does not contain any untrue statement of material fact or is otherwise false or misleading. It also bears noting that, as described above, FINRA Rule 2241(e) states that members must comply with “applicable disclosure provisions” of FINRA Rule 2210 (and the federal securities laws), but FINRA Rule 2241(e) does not otherwise subject a member to the principal approval provisions of FINRA Rule 2210(b) or any other specific principal review/approval requirement.

39 FINRA Rule 2241(g). 40 FINRA Rule 2241.07 (supplementary material). FINRA recently brought an action against a major securities firm where research analysts

attended “idea dinners” with select institutional clients whereby such analysts would offer recommendations around securities that sometimes contradicted (were inconsistent with) their published opinions on whether to buy, sell, or hold a stock. See FINRA AWC No. 2013036054901.

41 FINRA Rule 2241(h)(3).

42 See FINRA Rule 2241(h)(1), (h)(2) (requiring determination of “objective or reliable” under provision (h)(2) and subjecting such review to principal approval under provision (h)(1)).

i. Exemption for Members with Limited Investment Banking Activity (Rule 2241(i))

The New Equity Research Rule exempts firms with limited investment banking activity43 from the provisions of (b)(2)(A), (B), (C), (D), (F) and (G). Thus, similar to the current exemption for firms with limited investment banking activity, the exemption allows those who supervise research analysts (including investment banking department personnel) to be involved in all aspects of the evaluation and determination of those analysts’ compensation.44 Firms with limited investment banking activity are permitted to have investment banking personnel participate in the compensation review process for research analysts. In addition, the New Equity Research Rule exempts firms with limited investment banking activity from the provisions restricting or limiting research coverage decisions and budget determinations, as well as the prohibitions and restrictions on prepublication review by the firm’s non-research personnel.

Notwithstanding the foregoing, however, such firms are subject to prohibitions and requirements to the same extent as non-exempt firms in respect of:

• Rule 2241(b)(2)(E): Prohibiting paying research analysts compensation based on specific investment banking services transactions or contributions to a member’s investment banking services activities;

• Rule 2241(b)(2)(G) (pressuring): Establishing information barriers or other institutional safeguards reasonably designed to ensure research analysts are insulated from pressure by investment banking and sales and trading personnel or others who might be biased in their judgment or supervision;

• Rule 2241(b)(2)(H): Prohibiting direct or indirect retaliation or threat of retaliation;

• Rule 2241(b)(2)(I): Subjecting the firm to the quiet periods and related requirements;

• Rule 2241(b)(2)(J): Restricting or limiting analyst account trading;

• Rule 2241(b)(2)(K): Prohibiting explicit or implicit promises of favorable research;

• Rule 2241(b)(2)(L): Restricting or limiting activities by analysts that can reasonably be expected to compromise their objectivity (including with regard to participation in “pitches” and other solicitations of investment banking services transactions or participating in road shows and other marketing on behalf of an issuer in respect of an investment banking services transactions);

• Rule 2241(b)(2)(M): Prohibiting investment banking department personnel from, directly or indirectly, directing analysts to (i) engage in sales or marketing efforts related to investment banking services transactions or (ii) engage in any communication with a current or prospective customer about an investment banking services transaction; and

• Rule 2241(b)(2)(N): Prohibiting prepublication review of a research report by a subject company for purposes other than verification of facts.

43 Firms with limited investment banking activity include those firms that over the previous three years, on average per year, have managed or co-

managed 10 or fewer investment banking transactions and generated $5 million or less in gross revenues from those transactions. 44 FINRA Rule 2241(i).

j. Exemption for Good Cause (Rule 2241(j))

The New Equity Research Rule permits FINRA in exceptional and unusual circumstances to conditionally or unconditionally grant an exemption from any requirements of the rule for good cause shown.

k. Related Amendments to NASD Rule 1050

FINRA is concurrently amending NASD Rule 1050 in several respects. In particular, it is refining the definition of “research analyst” (for purposes of the rule’s registration and qualification requirements) to include only an associated person whose “primary” job function is to provide investment research and who is primarily responsible for the preparation of the substance of a report or whose name appears on a research report. It is important to note that this definition is only relevant to the licensing requirements in NASD Rule 1050 and not to the application of FINRA Rule 2241. FINRA is also making a series of technical amendments to NASD Rule 1050, to account for the replacement of NASD Rule 2711 with new FINRA Rule 2241.

2. Proposed FINRA Rule 2242 – the New Debt Research Rule The New Debt Research Rule, FINRA Rule 2242, aims to address conflicts of interest that relate to the publication and distribution of debt research reports. The New Debt Research Rule imposes extensive requirements generally comparable to those contained in the New Equity Research Rule, subject to certain exemptions and modifications in recognition of various differences in the trading market for debt securities. As with equity reports, debt research reports issued by members are required to conform with the content standards described in FINRA Rule 2210(d)(1).45

As further discussed below, the New Debt Research Rule also includes three exemptions that provide relief from certain but not all of the new rule’s provisions: the limited investment banking exemption, the limited principal trading exemption and the institutional debt research exemption.

Following are some of the highlights of the provisions found in the New Debt Research Rule along with certain of our observations related thereto. For convenience, we have identified when one or more of the exemptions are available with respect to a particular requirement of Rule 2242.

a. Definitions (Rule 2242(a))

The New Debt Research Rule defines several key terms. Most of the defined terms closely follow the counterpart definitions in the New Equity Research Rule, with various modifications and adjustments intended to reflect certain unique properties of debt research.

The New Debt Research Rule defines a debt research report as any written (including electronic) communication that includes an analysis of a debt security or an issuer of a debt security and in either case provides information reasonably sufficient upon which to base an investment decision, excluding, among other things, communications that solely constitute an equity research report under the New Equity Research Rule.46

45 Among other things, all member communications must be based on principles of fair dealing and good faith, must be fair and balanced and

must provide a sound basis for evaluating the facts in regard to any particular security or type of security, industry or service. 46 FINRA Rule 2242(a)(3).

The New Debt Research Rule does not appear to preclude the possibility of any particular communication constituting both a debt research report and an equity research report. In order to avoid certain inherent tensions between the rules applicable to equity research reports versus debt research reports, it would have been desirable for the two types of research reports to be mutually exclusive. The new definitions further complicate inconsistencies in the definition of “research reports” across FINRA’s research regulation.47 This could be potential fodder for future examinations and enforcement attention.

As with the New Equity Research Rule, various specific types of written communications are excluded from the definition, for example:

• Discussions of broad-based indices;

• Commentaries on economic, political or market conditions;

• Commentaries on or analyses of particular types of debt securities or characteristics of debt securities;

• Technical analyses concerning the demand and supply for a sector, index or industry based on trading volume and price;

• Recommendations regarding increasing or decreasing holdings in particular industries or sectors or types of debt securities;

• Notices of ratings or price target changes; and

• Analysis prepared for a specific person or a group of fewer than 15 persons.48

Like the New Equity Research Rule, communications that constitute private placement memoranda are expressly excluded from the definition of a debt research report.49 Also like the New Equity Research Rule, communications concerning mutual funds fall outside the definition of debt research. However, unlike the New Equity Research Rule, this is not because there is a dedicated exclusionary provision but rather because mutual funds are equity securities under Section 3(a)(11) of the Exchange Act and thus outside the definition of debt research reports.50

The New Debt Research Rule has several definitions in common with the New Equity Research Rule. For example, the New Debt Research Rule defines a debt research analyst in a manner comparable to the counterpart definition under the New Equity Research Rule – i.e., an associated person who is 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 any such person has a research analyst job title.51 Likewise, the definition for “sales and trading personnel” is identical for both the

47 Compare Order Approving Proposed Rule Change to Adopt FINRA Rule 5280 (Trading Ahead of Research Reports), Release No. 34-59254

(Jan. 15, 2009) (recognizing that “the term ‘research report’ in the [FINRA Rule 5280] is intended to be much broader than that in NASD Rule 2711(a)(9),” including by “encompass[ing] both debt and equity research”) with 17 C.F.R. § 242.500 (Regulation AC) (defining “research report” as a written communication that “includes an analysis of a security or an issuer and provides information reasonably sufficient upon which to base an investment decision” without exceptions) with FINRA Rule 2242(a)(3) (New Debt Research Rule definition with exceptions) with FINRA Rule 2241(a)(11) (New Equity Research Rule definition with exceptions).

48 FINRA Rule 2242(a)(3)(A),(B). 49 FINRA Rule 2242(a)(3)(D).

50 FINRA Rule 2242(a)(3) (requiring analysis of a debt security or an issuer of a debt security); FINRA Rule 2242(a)(4)(defining debt security). 51 FINRA Rule 2242(a)(1).

New Debt Research Rule and New Equity Research Rule.52 That definition, as worded, would appear to include principal trading personnel (i.e., as a subset of the universe of sales and trading personnel), thereby potentially contributing to confusion in instances where the rules delineate between sales and trading personnel and principal trading personnel. It is also worth noting the distinctions between sales and trading and principal trading may not be material because debt trading is generally done on a principal basis so that limiting a particular provision to “principal traders,” may not be a useful carve-out for firms.

For purposes of the New Debt Research Rule, a “debt security” is defined as any security (as defined in Section 3(a)(10) of the Exchange Act), except for:

• An “equity security” (as defined in Section 3(a)(11) of the Exchange Act);

• A “municipal security” (as defined in Section 3(a)(29) of the Exchange Act);

• Any “security-based swap”53 (as defined in Section 3(a)(68) of the Exchange Act); and

• Any “U.S. Treasury Security” (as defined in FINRA Rule 6710(p)).54

Thus, notwithstanding their treatment as “fixed income”/debt securities for certain other purposes, it seems that FINRA still intends for research relating to preferreds and convertibles to be subject to the Equity Research Rules (versus the New Debt Research Rule).

b. Identifying and Managing Conflicts of Interest (Rule 2242(b))

The New Debt Research Rule requires members to establish, maintain and enforce written policies and procedures reasonably designed to identify and effectively manage conflicts of interest related to the preparation, content and distribution of debt research reports, public appearances by debt research analysts and the interaction between debt research analysts and persons outside of the research department, including investment banking, sales and trading and principal trading personnel, as well as subject companies and customers.55

Supplementary Material to the New Debt Research Rule outlines certain requirements regarding how firms should understand the provisions related to managing conflicts of interest. As with the New Equity Research Rule, FINRA interprets the requirement to monitor conflicts between debt research analysts and investment banking personnel as prohibiting the performance of joint due diligence prior to the selection of underwriters for the investment banking services transaction.56 Similarly, FINRA interprets the requirement to monitor conflicts between debt research analysts and sales and trading personnel as requiring members to establish, maintain and enforce written policies and procedures reasonably designed to prohibit sales and trading and principal trading personnel from attempting to influence a debt research analyst’s opinions or view for the purpose of benefiting the trading position of the firm, a customer or a class of customers. The requirement also prohibits debt research 52 FINRA Rule 2242(a)(15); see supra p. 4 (discussing definition of “sales and trading personnel” under FINRA Rule 2241).

53 FINRA stated it excluded security-based swaps from the definition of a debt security “because of the nascent and evolving nature of security-based swap regulation.” (citation omitted).

54 FINRA Rule 2242(a)(4).

55 FINRA Rule 2242(b)(1)(A)-(C). 56 FINRA Rule 2242.09 (supplementary material). FINRA believes that there are certain circumstances under which investment bankers may

pressure debt research analysts to produce favorable research that may, in effect, bolster the firm’s bid to become an underwriter for the offering.

analysts from identifying or recommending specific potential trading transactions to sales and trading or principal trading personnel that are inconsistent with the debt research analyst’s currently published debt research reports, or from disclosing the timing of or material investment conclusions in a pending debt research report.57 Lastly, FINRA interprets the requirement to monitor conflicts between debt research analysts and customers and internal sales personnel as requiring firms to ensure that any written or oral communication by a debt research analyst with a current or prospective customer or internal personnel related to an investment banking services transaction is fair and balanced.58

The New Debt Research Rule also sets forth requirements for these written policies and procedures, which must be designed to promote objective and reliable debt research that reflects the truly held opinions of debt research analysts and to prevent the use of debt research reports or debt research analysts to manipulate or condition the market or favor the interests of the firm or current or prospective customers or class of customers.59 While these requirements are largely comparable to the provisions in the New Equity Research Rule, there are certain differences between the two rules, in recognition of perceived differences between the two markets. For example, whereas the New Equity Research Rule imposes quiet periods for equity offerings, the New Debt Research Rule does not include any “blackout” or “quiet” periods for research following a debt offering.

Prepublication Review, Clearance or Approval of Reports. The New Debt Research Rule requires that members’ policies and procedures be designed to prohibit prepublication review, clearance or approval of debt research reports by investment banking, sales and trading and principal trading personnel,60 and either restrict or prohibit such review, clearance and approval by other non-research personnel, other than legal and compliance.61 It also requires that the policies and procedures prohibit prepublication review of a debt research report by a subject company, other than for verification of facts.62 As with the New Equity Research Rule, the supplementary material provides details as to the circumstances under which sections of a research report may be provided to non-investment banking personnel or the subject company for factual review.

The limited investment banking exemption in paragraph (h) of the rule provides eligible firms with relief from the specific prohibition against prepublication review, clearance or approval by the firm’s investment banking personnel, as well as the specific prohibitions and restrictions against such review, clearance or approval by the firm’s other non-research personnel (other than sales and trading and principal trading personnel). Prepublication review by the subject company is still limited to review for verification of facts.

The limited principal trading exemption in paragraph (i) of the rule provides eligible firms with relief from the prohibition against prepublication review, clearance or approval by the firm’s sales and trading and principal trading personnel, as well as the prohibitions or restrictions against such review, clearance or approval by the firm’s other non-research personnel (other than investment banking personnel). As with the limited investment

57 FINRA Rule 2242.03(a)(2) (supplementary material). 58 FINRA Rule 2242.02(b) (supplementary material).

59 FINRA Rule 2242(b)(2). 60 FINRA Rule 2242(b)(2)(A)(i)-(iii).

61 FINRA Rule 2242(b)(2)(B). 62 FINRA Rule 2242(b)(2)(N).

banking exemption, prepublication review by the subject company is still limited to review for verification of facts.

While institutional debt research reports eligible for the exemption in paragraph (j) of the rule are exempt from many of the New Debt Research Rule’s requirements, they remain subject to the prohibitions on prepublication review, clearance or approval by the firm’s investment banking personnel (unless the member firm is separately able to claim the limited investment banking exemption), as well as the limitation on prepublication review by the subject company solely for verification of facts.

Research Coverage and Budgetary Decisions. With respect to coverage decisions, the New Debt Research Rule requires that a member’s written policies and procedures restrict or limit input by investment banking, sales and trading and principal trading personnel to ensure that research management independently makes all final decisions regarding the research coverage plan.63

With respect to budgetary decisions, the New Debt Research Rule requires that a member’s written policies and procedures must limit the determination of the firm’s debt research department budget to senior management, excluding senior management engaged in investment banking or principal trading activities, and without regard to specific revenues or results derived from investment banking.64

Firms eligible for the limited investment banking exemption are relieved of these requirements, insofar as they relate to investment banking personnel. Similarly, firms eligible for the limited principal trading exemption are relieved of these requirements, insofar as they relate to sales and trading and principal trading personnel, as applicable. Finally, debt research reports eligible for the institutional debt research exemption are exempt from these requirements.

Supervision, Review and Compensation of Debt Research Analysts; Information Barriers. The New Debt Research Rule requires that a member firm’s written policies and procedures limit the supervision of debt research analysts to personnel who are not engaged in investment banking, sales and trading or principal trading activities.65 In addition, the policies and procedures must include information barriers or other institutional safeguards reasonably designed to ensure that debt research analysts are insulated from the review, pressure or oversight by investment banking, sales and trading and principal trading personnel, as well as other persons who might be biased in their judgment or supervision.66 As with the New Equity Research Rule, the New Debt Research Rule does not itself mandate physical separation between these groups. However, FINRA has expressed the view that physical separation is expected “except in extraordinary circumstances where the costs are unreasonable due to a firm’s size and resource limitations.”67

With respect to compensation determinations, a member’s written policies and procedures must prohibit compensation based on specific investment banking services or trading transactions or contributions to a firm’s

63 FINRA Rule 2242(b)(2)(C).

64 FINRA Rule 2242(b)(2)(E).

65 FINRA Rule 2242(b)(2)(D). 66 FINRA Rule 2242(b)(2)(H). 67 See Debt Adopting Release at n.192. See also Notice of Filing of a Proposed Rule Change to Adopt FINRA Rule 2242 (Debt Research Analysts

and Debt Research Reports), Release No. 34-73623 (Nov. 18, 2014) (in which the SEC originally published proposed FINRA Rule 2242 for comment).

investment banking or principal trading activities.68 Investment banking and principal trading personnel are precluded from having input into the compensation of debt research analysts,69 and final compensation determinations with respect to debt research analysts are required to be made by research management.70 In addition, compensation of a debt research analyst who is primarily responsible for the substance of a research report must be reviewed and approved at least annually by a committee that reports to the member’s board of directors. If the member has no board of directors, it must be approved by a senior executive officer of the member.71 This compensation committee is not permitted to have any representation from the firm’s investment banking or principal trading personnel and must consider various factors as further specified in the rule.72 According to FINRA, these compensation provisions are intended to parallel those that have proven effective with respect to equity research. However, under the New Debt Research Rule, the separation extends to not only investment banking, but also those engaged in principal trading activities.

Firms eligible for the limited investment banking exemption are exempt from the specific supervisory limitations in paragraph (b)(2)(D) of the New Debt Research Rule, as well as the information barrier/institutional safeguard requirements of paragraph (b)(2)(H) of the New Debt Research Rule, to the extent they relate to investment banking personnel or other persons who might be biased in their judgment or supervision, as applicable (except that eligible firms would still be required to have procedures to insulate debt research analysts from pressure by such persons). In addition, firms eligible for the limited investment banking exemption are exempt from the annual compensation committee review and approval requirements of paragraph (b)(2)(G) of the New Debt Research Rule. However, the prohibitions of paragraph (b)(2)(F) of the New Debt Research Rule (relating to compensation based upon specific investment banking services or trading transactions or contributions to a member’s investment banking services or principal trading activities) continue to apply.

Debt research reports eligible for the institutional debt research exemption are exempt from all of the foregoing requirements, other than the provisions of paragraph (b)(2)(H) of the New Debt Research Rule relating to insulating debt research analysts from pressure by investment banking, sales and trading and principal trading personnel, as well as other persons who might be biased in their judgment or supervision.

Anti-Retaliation Provisions and Prohibition Against Promises of Favorable Research. Under the New Debt Research Rule, a member’s written policies and procedures must prohibit member firm employees from directly or indirectly retaliating or threatening to retaliate against a debt research analyst for publishing research or making a public appearance that may adversely affect the member’s current or prospective business interests.73 In addition, the policies and procedures are required to prohibit explicit or implicit promises of favorable debt research, specific research content or a specific rating or recommendation as inducement for the receipt of

68 FINRA Rule 2242(b)(2)(F). 69 FINRA Rule 2242(b)(2)(D). 70 FINRA Rule 2242(b)(2)(G). 71 Id. 72 Id. 73 FINRA Rule 2242(b)(2)(I).

business or compensation.74 None of the limited investment banking, limited principal trading or institutional debt research report exemptions provide relief from these requirements.

Personal Trading Restrictions. The New Debt Research Rule requires a member’s written policies and procedures to restrict or limit trading by a “debt research analyst account” in securities covered by the debt research analyst, derivatives of such securities and any fund whose performance is materially dependent upon the performance of securities covered by the debt research analyst.75 The procedures also are required to ensure that debt research analyst accounts and supervisors of debt research analysts, as well as any associated persons who have the ability to influence the content of debt research reports,76 do not benefit in their trading from knowledge of the content or timing of debt research reports before the intended recipients have the opportunity to act on the information in the report.77 Finally, the policies and procedures would have to prohibit a debt research analyst account from purchasing or selling any security (or any option on or derivative of such security) in a manner inconsistent with the analyst’s recommendation with respect to the security, as reflected in the firm’s most recent debt research report, subject to a financial hardship exception.78

The institutional debt research report exemption provides relief from these requirements.

Prohibition Against Solicitation and Marketing of Investment Banking Transactions. The New Debt Research Rule requires that a member’s written policies and procedures restrict or limit activities by debt research analysts that can reasonably be expected to compromise their objectivity.79 This includes prohibiting participation in pitches and other solicitations of investment banking services transactions, as well as road shows and other marketing on behalf of issuers related to such transactions.80 The New Debt Research Rule also prohibits investment banking personnel from directing debt research analysts to engage in sales or marketing efforts related to an investment banking services transaction or any communication with a current or prospective customer about an investment banking services transaction.81 None of the limited investment banking, limited principal trading or institutional debt research report exemptions provide relief from these requirements.

c. Content and Disclosure in Debt Research Reports (Rule 2242(c))

The New Debt Research Rule imposes content and disclosure requirements similar to those in the New Equity Research Rule, with modifications intended to reflect and accommodate the different characteristics of the debt market. More specifically, the New Debt Research Rule requires members to establish, maintain and enforce written policies and procedures reasonably designed to ensure that purported facts in their debt research reports 74 FINRA Rule 2242(b)(2)(K).

75 FINRA Rule 2242(b)(2)(J). A “debt research analyst account” means any account in which a debt research analyst or member of the debt research analyst’s household has a financial interest, or over which such analyst has discretion or control.

76 Akin to the New Equity Research Rule, the New Debt Research Rule provides an equivalent definition of the “ability to influence the content of” a debt research report. See FINRA Rule 2242.07 (supplementary material); see also supra note 33 (discussing FINRA Rule 2241.08 (supplementary material)).

77 FINRA Rule 2242(b)(2)(J)(i).

78 FINRA Rule 2242(b)(2)(J)(ii). 79 FINRA Rule 2242(b)(2)(L).

80 Id. 81 FINRA Rule 2242(b)(2)(M).

are based on reliable information and any recommendation or rating in a debt research report has a reasonable basis and is accompanied by a clear explanation of any valuation methodology used, as well as a fair presentation of the risks that may impede achievement of the recommendation or rating.82 Among other things, the New Debt Research Rule requires a member to disclose certain information relating to potential conflicts of interest in any debt research report at the time of publication or distribution of the report.83 The New Debt Research Rule also requires a member to disclose if the member or its affiliates have received any compensation for products or services, other than investment banking services, from the subject company of a debt research report.84 Members are permitted to satisfy this requirement by implementing written policies and procedures reasonably designed to prevent the debt research analyst and associated persons of the member with the ability to influence the content of debt research reports from directly or indirectly receiving information from the affiliate as to whether the affiliate received such compensation.85

Of particular note and consistent with the New Equity Research Rule, the New Debt Research Rule requires disclosure if the debt research analyst or a member of the debt research analyst’s household has a financial interest in the debt or equity securities of the subject company (including but not limited to any option, right, warrant, future, long or short position), and the nature of such interest.86 While the New Debt Research Rule outlines certain circumstances under which a member must disclose conflicts of interest, the New Debt Research Rule also has a general provision that requires members to disclose any other material conflict of interest of the debt research analyst or member that the analyst, or an associated person of the member with the ability to influence the content of a debt research report, knows or has reason to know at the time of the publication or distribution of a debt research report.87

Consistent with the New Equity Research Rule, the New Debt Research Rule provides an exception from the disclosure requirements of Rule 2242(c)(4) to the extent such disclosure would reveal material non-public information regarding specific potential future investment banking transactions.88 Similarly, it also permits a member that distributes a debt research report covering six or more companies to direct the reader in a clear manner to the applicable disclosures.89

Institutional debt research reports eligible for the exemption in paragraph (j) of the New Debt Research Rule (discussed below) are exempt from the foregoing disclosure requirements and instead need to prominently disclose on the first page that the research report is not subject to the same independence and disclosure protections.

d. Disclosure in Public Appearances (Rule 2242(d))

82 FINRA Rule 2242(c)(1)(A)-(B).

83 FINRA Rule 2242(c)(4). 84 Id. 85 FINRA Rule 2242.04 (supplementary material).

86 FINRA Rule 2242(c)(4)(A). 87 FINRA Rule 2242(c)(4)(H).

88 FINRA Rule 2242(c)(5). 89 FINRA Rule 2242(c)(7).

Under the New Debt Research Rule, a debt research analyst is required to disclose certain information when making public appearances.90 The New Debt Research Rule defines a “public appearance” as any participation in a conference call, seminar, forum (including an interactive electronic forum) or other public speaking activity before 15 or more persons, or before one or more representatives of the media, a radio, television or print media interview, or the writing of a print media article in which a debt research analyst makes a recommendation or offers an opinion concerning a debt security or an issuer of a debt security.91 The disclosures for public appearances are similar but not identical to those required for research reports.

In the case of public appearances, the debt research analyst is only specifically required to disclose whether the subject company is or was (within the preceding 12 months) a client of the member, and whether the member or any affiliate received any compensation from the subject company within the preceding 12 months, if the debt research analyst knows or has reason to know of such relationships and compensation. In addition, the “catch-all” disclosure requirement for public appearances is limited to “any other material conflict of interest of the debt research analyst or member that the debt research analyst knows or has reason to know at the time of the public appearance.”92 Similar to the disclosure requirements for debt research reports, as well as the counterpart disclosure requirements contained in the New Equity Research Rule, a member or debt research analyst is not required to make any such disclosure to the extent that it would reveal material non-public information regarding specific potential future investment banking transactions.93

e. Disclosure Required by Other Provisions (Rule 2242(e))

In addition to the disclosures required by the New Debt Research Rule, members and debt research analysts continue to be subject to the applicable disclosure provisions of FINRA Rule 2210 and the federal securities laws.94

f. Distribution of Member Research Reports (Rule 2242(f))

The New Debt Research Rule requires member firms to establish, maintain and enforce written policies and procedures reasonably designed to ensure that a debt research report is not distributed selectively to internal trading personnel or a particular customer or class of customers in advance of other customers that the member has previously determined are entitled to receive the debt research report.95 The Supplementary Material explains that while a member may offer one debt research product to customers who have long-term investment goals and a different research product to customers with short-term investment goals, a member may not differentiate a debt research product based on the timing or receipt of a recommendation, rating or other

90 FINRA Rule 2242(d)(1). 91 FINRA Rule 2242(a)(11). 92 FINRA Rule 2242(d)(1)(E). This catch-all provision differs from the catch-all provision for research reports contained in (c)(4)(H) of Rule 2242

in that it does not explicitly extend the disclosure requirement to material conflicts known by certain other categories of associated persons of the member. By contrast, research reports must also disclose “any other material conflict that an associated person of the member with the ability to influence the content of a debt research report knows or has reason to know at the time of the publication or distribution of a debt research report.” FINRA Rule 2242(c)(4)(H) (emphasis added).

93 FINRA Rule 2242(d)(2).

94 FINRA Rule 2242(e). 95 FINRA Rule 2242(f).

potentially market moving information.96 Additionally, “a member that provides different debt research products and services for different customers must inform its other customers that receive a research product that its alternative debt research products and services may reach different conclusions or recommendations that could impact the price of the debt security.”97

g. Distributions of Third-Party Debt Research Reports (Rule 2242(g))

Similar to the New Equity Research Rule, the New Debt Research Rule prohibits a member from distributing third-party debt research if it knows or has reason to know that such research is not objective or reliable.98 It also requires a member to establish, maintain and enforce written policies and procedures reasonably designed to ensure that any third-party debt research report it distributes contains no untrue statement of material fact and is otherwise not false or misleading.99 Furthermore, third-party research reports (other than certain ITPRR, as discussed below) are required to disclose any material conflict of interest that can reasonably be expected to have influenced the choice of a third-party debt research report provider or the subject company of a third-party debt research report, including the disclosures called for by paragraphs (c)(4)(C), (F) and (H) of the New Debt Research Rule (collectively, the “third-party research disclosures”).100

However, unlike the New Equity Research Rule, the New Debt Research Rule does not have a counterpart provision to FINRA Rule 2241(h)(1), and the distribution of third-party debt research reports is not subject to principal or supervisory analyst review for compliance and approval. Similarly, while FINRA Rule 2242(e) states that members must comply with “applicable disclosure provisions” of FINRA Rule 2210 (and the federal securities laws), it does not otherwise subject a member to the principal approval provisions of FINRA Rule 2210(b) or any other specific principal review/approval requirement.

With respect to ITPRR, and akin to the New Equity Research Rule, member firms are not required to review “independent third-party research reports” for untrue statements or information that is otherwise false or misleading. Likewise, members do not need to include the third-party research disclosures in independent third-party research reports that are only made available to customers upon request or via a member-maintained website. As with third-party debt research reports generally, member firms are not permitted to distribute third-party debt research if they know or have reason to know that such research is not objective or reliable.

h. Exemption for Members with Limited Investment Banking Activity (Rule 2242(h))

The New Debt Research Rule exempts from certain provisions regarding the supervision and compensation of debt research analysts those members that over the previous three years, on average per year, have participated in 10 or fewer investment banking services transactions as manager or co-manager and generated $5 million or less in gross investment banking revenues from those transactions.101 Members that meet these thresholds are

96 FINRA Rule 2242.06 (supplementary material). 97 Id. 98 FINRA Rule 2242(g)(1). 99 FINRA Rule 2242(g)(2).

100 FINRA Rule 2242(g)(3). 101 FINRA Rule 2242(h).

exempt from the requirement to establish, maintain and enforce a wide array of policies and procedures, as discussed above.102

Under the exemption, however, firms nonetheless are subject to prohibitions and requirements, to the same extent as non-exempt firms, with regards to:

• Rule 2242(b)(2)(A)(ii), (iii): Prohibiting prepublication review, clearance, or approval of debt research reports by principal trading personnel and sales and trading personnel;

• Rule 2242(b)(2)(C): Restricting or limiting input by sales and trading personnel and principal trading personnel into debt research coverage decisions;

• Rule 2242(b)(2)(D)(ii), (iii): Limiting supervision of a debt research analyst to persons not engaged in principal trading activities or sales and trading; precluding principal trading personnel from input into debt research analyst compensation;

• Rule 2242(b)(2)(E): Limiting determination of the debt research department budget to senior management, except those engaged in principal trading activities;

• Rule 2242(b)(2)(F): Prohibiting paying research analysts compensation based on specific investment banking services transactions or specific trading transactions, or contributions to such activities;

• Rule 2241(b)(2)(H): Establishing information barriers or other institutional safeguards reasonably designed to ensure research analysts are insulated from review, pressure or oversight by principal trading or sales and trading personnel; establishing the same to ensure insulation from pressure by investment banking personnel or others who might be biased in their judgment or supervision;

• Rule 2242(b)(2)(I): Prohibiting direct or indirect retaliation or threat of retaliation;

• Rule 2242(b)(2)(J): Restricting or limiting analyst account trading;

• Rule 2242(b)(2)(K): Prohibiting explicit or implicit promises of favorable research;

• Rule 2242(b)(2)(L): Restricting or limiting activities by analysts that can reasonably be expected to compromise their objectivity (including with regard to participation in “pitches” and other solicitations of investment banking services transactions or participating in road shows and other marketing on behalf of an issuer in respect of an investment banking services transaction);

• Rule 2242(b)(2)(M): Prohibiting investment banking department personnel from, directly or indirectly, directing analysts to (i) engage in sales or marketing efforts related to investment banking services transactions or (ii) engage in any communication with a current or prospective customer about an investment banking services transaction; and

• Rule 2242(b)(2)(N): Prohibiting prepublication review of a research report by a subject company for purposes other than verification of facts.

i. Exemption for Members with Limited Principal Trading Activity (Rule 2242(i))

102 Specifically, the exemption provides relief from the provisions of FINRA Rule 2242(b)(2)(A)(i), (b)(2)(B), (b)(2)(C) (with respect

to investment banking), (b)(2)(D)(i), (b)(2)(E) (with respect to investment banking), (b)(2)(G) and (b)(2)(H)(i) and (iii).

The New Debt Research Rule also exempts from certain provisions regarding the separation of debt research from sales and trading and principal trading, firms whose limited principal trading operations result in an appreciably increased burden of compliance relative to the expected investor protection benefits. More specifically, the New Debt Research Rule includes an exemption from certain provisions regarding supervision and compensation of debt research analysts for members that engage in limited principal trading activity where (i) in absolute value on an annual basis, the member’s trading gains or losses on principal trades in debt securities are $15 million or less over the previous three years, on average per year and (ii) the member employs fewer than 10 debt traders, provided such members must establish information barriers or other institutional safeguards reasonably designed to ensure debt research analysts are insulated from pressure by persons engaged in principal trading or sales and trading activities or other persons who might be biased in their judgment or supervision.103

j. Exemption for Debt Research Reports Provided Exclusively to Eligible Institutional Investors (Rule 2242(j))

Debt research distributed solely to eligible institutional investors (institutional debt research) under certain specified conditions is exempt from most of the New Debt Research Rule’s provisions regarding supervision, coverage determinations, budget and compensation determinations and all of the disclosure requirements applicable to debt research reports distributed to retail investors (retail debt research).104 The exemption requires that eligible institutional investors “opt in” to receipt of institutional debt research, depending on the type of institutional investor.

In the case of an investor which is a qualified institutional buyer (QIB), a member may distribute institutional debt research to such a QIB customer via “negative consent” under certain circumstances. Specifically, “negative consent” is permitted, when (i) the member has a reasonable basis to believe that a QIB customer is capable of evaluating the investment risks independently, both in general and with regard to the particular transactions and investment strategies involving a debt security or debt securities and (ii) the QIB customer has affirmatively indicated that it is exercising independent judgment in evaluating the member’s recommendations pursuant to FINRA Rule 2111(b) (FINRA’s institutional suitability requirement) and such affirmation is sufficiently broad to encompass transactions in debt securities.

With respect to other institutional customers – those who meet the definition of “institutional account” in FINRA Rule 4512(c), but who do not qualify as QIBs – a member may distribute institutional debt research thereto only if the institutional customer has affirmatively elected in writing to receive institutional debt research.

Although FINRA characterizes the QIB prong of the exemption as a “negative consent” approach, we note that the ability to claim the exemption would key off the firm’s reliance upon the institutional exemption in FINRA Rule 2111(b). FINRA Rule 2111(b), in turn, requires that an eligible institutional investor provide the member with an “affirmative indication” that it is exercising independent judgment in evaluating the member’s

103 FINRA Rule 2242(i). The exemption affords eligible firms with relief from the requirements of FINRA Rule 2242(b)(2)(A)(ii) and (iii), (b)(2)(B),

(b)(2)(C) (with respect to sales and trading and principal trading), (b)(2)(D)(ii) and (iii), (b)(2)(E) (with respect to principal trading), (b)(2)(G) and (b)(2)(H)(ii) and (iii) (other than the requirement to insulate debt research analysts from pressure by the specified categories of persons, as discussed above).

104 FINRA Rule 2242(j)(1).

recommendations. Although FINRA has interpreted FINRA Rule 2111(b) to not require a formal written representation from the investor,105 many firms nonetheless require eligible institutional customers to provide such “affirmative indication” to the member in the form of a written certificate. In many cases compliance will be unworkable, for example, with respect to offshore accounts involving foreign institutions that are not required to submit QIB Certifications.106 In addition, it is unclear how many institutional investors, particularly those that are not QIBs, will avail themselves of the “reduced protections,” if doing so does not result in obtaining the research any earlier. It is also possible that some managers may find the less regulated version of research inconsistent with their fiduciary duties.

It bears noting that member firms may not necessarily be able to rely on existing FINRA Rule 2111(b) certifications from institutional investors that qualify as QIBs, unless the certifications contain an affirmative indication that specifically references debt securities transactions.107 Furthermore, even if an existing investor has provided a specific certification under FINRA Rule 2111(b) that covers debt securities, members nonetheless need to provide that rule’s required written disclosures to the investor. In the absence of FINRA guidance on updating QIB Certifications, members will probably follow the same approaching for updating those certifications as they do for certifications under FINRA Rule 2111(b).

Under the institutional investor exemption, firms still must establish, maintain and enforce written policies and procedures reasonably designed to identify and effectively manage conflicts of interest, to the same extent as non-exempt firms, with regards to:

• Rule 2242 (b)(2)(A)(i): Prohibiting prepublication review, clearance, or approval of debt research reports by investment banking personnel;

• Rule 2242 (b)(2)(H) (pressuring): Establishing information barriers or other institutional safeguards reasonably designed to ensure research analysts are insulated from pressure by investment banking personnel, principal trading or sales and trading personnel or others who might be biased in their judgment or supervision;

• Rule 2242 (b)(2)(I): Prohibiting direct or indirect retaliation or threat of retaliation;

• Rule 2242 (b)(2)(K): Prohibiting explicit or implicit promises of favorable research;

• Rule 2242 (b)(2)(L): Restricting or limiting activities by analysts that can reasonably be expected to compromise their objectivity (including with regard to participation in “pitches” and other solicitations of investment banking services transactions or participating in road shows and other marketing on behalf of an issuer in respect of an investment banking services transaction);

• Rule 2242(b)(2)(M): Prohibiting investment banking department personnel from, directly or indirectly, directing analysts to (i) engage in sales or marketing efforts related to investment banking services transactions or (ii) engage in any communication with a current or prospective customer about an investment banking services transaction;

105 See FINRA’s Frequently Asked Questions regarding FINRA Rule 2111 at A.8.3. 106 See also Letter from Kevin Zambrowicz, Associate General Counsel and Managing Director, and Sean Davy, Managing Director, Securities

Industry and Financial Markets Association, to Brent J. Fields, Secretary, SEC, at 6 (Dec. 15, 2014). 107 See FINRA Rule 2242(j)(1)(A)(ii)(requiring that a QIB’s affirmative indication “covers transactions in debt securities”).

• Rule 2242(b)(2)(N): Prohibiting prepublication review of a research report by a subject company for purposes other than verification of facts; and

• Rule 2242.02(a) (supplementary material): Prohibiting debt research analysts from communicating with customers before investment banking department personnel or company management about an investment banking transaction.

k. General Exemptive Authority (Rule 2242(k))

As a catch-all, the New Debt Research Rule provides FINRA with the authority, in exceptional and unusual circumstances, to conditionally or unconditionally grant an exemption from any requirement of the New Debt Research Rule for good cause shown, after taking into account all relevant factors and provided that such exemption is consistent with the purposes of the New Debt Research Rule, the protection of investors, and the public interest.108

If you have any questions regarding this update, please contact the Sidley lawyer with whom you usually work, or

James Brigagliano Partner

[email protected] +1 202 736 8135

David M. Katz Partner


Barbara J. Endres Counsel


Sidley Securities & Derivatives Enforcement and Regulatory Practice Sidley’s Securities & Derivatives Enforcement and Regulatory group advises and defends clients in a wide range of securities- and derivatives-related matters. With more than 150 lawyers in 10 offices worldwide, we provide comprehensive regulatory, enforcement, and litigation solutions in matters involving the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), the Financial Industry Regulatory Authority (FINRA), self-regulatory organizations (SROs), state attorneys general, and state securities regulators. Our team is distinctive in that it combines the strength of nationally recognized enforcement lawyers with the skills of equally prominent counseling lawyers. We work collaboratively to provide our clients with informed, efficient, and effective representation.

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108 FINRA Rule 2242(k).

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