March 19, 2010
Global Settlement of Analyst ConflictsUpdate: The SEC Needs a Marketing Team
Posted by Christine Hurt

So the headline of a WSJ article today is "SEC Didn't Expand Upon Stock-Abuse Settlement," and the first sentence reads:  "The Securities and Exchange Commission has failed to turn key parts of a landmark stock-research settlement into industrywide rules, a move that threatens to gut pieces of the pact."

So, what's going on?  The 2003 "Global Settlement" among the ten biggest Wall Street firms (at the time), the NY AG's office (remember Spitzer?), the DOJ and the SEC required the banking parties to implement certain reforms with regard to conflicts between analysts employed by the banks, who were issuing research reports on current or prospective investment banking clients.  At the same time, Sarbanes-Oxley had been passed, requiring the SEC to promulgate rules addressing analyst conflicts of interests.  In response, the SEC passed Regulation AC and the NASD (now FINRA) passed several rules, including Rule 2711, to address the same issues.  As you might imagine, the SEC regulation addressed a tiny slice of the problem, requiring "clear and prominent certifications" by resarch analysts providing reports about any conflicts of interest.  Rule 2711 went further, addressing disclosure of conflicts, but also compensation, supervision, and communication between analysts and investment bankers at the same firm.  The Global Settlement admittedly went even further, requiring disclosures on the first page of research reports, physical separation of analyst and investment banking activities, and the presence of a compliance officer during communications between analysts and bankers.  So, seven years later, what's wrong?

Hard to discern from the article.  In August, the SEC went to U.S. District Judge Pauley, who approved the Global Settlement, to loosen some of the accords in that settlement.  Now, apparently the settlement was to be reviewed after five years, and the settlement was always intended to be stricter than industry-wide rules put in place at the same time.  However, the media has latched on to the fact that (1) the SEC wants to loosen its regulatory grip on some former wrong-doers and (2) the SEC never put in place regulation that would make these settlement terms permanent and industry-wide.

So what parts of the settlement were amended, and how does it change analyst practice now, with Regulation AC and Rule 2711 still in place?  Pauley may have kept in place the strictest reforms.  In fact, the WSJ Blog describes the incident as Pauley rejecting the SEC's request.  But, the article tells us "[t]hough it keeps a firewall that forbids stock analysts and investment bankers from talking without a rules-compliance officer present, the decision essentially eased other restrictions involving the dealings between investment bankers and analysts, including a clear separation between analysts and the firms' investment-banking operations."  However, it doesn't tell us what that restriction was or how it was eased.  So, let's take a look at Pauley's Monday, March 15, 2010 order, which amends "Addendum A" of the Global Settlement, here.  To find out what parts of the Global Settlement stay in place, we need to compare it to the original Addendum A, here.  The changes are actually substantial.  Here are the changes the banks agreed to in 2003 that now go away: 

2. Legal Compliance. Research will have its own dedicated legal and compliance staff, who may be a part of the firm's overall compliance/legal infrastructure

5. Compensation. Compensation of professional Research personnel will be determined exclusively by Research management and the firm's senior management (but not including Investment Banking personnel) using the following principles:

a. Investment Banking will have no input into compensation decisions.

b. Compensation may not be based directly or indirectly on Investment Banking revenues or results; provided, however, that compensation may relate to the revenues or results of the firm as a whole.

c. A significant portion of the compensation of anyone principally engaged in the preparation of research reports (as defined in this Addendum) that he or she is required to certify pursuant to Regulation AC (such person hereinafter a "lead analyst") must be based on quantifiable measures of the quality and accuracy of the lead analyst's research and analysis, including his or her ratings and price targets, if any. In assessing quality, the firm may rely on, among other things, evaluations by the firm's investing customers, evaluations by the firm's sales personnel and rankings in independent surveys. In assessing accuracy, the firm may use the actual performance of a company or its equity securities to rank its own lead analysts' ratings and price targets, if any, and forecasts, if any, against those of other firms, as well as against benchmarks such as market or sector indices.

d. Other factors that may be taken into consideration in determining lead analyst compensation include: (i) market capitalization of, and the potential interest of the firm's investing clients in research with respect to, the industry covered by the analyst; (ii) Research management's assessment of the analyst's overall performance of job duties, abilities and leadership; (iii) the analyst's seniority and experience; (iv) the analyst's productivity; and (v) the market for the hiring and retention of analysts.

e. The criteria to be used for compensation decisions will be determined by Research management and the firm's senior management (not including Investment Banking) and set forth in writing in advance. Research management will document the basis for each compensation decision made with respect to (i) anyone who, in the last 12 months, has been required to certify a research report (as defined in this Addendum) pursuant to Regulation AC; and (ii) anyone who is a member of Research management (except in the case of senior-most Research management, in which case the basis for each compensation decision will be documented by the firm's senior management).

On an annual basis, the Compensation Committee of the firm's holdinglparent company (or comparable independent personslgroup without management responsibilities) will review the compensation process for Research personnel. Such review will be reasonably designed to ensure that compensation decisions have been made in a manner that is consistent with these requirements.

6. Evaluations. Evaluations of Research personnel will not be done by, nor will there be input fiom, Investment Banking personnel.

8. Termination of Coverage. When a decision is made to terminate coverage of a particular company in the firm's research reports (whether as a result of a company-specific or category-by-category decision), the firm will make available a final research report on the company using the means of dissemination equivalent to those it ordinarily uses; provided, however, that no final report is required for any company as to which the firm's prior coverage has been limited to quantitative or technical research reports. Such report will be comparable to prior reports, unless it is impracticable for the firm to produce a comparable report (e.g., if the analyst covering the company andor sector has left the firm). In any event, the final research report must disclose: the firm's termination of coverage; and the rationale for the decision to terminate coverage.

9. Prohibition on Soliciting Investment Banking -Business. Research is prohibited from participating in efforts to solicit investment banking business. Accordingly, Research may not, among other things, participate in any "pitches7' for investment banking business to prospective investment banking clients, or have other communications with companies for the purpose of soliciting investment banking business. a. Research personnel are prohibited from participating in company- or Investment Banking-sponsored road shows related to a public offering or other investment banking transaction. b. Investment Banking personnel are prohibited from directing Research personnel to engage in marketing or selling efforts to investors with respect to an investment banking transaction.

11 (c)(3)-(5): [discussing when analysts may speak to prospective investors prior to an IPO]

3) All such oral communications to a group of ten or more investors must be made in the presence of internal legal or compliance personnel;

4) A written log of all oral communications described in (2) above must be maintained; and

5) All written logs must be retained for the period required by Rule 17a-4(b)(4). 2.

II.2 Transparency of Analysts' Performance. The firm will make publicly available (via its website, in a downloadable format), no later than 90 days after the conclusion of each quarter (beginning with the first full calendar quarter that commences at least 120 days following the entry of the Final Judgment), the following information, if such information is included in any research report (other than any quantitative or technical research report) prepared and furnished by the firm during the prior quarter: subject company, name(s) of analyst(s) responsible for certification of the report pursuant to Regulation AC, date of report, rating, price target, period within which the price target is to be achieved, earnings per share forecast(s) for the current quarter, the next quarter and the current full year, indicating the period(s) for which such forecast(s) are applicable (e.g., 3Q03, FY04, etc.), and definitiodexplanation of ratings used by the firm.

There's a lot there that is deleted. It may be that Rule 2711 covers these things now, so they are superfluous.  It may be that some of the accords turned out not to matter.  Or a combination.  (Do not have time to check word for word, but there are a lot of headings that seem to address the same topics -- compensation, communication, etc.)  Or it may be that the SEC is bowing to industry pressure to loosen its grip on analyst research. Either way, either the WSJ article is right and the SEC is being successful in going against public sentiment in loosening regulation right now or the WSJ Law Blog is right and the court rejected the SEC's attempt to loosen regulation right now.

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