[Federal Register Volume 67, Number 95 (Thursday, May 16, 2002)]
[Notices]
[Pages 34968-34978]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-12207]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-45908; File No. SR-NASD-2002-21; SR-NYSE-2002-09]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Changes by the National Association of Securities Dealers, Inc. and the 
New York Stock Exchange, Inc. and Notice of Filing and Order Granting 
Accelerated Approval of Amendment No. 2 to the Proposed Rule Change by 
the National Association of Securities Dealers, Inc. and Amendment No. 
1 to the Proposed Rule Change by the New York Stock Exchange, Inc. 
Relating to Research Analyst Conflicts of Interest

May 10, 2002.

I. Introduction

    Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 
(``Exchange Act'')\1\ and Rule 19b-4 thereunder, \2\ on February 13, 
2002, the National Association of Securities Dealers, Inc. (``NASD'' or 
``Association''), through its wholly owned subsidiary, NASD Regulation, 
Inc. (``NASDR''), and on February 27, 2002, the New York Stock 
Exchange, Inc. (``NYSE'' or ``Exchange''), filed with the Securities 
and Exchange Commission (``SEC'' or ``Commission'') proposed rule 
changes relating to research analyst conflicts of interest. On March 7, 
2002, NASDR submitted Amendment No. 1 (``NASD Amendment No. 1'') to its 
proposed rule change. \3\ The proposed rule changes, as amended, were 
published for comment in the Federal Register on March 14, 2002. \4\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Letter from Thomas M. Selman, Senior Vice President, 
Investment Companies, Corporate Financing, NASDR, to Katherine A. 
England, Assistant Director, Division of Market Regulation 
(``Division''), Commission (March 7, 2002) (``NASDR Amendment No. 
1''). In Amendment No. 1, NASDR revised its response to Items 1(b) 
and 1(c) of the Form 19b-4 to indicate the impact that proposed NASD 
Rule 2711 would have on NASD Rule 2210. Additionally, NASDR inserted 
language in its Purpose section to clarify how the current 
disclosure requirements regarding securities recommendations in NASD 
Rule 2210 would apply if proposed NASD Rule 2711 was approved by the 
SEC. Finally, NASDR revised the provisions requiring disclosure of 
actual material conflicts of interest to conform its provisions to 
those of the NYSE.
    \4\ Release No. 34-45526 (March 8, 2002), 67 FR 11526 (March 14, 
2002).
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    On April 2, 2002, the Commission extended the comment period until 
April 18, 2002. \5\ The Commission received 55 comment letters on the 
proposed rule changes from 52 different commenters. \6\ On April 30, 
2002, the

[[Page 34969]]

NYSE submitted Amendment No. 1 (``NYSE Amendment No. 1'') to its 
proposed rule change.\7\ On May 2, 2002, the NASDR submitted Amendment 
No. 2 (``NASD Amendment No. 2'') to its proposed rule change.\8\ On May 
2, 2002, the NASD submitted a letter responding to comments.\9\ On May 
3, 2002, the NYSE also submitted a letter responding to comments.\10\
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    \5\ Release No. 34-45679 (April 2, 2002), 67 FR 11526 (April 4, 
2002). In response to the solicitation of comments, the Commission 
received two requests to extend the comment period. See Letters to 
Jonathan G. Katz, Secretary, Commission, from: Securities Industry 
Association, dated March 15, 2002; Pickard and Djinis LLP, dated 
March 28, 2002. In response to these requests, the Commission 
extended the comment period from April 4, 2002 until April 18, 2002.
    \6\ See Letters to Jonathan G. Katz, Secretary, Commission, as 
of the time that this order was prepared, from: The Alliance in 
Support of Independent Research, dated May 1, 2002 (``Alliance 
letter''); A.G. Edwards & Sons, Inc., dated April 17, 2002 (``A.G. 
Edwards letter''); American Bankers Association, ABA Securities 
Association, dated April 18, 2002 (``ABASA letter''); American 
Society of Corporate Secretaries, dated April 17, 2002 (``ASCS 
letter''); Association for Investment Management and Research, dated 
April 18, 2002 (``AIMR letter''); Ramesh Bodapati, dated March 4, 
2002 (``Bodapati letter''); BBVA Securities Inc., dated March 22, 
2002 (``BBVA letter''); Biotech Monthly, dated April 26, 2002 
(``Biotech Monthly letter''); Charles Schwab & Co., Inc., dated 
April 18, 2002 (``Charles Schwab letter''); Cleary, Gottlieb, Steen 
& Hamilton, dated April 4, 2002 (``Cleary letter''); Credit Suisse 
First Boston, dated April 19, 2002 (``CSFB letter''); Davenport & 
Company LLC, dated April 17, 2002 (``Davenport letter''); Dorsey & 
Whitney LLP, dated April 18, 2002 (``Dorsey letter''); Edward Jones 
& Co., dated April 3, 2002 (``Edward Jones letter''); First Analysis 
Securities Corp., dated March 20, 2002 and First Analysis Securities 
Corp., dated April 17, 2002 (First Analysis letter''); Fried Frank 
Harris Shriver & Jacobson, dated April 18, 2002 (``Fried Frank 
letter''); Goldman Sachs, dated April 18, 2002 (``Goldman Sachs 
letter''); David Hauck, dated May 5, 2002 (``Hauck letter''); HSBC 
Securities (USA) Inc., dated April 4, 2002 (``HSBC letter''); 
Investment Company Institute, dated April 18, 2002 (``ICI letter''); 
Investment Counsel Association of America, dated April 23, 2002 
(``ICAA letter''); Dan Jamieson, dated May 6, 2002 (``Jamieson 
letter''); Janney Montgomery Scott LLC, dated April 17, 2002 
(``Janney Montgomery Scott letter''); Jefferies & Company, Inc., 
dated April 17, 2002 (``Jefferies & Co. letter''); Jovus, Inc., 
dated April 18, 2002 (``Jovus letter''); Legg Mason, Inc., dated 
April 17, 2002 (``Legg Mason letter''); Bruce Locke, dated February 
8, 2002 (``Locke letter''); Congressman Edward J. Markey, dated May 
7, 2002 (``Congressman Markey letter''); Merrill Lynch, Pierce, 
Fenner & Smith Incorporated, dated April 18, 2002 (``Merrill Lynch 
letter''); David Miller, dated April 26, 2002 (``Miller letter''); 
Morgan Lewis, dated April 18, 2002 (``Morgan Lewis letter''); Morgan 
Stanley, dated April 22, 2002 (``Morgan Stanley letter''); National 
Investor Relations Institute, dated April 15, 2002 (``NIRI 
letter''); New York State Bar Association Committee on Securities 
Regulation, dated April 17, 2002 (``NYSBA letter''); Nomura 
Securities International, Inc., dated March 19, 2002 (``Nomura 
letter''); North American Securities Administrators Association, 
Inc., dated April 18, 2002 (``NASAA letter''); Thomas Olsen, dated 
April 25, 2002 (``Olsen letter''); Pacific Growth Equities, Inc., 
dated April 18, 2002 (``Pacific Growth letter''); Pickard and Djinis 
LLP, dated March 28, 2002 and Pickard and Djinis LLP, dated April 
15, 2002 (``Pickard and Djinis letter''); Prudential Securities 
Incorporated, dated April 22, 2002 (``PSI letter''); RBC Capital 
Markets, dated May 3, 2002 (``RBC letter''); Charles Rothschild, 
dated March 8, 2002 (``Rothschild letter''); Ryan Beck & Co., LLC, 
dated April 3, 2002 (``Ryan Beck letter''); Salomon Smith Barney 
Inc., dated April 18, 2002 (``SSB letter''); Securities Industry 
Association, dated March 15, 2002 and Securities Industry 
Association, dated April 11, 2002 (``SIA letter''); Kevin Silverman, 
dated February 26, 2002 (``Silverman letter''); StarMine 
Corporation, dated April 18, 2002 (``StarMine letter''); Sullivan & 
Cromwell, dated April 18, 2002 (``Sullivan & Cromwell letter''); Sun 
Trust Capital Markets, Inc., dated April 18, 2002 (``Sun Trust 
letter''); UBS Warburg LLC, dated April 25, 2002 (``UBS letter''); 
Wachovia Securities, Inc., dated April 18, 2002 (``Wachovia 
letter''); and Wells Fargo Securities, dated March 15, 2002 (``Wells 
Fargo letter'').
    \7\ See Letter from Richard P. Bernard, Assistant Corporate 
Secretary, NYSE, to James A. Brigagliano, Assistant Director, 
Division, Commission (April 30, 2002).
    \8\ See Letter from Philip Shaikun, Assistant General Counsel, 
NASDR, to James A. Brigagliano, Assistant Director, Division, 
Commission (May 2, 2002).
    \9\ See Letter from Philip Shaikun, Assistant General Counsel, 
NASDR, to James A. Brigagliano, Assistant Director, Division, 
Commission (May 2, 2002).
    \10\ See Letter from Darla Stuckey, Corporate Secretary, NYSE, 
to James A. Brigagliano, Assistant Director, Division, Commission 
(May 3, 2002).
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    This order approves the proposed rule changes, as amended. The 
Commission also seeks comment from interested persons on NYSE Amendment 
No. 1 and NASD Amendment No. 2.

II. Description of the Proposed Rule Changes

    The NYSE and the NASD (``SROs'') proposed to amend their rules to 
address conflicts of interest that are raised when research analysts 
recommend securities in public communications. These conflicts can 
arise when analysts work for firms that have investment banking or 
other business relationships with issuers of the recommended 
securities, or when the analyst or firm owns securities of the 
recommended issuer. The approved rules implement structural reforms 
designed to increase analysts' independence and further manage 
conflicts of interest, and require increased disclosure of conflicts in 
research reports and public appearances.

A. Current Rules Governing Disclosure of Conflicts of Interest

    NYSE Rule 472 and NASD Rule 2210 currently require member firms to 
disclose certain conflicts of interest whenever a firm (or one of its 
analysts) recommends the purchase or sale of a specific security. Under 
existing rules, a firm must disclose if it makes a market in the 
recommended security and if it was manager or co-manager of a public 
offering of the issuer within the last three years. In addition, a firm 
generally must divulge if it has a financial interest in the 
recommended security.
    The NYSE and NASD disclosure requirements are similar, but contain 
some significant differences, which have led to gaps and 
inconsistencies between the two rules. For instance, NASD Rule 2210 
requires a firm and/or its officers or partners affirmatively to 
disclose ownership of options, rights or warrants to purchase any of 
the securities of the issuer whose securities are recommended (unless 
such ownership is nominal), but it does not mandate they disclose 
ownership of common shares of a recommended issuer. Nor does NASD Rule 
2210 require that the analyst who prepared a research report disclose 
ownership of any financial interest in a recommended issuer. NYSE Rule 
472, on the other hand, requires disclosure of all financial positions 
(including common shares) held by a firm and its analysts, but permits 
the use of conditional disclosure language such as, ``* * * the firm or 
employees may own options of a recommended issuer.''
    Although the conflict disclosure obligations are triggered by the 
making of a recommendation, neither rule has historically been applied 
by the SROs to oral recommendations by analysts appearing on 
television. In addition, these rules are not designed to mitigate the 
various pressures to which analysts are subject. For instance, 
reporting structures at firms where analysts are under the supervision 
or control of investment banking personnel, and where compensation 
arrangements tie analyst pay to specific investment banking deals, may 
exert such pressures.

B. Proposed Changes to NYSE and NASD Rules

    The proposed rule changes address analyst conflicts of interest in 
connection with the preparation and publication of research reports for 
equity securities.\11\ We provide here a general overview of the 
proposed rule changes.\12\
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    \11\ The SRO rules apply only to research reports on equity 
securities. Therefore, research reports on debt securities are not 
within the scope of these rules. Telephone conversation between 
NYSE, NASD, and Division Staff, on May 3, 2002.
    \12\ The NASD and NYSE rules, as amended, are substantially 
identical and are intended to operate identically. The text of the 
proposed rules as originally filed, and all amendments, are 
available at http://www.nasdr.com/filings/rf02_21.asp and http://www.nyse.com/regulation/regulation.html.
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    First, the proposals limit the relationships and communications 
between a firm's investment banking department and its research 
department. Specifically, no research analyst may be supervised or 
controlled by a firm's investment banking department. In addition, the 
investment banking personnel may not discuss pending research reports 
with research analysts prior to distribution, unless the communication 
was intermediated by staff from the legal/compliance department. 
Similarly, the research report may not be reviewed by the company that 
is the subject of the report, except for checking factual sections for 
accuracy.
    Second, the proposed changes to SRO rules place various 
restrictions on, and impose certain disclosure requirements with 
respect to, analyst and firm compensation arrangements. An analyst's 
compensation may not be tied to specific investment banking 
transactions. If an analyst received compensation that was based on the 
firm's general investment banking revenues, that fact must be disclosed 
in the firm's research reports. The firm also would have to disclose in 
a company's research report if it or its affiliates have managed or co-
managed a public offering of equity securities for or received 
investment banking compensation from the subject company in the past 12 
months, and if it expects to receive or intends to seek compensation 
for investment banking services in the next three months. Finally, if 
an analyst recommends a security in a public appearance, and the issuer 
was a client of his or her firm, the analyst must disclose that fact.
    Third, the proposed rule changes would take certain measures to 
prevent promises of favorable research. A firm may not offer a 
favorable research rating or specific price target to a company as 
consideration or inducement for the receipt of business or 
compensation. The proposal also would require ``quiet periods'' during 
which a firm acting as manager or co-manager of a securities offering 
could not issue a report on a company: within 40 days after an initial 
public offering (``IPO'') or within 10 days after a secondary offering 
of an inactively traded security.

[[Page 34970]]

    Fourth, the proposals place various restrictions on an analyst's 
personal trading. In general, no analyst (or household member) may 
purchase or receive an issuer's securities prior to its IPO, if the 
company engages in a type of business covered by the analyst. In 
addition, no analyst may trade securities issued by companies the 
analyst follows for the period beginning 30 days prior to the issuance 
of the research report and ending five days after the date of the 
report. The analyst also may not engage in trading contrary to the 
analyst's most recent recommendations.
    Fifth, the proposed rule changes require certain disclosures about 
the ownership of securities by the firm and the analyst. An analyst 
must disclose in public appearances, and a firm must disclose in 
research reports, if the analyst or a member of his or her household 
has a financial interest in the securities of a recommended company. 
If, as of the previous month end, the firm owns one percent or more of 
any equity class of the company, that fact also must be disclosed 
during the analyst's public appearance or in the research report.
    Finally, the proposal requires specific additional disclosures in 
research reports to provide investors with better information to make 
assessments of a firm's research. Firms must define in research reports 
the meaning of all ratings used in the ratings system and the 
definition of each rating must be consistent with its plain meaning 
(e.g., ``hold'' must mean hold and not ``sell''). In addition, 
regardless of the ratings system employed, firms must provide the 
percentage of all ratings assigned to buy/hold/sell categories. The 
proposal also requires a price chart that maps the historical price 
movements of the recommended security and indicates those points at 
which ratings or price targets were assigned or changed.

III. Summary of Comments

    The Commission received 55 comments from 52 commenters on the 
proposed rule changes. Although the vast majority of commenters 
supported the fundamental goals and objectives behind the proposed rule 
changes, many commenters also believed the initial proposal needed to 
be revised and suggested substantive changes.\13\ In response to 
various concerns and suggestions raised by commenters, the NYSE and the 
NASD filed amendments to their proposals. The NYSE and NASD responded 
to the comments in separate letters.\14\
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    \13\ See, e.g., SIA letter; Morgan Stanley letter.
    \14\ See notes 9 and 10 above.
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IV. Discussion

    After careful review, the Commission finds, as discussed more fully 
below, that the proposed rule changes, as amended, are consistent with 
the requirements of the Exchange Act and the regulations thereunder 
applicable to the NYSE and NASD.\15\ In particular, the Commission 
believes that the changes are consistent with Sections 6(b)(5) and 
6(b)(8) of the Exchange Act,\16\ and also Sections 15A(b)(6) and 
15A(b)(9) of the Exchange Act.\17\
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    \15\ See 15 U.S.C. 78c(f).
    \16\ 15 U.S.C. 78f(b)(5) and (8).
    \17\ 15 U.S.C. 78o-3(b)(6) and (9).
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    Section 6(b)(5) requires, among other things, that the rules of an 
exchange be designed to prevent fraudulent and manipulative acts and 
practices, to promote just and equitable principles of free trade, to 
remove impediments to and perfect the mechanism of a free and open 
market, and to protect investors and the public interest. Section 
6(b)(5) also requires that the rules of an exchange not be designed to 
permit unfair discrimination between customers, issuers, brokers, or 
dealers. Section 6(b)(8) of the Exchange Act prohibits the rules of an 
exchange from imposing any burden on competition not necessary or 
appropriate in furtherance of the purposes of the statute.
    Section 15A(b)(6) requires that the rules of a registered national 
securities association be designed to prevent fraudulent and 
manipulative acts and practices, to promote just and equitable 
principles of trade, to foster cooperation and coordination with 
persons engaged in regulating, clearing, settling, processing 
information with respect to and facilitating transactions in 
securities, to remove impediments to and perfect the mechanism of a 
free and open market and a national market system, and, in general, to 
protect investors and the public interest. Section 15A(b)(9) requires 
that the rules of an association not impose any burden on competition 
that is not necessary or appropriate in furtherance of the purposes of 
the Exchange Act.
    Section 3(f) directs the Commission to consider, in addition to the 
protection of investors, whether approval of the rule change will 
promote efficiency, competition, and capital formation.\18\ In 
approving the proposed rule changes, the Commission has considered 
their impact on efficiency, competition, and capital formation.
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    \18\ 15 U.S.C. 78c(f).
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    The Commission believes the rule changes, as amended, represent an 
important step towards helping to rebuild investors' confidence in the 
integrity of research and in the equities markets as a whole.

A. Definition of the Term ``Research Reports''

    There was substantial concern among commenters regarding 
inconsistencies between the NASD's and NYSE's definitions of research 
reports, and requests that the SROs harmonize their language.\19\ Many 
commenters also argued that the scope of the proposed definitions of 
research report was overbroad and would impede the flow of information 
to investors. They asserted that the definitions may be read to include 
quantitative technical analysis, other general market commentary, 
company updates not containing a change in rating or target, other 
reports concerning indexes, baskets, or market sectors, and sales 
literature.\20\ They also requested exceptions for reports distributed 
solely to institutions and for commentaries not including a 
recommendation.\21\ The commenters argued that those sorts of 
communications were either subject to other rules or that the 
disclosures mandated for research reports were not warranted or 
suitable for such communications because, for example, they were 
directed at registered representatives or institutional investors or 
did not include an analysis and a recommendation.
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    \19\ See, e.g., Charles Schwab letter.
    \20\ See, e.g., SIA letter; NYSBA letter.
    \21\ See, e.g., SIA letter; Pickard and Djinis letter.
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    In response to these comments, the NASD and NYSE amended their 
proposal to harmonize the definitions of ``research report'' under both 
rules. ``Research report'' is now defined as ``a written or electronic 
communication which includes an analysis of equity securities of 
individual companies or industries, and which provides information 
reasonably sufficient upon which to base an investment decision and 
includes a recommendation.'' \22\ In addition, the types of 
communications covered by the new requirements have been narrowed 
because the NYSE eliminated the phrase ``but not limited to'' in its 
definition. Further, the SROs stated their intentions to address, 
through written interpretation, in a manner consistent with the rules, 
practical issues raised by commenters. In particular, they will examine 
various communications, such as abstracts, updates, weekly and monthly

[[Page 34971]]

summaries, industry/market sector reports, portfolio strategy pieces, 
quantitative research and technical analysis, and general market 
commentary and trading strategies, to determine whether they meet the 
definition of research reports.
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    \22\ This definition of research reports is narrower in scope 
than the reports covered by the Commission's Rules 137, 138 and 139 
under the Securities Act of 1933 (``Securities Act'') and should not 
be construed as relating to those rules.
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    Commenters also raised concerns regarding their ability to meet all 
disclosure requirements under the proposed rules when issuing 
compendium reports on numerous issuers.\23\ They argued that the 
disclosures required for all of the issuers in such reports would be 
voluminous and would be difficult to include in the reports. 
Specifically, including a price chart for each security in a research 
report that discusses multiple securities could add considerable length 
to such communications. Commenters noted that technological limitations 
would make it impossible to transmit electronically the required 
disclosures for each subject company through many systems.\24\
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    \23\ See, e.g., CSFB letter.
    \24\ See, e.g., PSI letter.
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    The NASD and NYSE responded to these concerns by providing that, 
instead of including the required disclosures in compendiums, research 
reports covering six or more subject companies may use prominent 
disclosure that advises the reader as to where the required disclosures 
can be accessed. The SROs stated their intention to issue additional 
guidance on the mechanics of satisfying the disclosure requirements for 
compendium reports, whether they are issued electronically or in paper 
format.
    Commenters' concerns also included whether the research report 
definition would capture reports by investment advisers not principally 
responsible for preparation of research, and reports distributed by 
third party research vendors. One commenter stated that ``a significant 
portion of this research provided by broker-dealers to institutional 
money managers consists of independent and disinterested research 
(sometimes referred to as ``third party research''),'' which is 
produced by third parties that are ``independent and unaffiliated'' 
with the broker-dealer providing the research.\25\ This commenter urged 
that the NASD's definition of ``research report'' be modified to mean a 
report that the broker-dealer has ``authored, prepared or over which he 
has editorial control,'' rather than one that the ``member has 
distributed.''\26\
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    \25\ Alliance letter.
    \26\ Id.
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    Many commenters also inquired as to whether the proposals' 
disclosure requirements would apply to research reports that are 
distributed by SRO member firms to their customers, but have been 
prepared by non-member organizations affiliated with or not affiliated 
with the member, including investment advisers or foreign broker-
dealers.
    The SROs have acknowledged that the distribution of research 
reports prepared by non-member firms raises complex issues that will 
vary depending on the type of report, the entity that created the 
report, and the member's participation in the production or 
distribution of the report. The SROs intend to review the application 
of the rules to research reports not produced by the member firm on a 
case-by-case basis; however, generally where a member firm is 
distributing in the United States research of its affiliate, the member 
firm should disclose applicable conflicts that must include the 
disclosures required by the rules regarding the member. These rules do 
not require the member firm to include disclosures about the non-member 
affiliate or its employees.\27\ The disclosure requirements will not 
apply to independently produced research such as that distributed 
pursuant to the provisions of Exchange Act Section 28(e).\28\
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    \27\ Some firms may choose to disclose that the non-member 
affiliates and their employees are not subject to the SROs' 
disclosure rules, which apply to members and associated persons. We 
note, however, that other provisions, including antifraud provisions 
such as Exchange Act Section 10(b) and Rule 10b-5, apply to non-
member affiliates and their employees.
    \28\ 15 U.S.C. 78bb(e). Telephone conversation between NYSE, 
NASD, and Division Staff, on May 3, 2002.
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    The Commission finds that the rules defining the term ``research 
report,'' as amended, are consistent with the Exchange Act, and 
specifically, Exchange Sections 6(b)(5) and 15A(b)(6) in that the rules 
should help prevent fraudulent and manipulative practices, help perfect 
the mechanism of a free and open market, and protect investors and the 
public interest. Further, consistent with Exchange Act Sections 6(b)(8) 
and 15A(b)(9), the Commission believes that the definition of research 
report, as amended, does not impose any burden on competition not 
necessary or appropriate in furtherance of the Exchange Act. We note 
that the SROs have tailored the definition to capture the 
communications that are most likely to benefit from the coverage of the 
rules, while at the same time tailoring the definition and the rules' 
application in response to concerns expressed by commenters. This 
amendment preserves for readers of research reports the availability of 
important disclosures while allowing compendium reports to remain 
succinct and manageable. We believe that the SROs' expressed intent to 
provide interpretive guidance should help refine the rules' application 
to achieve the SROs' intended goals.

B. Relationships and Communications between Research, Investment 
Banking, and Subject Companies

    The proposed rules prohibit research analysts from being subject to 
the supervision or control of a firm's investment banking department, 
and require legal and compliance personnel to act as intermediaries 
between research and investment banking with regard to the contents of 
research reports. The proposals also limit the extent to which subject 
companies can review research reports prior to distribution, and 
require legal or compliance personnel to receive copies of the portions 
of reports that are submitted to subject companies and approve any 
resultant changes to ratings or price targets.
    Commenters opposing these provisions primarily argued that 
compliance personnel are not suited for the gatekeeper role called for 
in the proposal.\29\ For example, one commenter asserted the proposal 
would require legal/compliance departments to have a direct role in the 
preparation of research and act, in essence, as supervisory 
analysts.\30\ Unlike senior research management, they argued, legal/
compliance staff would be unable to independently assess the 
credibility of a claim by a research analyst that a recommendation was 
changed as a result of information given by the subject company.\31\ 
Commenters also argued that the proposed compliance structure would 
impose inordinate cost burdens, especially on smaller firms that may be 
driven out the research business as a result.\32\ One commenter argued 
that this might ultimately reduce research coverage, especially of 
smaller companies.\33\ On the other hand, one commenter stated that 
analysts are expected to be experts in fact gathering, and that there 
was therefore no reason to allow a draft research report to be shown to 
the investment banking unit or

[[Page 34972]]

the issuer.\34\ At least one commenter supported the ``gatekeeper'' 
provisions for legal/compliance personnel and suggested only minor 
clarifying changes, noting these provisions ``go to the heart of the 
public perception issues with respect to analyst independence issues.'' 
\35\
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    \29\ See, e.g., SIA letter; Morgan Lewis letter; PSI letter; 
NASAA letter. NASAA argued that analysts should be prohibited from 
showing draft research reports to investment banking or issuer 
personnel.
    \30\ See, e.g., ABA letter.
    \31\ SIA letter.
    \32\ See, e.g., Ryan Beck letter; Janney Montgomery Scott 
letter; Pacific Growth letter.
    \33\ SIA letter.
    \34\ NASAA letter.
    \35\ See, e.g., Goldman Sachs letter.
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    The NYSE and NASD considered commenters' concerns, but retained the 
limits on relationships and communications in the proposed rules. The 
SROs stated their belief that increased involvement by legal/compliance 
personnel is necessary to bolster their traditional role of monitoring 
for potential conflicts of interest between a firm's research 
department and investment banking department, which is already codified 
in the SROs' rules. Moreover, their participation would further the 
purpose of this regulatory initiative by reducing the possibility of 
any undue influence or pressure by investment banking or subject 
companies on the integrity and objectivity of a research report.
    The NYSE stated its belief that the benefits of the ``gatekeeper'' 
function far outweigh the unavoidable costs and administrative burdens 
to member organizations, and are necessary to restore integrity to the 
research process and the marketplace as a whole. The NYSE stated these 
are common concerns to the SROs and member organizations, both large 
and small. The NASD considered possible exemptions for small firms, but 
believes that some smaller firms' environments may present similar 
conflicts of interest as large firms. The NASD intends to review this 
issue again in the future to determine what accommodations may be made 
consistent with investor protection.
    The Commission considers this provision to be a significant 
improvement over current SRO rules. The Commission believes the 
prohibition on research department personnel being subject to the 
supervision or control of the investment banking department helps 
protect analysts from undue influences.\36\ The Commission also 
believes the communication restrictions between analysts and investment 
banking and between analysts and subject companies are appropriate. 
These new requirements are designed to foster an environment where 
research analysts, and the research reports they write, remain 
independent of the inappropriate influences of investment banking 
departments and covered companies. The Commission notes that the 
prohibition is limited to communications regarding pending research 
reports and does not apply to interdepartmental communications that are 
not about reports. Therefore, the rules only prohibit the type of 
communications that raise the core concern of investment banking 
pressuring the research department personnel into issuing a particular 
report or rating. Communications intermediated by legal/compliance 
personnel should allow for the issuance of factually accurate research 
reports while shielding analysts from improper pressures and 
influences.\37\
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    \36\ This prohibition codifies one of the guidelines recommended 
by the SIA in its ``Best Practices for Research,'' published in June 
2001.
    \37\ As noted by the SROs, this is not an entirely new role for 
member compliance departments. For example, member compliance 
departments presently are expected to perform substantive 
supervision of interdepartmental communications. See ``NASD/NYSE 
Joint Memo on Chinese Wall Policies and Procedures'' (July 1991).
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    The SROs have represented that legal/compliance personnel are not 
expected to become as knowledgeable as analysts about the content of 
research reports or ratings.\38\ Rather, as ``gatekeepers,'' they are 
expected to verify that only appropriate communications about the 
content of research reports take place between analysts and personnel 
in investment banking or at issuers, and that any changes that are made 
to reports after such communications appear to have a substantial 
basis. The Commission also notes that the SROs intend to review the 
application of this provision to determine possible accommodations for 
small firms.
---------------------------------------------------------------------------

    \38\ Telephone conversation between NYSE, NASD, and Division 
Staff, on May 3, 2002.
---------------------------------------------------------------------------

    The Commission finds that the rules addressing the relationships 
between research, investment banking and companies that are the subject 
of research analyst reports should further the purposes of the Exchange 
Act. Specifically, the rules address the potential pressures on 
research analysts by adopting measures designed to reduce the 
possibility of undue influence or pressure by investment banking 
departments or the subjects of the research report. We believe these 
rules should help prevent fraudulent and manipulative practices, help 
perfect the mechanism of a free and open market, and protect investors 
and the public interest. Further, we believe that the rules will not 
impose any burden on competition that is not necessary or appropriate 
to achieve the goals of the Exchange Act.

C. Disclosure of Firm Compensation From Covered Companies

    In the initial filing of the proposed rule changes, firms would 
have been required to disclose in research reports and public 
appearances if the member organization or its affiliates received 
compensation from the subject company within the past twelve months, or 
reasonably expected to receive compensation from the subject company 
within three months following the publication of the research report.
    Industry commenters raised three primary concerns. First, 
commenters expressed concerns about the potential for ``signaling'' or 
``tipping'' about non-public transactions.\39\ One commenter noted 
``the required disclosures could serve to alert investors and public 
side employees of the member firm, such as research analysts and 
traders, to the existence of a confidential investment banking 
transaction or assignment.'' \40\ Second, commenters argued that the 
provision's scope was overly broad in that it required disclosure of 
all forms of compensation from the issuer, including compensation 
received or reasonably expected by affiliates of the member firm, which 
would result in a large volume of meaningless disclosures to 
investors.\41\ Third, commenters noted that it would be extremely 
expensive for firms to implement compensation tracking systems for 
members and their affiliates.\42\ However, one commenter stated that 
the disclosure periods should be expanded to three years before and one 
year after publication of the research report.\43\
---------------------------------------------------------------------------

    \39\ See, e.g., CSFB letter; ASCS letter; Sullivan & Cromwell 
letter.
    \40\ Morgan Stanley letter.
    \41\ See, e.g., SIA letter; Legg Mason letter; Wachovia letter.
    \42\ See, e.g., SIA letter.
    \43\ NASAA letter.
---------------------------------------------------------------------------

    In response to these concerns, the SROs modified their proposals to 
require disclosure if the member or its affiliates (1) managed or co-
managed a public offering of securities for the subject company in the 
past twelve months; (2) received compensation for investment banking 
services from the subject company in the past twelve months; or (3) 
expects to receive or intends to seek compensation for investment 
banking services from the subject company in the next three months.
    The amended proposals continue to require disclosure of member and 
affiliate compensation. However, the scope is focused on the core 
concern, compensation from investment banking services, as some 
commenters

[[Page 34973]]

suggested.\44\ Investment banking services are defined for purposes of 
these rules as including: acting as an underwriter in an offering for 
the issuer; acting as a financial adviser in a merger or acquisition; 
providing venture capital, equity lines of credit, PIPEs (private 
investment, public equity transaction) or similar investments; or 
serving as placement agent for the issuer. Therefore, the amended 
proposals are now targeted to the potential for conflicts of interest 
arising from the receipt of investment banking revenue. Limiting 
reporting of compensation to investment banking services should also 
significantly reduce the costs and difficulties associated with 
tracking the relevant information compared with the original proposal.
---------------------------------------------------------------------------

    \44\ See, e.g., SIA letter. The SIA, however, recommended 
limiting the disclosure to publicly announced transactions.
---------------------------------------------------------------------------

    The development of this disclosure requirement reflects the tension 
between disclosure that (1) is specific enough to provide meaningful 
information to investors about a firm's interest in obtaining revenue 
from providing services to an issuer covered by its research, but also 
may reveal (i.e., ``tip'') information about confidential transactions; 
and (2) is so general that it will not reveal significant information 
about non-public transactions, but also will not alert investors to the 
nature of the firm's conflict of interest. The tipping concern is 
addressed by the amendments. First, ``investment banking services'' is 
broadly defined so that the existence of the compensation is clear, but 
the type of transaction(s) involved is not. It is not limited to public 
transactions as some commenters urged \45\ because, as the NASD has 
noted, the receipt of investment banking revenue for non-public 
transactions can provide an equally strong incentive to publish 
favorable research.\46\ Second, the forward-looking disclosure 
provision now requires disclosure of compensation for investment 
banking services that the firm ``expects to receive or intends to 
seek'' from the issuer in the next three months. This addresses the 
concern of commenters that the prior formulation requiring disclosure 
if the firm ``reasonably expects to receive'' compensation from the 
issuer had substantial interpretive uncertainty.\47\
---------------------------------------------------------------------------

    \45\ See, e.g., SIA letter.
    \46\ Release No. 34-45526 (March 8, 2002), 67 FR 11526, 11534.
    \47\ See, e.g., SIA letter.
---------------------------------------------------------------------------

    Various scenarios are set forth by commenters where the proposed 
disclosures could tip the research department or investors that an 
undisclosed investment banking transaction was in the offing. The SROs 
believe that the present form of disclosure reduces these concerns by 
including compensation the firm ``intends to seek.'' Thus, it 
represents a reasonable balance between broad, meaningless disclosure, 
and disclosure that would reveal confidential information. In some rare 
cases a firm may have to choose between making the disclosure and 
refraining from issuing research, in order to preserve client 
confidences in connection with an investment banking transaction.
    Some commenters predict that the forward-looking disclosure will 
become boilerplate and not meaningful for investors because all firms 
will state that they intend to seek investment banking business from 
every issuer. However, this disclosure does have meaningful content. 
First, if the securities firm does not in fact plan to seek investment 
banking business in three months, including the language in disclosures 
would constitute a false statement. Even if firms regularly state that 
they intend to seek compensation, the inclusion of this disclosure can 
put investors on notice of potential conflicts concerning any 
recommendations that the firm may make about the issuer's securities. 
Finally, for firms that produce research but do not provide investment 
banking services, the absence of the disclosures (because the firm does 
not have the types of conflicts covered by the SRO rules) can be 
meaningful to investors.
    Finally, we believe it is appropriate for the SROs to require that 
the firm disclose if it was the manager or co-manager of a public 
offering for the subject company within the past twelve months, given 
that this is a more limited statement of an existing requirement.\48\
---------------------------------------------------------------------------

    \48\ NYSE Rule 472; NASD Rule 2210. Retention of this disclosure 
requirement was also suggested by some commenters. See, e.g., SIA 
letter.
---------------------------------------------------------------------------

    In conclusion, as discussed in detail above, we find that the SROs 
rules relating to disclosures of broker-dealer compensation from 
companies covered by the broker-dealers in research analyst reports 
meet the requirements of the Exchange Act, including Sections 6(b)(5), 
6(b)(8), 15A(b)(6) and 15A(b)(9).

D. Research Analyst Compensation Arrangements

    The proposed rules provide that SRO members may not pay any bonus, 
salary, or other form of compensation to a research analyst that is 
based upon a specific investment banking services transaction. In 
addition, analysts must disclose if their compensation is based upon 
(among other factors) the member's investment banking revenues. 
Generally, commenters agreed that analyst compensation should not be 
based on specific investment banking services transactions. Some 
commenters believed that if investment banking services transactions 
factored into analyst compensation in any way, there would be a 
competing incentive creating a conflict of interest.\49\ Other 
commenters believed that analyst compensation should be tied to the 
merit and success of recommendations, which would align analysts' 
compensation interest with research performance.\50\ Other commenters 
noted that research analysts provide valuable services to investment 
banking business and they should therefore be able to receive some form 
of compensation for their expertise and contributions.\51\ One 
commenter argued that the prohibition on compensation for specific 
investment banking transactions should be limited to transactions for 
public company clients.\52\
---------------------------------------------------------------------------

    \49\ See, e.g., Pacific Growth letter.
    \50\ See, e.g., AIMR letter.
    \51\ See, e.g., Wachovia letter; NYSBA letter.
    \52\ SunTrust letter.
---------------------------------------------------------------------------

    The NYSE and NASD believe that the proposed restrictions on analyst 
compensation are appropriate. By prohibiting compensation from specific 
investment banking transactions, the proposals would significantly 
curtail a potentially major influence on a research analyst's 
objectivity, without preventing a research analyst from sharing 
generally in the overall success of the firm, which may derive in part 
from investment banking transactions for subject companies. The SROs 
believe that investors can consider disclosure in research reports of 
whether the research analyst has been compensated based in part upon 
the member's investment banking revenues, in evaluating the objectivity 
of a research report.
    The Commission believes that the proposed amendments are a 
significant improvement on the existing SRO rules, which neither 
prohibit tying analyst compensation to specific investment banking 
activities nor require disclosure of analyst compensation arrangements. 
Moreover, the proposed disclosure requirements provide investors with 
material information regarding possible conflicts that an analyst may 
have, allowing them to better determine the value of the research in 
making investment decisions. Therefore, we find that the amendments 
relating to analyst compensation are consistent with the Exchange Act, 
including Sections 6(b)(5), 6(b)(8), 15A(b)(6) and 15A(b)(9).

[[Page 34974]]

E. Price Charts

    The proposed rules require disclosure of the percentage of all 
securities rated by the member to which the member would assign a 
``buy,'' ``hold/neutral,'' or ``sell'' rating, and the percentage of 
subject companies within each of these three categories for whom the 
member has provided investment banking services within the previous 
twelve months. The proposed rules also require members to present a 
line graph/chart of the security's daily closing prices for certain 
periods when the member has assigned a rating on that security for at 
least one year. The line graph/chart must indicate the dates on which 
the member assigned or changed each rating or price target and each 
rating and price target assigned or changed on those dates. In 
addition, the rules require members to provide the meanings of all 
ratings used by the member.
    Generally, commenters agreed with the goal of providing investors 
with information about the distribution of a firm's recommendations and 
price information about rated securities. However, some commenters 
argued that this information would be costly to broker-dealers while 
providing little actual benefit to investors.\53\ Other commenters 
expressed concern that certain electronically transmitted reports will 
not technologically support a price chart format, and that tables 
should therefore be permitted in those instances.\54\
---------------------------------------------------------------------------

    \53\ See, e.g., Morgan Stanley letter.
    \54\ See, e.g., CSFB letter.
---------------------------------------------------------------------------

    The SROs did not amend these provisions. We understand the SROs 
intend to provide guidance on a case-by-case basis that tables will be 
acceptable in situations where charts are not feasible so long as the 
table contains the information required by the rule.\55\
---------------------------------------------------------------------------

    \55\ Telephone conversation between NYSE, NASD, and Division 
Staff, on May 3, 2002.
---------------------------------------------------------------------------

    The Commission believes that these disclosures, including ratings 
distributions and price charts, are consistent with the Exchange Act. 
These provisions should help to address public concerns regarding the 
fact that analysts have issued very few sell ratings, and that firms 
often did not change recommendations even when a security's price was 
falling precipitously.\56\ The rule will assist investors in evaluating 
what value to place on the ratings assigned to securities.
---------------------------------------------------------------------------

    \56\ See, e.g., Keenan, ``Bad Advice: How Wall Street Analysts 
Burn Investors,'' Bloomberg, July 2000, page 24; Oppel, Jr., ``Wall 
Street Analysts Faulted on Enron,'' New York Times, February 28, 
2002; Smith & Lucchetti, ``Analysts'' Picks of Enron Stock Face 
Scrutiny,'' Wall Street Journal, February 26, 2002.
---------------------------------------------------------------------------

    As a result, the Commission finds that the disclosures relating to 
ratings distributions and price charts should help perfect the 
mechanism of a free and open market, and protect investors and the 
public interest, consistent with the Exchange Act, particularly 
Sections 6(b)(5) and 15A(b)(6). Further, the Commission finds that such 
disclosure imposes no burden on competition not necessary or 
appropriate in furtherance of the purposes of the Exchange Act, 
consistent with the requirements of Exchange Act Sections 6(b)(8) and 
15A(b)(9).

F. Prominence of Disclosures

    The proposed SRO rules require that the front page of a research 
report either must include the disclosures required under the rules, or 
must refer the reader to the page or pages in the report on which each 
such disclosure is found. Disclosures, and references to disclosures, 
are required to be clear, comprehensive and prominent. No commenters 
disagreed with these requirements. However, some commenters argued that 
the provisions requiring that disclosures be prominent may present 
difficulties in the context of electronic reports.\57\
---------------------------------------------------------------------------

    \57\ See, e.g., Wachovia letter; PSI letter.
---------------------------------------------------------------------------

    The Commission believes that these proposals are essential to alert 
investors to analysts' conflicts. With respect to compendium reports, 
the SROs' response to provide alternative access where the required 
disclosures would be voluminous is reasonable. Importantly, a 
compendium must contain clear and prominent information about where 
investors may obtain disclosures about securities discussed in the 
compendium. Therefore, the Commission finds that these provisions are 
consistent with the Exchange Act, specifically Sections 6(b)(5), 
6(b)(8), 15A(b)(6) and 15A(b)(9).

G. Quiet Periods Following the Issuance of Research Reports

    Commenters heavily criticized the SROs' proposal to bar firms that 
acted as manager or co-manager of the subject company's offering from 
publishing research about the issuer for forty days following an IPO 
and for ten days following a secondary (i.e., non-IPO) offering. 
Commenters argued that these prohibitions were inconsistent with the 
spirit of Rules 138, 139, and 174 of the Securities Act \58\ as well as 
Regulation M,\59\ and that the rules would impede the flow of 
information at a time when information is most useful.\60\ Commenters 
also argued that the provisions should not apply to secondary offerings 
for seasoned issuers, because underwriter research would not have as 
great an influence on these securities.\61\ Commenters further argued 
that the rules would unfairly discriminate against managers and co-
managers as compared to other syndicate members that are not subject to 
the quiet periods.\62\ Many commenters also asserted that the 
provisions would disadvantage domestic firms that would be subject to 
these restrictions as compared to foreign competitors who would not 
need to comply with the rules when distributing research to 
institutions under Exchange Act Rule 15a-6.\63\ These commenters noted 
that, therefore, the restrictions would harm retail investors who, 
unlike institutional investors, would not have access to research from 
the manager or co-manager during this period.\64\ One commenter, 
however, supported the proposals and argued that there should be no 
exceptions for seasoned issuers.\65\
---------------------------------------------------------------------------

    \58\ 17 CFR 230.138, 230.139, and 230.174.
    \59\ 17 CFR 242.101-105.
    \60\ See, e.g., Sullivan & Cromwell letter; Merrill Lynch 
letter; SSB letter.
    \61\ See, e.g., SIA letter; Goldman Sachs letter.
    \62\ See, e.g., Cleary letter; A.G. Edwards letter; Morgan Lewis 
letter.
    \63\ 17 CFR 240.15a-6. See, e.g., Dorsey letter; HSBC letter; 
Fried Frank letter.
    \64\ See, e.g., Morgan Stanley letter.
    \65\ AIMR letter.
---------------------------------------------------------------------------

    With regard to commenters' concerns, the NYSE and NASD noted that 
the rules are not intended to prevent a managing or co-managing 
underwriter from issuing a positive research report. Rather, the quiet 
period will reinforce the prohibition against a member offering to 
reward a subject company for its securities underwriting business by 
publishing favorable research right after the completion of the 
distribution. The SROs also stated their belief that the quiet period 
for an IPO will permit market forces to determine the price of the 
security in the aftermarket unaffected by research reports issued by 
firms with the most substantial interest in the offering. Finally, the 
SROs noted that while the rules will prohibit the managers and co-
managers from publishing research reports during the quiet period, 
other broker-dealers will be able to initiate and maintain research 
coverage on the subject company.
    The NASD and NYSE filed amendments to respond to commenters' 
concerns about the proposed quiet period for secondary offerings. The 
amendments provide an exception for research reports that are issued 
under Rule 139 under the Securities Act as to those issuers whose 
securities are

[[Page 34975]]

actively traded as defined in Rule 101(c)(1) of Regulation M.\66\ The 
SROs noted the proposed amendments would support market efficiency by 
permitting the dissemination of research reports for certain actively 
traded securities.
---------------------------------------------------------------------------

    \66\ 17 CFR 242.101(c)(1).
---------------------------------------------------------------------------

    We believe that the determination of the SROs to impose a quiet 
period for IPOs, while different from the requirements under Commission 
rules under the Securities Act, is consistent with the Exchange Act. 
Some commenters stated that the forty-day quiet period was inconsistent 
with Securities Act Rule 174.\67\ We do not agree. Under Section 4(3) 
of the Securities Act \68\ and Rule 174 thereunder, a dealer (including 
an underwriter no longer acting as an underwriter) may not distribute a 
prospectus (including a research report) unless accompanied or preceded 
by a prospectus satisfying the requirements of Section 10 of the 
Securities Act \69\ during the twenty-five days following an IPO for a 
security listed on a national securities exchange or on Nasdaq. For 
most IPOs of other securities, the prospectus delivery period is ninety 
days. In practice, dealers (including the underwriters) do not issue 
research during this period (and it also has been called a quiet 
period).
---------------------------------------------------------------------------

    \67\ 17 CFR 230.174. See, e.g., ABA letter.
    \68\ 15 U.S.C. 77(d)(3).
    \69\ 15 U.S.C. 77j.
---------------------------------------------------------------------------

    The NASD and NYSE rules apply only to the manager and co-manager(s) 
of an IPO. With respect to these firms, the rules in effect extend the 
quiet period in many cases by fifteen days. The quiet period should act 
to reinforce the prohibition on the use of research reports as an 
inducement for investment banking business. A promise of favorable 
research as an inducement to an issuer to use a particular firm's 
investment banking services will likely not be as attractive if the 
research potentially will follow research issued by other analysts. 
During this period, investors will not be bereft of information, as 
they will be able to consider the reports of independent analysts as 
well as other syndicate members for fifteen days until the lead 
underwriters may again publish research. In our view, the quiet period 
is an acceptable means to mitigate the pressures to solicit business on 
the basis of favorable research.
    We agree with the conclusion of the SROs that the argument that 
institutions will have greater access to research (such as from foreign 
firms) than will U.S. retail investors during the forty-day quiet 
period is not determinative of the value of these rules. If the 
security is followed by others than the manager or co-manager, this 
research may be available to institutions and retail investors alike. 
The fact that institutions may have greater access to research from 
sources not subject to these rules does not diminish the salutary 
effect of the quiet period with respect to research issued by managers 
or co-managers of offerings.
    The SROs have a valid rationale for imposing the forty-day quiet 
period for IPOs and there is no conflict with Securities Act Rule 174. 
Thus, we view the rules as consistent with the Exchange Act.
    The SROs' determination to except from the ten-day quiet period 
research in connection with secondary offerings for seasoned issuers 
whose securities are actively traded appears consistent both with the 
spirit of the proposals and the securities laws. As many commenters 
have pointed out, Rules 139 of the Securities Act and Regulation M 
recognize that research on large seasoned issuers will have a 
relatively lower market impact.\70\ Because there is likely to be 
substantial information regarding these issuers in the marketplace, 
investors are less likely to be influenced by any one research report, 
even one issued by a managing underwriter, and there is a lower 
likelihood that investment banking business will be tied to a favorable 
research report.
---------------------------------------------------------------------------

    \70\ The SROs have not included a reference to Securities Act 
Rule 138 in their rule amendments, as some commenters suggested, 
because the quiet period applies only to offerings of equity 
securities. Telephone conversation between NYSE, NASD, and Division 
Staff, on May 3, 2002.
---------------------------------------------------------------------------

    As discussed above, the Commission believes that the SROs' rules 
relating to quiet periods should permit market forces to determine the 
price of the security in the aftermarket unaffected by research reports 
issued by firms with the most substantial interest in the offering. The 
Commission finds that, as a result, these rules are consistent with the 
Exchange Act, particularly Sections 6(b)(5), 6(b)(8), 15A(b)(6) and 
15A(b)(9), in that they should help prevent fraudulent and manipulative 
practices, help perfect the mechanism of a free and open market, and 
protect investors and the public interest. Further, we believe that the 
rules will not impose any burden on competition that is not necessary 
or appropriate to achieve the goals of the Exchange Act.

H. Disclosure of Firm Ownership of Securities

    The SROs' original proposals would have required disclosure in 
reports or appearances if, as of five business days before the 
publication of the research report or a public appearance, the firm or 
its affiliates beneficially owned 1% or more of any class of common 
equity securities of the subject company.
    Commenters almost uniformly opposed this provision.\71\ Most 
commenters argued the ownership threshold and rolling look-back 
component were impractical, because they imposed a lower ownership 
disclosure and more onerous timing than Sections 13(d) and 13(g) of the 
Exchange Act.\72\ Several commenters noted that concerns would be 
mitigated if firms were permitted instead to disclose 5% beneficial 
ownership on a quarterly basis, as required under Section 13.\73\ 
Otherwise, commenters argued, member firms would incur costly systems 
changes to track beneficial ownership at the proposed 1% threshold on a 
rolling five-day look back basis.\74\
---------------------------------------------------------------------------

    \71\ See, e.g., Goldman Sachs letter; Morgan Stanley letter; UBS 
letter; SIA letter.
    \72\ 15 U.S.C 78m(d), (g).
    \73\ See, e.g., UBS letter.
    \74\ See, e.g., Morgan Stanley letter.
---------------------------------------------------------------------------

    In response to these concerns, the SROs filed amendments with a 
more flexible approach that does not undermine the effectiveness of the 
proposals. The amended provisions require disclosure of the 1% 
ownership as of the month-end prior to issuance of the research report 
or public appearance, determined within ten calendar days after the 
month-end. In the event that the research report or public appearance 
is made less than ten calendar days from the end of the previous month, 
the 1% disclosure may be as of the end of the second most recent month.
    The Commission believes that this disclosure will provide investors 
with useful information to better evaluate the nature and extent of a 
firm's financial interest in a recommended company. The Commission 
believes the disclosure requirements under the proposals represent a 
significant improvement over the current ownership disclosure rules of 
the NASD and NYSE, which are inconsistent with one another and allow 
for conditional disclosure of financial interests. The amendments to 
the original proposal respond to commenters' concerns by reducing the 
burden of the frequency of calculations, while continuing to provide 
readers of research reports with reasonably timely disclosure of 
ownership. The snapshot approach of a monthly calculation is much less 
onerous than the original rolling requirement. The Commission

[[Page 34976]]

also notes that although the 1% ownership threshold is lower than that 
tracked for Section 13 purposes, it is actually less burdensome than 
the current requirement under NASD Rule 2210, which has no minimum 
threshold. Therefore, the Commission finds that the rules relating to 
disclosure of firm ownership of securities is consistent with the 
Exchange Act, particularly Sections 6(b)(5), 6(b)(8), 15A(b)(6) and 
15A(b)(9).

I. Restrictions on Personal Trading by Research Analysts

    The proposal prohibits analysts and their household members from: 
(1) purchasing or receiving pre-IPO shares in companies/industries that 
are the subject of their research reports; (2) trading in recommended 
securities thirty days prior and five days after issuance of a research 
report or a change in rating or price target; and (3) trading in a 
manner contrary to the analyst's recommendations.
    Some commenters believed that research analysts should not be 
singled-out for special restrictions.\75\ Others argued that research 
analysts should only be required to obtain pre-approval of trades.\76\ 
One commenter said that analysts should be banned from any trading in 
securities that they cover.\77\ There was general agreement among 
commenters that an analyst should not trade in a manner contrary to his 
or her recommendations.
---------------------------------------------------------------------------

    \75\ See, e.g., AIMR letter.
    \76\ See, e.g., AIMR letter; A.G. Edwards letter.
    \77\ NASAA letter.
---------------------------------------------------------------------------

    The NYSE and NASD believe that disclosure alone is not sufficient 
to mitigate the conflicts of interest that can arise when a research 
analyst invests in securities of companies he covers, particularly with 
respect to the purchase or receipt of pre-IPO shares. Accordingly, the 
SROs included personal trading restrictions in addition to requiring 
associated persons to disclose any financial interest they or a 
household member may have in a subject company. Pre-IPO shares often 
are acquired at low cost, but are likely to generate substantial 
profits when a public offering is made of the issuer's equity. The 
desire to liquefy holdings of these securities can create a strong 
incentive for an analyst to publish favorable research. Commenters also 
expressed concern that the thirty and five-day trading restrictions 
could significantly interfere with the production of research. The 
effect of this provision is to prevent the analyst from issuing 
research if she has traded in securities of the subject company within 
the preceding thirty days. The firm could still publish research on the 
company if it is prepared by another analyst.
    We think the trading restrictions, while stringent, have been 
justified by the SROs as needed to remove an incentive to trade around 
the time of issuing a research report that could affect the value of 
the acquired security, thereby increasing the reliability of published 
research. Moreover, the trading prohibitions are not absolute. They 
limit trading only close in time to the issuance of a research report. 
Changing holdings outside of these time frames is still permitted. The 
rules also contain an exception for significant changes in the 
analyst's financial circumstances if the analyst receives approval for 
a transaction from the legal/compliance department. In addition, the 
SRO rules provide that an analyst can dispose of an existing position 
in a security when the analyst initiates coverage of the issuer, to 
avoid being constrained from changing its holdings.
    Finally, the proposed rules, as amended, also contain exceptions to 
the prohibitions on analyst personal trading for the purchase or sale 
of the securities of a registered diversified investment company as 
defined under Section (5)(b)(1) of the Investment Company Act of 1940, 
or any other investment fund that neither the analyst nor a member of 
the research analyst's household has any investment discretion or 
control, provided that: the research analyst accounts collectively own 
interests representing no more than 1% of the assets of the fund; the 
fund invests no more than 20% of its assets in securities of issuers 
principally engaged in the same types of business as companies that the 
research analyst follows; and, if the investment fund distributes 
securities in kind to the research analyst or household member before 
the issuer's initial public offering, the research analyst or household 
member must either divest those securities immediately or refrain from 
participating in the preparation of research reports regarding that 
issuer.
    Some commenters suggested changes to these exceptions.\78\ 
Commenters raised issues regarding the treatment of bank collective 
funds as compared to the treatment of diversified investment companies, 
as defined by the Investment Company Act of 1940; \79\ potential 
difficulty in monitoring the 1% and 20% thresholds after the initial 
investment was made; \80\ and interpretive questions regarding the 20% 
threshold.\81\ The SROs did not make any changes to this exception 
other than to conform the text of their rules. We believe that these 
provisions are consistent with the Act and that these matters raised by 
commenters can be addressed through an interpretive process.
---------------------------------------------------------------------------

    \78\ See, e.g., NYSBA letter.
    \79\ ABASA letter.
    \80\ See, e.g., Goldman Sachs letter; Nomura letter.
    \81\ See, e.g., Moran Lewis letter; NASAA letter.
---------------------------------------------------------------------------

    A number of commenters questioned whether the term ``household 
member'' would include roommates and other unrelated persons who occupy 
the same residence as an associated person.\82\ These commenters argued 
``household member'' should be limited to family members and others who 
are financially dependent on the associated person. While it seems 
appropriate that dependents be covered, it is not clear that the term 
should be limited to these relationships. The NYSE and NASD agree that 
interpretations may be necessary to address specific applications of 
the term.\83\
---------------------------------------------------------------------------

    \82\ See, e.g., SunTrust letter.
    \83\ In this context and others where interpretations of terms 
may be required, we expect that the NYSE and NASD will consult with 
each other.
---------------------------------------------------------------------------

    The NASD and NYSE rules relating to trading by analysts and their 
household members should help mitigate conflicts of interest that can 
arise when a research analyst invests in the securities of companies 
the analyst covers, particularly when that investment is in pre-IPO 
shares. The Commission finds that these rules are consistent with the 
Exchange Act, particularly Sections 6(b)(5) and 15A(b)(6). By reducing 
the likelihood that analysts will face conflicts of interest, these 
rules should help prevent fraudulent and manipulative acts and 
practices, help perfect the mechanism of a free and open market, and 
protect investors and the public interest.\84\ In addition, consistent 
with Sections 6(b)(8) and 15A(b)(9) of the Exchange Act, burdens on 
competition not necessary or appropriate in the furtherance of the 
purposes of the Exchange Act.
---------------------------------------------------------------------------

    \84\ The proposed rules require that a senior officer submit an 
annual attestation that the member organization has established and 
implemented procedures reasonably designed to comply with the new 
rules. One commenter thought that these rules should not be singled 
out for attestation. See A.G. Edwards letter. Another commenter 
thought that an attestation requirement should extend to individual 
analysts. See AIMR letter. The SROs determined to retain the 
attestation requirement. We find that this requirement is consistent 
with the Exchange Act.
---------------------------------------------------------------------------

J. Implementation

    Several commenters requested that the rule changes be phased in 
over a staggered period, if adopted, because

[[Page 34977]]

some of the proposals require the development of new disclosure systems 
and procedures that will require time to create, test, and 
implement.\85\ At least one commenter suggested up to a twelve-month 
implementation period for certain disclosure provisions.\86\ Commenters 
also noted that amendments to certain disclosures could significantly 
shorten the timeframe and reduce the costs for implementation.\87\
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    \85\ See, e.g., SIA letter; CSFB letter; SSB letter.
    \86\ See, e.g., SIA letter.
    \87\ See, e.g., Morgan Stanley letter.
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    In response to the comments, the SROs decided upon the following 
implementation schedule for the proposed amendments (all time periods 
run from the date that the Commission approves the filings) in order to 
provide reasonable time periods for members and member organizations to 
develop and implement policies, procedures and systems to comply with 
the new requirements:
     Disclosure of 1% firm ownership positions--180 calendar 
days.
     Legal/compliance department intermediation--120 calendar 
days.
     Charts of ratings distribution--120 calendar days.
     Price charts--120 calendar days.
     All other provisions--60 calendar days.
    The Commission believes that the above implementation schedule 
suggested by the SROs is reasonable, especially given that the NYSE and 
NASD made a number of substantive amendments to their original proposal 
to reduce burdens in response to concerns raised by commenters.
    Some commenters asserted that the proposed rules would aggravate 
the competitive imbalance between research practices within the United 
States (``U.S.'') and those outside the U.S., and provide an incentive 
for issuers and institutional investors to turn to other capital 
markets and obtain research that is subject to less stringent 
regulation.\88\ Maintaining the preeminent role of the U.S. capital 
markets and guarding against unfair competition are substantial 
concerns for the Commission. In today's dynamic environment, we believe 
that the proposed rule changes likely will increase confidence in the 
integrity of our markets, which may further attract issuers to the U.S. 
for their capital raising needs.\89\ We also note that the SROs intend 
to further consider the issue of research prepared by affiliates, 
including foreign affiliates, distributed by members within the U.S.
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    \88\ See, e.g., ABA letter.
    \89\ For example, the International Organization of Securities 
Commissions currently has a task force considering research 
dissemination.
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    Some aspects of the rules incorporate novel approaches to dealing 
with conflicts problems. In addition, the quiet periods and the 
``gatekeeper'' requirements attracted substantial negative comment 
about their potential impact on firms and the markets.\90\ The rules 
may have effects that cannot be foreseen at this time. Therefore, we 
believe that the NASD and the NYSE should assess the operation and 
effectiveness of the rule amendments approved today after they have 
been in effect for a suitable period. Accordingly, we request that the 
SROs prepare a report on the operation and effectiveness of these 
provisions and submit it, together with any recommendations for changes 
or additions to the rules, on or before November 1, 2003 or sooner if 
the SROs determine it is warranted. Moreover, on April 25, 2002, the 
Commission announced that it had commenced a formal inquiry into market 
practices concerning research analysts and the conflicts that can arise 
from the relationship between research and investment banking. It is 
possible that this inquiry will indicate the need for further SRO 
rulemaking or additional Commission action.\91\
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    \90\ See, e.g., SIA letter.
    \91\ The Commission notes that when an analyst or her firm 
issues a recommendation that is knowingly false, or made without a 
reasonable basis in fact, it may operate as a fraud and deceit on 
investors in violation of the federal securities laws, including 
Securities Act Section 17(a) and Exchange Act Sections 10(b) and 
15(c) and Rules 10b-5 and 15c1-2 thereunder. See, e.g., Heft, Kahn & 
Infante, Inc., 41 SEC 379, 386-390 (1963); See also Hanly v. SEC, 
415 F.2d 589 (2d Cir. 1969); Mac Robbins & Co., 41 SEC 116, 119 
(1962), aff'd sub nom. Berko v. SEC, 316 F.2d 137 (2d Cir. 1963) 
(``the making of recommendations to prospective purchasers without a 
reasonable basis, couched in terms of either opinion or fact 
designed to induce purchases, is contrary to the basic obligation of 
fair dealing borne by those who engage in the sale of securities to 
the public''). Cf. Virginia Bankshares, Inc. v. Sandberg, 501 U.S. 
1083 (1991) (discussing when false statements of opinion can give 
rise to anti-fraud liability under Exchange Act Section 14(a) and 
Rule 14a-9).
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V. Accelerated Approval of Amendments; Solicitation of Comments

    The Commission finds good cause to approve NYSE Amendment No. 1 and 
NASD Amendment No. 2 to the proposed rule changes prior to the 
thirtieth day after the date of publication of notice of filing of the 
amendments in the Federal Register. The original proposed rule changes 
and NASD Amendment No. 1 were published in the Federal Register.\92\ 
The Commission believes that NYSE Amendment No. 1 and NASD Amendment 
No. 2 clarify the obligations of SRO members under the rules, refine 
the rules and make the NASD and NYSE proposals consistent with each 
other.\93\ The amendments do not contain major modifications from the 
scope and purpose of the rules as originally proposed, and were 
developed from the original proposal. Further, the majority of the 
modifications contained in the amendments submitted by the NASD and 
NYSE were made in response to comments received on the proposed rule 
changes. The Commission believes, moreover, that approving NYSE 
Amendment No. 1 and NASD Amendment No. 2 will provide greater clarity, 
thus furthering the public interest and the investor protection goals 
of the Exchange Act. Finally, the Commission also finds that it is in 
the public interest to approve the rules as soon as possible to 
expedite the implementation of the new and amended rules.
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    \92\ Release No. 34-45526 (March 8, 2002), 67 FR 11526 (March 
14, 2002).
    \93\ The text of the amendments are available at http://www.nasdr.com/filings/rf02_21.asp and http://www.nyse.com/regulation/regulation.html.
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    Accordingly, the Commission believes good cause exists, consistent 
with Sections 6(b)(5), 15A(b)(6) and 19(b) of the Exchange Act,\94\ to 
approve NYSE Amendment No. 1 and NASD Amendment No. 2 to the proposed 
rule changes on an accelerated basis.
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    \94\ 15 U.S.C. 78f(b)(5), 78o-3(b)(6), and 78s(b).
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    Interested persons are invited to submit written data, views, and 
arguments concerning NYSE Amendment No. 1 and NASD Amendment No. 2, 
including whether the amendments are consistent with the Exchange Act. 
Persons making written submissions should file six copies thereof with 
the Secretary, Securities and Exchange Commission, 450 Fifth Street, 
NW., Washington, DC 20549-0609. Copies of the submission, all 
subsequent amendments, all written statements with respect to the 
proposed amendments that are filed with the Commission, and all written 
communications relating to the amendments between the Commission and 
any person, other than those that may be withheld from the public in 
accordance with the provisions of 5 U.S.C. 552, will be available for 
inspection and copying at the Commission's Public Reference Room. 
Copies of such filing also will be available for inspection and copying 
at the principal office of the SROs.
    All submissions should refer to File No. SR-NASD-2002-21 and SR-
NYSE-

[[Page 34978]]

2002-09 and should be submitted by [June 17, 2002].

VI. Conclusions

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Exchange Act,\95\ that the proposed rule changes (SR-NASD-2002-21; SR-
NYSE-2002-09), as amended, are approved.
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    \95\ 15 U.S.C. 78s(b)(2).

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-12207 Filed 5-15-02; 8:45 am]
BILLING CODE 8010-01-P