SEC Approves NASD, NYSE Analyst Rules – Who Benefits?

New regulations enacted to address analyst conflicts, and insure disclosure. Given the fact that such regulations already exist, who is benefiting from these new regulations?

By Mark J. Astarita, Esq.

On May 8, 2002, the SEC approved proposed rule changes by the NASD and the NYSE to address conflicts of interest that are raised when research analysts recommend securities in public communications. The issue has arisen during the past few months, and made headlines, as investigations have revealed the existence of these conflicts at some broker-dealers.

Conflicts of interest can arise when analysts work for firms that have investment banking relationships with the issuers of the recommended securities, or when the analyst or firm owns securities of the recommended issuer. While no one can seriously argue that the underlying concept of the rules are not proper, there is a serious concern as to the necessity of yet another set of rules governing the brokerage industry, and whether such exacting and radical rules are required.

Over-regulation is an existing and ongoing problem in the securities industry, and the creation of even more rules will not be a welcome event for those who work in the industry. Additional rules require additional staff, additional time, additional reporting, and additional costs. The ultimate cost of such rules is borne by the investor, in this case, by less research, less information, and perhaps higher commissions.

Before I am misunderstood, I am not advocating saving money over investor protection. The simple fact is that every abuse that has been alleged in the research analyst area is already a violation of existing rules, and certainly a violation of the anti-fraud provisions of the securities acts and regulations.

It certainly appears that these violations exist at some brokerage firms, as demonstrated by the investigation by the New York Attorney General Elliot Spitzer, as reflected in the affidavits filed in court by his office in their proceeding against Merrill Lynch. These new rules are a significant improvement over the proposed rules floated by the NASD earlier this year, (see Analyst Disclosure Issue Would Snag Brokers) and in creating a specific prohibition on a practice, the exchanges have given themselves the ability to deal with violations in a much easier manner.

But is the goal of the securities laws to make a regulator’s work easier? While some will immediately jump on these new rules, the creation of specific rules simply leads to more controversy. Haven’t the regulatory bodies learned from 70 years of securities law enforcement? In 1934 when Congress created the Securities Exchange Act of 1934, it had the foresight to create an anti-fraud provision which was specific enough to provide notice of a violation, and broad enough to cover whatever scheme a person could conceive.

The securities industry is the most regulated industry in the nation, and the practices that these new rules are designed to attack are currently violations of existing law. The anti-fraud provisions of the Securities Exchange Act of 1934, and the court interpretations of that act, prohibit the undisclosed conflicts of interest that the new rules are intended to address. For example , is there anyone who doubts that Rule 10b-5 prohibits an analyst from purchasing the subject security for his own benefit in the days leading up to the release of a new buy rating? Can it seriously be argued that an analyst who presents the draft of his “independent” research report to management of the subject company for review and comment has committed a fraud by misrepresenting the independent nature of the report? Doesn’t the failure to disclose that an analyst has been compensated based on the revenues generated from the subject company violate existing securities laws? Isn’t it clear that publishing a research report that is not based on fact is a violation of law?

The answers to those questions are of course, yes. All of the foregoing violates existing law, and there is no real need for any of the new provisions from a legal standpoint. This fact was demonstrated by the NASD itself. On May 7, the day before the approval of the new rules, the NASD announced the imposition of significant sanctions against a brokerage firm for its alleged improper research reports.

The firm, a small broker-dealer in New York, was fined $100,000 and forced the firm to suspend its research activities for six months and, before resuming research reports, to retain an outside consultant to review and make recommendations concerning the firm’s procedures relating to research reports. This is a significant fine for a small firm, and the suspension of research reports for six months will undoubtedly impact its business.

While I do not know anything about that case other than the press reports, the significant part of the story is the press release by the NASD regarding same. First, a press release is a bit unusual, in that there are dozens and dozens of fines and censures levied against any of the 5,000 broker-dealers in this country every month. However, what was significant was the NASD’s recognition that the conduct was “in violation of NASD antifraud and advertising rules, as well as the antifraud provisions of the federal securities laws.”

Clearly the allegations made by the NASD against this broker-dealer, if true, violated existing law. Likewise, the allegations made by the New York Attorney General against Merrill Lynch, if true, are also violations of existing law, and virtually every allegation made in the entire controversy over analyst recommendations violates existing law.

So why all of these new regulations? Securities regulation is often more about perception than reality, and unfortunately, is sometimes about the regulators themselves than the public good.

Clearly these accusations against the analysts at major brokerage firms have had an impact on the public’s perception of the industry, and the confidence of the public in the markets themselves. Clearly, when we learn that an analyst who has a buy rating on a stock is calling that same stock “a piece of crap” in emails to his colleagues, there is a problem.

What these new rules do is to make it easier for regulators to establish and prove violations. NASD Chairman and CEO Robert R. Glauber admitted that existing rules cover the allegation violations in an NASD press release regarding the new rules, stating “[o]ur new rules will greatly strengthen NASD’s hand in bringing cases in this area. But as demonstrated by our enforcement record in this area, NASD has not hesitated to use its existing enforcement tools against analysts whose conduct has undermined market integrity.” It is a bit more work for a regulator to prove the violation of a rule like 10b-5 than the violation of a specific rule addressed to a specific act or disclosure. The problem is that the securities regulatory scheme is not designed to make life easy for regulators, it is designed to protect the investing public.

Some say what is the harm. The harm is turning the securities laws into the IRS code, and making these regulations so complicated that they become impossible to comply with. The industry, particularly in the area of retail sales, has a significant problem in compliance with the morass of rules and regulations. In fact, more than one commentator has noted that it is already impossible for a broker-dealer to completely comply with every rule and regulation that applies to their business. A regulatory system that is too complicated to comply with promotes noncompliance and unfortunately, selective compliance, and increased costs to the investor as brokers are forced to recoup their additional costs.

Additionally, some of the top research in this country is put out by the small regional firms. A recent study of brokerage firm recommendations found that the major firms have the worst track record in making investment recommendations, and that the smaller firms do significantly better. What service was done for investors when the firms with the best stock recommendations are forced to stop making recommendations because of overbearing regulations?

And that overlooks the fact that there has been a $100,000 fine against the small broker dealer, verses no fines, and no actions, against the “big” broker-dealers. The Merrill Lynch settlement was $100 million, but that is substantially less than Merrill spends in postage and office supplies in a year. The $100,000 fine against the small broker-dealer was undoubtedly a significant hit to its capital. Are we seeing not only selective compliance, selective enforcement and even discriminatory fines and penalties? Is this where these new regulations are going to lead?

Nevertheless, there are new rules, and those rules are significant. In fact, the rules may radically alter the way research is conducted and distributed. Time will tell whether these changes are to the benefit of the public, or to the detriment of the financial markets in general.

The more significant provisions of the new rules are:

PROMISES OF FAVORABLE RESEARCH. One of the more significant issues raised by the New York Attorney General is the allegation of collusion between the company that is the subject of a research report, and the brokerage firm A prohibition against analysts offering, or threatening to withhold, a favorable research rating or specific price target to induce investment banking business from companies. While such conduct would undoubtedly violate existing fraud rules, the rule changes also impose “quiet periods” that bar a firm that is acting as manager or co-manager of a securities offering from issuing a report on a company within 40 days after an initial public offering or within 10 days after a secondary offering for an inactively traded company.

ANALYST COMPENSATION. The new rules will bar securities firms from basing an analyst’s compensation to specific investment banking transactions. This issue was a significant issue for the industry, as someone must pay for research. Firms have often based analyst compensation on firm revenues, or on a more specific measure of investment banking fees. The rules not only prohibit compensation based on a specific transaction, the new rules require specific disclosure in all research reports if an analyst’s compensation is based on the firm’s general investment banking revenues. This should make for some interesting disclosures on new research reports; or the elimination of the practice.

LIMITATIONS ON RELATIONSHIPS AND COMMUNICATIONS. A prohibition on using the investment banking department from supervising research analysts. In addition, investment banking personnel will be prohibited from discussing research reports with analysts prior to distribution, unless staff from the firm’s legal/compliance department monitor those communications. Analysts will also be prohibited from sharing draft research reports with the target companies, other than to check facts after approval from the firm’s legal/compliance department. This provision helps protect research analysts from influences that could impair their objectivity and independence. Once again, sharing a draft report with the subject company, for purposes of obtaining approval of the report, would undoubtedly violate existing fraud statutes.

FIRM COMPENSATION. The rule changes will require a securities firm to disclose in a research report if it managed or co-managed a public offering of equity securities for the company or if it received any compensation for investment banking services from the company in the past 12 months. A firm will also be required to disclose if it expects to receive or intends to seek compensation for investment banking services from the company during the next 3 months.

RESTRICTIONS ON PERSONAL TRADING BY ANALYSTS. The rule changes will bar analysts and members of their households from investing in a company’s securities prior to its initial public offering if the company is in the business sector that the analyst covers. In addition, the rule changes will require “blackout periods” that prohibit analysts from trading securities of the companies they follow for 30 days before and 5 days after they issue a research report about the company. Analysts will also be prohibited from trading against their most recent recommendations. This provision has been the subject of much controversy, as there has been no showing that such a rule is necessary, and no showing that analysts are buying, or selling, the stock in anticipation of their own research reports. Of course, such a practice would be a clear violation of Rule 10b-5, and the SEC has instituted cases against analysts and other individuals when such trading has occurred in the past. The SEC, NASD and NYSE have not publicly disclosed any information that would lead anyone to believe that such a practice is widespread, and there is nothing disclosed to demonstrate that such a broad prohibition against trading is necessary or required.

DISCLOSURES OF FINANCIAL INTERESTS IN COVERED COMPANIES. The rule changes address another issue which is already prohibited, and require analysts to disclose if they own shares of recommended companies. Firms will also be required to disclose if they own 1% or more of a company’s equity securities as of the previous month end. Requiring analysts and securities firms to disclose financial interests can alert investors to potential biases in their recommendations.

DISCLOSURES IN RESEARCH REPORTS REGARDING FIRM’S RATINGS. The rule changes will require firms to clearly explain in research reports the meaning of all ratings terms they use, and this terminology must be consistent with its plain meaning. Additionally, firms will have to provide the percentage of all the ratings that they have assigned to buy / hold / sell categories and the percentage of investment banking clients in each category. Firms will also be required to provide a graph or chart that plots the historical price movements of the security and indicates those points at which the firm initiated and changed ratings and price targets for the company. The reality is that this change, by itself, may cause the elimination of research reports from brokerage firms. While the major wirehouses have the ability and financial backing to prepare lengthy disclosures, charts and graphs, smaller regional firms, where research is often published by one person or a small team, simply do not.

DISCLOSURES DURING PUBLIC APPEARANCES BY ANALYSTS. The rule changes will require disclosures from analysts during public appearances, such as television or radio interviews. Guest analysts will have disclose if they or their firm have a position in the stock and also if the company is an investment banking client of the firm. This disclosure will inform investors who learn of analyst opinions and ratings through the media, rather than in written research reports, of analyst conflicts.

The Commission will request the NASD and NYSE to report within a year of implementing these rules on their operation and effectiveness, and whether they recommend any changes or additions to the rules. These rules are part of an ongoing process by the Commission, NASD, NYSE, and the states to address conflicts of interest affecting the production and dissemination of research by securities firms.

Analysts recommendations and conflicts is certainly an important topic, and a situation which must be addressed by regulators. The Commission has previously 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. Approval of these new rules is the first step, and the Commission has stated that it is possible that this inquiry will indicate the need for further rulemaking by the NASD and NYSE or additional Commission action.

How about simply enforcing existing rules in a meaningful fashion?

Nothing herein is intended as legal or financial advice. The law is different in different jurisdictions, and the facts of a particular matter can change the application of the law. Please consult an attorney or your financial advisor before acting upon the information contained in this article.


Copyright 2010. VGIS Communications LLC. All Rights Reserved. VGIS Communications 60 Pompton Avenue, Verona, New Jersey 07044 – 973-559-5566. Nothing herein is intended as legal or financial advice. The law is different in different jurisdictions, and the facts of a particular matter can change the application of the law. Please consult an attorney or your financial adviser before acting upon the information contained in this article. For additional information, contact Mark J. Astarita, Esq., a partner in the law firm of Sallah Astarita & Cox, who represents clients in a wide variety of finance related matters. Mr. Astarita can be contacted by email at or at New York Securities Lawyer.


Securities Attorney at Sallah Astarita & Cox | 212-509-6544 | | Website | + posts

Mark Astarita is a nationally recognized securities attorney, who represents investors, financial professionals and firms in securities litigation, arbitration and regulatory matters, including SEC and FINRA investigations and enforcement proceedings.

He is a partner in the national securities law firm Sallah Astarita & Cox, LLC, and the founder of The Securities Law Home Page -, which was one of the first legal topic sites on the Internet. It went online in 1995 and is updated daily with news, commentary and securities law related links.