30 October 2002

 

Mr. Usman Butt
Business Standards Department
Conduct of Business Standards Division
Financial Services Authority
25 The North Colonnade
Canary Wharf
London E14 5HS
United Kingdom

 

Re: Discussion Paper 15 - "Investment Research: Conflicts and Other Issues" (Ref. FSA DP15)

 

Dear Mr. Butt:

 

The European Advocacy Committee ("EAC" or the "Committee") of the Association for Investment Management and Research ("AIMR")¹ is pleased to comment on the Financial Services Authority's ("FSA" or the "Authority") discussion paper, Investment Research: Conflicts and Other Issues ("DP 15" or the "Paper"). The EAC is a standing committee of AIMR charged with reviewing and responding to major new regulatory, legislative, and other developments that may affect investors, the investment profession, and the efficiency and integrity of European financial markets.

 

General Comments

 

Investment research, including research produced by sell-side firms, is vital to the efficient functioning of global capital markets. Moreover, investment research is an efficient way of disseminating critical information about the relative value of specific securities into the hands of investors. Without such analyses, investors would have to recreate the research currently conducted by analysts, but often without the specialized knowledge analysts have regarding accounting, finance, markets and investment strategies.

 

Nonetheless, investment analysis suffers from inherent conflicts of interest. Even independent research boutiques whose only role is to produce investment analysis of selected securities may still face significant conflicts of interest. Because such firms are largely dependent upon access to management of subject companies for insights that would make their analyses valuable to investors, some analysts and firms may refrain from issuing negative ratings out of fear of losing that access.

 

As the example above illustrates, it is not just internal conflicts within sell-side firms that affect financial analysis. Pressure on analysts may come from different sources. Companies that are the subject of research reports may use different methods and exert varying degrees of pressure to ensure only positive reports are issued. Likewise, institutional investors may use pressure on analysts' employers to ensure that negative research reports do not "broadside" them.

 

With this reality in mind, the Committee believes that there are issues that warrant more specific guidance and regulation than is typically provided under a principles-based approach. Additional guidance is valuable when it relates to matters subject to conflicts of interest; when principles about communications with clients may not go far enough to provide adequate protection to investors; and when issuers and investors exercise undue power to influence investment research.

 

Specific Comments

 

Listing Rules on Analysts as Insiders
As described in its Discussion Paper 14: Review of the Listing Regime, the FSA has determined that non-public, price-sensitive information was often passed along to groups not originally envisioned by its Listing Rules. Analysts, rating agencies and investment banking sales staffs all were routinely given unpublished price-sensitive information even though they were not approved to receive such information by the Authority.

 

In general, the Committee does not find anything wrong with analysts becoming insiders on certain transactions. However, the Committee does believe strongly that anyone, including analysts, in such positions should not publish research reports on the companies involved in the transactions and refrain from initiating trading for their own accounts in such situations, or those over which they have influence.

 

Analysts working on behalf of rating agencies, on the other hand, are typically seen as insiders by issuers and investors alike. As a result, the Committee urges the FSA to consider such analysts as advisers to debt issuers who are able to receive unpublished, price-sensitive information without triggering full and broad-based disclosure of the information to all investors.

 

Balancing Principles-based Regulation with the Need for More Prescriptive Measures
The Committee believes that there are times when leaving it up to the firms and individuals involved to determine the appropriateness of certain actions or disclosures is not advisable. Such situations are most common in matters where the interests of an issuer, a firm, an analyst or the management of a firm or issuer are in conflict, or are potentially in conflict, with those of investors and the markets. For example, leaving it up to insiders to decide whether to disclose conflicts of interest and in what form those disclosures should appear will most likely result in inadequate information for investors.

 

In light of the potential for this type of conflict of interest on the part of analysts and firms involved in the preparation of research reports, and to help provide investors with the information they need to weigh the fairness, accuracy and objectivity of such reports, the Committee urges the FSA to propose and implement regulations that require specific types of disclosures relating to three separate issues.

 

First, the Committee urges the FSA to require analysts and firms to disclose whether they have holdings in the subject company or other companies specifically mentioned in their research reports. The EAC also urges the Authority to clarify the situations that would create potential or existing conflicts of interest for analysts and their firms, for example, whether a subject company is a client of the investment banking department of a firm. The FSA should then prescribe the manner in which such conflicts are disclosed - including the timing, placement and items included in such disclosures - to investors.

 

In determining what constitutes a conflict, the Committee reiterates a position it took in the Market Abuse Letter² . Specifically, the Committee does not believe that determination of an existing or potential conflict of interest is solely a function of the size of the interest held by the analyst or their firm. Rather, determination of a conflict should consider how a holding may affect the independence of the author or the author's firm. In the Market Abuse Letter, the Committee pointed out that "objectivity of an analyst can become impaired with the ownership or control of just 100 call or put options."³ We reiterate that position here.

 

A second area requiring disclosure relates to the definitions of ratings, time horizons and risk categories analysts and their firms use in the reports they issue, the research philosophies and methodologies employed and performance of past research. In many cases, firms are already doing this in light of recent scandals. However, the Committee believes it will prevent confusion among investors if the FSA were to codify such requirements. By requiring analysts and firms to provide a comprehensive and understandable description of these factors, the Authority will enhance the credibility of the investment research that serves the U.K. markets.

 

Third, it is the view of the Committee that the FSA should create a rule requiring firms and analysts to disclose in their reports how analysts' compensation is determined as a means of giving investors information that may help them gauge the objectivity of the research. Moreover, the Authority should adopt a rule ensuring that analysts' compensation is not based on their participation in the public offering of securities or in corporate finance and merger and acquisition deals.

 

Finally, the Committee urges the FSA to adopt rules that discourage companies that are the subject of investment research, as well as investment firms that use such research, from taking retaliatory actions against analysts and firms that write negative reports. By establishing fines and other sanctions against such activities, the Authority would make it more likely that investors will receive objective research reports.

 

Beyond the above issues, the Committee also is concerned that certain prescriptive measures suggested in the Paper may bring few benefits while making investment research less useful to investors. In particular, the Committee urges the FSA to reject any proposal to label sell-side research as financial promotion. It is unlikely that a "financial promotion" label placed on the cover of a research report will prevent analysts or their firms from promoting unsuitable investments to market participants. More importantly, however, is that including such a disclaimer might eliminate any pretense of the de facto fiduciary responsibility analysts owe to their clients. It is the Committee's view that the fiduciary bonds between analyst and the investment client should be tightened, not loosened, with appropriate sanctions applied to individuals and firms who breach those responsibilities.

 

Convergence Toward U.S. Standards
While the Committee does not have a strong position on the advisability of wholesale adoption or rejection of standards currently used in the United States, it does feel strongly that securities regulators from all regions should strive to coordinate their rules. In doing so, the Committee also urges regional regulators to strive for adoption of the best rules for investors, regardless of their place of origin. If regulators coordinate their efforts to adopt regulatory best practices, the benefits would result from the ease with which investors could put their money into securities that provide the best returns, regardless of where the securities are traded, and from elimination of many of the costs that currently make international investing less valuable.

 

Analyst Registration and Testing
It is the understanding of the Committee that the FSA's suggestion regarding the imposition of training, testing and registration requirements is part of a larger effort by the Authority to promote professional qualifications in other parts of the financial services industry. Further, it is the Committee's understanding that the goal in this endeavor is to improve not only the training and educational backgrounds of persons practicing investment analysis, but also to improve the ethical standards of those same individuals.

 

The Committee encourages the FSA to proceed with its efforts along these lines. Indeed, throughout its 40-year existence, AIMR has consistently maintained the position that through education and the pursuit of the CFA Charter, AIMR members not only deepen their knowledge of the investment process, but also develop higher standards of ethical and professional behavior.

 

Closing Remarks

 

The EAC appreciates the opportunity to comment on the FSA discussion paper 15 on Investment Research: Conflicts and Other Issues. If you or your staff have questions or seek amplification of our views, please feel free to contact James C. Allen, CFA, by phone at +1.434.951.5558 or by e-mail at james.allen@cfainstitute.org.

 

Sincerely,

 

Dr. Luigi Gubitosi, CFA Chair European Advocacy Committee

James C. Allen, CFA Associate, AIMR Professional Standards & Advocacy

 

¹ The Association for Investment Management and Research is a global, non-profit organization of over 61,000 investment professionals from more than 113 countries. Through its headquarters in the U.S. and 117 Member Societies and Member Chapters worldwide, AIMR provides global leadership in investment education, professional standards, and advocacy programs.

² AIMR European Advocacy Committee letter to the Committee of European Securities Regulators, dated 30 September 2000, regarding CESR's Advice on Possible Level 2 Implementing Measures for the Proposed Market Abuse Directive, page 11.

³Ibid, page 14.