3 June 2003

 

Mr. Sheetal Radia
Business Standards Department
Financial Services Authority
25 The North Colonnade
Canary Wharf
London E14 5HS
United Kingdom

 

Re: Consultation Paper 171 - "Conflicts of Interest: Investment Research and Issues of Securities" (Ref. FSA CP171)

 

Dear Mr. Radia:

 

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") consultation paper, Conflicts of Interest: Investment Research and Issues of Securities ("CP 171" or the "Consultation"). The EAC is a standing committee of AIMR which benefits from the collective experience and expertise of its 15 European members. The Committee is 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.

 

 

The Committee applauds the FSA for its consideration of this important issue. Despite their existence over the years, conflicts of interest affecting investment research and the individuals who produce that research are only now getting attention they deserve. Maintaining the independence and objectivity of analysts and their research is an issue that directly affects the integrity of financial markets. Through the proposals made in this Consultation and the earlier Discussion Paper 15, the Authority has shown it is aware of this issue and its relevance to market performance.

 

Flawed Research
The Committee is concerned that the Authority may have relied too heavily on the Loughran and Ritter working paper ("L&R") summarized in Annex 3 of the Consultation. L&R appear to have failed to consider other possible reasons for the IPO discounts and, consequently, this paper may provide a seriously flawed basis. Public policy should not be based on flawed or insufficient data or theory.

 

In general, L&R calculated that the total discount - defined as the difference between the closing price on the first day of dealing in a new equity security, and the initial offer price for those securities - on IPOs brought to market in 1999 and 2000 was eight times as high as in the period running cumulatively from 1990 to1998. They hypothesized three reasons for this change:

 

• There was a higher concentration of issuers in new industries in 1999 and 2000 than previously, making it difficult to accurately price initial offerings;
  
• Issuers were more prepared to accept a discount because key executives were not always major shareholders and, therefore, not directly affected by the underpricing; and
  
• Issuers were less concerned with maximizing proceeds to the company than they were in obtaining higher after-market prices produced by coverage by analysts with strong followings.
  

 

The implication of the third is that key executives in the Issuers stood to gain personally much more from the aftermarket price increase than they would from a higher initial offering price. Indeed, Loughran and Ritter suggest that while all three explanations were valid, corruption likely had a bigger effect on pricing in the latter two years than in the previous nine.

 

However, the reasoning used in the third item - that executives had more to gain from aftermarket price appreciation - contradicts the second item - that executives were not major shareholders. In fact, management participation in ownership through stock options grew throughout this period, particularly in the more volatile industries of telecommunications and high technology.

 

The Committee notes that the L&R is just one study of the situation and may not represent all, or even the best analysis of the situation. Moreover, some Committee members believe there are other potential flaws with the L&R report.

 

For example, market sentiment at the time was, as one central banker already noted in 1996, bordering on irrational exuberance. Analysts involved in the pricing of these securities may have underestimated the level of hype in the market, leading to lower offering prices relative to the one-day pop. At the same time, the irrationality may have helped push aftermarket prices higher than in earlier periods, making the disparity between offer price and first-day closing price that much greater.

 

In hindsight, it appears that the offer prices were not too low but, in fact, too high. In fact, a comparison with current valuations would indicate that what was considered under-priced in 1999 and 2000 is often considered overpriced in today's market. Ultimately, both examples show that securities valuations are relative, not absolute.

 

The Committee's conclusion is that while the hypotheses of Loughran and Ritter about corruption of some analysts may tell part of the story about the pricing disparities in initial public offerings, the Committee does not consider their analysis to be comprehensive. As a result, the Committee recommends that the Authority consider other studies of the causes of the pricing disparities before deciding on a specific course of action with regard to management of securities offerings.

 

Flawed Business Model
In general, the committee members feel that the current business model for investment research is flawed. Even though investors seemingly want research, and investment banks provide it, there is a feeling that the product could not achieve profitability on its own under the current model.

 

In many ways, producers of investment research (the "Producers") use the product to generate interest in their securities products and services, including everything from asset management services to securities brokerage, underwriting and derivatives solutions. The marketing and public relations value of investment research for the Producers, therefore, derives from its indication of the firm's market expertise.

 

On the other hand, it appears that many investors lack faith in the objectivity of sell-side research. In part, this is the result of remuneration policies that reward analysts not so much for the quality of their insights but for their ability to generate investment banking fee income. In some markets, like the United States, this more often is a function of the analyst's public visibility than the quality of his or her recommendations, particularly as measured over a number of years.

 

If investment research is to stand on its own, it will have to provide value for both the Producers and the consumers of the research. For Producers, it will have to generate enough business to warrant its cost. For consumers, it will have to provide value through the demonstrable quality of its insights about individual securities and industries over time.

 

There is concern, however, that some remedies for the unethical behavior of research analysts and firms could cause firms to eliminate investment research altogether. For example, in its proposal, the FSA suggest in paragraph 4.7 that it does "not believe that analysts should be used in a marketing capacity," and that "it would be unacceptable for analyst to be involved either in pitches for new investment banking mandates or in the active marketing of new issues - whether by issuing research recommendations or by involvement in advice or sales to clients."

 

To achieve an appropriate balance, therefore, the Committee suggests the FSA adopt a strategy for dealing with marketing activities that follows the approach taken in Standard 4.3 in the sell-side section of AIMR's proposed ROS.

 

AIMR Research Objectivity Standards
While AIMR's proposed Research Objectivity Standards (referred to collectively as the "ROS" and individually as the "Standard") expresses similar concerns in Standard 4.1 - that collaboration between research and investment banking creates severe conflicts of interest for analysts -- the ROS does not call for a blanket prohibition against analyst participation in marketing activities. Specifically, Standard 4.3 in the sell-side section recommends against using analysts in marketing activities for initial and secondary public offerings of securities, adding:

 

"If firms permit research analysts to participate in such [marketing] activities, the research analysts should disclose this participation in all interviews and public appearances."

 

Standard 10.0 in the same section further requires firms to "provide full and fair disclosure of all conflicts of interests to which the firm or its covered employees are subject." These disclosures would supplement such disclosures in interviews and public appearances with disclosures in published research reports.

 

Furthermore, the ROS recommends that firms implement quiet periods extending to 40 calendar days after issuance for IPOs and 10 calendar days after issuance in a secondary offering. These quiet periods would further restrict analysts' ability to use marketing activities to promote a stock following issuance.

 

Nonetheless, Standard 4.1 also states that firms should "prohibit analysts from sharing with, or communicating to, members of the investment banking or corporate finance department, prior to publication, any section of the research report that might communicate the research analyst's proposed recommendation." The Standard suggests that firms' compliance or legal departments act as intermediaries between analysts and investment banking or corporate finance departments, and that investment banking or corporate finance personnel review research reports "only to verify factual information or to identify potential conflicts of interest." The Standard also suggests that the compliance or legal department document and conduct any communications between the two groups.

 

Marketing Independent Research
Finally, the Committee is concerned that a strict reading of the prohibition against participation in marketing might lead some to conclude that independent research firms without investment banking or trading income cannot market their research product. While we recognize that this was not the intent of the Consultation's recommendation, both from discussions with an FSA representative and from the next sentence in paragraph 4.7 of the Consultation, the Committee suggests that the Authority more explicitly indicate this intention to avoid confusion.

 

 

In the section below, we answer the Authority's specific questions.
Q1: Do our proposals address the main sources of conflict, and set a sufficiently clear line on acceptable and unacceptable conduct?

 

In this question, the Authority is referring to its proposals for internal management arrangements. Specifically, the proposals cover the following:

 

• Analysts should not report to departments that might create conflicts
  
• Analysts' involvement in investment banking, equity sales and trading is
  
  • Acceptable for researching investment banking opportunities, providing ideas to sales and trading, or providing information and advice to institutional clients, but
  • Unacceptable to participate in pitches for investment banking opportunities, active marketing of new issues or involvement in sales or advice to clients
• The basis for analysts' compensation and rewards is:
  
  • Acceptable if it relates to overall firm profits, but
  • Unacceptable if it is based on contributions to specific investment banking deals, or determined by investment banking, equity sales or trading managers
• Firm controls to prevent managers from other departments attempting to influence analyst opinions and recommendations
  

 

Aside from the concerns discussed in "General Comments: AIMR Research Objectivity Standards," regarding analyst involvement in non-research functions, the Committee supports the proposals provided by the Authority. Indeed, these issues are covered in a similar manner in the ROS. The first, second and last of the Authority's proposals are covered by Standards 4.0 through 4.3. Analyst compensation matters are covered by Standards 5.0 through 5.2.

 

Q2: Do you think the proposed approach to quiet periods for primary and secondary issues of securities would remove a significant source of conflict?

 

Q3: Do you agree with the proposed length of the quiet period for primary issues?

 

The proposals made by the Authority include a 30-day quiet period following an initial public offering and no quiet period for secondary offerings. The FSA said it does not wish to impose a quiet period for secondary offerings because some firms may already cover the issuers and a blanket prohibition would prevent them from responding to requests from clients for information or advice on the relevant securities.

 

The Committee suggests the FSA pursue quiet periods in line with its ROS, Standard 4.2. Here, the recommended length of quiet periods is 40 days for primary offerings and 10 days for secondary offerings. This Standard seeks to "ensure that research reports and recommendations will not be based on inside information gained by the research analyst through investment banking sources." The Standard does make allowances for normal, information-only updates relating to significant events affecting the subject company, but to prevent abusive behavior, it stipulates that these updates receive approval from the Producer's compliance or legal department prior to dissemination.

 

Q4: Do you think that prohibiting personal dealing by analysts in the stocks and sectors they cover is an appropriate standard for tackling their conflicts of interest?

 

Q5: If not, what controls could be implemented that would constitute a viable alternative to prohibition?

 

The Committee does not believe prohibiting analysts from dealing in the stocks and sectors they cover is an appropriate standard to manage this potential conflict of interest. The Committee looks to Standard 7.1 to justify this position. The Standard states:

 

"permitting research analysts and other covered employees to invest and trade in the securities of subject companies and industry industries may better align their personal interests with the interests of investing clients provided that precautions are taken to ensure that the interests of investing clients are always placed before the interests of the employee, members of their immediate families, and the firm"

 

Moreover, the Committee believes that a blanket prohibition against personal investments in covered securities might lead good analysts to leave the business in favor of other activities such as hedge funds that permit them to take advantage of their expertise. Consequently, the quality of financial analysis reaching investors would suffer.

 

To prevent abuse of personal investing, the ROS suggests that firms permitting analysts to personally invest in the securities they cover should provide the following safeguards:

 

• Require notification to, and approval by, the compliance or legal department in advance of all trades of securities in subject companies in the industry or industries assigned to that covered employee.
  
• Enact specific policies and procedures that adequately prevent "front running" of investing client trades, including restricted periods before and after issuing a research report of at least 30 calendar days before and 5 calendar days after issuance, with exceptions permitted on the announcement of significant news or events by the subject company if investing clients are given adequate notice and the ability to trade.
  
• Firms must prohibit analysts and other covered employees from trading contrary to the published recommendations of the firm on these companies.
  
• Firms should require covered employees to provide to the firm or its compliance or legal department a complete list of all personal investments in which they or members of their immediate families have a financial interest. This list should be provided on a regular basis, but at least annually.
  
• Firms should establish policies and procedures that require covered employees to hold securities for a minimum of 60 calendar days.
  

 

Standard 7.5 provides one exception to the rule preventing analysts from trading against their recommendations. This exception would involve situations where the analyst would suffer "extreme financial hardship" if he or she were not permitted to liquidate the securities.

 

To prevent abuse, however, the Standard suggests that firms have "clear definitions of what constitutes extreme financial hardship" that require a significant change in the employee's personal financial circumstances. Furthermore, the firm's compliance or legal departments must approve any such trades ahead of time, and the firms should maintain appropriate documentation of the hardship conditions and the decision process.

 

Q6: Do you think that 1% is the appropriate threshold for disclosure of material shareholdings?

 

The Committee supports the 1% threshold for disclosure of material shareholdings. The proposal matches the threshold proposed in Standard 10.4.

 

The Committee also considered the influence a much smaller ownership may have on the judgment of individual analysts. A £1 million stake in a company worth £50 billion would not come close to meeting the thresholds proposed by the Authority. Nonetheless, it may have a significant effect on the analyst's perception and objectivity.

 

In the end, though, the Committee recognized that monitoring such investments is not the role of the FSA. Rather, it is the role of firm compliance departments. However, compliance departments should require analysts to disclose ownership or control - such as short positions or options holdings - positions, regardless of the size of those holdings to provide investors with information that may help them assess the objectivity of the recommendations.

 

Q7: Do you agree that a firm's positions in other company securities, and related derivatives, should be disclosed?

 

Q8: Would thresholds be useful for this purpose, and, if so, at what level(s) should they be set?

 

The Committee strongly supports the disclosure of a firm's positions in all securities of, or derivatives related to, companies covered by their research departments.

 

As noted in our reply to Questions 5 and 6 above, Standard 10.4 of the ROS calls on firms to disclose when they own 1% or more of any class of outstanding common equity of the company covered. However, Standards 10.3 and 10.4 both call on Producers to disclose whether they also make a market in the "securities of the subject company." While this requirement does not require firms to disclose their market-making holdings, it nonetheless requires firms to meet a lower threshold than 1% if it involves making a market in any securities of a subject firm.

 

Q9: Do you agree with our conclusion?

 

Q10: If not, what arguments are there in favor of self-certification by analysts?

 

The conclusion to which Q9 refers is that the Authority does not believe requiring analysts to certify that their research reports accurately reflect their personal views and were not influenced by other considerations would be a useful disclosure. In part, the FSA's conclusion is based on a concern that self-certification would shift responsibility for such reports to analysts and away from senior management.

 

While recognizing the Authority's concerns about inadvertently providing a safe harbor for senior management, the Committee believes the FSA can allay such concerns in other ways while still requiring self-certification.

 

In general, the Committee advocates the use of self-certification. Indeed, self-certification is a fundamental tenet of being a Chartered Financial Analyst and AIMR member. Standard IV, subsection A of AIMR's Standards of Professional Conduct sets out the requirements that Charterholders and AIMR members must meet in producing investment research. If the research does not meet these standards, members are not permitted to publish it.

 

However, the Committee also is concerned that without proper regulatory guidance and liability, management may take advantage of the situation to place pressure on analysts. To avoid this pitfall and those offered by the Authority in paragraph 4.31 of the Consultation, the Committee suggests that rules explicitly include a discussion of management's liability in the investment research process. In general, the rule could state that the FSA will hold management, as well as the analyst involved in producing the research, responsible for any fraudulent activities or recommendations resulting from the research.

 

Q11: Do you think that these proposed amendments address the scope for abuse of the existing dealing-ahead rules?

 

The question refers to amendments that eliminate the following exemptions from the rules against "dealing ahead" or "front-running":

 

• If the firm believes the research will not materially move the price of the security involved;
  
• If the firm is merely anticipating expected customer demand; or
  
• If the firm has disclosed in the research report that it has or may have dealt.
  

 

By eliminating these exemptions, the only circumstances remaining under which firms can deal ahead of a research report is if it deals in good faith as part of its market-making functions, or if it executes unsolicited customer trades. The Authority states that it does not think that a firm dealing in these circumstances should take advantage of research it is preparing to issue.

 

The Committee supports the FSA in its amendments and supports its view that the interests of neither firms nor their employees should take priority over those of investing clients.

 

Q12: Do you think there are any other circumstances in which a firm could legitimately deal knowingly without prejudice to its clients' interests?

 

The Committee believes that some client-directed trades might fall into this category. However, firms should receive this safe harbor only if they have already taken precautions to ensure that the department filling such orders did not have access to or influence over either the research in question or analysts in the research department.

 

Q13: What arguments are there for requiring investment firms in the UK to fund the provision of independent investment research for the benefit of retail investors?

 

As stated in the Consultation, the genesis of this question comes from actions taken by U. S. regulators against sell-side firms that were alleged to have misled investors with biased research. In general, these actions resulted in a settlement that included fines and the requirement that the firms involved provide an estimated $450 million to fund and distribute research prepared by independent firms.

 

So far, neither the FSA nor any other legal body have found that firms operating in the U.K., including those U.S. firms involved in the settlement, had engaged in the type of widespread behavior that would warrant the unprecedented fines imposed on firms in the United States. Therefore, to require U.K.-based firms and operations to endure the same burdens as those admitting to misconduct overseas would unfairly punish them for actions taken by others in different markets.

 

Q14: Do the conflicts of interest, and the measures to combat them, also apply to the production of non-equity research?

 

The Committee believes that, yes, the conflicts of interest related to equity research and the measures to combat them should also apply to the production of non-equity research.

 

Q15: Do you agree that this analysis addresses all the conflicts that exist in this type of business?

 

The Authority is referring to the issuance of securities in either initial public offerings ("IPOs") or secondary offerings and the analysis refers to a list in paragraph 5.34 of four conflicts affecting underwriters whereby they work for the issuers and:

 

• Their own interests by allocating securities to their proprietary trading desks;
  
• Their own interests in facilitating their distribution capabilities;
  
• Investment customers that may receive unsuitable investments; and
  
• Their own interests in future investment banking mandates.
  

 

The Committee believes the analysis performed by the Authority is comprehensive and does not have anything to add to the list.

 

Q16: Do you agree that the proposed guidance provides the appropriate framework for the management of conflicts of interest arising in issues of securities?

 

The question refers to guidance proposed for section 5.10 of the FSA's Conduct of Business Sourcebook. The guidance is designed to help firms and senior management:

 

• Identify the conflicts and the duties owed to customers;
  
• Clarify some important areas in which we expect firms to have specific arrangements in place to manage these conflicts; and
  
• Make clear that laddering - participating in profits made by investment clients from IPO allocations - and spinning - using IPO allocations to obtain investment banking business - would be contrary to the Principles and Conduct of Business rules.
  

 

The Committee agreed the proposed guidance would provide the appropriate framework for managing conflicts of interest resulting from the issuance of securities.

 

 

The EAC appreciates the opportunity to comment on the FSA consultation paper 171 on Conflicts of Interest: Investment Research and Issues of Securities. 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,

 

Frederic P. Lebel, CFA Co-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 nearly 64,000 investment professionals from more than 116 countries and territories. Through its headquarters in the U.S. and 125 Member Societies and Member Chapters worldwide, AIMR provides global leadership in investment education, professional standards, and advocacy programs.