7 May 2003

 

European Commission
DG Internal Market
Directorate G
Rue de la Loi 200
B-1049 Bruxelles
Belgium

 

Re: Working Documents on the Implementation of the European Parliament and Council Directive 2003/6/EC on Market Abuse (ESC 12/2003, 13/2003, 14/2003)

 

Dear Commissioners:

 

The European Advocacy Committee (EAC or the Committee) of the Association for Investment Management and Research® (AIMR®) is pleased to respond to the DG Internal Market (the "Directorate") regarding its Working Documents (individually, the "Document" or the "Proposal," and collectively, the "Documents" or the "Proposals") for the implementation of the Market Abuse Directive. 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.

 

 

In general, the Committee is supportive of the manner in which the Documents are presented, as well as the goals they seek to achieve. Efforts to create a common basis for combating market manipulation is a worthwhile endeavor and one that the Committee believes will ultimately make the European Union a more competitive and efficient financial marketplace.

 

Nonetheless, the Committee believes the Documents, and hence European financial markets, would benefit from some changes.

 

Too Much Detail, Too Little Flexibility
In general, we commend the Directorate on eliminating much of the detail that was contained in early proposals for the Market Abuse Directive. Indeed, in the Committee's 30 September 2002 letter to the Committee for European Securities Regulators ("CESR"), we specifically suggested a reduction in the level of prescriptive detail contained in that early document.

 

The Committee stated in that letter, and continues to believe, that at level 2 in the Lamfalussy Process, it is better in most cases to provide legal and regulatory principles (see "Defining Significant and Material" below for one exception). In general, we see this providing regulatory flexibility while also giving sufficient direction for drafting of more-detailed level 3 regulations that will guide Competent Authorities in Member States.

 

Likewise, the Committee feels strongly that at this level, providing detailed lists of either required or proscribed actions, specific time periods or precise percentages will likely overlook some issues or fail to anticipate items needed for the future. Detailed lists or specific percentages or time periods could limit the ability of Competent Authorities in the Member States to respond to changes in local market practices or products.

 

Despite the efforts to eliminate detailed lists from the Proposals, there are, however, articles that, in the view of the Committee, provide too much detail for measures at this stage in the legislative and regulatory process.

 

One example is Article 4 of Document 13 (ESC 13/2003). This item seeks to provide firms and individuals that produce research ("Producers") with a list of items to include when making investment recommendations. While the items listed are important and relevant disclosures, the list is not exhaustive. Other disclosures relevant to investor decisions include, among other things, an analysis of the risk and liquidity levels of the securities covered in research or recommendations.

 

Article 6 of the same Document suffers from similar omissions. Its list of possible conflicts requiring disclosure does not include a discussion of large contracts for consulting, outsourcing or other services that a firm may have with the subject of investment research.

 

It is the Committee's view that further attempts to cover all the relevant issues in either of the above mentioned citations likely would highlight further omissions, all the while restricting the ability of Competent Authorities to respond to manipulative behavior. Consequently, the Committee reiterates its belief that the Directorate should strive for a description of principles in the Documents and use detailed checklists at Level 3.

 

To accomplish this goal, the Committee recommends a possible revision of Article 4 which would state that Member States shall require that the person producing recommendations use reasonable care to "include in their communications with clients or prospective clients those factors important to their investment analysis, recommendation or action."

 

Likewise, a possible revision for Article 6 might state that Member States should require Producers of investment recommendations to disclose "all matters that could be expected to interfere with their duty to their clients or prospective clients, or that could inhibit their independence and objectivity. Disclosures must be prominent, written in plain language and be designed to communicate the relevant information effectively."

 

Defining "Significant" and "Material"
While in general we favor principles-based rules in Level 2 implementing measures rather than lists of proscribed actions or specific time periods, the Committee feels that further guidance is needed in the definition of key terms such as "significant" or "material." In at least 15 instances, the Documents use those terms without adequate assistance as to what constitutes such proposals as "significant changes" or "material holdings." While the Committee does not believe the Directorate should provide "bright line" numbers at Level 2, it does believe additional guidance might prevent confusion.

 

For example, in Document ESC 12/2003, paragraph 2 of Article 5 requires companies to promptly disclose "any significant changes concerning already publicly disclosed information." Likewise, in Article 6 of Document ESC 13/2003, the fifth bullet point of paragraph (1) requires Producers of investment recommendations to disclose if they have provided "material investment banking services" to the subject of investment research during the previous 12 months.

 

Without proper guidance about such terms, Competent Authorities in Member States may make different interpretations about the significance of certain events, resulting in the possible withholding of critical information in one or more markets.

 

In both cases, the Committee suggests that the Directorate apply the "average person" rule - described in ESC 12/2003, Article 3 - to those cases in the Documents where it uses the terms material or significant. For example, the Documents could state that material in instances such as in Article 6 described above should cover any situation that may cause an average person to view such arrangements as potentially affecting the objectivity of the recommendation. Likewise, Article 4 could state that "significant" in this instance refers to any change that might affect the investment decision of the "average person."

 

By providing this kind of guidance, the Directorate will provide more direction for Competent Authorities about what is expected from them without reducing regulatory flexibility with detailed lists. Concurrently, this approach is more likely to ensure investors receive the information they need to make informed decisions.

 

 

Legitimate Reasons for Delayed Disclosures (Article 6, ESC 12/2003)
In paragraph 1 of this citation, the Directorate proposes to permit companies to delay public disclosure of material inside information for, among other things:

"Matters in course of negotiation, when public disclosure would be likely to affect the conclusion of a deal or the normal course of negotiations"

 

The Committee recognizes the need for the Directorate to explicitly include such an exemption in the Documents. Without them, it is possible that some parties will interpret their omission to mean there are no such disclosure exemptions.

 

Nonetheless, the Committee is concerned that the wording of this exception might create confusion among issuers.

 

In part, the confusion might result from the current understanding in the EU that transactions under negotiation are exempt from disclosure requirements, unless information about such negotiations is prematurely leaked to the public. Implicit in this current understanding is a further acceptance that companies also do not have to disclose informal, one-time discussions with third parties that do not and would not lead to a material transaction.

 

By stating the exception in the manner provided in the proposal, however, the Committee is concerned Competent Authorities in some jurisdictions may interpret the rule more broadly than the Directorate intends. For example, they might interpret the description to imply that companies will have to disclose negotiations when such disclosure would not alter the outcome of a potential transaction. Taking this interpretation a step further, it might lead Competent Authorities to require companies to disclose all discussions, regardless of their likelihood to lead to a transaction that, if completed, might have an effect the company's performance or its share price.

 

The Committee recognizes that writing such a standard requires the Directorate to balance different objectives. On the one hand, the Committee does not want to prevent disclosure of failed discussions that, if they had led to a transaction, might have affected the earnings, financial condition and share price of the company.

 

On the other hand, an interpretation such as the one mentioned above, could lead to a stifling of communications between management and various outside groups. Indeed, company managers engage in discussions with many different groups and individuals on a regular basis, most of which do not lead to subsequent transactions; nor do most involve situations that might have a material affect on the company or its investors.

 

To help avoid such confusion while also achieving the Directorate's goal of disclosure of information relevant to investors, the Committee suggests altering this paragraph to say that companies can delay disclosure of:

"Matters in course of negotiation - when public disclosure would be likely to affect the conclusion of a deal -, or negotiations or discussions that will not lead to a transaction that would have had a noticeable effect on the company's operations, financial condition or securities prices."

 

Use of Unreliable Sources (Article 3, ESC 13/2003)
In this Proposal, the Directorate requires that Producers of recommendations "take reasonable care to ensure that all sources are reliable or that, where a source is not considered reliable, this is clearly indicated."

 

In general, the Committee strongly disapproves of the use of unreliable sources. In AIMR's Standards of Professional Conduct, members are required to:

"Make reasonable and diligent efforts to avoid any material misrepresentation in any research report or investment recommendation."

 

To use a source known to be unreliable could contradict this Standard.

 

However, the Committee recognizes that sources have potentially varying degrees of reliability that may require analysts and investment managers to at least consider their comments. As a result, the Committee suggests that the Directorate alter its proposal to require Producers of investment research and recommendations to:

 

• Clearly disclose if the accuracy of the information from a source is questionable, and
  
• Refrain from using information from a source that is known to be unreliable.

 

Additional Conflict of Interest Disclosures (Article 6, ESC 13/2003)
Aside from its concerns about the level of detail in this Article (see General Comments above), the Committee is also concerned that the Article does not specify that firms issuing research should disclose all investment positions.

 

Such requirements are often interpreted as meaning disclosures of long positions in equity securities. Consequently, short positions or interests in derivative instruments in a subject of a research report or recommendation that is owned or controlled by the Producer may not get disclosed to investors. The result is that investors may not have a clear picture of the objectivity of a recommendation or research report.

 

In the interests of full disclosure, the Committee recommends that the Directorate alter the Proposal to require Producers to

"disclose all circumstances that might impair the objectivity of investment research or recommendations, including all positions owned or controlled by the Producer, or such recommendations or any contractual arrangements in force currently or in the past, that might affect the objectivity of such reports or recommendations."

 

The Committee is also concerned that by limiting the time period during which Producers have provided investment banking services to the subject of investment research to the preceding 12 months will not accomplish the goal of uncovering potential conflicts of interest. The Committee supported the three-year proposal from CESR in its July 2002 consultation paper and believes it is more appropriate because one year of inactivity may not indicate the severing of conflicting relationship in the way that a three-year interval would.

 

Green Shoe Options (Article 10, ESC 14/2003)
In paragraph 4 of this citation, the Directorate proposes that stabilization programs will enjoy the benefits of a safe harbour if, among other conditions, the green shoe option does not exceed 15% of the original offer. While the Committee believes a preferable green shoe limit would be 5% of the original offer, we recognize that 15% is common in other major financial markets and therefore do not suggest any changes.

However, the Committee does recommend that the Directorate require issuers to disclose exercise of the green shoe option immediately. As currently drafted, the proposal requires firms to "promptly" disclose such actions. Some Committee members felt this language might give issuers too much leeway to delay disclosure. Delays of any kind could have a negative effect on the ability of investors to accurately assess market conditions and, therefore, market prices.

 

 

The EAC appreciates the Directorate's willingness to accept these comments on its Working Documents for the Market Abuse Directive. 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,

 

Luigi Gubitosi, CFA Chair European Advocacy Committee

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