Research Requirements

Q: Many firms use third-party investment research to cover companies their own analysts don't or to supply a second opinion. As part of these arrangements, the firms often enter into contractual agreements with unregistered third parties. The duties of these third-party firms seem similar to those of registered research analysts, with one important difference: The unregistered folks are not saddled

Q:

Many firms use third-party investment research to cover companies their own analysts don't or to supply a second opinion. As part of these arrangements, the firms often enter into contractual agreements with unregistered third parties. The duties of these third-party firms seem similar to those of registered research analysts, with one important difference: The unregistered folks are not saddled with the risks and requirements (customer complaints, continuing education) that come with NASD registration. Of course, the unregistered analysts also do not directly solicit business for the firm. They touch the end user (the advisor's client) only when I present the research.

Now for my questions: It appears to me that being an unregistered third-party research analyst carries none of the risks that accompany registration. Still, such analysts can operate in pretty much the same way as their registered counterparts. Is my interpretation of this correct?

Also, what specific rules or restrictions, particularly NASD/SEC rules, govern third-party research providers? May firms offer their clients opportunities to contact these research providers for clarifications or questions regarding specific reports? What disclosures must firms make regarding them? Finally, do the new research analyst registration rules have any effect on third-party research providers?

A:

After the bubble burst on the Internet craze of the late 1990s, various regulators — in particular, New York State Attorney General Eliot Spitzer — uncovered numerous less-than-savory research practices at large Wall Street firms. Their research departments, it was shown, were little more than accessories to the firms' investment banking clientele.

In response, the SEC approved new NASD and NYSE rules to improve the objectivity of member firm research and provide investors with more useful and reliable information. These new rules are intended to ensure that research reports provided by member firms to their customers were accurate (reflected the analyst's opinion), thus restoring investor confidence in the securities markets. The “stick,” of course, to member firms and their research analysts would be that if an analyst issued a report that did not constitute his or her actual opinion, the regulators would consider such a report to be fraudulent.

To avoid future problems, the new rules instituted a regulatory structure for the previously unregistered research analysts. They must now register as associated persons with their member firms, as well as take and pass qualifying examinations to become licensed as research analysts. They must attend firm and regulatory-sponsored continuing education courses. These new rules also forbid research analysts from issuing “booster shot” research reports — reports designed to keep a company's stock price up — and prohibit research analysts from soliciting investment banking business for their member firms.

The new rules, however, waive certain qualification requirements for foreign research analysts employed by member firms' affiliates in Europe and Asia. The exemptions are conditioned on several factors, such as requiring member firms to follow the new rules for their foreign research analysts at foreign affiliates when contributing to the member firms' research report preparation.

Firms also are subject to new regulation in this area. They are now required to disclose to the public if they are a market maker of the subject company's securities when publishing a research report. They must disclose if they've been the manager or co-manager of an issuer's securities public offering within the last 12 months. Further, they must publish a final research report when the member firm opts to terminate coverage on a particular company.

It's a fair question as to whether member firms are attempting to avoid these substantial requirements by using third-party “unregistered” research analysts, but this perception doesn't square with reality. Many of these so-called third-party “unregistered” research analysts are, in fact, registered, not pursuant to NASD or NYSE rules, but through the Investment Advisers Act of 1940 as investment advisors.

This law requires many of the standards that you think third-party research analysts are avoiding — including investment advisor registration with either the SEC or with the state regulators where the investment company's principal business is located. As a condition of registration, the investment advisor must also provide business and investment disclosure information to their clients. They can't misuse nonpublic information or disseminate any material misstatements to their customers, and they must disclose certain financial information concerning their operations to their clientele.

Although third-party research analysts have some indirect contact with the member firms' potential or existing customers, no direct solicitation of business usually occurs, because the member firm limits such contact to avoid losing business to these investment advisors. Any questions or explanations regarding research reports are channeled through the member firms' registered representatives.

Many agreements between member firms/investment advisors delineate specific procedures if there are customer complaints or liability arising from an investment advisor's advice. Many advisors guarantee the accuracy of the reports they put before their clients. However, caveats exist. Such guarantees are usually restricted to the date of the report, since material changes to the company's condition can occur afterward. Investment advisors do promise to notify the member firm customers and provide updates or revised analyses, should events warrant it.

Why do member firms enter into these relationships? Although there is a perception that it avoids regulation, this is simply not the case. Member firms are maximizing their research coverage. By seeking outside research assistance, they are expanding their research capabilities into other areas and sectors without large start-up costs and maintenance expenses. They protect their clients from pirate attacks by contractually agreeing with the outside research firm to a “hands off” arrangement. In return, the outside research firm usually sells research to more than one member firm.
Ernest E. Badway
Saiber Schlesinger Satz & Goldstein
Newark, N.J.
973-622-3333
[email protected].

Ethical Rep is a monthly feature in which more than 30 prominent securities attorneys, experts and law school professors help Rep. readers deal with work-related ethical quandaries. Have you encountered a situation at work that makes you uncomfortable? Are you confused about how your responsibilities to clients might change as regulations continue to evolve? Drop a line to Rep.'s contributing editor, Ann Therese Palmer, and our group of experts will help you work through the problem.

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