Securities Research: Additional Actions Could Improve Regulatory Oversight of Analyst Conflicts of Interest
Published: 2012-01-12T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: In 2003 and 2004, the Securities and Exchange Commission (SEC), self-regulatory organizations (SRO), and others settled with 12 broker-dealers to address conflicts of interest between the firms research and investment banking personnel. The regulators alleged that the firms allowed their investment bankers to pressure equity research analysts in ways that could cause them to issue misleading research to the harm of investors. Under the Global Research Analyst Settlement (Global Settlement), the firms had to undertake reforms designed to sever links between research and investment banking. The SROs also adopted equity research rules to address analyst conflicts across the industry, but these rules were not as stringent in some areas as the Global Settlement. The Dodd-Frank Wall Street Reform and Consumer Protection Act required GAO to study these issues. This report discusses (1) what is known about the effectiveness of the regulatory actions taken to address analyst conflicts and (2) what further actions, if any, could be taken to address analyst conflicts. GAO reviewed empirical studies and SEC and SRO rules, examination findings, and enforcement actions. GAO interviewed SEC and Financial Industry Regulatory Authority (FINRA) staff, and market participants and observers.
section_title: What GAO Found
paragraphs: Existing research and stakeholder views suggest that the Global Settlement and other regulatory actions have helped to address conflicts faced by equity research analysts. The results of the empirical studies that GAO reviewed generally suggest that the Global Settlement and equity research rules adopted by the SROs were associated with improvements in analysts stock recommendations. FINRA officials and SEC staff told GAO that the regulatory reforms have been effective, citing minor deficiencies in their examinations and the limited number of enforcement actions involving conflicts between research and investment banking as evidence of the reforms effectiveness. Independent monitors, which were required as part of the Global Settlement, also found that the 12 firms generally were complying with the Global Settlement. Finally, broker-dealers, institutional investors, and others told GAO that the regulatory actions have helped insulate equity research from investment banking influence, although some noted that not all conflicts can be eliminated and certain restrictions can be circumvented.
Although SEC and FINRA have been taking regulatory action to further address conflicts faced by research analysts, additional action is warranted. FINRA has been working to finalize a rule proposal designed to broaden the obligations of firms to identify and manage equity analyst conflicts and better balance the goals of helping ensure objective and reliable research with minimizing regulatory costs and burdens. FINRA also has been working to finalize another rule proposal that would address conflicts faced by debt research analysts. The current SRO research rules do not cover debt research analysts, although these analysts face conflicts of interests similar to those faced by their equity analyst counterparts. In the absence of an SRO debt research rule, the SROs have relied on antifraud statutes and SRO rules requiring ethical conduct. They also have encouraged firmswith limited successto comply voluntarily with industry-developed principles designed to address debt analyst conflicts. FINRA plans to package its two rule proposals together and submit them to SEC in the first half of 2012. In contrast, SEC and FINRA have not proposed codifying the Global Settlements remaining terms. At the request of the broker-dealers, a court modified the Global Settlement in 2010 and eliminated settlement terms where, for the most part, comparable SRO rules existed. Nonetheless, some of the Global Settlements terms that serve to protect investors have not been codified. As a result, the Global Settlement firms continue to be subject to the requirements of the Global Settlement and the SRO research analyst rules, while other firms that provide the same services are subject only to the SRO research analyst rules. As a result, investors may not be provided the same level of protection. GAO has previously reported that a regulatory framework should ensure that market participants receive consistent and useful information as well as consistent protections for similar financial products and services. SEC staff told GAO that they periodically have discussed and analyzed the Global Settlement terms but have not formally assessed and documented whether any of the Global Settlements remaining terms should be codified. By not formally assessing whether codifying any of the Global Settlements remaining terms provides an effective way of furthering investor protection, SEC may be missing an opportunity to provide the same level of protection for all investors.
section_title: What GAO Recommends
paragraphs: GAO recommends that SEC formally assess and document whether any of the Global Settlements remaining terms should be codified. SEC agreed with the recommendation.

section_title: Letter
paragraphs: In 2003, federal and state authorities reached a landmark settlement with  10 of the nation’s top broker-dealers to address conflicts of interest  between their equity research analysts and investment bankers— resulting in more than $1.4 billion in penalties and other payments. In the  enforcement actions leading to the Global Research Analyst Settlement  (Global Settlement), the Securities and Exchange Commission (SEC) and  other authorities alleged that the firms allowed their investment bankers to  pressure equity research analysts in ways that could and, in some cases,  did cause them to issue misleading or false research to the potential harm  of investors. For example, investment bankers at certain firms could  influence the amount of compensation received by equity analysts,  potentially enabling them to pressure the analysts into improperly  promoting the stocks of companies whose investment banking business  the firms were seeking to attract. To resolve the allegations of  misconduct, the broker-dealers agreed under the Global Settlement to  implement a number of structural reforms intended to sever links between  equity research and investment banking, thereby insulating analysts from  investment banking influence or pressure.
Prior to the Global Settlement, the National Association of Securities  Dealers (NASD) and New York Stock Exchange (NYSE)—the principal  self-regulatory organizations (SRO) in the securities industry at the time— had adopted rules specifically to address analyst conflicts at their member  firms. They later amended their rules to include additional requirements  that were similar to some of the Global Settlement’s reforms. Although the  NASD and NYSE rules generally apply across the industry—not just to  the broker-dealers subject to the Global Settlement (Global Settlement  firms), the rules are less stringent than the Global Settlement’s reforms in  some areas and more stringent in other areas. In that regard, some  market observers have raised concerns that the current lack of  industrywide rules mirroring the Global Settlement’s reforms creates  regulatory inconsistencies: for example, investors could be provided with  different levels of protection, depending on whether the securities  research was produced by a Global Settlement firm or other firm.
Section 919A of the Dodd-Frank Wall Street Reform and Consumer  Protection Act requires us to identify and examine potential conflicts of  interest between investment banking and both equity and fixed-income  (debt) research staff in the same firm. This report examines (1) the effectiveness of the regulatory actions taken to address research analyst  conflicts of interest, and (2) additional actions regulators could take to  further address research analyst conflicts.
To understand the nature of research analyst conflicts and identify  regulatory actions to address them, we reviewed academic, GAO, and  other studies; enforcement actions taken by SEC and state attorneys  general beginning in the early 2000s; existing and proposed SEC and  SRO rules and other releases; and Global Settlement documents. To help  evaluate the effectiveness of regulatory actions taken to address research  analyst conflicts, we reviewed and analyzed studies that empirically  examined the effects of the regulatory reforms on analyst research and  recommendations. We limited our review to studies issued after January  1, 2005, because of the time frames in which the regulatory reforms were  adopted. We also analyzed data on relevant broker-dealer examinations  and investigations conducted by the Financial Industry Regulatory  Authority (FINRA) between 2005 and 2010, SEC and FINRA enforcement  actions that involved conflicts between research and investment banking  and were taken between 2005 and 2010, and independent monitor  reports that assessed the Global Settlement firms’ compliance with the   We assessed the reliability of the examination and  Global Settlement.investigation data obtained from FINRA and found the data sufficiently  reliable for our purposes. To gain insights on the effectiveness of the  regulatory actions taken to address analyst conflict and to identify  additional actions that could be taken to address such conflicts, we  interviewed officials from SEC, FINRA, and the North American Securities  Administrators Association (NASAA), including officials from five of its  member state securities commissions. We also interviewed academics  and representatives from broker-dealers, institutional investors,  independent research firms, and associations representing such entities  and retail investors. Our report focuses on potential conflicts between a  broker-dealer’s research analysts and investment bankers and is not a  comprehensive review of potential conflicts that could arise from other  sources. Appendix I contains more information on our scope and  methodology, and we provide a list of studies included in our literature  review at the end of the report.
We conducted this performance audit from September 2010 to January  2012 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
subsections: section_title: Background
subsections: section_title: Broker-Dealers May Provide a Range of Services, Including Research for Investors
paragraphs: Broker-dealers may provide a range of financial services to clients,  including corporations, financial institutions, governments, and  individuals. A full-service broker-dealer (or a related subsidiary or affiliate)  may employ (1) investment bankers to assist clients with raising capital  through underwritings and private placements of equity and debt  securities and by offering advisory services on mergers, acquisitions, and  restructurings; (2) investment advisers who provide investment advisory  and financial planning services to clients; (3) brokers who facilitate client  transactions in fixed-income, equity, currency, and commodity products;  and (4) securities research analysts who provide equity and fixed-income  research services.
Securities research analysts play an important role in providing investors  with information that may affect their investment decisions. Analysts  typically research the current and prospective financial condition of  publicly traded companies in the particular industry or sector of the  economy in which they specialize. They then make recommendations  (e.g., buy, sell, or hold) about investing in the securities issued by the  companies the analysts cover in their research. To develop judgments  about the future prospects of a company and its securities, analysts may  evaluate the company’s expected earnings, revenue, and cash flow;  operating and financial strengths and weaknesses; long-term viability;  and dividend potential.
Analysts often specialize in equity or fixed-income (debt) securities  research. Sell-side analysts typically work for full-service broker-dealers  and make recommendations on the securities they cover through their  research. In contrast, buy-side analysts typically work for institutional  money managers, such as mutual funds, hedge funds, or investment  advisers, which purchase securities for their own accounts. Finally,  independent analysts typically are not associated with firms that  underwrite the securities they cover in their research.
section_title: Oversight of Securities Broker-Dealers and the Global Settlement
paragraphs: The securities industry generally is regulated under a combination of self- regulation (subject to oversight by SEC) and direct oversight by SEC.  Securities industry SROs primarily are responsible for establishing the  standards under which their members conduct business; monitoring the  way that business is conducted through regularly scheduled compliance  examinations; bringing disciplinary or enforcement actions against their  members for violating applicable federal statutes, SEC rules, and their  own rules; and referring potential violations of nonmembers to SEC. In  2007, NASD and NYSE’s member regulation, enforcement, and  arbitration functions merged to form FINRA, the primary securities  industry SRO responsible for overseeing broker-dealers.November 2011, FINRA’s membership included nearly 4,500 broker- dealers. According to FINRA, as of November 2010, approximately 220  firms conduct both investment banking and research. SEC’s oversight of  FINRA includes inspecting its operations and reviewing and approving its  rule proposals. SEC also directly regulates broker-dealers by conducting   As of  examinations; taking disciplinary actions against broker-dealers; and  interpreting, implementing, or changing its existing regulations.
A series of actions involving various federal and state entities culminated  in the Global Settlement. SEC reviewed industry practices and conducted  targeted examinations regarding analyst conflicts in 1999 and reported  the preliminary findings of the examinations to Congress in 2001. In April  2002, the New York Attorney General’s office announced an enforcement  action against a broker-dealer based on evidence that analysts were  pressured to issue positive stock recommendations to please investment  banking clients. Soon after, state regulators, SROs, NASAA, and SEC  formed a joint task force to investigate the undue influence of investment  banking interests on securities research at broker-dealers. Analyst  conflicts allegedly found by the investigations included the following  examples.
Research analysts supported investment banking by pitching  business to prospective clients and marketing investment banking  deals to institutional customers through road shows.
Equity research analysts’ compensation was determined partly by the  degree to which they assisted investment banking or their contribution  to investment banking revenue.
Investment bankers evaluated research analysts’ performance,  influencing research analysts’ compensation.
Investment bankers implicitly promised their potential clients favorable  research, with analysts participating in the sales presentations.
Investment bankers influenced whether analysts would start or  continue research coverage on existing or potential investment  banking clients.
Based on evidence compiled in their investigations, the joint task force  members determined the conditions of a settlement to resolve the  allegations of misconduct. In April 2003, 10 broker-dealers agreed to the  Global Settlement, concluding the joint investigation. In 2004,  enforcement actions were commenced against two other broker-dealers  involving analyst conflicts, and the firms settled substantively under the  same terms as the Global Settlement.
Under the Global Settlement, the firms were required to reform their  structures and practices to insulate equity analysts from investment  banking pressures. A three-part addendum to the Global Settlement  constitutes its operative portions (see app. II for a complete description  for the separation of research and investment banking, and the  disclosure/transparency and other issues sections). Section I of the  addendum set forth the structural reforms designed to separate equity  research from investment banking. For example, the firms had to physically separate research and investment banking departments; not base research analysts’ compensation, directly or indirectly, on  investment banking revenues or input from investment banking  personnel; prohibit investment bankers from having a role in company-specific prohibit research analysts from participating in efforts to solicit  investment banking business; and create and enforce firewalls restricting interaction between investment  banking and research personnel, except in specifically designated  circumstances.
Section II of the addendum includes disclosure requirements that serve to  inform investors about potential analyst conflicts and the performance of  analysts’ recommendations. It also includes a provision that allows any  Global Settlement term to be superseded by an SEC or SRO rule that  expressly purports to do so. With regards to any term that was not  superseded in this way within 5 years from the entry of the final judgment  of the Global Settlement, the firms could move to amend or modify any  term (other than the terms relating to independent research), subject to  court approval, unless SEC believed that such amendment or  modification was not in the public interest. Section III required the Global  Settlement firms to provide customers with independent research.
Firms also had to make various payments under the Global Settlement— totaling more than $1.4 billion. Specifically, each firm had to pay civil  penalties and disgorgements, in part to establish distribution funds to  recompense harmed investors, and other monies to create investor  education funds and provide customers with independent research.
section_title: Analyst Conflicts and Investor Harm
paragraphs: Views about what harm, if any, analyst conflicts cause investors vary.  SEC and FINRA have asserted that analyst conflicts can harm investors.  For instance, because of a conflict, an analyst could issue a misleading  recommendation on which investors rely and suffer a loss. In a 2003  report, the International Organization of Securities Commissions similarly  noted that the conflicts faced by sell-side analysts can result in biased  research that harms investors and undermine the fairness, efficiency, and   Also, some investors claimed in lawsuits that  transparency of markets.biased analyst recommendations artificially inflated market prices of the  covered stocks. In turn, they claimed that they bought stocks or held onto  stocks that they otherwise would have sold based on the biased  recommendations and suffered losses when the stocks returned to their  true value. Finally, some academics have suggested that institutional  investors may be able to trade strategically to take advantage of  misinformed individual investors that naively follow biased analyst  recommendations.
In contrast to such views, some economists and others have questioned  whether biased analyst recommendations, such as overly optimistic  recommendations, can lead to investor harm. For example, one  economist has argued that SEC enforcement actions against the Global  Settlement firms did not establish a clear connection between the analyst  conflicts and losses suffered by investors. he noted that in private litigation against one of the firms involving analyst  conflicts, the judge found that the plaintiff’s attorneys were not able to  craft an argument to show that investor losses could be attributed to the  allegedly conflicted research reports issued by a broker-dealer. In  addition, some evidence from empirical studies indicates that market  prices anticipate and incorporate analysts’ biases, suggesting that biased  analyst recommendations do not artificially inflate stock prices to the harm  of investors.
Erik Sirri, “Investment Banks, Scope, and Unavoidable Conflicts of Interest,” Economic  Review, Federal Reserve Bank of Atlanta, Fourth Quarter 2004.
section_title: Data and Stakeholders’ Views Suggest That Regulatory Actions Have Helped Address Conflicts Faced by Equity Analysts
paragraphs: We reviewed empirical studies, analyzed examination and enforcement  action data, and interviewed market participants and observers to assess  the extent to which regulatory actions have addressed equity analysts’  conflicts of interest. In addition to the Global Settlement, regulatory  actions taken to address conflicts faced primarily by equity research  analysts include the following SEC, NASD, and NYSE rules issued  between 2002 and 2005:  In May 2002, SEC approved NASD and NYSE proposals to address  analyst conflicts. NYSE’s proposal amended NYSE Rule 472, and  NASD’s proposal established NASD Rule 2711. These rules (SRO  research analyst rules) were substantively similar and designed to  restore public confidence in the validity of research and the veracity of  equity research analysts, who were expected to function as unbiased  intermediaries between securities issuers and investors. The SRO  research analyst rules require clear, comprehensive, and prominent  disclosure of conflicts in research reports and public appearances by  equity analysts. The rules also implement basic reforms to separate  research from investment banking. These include prohibiting  investment banking personnel from supervising analysts or approving  research reports, members from offering favorable research to induce  investment banking business, and analysts from receiving  compensation based on specific investment banking transactions.
In February 2003, SEC adopted Regulation Analyst Certification,  which requires, among other things, equity and fixed-income analysts  to certify that the views expressed in their research reports accurately  reflect their personal views and disclose whether they received  compensation or other payments in connection with their views.
In July 2003, SEC approved amendments to the SRO research  analyst rules. The rule amendments were designed to further  promote analyst objectivity and transparency of conflicts in research  reports and implement changes mandated by the Sarbanes-Oxley Act  of 2002. This act required SEC or SROs to adopt rules “reasonably  designed to address conflicts of interest that can arise when securities  analysts recommend equity securities in research reports and public  appearances.” The act also set forth specific rules to be promulgated,  some of which were not already in the SRO research rules, including  the prohibition on research analysts participating in investment  banking pitches. Accordingly, NASD and NYSE amended their rules.  The amendments require disclosure of a client relationship and  noninvestment banking compensation a firm receives from a covered  company and prohibit retaliation against research analysts for  publishing unfavorable research on an investment banking client.
In April 2005, SEC approved an amendment to the SRO research  analyst rules to prohibit research analysts from participating in road  shows and other matters, which are similar in certain aspects to the  Global Settlement’s terms.
While the SRO research analyst rules generally apply to all broker- dealers, they are less stringent than the Global Settlement’s terms in  some respects and more stringent in other respects (as discussed in  detail in the following section and in app. II).
subsections: section_title: Research Suggests Regulatory Reforms Were Associated with Improvements in Analyst Recommendations, but Other Effects Were Mixed
paragraphs: Numerous academic studies empirically examined the effects of the  regulatory reforms—namely NASD Rule 2711, NYSE Rule 472, and the  Global Settlement—on various aspects of recommendations and  research issued by research analysts. We reviewed 10 of these studies.Because the vast majority of the outstanding recommendations in mid- 2000 were buy recommendations (in contrast to hold or sell), some  market observers believed that sell-side equity analysts were issuing  overly optimistic or positive recommendations to help their firms attract or  retain investment banking business. Six of the 10 studies in our review  examined whether the reforms made sell-side analyst recommendations  less optimistic, and these and the other studies also examined other  effects of the reforms.indicated the stock recommendations of sell-side analysts became less  optimistic after the regulatory reforms, suggesting the reforms have  helped to address analyst conflicts. In addition, some of these studies  examined other effects, such as whether one or more of the reforms  made analyst recommendations more informative for investors, increased  the profitability of recommendations, or increased the accuracy of analyst  earnings forecasts. However, these results generally were mixed.
Five of the six studies examining changes in the distribution or relative  optimism of recommendations issued by analysts found that sell-side  analysts were issuing fewer positive recommendations, more negative  recommendations after the regulatory reforms, or both. studies commonly inferred from the empirical evidence that the regulatory  reforms helped to make recommendations less optimistic, they  recognized that other factors could have played a role. Key findings of  these studies include the following:
Buy recommendations of analysts at investment banks and brokers  increased substantially from 1996 to 2000, with the ratio of buy-to-sell  recommendations reaching 35 to 1 at one point. From mid-2000 to June 2003, the percentage of buy recommendations declined steadily,  with the ratio declining to 3 to 1. The buy recommendations issued by  the Global Settlement analysts declined more sharply than the buy  recommendations issued by other analysts after the adoption of  NASD Rule 2711.
Leslie Boni, “Analyzing the Analysts after the Global Settlement,” working paper,  University of New Mexico (Sept. 28, 2005). The author classified recommendations made  by the Global Settlement analysts as “high” (strongest recommendation), “medium”  (middle), and “low” (least strongly recommended) and found that the analyst  recommendations were more optimistic after the Global Settlement. However, these  results do not attempt to control for differences in analyst characteristics and other factors  that might influence recommendations.
Analysts affiliated with firms engaging in investment banking issued  fewer strong buy recommendations after the regulatory reforms and  fewer strong buy recommendations than independent analysts after  the adoption of NASD Rule 2711, NYSE Rule 472, and the Global  Settlement.
Settlement bank analysts issued, on average, less-optimistic  recommendations relative to the other types of analysts after the  adoption of NASD Rule 2711 and NYSE Rule 472, as well as the  Global Settlement. More specifically, these analysts issued not only fewer favorable recommendations but also more unfavorable  recommendations than the other analysts for the same stocks.
After the adoption of NASD Rule 2711 and NYSE Rule 472, and the  Global Settlement, analysts at the Global Settlement firms and the  next 10 largest brokerage houses started to issue more neutral and  pessimistic recommendations and fewer optimistic  recommendations. In addition, the Global Settlement analysts started to issue pessimistic recommendations much more often than  analysts at the other brokerage houses.
Two studies found evidence indicating that the influence of conflicts of  interest on analyst recommendations weakened after the regulatory  reforms.
Before the adoption of the regulatory reforms, analysts affiliated with  brokers that recently underwrote securities were more likely to make  buy recommendations for those securities than unaffiliated analysts.The bias largely disappeared after the reforms. At the same time,  affiliated analysts were less likely than unaffiliated analysts to issue  hold or sell recommendations after the regulatory reforms.
Before the adoption of NASD Rule 2711, sell-side analysts’  recommendations were positively related to two variables—a  company’s net external financing and the underwriting business  provided by analysts’ employers—which were intended to capture  factors that could lead sell-side analysts to issue overly optimistic  recommendations to attract new or retain existing investment banking  business.  After the rule adoption, the positive relationship continued  but became weaker—suggesting that the influence of conflicts on  analyst recommendations had weakened.
Chih-Ying Chen and Peter F. Chen, “NASD Rule 2711 and Changes in Analysts’  Independence in Making Stock Recommendations,” The Accounting Review, vol. 84, no. 4  (2009). The study focuses on sell-side analysts and has a sample period from 1994  through 2005. estimate stock values and then compare their valuation estimates to the  current stock prices to arrive at their buy, hold, or sell recommendations.
The consensus recommendations of sell-side analysts were  negatively related to stock valuation estimates based on earnings  forecasts before the adoption of SEC Regulation Full Disclosure.  However, the relationship became less negative after the adoption of  the regulation and turned positive after the adoption of NASD Rule  2711, NYSE Rule 472, and the Global Settlement.
The relationship between sell-side analysts’ stock recommendations  and valuation estimates based on earnings forecasts became  significantly stronger after the adoption of NASD Rule 2711.
Most of the studies we reviewed also examined other effects of the  regulatory reforms. However, the empirical results generally were mixed  on whether the regulatory reforms increased the profitability of analysts’  recommendations, made analysts’ recommendations more informative for  investors, or increased the accuracy of analysts’ earnings forecasts. That  is, some studies arrived at different conclusions about the effectiveness of  the regulatory reforms on factors other than analyst independence and  objectivity.
Three studies examined whether the regulatory reforms improved the  profitability of analyst recommendations. The results of one of the  studies suggested that NASD Rule 2711 enhanced the investment  value of sell-side analyst recommendations, but the results of the  other studies generally did not.
Four studies examined whether investors found analyst  recommendations to be more informative after the regulatory reforms.  Three studies found evidence indicating that investors viewed  changes in recommendations made by sell-side analysts to be less or  equally informative after the reforms. One study found that after the  adoption of NASD Rule 2711 the market reacted more strongly to buy  and sell recommendations made by sell-side analysts.
Two studies examined the effect of the regulatory reforms on the  accuracy of analyst earnings forecasts. One study found that the  earnings forecasts of investment bank analysts became less accurate,  on average, in comparison with the forecasts of other types of  analysts after the regulatory reforms.
The other study found that the  analyst forecasts overestimated actual earnings before the Global  Settlement, but the bias declined after the Global Settlement.
section_title: SEC and SROs Generally View the Regulatory Reforms as Effective in Addressing Equity Analyst Conflicts
paragraphs: The SROs reviewed the effectiveness of the research analyst rules  shortly after their adoption and concluded that the reforms were generally  effective. At SEC’s request, NASD and NYSE staff jointly conducted a  review of the operation and effectiveness of their research analyst rules  and submitted their report to SEC in December 2005. As part of their  study, NASD and NYSE staff reviewed examinations of their members for  compliance with the research analyst rules, enforcement actions taken  against members for violations of the rules, and academic studies and  media reports and commentary. The NASD and NYSE staff concluded  that the SRO research analyst rules were effective in helping to restore  integrity to analyst research by minimizing the influences of investment  banking and promoting transparency of other potential conflicts of  interest. They also noted that evidence suggested that investors were  benefiting from more balanced and accurate research to aid their  investment decisions.
In addition, FINRA officials and SEC staff told us that they view the  regulatory reforms as effective—citing their examination findings and the  limited number of enforcement actions involving conflicts between  research and investment banking as evidence of the reforms’  effectiveness. According to FINRA officials, FINRA examines its member  broker-dealers on a cyclical basis. The officials said that the scope of  each examination is based on a risk-assessment of the firm. In that  regard, although FINRA has developed examination modules to assess  broker-dealer compliance with the SRO research analyst rules and the  Global Settlement, examiners may not cover these areas in every  examination. In addition, FINRA officials and SEC staff told us that they  can bring enforcement actions against broker-dealers for violations of rule  or statute. Examination findings and enforcement actions provide useful  information on the extent to which firms have been complying with the  research analyst rules and the Global Settlement and, in conjunction with  the empirical studies and other evidence, an indication of the  effectiveness of those regulatory actions.
Although FINRA found deficiencies in a high percentage of its  examinations, the nature of the findings generally were minor, according  to FINRA’s data, and indicated that broker-dealers largely have been  complying with the SRO research analyst rules. From 2005 through 2010,  FINRA conducted 791 cycle broker-dealer examinations that covered  compliance with the SRO research analyst rules, according to data  provided by FINRA. Of the 791 examinations that included a review of  general research, 309 (39 percent) found some rule-related deficiencies.  As shown in figure 1, the number of examinations covering the SRO  research analyst rules declined steadily each year, from a high of 221 in  2005 to a low of 65 in 2010. While the number of examinations declined  over this period, so did the number with deficiencies, from 79 in 2005 to  23 in 2010. The nature of the exceptions found in the examinations  generally included technical disclosure or supervisory deficiencies.  Matters considered for formal action included instances of noncompliance  with the requirements to separate research and banking or to disclose  relevant information about potential or actual conflicts. For example,  some firms failed to implement firewalls to properly separate investment  banking from research, and some failed to disclose that they were to  receive or already had received investment banking compensation from a  company covered by their research analysts. FINRA referred 38 of the  309 examinations with deficiencies to its Enforcement Department for  formal disciplinary action. While some referrals involved firms that failed  to properly separate research from investment banking, most involved  matters other than conflicts between research and investment banking,  such as analysts engaging in personal trading against their  recommendations.
Similarly, FINRA’s examination findings indicate that the Global  Settlement firms generally have complied with the Global Settlement.  From 2005 through 2010, FINRA conducted 36 cycle examinations of the  Global Settlement firms that covered their compliance with the Global  Settlement, according to data provided by FINRA (see fig. 2). While some  Global Settlement firms were examined more often than others, each was  examined at least once during this period for compliance with the Global  Settlement’s terms.found deficiencies. Five of the deficiencies involved disclosure violations,  such as failing to reference the specific page number on which investors  could locate disclosure information. The remaining three deficiencies  involved violations of the Global Settlement’s structural reforms. For   Eight of the 36 Global Settlement examinations  example, one firm failed to ensure that its oversight committee reviewed  research reports for changes in ratings or price targets before publication,  while another firm disclosed to examiners that its communications firewall  failed to block electronic communications between its research and  investment banking staff for nearly 9 months. According to FINRA  officials, none of the deficiencies in the examinations resulted in a referral  for formal disciplinary action, although the matter involving problems with  one firm’s communications firewall still is under review.
During the same time frame, FINRA also initiated numerous cause  examinations involving the SRO research analyst rules, but most did not  involve conflicts between research and investment banking. In 2010,  FINRA initiated two cause examinations to examine whether the broker- dealers were permitting their investment banking staff to improperly  influence their research analysts’ recommendations. According to FINRA  officials the two examinations are ongoing.
According to SEC staff, their broker-dealer examination findings indicate  that the regulatory reforms have been effective in addressing analyst  conflicts. SEC staff said that they do not have an examination module  specifically designed to cover the SRO research analyst rules or the  Global Settlement but have reviewed whether broker-dealers were  complying with such requirements in some of their examinations of  broker-dealers examined by FINRA. Based on their review of broker- dealer examination reports dating to 2005, SEC staff told us that they  identified a few examinations that found deficiencies related to the SRO  research analyst rules. According to the staff, these deficiencies  included broker-dealers failing to disclose analyst conflicts in their  research reports and failing to comply with requirements that restrict an  analyst’s public appearance.
In addition to their findings from broker-dealer examinations, FINRA  officials and SEC staff said that the limited number of enforcement  actions involving conflicts between equity research and investment  banking suggests that the regulatory reforms have been effective. From  2005 through 2010, FINRA took 10 enforcement actions against broker- dealers for violations of NASD Rule 2711 that involved conflicts between  research and investment banking. Five of the enforcement actions were  taken against Global Settlement firms and largely involved failures to  adequately comply with disclosure requirements (see fig. 3). The other  five enforcement actions were taken against nonGlobal Settlement firms:  three for allowing investment banking personnel to influence analyst  compensation and two for failing to comply with requirements to disclose  the firm’s compensation for investment banking services. In each  instance, the firm was required to sign an Acceptance, Waiver, and  Consent, a settlement wherein the broker-dealer consents, without  admitting or denying the findings, to the entry of the findings and to the  imposition of sanctions. In addition, FINRA censured the firms for their  misconduct and imposed monetary fines.
SEC also has taken enforcement actions involving conflicts between  research and investment banking. Specifically, SEC took a total of three  such actions from 2005 through 2010. In 2005, SEC brought a settled  action against two research supervisors for their failure to reasonably  supervise an equity research analyst who published fraudulent research.  The case focused on the adequacy of supervision of a research analyst,  who was subject to a prior enforcement action that alleged the analyst  produced biased research to support the firm’s investment banking  business. In 2007, SEC issued a cease and desist order against a firm for  employing business practices that linked research and investment  banking, creating incentives for its analysts to support the firm’s  investment banking business. In 2010, SEC issued a cease and desist  order against a firm for failing to establish and enforce policies and  procedures to prevent the misuse of material, nonpublic information. The  firm engaged in securities research and was the parent of an investment  advisory subsidiary that shared the same chief compliance officer. In its  order, SEC alleged that the firm failed to prevent its investment advisory  subsidiary from misusing material research information, such as the  initiation of research coverage or changes in price targets, produced by  its research department.
Additionally, under the Global Settlement, each of the 12 broker-dealers  had to (1) hire an independent monitor to assess whether the firm had  developed adequate policies and procedures to ensure compliance with  the Global Settlement and (2) certify compliance with the Global  Settlement within 5 years of the date of the entry of the final judgment.  Each independent monitor generally completed and filed their reports  between October 2003 and February 2006.
Based on our review of the independent monitor reports, all the monitors  generally concluded that each firm had implemented effective policies  and procedures to comply with the Global Settlement. To conduct their  reviews, the monitors typically examined each firm’s policies and  procedures, reviewed supporting documents to verify the implementation  and effectiveness of the policies and procedures, made observations,  conducted inspections (for example, of physical separation of research  and investment banking), and interviewed the firm’s management and  staff. Although the independent monitors concluded that each firm was in  compliance with the Global Settlement, all of them included  recommendations in their reports. The recommendations generally were  intended to clarify or enhance a firm’s compliance policies and  procedures or improve a firm’s ability to track and monitor its compliance.  According to SEC staff, all the Global Settlement firms certified that they  were in compliance with the Global Settlement by August 2008.  According to SEC staff, on a number of occasions, the Global Settlement  firms self-reported instances of noncompliance with the Global Settlement  to SEC staff. These reported instances largely concerned technical  failures to provide disclosures regarding the availability of independent  research or ratings on customer account statements and confirmations.  Upon receiving these reports, SEC staff typically notified the other  regulators involved in the Global Settlement, discussed the violations and  remedial measures with the reporting firm, and asked that the firm write to  inform the court of the matter.
section_title: While Market Participants and Others Generally View the Reforms as Effective, Some Noted Conflicts Could Not Be Completely Addressed or Eliminated
paragraphs: Most market participants and observers we interviewed told us that the  regulatory reforms have been effective in mitigating analyst conflicts but  provided different reasons why. Examples cited by market participants  and observers as to why the structural reforms have been effective  include the following:
Research analysts are shielded from investment banking influence,  according to officials from broker-dealers, an independent research  firm, and institutional money managers;
Securities research is more independent but not necessarily better,  according to officials from an institutional money manager; and
The regulatory reforms provide a compliance structure that requires  broker-dealers to manage their analyst conflicts, according to state  securities regulators.
In addition to the structural reforms, market participants and observers  said that the disclosure requirements have been effective in addressing  analyst conflicts, in part because investors are more aware of potential  analyst conflicts, according to officials from broker-dealers, a consumer  interest group, and independent research firms. Furthermore, officials  from the consumer interest group said that the media attention  surrounding the investigations that led to the Global Settlement helped to  raise investors’ awareness of analyst conflicts.
Despite generally viewing the regulatory reforms as effective, some  market participants and observers told us that the reforms do not  completely eliminate research analysts’ conflicts. For example, according  to an academic, the SRO research analyst rules and the Global  Settlement prohibit sell-side analysts from being compensated based on  their investment banking contributions, but their pay may be based on  their firm’s overall profitability—of which investment banking can be a  major source. As a result, sell-side analysts face inherent conflicts  because they know that negative ratings can harm their firm’s investment  banking business and, in turn, their personal compensation, according to  state securities regulators, institutional investors, academics, and others  with whom we spoke. Officials from a consumer interest group told us that  this inherent conflict can be eliminated by prohibiting firms from engaging  in both investment banking and research. In addition, although the Global  Settlement requires the firms to physically separate research and  investment banking staff, this prophylactic measure can be circumvented,  according to officials from an investor advocacy group and a consumer  interest group. For example, officials from the investor advocacy group  said analysts and investment bankers could talk outside of the firm. In  their reports, two independent monitors recognized the limitations of the  reform but their reports suggest that physical separation reinforced the  idea that analysts and investment bankers were not supposed to talk with  each other.
section_title: Regulators Have Opportunities to Enhance Investor Protection and Streamline or Harmonize Oversight
paragraphs: Although SEC and FINRA have taken regulatory actions to address  conflicts of interest faced by securities research analysts, additional  opportunities exist to adopt or revise rules to enhance investor protection  and streamline or harmonize oversight.
subsections: section_title: FINRA Plans to Finalize Equity Analyst Rules Intended to Enhance Investor Protections and Reduce Regulatory Burden
paragraphs: FINRA plans to finalize an equity analyst rule that includes longstanding  internal recommendations intended to enhance investor protections,  increase information flow to investors, and reduce regulatory burden,  according to FINRA officials. In a December 2005 report, NASD and  NYSE staff made recommendations to amend the SRO research analyst  rules, but the recommendations have yet to be implemented. As part of its  2005 request that the SROs review the effectiveness of their research  rules, SEC asked NASD and NYSE to make any recommendations for  rule changes or additions. To address this request, NASD and NYSE staff  conducted a section-by-section review of the rules, which included  assessing whether the rules were accomplishing their purpose,  comparing the rules to the Global Settlement, considering gaps in  coverage, and reviewing industry questions and comments about the  rules. As discussed in the following paragraphs, the SRO staff  recommended revising their rules to prohibit a practice that was not  permitted under the Global Settlement’s terms. In general, the staff  recommended several rules changes that were intended to improve rule  effectiveness by striking a better balance between trying to ensure  objective and reliable research and permitting the flow of information to  investors and minimizing costs and burdens to firms. Specifically, the  recommendations included:  changing the definition of “research analyst,” “research report,” and  other terms used in the rule, to codify exceptions set forth in previous  interpretive material and to align with SEC Regulation Analyst  Certification and the Global Settlement; eliminating a provision that permitted investment banking personnel to  review research before publication (to verify factual information),  because SRO staff believed that such a review raised concerns about  the objectivity of the research and noted that such a review was not  permitted under the Global Settlement’s terms; amending the disclosure rules to provide more effective disclosure by  allowing, in lieu of disclosure in the research report itself, a prominent  warning on the cover of research reports that conflicts exist and  information about how investors could obtain more details about those  conflicts of interest on the firm’s website, because staff were  concerned that the volume of disclosures in the reports could obscure  their overall message; and amending the provision that prohibited investment banking personnel  from retaliating against research analysts as a result of unfavorable  research to include all of a firm’s employees.
Similar to the concerns raised by the SRO staff about the conflict  disclosures, various market participants and observers we interviewed  questioned the effectiveness of or raised concerns about the burden of  the conflict disclosures. For example, some broker-dealers told us that  that the volume and complexity of the disclosures have made the  information less useful for investors. Also, officials from three associations  representing investors and an institutional investor said the disclosures  are important but do not convey sufficient information for investors to fully  understand the nature and magnitude of analyst conflicts. Broker-dealers  further noted that their need to continually collect a wide range of data to  track analyst conflicts is costly and burdensome.
In 2008, FINRA issued a proposal to consolidate the NASD and NYSE  research analyst rules in a new FINRA rule and move to a more  principles-based regulatory approach in this area. The proposal  included most of the recommendations made by the NASD and NYSE  staff in their December 2005 report. Additionally, FINRA’s proposed  consolidated rule would broaden the obligations of its member broker- dealers to identify and manage analyst conflicts. Specifically, it included a  provision to require FINRA members to establish, maintain, and enforce  policies and procedures reasonably designed to identify and effectively  manage conflicts related to the preparation, content, and distribution of  research reports and public appearances by equity analysts. The  proposal also specified that the policies and procedures must address  information barriers and other safeguards to insulate research analysts  from pressure by investment banking personnel. The proposal largely  maintained the same disclosures, including a provision that would require  a member to disclose in any research report all conflicts that reasonably  could be expected to influence the objectivity of the report and that are  known or should have been known on the date of the report’s publication  or distribution. FINRA received five comment letters on its proposal. The  comments (which were from a venture capital association, a securities  industry association, a securities firm, a law office, and an individual)  generally supported the proposal but expressed concerns, including that  some terms were too broadly defined and, thus, would make compliance  difficult.
FINRA has not yet finalized its 2008 proposal designed to consolidate the  SRO research analyst rules and implement recommendations made by  NASD and NYSE staff in 2005. According to FINRA officials, FINRA has  delayed finalizing the proposal until it finalizes a proposal to address  conflicts of interest faced by fixed-income (debt) research analysts. SEC  staff and FINRA officials told us that SEC encouraged FINRA to consider  adopting a rule to address conflicts of interest faced by fixed-income  research analysts. As discussed later in the report, FINRA recently issued  a concept release for a fixed-income research rule. According to FINRA  officials, their tentative plan is to seek comment on a regulatory notice on  a revised debt research proposal and then package the final debt and  equity research rule proposals together and submit a single proposed  consolidated research analyst rule to SEC in the first half of 2012.
section_title: SEC and FINRA Have Not Formally Assessed and Documented Whether Any of the Global Settlement’s Remaining Terms Should Be Codified
paragraphs: Although the Global Settlement has been in place since 2003 and  includes a provision that allows for it to be modified or superseded, SEC  and FINRA have not proposed codifying the Global Settlement’s  remaining terms. The Global Settlement provided that if SEC adopts a  rule or approves an SRO rule with the stated intent to supersede any of  the Global Settlement’s terms, then that term would be superseded. The  Global Settlement also originally provided that SEC would agree, subject  to court approval, to modify any term in Section I or II of the addendum  that had not been superseded within 5 years of the entry date of the  Global Settlement, unless SEC determined the modification would not be  in the public interest.
While NASD and NYSE adopted research analyst rules that are similar to  many of the Global Settlement’s terms (see app. II for a comparison of  the Global Settlement and SRO research analyst rules), they did not  expressly state that their rules superseded the terms.Global Settlement firms, with SEC’s agreement, submitted a request to a   In 2009, the  federal district court to modify the Global Settlement’s addendum. In their  request, the firms stated that the addendum should be terminated in its  entirety, and they, like other broker-dealers, should be subject only to the  SEC and SRO research analyst rules. However, the firms noted in their  request that SEC indicated that certain provisions should be retained in  the public interest. Consequently, the firms did not ask the court to  terminate in full Sections I and II, but instead to modify the majority of the  terms in Section I and a disclosure requirement in Section II. The  broker-dealers primarily justified their requested changes based upon the  existence of the SRO research analyst rules that addressed the same  concerns and provided comparable protections.
On March 15, 2010, the federal district court approved all but one of the  requested changes.investment banking personnel to communicate with each other—outside  the presence of internal legal or compliance staff—about market or  industry trends, conditions, or developments, provided that such  communications were consistent in nature with communications that an  analyst might have with investing customers. The court noted that the  change was counterintuitive and would undermine the separation  between research and investment banking. Under the modified Global  Settlement approved by the court, terms that remain in place include:   The court declined to allow research and  investment banking cannot have input into the research budget, research analysts and investment banking must be physically  separated, investment banking cannot have input into company-specific coverage  decisions,  research oversight committees must ensure the integrity and  independence of equity research,  investment banking personnel and research analysts cannot  communicate about the merits of a proposed transaction or a potential  candidate for a transaction unless a chaperone from the firm’s legal or  compliance department is present, research analysts and investment bankers cannot communicate for  the purpose of having research personnel identify specific potential  investment banking transactions, and research analysts must be able to express their views to a  commitment committee about a proposed investment banking  transaction outside the presence of investment bankers working on  the deal.
While the court maintained these terms in the modified Global Settlement,  the court’s March 15, 2010, order provided that the parties expected SEC  would agree to further modification of the Global Settlement’s terms at the  earlier of March 15, 2011, or the effective date of the consolidated  research rule proposed by FINRA in October 2008 (if such rules  addressed the Global Settlement’s remaining terms), unless SEC  believes such amendment or modification would not be in the public  interest. Any such amendment or modification would be subject to court  approval.  To date, the Global Settlement firms have not requested any  further modification of the settlement. See figure 4 for a summary of  events relating to the Global Settlement and SRO research analyst rules.
Certain SEC staff and FINRA officials have different views about whether  the remaining Global Settlement’s terms should be codified. According to  SEC staff, the reference to FINRA’s consolidated rule proposal was  included in the modified Global Settlement because of the possibility that  FINRA would amend its rule proposal to include the remaining terms.  According to FINRA officials, FINRA does not plan to state that its  consolidated rule, when finalized, would supersede the Global  Settlement. FINRA officials said the Global Settlement serves to address  bad behavior in which the Global Settlement firms allegedly engaged;  thus, some of the Global Settlement’s terms are more stringent than the  SRO research analyst rules and should not apply to firms that did not  engage in such behavior. FINRA officials said that the decision to modify  or terminate the Global Settlement should not be done through a FINRA  rulemaking; rather, it should be determined by the court based on  whether the remedial actions required under the Global Settlement have  reached their finality. SEC staff told us that any rulemaking to codify the  provisions of the Global Settlement would be most appropriate as SRO  rules.  SEC staff continue to work with FINRA to achieve this goal.
According to FINRA officials, they have carefully considered the  appropriateness and impact of codifying the Global Settlement’s  remaining terms. They are concerned that some of the remaining terms  are potentially costly and burdensome and would affect unfairly those  firms that were not alleged to have engaged in wrongful conduct,  particularly some small firms that provide both research and investment  banking services. As discussed, NASD and NYSE staff conducted a  section-by-section review of the research analyst rules in 2005, which  included comparing the rules to the Global Settlement’s terms, and  recommended codifying one of the terms not already in the rules. For  FINRA’s consolidated equity rule proposal, FINRA officials told us that  they recently analyzed and discussed the Global Settlement’s remaining  terms with SEC staff and conveyed to the SEC staff their position on  which ones should be codified. According to the FINRA officials, their  analysis considered the investor protection benefits of adopting the  Global Settlement’s remaining terms and the costs and burdens that such  action would impose on non-Global Settlement firms. The officials told us  that their analysis largely was done through internal discussions and was  not documented.
According to SEC staff, it is incumbent on the Global Settlement firms to  initiate action to repeal or modify any of the Global Settlement’s terms (as  provided in the modified Global Settlement), and none of the firms have  contacted SEC to discuss further modifications since 2009. The staff said  that if the firms requested that the Global Settlement be modified, SEC  would have to find that the modifications were counter to the public  interest for SEC to oppose the request. Moreover, SEC staff said that the  Global Settlement firms continue to be subject to the Global Settlement,  because the related enforcement actions found them to be allegedly  engaged in a litany of misconduct. They told us that the Global Settlement  was not intended to create a competitive disadvantage for the Global  Settlement firms, but rather to address their conduct. At the same time,  the SEC staff said that the Global Settlement’s terms provide useful  protections that could benefit all investors if applied more broadly.  According to SEC staff, the Global Settlement firms account for the vast  majority of the U.S. investment banking business, and other broker- dealers have opted to comply voluntarily with the Global Settlement. As a  result, SEC staff said that the majority of research produced by broker- dealers also engaged in investment banking is, in effect, affording  investors the protections provided under the Global Settlement’s terms.
Although SEC staff and FINRA officials periodically have discussed and  analyzed the Global Settlement’s terms, they have not formally  determined and documented the benefits and costs of adopting rules  based on the Global Settlement’s remaining terms. Such analysis would  serve to determine and make transparent whether the benefits of such  action would likely justify the costs. However, as long as the Global  Settlement remains in effect, the Global Settlement firms continue to be  subject to the requirements of the Global Settlement and the SRO  research analyst rules, while other firms that provide the same services  are subject only to the SRO research analyst rules. As a result, investors  may not be provided the same level of protection. We have previously  reported that a regulatory framework should include investor protection as  part of its mission to ensure that market participants receive consistent,  useful information, as well as consistent legal protections for similar  financial products and services. To the extent that any of the Global  Settlement’s remaining terms provide a cost-effective way of furthering  investor protection, by not formally assessing their codification SEC may  be missing an opportunity to provide consistent investor protection.
section_title: FINRA Has Been Drafting a Rule to Address Conflicts of Interest Faced by Fixed- Income Research Analysts
paragraphs: FINRA has been drafting a rule to address longstanding concerns about  conflicts of interest that fixed-income analysts face. Although fixed- income research analysts, like equity research analysts, face conflicts of  interest, fixed-income research conflicts were not addressed in the SRO  research analyst rules. For instance, Enron Corporation’s (Enron)  bankruptcy in the early 2000s drew attention to the harm that could result  from fixed-income analysts’ conflicts. In particular, a sell-side fixed- income analyst assigned to cover Enron’s debt securities testified in 2001  that she perceived pressure from her superiors not to issue negative  public comments on Enron because of Enron’s importance as an  investment banking client of the broker-dealer. When NASD and NYSE  initially adopted their research analyst rules in 2002, the rules did not  cover fixed-income analysts. And neither the Global Settlement nor the  research-related provisions of the Sarbanes-Oxley Act (which resulted in  subsequent amendments to the SRO research analyst rules in 2004)  apply to fixed-income research. However, in 2003, SEC adopted  Regulation Analyst Certification to require both equity and fixed-income  analysts to certify that the views expressed in their research reports  accurately reflected their personal views and disclose whether they  received compensation or other payments in connection with their views.
In the absence of specific SRO research analyst rules covering fixed- income research conflicts, NASD and NYSE generally relied on antifraud  statutes and SRO rules prohibiting fraud and requiring ethical conduct  and a comprehensive supervisory scheme to oversee a firm’s securities  business. In addition, NASD and NYSE encouraged firms to consider  adopting industry-developed principles to address such conflicts. In 2004,  to promote the integrity of fixed-income research, the Bond Market  Association (BMA), an industry association, issued voluntary, principle- based guidelines designed to help firms manage potential conflicts faced  by fixed-income analysts. At the time, BMA did not support the adoption of SRO rules designed to address fixed-income conflicts. The industry  maintained that the nature and intensity of the conflicts fixed-income  analysts faced differed from those equity analysts faced. For example,  industry participants held that prices of debt securities were relatively less  sensitive to the views of research analysts, credit rating agencies played  an important role in the debt markets by providing investors with  independent information, and users of fixed-income research typically  were sophisticated investors presumed to be less in need of protection. In  a December 2005 report on the effectiveness of the SRO research  analyst rules, NASD and NYSE staff concluded that it was not appropriate  at the time to amend the rules to cover fixed-income analysts or codify  BMA’s guiding principles. Instead, staff noted that the SROs were  monitoring the extent to which firms adopted the BMA principles and  would consider rulemaking after assessing the effectiveness of voluntary  compliance with the principles. NASD and NYSE staff further noted that  the existing antifraud statutes and SRO rules could cover any egregious  conduct involving fixed-income research.
NASD, Research Analysts and Research Reports: NASD and NYSE Joint Interpretive  Guidance on Fixed Income Research, Notice to Members 06-36 (July 2006). systems reasonably designed to achieve compliance with applicable SRO  rules and securities laws and regulations. According to FINRA officials,  the joint interpretative guidance served as a “warning shot” to the firms.
Following NASD and NYSE’s 2006 interpretive guidance, FINRA  continued to examine its member firms for compliance with the BMA  principles and find instances of noncompliance. Based partly on BMA’s  guiding principles, FINRA developed an examination module to assess  whether a firm’s fixed-income research supervisory procedures, policies,  and processes promote the integrity of fixed-income research and  address potential conflicts of interest. According to FINRA officials,  FINRA has included a review of fixed-income research in some of its  cycle examinations. As shown in figure 5, between 2005 and 2010,  FINRA (or its predecessors) conducted 55 cycle examinations that  covered fixed-income research and found related deficiencies in 11  examinations. The deficiencies generally involved inadequate supervisory  procedures for managing fixed-income analyst conflicts or inadequate  disclosures of such conflicts. Although none of the examinations resulted  in a formal disciplinary action, one examination found that the firm lacked  procedures not only to prohibit staff from directly or indirectly offering  favorable fixed-income research coverage to issuers but also to prevent  nonresearch staff from attempting to coerce fixed-income analysts to alter  their views on the content of a research report. Finally, the examinations  included eight Global Settlement firms; deficiencies were found in one of  these eight firms.
In March 2011, FINRA issued a regulatory notice to explore and obtain  public comment on the concept of adopting a rule to address conflicts of  interest faced by fixed-income analysts. In its release, FINRA noted that it  long had been monitoring broker-dealers’ management of conflicts of  interest in fixed-income research and that it was an appropriate time to  engage in rulemaking to address such conflicts because, among other  things, FINRA staff had observed increased retail investment risk in  complex debt securities, such as auction rate securities. Specifically, the  staff noted that the allegations of misconduct in the sale of auction rate  securities illustrated this risk and provided a concrete example that  potential conflicts of interest in the publication and distribution of debt  research existed just as they did for equity research. FINRA officials told  us that SEC staff also encouraged FINRA to adopt a rule to address  fixed-income analyst conflicts.
According to FINRA officials, the primary purpose of the fixed-income  research rule is to protect retail investors. To that end, the majority of the  existing structural safeguards and disclosures in NASD’s research analyst  rule would apply to retail debt research. Similarly, the disclosures  applicable to equity research largely should apply to debt research and  would include the disclosure of personal and firm financial interests and  the receipt of compensation for investment banking services from  companies covered by fixed-income analysts. However, the scope of the  safeguards would be expanded to cover conflicts between debt research  and sales and trading personnel. Specifically, a firm’s sales and trading  staff would be prohibited from attempting to influence a fixed-income  analyst’s opinion or views for the purpose of benefiting the trading  position of the firm—which allegedly occurred in certain firms engaged in  auction rate securities—or a customer or class of customers. For  example, in 2008, a state securities regulator alleged that a broker-dealer  permitted its sales and trading managers to unduly influence and  pressure its fixed-income research department. The managers did not  agree with the tone or context of a published research report and  allegedly insisted that the report be retracted and replaced with a more  sales-friendly report.
FINRA officials told us they faced challenges in balancing the benefits of  the rule in providing protections for retail investors with the cost and  burden of the rule for institutional investors. According to the officials,  institutional investors use the analytics, not the recommendations,  generated by fixed-income analysts and do not want rules that would  restrict the flow of timely information. Moreover, institutional investors  trading debt securities generally tend to interact with broker-dealers more  as counterparties than customers and are aware of potential conflicts  faced by fixed-income analysts. FINRA’s concept proposal exempts fixed- income research that is disseminated solely to institutional investors from  some of the structural safeguards and most of the disclosures that would  be applicable to retail debt research. Firms operating under the  exemption would have to clearly distinguish such research from research  disseminated to retail investors. The proposal noted that not all  institutional investors are necessarily alike; therefore, institutional  investors would be allowed to opt out of the exemption and be treated like  retail investors.
Another challenge in developing a fixed-income research rule is  separating fixed-income research from sales and trading, according to  FINRA. FINRA officials told us that it was easier to describe the conflicts  between fixed-income research and sales and trading than to craft  communication firewalls to separate the two departments. The officials  said that broker-dealers maintain that sales and trading should not be  wholly prohibited from communicating with research, because sales and  trading staff need information from research regarding the  creditworthiness of an issuer and other information reasonably related to  the price or performance of a debt security. In turn, debt analysts need  information from sales and trading to help, among other things, determine  the coverage universe and to assess current prices, spreads, and liquidity  of debt securities.
Most market participants and observers we interviewed generally  supported the adoption of a FINRA rule to address conflicts faced by  fixed-income research analysts. Stakeholders cited the lack of  transparency in the fixed-income markets as the primary reason for the  need for a fixed-income research rule. Some said that investors lack  sufficient information about the securities in which they sought to invest,  because no regulations require broker-dealers to disclose potential  conflicts. Similarly, FINRA received six comment letters about the concept  proposal, all of which generally supported FINRA’s efforts to develop the   However, all of the letters expressed concerns, including that  proposal.the communication restrictions were unclear and could limit fixed-income  analysts’ ability to support sales and trading.
As previously discussed, FINRA officials told us that they plan to submit a  proposed fixed-income rule to FINRA’s Board of Governors for its review  and approval in December 2011. The officials said that FINRA then  tentatively plans to file the proposed rule, assuming its board approves it,  with SEC in the first half of 2012. While antifraud statutes and existing  SRO rules serve to protect investors from abuse arising from fixed- income analyst conflicts, SEC and FINRA staff, as well as most market  participants and observers we interviewed, acknowledged that additional  rulemaking is needed to protect investors, particularly retail investors. In  that regard, until FINRA adopts a fixed-income research rule, investors  continue to face a potential risk.
section_title: Conclusions
paragraphs: Since the early 2000s, SEC and the SROs have taken and continue to  take a variety of actions to address conflicting interests between research  analysts and investment bankers and, in turn, protect investors. Principal  actions include Regulation Analyst Certification, the SRO research  analyst rules, and the Global Settlement—which include similar structural  requirements designed to separate research from investment banking  and thereby insulate research analysts from investment banking pressure  and influence. The Global Settlement imposes, in some areas, more  stringent requirements on the Global Settlement firms than the SRO rules  impose on other broker-dealers engaged in research and investment  banking, because the Global Settlement resulted from enforcement  actions involving analyst conflicts. Nonetheless, the structural  requirements in the SRO rules and the Global Settlement were  developed, in part, based on similar findings and generally seek to  achieve the same fundamental objective—to enhance the integrity and  independence of securities research. But unlike the SRO rules, the Global  Settlement was not intended to be permanent.
By establishing, in effect, separate but different requirements for  addressing analyst conflicts, the SRO research analyst rules and the  Global Settlement raise the question of whether any of the Global  Settlement’s remaining terms need to be adopted as SEC or SRO rules to  better protect investors. While SEC staff and FINRA officials have  discussed this issue, they have not reached a consensus or formally  determined and documented whether any of the Global Settlement’s  remaining terms should be codified. Through some of its more stringent  requirements, the Global Settlement potentially affords greater  protections to investors in some areas than the SRO rules but imposes  greater burdens on broker-dealers. Whether these burdens are  appropriate in comparison to the greater protections of the requirements  has yet to be determined and documented. However, an analysis as to  whether the Global Settlement’s remaining terms should be codified  would provide SEC with a basis for reconciling the differences between  the SRO rules and the Global Settlement. To the extent that any of the  Global Settlement’s remaining terms provide an effective way of  furthering investor protection, by not assessing their codification SEC may  be missing an opportunity to provide consistent investor protection.
section_title: Recommendation for Executive Action
paragraphs: To help ensure that investors consistently are protected from potential  conflicts of interest between research analysts and investment bankers  employed by the same broker-dealers, the Chairman of SEC should  direct the appropriate divisions or offices to formally assess and  document in a recommendation whether any of the Global Settlement’s  remaining terms should be codified.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a copy of this draft report to SEC and FINRA for their review  and comment. In its comment letter, which is reprinted in appendix III,  SEC generally agreed with our findings and recommendation. SEC staff  noted that the agency has been working to promote the objectivity and  independence of securities research analysts. They agreed that the  appropriate SEC staff should assess whether any of the remaining Global  Settlement provisions should be codified and applied to the entire  industry.  SEC and FINRA also provided technical comments that we  have incorporated as appropriate.
We are sending copies of this report to SEC, FINRA, interested  congressional committees and members, and others. The report also is  available at no charge on the GAO website at http://www.gao.gov.
If you or your staff have any questions about this report, please contact  me at (202) 512-8678 or clowersa@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on  the last page of this report. GAO staff who made major contributions to  this report are listed in appendix IV.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: Section 919A of the Dodd-Frank Wall Street Reform and Consumer  Protection Act requires us to identify and examine potential conflicts of  interest between investment banking and research staff in the same firm.To address this mandate, we examined (1) what is known about the  effectiveness of the regulatory actions taken to address research analyst  conflicts of interest and (2) what additional actions, if any, could  regulators take to further address research analyst conflicts.
Note that working papers are subject to revision, and some include additional limitations  in areas on which we do not report. collective reforms and do not believe the evidence can be used to  selectively attribute causality to any specific reform.
To evaluate the effectiveness of the regulatory reforms, we also reviewed  data provided by the Financial Industry Regulatory Association (FINRA)  from its electronic system used to track the lifecycle of FINRA’s regulatory  matters, including examinations and investigations. Specifically, FINRA  provided us with data on examinations and investigations that were  conducted between 2005 and 2010; covered its member broker-dealers;  and a review of research practices and compliance with the Global  Settlement, NASD 2711, or New York Stock Exchange (NYSE) Rule 472.  To assess the reliability of the data that we used to help support one of  our findings, we reviewed relevant documentation about the system’s  operation and administration and interviewed knowledgeable FINRA  officials about the system and integrity of the data. Based upon our  review, we found the data sufficiently reliable for our purposes. In  addition, we discussed with SEC staff the nature and findings of their  broker-dealer examinations conducted between 2005 and 2010 and  involving conflicts between research analysts and investment bankers. We also reviewed enforcement actions taken by SEC between 2005 and  2010 involving conflicts between research analyst and investment  bankers, and reports prepared by independent, or third-party, monitors  that assessed the settlement firms’ compliance with the Global  Settlement.
SEC staff told us that the agency’s examination database does not have an electronic  search capability that can be used to identify which broker-dealer examinations included a  review of which specific SRO rules. According to SEC staff, the agency is currently  developing a new examination database with improved search capabilities and plans for  the system to be online as early as 2012. contact because of their involvement in the investigations that led to the  Global Settlement. We also interviewed representatives from 20 broker- dealers, including 10 of the settlement broker-dealers, and their industry  association, the Securities Industry and Financial Markets Association.  With the Securities Industry and Financial Markets Association’s logistical  assistance, we interviewed 1 broker-dealer separately and the other 19  broker-dealers in two separate groups. In addition, we spoke with four law  or economics professors; two money managers; four independent  research firms; a securities research consultant; and various  organizations representing retail investors, institutional investors, or other  investment professionals, including AARP, the American Association of  Individual Investors, the American Federation of Labor and Congress of  Industrial Organizations, the Association of Institutional Investors, the  CFA institute, the Consumer Federation of America, the Investment  Company Institute, the National Association of Shareholder and  Consumer Attorneys, and the National Investor Relations Institute.  Finally, we contacted several state attorney general offices and the  National Association of Attorneys General to gain their perspectives;  however, these organizations either declined to participate because the  staff involved in the Global Settlement or related investigations no longer  worked there or they deferred to officials from their state securities  commissions.
To identify additional actions that regulators could take to further address  research analyst conflicts, we also reviewed SRO concept proposals,  proposed rules, and related comment letters and Global Settlement  documents, including the settlement firms’ 2009 request to modify the  Global Settlement’s addendum and the federal court’s 2010 order  approving modifications to the addendum. In addition, we reviewed recent  enforcement actions involving fixed-income research conflicts; academic,  industry, and GAO reports; and commentaries from market observers.
We conducted this performance audit from September 2010 to January  2012 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
section_title: Appendix II: Original and Modified Global Settlement Addendum Compared with NASD Rule 2711
paragraphs: In April 2003, the SEC, National Association of Securities Dealers, New  York Stock Exchange, North American Securities Administrators  Association, the New York Attorney General and other state authorities  announced that the enforcement actions against 10 of the largest broker- dealers had been completed and the terms of the agreement had been  finalized (the Global Settlement). The Global Settlement relates to  charges that the firms had engaged in acts and practices that created or  maintained inappropriate influence by investment banking personnel over  equity research analysts, which created conflicts of interest that were not  adequately managed or disclosed. The Global Settlement was approved  by the U.S. District Court for the Southern District of New York on   In August 2009, the Global Settlement firms submitted  October 31, 2003.a motion proposing certain modifications for the court’s consideration and  SEC did not oppose this motion. In March 2010, the court entered an  order approving all but one of the requested modifications. The order  provided that the parties expected SEC would agree to further  modification of the Global Settlement’s terms at the earlier of March 15,  2011, or the effective date of the consolidated research rule proposed by  FINRA in October 2008 (if such rules addressed the Global Settlement’s  remaining terms), unless SEC believes such amendment or modification  would not be in the public interest.  Any such amendment or modification  would be subject to court approval.  To date, the Global Settlement firms  have not requested any further modification of the settlement.
section_title: Appendix III: Comments from the Securities and Exchange Commission
section_title: Appendix IV: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Richard Tsuhara, Assistant  Director; Rachel DeMarcus; Lawrance Evans Jr.; Tiffani Humble; Jim  Lager; Marc W. Molino; Angela Pun; Barbara Roesmann; Jessica  Sandler; and Cynthia Saunders made key contributions to this report.
section_title: Bibliography
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