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

Letter

Background

Broker-Dealers May Provide a Range of Services, Including Research for Investors

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.

Oversight of Securities Broker-Dealers and the Global Settlement

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.

Analyst Conflicts and Investor Harm

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.

Data and Stakeholders’ Views Suggest That Regulatory Actions Have Helped Address Conflicts Faced by Equity Analysts

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).

Research Suggests Regulatory Reforms Were Associated with Improvements in Analyst Recommendations, but Other Effects Were Mixed

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.

SEC and SROs Generally View the Regulatory Reforms as Effective in Addressing Equity Analyst Conflicts

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.

While Market Participants and Others Generally View the Reforms as Effective, Some Noted Conflicts Could Not Be Completely Addressed or Eliminated

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.

Regulators Have Opportunities to Enhance Investor Protection and Streamline or Harmonize Oversight

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.

FINRA Plans to Finalize Equity Analyst Rules Intended to Enhance Investor Protections and Reduce Regulatory Burden

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.

SEC and FINRA Have Not Formally Assessed and Documented Whether Any of the Global Settlement’s Remaining Terms Should Be Codified

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.

FINRA Has Been Drafting a Rule to Address Conflicts of Interest Faced by Fixed- Income Research Analysts

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.

Conclusions

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.

Recommendation for Executive Action

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.

Agency Comments and Our Evaluation

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.

Appendix I: Objectives, Scope, and Methodology

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.

Appendix II: Original and Modified Global Settlement Addendum Compared with NASD Rule 2711

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.

Appendix III: Comments from the Securities and Exchange Commission

Appendix IV: GAO Contact and Staff Acknowledgments

GAO Contact

Staff Acknowledgments

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.

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