On December 24, 2015 FINRA’s new equity research rule, Rule 2241, will go into effect. This rule modifies and expands the existing regulatory framework governing equity research, see FINRA’s release here. The key changes in the rules are below.

1) Identifying and Managing Conflicts of Interest

FINRA adopted new provisions that explicitly requires firms to have and enforce written policies and procedures to prevent conflicts of interest in the preparation and distribution of research reports and public appearances.

2) Quiet Periods

The new rule changes the quiet periods for equity research following an initial public offering (IPO) and secondary offerings.

• For IPOs the quiet period is 10 days for both syndicate managers and members.
• For secondary offering the quiet period is 3 days for syndicate managers and co-managers, while syndicate members do not have a quiet period.

These 10-day and 3-day periods replace the prior 40-day and 25-day quiet periods. The rule also eliminates the 15-day quiet period surrounding the expiration of any lock-up agreement.

3) Prepublication Review

Investment bankers are totally prohibited from reviewing or approving research reports in any way or for any reason. Under the old rules investment bankers could preview a report for factual accuracy only, but are no longer allowed to do so.

4) Coverage Decisions

All final research coverage decisions must be independently made by research management. Investment banking personnel are prohibited from making any final research coverage decisions, though they may convey to their customers’ interests to research management.

5) Research Budget

The research budget must be determined by the firm’s senior management, without any input from anyone engaged in investment banking services activities. Individuals within senior management who engage in investment banking services would therefore not participate when senior management is setting the research budget.

6) Personal Trading Restrictions

Firms must adopt policies to ensure that research department personnel do not trade based on their knowledge of the content or timing of a research report before the intended recipients of such research have had a reasonable opportunity to act on the information in the research report. In other words, before a research analyst can trade based on the information contained in his research report, the intended recipients must receive and be able to trade on the recommendations in the report. This flexible standard replaces the previously defined 30-day and 5-day time periods during which research analysts could not trade.

The rule prohibiting analysts trading against their most recent recommendation remains in force; i.e. analysts must trade consistent with their published recommendations, though there is an exception for firm-required liquidations of a position at initiation of coverage (e.g. an analyst may sell positions as required by her firm when initiating coverage with a buy rating).

7) Joint Due Diligence

The rule prohibits due diligence by the research department in the presence of investment banking personnel prior to the selection of underwriters for investment banking services transaction. This provision does not apply to emerging growth companies.

8) Research Report Disclosures

A research report must disclose all material conflicts, whether known by the research analyst or any associated person of the member who can influence the content of a research report. This change broadens the disclosure requirement to include conflicts known by any associated person of the firm.

If, however, such disclosure would reveal material non-public information about a specific potential future investment banking transaction regarding the subject company or a related company (e.g. a competitor, supplier, customer, etc) that information should not be disclosed.

9) Selective Distribution Prohibited

Firm may not selectively disseminate research. This means that all customers who will receive the report gain access to the report at the same time. Firms may not provide its internal traders or any particular type of customer advance access to a report. Firms are permitted, however, to provide different research to different types of customers as long as the difference is not based on the timing of receipt of a research recommendation or rating.

10) Third-party research reports

Firms may only distribute third-party research that it believes to be objective and reliable. Meeting this standard requires firms review third-party research to ensure there are no untrue statements of material fact and do not contain any false or misleading information based on the information in the report itself, or that is known to the distributing firm. That is, the review does not require outside diligence or research. All third-party research must be labeled as third-party research.

11) Exemption for Members with Limited Investment Banking Activity

Firms that engage in limited investment banking activity are exempt from the research rules that prohibit investment banking personnel from being involved with the review and supervision of research reports and research departments.

It also permits firms with limited investment banking activity to include investment bankers on the research compensation committee, though research may still not be awarded compensation based on any specific investment banking services transactions or contributions to a member’s investment banking services activities.

Limited investment banking activity is defined as a firm that over the previous three years, on average per year, have (1) participated in 10 or fewer investment banking transactions as manager or co-manager and (2) generated $5 million or less in gross revenue from those transactions.

12) Registration of research analysts

Individuals who only occasionally produce research reports are no longer considered research analysts. The definition of “research analyst” is someone who is primarily responsible for the preparation of the substance of a research report (plus their direct and indirect reports).

Knopman Note

Candidates preparing for their FINRA exams should be familiar with these rules once they take effect on December 24, 2015.