Is the proposed safe harbor for desk commentary a lifeline for sales and trading communications, or a death knell? 

In Regulatory Notice 17-16, the Financial Industry Regulatory Authority (FINRA) proposes amendments to FINRA Rules 2241 and 2242, which regulate the preparation and distribution of “research reports” and “debt research reports” (referred to here, generally, as “research reports”) by FINRA member firms (Research Rules).^[1] FINRA has proposed these amendments in concept and does not provide draft text of the proposed rule changes.

The amendments would provide a limited, nonexclusive safe harbor for firms that distribute desk commentary to eligible institutional investors, as well as for the individuals who prepare such desk commentary. A firm relying on the safe harbor would be relieved of certain Research Rule requirements, and personnel preparing desk commentary would be excluded from the registration and qualification requirements imposed on equity research analysts. The proposed safe harbor is limited, however, and does not fully relieve the pressure on FINRA member firms’ sales and trading personnel who regularly send out a range of commentary on markets, trading, and related subjects. As a result, the proposed safe harbor, if adopted, might not quell the concern that desk commentary is in the crosshairs for termination by regulatory fiat.

The proposed safe harbor would ease many elements of the Research Rules, but many would be retained. For example, firms would still be required to maintain conflict of interest policies and procedures, require “health warnings” on desk commentary in lieu of issuer-specific disclosure, and establish prohibitions on investment banking personnel (1) supervising or controlling and/or making compensation decisions regarding personnel preparing desk commentary, (2) having input into the budget of the research department (which should not impact desk commentary under the proposed safe harbor), and (3) receiving compensation based on specific investment banking services transactions or specific contributions to the firm’s investment banking services activities. As a result, it is possible that the proposed safe harbor would be of limited utility.

While FINRA included an exemption for institutional debt research in Rule 2242, the proposed safe harbor would allow for the dissemination of materials—on a “negative consent” basis—that are more limited in the nature of their content (see “Desk Commentary” discussion below) to a broader group of institutional accounts than is currently permitted under the “institutional debt research exemption.”^[2]

FINRA seeks comments on this proposed safe harbor no later than May 30, 2017.

“Desk Commentary”

At the core of the proposed safe harbor is FINRA’s concept of “desk commentary” as distinct from a “research report.” FINRA describes “desk commentary” as sales materials that are “brief, written analysis” for eligible institutional investors that come from sales and trading or principal trading personnel that could rise to the level of a research report. FINRA further states that these brief communications usually are focused on the “near term, and are prepared and disseminated quickly in response to trading events or news flashes.” This implies a temporal aspect to desk commentary. 

FINRA understands that desk commentary, as sales material sent by sales and trading or proprietary traders, often is used by buy-side traders, rather than portfolio managers, to carry out previously made investment decisions; FINRA also observes that the recipients of desk commentary understand the types of potential conflicts that may exist between the trading ideas and recommendations generated by desk personnel and a members’ trading interests, and therefore such recipients are less in need of the specific conflict of interest disclosures required by the Research Rules.

Proposed Safe Harbor Conditions

The proposed safe harbor would require a firm to meet author, content, and recipient conditions, as well as satisfy the conflict management requirements described in the next section of this article. As a nonexclusive safe harbor, if the conditions are not satisfied, desk commentary nevertheless could be analyzed and found not to be a “research report” or “debt research report” subject to Rule 2241 and 2242.

Author Conditions

The proposed safe harbor would be available only for material produced by sales and trading and principal trading personnel who 

• are not primarily engaged in the preparation of research reports that are outside the content limitation for “desk commentary,” 

• are not required to register as research analysts pursuant to NASD Rule 1050 because their primary job function is not the provision of investment research, and 

• do not report directly or indirectly to research department personnel.^[3]

Content Conditions 

The content of “desk commentary” must be limited to brief observations and cannot include the author’s rating, price target, or earnings estimate. Note, however, that FINRA states in a footnote that desk commentary could refer to a rating, price target, or earnings estimate from published research reports and could discuss the directional effect of an event on an issuer’s rating, price target, or earnings.^[4] The content also must be regarding recent, current, or near-term expected trading activity, trading ideas or opportunities, market conditions, economic statistics or company results, or regarding a recent recommendation or research report (presumably prepared by a “research analyst” and subject to the Research Rules). This suggests that desk commentary expressing long-term views may be problematic, although the Regulatory Notice does not provide any guidance as to what might be “near-term” as distinguished from longer-term views.  

Recipient Conditions 

“Desk commentary” could be provided to consenting investors that meet the definition of “institutional account” in Rule 4512(c). Notably, this includes natural persons with at least $50 million in assets. The safe harbor would require that the firm, pursuant to Rule 2111(b), has a reasonable basis to believe that the institutional account is capable of evaluating investment risks independently, generally, and regarding particular transactions and investment strategies, and that the institutional account has affirmatively indicated that it is exercising independent judgment in evaluating the firm’s recommendations. FINRA anticipates that such consent could be obtained by providing written disclosure to an institutional account regarding (1) the provision of desk commentary that may at times constitute research reports under FINRA rules and (2) that the desk commentary is intended only for institutional investors/accounts and is not subject to the independence and disclosure standards applicable to research reports prepared for retail investors.^[5]  

A firm would be required to have policies and procedures reasonably designed to (1) ensure that desk commentary is available only to eligible institutional investors^[6] and (2) safeguard against the dissemination of internal material nonpublic information from the research department.^[7]

Conflict Management

While FINRA acknowledges that desk commentary carries with it inherent conflicts that FINRA presumes will not impede an institutional investor able to make independent evaluation of risks, FINRA nevertheless would require a firm to have policies and procedures reasonably designed to address certain of the conflicts of interest addressed in the Research Rules. FINRA identifies these as policies and procedures covering the following:

• Prevention of the use of desk commentary and its authors to manipulate markets.

• Prohibitions on prepublication review, clearance, or approval of desk commentary by investment banking personnel and prohibiting prepublication review by a subject company.

• Establishment of information barriers or other safeguards designed to insulate research analysts from pressure by persons engaged in investment banking or others, including sales and trading personnel who might be biased in their judgment or supervision of the authors of the desk commentary. 

  • FINRA clarifies in a footnote that this would not require physical separation of persons producing desk commentary from other sales and trading and principal trading department personnel.^[8]

  • FINRA also states, helpfully, that in the context of desk commentary, “pressure” by sales and trading or principal trading personnel would not be deemed to exist merely because a firm produces desk commentary on securities in which it trades, or where the authors of desk commentary report to such personnel. FINRA suggests, however, that a firm would have to have policies and procedures reasonably designed to ensure that investment banking personnel or sales and trading or principal trading personnel do not overtly pressure a person who produces desk commentary to express a particular view.^[9]

• Prohibitions on explicit or implicit promises of favorable research.

• Limitations on activities of desk commentary authors that could be reasonably expected to compromise objectivity such as participating in pitches and other solicitation of investment banking services transactions and participating in road shows and other marketing on behalf of issuers related to an investment banking services transaction.

• Prohibitions on investment banking department personnel directly or indirectly directing the author of desk commentary to engage in sales or marketing related to an investment banking services transaction or to engage in communications with a customer about an investment banking services transaction.

• Prohibitions that prevent the author of desk commentary from engaging in communications with a customer in the presence of investment banking department personnel or issuer management regarding an investment banking services transaction of the issuer.

“Health Warnings” Disclosure

FINRA provides in Rule 2242 for the use of limited “health warning” disclosures on “institutional debt research” in lieu of the detailed issuer-specific disclosures required for all other research reports subject to the Research Rules. This concept is found in the proposed safe harbor as well. 

The proposed health warnings for desk commentary are as follows:

• “This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to research reports prepared for retail investors”

• If applicable: “Clients should assume that this document is not independent of [Firm’s] proprietary interests. [Firm] trades, and will continue to trade, the securities covered in this document for its own account and on a discretionary basis on behalf of certain clients. Such trading interests may be contrary to or entered into in advance of this document.”

Request for Comment

While FINRA requests comment generally on the proposed safe harbor, FINRA also asks a number of specific questions, including whether there should be additional limitations on the personnel who prepare desk commentary. 

FINRA also requests comments on the following:

• The economic impact associated with the proposal

• Whether the proposal is well designed to maintain information flow from trading desks while managing potential serious conflicts of interest

• Whether and how the proposal could change business practices and competition among firms producing desk commentary and potential second order impacts that might result from such practices

Conclusion

The proposed safe harbor described in Regulatory Notice 17-16 is intended to address concerns expressed to FINRA staff from a wide range of stakeholders—including buy-side firms and sell-side recipients of desk commentary—about ambiguities created by the current regulatory framework of the Research Rules and recent FINRA enforcement actions.^[10] To the extent that the safe harbor as currently proposed does not acknowledge current practices or creates additional confusion, however, it will need to be refined before it can be finalized in order to be useful to firms that have produced desk commentary for decades. 

Draft rule language would assist in providing a closer comparison to existing rules. Therefore, comments—from both the sell-side, whose sales and trading personnel produce and disseminate desk commentary, and the buy-side recipients of such desk commentary—will be critically important in directing the shaping of any final desk commentary safe harbor in the Research Rules into something that firms can rely upon as a lifeline for sales and trading communications—rather than a death knell. 

^{[1] Desk Commentary Safe Harbor, Regulatory Notice 17-16 (April 2017),.}

^{[2] The institutional debt research exemption in Rule 2242 is available for materials that are debt research reports as defined in Rule 2242, regardless of whether produced in a research department or elsewhere. These materials can be distributed in reliance on negative consent only to qualified institutional buyers (QIBs) as defined in SEC Rule 144A. Affirmative consent is required to provide institutional debt research to institutional accounts as defined in FINRA Rule 4512(c).} 

^{[3] A “research analyst” is defined in FINRA Rule 1050(b) as an associated person of a FINRA member firm whose primary job function is to provide investment research and who is primarily responsible for the preparation of the substance of a research report or whose name appears on a research report.}

^{[4] Regulatory Notice 17-16, n.6.}

^{[5] This text tracks the standard that currently applies for distributing debt research reports to QIBs under the institutional investor exemption in Rule 2242(j). FINRA proposes a 90-day transition period between the effective date of the amendments to 2241 and 2242 implementing the safe harbor to permit firms to continue sending desk commentary to such accounts while the written notices are distributed.} 

^{[6] The “institutional debt research exemption” allows for the distribution of debt research reports exclusively to institutional investors, but requires affirmative consent from recipients that are institutional accounts but that are not “qualified institutional buyers” as defined in Rule 144A under the Securities Act of 1933.} 

^{[7] FINRA states that “as a practical matter, desk commentary that includes material non-public research information inherently would not satisfy the content limitation to be considered eligible for the proposed safe harbor.”}

^{[8] See Regulatory Notice 17-16, n.9.}

^{[9] See id.}

^{[10] See Stephens Inc., Letter of Acceptance, Waiver and Consent No. 2014041823201 (May 11, 2016); Stifel, Nicolaus & Company, Inc.; Kurt A. LaLomia, Letter of Acceptance, Waiver and Consent No. 2012032945601 (January 5, 2016).}