Conflicts of interest in investment research

The Financial Services Authority (FSA) has completed its review of conflicts of interest in the production and distribution of investment research by the firms that it regulates. Some changes to the FSA's regulation of this area are already in force and the remainder come into effect on 1 July 2004.

For the purposes of the FSA's rules, "investment research" means broadly a document which contains:

• the results of research into a designated investment (for example a share) or its issuer;
• analysis of factors likely to influence the future performance of a designated investment or its issuer; or

• advice or recommendations based on those results or that analysis.

Personal recommendations are not investment research unless the substance is common to a number of documents that have been personalised for recipients.

The nature and purpose of investment research differs from firm to firm, between sell-side and buy-side and across different types of investment or financial instrument. This article focuses on investment research on listed and AIM-quoted companies. This includes investment research produced by analysts at an investment bank or broker for distribution to prospective placees ahead of an initial public offering (IPO) or a secondary share issue, and research notes on quoted companies or sectors produced for distribution to the firm's clients.

Why new rules and guidance now?

Conflicts of interest in investment research first became headline news in 2001-2002 with the New York Attorney General's investigation of US investment banks' conflicts of interest. Attention focussed on significant conflicts for US investment banks in the production of research on dotcom or high-tech companies that were floating and the allocation of shares in IPOs which were expected to start trading at a premium to the issue price (with an immediate profit for the fortunate placees). Some analysts did not believe what they wrote about the prospects of these new issues. In other cases, banks tried to win prospective clients by giving their CEOs the chance to act as placees in unrelated hot IPOs.

In July 2002 the FSA issued a Discussion Paper on conflicts and subsequently undertook public consultations – CP 171 and CP 205. This process has culminated in the FSA's Policy Statement issued in March 2004.

Abuses of the type and scale seen in the US have not been apparent in the UK. UK investment research is usually produced for institutional clients who are aware of the nature of the research and the conflicts in its production, although this research does sometimes reach retail investors and the investment press. In the US, in contrast, much more of the research is produced for retail investors.

What conflicts?

Conflicts of interest arise from the different commercial activities and relationships of investment firms - for example, when a firm's income comes from corporate finance business (such as issues of securities, advice on mergers and acquisitions, brokerage activity, and executing share-trades for clients) and from trading in shares for the firm's own account.

Possible conflicts of interest identified by the FSA include:

• analysts being involved in – or influencing – other functions within the firm apart from investment research, such as corporate finance and sales;

• reward and reporting structures where, for example, analysts might report to senior management in the corporate finance department or receive bonuses calculated by reference to the performance of the firm's corporate finance business;

• conflicts because of the analyst's or the firm's own investments or those of other clients;

• companies' ability to exert pressure on firms;

• conflicts because of access to unpublished price-sensitive information; and

• conflicts because of the power of investment research recommendations.

New regulatory provisions

The FSA has decided to continue with an approach based on its existing Principles for Business and guidance rather than by making additional detailed rules. It has concluded that a clearer regulatory line should be drawn on acceptable conduct within the existing framework and that some practices should change.

To understand the new regulatory provisions one has to look at the existing Principles for Business, as well as the new rules and guidance in CP 205 and the Policy Statement. All are to be found in the FSA's misleadingly-named "Handbook" (it is enormous, not handy).

The existing Principles for Business

The FSA's Principles for Business are applicable to all regulated firms. Some Principles apply to conflicts of interest in investment research and arguably already covered the abuses that might arise. However, further guidance from the FSA on how the Principles apply was clearly required.

The FSA has identified the Principles it considers most relevant and given guidance on how they apply. They are, in summary:

• Integrity – a firm must conduct business with integrity;

• Skill, care and diligence – a firm must conduct its business with skill, care and diligence;

• Management and control – a firm must take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems;

• Clients' interests – a firm must pay due regard to the interests of clients and treat them fairly;

• Communications with clients – in relation to the information needs of its clients, a firm's communications must be clear, fair and not misleading;

• Conflicts of interest - a firm must manage conflicts fairly both between the firm and its customers and between a customer and another client; and

• Relationship of trust – a firm must take reasonable care to ensure suitability of advice and discretionary decisions for its clients who rely on its judgement.

New rules and guidance

During the consultation process it became apparent that some banks and brokers, particularly those which research smaller quoted companies' shares, would not be able to re-organise their businesses in order to separate investment research from other activities, such as corporate finance and sales. Such a significant change would have meant that many of these firms would have had to stop producing research, and some companies would not have been researched at all.

The FSA has accepted that the firms' clients – typically institutional investors - understand the nature of their research and their relationship with the companies being researched. The FSA has said that the key regulatory problem is that firms should be, and should be seen to be, managing the conflicts that could undermine their claims to be objective or impartial. A fundamental issue is therefore whether investment research is held out, or reasonably relied on, as an objective assessment of the value or prospects of a particular share or other investment. In this context, objective research means research that is held out to be impartial or independent. Being objective, incidentally, does not mean the opposite of being subjective (in one sense, good research should be subjective, in that it reflects the writer's opinions).

Many firms - particularly those that produce research on smaller quoted companies - will decide that the nature of their research is understood by their clients and that it is not held out to be independent or impartial.

Section 7.1.6 of the Handbook

If a firm does prepare or distribute objective research, the FSA will require its senior management to have, maintain, enforce and publish a conflicts management policy for its research. The policy must be appropriate for the firm's business model, the nature and sophistication of its clients and the types of investments or instruments that the firm deals with.

Investment research may be held out as impartial in various ways: for example, if it is labelled with that term or similar terms like "independent" or "objective." Even without this kind of labelling on the investment research itself, it may still be held out as impartial: if, for example, the firm's representatives state that it is so (in writing or orally), or behave in a way that reasonably gives that impression.

Section 7.1.6 contains new rules and guidance when a firm prepares investment research for publication or distribution to clients, or publishes or distributes investment research to clients where either:

• the firm holds it out as being an impartial assessment of the value or prospects of its subject matter; or

• it is reasonable for those to whom the firm has published or distributed it to rely on it as an impartial assessment of the value or prospects of its subject matter.

The new requirements for such firms are, in summary, to:

• establish and implement a policy, appropriate to the firm, for managing effectively the conflicts of interest which might affect the impartiality of investment research held out, or reasonably relied on, as impartial;

• make a record of the policy and retain it until at least three years after it ceases to have effect;

• take reasonable steps to ensure that the firm and its employees comply with the policy;

• make a copy of the policy available to any person on request (for example, on an appropriate website); and

• take reasonable steps to ensure that the policy remains appropriate and effective.

The FSA emphasises that senior management is responsible for ensuring that systems, controls and procedures are robust and adequate to identify and manage conflicts of interest in relation to investment research or similar publications, and to ensure that arrangements operate effectively.

The Handbook contains guidance on a range of issues. For example, it states that it is inappropriate for analysts to prepare research papers or analyses which are intended initially for internal use for the firm's own advantage, and then for later publication to clients (in circumstances in which it might reasonably be expected to have a material influence on the clients' investment decisions).

The guidance states that conflicts cannot be adequately managed by disclosure alone.

Questions arise about the involvement of analysts in winning new business for firms and in marketing new issues. The FSA guidance states that it is likely to be inappropriate for the policy to allow the firm to:

• use an investment analyst in a marketing capacity (for example, in pitches to solicit or obtain corporate finance business from the issuer of a relevant investment) if this would give a reasonable perception of lack of impartiality in his investment research; or

• allow an investment analyst to act in a way which reasonably appears to be representing the issuer of a relevant investment (for example, in roadshows relating to issues or allocations of relevant investments).

Comment

The FSA's approach - regulating conflicts through existing principles and further guidance rather than by introducing new detailed rules - is to be welcomed. The emphasis on whether investment research is held out, or reasonably relied on, as an impartial and independent assessment of the value or prospects of an investment accommodates the range of firm producing and distributing research.

A critical decision for all firms is whether they will produce or distribute research held out as objective in this way. Many firms will decide they need not do so.

Firms intending to produce objective research must identify the conflicts relevant to them. They must design and apply procedures to manage conflicts and publish their policy by 1 July 2004. Firms that decide not to hold their research out as objective should remember that the Principles for Business apply to research and that the FSA's views on their application are set out in the new guidance.

Quoted companies that are the subject of investment research should appreciate that the investment banks and brokers they deal with - and analysts in particular - will be sensitive to the FSA's greater focus on this area.

For further information please contact Peter Smith (corporate partner) on + 44(0)20 7367 2816 or at [email protected].