In an echo of the 2003 Global Research Analyst Settlement, FINRA fined ten investment banks $43.5 million for allowing equity analysts to solicit investment banking business in connection with a proposed IPO for Toys ‘R’ Us (TRU). Eight of the ten banks had participated directly in the Global Settlement. Plus ça change, plus c’est la même. However, FINRA’s actions make it harder for investment banks to monetize their research operations. If banking research remains primarily funded by trading commissions, the future is not a happy one.
The 10 Banks
FINRA fined Barclays Capital (whose acquisition Lehman had been a Settlement participant), Citigroup, Credit Suisse, Goldman Sachs and JP Morgan $5 million each for violations of NASD Rule 2711, the research analyst conflict of interest rule.
Deutsche Bank, Merrill Lynch, Morgan Stanley and Wells Fargo were fined $4 million each, and Needham & Company was fined $2.5 million. The banks consented to the fines but neither admitted nor denied the charges.
The Alleged Wrongdoing
FINRA alleges that each of the ten banks included their analysts in meetings their bankers held with TRU management and TRU’s private equity owners (Bain Capital, KKR and Vornado Realty Trust). The meetings were set up to solicit the analysts’ views on key issues, including valuation factors, and to determine if the analysts were aligned with the views expressed by the firms’ investment bankers. According to FINRA, each firm understood that the performance of their analysts at the presentations would be a key factor in determining whether the firm received an underwriting role in the IPO.
According to the settlement documents, each of the firms implicitly or explicitly offered favorable research coverage in return for a role in the IPO. As an example, the unnamed analyst at Citigroup sent an email to a supervisor stating: “I so want the bank to get this deal!” One of the private equity owners of TRU wrote that the bullishness of the Credit Suisse analyst was “off the charts.” Most fervent of all, however, was the analyst at Needham, who wrote “I would crawl on broken glass dragging my exposed junk to get this deal.”
Rule 2711
FINRA charged the banks with violations of Rule 2711(c)(4), which prohibits participation by analysts in pitch meetings, and Rule 2711(e), which forbids the promise of favorable research. Some of the banks were also charged with a failure to supervise, in violation of 2711(i), which outlines supervisory procedures.
Rule 2711(c)(4) states, “No research analyst may participate in efforts to solicit investment banking business. Accordingly, no research analyst may, among other things, participate in any ‘pitches’ for investment banking business to prospective investment banking clients, or have other communications with companies for the purpose of soliciting investment banking business.”
Under Rule 2711(c)(4), an analyst is allowed to communicate with an issuer during the solicitation period for due diligence purposes, but is not permitted to help solicit a role in the underwriting. An analyst is prohibited from communicating views on the issuer, the issuer’s industry, valuation or comparable companies.
Rule 2711(e) states, “No member may directly or indirectly offer favorable research, a specific rating or a specific price target, or threaten to change research, a rating or a price target, to a company as consideration or inducement for the receipt of business or compensation.”
Reforms to Rule 2711
In 2012, the JOBS Act allowed analysts to participate in pitch meetings for Emerging Growth Companies, but the other Rule 2711 restrictions were not relaxed. In other words, analysts could attend to the meetings but could not help efforts to solicit banking business. The regulation begged the question of why bother to invite the analysts if they can’t help the bankers?
FINRA is also proposing to consolidate Rule 2711 into a new Rule 2241, with some minor changes. One not-so-minor proposed change would be to reduce the current 15-day quiet period to 10 days prior to an IPO and 3 days after. The comment period for the proposed changes expired December 16th.
Our Take
The 2003 Global Settlement weakened one the key business supports for investment research, the link to investment banking. Post-settlement, research has been mainly funded by trading commissions. However, with equity commissions increasingly under market and regulatory pressure, the temptation is very strong to “re-bankerize” research. After all, why else would Evercore buy ISI?
The FINRA action throws cold water on the proposition of diversifying the research revenue base away from commissions, at least for U.S.-based research. (Outside the U.S., analysts and bankers are permitted to be cozier.) The weakened ties between banking and research makes it more difficult to monetize research in an environment of structurally declining commissions, increasing the likelihood of further rationalization of investment banking research operations.