Keeping Regulators At Bay


New York—Susan Mathews, SEC Enforcement’s point person for the independent research portion of the Global Research Settlement, has agreed to share insights on how SEC Enforcement (and regulators generally) approach research-related conflicts.  Among other accomplishments at the SEC, she was co-author of “A Practitioner’s Guide to the SEC’s Investigative and Enforcement Process.”  Continuing her track record of providing transparency into the regulatory enforcement process, here are her…

Practical Tips to Avoid Regulator Scrutiny on Conflicts

 Susan A. Mathews, Madigail Consulting LLC             Regulators’ focus on conflicts of interest on the Street continues with their scrutiny of ratings agencies in the subprime mortgage debacle.  Research firms should take this opportunity to step back and examine the safeguards they have put in place within their own firms to guard against conflicts and to ensure the objectivity of their work.

            In this piece, I will touch on just three of the many areas you should examine to ensure you are effectively guarding against potential taint of your product and to prevent the scrutiny of regulators.  This advice is not just for small independent firms, keeping in mind that in the past year large firms such as Bank of America Securities and Morgan Stanley, and employees at UBS and Bear Stearns, have been charged by the SEC with violations relating to the inadequacy of these policies or their implementation.

Information Safeguards 

 The SEC has recently brought an astounding number of insider trading cases against industry professionals, including research executives and in-house compliance attorneys.  In addition to the business incentive to keep your proprietary information safeguarded from the outside world, you need to examine your information protections from a regulatory perspective within your firm and among your employees.  Do you have an employee ethics code with which your employees are required to familiarize themselves on an annual basis?  Do you have an explicit insider trading policy and compliance personnel who ensure that the policy is periodically updated as your business evolves and that the policy is actually followed by all employees? Even in the post-Reg FD era, analysts are still put in positions in which they may obtain information from company management that may not be public and which they should not share with others.  Moreover, analysts possess material non-public information about whether they are going to issue a change in ratings or price target.  As such, your firm needs to have clearly written policies that, on an annual basis, your employees review and to which they agree to abide.

Writing and reading the policies is not enough. Your firm also must have established mechanisms to detect whether your policies are being followed and are effectively preventing violations.  At a minimum, the policies must address:

  • the consequences for misuse of confidential information;

  • whether analysts (and their families) can trade in the securities of the companies that they research (including mutual funds, ETFs or derivatives consisting of companies in the sector that the analyst covers);

  • the appropriate timing of the release of analysts’ research to the public, within the firm, and to customers; 

  • an adequate standard for communications, including that they must have a reasonable basis and are not false or misleading;

  • a procedure for handling mistakes in research reports; and

  • the parameters for when an analyst can show the subject company a draft of the analyst’s research report for fact review and how to properly document these reviews.

In addition, your firm should have systems in place that allow you to review employee securities accounts and the trading that occurs in them.  If your firm maintains a “watch list” of securities in which employees should not trade, you must also have effective surveillance through, for example, exception reports that reveal when employees have traded in watch list securities.  It is not enough to simply have good written policies — you must also have active enforcement.

Securities Holdings and Trading 

 Research staff and their families who have personal interests in securities must abide by your firm’s guidelines to prevent conflicts that might affect the objectivity of your product.  This requirement is especially complicated by firms that have a money management subsidiary or some other kind of affiliated business in which securities are bought and sold.  Your firm must have a clear policy relating to when and if employees can trade in the securities that your firm covers.  If you allow trading in the securities that your firm covers, you need to establish maximum holding levels so that your employees are not so concentrated in one particular stock that an argument can be made that your firm’s research relating to the covered company is no longer objective or independent.  A regulator could argue that if a technology analyst’s wife owns a significant portion of the couple’s combined net worth in a non-diverse concentrated technology fund consisting of a high percentage of the very companies that the analyst is following, the technology analyst’s judgment might be affected by that personal ownership.   Some think it’s a good idea from a business perspective to allow your employees or the firm to invest in the companies that your firm is rating or touting to its money management customers.  However, from a regulatory perspective, this can only lead to problems.  You may be putting “your money where your mouth is,” but you are also creating mixed incentives and clouding judgment.  If it is untenable for your firm to outright ban this practice, you should put “Chinese walls” in place, require supervisory and compliance approval of all trades, and keep an accurate paper trail to protect your firm.  Just remember that the “Chinese walls” defense may not always prevail, since the presumption is that information within a firm can be easily exchanged or overheard even with a strong wall in place.

Some policies seem so obvious that your firm may forget to put them in writing, which will not help you when an unhappy customer or curious regulator comes knocking.  For example, you need to put in writing that your analysts do not trade against their recommendations.  If an analyst has a “buy” or “hold” on a particular security, the analyst or the analyst’s family cannot sell that security.  Similarly, if an analyst has a “sell” rating on a company’s securities, that analyst and family may not establish a short position because settling the short requires buying the security first.

Another seemingly obvious policy that your firm should not overlook is that an analyst’s opinions and projections should not be presented without a reasonable basis or in a way that confuses the reader as to their intent.  If you have an analyst whose specialty is reading tea leaves and his/her opinion is based on tea leaves, you are better off having a stated written policy in place setting standards for the tea leaf readers in your firm.  The policy could state something like:

 “You must adequately disclose in your research and in your communications with customers your tea leaf reading techniques and any other bases for your recommendations.”

Lastly, your policies should be written in “plain English,” not legalese, so that you can prove (if necessary) that your employees actually understand the policies.  If you decide to hire a law firm to draft your policies, make sure they are not filled with “therefore,” “including but not limited to,” “per se,” or other legal terms that complicate the text and cause the average reader to glaze over.

Firm Structure

 Sometimes conflicts can arise simply by the duties with which your personnel are tasked or as a result of the hierarchy in your firm.  A recent Bank of America case involved a marketing director who had multiple roles that created conflicts.  The marketing director had responsibility for branding the firm’s analysts, supervising morning sales meetings, guiding research positioning, organizing non-deal roadshows and providing trading advice to the firm’s traders.  As such, he frequently came into possession of material nonpublic information relating to soon-to-be-released research.  The SEC found that Bank of America “failed to establish specific policies and procedures to address the conflicts created by the multiple roles and activities performed by the Marketing Director; to the extent policies existed to address them, [Bank of America] failed adequately to enforce and maintain them.”  See In the Matter of Banc of America Securities LLC, Securities Exchange Act Rel. No. 55466, March 14, 2007.  You can bet that Bank of America had policies in place that it thought were adequate to protect against allegations of antifraud violations.  Yet, as part of its settlement with the SEC, Bank of America agreed to adopt the recommendations of an outside consultant with respect to its insider trading policies, to revamp its equity research and investment banking policies and procedures, and to pay $26 million in civil penalties and disgorgement.             Your firm policies must differentiate between behavior that is prohibited by a covering analyst versus a supervisor.  Supervisors have heightened duties given their position, and as such, they must have correspondingly heightened conflicts-prevention awareness.  Thus, your firm must explicate if, when, and how many securities these supervisors and their families are allowed to trade in, depending on the supervisor’s duties and control.              Firms that conduct money management or run a hedge fund on the side pose special conflicts issues that must be managed effectively.  At a minimum, firms with multiple areas of focus need to disclose to all of their customers the different activities in which each part of the firm engages.  Even with adequate disclosure, the firm needs to take extra precautions to ensure that actual conflicts will not negatively impact the firm’s products or performance.  If the money management side of a firm trades in the securities of those companies that are subjects of the firm’s research reports, this needs to be disclosed in plain language in a prominent part of the firm’s research reports or other firm communications.   The above is a much abbreviated list of conflicts issues that you should be thinking about each day you read the latest headline about another part of the Street that has suffered by failing to properly guard itself against conflicts.  You may have written policies in place, but as the Bank of America case teaches, the policies cannot simply exist – – they must also be adequately enforced and maintained.

Susan A. Mathews spent almost ten years as Senior Counsel and Deputy Ethics Liaison in the Enforcement Division at the SEC, following several years in private practice as a securities litigator.  Susan’s last few years at the SEC were spent overseeing the implementation of the independent research portion of the landmark Global Research Analyst Settlement.  Susan is currently advising firms on ethics, conflicts and independence issues through her consulting practice, Madigail Consulting LLC.  Susan can be contacted at or 301-654-0406.


About Author

Leave A Reply