FINRA Issues Guidance on NASD Rule 2711

By Cydney Posner

FINRA has issued a Notice providing guidance on the prohibition against offering favorable research to induce investment banking business under NASD Rule 2711. Section (e) of that rule prohibits firms from directly or indirectly offering favorable research or a specific rating or price target as consideration or inducement for the receipt of business or compensation. Section (c)(4) prohibits research analysts from participating in "pitches" to prospective investment banking clients and other types of solicitations of business. That provision has been interpreted to prohibit the inclusion of discussion in pitch materials about research capacity that suggests, directly or indirectly, that the firm might provide favorable research coverage.

FINRA has become aware of some issuers that have tried to obtain "implicit promises" of favorable research through statements made publicly or to deal participants "that positive research coverage will be an implicit or explicit condition to selection as an underwriter or selling group member. The suggestions may take the form of hints, insinuations or other subtle references, but are intended to condition the award of investment banking business on the nature of research attendant to the deal. For example, the CEO of an issuer recently stated in an interview that he was dissatisfied with the tone of research coverage of his company by certain firms that previously served as underwriters for the company. As a result, the CEO reportedly intends to require candidates for the company's next offering to demonstrate ‘a clear understanding of who [the company] is and our trajectory, and why [the company] is a stock that investors should own.' He further is quoted as saying, ‘If I'm confident they can articulate that well, they will have a chance' at being selected as an offering participant."

In FINRA's view, statements of this type are disguised attempts to "create an expectation" that the selected underwriter "will maintain favorable research on the issuer's stock, irrespective of the stock price or the company's ongoing performance." Moreover, "tacit acquiescence" by the underwriter in those circumstances violates NASD Rule 2711(e) and possibly NASD Rule 2711(c)(4). While the issuer may be the bad actor here, FINRA would not typically have jurisdiction over the conduct of the issuer. While addressing issuer statements of that kind may create a competitive challenge, nevertheless, "in circumstances where an issuer makes known, expressly or implicitly, that the selection of an offering participant will be predicated on an expectation of positive research coverage, FINRA will closely scrutinize offering participants' research and other deal-related activities for compliance with, among others, NASD Rule 2711 and SEC Regulation Analyst Certification."

FINRA advises that member firms "must expressly repudiate to the issuer any expectation with respect to the content of research coverage and document such repudiation. In addition, the firms must implement heightened supervision of their solicitation activities, including pitch meetings and other communications with the issuer, to ensure there is no express or implied acknowledgement or accedence to the research expectation. Finally, members must increase oversight of the preparation and content of their research on the subject company—both before and after deal participants are chosen—including any permissible communications between research and investment banking personnel."

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