SEC Adopts New Regulation AC — Analyst Certification

Article by Barbara M Johnson, Gordon H Hayes, Jocelyn M Arel, Brian E Pastuszenski, Jordan D Hershman

Recently, the Securities and Exchange Commission (the "SEC" or the "Commission") gave final approval to new Regulation AC – Analyst Certification ("Regulation AC"), which became effective on April 14, 2003. The text of the SEC’s final rule and the release that accompanied it is available at http://www.sec.gov/rules/final/33-8193.htm.

Regulation AC requires that brokers, dealers, and certain other associated persons include in any research reports that they publish, circulate, or provide: (1) a certification by the research analyst that the views expressed in such research reports accurately reflect the analyst’s personal views; and (2) a certification as to whether or not the analyst received compensation in connection with his or her specific recommendations or views, and if so, a disclosure of the source, amount, and purpose of such compensation, and that such compensation may influence the recommendation in the research report. The distribution by a broker-dealer of any report that does not contain a certification of accuracy regarding the analyst’s personal views and one of the two alternative compensation certifications constitutes a violation of Regulation AC.

In addition, Regulation AC requires brokers, dealers, and certain other associated persons to obtain from research analysts whom they or other associated persons employ: (1) a certification by the research analyst that the views expressed in all public appearances during the prior calendar quarter accurately reflect the analyst’s personal views; and (2) a certification that no part of such analyst’s compensation is related to any specific recommendations or views expressed in any public appearances during the prior calendar quarter. Research analysts who are unable to make these required certifications regarding their public appearances must provide notice of such failure to their examining authorities, and for 120 days following such notification, broker-dealers must disclose such failure in any research reports authored by such analysts. Further, the broker-dealer must keep and maintain these records for a period of not less than 3 years.

Regulation AC is intended to complement, and is in addition to, other rules governing conflicts of interest disclosure by research analysts, including the existing anti-fraud provisions of the federal securities laws and the new NASD Rule 2711 and amended NYSE Rule 472, which the SEC approved on May 10, 2002, as amended on December 4, 2002. On December 31, 2002, the SEC published for comment a second set of proposed rules filed by the NASD and the NYSE to further address research analyst conflicts of interest. These additional proposals would require member organizations to document the basis and approval of compensation received by research analysts and to implement continuing education for research analysts regarding applicable rules, ethics, and professional responsibility. See TH&T Client Bulletins http://www.tht.com/pubs/SearchMatchPub.asp?ArticleID=804 and ID=796 and SEC Release 34-47110 http://www.sec.gov/rules/sro/34-47110.htm.

The key provisions of the final rule are summarized below.

Regulation AC requires all brokers, dealers, and certain associated persons who publish, circulate, or provide research reports to include in each such research report clear and prominent certifications by the authoring research analyst stating:

That the views expressed in the research report accurately reflect the research analyst’s personal views about the subject securities and issuers; and

Whether or not any of the research analyst’s compensation was, is, or will be directly or indirectly related to the analyst’s specific recommendations or views contained in the research report; and if so, the source, amount, and purpose of such compensation, and the fact that such compensation could influence the recommendations expressed in the research report, if part or all of the research analyst’s compensation was, is, or will be directly or indirectly related to the analyst’s specific recommendations or views contained in the research report.

A "research report" for purposes of Regulation AC is a "written communication (including an electronic communication) that includes an analysis of a security or an issuer and provides information reasonably sufficient upon which to base an investment decision." Under Regulation AC, a "research report" includes both the written analysis and recommendations relating to issuers and their debt and equity securities. In its release accompanying the final Regulation AC, the SEC declined to list the types of communications that would be deemed "research reports," but rather emphasized that the determination of whether a particular communication is a research report is fact-specific. The Commission did, however, identify certain communications that will not be deemed to be research reports, such as reports discussing broad-based indices or reports analyzing the demand and supply for a sector, index, or industry. The Commission also identified certain communications, even if they recommend or rate individual securities or companies, that will generally not be deemed research reports, such as statistical summaries of multiple companies’ financial data or analysis prepared for a specific person or a limited group of fewer than 15 people.

Public Appearances

Regulation AC also requires a broker-dealer who publishes, circulates, or provides a research report prepared by a research analyst employed by the broker-dealer or by certain associated persons to create a record within 30 days after each calendar quarter in which the research analyst has made a public appearance that includes certifications by the research analyst stating that:

The views expressed in all public appearances during the calendar quarter accurately reflected the research analyst’s personal views at that time about any and all of the subject securities or issuers; and

No part of such research analyst’s compensation was, is, or will be directly or indirectly related to any specific recommendations or views expressed in any of these public appearances.

A "public appearance" for purposes of Regulation AC includes any "participation by a research analyst in a seminar, forum (including an interactive electronic forum), or radio or television or other interview, in which the research analyst makes a specific recommendation or provides information reasonably sufficient upon which to base an investment decision about a security of an issuer." In its release accompanying final Regulation AC the SEC clarified that research analysts do not need to make these certifications during their public appearances.

Regulation AC applies to broker-dealers, "covered persons," and "research analysts." A "covered person" includes persons associated with a broker-dealer, but it does not include an associated person that has no officers or employees in common with the broker-dealer and where the broker-dealer maintains and enforces policies reasonably designed to prevent the broker-dealer from influencing the activities of research analysts and the content of research reports prepared by the associated person ("Independence Criteria"). In order to ensure that associated persons know whether they are subject to the new rules, Regulation AC requires broker-dealers to deliver notice to any of their associated persons who publish, circulate, or provide research reports specifying whether the Independence Criteria are met.

The definition of "research analyst" in final Regulation AC is broad and includes any natural person who prepares a research report. The certification requirements of Regulation AC, however, only apply to research analysts who are primarily responsible for the content of the research report. If more than one person is responsible for the content of a research report, each such person will be subject to Regulation AC.

Broker-dealers who distribute research reports prepared by "third party research analysts" are not required to obtain research report certifications from such a third party research analyst if the research analyst’s employer meets the Independence Criteria. Broker-dealers who distribute third party research are also not required to obtain the public appearance certifications.

In addition, Regulation AC does not apply to: (1) investment advisers prohibited from registering with the SEC under the Investment Advisers Act of 1940 who are not otherwise registered as broker-dealers; (2) investment advisers or banks that are associated with broker-dealers provided the Independence Criteria are met by the investment advisers or banks; (3) publishers of newspapers, magazines or business or financial publications that are not registered broker-dealers; or (4) foreign persons located outside the United States who are not associated with a broker-dealer and who prepare and provide research on foreign securities to major Unites States institutions within the United States.

Regulation AC became effective on April 14, 2003, and all broker-dealers and other parties subject to its provisions must comply with it immediately. In connection with such compliance, we recommend taking the following steps:

Determine who within your organization will be deemed a "covered person."

Identify each party within your organization who will need to make the required certifications as to research reports and public appearances, and identify the parties who will be responsible for ensuring that such certifications are made.

Make certain that each party in your organization who is subject to Regulation AC is aware of the new certification requirements. Discuss with such parties if there are any reasons they will not be able to make the certifications. Proactively address any concerns that are expressed.

Review your organization’s compensation policies for research analysts to determine whether any compensation is directly or indirectly tied to research analyst recommendations. If yes, consider revising the compensation policies to de-link analysts’ compensation from the substance of their recommendations.

Analyze the corporate and supervisory structures of any entities within your organization that employ research analysts in order to identify any inherent conflicts of interests or pressures in regard to research reports or other securities recommendations, such as situations where investment banking personnel oversee or supervise research analysts. If any such conflicts or institutional pressures are identified, consider restructuring such organizations to separate the analysts from such pressures or conflicts.

If your organization publishes third party analyst reports, evaluate whether Regulation AC applies in such circumstances. If yes, implement procedures to ensure compliance with Regulation AC as to such third party analyst reports.

As to broker-dealers, determine what persons you need to notify pursuant to the notification provisions of Regulation AC.

Review NASD Rule 2711 and NYSE Rule 472 to ensure that you are in compliance with such conflicts of interest rules previously adopted by the NASD and the NYSE. Also, review the proposed amendments to such rules that the SEC is currently considering. See TH&T Client Bulletins
http://www.tht.com/pubs/SearchMatchPub.asp?ArticleID=804 and ID=796 and SEC Release 34-47110 (http://www.sec.gov/rules/sro/34-47110.htm).