oversight

Securities Research: Additional Actions Could Improve Regulatory Oversight of Analyst Conflicts of Interest

Published by the Government Accountability Office on 2012-01-12.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

               United States Government Accountability Office

GAO            Report to Congressional Committees




January 2012
               SECURITIES
               RESEARCH
               Additional Actions
               Could Improve
               Regulatory Oversight
               of Analyst Conflicts of
               Interest




GAO-12-209
                                              January 2012

                                              SECURITIES RESEARCH
                                              Additional Actions Could Improve Regulatory
                                              Oversight of Analyst Conflicts of Interest
Highlights of GAO-12-209, a report to
congressional committees




Why GAO Did This Study                        What GAO Found
In 2003 and 2004, the Securities and          Existing research and stakeholder views suggest that the Global Settlement and
Exchange Commission (SEC), self-              other regulatory actions have helped to address conflicts faced by equity
regulatory organizations (SRO), and           research analysts. The results of the empirical studies that GAO reviewed
others settled with 12 broker-dealers to      generally suggest that the Global Settlement and equity research rules adopted
address conflicts of interest between         by the SROs were associated with improvements in analysts’ stock
the firms’ research and investment            recommendations. FINRA officials and SEC staff told GAO that the regulatory
banking personnel. The regulators             reforms have been effective, citing minor deficiencies in their examinations and
alleged that the firms allowed their          the limited number of enforcement actions involving conflicts between research
investment bankers to pressure equity         and investment banking as evidence of the reforms’ effectiveness. Independent
research analysts in ways that could          monitors, which were required as part of the Global Settlement, also found that
cause them to issue misleading                the 12 firms generally were complying with the Global Settlement. Finally, broker-
research to the harm of investors.            dealers, institutional investors, and others told GAO that the regulatory actions
Under the Global Research Analyst             have helped insulate equity research from investment banking influence,
Settlement (Global Settlement), the
                                              although some noted that not all conflicts can be eliminated and certain
firms had to undertake reforms
                                              restrictions can be circumvented.
designed to sever links between
research and investment banking. The          Although SEC and FINRA have been taking regulatory action to further address
SROs also adopted equity research             conflicts faced by research analysts, additional action is warranted. FINRA has
rules to address analyst conflicts            been working to finalize a rule proposal designed to broaden the obligations of
across the industry, but these rules          firms to identify and manage equity analyst conflicts and better balance the goals
were not as stringent in some areas as        of helping ensure objective and reliable research with minimizing regulatory costs
the Global Settlement. The Dodd-              and burdens. FINRA also has been working to finalize another rule proposal that
Frank Wall Street Reform and                  would address conflicts faced by debt research analysts. The current SRO
Consumer Protection Act required
                                              research rules do not cover debt research analysts, although these analysts face
GAO to study these issues. This report
                                              conflicts of interests similar to those faced by their equity analyst counterparts. In
discusses (1) what is known about the
effectiveness of the regulatory actions       the absence of an SRO debt research rule, the SROs have relied on antifraud
taken to address analyst conflicts and        statutes and SRO rules requiring ethical conduct. They also have encouraged
(2) what further actions, if any, could       firms—with limited success—to comply voluntarily with industry-developed
be taken to address analyst conflicts.        principles designed to address debt analyst conflicts. FINRA plans to package its
GAO reviewed empirical studies and            two rule proposals together and submit them to SEC in the first half of 2012. In
SEC and SRO rules, examination                contrast, SEC and FINRA have not proposed codifying the Global Settlement’s
findings, and enforcement actions.            remaining terms. At the request of the broker-dealers, a court modified the Global
GAO interviewed SEC and Financial             Settlement in 2010 and eliminated settlement terms where, for the most part,
Industry Regulatory Authority (FINRA)         comparable SRO rules existed. Nonetheless, some of the Global Settlement’s
staff, and market participants and            terms that serve to protect investors have not been codified. As a result, the
observers.                                    Global Settlement firms continue to be subject to the requirements of the Global
                                              Settlement and the SRO research analyst rules, while other firms that provide the
What GAO Recommends                           same services are subject only to the SRO research analyst rules. As a result,
GAO recommends that SEC formally              investors may not be provided the same level of protection. GAO has previously
assess and document whether any of            reported that a regulatory framework should ensure that market participants
the Global Settlement’s remaining             receive consistent and useful information as well as consistent protections for
terms should be codified. SEC agreed          similar financial products and services. SEC staff told GAO that they periodically
with the recommendation.                      have discussed and analyzed the Global Settlement terms but have not formally
                                              assessed and documented whether any of the Global Settlement’s remaining
                                              terms should be codified. By not formally assessing whether codifying any of the
View GAO-12-209. For more information,        Global Settlement’s remaining terms provides an effective way of furthering
contact A. Nicole Clowers at (202) 512-8678   investor protection, SEC may be missing an opportunity to provide the same
or clowersa@gao.gov.                          level of protection for all investors.

                                                                                        United States Government Accountability Office
Contents


Letter                                                                                    1
               Background                                                                 4
               Data and Stakeholders’ Views Suggest That Regulatory Actions
                 Have Helped Address Conflicts Faced by Equity Analysts                 10
               Regulators Have Opportunities to Enhance Investor Protection and
                 Streamline or Harmonize Oversight                                      26
               Conclusions                                                              41
               Recommendation for Executive Action                                      42
               Agency Comments and Our Evaluation                                       42

Appendix I     Objectives, Scope, and Methodology                                       43



Appendix II    Original and Modified Global Settlement Addendum Compared with
               NASD Rule 2711                                                           46



Appendix III   Comments from the Securities and Exchange Commission                     61



Appendix IV    GAO Contact and Staff Acknowledgments                                    63



Bibliography                                                                            64



Table
               Table 1: Sections I and II of the Global Settlement’s Addendum and
                        Modified Addendum, and a Crosswalk between the Global
                        Settlement’s Addendum to NASD Rule 2711                         47


Figures
               Figure 1: FINRA Cycle Examinations That Included Reviews for
                        Compliance with SRO Research Analyst Rules and
                        Number of Deficiencies, 2005 through 2010                       19




               Page i                                         GAO-12-209 Securities Research
Figure 2: FINRA Cycle Examinations That Included Reviews for
         Compliance with the Global Settlement and Number of
         Deficiencies, 2005 through 2010                                                  20
Figure 3: Violations Involving Research and Investment Banking
         Conflicts That Led to FINRA Enforcement Actions, 2005
         through 2010                                                                     23
Figure 4: Significant Developments in Oversight of Research
         Analyst Conflicts, Including the Global Settlement and
         SRO Research Analyst Rules, 2001 through 2011                                    32
Figure 5: FINRA Cycle Examinations That Included Reviews of
         Fixed-Income Research and Number of Deficiencies, 2005
         through 2010                                                                     38




Abbreviations

BMA                        The Bond Market Association
FINRA                      Financial Industry Regulatory Authority
Global Settlement          Global Research Analyst Settlement
NASD                       National Association of Securities Dealers
NASAA                      North American Securities Administrators
                           Association
NYSE                       New York Stock Exchange
SEC                        Securities and Exchange Commission
SRO                        self-regulatory organizations




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Page ii                                                    GAO-12-209 Securities Research
United States Government Accountability Office
Washington, DC 20548




                                   January 12, 2012

                                   The Honorable Tim Johnson
                                   Chairman
                                   The Honorable Richard C. Shelby
                                   Ranking Member
                                   Committee on Banking, Housing and Urban Affairs
                                   United States Senate

                                   The Honorable Spencer Bachus
                                   Chairman
                                   The Honorable Barney Frank
                                   Ranking Member
                                   Committee on Financial Services
                                   House of Representatives

                                   In 2003, federal and state authorities reached a landmark settlement with
                                   10 of the nation’s top broker-dealers 1 to address conflicts of interest
                                   between their equity research analysts and investment bankers—
                                   resulting in more than $1.4 billion in penalties and other payments. 2 In the
                                   enforcement actions leading to the Global Research Analyst Settlement
                                   (Global Settlement), the Securities and Exchange Commission (SEC) and
                                   other authorities alleged that the firms allowed their investment bankers to
                                   pressure equity research analysts in ways that could and, in some cases,
                                   did cause them to issue misleading or false research to the potential harm
                                   of investors. For example, investment bankers at certain firms could
                                   influence the amount of compensation received by equity analysts,
                                   potentially enabling them to pressure the analysts into improperly
                                   promoting the stocks of companies whose investment banking business
                                   the firms were seeking to attract. To resolve the allegations of


                                   1
                                    In 2004, the federal and state authorities commenced enforcement actions against 2
                                   other broker-dealers involving analyst conflicts, and the firms settled substantively under
                                   the same terms as the other 10 firms.
                                   2
                                    Conflict of interest often describes a situation in which a fiduciary who, contrary to the
                                   obligation and duty to act for the benefit of a designated individual, exploits the
                                   relationship for personal benefit. We are defining a conflict of interest more generally in
                                   this report as a situation in which financial or other personal considerations reasonably
                                   could interfere with the independence of an analyst’s securities research or
                                   recommendations. However, it is important to note that the existence of a potential conflict
                                   of interest does not necessarily mean that research analysts or their research is biased.




                                   Page 1                                                      GAO-12-209 Securities Research
misconduct, the broker-dealers agreed under the Global Settlement to
implement a number of structural reforms intended to sever links between
equity research and investment banking, thereby insulating analysts from
investment banking influence or pressure.

Prior to the Global Settlement, the National Association of Securities
Dealers (NASD) and New York Stock Exchange (NYSE)—the principal
self-regulatory organizations (SRO) in the securities industry at the time—
had adopted rules specifically to address analyst conflicts at their member
firms. 3 They later amended their rules to include additional requirements
that were similar to some of the Global Settlement’s reforms. Although the
NASD and NYSE rules generally apply across the industry—not just to
the broker-dealers subject to the Global Settlement (Global Settlement
firms), the rules are less stringent than the Global Settlement’s reforms in
some areas and more stringent in other areas. 4 In that regard, some
market observers have raised concerns that the current lack of
industrywide rules mirroring the Global Settlement’s reforms creates
regulatory inconsistencies: for example, investors could be provided with
different levels of protection, depending on whether the securities
research was produced by a Global Settlement firm or other firm.

Section 919A of the Dodd-Frank Wall Street Reform and Consumer
Protection Act requires us to identify and examine potential conflicts of
interest between investment banking and both equity and fixed-income
(debt) research staff in the same firm. 5 This report examines (1) the
effectiveness of the regulatory actions taken to address research analyst



3
 An SRO is an entity responsible for regulating its members by adopting and enforcing
rules that govern its members’ business conduct. In 2007, NASD and NYSE’s member
regulation, enforcement, and arbitration functions merged to form the Financial Industry
Regulatory Authority, the primary securities industry SRO responsible for overseeing
broker-dealers.
4
 The Global Settlement includes provisions requiring the firms to reform their practices in
many areas where investment bankers can influence or pressure research analysts. As
described in appendix II, many of these provisions have been incorporated into the SRO
rules. However, the SRO rules also cover areas where research and investment banking
can intersect but which are not covered under the Global Settlement. These include an
anti-retaliation provision, a prohibition on the promise of favorable research, quiet periods,
personal trading restrictions, specific disclosure requirements, and restrictions on
communication with a subject company regarding a research report.
5
 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §
919A, 124 Stat. 1376, 1837-1838 (2010).




Page 2                                                       GAO-12-209 Securities Research
conflicts of interest, and (2) additional actions regulators could take to
further address research analyst conflicts.

To understand the nature of research analyst conflicts and identify
regulatory actions to address them, we reviewed academic, GAO, and
other studies; enforcement actions taken by SEC and state attorneys
general beginning in the early 2000s; existing and proposed SEC and
SRO rules and other releases; and Global Settlement documents. To help
evaluate the effectiveness of regulatory actions taken to address research
analyst conflicts, we reviewed and analyzed studies that empirically
examined the effects of the regulatory reforms on analyst research and
recommendations. We limited our review to studies issued after January
1, 2005, because of the time frames in which the regulatory reforms were
adopted. We also analyzed data on relevant broker-dealer examinations
and investigations conducted by the Financial Industry Regulatory
Authority (FINRA) between 2005 and 2010, SEC and FINRA enforcement
actions that involved conflicts between research and investment banking
and were taken between 2005 and 2010, and independent monitor
reports that assessed the Global Settlement firms’ compliance with the
Global Settlement. 6 We assessed the reliability of the examination and
investigation data obtained from FINRA and found the data sufficiently
reliable for our purposes. To gain insights on the effectiveness of the
regulatory actions taken to address analyst conflict and to identify
additional actions that could be taken to address such conflicts, we
interviewed officials from SEC, FINRA, and the North American Securities
Administrators Association (NASAA), including officials from five of its
member state securities commissions. We also interviewed academics
and representatives from broker-dealers, institutional investors,
independent research firms, and associations representing such entities
and retail investors. Our report focuses on potential conflicts between a
broker-dealer’s research analysts and investment bankers and is not a
comprehensive review of potential conflicts that could arise from other
sources. Appendix I contains more information on our scope and
methodology, and we provide a list of studies included in our literature
review at the end of the report.



6
 FINRA is an SRO. It is involved in various aspects of the securities business, including
registering and educating industry participants, examining securities firms, writing rules,
enforcing those rules and the federal securities laws, informing and educating the
investing public, providing trade reporting and other industry utilities, and administering a
dispute resolution forum for investors and registered firms.




Page 3                                                       GAO-12-209 Securities Research
                         We conducted this performance audit from September 2010 to January
                         2012 in accordance with generally accepted government auditing
                         standards. Those standards require that we plan and perform the audit to
                         obtain sufficient, appropriate evidence to provide a reasonable basis for
                         our findings and conclusions based on our audit objectives. We believe
                         that the evidence obtained provides a reasonable basis for our findings
                         and conclusions based on our audit objectives.



Background
Broker-Dealers May       Broker-dealers may provide a range of financial services to clients,
Provide a Range of       including corporations, financial institutions, governments, and
Services, Including      individuals. A full-service broker-dealer (or a related subsidiary or affiliate)
                         may employ (1) investment bankers to assist clients with raising capital
Research for Investors   through underwritings and private placements of equity and debt
                         securities and by offering advisory services on mergers, acquisitions, and
                         restructurings; (2) investment advisers who provide investment advisory
                         and financial planning services to clients; (3) brokers who facilitate client
                         transactions in fixed-income, equity, currency, and commodity products;
                         and (4) securities research analysts who provide equity and fixed-income
                         research services.

                         Securities research analysts play an important role in providing investors
                         with information that may affect their investment decisions. Analysts
                         typically research the current and prospective financial condition of
                         publicly traded companies in the particular industry or sector of the
                         economy in which they specialize. They then make recommendations
                         (e.g., buy, sell, or hold) about investing in the securities issued by the
                         companies the analysts cover in their research. 7 To develop judgments
                         about the future prospects of a company and its securities, analysts may
                         evaluate the company’s expected earnings, revenue, and cash flow;
                         operating and financial strengths and weaknesses; long-term viability;
                         and dividend potential.



                         7
                          Although research analysts usually summarize their research reports with a brief
                         recommendation, firms use their own rating system. For example, one firm’s rating system
                         may consist of buy, outperform, neutral, underperform, and avoid recommendations, and
                         another firm’s rating system may consist of strong buy, buy, hold, and sell
                         recommendations.




                         Page 4                                                   GAO-12-209 Securities Research
                          Analysts often specialize in equity or fixed-income (debt) securities
                          research. 8 Sell-side analysts typically work for full-service broker-dealers
                          and make recommendations on the securities they cover through their
                          research. In contrast, buy-side analysts typically work for institutional
                          money managers, such as mutual funds, hedge funds, or investment
                          advisers, which purchase securities for their own accounts. Finally,
                          independent analysts typically are not associated with firms that
                          underwrite the securities they cover in their research.


Oversight of Securities   The securities industry generally is regulated under a combination of self-
Broker-Dealers and the    regulation (subject to oversight by SEC) and direct oversight by SEC.
Global Settlement         Securities industry SROs primarily are responsible for establishing the
                          standards under which their members conduct business; monitoring the
                          way that business is conducted through regularly scheduled compliance
                          examinations; bringing disciplinary or enforcement actions against their
                          members for violating applicable federal statutes, SEC rules, and their
                          own rules; and referring potential violations of nonmembers to SEC. 9 In
                          2007, NASD and NYSE’s member regulation, enforcement, and
                          arbitration functions merged to form FINRA, the primary securities
                          industry SRO responsible for overseeing broker-dealers. 10 As of
                          November 2011, FINRA’s membership included nearly 4,500 broker-
                          dealers. According to FINRA, as of November 2010, approximately 220
                          firms conduct both investment banking and research. SEC’s oversight of
                          FINRA includes inspecting its operations and reviewing and approving its
                          rule proposals. SEC also directly regulates broker-dealers by conducting



                          8
                           Although equity and fixed-income securities analysts serve similar functions, the nature
                          of the markets and role of the analysts can differ. For example, some market participants
                          have noted that prices of debt securities are relatively less sensitive to the views of
                          research analysts than the prices of equity securities. For example, see the Bond Market
                          Association, Guiding Principles to Promote the Integrity of Fixed-Income Research: A
                          Global Approach to Managing Potential Conflicts of Interest (May 2004).
                          9
                           As part of their statutory responsibilities for regulating their members, SROs examine
                          their members to ensure compliance with SRO rules and federal securities laws. SROs
                          also can take enforcement or other disciplinary actions against their members for
                          violations of SRO rules and federal securities laws.
                          10
                            FINRA has been developing a consolidated rulebook that will consist solely of FINRA
                          rules. Until the completion of this process, the FINRA rulebook will include NASD rules,
                          NYSE rules, and FINRA rules. While the NASD rules generally apply to all FINRA
                          members, the NYSE rules apply only to those members of FINRA that also are members
                          of NYSE.




                          Page 5                                                    GAO-12-209 Securities Research
examinations; taking disciplinary actions against broker-dealers; and
interpreting, implementing, or changing its existing regulations.

A series of actions involving various federal and state entities culminated
in the Global Settlement. SEC reviewed industry practices and conducted
targeted examinations regarding analyst conflicts in 1999 and reported
the preliminary findings of the examinations to Congress in 2001. In April
2002, the New York Attorney General’s office announced an enforcement
action against a broker-dealer based on evidence that analysts were
pressured to issue positive stock recommendations to please investment
banking clients. Soon after, state regulators, SROs, NASAA, and SEC
formed a joint task force to investigate the undue influence of investment
banking interests on securities research at broker-dealers. Analyst
conflicts allegedly found by the investigations included the following
examples.

•    Research analysts supported investment banking by pitching
     business to prospective clients and marketing investment banking
     deals to institutional customers through road shows. 11

•    Equity research analysts’ compensation was determined partly by the
     degree to which they assisted investment banking or their contribution
     to investment banking revenue.

•    Investment bankers evaluated research analysts’ performance,
     influencing research analysts’ compensation.

•    Investment bankers implicitly promised their potential clients favorable
     research, with analysts participating in the sales presentations.

•    Investment bankers influenced whether analysts would start or
     continue research coverage on existing or potential investment
     banking clients.
Based on evidence compiled in their investigations, the joint task force
members determined the conditions of a settlement to resolve the
allegations of misconduct. In April 2003, 10 broker-dealers agreed to the
Global Settlement, concluding the joint investigation. In 2004,



11
  A road show is a series of presentations made to potential investors in conjunction with
the marketing of an upcoming underwriting.




Page 6                                                     GAO-12-209 Securities Research
enforcement actions were commenced against two other broker-dealers
involving analyst conflicts, and the firms settled substantively under the
same terms as the Global Settlement.

Under the Global Settlement, the firms were required to reform their
structures and practices to insulate equity analysts from investment
banking pressures. A three-part addendum to the Global Settlement
constitutes its operative portions (see app. II for a complete description
for the separation of research and investment banking, and the
disclosure/transparency and other issues sections). 12 Section I of the
addendum set forth the structural reforms designed to separate equity
research from investment banking. For example, the firms had to

•    physically separate research and investment banking departments;

•    not base research analysts’ compensation, directly or indirectly, on
     investment banking revenues or input from investment banking
     personnel;

•    prohibit investment bankers from having a role in company-specific
     coverage decisions;

•    prohibit research analysts from participating in efforts to solicit
     investment banking business; and

•    create and enforce firewalls restricting interaction between investment
     banking and research personnel, except in specifically designated
     circumstances.
Section II of the addendum includes disclosure requirements that serve to
inform investors about potential analyst conflicts and the performance of
analysts’ recommendations. It also includes a provision that allows any
Global Settlement term to be superseded by an SEC or SRO rule that
expressly purports to do so. With regards to any term that was not
superseded in this way within 5 years from the entry of the final judgment
of the Global Settlement, the firms could move to amend or modify any
term (other than the terms relating to independent research), subject to
court approval, unless SEC believed that such amendment or



12
  Appendix II does not include a discussion of the independent, third-party research
section because the section is no longer in effect.




Page 7                                                    GAO-12-209 Securities Research
                        modification was not in the public interest. Section III required the Global
                        Settlement firms to provide customers with independent research. 13

                        Firms also had to make various payments under the Global Settlement—
                        totaling more than $1.4 billion. Specifically, each firm had to pay civil
                        penalties and disgorgements, in part to establish distribution funds to
                        recompense harmed investors, and other monies to create investor
                        education funds and provide customers with independent research. 14


Analyst Conflicts and   Views about what harm, if any, analyst conflicts cause investors vary.
Investor Harm           SEC and FINRA have asserted that analyst conflicts can harm investors.
                        For instance, because of a conflict, an analyst could issue a misleading
                        recommendation on which investors rely and suffer a loss. In a 2003
                        report, the International Organization of Securities Commissions similarly
                        noted that the conflicts faced by sell-side analysts can result in biased
                        research that harms investors and undermine the fairness, efficiency, and
                        transparency of markets. 15 Also, some investors claimed in lawsuits that
                        biased analyst recommendations artificially inflated market prices of the
                        covered stocks. In turn, they claimed that they bought stocks or held onto
                        stocks that they otherwise would have sold based on the biased
                        recommendations and suffered losses when the stocks returned to their
                        true value. Finally, some academics have suggested that institutional
                        investors may be able to trade strategically to take advantage of




                        13
                         This obligation expired for most of the Global Settlement firms in July 2009.
                        14
                          A penalty is a monetary payment from a securities law violator that SEC obtains
                        pursuant to statutory authority. A penalty fundamentally is a punitive measure, but
                        penalties occasionally can be used to compensate harmed investors. A disgorgement is
                        the repayment of illegally gained profits (or avoided losses) for distribution to harmed
                        investors whenever feasible.
                        15
                          International Organization of Securities Commissions, Report on Analyst Conflicts of
                        Interest, A Report of the Technical Committee of the International Organization of
                        Securities Commissions (September 2003). Sell-side research analysts typically work for
                        full-service broker-dealers and make recommendations on the securities they cover.




                        Page 8                                                     GAO-12-209 Securities Research
misinformed individual investors that naively follow biased analyst
recommendations. 16

In contrast to such views, some economists and others have questioned
whether biased analyst recommendations, such as overly optimistic
recommendations, can lead to investor harm. For example, one
economist has argued that SEC enforcement actions against the Global
Settlement firms did not establish a clear connection between the analyst
conflicts and losses suffered by investors. 17 In support of his argument,
he noted that in private litigation against one of the firms involving analyst
conflicts, the judge found that the plaintiff’s attorneys were not able to
craft an argument to show that investor losses could be attributed to the
allegedly conflicted research reports issued by a broker-dealer. In
addition, some evidence from empirical studies indicates that market
prices anticipate and incorporate analysts’ biases, suggesting that biased
analyst recommendations do not artificially inflate stock prices to the harm
of investors. 18




16
  See, for example, Gus De Franco, Hai Lu, and Florin P. Vasvari, “Wealth Transfer
Effects of Analysts’ Misleading Behavior,” Journal of Accounting Research, vol. 45 (2007).
The study examined the economic consequences of the trading behavior of individuals
and institutions over the period in which the equity analysts at the Global Settlement firms
allegedly issued biased recommendations. It found statistical evidence suggesting that the
recommendations issued by analysts led to a systematic wealth transfer from individual
investors to institutional investors.
17
 Erik Sirri, “Investment Banks, Scope, and Unavoidable Conflicts of Interest,” Economic
Review, Federal Reserve Bank of Atlanta, Fourth Quarter 2004.
18
  For example, see Oya Altınkılıç and Robert S. Hansen, “On the Information Role of
Stock Recommendation Revisions,” Journal of Accounting and Economics, vol. 48 (2009);
Hamid Mehran, René M. Stulz, “The Economics of Conflicts of Interest in Financial
Institutions,” Journal of Financial Economics, vol. 85 (2007); Erik Sirri, “Investment Banks,
Scope, and Unavoidable Conflicts of Interest,” Federal Reserve of Atlantic Economic
Review, 4th Quarter (2004).




Page 9                                                      GAO-12-209 Securities Research
                      We reviewed empirical studies, analyzed examination and enforcement
Data and              action data, and interviewed market participants and observers to assess
Stakeholders’ Views   the extent to which regulatory actions have addressed equity analysts’
                      conflicts of interest. In addition to the Global Settlement, regulatory
Suggest That          actions taken to address conflicts faced primarily by equity research
Regulatory Actions    analysts include the following SEC, NASD, and NYSE rules issued
Have Helped Address   between 2002 and 2005:

Conflicts Faced by    •    In May 2002, SEC approved NASD and NYSE proposals to address
                           analyst conflicts. NYSE’s proposal amended NYSE Rule 472, and
Equity Analysts            NASD’s proposal established NASD Rule 2711. 19 These rules (SRO
                           research analyst rules) were substantively similar and designed to
                           restore public confidence in the validity of research and the veracity of
                           equity research analysts, who were expected to function as unbiased
                           intermediaries between securities issuers and investors. The SRO
                           research analyst rules require clear, comprehensive, and prominent
                           disclosure of conflicts in research reports and public appearances by
                           equity analysts. The rules also implement basic reforms to separate
                           research from investment banking. These include prohibiting
                           investment banking personnel from supervising analysts or approving
                           research reports, members from offering favorable research to induce
                           investment banking business, and analysts from receiving
                           compensation based on specific investment banking transactions.

                      •    In February 2003, SEC adopted Regulation Analyst Certification,
                           which requires, among other things, equity and fixed-income analysts
                           to certify that the views expressed in their research reports accurately
                           reflect their personal views and disclose whether they received
                           compensation or other payments in connection with their views.

                      •    In July 2003, SEC approved amendments to the SRO research
                           analyst rules. 20 The rule amendments were designed to further
                           promote analyst objectivity and transparency of conflicts in research


                      19
                        NYSE also proposed amendments to NYSE Rule 351 to require members to submit, on
                      an annual basis, a written attestation that they have established and implemented written
                      procedures reasonably designed to comply with NYSE Rule 472. SEC approved the
                      amendment.
                      20
                        As part of these amendments, SEC approved SRO rules that put in place registration
                      and qualification requirements for research analysts. The rules were intended to ensure
                      that research analysts possess a certain competency level to perform their jobs effectively
                      and in accordance with applicable rules and regulations.




                      Page 10                                                    GAO-12-209 Securities Research
                                reports and implement changes mandated by the Sarbanes-Oxley Act
                                of 2002. This act required SEC or SROs to adopt rules “reasonably
                                designed to address conflicts of interest that can arise when securities
                                analysts recommend equity securities in research reports and public
                                appearances.” The act also set forth specific rules to be promulgated,
                                some of which were not already in the SRO research rules, including
                                the prohibition on research analysts participating in investment
                                banking pitches. Accordingly, NASD and NYSE amended their rules.
                                The amendments require disclosure of a client relationship and
                                noninvestment banking compensation a firm receives from a covered
                                company and prohibit retaliation against research analysts for
                                publishing unfavorable research on an investment banking client.

                           •    In April 2005, SEC approved an amendment to the SRO research
                                analyst rules to prohibit research analysts from participating in road
                                shows and other matters, which are similar in certain aspects to the
                                Global Settlement’s terms.
                           While the SRO research analyst rules generally apply to all broker-
                           dealers, they are less stringent than the Global Settlement’s terms in
                           some respects and more stringent in other respects (as discussed in
                           detail in the following section and in app. II).


Research Suggests          Numerous academic studies empirically examined the effects of the
Regulatory Reforms Were    regulatory reforms—namely NASD Rule 2711, NYSE Rule 472, and the
Associated with            Global Settlement—on various aspects of recommendations and
                           research issued by research analysts. We reviewed 10 of these studies. 21
Improvements in Analyst
                           Because the vast majority of the outstanding recommendations in mid-
Recommendations, but       2000 were buy recommendations (in contrast to hold or sell), some
Other Effects Were Mixed   market observers believed that sell-side equity analysts were issuing
                           overly optimistic or positive recommendations to help their firms attract or
                           retain investment banking business. Six of the 10 studies in our review
                           examined whether the reforms made sell-side analyst recommendations
                           less optimistic, and these and the other studies also examined other




                           21
                             Although the breadth of research on research analyst conflicts is extensive, we focused
                           our review of the literature on academic studies that empirically examined the effects of
                           the regulatory reforms on recommendations and research issued by sell-side securities
                           analysts. We included both published papers and working papers but limited our review to
                           studies issued after January 1, 2005.




                           Page 11                                                   GAO-12-209 Securities Research
                              effects of the reforms. 22 The studies generally found evidence that
                              indicated the stock recommendations of sell-side analysts became less
                              optimistic after the regulatory reforms, suggesting the reforms have
                              helped to address analyst conflicts. In addition, some of these studies
                              examined other effects, such as whether one or more of the reforms
                              made analyst recommendations more informative for investors, increased
                              the profitability of recommendations, or increased the accuracy of analyst
                              earnings forecasts. However, these results generally were mixed.

Empirical Results Indicate    Five of the six studies examining changes in the distribution or relative
Relationship between the      optimism of recommendations issued by analysts found that sell-side
Reforms and Less Optimistic   analysts were issuing fewer positive recommendations, more negative
Analyst Recommendations       recommendations after the regulatory reforms, or both. 23 While the
                              studies commonly inferred from the empirical evidence that the regulatory
                              reforms helped to make recommendations less optimistic, they
                              recognized that other factors could have played a role. Key findings of
                              these studies include the following:

                              •    Buy recommendations of analysts at investment banks and brokers
                                   increased substantially from 1996 to 2000, with the ratio of buy-to-sell
                                   recommendations reaching 35 to 1 at one point. 24 From mid-2000 to
                                   June 2003, the percentage of buy recommendations declined steadily,
                                   with the ratio declining to 3 to 1. The buy recommendations issued by
                                   the Global Settlement analysts declined more sharply than the buy
                                   recommendations issued by other analysts after the adoption of
                                   NASD Rule 2711.


                              22
                                As noted previously, sell-side research analysts typically work for full-service broker-
                              dealers and make recommendations on the securities they cover. The studies we
                              reviewed generally focus on sell-side research analysts but may use affiliated analysts or
                              other terms to refer to them and may draw distinctions between them.
                              23
                                Leslie Boni, “Analyzing the Analysts after the Global Settlement,” working paper,
                              University of New Mexico (Sept. 28, 2005). The author classified recommendations made
                              by the Global Settlement analysts as “high” (strongest recommendation), “medium”
                              (middle), and “low” (least strongly recommended) and found that the analyst
                              recommendations were more optimistic after the Global Settlement. However, these
                              results do not attempt to control for differences in analyst characteristics and other factors
                              that might influence recommendations.
                              24
                                Brad Barber, M. Reuven Lehavy, Maureen McNichols, and Brett Trueman, “Buys, Holds,
                              and Sells: The Distribution of Investment Banks’ Stock Ratings and the Implications for the
                              Profitability of Analysts’ Recommendations,” Journal of Accounting and Economics, vol.
                              41 (2006). The study focuses on analysts at investment banks and brokerage firms, with a
                              sample period from January 1996 through June 2003.




                              Page 12                                                      GAO-12-209 Securities Research
•    Analysts affiliated with firms engaging in investment banking issued
     fewer strong buy recommendations after the regulatory reforms and
     fewer strong buy recommendations than independent analysts after
     the adoption of NASD Rule 2711, NYSE Rule 472, and the Global
     Settlement. 25

•    Settlement bank analysts issued, on average, less-optimistic
     recommendations relative to the other types of analysts after the
     adoption of NASD Rule 2711 and NYSE Rule 472, as well as the
     Global Settlement. 26 More specifically, these analysts issued not only
     fewer favorable recommendations but also more unfavorable
     recommendations than the other analysts for the same stocks.

•    After the adoption of NASD Rule 2711 and NYSE Rule 472, and the
     Global Settlement, analysts at the Global Settlement firms and the
     next 10 largest brokerage houses started to issue more neutral and
     pessimistic recommendations and fewer optimistic
     recommendations. 27 In addition, the Global Settlement analysts
     started to issue pessimistic recommendations much more often than
     analysts at the other brokerage houses.




25
  Jonathan E. Clarke, Ajay Khorana, Ajay Patel, and P. Raghavendra Rau,
“Independents’ Day? Analyst Behavior Surrounding the Global Settlement,” Annals of
Finance, vol. 7, no. 4 (2009). The study focuses on (1) independent analysts whose
employers were never classified as a lead or comanager on any equity deal or advised
either the target or acquirer in an acquisition at any point in its sample period, (2) affiliated
analysts whose employers advised a firm at any point during 2004-2007, and (3)
unaffiliated analysts. The sample period was from November 2000 through December
2007.
26
   Yuyan Guan, Hai Lu, and M.H. Franco Wong, “Conflict-of-Interest Reforms and
Investment Bank Analysts’ Research Biases,” Journal of Accounting, Auditing & Finance
(2011). The study focuses on analysts at investment banks, syndicate firms, brokerage
firms, and research firms. The sample period (from January 1998 through December
2007) was divided into three subperiods: (1) from January 1998 through December 2001,
the prereform period; (2) from January 2002 through December 2003, the transition
period; and (3) from January 2004 through December 2007, the postreform period.
27
  Leonardo Madureira, “Conflicts of Interest, Regulations and Stock Recommendations,”
working paper, University of Pennsylvania (2004). The study focuses on analysts at the 10
Global Settlement firms and the next 10 largest brokerage houses. Its sample period was
from July 1995 through December 2003.




Page 13                                                        GAO-12-209 Securities Research
Empirical Results Suggest       Two studies found evidence indicating that the influence of conflicts of
Relationship between the        interest on analyst recommendations weakened after the regulatory
Reforms and Weakened            reforms.
Influence of Conflicts on
Analyst Recommendations         •    Before the adoption of the regulatory reforms, analysts affiliated with
                                     brokers that recently underwrote securities were more likely to make
                                     buy recommendations for those securities than unaffiliated analysts. 28
                                     The bias largely disappeared after the reforms. At the same time,
                                     affiliated analysts were less likely than unaffiliated analysts to issue
                                     hold or sell recommendations after the regulatory reforms.
                                •    Before the adoption of NASD Rule 2711, sell-side analysts’
                                     recommendations were positively related to two variables—a
                                     company’s net external financing and the underwriting business
                                     provided by analysts’ employers—which were intended to capture
                                     factors that could lead sell-side analysts to issue overly optimistic
                                     recommendations to attract new or retain existing investment banking
                                     business. 29 After the rule adoption, the positive relationship continued
                                     but became weaker—suggesting that the influence of conflicts on
                                     analyst recommendations had weakened.
Empirical Results Suggest       Two studies found that the relationship between analyst
Association between the         recommendations and valuation estimates strengthened after the
Reforms and Increased Analyst   regulatory reforms, indicating that the reforms improved analyst
Independence                    independence. The studies examined the relationship between the
                                recommendations and earnings forecasts of sell-side analysts and
                                expected these two variables to be positively correlated. Underlying the
                                analysis is the assumption that analysts use their earnings forecasts to




                                28
                                  Ohad Kadan, Leonardo Madureira, Rong Wang, and Tzachi Zach, “Conflicts of Interest
                                and Stock Recommendations: The Effects of the Global Settlement and Related
                                Regulations,” The Review of Financial Studies, vol. 22, no. 10 (2009). The study focuses
                                on analysts at brokers and covers two periods: (1) from November 2000 through August
                                2002, the preregulatory reform period, and (2) from September 2002 through December
                                2004, the postregulatory reform period.
                                29
                                  Chih-Ying Chen and Peter F. Chen, “NASD Rule 2711 and Changes in Analysts’
                                Independence in Making Stock Recommendations,” The Accounting Review, vol. 84, no. 4
                                (2009). The study focuses on sell-side analysts and has a sample period from 1994
                                through 2005.




                                Page 14                                                   GAO-12-209 Securities Research
                             estimate stock values and then compare their valuation estimates to the
                             current stock prices to arrive at their buy, hold, or sell recommendations. 30

                             •    The consensus recommendations of sell-side analysts were
                                  negatively related to stock valuation estimates based on earnings
                                  forecasts before the adoption of SEC Regulation Full Disclosure.
                                  However, the relationship became less negative after the adoption of
                                  the regulation and turned positive after the adoption of NASD Rule
                                  2711, NYSE Rule 472, and the Global Settlement. 31
                             •    The relationship between sell-side analysts’ stock recommendations
                                  and valuation estimates based on earnings forecasts became
                                  significantly stronger after the adoption of NASD Rule 2711. 32

Empirical Results on Other   Most of the studies we reviewed also examined other effects of the
Effects of the Regulatory    regulatory reforms. However, the empirical results generally were mixed
Reforms Were Mixed           on whether the regulatory reforms increased the profitability of analysts’
                             recommendations, made analysts’ recommendations more informative for
                             investors, or increased the accuracy of analysts’ earnings forecasts. That
                             is, some studies arrived at different conclusions about the effectiveness of
                             the regulatory reforms on factors other than analyst independence and
                             objectivity.




                             30
                               The studies further assume that their valuation models are the same models used by
                             analysts and that these models do not vary across the firms. See Mark T. Bradshaw,
                             “Analyst Information Processing, Financial Regulation, and Academic Research,” The
                             Accounting Review, vol. 84, no. 4 (2009).
                             31
                               Ran Barniv, Ole-Kristian Hope, Mark J. Myring, and Wayne B. Thomas, “Do Analysts
                             Practice What They Preach and Should Investors Listen? Effects of Recent Regulations,”
                             The Accounting Review, vol. 84, no. 4 (2009). The study focuses on sell-side analysts. Its
                             sample period was from January 1993 through May 2005, divided into four subperiods
                             corresponding to periods before and after the adoption of SRO research analyst rules and
                             SEC Regulation Full Disclosure, effective October 2000. The SEC regulation prohibits
                             issuers from selectively disclosing material nonpublic information to certain people—often,
                             research analysts or institutional investors—before disclosing the same information to the
                             public.
                             32
                               Chen and Chen, “NASD Rule 2711 and Changes in Analysts’ Independence in Making
                             Stock Recommendations.”




                             Page 15                                                    GAO-12-209 Securities Research
•    Three studies examined whether the regulatory reforms improved the
     profitability of analyst recommendations. 33 The results of one of the
     studies suggested that NASD Rule 2711 enhanced the investment
     value of sell-side analyst recommendations, but the results of the
     other studies generally did not. 34

•    Four studies examined whether investors found analyst
     recommendations to be more informative after the regulatory reforms.
     Three studies found evidence indicating that investors viewed
     changes in recommendations made by sell-side analysts to be less or
     equally informative after the reforms. 35 One study found that after the
     adoption of NASD Rule 2711 the market reacted more strongly to buy
     and sell recommendations made by sell-side analysts. 36

•    Two studies examined the effect of the regulatory reforms on the
     accuracy of analyst earnings forecasts. One study found that the
     earnings forecasts of investment bank analysts became less accurate,
     on average, in comparison with the forecasts of other types of
     analysts after the regulatory reforms. 37 The other study found that the



33
   The general question of whether analysts’ stock recommendations have investment
value has been studied extensively. Some studies suggest that investors can earn positive
risk-adjusted returns by following stock recommendations, but other studies suggest that
revisions of analysts’ recommendation generally do not provide new information. For
example, Lily H. Fang, and Ayako Yasuda, “Are Stars’ Opinions Worth More? The
Relation between Analyst Reputation and Recommendation Values,” working paper
(2010).
34
  See Chen and Chen, “NASD Rule 2711 and Changes in Analysts’ Independence in
Making Stock Recommendations”; Guan et al., “Conflict-of-Interest Reforms and
Investment Bank Analysts’ Research Biases”; and Boni, “Analyzing the Analysts after the
Global Settlement.”
35
  Clarke et al., “Independents’ Day? Analyst Behavior Surrounding the Global Settlement”;
Boni, “Analyzing the Analysts after the Global Settlement”; and Kadan et al., “Conflicts of
Interest and Stock Recommendations: The Effects of the Global Settlement and Related
Regulations.”
36
   Michael T. Cliff, “Do Affiliated Analysts Mean What They Say?” Financial Management,
vol. 36, issue 4 (2007). The study focuses on two groups of analysts: (1) analysts at
brokers that served as lead or joint-lead for a firm’s securities issuance and (2) analysts at
firms that do not perform a material amount of underwriting. Its sample period was
between 1992 and 2005.
37
  Guan et al., “Conflict-of-Interest Reforms and Investment Bank Analysts’ Research
Biases.”




Page 16                                                      GAO-12-209 Securities Research
                                 analyst forecasts overestimated actual earnings before the Global
                                 Settlement, but the bias declined after the Global Settlement. 38


SEC and SROs Generally      The SROs reviewed the effectiveness of the research analyst rules
View the Regulatory         shortly after their adoption and concluded that the reforms were generally
Reforms as Effective in     effective. At SEC’s request, NASD and NYSE staff jointly conducted a
                            review of the operation and effectiveness of their research analyst rules
Addressing Equity Analyst   and submitted their report to SEC in December 2005. 39 As part of their
Conflicts                   study, NASD and NYSE staff reviewed examinations of their members for
                            compliance with the research analyst rules, enforcement actions taken
                            against members for violations of the rules, and academic studies and
                            media reports and commentary. The NASD and NYSE staff concluded
                            that the SRO research analyst rules were effective in helping to restore
                            integrity to analyst research by minimizing the influences of investment
                            banking and promoting transparency of other potential conflicts of
                            interest. They also noted that evidence suggested that investors were
                            benefiting from more balanced and accurate research to aid their
                            investment decisions.

                            In addition, FINRA officials and SEC staff told us that they view the
                            regulatory reforms as effective—citing their examination findings and the
                            limited number of enforcement actions involving conflicts between
                            research and investment banking as evidence of the reforms’
                            effectiveness. According to FINRA officials, FINRA examines its member
                            broker-dealers on a cyclical basis. The officials said that the scope of
                            each examination is based on a risk-assessment of the firm. In that
                            regard, although FINRA has developed examination modules to assess
                            broker-dealer compliance with the SRO research analyst rules and the
                            Global Settlement, examiners may not cover these areas in every
                            examination. In addition, FINRA officials and SEC staff told us that they
                            can bring enforcement actions against broker-dealers for violations of rule
                            or statute. Examination findings and enforcement actions provide useful
                            information on the extent to which firms have been complying with the



                            38
                              Armen Hovakimian and Ekkachai Saenyasiri, “Conflicts of Interest and Analyst Behavior:
                            Evidence from Recent Changes in Regulation,” Financial Analysts Journal, vol. 66, no. 4
                            (2010). The study focuses on sell-side analysts, and its sample period was from 1996
                            through 2006.
                            39
                              NASD and NYSE, Joint Report by NASD and the NYSE on the Operation and
                            Effectiveness of the Research Analyst Conflict of Interest Rules (2005).




                            Page 17                                                  GAO-12-209 Securities Research
                             research analyst rules and the Global Settlement and, in conjunction with
                             the empirical studies and other evidence, an indication of the
                             effectiveness of those regulatory actions.

FINRA Examination Findings   Although FINRA found deficiencies in a high percentage of its
                             examinations, the nature of the findings generally were minor, according
                             to FINRA’s data, and indicated that broker-dealers largely have been
                             complying with the SRO research analyst rules. From 2005 through 2010,
                             FINRA conducted 791 cycle broker-dealer examinations that covered
                             compliance with the SRO research analyst rules, according to data
                             provided by FINRA. 40 Of the 791 examinations that included a review of
                             general research, 309 (39 percent) found some rule-related deficiencies.
                             As shown in figure 1, the number of examinations covering the SRO
                             research analyst rules declined steadily each year, from a high of 221 in
                             2005 to a low of 65 in 2010. While the number of examinations declined
                             over this period, so did the number with deficiencies, from 79 in 2005 to
                             23 in 2010. The nature of the exceptions found in the examinations
                             generally included technical disclosure or supervisory deficiencies.
                             Matters considered for formal action included instances of noncompliance
                             with the requirements to separate research and banking or to disclose
                             relevant information about potential or actual conflicts. For example,
                             some firms failed to implement firewalls to properly separate investment
                             banking from research, and some failed to disclose that they were to
                             receive or already had received investment banking compensation from a
                             company covered by their research analysts. FINRA referred 38 of the
                             309 examinations with deficiencies to its Enforcement Department for
                             formal disciplinary action. While some referrals involved firms that failed
                             to properly separate research from investment banking, most involved
                             matters other than conflicts between research and investment banking,
                             such as analysts engaging in personal trading against their
                             recommendations.




                             40
                              Some of these examinations were conducted by NASD or NYSE Regulation before they
                             merged to form FINRA.




                             Page 18                                             GAO-12-209 Securities Research
Figure 1: FINRA Cycle Examinations That Included Reviews for Compliance with
SRO Research Analyst Rules and Number of Deficiencies, 2005 through 2010




Similarly, FINRA’s examination findings indicate that the Global
Settlement firms generally have complied with the Global Settlement.
From 2005 through 2010, FINRA conducted 36 cycle examinations of the
Global Settlement firms that covered their compliance with the Global
Settlement, according to data provided by FINRA (see fig. 2). While some
Global Settlement firms were examined more often than others, each was
examined at least once during this period for compliance with the Global
Settlement’s terms. 41 Eight of the 36 Global Settlement examinations
found deficiencies. Five of the deficiencies involved disclosure violations,
such as failing to reference the specific page number on which investors
could locate disclosure information. The remaining three deficiencies
involved violations of the Global Settlement’s structural reforms. For


41
  Specifically, two of the Global Settlement firms were examined five times, three were
examined four times, two were examined three times, three were examined twice, and two
were examined once for compliance with the Global Settlement’s terms.




Page 19                                                 GAO-12-209 Securities Research
example, one firm failed to ensure that its oversight committee reviewed
research reports for changes in ratings or price targets before publication,
while another firm disclosed to examiners that its communications firewall
failed to block electronic communications between its research and
investment banking staff for nearly 9 months. According to FINRA
officials, none of the deficiencies in the examinations resulted in a referral
for formal disciplinary action, although the matter involving problems with
one firm’s communications firewall still is under review.

Figure 2: FINRA Cycle Examinations That Included Reviews for Compliance with
the Global Settlement and Number of Deficiencies, 2005 through 2010




During the same time frame, FINRA also initiated numerous cause
examinations involving the SRO research analyst rules, but most did not
involve conflicts between research and investment banking. 42 In 2010,
FINRA initiated two cause examinations to examine whether the broker-


42
  In addition to its cycle examinations, FINRA officials said they conduct cause
examinations based on a tip, complaint, prior examination finding, or other reason.




Page 20                                                    GAO-12-209 Securities Research
                            dealers were permitting their investment banking staff to improperly
                            influence their research analysts’ recommendations. According to FINRA
                            officials the two examinations are ongoing.

                            According to SEC staff, their broker-dealer examination findings indicate
                            that the regulatory reforms have been effective in addressing analyst
                            conflicts. 43 SEC staff said that they do not have an examination module
                            specifically designed to cover the SRO research analyst rules or the
                            Global Settlement but have reviewed whether broker-dealers were
                            complying with such requirements in some of their examinations of
                            broker-dealers examined by FINRA. 44 Based on their review of broker-
                            dealer examination reports dating to 2005, SEC staff told us that they
                            identified a few examinations that found deficiencies related to the SRO
                            research analyst rules. 45 According to the staff, these deficiencies
                            included broker-dealers failing to disclose analyst conflicts in their
                            research reports and failing to comply with requirements that restrict an
                            analyst’s public appearance.

FINRA and SEC Enforcement   In addition to their findings from broker-dealer examinations, FINRA
Actions                     officials and SEC staff said that the limited number of enforcement
                            actions involving conflicts between equity research and investment
                            banking suggests that the regulatory reforms have been effective. From
                            2005 through 2010, FINRA took 10 enforcement actions against broker-
                            dealers for violations of NASD Rule 2711 that involved conflicts between
                            research and investment banking. Five of the enforcement actions were
                            taken against Global Settlement firms and largely involved failures to




                            43
                              SEC directly assesses broker-dealer compliance with the federal securities laws through
                            examinations, such as cause and risk-targeted examinations. If examiners identify
                            compliance findings during broker-dealer examinations, they may assess the quality of
                            any recent FINRA examinations of the broker-dealer and provide oversight comments to
                            FINRA.
                            44
                               SEC also may conduct other types of examinations of broker-dealers, such as cause or
                            risk-targeted examinations.
                            45
                              The SEC staff’s review may not have captured all of the examinations that covered
                            conflicts between research and investment banking. SEC staff told us that the agency’s
                            examination database does not have an electronic search capability that can be used to
                            identify which examinations included a review of which specific SRO rules. According to
                            SEC staff, the agency has been developing a new examination database with improved
                            search capabilities and currently is testing the system.




                            Page 21                                                   GAO-12-209 Securities Research
adequately comply with disclosure requirements (see fig. 3). 46 The other
five enforcement actions were taken against nonGlobal Settlement firms:
three for allowing investment banking personnel to influence analyst
compensation and two for failing to comply with requirements to disclose
the firm’s compensation for investment banking services. In each
instance, the firm was required to sign an Acceptance, Waiver, and
Consent, a settlement wherein the broker-dealer consents, without
admitting or denying the findings, to the entry of the findings and to the
imposition of sanctions. In addition, FINRA censured the firms for their
misconduct and imposed monetary fines.




46
  A total of seven enforcement actions were taken against Global Settlement firms during
the period. In addition to the five actions involving conflicts between research and
investment banking, the remaining two actions involved failure to disclose the availability
of independent third-party research per the requirements of the Global Settlement.




Page 22                                                    GAO-12-209 Securities Research
Figure 3: Violations Involving Research and Investment Banking Conflicts That Led to FINRA Enforcement Actions, 2005
through 2010




                                        SEC also has taken enforcement actions involving conflicts between
                                        research and investment banking. Specifically, SEC took a total of three
                                        such actions from 2005 through 2010. In 2005, SEC brought a settled
                                        action against two research supervisors for their failure to reasonably
                                        supervise an equity research analyst who published fraudulent research.
                                        The case focused on the adequacy of supervision of a research analyst,
                                        who was subject to a prior enforcement action that alleged the analyst
                                        produced biased research to support the firm’s investment banking
                                        business. In 2007, SEC issued a cease and desist order against a firm for
                                        employing business practices that linked research and investment
                                        banking, creating incentives for its analysts to support the firm’s
                                        investment banking business. In 2010, SEC issued a cease and desist
                                        order against a firm for failing to establish and enforce policies and
                                        procedures to prevent the misuse of material, nonpublic information. The
                                        firm engaged in securities research and was the parent of an investment
                                        advisory subsidiary that shared the same chief compliance officer. In its
                                        order, SEC alleged that the firm failed to prevent its investment advisory
                                        subsidiary from misusing material research information, such as the



                                        Page 23                                             GAO-12-209 Securities Research
                                 initiation of research coverage or changes in price targets, produced by
                                 its research department.

Independent Monitors             Additionally, under the Global Settlement, each of the 12 broker-dealers
Generally Found the Broker-      had to (1) hire an independent monitor to assess whether the firm had
Dealers in Compliance with the   developed adequate policies and procedures to ensure compliance with
Global Settlement                the Global Settlement and (2) certify compliance with the Global
                                 Settlement within 5 years of the date of the entry of the final judgment.
                                 Each independent monitor generally completed and filed their reports
                                 between October 2003 and February 2006.

                                 Based on our review of the independent monitor reports, all the monitors
                                 generally concluded that each firm had implemented effective policies
                                 and procedures to comply with the Global Settlement. To conduct their
                                 reviews, the monitors typically examined each firm’s policies and
                                 procedures, reviewed supporting documents to verify the implementation
                                 and effectiveness of the policies and procedures, made observations,
                                 conducted inspections (for example, of physical separation of research
                                 and investment banking), and interviewed the firm’s management and
                                 staff. Although the independent monitors concluded that each firm was in
                                 compliance with the Global Settlement, all of them included
                                 recommendations in their reports. The recommendations generally were
                                 intended to clarify or enhance a firm’s compliance policies and
                                 procedures or improve a firm’s ability to track and monitor its compliance.
                                 According to SEC staff, all the Global Settlement firms certified that they
                                 were in compliance with the Global Settlement by August 2008.
                                 According to SEC staff, on a number of occasions, the Global Settlement
                                 firms self-reported instances of noncompliance with the Global Settlement
                                 to SEC staff. These reported instances largely concerned technical
                                 failures to provide disclosures regarding the availability of independent
                                 research or ratings on customer account statements and confirmations.
                                 Upon receiving these reports, SEC staff typically notified the other
                                 regulators involved in the Global Settlement, discussed the violations and
                                 remedial measures with the reporting firm, and asked that the firm write to
                                 inform the court of the matter.

While Market Participants        Most market participants and observers we interviewed told us that the
and Others Generally View        regulatory reforms have been effective in mitigating analyst conflicts but
the Reforms as Effective,        provided different reasons why. Examples cited by market participants
                                 and observers as to why the structural reforms have been effective
Some Noted Conflicts             include the following:
Could Not Be Completely
Addressed or Eliminated


                                 Page 24                                          GAO-12-209 Securities Research
•   Research analysts are shielded from investment banking influence,
    according to officials from broker-dealers, an independent research
    firm, and institutional money managers;

•   Securities research is more independent but not necessarily better,
    according to officials from an institutional money manager; and

•   The regulatory reforms provide a compliance structure that requires
    broker-dealers to manage their analyst conflicts, according to state
    securities regulators.
In addition to the structural reforms, market participants and observers
said that the disclosure requirements have been effective in addressing
analyst conflicts, in part because investors are more aware of potential
analyst conflicts, according to officials from broker-dealers, a consumer
interest group, and independent research firms. Furthermore, officials
from the consumer interest group said that the media attention
surrounding the investigations that led to the Global Settlement helped to
raise investors’ awareness of analyst conflicts.

Despite generally viewing the regulatory reforms as effective, some
market participants and observers told us that the reforms do not
completely eliminate research analysts’ conflicts. For example, according
to an academic, the SRO research analyst rules and the Global
Settlement prohibit sell-side analysts from being compensated based on
their investment banking contributions, but their pay may be based on
their firm’s overall profitability—of which investment banking can be a
major source. As a result, sell-side analysts face inherent conflicts
because they know that negative ratings can harm their firm’s investment
banking business and, in turn, their personal compensation, according to
state securities regulators, institutional investors, academics, and others
with whom we spoke. Officials from a consumer interest group told us that
this inherent conflict can be eliminated by prohibiting firms from engaging
in both investment banking and research. In addition, although the Global
Settlement requires the firms to physically separate research and
investment banking staff, this prophylactic measure can be circumvented,
according to officials from an investor advocacy group and a consumer
interest group. For example, officials from the investor advocacy group
said analysts and investment bankers could talk outside of the firm. In
their reports, two independent monitors recognized the limitations of the
reform but their reports suggest that physical separation reinforced the
idea that analysts and investment bankers were not supposed to talk with
each other.



Page 25                                         GAO-12-209 Securities Research
                           Although SEC and FINRA have taken regulatory actions to address
Regulators Have            conflicts of interest faced by securities research analysts, additional
Opportunities to           opportunities exist to adopt or revise rules to enhance investor protection
                           and streamline or harmonize oversight.
Enhance Investor
Protection and
Streamline or
Harmonize Oversight
FINRA Plans to Finalize    FINRA plans to finalize an equity analyst rule that includes longstanding
Equity Analyst Rules       internal recommendations intended to enhance investor protections,
Intended to Enhance        increase information flow to investors, and reduce regulatory burden,
                           according to FINRA officials. In a December 2005 report, NASD and
Investor Protections and   NYSE staff made recommendations to amend the SRO research analyst
Reduce Regulatory Burden   rules, but the recommendations have yet to be implemented. As part of its
                           2005 request that the SROs review the effectiveness of their research
                           rules, SEC asked NASD and NYSE to make any recommendations for
                           rule changes or additions. To address this request, NASD and NYSE staff
                           conducted a section-by-section review of the rules, which included
                           assessing whether the rules were accomplishing their purpose,
                           comparing the rules to the Global Settlement, considering gaps in
                           coverage, and reviewing industry questions and comments about the
                           rules. As discussed in the following paragraphs, the SRO staff
                           recommended revising their rules to prohibit a practice that was not
                           permitted under the Global Settlement’s terms. In general, the staff
                           recommended several rules changes that were intended to improve rule
                           effectiveness by striking a better balance between trying to ensure
                           objective and reliable research and permitting the flow of information to
                           investors and minimizing costs and burdens to firms. Specifically, the
                           recommendations included:

                           •   changing the definition of “research analyst,” “research report,” and
                               other terms used in the rule, to codify exceptions set forth in previous
                               interpretive material and to align with SEC Regulation Analyst
                               Certification and the Global Settlement;

                           •   eliminating a provision that permitted investment banking personnel to
                               review research before publication (to verify factual information),
                               because SRO staff believed that such a review raised concerns about
                               the objectivity of the research and noted that such a review was not
                               permitted under the Global Settlement’s terms;




                           Page 26                                           GAO-12-209 Securities Research
•    amending the disclosure rules to provide more effective disclosure by
     allowing, in lieu of disclosure in the research report itself, a prominent
     warning on the cover of research reports that conflicts exist and
     information about how investors could obtain more details about those
     conflicts of interest on the firm’s website, because staff were
     concerned that the volume of disclosures in the reports could obscure
     their overall message; and

•    amending the provision that prohibited investment banking personnel
     from retaliating against research analysts as a result of unfavorable
     research to include all of a firm’s employees.
Similar to the concerns raised by the SRO staff about the conflict
disclosures, various market participants and observers we interviewed
questioned the effectiveness of or raised concerns about the burden of
the conflict disclosures. For example, some broker-dealers told us that
that the volume and complexity of the disclosures have made the
information less useful for investors. Also, officials from three associations
representing investors and an institutional investor said the disclosures
are important but do not convey sufficient information for investors to fully
understand the nature and magnitude of analyst conflicts. Broker-dealers
further noted that their need to continually collect a wide range of data to
track analyst conflicts is costly and burdensome.

In 2008, FINRA issued a proposal to consolidate the NASD and NYSE
research analyst rules in a new FINRA rule and move to a more
principles-based regulatory approach in this area. 47 The proposal
included most of the recommendations made by the NASD and NYSE
staff in their December 2005 report. 48 Additionally, FINRA’s proposed
consolidated rule would broaden the obligations of its member broker-
dealers to identify and manage analyst conflicts. Specifically, it included a
provision to require FINRA members to establish, maintain, and enforce



47
  FINRA, Research Analysts and Research Reports, Regulatory Notice 08-55 (October
2008).
48
  In a December 2005, NASD and NYSE staff recommended a number of changes to the
SRO research analyst rules. NASD and NYSE filed proposals with SEC in September
2006 to amend their research analyst rules and implement the recommendations. FINRA’s
2008 proposal would supersede the NASD and NYSE proposals and omitted the
recommendation to allow for Web-based conflict disclosures, because SEC interpreted
the Sarbanes-Oxley Act as requiring that such disclosures be made only in the research
reports.




Page 27                                                GAO-12-209 Securities Research
policies and procedures reasonably designed to identify and effectively
manage conflicts related to the preparation, content, and distribution of
research reports and public appearances by equity analysts. The
proposal also specified that the policies and procedures must address
information barriers and other safeguards to insulate research analysts
from pressure by investment banking personnel. The proposal largely
maintained the same disclosures, including a provision that would require
a member to disclose in any research report all conflicts that reasonably
could be expected to influence the objectivity of the report and that are
known or should have been known on the date of the report’s publication
or distribution. FINRA received five comment letters on its proposal. The
comments (which were from a venture capital association, a securities
industry association, a securities firm, a law office, and an individual)
generally supported the proposal but expressed concerns, including that
some terms were too broadly defined and, thus, would make compliance
difficult.

FINRA has not yet finalized its 2008 proposal designed to consolidate the
SRO research analyst rules and implement recommendations made by
NASD and NYSE staff in 2005. According to FINRA officials, FINRA has
delayed finalizing the proposal until it finalizes a proposal to address
conflicts of interest faced by fixed-income (debt) research analysts. SEC
staff and FINRA officials told us that SEC encouraged FINRA to consider
adopting a rule to address conflicts of interest faced by fixed-income
research analysts. As discussed later in the report, FINRA recently issued
a concept release for a fixed-income research rule. According to FINRA
officials, their tentative plan is to seek comment on a regulatory notice on
a revised debt research proposal and then package the final debt and




Page 28                                          GAO-12-209 Securities Research
                             equity research rule proposals together and submit a single proposed
                             consolidated research analyst rule to SEC in the first half of 2012. 49


SEC and FINRA Have Not       Although the Global Settlement has been in place since 2003 and
Formally Assessed and        includes a provision that allows for it to be modified or superseded, SEC
Documented Whether Any       and FINRA have not proposed codifying the Global Settlement’s
                             remaining terms. The Global Settlement provided that if SEC adopts a
of the Global Settlement’s   rule or approves an SRO rule with the stated intent to supersede any of
Remaining Terms Should       the Global Settlement’s terms, then that term would be superseded. The
Be Codified                  Global Settlement also originally provided that SEC would agree, subject
                             to court approval, to modify any term in Section I or II of the addendum
                             that had not been superseded within 5 years of the entry date of the
                             Global Settlement, unless SEC determined the modification would not be
                             in the public interest.

                             While NASD and NYSE adopted research analyst rules that are similar to
                             many of the Global Settlement’s terms (see app. II for a comparison of
                             the Global Settlement and SRO research analyst rules), they did not
                             expressly state that their rules superseded the terms. 50 In 2009, the
                             Global Settlement firms, with SEC’s agreement, submitted a request to a


                             49
                               FINRA’s Board of Governors must approve a proposed rule for filing with SEC. When
                             FINRA files a proposal with SEC for notice and comment, SEC staff must review the
                             proposal to determine whether the proposed rule change is consistent with the Securities
                             and Exchange Act of 1934 and the rules and regulations thereunder. In response to
                             comments or questions from SEC staff, FINRA may seek to modify or supplement its
                             proposal with additional descriptive text or legal analysis. SEC then publishes the
                             proposed rule in the Federal Register for public comment. Depending on the comments
                             received, FINRA may respond to the questions and concerns raised by the commenters.
                             For proposals subject to SEC approval before they may take effect, SEC would publish an
                             approval order or disapproval order in the Federal Register. If approved, FINRA may
                             announce the approval in a regulatory notice. For proposals that are immediately effective
                             by operation of law, no further SEC action is necessary for the rule to take effect.
                             However, SEC may suspend an immediately effective proposal within 60 days of the filing
                             thereof, in which case it would institute proceedings to determine whether to approve or
                             disapprove the proposal.
                             50
                               For example, in 2005, NASD and NYSE proposed amending their research analyst rules
                             to prohibit research analysts from participating in road shows relating to investment
                             banking services transactions. The SROs noted that the proposed rule changes were
                             similar in certain aspects to the Global Settlement’s provisions. They stated that the
                             proposed rule changes were not proposed for the purpose of conforming to the Global
                             Settlement or addressing differences between the Global Settlement and SRO rules.
                             Rather, the SROs believed that the proposed rules were appropriate in that they would
                             facilitate the goal of more objective and reliable research.




                             Page 29                                                   GAO-12-209 Securities Research
federal district court to modify the Global Settlement’s addendum. In their
request, the firms stated that the addendum should be terminated in its
entirety, and they, like other broker-dealers, should be subject only to the
SEC and SRO research analyst rules. However, the firms noted in their
request that SEC indicated that certain provisions should be retained in
the public interest. Consequently, the firms did not ask the court to
terminate in full Sections I and II, but instead to modify the majority of the
terms in Section I and a disclosure requirement in Section II. 51 The
broker-dealers primarily justified their requested changes based upon the
existence of the SRO research analyst rules that addressed the same
concerns and provided comparable protections.

On March 15, 2010, the federal district court approved all but one of the
requested changes. 52 The court declined to allow research and
investment banking personnel to communicate with each other—outside
the presence of internal legal or compliance staff—about market or
industry trends, conditions, or developments, provided that such
communications were consistent in nature with communications that an
analyst might have with investing customers. The court noted that the
change was counterintuitive and would undermine the separation
between research and investment banking. Under the modified Global
Settlement approved by the court, terms that remain in place include:

•    investment banking cannot have input into the research budget,

•    research analysts and investment banking must be physically
     separated,

•    investment banking cannot have input into company-specific coverage
     decisions,

•    research oversight committees must ensure the integrity and
     independence of equity research,

•    investment banking personnel and research analysts cannot
     communicate about the merits of a proposed transaction or a potential


51
  As previously noted, Section III expired in July 2009 and therefore was not discussed in
the Letter Motion request to amend the Final Judgment, which was filed in August 2009.
52
 See appendix II for a description of the March 15, 2010, modifications to the Global
Settlement.




Page 30                                                    GAO-12-209 Securities Research
     candidate for a transaction unless a chaperone from the firm’s legal or
     compliance department is present,

•    research analysts and investment bankers cannot communicate for
     the purpose of having research personnel identify specific potential
     investment banking transactions, and

•    research analysts must be able to express their views to a
     commitment committee about a proposed investment banking
     transaction outside the presence of investment bankers working on
     the deal. 53
While the court maintained these terms in the modified Global Settlement,
the court’s March 15, 2010, order provided that the parties expected SEC
would agree to further modification of the Global Settlement’s terms at the
earlier of March 15, 2011, or the effective date of the consolidated
research rule proposed by FINRA in October 2008 (if such rules
addressed the Global Settlement’s remaining terms), unless SEC
believes such amendment or modification would not be in the public
interest. Any such amendment or modification would be subject to court
approval. To date, the Global Settlement firms have not requested any
further modification of the settlement. See figure 4 for a summary of
events relating to the Global Settlement and SRO research analyst rules.




53
  A commitment committee generally reviews and approves all proposed securities
offerings to investment banking clients to determine whether the broker-dealer will act as
lead underwriter or otherwise participate in the offering.




Page 31                                                    GAO-12-209 Securities Research
Figure 4: Significant Developments in Oversight of Research Analyst Conflicts, Including the Global Settlement and SRO
Research Analyst Rules, 2001 through 2011




                                        Certain SEC staff and FINRA officials have different views about whether
                                        the remaining Global Settlement’s terms should be codified. According to
                                        SEC staff, the reference to FINRA’s consolidated rule proposal was
                                        included in the modified Global Settlement because of the possibility that
                                        FINRA would amend its rule proposal to include the remaining terms.
                                        According to FINRA officials, FINRA does not plan to state that its
                                        consolidated rule, when finalized, would supersede the Global
                                        Settlement. FINRA officials said the Global Settlement serves to address
                                        bad behavior in which the Global Settlement firms allegedly engaged;
                                        thus, some of the Global Settlement’s terms are more stringent than the
                                        SRO research analyst rules and should not apply to firms that did not
                                        engage in such behavior. FINRA officials said that the decision to modify


                                        Page 32                                               GAO-12-209 Securities Research
or terminate the Global Settlement should not be done through a FINRA
rulemaking; rather, it should be determined by the court based on
whether the remedial actions required under the Global Settlement have
reached their finality. SEC staff told us that any rulemaking to codify the
provisions of the Global Settlement would be most appropriate as SRO
rules. SEC staff continue to work with FINRA to achieve this goal.

According to FINRA officials, they have carefully considered the
appropriateness and impact of codifying the Global Settlement’s
remaining terms. They are concerned that some of the remaining terms
are potentially costly and burdensome and would affect unfairly those
firms that were not alleged to have engaged in wrongful conduct,
particularly some small firms that provide both research and investment
banking services. As discussed, NASD and NYSE staff conducted a
section-by-section review of the research analyst rules in 2005, which
included comparing the rules to the Global Settlement’s terms, and
recommended codifying one of the terms not already in the rules. For
FINRA’s consolidated equity rule proposal, FINRA officials told us that
they recently analyzed and discussed the Global Settlement’s remaining
terms with SEC staff and conveyed to the SEC staff their position on
which ones should be codified. 54 According to the FINRA officials, their
analysis considered the investor protection benefits of adopting the
Global Settlement’s remaining terms and the costs and burdens that such
action would impose on non-Global Settlement firms. The officials told us
that their analysis largely was done through internal discussions and was
not documented.

According to SEC staff, it is incumbent on the Global Settlement firms to
initiate action to repeal or modify any of the Global Settlement’s terms (as
provided in the modified Global Settlement), and none of the firms have
contacted SEC to discuss further modifications since 2009. The staff said
that if the firms requested that the Global Settlement be modified, SEC
would have to find that the modifications were counter to the public
interest for SEC to oppose the request. Moreover, SEC staff said that the



54
  Although FINRA does not anticipate that its consolidated rule would supersede the
Global Settlement, FINRA officials told us that they are considering modifying FINRA’s
proposed consolidated research rule to include two of the remaining Global Settlement’s
terms: (1) express restrictions on investment banking input into research coverage
decisions and (2) restrictions on communications between research and investment
banking when conducting due diligence on an investment banking mandate.




Page 33                                                  GAO-12-209 Securities Research
Global Settlement firms continue to be subject to the Global Settlement,
because the related enforcement actions found them to be allegedly
engaged in a litany of misconduct. They told us that the Global Settlement
was not intended to create a competitive disadvantage for the Global
Settlement firms, but rather to address their conduct. At the same time,
the SEC staff said that the Global Settlement’s terms provide useful
protections that could benefit all investors if applied more broadly.
According to SEC staff, the Global Settlement firms account for the vast
majority of the U.S. investment banking business, and other broker-
dealers have opted to comply voluntarily with the Global Settlement. As a
result, SEC staff said that the majority of research produced by broker-
dealers also engaged in investment banking is, in effect, affording
investors the protections provided under the Global Settlement’s terms.

Although SEC staff and FINRA officials periodically have discussed and
analyzed the Global Settlement’s terms, they have not formally
determined and documented the benefits and costs of adopting rules
based on the Global Settlement’s remaining terms. Such analysis would
serve to determine and make transparent whether the benefits of such
action would likely justify the costs. However, as long as the Global
Settlement remains in effect, the Global Settlement firms continue to be
subject to the requirements of the Global Settlement and the SRO
research analyst rules, while other firms that provide the same services
are subject only to the SRO research analyst rules. As a result, investors
may not be provided the same level of protection. We have previously
reported that a regulatory framework should include investor protection as
part of its mission to ensure that market participants receive consistent,
useful information, as well as consistent legal protections for similar
financial products and services. 55 To the extent that any of the Global
Settlement’s remaining terms provide a cost-effective way of furthering
investor protection, by not formally assessing their codification SEC may
be missing an opportunity to provide consistent investor protection.




55
  To help Congress and others evaluate proposals for financial regulatory reform, we
developed a framework comprised of nine characteristics that a regulatory regime should
reflect. See GAO, Financial Regulation: A Framework for Crafting and Assessing
Proposals to Modernize the Outdated U.S. Financial Regulatory System, GAO-09-216
(Washington, D.C.: Jan. 8, 2009).




Page 34                                                  GAO-12-209 Securities Research
FINRA Has Been Drafting       FINRA has been drafting a rule to address longstanding concerns about
a Rule to Address Conflicts   conflicts of interest that fixed-income analysts face. 56 Although fixed-
of Interest Faced by Fixed-   income research analysts, like equity research analysts, face conflicts of
                              interest, fixed-income research conflicts were not addressed in the SRO
Income Research Analysts
                              research analyst rules. For instance, Enron Corporation’s (Enron)
                              bankruptcy in the early 2000s drew attention to the harm that could result
                              from fixed-income analysts’ conflicts. In particular, a sell-side fixed-
                              income analyst assigned to cover Enron’s debt securities testified in 2001
                              that she perceived pressure from her superiors not to issue negative
                              public comments on Enron because of Enron’s importance as an
                              investment banking client of the broker-dealer. 57 When NASD and NYSE
                              initially adopted their research analyst rules in 2002, the rules did not
                              cover fixed-income analysts. And neither the Global Settlement nor the
                              research-related provisions of the Sarbanes-Oxley Act (which resulted in
                              subsequent amendments to the SRO research analyst rules in 2004)
                              apply to fixed-income research. However, in 2003, SEC adopted
                              Regulation Analyst Certification to require both equity and fixed-income
                              analysts to certify that the views expressed in their research reports
                              accurately reflected their personal views and disclose whether they
                              received compensation or other payments in connection with their views.

                              In the absence of specific SRO research analyst rules covering fixed-
                              income research conflicts, NASD and NYSE generally relied on antifraud
                              statutes and SRO rules prohibiting fraud and requiring ethical conduct
                              and a comprehensive supervisory scheme to oversee a firm’s securities
                              business. In addition, NASD and NYSE encouraged firms to consider
                              adopting industry-developed principles to address such conflicts. In 2004,
                              to promote the integrity of fixed-income research, the Bond Market
                              Association (BMA), an industry association, issued voluntary, principle-
                              based guidelines designed to help firms manage potential conflicts faced
                              by fixed-income analysts. 58 At the time, BMA did not support the adoption



                              56
                                FINRA, Debt Research Reports: FINRA Requests Comment on Concept Proposal to
                              Identify and Manage Conflicts Involving the Preparation and Distribution of Debt Research
                              Reports, Regulatory Notice 11-11 (March 2011).
                              57
                                Final Report of Neal Batson, Ct.-Appointed Examiner, App. F (Role of CSFB and Its
                              Affiliates) to Final Report of Neal Batson, Ct.-Appointed Examiner at n. 101, In re Enron
                              Corp., et al., No. 01-16034 (AJG) (Bankr. S.D.N.Y., November 24, 2003).
                              58
                                The Bond Market Association, Guiding Principles to Promote the Integrity of Fixed-
                              Income Research: A Global Approach to Managing Potential Conflicts of Interest.




                              Page 35                                                    GAO-12-209 Securities Research
of SRO rules designed to address fixed-income conflicts. The industry
maintained that the nature and intensity of the conflicts fixed-income
analysts faced differed from those equity analysts faced. For example,
industry participants held that prices of debt securities were relatively less
sensitive to the views of research analysts, credit rating agencies played
an important role in the debt markets by providing investors with
independent information, and users of fixed-income research typically
were sophisticated investors presumed to be less in need of protection. In
a December 2005 report on the effectiveness of the SRO research
analyst rules, NASD and NYSE staff concluded that it was not appropriate
at the time to amend the rules to cover fixed-income analysts or codify
BMA’s guiding principles. Instead, staff noted that the SROs were
monitoring the extent to which firms adopted the BMA principles and
would consider rulemaking after assessing the effectiveness of voluntary
compliance with the principles. NASD and NYSE staff further noted that
the existing antifraud statutes and SRO rules could cover any egregious
conduct involving fixed-income research. 59

To encourage adoption of the BMA principles or other policies and
procedures to manage debt research conflicts, the SROs issued guidance
and conducted examinations that included a review of issues relating to
fixed-income analyst conflicts. In July 2006, NASD and NYSE issued joint
interpretive guidance on fixed-income research to prompt better
management of fixed-income-research conflicts. 60 The SROs developed
the guidance based on their examinations of how some firms addressed
conflicts faced by fixed-income analysts. Through their examinations, the
SROs found many instances in which firms had failed to adhere to BMA’s
principles. The examinations also found several instances in which firms
failed to establish, maintain, and enforce written supervisory procedures
in the fixed-income research area—a fundamental obligation under the
SRO rules—or comply with SEC’s Regulation Analyst Certification. In
considering whether to engage in more definitive rulemaking, the SROs
stated in their guidance that they would continue to monitor the extent to
which firms adopted and adhered to BMA principles or other supervisory


59
  See, for example, NASD Rule 2110’s requirement that members “observe high
standards of commercial honor and just and equitable principles of trade” and similar
obligations under NYSE Rules 401 and 476(a)(6). These rules have been consolidated
into FINRA Rule 2010.
60
 NASD, Research Analysts and Research Reports: NASD and NYSE Joint Interpretive
Guidance on Fixed Income Research, Notice to Members 06-36 (July 2006).




Page 36                                                  GAO-12-209 Securities Research
systems reasonably designed to achieve compliance with applicable SRO
rules and securities laws and regulations. According to FINRA officials,
the joint interpretative guidance served as a “warning shot” to the firms.

Following NASD and NYSE’s 2006 interpretive guidance, FINRA
continued to examine its member firms for compliance with the BMA
principles and find instances of noncompliance. Based partly on BMA’s
guiding principles, FINRA developed an examination module to assess
whether a firm’s fixed-income research supervisory procedures, policies,
and processes promote the integrity of fixed-income research and
address potential conflicts of interest. According to FINRA officials,
FINRA has included a review of fixed-income research in some of its
cycle examinations. As shown in figure 5, between 2005 and 2010,
FINRA (or its predecessors) conducted 55 cycle examinations that
covered fixed-income research and found related deficiencies in 11
examinations. The deficiencies generally involved inadequate supervisory
procedures for managing fixed-income analyst conflicts or inadequate
disclosures of such conflicts. Although none of the examinations resulted
in a formal disciplinary action, one examination found that the firm lacked
procedures not only to prohibit staff from directly or indirectly offering
favorable fixed-income research coverage to issuers but also to prevent
nonresearch staff from attempting to coerce fixed-income analysts to alter
their views on the content of a research report. Finally, the examinations
included eight Global Settlement firms; deficiencies were found in one of
these eight firms.




Page 37                                         GAO-12-209 Securities Research
Figure 5: FINRA Cycle Examinations That Included Reviews of Fixed-Income
Research and Number of Deficiencies, 2005 through 2010




In March 2011, FINRA issued a regulatory notice to explore and obtain
public comment on the concept of adopting a rule to address conflicts of
interest faced by fixed-income analysts. In its release, FINRA noted that it
long had been monitoring broker-dealers’ management of conflicts of
interest in fixed-income research and that it was an appropriate time to
engage in rulemaking to address such conflicts because, among other
things, FINRA staff had observed increased retail investment risk in
complex debt securities, such as auction rate securities. 61 Specifically, the
staff noted that the allegations of misconduct in the sale of auction rate
securities illustrated this risk and provided a concrete example that
potential conflicts of interest in the publication and distribution of debt
research existed just as they did for equity research. FINRA officials told


61
  Auction rate securities are municipal and corporate bonds, as well as preferred stocks,
with interest rates or dividend yields that are periodically reset through auctions, typically
every 7, 14, 28, or 35 days. The alleged misconduct did not involve conflicts between
research and investment banking but between research and sales and trading.




Page 38                                                       GAO-12-209 Securities Research
us that SEC staff also encouraged FINRA to adopt a rule to address
fixed-income analyst conflicts.

According to FINRA officials, the primary purpose of the fixed-income
research rule is to protect retail investors. To that end, the majority of the
existing structural safeguards and disclosures in NASD’s research analyst
rule would apply to retail debt research. Similarly, the disclosures
applicable to equity research largely should apply to debt research and
would include the disclosure of personal and firm financial interests and
the receipt of compensation for investment banking services from
companies covered by fixed-income analysts. However, the scope of the
safeguards would be expanded to cover conflicts between debt research
and sales and trading personnel. Specifically, a firm’s sales and trading
staff would be prohibited from attempting to influence a fixed-income
analyst’s opinion or views for the purpose of benefiting the trading
position of the firm—which allegedly occurred in certain firms engaged in
auction rate securities—or a customer or class of customers. For
example, in 2008, a state securities regulator alleged that a broker-dealer
permitted its sales and trading managers to unduly influence and
pressure its fixed-income research department. The managers did not
agree with the tone or context of a published research report and
allegedly insisted that the report be retracted and replaced with a more
sales-friendly report.

FINRA officials told us they faced challenges in balancing the benefits of
the rule in providing protections for retail investors with the cost and
burden of the rule for institutional investors. According to the officials,
institutional investors use the analytics, not the recommendations,
generated by fixed-income analysts and do not want rules that would
restrict the flow of timely information. Moreover, institutional investors
trading debt securities generally tend to interact with broker-dealers more
as counterparties than customers and are aware of potential conflicts
faced by fixed-income analysts. FINRA’s concept proposal exempts fixed-
income research that is disseminated solely to institutional investors from
some of the structural safeguards and most of the disclosures that would
be applicable to retail debt research. Firms operating under the
exemption would have to clearly distinguish such research from research
disseminated to retail investors. The proposal noted that not all
institutional investors are necessarily alike; therefore, institutional
investors would be allowed to opt out of the exemption and be treated like
retail investors.




Page 39                                           GAO-12-209 Securities Research
Another challenge in developing a fixed-income research rule is
separating fixed-income research from sales and trading, according to
FINRA. FINRA officials told us that it was easier to describe the conflicts
between fixed-income research and sales and trading than to craft
communication firewalls to separate the two departments. The officials
said that broker-dealers maintain that sales and trading should not be
wholly prohibited from communicating with research, because sales and
trading staff need information from research regarding the
creditworthiness of an issuer and other information reasonably related to
the price or performance of a debt security. In turn, debt analysts need
information from sales and trading to help, among other things, determine
the coverage universe and to assess current prices, spreads, and liquidity
of debt securities.

Most market participants and observers we interviewed generally
supported the adoption of a FINRA rule to address conflicts faced by
fixed-income research analysts. Stakeholders cited the lack of
transparency in the fixed-income markets as the primary reason for the
need for a fixed-income research rule. Some said that investors lack
sufficient information about the securities in which they sought to invest,
because no regulations require broker-dealers to disclose potential
conflicts. Similarly, FINRA received six comment letters about the concept
proposal, all of which generally supported FINRA’s efforts to develop the
proposal. 62 However, all of the letters expressed concerns, including that
the communication restrictions were unclear and could limit fixed-income
analysts’ ability to support sales and trading.

As previously discussed, FINRA officials told us that they plan to submit a
proposed fixed-income rule to FINRA’s Board of Governors for its review
and approval in December 2011. The officials said that FINRA then


62
   The six letters were from a broker-dealer industry association, a broker-dealer
compliance consulting firm, two public investor arbitration groups, and four full service
broker-dealers. Comments from the public investor arbitration groups and investment
banking firms were each represented by two separate letters. Four of the letters noted that
the institutional investor exemption creates the potential for (1) retail investors to
mistakenly obtain research without the appropriate disclosures, (2) reduction in retail
investors’ access to research, (3) increased costs and burden for firms to identify which
clients have opted out of the disclosure requirements, (4) firms to relax efforts to disclose
any conflicts to institutional investors because of the assumption that they were
sophisticated investors; or (5) conflict and fraud. In addition, two letters noted that the
communication restrictions were unclear and could limit the ability of fixed-income
analysts’ to support the sales and trading departments.




Page 40                                                     GAO-12-209 Securities Research
              tentatively plans to file the proposed rule, assuming its board approves it,
              with SEC in the first half of 2012. While antifraud statutes and existing
              SRO rules serve to protect investors from abuse arising from fixed-
              income analyst conflicts, SEC and FINRA staff, as well as most market
              participants and observers we interviewed, acknowledged that additional
              rulemaking is needed to protect investors, particularly retail investors. In
              that regard, until FINRA adopts a fixed-income research rule, investors
              continue to face a potential risk.


              Since the early 2000s, SEC and the SROs have taken and continue to
Conclusions   take a variety of actions to address conflicting interests between research
              analysts and investment bankers and, in turn, protect investors. Principal
              actions include Regulation Analyst Certification, the SRO research
              analyst rules, and the Global Settlement—which include similar structural
              requirements designed to separate research from investment banking
              and thereby insulate research analysts from investment banking pressure
              and influence. The Global Settlement imposes, in some areas, more
              stringent requirements on the Global Settlement firms than the SRO rules
              impose on other broker-dealers engaged in research and investment
              banking, because the Global Settlement resulted from enforcement
              actions involving analyst conflicts. Nonetheless, the structural
              requirements in the SRO rules and the Global Settlement were
              developed, in part, based on similar findings and generally seek to
              achieve the same fundamental objective—to enhance the integrity and
              independence of securities research. But unlike the SRO rules, the Global
              Settlement was not intended to be permanent.

              By establishing, in effect, separate but different requirements for
              addressing analyst conflicts, the SRO research analyst rules and the
              Global Settlement raise the question of whether any of the Global
              Settlement’s remaining terms need to be adopted as SEC or SRO rules to
              better protect investors. While SEC staff and FINRA officials have
              discussed this issue, they have not reached a consensus or formally
              determined and documented whether any of the Global Settlement’s
              remaining terms should be codified. Through some of its more stringent
              requirements, the Global Settlement potentially affords greater
              protections to investors in some areas than the SRO rules but imposes
              greater burdens on broker-dealers. Whether these burdens are
              appropriate in comparison to the greater protections of the requirements
              has yet to be determined and documented. However, an analysis as to
              whether the Global Settlement’s remaining terms should be codified
              would provide SEC with a basis for reconciling the differences between


              Page 41                                          GAO-12-209 Securities Research
                     the SRO rules and the Global Settlement. To the extent that any of the
                     Global Settlement’s remaining terms provide an effective way of
                     furthering investor protection, by not assessing their codification SEC may
                     be missing an opportunity to provide consistent investor protection.


                     To help ensure that investors consistently are protected from potential
Recommendation for   conflicts of interest between research analysts and investment bankers
Executive Action     employed by the same broker-dealers, the Chairman of SEC should
                     direct the appropriate divisions or offices to formally assess and
                     document in a recommendation whether any of the Global Settlement’s
                     remaining terms should be codified.


                     We provided a copy of this draft report to SEC and FINRA for their review
Agency Comments      and comment. In its comment letter, which is reprinted in appendix III,
and Our Evaluation   SEC generally agreed with our findings and recommendation. SEC staff
                     noted that the agency has been working to promote the objectivity and
                     independence of securities research analysts. They agreed that the
                     appropriate SEC staff should assess whether any of the remaining Global
                     Settlement provisions should be codified and applied to the entire
                     industry. SEC and FINRA also provided technical comments that we
                     have incorporated as appropriate.


                     We are sending copies of this report to SEC, FINRA, interested
                     congressional committees and members, and others. The report also is
                     available at no charge on the GAO website at http://www.gao.gov.

                     If you or your staff have any questions about this report, please contact
                     me at (202) 512-8678 or clowersa@gao.gov. Contact points for our
                     Offices of Congressional Relations and Public Affairs may be found on
                     the last page of this report. GAO staff who made major contributions to
                     this report are listed in appendix IV.




                     A. Nicole Clowers
                     Director,
                     Financial Markets and Community Investment Issues




                     Page 42                                          GAO-12-209 Securities Research
Appendix I: Objectives, Scope, and
              Appendix I: Objectives, Scope, and
              Methodology



Methodology

              Section 919A of the Dodd-Frank Wall Street Reform and Consumer
              Protection Act requires us to identify and examine potential conflicts of
              interest between investment banking and research staff in the same firm. 1
              To address this mandate, we examined (1) what is known about the
              effectiveness of the regulatory actions taken to address research analyst
              conflicts of interest and (2) what additional actions, if any, could
              regulators take to further address research analyst conflicts.

              To understand the nature of research analyst conflicts and identify
              regulatory actions taken to address them, we reviewed financial journal
              articles as well as industry, GAO, and other studies; a congressional
              hearing that included testimonies by the Securities and Exchange
              Commission (SEC), National Association of Securities Dealers (NASD),
              and North American Securities Administrators Association (NASAA); SEC
              and state attorney general enforcement actions taken against broker-
              dealers involving analyst conflicts; SEC and SRO proposed and final
              rules and related releases; and Global Research Analyst Settlement
              (Global Settlement) documents, including the addendum and independent
              monitor reports. To help evaluate the effectiveness of the regulatory
              actions taken to address research analyst conflicts, we reviewed and
              analyzed academic studies that empirically examined the effects of the
              regulatory reforms—SEC and SRO research analyst rules and the Global
              Settlement—on analyst research and recommendations. We limited our
              review to studies issued after January 1, 2005, because of the time
              frames in which the regulatory reforms were adopted. (See the end of the
              report for a bibliography listing the studies included in our review.) We
              included published and working papers in our review. 2 Although we found
              these studies to be sufficiently reliable for the purposes of our report,
              attributing effect to any particular regulatory reform is difficult. Therefore,
              we interpret the literature more broadly as gauging the effect of the




              1
               Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub.L. No. 111-203, 124
              Stat. 1837-1838 (July 21, 2010).
              2
               Note that working papers are subject to revision, and some include additional limitations
              in areas on which we do not report.




              Page 43                                                    GAO-12-209 Securities Research
Appendix I: Objectives, Scope, and
Methodology




collective reforms and do not believe the evidence can be used to
selectively attribute causality to any specific reform. 3

To evaluate the effectiveness of the regulatory reforms, we also reviewed
data provided by the Financial Industry Regulatory Association (FINRA)
from its electronic system used to track the lifecycle of FINRA’s regulatory
matters, including examinations and investigations. Specifically, FINRA
provided us with data on examinations and investigations that were
conducted between 2005 and 2010; covered its member broker-dealers;
and a review of research practices and compliance with the Global
Settlement, NASD 2711, or New York Stock Exchange (NYSE) Rule 472.
To assess the reliability of the data that we used to help support one of
our findings, we reviewed relevant documentation about the system’s
operation and administration and interviewed knowledgeable FINRA
officials about the system and integrity of the data. Based upon our
review, we found the data sufficiently reliable for our purposes. In
addition, we discussed with SEC staff the nature and findings of their
broker-dealer examinations conducted between 2005 and 2010 and
involving conflicts between research analysts and investment bankers. 4
We also reviewed enforcement actions taken by SEC between 2005 and
2010 involving conflicts between research analyst and investment
bankers, and reports prepared by independent, or third-party, monitors
that assessed the settlement firms’ compliance with the Global
Settlement.

To gain insights on the effectiveness of the regulatory actions taken to
address analyst conflicts and to identify additional actions that could be
taken to address such conflicts, we interviewed officials from SEC,
FINRA, and NASAA, including its members from the state securities
commissions of Florida, Illinois, Washington state, Texas, and
Connecticut. NASAA officials identified these states as appropriate to


3
 The inclusion of a particular finding for a given study does not imply we found other
portions of the study to be equally reliable. Given the difficulty in disentangling the effect of
the regulatory reforms from other important causal forces and computing estimates of
fundamental value, as well as other limitations, the findings should be interpreted with
some caution.
4
 SEC staff told us that the agency’s examination database does not have an electronic
search capability that can be used to identify which broker-dealer examinations included a
review of which specific SRO rules. According to SEC staff, the agency is currently
developing a new examination database with improved search capabilities and plans for
the system to be online as early as 2012.




Page 44                                                       GAO-12-209 Securities Research
Appendix I: Objectives, Scope, and
Methodology




contact because of their involvement in the investigations that led to the
Global Settlement. We also interviewed representatives from 20 broker-
dealers, including 10 of the settlement broker-dealers, and their industry
association, the Securities Industry and Financial Markets Association.
With the Securities Industry and Financial Markets Association’s logistical
assistance, we interviewed 1 broker-dealer separately and the other 19
broker-dealers in two separate groups. In addition, we spoke with four law
or economics professors; two money managers; four independent
research firms; a securities research consultant; and various
organizations representing retail investors, institutional investors, or other
investment professionals, including AARP, the American Association of
Individual Investors, the American Federation of Labor and Congress of
Industrial Organizations, the Association of Institutional Investors, the
CFA institute, the Consumer Federation of America, the Investment
Company Institute, the National Association of Shareholder and
Consumer Attorneys, and the National Investor Relations Institute.
Finally, we contacted several state attorney general offices and the
National Association of Attorneys General to gain their perspectives;
however, these organizations either declined to participate because the
staff involved in the Global Settlement or related investigations no longer
worked there or they deferred to officials from their state securities
commissions.

To identify additional actions that regulators could take to further address
research analyst conflicts, we also reviewed SRO concept proposals,
proposed rules, and related comment letters and Global Settlement
documents, including the settlement firms’ 2009 request to modify the
Global Settlement’s addendum and the federal court’s 2010 order
approving modifications to the addendum. In addition, we reviewed recent
enforcement actions involving fixed-income research conflicts; academic,
industry, and GAO reports; and commentaries from market observers.

We conducted this performance audit from September 2010 to January
2012 in accordance with generally accepted government auditing
standards. Those standards require that we plan and perform the audit to
obtain sufficient, appropriate evidence to provide a reasonable basis for
our findings and conclusions based on our audit objectives. We believe
that the evidence obtained provides a reasonable basis for our findings
and conclusions based on our audit objectives.




Page 45                                           GAO-12-209 Securities Research
Appendix II: Original and Modified Global
             Appendix II: Original and Modified Global
             Settlement Addendum Compared with NASD
             Rule 2711


Settlement Addendum Compared with NASD
Rule 2711
             In April 2003, the SEC, National Association of Securities Dealers, New
             York Stock Exchange, North American Securities Administrators
             Association, the New York Attorney General and other state authorities
             announced that the enforcement actions against 10 of the largest broker-
             dealers had been completed and the terms of the agreement had been
             finalized (the Global Settlement). The Global Settlement relates to
             charges that the firms had engaged in acts and practices that created or
             maintained inappropriate influence by investment banking personnel over
             equity research analysts, which created conflicts of interest that were not
             adequately managed or disclosed. The Global Settlement was approved
             by the U.S. District Court for the Southern District of New York on
             October 31, 2003. 1 In August 2009, the Global Settlement firms submitted
             a motion proposing certain modifications for the court’s consideration and
             SEC did not oppose this motion. In March 2010, the court entered an
             order approving all but one of the requested modifications. The order
             provided that the parties expected SEC would agree to further
             modification of the Global Settlement’s terms at the earlier of March 15,
             2011, or the effective date of the consolidated research rule proposed by
             FINRA in October 2008 (if such rules addressed the Global Settlement’s
             remaining terms), unless SEC believes such amendment or modification
             would not be in the public interest. Any such amendment or modification
             would be subject to court approval. To date, the Global Settlement firms
             have not requested any further modification of the settlement.




             1
              The Global Settlement firms and Regulators subsequently agreed to amend certain
             provisions of the Global Settlement, which amendments were approved by the district
             court on September 24, 2004.




             Page 46                                                  GAO-12-209 Securities Research
                                          Appendix II: Original and Modified Global
                                          Settlement Addendum Compared with NASD
                                          Rule 2711




Table 1: Sections I and II of the Global Settlement’s Addendum and Modified Addendum, and a Crosswalk between the Global
Settlement’s Addendum to NASD Rule 2711

                                                                       Modified provision   Alternative SRO provision
                                                                       following the        provided for judicial
                                                                                                          a
Topic           Section   Original provision                           2010 Order           consideration
Section I of the addendum: structural reforms
                      b            c                         d
Reporting lines I.1       Research and Investment Banking will         Removed entire       NASD 2711(b)(1). No research
                          be separate units with entirely separate     provision.           analyst may be subject to the
                          reporting lines within the firm.                                  supervision or control of any
                                                                                            employee of the firm’s investment
                                                                                            banking department.
                                                                                                                      e
Legal/          I.2       Research will have its own dedicated legal Removed entire         No similar requirement.
compliance                and compliance staff, who may be part of provision.
                          the firm’s overall compliance/legal
                          infrastructure.
Budget          I.3        The Research budget and allocation of     Unchanged.             No similar requirement.
                Budget     Research expenses will be determined by
                Allocation the firm’s senior management without
                           input from Investment Banking and without
                           regard to specific revenues or results
                           derived from Investment Banking.
                                                                                                                      f
                I.3       Annually, the Audit Committee of the firm’s Removed provision.    No similar requirement.
                Budget    holding/parent company will review the
                Review    budgeting and expense allocation process
                          with respect to Research to ensure
                          compliance with the Global Settlement
                          requirements.
Physical        I.4       Research and Investment Banking will be      Unchanged.           No similar requirement considered
Separation                physically separated in a way designed to                         by the court.
                          prevent intentional and unintentional flow
                          of information between the two groups.




                                          Page 47                                                GAO-12-209 Securities Research
                                       Appendix II: Original and Modified Global
                                       Settlement Addendum Compared with NASD
                                       Rule 2711




                                                                   Modified provision   Alternative SRO provision
                                                                   following the        provided for judicial
                                                                                                      a
Topic        Section   Original provision                          2010 Order           consideration
Compensation I.5       Professional Research personnel                Removed entire    NASD 2711(b)(1.) No person
                       compensation must be determined                provision.        engaged in investment banking
                       exclusively by Research management and                           activities may have influence or
                       the firm’s senior management—excluding                           control over the compensatory
                       Investment Banking personnel—using set                           evaluation of a research analyst.
                       principals including: (i) Investment                             NASD 2711(d). (1) No bonus, salary
                       Banking has no input; (ii) compensation                          or other form of compensation may
                       will not be based directly or indirectly on                      be paid to a research analyst that is
                       Investment Banking revenue, but may                              based on a specific investment
                       relate to the revenues or results of the                         banking services transaction. (2)
                       entire firm; (iii) compensation must be                          Compensation of a research analyst
                       significantly based on a lead analyst’s                          primarily responsible for the
                       accuracy of research and analysis, in part                       preparation of the substance of a
                       relying on evaluations by the firm’s                             research report must be reviewed
                       investing customers and the firm’s sales                         and approved at least annually by a
                       personnel, and rankings in independent                           committee that reports to the board
                       surveys; and (iv) other criteria. All criteria                   of directors, or if none, to a senior
                       must be set in advance in writing.                               executive officer. The committee
                       Compensation decisions must be                                   may not have representation from
                       documented for: (i) anyone who, in the last                      the firm’s investment banking
                       12 months, has been required to certify a                        department. The committee must
                       research report; and (ii) generally, anyone                      consider factors including: (i) the
                       who is a member of Research                                      research analyst’s individual
                       management.                                                      performance including productivity
                                                                                        and quality; (ii) the correlation
                                                                                        between the analyst’s
                                                                                        recommendations and stock price
                                                                                        performance; and (iii) overall ratings
                                                                                        received from clients, sales force,
                                                                                        and peers independent of the
                                                                                        investment banking department. The
                                                                                        committee may not consider as a
                                                                                        factor the analyst’s contributions to
                                                                                        the firm’s investment banking
                                                                                        business. The basis for the decision
                                                                                        must be documented and an
                                                                                        attestation must certify that the
                                                                                        committee reviewed and approved
                                                                                        the compensation and documented
                                                                                        the basis.
                                                                                        NASD 2711(i). The firm must adopt
                                                                                        and implement a written supervisory
                                                                                        procedure reasonably designed to
                                                                                        ensure that the firm and its
                                                                                        employees comply with NASD
                                                                                        2711(d)(2) and a senior officer must
                                                                                        attest by April 1 annually that the
                                                                                        firm has adopted and implemented
                                                                                        the procedures.




                                       Page 48                                                GAO-12-209 Securities Research
                                           Appendix II: Original and Modified Global
                                           Settlement Addendum Compared with NASD
                                           Rule 2711




                                                                        Modified provision   Alternative SRO provision
                                                                        following the        provided for judicial
                                                                                                           a
Topic            Section   Original provision                           2010 Order           consideration
Evaluation       I.6       Investment Banking personnel may not do Removed entire            NASD 2711(b)(1) and NASD
                           or provide input on Research personnel  provision.                2711(d)(2), as described under I.5.
                           evaluations.
Coverage         I.7       Investment Banking will have no input into Unchanged.             No similar requirement.
                           company-specific coverage decisions and
                           investment banking revenues or potential
                           revenues will not be taken into account in
                           making company-specific coverage
                           decisions. The requirement does not apply
                           to category-by-category coverage
                           decisions.
Termination of   I.8       When a decision is made to terminate         Removed entire       NASD 2711(f)(5). A firm must give
coverage                   coverage of a particular company in the      provision.           notice if it terminates its research
                           firm’s research reports, the firm will make                       coverage of a subject company. The
                           available a final research report on the                          firm must make available a final
                           company using the means of                                        research report using the means of
                           dissemination equivalent to those                                 dissemination equal to those it
                           ordinarily used. The final report must be                         ordinarily uses for research on the
                           comparable to prior reports unless it is                          company. The report must be
                           impracticable for the firm. The final report                      comparable in scope and detail to
                           must disclose the firm’s termination of                           prior research reports and include a
                           coverage and rationale for the decision.                          final recommendation or rating,
                           No final report is required for a company                         unless it is impracticable for the firm
                           when the firm’s prior coverage was limited                        to produce a comparable report. If it
                           to quantitative or technical research                             is impracticable to produce a final
                           reports.                                                          recommendation or rating, the final
                                                                                             research report must disclose the
                                                                                             firm’s rationale for the decision to
                                                                                             terminate coverage.
Prohibition on   I.9       Research is prohibited from participating  Removed entire         NASD 2711(c)(4). No research
soliciting                 in efforts to solicit investment banking   provision.             analyst may participate in efforts to
investment                 business. Research may not, among other                           solicit investment banking business.
banking                    things, participate in any “pitches” for                          No research analyst may, among
business                   investment banking business to                                    other things, participate in any
                           prospective investment banking clients, or                        “pitches” for investment banking
                           have communications with companies for                            business to prospective investment
                           the purpose of soliciting investment                              banking clients, or have other
                           banking business.                                                 communications with companies for
                                                                                             the purpose of soliciting investment
                                                                                             banking business.


Firewalls        I.10      To reduce the potential for conflicts of
between                    interest or the appearance of conflicts of
Research and               interest, the firm must create and enforce
Investment                 firewalls between Research and
Banking                    Investment Banking reasonably designed
                           to prohibit all communications between the
                           two except as in I.10(a) through I.10(g).




                                           Page 49                                                 GAO-12-209 Securities Research
                                 Appendix II: Original and Modified Global
                                 Settlement Addendum Compared with NASD
                                 Rule 2711




                                                           Modified provision   Alternative SRO provision
                                                           following the        provided for judicial
                                                                                              a
Topic   Section   Original provision                       2010 Order           consideration
                                                                       g
        I.10(a)   Investment Banking personnel may seek, Unchanged.             No similar requirement considered
                  through Research management or in the                         by the court.
                  presence of internal legal or compliance
                  staff, the views of Research personnel
                  about the merits of a proposed
                  transaction, a potential candidate for a
                  transaction, or market or industry trends,
                  conditions or developments. Research
                  personnel may respond to such inquiries
                  through Research management or an
                  appropriate designee or in the presence of
                  internal legal or compliance staff.
                  Research personnel, through Research
                  management, designee or in the presence
                  of internal legal or compliance staff, may
                  initiate communications with Investment
                  Banking personnel relating to market or
                  industry trends, conditions or
                  developments, provided the
                  communications are consistent in nature
                  with the types an analyst might have with
                  investing customers. Any communication
                  between Research and Investment
                  Banking personnel must not be made for
                  the purpose of having Research personnel
                  identify specific potential investment
                  banking transactions.
        I.10(b)   In response to a request by a commitment Unchanged.           No similar requirement.
                  or similar committee (or subgroup),
                  Research personnel may communicate
                  their views about a proposed transaction
                  or potential candidate for a transaction to
                  the committee or subgroup in connection
                  with the review of the transaction or
                  candidate by the committee. Investment
                  Banking personnel working on the
                  proposed transaction may participate with
                  the Research personnel in these
                  discussions. But, the Research personnel
                  also must have an opportunity to express
                  their views to the committee or subgroup
                  outside the presence of the Investment
                  Banking personnel.




                                 Page 50                                             GAO-12-209 Securities Research
                                 Appendix II: Original and Modified Global
                                 Settlement Addendum Compared with NASD
                                 Rule 2711




                                                              Modified provision       Alternative SRO provision
                                                              following the            provided for judicial
                                                                                                     a
Topic   Section   Original provision                          2010 Order               consideration
        I.10(c)   Research personnel may assist the firm in   Modified.                  No similar requirement.
                  confirming the adequacy of disclosure in    The modified language
                  offerings or other disclosure documents     states that Research
                  for a transaction based on the analysts’    personnel may assist
                  communications with the company and         the firm in confirming
                  other vetting conducted outside the         the adequacy of
                  presence of Investment Banking              disclosure in offering or
                  personnel. However, to the extent           other disclosure
                  communicated to Investment Banking          documents for a
                  personnel, the communications must only     transaction based on
                  be made in the presence of underwriters’    the analysts’
                  or other counsel on the transaction or      communications with
                  internal legal or compliance staff.         the company and other
                                                              third parties (including,
                                                              e.g., suppliers,
                                                              customers,
                                                              accountants, vendors,
                                                              and regulatory
                                                              authorities). However,
                                                              (i) there are restrictions
                                                              on the
                                                              communication’s
                                                              purpose and those
                                                              who may be present
                                                              and (ii) to the extent
                                                              such communications
                                                              are later
                                                              communicated by
                                                              Research personnel to
                                                              Investment Banking
                                                              personnel, the
                                                              communication must
                                                              only be made in the
                                                              presence of internal
                                                              legal or compliance
                                                              staff, or underwriters or
                                                              other counsel on the
                                                              transaction who are
                                                              knowledgeable
                                                              regarding Research
                                                              and Investment
                                                              Banking conflicts and
                                                              Addendum A.




                                 Page 51                                                     GAO-12-209 Securities Research
                                   Appendix II: Original and Modified Global
                                   Settlement Addendum Compared with NASD
                                   Rule 2711




                                                                  Modified provision          Alternative SRO provision
                                                                  following the               provided for judicial
                                                                                                            a
Topic   Section   Original provision                              2010 Order                  consideration
        I.10(d)   After the firm receives an Investment           Modified.                   NASD 2711(c)(7). Any written or
                  Banking mandate or in connection with a         The provision becomes       oral communication by a research
                  block bid or similar transaction, Research      effective also in the       analyst with a current or prospective
                  personnel may: (i) communicate views on         case of investment          customer or internal personnel
                  pricing and structuring of the transaction to   banking transactions        related to an investment banking
                  the firm’s equity capital market group          other than initial public   services transaction must be fair,
                  personnel; (ii) provide equity capital          offerings and in            balanced and not misleading, taking
                  markets group information obtained from         connection with,            into consideration the overall context
                  investing customers relevant to pricing         among those previous,       in which the communication is
                  and structuring of the transaction; (iii)       a competitive               made.
                  participate with the equity capital markets     secondary follow-on
                  group, or independently, in efforts to          offering where the
                  educate the firm’s sales force regarding        issuer or selling
                  transactions (including assisting in            shareholder has
                  preparation of internal-use memos),             contacted the firm to
                  provided that Research personnel may not        request that the firm
                  appear jointly with management of the           submit a transaction
                  issuer or Investment Banking personnel,         proposal.
                  with some exclusions, and provided that
                  (1) oral communications by Research             In Section (iii)(2), the
                  personnel must have a reasonable basis;         requirement for all oral
                  (2) oral communication to a group of ten or     communication to a
                  more of the sales force must be “fair and       group of ten or more of
                             h
                  balanced” and made in the presence of           the firm’s sales force to
                  internal legal or compliance personnel; (3)     be made in the
                  all internal-use memos regarding the            presence of internal
                  transaction that are identified as being the    legal or compliance
                  views of Research personnel must comply         personnel has been
                  with the fair and balanced standard; (4)        removed.
                  internal research memos distributed to a        Sections (iii)(4)-(6)
                  group of ten or more of the firm’s sales        were removed.
                  force must be reviewed in advance by
                  internal legal or compliance personnel; (5)
                  a written log of all oral communications
                  under (2) must be maintained; and (6) all
                  written logs and internal Research memos
                  described in (4) must be retained.
        I.10(e)   Research personnel may attend and               Modified.                   No similar requirement.
                  participate in a widely-attended                Research personnel
                  conference attended by Investment               may also attend an
                  Banking personnel or in which Investment        “other widely attended
                  Banking personnel participate, as long as       event,” not just a
                  Research personnel do not participate in        “conference.”
                  activities otherwise prohibited.




                                   Page 52                                                          GAO-12-209 Securities Research
                                  Appendix II: Original and Modified Global
                                  Settlement Addendum Compared with NASD
                                  Rule 2711




                                                               Modified provision   Alternative SRO provision
                                                               following the        provided for judicial
                                                                                                  a
Topic   Section   Original provision                           2010 Order           consideration
        I.10(f)   Research and Investment Banking           Unchanged.              No similar requirement.
                  personnel may attend or participate in
                  widely attended firm or regional meetings
                  at which matters of general firm interest
                  are discussed. Research and Investment
                  Banking management may attend
                  meetings or sit on firm management risk
                  or compliance committees at which
                  matters of general firm interest are
                  discussed. Research and Investment
                  Banking personnel may communicate with
                  each other with respect to legal or
                  compliance issues provided that internal
                  legal or compliance staff is present.
        I.10(g)   Research and Investment Banking              Unchanged.           No similar requirement.
                  personnel may communicate without
                  restrictions on issues not related to
                  investment banking or research activities.




                                  Page 53                                                GAO-12-209 Securities Research
                                             Appendix II: Original and Modified Global
                                             Settlement Addendum Compared with NASD
                                             Rule 2711




                                                                           Modified provision     Alternative SRO provision
                                                                           following the          provided for judicial
                                                                                                                a
Topic             Section   Original provision                             2010 Order             consideration
Additional        I.11      (a) Research personnel are prohibited          Modified.              NASD 2711(c)(5). A research
restrictions on             from participating in company or               Sections (a) and (b)   analyst is prohibited directly or
activities by               Investment Banking sponsored road              were removed.          indirectly from participating in a road
Research and                shows related to a public offering or other                           show related to an investment
Investment                  investment banking transaction.                Sections (c)(3)-(5)    banking services transaction and
Banking                                                                    were removed.          engaging in any communication with
                            (b) Investment Banking personnel are
personnel                   prohibited from directing Research                                    a current or prospective customer in
                            personnel to engage in marketing or                                   the presence of investment banking
                            selling efforts to investors with respect to                          department personnel or company
                            an investment banking transaction.                                    management about an investment
                                                                                                  banking services transaction.
                            (c) After the firm receives an investment
                            banking mandate relating to a public                                  NASD 2711(c)(6). Investment
                            offering of securities, Research personnel                            banking department personnel are
                            may communicate with investors                                        prohibited from directly or indirectly
                            regarding the offering provided that                                  directing a research analyst to
                            Research personnel may not appear                                     engage in sales or marketing efforts
                            jointly with management of the issuer or                              related to an investment banking
                            Investment Banking personnel in the                                   services transaction and directing a
                            communications, and also: (1) oral                                    research analyst to engage in any
                            communication by Research personnel                                   communication with a current or
                            with investors regarding the offering in                              prospective customer about an
                            which a recommendation or views (even if                              investment banking services
                            not labeled as such) is expressed by the                              transaction.
                            Research personnel regarding the offering
                            must have a reasonable basis; (2) oral
                            communication to a group of 10 or more
                            investors regarding the offering must
                            comply with fair and balanced standards;
                            (3) all oral communication to a group of 10
                            or more investors must be in the presence
                            of internal legal or compliance personnel;
                            (4) a written log of all oral communications
                            in (2) must be maintained; and (5) all
                            written logs must be retained.
Oversight         I.12      An oversight/monitoring committee(s),       Unchanged.                No similar requirement.
                            which will be comprised of representatives
                            of Research management and may
                            includes others (but not Investment
                            Banking personnel), will be created to: (a)
                            reviews all changes in rating, and material
                            changes in price targets contained in the
                            firm’s research reports; (b) conduct
                            periodic reviews of research reports to
                            determine whether changes in ratings or
                            price targets should be considered; and
                            (c) monitor the overall quality and
                            accuracy of the firm’s research reports.
                            The reviews are not required for
                            quantitative or technical research reports.




                                             Page 54                                                    GAO-12-209 Securities Research
                                          Appendix II: Original and Modified Global
                                          Settlement Addendum Compared with NASD
                                          Rule 2711




                                                                         Modified provision      Alternative SRO provision
                                                                         following the           provided for judicial
                                                                                                               a
Topic          Section   Original provision                              2010 Order              consideration



Section II of the Addendum: disclosure reforms
Disclosures    II.1      Firms must disclose prominently on the          Unchanged, but the        No similar requirement considered
                         first page of any research report and any       requirement to provide by the court.
                         summary or listing of recommendations or        independent research
                         ratings contained in previously-issued          has expired so the
                         research reports, in type no smaller than       disclosure required by
                         the type used for the text of the report or     II.1(b) is not applicable
                         summary or listing, that:                       at this time.
                         (a) “[Firm] does and seeks to do business
                         with companies covered in its research
                         reports. As a result, investors should be
                         aware that the firm may have conflicts of
                         interest that could affect the objectivity of
                         this report.”
                         (b) With respect to Covered Companies as
                         to which the firm is required to make
                         available Independent Research:
                         “Customers of [firm] in the United States
                         can received independent, third-party
                         research on the company or companies
                         covered in this report, at no cost to them,
                         where such research is available.
                         Customers can access this independent
                         research at [website address/hyperlink] or
                         can call [toll-free number] to request a
                         copy of the research.”
                         (c) “Investors should consider this report
                         as only a single factor in making their
                         investment decision.”




                                          Page 55                                                      GAO-12-209 Securities Research
                                          Appendix II: Original and Modified Global
                                          Settlement Addendum Compared with NASD
                                          Rule 2711




                                                                        Modified provision   Alternative SRO provision
                                                                        following the        provided for judicial
                                                                                                           a
Topic          Section   Original provision                             2010 Order           consideration
Transparency   II.2      The firm must make publicly available no       Removed entire       NASD 2711(h)(4). If a research
of analysts’             later than 90 days after the end of each       provision.           report contains a rating, the firm
performance              quarter specific information, if included in                        must define in the research report
                         any research report prepared and                                    the meaning of each rating used by
                         furnished by the firm during the prior                              the firm in its rating system. The
                         quarter: company, names of analysts                                 definition must be consistent with its
                         responsible for certification of the report                         plain meaning.
                         pursuant to Regulation Analyst                                      NASD 2711(h)(5). A firm must
                         Certification, date of report, rating, price                        disclose in each research report the
                         target, period within which the price target                        percentage of all securities that the
                         is to be achieved, earning per share                                firm assigned a “buy,” “hold/neutral,”
                         forecast for the current and next quarter                           or “sell” rating. In each report, the
                         and current full year, and                                          firm must disclose the percentage of
                         definition/explanation of ratings used by                           subject companies within each of
                         the firm.                                                           the three categories for whom the
                                                                                             firm has provided investment
                                                                                             banking services within the prior 12
                                                                                             months. The information disclosed
                                                                                             must be current as of the end of the
                                                                                             most recent calendar quarter and
                                                                                             reflect the distribution of the most
                                                                                             recent ratings issued by the firm for
                                                                                             all subject companies, unless the
                                                                                             recent rating was issued more than
                                                                                             12 months ago. But the requirement
                                                                                             does not apply to any research
                                                                                             report without a rating.
                                                                                             NASD 2711(h)(6). If a research
                                                                                             report contained a rating or a price
                                                                                             target and the firm has assigned a
                                                                                             rating or price target to the subject
                                                                                             company’s securities rating for at
                                                                                             least 1 year, the research report
                                                                                             must include a line graph of the
                                                                                             security’s daily closing price for the
                                                                                             period that the firm has assigned
                                                                                             any rating or price target or for a 3-
                                                                                             year period, whichever is shorter.
                                                                                             NASD 2711(h)(7). If a research
                                                                                             report contains a price target, the
                                                                                             firm must disclose in the report the
                                                                                             valuation methods used to
                                                                                             determine the price target. Price
                                                                                             targets must have a reasonable
                                                                                             basis and must be accompanied by
                                                                                             a disclosure concerning the risks
                                                                                             that may impede achievement of the
                                                                                             price target.




                                          Page 56                                                  GAO-12-209 Securities Research
                                         Appendix II: Original and Modified Global
                                         Settlement Addendum Compared with NASD
                                         Rule 2711




                                                                     Modified provision   Alternative SRO provision
                                                                     following the        provided for judicial
                                                                                                        a
Topic           Section   Original provision                         2010 Order           consideration
Applicability   II.3      Generally, Sections I and II will only apply Unchanged.         No similar requirement.
                          to a research report this is both: (i)
                          prepared by the firm; and (ii) that relates to
                                                       i
                          either (a) a U.S. company, or (b) a non-
                          U.S. company for which a U.S. market is
                                                                 j
                          the principal equity trading market. But the
                          restrictions and requirements do not apply
                          to Research activities relating to a non-
                          U.S. company until the second calendar
                          quarter following the calendar quarter in
                          which the U.S. market became the
                          principal equity trading market for the
                          company.
                          Additionally, Section I.7 will apply to any
                          research report that has been furnished by
                          the firm to investors in the U.S., but not
                          prepared by the firm, but only to the extent
                          that the report relates to either (a) a U.S.
                          company or (b) a non-U.S. company from
                          which a U.S. market is the principal equity
                          trading market.
                          Also, Section II.1 will apply to any
                          research report that has been furnished by
                          the firm to investors in the U.S., but not
                          prepared by the firm, including a report
                          that relates to a non-U.S. company for
                          which a U.S. market is not the principal
                          equity trading market, but only to the
                          extent that the report has been furnished
                          under the firm’s name, has been prepared
                          for the exclusive or sole use of the firm or
                          its customers, or has been customized in
                          any material respect for the firm or its
                          customers.
General         II.4      A firm may not knowingly do indirectly      Unchanged.          No similar requirement considered
                          what it cannot do directly.                                     by the court.
                          The firm will adopt and implement policies
                          and procedures reasonably designed to
                          ensure that its associated persons cannot
                          and do not seek to influence the content of
                          a research report or activities of Research
                          personnel for the purpose of obtaining or
                          retaining investment banking business.
                          Firm procedures will instruct firm
                          personnel to immediately report to the
                          firm’s legal or compliance staff any
                          attempt to influence the contents of a
                          research report or activities of Research
                          personnel for such a purpose.




                                         Page 57                                               GAO-12-209 Securities Research
                                         Appendix II: Original and Modified Global
                                         Settlement Addendum Compared with NASD
                                         Rule 2711




                                                                    Modified provision   Alternative SRO provision
                                                                    following the        provided for judicial
                                                                                                       a
Topic          Section   Original provision                         2010 Order           consideration
Timing         II.5      Provisions will generally be effective within Unchanged.        No similar requirement.
                         120 days, with some effective within 60
                         days and others effective within 270 days
                         of the entry of the final judgment.
Review of      II.6      At their own expense, the firms retained   Unchanged.           No similar requirement.
implementation           an Independent Monitor acceptable to the
                         staff of the SEC, NYSE, NASD, the
                         President of NASAA and the New York
                         Attorney General’s Office to conduct a
                         review to provide reasonable assurance of
                         the implementation and effectiveness of
                         the firm’s policies and procedures
                         designed to achieve compliance with the
                         requirements. The review started 18
                         months after the entry of the final
                                     k
                         judgment. The monitors were to produce
                         a report including recommendations to
                         achieve compliance with the requirements
                         and prohibitions. The report must be
                         produced to the agencies no later than 24
                         months after the final judgment. The firm
                         could comment on the report prior to
                         submission. The firm must adopt all
                         recommendations, unless, after
                         demonstration of undue burden, the
                         agencies determine it is not necessary.
                         The Independent Monitor is restricted from
                         certain other employment opportunities for
                         3 years from the end of the engagement.




                                         Page 58                                              GAO-12-209 Securities Research
                                          Appendix II: Original and Modified Global
                                          Settlement Addendum Compared with NASD
                                          Rule 2711




                                                                                 Modified provision       Alternative SRO provision
                                                                                 following the            provided for judicial
                                                                                                                        a
Topic           Section   Original provision                                     2010 Order               consideration
Superseding     II.7      If the SEC adopts a rule or approves an                Modified.                 No similar requirement.
rules and                 SRO rule or interpretation with the stated             In addition to the
amendments                intent to supersede any of the settlement              original language,
                          provisions, the SEC or SRO rule or                     additional language
                          interpretation will govern and the                     was added that in the
                          settlement will be superseded.                         event of provisions
                          Amendments are permitted with                          remaining after the five
                          appropriate court and agency permissions.              year period, then upon
                          With respect to Sections I and II that have            the earlier of (i) 1 year
                          not been superseded within 5 years of the              following the court
                          final judgment, it is the expectation of all           approval; or (ii) the
                          parties that the SEC would agree to an                 effective date of new
                          amendment or modification of terms,                    research rules
                          subject to court approval, unless the SEC              proposed by FINRA
                          believes they would not be in the public               (08-55), if such rules
                          interest.                                              address the remaining
                                                                                 provisions of the
                                                                                 modified Addendum A,
                                                                                 it is the expectation of
                                                                                 the parties that the
                                                                                 SEC would agree to a
                                                                                 further amendment or
                                                                                 modification of the
                                                                                 agreement, subject to
                                                                                 court approval, unless
                                                                                 the SEC believes the
                                                                                 amendment or
                                                                                 modification is not in
                                                                                 the public interest.
Other           II.8      Except as otherwise specified, the         Unchanged.                           No similar requirement.
obligations and           requirements and prohibitions of the
requirements              agreement must not relieve the firm of any
                          other applicable legal obligation or
                          requirement.
                                          Source: GAO analysis of court documents.
                                          a
                                           On August 3, 2009, the Defendants made parties to Addendum A of SEC v. Bear, Stearns & Co (03
                                          Civ. 2937) and its associated cases (the “Case”), filed a letter brief requesting amendments and
                                          modifications to the Addendum A (the “Letter Brief”). The Defendants provided detailed rational for
                                          each request including citing the pertinent NASD or FINRA rule which the Defendants proposed was
                                          applicable to the same topic. On March 15, 2010, Judge William H. Pauley III “revised Addendum A
                                          as proposed by the parties …” except for a requested change in Section I.10(a) which was declined.
                                          See SEC v. Bear, Stearns & Co. Order.
                                          b
                                           Section I.1 includes a definition section which was not altered by the 2010 Order revising Addendum
                                          A. The definitions will not be discussed within this chart except where pertinent to explain another
                                          requirement.
                                          c
                                           ”Research” means all firm personnel engaged principally in the preparation or publication of research
                                          reports, including firm personnel who are directly or indirectly supervised by such persons and those
                                          who directly or indirectly supervise such persons, up to and including research management.
                                          Addendum A at Section I.1(d).




                                          Page 59                                                               GAO-12-209 Securities Research
Appendix II: Original and Modified Global
Settlement Addendum Compared with NASD
Rule 2711




d
 ”Investment banking” means all firm personnel engaged principally in investment banking activities,
including the solicitation of issuers and structuring of public offering and other investment banking
transactions. It also includes all firm personnel who are directly or indirectly supervised by such
persons and all personnel who directly or indirectly supervise such persons, up to and including
Investment Banking management. Addendum A at Section I.1(c).
e
 The Case Letter Brief stated that the firms “now have legal and compliance personnel who are
experienced in monitoring compliance with the Addendum.” SEC v. Bear, Stearns & Co. Letter Brief
at p. 5.
f
The Case Letter Brief stated that the parties to the settlement have “agreed that it would be
consistent with the public interest to eliminate the annual Audit Committee review requirement ….”
SEC v. Bear, Stearns & Co. Letter Brief at p. 5.
g
 The Case Letter Brief requested changes to Section I.10(a) to provide that “research personnel and
investment banking personnel may communicate with each other, outside the presence of the internal
legal or compliance staff, regarding market or industry trends, conditions or development, provided
that such communications are consistent in nature with the types of communications that an analyst
might have with investing customers.” SEC v. Bear, Stearns & Co. Letter Brief (Aug. 3, 2009) at p. 5.
However, the court determined that the proposed modification “would be inconsistent with the final
judgment and contrary to the public interest” and therefore, denied the request. SEC v. Bear, Stearns
& Co. Order (Mar. 15, 2010) at p. 2.
h
    ”Fair and balanced” as defined in NASD Rule 2210(d)(1).
i
 A “U.S. company” means any company incorporated in the United States or whose headquarters is in
the U.S. Addendum A at Section II.3(b).
j
The “principal equity trading market” becomes the U.S. market in a quarter when more than 50
percent of the worldwide trading in the company’s common stock and equivalents takes place in the
U.S. Addendum A at Section II.3(c).
k
 The “final judgment” is the date of the entry of judgment in the SEC’s action against the Defendants.
The court entered final judgments against the defendant investment banks in all but two cases
(against Deutsche Bank Securities Inc. and Thomas Weisel Partners LLC) on October 31, 2003. The
court entered final judgment against the remaining two on September 27, 2004.




Page 60                                                           GAO-12-209 Securities Research
Appendix III: Comments from the Securities
              Appendix III: Comments from the Securities
              and Exchange Commission



and Exchange Commission




              Page 61                                      GAO-12-209 Securities Research
Appendix III: Comments from the Securities
and Exchange Commission




Page 62                                      GAO-12-209 Securities Research
Appendix IV: GAO Contact and Staff
                  Appendix IV: GAO Contact and Staff
                  Acknowledgments



Acknowledgments

                  A. Nicole Clowers, (202) 512-8678 or clowersa@gao.gov
GAO Contact
                  In addition to the contact named above, Richard Tsuhara, Assistant
Staff             Director; Rachel DeMarcus; Lawrance Evans Jr.; Tiffani Humble; Jim
Acknowledgments   Lager; Marc W. Molino; Angela Pun; Barbara Roesmann; Jessica
                  Sandler; and Cynthia Saunders made key contributions to this report.




                  Page 63                                        GAO-12-209 Securities Research
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               Page 64                                         GAO-12-209 Securities Research
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