Much like some people (well, me, anyway) enjoy debating what was the first “punk rock” song to go mainstream (Pump It Up, by Elvis Costello, of course), others more erudite than I prefer, instead, to argue about what it was that initially propelled FINRA down its current Enforcement oriented path. To me, the answer has always been clear: the research analyst “Global Settlement” largely brokered in 2003 by then New York Attorney General Eliot Spitzer with Wall Street’s elite firms. At a time when NASD sat blithely by, raking in money from the enormous trading volumes on Nasdaq (which NASD still owned at the time) generated during the “tech bubble,” Mr. Spitzer was aggressively investigating the overly cozy relationship between the investment banking and research departments of the big broker-dealers who were underwriting the many technology-based IPOs that were coming out. According to his investigation, issuers were promised, in essence, that no matter how sketchy their stories, no matter how non-existent their profits, they would nevertheless be provided positive research coverage in exchange for entering into an underwriting agreement. Thanks to a broadly drafted New York statute that effectively gave him greater remedial powers than NASD (or the SEC), Mr. Spitzer was able to do what neither of those regulators did on their own, and shut that down.
In an obvious effort to catch up to the State of New York, NASD eventually ended up promulgating Rule 2711, the Research Analyst rule, which served to prohibit much of the misconduct detailed in Mr. Spitzer’s settlement by ensuring that research be conducted independently of whatever a firm’s bankers wanted, or didn’t want. From that point in 2002 forward, it has basically been a steady deluge of new rules and rule changes, and tougher enforcement of those rules, which continues to this day.
One of the unique aspects of Rule 2711 is that it only applied to equity securities, but not debt instruments. As of February 22, 2016, however, and 14 years after the rule initially went into effect, that will no longer be the case. On that date, new Rule 2242 becomes effective, extending to debt securities much of the firewall that presently exists between equity research analysts and bankers.
Frankly, this is not particularly surprising. In fact, in retrospect, it seems pretty clear that it would happen. This is a result of the confluence of two things, first, the fact that the research analyst rule is largely predicated on the identification and avoidance of the obvious conflict of interest between bankers (who want to bring in underwriting business, perhaps by promising favorable coverage) and analysts (who are supposed to be independent), and, second, the fact (as we have blogged about before) that FINRA is increasingly focused on the efforts by its members to – you guessed it – identify and avoid obvious conflicts of interest. Indeed, Regulatory Notice 11-11, which first announced FINRA’s interest in extending Rule 2711 to debt securities, is expressly subtitled, “FINRA Requests Comment on Concept Proposal to Identify and Manage Conflicts Involving the Preparation and Distribution of Debt Research Reports.” Regulatory Notice 15-31 bears a similar name. It is no mystery, then, that conflicts of interest lie at the heart of this rule.
Back in May, in a post I wrote after the first day of FINRA’s national conference, I made the following statement about conflicts of interest: “There is no specific rule that dictates that BDs address conflicts of interest, but FINRA expects that firms do it anyway. As with cybersecurity issues, Susan Axelrod said that while FINRA examines for conflict management, the goal is for FINRA to ‘understand’ how firms are managing that part of their business. The cynic in me can only wonder whether, and when, that goal will change, and encompass Enforcement actions.” With the passage of new Rule 2242, I feel rather prescient. Clearly, with its research analyst rule, FINRA has taken conflict avoidance from a mere concept to an enforceable reality.
The problem, however, is that, as with many rules, while FINRA theoretically leaves it to BDs in Rule 2242 to create their own policies and procedures “reasonably designed” to address the requirement to manage conflicts of interest, historically, FINRA has demonstrated very little actual willingness to accept viewpoints contrary to its own on what constitutes “reasonableness.” In other words, FINRA freely substitutes its own business judgment for that of its member firms, insisting that only its interpretation of “reasonableness” matters. That has not worked with other rules which incorporate a “reasonableness” standard, so I have no reason to believe it will work any better here. The sad fact is that, once again, firms need to be prepared to be second-guessed by FINRA examiners who, starting next year, will begin gauging compliance with Rule 2242.
 The Martin Act is an antifraud statute that empowers the New York Attorney General to bring cases against allegedly fraudulent conduct without having to prove either intent or even negligence, as is the case under Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934.
 FINRA has also created new Rule 2241, which replaces Rule 2711. While Rule 2241 maintains most of the content of Rule 2711, there are some aspects that have been modified. Perhaps I will discuss them some other time, in another post.