FINRA Issues Regulatory Notices On Foreign Research Analysts, Third-Party Research Reports And Unauthorized Proprietary Trading

FINRA recently issued three Regulatory Notices addressing: (1) the rules governing exemptions from the research analyst qualification examination for foreign research analysts; (2) the rules governing member firm disclosure and supervisory review obligations for third-party research reports; and (3) sound practices to prevent and detect unauthorized proprietary trading.¹

This alert briefly summarizes each of these important FINRA Regulatory Notices.

RESEARCH ANALYST RULES

The SRO research analyst rules generally address the potential conflicts of interest associated with research analysts who work for brokerage firms that are also engaged in the investment banking business. The SRO rules establish safeguards to separate research analysts from pressure or oversight from investment banking personnel and limit company influence over research analysts. Among other things, the SRO research analyst rules require research analysts to register as such with the respective SROs and pass a qualification examination (Series 86/87).² The SRO research analyst rules also require firms to make certain disclosures and conduct supervisory reviews when they make available and/or distribute research reports.³

Research Analyst Qualification Examination

Research analysts are required to pass a qualification examination, unless they qualify for one of the exemptions from the examination requirements.⁴ FINRA previously exempted from the qualification examination certain "associated persons who [are] employee[s] of & non-member foreign affiliate[s] who contribute to the preparation of a member's research report" in certain FINRA-approved jurisdictions, so long as certain conditions were met ("Foreign Affiliate Exemption").⁵ FINRA recently amended the Foreign Affiliate Exemption to include "research analysts employed by a member's foreign affiliate residing anywhere outside of the United States" rather than limiting the availability of the exemption to research analysts in certain FINRA-approved jurisdictions.⁶ Consequently a research analyst can now qualify for an exemption from the qualification examination if the research analyst: "(1) is an employee of a non-member foreign affiliate of a member firm (foreign research analyst'); (2) resides outside the United States; and (3) contributes, partially or entirely, to the preparation of globally branded' or foreign affiliate research reports, but does not contribute to the preparation of a member's research, including a mixed-team' report, that is not globally branded."⁷

In order for an associated person to qualify for the amended Foreign Affiliate Exemption, however, the member firm must also satisfy certain supervisory, disclosure and recordkeeping requirements. Consequently, member firms must ensure that:

1. Foreign research analysts' research is subject to a "pre-use review and approv[ed] by a registered principal or supervisory analyst;"⁸
   
   
2. Such research reports "comply with NASD Conduct Rule 2711 and Incorporated NYSE Rule 472;"⁹
   
   
3. Members "prominently disclose:
   
   

4. Records are established and maintained identifying those persons who have "availed themselves of the exemption, the basis for such exemption and evidence of compliance with the conditions of the exemption," as well as evidence of compliance with the applicable content, disclosure and supervision provisions of NASD Conduct Rule 2711 and Incorporated NYSE Rule 472."¹¹
   
   

The amendments to the Foreign Affiliate Exemption became effective on April 7, 2008.

Third-Party Research Reports

FINRA also recently amended NASD Conduct Rule 2711(h)(13) and Incorporated NYSE Rule 472(k)(4) (collectively, the "Third-Party Research Rules") to reduce members' disclosure and supervisory review obligations associated with third-party research reports.¹² Generally, when members distribute or make third-party research reports available, they must comply with certain disclosure and supervisory review obligations. Previously, if a member made third-party research reports available to its customers upon request or through its Web site, the aforementioned disclosure obligations did not apply. FINRA's recent amendments to the Third-Party Research Rules maintain the aforementioned exceptions, but only for "independent third-party research."¹³ FINRA has also added an additional exception to the disclosure obligations for "registered representatives [who have] informed [a] customer, during the course of a solicited order, of the availability of an independent third-party research report and the customer requests such research report."¹⁴

These amendments to the Third-Party Research Rules create a new category of research reports called "independent third-party research reports." An independent third-party research report is defined as "a research report in respect of which the person or entity producing the report: (1) has no affiliation or contractual relationship with the distributing member or that member's affiliates that is reasonably likely to inform the content of its research reports; and (2) makes content determinations without any input from the distributing member or that member's affiliates."¹⁵ If a member does not fall under one of the three aforementioned exceptions, and if a third-party research report does not meet the requirements of an independent third-party research report, "irrespective of whether it is distributed or made available," member firms must comply with the disclosure obligations.¹⁶

The Third-Party Research Rules also previously "require[d] a registered principal or a supervisory analyst, approved pursuant to NYSE Rule 344, to approve by signature or initial any third-party research distributed by a member firm and to review such research to ensure that the applicable disclosures [were] complete and accurate (disclosure review) and the content of the research reports contain[ed] no untrue statement of material fact or [was] otherwise not false or misleading (content review)."¹⁷ The recent amendments to the Third-Party Research Rules have removed this rules-based approach and instead have embraced a principles-based approach whereby members "must establish written supervisory policies and procedures "reasonably designed to ensure the completeness and accuracy of all applicable disclosures."¹⁸

FINRA also codified its previous interpretation regarding the requisite scope of third-party research report content reviews within the amended Third-Party Research Rules. NASD Conduct Rule 2711(h)(13) and Incorporated NYSE Rule 472(k)(4) now specifically provide that third-party research reports shall be reviewed to determine that the report does not contain "any untrue statement of material fact or any false or misleading information that (1) should be known from a reading of the report or (2) is known based on information otherwise possessed by the member."¹⁹ The aforementioned content review is now only applicable to third-party research reports, as FINRA has excepted the distribution of independent third-party research reports from the content review requirements.²⁰

FINRA intends that the aforementioned amendments will make independent third-party research more freely available to investors, while still protecting against conflicts of interest that can occur between firms and research providers.

The aforementioned amendments to the Third-Party Research Rules became effective on April 7, 2008.

UNAUTHORIZED PROPRIETARY TRADING

FINRA recently issued guidance to assist member firms in the prevention and detection of unauthorized trading, due to several recent cases involving unauthorized proprietary trading.²¹ Although FINRA noted that many firms have implemented internal controls and risk management systems to detect and prevent unauthorized proprietary trading, FINRA believes that such controls must be reassessed to account for changes in the marketplace.

Based on information regarding internal controls and internal reviews obtained from various types of firms, FINRA has identified six practices that it believes will assist firms, where relevant and feasible, in preventing and detecting unauthorized proprietary trading:

• Mandatory Vacation Policies;
  
  
• Heightened Scrutiny of Red Flags;
  
  
• Protection of Systems and Risk Management Information;
  
  
• Supervision and Accountability;
  
  
• Intercompany Transactions; and
  
  
• Compliance Culture.
  
  

Mandatory Vacation Policies

FINRA recommended that, where feasible and reasonable, firms should implement and enforce mandatory vacation policies whereby certain persons who have "sensitive jobs," such as traders, are required to take a certain minimum number of consecutive vacation days, typically ten consecutive trading days.²² During such persons' mandatory vacation periods, they must be prohibited from physically or electronically accessing the firm, its facilities and systems. FINRA believes that mandatory vacation policies for persons with sensitive jobs would assist firms in detecting unauthorized trading because any employee involved in rogue activities would not be able to conceal his or her activities while blocked from physically or electronically accessing the firm and its systems. Consequently, firms would be able to detect any rogue activity during the mandatory vacation period.

In order for such policies to be effective, however, FINRA stressed that exceptions from mandatory vacation policies should only be granted in unusual circumstances and requests for repeated exemptions should raise a red flag to firms. FINRA also noted that if firms are unable to implement mandatory vacation policies they should have policies in place to identify and review "the trading activity of traders who have not taken an extended vacation in the past year."²³

Heightened Scrutiny of Red Flags

Firms must adequately surveil, either manually or via automated tools, for red flags and investigate such red flags as they arise. FINRA cautioned firms that red flags cannot only indicate proprietary business risk, but also regulatory risk. FINRA recommended that firms should monitor and scrutinize, when necessary, the following activities:

• Trading limit breaches;
  
  
• Unrealized profit and loss ("P&L") on unsettled transactions;
  
  
• Unusual patterns of cancellations and corrections, particularly those involving multiple cancellations or corrections by the same trader or involving the same counter-party;
  
  
• Transactions in which confirmation and settlement do not occur on a timely basis, or where settlement is outside of normal cycles;
  
  
• Reports of aged unresolved reconciling items and aged outstanding confirmations;
  
  
• Reports of P&L that exceed a certain de minimus amount by traders who are supposed to be flat or unusually large one-day P&L reports;
  
  
• Details underlying a trader's Value at Risk;
  
  
• Repeated or unusual requests by a trader to relax existing controls, including position or P&L limits;
  
  
• Trading in products that are outside of a trader's known expertise, without prior approval;
  
  
• Unusual or significant differences between a trader's account positions and account activity; or
  
  
• Patterns of aged fails to deliver for long or short sales.²⁴
  
  

FINRA reminded member firms that automated surveillance tools intended to detect activities such as those listed above must be maintained and tested on a routine basis in order to ensure that they are adequate and effective.

Protection of Systems and Risk Management Information

FINRA reminded firms that employee access to firm systems should be "strictly limited to what is appropriate for the employee's function within the firm."²⁵ Consequently, if an employee's role within the firm changes, his or her access to firm systems must change accordingly. Furthermore, firms must ensure that employee access to firm systems is blocked during mandatory vacation periods and cancelled upon termination of an employee.

Under the recently issued FINRA guidance, firms are reminded that they should always ensure that there are appropriate controls in place to surveil activities of traders. Firms also "should limit knowledge about the details of their risk management procedures and systems to the extent possible and consider modifying them in response to personnel changes, such as a back office employee becoming a trader."²⁶ It is also recommended that firms consider requiring multiple authentication measures in order to prevent unauthorized access to firm systems.

Supervision and Accountability

FINRA noted that employees tend to have multiple reporting lines, which can lead to confusion regarding who such employees "report to and what they are held accountable for in their day-to-day job responsibilities."²⁷ Consequently, FINRA reminded firms that they must clearly communicate to managers their respective lines of authority and responsibility. In addition, firms must make clear to their employees what responsibilities have been delegated to which persons within the firm. FINRA also recommended that firms document the aforementioned supervisory responsibilities in writing.

Intercompany Transactions

FINRA member firms tend to be affiliated with large, complex financial services organizations. Consequently, firms tend to conduct transactions with their affiliates rather than unaffiliated third parties. When member firms conduct transactions with unaffiliated third parties, however, they tend to implement certain controls that are often waived for transactions with affiliates. FINRA recommended that firms "may want to reevaluate whether certain third-party controls that limit [a firm's] exposure would be appropriate for affiliated transactions."²⁸ FINRA also reminded firms of their obligation to regularly reconcile intercompany transactions.

Compliance Culture

FINRA reminded member firms of the importance of fostering a culture of compliance starting from the top of an organization. FINRA noted that firms must ensure that they do not marginalize persons or departments responsible for trade reconciliation and risk management and that they should pay close attention to "any systemic or cultural dynamics that may undermine the effectiveness" of their internal controls to prevent unauthorized proprietary trading.²⁹

In light of the foregoing, FINRA recommends that firm's review their policies and procedures, internal controls and culture of compliance to ensure that such firms are sufficiently equipped to prevent and detect unauthorized proprietary trading.

ENDNOTES

¹ FINRA Regulatory Notice 08-15 (April 2008); FINRA Regulatory Notice 08-16 (April 2008); FINRA Regulatory Notice 08-18 (April 2008).
² See NASD Membership Rule 1050 and Incorporated NYSE Rule 344.
³ NASD Conduct Rule 2711(h)(13) and Incorporated NYSE Rule 472(k)(4).
⁴ See NASD Membership Rule 1050, Incorporated NYSE Rule 344 and NYSE Rule Interpretation 344/02.
⁵ See NASD Membership Rule 1050(f) (2007).
⁶ See FINRA Regulatory Notice 08-15 (April 2008).
⁷ See NASD Membership Rule 1050(f), Incorporated NYSE Rule 344 and NYSE Rule Interpretation 344/02. A "globally branded research report" is defined as "the use of a single marketing identity that encompasses the member and one or more of its affiliates." A "mixed team research report" is defined as "any member research report that is not globally-branded and includes a contribution by a research analyst who is not an associated person of the member." See NASD Membership Rule 1050(f)(3)(H)(ii)-(iii), Incorporated NYSE Rule 344 and NYSE Rule Interpretation 344/02.
⁸ See FINRA Regulatory Notice 08-15 (April 2008).
⁹ Id.
¹⁰ See NASD Membership Rule 1050(f)(3)(B), Incorporated NYSE Rule 344 and NYSE Rule Interpretation 344/02.
¹¹ See FINRA Regulatory Notice 08-15 (April 2008).
¹² See NASD Conduct Rule 2711(h)(13) and NYSE Rule 472(k)(4). Third-party research reports are defined as "research report[s] produced by a person or entity other than the member." FINRA Regulatory Notice 08-16 (April 2008).
¹³ See FINRA Regulatory Notice 08-16 (April 2008).
¹⁴ See FINRA Regulatory Notice 08-16 (April 2008).
¹⁵ Id. FINRA has noted that "independent third party research is meant to & [exclude] from the definition all research produced by (1) an affiliate; and (2) all other parties that have a contractual relationship with the distributing member firm or that firm's affiliates that is reasonably likely to inform the content of its research reports." Id. at n.3.
¹⁶ The recent amendments to the Third-Party Research Rules also permit members to "accompany third-party research reports with the applicable disclosures or provide a web address in the report that directs the recipient to the location where such disclosures can be found." FINRA Regulatory Notice 08-16 (April 2008).
¹⁷ FINRA Regulatory Notice 08-16 (April 2008).
¹⁸ Id. See also NASD Conduct Rule 2711(h)(13)(A) and Incorporated NYSE Rule 472(k)(4)(i).
¹⁹ See NASD Conduct Rule 2711(h)(13)(C) and Incorporated NYSE Rule 472(k)(4)(iii).
²⁰ See NASD Conduct Rule 2711(h)(13)(D) and Incorporated NYSE Rule 472(k)(4)(iv).
²¹ FINRA Regulatory Notice 08-18 (April 2008).
²² Id.
²³ Id.
²⁴ FINRA Regulatory Notice 08-18 (April 2008).
²⁵ Id.
²⁶ Id.
²⁷ FINRA Regulatory Notice 08-18 (April 2008)
²⁸ Id.
²⁹ Id.

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