UPDATE - CONFLICTS OF INTEREST AND ANALYST RESEARCH - BRITISH BANKERS ASSOCIATION GUIDANCE

1 Introduction

In October 2003 the Financial Services Authority ("FSA") issued its final consultation paper on the subject of investment research by investment banks, CP205 (Conflicts of Interest: Investment Research and Issues of Securities). CP205 proposed a series of amendments to the Conduct of Business Rules ("COB") in relation to investment research in two broad areas: dealing ahead of investment research (both by firms (COB 7.3) and individual analysts (COB 7.13)), and on the implementation of a conflicts management policy by firms which produce research (COB 7.16).

Full details of the proposed changes set out in CP205 were summarised in the January 2004 Charles Russell Public Companies Update, which can be viewed at http://www.cr-law.co.uk/services/corporate_finance/public_companies/january04.asp

COB 7.3 and 7.13 were presented in their final form in CP205, and these new rules,originally intended to be introduced on 1 February 2004, are expected to come into force on 1 May 2004. They can be viewed at http://www.fsa.gov.uk/pubs/cp/cp205.pdf

2 COB 7.3

As set out briefly in the January 2004 Charles Russell Public Companies Update, the amendments to COB 7.3 tighten the exemptions to the general rule prohibiting firms from undertaking own account transactions when the firm or its associate publishes investment research to clients.

The rules now only allow a firm to establish a reduced or extended position in an issue of securities in advance of publication of substantive research relating to that issuer, if it is within the ordinary course of the firm's market making activities or to fulfil an unsolicited customer order. The ordinary course of a firm's marketing activities includes a firm holding itself out continuously to clients or the market as being willing to quote a price in those securities and to deal at that price and size on request.

The amendments have removed the exemptions in relation to the effect on price of the publication, customer orders resulting from the publication and notification of dealing to the clients.

2.1 Industry Guidance on COB 7.3
The British Bankers' Association, London Investment Banking Association, International Securities Market Association and International Primary Markets Association published a guidance note in February on the intended effect of the provisions of COB 7.3. The guidance, which is not FSA guidance, has been checked with the FSA to agree that it is consistent with the intended effect of the rule. If there is any conflict between the guidance and the FSA Handbook, the text of the FSA Handbook prevails.

The guidance states that the purpose of COB 7.3 is to ensure that where a firm releases investment research which includes new information not previously available to the clients the firm does not take unfair advantage of its prior knowledge of the intention to publish that research by using the research for its own purposes before those clients have had a reasonable opportunity to use it.

The rule in COB 7.3 relates to those within a firm with prior knowledge of the intention to publish and the timing of publication which means that internal recipients with no prior knowledge of the publication of the research who received it at the same time as clients are free to react to the research in the same way as clients.

Generic material is not covered by COB 7.3 unless it also includes substantive current analysis of factors which are likely to influence the current prospective performance of one or more investments of the issuer.

COB 7.3 applies to investment research which is usually labelled as such. Where it is not labelled investment research it does not mean that the rules do not apply however as the rule concentrates on the substance rather than the designation applied by the firm.

A firm should not deal in the knowledge that it or its associate intends to publish investment research but this means exclusive knowledge and not market knowledge or expectations. The rules do not therefore apply in relation to knowledge shared by the markets such as regular reporting or reasonable market expectations that research will be issued.

Knowledge in relation to a firm means the knowledge of the employees carrying out the relevant dealing. In accordance with other conduct of business rules, individuals on one side of a Chinese wall carrying out dealings will not be regarded as being in possession of research information denied to them by the Chinese wall. The question of whether an employee has knowledge will be dealt with on a case by case basis, taking into account relevant internal procedures on the dissemination of information.

Firms must take appropriate steps so that their research analysts can take reasonable care to ensure that in their interactions with sales and trading personnel they do not intimate the time of or content of research with sufficient clarity so as to enable the sales or trading personnel to form a reasonable expectation concerning the timing or content of any such publication.

3 COB 7.16

COB 7.16 was presented in draft form in CP205, with responses sought by the FSA on certain specific questions in relation to the proposed changes. On 22 March 2004, the FSA published Policy Statement 04/6 ("PS04/6"), which included a summary of the responses received, together with the final text of COB 7.16, which is expected to come into force on 1 July 2004. The final text can be viewed at http://www.fsa.gov.uk/pubs/policy/ps04_06.pdf

3.1 Responses to CP205
The FSA had sought responses on the following proposals included in the draft of COB 7.16 circulated with CP205: (a) that the new COB Rules on investment research should apply only to research distributed externally and which purports to be objective (b) that the producers of such research should be required to have in place, and to publish, a conflicts management policy, and (c) that the new rules should apply to all firms which produce research purporting to be objective.

Following the responses to CP205, the FSA has decided not to deviate from any of these three core principles in the final text of COB 7.16:

(a) The FSA has rejected requests from some sell-side firms to provide a narrower definition of investment research, such as research produced by investment analysts or in a Research Department. The FSA has also maintained its position of offering a distinction between research purporting to be objective, and other research, all owing smaller firms not able to meet appropriate conflicts management standards to continue to produce research, provided they do not hold it out as objective, or the recipients do not take it to be objective research. An amended definition of the type of investment research that will be caught by the conflicts management requirements has been included at 7.16.5 and 7.16.6, and is discussed further below.
(b) Firms which produce investment research will be required to have in place an appropriate conflicts management policy, and to make this publicly available, by 1 July 2004. The final text does offer a distinction between the policy that a firm is required to make publicly available, and the more detailed internal procedures it uses to implement such a policy, which do not have to be published (7.16.6(2)).
(c) COB 7.16 will apply to all firms which produce investment research, and in relation to any financial product, where conflicts of interest arise. The FSA has rejected requests to exempt smaller or buy-side firms, or non-equity research, from the new rules.

3.2 COB 7.16 - changes since CP205
Whilst the core principles underpinning COB 7.16 remain unchanged form CP205, a series of amendments have been made to the drafting of the final text, as part of the last phase of consultation, and these changes are summarised briefly below:

7.16.3 Whereas previously the FSA had stated that firms could not distribute to clients research produced for internal purposes, this amended rule states that they cannot do this only when such research may have a "material influence" on the client's investment decisions. This is to allow firms to produce internal research to clients for non-investment purposes, for example as part of an audit trail.

7.16.5(1) The FSA has amended slightly its definition of the type of investment research to which the requirement to produce a conflicts management policy will apply, now preferring to use the term impartial instead of objective (although the FSA does state in PS04/6 that the terms should be regarded as essentially synonymous). COB 7.16 applies to firms which produce investment research which hold themselves out as being impartial (7.16.5(1)(a)) or where recipients of the research reasonably rely on it as being impartial (7.16.5(1)(b)).

7.16.5(2) Firms which produce the kind of investment research caught by 7.16.5(1) are required to have in place a policy for managing conflicts which might affect the impartiality of such research. This position is further clarified in PS04/6: all firms which produce applicable investment research are responsible for identifying any conflicts of interest which might affect their research, and must have in place a policy that allows them to do this, but where a firm reasonably concludes that there are no conflicts of interest affecting the impartiality of its research, then it is not required to have policy provisions in place in respect of conflicts management.

7.16.5(3) A conflicts management policy must detail the extent to which a firm uses Chinese walls, or other internal information barriers, to address its conflicts of interest.

7.16.6 As discussed above, the FSA has distinguished between the conflicts management policy which must be published and the more detailed internal procedures which need not. However, the FSA does state in PS04/6 that a published policy must still be sufficiently detailed to inform a reader properly of the topics which it is required to cover.

7.16.11 Where a firm's requirement to police conflicts effectively depends at least in part on the perception of its clients or third parties, the FSA has added in various reasonableness requirements for such perceptions. For example, 7.16.11 now states that a firm is unlikely to be able to use an analyst for marketing purposes where this would give rise to "a reasonable perception of a lack of impartiality" in that analyst's subsequent research.

4 Conclusion

COB 7.16 is expected to come into force on 1 July, by which date the FSA has already stated it expects firms to have published and implemented their conflicts management policies in relation to investment research.

A final point to note in respect of these new COB provisions on investment research is that they do not exist in isolation. Firms will still need to be mindful of other requirements of the general law when policing this area. For example, when considering an appropriate "blackout" period around an investment offering during which research should not be published, a firm will need to have regard to the financial promotions regime, under the Financial Services and Markets Act 2000, in addition to the requirements of COB 7.16.14.

Looking ahead, the regulatory regime in this area will continue to develop, with the next stage set to be the implementation of the Market Abuse Directive, following consultation, in quarter 4 2004. This will address in detail the disclosure requirements for conflicts of interest in investment research, which are touched on only in very broad outline at COB 7.16.15.

If you require further information on any matter covered in this note, please contact your principal contact at Charles Russell or Simon Gilbert, Katy Knight, Clive Hopewell or Alexander Keepin (London), Francis Rundall or Richard Norton (Cheltenham) or Geoff Sparks (Guildford) and on 0207 203 5000.

Please note that the summaries above are a general indicative guide only. They are not exhaustive. This information has been prepared by the firm as a service to our clients. As it is a general guide, we recommend that you seek professional advice before taking action. No liability can be accepted by the firm for any action taken or not taken as a result of this information. The firm is not authorised under the Financial Services and Markets Act 2000 but we are able in certain circumstances to offer a limited range of investment services to clients because we are members of the Law Society. We can provide these investment services if they are an incidental part of the professional services we have been engaged to provide.