CONFLICTS OF INTEREST AND ANALYST RESEARCH

During the past two years the Financial Services Authority ("FSA") has issued three consultation papers on the subject of investment research and conflicts of interest: DP15 (Investment Research: Conflict and Other Issues) in July 2002, CP171 (Conflicts of Interest: Investment Research and Issues of Securities) in February 2003, and CP205 (Conflicts of Interest: Investment Research and Issues of Securities) in October 2003. This has in large part been in response to events in the US, where a series of high-profile scandals involving investment analysts led to a $1.4 billion settlement between leading investment banks and the Securities and Exchange Commission ("SEC") and other regulators, and served as the catalyst for extensive regulatory change. In the UK, the FSA's consultation period is now at an end, and this year will see the implementation of a series of new regulations, with the first to be introduced on 1 February 2004.

The starting point from which the FSA conducted its investigations, soon confirmed by its consultations, was that there are inherent conflicts of interest in the production of investment research by firms on companies for whom such firms also act in a corporate finance capacity.

urthermore, the FSA has seemed persuaded that these conflicts do impact upon the content of research prepared by investment firms. For example, DP15 cites an FSA study showing that corporate finance advisers to the FTSE 100 companies would provide a 'buy' recommendation in relation to their client companies in almost twice as many instances as would unconnected brokers. The report concluded "It is difficult to see how this differential can be justified on objective grounds."

The question exercising the FSA for most of the consultation period has been how, not whether, regulatory changes should be introduced in this area. The answer is provided in CP205, mostly by way of a series of amendments to the Conduct of Business Rules ("COB").

1.1 Amendments to COB
CP205 includes two sets of proposed amendments to COB, respectively the Draft Handbook text and the Made Handbook text. As the titles suggest, the first set of changes was in near-final form and the second in final form at the time of CP205. Each is intended to be introduced in 2004.

1.2 The Draft Handbook text (CP205 Annex 8)
The Draft Handbook Text inserts a new rule into COB (7.16), requiring each firm which produces investment research to establish, and police, a conflicts management policy that is appropriate to the firm, - taking into account such factors as the size and organisational structure of the firm, the expertise of its clients, the nature of the firm's business and the types of financial instruments it trades. COB 7.16 then sets out guidance on what a firm's conflicts management policy should include (COB 7.16.10-16).

In CP205 the FSA sought responses on the following proposals in the Draft Handbook Text:

The deadline for responses to these proposals was 24 December 2003. The FSA is yet to publish its findings following this final period of consultation.

In contrast, the FSA was no longer seeking responses on the terms of its guidance on what should be included in a conflicts management policy (COB 7.16.10-16) - this was presented in its final form in CP205 and is summarised below.

Supervision and remuneration of analysts (COB 7.6.10-11) - an investment analyst should not be subject to the supervision or control of anybody with a conflicting interest to those of the recipients of an analyst's research, i.e. somebody involved in raising funds for the subject company of an analyst's research (COB 7.6.10). The intended targets of this rule are conflicted representatives from either the investment banking or sales and trading arms of an analyst's firm.

An investment analyst's remuneration should not be organised in such a way as to give off the appearance of a conflict, for example by linking it to the successful completion of a transaction (COB 7.6.11).

Involvement of analysts in other activities (COB 7.6.12) - an investment analyst should not be involved in activities that could appear to compromise the objectivity of his research (COB 7.6.12). This will ordinarily include involvement in pitches by an investment firm to win business from companies that will form the subject of an analyst's research, and involvement in promoting a share issue by a company on which he has reported (COB 7.6.12).

These proposed changes have proved contentious during the consultation stage, with firms arguing that an analyst can have an important part to play in attracting new business, and that it is proper for firms to use analysts for this purpose. The rule, we are told in CP205, will remain in place however. The FSA notes in mitigation that it has not issued a blanket ban on the involvement of analysts in marketing, only where this will give rise to the appearance of a conflict of interest.

Avoiding inappropriate influences (COB 7.6.13) - a firm should prohibit analysts from receiving any inducement to provide favourable research (COB 7.6.13.1). A firm should not allow an analyst's research to be subject to the editorial control of anybody who may have a conflict of interest with the recipients of the research, nor should research be sent to third parties prior to publication, except for the purpose of fact-checking by representatives of the subject company (COB 7.6.13.2).

The latter rule is aimed at preventing subject companies from attempting to influence the content of research prior to publication. It is not expressly stated in the latest draft rule, but CP205 notes that there is general agreement that ratings, recommendations and price targets should be removed from a report before it is submitted to a subject company for fact-checking.

Means and timing of publication (COB 7.6.14-15) - the FSA has opted not to impose a prescribed quiet period immediately before or following the publication of a prospectus or listing particulars, during which the publication of research on a subject company is prohibited. However, firms are required to control the release of an investment analyst's report in an appropriate manner (COB 7.6.14), and are encouraged to consider restricting the release of an analyst's report around the time of an investment offering (COB 7.6.15). It should be noted, however, that there are risks if research is published around the time of issuing a prospectus or listing particulars as it may be deemed to constitute part of the prospectus, with prospectus style liability but without a full verification process having been carried out to try to protect against such liabilities. There should always be a gap between the issue of research and publication of the Prospectus.

Disclosures (COB 7.6.16) - a firm is also required to consider what disclosures should accompany an analyst's report. Detailed disclosure requirements on firms have not been included as part of these rule changes, as the FSA has opted to deal with this issue when implementing the amended Market Abuse Directive ("MAD") in the second half of 2004.

1.3 Made Handbook text (CP205 Appendix 1)
The Made Handbook text addresses the issue of dealing ahead of investment research, either by the firm or the individual analyst producing it, by way of amendment to existing COB rules 7.3 and 7.13. This text was presented in final form in CP205, with no responses sought. It will It will be introduced by the Conflicts of Interest (Corporate Finance and Investment Analysts) Instrument 2003 from 1 February 2004.

Dealing ahead of investment research
A new COB 7.3.2A states expressly that dealing ahead of investment research by a firm is a potential source of conflicts of interest, and one which cannot be reconciled by mere disclosure.

By firms (COB 7.3) - a firm distributing investment research may not, following publication of that research, knowingly undertake an own account transaction in the investments covered by the research, and must take reasonable steps to ensure that its associates do not, until the recipients of the research have had a reasonable opportunity to act upon it (COB 7.3.3).

The exceptions to this rule have been reduced to just two situations: where the firm or its associate is a market maker in the relevant investment and undertakes a transaction in the normal course of market making (COB 7.3.3(2)), or where the firm or its associate deals in order to fulfil an unsolicited order (COB 7.3.3(3)).

By individual analysts (COB 7.13) - a firm must also take reasonable steps to ensure that an analyst does not trade on his own account in investments covered by his own, recently published, research, unless either the transaction is not contrary to a recommendation made by the analyst, or where the analyst is realising the cash value of a holding in order to meet an obligation not related to the relevant investment (COB 7.13.7).

In addition, new COB provisions entitle a firm to prohibit investment analysts from dealing on their own account in investments on which they have reported, either absolutely or for a set period of time after the publication of a report (COB 7.13.10A).

1.4 Conclusions
The rule changes are nearly upon us. The amended prohibitions on dealing ahead of investment research will be mandatory from 1 February. The more general requirements as to the management of investment analysts and their activities will follow soon afterwards. Whilst the FSA is still to confirm that investment firms who publish research will be required to have in place an appropriate conflicts management policy, the guidance on what such a policy should include is now in its final form. It would clearly therefore seem sensible to be following the steps outlined in the guidance as a matter of best practice, if not yet as a matter of law.

Looking ahead, we shall see further regulatory change in this developing area in the near future, in particular at the EU level, with Market Abuse Directive and an amended Investment Services Directive, set to be introduced in 2005/6, both due to cover investment analysts. We shall also see the effects on the industry of the £20.8 million fine recently levied on Morgan Stanley by the Paris Tribunal of Commerce for publishing unfair research, announced on 12 January 2004. The impact of this decision, which the bank is set to appeal and which it has stated will not lead to a change in strategy in its European operations, remains to be seen. If nothing else the decision does serve to underline the seriousness with which the regulators and the courts, in Europe as well as the US, are now treating this issue.

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.

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