In March 2004, the SEC approved the new NASD research analyst qualification and examination requirements that were required in the May 2002 NASD Rule 2711 on Research Analysts and Research Reports. These requirements cause all research analysts to pass a series of three NASD examinations in order to continue to function in their newly regulated position. The series 86 exam tests skills in economic and financial analysis. Analysts who had proven their competency by recently passing level II of the Chartered Financial Analysts or the Chartered Market Technicians exam are exempt from the series 86 exam. All prospective analysts must also pass the series 87 exam, which tests the analyst's knowledge of the new regulations regarding the conduct of research analysts. Finally, all analysts must also pass the series 7 exam for registered representatives, which is required for most salespeople in the securities industry. Additionally, those who supervise research analysts must have passed the series 24 and the series 87 exams.
Once research analysts are qualified through these exams, they must maintain registration through their brokerage firm, where they are required to submit to the continued compliance oversight of the firm to ensure that analysts have no material conflicts of interest. General requirements include a documentation of trading activity, to confirm that the analyst is not trading securities in a manner contrary to their recommendations or to profit from the release of their reports, or that they are not receiving initial public offering (IPO) shares in compensation for their opinions. The role of the analyst is also separated from the investment banking function, as analysts typically cannot influence customers during an investment sales presentation or have a variable portion of their compensation determined by investment banking personnel.
While many market participants believe that only sell-side equity analysts are required to register as research analysts, recent interpretations by regulators strongly imply that the statutes also require many others to register, including those involved in the preparation of research reports describing investments in private placement hedge fund products that are exempt from SEC registration under rule 506, Regulation D of the Securities Act of 1933.
The term research analyst is being applied very broadly, as an SEC interpretation states that:
… a client communication that analyzes individual securities … will be considered a research report if it provides information reasonably sufficient to reach an investment recommendation and is distributed to at least 15 persons. This conclusion applies even if the author of the communication does not hold the title of “research analyst” and does not work in the [NASD] member's research department1.
As noted in an example below, the terms “reasonably sufficient” are being interpreted in a very broad fashion so as to potentially capture what would normally be thought of as sales literature or client communications.
The background for these research analyst regulations were derived from the excesses of the late 1990s, where the public opinions of research analysts differed from their private opinions and trading activity. Other abuses included the spinning of IPO shares, providing large allocations to individuals with the expectation of winning future investment banking business, such as the CEO or CFO of a company expected to float their own IPO in coming months. The regulators were also concerned with the role of the analyst in the IPO process; where there may have been a promise of favorable analyst coverage should the analyst's firm earn the IPO mandate.
Essentially, the regulations divide the research process from the investment banking process. Research analysts may not participate in investment banking fees. Communications between research analysts and investment bankers is extremely limited.
NASD Rule 2711(a)(8) states that: “Research reports” are reports which “include an analysis of equity securities of individual companies or industries, and that provide information reasonably sufficient upon which to base an investment decision.” Thus, the key elements of a research report are “analysis” about securities of “individual companies” and “information reasonably sufficient upon which to base an investment decision.”
One might reasonably assume this was meant to cover equity securities and not meant to cover private offerings like hedge funds. However, such assumptions are not correct. In conversations with senior...