The Jumpstart Our Business Startups Act of 2012 (the JOBS Act) brings back into the spotlight "sell-side research"--which was turned into a four-letter word by former New York State Attorney General Eliot Spitzer back in the early 2000s. This time, however, it is not the alleged evils of research, but rather the desire to make research available to more investors and during those periods when information regarding a company is most in demand that is the rallying cry.
This renewed interest in research availability was prompted by a task force (the Task Force) that was formed in mid-2011 following the U.S. Treasury Department's "Access to Capital Conference." The Task Force, which was comprised of a group of venture capitalists, CEOs, public investors, securities lawyers, academics, and investment bankers, studied the market for initial public offerings (IPOs) over various periods in order to determine the relationship between IPO volume and job growth and concluded that the decline in the number of IPOs in recent years resulted in considerable job loss and damage to the American economy. Their recommendations to increase U.S. job creation and overall economic growth are embodied in a report, Rebuilding the IPO On-Ramp, which was issued and presented to the U.S. Treasury Department on October 20, 2011 (the IPO Task Force Report). At the heart of the Task Force's conclusions is the notion that the cumulative effect of various regulatory actions has made it more difficult and costly for emerging growth companies (EGCs) to access capital via the public market, thereby reducing opportunities for innovation and job creation. The IPO Task Force Report serves as the base for much of what later became Title I of the JOBS Act.
Among the factors identified by the Task Force as having a negative impact on the ability of EGCs to successfully go public is the limited information about such companies available to prospective investors. The Task Force noted that the Global Research Analyst Settlement entered into between certain large investment banking firms and several regulators in 2003 (the Global Settlement) increased the stress already placed on the economic viability of sell-side research departments by decimalization and other market forces and caused sell-side analysts to shift "their attention to the high volume, high-liquidity large-cap stocks that now drive revenues for their institutions and provide the basis for their compensation." This shift, the Task Force concluded, "resulted in less research coverage of emerging growth companies and thus less transparency and visibility into emerging growth companies for investors." To correct this informational imbalance, the Task Force recommended that various changes be made to the existing rules regarding the issuance of research reports and communications by research analysts, including the elimination of unnecessary research quiet periods and other constraints on analyst communications around the time of an IPO. These recommendations, however, were made against the backdrop of the existing regulatory framework for research and with the acknowledgment that the "extensive and robust nature" of the substantive regulations already in place warranted further changes to allow greater research coverage without sacrificing appropriate investor protections.
What the JOBS Act Does
Incorporating the Task Force's suggestions regarding research, the JOBS Act prohibits the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority, Inc. (FINRA), from adopting or maintaining any rule or regulation in connection with an IPO of an EGC that:
- restricts based on "functional role" which employees of a broker-dealer may arrange for communications between research analysts and prospective investors;
- prohibits research analysts from participating in communications with company management in the presence of non-research personnel (including, e.g., investment banking and sales force personnel); or
- prohibits the publication or distribution of a research report or making of a public appearance within any prescribed period of time either (1) following the effective date of the EGC's IPO, or (2) prior to the expiration date of a company or shareholder lock-up agreement.
As a result of the foregoing, the JOBS Act effectively supersedes current FINRA rules that impose research quiet periods during the 40 days (or, for participating firms other than managers and co-managers, the 25 days) immediately following an IPO, as well as during the 15 days preceding the expiration of a company or shareholder lock-up agreement with the underwriters. The JOBS Act also appears to override a FINRA interpretation expressed in Notice to Members 05-34 that prevented research analysts from participating in communications with internal sales personnel in the presence of company management, as well as other FINRA guidance that was generally viewed as restricting the ability of research analysts to participate in communications (other than for offering-related due diligence purposes) with company management in the presence of investment banking personnel.
What the JOBS Act Does Not Do
There are, however, a number of important caveats. The JOBS Act only impacts SEC and FINRA rules to the extent they apply in respect of an IPO by an EGC. That means it doesn't impact those rules that relate to IPOs by companies that do not satisfy the EGC criteria, nor does it impact rules relating to secondary or follow-on offerings by EGCs or other issuers.
Moreover, the JOBS Act does not by its terms override other FINRA restrictions adopted in response to the tech boom scandal that erupted in the late 1990s and was alleged to have resulted from growing conflicts of interest between investment banking and research personnel. These restrictions include provisions that prohibit:
- research analysts from participating in efforts to solicit investment banking business or in investment banking-related road shows;
- investment banking personnel from directing analysts to engage in sales or marketing efforts, or in communications with investors, regarding an investment banking transaction;
- research analysts from engaging in communications with investors in the presence of company management or investment banking personnel;
- non-research personnel (other than legal and compliance staff) from reviewing or approving a research report prior to its publication except (under certain circumstances) to verify certain information for factual accuracy;
- member firms from directly or indirectly promising favorable research coverage, or threatening unfavorable research coverage, as consideration for the receipt of investment banking business; and
- the involvement of investment banking personnel and investment banking considerations in connection with the supervision, control, evaluation and compensation of research analysts.
The JOBS Act also has no impact on SEC Regulation AC, which was adopted in 2003 and requires research analysts to include in their research reports (1) a certification that the views expressed in the reports accurately reflect their personal views about the subject securities or subject issuers, and (2) disclosure as to whether they were compensated in connection with the specific recommendations or views expressed in the reports.
Similarly the JOBS Act does not supersede the provisions of the Sarbanes-Oxley Act of 2002 that directed the regulators to adopt certain rules to prevent conflicts of interest between investment banking personnel and research analysts (provisions that are now embodied in the existing FINRA research rules). In particular, Section 501(a)(3) of the Sarbanes-Oxley Act required the adoption of rules pursuant to which broker-dealers must establish internal safeguards to assure that research analysts are separated by appropriate informational barriers from "the review, pressure, or oversight of those whose involvement in investment banking activities might potentially bias their judgment or supervision." Section 501(a)(2) of the Sarbanes-Oxley Act also mandated the adoption of rules that would "define the periods during which [broker-dealers] that have participated, or are to participate, in a public offering of securities as underwriters or dealers should refrain from publishing or distributing research reports relating to such securities or the issuer of those securities." Notably, however, this provision did not include any specific time periods or category of issuers to which such rules would apply; thereby allowing for considerable flexibility in implementation.
Finally, the JOBS Act has no impact on the remaining provisions of the Global Settlement (which was substantially amended in March 2010 to remove various requirements, including those largely subsumed in existing FINRA rules). Indeed, the Global Settlement may only be modified by court order or the adoption by the SEC or FINRA of a rule or interpretation that is expressly intended to supersede a particular provision or provisions of the settlement.
Nonetheless, it remains to be seen whether the JOBS Act will prompt the SEC and/or FINRA to make further revisions to their respective rules and interpretations (or to support a request for court modification of the Global Settlement) in order to address the JOBS Act's implicit desire that the production of research and the ability of research analysts to engage in communications with prospective investors and company management not be artificially and unnecessarily constrained. (It does appear somewhat anomalous, however, that there are now fewer restrictions relating to research coverage on EGCs than there are in respect of the largest and most widely followed companies.)
Interestingly, a comprehensive review of the research rules by the SEC and FINRA is already underway as a result of FINRA's ongoing efforts to consolidate the former NASD and NYSE equity research rules (respectively, NASD Rule 2711 and NYSE Rule 472) into a new FINRA-denominated rule (proposed FINRA Rule 2240), as well as by the issuance in January 2012 of the GAO's report on Securities Research, which was mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Thus, the door to additional change appears to be open.
One thing, however, is certain. The JOBS Act acknowledges that research is not inherently bad and, indeed, if used properly may be a force for good. The challenge for our regulators lies in creating appropriate incentives for sell-side firms to expend resources to cover EGCs in the same manner as they cover larger companies while maintaining requirements designed to enhance investor protection and remove improper influences that could erode the continued utility and independence of research analysts.