SECURITIES AND FUTURES REGULATORY UPDATE FINRA Publishes Debt Research Rule Proposal

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1 FEBRUARY 27, 2012 SECURITIES AND FUTURES REGULATORY UPDATE FINRA Publishes Debt Research Rule Proposal On February 17, 2012, the Financial Industry Regulatory Authority, Inc. ( FINRA ) published its debt research conflicts of interest proposal ( rule proposal or proposed rule ) in Regulatory Notice While the rule proposal addresses certain comments submitted in response to FINRA s March 2011 concept proposal on managing debt research conflicts of interest ( concept proposal ), 2 it maintains many of the core themes set forth in the concept proposal. In particular, the rule proposal incorporates many of the general prohibitions, restrictions and disclosure requirements applicable to equity research reports. 3 Of note, however, the scope of the rule proposal is broader than the equity research rules in certain respects, in that it addresses potential conflicts of interest and permissible communications between debt research analysts and sales and trading and principal trading personnel, in addition to investment banking personnel. The proposed rule text is included as Attachment A to Regulatory Notice Comments to Regulatory Notice must be submitted to FINRA no later than April 2, I. Structure and Overview of the Proposed Rule The proposed rule includes the following key provisions, which are further discussed in Section II: Definitions. Key terms used throughout the proposed rule (e.g., debt security and debt research analyst ) are set forth in paragraph (a) of the proposed rule. Minimum requirements for identifying and managing conflicts of interest in connection with debt research are set forth in paragraph (b) of the proposed rule. While many of these requirements echo those contained in the equity research rules, there are certain elements that are even more restrictive than the equity research rules. Certain content and disclosure requirements for debt research reports and public appearances by debt research analysts are set forth in paragraphs (c) and (d), respectively. Many of these are similar to the counterpart provisions in the equity research rules but with certain modifications intended to account for the different nature of the debt markets and debt research coverage. Other disclosure requirements. Paragraph (e) of the proposed rule reminds members that disclosure requirements imposed by other rules and regulations may also apply. 1 FINRA Regulatory Notice (Feb. 2012), available at 2 FINRA Regulatory Notice (Mar. 2011), available at 3 See, e.g., NASD Rule 2711 and NYSE Rule 472 (the equity research rules ). This Sidley update has been prepared by Sidley Austin LLP for informational purposes only and does not constitute legal advice. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers. Attorney Advertising - For purposes of compliance with New York State Bar rules, our headquarters are Sidley Austin LLP, 787 Seventh Avenue, New York, NY 10019, and One South Dearborn, Chicago, IL 60603, Prior results do not guarantee a similar outcome.

2 Page 2 Voluntary opt-out provision for institutional investors. Paragraph (f) of the proposed rule would allow certain institutional investors to opt-out of (versus opt-in to) many of the protections otherwise afforded by the proposed rule. Requirements related to the distribution of member and third-party debt research reports are contained in paragraphs (g) and (h) of the proposed rule. Exemption for firms with limited investment banking activity. Paragraph (i) provides an exemption from certain provisions of the proposed rule for firms with limited investment banking activity. Supplementary material. The proposed rule contains certain supplementary material intended to provide additional guidance on complying with the provisions of the proposed rule. II. Individual Provisions of the Proposed Rule Following is a summary of the proposed rule, including certain of our observations regarding instances in which the proposed rule may impose requirements different or more onerous than its equity research rule counterpart. A. Definitions Key terms defined in the proposed rule include: Debt security. The term debt security is proposed to be defined as any security other than an equity security, a treasury security, a municipal security, or a security-based swap, 4 as those terms are defined in the federal securities laws. 5 Given the breadth of the definition of equity security in Section 3(a)(11) of the Securities Exchange Act of 1934 ( Exchange Act ), we note that this could lead to the seemingly anomalous result that securities traditionally characterized as fixed income instruments e.g., preferred securities and certain asset-backed securities representing undivided interests in debt securities or other obligations would be subject to the equity research rules instead of the proposed debt research rule. Debt research report. The proposed definition of debt research report closely follows the counterpart definition in the equity research rules. Specifically, the term would be defined as any written (including electronic) communication that includes an analysis of debt securities and that provides information reasonably sufficient upon which to base an investment decision. The proposed definition would also include a carve out for communications excepted from the definition of research report in NASD Rule 2711, as applicable. Unlike the equity research report definition, however, the proposed definition does not include language requiring that the analysis relate to debt securities of individual companies or industries. Debt research analyst. The proposed rule would define a debt research analyst in a manner virtually identical to the counterpart definition under the equity research rules. Specifically, a debt research analyst would be defined as an associated person of the firm who is primarily responsible for, and any associated person of the firm who reports directly or indirectly to a debt research analyst in connection with, the preparation of the substance of a debt research report, whether or not any such person has the job title of research analyst. 4 The exemption of a security-based swap from the definition of debt security is due, FINRA explains in Regulatory Notice 12-09, to the growing, evolving nature of security-based swap regulation. Notwithstanding, firms should be aware that FINRA indicated it will continue to monitor developments with respect to security-based swaps and may later decide to include security-based swaps in the definition of debt security. 5 Notably, FINRA chose not to except various other financial instruments from the definition of debt security, including: (i) other non-equity securities that do not fall within the traditional notion of debt securities; (ii) agency securities; and (iii) foreign sovereign debt.

3 Page 3 Debt research analyst account. Similar to the equity research rules, a debt research analyst account is proposed to generally include any account in which a debt research analyst or member of his/her household has a financial interest, or over which the analyst has discretion or control. While the proposed definition also includes a carve out for registered investment companies and certain blind trusts, the definition would, unlike the equity research rules, attach certain conditions to the registered investment company carve out. Investment banking services. This term is proposed to be defined similar to the definition in the equity research rules. In addition to covering the types of services enumerated in the equity research rules definition of the term, however, it would also include a catch-all reference to otherwise acting in furtherance of a public or private offering of an issuer. This could potentially capture a variety of firm personnel engaged in activities not otherwise traditionally considered to involve investment banking services. Institutional investor. The proposed rule would define an institutional investor (relevant to determining those investors who are eligible to voluntarily opt-out of many of the proposed rule s protections, as discussed herein) by a reference to the definition of institutional account in FINRA Rule 4512(c). 6 FINRA specifically determined not to include accredited investors, as defined in Rule 501 of Regulation D of the Securities Act of 1933 (the Securities Act ), noting that the definition s monetary thresholds for entities and individuals are far too low. The rule proposal contains a variety of additional definitions including for investment banking department, member of a debt research analyst s household, public appearance, research department, and subject company that are generally comparable to the counterpart definitions in the equity research rules. B. Minimum Requirements for Identifying and Managing Conflicts of Interest The rule proposal s conflicts of interest protections predominantly are based on the conflicts safeguards set forth in the equity research rules, although they are presented in a somewhat more principles-based format and contain certain additional provisions directed at the different nature of the debt securities markets. Generally, the rule proposal would require firms to establish, maintain and enforce policies and procedures reasonably designed to identify and manage conflicts of interest related to: (i) the preparation, content and distribution of debt research reports; (ii) public appearances by debt research analysts; and (iii) the interaction between debt research analysts and those outside the research department, including investment banking, sales and trading and principal trading personnel, subject companies and investors. The proposed rule then sets forth various minimum requirements for such policies and procedures. Prepublication review. The rule proposal would require a firm s policies and procedures to prohibit the prepublication review, clearance or approval of debt research by the firm s investment banking, sales and trading or principal trading personnel. Unlike the equity research rules, this is an express prohibition with no exception for verifying factual accuracy or assistance in identifying potential conflicts. The proposed rule would also require a firm s policies and procedures to either restrict or prohibit review, clearance or approval of debt research by any other persons not directly responsible for the preparation, content and distribution of debt research reports, other than legal and compliance personnel. Yet another provision would prohibit prepublication review of a debt research report by the subject company, other than for verification of facts. Unlike the equity research rules, the proposed rule does not impose specific requirements as to whether or how any factual corrections stemming from the subject company review must be vetted through the firm s legal and compliance personnel. 6 The proposed definition would therefore generally include: (i) a bank, savings and loan association, insurance company or registered investment company; (ii) an investment adviser registered either with the Securities and Exchange Commission under Section 203 of the Investment Advisers Act of 1940 or with a state securities commission (or any agency or office performing like functions); and (iii) any other person (whether a natural person, corporation, partnership, trust or otherwise) with total assets of at least $50 million.

4 Page 4 Soliciting and marketing. With respect to soliciting and marketing investment banking transactions and services, the rule proposal would require a firm to restrict or limit activities by debt research analysts that can reasonably be expected to compromise their objectivity, including prohibiting the analyst from participating in (i) pitches and other solicitations of investment banking services transactions, and (ii) road shows and other marketing on behalf of issuers. The second prong of this prohibition is somewhat broader than the counterpart provision in the equity research rules (which speaks in terms of other marketing related to an investment banking transaction). As with the equity research rules, investment banking personnel also would be prohibited from directing a debt research analyst to engage in sales or marketing efforts, or communications with a current or prospective customer, related to an investment banking services transaction. Coverage. With respect to debt research coverage decisions, the rule proposal would require a firm to restrict or limit input by investment banking, sales and trading and principal trading personnel. All final decisions regarding debt research coverage would have to be made independently by research management. Budget. The rule proposal would require a firm to limit debt research department budget decisions to senior management personnel not engaged in investment banking services or principal trading activities, and without regard to specific revenues or results from such activities. By contrast, senior management would be permitted to consider firmwide revenues and results in making budgetary decisions. The proposed rule would also allow senior management to receive and consider input from any person, including those engaged in investment banking services or principal trading activities, regarding the demand for and quality of debt research, including product trends and customer interests. Notably, this proposed rule provision does not have a similar counterpart in the equity research rules. Supervision. Under the proposed rule, a firm s policies and procedures would need to be reasonably designed to (i) promote objective and reliable debt research that reflects the truly held opinions of debt research analysts, and (ii) prevent the use of debt research reports or debt research analysts to manipulate or condition the market in favor of the firm s, or one or more current or prospective customers, interests. Along these lines, such policies and procedures would need to prohibit supervision of debt research analysts by persons engaged in investment banking services transactions, principal trading activities or sales and trading. Furthermore, firms would have to establish information barriers or other institutional safeguards to insulate debt research analysts from review, pressure or oversight by persons engaged in investment banking or principal trading activities, or others who might be biased in their judgment or supervision. These proposed supervisory restrictions are considerably broader than the corresponding provisions in the equity research rules, which prohibit only investment banking department personnel from supervising equity research analysts. FINRA does not elaborate on what types of safeguards it believes firms could implement to meet the information barriers/institutional safeguards requirement. For example, it is unclear whether the chaperoning requirement in NASD Rule 2711, which requires written and oral communications between research and non-research personnel to be made through authorized legal or compliance personnel, would be an appropriate measure. The proposed rule s reference to insulating debt research analysts from review, pressure or oversight by others who might be biased in their judgment or supervision could present compliance challenges, given its subjective nature. It would also be helpful to clarify that the bias in question is one relating to the substance of an analyst s research report or public appearance. Compensation. The rule proposal would prohibit compensating debt research analysts based on specific investment banking services or trading transactions or contributions to the firm s investment banking services or principal trading activities. This compensation restriction is broader than the corresponding restriction in the equity research rules (the latter only prohibit equity research analyst compensation from being based on specific investment banking transactions). Similar to the equity research rules, the proposed rule also would require the annual review and approval of the compensation of a debt research analyst primarily responsible for the substance of a research report. The review would have to be performed by a committee that reports to the firm s board of directors or, if none, a senior executive

5 Page 5 officer. This compensation review committee would not be permitted to include representatives from the firm s investment banking personnel or principal trading personnel (we note that the prohibition against committee representatives from the firm s principal trading personnel does not appear in the equity research rule). The factors to be considered by the committee would be generally similar to those required for equity research analysts. The rule proposal would allow sales and trading personnel, but not principal trading personnel, to provide input to debt research management regarding the evaluation of a debt research analyst in order to convey customer feedback, so long as the final compensation decisions are made by research management. The committee also would have to document the basis upon which each such debt research analyst s compensation is established, including any input from sales and trading. Personal trading. The rule proposal would require a firm to restrict or limit trading by a debt research analyst account in securities, derivatives and funds whose performance is materially dependent on the performance of securities covered by the debt research analyst. This would include having to: i. ensure that debt research analyst accounts, supervisors of debt research analysts and associated persons with the ability to influence the content of debt research reports do not benefit in their trading from knowledge of the content or timing of a debt research report before the intended recipients of such debt research have had a reasonable opportunity to act on the information in the debt research report, and ii. prohibit a debt research analyst account from trading a security (or an option or derivative thereon/thereof) in a manner inconsistent with the analyst s most recently published recommendation for the security, except in circumstances of financial hardship, if any, which the firm must define. This principles-based standard appears to be broader than the corresponding restriction in the equity research rules, which limit trading by an equity research analyst in any security issued by a company that the research analyst follows, or any option on or derivative of such security. On the other hand, while the proposed rule requires any financial hardship exceptions to be defined, it does not impose any additional specific conditions akin to those attached to the exception in the equity research rules (e.g., no express requirement for authorization through legal and compliance; no specific recordkeeping requirement regarding exceptions). Retaliation for unfavorable research; promises of favorable research. The rule proposal would require a firm to prevent its employees from directly or indirectly retaliating, or threatening to retaliate, against debt research analysts in connection with an unfavorable debt research report or public appearance that may adversely affect the firm s present or prospective business interests. The reference to unfavorable research that may adversely affect the firm s business interests is substantially broader than the counterpart language in the equity research rules, which focuses on adverse affects to the firm s present or prospective investment banking relationship with the subject company. The rule proposal also does not include a clarifying sentence that appears in the equity research rules and that emphasizes a member firm s continued ability to terminate or discipline analysts for reasons unrelated to a negative report. This broad language, especially when coupled with the absence of the clarifying language, could create challenges for a firm s human resources department. As with the equity research rules, the proposed rule also would prohibit explicit or implicit promises of favorable debt research or a specific debt research rating, recommendation or content as inducement for the receipt of business or compensation. Finally, the restriction against retaliation would apply to all firm employees and thus, as with the other provisions in the rule proposal, would capture sales and trading and principal trading personnel in addition to investment banking personnel. C. Content and Disclosures in Debt Research Reports and Public Appearances The proposed rule would impose content and disclosure requirements substantially comparable to those contained in the equity research rules. In light of the unique characteristics of the debt market, however, there are a few differences worth noting. In addition, and as further discussed in Section II.D, the rule proposal would allow institutional investors to opt-out of many of the protections afforded by these content and disclosure requirements.

6 Page 6 Ratings and recommendations. The rule proposal would require all purported facts, recommendations and ratings in a debt research report to have a reasonable basis, and any recommendation or rating to be accompanied by a clear explanation of the valuation method used and to fairly present the risks that may impede achievement of the recommendation or rating. If a firm were to use a rating system in a debt research report, it would have to clearly define the meaning of each rating, including the time horizon and any benchmark, and such definition would have to be consistent with its plain meaning. Similar to the equity research rules, a firm that includes a rating in a debt research report would also have to include the percentage of all securities (not just debt securities) rated by the firm to which it would assign a buy, hold or sell rating, and would have to disclose the percentage of subject companies within each of the buy, hold and sell categories for which the firm has provided investment banking services within the past 12 months. Also like the equity research rules, the proposed rule would require the foregoing information to be current as of the end of the most recent calendar quarter, or the second most recent calendar quarter if the publication date of the debt research report is less than 15 days after the most recent calendar quarter. If a firm has rated a debt security for at least one year, the firm would have to disclose in the debt research report all ratings previously assigned to that security by the firm, and the date on which each rating was assigned. 7 Conflicts of interest disclosures. The rule proposal would require a firm to disclose in debt research reports all conflicts that reasonably could be expected to influence the objectivity of the debt research report and that are known or should have been known by the firm or debt research analyst on the date of publication or distribution of the report. Specifically, the rule proposal would require disclosure if: (i) the debt research analyst or a member of his/her household has a financial interest in the debt or equity securities of the subject company (and if so, the nature of such financial interest); (ii) the debt research analyst has received compensation based upon, among other factors, the firm s investment banking or sales and trading revenues; or (iii) the firm or any of its affiliates managed or co-managed a public offering of securities for the subject company in the past 12 months, received compensation for investment banking services from the subject company in the past 12 months, or expects to receive or intends to seek compensation for investment banking services from the subject company in the next three months. The rule proposal also would require disclosure if, as of the end of the month immediately preceding the date of publication or distribution of a debt research report, the firm or its affiliates has received compensation for any noninvestment banking products or services in the past 12 months. 8 Additionally, the rule proposal would require disclosure if the subject company is, or has been over the 12 month period prior to the publication or distribution of a debt research report, a client of the firm and, if so, the services provided to the subject company. Similar to the requirement in the equity research rules that a firm disclose its market making activity with respect to the subject company of an equity research report, the rule proposal would require disclosure if the firm trades or may trade as principal in the debt securities, or related derivatives, discussed in the debt research report. A firm also would have to disclose if the debt research analyst received compensation from the subject company in the past 12 months. Furthermore, the rule proposal contains a catch-all provision that would require disclosure of any other material conflict of interest of the debt research analyst or firm that the debt research analyst, or an associated person of the firm with the ability to influence the content of a debt research report, knows or has reason to know 9 at the time of publication or distribution of a debt research report. FINRA states in Regulatory Notice that the knows or has 7 Unlike the equity research rules, however, the proposed rule would not require the debt security ratings to be plotted on a price chart. 8 Notwithstanding, and similar to the equity research rules, the rule proposal includes supplementary material that allows firms to meet this requirement with respect to affiliates by implementing policies and procedures reasonably designed to prevent debt research analysts, and associated persons able to influence the content of debt research reports, from receiving information about noninvestment banking compensation received by firm affiliates (unless such persons have actual knowledge of such receipt). 9 Similar to the equity research rules, this reason to know standard requires disclosure of conflicts that should be reasonably discovered in the ordinary course of business, and does not impose a duty of inquiry on the debt analyst or others who can influence the debt research report content.

7 Page 7 reason to know standard would provide a firm with the choice to wall off the debt research analysts and persons who can influence debt research report content instead of tracking and disclosing such material conflicts of interest. Finally, and similar to the equity research rules, the rule proposal includes a provision emphasizing that a disclosure would not be required to the extent it would reveal material non-public information regarding specific potential future investment banking transactions of the subject company. Public appearances. The rule proposal would require a debt analyst to provide, in public appearances, disclosures generally comparable to those required by the equity research rules (i.e., if the debt research analyst or a member of his/her household has a financial interest in the debt or equity securities of the subject company (and if so, the nature of such interest); if the analyst received any compensation from the subject company in the previous 12 months; if, to the extent the analyst knows or has reason to know, the member or any affiliate received any compensation from the subject company in the previous 12 months or the subject company currently is (or during the 12-month period preceding the date of publication or distribution of the debt research report, was) a client of the member; and any other material conflict of interest of the analyst or member that the analyst knows or has reason to know at the time of the public appearance). While the proposed requirements generally follow the counterpart requirements in the equity research rules, we note that, instead of requiring disclosure of the firm s holdings of the equity of the subject company, the proposed rule would apply the aforementioned catch-all provision to debt research analysts in public appearances. Additional disclosures. The proposed rule includes a provision reminding firms that their obligations concerning debt research report disclosures are not limited to those set forth in the proposed rule. Specifically, the rule proposal explicitly would require firms and their debt research analysts to comply with all other applicable disclosure provisions, including those in NASD Rule 2210 and the federal securities laws. D. Exemption for Debt Research Disseminated Exclusively to Institutional Investors As previously noted, the proposed rule takes a tiered approach to the regulation of debt research, based on whether the research is distributed to retail investors or institutional investors. A major implication of this tiered approach would be that many of the foregoing requirements applicable to retail debt research recipients may not be applicable to debt research provided solely to institutional investors, to the extent such institutional investors affirmatively elect to opt-out of the protections. 10 This is a significant divergence from FINRA s approach to equity research. Under the proposed rule, an institutional investor that wishes to receive institutional debt research without being afforded the full panoply of protections provided to retail investors would have to affirmatively notify a firm in writing of such election to receive institutional debt research (i.e., debt research disseminated solely to institutional investors). Even in the case of firms whose institutional clients have made such an election, certain of the proposed rule s provisions would continue to apply, including, for example: i. the prohibition and restrictions on prepublication review of debt research reports by investment banking personnel and subject companies; ii. the prohibitions on debt research analysts participating in pitches and other solicitations of investment banking services transactions, road shows and other marketing on behalf of issuers and on investment banking personnel directly or indirectly directing a debt research analyst to engage in sales and marketing efforts, or to communicate with a current or prospective customer, related to an investment banking deal; and 10 This opt-out requirement is the opposite of what was suggested in the concept proposal, which provided that institutional investors would need to opt-in to being treated as a retail investors (and thus afforded the full protections of the proposed rule). FINRA indicates in Regulatory Notice that this change is based on its recognition that not all institutional investors have equal sophistication, that some may want the additional protections, and that it is more appropriate for investors to not have to take additional steps to receive the additional protections.

8 Page 8 iii. the prohibitions on retaliation against debt research analysts and on promises of favorable debt research, a particular debt research rating or recommendation or specific debt research content as an inducement for the receipt of business or compensation. Furthermore, although the rule proposal would not require the same disclosures applicable to debt research distributed to retail investors (discussed above) to be included in debt research distributed to institutional investors, it would require that such research prominently display the following specific health warning disclosures on the first page of the report: i. This research report is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors; ii. iii. If applicable, The views expressed in this report may differ from the views offered in [Firm s] debt research reports prepared for retail investors; and If applicable, This report may not be independent of [Firm s] proprietary interests. [Firm] trades the securities covered in this report for its own account and on a discretionary basis on behalf of certain clients. Such trading interests may be contrary to the recommendation(s) offered in this report. Additionally, the rule proposal would require firms to establish, maintain and enforce policies and procedures reasonably designed to ensure that institutional debt research is made available only to eligible institutional investors and would prohibit firms from relying on the exemption for debt research distributed to institutional investors if the firm has reason to believe the debt research report will be redistributed to a retail investor. FINRA notes that this latter requirement would require a firm to discontinue distribution of institutional-only debt research to a party it has reason to believe is redistributing such research to a retail investor, until the firm reasonably concludes that measures have been taken to prevent future redistribution. Towards this end, member firms may want to consider adopting certain protocols for institutional-only research, including, for example, entering into a formal agreement with institutional investors that prohibits them from redistributing the firm s debt research reports. E. Distribution of Research Reports The rule proposal would require firms to establish, maintain and enforce policies and procedures reasonably designed to ensure that a debt research report is not distributed selectively to trading personnel, or a particular customer or class of customers, in advance of other customers that are entitled to receive the debt research report. The proposed rule s restriction on selective/early distribution to the firm s trading personnel is similar to the trading ahead restrictions in FINRA Rule However, the proposed rule also would restrict distribution to certain customers ahead of other customers, which does not have an explicit corresponding requirement in the equity research rules. 11 The supplementary material in the rule proposal clarifies that this requirement would not prohibit a firm from offering different debt research products and services to certain classes of customers, provided that the differentiation is not based on the timing of receipt of recommendations, ratings or other potential market-moving information. Notwithstanding, the rule proposal would require firms to take care to avoid unfairly discriminating among customers in connection with the distribution of debt research reports. With respect to the distribution of third-party debt research reports, the rule proposal generally would adopt the same standards applicable to third-party equity research reports, including maintaining the distinction between independent and non-independent third-party research. Specifically, for non-independent third-party research, firms would be 11 In its proposal of a consolidated equity research rule, FINRA proposed to add a similar restriction to equity research reports. However, this consolidated rule was never adopted. See FINRA Regulatory Notice (Oct. 2008), available at Notwithstanding, in light of the recent settlement between the Commonwealth of Massachusetts and Goldman Sachs Group, Inc., concerning Goldman s huddles and earlier dissemination of information to favored clients, Securities and Exchange Commission and FINRA regulators are generally concerned with this practice and may seek enforcement against such practice under a more general conduct rule.

9 Page 9 required to review such research to ensure it is reliable and objective, contains complete and accurate disclosures, contains no untrue statement of material fact, and is not otherwise false or misleading. Furthermore, firms would have to accompany any non-independent third-party research it distributes, or to which it directs a recipient, with disclosures of any material conflicts of interest that can reasonably be expected to have influenced the choice of a third-party debt research report provider or the subject company of a third-party debt research report. Such disclosures would not, however, be required for independent third-party research that the firm made available (as opposed to distributed ). Finally, the rule proposal would require that third-party research be clearly labeled as such. F. Exemption for Firms with Limited Investment Banking Activity Similar to the equity research rules, the rule proposal would exempt from certain of the supervision and compensation requirements firms that, over the past three years, on average per year, have participated in no more than 10 investment banking services transactions as a manager or co-manager and generated no more than $5 million in gross investment banking revenues from those transactions. FINRA explicitly seeks comments on whether there is a more appropriate metric for this exemption in the debt research context. G. Supplementary Material The proposed rule contains supplementary material, which provides further guidance on many of the provisions. Information barriers between research analysts and trading desk personnel. The proposed supplementary materials includes various examples of communications that would be permissible, and communications that would be prohibited, between debt research analysts and sales and trading personnel. These communications firewalls would be unique to debt research, and have no corresponding requirement in the equity research rules. For example, the proposed supplementary material would provide that: i. Sales and trading and principal trading personnel may communicate customers interests to a debt research analyst, so long as the debt research analyst does not respond by publishing debt research for the purpose of benefiting the trading position of the firm, a customer or a class of customers; and ii. Debt research analysts may provide customized analysis, recommendations or trade ideas to sales and trading and principal trading personnel and customers, provided that any such communications are not inconsistent with the analyst s currently published or pending debt research, and that any subsequently published debt research is not for the purpose of benefiting the trading position of the firm, a customer or a class of customers. The intent of these examples is to demonstrate communications that do not inherently involve the prepublication review, clearance or approval of debt research by sales and trading and principal trading personnel. Such personnel would continue to be prohibited from prepublication review, clearance or approval of debt research, as discussed above. Additionally, the proposed supplementary material would provide examples of the types of communications generally prohibited, including: i. Sales and trading and principal trading personnel attempting to influence a debt research analyst s opinion or views for the purposes of benefiting the trading position of the firm, a customer or a class of customers, and ii. Debt research analysts identifying or recommending specific potential trading transactions to sales and trading or principal trading personnel that are inconsistent with the debt research analyst s currently published debt research report and from disclosing the timing of, or material investment conclusions in, a pending debt research report. Other provisions. In addition to the provisions discussed above, the supplementary material addresses, among other things, information that would be prohibited in pitch materials, restrictions on communications with customers and internal personnel, and what it would mean to have the ability to influence the content of a research report.

10 Page 10 III. Additional Observations and Potential Compliance Concerns The rule proposal raises a number of potential concerns for FINRA member firms, in addition to those already discussed. For example, the tiered approach to debt research regulation may require firms to create and maintain two different sets of reports and disclosures, which may create additional complexities and compliance burdens for firms distributing a range of products aimed at different customers. Additionally, in light of FINRA s rationale for changing from an opt-in to opt-out position with respect to institutional investors, firms may wish to draft a standard opt-out form that their institutional customers could use to clearly acknowledge that they are choosing to forego the additional protections under the proposed rule afforded to retail customers. Furthermore, although such conduct is not explicitly prohibited by the proposed rule itself, it likely may raise concerns with FINRA if firms pressure or incentivize institutional customers to opt-out of the additional protections of the proposed rule. Concerning the conflicts of interest disclosures, the rule proposal contains some notable differences from the equity research rules. For example, the rule proposal does not include a blackout period similar to NASD Rule 2711(f), which places restrictions on a firm s publication and distribution of equity research reports and public appearances concerning a subject company for which the firm acted as manager or co-manager of an initial public offering. This is likely due to the differences between the debt and equity markets, including lower liquidity among debt securities, which thereby decreases the concern of price manipulation from booster shot research reports, and lower likelihood of lock-up agreements in debt offerings. Additionally, unlike the equity research rules (and unlike the concept proposal), the rule proposal would not require a firm to disclose if it or its affiliates beneficially own 1% or more of any class of debt securities of the subject company. FINRA states in Regulatory Notice that it determined not include this requirement, given commenters concerns about the hardship of tracking such ownership, and in order to sharpen the focus of when disclosure is necessary. Finally, the rule proposal would not require disclosure concerning a firm s intent to terminate coverage in a debt security, which is required by the equity research rules (and was also suggested by the concept proposal). FINRA notes in Regulatory Notice that such disclosure may be overly burdensome to firms relative to its investor protection value. The rule proposal may also have implications on other FINRA rules. For example, NASD Rule 1050, which establishes qualification requirements for research analysts, is currently limited to NASD Rule 2711 and equity research personnel. If the proposed rule is adopted, NASD Rule 1050 would presumably need to be expanded to incorporate debt research personnel, and thus qualification requirements, including examinations, for debt research analysts and their supervisors may be forthcoming. Additionally, the definition of sales literature in NASD Rule 2210(a)(2) includes any research report, and thus, upon adoption of the rule proposal, would presumably include a debt research report, at least unless such report is distributed solely to institutional investors who opt-out of being treated as retail investors. By contrast, research distributed exclusively to institutional investors who have opted out of the retail protections presumably should instead constitute institutional sales material 12 under NASD Rule 2211(a)(2), and thus be excluded from the definition of sales literature. Sales literature under NASD Rule 2210 (including research reports ), but not institutional sales material under NASD Rule 2211, is subject to principal pre-approval. Both sales literature and institutional sales material, however, are subject to the fairness and content requirements of NASD Rule 2210(d)(1) and the spot-check requirements of NASD Rule A significant implication is that a debt research report, as a sales literature under NASD Rule 2210(a)(2), would be subject to a general prohibition against using projections or forecasts under NASD Rule 2210(d)(1)(D) (unless it fits within FINRA s investment analysis tool guidance under NASD IM ), as would, presumably, research that is provided solely to institutional investors who have opted-out of being treated as 12 NASD Rule 2211(a)(2) defines institutional sales material as any communication that is distributed or made available only to institutional investors.

11 Page 11 retail investors and thereby constitutes institutional sales material under NASD Rule In this regard, Regulatory Notice states that trader commentary could be included in the scope of the debt research report definition. Finally, while the rule proposal is based heavily on the current equity research rules, FINRA has not yet adopted a consolidated rule to replace these rules. As previously noted, the rule proposal contains many provisions substantially similar to the equity research rules, but the actual language of the proposed rule diverges from the equity research rules in certain ways that would not appear to be fully explained by the inherent differences between debt and equity securities, or research related thereto. These disparities may serve to foretell what we can expect from FINRA s final, consolidated equity research rule proposal. IV. Request for Comment FINRA is soliciting comments on all aspects of the proposed rule. Comments should be submitted on or before April 2, If you have any questions regarding the proposed rule, or if you require assistance in preparing a comment letter, please contact any of the Sidley lawyers identified below or the Sidley lawyer with whom you usually work: Jamie Brigagliano jbrigagliano@sidley.com David Katz dkatz@sidley.com Barbara Endres bendres@sidley.com The Securities and Futures Regulatory Practice of Sidley Austin LLP Sidley Austin LLP has one of the nation's premier securities and futures regulatory practices, with more than 50 lawyers spanning Sidley offices in the United States, Europe and Asia. Lawyers in this practice group represent major investment banks, broker-dealers, futures commission merchants, commercial banks, insurance companies, hedge funds complexes, alternative trading systems and ECNs, and exchanges, both domestic and foreign. Drawing from its breadth and depth, Sidley's Securities and Futures Regulatory group handles a wide spectrum of matters assisting clients with the formation of their businesses; counseling on general compliance, proposed laws and regulations, and regulatory trends; representing clients on securities and derivatives transactions; and defending firms in regulatory inquiries and enforcement proceedings. To receive future copies of this and other Sidley updates via , please sign up at BEIJING BRUSSELS CHICAGO DALLAS FRANKFURT GENEVA HONG KONG HOUSTON LONDON LOS ANGELES NEW YORK PALO ALTO SAN FRANCISCO SHANGHAI SINGAPORE SYDNEY TOKYO WASHINGTON, D.C. Sidley Austin LLP, a Delaware limited liability partnership which operates at the firm s offices other than Chicago, New York, Los Angeles, San Francisco, Palo Alto, Dallas, London, Hong Kong, Houston, Singapore and Sydney, is affiliated with other partnerships, including Sidley Austin LLP, an Illinois limited liability partnership (Chicago); Sidley Austin (NY) LLP, a Delaware limited liability partnership (New York); Sidley Austin (CA) LLP, a Delaware limited liability partnership (Los Angeles, San Francisco, Palo Alto); Sidley Austin (TX) LLP, a Delaware limited liability partnership (Dallas, Houston); Sidley Austin LLP, a separate Delaware limited liability partnership (London); Sidley Austin LLP, a separate Delaware limited liability partnership (Singapore); Sidley Austin, a New York general partnership (Hong Kong); Sidley Austin, a Delaware general partnership of registered foreign lawyers restricted to practicing foreign law (Sydney); and Sidley Austin Nishikawa Foreign Law Joint Enterprise (Tokyo). The affiliated partnerships are referred to herein collectively as Sidley Austin, Sidley, or the firm.