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Client Update: ASIC sell-side research consultation and proposed regulatory guidance

4 July 2017

In brief: ASIC's new regulatory guidance focuses on managing conflicts of interest and material, non-public information when providing sell-side research. As well as providing extensive guidance on managing conflicts of interest during the capital raising process, ASIC provides its views on payment of discretionary fees, and the funding and structure of the research arm of banks, as well as foreshadowing a further view on allocation policies. Partner Julian Donnan (view CV) and Senior Associate Addison Ma report.

Background

On 30 June 2017, ASIC commenced consultation on its proposed guidance on sell-side research under ASIC Consultation Paper 290: Sell-side research (CP 290). The proposals under CP 290 are designed to supplement ASIC Regulatory Guide 79: Research report providers: Improving the quality of investment research (RG 79) which was last updated in December 2012.

The consultation and proposed guidance follows ASIC's review between September 2014 and June 2016 of the policies, procedures and practices of a range of Australian financial services licensees who were engaged in research and corporate advisory in Australia, the results of which were published in ASIC Report 486: Sell-side research and corporate advisory: Confidential information and conflicts (REP 486) in August 2016.

REP 486 highlighted that a number of licensees did not have appropriate arrangements to manage the situations where staff came into possession of material, non-public information (MNPI) and inconsistent practices that indicated a lack of research independence and an absence of separation between research and corporate advisory activities. 

The proposed guidance is designed to assist licensees who provide research and corporate advisory services to comply with their general obligations under the Corporations Act 2001 (Cth) to manage conflicts of interest and handle MNPI.

The proposed guidance focuses on sell-side research, being general financial advice and research prepared and distributed by a licensee to its clients (or potential clients) to help them make investment decisions about financial products, and the guidance broadly covers the following areas:

  • Research analysts and MNPI
  • Managing research conflicts during the capital raising process
  • Structure and funding of research

Research analysts and MNPI

Research analysts are in constant receipt of information from a variety of sources. It is important for research analysts to be able to identify whether such information is MNPI and how to manage such information and not pass on such information to other parts of the licensee. This not only protects the licensee but also their listed clients, given their continuous disclosure and inside information obligations under the Corporations Act.

For the purposes of ASIC's guidance, MNPI is taken to mean 'inside information' as defined in section 1042A of the Corporations Act.1

With respect to MNPI, ASIC have proposed a number of guidelines and recommendations for licensees to implement including:

  1. specific policies, procedures and training that help staff to identify, verify and manage MNPI;
  2. specific approval and review processes that identify any material changes to sell-side research;
  3. practices for managing requests for a research analyst's model, including requests that are made by other teams of the licensee;
  4. wall-crossing practices and robust physical and electronic information barriers;
  5. the requirement for a research analyst declaration or certification; and
  6. a review process by compliance or another control function to identify and review certain communications and material changes to research.

Managing research conflicts during the capital raising process

Pre-prospectus investor education has been a common activity undertaken on most recent IPOs aiding price discovery but there are potential conflict issues between the research team and the corporate advisory team throughout the course of a capital raising transaction (from the pre-mandate phases all the way through to stock allocation) that ASIC have identified and have sought to provide guidance on.

ASIC guidance on research conflicts cover the four following stages:

  1. Pre-solicitation – independent of pursuing a capital raising transaction, the period where a company may meet with a licensee's corporate advisory and research team to have a general discussion about the company's operations, growth plans and capital requirements.
  2. Transaction vetting – the period where a licensee is internally determining whether it should submit a proposal for a mandate.
  3. Transaction pitching – the period where a licensee is pitching or seeking a mandate for a capital raising transaction.
  4. Post-mandate period – the period where licensees have been mandated and work is done on the transaction (including preparation of offer documents, due diligence, marketing, allocation of shares to investors).

ASIC's guidelines on managing research conflicts for the first three stages (effectively, the pre-mandate phases) are set out below:

Phase Guidelines
Pre-solicitation
  1. For genuine pre-solicitation discussions, representatives from various parts of the licensee may attend.
  2. Licensees should not commit to provide research coverage on the company.
  3. There should be no discussion of valuation information by research analysts or by others when research analysts are present.
  4. If there is any discussion that is to involve MNPI or a capital raising transaction, staff from the public side of the licensee should leave the meeting.
  5. If, however, MNPI has already been discussed or staff from the public side of the licensee obtain MNPI they should follow the internal protocols for the management of MNPI.
  6. Research analysts should maintain a written record of any pre-solicitation meetings.
  7. Compliance or another control function should undertake periodic reviews to determine the effectiveness of the licensee's arrangements.
Transaction vetting
  1. Research and corporate advisory may interact during the transaction vetting process; however, they should not be aware of each other's opinions on valuation information or unpublished research analyst models.
  2. Corporate advisory should not place pressure on research or otherwise seek to influence research.
  3. Research should not provide feedback on valuation information during the transaction vetting process in internal discussions or meetings with the licensee's corporate advisory staff.
  4. If research staff obtain MNPI during the transaction vetting process they should follow the licensee's internal protocols for the management of MNPI.
  5. Compliance or another control function should be aware of and monitor transaction vetting to ensure that the licensee's policies and procedures are being adhered to.
  6. Compliance or another control function should undertake periodic reviews to determine the effectiveness of the licensee's arrangements.
  7. Research analysts should not interact directly with the issuing company.
  8. Any communication between the research analyst and the issuing company should be passed through compliance or another control function.
  9. Research analysts may forward questions to compliance or another control function, which will then submit them to the issuing company. The research analyst may respond to any subsequent questions from the issuing company that relate to the research analyst's queries, but may not respond to any other questions.
Transaction pitching
  1. Research should not communicate with or discuss the company or the potential transaction with the licensee's corporate advisory team as part of the pitching stage. This also includes any discussion of valuation information.
  2. Corporate advisory and research should not be made aware of each other's opinions on valuation information or research analyst models.
  3. Corporate advisory should not place pressure on research or seek to influence research to initiate research coverage or to amend their valuation or price target assessments on issuing companies.
  4. Corporate advisory should not represent to issuing companies or their advisers that their research team or analysts were involved in the preparation of or endorse the pitch valuation.
  5. Corporate advisory staff should not represent to issuing companies that favourable research coverage will be provided on the issuing company in an attempt to secure a mandate: see RG 79.86, Table 3.
  6. In no circumstances should a licensee commit to favourable research coverage of an issuing company (whether expressly or impliedly).
  7. Any pitch document should contain a brief explanation of the licensee's policy on the independence of its research and information on how a full copy of those policies can be accessed.
  8. Corporate advisory mandates should not include any commitment or inducement to provide research.
  9. If research obtains MNPI during the pitching process they should follow their licensee's internal protocols for the management of MNPI.
  10. Compliance or another control function should be aware of and monitor the pitching stage to ensure policies and procedures are being adhered to.
  11. Before the capital raising mandate is signed, research should not communicate or meet with the issuing company or its advisers.
  12. Any information sought by or provided to the research analyst from the issuing company or its advisers should be passed through compliance or another control function.
  13. Research analysts may forward questions to compliance or another control function, who will then submit them to the issuing company. The issuing company may seek clarification of the research analyst's questions, but may not ask any other questions of the research analyst.
  14. Compliance or another control function should undertake periodic reviews to determine the effectiveness of the licensee's arrangements.
Post-mandate period

In CP290, ASIC expands on an example provided in RG79 of a conflict where a licensee provides other services to an entity that is subject to research by the same licensee. The risk of conflicts of interest arising and the potential impact on research independence and integrity apply equally to both the pre- and post-mandate periods.

In the post-mandate period, the role of research may include the preparation of investor education research (IER) and helping market this research to potential investors. An IER commonly includes information about the issuing company's operations/management and the industry sector and historical/project financial information. They have commonly included the analyst's views on the valuation of the issuing company as well.

Unlike the approach adopted in the US2 or preferred in the UK3, ASIC's view is that the early availability of the IER plays a useful role in price discovery and that any inherent conflicts of interest can be managed through conformance with more detailed regulatory guidance. ASIC were nonetheless open to contrary views/submissions.

However, ASIC noted that if it subsequently found that poor management of conflicts continued to compromise the integrity of IERs, it would likely review and revisit the issue of whether mandated licensees on a capital raising should distribute IERs.

IER preparation

IERs have historically been subject to 'research guidelines', internal bank protocols specific to the relevant transaction that deal with the general categories of content and disclaimers to be included in IERs and the procedures to be followed internally and externally with respect to the IER.

ASIC has provided general guidelines on the preparation of IERs and the interactions between research and corporate advisory on the preparation of IERs, which would be expected to be incorporated into transaction research guidelines once the final regulatory guide is released.

IER preparation guidelines

  1. To minimise the risk of communicating MNPI, valuation information in an IER should be expressed as an enterprise or total value for the issuing company.
  2. An IER should include a warning that any initiating coverage value may not be consistent with any IER valuation.
  3. Research analysts should not have a policy of adopting the mid-point in the IER valuation as a default valuation reference point from which to determine their initiating coverage valuation after the issuing company's securities are issued.
  4. An IER should not be used to communicate financial and non-financial information to potential investors that is not public or reasonably expected to be contained in the prospectus relating to the offer. Any valuation information or assumptions in the IER should be based on the financial information to be contained in the prospectus.
  5. Research analysts should not release the IER outside the research team (except to compliance or another control function or legal counsel) or circulate it for fact checking until the licensee has a signed mandate to provide corporate advisory services on the relevant transaction.

Interactions between research analysts and corporate advisory when preparing an IER

  1. A licensee's corporate advisory or other non-research staff should not be able to access the licensee's research analyst's research data, working files or draft research: see RG 79.128.
  2. A licensee's corporate advisory and research staff should not communicate directly or indirectly during the post-mandate period about the issuing company before the IER is widely distributed to potential investors.
  3. Discussion or interaction between a licensee's research and corporate advisory staff should be limited to administrative issues relating to the transaction. These may include schedules to meet with potential investors and the timing of the release of the IER.
  4. Any interactions between a licensee's corporate advisory and research analysts should be subject to oversight by compliance or another control function.
  5. A research analyst's views on valuation information in relation to an issuing company should not be shared outside the research team before it is widely distributed to investing clients, except to compliance or another control function and legal counsel which must keep it confidential: see RG 79.141–RG 79.142.
  6. Licensees should have robust physical and electronic information barriers between a licensee's research team and staff performing corporate advisory or sales functions.

Interactions between research analysts and the issuing company are broadly similar to the guidelines in respect of pre-mandate periods as set out above.  It is important that valuation information is not disclosed or influenced prior to the publication of an IER. 

In addition, where there may be a syndicate of joint lead managers on a transaction, research analysts for each of those joint lead managers should not interact on the merits of the issuing company or on the valuation information relating to the issuing company or the transaction and not discuss or provide access to each other's models or research on the issuing company.

Fact-checking the IER

ASIC have proposed guidelines for the fact-checking of the contents of the IER, a number of which are largely consistent with existing practices under recent IPO research guidelines.

  1. A draft copy of the IER (ie before its distribution to investors) may only be distributed outside the licensee's research team in the following situations:
    1. for a review by the licensee's compliance or another control function and/or legal advisers; or
    2. to the issuing company and its legal advisers for fact and legal checking provided all valuation information is redacted and the issuing company and its lawyers agree in writing not to share the draft IER or opinions expressed in it with any other party except each other.
  2. Feedback that the issuing company or legal advisers may pass to research is limited to factual or legal observations.
  3. A licensee's corporate advisory staff and the issuing company's other non-legal advisers may not review a draft copy of the IER (redacted or un-redacted) before its release to investors.
  4. Compliance or another control function must manage the distribution process for the unpublished redacted IER, including sending, receiving and vetting comments from the issuing company and its legal advisers.
  5. The final copy of the IER (including valuation information) may be provided to the issuing company only after it has been widely distributed to potential investors.
  6. Licensees should maintain a written record of any meetings between a research analyst, the issuing company and, if relevant, the issuing company's legal advisers.
Post IER publication

ASIC have proposed a number of guidelines for research analysts following the publication of the IER, aiming to minimise the risk of pressure placed on research to revise the IER after it has been distributed and to manage conflicts post IER publication.

  1. The IER should not be amended, updated, reissued or replaced following its distribution to potential investors.
  2. If new information comes to light after the release of the IER (but before the transaction is completed) which renders material statements or information in the IER false, misleading or deceptive, the IER should be withdrawn. All parties who were provided with the IER should be notified that it has been withdrawn and no further IER should be issued; nor should the withdrawn IER be updated, amended, reissued or replaced.
  3. Meetings with potential investors to discuss the IER may include the licensee's research analyst and sales staff. Corporate advisory staff should not be present, nor should the issuing company or its other advisers.
  4. Factual information discussed by research analysts at IER meetings should be consistent with the factual information generally available or reasonably expected to be contained in the prospectus, and licensees should have appropriate review processes.
  5. Any subsidies or reimbursement of expenses in relation to a research analyst's involvement in preparing the IER or meetings to discuss the IER should be subject to the licensee's usual policy and procedures for reimbursement of expenses.
  6. Any research analyst participation in due diligence of the issuing company may only occur after the IER has been widely distributed to investors.
  7. Research analysts should not attend 'management roadshow' meetings (that is, meetings with the issuing company or its advisers and potential investors).
Discretionary fees

Another aspect ASIC has considered is the use of discretionary or incentive fees in capital raising mandates. An inherent conflict arises as such fees can create inappropriate incentives and create an environment for poor conduct by licensees in order to secure the fee. In addition, there may be pressure on research to produce an IER that is consistent with the issuing company's expectations.

ASIC has provided guidance on the use of discretionary fees noting that the core mitigant is the licensee's ability to effectively manage any potential conflicts.

  1. Where a capital raising mandate includes a discretionary fee, licensees should have appropriate and robust controls to manage the conflicts inherent in discretionary fees.
  2. If conflicts are likely to be created or exacerbated through fee arrangements and those conflicts cannot be effectively managed, the fee arrangements should be adjusted or the conflict otherwise avoided: see RG 79.120, Table 4; RG 79.123, Table 5.
  3. If a discretionary fee is included in a capital raising mandate and its payment determined following the release of the IER, care should be taken by licensees to ensure this does not place pressure on a research analyst to produce an IER that is consistent with the issuing company's expectations. Disclosure of the discretionary fee arrangements is unlikely to be sufficient mitigation of this conflict risk and licensees should consider a range of additional controls.
  4. Research analysts should not be made aware of the fee arrangements of any existing transactions before the IER is widely distributed to investors. Where a draft prospectus has information about fee arrangements, that information should be redacted from any copy provided to a research analyst before the IER is distributed.

Structure and funding of research

Following on a theme of RG79, which discussed business model conflicts (both direct and indirect) and its potential impact on research independence, CP 290 provides guidance aimed at both the structure of the research function and also the funding for the research function of licensees which includes:

  • research being segregated (physically and technologically) from staff performing corporate advisory or sales functions
  • information about research should be restricted to the research team (eg initiation/cessation of coverage, changes to recommendations) until widely distributed to clients
  • compliance arrangements should be clearly documented and training provided to all staff
  • licensee's research policies should be published on its website
  • guidelines on the decision-making process on coverage (and its disclosure)
  • guidelines on the disclosure of interests

In addition, given the potential conflict on the quality and independence of research where research funding is linked to corporate advisory revenues or where research analyst remuneration is tied to securing capital raising mandates (or related benchmarks), ASIC has provided guidance that there should be a complete segregation between the arms and that research budgets should be determined by senior management without input from corporate advisory or by reference to corporate advisory revenues/results. ASIC have also provided guidance on research analyst compensation and the factors that could be taken into account (which are not tied to corporate advisory revenues/results or subject to corporate advisory input).

Timetable

Submissions for responses to CP 290 close on 31 August 2017 and the final regulatory guide is expected to be published in December 2017.

Future ASIC review on share allocation policies

Interestingly, in the context of inadequate disclosure of conflicts of interest, ASIC foreshadowed a future review and consultation on share allocations in capital raisings, although no further details were given.

 
Footnotes
  1. Inside information means information: (a) that is not generally available; and (b) if the information were generally available, a reasonable person would expect it to have a material impact on the price or value of a financial product.
  2. The distribution of a pre-listing IER, as well as research analysts meeting with issuing companies during the pitching phase of a transaction, are prohibited under the US Financial Industry Regulatory Authority's (FINRA) equity research rules.
  3. The UK FCA’s preferred position during its recent consultation in March 2017 was to allow IERs to be distributed but not prior to the publication of the prospectus.

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