Re SEC Publishes NASD and NYSE Proposals to Modify

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                                                                January 19, 2007

  Memorandum For: Interested Persons

                        Re: SEC Publishes NASD and NYSE Proposals to Modify
                            Their Research Rules


Summary

         On January 9, 2007, the Securities and Exchange Commission (the
“SEC”) published proposals (each, a “Proposal”) by the National Association of
Securities Dealers and New York Stock Exchange (the “NASD” and “NYSE,”
respectively, and collectively the “SROs”) to amend certain provisions of their
rules (the “SRO Research Rules”) relating to research analysts.1 If approved by
the SEC, the Proposals would, among other things, clarify which firm personnel
are subject to analyst registration; eliminate pre-publication review of research
reports for factual accuracy and identification of any potential conflicts of interest
by certain non-research personnel; modify the quiet periods following securities
offerings and shorten the quiet periods surrounding lock-up agreements; liberalize
slightly the restrictions on personal trading by research analysts; expand
disclosure requirements relating to conflicts of interest; extend the prohibition on
retaliation; and impose new limitations on research personnel communications
with internal sales personnel in the presence of investment bankers.

           The public comment period for the Proposals expires on March 5, 2007.

Background

       In response to a number of high-profile enforcement actions over allegedly
improper research practices regarding research analyst conflicts of interest due to
pressures from investment banking, in May 2002, the SEC approved the SRO
Research Rules governing the conduct of research analysts and the preparation
and content of research reports.2 In broad strokes, the SRO Research Rules

           1
          SEC Release No. 34-55072 (Jan. 9, 2007) (the “Research Analyst Proposing
Release”), available at: http://www.sec.gov/rules/sro/nyse/2007/34-55072.pdf.
           2
        While there are a number of carve-outs to this definition, a “research report” under the
SRO Research Rules generally means a written or electronic communication that includes an
This memorandum is a summary for general information only. It is not a full analysis of the matters presented and should
not be relied upon as legal advice.
contain (a) limitations on communications with issuers, including limitations on
the pre-publication review of equity research reports and a prohibition on equity
research analyst participation in solicitations for investment banking business; (b)
requirements for the supervision and compensation of equity research analysts; (c)
restrictions on the timing of the publication of equity research reports (i.e., quiet
periods); (d) limitations on securities ownership and trading activities by equity
research analysts; and (e) required conflict of interest disclosures for equity
research reports and public appearances by equity research analysts.

The Research Analyst Proposing Release

        Exception to Registration Requirements for Non-Research Personnel that
Produce Research Reports – The Proposals would explicitly limit the definition
of “research analyst” in NYSE Rule 344 and NASD Rule 1050 to “an associated
person whose primary job function is to provide investment research and who is
primarily responsible for the preparation of the substance of a research report or
whose name appears on [a research report]” (proposed language in italics). This
change should reduce the number of firm personnel who are considered research
analysts.

        Prohibition on Pre-Publication Review of Research Reports by Investment
Banking – The Proposals would eliminate the exception in the SRO Research
Rules permitting pre-publication review of research reports by investment
banking and other non-research personnel for factual accuracy and identification
of any potential conflicts of interest that may exist.3 According to the SROs,
factual review of a research report by investment banking personnel is
unnecessary in view of many other available sources to verify such information,
including the subject company, and in many cases such review may only raise
concerns about the objectivity of the report.

        Restrictions on Publishing Research Reports and Public Appearances –
The SRO Research Rules presently apply quiet periods, in which member firms
may not distribute research and an analyst may not make a public appearance, in
two situations: (a) after a public offering of securities, and (b) before and after the
expiration, waiver or termination of a lock-up agreement.4 In the former

analysis of equity securities of individual companies or industries, and that provides information
reasonably sufficient upon which to base an investment decision. See NASD Rule 2711(a)(8);
NYSE Rule 472.10(2). The Proposals seek to explicitly carve-out from the definition of “research
report” any communication that otherwise meets the definition but that includes an analysis of the
equity securities of an “open-end registered investment company that is not listed or traded on an
exchange or a public direct participant program.”
           3
               In particular, the Proposals would eliminate NASD Rule 2711(b)(3) and NYSE Rule
472(b)(3).
           4
               See generally NASD Rule 2711(f); NYSE Rule 472(f).

                                                           2
This memorandum is a summary for general information only. It is not a full analysis of the matters presented and should
not be relied upon as legal advice.
situation, the SRO Research Rules currently provide for a two-tiered system
where the quiet period is based on the firm’s role in the public offering and the
type of offering (i.e., initial public offering versus secondary offering).5 The
Proposals would amend the SRO Research Rules by (a) imposing a uniform 25-
day quiet period following an initial public offering of securities for all offering
participants, including managers, co-managers, underwriters and dealers, and (b)
eliminating altogether the quiet period following a secondary offering.

        For lock-up agreements, the NYSE and NASD Proposals differ in material
respects. The NYSE’s Proposal would reduce the current 15-day quiet period
surrounding the expiration, waiver or termination of a lock-up agreement to a 5-
day period. By contrast, the NASD’s Proposal would eliminate the quiet period
altogether around the expiration, waiver or termination of a lock-up agreement,
provided that the analyst who authored the report provides an additional
certification, in such form as prescribed by the NASD, that the firm and/or
research analyst “has a bona fide reason for issuing the research during such
periods.”6

        Finally, the SRO Research Rules currently provide for an exception to the
quiet periods for the publication and distribution of research or a public
appearance by an analyst so long as the research report or public appearance
relates to significant news or a significant event on the subject company and is
pre-approved in writing by legal or compliance personnel.7 The SROs have not
interpreted this exception to include an earnings release by the covered company
absent some other significant news or significant event. The NYSE’s Proposal
(but not the NASD’s) would expand this exception by now explicitly considering
an earnings announcement by the subject company as significant news or a
significant event and therefore within the exception.

        Restrictions on Personal Trading by Research Analysts – The Proposals
would allow a member firm to adopt policies that permit research analysts to
divest their holdings in a subject company in an orderly and controlled manner
with the oversight of the firm’s legal and compliance personnel. In addition, the
NASD’s Proposal (but not the NYSE’s) would generally permit analysts to invest
in any investment fund (including a registered diversified investment company) so
           5
           For example, the SRO Research Rules presently prohibit a member firm that acted as a
manager or co-manager of an initial public offering from publishing or otherwise distributing
research reports for 40 calendar days following the date of the offering, while all other member
firms that participate in the initial public offering are subject to a 25-day quiet period. For
secondary offerings, a 10-day quiet period applies to the manager and co-manager of the offering.
See NASD Rule 2711(f)(1) and (2); NYSE Rule 472(f).
           6
        The specific language of the NASD’s required certification will be set forth in a Notice
to Members upon approval of the NASD’s Proposal.
           7
               See NASD Rule 2711(f)(4); NYSE Rule 472(f)(5).

                                                           3
This memorandum is a summary for general information only. It is not a full analysis of the matters presented and should
not be relied upon as legal advice.
long as neither the analyst nor a member of his household is aware of the fund’s
holdings or transactions and the account holds no more than 1% of the fund.8

        Disclosure Requirements Relating to Conflicts of Interest – The Proposals
seek to amend the current requirement regarding conflict of interest disclosure by
giving the firm two disclosure options: either (a) include on the front page cover
of the research report the required disclosures under the current SRO Research
Rules or refer the reader to the page(s) of the report on which such disclosures
may be found, or (b) state prominently on the front page of the research report
language that the firm and/or research analyst preparing the report “has a conflict
of interest that may affect the ability of the firm or the analyst to provide objective
analysis about the company,” and follow this disclosure with language directing
the recipient of the report to the firm’s website for more information where the
firm would be required to post specific details about the conflict.9, 10

       Prohibition on Retaliation Against Research Analysts – The Proposals
would broaden the prohibition on retaliation against research analysts to all
employees of the member firm, not just individuals involved in investment
banking activities.

        Prohibition on Communications of Research Analysts in the Presence of
Investment Banking Personnel – The SRO Research Rules presently prohibit
research analysts from communicating about an investment banking services
transaction with clients or proposed clients in the presence of investment banking
personnel.11 If adopted, the Proposals would extend this prohibition to also apply
to research analyst communications with internal sales personnel in the presence
of investment banking personnel.




           8
           This change would eliminate one prong in an exception to the general prohibition
against the analyst purchasing or selling any security issued by a company that the analyst follows.
At present, to satisfy this exception, the trade must involve interests in an investment fund over
which (a) neither the analyst nor a household member has any investment discretion or control, (b)
the research analyst accounts collectively own no more than 1% of the fund’s assets, and (c) the
fund invests no more than 20% of its assets in securities of issuers principally engaged in the same
types of business as companies that the analyst follows (the “20% Prong”). See NASD
2711(g)(4)(B); NYSE Rule 472(e)(4). The NYSE’s Proposal seeks to retain the 20% Prong, but
seeks comment on its decision to do so.
           9
          It should be noted that the Proposals do not seek to change the substance of the required
disclosure, only the manner of disclosure.
           10
           The SROs also seek comment on whether a similar approach could be used for
disclosure of analyst conflicts of interest in connection with public appearances.
           11
                See NASD Rule 2711(c)(5)(B); NYSE Rule 472(b)(6)(i)(b).

                                                           4
This memorandum is a summary for general information only. It is not a full analysis of the matters presented and should
not be relied upon as legal advice.
Observations

        Although the Proposals are mostly uniform, they differ in certain
significant respects, including the approaches of the SROs in regard to quiet
periods surrounding lock-up agreements and the NYSE’s quiet period exception
for an earnings announcement by the subject company. These differences seem
anomalous in light of the proposed consolidation of the NASD’s and NYSE’s
regulatory franchises,12 and the NYSE’s recent undertaking to the SEC to seek to
eliminate inconsistencies between the NASD’s and the NYSE’s regulatory
requirements.13


                                  ********
       For further information, please contact Lanny A. Schwartz at (212) 450-
4174 or Derek Dostal at (212) 450-4322.




           12
           In November of 2006, NYSE Group, Inc., NYSE Regulation, Inc., and the NASD
announced that their respective Boards had approved a letter of intent outlining a proposal to
consolidate their member regulation functions in a new self-regulatory organization (the “New
SRO”). The New SRO would be responsible for all member examination, enforcement,
mediation, arbitration, while NYSE Regulation would continue to regulate the NYSE and NYSE
Arca trading markets and oversee listed company compliance. For more information on the
proposed consolidation, see Davis Polk & Wardwell Memorandum to Interested Persons (Dec. 7,
2006), available at http://www.dpw.com/1485409/dpw/12_07_06_nyse_nasd.pdf.
           13
           See SEC Release 34-53382 at p. 6 (Feb. 27, 2006) (“[T]he NYSE . . . represented [in its
proposed rule change as amended] that it will work with NASD and securities firm representatives
to eliminate inconsistent rules . . . and will use its best efforts to submit to the [SEC], within one
year, proposed rule changes reconciling inconsistent rules and a report setting forth those rules that
have not been reconciled.”).

                                                           5
This memorandum is a summary for general information only. It is not a full analysis of the matters presented and should
not be relied upon as legal advice.