Investment Research, Revisited: Remarks to the International Bar Association’s Asset Management Industry Conference

Thank you for the kind introduction. I’m pleased to be at the International Bar Association’s Asset Management Industry Conference on Global Challenges and Opportunities.[1] For the participants attending from abroad, welcome to Boston. It is an exciting time to be in the city, with the Boston Celtics competing at this moment for the NBA championship.

I understand that this particular IBA committee focuses on the global fund industry. It is no small feat to navigate the maze of laws and regulations and to counsel clients on complex issues that cross jurisdictions.

Despite our differences around the world, one constant is that the effectiveness of capital markets depends on the quality of the information environment. Today, I will discuss investment research provided by sell-side firms to asset managers and the rules governing such research. I have followed with much interest the United Kingdom Financial Conduct Authority’s (“UK FCA”) recent consultation on modifying certain research unbundling rules required by the UK Markets in Financial Instruments Directive (“UK MiFID”), which were derived from the European Union’s MiFID II.[2] I commend the UK FCA for taking up this important issue and believe it is past time to review how investment research is regulated, including in the United States.

Investment research serves an important role in the global capital markets. It promotes the efficient allocation of capital and risk, resulting in increased economic growth and market liquidity. Sell-side and independent investment research help contribute to the efficient market hypothesis, in which prices reflect publicly available information. By contrast, buy-side research is typically proprietary and often only becomes incorporated into market prices when reflected by a manager’s buy and sell orders. The decline of third-party investment research runs the risk that social media and rumors may increase in outsized influence – as nature abhors a vacuum. The result might be less informed and less efficient markets that do not serve investors and increase the cost of capital.

Regulators are demanding more disclosure than ever from public companies. For example, in the United States, the Securities and Exchange Commission’s (“SEC”) climate-related disclosure rule would require extensive new public company disclosure. [3] Public companies are also now required to disclose material cybersecurity incidents and describe their approach to cybersecurity risk management, strategy, and governance.[4] The New York Stock Exchange (“NYSE”) and Nasdaq-listed companies must also adopt and file policies regarding the recovery or “clawback” of excessive incentive-based compensation from current and former executive officers in the event of an accounting restatement.[5] Third-party research can be an important resource in helping investors and asset managers digest the increasing volume of public company disclosures mandated by regulators. After all, what good is disclosure if no one has time to read it?

Despite the role played by investment research in price discovery and market efficiency, sell-side investment research that is bundled with trade execution has been viewed with skepticism by regulators, including by the SEC, due to potential conflicts of interest. First, a brief history about sell-side research in the United States: until May 1, 1975, when the SEC adopted Rule 19b-1 under the Securities Exchange Act of 1934 (“Exchange Act”), NYSE required brokers to charge a minimum brokerage rate.[6]

Fixed commission rates meant that broker-dealers had to compete in other ways, such as by providing customers with bundled research. The elimination of fixed commission rates thus raised questions for investment managers and the capital markets: for example, would managers be required by their fiduciary duty to pay the lowest commission rate and forgo bundled research? If brokers decided to stop producing research and compete solely on execution costs and speed, would smaller companies receive less research coverage and be less successful in raising capital? Would fewer companies decide to go public due to a concern about research coverage?

Congress recognized these potential problems and enacted section 28(e) of the Exchange Act in 1975.[7] Section 28(e) provides a safe harbor for investment managers to pay more than the lowest commission rate if the manager determines in good faith that the commission is reasonable in relation to the value of such services. This permitted investment managers to “pay up” for soft dollars (e.g., research) alongside execution services and continue to use client funds to do so. With this safe harbor, however, came difficult interpretative questions about whether a product or service could be paid with soft dollars. To this end, the Commission and its staff have studied and issued guidance over the years about certain services and practices that were remotely connected to the investment decision-making process and thus did not likely qualify to be paid with soft dollars.[8]

However by its terms, section 28(e) expressly permits broker-dealers to continue bundling execution and research and recognized that research can benefit investors by promoting more informed decision making from asset managers. Section 28(e) also demonstrates Congress’s view of the importance of the service that broker-dealers provide in producing research, and that it is acceptable for managers to use client funds to pay for bundled research and execution, subject to certain safeguards.

During the dot-com bubble of the late-1990s that eventually crashed, concerns were raised about the role played by sell-side investment research. It culminated in the global research analyst settlements, when the then-NASD (now FINRA), the SEC, the NYSE, the North American Securities Administrators Association (NASAA), and the New York State Attorney General settled with 12 major broker-dealer firms for conflicts of interest between their research analysts and investment bankers (“Global Research Settlement”).[9] Investment bankers also were alleged to have supervised and taken part in research analyst compensation decisions. The Global Research Settlement required these broker-dealers to wall off research analysts from investment banking due to allegations that analysts published research designed to attract investment banking business based on favorable company reports. The Global Research Settlement’s terms were modified in 2010. Only specific 12 firms were subject to the Global Research Settlement, and two – Bear Stearns and Lehman Brothers – are no longer in existence, and Credit Suisse has since been acquired by UBS.

In addition, Regulation AC – which stands for “Analyst Certification” – was adopted by the SEC in 2003. While the proposal predated the enactment of the Sarbanes-Oxley Act (“SOX”), which required the SEC to adopt certain rules regarding research analysts, the SEC noted that it would abide by the SOX directives in adopting Regulation AC.[10] Regulation AC generally requires research analysts to certify to the truthfulness of the views they express in research reports and public appearances, and to disclose whether they have received any compensation related to the specific recommendations or views expressed in those reports and appearances.

Regulators elsewhere in the world, notably the EU and the UK, have taken a different approach, viewing the bundling of execution and research as an inducement to asset managers and thus an investor protection issue. Accordingly, MiFID II generally requires managers to pay for research separately from execution services, charge clients a separate fee, or pay for research themselves. MiFID II’s research rules may have intended for independent research and lower commissions to offset the reduction in sell-side research; however, it appears that this experiment may have not accomplished these goals and has had unintended results.

For example, due to concerns about MiFID II leading to a decline in research on small and medium companies, the French Authorité de Marchés Financiers has recommended that MiFID II’s inducements regime should not apply to research on companies with market capitalizations of €1 billion or less.[11] Across the English Channel, the UK FCA has issued a consultation requesting input on re-bundling investment research with brokerage execution services. This consultation follows up other work by the UK FCA, including the concerns noted by an Independent Research Review (“IRR”) study.[12] The IRR found that the UK MiFID unbundling requirements adversely affected the quality and coverage of investment research for UK companies, and the UK’s economic growth as a result. In addition, UK asset managers were disadvantaged as compared to their international peers in accessing global investment research, making them less competitive. Finally, the IRR noted a possible decline in the quality of UK research due to a “juniorization” in the ranks of sell-side research analysts. The efforts of these regulators to take a hard look at whether their regulatory policies achieved their intended goals is commendable.

MiFID II’s inducements regime also caused challenging conflicts of laws issues for U.S. broker-dealers: charging separately for research services implicated questions of whether U.S. broker-dealers could rely on the exclusion from the definition of an investment adviser if they complied with MiFID II.[13] To that end, the SEC’s Division of Investment Management issued temporary no-action letter relief to permit U.S. broker-dealers to comply with MiFID II’s research requirements and continue their business models.[14] This relief was left to expire in July 2023, which was most unfortunate. In my view, the no-action letter should have been extended for a modest period to accommodate potential changes in UK MiFID and MiFID II.[15] With the UK FCA’s consultation, it become even more apparent that allowing the letter to expire was premature.

At the conclusion of the Global Settlement, the SEC’s then-enforcement director stated that “the full impact remains to be seen” and others hoped that it would lead to “more straight talk on Wall Street.”[16] The impact, unfortunately, has been a lot less research out of Wall Street, particularly for small and medium sized companies. I hope that the SEC can learn from our international colleagues and examine our own research rules, including the Global Research Settlement.

The SEC should further undertake a retrospective review of the similarly 20-year-old Regulation AC, which would be an exercise of good government and responsible regulation. In this regard, the SEC should take heed of the 2017 recommendation from the U.S. Department of the Treasury that the SEC should conduct a holistic review of the Global Research Settlement and the research analyst rules to determine which provisions should be retained, amended, or removed, with the objective of harmonizing a single set of rules for all financial institutions.[17]

Turning to today, I noticed that the IBA is holding two discussions on artificial intelligence (“AI”). AI is a hot topic, as it touches many areas of financial services and the capital markets, including investment research. AI and machine learning can automate and analyze vast quantities of data, such as financial statements and other public company disclosures. With AI, the research analyst’s role could change, perhaps focusing less on data collection and more on interpretation and qualitative analysis. AI also could increase the resources available for smaller company coverage.  Of course, AI is fallible and if not properly constructed and monitored, it could miss patterns, correlations, and risks. Therefore, while I am not overly concerned about a dystopian future where we are ruled by AI, we should continue to evaluate its use.

Thank you again for the invitation to speak and for your continued commitment to the global rule of law.