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Part 7 - Analyst independence and the regulation of general advice

Date

7.1 Introduction

Analysts promote the operation of informed and efficient markets by collecting and analysing information about companies and financial products. The research prepared by analysts helps to filter the wide range of information available to investors about product issuers and investments.

Developments in the global financial services industry have given rise to conglomerate firms, which may achieve cost efficiencies by providing a full range of services and using employees in different capacities across the firm. As a consequence, analysts may participate in, and make a valuable contribution to, the provision of services other than research. However, this may create conflicts of interest that undermine the independence of analysts. Investor confidence may be eroded if they perceive a lack of objective research, and they may be reluctant to participate and invest in markets.

Firms have responded to these pressures by developing policies and procedures for managing potential conflicts of interest, such as by putting in place Chinese walls between research and other areas of the firm. However, the efficacy of existing mechanisms has been questioned, particularly in the United States (US). In April 2002, the US Securities and Exchange Commission (SEC) launched a national inquiry into market practices concerning analysts and the conflicts of interest that can arise between research and investment banking. In May 2002, following a similar investigation, the New York State Attorney-General announced a settlement whereby Merrill Lynch agreed to pay a US$100 million penalty, issue a statement of contrition and adopt a range of internal reforms in exchange for avoiding criminal liability and a forced separation of its research and investment banking areas. The SEC also approved comprehensive changes to the rules of the National Association of Securities Dealers and the New York Stock Exchange (NASD/NYSE rules) in May 2002, which prohibit certain research practices and strengthen disclosure obligations for analysts and firms.

In Australia, there has not been the same level of problem or concern in relation to conflicts of interest and research practices. Nonetheless, it is timely to consider the Australian regulatory framework with a view to identifying a range of possible options for consultation. Consideration is given to key policy objectives and the options available to the Government, regulators and industry participants to achieve those objectives. The objectives include market integrity, greater transparency to investors about conflicts of interest so that they can be considered in evaluating the objectivity of research, and for firms to manage conflicts of interest effectively so that investors will have confidence in research.

7.2 Sources of conflicts of interest

The way analysts are compensated for the services they provide can create pressure on their independence and objectivity. A research analyst's salary or bonus might be linked to the profitability of other corporate and trading services, such as investment banking services. This might give the analyst an incentive to provide positive research reports and recommendations, which may foster the client company's continued relationship with the analyst's firm and increase the analyst's compensation. Alternatively, an analyst's compensation might be linked to the profitability of the firm as a whole. A conflict of interest might arise if positive research tends to generate more business for the firm, for example if it results in more trading of the financial products covered in an analyst's report and hence more revenue from brokerage services.

Relationships between product issuers and firms that employ research analysts can potentially affect the integrity of research. For example, a firm that is underwriting a company's initial public offering of securities has a financial interest in its success, which might create pressure for analysts to recommend that investors buy the client company's securities. An analyst's research might also be influenced by the firm's desire to retain existing clients by not issuing unfavourable research, and attract new clients through favourable analyst coverage. Further, a firm might have a significant share holding in a company, which might create pressure for analysts to issue buy ratings for the company's securities. Analysts might also be influenced by an association with the product issuer, such as share ownership in the company and might profit if favourable research causes those shares to rise in value.

7.3 Current regulatory framework

The current regulatory framework is contained in Chapter 7 of the Corporations Act, as amended by the Financial Services Reform Act 2001 (FSR Act). For analysts, the new regime is similar to the previous regime under the Corporations Law, but with added protections for retail investors. There is a single licensing regime for all financial service providers and a harmonised disclosure regime for the provision of financial services and advice. The FSR Act contains obligations to disclose certain conflicts of interest where financial services are provided to retail clients through a Financial Services Guide. In the event of a failure to disclose these matters, the new regime no longer provides that it is a defence if Chinese wall arrangements were in place. More generally, the FSR Act introduces additional disclosure protections where retail investors are provided with personal advice through a Statement of Advice, which includes enhanced disclosure of certain conflicts of interest.

7.4 Forced separation

The current regulatory framework does not prohibit research and other financial activities being provided by the same firm. An option for reform that has been suggested in response to concerns in the United States is to require a complete separation of research activities from other areas. This would be intended to remedy the problem of analysts being involved in, or aware of, other financial activities within the same firm, which could create conflicts of interest that diminish the integrity of their research. The potential benefits of this proposal include close to complete analyst independence. A forced separation of analysts from other financial activities within the same firm would ensure almost no conflicts of interest in relation to research. As a result, investors could be confident that research is objective and impartial.

However, a forced separation of analysts would impose large efficiency costs on conglomerate firms. Multi-service firms would be required to incur the costs of restructuring their business to ensure complete separation of research analysts from other financial service areas, and any economies of scale or scope from analysts working with other areas of the firm would be lost.

A forced separation could also raise the cost of research for investors. Research is often cross-subsidised by other financial services, such as brokerage commissions and investment banking services, which allows research to be provided free-of-charge to investors. If firms were prohibited from using analysts in other areas of their business, they may not be able to fully recover the costs of research and may reduce the amount of research available. Similarly, the quality of research may be diminished if analysts lose access to companies that are clients of their firms.

In view of these factors, the Government does not support complete separation of research from other financial activities. It considers options that will promote objective research through more effective management of potential conflicts of interest are more appropriate. Where potential conflicts of interest do exist there should be transparent disclosure so that investors are in a position to consider and assess their impact before making investment decisions.

7.5 Licensing

Firms that offer research and other financial services are generally subject
to the licensing provisions of Chapter 7, which require persons in the business of providing financial services to hold an Australian Financial Services Licence (AFSL). Financial services include financial product advice, which covers research that contains recommendations or statements of opinion about financial products that are intended to influence persons making decisions in relation to those products.

7.5.1 General obligations

Financial services licensees are responsible for meeting a number of general obligations relevant to the integrity of the financial services that they provide. These include an obligation to do all things necessary to ensure that the financial services covered by their AFSL are provided 'efficiently, honestly and fairly'.

As part of this general duty, financial services licensees would be expected to ensure that conflicts of interest are disclosed adequately and managed effectively. This would include implementing and monitoring robust and efficient policies and procedures for managing potential conflicts of interest, ensuring that analysts provide honest and objective assessments of investment opportunities, and the fair treatment of all investors through full and transparent disclosure of relevant conflicts of interest. Financial services licensees should also disclose any financial interest that they or a related party have in the subject of their advice or recommendation.

Another approach would be for the legislation to prescribe rules for the management and disclosure of relevant conflicts of interest. For example, by amending Part 7.8 of the Corporations Act or imposing conditions on AFSLs. The potential benefits of prescribing rules in legislation include greater clarity and certainty for licensees about how they should manage and disclose relevant conflicts of interest and a more consistent standard across the industry.

However, legislative rules would be likely to impose higher compliance costs on industry than a general obligation for licensees to ensure financial services are provided 'efficiently, honestly and fairly'. Under a general obligation, licensees would continue to have primary responsibility for determining the processes and procedures necessary to ensure compliance with their obligations. In contrast, prescribing rules in legislation for the conduct of licensees would reduce the flexibility for individual licensees to determine whether their existing policies for managing and disclosing relevant conflicts of interest are sufficient to meet their legal obligations, and to adopt those measures best suited to their business.

7.5.2 Administration and enforcement of general obligations

The Corporations Act is administered and enforced by the Australian Securities and Investments Commission (ASIC). In granting an AFSL, ASIC will consider an applicant's likely compliance with all of the general obligations of a licensee. Similarly, ASIC has power to suspend or cancel an AFSL if it has reason to believe that a licensee has not complied with its obligations. ASIC's role also includes providing guidance, monitoring compliance and, where necessary, taking appropriate enforcement action.

ASIC could provide guidance by policy statement on the level and manner of disclosure required under the general duty to act 'efficiently, honestly and fairly'. This would supplement the general guidance that ASIC has provided already on the obligations of financial services licensees.

Policy guidance developed by ASIC, in consultation with relevant stakeholders, could provide several benefits. This includes greater clarity for licensees about the relationship between the duty to ensure financial services are provided 'efficiently, honestly and fairly' and the effective disclosure of material conflicts of interest. Policy guidance could also provide more certainty about how ASIC considers licensees can meet this obligation, including greater public awareness and an impetus for licensees to review and strengthen existing policies for disclosing relevant conflicts of interest.

ASIC's existing policy statement about the general obligations of licensees does not seek to provide comprehensive guidance on the measures necessary to ensure compliance with those obligations. This recognises that the licensing regime is designed to work in a flexible way, and that the compliance measures an individual licensee needs to adopt would be likely to depend on the nature, scale and complexity of their business. A similar approach in this area would be likely to minimise the impact of any additional compliance costs on industry.

7.5.3 Industry guidance

There are a wide range of industry guidance options available to industry, such as industry standards or codes of conduct. Industry guidance can range from setting out general statements of principle about how an industry or business will operate, to listing rules against specific business practices. It can contain minimum standards or standards aimed at best practice.

In November 2001, the Securities Institute of Australia (SIA) and the Securities and Derivatives Industry Association (SDIA) released Best Practice Guidelines for Research Integrity (SIA/SDIA Guidelines). The Guidelines are an industry-based initiative designed to assist analysts and firms to manage potential conflicts of interest that might affect the integrity of research. However, the Guidelines are not as comprehensive as the NASD/NYSE rules.

Industry guidance may provide a more flexible and adaptable framework for dealing with emerging issues than direct government intervention. It would raise industry awareness of the issue of analyst independence and promote a better understanding by firms of how to manage conflicts of interest effectively. Industry guidance would be based upon industry expertise and support for improved industry practices.

However, the benefits of industry guidance, in terms of enhanced investor protection, depend upon the form and nature of the initiatives adopted by industry:

  • whether they are binding and enforceable against industry participants through contractual obligations;
  • are reinforced by measures to monitor compliance;
  • provide remedies and sanctions for breach; and
  • are reviewed regularly to ensure their continued effectiveness.

These factors also have implications for compliance costs associated with industry guidance. As compliance costs would be passed on to consumers through higher prices for financial services, they should be the minimum necessary to ensure conflicts of interest are managed effectively. Industry guidance should not hinder competition among industry participants, such as by creating entry barriers. The Government encourages effective industry guidance as a means of assisting firms and analysts to manage conflicts of interest effectively.

Proposal 17 - General obligation

There is a general duty on financial services licensees to ensure that financial services are provided 'efficiently, honestly and fairly'. Licensees should disclose any financial interest that they or a related party have in the subject of their advice or recommendation.

 

Proposal 18 - Further guidance

The Australian Securities and Investments Commission (ASIC) will be asked to provide guidance by policy statement on the level and manner of disclosure required under this general duty, following consultations with relevant stakeholders.

 

7.5.4 Misconduct and general obligations

The Corporations Act prohibits certain kinds of conduct in relation to financial services, products and markets. The misconduct provisions reinforce the general obligations on licensees by providing civil liability,
civil penalties and criminal consequences for conduct that offends the principles of market integrity and investor protection. A wide range of the misconduct provisions are potentially relevant to the provision of research services, such as the prohibitions against conduct that is misleading and deceptive, unconscionable or dishonest. An issue is whether the legislation should prohibit particular practices in relation to the provision of research services, or whether the existing prohibitions are sufficient for this purpose.

For example, the NASD/NYSE rules contain particular restrictions on personal trading by analysts, whereas the Corporations Act contains a general prohibition against insiders disclosing or trading on the basis of price sensitive information not generally available to the market. Similarly, the Corporations Act does not contain general prohibitions with respect to the remuneration arrangements for financial service providers but contains obligations to disclose remuneration, commissions and other benefits to alert retail investors to conflicts of interest arising from these matters. In contrast, the NASD/NYSE rules contain rules that a firm must not tie an analyst's compensation to specific investment banking transactions. However, subject to appropriate disclosure, it is permissible for firms to compensate analysts based on overall performance, including services provided to the investment banking department.

An option for consultation would be for industry guidance to specify certain research practices that should not be engaged in by firms and analysts. For example, the SIA/SDIA Guidelines provide that, as a matter of best practice, analysts should not trade against their recommendations. Industry guidance in this area might provide a more targeted means of identifying particular research practices than general prohibitions under the Corporations Act.

The potential risks of industry guidance include a lack of enforceability and sanctions for non-compliance. Persons engaging in misconduct that has serious consequences for investors and the market as a whole would be expected to be exposed to criminal and civil sanctions for breaching the Corporations Act. However, the flexible nature of industry guidance suggests that a wide range of enforcement mechanisms are possible depending upon the nature and severity of the misconduct. This could range from adverse publicity to disciplinary measures by industry bodies.

The Government considers that the misconduct provisions of the Corporations Act are sufficient to protect investors against conduct that undermines market integrity. It considers that it is not necessary for the legislation to include additional prohibitions in relation to specific research practices. However, the Government encourages effective industry guidance on research practices that might constitute misconduct. While industry guidance is the responsibility of industry, consultation with regulators, consumers and the Government would help to ensure that public policy goals and community expectations are addressed adequately.

7.6 Disclosure

Market failure can result if investors do not have access to adequate information about conflicts of interest capable of influencing the integrity of research. If investors are not aware of potential conflicts of interest they will not be in a position to assess and compare the objectivity of research available to them. As a result, they will not be in a position to decide how much weight to give research recommendations in making investment decisions. The purpose of disclosure obligations is to correct market failures caused by incomplete or asymmetric information and ensure that investors receive the information they would reasonably require to make informed investment decisions.

Chapter 7 imposes disclosure obligations on financial services licensees and their authorised representatives ('providing entities') in relation to the provision of financial services and advice to retail clients. The relevant disclosure documents are a Financial Services Guide (FSG) and a Statement of Advice (SoA). The obligation to provide an FSG applies to financial services in general, whereas the obligation to provide an SoA is an additional disclosure obligation that only applies if the financial service is personal advice. Providing entities are obliged to disclose certain types of information about conflicts of interest in both FSGs and SoAs. Conflicts of interest are also relevant to whether a providing entity can call themselves independent. As discussed below, the obligations in relation to conflicts of interest differ in these three situations.

7.6.1 Financial Services Guide (FSG)

Providing entities that provide financial services to retail clients are generally obliged to give those clients an FSG as a 'one off' up front disclosure requirement before the financial services are provided. The purpose of an FSG is to ensure that retail clients receive sufficient information to make an informed decision about whether to acquire financial services from the providing entity. In relation to possible conflicts of interest, this includes information about the receipt of remuneration and other benefits; as well as information about associations and relationships with product issuers that might influence the provision of those services. However, these disclosure obligations do not extend to a wider range of potential conflicts of interest and in some ways are narrower than the disclosure obligations for SoAs.

Further, the provision of research services may not require an FSG because there is an exemption for general advice provided in a public forum. Research is usually general advice because the opinions and recommendations it contains do not involve consideration of the objectives, financial situation and needs of the particular person to whom it is provided. However, this exemption does not affect the obligation for providing entities to disclose conflicts of interest. If this exemption applies, retail clients must still be given information about conflicts of interest that would otherwise be included in an FSG.

7.6.2 Statement of Advice (SoA)

Providing entities that provide personal advice to retail clients are generally obliged to give those clients an SoA, in addition to an FSG. An SoA can be how the personal advice is provided to the retail client or a separate record of that advice. An SoA ensures that retail clients receive sufficient information to make an informed decision about whether to act on the personal advice received from the providing entity. This includes information about certain types of conflicts of interest that might influence the provision of the personal advice.

However, there is no equivalent of an SoA for general advice. Research is usually general advice because it does not involve consideration of the objectives, financial situation or needs of the particular person to whom it is provided. As a result, retail investors do not receive any disclosures in addition to an FSG about potential conflicts of interest in relation to research or other general advice. In particular, they do not receive the benefit of the disclosure obligations for personal advice, which oblige providing entities to disclose a wider range of potential conflicts of interest.

7.6.3 Terminology restrictions

The use of the words 'independent', 'impartial' or 'unbiased' is restricted in relation to the provision of financial services. It is generally an offence for financial service providers to use these words unless:

  • the financial service provider and certain other persons do not receive certain commissions, remuneration or other gifts or benefits;
  • they operate free from any direct or indirect restrictions relating to the financial products in respect of which they provide financial services, and
  • they operate without any conflicts of interest that might arise from their associations or relationships with produ
    ct issuers and might reasonably be expected to influence them in providing the financial services.

7.6.4 Other possible reforms

Given these different obligations in relation to conflicts of interest, two additional options for reform that could be pursued are:

  • bringing the obligations for general advice in line with those for personal advice; and
  • extending the range of conflicts of interest that are relevant.

These options are discussed in detail below. The Government seeks views on whether all or any of these options should be pursued further.

Bring general advice obligations in line with personal advice obligations

Information about remuneration, commissions and benefits

An FSG must include information about remuneration, commissions or other benefits that are in respect of, or attributable to, the provision of the financial services. The purpose of this disclosure obligation is to ensure that retail clients are in a position to understand how they will be paying for the financial service offered to them. However, this purpose is less relevant to research services as brokerage firms often allow retail investors to access research free-of-charge. In contrast, an SoA must include information about any remuneration, commissions or other benefits that 'might reasonably be expected to be or have been capable of influencing the providing entity' in providing the personal advice. This recognises that remuneration, commissions and other benefits are a potential source of conflicts of interest and ensures that retail investors are alerted to them. The terminology restrictions also refer to 'other gifts'.

Information about associations and relationships

Providing entities are obliged to disclose in FSGs information about certain associations or relationships that 'might reasonably be expected to be capable of influencing the providing entity in providing any of the authorised services'. The disclosure obligation for SoAs is broader because it extends to associations or relationships expected 'to be or have been' capable of influencing the providing entity. This ensures that retail clients are alerted to potential conflicts of interest arising from this source.

Information about other interests

Providing entities are also obliged to disclose in an SoA information about any other interests of certain persons that 'might reasonably be expected to be or have been capable of influencing the providing entity in providing the advice'. However, there is no obligation to disclose other interests in FSGs. As a result, retail investors do not receive the benefit of the disclosure of this source of potential conflicts of interest for financial services, other than personal advice.

Basis for personal advice and general advice warnings

An SoA must include information and any required warnings about the basis for personal advice. This is linked to the obligation to have a reasonable basis for personal advice, which requires providing entities to make reasonable inquiries to determine the relevant personal circumstances of the retail client, and to consider and investigate the appropriateness of the advice for that client. Providing entities must warn retail clients if the personal advice could be based on incomplete or inaccurate information relating to the client's relevant personal circumstances, and that the client should consider the appropriateness of the advice before acting on it. The legislation could also oblige financial services licensees and their authorised representatives to have a reasonable factual basis for general advice, disclose information about that basis to retail clients, and warn retail clients if general advice could be based on any incomplete or inaccurate information.

Providing entities are also obliged to warn retail clients to consider the appropriateness of the general advice to their situation before acting on it, as it has been prepared without taking account of their objectives, financial situation or needs. It is an offence to fail to comply with this obligation. However, there is no obligation to warn retail clients that they should consider information about potential conflicts of interest before acting on general advice. The legislation could oblige financial services licensees and their authorised representatives to warn retail clients that they should, before acting on general advice, consider information about any potential influences on that advice, and to direct retail clients to the source of that information, for example, the appropriate page number in a research report.

This would foster greater consumer awareness of the need to consider potential conflicts of interest before acting on general advice, such as an analyst's recommendation to buy, sell or hold securities in a particular company. It would also encourage retail investors to consider potential conflicts of interest when they consider the overall appropriateness of general advice to their particular situation and financial circumstances. Retail investors would also benefit from more transparent and prominent disclosure of where to find information about potential influences on general advice.

The extra warning would be largely generic and could accompany the warnings that providing entities already provide, so that compliance costs associated with this option would be relatively low.

Extend the range of conflicts of interest

Information about certain persons

Providing entities are only obliged to disclose information about the remuneration, commissions or other benefits to be received by certain persons, associations or relationships between certain persons and the issuers of any financial products, and other interests of certain persons. Similarly, the restrictions on the use of terminology are linked to certain persons.

These obligations could be extended to capture a wider range of persons in both FSGs and SoAs. For example, some reforms adopted overseas include disclosure of information about associations between product issuers and members of an analyst's household or immediate family.

The legislation or the regulations could also provide more detail about the obligation to disclose these matters. For example, by indicating that remuneration based on the volume of business placed with product issuers should be disclosed, or in relation to the presentation or prominence of this information.

Obligation to disclose 'Conflicts of Interest' in FSGs and SoAs

An issue is whether the disclosure obligations for FSGs and SoAs are wide enough to capture the full range of potential conflicts of interest. At present, providing entities are only obliged to disclose information about certain types of conflicts of interest; however, the sources of potential influence on financial services are not limited to these matters.

Providing entities could be obliged to disclose information about 'conflicts of interest' in FSGs and SoAs. The same test could apply to FSGs and SoAs. For example, providing entities could be obliged to disclose conflicts of interest that 'might reasonably be expected to be or have been capable of influencing the providing entity'. This would ensure a consistent obligation for financial services licensees and their authorised representatives to disclose conflicts of interest that might influence them, to enable retail investors to consider and assess potential influences on financial services and advice before making investment decisions.

There would be compliance costs associated with providing entities meeting a wider obligation to disclose 'conflicts of interest'. However, providing entities would only need to disclose conflicts of interest that might reasonably be expected to influence them, and the information that retail clients would reasonably require to make informed investment decisions. This would help to minimise the compliance costs for providing entities.

A related concern is that a gene
ral obligation to disclose 'conflicts of interest' could create uncertainty for providing entities. This could be largely resolved by defining 'conflicts of interest' to include the types of conflicts of interest that providing entities are already obliged to disclose, such as conflicts of interest arising from remuneration, commissions, benefits, gifts, associations and relationships with product issuers, and other interests. This would provide guidance to providing entities about the types of conflicts of interest that should be disclosed, while emphasising that the sources of potential influence are not limited to these matters.

The NASD/NYSE rules prescribe a wide range of specific conflicts of interest that should be disclosed, such as if a firm has a shareholding in a recommended company or if the company is a past, present or possible future client of the firm. In contrast, a general obligation to disclose conflicts of interest would avoid the need to anticipate and prescribe those matters that might constitute a potential influence on financial services or advice. This would ensure that the disclosure regime is sufficiently flexible to accommodate future possible conflicts of interest.