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Research Analysts: Beware!

Published on Wed, Dec 04,2013 | 20:29, Updated at Wed, Dec 04 at 20:29Source : 

By: Tejesh Chitlangi, IC Legal

The  Securities and Exchange Board of India (SEBI), following the international best practises, has decided to plug a significant regulatory gap currently existing due to unregulated activities of research analysts. SEBI on November 29, 2013 has issued a consultation paper along with a draft set of regulations (Proposed Regulations) proposing to govern research analysts and has invited public comments by December 21, 2013. The routine buy/sell/hold recommendations in research reports, stock recommendations on business channels, public media would no longer exist in a regulatory vacuum as they are proposed to be regulated by an exclusive and comprehensive regulation to govern activities of research analysts and mitigate conflicts of interest arising out of their functioning.

Even today there are provisions contained in SEBI Prohibition of Insider Trading Regulations, whereby listed companies are permitted to provide only public information to the research analysts or alternatively, the information given to the analysts is required to be simultaneously made public at the earliest. Furthermore, research analysts are required to disclose their shareholding/interest in companies under research to such analyst’s compliance officers and the analysts who prepare research report of listed companies are prohibited from trading in securities of researched company for thirty days from preparation of such report. However, the existing provisions are grossly inadequate to curb the real conflicts of interest which the Proposed Regulations seek to regulate. The key aspects of the Proposed Regulations are summarised hereunder. 

First, the Proposed Regulations intend to register and regulate independent research analysts and intermediaries that employ research analysts and issue research reports. Second, the Proposed Regulations specify qualifications and net worth requirements for research analysts, specify provisions for improvement in governance standards, minimize market malpractices etc. and foster objectivity and transparency in security research so as to provide investors with more reliable and useful information to make investment decisions. The quality of analysis is crucial for the right development of the markets and hence the Proposed Regulations are aimed to ensure the neutrality of the research reports and also improve their quality. Third, the Proposed Regulations mandate comprehensive disclosure of conflicts of interest in research reports and public appearances by research analysts including limitations of dealings, restrictions on compensation, etc. Investors often rely on the expertise of the research analysts whilst taking decisions on buying/selling securities hence it gets critical to ensure that the advice from investment analysts is independent and unbiased, which otherwise may affect the securities market at large. Mechanisms have been prescribed so that the analysts’ research and recommendations are not prejudiced by the trading activities or financial interests or business relationships of their own or of the firms that employ them.

The Proposed Regulations however miss out on certain key areas of concern and also contain certain provisions which may be impractical and need to be suitably modified or omitted from the final set of regulations. The same are discussed below.

First, the Proposed Regulations do not restrict the paid research model whereby the subject company under research pays the research analyst or intermediary (who has employed the research analyst) for conducting research. This is one of big conflict areas which the Proposed Regulations do not seem to specifically address. The Proposed Regulations require the research analyst to not directly or indirectly offer favourable research to a subject company in lieu of receipt of business or compensation. However, whether the research provided has been biased or is unbiased, may remain subjective when the research analysts receives compensation from the subject company involved. An outcome of a paid research which is less positive or more negative than expected by the subject company may always come with a risk of subject company not continuing the business with the research analyst and this may deter the research analyst from providing an unbiased report.

If a complete prohibition of paid research model is not an option with SEBI, then at the least detailed disclosures of the compensation received from the subject company, detailed basis of arriving at the research recommendation etc. should be prescribed. Also, recommendation of any other research service provider who has covered the subject company should also be mandatorily included/highlighted along with the research report provided by the paid analyst so as to ensure that a balanced view emerges.

Second, it has been proposed that the research analyst or the intermediary (who has employed the Research Analyst) shall not deal in or trade any securities that the research analyst recommends or follows within 30 days before and 5 days after the publication of a research report on the subject company or in a manner contrary to the recommendation. What has also been prescribed is that the aforesaid intermediary should maintain an arms-length relationship between its research activity and other activities which may impair its neutrality in respect of activity as research analyst.

However, the Proposed Regulations do not resolve the conflicts which may arise if an affiliate, group company of the intermediary conducting research, deals in security of the subject company or if an affiliate, group company of the intermediary conducting research, is currently undertaking an assignment for the subject company as its merchant/investment banker. It would be possible to outwit the requirements of the Regulations with the intermediary’s affiliate/group companies carrying on assignments for the subject companies under research or dealing in its securities. The investment/merchant banking and broking outfits by housing research activities in a separate entity should be able to find out a way around the aforesaid prohibitions contained in the Proposed Regulations. Accordingly, SEBI may consider bringing the activities of the research analyst’s affiliates/group companies also within the ambit of above discussed regulatory provisions so as to prevent an in spirit violation of the regulations. Else, conflicts vis-à-vis the affiliates/group companies would at the best be a disclosure item for the research service provider without imposing any material prohibitions which otherwise would have been applicable, had the research and other merchant banking/broking activities would have been housed in the same entity.

Third, a minimum net worth of Rs. 50 lakhs for body corporates and net tangible assets of Rs. 5 lakhs for individuals/ firms has been prescribed to carry out activities of a research analyst. Such high net worth requirement is uncalled for a non fund based activity in the nature of research analysis. Even for an activity in the nature of investment advisory, SEBI has prescribed a net worth of Rs. 25 lakhs for body corporates and 1 lakh for individuals and firms. Why research analysts require a much higher net worth is difficult to understand. A team of smart business school graduates or a qualified professional may not necessarily have such a net worth to begin with. SEBI should consider diluting the proposed net worth criteria substantially.

Fourth, the foreign entities proposing to provide research report or engage in research activity in respect of Indian listed/to be listed securities, are mandated under the Proposed Regulations to set up an office in India and provide services through such office. However, opening a company/representative office in India will also attract foreign exchange management, Reserve Bank of India (RBI) provisions, for instance – research services would tantamount to non-fund based NBFC activity under exchange control laws and require a minimum capitalisation of USD 0.5 million. Similarly a representative office in India would require RBI filings/approval. From practical perspective, it’s suggestive that SEBI may register the overseas entity itself (similar to how SEBI registers overseas entities like FIIs/sub-accounts) without a requirement of such entity opening an office/company in India and facing several other practical consequences.

SEBI whilst drafting the Proposed Regulations has considered international best practises which the International Organization of Securities Commissions (IOSCO) has prescribed. Furthermore, the regulatory regimes prevalent in USA, UK, Hong Kong etc. have also been considered by SEBI which all prescribe measures to strengthen “Chinese walls” between research and business units in integrated financial services firms, regulate analysts’ from trading in equities of the subject companies, regulate the analyst’s incentive structure so as to remove possibility of any biased research and prescribe measures for conflicts of interest management. However, certain concerns as highlighted in this article need to be examined by SEBI whilst finalising the regulations.

Research Analysts will have to carefully carry out their operations once the new regime is notified. Conflicts can never be completely eliminated from the system and would be inherent in any financial services activity. However, from SEBI perspective, the key would be to ensure a regulatory regime which ensures that conflicts are appropriately managed/mitigated and adequately disclosed so that the interest of investors and markets stand guarded and uncompromised.


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