Submission to the Securities and Futures Commission on the Consultation Paper on the Regulatory Framework for Addressing Analyst Conflicts of Interest

INTRODUCTION

1. The Consumer Council is pleased to provide a submission to the Securities and Futures Commission (SFC) on the proposed regulatory framework for addressing securities analyst conflicts of interest.
2. The Council welcomes the SFC taking a proactive role in drafting clearer and more specific guidelines to deal with the potential and actual analyst conflicts that may exist in the Hong Kong.
3. From the perspective of investor protection, it is important to ensure that the research produced by analysts is objective, clear, fair and not misleading, as "over 44% of stock investors rely on celebrity analysts' comments in making investment decisions" (SFC Retail Investors Survey 2003). Another survey by SFC, the Securities Firm Survey, reveals that "87% of the firms' analysts reviewed issuers with whom these firms had investment banking relationships in the past two years". The Council believes that the close linkage between firms and issuers will be of concern to the investing public in respect of the objectivity of firms' analysts.
4. In this paper, the Council has directed its response to proposals in the consultation paper that directly concern investor protection with regard to analyst conflicts issues.

COUNCIL RESPONSE TO THE CONSULTATION PROPOSALS

Designation mechanism for analysts

5. The Council is of the view that setting up a designation mechanism for analysts would definitely help investors delineate analysts from sales or marketing professionals. Moreover, as some commentators or financial journalists are exempted from licensing and thus regulation and disclosure requirements, the designation mechanism will enable investors to differentiate between analysts and such non-licensed commentators or financial journalists.
6. In this regard, the Council suggests that some measures should be in place to ensure investors can readily ascertain the status of analysts such as maintaining a separate analysts list on the SFC's website to allow the investing public to do checking if they have any queries about an analyst's status. The Council welcomes the SFC proposal that analysts be required to disclose status when giving out comments or recommendations on financial products to the investing public.

Analyst trading and financial interest

7. The Council supports the proposal for firms to establish internal controls to govern analysts' dealing activities in order to address conflicts arising from analysts' financial interests. However, the Council is concerned if the proposed post issuance "blackout period" should be set at one business day. The Council doubts if such a short duration is sufficient for non-professional investors to digest the research report, and analysts could still trade the relevant financial product to serve their interests before the relevant information is fully digested.
8. If the blackout periods prescribed by the NASD and the NYSE are 30 calendar days before and 5 calendar days after issuance of research reports, the Council considers that Hong Kong investors should have a similar blackout period in line with the advanced securities markets.
9. The Council also sees investor benefit in requiring analysts to disclose if they or their associates have any relevant relationship or financial interest in the company or investment that is covered by the analysts. However, the extent to which investors can benefit from this requirement will depend on to whom such disclosure is to be made and whether disclosure is of a public nature.

Firm financial interests & business relationships

10. The SFC proposes amongst others that firm should disclose in its research reports any investment banking relationship with the issuer within the past 12 months. The Council considers that such requirement should not be limited to historical fact but should be extended to cover situation where a firm is currently seeking investment banking relationship with an issuer that the firm's analyst reviews. Making this extra piece of information available strengthens public confidence over the objectivity in analysts' comments.
11. As to the definition of "material financial interests", the SFC proposes a monetary threshold of HK$ 5 million in addition to the 1% market capitalization threshold. The Council is of the view that disclosure should be required if certain capitalization percentage of a listed company be reached rather than at a monetary sum comparing significantly to others. The Council therefore supports adopting a 1% market capitalization threshold which is commonly used in the overseas jurisdictions.
12. The Council fully supports the SFC's proposal that analysts should be prohibited from participating in any investment banking business solicitation such as sales pitches and road shows. However, the SFC has put in a carve-out for the provision of information in response to unsolicited queries. The Council feels that a carve-out erodes the effectiveness of the proposed prohibition and is therefore unacceptable.
13. With regard to the "quiet period" for firms who act as the manager or sponsor of a public offering, the Council supports the proposed limits to restrict the firms' issuance of any investment research in relation to the issuer following the conclusion of the public offering.
14. In respect of mandating a "pre-deal quiet period", the Council agrees that this is necessary considering the possibilities of analysts crossing the wall, or a pre-deal research being used as a marketing tool by firms. Since investors would refer to research information released by analysts to formulate their investment decision prior to a public offering, it is important to minimize the possibility of a conflict of interest on the part of analysts. As to the concern that such restriction may deprive the market of relevant information, the Council believes that a potential issuer of great interest to the investing public should attract other analysts in the market to issue research reports on the issuer. The Council considers it of utmost importance for investors to receive unbiased and reliable information to base their investment decision.

Analysts' reporting lines and compensation

15. The Council notes from the consultation paper that the SFC proposes to leave it to firms to work out the desirable reporting line and not to link analysts' compensation directly to any specific investment banking, corporate advisory, or dealing transaction. Taking into consideration that the absence of independent reporting line and independent remuneration mechanism could be important sources of conflicts of interest confronting analysts, the Council suggests that there should at least be a disclosure requirement put on firms to disclose the manner by which analysts are compensated and the reporting structure within their firms. This will enable investors to make informed decisions.

Firm compliance systems

16. It is noted that the SFC adopts a self-regulatory approach relying on firms to establish and enforce their own set of policies and procedures to curb analyst conflicts. The Council suggests that there should be a requirement on the firms to publicly disclose and to submit their policies and procedures together with an annual compliance report for consideration of the SFC. Making information transparent not only works to the benefits of the investing public but also improves corporate governance. Ultimately, the Council thinks it could be useful if the SFC could conduct "audits" (if this is not in the system) to see the accuracy of analyst reports and also check compliance with rules.

Clarity, specificity and prominence of disclosure

17. The Council notes that the proposed disclosure required of an analyst and a firm is apparently limited to recipients of an investment research report/ media article, and audience in a public appearance/in a broadcast programme. This may not be sufficient to address the needs of the investing public as they may not be the direct recipients of a research report but rather receive second-hand information in a media article. In addition, comprehensive disclosure may not be practical in circumstances such as radio or television programmes. The Council suggests that a 'complete' disclosure should be mandated by making it readily available when requested by the investing public and posting it on the firms' websites.

Public commentaries

18. The Council firmly supports the SFC's proposal to require an analyst to disclose his real name, license status and the name of his firm when providing comments in or through the media. This ensures investors would be able to differentiate licensed persons from non-licensed persons and makes analysts accountable for their commentaries. Whether the SFC will be in a position to verify the identity of commentators using pen names is a separate concern. The Council invites the SFC to consider the practicability of requiring an analyst to disclose the use of pen names to the SFC and to undertake not to write articles under pen names in cases where he has material interest.

Investor education

19. The Council shares the view expressed in the consultation paper that "an essential element to any regulatory approach in addressing analyst conflicts is making the investing public aware of such conflicts". In this regard, the Council is willing to offer its assistance in respect of education and information dissemination activities to help make investors aware of analyst conflicts and the disclosure rules in the Hong Kong market.