Research houses to be more tightly regulated under proposed ASIC reforms
by Gavin Creighton and James Stanton
In brief - Reforms aimed at compliance, transparency and avoidance of conflict
On 16 November 2011 the Australian Securities and Investments Commission (ASIC) released a consultation paper relating to the independence and conflict management of research houses and research report providers in Australia. Consultation Paper 171, as it is known, seeks to update and amend ASIC's current Regulatory Guide 79 which is designed to assist research report providers to manage any conflicts of interest. The consultation paper opens the floor to the industry and any interested parties to make submissions on the proposed amendments.
Concerns that current regulation of research report providers insufficient
Research report providers are defined in ASIC's current Regulatory Guide 79 (RG 79)1 as licensees who provide research reports to clients. In providing research reports, providers have the same obligations as other licensees under section 912 of the Corporations Act 2001 (Cth) to:
- do all things necessary to ensure that their financial services are provided efficiently, honestly and fairly (section 912(1)(a))
- have in place adequate arrangements for managing conflicts of interest that may arise wholly, or partially, in their financial services business (section 912(1)(aa))
ASIC's Consultation Paper 171: strengthening the regulation of research report providers (including research houses)2 was born from a number of discussions with research houses and financial planning and industry bodies about concerns that the current regulation of research report providers was insufficient in light of recent major product failures such as the Bridgecorp, Westpoint and Fincorp collapses.
Since the industry and consumers rely to an extent on expert research when making investment choices, it is important that research houses are not only seen to be delivering "high quality, appropriate and compliant services"3, but also are actually delivering those services appropriately.
ASIC identifies conflicts, calibre of analysts and transparency as concerns
The three principal issues identified in ASIC's discussions were:
- the number of (or perceived number of) conflicts of interest arising through the business arrangements, ancillary analyst arrangements and revenue model of research houses
- the adequacy of research analysts' skill and experience
- a lack of transparency and comparability in research methodology
By way of an example, in the Administrative Appeals Tribunal case Re Kofkin, ex parte ASIC4, the tribunal noted that the Australian Financial Services Licence (AFSL) holder in question was under an obligation to research products on its Authorised Product List (APL) independently. It was noted that certain research firms may not be considered independent when their internal systems and business arrangements are examined. The tribunal noted that:
"The Professor considered it was common practice to obtain research information which was paid for by the promoter provided that the research was carried out by a researcher recognised by the industry as being independent. In his oral evidence the Professor stated that while he regarded Property Investment Research ("PIR") as independent, he did not regard [two other firms] as independent research houses".5
In that case, the issue raised by the tribunal was that the two other research houses were not only being paid for the research but also to promote the product. It seemed that there was a significant risk of conflicting interests, which jeopardised the firms' independence.
Current regulatory framework to be more tailored and comprehensive
As noted above, there is an existing regulatory regime governing the actions and accountability of research report providers. It is accepted that they are governed, as are all licensees, by the restrictions and regulations of the Corporations Act and the Corporations Regulations 2001 (Cth). Additionally, the existing statutory rules include (but are not necessarily limited to):
- the obligation of efficiency, honesty and fairness in section 912 of the Corporations Act
- compliance with financial services laws as they exist from time to time
- maintenance of adequate compliance arrangements and pro forma
- the obligation to have adequate resources, competency, training and supervision
- obligation to provide a Financial Services Guide to retail clients
- requirement to warn if general advice does not take into account objectives, financial situations or needs
- prohibitions against misleading or deceptive conduct, dishonesty, unconscionable conduct and insider trading
Although these obligations are extensive, ASIC has proposed that further amendments should be made to RG 79 in order to provide for more comprehensive and tailored regulation of research report providers. A number of significant changes have been proposed, accompanied by a list of minor amendments.
Proposed new regulatory framework for research report providers
The main amendments as they appear in Consultation Paper 171 will insert new parts into the current RG 79 requirements. There are 11 key proposed changes which can be summarised as follows:
1. Continued ASIC monitoring of research report providers by way of a two year compliance report from the research report provider which is to describe the measures taken to implement key issues in RG 79. In an appendix to the Consultation Paper, it is noted that the report must address:
- research methodology and processes
- internal conflicts management procedures
- research publication and distribution
- conflicts disclosure to users
- monitoring and updating research
- staff training and supervision
- compliance and risk management
- procedure for managing research quality and transparency
2. Research report providers should ensure robust segregation between "ancillary business units" and the research business. Ancillary business units are other operations of the business, such as consulting services and fund management services. A robust segregation would require establishment of information barriers, remuneration separation and a separate team to monitor compliance.
3. Research report providers should not publish research on their own (or a related entity's) products.
4. Research report providers should have a rigorous research process that ensures they have adequate information about the product and product issuer they are assessing. This would involve entering agreements for information disclosure with the product issuer as well as implementing internal processes such as a peer review of data and information on a particular product.
5. Research report providers should publish or otherwise make available all research for a reasonable period of time. This would include all adverse research discovered about a product even if the product issuer objects, but should not apply to privately retained research opinions. The proposed time frame for public access to the information is 30 days and the information should be fully available free of charge.
6. Full disclosure of any potential and material conflicts and disclosure of the firm's management of conflicts in plain English. The disclosure requirements already exist in RG 79 and the proposed amendments would require those to be done plainly and simply to aid comprehension.
7. Quality control of research through adequate human and other resources, including adequate training, supervision and a proper sign-off process. This would require research report providers to allocate an adequate number of analysts to a product, appropriately price their services and manage an appropriate number of research projects at a time.
8. A public system be made available with a list of all financial products covered by the research report provider, the nature of their service offering and expertise, a yearly spread of ratings and a comparison of product performance against relevant benchmarks.
9. Transparency (and explanation) of the methodology used by research firms in making their findings and recommendations, but not an enforced uniformity. This will require an awareness of other research report providers' methodologies and will be aided by the publicly available information set out by those providers. ASIC notes that the methodology could be published in summary form but must be robust.
10. Transparency and clarity on the view expressed of the product, a past performance warning, a use by date or constant monitoring of the product and a clear and prominent statement of who commissioned and paid for the report.
11. Careful due diligence of the research report providers must be conducted by licensees who seek to rely on the report given that a Financial Service Provider (FSP) cannot abrogate its "know the product" duties onto research firms.
Financial service providers will need to research the researchers
It is clear from the above points that ASIC has adopted a strict approach to compliance, transparency and avoidance of conflict. The amendments are couched in general law fiduciary language and seek to impose a high level of monitoring and regulation on research providers.
Further, the due diligence proposal will also reinforce the duty of an FSP to "know the product" before making recommendations. Should the amendments be accepted, it suggests that there will be a higher level of responsibility on FSPs effectively to "research the researchers". This would obviously be made less difficult through the transparency provisions, making all research information publicly available.
ASIC call for submissions on proposed reforms
Nonetheless, it will be open for FSPs, industry bodies and any interested party to make submissions on these points, given the blanket imposition of a high-level duty on research firms and FSPs alike.
Because they are so new, the current proposals are yet to undergo public scrutiny. The measures proposed are designed to create greater regulation of research reports. The desired outcomes behind the tighter regulatory scheme seem to be:
- greater accountability of research firms
- clear and publicly available justification of research findings
- quality control of published (and private) research
- complete and understandable disclosure of potential conflicts of interest
- transparency in the research and recommendation process
ASIC has called for comments on the proposals and asked for submissions agreeing or disagreeing with each particular proposal raised above. In addition, ASIC has asked for comments about whether the requirements should be extended to other areas or limited, whether there are any practical problems arising from the proposals, whether there are other issues that need to be accounted for by research report providers and how to properly define the terms and requirements in the proposals.
Any submissions must be provided to ASIC by 3 February 2012, with a new Regulatory Guide to be drafted and released by May 2012. For further information, please contact the writers.
1Regulatory Guide 79 is publicly available on ASIC's website at http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/managing_conflicts_interest_guide.pdf/$file/managing_conflicts_interest_guide.pdf .
2Consultation Paper 171 is publicly available on ASIC's website at: http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/cp171-published-16-November-2011.pdf/$file/cp171-published-16-November-2011.pdf .
3Consultation Paper 171 at .
4 AATA 660.
5Re Kofkin at -.