What does ASIC’s report on the handling of material non-public information and the management of conflicts mean for Australian market practice?

Following an almost 2 year investigation into the policies, procedures and practices of a range of investment banks and brokers in Australia, ASIC has released a new report (Report 486) setting out its findings on the identification and handling of material non-public information (MNPI) and the management of conflicts in the context of sell-side (or broker) research and corporate advisory activities.

The report is a further example of the enquiries ASIC has been making into practices by corporate advisers and investment bank research analysts (for example, see ASIC Report 393: Handling of confidential information: Briefings and unannounced corporate transactions)

Although ASIC provides many interesting examples of behaviour that it found concerning during the course of its investigation, the “better practices” recommendations sections of its report do not provide detailed guidance on how to manage all such potential conflicts.  The examples included in the report have been chosen to highlight the most problematic behaviour, but the commentary casts a shadow across practices more broadly.

Report 486 identifies some practices in Australian firms that raise concerns including:

• failure to identify and appropriately handle MNPI;
• a lack of research independence;
• inadequate use and supervision of information barriers and restricted lists;
• insufficient separation (physical and technological) of research and corporate advisory activities;
• inconsistent conflict management practices; and
• questionable practices around allocation of securities in capital raising transactions and staff and principal trading.

In response to these findings, ASIC has outlined a number of controls that it expects firms to consider in order to better handle MNPI and manage conflicts.  Implementing these recommendations will be key for minimising the risk that a breach of financial services law may occur – for example, insider trading, market manipulation, misleading and deceptive conduct and breaches by AFS licensees of their general obligations.

With ASIC indicating that it will be seeking industry consultation on a proposed new regulatory guide addressing its findings and recommendations from Report 486, it is likely that the Australian market may have to change certain existing practices and adopt new practices to ensure that the principles underpinning the preparation and use of analyst research are sound.

In particular, ASIC’s findings and recommendations for better practice are particularly significant in relation to:

• the structure and funding of research, including remuneration structures for research analysts;
• expectations around the provision of research coverage (including in mandate letters); and
• the nature of involvement of research teams in pre-deal investor education (PDIE) and compliance monitoring for investor education research.

The key findings of Report 486 in relation to each of the above were:

Structure and funding of research

Where research funding is linked to corporate advisory revenues, or individual research analyst bonuses are linked to their contribution to securing capital raising mandates, the quality and independence of research teams may be compromised.  ASIC found that corporate advisory departments of large firms typically subsidise between 30%-50% of their research teams’ costs (and speculate that figure is higher for smaller firms), and that firms often look for synergies between their research, sales and corporate advisory teams in order capitalise on that investment.

In ASIC’s view, risk areas, including wall crossings, restricted lists and staff trading approvals, should be subject to oversight by compliance or an independent control function.

Better practices:  ASIC’s recommendations for better practice include:

• effective physical and technological barriers between research staff and staff performing corporate advisory or sales functions; and
• decisions about remuneration of research staff not being made by corporate advisory or other conflicted staff, and not taking into account any specific corporate advisory transaction.

Pressure for favourable coverage

Research reports may breach the misleading and deceptive conduct provisions of the Corporations Act if they are not based on reasonable grounds.  Where there is an expectation of research coverage (e.g. because coverage is promised if a mandate is awarded), or pressure that research will be supportive of a transaction, there may be a higher risk that the report is therefore not based on reasonable grounds.

ASIC observed instances of firms’ corporate advisory staff seeking to influence their research team to cover particular companies or to adjust their approach to valuation.  Such behaviours may be seen as assisting a firm to secure a prospective mandate or a discretionary incentive fee – for example, where a mandate letter includes an incentive fee determinable following completion of the transaction and release of any “investor education” research – the implication being that this arrangement may influence the research analyst delivering a report in line with the issuer’s expectations.

Better practices:  ASIC’s recommendations for better practice include:

• decisions about research coverage should be made by the research team and not subject to influence from other parts of the firm or from corporate issuers;
• when pitching for corporate advisory work, the corporate advisory team should not express or imply that the firm will initiate research; and
• research analysts should only provide draft research to persons outside the research department for fact checking.  These draft reports should not contain financial forecasts, valuation information, price targets, recommendations, opinions, information that is not public or, in the case of an IPO, information that is not included in the prospectus.

Research involvement in corporate transactions

ASIC found a number of instances where research analysts were involved in IPO pitches, including providing valuation opinions and attending pitch meetings.  On occasion, implicit or explicit promises were given to issuers that research coverage would be provided. 

It was also found that firms with key roles in IPOs generally initiate research coverage with a recommendation of ‘buy’ or above; that independent advisers are increasingly requiring firms to assist in marketing and share their un-redacted research with the corporate issuer before the research is published; and independent advisers are also requiring mandated firms to explain their policies and procedures should a research analyst’s research ‘not be supporting of the IPO for valuation, timing or other issues’.

All of these instances have the potential to affect the integrity of research.

In addition, ASIC provided some specific observations about PDIE research – both in relation to MNPI and conflict management.  There are a number of concerns around the use of PDIE research for investment banks, for corporate issuers and for potential investors.

For example, although PDIE research can be useful to provide information to potential investors on a company or sector they may not be familiar with, the provision of PDIE research only to a select number of investors increases the risk that the investor may be in receipt of MNPI.  In particular, ASIC has raised concerns about the risks of MNPI where there is a close and predictable correlation between valuations given to a corporate issuer in post-IPO initiating research and the research analyst’s earlier ‘investor education’. 

From a conflict management perspective, Report 486 describes instances where investors who participated in investor education meetings and provided feedback received priority or favourable treatment in the eventual share allocation process in some cases.

Investors who have received PDIE appear to be advantaged over other potential investors because, although price per share targets are not usually included in PDIE, a valuation range or other valuation information may be included.  Investors are given an indication of the research analysts’ approach to valuation and an indicative valuation range, which may provide a guide of the likely price target to be contained in the research released post-listing. 

Report 486 confirms that ‘investor education’ research should not contain information that is not included in the prospectus – for example, PDIE research should not contain financial information which extends beyond the forecast period in the prospectus.  As the Corporations Act requires that a prospectus contain all information that investors and their professional advisers would reasonably require to make an informed assessment of an offer, to include additional forecast information in PDIE research and not in the prospectus would open the corporate issuer to scrutiny for omitting material information from the prospectus.  Conversely, a research publisher that includes extended forecast information in its research reports may find it difficult to justify the reasonable grounds upon which the extended forecast is made, if the corporate issuer has not included that information in their offer document.

ASIC proposes further consultation with industry regarding the role and appropriateness of ‘investor education’, to ensure that good research practices are followed.

Better practices:  ASIC’s recommendations for better practice include:

• restricting research analyst involvement in pitching for corporate advisory mandates;
• not committing to provide research coverage (either explicitly or implicitly) for an issuer where the firm is currently mandated or where the firm is seeking a mandate; and
• improved compliance monitoring in investor education research, including:
• reviewing and maintaining records of communications between the research analyst and the corporate issuer when preparing investor education; and
• reviewing investor education research to make sure it does not include information that is not contained in the prospectus or otherwise publicly available, and is not tipping-off potential investors about the price target to be contained in the subsequent initiating research report.

Going forward, the likely practical consequences of ASIC’s recommendations (and expected regulatory guidance) will be that investment banks in Australia will need to:

• Mandate letters: Ensure mandate letters do not promise research coverage should a mandate be awarded (whether directly or indirectly)
• Remuneration: Remove any nexus between the provision or outcome of research and the remuneration of research analysts
• PDIE research: Ensure PDIE research does not contain information that is inconsistent with or goes beyond information included in a prospectus
• Pitches: Restrict research analyst involvement in pitching for corporate advisory mandates
• Separation: Implement and monitor compliance with effective physical and technological barriers between research staff and staff performing corporate advisory or sales functions
• Compliance: Ensure that wall crossings, restricted lists and staff trading approvals are subject to oversight by compliance or an independent control function

ASIC is also conducting a review of the practices used by firms to market IPOs to investors other than institutions, including the use of social media and other platforms to market these transactions.  A separate report on this issue is expected from ASIC later this year.