Joint NASD and NYSE interpretation that individuals involved in the development of certain quantitative equity research ratings model are not “research analysts” as defined by the SRO research analyst conflict of interest rules.
August 20, 2004
Mark W. Riepe, CFA
Senior Vice President
Schwab Center for Investment Research
Charles Schwab & Co., Inc.
101 Montgomery Street
San Francisco, CA 94104
RE: Schwab Equity Ratings Quantitative Model Research And the Role of Quantitative Analysts
Dear Mr. Riepe:
This will serve as a response to your correspondence dated February 23, 2004 and July 12, 2004, and additional discussions with the staffs of the New York Stock Exchange, Inc. ("NYSE") and NASD (the "SROs"), in which you requested an interpretation that the Schwab Equity Ratings ("Ratings") quantitative model (the "Model"), an equity research ratings model employed by Charles Schwab & Co., Inc. ("Schwab") does not produce "research reports," as defined by NYSE Rule 472 and NASD Rule 2711 (the "SRO Rules").1 You also request an interpretation that the individuals involved in the Model development are not "research analysts," as defined in the SRO Rules, and therefore should not be subject to the personal trading restrictions as set forth in those rules.
Based on the facts as you have described them and on certain other assurances, the SRO staffs are of the opinion that the individuals associated with developing the Model are not "research analysts" as defined by the SRO Rules. However, as discussed below, the staffs believe that the Model produces "research reports" that must comply with all disclosure and other obligations under the SRO Rules that do not relate to the "research analyst" who produced the report.
You describe the pertinent facts regarding the Model as follows. The Model collects raw data from three independent third party financial information providers to compute 24 fixed-weight factors for each security in a defined universe of over 3,000 stocks.2 The Model produces ratings that rank stocks according to their expected relative total performance over the next 12 months. Each of the stocks in the Schwab universe receives a composite score, and those scores are then ranked and assigned a rating of A, B, C, D, or F, based on a fixed distribution pattern of approximately 10%, 20%, 40%, 20% and 10%, respectively. The Model is run weekly, and the resultant Schwab Equity Ratings are then provided to select clients, primarily through posting on the Schwab website.
The Model was designed by a team of Schwab Chicago-based "quantitative analysts" who have no involvement in running the Model each week. The function of the quantitative analysts is to research for potential new factors that might expect to correlate with future stock returns. They also monitor the performance of the Model and contribute to the production of written materials used to educate brokers and clients as to the methodology of the Model and why Schwab believes the Model is of benefit. In addition, on certain occasions, these analysts participate in forums, such as webcasts or client meetings, or write materials in which they reference individual securities.
The Schwab Equity Ratings are not attributable to the quantitative analysts because the Ratings are not the product of the direct substantive analysis of those quantitative analysts. Further, you represent that the quantitative analysts cannot manipulate the Model to produce a particular rating on any individual or group of stocks and cannot know the results of the Model in advance.
There are four primary reasons why the Schwab quantitative analysts cannot manipulate or predict the Model. First, quantitative analysts are not involved with the weekly Model production run. The actual production of the Ratings is greatly automated and performed in San Francisco by a separate team of computer technicians who have no role in determining the Model inputs or source data. There are quality assurance controls in place to avoid tampering by these technicians with the computer coding to run the Model.
Second, quantitative analysts are excluded from the Schwab Equity Ratings governance structure, including decisions to change the Model's factors and formula. The Schwab Equity Ratings Policy Committee (the "Committee") has oversight and supervisory responsibility for all aspects of the Ratings.3 The Committee is composed of three senior research personnel and a senior official from Schwab Compliance. Schwab legal counsel regularly attends Committee meetings and provides legal advice as necessary. The quantitative analysts are excluded from membership on the Committee, but do make presentations and report on the development of predictive models of stock selection, the performance of the Model, and the production of educational materials in regard to the Model.
Third, all raw data used by the Model is taken from independent third-party sources that compile it. Quantitative analysts do not enter any information into the Model - all "hard" data inputs are taken from well-known, independent third-party sources. There is no subjective selection of data that is input into the Model, since every piece of data is precisely pre-defined and sourced.
Finally, all aspects of the Model are based on the consistent application of predetermined rules. All aspects of the Schwab Equity Ratings process and distribution are pre-set and internally rules-based,4 including selection of the universe of stocks, all Model data inputs and calculations, and Schwab Equity Rating assignments. The production process is automated and executed by computer with no human involvement (other than oversight and monitoring). The size of the universe covered by the Ratings, the complexity of the Model, and the fact that any given stock's Rating is dependent upon not only its own performance measures, but that of every other stock within the coverage universe makes it effectively impossible to predict the Rating for any stock, or groups of stocks, or how a Schwab Equity Rating may change over time.
Schwab notes that the Chicago-based quantitative analysts have access to a non-production facsimile of the Model that is used by them to back-test data and to provide more detail behind particular ratings during educational presentations. To guard against front-running by the quantitative analysts, the non-production facsimile Model can only be run after a substantial amount of time has passed after the Schwab Equity Ratings have been released to the public, use is limited, and an audit trail is created whenever it is run, including the identity of the quantitative analyst running the Model.
A March 2004 Joint Memorandum issued by the "SROs" noted that many research reports labeled as "quantitative" by members can and do raise conflict concerns addressed by the SRO Rules. The Joint Memorandum specifically pointed to the concern that many "quantitative" models are based on subjective formulas that could be manipulated by individuals to produce a specific result. Nonetheless, the Joint Memorandum held out the prospect that a model could be designed that was either so free from potential conflicts that the reports it generates may fall outside of the definition of a "research report" or that its structure and operation are such that it effectively does not involve "research analysts."
The SRO Rules place certain restrictions on trading by a "research analyst" of securities that the analyst covers. Specifically, the rules prohibit a "research analyst account" from: (1) purchasing or receiving pre-IPO securities if the issuer is principally engaged in the same types of business as the analyst covers; (2) purchasing or selling any security issued by a company that the analyst follows, or any option or derivative of such security, for a period beginning 30 days before and ending five days after the publication of a research report on the company or a change in rating or price target of the company's securities; and (3) trading in a manner inconsistent with the research analysts' most current published recommendation.5
Schwab seeks an interpretation that the structure and application of the Model as set forth above effectively has no "research analysts" as that term was contemplated by the SRO Rules. In addition, Schwab asserts that its processes and supervision sufficiently guard against the potential conflicts of interest that the rules address. As a result, Schwab seeks to clarify that such an interpretation would permit its quantitative analysts (and members of their households) to buy and sell securities covered by the Schwab Equity Ratings without the restrictions on personal trading proscribed by the SRO Rules.6
As part of its request, Schwab represents that the quantitative analysts would be subject to enhanced monitoring and surveillance of their personal trades. In addition, members of the Committee and the Model computer technicians would be subject to the same personal trading restrictions, monitoring and surveillance, as proposed for the quantitative analysts. Schwab Compliance will monitor the trading activity of these quantitative analysts, computer technicians and Committee members (and their household members) to ensure the integrity of the Model's control structure. In the event a suspicious trade is identified, Schwab Compliance will investigate, take appropriate action and notify their designated examining authority.
Furthermore, on infrequent occasions quantitative analysts participate in forums or write materials in which they mention individual stocks. These activities may include web casts, written articles, and live presentations to groups of Schwab clients and prospective clients. In these instances, Schwab will require the quantitative analyst to abide by all of the requirements in the SRO Rules, including the restrictions on personal trading and disclosure by research analysts. Quantitative analysts will only be permitted to discuss a subject company (and its particular Schwab Equity Rating) during a web cast, live presentation (or other type of public appearance) or written article if the quantitative analyst (or a member of his or her household) has not placed a trade in the securities of the issuer in the last 30 days prior to the date of the public appearance or written article. Similarly, they will be restricted from trading in the securities of the issuer for the five days following the public appearance or written article.
Schwab Equity Ratings Are Research Reports
The SRO Rules define a research report as a written or electronic communication that includes an analysis of equity securities of individual companies that provides information reasonably sufficient upon which to base an investment decision. It is the position of the SRO staffs that the Schwab Equity Ratings are "research reports" for purposes of the SRO Rules. As such, written communications that contain the Schwab Equity Ratings must include all applicable disclosures and otherwise comply with the SRO Rules.
Schwab Quantitative Analysts are not "Research Analysts"
Based on the facts set forth above, the SRO staffs believe the Schwab quantitative analysts fall outside the definition of "research analyst" under the SRO Rules with respect to their participation in the development of the Model.7 Specifically, NYSE Rule 472.40 and NASD Rule 2711(a)(5) define a research analyst to include an "employee of a member or member organization primarily responsible for … preparation of the substance of a research report…" (emphasis added). Although the Schwab quantitative analysts help develop the Model, the structure and application of the Model is such that no individual quantitative analyst can be deemed to be primarily responsible for the substance of the resulting "research reports" that contain the Schwab Equity Ratings. Schwab and its quantitative analysts would be expected to comply with all other applicable sections of the SRO rules and the federal securities laws.
The staffs' determination that members of the quantitative research team are not "research analysts" for the purposes of the applicable SRO Rules is based upon the objective application of the Model and the inability to manipulate or predict its results. The following aspects of the Model are significant in our conclusion: the universe of stocks; the input selection process; the number, nature and source of the inputs; the complexity of the formula and its consistent application to the universe; the inability of the quantitative analysts or technicians to alter or manipulate the model or learn of the results in advance of their public distribution; the enhanced supervision and trade monitoring; and the procedures to change the process, composition or formulas of the Model. The staffs further believe that the absence of predictability of the Model, buttressed by the enhanced supervisory procedures, provides protection against personal trading conflicts and abuses commensurate with the personal trading restrictions under the SRO Rules.
The opinions expressed herein are that of the staffs of the NYSE and NASD and have not been reviewed or endorsed by the Boards of the NYSE or NASD, respectively. This letter is in response to the issues you have raised under NYSE Rule 472 and NASD Rule 2711 and the facts you have described. In the event that any of the material facts or circumstances described herein change, Schwab would need to re-address those issues with the SRO staffs. This letter does not address any other rule or interpretation of the NYSE or NASD, or any other regulatory or legal issues, including Regulation AC. The opinions expressed herein are not to be applied to any other rule or interpretation of the NYSE or NASD and are to be used solely by Charles Schwab & Co., Inc. for the stated purposes herein.
Please contact the undersigned if you have any questions.
Don Van Weezel
New York Stock Exchange
Associate General Counsel
NASD, Regulatory Policy
cc Beth Owens Director, NASD District 1
Bruce W. Maisel, Charles Schwab & Co., Inc.
1 NASD Rule 2711 and NYSE Rule 472. See SEC Release No. 34-48252 (July 29, 2003), 68 Fed. Reg. 45875 (August 4, 2003).
2 The universe is made up of approximately 3,200 of the largest (by market capitalization) U.S.- headquartered stocks traded on the NYSE, NASDAQ or AMEX. REITs, ADRs and LPs are excluded because of the lack of comparable financial statements and "earnings per share" data. There are no subjective determinations made as to the addition or deletion of individual stocks and the process is done without manual intervention.
3 Schwab has indicated that trading by the computer technicians and members of the Committee would be subject to the same heightened monitoring and surveillance as proposed for the quantitative analysts.
4 For example, "earnings per share" ("EPS") is used in some form or fashion by many of the 24 factors. There are many definitions, methods of calculation, and sources for EPS information. For the Model, the exact form of EPS and source is pre-specified and invariant. There is no opportunity for anyone, including quantitative analysts, to plug in a different version of EPS to boost or hurt the Schwab Equity Rating of a specific stock or group of stocks.
5 The term "research analyst account" is defined as any account in which a research analyst or a member of that analyst's household has a financial interest or over which the analyst has discretion or control, except for an investment company registered under the Investment Company Act of 1940 or a blind trust account that is controlled by a person other than the analyst or a household member. The purpose of these restrictions is to ensure that publication or content of research reports are not influenced by the prospect of personal enrichment by research analysts or members of their household. See NASD Rule 2711(g)(5) and NYSE Rule 472.40.
6 See NYSE Rule 472(e) and NASD Rule 2711(g).
7 The staffs of the NYSE and NASD are not opining on whether other activities of the quantitative analysts, such as authorship of written articles concerning specific securities, might be so substantive as to render them "research analysts" for the purposes of the SRO Rules.