Interpretive Letter to Russell D. Sacks, Shearman & Sterling LLP
April 28, 2014
Russell D. Sacks
Shearman & Sterling LLP
599 Lexington Avenue
New York, NY 10022-6069
Re: Request for Interpretive Guidance Under NASD Rule 2711
Dear Mr. Sacks:
By letter dated April 8, 2014, you request guidance regarding the application of NASD Rules 2711(h)(1)(B) and (h)(13)(A) where timely disclosure cannot be made by a member that distributes third-party research due to foreign laws that prohibit the member from obtaining the required information about its affiliate's holdings. For the reasons set forth below, FINRA staff believes that under such circumstances, the distributing member may satisfy the rule by making the required disclosure, if applicable, based on the most current information available under the foreign law.
Based upon your letter and additional conversations, we understand the facts to be as follows.
CCB International Overseas (USA) Inc. (the Firm) is a U.S. registered broker-dealer and FINRA member. The Firm is an indirect, wholly-owned subsidiary of China Construction Bank (CCB), a stated-owned bank organized under the laws of the People's Republic of China (PRC). The Firm seeks to distribute research reports on Hong Kong listed companies prepared by China Construction Bank International Securities (CCBIS), an affiliate of the Firm and also an indirect, wholly-owned subsidiary of CCB International (Holdings) Limited (CCBI), which in turn is an indirectly wholly-owned subsidiary of CCB. Among other things, CCB controls investment funds that are subject to PRC law, rules and regulations (PRC Rules). The Firm has been informed by CCB that PRC Rules prohibit disclosure of the holdings in an investment fund controlled by CCB, except for required disclosures in particular circumstances. More specifically, the PRC Rules states that with respect to investment funds controlled by CCB, only the following must be – and can be – disclosed publicly: (1) on a quarterly basis, the top ten stock holdings in those investment funds and (2) on a semi-annual and annual basis, all of CCB's stock holdings.
The Firm's requests for monthly information regarding CCB's holdings have been denied based on the PRC Rules. CCBIS has informed the Firm that it similarly cannot obtain from CCB any holdings information beyond that which is disclosed in accordance with the PRC Rules. The Firm can obtain timely holdings information with respect to all other affiliates, including CCBIS.
NASD Rule 2711(h)(13)(A) requires a member that distributes or makes available third-party research reports to include certain conflict of interest disclosures pertaining to the distributing member. One such disclosure relates to ownership interest in securities of the subject company by the distributing member or its affiliates. NASD Rule 2711(h)(1)(B) requires disclosure if, as of the end of the month immediately preceding the date of publication of the research, the member or its affiliates beneficially own 1% or more of any class of common equity securities of the subject company. For the purposes of disclosure by a member that distributes third-party research, the requirement applies to the end of the month immediately preceding the date of distribution of the third-party research report, or if the date of distribution is less than 10 calendar days after the end of the most recent month, the disclosure information must be current as of the second most recent month.
In computing beneficial ownership of the subject company securities, a member must apply the same standards used to compute ownership pursuant to Section 13(d) of the Securities Exchange Act of 1934. The disclosure requirements generally do not apply to independent third-party research distributed or made available to customers; however, affiliate research is not considered under the Rule to be independent third-party research.
The purpose of this provision, as with the other third-party research report disclosure requirements, is to inform the recipient of a conflict that may have influenced the decision to distribute or make available third-party research on a particular subject company. The look-back period is intended to ensure that the disclosures are current, while providing a reasonable amount of time to calculate beneficial ownership and transmit that information to the appropriate personnel to include in a research report or accompany a distribution of a third-party research report.
Based on the facts presented, the complete information that may be needed to determine the applicability of the disclosure obligation is unattainable as a matter of foreign law. The Firm instead proposes to include in the calculation to determine if the disclosure threshold is met: (1) its own holdings as of the most recent or second most recent month's end; (2) the holdings of all other affiliates other than CCB, including CCBI and CCBIS, as of the most recent or second most recent month's end; (3) the most recent holdings information for CCB published in accordance with the PRC Rules and (4) to the extent the Firm has actual knowledge, additional holdings information of CCB as of the most recent month not otherwise contained in the required PRC Rules. Thus, the Firm would make the required third-party disclosure if the most current disclosed CCB holdings, as supplemented by the Firm's actual knowledge of any additional holdings, combined with the Firm and its other affiliates' holdings, results in beneficial ownership of 1% or more of any class of common equity securities of the subject company. The Firm also proposes to accompany distribution of any third-party research report with a clear and prominent explanatory note that, pursuant to the PRC Rules, the holdings of its CCB affiliate is known only as of the most recent applicable disclosure period and that the 1% calculation is based on the information from the most recent disclosure, specifying the date of that disclosure.
The staff believes the Firm's proposed disclosures under the circumstances are consistent with the purpose of the disclosure provision at issue. The Firm would be making the required disclosure based on the most current legally-available information that can be provided by its affiliates and any additional actual knowledge the Firm may have. To the extent that CCB has undisclosed holdings that would cause the disclosure threshold to be met, FINRA believes those unknown holdings could not reasonably impact the Firm's decision as to which third-party research to distribute or make available. The conflict that the provision is intended to bring to light to an investor is defined to be when the distributing member or its affiliates beneficially own 1% or more of any class of common equity securities of the subject company. Implicit in that definition is that known holdings below that threshold do not rise to the level of a conflict that requires disclosure. Thus, under the circumstances as you have described them, the conflict would not be present when, by law, the Firm cannot obtain information on existence of holdings that might otherwise cause the disclosure threshold to be exceeded.
We trust that this letter is responsive to your request. Please note that the opinions expressed herein are staff opinions only and have not been reviewed or endorsed by the FINRA Board of Governors. In addition, you should be aware that any changes in the facts as you have described them or any amendments to NASD Rule 2711 will require further consideration and may cause us to reach a different conclusion.
If you have any questions on this matter, please contact me at (202) 728-8451.
Very truly yours,
Michael D. Solomon, Senior Vice President and Regional Director – New York District Office
Melissa Wong, Senior Regulatory Coordinator, New York District Office