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Cablegate: Expert Report On Best Practices for Financial

This record is a partial extract of the original cable. The full text of the original cable is not available.

UNCLAS SECTION 01 OF 04 FRANKFURT 008629

SIPDIS

STATE FOR EUR PDAS RIES, EB, EUR/AGS, AND EUR/ERA
STATE PASS FEDERAL RESERVE BOARD
STATE PASS NSC
TREASURY FOR DAS SOBEL
TREASURY ALSO FOR ICN COX, STUART
PARIS ALSO FOR OECD
TREASURY FOR OCC RUTLEDGE, MCMAHON

E.O. 12958: N/A
TAGS: ECON EFIN EUN
SUBJECT: Expert report on best practices for financial
analysts in the EU


T-IA-F-03-0054

This cable is sensitive but unclassified. Not/not for
Internet distribution.

1. (SBU) Summary: In September a group of European experts
issued a report to the European Commission with 31
recommendations on best practices for financial analysts.
This work coincides with work underway in the US, UK and the
International Organization of Securities Commissions
(IOSCO). In September IOSCO issued a statement of principles
to guide regulators regarding potential conflicts of
interest financial analysts may encounter. The Commission
has called for comments on the expert report and will issue
a Communication of its policy approach next year. Since
financial analysts issue products for use globally, they
have to adhere to the strictest rules. A European approach
that is in line with IOSCO principles may help to avoid
potential conflicts with other national laws in the future -
assuming IOSCO members implement the principles themselves.
End Summary.

Ministers Ask for a Report
--------------------------
2. (SBU) In April 2002, against the background of market
abuses that have shaken investor confidence, the European
Commission and the EU Economics and Finance Ministers, at
their informal meeting at Oviedo, Spain, invited the
Commission to assess the role of financial analysts and
possible measures to improve their participation in the
market. In November 2002, the Commission asked a group of
experts to research and evaluate current regulatory and
market practice issues concerning financial analysis,
notably those pertaining to the assessment of securities
traded on debt and equity markets, with a view to
recommending optimal regulatory and best practice options
within an integrated European capital market. The group
consisted of 21 European experts, mostly from private banks
and investment firms and their associations, but also from
national regulators, as well as consultants and one
academic.

Report on Financial Analysts
-----------------------------
3. (SBU) The report of the group, which was released at
the beginning of September 2003, is meant to be a first step
in a process which should develop over time through
"continued and thorough consultation involving national
regulators, professional bodies and market practitioners."
The report particularly covers conflicts of interest
resulting from analyst involvement in new issues and other
corporate finance work, best practices for issuers,
analysts' remuneration and own account dealing in
securities.
4. (SBU) The group notes that while its recommendations
should respect and reflect the nature, structure and
practices of European financial markets, Europe is part of a
global marketplace and cannot be treated in isolation. For
instance, the recent comprehensive regulatory reforms in the
US will have a global impact because the firms they affect
are globally active and may thus decide to adhere to US
rules in other jurisdictions.
5. (SBU) The experts agreed that the European approach to
problems perceived in the investment research industry world-
wide should be principles-based, emphasizing transparency
and self-governance, rather than rules-based. Their
recommendations deliberately concentrate on actions,
behaviors and outcomes, rather than the legal means of
delivery. The recommendations have been framed so that they
could be implemented on a pan-European basis - either
through EU legislation or by cooperation among national
regulators and supervisors, assisted by professional bodies
and market practitioners.
6. (SBU) The Forum Group produced a list of five core
principles which it believes should be applied by those
producing and disseminating investment research:
Clarity: research should be fair, clear and not
misleading
Competence, conduct and personal integrity:
research should be produced by competent analysts
with skill, care, diligence and integrity; and it
should reflect the opinion of its author(s)
Suitability and market integrity: research should
be distributed taking into account the different
categories of its intended recipients and the need
to maintain market integrity
Conflict avoidance, prevention and management:
analysts' firms should have in place systems and
controls to identify and avoid, prevent or manage
personal and corporate conflicts of interest
7. (SBU) Disclosure: conflicts of interest, whether
corporate or personal, should be prominently disclosed.
8. (SBU) The report makes 31 recommendations which relate
to these principles. These focus in particular on conflicts
of interest resulting from analyst involvement in securities
offerings and other corporate finance work; best practice
for companies issuing securities; remuneration of analysts;
securities dealing by analysts; qualifications; and the
distribution of investment research to the retail market.
More generally, the experts recommend that investment
research produced and disseminated in the EU should comply
with the principles and standards advocated in their report
, regardless of the location of the subject companies
covered in the research.
9. (SBU) With regard to research from third countries, the
group argues that it should be permitted for use in the EU
if it was produced under equivalent rules. Where the
dissemination of research from third countries that is not
produced to equivalent standards is permitted, this should
be prominently disclosed. Moreover, the experts recommend
that the EU should seek acceptance of its standards in other
jurisdictions relating to the production and dissemination
of research.
10. (SBU) The group also notes that some of the issues
discussed are already covered by the EU Market Abuse
Directive or the Investment Services Directive.
11. (SBU) Overall, the principles and recommendations
appear to be rather general and self-evident. For instance,
"research analysts should adhere to the highest ethical
standards." According to a Commission official the expert
group did not always agree, so that their report reflects a
rather low common denominator.
12. (SBU) The Commission announced that in assessing the
Group's report and any necessity for follow-up action at the
EU-level, it will seek to strike a balance between ensuring
investor protection, allowing investors to benefit from an
open and competitive market for financial research and
investment advice, and avoiding undue restrictions on the
services investment banks can offer, thus ensuring that
listed companies have access to the corporate finance
services they need. The Commission has asked for comments
from interested parties by November 30th 2003.

Commission expert View
----------------------
13. (SBU) A Commission expert working on the report
explained that the trickiest issue was whether banks could
manage the potential conflict between its financial analysts
and investment banking department. He also admitted that
the report was rather broad and hoped that the comments the
Commission will receive will give them "more orientation" on
how to address the issue. He personally doubted that new
legislation was needed, particularly given that the Market
Abuse Directive and Investment Services Directive address
some of the potential conflict of interest issues. He
thought that next year the Commission would issue a
"Communication" that would present its views on how to
proceed.
14. (SBU) On the provisions regarding financial analysts
from third countries, this expert reported that the topic
had been subject to very little discussion. The group also
did not have a real discussion of the US Securities and
Exchange Commission's approved changes to the NASD and NYSE
rules to address conflicts of interest raised when research
analysts recommend securities in public communications. He
thought that investment banks had not reacted to these rules
as negatively as auditing firms had reacted to the new US
registration requirements.

A View From the Market
-----------------------
15. (SBU) We talked to a contact at Deutsche Bank who had
been listed as member of the expert group. He told us that
he only participated in the very first meeting and would
have considered it a "waste of time" to come back. He
criticized that most other members of the expert group, even
from banks, were not practicing analysts, i.e. often came
from other departments and did not know much about the
practical side. He felt that his views were not
sufficiently taken into account.
16. (SBU) Our contact argued that the approach of the group
was wrong, as it focused on bank analysts. In his opinion
journalists and tip letters should be regulated as well. He
stressed that while analysts only speak with professional
investors, the other two groups give their advise to retail
investors, are not regulated as banks are, and have a very
small reputational risk. Moreover, our contact argued that
the issuer's prospectus is the most important source of
information in an IPO and that regulation should thus focus
on its accuracy. He pointed out that as a consequence of
regulation, independent research houses are being opened,
which are not regulated and make investment recommendations
that could just be as harmful to investors as those of
banks. (Note: The expert group recommended that analysts in
independent houses should be required to respect the
principle of the report.) With regard to EU regulation, the
Deutsche Bank analyst stated that banks doing business on a
global scale will always adhere to the strictest rules world-
wide anyway. It makes no sense to differentiate between
markets.

Other Developments
--------------------
17. (SBU) At the beginning of September, the British
Financial Services Authority (FSA) announced that it will
not enact specific rules for analysts regarding their
independence as well as conflicts of interest. Instead it
will publish general principles, which will be in line with
those formulated by IOSCO as well as with EU policies in the
framework of the market abuse directive. FSA chairman
Howard Davies stressed that his organization starts from the
assumption that it is the obligation of each bank's top
management to eliminate obvious conflicts of interest.
Thus, the FSA continues to rely on the self-regulation
approach it has been following so far.
18. (SBU) In May the SEC approved proposed changes of rules
by NASD and NYSE to address conflicts of interest that are
raised when research analysts recommend securities in public
communications. The EU expert group's report and the Market
Abuse Directive overlaps with several of these, such as
limitations on relationships and communications between
investment banking departments and analysts, linking an
analysts compensation to specific investment banking
transactions, compensation by firms for investment banking
services, restrictions on trading by analysts and
disclosures of financial interests. However, the SEC
approved rules, generally, tend to be more prescriptive and
not general principles.
19. (SBU) At the end of September, the International
Organization of Securities Commissions (IOSCO) issued a
Statement of Principles to guide regulators and other in
addressing the conflicts of interest that analysts may face.
The principles, inspired by the SEC approved rules cited
above, stipulate that mechanisms should exist so that
analysts' work is not prejudiced by their or their
employers' financial or business relationship interests, and
that reporting lines should be structured to eliminate or
severely limit actual or potential conflicts of interest.
Moreover, firms should establish written internal procedures
to identify, eliminate, manage or disclose actual or
potential conflicts of interest. There should be no undue
influence of issuers, institutional investors or other
outside parties on analysts. Disclosure of actual or
potential conflicts of interest should be complete, timely,
clear, concise, specific and prominent. Analysts should be
held to high integrity standards. Investor education should
play an important role in managing analyst conflicts of
interest.
20. (SBU) These principles are combined with a set of "core
measures" that are considered necessary to properly address
potential conflicts of interests. These "core measures"
contain clear prohibitions, e.g. of analysts or their
employers trading securities ahead of publishing research on
the issuer, of analysts reporting to the investment banking
function or participating in investment banking sales
pitches. The German Financial Supervisory Authority (BaFin)
announced that it is in favor of making these principles
binding in Germany. The British FSA stated that it will
largely adopt the IOSCO principles. Experts believe that
they will also considerably influence the EU directives on
market abuse and investment services.

Comment
-------
21. (SBU) The issue of investment banks and analysts has
been an issue raised in Germany while the "Neuer Market" was
melting down. Efforts by the Economics Ministry to forge a
voluntary code of conduct could not secure sufficient
agreement among all interested parties. Investors' groups,
however, still see a need.
22. (SBU) EU legislation is already covering part of these
issues, such as the Market Abuse Directive and its
implementing measures on the fair presentation of investment
recommendations and the disclosure of conflicts of interest.
However, even in those rules developed by the Committee of
European Securities Regulators, the approach is more towards
disclosure than prescriptive rules. As the Deutsche Bank
analyst observed, global investment banks have to comply
with the strictest rules. If those are in the US, then, in
his view, the US rules rule.
23. (SBU) Since the EU has yet to propose any standards on
financial analysts it would stand to reason that whatever
they propose should be in line with those adopted by IOSCO.
The fact that IOSCO standards reflect US standards is
partially a function that securities market regulators have
similar views on the topic rather than bowing to US
influence. Having similar rules in the US and EU could help
avoid potential problems and conflicts in the future.
24. (U) This cable was coordinated with Embassy Berlin and
USEU.

25. (U) POC: Claudia Ohly, Treasury Representative, e-mail
ohlyc@state.gov; tel. 49-(69)-7535-2367, fax 49-(69)-7535-
2238.

BODDE

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