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SEC Comes Down Hard on Misleading Issuer-Paid Research Reports Giving the Impression of Professional Impartiality

In compliance with Section 17(b) of the Securities Act of 1933, any and all compensation received from a specific company must be publicly stated in all research reports and other correspondence, with the amount and paying party disclosed.

On April 10, the Securities and Exchange Commission (SEC) announced enforcement actions against numerous individuals and entities allegedly responsible for various stock promotion schemes that left investors with the impression they were reading independent, unbiased analyses on investing websites, while writers were secretly compensated for touting company stocks. The writers allegedly posted bullish articles about the companies on the Internet under the guise of impartiality when in reality they were nothing more than paid advertisements. More than 250 articles specifically included false statements that the writers had not been compensated by the companies they were writing about, the SEC alleged.

According to the SEC’s orders as well as a pair of complaints filed in federal district court, deceptive measures were often used to hide the true sources of the articles from investors. For example, one writer wrote under his own name as well as at least nine pseudonyms, including a person he invented who claimed to be “an analyst and fund manager with almost 20 years of investment experience.” One of the stock promotion firms went so far as to have some writers it hired sign non-disclosure agreements specifically preventing them from disclosing compensation they received. In another scheme, a chief executive secretly authored articles.

The SEC filed fraud charges against three public companies and seven stock promotion or communications firms as well as two company chief executives, six individuals at the firms, and nine writers. While the stock promoters were charged under Section 17(b), which does not apply to issuers, the companies were alleged to have participated in a fraudulent scheme under Rule 10b-5(c). Of those charged, most agreed to settlements that included disgorgement or penalties ranging from approximately $2,200 to nearly $3 million based on the frequency and severity of their actions, and penny stock and officer and director bars. Separately, two of the public companies and many of the individuals were sued for this conduct in securities class action lawsuits brought after a journalist revealed the scheme. The SEC also released an investor alert on the SEC webpage warning that articles on an investment research website that appear to be an unbiased source of information or provide commentary on multiple stocks may in fact be undisclosed paid stock promotion.

The SEC release again highlights the dire lengths some people will take in view of the absence of independent research and trading support in the micro- and small-cap market. There is a real issue of what companies may legally do if they cannot get research coverage. By some measures, it is estimated that about two-thirds of all life sciences companies have this problem. Purchased research coverage is often reasonably debated by company boards of directors, with critics charging that such research is generally considered biased and is usually discounted. Other boards credit industry-experienced providers of research coverage who have the ability to provide independent interpretation, albeit paid for by the issuer. Finally, there has always been the question as to whether an issuer, by purchasing research with little or no independent interpretation, assumes a responsibility to investors beyond conforming to Regulation FD.

To address the issues identified in the SEC’s enforcement actions, preparers of research reports should prominently indicate in the main text of any report (and the featured company, in the instance of issuer-paid research, should verify that the report includes) the following disclosures:

  • Whether the author is a FINRA registered broker-dealer or investment adviser and whether it provides investment banking services.
  • Whether the author accepted or will receive fees, stock or other compensation for preparing its research report (and are those fees fairly reflective of the costs associated with such services).
  • Whether the author has been retained or hired by the company featured in its report or by any other party to prepare the report.
  • Whether the author (or its officers, directors or affiliates) may receive compensation from the company featured in its report for non report-related services which may include charges for presenting at author-sponsored investor conferences, distributing press releases and performing certain other ancillary services, and indicate the dollar amount or range of those fees.
  • Whether the company on which the author has issued a report is required to engage it with respect to these non report-related services.
  • Whether the company featured in the report previously paid the author in cash or in the company’s stock for a research report or other non report-related services.
  • Whether compensation is received on the basis of a fixed fee, or whether the fee is in any way contingent upon positive opinions and conclusions in its research report.
  • Whether the author (or its affiliates) may have a long equity position (or short sale position) with respect to a non-controlling interest in the publicly traded shares of the company featured in its report, and whether it follows customary internal trading restrictions pending the release of its report.
  • Whether the report belongs to the author and is not attributable to the company featured in its report.
  • Whether the report was based solely on publicly available information about the company featured in the report and whether the author considers it accurate, complete and reliable.
  • Whether the author’s report is disseminated primarily electronically or in printed form, and whether the electronic report is made simultaneously available to all recipients.