[Federal Register Volume 59, Number 18 (Thursday, January 27, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-1716]


[[Page Unknown]]

[Federal Register: January 27, 1994]


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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-33498; File No. SR-MSRB-94-01]

 

Self-Regulatory Organizations; Proposed Rule Change by the 
Municipal Securities Rulemaking Board Relating to Suitability of 
Recommendations

January 21, 1994.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''), 15 U.S.C. 78s(b)(1), notice is hereby given that on January 
7, 1994, the Municipal Securities Rulemaking Board (``Board'' or 
``MSRB'') filed with the Securities and Exchange Commission 
(``Commission'') a proposed rule change as described in Items I, II, 
and III below, which Items have been prepared by the self-regulatory 
organization. The purpose of the proposed rule change is to strengthen 
the MRSB's rules governing customer suitability. The Commission is 
publishing this notice to solicit comments on the proposed rule change 
from interested persons.

I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The Board is filing amendments to rule G-19, concerning suitability 
of recommendations and rule G-8 concerning recordkeeping. The proposed 
rule change: (1) Clarifies and strengthens the existing language of 
rule G-19 that requires suitability determinations to be made when 
recommending transactions to customers; (2) clarifies the obligation of 
dealers to make reasonable efforts to obtain specific types of customer 
suitability information for all accounts that are not ``institutional 
accounts'' (i.e., retail accounts); and (3) clarifies the definition of 
``institutional account.''

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the Board included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below and is set forth in sections (A), (B), and (C) below.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    The proposed rule change is designed to strengthen the Board's 
customer suitability rule. In a letter dated May 8, 1992, the 
Commission's Division of Market Regulation asked the Board to review 
the requirements of rule G-19 on suitability of recommendations.\1\ In 
September 1992, the Board published a Request for Comments on a number 
of customer protection issues, including the application of rule G-19 
to customer transactions. After reviewing these matters, the Board 
decided that rule G-19 embodies the appropriate general standard for 
dealers in making recommendations to customers. Nevertheless, the Board 
recognized there was a perception that certain provisions of the rule 
could be viewed as permitting recommendations to go forward without 
proper regard to the nature of the security being recommended and the 
customer to whom it is recommended. Accordingly, at the May 1993 Board 
meeting, the Board approved a Request for Comments on draft amendments 
to clarify and strengthen the suitability requirements of rule G-19. 
The draft amendments were approved at the November 1993 Board meeting 
and form the basis of the proposed rule change.
---------------------------------------------------------------------------

    \1\Letter from William H. Heyman, Director, Division, 
Commission, to Christopher A. Taylor, Executive Director, MSRB (May 
8, 1992).
---------------------------------------------------------------------------

    Rule G-19 generally requires that, before making any recommendation 
to a customer, a dealer must first determine that the proposed 
transaction is suitable for the customer. To strengthen rule G-19, the 
proposed rule change eliminates two provisions from the rule which, in 
effect, are exceptions to this general requirement. The first such 
provision permits a dealer to make a recommendation when a customer 
refuses to provide sufficient information about himself for the dealer 
to determine that the recommendation is suitable for the customer. The 
provision states that a recommendation can go forward in this case as 
long as the dealer has no reasonable grounds to believe and does not 
believe that the recommendation is unsuitable (the ``not unsuitable'' 
provision). Although the Board did not conclude that this provision was 
the cause of customer protection problems (i.e., there was no evidence 
that dealers relied on this provision to make unsuitable 
recommendations), the Board believed that the provision should be 
deleted to avoid any ambiguities regarding a dealer's obligation to 
make a suitability determination. Eliminating the provision also will 
prevent any future use of the provision as an excuse for unsuitable 
recommendations.
    The second provision of rule G-19 that is removed by the proposed 
rule change provides that a dealer, notwithstanding its determination 
that a transaction is not suitable for a customer, may, after so 
informing the customer of this, nevertheless respond to the customer's 
requests for investment advice and execute transactions at the 
direction of the customer. This ``notwithstanding'' provision allows 
dealers to recommend specific municipal securities to investors who 
want to invest in municipal securities even after being informed by the 
dealer that, based on their financial circumstances, investments in 
municipal securities would not be suitable. While there have been no 
reported problems associated with this provision, the Board, 
nevertheless, believed that this exemptive provision also should be 
deleted to strengthen the suitability rule.
    The Board also reviewed and clarified the customer data inquiries 
that are necessary for non-institutional and institutional accounts. 
For non-institutional (i.e., retail) accounts, the proposed rule change 
clarifies that dealers must make reasonable efforts to obtain the 
following information: the customer's financial status, tax status, 
investment objectives and such other information used or considered to 
be reasonable and necessary by the dealer in making recommendations to 
the customer. For some institutional customers, however, these specific 
information requests may not be appropriate. For example, the ``tax 
status'' of a tax-exempt bond fund generally is not relevant to a 
suitability determination. Therefore, the proposed rule change does not 
provide a specific list of items that must be requested from all 
institutional accounts, but does state that dealers must obtain 
appropriate and sufficient data from each institutional customer to 
make a suitability determination for each transaction that is 
recommended (as also is required for non-institutional accounts).
    Finally, the proposed rule change revises the definition of 
``institutional account'' contained in rule G-8. This definition is 
used in rule G-19, by cross-reference. This amendment would make the 
Board's definition of institutional account the same as the National 
Association of Securities Dealers' (``NASD'') definition for purposes 
of suitability determinations. Accounts that do not qualify as 
``institutional accounts'' (i.e., retail accounts) would be subject to 
the specific information inquiries described above.
    The Board believes the proposed rule change is consistent with 
Section 15B(b)(2)(C) of the Act which provides that the Board's rules:

be designed to prevent fraudulent and manipulative acts and 
practices, to promote just and equitable principles of trade * * * 
to remove impediments and to perfect the mechanism of a free and 
open market in municipal securities, and, in general, to protect 
investors and the public interest.

    The Board believes that the proposed rule change will protect 
investors and the public interest because it is designed to ensure that 
dealers, before making a recommendation to a customer, make a 
determination that the municipal securities transaction is suitable.

B. Self-Regulatory Organization's Statement on Burden on Competition

    Because the proposed rule change will have an equal impact on all 
dealers, the Board believes that the proposed rule change will not have 
any impact on competition.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

September 1992 Request for Comments

    In September 1992, as part of the Board's general review of 
customer protection measures, the Board requested comment on potential 
problem areas in the municipal securities market and suggestions for 
how customer protection could be improved. Specific questions were 
asked about the effectiveness of rule G-19 and the Board obtained 
various comments on the ``not unsuitable'' provision of rule G-19 from 
Merrill Lynch, North American Securities Administrators Association, 
Barre & Co., Griffen, Kubik, Stephens & Thompson, and the Public 
Securities Association.
    While some of these commentators at that time believed that the 
``not unsuitable'' provision should be deleted, other commentators 
believed it should be retained because some customers do not wish to 
provide certain information about themselves. Specifically, two 
commentators believed that removing the provision would not be a 
problem and would make the Board's rule consistent with normal practice 
in other securities markets. Three commentators noted that some 
customers do not want to provide their financial information to a 
dealer. One of those commentators indicated, however, that ``in the 
vast majority of cases, dealers do routinely obtain information for 
each customer account reflecting net worth, income level and investment 
objectives.''

August 1993 Request for Comments

    In August 1993, the Board published for comment the proposed rule 
change. Comment letters were received from Fidelity Investments, First 
Interstate Bank of Oregon, Heitner Corporation, Lehman Brothers, 
Liberty Bank and Trust Company of Tulsa, Merrill Lynch, and the 
Securities Department of Arkansas.

Comments on the General Approach of the Proposed Rule Change

    In general, the commentators' reaction to the approach taken by the 
proposed rule change was favorable. One commentator agreed with the 
Board's approach by stating that the proposed rule change would address 
a ``difficult problem'' by deleting the ``not unsuitable'' and 
``notwithstanding'' provisions from the current suitability rule. 
Another commentator noted that rule G-19 ``as reformulated by the Board 
sets forth an appropriate affirmative standard.'' Two other 
commentators also expressed general support for the approach taken by 
the proposed rule change.
    Two commentators expressed reservations over removal of the ``not 
unsuitable'' and the ``notwithstanding'' provisions. One commentator 
opposed both changes because of its belief that the majority of its 
customers are not willing ``to divulge their financial strength.'' 
Another commentator, while indicating that it does not make 
recommendations in municipal securities to customers, also believes 
that the ``notwithstanding'' provision should be retained because a 
customer may disagree with a dealer's opinion of unsuitability. That 
commentator indicated that dealers should be permitted to make 
recommendations to a customer who has already decided to purchase a 
municipal security and who asks for assistance in choosing an issue, 
even if the transaction would be unsuitable for the customer.
    While the ``not unsuitable'' and the ``notwithstanding'' provisions 
were initially adopted by the Board in the late 1970s for reasons 
similar to those cited by the commentators, the Board notes that there 
have been significant changes in the municipal securities market since 
that time. The number of retail investors has increased and the 
introduction of increasing numbers of complex, and in some cases, 
speculative municipal securities has become a characteristic of today's 
market. In such an environment, the Board believes that it is critical 
that dealers have clear policies to ensure that sales personnel do not 
recommend securities to customers without first establishing the 
suitability of the transaction. Therefore, the Board believes that the 
proposed rule change deleting these provisions is necessary.

Comments on Specific Provisions of the Proposed Rule Change

    Commentators offered several specific suggestions and sought 
guidance from the Board in a number of areas of the proposed rule 
change.

Customer Account Data and Suitability Determinations

    The proposed rule change includes an amendment to rule G-19(b) 
which states that, for retail customers, prior to making a 
recommendation a dealer must ``make reasonable effort to obtain 
information concerning: (i) The customer's financial status; (ii) the 
customer's tax status; (iii) the customer's investment objectives; and 
(iv) such other information used or considered to be reasonable and 
necessary by such broker, dealer or municipal securities dealer in 
making recommendations to the customer.'' Two commentators were 
concerned as to what would happen if all such information could not be 
obtained. As indicated in the Request for Comments, the language of the 
proposed rule change does not necessarily preclude a dealer from making 
a recommendation if all items of information enumerated in the proposed 
amendment to rule G-19(b) cannot be obtained. Given the nature of the 
transaction (e.g., the nature of the security and the known items of 
information about the customer), the dealer may have enough customer 
data to make a specific, affirmative suitability determination for the 
recommendation, even if the customer refuses to provide some of the 
requested information. However, reasonable efforts must be made to 
obtain all customer information listed in the proposed amendment to 
rule G-19(b), in any event.
    As noted above, the amount of customer information that is required 
to make a suitability determination depends in part upon the nature of 
the transaction recommended. With respect to some types of 
transactions--for example, those in more speculative securities--the 
amount of information needed to make a suitability determination will 
be greater than if a more conservative recommendation is being made. 
One commentator requested that the Board provide guidance on this 
subject by specifying ``core'' suitability information that must be 
obtained from a customer even when making a ``conservative'' 
recommendation. That commentator also requested that the Board provide 
specific guidance on what would be considered ``more speculative'' 
securities for which more detailed customer account data would be 
needed.
    The proposed rule change to rule G-19(b) states that dealers must 
make reasonable efforts to obtain certain ``core'' customer suitability 
data for recommendations to non-institutional customers including: (i) 
The customer's financial status; (ii) the customer's tax status; (iii) 
the customer's investment objectives; and (iv) such other information 
used or considered to be reasonable and necessary by such broker, 
dealer or municipal securities dealer in making recommendations to the 
customer. The Board notes that if, after reasonable efforts, a dealer 
cannot obtain all such information regarding a customer, but 
nevertheless desires to proceed with a ``conservative'' transaction, 
the dealer must exercise its judgment, based on known information about 
the customer and the security, as to whether a suitability 
determination can be made. Furthermore, all information about the 
customer that is used in making this determination must be recorded in 
the customer account record under rule G-8(a)(xi)(F).
    The Board also believes it to be inadvisable to attempt to provide 
detailed guidance on whether a particular security or proposed 
transaction is more ``conservative'' or more ``speculative.'' The Board 
notes that dealers will have to make such decisions based on their 
knowledge of the security and the risks involved in the transaction. 
Attempts to state a universally applicable formula for such 
considerations could encourage the substitution of simplistic 
guidelines for the broader judgment that is sometimes required to 
determine whether a proposed municipal securities transaction includes 
a relatively low or high degree of risk.

Unsolicited Transactions

    Several commentators requested that the Board provide guidance on 
how to identify and document ``unsolicited'' transactions, i.e., 
transactions that are not recommended. Neither the current version of 
rule G-19 nor the proposed rule change precludes dealers from executing 
specific transactions at the request of customers, where no 
recommendation is made. Thus, the suitability requirements of the 
proposed rule change would not apply to such ``unsolicited'' 
transactions. The Board notes, however, that most municipal securities 
transactions are made in connection with recommendations. Because of 
its concern with customer protection and in recognition of the special 
characteristics of the municipal securities market, the Board views the 
term ``recommendation'' (and the application of the Board's suitability 
requirement) broadly. For example, with respect to transactions 
occurring after investment seminars and in response to a dealer's 
advertisements, the Board has indicated that the suitability 
requirements of G-19 apply ``in the same way they apply to all other 
recommendations made to customers.'' Thus, although transactions may, 
in some instances, be ``unsolicited'' if a customer places an order for 
a specific security, transactions cannot be considered unsolicited if 
the order occurs after a dealer has mentioned a specific security to a 
customer (e.g., in a listing of offerings, an advertisement or in any 
other communication by the dealer to the customer).
    One commentator asked how ``unsolicited'' orders should be 
specified in a dealer's records, and whether such orders should always 
be handled by the dealer ``as agent.'' Board rules do not require 
dealers to handle specific types of orders as either principal or 
agent. Rule G-8(a)(vi), however, specifies the recordkeeping 
requirements for the terms and conditions of an agency order, including 
the fact that it is an agency order. Similarly, rule G-15(a)(vii) 
requires the confirmation to state the agency role of a dealer in a 
transaction. Neither rule G-8 nor rule G-15 has provisions for 
documenting orders as ``unsolicited.''
    As previously noted, the Board believes that relatively few 
transactions in municipal securities actually are ``unsolicited.'' 
While documenting these relatively rare transactions as such on the 
confirmation and in the dealer's records may be prudent for the 
dealer's own protection, the Board is concerned that incorporating a 
requirement in the Board's rules might have the unintended and 
undesired effect of encouraging the classification of transactions as 
``unsolicited,'' even when they are not ``unsolicited'' under Board 
rules.

Institutional Accounts

    The Board received several comments concerning the proposed 
definition for institutional account contained in the proposed rule 
change and the more generally stated suitability standard for 
institutional accounts. No commentator argued that it was inappropriate 
to distinguish between institutional and non-institutional investors 
when obtaining customer account data and making suitability 
determinations. One commentator believed the proposed standard for 
institutional investors was appropriate and noted that the information 
relevant to a suitability determination for a specific institutional 
account is necessarily a matter of judgment for the dealer. One 
commentator, however, suggested the establishment of specific minimum 
requirements for institutional accounts and specifically suggested that 
dealers should document the customer's investment objectives (including 
credit quality and maturity standards) and ``other information'' used 
or considered reasonable or necessary by the dealer. Another 
commentator suggested including corporate resolutions, trading 
authorization, and yearly audited financial statements as required 
information for institutional customers.
    As indicated by several commentators, it is often necessary or 
advisable to obtain specific kinds of information from an institutional 
investor. Rule G-8(a)(xi)(F) currently requires that the customer 
suitability information used to make a suitability determination be 
recorded in the customer account record. The proposed rule change to 
rule G-8 also makes this requirement clear. In addition, rule G-
8(a)(xi) also requires other customer account information including, 
among other things, the customer's name and address, tax identification 
or social security number and with respect to discretionary accounts, 
the customer's written authorization. For various types of 
institutional accounts, it may be advisable for dealers to obtain 
certain additional data and documentation. Often this additional 
documentation may be necessary for the dealer's own protection (e.g., 
trading authorizations). Similarly, for certain institutional accounts, 
dealers may wish to obtain yearly audited financial statements where 
assurance is desired that the account is and remains an institutional 
account for the purpose of rule G-19.
    Because of the wide variety in the types of institutional accounts 
and the documentation that might be necessary to establish suitability 
or otherwise considered to be necessary and prudent by the dealer, the 
Board believes that dealers ultimately will have to employ a certain 
degree of judgment in determining what information and documentation 
should be obtained and recorded for specific institutional customers 
beyond that now required by rule G-8(a)(xi).
    One commentator noted that, in many instances, a suitability 
determination should be made on the basis of the investment objectives 
articulated by an institution for a specific transaction or a specific 
component of a large investment portfolio. In these cases, the overall 
investment objectives of the institution or portfolio may not be the 
deciding factor in determining suitability. The Board notes that this 
view is consistent with the current language of rule G-19 and the 
proposed rule change, which requires that a dealer have reasonable 
grounds for recommending a transaction ``based on the facts disclosed 
by such customer or otherwise known about such customer.'' Clearly, if 
specific portfolio or transaction objectives are given, the proposed 
rule change and current Board rules require that such information be 
used to make a suitability determination and be recorded pursuant to 
rule G-8(a)(xi)(F).
    One commentator preferred the Commission's definition of 
``accredited investor'' to the definition of ``institutional account'' 
in the proposed rule change. The Commission's accredited investor 
definition includes a wide range of investors, such as any private 
business development company or individuals making in excess of 
$200,000 per year for three years. The term ``accredited investor'' is 
used as part of an exemptive provision from certain registration 
requirements under the Securities Act of 1933. Having a customer 
classified as an ``accredited investor,'' however, does not excuse 
dealers from obtaining specific customer account data when making 
recommendations in equity transactions. Moreover, because 
``institutional account''--rather than ``accredited investor''--is used 
by the NASD to define a dealer's customer account requirements, the 
Board believes that the use of a different test for municipal 
securities transactions would complicate the internal recordkeeping 
requirements of most securities firms.

Transactions With Investment Advisors

    Two commentators requested clarification of the suitability 
requirements that exist when a dealer executes a transaction for an 
investment advisor. The Board notes that this question is answered by 
determining who the dealer's customer is--the investment advisor or the 
investment advisor's client. The Board believes that, in general, the 
investment advisor will be the dealer's customer. However, it is not 
possible to state this as an ironclad rule. The requirement for 
establishing suitability may depend on whether the beneficial owner is 
looking to the dealer or exclusively to the investment advisor for 
recommendations on investments. The dealer, of course, should obtain 
the necessary customer account data from whomever is the customer. If 
the investment advisor is the customer, then the dealer would proceed 
as with other institutional accounts. However, if a dealer has a 
dealer-customer relationship with the beneficial owner and treats that 
entity as its own customer, then the dealer must obtain the information 
necessary to make a suitability determination prior to making a 
recommendation. In this case, the investment advisor is treated as an 
interested party to the transaction.

III. Date of Effectiveness of the Proposed Rule Change and Timing 
for Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:

    (A) By order approve such proposed rule change, or
    (B) Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street NW., Washington, DC 20549. Copies 
of the submission, all subsequent amendments, all written statements 
with respect to the proposed rule change that are filed with the 
Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for inspection and copying in the 
Commission's Public Reference Room. Copies of the filing will also be 
available for inspection and copying at the principal office of the 
MSRB. All submissions should refer to the file number in the caption 
above and should be submitted on February 17, 1994.

    For the Commission by the Division of Market Regulation, 
pursuant to delegated authority, 17 CFR 200-30-3(a)(12).
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-1716 Filed 1-26-94; 8:45 am]
BILLING CODE 8010-01-M