[Federal Register Volume 60, Number 124 (Wednesday, June 28, 1995)]
[Notices]
[Pages 33444-33447]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-15812]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-35877; File No. SR-NASD-95-28]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by National Association of Securities Dealers, Inc. Regarding 
Trading in Anticipation of the Issuance of a Research Report

June 21, 1995.
    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 May 25, 
1995, the National Association of Securities Dealers, Inc. (``NASD'' or 
Association'') filed with the Securities and Exchange Commission 
(``SEC'' or ``Commission'') the proposed rule change as described in 
Items I, II, and III below, which Items have been prepared by the NASD. 
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

    Pursuant to the provisions of Section 19(b)(1) of the Act, the NASD 
hereby proposes to amend Article III, Section 1 of the NASD Rules of 
Fair Practice \1\ by adding a new Interpretation regarding a 
prohibition against purposeful trading that affects a member firm's 
inventory position in a given security prior to the firm's issuance of 
a research report in that same security. Below is the text of the 
proposed rule change. Proposed new language is in italics.

    \1\ NASD Manual, Rules of Fair Practice, Art, III, Sec. 1 (CCH) 
para. 2151.
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Trading Ahead of Research Reports Interpretation to Article III, 
Section 1 of the NASD Rules of Fair Practice

    The Board of Governors, under its statutory obligation to protect 
investors and enhance market quality, is issuing an Interpretation to 
the Rules of Fair Practice regarding a member firm's trading activities 
that occur in anticipation of a firm's issuance of a research report 
regarding a security. The Board of Governors is concerned with 
activities of member firms that purposefully establish or adjust firm's 
inventory position in Nasdaq-listed securities, an exchange-listed 
security traded in the OTC market, or a derivative security based 
primarily on a specific Nasdaq or exchange-listed security in 
anticipation of the issuance of a research report in that same 
security. For example, a firm's research department may prepare a 
research report recommending the purchase of a particular Nasdaq-listed 
security. Prior to the publication and dissemination of the report, 
however, the trading department of the member firm might purposefully 
accumulate a position in that security to meet anticipated customer 
demand for that security. After the firm had established its position, 
the firm would issue the report, and thereafter fill customer orders 
from the member firm's inventory positions.
    The NASD believes that such activity is conduct which is 
inconsistent with just and equitable purposes of trade, and not in the 
best interests of investors. Thus, this Interpretation prohibits a 
member from purposefully establishing, creating or changing the firm's 
inventory position in a Nasdaq-listed stock, and exchange-listed stock 
traded in the third market, or a derivative security related to the 
underlying equity security, in anticipation of the issuance of a 
research report regarding such security by the member firm.
    Article III, Section 1 of the Rules of Fair Practice states that:
    A member, in the conduct of its business, shall observe high 
standards of commercial honor and just and equitable principles of 
trade.
    In accordance with Article VII, Section 1(a)(2) of the NASD By-
laws, the NASD Board of Governors has approved the following 
Interpretation of Article III, Section 1:
    Trading activity purposefully establishing, increasing, decreasing, 
or liquidating a position in a Nasdaq security, an exchange-listed 
security traded in the over-the-counter market, or a derivative 
security based primarily upon a specific Nasdaq or exchange-listed 
security, in anticipation of the issuance of a research report in that 
security is inconsistent with just and equitable principles of trade 
and is a violation of Article III, Section 1 of the Rules of Fair 
Practice.
    For the purposes of this Interpretation, a ``purposeful'' change in 
the firm's inventory position means any trading activities undertaken 
with the intent of altering a firm's position in a security in 
anticipation of accommodating investor interest once the research 
report has been published. Hence, the Interpretation does not apply to 
changes in an inventory position related to unsolicited order flow from 
a firm's retail or broker-dealer client base or to research done solely 
for in-house trading and not in any way used for external publication.
    Under this Interpretation, the Board recommends, but does not 
require, that member firms develop and implement policies and 
procedures to establish effective internal control systems and 
procedures that would isolate specific information within research and 
other relevant departments of the firm so as to prevent the trading 
department from utilizing the advance knowledge of the issuance of a 
research report. Firms that choose not to develop ``Chinese Wall'' 
procedures bear the burden of demonstrating that the basis for changes 
in inventory positions in advance of research reports was not 
purposeful.

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 NASD 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. The NASD has prepared summaries, set forth in Sections 
(A), (B), and (C) below, of the most significant aspects of such 
statements.

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

(a) Background
    At times, broker-dealers that have research departments prepare 
research reports that recommend that customers take certain actions 
with respect to certain identified securities. The research reports may 
advise the firm's customers to buy or sell the security that is the 
subject of the research report. For instance, prior to publication of a 
research report, some firms would intentionally establish a proprietary 
position in the security that was to be the subject of a report in 
anticipation of meeting expected customer demand in response to the 
research report. Once the firm had accumulated stock, it would issue 
the research report and commence solicitation of orders, expecting to 
fill customer orders from the inventory position it had accumulated.

[[Page 33445]]

    In 1991, the New York Stock Exchange (``NYSE''), in NYSE 
Information Memo 91-8, issued a policy statement regarding stock 
accumulations by a NYSE member organization in advance of that member's 
issuance of research reports. NYSE Information Memo 91-8 stated that 
where an NYSE member organization intended to purposefully acquire a 
position in an NYSE-listed security in contemplation of its issuance of 
a favorable research report, the NYSE would find such conduct to be 
inconsistent with just and equitable principles of trade.
    At that time, the NASD also considered the issue of trading 
activity in anticipation of the issuance of research reports but 
determined to address the issue on a case-by-case basis. Thus, in 
response to individual member firm requests for a position on the 
issue, the NASD staff informally had taken the position that trading 
based upon material, non-public market information could be considered 
a violation of just and equitable principals of trade. In 1994, 
however, the NASD solicited member comment in Notice To Members 94-40 
(``NTM 94-40'') on the development of a formal policy that clearly 
would state that trading in anticipation of a research report would be 
deemed a violation of Article III, Section 1 of the Rules of Fair 
Practice. The NASD Board, in proposing this new Interpretation, also 
sought comment on a policy to recommend, but not require, that member 
firms develop and implement ``Chinese Wall'' restrictions that would 
isolate research and trading activities within individual departments 
of the firm.
(b) Comments Received
    In response to its proposal on trading ahead of research reports, 
the NASD received eleven comments that were fairly evenly split between 
support of and opposition to the proposed policy. Three firms either 
fully supported the proposal or suggested very minor changes. These 
firms believed that the proposed Interpretation would: (1) Clarify a 
member firm's obligations in Nasdaq and third market securities; (2) 
promote consistency among self-regulatory organization rules; (3) ease 
the compliance burden on the firms; and (4) engender greater investor 
confidence that the investor will not be disadvantaged by the 
professional.\2\ Two other firms\3\ supported the proposed policy in 
part, but expressed certain reservation. For example, A.G. Edwards 
believed that it was important that an Interpretation be developed to 
address issues related to a firm's unfair trading in advance of a 
research report. The firm also believed that any Interpretation should 
be extended to third Market trading in advance of research report on 
NYSE-listed companies. However, Edwards was concerned that the proposal 
could harm small capitalized issues with limited liquidity and it could 
undercut a firm's interest in developing research reports, especially 
with low liquidity stocks. J.P. Morgan's letter raised similar 
concerns.

    \2\ See letters from Merrill Lynch; Lehman Bros.; and the 
Association for Investment Management and Research (``AIMR'').
    \3\ See letters from J.P. Morgan Securities and A.G. Edwards.
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    Finally, six comments\4\ opposed the adoption of the proposed 
Interpretation. These comments expressed two principle concerns with 
the proposal: (1) It would adversely affect the liquidity and pricing 
of Nasdaq SmallCap stocks because firms would not be able to develop a 
readily available inventory in such stock to meet investor demand after 
the issuance of the report; and (2) member firms likely would diminish 
their research efforts because their own customers would not be able to 
benefit from securities that the firm had been able to secure at 
advantageous prices.

    \4\ See letters from Kemper Securities, Inc.; Brown & Wood; 
Pacific Growth Equities; Conning & Co.; First Albany; and Rauscher 
Pierce Refsnes, Inc.
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(c) Discussion
    As noted above, the NASD has carefully examined its policies 
regarding the trading practices for member firms in anticipation of the 
issuance of a firm's research reports. The NASD believes that 
purposeful inventory adjustments made in anticipation of customer 
trading activity as a result of the firm's research report could appear 
to, and at times would, conflict with the firm's fiduciary duties 
toward its customers. The NASD, after weighing the issues related to 
the matter, has determined that in the interests of investor 
protection, it would be deemed a violation of just and equitable 
principles of trade if a member firm purposefully adjusts its inventory 
position in a Nasdaq security, in an exchange listed security that is 
traded in the third market, or in a derivative product of any such 
securities in anticipation of the issuance of a research report in that 
security. At the least, such purposeful activity creates an appearance 
of impropriety that harms the perception of the marketplace and could 
lead to a loss of investor confidence. The NASD notes that it is 
important that investors understand that they will not be disadvantaged 
by professionals, and accordingly, it seeks to further enhance its 
rules and policies that promote the fair treatment of investors and 
maintain the confidence of such investors. This new policy should 
enhance the overall perception of Nasdaq and the third market and 
encourage investors to participate in those markets, thereby promoting 
liquidity. In addition, because the NASD believes that the proposed 
Interpretation is consistent with the policy found in NYSE Information 
Memorandum 91-8, this clear statement of NASD policy will promote 
consistency among self-regulatory organizations and help to alleviate 
compliance burdens for member firms that operate in multiple markets.
    After considering the comments on the proposal in NTM 94-40, the 
NASD Board determined to refine the proposal slightly to incorporate 
comments recommending that the proposed Interpretation address third 
market trading in listed securities that are the subject of a firm's 
research report. The NASD believes it important from an investor 
protection viewpoint to clearly state that it would be a violation of 
just and equitable principles of trade if a member firm trading in the 
third market in anticipation of the issuance of a research report were 
to establish, increase, or decrease a position in an exchange-listed 
security. Without the inclusion of exchange-listed securities traded in 
the third market, there could be a significant gap in customer 
protection rules on this issue. Similarly, the NASD has amended its 
policy as proposed in NTM 94-40 to clarify that it would also be a 
violation if the firm were to decrease or liquidate its position in a 
security because it was about to issue a negative research report. This 
amendment to the proposed policy also closed a potential gap in the 
policy and clarified the intent of the NASD.
    Finally, the NASD, in reaction to a comment letter \5\ decided to 
include in the proposed Interpretation a prohibition regarding a member 
firm's attempts to do indirectly what it is not permitted to do 
directly. Accordingly, the proposed Interpretation prohibits a member 
firm from purposefully establishing, increasing, decreasing or 
liquidating a derivative security position in anticipation of the 
firm's issuance of a research report on the security underlying the 
derivative position. The NASD's concern is, for example, that by 
trading in options on an underlying security that is to be the subject 
of a research report, the member [[Page 33446]] firm is doing by means 
of an economically equivalent transaction that which it would otherwise 
be prohibited from doing. Such activity would undermine the 
effectiveness of the proposed Interpretation.

    \5\ See Lehman Bros. letter.
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    The proposed Interpretation specifically notes that the intent of 
the prohibition is to cover situations where the member firm is 
``purposefully'' altering its inventory position in anticipation of the 
issuance of a favorable or unfavorable research report. In accord with 
that intent, the proposed Interpretation is not intended to halt all of 
a firm's trading activity in that security. Even if the trading desk 
knows of a forthcoming research report on a particular security, the 
trading desk is fully permitted to continue to trade with its retail 
customers or with other broker-dealers if such trading arises from 
unsolicited order flow. Similarly, the proposed Interpretation would 
not apply to situations where the firm conducts research solely for in-
house use and such research is not made available for external 
distribution.
    In addition, the proposed Interpretation encourages but does not 
require firms to establish Chinese Wall procedures to control the flow 
of information between their research and trading departments. Such 
Chinese Wall procedures are risk management control adopted by 
securities firms that include physical and informational barriers 
between different departments of firms to enhance the likelihood that 
knowledge of upcoming events will be isolated within a single group and 
not disclosed to other groups that might trade on or otherwise benefit 
from the information. Because many firms today already use Chinese Wall 
restrictions between the research and trading departments of their 
firms, the NASD decided that the policy should encourage but not 
require the use of Chinese Walls as the preferred method of complying 
with the new policy.
    While the NASD's proposed Interpretation would not require a member 
to develop Chinese Wall procedures, the NASD believes that Chinese Wall 
restrictions are the most effective means for a member firm to 
demonstrate that any trading activity before its issuance of a research 
report had not been in violation of the proposed Interpretation. 
Accordingly, if a member decides not to implement Chinese Wall 
procedures, it would carry the significantly greater burden of proving 
that stock accumulations or liquidations prior to the issuance of a 
research report had not been purposeful if an NASD investigation into 
the firm's buying or selling activity were initiated. Chinese Wall 
procedures are therefore, the recommended and preferred approval, but 
members are allowed to analyze their own environments and determine 
where Chinese Wall procedures were appropriate for their firm.
    While some commenters on NTM 94-40 objected to the proposed policy, 
the NASD notes that such comments were almost equally balanced by 
comments expressing strong support for the proposed policy. Indeed, 
even those commenters objecting to the proposal recognized that there 
were significant investor protection concerns that could arise when a 
firm adjusted its inventory positions in anticipation of its issuance 
of a research report. While not disregarding such investor protection 
issues, such commenters were more concerned about how they believed the 
proposed Interpretation would impact the liquidity of less well-
capitalized stocks, and the potential dissemination of research into 
such smaller companies. Several firms raising this issue argued that 
they should be permitted to ``passively'' accumulate inventory 
positions and pass along the advantageous cost of acquisition to its 
customers when the research report was released.
    Such comments, however, did not deal with two fundamental issues: 
(1) Trading ahead of customers based on non-public information; and (2) 
fair pricing in subsequent resales. Accordingly, because the practice 
of purposefully adjusting inventory in anticipation of research report 
issuance raises such significant potential for disadvantaging public 
investors, the NASD believes that the better practice is to prohibit 
such activity as violative of just and equitable principles of 
trade.\6\ Accordingly, the NASD believes that the proposed rule change 
is consistent with Section 15A(b)(6) in that these proposed changes are 
designed to prevent fraudulent and manipulative acts and practices, to 
promote just and equitable principles of trade, to facilitate 
transactions in these securities, to remove impediments to and to 
perfect the mechanism of a free and open market and a national market 
system, and in general to protect investors and the public interest. 
The NASD believes that any potential negative effects of the policy 
will be significantly outweighed by the increased confidence of 
investors and their corresponding willingness to trade with member 
firms.

    \6\ The issuance of research reports also may raise issues under 
the Securities Act of 1933 and the Act. See, e.g., Section 5 of, and 
Rules 137, 138 and 139 under, the Securities Act of 1933 and Rule 
10b-6 under the Act.
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(B) Self-Regulatory Organization's Statement on Burden on Competition

    The NASD believes that the proposed rule change will not result in 
any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act, as amended.

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

    Written comments regarding the NASD's proposal in NTM 94-40 are 
summarized above.

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 NASD 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 such filing will also be 
available for inspection and copying at the principal office of the 
NASD. All submissions should refer to SR-NASD-95-28 and should be 
submitted by July 19, 1995.

    [[Page 33447]] 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. 95-15812 Filed 6-27-95; 8:45 am]
BILLING CODE 8010-01-M