[Federal Register Volume 60, Number 157 (Tuesday, August 15, 1995)]
[Notices]
[Pages 42204-42205]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-20155]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36077; File No. SR-NASD-95-28]


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

August 9, 1995.
    On May 25, 1995, the National Association of Securities Dealers, 
Inc. (``NASD'' or ``Association'') filed a proposed rule change with 
the Securities and Exchange Commission (``SEC'' or ``Commission'') 
pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') \1\ and Rule 19b-4 thereunder.\2\ The proposed rule change 
amends Article III, Section 1 of the NASD Rules of Fair Practice \3\ by 
adding a new Interpretation prohibiting 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 
(``Interpretation'').

    \1\ 15 U.S.C. Sec. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ NASD Manual, Rules of Fair Practice, Art. III, Sec. 1 (CCH) 
para. 2151.
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    Notice of the proposed rule change, together with the substance of 
the proposal as initially filed, was provided by issuance of a 
Commission release (Securities Exchange Release No. 35877, June 21, 
1995) and by publication in the Federal Register (60 FR 33444, June 28, 
1995). Two comment letters were received.\4\ This order approves the 
proposed rule change.

    \4\ See Letter from Brian C. Underwood, Vice President-Director 
of Compliance, A.G. Edwards & Sons, Inc. (``A.G. Edwards''), to 
Jonathan G. Katz, Secretary, SEC, dated July 18, 1995 (``A.G. 
Edwards Letter''); and Letter from Joseph McLaughlin Esq. , Brown & 
Wood, to Jonathan G. Katz, Secretary, SEC, dated July 21, 1995 
(``Brown & Wood Letter'').
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I. Introduction

    Certain broker-dealers that have research departments may prepare 
research reports for customers with respect to certain identified 
securities. A research report may advise customers to buy or sell the 
security that is the subject of that report.
    Certain of these broker-dealers may intentionally establish a 
proprietary position in the security that is to be the subject of a 
report in anticipation of meeting expected customer demand in response 
to the research report. A broker-dealer that intends to issue a 
positive research report may accumulate stock before issuing the 
research report. Once it issues the research report, it would then 
commence solicitation of orders, expecting to fill customers orders 
from the inventory position it has accumulated.
    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 an 
NYSE member organization would engage in conduct inconsistent with just 
and equitable principles of trade if it purposefully acquired a 
position in an NYSE-listed security in contemplation of its issuance of 
a favorable research report.

II. Description and Scope of the Proposed Rule Change

    In 1994 the NASD solicited member comment on developing a formal 
policy deeming trading in anticipation of a research report to be a 
violation of Article III, Section 1 of the NASD Rules of Fair Practice. 
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. Therefore, the Interpretation approved today 
provides that an NASD member will violate just and equitable principles 
of trade if it 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 security in anticipation 
of the issuance of a research report in that security. Such purposeful 
activity can create an appearance of impropriety that harms the 
perception of the marketplace and could cause a loss of investor 
confidence.
    The Interpretation approved today is intended to enhance the 
overall perception of Nasdaq and the third market and encourage 
investors to participate in those markets, thereby promoting liquidity. 
The Interpretation also is intended to be consistent with the policy 
found in NYSE Information Memo 91-8, thereby promoting consistency 
among self-regulatory organizations and helping to alleviate compliance 
burdens for member firms that operate in multiple markets. However, 
unlike NYSE Information Memo 91-8, the Interpretation also provides 
that a member firm will violate just and equitable principles of trade 
if it purposefully decreases or liquidates its position in a security 
because it was about to issue a negative research report.
    The Interpretation applies to third market trading in listed 
securities that are the subject of a firm's research report as well as 
to Nasdaq securities. The Interpretation covers third market trading 
because there could be a significant gap in customer protection rules 
on exchange-listed securities traded in the third market absent the 
inclusion of those securities.
    Finally, the Interpretation prohibits a member firm from attempting 
to do indirectly what it is not permitted to do directly. For example, 
a member firm may trade in options on an underlying security that is to 
be the subject of a research report in order to do by means of an 
economically equivalent transaction that which it would otherwise be 
prohibited from doing.
    Therefore, the 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 Interpretation specifically notes that it is intended to apply 
to situations in which the member firm ``purposefully'' alters its 
inventory position in anticipation of the issuance of a favorable or 
unfavorable research report in anticipation of meeting expected 
customer demand in response to the research report. The 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, it may continue to trade with its 
retail customers or with other broker-dealers if such trading arises 
from unsolicited order flow. The Interpretation also does 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 Interpretation encourages but does not require 
firms to establish information barriers (also known as Chinese Wall 
procedures or Chinese Walls) to control the flow of information between 
their research and trading departments. Information barriers are risk 
management controls 

[[Page 42205]]
adopted by securities firms 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 information barriers between the research and 
trading departments of their firms, the Interpretation encourages the 
use of information barriers as the preferred method of complying with 
the Interpretation. If a member determines not to implement information 
barriers, 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.
III. Summary of Comments

    Two commenters objected to the Interpretation. A.G. Edwards stated 
that the Interpretation would adversely affect retail customers of a 
firm with an active research department. A.G. Edwards suggested that 
the Interpretation would prevent a firm from accumulating stock to 
satisfy expected customer demand once it issued a favorable research 
report. The A.G. Edwards Letter stated that a firm would need to use 
outside dealers in order to meet client demand for the security once 
the research report was issued. This, in turn, would cause the price of 
the security to rise, which would mean that retail orders would go 
unfilled or would be executed only at a price above the price at which 
the security was trading before the report was issued.
    A.G. Edwards claimed that the Interpretation would discourage small 
issuers from issuing their securities because the Interpretation, if 
adopted, would discourage firms from initiating coverage of their 
securities. It also claimed that the Interpretation is flawed because 
it does not similarly prohibit firms from adjusting their inventory 
when conducting research not available for external distribution. A.G. 
Edwards suggested prohibiting firms from accumulating securities for a 
specified period in advance of the issuance of a favorable research 
report concerning the issuer of those securities, or requiring firms to 
sell accumulated securities to customers at a price based on the firm's 
average cost.
    Brown & Wood also objected to the Interpretation. The Brown & Wood 
Letter stated that the Interpretation could not be intended to protect 
customers because it would apply not only to trading with a firm's own 
customers but to any trading with any person. The Brown & Wood Letter 
stated that the Interpretation would discourage firms from maintaining 
research staffs, would encourage firms not to distribute research to 
their customers, would encourage other firms not to maintain research 
staffs and would cause firms to transfer the value of their research 
without compensation.
    The Commission does not believe that the objections raised by these 
commenters warrant disapproval of the Interpretation. The Commission 
notes that trading ahead of research reports raises questions about the 
motivation of the firm in issuing the research report and about the 
quality of information within the research report. In this regard, the 
Commission notes that a firm preparing a research report concerning a 
security solely for ``in-house'' use cannot expect the repot to affect 
public demand for the security; hence, such reports do not raise the 
same ``trading ahead'' concerns as do reports prepared for public 
investors.
    Furthermore, the Commission does not believe that the prior 
accumulation of a security that is to be the subject of a favorable 
research report affects the level of investor demand for that security; 
therefore, the Commission does not believe that the Interpretation will 
cause firm customers to pay higher prices for the securities that are 
the subject of research reports than they would pay if firms could 
trade ahead of research reports.
    The Commission finds that the proposed rule change is consistent 
with Section 15A(b)(6) of the Act in that the proposed rule change will 
increase investor confidence in the integrity of research reports, 
thereby protecting investors and the public interest.
    It is therefore ordered, pursuant to Section 19(b)(2) of the Act, 
that the proposed rule change SR-NASD-95-28 be, and hereby is, 
approved.

    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. 95-20155 Filed 8-14-95; 8:45 am]
BILLING CODE 8010-01-M