[Federal Register Volume 60, Number 205 (Tuesday, October 24, 1995)]
[Notices]
[Pages 54530-54557]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-26231]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36383; File No. SR-NASD-95-39]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by National Association of Securities Dealers, Inc., Relating to 
Application of the Rules of Fair Practice to Transactions in Exempted 
Securities and an Interpretation of Its Suitability Rule

October 17, 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 
September 18, 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, and on October 17, 1995, filed amendment No. 1 to 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

    The NASD is herewith filing a proposed rule change to: (i) amend 
Article I, Sections 4 and 5 of the Rules of Fair Practice in order to 
apply the Rules of Fair Practice to those members registered with the 
Securities and Exchange Commission solely under the provisions of 
Section 15C of the Act and to transactions in all securities, except 
municipals; (ii) merge the NASD's Government Securities Rules, where 
applicable, into the Rules of Fair Practice; (iii) make clarifying 
amendments to certain sections and Interpretations under Articles III 
and IV of the Rules of Fair Practice relating to the government 
securities business; (iv) amend certain Rules of Fair Practice and 
Board Interpretations to exempt transactions in government securities; 
(v) amend Article III, Section 2 of the Rules of Fair Practice by 
amendment to Subsection 2(b) and adoption of an Interpretation of the 
Board of Governors--Suitability Obligations to Institutional Customers; 
(vi) make technical changes to NASD By-Laws, Schedules to the By-Laws, 
the Rules of Fair Practice and the Code of Procedure to replace 
references to provisions of the Government Securities Rules with 
references to the appropriate Rules of Fair Practice, and to delete the 
terms ``exempted security'' or ``exempted securities,'' or, replace 
these terms with the term ``municipal securities,'' as applicable; and 
(vii) modify references to SEC Rules 15c3-1 and 15c3-3 to reflect SEC 
amendments to those rules. Below is the text of the proposed rule 
change. Proposed new language is italicized; proposed deletions are in 
brackets.
Certificate of Incorporation--By-Laws
* * * * *
By-Laws
Article I
Definitions
    When used in these By-Laws, and any rules of the Corporation, 
unless the context otherwise requires, the term:
    (a)-(r) No change.
    (s) ``rules of the Corporation'' means all rules of the Corporation 
including the Certificate of Incorporation, By-Laws, Rules of Fair 
Practice, [Government Securities Rules,] Code of Procedure, Uniform 
Practice Code, and any interpretations thereunder.
* * * * *
Schedules to the By-Laws
* * * * *
Schedule A
* * * * *
    Sec. 13. Service Charge for Advertisement, Sales Literature, and 
Other Such Material Filed or Submitted
    There shall be a service charge for each and every item of 
advertisement, sales literature, and other such material, whether in 
printed, video or other form, filed with or submitted to the 
Association, except for items that are filed or submitted in response 
to a written request from the Association's Advertising Regulation 
Department issued pursuant to the spot check procedures set forth in 
the Association's Rules of Fair Practice [and Government Securities 
Rules], as follows: (1) for printed material reviewed, $50.00, plus 
$10.00 for each page reviewed in excess of 10 pages; and (2) for video 
or audio media, $50.00, plus $10.00 per minute for each minute of tape 
reviewed in excess of 10 minutes.
* * * * * 

[[Page 54531]]

Schedule C
    This schedule has been prepared pursuant to the provisions of 
Section 2 of Article II of the Corporation's By-Laws and contains the 
requirements of registration with the Corporation of persons associated 
with a member, including the requirements for qualification 
examinations to be given.
* * * * *
Part II--Registration of Principals
* * * * *
    (2) Categories of Principal Registration
* * * * *
    (b) Limited Principal--Financial and Operations--
    (i)-(iii) No change.
    (iv) A member, or an applicant for membership in the Corporation, 
may upon written request, be exempted by the President of the 
Corporation, or his delegate, from the requirement to have a Limited 
Principal-Financial and Operations if:
    a. it has been expressly exempted by the Securities and Exchange 
Commission from SEC Rule 15c3-1 pursuant to the provisions of paragraph 
(b)([3]1)(iii) thereof; or
    b. it is subject to the provisions of SEC Rule 15c3-1(a)(2) [or 
(3)] or to Section 402.2(c) of the rules of the Treasury Department.
* * * * *
Part VI--Persons Exempt From Registration
    (1) The following persons associated with a member are not required 
to be registered with the Corporation:
* * * * *
    (d) persons associated with a member whose functions are related 
solely and exclusively to:
    (i) effecting transactions on the floor of a national securities 
exchange and who are registered as floor members with such exchange;
    (ii) transactions in [exempted] municipal securities[, except as 
provided in Part X hereof,]; or,
    (iii) transactions in commodities.
* * * * *
Rules of Fair Practice
Article I
Adoption and Application
Adoption of Rules
    Sec. 1.-3. No change.
Effect on Transactions in [Exempted] Municipal Securities
    Sec. 4. The Rules shall not be construed to apply to contracts made 
prior to the effective date of the Rules or to transactions in 
[exempted] municipal securities (as defined in section 3(a)([12] 29) of 
the Act).
Applicability
    Sec. 5. (a) These Rules of Fair Practice shall apply to all members 
and persons associated with a member[, other than those members 
registered with the Securities and Exchange Commission solely under the 
provisions of Section 15C of the Act and persons associated with such 
members]. Persons associated with a member shall have the same duties 
and obligations as a member under these Rules of Fair Practice.
* * * * *
Article III
Rules of Fair Practice
Business Conduct of Members
    Sec. 1. A member, in the conduct of his business, shall observe 
high standards of commercial honor and just and equitable principles of 
trade.
* * * * *
   Interpretation of the Board of Governors
Prompt Receipt and Delivery of Securities
    It shall be deemed a violation of Article III, Section 1 of the 
Rules of Fair Practice of the Association for a member or person 
associated with a member to violate the provisions of the following 
interpretation thereof;
* * * * *
    (b) Sales:
    (1) Long Sales No change.
    (2) ``Short Sales''
    (a) Customer short sales No member or person associated with a 
member shall accept a ``short'' sale order for any customer in any 
security unless the member or person associated with a member makes an 
affirmative determination that the member will receive delivery of the 
security from the customer or that the member can borrow the security 
on behalf of the customer for delivery by settlement date. This 
requirement shall not apply, however, to transactions in [corporate] 
debt securities.
    (b) Proprietary short sales No member or person associated with a 
member shall effect a ``short'' sale for its own account in any 
security unless the member or person associated with a member makes an 
affirmative determination that the member can borrow the securities or 
otherwise provide for delivery of the securities by the settlement 
date. This requirement will not apply to transactions in [corporate] 
debt securities, to bona fide market making transactions by a member in 
securities in which it is registered as a Nasdaq market maker, to bona 
fide market maker transactions in non-Nasdaq securities in which the 
market maker publishes a two-sided quotation in an independent 
quotation medium, or to transactions which result in fully hedged or 
arbitraged positions.
* * * * *
   Interpretation of the Board of Governors
``Free-Riding and Withholding''
Introduction
    The following Interpretation of Article III, Section 1 of the 
Association's Rules of Fair Practice is adopted by the Board of 
Governors of the Association pursuant to the provisions of Article VII, 
Section 3(a) of the Association's By-Laws and Article I, Section 3 of 
the Rules of Fair Practice.
    This Interpretation is based upon the premise that members have an 
obligation to make a bona fide public distribution at the public 
offering price of securities of a public offering which trade at a 
premium in the secondary market whenever such secondary market begins 
(a ``hot issue'') regardless of whether such securities are acquired by 
the member as an underwriter, as a selling group member, or from a 
member participating in the distribution as an underwriter or a selling 
group member, or otherwise. The failure to make a bona fide public 
distribution when there is a demand for an issue can be a factor in 
artificially raising the price. Thus, the failure to do so, especially 
when the member may have information relating to the demand for the 
securities or other factors not generally known to the public, is 
inconsistent with high standards of commercial honor and just and 
equitable principles of trade and leads to an impairment of public 
confidence in the fairness of the investment banking and securities 
business. Such conduct is, therefore, in violation of Article III, 
Section 1 of the Association's Rules of Fair Practice and this 
Interpretation thereof which establishes guidelines in respect to such 
activity.
    As in the case of any other Interpretation issued by the Board of 
Governors of the Association, the implementation thereof is a function 
of the District Business Conduct Committees and the Board of Governors. 
Thus, the Interpretation will be applied to a given factual situation 
by individuals active in the investment banking and securities business 
who are serving on these committees or on the Board. 

[[Page 54532]]

    They will construe this Interpretation to effectuate its overall 
purpose to assure a public distribution of securities for which there 
is a public demand.
    This Interpretation will not apply to government securities as 
defined in Section 3(a)(42) of the Securities Exchange Act of 1934.
* * * * *
Recommendations to Customers
    Sec. 2. (a) In recommending to a customer the purchase, sale or 
exchange of any security, a member shall have reasonable grounds for 
believing that the recommendation is suitable for such customer upon 
the basis of the facts, if any, disclosed by such customer as to his 
other security holdings and as to his financial situation and needs.
    (b) Prior to the execution of a transaction recommended to a non-
institutional customer, other than transactions with customers where 
investments are limited to money market mutual funds, a member shall 
make reasonable efforts 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 by 
such member or registered representative in making recommendations to 
the customer.
    For purposes of this subsection 2(b), the term ``non-institutional 
customer'' shall mean a customer that does not qualify as an 
``institutional account'' under Article III, Section 21(c)(4) of the 
Rules of Fair Practice.
       Interpretation of the Board of Governors

Suitability Obligations to Institutional Customers

Preliminary Statement as to Members' Obligations

    As a result of broadened authority provided by amendments to the 
Government Securities Act adopted in 1993, the Association is extending 
its sales practice rules to the government securities market, a market 
with a particularly broad institutional component. Accordingly, the 
Board believes it is appropriate to provide further guidance to members 
on their suitability obligations when making recommendations to 
institutional customers. The Board believes this Interpretation is 
applicable not only to government securities but to all debt 
securities, excluding municipals.1 Furthermore, because of the 
nature and characteristics of the institutional customer/member 
relationship, the Board is extending this Interpretation to apply 
equally to the equity securities markets as well.

    \1\Rules for municipal securities are promulgated by the 
Municipal Securities Rulemaking Board.
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    The NASD's suitability rule is fundamental to fair dealing and is 
intended to promote ethical sales practices and high standards of 
professional conduct. Members' responsibilities include having a 
reasonable basis for recommending a particular security or strategy, as 
well as having reasonable grounds for believing the recommendation is 
suitable for the customer to whom it is made. Members are expected to 
meet the same high standards of competence, professionalism, and good 
faith regardless of the financial circumstances of the customer.
    Article III, Section 2(a) requires that,
    In recommending to a customer the purchase, sale or exchange of any 
security, a member shall have reasonable grounds for believing that the 
recommendation is suitable for such customer upon the basis of the 
facts, if any, disclosed by such customer as to his other security 
holdings and as to his financial situation and needs.
    This Interpretation concerns only the manner in which a member 
determines that a recommendation is suitable for a particular 
institutional customer. The manner in which a member fulfills this 
suitability obligation will vary depending on the nature of the 
customer and the specific transaction. Accordingly, this Interpretation 
deals only with guidance regarding how a member may fulfill such 
``customer-specific suitability obligations'' under Article III, 
Section 2(a) of the Rules of Fair Practice.\2\

    \2\This Interpretation does not address the obligation related 
to suitability that requires that a member have ``* * * a 
`reasonable basis' to believe that the recommendation could be 
suitable for at least some customers.'' In the Matter of the 
Application of F.J. Kaufman and Company of Virginia and Frederick J. 
Kaufman, Jr., 50 SEC 164 (1989).
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    While it is difficult to define in advance the scope of a member's 
suitability obligation with respect to a specific institutional 
customer transaction recommended by a member, the Board has identified 
certain factors which may be relevant when considering compliance with 
Article III, Section 2(a) of the Rules of Fair Practice. These factors 
are not intended to be requirements or the only factors to be 
considered but are offered merely as guidance in determining the scope 
of a member's suitability obligations.

Considerations Regarding the Scope of Members' Obligations to 
Institutional Customers

    The two most important considerations in determining the scope of a 
member's suitability obligations in making recommendations to an 
institutional customer are the customer's capability to evaluate 
investment risk independently and the extent to which the customer 
intends to exercise independent judgment in evaluating a member's 
recommendation. A member must determine, based on the information 
available to it, the customer's capability to evaluate investment risk. 
In some cases, the member may conclude that the customer is not capable 
of making independent investment decisions in general. In other cases, 
the institutional customer may have general capability, but may not be 
able to understand a particular type of instrument or its risk. This is 
more likely to arise with relatively new types of instruments, or those 
with significantly different risk or volatility characteristics than 
other investments generally made by the institution. If a customer is 
either generally not capable of evaluating investment risk or lacks 
sufficient capability to evaluate the particular product, the scope of 
a member's customer-specific obligations under the suitability rule 
would not be diminished by the fact that the member was dealing with an 
institutional customer. On the other hand, the fact that a customer 
initially needed help understanding a potential investment need not 
necessarily imply that the customer did not ultimately develop an 
understanding and make an independent investment decision.
    A member may conclude that a customer intends to exercise 
independent judgment if the customer's investment decision will be 
based on its own independent assessment of the opportunities and risks 
presented by a potential investment, market factors and other 
investment considerations. Where the broker-dealer has reasonable 
grounds for concluding that the institutional customer is making 
independent investment decisions and is capable of independently 
evaluating investment risk, then a member's obligation to determine 
that a recommendation is suitable for a particular customer is 
fulfilled.\3\ Where a customer has delegated decision-making authority 
to an agent, such as an investment advisor or a bank trust 

[[Page 54533]]
department, this Interpretation shall be applied to the agent.

    \3\See, note 2.
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    A determination of capability to evaluate investment risk 
independently will depend on an examination of the customer's 
capability to make its own investment decisions, including the 
resources available to the customer to make informed decisions. 
Relevant considerations could include:
     the use of one or more consultants, investment advisers or 
bank trust departments;
     the general level of experience of the institutional 
customer in financial markets and specific experience with the type of 
instruments under consideration;
     the customer's ability to understand the economic features 
of the security involved;
     the customer's ability to independently evaluate how 
market developments would affect the security; and
     the complexity of the security or securities involved.
    A determination that a customer is making independent investment 
decisions will depend on the nature of the relationship that exists 
between the member and the customer. Relevant considerations could 
include:
     any written or oral understanding that exists between the 
member and the customer regarding the nature of the relationship 
between the member and the customer and the services to be rendered by 
the member;
     the presence or absence of a pattern of acceptance of the 
member's recommendations;
     the use by the customer of ideas, suggestions, market 
views and information obtained from other members or market 
professionals, particularly those relating to the same type of 
securities; and
     the extent to which the member has received from the 
customer current comprehensive portfolio information in connection with 
discussing recommended transactions or has not been provided important 
information regarding its portfolio or investment objectives.
    Members are reminded that these factors are merely guidelines which 
will be utilized to determine whether a member has fulfilled its 
suitability obligations with respect to a specific institutional 
customer transaction and that the inclusion or absence of any of these 
factors is not dispositive of the determination of suitability. Such a 
determination can only be made on a case-by-case basis taking into 
consideration all the facts and circumstances of a particular member/
customer relationship, assessed in the context of a particular 
transaction.
    For purposes of this Interpretation, an institutional customer 
shall be any entity other than a natural person. In determining the 
applicability of this Interpretation to an institutional customer, the 
NASD will consider the dollar value of the securities that the 
institutional customer has in its portfolio and/or under management. 
While this Interpretation is potentially applicable to any 
institutional customer, the guidance contained herein is more 
appropriately applied to an institutional customer with at least $10 
million invested in securities in the aggregate in its portfolio and/or 
under management.
* * * * *
    Sec. 3.-20. No change.
Books and Records
    Sec. 21.
* * * * *
Marking of Customer Order Tickets
    (b) (i) A person associated with a member shall indicate on the 
memorandum for the sale of any security whether the order is ``long'' 
or ``short,'' except that this requirement shall not apply to 
transactions in [corporate] debt securities. An order may be marked 
``long'' if (1) the customer's account is long the security involved or 
(2) the customer owns the security and agrees to deliver the security 
as soon as possible without undue inconvenience or expense.
    (ii) No change.
Customer Account Information
    (c) Each member shall maintain accounts opened after January 1, 
1991 as follows:
    (1)-(2) No change.
    (3) for discretionary accounts, in addition to compliance with 
subsections (1) and (2) above, and Article III, Section 15(b) of these 
rules, the member shall:
    (i) obtain the signature of each person authorized to exercise 
discretion in the account;[ and]
    (ii) record the date such discretion is granted[.]; and
    (iii) in connection with exempted securities other than municipals, 
record the age or approximate age of the customer.
* * * * *
    Sec. 22.-24. No change.
Dealing with Non-Members
    Sec. 25. (a) No member shall deal with any non-member broker or 
dealer except at the same prices, for the same commissions or fees, and 
on the same terms and conditions as are by such member accorded to the 
general public.
* * * * *
   Interpretation of the Board of Governors
Transactions Between Members and Non-Members
* * * * *
    2. Transactions in ``Exempted Securities''
    [Section 4 of Article I of the Rules of Fair Practice provides that 
the Rules shall not apply to transactions, whether between members or 
between members and non-members, in] Section 25 of Article III of the 
Rules of Fair Practice shall not apply to ``exempted securities,'' 
which are defined by Section 3(a)(12) of the Securities Exchange Act of 
1934 as follows:
Text of Sec. 3(a)(12) of '34 Act
    ``The term `exempted security' or `exempted securities' shall 
include securities which are direct obligations of or obligations 
guaranteed as to principal or interest by the United States; such 
securities issued or guaranteed by corporations in which the United 
States has a direct or indirect interest as shall be designated for 
exemption by the Secretary of the Treasury as necessary or appropriate 
in the public interest or for the protection of investors; securities 
which are direct obligations of or obligations guaranteed as to 
principal or interest by a State or any political subdivision thereof 
or any agency or instrumentality of a State or any political 
subdivision thereof or any municipal corporate instrumentality of one 
or more States; and such other securities (which may include, among 
others, unregistered securities, the market in which is predominantly 
intrastate) as the Commission may, by such rules and regulations as it 
deems necessary or appropriate in the public interest, or for the 
protection of investors, either unconditionally or upon specified terms 
and conditions or for stated periods, exempt from the operation of any 
one or more provisions of this title which by their terms do not apply 
to an `exempted security' or to `exempted securities'.''
    [The rules] Section 25 of Article III of the Rules of Fair Practice 
therefore does not apply to transactions in government or municipal 
securities if within the definition of ``exempted securities.'' Members 
may join with non-members or with banks in a joint account, syndicate 
or group to purchase and distribute an issue of ``exempted securities'' 
and may trade such securities with non-members or with banks at 
different prices or on 

[[Page 54534]]
different terms and conditions than are accorded to members of the 
general public.
* * * * *
    Sec. 26.-34. No change.
Communications With the Public
    Sec. 35.
* * * * *
(c) Filing Requirements and Review Procedures
* * * * *
    (3)(C) Except for advertisements related to exempted securities (as 
defined in Section 3 (a)(12) of the Securities Exchange Act of 1934), 
municipal securities, direct participation programs or investment 
company securities, members subject to the requirements of 
subparagraphs (c)(3)(A) or (c)(3)(B) of this section may, in lieu of 
filing with the Association, file advertisements on the same basis, and 
for the same time periods specified in those subparagraphs, with any 
registered securities exchange having standards comparable to those 
contained in this section.
    (4) No change.
    (5) In addition to the foregoing requirements, every member's 
advertising and sales literature shall be subject to a routine spot-
check procedure. Upon written request from the Association's 
Advertising Department, each member shall promptly submit the material 
requested. Members will not be required to submit material under this 
procedure which has been previously submitted pursuant to one of the 
foregoing requirements and, except for material related to exempted 
securities (as defined in Section 3(a)(12) of the Securities Exchange 
Act of 1934), municipal securities, direct participation programs or 
investment company securities, the procedure will not be applied to 
members who have been, within the NASD's current examination cycle 
subjected to a spot-check by a registered securities exchange or other 
self-regulatory organization using procedures comparable to those used 
by the Association.
    (6) No change.
    (7) Material which refers to investment company securities or 
direct participation programs, or exempted securities (as defined in 
Sections 3(a)(12) of the Securities Exchange Act of 1934) solely as 
part of a listing of products and/or services offered by the member, is 
excluded from the requirements of paragraphs (c)(1) and (c)(2) of this 
section.
* * * * *
    Sec. 36.-37. No change.
* * * * *
Regulation of Activities of Members Experiencing Financial and/or 
Operational Difficulties
    Sec. 38. (a) Application--For the purposes of this rule, the term 
``member'' shall be limited to any member of the Association who is not 
designated to another self-regulatory organization by the Securities 
and Exchange Commission for financial responsibility pursuant to 
Section 17 of the Securities Exchange Act of 1934 and Rule 17d-1 
thereunder. Further, the term shall not be applicable to any member who 
is subject to paragraphs (a)(2)(iv), (a)(2)(v) or (a)(2)(vi) [and 
(a)(3)] of SEC Rule 15c3-1, or is subject to Article III, Section 38A 
of the Rules of Fair Practice, or is otherwise exempt from the 
provisions of said rule.
* * * * *

Regulation of Activities of Section 15C Members Experiencing Financial 
and/or Operational Difficulties

    Sec. 38A. (a) Application--For the purposes of this rule, the term 
``member'' shall be limited to any member of the Association registered 
with the Securities and Exchange Commission pursuant to Section 15C of 
the Securities and Exchange Act of 1934 that is not designated to 
another self-regulatory organization by the Securities and Exchange 
Commission for financial responsibility pursuant to Section 17 of the 
Securities Exchange Act of 1934 and Rule 17d-1 thereunder. Further, the 
term shall not be applicable to any member that is subject to Section 
402.2(c) of the rules of the Treasury Department, or is otherwise 
exempt from the provisions of said rule.
    (b) A member, when so directed by the Association, shall not expand 
its business during any period in which:
    (1) Any of the following conditions continue to exist, or have 
existed, for more than fifteen (15) consecutive business days:
    (A) A firm's liquid capital is less than 150 percent of the total 
haircuts or such greater percentage thereof as may from time to time be 
prescribed by the Association.
    (B) A firm's liquid capital minus total haircuts is less than 150 
percent of its minimum dollar capital requirement.
    (C) The deduction of ownership equity and maturities of 
subordinated debt scheduled during the next six months would result in 
any one of the conditions described in (A) or (B) of this subparagraph 
(1).
    (2) The Association restricts the member for any other financial or 
operational reason.
    (c) A member, when so directed by the Association, shall forthwith 
reduce its business:
    (1) To a point enabling its available capital to comply with the 
standards set forth in subparagraphs (b)(1) (A), (B), or (C) of this 
rule if any of the following conditions continue to exist, or have 
existed, for more than fifteen (15) consecutive business days:
    (A) A firm's liquid capital is less than 125 percent of total 
haircuts or such greater percentage thereof as may from time to time be 
prescribed by the Association.
    (B) A firm's liquid capital minus total haircuts is less than 125 
percent of its minimum dollar capital requirement.
    (C) The deduction of ownership equity and maturities of 
subordinated debt scheduled during the next six months would result in 
any one of the conditions described in (A) or (B) of this subparagraph 
(1).
    (2) As required by the Association when it restricts a member for 
any other financial or operational reason.
   Explanation of the Board of Governors
Restrictions on a Member's Activity
    This explanation outlines and discusses some of the financial and 
operational deficiencies which could initiate action under the rule. 
Subparagraphs (b)(2) and (c)(2) of [the rule] Sections 38 and 38A 
recognize that there are various unstated financial and operational 
reasons for which the Association may impose restrictions on a member 
so as to prohibit its expansion or to require a reduction in overall 
level of business. These provisions are deemed necessary in order to 
provide for the variety of situations and practices which do arise and, 
which if allowed to persist, could result in increased exposure to 
customers and to broker-dealers.
    In the opinion of the Board of Governors, it would be impractical 
and unwise to attempt to identify and list all of the situations and 
practices which might lead to the imposition of restrictions or the 
types of remedial actions the Corporation may direct be taken because 
they are numerous and cannot be totally identified or specified with 
any degree or precision. The Board believes, however, that it would be 
helpful to members' understanding to list some of the other bases upon 
which the Corporation may conclude that a member is in or approaching 
financial difficulty. 

[[Page 54535]]

   Explanation of Board of Governors
Explanation
    (a) For purposes of subparagraphs (b)(2) and (c)(2) of [the rule] 
Section 38, a member may be considered to be in or approaching 
financial or operational difficulty in conducting its operations and 
therefore subject to restrictions if it is determined by the 
Corporation that any of the parameters specified therein are exceeded 
or one or more of the following conditions exist:
    (1) The member has experienced a reduction in excess net capital of 
25% in the preceding two months or 30% or more in the three-month 
period immediately preceding such computation.
    (2) The member has experienced a substantial change in the manner 
in which it processes its business which, in the view of the 
Corporation, increases the potential risk of loss to customers and 
members.
    (3) The member's books and records are not maintained in accordance 
with the provisions of SEC Rules 17a-3 and 17a-4.
    (4) The member is not in compliance, or is unable to demonstrate 
compliance, with applicable net capital requirements.
    (5) The member is not in compliance, or is unable to demonstrate 
compliance, with SEC Rule 15c3-3 (Customer Protection Reserves and 
Custody of Securities).
    (6) The member is unable to clear and settle transactions promptly.
    (7) The member's overall business operations are in such a 
condition, given the nature and kind of its business that, 
notwithstanding the absence of any of the conditions enumerated in 
subparagraphs (1) through (6), a determination of financial or 
operational difficulty should be made, or
    (8) The member is registered as a Futures Commission Merchant and 
its net capital is less than 7% of the funds required to be segregated 
pursuant to the Commodity Exchange Act and the regulations thereunder.
    (b) For purposes of subparagraphs (b)(2) and (c)(2) of Section 38A, 
a member may be considered to be in or approaching financial or 
operational difficulty in conducting its operations and therefore 
subject to restrictions if it is determined by the Corporation that any 
of the parameters specified therein are exceeded or one or more of the 
following conditions exist: 
    (1) The member has experienced significant reduction in excess 
liquid capital in the preceding month or in the three-month period 
immediately preceding such computation.
    (2) The member has experienced a substantial change in the manner 
in which it processes its business which, in the view of the 
Corporation, increases the potential risk of loss to customers and 
members.
    (3) The member's books and records are not maintained in accordance 
with the provisions of Section 404.2 of the Treasury Department rules.
    (4) The member is not in compliance, or is unable to demonstrate 
compliance, with applicable capital requirements of Section 402 of the 
Treasury Department rules.
    (5) The member is not in compliance, or is unable to demonstrate 
compliance, with Section 403.4 of the Treasury Department rules 
(Customer Protection--Reserve and Custody of Securities).
    (6) The member is unable to clear and settle transactions promptly.
    (7) The member's overall business operations are in such a 
condition, given the nature and kind of its business that, 
notwithstanding the absence of any of the conditions enumerated in 
subparagraphs (1) through (6), a determination of financial or 
operational difficulty should be made.
    (8) The member is registered as a Futures Commission Merchant and 
its net capital is less than required by Section 402.1(d) of the 
Treasury Department rules.
    ([b]c) If the Corporation determines that any of the conditions 
specified in subparagraphs (a) or (b) of this Explanation exist, it may 
require that the member take appropriate action by effecting one or 
more of the following actions until such time as the Corporation 
determines they are no longer required:
    (1) Promptly pay all free credit balances to customers.
    (2) Promptly effect delivery to customers of all fully-paid 
securities in the member's possession or control.
    (3) Introduce all or a portion of its business to another member on 
a fully-disclosed basis.
    (4) Reduce the size or modify the composition of its inventory.
    (5) Postpone the opening of new branch offices or require the 
closing of one or more existing branch offices.
    (6) Promptly cease making unsecured loans, advances or other 
similar receivables, and, as necessary, collect all such loans, 
advances or receivables where practicable.
    (7) Accept no new customer accounts.
    (8) Undertake an immediate audit by an independent public 
accountant at the member's expense.
    (9) Restrict the payment of salaries or other sums to partners, 
officers, directors, shareholders, or associated persons of the member.
    (10) Effect liquidating transactions only.
    (11) Accept unsolicited customer orders only.
    (12) File special financial and operating reports and/or
    (13) Be subject to such other restrictions or take such other 
action as the Corporation deems appropriate under the circumstances in 
the public interest and for the protection of members.
Approval of Change in Exempt Status Under SEC Rule 15c3-3
    Sec. 39. (a) Application--For the purposes of this section, the 
term ``member'' shall be limited to any member of the Association who 
is subject to SEC Rule 15c3-3 and is not designated to another self-
regulatory organization by the Securities and Exchange Commission for 
financial responsibility pursuant to Section 17 of the Securities 
Exchange Act of 1934 and Rule 17d-1 promulgated thereunder. Further, 
the term shall not be applicable to any member that is subject to 
Section 402.2(c) of the rules of the Treasury Department.
    (b) A member operating pursuant to any exemptive provision as 
contained in subparagraph (k) of SEC Rule 15c3-3 under the Securities 
Exchange Act of 1934 (``Rule 15c3-3''), shall not change its method of 
doing business in a manner which will change its exemptive status from 
that governed by subparagraph (k)(1) or (k)(2)([b]ii) to that governed 
by subparagraph (k)(2)([a]i); or from subparagraph (k)(1), (k)(2)([a]i) 
or (k)(2)([b]ii) to a fully computing firm that is subject to all 
provisions of Rule 15c3-3; or commence operations that will disqualify 
it for continued exemption under Rule 15c3-3 without first having 
obtained the prior written approval of the Association.
* * * * *
    Sec. 40.-49. No change.
Article IV
Complaints
    Sec. 1. No change.
* * * * *
Complaints by Public against Members for Violations of Rules
    Sec. 2. Any person feeling aggrieved by any act, practice or 
omission of any member or any person associated with a member of the 
Corporation, which such person believes to be in violation of the 
Securities Exchange Act of 1934, 

[[Page 54536]]
the rules and regulations thereunder, the rules of the Municipal 
Securities Rulemaking Board, or any of the Rules of Fair Practice of 
the Corporation, may, on the form to be supplied by the Board of 
Governors, file a complaint against such member or such persons 
associated with a member in regard thereto with any District Business 
Conduct Committee of the Corporation, and any such complaint shall be 
handled in accordance with the Code of Procedure of the Corporation.
Complaints by District Business Conduct Committees
    Sec. 3. Any District Business Conduct Committee which, on 
information and belief, is of the opinion that any act, practice, or 
omission of any member of the Corporation or any person associated with 
a member is in violation of the Securities Exchange Act of 1934, the 
rules and regulations thereunder, the rules of the Municipal Securities 
Rulemaking Board, or any of the Rules of Fair Practice of the 
Corporation, may, on the form to be supplied by the Board of Governors, 
file a complaint against such member or such person associated with a 
member in regard thereto with itself or with any other District 
Business Conduct Committee of the Corporation, as the necessities of 
the complaint may require, and any such complaint shall be handled in 
accordance with the Code of Procedure and in the same manner as if it 
had been filed by an individual or member.
Complaints by the Board of Governors
    Sec. 4. The Board of Governors shall have authority when on the 
basis of information and belief it is of the opinion that any act, 
practice or omission of any member of the Corporation or of any person 
associated with a member is in violation of the Securities Exchange Act 
of 1934, the rules and regulations thereunder, the rules of the 
Municipal Securities Rulemaking Board, or any rule of fair practice of 
the Corporation to file a complaint against such member of such person 
associated with a member in respect thereto or to instruct any District 
Business Conduct Committee to do so, and any such complaint shall be 
handled in accordance with the Code of Procedure.
Article V

Sanctions for Violation of the Rules

    Sec. 1. Any District Business Conduct Committee, Market 
Surveillance Committee, the National Business Conduct Committee, any 
other committee exercising powers assigned by the Board, or the Board 
in the administration and enforcement of the[se Rules,] Securities 
Exchange Act of 1934, the rules and regulations thereunder, or the 
rules of the Municipal Securities Rulemaking Board, or any of the Rules 
of Fair Practice, and after compliance with the Code of Procedure, may 
(1) censure any member or person associated with a member, and/or (2) 
impose a fine upon any member or person associated with a member, and/
or (3) suspend the membership of any member or suspend the registration 
of a person associated with a member, if any, for a definite period, 
and/or for a period contingent on the performance of a particular act, 
and/or (4) expel any member or revoke the registration of any person 
associated with a member, if any, and/or (5) suspend or bar a member or 
person associated with a member from association with all members, and/
or (6) impose any other fitting sanction deemed appropriate under the 
circumstances, for each or any violation of any of these Rules by a 
member or person associated with a member or for any neglect or refusal 
to comply with any orders, directions or decisions issued by any such 
committee or by the Board in the enforcement of these Rules, including 
any interpretative ruling made by the Board, as any such committee or 
the Board, in its discretion, may deem to be just; provided, however, 
that no such sanction imposed by any such committee shall take effect 
until the period for appeal therefrom or review thereof by the National 
Business Conduct Committee or the Board, as applicable, has expired and 
any such appeal or review has been completed in accordance with the 
Code or Procedure; and provided, further, that all parties to any 
proceeding resulting in a sanction shall be deemed to have assented to 
or to have acquiesced in the imposition of such sanction unless any 
party aggrieved thereby shall have made application for review thereof 
pursuant to the Code of Procedure, within fifteen (15) days after the 
date of the decision rendered in such proceeding.
* * * * *
Article VI
    No change.
* * * * *

                      [Government Securities Rules]                     
                           [Table of Contents]                          
------------------------------------------------------------------------
             [Section                             Subject]              
------------------------------------------------------------------------
[1.                                 Adoption of Rules]                  
[2.                                 Applicability]                      
[3.                                 Definitions in By-Laws and Rules of 
                                     Fair Practice]                     
[4.                                 Book and Records]                   
[5.                                 Supervision]                        
[6.                                 Regulation of Activities of Members 
                                     Experiencing Financial and/or      
                                     Operational Difficulties]          
[7.                                 Approval of Change in Exempt Status 
                                     Under SEC Rule 15c3-3]             
[8.                                 Communications With the Public]     
[9.                                 Availability to Customers of        
                                     Certificate, By-Laws, Rules, and   
                                     Code of Procedure]                 
[10.                                Complaints]                         
[11.                                Reports and Inspection of Books for 
                                     Purpose of Investigating           
                                     Complaints]                        
[12.                                Sanctions for Violation of Rules]   
[13.                                Payment of Fines or Costs]          
[14.                                Cost of Proceedings]                
------------------------------------------------------------------------

[Government Securities Rules]
[Adoption of Rules]
    [Sec. 1. The following provisions are adopted pursuant to Article 
VII, Section 1(a)(8) of the NASD By-Laws and Section 15A(f)(2) of the 
Securities Exchange Act of 1934.]
[Applicability]
    [Sec. 2. (a) These rules shall apply to the government securities 
business of all members and persons associated with a member in order 
to implement and enforce the provision of the Securities Exchange Act 
of 1934 and the rules promulgated thereunder including the rules of the 
Treasury Department. Unless otherwise indicated herein, the 
requirements of these rules are in addition to those contained in the 
Rules of Fair Practice for members that are subject to the provisions 
of the Rules of Fair Practice. Persons associated with a member shall 
have the same duties and obligations as a member under these rules.]
    [(b) A member or person associated with a member, who has been 
expelled, cancelled, or revoked from membership or from registration or 
who has been barred from being associated with all members, shall cease 
to have any privileges of membership or registration. A member or 
person associated with a member who has been suspended from membership 
or registration shall also cease to have any privileges of membership 
or registration other than those under the Code of Procedure or 
insurance programs sponsored by the 

[[Page 54537]]
Corporation. In neither case shall such a member or person associated 
with a member be entitled to recover any admission fees, dues, 
assessments, or other charges paid to the Corporation.]
    [(c) A member or person associated with a member who has been 
suspended from membership or from registration shall have all of the 
obligations imposed by the By-Laws, these rules, and other regulations 
of the Corporation.]
[Definitions in By-Laws and Rules of Fair Practice]
    [Sec. 3. Unless the context otherwise requires, or unless defined 
in these rules, terms used in the rules and provisions hereby adopted, 
if defined in the By-Laws or Rules of Fair Practice shall have the 
meaning as defined therein.]
[Books and Records]
[Sec. 4.]
[Requirements]
    [(a) Each member shall keep and preserve books, accounts, records, 
memoranda, and correspondence in conformity with all applicable laws, 
rules, regulations, and statements of policy promulgated thereunder and 
with the rules of this Association.]
[Information on accounts]
    [(b) Each member shall maintain accounts of customers in such form 
and manner as to show the following information: name, address, and 
whether the customer is legally of age; signature of the registered 
representative introducing the accounts and signature of the member or 
the partner, officer, or manager accepting the account for the member. 
If the customer is associated with or employed by another member, this 
fact must be noted. In discretionary accounts, the member shall also 
record the age or approximate age and occupation of the customer as 
well as the signature of each person authorized to exercise discretion 
in such account.]
[Record of written complaints]
    [(c) Each member shall keep and preserve either a separate file of 
all written complaints of customers and action taken by the member, if 
any, or a separate record of such complaints and a clear reference to 
the files containing the correspondence connected with such complaint.]
[``Complaint'' defined]
    [(d) A ``complaint'' shall be deemed to mean any written statement 
of a customer or any person acting on behalf of a customer alleging a 
grievance involving the activities of those persons under the control 
of the member in connection with the solicitation or execution of any 
transaction or the disposition of securities or funds of that 
customer.]
[Supervision]
[Sec. 5.]
[Written procedures]
    [(a) Each member shall establish, maintain, and enforce written 
procedures that will enable it to supervise properly the activities of 
each registered representative and associated person to ensure 
compliance with the applicable provisions of the Securities Exchange 
Act of 1934, rules, regulations, and statements of policy promulgated 
thereunder including the rules of the Treasury Department, and with the 
applicable rules of this Association.]
[Responsibility of member]
    [(b) Final responsibility for proper supervision shall rest with 
the member. The member shall designate a partner, officer, or manager 
to carry out the written supervisory procedures. A copy of such 
procedures shall be kept in each office of the member.]
[Eligibility investigated]
    [(c) Each member shall have the responsibility and the duty to 
ascertain by investigation the absence of any statutory 
disqualification as that term is defined under Section 3(a)(39) or 
15C(c) of the Securities Exchange Act of 1934 and that any application 
for registration by an associated person is complete and accurate.]
[Regulation of Activities of Members Experiencing Financial and/or 
Operational Difficulties]
    [Sec. 6. (a) Application--For the purposes of this rule, the term 
``member'' shall be limited to any member of the Association registered 
with the Securities and Exchange Commission pursuant to Section 15C of 
the Securities Exchange Act of 1934 that is not designated to another 
self-regulatory organization by the Securities and Exchange Commission 
for financial responsibility pursuant to Section 17 of the Securities 
Exchange Act of 1934 and Rule 17d-1 thereunder. Further, the term shall 
not be applicable to any member that is subject to Section 402.2(c) of 
the rules of the Treasury Department.]
    [(b) A member, when so directed by the Association, shall not 
expand its business during any period in which:]
    [(1) Any of the following conditions continue to exist, or have 
existed, for more than fifteen (15) consecutive business days:]
    [(A) A firm's liquid capital is less than 150 percent of the total 
haircuts or such greater percentage thereof as may from time to time be 
prescribed by the Association.]
    [(B) A firm's liquid capital minus total haircuts is less than 150 
percent of its minimum dollar capital requirement.]
    [(C) The deduction of ownership equity and maturities of 
subordinated debt scheduled during the next six months would result in 
any one of the conditions described in (A) or (B) of this subparagraph 
(1).]
    [(2) The Association restricts the member for any other financial 
or operational reason.]
    [(c) A member, when so directed by the Association, shall forthwith 
reduce its business:]
    [(1) To a point enabling its available capital to comply with the 
standards set forth in subparagraphs (b)(1)(A), (B), or (C) of this 
rule if any of the following conditions continue to exist, or have 
existed, for more than fifteen (15) consecutive business days:]
    [(A) A firm's liquid capital is less than 125 percent of total 
haircuts or such greater percentage thereof as may from time to time be 
prescribed by the Association.]
    [(B) A firm's liquid capital minus total haircuts is less than 125 
percent of its minimum dollar capital requirement.]
    [(C) The deduction of ownership equity and maturities of 
subordinated debt scheduled during the next six months would result in 
any one of the conditions described in (A) or (B) of this subparagraph 
(1).]
    [(2) As required by the Association when it restricts a member for 
any other financial or operational reason.]
[   Explanation of the Board of Governors]
[Restrictions on a Member's Activity]
    [This explanation outlines and discusses some of the financial and 
operational deficiencies which could initiate actions under the rule. 
Subparagraphs (b)(2) and (c)(2) of the rule recognize that there are 
various unstated financial and operational reasons for which the 
Association may impose restrictions on a member so as to prohibit its 
expansion or to require a reduction in overall level of business. These 
provisions are deemed necessary in order to provide for the variety of 
situations and practices which do arise and, which if allowed to 
persist, could result in increased exposure to customers and to broker-
dealers.]
    [In the opinion of the Board of Governors, it would be impractical 
and 

[[Page 54538]]
unwise to attempt to identify and list all of the situations and 
practices that might lead to the imposition of restrictions or the 
types of remedial actions the Corporation may direct be taken because 
they are numerous and cannot be totally identified or specified with 
any degree of precision. The Board believes, however, that it would be 
helpful to members' understanding to list some of the other bases upon 
which the Corporation may conclude that a member is in or approaching 
financial difficulty.]
    [(a) For purposes of subparagraphs (b)(2) and (c)(2) of the rule, a 
member may be considered to be in or approaching financial or 
operational difficulty in conducting its operations and therefore 
subject to restrictions if it is determined by the Corporation that any 
of the parameters specified therein are exceeded or one or more of the 
following conditions exist:]
    [(1) The member has experienced significant reduction in excess 
liquid capital in the preceding month or in the three-month period 
immediately preceding such computation.]
    [(2) The member has experienced a substantial change in the manner 
in which it processes it business which, in the view of the 
Corporation, increases the potential risk of loss to customers and 
members.]
    [(3) The member's books and records are not maintained in 
accordance with the provisions of Section 404.2 of the Treasury 
Department rules.]
    [(4) The member is not in compliance, or is unable to demonstrate 
compliance, with applicable capital requirements of Section 402 of the 
Treasury Department rules.]
    [(5) The member is not incompliance, or is unable to demonstrate 
compliance, with Section 403.4 of the Treasury Department rules 
(Customer Protection--Reserve and Custody of Securities).]
    [(6) The member is unable to clear and settle transactions 
promptly.]
    [(7) The member's overall business operations are in such a 
condition, given the nature and kind of its business that, 
notwithstanding the absence of any of the conditions enumerated in 
subparagraphs (1) through (6), a determination of financial or 
operational difficulty should be made.]
    [(8) The member is registered as a Futures Commission Merchant and 
its net capital is less than required by Section 402.1(d) of the 
Treasury Department rules.]
    [(b) If the Corporation determines that any of the conditions 
specified in subparagraph (a) of this Explanation exists, it may 
require that the member take appropriate action by effecting one or 
more of the following actions until such time as the Corporation 
determines they are no longer required:]
    [(1) Promptly pay all fee credit balances to customers.]
    [(2) Promptly effect delivery to customers of all fully paid 
securities in the member's possession or control.]
    [(3) Introduce all or a portion of its business to another member 
on a fully disclosed basis.]
    [(4) Reduce the size or modify the composition of its inventory.]
    [(5) Postpone the opening of new branch offices or require the 
closing of one or more existing branch offices.]
    [(6) Promptly cease making unsecured loans, advances, or other 
similar receivables, and, as necessary, collect all such loans, 
advances, or receivables where practicable.]
    [(7) Accept no new customer accounts.]
    [(8) Undertake an immediate audit by an independent public 
accountant at the member's expense.]
    [(9) Restrict the payment of salaries or other sums to partners, 
officers, directors, shareholders, or associated persons of the 
member.]
    [(10) Effect liquidating transactions only.]
    [(11) Accept unsolicited customer orders only.]
    [(12) File special financial and operating reports.]
    [(13) Be subject to such other restrictions or take such other 
actions as the Corporation deems appropriate under the circumstances in 
the public interest and for the protection of members.]
[Approval of Change in Exempt Status Under SEC Rule 15c3-3]
    [Sec. 7. (a) Application--For the purposes of this rule, the term 
``member'' shall be limited to any member of the Association that is 
not designated to another self-regulatory organization by the 
Securities and Exchange Commission for financial responsibility 
pursuant to Section 17 of the Securities Exchange Act of 1934 and Rule 
17d-1 thereunder. Further, the term shall not be applicable to any 
member that is subject to Section 402.2(c) of the rules of the Treasury 
Department.]
    [(b) A member operating pursuant to any exemptive provision as 
contained in subparagraph (k) of SEC Rule 15c3-3 under the Securities 
Exchange Act of 1934 (Rule 15c3-3), shall not change its method of 
doing business in a manner that will change its exemptive status from 
that governed by subparagraph (k)(1) or (k)(2)(ii) to that governed by 
subparagraph (k)(2)(i); or from subparagraph (k)(1), (k)(2)(i), or 
(k)(2)(ii) to a fully computing firm that is subject to all provisions 
of Rule 15c3-3; or commence operations that will disqualify it for 
continued exemption under Rule 15c3-3 without first having obtained the 
prior written approval of the Association.]
    [(c) In making the determination as to whether to approve or to 
deny in whole or in part an application made pursuant to subsection 
(b), the Association staff shall consider, among other things, the type 
of business in which the member is engaged, the training, and 
experience, of persons associated with the member, the member's 
procedures for safeguarding customer funds and securities, the member's 
overall financial and operational condition and any other information 
deemed relevant in the particular circumstances and the time these 
measures would remain in effect.]
[Communications With the Public]
[Sec. 8]
[(a) Definitions]
    [(1) Advertisement--For purposes of this section and any 
interpretation thereof, ``advertisement'' means material published, or 
designed for use in, a newspaper, magazine, or other periodical, radio, 
television, telephone or tape recording, videotape display, signs or 
billboards, motion pictures, telephone directories (other than routine 
listings), or other public media.]
    [(2) Sales Literature--For purposes of this section and any 
interpretation thereof, ``sales literature'' means any written 
communication distributed or made generally available to customers or 
the public that does not meet the foregoing definition of 
``advertisement.'' Sales literature includes, but is not limited to, 
circulars, research reports, market letters, performance reports or 
summaries, form letters, standard forms of option worksheets, seminar 
texts, and reprints or excerpts of any other advertisement, sales 
literature, or published article.]
[(b) Approval and Recording]
    [(1) Each item of advertising and sales literature shall be 
approved by signature or initial, prior to use, by a registered 
principal (or designee) of the member.]
    [(2) A separate file of all advertisements and sales literature, 
including the name(s) of the person(s) who prepared them and/or 
approved their use, shall be maintained for a period of three years 
from the date of each use.] 

[[Page 54539]]

[(c) Filing Requirements and Review Procedures]
    [(1) Members shall file advertisements for review with 
Association's Advertising Regulation Department as follows:]
    [(A) Advertisements concerning government securities (as defined in 
Section 3(a)(42) of the Securities Exchange Act of 1934) other than 
collateralized mortgage obligations shall be filed by members with the 
Association's Advertising Department for review within 10 days of first 
use or publication; and]
    [(B) advertisements concerning collateralized mortgage obligations 
shall be filed with the Association's Advertising Regulation Department 
for review at least 10 days prior to use (or such shorter period as the 
Department may allow in particular circumstances) for approval and, if 
changed or expressly disapproved by the Association, shall be withheld 
from publication or circulation until any changes specified by the 
Association have been made or, in the event of disapproval, until the 
advertisement has been refiled for, and has received, Association 
approval.]
    [(2) Each member of the Association that has not previously filed 
advertisements with the Association shall file its initial 
advertisement concerning government securities with the Association's 
Advertising Department at least 10 days prior to use and shall continue 
to file its advertisements concerning government securities at least 10 
days prior to use for a period of one year.]
    [(3) Notwithstanding the foregoing provisions, any District 
Business Conduct Committee of the Association, upon review of a 
member's government securities advertising and/or sales literature, and 
after determining that the member will again depart from the standards 
of this section, may require that such member file all government 
securities advertising and/or sales literature, or the portion of such 
member's material that is related to any specific types or classes of 
securities or services, with the Association's Advertising Department 
and/or the District Committee, at least 10 days prior to use.]
    [The Committee shall notify the member in writing of the types of 
material to be filed and the length of time such requirement is to be 
in effect. The requirement shall not exceed one year, however, and 
shall not take effect until 30 days after the member receives the 
written notice, during which time the member may request a hearing 
before the District Business Conduct Committee, and any such hearing 
shall be held in reasonable conformity with the hearing and appeal 
procedures of the Code of Procedure.]
    [(4) In addition to the foregoing requirements, every member's 
government securities advertising and sales literature shall be subject 
to a routine spot-check procedure. Upon written request from the 
Association's Advertising Department, each member shall promptly submit 
the material requested. Members will not be required to submit material 
under this procedure that has been previously submitted pursuant to one 
of the foregoing requirements.]
    [(5) The following types of material are excluded from the 
foregoing filing requirements and spot-check procedure:]
    [(A) Advertisements of sales literature solely related to changes 
in a member's name, personnel, location, ownership, offices, business 
structure, officers or partners, telephone or teletype numbers, or 
concerning a merger with, or acquisition by, another member;]
    [(B) Advertisements or sales literature that do no more than 
identify the member and/or offer a specific security at a stated 
price;]
    [(C) Material sent to branch offices or other internal material 
that is not distributed to the public;]
    [(6) Material that refers to government securities solely as part 
of a listing products and/or services offered by the member, is 
excluded from the requirements of paragraph (c)(1) of this section.]
[(d) Standards Applicable to Communications With the Public]
[(1) General Standards]
    [(A) All member communications with the public shall be based on 
principles of fair dealing and good faith and should provide a sound 
basis for evaluating the facts in regard to any particular security or 
securities or type of security, industry discussed, or service offered. 
No material fact or qualification may be omitted if the omission, in 
light of the context of the material presented, would cause the 
advertising or sales literature to be misleading.]
    [(B) Exaggerated, unwarranted, or misleading statements or claims 
are prohibited in all public communications of members. In preparing 
such literature, members must bear in mind that inherent in investment 
are the risks of fluctuating prices and the uncertainty of dividends, 
rates of return, and yield, and no member shall, directly or indirectly 
publish, circulate, or distribute any public communication that the 
member knows or has reason to know contains any untrue statement of a 
material fact or is otherwise false or misleading.]
    [(C) When sponsoring or participating in a seminar, forum, radio, 
or television interview, or when otherwise engaged in public 
appearances or speaking activities that may not constitute 
advertisements, members and persons associated with members shall 
nevertheless follow the standards of paragraph (d) of this section.]
[(2) Specific Standards]
    [In addition to the foregoing general standards, the following 
specific standards apply:]
    [(A) Necessary Data: Advertisements and sales literature shall 
contain the name of the member, the person or firm preparing the 
material, if other than the member, and the date on which it is first 
published, circulated, or distributed (except that, in advertisements, 
only the name of the member need be stated; and except also that, in 
any so-called ``blind'' advertisement used for recruiting personnel, 
the name of the member may be omitted). If the information in the 
material is not current, this fact should be stated.]
    [(B) Recommendations: In making a recommendation, whether or not 
labeled as such, a member must have a reasonable basis for the 
recommendation made and must disclose the price at the time the 
recommendation is made, as well as any of the following situations 
which are applicable:]
    [(i) that the member usually makes a market in the securities being 
recommended, or in the underlying security if the recommended security 
is an option, and/or that the member or associated persons will sell to 
or buy from customers on a principal basis;]
    [(ii) that the member and/or its officers or partners own options, 
rights, or warrants to purchase any of the securities of the issuer 
whose securities are recommended, unless the extent of such ownership 
is nominal;]
    [(iii) that the member was manager or co-manager of a public 
offering of any securities of the recommended issuer within the last 
three years.]
    [The member shall also provide, or offer to furnish upon request, 
available investment information supporting the recommendation.]
    [A member may use material referring to past recommendations if it 
sets forth all recommendations as to the same type, kind, grade, or 
classification of securities made by a member within the 

[[Page 54540]]
last year. More years may be covered if they are consecutive and 
include the most recent year. Such material must also name each 
security recommended and give the date and nature of each 
recommendation (e.g., whether to buy or sell), the price at the time of 
the recommendation, the price at which or the price range within which 
the recommendations was to be acted upon, and the general market 
conditions during the period covered.]
    [Also permitted is material that does not make any specific 
recommendation but offers to furnish a list of all recommendations made 
by a member within the past year or over more consecutive years, 
including the most recent year, if this list contains all the 
information specified in the previous paragraph. Neither the list of 
recommendations, nor material offering such list, shall imply 
comparable future performance. Reference to the results of a previous 
specific recommendation, including such a reference in a follow-up 
research report or market letter, is prohibited if the intent or the 
effect is to show the success of a past recommendation, unless all of 
the foregoing requirements with respect to past recommendations are 
met.]
    [(C) Claims and Opinions: Communications with the public must not 
contain promises of specific results, exaggerated, or unwarranted 
claims or unwarranted superlatives, opinions for which there is no 
reasonable basis, or forecasts of future events that are unwarranted or 
that are not clearly labeled as forecasts.]
    [(D) Testimonials: In testimonials concerning the quality of a 
firm's investment advice, the following points must be clearly stated 
in the communication:]
    [(i) the testimonial may not be representative of the experience of 
other clients;]
    [(ii) the testimonial is not indicative of future performance or 
success;]
    [(iii) if more than a nominal sum is paid, the fact that it is a 
paid testimonial must be indicated;]
    [(iv) if the testimonial concerns a technical aspect of investing, 
the person making the testimonial must have knowledge and experience to 
form a valid opinion.]
    [(E) Offers of Free Service: Any statement to the effect that any 
report, analysis, or other service will be furnished free or without 
any charge must not be made unless such report, analysis, or other 
service actually is or will be furnished entirely free and without 
condition or obligation.]
    [(F) Claims for Research Facilities: No claim or implication may be 
made for research or other facilities beyond those that the member 
actually possesses or has reasonable capacity to provide.]
    [(G) Hedge Clauses: No cautionary statements or caveats, often 
called ``hedge clauses,'' may be used if they are misleading or 
inconsistent with the content of the material.]
    [(H) Recruiting Advertising: Advertisements in connection with the 
recruitment of sales personnel must not contain exaggerated or 
unwarranted claims or statements about opportunities in the investment 
banking or securities business and should not refer to specific 
earnings figures or ranges that are not reasonable under the 
circumstances.]
    [(I) Periodic Investment Plans: Communications with the public 
should not discuss or portray any type of continuous or periodic 
investment plan without disclosing that such a plan does not assure a 
profit and does not protect against loss in declining markets. In 
addition, if the material deals specifically with the principles of 
dollar cost averaging, it should point out that since such a plan 
involves continuous investment in securities regardless of fluctuating 
price levels of such securities, the investor should consider his 
financial ability to continue his purchases through periods of low 
price levels.]
    [(J) References to Regulatory Organizations: Communications with 
the public shall not make any reference to membership in the 
Association or to registration or regulation of the securities being 
offered, or of the underwriter, sponsor, or any member or associated 
person, that could imply endorsement or approval by the Association or 
any federal or state regulatory body.]
    [References to membership in the Association or the Securities 
Investor Protection Corporation shall comply with all applicable by-
laws and rules pertaining thereto].
    [(K) Identification of Sources: Statistical tables, charts, graphs, 
or other illustrations used by members in advertising or sales 
literature should disclose the source of the information if not 
prepared by the member.]
[Availability to Customers of Certificate, By-Laws, Rules, and Code of 
Procedure]
    [Sec. 9. Every member of the Corporation shall keep in each office 
maintained by him, in the form to be supplied by the Board of 
Governors, a copy of the Certificate of Incorporation, By-Laws, 
Government Securities Rules, and Code of Procedure of the Corporation, 
and of all additions and amendments from time to time made thereto, and 
of all interpretative rulings made by the Board of Governors, all of 
which shall be available for the examination of any customer who makes 
requests therefore.]
[Complaints]
[Sec. 10.]
[Complaints by public against members]
    [(a) Any person feeling aggrieved by any act, practice, or omission 
of any member or any person associated with a member of the 
Corporation, which such person believes to be in violation of the 
Securities Exchange Act of 1934, the rules and regulations thereunder 
including the rules of the Treasury Department or these Government 
Securities rules, may, on the form to be supplied by the Board of 
Governors, file a complaint against such member or such persons 
associated with a member in regard thereto with any District Business 
Conduct Committee of the Corporation, and any such complaint shall be 
handled in accordance with the Code of Procedure of the Corporation.]
[Complaints by District Business Conduct Committees]
    [(b) Any District Business Conduct Committee which, on information 
and belief, is of the opinion that any act, practice, or omission of 
any member of the Corporation or any person associated with a member is 
in violation of the Securities Exchange Act of 1934, the rules and 
regulations thereunder including the rules of the Treasury Department 
or these Government Securities rules may, on the form to be supplied by 
the Board of Governors, file a complaint against such member or such 
person associated with a member in regard thereto with itself or with 
any other District Business Conduct Committee of the Corporation, as 
the necessities of the complaint may require, and any such complaint 
shall be handled in accordance with the Code of Procedure and in the 
same manner as if it had been filed by an individual or member.]
[Complaints by the Board of Governors]
    [(c) The Board of Governors shall have authority, when on the basis 
of information and belief, it is of the opinion that any act, practice, 
or omission of any member of the Corporation or of any person 
associated with a member is in violation of the Securities Exchange Act 
of 1934, the rules and regulations thereunder including the rules of 
the Treasury Department or these Government Securities rules, to file a 
complaint against such member or such person 

[[Page 54541]]
associated with a member in respect thereto or to instruct any District 
Business Conduct Committee to do so, and any such complaint shall be 
handled in accordance with the Code of Procedure.]
[Reports and Inspection of Books for Purpose of Investigating 
Complaints]
    [Sec. 11. For the purpose of any investigation, or determination as 
to filing of a complaint, or any hearing of any complaint against any 
member of the Corporation or any person associated with a member made 
or held in accordance with the Code of Procedure, any District Business 
Conduct Committee, or the Board of Governors, or any duly authorized 
agent or agents of any such Committee or Board shall have the right 
to:]
    [(1) require any member of the Corporation or person associated 
with a member to report orally or in writing with regard to any matter 
involved in any such investigation or hearing; and]
    [(2) to investigate the books, records and accounts of any such 
member with relation to any matter involved in any such investigation 
or hearing.]

[No member or person associated with a member shall refuse to make any 
report as required in this Section, or refuse to permit any inspection 
of books, records, and accounts as may be validly called for under this 
Section.]
[Sanctions for violation of the Rules]
    [Sec. 12. Any District Business Conduct Committee, Market 
Surveillance Committee, or the Board of Governors, in the 
administration and enforcement of the Securities Exchange Act of 1934, 
the rules and regulations thereunder including the rules of the 
Treasury Department or these Government Securities rules, and after 
compliance with the Code of Procedure, may:]
    [(1) censure any member or person associated with a member; and/or]
    [(2) impose a fine upon any member or person associated with a 
member; and/or]
    [(3) suspend the membership of any member or suspend the 
registration of a person associated with a member, if any, for a 
definite period; and/or]
    [(4) expel any member or revoke the registration of any person 
associated with a member, if any; and/or]
    [(5) suspend or bar a member or person associated with a member 
from association with all members; or]
    [(6) impose any other fitting sanction deemed appropriate under the 
circumstances, for each or any violation of such provisions by a member 
or person associated with a member or for any neglect or refusal to 
comply with any orders, directions, or decisions issued by any District 
Business Conduct Committee, Market Surveillance Committee, or by the 
Board of Governors in the enforcement of these rules, including any 
interpretation made by the Board of Governors, as any such Committee or 
Board, in its discretion, may deem to be just;]

[provided, however, that no such sanction imposed by any District 
Business Conduct Committee or Market Surveillance Committee, shall take 
effect until the period for appeal therefrom or review has expired, as 
provided in Article III, Section 1 of the Code of Procedure; and 
provided, further, that all parties to any proceeding resulting in a 
sanction shall be deemed to have assented to or to have acquiesced in 
the imposition of such sanction unless any party aggrieved thereby 
shall have made application to the Board of Governors for review 
pursuant to the Code of Procedure, within fifteen (15) days after the 
date of such notice.]
    [Sec. 13. All fines imposed pursuant to Section 12 of these rules 
shall be paid to the Treasurer of the Corporation and shall be used for 
the general corporate purposes. Any member that fails promptly to pay 
any fine imposed pursuant to Section 12 of these rules, or any costs 
imposed pursuant to Section 12 of these rules, or any costs imposed 
pursuant to Section 14 of these rules after such fine or costs have 
become finally due and payable, may after seven (7) days' notice in 
writing be summarily suspended or expelled from membership on the 
Corporation. A member may also be summarily suspended or expelled from 
membership in the Corporation if the member fails to immediately 
terminate the association of any person who fails to pay promptly any 
fine imposed pursuant to Section 12 of these rules or any costs imposed 
pursuant to Section 14 of these rules after such fine or costs have 
become finally due and payable after seven (7) days' notice in writing. 
The registration of a person associated with a member, if any, may be 
summarily revoked if such person fails to pay promptly any fine imposed 
pursuant to Section 12 of these rules, or any costs pursuant to Section 
14 of these rules after such fine or costs have become finally due and 
payable after seven (7) days' notice in writing.]
[Cost of proceedings]
    [Sec. 14. Any member or person associated with such member 
disciplined pursuant to Section 12 of these rules shall bear such part 
of the costs of the proceedings as the District Business Conduct 
Committee or the Board of Governors deems fair and appropriate in the 
circumstances.]
Code of Procedure
Article I
    No change.
Article II
Disciplinary Actions by District Business Conduct Committees, the 
Market Surveillance Committee and Others
* * * * *
Acceptance, Waiver and Consent, Minor Rule Violations, and Summary 
Complaint Procedures
    Sec. 10. A Committee, may, prior to issuance of a complaint under 
Section 1 of this Article, impose disciplinary penalties pursuant to 
the procedures set forth under this Section 10.
* * * * *
Appendix
Violations Appropriate For Disposition Under The Minor Rule Violations 
Plan
* * * * *
     Article III, Subsections 35 (b) and (c) and 35A (b) and 
(c) of the Rules of Fair Practice [and Subsections 8 (b) and (c) of the 
Government Securities Rules]--Failure to have advertisements and sales 
literature approved by a principal prior to use, failure to maintain 
separate files of advertisements and sales literature containing 
required information, and failure to file advertisements with the 
Association within the required time limits.

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. 

[[Page 54542]]


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

1. Purpose
Application of the Rules of Fair Practice to Exempted Securities Except 
Municipals and Merger of Government Securities Rules
    The Government Securities Act Amendments of 1993 (``Government 
Securities Amendments'') were signed into law on December 13, 1993, and 
eliminated the statutory limitations on the NASD's authority to 
regulate the sales practices of exempted securities, including 
government securities transactions, other than municipals.4

    \4\Id.
---------------------------------------------------------------------------

    In order to implement the expanded sales practice authority granted 
to the NASD pursuant to the Government Securities Amendments, the NASD 
is proposing to delete the NASD Government Securities Rules and apply 
the NASD Rules of Fair Practice, where applicable, to exempted 
securities, including government securities other than 
municipals.5 The Government Securities Rules, therefore, are being 
deleted in their entirety and certain of these rules are proposed to be 
merged into the Rules of Fair Practice.

    \5\The terms exempted securities, government securities and 
municipal securities are defined in Sections 3(a)(12), 3(a)(42) and 
3(a)(29) of the Act.
---------------------------------------------------------------------------

    Set forth below is a description of the amendments proposed to the 
Rules of Fair Practice that would apply the Rules of Fair Practice to 
exempted securities (except municipals) and would merge certain 
provisions of the Government Securities Rules. This is followed by a 
chart depicting the applicability of the Rules of Fair Practice to 
transactions in exempted securities (except municipals).

Article I of the Rules of Fair Practice

    Section 4. The NASD proposes to amend Article I, Section 4 of the 
Rules of Fair Practice to replace the term ``exempted'' with the term 
``municipal'' in order to make the Rules of Fair Practice applicable, 
as appropriate, to exempted securities, including government securities 
other than municipals.
    Section 5. The NASD proposes to amend Article I, Section 5(a) of 
the Rules of Fair Practice by deleting the phrase ``other than those 
members registered with the Securities and Exchange Commission solely 
under the provisions of Section 15C of the Act and persons associated 
with such members'' in order to expand the application of the Rules of 
Fair Practice to members involved in the government securities business 
pursuant to Section 15C of the Act.

Article III of the Rules of Fair Practice: Primary Amendments

    Section 1: Prompt Receipt and Delivery Interpretation. Paragraph 
(b)(2)(a) of the Interpretation of the Board of Governors--Prompt 
Receipt and Delivery and Securities under Article III, Section 1 of the 
Rules of Fair Practice exempts ``transactions in corporate debt 
securities'' from the NASD requirement that a member cannot accept a 
``short'' sale order for any customer in any security unless the member 
can make an affirmative determination that the member will receive the 
security from the customer or that the member can borrow the security 
on behalf of the customer for delivery by settlement date. Paragraph 
(b)(2)(b) under this Interpretation similarly exempts ``transactions in 
corporate debt securities'' from the NASD requirement that a member 
cannot effect a ``short sale'' for any customer or its own account in 
any security unless the member or person associated with a member makes 
an affirmative determination that the member can borrow the securities 
or otherwise provide for delivery of the securities by the settlement 
date.
    The regulatory rationale for exempting transactions in corporate 
debt securities from the Prompt Receipt and Delivery Interpretation is 
that many short-selling transactions in the corporate debt market are 
``for the purpose of risk reduction and market liquidity and to ensure 
their availability for bona fide purposes.''6 The NASD believes 
that short-selling transactions provide similar risk reduction and 
market liquidity in all debt markets. The NASD therefore, proposes to 
delete the term ``corporate'' from both paragraphs (b)(2)(a) and (b) of 
the Interpretation of the Board of Governors--Prompt Receipt and 
Delivery of Securities, under Article III, Section 1 of the Rules of 
Fair Practice to expand the short-sale exemptions under those 
provisions to all debt.

    \6\Securities Exchange Act Release No. 27409 (October 31, 1989), 
54 FR 46665 (November 6, 1989).
---------------------------------------------------------------------------

    Section 1: Free-Riding and Withholding Interpretation. The NASD has 
determined that the Interpretation of the Board of Governors--Free-
Riding and Withholding under Article III, Section 1 of the Rules of 
Fair Practice may apply to certain arrangements necessary for the 
distribution of government securities, i.e., that members may be 
considered to purchase government securities for their own account. The 
NASD, however, is not aware of any situation which would indicate that 
there are abuses in the distribution practices related to government 
securities that requires the application of the Interpretation. The 
NASD, therefore, proposes to amend the Interpretation to clarify that 
it does not apply to transactions in government securities in order to 
ensure that normal distribution practices in government securities are 
not adversely affected by this rule.
    Section 21(b)(i): ``Marking of Customer Order Ticket'' Rule. 
Corporate debt is exempted from Article III, Section 21(b)(i) of the 
Rules of Fair Practice, which requires that a person associated with a 
member indicate on the memorandum for sale of a security whether the 
order is ``long'' or ``short.'' The NASD has determined that Section 
21(b)(i) to Article III of the Rules of Fair Practice should not be 
applicable to the market for any debt securities, where short sales are 
not known to raise the investor protection concerns that are associated 
with transactions in equity securities. In particular, with respect to 
the market for mortgage-backed securities, the concern exists that the 
application of Section 21(b)(i) would create confusion for brokers 
selling securities that have been purchased but not yet received 
because of this market's extended settlement periods. The NASD, 
therefore, proposes to amend Section 21(b)(i) to exempt all debt 
securities, other than municipals from the ``marking of customer order 
ticket'' rule.
    Section 25: Transactions in Exempted Securities. Section 25 to 
Article III of the Rules of Fair Practice prohibits NASD members from 
dealing with a non-member broker/dealer except at the same prices and 
on the same terms afforded the general public. At Section 25 to Article 
III of the Rules of Fair Practice is the Interpretation of the Board of 
Governors--Transactions Between Members and Non-Members. This 
Interpretation, under Part 2--Transactions in ``Exempted Securities'' 
reminds members that the Rules of Fair Practice do not apply to 
transactions, whether between members or between members and non-
members, in ``exempted securities'' pursuant to Article I, Section 4 of 
the Rules of Fair Practice.
    In light of the proposed rule change to Article I Section 4 of the 
Rules of Fair Practice that reflects the NASD's expanded authority over 
exempted securities, the Association is proposing 

[[Page 54543]]
to amend Part 2 to the above Interpretation to state that Section 25 of 
Article III of the Rules of Fair Practice shall not apply to ``exempted 
securities.'' The NASD has determined that the provisions of Section 25 
should continue to not apply to transactions in exempted securities in 
order to permit foreign non-member broker/dealers to continue to 
purchase exempted securities, including government securities, without 
compliance with Article III, Section 25(c). Section 25(c) requires a 
foreign non-member broker/dealer to agree in writing to conform to the 
requirements of Section 25 when making any sales to purchasers within 
the U.S. of securities acquired as a result of a transaction with the 
member. The NASD believes it would difficult at this time to accurately 
determine the potential adverse effects to the government securities 
markets if the NASD required members to obtain such agreements from 
foreign non-member broker/dealers that purchase government securities 
from NASD members.

Amendments Merging Government Securities Rules into Rules of Fair 
Practice

    The NASD proposes to merge certain provisions contained solely 
under the Government Securities Rules into corresponding sections of 
the Rules of Fair Practice in order to provide NASD members with one 
set of sales practice rules that will reflect the NASD's expanded 
authority under the Government Securities Amendments. The NASD 
specifically proposes to add provisions of the Government Securities 
Rules into Article III, Section 21(c)(3), 38, and 39; Article IV, 
Sections 1 to 4; and Article V, Section 1 of the Rules of Fair 
Practice. The NASD also proposes to move provisions contained under 
Section 6 of the Government Securities Rules into a new Section 38A to 
Article III of the Rules of Fair Practice. The NASD also proposes to 
add references, where appropriate, to Section 402.2(c) of the rules of 
the Treasury Department. To effect these amendments, the NASD has 
reorganized and renumbered a number of the provisions contained in the 
above-referenced sections of the Rules of Fair Practice.
    Set forth below is a table identifying the provisions of the 
Government Securities Rules and the corresponding provisions of the 
Rules of Fair Practice into which the Government Securities Rules have 
been merged by amendment to those provisions. In addition, the table 
indicates the corresponding section of the Rules of Fair Practice for 
each Government Securities Rule where no rule language change is 
necessary because of the expanded authority under Article I, Section 5 
of the Rules of Fair Practice.

   Government Securities Rules Merged Into the Rules of Fair Practice   
------------------------------------------------------------------------
                                                                        
------------------------------------------------------------------------
     Government Securities Rules Merged Into Rules of Fair Practice     
                                                                        
------------------------------------------------------------------------
Sec. 1 Adoption of Rules...............  Article I, Sec. 1--No change.  
Sec. 2 Applicability:                                                   
    Subsection (a).....................  Subsection (b).                
Sec. 3 Definitions in By-Laws and Rules  Article I, Sec. 4 and 5(a).    
 of Fair Practice.                       Article I, Sec. 5(b) and (c)-- 
                                          No change.                    
                                         Article II, Sec. 1 and 2--No   
                                          change.                       
Sec. 4 Books and Records...............  Article III, Sec. 21.          
Sec. 5 Supervision.....................  Article III, Sec. 27--No       
                                          change.                       
Sec. 6 Regulation of Activities of       Article III, Sec. 38 and 38A.  
 Members Experiencing Financial and/or                                  
 Operational Difficulties.                                              
      Explanation of Board of            Explanation of Board of        
       Governors--Restrictions on a       Governors, Restrictions on a  
       Member's Activity.                 Members Activity, Article III,
                                          Sec. 38 and 38A.              
Sec. 7 Approval of Change in Exempt      Article III, Sec. 39.          
 Status under SEC Rule 15c3-3.                                          
Sec. 8 Communications with the Public..  Article III, Sec. 35--No       
                                          change.                       
Sec. 9 Availability to Customers of      Article IV, Sec. 1--No change. 
 Certificate, By-Laws, Rules, and Code                                  
 of Procedure.                                                          
Sec. 10 Complaints:                                                     
    Subsection (a) Complaints by Public  Article IV, Sec. 2.            
     Against Members.                                                   
    Subsection (b) Complaints by         Article IV, Sec. 4.            
     District Business Conduct                                          
     Committees.                                                        
    Subsection (c) Complaints by the     Article IV, Sec. 4.            
     Board of Governors.                                                
Sec. 11 Reports and Inspection of Books  Article IV, Sec. 5--No change. 
 for Purpose of Investigating                                           
 Complaints                                                             
    Resolution of Board of Governors--   Resolution of Board of         
     Suspension of Members for Failure    Governors--Suspension of      
     to Furnish Information Duly          Members for Failure to Furnish
     Requested.                           Information Duly Requested--No
                                          change.                       
Sec. 12 Sanctions for Violation of the   Article V, Sec. 1.             
 Rules.                                                                 
Sec. 13 Payment of Fines or Costs......  Article V, Sec. 2--No change.  
Sec. 14 Cost of Proceedings............  Article V, Sec. 3--No change.  
------------------------------------------------------------------------

Conforming References

    The NASD proposes to make conforming changes to NASD By-Laws, 
Schedules to the By-Laws, the Rules of Fair Practice, and the Code of 
Procedure by eliminating references to provisions of the Government 
Securities Rules or the terms ``exempted security'' or ``exempted 
securities'' and replacing these terms, where applicable, with the 
appropriate Rules of Fair Practice or the term ``municipal'' 
securities, respectively. The conforming changes regarding such 
references are made to Section (o) to Article I of the By-Laws; Section 
13 to Schedule A of the By-Laws; Part VI, Section 1 Schedule C to the 
By-Laws; Article III, Section 35 of the Rules of Fair Practice; and the 
Appendix entitled ``Violations Appropriate For Disposition Under the 
Minor Rule Violations Plan'' under Article II, Section 10 of the Code 
of Procedure.

Other Technical Amendments

    The NASD proposes to modify references to SEC Rules 15c3-1 and 
15c3-3 to reflect amendments by the SEC to those rules. Such technical 
changes are made under Part II, Section 2(b)(iv) of Schedule C to the 
By-Laws 

[[Page 54544]]
and under Article III, Sections 38, and 39 of the Rules of Fair 
Practice.
Applicability of the Rules of Fair Practice
    The NASD intends that the proposed rule change would apply the 
Rules of Fair Practice, where appropriate, to activities involving 
exempted securities, pursuant to the proposed changes described above 
under Article I, Sections 4 and 5 to the Rules of Fair Practice. The 
NASD, therefore, has reviewed all Rules of Fair Practice, as well as 
Interpretations and Policies thereunder, to determine their 
applicability or non-applicability to exempt securities. To clarify the 
application of specific rules, interpretations and policies of the 
Rules of Fair Practice under the proposed rule change, the NASD intends 
to provide by publication in a Notice to Members (upon approval of the 
proposed rule change by the Commission) the following summary of 
applicable and non-applicable rules, interpretations and policies of 
the Rules of Fair Practice.

   Applicability of the Rules of Fair Practice to Exempted Securities, Including Government Securities (Except  
                                                   Municipals)                                                  
----------------------------------------------------------------------------------------------------------------
                                                                                                                
----------------------------------------------------------------------------------------------------------------
                                                   Article III                                                  
                                                                                                                
----------------------------------------------------------------------------------------------------------------
Section 1..................  Business Conduct of Members....  Applicable.                                       
                             Interpretations of the Board of                                                    
                              Governors--.                                                                      
                             Execution of Retail              Applicable.                                       
                              Transactions in the Over-the-                                                     
                              Counter Market.                                                                   
                             Prompt Receipt and Delivery....  Applicable.                                       
                             Forwarding of Proxy and Other    Not Applicable.                                   
                              Materials.                                                                        
                             Free-Riding and Withholding....  Amending to be Not Applicable.                    
                             Interpretation on Limit Order    Not Applicable.                                   
                              Protection.                                                                       
                             Front Running Policy...........  Applicable.                                       
Section 2..................  Recommendations to Customers...  Applicable.                                       
                             Policy of the Board of           Applicable.                                       
                              Governors--Fair Dealing With                                                      
                              Customers Policy.                                                                 
Section 3..................  Charges to Customers...........  Applicable.                                       
Section 4..................  Fair Prices and Commission.....  Applicable.                                       
                             Interpretation of the Board of   Applicable.7                                      
                              Governors--NASD Mark-Up Policy.                                                   
Section 5..................  Publication of Transactions and  Applicable.                                       
                              Quotations.                                                                       
                             Interpretation of the Board of   Applicable.                                       
                              Governors--Manipulative and                                                       
                              Deceptive Quotations.                                                             
Section 6..................  Offers at Stated Prices........  Applicable.                                       
                             Policy of the Board of           Applicable.                                       
                              Governors--Policy With Respect                                                    
                              to Firmness of Quotations.                                                        
Section 7..................  Disclosure of Prices in Selling  Applicable only to traditional underwriter        
                              Agreements.                      arrangements.                                    
Section 8..................  Securities Taken in Trade......  Not Applicable.                                   
                             Interpretation of the Board of   Not Applicable.                                   
                              Governors--Safe Harbor and                                                        
                              Presumption of Compliance.                                                        
Section 9..................  Use of Information Obtained in   Applicable.                                       
                              Fiduciary Capacity.                                                               
Section 10.................  Influencing or Rewarding         Applicable.                                       
                              Employees of Others.                                                              
Section 11.................  Payment Designed to Influence    Applicable.                                       
                              Market Prices, Other than Paid                                                    
                              Advertising.                                                                      
Section 12.................  Disclosure on Confirmations....  Not Applicable; superseded by SEC rules.          
Section 13.................  Disclosure of Control..........  Not Applicable.                                   
Section 14.................  Disclosure of Participation or   Applicable.                                       
                              Interest in Primary or                                                            
                              Secondary Distribution.                                                           
Section 15.................  Discretionary Accounts.........  Applicable.                                       
Section 16.................  Offers ``At the Market''.......  Not Applicable.                                   
Section 17.................  Solicitation of Purchases on an  Applicable.                                       
                              Exchange to Facilitate a                                                          
                              Distribution of Securities.                                                       
Section 18.................  Use of Fraudulent Devices......  Applicable.                                       
Section 19.................  Customers Securities or Funds..  Applicable.                                       
Section 20.................  Installment or Partial Payment   Applicable.                                       
                              Sales.                                                                            
Section 21.................  Books and Records..............  Applicable, except for proposed amendments to     
                                                               Subsection (b)(i).                               
Section 22.................  Disclosure of Financial          Applicable.                                       
                              Condition.                                                                        
Section 23.................  Net Prices to Persons Not in     Applicable.                                       
                              Investment Banking or                                                             
                              Securities Business.                                                              
Section 24.................  Selling Concessions............  Not Applicable.                                   
                             Interpretation of the Board of   Not Applicable.                                   
                              Governors--Services in                                                            
                              Distribution.                                                                     
Section 25.................  Dealing with Non-Members.......  Amending to be Not Applicable.                    
                             Interpretation of the Board of   Not Applicable.                                   
                              Governors--Transactions                                                           
                              Between Members and Non-                                                          
                              members.                                                                          
Section 26.................  Investment Companies...........  Not Applicable.                                   
Section 27.................  Supervision....................  Applicable.                                       
Section 28.................  Transactions for or by           Applicable.                                       
                              Associated Persons.                                                               
Section 29.................  Variable Contracts of an         Not Applicable.                                   
                              Insurance Co.                                                                     
Section 30.................  Margin Accounts................  Applicable.                                       
Section 31.................  Securities Failed to Receive     Not Applicable.                                   
                              and Failed to Deliver.                                                            
Section 32.................  Fidelity Bonds.................  Applicable.                                       
Section 33.................  Options........................  Not Applicable.                                   
Section 34.................  Direct Participation Programs    Not Applicable.                                   
                              Appendix F.                                                                       
Section 35.................  Communications With the Public.  Applicable.                                       
Section 35A................  Options Communications With the  Applicable.                                       
                              Public.                                                                           
Section 36.................  Transactions with Related        Not Applicable.                                   
                              Persons.                                                                          
                             Interpretations of the Board of  Not Applicable.                                   
                              Governors--Transactions With                                                      
                              Related Persons.                                                                  
Section 37.................  Operating Rules for ITS/CAES     Not Applicable.                                   
                              and CAES.                                                                         

[[Page 54545]]
                                                                                                                
Section 38.................  Regulation of Activities of      Applicable.                                       
                              Members Experiencing Financial                                                    
                              and/or Operational                                                                
                              Difficulties.                                                                     
Section 39.................  Approval of Change in Exempt     Applicable.                                       
                              Status under SEC Rule 15c3-3.                                                     
Section 40.................  Private Securities Transactions  Applicable.                                       
Section 41.................  Short-Interest Reporting.......  Not Applicable.                                   
Section 42.................  Prohibition on Transactions      Not Applicable.                                   
                              During Trading Halts.                                                             
Section 43.................  Outside Business Activities....  Applicable.                                       
Section 44.................  The Corporate Financing Rule...  Not Applicable.                                   
Section 45.................  Customer Account Statements....  Applicable.                                       
Section 46.................  Adjustment of Open Orders......  Not Applicable.                                   
Section 47.................  Clearing Agreements............  Applicable.                                       
Section 48.................  Short Sale Rule................  Not Applicable.                                   
Section 49.................  Primary Nasdaq Market Maker      Not Applicable.                                   
                              Standards.                                                                        
                                                                                                                
----------------------------------------------------------------------------------------------------------------
                                             Article IV--Complaints                                             
                                                                                                                
----------------------------------------------------------------------------------------------------------------
Section 1..................  Availability to Customers of     Applicable.                                       
                              Certificate, by-laws, Rules                                                       
                              and Code of Procedures.                                                           
Section 2..................  Complaints by Public Against     Applicable.                                       
                              Members for Violations of                                                         
                              Rules.                                                                            
Section 3..................  Complaints by District Business  Applicable.                                       
                              Conduct Committee.                                                                
Section 4..................  Complaints by Board of           Applicable.                                       
                              Directors.                                                                        
Section 5..................  Reports and Inspection of Books  Applicable.                                       
                              for Purpose of Investigating                                                      
                              Complaints.                                                                       
                                                                                                                
----------------------------------------------------------------------------------------------------------------
                                                    Article V                                                   
                                                                                                                
----------------------------------------------------------------------------------------------------------------
Section 1..................  Sanctions for Violations of      Applicable.                                       
                              Rules.                                                                            
Section 2..................  Interpretation of the Board of   Applicable.                                       
                              Governors--The Effect of a                                                        
                              Suspension or Revocation of                                                       
                              the Registration, if any, of a                                                    
                              Person Associated with a                                                          
                              Member or the Barring of a                                                        
                              Person from further                                                               
                              Association with any Member.                                                      
                             Payment for Fines, Other         Applicable.                                       
                              Monetary Sanctions, or Costs.                                                     
Section 3..................  Posts of Proceedings...........  Applicable.                                       
----------------------------------------------------------------------------------------------------------------
7Article III, Section 4 of the Rules of Fair Practice and the NASD Mark-Up Policy currently apply to            
  transactions in equity and corporate debt securities. The NASD is developing an Interpretation of the Mark-Up 
  Policy with respect to exempt securities and other debt securities. Therefore, the current application of     
  Article III, Section 4 of the Rules of Fair Practice and the NASD Mark-Up Policy will not apply to            
  transactions in exempt securities until adoption of the proposed Interpretation of the NASD Mark-Up Policy    
  with respect to all debt securities. However, current Article III, Section 4 of the Rules of Fair Practice and
  the Mark-Up Policy remain in full force and effect for all equity and corporate debt transactions. See letter 
  from Elliott R. Curzon, Assistant General Counsel, NASD, to Mark P. Barracca, Branch Chief, Division of Market
  Regulation, SEC, dated October 17, 1995 (Amendment No. 1 to the proposed rule change).                        



Interpretation of the Board of Governors--Suitability Obligations to 
Institutional Customers

    The NASD is proposing to adopt an Interpretation of the Board of 
Governors--Suitability Obligations to Institutional Customers under 
Article III, Section 2 of the Rules of Fair Practice (``Suitability 
Interpretation''). The NASD intends the proposed Suitability 
Interpretation to clarify that the NASD's suitability rule under 
Article III, Section 2(a) of the Rules of Fair Practice is applicable 
to institutional customers, while recognizing that generally, a 
member's relationship with an institutional customer is different than 
the member relationship with retail customers.
    The first paragraph of the proposed Suitability Interpretation 
acknowledges that the Association's broadened authority, pursuant to 
the Government Securities Amendments, was the initial impetus for the 
Association's decision to provide further guidance to members on their 
suitability obligations when making recommendations to institutional 
customers. The first paragraph clarifies, however, that the Board 
intends the proposed Suitability Interpretation to be applicable to all 
debt and equity securities, except municipals.
    The second paragraph of the proposed Suitability Interpretation 
states that the suitability rule is fundamental to fair dealing and is 
intended to promote ethical sales practices and high standards of 
professional conduct. This paragraph further states that members' 
responsibilities include having a reasonable basis for recommending a 
particular security or strategy, as well as reasonable grounds for 
believing the recommendation is suitable for the customer to whom it is 
made. This paragraph further clarifies that members are expected to 
meet the same high standards of competence, professionalism, and good 
faith regardless of the financial circumstances of the customer.
    The proposed Suitability Interpretation clarifies that it is 
intended to provide guidance to members in fulfilling only their 
customer-specific suitability obligations. The third paragraph of the 
proposed Suitability Interpretation states that the Interpretation 
concerns only the manner in which a member determines that a 
recommendation is suitable for a particular customer and that the 
manner in which a member fulfills this suitability obligation will vary 
depending on the nature of the customer and the specific transaction. 
This paragraph further states that the Interpretation deals only with 
guidance regarding how a member may fulfill such ``customer-specific 
suitability obligations'' under Article III, Section 2(a) of the Rules 
of Fair Practice. This third paragraph of the Suitability 
Interpretation contains a footnote to a Commission administrative 
decision that references a non-customer specific suitability obligation 
that is not addressed by the proposed Suitability Interpretation.
    The proposed Suitability Interpretation and the factors contained 
therein are not intended either to create a safe harbor for members, or 
a burdensome evidentiary checklist for members. The fourth paragraph of 
the proposed Suitability Interpretation states that, while it is 
difficult to define 

[[Page 54546]]
in advance the scope of a member's suitability obligation with respect 
to a specific institutional customer transaction recommended by a 
member, the Board has identified certain factors that may be relevant 
when considering compliance with Article III, Section 2(a) of the Rules 
of Fair Practice. This paragraph further states that factors are not 
intended to be requirements or the only factors to be considered, but 
are offered merely as a guidance in determining the scope of a member's 
suitability obligations.
    The proposed Suitability Interpretation contains a subheading 
entitled ``Considerations Regarding the Scope of Members' Obligations 
to Institutional Customers.'' Under this subheading, the proposed 
Suitability Interpretation states that the two most important 
considerations in determining the scope of a member's suitability 
obligations in making recommendations to an institutional customer are 
the customer's capability to evaluate investment risk independently, 
and the extent to which the customer intends to exercise independent 
judgment in evaluating a member's recommendation.

Presence of Customer Capability

    The proposed Suitability Interpretation states that a member must 
determine, based on the information available to it, the customer's 
capability to evaluate investment risk. In some cases, the member may 
conclude that the customer is not capable of making independent 
investment decisions in general. In other cases, the institutional 
customer may have general capability, but may not be able to understand 
a particular type of instrument or its risk. The proposed Suitability 
Interpretation states that this latter case is more likely to arise 
with relatively new types of instruments, or those with significantly 
different risk or volatility characteristics than other investments 
generally made by the institution. The proposed Suitability 
Interpretation states that if a customer is either generally not 
capable of evaluating investment risk or lacks sufficient capability to 
evaluate the particular product, the scope of a member's customer-
specific obligations under the suitability rule would not be diminished 
by the fact that the member was dealing with an institutional customer. 
On the other hand, the fact that an institutional customer initially 
needed help understanding a potential investment need not necessarily 
imply that the customer did not ultimately develop an understanding and 
make an independent investment decision.
    Further guidance regarding the subject of customer capability is 
provided when the proposed Suitability Interpretation states that a 
determination of the customer's capability to evaluate investment risk 
independently will depend on an examination of the customer's 
capability to make its own investment decisions including the resources 
available to the customer to make informed decisions. The proposed 
Suitability Interpretation states that relevant considerations could 
include:
     The use of one or more consultants, investment advisers or 
bank trust departments;
     The general level of experience of the institutional 
customer in financial markets and specific experience with the type of 
instruments under consideration;
     The customer's ability to understand the economic features 
of the security involved;
     The customer's ability to independently evaluate how 
market developments would affect the security; and
     The complexity of the security or securities involved.

Presence of Independent Investment Judgment

    The proposed Suitability Interpretation states that a member may 
conclude that an institutional customer intends to exercise independent 
judgment if the customer's investment decision will be based on its own 
independent assessment of the opportunities and risks presented by a 
potential investment, market factors and other investment 
considerations. The proposed Suitability Interpretation clarifies that 
a member's determination that a customer is making independent 
investment decisions will depend on the nature of the relationship that 
exists between the member and the customer. Relevant considerations 
could include:
     Any written or oral understanding that exists between the 
member and the customer regarding the nature of the relationship 
between the member and the customer and the services to be rendered by 
the member;
     The presence or absence of a pattern of acceptance of the 
member's recommendations;
     The use by the customer of ideas, suggestions, market 
views and information obtained from other members or market 
professionals, particularly those relating to the same type of 
securities; and
     The extent to which the member has received from the 
customer current comprehensive portfolio information in connection with 
discussing recommended transactions or has not been provided important 
information regarding its portfolio or investment objectives.

Fulfillment of the Suitability Obligation

    The proposed Suitability Interpretation states that the factors 
contained therein are merely guidelines that will be utilized to 
determine whether a member has fulfilled its suitability obligations 
with respect to a specific institutional customer transaction and that 
the inclusion or absence of any of these factors is not dispositive of 
the determination of suitability. Such a determination can only be made 
on a case-by-case basis taking into consideration all the facts and 
circumstances of a particular member/customer relationship, assessed in 
the context of a particular transaction.
    The Association believes it is important to further clarify when a 
member may consider its suitability obligations fulfilled pursuant to 
the guidance provided by the proposed Suitability Interpretation. The 
proposed Suitability Interpretation, therefore, states that where the 
broker-dealer has reasonable grounds for concluding that the 
institutional customer is making independent investment decisions and 
is capable of independently evaluating investment risk, then a member's 
obligation to determine that a recommendation is suitable for a 
particular customer is fulfilled.

Application of Proposed Suitability Interpretation to Delegated Agents

    The NASD believes it is important to clarify the application of the 
Suitability Rule to transactions wherein the institutional customer has 
delegated decision-making authority to an agent. The proposed 
Suitability Interpretation states that where a customer has delegated 
decision-making authority to an agent, such as an investment advisor or 
a bank trust department, this Interpretation shall be applied to the 
agent.

Definition of Institutional Customer

    For purposes of the proposed Suitability Interpretation, the NASD 
believes that the term ``institutional customer'' should not be 
arbitrarily defined by referencing a threshold of institutional asset 
size, portfolio size, or by referencing various statutory designations. 
The proposed Suitability Interpretation, therefore, states that for 
purposes of this Interpretation, an institutional customer shall be any 
entity other than a natural person.
    The proposed Suitability Interpretation does not intend the size 

[[Page 54547]]
    of the institutional customer's securities portfolio to be a 
dispositive consideration in determining the member's fulfillment of 
its suitability obligation under Article III, Section 2(a) of the Rules 
of Fair Practice. The proposed Suitability Interpretation, however, 
does state that in determining the applicability of this Interpretation 
to an institutional customer, the NASD will consider the dollar value 
of the securities that the institutional customer has in its portfolio 
and/or under management. The proposed Suitability Interpretation also 
states that, while this Interpretation is potentially applicable to any 
institutional customer, the guidance contained herein is more 
appropriately applied to an institutional customer with at least $10 
million invested in securities in the aggregate in its portfolio and/or 
under management. The NASD intends this reference to ``$10 million 
invested in securities'' to be a non-dispositive factor that may be 
considered along with the other considerations contained in the 
proposed Suitability Interpretation.
    The NASD believes that the proposed rule change will clarify that 
the NASD's suitability rule under Article III, Section 2(a) of the 
Rules of Fair Practice is applicable to institutional customers, while 
recognizing that a member's relationship with an institutional customer 
is different than with retail customers in those situations where the 
institutional customer is able to, and in fact does, make an 
independent investment decision. It is believed that the proposed 
Suitability Interpretation will provide important guidance to members 
regarding their suitability obligations to institutional customers by 
clarifying the type of considerations that should be part of the 
member's decision-making process in determining its suitability 
obligations. In providing such guidance, the NASD also believes that 
the proposed Suitability Interpretation furthers the goals of the 
Government Securities Amendments to expand the Association's sales 
practice rules to exempted securities by clarifying that the 
suitability rule under Article III, Section 2(a) of the Rules of Fair 
Practice applies to members' transactions in all debt and equity 
securities, including government and other exempted securities, except 
for municipals.
Amendment to Article III, Section 2(b) of the Rules of Fair Practice
    The NASD is proposing to amend Article III, Section 2(b) to clarify 
that the definition of a ``non-institutional customer'' for purposes of 
the account records requirement of that provision shall mean a customer 
that does not qualify as an ``institutional account'' under Article 
III, Section 21(c)(4) of the Rules of Fair Practice. The NASD believes 
this provision will clarify that the definition of ``institutional 
customer'' contained in the Suitability Interpretation does not apply 
to Article III, Section 2(b) of the Rules of Fair Practice.
Effectiveness of Rule Change
    The NASD proposes that the rule change would be effective and 
applicable upon approval by the Commission with the following 
exceptions. Article III, Sections 21, 27, and 32 of the Rules of Fair 
Practice will be implemented within three months after the effective 
date of the rule change to provide members sufficient time to change 
their internal procedures to comply with such rules.8

    \8\See letter from Elliott R. Curzon, Assistant General Counsel, 
NASD, to Mark P. Barracca, Branch Chief, Division of Market 
Regulation, SEC, dated October 17, 1995 (Amendment No. 1 to the 
proposed rule change).
---------------------------------------------------------------------------

2. Statutory Basis
    The NASD believes that the proposed rule change is consistent with 
the provisions of Section 15A(b)(6) of the Act,9 as amended, which 
requires that the rules of the Association be designed to prevent 
fraudulent and manipulative acts and practices, to promote just and 
equitable principles of trade, to remove impediments to and perfect the 
mechanism of a free and open market and a national market system, and, 
in general, to protect investors and the public interest in that the 
rule change will implement the Association's expanded sales practice 
authority over exempted securities, except for municipals, by creating 
one set of sales practice rules for members by merging the Government 
Securities Rules into the Rules of Fair Practice and applying, where 
applicable, the Rules of Fair Practice to those members registered with 
the SEC solely under the provisions of Section 15C of the Act and to 
transactions in exempted securities, including government securities, 
except municipals. The proposed rule change will also further the 
above-purposes of the Act, as amended, by adopting a new Interpretation 
of the Board of Governors--Suitability Obligations to Institutional 
Customers under Article III, Section 2 of the Rules of Fair Practice 
to: (i) Apply the NASD's suitability rule under Article III, Section 
2(a) of the Rules of Fair Practice to transactions in exempted 
securities including government securities, except municipals; and (ii) 
provide guidance to members on their suitability obligations when 
making recommendations to institutional customers, of which the 
government securities markets has a particularly broad institutional 
component. The proposed rule change will also further the above-
purposes of the Act, as amended, by: (i) making clarifying amendments 
to certain sections and Interpretations under Articles III and IV of 
the Rules of Fair Practice relating to the government securities 
business; (ii) making technical changes to NASD By-Laws, Schedules of 
the By-Laws, the Rules of Fair Practice, and the Code of Procedure to 
replace references to provisions of the Government Securities Rules 
with references to the appropriate Rules of Fair Practice, and to 
delete the terms ``exempted security'' or ``exempted'' securities, or, 
replace these terms with the term ``municipal securities,'' as 
applicable; and (iii) modifying references to SEC Rules 15c3-1 and 
15c3-3 to reflect SEC amendments to those rules.

    \9\15 U.S.C. Sec. 78o-3.
---------------------------------------------------------------------------

(B) Self-Regulatory Organization's Statement on Burden on Competition

    The NASD believes that the proposed Suitability Interpretation 
contained in the proposed rule change is consistent with the intent of 
the Act as amended by the Government Securities Amendments.10 The 
proposed Suitability Interpretation expands the suitability rule 
contained under Article III, Section 2(a) of the Rules of Fair Practice 
to all securities transactions, including transactions in exempted 
securities, except for municipals. While the proposed Suitability 
Interpretation acknowledges that a member's relationships with 
institutional customers may be different from the normal member/retail 
customer relationship, it does not unfairly discriminate against such 
institutional customers. The proposed rule change applies the 
suitability rule under Article III, Section 2 of the Rules of Fair 
Practice to both retail and institutional customers in connection with 
all securities transactions, other than municipals. The proposed 
Suitability Interpretation provides members with an appropriate 
analysis of their suitability obligations to institutional customers 
based on the institutional customer's capability to evaluate investment 
risk independently and the 

[[Page 54548]]
extent to which the customer intends to exercise independent judgement 
in evaluating the member's recommendation.11

    \10\The Association received one comment letter that argued that 
the proposed Suitability Interpretation distinguished between 
institutional and retail customers and, therefore, was contrary to 
the intent of the Government Securities Amendments. See Letter No. 
10, infra note 19.
    \11\See H.R. 103-225, 103rd Cong., 1st Sess. (September 23, 
1993).
---------------------------------------------------------------------------

    On the basis of the foregoing, the NASD does not believe that the 
proposed rule change will 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

    A draft of the proposed Suitability Interpretation contained in the 
proposed rule change was first published for comment in Notice to 
Members 94-62 (August 1994) (``NTM 94-62'').12 Fifteen comments 
were received from fourteen commentors in response thereto.13 Of 
the fourteen commentors providing comments in response to NTM 94-62, 
one commentor supported without significant change;14 eleven 
commentors supported with changes;15 one commentor was 
opposed;16 and one commentor addressed issues in NTM 94-62 other 
than the proposed Suitability Interpretation.17

    \12\A copy of the NTM 94-62 is included in File No. SR-NASD-95-
39 as Exhibit 2 thereto.
    \13\The NASD received letters regarding NTM 94-62 from the 
following: (1) Brian C. Underwood, Director of Compliance, A.G. 
Edwards & Sons, Inc., dated September 29, 1994; (2) Alan S. Kramer, 
Senior Managing Director, Bear Sterns & Co. Inc., dated October 17, 
1994; (3) Marjorie E. Gross, Senior Vice President & Associate 
General Counsel, Chemical Bank, dated September 29, 1994; (4) 
Marjorie E. Gross, Senior Vice President & Associate General 
Counsel, Chemical Bank, dated October 14, 1994; (5) F. Smith, 
President, Freeman Securities Company, Inc., dated September 30, 
1994; (6) Wendy R. Beer, Compliance Counsel, Furman Selz, dated 
October 31, 1994; (7) Betsy Dotson, Assistant Director, Federal 
Liaison Center, Government Finance Officers Association, dated 
September 30, 1994; (8) Kathryn S. Reimann, Senior Vice President 
and Director of Fixed Income Compliance, Lehman Brothers Inc., dated 
October 17, 1994; (9) Larry Forrester, Senior Vice President, Lyn-
Hayes Financial, Inc., dated August 23, 1994; (10) Marguerite C. 
Willenbucher, Vice President and Senior Counsel, Debt and Equity 
Markets Group, Merrill Lynch, Pierce, Fenner & Smith Inc., dated 
October 17, 1994; (11) Ken deRegt, Managing Director, Morgan Stanley 
& Co. Incorporated, dated October 14, 1994; (12) letter from 
Prudential Insurance Company of America, dated October 31, 1994; 
(13) letter from Marianna Maffucci, Senior Vice President and 
General Counsel, Public Securities Association, dated October 17, 
1994; (14) William A. McIntosh, Managing Director and Co-head of 
U.S. Fixed Income, Salomon Brothers Inc., dated September 30, 1994; 
and (15) Robert F. Price, Chairman, Federal Regulation Committee, 
and Mark T. Commander, Chairman, Self-Regulation and Supervisory 
Practice Committee, Securities Industry Association, dated October 
17, 1994. A copy of the comment letters listed above is included in 
File No. SR-NASD-95-39 as Exhibit 3 thereto. These letters will be 
referred to hereinafter by their number as indicated in this 
footnote. The two comment letters submitted by Chemical Bank will be 
referred to as No. 3 for the purpose of this discussion.
    \14\Letter No. 14, supra note 13.
    \15\Letter Nos. 1, 2, 3, 5, 6, 8, 10, 11, 12, 13, and 15, supra 
note 13.
    \16\Letter No. 7, supra note 13.
    \17\Letter No. 9, supra note 13. Notice to Members 94-62 also 
requested comment on the proposed NASD Board Interpretation 
regarding the NASD Mark-Up Policy to Transactions in Government and 
other debt securities. The proposed Mark-Up Interpretation is not 
included in this rule filing.
---------------------------------------------------------------------------

    The proposed Suitability Interpretation published in NTM 94-62 was 
revised, and a second draft was published for comment in Notice to 
Members 95-21 (April 1995) (``NTM 95-21'').18 Sixteen comments 
were received in response thereto.19 Of the sixteen comment 
letters received in response to NTM 95-21, nine commentors supported 
the proposal with changes;20 three commentors considered the 
proposal either unworkable or insufficient and requested greater 
protection for either the member or the investor;21 three 
commentors opposed the proposal;22 and one commentor did not 
express an opinion.23

    \18\A copy of NTM 95-21 is included in File No. SR-NASD-94-39 as 
Exhibit 4 thereto.
    \19\The NASD received letters regarding NTM 95-21 from the 
following: (1) Allen Weintraub, Chairman and Chief Executive 
Officer, The Advest Group, Inc., dated May 5, 1995; (2) Brian C. 
Underwood, Director of Compliance, A.G. Edwards & Sons, Inc., dated 
May 15, 1995; (3) Michael S. Caccese, Esq., Senior Vice President, 
General Counsel, and Secretary, Association for Investment 
Management and Research; (4) Marjorie E. Gross, Senior Vice 
President & Associate General Counsel, Chemical Bank, dated May 17, 
1995; (5) Michael J. Wilk, Managing Director, Comerica Securities, 
dated May 12, 1995; (6) Douglas E. Harris, Senior Deputy Comptroller 
for Capital Markets, Comptroller of the Currency, dated May 17, 
1995; (7) Lawrence Jacob, Senior Vice President, Assistant Secretary 
and Director of Compliance, Daiwa Securities America Inc., dated May 
16, 1995; (8) James A. Brickley, President and CEO, Federal Farm 
Credit Banks Funding Corp., dated May 17, 1995; (9) Mitchell Delk, 
Vice President Government and Industry Relations, Freddie Mac, dated 
June 1, 1995; (10) Betsy Dotson, Assistant Director, Federal Liaison 
Center, Government Finance Officers Association, dated May 17, 1995; 
(11) Matthew Lee, Executive Director, Inner City Press/Community on 
the Move, dated May 15, 1995; (12) Matthew Elderfield, Assistant 
Director, London Investment Banking Association, dated June 13, 
1995; (13) Linda D. Edwards, Vice President Compliance, Llama 
Company, dated May 9, 1995; (14) Scott H. Rockoff, Managing 
Director, Director of Compliance, and Assistant General Counsel, 
Nomura Securities International, Inc., dated May 17, 1995; (15) 
Robert D. Mc.Knew, Chairman, Public Securities Association, dated 
May 18, 1995; and (16) Robert F. Price, Chairman Federal Regulation 
Committee, Richard O. Scribner, Chairman Self-Regulation and 
Supervisory Practices Committee, and Zachary Snow, Chairman OTC 
Derivative Products Committee, Securities Industry Association, 
dated June 7, 1995. A copy of the comment letters listed above is 
included in File No. SR-NASD-95-39 as Exhibit 5 thereto. These 
letters will be referred to hereinafter by their number as indicated 
in this footnote.
    \20\Letter Nos. 1, 3, 4, 7, 8, 9, 12, 15 and 16, supra note 19.
    \21\Letter Nos. 6, 10, and 14, supra note 19.
    \22\Letter Nos. 2, 9, and 13, supra note 19.
    \23\Letter No. 11, supra note 19. In addition, the NASD received 
a letter from the Honorable Edward J. Markey, Chairman of U.S. House 
of Representatives, Subcommittee on Telecommunications and Finance 
dated October 7, 1994, commenting on the proposed Suitability 
Interpretation published in Notice to Members 94-62 (August 1994). 
The letter from Congressman Markey and the NASD's response thereto 
dated November 4, 1994, are contained at Exhibit 6 of the rule 
filing.
---------------------------------------------------------------------------

    The Association's statements on the comments in response to the 
drafts of the proposed Suitability Interpretation contained in NTM 94-
62 and NTM 95-21 are as follows.
Notice to Members 94-62
    The NASD published NTM 94-62 to request member comment on the 
proposed Suitability Interpretation. The proposed Suitability 
Interpretation published for comment in NTM 94-62 stated that a 
member's obligation to an institutional customer would be fulfilled if, 
at the time of the specific transaction, the member has reasonable 
grounds for determining that the customer: (1) has developed resources 
and procedures to make its own investment decisions; (2) is not relying 
on the member's recommendation on the specific transaction; and (3) is 
capable of understanding the product and its risks and of making an 
independent investment decision. Several examples were in the proposed 
Suitability Interpretation to provide guidance to members regarding 
these determinations.

Comments Regarding the General Purpose of the Proposed Suitability 
Interpretation

    Eleven commentors supported the proposed Suitability 
Interpretation's general intent to clarify the application of a 
member's obligations to institutional customers pursuant to the 
suitability rule under Article III, Section 2 of the Rules of Fair 
Practice.24 These commentors, however, raised substantial and 
numerous issues regarding the proposed considerations and supporting 
factors underlying a member's suitability determination to an 
institutional customer. In response to these and other comments, the 
Association significantly revised and clarified the proposed 
Suitability Interpretation, as described below. One commentor argued 
that Congress, when adopting the Government Securities Act 

[[Page 54549]]
Amendments of 1993, intended the NASD's suitability rule under Article 
III, Section 2 of the Rules of Fair Practice to apply equally to all 
customers without distinction.25 The commentor opposed the 
Suitability Interpretation's intent to clarify the applicability of a 
member's suitability obligations to institutional customers.

    \24\Letter Nos. 1, 2, 3, 5, 6, 8, 10, 11, 12, 13, and 15, supra 
note 19.
    \25\Letter No. 7, supra note 13.
---------------------------------------------------------------------------

    The NASD believes that the Suitability Interpretation contained in 
NTM 94-62 appeared to create a safe harbor because of the unintended 
mechanical nature of the suggested list of factors for member 
consideration. The Association revised the Suitability Interpretation 
to eliminate the mechanical nature of the examples of factors for 
consideration. The Suitability Interpretation contained in the proposed 
rule change states that members are reminded that the factors are 
merely guidelines that will be utilized to determine whether a member 
has fulfilled its suitability obligations with respect to a specific 
institutional customer transaction and that the inclusion or absence of 
any of these factors is not dispositive of the determination of 
suitability. The NASD believes the Suitability Interpretation as 
drafted in the proposed rule change is consistent with the intent of 
the Act, as amended by the Government Securities Amendments. The 
Association believes the proposed rule change expands the suitability 
obligations under Article III, Section 2 of the Rules of Fair Practice 
to all securities, except municipals and to all members in connection 
with their dealings with all customers. The NASD believes that the 
Suitability Interpretation contained in the proposed rule change does 
not unfairly discriminate against institutional customers, but does 
provide guidance to members to help them fulfill their suitability 
obligations under Article III, Section 2 of the Rules of Fair Practice 
to all institutional investors.
    One commentor supported the proposed Suitability Interpretation's 
underlying notion that NASD members should recommend to their customers 
only financial products that meet their customers' needs and investment 
objectives.26 The commentor, however, believes that this 
obligation arises under Article III, Section 1 of the Rules of Fair 
Practice, which states that members, in the conduct of their business, 
shall observe high standards of commercial honor and just and equitable 
principles of trade. The commentor argued that the Association's 
discussion regarding the Suitability Standard under Article III, 
Section 2 of the Rules of Fair Practice with reference to the 
institutional marketplace is misguided and should be guidance regarding 
the proper business conduct of member firms under Article III, Section 
1 of the Rules of Fair Practice.

    \26\Letter No. 12, supra note 13.
---------------------------------------------------------------------------

    The NASD agrees that members have significant obligations under 
Article III, Section 1 of the Rules of Fair Practice. Such obligations 
are, in some cases, distinct from the suitability obligation arising 
under Article III, Section 2 and in other cases appear to overlap. The 
Association, however, believes that a member's Suitability Obligations 
to institutional customers have been more specifically set forth in 
Article III, Section 2(a) of the Rules of Fair Practice and that it 
would be contrary to the mandate of the Act, as amended, to limit the 
application of Article III, Sec. 2(a) to non-institutional customers or 
in any manner provide a ``suitability'' safe harbor to members when 
dealing with institutional customers.

Definition of Institutional Customer

    The proposed Suitability Interpretation published for comment in 
NTM 94-62 defined the term ``institutional customer'' to mean the term 
``institutional account'' under Article III, Section 21(c)(4) of the 
Rules of Fair Practice.27 Two commentors suggested that the term 
``institutional customer'' be expanded to include non-U.S. institutions 
such as foreign investment companies and foreign investment advisers 
subject to their home country regulation.28 The commentors stated 
that without this change, members under the proposed Suitability 
Interpretation would have suitability responsibilities for foreign 
investors with professional managers having less than $50 million in 
assets. One commentor concluded that such foreign investors 
consequently would have greater protection under Article III, Section 2 
of the Rules of Fair Practice than domestic investors.29 The 
Suitability Interpretation contained in the rule change does not 
distinguish between U.S. and non-U.S. institutions and is not intended 
to be limited solely to domestic institutions.

    \27\The term ``institutional account'' under Article III, 
Section 21(c)(4) of the Rules of Fair Practice means: (i) a bank, 
savings and loan association, insurance company, or registered 
investment company; (ii) an investment adviser registered under 
Section 203 of the Investment Advisers Act of 1940; or (iii) any 
other entity (whether an natural person, corporation, partnership, 
trust or otherwise) with total assets of at least $50 million.
    \28\Letter Nos. 3 and 11, supra note 13.
    \29\Letter No. 3, supra note 13.
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    One commentor stated that the $50 million asset threshold set forth 
in Article III, Section 21(c)(4) of the Rules of Fair Practice that is 
applicable to Article III, Section 2(a) of the Rules of Fair Practice, 
was too high and the list of institutions referenced under provisions 
(i) and (ii) contained therein was too narrow.30 The commentor 
submitted a list of institutions to include under the definition of 
institutional customer. The NASD revised the definition of 
``institutional customer'' to not reference Article III, Section 
21(c)(4), the asset threshold test therein, or any specific 
institutional types. The Suitability Interpretation contained in the 
proposed rule change would define an institutional customer to mean any 
entity other than a natural person. One commentor argued that state and 
local governments should not be classified as institutional customers 
by reference to the asset test under Article III, Section 21(c)(4) of 
the Rules of Fair Practice.31 The commentor stated that government 
units may have assets of at least $50 million in buildings, land and 
other facilities, as well as significant amounts of money to invest 
from revenues derived primarily from tax receipts, but be unable to 
afford highly skilled investment experts to handle their funds. As 
indicated above, the NASD has determined not to rely on the asset test 
in Article III, Section 21(c)(4) for purposes of defining the term 
``institutional customer'' with respect to the proposed Suitability 
Interpretation. The Association disagrees, moreover, with the 
commentor's suggestion that state and local governments be excluded 
from the definition of institutional customer. The Suitability 
Interpretation contained in the proposed rule change provides guidance 
regarding factors and considerations that may (or may not) be 
applicable to any institutional customer. The Suitability 
Interpretation provides guidance to members on the relevant 
considerations that should be examined by a member in fulfilling its 
suitability obligations to all institutional customers and does not 
unfairly discriminate between institutional customers based on asset 
size, portfolio size, or institutional type. The Association believes 
this regulatory approach is in furtherance of the Act, as amended.

    \30\Letter No. 5, supra note 13.
    \31\Letter No. 7, supra note 13.
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    One commentor suggested that the proposed Suitability 
Interpretation apply to retail customers who are capable of making 
independent investment decisions.32 The NASD believes that the 
proposed Suitability Interpretation and the considerations 

[[Page 54550]]
contained therein are not generally applicable to retail customers as a 
class. The NASD further believes that members already have guidance in 
the form of NASD administrative decisions that clarify the application 
of a member's suitability obligation to retail customers under Article 
III, Section 2 of the Rules of Fair Practice.

    \32\Letter No. 10, supra note 13.
---------------------------------------------------------------------------

    One commentor stated that the reference to customer 
``sophistication'' in the discussion part of NTM 94-62, appeared to 
create an assumption that institutional customers, as defined by the 
term ``institutional account'' under Article III, Section 21(c)(4) of 
the Rules of Fair Practice, are sophisticated and entitled to a lesser 
standard of care from members.33 The Association has revised the 
Suitability Interpretation contained in the proposed rule change to 
eliminate any appearance that customer ``sophistication'' is 
automatically linked to the term ``institutional account.'' The 
Association has deleted the reference to sophistication in discussing 
the proposed Suitability Interpretation and revised the definition of 
``institutional customer'' to mean any entity other than a natural 
person. The NASD believes that such revision eliminates the unintended 
appearance that an institutional customer, as defined in the proposed 
Suitability Interpretation, is entitled to any lesser standard of care 
from members.

    \33\Letter No. 7, supra note 13.
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Presence of Customer Capability: Resources and Procedures

    The proposed Suitability Interpretation in NTM 94-62 suggested that 
a member consider whether the institutional customer has developed 
resources and procedures (or ``capability'') for the purpose of making 
independent investment decisions. Three commentors supported the 
consideration of the customer's capability and suggested it be the 
primary basis for determining if a member has fulfilled the suitability 
obligations.34 The Association has modified the Suitability 
Interpretation contained in the proposed rule change to provide that 
the member's considerations regarding the customer's capability and 
whether the customer intends to make an independent investment decision 
are equally important.35

    \34\Letter Nos. 1, 3, and 15, supra note 13.
    \35\This latter consideration replaces the ``reliance'' 
consideration proposed in NTM 94-62 (August 1994) and NTM 95-21 
(April 1995).
---------------------------------------------------------------------------

    One commentor stated that the reference to the customer's 
``procedures'' was confusing and could imply that the member is 
required to review the investment procedures of the customer.36 
The commentor stated that many institutional customers will not share 
their investment procedures with their broker/dealers. In response to 
these comments, the Suitability Interpretation contained in the 
proposed rule change was revised to require consideration of the 
``customer's capability to evaluate investment risk independently'' 
rather than the ``customer's resources and procedures to make 
independent investment decisions.''

    \36\Letter No. 3, supra note 13.
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Absence of Customer Reliance on the Member's Recommendations

    The proposed Suitability Interpretation published in NTM 94-62 
stated that, even if the institutional customer has developed resources 
and procedures to make independent investment decisions, factors should 
be present that provide reasonable grounds for the belief that the 
institutional customer is not relying on the member's recommendations 
in connection with a particular transaction or market product.
    Six commentors supported the member consideration regarding the 
absence of customer ``reliance'' and argued that it should be the 
primary consideration in determining whether the member has fulfilled 
its suitability obligation in connection with a customer 
transaction.37 The Association determined that the term 
``reliance'' might incorporate unintended case law and imply that the 
member's suitability obligations under Article III, Section 2(a) of the 
Rules of Fair Practice are only triggered by customer reliance rather 
than acting as an ongoing obligation. Further, the ``reliance'' 
consideration required a member to determine the absence of customer 
reliance on a member's recommendation. The NASD has, therefore, deleted 
the term ``reliance'' and replaced it with language that would require 
the member to affirmatively consider the extent to which the ``customer 
intends to exercise independent judgment in evaluating a member's 
recommendation.'' The Association believes the revised language 
contained in the proposed Suitability Interpretation continues, 
nonetheless, to address the independent nature of the institutional 
customer, which concept was strongly supported by the above commentors.

    \37\Letter Nos. 2, 8, 10, 11, 13, and 14, supra note 13.
---------------------------------------------------------------------------

    In response to the comments stating that ``reliance'' should be the 
primary consideration, the NASD, as noted above, has revised the 
Suitability Interpretation contained in the proposed rule change to 
clarify that neither the customer's capability nor the customer's 
intent to exercise independent judgment should be given priority in 
determining whether a member's suitability obligations have been 
fulfilled. Both considerations are considered equally important under 
the Suitability Interpretation contained in the proposed rule change.
    Four commentors stated that many institutional accounts, such as 
banks, insurance companies and registered investment companies, are 
subject to various regulatory and investment restrictions at the state 
and federal level and, in the case of foreign entities, are also 
subject to additional foreign strictures.38 Commentors suggested 
that members should have reduced suitability obligations to such 
regulated institutional customers because such customers are in the 
best position to ensure that their investments are appropriate. The 
NASD acknowledges the existence of various regulatory and investment 
restrictions imposed on various domestic and foreign institutions but 
emphasizes that such restrictions do not supersede or waive the 
regulatory responsibilities that the NASD's Rules of Fair Practice 
impose on members in furtherance of the rules and regulations of the 
Act, as amended.

    \38\Letter Nos. 6, 10, 13, and 15, supra note 13.
---------------------------------------------------------------------------

    Many commentors supporting the proposal contained in NTM 94-62 
argued that if a client uses outside expertise such as investment 
professionals (whether employees, third-party money managers, bank 
trustees, etc.) to manage its accounts, then the client must bear the 
responsibility for the investment decisions made by such professionals. 
The NASD acknowledges that a member/institutional customer relationship 
changes when the customer uses outside expertise to manage its 
accounts. The Association believes, however, that the use of investment 
professionals does not eliminate a member's suitability obligations.

Comments Regarding Customer Reliance Factors

    Investment Guidelines. One of the factors provided in NTM 94-62 
regarding the consideration of customer reliance was whether the 
member's investment recommendation is consistent with the customer's 
explicit investment guidelines. One commentor suggested that a member 
should be encouraged to become familiar with 

[[Page 54551]]
customer investment guidelines, but not be obliged to assure compliance 
with customer investment guidelines because, in practice, members 
cannot do so effectively and should not be required to assume 
monitoring functions that can be better carried out by the 
customer.39 Another commentor argued that any consideration of 
customer's investment guidelines for purposes of determining the 
absence of customer ``reliance'' would only discourage institutional 
customers from sharing their investment guidelines with members.40 
The commentor also argued that the member's fulfillment of its 
suitability obligations should not be determined only on information 
received prior to the transaction, but should also be determined after 
the transaction if the member receives notice that the transaction was 
contrary to the jurisdiction's investment guidelines. The commentor 
expressed concern that, as a result, a customer's rights would be 
negatively affected under the applicable statute of limitations. The 
NASD has determined to delete the factor regarding investment 
guidelines from the proposed Suitability Interpretation. With regard to 
the commentor's latter statements regarding the timing of the member's 
suitability determination and its effect on the customer's rights under 
statute of limitations, the NASD believes that a member's suitability 
determination is intended by Article III, Section 2(a) to be made prior 
to a recommendation and a member's satisfaction of its suitability 
obligation is determined based on information it knows or should have 
known at the time of the transaction. Thus, the NASD does not believe 
that an institutional customer's rights under an applicable statute of 
limitations would be negatively affected.

    \39\Letter No. 11, supra note 13.
    \40\Letter No. 7, supra note 13.
---------------------------------------------------------------------------

    Affirmative Statement of Reliance. One of the suggested factors 
regarding customer reliance in NTM 94-62 was the existence of 
``affirmative statements'' made by the customer at the time of the 
transaction that it is relying on the member's recommendations. One 
commentor opposed this affirmative statements factor, arguing that 
unless the broker/dealer requires a written statement of non-reliance 
(which, the commentor argued, would be a waiver of duty for the broker/
dealer), this standard would be impossible to confirm after the 
fact.41 One commentor also argued that the ``customer reliance'' 
factor is flawed if based solely on the customer's affirmative 
statements because sophisticated investors will be encouraged to make 
an ``affirmative statement'' regarding reliance on the member in order 
to preserve a cause of action if the investment fails.42

    \41\Letter No. 7, supra note 13.
    \42\Letter No. 3, supra note 13.
---------------------------------------------------------------------------

    In response to both commentors, the NASD believes that written and 
oral statements are useful considerations in determining whether a 
member has fulfilled its suitability obligations. The NASD acknowledges 
that the factor, as published in NTM 94-62, may have unintentionally 
appeared to be dispositive, and the NASD has revised this factor to 
eliminate this appearance. The factor in the proposed rule change is 
revised to state that a member may consider ``any written or oral 
understanding that exists between the member and the customer regarding 
the nature of the relationship between the member and the customer and 
the services to be rendered by the member'' in determining whether the 
customer intends to exercise independent judgment in evaluating the 
member's recommendation.
    Pattern of Acceptance of Member's Recommendation. The proposed 
Suitability Interpretation published in NTM 94-62 stated that one of 
the factors that may be considered regarding customer reliance is a 
``pattern of acceptance'' by the customer of the member's advice 
through the execution of all or nearly all of the recommended 
transactions. One commentor opposed this factor and argued that no 
conclusion can be drawn from a simple look at how frequently a customer 
follows the recommendations of an individual broker/dealer.43 The 
commentor further stated that while government finance officers are 
authorized to carry out investing for a jurisdiction, they must 
consider a number of factors in their decision, and advice from a 
broker/dealer is not the sole factor. The NASD believes that a 
customer's pattern of acceptance of a member's recommendations is a 
useful consideration in determining whether the member has fulfilled 
its suitability obligations under the proposed Suitability 
Interpretation. The NASD believes, however, that the proposed 
Suitability Interpretation contained in NTM 94-62 may have appeared to 
make this factor dispositive regarding the issue of fulfilling a 
member's suitability obligation. The NASD agrees that making this 
factor dispositive of the issue would be inappropriate and has revised 
the Suitability Interpretation contained in the proposed rule change to 
eliminate this appearance. The proposed Suitability Interpretation 
clarifies that all the factors are merely guidelines and that the 
inclusion or absence of any of these factors is not dispositive of the 
determination of suitability.

    \43\Letter No. 7, supra note 13.
---------------------------------------------------------------------------

    Customer Relationships with Other Broker/Dealers. The proposed 
Suitability Interpretation published in NTM 94-62 stated that another 
factor that may be considered regarding customer reliance is whether 
the customer maintains substantive relationships with a number of 
members. One commentor opposed this consideration and argued that this 
consideration would automatically shift the suitability responsibility 
to all institutional investors because all responsible institutions 
rely on multiple broker/dealers.44 The NASD believes that an 
institutional customer's relationships with other members, particularly 
in regard to the same type of security, is a useful consideration in 
determining whether the member has fulfilled its suitability 
obligations. As noted above, the NASD has revised the proposed 
Suitability Interpretation contained in NTM 94-62 to clarify that such 
factors are only guidelines and that the inclusion or absence of any of 
these factors is not dispositive of whether a member has fulfilled its 
suitability obligations to an institutional customer. The NASD also has 
revised the above factor in the Suitability Interpretation contained in 
the proposed rule change to state that a member's consideration of 
whether the customer intends to exercise independent judgment in 
evaluating the member's recommendation may include the ``use by the 
customer of ideas, suggestions, market views and information obtained 
from other members or market professionals, particularly those relating 
to the same type of securities.''

    \44\Letter No. 7, supra note 13.
---------------------------------------------------------------------------

    Transactions in Connection with ``New'' Products. The proposed 
Suitability Interpretation published in NTM 94-62 stated that, in the 
case of a new product, or a security with significantly different risk 
or volatility characteristics than other investments generally made by 
the institution, the member should ascertain whether the institutional 
customer is relying on the member to explain the product and its 
risk(s) or is relying on other sources. One commentor stated that the 
NASD's Policy regarding Fair Dealings with Customers under Article III, 
Section 2 of the Rules of Fair Practice already imposes on the dealer a 
responsibility to ensure that adequate disclosure and information is 
made available to all 

[[Page 54552]]
customers institutional or otherwise, in the case of derivative 
products or new financial products.45 The NASD believes it is 
appropriate for the NASD to provide additional guidance in the proposed 
Suitability Interpretation regarding member's suitability obligations 
to institutional investors in connection with new products or products 
with significantly different risk or volatility characteristics. Such 
guidance would be in addition to the general guidance regarding new 
products contained in the NASD's Policy regarding Fair Dealings with 
Customers under Article III, Section 2 of the Rules of Fair Practice. 
As revised, the Suitability Interpretation contained in the proposed 
rule change states that the institutional customer may have general 
capability, but may not be able to understand a particular type of 
instrument of its risk. The proposed Suitability Interpretation states 
that this situation is more likely to occur with relatively new types 
of instruments, or those with significantly different risk or 
volatility characteristics, other than investments generally made by 
the institution.

    \45\Letter No. 2, supra note 13.
---------------------------------------------------------------------------

    Another commentor raised concerns that the Suitability 
Interpretation created a higher standard of duty for the member in 
connection with a ``new'' product, but did not define the term 
``new.''46 The NASD believes that the term ``new'' should not be 
defined in the context of the member's suitability obligation. The 
determination of whether the product is ``new'' must be considered on a 
case-by-case basis in the context of the member/dealer relationship and 
considering the prior investments generally made by the institution.

    \46\Letter No. 10, supra note 13.
---------------------------------------------------------------------------

    Member Knowledge That The Customer Is Incapable Of Understanding 
the Product or its Risks or Making an Independent Investment Decision. 
The Suitability Interpretation published in NTM 94-62 stated that a 
member would not be considered to be fulfilling its suitability 
obligations if, prior to the transaction, the member knows or can 
reasonably conclude, based on information available to it, that the 
customer is not capable of understanding the product or its risks, or 
of making an independent investment decision. One commentor requested 
that this provision be clarified to reflect that it is the 
institutional customer's investment professional, and not the senior 
officer of the institutional customer, who must be capable of 
understanding the investment decision.47 The NASD believes the 
structure of institutional customers may vary and, therefore, 
particular staff or professionals who provide the customer with 
capability to evaluate investment risk independently must be considered 
on a case-by-case basis. The proposed Suitability Interpretation 
contained in the proposed rule change, therefore, references only the 
institutional customer as an entity and does not reference any 
particular staff. Moreover, the proposed Suitability Interpretation 
discusses this issue within a broader context in the first paragraph 
following the heading ``Considerations Regarding the Scope of Member's 
Obligations to Institutional Customer.''

    \47\Letter No. 3, supra note 13.
---------------------------------------------------------------------------

Transaction-by-Transaction Determinations

    The proposed Suitability Interpretation published in NTM 94-62 
stated that member compliance is to be determined on a transaction-by-
transaction basis. Three commentors recommended replacing the proposed 
transaction-by-transaction analysis in favor of product-by-product 
determinations and argued there is no time in the case of normal 
institutional transactions to perform such transaction-by-transaction 
``due diligence.''48 The NASD recognizes that, while the 
suitability rule imposes an ongoing obligation, it may not be necessary 
for a member to make the determination on a transaction-by-transaction 
basis in order to fulfill it suitability obligation. The NASD believes 
it is appropriate for a member to determine when additional due 
diligence is necessary in order to fulfill its suitability obligations. 
The Suitability Interpretation contained in the proposed rule change 
states that a determination that a member has fulfilled its suitability 
obligations can only be made on a case-by-case basis taking into 
consideration all the facts and circumstances of a particular member/
customer relationship, assessed in the context of a particular 
transaction.

    \48\Letter Nos. 3, 11, and 6, supra note 13.
---------------------------------------------------------------------------

    One commentor suggested that if a transaction-by-transaction 
analysis was required, it should be limited to certain narrowly-defined 
categories of products. The Association has determined that such 
narrowly defined categories would not be appropriate in the context of 
determining a member's suitability obligation because what may be 
understood by one customer, may not be understood by another customer.
Notice to Members 95-21
    In response to the comments to NTM 94-62, the NASD published a 
revised proposed Suitability Interpretation in Notice to Member 95-21. 
The revised proposed Suitability Interpretation clarified that it 
merely provided guidelines to determine whether a member has fulfilled 
its suitability obligations to institutional customers with respect to 
transactions in all equity or debt securities, except municipals. The 
NASD also emphasized in the discussion part of NTM 95-21 that the 
proposed Suitability Interpretation was not intended to be a safe 
harbor.
    The proposed Suitability Interpretation published for comment in 
NTM 95-21 provided that the manner in which a member fulfills its 
suitability obligation in making a recommendation to a customer will 
vary depending on the nature of the customer and the specific 
transaction. It stated that, while it is difficult to define in advance 
a member's suitability obligation with respect to a specific 
institutional customer transaction recommended by a member, the Board 
has identified certain factors that are considered when the NASD 
conducts its reviews for compliance with Article III, Section 2(a) of 
the Rules of Fair Practice. It also stated the factors were not 
intended to be requirements or the only factors to be considered but 
are offered merely as guidance in determining a member's suitability 
obligation. The proposed Suitability Interpretation published for 
comment in NTM 95-21 emphasized that a member must determine, based on 
the information available to it, the customer's capability to evaluate 
investment risk. In discussing this first obligation, the proposed 
Suitability Interpretation contrasted situations where a member 
concludes the customer is not capable (in general or with respect to 
the particular type of instrument) of making an independent investment 
decisions with other situations where the customer ultimately can make 
an independent investment decision without relying on the member.
    The primary consideration in determining a member's suitability 
obligation under the proposed Suitability Interpretation published for 
comment in NTM 95-21 was whether the customer was relying on the 
member's judgement as reflected in a recommendation rather than making 
an investment decision based on its own independent assessment of the 
opportunities and risks presented by a potential investment, market 
factors and other investment considerations. It 

[[Page 54553]]
stated that a determination regarding such customer's reliance would 
depend on (i) the nature of the relationship that exists between the 
member and the customer; and (ii) the customer's capability to make its 
own investment decisions including the resources available to the 
customer to make informed decisions.
    Four relevant factors were provided to help the member determine 
the nature of the relationship that exists between the member and the 
customer. The first factor suggested that the member consider any 
written or oral agreement between the member and the customer regarding 
the customer's reliance on the member for recommendations. The second 
factor suggested that the member consider the presence or absence of a 
pattern of acceptance of the member's recommendations by the 
institutional customer. The third factor suggested that the member 
consider the use by the customer of ideas, suggestions, market views, 
and information obtained from other members or market professionals, 
particularly those relating to the same type of securities. The fourth 
factor suggested that the member consider the extent to which the 
customer provided the member with current comprehensive portfolio 
information in connection with discussing recommended transactions or 
did not provide important information about its portfolio or investment 
objectives
    Four relevant factors were also provided to help the member 
consider the customer's capability to make independent investment 
decisions, including the resources available to the customer to make 
informed decisions. The first factor suggested that the member consider 
whether the customer had use of one or more investment advisers or bank 
trust departments. The second factor suggested that the member consider 
the general level of experience of the staff of the institutional 
customer in financial markets and specific experience with the type of 
instruments under consideration. The third and fourth factors suggested 
that the member consider the customer's ability to independently 
evaluate how market developments would affect the security and the 
complexity of the security or securities involved.
    Members were reminded that the factors were merely guidelines which 
would be utilized to determine whether a member had fulfilled its 
suitability obligations and that the inclusion or absence of any of 
these factors was not dispositive of the determination of suitability. 
It clarified that such a determination could only be made on a case-by-
case basis taking into consideration all the facts and circumstances of 
a particular member/customer relationship, assessed in the context of a 
particular transaction.
    The definition of the term ``institutional customer'' was also 
revised to mean any entity other than a natural person. It stated that 
in determining the applicability of this Interpretation to an 
institutional customer, the NASD would consider the dollar value of the 
securities that the institutional customer has in its portfolio and 
under management. It also stated that while the Interpretation was 
potentially applicable to any institutional customer, the guidance 
contained therein should at a minimum be applied to an institutional 
customer with at least $10 million invested in securities in the 
aggregate in its portfolio and under management.

General Comments

    Four commentors stated that the factors contained in the proposed 
Suitability Interpretation should not be a checklist for NASD 
compliance purposes.49 One commentor stated that it is not 
practical for members to make on-going assessments of many of the 
factors and noted, for example, that members cannot monitor the 
experience level of client's staff.50 One commentor argued that 
the factors, in general, should not be considered an evidentiary 
checklist which would require additional bookkeeping by the 
member.51 The NASD did not intend that the proposed Suitability 
Interpretation create an evidentiary checklist that required additional 
bookkeeping. The NASD, therefore, eliminated the appearance that the 
factors create an evidentiary checklist for NASD compliance review by 
replacing the phrase ``the Board has identified certain factors which 
are considered when the NASD conducts its reviews for compliance'' in 
the fourth paragraph of the Suitability Interpretation contained in the 
proposed rule change, with the phrase ``the Board has identified 
certain factors which may be relevant when considering compliance.''

    \49\Letter Nos. 1, 2, 15, and 16, supra note 19.
    \50\Letter No. 2, supra note 19.
    \51\Letter No. 15, supra note 19.
---------------------------------------------------------------------------

    One commentor stated that, while not asking for a safe harbor, it 
believed that the proposed Suitability Interpretation should clarify 
procedures that create a ``clear rebuttable assumption'' that 
suitability of the recommendation has been established.52 The NASD 
believes that a member's suitability obligation under Article III, 
Section 2(a) of the Rules of Fair Practice remains with the member 
until fulfilled, and that, therefore, the creation of ``clear 
rebuttable presumption'' through fulfillment of certain procedures 
would not be appropriate. One commentor recommended that the proposed 
Suitability Interpretation should only be applicable to relatively new 
types of instruments and not to ``basic securities'' because it would 
be too expensive for some firms to capture the proposed information on 
the customer and provide such information to its registered 
representatives for all such basic securities.53 The NASD believes 
that Article III, Section 2 of the Rules of Fair Practice imposes 
suitability obligations on members when making recommendations 
regardless of the type of security, except for municipals. The NASD, 
therefore, believes that the scope of the proposed Suitability 
Interpretation in the proposed rule change must include all such 
securities, except municipals, regardless of whether the security is 
relatively basic or complex. In addition, the NASD believes that the 
term ``basic securities'' is not amenable to definition, as what is a 
basic security to one customer may not be basic to another.

    \52\Letter No. 14, supra note 19.
    \53\Letter No. 1, supra note 19.
---------------------------------------------------------------------------

    One commentor stated that the proposed Suitability Interpretation, 
as a whole, is unworkable for members because of its complexity. The 
commentor believes the proposed Suitability Interpretation would 
provide little relief from the Suitability Rule under Article III, 
Section 2 of the Rules of Fair Practice for members dealing with 
institutional customers. The commentor proposed that the NASD adopt a 
two-part test based on portfolio size and the existence of a written 
agreement. Under the test, a member could assume that the suitability 
rule would not apply to institutional customers with an investment 
portfolio of $10 million or more if there were a written agreement on 
point stating that the customer was not relying on the member for 
recommendations.54 The NASD does not believe it is appropriate to 
create a safe harbor for members' suitability obligations nor to change 
or reduce members' obligations under the suitability rule in Article 
III, Section 2 of the Rules of Fair Practice, as recommended by the 
commentor. The NASD believes the Suitability Interpretation, as 
contained in the proposed rule change, provides important guidance to 
members in fulfilling their suitability obligations 

[[Page 54554]]
under Article III, Section 2(a) of the Rules of Fair Practice to 
institutional customers.

    \54\Letter No. 6, supra note 19.
---------------------------------------------------------------------------

Definition of Institutional Customer

    One commentor argued that the statement in the proposed Suitability 
Interpretation that the guidance contained therein ``should at a 
minimum be applied to an institutional customer with at least $10 
million invested in securities in the aggregate in its portfolio and/or 
under management'' is contrary to Congressional intent, under the 
Government Securities Act Amendments of 1993, to not distinguish 
between customers based on portfolio size.\55\ The commentor also 
argued that if the proposed definition of institutional customer is 
used, further clarification is needed regarding: (i) the issue of 
aggregating government units that contain sub-units; (ii) the period to 
be reviewed for determining whether $10 million is invested in 
securities in its portfolio and under management; and (iii) the 
definition of the term ``under management.'' Another commentor argued 
that portfolio size should not matter in connection with the definition 
of institutional customer.\56\ Another commentor requested 
clarification on whether the NASD intended by its discussion regarding 
the above $10 million threshold, to create a presumption of 
applicability either above or below the $10 million threshold.\57\ The 
NASD agrees that portfolio size is not dispositive of a member's 
suitability obligations, but believes it is appropriate for the NASD to 
consider the portfolio size of the customer in determining the 
applicability of the proposed Suitability Interpretation. The NASD 
believes that there is a greater likelihood that the member can apply 
the proposed Suitability Interpretation to an institutional customer 
with at least $10 million invested in securities in the aggregate in 
its portfolio and/or under management, but the NASD has no intent to 
create a presumption either above or below that aggregate dollar amount 
that the Interpretation will, in fact, apply to a particular 
institutional customer. In connection with concerns regarding the 
NASD's method of calculating the $10 million test, the NASD intends to 
look for guidance for such calculations to SEC Rule 144A.\58\

    \55\Letter No. 10, supra note 19.
    \56\Letter No. 3, supra note 19.
    \57\Letter No. 14, supra note 19.
    \58\See 17 CFR 230.144A (1994).
---------------------------------------------------------------------------

    One commentor recommended that the phrase ``$10 million invested in 
securities and under management'' be changed to ``$10 million invested 
in securities in the aggregate in its portfolio or under management'' 
in order to recognize securities in the customer's portfolio that are 
not actively managed.\59\ Upon review, the NASD agrees with this 
recommendation and changed the word ``and'' to ``and/or'' to make it 
clear that the $10 million that is applied to the total of securities 
that are: (1) beneficially owned by the institutional customer; and (2) 
in any accounts of other investors that are managed by the customer. As 
set forth above, the type of securities to be included in the 
calculation and the method of calculation will be determined by 
reference to SEC Rule 144A.

    \59\Letter No. 4, supra note 19.
---------------------------------------------------------------------------

Presence of Customer Capability

    One commentor noted that guidance regarding the consideration of 
the customer's capability to make its own investment decisions was 
referenced twice in the proposed Suitability Interpretation published 
for comment in NTM 95-21 and questioned whether this was 
intentional.\60\ The NASD has modified the proposed Suitability 
Interpretation to clarify this discussion of customer capability under 
the heading ``Considerations Regarding the Scope of Members' 
Obligations to Institutional Customers.''

    \60\Letter No. 16, supra note 19.
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    Two commentors recommended that the proposed Suitability 
Interpretation should state that a rebuttable presumption exists that 
institutions are capable of making their own independent investment 
decisions if the institutions: (i) are engaged in the financial 
industry or in the business of managing their own or others 
investments; (ii) have in-house or outside investment professionals 
charged with the responsibility for recommending or making investment 
decisions on behalf of the institution; or (iii) independently adopt an 
investment guideline and provide explicit investment guidelines to the 
member.\61\ As discussed above, it is the position of the NASD that 
rebuttable presumptions are not appropriate under Article III, Section 
2 of the Rules of Fair Practice and that the factors are merely 
guidelines.

    \61\Letter Nos. 12 and 16, supra note 19.
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    One commentor recommended that the party that the member may 
consider ``capable'' be clarified to mean the ``institutional 
customer'' rather than the ``staff of the institutional customer'' as 
set forth in NTM 95-21.\62\ One commentor similarly recommended that 
the party that the member may consider ``capable'' be defined as ``all 
of the staff of the institutional customer'' and not just one staff 
person.\63\ The NASD believes it is difficult to define the particular 
staff responsible for the investment decision of the institutional 
customer. The NASD has modified the proposed Suitability Interpretation 
contained in the proposed rule change to delete the reference to the 
institutional customer's ``staff.''

    \62\Letter No. 15, supra note 19.
    \63\Letter Nos. 4, supra note 19.
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Absence of Customer Reliance

    One commentor stated that the primary focus on customer reliance or 
the absence of customer reliance on a member's recommendation in NTM 
95-21 appeared to permit a broker/dealer to make a recommendation to an 
institutional customer without having reasonable grounds for believing 
that the recommendation is suitable for the customer.\64\ The commentor 
argued that a determination that the customer is not relying on the 
member's recommendation should not relieve the member of the 
responsibility to have reasonable grounds, based on some information 
about the customer, for believing that the recommendation is suitable 
for that customer. Upon review of this comment and others discussed 
above with respect to NTM 94-62, the NASD acknowledges that the term 
``reliance'' leads to confusion regarding the status of the member's 
suitability obligation. The term ``reliance'' has, therefore, been 
eliminated from the proposed Suitability Interpretation contained in 
the proposed rule change. It has been replaced with language that would 
require the member to affirmatively consider the extent to which the 
``customer intends to exercise independent judgment in evaluating a 
member's recommendation.''

    \64\Letter No. 9, supra note 19.
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    One commentor recommended that the proposed Suitability 
Interpretation state that members are not guarantors and that the 
governing body of the institutional customer is responsible for the 
amount of risk the institution should undertake.\65\ The NASD 
acknowledges that members are not guarantors of the customer's 
investment. The proposed Suitability Interpretation contained in the 
proposed rule change is not intended to imply such responsibility. To 
the contrary, the proposed Suitability Interpretation seeks to clarify 
the circumstances under which a member has fulfilled its suitability 
obligations to an institutional customer 

[[Page 54555]]
based on the member's consideration of the customer's capability to 
evaluate investment risk independently and the extent to which the 
customer intends to exercise independent judgement in evaluating the 
member's recommendation.

    \65\Letter No. 4, supra note 19.
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    One commentor argued that the proposed considerations regarding 
customer reliance are unworkable because a member is not in a position 
to second-guess the qualifications or knowledge of an institutional 
customer.\66\ The commentor opposed the suggestion that members may 
consider oral or written agreements and stated that referencing such 
oral or written agreements is not practical as the member/customer 
relationship is subject to continual change. The commentor stated that 
the fact that an institutional account is managed should be dispositive 
that the client is not relying on the member's recommendations. The 
Association believes that a member in an ongoing member/customer 
relationship will often gain knowledge of factors pertaining to the 
customer's capability to independently evaluate investment risk, as 
well as whether the customer intends to and is making independent 
investment judgments. Where the member does not gain such knowledge 
regarding a specific customer, the Association acknowledges that the 
Suitability Interpretation is not applicable to the member's 
relationship with the customer.

    \66\Letter No. 2, supra note 19.
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    One commentor stated that Article III, Section 2 of the Rules of 
Fair Practice and the related Policy of the Board of Governors--Fair 
Dealing with Customers set forth adequate suitability guidelines for 
retail and institutional customers, and for new products.\67\ The 
commentor argues that, given the adequacy of such rules, the only 
purpose of the proposed Suitability Interpretation is to establish a 
detailed determination of the customer's reliance upon the members' 
investment recommendations. The commentor further states that this 
determination is an obligation of an investment advisor and not a 
broker/dealer's obligation under Article III, Section 2 of the Rules of 
Fair Practice. The commentor argues that members who continue to merely 
make investment recommendations based on the existing guidelines for 
suitability should not be required to assume the responsibility of 
investment advisors. As noted above, the proposed Suitability 
Interpretation, published in NTM 95-21, was revised to eliminate 
consideration regarding reliance by the customer on the member's 
recommendation. The NASD believes that the Suitability Interpretation 
in the proposed rule change addresses relevant issues for members to 
consider in fulfilling their suitability obligations to institutional 
customers and that the obligations discussed therein are separate from 
the obligations of an investment advisor under the Investment Advisers 
Act of 1940.

    \67\Letter No. 5, supra note 19.
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    One commentor recommended that if an institutional customer 
provides a document or affirmative statement that it is not relying on 
the member's recommendations, then the member would not have a reason 
to evaluate any of the proposed Suitability Interpretation's factors or 
any other factors in order to fulfill its suitability obligation to 
that client.\68\ One commentor submitted a draft Trading Authorization 
form that would require representations by the institutional customer 
that the customer: (i) has the resources and procedures to make its own 
investment decisions; (ii) will not rely solely on the firms 
recommendations for investment decisions; and (iii) is capable of 
understanding the products and risks as presented.\69\

    \68\Letter No. 16, supra note 19.
    \69\Letter No. 13, supra note 19.
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    The NASD believes that the Suitability Interpretation contained in 
the proposed rule change is clear that it does not provide any safe 
harbor from the suitability obligations under Article III, Section 2 of 
the Rules of Fair Practice. Earlier versions of the proposed 
Suitability Interpretation were revised to eliminate any appearance 
that it provided a mechanical method by which a member could fulfill 
its suitability obligation under Article III, Section 2 of the Rules of 
Fair Practice. While the Suitability Interpretation contained in the 
proposed rule change continues to provide factors for the member to 
consider in making its suitability determination, these examples are 
not dispositive. The Suitability Interpretation contained in the 
proposed rule change states that members are reminded that these 
factors are merely guidelines that will be utilized to determine 
whether a member has fulfilled its suitability obligations with respect 
to a specific institutional customer transaction and that the inclusion 
or absence of any of these factors is not dispositive of the 
determination of suitability.
    One commentor recommended that the NASD adopt the standards for 
suitability determinations set forth in the Municipal Securities 
Rulemaking Board (``MSRB'') Rule G-19 as the NASD suitability standard 
for all securities, other than municipals.\70\ The commentor stated 
that the MSRB Rule G-19 prohibits a transaction unless the member, 
after reasonable inquiry, has reasonable grounds to believe that the 
recommendation is suitable for a customer in light of its financial 
background, investment experience and investment objectives; and has no 
reasonable grounds to believe the recommendation is unsuitable. This 
commentor also argued that if reliance by the customer on the member's 
recommendation is to be the test, then an affirmative duty should be 
imposed on the member to request ``material relevant to a particular 
transaction,'' and to inform the customer of the instrument's 
characteristics, including behavior under different market conditions 
and valuation information. The NASD acknowledges the parallel 
regulatory function that MSRB Rule G-19 serves in the municipal 
securities business. It is believed that differences between the 
municipal securities business and the general securities business, 
which involves many different types of securities of greater or lesser 
complexity, have resulted in different suitability standards adopted by 
the NASD and MSRB. The NASD believes that Article III, Section 2 of the 
Rules of Fair Practice has served as a key regulation to further 
investor protection and the public interest under the Act, as amended, 
and continues to be the most appropriate suitability standard for the 
securities business, except municipals.

    \70\Letter No. 10, supra note 17.
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Other Comments

    One commentor recommended that all the Rules of Fair Practice be 
reviewed to ensure consistency and uniformity of treatment for 
securities having similar risk characteristics.\71\ The NASD has 
reviewed the Rules of Fair Practice to ensure consistency and 
uniformity of treatment in the application of the Rules of Fair 
Practice to debt securities having similar characteristics. The 
proposed rule change includes a chart that clarifies the applicability 
of the Rules of Fair Practice to exempted securities.

    \71\Letter No. 9, supra note 19.
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    One commentor requested that the proposed Suitability 
Interpretation provide a definition of the term ``recommendation'' 
under Article III, Section 2 of the Rules of Fair Practice and the 
proposed Suitability 

[[Page 54556]]
Interpretation.\72\ One commentor was concerned that a rule that is 
triggered by the occurrence of a recommendation will result in a debate 
as to what is a ``recommendation.''\73\ Article III, Section 2 of the 
Rules of Fair Practice has been applicable to members' recommendations 
since the inception of the NASD. A significant amount of case law has 
been developed as a result of NASD disciplinary actions with respect to 
this provision, which is available as guidance to the membership. The 
NASD believes that defining the term ``recommendation'' raises many 
complex issues in the absence of the specific facts of a particular 
case. Finally, the NASD believes that the requested definition is not 
required in order to provide the guidance to members that is intended 
by the proposed Suitability Interpretation.

    \72\Letter No. 2, supra note 19.
    \73\Letter No. 10, supra note 19.
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    One commentor was concerned that the proposed Suitability 
Interpretation would lead investment practitioners to err on the side 
of conservatism in dispensing investment advice.\74\

    \74\Letter No. 3, supra note 19.
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    The commentor recommended that the NASD clarify that ``suitable 
investment advice'' shall not mean ``the most conservative advice.'' 
The NASD does not believe that the proposed Suitability Interpretation 
contained in the proposed rule change addresses the appropriate level 
of investment advise. Rather, the focus of the proposed Suitability 
Interpretation is on clarifying the relationship of a member to its 
institutional customer when making a recommendation in connection with 
a securities transaction.
    One commentor raised concerns regarding the general regulatory 
environment of the derivatives markets and urged the NASD to 
investigate a U.S. bank's activities in the derivatives markets.75 
The NASD intends the proposed rule change to further enhance the 
regulatory environment of the derivatives markets to the extent that 
exempted securities, including government securities other than 
municipals, are part of such markets. The NASD does not have 
jurisdiction to investigate a banking institution.

    \75\Letter No. 11, supra note 19.
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    One commentor requested clarification that the proposal will not be 
vitiated or affected by the draft Principles and Practices for 
Wholesale Finance Market Transactions (``Draft Principles'').76 
The commentor noted that the Draft Principles provide that, absent a 
written agreement to the contrary, no communications (including ideas 
or suggestions regarding potential transactions) by a member should be 
construed as recommendations or investment advice.

    \76\Letter No. 8, supra note 19.
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    On August 17, 1995, the final version of the Principles was issued 
by a committee consisting of representatives of the Emerging Markets 
Traders Association, the Foreign Exchange Committee of the Federal 
Reserve Bank of New York, the International Swaps and Derivatives 
Association, the New York Clearing House Association, the Public 
Securities Association, and the Securities Industry Association. The 
Principles are a voluntary industry standard. The position on 
suitability set forth in the final version of the Principles, as stated 
in the cover memorandum thereto issued by the Federal Reserve Bank of 
New York, is that the investor is encouraged to take responsibility for 
its own decisions regarding securities transactions. As set forth in 
Section 4.2.2. of the Principles, the investor is required to assume 
that the member is acting at arm's length for its own account and that 
any communications are not recommendations or investment advice on 
which the investor may rely unless a written agreement or applicable 
law is to the contrary. The Principles go on to recognize, however, 
that certain rules or regulations expressly provide that the facts and 
circumstances of a relationship alone may give rise to ``an advisory or 
fiduciary relationship''--even in the presence of a written agreement 
purporting to negate such a relationship. Additionally, Section 4.2.1. 
of the Principles focuses on whether the investor has the capability to 
understand and make independent investment decisions. In comparison, 
the Suitability Interpretation contained in the proposed rule change 
focuses on the customer's capability to evaluate investment risk 
independently and the extent to which the customer intends to exercise 
independent judgment in evaluating a member's recommendation--somewhat 
similar concepts.
    The proposed Suitability Interpretation clarifies that the NASD's 
fundamental standard of suitability contained in Article III, Section 
2(a) of the Rules of Fair Practice applies to all recommendations by a 
member to an institutional customer and recognizes that the manner in 
which a member fulfills this suitability obligation will vary depending 
on the nature of the customer and the specific transaction. The 
proposed Suitability Interpretation does not, however, provide 
definitive guidance on what constitutes a recommendation, leaving to 
the facts and circumstances of each case the determination of exactly 
when the suitability obligation imposed by Article III, Section 2(a) is 
triggered. Thus, under the NASD's suitability rule, whenever a 
recommendation is made, a member is responsible for the suitability of 
its recommendations to institutional customers in all cases, but will 
be deemed to have met its customer-specific suitability obligations if 
the member determines with respect to a transaction that a customer has 
the capability to evaluate investment risk independently and intends to 
exercise independent judgement in evaluating the member's 
recommendation. The Suitability Interpretation contained in the 
proposed rule change is not modified or superseded by the Principles as 
adopted. Rather, a member of the NASD will remain subject to Article 
III, Section 2(a), regardless of any different position on an issue set 
forth in the Principles.

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, N.W., Washington, D.C. 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 

[[Page 54557]]
available for inspection and copying at the principal office of the 
NASD. All submissions should refer to the file number in the caption 
above and should be submitted by November 14, 1995.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.77

    \77\17 CFR 200.30-3(a)(12).
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Jonathan G. Katz,
Secretary.
[FR Doc. 95-26231 Filed 10-23-95; 8:45 am]
BILLING CODE 8010-01-P