[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).
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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.
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(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).
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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.
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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.
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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.
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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.
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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.
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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).
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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).
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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.
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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