[Federal Register Volume 61, Number 56 (Thursday, March 21, 1996)]
[Notices]
[Pages 11655-11668]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-6765]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36973; File No. SR-NASD-95-39, Amendment No. 3]
Self-Regulatory Organizations; Notice of Amendment No. 3 to
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
March 14, 1996.
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'') a proposed rule change
regarding the application of the Rules of Fair Practice to transactions
in exempted securities and an interpretation of the NASD's suitability
[[Page 11656]]
rule.1 On October 17, 1995, the NASD filed Amendment No. 1 to the
proposed rule change. The Commission solicited comments on the proposed
rule change and Amendment No. 1 from interested persons on October 24,
1995.2 On January 22, 1996, the NASD filed Amendment No. 2 to the
proposed rule change,3 and on February 15, 1996, replaced
Amendment No. 2 with Amendment No. 3. to the proposed rule
change.4 Amendment No. 3 is 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 amendments to the
proposed rule change from interested persons.
\1\ 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''). 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''). Copies of NTM 94-62 and NTM 95-21 are
included in File No. SR-NASD-95-39 as Exhibits 2 and 4 to the
original rule filing respectively.
\2\ See Securities Exchange Act Release No. 36383 (October 17,
1995), 60 FR 54530 (October 24, 1995). The Commission received nine
comment letters in connection with the proposed rule change. See
infra note 5.
\3\ See letter from Suzanne E. Rothwell, Associate General
Counsel, NASD, to Mark P. Barracca, Branch Chief, SEC, dated January
22, 1996.
\4\ Amendment No. 2 responded to some of the comments received
on the proposed rule change. Amendment No. 3 expands upon the
discussion contained in Amendment No. 2 by including responses to
all of the comment letters received on the proposed rule change.
Amendment No. 3 to SR-NASD-95-39 completely replaces and supersedes
Amendment No. 2. See letters from Joan C. Conley, Secretary, NASD,
to Mark P. Barracca, Branch Chief, SEC, dated February 15, 1996, and
March 4, 1996.
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I. Self-Regulatory Organization's Statement of the Terms of Substance
of the Proposed Rule Change
Below is the text of proposed changes to the original proposal.
Proposed new language is italicized and deletions are in brackets.
Interpretation of the Board of Governors Prompt Receipt and Delivery
Interpretation
* * * * *
(b) Sales:
(1) Long Sales.
No member or persons associated with a member shall accept a long
sale order from any customer in any security (except exempt securities
other than municipals) unless:
(A) The member has possession of the security;
(B) The customer is long in his account with the member;
(C) The member or person associated with a member makes an
affirmative determination that the customer owns the security and will
deliver it in good deliverable form within three (3) business days of
the execution of the order; or
(D) The security is on deposit in good deliverable form with a
member of the Association, a member of a national securities exchange,
a broker-dealer registered with the Securities and Exchange Commission,
or any organization subject to state or federal banking regulations and
that instructions have been forwarded to that depository to deliver the
securities against payment.
* * * * *
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,
[[Page 11657]]
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] is exercising 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] is
exercising 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 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.
* * * * *
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 self-regulatory organization
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 self-regulatory organization
has prepared summaries, set forth in Sections A, B, and C below, of the
most significant aspects of such statements.
A. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
This amendment completely replaces and supersedes Amendment No. 2.
This Amendment responds to public comments received by the SEC to the
publication of the proposed rule change in Securities Exchange Act
Release No. 36383 (October 17, 1995), 60 FR 54530 (October 24, 1995)
(the ``Release'').5 This
[[Page 11658]]
amendment, in response to certain public comments, makes certain
changes to the text of the proposed rule change, the statement of
purpose section of the proposed rule change, and the applicability of
certain Rules of Fair Practice in the chart (reproduced below) entitled
``Applicability of the Rules of Fair Practice to Exempted Securities,
Including Government Securities (Except Municipals)'' (``Applicability
Table'').
\5\ The Commission received letters from the following: (1)
Brian C. Underwood, Vice President-Director of Compliance, A.G.
Edwards & Sons, Inc., dated November 14, 1995; (2) David J. Master,
Chairman and CEO, Coastal Securities Ltd., dated November 28, 1995;
(3) Betsy Dotson, Assistant Director Federal Liaison Center,
Government Finance Officers Association, dated November 14, 1995;
(4) Thomas M. Selman, Associate Counsel, Investment Company
Institute, dated November 14, 1995; (5) Jane D. Carlin, Principal
and Counsel, Morgan Stanley & Co. Incorporated, dated December 5,
1995; (6) Paul Saltzman, Senior Vice President and General Counsel,
Public Securities Association, dated November 30, 1995; (7) Scott H.
Rockoff, Managing Director, Director of Compliance, and Assistant
General Counsel, Nomura Securities International, Inc., dated
December 14, 1995; (8) Robert F. Prince, Chairman Federal Regulation
Committee, and Zachary Snow, Chairman OTC Derivatives Products
Committee, Securities Industry Association, dated December 17, 1995;
and (9) David Rosenau, President, The Winstar Government Securities
Company L.P., dated December 27, 1995. These letters will be
referred to hereinafter by their number as indicated in this
footnote.
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1. Purpose
a. Application of the NASD Rules of Fair Practice to Government
Securities
Interpretation of the Board of Governors--Prompt Receipt and Delivery
of Securities, Article III, Section 1 of the Rules of Fair Practice
(``Prompt Receipt and Delivery Interpretation'')
The proposed rule change would expand the short-sale exemption
under paragraphs (b)(2) (a) and (b) of the Prompt Receipt and Delivery
Interpretation from corporate debt to all debt. One commenter suggests
that the long-sale provisions under paragraph (b)(1) of the Prompt
Receipt and Delivery Interpretation be similarly amended to exempt a
member from making affirmative determinations required under that
paragraph prior to accepting a long sale from any customer.6 The
commenter states that the Interpretation will otherwise require a
dealer who purchases a government security from a customer to ascertain
that the customer is ``long'' the security at the time of the
transaction. The commenter argues that this affirmative determination
requirement would be contrary to the practice in the government
securities market that allows a customer to sell a security to a dealer
and cover the sale with a subsequent purchase or repurchase transaction
in the ``specials market''. The commenter states that this practice has
been recognized by the Federal Reserve Board and is allowed under
Regulation T. The commenter further argues that the ability of
customers to finance such short positions along with their ability to
keep their positions confidential from the executing dealer helps to
make the government securities market extremely liquid.
\6\ See Comment Letter No. 6, supra note 5.
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The NASD acknowledges that, in some circumstances, it may be
difficult for members to ascertain the position of a customer's account
prior to accepting a long-sale in the government securities market. The
NASD also recognizes that purchase and repurchase transactions in the
government securities market reduce fails and increase the liquidity of
the market. It is also important to note that the proposed rule change
would amend Article III, Section 21(b)(i) of the Rules of Fair Practice
to exempt all debt from the member requirement to mark order tickets
``long'' or ``short.'' In addition, the proposed rule change would
amend paragraph (b)(2) of the Prompt Receipt and Delivery
Interpretation to exempt all debt from the affirmative determination
requirement regulating short sales. Consistent with these positions,
the NASD proposes: (1) to amend paragraph (b)(1) of the Prompt Receipt
and Delivery Interpretation to provide an exemption from the
requirements applicable to long sales for exempt securities except for
municipals; and (2) to make a conforming change to the Applicability
Table to provide that the Prompt Receipt and Delivery Interpretation is
``Not Applicable''.
Interpretation of the Board of Governors--Execution of Retail
Transactions in the Over-the-Counter Market, Article III, Section 1 of
the Rules of Fair Practice (``Best Execution Interpretation'')
The proposed rule change would apply the Best Execution
Interpretation to exempt securities including government securities,
except for municipals. Two commenters state that members will have
difficulty readily determining the best bid/ask price for a particular
government security or similar security, or even the last sale price,
as the government securities market and the over-the-counter (``OTC'')
debt markets lack systems similar to the consolidated quotation system
and the inter-market trading system.7 One commenter states that
the best execution concept has occurred largely in the context of the
equity markets and questions the Interpretation's application to the
fixed income principal markets where transactions are executed at a
``net price''.8 The commenter argues that the application of the
Best Execution Interpretation should be delayed and considered with the
NASD's Mark-Up Proposal 9 in order to consider the extent to which
both interpretations provide guidance in connection with pricing
securities fairly. One commenter also argues that the NASD should
provide guidance that government securities transactions ``be executed
at a resultant price to the customer that is reasonable related to the
market''. 10 The commenter argues that this concept more
accurately reflects important issues in the government securities
markets relating to the: (i) mechanics of odd-lot transactions; (ii)
difficulty of obtaining the ``best price'' as that term is considered
in the equity markets; and (iii) quotations of active versus non-active
government issues of the same maturity in order to serve different
customer needs, i.e., institutional liquidity-goals versus retail
customer yield-goals. The commenter also argues that applying the Best
Execution Interpretation to government securities is counter to the
SEC's initiative of providing more market transparency to the
government securities markets because, for example, it will force firms
to continue to use verbal/paper ticket order desks.
\7\ See Comment Letters Nos. 6 and 9, supra note 5.
\8\ See Comment Letter No. 6, supra note 5.
\9\ See NTM 94-62 (requesting comment on the proposed
Interpretation of the Board of Governors application of the NASD
Mark-Up Policy to Transactions in Government and Other Debt
Securities).
\10\ See Comment Letter No. 9, supra note 5.
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The NASD believes that the general concept of the Best Execution
Interpretation, i.e., that a member should seek in executing customer
transactions to obtain the best price for the customer, should apply in
the government securities market even though certain specific
provisions of the Best Execution Interpretation may not be applicable
to the government securities market. The NASD's position regarding the
applicability of the Best Execution Interpretation to government
securities is consistent with its position that the concepts of the
Interpretation apply as well to all OTC markets that the NASD
regulates, including direct participation programs.11 The NASD
will further consider whether an amendment to the Best Execution
Interpretation is necessary to clarify this position as it applies to
government securities, but believes such an amendment is not necessary
at this time given the clarification provided herein.
\11\ See NTM 91-69 (discussing the application of the
Interpretation to transactions in direct participation program
securities).
[[Page 11659]]
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Interpretation of the Board of Governors--Front Running Policy, Article
III, Section 1 of the Rules of Fair Practice (``Front Running Policy'')
The proposed rule change would apply the Front Running Policy to
exempt securities including government securities, except for
municipals. One commenter requests that the effectiveness of the Front
Running Policy be delayed to determine how this policy applies to the
government securities market.12 The commenter argues that the
Front Running Policy was intended to apply solely to equities and is
currently limited to transactions that are required to be reported on
the last sale reporting systems administered by Nasdaq, the
Consolidated Tape Association or the Options Price Reporting Authority,
whereas government securities transactions are not reported on such
systems. The commenter further argues that whereas a member's advance
knowledge of a block trade can have a substantial effect on an equity
security, it is less clear that such prior knowledge permits a broker-
dealer to predict and benefit from the effect of a transaction on the
price of a government security transaction because of differences in
the government securities markets. The commenter requests
clarification, for purposes of the Front Running Policy, regarding what
constitutes a ``block trade'' in the government securities markets,
because government securities do not trade as ``shares.''
\12\ See Comment Letter No. 6, supra note 5.
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In response, the NASD acknowledges that the Front Running
Interpretation is drafted to apply only to equity securities. The NASD
proposes to amend the Applicability Table to indicate that the Front
Running Policy under Article III, Section 1 of the Rules of Fair
Practice is ``Not Applicable.'' The NASD believes, however, that the
member conduct prohibited by the Front Running Interpretation may occur
under certain circumstances in the government securities markets. The
NASD intends to review the application of the Front Running
Interpretation to the government securities markets. In the interim,
the NASD will remind members that actions for similar front running
conduct occurring in the government securities markets may be brought
under Article III, Section 1 of the Rules of Fair Practice.13
\13\ A footnote has been added to the Applicability Table to
indicate that such conduct in the government securities market may
be brought under Article III, Section 1 of the Rules of Fair
Practice.
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The NASD similarly notes that the Interpretation of the Board of
Governors at paragraph 2125.07 regarding the trading ahead of customer
limit orders and the Interpretation of the Board of Governors--Trading
Ahead of Research Reports, are drafted to apply only to equity
securities. The NASD believes the Conduct addressed by these
Interpretations also may occur under certain circumstances in the
government securities markets and intends to review the application of
these Interpretations to the government securities markets. In the
interim, the NASD will remind members that actions for similar conduct
occurring in the government securities markets may be brought under
Article III, Section 1 of the Rules of Fair Practice. The NASD would
further amend the Applicability Table by adding the recently approved
Interpretation of the Board of Governors at paragraph 2125.07, and the
Interpretation of the Board of Governors--Trading Ahead of Research
Reports under Article III, Section 1 of the Rules of Fair Practice,
with the statement that these Interpretations are ``Not Applicable,''
and followed by footnotes stating that violations for such conduct in
the government securities markets may be brought under Article III,
Section 1 of the Rules of Fair Practice.
Article III, Section 23 of the Rules of Fair Practice--Net Prices to
Persons Not in Investment Banking or the Securities Business
The proposed rule change would apply Article III, Section 23 of the
Rules of Fair Practice to exempt securities, except for municipals. One
commenter requests clarification of the application of that section to
the government securities markets.14 In response, the NASD has
determined that the requirements contained in Article III, Section 23
are superseded and more clearly provided for under: (i) Rule 10b-10 of
the Act relating to Confirmation of Transactions; and (ii) Article III,
Section 25 of the Rules of Fair Practice relating to Dealing with Non-
Members. The NASD, therefore, proposes to amend the Applicability Table
to indicate that Article III, Section 23 of the Rules of Fair Practice
is ``Not Applicable; Superseded by SEC and NASD Rules.''
\14\ See Comment Letter No. 6, supra note 5.
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Article III, Section 35A of the Rules of Fair Practice/Schedule C to
the By-laws
The proposed rule change would apply Schedule C of the By-Laws
(``Schedule C''), regarding NASD registration requirements of persons
associated with a member, to the personnel of sole-government
securities broker-dealers, including persons selling options on
government securities. The proposed rule change also would have the
effect of applying Article III, Section 35A of the Rules of Fair
Practice (``Section 35A'') to the options communications of such
members with the public. One commenter states that Section 35A(b)
requires a Compliance Registered Options Principal to approve such
literature, but Schedule C requires a member to designate such a
principal only according to Article III, Section 33.15 Pursuant to
the Applicability Table of the proposed rule change, however, the
commenter notes that the NASD would not apply the provisions of Article
III, Section 33 to government securities. The commenter requests
clarification as to whether the proposed rule change will require a
government securities broker-dealer to register an associated person as
its ``Compliance Registered Options Principal'' under Part II, Section
2(f) of Schedule C in order to comply with Section 35A(b) of the Rules
of Fair Practice that requires the registration of such a Principal in
order to approve certain options advertisements, sales materials and
other literature for government securities options transactions.16
The commenter argues that this compliance issue is unclear because the
registration provision under Part II, Section 2(f) of Schedule C
provides that a member should designate a Compliance Registered Options
Principal only according to the options provisions of Article III,
Section 33 of the Rules of Fair Practice which would not be applicable
to government securities.
\15\ Id.
\16\ Id.
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In response, the NASD is currently reviewing the issue of whether a
``Compliance Registered Options Principal'' under Schedule C should be
required for members that trade options on government securities, and
the NASD intends to file in 1996 a proposed rule change regarding this
registration issue. Therefore, the NASD is amending the Applicability
Table to indicate that Article III, Section 35A(b) is ``Not Applicable/
Under Review.'' Article III, Section 35A(b) will not be applicable to
options advertisements, sales materials and other literature for
government securities options transactions during this interim review
period.
Article III, Section 45 of the Rules of Fair Practice--Customer Account
Statements
The proposed rule change would phase-in the implementation of
Article
[[Page 11660]]
III, Sections 21, 27 and 32 of the Rules of Fair Practice to dealers in
government securities within three months after the effective date of
the rule change to provide members with sufficient time to change their
internal procedures to comply with the rules. One commenter requests
that the effective date of the application of Article III, Section 45
of the Rules of Fair Practice be provided the same implementation
period. The NASD, upon review, concurs with this suggestion and
proposes that Article III, Section 45 of the Rules of Fair Practice be
implemented within three months after the effective date of the rule
change to provide members with sufficient time to change their internal
procedures to comply with this rule.
Set forth below is a table identifying the applicability of the
Rules of Fair Practice to exempted securities, including government
securities (except municipals). Proposed changes to the original table
contained in the Release are indicated, with additions in italics and
deletions in brackets.
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 Transactions Applicable.
in the Over-the Counter Market.
Prompt Receipt and Delivery..... Not 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.
Interpretation of the Board of Not Applicable.*
Governors para. 2125.07.
Front Running Policy............ Not Applicable.*
Trading Ahead of Research Not Applicable.*
Reports.
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.**
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 Not 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........ 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 and Not Applicable.
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.
[[Page 11661]]
Section 35A.............. Options Communications With the Not Applicable/ Under Review.
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 and Not Applicable.
CAES.
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 Directors Applicable.
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.
----------------------------------------------------------------------------------------------------------------
* The NASD intends to review the application of this Interpretation to the government securities markets. In the
interim, members are reminded that actions for similar conduct occurring in the government securities markets
may be brought under Article III, Section 1 of the Rules of Fair Practice.
** Article 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).
*** The NASD intends to review the application of this Interpretation to the government securities markets. In
the interim, members are reminded that actions for similar conduct occurring in the government securities
markets may be brought under Article III, Section 1 of the Rules of Fair Practice.
b. Interpretation of the Board of Governors--Suitability Obligations to
Institutional Customers, Article III, Section 2 of the Rules of Fair
Practice
Amendment to the Text of the Proposed Interpretation
One commenter pointed out that in the sixth and seventh paragraphs
of the proposed Suitability Interpretation the NASD states that the two
most important factors in determining a member's suitability
obligations are a 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.'' 17 The commenter notes that the NASD goes on to
state in the ninth paragraph that a member's obligation to determine
suitability is fulfilled if it determines that the customer is capable
of evaluating risk and ``is making independent investment decisions.''
The commenter states that such language in the Suitability
Interpretation is confusing as it appears to create two different
standards, i.e, ``intends to exercise independent judgment'' versus
``is making independent investment decisions.'' The commenter suggests
replacing the phrase ``intends to exercise'' with the phrase ``is
exercising'' to eliminate this confusion.
\17\ See Comment Letter No. 5, supra note 5.
---------------------------------------------------------------------------
Upon review, the NASD proposes to conform the language contained in
the sixth and seventh paragraphs by replacing the phrase ``intends to
exercise'' with the phrase ``is exercising.'' This change is consistent
with the purpose of the Suitability Interpretation to provide guidance
to members in fulfilling their obligation under Article III, Section
2(a) to have reasonable grounds for believing that the recommendation
to a customer for the purchase, sale or exchange of any security is
suitable for the customer upon the basis of factors, if any, disclosed
by such customer as to his other security holdings and as to his
financial situation and needs. Under this rule, the member's
suitability obligation relates to the member's
[[Page 11662]]
recommendation and not to a future transaction date. Under the proposed
Suitability Interpretation, therefore, a member should be considering
whether a customer ``is making independent investment decisions'' in
connection with the member's present recommendation(s) rather than
speculating on the customer's intent to exercise independent judgment
at some future transaction date.
Regulatory Status of Language Contained in NASD Notice to Members
Requesting Member Comment
One commenter expressed concern that the earlier proposals of the
Suitability Interpretation contained in Notice to Members 94-62 (``NTM
94-62'') and Notice to Members 95-21 (``NTM 95-21'') 18 may be
interpreted by end-users and private litigants to support the
proposition that there has been a shift in the underlying substantive
policy position on the part of both the NASD and the Commission to
increase a member's suitability obligations to institutional
accounts.19 The commenter specifically expressed strong opposition
to the language contained in NTM 94-62 that ``the member's relationship
with the customer gives rise to a duty to help the customer determine
reasonable investment parameters.''
\18\ See supra note 1.
\19\ See Comment Letter No. 6, supra note 5.
---------------------------------------------------------------------------
It is the position of the NASD that language contained in any NASD
Notice to Members publishing a proposal for comment prior to the filing
of resulting NASD rule changes with the SEC should be deemed to have no
regulatory status unless the NASD states otherwise. The primary
regulatory purpose of the NASD publishing draft proposals for member
comment, such as earlier versions of the Suitability Interpretation, is
to receive member comment on the initiative without adopting any final
position on the particular matter. Any subsequent revisions to proposed
rule language or in narrative discussion contained in Notices to
Members are not intended by the Association to imply any position
regarding the merit of the published language or discussion. The
attachment of any regulatory significance to language and discussion
contained in Notices to Members publishing a proposal for comment would
be contrary to and harm the self-regulatory process envisioned by
Section 15A of the Act, as amended, whereby the Association, through
the contributions of industry and non-industry volunteers, is able to
publish often controversial regulatory proposals for member comment.
Therefore, the language contained in NTM 95-21 and NTM 94-62 should not
be interpreted by end-users, private litigants, or others, to support
the proposition that there has been a shift in any underlying
substantive policy position on the part of the NASD to change a
member's suitability obligations to institutional accounts.
Member Determination Regarding the Institutional Customer's Capability
To Evaluate Investment Risk Independently
One commenter states that three additional factors should be
included for consideration by a member in determining an institutional
customer's capability to evaluate investment risk independently.20
The commenter considers the following to be typical indicia of
financial sophistication and sufficient trading experience: (i) Whether
or not the customer is engaged in the financial industry or in the
business of managing its own or others' investments; (ii) whether the
customer has in-house investment professionals charged with the
responsibility for recommending or making investment decisions on
behalf of the customer; and (iii) whether the customer has
independently adopted investment guidelines and provides explicit
investment guidelines to the member broker-dealer.
\20\ See Comment Letter No. 5, supra note 5.
---------------------------------------------------------------------------
The NASD acknowledges that additional factors may be of value to
members when considering whether an institutional customer is capable
of evaluating investment risk independently. The NASD's proposed
Suitability Interpretation states that the considerations included
therein 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. The NASD will look at the listed
factors in the Suitability Interpretation in the context of an
examination of a member, but recognizes that in certain cases the
listed factors may be inappropriate or other factors may also be
pertinent to the specific situation.
One commenter argues that the Suitability Interpretation should
require that broker-dealers provide specific types of information to
customers with regard to specific transactions, such as the
instrument's behavior under a variety of conditions, types of risk
incurred with certain instruments, and valuation information.21
The commenter suggests that the absence of affirmative broker-dealer
duties may lead to a debate regarding what constitutes a recommendation
that triggers the NASD's suitability rule contained in Article III,
Section 2 of the Rules of Fair Practice.
\21\ See Comment Letter No. 3, supra note 5.
---------------------------------------------------------------------------
The NASD is not seeking by the proposed rule change to adopt the
Suitability Interpretation in order to impose additional duties on
members which are not already imposed by current Article III, Section 2
of the Rules of Fair Practice, by general anti-fraud principles
contained in Section 10(b) of the Act and other provisions of the
federal securities laws, or in Article III, Section 18 of the NASD's
Rules of Fair Practice.22 With respect to the issue raised
regarding what constitutes a recommendation, the NASD stated in the
Release that a significant amount of caselaw has been developed as a
result of NASD disciplinary actions and SEC enforcement cases with
respect to this concept, which is available as guidance to the
membership.
\22\ See infra discussion under ``Other Comments.''
---------------------------------------------------------------------------
One commenter argues that the relevance of the customer's use of
consultants, investment advisers or bank trust departments should
depend on the extent of the use and nature of the outside
advice.23 The Commenter also questions whether outside managers
for investment pools and trustees fall within the scope of this factor.
The NASD agrees that the relevance of a customer's use of professional
advisers will depend on the extent of the use of such outside advice.
In addition, 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, the Interpretation
shall be applied to the agent. The Suitability Interpretation,
therefore, would apply to any delegated agents of the customer,
including outside managers for investment pools, trustees, and other
agents.
\23\ See Comment Letter No. 3, supra note 5.
---------------------------------------------------------------------------
One commenter argues that the relevance of the customer's general
level of experience in the financial markets and with types of
instruments under consideration will depend not only on the expertise
of the staff but on the nature of changing markets as well.24 The
commenter argues that the relevance of the customer's ability to
understand economic features or the complexity of the security involved
may turn on the nature of information provided to the investor
regarding the features of a specific instrument. The
[[Page 11663]]
commenter also argues that a customer's track record or an affirmative
statement by the customer that it has the ability to independently
evaluate the effect of the market on a security are unreliable
indicators of a customer's ability to independently evaluate the effect
of the market on the security. The NASD agrees that the relevance of
factors listed in the Suitability Interpretation will vary depending on
numerous circumstances. Both the Suitability Interpretation and the
discussion of the proposed rule change in the Release emphasized that
the factors listed in the Suitability Interpretation are merely
guidelines and that the inclusion or absence of any of these factors is
not dispositive of the determination of suitability. With regard to the
member's consideration of a customer's track record, the NASD addressed
this concern in the Release by stating that it 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. The NASD believes that
a customer's track record or an affirmative statement by the customer
are helpful factors for consideration, though not dispositive in
themselves.
\24\ Id.
---------------------------------------------------------------------------
Member Determination Regarding the Institutional Customer's Making of
Independent Investment Decisions
One commenter argues that the factor regarding the ``presence or
absence of a pattern of acceptance of a member's recommendation'' is
too broad and should apply only to ``captive'' account situations,
where a single broker-dealer is effectively controlling substantially
all investment decisions of an account.25 In response, the NASD
believes that it would be inappropriate to limit to ``captive
accounts'' the member's consideration of the presence or absence of a
pattern of a customer's acceptance of a member's recommendation. The
NASD believes that a member should be allowed to consider this factor
whenever it is appropriate and reasonable to the member's
determination.
\25\ See Comment Letter No. 5, supra note 5.
---------------------------------------------------------------------------
One commenter argues that three of the listed factors warrant
reconsideration as determinative factors or rebuttable presumptions
that the member has fulfilled its suitability obligation.26
Another commenter also argues that the Suitability Interpretation
should be amended to create a rebuttable presumption that a member's
recommendations to defined institutional customers are suitable.27
In response, 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.
\26\ See Comment Letter No. 6, supra note 5.
\27\ See Comment Letter No. 8, supra note 5.
---------------------------------------------------------------------------
One commenter requests clarification that the lack of a written
agreement will not work against investors in disputed cases, and that
the inclusion of such a provision in the rule does not indicate a
preference for such agreements.28 The NASD believes that the act
of developing such agreements with a customer may be helpful to a
member in determining its suitability obligations to the customer, but
the existence or absence of such an agreement is not intended to create
a presumption as to whether the member has or has not fulfilled its
suitability obligations under Article III, Section 2 of the Rules of
Fair Practice.
\28\ See Comment Letter No. 3, supra note 5.
---------------------------------------------------------------------------
One commenter argues that member consideration of the customer's
use of other information as a means of limiting a broker-dealer's
suitability obligation may discourage investors from becoming more
informed and responsible.29 The NASD does not agree that the
referenced factor or any of the factors listed in the Suitability
Interpretation will discourage institutional customers from being more
informed and responsible. Rather, this factor recognizes that in many
cases institutional customers rely on financial information other than
that provided by the member and may, in fact, be subject to a fiduciary
obligation to do so.
\29\ Id.
---------------------------------------------------------------------------
One commenter argues that member consideration of ``the extent to
which the member has received from the customer current comprehensive
portfolio information in connection with discussion of recommended
transactions'' may not be prudent for the institutional investor with
concerns that a member's detailed knowledge of the institution's
holdings may affect the institution's ability to trade certain portions
of the portfolio or may adversely affect the market for the
institution's holdings.30 The commenter, however, supports the
Interpretation's provision that the member consider the extent to which
the member has not been provided important information regarding the
institution's portfolio or investment objectives.31 The commenter
considers this latter provision to include a jurisdiction's 32
investment guidelines and risk constraints, as well as relevant state
and local law. The commenter recommends replacing both of the above
considerations with language that would focus on whether the customer
has provided ``material relevant to a particular transaction'' and
requiring that the member make a reasonable request to obtain relevant
portfolio or investment objectives information. The NASD agrees with
the commenter that any material relevant to a particular transaction
provided by a customer would help members fulfill their suitability
obligations under the Suitability Interpretation. The NASD, however,
believes that such material information would include current
comprehensive portfolio information in connection with the transaction
and that the more specific guideline is appropriate even though a
customer may not be willing to provide such information. The NASD
recognizes the commenter's concerns and reminds members that the
Suitability Interpretation states that all the factors are merely
guidelines, and that the inclusion or absence of any of these factors
is not dispositive in the determination of suitability.
\30\ Id.
\31\ Id.
\32\ The commenter's reference to the term ``jurisdiction''
reflects that the commenter represents state and local government
officials and other public finance specialists involved in all the
disciplines comprising public finance.
---------------------------------------------------------------------------
Application of Suitability Interpretation to Certain Agents Delegated
by the Institutional Customer
The Suitability Interpretation would require that if an
institutional customer has delegated investment authority to an agent
such as an investment advisor or money manager, then the Interpretation
applies to the agent rather than the customer. One commenter believes
that investment professionals employed by institutional customers
should bear the total responsibility for their investment decisions
made on behalf of their institutional customers, i.e., where the
customer relies on an investment professional, the determination of
suitability should be presumed to be made by the investment
professional.33 The NASD has stated in the Release that it does
not believe it is appropriate to create a safe harbor for members'
suitability obligations nor to change or reduce members' obligations
under the
[[Page 11664]]
suitability rule in Article III, Section 2 of the Rules of Fair
Practice.34
\33\ See Comment Letters Nos. 1 and 8, supra note 5.
\34\ See also Comment Letters Nos. 6 and 8, supra note 5.
---------------------------------------------------------------------------
Application of Suitability Interpretation to Institutional Customer:
$10 Million Threshold
The Suitability Interpretation provides that for its purposes, an
institutional customer shall be any entity other than a natural person.
It also provides that in determining the applicability of the
Suitability 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. It further
states that while it is potentially applicable to any institutional
customer, the guidance contained therein 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.
One commenter argues that the $10 million threshold is contrary to
language contained in the Congressional report on the Government
Securities Act Amendments of 1993, which states that no distinction
should be made in the application of the NASD's rules between investors
on the basis of size of portfolio.35 The commenter also argues
that the $10 million portfolio threshold contradicts other language in
the Suitability Interpretation that states that the Interpretation is
potentially applicable to any institutional customer. The commenter
further states the $10 million portfolio threshold provision is,
therefore, confusing, difficult to apply, and requests clarification
on: (i) what is meant by the reference to securities in the aggregate
in its portfolio and/or under management; (ii) what is the period
during which the $10 million portfolio size criteria applies; (iii)
what is intended by the phrase ``under management''; and (iv) what
connection the portfolio size has to the rest of the rule. The
commenter also requests clarification on how institutional investors
with a portfolio less than the threshold will be treated and recommends
that if the threshold amount remains, that it be significantly higher
than $10 million because otherwise the Interpretation would
inappropriately apply to certain small governmental entities with
portfolios that are nominal in the context of government operations.
\35\ See Comment Letter No. 3, supra note 5.
---------------------------------------------------------------------------
The NASD responded to such concerns when it stated in the Release
that it ``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.'' 36
\36\ See Securities Exchange Act Release No. 36383, supra note
2, at 54549.
---------------------------------------------------------------------------
One commenter supports the $10 million threshold but states that
this threshold suggests that the dealer is more likely to be able to
reach the determination called for by the Suitability Interpretation
for accounts of at least that size.37 One commenter requests
clarification that a member's suitability obligations and the guidance
provided by the Interpretation apply identically to all registered
investment companies regardless of the amount of assets that a
particular investment company has under management.38 The
commenter is concerned that the Interpretation will otherwise
inadvertently lead to discrimination against smaller investment
companies. The commenter argues that all investment companies are
subject to equal treatment under the Investment Company Act of 1940 and
must operate within the same competitive environment in which they are
expected to obtain professional, experienced investment management for
their shareholders. One commenter similarly argued that the
Interpretation will have an adverse impact on all smaller institutional
accounts.39 The commenter argues that the burden on competition is
not necessary or appropriate for such smaller accounts.
\37\ See Comment Letter No. 6, supra note 5.
\38\ See Comment Letter No. 4, supra note 5.
\39\ See Comment Letter No. 1, supra note 5.
---------------------------------------------------------------------------
The NASD believes the commenters referenced in the preceding
paragraph have misinterpreted the reference to $10 million to imply a
definitive threshold that distinguishes capable from non-capable
institutional customers. The NASD further believes that the additional
provisions in the paragraph containing the $10 million dollar reference
eliminate any inference that $10 million is a definitive threshold.
Also, as noted above, the NASD stated in the Release that it does not
intend to create a presumption either above or below that aggregate
dollar amount that the Interpretation will, in fact, apply to a
particular institutional customer. The $10 million threshold,
therefore, in the context of the complete paragraph does not and should
not result in inadvertent discrimination against either investment
companies or other institutional customers with less than $10 million
invested in securities in the aggregate in their portfolios and/or
under management.
Another commenter supports the threshold and states that the $10
million provision acknowledges that although certain investors with
substantial assets do not fall within the NASD definition of
``institutional account'' in Article III, Section 21 of the Rules of
Fair Practice (which establishes a $50 million asset threshold), they
are nevertheless capable of evaluating investments and exercising
independent investment judgment.40 The NASD agrees with this
commenter's understanding of the $10 million provision contained in the
Suitability Interpretation.
\40\ See Comment Letter No. 5, supra note 5.
---------------------------------------------------------------------------
The proposed rule change would also amend Article III, Section 2(b)
of the Rules of Fair Practice to clarify that for purposes of the
account information requirements, the definition of a ``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. One commenter argues that the information-
gathering requirement in Article III, Section 2(b) should apply only to
customers that are not considered institutional customers under the
Suitability Interpretation.41 The commenter states that a member
will be required to attempt to gather the information required by
Article III, Section 2(b) from a customer (such as an entity with total
assets of less than $50 million) even if the member reasonably
concludes, consistent with the proposed Suitability Interpretation,
that the institutional customer is capable of understanding the risks
of the recommended transaction and intends to exercise independent
judgment in evaluating the member's recommendation.
\41\ See Comment Letter No. 6, supra note 5.
---------------------------------------------------------------------------
It is the position of the NASD that the proposed rule change to
Article III, Section 2(b) of the Rules of Fair Practice is to
distinguish this requirement from
[[Page 11665]]
the suitability obligations under Article III, Section 2(a) of the
Rules of Fair Practice and the Suitability Interpretation. The proposed
rule change clarifies that fulfilling the suitability obligation under
the Suitability Interpretation does not reduce the member's other
obligation under Article III, Section 2(b) to customers that do not
qualify as institutional accounts under Article III, Section 21(c)(4)
of the Rules of Fair Practice, even though some of these customers
would be considered institutional customers according to the
Suitability Interpretation. The NASD considers the account information
requirements contained under Article III, Section 2(b) to be an
obligation with regulatory merit separate from and not superseded by
the guidance contained in the Suitability Interpretation.
Additional Comments
One commenter states that Article III, Section 2(a) of the Rules of
Fair Practice is an unclear rule.42 The NASD disagrees with this
statement. The source of the language for Article III, Section 2(a) of
the Rules of Fair Practice dates from the 1930s Investment Bankers Code
drafted during the days of the National Recovery Administration. The
NASD believes that during those difficult financial times it would not
have been unusual for the involved business and government leaders to
have determined that the U.S. financial markets could not be revived
and flourish in an business environment with a fair practice standard
of caveat emptor. The NASD believes the drafters of the suitability
rule language must have developed the suitability rule to establish a
basic obligation that a broker-dealer is responsible for its
recommendations, similar to the basic responsibility of a manufacturer
for the quality of its product. In developing the rule, it is believed
that the drafters recognized that a workable suitability rule could not
go so far as to provide detailed guidance for all circumstances, yet
must address all circumstances. The result of their efforts is the
language subsequently adopted as the NASD's suitability rule in Article
III, Section 2(a) of the Rules of Fair Practice. The historical use of
this rule has demonstrated that it sets a standard of behavior that is
workable and enforceable when applied to the specific facts and
situations giving rise to a complaint of violation. Contrary to the
commenter's suggestion that Article III, Section 2(a) is an unclear
rule, the NASD believes that the suitability rule is an important and
proven regulatory standard of fair dealing in the securities industry
much the same as the NASD's requirement under Article III, Section 1 of
the Rules of Fair Practice that a member, in the conduct of his
business, shall observe high standards of commercial honor and just and
equitable principles of trade. The NASD believes that the language
contained in its suitability rule has achieved its intended purpose of
protecting the investing public and maintaining confidence in the U.S.
securities markets and has, thereby, contributed to the global
competitiveness and growth of the U.S. financial markets since the
1930s.
\42\ See Comment Letter No. 7, supra note 5. The commenter
states that the Suitability Interpretation proposed to be adopted
under Article III, Section 2 ``muddies an already unclear rule.''
---------------------------------------------------------------------------
The commenter also argues that the Suitability Interpretation would
impose an ``unclearly articulated burden of proof'' on a member
regarding how to fulfill suitability obligations to institutional
customers.43 The NASD disagrees. The Suitability Interpretation
would provide a member with significantly more guidance than now exists
under Article III, Section 2(a) of the Rules of Fair Practice regarding
when the member is considered to have ``reasonable grounds for
believing'' that it has fulfilled its suitability obligations under
Article III, Section 2(a) of the Rules of Fair Practice.
\43\ See Comment Letter No. 7, supra note 5.
---------------------------------------------------------------------------
The commenter also argues that the Suitability Interpretation
unfairly allocates responsibilities between the customer and the
broker-dealer and is confusing because it would: (i) Impose new duties
on members to obtain certain information from institutional customers
regarding the Interpretation's listed factors and to keep books and
records regarding their suitability determinations for future
examination by the NASD; (ii) fails to provide a clear definition of
``institutional investor'' and ``recommendation;'' and (iii) fails to
establish a rebuttable presumption that a member's recommendations to
institutional customers are suitable.
The commenter states that the Suitability Interpretation imposes
new duties that do not currently exist as Article III, Section 2(a) of
the Rules of Fair Practice requires only that a member make a
suitability determination ``upon the basis of the facts, if any,
disclosed by such customer,'' and Article III, Section 2(b) of the
Rules of Fair Practice requires only that a member must make reasonable
efforts to obtain current information with regard to non-institutional
accounts. The commenter argues that the text of these two subsections
of Article III, Section 2 of the Rules of Fair Practice suggests that
it is not currently mandatory for members to obtain the information set
forth in the list of relevant factors for institutional investors.
Another commenter also argues that the Suitability Interpretation
should not increase member documentation or record keeping
requirements.44
\44\ See Comment Letter No. 8, supra note 5.
---------------------------------------------------------------------------
The NASD agrees that Article III, Section 2(a) of the Rules of Fair
Practice does not contain books and records requirements, and the NASD
does not bring actions under Section 2(a) on this basis. The
Suitability Interpretation also does not contain books and records
requirements. Members, however, are responsible for demonstrating the
fulfillment of their suitability obligations under Article III, Section
2(a) in NASD examinations. Members would have the same responsibility
under the Suitability Interpretation. With regard to the member
obligations contained in the Suitability Interpretation, the NASD
states in the Release that in revising earlier drafts of the
Suitability Interpretation, the NASD intended to eliminate the
appearance that the listed 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 review 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.'' 45 Thus, the NASD agrees with the
commenter that the responsibilities of the member are limited under
Article III, Section 2(a) of the Rules of Fair Practice in that the
member is not the guarantor of the investment nor responsible for the
absence of information not provided by the institutional customer.
\45\ See Securities Exchange Act Release No. 36383, supra note
2, at 54553.
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In a related comment, one commenter also objects that the proposed
Suitability Interpretation would impose a ``heavy burden of proof''
when dealing in an institutional context.46 The NASD's position is
that a member is responsible for demonstrating in an NASD examination
or investigation that it has fulfilled its obligations under Article
III, Section 2(a) of the Rules of Fair Practice, in the same manner
that the member must demonstrate
[[Page 11666]]
compliance with its obligations under any federal security law. Thus, a
member may determine that it is necessary to establish internal
procedures that will facilitate a demonstration that the member has met
its regulatory obligations. This responsibility exists under Article
III, Section 2(a) today.
\46\ See Comment Letter No. 7, supra note 5.
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With regard to the commenter's specific proposal that the
Suitability Interpretation provide an objective definition of the term
``institutional investor,'' the NASD believes this approach would
arbitrarily discriminate between institutional investors based on
factors such as asset size, portfolio size or institutional type. The
NASD states in the Release that 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 such factors.47 The NASD further
states in the Release that it believes this regulatory approach is in
furtherance of the Act, as amended.48
\47\ See Securities Exchange Act Release No. 36383, supra note
2, at 54549.
\48\ See supra discussion under ``Application of Suitability
Interpretation to Institutional Customer: $10 Million Threshold.''
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With respect to the commenter's proposal that a definition of
``recommendation'' be adopted, the NASD stated in the Release that
Article III, Section 2 of the Rules of Fair Practice has been
applicable to members' recommendations since the inception of the
NASD.49 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'' is unnecessary and would
raise many complex issues in the absence of the specific facts of a
particular case.
\49\ See Securities Exchange Act Release No. 36383, supra note
2, at 54556.
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With regard to the commenter's proposal that the Suitability
Interpretation provide a rebuttable presumption that member
recommendations to institutional customers are suitable, the NASD
states in the Release that it 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 a ``clear rebuttable presumption'' through the
fulfillment of certain procedures would not be appropriate.50 In
addition, as set forth below, such a rebuttable presumption would only
be acceptable if a definable class of institutional investors could be
identified that would not need the protection of the NASD's suitability
rule under all conceivable circumstances.
\50\ Id. at 54553.
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The commenter also suggests there is regulatory precedent for its
position that the Suitability Interpretation should be amended to
provide for a rebuttable presumption that member transactions with
institutional investors are suitable. The commenter cites Rule 144A
under the Securities Act of 1933, as amended (``1933 Act''), which
provides exemptions from the registration requirements of the 1933 Act
by allowing unregistered securities to be resold to objectively defined
``qualified institutional investors'' (``QIBs''). The commenter also
cites Rule 15a-6 of the Securities Exchange Act of 1934, as amended
(``Exchange Act''), which provides exemptions for certain foreign
brokers and dealers from the broker-dealer registration requirements of
Section 15(a)(1) and 15B(a)(1) of the Exchange Act when, among other
things, such foreign broker-dealers deal under certain conditions with
``U.S. institutional investors'' or ``major U.S. institutional
investors.'' 51 The commenter states that it is difficult to
understand why the NASD's suitability rule is ``sacrosanct'' relative
to the above statutorily-required securities and broker-dealer
registration requirements.
\51\ The discussion of Rule 144A and Rule 15a-6 contained in
this Release was prepared by the NASD's Office of General Counsel.
Accordingly, the discussion of Rule 144A and Rule 15a-6 contained
herein is not a description or interpretation of the rules by the
Commission or Commission staff. See Securities Exchange Act Release
No. 27017 (July 11, 1989), 54 FR 30013 (July 18, 1989).
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The NASD notes that Rule 144A under the 1933 Act allows
unregistered securities to be resold to certain institutional buyers
who are of sufficient size they are presumed to have the sophistication
52 to purchase securities based upon disclosure documents meeting
the anti-fraud requirements rather than the SEC standardized disclosure
forms. In the NASD's opinion, Rule 144A is not a safe harbor from
disclosure because, regardless of the lack of reliance on the SEC's
disclosure documents and pre-offering registration with the SEC,
disclosure regarding the securities offered is generally provided to
QIBs in order for the offering to be in compliance with the anti-fraud
provisions of the federal securities laws.53 The creation of a
``rebuttable presumption'' under the NASD's suitability rule would,
however, create a safe harbor from the NASD's fair practice standard
that a member shall reasonably believe that its recommendation is
suitable, which the NASD believes is totally inappropriate. As
important, the NASD is unable to identify a class of institutional
investors that would not need the protection of the NASD's suitability
rule under all conceivable circumstances. For the above reasons, the
NASD believes that a proposed ``rebuttable presumption'' for the NASD's
suitability rule in connection with transactions with institutional
customers is significantly different than the SEC's Rule 144A safe
harbor for resales of unregistered securities to QIBs.
\52\ Rule 144A relies on an extremely high standard of $100
million invested in securities in order to ensure that potential
investors have sufficient sophistication to make investment
decisions without need for SEC registration.
\53\ In fact, the introduction to Rule 144A specifically states
that ``[t]his section relates solely to the application of Section 5
of the Act and not to antifraud or other provisions of the Federal
securities laws.''
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With regard to the commenter's argument that there is precedent for
providing a status safe harbor in the Suitability Interpretation based
on Rule 15a-6 of the Exchange Act, the NASD believes that these
provisions are too different for any comparison and precedent to be
used. Rule 15a-6 of the Exchange Act does not waive major investor
protection standards for U.S. institutions, whereas the NASD believes a
safe harbor in the Suitability Interpretation would waive such
protections. Rule 15a-6, inter alia, provides an exemption from broker-
dealer registration (referred to as the direct contact exemption) that
generally permits certain foreign broker-dealers 54 to engage in
solicited transactions with ``U.S. institutional investors'' or ``major
U.S. institutional investors'' through a registered broker-dealer
acting as an intermediary. The rule permits foreign broker-dealers to
contact U.S. institutional investors only with the participation of an
associated person of a registered broker-dealer. Rule 15a-6 also
generally permits certain foreign broker-dealers to send research
reports
[[Page 11667]]
under certain conditions 55 to ``major U.S. institutional
investors'' and to engage in unsolicited transactions from such
investors without a registered broker-dealer acting as an
intermediary.56 The SEC has stated that under these conditions, it
believes that direct distribution would be consistent with the free
flow of information across national boundaries without raising
substantial investor protection concerns.57 The NASD believes that
different procedures adopted under Rule 15a-6 for solicited and
unsolicited transactions and for ``U.S. institutional investors'' and
``major U.S. institutional investors'' demonstrates that the SEC sought
to carefully preserve the safe-guards offered by broker-dealer
registration, and not adopt an across-the-board exemption similar to
the securities registration exemption provided by Rule 144A for QIBs.
In this connection, the SEC states in the adopting release that ``* * *
the Commission does not believe that sophistication is in all
circumstances an effective substitute for broker-dealer regulation.''
58 The exemption adopted under Rule 15a-6 that permits
unregistered foreign broker-dealers to send research reports under
certain conditions to a ``major U.S. institutional investor'' and
permits such institutions in certain circumstances to engage in
unsolicited transactions is narrowly drawn. The NASD believes that the
definition of ``major U.S. institutional investor'' sets a very high
standard 59 for a very small exemption and recognizes the reality
that such U.S. investors interested in foreign securities are capable
of accessing research and entering into transactions with unregistered
foreign broker-dealers with respect to foreign securities. Rule 15a-6,
therefore, is significantly more narrow than that proposed by the
commenter with respect to the NASD's suitability rule that would
relieve members of their suitability obligations with respect to the
entire class of institutional investors. Moreover, the provisions of
Rule 15a-6 are intended to accommodate regulatory comity and facilitate
access to foreign markets by certain U.S. institutional investors.
\54\ Rule 15a-6(a) exempts only foreign brokers or dealers,
which are defined in paragraph (b)(3) to mean persons not resident
in the United States that are not offices or branches of, or natural
persons associated with, registered broker-dealers, and whose
securities activities fall within the definitions of ``broker'' or
``dealer'' in sections 3(a)(4) or 3(a)(5) of the Exchange Act. The
definition in paragraph (b)(3) expressly includes any U.S. person
engaged in business as a broker or dealer entirely outside the
United States. This definition also includes foreign banks to the
extent that they operate from outside the United States, but not
their U.S. branches or agencies.
\55\ The research report must not recommend the use of the
foreign broker-dealer to effect trades in any security, and the
foreign broker-dealer must not initiate follow-up contact with the
major U.S. institutional investors who receive the research, or
otherwise induce or attempt to induce the purchase or sale of any
security by those major U.S. institutional investors.
\56\ If, however, the foreign broker-dealer already had a
relationship with a registered broker-dealer that facilitated
compliance with the direct contact exemption in the rule, the rule
would require all trades resulting from the provision of research to
be effected through that registered broker-dealer pursuant to the
provisions of that exemption.
\57\ See Securities Exchange Act Release No. 27017 (July 11,
1989), 54 FR 30013 (July 17, 1989).
\58\ Id.
\59\ Paragraph (b)(4) of Rule 15a-6 of the Exchange Act
generally defines ``major U.S. institutional investor'' as a U.S.
institutional investor with assets, or assets under management, in
excess of $100 million, or a registered investment adviser with
assets under management in excess of $100 million. Paragraph (b)(7)
of Rule 15a-6 of the Exchange Act generally defines ``U.S.
institutional investor'' as a registered investment company, bank,
savings and loan association, insurance company, business
development company, small business investment company or employee
benefit plan defined in Rule 501(a)(1) of Regulation D under the
Securities Act, a private business development company as defined in
Rule 501(a)(2), an organization described in Section 501(c)(3) of
the Internal Revenue Code, as defined in Rule 501(a)(3) or a trust
defined in Rule 501(a)(7).
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The commenter also argues, contrary to its prior argument, that
``even though the NASD does not intend to create a safe harbor, the
Proposal adopts the framework of a safe harbor when it suggests that
`where the broker-dealer has reasonable grounds for concluding that the
institutional customer is making independent investment decisions and
is capable of independently calculating investment risk, then a
member's obligation to determine that a recommendation is suitable for
a particular customer is fulfilled.' '' The NASD disagrees; there are
no safe harbors in the suitability Interpretation. The Suitability
Interpretation clarifies, by discussion and examples of relevant
factors, the standard to establish the ``reasonable grounds'' that a
member should have under Article III, Section 2(a) of the Rules of Fair
Practice regarding the suitability of its recommendations to
institutional customers. Under the Suitability Interpretation, a member
is unable to determine whether its obligation to an institutional
customer under Article III, Section 2(a) of the Rules of Fair Practice
is fulfilled unless the member engages in a subjective inquiry and
analysis of the factors in the Suitability Interpretation and any other
relevant factors. The Suitability Interpretation requires the member to
have sufficient knowledge of the customer in order to rely on the
Interpretation in fulfilling its obligation under Article III, Section
2(a) of the Rules of Fair Practice. The NASD states in the Release
60 that it believes such knowledge is often gained in an ongoing
member/customer relationship, but acknowledges that a consideration
would include 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.
\60\ See Securities Exchange Act Release No. 36383, supra note
2, at 54555.
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2. Statutory Basis
The NASD believes that the proposed rule change, as amended, is
consistent with the provisions of Section 15A(b)(6) of the Act,61
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, as amended, will also
further the above purposes of the Act 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, as amended, will also further the
above-purposes of the Act 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
[[Page 11668]]
applicable; and (iii) modifying references to SEC Rules 15c3-1 and
15c3-3 to reflect SEC amendments to those rules.
\61\ 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, as amended, is consistent with
the intent of the Act as amended by the Government Securities
Amendments.62 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 extent to which the customer is exercising
independent judgement in evaluating the member's recommendation.63
\62\ 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 Comment
Letter No. 3, supra note 5.
\63\ 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.
(C) Self-Regulatory Organization's Statement on Comments on the
Proposed Rule Change Received from Members, Participants, or Others
No written comments were solicited or received as to Amendment No.
3 to the proposed rule change.
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. Sec. 552, will be available for inspection and copying at
the Commission's Public Reference Section, 450 Fifth Street, N.W.,
Washington, D.C. 20549. Copies of such filing will also be available
for inspection and copying at the principal office of the NASD. All
submissions should refer to File No. SR-NASD-95-39 and should be
submitted by April 22, 1996.
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-6765 Filed 3-20-96; 8:45 am]
BILLING CODE 8010-01-P