[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.
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    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.
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    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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.''
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

(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).
---------------------------------------------------------------------------

    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