[Federal Register Volume 61, Number 102 (Friday, May 24, 1996)]
[Notices]
[Pages 26239-26243]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-13143]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-37223; File No. SR-NASD-96-17]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by National Association of Securities Dealers, Inc. Relating to 
the Definitions of Bona Fide Independent Market and Bona Fide 
Independent Market Maker

May 17, 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 April 
24, 1996, the National Association of Securities Dealers, Inc. 
(``NASD'' or ``Association'') filed with the Securities and Exchange 
Commission (``SEC'' or ``Commission'') the proposed rule change as 
described in Items I, II, and III below, which Items have been prepared 
by the NASD. The Commission is publishing this notice to solicit 
comments on the proposed rule change from interested persons.

I. Self-Regulatory Organization's Statement of the Terms of Substance 
of The Proposed Rule Change

    The NASD is herewith filing a proposed rule change to Rule 2720 of 
the NASD's Conduct Rules to amend the definitions of ``Bona fide 
independent market'' and ``Bona fide independent market maker.'' Below 
is the text of the proposed rule change. Proposed new language is 
italicized; proposed deletions are in brackets.

Conduct Rules

2000. Business Conduct
* * * * *
2700. Securities Distributions
2720. Distribution of Securities of Members and Affiliates--Conflicts 
of Interest
(a) General
    (1) No member or person associated with a member shall participate 
in the distribution of a public offering of debt or equity securities 
issued or to be issued by the member, the parent of the member, or an 
affiliate of the member and no member or parent of a member shall issue 
securities except in accordance with this Rule.
    (2) No member or persons associated with a member shall participate 
in the distribution of a public offering of debt or equity securities 
issued or to be issued by a company if the member and/or its associated 
persons, parent or affiliates have a conflict of interest with the 
company, as defined herein, except in accordance with this Rule.
(b) Definitions
    For purposes of this Rule, the following words shall have the 
stated meanings:
    (1) and (2) No change.
    (3) Bona fide independent market--a market in a security which:
    (A) Is registered pursuant to the provisions of Sections 12(b) or 
12(g) of the Act or issued by a company subject to Section 15(d) of 
such Act, unless exempt from those provisions;
    [(B) Has an aggregate trading volume for the 12 months immediately 
preceding the filing of the registration statement of at least 100,000 
shares;]
    [(C) Has outstanding for the entire 12 month period immediately 
preceding the filing of the registration statement, a minimum of 
250,000 publicly held shares; and]
    [(D) In the case of over-the-counter securities, has had at least 
three bona fide independent market makers for a period of at least 30 
days immediately preceding the filing of the registration statement and 
the effective date of the offering.]
    (B) Has a market price as of the close of trading on the trade date 
immediately preceding filing of the registration statement or offering 
circular of five dollars or more per share, and which has traded at a 
price of five dollars or more per share in at least 20 of the 30 
trading days immediately preceding the filing of the registration 
statement or offering circular; and
    (C) For at least 90 calendar days immediately preceding the filing 
of the registration statement or offering circular with the Department:
    (i) Has been listed on and is in compliance with the requirements 
for continued listing on a national securities exchange; or
    (ii) Has been listed on and is in compliance with the requirements 
for continued listing on The Nasdaq Stock Market and has had at least 
two bona fide independent market makers for a period of at least 30 
trading days immediately preceding the filing of the registration 
statement and the effective date of the offering; and
    (D) For the 90 calendar day period immediately preceding the filing 
of the registration statement or offering circular:
    (i) Has an aggregate trading volume of at least 500,000 shares; or
    (ii) Has outstanding a minimum of 5,000,000 publicly held shares.
    (4) Bona fide independent market maker--a market maker which:
    [(A) Continually maintains net capital as determined by Rule 15c3-1 
under the Act, of $50,000 or $5,000 for each security in which it makes 
a market, whichever is less;]
    [(B) Regularly publishes bona fide competitive bid and offer 
quotations in a recognized interdealer quotation system;]
    [(C) Furnishes bona fide competitive bid and offer quotations to 
other brokers and dealers on request; and]
    ((D) Stands ready, willing and able to effect transactions in 
reasonable amounts, and at his quoted prices, with other brokers and 
dealers.)
    (A) Is registered as a Nasdaq market maker in the security to be 
distributed pursuant to this Schedule;
    (B) Is not an affiliate of the entity issuing securities pursuant 
to paragraph (c) of this Schedule and, together with its associated 
persons, does not in the aggregate beneficially own, at the time of the 
filing of the registration statement and at the commencement of the 
distribution, five percent or more of the outstanding voting securities 
of such entity which is a corporation or beneficially own a partnership 
interest

[[Page 26240]]

in five percent or more of the distributable profits or losses of such 
entity which is a partnership; and
    (C) Is not a recipient of any of the net proceeds of the offering.
 * * * * *

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, the NASD included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. The NASD has prepared summaries, set forth in Sections 
(A), (B), and (C) below, of the most significant aspects of such 
statements.

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

Introduction and Background

    Rule 2720 of the NASD's Conduct Rules (the ``Rule'') (formerly, 
Schedule E to the NASD's By-Laws) addresses the concern that public 
investors be adequately protected against conflicts of interest 
regarding the conduct of due diligence and pricing of securities when 
investing in securities issued by an NASD member, its parent or an 
affiliate of a member that is going public or by an issuer with which 
the member has a conflict of interest (``Rule 2720 offering''). The 
Rule prohibits a member from underwriting or participating in the 
underwriting or distribution of a Rule 2720 offering of equity or debt 
unless the price of the equity offering is established no higher, or 
the yield of the debt offering is established no lower, than the price 
recommended by a qualified independent underwriter, who shall also 
participate in the preparation of the registration statement and 
prospectus, offering memorandum, or similar document, and exercise 
usual standards of ``due diligence'' regarding the offering. Rule 2720 
provides an exception from the qualified independent underwriter 
requirement for offerings of equity securities for which a bona fide 
independent market exists. Rule 2720 defines a bona fide independent 
market as a market in a security which has, among other things, at 
least three bona fide independent market makers.
    The NASD has reviewed the definitions of bona fide independent 
market and bona fide independent market maker, which were part of the 
original version of Rule 2720 when it was adopted as Schedule E in 
1972. The NASD is proposing to revise the definitions to incorporate 
new requirements for listing, public float, trading volume, price, 
number of bona fide independent market makers, and limitations on the 
relationship of the bona fide independent market maker to the issuer 
that will significantly improve the criteria used for determining that 
a market of sufficient depth and duration exists to constitute an 
efficient pricing mechanism for the securities to be distributed. The 
NASD believes that the proposed new definitions will permit members, in 
appropriate situations, to conduct a secondary offering without the 
burden and expense of engaging a qualified independent underwriter, 
while ensuring the public that the added protection of a qualified 
independent underwriter will be required in situations where the market 
cannot be relied on to price the securities appropriately.

Description of Proposed Amendments

Bona Fide Independent Market Definition

Registration Requirement
    The proposed rule change retains the current requirement in the 
definition of bona fide independent market that it must be a market in 
a security which is registered pursuant to Sections 12(b) or 12(g) of 
the Act or issued by a company subject to Section 15(d) of that Act.
Price Requirement
    The current definition of bona fide independent market does not 
contain a price requirement. The NASD is concerned that a public float 
requirement, as set forth below, without a corresponding standard for 
the market price of the securities does not establish a valid benchmark 
for a bona fide independent market. Therefore, the NASD is proposing to 
adopt a new provision in the definition of a bona fide independent 
market that would require that the security have a market price of at 
least $5 a share as of the close of trading on the day immediately 
preceding the filing of the registration statement or offering 
circular, and have traded at a price of $5 or more per share on at 
least 20 of the 30 trading days immediately preceding the date on which 
the offering circular or registration statement was filed.
Listing and Market Maker Requirement
    The current definition of bona fide independent market does not 
contain a listing requirement. The NASD believes that a listing on a 
national securities exchange or The Nasdaq Stock Market indicates that 
the security trades in an efficient, regulated, and active market and 
would bring to the definition of bona fide independent market the 
qualitative standards of a regulated trading environment, such as quote 
transparency and real-time transaction reporting. Therefore, the NASD 
is proposing to adopt as one of the requirements for the definition of 
a bona fide independent market that the security, for at least 90 
calendar days immediately preceding the filing of the registration 
statement or offering circular, have been listed on, and is in 
compliance with, the requirements for continued listing on (i) a 
national securities exchange, or (ii) The Nasdaq Stock Market so long 
as such Nasdaq listing has two bona fide independent market makers for 
a period of at least 30 trading days immediately preceding the filing 
of the registration statement or offering circular and the effective 
date of the offering. Securities quoted on the NASD OTC Bulletin Board 
service and those traded in the general over-the-courter market, such 
as the ``pink sheets,'' cannot rely on this requirement.
    The proposed requirement that the security have at least two bona 
fide independent market makers for listings on the Nasdaq Stock Market 
would replace the current requirement of at least three bona fide 
independent market makers. Given that a security is permitted to be 
listed on the Nasdaq Stock Market with two market makers, the NASD 
believes that two market makers are sufficient to demonstrate the 
presence of a bona fide independent market away from any Rule 2720 
affiliate that may also be making a market in the issuer's securities.
Trading Volume and Public Float Requirement
    The current definition of bona fide independent market contains 
independent requirements for trading volume and public float. Under the 
current rule, a security is considered to have a bona fide independent 
market if, for the 12 months immediately preceding the filing of the 
registration statement, it has both an aggregate trading volume of at 
least 100,000 shares and  a minimum of 250,000 publicly held shares. 
Under the proposed rule change, the requirements for trading volume and 
public float will be in the alternative. That is, for a bona fide 
independent market to exist, the proposed rule would require a security 
to have for the 90 calendar day period

[[Page 26241]]

immediately preceding the filing of the registration statement or 
offering circular either an aggregate trading volume of at least 
500,000 shares or a minimum of 5,000,000 publicly held shares 
outstanding.
    The NASD believes that raising the current aggregate 12-months 
trading volume requirement of 100,000 shares to 500,000 shares in the 
90-calendar-day period before the filing of the registration statement 
or offering circular provides a criterion that is more indicative of an 
active, current and, therefore, efficient market. Such greater price 
efficiency establishes a better benchmark for justifying an exemption 
from the requirement that a qualified independent underwriter establish 
the price of the offering.
    The NASD considers the alternative requirement of a five-million-
share public float as the minimum necessary to assure that the market 
for an issuer's securities will not suffer undue volatility from the 
dilution that occurs when a large number of shares is offered to the 
public. In this regard, the NASD notes that a typical ``follow-on'' 
offering\1\ of a company's stock adds between one- and two-million 
shares to the public float, which is equal to a 40 percent dilution at 
the five-million-share level.
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    \1\ The term ``follow-on'' offering refers to a secondary 
offering of shares by the issuer.
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Bona Fide Independent Market Maker Definition

    The Rule currently defines a bona fide independent market maker as 
one which meets certain net capital requirements, publishes bona fide 
bid and ask quotations in a recognized interdealer quotation system, 
furnishes such quotes to other brokers and dealers on request, and 
stands ready, willing and able to effect transactions at quoted prices 
with other brokers and dealers. The current standards of the definition 
were developed at the time the Rule was adopted in 1972 as Schedule E 
and applied to all securities in the over-the-counter market.
    The NASD believes that the current standards for the definition of 
bona fide independent market maker are no longer necessary in light of 
the proposed requirement of the definition of bona fide independent 
market that the security be listed on The Nasdaq Stock Market. Market 
makers for securities listed on The Nasdaq Stock Market are required to 
meet certain net capital standards, publish bona fide bid and ask 
quotations in Nasdaq, which is a recognized interdealer quotation 
system, furnish quotes to other brokers and dealers on request, and 
stand ready, willing and able to effect transactions at quoted prices 
with other brokers and dealers. Therefore, the NASD is proposing that 
the current requirements be incorporated into a single standard 
requiring that the market maker be registered as a Nasdaq market maker.
    The NASD believes that the definition of bona fide independent 
market maker should also provide investors with greater assurance that 
the market maker's activities are independent of any influences that 
may arise when the issuer's ownership of securities or interest in the 
offering becomes material. Therefore, the NASD is also proposing to 
adopt as part of the new definition that a bona fide independent market 
maker (i) must not be a recipient of any of the net proceeds of the 
offering, (ii) must not be an affiliate of the entity issuing the 
securities, and, (iii) together with its associated persons, does not 
in the aggregate beneficially own, at the time of the filing of the 
registration statement or offering circular, five percent or more of 
the outstanding voting securities of the entity issuing the securities, 
if a corporation, or a five percent or more partnership interest in the 
distributable profits or losses of the entity, if a partnership.
    The NASD believes that the proposed rule change is consistent with 
the provisions of Section 15A(b)(6) of the Act,\2\ which require that 
the Association adopt and amend its rules to promote just and equitable 
principles of trade, and generally provide for the protection of 
customers and the public interest in that the proposed rule change, by 
amending the requirements to qualify for the exception to the qualified 
independent underwriter requirement for an equity security with a bona 
fide independent market, significantly improves the criteria used for 
determining the presence of a bona fide independent market for Rule 
2720 offerings and reinforces the standard that a bona fide independent 
market should be stringent enough to assure the public that a market of 
sufficient depth and duration exists to constitute an efficient pricing 
mechanism for the securities to be distributed.
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    \2\ 15 U.S.C. 78o-3.
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(B) Self-Regulatory Organization's Statement on Burden on Competition

    The NASD does not believe that the proposed rule change will result 
in any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act, as amended.

(C) Self-Regulatory Organization's Statement on Comments on the 
Proposed Rule Change Received From Members, Participants, or Others

    The proposed rule change was published for comment in Notice to 
Members 95-44 (June, 1995) (``NTM 95-44''). Three (3) comment letters 
were received in response. All 3 commenters were in favor of the 
proposed rule change; one commenter suggested substantive changes to 
the proposed rule change.
    Sullivan and Cromwell (``S&C'') suggested revisions to clarify the 
meanings of the definitions of both ``bona fide independent market'' 
and ``bona fide independent market maker'' and to ease compliance with 
these requirements.

Bona Fide Independent Market Definition

    The term ``listing requirements'' in the version of the definition 
of ``bona fide independent market'' published for comment in NTM 95-44 
would have required compliance with listing requirements on a national 
securities exchange or the Nasdaq Stock Market. S&C stated it presumed 
that this requirement referred to maintenance criteria rather than 
original listing standards since the definition would otherwise exclude 
various issuers currently in compliance with appropriate maintenance 
criteria for continued listing but who, for various reasons, no longer 
meet initial listing standards.
    The NASD agrees that the proposed definition of ``bona fide 
independent market'' was not intended to require continuous 
satisfaction of initial listing requirements of the Nasdaq Stock Market 
or national securities exchanges. Therefore, the proposed rule language 
has been amended to specifically require compliance with the 
requirements for continued listing on The Nasdaq Stock Market or a 
national securities exchange.
    The NASD also agrees with S&C that the parenthetical ``(Trading 
Volume Test)'' in Section 2(c)(4)(i) should be deleted since the term 
is not used again in the rule language.
    S&C also stated that the definition of ``bona fide independent 
market'' appears to require compliance with ``listing requirements'' 
only on the filing date of the registration statement and not 
throughout the preceding 90 calendar days. The NASD believes that the 
literal language of the proposed rule is clear that compliance with the 
listing requirements is required throughout the 90 calendar days 
preceding the filing of the registration statement.

[[Page 26242]]

Bona Fide Independent Market Maker Definition

    In the version of the proposed rule change published for comment in 
NTM 95-44, ``bona fide independent market maker'' was defined, in part, 
as a market maker who is not affiliated with the issuer and, together 
with its associated persons, does not in the aggregate beneficially 
own, at the time of the filing of the registration statement, 5% or 
more of the issuer's outstanding voting securities, common equity, 
preferred equity, or subordinated debt (``five percent requirement''). 
The NASD stated in NTM 95-44 that the proposed new standards for the 
definition of bona fide independent market maker were largely drawn 
from the current definition of qualified independent underwriter in the 
Rule and from the current definition of qualified independent 
underwriter in the Rule and from the reporting requirements imposed on 
beneficial owners by Section 13 of the Act. S&C objected to the five 
percent requirement on a number of grounds.
    First, S&C stated that there is a fundamental difference between 
qualified independent underwriters and bona fide independent market 
makers that makes it inappropriate to apply the same standards to each. 
In particular, a qualified independent underwriter directly 
participates in the offering process and is usually a party to an 
agreement with the issuer outlining each party's responsibilities under 
the Rule. A registered market maker for a Nasdaq-listed stock, however, 
might not be a participant in the distribution and thus not a party to 
any agreement with either the issuer or the managing underwriter. Thus, 
a market maker could not be compelled, contractually or otherwise, to 
divulge the information needed for the issuer and managing underwriter 
to determine whether the market maker qualifies under the five percent 
requirement as a bona fide independent market maker.
    Second, S&C stated that, contrary to the suggestion in NTM 95-44, 
the issuer and managing underwriter cannot necessarily obtain the 
required information from filings made by market makers under Section 
13 of the Act. Section 13 (d) and (g) filing requirements apply only to 
acquisitions of equity securities that are ``voting securities'' and do 
not provide information regarding a market maker's investment in an 
issuer's non-convertible preferred stock or subordinated debt. 
Additionally, under Exchange Act Rule 13d-1(b)(1), many market makers 
which beneficially own more than five percent (but less than ten 
percent) of an issuer's outstanding voting securities will not be 
required to file any related disclosure statement under Section 13, 
thus eliminating the need to file a Schedule 13 regarding registered 
equity securities acquired by them in the ordinary course of business 
and not with the purpose or effect of changing or influencing the 
control of the issuer.
    Third, S&C noted that the five percent requirement prohibits a bona 
fide independent market maker from holding a five percent securities 
position either at the filing date or at the commencement of the 
distribution. S&C stated that a market maker not participating in the 
distribution, who would otherwise qualify as a bona fide independent 
market maker on the filing date, might very well refuse to provide any 
undertakings to the issuer regarding the securities positions it will 
hold on the commencement date. Consequently, an issuer may be unable to 
ensure that a broker-dealer who qualifies as a bona fide independent 
market maker on the filing date will remain so qualified on the 
commencement date.
    Finally, S&C noted that the definition of bona fide independent 
market maker proposed in NTM 95-44 requires that securities ownership 
by the member's associated persons and immediate family members, 
parents, and affiliates be aggregated for purposes of the five percent 
limitation, whereas the current definition of qualified independent 
underwriter does not require such aggregation. S&C stated that it is 
odd to include such an aggregation requirement in view of the fact that 
NTM 95-44 stated that the proposed definition of bona fide independent 
market maker is intended, in part, to conform to the current definition 
of qualified independent underwriter.
    S&C recommended that the NASD either delete the five percent 
ownership requirement entirely or at least that element of the five 
percent requirement that requires aggregation of ``associated persons 
and their immediate family, parents and affiliates.''
    The NASD agrees that the nature of Section 13 filing requirements 
appears to make such reporting an inadequate substitute source of 
information for ensuring compliance with the definition of bona fide 
independent market maker proposed in NTM 95-44. Therefore, the NASD has 
eliminated the requirement that a bona fide independent market maker 
have no more than a five percent beneficial ownership position in the 
non-voting securities of an issuer including common equity, preferred 
equity, and subordinated debt, but has retained the five percent 
ownership requirement with respect to the issuer's voting securities. 
The NASD believes that if a market of sufficient depth and liquidity 
exists to meet the other stringent requirements of the definition of a 
bona fide independent market, then the integrity of the pricing of the 
offering is preserved regardless of whether one or more market makers 
hold positions in the issuer's non-voting securities.
    The NASD also agrees that the requirements for a bona fide 
independent market maker proposed in NTM 95-44 are more stringent than 
the current requirements imposed on a qualified independent underwriter 
under the Rule. Therefore, the NASD has eliminated the requirement to 
aggregate the ownership of the immediate family, parents and affiliates 
of the member and its associated persons with any direct ownership by 
the market maker and its associated persons. However, when a bona fide 
independent market maker and its associated persons ``beneficially 
own'' voting securities of the same issuer, the NASD considers 
aggregation of ownership to be appropriate.\3\
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    \3\ ``Beneficial Ownership'' is defined in the Rule to mean the 
right to the economic benefits of a security.
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III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:
    A. By order approve such proposed rule change, or
    B. Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549. 
Copies of the submission, all subsequent amendments, all written 
statements with respect to the proposed rule change that are filed with 
the Commission, and all written

[[Page 26243]]

communications relating to the proposed rule change between the 
Commission and any person, other than those that may be withheld from 
the public in accordance with the provisions of 5 U.S.C. 552, will be 
available for inspection and copying in the Commission's Public 
Reference Room. Copies of such filing will also be available for 
inspection and copying at the principal office of the NASD. All 
submissions should refer to the file number in the caption above and 
should be submitted by June 14, 1996.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority, 17 CFR 200.30-3(a)(12).
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-13143 Filed 5-23-96; 8:45 am]
BILLING CODE 8010-01-M