[Federal Register Volume 61, Number 148 (Wednesday, July 31, 1996)]
[Notices]
[Pages 40054-40056]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-19469]


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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-37471; File No. SR-NASD-96-17]


Self-Regulatory Organizations; Order Approving 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

July 23, 1996.

I. Introduction

    On April 24, 1996, the National Association of Securities dealers, 
Inc. (``NASD'' or ``Association'') submitted to the Securities and 
Exchange Commission (``SEC'' or ``Commission''), pursuant to Section 
19(b)(1) of the Securities Exchange Act of 1934 (``Act'') \1\ and Rule 
19b-4 thereunder,\2\ a proposed rule change to Rule 2720 of the NASD's 
Conduct Rules \3\ to amend the definitions of ``bona fide independent 
market'' and ``bona fide independent market maker.'' A notice of the 
proposed rule change appeared in the Federal Register on May 24, 
1996.\4\ The Commission received one comment letter endorsing the 
proposed rule change.\5\ The Commission is approving the proposed rule 
change.
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    \1\ 15 U.S.C. Sec. 78s(b)(1) (1988).
    \2\ 17 CFR 240.19b-4 (1995).
    \3\ Prior to the NASD Manuel reorganization, this rule was 
designated as Schedule E of the NASD's By-Laws. See, NASD Notice to 
Members 96-24 (April 1996).
    \4\ Securities Exchange Act Release No. 37223 (May 17, 1996), 61 
FR 26239. Also, the NASD granted an extension of the time for 
Commission action on this rule filing to July 31, 1996. Letter to 
Katherine A. England, Assistant Director, Division of Market 
Regulation, SEC, from John Ramsay, Deputy General Counsel, NASD 
Regulation, Inc. (``NASDR''), dated July 19, 1996.
    \5\ Letter from Carter K. McDowell, Assistant General Counsel, 
BANC ONE Corporation, to Jonathan G. Katz, Secretary, SEC, dated 
June 13, 1996.
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    The proposed rule change addresses potential conflicts of interest 
that arise regarding the conduct of due diligence and the pricing of 
securities issued by an NASD member, its parent, or an affiliate of a 
member that is going public (``Rule 2720 offering''). Rule 2720 also 
would apply to an issuer with which the member has a conflict of 
interest. 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. The qualified independent underwriter also must 
participate in the preparation of the registration statement and 
prospectus, offering memorandum, or

[[Page 40055]]

similar document, and exercise the usual standards of ``due diligence'' 
regarding the offering. Rule 2720, however, 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 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 proposes 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 if a market of 
sufficient depth and duration exists to constitute an efficient pricing 
mechanism for the securities to be distributed. 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. However, in situations where the 
market cannot be relied on to price the securities appropriately, a 
member would still be required to enlist the services of such an 
underwriter.

II. Description of the Proposal

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 of issued by a company subject to Section 12(d) of the 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 blow, 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 five dollars ($5.00) per 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 Requirements
    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 
strengthens the definition of bona fide independent market by adding 
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-counter 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 irrespective of any Rule 
2720 affiliate that may also be making a market in the issuer's 
securities.
Trading Volume and Public Float Requirements
    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, for a bona fide independent market to 
exist, a security must have for the 90 calendar day period 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-month 
trading volume requirement from 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 better reflects an 
active, current and, presumably, efficient market. The increased volume 
requirement intimates a pricing efficiency which, in turn, establishes 
a better basis 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 ensure 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 \6\ 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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    \6\ 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 were 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

[[Page 40056]]

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 incorporating the current 
requirements 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 become material. Therefore, the NASD is proposing to adopt as 
part of the revised 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) does not in the aggregate itself beneficially 
own, nor together with its associated persons, 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 five percent or more of a partnership 
interest in the distributable profits or losses of the entity, if a 
partnership.

III. Discussion

    The Commission believes that the proposed rule change is consistent 
with the Act and the rules and regulations promulgated thereunder. 
Specifically, the Commission believes that approval of the proposed 
rule change is consistent with Sections 15A(b)(6) \7\ and 15A(b)(9) \8\ 
of the Act. Pursuant to Section 15A(b)(6), the proposed rule change 
clarifies and strengthens the criteria for determining a bona fide 
independent market and the related concept of a bona fide independent 
market maker. In so doing, the NASD has removed an impediment to the 
functioning of a free and open market by improving the criteria used 
for determining that a market of sufficient depth and liquidity exists 
to constitute an efficient pricing mechanism for the securities to be 
distributed. The new definitions also promote economic efficiency 
because in applicable situations, members will now be able to conduct 
secondary offerings without incurring the time and expense of engaging 
a qualified independent underwriter.
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    \7\ Section 15A(b)(6) requires the Commission to determine that 
a registered national securities association's rules are designed to 
promote just and equitable principles of trade, to remove 
impediments to and perfect the mechanism of a free and open market 
and national market system; and are not designed to permit unfair 
discrimination among customers, issuers, brokers, or dealers.
    \8\ Section 15A(b)(9) requires the Commission to determine that 
a registered national securities association's rules not impose any 
burden on competition not necessary or appropriate in furtherance of 
the purposes of the Act.
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    The Commission requested clarification from the NASD regarding the 
term ``traded'' in proposed paragraph (b)(3)(B) of Rule 2720.\9\ NASDR 
has confirmed that ``traded'' encompasses any completed transaction of 
the day for the security during normal trading hours, up to and 
including the last reported trade for the day.\10\
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    \9\ The relevant language of paragraph (b)(3)(B) to Rule 2720 is 
as follows: ``. . . and which has traded at a price of five dollars 
or more per share in at least 20 of the 30 trading days. . . .''
    \10\ Letter to Katherine A. England, Assistant Director, 
Division of Market Regulation, SEC, from Alden S. Adkins, General 
Counsel, NASD Regulation, Inc., dated July 3, 1996. See also letter 
to Katherine A. England, Assistant Director, Division of Market 
Regulation, SEC, from John Ramsay, Deputy General Counsel, NASD 
Regulation, Inc., dated July 15, 1996, confirming that the 
definition applies to trades completed during normal trading hours.
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    Pursuant to Section 15A(b)(9), the proposed rule change does not 
impose any unnecessary or inappropriate burden on competition, but 
reflects an attempt to update definitions that contain provisions that 
no longer adequately represent current market practices or pricing. The 
revised definitions are stringent enough to properly regulate public 
distributions where a member issues its own securities or where a 
conflict or control relationship with a parent or affiliate exists, 
while still providing protection for investors in this type of 
offering.

IV. Conclusion

    For the above reasons, the Commission believes that the proposed 
rule change is consistent with the provisions of the Act, and in 
particular with Sections 15A(b)(6) and 15A(b)(9).
    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\11\ that the proposed rule change (SR-NASD-96-17) be, and hereby 
is approved.

    \11\ 15 U.S.C. 78s(b)(2) (1988).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\12\
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    \12\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-19469 Filed 7-30-96; 8:45 am]
BILLING CODE 8010-01-M