[Federal Register Volume 61, Number 167 (Tuesday, August 27, 1996)]
[Notices]
[Pages 44100-44116]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-21757]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-37588; File No. SR-NASD-95-39]
Self-Regulatory Organizations; National Association of Securities
Dealers, Inc; Order Granting Approval to Proposed Rule Change and
Notice of Filing and Order Granting Accelerated Approval to Amendment
Nos. 4 and 5 to Proposed Rule Change Relating to Application of the
Rules of Fair Practice to Transactions in Exempted Securities (Except
Municipals) and an Interpretation of Its Suitability Rule
August 20, 1996.
I. Introduction
On September 18, 1995, 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 apply the
Association's Rules of Fair Practice to transactions in exempted
securities, other than municipals, and to adopt an interpretation of
the Association's suitability rule as it applies to institutional
customers.\3\ The NASD filed Amendment No. 1 to the proposed rule
change on October 17, 1995, Amendment No. 2 on January 22, 1996, and
Amendment No. 3 on February 15, 1996.
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\1\ 15 U.S.C. Section 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ The proposed rule change (i) Amends Article I, Section 4 and
5 of the Rules of Fair Practice to apply 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 all securities,
except municipals; (ii) merges the NASD's Government Securities
Rules, where applicable, into the Rules of Fair Practice, (iii)
makes clarifying amendments to certain sections and Interpretations
under Articles III and IV of the Rules of Fair Practice relating to
the government securities business; (iv) amends certain Rules of
Fair Practice and Board Interpretations to exempt transactions in
government securities; (v) amends Article III, Section 2 of the
Rules of Fair Practice by amendment to Subsection 2(b) and adoption
of an Interpretation of the Board of Governors--Suitability
Obligations to Institutional Customers; (vi) makes technical changes
to NASD By-Laws, Schedules to the By-Laws, the Rules of Fair
Practice and the Code of Procedure to replace references to
provisions of the Government Securities Rules with references to the
appropriate Rules of Fair Practice, and to delete the terms
``exempted security'' or ``exempted securities,'' or, replace these
terms with the term ``municipal securities,'' as applicable; and
(vii) modifies references to SEC Rules 15c3-1 and 15c3-3 to reflect
SEC amendments to those rules.
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The proposed rule change and Amendment No. 1 were published for
comment in Securities Exchange Act Release No. 36383 (Oct. 17, 1995),
60 FR 54530 (Oct. 24, 1995). Amendment No. 2 was replaced by Amendment
No. 3 before publication.\4\ Amendment No. 3 was published for comment
in Securities Exchange Act Release No. 36973 (Mar. 14, 1996), 61 FR
11655 (Mar. 21, 1996). On July 22, 1996 and August 14, 1996, the NASD
filed Amendment Nos. 4 and 5, respectively, to the proposed rule
change.\5\ This order permanently approves the proposed rule change, as
amended, and Amendment Nos. 4 and 5 on an accelerated basis.
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\4\ Amendment No. 2 responded to some of the comments received
on the original proposed rule change. Amendment No. 3 expanded upon
the discussion contained in Amendment No. 2 by including responses
to nine comment letters received on the original proposed rule
change. Amendment No. 3 to SR-NASD-95-39 completely replaced and
superseded 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. The Commission received seven
additional comment letters after the publication of Amendment No. 3.
\5\ See Letter from Joan C. Conley, Secretary, NASD, to
Katherine A. England, Assistant Director, Division of Market
Regulation, SEC, dated July 22, 1996. Pursuant to an NASD rule
proposal that became effective in May 1996, the NASD Manual has been
reorganized to make it easier to use. See Securities Exchange Act
Release No. 36698 (Jan. 11, 1996) (Rules that were formerly
organized under the ``Rules of Fair Practice'' generally are grouped
under the NASD's Conduct Rules at Rules 2000-3000). Amendment No. 4
provides the new numbering of those provisions of the NASD Manual
that are being affected by this rule proposal. A conversion chart is
attached to this order as Exhibit 1. Moreover, Amendment No. 4
proposes to apply Section 50, Article III of the Rules of Fair
Practice to transactions in exempted securities (except municipals).
The NASD states that Section 50, Article III, which requires NASD
members to report to the NASD the occurrence of certain specified
events and quarterly summary statistics concerning customer
complaints, would be applicable to exempted securities (except
municipals). See Letter from John A. Ramsay, Deputy General Counsel,
to Katherine A. England, Assistant Director, Division of Market
Regulation, SEC, dated August 14, 1996 (``Amendment No. 5''). In
Amendment No. 5, the NASD notes that actions for conduct violating
``Fair Prices and Commissions'' of Article III, Section 4, and the
Mark-Up Policy may be brought under Article III, Section 1,
requiring members to adhere to just and equitable principles of
trade.
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II. Background
The Government Securities Act Amendments of 1993 (``GSAA'')
eliminated the statutory limitations on the NASD's authority to apply
sales practice rules to transactions in exempted securities, including
government securities, other than municipals.\6\ To implement the
expanded sales practice authority granted to the NASD pursuant to the
GSAA, the Association has proposed to delete the NASD Government
Securities Rules and apply the NASD Rules of Fair Practice, where
applicable, to exempted securities, including government securities,
other than municipals.\7\
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\6\ Government Securities Act Amendments of 1993, Pub. L. No.
103-202, Sec. 1(a), 107 Stat. 2344 (1993).
\7\ The terms ``exempted securities,'' ``government securities''
and ``municipal securities'' are defined in Sections 3(a)(12),
3(a)(42) and 3(a)(29) of the Act respectfully.
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Concurrently, the NASD has proposed an interpretation of its
suitability rule as it applies to members' dealings with institutional
customers (``Suitability Interpretation'' or ``Interpretation''). The
Interpretation would apply to all securities, except municipals, the
purchase or sale of which is recommended by a broker-dealer. A draft of
the proposed suitability interpretation contained in this proposed rule
change was first published for comment in NASD Notice to Members 94-62
(August 1994) (``NTM 94-62'').\8\ In response to this solicitation of
comments, the NASD received 15 comment letters.\9\ The
[[Page 44101]]
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'').\10\ Sixteen comments were received in
response thereto.\11\ Thereafter, the NASD filed a proposed
interpretation with the Commission.
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\8\ A copy of the NTM 94-62 is included in File No. SR-NASD-95-
39 as Exhibit 2 thereto.
\9\ The NASD received letters regarding NTM 94-62 from the
following: (1) Brian C. Underwood, Director of Compliance, A.G.
Edwards & Sons, Inc., dated September 29, 1994; (2) Alan S. Kramer,
Senior Managing Director, Bear Stearns & Co. Inc., dated October 17,
1994; (3) Marjorie E. Gross, Senior Vice President & Associate
General Counsel, Chemical Bank, dated September 29, 1994; (4)
Marjorie E. Gross, Senior Vice President & Associate General
Counsel, Chemical Bank, dated October 14, 1994; (5) F. Smith,
President, Freeman Securities Company, Inc., dated September 30,
1994; (6) Wendy R. Beer, Compliance Counsel, Furman Selz, dated
October 31, 1994; (7) Betsy Dotson, Assistant Director, Federal
Liaison Center, Government Finance Officers Association, dated
September 30, 1994; (8) Kathryn S. Reimann, Senior Vice President
and Director of Fixed Income Compliance, Lehman Brothers Inc., dated
October 17, 1994; (9) Larry Forrester, Senior Vice President, Lyn-
Hayes Financial, Inc., dated August 23, 1994; (10) Marguerite C.
Willenbucher, Vice President and Senior Counsel, Debt and Equity
Markets Group, Merrill Lynch, Pierce, Fenner & Smith Inc., dated
October 17, 1994; (11) Ken DeRegt, Managing Director, Morgan Stanley
& Co. Incorporated, dated October 14, 1994; (12) Prudential
Insurance Company of America, dated October 31, 1994; (13) Marianna
Maffucci, Senior Vice President and General Counsel, Public
Securities Association, dated October 17, 1994; (14) William A.
McIntosh, Managing Director and Co-Head of U.S. Fixed Income,
Salomon Brothers Inc., dated September 30, 1994; and (15) Robert F.
Price, Chairman, Federal Regulation Committee, and Mark T.
Commander, Chairman, Self-Regulation and Supervisory Practice
Committee, Securities Industry Association, dated October 17, 1994.
A copy of each comment letter listed above is included in File No.
SR-NASD-95-39 as Exhibit 3 thereto. These letters are discussed in
Securities Exchange Act Release No. 36383 (Oct. 17, 1995), 60 FR
54530 (Oct. 24, 1995) (notice of proposed rule change for File No.
SR-NASD-95-39).
\10\ A copy of NTM 95-21 is included in File No. SR-NASD-95-39
as Exhibit 4 thereto.
\11\ The NASD received letters regarding NTM 95-21 from the
following: (1) Allen Weintraub, Chairman and Chief Executive
Officer, The Advest Group, Inc., dated May 5, 1995; (2) Brian C.
Underwood, Director of Compliance, A.G. Edwards & Sons, Inc., dated
May 15, 1995; (3) Michael S. Caccese, Esq., Senior Vice President,
General Counsel, and Secretary, Association for Investment
Management and Research; (4) Marjorie E. Gross, Senior Vice
President & Associate General Counsel, Chemical Bank, dated May 17,
1995; (5) Michael J. Wilk, Managing Director, Comerica Securities,
dated May 12, 1995; (6) Douglas E. Harris, Senior Deputy Comptroller
for Capital Markets, Comptroller of the Currency, dated May 17,
1995; (7) Lawrence Jacob, Senior Vice President, Assistant Secretary
and Director of Compliance, Daiwa Securities America Inc., dated May
16, 1995; (8) James A. Brickley, President and CEO, Federal Farm
Credit Banks Funding Corp., dated May 17, 1995; (9) Mitchell Delk,
Vice President Government and Industry Relations, Freddie Mac, dated
June 1, 1995; (10) Betsy Dotson, Assistant Director, Federal Liaison
Center, Government Finance Officers Association, dated May 17, 1995;
(11) Matthew Lee, Executive Director, Inner City Press/Community on
the Move, dated May 15, 1995; (12) Matthew Elderfield, Assistant
Director, London Investment Banking Association, dated June 13,
1995; (13) Linda D. Edwards, Vice President Compliance, Llama
Company, dated May 9, 1995; (14) Scott H. Rockoff, Managing
Director, Director of Compliance, and Assistant General Counsel,
Nomura Securities International, Inc., dated May 17, 1995; (15)
Robert D. McKnew, Chairman, Public Securities Association, dated May
18, 1995; and (16) Robert F. Price, Chairman Federal Regulation
Committee, Richard O. Scribner, Chairman, Self-Regulation and
Supervisory Practices Committee, and Zachary Snow, Chairman OTC
Derivative Products Committee, Securities Industry Association,
dated June 7, 1995. A copy of each comment letter listed above is
included in File No. SR-NASD-95-39 as Exhibit 5 thereto. These
letters are discussed in Securities Exchange Act Release No. 36383,
supra note 9 (notice of proposed rule change for File No. SR-NASD-
95-39).
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III. Description
A. Application of the Rules of Fair Practice to Exempted Securities
Except Municipals and Merger of Government Securities Rules
As shown in Table 1 below, the proposed rule change merges certain
provisions of the current Government Securities Rules into the Rules of
Fair Practice. The proposed rule change also applies certain of the
NASD Rules of Fair Practice to exempted securities (except municipals)
for the first time. Table 2 below indicates the Rules of Fair Practice
that will be applicable to exempted securities (except municipals).
Amendments Merging Government Securities Rules into Rules of Fair
Practice
The NASD proposes to merge certain provisions contained solely
under the Government Securities Rules into corresponding sections of
the Rules of Fair Practice to provide NASD members with one set of
sales practice rules that will reflect the NASD's expanded authority
under the GSAA. Specifically, the NASD proposes to add provisions of
the Government Securities Rules into Article III, Section 21(c)(3), 38,
and 39; Article IV, Sections 1 to 4; and Article V, Section 1 of the
Rules of Fair Practice. The NASD also proposes to move provisions
contained in Section 6 of the Government Securities Rules into new
Section 38A of Article III of the Rules of Fair Practice. To effect
these amendments, the NASD has reorganized and renumbered many of the
provisions contained in the above-referenced sections of the Rules of
Fair Practice.
Table 1 identifies the provisions of the Government Securities
Rules and the corresponding provisions of the Rules of Fair Practice
into which the Government Securities Rules will be merged. In addition,
Table 1 indicates the corresponding section of the Rules of Fair
Practice for each Government Securities Rule where no rule language
change is necessary because of expanded authority under Article I,
Section 5 of the Rules of Fair Practice.\12\
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\12\ The NASD proposes to amend Article I, Section 5(a) of the
Rules of Fair Practice by deleting the phrase ``other than those
members registered with the Securities and Exchange Commission
solely under the provisions of Section 15C of the Act and persons
associated with such members'' to expand the application of the
Rules of Fair Practice to members involved in the government
securities business pursuant to Section 1 15C of the Act.
Table 1.--Government Securities Rules Merged Into Rules of Fair Practice
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Sec. 1. Adoption of Rules.............. Article I, Sec. 1--No change.
Sec. 2. Applicability:
Subsection (a)..................... Article I, Sec. 4 and 5(a).
Subsection (b)..................... Article I, Sec. 5 (b) and (c)--
No change.
Sec. 3. Definitions in By-Laws and Article II, Sec. 1 and 2--No
Rules of Fair Practice. change.
Sec. 4. Books and Records.............. Article III, Sec. 21.
Sec. 5. Supervision.................... Article III, Sec. 27--No
change.
Sec. 6. Regulation of Activities of Article III, Sec. 38 and 38A.
Members Experiencing Financial and/or
Operational Difficulties.
Explanation of Board of Governors-- Explanation of Board of
Restrictions on a Member's Governors Restrictions on a
Activity. Member's Activity--Article
III, Sec. 38 and 38A.
Sec. 7. Approval of Change in Exempt Article III, Sec. 39.
Status under SEC Rule 15c3-3.
Sec. 8. Communications with the Public. Article III, Sec. 35--No
change.
Sec. 9. Availability to Customers of Article IV, Sec. 1--No change.
Certificate, By-Laws, Rules, and Code
of Procedure.
Sec. 10. Complaints:
Subsection (a) Complaints by Public Article IV, Sec. 2.
Against Members.
[[Page 44102]]
Subsection (b) Complaints by Article IV, Sec. 3.
District Business Conduct
Committees.
Subsection (c) Complaints by the Article IV, Sec. 4.
Board of Governors.
Sec. 11. Reports and Inspection of Article IV, Sec. 5--No change.
Books for Purpose of Investigating
Complaints.
Resolution of Board of Governors-- Resolution of Board of
Suspension of Members for Failure Governors--Suspension of
to Furnish Information Duly Members for Failure to Furnish
Requested. Information Duly Requested--No
change
Sec. 12. Sanctions for Violation of the Article V, Sec. 1.
Rules.
Sec. 13. Payment of Fines or Costs..... Article V, Sec. 2--No change.
Sec. 14. Cost of Proceedings........... Article V, Sec. 3--No change.
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Application of NASD Rules of Fair Practice to Government Securities
As indicated in Table 2 below, certain provisions of the Rules of
Fair Practice will not be immediately applicable to transactions in
government securities. The NASD intends to review the application of
these rules to the government securities market.
Front Running. Currently, the NASD Front Running Interpretation
\13\ applies only to equity securities. The NASD believes, however,
that the member conduct prohibited by the Front Running Interpretation
may occur under certain circumstances in the government securities
market, and will review the application of the Front Running
Interpretation to the government securities market.\14\ In the interim,
the NASD believes that actions for similar front running conduct
occurring in the government securities market may be brought under
Article III, Section 1 of the Rules of Fair Practice.\15\
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\13\ Interpretation of the Board of Governors at paragraph
2151.08.
\14\ Securities Exchange Act Release No. 36973 (Mar. 14, 1996),
61 FR 11655 (Mar. 21, 1996).
\15\ Id.
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Trading ahead of customer limit orders \16\ and trading ahead of
research reports,\17\ also are currently 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 market and intends to review the application of
these Interpretations to the government securities market. The NASD
also believes that actions for similar conduct occurring in the
government securities market may be brought under Article III, Section
1 of the Rules of Fair Practice.
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\16\ Interpretation of the Board of Governors at paragraph
2151.07.
\17\ Interpretation of the Board of Governors at paragraph
2151.09.
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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. The NASD currently is considering whether it
is appropriate to 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. The NASD intends
to file separately a proposed rule change concerning this issue.\18\
Section 35A(b) of the Rules of Fair Practice requires the registration
of such a Principal to approve certain options advertisements, sales
materials and other literature for government securities options
transactions. The NASD has determined that Article III, Section 35A(b)
will not be applicable to options advertisements, sales materials and
other literature for government securities options transactions during
the interim period when the NASD is reviewing the registration issue.
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\18\ Securities Exchange Act Release No. 36973, supra note 14.
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Customer Account Statements. The proposed rule change would phase-
in the implementation of Article III, Sections 21, 27, 32, and 45 of
the Rules of Fair Practice to dealers in government securities within
three months of the effective date of the rule change. The NASD
believes that the phase-in is necessary to provide members with
sufficient time to change their internal procedures to comply with
these rules.
Table 2.--Applicability of the Rules of Fair Practice to Exempted
Securities, Including Government Securities (Except Municipals)
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ARTICLE III
Section 1:
Business Conduct of Members... Applicable.
Interpretations of the Board
of Governors:
Execution of Retail Applicable.
Transactions in the Over-
the Counter Market.
Prompt Receipt and Not Applicable.
Delivery.
Forwarding of Proxy and Not Applicable.
Other materials.
Free-Riding and Amending to be Not Applicable.
Withholding.
Interpretation on Limit Not Applicable.
Order Protection.
Front Running Policy...... Not Applicable.
Trading Ahead of Research Not Applicable.\1\
Reports.
Section 2:
Recommendations to Customers.. Applicable.
Policy of the Board of Applicable.
Governors--Fair Dealing With
Customers Policy.
[[Page 44103]]
Section 3:
Charges to Customer........... Applicable.
Section 4:
Fair Prices and Commissions... Applicable.\2\
Interpretation of the Board of Applicable.\3\
Governors--NASD Mark-Up
Policy.
Section 5:
Publication of Transactions Applicable.
and 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 Applicable only to traditional
Selling Agreements. underwriter 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.\4\
Section 17:
Solicitation of Purchases on Applicable.
an 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:
Transaction for or by Applicable.
Associated Persons.
Section 29:
Variable Contracts of an Not Applicable.
Insurance Co..
Section 30:
Margin Accounts............... Applicable.
Section 31:
Securities Failed to Receive Not Applicable.
and Failed to Deliver.
Section 32:
Fidelity Bonds................ Applicable.
Section 33:
Options....................... Not Applicable.
[[Page 44104]]
Section 34:
Direct Participation Programs Not Applicable.
Appendix F.
Section 35:
Communications With the Public Applicable.
Section 35A:
Options Communications With Not Applicable/Under Review.
the Public.
Section 36:
Transactions with Related Not Applicable.
Persons.
Interpretation of the Board of Not Applicable.
Governors--Transactions With
Related Persons.
Section 37:
[Reserved] \5\ ....................................
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 Applicable.
Transactions.
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.
Section 50:
Reporting Requirements........ Applicable.\6\
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ARTICLE IV
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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 Applicable.
Business Conduct Committee.
Section 4:
Complaints by Board of Applicable.
Governors.
Section 5:
Reports and Inspection of Applicable.
Books for Purpose of
Investigating Complaints.
------------------------------------------------------------------------
ARTICLE V
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Section 1:
Sanctions for Violations of Applicable.
Rules.
Interpretation of the Board of
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.
Section 2:
Payment for Fines, Other Applicable.
Monetary Sanctions, or Costs.
Section 3:
Costs of Proceedings.......... Applicable.
------------------------------------------------------------------------
\1\ As noted previously, the NASD will review the application of this
Interpretation to the government securities market.
\2\ Amendment No. 5 states that the NASD may bring action for conduct
violating Article III, Section 4 (``Fair Prices and Commissions'')
under its just and equitable principles of trade rule. See Amendment
No. 5, supra note 5.
\3\ 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 exempted 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 exempted securities until adoption of an
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). In
Amendment No. 5, the NASD clarifies that it may bring action for
conduct violating the Mark-Up Policy under its just and equitable
principles of trade rule. See Amendment No. 5, supra note 5.
[[Page 44105]]
\4\ The NASD has indicated that it will review the application of this
Interpretation to the government securities market.
\5\ In Amendment No. 4, the NASD indicated that the reference to Section
37 in Amendment No. 3 was in error because the Commission approved the
NASD's deletion of this section on March 8, 1994. See Amendment No. 4,
supra note 5.
\6\ In Amendment No. 4, the NASD proposed that the Reporting
Requirements be applicable to exempted securities (except municipals).
The NASD noted that Section 50, Article III was approved by the
Commission on September 8, 1995. See Amendment No. 4, supra note 5.
B. Suitability Interpretation--Description of the Proposal
The NASD is proposing to adopt an interpretation of the Board of
Governors--Suitability Obligations to Institutional Customers under
Article III, Section 2 of the Rules of Fair Practice. The NASD intends
the proposed Suitability Interpretation to clarify that the NASD's
suitability rule under Article III, Section 2(a) of the Rules of Fair
Practice is applicable to institutional customers, while recognizing
that generally, a member's relationship with an institutional customer
is different from the member's relationship with retail customers.
The proposed Suitability Interpretation states that 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 under the Suitability Interpretation
include having a reasonable basis for recommending a particular
security or strategy, as well as reasonable grounds for believing that
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.
In its proposal filed with the Commission, the NASD states that the
Suitability Interpretation is intended to provide guidance to members
in fulfilling their customer-specific suitability obligations, i.e.,
the manner in which a member determines that a recommendation is
suitable for a particular customer.\19\ The manner in which a member
fulfills this suitability obligation will vary depending on the
customer and the specific transaction. The NASD further states that the
proposed Suitability Interpretation and the factors contained therein
are not intended either to create a safe harbor for members or a
burdensome evidentiary checklist.
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\19\ 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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The proposed Suitability Interpretation states that the two most
important considerations in determining the scope of a member's
suitability obligations in making recommendations to an institutional
customer are the customer's capability to evaluate investment risk
independently, and the extent to which the customer is exercising
independent judgment in evaluating a member's recommendation. Thus,
under the proposed Interpretation, a member must determine, based on
information available to it, the customer's capability to evaluate
investment risk. In some cases, the member may conclude that the
customer is not capable of making independent investment decisions in
general. In other cases, the institutional customer may have general
capability, but may not be able to understand a particular type of
instrument or its risk. The NASD states that if a customer is either
generally not capable of evaluating investment risk or lacks sufficient
capability to evaluate the particular product, the scope of the
member's obligation under the suitability rule would not be diminished
by the fact that the member was dealing with an institutional
customer.\20\
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\20\ The NASD also states that a customer who initially needed
help understanding a potential investment may ultimately develop an
understanding and make an independent investment decision.
---------------------------------------------------------------------------
Members also must make a determination regarding whether the
customer is exercising independent judgment in its investment decision,
that is, whether the customer's investment decision will be based on
its own independent assessment of the opportunities and risks presented
by a potential investment, market factors and other investment
considerations. The proposed Suitability Interpretation states that a
member's determination that a customer is making independent investment
decisions will depend on the nature of the relationship that exists
between the member and customer.
A member's determination of a customer's capability to evaluate
investment risk independently will depend on an examination of the
customer's capability to make its own investment decisions, including
the resources available to the customer to make informed decisions. The
NASD specified several factors relevant to making such a determination.
These considerations include: (1) the use of one or more consultants,
investment advisers or bank trust departments; (2) the general level of
experience of the institutional customer in financial markets and
specific experience with the type of instruments under consideration;
(3) the customer's ability to understand the economic features of the
security involved; (4) the customer's ability to independently evaluate
how market developments would affect the security; and (5) the
complexity of the security or securities involved.
With respect to the determination that a customer is making
independent investment decisions, the NASD proposed several relevant
factors. These considerations include: (1) 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; (2) the presence or absence
of a pattern of acceptance of the member's recommendations; (3) 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 (4) 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.
The NASD states that the factors contained in the proposed
Suitability Interpretation are merely guidelines that will be utilized
to determine whether a member has fulfilled its suitability obligations
with respect to a specific institutional customer transaction. The
inclusion or absence of any of the factors is not dispositive of the
determination of suitability. Such a determination can only be made on
a case-by-case basis taking into consideration all the facts and
circumstances of a particular member/customer relationship, assessed in
the context of a particular transaction.
The NASD states that it is important to clarify when a member may
consider its suitability obligations fulfilled pursuant to the
guidelines provided by the proposed Suitability Interpretation.
Therefore, the proposed Suitability Interpretation provides that where
the broker-dealer has reasonable grounds for concluding that the
institutional customer is making independent
[[Page 44106]]
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.\21\
---------------------------------------------------------------------------
\21\ See supra note 19.
---------------------------------------------------------------------------
Finally, for purposes of the proposed Suitability Interpretation,
the NASD states that the term ``institutional customer'' should not be
arbitrarily defined by referencing a threshold institutional asset size
or portfolio size or various statutory designations. Rather, the NASD
states that for purposes of the Suitability Interpretation, an
institutional customer shall be any entity other than a natural person.
The NASD states that it believes the Interpretation is more
appropriately applicable to an entity having at least $10 million
invested in securities in the aggregate in its portfolio or under
management.
IV. Summary of Comments
The Commission received 16 comment letters from a total of 13
commenters.\22\ Most of the comment letters addressed the proposed
Suitability Interpretation of the rule proposal. The NASD responded to
most of the comment letters in Amendment No. 3.
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\22\ The Commission received letters from the following: (1)
Brian C. Underwood, Vice President-Director of Compliance, A.G.
Edwards & Sons, Inc., to Jonathan G. Katz, Secretary, SEC, dated
November 14, 1995 (``Edwards Letter''); (2) David J. Master,
Chairman and CEO, Coastal Securities Ltd., to Jonathan G. Katz,
Secretary, SEC, dated November 28, 1995 (``Coastal Letter''); (3)
Betsy Dotson, Assistant Director, Federal Liaison Center, Government
Finance Officers Association, to Jonathan G. Katz, Secretary, SEC,
dated November 14, 1995 (``GFOA Letter No. 1''); (4) Thomas M.
Selman, Associate Counsel, Investment Company Institute, to Jonathan
G. Katz, Secretary, SEC, dated November 14, 1995 (``ICI Letter'');
(5) Jane D. Carlin, Principal and Counsel, Morgan Stanely & Co.
Incorporated, to Jonathan G. Katz, Secretary, SEC, dated December 5,
1995 (``Morgan Stanley Letter''); (6) Paul Saltzman, Senior Vice
President and General Counsel, Public Securities Association, to
Jonathan G. Katz, Secretary, SEC, dated November 30, 1995 (``PSA
Letter No. 1''); (7) Scott H. Rockoff, Managing Director, Director
of Compliance, and Assistant General Counsel, Nomura Securities
International, Inc., to Jonathan G. Katz, Secretary, SEC, dated
December 14, 1995 (``Nomura Letter''); (8) Robert F. Price,
Chairman, Federal Regulation Committee, and Zachary Snow, Chairman,
OTC Derivatives Products Committee, Securities Industry Association,
to Jonathan G. Katz, Secretary, SEC, dated December 17, 1995 (``SIA
Letter No. 1''); (9) David Rosenau, President, The Winstar
Government Securities Company L.P., to Jonathan G. Katz, Secretary,
SEC, dated December 27, 1995 (``Winstar Letter''); (10) Steven Alan
Bennett, Senior Vice President and General Counsel, Banc One
Corporation, to Jonathan G. Katz, Secretary, SEC, dated April 16,
1996 (``Banc One Letter''); (11) Betsy Dotson, Assistant Director/
Legislative Counsel, Federal Liaison Center, Government Finance
Officers Association, to Jonathan G. Katz, Secretary, SEC, dated
April 22, 1996 (``GFOA Letter No. 2''); (12) Paul Saltzman, Senior
Vice President and General Counsel, Public Securities Association,
to Jonathan G. Katz, Secretary, SEC, dated April 22, 1996 (``PSA
Letter No. 2''); (13) Marshall Bennett, President, National
Association of State Auditors, Comptrollers and Treasurers, to
Secretary, SEC, dated April 22, 1996 (``NASACT Letter''); (14) C.
Evan Stewart, Chairman, Federal Regulation Committee, Zachary Snow,
Chairman, OTC Derivatives Products Committee, and Richard O.
Scribner, Chairman, Self-Regulation and Supervisory Practices
Committee, Securities Industry Association, to Jonathan G. Katz,
Secretary, SEC, dated April 23, 1996 (``SIA Letter No. 2''); (15)
Sarah A. Miller, General Counsel, American Bankers Association and
the American Bankers Association Securities Association to Jonathan
G. Katz, Secretary, SEC, dated April 24, 1996 (``ABA Letter''); and
(16) William R. Rothe, Chairman, and John L. Watson III, President,
Security Traders Association, to Jonathan G. Katz, Secretary, SEC,
dated April 29, 1996 (``STA Letter'').
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A. Application of the Rules of Fair Practice to Government Securities
1. Prompt Receipt and Delivery Interpretation
One commenter requested that the ``long sale'' provisions of the
Prompt Receipt and Delivery Interpretation,\23\ which would require a
member to make affirmative determinations regarding whether a customer
is ``long'' the security at the time the dealer is purchasing a
government security from a customer, prior to accepting a long sale
from any customer, not apply to transactions in government
securities.\24\ This commenter argued that an affirmative determination
requirement is contrary to the practice in the government securities
market that permits a customer to sell a security to a dealer and then
cover that sale with a subsequent purchase or repurchase transaction in
the ``specials market.'' The commenter noted that this practice has
been recognized by the Board of Governors of the Federal Reserve
System. In response to this comment, the NASD amended its proposal to
exempt government securities from the long sales requirements.\25\
---------------------------------------------------------------------------
\23\See Article III, Section 1 of the Rules of Fair Practice.
\24\ See PSA Letter No. 1, supra note 22.
\25\ See Securities Exchange Act Release No. 36973, supra note
14, at 9.
---------------------------------------------------------------------------
2. Best Execution Interpretation
One commenter had reservations about the application of the ``best
execution'' concept to government securities that are executed on a
principal basis at a ``net price.''\26\ Two commenters noted that
members would have difficulty complying with the procedural
requirements of the best execution concept because the government
securities market lacks systems similar to the Consolidated Quotation
System (``CQS'') and the Intermarket Trading System (``ITS'').\27\ The
NASD responded that it believes the general concept of the Best
Execution Interpretation (e.g., that a member should seek in executing
customer transactions to obtain the best price for the customer) \28\
should apply to the government securities market, just as it applies to
all other markets subject to the NASD's jurisdiction.\29\ The NASD
stated that it would further consider whether an amendment to the Best
Execution Interpretation is necessary to clarify its position as it
applies to government securities, but it considered such an amendment
unnecessary at this time.
---------------------------------------------------------------------------
\26\ See PSA Letter No. 1, supra note 22.
\27\ See PSA Letter No. 1 and Winstar Letter, supra note 22.
\28\ See Article III, Section 1 of the Rules of Fair Practice.
\29\ See Securities Exchange Act Release No. 36973, supra note
14, at 11.
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3. Front Running Policy
One commenter sought clarification on whether and how the front
running interpretation would apply to government securities brokers and
dealers.\30\ The commenter noted that the interpretation was designed
for the equity securities. In response, the NASD noted that its front
running interpretation was designed for the equity securities markets
and, accordingly, amended its proposal so that the front running
interpretation would not apply to the government securities market.\31\
The NASD, however, stated that because the member conduct probihited by
the front running interpretation may occur in the government securities
market under certain circumstances, it will review the application of
the front running interpretation to this market. In the interim, the
NASD reminded members that actions for front running conduct occurring
in the government securities market may be brought under Article III,
Section 1 of the Rules of Fair Practice.\32\
---------------------------------------------------------------------------
\30\ See PSA Letter No. 1, supra note 22.
\31\ See Securities Exchange Act Release No. 36973, supra note
14, at 12.
\32\ Similarly, the NASD noted that the Interpretation of the
Board of the Governors 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 to equity
securities. The NASD stated that it intends to review the
application of these Interpretations to the government securities
market because it believes that the conduct addressed by these
Interpretations may occur under certain circumstances in the
government securities market.
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[[Page 44107]]
4. Article III, Section 23 of the Rules of Fair Practice
One commenter sought clarification on the effect of the provision
``Net Prices to Persons Not in Investment Banking or Securities
Business'' on government securities transactions.\33\ In response, the
NASD 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.\34\ The NASD amended the proposal to reflect this change.
---------------------------------------------------------------------------
\33\ See PSA Letter No. 1, supra note 22.
\34\ See Securities Exchange Act Release No. 36973, supra note
14, at 14.
---------------------------------------------------------------------------
5. Article III, Section 35A of the Rules of Fair Practice/Schedule C to
the By-Laws
One commenter requested clarification as to whether the proposed
rule change would require a government securities broker or dealer to
register an associated person as its ``Compliance Registered Options
Principal'' under Part II, Section 2(f) of Schedule C to comply with
Section 35A(b) of the Rules of Fair Practice, which requires the
registration of such a Principal to approve certain options
advertisements, sales materials, and other literature for government
securities options transactions.\35\ In response, the NASD stated that
it is currently reviewing the issue of whether a ``Compliance
Registered Options Principal'' should be required for members that
trade options on government securities. The NASD further noted that it
intends to file a proposed rule change regarding this registration
issue and, therefore, the NASD amended to Applicability Table to
indicate that Article III, Section 35A(b) is ``Not Applicable/Under
Review.'' \36\
---------------------------------------------------------------------------
\35\ See PSA Letter, No. 1, supra note 22.
\36\ 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. See Securities Exchange Act Release No. 36973, supra
note 14, at 15.
---------------------------------------------------------------------------
6. Customer Account Statements
One commenter suggested that the implementation of Article III,
Section 45 (``Customer Account Statements'') be delayed for three
months after the effective date of the rule change to give affected
members sufficient time to set up appropriate procedures to comply with
the requirements of Section 45.\37\ The NASD agreed and amended the
proposal.\38\
---------------------------------------------------------------------------
\37\ See PSA Letter No. 1, supra note 22.
\38\ See Securities Exchange Act Release No. 36973, supra note
14, at 16.
---------------------------------------------------------------------------
B. Suitability Obligations to Institutional Customers
1. General Comments
Most of the commenters agreed with the general principles expressed
in the Suitability Interpretation, although some commenters disagreed
on the proper allocation of responsibility between members and
institutional customers for investment making decisions.\39\ Two
commenters did not support the proposal.\40\ One commenter believed
that the proposal would create both greater confusion and uncertainty
and additional duties for NASD members with respect to institutional
accounts.\41\ The other commenter believed that the proposal would
impose unnecessary regulatory burdens on members.\42\
---------------------------------------------------------------------------
\39\ See Coastal Letter, GFOA Letter No. 1, PSA Letter Nos. 1
and 2, SIA Letter Nos. 1 and 2, Banc One Letter, NASACT Letter, STA
Letter, and Morgan Stanley Letter, supra note 22.
\40\ See Nomura Letter and ABA Letter, supra note 22.
\41\ See Nomura Letter, sura note 22.
\42\ See ABA Letter, supra note 22.
---------------------------------------------------------------------------
One commenter believed that the proposal would create confusion
because it does not define the terms ``recommendation'' and
``institutional investor.'' \43\ The NASD responded that neither term
lent itself to definition. First, it noted that Article III, Section 2
of the Rules of Fair Practice has been applicable to members'
recommendations since the inception of the NASD and a significant
amount of case law has developed from NASD disciplinary actions with
respect to this provision.\44\ The NASD further 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.
Second, the NASD believes that an objective definition of
``institutional investor'' would arbitrarily discriminate between
institutional investors based on factors such as asset size, portfolio
size or institutional type. The NASD stated that the proposed
Suitability Interpretation would provide guidance to members on
relevant considerations that should be examined by a member in
fulfilling its suitability obligations to all institutional customers
and would not unfairly discriminate between institutional customers
based on such factors.\45\
---------------------------------------------------------------------------
\43\ See Nomura Letter, supra note 22.
\44\ See Securities Exchange Act Release No. 36973, supra note
14, at 39-40.
\45\ See id. at 39.
---------------------------------------------------------------------------
2. Considerations in Determining the Scope of a Member's Suitability
Obligations in Making Recommendations to an Institutional Customer
Several commenters had concerns about the specific guidelines
included in the proposal that the NASD stated could be used by a member
in determining the scope of the member's suitability obligations.
(i) Member Determination Regarding the Institutional Customer's
Capability to Evaluate Investment Risk Independently
One commenter asserted that the relevance of the customer's use of
consultants, investment advisers or a bank trust department would
depend on the extent of the use of the outside advice and what, if any,
contractual arrangement exists between the customer and the outside
adviser.\46\ This commenter questioned whether outside managers of
investment pools and trustees would fall within this guideline. In
response, the NASD agreed that the relevance of a customer's use of
professional advisers would depend on the extent of the use of such
outside advice.\47\ Moreover, the NASD believes that the proposed
Suitability Interpretation would apply to any delegated agents of the
customer, including outside managers for investment pools, trustees,
and other agents.\48\
---------------------------------------------------------------------------
\46\ See GFOA Letter No. 1, supra note 22.
\47\ See Securities Exchange Act Release No. 36973, supra note
14, at 26.
\48\ In fact, the Suitability Interpretation specifically states
that where a customer has delegated decision-making authority to an
agent, such as an investment adviser or a bank trust department, the
Interpretation shall be applied to the agent.
---------------------------------------------------------------------------
One commenter stated that the usefulness of the customer's general
level of experience in the financial markets and with the type of
instruments under consideration would depend not only on the expertise
of the customer's staff but also on the nature of the changing
markets.\49\ This commenter also argued that the relevance of a
customer's ability to understand economic features of a security would
depend on the nature of information provided to the investor by the
NASD member about the features of a specific instrument. The commenter
further contended that a customer's track record in making investment
decisions or an affirmative statement by the customer that it has the
ability to
[[Page 44108]]
evaluate independently the effect of the market on a security, are not
reliable indicators of a customer's ability to independently evaluate
the effects of the market on the security. The NASD agreed that the
relevance of the factors listed in the proposed Suitability
Interpretation would vary depending on numerous circumstances.\50\ The
NASD also noted its belief that a customer's track record and an
affirmative statement by the customer regarding its capability are
helpful, but not dispositive, factors pertaining to the customer's
capability to evaluate investment risk dependently.
---------------------------------------------------------------------------
\49\ See GFOA Letter No. 1, supra note 22.
\50\ See Securities Exchange Act Release No. 36973, supra note
14, at 27.
---------------------------------------------------------------------------
One commenter suggested three additional factors that should be
considered by a member in determining whether an institutional customer
has the capability to evaluate investment risk independently: (1)
whether the customer is engaged in either the financial industry or the
business of managing its or others' investments, (2) whether the
customer has in-house investment professionals charged with
responsibility for recommending or making investment decisions on
behalf of the customer, and (3) whether the customer independently
adopted investment guidelines and whether the customer provides
explicit investment guidelines to the member broker-dealer.\51\ In
response, the NASD acknowledged that additional factors may be valuable
to members in considering whether an institutional customer is capable
of evaluating investment risk independently or may be pertinent to a
specific situation.\52\
---------------------------------------------------------------------------
\51\ See Morgan Stanley Letter, supra note 22. Another commenter
believed that institutions with the first two characteristics are
capable of making their own independent investment decisions. See
SIA Letter Nos. 1 and 2, supra note 22. This commenter suggested
that the proposal be amended to state that a rebuttable presumption
exists that institutions are capable of making their own independent
investment decisions. See SIA Letter Nos. 1 and 2, supra note 22.
For more discussion on rebuttable presumptions, see infra Section
(B)(3) of the Summary of Comments.
\52\ See Securities Exchange Act Release No. 36973, supra note
14, at 24-25.
---------------------------------------------------------------------------
(ii) Member Determination Regarding Whether the Institutional Customer
is Exercising Independent Judgment
One commenter pointed out that one of the factors in determining
the scope of a member's suitability obligation--the extent to which the
customer intends to exercise independent judgment--is inconsistent with
a member's obligation to determine that a customer is making
independent investment decisions.\53\ In response to this comment, the
NASD amended the proposal to replace the phrase ``intends to exercise''
with the phrase ``is exercising'' to eliminate any confusion.\54\
---------------------------------------------------------------------------
\53\ See Morgan Stanley Letter, supra note 22.
\54\ See Securities Exchange Act Release No. 36973, supra note
14, at 22.
---------------------------------------------------------------------------
One commenter sought clarification that the lack of a written
agreement would not work against investors in disputed cases and that
the inclusion of written or oral understandings as a relevant
consideration in the proposal does not indicate a preference for such
agreements.\55\ The NASD responded that whereas developing such
agreements with a customer may be helpful to a member in determining
its suitability obligations to the customer, 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
obligation.\56\
---------------------------------------------------------------------------
\55\ See GFOA Letter No. 1, supra note 22.
\56\ See Securities Exchange Act Release No. 36973, supra note
14, at 28.
---------------------------------------------------------------------------
One commenter argued that the factor referencing the ``presence or
absence of a pattern of acceptance of a member's recommendation'' was
too broad and should refer only to captive accounts, where a single
broker-dealer is effectively controlling substantially all investment
decisions of an account.\57\ The NASD disagreed and stated that the
presence or absence of a pattern of customer acceptance of a member's
recommendation should be considered whenever appropriate and reasonable
and should not be limited to ``captive accounts.''\58\
---------------------------------------------------------------------------
\57\ See Morgan Stanley Letter, supra note 22.
\58\ See Securities Exchange Act Release No. 36973, supra note
14, at 27-28.
---------------------------------------------------------------------------
One commenter believed that the factor referencing the use by the
customer of ideas, suggestions and information obtained from other NASD
members or market professionals may discourage investors from becoming
more informed and responsible.\59\ The NASD disagreed, stating that
institutional customers often rely on financial information other than
that provided by the member and may be required by a fiduciary
obligation to do so.\60\
---------------------------------------------------------------------------
\59\ See GFOA Letter No. 1, supra note 22.
\60\ See Securities Exchange Act Release No. 36973, supra note
14, at 29.
---------------------------------------------------------------------------
One commenter believed that a member's consideration of ``the
extent to which the member has received from the customer current
comprehensive portfolio information in connection with discussing
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.\61\ This commenter recommended first,
replacing this factor with a requirement to provide ``material relevant
to a particular transaction'' and, second a requirement that the
broker-dealer make a reasonable request to obtain relevant portfolio or
investment objectives information. The NASD agreed that any material
relevant to a particular transaction provided by a customer would
assist members in fulfilling their suitability obligations under the
proposed Interpretation. The NASD believes, however, that the
``material information'' referred to by the commenter would include
current comprehensive portfolio information in connection with the
transaction. The NASD also believes that the more specific guideline is
appropriate even though a customer may not be willing to provide such
information.\62\
---------------------------------------------------------------------------
\61\ See GFOA Letter No. 1, supra note 22.
\62\ See Securities Exchange Act Release No. 36973, supra note
14, at 30. The NASD notes that all the factors are guidelines and
the inclusion or absence of any factor is not dispositive of the
suitability interpretation.
---------------------------------------------------------------------------
(iii) Portfolio Threshold
One commenter believed that the $10 million portfolio designation
is contrary to the language in the congressional report on the GSAA and
contradicts the intent of the suitability rule.\63\ This commenter
argued that the portfolio designation would be difficult to apply and
requested clarification on how the standard would be implemented in the
context of a government unit. The commenter also urged that if the NASD
retains the portfolio designation, an amount higher than $10 million be
used because the Interpretation inappropriately could be applied to
small governmental entities with portfolios that are nominal in the
context of government operations. The commenter further requested more
explanation on how institutional investors with a portfolio less than
the designated amount will be treated. The NASD responded that there is
greater likelihood that the member could 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 it had not intended to create a presumption either
above or below that aggregate dollar amount that the Interpretation
will apply to a
[[Page 44109]]
particular institutional customer.\64\ Moreover, the NASD stated that
in calculating the $10 million test, it intends to look to SEC Rule
144A for guidance.
---------------------------------------------------------------------------
\63\ See GFOA Letter No. 1, supra note 22.
\64\ See Securities Exchange Act Release No. 36973, supra note
14, at 32.
---------------------------------------------------------------------------
One commenter recommended that the $10 million threshold not be
considered for registered investment companies accounts.\65\ This
commenter argued that all registered investment companies are equally
subject to 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.
The commenter argued that an interpretation that liberalizes the
suitability requirements of its members with respect to larger
investment companies could inadvertently lead to discrimination against
smaller investment companies. Another commenter also believed that the
proposal would have an adverse effect on smaller institutional clients
by reducing competition for these accounts.\66\
---------------------------------------------------------------------------
\65\ See ICI Letter, supra note 22.
\66\ See Edwards Letter, supra note 22.
---------------------------------------------------------------------------
The NASD responded that the reference to $10 million does not imply
a definitive threshold that distinguishes capable from non-capable
institutional customers.\67\ Therefore, the NASD believed that the $10
million threshold should not result in inadvertent discrimination
against investment companies or other institutional customers with less
than $10 million invested in securities.
---------------------------------------------------------------------------
\67\ See Securities Exchange Act Release No. 36973, supra note
14, at 34.
---------------------------------------------------------------------------
One commenter criticized the definition of non-institutional
customer as being too broad and stated that the information-gathering
requirement in Article III, Section 2(b) should only apply to customers
that are not considered institutional customers under the proposed
Suitability Interpretation.\68\ This commenter argued that a member may
reasonably conclude that an institutional customer with less than $50
million in assets is capable of understanding the risks of the
recommended transaction and intends to exercise reasonable judgment in
evaluating the member's recommendation, but the member would still have
to gather information required by Article III, Section 2(b) from that
customer. The commenter suggested that the definition of non-
institutional customer be amended by eliminating the reference to
Section 21(c)(4) and incorporating a definition of institutional
customer in Section 2(b) that is consistent with the proposed
Suitability Interpretation.
---------------------------------------------------------------------------
\68\ See PSA Letter No. 1, supra note 22. Pursuant to Article
III, Section 2(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 NASD member must make reasonable efforts to obtain
information concerning: (1) the customer's financial status; (2) the
customer's tax status; (3) the customer's investment objectives; and
(4) 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 information gathering
requirement, an institutional customer means: (1) a bank, savings
and loan association, insurance company, or registered investment
company; (2) an investment adviser registered under Section 203 of
the Investment Advisers Act of 1940; or (3) any other entity
(whether a natural person, corporation, partnership, trust, or
otherwise) with total assets of at least $50 million.
---------------------------------------------------------------------------
In response, the NASD stated that the proposed rule change to
Article III, Section 2(b) of the Rules of Fair Practice is meant to
distinguish this requirement from the suitability obligations under
Article III, Section 2(a) of the Rules of Fair Practice and the
proposed Suitability Interpretation.\69\ The NASD stated that
fulfilling the suitability obligation under the proposed Suitability
Interpretation would 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 may be considered
institutional customers according to the proposed Suitability
Interpretation.
---------------------------------------------------------------------------
\69\ See Securities Exchange Act Release No. 36973, supra note
14, at 35.
---------------------------------------------------------------------------
3. Safe Harbor/Rebuttable Presumption
Several commenters were concerned that the proposal would in effect
make the member a guarantor of a recommended investment's performance
and inappropriately shift responsibility for poor investment decisions
to the broker-dealer.\70\ Some commenters recommended that the proposal
include a safe harbor for broker-dealers that comply with the proposed
interpretation.\71\ Other commenters believed that if the institutional
investor employs an investment professional, the investment
professional should bear the responsibility for the investment
decisions it makes.\72\
---------------------------------------------------------------------------
\70\ See Nomura Letter, Edwards Letter, Morgan Stanley Letter,
and ABA Letter supra note 22. One commenter was concerned that
market participants were inappropriately using the suitability
concept to make the dealer the guarantor of an investment's
performance. See PSA Letter No. 1, supra note 22.
\71\ See ABA Letter and Coastal Letter, supra note 22.
Alternatively, one of the commenters believed that compliance with
the interpretative guidance should create a rebuttable presumption
that a member's suitability obligations with respect to
institutional customers have been satisfied. See ABA Letter, supra
note 22.
\72\ See Edwards Letter, Morgan Stanley Letter, PSA Letter No.
1, and STA Letter, supra note 22. One commenter, however, disagreed
because there may be variation in the type and degree of services
offered by a third-party professional to its clients. See GFOA
Letter No. 2, supra note 22.
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In response, the NASD stated that it would not be appropriate to
create a safe harbor for member's suitability obligations or to change
or reduce members' obligations under the suitability rule in Article
III, Section 2 of the Rules of Fair Practice.\73\ The NASD stated that
there are no safe harbors in the Suitability Interpretation.\74\
---------------------------------------------------------------------------
\73\ See Securities Exchange Act Release No. 36973, supra note
14, at 30-31.
\74\ See id. at 45.
---------------------------------------------------------------------------
Rather than a safe harbor, one commenter suggested that the
proposal provide a rebuttable presumption that a member's
recommendations to institutional customers are suitable.\75\ This
commenter believed that the existence of an advisory relationship
should be the primary consideration and that, absent extraordinary
circumstances, an advisory relationship should be deemed to exist only
if the parties evidence such an agreement in writing.\76\
---------------------------------------------------------------------------
\75\ See Nomura Letter, supra note 22. One commenter stated that
there should be a cutoff for institutions with more than a stated
amount of assets under management. See STA Letter, supra note 22.
One commenter argued, however, that there should be no rebuttable
presumption that recommendations made to institutional investors are
suitable. See GFOA Letter No. 2, supra note 22. Another commenter
agreed that the broker-dealers should be held responsible for their
recommendations to institutional investors. See NASACT Letter, supra
note 22.
\76\ See Nomura Letter, supra note 22. Moreover, one commenter
argued that three particular situations warrant reconsideration as
determinative factors or rebuttable presumptions that the member has
fulfilled its suitability obligation: the presence of an investment
advisor; transactions executed consistent with investment guidelines
or permitted investment statutes; and the execution of a written
agreement. See PSA Letter Nos. 1 and 2, supra note 22.
---------------------------------------------------------------------------
In response, the NASD stated 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 therefore, the creation of a
rebuttable presumption through the fulfillment of certain procedures
would not be appropriate.\77\ Moreover, the NASD stated that 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
[[Page 44110]]
suitability rule under all conceivable circumstances. The NASD was
unable to define such a class.\78\
---------------------------------------------------------------------------
\77\ See Securities Exchange Act Release No. 36973, supra note
14, at 40.
\78\ See id. at 42.
---------------------------------------------------------------------------
4. Additional Obligations on Members
Several commenters argued that the NASD's proposed Suitability
Interpretation would impose new or additional duties on its members.
One commenter was concerned that the proposal would create an
obligation to document affirmative determinations of the factors
referenced under the two principal considerations because it believed
that the proposal implies that NASD examiners will expect to see an
affirmative determination on all or some of the described criteria for
compliance purposes.\79\ Another commenter believed that these analyses
will greatly increase a member's responsibility to gather detailed
information about its institutional customers and to keep extensive
records of any information gathered.\80\
---------------------------------------------------------------------------
\79\ See Nomura Letter, supra note 22.
\80\ See ABA Letter, supra note 22.
---------------------------------------------------------------------------
One commenter requested that the NASD incorporate explicit language
stating that it did not intend to create: (1) a checklist for NASD
compliance examinations; (2) an affirmative obligation on NASD members
to make trade-by-trade or continual suitability determinations based on
the designated considerations; or (3) new NASD member suitability
determination documentation or record maintenance requirements.\81\
---------------------------------------------------------------------------
\81\ See SIA Letter Nos. 1 and 2, supra note 22.
---------------------------------------------------------------------------
On the other hand, other commenters supported imposing additional
obligations on members. One commenter suggested that the proposal
require the broker-dealer to provide certain specific types of
information to customers with regard to specific transactions such as
an instrument's behavior under a variety of conditions, types of risk
incurred with certain instruments, and valuation information.\82\ This
commenter also supported the inclusion of an affirmative duty to
inquire about a customer's risks and constraints, including any
investment policies.\83\
---------------------------------------------------------------------------
\82\ See GFOA Letter No. 1, supra note 22.
\83\ See GFOA Letter No. 2, supra note 22.
---------------------------------------------------------------------------
The NASD responded that it was not imposing through the proposed
Suitability Interpretation additional duties on members that are not
already imposed by current Article III, Section 2 of the Rules of Fair
Practice, general anti-fraud principles 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.\84\ The NASD stated
that Article III, Section 2(a) of the Rules of Fair Practice does not
contain books and records requirements and, similarly, the proposed
Suitability Interpretation does not contain books and records
requirements.\85\ The NASD warned, however, that members are
responsible for demonstrating the fulfillment of their suitability
obligation under Article III, Section 2(a) in NASD examinations and
that members would have the same responsibility under the proposed
Suitability Interpretation. The NASD also stated that it had intended
to eliminate the appearance that the listed factors create an
evidentiary checklist for NASD compliance review. The NASD stated 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 reponsible for the absence of
information not provided by the institutional customer.
---------------------------------------------------------------------------
\84\ See Securities Exchange Act Release No. 36973, supra note
14, at 25.
\85\ See id. at 38.
---------------------------------------------------------------------------
V. Discussion
The government securities market, widely considered to be the
largest and most liquid securities market in the world, has enabled the
U.S. government to meet its large financing needs in an effective
manner. In 1991, however, certain events threatened the public
confidence in the fairness and integrity of this market and prompted
the Treasury Department, the Board of Governors of the Federal Reserve
System and the Commission to undertake an informal review of the
government securities market.\86\ As a result of this review, and
Congressional inquiries into the government securities market in
general, in 1993 Congress decided to modify the limited regulatory
structure in the Government Securities Act of 1986 by enacting the
GSAA.
---------------------------------------------------------------------------
\86\ The Treasury Department, the Board of Governors of the
Federal Reserve System, and the Commission produced a report on this
review of the government securities market. See Joint Report on the
Government Securities Market (Jan. 1992).
---------------------------------------------------------------------------
In the GSAA, Congress provided the NASD and bank regulators with
the authority to issue rules aimed at preventing fraudulent or
manipulative acts and practices and to promote just and equitable
principles of trade in the government securities market.\87\ Pursuant
to this legislation, the NASD has proposed rule changes to impose for
the first time various provisions of the Rules of Fair Practice to
transactions in exempted securities, including government securities,
other than municipals. The GSAA also stimulated the NASD to provide
further guidance to members on their suitability obligations in Section
2, Article III when making recommendations to institutional
customers.\88\
---------------------------------------------------------------------------
\87\ H.R. Rep. 103-255, 103d Cong., 1st Sess. (1993) (Congress
believed that ``it is appropriate to extend normal sales practice
standards and other registered securities association rules to
transactions in the government securities market by removing the
statutory restrictions on the authority of such associations in the
government securities market'').
\88\ The Office of the Comptroller of the Currency (``OCC''),
the Federal Deposit Insurance Corporation (``FDIC''), and the Board
of Governors of the Federal Reserve System (``Board'') also have
solicited comment on rules, largely similar to those proposed by the
NASD, to apply to government securities brokers and dealers under
the jurisdiction of these agencies. See Government Securities Sales
Practices, 61 FR 18470 (Apr. 25, 1996) (joint notice of proposed
rulemaking).
---------------------------------------------------------------------------
For the reasons discussed below, the Commission has determined that
the NASD's proposals are consistent with the requirements of the Act
and the rules and regulations thereunder applicable to the NASD and, in
particular, the requirements of Section 15A \89\ and the rules and
regulations thereunder.\90\ The Commission believes that the proposed
rule change is consistent with the Section 15A(b)(6) requirements that
the rules of the association be designed to prevent fraudulent and
manipulative acts and practices, promote just and equitable principles
of trade, 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.\91\
---------------------------------------------------------------------------
\89\ 15 U.S.C. 78o-3.
\90\ The GSAA also requires the Commission to consult with the
Treasury Department prior to the adoption of the NASD proposal. The
Commission has consulted with the Treasury Department.
\91\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------
A. Application of the Rules of Fair Practice to Exempted Securities
Except Municipals and Merger of Government Securities Rules
To implement the authority conferred by the GSAA to address abusive
and manipulative practices in the government securities market, the
NASD has proposed to merge certain provisions of its current Government
Securities Rules into the Rules of Fair Practice, and to apply certain
provisions of the Rules of Fair Practice to exempted securities (except
municipals) for the first time. The Commission believes that the
application of the various sections of the NASD's Rules of Fair
Practice, which the NASD deems to be appropriate and necessary for
regulating
[[Page 44111]]
transactions in exempted securities, including government securities,
other than municipals, is consistent with the purposes of the Act and
the intention of Congress in enacting the GSAA.\92\
---------------------------------------------------------------------------
\92\ See H.R. Rep. 103-255, 103d Cong., 1st Sess. (1993).
---------------------------------------------------------------------------
Under the proposal, the NASD has determined to exempt government
securities transactions from certain provisions of the Rules of Fair
Practice. The NASD found some provisions not to be applicable to the
government securities market while others will be considered for
further review. A few of the provisions under further review are
especially worthy of note.
First, the NASD acknowledged that its current front running
interpretation applies only to equity securities. The NASD has
committed, however, to review the application of its front running
interpretation to the government securities market because the NASD
believes that front running may occur in this market under certain
circumstances.\93\ Moreover, in the interim, the NASD has represented
that actions for front running conduct occurring in the government
securities market may be brought under its rule requiring members to
adhere to just and equitable principles of trade.\94\
---------------------------------------------------------------------------
\93\ See Securities Exchange Act Release No. 36973, supra note
14, at 12.
\94\ See id.
---------------------------------------------------------------------------
Second, with the proposed rule change, the NASD will not apply its
prohibitions against trading ahead of customer limit orders and trading
ahead of research reports to the government securities market. As with
the front running interpretation, the NASD intends to review the
application of these interpretations to the government securities
market because the NASD believes that conduct addressed by the
interpretations may occur in this market under certain
circumstances.\95\ In the meantime, the NASD will bring action for such
conduct under its just and equitable principles of trade rule.
---------------------------------------------------------------------------
\95\ See id. at 13.
---------------------------------------------------------------------------
The Commission believes that the NASD's determination to apply
certain of its general rules, only formerly applicable to equity or
corporate debt securities, to government securities is consistent with
the Act, and that the NASD has made a reasonable determination
regarding which of its general rules should be applicable to government
securities. With respect to those provisions of the Rules of Fair
Practice that the NASD plans to consider further for application to the
government securities markets, the Commission anticipates that the NASD
will undertake a prompt and thorough evaluation and submit proposed
rule changes with the Commission as appropriate.
B. Suitability Interpretation
The concept of suitability, rooted in notions of just and equitable
principles of trade and the protection of investors, plays an important
role in the scheme of the federal securities laws. Prohibitions against
making unsuitable recommendations arise under the rules of all self-
regulatory organizations.\96\ They lay the foundation for good and
sound business practices by broker-dealers and help avoid potential
abusive sales practices regarding customers. The NASD's articulation of
the suitability principles as set forth in Article III, Section 2 of
the Rules of Fair Practice has applied to members' recommendations
since the inception of the NASD. Article III, Section 2(a) requires
that in recommending to a customer the purchase, sale or exchange of
any security, a member must 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 financial situation and needs. With the enactment of the
GSAA, and NASD has decided to provide further guidance to members on
their suitability obligations and has proposed guidelines for its
members regarding how members may fulfill their ``customer-specific''
suitability obligations when making recommendations to institutional
customers.\97\
---------------------------------------------------------------------------
\96\ See, e.g., New York Stock Exchange Rule 405, NYSE Guide
(CCH) para. 2405; American Stock Exchange Rule 411, Amex Guide (CCH)
para. 9431. See also Duker & Duker, 6 S.E.C. 386, 388 (1939). As
part of the obligation of fair dealing, all broker-dealers are
required to have a reasonable basis for believing that their
securities recommendations are suitable for the customer in light of
the customer's financial needs, objectives, and circumstances.
\97\ The NASD Suitability Interpretation will be applicable to
all securities, except for municipals. Municipal Securities
Rulemaking Board (``MSRB'') rule G-19 governs the suitability
obligations for municipal securities. Like Article III, Section 2 of
the Rules of Fair Practice, MSRB rule G-19 makes no distinction
between institutional and non-institutional customers in requiring
that a broker, dealer, or municipal securities dealer must have
reasonable grounds for believing that a recommendation is suitable.
---------------------------------------------------------------------------
The current version of the Suitability Interpretation is the
product of the NASD's extensive consultation with broker-dealers,
investors and other participants in the securities industry over a
period of several years. It reflects much discussion and great
diversity of input by various parties. The first draft of the proposed
Suitability Interpretation was published for comment in Notice to
Members 94-62 (August 1994). Fourteen commenters submitted 15 comment
letters on the draft proposals. In response to the comments received,
the NASD amended the proposal and published a second draft for comment
in Notice to Members 95-21 (April 1995). Sixteen comments were received
on the second draft. The NASD, against, amended the proposal
Suitability Interpretation in response to the comments received, before
filing a proposed interpretation with the Commission. The NASD provided
further clarification and amendments to the proposal in March 1996,
when Amendment No. 3 to the proposal was filed. Thus, the final
proposal currently before the Commission reflects the NASD's effort to
consider all comments on the numerous versions of the proposal and
balance the issues raised in those comments.
The NASD's Suitability Interpretation is predicated on a
determination that the two most important considerations in determining
the scope of a member's suitability obligation in making
recommendations to an institutional customer are (1) the customer's
capability to evaluate investment risk independently, and (2) the
extent to which the customer is exercising independent judgment. The
Suitability Interpretation further describes factors that may be
relevant in a members evaluation of these two important considerations.
The NASD has emphasized that these factors are guidelines that will be
utilized to determine whether a member has fulfilled suitability
obligations with respect to a specific institutional customer
transaction and that the absence or inclusion of any of these factors
is not dispositive of the suitability determination.
The Commission believes that the NASD's approach to determining the
scope of a member's suitability obligation in making recommendations to
an institutional customer appropriately responds to the varied nature
of institutional customers and the varied significance of a member's
recommendation for different institutional customers. The NASD
acknowledges, as does the Commission, that the relationship between a
broker-dealer and an institutional customer generally may be different
in important respects from the relationship a broker-dealer has with a
non-institutional investor. In the latter circumstance, a broker-dealer
frequently has knowledge about the investment and its risks and costs
that are not possessed by or easily available to the investor. Some
[[Page 44112]]
sophisticated institutional customers, however, may in fact possess
both the capability to understand how a particular securities
investment could perform, as well as the desire to make their own
investment decisions, without reliance on the knowledge or resources of
the broker-dealer. Other investors that meet a definition of
``institutional customer'' may not possess the requisite capability to
understand the particular investment risk, or may not be exercising
independent judgment in making a particular investment decision, and so
may be largely dependent on the broker-dealer's analysis and
recommendation in evaluating whether to purchase a recommended
security.
The NASD proposal recognizes the varied nature of investor
profiles, even among investors that meet some definition of
``institutional investor.'' It accommodates a wide range of
relationships because it does not establish rigid thresholds or
requirements, but rather provides its members with some reasonable
factors by which an NASD member can determine the nature of its
relationship with a customer. The Interpretation correctly recognizes
that there can be instances in which an institutional customer
possesses a general capability to understand certain kinds of
investments, but does not have the requisite capability to understand
the particular investment under consideration. In such a circumstance,
the NASD appropriately notes that a broker-dealer's suitability
obligation would not be diminished based solely on the financial
wherewithal of the customer.
The Commission also believes that the factors enumerated in the
Interpretation, which could be relevant to the two considerations,
provide members with appropriate points to consider in satisfying their
suitability obligations. Some commenters were concerned about the
relevance of, and the proper weight to be given to, the considerations
listed. Some commenters also expressed concern regarding the specific
application of these considerations.\98\ The NASD acknowledges that
these considerations are not necessarily the only relevant factors, but
merely guidelines for use in determining whether a member has fulfilled
its suitability obligations with respect to a specific institutional
customer transaction. They neither create nor reduce a member's
suitability obligation and their relevance would vary depending on
numerous circumstances.\99\ The Commission concurs with the NASD in
this regard. Moreover, these enumerated factors are not meant to create
a checklist, which the Commission would consider inappropriate in these
circumstances because it could lead to a mechanical application of the
Interpretation without adequate consideration by the broker-dealer of
whether the customer understands the transaction or product.
---------------------------------------------------------------------------
\98\ For example, some commenters expressed concern about the
$10 million portfolio designation. A few commenters believed that
such a threshold may lead to discrimination against smaller
institutions or investments companies. One commenter believed that
the GSAA prohibited such a portfolio designation. The NASD has
represented that it had not intended to create a presumption that
the Interpretation would apply to a particular institutional
customer either above or below the aggregate dollar amount or to
imply that the $10 million constituted a definitive threshold in
determining whether a broker-dealer's suitability obligation was
satisfied in dealing with a particular institution. See Securities
Exchange Act Release No. 36973, supra note 14, at 32, 34. The
Commission agrees that the $10 million portfolio designation will
not discriminate against certain institutional customers nor is it
contrary to the language of the Congressional report on the GSAA.
The $10 million portfolio designation does not create a presumption
that institutions that exceed the $10 million portfolio amount
satisfy the Interpretation's factors and thus are not covered by the
protections of the suitability rule; rather, the Interpretation
indicates that the analysis of the suitability obligation to be
conducted using the factors set forth in the interpretation is more
appropriate for these larger institutions than for institutions with
a smaller portfolio.
\99\ See Securities Exchange Act Release No. 36973, supra note
14, at 27.
---------------------------------------------------------------------------
Some commenters, believing that the suitability responsibility is
already unevenly placed on broker-dealers, supported inclusion in the
Suitability Interpretation of a safe harbor or a rebuttable
presumption. In keeping with its purpose to provide guidance and not to
create or reduce a member's suitability obligations, the NASD did not
create a safe harbor or provide for a rebuttable presumption in the
Suitability Interpretation.\100\ In response to the arguments of some
industry members that if an investor employs an investment
professional, that professional should wholly bear the responsibility
for the investment decision it makes, the NASD clarified that while the
institution would still be covered by the suitability rule, the factors
analysis of the proposed Suitability Interpretation would apply to any
delegated agents of customers, including any professional advisers that
an investor may employ.
---------------------------------------------------------------------------
\100\ See id. at 40, 45.
---------------------------------------------------------------------------
The Commission believes that the NASD's decision not to create a
safe harbor or rebuttable presumption is consistent with the purposes
of the Act. A safe harbor or a rebuttable presumption that applied to
institutions that were likely to rely on a broker-dealer's guidance
regarding a security could lead to serious abuses that are inconsistent
with the purposes of the Act. For example, a safe harbor could allow a
broker-dealer to recommend a risky security to an institutional
investor without consideration of the appropriateness of the investment
for the investor, and despite knowing that the customer did not
understand the product. Moreover, a safe harbor or a rebuttable
presumption that all institutions with similar amounts to invest
possess similar or equal financial acumen, which has not proven to be
the case. As one commenter noted, ``institutional customers'' could be
educational institutions, churches, charities, or governments, which
range from small special districts to large state governments, and the
characteristics and portfolios of these customers vary widely.\101\ A
safe harbor or a rebuttable presumption would depend on the ability of
the NASD to define objectively a class of institutional investors that
uniformly would not need the protections of the NASD's suitability
rule.
---------------------------------------------------------------------------
\101\ See GFOA Letter No. 2, supra note 22.
---------------------------------------------------------------------------
The NASD, however, has not sought to define such a class. Rather,
the NASD has taken a flexible approach in defining the term
``institutional investor'' by not including financial criteria in the
term; for purposes of the Interpretation, an institutional customer may
be any entity other than a natural person. The Suitability
Interpretation potentially would apply to all institutional investors,
though more appropriately to institutional investors with portfolios of
at least $10 million in securities. The NASD believes that excluding
institutional investors from the protections of the suitability rule
based on objective financial criteria would arbitrarily discriminate
among institutional investors based on factors such as asset size,
portfolio size or institutional type that are not necessarily
determinative of financial sophistication. The Commission believes that
the NASD's choice not to rely on objective criteria that may mask what
is really an unsophisticated investor is reasonable in the context of a
standard that incorporates factors that reflect the nature of the
investor, and where the suitability of the recommendation itself
depends on the nature of the investor. Categorizing investors by an
isolated financial criteria may improperly attribute the capability to
evaluate investment risk independently and the exercise of
[[Page 44113]]
independent judgment to an customer without an appropriate analysis of
the investor's true characteristics.\102\
---------------------------------------------------------------------------
\102\ In testimony before the Subcommittee on Telecommunications
and Finance Committee on Commerce, SEC Chairman Arthur Levitt
testified against a provision in the proposed legislation that would
crate a presumption that a broker-dealer is not liable for
investment decisions of institutional clients unless the parties
have contracted to the contrary. Chairman Levitt testified that the
presumption under the federal securities laws that broker-dealers
generally are responsible for making suitability recommendations,
whether their clients are institutional or individual investors,
should be maintained. See Testimony of Arthur Levitt, Chairman, U.S.
Securities and Exchange Commission, Concerning H.R. 2131, The
``Capital Markets Deregulation and Liberalization Act of 1995,''
before the Subcomm. on Telecommunications and Finance Committee on
Commerce (Nov. 30, 1995).
---------------------------------------------------------------------------
Moreover, in view of the great diversity of institutional
customers, the Interpretation affords broker-dealers the flexibility to
negotiate understandings and terms with a particular customer. Such
agreements, freely negotiated between consenting parties, can be useful
in establishing, prior to a transaction, the obligations and
responsibilities of both parties. The NASD's approach assists broker-
dealers and customers to define their own expectations and roles with
respect to their specific relationship.
Some industry members were concerned that the Interpretation would
create greater confusion and uncertainty and additional duties on
broker-dealers. Industry members were especially concerned that the
proposed Interpretation would impose an obligation on members to
document and retain extensive records of information gathered or expose
them to NASD compliance examinations based on a ``checklist.'' Again,
the NASD represented that it was not imposing through the proposed
Interpretation additional duties on members that are not already
imposed by the NASD's suitability rules, general anti-fraud provisions
of the federal securities laws, or Article III, Section 18 of the
NASD's Rules of Fair Practice. The NASD confirmed that the proposed
Interpretation does not impose a books and records requirement nor does
it create an evidentiary checklist for NASD compliance review. The
NASD's reassurances that these considerations are provided merely for
guidance purposes and not to impose any additional duties or to reduce
any existing obligations should alleviate the commenters' concerns
regarding the specific application of the Interpretation. Moreover, the
NASD has repeatedly indicated that the Interpretation does not make the
broker-dealer a guarantor, which the Commission believes is
appropriate.
Moreover, the NASD has committed to continuing its examination of
members for compliance with the suitability obligations under Article
III, Section 2(a) and, upon the approval of the Interpretation,
members' compliance with the Interpretation.\103\ The Commission
expects the NASD to extend its examinations to members' compliance with
the Interpretation once it becomes effective.
---------------------------------------------------------------------------
\103\ See Securities Exchange Act Release No. 36973, supra note
14, at 38.
---------------------------------------------------------------------------
Finally, the Commission finds good cause for approving Amendment
Nos. 4 and 5 to the proposed rule change prior to the thirtieth day
after the date of publication of notice of filing thereof. The
Exchange's proposal was published in the Federal Register for the full
statutory period.\104\ Amendment No. 4 merely clarifies the new
numbering of the NASD Manual and proposes to apply Section 50, Article
III, to transactions in exempted securities (except municipals). The
NASD's adoption of reporting requirements in Section 50, Article III,
was the product of a review by the NASD and the New York Stock
Exchange, which was undertaken because of concerns on the part of the
Commission and others over the frequency and severity of sales
practices abuses.\105\ The Commission approved NASD adoption of Section
50, Article III stating that the reporting requirements will provide
important regulatory information that will assist in the detection and
investigation of sales practice violations. Therefore, the Commission
believes that applying this provision to transactions in exempted
securities, including government securities, other than municipals is
consistent with Congress' mandate to the NASD to extend its sales
practice standards and other rules to address abusive and manipulative
practices in the government securities market. Moreover, Amendment No.
5 merely clarifies and reminds members that its rules requiring members
to adhere to just and equitable principles of trade apply to conduct
that may violate the Fair Prices and Commissions provision and the
Mark-Up Policy. The Commission believes that this clarification is not
substantive because the rule requiring that members adhere to just and
equitable principles of trade would have applied to such conduct
regardless of this clarification. Based on the above, the Commission
finds that there is good cause, consistent with Section 6(b)(5) of the
Act, to accelerate approval of Amendment Nos. 4 and 5.
---------------------------------------------------------------------------
\104\ See Securities Exchange Act Release Nos. 36383 and 36973,
supra notes 9 and 14.
\105\ See Securities Exchange Act Release No. 36211 (Sept. 8,
1995) 60 FR 48182.
---------------------------------------------------------------------------
VI. Solicitation of Comments
Interested persons are invited to submit written data, views, and
arguments concerning Amendment Nos. 4 and 5. Persons making written
submissions should file six copies thereof with the Secretary,
Securities and Exchange Commission, 450 Fifth Street N.W., Washington,
D.C. 20549. Copies of the submission, all subsequent amendments, all
written statements with respect to the proposed rule change that are
filed with the Commission, and all written communications relating to
the proposed rule change between the Commission and any person, other
than those that may be withheld from the public in accordance with the
provisions of 5 U.S.C. 552, will be available for inspection and
copying 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
Exchange. All submissions should refer to File No. SR-NASD-95-39 and
should be submitted by September 17, 1996.
VII. Conclusion
In conclusion, the Commission believes that the NASD's proposal to
impose the Rules of Fair Practice to transactions in exempted
securities other than municipals, and to provide further guidance to
members on their suitability obligations in Section 2, Article III when
making recommendations to institutional customers is consistent with
the purposes of the Act and the GSAA. Especially with respect to the
proposed suitability Interpretation, the NASD has undergone an
extensive consultative process, whereby interested parties were able to
participate in the development of the Interpretation. The Commission
believes that the suitability Interpretation is a reasoned approach to
the concept of suitability, which fosters an environment for dialogue
between broker-dealers and customers regarding the nature of their
relationship, and, therefore, should promote the protection of
investors.
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\106\ that the proposed rule change (SR-NASD-95-39) is approved.
\106\ 15 U.S.C. 78s(b)(2).
---------------------------------------------------------------------------
[[Page 44114]]
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\107\
---------------------------------------------------------------------------
\107\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------
Margaret H. McFarland,
Deputy Secretary.
Exhibit 1.--Old-to-New Conversion Chart
------------------------------------------------------------------------
Former provision New number
------------------------------------------------------------------------
By-Laws........................................ Unchanged
* * * *
* * *
Schedules to the by-laws:
Schedule A................................... Unchanged
* * * *
* * *
Schedule C................................... 1000
* * * *
* * *
II. Registration of Principals................. 1020
* * * *
* * *
(2) Categories of Principal Registration....... 1022
* * * *
* * *
VI. Persons Exempt from Registration........... 1060
* * * *
* * *
Rules of fair practice......................... Titled deleted
Article I:
Adoption and application..................... 0110
* * * *
* * *
4. Effect on Transactions in Exempted 0114
Securities.
5. Applicability............................... 0115
* * * *
* * *
CONDUCT RULES
Article III--Rules of Fair Practice
1. Business Conduct of Members................. 2110
Interpretation on Execution of Retail 2320
Transactions in the Over-the-Counter Market.
Interpretation on Prompt Receipt and Delivery 3370
of Securities.
Interpretation on Forwarding of Proxy and 2260
Other Materials.
Interpretation on ``Free-Riding and IM-2110-1
Withholding''.
Interpretation on Trading Ahead of Customer IM-2110-2
Limit Orders.
Interpretation on Front Running Policy....... IM-2110-3
Interpretation on Trading Ahead of Research IM-2110-4
Reports.
2. Recommendations to Customers................ 2310
Policy on Fair Dealing with Customers........ IM-2310-2
3. Charges for Services Performed.............. 2430
4. Fair Prices and Commissions................. 2440
Interpretation on NASD Mark-Up Policy........ IM-2240
5. Publication of Transactions and Quotations.. 3310
Interpretation on Manipulative and Deceptive IM-3310
Quotations.
6. Offers at Stated Prices..................... 3320
Policy with Respect to Firmness of Quotations IM-3320
7. Disclosure of Price in Selling Agreements... 2770
8. Securities Taken in Trade................... 2730
Interpretation on Safe Harbor and Presumption IM-2730
of Compliance.
9. Use of Information Obtained in Fiduciary 3120
Capacity.
10. Influencing or Rewarding Employees of 3060
Others.
11. Payment Designed to Influence Market 3330
Prices, Other than Paid Advertising.
12. Disclosure on Confirmations................ 2230
Explanation on ``Third Market Confirmations'' IM-2230
13. Disclosure of Control...................... 2240
14. Disclosure of Participation or Interest in 2250
Primary or Secondary Distribution.
15. Discretionary Accounts..................... 2510
16. Offering ``At the Market''................. 2760
17. Solicitation of Purchases on an Exchange to 2780
Facilitate a Distribution of Securities.
18. Use of Fraudulent Devices.................. 2120
19. Customers' Securities or Funds............. 2330
Explanation of Paragraph (d) of Section 19. IM-2330
20. Installment or Partial Payment Sales....... 2450
[[Page 44115]]
21. Books and Records.......................... 3110
22. Disclosure of Financial Condition.......... 2270
Resolution on Requirements of Members to 2910
Furnish Recent Financial Statement to Other
Members.
23. Net Prices to Persons Not in Investment 2410
Banking or Securities Business.
24. Selling Concessions........................ 2740
Interpretation on Services in Distribution... IM-2740
25. Dealing with Non-Members................... 2420
Interpretation on Transactions Between IM-2420-1
Members and Non-Members.
26. Investment Companies....................... 2830
27. Supervision................................ 3010
28. Transactions for or by Associated Persons.. 3050
29. Variable Contracts of an Insurance Company. 2820
30. Margin Accounts............................ 2520
31. Securities ``Failed to Receive'' and 3210
``Failed to Deliver''.
32. Fidelity Bonds............................. 3020
33. Options.................................... 2860
Interpretation on Opening Accounts for IM-2860-2
Options Customers.
34. Direct Participation Programs.............. 2810
35. Communications with the Public............. 2210
Guidelines Regarding Communications with the IM-2210-1
Public about Collateralized Mortgage
Obligations (CMOs).
Guidelines Regarding Communications with the M-2210-2
Public about Variable Life Insurance and
Variable Annuities.
Guidelies for the Use of Rankings in M-2210-3
Investment Companies Advertisements and
Sales Literature.
35A. Options Communications with the Public.... 2220
36. Transactions with Related Persons.......... 2750
Interpretation on Transactions with Related IM-2750
Persons.
37. [Reserved].................................
38. Regulation of Activities of Members 3130
Experiencing Financial and/or Operational
Difficulties.
Explanation on Restrictions on a Member's IM-3130
Activity.
39. Approval of Change in Exempt Status under 3140
SEC Rule 15c3-3.
40. Private Securities Transactions............ 3040
41. Short-Interest Reporting................... 3360
42. Prohibition on Transactions During Trading 3340
Halts.
43. Outside Business Activities................ 3030
44. The Corporate Financing Rule............... 2710
45. Customer Account Statements................ 2340
46. Adjustment of Open Orders.................. 3220
47. Clearing Agreements........................ 3230
48. Short Sale Rule............................ 3350
Interpretation on Short Sale Rule............ IM-3350
49. Primary Nasdaq Market Maker Standards...... 4612
50. Reporting Requirements..................... 3070
* * * *
* * *
COMPLAINTS INVESTIGATIONS AND SANCTIONS
Article IV--Complaints
1. Availability to Customer of Certificate, By- 8110
Laws, Rules and Code of Procedure.
2. Complaints by Public Against Members for 8120
Violations of Rules.
3. Complaints by District Business Conduct 8130
Committees.
4. Complaints by the Board of Governors........ 8140
5. Reports and Inspection of Books for Purpose 8210
of Investigating Complaints.
Resolution on Suspension of Members for 8220
Failure to Furnish Information Duly
Requested.
Article V--Penalties
1. Sanctions for Violation of the Rules........ 8310
Interpretation on the Effect of a Suspension IM-8310-1
or Revocation of the Registration, if Any,
of a Person Associated with a Member or the
Barring of a Person from Further Association
with a Member.
Resolution on Notice to Membership and Press IM-8310-2
of Suspensions, Expulsions, Revocations, and
Monetary Sanctions and Release of Certain
Information Regarding Disciplinary History
of Members and Their Associated Persons.
2. Payment of Fines, Other Monetary Sanctions, 8320
or Costs.
3. Costs of Proceedings........................ 8330
* * * *
* * *
Code of procedure.............................. 9000
Article II:
Disciplinary Actions by District Business 9200
Conduct Committees, The Market Surveillance
Committee and Others.
* * * *
* * *
10. Acceptance, Waiver and Consent, Minor Rule 9217
Violations And Summary Complaint Procedures.
[[Page 44116]]
* * * *
* * *
Appendix:
Violations Appropriate For Disposition Under IM-9217
the Minor Rule Violations Plan.
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[FR Doc. 96-21757 Filed 8-26-96; 8:45 am]
BILLING CODE 8010-01-M