[Federal Register Volume 62, Number 10 (Wednesday, January 15, 1997)]
[Notices]
[Pages 2204-2210]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-896]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-38132; File No. SR-NASD-96-08]
Self-Regulatory Organizations; National Association of Securities
Dealers, Inc.; Order Granting Approval to Proposed Rule Change and
Notice of Filing of, and Order Granting Accelerated Approval to,
Amendment No. 1 to the Proposed Rule Change Relating to Quotation and
Reporting Requirements of Direct Participation Programs
January 7, 1997.
I. Introduction
On March 12, 1996, the National Association of Securities Dealers,
Inc. (``NASD'') 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 permit the quotation of Direct
Participation Programs (``DPPs'') on the OTC Bulletin Board Service
(``OTCBB'' or ``OTC Bulletin Board'') and require all transactions in
DPPs to be reported through the Automated Confirmation Transaction
Service (``ACT'').
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
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The proposed rule change was published for comment in the Federal
Register on April 25, 1996.\3\ The Commission received seven comment
letters concerning this proposal.\4\ The NASD initially responded to
these comments in a letter dated October 16, 1996.\5\ On November 26,
the NASD submitted Amendment No. 1 to the proposed rule change.\6\
After careful consideration of all of the comments, the Commission has
decided to approve the proposal, including Amendment No. 1 on an
accelerated basis.
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\3\ Securities Exchange Act Release No. 37131 (Apr. 19, 1996),
61 FR 18452.
\4\ See letter from James Frith, Jr., President, Chicago
Partnership Board, Inc. (``CPB''), to Jonathan G. Katz, Secretary,
SEC, dated May 14, 1996 (``CPB Letter No. 1''); letter from James F.
Fotenos, Attorney, Fotenos & Suttle, P.C., to Jonathan G. Katz,
Secretary, SEC, dated May 22, 1996 (``Fotenos & Suttle Letter'');
letter from James Frith, Jr., President, CPB, to Jonathan G. Katz,
Secretary, SEC, dated June 10, 1996 (``CPB Letter No. 2)
(concentrating primarily on the Qualified Matching Service Safe
Harbor); letter from James Frith, Jr., President, CPB, to Jonathan
G. Katz, Secretary, SEC, also dated June 10, 1996 (``CPB Letter No.
3) (focusing on the NASD's standardized Distribution Allocation
Agreement form); letter from George E. Hamilton, President, NAPEX,
to Jonathan G. Katz, Secretary, SEC, dated June 10, 1996 (``NAPEX
Letter''); letter from Gregory S. Paul, President, American
Partnership Services (``APS''), to Jonathan G. Katz, Secretary, SEC,
dated June 10, 1996 (``APS Letter''); letter from Laura J. Lacey,
President, Nationwide Partnership Marketplace Inc. (``NPM''), to
Jonathan G. Katz, Secretary, SEC, dated June 26, 1996 (``NPM
Letter'').
\5\ See letter from Joan Conley, Corporate Secretary, NASD, to
Katherine A. England, Assistant Director, Division of Market
Regulation, SEC, dated October 16, 1996 (``NASD Response'').
\6\ See letter from Joan Conley, Corporate Secretary, NASD, to
Katherine A. England, Assistant Director, Division of Market
Regulation, SEC, dated November 26, 1996 (``Amendment No. 1'').
Amendment No. 1 explained when a DPP trade needs to be reported,
made technical corrections to the proposal so that it now conforms
with the NASD Manual's new format, clarified the implementation
schedule for these new rules, and extended the time period for
Commission action.
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II. Background
In response to findings by the NASD's Direct Participation Programs
Committee (``DPP Committee'' or ``Committee'') and recently issued
Internal Revenue Service (``IRS'') regulations, the NASD submitted a
proposed rule change to permit the quotation of DPPs \7\ on the OTCBB
by NASD members and, subject to a few exceptions, require that all
transactions in DPPs be reported through ACT.
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\7\ The NASD defines a DPP as a program that provides for flow-
through tax consequences regardless of the structure of the legal
entity or vehicle for distribution including, but not limited to,
oil and gas programs, real estate programs, agriculture programs,
condominium securities, Subchapter S corporate offerings and all
other programs similar in nature, regardless of the industry
represented by the program, or any combination thereof. Excluded
from the definition are real estate investment trusts, tax qualified
pension and profit sharing plans pursuant to Sections 401 and 403(a)
of the Internal Revenue Code and individual retirement plans under
Section 408 of that code, tax sheltered annuities pursuant to
Section 403(b) of the Internal Revenue Code, and any company
including separate accounts, registered pursuant to the Investment
Company Act of 1940. Proposed NASD Rule 6910(a); NASD Rule
2810(a)(4).
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A. NASD Study of DPPs
The NASD has contemplated the implementation of a system that
facilitates the dissemination of information concerning DPPs for quite
some time. In fact, the NASD began examining this issue as early as
1980 when it solicited its members' opinions on this topic in the form
of a voluntary questionnaire mailed to all of its members.\8\ The
positive reaction to the questionnaire prompted the NASD to design the
``Electronic Bulletin Board'' system, draft the necessary rules, and
solicit comments from its members regarding these rules and ``the
overall concept of such a system.'' \9\ The NASD received eighteen
comment letters, most of which supported the concept.\10\ After
considering these comments, the NASD filed a proposed rule change with
the Commission on January 20, 1983.\11\ After notice of this proposed
rule change was published by the Commission, additional comment letters
were received.\12\ Subsequently, the NASD decided to further analyze
the issues raised in the comment letters and withdrew the proposal on
August 21, 1985.\13\
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\8\ Dennis C. Hensley, A Study of the NASD ``Electronic Bulletin
Board'' for Limited Partnerships in American Bar Association,
Section of Corporation, Banking and Business Law, Committee on
Partnerships and Unincorporated Business Organizations, Publicly
Traded Limited Partnerships IV-25 (Aug. 2, 1983). Nearly 20% of the
NASD membership responded. Id. of those members, 68% favored the
development of such a system. Id. Among those members who dealt in
DPPs, the percentage of those in favor of the idea rose to be over
80%. Id.
\9\ NASD Notice to Members 82-13.
\10\ Although most of the concerns raised by the commenters were
specific to that proposal, some of the comments focused on issues
that are pertinent to the current rule proposal (e.g., potential tax
law implications, appropriate level of general partner involvement,
and costs). See File No. SR-NASD-83-1 (comment letters attached as
Exhibit 2 to the Form 19b-4).
\11\ File No. SR-NASD-83-1.
\12\ Securities Exchange Act Release No. 19675A (May, 9, 1983),
48 FR 21693 (publishing notice of File No. SR-NASD-83-1).
\13\ Letter from Frank J. Wilson, then-Executive Vice President,
Legal and Compliance, NASD, to Stuart J. Kaswell, then-Branch Chief,
Over-the-Counter Regulation, SEC, dated August 20, 1985.
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The NASD revisited this issue in 1990. At the direction of the DPP
Committee, NASD staff undertook a study of the nature and operation of
the secondary market for limited partnership securities.\14\ This study
indicated that approximately $90 billion was invested in public DPPs in
the 1970s and 1980s by more than ten million investors. The programs
were organized to invest in a variety of
[[Page 2205]]
industries including, but not limited to, real estate, oil and gas,
cable television, commodities, and equipment leasing. Although these
securities were not intended to be liquid and tradeable, the study
found that a secondary market in DPP securities nevertheless had
developed.\15\
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\14\ See NASD Notice to Members 91-69 (``NTM-91-69'')
(publishing the Committee's findings and noting that the primary
concern of the study was to determine how the market currently
operates, whether it functions efficiently, and whether NASD members
are in compliance with the applicable securities laws and rules).
\15\ The NASD estimated at the time that approximately two dozen
participants acted as principal or agent for customers in a
fragmented secondary market that, in the aggregate, transferred
ownership of an estimated $250 to $300 million worth of limited
partnership securities annually. Id.
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In addition, the Committee found that some market participants were
miscalculating markups, markdowns, spreads, and expenses in the DPP
market; were making little effort to determine an investor's
suitability to purchase DPP securities; had no knowledge as to the
applicability of transaction reporting requirements; and were violating
NASD rules concerning predatory pricing practices, best execution, and
due diligence on behalf of customers.\16\ The Committee also found that
some members were not complying with the requirement to file sales
literature with the NASD and were improperly doing business with
nonmember broker-dealers. In addition, some members were not properly
disclosing expenses being charged in connection with the purchase or
sale of a DPP, conflicts of interest the broker-dealer may have with a
customer, and the basis on which the member was recommending the price
at which the securities were being bought or sold.
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\16\ See also William Power, Market for Limited Partnerships Is
Rife with ``Predatory Pricing,'' NASD Finds, Wall St. J., Nov. 18,
1991, at C1 (discussing the DPP Committee's findings).
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B. Tax Status of DPPs
In formulating a response to the Committee's findings, the NASD was
aware that facilitation of a more centralized means for the quotation
of DPPs could cause these securities to be deemed ``publicly traded
partnerships'' under the Internal Revenue Code (``IRC'' or
``Code'').\17\ This would lead to the unintended result of DPPs being
treated as corporations for federal tax purposes.\18\ To assist
partnerships wishing to avoid this result, the IRS issued regulations
in December 1995 that clarified the circumstances under which interests
in partnerships may be quoted without negatively affecting their tax
status.\19\
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\17\ 15 U.S.C. 1-9602.
\18\ I.R.C. Section 7704(a) providing that a publicly traded
partnership is treated as a corporation for federal tax purposes
unless the partnership meets the 90% qualifying income test of
Section 7704(c) or qualifies as an ``existing partnership'' as
defined in Treas. Reg. Sec. 1.7704-2).
\19\ See 60 FR 62026 (Dec. 4, 1995) (adopting Treas. Reg.
Sec. 1.7704-1 and discussing the definition of a publicly traded
partnership under Section 7704(b) of the Code).
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For tax purposes, a publicly traded partnership is defined as a
partnership whose interests are traded on an established securities
market, a secondary securities market, or the substantial equivalent of
a secondary market.\20\ An established securities market includes:
national securities exchanges registered pursuant to Section 6 of the
Act; national securities exchanges exempt from registration because of
the limited volume of transactions conducted thereon; foreign
securities exchanges; and interdealer quotation systems that regularly
disseminate firm quotations by identified brokers or dealers by
electronic means or otherwise.\21\ A secondary market or the
substantial equivalent thereof is an entity or arrangement that, based
on all of the facts and circumstances, readily permits partners to buy,
sell, or exchange their partnership interests in a manner that is
economically comparable to trading on an established securities
market.\22\
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\20\ I.R.C. Section 7704(b); Treas. Reg. Sec. 1.7704-1(a)(1).
\21\ Treas. Reg. Sec. 1.7704-1(b).
\22\ Id. Section 1.7704-(c)(1). For example, a partnership
interest is readily tradable if it is regularly quoted by persons
such as brokers or dealers who are making a market in the
partnership interests; the holder of the partnership interest has a
readily available and ongoing opportunity to sell or exchange the
partnership interest through a public means of obtaining or
providing information of offers to buy, sell, or exchange the
partnership interest; or prospective buyers and sellers otherwise
have the opportunity to buy, sell, or exchange the partnership
interest in a time frame and with the requisite regularity and
continuity described above. Id. Section 1.7704-1(c)(2).
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The broad reach of this expansive definition is tempered by five
nonexclusive safe harbor provisions.\23\ These safe harbors include
transfers not involving trading (private transfers); \24\ redemption or
repurchase agreements meeting certain requirements; \25\ transfers
through a qualified matching service (``QMS''); \26\ certain private
placement transactions; \27\ and a 2% de minimus rule.\28\ Transfers
that qualify for one of the safe harbors are disregarded when
determining whether interests in a partnership are readily tradable on
a secondary market or substantial equivalent thereof.
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\23\ Id. Section 1.7704-1(c)(3).
\24\ Id. Section 17704-1(e) (listing transfers not involving
trading). Among the types of transfers included on this list are
transfers at death, including transfers from an estate or
testamentary trust; transfers between members of a family; and
transfers involving distributions from a qualified retirement plan
or an individual retirement account.
\25\ Id. Section 1.7704-1(f) (listing the necessary
qualifications for a redemption or repurchase agreement).
\26\ Id. Section 1.7704-1(g) (detailing the requirements that a
QMS must abide by).
\27\ Id. Section 1.7704-1(h) (exempting partnership interests
issued pursuant to certain private placement transactions).
\28\ Id. Section 1.7704-1(j). Under this safe harbor provision,
there is no actual trading in a partnership's interests if the sum
of the percentage interests in partnership capital or profits
transferred during the taxable year of the partnership does not
exceed 2% of the total interests in partnership capital or profits.
Private transfers, transfers pursuant to redemption and repurchase
agreements meeting the specified requirements, and transfers
pursuant to a QMS are disregarded for purposes of applying the 2%
rule.
For partnerships that were actively engaged in an activity
before December 4, 1995, this rule applies for taxable years
beginning after December 31, 2005. Until then, these partnerships
may continue to rely on Notice 88-75, 1988-2 C.B. 386, including its
2%-5% safe harbor. This transitional relief expires, however, if the
partnership adds a substantial new line of business within the
meaning of Treas. Reg. Sec. 1.7704-2. Id. Sec. 1.7704-1(1)(2).
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III. Description of the Proposal
The NASD believes the majority of DPP resale transactions are
necessitated by events that force the sale of the partnership unit upon
the limited partner. Such events include estate sales by trustees due
to the death of a limited partner, liquidation of IRA accounts,
divorce, and unexpected or extraordinary expenses such as major medical
procedures or a post-secondary education. From this, the NASD concludes
that the inefficiencies of the fragmented secondary market for DPPs
tend to disproportionately affect investors who need liquidity, rather
than investors who are merely seeking liquidity.
According to the NASD, the proposed changes to its rules concerning
ACT and the OTCBB address this concern and the concerns raised in the
DPP Committee's report. Moreover, the NASD believes the changes reflect
the requirements contained in the IRS regulations so that the quotation
of DPPs on the OTC Bulletin Board would not, by itself, have negative
tax status consequences for the issuers or the holders of these
securities.
A. Quotes on the OTC Bulletin Board
Generally, the treatment of DPPs quoted on the OTC Bulletin Board
will be similar to that of foreign securities and ADRs currently--no
firm prices will be displayed. NASD members will be permitted to insert
only nonfirm prices or unpriced indications of interest (``bid wanted''
or ``offer wanted'' and ``name only'' entries). These nonfirm prices or
indications of interest will provide the
[[Page 2206]]
basis for the negotiations that will take place in order to complete a
transaction in a DPP security. The OTCBB display screen will reflect
the inside market, last sale, previous close, volume and, if available,
distribution information.
In addition, only NASD members will be permitted to apply to place
unpriced entries or indicative quotes on the OTC Bulletin Board. The
requirements of Rule 15c2-11 will apply and, thus, firms generally will
be required to submit Form 211 prior to initiating a quotation of a DPP
on the OTC Bulletin Board, unless an exemption applies.\29\ Finally,
there is no provision for any automatic executions of DPPs on the
OTCBB.
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\29\ See 17 CFR 240.15c2-11 (governing the initiation or
resumption of quotations by a broker-dealer for over-the-counter
securities in a non-Nasdaq interdealer quotation medium).
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B. ACT Trade Reporting
Subject to certain limited exceptions,\30\ all secondary market
transactions in DPPs will be required to be reported to the NASD,
without regard to whether the DPP was the subject of a quotation on the
OTCBB.\31\ Firms will report the transaction on ``T+1,'' \32\ designate
it ``as of'' the previous day, and include the time of execution.
Member firms that have the operational capability to report
transactions within ninety seconds of execution, however, may do so.
The NASD has prepared a symbol directory to facilitate transaction
reporting in DPPs.
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\30\ The proposed reporting requirements do not apply to (1)
transactions made in reliance on Section 4(2) of the Securities Act
of 1933, (2) transactions where the buyer and seller have agreed to
trade at a price substantially unrelated to the current market for
the DPP (e.g. gifts), or (3) transactions executed on a registered
national securities exchange or through Nasdaq. See proposed NASD
Rule 6920(g).
\31\ Certain minor changes have been made to the definition of
the term ``ACT eligible security'' to clarify that transactions in
Nasdaq SmallCap and certain other OTC securities must be reported
through ACT as well.
\32\ The date of the trade plus one.
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The transactions will be reported through ACT for reporting
purposes only.\33\ Thus, ACT will not be used to facilitate clearance
and settlement of these securities notwithstanding the possibility that
a particular DPP eligible for inclusion on the OTCBB also may be
eligible for clearing with a clearing agency. Moreover, the OTCBB will
not assist parties in completing the transfer documents and other forms
necessary to clear and settle a transaction in a DPP security.
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\33\ The NASD's understanding is that members who effect
transactions in DPPs predominately act in the capacity of agent. For
reporting purposes, the concepts of agency and principal have the
same meaning as those terms are commonly used or understood, unless
otherwise noted in proposed NASD Rule 6900.
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The NASD recognizes that some member firms who participate in this
market may not have the capability to report transactions through ACT.
Members without direct access to ACT may report such transactions
through the ACT Service Desk if the member averaged a limited number of
transactions per day during the previous calendar quarter.\34\
Alternatively, such members may consider obtaining a computer-to-
computer interface (``CTCI'') or a Nasdaq Workstation.
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\34\ As proposed, NASD Rule 6920 provides that a member may use
the ACT Service Desk if it averaged five fewer trades per day during
the previous calendar quarter. In calculating the average number of
trades per day, transactions in any security must be included, not
just transactions in DPPs.
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IV. Summary of Comments
The Commission received seven comment letters concerning this
proposal. Although the commenters discussed a number of different
topics, their comments generally addressed one of two categories: tax
issues and clearing issues. The NASD responded to these comments in
letters dated October 16, 1996 and November 26, 1996.
A. Tax Issues
1. IRS Private Letter Ruling
Several commenters noted that the NASD did not obtain a ruling from
the IRS assuring the NASD that the proposal would not run afoul of
Section 7704 of the IRC and the regulations promulgated thereunder.\35\
The commenters stated that this is particularly important in light of
the fact that the NASD sought such a ruling from the IRS on a prior
occasion concerning a similar five percent safe harbor as set forth in
IRS Notice 88-75, 1988-2 C.B. 386. Without such a ruling, they claimed
that the liquidity and efficiency of the market would be reduced.\36\
Therefore, the commenters maintained that, due to the importance of the
proposal to the secondary market, its approval should be conditioned
upon the NASD obtaining a favorable ruling from the IRS.
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\35\ See Fotenos & Suttle Letter, supra note 4; CPB Letter No.
2, supra note 4; APS Letter, supra note 4.
\36\ See CPB Letter No. 2, supra note 4 (asserting that an IRS
ruling is required to allow QMSs to participate in the OTCBB without
affecting their status as a QMS); APS Letter, supra note 4 (claiming
that certain general partners will use the absence of such a ruling
as an excuse to restrict the trading of their DPPs).
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In response, the NASD asserted that the IRS regulations were clear
and unambiguous in that the inclusion of quotations on the OTCBB would
not constitute an established securities market, a secondary securities
market, or the substantial equivalent thereof and, therefore, a ruling
from the IRS was not necessary to approve the proposal. Nevertheless,
the NASD obtained a private letter ruling from the IRS to gain absolute
certainty regarding the impact of this proposal on the tax status of
DPPs. Specifically, the IRS ruled that: (1) the OTCBB is not an
established securities market for purposes of Section 7704(b) of the
IRC and Section 1.7704-1(b) of the Income Tax Regulations; (2) a
partnership whose interests are displayed on the OTCBB will not be
considered to be publicly traded solely by reason of being displayed on
the OTCBB because the OTCBB undertakes to display partnership interests
in compliance with Example 2 of Treasury Regulation 1.7704-1(j)(2); (3)
such partnerships may rely on this ruling provided it is not revoked
and the OTCBB continues to operate in a manner consistent with the
facts represented; (4) calculations relating to qualification for any
applicable safe harbor in Treasury Regulation 1.7704-1 or in IRS Notice
88-75 remain the responsibility of the partnerships whose interests are
traded and are not the responsibility of the NASD, The Nasdaq Stock
Market Inc., NASD Regulation, Inc., or the OTCCBB; and (5)
notwithstanding that the OTCBB does not meet the requirements to be a
QMS under Treasury Regulation 1.7704-1(g), matching services eligible
for participation in the OTCBB may utilize the OTCBB to display nonfirm
prices and unpriced indications of interest without disqualifying
themselves as a QMS, provided that they otherwise meet all of the
requirements for a QMS under Treasury Regulation 1.7704-1(g).\37\
Compliance with the requirements for a QMS will be the sole
responsibility of the matching service, not the NASD, The Nasdaq Stock
Market, Inc., NASD Regulation, Inc., or the OTCBB.
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\37\ See letter from William P. O'Shea, Chief, Branch 3, Office
of the Assistant Chief Counsel, IRS, to Richard G. Ketchum,
Executive Vice President and Chief Operating Officer, NASD, dated
October 7, 1996 and attached as Exhibit 3 to the NASD Response
(``IRS Ruling'').
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2. Procedural Safeguards
One commenter requested that the NASD provide additional
information concerning the procedures the NASD would employ to
reasonably assure general partners that the DPP securities of the
partnerships they manage would not afoul of the safe harbors in
Treasury
[[Page 2207]]
Regulation 1.7704-01.\38\ The NASD addressed this comment by noting
that virtually all partnership agreements require that general partners
first approve all transfers of partnership interests and grant the
general partner the authority to reject transfers that may jeopardize
the tax status of the partnership. The NASD explained that the proposal
would not affect the fiduciary responsibility currently born by general
partners of ensuring the tax status of their DPPs. Thus, the monitoring
of the safe harbor threshold levels would continue to be the
responsibility of the general partners.\39\
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\38\ See Fotenos & Suttle Letter, supra note 4.
\39\ See Amendment No. 1 supra note 6; IRS Ruling, supra note
37. To assist the general partners with such compliance, the NASD
will make transaction reporting information available for a nominal
fee.
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3. Qualified Matching Services
One comment letter discussed the potential impact the proposal
might have on the QMS safe harbor.\40\ The commenter alleged that a
shadow of uncertainty would be cast on the status of QMSs that also
wished to publish quotes on the OTCBB because the OTCBB was not a QMS.
The commenter claimed that such dual participation would jeopardize the
QMS status of those members. In order to protect their QMS safe harbor
status, the commenter predicted that QMSs would not publish quotes on
the OTCBB and thereby lead to further fragmentation of the DPP market.
In addition, the commenter asserted that this uncertainty would
disadvantage those firms that made the investment in becoming qualified
as a QMS because some general partners will simply suspend all trading
at the 2% level, regardless of who is involved in the trades. To avoid
these problems, the commenter suggested that the NASD modify the rules
of the OTCBB to accommodate different turnover levels and obtain a
private letter ruling from the IRS that specified that publishing
nonfirm quotes on the OTC Bulletin Board would not disqualify a system
as a QMS.
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\40\ See CPB Letter No. 2, supra note 4.
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The NASD responded by noting that the proposal would have no effect
whatsoever on the application of the QMS safe harbor because a QMS
could maintain its status by simply complying with that safe harbor's
requirements while utilizing the OTCBB.\41\ Moreover, the NASD asserted
that QMSs may actually enjoy some advantages over non-QMS participants
utilizing the OTCBB because QMSs could continue to utilize the OCTBB
until the 10% QMS safe harbor level was reached, while other OCTBB
participants will be effectively capped by the IRS regulations at the
2% de minimis level.
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\41\ See Amendment No. 1 supra note 6. See also IRS Ruling supra
note 37.
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B. Clearing Issues
1. Timing of Trade Reports
The commenters requested further guidance concerning the timing of
DPP trade reporting.\42\ The commenters explained that transfers in the
DPP secondary market differ significantly from transfers in other
secondary securities markets in that these contracts are subject to a
number of unique contingencies.\43\ These contingencies often cause
significant delays in the transfer process. As a result, many
``trades'' fail. Therefore, the commenters requested that the NASD
reconsider when a trade takes place for ACT reporting purposes.
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\42\ See Fotenos & Suttle Letter, supra note 4; NAPEX Letter,
supra note 4.
\43\ For example, transfers in the DPP secondary market are
subject to the approval of the general partner(s), which often
impose informational requirements. In addition, the prior consent of
a state regulator may be required under certain circumstances. See
Dudley Muth et al., Transferring Limited Partnership Interests, Real
Est. Sec. J. Winter 1981, at 51 (detailing the transfer process of a
DPP).
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The NASD explained that an obligation to report a transaction in a
DPP security is triggered on the day following the ``date of
execution.'' \44\ Once an agreement to trade has been reached, the NASD
expects the appropriate member to report the transaction. The NASD
believes delaying the transaction report until a later date when the
transfer actually occurs could mislead market participants and
regulators who need to access the current value of a DPP.
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\44\ See Amendment No. 1, supra note 6. Proposed NASD Rule
6910(e) defines the ``date of execution'' as ``the date when the
parties to a transaction in a DPP have agreed to all of the
essential terms of the transaction, including the price and number
of units to be traded.''
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In addition, the NASD does not believe it is necessary for the
reporting member to submit a correction or fail to notice if a transfer
does not take place after a transaction is reported. The NASD
maintained that the subsequent events that may impair the process of
transferring a DPP do not negate the circumstances surrounding the
events that initially gave rise to the intent to trade the security.
2. OTC Bulletin Board Symbols
The commenters questioned the ability of the NASD's current six
digit symbol format to sufficiently service all of the DPPs in
existence, inquired whether it would be necessary to report a DPP
transaction through ACT if a NASD symbol did not exist, and requestd
that the NASD provide a symbol directory at least sixty days prior to
the final implementation of this proposal so that NASD members would
have ample time to input this information into their computer
systems.\45\
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\45\ See CPB Letter No. 1, supra note 4; NAPEX Letter, supra
note 4.
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In response to these comments, the NASD assured the Commission that
it will announce the effective date of the proposed rule change in a
Notice to Members no later than forty-five days following commission
approval of the proposed rule change and, in no event, will that
effective date be sooner than forty-five days after Commission approval
of the proposal.\46\
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\46\ See Amendment No. 1, supra note 6. The NASD also indicated
that the effective date will be no later than 90 days following the
publication of that Notice to Members. should this schedule need to
be revised, the NASD stated that it will immediately notify the
Commission.
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3. Associated Costs
One commenter asserted that the proposal would increase its costs
and reduce its allowable compensation.\47\ The commenter attributed the
increase in costs to the proposal's reporting requirement, the need for
additional equipment, and reduced spreads.
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\47\ See NAPEX Letter, supra note 4.
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4. Standardized Transfer Forms
Several commenters contended that the NASD's standardized transfer
forms, including the standardized distribution allocation agreement,
contain flaws that render them useless.\48\ The commenters maintained
that distribution terms are extremely material to the quoted price and,
therefore, quotations on the OTC Bulletin Board should not be allowed
until this matter is resolved.
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\48\ See CPB Letter No. 3, supra note 4; NAPEX Letter, supra
note 4; APS Letter, supra note 4. For example, one commenter
asserted that it is often necessary to prepare two sets of transfer
documents to effect transactions because many general partners
refuse to honor the NASD's forms. NAPEX Letter, supra note 4.
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In response, the NASD emphasized the importance of the standardized
forms, but also acknowledged the difficulty of bringing total
uniformity to every transfer in this market.\49\ As a result, the NASD
has filed a proposed amendment to NASD Rule 11580 that would permit
members to modify the forms after receiving authorization from NASD
Regulation staff.\50\
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\49\ NASD Response, supra note 5.
\50\ See Securities Exchange Act Release No. 38042 (Dec. 11,
1996), 61 FR 66339 (publishing notice of File No. SR-NASD-96-42).
Currently, NASD Rule 11580 does not allow NASD members to modify the
NASD's standardized forms concerning limited partnership interests.
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[[Page 2208]]
V. Discussion
The Commission finds that the proposed rule change is consistent
with the requirement of the Act and the rules and regulations
thereunder applicable to a national securities association.
Specifically, the Commission believes the proposed rule change is
consistent with Section 15A(b)(6) \51\ because it is designed to
promote just and equitable principles of trade, to prevent fraudulent
and manipulative acts, to perfect the mechanism of a free and open
market, and, in general, to protect investors and the public interest.
In making this finding, the Commission notes that the proposal should
promote more efficient regulation of the DPP market, as well as enhance
transparency, liquidity, and competition in that market.\52\ The
Commission also believes the proposed rule change is consistent with
Section 15A(b)(2) \53\ because it improves the NASD's ability to
regulate the DPP market by increasing its surveillance
capabilities.\54\
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\51\ 15 U.S.C. 78O-3(b)(6).
\52\ 15 U.S.C. 78c(f) (as added by the ``National Securities
Markets Improvement Act of 1996'').
\53\ 15 U.S.C. 78O-3(b)(2).
\54\ The Commission notes that the proposal also promotes many
of the same policy considerations Congress found appropriate for the
development of the National Market System. For example, the proposal
should improve the efficiency of DPP market operations, broaden the
distribution of market information, enhance the NASD's market
oversight capabilities, and foster competition among market
participants through the use of new data processing and
communications techniques. See 15 U.S.C. 78k-1(a)(1).
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During the 1980s, over $150 billion of public limited partnership
interests were sold to approximately eleven million U.S. investors,
most of whom were retail investors with an average investment of ten
thousand dollars.\55\ Investors usually purchased these securities with
the understanding that they were long-term, illiquid investments to be
held until the holding period expired and the partnership was
liquidated.\56\ The holding period of many of these securities,
however, had to be extended beyond the originally anticipated five to
ten year holding period due to weakness in the underlying value of many
partnership assets. This extended holding period has contributed to the
development of a viable secondary market for DPP securities.\57\ Given
the size and nature of this market, it is important that it operate
efficiently and fairly. In this regard, the proposal represents a
positive, evolutionary change in the DDP market.\58\ It increases
transparency without adversely affecting the tax status of the quoted
securities or inhibiting the clearance and settlement process.
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\55\ Senate Comm. on Banking, Housing, and Urban Affairs,
Limited Partnership Rollup Reform Act of 1993, S. Rep. No. 121. 103d
Cong., 1st Sess., 4 (1993). See also Deborah A. DeMott, Rollups of
Limited Partnerships: Questions of Regulation and Fairness, 70 Wash.
U. L.Q. 617 (1992) in Limited Partnerships: Hearings on H.R. 617
Before the Subcomm. on Telecommunications and Finance of the House
Committee on Energy and Commerce, 103d Cong., 1st Sess., 114-15
(1993) (classifying the limited partnership interests sold by
broker-dealers as an overwhelmingly ``retail'' product because 8
million of the 11 million purchasers of these securities were
individual investors).
\56\ House Comm. on Energy and Commerce, Limited Partnership
Rollup Reform Act of 1993, H.R. Rep. No. 21, 103 Cong., 1st Sess., 7
(1993); Securities Exchange Act Release No. 29883 (Oct. 30, 1991),
56 FR 57237 (adopting rules intended to enhance the quality of
information provided to investors in connection with transactions
involving rollups of limited partnerships). See also C. David Chase,
Mugged on Wall Street 195 (1987) (espousing the author's personal
opinion that it is easier to divorce one's spouse than to separate
from a partnership).
\57\ The longer the holding period, the more likely an event
requiring a limited partner to sell his interest will occur (e.g.,
death, liquidation of an IRA account, divorce, or an extraordinary
expense such as a major medical procedure or post-secondary
education). See also NASD Response, supra note 5 (asserting that, in
the aggregate, this market transfers an estimated $250 to $300
million worth of DPP securities annually).
\58\ One commenter suggested that the Commission delay its
consideration of the proposed rule change until it had rendered a
decision regarding two pending NASD petitions for rulemaking. See
NPM Letter, supra note 4 (discussing the NASD's pending rulemaking
petitions concerning the applicability of Rules 10b-17, 17Ad-2,
17Ad-3, 17Ad-4, and 17Ad-6 to the DPP market). The NASD withdrew its
request concerning the modification of SEC transfer agent rules
under Section 17A of the Act on December 23, 1996. See letter from
Suzanne E. Rothwell, Associate General Counsel, NASD Regulation,
Inc., to Jonathan G. Katz, Secretary, SEC, dated December 20, 1996
(File No. 4-387) Although the pending rulemaking petition addresses
important issues, the Commission believes the issues presented in
the proposed rule change may be addressed independently of those
matters.
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A. Benefits of the Proposal
By increasing transparency, the proposed rule change should enhance
investor protection and increase the actual and perceived fairness of
the DPP market. The proposal should benefit investors by improving
their ability to secure better prices in DPP transactions and by making
it easier for them to monitor the quality of executions they receive
from their intermediaries. Moreover, the increased transparency should
assist regulators by expanding their market oversight capabilities and
their ability to monitor member handling of DPP transactions and
markups. Finally, the increased transparency should assist NASD members
to fulfill their regulatory responsibilities and help prevent
overreaching by certain members of other, previously less informed
members.
In addition, the proposal should promote liquidity in the DPP
market by encouraging greater investor participation.\59\ For example,
a more transparent market can reduce trading costs by decreasing
spreads and, as noted previously, facilitate the investors' ability to
monitor the quality of executions they receive. This should foster
investor confidence in the DPP market and, as a result, investors
should be more willing to participate.\60\ This increased participation
should elevate the level of liquidity in the DPP market.\61\
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\59\ See Securities Exchange Act Release No. 37619A, 61 FR 48289
n.58, n.122 (Sept. 12, 1996) (adopting the ``Order Execution
Obligation Rules'' and noting that past Commission enhancements to
transparency have resulted in improved liquidity). One commenter
claimed that the proposal will harm liquidity because it will reduce
spreads which, in turn, will decrease members' compensation and,
ultimately, cause market participants to reevaluate the services
that they wish to provide. NAPEX Letter, supra note 4. The
Commission recently addressed a similar concern in connection with
its adoption of the Order Execution Obligation Rules. By mandating
the display of customer limit orders under most circumstances, the
Commission recognized that increased transparency may reduce market
maker profits through the narrowing of spreads and, as a result, may
force less efficient competitors to stop making markets in some of
the securities that they then quoted. Nevertheless, the Commission
did not believe the Order Execution Obligation Rules would have a
significant negative impact on the market because customers are the
ultimate source of liquidity for the markets. Order Execution
Obligation Rules, supra note 59, at n.118. See also ``Why Protect
Investors?'' Remarks by SEC Chairman Arthur Levitt Before the
Commonwealth Club, San Francisco, California (May 17, 1996)
available on SEC World Wide Web site at ``www.sec.gov/news/
spchindx.htm#chair'' (noting that a market can exist without
brokers, but it cannot exist without investors). Similarly, the
Commission believes the proposal's benefits of increased investor
protection, elevated liquidity, and improved efficiency outweigh its
associated costs, including the potential loss of liquidity provided
by market makers.
\60\ One commenter expressed concern that approval of the
proposal will cause the volume of DPP transactions to explode and
unduly exacerbate certain clearance and settlement issues that
currently exist in this market. See NPM Letter, supra note 4. So
also Muth et al., supra note 43 (detailing the complicated clearance
and settlement process). The Commission disagrees. Although more
investors, traders, and dealers may be willing to participate in a
fairer, more transparent, more competitive DPP market, any potential
increase in the volume of transactions that may occur in this market
is limited by the applicable IRC provisions and the rules and
regulations promulgated thereunder. Furthermore, this inhibition on
volume should prevent these long-term investments from being
converted into short-term speculative securities and minimize any
potential effect on the primary market for DPPs.
\61\ SEC, Division of Market Regulation, Market 2000: An
Examination of Current Equity Market Developments IV-3 (Jan. 1994)
(``Market 2000 Study''); Securities Exchange Act Release No. 37273
(June 4, 1996), 61 FR 29438 (noting that the depth and liquidity of
any particular security is dependent on numerous variables,
including the degree of customer buying and selling interest in the
security and the quality and capitalization of the issuer).
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[[Page 2209]]
The proposal also fosters market efficiency by helping unite the
extremely fragmented DPP market. The current structure of this market
requires the DPP securities be traded ``in the dark'' (i.e., with
little or not transparency for those trades). This prevents investors
from assessing the overall supply and demand for a particular DPP
security and, consequently, hampers their ability to determine that
security's optimal price. Furthermore, this opaque trading makes price
competition difficult and inefficient.\62\
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\62\ American Bar Association, Committee on Partnerships and
Unincorporated Business Organizations, Publicly Traded Limited
Partnership, 39 Bus. Law. 717-18 (1984) (explaining that secondary
sales of limited partnership often result in a ``haphazard search''
to find a buyer for the unit).
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The proposal addresses both of these inefficiencies. First, by
requiring that all transactions in DPP securities be reported through
ACT \63\ and permitting quotes and market information to be
disseminated via the OTC Bulletin Board, the proposal provides
investors with valuable information that enhances their ability to
accurately determine the current value of a DPP, discern the direction
of recent trading activity, and determine whether significant trading
is occurring between, or outside of, the displayed nonfirm quotes.
Second, the proposed rule change fosters price competition in this
market \64\ because pricing information will be more readily
available.\65\
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\63\ See supra note 30 (listing the limited exemptions from the
reporting requirement).
\64\ One commenter asserted that utilizing nonfirm quotes and
unpriced indications of interest will encourage market participants
to place unrealistic bids to attract sellers. See NAPEX Letter,
supra note 4. This assertion, however, overlooks at least three
policing mechanisms inherent in a competitive market.
First, the existence of other quotes limit the ability of a
market participant to place an unrealistic quote to attract interest
and then move away form this quote once negotiations begin. Assume,
for example A, B, and C each place a bid on the OTCBB for a
particular DPP at $1050, $1025, and $1000 respectively. Naturally, a
prospective seller would begin negotiating with the most favorable
bidder, in this case A. If A attempts to reduce its bid lower than
$1025, A risks losing the transaction because A does not know B's
intentions--B may be willing to pay $1025.
Second, members are under a duty to provide their customers with
best execution as to price. NTM-91-69 points out that this requires
a member to obtain quotations from at least three dealers to
determine the best interdealer market price for a non-Nasdaq
security. For example, if W, X, Y, and Z each place a bid on the
OTCBB for a particular DPP at $1050, $1025, $1000, and $975
respectively, the seller's broker would contact, at a minimum, W, X,
and Y. If W, X, and Y are only willing to trade at prices below Z's
bid, the broker should contact Z as well.
Third, the Commission notes that NASD Rule 3310 prohibits
members from publishing any quotation for any security without
having reasonable cause to believe that such quotation is a bona
fide quotation and is not published for any deceptive or
manipulative purpose.
\65\ This information will be accessible from almost 6,000
Nasdaq Workstations and an additional 290,000 market data vendor
terminals. NASD Repsonse, supra note 5.
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In sum, the increased transparency should reduce the effects of
fragmentation and encourage competition.\66\ Thus, the Commission
believes that proposal's benefits of increased transparency for the DPP
market outweigh its potential costs.\67\
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\66\ Market 2000 Study, supra note 61, at IV-1.
\67\ One commenter claimed that the reporting requirement would
increase members' costs by requiring them to procure additional
equipment. See NAPEX Letter, supra note 4. The Commission does not
believe the proposal will have a significant impact on the NASD's
membership as a whole because this justifiable cost will be limited
to a relatively small group of members. Cf. NTM-91-69, supra note 14
(finding that the DPP market was consisted primarily of two dozen
participants acting as principal or agent); CPB Letter No. 2, supra
note 4 (claiming to have effectuated one-third of all transactions
reported to independent sources since 1992); NASD Response, supra
note 5 (noting that the NASD interviewed all identifiable
participants in the secondary market for DPPs). Moreover, the
Commission notes that members that average five or fewer trades per
day for the previous calendar quarter will not need to acquire any
additional equipment because they may utilize the ACT Service Desk
to report their trades. Proposed NASD Rule 6920. Thus, of this
already limited group, only active members who do not already
possess the necessary equipment will be affected. See also supra
note 59 and accompanying text (discussing the costs associated with
increased transparency).
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B. Tax Issues
Although most of the commenters' concerns \68\ are explicitly
addressed in Treasury Regulation 1.7704-1,\69\ the NASD obtained a
private letter ruling that, among other things, specifically addresses
each of their tax concerns.\70\ In that ruling, the IRS explained that
(1) the OTCBB is not an established securities market, a secondary
securities market, or the substantial equivalent thereof and (2) the
calculations relating to qualification for any applicable safe harbor
in Treasury Regulation 1.7704-1 or IRS Notice 88-75 are the sole
responsibility of the partnerships whose interests are traded.\71\
Thus, there is no need for the NASD to make any additional
modifications to the OTCBB.\72\
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\68\ As noted above, the commenters raised several concerns
regarding the potential tax implications they believed the proposed
rule change could have. Specifically, the commenters requested that:
(1) the NASD obtain a private letter ruling from the IRS stating
that the inclusion of a DPP on the OTCBB would not, by itself,
transform that DPP into a publicly traded partnership; (2) the NASD
detail what procedural protections were going to exist to ensure
that the IRS safe harbor provisions were not exceeded; and (3) the
NASD consider the potential impact the proposal could have on QMSs.
\69\ See Treas. Reg. Sec. 1.7704-1(j)(2) (setting forth in
Example 2 a hypothetical situation that is virtually identical to
the NASD's proposed rule change).
\70\ IRS Ruling, supra note 37.
\71\ IRS Ruling, supra note 37.
\72\ Nevertheless, the NASD has indicated that it will assist
general partners by making transaction data available to them for a
nominal fee. The Commission notes, however, that the NASD's rules
currently do not contain the formula by which such charges will be
calculated. Therefore, the NASD must submit a proposed rule change
to the Commission pursuant to Section 19 of the Act before charging
such a fee. Moreover, given that this fee will be imposed on non-
NASD members, it must be submitted for full notice and comment
because it does not qualify for immediate effectiveness pursuant to
Section 19(b)(3)(A) of the Act. See 15 U.S.C. 78s(b); Securities
Exchange Act Release No. 35123 (Dec. 20, 1994), 59 FR 66692
(amending Rule 19b-4 and stating that, as a matter of general
policy, a proposed rule change that establishes or changes a fee
applicable to nonmembers must be filed under Section 19(b)(2) of the
Act for full notice and comment).
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The IRS also clarified that a QMS may utilize the OTCBB without
jeopardizing its status as a QMS, as long as the QMS continues to
comply with all of the applicable safe harbor provisions.\73\ Hence, a
member that has made the capital investment to become a QMS may enjoy
an advantage over those members that are not a QMS because the IRS
regulations permit QMSs to facilitate transactions until the 10% QMS
safe harbor threshold is met, while members relying on the de minimis
safe harbor are capped at 2%.\74\ This advantage should promote
competition and increase the market's liquidity by encouraging other
NASD members to become QMSs.
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\73\ IRS Ruling, supra note 37.
\74\ Certain transactions, such as those not involving trading,
are not subject to a strict, predetermined cap. See supra notes 23
to 28 and accompanying text (providing a general explanation of the
IRS safe harbor provisions).
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C. Clearing Issues
1. Trade Reporting
Notwithstanding the unique contingencies that exist in a DPP
transaction, the Commission believes it is appropriate for the NASD to
require its members to report transactions in DPP securities as soon as
an agreement to trade has been reached. By reporting transactions by
T+1, the member will be reporting the current trading interest in a
particular DPP. If the reporting requirement were postponed until the
date the transfer actually takes place, investors would be receiving
information that was several weeks, or possibly months, old. The
usefulness of such information to parties attempting to ascertain the
current value of a DPP
[[Page 2210]]
is minimal when compared to information reported by T+1. Moreover,
reporting a trade when the agreement occurs, rather than waiting until
the transfer actually takes place, is consistent with current industry
practice for other securities.
The Commission also does not believe it is necessary for members to
submit a notice at a later date if a trade fails due to the unique
post-trade contingencies that exist in the DPP market.\75\ Ultimately,
the price of a security is determined by two factors: the amount of
money a buyer is willing to spend to acquire a certain amount of a
particular security and the amount of money a seller is willing to
accept to sell the same amount of that security. It is this information
that investors value the most. The fact that a transaction fails at a
later date because a general partner refuses to acknowledge the trade
does not disparage the quality of the previously reported information
concerning current market interest.\76\
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\75\ Of course, members must correct inaccurate trade reports.
For example, a member must correct a trade reported at $680 if, in
fact, the trade price was $860.
\76\ The Commission assumes that the parties are bargaining in
good faith when they reach an agreement that is subsequently
reported through ACT. Cf. NASD Rule 3310 (prohibiting members from
publishing the notice of a purchase or sale of any security without
having reasonable cause to believe that such transaction was a bona
fide purchase or sale).
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2. Implementation
The Commission believes the NASD's implementation plan adequately
addresses the commenters' concerns. The NASD intends to announce the
effective date of the proposed rule change in a Notice to Members
within forty-five days following the date of this order. This effective
date will be no later than 90 days following the publication of that
Notice to Members but, in no event, will the effective date be sooner
than forty-five days after the date of this order.\77\ This
implementation schedule should provide the NASD's members with ample
time to procure any necessary equipment and enter any essential data
into their computer systems.
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\77\ Amendment No. 1, supra note 6.
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To facilitate transaction reporting, the NASD has compiled a
comprehensive list of symbols that will be utilized by members when
reporting a transaction through ACT.\78\ If a symbol does not exist for
a particular DPP, a member simply calls the ACT Service Desk before
reporting the transaction, and a symbol will be assigned.\79\
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\78\ This list will automatically be incorporated into the
Nasdaq Workstation's on-line symbols directory when the proposed
rule change becomes effective. If members would like a copy of this
list prior to the proposal's implementation, however, they simply
have to contact the Nasdaq Market Operations staff in Trumbull,
Connecticut, and an electronic or paper copy will be provided.
\79\ The Commission believes the current six digit format is
sufficient to service the DPP market. Contra NAPEX Letter, supra
note 4. After polling the major market participants, the NASD
represented that it anticipates approximately 2,000 DPP securities
to be quoted on the OTCBB. Telephone conversation between Andrew S.
Margolin, Senior Attorney, The Nasdaq Stock Market, Inc., and
Anthony P. Pecora, Attorney, Division of Market Regulation, SEC
(Jan. 3, 1996). Notwithstanding that the NASD intends to utilize the
prefixes of ``xx,'' ``yy,'' and ``zz'' to indicate DPP securities,
the remaining four digits still provide ample capacity because a
surplus of approximately 86,000 symbols will exist to accommodate
unanticipated or new DPP securities. In addition, the Commission
does not believe the expense associated with mandating an entirely
new, expanded symbol format to ensure the symbols assigned clearly
indicate the issuer of a particular DPP outweighs the potential
benefits such a convenience would confer upon NASD members.
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D. Amendment No. 1
The Commission finds good cause for approving Amendment No. 1 prior
to the thirtieth day after the date of publication of notice thereof in
the Federal Register. Amendment No. 1 simply updates the proposal's
internal citations to conform with the new rule numbering system that
was implemented by the NASD after it filed SR-NASD-96-08 with the
Commission. Therefore, the Commission believes that granting
accelerated approval to Amendment No. 1 is appropriate and consistent
with Section 15A and Section 19(b)(2) of the Act.\80\
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\80\ 15 U.S.C. 70o-3, 78s(b)(2).
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Interested persons are invited to submit written data, views and
arguments concerning Amendment No. 1 to the proposed rule change.
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 rules
change that are filed with the Commission, and all written
communications relating to Amendment No. 1 between the Commission and
any persons, other than those that may be withheld from the public in
accordance with the provisions of 5 U.S.C. Sec. 552, will be available
for inspection and copying in the Commission's Public Reference Room.
Copies of such filing will also be available at the principal office of
the NASD. All submissions should refer to File No. SR-NASD-96-08 and
should be submitted by February 5, 1997.
VI. Conclusion
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\81\ that the proposed rule change (SR-NASD-96-08) is approved,
including Amendment No. 1 on an accelerated basis.
\81\ 15 U.S.C. 78s(b)(2).
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For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\82\
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\82\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-896 Filed 1-14-97; 8:45 am]
BILLING CODE 8010-01-M