[Federal Register Volume 62, Number 104 (Friday, May 30, 1997)]
[Notices]
[Pages 29382-29385]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-14120]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-38670 File No. SR-NASD-97-29]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change and Amendments No. 1 and No. 2 Thereto by the National 
Association of Securities Dealers, Inc. Relating to Prohibition on 
Members Receiving any Payment to Publish a Quotation, Make a Market in 
an Issuer's Securities or Submit an Application to Make a Market in an 
Issuer's Securities

May 22, 1997.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') \1\ and rule 19b-4 thereunder, \2\ notice is hereby given 
that on April 18, 1997, the National Association of Securities Dealers, 
Inc. (``NASD'' or ``Association'') filed with the Securities and 
Exchange Commission (``SEC'' or ``Commission'') the proposed rule 
change as described in Items I, II and III below, which Items have been 
prepared by the self-regulatory organization. On May 19, 1997 and May 
21, 1997, NASD submitted two amendments (``Amendment No. 1'') and 
``Amendment No. 2''), respectively, to the proposed rule change. \3\ 
The Commission is publishing this notice to solicit comments on the 
proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Letter from Alden Adkins, Vice President and General 
Counsel, NASD Regulation, to Elaine Darroch, Attorney, Division of 
Market Regulation, SEC (May 16, 1997)(``Amendment No. 1''). In 
Amendment No. 1, NASD Regulation made technical corrections to the 
text of the rule, provided an explanation for not expressly 
prohibiting member-to-member payments of making a market, and added 
an explanatory footnote concerning the rule's coverage. Letter from 
Alden Adkins, Vice President and General Counsel, NASD Regulation, 
to Elaine Darroch, Division of Market Regulation, SEC (May 21, 
1997)(``Amendment No. 2''). Amendment No. 2 corrected a minor 
omission in Amendment No. 1.
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1. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The NASD is proposing Rule 2460 to prohibit members from receiving 
any payment to publish a quotation, make a market in an issuer's 
securities, or submit an application to make a market. \4\ Below is the 
text of the proposed rule change. Proposed new language is in italics.
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    \4\ The proposed rule change was approved by the Board of 
Directors of the NASD Regulation at its meeting on March 12, 1997, 
which authorized the filing of the rule change with the SEC. The 
NASD, Inc., Board of Governors declined to review the proposed rule 
change at its meeting on April 10, 1997. No other action is 
necessary to approve the proposed rule change. See Amendment No. 1, 
supra note 3.
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2460. Payments for Market Making

    (a) No member or person associated with a member shall accept any 
payment or other consideration, directly or indirectly, from an issuer 
of a security, or any affiliate or promoter thereof, for publishing a 
quotation, acting as market marker in a security, or submitting an 
application in connection therewith.
    (b) The provisions of paragraph (a) shall not preclude a member 
from accepting:
    (1) payment for bona fide services, including, but not limited to, 
investment banking services (including underwriting compensation and 
fees); and
    (2) reimbursement of any payment for registration imposed by the 
Securities and Exchange Commission or state regulatory authorities and 
for listing of an issue of securities imposed by a self-regulatory 
organization.
    (c) For Purposes of this rule, the following terms shall have the 
stated meanings:
    (1) ``affiliate'' shall have the same definition as used in Rule 
2720 of the business Conduct Rules of the Association:
    (2) ``promoter'' means any person who founded or organized the 
business of enterprise of an issuer, is a director or employee of an 
issuer, acts or has acted as a consultant, advisor, accountant, or 
attorney to an issuer, is the beneficial owner of any of an issuer's 
securities that are considered ``restricted securities'' under Rule 
144, or is the beneficial owner of five percent (5%) or more of the 
public float of any class of an issuer's securities, and any other 
person with a similar interest in promoting the entry of quotations or 
market marking in an issuer's securities; and
    (3) ``quotation'' shall mean any bid or offer at a specified price 
with respect to a security, or any indication of interest by a member 
in receiving bids or offers from others for a security, or an 
indication by a member that he wishes to advertise his general interest 
in buying or selling a particular security.

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

    In its filing with the Commission, the NASD included statements 
concerning the purpose of, and basis for, the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements

[[Page 29383]]

may be examined at the places specified in Item IV below. The NASD has 
prepared summaries, set forth in Section A, B, and C below, of the most 
significant aspects of such statements.

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

    It has been a longstanding policy and position of the NASD that a 
broker-dealer is prohibited from receiving compensation or other 
payments from an issuer for quoting, making a market in an issuer's 
securities, or for covering the member's out-of-pocket expenses for 
making a market, or for submitting an application to make a market in 
an issuer's securities.\5\ As stated in Notice to Members 75-16 
(February 20, 1975), such payments may be viewed as a conflict of 
interest since they may influence the member's decision as to whether 
to quote or make a market in a security and, thereafter, the prices 
that the member would quote.
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    \5\ See NASD Notice to Members 75-16 (February 20, 1975) and 92-
50 (October 1992).
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    In the past, certain broker-dealers have entered into arrangements 
with issuers to accept payments from an issuer, affiliate, or promoter 
of the issuer to make a market in the issuer's securities, or for 
covering out-of-pocket expenses of the member incurred in the course of 
market making, or for submitting an application to act as a market 
maker. As stated above, the NASD believes that such conduct may be 
viewed as a conflict of interest. The NASD believes that a market maker 
should have considerable latitude and freedom to make or terminate 
market making activities in an issuer's securities. The decision by a 
firm to make a market in a given security and the question of price 
generally are dependent on a number of factors, including, among 
others, supply and demand, the firm's expectations toward the market, 
its current inventory position, and exposure to risk and competition. 
This decision should not be influenced by payments to the member from 
issuers or promoters.
    On October 27, 1994, the United States Court of Appeals, Tenth 
Circuit, reversed, in part, an SEC decision in the matter of General 
Bond & Share Co. (``General Bond'').\6\ The NASD had held that General 
Bond had, among other things, violated Article III, Section 1 of the 
Association's Rules of Fair Practice (currently NASD Rule 2110) by 
accepting payments from issuer's in return for listing itself as a 
market maker for the securities in the National Quotation Bureau, Inc. 
(``NQB'') Pink Sheets (``Pink Sheets''). The NASD position was based on 
NASD policy as articulated to the members in Notice to Members 75-16 
(February 20, 1975). The SEC, in affirming the NASD decision, agreed 
with the NASD that this conduct was inappropriate and in violation of 
NASD rules.\7\
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    \6\ General Bond & Share Co. v. Securities and Exchange 
Commission, 39 F. 3d 1451 (10th Cir. 1994).
    \7\ In the Matter of General Bond & Share Co., Securities 
Exchange Act Release No. 32291 (May 11, 1993), 54 SEC Docket 129.
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    The Tenth Circuit decision held that the NASD rules at the time did 
not prohibit a member firm from accepting issuer-paid compensation for 
making a market in a security.\8\ Although the NASD had previously 
stated that such specific conduct was prohibited, the Court held that 
the NASD was required by statute to submit a filing with the SEC 
amending NASD rules in this respect. The NASD is proposing this rule to 
clarify the application of NASD rules to situations involving the 
acceptance of compensation for market making activities.
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    \8\ The Court reversed the SEC's finding of violation that 
related to the firm's acceptance of issuer-paid compensation, but 
sustained all of the SEC's other findings of violation by General 
Bond. General Bond, 39 F.3d 1458, 1461.
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    The proposed rule is intended to apply a fair practice standard to 
a particular course of conduct of a member as described below. In 
addition, however, the action of a member in charging an issuer a fee 
for making a market, or accepting an unsolicited payment from an issuer 
where the member makes a market in the issuer's securities, could also 
subject the member to violations of the antifraud provisions of federal 
securities laws and NASD Rule 2120. Further, the payment by an issuer 
to a market maker to facilitate market making activities also may cause 
the member to contribute to violations of Section 5 of the Securities 
Act of 1933.\9\
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    \9\ The insertion of quotations for a security in an interdealer 
quotation system in exchange for a payment by an issuer may result 
in a violation of Section 5 of the Securities Act of 1933 based on 
the issuer's interest in facilitating the subsequent sale. This 
``second sale'' theory was articulated by the SEC and upheld by the 
court in SEC v. Harwyn Industries, Inc., 326 F. Supp. 943 (S.D.N.Y. 
1971) See, Letter from Kenneth S. Spirer, Attorney, Division of 
Market Regulation, SEC, to Jack Rubens, Monroe Securities, Inc. (May 
4, 1973).
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Description of Proposed Rule
    The proposed rule would prohibit receipt by a broker-dealer of 
``any payment or other consideration'' from a prohibited party and is 
intended to cover any form of payment in cash, non-cash items, or 
securities. The term ``consideration'' would include, for example, 
granting or offering of securities products on terms more favorable 
than those granted or offered to the public. This term would include 
the granting of options in any security, where the options are 
exercisable at a price that is discounted from the prevailing market 
price. The rule also would cover the purchase of securities by a member 
from a prohibited party at a discount from the prevailing market. Such 
payments are intended to be prohibited because they may, as discussed 
in Notice to Members 75-16, create a conflict of interest that would 
influence the member to enter a quotation or make a market in a 
security.
    The proposed rule prohibits payments that are made ``for publishing 
a quotation, acting as a market maker in a security, or submitting an 
application in connection therewith.'' This language would apply the 
prohibitions of the rule to the entry of a quotation in a security, 
making a market in a security, and the entry of a quotation or the 
quotation of a security at a particular price.\10\ The definition of 
``quotation'' is drawn from Rule 15c2-11 of the Act \11\ and includes 
indications of interest.\12\ The proposed rule also specifies that a 
member may not impose a fee or accept a payment for submitting an 
application to enter quotations or make a market in an issuer's 
securities, e.g., a NASD Form 211 application to enter a quotation in 
the OTC Bulletin Board or NQB Pink Sheets.
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    \10\ NASD Notice to Members 75-16 states that questionable 
payments to market marker have the potential to influence the 
member's ``* * * decision to make a market and thereafter, perhaps, 
the prices it would quote.'' NASD Notice to Members, supra note 5.
    \11\ 17 CFR 240.15c2-11(e)(3).
    \12\ The proposed rule would apply to any situation in which 
member broker-dealer quotations are published in any interdealer 
quotation system, or any publication or electronic communication 
network or device which is used by brokers or dealers to make known 
to others their interest in transactions in any security, including 
offers to buy and sell at a stated price or otherwise, or 
invitations of offers to buy or sell. See Amendments No. 1 and No. 
2, supra note 3.
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    The proposed rule would apply to payments by an issuer, an 
affiliate of the issuer, or a promoter, whether received directly or 
indirectly through another party. Whether a person is considered an 
affiliate would be determined under the provisions of NASD Rule 2720 
that relate to the existence of a control relationship between an 
issuer and a member. For purposes of NASD Rule 2720, the term 
``affiliate'' shall mean ``a company which controls, is controlled by 
or is under common control with a member.'' In addition, the term

[[Page 29384]]

``affiliate'' is also presumed under certain circumstances in which a 
member or company is presumed to control, or presumed to be under 
common control, when the respective entities beneficially own ten 
percent or more of the outstanding voting securities of the other 
entity.\13\
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    \13\ See NASD Rule 2720(b)(1)(B) (i), (ii), and (iii).
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    The concept of ``promoter'' is broadly defined to encompass all 
persons other than the issuer and its affiliates who would have an 
interest in influencing a member to make a market in a security. Thus, 
the definition includes not only the organizer of the issuer's 
business, but also any director, employee, consultant, accountant, or 
attorney of the issuer. In addition, certain categories of 
securityholders are also within the definition, since these persons are 
considered to have an interest greater than that of the average 
securityholder in ensuring the existence of an active market. The 
categories in the definition, however, are intended to be illustrative 
only, and the proposed rule would prohibit payments by any similar 
person with an interest in promoting the entry of quotations or market 
making in the issuer's securities.
    The proposed rule change does not specifically cover member-to-
member payments in the express language of the proposed rule.\14\ The 
reasons for the exclusion of member-to-member conduct in the express 
language of the rule are as follows. This member-to-member conduct 
arguably is already covered by other provisions of the proposed rule, 
provisions of another proposed Conduct Rule, and an existing Conduct 
Rule.\15\ First, the definition of a promoter could apply to payments 
by one member to another member to publish a quote, make a market, or 
file an application therewith for a particular security for the purpose 
of promoting interest in a particular security.\16\ In addition, such 
payments may also fall within the scope of proposed conduct rule 
interpretation IM-2110-5 (SR-NASD-97-37),\17\ which would prohibit 
certain anticompetitive conduct of member broker-dealers. In 
particular, the proposed rule interpretation would prohibit certain 
``coordinated'' activity among member broker-dealers regarding prices 
(including quotations), trades, or trade reports. Thus, certain 
coordinated efforts in publishing quotations or setting prices may be 
subject to the provisions of the proposed rule.\18\ Furthermore, 
member-to-member payments in some cases may also be covered by NASD 
Conduct Rule 2110 as conduct that is inconsistent with high standards 
of commercial honor and just and equitable principles of trade.\19\ In 
addition, member-to-member payments not specifically prohibited under 
the provisions above may involve legitimate broker-dealer activity for 
which exemptions from the proposed rule would have to be crafted. 
Crafting appropriate exemptions would complicate the proposed rule 
unnecessarily in light of the absence of a history of abusive conduct 
in member-to-member payments that would not otherwise be prohibited 
under the provisions above.\20\
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    \14\ See Amendment No. 1, supra note 3.
    \15\ Id.
    \16\ Id.
    \17\ The NASD filed this proposed rule change with the 
Commission on May 7, 1997. The notice of the proposed rule change 
will be published in the near future.
    \18\ Id.
    \19\ Id.
    \20\ Id.
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    The proposed rule also is intended to prohibit indirect payments by 
the issuers, affiliates, or promoters through other members. Thus, 
members may not accept payments from other members that originate from 
an issuer, affiliate, or promoter of the issuer.
    In addition, the proposed rule contains a general exception that 
permits payments to a member by prohibited persons for ``bona fide 
services''. Such bona fide services are intended to include, but not be 
limited to, investment banking services, including traditional 
underwriting compensation and fees. The proposed rule contains a 
further exemption for reimbursement of fees imposed by the SEC and 
states and listing fees imposed by self-regulatory organizations. Such 
fees have been generally considered costs of the issuer, even when paid 
by a broker-dealer.
    The proposed rule as originally proposed for public comment \21\ 
included a third exception,\22\ which was intended to encourage members 
to conduct an initial Rule 15c2-11 review \23\ of the issuer and the 
security by permitting reimbursement of the member's reasonable out-of-
pocket expenses related to this review. The third exception was 
eliminated from the proposed rule due to concerns that such payments 
could violate Section 17(b) of the Securities Act of 1933 \24\ and 
could be used inappropriately to avoid the limitations of the proposed 
rule.
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    \21\ NASD Notice to Members 96-83 (December 1996).
    \22\ The third exception to the original proposed rule stated: 
(b) The provisions of paragraph (a) shall not preclude a member from 
accepting: . . . (3) reimbursement of reasonable out-of-pocket 
expenses on an accountable basis, not including the member's 
overhead, in connection with the member's initial review process in 
determining whether to agree to publish a quotation or to act as a 
market maker in a particular security.
    \23\ Rule 15c2-11 imposes an ``affirmative review'' obligation 
on a broker-dealer to form a reasonable belief that the information 
submitted in connection with an application to enter a quotation is 
accurate in all material respects and that the sources of the 
information are reliable. See Securities Exchange Act Release No. 
29094 (April 17, 1991), 56 FR 19148 (April 25, 1991).
    \24\ Section 17(b) of the Securities Act of 1933 explicitly 
makes it unlawful for any person receiving consideration, directly 
or indirectly from an issuer, to publish or circulate any material 
which describes such issuer's securities without fully disclosing 
the receipt of such consideration, whether past or prospective, and 
the amount thereof.
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    The NASD will announce the effective date of the proposed rule 
change in a Notice to Members to be published no later than 45 days 
following Commission approval. The effective date will be no more than 
30 days following the publication of the Notice to Members announcing 
Commission approval.
    (b) The NASD believes that the proposed rule change is consistent 
with the provisions of Section 15A(b)(6) of the Act \25\ in that 
regulating the conduct of member broker-dealers by prohibiting the 
receipt of compensation or other payments from an issuer or others for 
quoting, or make a market in an issuer's securities is in furtherance 
of the requirements that the Association's rules promotes just and 
equitable principles of trade, prevent fraudulent and manipulative acts 
and practices, and to protect investors and the public interest.
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    \25\ 15 U.S.C. Sec. 78o-3.
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B. Self-Regulatory Organization's Statement on Burden on Competition

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

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

    The proposed rule change was published for comment in Notice to 
Members 96-83 dated December, 1996. In addition, the proposed rule was 
posted on the NASD website (www.nasdr.com), which also solicited 
comments via E-mail. In total, four (4) comments were received in 
response thereto. A copy of the Notice to Members is attached as 
Exhibit 2 to the rule filing. A copy of the comment letters received in 
response thereto are attached as Exhibit 3 to the rule filing. Of the 
four (4) comment letters received, two (2) were in favor of the 
proposed

[[Page 29385]]

rule change, one (1) was opposed, and one (1) was neither in favor nor 
opposed.
    Of the two commentators that were in favor of the proposal, one was 
in favor on the assumption that the proposed rule would continue not to 
cover member reimbursements for payment for order flow and directed 
orders.\26\ The other commentator was in favor of the proposed rule, 
and further suggested that we eliminate the third exception (i.e., 
permitting reimbursement for certain accountable costs) to the proposed 
rule on the ground that it represents an invitation for abuse by 
certain market makers.\27\ One commentator opposed the proposed rule on 
the grounds that the proposed rule was complex and suggested that the 
proposed rule should require disclosure of all such payments and 
relationships similar to the requirements on market makers to disclose 
payment for order flow arrangements.\28\ One commentator neither 
favored nor opposed the proposed rule and offered a suggestion that 
small issuers provide the required documentation to the NASD after 
issuer's counsel review. Apparently, the issuer's counsel review would 
substitute for the member broker-dealer's review.\29\
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    \26\ See, comment letter 2.
    \27\ See, comment letter 3.
    \28\ See, comment letter 4.
    \29\ See, comment letter 1.
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    Based on the above responses, the NASD does not believe that any 
modification to the proposed rule is warranted. The only negative 
response supports requiring disclosure of payments and relationships, 
rather than prohibiting the conduct with exceptions. The NASD continues 
to believe that the inherent conflicts addressed by the proposal 
continue to require direct regulatory action, and that disclosure of 
such conflicts would not be an adequate substitute. Further, the text 
of the proposed rule is consistent with the NASD's longstanding policy.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

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

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing. The Commission requests particular 
comments addressing whether payments by other members to publish a 
quotation, act as a market maker, or submitting an application 
therewith should be specifically prohibited and what impact such a 
prohibition would have on existing payment arrangements between broker-
dealers. 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 NASD. All submissions should refer to 
File No. SR-NASD-97-29 and should be submitted by June 20, 1997.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\30\
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    \30\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-14120 Filed 5-29-97; 8:45 am]
BILLING CODE 8010-01-M