[Federal Register Volume 62, Number 132 (Thursday, July 10, 1997)]
[Notices]
[Pages 37105-37108]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-18090]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-38812; File No. SR-NASD-97-29]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Order Granting Approval to Proposed Rule Change and 
Amendments No. 1 and No. 2 Thereto 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

July 3, 1997.
    On April 18, 1997, 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 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 in an 
issuer's securities. On May 19, 1997 and May 21, 1997, the NASD 
submitted two amendments (``Amendment No. 1'' and

[[Page 37106]]

``Amendment No. 2''), respectively, to the proposed rule change.\3\
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    \1\ 15 U.S.C. Sec. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ In Amendment No. 1, the NASD made technical corrections to 
the text of the rule, provided an explanation for not expressly 
prohibiting member-to-member payments for 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, Attorney, Division of Market Regulation, SEC (May 
16, 1997). Amendment No. 2 corrected a minor omission in Amendment 
No. 1. Letter from Alden Adkins, Vice President and General Counsel, 
NASD Regulation, to Elaine Darroch, Attorney, Division of Market 
Regulation, SEC (May 19, 1997).
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    The proposed rule change and Amendments No. 1 and No. 2 thereto 
were published for comment in Securities Exchange Act Release No. 38670 
(May 22, 1997), 62 FR 29382 (May 30, 1997). No comments were received 
on the proposal. This order approves the proposed rule change.

I. Introduction

    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. 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.
    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'').\4\ 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 issuers 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.\5\
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    \4\ General Bond & Share Co. v. Securities and Exchange 
Commission, 39 F. 3d 1451 (10th Cir. 1994).
    \5\ 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.\6\ 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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    \6\ 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 at 1458, 1461.
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II. Description of the Proposal

    The NASD proposes to add Rule 2460 to prohibit receipt by a broker-
dealer of ``any payment or other consideration'' from a prohibited 
party for publishing a quotation, acting as a market maker, or 
submitting an application in connection therewith. It 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.\7\ The definition of 
``quotation'' is drawn from Rule 15c2-11 of the Act\8\ and includes 
indications of interest.\9\ 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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    \7\ NASD Notice to Member 75-16 states that questionable 
payments to a 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.
    \8\ 17 CFR 240.15c2-11(e)(3)
    \9\ 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 or 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 
``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.\10\
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    \10\ 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, account, 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.\11\ The 
reason for the exclusion of member-to-member conduct in the express 
language of the rule are as follows. This member-to-

[[Page 37107]]

member conduct arguably is already covered by other provisions of the 
proposed rule, provisions of another proposed Conduct Rule, and an 
existing Conduct Rule.\12\ 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.\13\ In addition, such payments may also fall within the scope 
of proposed conduct rule interpretation IM-2110-5 (SR-NASD-97-37),\14\ 
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. 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. 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.
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    \11\ See Amendment No. 1, supra note 3.
    \12\Id.
    \13\Id.
    \14\ Securities Exchange Act Release No. 38715 (June 4, 1997), 
62 FR 31845 (June 11, 1997) (notice of proposed rule change (SR-
NASD-97-37)).
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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 the 
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 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.\15\ 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.\16\
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    \15\ Rule 2120 prohibits members from effecting transactions in, 
or inducing the purchase or sale of, any security by means of any 
manipulative, deceptive, or other fraudulent device or contrivance.
    \16\ 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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    The proposed rule as originally proposed for public comment \17\ 
included a third exception,\18\ which was intended to encourage members 
to conduct an initial Rule 15c2-11 review \19\ 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 \20\ and 
could be used inappropriately to avoid the limitations of the proposed 
rule.
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    \17\ NASD Notice to Members 96-83 (December 1996).
    \18\ 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.
    \19\ 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).
    \20\ 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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III. Discussion

    The Commission finds that the proposed rule change is consistent 
with the requirements of the Act and the rules and regulations 
thereunder applicable to a national securities association, and, in 
particular, with the requirements of Section 15A(b) of the Act.\21\ 
Among other things, Section 15A(b)(6) of the Act requires that the 
rules of a national securities association be designed to prevent 
fraudulent and manipulative acts and practices, to promote just and 
equitable principles of trade, and in general, to protect investors and 
the public. The Commission believes that the proposed rule change in 
designed to prevent fraudulent and manipulative acts, to promote just 
and equitable principles of trade, and to protect investors and the 
public.\22\
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    \21\ 15 U.S.C. Sec. 78f(b).
    \22\ In approving this rule change, the Commission has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. 15 U.S.C. Sec. 78c(f).
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    Specifically, the Commission finds that the rule preserves the 
integrity of the marketplace by ensuring that quotations accurately 
reflect a broker-dealer's interest in buying or selling a security. 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. Public investors expect broker-
dealers' quotations to be based on the factors described above. If 
payments to broker-dealers by promoters and issuers were permitted, 
investors would not be able to ascertain which quotations in the 
marketplace are based on actual interest and which quotations are 
supported by issuers or promoters. This structure would harm investor 
confidence in the overall integrity of the marketplace. The Commission 
finds that the proposed rule supports a longstanding policy and 
position of the NASD \23\ and establishes a clear standard of fair 
practice for member firms.
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    \23\ NASD Notice to Members 75-16 (February 20, 1975). See also 
Letter from Kenneth S. Spirer, Attorney, Division of market 
Regulation, SEC, to Mr. Jack Rubens, Monroe Securities, Inc. (May 4, 
1973) (regarding acceptance of a fee or service charge from issuers 
in connection with making a market).

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[[Page 37108]]

    The Commission notes that the rule does not specifically prohibit 
member-to-member payments to make a market. Nevertheless, the 
Commission agrees with the NASD that the definition of a promoter in 
NASD Rule 2460 being approved today, is broad enough to cover 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 an interest in a particular security. In addition, another 
proposed rule, IM-2110-5 (SR-NASD-97-37),\24\ would prohibit certain 
anticompetitive conduct of broker-dealers. In particular, the rule 
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. 
The Commission notes that the NASD was concerned that if all member-to-
member payments were prohibited, then activity which involved 
legitimate broker-dealer activity would have to become subject to an 
exemption. The Commission agrees with the NASD that crafting 
appropriate exemptions would complicate the rule unnecessarily, when 
other provisions of the rule and other proposed rules cover the 
prohibited conduct.
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    \24\ Securities Exchange Act Release No. 38715 (June 4, 1997), 
62 FR 31854 (June 11, 1997) (notice of proposed rule change (SR-
NASD-97-37)).
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IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\25\ that the proposed rule change (SR-NASD-97-29) is approved.

    \25\ 15 U.S.C. Sec. 78s(b)(2).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\26\
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    \26\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-18090 Filed 7-9-97; 8:45 am]
BILLING CODE 8010-01-M