[Federal Register Volume 62, Number 250 (Wednesday, December 31, 1997)]
[Notices]
[Pages 68331-68334]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-33994]
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SECURITIES AND EXCHANGE COMMISSION
(Release No. 34-39478; File No. SR-NASD-97-85)
Self-Regulatory Organizations; Notice of Filing and Immediate
Effectiveness of Proposed Rule Change by the National Association of
Securities Dealers, Inc., Relating to NASD Rule 2460 Concerning
Payments for Market Making
December 22, 1997.
Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Exchange Act''),\1\ notice is hereby given that on December 1, 1997,
the National Association of Securities Dealers, Inc. (``NASD''),
through its wholly owned subsidiary, NASD Regulation, Inc. (``NASD
Regulation'') 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 NASD
Regulation.\2\ 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. Sec. 78s(b)(1).
\2\ The proposal was originally filed with the Commission on
November 18, 1997, but was withdrawn on December 1, 1997. See Letter
from Alden S. Adkins, Vice President and General Counsel, NASD
Regulation, to Richard C. Strasser, Assistant Director, Division of
Market Regulation, Commission. (File No. SR-NASD-97-84). On December
22, 1997, the NASD filed Amendment No. 1 with the Commission. See
Letter from Alden S. Adkins, Vice President and General Counsel,
NASD Regulation, to Richard C. Strasser, Assistant Director,
Division of Market Regulation, Commission. In addition, several
minor technical corrections authorized by NASD Regulation are
included in this Notice. Telephone conversation between David A.
Spotts, Office of the General Counsel, NASD Regulation, and Elaine
M. Darroch, Office of Market Supervision, Division of Market
Regulation, Commission (December 4, 1997).
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I. Self-Regulatory Organization's Statement of the Terms of Substance
of the Proposed Rule Change
NASD Regulation, pursuant to Section 19(b)(3)(A)(i) of the Act \3\
and Rule 19b-4(e)(i) under the Act,\4\ is proposing this interpretation
of NASD Rule 2460 concerning payments for market making. The text of
the letter setting forth the interpretation is attached as Exhibit 1.
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\3\ 15 U.S.C. Sec. 78s(b)(3)(A)(i).
\4\ 17 CFR 240.19b-4(e)(i).
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II. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
In its filing with the Commission, NASD Regulation included
statements concerning the purpose of, and basis for, the proposed rule
change and discussed any comments it received on the proposed rule
filing. The text of these statements may be examined at the places
specified in Item IV below. NASD Regulation has prepared summaries, set
forth in Sections (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
NASD Regulation is proposing to issue a staff interpretation of
NASD Rule 2460 to clarify the position of NASD Regulation with respect
to the application of the rule to certain member broker-dealers that
participate in a Freddie Mac Interdealer Cash Market Trading
Initiative, as described below.
NASD Rule 2460--Payments for Market Making
On July 3, 1997, the SEC approved NASD Rule 2460 (``Rule''),\5\
which explicitly prohibits an NASD member or person associated with a
member from accepting any payment or other consideration from issuers
or the issuers' affiliates or promoters, directly or indirectly, for:
(1) publishing a quotation, (2) acting as a market maker, or (3)
submitting an application in connection therewith. The rule was
intended, among other things, to assure that members act in an
independent capacity when publishing a quotation or making a market in
an issuer's securities.
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\5\ Securities Exchange Act Release No. 38812 (July 3, 1997), 62
FR 37105 (July 10, 1997) (File No. SR-NASD-97-29).
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NASD Regulation originally proposed this new rule and requested
comment from members and the public in Notice to Members 96-83 (``NTM
96-83'') in December 1996. As stated in NTM 96-83, 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 listing, quoting, or making a market in an issuer's securities or
for covering the member's out-of-pocket
[[Page 68332]]
expenses for making a market, or for submitting an application to make
a market in an issuer's securities.\6\ As stated in Notice to Members
75-16 (February 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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\6\ See Notices to Members 75-16 (February 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 the issuers, their affiliates or
promoters 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, NASD Regulation believes that such conduct may be viewed
as a conflict of interest. NASD Regulation believes that a market maker
should have considerable latitude and freedom to commence 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 what
price the firm will quote for that security 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.
NASD Rule 2460 establishes a fair practice standard regarding a
particular course of conduct of a member. Members should be mindful
that certain actions of a member in accepting a fee from an issuer for
making a market, or accepting an unsolicited payment from an issuer
where the member makes a market in the issuer's securities, in addition
to violating NASD Rule 2460, could also violate the anti-fraud
provisions of the federal securities laws and NASD Rule 2120, an NASD
anti-fraud provision. Further, the payment by an issuer to a market
maker to facilitate market making activities could also violate the
registration requirements of Section 5 of the Securities Act of 1933
(``Securities Act'').\7\
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\7\ 15 U.S.C. Sec. 77e.
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Freddie Mac Interdealer Cash Market Trading Initiative
The Federal Home Loan Mortgage Corporation (``Freddie Mac'') is a
government-sponsored enterprise created pursuant to the Federal Home
Loan Mortgage Corporation Act, Title III of the Emergency Home Finance
Act of 1970, as amended, to provide a continuous flow of funds for
residential mortgages.\8\ To finance its mortgage purchase activities,
Freddie Mac sells its securities to investors directly and through
securities dealers. The primary financing vehicle for its mortgage
purchases is the sale of Mortgage Passthrough Certificates (``PCs'').
These securities are exempt from registration under the Securities Act
and the Exchange Act. In 1990, Freddie Mac redesigned its fixed-rate PC
structure and issues a new type of PC, called Gold PC. Since the Gold
PCs were entirely new and a separate product, there was limited initial
liquidity in the Gold PC market. As a result, dealers responded to the
initial lack of liquidity in the Gold PC market, with its potential
volatility, by maintaining primary Federal National Mortgage
Association (``Fannie Mae'') security positions, and by entering into
synthetic transactions in the swap market.\9\
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\8\ Freddie Mac's statutory purpose is to, among other things,
promote access to mortgage credit throughout the Nation by
increasing the liquidity of mortgage investments and improving the
distribution of investment capital available for residential
mortgage financing (12 U.S.C. Sec. 1451(b)).
\9\ In the years following 1990, Freddie Mac has built a supply
of tradable Gold PCs in an attempt to achieve a liquid market of 30-
year Gold PCs ($152 billion as of September 1, 1997). The dealer
response, however, has primarily remained unchanged in maintaining
Fannie Mae Mortgage-Backed Security (``MBS'') positions and entering
into synthetic transactions in the swap market despite the
availability of a sizable amount of tradable Gold PCs. Broker-
dealers primarily enter into Gold PC transactions synthetically as
opposed to direct transactions in the Gold PC cash market. The
synthetic transactions are structured generally as follows: A dealer
will first purchase a 30-year Fannie Mae MBS in the cash market with
a forward delivery (with a fixed settlement date in the future). The
dealer will enter into another separate transaction in the swap
market. The dealer will swap the obligation to buy the Fannie Mae
MBS for a commitment to purchase (accept delivery at settlement)
Gold PCs.
To gain an understanding of the relative size of the cash market
for MBS, the following statistics are provided. In 1996, the average
cash market volume on the interdealer broker screens for MBS was
approximately $20 billion per month. Of this, approximately 96% was
conducted in Fannie Mae MBS transactions and approximately 4% was
conducted directly in the cash market in 30-year Gold PCs.
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As a result of the above, Freddie Mac launched a program to
encourage dealers to purchase Gold PCs directly, rather than through
the swap market mechanism (the ``Initiative''). Freddie Mac and The
Bond Market Association (``BMA'') submitted to the staff of NASD
Regulation a letter dated October 7, 1997, regarding the application of
NASD Rule 2460 to members participating in the Initiative.
The Initiative includes offering dealers ``credits'' for trading
directly on the interdealer cash market, as opposed to the swap market.
Freddie Mac has developed procedures and internal controls to calculate
trading volume credits monthly to the dealers and assure proper
administration of the program. According to the October 7, 1997 letter
from Freddie Mac and the BMA, this Initiative is intended to be
temporary, and the value of the credits were selected so as to provide
a nominal economic incentive over the transaction costs on the swap
market, while not providing so much of an incentive as to alter pricing
of the securities in the open market.\10\ The credits awarded under
this Initiative may only be redeemed through transactions with Freddie
Mac, that is, the credits are utilized by participating broker-dealers
to reduce the fees associated with future transactions with Freddie
Mac.
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\10\ To normalize the environment for dealers to accumulate
credits) so as not to favor larger dealers who naturally conduct a
higher volume business), a system for accumulation of credits was
established that would be based on the individual dealer's level of
participation. Credits are awarded on the current volume traded on
the cash screens. Credits are awarded at an increasing rate when
dealers exceed their previous monthly cash trading volume, as
calculated since the beginning of the Initiative, that the dealers
have traded on the cash screens. This feature was designed to limit
the duration of the Initiative by creating momentum in moving
dealers progressively away from the swap market.
Under this Initiative, credits are redeemable at a value of \1/
64\th of a point (or $156.25 per million). This value was selected
so as to provide nominal economic incentive over the additional \1/
4\th to \3/8\ths of a 32nd (or $78.13 to $117.20 per million) in the
transaction cost of executing a synthetic Gold PC in the MBS cash
and swap markets.
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Due to unique characteristics of the Initiative, Freddie Mac
presented principally three arguments why NASD Rule 2460 was not
intended to cover the Initiative: (1) The Initiative promotes Freddie
Mac's statutory purpose; (2) the Initiative does not affect the
integrity of the marketplace; and (3) the Initiative is intended to be
temporary.
First, Freddie Mac represents that the Initiative appears to
promote Freddie Mac's statutory purpose, in that, Freddie Mac was
created by Congress to provide a conduit for ensuring a continuous
supply of funds from the capital markets to the mortgage markets.
Freddie Mac purchases mortgages daily and finances them primarily with
the issuance of MBS. The prices Freddie Mac pays for its mortgage
purchases is based directly on the prices at which its sells its PCs.
Freddie Mac represents that this Initiative was developed to eliminate
certain unnecessary costs in the mortgage finance system by improving
interdealer PC liquidity through
[[Page 68333]]
encouraging dealers to purchase Gold PCs directly, as opposed to
entering into transactions in the swap market.\11\
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\11\ Currently, broker-dealers enter into gold PC transactions
synthetically, first by conducting a transaction in a 30-year Fannie
Mae MBS followed by a subsequent swap transaction into or out of
Gold PCs. This process subjects Gold PCs to an additional bid-ask
spread (that of the cash market and that of the swap market) of \1/
8\th to \1/4\th of a 32nd (or up to $78.13 per million). In
addition, the two-step process results in broker fees for the
trading on the interdealer screens of an additional \1/16\th to \1/
8\th of a 32nd (or up to $39.07 per million). Thus, this persistent
trading pattern creates additional costs in the marketplace,
preventing investors from obtaining up to \3/8\ths of \1/32\nd (or
$117.20 per million) of the true economic value of the Gold PCs that
an efficient market would produce.
As of May 1997, the average monthly dollar volume of cash trades
in Fannie Mae MBS and Gold PCs approximated $19,239 million, $1,021
million, respectively. As of that date, the average monthly swap
trades in Gold PCs and MBS approximated $4,177 million.
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Second, Freddie Mac represents that the Initiative does not appear
to affect the integrity of the marketplace, since the nature and
characteristics of the agency mortgage pass-through securities market
is unique and appears outside of the intended scope of NASD Rule 2460.
The dealers in this market trade PCs and similar securities essentially
as fungible products and trade these securities indiscriminately on the
interdealer broker screens to meet customer demand. As a result, the
concept of market making a particular security in this market has
little application. In addition, Freddie Mac represents that the
incentives which lead a broker-dealer to make a quotation on a PC
differ from traditional equity trading. Customer demand in fixed-income
securities is based primarily on changes in interest rates, supply and
demand, and the quality of the credit backing the security. In the
agency MBS market, the credit of the three primary agencies (Freddie
Mac, Fannie Mae and Government National Mortgage Association) is
considered comparable, the supply of the securities is considered
plentiful, and a well-developed forward trading market permits ready
hedging of positions. This market differs from the characteristics of
the traditional equity market. Accordingly, Freddie Mac represents
that, given the number of comparable securities in the yield-driven
debt market, it is unlikely that certain dealer credits to purchase
Gold PCs would mislead market participants to purchase the Gold PCs
versus other comparable securities.
Further, Freddie Mac represents that this Initiative is intended to
be temporary. It is expected that dealer behavior will eventually
become self-sustaining and no further incentives will be required.
Based on the above information and representations presented by
Freddie Mac, and the importance of the role of Freddie Mac in promoting
liquidity of these instruments under statutory mandate, it is NASD
Regulation's opinion that the participation of member firms in the
Freddie Mac Initiative as described in the letter would not be deemed
in violation of NASD Rule 2460.
NASD Regulation believes that this interpretation maintains
investor protection and clarifies a member's obligations under NASD
Rule 2460 while participating in the Freddie Mac Interdealer Cash
market Trading Initiative. Accordingly, NASD Regulation believes that
the interpretation is consistent with the provisions of Section
15A(b)(6) in that it protects investors and the public interest, and is
designed to promote just and equitable principles of trade.
(B) Self-Regulatory Organization's Statement on Burden on Competition
NASD Regulation 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
Written comments were neither solicited nor received.
III. Date of Effectiveness of the Proposed Rule Change and Timing
for Commission Action
The foregoing rule change has become effective upon filing pursuant
to Section 19(b)(3)(A)(i) of the Exchange Act \12\ and Rule 19b-4(e)(1)
\13\ thereunder in that it constitutes a stated policy, practice or
interpretation with respect to the meaning, administration, or
enforcement of an existing rule.
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\12\ 15 U.S.C. Sec. 78s(b)(3)(A)(i).
\13\ 17 CFR 240.19b-4(e)(1).
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At any time within 60 days of the filing of the proposed rule
change, the Commission may summarily abrogate such rule change if it
appears to the Commission that such action is necessary or appropriate
in the public interest, for the protection of investors, or otherwise
in furtherance of the purposes of the Act.
IV. Solicitation of Comments
Interested persons are invited to submit written data, views, and
arguments concerning the foregoing. 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. Sec. 552, will be available for inspection and copying in
the Commission's Public Reference Room. 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-97-85 and should
be submitted by January 21, 1998.
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\14\
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\14\ 17 C.F.R. 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
Exhibit 1
November 25, 1997.
Ms. Gail Vance, Associate General Counsel, Freddie Mac, 8200 Jones
Branch Drive, McLean, VA 22102-3110.
Mr. George P. Miller, Vice President and Deputy General Counsel, The
Bond Market Association, 40 Broad Street, New York, NY 10004-9400.
Re: Interpretive Guidance Under NASD Rule 2460.
Dear Ms. Vance and Mr. Miller: We are in receipt of your letter
dated October 7, 1997 in which you request interpretive guidance of
NASD Rule 2460 (Rule) and its potential application to Freddie Mac's
Interdealer Cash Market Trading initiative (``Initiative''). As
represented in your letter, Freddie Mac launched this Initiative on
June 2, 1997 in an attempt to encourage dealers to purchase Gold PCs
directly, as opposed to entering into swap market transactions.
Background
As stated in your letter, Freddie Mac is a government-sponsored
enterprise created pursuant to the Federal Home Loan Mortgage
Corporation Act, Title III of the Emergency Home Finance Act of
1970, as amended, to provide a continuous flow of funds for
residential mortgages.\1\ To finance its mortgage purchase
activities, Freddie Mac sells its securities to investors directly
and
[[Page 68334]]
through securities dealers. The primary financing vehicle for its
mortgage purchases is the sale of Mortgage Passthrough Certificates
(PCs). These securities are exempt from registration under the
Securities Act of 1933 and the Exchange Act of 1934. In 1990,
Freddie Mac redesigned its fixed-rate PC structure and issued a new
type of PC, called Gold PC. Since the Gold PCs were entirely new and
a separate product, there was limited initial liquidity in the Gold
PC market. As a result, dealers responded to the initial lack of
liquidity in the Gold PC market, with its potential volatility, by
maintaining primary Fannie Mae security positions, and by entering
into synthetic transactions in the swap market.
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\1\ Freddie Mac's statutory purpose is to, among other things,
promote access to mortgage credit throughout the Nation by
increasing the liquidity of mortgage investments and improving the
distribution of investment capital available for residential
mortgage financing (12 U.S.C. Section 1451(b)).
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As a result of the above, Freddie Mac launched this Initiative
to encourage dealers to purchase Gold PCs directly, rather than
through the swap market mechanism. The Initiative includes offering
dealers ``credits'' for trading directly on the interdealer cash
market, as opposed to the swap market. Freddie Mac has developed
procedures and internal controls to calculate trading volume credits
monthly to the dealers and assure proper administration of the
program. According to your letter, this Initiative is intended to be
temporary, and the value of the credits were selected so as to
provide a nominal economic incentive over the transaction costs on
the swap market, while not providing so much of an incentive as to
alter pricing of the securities in the open market. More important,
the credits awarded under this Initiative may only be redeemed
through transactions with Freddie Mac.
Discussion
NASD Rule 2460 prohibits NASD members from receiving payments or
other consideration from an issuer for publishing a quotation or
acting as a maker in a security, or for submitting an application to
make a market in the issuer's securities. The definition of
``consideration'' specifically includes offering securities products
on terms that are more favorable than those granted or offered to
the public. The Rule was intended to prevent certain conflicts of
interest that may influence a broker-dealer's decision regarding
whether to quote or make a market in a security and prices that are
quoted and to prevent a misleading appearance of market activity
based on such conflicts. Paragraph (b) of the Rule also provides an
exemption, among others, for certain payment to members for ``bona
fide'' services, including, but not limited to, investment banking
services.
Due to unique characteristics of the Freddie Mac Initiative, you
principally present three arguments why the Rule was not intended to
cover your Initiative: (1) the Initiative promotes Freddie Mac's
statutory purpose; (2) the Initiative does not affect the integrity
of the marketplace; and (3) the Initiative is intended to be
temporary.
First, you represent that the Initiative appears to promote
Freddie Mac's statutory purpose, in that, Freddie Mac was created by
Congress to provide a conduit for ensuring a continuous supply of
funds from the capital markets to the mortgage markets. Freddie Mac
purchases mortgages daily and finances them primarily with the
issuance of mortgage-backed securities. The prices Freddie Mac pays
for its mortgage purchases is based directly on the prices at which
it sells its PCs. It has been represented in your letter that this
Initiative was developed to eliminate certain unnecessary costs in
the mortgage finance system by improving interdealer PC liquidity
through encouraging dealers to purchase Gold PCs directly, as
opposed to entering into transactions in the swap market.
Second, you represent that the Initiative does not appear to
affect the integrity of the marketplace, since the nature and
characteristics of the agency mortgage pass-through securities
market is unique and appears outside of the intended scope of the
Rule. Since the dealers in this market trade these securities as
fungible products (i.e., PCs, Mortgage-backed securities, Ginnie
Maes) and trade on the interdealer broker screens daily as a matter
of course to meet their customer's demand, the concept of market
making a particular security has little application in this
marketplace.
In addition, you represent that the incentives which lead a
broker-dealer to make a quotation on a PC differ from traditional
equity trading. Customer demand in fixed-income securities is based
primarily on changes in interest rates, supply and demand, and the
quality of the credit backing the security. In the agency mortgage-
backed securities market, the credit of the three primary agencies
(Freddie Mac, Fannie Mae and Ginnie Mae) is considered comparable,
the supply of the securities is considered plentiful, and a well-
developed forward trading market permits ready hedging of positions.
This market differs from the characteristics of the traditional
equity market. Accordingly your letter represents that, given the
number of comparable securities in the yield driven debt market, it
is unlikely that certain dealer credits to purchase Gold PCs would
mislead market participants to purchase the Gold PCs versus other
comparable securities.
Lastly, you represent that this Initiative is intended to be
temporary. According to your letter, it is expected that dealer
behavior will eventually become self-sustaining and no further
incentives will be required.
Based on the above information and the representations presented
by Freddie Mac, and the importance of the role of Freddie Mac in
promoting liquidity of these instruments under statutory mandate, it
is the staff's opinion that the participation of member firms in the
Freddie Mac Initiative as described in your letter would not be
deemed in violation of Rule 2460.
I hope this letter is responsive to your inquiry. Please note
that the opinions expressed herein are staff opinions only and have
not been reviewed or endorsed by the Board of Directors of NASD
Regulation. This letter responds only to the issues that you have
raised based on the facts as described, and does not address any
other rule or interpretation of the Association, or all the possible
regulatory and legal issues involved.
Sincerely,
David A. Spotts,
Office of General Counsel, NASD Regulation, Inc.
[FR Doc. 97-33994 Filed 12-30-97; 8:45 am]
BILLING CODE 8010-01-M