[Federal Register Volume 63, Number 195 (Thursday, October 8, 1998)]
[Notices]
[Pages 54169-54175]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-26998]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-40511; File No. SR-NASD-97-61]
Self-Regulatory Organizations; Notice of Filing of Proposed Rule
Change and Amendments Nos. 1 and 2 by the National Association of
Securities Dealers, Inc., Relating to the Application of NASD's Mark-up
Policy to Transactions In Government And Other Debt Securities
September 30, 1998.
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 August 20, 1997, the National Association of Securities Dealers,
Inc. (``NASD'' or ``Association''), filed with the Securities Exchange
Commission (``SEC'' or ``Commission'') a proposed rule change, On
August 26, 1998, the Association filed Amendment No. 1 to the proposed
rule change.\3\ Amendment No. 1 replaces and supersedes the original
proposed rule change and is described in Items I, II, and III below,
which Items have been prepared by NASD Regulation, Inc. (``NASD
Regulation''). On September 8, 1998, the Association filed Amendment
No. 2 in which the Association consented to an extension of the time
period to 60 days for Commission action specified in Section 19(b)(2)
of the Act \4\ 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, Senior Vice President and General
Counsel, NASD Regulation, to Katherine A. England, Assistant
Director, SEC (Aug. 26, 1998).
\4\ Letter from Alden Adkins, Senior Vice President and General
Counsel, NASD Regulation, to Katherine A. England, Assistant
Director, SEC (Sept 8, 1998).
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I. Self-Regulatory Organization's Statement of the Terms of
Substance of the Proposed Rule Change
NASD Regulation is proposing NASD Rule IM-2440-2 to provide
guidance to the membership on mark-up and mark-down practices for debt
securities, excluding municipal securities. NASD Regulation also
proposes to renumber current Rule IM-2440 as Rule IM-2440-1. Below is
the text of the proposed rule change. Proposed new language is in
italics.
IM-2440-1. Mark-Up Policy
* * * * *
IM-2440-2. Interpretation Of The Board of Governors--Application Of
the NASD Mark-Up Policy To Transactions In Government And Other
Debt Securities \5\
As a result of the Government Securities Act Amendments of 1993
that expanded the NASD's sales practices authority to encompass
government securities, the Board believes it is appropriate to
provide guidance to the membership on mark-up and mark-down \6\
practices for such securities, as well as for other debt securities,
except for municipal securities.\7\ The market for government and
debt securities is as multidimensional as the securities themselves.
The markets range from the Treasury securities market--representing
the largest, most liquid securities market in the world--to markets
for collateralized mortgage obligations and structured securities,
which often are substantially less liquid and which include
securities with features that are highly unique or are customized
for particular investors. Therefore, the mark-ups and mark-downs
charged on government and other debt securities must properly
reflect the facts and circumstances of each particular
transaction,\8\ including the specific type of
[[Page 54170]]
government or other debt securities involved. This interpretation is
intended to clarify the application of the Association's Mark-Up
Policy in determining the prevailing market price for principal
transactions in government and other debt securities. This
interpretation is not intended to provide new guidance with respect
to the percentage amounts that would constitute excessive mark-ups
or mark-downs in particular cases. The Association and the SEC have
made clear that the appropriate mark-up or mark-down from the
prevailing market price for most types of government and other debt
securities is usually substantially less than 5 percent.
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\5\ This interpretation does not address the application of the
mark-up policy to transactions involving the domination and control
of the market for a particular security. When a dealer dominates and
controls the market for a particular security, that dealer's
contemporaneous cost is the best evidence of the prevailing market
price. The analysis of whether the market for any particular
security is dominated or controlled should take into account the
extent to which the particular security is fungible with other
similar securities.
\6\ A mark-up is the difference between the price that the
dealer, acting as a principal, charged to the customer and the
prevailing market price for the security. Lehman Brothers Inc.,
Exchange Act Release No. 37673 (Sept. 12, 1996). A mark-down is the
difference between the price that the dealer, acting as principal,
paid to the customer and the prevailing market price for the
security.
\7\ Rules for municipal securities are promulgated by the
Municipal Securities Rulemaking Board.
\8\Whether the amount of mark-ups charged on a particular
transaction is excessive depends on whether, based on all the
relevant facts and circumstances, the price charged the customer is
reasonably related to the prevailing inter-dealer market price. SEC
v. Feminella, 947 F. Supp. 722, 729 (S.D.N.Y. 1996).
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As described below, the prevailing market price for a security
against which to measure a mark-up or mark-down is based primarily
on the dealer's contemporaneous cost or, in certain cases,
contemporaneous inter-dealer transaction prices in that specific
security. For example, when a dealer is not acting as a market
maker, the Association and the SEC have consistently held that,
absent countervailing evidence, the best evidence of the prevailing
market price is the dealer's contemporaneous cost of acquiring the
securities.\9\ Countervailing evidence of the prevailing market
price may be considered only where the dealer made no
contemporaneous transactions or can show that in the particular
circumstances the dealer's contemporaneous cost is not indicative of
the prevailing market price.\10\ This may occur, for example, when
the debt securities were bought from knowledgeable customers below
the prevailing market price, or where, in the interim, interest
rates have changed or other market events have occurred.
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\9\ See, e.g., F.B. Horner & Associates, Inc., 50 S.E.C. 1063
(1992).
\10\ Lehl v. SEC, 90 F.3d 1483, 1485-96 (10th Cir. 1996); First
Independence Group, Inc. v. SEC, 37 F 3e 30, 32 (2d Cir. 1994);
Orkin v. SEC, 31 F.3d 1056, 1064 (11th Cir. 1994).
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In contrast, integrated dealers, i.e, dealers that not only sell
to retail customers, but also act as wholesale market makers, in
active, competitive markets, are permitted to calculate their mark-
ups from their contemporaneous sales prices to other dealers.\11\ In
this case, these contemporaneous transactions constitute highly
reliable evidence of the prevailing market price of a security. In
the debt securities markets, a market marker is a dealer who, with
respect to a particular security, furnishes bona fide competitive
bid and offer quotations on request and is ready, willing, and able
to effect transactions in reasonable quantities at his or her quoted
prices with other brokers or dealers.
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\11\ Alstead, Dempsey & Co., 47 S.E.C. 1034 (1984).
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The use of contemporaneous cost also applies to riskless
principal transactions. The Commission has held that when a dealer
that is not a market maker effects a riskless principal transaction,
the dealer's cost must always be used as the base on which to
calculate mark-ups.\12\ Similarly, contemporaneous resale price
would constitute evidence of prevailing market price for mark-downs.
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\12\ Kevin B. Waide, et al, S.E.C. 932, 935-37 (1992)
(``Waide''). See also Strategic resource management, Inc., Exchange
Act Release No. 36618 (Dec. 21, 1995), (market makers in equity
securities are not subject to the Waide analysis).
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When government or other debt securities trade inactively,
inter-dealer transactions may be rare on non-existent. Therefore,
establishing the prevailing market price in a transaction involving
an inactively traded bond, note, or other debt obligation may be
difficult. In such circumstances, absent countervailing evidence,
the contemporaneous cost to the dealer of acquiring the security
should be used as the basis for determining the appropriate mark-up.
A transaction is ``contemporaneous'' if it occurs close enough in
time to a later transaction that it would not be contemporaneous if
it is followed by intervening changes in interest rates or other
market events that reasonable would be expected to affect the market
price.
Accordingly, when inter-dealer transactions are not available, a
dealer that effects a transaction in government or other debt
securities with a customer and determines the mark-up or mark-down
on a basis other than its own contemporaneous cost must be prepared
to provide evidence that is sufficient to overcome the presumption
that contemporaneous cost provides the best measure of the
prevailing market price. In this case, factors that the Board
believes may be taken into consideration for a mark-up or a mark-
down include but are not limited to:\13\
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\13\ In analyzing the factors, the relative importance of the
factors, listed depends on the facts and circumstances relating to
the transaction, such as the order size, timeliness of the source of
information, and the relative spread of the quotations. In addition,
because the ultimate evidentiary issue is the prevailing market
price, isolated transactions or quotations generally will not have
much, if any, weight or relevance. Finally, in the case of a mark-up
charged by a dealer that is not a market maker, the price must be
based on the bid side of the market or, in the case of a mark-down,
the offer side.
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1. Prices of any dealer transactions in the security in question
with institutional accounts with which any dealer regularly effects
transactions in the same or a similar security;
2. Contemporaneous inter-dealer quotations in the security in
question made through an inter-dealer quotation mechanism through
which transactions do in fact occur in that security at prices that
are reasonably related to the displayed quotations;
3. Yields calculated from prices of inter-dealer transactions in
``similar'' securities, as defined below;
4. Yields calculated form prices of transactions with
institutional accounts in ``similar'' securities; and
5. Yields calculated from validated inter-dealer quotations in
``similar'' securities. In considering yields of ``similar''
securities, members may not rely on a limited number of transactions
that are not fairly representative of the yields of transactions of
``similar'' securities taken as a whole.
Ideally, a ``similar'' security should be sufficiently similar
to the security under review that it would serve as a reasonable
alternative to an investor seeking the risk profile of an investment
in the security under review. At a minimum, the security or
securities should be sufficiently similar that a market yield for
the security under review can be fairly estimated by interpolation
or extrapolation from the yields of the ``similar'' security'' or
securities. Where a security has several components, appropriate
consideration may also be given to the prices or yields of the
various components of the security.
The degree to which a ``security is similar'' as that term is
used in Items 3, 4, and 5 above, may be determined by factors that
include but are not limited to:
1. Credit quality considerations, such as whether the security
is issued by the same or similar entity, bears the same or similar
credit rating, or is supported by a similarly-strong guarantee or
collateral;
2. The extent to which the security trades at a comparable
spread over Treasuries of similar duration;
3. General structural characteristics of the issue, such as
coupon, maturity, duration, complexity or uniqueness of the
structure, callability, the likelihood that the security will be
called, tendered or exchanged, and other embedded options; and
4. Technical factors such as the size of the issue, the size of
the transactions or quotations being compared, the float and recent
turnover of the issue and legal restrictions on transferability.
In the case of those debt securities that trade with significant
equity-like characteristics (that is, where the value of the
security is highly dependent on the particular circumstances of the
issuer rather than responding to changes in interest rates in a
manner typical of most other debt securities), the use of
comparisons with similar securities of unrelated companies will
generally not be relevant.
* * * * *
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 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
I. Purpose
The Government Securities Act of 1986 (``GSA'') established a
federal system for the regulation of brokers and dealers who transact
business in
[[Page 54171]]
government securities and certain other exempted securities. The GSA,
however, did not grant the NASD authority to apply its sales practice
rules to such transactions. In December 1993, Congress enacted the
Government Securities Act Amendments of 1993, which eliminated the
statutory limitations on the NASD's authority to apply its sales
practice rules to transactions in exempted securities, including
government securities, but excluded municipal securities (``previously
exempted securities'').
On July 15, 1994, the NASD Board of Governors (``NASD Board'')
authorized publishing the proposed mark-up interpretation for member
comment. (See Notice to Members (``NTM'') 94-62 (Aug. 1994).\14\ The
mark-up interpretation filed in SR-NASD-97-61 on August 20, 1997, was
revision of the mark-up interpretation that was originally published in
NTM 94-62.
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\14\ At the same time the mark-up interpretation was published,
the NASD also published a suitability interpretation (``Suitability
Interpretation''). The many public comments received about the
Suitability Interpretation raised significant issues. As a result,
the Association deferred action on the proposed mark-up
interpretation until the Commission approved the Suitability
Interpretation and the NASD's general authority to subject persons
engaging in transactions in previously exempted securities to
specified rules in the Rule 2000 Series, the Rule 3000 Series, and
related rules. See SR-NASD-95-39, Securities Exchange Act Release
No. 37588 (Aug. 20, 1996), 61 FR 44100 (Aug. 27, 1997); and NTM 96-
66 (Oct. 1996).
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The mark-up interpretation for transactions in debt securities set
forth in Amendment No. 1 (``Debt Mark-Up Interpretation'') reflects the
additional efforts of NASD Regulation to address the application of the
NASD's general rule concerning fair pricing, Rule 2440, to fixed income
securities. Because of the lapse of time since the filing of SR-NASD-
97-61, NASD Regulation is substituting new language of Rule IM-2440-2
in its entirety for that contained in the original filing and deleting
the previously filed discussion under Part II., A., entitled
``Purpose,'' and substituting this text, which sets forth again the
purpose of the proposed Debt Mark-Up Interpretation, appropriately
amended to reflect changes in the text of proposed Rule IM-2440-2.
The NASD's existing policy relating to appropriate mark-ups in
transactions with customers in current Rule IM-2440, ``Mark-Up
Policy,'' was adopted by the NASD to provide guidance in applying Rule
2440, which generally requires members to conduct transactions with
customers at fair prices. In particular, Rule IM-2440 (proposed to be
renumbered as Rule IM-2440-1) provides guidance in determining whether
a mark-up or mark-down is reasonably related to the prevailing market
price of a particular security. Rule IM-2440 states that, in the
absence of other bona fide evidence of the prevailing market, a
member's own contemporaneous cost is the best indication of the
prevailing market price of a security. With regard to debt securities,
Rule IM-2440 notes that a higher percentage mark-up customarily is
appropriate for a common stock transaction compared with the
transaction in a debt security of the same size.
Rule 2440 and Rule IM-2440 apply to all over-the-counter
transactions, whether in listed or unlisted equity and debt securities.
These rules apply to corporate debt transactions but do not apply to
exempted securities, such as government securities. After approval of
the proposed rule change, these rules will apply to all debt
securities, except municipal securities. Fraudulent mark-ups, however,
violate existing legal standards and NASD Rule 2110, which prohibits
conduct that is inconsistent with just and equitable principles of
trade.
Rule IM-2440 describes a number of factors to be considered in
determining the fairness of a mark-up or mark-down, and generally
limits permissible mark-ups to no more than five percent. This test is
not a bright line standard, however, and the appropriateness of the
amount of a mark-up in a given case is heavily affected by the facts
and circumstances of each case.
Under the law derived from Commission and NASD decisions applying
the Mark-Up Policy, as approved by court review, the prevailing market
price of a particular security for pricing purposes may be demonstrated
by reference to inter-dealer transaction prices or, in some cases,
quotations, where those quotations are validated by actual transactions
that are close in time to the trade in question. Where such prices or
quotations do not exist, the mark-up must be determined by reference to
the dealer's contemporaneous cost of acquiring the security, absent
other bona fide evidence of the prevailing market price.
The importance placed by the NASD on fair pricing and current Rule
IM-2440 reflect the critical role that fair pricing considerations play
in assuring the integrity of security markets and the confidence that
investors place in those markets. The Debt Mark-Up Interpretation
attempts to adequately protect those interests in a way that gives due
consideration to the differences between debt and equity markets, and
the differences among various debt instruments and their markets, but
does not depart from the basic tenets of current Rule IM-2440.
In general, proposed Rule IM-2440-2 is based on the premise that
the fundamental principles that are applied to mark-ups in equity
markets apply also to the debt markets. Specifically, proposed Rule IM-
2440-2 seeks to provide guidance as to how to determine the
``prevailing market price'' for debt securities. This determination
forms the basis for calculating the amount of an appropriate mark-up or
mark-down in a particular transaction.
Proposed Rule IM-2440-2 distinguishes transactions entered into by
dealers who are market makers and states that market makers ordinarily
are entitled to calculate mark-ups based on their contemporaneous sales
prices to other dealers. The Debt Mark-Up Interpretation does not
address the application of mark-up principles in cases involving a
market maker that exercises domination and control of a market in a
particular security but notes that in such cases, the dealer's
contemporaneous cost is the best evidence of the prevailing market
price.
Proposed Rule IM-2440-2 recognizes that debt and equity markets
often differ in the extent and availability of inter-dealer transaction
prices for a particular security. It makes clear that a dealer, other
than a dealer acting as a market maker in a particular security, must
be prepared to rely on its own contemporaneous cost in acquiring a
security when pricing the security for mark-up purposes, unless the
dealer made no contemporaneous trades or can show that in the
particular circumstances the dealer's cost is not indicative of the
prevailing market price.
The Debt Mark-Up Interpretation sets forth various factors other
than contemporaneous cost that relate to the prevailing market price of
debt securities. Some of these factors relate to yields derived from
``similar securities.'' In addition, in determining whether one
security is sufficiently ``similar'' to another for these purposes, the
Debt Mark-Up Interpretations sets forth four factors to consider. In
this respect, proposed Rule IM-2440-2 recognizes that securities of
different types and issuers may be more highly fungible in debt than in
equity markets, to the extent that debt markets are more often driven
by yield than by other considerations that are unique to a particular
issuer.
Difficult questions often are posed with respect to mark-ups of
debt securities that are relatively illiquid or
[[Page 54172]]
that are designed for a particular customer or type of customer. The
Interpretation presumes that a comparison to ``similar'' securities may
be helpful in establishing the prevailing market price in these cases,
while adhering to the principle that contemporaneous cost remains the
default standard in these cases unless the dealer can show that this
measure is not indicative of the prevailing market price.
The Debt Mark-Up Interpretation provides guidance regarding how
members, in their principal transactions, should determine the
prevailing market price of a government or other debt security as the
basis for establishing the amount of the mark-up or mark-down for the
security. In providing such guidance, proposed Rule IM-2440-2 addresses
consideration of factors relating to yields and related prices of
similar securities.
Description of Proposed Rule
Standard for Determining the Prevailing Market Price
The Debt Mark-Up Interpretation is not intended to represent a
departure from Rule IM-2440 (proposed to be renumbered as Rule IM-2440-
1), but is being proposed to more accurately apply existing principles
to government securities and other debt securities. It states that
``the prevailing market price for a security against which to measure a
mark-up or mark-down is based primarily on the dealer's contemporaneous
cost or, in certain cases, contemporaneous inter-dealer transaction
prices in that specific security.''
The proposed Debt Mark-Up Interpretation notes that contemporaneous
cost is not always the best indicator of prevailing market price in
certain circumstances. As is the case in the equity markets, integrated
dealers who sell both to retail customers and also act as wholesale
market makers in active and competitive markets are permitted to
calculate mark-ups from their contemporaneous sales prices to other
dealers. This principle recognizes that contemporaneous transactions by
market makers in active and competitive markets constitute highly
reliable evidence of the prevailing market price and thus, in these
circumstances, the presumption that contemporaneous cost provide the
best measure does not apply. The Debt Mark-Up Interpretation states
that, in the context of the debt markets, a market maker is a dealer
who, with respect to a particular security, furnishes bond fide
competitive bid and offer quotations on request and is ready, willing,
and able to effect transactions in reasonable quantities at his or her
quoted prices with other brokers or dealers. This language recognizes
that dealers in debt markets may act effectively as market makers in a
group of securities without publishing continuous two-sided quotations
for each security within the group. Consistent with these principles as
recognized in the equity markets, this rationale does not apply where a
market is dominated and controlled by one firm.
In addition, the Debt Mark-Up Interpretation notes that
contemporaneous cost is not the appropriate measure where the dealer
made no contemporaneous trades in the security in question. In this
regard, the Debt Mark-Up Interpretation states that a transaction is
``contemporaneous'' if it occurs close enough in time to a later
transaction that it would reasonably be expected to reflect the current
market price for the security. Conversely, a transaction is not
contemporaneous if it is followed by intervening changes in interest
rates or other market events that reasonably would be expected to
affect the market price.
In cases where a contemporaneous trade does exist, a dealer that is
not a market maker may adduce countervailing evidence when it can show
that in the particular circumstances cost is not indicative of the
prevailing market price. The Debt Mark-Up Interpretation cites, for
example, the circumstance in which a dealer can show that the
securities were bought from knowledgeable customers at prices below the
prevailing market price.
Evidence That Overcomes the Presumption Regarding Contemporaneous Cost
The Debt Mark-Up Interpretation states that when inter-dealer
transactions are not available, a dealer that effects a transaction in
government securities or other debt securities with a customer and
determines the mark-up or mark-down on a basis other than its own
contemporaneous cost, must be prepared to ``provide evidence that is
sufficient to overcome the presumption that contemporaneous cost
provides the best measure of the prevailing market price.''
A member should maintain sufficient information and documentation
to overcome the presumption and to justify the price relied upon in
such circumstances. The type of information that should be maintained
will vary from member to member, based on the type of security in
question. However, the information being maintained should place the
member in a position to provide a clear and concise explanation when
questioned about its mark-ups and mark-downs. Examples of such factors
supporting bona fide evidence of a better market price, however, could
include information such as the pre-payment speeds (PSA) used when
pricing the debt instrument being acquired or sold, and the yield curve
for U.S. Treasury securities at the time the transaction is executed.
Reliance On Other Transaction Prices and Quotations
The Debt Mark-Up Interpretation states that, in the absence of
inter-dealer transactions, other factors may be taken into
consideration in determining the prevailing market price of debt
securities. None of the factors listed is intended to be per se bona
fide evidence of a better market price. This determination must always
be made by the member on a case-by-case basis.
The first factor is prices of any dealer transactions in the
security in question with institutional accounts with which any dealer
regularly effects transactions in the same or a similar security. This
statement recognizes that the regularity of dealing with other
institutions in the same security may increase the validity of
referencing such transactions from pricing purposes.
The second factor for consideration is contemporaneous inter-dealer
quotations in the security made through an inter-dealer quotation
mechanism through which transactions do in fact occur at prices that
are reasonably related to the displayed quotations.
The other factors enumerated are related to yields that are
calculated by reference to similar securities, including yields
calculated by reference to inter-dealer transactions, transactions with
institutional accounts and validated inter-dealer quotations.
Collectively, these factors assume that reliable indications of the
market price for one security may be helpful in determining the market
price for another security that is similar in terms of characteristics
and trading environment. The inclusion of these factors reflects the
importance of yield as a measure of comparison in the debt markets.
However, the Debt Mark-Up Interpretation also states that, in
considering such factors, firms may not rely on a limited,
unrepresentative number of transactions. This point is particularly
relevant with respect to isolated transactions with institutional
accounts, the prices for which may be heavily affected by factors
unique to the transactions, including the nature, size, and
sophistication of the customers who
[[Page 54173]]
are counterparties to the transactions. The inclusion of this factor is
intended to recognize that in some cases, institutional customers that
trade frequently in the debt markets may possess levels of
sophistication and influence that are equivalent to dealers in the same
markets.
Determining the ``Similarity'' of Securities for Pricing Purposes
The consideration of similar securities for pricing purposes
requires a determination that other securities are, in fact, similar
enough to be used as a pricing reference. The proposed rule change,
therefore, provides examples of factors that a member should consider
to determine whether another security is similar enough to be a useful
pricing reference.
The first factor for consideration relates to credit quality
issues, i.e., whether the security is issued by the same or similar
entity, bears the same or similar credit rating, or is supported by the
same or a similar guarantee or collateral. These factors may be
significant with regard to certain corporate debt and other securities
for which creditworthiness is important.
The second factor for consideration is the extent to which a
security trades at a comparable spread over U.S. Treasury securities of
similar duration.
The third set of factors relates to the general structural
characteristics of the issue, including coupon, maturity, duration,
complexity or uniqueness of the structure, callability (and likelihood
of being called, tendered or exchanged), and other embedded options.
The fourth set of factors relate to other issues that may affect
how the market determines prices for the security in certain
circumstances, such the size of the issue, the size of the transactions
or quotations being compared, the float and recent turnover of the
issue and legal restrictions on transferability.
The factors described relate both to the unique characteristics of
the security and also to the characteristics affecting the trading
market for the security in question. The latter set of factors, e.g.,
the extent to which a security trades at comparable spreads to U.S.
Treasury securities, are intended to refer to the market that exists at
the time of the transaction that is being analyzed for purposes of
determining the mark-up
Applicability to Particular Debt Securities
The Debt Mark-up Interpretation states that it is not intended to
apply to all debt securities. It clarifies that the use of similar
securities of unrelated companies will generally not be relevant for
pricing purposes in the case of those debt securities that trade with
significant equity-like characteristics (that is, where the value of
the security is highly dependent on the particular circumstances of the
issuer, rather than responding to changes in interest rates in a manner
typical of most other debt securities).
2. Statutory Basis
NASD Regulation believes that the proposed rule change is
consistent with Section 15A(b)(6) of the Act,\15\ which requires, among
other things, that the Association's rules 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 interest. The NASD believes that the proposed Debt Mark-
Up Interpretation will provide guidance regarding mark-ups and mark-
downs in fixed income securities and will aid members in complying with
their obligations under the Association's rules, including Rule 2440.
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\15\ 15 U.S.C. 78o-3(b)(6).
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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
The proposed rule change was published for comment in NASD Notice
to Members (``NTM'') 94-62 (Aug. 1994), and eight comment letters were
received in response. Of the eight comment letters, one was in favor of
the proposed rule change without change, six were in favor with
recommendations, and one was opposed. Because a period of time has
elapsed between the filing of SR-NASD-97-61 and the amendments, by
Amendment No. 1, NASD Regulation is deleting the previously filed
discussion under Part II, C., and substituting this text, which sets
forth the concerns of the commenters and the Association's response,
appropriately amended to reflect any changes in the text of the Debt
Mark-Up Interpretation.
The Debt Mark-Up Interpretation reflects revisions from the
proposal contained in NTM 94-62 and this proposed rule change (SR-NASD-
97-61) as it was originally filed. These changes should provide
additional guidance to members.
With several revisions, the Association seeks to clarify that the
Debt Mark-Up Interpretation is not a departure from the Association's
existing Mark-Up Policy, but rather makes clearer the application of
the Mark-Up Policy to markets for government and other debt securities.
First, a statement to this effect has been added to the Debt Mark-Up
Interpretation. In addition, for similar reasons, a sentence has been
added in the first paragraph to reiterate the long-standing policy that
the mark-up or mark-down from the prevailing market price for most
types of government and other debt securities should usually be
substantially less than 5 percent.
The fifth paragraph of the Debt Mark-Up Interpretation has been
modified to clearly articulate that, absent countervailing evidence,
the contemporaneous cost to the dealer of acquiring a security should
be used as the basis for determining a mark-up, although the new Debt
Mark-Up Interpretation also explicitly says this standard does not
apply to market makers, who generally are able to price from their
inter-dealer sales prices. The Debt Mark-Up Interpretation also
contains language to clarify that where inter-dealer transactions are
not available, a dealer determining a mark-up or mark-down on a basis
other than its own contemporaneous cost must be prepared to provide
evidence that is sufficient to overcome the presumption that
contemporaneous cost provides the best measure of the prevailing market
price of the security.
In addition, to provide more clarity in the Debt Mark-Up
Interpretation relating to the pricing of a security when a dealer is a
market maker or when the dealer is engaging in a riskless principal
transaction, the Association has added the following. First, the Debt
Mark-Up Interpretation defines market maker in the context of fixed
income securities and also makes clear that a dealer who is a market
maker in an active, competitive market is permitted to calculate its
mark-up from contemporaneous sales prices to other dealers, rather than
relying on the dealer's own contemporaneous cost in acquiring the
security. Second, proposed Rule IM-2440-2 notes that the Commission has
held that when a dealer that is not a market maker effects a riskless
principal transaction, the dealer's cost must always be used as the
basis for the mark-up.
The Debt Mark-Up Interpretation also addresses the increased
complexity for compliance and enforcement purposes
[[Page 54174]]
surrounding use of similar securities for pricing purposes. Central to
this matter is the issue of which characteristics make two securities
similar enough for pricing purposes. In the seventh paragraph, the Debt
Mark-Up Interpretation states that, ideally, a security should be
sufficiently similar to the security under review that it would serve
as a reasonable alternative to an investor seeking the risk profile of
an investment in the security under review. It also states that, at a
minimum, a security or securities should be sufficiently similar that a
market yield for the security under review can be fairly estimated by
interpolation or extrapolation from the yields of a similar security or
securities.
The Debt Mark-Up Interpretation also clarifies that the factors
listed for consideration in determining the prevailing market price of
a particular security should not be mechanically prioritized in the
order listed. Rather, the relative importance of the factors listed
depends on the facts and circumstances relating to the transaction,
such as the order size, timeliness of the source of information, and
relative spread of the quotations.
In note one, the Association has clarified that certain regulatory
issues that are related to the pricing of a security are not intended
to be addressed by the proposed rule change. Specifically, the Debt
Mark-Up Interpretation does not apply to transactions involving the
domination and control of the market for a particular security.
Specific Comments
Two commenters (Nos. 1 and 6) expressed concerns that the list of
factors for consideration in determining the prevailing market price of
a security are not correctly prioritized. One commenter (No. 1)
suggested that the Debt Mark-Up Interpretation clarify that the factors
used to determine the prevailing market price are not necessarily
listed in preferential order, or if so, that the factors be reordered
to reflect that factors such as inter-dealer transactions in similar
securities and validated inter-dealer quotations in similar securities
are more significant factors than their current order in the list
indicated. Similarly, one commenter (No. 6) stated that the first two
factors, i.e., prices of dealer transactions with institutional
customers and validated inter-dealer quotations in the same security,
may be equally as rare as inter-dealer transaction prices for some debt
securities, particularly for those securities specifically designed to
meet the needs of a specific investor. In response, the Debt Mark-Up
Interpretation now contains a footnote stating that the relative
importance of the factors listed depends on the facts and circumstances
relating to the transaction, such as the order size, timeliness of the
source of information, and relative spread of the quotations. In
addition, because the ultimate evidentiary issue is the prevailing
market price, isolated transactions or quotations generally will not
have much, if any, weight or relevance. Finally, when those factors are
applied to trades by dealers that are not market makers, the footnote
states that the mark-up must be based on the bid side of the market,
e.g., the inter-dealer bid quotation, or in the case of a mark-down, on
the offer side of the market, e.g., the inter-dealer offer quotation.
One commenter (No. 1) questioned why some of the factors listed for
determining the prevailing market price reference the term ``price''
and the other factors reference the term ``yield.'' This commenter also
was concerned that the proposal did not clarify that most bonds are
traded on a ``basis-point spread'' against U.S. Treasury securities and
that debt securities with similar characteristics will trade at similar
``base-point spreads'' against comparable U.S. Treasury securities. The
commenter argued that this issue is important because it is the
practice in the government security inter-dealer market to determine a
particular bond's market price by comparing it with the basis-point
spread of similar securities rather than a similar security's
``execution price.''
In response, NASD Regulation agrees with the commenter that the
terms ``price'' and ``yield'' are interchangeable for referencing
transactions in the ``same security.'' However, the terms are not
interchangeable when referencing ``similar'' securities. This
distinction exists because similar securities may have different prices
depending on their maturity, coupon, or other characteristics, while at
the same time the yields of the two securities may be related (for
example, both trade with a similar basis-point spread against U.S.
Treasury securities). NASD Regulation has continued to frame the first
two factors in terms of price because the Association preliminarily
believes that these factors will be more readily understood in this
way, although NASD Regulation would wish to consider any comments on
whether the Debt Mark-Up Interpretation should provide more focus on
yield.
One commenter (No. 1) raised concerns that the proposed rule change
should reflect that the prevailing market price of a government
security will depend on whether the transaction involves an odd or
whole lot and, further, that the wholesale price of government
securities, in general, varies depending on the quantity of the
securities in the transaction involved. In response, the Debt Mark-Up
Interpretation provides that the degree to which a security is
``similar'' to another security may be determined by technical factors,
such as the size of the transactions and quotations being compared.
One commenter (No. 1) questioned the merit of proposed language
that would allow a member to aggregate the value of components of a
security where such values can be derived from prices or yields of
similar securities as reflected in transactions or quotations in the
market between dealers or with sophisticated institutional customers.
The commenter suggested that this was actually a subset of what could
be taken into account when evaluating prices of similar securities,
rather than a discrete approach for determining the prevailing market
price of a particular security. NASD Regulation concurs with the
comment and the language in question was deleted from the
Interpretation.
One commenter (No. 2) suggested that the proposed rule change
should contain a definition of the term ``contemporaneous cost.'' In
response, in the fifth paragraph NASD Regulation has stated that a
transaction is ``contemporaneous'' if it occurs close enough in time to
a later transaction that it would reasonably be expected to reflect the
current market price for the security, and that a transaction is not
``contemporaneous'' if it is followed by intervening changes in
interest rates or other market events that reasonably would be expected
to affect the market price.
One commenter (No. 3) recommended that the proposed rule change use
the ``fair and reasonable'' pricing approach employed by Rule G-30 of
the Municipal Securities Rulemaking Board (``MSRB''). Similarly, one
commenter (No. 4) suggested that the proposed rule change should
address the size of spreads of different government securities, taking
into account the complexity and familiarity of the industry with the
type of security. In response, NASD Regulation notes that the Debt
Mark-Up Interpretation is not intended to duplicate or replace either
Rule 2440 or the Mark-Up Policy, which provide a regulatory purpose
similar to MSRB Rule G-30, but to apply the principles of these NASD
rules to the debt markets for purposes of determining the prevailing
market price
[[Page 54175]]
of a particular security on which to base a mark-up or mark-down. The
Mark-Up Policy also currently allows for differences in mark-ups and
mark-downs based on considerations such as the complexity of the
security.
One commenter (No. 8) supported the methodology contained in the
proposed rule change, but noted that a degree of subjectivity will of
necessity accompany the use of the factors. Similarly, one commenter
(No. 6) stated that the process of evaluating the degree of similarity
between and among securities is clearly more subjective and qualitative
than reference to actual prices or quotations in the same security, and
subsequently, much will depend on the analytical approach utilized by
members, customers and regulatory officials to determine which
securities are similar. This commenter, therefore, suggested that a
continuing effort may be required to refine the NASD's regulatory
approach to determining and quantifying degrees of similarity among
debt securities. NASD Regulation acknowledges that the Debt Mark-Up
Interpretation, in providing guidance, does not answer all questions
that will arise but presently does not believe that more objective
standards are feasible. NASD Regulation would wish to consider any
comments relating to this issue.
One commenter (No. 1) noted that the proposal contained the two
terms, ``sophisticated institutional investors'' and ``institutional
accounts,'' which appeared duplicative. In response, NASD Regulation
replaced the term ``sophisticated institutional investors'' with the
term ``institutional accounts.''
III. Date of Effectiveness of the Proposed Rule Change and Timing
for Commission Action
Within 90 days of the date of 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, \16\ the Commission
will:
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\16\ The NASD will file Amendment No. 3 consenting to a period
of 90 days, beginning from the date of publication of notice of
filing of the proposed rule change SR-NASD-97-61 in the Federal
Register, for the Commission to act as provided in Section 19(b)(2).
Telephone conversation between Sharon Zackula, Assistant General
Counsel, NASD Regulation, and Karl Varner, Attorney, SEC (Sept. 30,
1998).
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(A) by order approve such 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, including whether the proposed rule
change is consistent with the Act. Persons making written submissions
should file six copies thereof with the Secretary, Securities and
Exchange Commission, 450 Fifth Street, N.W., Washington, DC 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 in the
Commission's Public Reference Room. Copies of the filing will also be
available for inspection and copying at the principal office of the
NASD. All submissions should refer to the File No. SR-NASD-97-61 and
should be submitted by December 7, 1998.
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\17\
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\17\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-26998 Filed 10-7-98; 8:45 am]
BILLING CODE 8010-01-M