[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