[Federal Register Volume 65, Number 205 (Monday, October 23, 2000)]
[Notices]
[Pages 63275-63278]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-27138]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-43441; File No. SR-NASD-00-55]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by the National Association of Securities Dealers, Inc. Relating 
to the Delivery Requirement of a Margin Disclosure Statement to Non-
Institutional Customers

October 12, 2000.
    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 September 5, 2000, the National Association of Securities Dealers, 
Inc. (``NASD'' or ``Association''), through its wholly owned 
subsidiary, NASD Regulation, Inc. (``NASD Regulation''), filed with the 
Securities and Exchange Commission (``SEC'' or ``Commission''), the 
proposed rule change as described in Items I, II, and III below, which 
Items have been prepared by NASD Regulation. On September 26, 2000, the 
NASD submitted Amendment No. 1 to the proposed rule change.\3\ The 
Commission is publishing this notice to solicit comments on the 
proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ In Amendment No. 1, NASD Regulation proposes to amend the 
proposed rule language. Specifically, Amendment No. 1 clarifies that 
if the equity in a customer's margin account falls below applicable 
requirements, an NASD member firm can force the sale of any of the 
securities in any of the customer's accounts held at the firm and 
such liquidations are not limited to the customer's margin account. 
Additionally, NASD Regulation deletes the phrase ``under the law'' 
from its original filing to clarify that maintenance margin 
requirements are requirements of self-regulatory organizations. See 
Letter from Alden S. Adkins, General Counsel and Senior Vice 
President, NASD Regulation, to Katherine A. England, Assistant 
Director, Division of Market Regulation, Commission, dated September 
25, 2000.
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    NASD Regulation is proposing to add a new NASD Rule 2341 to require 
its members to deliver to their non-institutional customers, prior to 
or at the opening of a margin account, a specified disclosure statement 
that discusses the operation of margin accounts and the risk associated 
with trading on margin. NASD Regulation also proposes to require NASD 
members to deliver the specified disclosure statement to their non-
institutional customers with margin accounts on an annual basis. Below 
is the test of the proposed rule change. Proposed new language is in 
italics.
Rule 2341. Margin Disclosure Statement
    (a) No member shall open a margin account, as specified in 
Regulation T of the Board of Governors of the Federal Reserve System, 
for or on behalf of a non-institutional customer, unless, prior to or 
at the time of opening the account, the member has furnished to the 
customer, individually, in writing or electronically, the following 
margin disclosure statement:
    Your brokerage firm is furnishing this document to you to provide 
some basic facts abut purchasing securities on margin, and to alert you 
to the risks involved with trading securities in a margin account. 
Before trading stocks in a margin account, you should carefully review 
the margin agreement provided by your firm. Consult your firm regarding 
any questions or concerns you may have with your margin accounts.
    When you purchase securities, you may pay for the securities in 
full or you may borrow part of the purchase price from your brokerage 
firm. If you choose to borrow funds from your firm, you will open a 
margin account with the firm. The securities purchased are the firm's 
collateral for the loan to you. If the securities in your account 
decline in value, so does the value of the collateral supporting your 
loan and, as a result the firm can take action, such as issue a margin 
call and/or sell securities in any of your accounts held with the 
member, in order to maintain the required equity in the account.
    It is important that you fully understand the risks involved in 
trading securities on margin. These risks include the following:
     You can lose more funds than you deposit in the margin 
account A decline in the value of securities that are purchased on 
margin may require you to provide additional funds to the firm that has 
made the loan to avoid the forced sale of those securities or other 
securities in your account(s).
     The firm can force the sale of securities in your 
account(s). If the equity in your account falls below the maintenance 
margin requirements of the firm's higher ``house'' requirements, the 
firm can sell the securities in any of your accounts held at the firm 
to cover the margin deficiency. You also will be responsible for any 
short fall in the account after such a sale.
     The firm can sell your securities without contacting you. 
Some investors mistakenly believe that a firm must contact them for a 
margin call to be valid, and that the firm cannot liquidate securities 
in their accounts to meet the call unless the firm has contacted them 
first, This is not the case. Most firms will attempt to notify their 
customers of margin calls, but they are not required to do so. However, 
even if a firm has contacted a customer and provided a specific date by 
which the customer can meet a margin call, the firm can still take 
necessary steps to protect its financial interests, including 
immediately selling the securities without notice to the customer.
     You are not entitled to choose which securities in your 
account(s) are liquidated or sold to meet a margin call. Because the 
securities are collateral for the margin loan, the firm has the right 
to decide which security to sell in order to protect its interests.
     The firm can increase its ``house'' maintenance margin 
requirements at any time and is not required to provide you advance 
written notice. These changes in firm policy often take effect 
immediately and may result in the issuance of a maintenance margin 
call. Your failure to satisfy the call may cause the member to 
liquidate or sell securities in your account(s).
     You are not entitled to an extension of time on a margin 
call. While an extension of time to meet margin requirements may be 
available to customers under certain conditions, a customer does not 
have a right to the extension.

[[Page 63276]]

    (b) Members shall, with a frequency of not less than once a 
calendar year, deliver individually, in writing or electronically, the 
disclosure statement described in paragraph (a) to all non-
institutional customers with margin accounts.
    (c) In lieu of providing the margin disclosure statement specified 
in paragraph (a), a member may provide to the customer an alternative 
disclosure statement, provided that the alternative disclosure 
statement shall be substantially similar to the disclosure statement 
specified in paragraph (a).
    (d) For purposes of this Rule, the term ``non-institutional 
customer'' means a customer that does not qualify as an ``institutional 
account'' under Rule 3110(c)(4).

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

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

1. Purpose
    a. Background. The recent growth in the level of customer margin 
account balances, coupled with the increase in customer inquiries and 
complaints to NASD Regulation and SEC staffs relating to the handling 
of margin accounts, has raised concerns as to whether investors 
understand the operation and risks associated with margin trading. NASD 
Regulation believes that investors' misconceptions about margin 
requirements, particularly with respect to maintenance margin, may 
cause investors to underestimate the risks of margin trading and to 
misunderstand the operation of and reasons for margin calls.
    In this regard, a recent report issued by the General Accounting 
Office (``GAO'') noted that the SEC has determined from the customer 
complaints it has received that many investors who traded on-line did 
not understand margin requirements.\4\ The lack of disclosures relating 
to when firms would sell securities in a margin account to cover margin 
loans was among the leading margin-related complaints that the SEC 
received.
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    \4\ See On-Line Trading, Better Investor Protection Information 
Needed, Report to Congressional Requesters, GAO, GGD-00-43 (May 
2000) (the ``GAO Report''). According to the GAO Report, between 
January 1998 and June 1999, 140 margin-related complaints concerning 
on-line trading firms were submitted to the SEC.
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    The GAO Report also collected and summarized information from 12 
on-line broker-dealers.\5\ All of the on-line firms contacted did 
provide their customers the limited information currently required on 
margin trading.\6\ Some firms also provided additional information 
relating to margin, such as requirements for account opening, 
procedures for selling securities to cover account losses, or special 
requirements for volatile stocks. However, nearly half of the firms 
contacted automatically opened margin accounts for new customers 
without providing the customer information relating to the risks 
associated with margin trading. At three firms that automatically \7\ 
opened margin accounts, customers would find out about their account 
type only if they read and understood their account agreements, which 
SEC staff indicated were written in legal language and may be difficult 
for investors to understand. Three of the 12 on-line broker-dealers 
contacted did take ``extra measures'' to ensure that their customers 
understood that stocks could be sold to cover outstanding loans in a 
margin account. These firms included information on their web sites 
that explained that accounts could be liquidated in fast-moving markets 
before the customary period.
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    \5\ These firms represented less than 10 percent of the total 
estimated number of firms that offer on-line trading. However, they 
accounted for about 90 percent of the on-line trading volume during 
early 1999.
    \6\ Rule 10b-16 under the Act (``SEC Rule 10b-16'') requires 
broker-dealers that extend credit to customers to finance securities 
transactions to furnish, in writing, specified information regarding 
the terms of the loan. These disclosures must be made on both an 
initial and periodic basis. For example, at the time a customer 
opens a margin account, the broker-dealer must provide the customer 
with a written statement disclosing, among other things, the annual 
rate of interest, the method of computing interest, and what other 
credit charges may be imposed.
    \7\ Those firms that provided clear indications of the type of 
account to be opened offered their customers the option on the web 
site to choose either a cash or margin account, or both. However, 
those firms that automatically opened margin accounts only offered 
new customers a choice with respect to account ownership, such as 
joint or individual account.
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    The GAO Report concluded that better investor protection 
information, including information relating to margin requirements, was 
needed on web sites of some on-line broker-dealers. In this regard, the 
GAO Report recommended that the SEC ensure that broker-dealers with on-
line trading systems include accurate and complete information on their 
web sites regarding, among other things, margin requirements.
    b. Specific Areas of Concern. Based on customer complaints and 
inquiries it has received, NASD Regulation identified several areas 
associated with margin trading that may have generated confusion and 
misunderstanding between NASD customers and members. These include:
    i. Margin Calls--Notification. Some investors hold the mistaken 
belief that their broker-dealer must contact them for a margin call to 
be valid, and that their broker-dealer cannot liquidate securities in 
their account to meet the call unless a specified number of days have 
passed and/or the broker-dealer has contacted the customer. There are 
no such restrictions in Regulation T \8\ of the Board of Governors of 
the Federal Reserve System or NASD Rule 2520.\9\ Moreover, securities 
that have been purchased on margin by a customer are collateral for the 
margin loan and are, therefore, subject to the security claim of the 
broker-dealer until the customer fully pays for the securities. Thus, 
if a broker-dealer believes that the collateral for the margin loan is 
at risk, the broker-dealer is entitled to take any steps necessary to 
protect its financial interests, including immediate liquidation 
without notice to the customer. Some broker-dealers will attempt to 
notify their customers of margin calls, but they are not required to do 
so. However, even if a broker-dealer has contacted a customer and 
provided a specific date by which the customer can meet a margin call, 
the broker-dealer can still take necessary steps to protect its 
financial interests, including immediate liquidation, without further 
notice to the customer.
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    \8\ 12 CFR 220 et seq.
    \9\ NASD Rule 2520 governs margin requirements.
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    ii. Extensions of time on margin calls. Some investors believe they 
are automatically entitled to an extension of time to meet margin 
calls. While an extension of time to meet initial margin requirements 
may be available to the customer under certain conditions, it is only 
granted if the clearing firm chooses to request an extension from its 
Designated Examining Authority; the customer does not have a right to 
an automatic extension.
    In addition, some investors believe that when a maintenance margin 
call

[[Page 63277]]

has been issued they are entitled to one or more extensions of time to 
meet the call; however, there is no mechanism for extending maintenance 
margin calls. If the customer fails to meet a maintenance margin call, 
the broker-dealer can, under certain circumstances, take a charge to 
its net capital in lieu of collecting the call, but the broker-dealer 
is not required to do so, and the customer has no right to demand it.
    iii. Right to dictate which security is liquidated. Some investors 
believe that they have the right to control which securities are 
liquidated to meet a maintenance margin call if there is more than one 
security in the NASD customer's accounts.\10\ There is no provision in 
the margin rules that gives the customer the right to control 
liquidation decisions. As discussed above, because the securities are 
collateral for the margin loan, the broker-dealer has the right to 
control the disposition of the collateral in order to protect its 
interests. In this regard, the broker-dealer may choose which 
securities in the margin account, or any other account held by NASD 
member on behalf of the customer, to liquidate, and this selection need 
not relate to factors associated with the individual customer.\11\ For 
example, the NASD broker-dealer may choose a particular security in a 
customer's account to liquidate based on a high concentration of the 
security held by customers firm-wide.
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    \10\ See Amendment No. 1, supra note 3.
    \11\ Id.
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    iv. NASD members raising their maintenance margin requirements. 
Some NASD members have increased their ``house'' maintenance margin 
requirements as a result of concerns about the volatility and extreme 
price run-ups on certain stocks, the risks to their customers, and the 
NASD member's own potential exposure to losses from margin defaults. 
These changes in policy often take effect immediately and may result in 
the issuance of a maintenance margin call. A customer's failure to 
satisfy the call will usually cause the NASD member to liquidate a 
portion of the customer's account.
    Some investors believe that an NASD member must provide thirty days 
written notice before implementing this type of change. While SEC Rule 
10b-16 requires members to disclose to customers the credit terms 
(interest rates and methods of calculating interest) for margin 
transactions and requires advance written notice of such changes, it 
does not require advance notice of the amount of margin required.
    C. Proposed Requirements. Although NASD Regulation recognizes that 
some NASD members are providing additional disclosures to customers 
relating to margin, the content of these disclosures is not consistent 
from firm to firm and may not always be in a form that is 
understandable to investors. Thus, NASD Regulation proposes to 
implement a new NASD Rule 2341 that would require NASD members to 
deliver a disclosure statement that includes all the ``bulleted'' 
information as specified in the proposed NASD Rule 2341, or a 
substantially identical disclosure statement \12\ to their non-
institutional customers.\13\ NASD members would be required to deliver 
the mandated disclosure statement, in writing or electronically, to 
customers individually,\14\ prior to or at the opening of a margin 
account. NASD Regulation also would require NASD members to deliver the 
mandated disclosure statement annually to all of their non-
institutional customers with margin accounts. NASD members would be 
required to provide the mandated disclosure statement to existing 
margin customers at the time the NASD member is required to send the 
next annual statement to the customer (following the effective date of 
the rule change), but not to exceed 180 days following the effective 
date of the rule change.
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    \12\ NASD Regulation represents that it will determine whether 
an alternative disclosure statement contains substantially identical 
information as required by the proposed NASD Rule 2341 at its 
examination of the particular NASD firm. Telephone conversation 
between Stephanie Dumont, Counsel, NASD Regulation, and Hong-anh 
Tran, Special Counsel, Division, Commission, September 28, 2000.
    \13\ The term ``non-institutional customer'' would mean a 
customer that does not qualify as an ``institutional account'' under 
NASD Rule 311(c)(4). NASD Rule 3110(c)(4) defines ``institutional 
account'' to mean the account of: (1) a bank, savings and loan 
association, insurance company, or registered investment company; 
(2) an investment adviser registered either with the Commission 
under Section 203 of the Investment Advisers Act of 1940 or with a 
state securities commission (or agency or office performing similar 
functions); or (3) any other entity (whether a natural person, 
corporation, partnership, trust, or otherwise) with total assets of 
at least $50 million.
    \14\ Members would be required to deliver the disclosure 
statement to each customer individually. A member firm posting the 
disclosure statement on its web site would not fulfill the proposed 
delivery requirements.
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    The mandated margin disclosure statement would: (1) Describe the 
operation of a margin account; (2) emphasize that customers should 
carefully review their margin agreements; and (3) clarify some of the 
risks associated with margin trading, including among others, that the 
customer can lose more funds than initially deposited, the firm can 
force the sale of the securities in the customer's account(s) held by 
the firm without notice to the customer, the firm can dictate which 
security is selected for liquidation, and the customer is not entitled 
to an extension of time on a margin call.
    NASD members would be permitted to develop an alternative margin 
disclosure statement, provided that the alternative disclosure 
statement is substantially similar to the mandated disclosure statement 
and incorporates all of the relevant concepts. Under the proposed rule 
change, disclosure at or prior to the opening of the account would be 
made in a separate document, even if an NASD member firm chooses to 
deliver the margin disclosure statement as part of or within the margin 
agreement or other opening account documentation.\15\ However, with 
respect to the annual disclosure statement requirement, NASD members 
would be permitted to provide the margin disclosure statement within 
other documentation, such as the customer account statement.
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    \15\ NASD Regulation represents that an NASD member firm may 
choose to deliver the disclosure statement or other opening account 
documentaiton on a separate page of, or as an attachment to, the 
margin agreement. Telephone conversation between Stephanie Dumont, 
Counsel, NASD Regulation, and Sapna Patel, Law Clerk, Division, 
Commission, October 12, 2000.
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    NASD Regulation intends to announce the effective date of the 
proposed rule change in a Notice to Members to be published no later 
than 60 days following Commission approval of the proposed rule change. 
The effective date will be 30 days following publication of the Notice 
to Members announcing Commission approval of the proposed rule change. 
With respect to the annual delivery requirement, members would be 
required to provide the margin disclosure statement to each existing 
margin customer at the time the member is required to send the next 
annual statement to the NASD customer (following the effective date of 
the rule change), but not to exceed 180 days following the effective 
date of the rule change.
2. Statutory Basis
    NASD Regulation beleives that the proposed rule change is 
consistent with Section 15A(b)(6) \16\ of the Act, in that the proposed 
rule change is 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. NASD Regulation

[[Page 63278]]

believes that the proposed rule change will provide non-institutional 
customers, who may have margin accounts with NASD members, with a 
better understanding of the operation of a margin account and the risks 
associated with margin trading.
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    \16\ 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.

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

    No written comments were solicited or received with respect to the 
proposed rule change.

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

    Within 35 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, the Commission 
will:
    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. The Commission is specifically 
soliciting comments on whether the proposed disclosure is sufficient 
and non-misleading, or whether changes to the disclosure statement 
should be made. For example, the Commission is concerned that the 
proposed rule language would not require NASD member firms to disclose 
to customers that any and all assets, including securities or any other 
property the customer has on account at the member firm and any of its 
affiliates, whether carried individually or jointly with others, may, 
depending on the margin agreement, be used by the broker-dealer to 
satisfy a maintenance margin call. Should broker-dealer disclose this 
fact? Are other changes to the proposed disclosure merited? Persons 
making written submissions should file six copies thereof with the 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., 
Washington, DC 20549-0609. 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 the Commission's Public Reference 
Room. Copies of such filing will also be available for inspection and 
copying at the principal office of the NASD. All submissions should 
refer to File No. SR-NASD-00-55 and should be submitted by November 13, 
2000.

    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. 00-27138 Filed 10-20-00; 8:45 am]
BILLING CODE 8010-01-M