[Federal Register Volume 67, Number 165 (Monday, August 26, 2002)]
[Notices]
[Pages 54832-54835]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-21651]


-----------------------------------------------------------------------

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-46376; File No. SR-NASD-99-04]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change and Notice of Filing and Order Granting Accelerated Approval to 
Amendment No. 2 to the Proposed Rule Change by the National Association 
of Securities Dealers, Inc. Relating to Microcap Initiative--
Recommendation Rule

August 19, 2002.

I. Introduction

    On February 19, 1999, 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'') pursuant 
to Section 19(b)(1) of the Securities Exchange Act of 1934 (``Act'') 
\1\ and Rule 19b-4 thereunder,\2\ a proposed rule change that would 
require members to review current financial statements of, and current 
material business information about, an issuer prior to recommending a 
transaction to a customer in an over-the-counter (``OTC'') equity 
security.
---------------------------------------------------------------------------

    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
---------------------------------------------------------------------------

    The proposed rule change was published for comment in the Federal 
Register on March 1, 1999.\3\ The Commission received six comment 
letters on the Original Proposal. On January 11, 2002, the NASD filed 
Amendment No. 1 to the proposed rule change, which among other things 
addressed the issues raised by commenters.\4\ Amendment No. 1 was 
published for comment in the Federal Register on January 22, 2002.\5\ 
On July 26, 2002, the NASD filed Amendment No. 2 to the proposed rule 
change.\6\
---------------------------------------------------------------------------

    \3\ See Securities Exchange Act Release No. 41075 (February 19, 
1999), 64 FR 10037 (``Original Proposal'').
    \4\ In the Original Proposal, the NASD proposed subparagraph (e) 
to NASD Rule 6740. That provision would have permitted a member to 
submit a certification to the NASD stating that the firm complied 
with the requirements of SEC Rule 15c2-11, 17 CFR 240.15c2-11, 
including the member's review obligation, if the documents the firm 
was required to review were contained in the Commission's Electronic 
Data Gathering and Retrieval System, in lieu of submitting a copy of 
the documents reviewed. This proposed rule text was deleted as part 
of Amendment No. 1, although the change was not reflected in the 
narrative portion of the Amendment.
    \5\ See Securities Exchange Act Release No. 45277 (January 14, 
2002), 67 FR 2937.
    \6\ See Letter from Marc Menchel, Senior Vice President and 
General Counsel, NASD, to Katherine A. England, Assistant Director, 
Division of Market Regulation (``Division''), Commission, dated July 
26, 2002 (``Amendment No. 2). In Amendment No. 2, the NASD amended 
proposed NASD Rule 2315(a) to clarify that members conducting 
transactions in securities that are listed on a regional securities 
exchange, but do not qualify for dissemination of transaction 
reports via the Consolidated Tape, must comply with the review 
requirements of the Recommendation Rule if such securities are 
published or quoted in a quotation medium. The NASD also amended 
NASD Rule 2315(e)(1)(G)(2) to substitute ``NASD'' for the reference 
to ``the Association'' contained in the Rule.
---------------------------------------------------------------------------

    The Commission received no comments regarding the proposal as 
amended. This order approves the proposed rule change, as amended.

II. Description of Proposal

    To respond to concerns about abuses in the trading and sales of 
thinly traded, thinly capitalized securities (i.e., microcap 
securities) quoted in the OTC market, NASD Regulation has proposed to 
amend NASD rules to include new NASD Rule 2315, entitled 
``Recommendations to Customers in OTC Equity Securities'' 
(``Recommendation Rule'' or ``Rule''). In the view of NASD Regulation, 
the lack of reliable and current financial information about issuers of 
microcap securities can create the potential for fraud and 
manipulation.
    The proposed rule would be limited to equity securities that are 
published or quoted in a quotation medium and that either: (1) Are not 
listed on Nasdaq or a national securities exchange, or (2) are listed 
on a regional securities exchange and do not qualify for dissemination 
of transaction reports via the Consolidated Tape (``covered 
securities'').\7\ The requirements in the Recommendation Rule is 
intended to supplement requirements under the federal securities laws 
and under NASD rules that a broker-dealer that recommends securities to 
its customers is required to have a reasonable basis for those 
recommendations.\8\ In addition, the proposed rule is not intended to 
act or operate as a presumption or as a safe harbor for purposes of 
determining suitability or for any other legal

[[Page 54833]]

obligation or requirement imposed under NASD rules or the federal 
securities laws.
---------------------------------------------------------------------------

    \7\ ``Quotation medium'' is defined as a system of general 
circulation to brokers or dealers that regularly disseminates 
quotations or indications of interest of identified brokers or 
dealers; or a publication, alternative trading system or other 
device that is used by brokers or dealers to disseminate quotations 
or indications of interest to others. The Recommendation Rule is 
intended to cover equity securities that are published or quoted in 
a quotation medium and that either: (1) Are not listed on Nasdaq or 
a national securities exchange, or (2) are listed on a regional 
securities exchange and do not qualify for dissemination of 
transaction reports via the Consolidated Tape.
    \8\ See NASD Rule 2310 (Suitability Rule), which requires a 
member to have reasonable grounds for believing that a 
recommendation to a customer is suitable based on facts disclosed, 
other security holdings and financial situation and needs.
---------------------------------------------------------------------------

A. Review Requirements

    Proposed NASD Rule 2315 would require a member and its associated 
persons to review the current financial statements of an issuer and 
current material business information about an issuer prior to 
recommending the purchase or short sale of any OTC equity security to a 
customer.\9\ Under the proposed rule, members must designate a person 
who is registered as a Series 24 principal, or who is supervised by a 
Series 24 principal, to conduct the required review. The person 
designated by the member must have the requisite skills, background and 
knowledge to conduct the review. Members are also required to document 
the information reviewed, the date of the review, and the name of the 
person performing the review of the required information.
---------------------------------------------------------------------------

    \9\ The current financial and business information that a 
broker-dealer must review prior to recommending the purchase or 
short sale of a covered security is similar to that required by Rule 
15c2-11 under the Act for those broker-dealers initiating or 
resuming quotations for securities covered by that rule. 17 CFR 
240.15c2-11.
---------------------------------------------------------------------------

B. Information To Be Reviewed

    As stated above, members must review the ``current financial 
statements'' of the issuer, as well as ``current material business 
information'' about the issuer, before recommending the purchase or 
short sale of an OTC security. NASD Regulation has stated that current 
material business information includes material information that is 
available or relates to events that have occurred within the last 12 
months prior to the recommendation. Under the Recommendation Rule, 
because of differences in accounting practices, what constitutes 
``current financial statements'' depends on whether the issuer is or is 
not a foreign private issuer.
1. Issuers That Are Not Foreign Private Issuers
    The current financial statements of issuers that are not foreign 
private issuers that must be reviewed prior to a recommendation to 
purchase or sell short a covered security are as follows:
     Publicly available financial statements and other 
financial reports filed during the 12 months preceding the date of the 
recommendation with the issuer's principal financial or securities 
regulatory authority in its home jurisdiction;
     All publicly available financial information filed with 
the Commission during the 12 months preceding the date of the 
recommendation contained in registration statements or Regulation A 
filings;
     A balance sheet as of a date less than 15 months before 
the date of recommendation; and
     A statement of profit and loss for the 12 months preceding 
the date of the balance sheet.
    However, if the balance sheet is not as of a date less then 6 
months before the date of the recommendation, the member must review 
additional statements of profit and loss for the period from the date 
of the balance sheet to a date less than 6 months before the date of 
the recommendation.
2. Issuers That Are Foreign Private Issuers
    The current financial statements of issuers who are foreign private 
issuers that must be reviewed prior to a recommendation for purchase or 
short sale are as follows:
     Publicly available financial statements and other 
financial reports filed during the 12 months preceding the date of the 
recommendation and up to the date of the recommendation with the 
issuer's principal financial or securities regulatory authority in its 
home jurisdiction, including the Commission, foreign regulatory 
authorities, bank and insurance regulators;
     A balance sheet as of a date less than 18 months before 
the date of the recommendation; and
     A statement of profit and loss for the 12 months preceding 
the date of the balance sheet.
    However, if the balance sheet is not as of a date less than 9 
months before the date of the recommendation, the member must review 
additional statements of profit and loss for the period from the date 
of the balance sheet to a date less than 9 months before the date of 
the recommendation, if any such statements have been prepared by the 
issuer.
    In addition, if any issuer has not made current filings required by 
the issuer's principal financial or securities regulatory authority in 
its home jurisdiction, including the Commission, foreign regulatory 
authorities, or bank and insurance regulators, the required review must 
include an inquiry into the circumstances concerning the failure to 
make current filings, and a determination, based on all the facts and 
circumstances, that a recommendation is appropriate under the 
circumstances. Such a determination must be made in writing and 
maintained by the member.

C. Exemptions

    Under the Recommendation Rule, there are several transactions that 
are not subject to the Rule. Broker-dealers are not required to comply 
with the Recommendation Rule when effecting the following transactions:
     Transactions that meet the requirements of Rule 504 of 
Regulation D of the Securities Act of 1933 (``Securities Act'') \10\ 
and transactions by \11\ an issuer not involving any public offering 
pursuant to Section 4(2) of the Securities Act; \12\
---------------------------------------------------------------------------

    \10\ 17 CFR 230.504.
    \11\ Proposed NASD Rule 2315(e)(1)(A) contained a typographical 
error. In pertinent part, the Rule should read ``transactions by an 
issuer not involving any public offering pursuant to Section 4(2) of 
the Securities Act'' instead of ``transactions with an issuer not 
involving any public offering pursuant to Section 4(2) of the 
Securities Act.'' (Emphasis added.) Telephone conversation between 
Phil Shaikun, Associate General Counsel, NASD Regulation, and 
Jennifer Colihan, Special Counsel, Division, Commission, on August 
12, 2002.
    \12\ 15 U.S.C. 77d(2).
---------------------------------------------------------------------------

     Transactions with or for an account that qualifies as an 
``institutional account'' under NASD Rule 3110(c)(4) or with a customer 
that is a ``qualified institutional buyer'' under Rule 144A of the 
Securities Act \13\ or ``qualified purchaser'' under Section 2(a)(51) 
of the Investment Company Act of 1940;\14\
---------------------------------------------------------------------------

    \13\ 15 U.S.C. 77(a).
    \14\ 15 U.S.C. 80a-2(a)(51).
---------------------------------------------------------------------------

     Transactions in an issuer's securities if the issuer has 
at least $50 million in total assets and $10 million in shareholder's 
equity are exempt;
     Transactions in securities of a bank as defined in Section 
3(a)(6) of the Act \15\ and/or insurance company subject to regulation 
by a state or federal bank or insurance regulatory authority are 
exempt;
---------------------------------------------------------------------------

    \15\ 15 U.S.C. 78c(a)(6).
---------------------------------------------------------------------------

     Transactions involving securities with a worldwide daily 
trading volume value of at least $100,000 during each month of the six 
full calendar months immediately before the date of the recommendation, 
and transactions involving any convertible security based on a security 
meeting this requirement are exempt; \16\ and
---------------------------------------------------------------------------

    \16\ See Securities Exchange Act Release No. 41110 (February 25, 
1999), 64 11124 (March 8, 1999)(``Rule 15c2-11 Reproposing 
Release''). This exemption is consistent with exemptions contained 
proposed Rules 15c2-11(h)(6) and (7).
---------------------------------------------------------------------------

     Transactions involving securities that have a bid price, 
as published in a quotation medium, of at least $50 per share.\17\
---------------------------------------------------------------------------

    \17\ This exemption is consistent with an exemption contained in 
proposed Rule 15c2-11(h)(8). See Rule 15c2-11 Reproposing Release, 
supra note 16.

---------------------------------------------------------------------------

[[Page 54834]]

    In addition, under the proposed rule the NASD may, for good cause 
shown, exempt any person, security or transaction, or any class or 
classes of person, securities or transactions, either unconditionally 
or on specified terms, from any or all of the requirements of the Rule 
if it determines that such exemption is consistent with the purpose of 
the rule, the protection of investors and the public interest.\18\
---------------------------------------------------------------------------

    \18\ As part of this proposed rule change, the NASD has added 
the Recommendation Rule to NASD Rule 9610, which provides the 
procedures for requesting exemptive relief from various Association 
rules.
---------------------------------------------------------------------------

III. Discussion

    For the reasons discussed below, the Commission finds that the 
proposed rule is consistent with the provisions of Section 15A(b)(6) of 
the Act,\19\ which requires, among other things, that the Association's 
rules must 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.
---------------------------------------------------------------------------

    \19\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------

A. Review Requirements

    Manipulative and fraudulent schemes often have involved 
infrequently-traded securities of little-known issuers. Unscrupulous 
broker-dealers have recommended that customers purchase the securities 
of unseasoned issuers whose securities do not trade in a listed market, 
without giving due regard to the fundamentals regarding these issuers. 
Among the most critical pieces of information that a broker-dealer 
should have before making a recommendation regarding a security are the 
financial condition of, and business information about, the issuer, 
particularly with respect to those issuers whose securities are not 
listed on a national securities exchange or Nasdaq. Therefore, the 
Commission finds that the NASD's proposal to require broker-dealers to 
independently review current financial and business information about 
these issuers prior to making a recommendation to purchase or sell 
short covered securities is consistent with the Act, particularly its 
mandate that the Association's rules be designed to prevent fraudulent 
and manipulative acts.\20\
---------------------------------------------------------------------------

    \20\ The Recommendation Rule will apply to equity securities 
that are quoted on the OTCBB, in The Pink Sheets, or in any other 
system that regularly disseminates indications of interest and 
quotation information among broker-dealers and those securities 
either: (1) Are not listed on Nasdaq or a national securities 
exchange, or (2) are listed on a regional securities exchange and do 
not qualify for dissemination of transaction reports via the 
Consolidated Tape. See Proposed NASD Rule 2315(a). As part of its 
application to become a national securities exchange, Nasdaq has 
filed rules to operate the OTCBB, which is expected to be renamed 
the Bulletin Board Service (``BBS''). NASD Regulation has advised 
the Commission that the Recommendation Rule will apply to BBS 
securities when Nasdaq operates the BBS. The Commission is also 
aware that Nasdaq intends to develop the OTCBB/BBS into a listed 
market, which will be called the Bulletin Board Exchange (``BBX''). 
See NASD-2001-82, pending before the Commission. Securities trading 
on the BBX would be listed securities, and therefore would not be 
covered under the current wording of the Recommendation Rule. NASD 
Regulation has advised the Commission that it will amend the 
Recommendation Rule at the appropriate time to ensure that 
securities listed on the BBX are covered by the Rule.
---------------------------------------------------------------------------

    While the Commission considers the review requirement to be 
appropriate, it also believes that the requirement is properly tailored 
to meet the Rule's objectives without over-burdening members. Under the 
Recommendation Rule, broker-dealers are required to review publicly 
available current financial statements and material business 
information. The Commission believes that the Recommendation Rule 
establishes appropriate parameters regarding what constitutes ``current 
financial information'' and ``current material business information'' 
that members and their sales personnel must review before making a 
recommendation as a means to lessen the opportunity for abusive 
practices when broker-dealers recommend covered securities to 
investors.
1. Foreign Private Issuers vs. Non-foreign Private Issuers
    Further, as detailed above, these definitions also distinguish 
between information that must be reviewed for issuers that are foreign 
private issuers and those that are not. The Commission believes that 
this is an important distinction because the customary accounting 
periods for foreign issuers are often different from those for domestic 
issuers. Foreign issuers maybe permitted to report financial 
information on a semi-annual basis, rather than on a quarterly basis, 
as is required for domestic issuers. Therefore, the Commission believes 
that it is appropriate to establish different time parameters regarding 
when financial information should be considered ``current'' for foreign 
private issuers in order to address this difference in accounting 
practices.
2. Delinquent Issuers
    The Commission notes that the Recommendation Rule contains a 
provision covering the situation when the issuer has not made current 
filings as required by the issuer's principal financial or securities 
regulatory authority in its home jurisdiction, including the 
Commission, foreign regulatory authorities, and bank and insurance 
regulators. In the event the issuer is delinquent with its filings, the 
Recommendation Rule requires that the member make an inquiry into the 
circumstances concerning the failure to make current filings and make a 
determination that a recommendation is appropriate under the 
circumstances.
    The Commission believes that the Rule is appropriately limited in 
that it does not prohibit recommendations in the event the issuer's 
filings are delinquent, nor does it require that a member confirm that 
the issuer is not delinquent in its filings with any regulatory 
authority prior to making a recommendation. Rather, the Rule requires 
that a member conduct an inquiry in the event that an issuer has been 
delinquent in its filings with its principal financial or securities 
regulatory authority in its home jurisdiction and then determine 
whether the recommendation is appropriate. The Commission believes that 
this requirement strikes a proper balance in those cases where the 
issuer has failed to make current filings.
3. Persons Responsible for Review
    The Commission believes that it is appropriate to require that the 
person responsible for conducting the financial information review be 
registered as a Series 24 principal or be someone who is supervised by 
a Series 24 principal, as these individuals are under the jurisdiction 
of the NASD. Registered Series 24 principals are persons who are 
associated with a member and are permitted to manage or supervise the 
member's investment banking or securities business for corporate 
securities, direct participation programs, and investment company 
products/variable contracts. Therefore, the Commission believes that 
this requirement will ensure that financial information is reviewed by 
individuals who have the proper skills, background and knowledge to 
conduct a thorough analysis of the information prior to the firm or its 
associated persons making a recommendation.

B. Exemptions From Recommendation Rule

    As indicated above, the Recommendation Rule lists several 
transactions that are exempt from the Rule and provides the Association 
with the authority, for good cause, to grant additional exemptions from 
its provisions. The Commission believes

[[Page 54835]]

that these provisions are appropriately tailored to serve the purposes 
of the Rule so that only those transactions that are more likely to 
raise risks for retail investors are subject to the Rule, and that 
those transactions that are less likely to be the subject of fraudulent 
sales practices are not covered by the Rule.

C. Interaction With Other NASD Rules and Federal Securities Laws

    Finally, as noted in the Preliminary Note to the Recommendation 
Rule, the Commission emphasizes that the requirements of the Rule are 
in addition to other existing broker-dealer obligations under NASD 
rules and the federal securities laws, including obligations to 
determine the suitability of particular securities transactions with 
customers and to have a reasonable basis for any recommendation made to 
a customer. The Commission reiterates that the Recommendation Rule is 
not intended to act or operate as a presumption or as a safe harbor for 
purposes of determining suitability or for any other legal obligation 
or requirement imposed under NASD rule or the federal securities laws.

D. Operational Date

    The Commission notes that the NASD will announce the operational 
date of the proposed rule change in a Notice to Members to be published 
no later than 60 days following the date of approval by the Commission. 
The operational date will be 30 days following the date of publication 
of the Notice to Members announcing Commission approval.

IV. Amendment No. 2

    The Commission finds good cause for approving Amendment No. 2 prior 
to the thirtieth day after the date of publication of notice thereof in 
the Federal Register. In Amendment No. 2, the NASD amended NASD Rule 
2315(a) to add a category of equity securities that, pursuant to NASD 
Rule 6530(b)(2), are eligible for quotation on the OTCBB. This change 
provides that members conducting transactions in securities that are 
listed on a regional securities exchange, but do not qualify for 
dissemination of transaction reports via the Consolidated Tape, must 
comply with the review requirements of the Recommendation Rule if such 
securities are published or quoted in a quotation medium.
    Because securities that are listed on a regional securities 
exchange but not eligible for the reporting of transactions to the 
Consolidated Tape are eligible for quotation on the OTCBB, and thus 
fall within the category of securities contemplated to be covered by 
the Recommendation Rule, the Commission believes that it is appropriate 
for these securities to be covered by the Recommendation Rule.
    In Amendment No. 2, the NASD also amended NASD Rule 
2315(e)(1)(G)(2) to substitute ``NASD'' for the reference to ``the 
Association'' contained in the Rule. The Commission believes that this 
is a technical, non-substantive change to the proposal.
    In sum, the Commission finds that the NASD's proposed changes in 
Amendment No. 2 further strengthen and clarify the proposed rule change 
and raise no new regulatory issues. Further, the Commission believes 
that Amendment No. 2 does not significantly alter the original 
proposal, which was subject to a full notice and comment period. 
Therefore, the Commission finds that granting accelerated approval to 
Amendment No. 2 is appropriate and consistent with Section 19(b)(2) of 
the Act.\21\
---------------------------------------------------------------------------

    \21\ 15 U.S.C. 78s(b)(2).
---------------------------------------------------------------------------

V. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment No. 2, including whether the proposed 
amendment is consistent with the Act. 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 amendment that are 
filed with the Commission, and all written communications relating to 
the amendment 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 at the 
Commission's Public Reference Room. Copies of such filing also will be 
available for inspection and copying at the principal office of the 
NASD. All submissions should refer to File No. SR-NASD-99-04 and should 
be submitted by [insert date 21 days from date of publication].

VI. Conclusion

    For all of the aforementioned reasons, the Commission finds that 
the proposed rule change is consistent with the requirements of the Act 
and the rules and regulations thereunder applicable to a national 
securities association.
    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\22\ that the proposed rule change (SR-NASD-99-04), as amended, is 
approved.
---------------------------------------------------------------------------

    \22\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\23\
---------------------------------------------------------------------------

    \23\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-21651 Filed 8-25-02; 8:45 am]
BILLING CODE 8010-01-P