Notice To Members 87-46

SEC Approval of NASD Corporate Governance Standards for NASDAQ/NMS Issuers and Amendments to Schedule D to the NASD By-Laws Concerning Designation of NASDAQ National Market System (NASDAQ/NMS) Securities

Published Date:

TO: All NASD Members and Other Interested Persons

EXECUTIVE SUMMARY

The Securities and Exchange Commission has approved amendments to its rules, to Schedule D to the NASD By-Laws, and to the NASD's Transaction Reporting Plan, which will have the effect of: (1) requiring NASDAQ/NMS companies to comply with certain standards of corporate governance; (2) moving NASDAQ/NMS designation criteria from an SEC rule to Schedule D to the NASD By-Laws; (3) eliminating the concept of mandatory NASDAQ/NMS designation; and (4) designating all securities subject to an effective transaction reporting plan as "national market system securities."

The new corporate governance standards will become effective for issuers that have securities designated as NASDAQ/NMS securities after August 4, 1987. For issuers having securities that are currently designated or will become designated on or before August 4, the standards will become effective 18 months thereafter.

The text of the amendments to Schedule D to the NASD By-Laws is attached.

BACKGROUND

At a meeting on June 11, 1987, the SEC approved amendments to Schedule D to the NASD By-Laws and to the NASD's Transaction Reporting Plan. The primary effect of these amendments is to give SEC approval to corporate governance rules for NASDAQ/NMS securities that were adopted by the NASD Board of Governors in July 1985. The rules were developed by the NASD Corporate Advisory Board and the NASD Board of Governors during late 1984 and early 1985. Comments on the proposed rules were solicited from NASD members and NASDAQ issuers in March 1985. The SEC also solicited public comment on the proposed rules as its normal routine in its consideration of them.

SUMMARY OF AMENDMENTS

In addition to corporate governance standards, the amendments to Schedule D to the NASD By-Laws incorporate the Tier 2 NASDAQ/NMS criteria currently in SEC Rule 11Aa2-l.

The SEC is amending Rule 11Aa2-l to replace the existing NASDAQ/NMS designation criteria with a standard that will designate as "national market system securities" all over-the-counter and exchange-listed securities for which transactions are reported pursuant to an effective transaction reporting plan approved by the SEC.

The SEC is also amending Rule 11Aa3-l, its transaction reporting rule, to require the NASD to designate those NASDAQ securities that are subject to transaction reporting.

The amendments are contained in a new Part III of Schedule D to the NASD By-Laws. The following summarizes the provisions of the corporate governance standards as well as other changes approved by the SEC.

• Corporate Governance Provisions

The NASD's new corporate governance standards for NASDAQ/NMS issuers are included in Section 5 of new Part III of Schedule D. The rules will become effective for issuers having securities designated as NASDAQ/NMS securities after August 4, 1987. For issuers having securities that are currently designated or will become designated as NASDAQ/NMS securities on or before August 4, the standards will become effective 18 months thereafter (February 1989).

Substantive provisions of the corporate governance rules are:

Applicability of Rules to Foreign Issuers—The NASD has the authority to exempt a foreign issuer from application of the rules in cases where compliance would be in contravention of law or business practice in the issuer's country of domicile.

Distribution of Annual and Interim Reports—Issuers are required to distribute annual, quarterly, and other interim reports to shareholders. Annual reports must be distributed a reasonable period of time prior to the company's annual meeting. Interim reports must be distributed either before or as soon as practicable following filing of reports with the issuer's regulatory authority. Issuers filing Form 10-Q with the SEC must distribute statements of operations. Other issuers must distribute information as contained in their required interim reports.

Independent Directors—Issuers are required to maintain a minimum of two independent directors on their boards. An "independent director" is defined to exclude officers or employees of the company or its subsidiaries or other individuals having a relationship with the issuer that, in the opinion of the board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director.

Audit Committees—Issuers are required to establish and maintain an audit committee, a majority of the members of which must be independent directors.

Shareholder Meetings—Issuers are required to hold an annual shareholder meeting.

Quorum—Issuers must establish a quorum requirement of at least 33 1/3 percent of the outstanding shares, or at such greater level as specified in the corporate by-laws, for any meeting of the holders of common stock.

Solicitation of Proxies—Issuers are required to solicit proxies for all shareholder meetings and to file copies of proxy solicitations with the NASD.

Conflicts of Interest—Issuers are required to conduct an appropriate review of all related-party transactions. The rules provide that either the audit committee or a comparable body must be used for reviewing potential conflicts.

Listing Agreement—Each NASDAQ/NMS issuer must execute a listing agreement as prescribed by the NASD.

• Related Amendments

Also approved by the SEC was a restructuring, without major substantive change, of the manner in which "national market system securities" are designated. These amendments eliminate from SEC Rule 11Aa2-l the NASDAQ/NMS financial designation criteria and place those criteria in Schedule D to the NASD By-Laws. Also, the mandatory designation criteria that were included in the SEC rule have been eliminated.*

In addition, the SEC approved amendments which transfer the NASDAQ/NMS designation procedures in the NASD's National Market System Designation Plan to Schedule D to the By-Laws. The overall effect of these changes is to place NASDAQ/NMS designation procedures in the same posture under SEC rules as the listing procedures of the exchanges.

* * * * *

Questions concerning this notice may be directed to either S. William Broka, Vice President, NASDAQ Operations-Companies, at (202) 728-8050, or T. Grant Callery, NASD Associate General Counsel, at (202) 728-8285.

Sincerely

Frank J. Wilson
Executive Vice President
and General Counsel

Attachment

AMENDMENTS TO SCHEDULE D TO THE NASD BY-LAWS

NEW PART III

III

DESIGNATION OF NASDAQ NATIONAL MARKET SYSTEM SECURITIES

INTRODUCTION

Pursuant to Securities and Exchange Commission Rule 11Aa2-l, those securities for which transaction reporting is required by an effective transaction reporting plan are designated as national market system securities. The Association has filed with the Securities and Exchange Commission a transaction reporting plan under which securities satisfying the requirements of this Part III are covered by the transaction reporting plan and transactions in such securities are subject to the transaction reporting provisions of Part XI of this schedule.

Section 1

Applications for Designation

(a) Application for designation shall be on a form supplied by the Association and signed by a corporate officer of the issuer. Compliance with the designation criteria will be determined on the basis of information filed with the appropriate regulatory authority and the records of the Association as of the application date. The Association may require the issuer to submit such other information as is relevant to a determination of designation as a national market system security.
(b) Designation of a security shall be declared effective within a reasonable time after determination of qualification. The effective date of designation shall be determined by the Association giving due regard to the requirements of the NASDAQ System, the media and market makers. Effectiveness of designation may be delayed upon written request by the issuer. An issuer which has been determined to be qualified but is pending effectiveness shall not be required to meet the designation criteria prior to effectiveness.
(c) The Association may make exceptions to the criteria contained in this Part III where it deems appropriate.

Section 2

Quantitative Designation Criteria

In order to be designated, an issuer shall be required to substantially meet the criteria set forth in paragraph (a), (b), or (c) below.

Initial public offerings substantially meeting such criteria are eligible for immediate inclusion in NASDAQ/NMS upon prior application and with the written consent of the managing underwriter that immediate inclusion is desired. All other qualifying issues, excepting special situations, are included on the next inclusion date established by the Association.

(a) Alternative 1
(1) The issuer of the security had annual net income of at least $300,000 in the most recently completed fiscal year or in two of the last three most recently completed fiscal years.
(2) There are at least 350,000 publicly held shares.
(3) The market value of publicly held shares is at least $2 million.
(4) The price per share on each of the five business days prior to the date of application by the issuer is $3 or more.
(5) At least two dealers act as NASDAQ market makers with respect to the security on each of the five business days preceding the date of application by the issuer.
(b) Alternative 2
(1) The issuer of the security has capital and surplus of at least $8 million.
(2) There are at least 800,000 publicly held shares.
(3) The market value of publicly held shares is at least $8 million.
(4) At least two dealers act as NASDAQ market makers with respect to the security on each of the five business days preceding the date of application by the issuer.
(5) The issuer has a four-year operating history.
(c) Warrants
Warrants to purchase designated securities may be designated if the warrants substantially meet the above criteria; provided, however, that they shall not be required to meet the criteria set forth in paragraph (a)(2) if immediately after the distribution, there are at least 450,000 warrants outstanding.
(d) Computations
The computations required by paragraphs (a)(l) and (b)(l) shall be taken from the issuer's most recent financial information filed with the Association. The computations required in paragraphs (a)(2), (a)(3), (b)(2), and (b)(3) shall be as of the date of application of the issuer. Determinations of beneficial ownership for purposes of paragraphs (a)(2) and (b)(2) shall be made in accordance with SEC Rule 13d-3. In the case of American Depositary Receipts, the computations required by paragraphs (a)(l) and (b)(l) shall relate to the foreign issuer and not to any depositary or any other person deemed to be an issuer for purposes of Form S-12 under the Securities Act of 1933.

Section 3

Registration Standards

In addition to meeting the quantitative criteria for NASDAQ/NMS inclusion, the issue must also be:

(a) registered under Section 12(g)(l) of the Securities Exchange Act of 1934 (Act); or
(b) issued by an insurance company meeting the conditions of Section 12(g)(2)(G) of the Act; or
(c) registered under the Securities Act of 1933 and issued by a closed- end investment management company registered under Section 8 of the Investment Company Act of 1940; or
(d) an American Depositary Receipt issued against the equity security of a foreign issuer if such equity securities are registered pursuant to Section 12 of the Act; or
(e) registered under Section 12(b) of the Act and listed on a national securities exchange, or admitted to unlisted trading privileges on an exchange, provided that:
(1) No rule, stated policy, or practice of such exchange shall prohibit or condition, or be construed to prohibit or condition or otherwise limit, directly or indirectly, the ability of any member to effect any transaction in such security otherwise than on such exchange; and
(2) Such exchange shall permit NASDAQ market makers telephone access to exchange trading facilities with respect to transactions in NASDAQ/NMS securities to the same extent that exchange market makers are permitted access to NASDAQ market makers; and
(3) Transaction reports in such security are not collected, processed, and made available pursuant to the plan submitted to the Securities and Exchange Commission pursuant to Rule 11Aa3-l under the Securities Exchange Act of 1934, as amended, (the "CTA Plan"), which plan was declared effective as of May 17, 1974.
(f) Foreign securities and American Depositary Receipts where either the issuer is required to file reports pursuant to Section 15(d) of the Act or the security is exempt from registration under Section 12(g) of the Act by reason of the applicability of Rule 12g3-2(b) are not eligible for designation in NASDAQ/NMS.

Section 4

Quantitative Maintenance Criteria

After designation as a NASDAQ National Market System security, a security must substantially meet the criteria set forth below to continue to be designated as a national market system security.

(a) Common Stock, Preferred Stock, Shares or Certificates of Beneficial Interest of Trusts, and Limited Partnership Interests in Foreign or Domestic Issues
(1) 200,000 shares publicly held.
(2) Market value of publicly held shares of $2 million.
(3) Either annual net income of $200,000 for the previous fiscal year or in two of the last three fiscal years or net worth of at least $ 1 million.
(b) Rights and Warrants
Common stock of issuer must continue to be designated.
(c) Market Makers
At least two authorized NASDAQ market makers.
(d) Bankruptcy and/or Liquidation
Should an issuer file under any of the sections of the Bankruptcy Act or announce that liquidation has been authorized by its board of directors and that it is committed to proceed, its securities shall not remain designated unless it is determined that the public interest and the protection of investors would be served by continued designation.

Section 5

Non-Quantitative Designation Criteria

(a) Applicability
No provision of this Section 5 shall be construed to require any foreign issuer to do any act that is contrary to a law, rule, or regulation of any public authority exercising jurisdiction over such issuer or that is contrary to generally accepted business practices in the issuer's country of domicile. The Association shall have the ability to provide exemptions from the applicability of these provisions as may be necessary or appropriate to carry out this intent.
(b) Distribution of Annual and Interim Reports
(1) Each NASDAQ/NMS issuer shall distribute to shareholders copies of an annual report containing audited financial statements of the company and its subsidiaries. The report shall be distributed to shareholders a reasonable period of time prior to the company's annual meeting of shareholders and shall be filed with the Association at the time it is distributed to shareholders.
(2)
a. Each NASDAQ/NMS issuer that is subject to SEC Rule 13a-13 shall distribute copies of quarterly reports including statements of operating results to shareholders either prior to or as soon as practicable following the company's filing of its Form 10-Q with the Securities and Exchange Commission. If the form of such quarterly report differs from the Form 10-Q, the issuer shall file one copy of the report with the Association in addition to filing its Form 10-Q pursuant to Section l(c)(13) of Part II. The statement of operations contained in quarterly reports shall disclose, as a minimum, any substantial items of unusual or non-recurrent nature and net income before and after estimated federal income taxes or net income and the amount of estimated federal taxes.
b. Each NASDAQ/NMS issuer that is not subject to SEC Rule 13a-13 and that is required to file with the Securities and Exchange Commission, or another federal or state regulatory authority, interim reports relating primarily to operations and financial position, shall distribute to shareholders reports that reflect the information contained in those interim reports. Such reports shall be distributed to shareholders either before or as soon as practicable following filing with the appropriate regulatory authority. If the form of the interim report provided to shareholders differs from that filed with the regulatory authority, the issuer shall file one copy of the report to shareholders with the Association in addition to the report to the regulatory authority that is filed with the Association pursuant to Section l(c)(13) of Part II.
(c) Independent Directors
Each NASDAQ/NMS issuer shall maintain a minimum of two independent directors on its board of directors. For purposes of this section, "independent director" shall mean a person other than an officer or employee of the company or its subsidiaries or any other individual having a relationship that, in the opinion of the board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director.
(d) Audit Committee
Each NASDAQ/NMS issuer shall establish and maintain an audit committee, a majority of the members of which shall be independent directors.
(e) Shareholder Meetings
Each NASDAQ/NMS issuer shall hold an annual meeting of shareholders and shall provide notice of such meeting to the Association.
(f) Quorum
Each NASDAQ/NMS issuer shall provide for a quorum as specified in its by-laws for any meeting of the holders of common stock; provided, however, that in no case shall such quorum be less than 33 1/3 percent of the outstanding shares of the company's common voting stock.
(g) Solicitation of Proxies
Each NASDAQ/NMS issuer shall solicit proxies and provide proxy statements for all meetings of shareholders and shall provide copies of such proxy solicitation to the Association.
(h) Conflicts of Interest
Each NASDAQ/NMS issuer shall conduct an appropriate review of all related party transactions on an ongoing basis and shall utilize the company's audit committee or a comparable body for the review of potential conflict-of-interest situations where appropriate.
(i) Listing Agreement
Each NASDAQ/NMS issuer shall execute a Listing Agreement in the form designated by the Association.
(j) Effective Date
This Part III, Section 5 shall apply to any issuer that first has a security designated as a national market system security after August 4, 1987, and shall become effective as to any other NASDAQ/NMS issuer on February 1, 1989.

Section 6

Termination Procedure

(a) Failure to maintain compliance with the provisions of Sections 4 and 5 of this Part III will result in the termination of an issue's designation unless an exception is granted as provided in this section. Termination shall become effective in accordance with the terms of notice by the Association.
(b) An issuer that is subject to termination of its designation may request a review by a Committee of the Board of Governors. If a review is requested, the issuer is entitled to submit materials and arguments in connection with such review.
(c) The Committee may grant or deny continued designation on the basis of the written submission by the issuer and whatever other data it deems relevant.
(d) Determinations by the Committee may be appealed to the NASD Board of Governors by any aggrieved person. An appeal to the Board shall not operate as a stay of the decision of the Committee unless the Board in its discretion determines to grant such a stay.
(e) An issuer may voluntarily terminate its designation upon written notice to the Association.

Note: Current Parts III through XI are renumbered Parts IV through XII, respectively.

* The original purpose of establishing mandatory designation criteria was to enable the SEC and the securities industry to gain experience in transaction reporting for over-the-counter securities which had not previously been subject to last-sale trade reporting. While this was true in 1981 when the rule was adopted, both the NASD and the SEC have concluded that last-sale trade reporting in the over-the-counter market has been well established and, since most issuers enter NASDAQ/NMS by voluntary designation, the mandatory designation standards no longer serve a useful purpose.