Proposed Amendment to Definition of "Bona Fide Research" - Last Voting Date: November 3, 1988

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IMPORTANT MAIL VOTE

EXECUTIVE SUMMARY

NASD members are invited to vote on a proposed amendment to Article III, Section 24(b) of the NASD Rules of Fair Practice to conform the definition of "bona fide research" to the standard announced by the Securities and Exchange Commission with respect to the meaning of "research" under Section 28(e) of the Securities Exchange Act of 1934, as amended.

BACKGROUND

Section 24(a) of Article III of the NASD Rules of Fair Practice provides that in connection with the sale of securities that are part of a fixed-price offering, no NASD member may grant selling concessions, discounts, or other allowances to anyone other than another broker/dealer for services rendered in distribution.

However, nothing in this Section prohibits any NASD member from selling any such securities to any person or account to which it has provided or will provide bona fide research if the stated public offering price is paid by the purchaser.¹

The proposed amendment would change the definition of "bona fide research" contained in Section 24(b) of Article III of the NASD Rules of Fair Practice (hereinafter "Section 24(b) definition"). The Board of Governors has also determined to make conforming changes to the Interpretation of the Board of Governors under Section 24, which interprets and explains the Section 24(b) definition ("Interpretation"). The amendments to the Interpretation do not require membership vote and are attached for information purposes only.

The definition proposed to be amended and the Interpretation were originally incorporated into the NASD rules as part of a larger package of new rules submitted by the NASD to the Securities and Exchange Commission ("SEC" or "Commission") regulating the granting by NASD members of selling concessions, discounts, and other allowances in connection with sales of fixed price offerings.²

The rule package, including the provisions proposed to be amended by this filing, came to be known as the "Papilsky" rules and were approved by the Commission on December 12, 1980.³ Currently, subsection (a)(l) of Section 24 provides that nothing in the Section shall prevent any member from selling any securities that are part of a fixed- price offering to any person to whom it has or will provide "bona fide research" if the stated public offering price is paid by the purchaser.

The proposed rule change would amend the definition contained in Section 24(b), which exempts certain products and services from being considered "bona fide research." The term "bona fide research" contained in Section 24(b) is defined to mean "advice, rendered directly or through publications or writings, as to the value of securities, the advisability of investing in, purchasing, or selling securities, and the availability of securities or purchasers or sellers of securities, or analyses and reports concerning issuers, industries, securities, economic factors and trends, portfolio strategy, and performance of accounts; provided, however, that (1) investment management or investment discretionary services, and (2) products or services that are readily and customarily available and offered to the general public on a commercial basis are not bona fide research."

The Interpretation of the NASD Board of Governors adopted under Section 24 presently states that the definition of "bona fide research" is substantially the same as the definition of the term research in Section 28(e)(3) of the Securities Exchange Act of 1934 ("Exchange Act"), as interpreted by the Commission.

The existing exclusion from the definition of "bona fide research" provided by subsection (b)(2) of Section 24 incorporates into the NASD provision the SEC's interpretation of the term "research" under Section 28(e)(3), which was published in Securities Exchange Act Release No. 12251 (March 24, 1976).⁴ Thus, Section 24(b)(2) presently excludes "products or services that are readily and customarily available and offered to the general public on a commercial basis." The Board of Governors' Interpretation following Section 24 states that, for guidance concerning the meaning of "bona fide research" under Section 24(b), NASD members should refer to SEC interpretations of the definition of "research" under Section 28(e) of the Exchange Act.

On April 30,1986, the Commission withdrew its 1976 standard and announced a revised standard to be used in determining what products and services shall be deemed protected "research" under Section 28(e) of the Act. The change being submitted for vote is intended to amend the language of Section 24(b)(2) of Article III of the NASD Rules of Fair Practice to eliminate the existing exclusion from the definition and to allow the standard established by the Commission in its most recent release to determine the parameters of "bona fide research." The Commission, in its 1986 release, stated that the controlling principle to be used to determine whether something is research under the statute is "... whether it provides lawful and appropriate assistance to the money manager in the performance of his investment decision-making responsibilities."

The Commission also stated that, under the revised standard of "research," the fact that a product or service is readily and customarily available and offered to the general public on a commercial basis does not dictate the conclusion that the product or service is not research, as was the case under its earlier 1976 standard.

In short, the NASD Board of Governors' Interpretation under Section 24, with respect to the exclusion in Section 24(b)(2) from the definition of "bona fide research" for products and services that are commercially available and offered to the general public, states that it is based directly upon the standard established by the Commission in its 1976 release.

The 1986 Commission release, however, substituted a revised standard that the NASD Board of Governors now believes should be incorporated into Section 24 to replace the present language. The Board is concerned that a failure to do so may create confusion in the securities industry and among money managers who, without a change in Section 24, would be required to use one standard for fixed-price public offerings, but a totally different standard for other types of securities transactions such as secondary market trading. The NASD Board of Governors believes that consistency in the definitions under Section 24 of the NASD rules and Section 28(e) of the Exchange Act is appropriate.

EFFECTIVE DATE

Prior to becoming effective, the amendment to the Section 24 definition must be approved by the NASD membership and thereafter by the SEC. The conforming amendments to the Interpretation must also be approved by the SEC before they become effective. The NASD has not published the amendments to the Section 24 definition and the Interpretation for member comment prior to filing the amendments with the SEC for approval. However, NASD members and other interested persons are invited to make any comments they may have directly to the SEC at the time the Commission publishes the proposed rule changes for public comment, which is required prior to SEC approval.

The NASD Board of Governors believes that the proposed amendment is necessary and appropriate and recommends that members vote approval. The text of the amendment to Section 24 to be voted upon follows this notice. The text of the amendments to the Interpretation thereunder also follows for information purposes and not for vote.

Please mark the attached ballot according to your convictions and return it in the enclosed stamped envelope to "The Corporation Trust Company." Ballots must be postmarked no later than November 3, 1988.

Questions concerning this notice can be directed to either Dennis C. Hensley, Vice President and Deputy General Counsel at (202) 728-8245, or to John Mylod, Assistant General Counsel at (202) 728-8288 or to the attorney on duty for the NASD Office of General Counsel at (202) 728-8294.

PROPOSED AMENDMENTS TO NASD RULES OF FAIR PRACTICE

Article III

Sec. 24.

(Note: Deleted language is bracketed; no new language is to be added.)

SELLING CONCESSIONS

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In connection with the sale of securities which are part of a fixed price offering:

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(Note: For Information Purposes and Not for Vote)

PROPOSED AMENDMENTS TO THE INTERPRETATION OF THE BOARD OF GOVERNORS

BONA FIDE RESEARCH EXCLUSION

(Note: New language is underlined; deleted language is bracketed.)

While Section 24 provides that a member may grant or receive selling concessions, discounts and other allowances only as consideration for services rendered in distribution and may grant such concessions, discounts or other allowances only to brokers or dealers actually engaged in the investment banking or securities business, that Section also states that a member is not prohibited by Section 24 from selling securities at the stated public offering price to persons to whom it provides bona fide research. Accordingly, nothing in Section 24 prohibits a member from providing bona fide research to a customer who also purchases securities from fixed price offerings from the member whether or not there is an express or implied agreement between the member providing the research and the recipient that the member will be compensated for the research in cash, brokerage commissions, selling concessions or some other form of consideration.

The definition of bona fide research is substantially the same as the definition of the term research in Subsection 28(e)(3) of the Securities Exchange Act of 1934, as amended, and as interpreted by the Securities and Exchange Commission. Members should refer to the Commission's interpretation[s] in Securities Exchange Act Release No. 23170 (April 30, 1986) concerning the definition of research under Section 28(e) for guidance as well as to any interpretations of the Commission or its staff thereafter issued. [For example, in Securities Exchange Act Release No. 12251 (March 24,1976) the Commission indicated that items such as "newspapers, magazines and periodicals, directories, computer facilities and software, government publications, electronic calculators, quotation equipment, office equipment, airline tickets, office furniture and business supplies" are the type of products and services which are readily and customarily available and offered to the general public on a commercial basis. Accordingly, such services and products and other similar services and products are not bona fide research for purposes of Section 24.]

Moreover, while the provisions in the Section concerning bona fide research are intended to permit money managers to receive bona fide research from persons from whom securities are purchased, it is not intended to enable a money manager, who is also a member, to view its money management services as bona fide research. Accordingly, the performance of money management or investment discretionary services themselves are expressly excluded from the definition of bona fide research.

Another factor relating to bona fide research is that the research must be "provided by" the member who receives or retains the selling concession, discount or other allowance. Under Section 28(e) of the Securities Exchange Act of 1934, the Commission has stated that the "safe harbor" provided by Section 28(e) only extends to research that is "provided by" the broker to whom brokerage commissions are paid. In determining whether the exclusion for bona fide research under Section 24 is available in any given instance, members should refer to the interpretations of the Commission and its staff of the similar requirement applicable to Section 28(e). [In that regard, the Commission, in Securities Exchange Act Release No. 12251, stated that:

Section 28(e) might, under appropriate circumstances, be applicable to situations where a broker provides a money manager with research produced by third parties....]

Whether research is provided by the member will depend on all the facts and circumstances surrounding the relationship of the member and the recipient of the research, relying upon interpretations by the Commission and staff with respect to similar questions under Section 28(e). See also Securities Exchange Act Releases 12251 (March 24, 1976, and 23170 (April 30, 1986).

INDIRECT DISCOUNTS

A member who, itself or through its affiliate, supplies another person with services or products which are readily and customarily available and offered to the general public on a commercial basis and which fail to qualify as bona fide research, or which, in the case of services or products other than bona fide research, are provided by the member or its affiliate to such person or others for cash or for some other agreed upon consideration, and also retains or receives selling concessions, discounts or other allowances from purchases by that person or its affiliate of securities from a fixed price offering is improperly granting a selling concession, discount or other allowance to that person unless the member or its affiliate has been, or has arranged and reasonably expects to be, fully compensated for such services or products from sources other than the selling concession, discount or allowance retained or received on the sale.

¹ NASD Manual (CCH), ¶ 2174, pp. 2097-2098.

² The term "fixed price offering" is defined by Section l(m) of Article II of the Rules of Fair Practice to mean the offering of securities at a stated public offering price or prices, with certain specified exceptions, including securities exempted under Sections 3(a)(12) and 3(a)(29) of the Exchange Act and certain redeemable securities of registered investment companies. NASD Manual (CCH), ¶ 2101, p. 2013.

³ Securities Exchange Act Release No. 17371 (Dec. 12, 1980).

⁴ Securities Exchange Act Release No. 12251 (March 24, 1976).