Notice To Members 89-65

SEC Adoption of Rule 15c2-6 Re: Sales Practice and Suitability Requirements for Certain Low-Priced Securities

Published Date:

October 01, 1989

SUGGESTED ROUTING*

Senior Management
Legal & Compliance
Operations
Trading

*These are suggested departments only. Others may be appropriate for your firm.

EXECUTIVE SUMMARY

The SEC recently adopted Rule 15c2-6, which is effective January 1, 1990. It imposes sales-practice requirements on broker-dealers that recommend transactions in certain low-priced, non-NASDAQ over-the-counter securities (designated securities) to persons who are not "established customers." Such broker-dealers involved in the "penny stock" market are required to make a documented suitability determination regarding a nonestablished customer, and to obtain such customer's written agreement to the first three purchases of these designated securities. The rule specifically excludes all NASDAQ and exchange-listed securities.

BACKGROUND

In February 1989, the SEC proposed Rule 15c2-6 (see Notice to Members 89-26) in response to the widespread incidence of misconduct by some broker-dealers in connection with high-pressure sales tactics in low-priced securities. In proposing this rule, the SEC "intended to prevent the indiscriminate use by broker-dealers of fraudulent, high-pressure telephone sales campaigns to sell such securities to unsophisticated investors."

The Commission received letters from numerous commenters, including the NASD, about the proposed rule. Commenters, according to the SEC, generally agreed that serious problems existed in the market for low-priced, non-NASDAQ OTC securities, and overwhelmingly supported increased enforcement efforts against broker-dealers and individuals who engaged in such misconduct.

The final rule defines an "established customer" as a customer who has maintained an account for at least one year, or has had three purchases of designated securities on separate days involving different issuers.

It also establishes procedures that must be followed before designated securities are recommended to nonestablished customers. Included is the requirement to obtain oral or written information concerning a new customer's previous investment experience, investment objectives, and financial situation. With that information, the broker or dealer must reasonably determine whether transactions in designated securities are suitable for the particular customer.

If the designated securities are determined to be suitable, the firm's written suitability determination must be delivered to the customer, who is required to manually sign and return the statement, if it is accurate, as a condition for opening the account. Also, the firm must obtain from the customer a written agreement to enter into each of the first three transactions in designated securities. The objectives of these requirements, the SEC said, are to provide the customer with an opportunity to make an investment decision "outside of a pressured telephone conversation with a salesperson," and enable the customer to decide whether the broker-dealer has made a good-faith attempt at a suitability determination.

The rule's recordkeeping requirements are partly designed to provide the basis for "simple and direct enforcement actions against broker-dealers that fail to comply." In this regard, the NASD will be responsible for examining firms for their compliance with Rule 15c2-6.

NASD ACTIVITIES

The NASD supports increased enforcement efforts to eliminate fraudulent, deceptive, and manipulative acts and practices in the penny stock market. As a top priority of the NASD, the Association continues to commit significant resources to its enforcement efforts in order to reach this objective.

Working on its own cases, as well as in cooperation with the SEC, state securities administrators, and federal law-enforcement agencies, the NASD has concluded or filed well in excess of 200 disciplinary actions involving penny stocks, producing sanctions including expulsions of firms, bars of individuals, and fines in excess of $500,000. More than 175 additional investigations are actively under way. Furthermore, certain of these cooperative efforts with federal law-enforcement agencies have resulted in criminal prosecution relating to securities fraud.

In its explanation of the rationale for the final adopted rule, the SEC noted that the NASD has implemented a program that requires broker-dealers to report to the NASD volume and price information concerning their principal transactions in non-NASDAQ OTC securities. "This program should provide assistance to regulators in monitoring the non-NASDAQ OTC market, and in identifying fraudulent or manipulative trading activities in that market," the Commission said. But it added that a comprehensive program to deter fraud in connection with transactions in low-priced securities must address the sales practices of broker-dealers actively involved in selling such securities to new customers.

MAJOR RULE PROVISIONS

The Rule makes it unlawful for a broker-dealer to recommend a "designated security" (defined as a non-NASDAQ OTC equity security issued by a company with less than $2 million in net tangible assets) unless:

1. The transaction is exempt under paragraph (c) of the Rule (as discussed below); or

2. Prior to the transaction, the broker-dealer has:

(a) approved and determined the customer's account to be suitable for transactions in designated securities;

(b) delivered to the customer the written suitability determination, which must be manually signed, dated, and returned by the customer, and

The exempted transactions under paragraph (c) of the Rule are:

Transactions in which the price of the security is $5 or more;¹
Transactions in which the purchaser is an accredited investor or an established customer of the broker-dealer;
Transactions that are not recommended by the broker-dealer; and
Transactions by a broker-dealer that has not been a market maker in the designated security in the 12 months preceding the transaction and which does not derive specified sales-related revenue from transactions in designated securities exceeding 5 percent of its total specified sales-related revenue from securities transactions.²

The text of the SEC rule follows. Members wishing to obtain the complete version of the Commission's Release No. 34-27160, File No. S7-3-89 should contact the Commission.

TEXT OF SEC RULE 15c2-6

CHAPTER II, TITLE 17 OF THE CODE OF FEDERAL REGULATIONS

Part 240 - General Rules and Regulations, Securities Exchange Act of 1934

1. The authority citation for Part 240 is amended by adding the following citation:
Authority: Sec. 23, 48 Stat. 901, as amended (15 U.S.C. 78w) . . . Section 240.15c2-6, also issued under sees. 3, 10, and 15, 15 U.S.C. 78c, 78j, and 78o;

2. By adding Section 240.15c2-6 as follows:
Section 240.15c2-6 Sales practice requirements for certain low-priced securities.

(a) As a means reasonably designed to prevent fraudulent, deceptive, or manipulative acts or practices, it shall be unlawful for a broker or dealer to sell a designated security to, or to effect the purchase of a designated security by, any person unless:

(1) The transaction is exempt under paragraph (c) of this section: or

(2) Prior to the transaction:

(i) The broker or dealer has approved the person's account for transactions in Designated Securities in accordance with the procedures set forth in paragraph (b) of this section; and

(ii) The broker or dealer has received from the person a written agreement to the transaction setting forth the identity and quantity of the designated security to be purchased.

(b) In order to approve a person's account for transactions in Designated Securities, the broker or dealer must:

(1) Obtain from the person information concerning the person's financial situation, investment experience, and investment objectives;

(2) Reasonably determine, based on the information required by paragraph (b)(l) of this section and any other information known by the broker-dealer, that transactions in Designated Securities are suitable for the person, and that the person (or the person's independent adviser in these transactions) has sufficient knowledge and experience in financial matters that the person (or the person's independent adviser in these transactions) reasonably may be expected to be capable of evaluating the risks of transactions in Designated Securities;

(3) Deliver to the person a written statement:

(i) Setting forth the basis on which the broker or dealer made the determination required by paragraph (b)(2) of this section;

(ii) Stating in a highlighted format that it is unlawful for the broker or dealer to effect a transaction in a designated security subject to the provisions of paragraph (a)(2) of this section unless the broker or dealer has received, prior to the transaction, a written agreement to the transaction from the person; and

(iii) Stating in a highlighted format immediately preceding the customer signature line that:

(A) The broker or dealer is required by this section to provide the person with the written statement; and

(B) The person should not sign and return the written statement to the broker or dealer if it does not accurately reflect the person's financial situation, investment experience, and investment objectives; and

(4) Obtain from the person a manually signed and dated copy of the written statement required by paragraph (b)(3) of this section.

(1) Transactions in which the price of the Designated Security is five dollars or more; provided, however, that if the Designated Security is a unit composed of one or more securities, the unit price divided by the number of components of the unit other than warrants, options, rights, or similar securities, must be five dollars or more, and any component of the unit that is a warrant, option, right, or similar securities, or a convertible security must have an exercise price or conversion price of five dollars or more.

(2) Transactions in which the purchaser is an accredited investor or an established customer of the broker or dealer.

(3) Transactions that are not recommended by the broker or dealer.

(4) Transactions by a broker or dealer:

(i) Whose commissions, commission equivalents, and mark-ups from transactions in Designated Securities during each of the immediately preceding three months, and during eleven or more of the preceding twelve months, did not exceed five percent of its total commissions, commission-equivalents, and mark-ups from transactions in Securities during those months; and

(ii) Who has not been a market maker in the Designated Security that is the subject of the transaction in the immediately preceding twelve months.

(5) Any transaction or transactions that, upon prior written request or upon its own motion, the Commission conditionally or unconditionally exempts as not encompassed within the purposes of this section.

(d) For the purpose of this section —

(1) The term "accredited investor" shall have the same meaning as in 17 CFR 230.501(a)

(2) The term "designated security" shall mean any equity security other than a security:

(i) Registered, or approved for registration upon notice of issuance, on a national securities exchange that makes transaction reports available pursuant to 17 CFR Part 11Aa3-l;

(ii) Authorized, or approved for authorization upon notice of issuance, for quotation in the NASDAQ system;

(iii) Issued by an investment company registered under the Investment Company Act of 1940;

(iv) That is a put option or call option issued by The Options Clearing Corporation; or

(v) Whose issuer has net tangible assets in excess of $2,000,000, as demonstrated by financial statements dated less than fifteen months previously that the broker or dealer has reviewed and has a reasonable basis to believe are true and complete in relation to the date of the transaction with the person, and

(A) In the event the issuer is other than a foreign private issuer, are the most recent financial statements for the issuer that have been audited and reported on by an independent public accountant in accordance with the provisions of 17 CFR 210.2-02; or

(B) In the event the issuer is a foreign private issuer, are the most recent financial statements for the issuer that have been filed with the Commission; furnished to the Commission pursuant to 17 CFR 240.12g3-2(b); or prepared in accordance with generally accepted accounting principles in the country of incorporation, audited in compliance with the requirements of that jurisdiction, and reported on by an accountant duly registered and in good standing in accordance with the regulations of that jurisdiction.

(3) The term "established customer" shall mean any person for whom the broker or dealer, or a clearing broker on behalf of such broker or dealer, carries an account, and who in such account:

(i) Has effected a securities transaction, or made a deposit of funds or securities, more than one year previously; or

(ii) Has made three purchases of designated securities that occurred on separate days and involved different issuers.

¹If a designated security is a unit comprised of one or more securities, the unit price divided by the components, exclusive of warrants, options, rights, or similar securities, must be $5 or more. So, for example, a unit selling for S10 comprised of 100 shares of common stock and 100 warrants would have an equivalent price of 10 cents ($10 unit divided by 100 shares common) and thus is a designated security subject to the rule.

²Market makers, however, regardless of the percentage of sales-related revenue, are fully subject to the rule for transactions in those designated securities in which they make a market.