NASD Solicits Member Comments On The Application Of The NASD Mark-Up Policy To Transactions In Government And Other Debt Securities, And Suitability Obligations To Institutional Customers In Debt And Equity Transactions;
Comment Period Expires September 30, 1994
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Executive Summary
With the enactment of the Government Securities Act Amendments of 1993, the NASD's regulatory jurisdiction was intended to encompass, among other things, sales practices relating to government securities. In conjunction with this authorization to adopt rules and regulations relating to government securities, the NASD requests member comment on proposed Interpretations of the Board of Governors to Article III, Sections 2 and 4 of the Rules of Fair Practice (RFP). The first Interpretation would provide further guidance to members on their suitability obligations under Article III, Section 2(a) of the RFP when making recommendations in equity or debt transactions, except municipals, to customers that are institutional accounts as defined under Article III, Section 21(c)(4) of the RFP. The second Interpretation would provide guidance to members regarding the application of the NASD Mark-Up Policy under Article III, Section 4 of the RFP to transactions in government and other debt securities, except municipals.
Background
In December 1993, Congress enacted the Government Securities Act Amendments of 1993 which, in part, authorizes the NASD to apply its sales practice rules to government securities, except municipal securities. To address this issue in the most effective and efficient manner and incorporate the views and ideas of those industry officials actually involved in the government securities markets, the NASD's Fixed Income Committee (Committee) appointed a Subcommittee on Government Securities (Subcommittee) to review the NASD's sales practice rules and draft proposed amendments to address the NASD's expanded authority to government securities.
On June 27, 1994, the Committee reviewed recommendations and draft amendments from its Subcommittee and approved a Resolution to the Board of Governors to merge the NASD Government Securities Rules into the RFP and to issue two Board Interpretations to the RFP.
On My 15, 1994, the NASD Board of Governors (Board) reviewed the Committee's Resolution and concurred with the Committee's recommendation that, consistent with the manner in which other securities products are handled, a single set of NASD sales practice rules is also appropriate for NASD membership in connection with government securities, and clarifications regarding the application of the RFP to government securities and other debt markets should be provided through Board Interpretations under the RFP.
The NASD Government Securities Rules, therefore, will be deleted and merged into the RFP, which will be expanded to cover government securities, except municipals, by replacing the phrase "exempted securities" with the phrase "municipal securities" in Article I, Section 4 of the RFP, "Effect on Transactions in Exempted Securities." In addition, the Rules of Fair Practice would be expanded to NASD members who do business solely in government securities, by amending Article I, Section 5(a) of the RFP, "Applicability," by deleting the phrase "other than those members registered with the Securities and Exchange Commission solely under the provisions of Section 15C of the Act and persons associated with such members."
In addition, the Board specifically requested member comment on two proposed Board Interpretations that address the application of the NASD's Mark-Up policy to government securities and other debt securities (except municipals), and member suitability obligations to institutional customers in debt and equity transactions (except municipals). The Board's action to approve the merger of the Government Securities Rules into the NASD's RFP will be filed with the SEC for approval as part of an overall filing that includes these proposed Interpretations once member comments have been received, analyzed, and acted upon by the Board.
Discussion And Summary Of Proposed Board Interpretations
The Committee affirmed Article III, Section 2(a) of the NASD Rules of Fair Practice (Section 2(a)) as an important investor-protection provision that should be applied to all transactions in the government securities market as well. However, the Committee also determined that the expansion of NASD rules to the government securities market, a market with a broad institutional component, requires that the Association provide further guidance to members on their suitability obligations under Section 2(a) of the RFP when making recommendations to certain institutional customers. Article III, Section 2(a) of the RFP states,
"In recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of facts, if any, disclosed by such customer as to his security holdings and as to his financial situation and needs."The Committee believes that a principal assumption underlying Section 2(a) is that the member's relationship with the customer gives rise to a duty to help the customer determine reasonable investment parameters. The Committee expressed concerns that, in the case of certain institutional customers, this principal assumption underlying Section 2(a) does not reflect the reality of the member/customer relationship leading to the execution of a transaction. The Committee, therefore, believes it is necessary to further clarify and give guidance as to a member's suitability obligations under Article III, Section 2(a) of the RFP with regard to certain institutional investors through the issuance of a new Interpretation of the Board. The Committee notes that many institutions develop resources and procedures that provide them with the sophistication to make independent investment decisions and, in certain cases, the institution develops more sophistication than that maintained by the NASD member. The Committee also believes that many such institutional customers do not rely on a particular member's recommendations, but only use the member as one source of market and/or product information and ideas for transactions.
The Committee, therefore, proposed a new Interpretation of the Board of Governors—Suitability Obligations to Institutional Customers (Suitability Interpretation). The purpose of the proposed Suitability Interpretation would be to explain how the suitability obligations contained under Article III, Section 2(a) of the RFP should operate in the context of certain institutional client relationships consistent with generally accepted business practices that have resulted from such clients' needs and demands. Because the Committee believes the nature of the relationship between the firm and customer is the same regardless of the product involved, the Committee recommends that the proposed Suitability Interpretation apply not only in government and other debt securities (except municipals) but to equity securities as well. The Committee referred the issue of applying the Suitability Interpretation to equity securities to the NASD National Business Conduct Committee (NBCC). The NBCC reviewed the request before the July 1994 Board meeting and supported the application of the proposed Suitability Interpretation to equity securities.
The proposed Suitability Interpretation would be applicable only to customers of institutional accounts, as defined in Article III, Section 21(c)(4) of the Rules of Fair Practice (institutional customer). Section 21(c)(4) defines the term "institutional account" for purposes of Article III, Section 2 of the RFP as the account of (i) a bank, savings and loan association, insurance company, or registered investment company; (ii) an investment adviser registered under Section 203 of the Investment Advisers Act of 1940; or (iii) any other entity (whether a natural person, corporation, partnership, trust or otherwise) with total assets of at least $50 million. The proposed Suitability Interpretation would be applicable to transactions in debt and equity markets, except municipal securities.
The proposed Suitability Interpretation states that underlying Article in, Section 2(a) is the assumption that a member's relationship with the customer gives rise to a duty to help the customer determine reasonable investment parameters. It then provides that, in the case of certain institutional customers, this assumption may not reflect the reality of the member/customer relationship. The proposed Suitability Interpretation specifically recognizes that the reality of the member/customer relationship can be significantly altered when institutional customers develop resources and procedures to make their own independent investment decisions. A non-exclusive list of examples is provided as guidance to members in determining when the resources and procedures for independent investment decisions may exist.
The proposed Suitability Interpretation further provides that even if the institutional customer has developed resources and procedures to make independent decisions, factors should also be present that provide reasonable grounds for the belief that the institutional customer is not relying on the member's recommendations in connection with a particular transaction or market product. In other words, there is no safe harbor presumption created for any institutional accounts, but rather the proposed Suitability Interpretation provides that in dealing with institutional customers, this method of compliance with its suitability obligations under Article III, Section 2(a) would continue to be determined on a transaction-by-transaction basis. The existence of such factors is key to members fulfilling their suitability obligations for each such institutional customer. The proposed Suitability Interpretation discusses a number of examples that help the member determine that it is fulfilling its suitability obligations under Article III, Section 2(a) of the RFP for a particular transaction with an institutional customer.
The proposed Suitability Interpretation also highlights that in the case of a new product, or a security with significantly different risk or volatility characteristics than other investments generally made by the institution, the member should ascertain whether the institutional customer is relying on the member to explain the new product and its risk(s) or is relying on other sources.
The proposed Suitability Interpretation clarifies that a member would not be considered to be fulfilling its suitability obligations under this Interpretation if, before the transaction, the member knows or can reasonably conclude, based on information available to it, that the institutional customer is not capable of understanding the product or its risks, or of making an independent investment decision.
The Committee believes that the proposed Suitability Interpretation will clarify the applicability of Article III, Section 2(a) of the RFP to certain member/customer relationships where such Section is currently difficult to apply. In doing so, the proposed Suitability Interpretation will promote just and equitable principles of trade, eliminate confusion that may currently impede the markets, and further protect investors and the public interest in the debt and equity markets.
The Committee believes the nature of the debt market often requires reconsideration or reexamination of the traditional equity analysis for calculating markups and mark-downs. For instance, unlike the equities market, inter-dealer transactions in certain debt securities are rare, and this difference can, at times or often, make applying the traditional method of determining the prevailing market price for purposes of calculating markups difficult. For example, government securities broker/dealers, unlike their equity counterparts, usually do not continuously trade or make markets in just one government security, but instead may make continuous markets in similar types of debt securities. Unlike the equity markets, where the concept of similar securities is not applicable because each issuer is a unique entity, in the government securities markets such a concept can be very relevant. Such similarity can reflect the financial nature of the instruments in the debt market and may exist because the price/yield of a particular debt security is more dependent on objective external market factors, such as interest rates, and comparable to alternative debt securities, the prices of which are based on the same or similar external market factors.
Based on its discussions, the Committee concluded that notwithstanding that inter-dealer transactions in certain debt securities are rare, the fact that broker/dealers often make continuous markets in similar types of debt securities provides the debt market with additional factors in determining the prevailing market price.
The Committee, therefore, recommends the addition of an Interpretation of the Board of Governors (Mark-Up Interpretation) regarding the application of the NASD Mark-Up Policy under Article III, Section 4 of the Rules of Fair Practice to transactions in debt securities, excluding municipal securities, which remain subject to MSRB Rule G-30. The proposed Mark-Up Interpretation recognizes that inter-dealer transactions ordinarily are the best evidence of the prevailing market price. The proposed Mark-Up Interpretation notes that inter-dealer transactions in the debt market may be rare or nonexistent and states that imposing a contemporaneous cost standard would not be appropriate without first considering other relevant factors.
In the absence of inter-dealer transactions, the proposed Mark-Up Interpretation lists five other contemporaneous factors for members to consider before contemporaneous cost is used for determining the prevailing market price. The first factor would allow the member to consider the prices of recent dealer transactions in the security in question with institutional accounts, as defined above under Article III, Section 21(c)(4) of the Rules of Fair Practice. The Committee believes that referencing the prices of such transactions is a fair and reasonable alternative to inter-dealer transactions, given the significant institutional participation in the debt market.
The second factor would allow the member to consider validated inter-dealer quotations in the security in question through a quotation mechanism, for example, inter-dealer brokers, through which transactions do occur from time to time at prices that are equal to or close to the displayed quotations.
The third, forth, and fifth factors would allow a member to consider (i) yields calculated from prices of inter-dealer transactions in similar securities; (ii) yields calculated from prices of transactions with sophisticated institutional customers in similar securities; and (iii) yields calculated from prices of validated inter-dealer quotations in similar securities. The Committee believes that allowing a member to reference prices in transactions of such similar securities reflects the important distinction from equities in the debt markets whereby prices of similar securities can be reasonably compared. When inter-dealer transactions in the same debt security are absent, the reference to contemporaneous transactions in such similar securities is often more fair and reasonable for determining prevailing market price than referencing contemporaneous cost.
The proposed Mark-Up Interpretation, in addition to listing the preceding five factors for determining prevailing market price, states that consideration may also be given to a value constructed by aggregating the values of components of the security where those values can be derived from the prices and yields of similar securities as reflected in transactions or validated quotations in the market between dealers or with sophisticated institutional customers. The proposed Mark-Up Interpretation provides a nonexclusive list of examples of such components, such as embedded call options, detachable call options, bond insurance, guarantees, and pools of collateral.
The Committee recommends that because the concept of similarity between securities in the debt market plays a significant role in the determination of prevailing market price, it would be appropriate for the Interpretation to provide guidance through a nonexclusive list of factors for members to reference in determining the similarity of debt securities. The proposed Mark-Up Interpretation, therefore, provides the following nonexclusive list of factors on the subject of similarity:
The Board of Governors asks all members and interested persons to comment on these proposed amendments. Comments should be directed to:
Ms. Joan C. Conley
Corporate Secretary
National Association of Securities Dealers, Inc.
1735 K Street, NW
Washington, DC 20006-1506
Questions concerning this Notice may be directed to Walter J. Robertson, NASD Compliance, (202) 728-8236; or John H. Pilcher, NASD Office of General Counsel, (202) 728-8287.
Comments must be received no later than September 30, 1994. Changes to the NASD Rules of Fair Practice must be approved by the Board of Governors and filed with and approved by the SEC before becoming effective.
Text Of Proposed Interpretation
(Note: New text is underlined.)
Interpretation Of The Board Of Governors—Suitability Obligations To Institutional Customers
As a result of broadened authority provided by amendments to the Government Securities Act adopted in 1993, the Association is extending its sales practice rules to the government securities market, a market with a particularly broad institutional component. Accordingly the Board believes it is appropriate to provide further guidance to members on their suitability obligations when making recommendations to customers who are institutional accounts as defined in Article III. Section 21(c)(4) of the NASD Rules of Fair Practice. The Board believes this Interpretation is applicable not only to government securities but to all debt securities.1Furthermore, because of the nature and characteristics of the institutional customer/member relationship, the Board is intending this Interpretation to apply equally to the equity securities markets as well.
Members have requested, in particular, further guidance regarding their suitability obligations under Article III. Section 2(a) of the NASD Rules of Fair Practice when dealing with institutional customers who have developed resources and procedures for the purpose of making their own independent investment decisions-Article III. Section 2Ca1 requires that.
In recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.
The Board believes that underlying Article III, Section 2(a) is the assumption that the member's relationship with the customer gives rise to a duty to help the customer determine reasonable investment parameters. In the case of certain institutional customers, the Board believes that this assumption may not reflect the reality of the member/customer relationship.
For example, institutional customers may have developed resources and procedures in order to make their own independent investment decisions. Many institutional customers have at least one or more experienced professionals charged with the specific responsibility for making or recommending investment decisions on behalf of the institution. Institutional customers may also invest through one or more registered investment advisors or a bank trust department, and these intermediary entities have a fiduciary responsibility for determining an appropriate investment strategy for the institutional customer. Many institutional customers have developed a pattern of utilizing the resources of more than one dealer to transact business. and taking into consideration numerous alternative investment recommendations prior to making an investment decision. The extent to which the institutional customer utilizes resources for alternative market information, including quotation services and research materials from independent sources, may also be relevant.
However, even if the institutional customer has developed resources and procedures to make independent investment decisions, factors should also be present that provide reasonable grounds for the belief that the institutional customer is not relying on the member's recommendations in connection with a particular transaction or market product.
A primary consideration is the extent to which the institutional customer appears to be relying on the member's recommendations. The element of reliance may be established to exist in the member/customer relationship through affirmative statements made at the time of the transaction that the institutional customer is relying on the member's recommendations, or by a pattern of acceptance of the member's advice through the execution of all or nearly all of the recommended transactions. On the other hand, an institutional customer that initiates transactions on an unsolicited basis or who maintains substantive relationships with a number of members may be demonstrating by such actions that it is not relying on a particular member's recommendations, but only using the member as one source of market and/or product information and ideas for transactions.
Many institutional customers independently determine their investment strategy and provide the member with explicit investment guidelines. If explicit guidelines are made available to the member, then it is reasonable to believe that the institutional customer is assuming responsibility for the suitability obligation traditionally held by the member. If the member's investment recommendations are consistent with such guidelines, then the member generally should be regarded as having fulfilled its suitability obligations to the institutional customer. Consistency with guidelines may be evident from the document or may be derived from a reasonable interpretation by responsible officers or agents of the institutional customer at or before the time of the transaction.
Sometimes the institutional customer's investment guidelines set forth percentage limitations for categories of investments. If the institutional customer does business with a number of dealers, and does not provide a particular member with current information on its portfolio holdings, then that member should generally not be responsible for investments that exceed the guideline limitations unless, the Registered Representative executing the transaction on behalf of the member or other persons with member supervisory responsibilities has actual knowledge that the transaction will result in a position that exceeds the guideline limitation.
If based on the consideration set forth above, the member has concluded that the institutional customer is not relying on the member for recommendations in connection with a particular transaction, then the member generally should be viewed as having fulfilled its suitability obligations regarding the institutional customer with respect to that particular transaction. In dealing with such institutional customers, this method of member compliance with its suitability obligations under Article III. Section 2(a) would continue to be determined on a transaction-by-transaction basis.
In the case of a new product, or a security with significantly different risk or volatility characteristics than other investments generally made by the institution, the member should ascertain whether the institutional customer is relying on the member to explain the new product and its risk(s) or is relying on other sources. A member would not be considered to be fulfilling its suitability obligations under this Interpretation if. prior to the transaction, the member knows or can reasonably conclude. based on information available to it, that the customer is not capable of understanding the product or its risks, or of making an independent investment decision
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Interpretation Of The Board Of Governors—Application Of The NASD Mark-Up Policy To Transactions In Government And Other Debt Securities
As a result of the amendments to the Government Securities Act adopted in 1993. expanding the NASD's sales practices authority to encompass government securities, the Board believes it is appropriate to provide guidance to the membership on markup and markdown practices for such securities, and at the same time, for other debt securities as well.2
Ordinarily, the best evidence of the prevailing market price for a security against which a markup or mark down should be measured, is inter-dealer transaction prices. In the market for government or other debt securities, however, inter-dealer transactions may be rare or non-existent for certain securities. Therefore, establishing inter-dealer transaction prices in a particular bond, note or other debt obligation may be difficult. In the equity securities market, if evidence does not exist of inter-dealer transaction prices, the contemporaneous cost to the dealer has traditionally been used as the basis for determining the appropriate markup and markdown.3 On the other hand, in the debt securities market, the Board believes that imposing such a contemporaneous cost standard would not be appropriate without first considering other relevant factors. The Board believes, specifically, that the use of the contemporaneous cost standard as the primary determinative factor in assessing the prevailing market price against which the fairness and reasonableness of a markup or markdown should be judged, is unnecessary because there are other sources of pricing information which more accurately reflect the prevailing market price of debt securities.
Factors which the Board believes may be taken into consideration in determining the prevailing market price of debt securities in the absence of inter-dealer transactions, include but are not limited to:
If the application of the foregoing factors does not assist in the analysis of the prevailing market price, the use of contemporaneous cost may be appropriate.
The degree to which a security is "similar" as that term is used in Items 3.4. and 5 above may be determined by factors which include but are not limited to:
1 Except for municipal securities, the rules for which are written by the Municipal Securities Rulemaking Board.
2 Except for municipal securities, the rules for which are written by the Municipal Securities Rulemaking Board.
3 The markup for sales to customers is the difference between the price to the customer and the prevailing market price on the sell side of the market. The markdown for purchases from customers is the difference between the price to the customer and the prevailing market price on the buy side of the market.