Self-Regulatory Organizations; Proposed Rule Change by the Municipal Securities Rulemaking Board Relating to Suitability of Recommendations

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-33498; File No. SR-MSRB-94-01]

Self-Regulatory Organizations; Proposed Rule Change by the

Municipal Securities Rulemaking Board Relating to Suitability of

Recommendations

January 21, 1994.

Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934

(``Act''), 15 U.S.C. 78s(b)(1), notice is hereby given that on January

7, 1994, the Municipal Securities Rulemaking Board (``Board'' or

``MSRB'') filed with the Securities and Exchange Commission

(``Commission'') a proposed rule change as described in Items I, II,

and III below, which Items have been prepared by the self-regulatory

organization. The purpose of the proposed rule change is to strengthen

the MRSB's rules governing customer suitability. The Commission is

publishing this notice to solicit comments on the proposed rule change

from interested persons.

I. Self-Regulatory Organization's Statement of the Terms of Substance

of the Proposed Rule Change

The Board is filing amendments to rule G-19, concerning suitability

of recommendations and rule G-8 concerning recordkeeping. The proposed

rule change: (1) Clarifies and strengthens the existing language of

rule G-19 that requires suitability determinations to be made when

recommending transactions to customers; (2) clarifies the obligation of

dealers to make reasonable efforts to obtain specific types of customer

suitability information for all accounts that are not ``institutional

accounts'' (i.e., retail accounts); and (3) clarifies the definition of

``institutional account.''

II. Self-Regulatory Organization's Statement of the Purpose of, and

Statutory Basis for, the Proposed Rule Change

In its filing with the Commission, the Board included statements

concerning the purpose of and basis for the proposed rule change and

discussed any comments it received on the proposed rule change. The

text of these statements may be examined at the places specified in

Item IV below and is set forth in sections (A), (B), and (C) below.

A. Self-Regulatory Organization's Statement of the Purpose of, and

Statutory Basis for, the Proposed Rule Change

The proposed rule change is designed to strengthen the Board's

customer suitability rule. In a letter dated May 8, 1992, the

Commission's Division of Market Regulation asked the Board to review

the requirements of rule G-19 on suitability of recommendations.\1\ In

September 1992, the Board published a Request for Comments on a number

of customer protection issues, including the application of rule G-19

to customer transactions. After reviewing these matters, the Board

decided that rule G-19 embodies the appropriate general standard for

dealers in making recommendations to customers. Nevertheless, the Board

recognized there was a perception that certain provisions of the rule

could be viewed as permitting recommendations to go forward without

proper regard to the nature of the security being recommended and the

customer to whom it is recommended. Accordingly, at the May 1993 Board

meeting, the Board approved a Request for Comments on draft amendments

to clarify and strengthen the suitability requirements of rule G-19.

The draft amendments were approved at the November 1993 Board meeting

and form the basis of the proposed rule change.

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\1\Letter from William H. Heyman, Director, Division,

Commission, to Christopher A. Taylor, Executive Director, MSRB (May

8, 1992).

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Rule G-19 generally requires that, before making any recommendation

to a customer, a dealer must first determine that the proposed

transaction is suitable for the customer. To strengthen rule G-19, the

proposed rule change eliminates two provisions from the rule which, in

effect, are exceptions to this general requirement. The first such

provision permits a dealer to make a recommendation when a customer

refuses to provide sufficient information about himself for the dealer

to determine that the recommendation is suitable for the customer. The

provision states that a recommendation can go forward in this case as

long as the dealer has no reasonable grounds to believe and does not

believe that the recommendation is unsuitable (the ``not unsuitable''

provision). Although the Board did not conclude that this provision was

the cause of customer protection problems (i.e., there was no evidence

that dealers relied on this provision to make unsuitable

recommendations), the Board believed that the provision should be

deleted to avoid any ambiguities regarding a dealer's obligation to

make a suitability determination. Eliminating the provision also will

prevent any future use of the provision as an excuse for unsuitable

recommendations.

The second provision of rule G-19 that is removed by the proposed

rule change provides that a dealer, notwithstanding its determination

that a transaction is not suitable for a customer, may, after so

informing the customer of this, nevertheless respond to the customer's

requests for investment advice and execute transactions at the

direction of the customer. This ``notwithstanding'' provision allows

dealers to recommend specific municipal securities to investors who

want to invest in municipal securities even after being informed by the

dealer that, based on their financial circumstances, investments in

municipal securities would not be suitable. While there have been no

reported problems associated with this provision, the Board,

nevertheless, believed that this exemptive provision also should be

deleted to strengthen the suitability rule.

The Board also reviewed and clarified the customer data inquiries

that are necessary for non-institutional and institutional accounts.

For non-institutional (i.e., retail) accounts, the proposed rule change

clarifies that dealers must make reasonable efforts to obtain the

following information: the customer's financial status, tax status,

investment objectives and such other information used or considered to

be reasonable and necessary by the dealer in making recommendations to

the customer. For some institutional customers, however, these specific

information requests may not be appropriate. For example, the ``tax

status'' of a tax-exempt bond fund generally is not relevant to a

suitability determination. Therefore, the proposed rule change does not

provide a specific list of items that must be requested from all

institutional accounts, but does state that dealers must obtain

appropriate and sufficient data from each institutional customer to

make a suitability determination for each transaction that is

recommended (as also is required for non-institutional accounts).

Finally, the proposed rule change revises the definition of

``institutional account'' contained in rule G-8. This definition is

used in rule G-19, by cross-reference. This amendment would make the

Board's definition of institutional account the same as the National

Association of Securities Dealers' (``NASD'') definition for purposes

of suitability determinations. Accounts that do not qualify as

``institutional accounts'' (i.e., retail accounts) would be subject to

the specific information inquiries described above.

The Board believes the proposed rule change is consistent with

Section 15B(b)(2)(C) of the Act which provides that the Board's rules:

be designed to prevent fraudulent and manipulative acts and

practices, to promote just and equitable principles of trade * * *

to remove impediments and to perfect the mechanism of a free and

open market in municipal securities, and, in general, to protect

investors and the public interest.

The Board believes that the proposed rule change will protect

investors and the public interest because it is designed to ensure that

dealers, before making a recommendation to a customer, make a

determination that the municipal securities transaction is suitable.

B. Self-Regulatory Organization's Statement on Burden on Competition

Because the proposed rule change will have an equal impact on all

dealers, the Board believes that the proposed rule change will not have

any impact on competition.

C. Self-Regulatory Organization's Statement on Comments on the Proposed

Rule Change Received From Members, Participants, or Others

September 1992 Request for Comments

In September 1992, as part of the Board's general review of

customer protection measures, the Board requested comment on potential

problem areas in the municipal securities market and suggestions for

how customer protection could be improved. Specific questions were

asked about the effectiveness of rule G-19 and the Board obtained

various comments on the ``not unsuitable'' provision of rule G-19 from

Merrill Lynch, North American Securities Administrators Association,

Barre & Co., Griffen, Kubik, Stephens & Thompson, and the Public

Securities Association.

While some of these commentators at that time believed that the

``not unsuitable'' provision should be deleted, other commentators

believed it should be retained because some customers do not wish to

provide certain information about themselves. Specifically, two

commentators believed that removing the provision would not be a

problem and would make the Board's rule consistent with normal practice

in other securities markets. Three commentators noted that some

customers do not want to provide their financial information to a

dealer. One of those commentators indicated, however, that ``in the

vast majority of cases, dealers do routinely obtain information for

each customer account reflecting net worth, income level and investment

objectives.''

August 1993 Request for Comments

In August 1993, the Board published for comment the proposed rule

change. Comment letters were received from Fidelity Investments, First

Interstate Bank of Oregon, Heitner Corporation, Lehman Brothers,

Liberty Bank and Trust Company of Tulsa, Merrill Lynch, and the

Securities Department of Arkansas.

Comments on the General Approach of the Proposed Rule Change

In general, the commentators' reaction to the approach taken by the

proposed rule change was favorable. One commentator agreed with the

Board's approach by stating that the proposed rule change would address

a ``difficult problem'' by deleting the ``not unsuitable'' and

``notwithstanding'' provisions from the current suitability rule.

Another commentator noted that rule G-19 ``as reformulated by the Board

sets forth an appropriate affirmative standard.'' Two other

commentators also expressed general support for the approach taken by

the proposed rule change.

Two commentators expressed reservations over removal of the ``not

unsuitable'' and the ``notwithstanding'' provisions. One commentator

opposed both changes because of its belief that the majority of its

customers are not willing ``to divulge their financial strength.''

Another commentator, while indicating that it does not make

recommendations in municipal securities to customers, also believes

that the ``notwithstanding'' provision should be retained because a

customer may disagree with a dealer's opinion of unsuitability. That

commentator indicated that dealers should be permitted to make

recommendations to a customer who has already decided to purchase a

municipal security and who asks for assistance in choosing an issue,

even if the transaction would be unsuitable for the customer.

While the ``not unsuitable'' and the ``notwithstanding'' provisions

were initially adopted by the Board in the late 1970s for reasons

similar to those cited by the commentators, the Board notes that there

have been significant changes in the municipal securities market since

that time. The number of retail investors has increased and the

introduction of increasing numbers of complex, and in some cases,

speculative municipal securities has become a characteristic of today's

market. In such an environment, the Board believes that it is critical

that dealers have clear policies to ensure that sales personnel do not

recommend securities to customers without first establishing the

suitability of the transaction. Therefore, the Board believes that the

proposed rule change deleting these provisions is necessary.

Comments on Specific Provisions of the Proposed Rule Change

Commentators offered several specific suggestions and sought

guidance from the Board in a number of areas of the proposed rule

change.

Customer Account Data and Suitability Determinations

The proposed rule change includes an amendment to rule G-19(b)

which states that, for retail customers, prior to making a

recommendation a dealer must ``make reasonable effort to obtain

information concerning: (i) The customer's financial status; (ii) the

customer's tax status; (iii) the customer's investment objectives; and

(iv) such other information used or considered to be reasonable and

necessary by such broker, dealer or municipal securities dealer in

making recommendations to the customer.'' Two commentators were

concerned as to what would happen if all such information could not be

obtained. As indicated in the Request for Comments, the language of the

proposed rule change does not necessarily preclude a dealer from making

a recommendation if all items of information enumerated in the proposed

amendment to rule G-19(b) cannot be obtained. Given the nature of the

transaction (e.g., the nature of the security and the known items of

information about the customer), the dealer may have enough customer

data to make a specific, affirmative suitability determination for the

recommendation, even if the customer refuses to provide some of the

requested information. However, reasonable efforts must be made to

obtain all customer information listed in the proposed amendment to

rule G-19(b), in any event.

As noted above, the amount of customer information that is required

to make a suitability determination depends in part upon the nature of

the transaction recommended. With respect to some types of

transactions--for example, those in more speculative securities--the

amount of information needed to make a suitability determination will

be greater than if a more conservative recommendation is being made.

One commentator requested that the Board provide guidance on this

subject by specifying ``core'' suitability information that must be

obtained from a customer even when making a ``conservative''

recommendation. That commentator also requested that the Board provide

specific guidance on what would be considered ``more speculative''

securities for which more detailed customer account data would be

needed.

The proposed rule change to rule G-19(b) states that dealers must

make reasonable efforts to obtain certain ``core'' customer suitability

data for recommendations to non-institutional customers including: (i)

The customer's financial status; (ii) the customer's tax status; (iii)

the customer's investment objectives; and (iv) such other information

used or considered to be reasonable and necessary by such broker,

dealer or municipal securities dealer in making recommendations to the

customer. The Board notes that if, after reasonable efforts, a dealer

cannot obtain all such information regarding a customer, but

nevertheless desires to proceed with a ``conservative'' transaction,

the dealer must exercise its judgment, based on known information about

the customer and the security, as to whether a suitability

determination can be made. Furthermore, all information about the

customer that is used in making this determination must be recorded in

the customer account record under rule G-8(a)(xi)(F).

The Board also believes it to be inadvisable to attempt to provide

detailed guidance on whether a particular security or proposed

transaction is more ``conservative'' or more ``speculative.'' The Board

notes that dealers will have to make such decisions based on their

knowledge of the security and the risks involved in the transaction.

Attempts to state a universally applicable formula for such

considerations could encourage the substitution of simplistic

guidelines for the broader judgment that is sometimes required to

determine whether a proposed municipal securities transaction includes

a relatively low or high degree of risk.

Unsolicited Transactions

Several commentators requested that the Board provide guidance on

how to identify and document ``unsolicited'' transactions, i.e.,

transactions that are not recommended. Neither the current version of

rule G-19 nor the proposed rule change precludes dealers from executing

specific transactions at the request of customers, where no

recommendation is made. Thus, the suitability requirements of the

proposed rule change would not apply to such ``unsolicited''

transactions. The Board notes, however, that most municipal securities

transactions are made in connection with recommendations. Because of

its concern with customer protection and in recognition of the special

characteristics of the municipal securities market, the Board views the

term ``recommendation'' (and the application of the Board's suitability

requirement) broadly. For example, with respect to transactions

occurring after investment seminars and in response to a dealer's

advertisements, the Board has indicated that the suitability

requirements of G-19 apply ``in the same way they apply to all other

recommendations made to customers.'' Thus, although transactions may,

in some instances, be ``unsolicited'' if a customer places an order for

a specific security, transactions cannot be considered unsolicited if

the order occurs after a dealer has mentioned a specific security to a

customer (e.g., in a listing of offerings, an advertisement or in any

other communication by the dealer to the customer).

One commentator asked how ``unsolicited'' orders should be

specified in a dealer's records, and whether such orders should always

be handled by the dealer ``as agent.'' Board rules do not require

dealers to handle specific types of orders as either principal or

agent. Rule G-8(a)(vi), however, specifies the recordkeeping

requirements for the terms and conditions of an agency order, including

the fact that it is an agency order. Similarly, rule G-15(a)(vii)

requires the confirmation to state the agency role of a dealer in a

transaction. Neither rule G-8 nor rule G-15 has provisions for

documenting orders as ``unsolicited.''

As previously noted, the Board believes that relatively few

transactions in municipal securities actually are ``unsolicited.''

While documenting these relatively rare transactions as such on the

confirmation and in the dealer's records may be prudent for the

dealer's own protection, the Board is concerned that incorporating a

requirement in the Board's rules might have the unintended and

undesired effect of encouraging the classification of transactions as

``unsolicited,'' even when they are not ``unsolicited'' under Board

rules.

Institutional Accounts

The Board received several comments concerning the proposed

definition for institutional account contained in the proposed rule

change and the more generally stated suitability standard for

institutional accounts. No commentator argued that it was inappropriate

to distinguish between institutional and non-institutional investors

when obtaining customer account data and making suitability

determinations. One commentator believed the proposed standard for

institutional investors was appropriate and noted that the information

relevant to a suitability determination for a specific institutional

account is necessarily a matter of judgment for the dealer. One

commentator, however, suggested the establishment of specific minimum

requirements for institutional accounts and specifically suggested that

dealers should document the customer's investment objectives (including

credit quality and maturity standards) and ``other information'' used

or considered reasonable or necessary by the dealer. Another

commentator suggested including corporate resolutions, trading

authorization, and yearly audited financial statements as required

information for institutional customers.

As indicated by several commentators, it is often necessary or

advisable to obtain specific kinds of information from an institutional

investor. Rule G-8(a)(xi)(F) currently requires that the customer

suitability information used to make a suitability determination be

recorded in the customer account record. The proposed rule change to

rule G-8 also makes this requirement clear. In addition, rule G-

8(a)(xi) also requires other customer account information including,

among other things, the customer's name and address, tax identification

or social security number and with respect to discretionary accounts,

the customer's written authorization. For various types of

institutional accounts, it may be advisable for dealers to obtain

certain additional data and documentation. Often this additional

documentation may be necessary for the dealer's own protection (e.g.,

trading authorizations). Similarly, for certain institutional accounts,

dealers may wish to obtain yearly audited financial statements where

assurance is desired that the account is and remains an institutional

account for the purpose of rule G-19.

Because of the wide variety in the types of institutional accounts

and the documentation that might be necessary to establish suitability

or otherwise considered to be necessary and prudent by the dealer, the

Board believes that dealers ultimately will have to employ a certain

degree of judgment in determining what information and documentation

should be obtained and recorded for specific institutional customers

beyond that now required by rule G-8(a)(xi).

One commentator noted that, in many instances, a suitability

determination should be made on the basis of the investment objectives

articulated by an institution for a specific transaction or a specific

component of a large investment portfolio. In these cases, the overall

investment objectives of the institution or portfolio may not be the

deciding factor in determining suitability. The Board notes that this

view is consistent with the current language of rule G-19 and the

proposed rule change, which requires that a dealer have reasonable

grounds for recommending a transaction ``based on the facts disclosed

by such customer or otherwise known about such customer.'' Clearly, if

specific portfolio or transaction objectives are given, the proposed

rule change and current Board rules require that such information be

used to make a suitability determination and be recorded pursuant to

rule G-8(a)(xi)(F).

One commentator preferred the Commission's definition of

``accredited investor'' to the definition of ``institutional account''

in the proposed rule change. The Commission's accredited investor

definition includes a wide range of investors, such as any private

business development company or individuals making in excess of

$200,000 per year for three years. The term ``accredited investor'' is

used as part of an exemptive provision from certain registration

requirements under the Securities Act of 1933. Having a customer

classified as an ``accredited investor,'' however, does not excuse

dealers from obtaining specific customer account data when making

recommendations in equity transactions. Moreover, because

``institutional account''--rather than ``accredited investor''--is used

by the NASD to define a dealer's customer account requirements, the

Board believes that the use of a different test for municipal

securities transactions would complicate the internal recordkeeping

requirements of most securities firms.

Transactions With Investment Advisors

Two commentators requested clarification of the suitability

requirements that exist when a dealer executes a transaction for an

investment advisor. The Board notes that this question is answered by

determining who the dealer's customer is--the investment advisor or the

investment advisor's client. The Board believes that, in general, the

investment advisor will be the dealer's customer. However, it is not

possible to state this as an ironclad rule. The requirement for

establishing suitability may depend on whether the beneficial owner is

looking to the dealer or exclusively to the investment advisor for

recommendations on investments. The dealer, of course, should obtain

the necessary customer account data from whomever is the customer. If

the investment advisor is the customer, then the dealer would proceed

as with other institutional accounts. However, if a dealer has a

dealer-customer relationship with the beneficial owner and treats that

entity as its own customer, then the dealer must obtain the information

necessary to make a suitability determination prior to making a

recommendation. In this case, the investment advisor is treated as an

interested party to the transaction.

III. Date of Effectiveness of the Proposed Rule Change and Timing

for Commission Action

Within 35 days of the date of publication of this notice in the

Federal Register or within such longer period (i) as the Commission may

designate up to 90 days of such date if it finds such longer period to

be appropriate and publishes its reasons for so finding or (ii) as to

which the self-regulatory organization consents, the Commission will:

(A) By order approve such proposed rule change, or

(B) Institute proceedings to determine whether the proposed rule

change should be disapproved.

IV. Solicitation of Comments

Interested persons are invited to submit written data, views, and

arguments concerning the foregoing. Persons making written submissions

should file six copies thereof with the Secretary, Securities and

Exchange Commission, 450 Fifth Street NW., Washington, DC 20549. Copies

of the submission, all subsequent amendments, all written statements

with respect to the proposed rule change that are filed with the

Commission, and all written communications relating to the proposed

rule change 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 in the

Commission's Public Reference Room. Copies of the filing will also be

available for inspection and copying at the principal office of the

MSRB. All submissions should refer to the file number in the caption

above and should be submitted on February 17, 1994.

For the Commission by the Division of Market Regulation,

pursuant to delegated authority, 17 CFR 200-30-3(a)(12).

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 94-1716 Filed 1-26-94; 8:45 am]

BILLING CODE 8010-01-M