Self-Regulatory Organizations; Notice of Filing of Proposed Rule Change by National Association of Securities Dealers, Inc. Relating to the Definitions of Bona Fide Independent Market and Bona Fide Independent Market Maker

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-37223; File No. SR-NASD-96-17]

Self-Regulatory Organizations; Notice of Filing of Proposed Rule

Change by National Association of Securities Dealers, Inc. Relating to

the Definitions of Bona Fide Independent Market and Bona Fide

Independent Market Maker

May 17, 1996.

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 April

24, 1996, the National Association of Securities Dealers, Inc.

(``NASD'' or ``Association'') filed with the Securities and Exchange

Commission (``SEC'' or ``Commission'') the proposed rule change as

described in Items I, II, and III below, which Items have been prepared

by the NASD. 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 NASD is herewith filing a proposed rule change to Rule 2720 of

the NASD's Conduct Rules to amend the definitions of ``Bona fide

independent market'' and ``Bona fide independent market maker.'' Below

is the text of the proposed rule change. Proposed new language is

italicized; proposed deletions are in brackets.

Conduct Rules

2000. Business Conduct

* * * * *

2700. Securities Distributions

2720. Distribution of Securities of Members and Affiliates--Conflicts

of Interest

(a) General

(1) No member or person associated with a member shall participate

in the distribution of a public offering of debt or equity securities

issued or to be issued by the member, the parent of the member, or an

affiliate of the member and no member or parent of a member shall issue

securities except in accordance with this Rule.

(2) No member or persons associated with a member shall participate

in the distribution of a public offering of debt or equity securities

issued or to be issued by a company if the member and/or its associated

persons, parent or affiliates have a conflict of interest with the

company, as defined herein, except in accordance with this Rule.

(b) Definitions

For purposes of this Rule, the following words shall have the

stated meanings:

(1) and (2) No change.

(3) Bona fide independent market--a market in a security which:

(A) Is registered pursuant to the provisions of Sections 12(b) or

12(g) of the Act or issued by a company subject to Section 15(d) of

such Act, unless exempt from those provisions;

[(B) Has an aggregate trading volume for the 12 months immediately

preceding the filing of the registration statement of at least 100,000

shares;]

[(C) Has outstanding for the entire 12 month period immediately

preceding the filing of the registration statement, a minimum of

250,000 publicly held shares; and]

[(D) In the case of over-the-counter securities, has had at least

three bona fide independent market makers for a period of at least 30

days immediately preceding the filing of the registration statement and

the effective date of the offering.]

(B) Has a market price as of the close of trading on the trade date

immediately preceding filing of the registration statement or offering

circular of five dollars or more per share, and which has traded at a

price of five dollars or more per share in at least 20 of the 30

trading days immediately preceding the filing of the registration

statement or offering circular; and

(C) For at least 90 calendar days immediately preceding the filing

of the registration statement or offering circular with the Department:

(i) Has been listed on and is in compliance with the requirements

for continued listing on a national securities exchange; or

(ii) Has been listed on and is in compliance with the requirements

for continued listing on The Nasdaq Stock Market and has had at least

two bona fide independent market makers for a period of at least 30

trading days immediately preceding the filing of the registration

statement and the effective date of the offering; and

(D) For the 90 calendar day period immediately preceding the filing

of the registration statement or offering circular:

(i) Has an aggregate trading volume of at least 500,000 shares; or

(ii) Has outstanding a minimum of 5,000,000 publicly held shares.

(4) Bona fide independent market maker--a market maker which:

[(A) Continually maintains net capital as determined by Rule 15c3-1

under the Act, of $50,000 or $5,000 for each security in which it makes

a market, whichever is less;]

[(B) Regularly publishes bona fide competitive bid and offer

quotations in a recognized interdealer quotation system;]

[(C) Furnishes bona fide competitive bid and offer quotations to

other brokers and dealers on request; and]

((D) Stands ready, willing and able to effect transactions in

reasonable amounts, and at his quoted prices, with other brokers and

dealers.)

(A) Is registered as a Nasdaq market maker in the security to be

distributed pursuant to this Schedule;

(B) Is not an affiliate of the entity issuing securities pursuant

to paragraph (c) of this Schedule and, together with its associated

persons, does not in the aggregate beneficially own, at the time of the

filing of the registration statement and at the commencement of the

distribution, five percent or more of the outstanding voting securities

of such entity which is a corporation or beneficially own a partnership

interest

[[Page 26240]]

in five percent or more of the distributable profits or losses of such

entity which is a partnership; and

(C) Is not a recipient of any of the net proceeds of the offering.

* * * * *

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 NASD 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. The NASD has prepared summaries, set forth in Sections

(A), (B), and (C) below, of the most significant aspects of such

statements.

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

Statutory Basis for, the Proposed Rule Change

Introduction and Background

Rule 2720 of the NASD's Conduct Rules (the ``Rule'') (formerly,

Schedule E to the NASD's By-Laws) addresses the concern that public

investors be adequately protected against conflicts of interest

regarding the conduct of due diligence and pricing of securities when

investing in securities issued by an NASD member, its parent or an

affiliate of a member that is going public or by an issuer with which

the member has a conflict of interest (``Rule 2720 offering''). The

Rule prohibits a member from underwriting or participating in the

underwriting or distribution of a Rule 2720 offering of equity or debt

unless the price of the equity offering is established no higher, or

the yield of the debt offering is established no lower, than the price

recommended by a qualified independent underwriter, who shall also

participate in the preparation of the registration statement and

prospectus, offering memorandum, or similar document, and exercise

usual standards of ``due diligence'' regarding the offering. Rule 2720

provides an exception from the qualified independent underwriter

requirement for offerings of equity securities for which a bona fide

independent market exists. Rule 2720 defines a bona fide independent

market as a market in a security which has, among other things, at

least three bona fide independent market makers.

The NASD has reviewed the definitions of bona fide independent

market and bona fide independent market maker, which were part of the

original version of Rule 2720 when it was adopted as Schedule E in

1972. The NASD is proposing to revise the definitions to incorporate

new requirements for listing, public float, trading volume, price,

number of bona fide independent market makers, and limitations on the

relationship of the bona fide independent market maker to the issuer

that will significantly improve the criteria used for determining that

a market of sufficient depth and duration exists to constitute an

efficient pricing mechanism for the securities to be distributed. The

NASD believes that the proposed new definitions will permit members, in

appropriate situations, to conduct a secondary offering without the

burden and expense of engaging a qualified independent underwriter,

while ensuring the public that the added protection of a qualified

independent underwriter will be required in situations where the market

cannot be relied on to price the securities appropriately.

Description of Proposed Amendments

Bona Fide Independent Market Definition

Registration Requirement

The proposed rule change retains the current requirement in the

definition of bona fide independent market that it must be a market in

a security which is registered pursuant to Sections 12(b) or 12(g) of

the Act or issued by a company subject to Section 15(d) of that Act.

Price Requirement

The current definition of bona fide independent market does not

contain a price requirement. The NASD is concerned that a public float

requirement, as set forth below, without a corresponding standard for

the market price of the securities does not establish a valid benchmark

for a bona fide independent market. Therefore, the NASD is proposing to

adopt a new provision in the definition of a bona fide independent

market that would require that the security have a market price of at

least $5 a share as of the close of trading on the day immediately

preceding the filing of the registration statement or offering

circular, and have traded at a price of $5 or more per share on at

least 20 of the 30 trading days immediately preceding the date on which

the offering circular or registration statement was filed.

Listing and Market Maker Requirement

The current definition of bona fide independent market does not

contain a listing requirement. The NASD believes that a listing on a

national securities exchange or The Nasdaq Stock Market indicates that

the security trades in an efficient, regulated, and active market and

would bring to the definition of bona fide independent market the

qualitative standards of a regulated trading environment, such as quote

transparency and real-time transaction reporting. Therefore, the NASD

is proposing to adopt as one of the requirements for the definition of

a bona fide independent market that the security, for at least 90

calendar days immediately preceding the filing of the registration

statement or offering circular, have been listed on, and is in

compliance with, the requirements for continued listing on (i) a

national securities exchange, or (ii) The Nasdaq Stock Market so long

as such Nasdaq listing has two bona fide independent market makers for

a period of at least 30 trading days immediately preceding the filing

of the registration statement or offering circular and the effective

date of the offering. Securities quoted on the NASD OTC Bulletin Board

service and those traded in the general over-the-courter market, such

as the ``pink sheets,'' cannot rely on this requirement.

The proposed requirement that the security have at least two bona

fide independent market makers for listings on the Nasdaq Stock Market

would replace the current requirement of at least three bona fide

independent market makers. Given that a security is permitted to be

listed on the Nasdaq Stock Market with two market makers, the NASD

believes that two market makers are sufficient to demonstrate the

presence of a bona fide independent market away from any Rule 2720

affiliate that may also be making a market in the issuer's securities.

Trading Volume and Public Float Requirement

The current definition of bona fide independent market contains

independent requirements for trading volume and public float. Under the

current rule, a security is considered to have a bona fide independent

market if, for the 12 months immediately preceding the filing of the

registration statement, it has both an aggregate trading volume of at

least 100,000 shares and a minimum of 250,000 publicly held shares.

Under the proposed rule change, the requirements for trading volume and

public float will be in the alternative. That is, for a bona fide

independent market to exist, the proposed rule would require a security

to have for the 90 calendar day period

[[Page 26241]]

immediately preceding the filing of the registration statement or

offering circular either an aggregate trading volume of at least

500,000 shares or a minimum of 5,000,000 publicly held shares

outstanding.

The NASD believes that raising the current aggregate 12-months

trading volume requirement of 100,000 shares to 500,000 shares in the

90-calendar-day period before the filing of the registration statement

or offering circular provides a criterion that is more indicative of an

active, current and, therefore, efficient market. Such greater price

efficiency establishes a better benchmark for justifying an exemption

from the requirement that a qualified independent underwriter establish

the price of the offering.

The NASD considers the alternative requirement of a five-million-

share public float as the minimum necessary to assure that the market

for an issuer's securities will not suffer undue volatility from the

dilution that occurs when a large number of shares is offered to the

public. In this regard, the NASD notes that a typical ``follow-on''

offering\1\ of a company's stock adds between one- and two-million

shares to the public float, which is equal to a 40 percent dilution at

the five-million-share level.

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\1\ The term ``follow-on'' offering refers to a secondary

offering of shares by the issuer.

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Bona Fide Independent Market Maker Definition

The Rule currently defines a bona fide independent market maker as

one which meets certain net capital requirements, publishes bona fide

bid and ask quotations in a recognized interdealer quotation system,

furnishes such quotes to other brokers and dealers on request, and

stands ready, willing and able to effect transactions at quoted prices

with other brokers and dealers. The current standards of the definition

were developed at the time the Rule was adopted in 1972 as Schedule E

and applied to all securities in the over-the-counter market.

The NASD believes that the current standards for the definition of

bona fide independent market maker are no longer necessary in light of

the proposed requirement of the definition of bona fide independent

market that the security be listed on The Nasdaq Stock Market. Market

makers for securities listed on The Nasdaq Stock Market are required to

meet certain net capital standards, publish bona fide bid and ask

quotations in Nasdaq, which is a recognized interdealer quotation

system, furnish quotes to other brokers and dealers on request, and

stand ready, willing and able to effect transactions at quoted prices

with other brokers and dealers. Therefore, the NASD is proposing that

the current requirements be incorporated into a single standard

requiring that the market maker be registered as a Nasdaq market maker.

The NASD believes that the definition of bona fide independent

market maker should also provide investors with greater assurance that

the market maker's activities are independent of any influences that

may arise when the issuer's ownership of securities or interest in the

offering becomes material. Therefore, the NASD is also proposing to

adopt as part of the new definition that a bona fide independent market

maker (i) must not be a recipient of any of the net proceeds of the

offering, (ii) must not be an affiliate of the entity issuing the

securities, and, (iii) together with its associated persons, does not

in the aggregate beneficially own, at the time of the filing of the

registration statement or offering circular, five percent or more of

the outstanding voting securities of the entity issuing the securities,

if a corporation, or a five percent or more partnership interest in the

distributable profits or losses of the entity, if a partnership.

The NASD believes that the proposed rule change is consistent with

the provisions of Section 15A(b)(6) of the Act,\2\ which require that

the Association adopt and amend its rules to promote just and equitable

principles of trade, and generally provide for the protection of

customers and the public interest in that the proposed rule change, by

amending the requirements to qualify for the exception to the qualified

independent underwriter requirement for an equity security with a bona

fide independent market, significantly improves the criteria used for

determining the presence of a bona fide independent market for Rule

2720 offerings and reinforces the standard that a bona fide independent

market should be stringent enough to assure the public that a market of

sufficient depth and duration exists to constitute an efficient pricing

mechanism for the securities to be distributed.

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\2\ 15 U.S.C. 78o-3.

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(B) Self-Regulatory Organization's Statement on Burden on Competition

The NASD does not believe that the proposed rule change will result

in any burden on competition that is not necessary or appropriate in

furtherance of the purposes of the Act, as amended.

(C) Self-Regulatory Organization's Statement on Comments on the

Proposed Rule Change Received From Members, Participants, or Others

The proposed rule change was published for comment in Notice to

Members 95-44 (June, 1995) (``NTM 95-44''). Three (3) comment letters

were received in response. All 3 commenters were in favor of the

proposed rule change; one commenter suggested substantive changes to

the proposed rule change.

Sullivan and Cromwell (``S&C'') suggested revisions to clarify the

meanings of the definitions of both ``bona fide independent market''

and ``bona fide independent market maker'' and to ease compliance with

these requirements.

Bona Fide Independent Market Definition

The term ``listing requirements'' in the version of the definition

of ``bona fide independent market'' published for comment in NTM 95-44

would have required compliance with listing requirements on a national

securities exchange or the Nasdaq Stock Market. S&C stated it presumed

that this requirement referred to maintenance criteria rather than

original listing standards since the definition would otherwise exclude

various issuers currently in compliance with appropriate maintenance

criteria for continued listing but who, for various reasons, no longer

meet initial listing standards.

The NASD agrees that the proposed definition of ``bona fide

independent market'' was not intended to require continuous

satisfaction of initial listing requirements of the Nasdaq Stock Market

or national securities exchanges. Therefore, the proposed rule language

has been amended to specifically require compliance with the

requirements for continued listing on The Nasdaq Stock Market or a

national securities exchange.

The NASD also agrees with S&C that the parenthetical ``(Trading

Volume Test)'' in Section 2(c)(4)(i) should be deleted since the term

is not used again in the rule language.

S&C also stated that the definition of ``bona fide independent

market'' appears to require compliance with ``listing requirements''

only on the filing date of the registration statement and not

throughout the preceding 90 calendar days. The NASD believes that the

literal language of the proposed rule is clear that compliance with the

listing requirements is required throughout the 90 calendar days

preceding the filing of the registration statement.

[[Page 26242]]

Bona Fide Independent Market Maker Definition

In the version of the proposed rule change published for comment in

NTM 95-44, ``bona fide independent market maker'' was defined, in part,

as a market maker who is not affiliated with the issuer and, together

with its associated persons, does not in the aggregate beneficially

own, at the time of the filing of the registration statement, 5% or

more of the issuer's outstanding voting securities, common equity,

preferred equity, or subordinated debt (``five percent requirement'').

The NASD stated in NTM 95-44 that the proposed new standards for the

definition of bona fide independent market maker were largely drawn

from the current definition of qualified independent underwriter in the

Rule and from the current definition of qualified independent

underwriter in the Rule and from the reporting requirements imposed on

beneficial owners by Section 13 of the Act. S&C objected to the five

percent requirement on a number of grounds.

First, S&C stated that there is a fundamental difference between

qualified independent underwriters and bona fide independent market

makers that makes it inappropriate to apply the same standards to each.

In particular, a qualified independent underwriter directly

participates in the offering process and is usually a party to an

agreement with the issuer outlining each party's responsibilities under

the Rule. A registered market maker for a Nasdaq-listed stock, however,

might not be a participant in the distribution and thus not a party to

any agreement with either the issuer or the managing underwriter. Thus,

a market maker could not be compelled, contractually or otherwise, to

divulge the information needed for the issuer and managing underwriter

to determine whether the market maker qualifies under the five percent

requirement as a bona fide independent market maker.

Second, S&C stated that, contrary to the suggestion in NTM 95-44,

the issuer and managing underwriter cannot necessarily obtain the

required information from filings made by market makers under Section

13 of the Act. Section 13 (d) and (g) filing requirements apply only to

acquisitions of equity securities that are ``voting securities'' and do

not provide information regarding a market maker's investment in an

issuer's non-convertible preferred stock or subordinated debt.

Additionally, under Exchange Act Rule 13d-1(b)(1), many market makers

which beneficially own more than five percent (but less than ten

percent) of an issuer's outstanding voting securities will not be

required to file any related disclosure statement under Section 13,

thus eliminating the need to file a Schedule 13 regarding registered

equity securities acquired by them in the ordinary course of business

and not with the purpose or effect of changing or influencing the

control of the issuer.

Third, S&C noted that the five percent requirement prohibits a bona

fide independent market maker from holding a five percent securities

position either at the filing date or at the commencement of the

distribution. S&C stated that a market maker not participating in the

distribution, who would otherwise qualify as a bona fide independent

market maker on the filing date, might very well refuse to provide any

undertakings to the issuer regarding the securities positions it will

hold on the commencement date. Consequently, an issuer may be unable to

ensure that a broker-dealer who qualifies as a bona fide independent

market maker on the filing date will remain so qualified on the

commencement date.

Finally, S&C noted that the definition of bona fide independent

market maker proposed in NTM 95-44 requires that securities ownership

by the member's associated persons and immediate family members,

parents, and affiliates be aggregated for purposes of the five percent

limitation, whereas the current definition of qualified independent

underwriter does not require such aggregation. S&C stated that it is

odd to include such an aggregation requirement in view of the fact that

NTM 95-44 stated that the proposed definition of bona fide independent

market maker is intended, in part, to conform to the current definition

of qualified independent underwriter.

S&C recommended that the NASD either delete the five percent

ownership requirement entirely or at least that element of the five

percent requirement that requires aggregation of ``associated persons

and their immediate family, parents and affiliates.''

The NASD agrees that the nature of Section 13 filing requirements

appears to make such reporting an inadequate substitute source of

information for ensuring compliance with the definition of bona fide

independent market maker proposed in NTM 95-44. Therefore, the NASD has

eliminated the requirement that a bona fide independent market maker

have no more than a five percent beneficial ownership position in the

non-voting securities of an issuer including common equity, preferred

equity, and subordinated debt, but has retained the five percent

ownership requirement with respect to the issuer's voting securities.

The NASD believes that if a market of sufficient depth and liquidity

exists to meet the other stringent requirements of the definition of a

bona fide independent market, then the integrity of the pricing of the

offering is preserved regardless of whether one or more market makers

hold positions in the issuer's non-voting securities.

The NASD also agrees that the requirements for a bona fide

independent market maker proposed in NTM 95-44 are more stringent than

the current requirements imposed on a qualified independent underwriter

under the Rule. Therefore, the NASD has eliminated the requirement to

aggregate the ownership of the immediate family, parents and affiliates

of the member and its associated persons with any direct ownership by

the market maker and its associated persons. However, when a bona fide

independent market maker and its associated persons ``beneficially

own'' voting securities of the same issuer, the NASD considers

aggregation of ownership to be appropriate.\3\

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\3\ ``Beneficial Ownership'' is defined in the Rule to mean the

right to the economic benefits of a security.

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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, N.W., Washington, D.C. 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

[[Page 26243]]

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 such filing will also be available for

inspection and copying at the principal office of the NASD. All

submissions should refer to the file number in the caption above and

should be submitted by June 14, 1996.

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. 96-13143 Filed 5-23-96; 8:45 am]

BILLING CODE 8010-01-M