Self-Regulatory Organizations; Notice of Filing of Proposed Rule Change by the National Association of Securities Dealers, Inc. Relating to Microcap InitiativeRecommendation Rule

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-41075; File No. SR-NASD-99-4]

Self-Regulatory Organizations; Notice of Filing of Proposed Rule

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

to Microcap Initiative--Recommendation Rule

February 19, 1999.

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

(``Act'' or ``Exchange Act''),\1\ and Rule 19b-4 thereunder,\2\ notice

is hereby given that on January 13, 1999, the National Association of

Securities Dealers, Inc. (``NASD'' or ``Association''), through its

wholly-owned subsidiary, NASD Regulation, Inc. (``NASD Regulation'')

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 NASD Regulation. The

Commission is publishing this notice to solicit comments on the

proposed rule change from interested persons.

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\1\ 15 U.S.C. 78s(b)(1).

\2\ 17 CFR 240.19b-4.

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

Substance of the Proposed Rule Change

The Association is proposing new NASD Rule 2315, which requires

members to review current financial statements of, and current business

information about, an issuer prior to recommending a transaction to a

customer in an over-the-counter (``OTC'') equity security.

Additionally, the proposed rule change would amend NASD Rule 6740 to

permit members to submit a certification to the Association that states

that the member has conducted a review of specified information and has

fulfilled its obligations under Rule 15c2-11 under the Act \3\ for

documents that currently reside on the SEC's Electronic Data Gathering

and Retrieval System (``EDGAR'') database. Below is the text

[[Page 10038]]

of the proposed rule change. Proposed new language is in italics.

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\3\ 17 CFR 240.15c2-11.

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* * * * *

2315. Recommendations to Customers in OTC Equity Securities

The requirements of this Rule are in addition to other existing

member obligations under NASD rules and the federal securities laws,

including obligations to determine suitability of particular securities

transactions with customers and to have a reasonable basis for any

recommendation made to a customer. This Rule is not intended to act or

operate as a presumption or as a safe harbor for purposes of

determining suitability or for any other legal obligation or

requirement imposed under NASD rules or the federal securities laws.

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

recommend to a customer the purchase, sale, or exchange of any equity

security that is not listed on Nasdaq or on a national securities

exchange and is published or quoted in a quotation medium unless the

member has reviewed current financial statements of, and current

business information about, the issuer, and makes a determination that

such information, and any other information available, provides a

reasonable basis under the circumstances for making the recommendation.

(2) For purposes of this Rule, ``current financial statements''

shall include:

(A) A balance sheet as of a date less than 16 months before the

date of the recommendation;

(B) A statement of profit and loss for the 12 months preceding the

date of the balance sheet;

(C) If the balance sheet is not as of a date less than 6 months

before the date of the recommendation, additional statements of profit

and loss for the period from the date of the balance sheet to a date

less than 6 months before the date of the recommendation;

Financial statements and other financial reports filed during the

12 months preceding the date of the recommendation and up to the date

of the recommendation with any regulatory authority, including the

Commission, foreign regulatory authorities, bank and insurance

regulators; and

(E) All financial information contained in registration statements,

including any amendments, with respect to securities transactions

registered under the Securities Act of 1933 (Securities Act), or in the

case of securities offered pursuant to the exemptions from

registrations provided by Regulation A, Rule 505, or Rule 506 under the

Securities Act, all financial information provided in connection with

offerings conducted pursuant to those rules.

(b) If an issuer has not made current filings required by any

regulatory authority, including the Commission, a foreign regulatory

authority, or bank and insurance regulators, such review must include

inquiry into the circumstances concerning the failure to make current

filings, and a determination, based on all the facts and circumstances,

that the recommendation is appropriate under the circumstances. Such a

determination must be made in writing and maintained by the member.

(c) For purposes of this Rule, ``quotation medium'' shall mean any

quotation system, publication, electronic communication network, or any

other device, including any issuer or inter-dealer quotation system,

that is used to regularly disseminate quotations or indications of

interest in transactions equity securities that are not listed on

Nasdaq or on a national securities exchange, including offers to buy or

sell at a stated price or otherwise or invitations of offers to buy or

sell.

(d) A member firm shall designate a registered individual to

conduct the review required by this rule. In making such designation,

the member firm must ensure that

(1) Either the individual is registered as a Series 24 principal,

or his conduct in complying with the provisions of this Rule is

appropriately supervised by a Series 24 individual; and

(2) Such designated individual has the requisite skills, background

and knowledge to conduct the review required under this rule.

(e) The requirements of this Rule shall not apply to:

(1) Transactions that meet the requirements of Rule 504 of

Regulation D under the Securities Act and transactions with an issuer

not involving and public offering pursuant to Section 4(2) of the

Securities Act;

(2) Transactions with or for an account that qualifies as an

``institutional account'' under Rule 3110(c)(4) or with a customer that

a ``qualified purchaser'' under Section 3(c)(7) of the Investment

Company Act;

(3) Transactions in an issuer's securities if the issuer has $100

million in assets and $10 million in shareholder's equity as of date of

the issuer's most recent audited balance sheet, which balance sheet

should be of a date within 6 months prior to the recommendation; or

(4) Transactions in securities of a bank under Section 3(a)(4) of

the Securities Exchange Act of 1934 and or insurance company subject to

regulation by a state or federal bank or insurance regulatory

authority.

* * * * *

6740. Submission of Rule 15c2-11 Information on Non-Nasdaq Securities

(a)-(d) No change.

(e) As an alternative to submitting to the Association a copy of

the documents required by paragraph (b) of the Rule, a member may

submit to the Association a certification signed by a principal of the

member firm stating that the firm has complied with the requirements of

SEC Rule 15c2-11, including the member's affirmative review obligation,

as to any submission with respect to which the required documents

currently reside in the SEC's EDGAR database.

* * * * *

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

1. Purpose

The NASD has actively studied the OTC market in an effort to

address abuses in the trading and sales of thinly-traded, thinly-

capitalized (``microcap'') securities quoted on the OTC market. The

securities that are the subject of the proposed rule change are not

listed on Nasdaq or any exchange and are quoted on the OTC Bulletin

Board (``OTCBB''),\4\ in the ``pink sheets'' published by the

[[Page 10039]]

National Quotation Bureau, Inc. (``Pink Sheets''), and in other

quotation media where there are no listing requirements. The NASD is

concerned with actual and potential fraud or manipulation in the

markets for these securities, and the connection between potential

fraud and manipulation and the lack of reliable and current financial

information about issuers of microcap securities.

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\4\ The OTCBB is a quotation service that displays real-time

quotes, last sale prices, and volume information in domestic and

certain foreign securities. Eligible securities include national,

regional, and foreign equity issues, warrants, units, and American

Depositary Receipts not listed on any other U.S. national securities

market or exchange. Unlike Nasdaq or registered national securities

exchanges where individual companies apply for listing on the

market--and must meet and maintain strict listing and maintenance

standards--individual brokerage firms, or market makers, enter

quotations for specific securities on their own behalf through the

OTCBB.

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In the listed securities markets, the quoted price of a security

helps to reflect the information available about the listed security

and its issuer. In the OTC market, there are no listing standards and,

therefore, there is a greater need for firms to independently review

financial statements to verify that a recommended transaction in a

microcap security is suitable.\5\ This proposal is meant to address

this issue.

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\5\ The Commission notes that the NASD has recently adopted

amendments to NASD Rule 6530, OTCBB Eligible Securities, to prohibit

members from quoting certain securities through the OTCBB. See

Securities Exchange Act Release No. 40878 (January 4, 1999), 63 FR

1255 (January 8, 1999) (order approving SR-NASD-98-51).

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Proposed Rule 2315--Recommendation Rule. Proposed Rule 2315

(``Recommendation Rule'') would prohibit a member or associated person

from recommending a transaction to a customer in an OTC equity security

that is published or quoted regularly in a quotation medium unless the

member has first reviewed current financial statements and other

business information about an issuer and determined that this

information, along with other information available, provides a

reasonable basis for making the recommendation. Application of the rule

would be limited to equity securities that are not listed on Nasdaq or

any national securities exchange, and that are quoted on the OTCBB, in

the Pink Sheets, or in any other system that regularly disseminates

indications of interest and quotation information. Such systems would

include Web sites, issuer trading services, and other member or non-

member systems that provide this data to the public.

The requirements in the proposed rule would not affect requirements

under the federal securities laws and under NASD rules requiring a

broker-dealer that recommends securities to its customers to have a

reasonable basis for those recommendations.\6\ In addition, the

proposed rule expressly is not intended to act or operate as a

presumption or as a safe harbor for purposes of determining suitability

or for any other legal obligation or requirement imposed under NASD

rules or the federal securities laws.

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\6\ See, e.g., SEC v. Hasho, 784 F. Supp. 1059 (S.D.N.Y. 1992),

citing SEC v. Hanley, 415 F. 2d 589 (2nd Cir. 1969); Securities

Exchange Act Release No. 29094 (April 17, 1991), 56 FR 19148 (April

25, 1991) (adopting amendments to Rule 15c2-11), n.22; and NASD Rule

2310, Recommendations to Customers (Suitability), which requires a

member to have reasonable grounds for believing that a

recommendation to a customer is suitable based on the facts

disclosed, the customer's other security holdings, and his or her

financial situation and needs.

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The proposed rule requires members to obtain and review the

issuer's ``current financial statements'' as defined in paragraph

(a)(2) of the proposed rule. Specifically, members would be required to

obtain and review an issuer's balance sheet that is dated within 16

months of the date of the recommendation, as well as a profit and loss

statement for the period of 12 months preceding the date of the balance

sheet. Also, members would have to obtain and review any financial

statements filed during the 12 months preceding the date of the

recommendation.

Under circumstances in which a proposed recommendation to the

customer is not made within 6 months of the date of the issuer's

balance sheet, the member would be required to obtain and review an

additional profit and loss statement of the issuer from the date of the

balance sheet to a date within 6 months of the proposed recommendation

to the customer.\7\ For example, if a member proposes to make a

recommendation to a customer on March 15, 1999, the member would be

required to obtain and review the following information to satisfy the

proposed rule: A balance sheet of the issuer with a calendar year-end

of December 31, 1997; a profit and loss statement for the 12-month

period ended December 31, 1997; and a 9-month interim profit and loss

statement for the period of January 1, 1998, through at least September

30, 1998.

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\7\ This requirement is similar to language in paragraph (a)(5)

of Rule 15c2-11 under the Act, which specifies the information a

broker-dealer must review before initiating or resuming quotations

for non-reporting issuers' securities. Rule 15c2-11 requires a

broker-dealer to obtain and review certain information before

initiating or resuming quotations in a quotation medium. 17 CFR

240.15c2-11; see also Securities Exchange Act Release No. 29094

(April 17, 1991), 56 FR 19148 (April 25, 1991). On February 19,

1999, the Commission approved the publication of a release

reproposing amendments to Rule 15c2-11.

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When issuers file reports with the SEC or with other foreign or

domestic regulatory authorities, the proposed rule would require

members to collect and review all financial statements and other

financial reports filed by the issuer within the 12 months preceding

the recommendation. Members also must obtain and review financial

information contained in registration statements of registered

securities and all financial information provided in connection with

securities offered pursuant to an exemption from registration.

If an issuer has not made current filings as required by a

regulatory authority, a member must inquire into the circumstances

concerning the issuer's failure to file current reports, and determine

based on all the facts and circumstances whether a recommendation is

appropriate under the circumstances. The evidence of the determination

to make a recommendation in this situation should be in writing and

maintained by the member.

The proposed rule requires a member to designate registered

individual to conduct a review of the information specified in

paragraph (a)(2) of the proposed rule. In making this determination, a

member firm must ensure that either the individual is registered as a

Series 24 principal, or his conduct in complying with the provisions of

this proposed rule is appropriately supervised by a Series 24

individual. The designated individual should possess the requisite

skills, background, and knowledge to conduct the review required by the

proposed rule. The associated person making the recommendation to the

customer is obligated, prior to the recommendation, to assure that the

member has conducted such a review of the specified information in

accord with the proposed rule. The member should document the list of

information reviewed, the date of the review, and the name of the

person performing the review of the required information under the

proposed rule.

Exemptions. The proposed rule exempts from its coverage

transactions that are exempt from registration under Section 4(2) of

the Securities Act of 1933 (``Securities Act'') \8\ and transactions

that meet the requirements of Rule 504 of Securities Act Regulation

D.\9\ This exemption is based on the fact that, unlike the specific

disclosure requirements that apply to registered and other offerings,

the Securities Act does not mandate that Section 4(2) and Rule 504

issuers furnish specified information to purchasers.

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\8\ 15 U.S.C. 77d(2).

\9\ 17 CFR 230.504.

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Because of this exemption, there are no specific review

requirements under the proposed Recommendation Rule for broker-dealers

that recommend transactions in securities exempt from registration

under Rule 504 or Section

[[Page 10040]]

4(2) of the Securities Act. However, under prevailing law, including

Rule 10b-5 under the Act \10\ and NASD Rule 2310, a broker-dealer must

have a reasonable basis for recommending a securities transaction to a

customer and must make an appropriate suitability determination. In

order to satisfy these requirements with respect to Rule 504 or Section

4(2) exempt offerings, the broker-dealer must review any information

provided by the issuer as well as other relevant information, including

information obtained in response to ``red flags'' and otherwise.

Broker-dealers that recommend transactions covered by the

Recommendation Rule also must comply with these requirements, as well

as with the Rule's requirement to review specific identified

information.

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\10\ 17 CFR 240.10b-5.

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The rule also exempts transactions with or for institutional

investors. For purposes of this exemption, an account or customer must

qualify either as an ``institutional account'' under NASD Rule

3110(c)(4) or as a ``qualified purchaser'' under section 3(c)(7) \11\

of the Investment Company Act of 1940 (``ICA'').\12\ Transactions with

or for institutional investors are exempt from the proposed rule

because institutional customers are generally knowledgeable and

sophisticated regarding investments in this marketplace.

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\11\ 15 U.S.C. 80a-3(c)(7).

\12\ NASD Rule 3110(c)(4) defines an ``institutional account''

as the account of a bank, savings and loan association, insurance

company, or registered investment company; an investment adviser

registered under Section 203 of the Investment Advisers Act of 1940;

or any other entity (whether a natural person, corporation,

partnership, trust, or otherwise) with total assets of at least $50

million. The term ``qualified purchaser'' as used in Section 3(c)(7)

of the ICA is described in Section 2(a)(51) of the ICA as: (1)

individuals (including any shared ownership interest in an issuer

with the person's qualified purchaser spouse) who own not less than

$5 million in investments; (2) specified family-owned companies with

not less than $5 million in investments; (3) trusts established and

funded by qualified purchasers for which investment decisions are

made by a qualified purchaser; and (4) entities that in the

aggregate own and invest on a discretionary basis for their own

account, or for the accounts of other qualified purchasers, not less

than $25 million in investments. 15 U.S.C. 80a-2(a)(51).

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In addition, the exemption would exclude from the scope of the

proposed rule securities of certain issuers, including foreign issuers,

with at least $100 million in assets and $10 million in shareholders'

equity, that are not listed on a national securities exchange or

Nasdaq. The exemption is based on the premise that securities of these

issuers are more likely to be followed by market analysts, are less

likely to be the subject of fraudulent sales practices, and are

generally more liquid. This exemption also minimizes the potential that

the proposed rule may competitively disadvantage well-capitalized,

internationally-traded issuers that have chosen not to list on a

national securities exchange or Nasdaq.

In setting the financial criteria for an exemption, the NASD

selected financial criteria of at least $100 million of total assets

and stockholders' equity of at least $10 million. These criteria

comport with NASD Rule 4420(f) and Section 107(A) of the American Stock

Exchange Guide, which set forth the financial standards to qualify to

quote on the Nasdaq and the Amex, respectively, for ``other

securities'' that are not otherwise covered by conventional listing

criteria for domestic and foreign issuers. In order to rely on the size

exemption, a member must obtain the issuer's audited financial

statements prepared in accordance with either U.S. or foreign Generally

Accepted Accounting Principles and dated within 6 months of the date of

the recommendation or trade to determine whether the issuer's

securities quality for the exemption.

Under the proposed rule, securities of banks, as defined under

section 3(a)(6) of the Exchange Act,\13\ and insurance companies are

exempt from the proposed rule on the ground that banks and insurance

companies are subject to independent oversight by federal and state

regulatory authorities, and are less likely to be the subject of market

manipulation or issuer fraud.

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\13\ 15 U.S.C. 78c(a)(6).

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Amendments to NASD Rule 6740. Currently, NASD Rule 6740 requires

members to submit the Association certain specified information as

required by Rule 15c2-11 under the Act before the member can initiate

or resume quotations in a non-Nasdaq security in any quotation medium.

The proposed amendment to NASD Rule 6740 will permit members to elect

not to submit to the Association hard copies of issuer reports that are

filed by the issuer through the SEC's EDGAR database and that currently

reside on such system. Under this alternative, members may submit to

the NASD a certification that states that the member has conducted a

review of the relevant documents and has fulfilled its Rule 15c2-11

obligations, including the affirmative review obligation. This

certification must be reviewed and signed by a principal of the member

firm.

2. Statutory Basis

The NASD believes that the proposed rule change is consistent with

the provisions of section 15A(b)(6) \14\ of the Act, which requires,

among other things, that the Association's rules must be designed to

prevent fraudulent and manipulative acts and practices, to promote just

and equitable principles of trade, and in general, to protect investors

and the public interest. The NASD believes that the proposed rule

change will address actual and potential fraud in the quotation and

trading of unlisted securities.

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\14\ 15 U.S.C. 78o-3(b)(6).

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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 impose

any inappropriate burden on competition.

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 NASD Notice

to Members 98-15 (``Notice'' or ``NTM'') in January 1998. A total of 43

comments were received in response to the Notice. As published in the

Notice, proposed Rule 2315 would have required members to review

certain financial statements of an issuer prior to making a

recommendation in an OTC equity security to a customer and deliver to

customers a disclosure statement regarding the differences between

listed and OTC markets prior to the first purchase and annually

thereafter (Rule 2360, which was proposed to be numbered Rule 2350 at

the time the NTM was published).

Of the 43 responses received, most (25 responses, or approximately

60%) were from broker-dealer firms or registered persons and the

balance (18 comments, or approximately 40%) were from individual

investors, issuers, various state agencies, trade associations, and

other interested parties. In providing comments, a majority of

commenters expressed a position (i.e., approval or disapproval)

regarding each specific proposal. Other commenters did not provide a

stated position on each proposal, but identified particular issues with

certain proposals and provided written comments.

As to proposed Rule 2315, 11 commenters approved or approved with

qualification, and 18 commenters disapproved of, the rule proposal. The

comments generally in favor of the proposal approved of the

rule'placing responsibility on the firm that is soliciting an order and

indicated that, unless a broker-dealer is compelled to maintain

information and review this

[[Page 10041]]

information, fraudulent omission of material fact will occur. The

comments opposing the proposal generally maintained that the current

rules are sufficient and the proposed rules are extremely burdensome.

In particular, the opponents state that the record-keeping and

compliance burden is particularly chilling to these stocks and the time

it takes to locate and review financial statements on a company will

limit a firm's choice of stocks to recommend.

The Association is not proposing to adopt Rule 2360 at this time.

Therefore, this proposed rule change does not discuss the comments on

that proposed rule.

After the public comment process, the staff recommended and the

NASD and NASD Regulation Boards approved the following modifications to

the proposed rule at their meetings in May 1998. Proposed Rule 2315 was

amended to add exemptions for securities of certain financially sizable

issuers, securities of banks and insurance companies, and transactions

with institutional investors. In addition, the Rule was amended to

require a member to review certain current financial information and

other business information about the issuer, in addition to the

requirements set out in the original rule proposal, before making a

recommendation to a customer, and to require members to designate a

qualified registered individual to review the information required by

the rule.

After NASD Board approval of the modifications to the proposed

rules in May, the staff received an additional comment that requested

the staff to consider an additional exemption from the scope of

proposed Rule 2315. The commenter suggested that recommended sales

transactions in OTC equity securities with customers should be exempt

from proposed Rule 2315. The premise for the exemption is based on the

need to expedite liquidation of customer positions in OTC equity

securities without the need for a member to review specified

information regarding the issuer as required by the proposed rule. The

commenter suggested that a delay in processing the sale may preclude a

customer from capturing a particular market opportunity which may

result in the customer reducing his return or increasing his loss in a

particular investment. The suggested exemption would not apply to short

sales by investors in these securities. Due to the nature and the

timing of the comment, NASD staff requested that the Commission

specifically seek comment in its notice to the public on the potential

need for such an exemption from proposed Rule 2315.

At a subsequent Board meeting in December 1998, the staff

recommended and the Board approved further modifications to Rule 2315.

In particular, the Board approved an expansion of the definition of

``current financial statements'' in NTM 98-15 to include financial

information contained in the registration statements of Securities Act

registered securities and all financial information provided in

connection with securities offered in connection with exemptions from

registration provided by Regulation A,\15\ Rule 505,\16\ or Rule

506.\17\ The Board also approved a revision to the exclusions from the

Rule for initial public offerings and offerings conducted in compliance

with Regulation A and Rules 504-506 under the Securities Act. That

exemption is now limited to transactions that meet the requirements of

Rule 504 and Section 4(2) transactions.

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\15\ 17 CFR 230.251.

\16\ 17 CFR 230.505.

\17\ 17 CFR 230.506.

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

for Commission Action

Within 35 days of the 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 the 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, including whether the proposal is

consistent with the Act. Specifically, the Commission seeks comment on

the potential need for an exemption from proposed NASD Rule 2315 for

recommended sales transactions in OTC equity securities. 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 at 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 File No. SR-NASD-99-4 and should be

submitted by March 22, 1999.

For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.\18\

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\18\ 17 CFR 200.30-3(a)(12).

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Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 99-4954 Filed 2-26-99; 8:45 am]

BILLING CODE 8010-01-M