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87-31 Mark-Ups and Mark-Downs on Zero-Coupon Securities

TO: All NASD Members and Other Interested Persons

EXECUTIVE SUMMARY

The NASD wishes to apprise its members of the SEC's recent release relating to mark-ups on zero-coupon securities. The SEC has become aware of potential abuses in this area and emphasizes that applicable provisions of the federal securities laws, NASD rules, and MSRB rules apply equally to zero-coupon securities. The SEC cautions broker-dealers to establish mark-ups in these securities based upon their face value rather than taking into account the discount at which such securities are sold.

The text of the SEC's release, as reprinted in the Federal Register, is attached.

SUMMARY OF THE SEC'S RELEASE

In Release No. 34-24368, dated April 21, 1987, the SEC expressed concern about the mark-up or mark-down practices of broker-dealers in conjunction with secondary market transactions in zero-coupon securities. In the release, the SEC defines "zero-coupon securities" to include securities sold at original issue discounts, stripped coupon bonds, or coupons stripped from bonds and sold as separate instruments.

The SEC states that the anti-fraud provisions of the federal securities laws proscribe charging excessive mark-ups to retail customers without proper disclosure to the customers, and that rules of the self-regulatory organizations proscribe excessive mark-ups on the sale of securities in a principal transaction, regardless of whether the mark-up is disclosed. The SEC further states that it has consistently held that mark-ups in excess of 10 percent above the prevailing market price are fraudulent in the sale of equity securities and that mark-ups in the sale of debt securities generally are expected to be lower than those on equities. The release also contains a detailed discussion of case law in the area of mark-ups, background and application of the NASD's Mark-Up Policy, and MSRB Rules G-17 and G-30 as they relate to mark-ups.

The SEC indicates that for zero-coupon securities, it is particularly difficult to ascertain the prevailing market price upon which to base a mark-up and that generally the best indication of the prevailing market is the broker-dealer's contemporaneous retail purchases adjusted to reflect mark-downs.

The SEC also believes that the market price for an "unstripped" security is not necessarily an appropriate indication of its zero-coupon components and that the market must be established for each stripped coupon and bond separately to ensure that the mark-up on each is not excessive.

Finally, the SEC states that basing mark-ups upon a percentage of a bond's face value may result in inappropriate mark-ups on securities trading at deep discounts.

For further information on the SEC's release, please contact either Alden Adkins, SEC Branch Chief, at (202) 272-2857, or Christine Sakach, SEC Attorney, at (202) 272-2418. Questions concerning this notice should be directed to the NASD Office of the General Counsel at (202) 728-8294.

Sincerely,

Frank J. Wilson
Executive Vice President and General Counsel

Attachment

SECURITIES AND EXCHANGE COMMISSION

(Release No.34-24368)

Zero-Coupon Securities

AGENCY: Securities and Exchange Commission.

ACTION: Notice to broker-dealers concerning disclosure requirements for mark-ups on zero-coupon securities.

SUMMARY: The Commission has become aware of potential abuses in the markups and mark-down practices of broker-dealers trading various, zero-coupon securities. Because there is limited market Information available concerning the secondary market for zero-coupon securities, and those securities generally are sold at a deep discount to the face amount, investors may not fully appreciate the size of the percentage mark-ups that sometimes have been charged by broker-dealers. Broker-dealers must recognize that sales of zero-coupon securities with mark-ups that are excessive and undisclosed violate the federal securities laws, and the rules and regulations of the Commission. Further, excessive markups, whether or not disclosed, violate the rules of the National Association of Securities Dealers, Inc. ("NASD") and the Municipal Securities Rulemaking Board ("MSRB").

DATE: April 21, 1987.

FOR FURTHER INFORMATION CONTACT: Alden Adkins, Branch Chief, (202) 272-2857. or Christine Sakach, Attorney, (202) 272-2418, Division of Market Regulation, Securities and Exchange Commission, 450 Fifth Street NW., Washington, DC 20549.

SUPPLEMENTARY INFORMATION:

I. Background

Zero-coupon securities are debt securities that do not pay interest to tbe holder periodically prior to maturity, and are sold, therefore, at a substantial discount from the face amount.1 Most bonds can be issued in zero-coupon form or can be stripped; tbe discount from face value in effect represents the aggregate interest the holder receives if he holds the security to its stated term of maturity. Zero-coupon securities have become increasingly popular with retail customers for various reasons including the substantially lower price of these instruments relative to coupon bonds and the locked-in yields they produce If held to maturity.2 While stripped United States Treasury securities initially were the most prevalent type of zero-coupon security,3 zero-coupon municipal securities also are now being issued.4

Dealers engaging in principal transactions with customers usually charge their customers a net price that, in lieu of or in addition to a commission or service charge, includes a mark-up or mark-down5 over the prevailing inter-dealer market price as compensation for effecting the trade. Rule 10b-10 under the Securities Exchange Act of 1934 ("Exchange Act")6 generally requires the customer's confirmation for transactions in debt securities to show the net dollar price and yield. It does not, however, require that the mark-up be separately stated. In addition to these confirmation requirements. Rule lOb-5 requires disclosure of excessive mark-ups7 and the rules of the NASD and MSRB prohibit excessive dealer mark-ups.8

II. Discussion

A. Federal Securities Law

The antifraud provisions of the federal securities laws proscribe deceptive pricing practices by broker-dealers.9 Charging retail customers excessive mark-ups without proper disclosure constitutes such a deceptive practice or scheme.10 The fact that a broker-dealer is acting in a principal capacity does not diminish its obligation to deal fairly with public customers.11 This duty of fair dealing includes the implied representation that the price a firm charges bears a reasonable relationship to the prevailing market price.12 If a dealers price to a customer includes an excessive mark-up over the prevailing market price, then, absent proper disclosure, the dealer has violated section 10(b) of the Exchange Act, and Rule 10b-5 thereunder, and section 17(a) of the Securities Act of 1933 ("Securities Act").13 The Commission consistently has held that, at the least, undisclosed mark-ups of more than 10% above the prevailing market price are fraudulent inthe sale of equity securities.14 The Commission also consistently has taken the position that mark-ups on debt securities, including municipal securities, generally are expected to be lower than mark-ups on equity securities,15 and has upheld NASD decisions finding mark-ups as low as 5.1% to violate the rules of the MSRB.16

As a result of the Commission's ongoing oversight of the secondary markets, the Commission believes that as a general matter, common industry practice regarding mark-ups is to charge a mark-up over the prevailing inter-dealer market price of between 1/32% and 3½% (including minimum charges) for principal sales to customers of conventional or "straight" Treasuries, depending on maturity, order size and availability. In light of this evidence, the Commission concludes that mark-ups on government securities, like mark-ups on corporate and municipal debt securities, usually are smaller than those on equity securities.

To determine the mark-up charged to the customer, the broker-dealer must determine the "prevailing market price." 17 The dealer mark-up equals the price charged to the customer minus the prevailing market price. The proper method for determining the prevailing market price for a security, however, is often the major contested issue in markup cases.18

As a general matter, the best evidence of the prevailing market price for a broker-dealer who is not making a market in the security is that dealer's contemporaneous cost of acquiring a security.19 For integrated market makers (i.e., dealers who both make a market in a security and sell it to retail customers), the best evidence of the prevailing market generally is contemporaneous sales by the firm (or by other market makers) to other dealers.20 For actively traded securities, if ask quotations have been determined to be an accurate indication of the offer side of the market [i.e., transactions generally occur at these quotations), they may be used instead of sales transactions. For inactively traded securities, inter-dealer sales transactions are of primary importance in calculating a firm's mark-ups because quotations for such securities frequently are the subject of negotiation.21 Thus, the quotations for the security may not accurately reflect the prevailing market price for the security.22

B. NASD and MSRB Regulation

Since 1943 the NASD has enforced an interpretation of its Rules of Fair Practice that deems it inconsistent with just and equitable principles of trade for a member to enter into any transaction with a customer at a price not reasonably lejated to the current market price of the Security.23 Under the NASD's Mark-Up Policy, mark-ups for equity securities greater than 5% above the prevailing market price generally are considered to be unreasonable, and thus violative of NASD rules.24

Similarly, excessive mark-ups involving municipal securities have been held to violate MSRB Rule G-17, which requires dealers to deal fairly with their customers,25 and MSRB Rule C-30, which requires dealers to sell municipal securities to customers at a price which is "fair and reasonable, taking into consideration all relevant factors."26 The NASD and MSRB rules cannot be satisfied by disclosure of the amount of the mark-up.27

C. Applicability of Policies to Zero-Coupon Bonds

Mark-ups for corporate, municipal and government debt securities, including zero-coupon securities, are subject to the applicable rules and policies described above. Thus, charging an excessive, undisclosed mark-up on a transaction in a zero-coupon security violates section 10(b) and Rule lOb-5.28 Similarly, excessive mark-ups on zero-coupon securities violate the NASD's and MSRB's rules within their respective jurisdictions.

(1) Prevailing Market Price29

As with other securities, the first step in calculating an appropriate mark-up for zero-coupon securities is to determine the prevailing market price. Ascertaining the prevailing market price is particularly difficult for zero-coupon securities because there usually it limited information regarding inter-dealer market transactions. Indeed, where the inter-dealer market is dominated by a single market maker (which may be the case where a zero-coupon security is a proprietary product of a broker-dealer), the best evidence of the prevailing market generally will be the broker-dealer's contemporaneous retail purchases, adjusted to reflect the mark-down inherent in such customer transactions.30 Moreover, because both the stripped interest coupons and the bond are separate securities, it is not sufficient for a broker-dealer to assure itself that the aggregate mark-up for the unstripped security taken as a whole is not excessive. Instead, the broker-dealer must evaluate the mark-up for each stripped coupon and the stripped bond separately and ensure that each is not excessive.

(2) Amount of Mark-up

As noted above, the Commission, the NASD and the MSRB have indicated that the percentage mark-up for debt securities historically has been less than the amount charged for equity securities. It is expected, therefore, that percentage mark-ups on zero-coupon securities, as with other debt securities, usually will be smaller than those on equity securities. Therefore, broker-dealers should be advised when marking up debt securities, including zero-coupon securities, that what might be an appropriate mark-up for the sale of an equity security may be an excessive mark-up for a debt security transaction of the same size.31

The Commission has become aware of the practice of a number of broker-dealers of charging a percentage markup based on the face amount of a zero-coupon security for all maturities, a pricing practice often employed in the market for conventional coupon bonds. Although this percentage may be as low as 1% of the face amount, such pricing can result in a mark-up that is excessive relative to the prevailing market price because zero-coupon bonds trade at a deep discount.33 This problem will be especially acute for securities with long maturities because the purchase price, net of the mark-up, that an investor will pay per $1,000 face amount for a zero-coupon bond with a long maturity is significantly less than that for a zero-coupon with a short maturity.

III. Conclusion

The established mark-up rules and policies of the Commission, the NASD and the MSRB apply fully to transactions in zero-coupon securities. The Commission's rules prohibit excessive undisclosed mark-ups, and the NASD's and MSRB's rules and policies prohibit excessive mark-ups whether or not disclosed. The Commission expects that mark-ups on zero-coupon securities, as with other debt securities, usually will be less than those charged for equity securities. In this regard, markups calculated based upon the face amount at maturity may be excessive in relation to the discounted price of the security.

The Commission urges broker-dealers to review their procedures and policies for marking up zero-coupon securities to ensure that they are consistent with the federal securities laws, the rules and regulations of the Commission, and the rules of the NASD and the MSRB.

Dated: April 21, 1987.

By the Commiision.

Jonathan G. Katx,

Secretary.

[FR Doc. 87-9628 Filed 4-28-87; 8:45 am]

BILLING CODE 8010-01-M


1 As used in this ralease the term "zero-coupon security" includes: (1) Original issue discount bonds (bonds sold by the issuer without coupons attached); (2) stripped coupon bonds (bonds originally issued with coupons from which the coupons have been stripped); and (3) interest coupons stripped from bonds and sold as separate instruments.

2 The holders of coupon bonds bear the risk that they may not be able to reinvest periodic interest payments at the same rate as that used to calculate their original yield to maturity.

3 More recently, an active secondary market has developed in "STRIPS" bonds that are directly issued by the US Treasury in a format that allows dealers immediately to sell them as zero-coupon products and thus do not entail the repackaging steps that are necessary to tranaform straight Treasuries into zero-coupon instruments. Prior to Treasury's stripping program, stripped U.S. Treasury bonds were created as proprietary products of certain broker-dealers. Merrill Lynch, Pierce, Penner & Smith Incorporated ("Merrill") and Salomon Brothers Inc. ("Salomon"), for example, sold proprietary zero-coupon U.S. Treasury products called TIGRs (Treasury Investment Growth Receipts) and CATS (Certificates of Accrual on Treasury Securities), respectively. Also, several other firms issued zero-coupon instruments under the nonproprietary name "Treasury Receipts" All were created by stripping the coupons from Treasury securities and setting a certificate representing an interest in the stripped coupons or securities. Since implementation of the Treasury program, Merrill and Salomon have not issued new TIGRs or CATS.

4 Since enactment of the Tax Reform Act of 1986, Pub. L. No. 99-514. 100 Stat.____ (1986), several broker-dealers have introduced stripped municipal bonds. See Monroe. "Stripped Municipal Bonds to Be Offered by Securities Firms Under New Tax Law." Wall St. J., at 53. col. 2. October 21 1986; "Morgan Stanley joining issuers of Stripped Munis" Wall St. J., at 41, col 1, October 29. 1986; and "More Zero-Coupons" Daily Bond Buyer, at 2. col 4. November 5, 1986.

5 This release generally will discuss broker-dealer sales transactions involving mark-ups. Tbe principles stated in the release, however, are equally applicable to broker-dealer purchase transactions involving mark-downs.

6 17 CFR 240.10b-10 (1986). Rule 10b-10 applies to transactions by broker-dealers in US. Treasury securities and corporate bonds but not municipal securities. The rule applies to zero-coupon securities as well as other forms of debt. The NASD and MSRB have substantially similar confirmation rules. See Disclosure on Confirmations, NASD Manual (CCH) ¶ 2182; and MSRB Rule G-12. MSRB Manual (CCH) ¶ 3571.

7 See, e.g., Krome v. Merrill Lynch & Co., 837 F. Supp. 910 (S.D.N.Y. 1986). But see Ettinger v. Merrill Lynch, Pierce, Penner & Smith Inc., Fed. Sec L. Rep. (CCH) ¶ 93.102 (E.D. Pa, Dec. 22, 1986), appeal pending. No 87-104S (3d Clr.). In Ettinger, the court held that Rule 10b-5 does not require that excessive mark-ups be disclosed. Tbe court also held that the Commission's failure to promulgate a rule defining under what circumstances a mark-up is excessive precluded the court's finding Merrill's mark-up excessive. The Commission disagrees with the district court's holding and will file a brief, amicus curiae in the court of appeals arguing that Rule 10b-5 imposes an obligation to disclose excessive mark-ups to customers and that decided cases and rules provide adequate guidance regarding what constitutes an excessive mark-up.

8 While disclosure is one of the factors to be considered in determining the reasonableness of a mark-up under self regulatory organization rules. In re Herrick. Waddell & Co., Inc., 25 S.E.C. 437, 448 (1947), these rules are not antifraud rules, but rules reflecting just and equitable principles of trade, and thus prohibit mark-ups which are unfair in the light of all other relevant circumstances, even if disclosed. In re Amsbray, Allen & Morton. Inc., 42 S.E.C. 919.922 (1986); In re Thill Securities Corporation, 42 S.E.C. 89.95 (1984).

9 The Commission recently has announced settlement of a mark-up case involving zero-coupon securities. See In re Sutro & Co. Incorporated. Securities Exchange Act Release No. 23883. 38 S.E.C. Doc. 1199.

10 The previous cases and Commission decisions have not addressed what disclosure would have been sufficient under the facts and circumstances of those cases.

11 In re Duker & Duker. 6 S.E.C. 388 (1939). cited in In re Alstead. Dempsey & Co., Securities Exchange Act Release No. 20825 (April 5 1984). 30 S.E.C. Doc. 259; and 3 L. Loss. Securities Regulation 1483(1961).

12 Charles Hughes & Co., Inc v. SEC. 139 F. 2d 434. (2d) Cir.). cert. denied. 321 U.S. 786 (1943). See L. Loss. Fundamentals of Securities Regulation 948-58 (1983). Although some cases have not been couched in terms of disclosure, the Commission believes that the gravamen of a mark-up violation under the federal securities laws is charging excessive mark-ups without disclosure

13 See. e.g., Ryan v. SEC. Sec Reg & L. Rep. (BNA) No 26 at 1273 (July 1. 1983) (9th Cir. May 23 1983). affg. In re James E. Ryan. Securities Exchange Act Release No 18617 (April 5. 1982). 24 S.E.C Doc. 1859; Barnett v. United States. 319 F. 2d 340 (8th Cir. 1981); Samuel B Franklin & Co v. SEC 290 F.2d 719 (9th Cir). cert denied 368 U.S. 889 (1981): and Charles Hughes & Co v. SEC. 139 F.2d 434. 437 (2d Cir. 1943). cert denied. 321 U.S. 788 (1944). If it needs repetition at this late date, dealers engaged in over-the-counter trading with their customers are held to a simple standard:
When nothing [is] said about market price, the natural implication in the untutored minds of the purchasers [is] that the price asked [is] close to the market. The law of fraud knows no difference between express representation on the one hand and implied misrepresentation or concealment on the other . . . .
Charles Hughes & Co., 139 F.2d at 437. The dealer's disclosure obligation reflects Congress' determination to regulate broker-dealers so as to require a "high standard of business ethics." US v.Naftalin. 441 U.S. 766, 778 (1979). The disclosure obligation also may be justified by that feature of the normal functioning of the secondary over-the-counter market which affords each purchaser the ability to make a realistic assessment of the risk of profit or loss upon resale immediately or (after allowing for intervening market movements and accompanying changes in inter-dealer bid-asked spreads) at some subsequent lime Undisclosed excessive mark-ups distort thai risk and frustrate that ability.

14 In re Alstead, Dempsey & Co.,supra note 11: In re Peter J. Kisch. Securities Exchange Act Release No. 19005 (August 24.1982). 25 S.E.C. 1533. 1539; In re Powell & Associates, Securities Exchange Act Release No. 18577 (March 22, 1982). 24 S.E.C. Doc. 1871. 1873; James E. Ryan, supra note 12; In re Sherman Cleason. IS SEC. 639. 8S1 (1944): and Duker&Duker. supra note 11. at 388-87

15 In re Crosby ft Elkm. Inc.. 22 S.E.C. Doc. 772. 77S (1981): In re Edward ). Blumenfeld. 18 SEC Doc. 1.379.1.381 (1980): and SEC v Charles A. Morris & Associates. Inc.. 788 F. Supp. 1327,1334 n.J (W.D. Term 1973). The Commission has observedthat It Is the Industry practice, in general, for broker-dealers in principal transaction! to charge retail customers mark-ups on sales of debt securities that are measurably lower than those charged on sales of equity securities.

16 In re Staten Securities Corporation. Securities Exchange Act Release No. 18628 (April 9. 1982). 25 SEC Doc 2008

17 See discussion, infra Section U C (l). on the method of determining the prevailing market price."

18 See N. Wolfson. R. Phillip* ft T. Ruseo. Regulation of Broken. Dealers and Securiliet Market* 2-48 (1977).

19 See e.g.. In re Peter |. Kisch. supra note 14. at 1530: and In re Alstead. Dempsey ft Co.. Inc. tupro note 11.

20 See id.

21 Stated otherwise, the quotation* are not firm and transactions often do not occur it or around the quotation*.

22 See In re Alstead. Dempsey ft Co.. Securities Exchange Act Release No 20825 (April 5.1984). 30 8 EC Doc 2S9. offg and rev g. in part AlsleadL Strangis ft Dempsey. Incorporated, Admin. Pro. File No. 3-8135 (December 2a 1982). Cf. B. Becker ft H. Kramer. SEC Plays Proper Role in OTC Pricing Regulation. Legal Times. November 28,1984. at 14.
In situations where the security I* not only inactively traded, but a competitive market does not exist, the u*e of market maker sales or quotation* may be impractical or misleading. Accordingly, the most reliable besls for determining the prevailing market in such a "dominated" market generally la the dealer's contemporaneous coet which is either the price the market maker paid to other dealer* or I* the price paid to retail customers, ad|usted for (/.«.. by adding beck) the mark-down inherent in the transaction.

23 Interpretation of the Board of Governors on the NASD Mark-Up Policy. NASD Manual (CCH) f 2154.

24 Samuel B. Franklin » Co.. supra note 13; and In re Vota ft Co.. Inc. Securities Exchange Act Release No. 21301 (September 10.1984). 31 S.E.C. Doc 490. As with the Commission's mark-up policy, the NASD's i% threshold is only a guideline. The circumstances surrounding trading in a security may suggest that mark-ups lass than 5% may be unreasonable, or that mark-up* greater than these figures may be reasonable. See. e.g.. In re SUten Securities Corporation, supra note 18.

25 MSRB Manual[CCH) • 3581.

26 MSRB Manual (CCH) 3648.

27 But cf.. supra note 8.

28 SECv. MVSecurities. Inc.. (S.D.N.Y.. No. 84 Civ 1184). Litigation Rel. No. 10288 (February 21. 1984). 29 S.E.C. Doc. 1454: and Litigation R*L No. 10303 (March 5.1984). 29 S.E.C. Doc 1501 (describing consent order). In that case, the Commission's memorandum of law requesting t temporary restraining order alleged mark-up* on tero-coupon bonds that were excessive compared to the firm'* contemporaneous cost. Set Memorandum in Support of Application for an Order lo Show CtuM, Temporary Restraining Order, and Motion for a Preliminary Injunction and Other Equitable Relief, at 23. in SEC v. MV Securities. Inc.. (S.D.N.Y.. No. 84 Civ. 1164). See In re Sutro a Co. Incorporated, lupra note 9.

29 See discussion. $upra Section 11 A

30 In re AUtead. Dampsey a Co. supra note 11. See Inn Manthoa. Moaa a Co. 40 S.E.C. 542.543-44 (1881). See N. Wolfton. R. Phillip* ft T. Ruaao. lupra not* 15. at 2-47; and S L Loaa. Securitiet Regulation 3088(1861).

31 Cf. eg.. "(A) higher percentage of mark-up customarily applie* to a common dock tranaactlon than to a bond transaction of the same tize." See NASD Mark-Up Policy. NASD Manual (CCH) 1 21S4.



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