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86-74 Proposed Amendments to Article III, Section 19(f) and Section 33(d) of the NASD Rules of Fair Practice and Article X, Section 6 of the NASD By-Laws

IMPORTANT MAIL VOTE

OFFICERS, PARTNERS AND PROPRIETORS

TO: All NASD Members

LAST VOTING DATE IS NOVEMBER 28, 1986.

••• Executive Summary

NASD members are invited to vote on the following amendments to the NASD Rules of Fair Practice and the NASD By-Laws:

  • Article III, Section 19(f) of the NASD Rules of Fair Practice — would permit members or persons associated with members to receive performance-type fees under circumstances similar to those in which investment advisers are permitted by the SEC to receive such fees. This amendment is a result of recent adoption by the SEC of a rule codifying its interpretation of performance-type compensation.
  • Article III, Section 33(d) of the NASD Rules of Fair Practice — is a technical rule change, made at the prompting of the SEC, amending the definition of "option" to incorporate the definition contained in the Securities Exchange Act of 1934.
  • Article X, Section 6 of the NASD By-Laws — creates a provision authorizing compensation of members of Extended Hearing Committees. This change is made in accordance with amendments to the NASD Code of Procedure.
    These proposed amendments have been approved by the NASD Board of Governors and now are being submitted for membership approval. Prior to becoming effective, they must also be approved by the SEC.

OVERVIEW

The proposed amendment to Article III, Section 19(f) of the NASD Rules of Fair Practice would, under certain circumstances, allow performance-type fees. Section 19(f) generally prohibits members or persons associated with members from sharing in the profits or losses in customer accounts other than in direct proportion to the amount invested. The proposed amendment would permit members and associated persons to receive performance fees under circumstances similar to those in which investment advisers are permitted by the SEC to receive such fees. The text of the proposed amendment is attached as Exhibit A.

The proposed amendment to Article III, Section 33(d) of the NASD Rules of Fair Practice is essentially a technical change that would amend the definition of "option" to include any put, call, straddle or other option that is a "security" as defined in Section 3(a)(10) of the Securities Exchange Act of 1934, rather than as defined in Section 2(1) of the Securities Act of 1933. The text of the proposed amendment is attached as Exhibit B.

The proposed amendment to Article X, Section 6 of the NASD By-Laws creates an exception to the general rule that members of NASD hearing panels do not receive compensation. This amendment would allow implementation of changes to the NASD Code of Procedure, which provide for extended hearings. Pursuant to those procedures, such committee members will be compensated at the same rate as members of NASD arbitration panels. The text of the proposed amendment is attached as Exhibit C.

BACKGROUND

I. Amendment to Article III, Section 19(f), NASD Rules of Fair Practice

This amendment was considered by the Board of Governors in view of the recent promulgation by the SEC of Rule 205-3 under the Investment Advisers Act of 1940 (Advisers Act). In the past, the NASD has occasionally taken no-action positions with respect to members' receipt of certain performance-type fees in circumstances where a customer has entered into an agreement with a member or persons associated with a member and the facts indicate that (1) the investment is relatively large; (2) the number of investors is limited; (3) there is evidence of the investors' sophistication; and (4) the agreement could be reasonably considered to be entered into by virtue of arm's-length negotiation.

The recent adoption of SEC Rule 205-3 under the Advisers Act marks the codification of the SEC staff's position since 1975 that, under certain factual circumstances, the prohibitions of Section 205(1) of the Advisers Act against performance-type fees may not be necessary or appropriate in the public interest. Rule 205-3 applies similar, although more specific, standards to those that have been utilized by the NASD with respect to Section 19(f) no-action positions.

Comments Received

The proposed amendment to Article III, Section 19(f) was published for comment on April 25, 1986 (Notice to Members 86-31). The NASD received 10 comments on the proposed amendment. Of these, one came from a state securities administrator, one from the Securities Industry Association Investment Adviser/Money Management Committee, and the remaining eight were from NASD member firms.

Two of the commentators generally favored the amendments, but both suggested the development of standardized contractual agreements to be used in connection with such a performance fee. Two commentators did not express any view as to the merits of the proposal but raised questions as to the manner in which the provision would be applied to accounts consisting of shares of direct participation programs.

One member firm's comments suggested that the rule be limited in its applicability to members registered with the SEC as investment advisers, questioning whether such arrangements could qualify as advisory services "incidental" to brokerage activities. Two member firms opposed adoption of the amendment, citing potential abuses and problems that could arise in the context of a declining market.

The state securities commissioner did not express an opinion as to the merits of the rule but suggested qualifying language recognizing the fact that performance fees are prohibited by a number of states' securities laws.

The SIA committee generally supported the amendment but recommended that qualification for the exemption be predicated upon compliance with SEC Rule 205-3. The committee felt that this would simplify enforcement and eliminate any potential competitive distinctions between NASD-member and non-member investment advisers.

The committee suggested that the rule be amended to track Rule 205-3 in a number of areas, including the member's "reasonable belief," prior to entering into the contract, in (1) the net worth and investment size requirements, (2) the customer's ability to understand the terms of the agreement, and (3) the fact that the contract represents an arms-length arrangement. The committee also suggested that the NASD rule contain the SEC language relating to methods of computing compensation and the provisions for disclosure of information to the client, which is required prior to entering into the agreement.

In response to these comments, the Board of Governors amended the proposal as originally set forth in Notice to Members 86-31 to clarify the fact that the proposal had never contemplated an arrangement whereby a member or a person associated with a member shares in losses in a customer account. It is contemplated that incentive fees will be based upon the overall profits in an account, with such fees reduced or eliminated based upon a netting of profits and losses during the period covered by the arrangement.

In addition, the Board has amended paragraphs B, C and E of the proposed rule to allow members or persons associated with members to act upon a reasonable belief that (1) the customer meets the net worth requirement, (2) the customer understands the proposed method of compensation, and (3) the agreement represents an arms-length arrangement. The reasonable-belief standard was utilized in SEC Rule 205-3, and, like that rule, a member or person associated with a member must make necessary inquiries to support such a conclusion. Upon examination by the NASD, the member or person associated with a member must document the basis for those conclusions.

The Board concluded that it was not necessary to amend the proposal to recognize explicitly the state and SEC rules that prohibit or restrict performance fees and that require registration as an investment adviser in certain circumstances. The proposed amendment is not intended to affect the responsibilities of members or associated persons under SEC or state regulatory requirements. In addition, the utilization of such a fee structure could constitute a beneficial interest of the member in the account for purposes of the NASD Board of Governors' Free-Riding and Withholding Interpretation.

II. Amendment to Article III, Section 33(d), NASD Rules of Fair Practice

Article III, Section 33(d) of the NASD Rules of Fair Practice was last amended on September 13, 1985. In approving that amendment, the SEC observed that because the NASD is a national securities association whose rules must comply with Section 15A of the Securities Exchange Act of 1934, the definition of "option" should more appropriately refer to Section 3(a)(10) of the Exchange Act rather than Section 2(1) of the Securities Act of 1933. 1/ After receiving assurances from the SEC's Division of Market Regulation that there is no material practical significance in the difference between the Acts' definitions, the NASD Options Committee and the Board of Governors approved the amendment to refer to the Securities Exchange Act of 1934. 2/

Comments were not solicited on this proposed amendment.

III. Amendment to Article X, Section 6 of the NASD By-Laws

The Board of Governors has approved amendments to the NASD Code of Procedure authorizing the appointment of Extended Hearing Committees to serve in the capacity of hearing subcommittees of the District Business Conduct Committees or Market Surveillance Committee and subcommittees of the Board of Governors in the event that a disciplinary hearing extends over several days. The amendments also identify the individuals eligible to serve on Extended Hearing Committees, provide that extended hearings are to be conducted in accordance with applicable NASD Code of Procedure provisions, and permit the compensation of Extended Hearing Committee members at the rate prescribed by the Board of Governors for arbitrators appointed under the Code of Arbitration Procedure.

To effectuate the compensation provision, Article X, Section 6 of the NASD By-Laws must be amended to exempt members of Extended Hearing Committees from the prohibition against the receipt of compensation by NASD committee members for committee-related services. The Board of Governors believes that it is appropriate to compensate members of Extended Hearing Committees, in addition to reimbursement for expenses, because service on such committees is expected to involve substantial time and effort.

Comments on this proposed amendment were solicited in conjunction with the amendments to the NASD Code of Procedure (Notice to Members 86-23, March 27, 1986); none were received.

* * *

The Board of Governors believes that the amendments to Article III, Section 19(f) and Section 33(d) of the NASD Rules of Fair Practice and Article X, Section 6 of the NASD By-Laws are necessary and appropriate and recommends that members vote their approval.

Please mark the attached ballot according to your convictions and return it in the enclosed, stamped envelope to "The Corporation Trust Company." Ballots must be postmarked no later than November 28, 1986. Questions concerning this notice may be directed to T. Grant Callery, NASD Office of General Counsel, at (202) 728-8285.

Sincerely,

Frank J. Wilson
Executive Vice President and General Counsel

Attachments

Exhibit A

PROPOSED AMENDMENT TO ARTICLE III, SECTION 19(f) NASD RULES OF FAIR PRACTICE*

Sharing in accounts; extent permissible

(f)
(1)
(A) Except as provided in Subsection (f)(2), no member or person associated with a member shall share directly or indirectly in the profits or losses in any account of a customer carried by the member or any other member [unless]; provided, however, that a member or person associated with a member may share in the profits or losses in such an account if (i) such member or person associated with a member obtains prior written authorization from the member carrying the account; and (ii) the member or person associated with a member shares in the profits or losses in the account only in direct proportion to the financial contributions made to such account by either the member or person associated with a member.
(B) Exempt from the direct proportionate share limitation of subsection (f)(l)(A)(ii) are accounts of the immediate family of such member or person associated with a member. For purposes of this section, the term "immediate family" shall include parents, mother-in-law or father-in-law, husband or wife, children or any relative to whose support the member or person associated with a member otherwise contributes directly or indirectly.
(2) Notwithstanding the prohibition of subsection (f)(l), a member or person associated with a member may receive compensation based on a share in profits or gains in an account if all of the following conditions are satisfied;
(A) The member or person associated with a member seeking such compensation obtains prior written authorization from the member carrying the account;
(B) The customer has at the time the account is opened either a net worth which the member or person associated with a member reasonably believes to be not less than $1,000,000, or the minimum amount invested in the account is not less than $500,000;
(C) The member or person associated with a member reasonably believes the customer is able to understand the proposed method of compensation and its risks prior to entering into the arrangement;
(D) The compensation arrangement is set forth in a written agreement executed by the customer and the member;
(E) The member or person associated with a member reasonably believes, immediately prior to entering into the arrangement, that the agreement represents an arm's-length arrangement between the parties;
(F) The compensation formula takes into account both gains and losses realized or accrued in the account over a period of at least one year; and
(G) The member has disclosed to the customer all material information relating to the arrangement including the method of compensation and potential conflicts of interest which may result from the compensation formula.

Exhibit B

PROPOSED AMENDMENT TO ARTICLE III, SECTION 33(d) NASD RULES OF FAIR PRACTICE*

(a) Unchanged.
(b) Unchanged.
(c) Unchanged.
(d) For purposes of this section, the term "option" shall mean any put, call, straddle, or other option or privilege, which is a "security" as defined in Section [2(1)1 3(a)(10) of the Securities Exchange Act of 193[3]4 as amended, but shall not include any tender offer, registered warrant, right, convertible security or any other option in respect to which the writer is the issuer of the security which may be purchased or sold upon the exercise of the option.

Exhibit C

PROPOSED AMENDMENT TO ARTICLE X, SECTION 6 NASD BY-LAWS*

Sec. 6.

No member of the Board of Governors (except the President of the Corporation or the President pro tern), no member of any District Committee and no member of any other committee, other than an Extended Hearing Committee as defined in Article I of the Corporation's Code of Procedure, shall be entitled to receive any compensation from the Corporation for any work done in connection with his duties as a member of the Board of Governors, any District Committee or any other committee. However, such persons shall be entitled to reimbursement for reasonable expenses incurred in connection with the business of the Corporation.


1/ Securities Exchange Act Release No. 22404 (September 13, 1985), 50 FR 38235, 38237 N. 27.

2/ Letter from Richard T. Chase, Associate Director, SEC Division of Market Regulation, to Peter Canada, NASD Associate Director, NASDAQ Operations, dated March 4, 1986.

*New language is underscored; deleted language is bracketed.

*New language is underscored.



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