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91-35 Proposed SEC "Penny Stock" Disclosure Rules

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EXECUTIVE SUMMARY

The Securities and Exchange Commission (SEC or "the Commission") recently issued Release No. 34-29093 proposing for public comment the so-called "Penny Stock Disclosure Rules" to implement certain provisions of the Securities Enforcement Remedies and Penny Stock Reform Act of 1990. These proposed rules further define the term "penny stock" and provide certain exemptions from the definition. They also would require broker-dealers selling penny stocks to their customers to provide the customers with (1) a risk disclosure document; (2) monthly statements giving the market value of penny stocks held for customers; (3) disclosure of current bid and ask quotations, if any; (4) disclosure of the compensation of the broker-dealer and the salesperson with respect to the trade; and (5) disclosure when the broker-dealer is acting as sole market maker in the security. Comments on the proposed rules may be submitted to the SEC until July 19, 1991.

BACKGROUND

In its Release 34-29093, the Securities and Exchange Commission (SEC) proposed for public comment rules under the Securities Exchange Act of 1934 to implement certain provisions of the Securities Enforcement Remedies and Penny Stock Reform Act of 1990. The Penny Stock Reform Act grants the SEC broad rule-making authority to address serious abuses and misconduct identified in the distribution and secondary trading of penny stocks.

The NASD continues to aggressively pursue its regulatory and enforcement efforts to eliminate fraud in the penny-stock market. Working on its own as well as with other enforcement agencies, the NASD remains focused on NASD members and associated persons who use high-pressure tactics and other fraudulent and deceptive practices to sell penny stocks to the public. Certain of these cooperative efforts with federal law enforcement agencies have resulted in criminal prosecution relating to securities fraud.

SUMMARY OF PROPOSED SEC RULES 3a51-1 AND 15g-1 THROUGH 15g-7 ("PENNY STOCK DISCLOSURE RULES")

Proposed SEC Rule 3a51-1 (Definition of "Penny Stock")

Proposed SEC Rule 3a51-1 would exclude securities from the definition of penny stock that are: (1) "reported securities" (i.e., securities for which last-sale reports are collected and made available pursuant to an effective transaction reporting plan). Reported securities generally consist of securities quoted on the Nasdaq system that are designated as Nasdaq National Market System securities (Nasdaq/NMS securities), New York Stock Exchange, Inc. (NYSE) and American Stock Exchange, Inc. (Amex) listed securities, and certain regional exchange-listed securities that meet NYSE or Amex listing standards; (2) securities that have a price of $5 per share or more; (3) securities issued by an investment company registered under the Investment Company Act of 1940; (4) put or call options issued by the Options Clearing Corporation; and (5) securities registered or approved for registration on a national securities exchange that has maintenance criteria authorizing, at a minimum, the delisting of a security whose issuer has less than $2 million in net tangible assets or in stockholder equity.

Proposed SEC Rule 15g-1 (Exemptions)

Proposed Rule 15g-1 would exempt selected transactions from the proposed disclosure obligations to customers as follows: (1) transactions in penny stocks by a broker-dealer that does less than 5 percent of its securities business in penny stocks and that has not been a market maker, during the past year, in the penny stock that is the subject of the transactions; (2) transactions in securities the issuer of which has net tangible assets exceeding $2 million, if that issuer has been in continuous operation for at least three years, or $5 million, if the issuer has been in continuous operation for less than three years; (3) transactions in securities where the customer is an institutional accredited investor; (4) transactions that are not recommended by the broker-dealer; and (5) transactions in which the purchaser is the issuer of the penny stock that is the subject of the transaction.

Separately, proposed Rule 15g-1 would exempt two categories of penny-stock transactions from proposed Rules 15g-2 (requiring provision of a risk disclosure document), 15g-3 (requiring disclosure of bid/ask prices), and 15g-6 (requiring provision of monthly account statements), as follows: (1) transactions in securities that are registered and that are executed on a national securities exchange that disseminates transaction reports pursuant to an effective reporting plan; and (2) transactions in Nasdaq securities qualifying as penny stocks that involve a Nasdaq market maker registered in that security, a broker crossing two orders on an agency basis, or an underwriter or any syndicate or selling-group member that is participating in a distribution of the affected penny stock.

Proposed SEC Rule 15g-2 (Risk Disclosure Document)

Proposed Rule 15g-2 would make it unlawful for a broker-dealer to effect transactions in penny stocks without first providing to the customer a standardized disclosure document as contained in proposed Schedule 15G. The document required by the proposed rule explains the risks of investing in penny stocks; important concepts associated with the penny-stock market, such as the meaning of the "bid" and "ask" prices and the significance of the spread between those prices; the broker-dealer's duties to the customers, including disclosures required by each of the proposed rules; a toll-free telephone number through which a customer may inquire about the disciplinary history of a broker-dealer; the customer's rights and remedies in cases of fraud or abuse in connection with transactions in penny stocks; and other significant information of which the investor should be aware.

Proposed SEC Rule 15g-3 (Bid-Offer Quotations Disclosure)

Proposed Rule 15g-3 would make it unlawful for a broker-dealer to effect a transaction in any penny stock without first disclosing and subsequently confirming to the customer current quotation prices or similar market information.

Proposed Rule 15g-4 (Broker-Dealer Compensation Disclosure)

Proposed Rule 15g-4 would make it unlawful for a broker-dealer to effect a penny-stock transaction for a customer unless the broker-dealer first discloses to the customer the amount of any compensation received in connection with that penny-stock transaction. "Compensation" is defined as (1) in an agency transaction, the amount of any remuneration received or to be received from a customer in connection with the transaction; (2) in a "riskless principal" transaction, the difference between the price to the customer and the contemporaneous purchase or sale price; and (3) in any other principal transaction, the difference between the price to the customer and the prevailing market price in the security.

Proposed Rule 15g-5 (Associated Person Compensation Disclosure)

Proposed Rule 15g-5 would make it unlawful for a broker-dealer to effect a transaction in any penny stock for a customer unless the broker-dealer first discloses and subsequently confirms to the customer (1) the aggregate or per-share amount of cash compensation that the associated person of the broker-dealer has received or will receive from any source in connection with the transaction, in cases where the firm determines compensation on a transactional or per-share basis; and (2) the amount of cash or other compensation that the associated person has received from any source during the preceding calendar year in connection with all penny-stock transactions, if this amount exceeds 25 percent of the total compensation that the associated person received during that year in connection with all securities transactions.

Proposed Rule 15g-6 (Monthly Account Statements)

Proposed Rule 15g-6 would make it unlawful for a broker-dealer that has effected a penny-stock sale to a customer to fail to furnish to that customer a monthly statement disclosing the identity and number of shares of each penny stock in the customer's account, the transaction dates, the purchase price, and the estimated market value of the security, based on the broker-dealer's recent purchase prices or recent dealer bids. The statement must also contain a standardized explanation of the limited market for the securities and the nature of an estimated market value in such a limited market. If the broker-dealer has not effected any penny-stock transactions for the customer for six consecutive months, the rule would provide a limited exemption to permit account statements to be provided on a quarterly basis.

Proposed Rule 15g-7 (Sole Market Maker Disclosure)

Proposed Rule 15g-7 would make it unlawful for a broker-dealer that is the sole market maker in a penny stock, or an affiliated broker-dealer, to effect transactions in the stock unless the broker-dealer has disclosed to the customer that it or its affiliate is the sole market maker and that, by virtue of such status, it or its affiliate exercises substantial influence over the market for the security.

Moreover, the proposed rule makes it unlawful for a broker-dealer or an affiliate that is a market maker in a penny stock to represent directly or indirectly to a customer that a transaction in the stock is being effected "at the market" or at a price related to the market unless the broker-dealer knows, or has reasonable grounds to believe, that a market exists outside the broker-dealer's control. Exempt transactions under proposed Rule 15g-1 would not be exempt from the disclosure required by proposed Rule 15g-7.

Members and other interested parties are urged to contact the SEC to obtain a copy of the full text of the Commission's proposed rules. Comments, in triplicate, on the proposed rule should be sent to Jonathan G. Katz, Secretary, SEC, 450 5th Street, NW, Mail Stop 6-9, Washington, DC 20549. Refer to file no. S7-8-91.


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