Legal & Compliance
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In response to a request by the Association, the staff of the SEC's Division of Market Regulation has issued its views on frequently raised interpretive questions regarding Rule 15c2-6 ("Rule") under the Securities Exchange Act of 1934 ("Exchange Act"). The Rule, which went into effect on January 1, 1990, was adopted to combat fraud and manipulation in the market for "penny stocks." Following a brief description of the Rule, the SEC staff's views are set forth in a question and answer format. The views are presented to assist Association members that recommend and sell low-priced, non-NASDAQ over-the-counter (OTC) securities.
The Rule imposes supplemental sales practice requirements on broker-dealers who recommend and sell "designated securities" to customers in transactions that do not qualify for an exemption from the Rule.
The Rule prohibits such a transaction unless prior to the transaction, the broker-dealer has:
1. approved the purchaser's account for transactions in designated securities through the following four steps:
A. obtain information concerning the customer's financial situation, investment experience, and investment objectives;
B. reasonably determine that transactions in designated securities are suitable for the customer and that the customer (or the customer's independent adviser in designated security transactions) has sufficient knowledge and experience in financial matters that the customer (or adviser) reasonably may be expected to be capable of evaluating the risks of transactions in designated securities;
C. deliver to the customer a written suitability statement ("Suitability Statement") (i) setting forth the basis of the broker-dealer's suitability determination; (ii) stating in highlighted format that it is unlawful for the broker-dealer to effect a transaction in a designated security covered by the Rule unless the broker-dealer has received, prior to the transaction, a written agreement to the transaction from the customer; and (iii) stating in highlighted format immediately preceding the customer signature line that the broker-dealer is required by the Rule to provide the customer with the Suitability Statement and that the customer should not sign and return the Suitability Statement to the broker-dealer if it does not accurately reflect the customer's financial situation, investment experience, and investment objectives;
D. obtain from the customer a manually signed and dated copy of the Suitability Statement; and
2. received the customer's written agreement to the transaction setting forth the identity and quantity of the designated security to be purchased.
The Rule does not apply to NASDAQ or national securities exchange listed securities (except for the Spokane Stock Exchange). Application of the Rule is limited to transactions in a designated security, which is defined in general as any non-NASDAQ OTC equity security whose issuer has less than $2 million in net tangible assets ("Net Tangible Assets Exclusion"). In addition, the Rule provides exemptions for the following types of transactions:
1. transactions in which the price of the security is five dollars or more ("$5 Price Exemption");
2. transactions in which the purchaser is an "accredited investor" ("Accredited Investor Exemption") or an "established customer" of the broker-dealer ("Established Customer Exemption");
3. transactions that are not recommended by the broker-dealer ("Unrecommended Transaction Exemption"); and
4. transactions by a broker-dealer (i) whose commissions, commission equivalents and mark-ups from transactions in designated securities have not exceeded 5 percent of its total commissions, commission equivalents, and mark-ups from all transactions in securities during each of the immediately preceding three months and during eleven or more of the preceding twelve months and (ii) which has not been a market maker in the particular designated security that is the subject of the transaction in the immediately preceding twelve months ("Market Activity Exemption").
Broker-dealers claiming exemptions or exclusions from the Rule's sales practice requirements have the burden of proving that they meet each of the elements of the particular exemption or exclusion.
QUESTIONS AND ANSWERS
A. Sales Practice Requirements
Question #1: Would the Rule's account approval requirement be satisfied if a broker-dealer (i) sends blank Suitability Statement forms to its customers containing language concluding that transactions in designated securities are suitable for the customer; and (ii) requests customers to fill in the blanks with their financial information and investment objectives, and manually sign, date, and return the Suitability Statement to the broker-dealer?
Answer: No. The Rule requires that a customer have an opportunity to review the broker-dealer's suitability determination. Consequently, the customer must receive a completed Suitability Statement from the broker-dealer indicating why the broker-dealer believes, based on the stated customer information, that transactions in designated securities are suitable for the particular customer. This Suitability Statement must be manually signed and dated by the customer and returned to the broker-dealer before trades can be effected. In addition, such a procedure clearly would be inappropriate because at least some customers will not be deemed suitable based upon the information filled in by the customer.
Question #2: What information must a broker-dealer obtain from the customer in order to make a reasonable suitability determination?
The Rule requires that the broker-dealer obtain information about the customer's "financial situation, investment experience, and investment objectives." The SEC release adopting the Rule states that a broker-dealer should seek to obtain the items of information in each of the three required categories as follows:
1. Financial situation — age, marital status, number of dependents, employment status, estimated annual income and the sources of that income, estimated net worth (exclusive of family residence), estimated liquid net worth (cash, securities, other).
2. Investment experience — number of years of experience, and the size, frequency, and types of transactions in stocks, bonds, options, commodities, and other investments.
3. Investment objectives — safety of principal, income, growth, or speculation.
A customer's refusal to provide certain information does not absolve a broker-dealer of its obligation to obtain sufficient information to make a reasonable suitability determination. It may not be necessary to obtain every item of information in each required category. The Rule does not permit an account to be approved for transactions in designated securities unless the broker-dealer has a reasonable basis, based on the information required by the Rule and any other information known by the broker-dealer, for determining that designated securities are suitable investments for the customer. In addition, the broker-dealer must have a reasonable basis for determining that the customer has sufficient knowledge and experience in financial matters that the customer reasonably may be expected to be capable of evaluating the risks of transactions in designated securities.
Question #3: Would the Rule's account approval requirement be satisfied if a broker-dealer obtains a written statement from a customer representing that the customer concludes or believes that designated securities are suitable investments for the customer?
Answer: No. The Rule requires the broker-dealer to make a reasonable suitability determination for every customer, and this obligation cannot be avoided by obtaining a customer's statement that designated securities are suitable investments.
Question #4: Does the Rule permit a broker-dealer to obtain the customer's signed Suitability Statement by telecopier?
Answer: No. A facsimile copy of the customer's signature does not satisfy the Rule's requirement that the Suitability Statement be manually signed and dated by the customer. Broker-dealers must obtain a copy of the Suitability Statement that contains the customer's "pen-on-paper" signature and date.
Question #5: With respect to a customer's written agreement to the transaction, does the Rule permit the quantity to be set forth in terms of the total purchase price to the customer, instead of the number of shares?
Answer: No. The customer's written agreement must set forth quantity in terms of the number of shares, units, warrants, or other type of designated security to be purchased.
Question #6: If a customer provides a written agreement setting forth the identity and quantity of the designated security to be purchased, is the customer bound to buy the security at whatever price exists when the broker-dealer receives the written agreement?
Answer: No. Price per share is a material term of the transaction that must be agreed to apart from identity and quantity.
B. Coverage of the Rule
Question #7: Does the Rule apply to agency transactions?
Answer: Yes. The broker-dealer's obligations under the Rule are not dependent upon the capacity in which the broker-dealer handles the transaction.
Question #8: Does the Rule apply to non-market makers?
Answer: Yes. However, a broker-dealer that has (i) not been a market maker in the particular designated security in the preceding twelve months and (ii) whose commissions, commission equivalents, and mark-ups from transactions in designated securities have not exceeded 5 percent of the total commissions, commission equivalents, and markups from transactions in securities during each of the immediately preceding three months and during eleven or more of the preceding twelve months is exempt from the provision of the Rule with respect to those designated securities in which the broker-dealer does not make a market.
Question #9: Does the Rule apply to broker-dealers that solicit customers to exercise warrants?
Answer: Yes. The exercise of a warrant for a designated security is a purchase of the designated security by the customer.
Question #10: Does any foreign stock exchange or the Spokane Stock Exchange qualify for the Rule's exclusion from the definition of designated security for exchange-listed securities?
Answer: No. The only exchanges that qualify for the exclusion are the New York Stock Exchange, American Stock Exchange, Boston Stock Exchange, Cincinnati Stock Exchange, Midwest Stock Exchange, Pacific Stock Exchange, and Philadelphia Stock Exchange. The Spokane Stock Exchange, as well as foreign stock exchanges, such as the Vancouver Stock Exchange, do not qualify for the exclusion because they do not make transaction reports available pursuant to Exchange Act Rule 1lAa3-1.2 Such reports must be made available pursuant to a transaction reporting plan that has been filed with and approved by the SEC.
Question #11: In calculating an issuer's net tangible assets, must the issuer's liabilities be deducted?
Answer: Net tangible assets are calculated by deducting the total liabilities of an issuer from its tangible assets. This calculation will be the same as the calculation of net tangible book value under Item 506 of Regulation S-K.3 None of the issuer's intangible assets can be included in the net tangible assets calculation. The definition of an intangible asset is addressed in Accounting Principles Board Opinion No. 17 (August 1970), and generally includes goodwill, patents, trademarks, trade names, secret processes, licenses, franchises, corporate organization costs, and stock promotion costs.
Question #12: In reviewing an issuer's audited financial statements to determine whether the issuer has more than $2 million in net tangible assets, what categories of assets is a broker-dealer entitled to include in its net tangible assets calculation, other than those specifically identified as tangible assets?
Answer: Broker-dealers are entitled to include only those categories of assets that clearly do not include intangible assets. Categories of assets that may include both tangible and intangible assets, such as "Other Assets," cannot be included in the determination of net tangible assets.
Question #13: If an issuer's audited financial statements do not clearly indicate on their face that the issuer has more than $2 million in net tangible assets, may a broker-dealer contact the issuer or other sources to determine whether the issuer qualifies for the Net Tangible Assets Exclusion?
Answer: No. The Rule requires that an issuer's net tangible assets be demonstrated by audited financial statements. Information from sources other than the audited financial statements therefore does not satisfy the Rule's requirement. For example, an unaudited statement from the issuer that it has $2 million in net tangible assets is not sufficient to establish the exclusion.
Question #14: Would sales in an offering qualify for the Net Tangible Assets Exclusion if the issuer will have more than $2 million in net tangible assets only after the completion of the offering?
Answer: No. To qualify for the Net Tangible Assets Exclusion the issuer must have $2 million in net tangible assets at the time that sales in the offering commence.
Question #15: For purposes of the $5 Price Exemption, does the price of a security include a broker-dealer's mark-up in a principal transaction?
Answer: Yes. The price of a security in a principal transaction generally will be the "net price" to the customer that is reported on the confirmation of the transaction pursuant to Exchange Act Rule 10b-10(a)(2). With respect to contemporaneous offsetting purchase and sale principal transactions by non-market makers that are covered by Rule 10b-10(a)(8)(i)(A), however, the price is the price exclusive of the disclosed mark-up. If the $5 Price Exemption is claimed for a transaction in which the broker-dealer charged an excessive mark-up, it would constitute a serious violation of SEC and NASD rules. The SEC and NASD will closely scrutinize transactions at prices near five dollars for excessive mark-ups.
Question #16: For purposes of the $5 Price Exemption, does the price of a security include the broker-dealer's commission in agency transactions?
Answer: No. Commissions in agency transactions are not included in the price of a security.
Question #17: How does the $5 Price Exemption apply to units? For instance, would transactions in units that are composed of 5 common shares and 10 warrants with an exercise price of $6 qualify for the $5 Price Exemption if the price of the units was $20?
Answer: Share price in units is calculated by dividing the unit price by the number of shares included in the unit. In addition, warrants must have an exercise price of $5 or more. In the above example, the $20 unit price would be divided by the 5 common shares, yielding a per share price of $4, which does not qualify for the exemption.
Question #18: After an initial public offering at $12 per unit of units that were composed of 2 common shares and 4 warrants with an exercise price of $7, the units are broken up and the warrants are sold in a secondary market transaction at a price of 20 cents per warrant. Sales in the initial public offering would qualify for the $5 Price Exemption, but would the secondary market warrant transaction qualify for the exemption?
Answer: No. After the components of a unit begin trading separately, the transaction price for the component must be $5 or more for the transaction to qualify for the $5 Price Exemption.
Question #19: Would a transaction in a designated security on 4/1/90 qualify for the Established Customer Exemption if the customer had purchased in its account with the broker-dealer another designated security on 5/15/89, a NASDAQ stock on 10/5/89, and another designated security on 1/14/90?
Answer: No. Purchases of non-designated securities do not count towards the three-purchase requirement in the definition of established customer. The designated security transaction on 4/1/90 would constitute the customer's third purchase of different designated securities, however, and thereafter the customer would qualify for the Established Customer Exemption.
Question #20: Would a transaction in a designated security on 5/15/90 qualify for the Established Customer Exemption if the customer had purchased a NASDAQ or national securities exchange listed security through the broker-dealer in 1988?
Answer: Yes. The customer would have purchased a security in its account with the broker-dealer more than one year prior to the transaction on 5/15/90. For purposes of the one-year-old account requirement in the definition of established customer, any securities transaction, or deposit of funds or securities, in the customer's account with the broker-dealer is sufficient to begin the one-year period.
Question #21: If a registered representative moves from Broker-Dealer X to Broker-Dealer Y and his customers transfer their accounts to Broker-Dealer Y, does the Rule permit Broker-Dealer Y to consider activity in the customers' accounts prior to the transfer for purposes of the Established Customer Exemption?
Answer: No. The definition of an established customer focuses on the relationship between customer and broker-dealer, and not customer and registered representative. Consequently, when customers transfer their accounts from one broker-dealer to another, the customers must be requalified for purposes of the Established Customer Exemption.
Question #22: Would the result in Question 19 differ if the customer accounts of Broker-Dealer X and Broker-Dealer Y were carried by the same clearing broker?
Answer: No. The customers still would have to be requalified as established customers of Broker-Dealer Y. Transactions in accounts carried by a clearing broker on behalf of one introducing broker cannot be used to qualify a customer as an established customer of another introducing broker whose accounts are carried by the clearing broker.
Question #23: If Broker-Dealer X sells its accounts to Broker-Dealer Y, can activity in the accounts prior to the sale be considered by Broker-Dealer Y for purposes of the Established Customer Exemption?
Answer: No. The customers will have to be requalified as established customers of Broker-Dealer Y (regardless of whether the same clearing broker carried the accounts of Broker-Dealer X and Broker-Dealer Y). The SEC staff has indicated, however, that with respect to mergers, successions, spin-offs, or other similar situations involving account transfers, the staff is willing to consider on a case-by-case basis whether pre-transfer activity can be considered by the receiving broker-dealer for purposes of the Established Customer Exemption.
One important factor in such a determination would be the continuity of legal identity between the broker-dealers transferring and receiving the accounts, including the extent to which the receiving broker-dealer assumed responsibility and liability for the pre-transfer activity.
Question #24: On 2/18/90, a broker-dealer relies on the Accredited Investor Exemption for a transaction after having made a reasonable determination that the customer is an accredited investor. For another designated security transaction on 4/1/90, must the broker-dealer make a new accredited investor determination?
Answer: A new determination would not be required unless the broker-dealer has reason to doubt whether the customer continues to qualify as an accredited investor.
Solely for purposes of the Rule, a broker-dealer is entitled, in the absence of information to the contrary, to assume that a person continues to qualify for the Accredited Investor Exemption for a period of one year after a reasonable accredited investor determination is made.
Question #25: If the order ticket for a transaction in a designated security is marked "unsolicited," will the order ticket conclusively establish that the transaction qualifies for the Un-recommended Transaction Exemption?
Answer: No. While genuinely unrecommended transactions are exempt from the Rule, an order ticket marked "unsolicited" is not conclusive evidence that the exemption has been satisfied. Furthermore, an unsolicited conversation with a customer may result in a recommended transaction.
Question #26: If a broker-dealer's commissions, commission equivalents, and mark-ups from transactions in one particular designated security have never exceeded 5 percent of its total commissions, commission equivalents, and mark-ups from all securities transactions, does the broker-dealer qualify for the Market Activity Exemption with respect to sales of that security?
Answer: No. Commissions, commission equivalents, and mark-ups from transactions in all designated securities must be included for purposes of the Market Activity Exemption.
Question #27: If a broker-dealer's commissions, commission equivalents, and mark-ups from transactions in all designated securities have never exceeded 5 percent of its total commissions, commission equivalents, and mark-ups from all securities transactions, will all of the broker-dealer's transactions in designated securities qualify for the Market Activity Exemption?
Answer: Not necessarily. Transactions in any designated security for which the broker-dealer has acted as a market maker within the previous twelve months will not qualify for the Market Activity Exemption.
Questions or comments regarding the interpretations of the Rule in this Notice should be addressed to Robert L.D. Colby, Chief Counsel, (202) 272-2844, or Dan Gray, Attorney, (202) 272-2848, Division of Market Regulation, Securities and Exchange Commission, 450 Fifth Street, N.W., Mail Stop 5-1, Washington, D.C. 20549 or to Daniel M. Sibears, Associate Director, Anti-Fraud, or Gary A. Carleton, Senior Attorney, at (202) 728-8959, National Association of Securities Dealers, Inc., 1735 K Street, N.W., Washington, D.C.20006.
1Securities Exchange Act Release No. 27160 (August 22,1989), 54 FR 35468, 35478.
217 CFR 240.11Aa3-l.
317 CFR 229.506.