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89-65 SEC Adoption of Rule 15c2-6 Re: Sales Practice and Suitability Requirements for Certain Low-Priced Securities
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The SEC recently adopted Rule 15c2-6, which is effective January 1, 1990. It imposes sales-practice requirements on broker-dealers that recommend transactions in certain low-priced, non-NASDAQ over-the-counter securities (designated securities) to persons who are not "established customers." Such broker-dealers involved in the "penny stock" market are required to make a documented suitability determination regarding a nonestablished customer, and to obtain such customer's written agreement to the first three purchases of these designated securities. The rule specifically excludes all NASDAQ and exchange-listed securities.
In February 1989, the SEC proposed Rule 15c2-6 (see Notice to Members 89-26) in response to the widespread incidence of misconduct by some broker-dealers in connection with high-pressure sales tactics in low-priced securities. In proposing this rule, the SEC "intended to prevent the indiscriminate use by broker-dealers of fraudulent, high-pressure telephone sales campaigns to sell such securities to unsophisticated investors."
The Commission received letters from numerous commenters, including the NASD, about the proposed rule. Commenters, according to the SEC, generally agreed that serious problems existed in the market for low-priced, non-NASDAQ OTC securities, and overwhelmingly supported increased enforcement efforts against broker-dealers and individuals who engaged in such misconduct.
The final rule defines an "established customer" as a customer who has maintained an account for at least one year, or has had three purchases of designated securities on separate days involving different issuers.
It also establishes procedures that must be followed before designated securities are recommended to nonestablished customers. Included is the requirement to obtain oral or written information concerning a new customer's previous investment experience, investment objectives, and financial situation. With that information, the broker or dealer must reasonably determine whether transactions in designated securities are suitable for the particular customer.
If the designated securities are determined to be suitable, the firm's written suitability determination must be delivered to the customer, who is required to manually sign and return the statement, if it is accurate, as a condition for opening the account. Also, the firm must obtain from the customer a written agreement to enter into each of the first three transactions in designated securities. The objectives of these requirements, the SEC said, are to provide the customer with an opportunity to make an investment decision "outside of a pressured telephone conversation with a salesperson," and enable the customer to decide whether the broker-dealer has made a good-faith attempt at a suitability determination.
The rule's recordkeeping requirements are partly designed to provide the basis for "simple and direct enforcement actions against broker-dealers that fail to comply." In this regard, the NASD will be responsible for examining firms for their compliance with Rule 15c2-6.
The NASD supports increased enforcement efforts to eliminate fraudulent, deceptive, and manipulative acts and practices in the penny stock market. As a top priority of the NASD, the Association continues to commit significant resources to its enforcement efforts in order to reach this objective.
Working on its own cases, as well as in cooperation with the SEC, state securities administrators, and federal law-enforcement agencies, the NASD has concluded or filed well in excess of 200 disciplinary actions involving penny stocks, producing sanctions including expulsions of firms, bars of individuals, and fines in excess of $500,000. More than 175 additional investigations are actively under way. Furthermore, certain of these cooperative efforts with federal law-enforcement agencies have resulted in criminal prosecution relating to securities fraud.
In its explanation of the rationale for the final adopted rule, the SEC noted that the NASD has implemented a program that requires broker-dealers to report to the NASD volume and price information concerning their principal transactions in non-NASDAQ OTC securities. "This program should provide assistance to regulators in monitoring the non-NASDAQ OTC market, and in identifying fraudulent or manipulative trading activities in that market," the Commission said. But it added that a comprehensive program to deter fraud in connection with transactions in low-priced securities must address the sales practices of broker-dealers actively involved in selling such securities to new customers.
MAJOR RULE PROVISIONS
The Rule makes it unlawful for a broker-dealer to recommend a "designated security" (defined as a non-NASDAQ OTC equity security issued by a company with less than $2 million in net tangible assets) unless:
The exempted transactions under paragraph (c) of the Rule are:
- Transactions in which the price of the security is $5 or more;1
- Transactions in which the purchaser is an accredited investor or an established customer of the broker-dealer;
- Transactions that are not recommended by the broker-dealer; and
- Transactions by a broker-dealer that has not been a market maker in the designated security in the 12 months preceding the transaction and which does not derive specified sales-related revenue from transactions in designated securities exceeding 5 percent of its total specified sales-related revenue from securities transactions.2
The text of the SEC rule follows. Members wishing to obtain the complete version of the Commission's Release No. 34-27160, File No. S7-3-89 should contact the Commission.
TEXT OF SEC RULE 15c2-6
CHAPTER II, TITLE 17 OF THE CODE OF FEDERAL REGULATIONS
Part 240 - General Rules and Regulations, Securities Exchange Act of 1934
Authority: Sec. 23, 48 Stat. 901, as amended (15 U.S.C. 78w) . . . Section 240.15c2-6, also issued under sees. 3, 10, and 15, 15 U.S.C. 78c, 78j, and 78o;
Section 240.15c2-6 Sales practice requirements for certain low-priced securities.
1If a designated security is a unit comprised of one or more securities, the unit price divided by the components, exclusive of warrants, options, rights, or similar securities, must be $5 or more. So, for example, a unit selling for S10 comprised of 100 shares of common stock and 100 warrants would have an equivalent price of 10 cents ($10 unit divided by 100 shares common) and thus is a designated security subject to the rule.
2Market makers, however, regardless of the percentage of sales-related revenue, are fully subject to the rule for transactions in those designated securities in which they make a market.