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89-20 Proposed Amendments to Article III, Sections 1-28 of the NASD Rules of Fair Practice — Last Voting Date: March 20, 1989

SUGGESTED ROUTING*

Senior Management
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*These are suggested departments only. Others may be appropriate for your firm.

IMPORTANT MAIL VOTE

EXECUTIVE SUMMARY

NASD members are invited to vote on extensive amendments to Article III, Sections 1 through 28 of the NASD Rules of Fair Practice that include a number of new sections. The amendments have been approved by the NASD Board of Governors and now require membership approval. Prior to becoming effective, the amendments must be filed with, and approved by, the Securities and Exchange Commission.

The proposed amendments include five entirely new sections to be added to Article III of the Rules of Fair Practice. The proposed new sections are identified in this notice by the letter designations Sections [A] through [E]. If approved by the membership and the SEC, the new sections will entirely replace certain current NASD Board of Governors' Interpretations.

The amendments to existing Sections 1 through 28 include proposals to delete several sections in their entirety, primarily because they duplicate existing standards already covered under SEC regulations.

Many of the remaining sections contain proposed language revisions that clarify standards and requirements or respond to members' comments. There are extensive changes in Section 4 to incorporate the "NASD Mark-Up Policy" (sometimes referred to as the "Five Percent Policy"), which currently is a Board of Governors' Interpretation under Section 4, as well as to Section 25 to incorporate existing statutory changes and SEC rulings affecting the latter section. Members are not being asked to vote on the existing sections in which no changes are being proposed, and the texts of these sections are reproduced in this notice solely for information.

The texts of the proposed amendments follow.

BACKGROUND

During the past several years, the NASD Ad Hoc Committee on Rule and By-Law Amendments (Committee) has been reviewing the NASD's By-Laws, rules, interpretations, policies, and resolutions and making recommendations. The Committee's initial review covered the NASD By-Laws and Code of Procedure that, following adoption by the NASD Board of Governors, were approved by the Securities and Exchange Commission (SEC) and have been in effect since early 1985.1

The proposed amendments to Article III, Sections 1 through 28 of the NASD Rules of Fair Practice contained in this notice represent a further step in the Committee's review and have been approved by the NASD Board of Governors. The amendments are primarily designed to conform the current provisions to statutory changes made over the years, to clarify their applications, to codify certain Board of Governors' Interpretations and policies into new rules, and generally to make the provisions more current and workable.

THE PROPOSED AMENDMENTS

The proposed amendments represent a revision of the proposals as previously published for comment in Notice to Members 86-9 (February 7, 1986). The NASD received 14 written comments, which were reviewed and considered by the Board of Governors and the Committee. The Board of Governors and the Committee believe that a number of these comments raised valid concerns about the application of the amendments to several substantive areas of NASD regulation. Therefore, the Board of Governors and the Committee revised the proposed amendments to reflect these concerns.

The proposed amendments are limited to Sections 1 through 28 of Article III of the NASD Rules of Fair Practice and certain interpretations and other published material thereunder. Although the Board of Governors and the Committee reviewed all the Rules of Fair Practice, Sections 1 through 28 have been specifically selected for revision because they have been in existence for many years without any overall Board of Governors' review. Almost all these sections date from the NASD's inception, and some were adopted shortly thereafter.2

Any future changes to the balance of the Rules of Fair Practice, when and if they appear necessary, will be submitted separately for membership vote.3 The proposed amendments fall into two broad categories: (1) several entirely new sections; and (2) proposed amendments to, or deletions of, certain existing sections.

NEW SECTIONS REPLACING CURRENT BOARD INTERPRETATIONS

The proposed amendments include five entirely new sections to be added to Article III of the Rules of Fair Practice. The proposed new sections are identified in this notice and on the ballot by the letter designations Sections [A] through [E]. If approved by the membership and the SEC, the new sections will entirely replace certain current NASD Board of Governors' Interpretations.

The new sections are intended to incorporate and codify four current, long-standing, and important Interpretations of the Board of Governors, which now appear in the NASD Manual under Section 1 of Article III of the Rules of Fair Practice.4 They include the Interpretations under Section 1 entitled "Execution of Retail Transactions in the Over-the-Counter Market," "Prompt Receipt and Delivery of Securities," "Forwarding of Proxy and Other Materials," and "Free-Riding and Withholding."5

New Sections [A] through [E] to Article III represent both a codification and a revision to the language of the existing Board Interpretations. The Board of Governors and the Committee believe the language changes made in the Interpretations clarify the applicable standards and requirements. Substantive changes have been kept to a minimum, and most are in response to members' comments. The Board of Governors and the Committee believe that the new sections are long overdue and should result in a major improvement in communicating — to persons entering the securities industry as well as to persons now in the industry — the basic ethical standards to which they may look for guidance and the standards they must meet to remain in compliance with NASD rules.

CHANGES IN CURRENT SECTIONS

The amendments to existing Sections 1 through 28 include proposals to delete several sections in their entirety, primarily because they duplicate existing standards that are already covered under SEC regulations. Many of the remaining sections contain proposed language revisions that primarily clarify standards and requirements or respond to members' comments. There are extensive changes in Section 4 to incorporate the "NASD Mark-Up Policy," sometimes referred to as the "Five Percent Policy," into the section, which currently is a Board of Governors' Interpretation under Section 4, as well as to Section 25 to incorporate existing statutory changes and SEC rulings affecting this section.6

MATTERS NOT COVERED BY THE AMENDMENTS

Several Board of Governors' Interpretations, Resolutions, and similar material now appearing in the NASD Manual under Sections 1 through 28 of Article III are not included in the attached proposed amendments because they constitute a relatively small volume of published material, compared with the extensive texts of the Board of Governors' Interpretations being codified into new sections of the Rules of Fair Practice. For a variety of reasons, the Board of Governors and the Committee believe that this material does not lend itself easily to codification as new Rules of Fair Practice.

After considering previous comments by members, the Board of Governors decided to withhold any action to modify or rescind these Interpretations and other materials, pending further study and review.7 The materials not codified in the proposed amendments, therefore, will continue to be effective and binding on members and persons associated with members.

REQUEST FOR VOTE

The attached texts of the proposed amendments are published in the sequence in which they now appear in the NASD Manual. Each proposed amendment also contains paragraph and page references to indicate where the existing material can be found in the Manual and the item number on the ballot, if applicable.

Proposed new Sections [A] through [E] to Article III will replace the Board of Governors' Interpretations under Section 1 of Article III. The new sections, however, will be given numerical identifiers prior to publication in the NASD Manual.

An explanation and description of each amendment immediately follows the text of the proposed amendment.

These amendments are important and merit members' immediate attention. The Board of Governors believes these amendments to the Rules of Fair Practice 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 March 20, 1989.

Questions concerning this notice may be directed to Dennis C. Hensley, NASD Vice President and Deputy General Counsel, at (202) 728-8294, or John F. Mylod, Jr., NASD Assistant General Counsel, at (202) 728-8288.

NASD RULES OF FAIR PRACTICE

(Note: New language is underlined, and deleted language is bracketed.)

CURRENT TEXT

NASD Manual, ¶ 2151, p. 2014

No Vote Required

Business Conduct of Members

Sec. 1. A member, in the conduct of his business, shall observe high standards of commercial honor and just and equitable principles of trade.

EXPLANATION

No change is being proposed to this section.

This is the broadest and most fundamental section of the NASD Rules of Fair Practice and the source of a great deal of the existing precedent that has evolved in NASD disciplinary actions. The section contains a long-accepted principle that expresses the basic statement of standards of ethical business conduct in the investment banking and securities businesses. Therefore, it would be unwise and without justification to amend the language.

The section also restates the requirements of the statute under which the NASD has been granted its self-regulatory authority.

CURRENT TEXT

Items 1 and 2 on ballot

NASD Manual, ¶ 2151.03, pp. 2037 — 2037-3

[...Interpretation of the Board of Governors]

[Execution of Retail Transactions in the Over-The-Counter Market]

[Background]

[.03 The Board of Governors, under its obligation to "remove impediments to and perfect the mechanism of a free and open market," has made a review of practices in the over-the-counter market that can affect the price of shares paid by public customers in retail transactions. This review has brought to light certain practices by members that may deny customers the benefit of the diversity and competition that may exist in the inter-dealer market]

[To make members more fully aware of their obligations in this area and to more expressly define the standards of fair practice pertaining, the Board of Governors has issued the following Interpretation:]

[Interpretation]

[A. In any transaction for or with a customer, a member and persons associated with a member shall use reasonable diligence to ascertain the best inter-dealer market for the subject security and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions. Failure to exercise such diligence shall constitute conduct inconsistent with just and equitable principles of trade in violation of Article III, Section 1 of the Rules of Fair Practice.]
[Comment: Among the factors that will be considered by the Business Conduct Committees in applying the standard of "reasonable diligence" in this area are:]
[(1) The character of the market for the security — e.g., price, volatility, relative liquidity, and pressure on available communications;]
[(2) the size and type of transaction;]
[(3) the number of primary markets checked;]
[(4) location and accessibility to the customer's broker-dealer of primary markets and quotations sources.]
[B. In any transaction for or with a customer, no member or person associated with a member shall interject a third party between the member and the best available market except in cases where the member can demonstrate that to his knowledge at the time of the transaction the total cost or proceeds of the transaction, as confirmed to the member acting for or with the customer, was better than the prevailing inter-dealer market for the security. Failure to comply with the provisions of this paragraph shall constitute conduct inconsistent with just and equitable principles of trade in violation of Article III, Section 1 of the Rules of Fair Practice.]
[Comment: Under this standard the member's obligations to his customers are generally not fulfilled when he channels transactions through another broker-dealer or some person in a similar position, unless he can show that by so doing he reduced the costs of the transactions to the customer.]
[The Board of Governors realizes that there are occasions when a member cannot execute directly with a market maker but must employ a broker's broker or some other means in order to insure an execution advantageous to the customer. Some examples are where a customer's order is "crossed" with another retail firm that has a corresponding order on the other side, or where the identity of the retail firm, if known, would likely cause undue price movements adversely affecting the cost or proceeds to the customer. In such situations, the burden of showing the circumstances is on the retail firm.]
[A simple failure to maintain or adequately staff an over-the-counter order room or other department assigned to execute customers' orders cannot be considered justification for executing away from the best available market; nor can channeling orders through a third party as described above as reciprocation for service or business operate to relieve a member of his obligations. However, this interpretation would not prohibit the channeling of customers' orders through a broker's broker or other third party pursuant to established correspondent relationships under which executions are confirmed directly to the member acting as agent for the customer, such as where the third party gives up the name of the retail firm, so long as the cost of such service is not borne by the customer.]
[A member through which a retail order is channeled, as described above, and which knowingly is a party to an arrangement whereby the initiating member has not fulfilled his obligations under this interpretation, will also be deemed to have engaged in conduct inconsistent with just and equitable principles of trade.]
[C. The obligations described in paragraphs A and B above exist not only where the member acts as agent for the account of his customer but also where retail transactions are executed as principal and contemporaneously offset. Such obligations do not relate to the reasonableness of commission rates, markups or markdowns that are governed by Article III, Section 4 of the Rules of Fair Practice.]
[D. In any transaction for or with a customer pertaining to the execution of an order in a non-NASDAQ security (as defined in Schedule H to the By-Laws) a member or person associated with a member shall contact and obtain quotations from three dealers (or all dealers if three or less) to determine the best inter-dealer market for the subject security.]

PROPOSED NEW SECTION [A] OF THE NASD RULES OF FAIR PRACTICE

Item 1 on ballot

Obligations in Effecting Customer Transactions In the Over-the-Counter Market

Sec. [A].

General

(a) A member and persons associated with a member, when effecting any agency or contemporaneous principal transaction, for or with a customer in the over-the-counter market, shall (1) use reasonable diligence to ascertain the best inter-dealer market for the security and (2) where the purchase or sale takes place in the inter-dealer market, shall use reasonable diligence to effect the transaction at a price to the customer, net of commissions charged or mark-ups or mark-downs applied by the member, which is as favorable as possible under existing market conditions. For purposes of this section, the term "contemporaneous principal transaction" shall mean any transaction by a member which is not a market maker in the security in which, after receiving a customer's order or indication of interest, the member purchases or sells the security in the inter-dealer market to offset a contemporaneous purchase or sale by such customer. For purposes of this section, the term "inter-dealer market" shall include the market on a national securities exchange if the security is traded in both the over-the-counter and exchange markets.
Due Diligence
(b) For purposes of determining whether the standard of "due diligence" has been satisfied, the following factors, as well as any other relevant factors and circumstances, shall be taken into consideration:
(l) The characteristics of the market for the security, including, but not limited to, price, volatility, depth, and liquidity;
(2) The pressure on communication systems available to the member;
(3) The size and kind of order;
(4) The total amount of the transaction;
(5) The type of security;
(6) The accessibility to the customer's broker-dealer of market makers and quotations sources; and
(7) The number of market makers checked.
(c) In any transaction for or with a customer pertaining to the execution of an order in a non- NASDAQ security (as defined in Schedule H to the By- Laws), a member or person associated with a member shall contact and obtain quotations from three dealers (or all dealers if three or less) to determine the best inter-dealer market for the subject security.

EXPLANATION

This new section will codify the language that now appears in the NASD Manual as an Interpretation of the Board of Governors — "Execution of Retail Transactions in the Over-the-Counter Market"— under Article III, Section 1 of the Rules of Fair Practice (Best Execution Interpretation). The new section will replace paragraphs A and C of the Best Execution Interpretation, which will be rescinded by the Board of Governors upon effectiveness of the new section. The new section is designated Section [A] and will be given a permanent section number and placement within Article III prior to effectiveness. The basic duty of "best execution" appears in current paragraph A, which has been codified as subsections (a) and (b) of new Section [A]; and the basic prohibition against "interpositioning," which is currently contained in paragraph B, has been codified as new Section [B] discussed below separately. The language defining the scope of the Best Execution Interpretation in current paragraph C has been incorporated into both new sections. The existing Interpretation of the Board of Governors was adopted in 1968 in response to a recommendation in the 1964 SEC Special Study of Securities Markets. The language of paragraph D relating to the execution of transactions in non-NASDAQ securities was added to the Interpretation effective September 1, 1988, and is proposed to be incorporated into new Section [A]. The Board of Governors believes that the Best Execution Interpretation is included with those existing interpretations and policies of the Board that establish basic standards of conduct and, therefore, merits codification and adoption as a new rule of fair practice. The new section appears on the ballot as Item 1.

Subsection (a):

The proposed recodification of the "best execution" part of the Interpretation clarifies the types of customer transactions covered. They are limited to agency and contemporaneous principal, i.e., so-called riskless principal transactions.

The rule contains a definition of "contemporaneous principal transaction." It appears that the original intent of the Interpretation was to cover principal trades that are the functional equivalent of agency transactions. The new definition covers only situations where, after a member has received a customer order, an offsetting purchase or sale is effected by the member.

The new definition parallels the language of SEC Rule 10b-10(a)(8), which requires disclosure of markups in confirmations for contemporaneous principal trades when the broker-dealer has the customer's order in hand and then effects the offsetting transaction. The NASD rule, however, also covers situations where the customer has indicated an interest in buying or selling a security but the member does not record the order to prevent evasion of the best-execution duty.

The proposed rule continues and clarifies the existing language that confines the Best Execution Interpretation's coverage to transactions where the offsetting trade is effected only in the inter-dealer market. The primary concern expressed in the Interpretation was for transactions effected by retail firms with wholesale firms. The current language in the Best Execution Interpretation states that the firm's duty is to ascertain the best inter-dealer market and "... buy or sell in such market..." The quoted phrase, however, is being deleted because it might imply an obligation to execute in the inter-dealer market. This is contrary to industry practice and presumably was never intended. There are many situations where effecting transactions outside the inter-dealer market is permissible. It is not uncommon for members to cross transactions with other customers' orders to buy or sell securities on behalf of customers from or to banks, other institutions, or even the issuer on some occasions. The substituted language is designed to clarify this point.

The revised language is not intended to impose a duty to ascertain the market outside the inter-dealer market since this would go beyond the apparent scope of the Interpretation. If, however, a member knows of a better market elsewhere and, without any justification, fails to execute the customer's order in such market, the member's conduct could be considered by an NASD District Business Conduct Committee or, if appropriate, the Market Surveillance Committee, to be inconsistent with high standards of commercial honor, in violation of the broad provisions of Article III, Section 1 of the Rules of Fair Practice.

By including the firm's duty to ascertain the market (in new Subsection (a)(l) above) and to obtain the most favorable price (in new Subsection (a)(2)), the rule clarifies that both duties are satisfied if the member uses reasonable diligence. The last sentence of existing paragraph C of the Interpretation has been rewritten to clarify that retail commissions and markups are to be evaluated separately from whether the duty of best execution has been satisfied.

This proposed new rule of fair practice is identical to that proposed for comment in Notice to Members 86-9, except for the added language to clarify that the "inter-dealer market" includes the "exchange markets" in dually traded securities. Also, a change in the title of the section reflects that the section protects both individual and institutional customers.

Subsection (b):

The "due diligence" factors to be considered are especially important because of the broad scope of the best-execution obligation. In Subsection (b)(l), the word "depth" has been added. The concepts of depth and liquidity are different. "Depth," meaning the ability of the market to rapidly absorb or supply a large block of securities, may not exist, even though the market may be liquid, due to the existence of several market makers willing to buy and sell a normal unit of trading.

The existing "pressure on available communications" has been repositioned to new Subsection (b)(2) since it appears to relate more to a particular member's situation rather than being a characteristic of the market for the security. In Subsection (b)(3), the word "order" has been substituted for "transaction" because "not held" orders, limit orders, all-or-none orders, and other types of orders require different handling.

The amount of the transaction is of obvious relevance and, although implicit under the existing language, is emphasized by placing it separately in new Subsection (b)(4).

The "type of security" is a factor not mentioned in the existing language. It has been added under Subsection (b)(5) because the market often differs depending on the type of security.

The word "primary" is deleted in Subsections (b)(6) and (b)(7) because it seems unwarranted to impose on members a duty to know which, if any, firms are the primary market makers in any given security. The requirement in Subsection (b)(7) could be satisfied by checking a NASDAQ Level 3 terminal.

Subsection (c):

This subsection is the identical language currently contained in paragraph D of the Interpretation with respect to the duty of members executing transactions in non-NASDAQ securities to obtain quotations from at least three dealers (or fewer if there are less than three dealers in the security) to determine the best inter-dealer market. The purpose and application of the provision, which became effective September 1, 1988, and certain other related requirements contained or to be contained shortly in other NASD rules and schedules, were previously announced in NASD Notices to Members 88-40 (June 1988) and 88-54 (July 1988).

PROPOSED NEW SECTION [B] OF THE NASD RULES OF FAIR PRACTICE

Item 2 on ballot

Interpositioning Prohibition

Sec. [B].

General

(a) No member or person associated with a member in any agency or contemporaneous principal transaction for or with a customer in the over-the-counter market shall interpose another broker-dealer or any other conduit between the member and the best available market for the security, unless the member can demonstrate that to his knowledge at the time of the transaction the total price paid, or amount received by the customer, as confirmed or billed to the member having the customer by the interposed person, net of commissions paid to the member by the customer, or mark-ups or mark-downs applied by the member, was better than or equal to the prevailing inter-dealer market for the security.

Exemptions

(b) The prohibitions of subsection (a) shall not be applicable to: (1) "principal disclosed" clearing arrangements under which transactions are effected by the clearing member for the introducing member and the market maker or other third member confirms the transaction directly with the clearing member, or (2) other relationships between members under which a correspondent intermediary member transmits the order to a market maker or other third member and the market maker confirms the transaction directly with the initiating member rather than with the intermediary member ("give- up" transactions), so long as the cost of such ser vice is not borne by the customer.

Obligations of Interposed Members

(c) No member shall permit an order to be channeled through it as described in subsection (a) of this section when it knowingly is a party to an arrangement whereby the initiating member has not fulfilled its obligations under this section.

Definitions

(d)
(l) As used in subsection (a), the term "best available market" shall mean the best inter-dealer market for the security, unless the member has actual knowledge of any market outside the inter-dealer market that is better than such inter-dealer market.
(2) As used in subsection (a), the term "contemporaneous principal transaction" shall have the same meaning as that used in Section [A] of the Rules of Fair Practice.

EXPLANATION

New Section [B] will replace paragraphs B and C of the Best Execution Interpretation, which together constitute the "interpositioning" part of the Interpretation, which will be rescinded on adoption of the new section. The new section has been temporarily designated Section [B] of Article III of the Rules of Fair Practice and will be given a permanent section number and placement within Article III prior to effectiveness. The new section appears on the ballot as Item 2.

Except as noted below, proposed new Section [B] retains the language originally proposed for comment. The new section is a rewording of existing paragraph B of the Best Execution Interpretation and the language found under the heading "Comment." The added language "in any agency or contemporaneous principal transaction for or with a customer in the over-the-counter market," which appears in Subsection (a) of new Section [B], is intended to clarify that the restriction against interpositioning applies to both types of transactions. It also parallels the language of proposed Section [A] that establishes a general best-execution standard.

The existing Best Execution Interpretation covers any interposed third party. This provision allows the NASD to bring disciplinary actions when the interposed account is the personal account of the member's trader or other persons associated with a member. Subsection (a) of the proposed rule substitutes the words "any other conduit" for the current "third party" language because this appears more consistent with the concept of interpositioning. The use of the term "conduit" is, thus, intended to clarify that the prohibitions of Section [B] apply when the proposed intermediary is simply a channel between the member and the market in which the transaction is executed.

A major change from the language of proposed Section [B] as published for comment relates to the scope of the interpositioning prohibition. Under both the existing Interpretation and the originally proposed new section, a member is prohibited from interposing someone between the customer and the best available market unless it can be demonstrated that the price paid or received by the customer was "better than" the prevailing inter-dealer price. One commenter stated that if a customer is not prejudiced because the price received or paid is the same as the prevailing inter-dealer price, it is unnecessary to limit the ability of the member to act in the best interest of the customer. It was further pointed out that if a member deems it advantageous for legitimate business reasons to buy or sell a security from a non-market maker and the customer receives a price equal to the inter-dealer price, the customer cannot be prejudiced. Therefore, Subsection (a) of new Section [B] prohibits interpositioning unless the member can demonstrate that the price paid or received by the customer was "better than or equal to" the prevailing inter-dealer price. A further change in new Section [B] is elimination of the word "retail" before "customer" to clarify that the protections of the section apply to institutional as well as individual customers.

The words "cost or proceeds" in the Best Execution Interpretation have been deleted and new language added to clarify that the amount paid or received by the customer is the amount the member paid or received from the interposed party without any adjustment for commissions paid by the customer to the member or markups or markdowns applied by the member in the transaction with the customer. The phrase "as confirmed to the member" is expanded because, where the interposed person is not a broker-dealer, the member would not necessarily receive a receipt or bill labeled a "confirmation."

Proposed Subsection (b) is entirely new and replaces the last sentence of the third paragraph under the heading "Comment" in paragraph B of the Best Execution Interpretation. New Subsection (b) would explicitly exempt (1) principal disclosed clearing arrangements and (2) other correspondent arrangements involving "give ups" of the name of the member initiating the transaction through another member.

Proposed Subsection (c) is a revision of the fourth paragraph under the heading "Comment" in the Best Execution Interpretation. The language clarifies the responsibility of the interposed member and is considered appropriate considering that one of the traditional motives for inter-positioning is to reward the interposed firm for business or services.

Subsection (d) contains a definition of the phrase "best available market." Without a definition in the current Best Execution Interpretation, the phrase appears to place an uncertain standard on members, which could be unfair if members are required to become aware of the existence of some little-known or obscure market, such as a single investor willing to buy the security whose interest is not advertised in conventional quotations media. As a result of member comment, however, the definition originally proposed has been revised slightly to more closely parallel the general duty of best execution in proposed new Section [A].

CURRENT TEXT

Item 3 on ballot

NASD Manual, ¶ 2151.04, p. 2037-4 — 2037-5

[...Interpretation of the Board of Governors]

[Prompt Receipt and Delivery of Securities]

[04. It shall be deemed a violation of Article III, Section 1 of the Rules of Fair Practice of the Association for a member to violate the provisions of the following Interpretation thereof:]

[(a) Purchases: No member may accept a customer's purchase order for any security unless it has first ascertained that the customer placing the order or its agent agrees to receive securities against payment in an amount equal to any execution, even though such an execution may represent the purchase of only a part of a larger order.]
[(b) Sales:]
[(1) Long Sales]
[No member or person associated with a member shall accept a long sale order from any customer in any security unless:]
[(A) The member has possession of the security;]
[(B) The customer is long in his account with the member;]
[(C) The member makes an affirmative determination that the customer owns the security and will deliver it in good deliverable form within five (5) business days of the execution of the order; or]
[(D) The security is on deposit in good deliverable form with a member of the Association, a member of a national securities exchange, a broker-dealer registered with the Securities and Exchange Commission, or any organization subject to state or federal banking regulations and that instructions have been forwarded to that depository to deliver the securities against payment.]
[(2) "Short" Sales]
[No member or person associated with a member shall accept a "short" sale order for any customer in any security unless the member makes an affirmative determination that it will receive delivery of the security from the customer or that it can borrow the security on behalf of the customer for delivery by settlement date. This requirement shall not apply, however, to transactions in corporate debt securities.]
[(3) Public Offering]
[In the case of a public offering of securities, paragraph 1 hereof shall not apply during the period from the commencement of the public offering until seven (7) business days following the date of settlement between the underwriter and the issuer of the securities; provided, however, that the member believes in good faith that the customer has purchased the securities.]
[(4) "Affirmative Determination" ]
[(C) To satisfy the requirements for an "affirmative determination" contained in Subsection (1)(C) above, the member or person associated with a member must make notation on the order ticket at the time he takes the order which reflects his conversation with the customer as to the present location of the securities in question, whether they are in good deliverable form and his ability to deliver them to the member within five (5) business days.]

PROPOSED NEW SECTION [C] OF THE NASD RULES OF FAIR PRACTICE

Item 3 on ballot

Prompt Receipt and Delivery of Securities

Sec. [C]

(a) Purchases. No member or person associated with a member shall accept a customer's purchase order for any security for more than a single unit of trading unless it has first ascertained that the customer placing the order or its agent agrees to receive securities against payment in an amount equal to any execution, even though such an execution may represent the purchase of only a part of a larger order.
(b) Sales
(1) Long Sales
No member or person associated with a member shall execute a long sale order from any customer in any security unless:
(A) The member has possession of the security;
(B) The customer is long in his account with the member;
(C) The member makes an affirmative determination that the customer owns the security and will deliver it in good deliverable form within five (5) business days of the execution of the order; or
(D) The security is on deposit in good deliverable form with a member of the Association, a member of a national securities exchange, a broker-dealer registered with the Securities and Ex- change Commission, or any organization subject to state or federal banking regulations and that instructions have been forwarded to that depository to deliver the securities against payment.
(2) "Short" Sales
No member or person associated with a member shall accept a "short" sale order for any customer in any security unless the member makes an affirmative determination that it will receive delivery of the security from the customer or that it can borrow the security on behalf of the customer for delivery by settlement date. This requirement shall not apply, however, to transactions in corporate debt securities.
(3) Public Offering
In the case of a public offering of securities, paragraph (1) hereof shall not apply during the period from the commencement of the public offering until seven (7) business days following the date of settlement between the underwriter and the issuer of the securities; provided, however, that the member believes in good faith that the customer has purchased the securities.
(4) "Affirmative Determination" and Notation on Order Ticket
To satisfy the requirements for an "affirmative determination" contained in subsection (1)(C) above, the member or person associated with a member must make a notation on the order ticket at the time he takes the order which reflects the conversation with the customer as to the present location of the securities in question, whether they are in good deliverable form, and his ability to deliver them to the member within five (5) business days. If subsections (1)(B) or (1)(D) above are applicable, the order ticket must contain a notation reflecting the requirements of these subsections.

EXPLANATION

As originally proposed, new Section [C] would have codified the language that now appears in the NASD Manual as an Interpretation of the Board of Governors —"Prompt Receipt and Delivery of Securities" — under Article III, Section 1 of the Rules of Fair Practice (Prompt Receipt Interpretation) and would have included a new provision to cover short sales. However, on October 15,1986, the short-sale provision became effective as an amendment to the existing Prompt Receipt Interpretation. Proposed new Section [C] converts the Interpretation as amended into rule form with certain changes explained below.

Subsection (a) of new Section [C] incorporates the current provision in the Prompt Receipt Interpretation requiring that the customer placing a purchase order agree to accept a partial delivery, but modifies the existing language to make the requirement applicable only to purchase orders for more than a single unit of trading. The Board of Governors believes that it is unfair to require a customer who places an order for less than a unit of trading to accept a partial delivery.

The other change is in Subsection (b)(4) of new Section [C], which would expand the existing order-ticket-notation requirement when the selling customer has possession of the securities to also require an appropriate order-ticket notation when the securities are long in the customer's account or in the possession of another member or bank. The new section appears as Item 3 on the ballot.

The NASD has filed a proposed rule change with the SEC to amend the current language of Subsection (b)(2) to impose the same requirement on short sales by members effecting short sales for their own accounts. See rule filing SR-NASD-89-5 and Notice to Members 88-47 (July 1988) publishing the proposal for comment. The rule filing has not been approved by the SEC. If SR-NASD 89-5 is approved by the SEC, the amendment proposed herein will be made to the Interpretation as amended by that rule change.

CURRENT TEXT

Item 4 on ballot

NASD Manual, ¶2151.05, pp. 2037-5 — 2038

[... Interpretation of the Board of Governors]

[Forwarding of Proxy and Other Materials]

[Introduction]

[.05 A member has an inherent duty in carrying out high standards of commercial honor and just and equitable principles of trade to forward all proxy material, annual reports, information statements and other material required by law to be sent to stockholders periodically, which are properly furnished to it by the issuer of the securities, to each beneficial owner of shares of that issue which are held by the member for the beneficial owner thereof. For the assistance and guidance of members in meeting their responsibilities, therefore, the Board of Governors has promulgated this Interpretation. The provisions hereof shall be followed by all members and failure to do so shall constitute conduct inconsistent with high standards of commercial honor and just and equitable principles of trade in violation of Article III, Section 1 of the Rules of Fair Practice of the Association.]

[Interpretation]

[Section 1. No member shall give a proxy to vote stock which is registered in its name, except as required or permitted under the provisions of Section 2 or 3 hereof, unless such member is the beneficial owner of such stock.]

[Section 2. Whenever a person soliciting proxies shall timely furnish to a member:]

[(1) sufficient copies of all soliciting material which such person is sending to registered holders, and]
[(2) satisfactory assurance that he will reimburse such member for all out-of-pocket expenses, including reasonable clerical expenses incurred by such member in connection with such solicitation, such member shall transmit promptly to each beneficial owner of stock of such issuer which is in its possession or control and registered in a name other than the name of the beneficial owner all such material furnished. Such material shall include a signed proxy indicating the number of shares held for such beneficial owner and bearing a symbol identifying the proxy with proxy records maintained by the member, and a letter informing the beneficial owner of the time limit and necessity for completing the proxy form and forwarding it to the person soliciting proxies prior to the expiration of the time limit in order for the shares to be represented at the meeting. A member shall furnish a copy of the symbols to the person soliciting the proxies and shall also retain a copy thereof pursuant to the provisions of Rule 17a-4 of the General Rules and Regulations under the Securities Exchange Act of 1934, 17 C. F. R. 240.17a-4. Notwithstanding the provisions of this section, a member may give a proxy to vote any stock pursuant to the rules of any national securities exchange to which the member is also responsible provided that the records of the member clearly indicate which procedure it is following.]

[This section shall not apply to beneficial owners residing outside of the United States of America though members may voluntarily comply with the provisions hereof in respect to such persons if they so desire.]

[Section 3. A member may give a proxy to vote any stock registered in its name if such member holds such stock as executor, administrator, guardian, trustee, or in a similar representative or fiduciary capacity with authority to vote.]

[A member which has in its possession or within its control stock registered in the name of another member and which desires to transmit signed proxies pursuant to the provisions of Section 2, shall obtain the requisite number of signed proxies from such holder of record.]

[Section 4. A member when so requested by an issuer and upon being furnished with:]

[(1) sufficient copies of annual reports, information statements or other material required by law to be sent to stockholders periodically, and]
[(2) satisfactory assurance that it will be reimbursed by such issuer for all out-of-pocket expenses, including reasonable clerical expenses, shall transmit promptly to each beneficial owner of stock of such issuer which is in its possession and control and registered in a name other than the name of the beneficial owner all such material furnished.]

[This section shall not apply to beneficial owners residing outside of the United States of America though members may voluntarily comply with provisions hereof in respect to such persons if they so desire.]

[Section 5. The Board of Governors for the guidance of members is authorized to establish a suggested rate of reimbursement of members for expenses incurred in connection with transmitting the proxy solicitation to the beneficial owners of the securities pursuant to Section 2 hereof or in transmitting information statements or other material to the beneficial owners of securities pursuant to Section 4 hereof. Such shall be attached hereto by appendix.]

PROPOSED NEW SECTION [D] OF THE NASD RULES OF FAIR PRACTICE

Item 4 on ballot

Proxies

Sec. [D].

Restrictions on giving of proxies

(a) No member shall give or authorize the giving of a proxy to vote any security which is registered in its name, or in the name of its nominee, except as permitted under the provisions of subsection (d), unless the member is the beneficial owner of the security. These restrictions shall also apply to voting in person.

Forwarding of proxy material to customers

(b) Whenever a person soliciting proxies shall timely furnish to a member sufficient copies ofidl soliciting material which the person is sending to registered holders, and satisfactory assurance that he will reimburse the member for all out-of-pocket expenses, including reasonable clerical expenses, incurred by the member in connection with the solicitation, the member shall:
(1) transmit or cause to be transmitted to each beneficial owner of the security that is in its possession or control and registered in the name of the member, or the name of its nominee, all such material furnished no later than five (5) business days after receipt thereof; and,
(2) transmit with the material a signed proxy and cover letter indicating the number of shares held for the beneficial owner and bearing a symbol identifying the proxy with proxy records main tained by the member, and also a letter informing the beneficial owner of the time limit and necessity for completing the proxy form and forwarding it to the person soliciting proxies in order for the securities to be represented at the meeting. A member shall furnish a copy of the symbols to the per son soliciting the proxies and shall also retain a copy as required by SEC Rule 17a-4 under the Securities Exchange Act of 1934.

Signed proxy and transmittal letter

(c) Notwithstanding the provisions of subsection (b), a member which is also a member of a national securities exchange may give a proxy to vote any security pursuant to the rules of any such exchange provided that the records of the member clearly indicate which rule it is following.

Member as executor or similar representative capacity

(d) A member may give a proxy to vote any security registered in its name if the member holds the security as executor, administrator, guardian, trustee, or in a similar representative or fiduciary capacity with authority to vote.

Signed proxies for security in names of other members

(e) A member which has in its possession or control any security registered in the name of another member and that desires to transmit signed proxies pursuant to the provisions of subsection (b) of this section shall request the requisite number of signed proxies from the other member, which shall have a duty to comply with the request.

Forwarding of annual reports and other material

(f) A member, when requested by an issuer, and upon being furnished with sufficient copies of annual reports, interim reports of earnings, information statements, or other material being sent to security holders and satisfactory assurance that it will be reimbursed by the issuer for all out-of- pocket expenses, including reasonable clerical expenses, shall transmit or cause to be transmitted promptly all the material received by the member to each beneficial owner of any security of the issuer that is registered in its name or the name of its nominee.

Suggested rates of reimbursement

(g) The Board of Governors, for the guidance of members, is authorized to establish a suggested rate of reimbursement of members for expenses incurred in connection with transmitting the proxy solicitation to the beneficial owners of the securities pursuant to subsection (b) hereof or in transmitting information statements or other material to the beneficial owners of securities pursuant to subsection (f) hereof. The suggested rates of reimbursement authorized hereby shall be incorporated into Appendix G to be attached to and made a part of this rule. The Board of Governors shall have the power to alter, amend, supplement, or modify the provisions of Appendix G from time to time without recourse to the membership for approval, as would otherwise be required by Article VII of the By-Laws.

Beneficial owners residing outside the United States

(h) The requirements of this section shall not apply to beneficial owners residing outside of the United States.

EXPLANATION

This new section codifies the language that now appears in the NASD Manual as an Interpretation of the Board of Governors — "Forwarding of Proxy and Other Materials," under Article III, Section 1 of the NASD Rules of Fair Practice (Proxy Interpretation). The existing Proxy Interpretation was adopted in 1967 to establish requirements applicable to proxies covering "street name" stock. The new section appears as Item 4 on the ballot.

The introduction to the Proxy Interpretation is not included in new Section [D] since it merely restates some of the substantive provisions that are contained later in the Interpretation. Section [D] would contain new headings above each subsection for clarity. The heading "Restrictions on Giving of Proxies" above Subsection (a), for example, is intended to emphasize the fact that there are only very limited circumstances that allow a member to give a proxy to vote securities registered in its name. Subsection (a) also would make the restrictions applicable to securities registered in the name of a nominee of a member to prevent technical evasion of the restrictions. For the same reason, the restrictions would be made expressly applicable to voting in person since the current language appears limited to situations involving voting by proxy.

Subsection (b) provides that, upon being furnished with sufficient copies of proxy solicitation material and assurance of reimbursement of expenses, a member is required to forward the material to the beneficial owners. The requirement applies whether the proxies are being solicited by the issuer or someone else, provided assurance of expense reimbursement is received. The new language authorizing a member to cause the material to be transmitted is intended only to clarify that a member may contract with another person to forward the material. The new language also clarifies that a member is responsible only for forwarding materials if it or its nominee is the record holder. The deletion of the word "promptly" and substitution of "a five-day period" to furnish the material conforms to the requirement of SEC Rule 14b-l(b).

Subsection (c) requires a member to transmit with the solicitation material a signed proxy to be completed by the beneficial owner and mailed directly to the issuer or other person soliciting proxies. Exchange rules permit a member to request voting instructions from the beneficial owners and, if instructions are received, the member is required to vote the proxies in accordance with the instructions received. With the exception of certain corporate events, the failure to receive voting instructions allows a member to vote a proxy at its discretion. The Proxy Interpretation deliberately omits this alternative procedure, but it does allow a member that is also an exchange member to elect to follow the exchange's proxy rules.

The changes in the second paragraph of Subsection (c) are for clarification only. The redraft retains these provisions. The third paragraph has been moved to new Subsection (h). The language of proposed Subsection (d) is basically unchanged from the existing language.

The changes in Subsection (e) concerning securities in the possession of a member that are registered in the name of another member are designed to clarify that the member in whose name the securities are registered must comply with any request by the member in possession to be furnished with signed proxies.

The changes in new Subsection (f) that impose a duty under certain conditions to forward annual reports and other materials not part of the proxy material are designed to make the language similar to the exchange rules. Thus, as revised, the requirement would apply to any material being sent to security holders by an issuer. The current language is limited to material "required by law" to be sent by an issuer to its security holders.

Under Subsection (g), the NASD Board is granted authority to adopt an Appendix G to new Section [D] establishing suggested rates of reimbursement for the cost of forwarding materials. It is contemplated that this appendix will be the same as the existing appendix under the Proxy Interpretation. The current appendix is not included in this notice since a membership vote is not required. When new Section [D] becomes effective, the current appendix will be placed immediately after the new section.

CURRENT TEXT

NASD Manual, ¶ 2151.06, pp. 2O40 — 2407-3

Item 5 on ballot

[...Interpretation of the Board of Governors]

["Free Riding and Withholding"]

[Introduction]

[The following Interpretation of Article III, Section 1 of the Association's Rules of Fair Practice is adopted by the Board of Governors of the Association pursuant to the provisions of Article VII, Section 3(a) of the Association's By-Laws and Article I, Section 3 of the Rules of Fair Practice.]

[This interpretation is based upon the premise that members have an obligation to make a bona fide public distribution at the public offering price of securities of a public offering which trade at a premium in the secondary market whenever such secondary market begins (a "hot issue") regardless of whether such securities are acquired by the member as an underwriter, as a selling group member, or from a member participating in the distribution as an underwriter or a selling group member, or otherwise. The failure to make a bona fide public distribution when there is a demand for an issue can be a factor in artificially raising the price. Thus, the failure to do so, especially when the member may have information relating to the demand for the securities or other factors not generally known to the public, is inconsistent with high standards of commercial honor and just and equitable principles of trade and leads to an impairment of public confidence in the fairness of the investment banking and securities business. Such conduct is, therefore, in violation of Article III, Section 1 of the Association's Rules of Fair Practice and this Interpretation thereof which establishes guidelines in respect to such activity.]

[As in the case of any other Interpretation issued by the Board of Governors of the Association, the implementation thereof is a function of the District Business Conduct Committees and the Board of Governors. Thus, the Interpretation will be applied to a given factual situation by individuals active in the investment banking and securities business who are serving on these committees or on the Board. They will construe this Interpretation to effectuate its overall purpose to assure a public distribution of securities for which there is a public demand.]

[Interpretation]

[Except as provided herein, it shall be inconsistent with high standards of commercial honor and just and equitable principles of trade and a violation of Article III, Section 1 of the Association's Rules of Fair Practice for a member, or a person associated with a member, to fail to make a bona fide public distribution at the public offering price of securities of a public offering which trade at a premium in the secondary market whenever such secondary market begins regardless of whether such securities are acquired by the member as an underwriter, a selling group member or from a member participating in the distribution as an underwriter or selling group member, or otherwise. Therefore, it shall be a violation of Article III, Section 1 for a member, or a person associated with a member, to:]

[1. Continue to hold any of the securities so acquired in any of the members' accounts;]
[2. Sell any of the securities to any officer, director, general partner, employee or agent of the member or of any other broker-dealer, or to a person associated with the member or with any other broker-dealer, or to a member of the immediate family of any such person;]
[3. Sell any of the securities to a person who is a finder in respect to the public offering or to any person acting in a fiduciary capacity to the managing underwriter, including, among others, attorneys, accountants and financial consultants, or to a member of the immediate family of any such person;]
[4. Sell any securities to any senior officer at a bank, savings and loan institution, insurance company, registered investment company, registered investment advisory firm or any other institutional type account, domestic or foreign, or to any person in the securities department of, or to any employee or any other person who may influence or whose activities directly or indirectly involve or are related to the function of buying or selling securities for any bank, savings and loan institution, insurance company, registered investment company, registered investment advisory firm, or other institutional type account, domestic or foreign, or to a member of the immediate family of any such person;]
[5. Sell any securities to any account in which any person specified under paragraphs 1, 2, 3, or 4 hereof has a beneficial interest;]
[Provided, however, a member may sell part of its securities acquired as described above to:]
[(a) persons enumerated in paragraphs 3 or 4 hereof; and]
[(b) members of the immediate family of persons enumerated in paragraph 2 hereof provided that such person enumerated in paragraph 2 does not contribute directly or indirectly to the support of such member of the immediate family; and]
[(c) any account in which any person specified under paragraph 3 or 4 or subparagraph (b) of this paragraph has a beneficial interest; if the member is prepared to demonstrate that the securities were sold to such persons in accordance with their normal investment practice with the member, that the aggregate of the securities so sold is insubstantial and not disproportionate in amount as compared to sales to members of the public and that the amount sold to any one of such persons is insubstantial in amount.]
[6. Sell any of the securities, at or above the public offering price, to any other broker-dealer; provided, however, a member may sell all or part of the securities acquired as described above to another member broker-dealer upon receipt from the latter in writing assurance that such purchase would be made to fill orders for bona fide public customers, other than those enumerated in paragraphs 1, 2, 3, 4 or 5 above, at the public offering price as an accommodation to them and without compensation for such.]
[7. Sell any of the securities to any domestic bank, domestic branch of a foreign bank, trust company or other conduit for an undisclosed principal unless:]
[(a) An affirmative inquiry is made of such bank, trust company or other conduit as to whether the ultimate purchasers would be persons enumerated in paragraphs 1 through 5 hereof and receives satisfactory assurance that the ultimate purchasers would not be such persons, and that the securities would not be sold in a manner inconsistent with the provisions of paragraph 6 hereof; otherwise, there shall be a rebuttable presumption that the ultimate purchasers were persons enumerated in paragraphs 1 through 5 hereof or that the securities were sold in a manner inconsistent with the provisions of paragraph 6 hereof;]
[(b) A recording is made on the order ticket, or its equivalent, or on some other supporting document, of the name of the person to whom the inquiry was made at the bank, trust company or other conduit as well as the substance of what was said by that person and what was done as a result thereof;]
[(c) The order ticket, or its equivalent, is initialed by a registered principal of the member; and]
[(d ) Normal supervisory procedures of the member provide for a close follow-up and review of all transactions entered into with the referred to domestic banks, trust companies or other conduits for undisclosed principals to assure that the ultimate recipients of securities so sold are not persons enumerated in paragraphs 1 through 6 hereof.]
[8. Sell any of the securities to a foreign broker-dealer or bank unless:]
[(a) In the case of a foreign broker-dealer or bank which is participating in the distribution as an underwriter, the agreement among underwriters contains a provision which obligates the said foreign broker-dealer or bank not to sell any of the securities which it receives as a participant in the distribution to persons enumerated in paragraphs 1 through 5 above, or in a manner inconsistent with the provisions of paragraph 6 hereof; or]
[(b) In the case of sales to a foreign broker-dealer or bank which is not participating in the distribution as an underwriter, the selling member:]
[(i) makes an affirmative inquiry of such foreign broker-dealer or bank as to whether the ultimate purchasers would be persons enumerated in paragraphs 1 through 5 hereof and receives satisfactory assurance that the ultimate purchasers of the securities so purchased would not be such persons, and that the securities would not be sold in a manner inconsistent with the provisions of paragraph 6 hereof;]
[(ii) a recording is made on the order ticket, or its equivalent, or upon some other supporting document, of the name of the person to whom the inquiry was made at the foreign broker-dealer or bank as well as the substance of what was said by that person and what was done as a result thereof; and]
[(iii) the order ticket, or its equivalent, is initialed by a registered principal of the member.]

[The obligations imposed upon members in their dealings with foreign broker-dealers or banks by this paragraph 8(b) can be fulfilled by having the foreign broker-dealer or bank to which sales falling within the scope of this Interpretation are made execute Form FR-1, or a reasonable facsimile thereof. This form, which gives a blanket assurance from the foreign broker-dealer or bank that no sales will be made in contravention of the provisions of this Interpretation, can be obtained at any District Office of the Association or at the Executive Office. The acceptance of an executed Form FR-1, or other written assurance, by a member must in all instances be made in good faith. Thus, if a member knows or should have known of facts which are inconsistent with the representations received, such will not operate to satisfy the obligations imposed upon him by this paragraph.]

[Scope and Intent of Interpretation]

[In addition to the obvious scope and intent of the above provisions, the intent of the Board of Governors in the following specific situations is outlined for the guidance of members.]

[Issuer Directed Securities]

[This Interpretation shall apply to securities which are part of a public offering notwithstanding that some or all of those securities are specifically directed by the issuer to accounts which are included within the scope of paragraphs 3 through 8 above. Therefore, if a person within the scope of those paragraphs to whom securities were directed did not have an investment history with the member or registered representative from whom they were to be purchased, the member would not be permitted to sell him such securities. Also, the "disproportionate" and "insubstantial" tests would apply as in all other situations. Thus, the directing of a substantial number of securities to any one person would be prohibited as would the directing of securities to such accounts in amounts which would be disproportionate as compared to sales to members of the public. This Interpretation shall also apply to securities which are part of a public offering notwithstanding that some of those securities are specifically directed by the issuer on a non-underwritten basis. In such cases, the managing underwriter of the offering shall be responsible for insuring compliance with this Interpretation in respect to those securities.]

[Notwithstanding the above, sales of issuer directed securities may be made to restricted persons without the required investment history after receiving permission from the Board of Governors. Permission will be given only if there is a demonstration of valid business reasons for such sales (such as sales to distributors and suppliers or key employees, who are in each case incidentally restricted persons), and the member seeking permission is prepared to demonstrate that the aggregate amount of securities so sold is insubstantial and not disproportionate as compared to sales to members of the public, and that the amount sold to any one of such persons is insubstantial in amount.]

[Investment Partnerships and Corporations]

[A member may not sell securities of a public offering which trade at a premium in the secondary market whenever such secondary market begins ("hot issue"), to the account of any investment partnership or corporation, domestic or foreign (except companies registered under the Investment Company Act of 1940) including but not limited to, hedge funds, investment clubs, and other like accounts unless the member complies with either of the following alternatives; ]

[(A) prior to the execution of the transaction, the member has received from the account a current list of the names and business connections of all persons having any beneficial interest in the account, and if such information discloses that any person enumerated in paragraphs (1) through (4) hereof has a beneficial interest in such account, any sale of securities to such account must be consistent with the provisions of this Interpretation, or]
[(B) prior to the execution of the transaction, the member has obtained a copy of a current opinion from counsel admitted to practice law before the highest court of any state stating that counsel reasonably believes that no person with a beneficial interest in the account is a restricted person under this Interpretation and stating that, in providing such opinion, counsel:]
[(1) has reviewed and is familiar with this Interpretation;]
[(2) has reviewed a current list of all persons with a beneficial interest in the account supplied by the account manager;]
[(3) has reviewed information supplied by the account manager with respect to each person with a beneficial interest in the account, including the identity, the nature of employment, and any other business connections of such persons; and]
[(4) has requested and reviewed other documents and other pertinent information and made inquiries of the account manager and received responses thereto, if counsel determines that such further review and inquiry are necessary and relevant to determine the correct status of such persons under the Interpretation.]

[The member shall maintain a copy of the names and business connections of all persons having any beneficial interest in the account or a copy of the current opinion of counsel in its files for at least three years following the member's last sale of a new issue to the account, depending upon which of the above requirements the member elects to follow. For purposes of this section, a list or opinion shall be deemed to be current if it is based upon the status of the account as of a date not more than 18 months prior to the date of the transaction.]

[The term beneficial interest means not only ownership interests, but every type of direct financial interest of any persons enumerated in paragraphs (1) through (4) hereof in such account, including, without limitation, management fees based on the performance of the account.]

[Violations by Recipient]

[In those cases where a member or person associated with a member has been the recipient of securities of a public offering to the extent that such violated the Interpretation, the member or person associated with a member shall be deemed to be in violation of Article III, Section 1 of the Rules of Fair Practice and this Interpretation as well as the member who sold the securities since their responsibility in relation to the public distribution is equally as great as that of the member selling them. In those cases where a member or a person associated with a member has caused, directly or indirectly, the distribution of securities to a person falling within the restrictive provisions of this Interpretation, the member or person associated with a member shall also be deemed to be in violation of Article III, Section 1 of the Rules of Fair Practice and this Interpretation. Receipt by a member or a person associated with a member of securities of a hot issue which is being distributed by an issuer itself without the assistance of an underwriter and/or selling group is also intended to be subject to the provisions of this Interpretation.]

[Violations by Registered Representative Executing Transaction]

[The obligation which members have to make a bona fide public distribution at the public offering price of securities of a hot issue is also an obligation of every person associated with a member who causes a transaction to be executed. Therefore, where sales are made by such persons in a manner inconsistent with the provisions of this Interpretation, such persons associated with a member will be considered equally culpable with the member for the violations found taking into consideration the facts and circumstances of the particular case under consideration.]

[Disclosure]

[The fact that a disclosure is made in the prospectus or offering circular that a sale of securities would be made in a manner inconsistent with this Interpretation does not take the matter out of its scope. In sum, therefore, disclosure does not affect the proscriptions of this Interpretation.]

[Explanation of Terms]

[The following explanation of terms is provided for the assistance of members. Other words which are defined in the By-Laws and Rules of Fair Practice shall, unless the context otherwise requires, have the meaning as defined therein.]

[Public Offering]

[The term public offering shall mean all distributions of securities whether underwritten or not; whether registered, unregistered or exempt from registration under the Securities Act of 1933, and whether they are primary or secondary distributions, including intra- state distributions and Regulation A issues, which sell at an immediate premium, in the secondary market. It shall not mean exempted securities as defined in Section 3(a)(12) of the Securities Exchange Act of 1934.]

[Immediate Family]

[The term immediate family shall include parents, mother-in-law or father-in-law, husband or wife, brother or sister, brother-in-law or sister-in-law, son-in-law or daughter-in-law, and children. In addition, the term shall include any other person who is supported, directly or indirectly, to a material extent by the member, person associated with the member or other person specified in paragraphs 2, 3, or 4 above.]

[Normal Investment Practice]

[Normal investment practice shall mean the history of investment of a restricted person in an account or accounts maintained with the member making the allocation. In cases where an account was previously maintained with another member, but serviced by the same registered representative as the one currently servicing the account for the member making the allocation, such earlier investment activity may be included in the restricted person's investment history. Usually the previous one-year period of securities activity is the basis for determining the adequacy of a restricted person's investment history. Where warranted, however, a longer or shorter period may be reviewed. It is the responsibility of the registered representative effecting the allocation, as well as the member, to demonstrate that the restricted person's investment history justifies the allocation of hot issues. Copies of customer account statements or other records maintained by the registered representative or the member may be utilized to demonstrate prior investment activity. In analyzing a restricted person's investment history the Association believes the following factors should be considered:]

[(1) The frequency of transactions in the account or accounts during that period of time. Relevant in this respect are the nature and size of investments.]
[(2) A comparison of the dollar amount of previous transactions with the dollar amount of the hot issue purchase. If a restricted person purchases $1,000 of a hot issue and his account reveals a series of purchases and sales in $100 amounts, the $1,000 purchase would not appear to be consistent with the restricted person's normal investment practice.]
[(3) The practice of purchasing mainly hot issues would not constitute a normal investment practice. The Association does, however, consider as contributing to the establishment of a normal investment practice, the purchase of new issues which are not hot issues as well as secondary market transactions.]

[Disproportionate]

[In respect to the determination of what constitutes a disproportionate allocation, the Association uses as a guideline 10% of the member's participation in the issue, however acquired. It should be noted, however, that the 10% factor is merely a guideline and is one of a number of factors which are considered in reaching determinations of violations of the Interpretation on the basis of disproportionate allocations. These other factors include, among other things:]

[the size of the participation;]

[the offering price of the issue;]

[the amount of securities sold to restricted accounts; and,]

[the price of the securities in the aftermarket.]

[It should be noted that disciplinary action has been taken against members for violations of the Interpretation where the allocations made to restricted accounts were less than 10% of the member's participation. The 10% guideline is applied as to the aggregate of the allocations.]

[Notwithstanding the above, a normal unit of trading (100 shares or 10 bonds) will in most cases not be considered a disproportionate allocation regardless of the amount of the member's participation. This means that if the aggregate number of shares of a member's participation which is allocated to restricted accounts does not exceed a normal unit of trading, such allocation will in most cases not be considered disproportionate. For example, if a member receives 500 shares of a hot issue, he may allocate 100 shares to a restricted account even though such allocation represents 20% of that member's participation. Of course, all of the remaining shares would have to be allocated to unrestricted accounts and all other provisions of the Interpretation would have to be satisfied. Specifically, the allocation would have to be consistent with the normal investment practice of the account to which it was allocated and the member would not be permitted to sell to restricted persons who were totally prohibited from receiving hot issues.]

[Insubstantiality]

[This requirement is separate and distinct from the requirements relating to disproportionate allocations and normal investment practice. In addition, this term applies both to the aggregate of the securities sold to restricted accounts and to each individual allocation. In other words, there could be a substantial allocation to an individual account in violation of the Interpretation and yet be no violation on that ground as to the total number of shares allocated to all accounts. The determination of whether an allocation to a restricted account or accounts is substantial is based upon, among other things, the number of shares allocated and/or the dollar amount of the purchase.]

[SALES BY ISSUERS IN CONVERSION OFFERINGS]

[Definitions]

[(a) For purposes of this Subsection, the following terms shall have the meanings stated:]
[(1) "Conversion offering" shall mean any offering of securities made as part of a plan by which a savings and loan association or other organization converts from a mutual to a stock form of ownership.]
[(2) "Eligible purchaser" shall mean a person who is eligible to purchase securities pursuant to the rules of the Federal Home Loan Bank Board or other governmental agency or instrumentality having authority to regulate conversion offerings.]

[Conditions for exemption]

[(b) This Interpretation shall not apply to a sale of securities by the issuer on a non-underwritten basis to any person who would otherwise be prohibited or restricted from purchasing a hot issue security if all of the conditions of this Subsection (b) are satisfied.]

[Sales to members, associated persons of members, and certain related persons]

[(1) If the purchaser is a member, person associated with a member, member of the immediate family of any such person to whose support such person contributes, directly or indirectly, or an account in which a member or person associated with a member has a beneficial interest:]
[(A) the purchaser shall be an eligible purchaser;]
[(B) the securities purchased shall be restricted from sale or transfer for a period of 150 days following the conclusion of the offering; and]
[(C) the fact of purchase shall be reported in writing to the member where the person is associated within one day of payment.]

[Sales to Other Restricted Persons]

[(2) If the purchaser is not a person specified in Subsection (b)(l) above, the purchaser shall be an eligible purchaser.]

PROPOSED NEW SECTION [E] OF NASD RULES OF FAIR PRACTICE

Item 5 on ballot

Free-Riding and Withholding

Sec. [E].

Application

(a)
(l) This section shall apply to the sale, purchase, and receipt by members and persons associated with members of a hot issue security.
(2) For purposes of this section, a "hot issue security" is defined as a security of a public offering which trades at a premium in the secondary market within a reasonable time during the initial phase of trading whenever such secondary market begins.

EXPLANATION

New Section [E] codifies the language that now appears in the NASD Manual as an Interpretation of the Board of Governors — "Free-Riding and Withholding" — under Article III, Section 1 of the NASD Rules of Fair Practice (Free-Riding and Withholding Interpretation). Because of the length and complexity of the Free-Riding and Withholding Interpretation and new Section [E], each subsection is discussed separately. The new section appears as Item 5 on the ballot.

Subsection (a) of new Section [E] is based on the current introduction to the Free-Riding and Withholding Interpretation, but eliminates what appears to be unnecessary language. It also clarifies that the provision applies both to purchases of "hot issues" by associated persons and members that are not participating in the offering as well as to purchases and sales by members and associated persons who are participants in the offering.

A major change in the subsection over the provision earlier submitted for comment is the addition of language to define "hot issue securities" as securities of a public offering that trade at a premium in the secondary market within a reasonable time during the initial phase of trading in such secondary market. The change has been made in response to several comments and is designed to introduce a greater degree of specificity into the definition by clarifying that the time period used to determine whether an offering is a "hot issue" following the commencement of aftermarket trading is not open ended and is determined by a standard of reasonableness that takes into account all relevant facts and circumstances.

PROPOSED NEW TEXT

Withholding by members

(b) No member that has acquired a hot issue security as an underwriter or a selling group member or from a broker or dealer participating in the distribution as an underwriter or selling group member, or otherwise, shall fail to make a bona fide public distribution by continuing to hold any part of the security in any of the member's proprietary accounts, including investment, trading, arbitrage, and similar accounts.

EXPLANATION

This provision expands upon the existing prohibition and incorporates certain language now appearing in the Introduction to the Free-Riding and Withholding Interpretation.

PROPOSED NEW TEXT

Sales to associated persons of brokers and dealers and certain other persons

(c)
(l) No member or associated person of a member shall sell or cause the sale of a hot issue security to any person who is an officer, director, general partner, registered principal, registered representative, or employee of a member or of any other broker or dealer, or to any other natural per-son engaged in the investment banking or securities business who is directly or indirectly controlling or controlled by a member or by any other broker or dealer.
(2) No member or associated person of a member shall sell or cause the sale of a hot issue security to a member of the immediate family of any person subject to subsection (1) above; provided that a member or associated person of a member may sell a hot issue security to any such member of the immediate family (i) if the person is not supported, directly or indirectly, by any person covered under subsection (c)(l) above, and (ii) if the member or associated person can demonstrate that the sale was in accordance with the person's established investment practice with the selling member and that the amount of the hot issue security sold to any one of such persons is insubstantial.

EXPLANATION

Subsection (c)(l) of new Section [E] parallels the existing language of the Free-Riding and Withholding Interpretation, with certain changes. The current language that prohibits sales to any officer, director, general partner, or employee of a member has been retained but the existing language also prohibiting sales to any "person associated with a member" has been deleted. New language has been added to specifically cover "any other natural person in the investment banking or securities business who is directly or indirectly controlling or controlled by a member" as persons to whom "hot issues" may not be sold. The new language codifies the NASD's longstanding interpretation that limited partners, non-voting stockholders, and subordinated lenders are not covered unless they are in a control relationship with a member.

Subsection (c)(2) of Section [E] carries forward the existing restrictions concerning sales to members of the immediate family of persons covered by Subsection (c)(l). The restrictions are combined with language now appearing in the proviso clause following paragraph 5 of the Free-Riding and Withholding Interpretation that permits sales to members of the immediate family under certain circumstances. The prohibition on selling a "hot issue" to any of the enumerated persons contained in both subsections (c)(l) and (c)(2) has been expressly made applicable to an "associated person of a member," although the existing language of the Free-Riding and Withholding Interpretation speaks only of sales by members. This is intended to clarify the responsibilities of registered representatives and other associated persons in making sales of "hot issues" to ensure compliance with new Section [E], which appears under the heading "Violations by Registered Representative Executing Transaction" in the Free-Riding and Withholding Interpretation.

The substitution of the "associated person" language also clarifies that the responsibility to ensure compliance with new Section [E] goes beyond the registered representative who executes the sale. The addition of the words "cause to sell" codifies the long-standing NASD position that members and associated persons who direct other participants in the offering to make sales are not relieved of responsibility because the sales are executed by someone else.

PROPOSED NEW TEXT

Sales to persons assisting in the distribution

(d) No member or associated person of a member shall sell or cause the sale of a hot issue security to any person who is a finder with respect to the public offering, or to any person who is acting in a fiduciary capacity to the managing underwriter in connection with the particular public offering, including, among others, attorneys, accountants, and financial consultants and advisers, or to a member of the immediate family of any such person; provided that a member or associated person of a member may sell the security to any person subject to this subsection if the member or associated person of a member can demonstrate that the sale was in accordance with the person's established investment practice with the selling member and that the amount of the hot issue security sold to any one of such persons is insubstantial.

EXPLANATION

Subsection (d) of proposed new Section [E] carries forward the existing restrictions of paragraph 3 of the Free-Riding and Withholding Interpretation and also combines into a single provision language now appearing in the proviso clause following paragraph 5 that allows sales where there is an investment history and the amount sold to the restricted person is insubstantial. In addition, pursuant to proposed Subsection (g) following, aggregate sales to all restricted and prohibited persons must be insubstantial and and not disproportionate. Subsection (d) also clarifies the Board's intent in adopting paragraph 3 that the restriction on sales of "hot issues" applies only to attorneys and accountants performing services for the managing underwriter. It does not apply to attorneys and accountants for participating underwriters or selected dealers. The proposed Subsection also clarifies the Board's intent that the restriction on sales applies only where the attorney or accountant is performing services with respect to the particular public offering being sold and does not apply to attorneys and accountants simply because they performed services in prior public offerings handled by the same managing underwriter.

PROPOSED NEW TEXT

Sales to officers and employees of financial institutions

(e) No member or associated person of a member shall sell or cause the sale of a hot issue security (1) to any person who is a senior officer of any foreign or domestic bank, savings and loan institution, trust company, insurance company, registered investment company, registered investment advisory firm, or who is a senior officer of any other institutional type account, domestic or foreign, or (2) to any person in the securities department of, or to any employee or other person who may influence or whose activities directly or indirectly involve or are related to the function of buying or selling securities for any foreign or domestic bank, savings and loan institution, trust company, insurance company, registered investment company, registered investment advisory firm, or other institutional type account, domestic or foreign, or (3) to a member of the immediate family of any such person; provided that a member or associated person of a member may sell the security to a person subject to this Subsection if: (i) the member or associated person of a member can demonstrate that the sale was in accordance with the person's established investment practice with the selling member and that the amount of the hot issue security sold to any one such person is insubstantial; or (ii) the issuer of the security is the employer, an affiliate of the employer or a proposed affiliate of the employer of the person or of a person who is a member of the immediate family of the person regardless of whether such person has an investment history with the member and without limitation as to the amount sold to any one such person.

EXPLANATION

Proposed Subsection (e) of new Section [E] carries forward the existing restrictions of paragraph 4 of the Free-Riding and Withholding Interpretation and also combines into a single provision language appearing in the proviso clause following paragraph 5. The listing of financial institutions has been enlarged to include "trust company." The language has also been changed to clarify that the restriction applies to sales to officers and employees of foreign banks and other foreign institutions. The new language also clarifies that the restrictions of Subsection (e) apply to sales to the institution's officers and employees and do not apply to sales to the institution for which they work when purchasing for its own account.

A major change in new Subsection (e) from the original proposal published for comment relates to the restricted status of officers and employees of financial institutions that are engaged in a public offering of their own securities. This change is in response to a comment received that officers and employees of financial institutions have a valid business reason for desiring to purchase the securities issued by their employers or issued by affiliates of their employers. The existing restrictions prevent the senior officers of the specified institutions, and employees involved in buying and selling securities for such employer institutions, from purchasing the publicly offered securities of their employer, or its affiliates, if they do not have an investment history with the member making the sales or the amount desired to be purchased is considered not insubstantial.

Accordingly, proposed Subsection (e) now expands the language of the proviso clause at the end of the subsection to allow purchases by any person subject to the provisions of the subsection if the issuer of the security is the employer, or an affiliate of the employer, or if they are members of the immediate families of persons who are employees or senior officers of the issuer or an affiliate of the issuer. The effect of this change is to exempt persons covered by Subsection (e)(ii) from the requirements that they have an investment history and that the amount sold to any such person is insubstantial. It is intended, however, that such persons will continue to be considered restricted persons under Subsection (g) of proposed Section [E], discussed below, which imposes an aggregate limitation on the amount of securities a member may sell to all restricted persons.

Under the expanded provision language, persons who now are included as members of the immediate families of senior officers and employees of financial institutions would be granted the same exemption both with respect to purchases of their own employers' securities and with respect to purchases of securities issued by financial institutions.

PROPOSED NEW TEXT

Sales to beneficial interest accounts

(f) No member or associated person of a member shall sell or cause the sale of a hot issue security to any account in which any person specified under Subsections (b), (c), (d), or (e) hereof has a beneficial interest; provided that a member or associated person of a member may sell a hot issue security to any such account (other than an account in which any person specified under subsections (b) or (c)(l) has a beneficial interest, or an account in which a beneficial interest is held by a member of the immediate family of any person specified under Subsection (c)(l) who is supported, directly or indirectly, by such person) if the member or associated person of a member can demonstrate that the sale was in accordance with the account's established investment practice with the selling member and that the amount of the hot issue security sold to any one such account is insubstantial.

EXPLANATION

Subsection (f) carries forward existing paragraph 5 of the Free-Riding and Withholding Interpretation with certain language changes to clarify that the exception that permits sales of "hot issues" to beneficial interest accounts, if the investment history and insubstantiality tests are met, does not apply to any beneficial interest account in which the beneficial interest is held by a member, an officer, director, or employee of a member or immediate family members, if supported by such officers, directors, or employees.

PROPOSED NEW TEXT

Overall limitation on sales

(g) Notwithstanding compliance with the foregoing requirements, a member or associated person of a member may sell a hot issue security to persons specified under Subsections (c)(2)(i), (d), (e), or (f) only if the aggregate of the securities sold to all such persons by the member is insubstantial in amount and not disproportionate compared to the member's sales to members of the public.

EXPLANATION

Proposed Subsection (g) is based on the part of the proviso following paragraph 5 of the Free-Riding and Withholding Interpretation that places an overall limitation on aggregate sales to restricted persons. The requirement has been placed in a separate subsection to clarify that it is separate and distinct from the requirement that a restricted person can receive a "hot issue" security only if the person has an investment history and the amount sold to the person is insubstantial. The new structure is designed to clarify the existence of four separate tests, i.e., (1) investment history, (2) sales insubstantial as to each recipient, (3) total sales not disproportionate, and (4) total sales insubstantial. In addition, new Subsection (g) attempts to clarify that the disproportionate and substantiality tests are to be measured against the selling member's sales, rather than the amount of the offering.

PROPOSED NEW TEXT

Sales to non-participating members

(h) No member or associated person of a member shall sell or cause the sale of a hot issue security to any member that is not participating in the distribution unless the member or associated person of a member receives, prior to the sale, written assurance from the non-participating member that none of the ultimate purchasers will include the non-participating member or any person specified under Subsections (b), (c), (d), (e), or (f) hereof and that the securities acquired by the non-participating member will be used only to fill orders for bona fide public customers at the public offering price as an accommodation to them and without any compensation to the non-participating member.

EXPLANATION

Proposed Subsection (h) incorporates the part of paragraph 6 of the Free-Riding and Withholding Interpretation restricting sales of "hot issues" to broker-dealers that are members of the NASD. The part dealing with sales to non-member broker-dealers has been separated and moved to new Subsection (m). The new provision applies to any "non-participating member" in the distribution since this was the original intended scope of paragraph 6 of the Interpretation.

PROPOSED NEW TEXT

Sales to foreign and domestic banks, foreign brokers and dealers, and other conduits for undisclosed principals

(i)
(l) No member or associated person of a member shall sell or cause the sale of a hot issue security to (i) any foreign or domestic bank or trust company, (ii) any foreign broker or dealer which is not a registered broker or dealer, or (iii) any other conduit for undisclosed principals, domestic or foreign, unless:
(A) the member, prior to any sale, affirmatively inquires of the bank, trust company, broker, dealer, or other conduit whether any of the ultimate purchasers in the particular offering will be persons specified under Subsections (b) through (f) hereof, and the member receives satisfactory assurance from the bank, trust company, broker, dealer, or other conduit that none of the ultimate purchasers will be persons specified under Subsections (b) through (f) hereof and that the securities will not be sold in a manner inconsistent with Subsection (h) hereof; provided, however, that a member will be presumed to have complied with this paragraph (i)(l)(A) if the member, acting in good faith, has accepted from the bank, trust company, broker or dealer, or other conduit an executed agreement providing blanket assurance that no sales of any hot issue security will be made in contravention of Section [E]; provided further, that said presumption shall not be applied if the member knows of facts which are inconsistent with the representations or assurances received;
(B) the member makes a notation on the order ticket or some other supporting document of the name of the person at the bank, trust company, broker, dealer, or other conduit to whom the inquiry was made and the substance of what was said by that person, and what was done as a result thereof;
(C) a registered principal of the member initials the order ticket or other document; and
(D) the member's supervisory procedures provide for a review of all transactions entered into with the bank, trust company, broker, dealer, or other conduit to assure that there has been compliance with this Subsection (i).
(2) If the inquiry discloses that any of the ultimate purchasers will be persons specified under Subsections (b) through (f) hereof, or that the securities will be sold in a manner inconsistent with Subsection (h) hereof, the member shall be prohibited from selling any part of the securities to the bank, trust company, broker, dealer, or other conduit.
(3) In the case of a foreign broker or dealer or foreign bank which participates in the distribution as an underwriter, the obligations of members and associated persons of members to make an affirmative inquiry under Subsection (1)(A) above shall be deemed satisfied if the agreement among under writers contains a provision which obligates such foreign broker or dealer or foreign bank not to sell any of the securities to any person specified under Subsections (b) through (f) hereof, or in a manner inconsistent with Subsection (h) hereof.

EXPLANATION

The provisions of Subsection (i) are designed to eliminate duplicative language by combining the existing language of paragraph 7 of the Free-Riding and Withholding Interpretation, dealing with domestic banks and other conduits for undisclosed principals, and paragraph 8 thereof, dealing with foreign banks and foreign broker-dealers. The language is broadened to expressly cover foreign trust companies and other foreign conduits. The reference to foreign broker-dealers that are not registered with the SEC is intended to clarify that the restrictions are not applicable to foreign broker-dealers that are registered with the SEC and that are members and covered by Subsection (h) if they are members, or by Subsection (m) if they are non-members. New Subsection (h)(2) simply makes explicit that if any of the ultimate purchasers are restricted persons, a member is absolutely prohibited from making a sale of a "hot issue" security to the conduit.

In response to comments received, the language of Subsection (i) has been revised to clarify that if a member has obtained a blanket agreement under paragraph (1)(A) of the subsection, the member is not required to obtain a new agreement for each offering. Under paragraph 8 of the Interpretation, the obligations to obtain assurances have always been deemed satisfied by a blanket agreement from foreign banks, and the language of the new subsection, as revised, is intended to make this equally applicable to domestic banks.

PROPOSED NEW TEXT

Sales to certain investment companies

(j) No member or associated person of a member shall sell or cause the sale of a hot issue security to any domestic or foreign investment company (except an investment company registered under the Investment Company Act of 1940), including but not limited to a hedge fund, investment partnership, or corporation, investment club, or any similar type account, unless the member or associated person complies with either of the following alternatives:
(1) prior to any sale, the member has received from the account a current list of the names and business connections of all persons having any beneficial interest in the investment company, and if such information discloses that any person specified under Subsections (b), (c), (d), or (e) hereof has a beneficial interest in the in vestment company, any sale of securities to the in vestment company must be consistent with the provisions of this Section (E); or
(2) prior to the execution of the transaction, the member has obtained a copy of a current opinion from counsel admitted to practice law before the highest court of any state stating that counsel reasonably believes that no person with a beneficial interest in the account is a restricted person under this Section (E) and stating that, in providing such opinion, counsel:
(A) has reviewed and is familiar with this Section (E);
(B) has reviewed a current list of all persons with a beneficial interest in the account supplied by the account manager;
(C) has reviewed information supplied by the account manager with respect to each person with a beneficial interest in the account, including the identity, the nature of employment, and any other business connections of such persons; and
(D) has requested and reviewed other documents and other pertinent information and made inquiries of the account manager and received responses thereto, if counsel determines that such further review and inquiry are necessary and relevant to determine the correct status of such persons under this Section (E).
(3) The member shall maintain a copy of the names and business connections of all persons having any beneficial interest in the account or a copy of the current opinion of counsel in its files for at least three years following the member's last sale of a new issue to the account, depending upon which of the above requirements the member elects to follow. For purposes of this section, a list or opinion shall be deemed to be current if it is based upon the status of the account as of a date not more than 18 months prior to the date of the transaction.

EXPLANATION

The provisions of Subsection (j) are based on current language that appears after the text of the Free-Riding and Withholding Interpretation under the heading "Scope and Intent of Interpretation" and the subheading "Investment Partnerships and Corporations." It has been reworded to clarify the provision and to broaden its scope to cover legal entities other than corporations and partnerships to reflect the original intent of the provision.

The last sentence of the existing language in the Free-Riding and Withholding Interpretation, which defines "beneficial interest," also has been moved to a new section of definitions.

PROPOSED NEW TEXT

Sales directed by issuers and others

(k)
(l) Every member and associated person of a member who at the direction of an issuer, underwriter, or any other person sells or causes the sale of a hot issue security to any person specified under Subsections (c) through (j) and (m) hereof shall comply with all the requirements of this section to the same extent as if the sale were made by the member or associated person of a member without any such direction.
(2) Notwithstanding paragraph (1) above, sales of issuer directed securities may be made to restricted or prohibited persons without the required investment history after receiving permission from the Board of Governors. Permission will be given only if there is a demonstration of valid business reasons for such sales (such as sales to distributors and suppliers or key employees who are in each case incidentally restricted or prohibited persons) and the member seeking permission is prepared to demonstrate that the aggregate amount of securities so sold is insubstantial and not disproportionate as compared to sales to members of the public, and that the amount sold to any one of such persons is insubstantial in amount.

EXPLANATION

The provisions of Subsection (k) are based on current language that appears after the text of the Free-Riding and Withholding Interpretation under the heading "Scope and Intent of Interpretation" and the subheading "Issuer Directed Securities." It has been reworded to clarify that members selling issuer-directed shares must comply in all respects with the applicable requirements to the same extent as if the sales had not been directed. It also has been broadened to cover sales directed by underwriters and others.

Subsection (k), as originally circulated for comment, unintentionally omitted language from the Free-Riding and Withholding Interpretation that gave the Board of Governors authority to grant exemptions to permit issuer-directed sales under limited circumstances. Accordingly, the authority to grant exemptions now appears in Subsection (k) as it was originally intended. The provision has been clarified to cover both prohibited and restricted persons.

PROPOSED NEW TEXT

Responsibility for non-underwritten securities

(1)
(1) Any sale of any part of a hot issue security made on an underwritten basis by an issuer or selling shareholder to any person specified under Subsections (c) through (j) and (m) hereof shall be deemed a sale made by any member also participating in sales or the distribution, and such member shall comply with all the requirements of this section to the same extent as if the sales were made directly by the member. If more than one member is participating in the distribution in a syndicate or similar undertaking, the responsibility for compliance with this subsection rests with the managing underwriter, or the equivalent.
(2) Notwithstanding paragraph (1) above, non-underwritten sales of securities may be made to persons who are restricted or prohibited under this Section if permission has been granted by the Board of Governors based upon the standards set forth under Subsection (k)(2) hereof.

EXPLANATION

The provisions of Subsection (i) are based on the last two sentences of the first paragraph under the existing Free-Riding and Withholding Interpretation under the subheading "Issuer Directed Securities." It also incorporates the Board's authority to grant exemptions under certain circumstances as contained in the Interpretation and to clarify that the exemptive authority covers both issuer-directed and non-underwritten sales.

PROPOSED NEW TEXT

Sales to non-member brokers and dealers

(m) No member or associated person of a member shall sell or cause to be sold any hot issue security at or above the public offering price to any registered broker or dealer which is not a member of the Corporation.

EXPLANATION

The provision of Subsection (m) is based on the first part of paragraph 6 of the existing interpretation.

PROPOSED NEW TEXT

Receipt of hot issue securities by associated persons of members

(n) No associated person of a member shall purchase or acquire any hot issue security during the distribution period, whether acquired from a member, broker, dealer, or from an issuer selling its own securities without the assistance of an underwriter, or otherwise.

EXPLANATION

The provision of Subsection (n) is based on the first and third sentences of language in the existing Free-Riding and Withholding Interpretation that appears under the heading "Scope and Intent of Interpretation" and the subheading "Violations by Recipients." The changes are intended to make the requirements more specific. The second sentence of the existing language that imposes liability on any member or person associated with a member who causes a "hot issue" to be sold to a restricted or prohibited person is codified in the phrase "cause to be sold" that appears throughout new Section (E).

PROPOSED NEW TEXT

Disclosure no defense

(o) This section shall be applicable to all sales, purchases, and receipts of any hot issue security by members and associated persons of members notwithstanding any disclosure made in any offering circular or prospectus, whether or not filed with the Corporation.

EXPLANATION

The provision of Subsection (o) is based on language in the existing Free-Riding and Withholding Interpretation that appears under the heading "Scope and Intent of Interpretation" and the subheading "Disclosure."

PROPOSED NEW TEXT

Definitions

(p) The following definitions of terms used in Section (E) are provided for the assistance of members. Other words which are defined in the By-Laws and Rules of Fair Practice shall, unless the context otherwise requires, have the meaning as defined therein.
(1) Public Offering: The term "public offering" shall mean all distributions of securities whether underwritten or not; whether registered, un registered, or exempt from registration under the Securities Act of 1933, and whether they are primary or secondary distributions, including intra- state distributions and Regulation A offerings. It shall not mean offerings of exempted securities as defined in Section 3 (a) (12) of the Securities Ex change Act of 1934.
(2) Immediate Family: The term "immediate family" shall include parents, mother-in-law or father-in-law, husband or wife, brother or sister, brother-in-law or sister-in-law, son-in-law or daughter-in-law, and children. In addition, the term shall also include any other person who is supported, directly or indirectly, to a material extent by a member, person associated with a member, or other person specified in Subsections (c), (d), or (e) above.
(3) Established Investment Practice: "Established investment practice" shall mean the history of investment of a restricted person in an account or accounts maintained with the member making the allocation. However, in cases where an account was previously maintained with another member, but serviced by the same registered representative as the one currently servicing the account for the member making the allocation, such earlier investment activity may be included in the restricted person's investment history. Usually the previous one-year period of securities activity is the basis for determining the adequacy of a restricted person's investment history. Where war ranted, however, a longer or shorter period may be reviewed. It is the responsibility of the registered representative effecting the allocation, as well as the member, to demonstrate that the restricted person's investment history justified the allocation of hot issues. Copies of customer account statements or other records maintained by the registered representative or the member may be utilized to demonstrate prior investment activity. In analyzing a restricted person's investment history, the following factors should be considered:
(A) The frequency of transactions in the account or accounts during that period of time. Relevant in this respect are the nature and size of investments.
(B) A comparison of the dollar amount of previous transactions with the dollar amount of the hot issue purchase. If a restricted person purchases $1,000 of a hot issue and his account revealed a series of purchases and sales in $100 amounts, the $1,000 purchase would not appear to be consistent with the restricted person's normal investment practice.
(C) The practice of purchasing mainly hot issues would not constitute an established in- vestment practice. The purchase of new issues that are not hot issues as well as secondary market trans actions may contribute to the establishment of an established investment practice.
(4) Disproportionate: In respect to the determination of what constitutes a disproportionate allocation, a guideline of 10% of the member's participation in the issue, however acquired, may be used. The 10% factor is merely a guideline and is one of a number of factors. These other factors include, among other things: (i) the size of the participation; (ii) the offering price of the issue; (iii) the amount of securities sold to restricted accounts; and (iv) the price of the securities in the aftermarket. The 10% guideline is applied as to the aggregate of allocations to restricted accounts. Notwithstanding the above, a normal unit of trading (100 shares or 10 bonds) will normally not be considered a disproportionate allocation regardless of the amount of the member's participation.
(5) Insubstantiality: The requirements that allocations be insubstantial are separate and distinct from the requirements relating to disproportionate allocation and established investment practice. In addition, this term applies both to the aggregate of the securities sold to restricted accounts and to each individual allocation. Although the total amount sold to restricted persons may satisfy the disproportionate requirement, the amount may still be considered substantial. The determination of whether an allocation to a restricted account or accounts is substantial is based upon, among other things, the number of shares allocated and the dollar amount of the purchase. Notwithstanding the above, the allocation of a normal unit of trading (100 shares or 10 bonds) to restricted persons will not be considered a substantial allocation, regardless of the amount of the member's participation or the size of the offering.
(6) Beneficial Interest: The term "beneficial interest" means not only ownership interest, but also every type of direct financial interest of any persons specified in this Section, including, without limitation, management fees based on the performance of the account.

EXPLANATION

These definitions are based on the language of the definitions appearing in the existing Free-Riding and Withholding Interpretation except that the term "established investment practice" in Subsection (p)(3) has been substituted for the existing "normal investment practice" because it appears more consistent with the intent of the requirement. The term "beneficial interest" has also been taken from its current location in the Free-Riding and Withholding Interpretation under the subheading "Investment Partnerships and Corporations."

PROPOSED NEW TEXT

Sales by issuers in conversion offerings

(q)
(a) For purposes of this subsection, the following terms shall have the meanings stated:
(1) "Conversion offering" shall mean any offering of securities made as part of a plan by which a savings and loan association or other organization converts from a mutual to a stock form of ownership.
(2) "Eligible purchaser" shall mean a person who is eligible to purchase securities pursuant to the rules of the Federal Home Loan Bank Board or other governmental agency or instrumentality having authority to regulate conversion offerings.
(b) Conditions for exemption. This Section shall not apply to a sale of securities by the issuer on a non-underwritten basis to any person who would otherwise be prohibited or restricted from purchasing a hot issue security if all of the conditions of this Subsection (b) are satisfied:
(1) Sales to members, associated persons of members, and certain related persons. If the purchaser is a member, person associated with a member, member of the immediate family of any such person to whose support such person contributes, directly or indirectly, or an account in which a member or person associated with a member has a beneficial interest:
(A) the purchaser shall be an eligible purchaser:
(B) the securities purchased shall be restricted from sale or transfer for a period of 150 days following the conclusion of the offering; and
(C) the fact of purchase shall be reported in writing to the member where the person is associated within one day of payment.
(2) Sales to other restricted persons. If the purchaser is not a person specified in Subsection (b)(l) above, the purchaser shall be an eligible purchaser.

EXPLANATION

The provisions of Subsection (q) parallel those of the amendment to the Free-Riding and Withholding Interpretation that became effective September 25,1986. See NASD Notice to Members 86-73 (October 16,1986) for the background and an explanation of the amendment.

PROPOSED AMENDED TEXT

NASD Manual, ¶ 2152, p. 2051

Item 6 on ballot

Recommendations to Customers

Sec. 2.

In recommending to a customer the purchase, sale, or exchange of any security, a member or person associated with a member shall have reasonable grounds for believing that the recommendation is suitable for [such] the customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.

EXPLANATION

Section 2 contains a minor language change and the addition of a specific reference to "associated persons."

CURRENT TEXT

NASD Manual, ¶ 2153, p. 2054

No Vote Required

Charges for Services Performed

Sec. 3.

Charges, if any, for services performed, including miscellaneous services such as collection of monies due for principal, dividends, or interest; exchange or transfer of securities; appraisals, safekeeping, or custody of securities, and other services, shall be reasonable and not unfairly discriminatory between customers.

EXPLANATION

No change is being proposed to this section.

CURRENT TEXT

NASD Manual, ¶ 2154, pp. 2054-2058

[Fair Prices and Commissions]

[Sec. 4.]

[In "over-the-counter" transactions, whether in "listed" or "unlisted" securities, if a member buys for his own account from his customer, or sells for his own account to his customer, he shall buy or sell at a price which is fair, taking into consideration all relevant circumstances, including market conditions with respect to such security at the time of the transaction, the expense involved, and the fact that he is entitled to a profit; and if he acts as agent for his customer in any such transaction, he shall not charge his customer more than a fair commission or service charge, taking into consideration all relevant circumstances including market conditions with respect to such security at the time of the transaction, the expense of executing the order and the value of any service he may have rendered by reason of his experience in and knowledge of such security and the market therefore.]

[... Interpretation of the Board of Governors]

[NASD Mark-up policy]

[The question of fair mark-ups or spreads is one which has been raised from the earliest days of the Association. No definitive answer can be given and no interpretation can be all-inclusive for the obvious reason that what might be considered fair in one transaction could be unfair in another transaction because of different circumstances.]

[However, it was recognized that the amount of mark-up was at least a starting point from which an answer to the question could be sought and that progress might be made if the general practice of the business on mark-ups could be established. To find this out, the Association, in 1943, made a membership-wide questionnaire examination of mark-ups in retail or customer transactions. Questionnaires were filed by 82 percent of the membership covering transactions which varied widely with respect to price, dollar amount, type of security, and degree of market activity. They included both listed and unlisted securities, with the latter, however, in the substantial majority. This information revealed that 47 percent of the transactions computed were made at markups of 3 percent or less and 71 percent of the transactions were effected at mark-ups of 5 percent or less.]

[In a letter to the membership on October 25, 1943, the Board of Governors made known the results of its survey and expressed its philosophy on what constitutes a fair spread or profit. The Board stated that it would be impractical and unwise, if not impossible, to define specifically what constitutes a fair spread on each and every transaction because the fairness of a mark-up can be determined only after considering all of the relevant factors. Under certain conditions a mark-up in excess of 5 percent may be justified, but on the other hand, 5 percent or even a lower rate is by no means always justified. The Board instructed District Business Conduct Committees to enforce Section 1 of Article III of the Rules of Fair Practice with respect to mark-ups, keeping in mind that 71 percent of the transactions computed from the questionnaires were effected at a mark-up of 5 percent or less. The philosophy which the Board expressed has since been referred to as the "5% Policy."]

[The Policy has been reviewed by the Board of Governors on numerous occasions and each time the Board has reaffirmed the philosophy expressed in the letter to members of October 25, 1943. The Board is aware, however, of the need for continually re-examining the mark-up policy and its application in the light of current economic conditions and with the benefit of experience gained from enforcement of the existing Policy. The Board has carefully considered the Policy adopted in 1943 and subsequent interpretations with respect thereto. It can find no justification for a change in the basic Policy. However, it recognizes that any clarification will materially aid members in complying with the Policy and the various committees in fulfilling their responsibility to exercise judgment in determining the fairness of mark-ups.]

[Based upon its review of the entire matter, the Board has adopted the Interpretation set forth below.]

[The Interpretation]

[Article III, Section 1 of the Rules of Fair Practice states that:]

["A member, in the conduct of his business, shall observe high standards of commercial honor and just and equitable principles of trade."]

[Article III, Section 4 of the Rules of Fair Practice states that:]

[ A member, in the conduct of his business, shall observe high standards of commercial honor and just and equitable principles of trade.]

[Article III, Section 4 of the Rules of Fair Practice states that:]

[In 'over-the-counter' transactions, whether in 'listed' or 'unlisted' securities, if a member buys for his own account from his customer, or sells for his own account to his customer, he shall buy or sell at a price which is fair, taking into consideration all relevant circumstances, including market conditions with respect to such security at the time of the transaction, the expense involved, and the fact that he is entitled to a profit; and if he acts as agent for his customer in any such transaction, he shall not charge his customer more than a fair commission or service charge, taking into consideration all relevant circumstances including market conditions with respect to such security at the time of the transaction, the expense of executing the order and the value of any service he may have rendered by reason of his experience in and knowledge of such security and the market therefore.]

[In accordance with Article VII, Section 3(a) of the By-Laws, the following interpretation under Article III, Sections 1 and 4 of the Rules of Fair Practice has been adopted by the Board:]

[It shall be deemed conduct inconsistent with just and equitable principles of trade for a member to enter into any transaction with a customer in any security at any price not reasonably related to the current market price of the security or to charge a commission which is not reasonable.]

[A. General Considerations]
[Since the adoption of the "5% Policy" the Board has determined that:]
[1. The "5% Policy" is a guide — not a rule.]
[2. A member may not justify mark-ups on the basis of expenses which are excessive.]
[3. The mark-up over the prevailing market price is the significant spread from the point of view of fairness of dealings with customers in principal transactions. In the absence of other bona fide evidence of the prevailing market, a member's own contemporaneous cost is the best indication of the prevailing market price of a security.]
[4. A mark-up pattern of 5% or even less may be considered unfair or unreasonable under the "5% Policy."]
[5. Determination of the fairness of mark-ups must be based on a consideration of all the relevant factors, of which the percentage of mark-up is only one.]
[B. Relevant Factors]
[Some of the factors which the Board believes that members and the Association's committees should take into consideration in determining the fairness of a mark-up are as follows:]
[1. The type of security involved — ]
[Some securities customarily carry a higher mark-up than others. For example, a higher percentage of mark-up customarily applies to a common stock transaction than to a bond transaction of the same size. Likewise, a higher percentage applies to sales of units of direct participation programs and condominium securities than to sales of common stock.]
[2. The availability of the security in the market—]
[In the case of an inactive security the effort and cost of buying or selling the security, or any other unusual circumstances connected with its acquisition or sale, may have a bearing on the amount of mark-up justified.]
[3. The price of the security — ]
[While there is no direct correlation, the percentage of mark-up or rate of commission generally increases as the price of the security decreases. Even where the amount of money is substantial, transactions in lower-priced securities may require more handling and expense and may warrant a wider spread.]
[4. The amount of money involved in a transaction —]
[A transaction which involves a small amount of money may warrant a higher percentage of markup to cover the expenses of handling.]
[5. Disclosure — ]
[Any disclosure to the customer, before the transaction is effected, of information which would indicate (a) the amount of commission charged in an agency transaction or (b) mark-up made in a principal transaction is a factor to be considered. Disclosure itself, however, does not justify a commission or mark-up which is unfair or excessive in the light of all other relevant circumstances.]
[6. The pattern of mark-ups — ]
[While each transaction must meet the test of fairness, the Board believes that particular attention should be given to the pattern of a member's markups.]
[7. The nature of the member's business — ]
[The Board is aware of the differences in the services and facilities which are needed by, and provided for, customers of members. If not excessive, the cost of providing such services and facilities, particularly when they are of a continuing nature, may properly be considered in determining the fairness of a member's mark-ups.]
[C. Transactions to Which the Policy is Applicable]
[The Policy applies to all securities handled in the over-the-counter market, whether oil royalties or any other security, in the following types of transactions:]
[1. A transaction in which a member buys a security to fill an order for the same security previously received from a customer — ]
[This transaction would include the so-called "riskless" or "simultaneous" transaction.]
[2. A transaction in which a member sells a security to a customer from inventory — ]
[In such case the amount of the mark-up should be determined on the basis of the mark-up over the bona fide representative current market. The amount of profit or loss to the member from market appreciation or depreciation before, or after, the date of the transaction with the customer would not ordinarily enter into the determination of the amount or fairness of the mark-up.]
[3. A transaction in which a member purchases a security from a customer — ]
[The price paid to the customer or the mark-down applied by the member must be reasonably related to the prevailing market price of the security.]
[4. A transaction in which the member acts as agent — ]
[In such a case, the commission charged the customer must be fair in light of all relevant circumstances.]
[5. Transactions wherein a customer sells securities to, or through, a broker/dealer, the proceeds from which are utilized to pay for other securities purchased from, or through, the broker/dealer at or about the same time — ]
[In such instances, the mark-up shall be computed in the same way as if the customer had purchased for cash and in computing the mark-up there shall be included any profit or commission realized by the dealer on the securities being liquidated, the proceeds of which are used to pay for securities being purchased.]
[D. Transactions to Which the Policy is Not Applicable]
[To the sale of securities where a prospectus or offering circular is required to be delivered and the securities are sold at the specific public offering price.]
[This Interpretation does no more than express what is clearly implied in Sections 1 and 4 of Article III of the Rules of Fair Practice. The Interpretation is made, however, in order to emphasize the obligation which is assumed by every member of this Association in every transaction with a customer.]

PROPOSED NEW SECTION 4 TO THE NASD RULES OF FAIR PRACTICE

Item 7 on ballot

Fair Prices and Commissions

Sec. 4.

Principal Transactions with Retail Customers

(a) In "over-the-counter" transactions, whether in "listed" or "unlisted" securities, if a member ac ting as principal buys from its customer or acting as principal sells to its customer, it shall buy or sell at a price which is fair, taking into consideration all relevant circumstances, including market conditions with respect to such security at the time of the transaction, the expense involved, and the fact that the member is entitled to a profit.
(b) the price paid or received by a retail customer in any principal transaction with a member, after any mark-up or mark-down charged by the member, shall not be considered fair unless the resulting price is reasonably related to the prevailing market price of the security.

Prevailing Market Price

(c) For purposes of determining the prevailing market price of a security, the following standards shall be applied:

NASDAQ and Exchange Securities

(1) When a member effects a principal trans action with a customer in any security for which quotation information is disseminated in the NASDAQ inter-dealer quotation system ("NASDAQ") or for which quotation information is disseminated by a national securities exchange, the lowest asked quotation in the case of a sale to a customer, or the highest bid quotation in the case of a purchase from a customer, as such quotations appear in the primary inter-dealer quotation system for the security, shall normally be considered the current market price of the security.

Non-NASDAQ and Non-Exchange Securities

(2) When a member effects a principal trans action with a customer in any security for which quotation information is not disseminated in NASDAQ or by a national securities exchange, the following guidelines shall apply:

Contemporaneous Transactions — Independent Competitive Market

(A) If there is an independent competitive market away from the member, the prices paid to the member by other brokers or dealers in contemporaneous transactions in the case of a sale to a customer, or the prices paid by the member in contemporaneous transactions in the case of a purchase from a customer shall normally be considered the current market price of the security.

Contemporaneous Transactions — No Independent Competitive Market

(B) If there is no independent competitive market away from the member, the member's cost of purchases from other brokers or dealers in contemporaneous transactions in the case of a sale to a customer, or the prices at which the member sold to other brokers or dealers in contemporaneous transactions in the case of a purchase from a customer, shall normally be considered the current market price of the security.

Quotations of Other Brokers and Dealers

(C) In the absence of contemporaneous transactions with other brokers or dealers, the lowest asked or highest bid quotations of other brokers or dealers appearing in the primary inter-dealer quotation system for the security, if such quotations accurately reflect the market for the security, shall normally be considered the current market price of the security.

Transactions by Other Brokers and Dealers

(D) In the absence of either contemporaneous transactions with other brokers or dealers or accurate inter-dealer quotations, the prices paid or received by other brokers or dealers in contemporaneous transactions shall normally be considered the current market price of the security.

"Riskless Principal" Transactions

(E) The guidelines under subparagraphs (A)-(D) shall not be applicable to any principal transaction in a security in which the member is not a market maker, if after having received an order to buy or sell the security from the customer the member purchases the security from or sells the security to another person to offset the transaction with the customer, and the current market price shall normally be considered the cost or proceeds of the offsetting transaction.

Definition

(3) For purposes of Subsection (c)(2), the term "contemporaneous transaction" shall mean any transaction or transactions which take place the day of or the day before or within a reasonable time before the transaction with the customer which determination shall be made in the context of the market for the security.

Agency Transactions with Retail Customers

(d) If a member acts as agent for its customer in any "over-the-counter" transaction, whether in "listed" or "unlisted" securities, the member shall not charge its customer more than a fair commission or service charge, taking into consideration all relevant circumstances including market conditions with respect to such security at the time of the transaction, the expense of executing the order and the value of any service it may have rendered by reason of its experience in and knowledge of such security and the market therefore.

Amount of Mark-ups or Mark-downs and Commissions

(e) For purposes of determining whether prices to customers in principal transactions (mark-ups and mark-downs) and commissions charged customers in agency transactions are fair and reasonable, the following factors, as well as any other relevant factors and circumstances, should be taken into consideration:
(1) the percentage of mark-up or mark-down based on the current market price of the security as determined under Subsection (c) above, or the percentage commission based on the execution price of the transaction;
(2) the type of security involved since some securities customarily carry a higher mark-up or commission than other types of securities;
(3) the availability of the security in the market since, in the case of an inactive security, the effort and cost of buying or selling the security may be greater than in the case of a more actively traded security;
(4) the price of the security as the percentage mark-up or commission generally increases as the price of the security decreases because transactions in lower-priced securities may require more handling and expense;
(5) the amount of money involved in a transaction as a transaction which involves a small amount of money may require proportionately higher handling expenses compared to expenses of handling transactions involving larger amounts of money:
(6) Any disclosure to the customer, before the transaction is effected, of the amount of commission charged in an agency transaction or mark-up made in a principal transaction; provided, however, that disclosure cannot justify a commission or mark up that is unfair or unreasonable in light of all other relevant factors covered by this subsection;
(7) the types of services and facilities that the member makes available to its customers and the costs to the member since there are differences among members in the amount and types of services and facilities provided to customers; provided, however, a member may not justify mark-ups or commissions on the basis of costs of services and facilities which are excessive; and
(8) in principal transactions with retail customers, the degree of risk assumed by the member since sales from and purchases for an existing inventory position may, because of a willingness to take on the uncertainties of a risk position, entitle the member to a higher percentage mark-up or mark-down than would be permissible for a "risk-less" principal transaction.
(f) Mark-ups in principal transactions in outstanding securities in excess of 5 percent will generally be presumed to be unfair and un reasonable; however, a mark-up pattern of 5 percent or even less may be shown to be unfair or unreasonable depending on a consideration of all other relevant factors and under certain circumstances, a mark-up in excess of 5 percent may be justified upon a consideration of such other relevant factors.

Mark-ups in Proceeds Transactions

(g) When a customer sells securities to, or through, a member, the proceeds of which are used to pay for other securities purchased from the member at or about the same time, the mark-up shall be computed in the same way as if the customer had purchased for cash, except that in computing the mark-up, there shall be included any mark-down or commission on the securities liquidated. In such circumstances, however, a reasonable allowance may be made for the additional cost of handling the liquidating transaction.

Exemptions

(h) This section shall not apply to transactions in municipal securities or to securities which are being publicly offered.

EXPLANATION

New Section [4] will replace current Article III, Section 4 of the Rules of Fair Practice, which establishes general standards of fairness required of members in transactions with customers. The major significance of the new section is that it will also codify and replace the NASD Mark-Up Policy adopted by the Board of Governors as an Interpretation of Article III, Section 4 and the broad ethical standards of conduct required under Article III, Section 1 of the Rules of Fair Practice. The Policy was adopted in 1943 and has been in place since then without any major revisions.

Proposed Subsections (a), (b), and (c) of new Section [4] deal with principal transactions with retail customers. Subsection (a) carries forward the existing language of Article HI, Section 4 that states that prices in principal transactions must be fair. Subsection (b) incorporates the language of the Mark-Up Policy that states that a "fair price" is one that is reasonably related to the prevailing market price of the security. Subsection (c), which provides general guidelines as to the term "prevailing market price," is entirely new and has no counterpart in the current Mark-Up Policy.

A substantive change has been made in new Section [4] as originally proposed for comment that relates to the definition of "current market price" to be used in computing the level of markups and mark-downs. The basic concept underlying the definition in Subsection (c) is similar to the originally proposed language circulated for comment and is intended to establish somewhat flexible standards that, in appropriate cases, will allow a member to demonstrate that the current market price should be based on a review of other factors not expressly mentioned.

The guidelines contained in Subsection (c) being submitted for vote would use both inter-dealer quotations and actual inter-dealer trades. The determination of which method would be used depends on the nature of the market in which the security is traded. Under Subsection (c)(l), the current market price of securities for which quotations are disseminated in NASDAQ or by a national securities exchange will normally be considered the best asked quotation appearing in the primary inter-dealer quotation system in the case of a principal sale to a customer. If the member purchases a security from a customer for which quotations are disseminated by NASDAQ or a national securities exchange, the current market price will normally be the best bid quotation appearing in the primary inter-dealer system. It is believed that for such securities NASDAQ or exchange quotations should be the norm, as such securities are subject to firm quotation rules and must meet minimum qualification requirements for inclusion in NASDAQ or trading on a national securities exchange.

If a security is a non-NASDAQ and non-exchange-traded security, the market price is determined by a descending priority scale which starts at a member's transaction prices with other brokers and dealers. These securities, which comprise all non-NASDAQ and non-exchange-traded securities, should not be measured against quotations in the first instance as they are generally less actively traded securities and are not subject to firm-quotation rules. Under Subsection (c)(2)(A), the norm for determining "current market price" for these securities if there is an independent market away from the member is considered to be the member's contemporaneous sale prices to other broker-dealers, in the case of a principal sale to a customer, and its contemporaneous purchase prices from other broker-dealers, in the case of a purchase from a customer. The term "contemporaneous transaction" is defined by Subsection (c)(2)(F) to be an inter-dealer transaction by the member the day of or the day before or a reasonable time before the retail principal transaction depending on the context of the market for the security. Under Subsection (c)(2)(C), the current market price for non-NASDAQ and non-exchange-traded securities in which the member has had no inter-dealer transactions is considered to be the available quotations appearing in the inter-dealer quotation system, but only if such quotations are accurate reflections of the true market for the security. If reliable quotations are not available, the norm for determining "current market price" under Subsection (c)(2)(E) is the actual transaction prices of other brokers and dealers. Notwithstanding these standards under Subsection (c)(2)(F), any "riskless principal transaction" in any non-NASDAQ or non-exchange-traded security shall be the cost of purchasing the security to fill a customer buy order or, in the case of a customer sell order, the proceeds from the sale to satisfy a customer sell order.

The method to be used in computing "current market price" under proposed Subsection (d) of Section [4] is substantially different from that originally proposed for comment. Under the original proposal, the cost of purchasing or proceeds from the sale of the security would have been the norm, regardless of the market in which the security was traded. Several commenters strongly objected to the original proposal because it failed to recognize bona fide quotations as a proper basis for determining "current market price," despite the existence of active trading markets in many NASDAQ and exchange-traded securities. In light of these and similar objections, the Board of Governors decided to distinguish active inter-dealer markets from less active markets and to introduce an element of certainty into members' pricing decisions. The structure currently proposed in Subsection (c) is based on whether the security is a NASDAQ security or exchange-traded security in which firm quotations are mandated or is a security where quotations appear, but is not subject to firm-quotation requirements.

A member's responsibility when executing agency transactions for customers is covered by Subsection (d), which contains substantially the same language that appears in the second half of existing Article III, Section 4 of the Rules of Fair Practice.

The language under the heading "Relevant Factors" in the Mark-Up Policy is incorporated into Subsection (e), which sets forth the factors that should be considered in determining whether the amount of a mark-up for a given transaction is fair and reasonable. It also applies to the fairness of the amount of commission in an agency transaction as does the existing Mark-Up Policy, although some of the factors appear primarily directed at principal transactions.

Subsections (e)(l)(i) and (ii) are intended to clarify that the percentage of mark-up, or commission, while a major consideration, is only one of a number of factors that should be taken into account. It also incorporates the basic concept of a "Five Percent Policy" currently appearing under the "General Considerations" section of the Mark-Up Policy. Subsections (e)(2) through (7) are simply a rewording of the existing language in rule format. Subsection (e)(8) has been added to reflect the fact that, in a principal transaction, a risk position may entitle a member to a higher mark-up than would be allowed in a "riskless" transaction.

The language of the Mark-Up Policy under the heading "Transactions to Which the Policy is Applicable" would be eliminated as unnecessary, with one exception. The exception is the unique handling of proceeds transactions, and the existing language would be carried forward and clarified. Subsection (g) carries forward the existing language, but clarifies that the amended rule does not apply to municipal securities, which are covered by Municipal Securities Rulemaking Board rules, or to securities being publicly offered where the fairness of compensation is governed by the Corporate Financing Interpretation (and the corresponding pending rule) or by Article III, Sections 26 and 29, in the case of mutual funds and variable annuities.

CURRENT TEXT

NASD Manual, ¶ 2155, p. 2071

No Vote Required

Publication of Transactions and Quotations

Sec. 5.

No member shall publish or circulate, or cause to be published or circulated, any notice, circular, advertisement, newspaper article, investment service, or communication of any kind which purports to report any transaction as a purchase or sale of any security unless such member believes that such transaction was a bona fide purchase or sale of such security; or which purports to quote the bid price or asked price for any security, unless such member believes that such quotation represents a bona fide bid for, or offer of, such security. If nominal quotations are used or given, they shall be clearly stated or indicated to be only nominal quotations.

EXPLANATION

No change is being proposed to this section.

CURRENT TEXT

NASD Manual, ¶ 2156, p. 2075

No Vote Required

Offers at Stated Prices

Sec. 6.

No member shall make an offer to buy from or sell to any person any security at a stated price unless such member is prepared to purchase or sell, as the case may be, at such price and under such conditions as are stated at the time of such offer to buy or sell.

EXPLANATION

No change is being proposed to this section.

CURRENT TEXT

NASD Manual, ¶ 2157, p. 2075

No Vote Required

Disclosure of Price in Selling Agreements

Concessions

Sec. 7.

Selling syndicate agreements or selling group agreements shall set forth the price at which the securities are to be sold to the public or the formula by which such price can be ascertained, and shall state clearly to whom and under what circumstances concessions, if any, may be allowed.

EXPLANATION

No change is being proposed to this section.

CURRENT TEXT

NASD Manual, ¶ 2158, p. 2075—2075-3

No Vote Required

Securities Taken in Trade

Sec. 8.

(a) A member engaged in a fixed price offering, who purchases or arranges the purchase of securities taken in trade, shall purchase the securities at a fair market price at the time of purchase or shall act as agent in the sale of such securities and charge a normal commission there fore.
(b) When used in this section —
(1) the term "taken in trade" means the purchase by a member as principal, or as agent for the account of another, of a security from a customer pursuant to an agreement or understanding that the customer purchase securities from the member which are part of a fixed price offering.
(2) the term "fair market price" means a price not higher than the price at which the securities would be purchased from the customer or from a similarly situated customer in the ordinary course of business by a dealer in such securities in trans actions of similar size and having similar characteristics but not involving a security taken in trade.
(3) the term "normal commission" means an amount of commission which the member would normally charge to that customer or a similarly situated customer in the ordinary course of business in transactions of similar size and having similar characteristics but not involving a security taken in trade.
(c) For purposes of this Section a member shall be:
(1) deemed, with respect to securities other than common stocks, to have taken such securities in trade at a fair market price when the price paid is not higher than the highest independent bid for the securities at the time of purchase, if such bid quotations for the securities are readily available.
(2) presumed, with respect to common stocks, to have taken such common stocks in trade at a fair market price when the price paid is not higher than the highest independent bid for the securities at the time of purchase, if such bid quotations for the securities are readily available.
(3) presumed to have taken a security in trade at a price higher than a fair market price when the price paid is higher than the lowest independent offer for the securities at the time of purchase, if such offer quotations for the securities are readily available.
(d) A member, in connection with every transaction subject to this Section, shall with respect to:
(1) common stocks, which are traded on a national securities exchange or for which quotations are entered in an automated quotation system, obtain the necessary bid and offer quotations from the national securities exchange or from the automated quotation sys tem; and
(2) other securities and common stocks not included in subparagraph (1) of this Subsection (d) obtain directly or with the assistance of an independent agent bid and offer quotations from two or more independent dealers relating to the securities to be taken in trade or, if such quotations are not readily available, exercise its best efforts to obtain such quotations with respect to securities having similar characteristics and of similar quality as those to be taken in trade.
(e) A member who purchases a security taken in trade shall keep or cause to be kept adequate records to demonstrate compliance with this Section and shall preserve the records for at least 24 months after the transaction. If an independent agent is used for the purpose of obtaining quotations, the member must request the agent to identify the dealers from whom the quotations were obtained and the time and date they were obtained or request the agent to keep and maintain for at least 24 months a record containing such information.

EXPLANATION

Section 8 was revised a few years ago as part of the "Papilsky" rule revisions. The Board of Governors proposes that no change be made in the current language.

CURRENT TEXT

NASD Manual, ¶ 2159, p. 2075-6

No Vote Required

Use of Information Obtained in Fiduciary Capacity

Sec. 9.

A member who, in the capacity of paying agent, transfer agent, trustee, or in any other similar capacity, has received information as to the ownership of securities, shall under no circumstances make use of such information for the purpose of soliciting purchases, sales, or exchanges, except at the request and on behalf of the issuer.

EXPLANATION

No change is being proposed to this section.

PROPOSED AMENDED TEXT

NASD Manual, ¶ 2160, p. 2075-6,2075-7

Item 8 on ballot

Influencing or Rewarding Employees of Others

Sec. 10.

(a) No member or person associated with a member shall, directly or indirectly, give or permit to be given anything of value, including gratuities, in excess of [fifty] one hundred dollars per individual per year to any person, principal, proprietor, employee, agent, or representative of another person where such payment or gratuity is in relation to the business of the employer of the recipient of the payment or gratuity. A gift of any kind is considered a gratuity.
(b) This section shall not apply to contracts of employment with or to compensation for services rendered by persons enumerated in Subsection (a) provided that there is in existence, prior to the time of employment or before the services are rendered, a written agreement between the member and the person who is to be employed to perform such ser vices. Such agreement shall include the nature of the proposed employment, the amount of the proposed compensation, and the written consent of such person's employer or principal.
(c) A separate record of all payments or gratuities in any amount known to the member, the employment agreement referred to in Subsection (b), and any employment compensation paid as a result thereof shall be retained by the member for the period specified by Rule 17a-4 of the General Rules and Regulations under the Securities Ex change Act of 1934.

EXPLANATION

The only amendment to Section 10 is an increase in the maximum allowable gift amount from $50 to $100 per individual per year.

CURRENT TEXT

NASD Manual, ¶ 2161, p. 2075-7

No Vote Required

Payment Designed to Influence Market Prices,

Other Than Paid Advertising

Sec. 11.

No member shall, directly or indirectly, give, permit to be given, or offer to give, anything of value to any person for the purpose of influencing or rewarding the action of such person in connection with the publication or circulation in any newspaper, investment service, or similar publication, of any matter which has, or is intended to have, an effect upon the market price of any security, provided that this rule shall not be construed to apply to matter which is clearly distinguishable as paid advertising.

EXPLANATION

No change is being proposed to this section.

CURRENT TEXT

NASD Manual, ¶ 2162, p. 2076

Item 9 on ballot

[Disclosure on Confirmations]

[Sec. 12.]

[A member at or before the completion of each transaction with a customer shall give or send to such customer written notification disclosing: (1) whether such member is acting as a broker for such customer, as a dealer for his own account, as a broker for some other person, or as a broker for both such customer and some other person; and (2) in any case in which such member is acting as a broker for such customer or for both such customer and some other person, either the name of the person from whom the security was purchased or to whom it was sold for such customer and the date and time when such transaction took place or the fact that such information will be furnished upon the request of such customer, and the source and amount of any commission or other remuneration received or to be received by such member in connection with the transaction.]

EXPLANATION

The Board of Governors recommends that Section 12 be deleted because the confirmation requirements of SEC Rule 10b-10 more than adequately cover the provisions of this section.

CURRENT TEXT

NASD Manual, ¶ 2163, p. 2078

Item 10 on ballot

[Disclosure of Control]

[Sec. 13.]

[A member controlled by, controlling, or under common control with the issuer of any security, shall, before entering into any contract with or for a customer for the purchase or sale of such security, disclose to such customer the existence of such control, and if such disclosure is not made in writing, it shall be supplemented by the giving or sending of written disclosure at or before the completion of the transaction.]

EXPLANATION

When originally circulated for comment, Section 13 was to remain unchanged. However, after further consideration, the Board of Governors recommends that it be deleted since it duplicates SEC Rule 15c 1-5.

CURRENT TEXT

NASD Manual, ¶ 2164, p. 2078

Item 11 on ballot

[Disclosure of Participation or Interest in Primary or Secondary Distribution]

[Sec. 14.]

[A member who is acting as a broker for a customer or for both such customer and some other person, or a member who is acting as a dealer and who receives or has promise of receiving a fee from a customer for advising such customer with respect to securities, shall, at or before the completion of any transaction for or with such customer in any security in the primary or secondary distribution of which such member is participating or is otherwise financially interested, give such customer written notification of the existence of such participation or interest.]

EXPLANATION

When originally proposed, Section 14 would have remained unchanged. After further consideration, the Board of Governors recommends that the section be deleted since it duplicates SEC Rule 15cl-6.

PROPOSED AMENDED TEXT

NASD Manual, ¶2165, p. 2078

Item 12 on ballot

Discretionary Accounts

Sec. 15.

Excessive transactions

(a) No member shall effect with or for any customer's account in respect to which such member or his agent or employee is vested with any discretionary power any transactions of purchase or sale which are excessive in size or frequency in view of the financial resources and character of such account.

Authorization and acceptance of account

(b) No member or [registered representative] person associated with a member shall exercise any discretionary power in a customer's account unless such customer has given prior written authorization to a stated [individual or individuals] associated person or persons, or to the member in which case such discretionary power shall be exercised by a properly authorized associated person or persons of the member, and the account has been accepted by the member, as evidenced in writing by the member or the partner, officer, or manager, duly designated by the member, in accordance with Section 27 of these rules.

Approval and review of transactions

(c) The member or the person duly designated shall approve promptly in writing each discretionary order entered and shall review all discretionary accounts at frequent intervals in order to detect and prevent transactions which are excessive in size or frequency in view of the financial resources and character of the account.

Exception

(d) This section shall not apply to discretion as to the price at which or the time when an order given by a customer for the purchase or sale of a definite amount of a specified security shall be executed.

EXPLANATION

As originally proposed, the existing requirement that limits the grant of discretion to a particular individual was left unchanged and members were asked to comment on whether a member firm should be allowed to exercise discretion. After reviewing the comments, the Board of Governors determined that it appears appropriate to allow members to exercise discretion. However, in an effort to ensure that discretion will be properly delegated, the amendment would require that member discretion be exercised only by an authorized person or persons within the member's organization.

CURRENT TEXT

NASD Manual, ¶ 2166, p. 2079

Item 13 on ballot

[Offerings "At the Market"]

[Sec. 16.]

[A member who is participating or who is otherwise financially interested in the primary or secondary distribution of any security which is not admitted to trading on a national securities exchange, shall make no representation that such security is being offered to a customer "at the market" or at a price related to the market price unless such member knows or has reasonable grounds to believe that a market for such security exists other than that made, created, or controlled by such member, or by any person for whom he is acting or with whom he is associated in such distribution, or by any person controlled by, controlling, or under common control with such member.]

EXPLANATION

Although no change was proposed in Section 16 when originally circulated for comment, the Board of Governors considered comments from the SEC and others and recommends that the section be deleted since it duplicates SEC Rule 15cl-8.

CURRENT TEXT

NASD Manual, ¶ 2167, p. 2079

Item 14 on ballot

[Solicitation of Purchases on an Exchange to Facilitate a Distribution of Securities]

[Sec. 17.]

[(a) No member, participating or otherwise financially interested in the primary or secondary distribution of any security of any issuer, shall:]
[(1) pay or offer or agree to pay, directly or indirectly, to any person any compensation for soliciting another to purchase any security of the same issuer on a national securities exchange, or for purchasing any security of the same issuer on any such exchange for any account other than the account of the member who pays or is to pay such compensation; or]
[(2) sell, offer to sell, or induce an offer to buy such security, or deliver such security after sale, if, in connection with such distribution, such member has paid, or has offered or agreed to pay, directly or indirectly, to any person, any compensation for soliciting another to purchase any security of the same issuer on any national securities exchange, or for purchasing any security of the same issuer on any such exchange for any account other than the account of the member who has paid or is to pay such compensation.]
[(b) No member, participating or otherwise financially interested in the primary or secondary distribution of any security of any issuer, shall cause a purchase or sale of any security of the same issuer on a national securities exchange by paying or offering or agreeing to pay, directly or indirectly, to any person any compensation for soliciting another to purchase such security on any such exchange, or for purchasing such security on any such exchange for any account other than the account of the member who pays or is to pay such compensation.]
[(c)] The provisions of this rule shall not apply in respect to any salary paid by a member to any person regularly employed by him whose ordinary duties include the solicitation or execution of brokerage orders on a national securities exchange, if such salary represents only ordinary compensation for the discharge by such person of such duties in the regular course of his employment, and is not paid, in whole or in part, directly or indirectly, for the inducement by such person of the purchase or sale on a national securities exchange of any security of the issuer of the security in the primary or secondary distribution of which such member is participating or otherwise financially interested.]

EXPLANATION

The Board of Governors recommends that Section 17 be deleted since it duplicates SEC Rule 10b-2.

CURRENT TEXT

NASD Manual, ¶ 2168, p. 2079

No Vote Required

Use of Fraudulent Devices

Sec. 18.

No member shall effect any transaction in, or induce the purchase or sale of, any security by means of any manipulative, deceptive, or other fraudulent device or contrivance.

EXPLANATION

No change is being proposed to this section.

PROPOSED AMENDED TEXT

NASD Manual, ¶ 2169, p. 2083-2091

Item 15 on ballot

Customers' Securities or Funds

Sec. 19.

Improper use

(a) No member or person associated with a member shall make improper use of a customer's securities or funds.

General Provisions

(b) [Every member in the conduct of its business shall adhere to the provisions or Rule 15c3-3 promulgated under the Securities Exchange Act of 1934 with respect to obtaining possession and control of securities, and the maintenance of appropriate cash reserves.] For the purposes of this Section, the definitions contained in Commission Rule 15c3-3 under the Securities Exchange Act of 1934 shall apply.

Authorization to lend

(c) No member shall lend, either to himself or to others, securities carried for the account of any customer, which are eligible to be pledged or loaned unless such member shall first have obtained from the customer a written authorization permitting the lending of securities thus carried by such member.

Segregation and identification of securities

(d) No member shall hold securities carried for the account of any customer which have been fully paid for or which are excess margin securities un less such securities are segregated and identified by a method which clearly indicates the interest of such customer in those securities.

Prohibition against guarantees

(e) No member or person associated with a member shall guarantee a customer against loss in any securities account of such customer carried by the member or in any securities transaction effected by the member with or for such customer.

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; 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 shall share in the profits or losses in any account of such customer 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.

EXPLANATION

Several commenters suggested deleting this section since it partially duplicates certain provisions in SEC Rule 15c3-3. Therefore, the language in Subsection (b) that duplicates the SEC's rule is proposed to be deleted.

CURRENT TEXT

NASD Manual, ¶ 2170, p. 2095

Item 16 on ballot

[Installment or Partial Payment Sales]

[Sec. 20.]

[Prohibition]

[(a) No member shall take or carry any account or make a transaction for any customer under any arrangement which contemplates or provides for the purchase of any security for the account of the customer or for the sale of any security to the customer, where payment for the security is to be made to the member by the customer over a period of time in installments or by a series of partial payments, unless:]

[Member acts as agent]

[(1) in the event such member acts as an agent or broker in such transaction he shall immediately, in the regular course of business, make an actual purchase of the security for the account of the customer, and shall immediately, in the regular course of business, take possession or control of such security and shall maintain possession or control thereof so long as he remains under obligation to deliver the security to the customer;]

[Member acts as principal]

[(2) in the event such member acts as a principal in such transaction, he shall, at the time of such transaction, own such security and shall maintain possession or control thereof so long as he remains under obligation to deliver the security to the customer;]

[Regulation T satisfied]

[(3) the provisions of Regulation T of the Federal Reserve Board, if applicable to such member, are satisfied.]

[Hypothecation]

[(b) No member, whether acting as principal or agent, shall, in connection with any transaction referred to in this rule, make any agreement with his customer under which such member shall be al-lowed to pledge or hypothecate any security involved in such transaction for any amount in excess of the indebtedness of the customer to such member.]

EXPLANATION

The provisions of Section 20 are inconsistent with Federal Reserve Board Regulation T, notwithstanding the attempted saving language in Subsection (a)(3), and are redundant with SEC Rule 15c3-3. It therefore appears appropriate to delete this section.

PROPOSED AMENDED TEXT

NASD Manual, ¶ 2171, p. 2095-2

Item 17 on ballot

Books and Records

Sec. 21.

Requirements

(a) Each member shall keep and preserve books, accounts, records, memoranda, and correspondence in conformity with all applicable laws, rules, regulations, and statements of policy promulgated thereunder and with the rules of this Association.

Marking of customer order tickets

(b)
(i) A person associated with a member shall indicate on the memorandum for each customer order for the sale of any security whether the order is "long" or "short." An order shall be marked "long" only if (1) the customer's account is "long" the security involved or (2) the member is informed that the customer owns the security and will deliver it as soon as possible without undue inconvenience or expense.
(b)
(ii) A person associated with a member shall indicate on the memorandum for each transaction in a non-NASDAQ security, as that term is defined in Schedule H to the NASD By-Laws, the name of each dealer contacted and the quotations received to determine the best inter-dealer market

Information on accounts

(c) Each member shall maintain accounts of customers in such form and manner as to show the following information: name, address, and whether the customer is legally of age; the signature of the registered representative introducing the account and the signature of the member or the partner, officer, or manager accepting the account for the member. If the customer is associated with or employed by another member, this fact must be noted. In discretionary accounts, the member shall also record the age or approximate age and occupation of the customer [as well as the signature of each person authorized to exercise discretion in such account].

Record of written complaints

(d) Each member shall keep and preserve in each office of supervisory jurisdiction, as defined in Section 27 of these rules, either a separate file of all written complaints of customers and action taken by the member, if any, or a separate record of such complaints and a clear reference to the files containing the correspondence connected with such complaint as maintained in such office.

"Complaint" defined

(e) A "complaint" shall be deemed to mean any written statement of a customer or any person ac ting on behalf of a customer alleging a grievance involving the activities of those persons under the control of the member in connection with the solicitation or execution of any transaction or the disposition of securities or funds of that customer.

EXPLANATION

The Board believes the signature of the person with discretion under Subsection (c) is unnecessary on new account forms.

CURRENT TEXT

NASD Manual, ¶ 2172, p. 2097

Item 18 on ballot

[Disclosure of Financial Condition]

[Sec. 22.]

[(a) A member shall make available to inspection by any bona fide regular customer, upon request, the information relative to such member's financial condition as disclosed in its most recent balance sheet prepared either in accordance with such member's usual practice or as required by any state or federal securities laws, or any rule or regulation thereunder.]
[(b) As used in paragraph (a) of this rule, the term "customer" means any person who, in the regular course of such member's business, has cash or securities in the possession of such member.]

EXPLANATION

Section 22 duplicates the provisions of SEC Rule 17a-5 that require brokers and dealers to send certain periodic financial reports to their customers. Therefore, this duplicative provision is proposed to be deleted.

CURRENT TEXT

NASD Manual, ¶ 2173, p. 2097

Item 19 on ballot

[Net Prices to Persons Not in Investment Banking or Securities Business]

[Sec. 23.]

[No member shall offer any security or confirm any purchase or sale of any security, from or to any person not actually engaged in the investment banking or securities business at any price which shows a concession, discount, or other allowance, but shall offer such security and confirm such purchase or sale at a net dollar or basis price.]

EXPLANATION

This provision is proposed to be deleted since the requirements of Section 23 are adequately covered by SEC Rule 10b-10.

CURRENT TEXT

NASD Manual, ¶ 2174, pp. 2097-2098

No Vote Required Selling Concessions

Sec. 24.

In connection with the sale of securities which are part of a fixed price offering:

(a) A member may not grant or receive selling concessions, discounts, or other allowances except as consideration for services rendered in distribution and may not grant such concessions, discounts, or other allowances to anyone other than a broker or dealer actually engaged in the investment banking or securities business; provided, however, that nothing in this Section shall prevent any member from (1) selling any such securities to any per son, or account managed by any person, to whom it has provided or will provide bona fide research, if the stated public offering price for such securities is paid by the purchaser; or (2) selling any such securities owned by him to any person at any net price which may be fixed by him unless prevented therefrom by agreement.
(b) The term "bona fide research," when used in this Section, means advice, rendered either directly or through publications or writings, as to the value of securities, the advisability of investing in, purchasing, or selling securities, and the availability of securities or purchasers or sellers of securities, or analyses and reports concerning issuers, industries, securities, economic factors and trends, portfolio strategy, and performance of accounts; provided, however, that investment management or investment discretionary services are not bona fide research.
(c) A member who grants a selling concession, discount, or other allowance to another person shall obtain a written agreement from that person that he will comply with the provisions of this Section, and a member who grants such selling concession, discount, or other allowance to a non-member broker or dealer in a foreign country shall also obtain from such broker or dealer a written agreement to comply, as though such broker or dealer were a member, with the provisions of Sections 8 and 36 of this Article and to comply with Section 25 of this Article as that Section applies to a nonmember broker-dealer in a foreign country.
(d) A member who receives an order from any person designating another broker or dealer to receive credit for the sale shall, within 30 days after the end of each calendar quarter, file reports with the Association containing the following information with respect to each fixed price offering which terminated during that calendar quarter: the name of the person making the designation; the identity of the brokers or dealers designated; the identity and amount of securities for which each broker or dealer was designated; the date of the commencement and termination of the offering, and such other information as the Association shall deem pertinent.
(e) A member who is designated by its customer for the sale of securities shall keep, and maintain for a period of 24 months, records in such form and manner to show the following information: name of customer making the designation; the identity and amount of securities for which the member was designated; the identity of the manager or managers of the offering, if any; the date of the commencement of the offering, and such other information as the Association shall deem pertinent.

EXPLANATION

The Board of Governors recommends that Section 24, adopted as part of the "Papilsky" rules, remain unchanged. On January 27, 1989, the SEC approved an amendment to the Interpretation of the Board of Governors — "Bona Fide Research Exclusion" — published in Notice to Members 88-72 (October 1988), which amends the exclusion from bona fide research in Section 24(b) by reference to the standard established by the SEC in Securities Exchange Act Release No. 23170 (April 30, 1986).

CURRENT TEXT

NASD Manual, ¶ 2175, p. 2101

Item 20 on ballot

[Dealing with Non-Members]

[Sec. 25.]

[(a) No member shall deal with any non-member broker or dealer except at the same prices, for the same commissions or fees, and on the same terms and conditions as are by such member accorded to the general public]
[(b) Without limiting the generality of the foregoing, no member shall:]
[(1) in any transaction with any non-member broker or dealer, allow or grant to such non-member broker or dealer any commission, selling concession, discount, or other allowance allowed by such member to a member of a registered securities association, and not allowed to a member of the general public;]
[(2) join with any non-member broker or dealer in any syndicate or group contemplating the distribution to the public of any issue of securities or any part thereof; or]
[(3) sell any security to or buy any security from any non-member broker or dealer except at the same price at which at the time of such transaction such member would buy or sell such security, as the case may be, from or to a person who is a member of the general public not engaged in the investment banking or securities business.]

[Transactions with foreign non-members]

[(c) The provisions of paragraphs (a) and (b) of this rule shall not apply to any non-member broker or dealer in a foreign country who is not eligible for membership in a registered securities association, but in any transaction with any such foreign non-member broker or dealer, where a selling concession, discount, or other allowance is allowed, a member shall as a condition of such transaction secure from such foreign broker or dealer an agreement that, in making any sales to purchasers within the United States of securities acquired as a result of such transactions, he will conform to the provisions of paragraphs (a) and (b) of this rule to the same extent as though he were a member of the Corporation.]

["Non-member broker or dealer"]

[(d) For the purpose of this rule, the term "non-member broker or dealer" shall include any broker or dealer who makes use of the mails or of any means or instrumentality of interstate commerce to effect any transaction in, or to induce the purchase or sale of, any security, otherwise than on a national securities exchange, who is not a member of any securities association, registered with the Commission pursuant to Section 15A of the Act, except a broker or dealer who deals exclusively in commercial paper, bankers' acceptances, or commercial bills.]
[(e) Nothing in this rule shall be so construed or applied as to prevent any member of the Corporation from granting to any other member of any registered securities association any dealer's discount, allowance, commission, or special terms.]

PROPOSED NEW TEXT

Dealing with Non-Members

Sec. 25.

Prohibition

(a) No member shall deal with any non-member broker or dealer except at the same prices, for the same commissions or fees, and on the same terms and conditions as are by such member accorded to the general public.
(b) Without limiting the generality of the foregoing, no member shall:
(1) in any transaction with any non-member broker or dealer, allow or grant to such non- member broker or dealer any commission, selling concession, discount, or other allowance allowed by such member to a member of a registered securities association, and not allowed to a member of the general public, or in the case of transactions in municipal securities, allowed by such member to a municipal securities dealer which is a bank or department or division of a bank, and not allowed to a member of the general public;
(2) join with any non-member broker or dealer in any syndicate or group contemplating the public or private sale of any issue of securities or any part thereof if the member, directly or indirectly, allows or grants any commission, selling concession, discount, or other allowance to such non-member broker or dealer; or
(3) sell any security to or buy any security from any non-member broker or dealer except at the same price at which at the time of such transaction such member would buy or sell such security, as the case may be, from or to a person who is a member of the general public not engaged in the investment banking or securities business.

Transactions with foreign non-members

(c) The provisions of Subsections (a) and (b) of this rule shall not apply to any non-member broker or dealer in a foreign country who is not eligible for membership in a registered securities association because it is not a registered broker or dealer; but in any transaction with any such foreign non- member broker or dealer, where a selling concession, discount, or other allowance is allowed, a member shall, as a condition of such transaction, obtain from such foreign broker or dealer an agreement that, in making any sales to purchasers within the United States of securities acquired as a result of such transactions, it will conform to Subsections (a) and (b) hereof to the same extent as though it were a member of the Corporation.

"Non-member broker or dealer"

(d) For the purpose of this Section, the term "non-member broker or dealer" shall mean any broker or dealer, if registered or required to be registered with the Commission, or municipal securities broker or dealer (other than a bank or a department or division of a bank) who makes use of the mails or of any means or instrumentality of interstate commerce to effect any transaction in, or to induce the purchase or sale of, any security, otherwise than on a national securities exchange, who is not a member of any securities association registered with the Commission pursuant to Sections 15A and 19(a) of the Act, except a broker or dealer who deals exclusively in commercial paper, bankers' acceptances, and commercial bills. The term shall also include a broker or dealer whose registration has been and is revoked or suspended by the Commission, who has been and is expelled or suspended from membership in the Corporation, or whose registration or membership has been and is canceled by the Commission or the Corporation.

Payments to members of other registered securities associations and to bank municipal securities dealers

(e) Nothing in this Section shall be so construed or applied to prevent any member of the Corporation from granting to a member of any other registered securities association any dealer's discount, allowance, commission, or special terms, nor shall this Section be construed or applied to prevent any member from granting to any municipal securities dealer, which is a bank or a division or department of a bank, any dealer's discount, allowance, commission, or special terms in connection with the purchase or sale of municipal securities.

Receipt of payments from non-member brokers or dealers or from bank municipal securities dealers

(f) Nothing in this Section shall be so construed or applied to prevent a member's receipt of commissions, concessions, discounts, or other allowances from non-member brokers or dealers, nor shall this rule be construed or applied to prevent a member's receipt of commissions, concessions, discounts, or other allowances from municipal securities dealers which are banks or departments or divisions of banks in connection with transactions in municipal securities.

EXPLANATION

The proposed changes are primarily designed to conform Section 25 to statutory amendments and SEC interpretations.

Section 15A(e) of the Securities Exchange Act of 1934 (Exchange Act) expressly authorizes the NASD to adopt a rule such as Section 25 that requires members to treat brokers and dealers that are non-members on terms and conditions no more favorable than are accorded the general public. Section 25 has existed since the NASD's inception, and the statutory language is almost identical to Subsection (a) of Section 25. The only change in the statutory language was made by the Securities Acts Amendments of 1975, which expressly authorized the NASD to apply the Section 25 restrictions to members' dealings with non-member brokers and dealers other than banks in the area of municipal securities. The remaining sections of the NASD's Rules of Fair Practice do not address members' municipal securities transactions since rulemaking authority in this area was granted to the Municipal Securities Rulemaking Board (MSRB), with the NASD having responsibility for enforcing MSRB rules.

The language added to Subsection (b)(l) of Section 25 is intended to clarify that the restrictions also apply to municipal securities. It is intended to make clear that, although a member may grant a municipal securities concession to a bank, it is prohibited from paying the same concession to non-member brokers and dealers.

The proposed changes to Subsection (b)(2) have two purposes. In Aetna proceeding, the SEC issued an order partially abrogating Section 25 and, in particular, Subsection (b)(2). (See 44 S.E.C. 896 (1972).) The SEC found that the statutory provision authorizing Section 25 did not allow the NASD to construe it to prevent member dealers in a public offering from receiving selling concessions from a non-member underwriter. The SEC also held that the NASD could not apply Section 25 to prevent a member and non-member broker or dealer from participating in a "parallel distribution" if the issuer makes separate commission payments to a member and a non-member. (Plaza Securities, 45 S.E.C. 449 (1974).) The added language at the end of the subsection is intended to codify this construction. The other language changes are intended to eliminate any misunderstanding that Section 25 does not apply to private placements.

The changes in Subsection (c) are designed to conform the provision to the current statutory requirements with respect to eligibility for membership and to eliminate an anomaly created by a construction of the NASD By-Laws that has not been followed for many years. The 1975 Securities Acts Amendments amended Section 15A(b)(3) of the Exchange Act to provide that, unless there is a bar or other statutory disqualification or failure to satisfy examination or other qualification requirements, the NASD must admit to membership any broker or dealer that is registered with the SEC. The statutory language thus eliminates an older provision authorizing the NASD to restrict membership on a geographic basis.

The new language of Subsection (c) simply codifies the statutory provisions. It also clarifies that if a registered foreign broker or dealer is ineligible for reasons apart from registration (for example, a failure to pass qualification examinations), the broker-dealer shall be treated the same way as a non-member United States broker-dealer must be treated.

As originally proposed, Section 25 would have deleted existing language requiring that, in making sales to a foreign broker-dealer that is a non-member, a member must obtain an agreement that such foreign non-member broker-dealer, in making resales to purchasers in the United States, will agree to comply with Subsections (a) and (b) as if it were a member. The Board of Governors decided to retain this requirement in Section 25 to prevent evasion if a member should allow a concession to a foreign broker or dealer that, in turn, could re-allow such concession to a non-member registered broker or dealer.

The added language at the beginning of Subsection (d) that defines the term "non-member broker or dealer" is intended to clarify that it has been construed to cover unregistered firms which are "... required to be registered ..." and are, therefore, conducting an unlawful broker-dealer business. In December 1983, amendments to the Exchange Act became effective that rescinded the SECO program regulating registered non-member brokers and dealers. Thereafter, all registered brokers and dealers were required to become NASD members, except certain exchange members with gross annual income from over-the-counter transactions of under $1,000. Therefore, it appears that the primary effect of the first sentence of Subsection (d) should be with respect to dealings with unregistered brokers and dealers. The existence of brokers and dealers that should be registered does not appear to be an isolated problem. The NASD staff is aware of situations — such as investment advisers receiving transaction-related compensation, purchaser representatives whose fees appear to be based on the amount purchased by an investor rather than being related to the evaluative effort, finders who receive fees from issuers for referring investors, and real estate and other syndicators who continuously engage in sales of limited partnerships — sometimes acquiring a sales force for this sole purpose.

A new sentence has been added to expressly state that a revoked or suspended member is a non-member broker or dealer during the period of the revocation or suspension penalty. This position is currently stated in the Board of Governors' Interpretation following Section 25.

The added language at the end of Subsection (e) and a part of the language added at the beginning of Subsection (d) is intended to conform to Section 15A(e)(3)(B) of the Exchange Act, added by the 1975 Securities Acts Amendments, prohibiting the NASD from applying Section 25 to prevent members from granting discounts, allowances, or special terms to municipal securities dealers that are banks, or divisions or departments of banks, in connection with transactions in municipal securities.

Subsection (f) is entirely new and codifies the SEC's partial abolition of Section 25 in the Aetna proceeding. The new language also codifies Section 15A(e)(3)(B) of the Exchange Act, which prohibits the NASD from applying Section 25 to prevent members from receiving discounts, allowances, or special terms from municipal securities dealers, which are banks, or divisions or departments of banks, in connection with transactions in municipal securities.

PROPOSED AMENDED TEXT

NASD Manual, ¶ 2176, pp. 2105-3 —2106

Item 21 on ballot

Investment Companies

Sec. 26.

Application

(a) This section shall apply exclusively to the activities of members in connection with the securities of companies registered under the Investment Company Act of 1940; provided, however, that Section 29 of this Article shall apply, in lieu of this Section, to members' activities in connection with "variable contracts" as defined therein.

Definitions

(b)
(1) The terms "underwriter," " principal underwriter," "redeemable security," "periodic payment plan," "open-end management investment company," and "unit investment trust" shall have the same definitions used in the Investment Company Act of 1940.
(2) "Public offering price" shall mean a public offering price as set forth in the prospectus of the issuing company.
(3) "Rights of accumulation," as used in Subsection (d) of this Section, shall mean a scale of reducing sales charges in which the sales charge applicable to the securities being purchased is based upon the aggregate quantity of securities previously purchased or acquired and then owned plus the securities being purchased. The quantity of securities owned shall be based upon:
(A) The current value of such securities (measured by either net asset value or maximum offering price); or
(B) Total purchases of such securities at actual offering prices; or
(C) The higher of the current value or the total purchases of such securities. The quantity of securities owned may also include redeemable securities of other registered investment companies having the same principal underwriter.
(4) "Any person" shall mean "any person" as defined in Subsection (a), or "purchaser" as defined in Subsection (b), of Rule 22d-l under the Investment Company Act of 1940.
(5) "Covered account," as used in subsection (k) of this Section, shall mean (A) any other investment company or other account managed by the in vestment adviser of such investment company, or (B) any other account from which brokerage commissions are received or expected as a result of the request or direction of any principal underwriter of such investment company or of any affiliated per son (as defined in the Investment Company Act of 1940) of such investment company or of such un derwriter, or of any affiliated person of such investment company.
(6) "Brokerage commissions," as used in Subsection (k) of this Section, shall not be limited to commissions on agency transactions but shall include underwriting discounts or concessions and fees paid to members in connection with tender offers.
(7) "Associated person of an underwriter," as used in Subsection (1) of this Section, shall include an issuer for which an underwriter is the sponsor or a principal underwriter, any investment adviser to such issuer, or any affiliated person (as defined in Section 2(a)(3) of the Investment Company Act of 1940) of such underwriter, issuer, or in vestment adviser.

Conditions for discounts to dealers

(c) No member who is an underwriter of the securities of an investment company shall sell any such security to any dealer or broker at any price other than a public offering price unless such sale is in conformance with Section 25 of this Article and, if the security is issued by an open-end management company or by a unit investment trust which invests primarily in securities issued by other in vestment companies, unless a sales agreement is in effect between the parties as of the date of the transaction, which agreement shall set forth the concessions to be received by the dealer or broker.

Sales charge

(d) No member shall offer or sell the shares of any open-end investment company or any "single payment" investment plan issued by a unit investment trust registered under the Investment Company Act of 1940 if the public offering price includes a sales charge which is excessive, taking into consideration all relevant circumstances. Sales charges shall be deemed excessive if they do not conform to the following provisions:
(1) The maximum sales charge on any transaction shall not exceed 8.5% of offering price.
(2)
(A) Dividend reinvestment shall be made available at net asset value per share to "any person" who requests such reinvestment at least 10 days prior to the record date, subject only to the right to limit the availability of dividend reinvestment to holders of securities of a stated minimum value, not greater than $1,200.
(B) If dividend reinvestment is not made available on terms at least as favorable as those specified in subparagraph (2)(A), the maximum sales charge on any transaction shall not exceed 7.25% of offering price.
(3)
(A) Rights of accumulation (cumulative quantity discounts) shall be made available to "any person" for a period of not less than 10 years from the date of first purchase in accordance with one of the alternative quantity discount schedules provided in subparagraph (4)(A) below, as in effect on the date the right is exercised.
(B) If rights of accumulation are not made available on terms at least as favorable as those specified in subparagraph (3)(A), the maximum sales charge on any transaction shall not exceed:
(i) 8.0% of offering price if the provisions of subparagraph (2)(A) are met; or
(ii) 6.75% of offering price if the provisions of subparagraph (2)(A) are not met.
(4)
(A) Quantity discounts shall be made available on single purchases by "any person" in accordance with one of the following two alternatives:
(i) A maximum sales charge of 7.75% on purchases of $10,000 or more and a maximum sales charge of 6.25% on purchases of $25,000 or more; or
(ii) A maximum sales charge of 7.50% on purchases of $15,000 or more and a maximum sales charge of 6.25% on purchases of $25,000 or more.
(B) If quantity discounts are not made available on terms at least as favorable as those specified in subparagraph (4)(A), the maximum sales charge on any transaction shall not exceed:
(i) 7.75% of offering price if the provisions of subparagraph (2)(A) and (3)(A) are met;
(ii) 7.25% of offering price if the provisions of subparagraph (2)(A) are met but the provisions of subparagraph (3)(A) are not met;
(iii) 6.50% of offering price if the provisions of subparagraph (3)(A) are met but the provisions of subparagraph (2)(A) are not met;
(iv) 6.25% of offering price if the provisions of subparagraph (2)(A) and (3)(A) are not met.

Selling dividends

(e) No member shall, in recommending the purchase of investment company securities, state or imply that the purchase of such securities shortly before an ex-dividend date is advantageous to the purchaser, unless there are specific, clearly described tax or other advantages to the purchaser, and no member shall represent that distributions of long-term capital gains by an investment company are or should be viewed as part of the income yield from an investment in such company's securities.

Withhold orders

(f) No member shall withhold placing customers' orders for any investment company security so as to profit himself as a result of such withholding.

Purchase For Existing Orders

(g) No member shall purchase from an under writer the securities of any open-end investment company, and no member who is an underwriter of such securities shall purchase such securities from the issuer, except (1) for the purpose of covering purchase orders previously received or (2) for its own investment. Nothing herein shall be deemed to prohibit any member from purchasing securities of any investment company specifically designed for short-term investment (e.g., money market fund).

Refund of sales charge

(h) If any security issued by an open-end management investment company is repurchased by the issuer, or by the underwriter for the account of the issuer, or is tendered for redemption within seven business days after the date of the transaction: (1) the dealer or broker shall forthwith refund to the underwriter the full concession allowed to the dealer or broker on the original sale and (2) the underwriter shall forthwith pay to the issuer the underwriter's share of the sales charge on the original sale by the underwriter and shall also pay to the issuer the refund which he receives under clause (1) when he receives it. The dealer or broker shall be notified by the underwriter of such repurchase or redemption within 10 days of the date on which the certificate or written request for redemption is delivered to the underwriter or issuer. If the original sale was made directly to the investor by the principal underwriter, the entire sales charge shall be paid to the issuer by the principal underwriter.

Purchases as principal

(i) No member who is a party to a sales agreement referred to in Subsection (c) shall, as principal, purchase any security issued by an open-end management investment company or unit investment trust from a record holder at a price lower than the bid price next quoted by or for the issuer.

Repurchase from dealer

(j) No member who is a principal underwriter of a security issued by an open-end management investment company shall repurchase such security, either as principal or as agent for the issuer, from a dealer acting as principal who is not a party to a sales agreement with a principal underwriter, nor from any investor, unless such dealer or investor is the record owner of the security so tendered for repurchase. No member who is a principal underwriter shall participate in the offering or in the sale of any such security if the issuer voluntarily redeems or repurchases its securities from a dealer acting as principal who is not a party to such a sales agreement nor from any investor, unless such dealer or investor is the record owner of the security so tendered for repurchase. Nothing in this subsection shall relate to compulsory redemption of any security upon presentation to the issuer pursuant to the terms of the security. Nothing in this subsection shall prevent any member, whether or not a party to a sales agreement, from selling any such security for the account of a record owner to the underwriter or issuer at the bid price next quoted by or for the issuer and charging the investor a reasonable charge for handling the transaction, provided that such member discloses to such record owner that direct redemption of the security can be accomplished by the record owner without incurring such charges.

Execution of investment company portfolio transactions

(k)
(1) No member shall, directly or indirectly, favor or disfavor the sale or distribution of shares of any particular investment company or group of investment companies on the basis of brokerage commissions received or expected by such member from any source, including such investment company, or any covered account.
(2) No member shall, directly or indirectly, demand or require brokerage commissions or solicit a promise of such commissions from any source as a condition to the sale or distribution of shares of an investment company.
(3) No member shall, directly or indirectly, offer or promise to another member, brokerage commissions from any source as a condition to the sale or distribution of shares of an investment company, and no member shall request or arrange for the direction to any member of a specific amount or percentage of brokerage commissions conditioned upon that member's sales or promise of sales of shares of an investment company.
(4) No member shall circulate any information regarding the amount or level of brokerage commissions received by the member from any investment company or covered account to other than management personnel who are required, in the overall management of the member's business, to have ac cess to such information.
(5) No member shall, with respect to such member's activities as an underwriter of investment company shares, suggest, encourage, or sponsor any incentive campaign or special sales effort of another member with respect to the shares of any investment company which incentive or sales effort is, to the knowledge or understanding of such underwriter-member, to be based upon, or financed by, brokerage commissions directed or arranged by the underwriter-member.
(6) No member shall, with respect to such member's retail sales or distribution of investment company shares:
(A) provide to salesmen, branch managers, or other sales personnel any incentive or additional compensation for the sale of shares of specific investment companies based on the amount of brokerage commissions received or expected from any source, including such investment companies or any covered account. Included in this prohibition are bonuses, preferred compensation lists, sales incentive campaigns or contests, or any other method of compensation which provides an incentive to sales personnel to favor or disfavor any investment company or group of investment companies based on brokerage commissions;
(B) recommend specific investment companies to sales personnel, or establish "recommended," selected," or "preferred" lists of investment companies, regardless of the existence of any special compensation or incentives to favor or disfavor the shares of such company or companies in sales efforts, if such companies are recommended or selected on the basis of brokerage commissions received or expected from any source;
(C) grant to salesmen, branch managers, or other sales personnel any participation in brokerage commissions received by such member from portfolio transactions of an investment company whose shares are sold by such member, or from any covered account, if such commissions are directed by, or identified with, such investment company or any covered account; or
(D) use sales of shares of any investment company as a factor in negotiating the price of, or the amount of brokerage commissions to be paid on, a portfolio transaction of an investment company or of any covered account, whether such transaction is executed in the over-the-counter market or elsewhere.
(7) Provided that the member does not violate any of the specific provisions of this Subsection (k), nothing herein shall be deemed to prohibit:
(A) the execution of portfolio transactions of any investment company or covered account by members who also sell shares of the investment company;
(B) a member from selling shares of, or acting as underwriter for, an investment company which follows a policy, disclosed in its prospectus, of considering sales of shares of the investment company as a factor in the selection of broker-dealers to execute portfolio transactions, subject to the requirements of best execution;
(C) a member from compensating its sales men and managers based on total sales of investment company shares attributable to such salesmen or managers, whether by use or overrides, accounting credits, or other compensation methods, provided that such compensation is not designed to favor or disfavor sales of shares of particular investment companies on a basis prohibited by this Sub section (k).

Dealer concessions

(1)
(1) No underwriter or associated person of an underwriter shall offer, pay, or arrange for the offer or payment to any other member, in connection with retail sales or distribution of investment company securities, any discount, concession, fee, or commission (hereinafter referred to as "concession") which:
(A) is in the form of securities of any kind, including stock, warrants, or options;
(B) is in a form other than cash (e.g., merchandise or trips), unless the member earning the concession may elect to receive cash at the equivalent of no less than the underwriter's cost of providing the non-cash concession; or
(C) is not disclosed in the prospectus of the investment company. If the concessions are not uniformly paid to all dealers purchasing the same dollar amounts of securities from the underwriter, the disclosure shall include a description of the circumstances of any general variations from the standard schedule of concessions. If special compensation arrangements have been made with individual dealers, which arrangements are not generally available to all dealers, the details of the arrangements, and the identities of the dealers, shall also be disclosed.
(2) No underwriter or associated person of an underwriter shall offer or pay any concession to an associated person of another member, but shall make such payment only to the member.
(3)
(A) In connection with retail sales or distribution of investment company shares, no underwriter or associated person of an underwriter shall offer or pay to any member or associated per son, anything of material value, and no member or associated person shall solicit or accept anything of material value, in addition to the concessions disclosed in the prospectus.
(B) For purposes of this paragraph (1)(3), items of material value shall include but not be limited to:
(i) gifts amounting in value to more than [$50] $100 per person per year.
(ii) gifts or payments of any kind which are conditioned on the sale of investment company securities.
(iii) loans made or guaranteed to a non-controlled member or person associated with a member.
(iv) wholesale overrides (commissions) granted to a member on its own retail sales unless the arrangement, as well as the identity of the member, is set forth in the prospectus of the investment company.
(v) payment or reimbursement of travel expenses, including overnight lodging, in excess of [$50] $100 per person per year unless such payment or reimbursement is in connection with a business meeting, conference or seminar held by an underwriter for informational purposes relative to the fund or funds of its sponsorship and is not conditioned on sales of shares of an investment company. A meeting, conference, or seminar shall not be deemed to be of a business nature unless: the person to whom payment or reimbursement is made is personally present at, or is en route to or from such meeting in each of the days for which payment or reimbursement is made; the person on whose behalf payment or reimbursement is made is engaged in the securities business; and the location and facilities provided are appropriate to the purpose, which would ordinarily mean the sponsor's office.
(C) For purposes of this paragraph (1)(3), items of material value shall not include:
(i) an occasional dinner, a ticket to a sporting event or the theatre, or comparable entertainment of one or more registered representatives which is not conditioned on sales of shares of an investment company and is neither so frequent nor so extensive as to raise any question of propriety.
(ii) a breakfast, luncheon, dinner, reception, or cocktail party given for a group of registered representatives in conjunction with a bona fide business or sales meeting, whether at the headquarters of a fund or its underwriter or in some other city.
(iii) an unconditioned gift of a typical item of reminder advertising, such as a ballpoint pen with the name of the advertiser inscribed, a calendar pad, or other gifts amounting in value to not more than [$50] $100 per person per year.
(4) The provisions of this Subsection (1) shall not apply to:
(A) Contracts between principal underwriters of the same security.
(B) Contracts between the principal under writer of a security and the sponsor of a unit in vestment trust which utilizes such security as its underlying investment.
(C) Compensation arrangements of an under-writer or sponsor with its own sales personnel.

Prompt Payment for Investment Company Shares

(m)
(l) Members (including underwriters) that engage in direct retail transactions for investment company shares shall transmit payments received from customers for such shares, which such members have sold to customers, to payees (i.e., underwriters, investment companies, or their designated agents) by (1) the end of the fifth business day following receipt of a customer's order to purchase such shares or by (2) the end of one business day following receipt of a customer's payment for such shares, whichever is the later date.
(2) Members that are underwriters and that engage in wholesale transactions for investment company shares shall transmit payments for investment company shares, which such members have received from other members, to investment company issuers or their designated agents by the end of two business days following receipt of such payments.

EXPLANATION

No comments were received on Section 26 as originally proposed. The Board of Governors recommends that the section be approved without change, except to raise the minimum permissible gift amounts from $50 to $100 in Subsection (1).

Subsequent to the time the proposed amendments herein were circulated for comment, a new Subsection (m) was approved by the SEC with respect to prompt payment for investment company shares.

CURRENT TEXT

NASD Manual, ¶ 2177, pp. 2107-2108

No Vote Required

Supervision

Sec. 27.

Supervisory System

(a) Each member shall establish and maintain a system to supervise the activities of each registered representative and associated person that is reasonably designed to achieve compliance with applicable securities laws and regulations, and with the rules of this Association. Final responsibility for proper supervision shall rest with the member. A member's supervisory system shall provide, at a minimum, for the following:
(1) The establishment and maintenance of written procedures as required by paragraphs (b) and (c) of this Section.
(2) The designation, where applicable, of an appropriately registered principal(s) with authority to carry out the supervisory responsibilities of the member for each type of business in which it engages for which registration as a broker-dealer is required.
(3) The designation as an office of supervisory jurisdiction (OSJ) of each location that meets the definition contained in paragraph (f) of this Section. Each member shall also designate such other OSJs as it determines to be necessary in order to supervise its registered representatives and associated persons in accordance with the standards set forth in this Section, taking into consideration the following factors:
(i) whether registered persons at the location engage in retail sales or other activities involving regular contact with public customers;
(ii) whether a substantial number of registered persons conduct securities activities at, or are otherwise supervised from, such location;
(iii) whether the location is geographically distant from another OSJ of the firm;
(iv) whether the member's registered persons are geographically dispersed; and
(v) whether the securities activities at such location are diverse and/or complex.
(4) The designation of one or more appropriately registered principals in each OSJ, including the main office, and one or more appropriately registered representatives or principals in each non-OSJ branch office with authority to carry out the supervisory responsibilities assigned to that office by the member.
(5) The assignment of each registered person to an appropriately registered representative(s) and/or principal(s) who shall be responsible for supervising that person's activities.
(6) Reasonable efforts to determine that all supervisory personnel are qualified by virtue of experience or training to carry out their assigned responsibilities.
(7) The participation of each registered representative, either individually or collectively, no less than annually, in an interview or meeting conducted by persons designated by the member at which compliance matters relevant to the activities of the representative(s) are discussed. Such interview or meeting may occur in conjunction with the discussion of other matters and may be conducted at a central or regional location or at the representative's (') place of business.
(8) Each member shall designate and specifically identify to the Association one or more principals who shall review the supervisory system, procedures, and inspections implemented by the member as required by this Section and who shall take or recommend to senior management appropriate action reasonably designed to achieve the member's compliance with applicable securities laws and regulations, and with the rules of this Association.

Written procedures

(b)
(l) Each member shall establish, maintain, and enforce written procedures to supervise the types of business in which it engages and to supervise the activities of registered representatives and associated persons that are reasonably designed to achieve compliance with applicable securities laws and regulations, and with the applicable rules of this Association.
(2) The member's written supervisory procedures shall set forth the supervisory system established by the member pursuant to Section 27(a) above, and shall include the titles, registration status, and locations of the required supervisory personnel and the responsibilities of each supervisory person as these relate to the types of business engaged in, applicable securities laws and regulations, and the rules of this Association. The member shall maintain on an internal record the names of all persons who are designated as supervisory personnel and the dates for which such designation is or was effective. Such record shall be preserved by the member for a period of not less than three years, the first two years in an easily accessible place.
(3) A copy of a member's written supervisory procedures, or the relevant portions thereof, shall be kept and maintained in each OSJ and at each location where supervisory activities are conducted on behalf of the member. Each member shall amend its written supervisory procedures as appropriate within a reasonable time after changes occur in applicable securities laws and regulations, including the rules of this Association, and as changes occur in its supervisory system, and each member shall be responsible for communicating amendments through its organization.

Internal inspections

(c) Each member shall conduct a review, at least annually, of the business in which it engages, which review shall be reasonably designed to assist in detecting and preventing violations of and achieving compliance with applicable securities laws and regulations, and with the rules of this Association. Each member shall review the activities of each office, which shall include the periodic examination of customer accounts to detect and prevent irregularities or abuses and at least an annual inspection of each office of supervisory jurisdiction. Each branch office of the member shall be inspected according to a cycle which shall be set forth in the firm's written supervisory and inspection procedures. In establishing such cycle, the firm shall give consideration to the nature and complexity of the securities activities for which the location is responsible, the volume of business done, and the number of associated persons assigned to the location. Each member shall retain a written record of the dates upon which each review and inspection is conducted.

Written approval

(d) Each member shall establish procedures for the review and endorsement by a registered principal in writing, on an internal record, of all trans actions and all correspondence of its registered representatives pertaining to the solicitation or execution of any securities transaction.

Qualifications investigated

(e) Each member shall have the responsibility and duty to ascertain by investigation the good character, business repute, qualifications, and experience of any person prior to making such a certification in the application of such person for registration with this Association.

Definitions

(f)
(l) "Office of Supervisory Jurisdiction" means any office of a member at which any one or more of the following functions take place:
(i) order execution and/or market making;
(ii) structuring of public offerings or private placements;
(iii) maintaining custody of customers' funds and/or securities;
(iv) final acceptance (approval) of new accounts on behalf of the member;
(v) review and endorsement of customer orders, pursuant to paragraph (d) above;
(vi) final approval of advertising or sales literature for use by persons associated with the member, pursuant to Article III, Section 35 (b)(l) of the Rules of Fair Practice; or
(vii) responsibility for supervising the activities of persons associated with the member at one or more other branch offices of the member.
(f)
(2) "Branch Office" means any location identified by any means to the public or customers as a location at which the member conducts an investment banking or securities business, excluding any location identified solely in a telephone directory listing or on a business card or letterhead, which listing, card, or letterhead also sets forth the address and telephone number of the branch office or OSJ of the firm from which the person(s) conducting business at the non-branch location are directly supervised.

EXPLANATION

No change is being proposed to this section.

PROPOSED AMENDED TEXT

NASD Manual, ¶ 2178, pp. 2110-2111

Item 22 on ballot

Transactions For Personnel of Another Member

Sec. 28.

[Determine adverse interest]

[(a) A member ("executing member") who knowingly executes a transaction for the purchase or sale of a security for the account of a person associated with another member ("employer member"), or for any account over which such associated person has discretionary authority, shall use reasonable diligence to determine that the execution of such transaction will not adversely affect the interests of the employer member.]

Obligations of executing member

[(b)]
(a) Where [an] a member ("executing member") knows that a person associated with [an] another member ("employer member") has or will have a financial interest in, or discretionary authority over, any existing or proposed account carried by the executing member, the executing member shall:
(1) notify the employer member in writing, prior to the execution of a transaction for such ac count, of the executing member's intention to open or maintain such an account;
(2) [upon written request by the employer member,] transmit duplicate copies of confirmations, statements, or other information with respect to such account; and
(3) notify the person associated with the employer member of the executing member's intention to transmit the information required by paragraphs (1) and (2) of this Subsection [(b)] (a).

Obligations of associated persons concerning an account with a member

[(c)]
(b) A person associated with a member who opens an account or places an order for the purchase or sale of securities with another member, shall notify the executing member of his or her association with the employer member, provided, however, that if the account was established prior to the association of the person with the employer member, the associated person shall notify the executing member promptly after becoming so associated.

Obligations of associated persons concerning an account with an investment adviser, bank, or other financial institution

[(d)]
(c) A person associated with a member who opens a securities account or places an order for the purchase or sale of securities with a domestic or foreign investment adviser, bank, or other financial institution, except a member, shall:
(1) notify his or her employer member in writing, prior to the execution of any initial transactions, of the intention to open the account or place the order; and
(2) upon written request by the employer member, request in writing and assure that the in vestment adviser, bank, or other financial institution provides the employer member with duplicate copies of confirmations, statements, or other information concerning the account or order; provided, however, that if an account subject to this Sub section [(d)] (c) was established prior to a person's association with a member, the person shall comply with this subsection promptly after becoming so associated.
[(e)]
(d) Subsections [(c)] (b) and [(d)](c) of this section shall apply only to an account or order in which an associated person has a financial interest or with respect to which such person has discretionary authority.

Exemption for transactions in investment company shares and unit investment trusts

[(f)]
(e) The provisions of this Section shall not be applicable to transactions in unit investment trusts and variable contracts or redeemable securities of companies registered under the Investment Company Act of 1940, as amended, or to accounts which are limited to transactions in such securities.

EXPLANATION

Subsequent to the time the proposed amendments were circulated for comment, Section 28 was amended to include certain changes that already are effective and reflected in the language of the section published in the NASD Manual and reproduced above. The proposed amendments would further change Section 28 to eliminate Subsection (a). The Board of Governors believes that the current requirement that an executing member affirmatively determine whether a particular transaction may adversely affect the interests of the employer member is unnecessary. The employer member's interests appear adequately protected by the requirements of existing Subsection (b) that state the employer member be notified by the executing member. The Board believes that the protection given the employer member should be strengthened by amending existing Subsection (b)(2) to require that copies of all confirmations be sent to the employer member, regardless of whether they are requested by the employer member.


1Securities Exchange Act of 1934, Release Nos. 21843 (March 12,1985) and 21838 (March 12, 1985); and NASD Notice to Members 85-27 (April 15, 1985).

2 Sections 1 through 25 of Article III of the NASD Rules of Fair Practice were part of the NASD's original registration statement approved when the SEC granted the NASD's application for registration as a national securities association. In the Matter of National Association of Securities Dealers. Inc.. 5 S.E.C. 627 (1939). Sections 26-28 were adopted shortly after such date..

3The proposed amendments do not cover Sections 29 et seq. of Article III of the Rules of Fair Practice. These provisions are comparatively new sections and, therefore, are more current in their scope and purpose. The proposed amendments also do not cover Articles I, II, IV, V, and VI of the Rules of Fair Practice, which cover matters other than basic ethical standards of conduct, e.g., definitions and procedural matters.

4The Board Interpretations relating to Section 1 and covered by this notice now appear at ¶ 2151.03-2151.06 (pp. 2037-2047-3), NASD Manual (CCH). The Board Interpretation relating to Section 4 now appears at ¶(2154 (pp. 2054-2058), NASD Manual (CCH).

5The one Board Interpretation under Section 1 not covered by the amendments is entitled "Review of Corporate Financing." This interpretation already has been codified into a new section of the Rules of Fair Practice and appoved by a separate membership vote. A filing has been made and is pending approval before the SEC. NASD Notice to Members 83-24 (May 19,1983); SR-NASD-83-27 (December 27, 1983).

6 Current Section 25 now appears at ¶2175 (p. 2101) NASD Manual (CCH).

7These Interpretations and similar material were included in the original amendments circulated for comment in NASD Notice to Members 86-9 (February 7, 1986). Some commenters expressed concern over the statement that the Committee and Board of Governors were considering deleting some of these materials or placing them in an "omnibus notice" to be sent separately to all members.

The commenters believed that these provisions establish important guidelines and standards that members should have readily available. In light of these comments, the Board of Governors and the Committee are continuing to study various ways of dealing with these materials, including a possible new manual of interpretations to be furnished to members, which could contain interpretations issued by both the NASD and the SEC.



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