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94-40 NASD Solicits Member Comment On Trading Activity In Advance Of Research Reports;

Comment Period Expires June 15, 1994

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Executive Summary

The Board of Governors of the NASD is soliciting member comment on a proposed Interpretation under Article III, Section 1 of the NASD Rules of Fair Practice whereby it would be considered a violation of just and equitable principles of trade for members to purposefully establish, increase, or liquidate a position in a security listed on The Nasdaq Stock Market prior to the members' issuance of a research report on that stock. The Board is also soliciting comment on a policy to recommend that member firms develop and implement "Chinese Wall" restrictions to isolate information within individual departments of the firm.

Background And Description Of Policy

In 1991, a New York Stock Exchange (NYSE) memorandum on stock accumulation in advance of issuing research reports was issued to NYSE member firms. That notice stated that where an NYSE member organization intended to purposefully acquire a position in an NYSE-listed security in contemplation of its issuance of a favorable research report, the exchange would find that conduct inconsistent with just and equitable principles of trade. The NYSE interpretation only applied to NYSE-listed securities, and the NASD did not at that time take a formal position on the practice of stock accumulation in advance of research on Nasdaq-listed issues or on third market trading of exchange-listed issues.

Since that time, the NASD has received inquiries from member firms concerning NASD policy with regard to the practice of accumulating inventory positions in Nasdaq-listed securities in contemplation of the issuance of research reports recommending purchase of those securities. For example, a firm's research department might prepare research reports recommending certain Nasdaq-listed securities to its customer base. Before publication of the research reports, however, the trading department of the member firm might accumulate a position in those securities to meet anticipated customer demand for the stocks. Once the stock accumulation had taken place, the firm would issue the recommendations and commence solicitation of orders for the stocks, expecting to fill customer orders from the member firm's inventory position.

In response to these inquiries requesting guidance on the NASD's position relative to Nasdaq-listed companies, the NASD's Market Surveillance Committee (MSC) and Trading Committee reviewed the recommendation of a task force appointed by the MSC to study and develop proposals to address this issue. Both Committees formulated a proposal that the NASD Board of Governors considered and approved. Accordingly, the Board authorized the issuance of this Notice to solicit comment from members on adoption of a new policy that in concept is consistent with the NYSE position.

The proposed NASD Board policy is as follows (the Interpretation follows this Notice):

Trading activity purposefully establishing, increasing or liquidating a position in a Nasdaq security prior to the issuance of a research report in that security is inconsistent with just and equitable principles of trade in violation of Article III, Section 1 of the Rules of Fair Practice.

In addition, the Board recommended that firms be encouraged to establish Chinese Wall procedures to control the flow of information between their research and trading departments. Chinese Wall procedures are risk management controls adopted by securities firms that include physical and informational barriers between different departments of firms so that knowledge of upcoming events will be isolated within a single group and not disclosed to other groups that might trade on or otherwise benefit from the information. Because many firms today already use Chinese Wall restrictions between the research and trading departments of their firms, the Board approved a policy to encourage use of Chinese Walls as the preferred method of complying with the Board's new policy.

While the Board's action would not require a member to develop Chinese Wall procedures, the Board noted that Chinese Wall restrictions are the most effective means for a member firm to demonstrate that any trading activity before its issuance of a research report had not been in violation of the policy. Accordingly, if a member decides not to implement Chinese Wall restrictions, it would carry the significantly greater burden of proving that stock accumulations or liquidations had not been purposeful if an NASD investigation into the firm's buying or selling activity were initiated. This approach would make Chinese Walls the recommended and preferred choice, but would allow members to analyze their own environments and choose whether Chinese Wall procedures were appropriate for their firm. The Board believed that although a Chinese Wall would be the preferable method for firms to comply with the standard, they did not believe it appropriate to adopt a mandatory requirement for such procedures.

The Board is soliciting comment from member firms on adoption of the new policy. The Board anticipates that the policy would be an Interpretation of Article IE, Section 1 of the Rules of Fair Practice governing just and equitable principles of trade. The Board is also requesting comment on these collateral issues: (1) whether the policy should also apply to third market trading of exchange-listed securities (i.e., apply the policy to non-NYSE member firms trading exchange-listed securities); and (2) whether the policy should apply to non-Nasdaq securities (i.e., issues quoted on the OTC Bulletin Board or in the pink sheets).

Comments should be sent to Joan C. Conley, Secretary, NASD, 1935 K Street, NW, Washington, DC 20006, and should be postmarked no later than June 15, 1994. Questions regarding this Notice may be directed to the Market Surveillance Department at (301) 590-6410.

Interpretation Of The Board Of Governors On Member Firm Trading Activity In Securities Prior To Issuance Of Research Reports

(Note: New language is underlined.)

The Board of Governors of the NASD is concerned with activities of member firms that purposefully establish or change inventory positions in Nasdaq-listed securities in contemplation of the issuance of research reports recommending purchase or sale of those securities. For example, a firm's research department might prepare research reports recommending certain Nasdaq-listed securities. Prior to publication and dissemination of the research reports, however, the trading department of the member firm might accumulate a position in those securities in order to meet anticipated customer demand for the stocks. Once the stock accumulation had taken place, the firm would issue the recommendations, expecting to fill customer orders from the member firm's inventory position.

Because such trading practices disadvantage the contra parties to the transactions who are unaware of the pending research report, the NASD is issuing this Interpretation and adopting a policy position that would find purposeful trading activity in advance of research reports a violation of just and equitable principles of trade:

Trading activity purposefully establishing, increasing or liquidating a position in a Nasdaq security prior to the issuance of a research report in that security is inconsistent with just and equitable principles of trade in violation of Article III, Section 1 of the Rules of Fair Practice.

For purposes of this Interpretation, the phrase "purposefully establishing, increasing or liquidating a position" means any trading activity undertaken with the intent of materially altering a firm's position in a security for the purpose of either profiting from or accommodating trading interest subsequent to the publication of the research report.

Hence the policy would not apply to stock accumulations or liquidations from unsolicited order flow from a firm's retail or broker/dealer client base or to research done solely for in-house trading and not intended for external publication.

In addition, the Board is recommending that firms establish effective Chinese Wall policies and procedures to control the flow of information between their research and trading departments. Chinese Wall procedures are risk management controls adopted by securities firms that include physical and informational barriers between different departments of firms so that knowledge of upcoming transactions will be isolated within a single group and not disclosed to other groups that might trade on or otherwise benefit from the information.

Where the firm has implemented one or a combination of Chinese Wall policies and procedures which are, taking into consideration the nature of the firm's business, reasonably designed to ensure that the individuals responsible for making trading decisions for the firm do not have access to information regarding the intention to release or timing of release of any firm research report and those procedures operated effectively with respect to the research report in question, then neither the firm nor its associated persons will be deemed to have violated misinterpretation.

While the NASD does not require members to develop Chinese Wall procedures, these restrictions are the most effective means for a member firm to safeguard against the inappropriate flow of sensitive information between research and trading departments and in demonstrating that trading activity had not been purposeful. Accordingly, if the member decides not to implement Chinese Wall restrictions, it bears the significantly greater burden of proving that stock accumulations or liquidations have not been purposeful.


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