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93-55 SEC Amends and Clarifies Penny Stock Rules

SUGGESTED ROUTING

Senior Management
Legal & Compliance
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Trading

Executive Summary

The Securities and Exchange Commission (SEC) has adopted amendments to certain rules under the Securities Exchange Act of 1934 (Act) that apply to transactions in low-priced securities traded in the over-the-counter market. Specifically, the SEC amended Rule 15c2-6, which makes it unlawful for a broker/dealer to sell or effect the purchase of a "designated security" with a customer in a nonexempt transaction, unless the broker/dealer has specifically approved the customer's account for transactions in designated securities and has received the customer's written agreement to the transaction. The amendments conform the definition of "designated security" in Rule 15c2-6 to the definition of "penny stock" in Rule 3a51-1. With certain exceptions, the exemptions under Rule 15g-1 replace the transactional exemptions under Rule 15c2-6. The amendments redesignate Rule 15c2-6 as Rule 15g-9. The SEC also amended Rule 15g-2 and Schedule 15G under the Act to require a broker/dealer to obtain, before effecting any transaction in a penny stock, a written acknowledgment from the customer that the customer has received the Risk Disclosure Document required by Rule 15g-2. Finally, the SEC clarified Rule 15g-3, which mandates the disclosure to customers of current quotation prices or similar market information in penny stock transactions.

Background

On January 1, 1990, Rule 15c2-6 became effective under the Act. The rule restricts high-pressure sales tactics by broker/dealers involving certain speculative, low-priced securities traded over the counter. In particular, Rule 15c2-6 prohibits a broker/dealer from selling to or effecting the purchase of a designated security by any person, unless the broker/dealer has approved the purchaser's account for transactions in designated securities and has received the purchaser's written agreement to the transaction. In approving an account for transactions in designated securities, a broker/dealer must obtain sufficient information from the customer to make an appropriate suitability determination, provide the customer with a written statement setting forth the basis of the determination, and obtain a signed copy of a suitability statement from the customer. (See Notice to Members 89-65, October 1989 and Notice to Members 90-18, March 19, 1990).

Following adoption of Rule 15c2-6, Congress passed the Penny Stock Reform Act (Reform Act). The Reform Act directed the SEC to adopt rules designed to address sales-practice abuses and manipulation involving speculative, low-priced over-the-counter securities by requiring broker/dealers to provide investors with material market and other information before effecting a transaction in a penny stock. In response, the SEC adopted Rule 3a51-1 and Rules 15g-1 through 15g-6 (Disclosure Rules). Rule 3a51-1 defines the term "penny stock"; Rule 15g-1 exempts certain transactions from the disclosure rules; and Rules 15g-2 through 15g6 generally require broker/dealers effecting transactions in penny stocks to provide their customers with a Risk Disclosure Document that describes the risks of investing in penny stocks, information regarding market quotations, information on the compensation of the broker/dealer and salesperson involved in the penny stock transaction, and monthly statements disclosing the market value of penny stocks held in the customer's account. (See Notice to Members 92-38, July 1992).

Rule 15c2-6 Amendments

The amendments to Rule 15c2-6 conform the rule to the scope of the disclosure rules by: (1) replacing the designated security definition of Rule 15c2-6 with the Rule 3a51-1 definition of penny stock; (2) substituting with two significant exceptions the list of exempt transactions in Rule 15g-1 for the exempt transactions in Rule 15c2-6(c); and (3) redesignating Rule 15c2-6 as Rule 15g-9. Making the scope of Rule 15c2-6 consistent with the disclosure rules will simplify compliance with all of the rules directly relating to penny stocks. The amendments to Rule 15c2-6 took effect on August 11, 1993.

Penny Stock Definition

Although the definition of penny stock is substantially the same as the definition of designated security, amended Rule 15c2-6 does cover a slightly different universe of securities transactions. For example, the definition of penny stock in Rule 3a51-1 contains an exclusion for securities whose issuer has demonstrated net tangible assets of $2 million or more, but adds a requirement that the issuer be in operation for at least three years. Issuers that have been in operation for less than three years must have at least $5 million in net tangible assets to be excluded from the definition of penny stock. In addition to the exclusion based on issuer net tangible assets, Rule 3a51-1, unlike Rule 15c2-6, includes an alternative exclusion for the securities of an issuer with average revenues of $6 million for the past three years (i.e., revenues of at least $18 million by the end of the three-year period).

Like the definition of designated security, the definition of penny stock excludes any security authorized, or approved for authorization on notice of issuance, for quotation in The Nasdaq Stock MarketSM. It also provides an exclusion for any security registered, or approved for registration on notice of issuance, on a national securities exchange provided the current price and volume information for transactions in that security is reported and made available to vendors under the rules of the national securities exchange. This exclusion is available for regional exchange-listed securities only if the securities actually are purchased or sold through the facilities of the regional exchange or in a distribution.

Rule 15c2-6 still does not cover securities priced at $5 or more, but when calculating the price of a security, broker/dealers now have to exclude the amount of any commission, commission equivalent, markup, or markdown charged in the respective agency or principal transaction. Finally, securities that a registered investment company issues and put and call options that the Options Clearing Corporation issues remain excluded from the rule.

Exempt Transactions

With two significant exceptions relating to established customers and private offerings, the exemptions under Rule 15g-1 replace the exempt transactions of Rule 15c2-6. Specifically, although Rule 15g-1 does not exempt transactions with defined "established customers" of the broker/dealer, the SEC has retained this exemption solely for purposes of Rule 15c2-6. Also, Rule 15g-1 exempts all private offering transactions that meet the requirements of Regulation D under the Securities Act of 1933 (Securities Act), as well as transactions with an issuer not involving any public offering pursuant to section 4(2) of the Securities Act. Amended Rule 15c2-6(c)(2) does not, however, exempt transactions that meet the requirements of Rule 504. In the SEC's view, the recent expansion of the Rule 504 exemption and the removal of all of the restrictions on transferability and general solicitation require that the protections provided investors by Rule 15c2-6 should continue to apply to customers purchasing securities in a Rule 504 offering.

Because the Rule 15g-1 exemptions have replaced the exempt transactions of Rule 15c2-6, Rule 15c2-6 no longer exempts transactions with all accredited investors. The amended rule now includes the Rule 15g-1 exemption for transactions with institutional accredited investors (defined in Rule 501) as well as transactions with the penny stock issuer and any director, officer, general partner, or beneficial owner of more than 5 percent of any class of equity security of the issuer. In addition, the rule provides the frequently referred to "de minimis exemption" for transactions by non-market makers receiving less than 5 percent of their total sales-related revenue from transactions in low-priced over-the-counter securities. Transactions not recommended by the broker/dealer remain exempt under Rule 15c2-6.

De Minimis Broker/Dealer Revenue Exemption

Broker/dealers relying on the de minimis exemption will be permitted to calculate their 5 percent revenue based on transactions in designated securities as originally defined in Rule 15c2-6, rather than penny stocks as defined in Rule 3a51-1, for a period of six months following publication of the SEC's adopting release in the Federal Register at 58 FR 37413.

Penny Stock Rule Amendments

Rule 15g-2 — Risk Disclosure Document

Rule 15g-2 makes it unlawful for a broker/dealer to effect a transaction in a penny stock with or for a customer account unless the broker/dealer distributes a Risk Disclosure Document to the customer before effecting the customer's first transaction in a penny stock. The Risk Disclosure Document, which is set forth in Schedule 15G to the disclosure rules, defines the term penny stock, identifies certain risks associated with investing in penny stocks, describes the penny stock market, provides a brief description of a broker/dealer's obligations under the disclosure rules, and informs customers of their rights and remedies under federal and state law, among other things. (See Notice to Members 92-42, August 1992).

To better enable broker/dealers to demonstrate, and regulators to examine for, compliance with the Rule 15g-2, the SEC adopted amendments that require a broker/dealer to obtain a signed and dated acknowledgment from its customer demonstrating that the customer has actually received the required Risk Disclosure Document before the customer's first transaction in a penny stock. Corresponding amendments to Schedule 15G, which take effect November 1, 1993, include a description of this new requirement. In this regard, the amended Rule 15g-2 requires that broker/dealers maintain a copy of the customer's written acknowledgment for at least three years (with the first two years in a readily accessible place) following the date on which the broker/dealer provided the Risk Disclosure Document to the customer.

Rule 15g-2 does not specify precisely how to obtain the customer's signature. A broker/dealer, for example, could provide the customer with two copies of the Risk Disclosure Document, one of which the customer could sign, date, and return to the broker/dealer. Alternatively, the broker/dealer could send the customer one Risk Disclosure Document with an attached receipt that the customer could sign, date, and return to the broker/dealer. For convenience, either the Risk Disclosure Document to be signed or the receipt could accompany the Rule 15c2-6 suitability statement and written agreement that also requires the customer's signature.

The amendments to Rule 15g-2 apply only to customers that have not received and were not required to have received the Risk Disclosure Document as of August 11, 1993. Accordingly, broker/dealers need not obtain a signature from customers that received the Risk Disclosure Document in the past year. However, broker/dealers will have to get signatures for customers entering into a penny stock transaction after August 11, 1993 (the effective date of this amendment), if they have not yet received the document from the broker/dealer effecting the transaction.

Rule 15g-3 — Clarification of Disclosure Requirements

By way of background, under Rule 15g-3 a broker/dealer may not effect a non-exempt transaction in a penny stock without first disclosing, and subsequently confirming in writing to the customer, current quotation prices or specified market information for the penny stock that is the subject of the transaction. For transactions effected on a non-risk-less principal basis, Rule 15g-3 requires the broker/dealer to provide the calculated inside bid and offer quotations for a penny stock as those inside quotations appear in a Qualifying Electronic Quotation System (QEQS). The Reform Act precisely defines a QEQS and the NASD's Over-the-Counter Bulletin Board® (OTCBB) service has been granted interim designation as the only QEQS. As a result, OTCBB calculated inside quotes are qualified for use in complying with Rule 15g-3 disclosure requirements.

If QEQS inside quotation information is unavailable, the broker/dealer must then look to its own bid and offer quotes in the penny stock for disclosure to the customer. However, a broker/dealer cannot use its own quotations to satisfy Rule 15g-3 disclosure requirements unless: (1) the broker/dealer has effected at least three bona fide inter-dealer transactions consistently at its bid or offer prices over the previous five business days, (2) no less than 75 percent of these transactions have occurred consistently at such quotes, and (3) the broker/dealer reasonably believes that such quotes accurately reflect the prices at which it is prepared to trade with other dealers.1

If the security does not have a QEQS inside quotation and the dealer cannot meet the referenced inter-dealer transactions standard, Rule 15g-3 specifies that the dealer must state to the customer that it has not traded consistently at its quotes and it must disclose the price at which it last purchased the penny stock from, or sold the penny stock to, another dealer in a bona fide transaction.

Confusion has apparently surfaced in those situations where there is no QEQS inside quotation calculated and the inter-dealer activity effected represents only one side of the broker/dealer's quotations. Under these circumstances, the broker/dealer must disclose its own quote (bid or ask) which is properly supported by appropriate inter-dealer executions. For the side of the market not meeting the referenced inter-dealer transactions standard, the broker/dealer must state that it has not consistently effected inter-dealer purchases or sales of the penny stock at its quoted price, and disclose to the customer the price at which it last purchased the penny stock from, or sold the penny stock to, another dealer in a bona fide transaction.

Attached to this Notice is a copy of the amended rules, as well as the additional language to Schedule 15G. For further information regarding amended Rule 15c2-6, the disclosure rules, or this Notice, contact Daniel M. Sibears, NASD, Regulation Division, at (202) 728-8221 or (202) 728-8412.


1 Simply because inside quotations appear in the NASD's OTCBB or the dealer executes a sufficient number of inter-dealer transactions at its quoted price to permit Rule 15g-3 disclosure does not allow for automatic execution at these prices. The validation process for determining the prevailing market price for markup/mark-down purposes remains necessary (See Notice to Members 92-16, April 1, 1992).


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