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93-11 SEC Grants OTC Bulletin Board® Interim Designation As a "Qualifying Electronic Quotation System"

SUGGESTED ROUTING

Legal & Compliance
Operations
Trading

Executive Summary

On December 30, 1992, the Securities and Exchange Commission (SEC) granted the NASD's request for interim designation of the OTC Bulletin Board® service (OTCBB) as a "Qualifying Electronic Quotation System" (QEQ System) for purposes of certain SEC Penny Stock Disclosure Rules that became effective on January 1, 1993. This designation will facilitate broker/dealer compliance with the new penny stock disclosure rules. Specifically, the QEQ System designation now permits broker/dealers to use inside quotations displayed in the OTCBB to: determine from the inside bid whether the stock is priced under $5 and is therefore a "penny stock" as defined by Rule 3a51-1 of the Securities Exchange Act of 1934 (Exchange Act); provide the bid/ask quotation disclosures to customers required by Exchange Act Rule 15g-3; and determine the market value of the penny stocks for customers' monthly or quarterly account statements as required by Exchange Act Rule 15g-6.

SEC Penny Stock Disclosure Rules Summary

The SEC Penny Stock Disclosure Rules were adopted in April 1992 pursuant to the requirements of the Securities Enforcement Remedies and Penny Stock Reform Act of 1990 (Penny Stock Reform Act). The Penny Stock Reform Act was enacted to require more stringent regulation of broker/dealers that recommend penny stock transactions to customers, and to promote the establishment of a structured electronic marketplace for dealers to quote such securities. The rules require a broker/dealer that has recommended a transaction to a customer in a "penny stock" as defined by the Rules to provide that customer with certain specified information. In general, a penny stock is defined as a non-Nasdaq® and non-exchange-listed equity security, currently priced under $5 per share, that is issued by a company with less than a specified amount of net tangible assets, continuous operations, or annual revenues.

Unless the transaction is exempt under the Rules, broker/dealers effecting customer transactions in such defined penny stocks are required to provide their customers with: a risk disclosure document; disclosure of the current inside bid and ask quotations, if any; disclosure of compensation to the broker/dealer and its salesperson in the transaction; and monthly or quarterly account statements showing the market value of each penny stock held in the customer's account. Several categories of penny stock transactions are exempt under Exchange Act Rule 15g-1, including transactions where the customer is an "institutional accredited investor" or customer transactions not recommended by the broker or dealer. The Rule 15g-2 requirement for the delivery of the risk disclosure document to penny stock customers became effective July 15, 1992. The other disclosure requirements became effective on January 1, 1993. (See Notice to Members 92-38 July 1992.)

OTCBB Inside Quotations Use

Presently, the OTCBB calculates and displays an inside bid and ask for all securities with at least two registered market makers displaying firm, two-sided quotations.

Interim designation of the OTCBB as a QEQ System for purposes of the Penny Stock Disclosure Rules permits member firms to use inside bid quotations for stocks displayed on the OTCBB to determine whether they should be classified as a penny stock. Essentially, Rule 3a51-1 defines a penny stock as any non-Nasdaq and non-exchange-listed security currently priced at less than $5 per share and issued by a company not having certain prescribed net tangible assets, continuous operations, or annual revenues. The inside bid quotation on the OTCBB for the security is one method to determine that price.

This interim designation as a QEQ System will facilitate compliance with the bid and ask quotation disclosure requirement (Rule 15g-3) and the monthly/quarterly account statement requirement (Rule 15g-6) also will be significantly facilitated. Broker/dealers may use the inside bid and offer quotation displayed on the OTCBB for a penny stock to make disclosures required by these rules.

Specifically, SEC Rule 15g-3 requires broker/dealers — before executing a penny stock transaction with a customer — to disclose to that customer the current inside bid and offer quotations or similar market information regarding the penny stock. This disclosure also must be provided at the time of the trade.

Members are cautioned, however, that disclosure of the OTCBB inside bid and ask quotation for a penny stock does not permit such quotations to be used as the best evidence of the prevailing market for markup or markdown purposes without proper validation of the quotes. (For more details about validation of quotations, see Notice to Members 92-16 April 1, 1992.)

SEC Rule 15g-6 requires broker/dealers that have sold penny stocks to customers in transactions not exempt under Rule 15g-1 to send those customers (within 10 days after the end of the month or quarter) monthly or quarterly account statements. The statements must include the penny stock issuer's name, the number of shares, and the estimated market value as of the end of the month or quarter covered. That estimated market value should be, if available, the "highest inside bid quotation" for the penny stock on the last trading day of the period to which the statement relates, multiplied by the number of shares or units of the security in the customer's account.

Designation of the OTCBB as a QEQ System facilitates members' compliance efforts with the new Penny Stock Disclosure Rules by permitting the use of OTCBB displayed inside bid/ask quotation. This benefit is only available for penny stocks quoted in the OTCBB since it is the only SEC-designated QEQ System to date. For penny stocks not quoted on the OTCBB or where lack of market-maker quotations precludes the calculation of an inside market, member firms must undertake more burdensome procedures to make the price determinations necessary to satisfy the disclosure requirements contained in the Penny Stock Disclosure Rules.

Expected 17B Status for OTCBB

The Penny Stock Reform Act also requires the permanent establishment of a structured electronic marketplace for dealers to quote penny stocks. The NASD® views the QEQ System status for the OTCBB as an intermediate step in permanently achieving SEC recognition of the OTCBB as an automated quotation system under Exchange Act Section 17B. Section 17B directs the SEC to facilitate and oversee the creation of one or more automated quotation systems for penny stocks with the following minimum characteristics: capacity to capture and display firm bids/offers entered by participating broker/dealers for individual securities; capacity to capture and display last-sale price and volume information for individual transactions reported by participating broker/dealers; ability to effect broad dissemination of participants' quotations and last-sale prices to broker/dealers and their customers; and sponsorship and regulation of the system by a national securities association or securities exchange. It should be emphasized that enactment of Section 17B reflects the Congress' intent to deter the fraudulent/manipulative trading practices chronicled in the Penny Stock Reform Act's legislative history. Often, those practices were facilitated by a lack of market transparency and reliable quotation and transaction price information for penny stocks. Hence, Congress mandated creation of an automated quotation system (or systems) to enhance the operation and regulation of dealer markets in penny stocks.

Presently, the OTCBB satisfies all requirements for Section 17B designation with the exception of collecting and disseminating trade reports on a real-time basis. However, the NASD has submitted a proposed rule change (File No. SR-NASD-92-48) to the SEC that would establish requirements for real-time reporting of members' transactions in penny stocks and other equity securities that may be quoted in the OTCBB or other inter-dealer quotation systems. At the same time, the NASD is developing the necessary system enhancements, which are expected to be implemented by mid-August. The OTCBB will then be eligible for permanent status as both a Section 17B system as well as a qualifying system for purposes of the applicable penny stock regulations. Meanwhile, member firms are encouraged to maximize their use of the OTCBB for quoting markets in penny stocks (as defined by Exchange Act Rule 3a51-1) to take advantage of the benefits of the OTCBB's interim designation as a QEQ System.

Questions concerning this Notice may be directed to Michael J. Kulczak of the NASD's Office of General Counsel at (202) 728-8811.

Compliance questions concerning the various penny stock regulations should be directed to Gary A. Carleton, Daniel M. Sibears, or William R. Schief of the NASD's Regulation staff at (202) 728-8959.


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