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92-16 NASD Policies and Procedures for Markups/Markdowns in Equity Securities

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EXECUTIVE SUMMARY

Fairness of markups and markdowns charged by members in principal equity transactions with customers has become an increasingly important issue to members as the NASD, Securities and Exchange Commission (SEC), state, and other federal regulatory and criminal agencies place greater emphasis on these practices in examination and enforcement programs. The NASD and other regulators have initiated a substantial number of disciplinary proceedings during the recent past alleging excessive markups. The Association has also placed great emphasis on member education in the area as well as a variety of other sales- and trading-practice abuses at NASD educational seminars and in Notices to Members.

In order to provide more guidance and assistance to our members, and in response to interest expressed by a significant segment of the membership for a comprehensive NASD release concerning markups and markdowns, the NASD is issuing this detailed Notice, which addresses the significant considerations in determining appropriate markups and mark-downs in connection with retail transactions in equity securities.

Members must take steps to develop compliance procedures designed to guard against abusive markup/markdown practices, and to ensure that critical issues such as prevailing market price, market-maker status, market environment for a security, and validation of quotations, among others, are routinely and consistently considered.

The NASD is committed to ensuring fair pricing with customers and requires strict adherence to all rules and regulations to accomplish this goal. We will continue to carefully review markup and markdown practices in examinations and investigations, and violations will be vigorously pursued. We are hopeful that this Notice, which embodies existing principles governing markups and markdowns, will aid members in their compliance efforts so customer protection is enhanced and fewer disciplinary actions required.

I. Introduction

NASD policies and procedures concerning markups and markdowns have been the subject of extensive interest by the membership. This remains a very significant subject, especially as the NASD as well as other securities regulators continue to review for and investigate potential fraud and other abusive sales and trading practices, which often involve excessive and unfair pricing to customers.

In response to numerous requests from the membership, the NASD is publishing this Notice to Members (Notice) to assist firms in resolving markup and markdown issues associated with principal transactions in equity securities executed with retail customers.1 Specifically, this Notice will address how to determine the prevailing market price of an equity security and the appropriate methodology for calculating a markup or mark-down under differing market conditions.2 The discussion will focus on the process to determine the prevailing market price at the time a member executes a transaction with its customer. This process is articulated in the leading markup case of Alstead Dempsey & Co., Inc., 47 S.E.C. 1034 (1984)3 and reiterated in subsequent SEC and NASD cases, and requires the member to determine: (1) whether it is a market maker or a retail broker/dealer; (2) whether the market for the stock is competitive or instead dominated and controlled; and (3) whether actual transactions or validated quotations may be used as the best evidence of the prevailing market price.

In preparing this Notice, the NASD has not established new rules, interpretations, or policies with respect to markup and markdown issues. Rather, this Notice embodies longstanding policies and principles developed by the NASD, SEC, and the courts. Recognizing that excessive and unfair pricing to customers and other sales-practice abuses continue to be a prime regulatory concern, members are encouraged to consult the full text of decisions, as well as existing interpretations and rules and regulations, which form the basis for these important policies and principles.
II. NASD Regulatory Concerns

For many years, the NASD and other regulatory authorities have been aggressively fighting against excessive markups and markdowns, especially in the "penny stock" market, which is primarily composed of non-Nasdaq over-the-counter (NNOTC) securities. In recent years, the NASD has also placed a great deal more emphasis and focus on sales practices and fair dealing with customers in general, as well as markups and mark-downs, during NASD examinations and investigations. Furthermore, there has been an increase in NASD disciplinary actions, as well as administrative, civil, and criminal proceedings by other regulatory and prosecutorial authorities against securities laws violators for abusive practices in these areas.

For the NASD's part, it is actively enforcing its markup/markdown policy, as well as the case law established in this area through SEC and NASD Board decisions and interpretations. Additionally, the NASD will continue to initiate disciplinary proceedings against firms and associated persons for other types of sales- or trading-practice violations, such as market manipulation, fraud in the offer and sale of securities, and unauthorized trading.
III. General Markup/Markdown Considerations

For more than 50 years, a broker/dealer's obligation to deal fairly with its customers in pricing securities has rested on the important principle that a broker/dealer holds itself out as a securities professional with special knowledge and ability, implicitly representing that it will deal fairly, honestly, and in accordance with industry standards with its public customers. In this regard, a securities dealer may not take advantage of its customer to extract unreasonable profits resulting from a price that bears no reasonable relation to the prevailing price. Article III, Section 4 of the NASD Rules of Fair Practice requires a NASD member, when trading for its own account, to purchase from or sell to a customer at a "fair" price, taking into consideration all relevant factors. Although the percentage of markup or markdown from the prevailing market price is a significant factor in determining the fairness of the dealer's pricing, that percentage must be viewed in light of: (1) the type of security involved; (2) the availability of the security in the market; (3) the price of the security; (4) the amount of money involved in a transaction; (5) disclosure; (6) the pattern of markups or markdowns; and (7) the nature of the member's business.

In an effort to ensure fair pricing, the NASD has, since 1943, deemed it inconsistent with just and equitable principles of trade under its Rules of Fair Practice for a member to enter into any securities transaction with a customer at a price not reasonably related to the current price of the security.4 To provide direction in this area, the Board of Governors adopted its "5% Policy." This policy serves as a guideline, not a rule, and states that markups or markdowns should generally not exceed 5 percent of the prevailing market price for equity securities. Thus, markups or markdowns exceeding 5 percent of the prevailing market price are generally viewed as excessive and a violation of Article III, Sections 1 and 4 of the Rules of Fair Practice unless the member can show the markup/markdown charged to be fair under the unique circumstances of the trade. In this regard, if a member seeks to charge its customers more than a 5 percent markup or markdown, it must be fully prepared to justify its reasons for the higher markup or markdown with adequate documentation.

The 5% Policy also points out that a markup/markdown pattern of 5 percent or even less may be considered unfair or unreasonable and that a determination of the fairness of markups or markdowns must be based on a consideration of the above factors.5 For example, where a broker/dealer is involved, selling to or purchasing from its customers on a principal basis a very liquid and readily available Nasdaq National Market System (Nasdaq/NMS) issue in riskless transactions, a 5 percent markup/markdown may indeed be excessive and unfair. Furthermore, the SEC and the courts have consistently held that undisclosed markups or markdowns in equity securities in excess of 10 percent of the prevailing market price are considered fraudulent under the federal securities laws.6 As a result, markups or markdowns exceeding 10 percent could also violate Article III, Section 18 of the Rules of Fair Practice, the NASD's anti-fraud provision.7
IV. Determination of Prevailing Market Price

This section focuses primarily on the manner in which a market maker determines prevailing market price for markup/markdown purposes. The SEC and NASD recognize that an integrated market maker simultaneously makes a wholesale market in a Nasdaq, or non-Nasdaq security while selling the same security to customers. In this regard, depending on the marketplace in which a security trades (i.e., Nasdaq/NMS, regular Nasdaq, or non-Nasdaq), an integrated market maker that risks its capital by continuously buying and selling a security in an active, competitive market may look to prices it charges other dealers in actual sale transactions, or validated quotations, as the best evidence of prevailing market price from which to calculate markups and markdowns, as opposed to its contemporaneous cost.

On the other hand, given the general illiquid nature of an inactive competitive market, integrated market makers may or may not be able to identify actual interdealer transactions or be able to validate quotations to arrive at prevailing market prices. These circumstances may require the use of cost with respect to markup/markdown computations. Moreover, market makers that dominate and control the market for a particular security must look to cost as the best evidence of prevailing market price. A full discussion follows regarding the proper methodology for determining prevailing market price for a market maker depending on the type of security and trading environment involved.
A. Prevailing Market Price in Active, Competitive Markets

An active, competitive market for a security generally exists where more than one market maker has daily or frequent interdealer trades at competitive prices and no market maker dominates and controls that trading activity by accounting for a large portion of the wholesale/retail volume.8 Nasdaq/NMS and some regular Nasdaq securities being sold by a market maker to retail customers trade in an active competitive market such that, as discussed further below, inside quotations (high bid, low ask) are usually sufficiently valid and reliable as evidence of the prevailing market price for markup and markdown purposes.

The integrity of Nasdaq/NMS quotations is a function of the real-time trade reporting system for these securities. Specifically, Nasdaq tests the validity of Nasdaq/NMS securities' quotations against actual transactions reported on a real-time basis throughout the trading day. Similarly, an active, competitive market in a regular Nasdaq security allows market makers executing frequent interdealer trades to use actual trades to validate the inside quotation displayed on Nasdaq.

The ability to use quotations from which to calculate markups and markdowns in Nasdaq/NMS and regular Nasdaq securities is founded on the ability to validate the quotations in an active, competitive market. Members should always be cognizant, therefore, that any quotations used to arrive at a prevailing market price must be validated and that SEC case law favors executed interdealer trades between market professionals as the best evidence of the prevailing market price at the time of contemporaneous retail transactions. Focusing on prices of executed transactions, rather than quotations, for determining prevailing market price should be particularly emphasized where the security is an NNOTC issue.

Members must also be aware that there is no "bright line" test for domination and control and that the facts and circumstances of each case must be carefully weighed. In this regard, a member should carefully consider its potential for domination and control of a market where it accounts for a sizeable portion of the wholesale/retail volume in a particular security.9 Importantly, the Commission in Alstead determined that the market for a security may be dominated by an integrated dealer "to such a degree that it control[s] wholesale prices" for the security. Factors such as the volume of interdealer activity, whether other dealers are purchasing stock, and whether the "demand" is essentially in-house are readily identifiable and should be critically considered in light of potential domination and control.
1. Nasdaq/NMS Securities

The Nasdaq/NMS market consists of active, liquid securities trading in a highly competitive market with real-time transaction reporting where actual interdealer trades are consistently executed at the inside quotations.10 Computerized surveillance systems at the NASD continuously monitor the validity of each quote by comparing these realtime trade reports to the inside quotations that existed in Nasdaq at the time of the transaction. As a result, members may use as the prevailing market price the lowest (inside) ask quotation for Nasdaq/NMS securities at the time of the sale to the customer unless they are aware of facts and circumstances that suggest otherwise. For example, in the event sales to customers (exclusive of markups) occur at prices that differ from the inside ask, a member should inquire into the basis for the execution price. Similarly, if the market maker executes trades immediately surrounding its retail sales, such as comparable sales to a non-market maker at a price lower than the inside ask, the use of these actual sale prices may be required to arrive at the prevailing market price.
2. Regular Nasdaq Securities

When regular Nasdaq securities trade in an active, competitive market, market makers would be frequently executing transactions in these securities with other dealers at or around the inside market displayed on Nasdaq. Recognizing that actual transactions are the best evidence of prevailing market price, routine monitoring by a market maker of its interdealer trades and comparison of those trades to the inside quotations would provide a mechanism for the market maker to validate regular Nasdaq quotations. This validation process, in turn, may permit the use of inside bid or ask quotations as accurate indicators of a security's prevailing market price for markup and markdown purposes.

As with Nasdaq/NMS securities, where the market maker has sales to other broker/dealers that are in immediate proximity to retail sales, the actual sale prices should be used as the prevailing market price for markup purposes unless there are unusual circumstances supported by documentary evidence that establishes a better measure of prevailing market price. In addition, if a member engages in sales to other market makers at prices that are consistently lower than the inside ask, the quotation may not be indicative of market price, and an internal inquiry into the circumstances of the trades would be warranted.
3. NNOTC Securities

The market maker's interdealer sales of NNOTC securities that occur contemporaneously with its retail sales are the best indication of the prevailing market price for an NNOTC security in an active, competitive market. In the absence of contemporaneous sales to other broker/dealers by a market maker, the lowest ask quotation may be used in limited circumstances as evidence of the prevailing market price if the quotations have been validated by comparing them with the member's actual interdealer transactions. Nevertheless, the Commission has required strong evidence that quotations accurately reflect prevailing market price for markup purposes before permitting such quotes to be used as a basis from which markups or mark-downs are computed.11

In the absence of executed interdealer sales or validated quotes, the market maker's contemporaneous cost is the next best indicator of the prevailing market price. Should any other measure be used under these circumstances, the broker/dealer has the burden of demonstrating that the use of contemporaneous cost is not appropriate for computing markups or mark downs. For example, the NASD Board and the SEC have said that the burden is on broker/dealers, if they wish to base markups on another dealer's ask quotation, to demonstrate "the competitiveness of the market and the reliability of the quotations."12

Importantly, members should not confuse the requirement of validating quotes through a review of actual trades with the so-called "three call rule" under Article III, Sections 113 and 21(b) of the NASD's Rules of Fair Practice. These sections require members to make a notation on the order ticket, before executing a transaction in a NNOTC security, which identifies the names of three dealers (or all dealers if less than three) contacted and the quotations received from each. Notice to Members 88-83 announcing the amendments to Article III, Section 21 states that the amendments do not change the NASD's markup policy and that "compliance with the new amendments will not necessarily assure compliance with the NASD Markup Policy." Thus, members may not automatically mark up or mark down an NNOTC security from quotations received from other dealers either over the telephone, electronically, or by other means, as those quotes are not validated and may be substantially different than the prevailing market price. So, for example, the mere fact that an inside bid/ask calculation appears with respect to a security quoted in the NASD's OTC Bulletin Board® does not serve to validate the quotes or permit automatic execution at these prices. The validation process remains necessary, and the use of quotations is still secondary to reliance on actual interdealer transactions.
B. Prevailing Market Price in Dominated and Controlled Markets

Domination and control occurs when real competition is not present in the marketplace, and the wholesale and retail trading by a single market maker, or by two or more market makers willfully acting together, accounts for a substantial percentage of the volume and transactions during the particular period. In these circumstances, the result is that the market price for the security is arbitrarily established by the market maker(s). It is clearly inappropriate for a market maker to use quotations rather than its cost in actual interdealer transactions as the prevailing market price where that market maker dominates and controls the market for the security. As already discussed, case law has not developed a "bright line" test for domination and control. A member should, therefore, monitor the nature and volume of its activity in a particular security to determine whether it is in a dominant and controlling position that would require the use of cost to arrive at prevailing market price.

A dominant and controlling market maker generally has the ability to set arbitrary and non-competitive price quotations and spreads, and control trading, since other market professionals have no real competitive interest or influence in the security. In the absence of a competitive interdealer market for the security, the dominant and controlling market maker is usually the only market "player" for the security. Therefore, a bona fide best bid and offer quotation among market makers does not usually exist, and the dominant and controlling market maker can quote an artificial price without any practical fear that competitive forces will establish the market price or limit the spread.

Moreover, as the Commission in Alstead said:
By their very nature, quotations only propose a transaction; they do not reflect the actual result of a completed arms-length sale. Thus, as we have frequently pointed out, quotations for obscure securities with limited interdealer trading activity may have little value as evidence of the current market. They often show wide spreads between the bid and ask prices and are likely to be subject to negotiation.
Given the character of a dominated and controlled market and the principles of Alstead, neither quotations nor sales to other dealers would be deemed the best indicators of the prevailing interdealer market. Rather, the actual cost to the dominant and controlling market maker based on prices it paid to other broker/dealers, not quotations or its interdealer sales, is the best indicator of the prevailing market price. However, where a member has only a few contemporaneous purchases from other dealers but many contemporaneous purchases from customers in a dominated and controlled market, it may be far more appropriate to use the retail purchase prices as the prevailing market price in lieu of its wholesale cost. This is especially relevant where the isolated wholesale transactions could be called into question due to size, frequency, price, or other features that suggest that these are not bona fide trades but rather are designed to artificially establish a particular prevailing market price.

Therefore, in the absence of bona fide, ongoing, contemporaneous purchases by a market maker from other broker/dealers, the next best indicator of the prevailing market price in such non-competitive market situations would be the price paid contemporaneously by the firm to customers (as adjusted for an appropriately imputed mark-down based on the 5% Policy.) This latter procedure was affirmed by the SEC in LSCO Securities, Inc., SEC Exchange Act Release No. 28994 (March 21, 1991) and in Manthos, Moss & Co., Inc., 40 S.E.C. 542 (1961).14

For the reasons discussed above, a dominant and controlling market maker is not entitled to any "dealer spread" between the bid and ask quotations. The NASD expressly addressed this issue in a notice distributed to the membership in 1988, stating that: "[i]n instances where no independent market exists, the dominant market maker would not be entitled to the spread, as it would be under competitive market conditions."15 That spread is designed to compensate the market maker in an active, independent market for its risk in maintaining markets and the capital commitment required to do so. A dominating and controlling market maker is entitled only to an appropriate markup above the prevailing market price, which in a dominated and controlled market is the member's cost because there is no independent market for the security.

A dominating and controlling market maker may attempt to present countervailing evidence showing that its cost in transactions with other broker/dealers or customers is not the best indication of the prevailing market. However, in dominated and controlled market situations, the NASD staff will closely review claims of countervailing evidence. As a result, the validity and reliability of such evidence must be demonstrated by the member. Importantly, countervailing evidence of the prevailing market price is not to be confused with the "Relevant Factors" outlined in the Board of Governors' Interpretation on markups that concern the permissible markup/markdown percentage under the circumstances of a particular trade.
C. Prevailing Market Price in Competitive, Inactive Markets

Market makers may be involved in an inactive yet competitive market for a particular security. The facts giving rise to this market condition vary widely. An example would be where there are two or three market makers, none of which dominates and controls trading in the security. There may also be very little activity in the security, with transactions occurring infrequently, sometimes weeks or more apart, and the inside bid and ask quotations remaining constant or nearly constant.

A market maker operating in a competitive, inactive market for a security should look to its contemporaneous sales prices to other broker/dealers as the best evidence of prevailing market price. In the absence of any contemporaneous interdealer sales, the low ask quotation for the security may be used if properly validated. Where quotations cannot be properly validated with actual transactions, the market maker must use its contemporaneous cost (preferably wholesale cost) as the best evidence of the prevailing market price, absent countervailing evidence.

Where the market maker in a competitive, inactive market seeks to purchase that security from its retail customers, the best evidence of the prevailing market price for markdown purposes would be the market maker's actual contemporaneous purchases from other broker/dealers, then the validated high bid quotation, and finally its contemporaneous sales. During any examination or investigation of the market maker's retail pricing practices, the NASD would consider the market maker's documentation of any countervailing evidence.
V. Markups/Markdowns by a Non-Market Maker

Where the subject member is not a market maker in the security (whether Nasdaq/NMS, regular Nasdaq, or NNOTC), the price that the firm pays other broker/dealers (i.e., its cost) contemporaneously with retail sales is the best indicator of the prevailing market price.16 If there are contemporaneous purchases from customers but no or very few wholesale purchases during the period, firms should consider using the prices contemporaneously paid to retail, after adjusting for an appropriate markdown.

Moreover, just because a dealer lists itself in a quotations medium does not necessarily mean that it has achieved market-maker status for purposes of the markup/markdown analysis and 10b-10 confirmation disclosure purposes. In LSCO Securities Inc., SEC Exchange Act Release No. 26779 (May 3, 1989), the SEC found that although LSCO held itself out as a market maker, the firm was not acting as a market maker in the subject security. The factors that the SEC found relevant to the LSCO case in concluding that the firm was not a market maker were that the firm: (1) did not enter quotes in the "Pink Sheets" (the interdealer quotation medium relevant to the case); (2) did not sell the security to other dealers; (3) did not provide quotations on the security to other dealers; and (4) simply acquired the stock for resale to retail customers. Thus, LSCO was not a market maker and thereby could not base its markups on its sales to other dealers.
VI. Validation of Quotes

As noted, the Commission has required strong evidence that quotations accurately reflect prevailing market price.17 In this regard, the circumstances required for the validation of inside ask quotes are as follows:
(1) a competitive market for the security exists;
(2) interdealer sales occur with some frequency, although not necessarily contemporaneously; and
(3) on the days when interdealer sales occur, they are consistently effected at prices at or around the quoted offers.
Addressing the procedure for validation of quotations, the SEC in Alstead stated that:
Where there is an active, independent market for a security, and the reliability of quoted offers can be tested by comparing them with actual inter-dealer transactions during the period in question, such quotations may provide a proper basis for computing markups. Thus, if inter-dealer sales occur with some frequency, and on the days when they occur they are consistently effected at prices at or around the quoted offers, it may properly be inferred that on other days such offers provide an accurate indication of the prevailing market.
Thus, in order to use a quotation in the absence of actual interdealer trades, the reliability of the bid and offer prices generally must be validated over time by comparing them with executed interdealer transactions. Retail transactions may not be used to validate quotations.
VII. Contemporaneous Dealer Transactions

"Contemporaneous transactions" in determining the prevailing market price are defined in SEC cases as transactions being "closely related in time." Thus, "same day" transactions are most preferable, although less contemporaneous wholesale trades occurring up to five business days prior to or subsequent to the retail sales have been considered contemporaneous.18 Clearly, during the "five day window," wholesale trades on the same day as or closest in time prior to the retail transactions are better indicators of prevailing market price than are trades occurring further away in time to the subject retail trades.

In the absence of wholesale purchases (or to the extent wholesale transactions are so de minimis, they may not be indicative of the prevailing market price), purchases by a market maker from customers are looked to as indicative of prevailing market price in dominated and controlled markets. In these instances, competitive forces are not at work with respect to the market maker's activity with its retail client base and, absent convincing countervailing evidence, cost is the best indicator of market price. Similarly, a market maker operating in what appears to be an inactive competitive market may have to look to its purchases from customers as the prevailing market price from which to calculate markups where it has no contemporaneous interdealer activity and quotations cannot be validated.
VIII. Additional Compliance Considerations

The focus of the Board of Governors' Mark-Up Policy is on fair and reasonable prices charged to customers and to prohibit markups and mark-downs that are excessive. In this regard, members must be mindful of unusual situations, in any market environment, involving, for example, the lack of any markup at all, negative markups, or the averaging of various transactions as a means of determining whether markup or markdown percentages are fair.19 The absence of quotations also should cause a member to question the method by which its traders, registered representatives, and others are arriving at execution prices for specified securities.

Furthermore, the facts and circumstances of a particular case may show that traders, registered representatives, or other associated persons share in a member's liability for excessive markups or markdowns or unfair pricing to customers. This liability could result even though the individual is not involved in establishing or setting the pricing and markup policies for the member, or may not possess the same degree of knowledge as the member firm about facts surrounding the retail trades. For example, part of the responsibility of being a trader is to determine the prevailing market price. A trader cannot simply delegate this function.20

Thus, traders may be positioned to recognize that they are engaging in little, or no, interdealer activity in a security, putting them on notice of the potential lack of an independent, competitive market. They may also see that they are simply absorbing stock from the street for resale to retail customers, placing them on notice that their firm could be dominating and controlling the market or that the firm is not actually a market maker. Similarly, registered representatives, particularly those reaping some of the ill-gotten gains derived from unfair pricing to customers, may also be held responsible for excessive markups and unfair pricing to customers. A salesperson may certainly be deemed to share responsibility where he participates in determining the prices the firm charges customers, and also where he knew or should have known that the prices being charged are excessive based on a comparison of the gross commission or markup to the total price charged the customer. Registered representatives do not merely function as salespersons; they are securities professionals operating in a highly regulated environment, and they are required to know and comply with the relevant laws and rules. Registered representatives may not claim ignorance of the NASD's markup policy or case histories to avoid being included in an investigation of a firm's role with respect to particular securities. In short, they cannot solicit transactions for excessive gains with regulatory impunity.

In addition, where a member discovers that large discrepancies exist through a comparison of markups or markdowns calculated on a quotation and the same markup or markdown calculated with an appropriate contemporaneous transaction, the transactional information should generally prevail. Members should also monitor for markup-policy compliance by continually reviewing for: (1) sales to customers executed at apparently unfair or excessively marked-up prices when compared with the firm's determination of prevailing market price; (2) disparate execution prices with customer trades occurring at or about the same time in relatively similar volume; (3) wide spreads; and (4) only limited trading activity with, or between, other broker/dealers. Furthermore, any additional fees charged to customers must be considered when determining the final markup percentage. Many such "miscellaneous" fees must be included in the markup calculation so that the total cost of the trade to the customer is considered. Specifically, the Board Interpretation on markups precludes firms from simply passing expenses on to customers, stating that "[a] member may not justify markups on the basis of expenses which are excessive."21 This Board position takes into account that the markup or markdown includes compensation to the member for its customary costs associated with the transaction that must be fair and reasonable at any price.

The referenced questionable situations identify just some of the potential compliance issues that members should be aware of so that appropriate procedures may be adopted and implemented. Members are reminded of their obligation to have in place adequate, written supervisory procedures designed to address their business activities, including markups and markdowns.

* * * * *

Questions concerning this Notice may be directed to your local NASD district office, or to William R. Schief (Vice President) or Daniel M. Sibears (Director), NASD Compliance Division, 1735 K Street, NW, Washington, DC 20006-1506.


1 See, Notice to Members 91-69, issued in November 1991, which addresses, among other things, the application of the NASD's Mark-Up Policy to the secondary market in direct participation program securities.

2 Although the narrative portion of this memorandum tends to focus on markups, the same principles are to be applied when considering markdowns in purchases from customers by a member.

3 In its House Report on the Penny Stock Reform Act of 1990, Congress cited Alstead as the leading case articulating the principles for calculating markups in equity securities.

4 NASD Manual (CCH) pi54.

5 See, Gerald M. Greenberg, 40 S.E.C. 133 (1960); Thill Securities Corp., 42 S.E.C. 89 (1964).

6 See, Peter J. Kisch, 47 S.E.C. 802 (1982); Staten Securities Corp., 47 S.E.C. 766 (1982); Powell & Associates, Inc., 47 S.E.C. 746 (1982).

7 Article III, Section 18 of the Rules of Fair Practice states:

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. NASD Manual (CCH) ¶ 2168.

8 In Hampton Securities, Inc., NASD, ATL-992 (June 1, 1989), the NASD Board said that a competitive market is characterized by three features: (i) the regular publication of quotations with relatively narrow spreads, (ii) frequent interdealer transactions consistently effected at or near the quoted prices so as to validate the reliability of quotations, and (iii) the absence of domination by a single firm.

9 Members should be aware that factors other than volume may indicate domination and control. For example, in the SEC case of Universal Heritage Investment Corp., SEC Exchange Act Release No. 19308 (Dec. 8, 1982), a market maker was the only firm to submit quotations on 109 of 189 days under review, and on 5 2 of those days it was the exclusive or shared high bid for the security, leading the Commission to conclude that the firm controlled the market for the security to such a degree that it could not use quotes for computing its markups.

10 Considerations for determining the best evidence of the prevailing market price in various situations are summarized in a matrix attached as Appendix A, which contains a separate matrix for arriving at the prevailing market price in both markup and markdown situations.

11 See, Alstead; Gateway Stock and Bond, Inc., 43 S.E.C. 191 (1966); aftatin & Co., Inc., 41 S.E.C. 823 (1964).

12 Hampton; See also, James E. Ryan, SEC Exchange Act Release No. 18617 (April 5, 1982); Powell & Associates, Inc., 47 S.E.C. 746 (1982); First Pittsburgh Securities Corp., 47 S.E.C. 299 (1980); Charles Michael West, 47 S.E.C. 39 (1979).

l3 See, NASD Manual (CCH) ¶ 2151.03.

14 See also, SEC Exchange Act Release No. 29093 (April 17, 1991 at 1189) in which the Commission explicitly accepted the use of contemporaneous purchases from retail customers as indicative of prevailing market price in a dominated and controlled environment that lacks interdealer purchases by the subject firm.

15 NASD Regulatory & Compliance Alert, Volume 2, No. 3 (October 1988).

16 Rule 10b-10 requires broker/dealers, other than market makers, that execute riskless principal trades in equity securities to disclose on the confirmation the amount of any markup, markdown, or similar remuneration received in the transaction. This confirmation disclosure does not alter the broker/dealer's responsibilities under the markup policy or the anti-fraud provision of Article III, Section 18 of the Rules of Fair Practice and the federal securities laws.

17 See Alstead; Gateway Stock and Bond, Inc.; Naftalin & Co.

18 See, LSCO Securities, Inc., ("absent some showing of a change in the prevailing market, a dealer's inter-dealer cost may be used to establish market price for a period up to five business days from the date of the dealer's purchase."); Alstead, (same day or day before sales); First Pittsburgh Securities Corp. (Sales within one business day of the firm's purchases are closely related in time); Under Bilotti & Co., Inc., 42 S.E.C. 807 (1965) (If no same-day purchase occurred, the price at which registrant made the most nearly contemporaneous purchase within three days before or after the sale.) Compare, Nicholas A. Codispoti, SEC Exchange Act Release No. 24946 (Sept. 29, 1987) (Firm purchases of municipal securities within five days of its sales to customers.); Naftalin & Co., Inc., at 829 n. 16 (no purchase on the day of sales but purchases made on the preceding day as well as the succeeding day.)

19 For example: "Transactions occurring over a period of time cannot be lumped together for the purpose of determining whether mark-downs or markups are fair." Markups and markdowns must be reasonably related to the prevailing market price at the time each transaction is executed. Hamilton Bohner, Inc., SEC Exchange Act Release No. 27232 (September 8, 1989).

20 See R.B. Marich, Inc., et. al, NASD, MS-849 (Dec. 23, 1991).

21 See General Investing Corporation, 41 S.E.C. 952 (1964).


APPENDIX A: MARKUPS*

General Guidelines for Determining the Best Evidence of Prevailing Market Price in Order of Priority for a Normal-Size Trade

 

Market Maker

Non-Market Maker

Active Competitive Market

Nasdaq/NMS

A. Comparable sales to other broker/dealers immediately surrounding retail sales.

B. Lowest ask (inside ask) quotation reflected in Nasdaq at time of sale to customer (if validated).

Regular Nasdaq

A. Comparable sales to other broker/dealers immediately surrounding retail sales.

B. Lowest ask (inside ask) quotation reflected in Nasdaq at time of sale to customer if validated by a comparison with interdealer transactions.

NNOTC

A. Contemporaneous sales to other broker/dealers.

B. Lowest ask quotation if validated by a comparison with interdealer transactions.

C. Contemporaneous purchases from other broker/dealers (i.e., cost).

D. Contemporaneous purchases from customers adjusted for appropriate imputed markdowns.

All Securities

A. Contemporaneous purchases from other broker/dealers (i.e., cost).

B. Contemporaneous purchases from customers adjusted for appropriate imputed markdown.

Inactive Competitive Market

All Securities

A. Contemporaneous sales to other broker/dealers.

B. Lowest ask quotation if validated by a comparison with interdealer transactions.

C. Contemporaneous purchases from other broker/dealers (i.e., cost).

D. Contemporaneous purchases from customers adjusted for appropriate imputed markdown.

All Securities

A. Contemporaneous purchases from other broker/dealers (i.e., cost).

B. Contemporaneous purchases from customers adjusted for appropriate imputed markdown.

Dominated and Controlled Market

All Securities

A. Contemporaneous purchases from other broker/dealers (i.e., cost).

B. Contemporaneous purchases from customers adjusted for appropriate imputed markdown.

All Securities

A. Contemporaneous purchases from other broker/dealers (i.e., cost).

B. Contemporaneous purchases from customers adjusted to account for appropriate imputed markdown.

* This matrix is part of Notice to Members 92-16 and cannot be relied on as a separate document. Consult the full text of the Notice when using this guide.

APPENDIX A: MARKDOWNS*

General Guidelines for Determining the Best Evidence of Prevailing Market Price in Order of Priority for a Normal-Size Trade

 

Market Maker

Non-Market Maker

Active Competitive Market

Nasdaq/NMS

A. Comparable purchases from other broker/dealers immediately surrounding retail sales.

B. Highest bid (inside bid) quotation reflected in Nasdaq at time of purchase from customer (if validated).

Regular Nasdaq

A. Comparable purchases from other broker/dealers immediately surrounding retail sales.

B. Highest bid (inside bid) quotation reflected in Nasdaq at time of purchase from customer if validated by a comparison with interdealer transactions.

NNOTC

A. Contemporaneous purchases from other broker/dealers.

B. Highest bid quotation if validated by a comparison with interdealer transactions.

C. Contemporaneous sales to other broker/dealers.

D. Contemporaneous sales to customers adjusted for appropriate imputed markup.

All Securities

A. Contemporaneous sales to other broker/dealers.

B. Contemporaneous sales to customers adjusted for appropriate imputed markup.

Inactive Competitive Market

All Securities

A. Contemporaneous purchases from other broker/dealers.

B. Highest bid quotation if validated by a comparison with interdealer transactions.

C. Contemporaneous sales to other broker/dealers.

D. Contemporaneous sales to customers adjusted for appropriate imputed markup.

All Securities

A. Contemporaneous sales to other broker/dealers.

B. Contemporaneous sales to customers adjusted for appropriate imputed markup.

Dominated and Controlled Market

All Securities

A. Contemporaneous sales to other broker/dealers.

B. Contemporaneous sales to customers adjusted for appropriate imputed markup.

All Securities

A. Contemporaneous sales to other broker/dealers.

B. Contemporaneous sales to customers adjusted for appropriate imputed markup.

* This matrix is part of Notice to Members 92-16 and cannot be relied on as a separate document. Consult the full text of the Notice when using this guide.


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