Executive Summary

On August 9, 1995, the Securities and Exchange Commission (SEC) approved a new Interpretation to Article III, Section 1 of the Rules of Fair Practice that prohibits a member firm from purposefully adjusting an inventory position in a particular security in anticipation of the firm's issuance of a research report in that same security. The amendment took effect on August 9, 1995.¹

Background

Historically, the NASD^® has monitored the trading activity of members that precedes a particular firm's issuance of research reports on a specific security. Firms with research departments frequently prepare research reports that recommend that customers take certain actions for a particular security. In some instances, firms may establish proprietary positions in a security in anticipation of meeting expected customer demand after a research report is issued.

In Notice to Members 94–40, the NASD solicited member comment on developing an interpretation that would clearly states that a member's purposefully establishing an inventory position in anticipation of a research report would violate just and equitable principles of trade. The NASD also sought comment on a policy that would recommend, but not require, that member firms develop and implement information barriers (Chinese Walls) to isolate research and trading activities within individual departments of the firm.

After considering comments, the NASD Board determined to adopt an Interpretation to the Rules of Fair Practice, and it was recently approved by the SEC.

Description

Under the new Trading Ahead of Research Reports Interpretation to Article III, Section 1 of the Rules of Fair Practice, NASD members are prohibited from engaging in trading activity that purposefully affects the firm's inventory position in a security in anticipation of the issuance of a research report in that security. The Interpretation specifically recommends, but does not require, that member firms develop procedures that create information barriers (Chinese Walls) to isolate information on research reports to prevent the trading department from adjusting its inventory position by using advance knowledge of an upcoming research report. If a firm does not choose to establish information barriers to prevent the improper flow of information to the trading desk or some other area, the firm will have a greater burden of showing that any inventory adjustments before the research report was issued were not caused by its knowledge of the report.

The new Interpretation applies to trading in securities listed on The Nasdaq Stock Market^SM, and to third-market trading in exchange-listed securities. Thus, NASD members must adhere to the new policy when trading Nasdaq National Market^® and The Nasdaq SmallCap Market^SM securities, as well as exchange-listed securities traded in the third market. The Interpretation also applies to derivative products, including options, that underlie these securities. The Interpretation does not specifically address securities that are quoted on the OTC Bulletin Board (OTCBB^®). However, when trading OTCBB securities that are the subject of a research report, members should remain cognizant of the general policy that trading based on knowledge of their impending research report could be deemed a violation of just and equitable principles of trade.

The new Interpretation also prohibits a firm from doing indirectly what it may not do directly. Thus, the Interpretation states that a member may not purposefully establish, increase, decrease, or liquidate a position in a derivative security based on a Nasdaq^® or exchange-listed security in anticipation of the firm's issuance of a research report on the security underlying the derivative position. For instance, trading in an option on a Nasdaq or exchange-listed security may be economically equivalent to trading the underlying equity.

The Interpretation defines purposeful trading activity as any trading that is undertaken to establish or adjust a firm's inventory position in a security based on advance knowledge of a research report the firm is about to issue. Adjustment to an inventory position in anticipation of a research report means that a firm has purposefully increased, decreased, liquidated a position, or established a long or a short position. Thus, the Interpretation covers any purposeful adjustment to inventory because the firm is about to issue a research report whether the report is bullish or bearish.

In addition, the Interpretation encourages but does not require firms to establish information barriers (i.e., also known as Chinese Wall procedures or Chinese Walls) to control the flow of information between their research and trading departments. Information barriers are risk management controls to enhance the likelihood 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 information barriers between the research and trading departments of their firms, the Interpretation encourages the use of information barriers as the preferred method of complying with the Interpretation. If a member determines not to implement information barriers, it would carry a significantly greater burden of proving that security accumulations or liquidations before the issuance of a research report had not been purposeful if an NASD investigation into the firm's buying or selling activity were initiated.

Finally, it should be noted that the new policy does not apply to research done solely for internal firm use. Such research, however, cannot be used in any way for external distribution.

Questions regarding this Notice may be directed to Eugene A. Lopez, Office of the General Counsel, The Nasdaq Stock Market, Inc., at (202) 728–6998, or Halley Milligan, NASD Market Surveillance Department, at (301) 590–6464.

¹ See, Securities Exchange Act Rel. No. 36077 (August 9, 1995).

Text Of Amendments To Article III, Section 1 Of The Rules Of Fair Practice

(Note: New text is underlined.)

Trading Ahead of Research Reports Interpretation To Article III, Section 1 of the NASD Rules of Fair Practice

The Board of Governors, under its statutory obligation to protect investors and enhance market quality, is issuing an Interpretation to the Rules of Fair Practice regarding a member firm's trading activities that occur in anticipation of a firm's issuance of a research report regarding a security. The Board of Governors is concerned with activities of member firms that purposefully establish or adjust the firm's inventory position in Nasdaq-listed securities, an exchange-listed security traded in the OTC market, or a derivative security based primarily on a specific Nasdaq or exchange-listed security in anticipation of the issuance of a research report in that same security. For example, a firm's research department may prepare a research report recommending the purchase of a particular Nasdaq-listed security. Prior to the publication and dissemination of the report, however, the trading department of the member firm might purposefully accumulate a position in that security to meet anticipated customer demand for that security. After the firm had established its position, the firm would issue the report, and thereafter fill customer orders from the member firm's inventory positions.

The NASD believes that such activity is conduct which is inconsistent with just and equitable principles of trade, and not in the best interests of investors. Thus, this Interpretation prohibits a member from purposefully establishing, creating or changing the firm's inventory position in a Nasdaq-listed security, an exchange-listed security traded in the third market, or a derivative security related to the underlying equity security, in anticipation of the issuance of a research report regarding such security by the member firm.

Article III. Section 1 of the Rules of Fair Practice states that:

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

In accordance with Article VII. Section l(a)(2) of the NASD By-Laws. the NASD Board of Governors has approved the following Interpretation of Article III, Section 1:

Trading activity purposefully establishing, increasing, decreasing, or liquidating a position in a Nasdaq security, an exchange-listed security traded in the over-the-counter market, or a derivative security based primarily upon a specific Nasdaq or exchange-listed security, in anticipation of the issuance of a research report in that security is inconsistent with just and equitable principles of trade and is a violation of Article III. Section 1 of the Rules of Fair Practice.

For the purposes of this Interpretation, a "purposeful" change in the firm's inventory position means any trading activities undertaken with the intent of altering a firm's position in a security in anticipation of accommodating investor interest once the research report has been published. Hence, the Interpretation does not apply to changes in an inventory position related to unsolicited order flow from a firm's retail or broker/ dealer client base or to research done solely for in-house trading and not in any way used for external publication.

Under this Interpretation, the Board recommends, but does not require-that member firms develop and implement policies and procedures to establish effective internal control systems and procedures that would isolate specific information within research and other relevant departments of the firm so as to prevent the trading department from utilizing the advance knowledge of the issuance of a research report. Firms that choose not to develop "Chinese Wall" procedures bear the burden of demonstrating that the basis for changes in inventory positions in advance of research reports was not purposeful.