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95-21 Request For Comments On Proposed Suitability Obligations To Institutional Customers Interpretation;

Comment Period Expires: May 17, 1995

SUGGESTED ROUTING

Senior Management
Debt Department
Equity Department
Government Securities
Institutional
Legal & Compliance
Trading

Executive Summary

The NASD requests member comment on a proposed Interpretation of the NASD Board of Governors to Article III, Section 2 of the NASD Rules of Fair Practice (RFP). The Interpretation would provide guidance to members to fulfill their suitability obligations under Article III, Section 2(a) of the RFP when making recommendations to institutional customers in all equity and debt transactions, except municipals.

Background

On August 15, 1994, the NASD published Notice to Members 94-62 to request member comment on the Fixed Income Committee's (the Committee) proposal that the NASD adopt a Board Interpretation regarding the suitability obligations of members to institutional investors in all equity and debt transactions, except municipals (the Suitability Proposal).1 The Suitability Proposal provided that a member's obligation to an institutional customer would be fulfilled if, at the time of the specific transaction, the member has reasonable grounds for determining that the customer:

  • has developed resources and procedures to make its own investment decisions;

  • is not relying on the member's recommendation on the specific transaction; and

  • is capable of understanding the product and its risks or of making an independent investment decision.

Several examples were in the Suitability Proposal to provide guidance to members regarding these determinations.

Fifteen comment letters were received from 14 commenters on the Suitability Proposal. Of the 14 commenters, one commenter supported the Suitability Proposal without significant change, 11 commenters supported the Suitability Proposal with recommended modifications, and one commenter was opposed to the Suitability Proposal. The Committee substantially redrafted the Suitability Proposal to clarify the Committee's original intent and to respond to the principle written and oral comments received by the NASD regarding Notice to Members 94-62. At its March 17, 1995, meeting, the Board of Governors approved the issuance of a Notice to Members to request additional member comment on the Committee's amended version of the Suitability Proposal.

Summary Of Amended Suitability Proposal

The amended version of the Suitability Proposal clarifies that it merely provides guidelines to determine whether a member has fulfilled its suitability obligations to institutional customers with respect to transactions in all equity or debt securities, except municipals. The Suitability Proposal, therefore, is not intended to create a safe harbor. The many examples that appeared to provide mechanical methods for determining the member's suitability obligation were eliminated. The amended text also provides that the manner in which a member fulfills its suitability obligations in making a recommendation to a customer will vary depending on the nature of the customer and the specific transaction.

The amended Suitability Proposal states that the Board has identified certain factors that will be considered when the NASD conducts its reviews for compliance with Article III, Section 2(a) of the RFP. These factors are neither requirements nor the only factors considered, but merely provide guidance to the member.

The amended Suitability Proposal first states that a member must determine, based on the information available to it, the customer's capability to evaluate investment risk. In discussing this obligation, the amended Suitability Proposal contrasts situations where a member concludes the customer is not capable, in general or with respect to the particular type of instrument, of making an independent investment decision with situations where the customer ultimately can make an independent investment decision without reliance on the member.

The amended Suitability Proposal also states that the primary consideration in a suitability determination is whether the customer is relying on the member's recommendation rather than the customer making an investment decision based on its own independent assessment of the opportunities and risks presented by a potential investment, market factors, and other investment considerations. This guidance encourages the member to consider the member/ customer relationship and to consider the customer's ability to make his or her own investment decisions, including the resources available to the customer to make informed decisions.

The amended Suitability Proposal provides four non-inclusive factors to help members examine the nature of the member/institutional customer relationship.

  • The first factor suggests that the member consider whether there exists any written or oral agreement between the member and the customer regarding the customer's reliance on the member for recommendations.

  • The second factor suggests that the member consider the presence or absence of a pattern of acceptance of the member's recommendations by the institutional customer.

  • The third factor suggests that the member consider the use by the customer of ideas, suggestions, market views, and information obtained from other members or market professionals, particularly those related to the same type of securities.

  • The fourth factor suggests that the member consider the extent to which the customer provides the member with current comprehensive portfolio information in connection with discussing recommended transactions or does not provide important information about its portfolio or investment objectives.

The amended Suitability Proposal also provides four non-inclusive factors to help the member consider the customer's capability to make independent investment decisions, including the resources available to the customer to make informed decisions.

  • The first factor suggests that the member consider whether the customer has the use of one or more investment advisers or bank trust departments.

  • The second factor suggests that the member consider the general level of experience of the staff of the institutional customer in financial markets and specific experience with the type of securities under consideration.

  • The third and fourth factors suggest that the member consider the customer's ability to independently evaluate how market developments would affect the security and the complexity of the security or securities involved.

One public commenter recommended that the institutional customer definition should not be drawn from the institutional account definition of $50 million in assets under Article III, Section 21(c)(4) of the RFP. The Committee agreed with the commenter's concern that the proposed asset test could inadvertently apply to certain small municipalities with significant assets but a nominal investment portfolio. The above Article III, Section 21(c)(4) definition of institutional account was eliminated.

As an alternative, the Committee considered the qualified institutional buyer definition in Rule 144A(a)(1) of the Securities Act of 1933, which focuses on the aggregate amount of securities the investor has in its portfolio and under management. Upon review, the Committee believes that the Suitability Proposal should not include a classification of customer sophistication based on mere portfolio size and that such a portfolio-size definition was not intended under the Government Securities Amendments of 1993. The amended Suitability Proposal, therefore, provides that while it is potentially applicable to all institutional customers other than natural persons, the guidance contained therein should be applied, at a minimum, to an institutional customer with at least $10 million invested in securities in the aggregate in its portfolio and under management.

The Board of Governors asks all members and interested persons to comment on these proposed amendments. Comments should be directed to:

Ms. Joan C. Conley
Corporate Secretary
National Association of
Securities Dealers, Inc.
1735 K Street, NW
Washington, DC 20006-1500

Questions concerning this Notice may be directed to Walter J. Robertson, NASD Compliance, at (202) 728-8236; or John H. Pilcher, NASD Office of General Counsel, at (202) 728-8287.

Comments must be received by May 17, 1995. Changes to the NASD RFP must be approved by the Board of Governors and filed with and approved by the SEC before becoming effective.


1 Notice to Members 94-62 also contained a proposed Interpretation of the application of the Mark-Up Policy to transactions in government and other debt securities. Revisions to this Mark-Up Policy proposal are under review by the Fixed Income Committee.


Text Of Proposed Amendment To Article III, Section 2 Of The Rules Of Fair Practice

(Note: New text is underlined.)

Interpretation Of The Board Of Governors—Suitability Obligations To Institutional Customers

As a result of broadened authority provided by amendments to the Government Securities Act adopted in 1993, the Association is extending its sales practice rules to the government securities market, a market with a particularly broad institutional component. Accordingly, the Board believes it is appropriate to provide further guidance to members on their suitability obligations when making recommendations to institutional customers. The Board believes this Interpretation is applicable not only to government securities but to all debt securities, excluding municipals.1 Furthermore, because of the nature and characteristics of the institutional customer/member relationship, the Board is intending this Interpretation to apply equally to the equity securities markets as well.

Article III, Section 2(a) requires that,

In recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.

The manner in which a member fulfills its suitability obligation in making a recommendation to a customer will vary depending on the nature of the customer and the specific transaction. While it is difficult to define in advance a member's suitability obligation with respect to a specific institutional customer transaction recommended by a member, the Board has identified certain factors which are considered when the NASD conducts its reviews for compliance with Article III, Section 2(a) of the Rules of Fair Practice. These factors are not intended to be requirements or the only factors to be considered but are offered merely as guidance in determining a member's suitability obligation.

In determining its suitability obligation, a member must determine, based on the information available to it, the customer's capability to evaluate investment risk. In some cases, the member may conclude that the customer is not capable of making independent investment decisions in general. In other cases, the staff employed by the institutional customer may have general capability, but may not be able to understand a particular type of instrument or its risks, and therefore may be relying on the member's opinion to a degree sufficient to trigger application of the suitability rule. This is more likely to arise with relatively new types of instruments, or those with significantly different risk or volatility characteristics than other investments generally made by the institution. On the other hand, the fact that a customer initially needed help understanding a potential investment need not necessarily imply that the customer did not ultimately develop an understanding and make an independent investment decision without reliance on the member.

The primary consideration in determining a member's suitability obligation is whether the customer is relying on the member's judgement as reflected in a recommendation rather than making an investment decision based on its own independent assessment of the opportunities and risks presented by a potential investment, market factors and other investment considerations. A determination of reliance will depend on an examination of the following:

1. The nature of the relationship that exists between the member and the customer. Relevant considerations could include:
  • any written or oral understanding that exists between the member and the customer regarding the customer's reliance on the member;

  • presence or absence of a pattern of acceptance of the member's recommendations;

  • the use by the customer of ideas, suggestions, market views and information obtained from other members or market professionals, particularly those relating to the same type of securities; and

  • the extent to which the customer provides the member with current comprehensive portfolio information in connection with discussing recommended transactions or does not provide important information regarding its portfolio or investment objectives.
2. The customer's capability to make its own investment decisions including the resources available to the customer to make informed decisions. Relevant considerations could include:
  • the use of one or more investment advisers or bank trust departments;

  • the general level of experience of the staff of the institutional customer in financial markets and specific experience with the type of instruments under consideration;

  • the customer's ability to independently evaluate how market developments would affect the security; and

  • the complexity of the security or securities involved.
Members are reminded that these factors are merely guidelines which will be utilized to determine whether a member has fulfilled its suitability obligations and that the inclusion or absence of any of these factors is not dispositive of the determination of suitability. Such a determination can only be made on a case-by-case basis taking into consideration all the facts and circumstances of a particular member/customer relationship, assessed in the context of a particular transaction.

For purposes of this Interpretation, an institutional customer shall be any entity other than a natural person. In determining the applicability of this Interpretation to an institutional customer, the NASD will consider the dollar value of the securities that the institutional customer has in its portfolio and under management. While this Interpretation is potentially applicable to any institutional customer, the guidance contained herein should at a minimum be applied to an institutional customer with at least $10 million invested in securities in the aggregate in its portfolio and under management.

1 Rules for municipal securities are written by the Municipal Securities Rulemaking Board.


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