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02-73 SEC Approves New Rules and Rule Amendments Concerning Security Futures
Business Conduct and Responsibility Rules
Effective Date: October 15, 2002
Legal & Compliance
On October 15, 2002, the Securities and Exchange Commission (SEC) approved rule changes by NASD that both create and amend certain rules and interpretive materials to address the requirements for NASD members engaging in a security futures business. These rule changes:
- amend registration rules to expand several registration categories to include engaging in and supervising security futures transactions;
- amend Rule 1060 (Persons Exempt from Registration) to exempt from NASD registration persons associated with a member who are already registered with a registered futures association and whose functions are related exclusively to security futures transactions;
- create Rule 2865 (Security Futures Rule) to regulate security futures sales practices and amend Interpretive Material 2310-2 (Fair Dealing with Customers) to refer to new Rule 2865 regarding security futures sales practices;
- amend Interpretive Material 2110-3 (Front Running Policy) to add block trading in single stock futures to the prohibition against front running;
- amend NASD's advertising rule - Rule 2210 (Communications with the Public) and create new Interpretive Material 2210-7 (Guidelines for Communications with the Public Regarding Security Futures) to regulate communications with the public regarding security futures;
- amend Rule 3010(b)(2) (the Taping Rule) to recognize the ability of futures regulators to expel a member from the futures industry for futures-related sales practice violations;
- amend Rule 3010(e) (Qualification of Job Applicants) to require firms to check the backgrounds of job applicants who have previously worked in the futures industry;
- amend Rule 3050 (Transactions for or by Associated Persons) to require associated persons to notify their member firm when they open certain futures accounts or engage in certain security futures transactions; and
- amend Rule 3370 (Prompt Receipt and Delivery of Securities) to exempt security futures from the affirmative determination requirement.
These changes are included with this Notice (see Attachment A). They become effective October 15, 2002.
This Notice also explains that adding a security futures business may constitute a material change of business and describes the factors a member should consider in determining whether engaging in a security futures business constitutes a material change that would require the member to file a continuing membership application with NASD and obtain prior approval before engaging in a security futures business. The Notice also clarifies that best execution obligations apply to transactions in security futures. In addition, the Notice explains that members engaged in a security futures business must comply with their obligations in the analyst rule, Rule 2711 ("Research Analysts and Research Reports").
Questions concerning this Notice may be directed to the Office of General Counsel, NASD Regulatory Policy and Oversight: Gary L. Goldsholle, Associate General Counsel, (202) 728-8104; Alan Lawhead, Associate General Counsel, (202) 728-8853; or Patricia Albrecht, Assistant General Counsel, (202) 728-8026.
The Commodity Futures Modernization Act of 2000 (CFMA) lifted the ban on the trading of security futures, i.e., single stock and narrow-based stock index futures ("security futures").1 The CFMA defines security futures both as securities under the federal securities laws,2 and as futures contracts for purposes of the Commodity Exchange Act (CEA).3 Accordingly, the SEC and the Commodity Futures Trading Commission (CFTC) have joint jurisdiction over the intermediaries and markets that trade security futures products.
Because they are subject to regulation both as securities and as futures contracts, security futures must be traded on trading facilities4 and through intermediaries that are registered with both the SEC and the CFTC. Broker/dealers that wish to conduct a business in security futures are required to notice register with the CFTC as Futures Commission Merchants (FCMs) or Introducing Brokers (IBs).5 Similarly, FCMs and IBs are required to notice register as broker/dealers if they wish to conduct a business in security futures.6 Firms that are fully registered as both FCMs or IBs and broker/dealers may engage in security futures transactions without any notice registration.
NASD has amended certain rules and interpretive materials and created new rules and interpretive materials to address security futures.7 This Notice explains and describes: (1) changes to the qualifications and testing requirements; (2) the provisions of new Rule 2865 and other rule changes; (3) that best execution obligations apply to transactions in security futures; (4) that adding a security futures business constitutes a material change of business under NASD rules and the implications of adding this new business; and (5) that members engaged in a security futures business must comply with their obligations in Rule 2711.
I. Qualification and Training
A. Changes to Registration; Continuing Education for Existing Registrants
Under the CFMA, self-regulatory organizations (SROs) are responsible for ensuring that individuals engaging in a security futures business are properly qualified.8 To accommodate the introduction of security futures, several registration categories have been modified to include the activities of engaging in and supervising securities futures. In general, where a registration category permits an individual to engage in an options business, that category has been modified to permit activity in security futures. Specifically, the modified categories are the Series 4 (Registered Options and Security Futures Principal (replaces Registered Options Principal)), Series 9/10 (Limited Principal - General Securities Sales Supervisor),9 Series 7 (General Securities Representative), and Series 42 (Limited Representative - Options and Security Futures (replaces Limited Representative - Options)).10
Until December 31, 2006, persons who are currently registered in the abovementioned categories or who become registered in one of these categories prior to the implementation of the revised examinations addressing security futures and who want to engage in a security futures business must complete a firm-element continuing education requirement addressing security futures before engaging in any security futures business. As discussed below, the continuing education requirement has been instituted as an alternative to retesting and is discussed below.
The opportunity for eligible registrants to qualify to engage in a security futures business by completing a firm-element continuing education requirement ends on December 31, 2006. After that date, if an eligible registrant has not taken the firm element continuing education program and wants to begin participating in a security futures business, that registrant must take a revised qualification examination before engaging in a security futures business.
We recognize that this is the first time NASD has mandated a particular firm-element continuing education program.11 Traditionally, member firms have determined the nature and content of their firm-element continuing education programs. The introduction of security futures in the United States, however, is an extraordinary situation. Following a nearly 20-year ban, securities professionals will be able to trade products that are both securities and futures. Accordingly, securities professionals may not be sufficiently familiar with the different risks, trading characteristics, and terms and nomenclature of these products, including the fact that the products are subject to the joint jurisdiction of the SEC and CFTC. Consequently, we have determined that firm element continuing education is the most effective method of ensuring that existing registrants are properly informed about security futures.12
To facilitate firms' compliance with the continuing education requirement, we have developed with the National Futures Association (NFA) and the Institute for Financial Markets an internet-based training program that firms may use to satisfy the firm element requirement. Attached to this Notice is an outline of the content of the continuing education program. (See Attachment B). Registered personnel may access the training through NASD's Web Site at www.nasd.com. Use of the NASD/NFA program, however, is not mandatory. Firms may develop their own firm element training programs following the NASD syllabus. Firms also may engage other continuing education providers to deliver the training, provided that the training covers all of the subjects in the NASD syllabus. NASD and NFA are offering a web-based training program because we recognize that many firms may not have the resources or expertise to develop such programs "in-house" or in a timely manner. NASD is offering the training program free of charge. More information about the NASD/NFA continuing education program can be found at the NASD Web Site.
B. Development of New Qualification Examinations
We are currently working with industry representatives and other SROs to develop revised qualification examination questions on security futures. These new questions on security futures will be added to the Series 4, Series 9/10, and Series 42.13
We also intend to offer a new Series 43 examination for general securities representatives seeking to engage in a security futures business. Once the Series 43 is developed, new applicants seeking to act as a general securities representative may choose to take only the Series 7, or, if they intend to engage in a security futures business, the Series 7 and Series 43 examinations. After the Series 43 examination is developed, persons taking only the Series 7 will not be permitted to engage in a security futures business, nor will they be able to qualify to engage in a security futures business by completing a firm-element continuing education program.14 Firmelement continuing education programs will be an option available only for persons who are registered as a general securities representative before the Series 43 examination becomes available.
We are not amending the Series 24 - General Securities Principal examination. The Series 24 does not permit a principal to supervise options activity, and consequently, we do not intend to amend the examination to allow such persons to supervise security futures activity.
NASD anticipates that the new and revised qualification examinations will be available six months after trading in security futures commences.
In addition, NASD is allowing individuals who have passed the Series 30 (NFA's Branch Manager Examination) to supervise security futures activities. This is principally an accommodation to members that are registered as a broker/dealer and an FCM or IB, which are likely to have Series 30 personnel in their futures business. Rule 1022(f) requires each Registered Options and Security Futures Principal to pass "the appropriate Qualification Examination for Registered Options and Security Futures Principal, or an equivalent examination acceptable to NASD." NASD has deemed the Series 30 examination to be an "equivalent examination acceptable to NASD" for purposes of supervising security futures activities. Persons who have passed the Series 30 and, if appropriate, the necessary firm-element continuing education, may supervise a member's security futures activities. Such persons, however, may not supervise options activities.
C. Limited Exemption from Registration for Certain Associated Persons Engaged Exclusively in Security Futures Transactions
We are also amending Rule 1060 (Persons Exempt from Registration) to exempt from NASD registration requirements associated persons whose securities activities are related solely and exclusively to transactions in security futures, provided that such persons are registered with a registered futures association. The NFA currently is the only registered futures association. This rule change recognizes that certain persons in a firm that is a broker/dealer and either an FCM or IB, who currently engage solely in a commodities business, may seek to expand their activities into security futures. The rule change has been made to avoid having such persons be required to register as representatives. While those persons are not required to register as representatives, they must follow NFA rules concerning, among other things, continuing education.
II. Security Futures Rule and Other Changes to Rules and Interpretive Materials
NASD has developed rules regulating members' activities in security futures. One of the underpinnings of the CFMA is that the regulation of security futures should be comparable to the regulation of options.15 As noted below, that principle has guided the rule and interpretive material changes addressing the introduction of security futures.
Rule 2865 — Security Futures Rule
A. Opening of Accounts
Rule 2865(b)(16) provides that a member may not open a security futures account unless the member follows specific procedures. These procedures generally include:
- providing the customer with the security futures risk disclosure statement;
- gathering specific, detailed information regarding the customer's financial situation and investment objectives;
- obtaining written approval for security futures trading in the account by a principal qualified to supervise security futures activities based upon the information gathered; and
- obtaining, within 15 days after the customer's account has been approved to trade security futures, the customer's verification of the background and financial information upon which the account was approved and a written agreement that the customer has received a copy of the security futures risk disclosure statement, agrees to be bound by NASD's security futures trading rules, and agrees not to violate applicable security futures position limits.
B. Delivery of Security Futures Risk Disclosure Statement17
In general, the requirements for delivery of the security futures risk disclosure statement are comparable to the requirements for the delivery of the options disclosure document. Under Rule 2865(b)(11), every member must deliver the security futures risk disclosure statement to each customer at or prior to the time such customer's account is approved for trading security futures. The SEC approved the security futures risk disclosure statement on October 10, 2002. Additionally, as noted above, under Rule 2865(b)(16)(D), a member must within 15 days after a customer's account has been approved for trading in security futures receive a written agreement from each customer that, among other things, states that the customer has received a copy of the security futures risk disclosure statement.
Copies of the security futures risk disclosure statement may be obtained from NASD Media Source at (301) 590-6500, or from the NFA. Electronic copies may be downloaded from NASD's Security Futures Web Page at www.nasdr.com/futures.asp, or NFA's Web Site.
When recommending security futures to a customer, a member must employ a heightened suitability standard similar to the suitability standard for options.18 This heightened standard recognizes that security futures carry a higher degree of risk to a customer than many other securities products. Specifically, if an associated person recommends a security futures transaction, Rule 2865(b)(19) imposes the additional requirement that the associated person have a reasonable basis for believing "that the customer has such knowledge and experience in financial matters that the customer may reasonably be expected to be capable of evaluating the risks of the recommended transaction and is financially able to bear the risks of the recommended position in the security future." To provide consistency with the suitability standard for security futures adopted by the NFA,19 our security futures standard also explicitly includes recommendations of "trading strategies."
In addition, the suitability obligations applicable to recommendations to institutional customers, as specified in Interpretive Material 2310-3, apply to transactions in security futures and options.
D. Discretionary Accounts
Discretionary account procedures for security futures are comparable to those for discretionary accounts for options. Notably, as with options, Rule 2865(b)(18) provides that the customer must specifically authorize in writing security futures trading conducted on a discretionary basis in the account. Even those accounts that are permitted to trade options cannot trade security futures unless a new written discretionary account authorization specifically authorizing trading of security futures is on file.
E. Statements of Account
Under Rule 2865(b)(15), members must send customers an account statement at least each month where there has been an entry in the account during the prior month with respect to a security futures contract. Also, members must send quarterly account statements to all customers that have an open security futures position or money balance in the account.
A customer account statement for a margin account must provide the market price, mark-to-market value and nominal value of each security futures position and the mark-to-market price and market value of other security positions in the margin account, the total market value of all positions in the account, the outstanding debit or credit balance in the account, and the account equity. In addition, an account statement must inform the customer that further information on commissions and other charges related to the security futures transactions covered in the statement have been included in the previously furnished transaction confirmations and that such information will be made available to the customer promptly upon request. Also, the statement must bear a legend requiring that the customer promptly report any material change in the customer's investment objectives or financial situation.
The SEC has adopted an amendment to Exchange Act Rule 10b-10 providing confirmation requirements for security futures transactions conducted in futures accounts.20 In view of the SEC's amendment, NASD currently is not amending its confirmation requirements to address transactions in security futures. However, irrespective of whether security futures are transacted in a futures account or a securities account, NASD members should ensure that the confirmations they provide to their customers for security futures transactions meet the appropriate requirements provided in Exchange Act Rule 10b-10.
G. Maintenance of Records
As part of their recordkeeping obligations, members are required under Rule 2865(b)(17) to maintain at their principal place of business or another designated principal office a separate record of all security futures-related complaints, through which these complaints can easily be identified and retrieved. In addition, Rule 2865(b)(17) requires members to maintain the background and financial information of any customer who has been approved for security futures trading at both the branch office servicing the customer's account and at the principal supervisory office having jurisdiction over that branch office. This recordkeeping provision is almost identical to the recordkeeping provision in the Options Rule.21
H. Restrictions in Security Futures Transactions
Rule 2865(b)(8) provides that NASD has the authority to impose on members any restrictions on security futures transactions if NASD deems the restrictions are necessary to maintain a fair and orderly market in security futures or in the underlying securities covered by those security futures or are otherwise necessary in the public interest or for the protection of investors. This provision is substantively similar to the provision on restrictions of option transactions in the Options Rule.22
I. Security Futures Transactions and Reports by Market Makers in Listed Securities
Under Rule 2865(b)(24), every member that is an off-board market maker in a security listed on a national securities exchange must report transactions involving 50 or more security futures contracts on such listed securities that are for the direct or indirect benefit of: (1) the member; or (2) any associated person or other employee of the member who is directly involved in the purchase or sale of the underlying security for the firm's proprietary account, is responsible for supervising such sales, or has information on the member's proprietary account in which the underlying security is traded. This provision applies to all security futures transactions, including transactions executed on an exchange in which the member belongs.
J. Trading Ahead of Customer Orders
Under Rule 2865(b)(25), every member must exercise due care to avoid trading ahead of customer security futures orders in a proprietary account or other account in which the member or an associated person has a direct or indirect interest. The prohibition is required only when a member has gained knowledge of or reasonably should have gained knowledge of the customer's order prior to the transmission of the member's order for a proprietary account or for any account in which it or any associated person has an interest.
The provision against trading ahead of customer orders is based on the NFA's Interpretive Notice regarding obligations to customers and other market participants.23 The NFA's Interpretive Notice gives two examples of when a firm would reasonably not be aware of a customer's order: (1) when a customer's order originates in a different branch office than the firm's proprietary order; and (2) when the firm's trading department does not have access to information about customer orders. We believe that these two situations are also examples of when a member would not violate the provisions in Rule 2865(b)(25). Moreover, generally there may be additional situations in which a member reasonably would not be aware of a customer's order for purposes of applying the rule. In those situations, the member would not violate the rule if it transmits a proprietary order to a securities exchange before a customer's order.
Interpretive Material 2110-3 (IM-2110-3) — Front Running Policy
NASD's front running policy, IM-2110-3, prohibits members and associated persons from trading options or an underlying security when they have material non-public market information concerning an imminent block transaction in the underlying security or in the overlying option. The front running policy applies to members' proprietary accounts, accounts in which members or associated persons have an interest or discretionary authority, and customer accounts when a member or an associated person of a member has shared material, non-public market information with a customer.
We have amended this policy to apply to security futures in the same manner that it applies to options. For example, when a member has material, non-public market information concerning an imminent block transaction in a stock, the member may not to trade the singlestock future overlying that stock in its proprietary account, other accounts in which it has an interest or discretionary authority, or in a customer's account if the member has shared the material, non-public information with the customer. The purpose of this amendment is to prohibit broker/dealers from trading security futures at a profit when they have material, non-public market information concerning a stock or from trading a stock at a profit when they have material, non-public market information concerning a security future. Once the material, non-public market information has been made publicly available, however, the front running policy restrictions no longer apply.
Rule 2210 — Communications with the Public and Interpretive Material 2210-7 (IM-2210-7) — Guidelines for Communications with the Public Regarding Security Futures
Rule 2210 (the Advertising Rule) has been amended to apply many of that rule's standards to security futures communications. In addition, new IM-2210-7 has been added to address additional advertising requirements for security futures. We have adopted this approach rather than create a standalone security futures advertising rule because we believe it will be easier for members to follow a modification of the general advertising rule.24
A. Rule 2210 - Communications with the Public
Under the Advertising Rule, only a principal qualified to supervise security futures activities can approve advertisements and sales literature concerning security futures.25 As with the pre-use filing requirements for options communications, a member must file its security futures advertisements with NASD's Advertising Regulation Department (Department) or another self-regulatory organization of which it is a member that has comparable standards applicable to security futures at least 10 days prior to use. NASD has determined that NFA's advertising rules are comparable. Thus, NASD members that are also NFA members may file their advertising materials with either the Department or NFA. The Department will review the advertisement and either approve it, disapprove it, or specify changes that the member must make to use the communication.
As noted above, many of the Advertising Rule's standards apply to these communications. In particular, communications must be based on principles of fair dealing and good faith and should provide a sound basis for evaluating the facts regarding any security futures.26 Exaggerated, unwarranted, or misleading statements about security futures are not allowed.27 Moreover, no member may distribute any communication that the member knows or has reason to know contains misleading material.28 Nor may a member omit a material fact or qualification if the omission, in light of the context of the material presented, would cause the communication to be misleading.29 Communications with the public cannot contain promises of specific results, exaggerated or unwarranted claims or unwarranted superlatives, opinions for which there is no reasonable basis, or forecasts of future events that are unwarranted.30 In addition, members making recommendations about security futures must generally inform the public if they make a market in the underlying securities or if they own security futures of any recommended underlying securities.31 Finally, as explained further below, security futures communications must include specific disclosures about the risks of security futures and the ability to obtain, upon written request, documents that will support any claims made in the communications.
B. IM-2210-7 - Guidelines for Communications with the Public Regarding Security Futures
IM-2210-7 provides additional advertising guidelines for security futures communications, including generally requiring that all communications concerning security futures be accompanied or preceded by the security futures risk disclosure statement.32 IM-2210-7 also restricts the content of security futures communications, which include advertisements, sales literature, and correspondence, that are not accompanied or preceded by the security futures risk disclosure statement. Those communications must be limited to general descriptions of the security futures being offered. In addition, they may not contain statements of historical performance or projections and must contain contact information for obtaining a copy of the security futures risk disclosure statement.
Only sales literature and correspondence that is accompanied or preceded by the security futures risk disclosure statement can contain projections or historical performance information. Additionally, IM-2210-7 provides stringent standards members must follow when making projections or using historical performance data in security futures sales literature and correspondence. For example, sales literature containing projections:
- cannot suggest the certainty of future performance;
- must clearly establish the performance parameters; and
- must reflect all relevant costs, including commissions in the projections, and disclose the risks involved in the proposed transactions.
Sales literature containing historical performance information must, among other things:
- confine historical performances to a specific "universe" that can be fully isolated and that covers at least the most recent 12-month period;
- include the date and price of each recommendation or transaction at the end of the period or when liquidation was suggested or effected;
- disclose all relevant costs, including commissions; and
- have a principal qualified to supervise security futures activities ratify that the records or statistics fairly represent the status of the recommendations or transactions reported upon.
These requirements are similar to provisions in the options advertising rule and also are substantially similar to the NFA's requirement regarding communications with the public for security futures.33
IM-2210-7 also requires three specific disclosures about security futures. First, if the communication refers to the potential advantages of security futures, the communication must balance the statement of advantages with a reference, in the same degree of specificity, about the corresponding risks. This requirement of a closely balanced presentation of advantages and risks is a more exacting standard than is contained in NASD's general standard for communications with the public, which prohibits exaggerated, unwarranted, or misleading statements.34 Second, the communication must include a warning that security futures are not suitable for all investors. Third, IM-2210-7 requires that the communications state that, upon request, the member will provide documents that support any claims, comparisons, recommendations, statistics, or other technical data used in the communication. All three of these disclosure requirements are similar to the requirements for options communications.35
Rule 3010(b)(2) — The Taping Rule
NASD Rule 3010(b)(2) (the Taping Rule) is applicable to NASD members if a certain percentage of their registered persons have been employed by a disciplined firm within the last three years. The Taping Rule requires subject NASD members to tape record "all telephone conversations between the member's registered persons and both existing and potential customers"36 and maintain other special written procedures for supervising the telemarketing activities of all of the member's registered persons. The Taping Rule seeks to prevent registered persons who have been employed by disciplined firms from clustering together at a different firm. For purposes of the Taping Rule, a disciplined firm is one that, in connection with sales practices involving the offer, purchase, or sale of any security, has been expelled from NASD membership, expelled from any other securities industry self-regulatory organization, or is subject to an SEC order revoking its registration as a broker/dealer.
In the futures industry, the NFA's taping rule requires NFA members that have a certain percentage of associated persons who have been employed by disciplined firms to tape record telephone conversations between associated persons and customers. The NFA has a three-fold definition of a disciplined firm that includes the following: (1) the firm has been charged formally by either the CFTC or NFA with deceptive telemarketing practices or promotional material; (2) the charges have been resolved; and (3) the firm has been closed and permanently barred from the industry as a result of those charges.37
NASD has incorporated this definition into the Taping Rule's existing definition of "disciplined firm" and has therefore broadened the scope of the Taping Rule to include FCMs and IBs that will be selling security futures within the group of intermediaries that can potentially meet the definition of a disciplined firm. We have adopted this amendment to promote consistency with the NFA in monitoring associated persons from disciplined firms that may engage in the security futures business.
Rule 3010(e) — Qualifications of Job Applicants
NASD Rule 3010(e) provides that members have a responsibility to investigate the good character, business repute, qualifications, and experience of a job applicant before the member applies to register that applicant with NASD. When the job applicant previously has been registered with NASD, the member must obtain a copy of the applicant's Uniform Termination Notice of Securities Industry Registration ("Form U-5") that was filed by the applicant's most recent member employer.
In light of the passage of the CFMA, Rule 3010(e) has been modified to provide that an NASD member must also review a job applicant's employment experience to determine if the applicant has been recently employed by an FCM or an IB that is notice-registered with the SEC pursuant to Exchange Act Section 15(b)(11).38 In such a case, the hiring firm would be required to review a copy of CFTC Form 8-T, Notice of Termination of Associated Person, NFA Associate, Branch Office Manage, Designated Supervisor or Principal. The Form 8-T asks for the same types of information as does the Form U-5. We anticipate that NASD members will be able to review the CFTC Form 8-T by requesting it from the applicant or the applicant's previous employer. Rule 3010(e) has been amended because an individual's prior experience at an FCM or an IB that conducts a security futures business may have particular bearing on his or her fitness to be sponsored by an NASD member.
In addition, Rule 3010(e) has been amended to provide members with greater flexibility in complying with its requirements. Currently, Rule 3010(e) requires members to obtain actual copies of the Form U-5 and amendments. When NASD replaced the Legacy Central Registration Depository ("CRD") system with Web CRDsm in August 1999, members received the ability to review Form U-5s and amendments via an internet connection. The Web CRD system allows members, with the applicant's consent, to review the Form U-5 by using a pre-hire search function. The amendment recognizes the ability of members to use the advanced functionality of Web CRD to review Form U-5s. Members, however, will be expected to be able to demonstrate compliance with the rule.
Rule 3050 — Transactions for or by Associated Persons
NASD Rule 3050(d) states that associated persons seeking to open accounts or place securities orders with a financial institution that is not their employer may not do so unless they notify their employer member and, upon written request by the employer member, obtain from the financial institution duplicate copies of certain documents concerning the orders or accounts. This rule allows NASD members to monitor the outside securities activities of their employees. The scope of this rule has been expanded to require the same notification standards for associated persons opening an account or placing an order with an FCM or IB that is notice-registered with the SEC to trade security futures.
Rule 3370 — Prompt Receipt and Delivery of Securities
Rule 3370 generally requires an NASD member, prior to accepting a short sale order from a customer in any security, to make an affirmative determination that the member can borrow or otherwise provide for delivery of the security by the settlement date.39 Because the CFMA exempts transactions in security futures from the short sale provisions of Exchange Act Section 10(a)(1),40 NASD has exempted security futures from the affirmative determination requirement of NASD Rule 3370.41 Members, however, would be prudent to ensure that their customers can provide delivery of the security by the settlement date.
We also have amended the definition of "bona fide fully hedged" positions in Rule 3370 to include certain long single stock futures positions in connection with short positions. These particular single stock future positions are similar to inthe-money call options, which are already included in the definition.42
III. Best Execution
The duty of best execution applies to members' transactions in securities, which includes transactions in security futures. The duty of best execution, which is rooted in common law agency principles and fiduciary obligations, requires that a broker/dealer seek to obtain for its customers' orders the most favorable terms reasonably available under the circumstances.43 The obligation of best execution is codified in NASD Rule 2320, which provides that in any transaction for or with a customer, a member and persons associated with a member shall use reasonable diligence to ascertain the best market for a security and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions. Best execution is, however, an obligation that necessarily involves a "facts and circumstances" analysis.
In the context of security futures, when a customer's order may be executed on two or more markets that trade security future contracts that are not materially different, members have an obligation to use reasonable diligence to ascertain the market in which the customer's order will receive the most favorable terms. Members should consider the factors enumerated in Rule 2320 when making these decisions. If, however, a customer's order may be executed on only one exchange, or when a customer requests that a security futures order be directed to a particular market, members do not have to decide where to route the order.
NASD recognizes the practical necessity of members automating the handling of retail orders and the impracticability of members making order-by-order routing decisions for typical retail orders. In the context of aggregate order handling decisions, members are required to have in place procedures to regularly and rigorously examine their execution quality as a whole.
For a fuller discussion of best execution obligations, members should review the SEC's recent interpretation regarding a broker/dealer's best execution obligation for security futures.44
IV. Membership Application Process
In November 2000, NASD amended its rules governing the membership application process. The amended rules provide additional guidance about the requirement that a member firm must file a continuing membership application with NASD and obtain approval prior to effecting a material change in business operations.45 Specifically, the membership rules now define a "material change in business operations" as including: (1) market making, underwriting, or acting as a dealer for the first time; (2) adding business activities that require a higher minimum net capital; and (3) removing or modifying a membership agreement restriction.46 All other business expansions are to be evaluated on a facts and circumstances, case-by-case basis, and firms must make a decision as to whether any particular expansion is "material" for purposes of the rules and thus requires an application. In cases requiring an application, members may not proceed with the planned expansion until NASD approves the application.
In making the required evaluation, members should consider the criteria identified in the guidance accompanying the amended rules.47 Specifically, as with any new line of business, an evaluation of all the relevant facts and circumstances should include, among other things, an assessment of the relationship between a security futures line of business and the firm's existing business; the effect that adding a security futures business will have on the firm's capital; the qualifications and experience of the firm's personnel; and the degree to which the firm's existing financial, operational, supervisory, and compliance systems can accommodate the addition of security futures.48
For purposes of analyzing whether the addition of security futures constitutes a material change in business operations, member firms are considered to fall into two general categories: firms that currently conduct an options business a nd those that do not.
Firms that currently conduct an options business should evaluate, based on the facts and circumstances, whether undertaking a security futures business constitutes a material change in business operations. These firms should apply the criteria identified previously for assessing the materiality of the proposed expansion.
For firms that currently do not engage in an options business, it is likely that engaging in a security futures business will constitute a material change in business operations. As to these firms, if they have assessed the potential impact on their firm of adding a security futures business and would like District Office input on the issue of whether an application is required to approve this expansion, they can consult with the District Offices by submitting notice of their intent to engage in a security futures business to their District Office. The District Office will conduct an informal, expedited review of the firm's query that will include asking the firm questions about its existing operations and its potential security futures business. The District Office will then advise the firm regarding whether adding a security futures line of business constitutes a material change in business operations. If the District Office concludes that the firm should submit a continuing membership application, the District Office, in calculating the allotted review time, will give the firm credit for the amount of time elapsed since it provided the initial notice to the District Office.
This approach provides certain firms the opportunity to have a quick, informal assessment of whether they need to submit a continuing membership application, reduces the regulatory burden on some firms, and increases the efficiency of the continuing membership application process.
V. Analysts and Research Reports
Rule 2711 ("Research Analysts and Research Reports") generally restricts the relationship between a member's research and investment banking departments; requires disclosure of financial interests in covered companies by the member's analyst and the member; requires members to disclose existing and potential investment banking relationships with subject companies; imposes quiet periods for the issuance of research reports; restricts personal trading by analysts; and requires disclosure of information that helps investors track the correlation between an analyst's rating and the stock's price movements.49 The provisions of Rule 2711 are generally applicable to security futures. For example, the restrictions on personal trading by analysts extend to trading in security futures on companies covered by the analyst. Similarly, provisions addressing disclosure of members' or research analysts' ownership interests in a security include security futures interests held by that person. And, the Rule 2711 definition of "Research Report" includes certain written or electronic communications on security futures because security futures are defined as "equity securities" under the Exchange Act.50
1 Appendix E of Pub. L. No. 106-554, 114 Stat. 2763. Under Section 3(a)(55)(A) of the Securities Exchange Act of 1934 ("Exchange Act"), the term "security future" is defined as a contract of sale for future delivery of a single security or of a narrow-based security index. 15 U.S.C. 78c(a)(55)(A). Under Exchange Act Section 3(a)(56), the term "security futures product" is defined as a security future or an option on a security future. 15 U.S.C. 78c(a)(56).
2 See, e.g., Exchange Act Section 3(a)(10) (15 U.S.C. 78c(a)(10)).
3 The term "security future" is defined in CEA Section 1a(31) (7 U.S.C. 1a(31)) as a contract of sale for future delivery of a single security or a narrow-based security index. Under CEA Section 1a(33) (7 U.S.C. 1a(33)), the term "security futures product" is defined as a security future or an option on a security future.
4 See Exchange Act Section 6(g) (15 U.S.C. 78f(g)); CEA Section 5f (7 U.S.C. 7b-1).
5 CEA Section 4f(a)(2) (7 U.S.C. 6f(a)(2)); 66 FR 43080 (August 17, 2001).
6 Exchange Act Section 15(b)(11)(a)(i) (15 U.S.C. 78o(b)(11)(a)(i)); 66 FR 45138 (August 27, 2001).
7 NASD rules apply only to NASD members. Because FCMs and IBs that are notice-registered with the SEC are not required to become NASD members, any NASD rule changes, including the ones explained here, may not apply to them.
8 See generally Exchange Act Section 19(b)(7)(A) (15 U.S.C. 78s(b)(7)(A)) (mandating that national securities exchanges or national securities associations registered with the SEC develop rules effectuating the obligation of these SROs to enforce the securities laws and to propose rule changes developing, among other things, sales practices for persons who effect transactions in security futures products); see also Exchange Act Section 15A(k)(2)(D) (15 U.S.C. 78o-3(k)(2)(D) (requiring registered futures associations that apply for registration as a limited purpose national securities association to have rules that ensure that members meet such standards of training, experience, and competence necessary to effect transactions in security futures products and are tested for their knowledge of securities and security futures products).
9 Rule 1022(f)(5) and (g)(3), respectively; see also changes to Interpretive Materials 1022-1 and 1022-2. IM-1022-1 replaces references to the old category, Registered Options Principals, with the new category of Registered Options and Security Futures Principals and reflects that a Registered Options and Security Futures Principal may supervise security futures trading activities. Likewise, IM-1022-2 now reflects that a Limited Principal - General Securities Sales Supervisor may also supervise security futures sales activities.
10 Rule 1032(a)(2)(E) and (d)(4), respectively.
11 See NASD Rule 1120(b)(4) (provision permits NASD to require a member to provide specific training in areas NASD deems appropriate).
12 Similarly, the National Futures Association (NFA) is requiring continuing education for its existing registrants.
13 Some of these qualification exams are NYSE examinations. NASD, NYSE, and other SROs are working collectively to revise qualification examinations to address security futures.
14 In contrast, persons registered in all of the other effected categories who intend to engage in a security futures business shall be able to elect to take firm-element continuing education programs until December 31, 2006, even if new qualifying examinations have been created prior to that date.
15 For example, the CFMA establishes that margin requirements for security futures be consistent with comparable option contracts and that listing standards for security futures be no less restrictive than comparable listing standards for options traded on a national securities exchange or a national securities association. See Exchange Act Sections 7(c)(2) & 6(h)(3)(C); 15 U.S.C. 78g(c)(2) & 78f(h)(3)(C).
16 On September 27, 2001, the SEC published a group of new NFA rules and amendments to NFA rules governing security futures. See 66 FR 49439 (September 27, 2001). The NFA's rules also were modeled after NASD's options rule. In developing NASD's security futures rule, we have sought to adopt requirements that are consistent with those of the NFA to avoid regulatory disparity between firms subject to the jurisdiction of the NFA and NASD.
17 The security futures risk disclosure statement has been developed collectively by NASD, NFA, the New York Stock Exchange, the American Stock Exchange, One Chicago, the Chicago Board Options Exchange, NQLX, and the Options Clearing Corporation.
18 See NASD Rule 2860(b)(19). We also are amending Interpretive Material 2310-2 (Fair Dealing with Customers) to require members to comply with the security futures sales practices and procedures contained in new Rule 2865.
19 See NFA Rule 2-30(j)(4).
20 See Exchange Act Release No. 46471 (Sept. 6, 2002), 67 FR 58302 (Sept. 13, 2002).
21 See Rule 2860(b)(17).
22 See Rule 2860(b)(8).
23 National Futures Association Manual, 9041 (Vol. 7, No. 2 2001).
24 Members also are advised that Rule 2240 ("Disclosure of Control Relationship with an Issuer") does not apply to security futures. Rule 2240 requires members that are controlled by, controlling, or under common control with, the issuer of any security to disclose to customers the existence of such control prior to entering into any contract with or for a customer for the purchase or sale of such security.
25 See Rule 2210(b)(1) & (c)(2). Although many of the advertising requirements for security futures are similar to the options advertising requirements, the definitions of "options advertisement," "educational material," and "sales literature" differ from the definitions that will apply to security futures. Because the security futures advertising requirements follow the requirements of the NASD's general advertising rule, the definition of "advertisement" is essentially material that is disseminated via mass media channels. See Rule 2210(a)(1). "Sales literature" is defined to include circulars, research reports, market letters, performance reports or summaries, form letters, telemarketing scripts, seminar texts, and reprints or excerpts of any other advertisement, sales literature, or published article that is distributed or made generally available to customers or the public. See Rule 2210(a)(2).
26 Rule 2210(d)(1)(A).
27 Rule 2210(d)(1)(B).
28 Rule 2210(d)(1)(B).
29 Rule 2210(d)(1)(A).
30 Rule 2210(d)(2)(C).
31 Rule 2210(d)(2)(B)(i)a & b.
32 These guidelines are similar in many respects to the requirements of Rule 2220, which governs the advertising of options.
33 See NFA Rule 2-29(j)(12); see also 66 FR 49439 (September 27, 2001).
34 See Rule 2210(d)(1)(B).
35 See Rule 2220(d)(2)(A)(i) & (ii), 2220(d)(2)(D)(i).
36 Rule 3010(b)(2)(iii).
37 NFA Rule 2-9: Enhanced Supervisory Requirements - Interpretive Notice.
38 66 FR 45137 (August 27, 2001).
39 For NASDAQ National Market securities, NASD rules include an additional short sale restriction: the bid test. See Rule 3350(a). We believe that the bid test has no application to security futures, and we are not proposing any amendments to Rule 3350.
40 See Exchange Act Section 10(a)(2) (15 U.S.C. 78j(a)(2)) (exempting transactions in security futures from short sale provisions in Exchange Act Section 10(a)(1)).
41 Currently, the affirmative determination requirement of Rule 3370 does not apply to options transactions.
42 See Rule 3370(b)(5)(iv).
43 See Notice to Members 01-22 (April 2001).
44 See SEC Interpretation: Commission Guidance on the Application of Certain Provisions of the Securities Act of 1933, the Securities Exchange Act of 1934, and Rules thereunder to Trading in Security Futures Products, Release Nos. 33-8107 & 34-46101 (June 27, 2002) (questions 21-23).
46 NASD Rule 1011(i).
47 See Notice to Members 00-73 (Oct. 2000).
48 See Notice to Members 02-39 (July 2002).
50 Exchange Act Section 3(a)(11) (15 U.S.C. 78c(a)(11)).
1000. Membership, Registration and Qualification Requirements
1020. Registration of Principals
1022. Categories of Principal Registration
IM-1022-1. Registered Options and Security Futures Principals
IM-1022-2. Limited Principal — General Securities Sales Supervisor
1032. Categories of Representative Registration
1060. Persons Exempt from Registration
IM-2110-3. Front Running Policy
2210. Communications with the Public
IM-2210-7. Guidelines for Communications with the Public Regarding Security Futures
IM-2310-2. Fair Dealing with Customers
2865. Security Futures
3050. Transactions for or by Associated Persons
3370. Prompt Receipt and Delivery of Securities
- With the circumstances as above (and assuming a contract size of 100) 100 shares would be exempt.
- Even if the expiration date for the single stock future was more than 90 calendar days, 100 shares would be exempt.
NASD Security Futures Information
The content outline provided below has been established by NASD and NFA for use by firms in developing their firm-element training programs. The outline contains five modules or segments: (1) Stock and Stock Options; (2) Futures Contracts; (3) Security Futures Products; (4) Regulatory Requirements for Security Futures; and (5) Supervision of the Offer and Sale of Security Futures.
Module 1 is intended primarily for futures professionals as an introduction to securities and securities law concepts. NASD will not require broker/dealers to administer the content of Module 1 to securities registrants. Firms should decide on their own whether their employees would benefit from the basic securities overview.
Module 2 is intended primarily for securities professionals as an introduction to the basic concepts and terminology of futures. In general, NASD will require that members administer the content of Module 2 to securities registrants, although firms employing dually-licensed persons (i.e., persons registered with a broker/dealer and an futures commission merchant or introducing broker), may not need to administer Module 2 to such persons.
Module 3 explains the characteristics and elements of security futures. Module 4 describes the regulatory framework, including sales practice and margin requirements, for these new products. All NASD member firms must administer the content of Modules 3 and 4 to their personnel before such persons may engage in a security futures business.
Lastly, Module 5 addresses issues relevant for persons who will be supervising personnel engaged in a security futures business. Firms must administer Module 5 to their appropriately qualified individuals before such persons can supervise security futures activity.
Module 1: Stocks and Stock Options
Introduction to Stocks
Shares in Corporate Ownership
- Stock splits
- Reverse stock splits
- Mergers and takeovers
Stock and Stock Options Markets and Clearing Organizations
The Nasdaq Stock Market
NYSE, AMEX and Regional Stock
Intermarket Trading System
Options Clearing Corporation
Price quotation conventions
- Uptick rule
- Stock loan
- Affirmative determination
Types of orders (different than those in the futures markets)
- All-or-none orders
Stock Options and Stock Index Options
Stock Market Analysis and Related Statistical Measures
Stocks by sector Stocks by strategy and Industry outlook
- Growth stocks
- Value stocks
- Income stocks
Stocks by market capitalization
- Large Cap
- Mid Cap
- Small Cap
Corporate Announcements and Other News and Information
Quarterly earnings reports
Corporate statements between reports
Short interest reports
Income Statement and Balance Sheet
Earnings per share
- Current assets
- Quick assets
- Current liabilities
- Working capital
- Current ratio
- Acid-test ratio
- Cash flow
Margin for Stocks and Stock Options
Initial and maintenance margin for stock purchases
Initial and maintenance margin for short stock positions
- Premium payments
- Margin for short positions
Securities Investor Protection Corporation
Purpose of SIPC
Module 2: Futures Contracts
Introduction to Futures Contracts
Equal treatment of buys and sells
Standardized contract terms
Futures Markets and Clearing Organizations
Non-fungibility across exchanges
Role of clearinghouse
- Matching trades
- Effecting settlement and payments
- Guaranteeing performance
- Facilitating deliveries
- Physical delivery
- Cash settlement
Daily price limits
Types of orders (different than those in the securities markets)
- Spread orders
- Switch orders
- Fill-or-kill orders
Commitments of traders
Pricing of futures
- Basis risk
- Intramarket spreads
- Intermarket spreads
Initial margin ("good faith deposit")
- Marking to market
Not covered by SIPC
Module 3: Security Futures
- Futures on single stocks
- Futures on narrow-based stock indexes
- Index changes from narrow to broad-based
Exchanges trading security futures
Restrictions on trading security futures on foreign markets
Contract Terms and Conditions for Security Futures Contracts
Buying security futures
Selling security futures
- No short sale requirement
Hours of trading
Contract months/trading cycle
Last trading date
Minimum price variation
- Large trader reporting levels
Position and position accountability limits
Other Characteristics of Security Futures
Fungibilty (or lack thereof)
- Regulatory halts
- Circuit breakers
Treatment of corporate actions
- Integral stock splits
- Non-integral stock splits
Block trading requirements
Module 4: Regulatory Requirements for Security Futures
Registration of markets
Registration of intermediaries with the SEC and CFTC
Registration of certain collective investment vehicles or providers of investment advice
Communications with the public Customer protection rules
- Segregated funds
Risk disclosure statement
- Definition of current market value
- Strategy offsets
- Portfolio-based margining systems (not allowed)
Applicability of Regulation T Collateral
- Type, form and use of collateral
- Acceptable collateral deposits
- Use of money market mutual funds
Computation of equity
Meeting margin calls
Extension of credit
Account approval and documentation
Best execution requirement
Reporting customer complaints
Anti-fraud and anti-manipulation requirements
- Section 4(b) of the CEA and 10(b) of the Securities Exchange Act
- Prohibition against trading on inside information
- Prohibition against trading ahead of research reports
- Prohibition against trading ahead of customer orders
Module 5: Supervision of the Offer and Sale of Security Futures
Security Futures Principals
Qualifications for principals and representatives
- Examination modules
- New candidates
- Existing candidates
Review of securities and futures employment background
Annual Compliance Meetings
Specific approval required
- Criteria used
Review of discretionary activity
Promotional Material and Correspondence
Review of correspondence
Review and approval of promotional material