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07-28 SEC Approves Additional Mark-Up Policy for Transactions in Debt Securities, Except Municipal Securities; Effective Date: July 5, 2007
Trading and Market Making
Legal and Compliance
Pricing of Debt Securities
Mark-Ups on Debt Securities
On April 16, 2007, the Securities and Exchange Commission (SEC) approved IM-2440-2, "Additional Mark-Up Policy for Transactions in Debt Securities, Except Municipal Securities" (Debt Mark-Up Interpretation or Interpretation), and renumbered IM-2440 as IM-2440-1.1 The Debt Mark-Up Interpretation supplements Rule 2440, "Fair Prices and Commissions," which requires broker-dealers to charge customers fair mark-ups and commissions, and IM-2440-1, "Mark-Ups."
In a debt security transaction with a customer, the broker-dealer's mark-up (mark-down) must be calculated from the prevailing market price of that security. The new Debt Mark-Up Interpretation states that, presumptively, the prevailing market price of a debt security is the broker-dealer's contemporaneous cost (or, in a sale, the broker-dealer's contemporaneous proceeds).
The Interpretation also addresses the procedures for determining prevailing market price (as a price other than contemporaneous cost) when a broker-dealer has the discretion, under the Interpretation, not to use its contemporaneous cost as the measure. In addition, the Interpretation includes an exemption for transactions in non-investment grade debt securities between broker-dealers and qualified institutional buyers (QIBs), as defined in Rule 144A under the Securities Act of 1933 (Securities Act) (QIB Exemption).2 The Interpretation and the amendment to IM-2440 are set forth in Attachment A of this Notice.
The Interpretation and the amendment to IM-2440 become effective July 5, 2007.
Questions regarding this Notice may be directed to Sharon K. Zackula, Associate Vice President and Associate General Counsel, Office of General Counsel, Regulatory Policy and Oversight, at (202) 728-8985; Malcolm P. Northam, Director, Fixed Income Securities Regulation, Regulation Policy, Member Regulation, at (202) 728-8085; and the Legal Section, Market Regulation, at (240) 386-5126.
Generally, under NASD Rule 2440 and IM-2440-1, broker-dealers may not charge compensation for the execution of customer transactions, whether in the form of a mark-up (mark-down) or commission, that is unfair, unreasonable or excessive. Unfair, unreasonable or excessive compensation for customer trades also violates Rule 2110, which requires broker-dealers to conduct their business in accordance with just and equitable principles of trade.3 The Debt Mark-Up Interpretation approved on April 16, 2007, supplements Rule 2440 and IM-2440-1.4
Rule 2440, IM-2440-1 and the Interpretation apply to transactions in debt securities between a broker-dealer and a customer except transactions in municipal securities, as defined in Section 3(a)(29) of the Securities Exchange Act of 1934 (Act),5 and exempted securities (other than municipal securities), as defined in Section 3(a)(12) of the Act.6
Prevailing Market Price
In a debt security transaction with a customer, the broker-dealer's mark-up (mark-down) must be calculated from the prevailing market price of that security. The Debt Mark-Up Interpretation focuses particularly on the key issue of the proper identification of the prevailing market price. The Interpretation states that, presumptively, the prevailing market price of a debt security is the broker-dealer's contemporaneous cost (or, in a sale, the broker-dealer's contemporaneous proceeds).7 The Interpretation also addresses the procedures for determining prevailing market price (as a price other than contemporaneous cost) when a broker-dealer, under the Interpretation, may chose not to use its contemporaneous cost as the measure of the prevailing market price. This occurs when there is no contemporaneous cost (proceeds) or certain events have occurred, as discussed on the next page.
A broker-dealer may seek to overcome the presumption that its contemporaneous cost (proceeds) is indicative of the prevailing market price in any of three events:
Pricing Alternatives to Contemporaneous Cost
When the broker-dealer has no contemporaneous transaction, or any of the events set forth above have occurred, the Debt Mark-Up Interpretation identifies three factors that must be considered, in the order listed, to determine the prevailing market price (hierarchy pricing factors). As set out more fully in the Interpretation, the hierarchy pricing factors are as follows in the order of consideration: contemporaneous inter-dealer transactions in the same security; qualifying contemporaneous institutional account-dealer trades in the same security; or qualifying contemporaneous quotations.9 The broker-dealer must determine that the relevant pricing information does not exist in each of the hierarchy pricing factors in their specified order before proceeding to any consideration of the next factor.
If none of the three hierarchy pricing factors are determinative of the relevant pricing information, the broker-dealer may then consider the pricing information from "similar" securities.10 The Interpretation provides specific guidance about what constitutes "similar" securities for purposes of the Interpretation.11 A broker-dealer should consider, among other things, credit quality of both securities, ratings, collateralization, spreads (over U.S. Treasury securities of similar duration) at which the securities are usually traded, general structural similarities (such as calls, maturity, embedded options), the size of the issue, float, recent turnover, and transferability or restrictions thereto.12 Also, the Interpretation recognizes that there may not be "similar" securities for certain securities.13 Generally, a "similar" security should be sufficiently equivalent to the subject security that it would serve as a reasonably fungible alternative investment. In addition, at a minimum, a broker-dealer must be able to fairly estimate the market yield for the subject security from the yields of "similar" securities.14
The pricing factors incorporating "similar" securities are not hierarchal; that is, they may be considered in any order. However, when reviewing them, the broker-dealer must consider that the burden on the broker-dealer is the correct identification of the prevailing market price.15
Finally, where neither the hierarchy pricing factors nor similar securities can be used to establish the prevailing market price, the Debt Mark-Up Interpretation allows that the broker-dealer may use pricing information derived from an economic model to determine the prevailing market price of a debt security for purposes of a mark-up.16
An economic model used to identify prevailing market price must take into account measures such as credit quality, interest rates, industry sector, time to maturity, call provisions and any other embedded option, coupon rate and face value, and all applicable pricing terms and conventions (e.g., coupon frequency and accrual methods).17
The Qualified Institutional Buyer (QIB) Exemption
The Interpretation contains a QIB Exemption, removing certain institutional customer transactions from the requirements of Rule 2440, IM-2440-1 and the Interpretation.18 To rely upon the QIB Exemption, a broker-dealer must determine that:
If the broker-dealer establishes all three elements, then the QIB Exemption may be applied by the broker-dealer.
IM-2310-3 contains extensive factors to be considered in making the determination as to whether a QIB has the expertise to make an independent decision in respect of a transaction and in fact is making an independent decision. Therefore, members are advised to fully review this rule when applying the QIB exemption.
NASD is providing 30 days from publication of this Notice for implementation to provide members with adequate time to comply with the amended requirements. As such, the amendments become effective July 5, 2007.
1 See Securities Exchange Act Release No. 55638 (April 16, 2007), 77 FR 20150 (April 23, 2007) (File No. SR-NASD-2003-141) (approval order).
In this Notice, the term "mark-up" generally refers to both mark-ups and mark-downs, and the term "contemporaneous cost" refers to both contemporaneous cost and contemporaneous proceeds (or either of them). Single terms in parentheses within sentences, such as the term "(proceeds)," refer specifically to customer sale transactions where the member charges a mark-down.
2 Under Rule 144A of the Securities Act of 1933 (Securities Act), the definition of QIB includes, among others: (1) specified entities (including insurance companies, registered investment companies, employee benefit plans or similar plans maintained by a state, or a state agency or political subdivision, and investment advisors) that act for their own account or the accounts of other QIBs, that in the aggregate own and invest on a discretionary basis at least $100 million in securities of issuers that are not affiliated with the entity; (2) any broker-dealer registered pursuant to Section 15 of the Securities Exchange Act of 1934 (Act), acting for its own account or the accounts of other QIBs, that in the aggregate owns and invests on a discretionary basis at least $10 million of securities of issuers that are not affiliated with the broker-dealer; (3) any broker-dealer acting in a riskless principal transaction on behalf of a QIB; (4) any investment company registered under the Investment Company Act of 1940, acting for its own account or for the accounts of other QIBs, that is part of a family of investment companies that own in the aggregate at least $100 million in securities of issuers, other than issuers that are affiliated with the investment company or are part of such family of investment companies; and (5) any bank or certain other domestic and foreign financial institutions, acting for its own account or the accounts of other QIBs, that in the aggregate owns and invests on a discretionary basis at least $100 million in securities of issuers that are not affiliated with it and that has an audited net worth of at least $25 million.
3 A broker-dealer may also be liable for excessive mark-ups under the anti-fraud provisions of the Securities Act and the Act. See Section 10(b)(5) of the Act and Rule 10b-5 thereunder, and Section 17(a) of the Securities Act.
4 See IM-2440-2, paragraph (a)(1).
5 See Section 3(a)(29) of the Act. "Municipal securities" include, among others, tax-exempt general obligation bonds and tax-exempt industrial revenue bonds. Transactions in municipal securities involving unfair pricing, including unfair mark-ups, are subject to the rules of the Municipal Securities Rulemaking Board (MSRB) and the anti-fraud provisions of the Securities Act and the Act. See note 3.
6 See Section 3(a)(12) of the Act. "Exempted securities" include, among others: government securities, as defined in Section 3(a)(42) of the Act; municipal securities, as defined in Section 3(a)(29) of the Act; any interest in any common trust fund or similar fund that is excluded from the definition of the term "investment company" under the Investment Company Act of 1940; any interest in any common trust fund, or a collective trust fund maintained by a bank, or any security arising out of a contract issued by an insurance company, which interest, participation or security is issued in connection with a qualified plan; any security issued by or any interest or participation in any pooled income fund, collective trust fund, collective investment fund, or similar fund that is excluded from the definition of an investment company; certain securities issued by or any interest in any church plan, company, or account that is excluded from the definition of an investment company; and other securities that the Commission may, by rules, exempt from any one or more provisions of the federal securities laws
NASD Rule 2110 (J&E rule) applies to broker-dealers charging excessive mark-ups or commissions in exempted securities transactions (other than municipal securities transactions). See Securities Exchange Act Release No. 37588 (August 20, 1996), 61 FR 44100 (August 27, 1996) (SR-NASD-1995-39) (order approving the application of the NASD's Rules of Fair Practice to transactions in exempted securities (except municipal securities)). In the order, the Commission states that for transactions in government securities between broker-dealers and customers, NASD may address conduct that is "similar to conduct that may violate the 'Fair Prices and Commissions' provision and the 'Mark-Up Policy'" under Rule 2110. The Commission said an NASD statement in the rule filing regarding this application of the J&E rule "merely clarifies and reminds members that its rules requiring members to adhere to just and equitable principles of trade apply to conduct that may violate the Fair Prices and Commissions provision and the Mark-Up Policy..." and the "rule requiring that members adhere to just and equitable principles of trade would have applied to such conduct regardless of this clarification." 61 FR 44100, 44113. Also, such conduct is subject to the anti-fraud provisions of the Securities Act and the Act. See note 3. See also NASD Rule 0116, paragraph (b).
7 See IM-2440-2, paragraphs (b)(1), (2) and (4).
8 See IM-2440-2, paragraph (b)(4).
9 See IM-2440-2, paragraphs (b)(5)(A) through (C).
10 See IM-2440-2, paragraph (b)(6).
11 See IM-2440-2, paragraphs (c)(1) and (2).
12 See IM-2440-2, paragraphs (c)(2)(A) through (D).
13 See IM-2440-2, paragraph (c)(3).
14 See IM-2440-2, paragraph (c)(1).
15 See IM-2440-2, paragraphs (b)(6) and (b)(8).
16 See IM-2440-2, paragraph (b)(7).
18 See IM-2440-2, paragraph (b)(9).
New language is underlined; deletions are in brackets.
IM-2440-1. Mark-Up Policy
The question of fair mark-ups or spreads is one which has been raised from the earliest days of the Association. No definitive answer can be given and no interpretation can be all-inclusive for the obvious reason that what might be considered fair in one transaction could be unfair in another transaction because of different circumstances. In 1943, the Association's Board adopted what has become known as the "5% Policy" to be applied to transactions executed for customers. It was based upon studies demonstrating that the large majority of customer transactions were effected at a mark-up of 5% or less. The Policy has been reviewed by the Board of Governors on numerous occasions and each time the Board has reaffirmed the philosophy expressed in 1943. Pursuant thereto, and in accordance with Article VII, Section 1(a)(ii) of the By-Laws, the Board has adopted the following interpretation under Rule 2440.
It shall be deemed a violation of Rule 2110 and Rule 2440 for a member to enter into any transaction with a customer in any security at any price not reasonably related to the current market price of the security or to charge a commission which is not reasonable.
* * * * *
IM-2440-2. Additional Mark-Up Policy For Transactions in Debt Securities, Except Municipal Securities1
(A member may consider a succeeding category of pricing information only when the prior category does not generate relevant pricing information (e.g., a member may consider pricing information under (B) only after the member has determined, after applying (A), that there are no contemporaneous inter-dealer transactions in the same security).) In reviewing the pricing information available within each category, the relative weight, for purposes of identifying prevailing market price, of such information (i.e., either a particular transaction price, or, in (C) above, a particular quotation) depends on the facts and circumstances of the comparison transaction or quotation (i.e., such as whether the dealer in the comparison transaction was on the same side of the market as the dealer is in the subject transaction and timeliness of the information).
The relative weight, for purposes of identifying prevailing market price, of the pricing information obtained from the factors set forth above depends on the facts and circumstances surrounding the comparison transaction (i.e., whether the dealer in the comparison transaction was on the same side of the market as the dealer is in the subject transaction, timeliness of the information, and, with respect to the final factor listed above, the relative spread of the quotations in the similar security to the quotations in the subject security).
1 The Interpretation does not apply to transactions in municipal securities. Single terms in parentheses within sentences, such as the terms "(sale)" and "(to)" in the phrase, "contemporaneous dealer purchase (sale) transactions with institutional accounts," refer to scenarios where a member is charging a customer a mark-down.