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85-54 Proposed New Rule of Fair Practice Relating to Private Securities Transactions
IMPORTANT MAIL VOTE
OFFICERS, PARTNERS AND PROPRIETORS
TO: ALL NASD Members
LAST VOTING DATE IS SEPTEMBER 13, 1985
Enclosed is a proposed addition to Article III of the NASD's Rules of Fair Practice. The proposed new rule has been approved by the Board of Governors and now requires the membership's approval,
The rule would establish new requirements for the private securities transactions of persons associated with members, and would entirely replace the private Securities Transactions Interpretation under Article III, Section 27 of the Rules of Fair Practice.
If approved, the rule must then be filed with and approved by the Securities and Exchange Commission. As discussed below, the proposed rule was published for membership comment on March 29, 1985 (Notice to Members 85-21).
The text of the new rule is attached as Exhibit 1. The text of the Private Securities Transactions Interpretation is attached as Exhibit 2,
The NASD has long been concerned about the private securities transactions of persons associated with broker-dealers. These transactions can generally be grouped into two categories.
The first category of transactions presents serious regulatory concerns because securities may be sold to public investors without the benefit of supervision or oversight by a member firm and perhaps without adequate attention to such regulatory protections as due diligence investigations and suitability determinations. In some cases, investors may be misled into believing that the associated person's firm has analyzed the security being offered and "stands behind" the product and transaction. The firm in fact may be unaware of the associated person's participation in the transaction. Under some circumstances, the firm may be liable for the actions of the associated person even though the firm was not aware of his or her participation in the transaction. 1/
In view of these concerns, the NASD promulgated the Private Securities Transactions Interpretation several years ago. The Interpretation requires associated persons to notify their employer firms prior to participating in private securities transactions. A significant number of associated persons have been disciplined by the NASD for violation of this Interpretation in recent years. It is believed that the existence of the Interpretation has allowed firms to exercise better supervision over their associated persons.
The Interpretation has been a source of substantial confusion, however, because it addresses only the responsibility of associated persons to notify their member firms of such transactions. It does not specifically address the supervisory and oversight responsibilities of the firms. The Board of Governors' Advisory Council and several District Business Conduct Committees have requested that the Interpretation be amended to clarify firms' responsibilities in this area. After careful study, the Board has decided to adopt a new rule of fair practice to replace the Interpretation.
The rule is designed to set forth specific responsibilities for associated persons and member firms regarding the handling of associated persons' private securities transactions. Based on an analysis of regulatory problems regarding private securities transactions, the rule would treat transactions differently depending upon whether the associated person receives selling compensation. In either case, the rule specifies the responsibilities of member firms.
As previously noted, the NASD published the proposed rule on private securities transactions for comment in Notice to Members 85-21 (March 29, 1985). Twenty-five comments were received. Two writers opposed the proposed rule as an abridgment of the rights of registered representatives to engage in legitimate private transactions. Seven encouraged the adoption of the rule as drafted. Five urged that the rule be strengthened by, for example, requiring the member firm to confirm private securities transactions similar to the way it confirms its own transactions, or by expanding the rule's application beyond securities transactions to all private transactions for compensation. Eleven commentators concurred generally with the proposal but suggested some change.
In response to the comments received, and following further consideration of the proposed rule, the Board of Governors made two amendments to the rule. These changes are noted in the following analysis.
ANALYSIS OF THE PROPOSED RULE
Applicability — The new rule, the text of which is attached as Exhibit 1, would apply to any situation in which an associated person of a member proposes to participate in any manner in a private securities transaction.
"Private securities transaction" is defined broadly, and generally parallels the concept in the present Interpretation. (See Exhibit 2.) Transactions subject to Article III, Section 28 of the NASD Rules of Fair Practice 2/ and personal transactions in investment company and variable annuity securities are excluded. Upon further consideration, the Board amended the rule as originally proposed to exclude also those transactions among immediate family members (as defined in the Interpretation of the Board of Governors on Free-Riding and Withholding 3/) for which no associated person receives any selling compensation. Because regulatory problems most frequently occur in connection with private placements of new offerings, those transactions are specifically included within the definition of "private securities transaction."
Written Notice — The present Interpretation requires associated persons to provide written notice of such transactions to their employers. The new rule also would require written notice to the employer member by the associated person prior to participating in any private securities transaction; however, under the new rule, the notice would be required to include a detailed description of the proposed transaction and the individual's proposed role therein. Because the rule would treat compensatory and noncompensatory transactions differently, it would also be necessary for the associated person to state whether he or she will receive selling compensation in connection with the transaction.
Transactions for Compensation — As noted above, the Board of Governors has concluded that it is important to draw a distinction between transactions in which persons receive selling compensation and those handled as an accommodation or under another noncompensatory arrangement. The most serious regulatory concerns relate to situations in which associated persons receive selling compensation and therefore have an incentive to execute sales, perhaps without adequate supervision or adequate attention to suitability and due diligence responsibilities.
For transactions in which an associated person has or may receive selling compensation, the rule would require that a member receiving written notice from its associated person respond to him or her in writing, indicating whether the firm approves or disapproves of his or her participation in the proposed transaction. If the firm approves of the associated person's participation, the firm would then be required to treat the transaction as its own, to record the transaction on the firm's books and records, and to supervise the associated person's participation in the transaction to the same extent as if the transaction were executed on behalf of the firm.
If the firm disapproves of the associated person's participation, he or she would be prohibited from participating in the transaction in any manner.
Transactions Not For Compensation — The Board of Governors believes that there may be some transactions in which associated persons participate without compensation that should not be subjected to the same level of scrutiny as other transactions. For example, a salesperson may own stock in a closely held family corporation and wish to transfer that stock to another family member. While the firm should be made aware of such a transaction, it appears unnecessary to treat that type of transaction as a transaction of the employer firm.
Accordingly, the new rule would require a member receiving notice that an associated person proposes to participate in a transaction or a series of related transactions 4/ without compensation to provide the associated person with written acknowledgment of the submitted notice.
The NASD has consistently taken the position that firms must be able to supervise and regulate effectively each associated person's securities activities. The rule would therefore give the employer firm the right to impose conditions upon each associated person's participation in noncompensatory transactions and would require that he or she adhere to such conditions. It is intended that a firm would have full discretion to utilize this authority to restrict its associated persons' private securities activities, including activities performed on a non-compensatory basis.
Definition of Selling Compensation — The definition of "selling compensation" plays a key role in the proposed rule. Because the treatment of transactions varies significantly depending upon whether selling compensation is to be received, the definition of "selling compensation" is deliberately broad in its scope.
The definition includes "any compensation paid directly or indirectly from whatever source in connection with or as a result of the purchase or sale of a security." Certain examples are provided, including commissions, finder's fees, securities, and rights of participation in profits, tax benefits, or dissolution proceeds as a general partner or otherwise. While these examples are intended to include some of the most common forms of compensation, the definition is not intended to be restricted to those examples but rather to include any item of value received or to be received directly or indirectly.
It is important to note that the definition of "selling compensation" includes compensation received or to be received by anyone acting in the capacity of either a salesperson or in some other capacity, specifically including the capacity of a general partner. The definition is intended to address a practice in which associated persons function as general partners in forming limited partnerships and then sell limited partnership interests in private securities transactions. Any involvement in a securities transaction by an associated person of an NASD member firm may be subject to the panoply of regulatory requirements applicable to persons associated with a broker-dealer. Participation in transactions as a general partner, therefore, carries with it significant regulatory responsibilities.
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The Board of Governors believes this proposed new rule of fair practice is necessary and appropriate. It recommends that members vote their approval.
Please mark the attached ballot according to your convictions and return it in the enclosed, stamped envelope to "The Corporation Trust Company." Ballots must be postmarked no later than September 13, 1985.
Questions concerning this notice may be directed to Dennis C. Hensley or Phillip A. Rosen, NASD Office of the General Counsel, at (202) 728-8446.
Gordon S. Macklin
PROPOSED NEW RULE OF FAIR PRACTICE *
Section _: Private Securities Transactions
INTERPRETATION OF THE NASD BOARD OF GOVERNORS ON PRIVATE SECURITIES TRANSACTIONS *
The Board of Governors, under its obligation to "prevent fraudulent and manipulative acts [and] practices and to promote just and equitable principles of trade," believes it should again emphasize to members their continuing responsibility to exercise appropriate supervision over associated personnel and, in particular, to emphasize to such personnel their responsibilities of good faith to the member and its customers. For purposes of this Interpretation, private securities transactions shall include securities transactions which involve a limited number of purchases or sales (as contrasted, for example, with transactions involving public offerings registered with the SEC) and other investment transactions involving associated personnel which may mislead customers or participants into believing the transactions are sponsored by the member.
Depending upon all the facts and circumstances, private securities transactions effected outside the usual or normal course or scope of employment and nowhere reflected on broker-dealer books and records may expose the participants to charges of serious violations of federal securities laws, as well as industry rules and regulations, and to civil liability. In some instances, severe sanctions have been imposed on registered and associated personnel for engaging in private securities transactions effected outside the scope of their association and nowhere reflected on broker-dealer books and records.
Persons associated with a member should also be aware that their involvement in private securities transactions outside the scope of their association with a member may raise serious questions regarding their need to register as broker-dealers and/or investment advisers under state and federal securities laws. In addition, effecting private securities transactions without disclosure to the member deprives the member of an ability to supervise the securities transactions of persons associated with it thereby making it difficult for the member to exercise its obligation of good faith in its dealings with its customers.
Accordingly, the Board of Governors has determined that no person may be involved in any way with a private securities transaction outside the regular course or scope of his association or employment without prior notice to the member with whom he is associated. To insure compliance with this determination, the member may, at its option, request duplicate copies of all documents and statements related to such transactions. It shall be the duty of any person associated with a member to promptly comply with such a request.
Personal securities transactions with another member of the Association, which transactions are properly recorded on the books of the executing member and which are subject to the notification requirements of Article III, Section 28 of the Rules of Fair Practice, are not considered to be private securities transactions for the purposes of this Interpretation. Purchases or redemptions of variable contracts or redeemable securities of companies registered under the Investment Company Act of 1940, for the personal account of the person associated with a member, are also not considered to be private securities transactions for purposes of this Interpretation.
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The following Interpretation of Article III, Sections 1, 27, and 28 of the Association's Rules of Fair Practice is adopted by the Board of Governors of the Association pursuant to the provisions of Article VII, Section 3(a) of the Association's By-Laws and Article I, Section 3 of the Rules of Fair Practice.
It shall be deemed conduct inconsistent with just and equitable principles of trade for any person associated with a member to engage in a private securities transaction outside the regular course or scope of his association or employment with a member, for himself, or with or for any other person without prior written notification to the member. In order for that member to exercise supervision over such transactions, it may request duplicate copies of all confirmations and other documents or other information related to such transactions from the person notifying the member, and it shall be deemed conduct inconsistent with just and equitable principles of trade for this person to fail to promptly comply with such request.
1/ This concern has been addressed in earlier NASD notices. See Notices to Members 82-39 (June 15, 1982) and 80-62 (December 1, 1980).
2/ Section 28 requires associated persons who handle personal securities
transactions through a member other than their employer (the "executing member") to notify the executing member of their employment with another member of the NASD. The executing member is then required to notify the employer member of all of the associated person's activity. See NASD Manual (CCH) 112178.
3/ NASD Manual (CCH) p. 2045.
4/ The Board of Governors added the phrase "or a series of related transactions" to the rule as originally proposed to allow associated persons to report a series of related transactions without compensation in a single notice.
* All language is new. This rule would replace the Private Securities Transactions Interpretation under Article III, Section 27 of the NASD Rules of Fair Practice. See Exhibit 2.
* This Interpretation is proposed to be deleted in its entirety.