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85-21 Request for Comments on Proposed Rule on Private Securities Transactions
TO: All NASD Members and Other Interested Persons
The National Association of Securities Dealers ("Association" or "NASD") is publishing for comment by members and all other interested persons a proposed rule which would establish new requirements for the private securities transactions of persons associated with member firms. The rule would replace in its entirety the Private Securities Transactions Interpretation under Article III, Section 27 of the NASD Rules of fair practice. 1/
The text of the new rule and the present interpretation are attached. A discussion of the background of the rule and its proposed provisions follows below.
The Association has long been concerned about private securities transactions of persons associated with broker-dealers. These transactions can be generally grouped into two categories: first, transactions in which an associated persion is selling securities to public investors on behalf of another party, e.g., as part of a private offering of limited partnership interests, without the participation of the person's employer firm; and second, transactions in securities owned by the associated person. The first category of transactions presents serious regulatory concerns because securities may be sold to public investors without the benefits of any supervision or oversight by a member firm and perhaps without adequate attention to various regulatory protections such 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 when in fact the firm may be totally unaware of the person's participation in the transaction. Under some circumstances, a firm may be held civilly liable for the actions of their associated person even though the firm was not aware of such person's participation in the transaction. 2/
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 the Interpretation over recent years. It is believed that the existence of the Interpretation has resulted in greater protection as firms have been able to exercise better supervision over their associated persons.
The Interpretation has been a source of substantial confusion, however, because it speaks only to associated persons' responsibilities in notifying member firms and does not specifically address responsibilities of those firms. The Board of Governors' Advisory Council and several District Business Conduct Committees have requested that the Interpretation be amended to clarify firms' responsibilities. After careful study and analysis, the Board has decided to propose a new rule of fair practice to replace the Interpretation.
ANALYSIS OF PROPOSED RULE
The proposed rule, the text of which is attached, would replace in its entirety the Private Securities Transactions Interpretation and would set forth specific responsibilities for associated persons and member firms regarding the handling of such persons' private securities transactions. On the basis of an analysis of regulatory problems regarding private securities transactions, the rule will treat transactions differently depending upon whether the associated person receives selling compensation. In either case, the rule specifies a member firm's responsibilities.
Applicability — The new rule 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. Transactions subject to Article III, Section 28 of the Rules of Fair Practice 3/ and personal transactions in investment company and variable annuity securities are excluded. Because the most frequent regulatory problems occur in connection with private placements of new offerings, those transactions are specifically identified as included within the definition of "private securities transaction."
Written Notice — The rule requires an associated person to provide written notice to the member with which he is associated prior to participating in any private securities transaction. The notice would be required to include a detailed description of the proposed transaction and the individual's proposed role therein. Because the rule treats compensatory transactions differently, it would also be necessary for an associated person to state whether he will receive selling compensation in connection with the transaction.
The present Interpretation requires associated persons to provide written notice to their employers. The new rule, however, would require more detail concerning the transaction and the person's involvement in it.
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 some other non-compensatory arrangement. The most serious regulatory concerns relate to situations in which associated persons are receiving selling compensation and therefore have an incentive to execute sales, perhaps without adequate supervision and without adequate attention to suitability and due diligence responsibilities. The rule would require that, in the case of transactions in which an associated person has or may receive selling compensation, a member receiving written notice from one of its associated persons shall respond to the person in writing indicating whether the firm approves or disapproves of the person's participation in the proposed transaction. If the firm approves of the person's participation, the firm is then required to treat the transaction as a transaction of the firm, to record the transaction on the firm's books and records, and to supervise the 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 a person's participation, the associated person is prohibited from participating in the transaction in any manner.
Transactions Not For Compensation — The Board believes that there may be some transactions in which associated persons participate without compensation which 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 his or her 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 a person proposes to participate in a transaction without compensation to provide that person with written acknowledgment of said 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 provide the employer firm with the right to impose conditions upon each person's participation in non-compensatory transactions and would require that any person 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 one 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 specifically 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 to which one subjects himself upon becoming associated with a broker-dealer. Participation in transactions as a general partner therefore carries with it significant regulatory responsibilities.
* * * *
The Association encourages all members and other interested persons to comment on the rule proposal. Comments should be directed to:
James M. Cangiano
National Association of Securities Dealers, Inc.
1735 K Street, N.W.
Washington, D.C. 20006
Comments must be received no later than April 29, 1985. All comments will be made available for public inspection.
Questions concerning this notice may be directed to Dennis C. Hensley, Vice President and Deputy General Counsel, at (202) 728-8245.
Gordon S. Macklin
PROPOSED NEW RULE OF FAIR PRACTICE
Sec. ____ Private Securities Transactions
National Association of Securities Dealers, Inc.,
1735 K Street, N.W.
Washington, D.C. 2006
March 28, 1985
TO: All NASDAQ Companies
RE: Request for comment on Proposed Corporate Governance Requirements for NASDAQ National Market System Companies
LAST DATE FOR COMMENT: APRIL 28, 1985
The National Association of Securities Dealers, Inc., is requesting comment on proposed rule amendments which would require that companies with securities included in the NASDAQ National Market System (NASDAQ/NMS) adhere to certain standards of corporate governance. This notice contains a discussion of the background of these rules and a section-by-section analysis. The text of the proposed rules is attached.
HISTORY AND BACKGROUND
The publication of the proposed rules is a result of an effort of several months by the NASD Corporate Advisory Board. The Corporate Advisory Board is a body consisting principally of the chief executive officers of NASDAQ companies, chaired by Wilson C. Wearn, Chairman and Chief Executive Officer of Multimedia, Inc., which reports to the NASD Board of Governors. The Advisory Board has played an important role in the evolution of NASDAQ as the fastest-growing and second-largest securities market in the United States, and in the development of NASDAQ/NMS.
Since its inception in 1982, NASDAQ/NMS has grown steadily in size and stature. In November 1984, the Securities and Exchange Commission approved a change to NASDAQ/NMS inclusion criteria which has resulted in a further enhancement in the quality of NASDAQ/NMS companies. As of the end of 1984, the average NASDAQ/NMS company had assets of over $570 million and equity in excess of $84 million. Their revenues averaged $181 million with net income of over $8 million. The average price per share for NASDAQ/NMS issues was in excess of $15 and the average issue had almost 8 million shares outstanding with a public float of 5.8 million shares and a market value in excess of $120 million. NASDAQ/NMS issues had an average of 11.5 market makers in the system.
As NASDAQ/NMS has matured, the Corporate Advisory Board has come to believe that it is appropriate to consider the quality of corporate governance of NASDAQ/NMS companies. This concern has been heightened by numerous state securities administrators who have noted the differences in approach to corporate governance by NASDAQ/NMS and certain of the exchanges. The Corporate Advisory Board believes that the likelihood of achieving a "blue-sky" exemption for NASDAQ/NMS companies in all 50 states will be greatly improved by the implementation of corporate governance criteria.
A special subcommittee of the Corporate Advisory Board chaired by B. Lee Karns, President and Chief Executive Officer of Comprehensive Care Corporation, devoted considerable time during the fall of 1984 to an analysis of corporate governance principles and the propriety of adopting corporate governance standards for NASDAQ/NMS. In January, the subcommittee reported its conclusions to the Corporate Advisory Board and recommended that numerous corporate governance rules be proposed for NASDAQ/NMS and that a survey be conducted of NASDAQ companies concerning additional aspects of corporate governance.
After careful consideration, the Corporate Advisory Board accepted the subcommittee's recommendations and in turn recommended to the NASD Board of Governors that the following corporate governance rules be proposed and that a survey on other possible rules be conducted. The NASD Board of Governors concurred in these recommendations.
SUMMARY OF PROPOSED RULES
The proposed rules, as drafted, would be added to Schedule D to the NASD By-Laws and would become additional criteria for eligibility in NASDAQ/NMS. The rules contain requirements generally similar to those of the New York Stock Exchange and the American Stock Exchange. The proposed rules are summarized below. The text of the rules appears as Exhibit A.
Applicability — The rules would apply to any issuer with a security traded in the NASDAQ/NMS market.
Eligibility — The Corporate Advisory Board contemplates that compliance with the corporate governance rules would be a requirement for a company to be eligible for continued inclusion in NASDAQ/NMS. 1/
Distribution of Annual and Interim Reports — The rules would require issuers to distribute both annual and interim reports to shareholders. Annual reports will be required to be distributed within "a reasonable period of time prior to the company's annual meeting," whereas interim reports would be distributed "within a reasonable time" following filing of required interim financial reports with the SEC or other regulatory authority. For companies required to file Form 10-Q with the SEC, quarterly reports to shareholders (on Form 10-Q or otherwise) would be required. Other companies would be required to provide shareholders with reports reflecting information contained in interim financial reports filed with the appropriate regulatory body.
Independent Directors — The rules would require issuers to maintain a minimum of two independent directors on each company's board. "Independent director" is defined so as to exclude officers or employees of the company or its subsidiaries or any other individual having a relationship which, in the opinion of the Board of Directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director. The determination of independence of any particular director would therefore be left to the judgment of each company's board.
Audit Committees — The rules require an issuer to establish and maintain an audit committee, a majority of the members of which shall be independent directors.
Shareholder Meetings — Companies will be required to hold an annual meeting of shareholders.
Quorum — The rules would require companies to establish a quorum requirement of at least 50% of the outstanding shares for any meeting of the holders of common stock.
Solicitation of Proxies — Issuers would be required to solicit proxies and distribute proxy statements for all meetings of shareholders and file copies of proxy solicitations with the NASD.
Conflicts of Interest — The rules would address situations in which companies may have a conflict of interest in transactions with persons related to the company. The rules would require that companies conduct "an appropriate review" of all related party transactions on an ongoing basis and that the audit committee be utilized for the review of potential conflicts where appropriate.
Listing Agreement — As drafted, the rules would require each NASDAQ/ NMS issuer to execute a listing agreement as prescribed by the NASD. A listing agreement would establish a contractual relationship between each issuer and the NASD.
Effective Date — The rules provide a 12-month "grandfather" period for any NASDAQ/NMS issuer in the system at the time the rules are approved. They would immediately apply to all companies entering the system after they became effective. In addition, the effectiveness of the rules could be delayed for securities entering the system until some reasonable period following approval of the rules.
In view of the fact that some companies may be required to change their corporate charters, comments are specifically requested with respect to the issues of grandfathering and an appropriate phase-in period for the rules.
SANCTIONS FOR NON-COMPLIANCE
The Corporate Advisory Board believes that the appropriate sanction for a NASDAQ/NMS company which fails to meet corporate governance criteria should be deleted from NASDAQ/NMS. Under such an approach, companies deleted from NASDAQ/NMS would remain in NASDAQ. Under present SEC rules, however, any NASDAQ security meeting Tier 1 criteria is mandated to be included in NASDAQ/ NMS and cannot be deleted from NASDAQ/NMS while remaining in NASDAQ. The NASD is submitting Section 2 of the proposed rules for comment with the expectation that these rules will be amended.
SURVEY ON VOTING RIGHTS AND CHANGE OF CORPORATE CONTROL
As noted above, the NASD Board of Governors has also approved a survey of NASDAQ companies on two other aspects of corporate governance. That survey will be sent to all NASDAQ companies in the near future.
The first topic addressed by the survey concerns voting rights. The NASD is not proposing at this time to restrict the voting rights assigned to various classes of stock issued by NASDAQ/NMS companies. As the question of voting rights has assumed greater importance in recent years, the New York Stock Exchange has undertaken a review of its policies in this area. The California Corporations Department is also conducting a review of that state's policies on voting rights. In this environment, it was concluded that the Association should survey NASDAQ companies to determine their views on this important issue.
The second matter included in the survey concerns possible restrictions on a corporation's issuance of stock in connection with a change of control. Certain exchanges restrict the percentage of new shares which a company may issue without shareholder approval. In view of the multiplicity of issues related to such restrictions and the continuing evolution of practices concerning mergers and acquisitions, it was concluded that the Association should obtain more information with respect to NASDAQ companies' views prior to developing specific rule proposals on this question.
NASDAQ companies are urged to review the survey carefully when it is received and return it to the Association with a complete expression of their views.
REQUEST FOR COMMENTS
The Association is requesting comments on the proposed rules prior to final Board consideration. All comments received during this comment period will be reviewed by the Corporate Advisory Board and changes will be recommended as deemed appropriate. The Board of Governors will then reconsider the proposal. If the Board approves the rules or an amended version, they must be filed with, and approved by, the Securities and Exchange Commission before becoming effective.
All written comments should be addressed to:
James M. Cangiano, Secretary
National Association of Securities Dealers, Inc.
1735 K Street, N.W.
Washington, D.C. 20006
All comments must be received by April 28, 1985. Any questions regarding this notice should be directed to either Dennis C. Hensley or T. Grant Callery at (202) 728-8294.
DRAFT CORPORATE GOVERNANCE PROVISIONS AS APPROVED BY THE CORPORATE ADVISORY BOARD
Add new Part II D to Schedule D to the NASD By-Laws as follows; existing sections D and E to be redesignated as E and F respectively.
D. Rules for Issuers of NASDAQ National Market System Securities
No security shall be eligible for inclusion in the NASDAQ National Market System unless the issuer of said security is in compliance with this Part II D.
Each NASDAQ/NMS issuer shall maintain a minimum of two independent directors on its board of directors. For purposes of this section,'"- dependent director" shall mean a person other than an officer or employee of the company or its subsidiaries or any other individual having a relationship which, in the opinion of the board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director.
Each NASDAQ/NMS issuer shall establish and maintain an Audit Committee, a majority of the members of which shall be independent directors.
Each NASDAQ/NMS issuer shall hold an annual meeting of shareholders and shall provide notice of such meeting to the Corporation.
Each NASDAQ/NMS issuer shall provide in its by-laws for a quorum for any meeting of the holders of common stock of at least 50% of the outstanding shares of the company's common voting stock.
Each NASDAQ/NMS issuer shall solicit proxies and provide proxy statements for all meetings of shareholders and shall provide copies of such proxy solicitation to the Corporation.
Each NASDAQ/NMS issuer shall conduct an appropriate review of all related party transactions on an ongoing basis and shall utilize the company's Audit Committee as a forum for the review of potential conflict of interest situations where appropriate.
Each NASDAQ/NMS issuer shall execute a Listing Agreement in the form designated by the Corporation.
This Part n D shall apply to any issuer which first has a security desig nated as a national market system security after______, and shall become effective as to any other NASDAQ/NMS issuer on [twelve months after approval].
1/ NASD Manual (CCH), p, 2109-2,
2/ This concern has been addressed in earlier NASD notices. See Notices to Members 82-39 (June 15, 1982), and 80-62 (December 1, 1980).
3/ Section 28 requires associated persons who handle personal securities transactions through a member (the "executing member") other than their employer to notify the executing member of their regulated status. That member is then required to notify the employer member of each person's activity. See NASD Manual (CCH), paragraph 2178.
1/ This approach is discussed further on in connection with sanctions.