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87-62 NASD Board of Governors' Decision Concerning Regulation of Market Making by Issuer Affiliates
TO: All NASD Members and Other Interested Persons
In Notice to Members 87-25, dated April 14, 1987, the NASD requested comments and suggestions on the concept of a rule that would restrict broker-dealers affiliated with issuers from making markets or trading in the securities of those issuers.
The NASD's request was the result of concerns as to whether conflicts of interest may exist or whether rule violations are more likely when broker-dealers engage in making markets or trading in securities issued by affiliates.
At its July 1987 meeting, the NASD Board of Governors considered the comments received in response to Notice to Members 87-25. The Board of Governors decided that, at this time, no restrictions should be placed on trading in proprietary products, such as limited partnerships, closed-end investment companies, unit investment trusts, or in mortgage-backed, asset-backed, and other pass-through instruments. However, the Subcommittee on Market Making by Issuer Affiliates will continue to consider the need for rulemaking to prevent trading abuses that might arise due to market making by a member in the common stock of its parent or other affiliate.
In January 1987, the Subcommittee on Market Making by Issuer Affiliates (Subcommittee) was created as a result of questions that arose late last year concerning situations in which members were, or were proposing to begin, making markets in NASDAQ securities issued by the firms' parents or affiliated issuers.
Upon the Subcommittee's recommendation, the NASD issued Notice to Members 87-25 (Notice) on April 14, 1987, requesting comments and suggestions on the concept of a rule that would restrict broker-dealers affiliated with issuers from making markets or trading in the securities of those issuers. The Notice pointed out that both the Securities Act of 1933 (Securities Act) and the Securities Exchange Act of 1934 (Exchange Act) contain numerous requirements that must be satisfied before an affiliate of an issuer can engage in such transactions. The Notice also stated that while some self-regulatory organizations restrict member broker-dealer activity in their own securities and those of affiliates,1/ the NASD currently does not have a rule that specifically prohibits or restricts trading by members in securities of their affiliates. Further, the Notice stated that the NASD had not formulated a specific approach on the regulation of trading by issuer affiliates and that it was soliciting comments on approaches that should be considered.
RESPONSE TO NASD NOTICE TO MEMBERS 87-25
The NASD received 42 comment letters in response to its Notice.2/ Six commentators favored the concept of a rule that would restrict market making by affiliates; 18 commentators said they would favor such a rule only if certain exemptions and/or restrictions were included in the rule's provisions; and 18 commentators opposed the concept of such a rule, citing various reasons.
Many of the commentators opposing the rule concept questioned whether such a rule should be promulgated, absent data evidencing the need for such a rule governing specific types of securities. Some also believed that existing regulatory provisions adequately regulate trading by affiliates in issuer securities. These commentators pointed to the existing disclosure and suitability requirements imposed under the federal securities laws and by the NASD Rules of Fair Practice as sufficient safeguards to protect investors and to guard against adverse effects of an affiliate's trading in the securities of an issuer.
Many commentators, while not opposing or favoring the rule concept, focused instead on exemptions or restrictions that they believe should be included in such a rule proposal. Several commentators believed that the provisions of any rule should exempt or exclude trading in proprietary products such as investment company products, limited partnerships, mortgage-backed, asset-backed, or other pass-through instruments. They believed that these products, and any conflicts related to trading in them, are already closely regulated.
SUBCOMMITTEE'S RECOMMENDATIONS AND BOARD APPROVAL
The Subcommittee on Market Making by Issuer Affiliates reviewed the comments received and considered the existing federal and NASD regulatory provisions pertaining to market making by affiliates. The Subcommittee then recommended to the NASD National Business Conduct Committee (NBCC) and to the NASD Board of Governors that no restrictions should be placed, at this time, on proprietary products or pass-through instruments, such as limited partnerships, closed-end investment companies, unit investment trusts, or on mortgage-backed and asset-backed instruments.
Notwithstanding its recommendation to the NBCC, the Subcommittee believes that it may be necessary to restrict market making by a member in its common stock, or that of its parent corporation or an affiliate.
The NBCC concluded that the Subcommittee should continue to consider the need for rulemaking and to provide recommendations on how the NASD should regulate market making by issuer affiliates in the future. The NASD will publish for comment any proposals developed by the Subcommittee that are approved by the NASD Board of Governors.
The NASD Board approved the Subcommittee's recommendations, concluding that the NASD should not at this time apply any further restrictions on affiliates' trading in proprietary products or pass-through instruments, including asset-backed instruments.
Provisions in the federal securities laws and in NASD rules govern a market maker trading in its issuer's common stock. Among the federal regulatory provisions, Section 5 of the Securities Act prohibits the use of interstate commerce to sell any security unless a registration statement has been filed with and declared effective by the Securities and Exchange Commission (SEC).3/ Resales in market-making transactions by an affiliate of an issuer of securities acquired in the open market may be subject to the registration provisions of Section 5. Members should consult their counsel to determine the applicability of this section to their activities.
In addition, Section 10 under the Exchange Act contains prohibitions against manipulating securities prices. Rule 10b-5 under Section 10 of the Exchange Act proscribes using manipulative or deceptive devices in the trading of securities and the fraudulent use of inside information in connection with the purchase or sale of any security. Trading by a firm in its own securities or in the securities of an affiliate presents serious concerns about the potential for misuse of non-public information and creates a need for the firm to focus particular attention on its mechanisms to guard against such abuse.
As indicated by several commentators, SEC Rules 10b-6 and 1 Ob-18 under the Exchange Act provide significant safeguards against market manipulation by an issuer's affiliates. Rule 10b-6 prohibits trading by persons interested in a distribution, and Rule 10b-18 regulates purchases of certain equity securities by the issuers of the securities and others. In addition, Rule 15c 1-5 under Section 15 of the Exchange Act requires that broker-dealers in the over-the-counter market disclose that they are trading in an affiliate's securities.
Schedule E to the NASD By-Laws regulates the distribution of securities of members and their affiliates, defines "affiliation," and ensures the fair pricing of securities. Article III, Section 13 of the NASD Rules of Fair Practice requires that a member disclose to a customer the firm's affiliation with the issuer of a security before engaging in the purchase or sale of those securities on behalf of the customer. The NASD Rules of Fair Practice also require that the business practices of members in connection with the investment banking and securities business shall be just and equitable.
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Members that propose to make markets in their own securities or in the securities of affiliates are strongly encouraged to consult counsel to ensure compliance with all applicable regulatory requirements.
While these regulatory provisions seem to provide substantial investor protection and guidance to market-maker affiliates and issuer corporations with regard to their obligations to customers and to the marketplace, any specific concerns that may arise in the future regarding market making by issuer affiliates will be brought to the attention of the Subcommittee for its review.
Questions concerning this notice may be directed to Eneida Rosa, NASD Assistant General Counsel, at (202) 728-8294.
Frank J. Wilson
Executive Vice President and General Counsel
1/ See, for example, New York Stock Exchange Rule 3 12(g).
2/ Thirty-one comment letters were from investment firms, five were from law firms, three were from industry associations, and the others were from a bank, an insurance company, and a government organization.
3/ The requirements of Section 5 under the Securities Act should be read in conjunction with the definitions in Section 2 and the exemptive-transaction provisions in Section 4. Section 2 also delineates categories of persons who may be involved in a transaction in securities covered by the registration requirements of the Securities Act.