April 6, 1999
Margaret H. McFarland
Securities and Exchange Commission
450 Fifth Street NW
Washington, D.C. 20549
Re: Proposed NASD Recommendation Rule 2315, File No. SR-NASD-99-4
Dear Ms. McFarland:
The Federal Regulation Committee and Self-Regulation Committee ("the Committees") of the Securities Industry Association ("SIA") appreciate the opportunity to submit this comment letter in response to NASD proposed rule 2315, Recommendations to Customers in OTC Equity Securities ("Recommendation Rule"). Brokers have a well-established obligation under the law to have an adequate basis for recommendations. While the Recommendation Rule in its current form is flawed, with the changes that we suggest below we believe that proposed rule 2315 would be a useful amplification of what this obligation requires in the context of OTC equity securities.
The proposed rule is intended to reduce the potential for manipulation and other abuses of "microcap" securities due to a lack of reliable and current financial information about the issuers of these securities. Attacking microcap fraud is a very worthy regulatory goal. Thousands of small entrepreneurial companies depend on these markets for growth capital. Microcap securities have been prone to abuse by dishonest promoters, and investors, legitimate companies and reputable broker-dealers have been harmed as a result.
In response to concerns raised by the Committees and other commenters to an earlier iteration of the Recommendation Rule published in NASD Notice to Members 98-15, the NASD has revised the proposal to narrow the range of securities covered, from essentially all OTC equity securities, including those of some of the world's largest corporations, to categories of securities that more closely comport to what one might reasonably regard as "microcap" securities. The Committees appreciate the NASD's effort to narrow the scope of the rule and believe that this change reduces many of the concerns that we raised that the proposed rule would unduly hamper markets as to which concerns about "microcap" abuses do not pertain.
In several other respects, the Committees continue to have concerns about unnecessary ambiguities and the possible unintended consequences of the proposed rule. These consequences could make the rule less effective, or possibly even counterproductive. The Committees believe that changes to address the concerns noted below will be necessary if the proposed Rule is to achieve its intended effect of addressing abuses in the "microcap" market.
AMBIGUITIES AND DRAFTING CONCERNS.
Rule 2315 would require that, when a member "recommends" a transaction in specified categories of OTC "equity" securities that are "published or quoted in a quotation medium," the member must have reviewed current financial statements of, and current business information about" the issuer, and make a determination that "such information, and any other information available, provides a reasonable basis under the circumstances" for the recommendation.
Each of the phrases quoted above contains ambiguities or unintended consequences that could unduly hinder normal brokerage activities. We address each in sequence.
"Recommendation." In response to the request by the Commission for comment on whether there should be an exemption from proposed Rule 2315 for recommended sales transactions in OTC equity securities, the Committees believe that such an exemption would be warranted. Any potential regulatory barrier to a broker's ability to urge a client to exit from a security would make it harder to quickly extricate a customer from what the broker may suspect is a pump-and-dump scheme, for example.
"Equity Securities." It is not clear whether the Rule is intended to apply to convertible securities. In its pending proposed amendments to Rule 15c2-11 the Commission proposes to exclude convertible securities if the underlying security meets an average daily trading volume test. The Committees believe that the two rules, both addressed to curbing abuses in microcap securities, should contain similar exclusions for non-microcap securities.
"Published or Quoted in a Quotation Medium." The phrase "published or quoted in a quotation medium" and its accompanying definition are inappropriately broad, especially coupled with a statement in the accompanying release that "such systems would include Web sites, issuer trading services, and other member or non-member systems that provide this data to the public." Given the trends in technology and market evolution toward global markets where enormous reservoirs of information are dispersed over an increasingly vast Internet and other electronic media, it is impossible for a broker-dealer to have certainty that it knows at all times whether a given security is the subject of quotations or indications of interest on a Web site, or in a foreign market, such that the obligations of the Recommendation Rule are triggered.
To address this concern, the Committees recommend that the Rule should require that a member have actual knowledge that a security is being published or quoted in a quotation medium before the review requirement is triggered. In addition, we suggest that, like the pending proposed changes to SEC Rule 15c2-11, the definition of "quotation medium" should be limited to quotation mediums that disseminate quotations of broker-dealers. We also recommend that the definition be limited to quotation mediums that give priced quotations.
"Current Financial Statements." The Recommendation Rule's definition of "current financial statements" is not well tailored to foreign issuers that report on a semi-annual rather than a quarterly basis. Section (a)(2) states that "current financial statements" includes a balance sheet as of a date less than 16 months prior to the date of the recommendation, and if the balance sheet is six months old or older, additional statements of profit and loss for the period from the date of the balance sheet to a date less than six months prior to the recommendation. On this basis, broker-dealers would be arbitrarily barred for significant periods of time from recommending equity securities of issuers that report on a semi-annual basis. This would impair access of U.S. investors to foreign OTC equity securities offerings. To avoid this result, the Committees recommend that the six-month period in Section (a)(2)(C) be changed to conform to the periods provided in the proposed amendments to Rule 15c2-11, which have been drafted in a way that satisfies our concerns.
Equally troubling is the requirement in Section (a)(2)(D) that the review encompass "financial statements and other financial reports" filed during the 12 months preceding the recommendation "with any regulatory authority," domestic or foreign. As written, this requirement could potentially include an endless array of reports, such as tax filings, filings with trade authorities, and even filings with environmental or labor regulators. Moreover, it could encompass filings that are not publicly available. This provision would more workably achieve its goal if it were limited to a requirement to review publicly available financial statements and other financial reports filed with the issuer's principal securities regulatory authority in its home country. A similar concern arises with the provision of Section (b) concerning inquiry into the reasons why an issuer has not made current regulatory filings "required by any regulatory authority."
Lack of public access is also a significant problem with Section (a)(2)(E)'s requirement that broker-dealers review all financial information "provided in connection with" exempt offerings under Rules 505 or 506, and Regulation A, to the extent that information is not publicly available. This information is not publicly filed, and is generally only available from the issuer or underwriter. Obtaining the information is therefore particularly burdensome on both the broker-dealer and the issuer. It may also place the issuer in a position to inappropriately affect the market for its securities by withholding financial information from broker-dealers who it believes will make "sell" recommendations. This may also place the underwriter in an enhanced position to make a market in the security, to the detriment of competition from other broker-dealers.
"Current Business Information and Any Other Information Available." The Recommendation Rule provides no guidance as to what "current business information about" the issuer should be reviewed. "Current business information" about a biotechnology company, for example, could mean almost anything, and could be available piecemeal in thousands of locations, on the Internet, in research publications and elsewhere. Assessing much information that could be deemed "business information," such as the status of a patent application or publication of a research paper, could require professional training and expertise that few if any broker-dealers could reasonably be expected to have. The gloss "and any other information available" heightens the concern that this obligation is boundless. At a minimum, for this provision to be workable, it should be limited to a reasonable review of current business information that the broker-dealer knows or should know at the time of its review is material. The modifier "and any other information available" should be deleted.
"Determination that Current Information Provides a Reasonable Basis." The Recommendation fails to provide any guidance on how frequently a broker-dealer must make a determination that currently available information provides a reasonable basis for its recommendation. "Current business information" about a company, and "other information available" change daily, or hourly, and impact stock price throughout the trading day. It is not clear what, if any, "shelf-life" a broker-dealer could give to its determination under the Rule. If broker-dealers must re-review all available information about an issuer on a monthly, weekly, or daily basis, it will simply not be cost-effective to recommend many securities, and broker-dealers are likely to restrict their recommendations to larger issuers, i.e., issuers outside the Rule's coverage. Guidance on what "current" means and how long a determination can be viewed as providing a reasonable basis are essential to the Rule achieving its purpose. As a general matter, we suggest that the Rule should be satisfied if a review is conducted at least every six months.
In addition to our concerns with the current wording of the Recommendation Rule discussed above, the Committees have several other concerns and suggestions for improvement to the Recommendation Rule.
Research Subject to New York Stock Exchange Requirements. New York Stock Exchange members are already subject to a separate standard for review of research prior to recommending a security under New York Stock Exchange Rule 472. Consequently, the Committees recommend that research subject to the New York Stock Exchange requirements be excluded from the Recommendation Rule.
Brokers Subject to Other Express Duties. In many circumstances, brokers making recommendations to customers are subject to other express regulatory obligations. For example, registered investment advisers making recommendations for fee-based customer accounts are subject to both the Investment Advisers Act and state law fiduciary obligations. Brokers acting in dual regulatory capacities such as this do not require another layer of regulatory requirements and should be excluded from Rule 2315.
Review Requirement. The Recommendation Rule is unduly restrictive in specifying that the review be conducted by a registered individual. In the case of foreign securities, broker-dealers with foreign affiliates may more effectively be able to meet their obligation by relying on personnel of a foreign affiliate to conduct the review. Such a person should be able to conduct the review if the U.S. broker-dealer can demonstrate that he or she has the requisite skills, background and knowledge.
Exemption for Securities With Audited Balance Sheets Less Than Six Months Old. The Committees wish to point out what we believe is an oversight in Section (e)(3) of the Recommendation Rule. That provision exempts from the Rule transactions in securities if the issuer has $100 million in assets and $10 million in shareholder's equity reflected in its most recent audited balance sheet, "which balance sheet should be of a date within six months prior to the recommendation." Public companies are generally audited once a year. This requirement, therefore, would eliminate the exemption for six months of each year. Since audited financial statements are often issued three months after the date that they reflect (six months in the case of many foreign private issuers), in order for this provision to work the balance sheet would have to be of a date within 15 months prior to the recommendation (18 months in the case of foreign private issuers).
Other Exempt OTC Equity Securities. As noted above, the Committees applaud the NASD for trying to delimit the types of small-capitalization securities as to which the Recommendation Rule should apply. Section (e) of the Rule goes far toward achieving this goal, with the exception concerning the date of audited balance sheets under Section (e)(3) noted above. In addition, the Committees respectfully suggest that, for consistency, the Rule should except securities with an average daily trading volume of $100,000 or more, as the Commission proposes to do in its pending proposed amendments to Rule 15c2-11.
We also believe that the $100 million asset test seems high for an issuer that bears the label "microcap," and we suggest lowering that test to $25 million. The $100 million test seems especially high for newly public companies, where assets would have to be measured as of a date before the public offering. It is often the case, especially with regard to newly public technology companies, that the company's asset value is significantly higher after the public offering than before. To cite one celebrated company, Amazon.com had $11 million in assets in its last audited balance sheet prior to going public, but had $61 million in assets on a pro forma basis after the offering. While our suggested $25 million test would not have been low enough to help broker-dealers recommending Amazon.com, we believe that a $25 million threshold is more appropriate than $100 million to reflect many legitimate newly public companies.
Impact on Competition. The Committees respectfully disagree with the NASD's assessment that its proposal would impose no inappropriate burden on competition. As noted above, the Committees have highlighted a number of presumably unintended consequences and ambiguities in the Recommendation Rule. In the aggregate, these concerns could create significant compliance costs and legal risks, discouraging broker-dealers from recommending microcap securities. By withdrawing advice to customers about microcap securities, many sectors of this market could lose significant liquidity, and become less competitive and more prone to abuse.
In addition, the requirement under Section (a)(2)(E) that broker-dealers review information concerning exempt offerings under Rules 505 or 506 of Regulation D would adversely affect market-making competition in those markets, and could provide issuers with the ability to hinder sell-side recommendations, distorting the value of those securities upwards.
The Committees appreciate the opportunity to comment on proposed NASD Rule 2315. The Committees fully share the NASD’s concern with eradicating fraud and abusive practices involving microcap securities. As discussed above, we believe that with the modifications that we suggest, proposed Rule 2315 could be a helpful step toward that goal without unnecessarily impeding liquidity or investment opportunities. If
we can be of further assistance, please do not hesitate to contact the undersigned, or George Kramer at 202/296-9410.
Lee B. Spencer, Jr., Chairman
R. Gerald Baker, Chairman
Federal Regulation Committee
cc: The Honorable Arthur Levitt, Chairman;
The Honorable Norman S. Johnson, Commissioner;
The Honorable Isaac C. Hunt, Jr., Commissioner;
The Honorable Paul R. Carey, Commissioner;
The Honorable Laura S. Unger, Commissioner;
Annette L. Nazareth, Director, Division of Market Regulation;
Robert L.D. Colby, Deputy Director, Division of Market Regulation;
Catherine McGuire, Associate Director and Chief Counsel, Division of Market Regulation;
Katherine England, Assistant Director, Division of Market Regulation
Mary N. Revell, Associate General Counsel, NASD Regulation
Sara Nelson Bloom, Associate General Counsel, The Nasdaq Stock Market