SECURITIES AND EXCHANGE COMMISSION Washington, D.C. SECURITIES EXCHANGE ACT OF 1934 Rel. No. 38893 / August 1, 1997 Admin. Proc. File No. 3-8801 In the Matter of the Application of RAYMOND JAMES & ASSOCIATES, INC. For Review of Disciplinary Action Taken by the NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC. OPINION OF THE COMMISSION REGISTERED SECURITIES ASSOCIATION -- REVIEW OF DISCIPLINARY PROCEEDINGS Violations of Rules of Fair Practice Conduct Inconsistent with Just and Equitable Principles of Trade Excessive Markups Member firm of registered securities association was charged with excessive markups in the sale of direct participation program securities to customers. Held, association's findings of violation and sanctions it imposed vacated and proceeding remanded. APPEARANCES: Paul L. Matecki, for Raymond James & Associates, Inc. T. Grant Callery and Norman Sue, Jr., for the National Association of Securities Dealers, Inc. Appeal filed: September 5, 1995 Briefing completed: January 16, 1996 I. Raymond James & Associates, Inc. ("Raymond James" or the "Firm"), a member of the National Association of Securities Dealers, Inc. ("NASD"), appeals from NASD disciplinary action. The NASD found that Raymond James charged its customers unfair markups in the sale of direct participation program ("DPP") limited partnership securities, in violation of Article III, Sections 1 and 4 of the NASD's Rules of Fair Practice (the "Rules"). <(1)> The NASD censured Raymond James and ordered it to pay restitution in the amount of $44,745.66, plus interest, to the appropriate customers. <(2)> The NASD ordered that, in the event that customers could not be located and compensated within 90 days, any amounts to be paid in restitution would be made payable to the NASD as a fine. Any findings in this decision are based on an independent review of the record. II. The NASD's Rules require that, when a member sells securities to a customer from its own account, the price must be fair. The NASD's Mark-Up Policy states that it is inconsistent with just and equitable principles of trade for any member to enter into a securities transaction with a customer at a price "not reasonably related to the current market price of the security." <(3)> This key phrase, "reasonably related to the current market price," is thus the measure of fairness. We have held that, unlike other dealers, a market maker in an active competitive market may use the bid or offer-side of the market (as appropriate and if validated) for determining the prevailing market price. <(4)> To be a market maker a broker-dealer must, among other things, advertise its willingness to buy and sell securities for its own account and stand ready to buy and sell to other dealers at its quoted prices. In any event, we must evaluate the retail price in relation to the prevailing market price to assess its fairness. Raymond James asserts that the NASD incorrectly determined that it was not a market maker. The Firm also contends that the NASD improperly relied on historical cost to establish the prevailing market price. In addition, Raymond James asserts that the NASD committed error when it held the Firm <(1)> The NASD recently revised and renumbered its Rules of Practice. Section 1 of the Rules [new Rule 2110] requires the observance of "high standards of commercial honor and just and equitable principles of trade." Section 4 [new Rule 2440] requires that prices charged to customers in over-the-counter principal transactions be "fair, taking into consideration all relevant circumstances . . . ." Section 34 [new Rule 2810] defines a DPP as a program which "provides for flow-through tax consequences regardless of the structure of the legal entity or vehicle for distribution" including, but not limited to, real estate programs. <(2)> The NASD also assessed costs. <(3)> The Interpretation of the Board of Governors regarding NASD Mark-up Policy [new IM-2440]. <(4)> Adams Securities, Inc., 51 S.E.C. 311, 313 (1993). If a broker-dealer is not a market maker, the price paid in contemporaneous purchases generally is an appropriate measure of the prevailing market price. ======END OF PAGE 2====== responsible under the NASD's Mark-Up Policy for transactions with its affiliates, since the Policy is limited to retail transactions with customers. III. Raymond James first engaged in secondary trading of DPP securities in late 1985. From that time, Raymond James held itself out as a market maker for DPP securities. Raymond James bought and sold DPP securities for its own account. In addition, Raymond James published its offer quotations in the Weekly Investment Digest, distributed offer sheets to other dealers, and encouraged financial publications to publish its quotations. The DPP securities at issue traded in an illiquid market, at prices that were at deep discounts to the original offering prices. There was little available information about contemporaneous transactions in a particular security. To set the prices at which it would buy or sell a particular DPP security, Raymond James employed research analysts to evaluate DPP securities. The analysts would review information provided by the particular issuer and data from independent services that reported actual purchases or sales of comparable real properties. The analysts then arrived at a "research value" for each DPP security. Although the research values were updated at least quarterly, the analysts did not alter the research values based on subsequent fluctuations in the secondary market. <(5)> Raymond James charged its customers the lesser of the research value plus a 7% markup or the lowest outside offer plus a 10% markup. <(6)> Raymond James made efforts to obtain other dealers' quotations, when available. Furthermore, where possible, it compared its quotations to actual transactions of other dealers, as reported in industry periodicals. The NASD determined that Raymond James was not a market maker in DPP securities. The NASD found, however, that, even if Raymond James were a market maker, the subject markets were not active and competitive, and the inter-dealer trading was unreliable and erratic. The NASD found that Raymond James' quotes were never validated by sales to dealers or otherwise. The NASD concluded that Raymond James' purchases of the securities from dealers and customers that were closest in time and prior to the retail sales were the best evidence of prevailing market price. The <(5)> The head of Raymond James' investment banking area testified that the research value was different from the prices in the marketplace "[a] lot of the time." <(6)> Raymond James noted that, in the wake of the NASD's National Business Conduct Committee's ("National Committee") decision in Partnership Exchange Securities Company, a prior DPP markup case, it reduced the 10% markup to 8%. ======END OF PAGE 3====== NASD permitted the Firm an 8% markup over the Firm's acquisition cost <(7)> (and a 5% imputed markdown when the purchase was from a retail customer). <(8)> Using this methodology, the NASD found that, from May 1, 1992 to June 30, 1992, Raymond James executed 59 transactions in approximately 24 DPP securities in which it charged markups in excess of 8%. <(9)> Under the NASD's analysis, Raymond James allegedly charged $44,745.66 in excessive markups. IV. While the secondary market for DPP securities is still evolving, the NASD's Mark-Up Policy generally applies to all securities, including DPP securities. <(10)> In 1991, the NASD issued a Notice to Members in which it affirmed that the Mark-Up Policy applied to DPP securities, such as those at issue here. <(11)> <(7)> The NASD stated that it permitted an 8% markup since the NASD had previously found in a certain case that markups in excess of that level were unfair. The NASD made clear that its determination to permit this high a markup was based on the facts at issue and was not intended to suggest that markups of less than 8% on DPP securities generally would be deemed fair. <(8)> The NASD's District Business Conduct Committee ("District Committee") had found that Raymond James was entitled to an 8% spread and a 5% markup. The National Committee found that the District Committee's determination to permit the spread and markup was unprecedented and inconsistent with the NASD's Mark-up Policy. The District Committee also determined that Raymond James was a market maker, a determination that was reversed by the National Committee. <(9)> The District Committee had found that Raymond James "charged markups ranging from 5.7 to 33.3 percent on 58 transactions." The National Committee did not explain why it found a different number of violations from that found by the District Committee. <(10)> The NASD's Mark-Up Policy specifies that markups or markdowns in principal transactions with customers involving equity securities should generally not exceed 5% of the prevailing market price. The Mark-Up Policy notes: Some securities customarily carry a higher mark-up than others . . . . [A] higher percentage applies to sales of units of direct participation programs . . . than to sales of common stock. <(11)> NASD Notice to Members 91-69 (November 1991). The NASD observed: (continued...) ======END OF PAGE 4====== On July 19, 1994, we issued our opinion in Partnership Exchange Securities Company ("PESCO"), 51 S.E.C. 1198 (1994), in which we addressed, for the first time, the question of markups in the sale of DPP securities. At that time, we noted that the secondary market for DPP securities had been and continued to be marked by the absence of a centralized trading facility or system, as well as a lack of a standardized clearing or transfer mechanism for these securities. Moreover, while prices for DPP securities were occasionally reported in some periodicals, there were no prices or quotations reported on any electronic bulletin board or in any other inter-dealer communication system. <(12)> Although Raymond James did not sell these securities to dealers other than Robert Thomas Securities, Inc. ("Robert Thomas") or Investment Management & Research, Inc. ("Investment Management") (collectively "Affiliates") <(13)> during the two-month period under review, on balance we conclude that, based on all the circumstances here, Raymond James acted as a market maker in the DPP securities at issue. <(14)> In reaching this result, we note that there are many qualities that may distinguish the secondary market for DPP securities from other markets. <(11)>(...continued) The Policy provides comfort to members that a markup or markdown of 5 percent or less will be acceptable for the vast majority of DPP trades. If a member incurs reasonable additional time or costs in effecting a trade because of the limited availability of the DPP securities, the flexibility of the Policy may permit a markup or markdown of greater than 5 percent. In fact, the Policy acknowledges that markups in DPP securities may be higher than for sales of common stock. But, the member should be fully prepared to support the reasons for the higher markup or markdown with adequate documentation of each transaction. <(12)> We approved an NASD rule change that permits the quotation of "non-firm" prices for DPP securities on the OTC Bulletin Board service. Securities Exchange Act Release No. 38132 (January 7, 1997), 62 Fed. Reg. 2204. <(13)> Raymond James and the Affiliates are each wholly-owned subsidiaries of Raymond James Financial, Inc. <(14)> Whether a firm is buying and selling to other broker- dealers is evidence of whether the firm is a market maker for a particular security. Raymond James claims that, during a six-month period surrounding the NASD's investigation, it engaged in 45 transactions with other dealers, including 15 sales to other dealers. Raymond James did not, however, sell any of the subject securities to broker-dealers that were not affiliated with the Firm during the period at issue. ======END OF PAGE 5====== Raymond James held itself out as a market maker for DPP securities. <(15)> Raymond James' advertising literature referred to the Firm as a market maker in limited partnership units. While the Firm did not publish quotations in an inter-dealer quotation system, no such system existed for the DPP market at that time and Raymond James made extensive efforts to disseminate its quotations widely. For example, it published offer quotations in the Weekly Investment Digest; distributed, on a regular basis, offer sheets among other dealers; and sought to have its quotations available in financial publications. Moreover, Raymond James incurred market risk and added liquidity to a largely illiquid market. <(16)> Although, on the record before us, we find that Raymond James acted as a market maker, such a finding does not relieve the Firm of its responsibility to charge its customers fair prices or establish how those prices should be calculated. V. Our review of the record has raised several issues with respect to the determination of the prevailing market price, the relationship of Raymond James and its Affliates, and the responsibility of Raymond James for these transactions. We have determined to remand this proceeding to the NASD to address these issues and to explain further the applicability of the markup requirements to the transactions at issue. Raymond James asserts that the NASD improperly relied on historical cost to establish the prevailing market price. The NASD's Mark-Up Policy states that a retail price is unfair if it is "not reasonably related to the current market price of the security." The NASD found that the market for these securities was not active. In some instances there was no contemporaneous purchase available to determine the current market price of the security and, in these instances, the NASD used Raymond James' historical cost. For example, in one instance, the prevailing market price was determined by using a trade that occurred 93 days before the trade at issue. In PESCO we held that, while historical cost might be a proper basis for calculating markups in DPP securities, evidence should be introduced that confirms the reliability of historical cost as a measure of current market price. The NASD found that Raymond James' internal research values and quotations demonstrated that the market did not change during the interim period between Raymond James' purchases and the transactions at <(15)> Section 3(a)(38) of the Securities Exchange Act of 1934 defines, in relevant part, a market maker as "any dealer who, with respect to a security, holds himself out (by entering quotations in a inter-dealer communications system or otherwise) as being willing to buy and sell such security for his own account on a regular or continuous basis." <(16)> Of course, a broker-dealer is not entitled to charge customers excessive markups because it is in a risk position in the securities. See G.K. Scott & Co., Inc., 51 S.E.C. 961, 966 n.25 (1994). ======END OF PAGE 6====== issue. <(17)> The NASD, however, did not state the basis on which the quotations and research values demonstrated the reliability of historical cost as a measure of current market price for these securities. We therefore remand this matter and ask that the NASD demonstrate or explain why the prevailing market price reasonably relates to the historic market price of the security in these transactions. <(18)> Our decision to remand this matter should not be construed as approval of Raymond James' pricing methodology or the markups charged. Raymond James also contends that the NASD committed error when it held that the Affiliates' customers were in fact Raymond James' customers for purposes of the NASD's Mark-Up Policy. Article III, Section 4 of the Rules [new Rule 2440] requires, in pertinent part, "[i]n 'over-the-counter' transactions, . . . if a member buys for his own account from his customer, or sells for his own account to his customer, he shall buy or sell at a price which is fair, taking into consideration all relevant circumstances . . ." (emphasis added). Article II, Section 1(f) of the Rules [new Rule 120(g)], however, states that "[t]he term customer shall not include a <(17)> The NASD found that Raymond James' quotations were based in large part on its internal research valuations. The NASD determined that these quotations could not be accepted as the best evidence of prevailing market price. We note that even a market maker cannot base retail markups on ask quotations unless there is an active independent market for the security in question and the reliability of quoted offers can be validated by comparing them with actual inter-dealer transactions during the period at issue. See, e.g., Alstead, Dempsey & Company, Incorporated, 47 S.E.C. 1034, 1036 (1984). The NASD, however, used these same quotations to support its conclusion that the market for these securities did not change during the period between Raymond James' purchases and the transactions. Raymond James asserts that, at least in some instances, there were changes in its research value or offer quotation. Raymond James also argues that its research values were not designed to reflect fluctuations in the secondary market. While the fact that Raymond James' quotations did not change for some of the securities at issue may have some probative value, the NASD has not established that this data confirms the reliability of historic cost as a measure of current market price. <(18)> In establishing the prevailing market price we have generally looked at trades occurring five or fewer business days away from the trades at issue. See Robert Bruce Orkin, 51 S.E.C. 336, 341 n.20 (1993); Nicolas A. Codispoti, 48 S.E.C. 842, 843 (1987). Due to the diffuse and illiquid nature of the DPP securities market and the lack of price transparency, we recognize that a longer period may be appropriate in this case. ======END OF PAGE 7====== broker or dealer" (emphasis added). Raymond James notes that 36 of the 59 trades at issue were made with its Affiliates, both broker-dealers. Raymond James argues that, because the Affiliates cannot be "customers" under the NASD's Rules, its transactions with the Affiliates cannot violate the markup restrictions. In PESCO, we noted that broker-dealers representing the customers had negotiated prices for DPP securities on behalf of their customers. Here, the NASD found that "[t]he registered representatives of the [A]ffiliates never negotiated prices on behalf of their customers, either with [Raymond James] or with unaffiliated broker-dealers, and it is not apparent that they sought to buy or sell elsewhere in the inter-dealer market." <(19)> In addition, the NASD found that: the [Affiliates] cooperated in a coordinated marketing operation which included shared research, internal marketing communications, waiver of fees on purchases from customers, and uniform caps on broker commissions. [Raymond James] was aware of the existence of the retail customer in this process, and designed its pricing and compliance policies with a view towards encompassing the entire marketing chain. The NASD concluded that "[w]e believe . . . that the ultimate buyers and sellers of DPP units, as alleged in the complaint, were [Raymond James'] customers." <(20)> While the NASD describes the Affiliates' conduct, the opinion does not establish facts showing that Raymond James was <(19)> The NASD found that "[t]he broker-dealer [A]ffiliates did not deal with [Raymond James] in a principal capacity and did not take title to the DPP interests at issue." In PESCO, we noted that failure to take title "evidence[d] merely the absence of any central or uniform clearing or transfer mechanism for DPP securities." 51 S.E.C. at 1202. In addition, buyers did not pay commissions to their brokers directly; they remitted those funds to Raymond James, which transmitted commissions to these individuals through bookkeeping entries. We note that the NASD included commissions in the markup calculations, regardless of whether they were retained by Raymond James. We stated in PESCO: Under traditional markup analysis it would appear appropriate to define PESCO's cost as the entire amount it paid for the security, independent of whether the seller's intermediary received a commission, and the purchase price as the amount PESCO received net of the buyer's commission. <(20)> We note that the record indicates Raymond James had "retail" and "wholesale" offer sheets. Affiliates received the Firm's ask prices from the retail offer sheets. ======END OF PAGE 8====== responsible for the conduct, nor does it necessarily explain why the definition in Article II, Section 1(f) is inapplicable. Our uncertainty is reinforced by clearing agreements in the record pursuant to which Raymond James acted as the clearing broker for the Affiliates. The clearing agreements, dated July 30, 1981 and February 18, 1983, state that the Affiliates would "introduce to clearing broker/dealer securities and business it originates with its customers . . . ." The agreements provided, among other things, that the Affiliates were responsible for opening customer accounts, obtaining all customer and transactional information, and making suitability determinations. <(21)> Raymond James was responsible for executing transactions, clearing transactions, sending confirmations, and carrying the accounts of the Affiliates. On remand, in light of Article II, Section 1(f) and these agreements, the NASD should explain why these 36 transactions are not transactions between broker-dealers, and how it determined that the ultimate retail customers were Raymond James' customers. We note that factors such as the common ownership of Raymond James and its Affiliates and lack of negotiation of prices on behalf of the customers may have significance in determining Raymond James' responsibility with respect to the Affiliates' customers. However, the NASD has not sufficiently demonstrated, given all the facts and circumstances, that these customers should be viewed as Raymond James' customers. <(22)> * * * In light of our findings, we hereby remand this proceeding to the NASD for action consistent with this opinion. We do not intend to suggest any view as to the outcome. <(21)> The clearing agreements further specified that the Affiliates will "enforce written supervisory procedures to ensure that all transactions in accounts carried by clearing broker/dealer are and remain in compliance with applicable federal and state securities laws, the rules and regulations of the various exchanges, . . . and the National Association of Securities Dealers, Inc." In addition, the clearing agreements stated that each of the Affiliates assumed full responsibility for its customers' failure to make timely payment or delivery of securities. <(22)> We also note that the NASD found that a fine was not "necessary or appropriate to effect deterrence of future misconduct." However, as noted supra, it required Raymond James to pay as a fine any amount that Raymond James was unable to repay in restitution to the customers. In light of this first statement, it is not clear why the NASD should nonetheless collect as a fine any amount ordered in restitution that Raymond James cannot pay to customers. ======END OF PAGE 9====== An appropriate order shall issue. By the Commission (Chairman LEVITT and Commissioners JOHNSON and HUNT); Commission WALLMAN concurring. Jonathan G. Katz Secretary ======END OF PAGE 10====== Concurrence of Steven M.H. Wallman I concur in the Commission s determination to remand this matter to the NASD for further explanation regarding the prices used to determine that Raymond James violated the NASD s mark-up policy. I write seperately to note a more general concern regarding the NASD s requirement that its members engage in securities transactions at fair prices and commissions (see, Article III, Section 4 of NASD Rules of Fair Practice). More specifically, and while the NASD s 5% mark-up policy is just a guideline <(1)> and was and is undoubtedly well intentioned, my strong concern is that such guidelines have the potential to set floors for pricing or to preclude or otherwise limit competition or innovation, thereby disadvantaging investors. For those reasons, in other industries, similar maximum price guidelines have been held to represent per se violations of the antitrust laws. See, e.g., Letter from Department of Justice to John R. Ferguson re: Pharmaceutical Manufacturers Association (October 1, 1993) <(2)> (citing, for example, Arizona v. Maricopa County Medical Society, 457 U.S. 332 (1982)). This issue is even more pointed here where the policy was established by an informal survey of industry participants over five decades ago <(3)> without any rate- making or other analysis. Therefore, while I support the decision to remand in this instance, I believe the NASD and the Commission must revisit the broader, competitive <(1)> Violations of the policy have been found for mark-ups of less than 5%. See, e.g., In re: Investment Planning, Inc., SEC File No. 3-7388 (July 28, 1993) (affirming NASD sanctions for markups of 4% and above on debt securities). Similarly, the NASD s interpretation of its markup rule indicates, in appropriate circumstances, mark-ups above 5% may not be unreasonable. See, Interpretation of Article III, Section 4 of NASD Rules of Fair Practice. <(2)> The DOJ letter also notes that the per se rule applies not only to agreements that fix or set the prices at which goods or services are sold [but also to] agreements that set price-related terms but not the specific price at which transactions occur. Letter at 2-3. <(3)> Notwithstanding extraordinary changes in the industry and costs of doing business since the policy was established, the standard for the mark-up policy remains and continues to be affirmed at 5%, underscoring the points made above. ======END OF PAGE 11====== implications of the 5% policy, and other similar policies, <(4)> as soon as possible. <(4)> I note the same concern with regard to certain other such policies of the NASD (some of which have been adopted at the request of the Commission), such as the rule requiring that members not charge customers more than a fair commission (Article III, Section 4 of NASD Rules of Fair Practice); and the rule setting limits on the amount of loads and 12b-1 fees that mutual funds may charge (Article III, Section 26 of NASD Rules of Fair Practice). Because these rules and interpretations may not fall within the prohibitions of the antitrust laws because they are subject to the Commission s extensive oversight and because the securities laws in some instances create an implied immunity from the antitrust laws, see U.S. v. NASD, 422 U.S. 694 (1975), it therefore is of paramount importance for the anticompetitive effects that these laws protect against to be part of the NASD s and Commission s reconsiderations. ======END OF PAGE 12====== UNITED STATES OF AMERICA before the SECURITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT OF 1934 Rel. No. 38893 / August 1, 1997 Admin. Proc. File No. 3-8801 In the Matter of the Application of RAYMOND JAMES & ASSOCIATES, INC. For Review of Disciplinary Action Taken by the NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC. ORDER VACATING AND REMANDING DISCIPLINARY ACTION TAKEN BY REGISTERED SECURITIES ASSOCIATION On the basis of the Commission's opinion issued this day, it is ORDERED that the disciplinary action by the National Association of Securities Dealers, Inc. be and it hereby is vacated, and this proceeding be, and it hereby is, remanded to the Association. By the Commission. Jonathan G. Katz Secretary