-------------------- BEGINNING OF PAGE #1 ------------------- SECURITIES AND EXCHANGE COMMISSION 17 CFR Part 240 Release No. 34-34962; File No. S7-6-94 RIN: 3235-AF84 Confirmation of Transactions AGENCY: Securities and Exchange Commission ACTION: Final Rule SUMMARY: The Commission is adopting amendments to Rule 10b-10 under the Securities Exchange Act of 1934 that will require brokers and dealers to provide customers immediate written notification of information relevant to their securities transactions. Consistent with the Commission's investor protection mandate and in keeping with innovations in securities products and markets, the amendments will require brokers and dealers to provide information concerning customer transaction costs in specified Nasdaq and exchange-listed securities, the status of certain unrated debt securities, the status of certain non-SIPC member broker-dealers, and the availability of information regarding asset-backed securities. EFFECTIVE DATE: April 3, 1995 FOR FURTHER INFORMATION CONTACT: Catherine McGuire, Chief Counsel, C. Dirk Peterson, Senior Counsel, or Terry R. Young, Attorney (202/942-0073), Division of Market Regulation, Securities and Exchange Commission, 450 Fifth Street, N.W., Mail Stop 7-10, Washington, D.C. 20549. SUPPLEMENTARY INFORMATION: I. INTRODUCTION AND SUMMARY A. PRICE TRANSPARENCY During the past year, the Commission has initiated efforts to further improve the efficiency of, and to protect investors in, the municipal securities and other debt markets. In September 1993, the Commission's Division of Market Regulation published the Staff Report on the Municipal Securities Market ("Staff Report"),-[1]- which contained several recommendations to improve the municipal securities market. The Staff Report recommended, among other things, riskless principal mark-up disclosure as a means of providing greater information to investors purchasing municipal securities.-[2]- The Staff Report noted that, unlike the equity markets where mark-ups and mark- downs-[3]- are disclosed to investors in non-market maker riskless principal transactions and principal transactions in "reported securities,"-[4]- mark-ups are not disclosed in any -[1]- Staff Report on the Municipal Securities Market (September 1993). -[2]- Staff Report, at 16 and 18. -[3]- For purposes of this release, references to mark-ups also will apply to mark-downs or commission equivalents. -[4]- See infra note 71 for a discussion of "reported securities." -------------------- BEGINNING OF PAGE #2 ------------------- principal transaction in municipal securities.-[5]- Thus, investors of municipal securities are constrained in their ability to compare transaction costs among broker-dealers and across markets. The Staff Report identified this ability as one of the benefits of mark-up disclosure.-[6]- In addition to enhanced confirmation disclosure, the Staff Report discussed the overall benefits of price transparency and the need for greater transparency in the municipal securities market.-[7]- Notably, price transparency enhances market liquidity and depth, and fosters investor confidence,-[8]- while a lack of price information impairs market pricing mechanisms, weakens competition, and prevents investors from monitoring the quality of their executions.-[9]- To address some of the recommendations contained in the Staff Report, on March 9, 1994, the Commission published for comment proposed Rule 15c2-13 under the Securities Exchange Act of 1934 ("Exchange Act")-[10]- to require disclosure of mark-ups in riskless principal transactions in municipal securities. Because the same benefits of mark-up disclosure apply to other debt transactions, the Commission proposed amendments to Rule 10b-10 ("Rule") under the Exchange Act that would require riskless principal mark-up disclosure for debt securities other than municipal securities.-[11]- Since the Proposing Release was published for comment on March 9, 1994, municipal market participants have proposed significant new ways of making pricing information more widely available to investors. The Municipal Securities Rulemaking Board ("MSRB") has taken the first step toward a system that will make publicly available price information for municipal securities transactions on a next day basis. Recently, the MSRB stated that its "ultimate goal for the [transparency] program is to collect and make available transaction information in a -[5]- Staff Report, at 15-16. -[6]- Id. at 16. -[7]- Staff Report, at 20 and 36. -[8]- Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Concerning International Markets and Individuals Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, September 28, 1994. -[9]- See Brandon Becker, Director, Division of Market Regulation, Address at 19th International Organization of Securities Commissions Annual Conference (1994). -[10]- Securities Exchange Act Release No. 33743 (March 9, 1994), 59 FR 12767 ("Proposing Release"). -[11]- The Commission previously proposed disclosure requirements of mark-ups in riskless principal transactions on three other occasions. See Securities Exchange Act Release No. 15220 (Oct. 6, 1978), 43 FR 47538 (proposing mark-up disclosure for riskless principal transactions in municipal securities); Securities Exchange Act Release No. 13661 (June 23, 1977), 42 FR 33348 (proposing mark-up disclosure by non-market makers in riskless principal equity and debt securities, but not municipal securities); and Securities Exchange Act Release No. 12806 (Sept. 16, 1976), 41 FR 41432 (proposing mark-up disclosure by non- market makers in riskless principal transactions involving equity and debt securities). -------------------- BEGINNING OF PAGE #3 ------------------- comprehensive and contemporaneous manner (footnote omitted) . . . [and] wishe[d] to reiterate to the Commission its commitment to these goals."-[12]- The Public Securities Association ("PSA") also has proposed a system to publicize municipal securities price information. These proposals will create the infrastructure necessary to enhance transparency in the market, and when fully implemented, will provide last sale reporting for virtually all municipal securities transactions. The Commission is encouraged by these developments, and after careful consideration, has determined to defer the riskless principal mark-up proposal for six months-[13]- in anticipation of meaningful progress by the industry toward enhanced price transparency in the municipal securities market. The riskless principal mark-up proposals would provide better information only to a certain segment of transactions in the debt markets. The industry's efforts to improve transparency, on the other hand, ultimately will result in enhanced price disclosure for all transactions. Moreover, better dissemination of price information will benefit investors by providing them with useful information at the time they are making their investment decision, rather than after-the-fact when the confirmation is received. If, at the end of the six-month period, industry initiatives to improve price transparency have not progressed to the Commission's satisfaction, however, the Commission may reconsider the riskless principal mark-up proposal in light of existing alternatives. B. OTHER DISCLOSURES In addition to the riskless principal mark-up proposals, the Commission proposed several other amendments designed to improve confirmation disclosure so that customers can better evaluate their securities transactions. Specifically, the Commission proposed amendments to Rule 10b-10 that would require broker- dealers to disclose (1) mark-ups in connection with transactions in certain Nasdaq and regional exchange-listed securities; (2) if they are not members of the Securities Investor Protection Corporation ("SIPC"); (3) information relevant to certain types of collateralized debt instruments; and (4) if a debt security has not been rated by a nationally recognized statistical rating organization ("NRSRO"). Proposed Rule 15c2-13 contained a similar provision requiring broker-dealers to disclose the unrated status of a municipal security. The Commission also requested comment on the broader issue of whether the shortened settlement period of three days ("T+3 Settlement") will have an effect on the future utility of the confirmation and whether some information currently required in -[12]- Letter from Robert H. Drysdale, Chairman, MSRB, to Arthur Levitt, Chairman, SEC (Nov. 3, 1994), at pp. 1-2. Available in Public Reference File No. S7-6-94. -[13]- Recently, the MSRB set forth a tentative schedule for the completion of each of the four phases of its proposal: phase one (inter-dealer transactions, January 1, 1995); phase two (addition of time of trade and institutional customer transactions, December 1995); phase three (addition of retail customer transactions, November 1996); and phase four (more contemporaneous trade reporting, April 1997). See Letter from Robert H. Drysdale, Chairman, MSRB, to Arthur Levitt, Chairman, SEC, (Nov. 3, 1994), at pp. 3-7. Available in Public Reference File No. S7-6-94. -------------------- BEGINNING OF PAGE #4 ------------------- the confirmation could be shifted to an account statement.-[14]- In addition, the Commission proposed adding a preliminary statement to Rule 10b-10 designed to clarify that the Rule is not intended as a safe harbor from the general antifraud provisions of the federal securities laws.-[15]- In response to the request for comment, the Commission received 344 comment letters, the majority of which addressed the mark-up disclosure proposals for riskless principal transactions. Commenters included regional and national broker-dealers, industry associations, financial institutions, law firms, insurance companies, and individual investors.-[16]- The comments presented a range of views with respect to the proposals and the effects that the proposed disclosure requirements may have on broker-dealers, investors, and markets. After a review of the comments, the Commission is adopting the proposed amendments to Rule 10b-10 that require disclosure if a debt security is not rated by an NRSRO, with a modification to exclude all government securities from the disclosure requirement; mark-up disclosure in connection with transactions in certain Nasdaq and regional exchange-listed securities; disclosure if a broker-dealer is not a member of SIPC, except for certain transactions in investment company shares by non-SIPC member firms that do not handle customer funds or securities; and disclosure with respect to the availability of information with respect to transactions in collateralized debt securities. The Commission also is adopting the preliminary note to Rule 10b-10. To allow firms the appropriate time to adapt their systems to accommodate these disclosure requirements, the proposals will become effective April 3, 1995. In addition, that portion of Rule 15c2-13 that would require disclosure if a municipal security was not rated by an NRSRO has been deferred and will be withdrawn if the MSRB acts to adopt similar amendments to its confirmation rule, Rule G-15.-[17]- The MSRB recently reiterated its willingness to amend Rule G-15 to require disclosure if a municipal security is not rated by an NRSRO.-[18]- II. DESCRIPTION OF AMENDMENTS A. ROLE OF THE CONFIRMATION The Commission's confirmation rule, Rule 10b-10-[19]- under the Exchange Act,-[20]- generally requires a broker-dealer effecting a customer transaction in securities (other than U.S. Savings Bonds or municipal securities) to provide written notification to its customer, at or before completion of a transaction, that discloses information specific to the -[14]- See Proposing Release, supra note 10, at 59 FR 12767- 68. -[15]- Id. at 59 FR 12772. -[16]- The comment letters and a summary of comments have been placed in Public Reference File No. S7-6-94, which is available for inspection in the Public Reference Room. -[17]- MSRB Rule G-15, MSRB Manual (CCH) 3571. -[18]- Letter from Robert H. Drysdale, Chairman, MSRB, to Arthur Levitt, Chairman, SEC (Nov. 3, 1994). Available in Public Reference File No. S7-6-94. -[19]- 17 CFR 240.10b-10. -[20]- 15 U.S.C. 78a et seq. -------------------- BEGINNING OF PAGE #5 ------------------- transaction. The confirmation requires, among other things, the disclosure of: the date, time, identity, and number of shares bought or sold;-[21]- the capacity of the broker-dealer;-[22]- the net dollar price and yield of a debt security;-[23]- and, under specified circumstances, the amount of compensation paid to the broker-dealer and whether payment for order flow is received.-[24]- For over 50 years, the customer confirmation has served basic investor protection functions by conveying information allowing investors to verify the terms of their transactions; alerting investors to potential conflicts of interest with their broker-dealers; acting as a safeguard against fraud; and providing investors the means to evaluate the costs of their transactions and the quality of their broker-dealer's execution. 1. T+3 Settlement. In the Proposing Release, the Commission requested comment on the future utility of the confirmation once T+3 Settlement is implemented on June 7, 1995.-[25]- Rule 10b-10 requires that a confirmation be sent at or before completion of a customer transaction.-[26]- Commenters noted that T+3 Settlement will diminish the confirmation's usefulness as a customer invoice and questioned the practicability of requiring the disclosure of additional information on a document that an investor will receive after already having made his or her investment decision and tendering funds or securities.-[27]- Notwithstanding the shortened settlement period of T+3 and the possibility that an investor may receive the confirmation after payment has been made, the Commission believes that the confirmation will continue to serve important investor protection -[21]- 17 CFR 240.10b-10(a)(2). -[22]- 17 CFR 240.10b-10(a)(1). -[23]- 17 CFR 240.10b-10(a)(4)(i); and 17 CFR 240.10b- 10(a)(5). -[24]- 17 CFR 240.10b-10(a)(7)(ii) and (iii); 17 CFR 240.10b- 10(a)(8)(i)(A); and 17 CFR 240.10b-10(a)(8)(i)(B). Recently, the Commission proposed for comment additional disclosures relevant to payment for order flow, which would include for monetary payment for order flow, the range of payments received on a per share basis and on an aggregate basis annually. For non-monetary payment for order flow, the Commission proposed requiring disclosure of an estimate of the range of payment for order flow on a per share basis and on an aggregate basis annually. See Securities Exchange Act Release No. 34903 (Oct. 27, 1994), 59 FR 55014. -[25]- T+3 Settlement was adopted in Securities Exchange Act Release No. 33023 (Oct. 6, 1993), 58 FR 52891. -[26]- Rule 15c1-1 under the Exchange Act defines "the completion of the transaction." 17 CFR 240.15c1-1(b). -[27]- See, e.g., Letters from A. George Saks, Executive Vice President, Secretary, and General Counsel, Smith Barney (Aug. 1, 1994); Robert M. Sweeney, Vice President/ Assistant Comptroller, Gibraltar Securities Co. (June 14, 1994); William J. Jester, Jr., Chemical Banking Corp. (June 14, 1994); and Kurt D. Halvorson, Vice President & Controller, AmeriTrade (May 27, 1994), to Jonathan G. Katz, Secretary, SEC. -------------------- BEGINNING OF PAGE #6 ------------------- functions. T+3 Settlement's implementation merely may mean that the confirmation may take on a different role. Some firms may continue to use the confirmation as a customer invoice, while financing positions when customer payment is received after settlement date. For other firms, the confirmation may not continue to serve in all circumstances as an invoice of a transaction because ordinary confirmation delivery and transfer of customer funds and securities may not be feasible within a three-day settlement cycle.-[28]- Rather, the confirmation may serve primarily as written evidence of the contract between the customer and broker-dealer.-[29]- As a written record of the transaction, the confirmation will continue to provide investors the necessary information to assist them in evaluating the quality and accuracy of their trades while assisting them in -[28]- One commenter suggested that the Commission reevaluate the meaning of "give or send" under Rule 10b-10 in light of T+3 Settlement and current technology, such as electronic messaging, E-mail, direct computer links, telefax, and fax modems. See Letter from Sullivan & Cromwell, to Jonathan G. Katz, Secretary, SEC (July 15, 1994). In the Proposing Release, the Commission recognized the use of a facsimile machine to send customer confirmations. See Proposing Release, supra note 10, at 59 FR 12767 n.5. To the extent that a customer has a facsimile machine, a broker-dealer would fulfill its confirmation delivery obligation if it sent the confirmation via facsimile transmission. The staff also has allowed, under specified conditions, confirmations to be sent by other electronic means. See Letter regarding Thomson Financial Services, Inc. (Oct. 8, 1993). The Commission agrees that T+3 Settlement may encourage alternatives to the mail system for sending confirmations and that a flexible approach may be necessary to accommodate T+3 Settlement with existing technology. The Commission, however, believes that each approach should be viewed on a case-by-case basis, as has been previous practice, to ensure the safety and reliability of the confirmation transmission. -[29]- Under the current text of the Uniform Commercial Code, the confirmation serves as a written record of the transaction, thus satisfying the statute of frauds. Uniform Commercial Code Section 8-319 states that a "contract for the sale of securities is not enforceable by way of action or defense unless . . . there is some writing signed by the party against whom enforcement is sought or by his authorized agent or broker, sufficient to indicate that a contract has been made for sale of a stated quantity of described securities at a defined or stated price." A confirmation, bearing the broker-dealer's letterhead or some other identifying marking, generally fulfills that requirement. Revised Article 8 of the Uniform Commercial Code, which was endorsed recently by both the American Law Institute and the National Conference of Commissioners on Uniform State Laws, would omit current Section 8-319. Due to the prior difficulties in applying Section 8-319 to the sale of securities over the telephone and the more common use of electronic means for securities transactions, proposed Section 8-113 states that "[a] contract or modification for the sale or purchase of a security is enforceable whether or not there is a writing signed or record authenticated by a party against whom enforcement is sought, even if the contract or modification is not capable of performance within one year of its making." -------------------- BEGINNING OF PAGE #7 ------------------- correcting mistakes and verifying the terms of their transactions. Accordingly, while T+3 Settlement may affect the mechanics of settlement, it will not eliminate the confirmation's investor protection functions. 2. Periodic Account Statement. The Commission also requested comment on the feasibility of transferring information currently disclosed on the confirmation to a periodic account statement.-[30]- Many commenters addressing this issue opposed such a use of the periodic account statement and noted that it was not the appropriate document to convey particularized trade information.-[31]- Rather, as one commenter indicated, account statements are intended to summarize the activity and status of an account; they are not intended to convey information regarding the features and risks of each individual securities transaction.-[32]- Other commenters, however, noted that, as investors increasingly rely upon periodic account statements, the confirmation will diminish as a primary disclosure device.-[33]- At this time, the Commission has determined to retain the confirmation as the basic transaction disclosure document and use the account statement, the account opening document, or annual disclosure requirements as needed to supplement or summarize confirmation disclosures. The Commission noted in the Proposing Release, however, that a customer may waive the receipt of an immediate confirmation in the context where a fiduciary has discretion over the customer's account.-[34]- The Commission noted that, in its view, the account, rather than the fiduciary, was the customer for purposes of Rule 10b-10. To effect a valid waiver, the broker-dealer must (1) obtain from the customer a written agreement that the fiduciary receive the immediate confirmation; and (2) send to the customer a periodic report, not less frequently than quarterly, containing the same information that would have been contained in -[30]- See Proposing Release, supra note 10, at 59 FR 12768. -[31]- See, e.g., Letters from A. George Saks, Executive Vice President, Secretary, and General Counsel, Smith Barney (Aug. 1, 1994); Barry H. Zucker, President & CEO, J.B. Hanauer & Co. (June 20, 1994); and Jon S. Corzine, Goldman, Sachs & Co. (June 15, 1994), to Jonathan G. Katz, Secretary, SEC. -[32]- See, e.g., Letter from Donald E. Walter, Compliance Director/Principal, Edward D. Jones & Co., to Jonathan G. Katz, Secretary, SEC (July 15, 1994). Another commenter noted that transferring confirmation information to an account statement may clutter the account statement and make it less readable. See Letter from Barry H. Zucker, President & CEO, J.B. Hanauer & Co., to Jonathan G. Katz, Secretary, SEC (June 20, 1994). -[33]- See, e.g., Letters from Robert M. Sweeney, Vice President/Assistant Comptroller, Gibraltar Securities Co. (June 14, 1994); William J. Jester, Jr., Chemical Banking Corp. (June 14, 1994); and Kurt Halvorson, Vice President & Comptroller, AmeriTrade (May 27, 1994), to Jonathan G. Katz, Secretary, SEC. -[34]- See Proposing Release, supra note 10, at 59 FR 12767 n.3. -------------------- BEGINNING OF PAGE #8 ------------------- an immediate confirmation.-[35]- The customer may not waive this periodic report.-[36]- The requirement to send a periodic report is intended to ensure that the beneficial owner of the account receives material -[35]- To satisfy this requirement, a broker-dealer may deliver, directly to its customer, duplicate confirmations representing each of the customer's transactions for the prior period, together with the customer's account statement. This procedure would allow investors to rely on the account statement to monitor their accounts, while referring to the confirmation for the details of each specific trade. Investors already look to old confirmations for details which are not present on the account statement, and this procedure would allow investors to continue to rely on their confirmations and their account statements in substantially the same way. -[36]- Some concerns have been raised with respect to the application of this policy and its relationship with Rule 409 of the New York Stock Exchange ("NYSE"). See, e.g., letter from Kevin J. Mackay, President/Compliance and Legal Division, Securities Industry Association ("SIA"), to Jonathan G. Katz, Secretary, SEC (July 22, 1994). Specifically, Rule 409(b) permits NYSE member firms to send a confirmation to a non-member person holding power of attorney over a customer account if "either (A) the customer has instructed the member organization in writing to send such confirmations, statements, or other communications in care of such person, or (B) duplicate copies are sent to the customer at some other address designated in writing by him." NYSE Rule 409, 2 NYSE Guide (CCH) 2409. Under the Commission's position articulated above, a customer who waived receipt of the immediate confirmation would receive more information with his quarterly account statement than that currently required under NYSE Rule 409. To the extent the rules of the NYSE, or any self-regulatory organization, conflict with the Commission's stated policy, the more restrictive requirement would govern. Thus, a NYSE member wishing to take advantage of a waiver would be required to adhere to these Commission requirements in addition to any obligations imposed by Rule 409. The SIA argued that this position would (1) lead to duplicative efforts on the part of broker-dealers because broker- dealers already will have sent trade information to the fiduciary in an immediate confirmation; (2) depart from standard industry practice; and (3) require expensive system changes to comply with the position. The Commission emphasizes that this substitution of quarterly statements for the immediate confirmation is optional. No broker-dealer is required in the first instance to include all relevant trade information in a quarterly statement; however, if the broker-dealer, with the written authorization of the customer, wishes to omit sending the customer an immediate confirmation and instead send it to the account fiduciary, then the requirements of written instructions from the customer and a non-waiveable periodic report, as described above, must be satisfied in order to effect a valid waiver. These requirements are necessary to allow investors to monitor their accounts in the absence of a transaction-by-transaction report in the confirmation. -------------------- BEGINNING OF PAGE #9 ------------------- information needed to verify the transaction in the account.-[37]- As the Commission noted in the release originally adopting Rule 10b-10, the Rule is not intended to require a broker-dealer dealing with the trustee of a plan to deliver statements to plan participants where the trustee is the shareholder of record of the securities being purchased or sold. In those instances, the Rule would require the broker-dealer to deliver a confirmation, or upon written request, a periodic report, only to the trustee.-[38]- A beneficiary of the trust would be required to receive an immediate confirmation, or upon written request, the periodic report, only if that beneficiary was a beneficial owner of the trust assets on the books of the broker-dealer, enjoying the rights and privileges of beneficial ownership. The Commission also believes that the broker-dealer can satisfy its obligation to send a confirmation to the customer if it sends the confirmation to a custodian of the customer authorized to receive securities and disburse funds for the customer.-[39]- The custodian in question must not be affiliated with a broker-dealer or an investment adviser or have any role in choosing the broker-dealer or investment adviser used;-[40]- and the customer must retain the right to request that the confirmation be sent directly to the customer, at no extra charge -[37]- The requirement to send a periodic report to the customer, if the customer has requested in writing that the immediate confirmation be sent to the customer's fiduciary, applies only if the broker-dealer has an existing duty under Rule 10b-10 to send an immediate confirmation directly to the customer in the absence of such a written request. This requirement therefore would not apply to paragraph 10b-10(b), which governs purchases and sales of securities in a money market fund, as defined in newly amended paragraph 10b-10(b)(1), a periodic plan, as defined in paragraph 10b-10(d)(5), and an investment company plan, as defined in paragraph 10b-10(d)(6). Paragraph (b) of Rule 10b-10 permits, upon written request of the customer, written statements containing the information specified in that paragraph to be sent not less frequently than quarterly, directly to the customer or some other person designated by the customer for distribution to the customer. Because there are circumstances, not enumerated specifically in Rule 10b-10, that would make compliance with the rule unduly burdensome, paragraph 10b-10(f) authorizes the Commission to exempt broker-dealers from the rule's requirements with regard to specific transactions or specific classes of transactions for which the broker or dealer will provide alternative procedures to effect the purposes of Rule 10b-10. This authority has been delegated to the Division of Market Regulation. 17 CFR 200.30- 3(a)(32). -[38]- Securities Exchange Act Release No. 13508 (May 5, 1977), at n.24. -[39]- The custodian must not hold itself out as a broker- dealer or an investment adviser. But see Investment Advisers Act Release No. 1406 (March 16, 1994), 59 FR 13464 (proposing a rule to require investment advisers to ensure that custodians of investment adviser client accounts provide the client or its designee with account statements not less than quarterly). -[40]- Securities orders must be placed by the customer or the customer's investment adviser, not the custodian. -------------------- BEGINNING OF PAGE #10 ------------------- by the custodian or broker-dealer. Moreover, an account custodian may not choose to receive a periodic report in place of an immediate confirmation. 3. Preliminary Note. The Commission proposed adding a preliminary note to Rule 10b-10 clarifying that the Rule is not intended as a safe harbor from disclosure obligations imposed by the general antifraud provisions of the federal securities laws.-[41]- This note is intended to respond to claims made by litigants that Rule 10b-10 prescribes all the necessary disclosure relevant to a customer's securities transaction.-[42]- A few commenters addressed the inclusion of the preliminary note to Rule 10b-10, with equal support for-[43]- and opposition to-[44]- the note. One supporter suggested that the Commission could accomplish the same purpose of clarification in an interpretative release.-[45]- One opponent of the preliminary note argued that its existence would lead to frivolous claims against broker-dealers.-[46]- After reviewing the comments, the Commission is adopting the preliminary note to Rule 10b-10. The Commission is not persuaded that the existence of the preliminary note would lead to any additional litigation against broker-dealers. The preliminary note is merely making explicit a longstanding position that the antifraud provisions of the federal securities laws may impose, given the circumstances, greater disclosure than what may be required by a specific rule or regulation.-[47]- -[41]- See Proposing Release, supra note 10, at 59 FR 12772. -[42]- See, e.g., Shivangi v. Dean Witter Reynolds, Inc., 637 F. Supp. 1001 (S.D. Miss. 1986), aff'd, 825 F.2d 885 (5th Cir. 1987); Krome v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 637 F. Supp. 910, 915-16 (S.D.N.Y. 1986); and Ettinger v. Merrill Lynch, Pierce, Fenner & Smith, Fed. Sec. L. Rep. (CCH) 93,102 (E.D. Pa. 1986), rev'd, 835 F.2d 1031 (3d Cir. 1987). -[43]- See, e.g., Letters from Donald E. Walter, Compliance Director/Principal, Edward D. Jones & Co. (July 11, 1993); and Douglas L. Kelly, Director/Law & Compliance Division, A.G. Edwards & Sons, Inc. (June 13, 1994), to Jonathan G. Katz, Secretary, SEC. -[44]- See, e.g., Letters from A.B. Krongard, Chief Executive Officer, Alex. Brown & Sons, Incorporated (July 14, 1994); and Jeffrey Rubin, President, InterCapital Assets, Inc. (June 13, 1994), to Jonathan G. Katz, Secretary, SEC. -[45]- Letter from Douglas L. Kelly, Director/Law & Compliance Division, A.G. Edwards & Sons, Inc., to Jonathan G. Katz, Secretary, SEC (June 13, 1994). This commenter also suggested that if a note were added to Rule 10b-10, a similar note also should precede Rule 15c2-13. At this time, the Commission is not adopting Rule 15c2-13. -[46]- Letter from A.B. Krongard, Chief Executive Officer, Alex. Brown & Sons, Incorporated, to Jonathan G. Katz, Secretary, SEC (July 14, 1994). -[47]- See supra note 42. One commenter argued that the preliminary note provides no useful guidance because the Commission has not articulated a set of guidelines concerning disclosure requirements in addition to those required in a prospectus and under the Exchange Act. See Letter from Sullivan (continued...) -------------------- BEGINNING OF PAGE #11 ------------------- B. MARK-UP AND MARK-DOWNS IN RISKLESS PRINCIPAL TRANSACTIONS IN DEBT SECURITIES The majority of comment letters addressed the proposed amendments to Rule 10b-10 and the portion of proposed Rule 15c2- 13 that would require mark-up disclosure of riskless principal trades in debt securities.-[48]- Generally, most commenters opposed the proposals on the grounds that the requirements would have detrimental effects on competition and market liquidity; would cause compliance difficulties; would create customer confusion; and are not based upon findings of abusive practices in the debt market. It has been argued by some commenters that greater price transparency in the municipal market could achieve similar goals as riskless principal mark-up disclosure without the alleged negative effects purported to result from mark-up disclosure.-[49]- Since the proposals were published for comment in March, progress has been made to develop price transparency in the debt markets. In particular, the MSRB has proposed a program that ultimately would provide same day price reporting of all transactions in municipal securities, including same day reporting of retail trades. This program is to be implemented in four phases. As proposed, the first phase of the MSRB program will collect reports of interdealer transactions and make available to the public daily high-low and average price figures for the most frequently traded issues (initially defined as those trading at least four times during the day).-[50]- These requirements will be expanded in phase two to include institutional customer transactions. The third phase will expand the daily reporting requirements to include retail customer transactions, and phase four will advance reporting times closer in time to the transaction, such as by the end of day or within a specified time period following the trade. In the initial phases -[47]-(...continued) & Cromwell, to Jonathan G. Katz, Secretary, SEC (July 15, 1994), at pp. 2-3. The Commission does not intend to specify key disclosure items under the antifraud provisions of the federal securities laws. Each circumstance is different and determining the materiality of any particular item of disclosure depends on the facts and circumstances of each case. -[48]- Of the 344 comment letters received, 313 addressed the mark-up disclosure proposals. -[49]- See, e.g., Letters from A.B. Krongard, Chief Executive Officer, Alex. Brown & Sons, Incorporated (July 14, 1994); James D. McKinney, Partner and Manager of Fixed Income Dept., William Blair & Company (July 13, 1994); Thomas W. Masterson, Chairman, Masterson Moreland Sauer Whisman, Inc. (July 13, 1994); G. Frederick Kasten, Jr., President and Chief Executive Officer, Robert W. Baird & Co., Incorporated (June 15, 1994); and Rauscher Pierce Refnes, Inc. (June 14, 1994), to Jonathan G. Katz, Secretary, SEC. -[50]- To implement phase one, the MSRB, pursuant to Rule 19b- 4 of the Exchange Act, has filed with the Commission a proposed rule change to amend Rule G-14 of the MSRB Rules, which, once approved, will require the reporting of interdealer municipal securities transactions to a designee (e.g., the National Securities Clearing Corporation) for compilation in a daily report and for use by regulators. -------------------- BEGINNING OF PAGE #12 ------------------- of the MSRB's proposal, information regarding the prices and volume of transactions in approximately 80 to 240 issues would be reported each day. As each phase is implemented, the MSRB will review closely this information and system operations, with a view toward reflecting a greater number of issues and transactions in the reports. In addition to the proposal by the MSRB, the PSA has proposed two initiatives to convey municipal securities pricing information to retail investors. First, the PSA proposes to develop a generic scale and yield curve for AAA-insured revenue bonds. This information, which will be made available to daily newspapers, is intended to provide customers with grade information on the price and yield of a representative range of bonds. Second, the PSA proposes to establish a 900-number which investors could call to obtain price information regarding particular municipal securities. Although the MSRB's initiative is in a developmental stage, the Commission believes it ultimately could provide the public with improved information about the price of municipal securities. If widely published, this information would allow investors to better assess the prices provided by their broker- dealers in a municipal securities trade. In light of these proposals, the Commission has decided to defer for a period of six months adoption of that part of Rule 15c2-13 requiring the disclosure of mark-ups for riskless principal transactions in municipal securities. The Commission has deferred adoption of the riskless principal mark-up disclosure proposal in order to ascertain whether the proposed price information systems can provide more meaningful benefits to investors in the long-term and to assess the progress of the industry in developing the proposed systems. Price transparency, if fully developed, will provide better market information to investors on a timely basis (e.g., before the transaction). Potentially, price transparency also could provide investors the ability to determine the value of their municipal securities purchased in principal transactions. The proposed mark-up disclosure, on the other hand, would have provided cost information to investors only in riskless principal transactions and would not have applied to other principal transactions, the majority of transactions in the debt market. Price transparency, if fully developed, meets investors' need for information without focusing on only one portion of the market, which commenters argued could lead to a deleterious restructuring of the market, thus reducing market liquidity and narrowing the available choices of securities sold to customers.-[51]- The Commission recognizes that these benefits depend on the sound design and successful implementation of transparency proposals. Their value to investors further depends on widespread availability of the information, and customer understanding of how it should be used. At the end of six months, the Commission will assess the need for further action based upon the prospects for the availability of meaningful pricing information to a broad range of investors about a full range of securities. If such information is not likely to be available, the Commission will explore alternatives to better provide information to fixed income investors. To this end, the Commission similarly is deferring the proposed amendment to Rule -[51]- See, e.g., Letters from Philip T. Colton, Maun & Simon (June 14, 1994); Lawrence T. Lewis, III, Managing Director, Clark Melvin Securities Corporation (June 8, 1994); and Adam Crews, President/Chief Executive Officer, Crews & Associates, Inc. (June 1, 1994), to Jonathan G. Katz, Secretary, SEC. -------------------- BEGINNING OF PAGE #13 ------------------- 10b-10 requiring mark-up disclosure for other debt securities. While the Commission believes it is appropriate to address transparency in municipal securities initially because of the presence of a large proportion of individual investors in that market, during the deferral, the Commission expects the industry to address the extent to which customer price information can be increased in debt markets other than the municipal securities market. The Commission recognizes that the government, corporate, and mortgage securities markets have different levels of price information publicly available. For example, GovPx, a joint venture of primary dealers and interdealer brokers formed in 1990, provides to investors real-time quotations, trade prices, and volume information for U.S. Treasury and other government securities via a worldwide network of 12,000 terminals. In addition, the National Association of Securities Dealers, Inc. ("NASD") developed the Fixed Income Pricing System ("FIPS"), which collects, processes, and disseminates real-time firm quotations for 30 to 50 of the most liquid, high yield bonds traded in the over-the-counter market.-[52]- The Commission expects the industry to review the availability of information to investors in each of these markets and consider methods of increasing transparency as an alternative to riskless principal disclosure in these markets. Even though the Commission is deferring the adoption of riskless principal mark-up disclosure, the Commission continues to believe that, absent transparency in the debt markets, the disclosure of the dealer's cost along with the mark-up would be of use to customers in assessing the value of their debt securities. In the absence of progress on transparency, the Commission will revisit its riskless principal proposal. The Commission also may consider whether to require the disclosure of all mark-ups in principal transactions based on the underlying inventory costs,-[53]- or the prevailing market price-[54]- or to mandate alternative price transparency systems. The Commission strongly believes that real progress is needed in a timely fashion to achieve the goal of better customer information for market prices in the debt market. Achievement of this goal will add strength to and confidence in the debt markets, to the benefit of both broker-dealers and investors. -[52]- See Securities Exchange Act Release No. 32019 (March 19, 1993), 58 FR 16428 for a discussion of the order approval allowing the NASD to implement FIPS. -[53]- To comply with this disclosure, broker-dealers would have to assign a value to a security bought into inventory on either a last in, first out or first in, first out accounting basis. -[54]- See 17 CFR 240.15g-4 and Securities Exchange Act Release No. 30608 (April 13, 1992), 57 FR 19022 for a discussion of compensation disclosure requirements for transactions in penny stocks. -------------------- BEGINNING OF PAGE #14 ------------------- C. DISCLOSURE OF UNRATED SECURITIES The Commission also published for comment a requirement to disclose, if applicable, that certain debt securities have not been rated by an NRSRO.-[55]- The proposal excluded government securities defined under Section 3(a)(42)(A) and (B) of the Exchange Act,-[56]- but requested specific comment on whether other securities should be excluded from this disclosure.-[57]- In addition, specific comment was requested whether the MSRB should implement the disclosure requirement with respect to municipal securities, rather than the Commission.-[58]- Of the 43 commenters that addressed this disclosure proposal, 24 supported the proposal.-[59]- Some commenters believed that the disclosure requirement did not go far enough and indicated that specific ratings also should be disclosed on the confirmation.-[60]- In particular, commenters believed that the confirmation should bear all ratings of securities, particularly those rated below investment grade.-[61]- -[55]- See Proposing Release, supra note 10, at 59 FR 12770. -[56]- Securities exempt from the proposed rating disclosure would include (1) securities that are direct obligations of the U.S., or in which the U.S. has guaranteed the principal or interest; or (2) securities which are issued or guaranteed by corporations in which the U.S. has a direct or indirect interest and which the Secretary of Treasury has designated for exemption. 15 U.S.C. 78c(a)(42)(A) and (B). -[57]- Proposing Release, supra note 10, at 59 FR 12770. -[58]- Id. -[59]- See, e.g., Letters from A.B. Krongard, Chief Executive Officer, Alex. Brown & Sons, Incorporated (July 14, 1994); David C, Clapp, Chairman, MSRB (June 15, 1994); and Douglas L. Kelly, Director, Law and Compliance, A.G. Edwards & Sons, Inc. (June 13, 1994), to Jonathan G. Katz, Secretary, SEC. Alex. Brown & Sons, Incorporated sought clarification that a bond rated by a single NRSRO, but not necessarily other NRSROs, nonetheless would be excluded from the disclosure requirement. (Letter from A.B. Krongard, Chief Executive Officer, Alex. Brown, to Jonathan G. Katz, Secretary, SEC (July 14, 1994), at p.6). The rule language states that a broker-dealer would be required to disclose when a security was not rated by an NRSRO. Accordingly, if a single NRSRO has rated a security, then it follows that no disclosure would be required. -[60]- See, e.g., Letters from Grant T. Callery, Vice President/General Counsel, NASD (July 26, 1994); and Robert Reeves, Sr. Vice President, Ferris Baker Watts, Incorporated (June 14, 1994), to Jonathan G. Katz, Secretary, SEC. -[61]- One commenter argued that disclosure of ratings, and in particular ratings below investment grade, would better assist investors in comparing an unrated security that may be of a high credit quality with one that, while rated, may be of lesser credit quality. See Letter from James H. Morgan, President/Chief Operating Officer, Interstate/Johnson Lane, to Jonathan G. Katz, Secretary, SEC (June 14, 1994). The Commission will revisit the issue of whether Rule 10b-10 should require the disclosure of ratings for corporate debt securities once commenters have (continued...) -------------------- BEGINNING OF PAGE #15 ------------------- Ten commenters opposed the disclosure requirement on the grounds that requiring this disclosure may be unhelpful to investors. They argued that such disclosure may cause investors to believe that unrated securities are inferior to rated securities, when the unrated security may pose less risk than a rated security, particularly a security rated below investment grade.-[62]- They noted that such disclosure does not explain the reasons why a security may not have a credit rating -- notably that smaller, but no less sound, issuers may not wish to bear the expense of obtaining a credit rating.-[63]- Commenters also questioned why the Commission excluded from the disclosure requirement only government securities defined under Section 3(a)(42)(A) and (B) of the Exchange Act.-[64]- In particular, Freddie Mac argued that securities issued by government sponsored enterprises ("GSEs"), including those issued by Freddie Mac, also should be excluded from the disclosure requirement. Freddie Mac argued that, because of the market's assessment of the creditworthiness of GSEs, it makes little economic sense for a GSE to bolster its creditworthiness with an independent rating.-[65]- Finally, some commenters believed that the MSRB should adopt any rule affecting the municipal securities market; other commenters were neutral whether the Commission or the MSRB implemented rulemaking. After considering the comments, the Commission is adopting the proposed amendments to Rule 10b-10 requiring disclosure if a debt security, other than a government security, has not been rated by an NRSRO. Such disclosure would be more meaningful to the investor if it is made together with the description of the security. As noted in the Proposing Release, this disclosure is not intended to suggest that an unrated security is inherently -[61]-(...continued) responded to a recent Commission proposal addressing the feasibility of disclosing ratings in a prospectus. See Securities Act Release No. 7086, (Aug. 31, 1994), 59 FR 46304. -[62]- See, e.g., Letters from Sullivan & Cromwell (July 15, 1994); R. Fenn Putman, Chairman, PSA (June 20, 1994); and Jon S. Corzine, Goldman, Sachs & Co. (June 15, 1994), to Jonathan G. Katz, Secretary, SEC. -[63]- One commenter noted that rural issuers would be harmed by the disclosure requirement because the size of a rural issue makes bearing the expense of obtaining a rating economically impractical. See Letter from Ian B. Davidson, Chairman, and Kreg A. Jones, Chief Operating Officer, D.A. Davidson & Co., to Jonathan G. Katz, Secretary, SEC (June 14, 1994). -[64]- See, e.g., Letter from Mitchell Delk, Vice President/Government and Industry Relations, Freddie Mac, to Jonathan G. Katz, Secretary, SEC (June 15, 1994). -[65]- Freddie Mac also described the anomalous situation in which, on the one hand, GSE securities would be subject to the disclosure requirement, but on the other hand, rated private label asset-backed securities would not, even though the underlying securities were GSE securities and primarily responsible for the rating. See Letter from Mitchell Delk, Vice President/Government and Industry Relations, Freddie Mac, to Jonathan G. Katz, Secretary, SEC (June 15, 1994), at pp. 2-3. -------------------- BEGINNING OF PAGE #16 ------------------- riskier than a rated security.-[66]- Rather, the disclosure is intended to alert customers that they may wish to obtain further information or clarification from their broker-dealers. In most cases, this disclosure should verify information that was disclosed to the investor prior to the transaction. If a customer was not previously informed of the security's unrated status, then confirmation disclosure may prompt a dialogue between the customer and broker-dealer. The Commission agrees with commenters that all "government securities" should be excluded from the unrated debt disclosure requirement, not just those defined under Section 3(a)(42)(A) and (B) of the Exchange Act.-[67]- Therefore, government securities meeting the definition under sub-paragraphs (C) and (D) of Section 3(a)(42), which includes securities issued by GSEs, will be exempt from the disclosure requirement. The Commission, however, does not intend to expand the class of securities subject to the exclusion beyond those defined as government securities in Section 3(a)(42). The non-rated debt proposal for municipal securities was contained in proposed Rule 15c2-13. In its comment letter, the MSRB stated that, "[t]he Board agrees with the Commission that, while the fact that a bond is unrated is not necessarily indicative of problems, disclosure of the fact would be helpful to investors."-[68]- The MSRB also noted that, if the Commission determined that such information was needed by investors in debt securities, it would amend its confirmation rule, Rule G-15, and require disclosure if a municipal security has not been rated by an NRSRO.-[69]- Inasmuch as other confirmation requirements for municipal securities are currently set forth in Rule G-15 of the MSRB, the Commission is willing to defer this portion of the proposal to allow the MSRB to adopt the requirement as part of its rules, and will withdraw it after the MSRB has taken action. D. DISCLOSURE OF MARK-UPS AND MARK-DOWNS IN CERTAIN NASDAQ AND EXCHANGE-LISTED SECURITIES As part of the amendments to Rule 10b-10, the Commission proposed requiring the disclosure of mark-up information for principal transactions in certain securities quoted on Nasdaq or listed on regional exchanges.-[70]- This proposal covered securities that are subject to last sale reporting, but are not technically "reported securities" under Rule 11Aa3-1 of the -[66]- Nevertheless unrated municipal bonds, which make up approximately 33% of the market, in the aggregate have a higher default rate than do rated bonds. See Municipal Bond Defaults - - The 1980's Decade in Review 1-2, at 1, J.J. Kenny Co., Inc. (1993). According to this study on default rates between January 1, 1980 to December 31, 1991, 628 unrated issues defaulted compared with 98 rated issues. According to data provided by the Securities Data Company, unrated debt defaults make up approximately 75% of all defaults. See also Public Securities Association, An Examination of Non-Rated Municipal Defaults 1986- 1991 4 (Jan. 8, 1993). -[67]- 15 U.S.C. 78c(a)(42). -[68]- Letter from David C. Clapp, Chairman, MSRB, to Jonathan G. Katz, Secretary, SEC (June 15, 1994). -[69]- Id. -[70]- See Proposing Release, supra note 10, 59 FR 12770. -------------------- BEGINNING OF PAGE #17 ------------------- Exchange Act.-[71]- As noted in the Proposing Release, the NASD adopted amendments to its confirmation rule requiring the disclosure of mark-up information in principal transactions in securities that are not Nasdaq/NMS securities -- i.e., Nasdaq Small Cap Securities.-[72]- The purpose of the proposed amendment is to consolidate disclosures already required under NASD rules. Because last sale information is available for regional exchange-listed securities, the Commission proposed to extend the disclosure requirements to those securities, in addition to Small Cap Securities. By adopting this proposal, the confirmation rule will treat all equity securities subject to last sale reporting similarly, irrespective of their trading markets. The two comments that addressed this requirement supported the proposal.-[73]- Accordingly, under Rule 10b-10, broker- dealers effecting principal transactions in Small-Cap Nasdaq and regional exchange-listed securities that are subject to last- sale reporting will be required to disclose on the confirmation the reported trade price, price to the customer, and the difference, if any, between the two prices. E. DISCLOSURE OF COVERAGE BY THE SECURITIES INVESTOR PROTECTION CORPORATION In order to reduce investor confusion concerning a firm's SIPC coverage,-[74]- the Commission proposed to amend Rule 10b- -[71]- 17 CFR 240.11Aa3-1(a)(4). This provision defines "reported security" as any exchange-listed equity security or Nasdaq security for which transaction reports are made available on a real-time basis pursuant to an effective transaction reporting plan. An "effective transaction reporting plan" refers to a transaction reporting plan that the Commission has approved pursuant to Rule 11Aa3-1. 17 CFR 240.11Aa3-1(a)(3). Reported securities currently include: 1. Nasdaq securities that meet standards set forth in the National Market System Securities Designation Plan ("Nasdaq/NMS securities). 2. Certain securities listed on a national securities exchange that meet standards of the transaction reporting plan known as the Restated Consolidated Tape Association Plan. This would include securities that are registered or admitted to unlisted trading privileges on a national securities exchange, including securities listed on various regional exchanges, and that substantially meet NYSE or American Stock Exchange, Inc. original listing criteria. -[72]- NASD Schedule to By-Laws, Schedule D, pt. XI, 3, NASD Manual (CCH) 1867D. -[73]- See Letters from Robert F. Price, Chairman/Federal Regulation Committee, SIA (July 15, 1994); and Kurt D. Halvorson, Vice President/Controller, AmeriTrade (May 27, 1994), to Jonathan G. Katz, Secretary, SEC. -[74]- SIPC, a non-profit, membership corporation, was established under the Securities Investor Protection Act of 1970. SIPC is funded by assessments on its members and interest earned on fund assets. The fund is used to protect securities customers of SIPC-member broker-dealers that fail financially. 15 U.S.C. (continued...) -------------------- BEGINNING OF PAGE #18 ------------------- 10 to require affirmative disclosure, if applicable, when a broker-dealer is not a member of SIPC and when an account is carried by a non-SIPC-member broker or dealer. Generally, the Securities Investor Protection Act of 1970 requires broker- dealers registered with the Commission under Section 15(b) of the Exchange Act to be members of SIPC. Certain types of broker- dealers registered under Section 15(b), as well as all broker- dealers registered as government securities brokers and dealers under Section 15C of the Exchange Act, are excluded from SIPC membership.-[75]- Many commenters addressing this issue supported the Commission's proposal to inform customers when their broker- dealers are not SIPC members.-[76]- Other commenters generally agreed with requiring the disclosure, but disagreed that the confirmation was the appropriate disclosure medium and suggested that non-membership status in SIPC be disclosed in a periodic account statement or opening account document.-[77]- Commenters opposing the disclosure initiative argued that the disclosure would be misleading to investors in that they would believe that they are at greater risk when dealing with a non-SIPC firm.-[78]- The Investment Company Institute ("ICI") argued that requiring "negative disclosure" concerning the lack of SIPC coverage is contrary to the reasons certain persons are exempted from the membership requirement in the first instance -- namely, excluded broker-dealers present limited risks to investors because they do -[74]-(...continued) 78aaa et seq. For example, in the event of the failure of a SIPC member firm, SIPC provides protection up to $500,000 for claims for cash and securities (although claims solely for cash are limited to $100,000) of each customer. 15 U.S.C. 78fff- 3(a)(1). -[75]- In addition to government securities brokers and dealers, the following broker-dealers are not required to be members of SIPC: (1) persons whose principal business in the determination of SIPC (and with Commission approval) is conducted outside the U.S.; and (2) persons whose business consists exclusively of (a) the distribution of shares of registered open- end investment companies or unit investment trusts, (b) the sale of variable annuities, (c) the business of insurance, or (d) the business of rendering investment advisory services to registered investment companies or insurance company separate accounts. 15 U.S.C. 78ccc(a)(2)(A) and 78lll(12). -[76]- See, e.g., Letters from Ronald S. Plaine, President, Comerica Securities (undated); David M. Beckius, Vice President/Sr. Attorney, Dean Witter Reynolds, Inc. (July 14, 1994); and William E. Kramer, Assistant Vice President, Nomura Securities International, Inc. (July 15, 1994), to Jonathan G. Katz, Secretary, SEC. -[77]- See, e.g., Letters from William E. Kramer, Assistant Vice President, Nomura Securities International, Inc. (July 15, 1994); A.B. Krongard, Chief Executive Officer, Alex. Brown & Sons, Incorporated (July 14, 1994); and R. Fenn Putman, Chairman, PSA (June 21, 1994), to Jonathan G. Katz, Secretary, SEC. -[78]- See, e.g., Letters from Lawrence J. Latto, Shea & Gardner (June 17, 1994); and Peter C. Clapman, Sr. Vice President/Chief Counsel, College Retirement Equities Fund (June 15, 1994); to Jonathan G. Katz, Secretary, SEC. -------------------- BEGINNING OF PAGE #19 ------------------- not hold customer funds.-[79]- The Commission, consistent with its authority under the Government Securities Act Amendments of 1993,-[80]- is adopting the proposed amendment to ensure that customers are not led to believe that their accounts are subject to protection beyond what actually is the case.-[81]- This disclosure is relevant and meaningful to investors. Further, the confirmation is the best vehicle to convey this information to customers on a transaction-specific basis, particularly in situations where a customer is dealing with affiliated broker- dealers and one or more of the affiliates is not a SIPC member. The Commission agrees, however, that certain instances exist where this disclosure should not apply.-[82]- For instance, the ICI stated that in some cases when a broker-dealer contracts with an investment company for the distribution of fund shares, customers purchasing such shares will send their purchase money directly to the fund's transfer agent.-[83]- The transfer agent then will issue shares to the customer against receipt of the purchase money and send the money to the fund's custodian bank. In this situation, customer funds are not handled by the broker- dealer. In addition, the ICI argued that the transfer agent or fund underwriter, when sending the confirmation on behalf of the broker-dealer, may not know the SIPC status of a particular broker-dealer. Accordingly, the disclosure provision contains an exclusion that is intended to apply only in cases where the non- SIPC broker-dealer does not receive or handle in any form customer funds or securities in connection with a purchase or redemption of registered open-end investment company or unit investment trust shares and the customer sends its purchase money or securities to the fund, its transfer agent, its custodian, or -[79]- See Letter from Paul Schott Stevens, General Counsel, ICI, to Jonathan G. Katz, Secretary, SEC (June 15, 1994). See also Letter from Fred J. Franklin, Vice President/Chief Compliance Officer, Aetna Life Insurance and Annuity Co., to Jonathan G. Katz, Secretary, SEC (June 14, 1994). -[80]- 15 U.S.C. 78O-5(a)(4). -[81]- The legislative history of the Government Securities Act Amendments of 1993 discussed SIPC coverage and the exemption from SIPC coverage afforded to government securities brokers and dealers. The Government Accounting Office noted that the gap in SIPC coverage could be confusing to investors and recommended, among other things, that the lack of SIPC coverage be disclosed. The amendments ultimately took a disclosure approach and authorized the Commission to require disclosure of non-SIPC status of government securities brokers and dealers. S. Rep. No. 422, 103rd Cong., 1st Sess. 16 (1993). The same reasons to require this disclosure of government securities brokers and dealers applies to other broker-dealers that are exempt from SIPC coverage. -[82]- Some commenters believed that the proposed disclosure was inconsistent with a letter, Letter regarding Benjamin M. Vandegrift (Dec. 21, 1993), issued by the Division of Investment Management. The disclosure requirement adopted today recognizes the position taken in the letter, reserving the right to revisit SIPC-related disclosure issues. -[83]- See Letter from Paul Schott Stevens, General Counsel, ICI, to Jonathan G. Katz, Secretary, SEC (June 15, 1994), at 2, n.5. -------------------- BEGINNING OF PAGE #20 ------------------- its designated agent, none of whom are associated persons of the broker-dealer. Furthermore, checks may not be made payable to the broker-dealer, and the broker-dealer may not handle any customer checks in connection with the transaction. Otherwise, the broker-dealer would be required to disclose its non-SIPC status. Therefore, if a broker-dealer, including a fund underwriter, receives customer funds or securities and promptly forwards funds or securities to the investment company, transfer agent, custodian, or other designated agent, the confirmation would have to disclose the non-SIPC status of the broker-dealer. F. DISCLOSURES RELATING TO ASSET-BACKED SECURITIES In 1983, the Commission adopted amendments to Rule 10b-10 to require disclosure of yield information on a customer confirmation, recognizing that such information is important to investors when evaluating the merits of investing in various debt securities.-[84]- Currently, Rule 10b-10 requires the disclosure of (1) the yield to maturity, if the transaction is effected on the basis of dollar price;-[85]- (2) the dollar price calculated from yield, if the transaction is effected on a yield basis;-[86]- and (3) if effected on a basis other than dollar price or yield to maturity, and the yield to maturity will be less than the represented yield, then both the yield to maturity and the represented yield.-[87]- Rule 10b-10 exempts from the yield disclosure requirements any instrument that is a "participation interest in notes secured by liens upon real estate continuously subject to prepayment."-[88]- Since the adoption of the yield disclosure requirements, structured financings have expanded to include securities backed by mortgage notes, automobile loans, computer leases, consumer debt, and other receivables. These asset- backed securities raised similar problems of variable yield. Accordingly, the Commission proposed to expand the range of securities subject to the exemptions from yield disclosure to include asset-backed securities that are not insulated from prepayment risk or susceptible to an accurate forecast of yield.-[89]- In addition, the Commission proposed to require particularized disclosures in connection with transactions in collateralized mortgage obligations ("CMOs").-[90]- -[84]- See Securities Exchange Act Release No. 19687 (Apr. 18, 1983), 48 FR 17583. -[85]- 17 CFR 240.10b-10(a)(4)(ii) and (5)(i). -[86]- 17 CFR 240.10b-10(a)(5)(ii). -[87]- 17 CFR 240.10b-10(a)(5)(iii). -[88]- 17 CFR 240.10b-10(a)(4)(ii) and (5)(iii). Essentially, this exemption was aimed at mortgage pass-through notes that were issued or guaranteed by the Government National Mortgage Association, Federal National Mortgage Association, and the Federal Home Loan Mortgage Corporation. -[89]- See Proposing Release, supra note ___, at 59 FR 12771. -[90]- CMOs are collateralized pools of residential mortgage loans that are divided into multiple tranches (sometimes as many as 15 to 20) which can be tailored to a broad spectrum of investors or particularized to the cash flow needs of a single or (continued...) -------------------- BEGINNING OF PAGE #21 ------------------- Specifically, the Commission proposed amendments that would require broker-dealers to disclose on the confirmation the particular CMO's (1) estimated yield; (2) weighted average life; and (3) prepayment assumptions underlying the yield.-[91]- Some commenters supported the Commission's proposal to require disclosure of CMO information and noted that such disclosures were provided to investors as a matter of course, either in a confirmation or other disclosure statements.-[92]- Other commenters opposed confirmation disclosure of the estimated yield, weighted average life, and prepayment assumptions on the grounds that the confirmation is not an appropriate disclosure vehicle to convey the information.-[93]- In addition, commenters opposed disclosing such complex information in a confirmation because it could not be accomplished in a meaningful way due to the document's limited size and space.-[94]- Many commenters noted that detailed discussions concerning particular aspects of CMOs are contained in the prospectus or other offering documents that are sent to investors prior to the time in which they make their investment decisions.-[95]- No comments were received regarding the proposal to expand the range of instruments that would be exempted from the yield -[90]-(...continued) discrete group of investors. Like other asset-backed securities, the rate of prepayment on the underlying collateral of CMOs is influenced by changes in interest rates and shifts in the general economy, which in turn may affect the actual maturities of CMOs as prepayment speeds accelerate or decrease. CMOs are priced on the basis of the estimated weighted average life of individual CMO tranches. As interest rates decline, prepayments increase, with a corresponding shortening of weighted average life. Conversely, an increase in interest rates results in a lengthening of maturity. -[91]- Proposing Release, supra note ___, at 59 FR 12771. -[92]- See, e.g., Letters from David M. Beckius, Vice President/Sr. Attorney, Dean Witter Reynolds, Inc. (July 14, 1994); Silas L. Matthies, Sr. Vice President, Norwest Securities, Inc. (June 14, 1994); Rauscher Pierce Refsnes, Inc. (June 14, 1994); and Bill Duepree, Jr., President, Morgan Keegan & Co., Inc. (June 1, 1994), to Jonathan G. Katz, Secretary, SEC. -[93]- Commenters noted that investors receive disclosure documents containing numerous models depicting different prepayment assumptions. These commenters questioned which of the multiple assumptions would be disclosed in the confirmation. See, e.g., Letters from Robert F. Price, Chairman/Federal Regulation Committee, SIA (July 15, 1994); and R. Fenn Putman, Chairman, PSA (June 21, 1994), to Jonathan G. Katz, Secretary, SEC. -[94]- See, e.g., Letters from Robert F. Price, Chairman, Federal Regulation Committee, SIA (July 15, 1994); R. Fenn Putman, Chairman, PSA (June 21, 1994); and Mitchell Delk, Vice President Government and Industry Relations, Freddie Mac, (June 15, 1994), to Jonathan G. Katz, Secretary, SEC. -[95]- See, e.g., Letters from Kathryn S. Reimann, Sr. Vice President, Lehman Brothers, Inc. (July 14, 1994); R. Fenn Putman, Chairman, PSA (June 21, 1994); and Mitchell Delk, Vice President/Government and Industry Relations, Freddie Mac (June 15, 1994), to Jonathan G. Katz, Secretary, SEC. -------------------- BEGINNING OF PAGE #22 ------------------- disclosure requirements. Because some instruments are not subject to predictable forecasts of the yield, the Commission is adopting amendments exempting asset-backed instruments that are continuously subject to prepayment. The exemption would apply only to those instruments that are not insulated from prepayment risk or otherwise susceptible to an accurate forecast of yield.-[96]- In addition, in light of the comments concerning the proposed CMO disclosure, the Commission is modifying the amendment requiring the disclosure of prepayment assumptions, weighted average life, and estimated yield of a CMO. The Commission recognizes that broker-dealers intend confirmations to be brief, and thus size limitations may affect the detail of disclosure that may be practically and meaningfully conveyed to the customer. Thus, while yield information is important to investors of CMOs, as well as all mortgage and asset-backed securities, the Commission agrees that these securities contain complexities that are difficult to explain using single figures in a confirmation. Accordingly, rather than require the disclosure in the confirmation of specific numbers identifying the estimated yield, weighted average life, and prepayment assumptions underlying the yield, the Commission is adopting a requirement that broker-dealers include on the confirmation a statement alerting investors that their yields are subject to fluctuation depending on the speed in which the underlying note or receivable prepays and that specific information is available upon written request of the customer.-[97]- While information concerning prepayment assumptions and pricing of CMOs and other asset-backed securities may be contained in disclosure documents at the offering stage, this type of detailed information has not been as readily available in the secondary market for some asset-backed securities and to some investors.-[98]- Under the Rule, as adopted, such information -[96]- This position codifies a no-action position in Letter regarding Merrill Lynch, Pierce, Fenner & Smith (Oct. 19, 1988), granting no-action with respect to the yield disclosure requirements for those mortgage and asset-backed securities that are not subject to an accurate forecast of yield. The staff noted that if an accurate forecast of yield could be made, then the yield should be disclosed in the confirmation. -[97]- This approach builds upon an alternative suggested by one commenter that rather than the proposed disclosure, the Commission impose a requirement that a broker-dealer print a legend on the confirmation. See Letter from Mitchell Delk, Vice President/Government and Industry Relations, Freddie Mac, to Jonathan G. Katz, Secretary, SEC (June 15, 1994). -[98]- The Commission recognizes the positive efforts made to educate and provide information to investors in the CMO market. For example, the PSA developed a brochure entitled, "Investors Guide to Real Estate Mortgage Investment Conduits (REMICs)," which is approved by the NASD as an investor education tool. In addition, one commenter stated that prepayment information and interest rate information are available to dealers and investors in the secondary market through various vendors and proprietary services. This commenter also indicated that for those market participants that do not have access to this information, they should be able to obtain it from the selling broker-dealer. See Letter from Mitchell Delk, Vice President/Government and Industry Relations, Freddie Mac, to Jonathan G. Katz, Secretary, SEC (June 15, 1994). -------------------- BEGINNING OF PAGE #23 ------------------- would be required to be sent to customers upon written request. In addition, if in fact a CMO or other asset-back security is sold solely on the basis of one yield amount, the yield and underlying assumptions should be disclosed on the confirmation, as well as the legend stating that these items may vary.-[99]- This is consistent with those commenters that noted that they disclose yield information in CMO transactions as a matter of course.-[100]- The antifraud provisions of the federal securities laws would require that any information provided upon request reflect changes or developments in the characteristics of the asset-backed security. III. EFFECTS ON COMPETITION AND REGULATORY FLEXIBILITY ACT CONSIDERATIONS Section 23(a)(2) of the Exchange Act-[101]- requires that the Commission, when adopting rules under the Exchange Act, consider the anticompetitive effects of those rules, if any, and balance any anticompetitive impact against the regulatory benefits gained in terms of furthering the purposes of the Exchange Act. The Commission believes that adoption of the amendments to Rule 10b-10 will not impose any burden on competition not necessary or appropriate in furtherance of the purposes of the Exchange Act. The Commission has prepared a Final Regulatory Flexibility Analysis ("FRFA") regarding the amendments to Rule 10b-10, in accordance with 5 U.S.C. 604. The FRFA notes the potential initial costs of operational and procedural changes that may be necessary to comply with the amendments. In addition, the FRFA notes the benefits to investors of increased disclosure that will result from these amendments. The Commission believes that the benefits of added disclosure outweigh the costs that will be incurred by industry participants in complying with these amendments. A copy of the FRFA will be available for inspection and copying in the Commission's Public Reference Section, 450 Fifth Street, N.W., Washington, D.C. 20549. List of Subjects in 17 CFR Part 240 Reporting and recordkeeping requirements, Securities. Statutory Basis and Text of Amendments For the reasons set forth in the preamble, the Commission hereby amends Part 240 of Chapter II of Title 17 of the Code of Federal Regulations as follows: PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 1934 1. The authority citation for Part 240 continues to read in part as follows: Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78i, 78j, 78l, 78m, 78n, 78o, 78p, -[99]- 17 CFR 240.10b-10(a)(5)(i). See also Securities Exchange Act Release No. 19687 (Apr. 18, 1983), 48 FR 17583. The Commission is concerned that in some cases asset-backed securities may be sold to retail investors on the basis of a single yield figure, without adequate disclosure that this yield can vary based upon prepayment speeds. This inadequate disclosure would potentially violate self-regulatory organization and Commission antifraud rules. In addition, to make this disclosure complete, a broker-dealer would need to disclose that the single yield may vary. -[100]- See supra note 92. -[101]- 15 U.S.C. 78w(a)(2). -------------------- BEGINNING OF PAGE #24 ------------------- 78q, 78s, 78w, 78x, 78ll(d), 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 and 80b-11, unless otherwise noted. * * * * * 2. Section 240.10b-10 is amended by adding a preliminary note prior to paragraph (a), revising paragraphs (a) and (b), removing paragraph (c), redesignating paragraphs (d) through (f) as paragraphs (c) through (e), adding a heading to newly designated paragraph (d), revising the introductory text of paragraph (d)(6), and adding paragraph (d)(10) to read as follows: 240.10b-10 Confirmation of transactions. Preliminary Note. This section requires broker-dealers to disclose specified information in writing to customers at or before completion of a transaction. The requirements under this section that particular information be disclosed is not determinative of a broker-dealer's obligation under the general antifraud provisions of the federal securities laws to disclose additional information to a customer at the time of the customer's investment decision. (a) Disclosure Requirement. It shall be unlawful for any broker or dealer to effect for or with an account of a customer any transaction in, or to induce the purchase or sale by such customer of, any security (other than U.S. Savings Bonds or municipal securities) unless such broker or dealer, at or before completion of such transaction, gives or sends to such customer written notification disclosing: (1) The date and time of the transaction (or the fact that the time of the transaction will be furnished upon written request to such customer) and the identity, price, and number of shares or units (or principal amount) of such security purchased or sold by such customer; and (2) Whether the broker or dealer is acting as agent for such customer, as agent for some other person, as agent for both such customer and some other person, or as principal for its own account; and if the broker or dealer is acting as principal, whether it is a market maker in the security (other than by reason of acting as a block positioner); and (i) If the broker or dealer is acting as agent for such customer, for some other person, or for both such customer and some other person: (A) The name of the person from whom the security was purchased, or to whom it was sold, for such customer or the fact that the information will be furnished upon written request of such customer; and (B) The amount of any remuneration received or to be received by the broker from such customer in connection with the transaction unless remuneration paid by such customer is determined pursuant to written agreement with such customer, otherwise than on a transaction basis; and (C) For a transaction in any subject security as defined in 240.11Ac1-2 or a security authorized for quotation on an automated interdealer quotation system that has the characteristics set forth in Section 17B of this Act (15 U.S.C. 78q-2), a statement whether payment for order flow is received by the broker or dealer for transactions in such securities and the fact that the source and nature of the compensation received in connection with the particular transaction will be furnished upon written request of the customer; and (D) The source and amount of any other remuneration received or to be received by the broker in connection with the transaction: Provided, however, that if, in the case of a purchase, the broker was not participating in a distribution, or in the case of a sale, was not participating in a tender offer, the written notification may state whether any other remuneration -------------------- BEGINNING OF PAGE #25 ------------------- has been or will be received and the fact that the source and amount of such other remuneration will be furnished upon written request of such customer; or (ii) If the broker or dealer is acting as principal for its own account: (A) In the case where such broker or dealer is not a market maker in that security and, if, after having received an order to buy from a customer, the broker or dealer purchased the security from another person to offset a contemporaneous sale to such customer or, after having received an order to sell from a customer, the broker or dealer sold the security to another person to offset a contemporaneous purchase from such customer, the difference between the price to the customer and the dealer's contemporaneous purchase (for customer purchases) or sale price (for customer sales); or (B) In the case of any other transaction in a reported security, or an equity security that is quoted on Nasdaq or traded on a national securities exchange and that is subject to last sale reporting, the reported trade price, the price to the customer in the transaction, and the difference, if any, between the reported trade price and the price to the customer. (3) Whether any odd-lot differential or equivalent fee has been paid by such customer in connection with the execution of an order for an odd-lot number of shares or units (or principal amount) of a security and the fact that the amount of any such differential or fee will be furnished upon oral or written request: Provided, however, that such disclosure need not be made if the differential or fee is included in the remuneration disclosure, or exempted from disclosure, pursuant to paragraph (a)(2)(i)(B) of this section; and (4) In the case of any transaction in a debt security subject to redemption before maturity, a statement to the effect that such debt security may be redeemed in whole or in part before maturity, that such a redemption could affect the yield represented and the fact that additional information is available upon request; and (5) In the case of a transaction in a debt security effected exclusively on the basis of a dollar price: (i) The dollar price at which the transaction was effected, and (ii) The yield to maturity calculated from the dollar price: Provided, however, that this paragraph (a)(5)(ii) shall not apply to a transaction in a debt security that either: (A) Has a maturity date that may be extended by the issuer thereof, with a variable interest payable thereon; or (B) Is an asset-backed security, that represents an interest in or is secured by a pool of receivables or other financial assets that are subject continuously to prepayment; and (6) In the case of a transaction in a debt security effected on the basis of yield: (i) The yield at which the transaction was effected, including the percentage amount and its characterization (e.g., current yield, yield to maturity, or yield to call) and if effected at yield to call, the type of call, the call date and call price; and (ii) The dollar price calculated from the yield at which the transaction was effected; and (iii) If effected on a basis other than yield to maturity and the yield to maturity is lower than the represented yield, the yield to maturity as well as the represented yield; Provided, however, that this paragraph (a)(6)(iii) shall not apply to a transaction in a debt security that either: -------------------- BEGINNING OF PAGE #26 ------------------- (A) Has a maturity date that may be extended by the issuer thereof, with a variable interest rate payable thereon; or (B) Is an asset-backed security, that represents an interest in or is secured by a pool of receivables or other financial assets that are subject continuously to prepayment; and (7) In the case of a transaction in a debt security that is an asset-backed security, which represents an interest in or is secured by a pool of receivables or other financial assets that are subject continuously to prepayment, a statement indicating that the actual yield of such asset-backed security may vary according to the rate at which the underlying receivables or other financial assets are prepaid and a statement of the fact that information concerning the factors that affect yield (including at a minimum estimated yield, weighted average life, and the prepayment assumptions underlying yield) will be furnished upon written request of such customer; and (8) In the case of a transaction in a debt security, other than a government security, that the security is unrated by a nationally recognized statistical rating organization, if such is the case; and (9) That the broker or dealer is not a member of the Securities Investor Protection Corporation (SIPC), or that the broker or dealer clearing or carrying the customer account is not a member of SIPC, if such is the case: Provided, however, that this paragraph (a)(9) shall not apply in the case of a transaction in shares of a registered open-end investment company or unit investment trust if: (i) The customer sends funds or securities directly to, or receives funds or securities directly from, the registered open- end investment company or unit investment trust, its transfer agent, its custodian, or other designated agent, and such person is not an associated person of the broker or dealer required by paragraph (a) of this section to send written notification to the customer; and (ii) The written notification required by paragraph (a) of this section is sent on behalf of the broker or dealer to the customer by a person described in paragraph (a)(9)(i) of this section. (b) Alternative Periodic Reporting. A broker or dealer may effect transactions for or with the account of a customer without giving or sending to such customer the written notification described in paragraph (a) of this section if: (1) Such transactions are effected pursuant to a periodic plan or an investment company plan, or effected in shares of any open-end management investment company registered under the Investment Company Act of 1940 that holds itself out as a money market fund and attempts to maintain a stable net asset value per share: Provided, however, that no sales load is deducted upon the purchase or redemption of shares in the money market fund; and (2) Such broker or dealer gives or sends to such customer within five business days after the end of each quarterly period, for transactions involving investment company and periodic plans, and after the end of each monthly period, for other transactions described in paragraph (c)(1) of this section, a written statement disclosing each purchase or redemption, effected for or with, and each dividend or distribution credited to or reinvested for, the account of such customer during the month; the date of such transaction; the identity, number, and price of any securities purchased or redeemed by such customer in each such transaction; the total number of shares of such securities in such customer's account; any remuneration received or to be received by the broker or dealer in connection therewith; and that any other information required by paragraph (a) of this section will be furnished upon written request: Provided, -------------------- BEGINNING OF PAGE #27 ------------------- however, that the written statement may be delivered to some other person designated by the customer for distribution to the customer; and (3) Such customer is provided with prior notification in writing disclosing the intention to send the written information referred to in paragraph (c)(1) of this section in lieu of an immediate confirmation. * * * * * (d) Definitions. For the purposes of this section: * * * * * (6) Investment company plan means any plan under which securities issued by an open-end investment company or unit investment trust registered under the Investment Company Act of 1940 are purchased by a customer (the payments being made directly to, or made payable to, the registered investment company, or the principal underwriter, custodian, trustee, or other designated agent of the registered investment company), or sold by a customer pursuant to: * * * * * (10) Asset-backed security means a security that is primarily serviced by the cashflows of a discrete pool of receivables or other financial assets, either fixed or revolving, that by their terms convert into cash within a finite time period plus any rights or other assets designed to assure the servicing or timely distribution of proceeds to the security holders. * * * * * By the Commission. Jonathan G. Katz Secretary November 10, 1994