[Federal Register Volume 60, Number 157 (Tuesday, August 15, 1995)]
[Notices]
[Pages 42204-42205]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-20155]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36077; File No. SR-NASD-95-28]
Self-Regulatory Organizations; Order Approving Proposed Rule
Change by National Association of Securities Dealers, Inc., Regarding
Trading in Anticipation of the Issuance of a Research Report
August 9, 1995.
On May 25, 1995, the National Association of Securities Dealers,
Inc. (``NASD'' or ``Association'') filed a proposed rule change with
the Securities and Exchange Commission (``SEC'' or ``Commission'')
pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act'') \1\ and Rule 19b-4 thereunder.\2\ The proposed rule change
amends Article III, Section 1 of the NASD Rules of Fair Practice \3\ by
adding a new Interpretation prohibiting purposeful trading that affects
a member firm's inventory position in a given security prior to the
firm's issuance of a research report in that same security
(``Interpretation'').
\1\ 15 U.S.C. Sec. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ NASD Manual, Rules of Fair Practice, Art. III, Sec. 1 (CCH)
para. 2151.
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Notice of the proposed rule change, together with the substance of
the proposal as initially filed, was provided by issuance of a
Commission release (Securities Exchange Release No. 35877, June 21,
1995) and by publication in the Federal Register (60 FR 33444, June 28,
1995). Two comment letters were received.\4\ This order approves the
proposed rule change.
\4\ See Letter from Brian C. Underwood, Vice President-Director
of Compliance, A.G. Edwards & Sons, Inc. (``A.G. Edwards''), to
Jonathan G. Katz, Secretary, SEC, dated July 18, 1995 (``A.G.
Edwards Letter''); and Letter from Joseph McLaughlin Esq. , Brown &
Wood, to Jonathan G. Katz, Secretary, SEC, dated July 21, 1995
(``Brown & Wood Letter'').
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I. Introduction
Certain broker-dealers that have research departments may prepare
research reports for customers with respect to certain identified
securities. A research report may advise customers to buy or sell the
security that is the subject of that report.
Certain of these broker-dealers may intentionally establish a
proprietary position in the security that is to be the subject of a
report in anticipation of meeting expected customer demand in response
to the research report. A broker-dealer that intends to issue a
positive research report may accumulate stock before issuing the
research report. Once it issues the research report, it would then
commence solicitation of orders, expecting to fill customers orders
from the inventory position it has accumulated.
In 1991, the New York Stock Exchange (``NYSE''), in NYSE
Information Memo 91-8, issued a policy statement regarding stock
accumulations by a NYSE member organization in advance of that member's
issuance of research reports. NYSE Information Memo 91-8 stated that an
NYSE member organization would engage in conduct inconsistent with just
and equitable principles of trade if it purposefully acquired a
position in an NYSE-listed security in contemplation of its issuance of
a favorable research report.
II. Description and Scope of the Proposed Rule Change
In 1994 the NASD solicited member comment on developing a formal
policy deeming trading in anticipation of a research report to be a
violation of Article III, Section 1 of the NASD Rules of Fair Practice.
Purposeful inventory adjustments made in anticipation of customer
trading activity as a result of the firm's research report could appear
to, and at times would, conflict with the firm's fiduciary duties
toward its customers. Therefore, the Interpretation approved today
provides that an NASD member will violate just and equitable principles
of trade if it purposefully adjusts its inventory position in a Nasdaq
security, in an exchange listed security that is traded in the third
market, or in a derivative product of any such security in anticipation
of the issuance of a research report in that security. Such purposeful
activity can create an appearance of impropriety that harms the
perception of the marketplace and could cause a loss of investor
confidence.
The Interpretation approved today is intended to enhance the
overall perception of Nasdaq and the third market and encourage
investors to participate in those markets, thereby promoting liquidity.
The Interpretation also is intended to be consistent with the policy
found in NYSE Information Memo 91-8, thereby promoting consistency
among self-regulatory organizations and helping to alleviate compliance
burdens for member firms that operate in multiple markets. However,
unlike NYSE Information Memo 91-8, the Interpretation also provides
that a member firm will violate just and equitable principles of trade
if it purposefully decreases or liquidates its position in a security
because it was about to issue a negative research report.
The Interpretation applies to third market trading in listed
securities that are the subject of a firm's research report as well as
to Nasdaq securities. The Interpretation covers third market trading
because there could be a significant gap in customer protection rules
on exchange-listed securities traded in the third market absent the
inclusion of those securities.
Finally, the Interpretation prohibits a member firm from attempting
to do indirectly what it is not permitted to do directly. For example,
a member firm may trade in options on an underlying security that is to
be the subject of a research report in order to do by means of an
economically equivalent transaction that which it would otherwise be
prohibited from doing.
Therefore, the Interpretation prohibits a member firm from
purposefully establishing, increasing, decreasing or liquidating a
derivative security position in anticipation of the firm's issuance of
a research report on the security underlying the derivative position.
The Interpretation specifically notes that it is intended to apply
to situations in which the member firm ``purposefully'' alters its
inventory position in anticipation of the issuance of a favorable or
unfavorable research report in anticipation of meeting expected
customer demand in response to the research report. The Interpretation
is not intended to halt all of a firm's trading activity in that
security. Even if the trading desk knows of a forthcoming research
report on a particular security, it may continue to trade with its
retail customers or with other broker-dealers if such trading arises
from unsolicited order flow. The Interpretation also does not apply to
situations where the firm conducts research solely for in-house use and
such research is not made available for external distribution.
In addition, the Interpretation encourages but does not require
firms to establish information barriers (also known as Chinese Wall
procedures or Chinese Walls) to control the flow of information between
their research and trading departments. Information barriers are risk
management controls
[[Page 42205]]
adopted by securities firms between different departments of firms to
enhance the likelihood that knowledge of upcoming events will be
isolated within a single group and not disclosed to other groups that
might trade on or otherwise benefit from the information. Because many
firms today already use information barriers between the research and
trading departments of their firms, the Interpretation encourages the
use of information barriers as the preferred method of complying with
the Interpretation. If a member determines not to implement information
barriers, it would carry the significantly greater burden of proving
that stock accumulations or liquidations prior to the issuance of a
research report had not been purposeful if an NASD investigation into
the firm's buying or selling activity were initiated.
III. Summary of Comments
Two commenters objected to the Interpretation. A.G. Edwards stated
that the Interpretation would adversely affect retail customers of a
firm with an active research department. A.G. Edwards suggested that
the Interpretation would prevent a firm from accumulating stock to
satisfy expected customer demand once it issued a favorable research
report. The A.G. Edwards Letter stated that a firm would need to use
outside dealers in order to meet client demand for the security once
the research report was issued. This, in turn, would cause the price of
the security to rise, which would mean that retail orders would go
unfilled or would be executed only at a price above the price at which
the security was trading before the report was issued.
A.G. Edwards claimed that the Interpretation would discourage small
issuers from issuing their securities because the Interpretation, if
adopted, would discourage firms from initiating coverage of their
securities. It also claimed that the Interpretation is flawed because
it does not similarly prohibit firms from adjusting their inventory
when conducting research not available for external distribution. A.G.
Edwards suggested prohibiting firms from accumulating securities for a
specified period in advance of the issuance of a favorable research
report concerning the issuer of those securities, or requiring firms to
sell accumulated securities to customers at a price based on the firm's
average cost.
Brown & Wood also objected to the Interpretation. The Brown & Wood
Letter stated that the Interpretation could not be intended to protect
customers because it would apply not only to trading with a firm's own
customers but to any trading with any person. The Brown & Wood Letter
stated that the Interpretation would discourage firms from maintaining
research staffs, would encourage firms not to distribute research to
their customers, would encourage other firms not to maintain research
staffs and would cause firms to transfer the value of their research
without compensation.
The Commission does not believe that the objections raised by these
commenters warrant disapproval of the Interpretation. The Commission
notes that trading ahead of research reports raises questions about the
motivation of the firm in issuing the research report and about the
quality of information within the research report. In this regard, the
Commission notes that a firm preparing a research report concerning a
security solely for ``in-house'' use cannot expect the repot to affect
public demand for the security; hence, such reports do not raise the
same ``trading ahead'' concerns as do reports prepared for public
investors.
Furthermore, the Commission does not believe that the prior
accumulation of a security that is to be the subject of a favorable
research report affects the level of investor demand for that security;
therefore, the Commission does not believe that the Interpretation will
cause firm customers to pay higher prices for the securities that are
the subject of research reports than they would pay if firms could
trade ahead of research reports.
The Commission finds that the proposed rule change is consistent
with Section 15A(b)(6) of the Act in that the proposed rule change will
increase investor confidence in the integrity of research reports,
thereby protecting investors and the public interest.
It is therefore ordered, pursuant to Section 19(b)(2) of the Act,
that the proposed rule change SR-NASD-95-28 be, and hereby is,
approved.
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority, 17 CFR 200.30-3(a)(12).
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 95-20155 Filed 8-14-95; 8:45 am]
BILLING CODE 8010-01-M
