Self-Regulatory Organizations: National Association of Securities Dealers, Inc.; Notice of Filing of Amendment Nos. 3, 4, and 5 to a Proposed Rule Change Relating to Additional Mark-Up Policy for Transactions in Debt Securities, Except Municipal Securities, 68856-68864 [E6-20068]

Download as PDF 68856 Federal Register / Vol. 71, No. 228 / Tuesday, November 28, 2006 / Notices burden on competition that is not necessary or appropriate in furtherance of the purposes of the Act, as amended. C. Self-Regulatory Organization’s Statement on Comments on the Proposed Rule Change Received From Members, Participants, or Others Written comments were neither solicited nor received. III. Date of Effectiveness of the Proposed Rule Change and Timing for Commission Action Within 35 days of the date of publication of this notice in the Federal Register or within such longer period (i) as the Commission may designate up to 90 days of such date if it finds such longer period to be appropriate and publishes its reasons for so finding, or (ii) as to which Nasdaq consents, the Commission will: (A) By order approve such proposed rule change, or (B) Institute proceedings to determine whether the proposed rule change should be disapproved. proposed rule change between the Commission and any person, other than those that may be withheld from the public in accordance with the provisions of 5 U.S.C. 552, will be available for inspection and copying in the Commission’s Public Reference Room. Copies of such filing also will be available for inspection and copying at the principal office of the Nasdaq. All comments received will be posted without change; the Commission does not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly. All submissions should refer to File Number SR–NASDAQ–2006–041 and should be submitted on or before December 19, 2006. For the Commission, by the Division of Market Regulation, pursuant to delegated authority.11 Jill M. Peterson, Assistant Secretary. [FR Doc. E6–20134 Filed 11–27–06; 8:45 am] BILLING CODE 8011–01–P IV. Solicitation of Comments Interested persons are invited to submit written data, views, and arguments concerning the foregoing, including whether the proposed rule change is consistent with the Act. Comments may be submitted by any of the following methods: Electronic Comments ycherry on PROD1PC61 with NOTICES • Use the Commission’s Internet comment form (https://www.sec.gov/ rules/sro.shtml); or • Send an e-mail to rulecomments@sec.gov. Please include File Number SR–NASDAQ–2006–041 on the subject line. SECURITIES AND EXCHANGE COMMISSION [Release No. 34–54799; File No. SR–NASD– 2003–141] 15:42 Nov 27, 2006 Jkt 211001 I. Self-Regulatory Organization’s Statement of the Terms of Substance of the Proposed Rule Change NASD is proposing to adopt NASD IM–2440–2 to NASD Rule 2440 to provide additional mark-up policy for transactions in debt securities, except municipal securities. Below is the amended text of the proposed rule change. Proposed new language is in italic. * * * * * IM–2440–1. Mark-Up Policy Remainder of IM–2440–1 No change. * * * * * Self-Regulatory Organizations: National Association of Securities Dealers, Inc.; Notice of Filing of Amendment Nos. 3, 4, and 5 to a Proposed Rule Change Relating to Additional Mark-Up Policy for Transactions in Debt Securities, Except Municipal Securities IM–2440–2. Additional Mark-Up Policy For Transactions in Debt Securities, Except Municipal Securities 1 November 21, 2006. (b) Prevailing Market Price (1) A dealer that is acting in a principal capacity in a transaction with Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 Paper Comments (‘‘Act’’) 1 and Rule 19b–4 thereunder,2 notice is hereby given that on October • Send paper comments in triplicate 11, 2005, November 22, 2005, and to Nancy M. Morris, Secretary, October 31, 2006, the National Securities and Exchange Commission, Association of Securities Dealers, Inc. Station Place, 100 F Street, NE., (‘‘NASD’’) filed with the Securities and Washington, DC 20549–1090. Exchange Commission (‘‘SEC’’ or All submissions should refer to File ‘‘Commission’’) Amendment Nos. 3, 4, Number SR–NASDAQ–2006–041. This and 5 to the proposed rule change as file number should be included on the subject line if e-mail is used. To help the described in Items I, II, and III below, which Items have been prepared by Commission process and review your NASD. NASD submitted the original comments more efficiently, please use only one method. The Commission will proposed rule change to the post all comments on the Commission’s Commission on September 17, 2003 and filed amendments on June 29, 2004, and Internet Web site (https://www.sec.gov/ February 17, 2005.3 The Commission rules/sro.shtml). Copies of the submission, all subsequent 11 17 CFR 200.30–3(a)(12). amendments, all written statements 1 15 U.S.C. 78s(b)(1). with respect to the proposed rule 2 17 CFR 240.19b–4. change that are filed with the 3 Amendment No. 1 to SR–NASD–2003–141 made Commission, and all written technical changes to the original rule filing. Amendment No. 2 to SR–NASD–2003–141 communications relating to the VerDate Aug<31>2005 published the proposed rule change, as amended by Amendment Nos. 1 and 2, for comment in the Federal Register on March 15, 2005.4 The Commission received six comments on the proposal.5 NASD submitted a response to these comments on October 4, 2005, and filed Amendment Nos. 3, 4, and 5 to further address the comments and propose responsive amendments.6 Amendment No. 5 replaces in their entirety the original rule filing and Amendment Nos. 1 through 4 thereto. The Commission is publishing this notice to solicit comments on the proposed rule change, as amended, from interested persons. PO 00000 Frm 00063 Fmt 4703 Sfmt 4703 (a) Scope (1) IM–2440–1 applies to debt securities transactions, and this IM– 2440–2 supplements the guidance provided in IM–2440–1. superseded in its entirety the original rule filing, as amended by Amendment No. 1. 4 See Securities Exchange Act Release No. 51338 (March 9, 2005), 70 FR 12764 (March 15, 2005) (NASD–2003–141). 5 The Commission received comments from Mr. Paul Scheurer, Banc of America Securities LLC, The Bond Market Association, CitiGroup Global Markets, Inc., The Asset Managers Forum, and the American Securitization Forum. Two comments were submitted during the comment period which closed on April 5, 2005, and four additional comment letters were submitted after the comment period closed. 6 Both Amendment Nos. 3 and 4 to SR–NASD– 2003–141 made technical changes to the rule filing as amended by Amendment No. 2. 1 The Interpretation does not apply to transactions in municipal securities. Single terms in parentheses within sentences, such as the terms ‘‘(sale)’’ and ‘‘(to)’’ in the phrase, ‘‘contemporaneous dealer purchase (sale) transactions with institutional accounts,’’ refer to scenarios where a member is charging a customer a mark-down. E:\FR\FM\28NON1.SGM 28NON1 ycherry on PROD1PC61 with NOTICES Federal Register / Vol. 71, No. 228 / Tuesday, November 28, 2006 / Notices a customer and is charging a mark-up or mark-down must mark-up or markdown the transaction from the prevailing market price. Presumptively for purposes of this IM–2440–2, the prevailing market price for a debt security is established by referring to the dealer’s contemporaneous cost as incurred, or contemporaneous proceeds as obtained, consistent with NASD pricing rules. (See, e.g., Rule 2320). (2) When the dealer is selling the security to a customer, countervailing evidence of the prevailing market price may be considered only where the dealer made no contemporaneous purchases in the security or can show that in the particular circumstances the dealer’s contemporaneous cost is not indicative of the prevailing market price. When the dealer is buying the security from a customer, countervailing evidence of the prevailing market price may be considered only where the dealer made no contemporaneous sales in the security or can show that in the particular circumstances the dealer’s contemporaneous proceeds are not indicative of the prevailing market price. (3) A dealer’s cost is considered contemporaneous if the transaction occurs close enough in time to the subject transaction that it would reasonably be expected to reflect the current market price for the security. (Where a mark-down is being calculated, a dealer’s proceeds would be considered contemporaneous if the transaction from which the proceeds result occurs close enough in time to the subject transaction that such proceeds would reasonably be expected to reflect the current market price for the security.) (4) A dealer that effects a transaction in debt securities with a customer and identifies the prevailing market price using a measure other than the dealer’s own contemporaneous cost (or, in a mark-down, the dealer’s own proceeds) must be prepared to provide evidence that is sufficient to overcome the presumption that the dealer’s contemporaneous cost (or, the dealer’s proceeds) provides the best measure of the prevailing market price. A dealer may be able to show that its contemporaneous cost is (or proceeds are) not indicative of prevailing market price, and thus overcome the presumption, in instances where (i) interest rates changed after the dealer’s contemporaneous transaction to a degree that such change would reasonably cause a change in debt securities pricing; (ii) the credit quality of the debt security changed significantly after the dealer’s VerDate Aug<31>2005 15:42 Nov 27, 2006 Jkt 211001 contemporaneous transaction; or (iii) news was issued or otherwise distributed and known to the marketplace that had an effect on the perceived value of the debt security after the dealer’s contemporaneous transaction. (5) In instances where the dealer has established that the dealer’s cost is (or, in a mark-down, proceeds are) no longer contemporaneous, or where the dealer has presented evidence that is sufficient to overcome the presumption that the dealer’s contemporaneous cost (or proceeds) provides the best measure of the prevailing market price, such as those instances described in (b)(4)(i), (ii) and (iii), a member must consider, in the order listed, the following types of pricing information to determine prevailing market price: (A) Prices of any contemporaneous inter-dealer transactions in the security in question; (B) In the absence of transactions described in (A), prices of contemporaneous dealer purchases (sales) in the security in question from (to) institutional accounts with which any dealer regularly effects transactions in the same security; or (C) In the absence of transactions described in (A) and (B), for actively traded securities, contemporaneous bid (offer) quotations for the security in question made through an inter-dealer mechanism, through which transactions generally occur at the displayed quotations. (A member may consider a succeeding category of pricing information only when the prior category does not generate relevant pricing information (e.g., a member may consider pricing information under (B) only after the member has determined, after applying (A), that there are no contemporaneous inter-dealer transactions in the same security).) In reviewing the pricing information available within each category, the relative weight, for purposes of identifying prevailing market price, of such information (i.e., either a particular transaction price, or, in (C) above, a particular quotation) depends on the facts and circumstances of the comparison transaction or quotation (i.e., such as whether the dealer in the comparison transaction was on the same side of the market as the dealer is in the subject transaction and timeliness of the information). (6) In the event that, in particular circumstances, the above factors are not available, other factors that may be taken into consideration for the purpose of establishing the price from which a customer mark-up (mark-down) may be PO 00000 Frm 00064 Fmt 4703 Sfmt 4703 68857 calculated, include but are not limited to: • Prices of contemporaneous interdealer transactions in a ‘‘similar’’ security, as defined below, or prices of contemporaneous dealer purchase (sale) transactions in a ‘‘similar’’ security with institutional accounts with which any dealer regularly effects transactions in the ‘‘similar’’ security with respect to customer mark-ups (mark-downs); • Yields calculated from prices of contemporaneous inter-dealer transactions in ‘‘similar’’ securities; • Yields calculated from prices of contemporaneous dealer purchase (sale) transactions with institutional accounts with which any dealer regularly effects transactions in ‘‘similar’’ securities with respect to customer mark-ups (markdowns); and • Yields calculated from validated contemporaneous inter-dealer bid (offer) quotations in ‘‘similar’’ securities for customer mark-ups (mark-downs). The relative weight, for purposes of identifying prevailing market price, of the pricing information obtained from the factors set forth above depends on the facts and circumstances surrounding the comparison transaction (i.e., whether the dealer in the comparison transaction was on the same side of the market as the dealer is in the subject transaction, timeliness of the information, and, with respect to the final factor listed above, the relative spread of the quotations in the similar security to the quotations in the subject security). (7) Finally, if information concerning the prevailing market price of the subject security cannot be obtained by applying any of the above factors, NASD or its members may consider as a factor in assessing the prevailing market price of a debt security the prices or yields derived from economic models (e.g., discounted cash flow models) that take into account measures such as credit quality, interest rates, industry sector, time to maturity, call provisions and any other embedded options, coupon rate, and face value; and consider all applicable pricing terms and conventions (e.g., coupon frequency and accrual methods). Such models currently may be in use by bond dealers or may be specifically developed by regulators for surveillance purposes. (8) Because the ultimate evidentiary issue is the prevailing market price, isolated transactions or isolated quotations generally will have little or no weight or relevance in establishing prevailing market price. For example, in considering yields of ‘‘similar’’ securities, except in extraordinary E:\FR\FM\28NON1.SGM 28NON1 68858 Federal Register / Vol. 71, No. 228 / Tuesday, November 28, 2006 / Notices ycherry on PROD1PC61 with NOTICES circumstances, members may not rely exclusively on isolated transactions or a limited number of transactions that are not fairly representative of the yields of transactions in ‘‘similar’’ securities taken as a whole. (9) ‘‘Customer,’’ for purposes of Rule 2440, IM–2440–1 and this IM–2440–2, shall not include a qualified institutional buyer (‘‘QIB’’) as defined in Rule 144A under the Securities Act of 1933 that is purchasing or selling a noninvestment grade debt security when the dealer has determined, after considering the factors set forth in IM–2310–3, that the QIB has the capacity to evaluate independently the investment risk and in fact is exercising independent judgment in deciding to enter into the transaction. For purposes of Rule 2440, IM–2440–1 and this IM–2440–2, ‘‘noninvestment grade debt security’’ means a debt security that: (i) If rated by only one nationally recognized statistical rating organization (‘‘NRSRO’’), is rated lower than one of the four highest generic rating categories; (ii) if rated by more than one NRSRO, is rated lower than one of the four highest generic rating categories by any of the NRSROs; or (iii) if unrated, either was analyzed as a non-investment grade debt security by the dealer and the dealer retains credit evaluation documentation and demonstrates to NASD (using credit evaluation or other demonstrable criteria) that the credit quality of the security is, in fact, equivalent to a noninvestment grade debt security, or was initially offered and sold and continues to be offered and sold pursuant to an exemption from registration under the Securities Act of 1933. (c) ‘‘Similar’’ Securities (1) A ‘‘similar’’ security should be sufficiently similar to the subject security that it would serve as a reasonable alternative investment to the investor. At a minimum, the security or securities should be sufficiently similar that a market yield for the subject security can be fairly estimated from the yields of the ‘‘similar’’ security or securities. Where a security has several components, appropriate consideration may also be given to the prices or yields of the various components of the security. (2) The degree to which a security is ‘‘similar,’’ as that term is used in this IM–2440–2, to the subject security may be determined by factors that include but are not limited to the following: (A) Credit quality considerations, such as whether the security is issued by the same or similar entity, bears the same or similar credit rating, or is supported by a similarly strong VerDate Aug<31>2005 15:42 Nov 27, 2006 Jkt 211001 guarantee or collateral as the subject security (to the extent securities of other issuers are designated as ‘‘similar’’ securities, significant recent information of either issuer that is not yet incorporated in credit ratings should be considered (e.g., changes to ratings outlooks)); (B) The extent to which the spread (i.e., the spread over U.S. Treasury securities of a similar duration) at which the ‘‘similar’’ security trades is comparable to the spread at which the subject security trades; (C) General structural characteristics and provisions of the issue, such as coupon, maturity, duration, complexity or uniqueness of the structure, callability, the likelihood that the security will be called, tendered or exchanged, and other embedded options, as compared with the characteristics of the subject security; and (D) Technical factors such as the size of the issue, the float and recent turnover of the issue, and legal restrictions on transferability as compared with the subject security. (3) When a debt security’s value and pricing is based substantially on, and is highly dependent on, the particular circumstances of the issuer, including creditworthiness and the ability and willingness of the issuer to meet the specific obligations of the security, in most cases other securities will not be sufficiently similar, and therefore, other securities may not be used to establish the prevailing market price. * * * * * II. Self-Regulatory Organization’s Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change In its filing with the Commission, NASD included statements concerning the purpose of and basis for the proposed rule change and discussed any comments it received on the proposed rule change. The text of these statements may be examined at the places specified in Item IV below. NASD has prepared summaries, set forth in sections A, B, and C below, of the most significant aspects of such statements. A. Self-Regulatory Organization’s Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change 1. Purpose Background and Introduction Under NASD Rule 2440, ‘‘Fair Prices and Commissions,’’ members are required to sell securities to a customer PO 00000 Frm 00065 Fmt 4703 Sfmt 4703 at a fair price.7 When a member acts in a principal capacity and sells a security to a customer, a dealer generally ‘‘marks up’’ the security, increasing the total price the customer pays. Conversely, when buying a security from a customer, a dealer that is a principal generally ‘‘marks down’’ the security, reducing the total proceeds the customer receives. NASD IM–2440, ‘‘Mark-Up Policy,’’ provides additional guidance on mark-ups and fair pricing of securities transactions with customers.8 Both Rule 2440 and IM– 2440 apply to transactions in debt securities, and IM–2440 provides that mark-ups for transactions in common stock are customarily higher than those for bond transactions of the same size.9 Under Rule 2440 and IM–2440, when a customer buys a security from a dealer, the customer’s total purchase price, and the mark-up included in the price, must be fair and reasonable. Similarly, when a customer sells a security to a dealer, the customer’s total proceeds from the sale, which were reduced by the mark-down, and the mark-down, must be fair and reasonable. A key step in determining whether a mark-up (mark-down) is fair and reasonable is correctly identifying the prevailing market price of the security, which is the basis from which the mark-up (mark-down) is calculated.10 7 Rule 2440 specifically provides that a member is required to buy or sell a security at a fair price to customers, ‘‘taking into consideration all relevant circumstances, including market conditions with respect to such security at the time of the transaction, the expense involved, and the fact that he is entitled to a profit * * * .’’ Rule 2320, ‘‘Best Execution and Interpositioning,’’ also addresses a member’s obligation in pricing customer transactions. In any transaction for or with a customer or a customer of another broker-dealer, NASD Rule 2320, as amended effective November 8, 2006, requires a member to ‘‘use reasonable diligence to ascertain the best market for the subject security and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions.’’ See Securities Exchange Act Release No. 54339 (August 21, 2006), 71 FR 50959 (August 28, 2006) (order approving proposed rule change and Amendment Nos. 1 through 5; File No. SR–NASD–2004–026); NASD Notice to Members 06–58 (October 2006). Together, Rule 2440 and Rule 2320 impose broad responsibilities on broker-dealers to price customer transactions fairly. Cf. ‘‘Review of Dealer Pricing Responsibilities,’’ MSRB Notice 2004–3 (January 26, 2004) (discussing MSRB Rules requiring municipal securities dealers to ‘‘exercise diligence in establishing the market value of [a] security and the reasonableness of the compensation received on [a] transaction’’). 8 The terms ‘‘mark-up’’ and ‘‘mark-down’’ are not found in Rule 2440, but are used in IM–2440. Statements regarding mark-ups also apply generally to mark-downs unless mark-downs are discussed specifically in a separate statement. 9 NASD IM–2440(b)(1). 10 IM–2440 states: ‘‘It shall be deemed a violation of Rule 2110 and Rule 2440 for a member to enter E:\FR\FM\28NON1.SGM 28NON1 Federal Register / Vol. 71, No. 228 / Tuesday, November 28, 2006 / Notices The Proposed Interpretation, ‘‘IM– 2440–2, Additional Mark-Up Policy For Transactions in Debt Securities, Except Municipal Securities’’ (‘‘Proposed Interpretation’’), provides additional guidance on mark-ups (mark-downs) in debt securities transactions, except municipal securities transactions.11 The Proposed Interpretation addresses two fundamental issues in debt securities transactions: (1) How does a dealer correctly identify the prevailing market price of a debt security; and (2) what is a ‘‘similar’’ security and when may it be considered in determining the prevailing market price. As part of the discussion of prevailing market price, the Proposed Interpretation provides guidance on the meaning of ‘‘contemporaneous.’’ 12 In addition, NASD proposes a significant exclusion from Rule 2440, IM–2440–1 13 and the Proposed Interpretation for brokerdealers engaging in non-investment grade debt securities transactions with certain institutional accounts.14 ycherry on PROD1PC61 with NOTICES Prevailing Market Price The Proposed Interpretation provides that when a dealer calculates a mark-up (or a mark-down), the best measure of the prevailing market price of the security is presumptively the dealer’s contemporaneous cost (proceeds).15 Further, the dealer may look to countervailing evidence of the into any transaction with a customer in any security at any price not reasonably related to the current market price of the security or to charge a commission which is not reasonable.’’ 11 MSRB rule G–30, ‘‘Prices and Commissions,’’ applies to transactions in municipal securities, and requires that a municipal securities dealer engaging in a transaction as a principal with a customer must buy or sell securities at an aggregate price that is ‘‘fair and reasonable.’’ 12 See Proposed IM–2440–2(b)(3). 13 If the Commission adopts the Proposed Interpretation, current IM–2440 will be renumbered as IM–2440–1. IM–2440 is referred to hereinafter as IM–2440–1. 14 See Proposed IM–2440–2(b)(9). 15 See Proposed IM–2440–2(b)(1). Of course, if a dealer violates NASD Rule 2320, the dealer’s contemporaneous cost (proceeds) in such transactions would not be a reliable indicator of the prevailing market price for the purpose of determining a mark-up or mark-down. If a dealer violates Rule 2320 because the dealer fails to exercise diligence, fails to negotiate at arms length in the market, or engages in fraudulent transactions, including those entered into in collusion with other dealers or brokers, including inter-dealer brokers, the price that the dealer obtains is not a price reflecting market forces, and, therefore, is not a valid indicator of the prevailing market price and should not be used to calculate a mark-up (markdown). In addition, if a dealer that is not a party to a transaction engages in conduct to improperly influence the pricing of such transaction, the dealer could not properly use the execution price as the basis from which to compute a mark-up (markdown) because the execution price does not represent the prevailing market price of the security. VerDate Aug<31>2005 15:42 Nov 27, 2006 Jkt 211001 prevailing market price only where the dealer, when selling a security, made no contemporaneous purchases in the security or can show that in the particular circumstances the dealer’s contemporaneous cost is not indicative of the prevailing market price.16 When buying a security from a customer, the dealer may look to countervailing evidence of the prevailing market price only where the dealer made no contemporaneous sales in the security or can show that in the particular circumstances the dealer’s contemporaneous proceeds are not indicative of the prevailing market price.17 The presumption that contemporaneous cost is the best evidence of prevailing market price is found in many cases and NASD decisions, and its specific applicability to debt securities transactions was addressed by the SEC as early as 1992 in F.B. Horner & Associates, Inc.18 (‘‘F.B. Horner’’), a debt mark-up case. In F. B. Horner, the SEC stated: ‘‘We have consistently held that where, as in the present case, a dealer is not a market maker, the best evidence of the current market, absent countervailing evidence, is the dealer’s contemporaneous cost.’’ 19 The basis for the standard was also restated by the Commission. ‘‘That standard, which has received judicial approval, reflects the fact that the prices paid for a security by a dealer in transactions closely related in time to his retail sales are normally a highly reliable indication of the prevailing market.’’20 The Proposed Interpretation recognizes that in some circumstances a dealer may seek to overcome the presumption that the dealer’s own contemporaneous cost is (or proceeds are) the prevailing market price of the subject security for determining a markup (mark-down), and sets forth a process for identifying a value other than the dealer’s own contemporaneous cost (proceeds).21 Cases Where the Presumption May Be Overcome A dealer may seek to overcome the presumption that its contemporaneous cost or proceeds are not indicative of the 16 See Proposed IM–2440–2(b)(2). id. 18 50 S.E.C. 1063 (1992), aff’d, 994 F.2d 61 (2d Cir. 1993). 19 F.B. Horner, 50 S.E.C. at 1065–66. The term ‘‘market maker’’ is defined in Section 3(a)(38) of the Act, 15 U.S.C. 78c(a)(38), and a dealer in debt securities must meet the legal requirements of Section 3(a)(38) to be considered a market maker. 20 F.B. Horner, 50 S.E.C. at 1066 (citations omitted). 21 See Proposed IM–2440–2(b)(4). 17 See PO 00000 Frm 00066 Fmt 4703 Sfmt 4703 68859 prevailing market price in any of three instances: (i) Interest rates changed after the dealer’s contemporaneous transaction to a degree that such change would reasonably cause a change in debt securities pricing; (ii) the credit quality of the debt security changed significantly after the dealer’s contemporaneous transaction; or (iii) news was issued or otherwise distributed and known to the marketplace that had an effect on the perceived value of the debt security after the dealer’s contemporaneous transaction.22 Interest Rates The Proposed Interpretation provides that a dealer may seek to overcome the presumption that its contemporaneous cost or proceeds are not indicative of the prevailing market price where interest rates changed after the dealer’s contemporaneous transaction to a degree that such change would reasonably cause a change in debt securities pricing.23 Changes in interest rates generally affect almost all debt securities pricing; when interest rates change, the price of a debt security is adjusted up or down so that the yield of the debt security remains comparable to other debt securities with the same or equivalent attributes, structures and characteristics (e.g., equivalent credit quality and ratings, equivalent call or put features, etc.). Credit Quality The Proposed Interpretation also provides that a dealer may be able to show that its contemporaneous cost is not indicative of prevailing market price where the credit quality of the debt security changed significantly after the dealer’s contemporaneous transaction.24 Although an announcement by a nationally recognized statistical rating organization (‘‘NRSRO’’) that it has reviewed the issuer’s credit and has changed the issuer’s credit rating is an easily identifiable incidence of a change of credit quality, the category is not limited to such announcements. It may be possible for a dealer to establish that the issuer’s credit quality changed in the absence of such an announcement; conversely, NASD may determine that the issuer’s credit quality had changed and such change was known to the market and factored into the price of the debt security before the dealer’s transaction (the transaction used to 22 See id. id. 24 See id. 23 See E:\FR\FM\28NON1.SGM 28NON1 68860 Federal Register / Vol. 71, No. 228 / Tuesday, November 28, 2006 / Notices measure the dealer’s contemporaneous cost) occurred. News NASD proposes that a dealer may be able to show that its contemporaneous cost is (or proceeds are) not indicative of prevailing market price where news was issued or otherwise distributed and known to the marketplace that had an effect on the perceived value of the debt security after the dealer’s contemporaneous transaction.25 In such cases the dealer would be permitted to look at factors, as set out in the proposal, other than the dealer’s own contemporaneous cost to establish prevailing market price. NASD proposes to include this provision in response to comments filed regarding the Proposed Interpretation. NASD agrees with commenters that certain news affecting an issuer, such as news of legislation, may affect either a particular issuer or a group or sector of issuer and may not clearly fit within the two previously identified categories—interest rate changes and credit quality changes. Such news may cause price shifts in a debt security, invalidating the dealer’s own ‘‘contemporaneous cost’’ as a reliable and accurate measure of prevailing market price.26 Determining What Is Contemporaneous A broker-dealer must determine whether a transaction is contemporaneous to apply the guidance in the Proposed Interpretation, and, particularly, to identify the prevailing market price of a debt security. Although what is considered contemporaneous for purposes of determining a mark-up (mark-down) in a particular transaction is a facts-andcircumstances test, in response to the requests of commenters, NASD proposes to include in the Proposed Interpretation the following guidance: A dealer’s cost is considered contemporaneous if the transaction occurs close enough in time to the subject transaction that it would reasonably be expected to reflect the current market price for the security. (Where a mark-down is being calculated, a dealer’s proceeds would be considered contemporaneous if the transaction from which the proceeds result occurs close enough in time to the subject 25 See id. ycherry on PROD1PC61 with NOTICES 26 ‘‘News’’ referred to in paragraph (b)(4) of the Proposed Interpretation that may not be included in either of the other two categories referred to in paragraph (b)(4) may affect specific issuers, a group of issuers or an industry sector and includes news such as pending or contemplated legislative developments (e.g., relating to asbestos claims); the announcement of a judicial decision; the announcement of new pension regulation or a new interpretation; and the announcement of a natural disaster, an attack or a war. VerDate Aug<31>2005 15:42 Nov 27, 2006 Jkt 211001 transaction that such proceeds would reasonably be expected to reflect the current market price for the security.) 27 Identifying Prevailing Market Price If Other Than Contemporaneous Cost or Proceeds When calculating a mark-up, where the dealer has established that the dealer’s cost is (or in a mark-down, proceeds are) no longer contemporaneous,28 or where the dealer has presented evidence that is sufficient to overcome the presumption that the dealer’s contemporaneous cost provides (or proceeds provide) the best measure of the prevailing market price, such as when there are interest rate changes, credit quality changes, or news events or announcements as described above and set forth in paragraph (b)(4) of the Proposed Interpretation, the dealer must follow a process for determining prevailing market price, considering certain factors in the appropriate order, as set forth in the Proposed Interpretation. Initially, a dealer must look to three factors or measures in the order they are presented (the ‘‘Hierarchy’’) to determine prevailing market price. The most important and first factor in the Hierarchy is the pricing of any contemporaneous interdealer transactions in the same security.29 The second most important factor in the Hierarchy recognizes the role of certain large institutions in the fixed income securities markets. In the absence of inter-dealer transactions, the second factor a dealer must consider is the prices of contemporaneous dealer purchases in the security in question from institutional accounts with which any dealer regularly effects transactions in the same security.30 If contemporaneous inter-dealer trades or dealer-institutional trades in the same security are not available, a dealer must look to the third factor in the Hierarchy, which may be applied only to actively traded securities. For actively traded securities, a dealer is required to look to 27 See Proposed IM–2440–2(b)(3). dealer that has not engaged in trading in the subject security for an extended period can evidence that it has no contemporaneous cost (proceeds) to refer to as a basis for computing a mark-up (mark-down). 29 See Proposed IM–2440–2(b)(5)(A). 30 See Proposed IM–2440–2(b)(5)(B). Contemporaneous dealer sales with such institutional accounts would be used to calculate a mark-down. If a dealer has overcome the presumption by establishing, for example, that the credit quality of the security changed significantly after the dealer’s trade, any inter-dealer or dealerinstitutional trades in the same security that occurred prior to the change in credit quality would not be valid measures of the prevailing market price as such transactions would be subject to the same defect. 28 A PO 00000 Frm 00067 Fmt 4703 Sfmt 4703 contemporaneous bid (offer) quotations for the security in question for proof of the prevailing market price if such quotations are made through an interdealer mechanism through which transactions generally occur at the displayed quotations.31 Additional Factors That May Be Considered If none of the three factors in the Hierarchy is available, the dealer then may take into consideration the nonexclusive list of four factors in the Proposed Interpretation in trying to establish prevailing market price using a measure other than the dealer’s contemporaneous cost (proceeds). In contrast to the Hierarchy of three factors discussed above, a dealer is not required to consider the four factors below in a particular order. The four factors reflect the particular nature of the debt markets and the trading and valuation of debt securities. They are: • Prices of contemporaneous interdealer transactions in a ‘‘similar’’ security, as defined below, or prices of contemporaneous dealer purchase (sale) transactions in a ‘‘similar’’ security with institutional accounts with which any dealer regularly effects transactions in the ‘‘similar’’ security with respect to customer mark-ups (mark-downs); • Yields calculated from prices of contemporaneous inter-dealer transactions in ‘‘similar’’ securities; • Yields calculated from prices of contemporaneous purchase (sale) transactions with institutional accounts with which any dealer regularly effects transactions in ‘‘similar’’ securities with respect to customer mark-ups (markdowns); and • Yields calculated from validated contemporaneous inter-dealer bid (offer) quotations in ‘‘similar’’ securities for customer mark-ups (mark-downs). When applying one or more of the four factors, a dealer must consider that the ultimate evidentiary issue is whether the prevailing market price of the security will be correctly identified. As stated in the Proposed Interpretation, the relative weight of the pricing information obtained from the factors depends on the facts and circumstances surrounding the comparison transaction (i.e., whether the dealer in the comparison transaction was on the same side of the market as the dealer is in the subject transaction, timeliness of the information, and, with respect to the final factor listed above, the relative spread of the quotations in the ‘‘similar’’ 31 See E:\FR\FM\28NON1.SGM Proposed IM–2440–2(b)(5)(C). 28NON1 Federal Register / Vol. 71, No. 228 / Tuesday, November 28, 2006 / Notices security to the quotations in the subject security).32 Finally, if information concerning the prevailing market price of the subject security cannot be obtained by applying any of the above factors, a member may consider as a factor in determining the prevailing market price the prices or yields derived from economic models that take into account measures such as credit quality, interest rates, industry sector, time to maturity, call provisions and any other embedded options, coupon rate, and face value; and consider all applicable pricing terms and conventions (e.g., coupon frequency and accrual methods).33 However, dealers may not use any economic model to establish the prevailing market price for mark-up (mark-down) purposes, except in limited instances where none of the three factors in the Hierarchy and none of the four factors in proposed paragraph (b)(6) apply. For example, application of the Hierarchy and the four factors in proposed paragraph (b)(6) may not yield pricing information when the subject security is infrequently traded, and the security is of such low credit quality (e.g., a distressed debt security) that a dealer cannot identify a ‘‘similar’’ security.34 The final principle in the Proposed Interpretation regarding prevailing market price addresses the use of pricing information from isolated transactions or quotations. The Proposed Interpretation provides that ‘‘isolated transactions or isolated quotations generally will have little or no weight or relevance in establishing prevailing market price. For example, in considering yields of ‘similar’ securities, except in extraordinary circumstances, members may not rely exclusively on isolated transactions or a limited number of transactions that are not fairly representative of the yields of transactions in ‘similar’ securities taken as a whole.’’35 32 See Proposed IM–2440–2(b)(6). Proposed IM–2440–2(b)(7). 34 When a dealer seeks to identify prevailing market price using other than the dealer’s contemporaneous cost or contemporaneous proceeds, the dealer must be prepared to provide evidence that will establish the dealer’s basis for not using contemporaneous cost (proceeds), and information about the other values reviewed (e.g., the specific prices and/or yields of securities that were identified as similar securities) in order to determine the prevailing market price of the subject security. If a firm relies upon pricing information from a model the firm uses or has developed, the firm must be able to provide information that was used on the day of the transaction to develop the pricing information (i.e., the data that was input and the data that the model generated and the firm used to arrive at prevailing market price). 35 See Proposed IM–2440–2(b)(8). ycherry on PROD1PC61 with NOTICES 33 See VerDate Aug<31>2005 15:42 Nov 27, 2006 Jkt 211001 Certain Institutions Not Treated As Customers in Transactions in NonInvestment Grade Debt Securities Commenters expressed concerns about the application of the original proposed rule change, as amended, to transactions between broker-dealers and large, knowledgeable institutions involving generally thinly traded, risky, and often volatile non-investment grade debt securities. In Amendment No. 5, NASD addresses these concerns and proposes, for purposes of Rule 2440, IM–2440–1 and the Proposed Interpretation, that in transactions in non-investment grade debt securities (including certain unrated securities), the term ‘‘customer’’ shall not include a qualified institutional buyer (‘‘QIB’’), as defined in Rule 144A under the Securities Act of 1933 (‘‘Securities Act’’) provided other conditions are met. Specifically, the Proposed Interpretation provides that, for purposes of Rule 2440, IM–2440–1 and the Proposed Interpretation, the term ‘‘customer’’ shall not include: A qualified institutional buyer (‘‘QIB’’) as defined in Rule 144A under the Securities Act of 1933 that is purchasing or selling a non-investment grade debt security, when the member has determined, after considering the factors set forth in IM–2310– 3, that the QIB has the capacity to evaluate independently the investment risk and in fact is exercising independent judgment in deciding to enter into the transaction.36 In NASD IM–2310–3, NASD sets forth a non-exclusive list of factors (or considerations) that a member may include in assessing and determining an institutional customer’s capability to evaluate investment risk independently. These factors allow a member to examine the institutional customer’s capability to make its own investment decisions, including examining the resources available to the institutional customer to make informed decisions, and include: • The use of one or more consultants, investment advisers or bank trust departments; • The general level of experience of the institutional customer in financial markets and specific experience with the type of instruments under consideration; • The customer’s ability to understand the economic features of the security involved; • The customer’s ability to independently evaluate how market developments would affect the security; and • The complexity of the security or securities involved. 36 See PO 00000 Proposed IM–2440–2(b)(9). Frm 00068 Fmt 4703 Sfmt 4703 68861 In addition, IM–2310–3 contains a non-exclusive list of factors (or considerations) for a member to use in determining if an institutional customer is making an independent investment decision. These factors probe the nature of the relationship that exists between the member and institutional customer and include: • Any written or oral understanding that exists between the member and the customer regarding the nature of the relationship between the member and the customer and the services to be rendered by the member; • The presence or absence of a pattern of acceptance of the member’s recommendations; • The use by the customer of ideas, suggestions, market views and information obtained from other members or market professionals, particularly those relating to the same type of securities; and • The extent to which the member has received from the customer current comprehensive portfolio information in connection with discussing recommended transactions or has not been provided important information regarding its portfolio or investment objectives. In addition, NASD proposes to define the term ‘‘non-investment grade debt security’’ broadly for purposes of NASD Rule 2440, IM–2440–1 and the Proposed Interpretation. Specifically, ‘‘noninvestment grade debt security’’ shall mean a debt security that (i) if rated by only one NRSRO, is rated lower than one of the four highest generic rating categories; (ii) if rated by more than one NRSRO, is rated lower than one of the four highest generic rating categories by any of the NRSROs; or (iii) if unrated, either was analyzed as a non-investment grade debt security by the member and the member retains credit evaluation documentation and demonstrates to NASD (using credit evaluation or other demonstrable criteria) that the credit quality of the security is, in fact, equivalent to a non-investment grade debt security, or was initially offered and sold and continues to be offered and sold pursuant to an exemption from registration under the Securities Act.37 The Proposed Interpretation recognizes and broadly addresses the most significant concerns of the comments received regarding the original proposed rule change, as amended. Many large institutional investors have sufficient knowledge of the market or certain sectors of the market to trade debt securities with broker-dealers at prices negotiated at 37 See E:\FR\FM\28NON1.SGM Proposed IM–2440–2(b)(9). 28NON1 68862 Federal Register / Vol. 71, No. 228 / Tuesday, November 28, 2006 / Notices arms length, reducing the need for such customers to be protected with respect to every transaction under Rule 2440, IM–2440–1 and the Proposed Interpretation. Further, the application of the Proposed Interpretation to generally illiquid market sectors, such as non-investment grade debt securities and bespoke or unique structured products that are sold pursuant to an exemption from registration under the Securities Act, and thereafter continue to be resold in private transactions rather than in the public markets, often may yield little or no pricing information that a dealer may use with confidence to determine the prevailing market price and a fair mark-up or mark-down for such debt securities transactions. It should be noted that even with respect to transactions with institutions that do not qualify for the exemption under proposed paragraph (b)(9), it would still be possible for a dealer to identify prevailing market price using information other than the dealer’s contemporaneous cost (or proceeds), if done in accordance with the other provisions of the Proposed Interpretation. Previously Proposed Concepts About Prevailing Market Price That Are Withdrawn ycherry on PROD1PC61 with NOTICES Specified Institutional Trade. In Amendment No. 1, NASD proposed that a dealer could seek to overcome the presumption that its contemporaneous cost or proceeds are indicative of the prevailing market price where the dealer establishes that the dealer’s contemporaneous trade was a ‘‘Specified Institutional Trade’’—a trade with an institutional account with which the dealer regularly effected transactions in the same or a similar security under certain conditions (‘‘SIT’’).38 NASD subsequently withdrew the concept of SIT and 38 A ‘‘Specified Institutional Trade’’ was defined as a dealer’s contemporaneous trade with an institutional account with which the dealer regularly effects transactions in the same or a ‘‘similar’’ security, as defined in the Proposed Interpretation, and in the case of a sale to such an account, the trade was executed at a price higher than the then prevailing market price, or in the case of a purchase from such an account, the trade was executed at a price lower than the then prevailing market price, and the execution price was away from the prevailing market price because of the size and risk of the transaction. In instances when the dealer would have established that the dealer’s contemporaneous trade was an SIT, to overcome the presumption that the dealer’s contemporaneous cost was (or proceeds were) the best measure of the prevailing market price, the dealer would have been required to provide evidence of prevailing market price by referring exclusively to inter-dealer trades in the same security executed contemporaneously with the dealer’s SIT. VerDate Aug<31>2005 15:42 Nov 27, 2006 Jkt 211001 substituted the size proposal set forth below. Size Proposal. In Amendment Nos. 3 and 4, NASD proposed, instead of Specified Institutional Trades, the size proposal (‘‘Size proposal’’). As NASD stated in its Statement of Purpose for Amendment No. 3, ‘‘a large or a small transaction executed at a price away from the prevailing market price of the security, as evidenced by certain contemporaneous transactions, is an instance where it may be appropriate for the dealer to show that its contemporaneous cost (proceeds) is not indicative of prevailing market price.’’ The proposed change was intended to provide dealers greater flexibility to identify prevailing market price using a non-contemporaneous cost value than provided by the SIT provision proposed in Amendment No. 1.39 NASD also withdraws the Size proposal. Instead, NASD is proposing that, for purposes of Rule 2440, IM– 2440–1 and the Proposed Interpretation, broker-dealers would not be required to treat QIBs engaging in transactions in non-investment grade debt securities as customers, if the broker-dealer determines, ‘‘after considering the factors set forth in IM–2310–3, that the QIB has the capacity to evaluate independently the investment risk and in fact is exercising independent judgment in deciding to enter into the transaction.’’ The proposed amendment recognizes and addresses the concerns of commenters more clearly and more broadly than either the withdrawn SIT or Size proposals. ‘‘Similar’’ Securities. The definition of ‘‘similar’’ security, and the uses and limitations of ‘‘similar’’ securities are the second part of the Proposed Interpretation. Several of the factors referenced above to which a dealer may refer when determining the prevailing market price as a value that is other than the dealer’s contemporaneous cost (proceeds) require a dealer to identify one or more ‘‘similar’’ securities. The Proposed Interpretation provides that a ‘‘similar’’ security should be sufficiently similar to the subject security that it would serve as a reasonable alternative investment. In addition, at a minimum, a dealer must be able to fairly estimate the market yield for the subject security from the 39 The SIT proposal was proposed in Amendment No. 1. In Amendment No. 3, NASD deleted the SIT proposal and replaced it with the Size proposal. Also in Amendment No. 3, references to size of trade as a consideration or a factor in pricing were added in other provisions. In Amendment No. 4, NASD submitted clarifications regarding the Size proposal. In Amendment No. 5, such references to size were deleted. PO 00000 Frm 00069 Fmt 4703 Sfmt 4703 yields of ‘‘similar’’ securities.40 Finally, to aid members in identifying ‘‘similar’’ securities when appropriate, the Proposed Interpretation sets forth a list of non-exclusive factors to determine the similarity between the subject security and one or more other securities. The non-exclusive list of factors that can be used to assess similarity includes the following: (a) Credit quality considerations, such as whether the security is issued by the same or similar entity, bears the same or similar credit rating, or is supported by a similarly strong guarantee or collateral as the subject security (to the extent securities of other issuers are designated as ‘‘similar’’ securities, significant recent information of either issuer that is not yet incorporated in credit ratings should be considered (e.g., changes in ratings outlooks)); 41 (b) The extent to which the spread (i.e., the spread over U.S. Treasury securities of a similar duration) at which the ‘‘similar’’ security trades is comparable to the spread at which the subject security trades; 42 (c) General structural characteristics and provisions of the issue, such as coupon, maturity, duration, complexity or uniqueness of the structure, callability, the likelihood that the security will be called, tendered or exchanged, and other embedded options, as compared with the characteristics of the subject security;43 and (d) Technical factors, such as the size of the issue, the float and recent turnover of the issue, and legal restrictions on transferability as compared with the subject security.44 The provisions regarding ‘‘similar’’ securities, if adopted, would affirm 40 See Proposed IM–2440–2(c)(1). Proposed IM–2440–2(c)(2)(A). 42 See Proposed IM–2440–2(c)(2)(B). 43 See Proposed IM–2440–2(c)(2)(C). 44 See Proposed IM–2440–2(c)(2)(D). The Proposed Interpretation also states that, for certain securities, there are no ‘‘similar’’ securities. Specifically, when a debt security’s value and pricing is based substantially on, and is highly dependent on, the particular circumstances of the issuer, including creditworthiness and the ability and willingness of the issuer to meet the specific obligations of the security, in most cases other securities will not be sufficiently similar, and therefore, other securities may not be used to establish prevailing market price of the subject security. See Proposed IM–2440–2(c)(3). As noted above, NASD may consider a dealer’s pricing information obtained from an economic model to establish prevailing market price, when ‘‘similar’’ securities do not exist and facts and circumstances have combined to create a price information void in the subject security. In addition, as provided in the Proposed Interpretation, NASD also may look to economic models other than the dealer’s to make determinations as to the prevailing market price of a security. 41 See E:\FR\FM\28NON1.SGM 28NON1 ycherry on PROD1PC61 with NOTICES Federal Register / Vol. 71, No. 228 / Tuesday, November 28, 2006 / Notices explicitly, for the first time, that it may be appropriate under specified circumstances to refer to ‘‘similar’’ securities to determine prevailing market price. In addition, the Proposed Interpretation provides guidance as to the degree of similarity that is required. Also, the Proposed Interpretation recognizes an additional source of pricing information, i.e., certain economic models, that a dealer may consider in determining prevailing market price when all other factors, including those employing ‘‘similar’’ securities, do not render relevant pricing information because transactions and quotes (that have been validated by active trading) have not occurred in the subject security and there are no ‘‘similar’’ securities. Thus, when all other factors have been considered but are irrelevant, such as when a very distressed, very illiquid security is traded, the Proposed Interpretation provides the flexibility to determine prevailing market price and an appropriate mark-up (mark-down). Conclusion. NASD believes that the Proposed Interpretation recognizes the special characteristics of debt instruments, reflects the particular nature of trading in the debt markets, and provides important guidance to all members engaged in debt securities transactions. The guidance sets forth clearly a basic principle in NASD’s rules: a dealer’s contemporaneous cost (or, when calculating a mark-down, a dealer’s contemporaneous proceeds) is presumptively the prevailing market price in debt securities transactions. In addition, the Proposed Interpretation provides guidance on when this principle may not be applicable, and, in those cases, guidance on the dealer’s obligation to provide evidence of the prevailing market price using the factors set forth above, and, as applicable, in the priority set forth above, and any other relevant evidence of prevailing market price. NASD also proposes to recognize, in limited circumstances, that a dealer may refer to an economic model to provide evidence of the prevailing market price of a security when the security is sufficiently illiquid that the debt market does not provide evidence of the prevailing market price, and the security does not meet other criteria and therefore cannot be compared with a ‘‘similar’’ security. The Proposed Interpretation now includes an exemption from Rule 2440, IM–2440–1 and the Proposed Interpretation for certain transactions in non-investment grade debt securities between broker-dealers and certain QIB customers. NASD believes that many of the concerns and objections raised by VerDate Aug<31>2005 15:42 Nov 27, 2006 Jkt 211001 commenters regarding the regulation of mark-ups (mark-downs) in debt securities transactions between brokerdealers and institutional customers are addressed by the inclusion of the proposed exemption. Finally, the Proposed Interpretation announces explicitly that a dealer is permitted to use ‘‘similar’’ securities in some cases where the dealer is identifying the prevailing market price of a security using a measure other than the dealer’s contemporaneous cost (or contemporaneous proceeds). NASD’s recognition of the limited but appropriate use of a ‘‘similar’’ security includes guidance on which securities may be considered ‘‘similar’’ securities. NASD believes that the Proposed Interpretation is an important first step in developing additional mark-up guidance for members engaged in debt securities transactions with customers on a principal basis. 2. Statutory Basis NASD believes that the proposed rule change is consistent with the provisions of Section 15A(b)(6) of the Act,45 which requires, among other things, that NASD rules must be designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and, in general, to protect investors and the public interest. NASD believes that clarifying the standard for correctly identifying the prevailing market price of a debt security for purposes of calculating a mark-up (mark-down), clarifying the additional obligations of a member when it seeks to use a measure other than the member’s own contemporaneous cost (proceeds) as the prevailing market price, and confirming that similar securities may be used in certain instances to determine the prevailing market price are measures designed to prevent fraudulent practices, promote just and equitable principles of trade, and protect investors and the public interest. Further, the inclusion of an exemption from Rule 2440, IM–2440–1 and the Proposed Interpretation for transactions in noninvestment grade debt securities between broker-dealers and certain QIBs provides such parties flexibility and will not impair or burden the markets or the parties trading in non-investment grade debt securities. B. Self-Regulatory Organization’s Statement on Burden on Competition NASD does not believe that the proposed rule change will result in any burden on competition that is not 45 15 PO 00000 U.S.C. 78o–3(b)(6). Frm 00070 Fmt 4703 Sfmt 4703 68863 necessary or appropriate in furtherance of the purposes of the Act. C. Self-Regulatory Organization’s Statement on Comments on the Proposed Rule Change Received From Members, Participants, or Others NASD has responded previously to industry and SEC comments regarding this rule change. See NASD Response to Comments, filed on October 4, 2005. III. Date of Effectiveness of the Proposed Rule Change and Timing for Commission Action Within 35 days of the date of publication of this notice in the Federal Register or within such longer period (i) as the Commission may designate up to 90 days of such date if it finds such longer period to be appropriate and publishes its reasons for so finding or (ii) as to which the self-regulatory organization consents, the Commission will: (A) By order approve such proposed rule change, or (B) Institute proceedings to determine whether the proposed rule change should be disapproved. IV. Solicitation of Comments Interested persons are invited to submit written data, views and arguments concerning the foregoing, including whether the proposed rule change is consistent with the Act.46 Comments may be submitted by any of the following methods: Electronic Comments • Use the Commission’s Internet comment form (https://www.sec.gov/ rules/sro.shtml); or • Send an e-mail to rulecomments@sec.gov. Please include File Number SR–NASD–2003–141 on the subject line. Paper Comments • Send paper comments in triplicate to Nancy M. Morris, Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549–1090. All submissions should refer to File Number SR–NASD–2003–141. This file number should be included on the subject line if e-mail is used. To help the Commission process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission’s Internet Web site (https://www.sec.gov/ rules/sro.shtml). Copies of the submission, all subsequent 46 The Commission will consider the comments we previously received. Commenters may reiterate or cross-reference previously submitted comments. E:\FR\FM\28NON1.SGM 28NON1 68864 Federal Register / Vol. 71, No. 228 / Tuesday, November 28, 2006 / Notices amendments, all written statements with respect to the proposed rule change that are filed with the Commission, and all written communications relating to the proposed rule change between the Commission and any person, other than those that may be withheld from the public in accordance with the provisions of 5 U.S.C. 552, will be available for inspection and copying in the Commission’s Public Reference Room. Copies of such filing also will be available for inspection and copying at the principal office of NASD. All comments received will be posted without change; the Commission does not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly. All submissions should refer to File Number SR–NASD–2003–141 and should be submitted on or before December 19, 2006. For the Commission, by the Division of Market Regulation, pursuant to delegated authority.47 Nancy M. Morris, Secretary. [FR Doc. E6–20068 Filed 11–27–06; 8:45 am] BILLING CODE 8011–01–P solicit comments on the proposed rule change, as amended, from interested persons. I. Self-Regulatory Organization’s Statement of the Terms of Substance of the Proposed Rule Change The Exchange proposes to list and trade exchange-traded notes (‘‘Notes’’) of Barclays Bank PLC (‘‘Barclays’’) linked to the performance of the MSCI India Total Return IndexSM (‘‘Index’’). II. Self-Regulatory Organization’s Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change In its filing with the Commission, the Exchange included statements concerning the purpose of and basis for the proposed rule change and discussed any comments it received on the proposed rule change. The text of these statements may be examined at the places specified in Item IV below. The NYSE has prepared summaries, set forth in Sections A, B and C below, of the most significant aspects of such statements. A. Self-Regulatory Organization’s Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change SECURITIES AND EXCHANGE COMMISSION 1. Purpose [Release No. 34–54800; File No. SR–NYSE– 2006–69] Under Section 703.19 of the Listed Company Manual (‘‘Manual’’), the Exchange may approve for listing and trading securities not otherwise covered by the criteria of Sections 1 and 7 of the Manual, provided the issue is suited for auction market trading. The Exchange proposes to list and trade, under Section 703.19 of the Manual, the Notes, which are linked to the performance of the Index. Barclays intends to issue the Notes under the name ‘‘iPathSM Exchange-Traded Notes.’’ The Exchange believes that the Notes will conform to the initial listing standards for equity securities under Section 703.19, as Barclays is an affiliate of Barclays PLC,4 which is an Exchangelisted company in good standing, the Notes will have a minimum life of one The Notes Self-Regulatory Organizations; New York Stock Exchange LLC; Notice of Filing of a Proposed Rule Change and Amendment No. 1 Thereto To List and Trade Exchange-Traded Notes of Barclays Bank PLC Linked to the Performance of the MSCI India Equities Index ycherry on PROD1PC61 with NOTICES November 21, 2006. Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (‘‘Act’’),1 and Rule 19b–4 thereunder,2 notice is hereby given that on August 24, 2006 the New York Stock Exchange LLC (‘‘NYSE’’ or ‘‘Exchange’’) filed with the Securities and Exchange Commission (‘‘Commission’’) the proposed rule changes as described in Items I, II and III below, which Items have been prepared by the Exchange. On November 8, 2006, the Exchange submitted Amendment No. 1.3 The Commission is publishing this notice to 47 17 CFR 200.30–3(a)(12). U.S.C. 78s(b)(1). 2 17 CFR 240.19b–4. 3 Amendment No. 1 replaced and superseded the Exchange’s original submission in its entirety. 1 15 VerDate Aug<31>2005 15:42 Nov 27, 2006 Jkt 211001 4 The issuer of the Notes, Barclays, is an affiliate of an Exchange-listed company (Barclays PLC) and not an Exchange-listed company itself. However, Barclays, though an affiliate of Barclays PLC, would exceed the Exchange’s earnings and minimum tangible net worth requirements in Section 102 of the Manual. Additionally, Barclays has informed the Exchange that the original issue price of the Notes, when combined with the original issue price of all other iPath securities offerings of the issuer that are listed on a national securities exchange (or association), does not exceed 25% of the issuer’s net worth. PO 00000 Frm 00071 Fmt 4703 Sfmt 4703 year, the minimum public market value of the Notes at the time of issuance will exceed $4 million, there will be at least one million Notes outstanding, and there will be at least 400 holders at the time of issuance. The Notes are a series of debt securities of Barclays that provide for a cash payment at maturity or upon earlier redemption at the holder’s option, based on the performance of the Index subject to the adjustments described below. The original issue price of each Note will be $50. The Notes will trade on the Exchange’s equity trading floor, and the Exchange’s existing equity trading rules will apply to trading in the Notes. The Notes will not have a minimum principal amount that will be repaid and, accordingly, payment on the Notes prior to or at maturity may be less than the original issue price of the Notes. In fact, the value of the Index must increase for the investor to receive at least the $50 principal amount per Note at maturity or upon redemption. If the value of the Index decreases or does not increase sufficiently to offset the investor fee (described below), the investor will receive less, and possibly significantly less, than the $50 principal amount per Note. In addition, holders of the Notes will not receive any interest payments from the Notes. The Notes will have a term of 30 years. The Notes are not callable. Holders who have not previously redeemed their Notes will receive a cash payment at maturity equal to the initial issue price of their Notes times the index factor on the Final Valuation Date (as defined below) minus the investor fee on the Final Valuation Date. The ‘‘index factor’’ on any given day will be equal to the closing value of the Index on that day divided by the initial index level. The ‘‘initial index level’’ is the closing value of the Index on the date of issuance of the Notes, and the ‘‘final index level’’ is the closing value of the Index on the Final Valuation Date. The investor fee will be equal to 0.89% per year times the principal amount of Holders’ Notes times the index factor, calculated on a daily basis in the following manner: The investor fee on the date of issuance will equal zero. On each subsequent calendar day until maturity or early redemption, the investor fee will increase by an amount equal to 0.89% times the principal amount of holders’ Notes times the index factor on that day (or, if such day is not a trading day, the index factor on the immediately preceding trading day) divided by 365. Prior to maturity, holders may, subject to certain restrictions, redeem their Notes on any Redemption Date (defined E:\FR\FM\28NON1.SGM 28NON1

Agencies

SECURITIES AND EXCHANGE COMMISSION

[Federal Register Volume 71, Number 228 (Tuesday, November 28, 2006)]
[Notices]
[Pages 68856-68864]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E6-20068]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-54799; File No. SR-NASD-2003-141]


Self-Regulatory Organizations: National Association of Securities 
Dealers, Inc.; Notice of Filing of Amendment Nos. 3, 4, and 5 to a 
Proposed Rule Change Relating to Additional Mark-Up Policy for 
Transactions in Debt Securities, Except Municipal Securities

November 21, 2006.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on October 11, 2005, November 22, 2005, and October 31, 2006, the 
National Association of Securities Dealers, Inc. (``NASD'') filed with 
the Securities and Exchange Commission (``SEC'' or ``Commission'') 
Amendment Nos. 3, 4, and 5 to the proposed rule change as described in 
Items I, II, and III below, which Items have been prepared by NASD. 
NASD submitted the original proposed rule change to the Commission on 
September 17, 2003 and filed amendments on June 29, 2004, and February 
17, 2005.\3\ The Commission published the proposed rule change, as 
amended by Amendment Nos. 1 and 2, for comment in the Federal Register 
on March 15, 2005.\4\ The Commission received six comments on the 
proposal.\5\ NASD submitted a response to these comments on October 4, 
2005, and filed Amendment Nos. 3, 4, and 5 to further address the 
comments and propose responsive amendments.\6\ Amendment No. 5 replaces 
in their entirety the original rule filing and Amendment Nos. 1 through 
4 thereto. The Commission is publishing this notice to solicit comments 
on the proposed rule change, as amended, from interested persons.
---------------------------------------------------------------------------

    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Amendment No. 1 to SR-NASD-2003-141 made technical changes 
to the original rule filing. Amendment No. 2 to SR-NASD-2003-141 
superseded in its entirety the original rule filing, as amended by 
Amendment No. 1.
    \4\ See Securities Exchange Act Release No. 51338 (March 9, 
2005), 70 FR 12764 (March 15, 2005) (NASD-2003-141).
    \5\ The Commission received comments from Mr. Paul Scheurer, 
Banc of America Securities LLC, The Bond Market Association, 
CitiGroup Global Markets, Inc., The Asset Managers Forum, and the 
American Securitization Forum. Two comments were submitted during 
the comment period which closed on April 5, 2005, and four 
additional comment letters were submitted after the comment period 
closed.
    \6\ Both Amendment Nos. 3 and 4 to SR-NASD-2003-141 made 
technical changes to the rule filing as amended by Amendment No. 2.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    NASD is proposing to adopt NASD IM-2440-2 to NASD Rule 2440 to 
provide additional mark-up policy for transactions in debt securities, 
except municipal securities. Below is the amended text of the proposed 
rule change. Proposed new language is in italic.
* * * * *

IM-2440-1. Mark-Up Policy

    Remainder of IM-2440-1 No change.
* * * * *

IM-2440-2. Additional Mark-Up Policy For Transactions in Debt 
Securities, Except Municipal Securities \1\

(a) Scope

    (1) IM-2440-1 applies to debt securities transactions, and this IM-
2440-2 supplements the guidance provided in IM-2440-1.
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    \1\ The Interpretation does not apply to transactions in 
municipal securities. Single terms in parentheses within sentences, 
such as the terms ``(sale)'' and ``(to)'' in the phrase, 
``contemporaneous dealer purchase (sale) transactions with 
institutional accounts,'' refer to scenarios where a member is 
charging a customer a mark-down.
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(b) Prevailing Market Price

    (1) A dealer that is acting in a principal capacity in a 
transaction with

[[Page 68857]]

a customer and is charging a mark-up or mark-down must mark-up or mark-
down the transaction from the prevailing market price. Presumptively 
for purposes of this IM-2440-2, the prevailing market price for a debt 
security is established by referring to the dealer's contemporaneous 
cost as incurred, or contemporaneous proceeds as obtained, consistent 
with NASD pricing rules. (See, e.g., Rule 2320).
    (2) When the dealer is selling the security to a customer, 
countervailing evidence of the prevailing market price may be 
considered only where the dealer made no contemporaneous purchases in 
the security or can show that in the particular circumstances the 
dealer's contemporaneous cost is not indicative of the prevailing 
market price. When the dealer is buying the security from a customer, 
countervailing evidence of the prevailing market price may be 
considered only where the dealer made no contemporaneous sales in the 
security or can show that in the particular circumstances the dealer's 
contemporaneous proceeds are not indicative of the prevailing market 
price.
    (3) A dealer's cost is considered contemporaneous if the 
transaction occurs close enough in time to the subject transaction that 
it would reasonably be expected to reflect the current market price for 
the security. (Where a mark-down is being calculated, a dealer's 
proceeds would be considered contemporaneous if the transaction from 
which the proceeds result occurs close enough in time to the subject 
transaction that such proceeds would reasonably be expected to reflect 
the current market price for the security.)
    (4) A dealer that effects a transaction in debt securities with a 
customer and identifies the prevailing market price using a measure 
other than the dealer's own contemporaneous cost (or, in a mark-down, 
the dealer's own proceeds) must be prepared to provide evidence that is 
sufficient to overcome the presumption that the dealer's 
contemporaneous cost (or, the dealer's proceeds) provides the best 
measure of the prevailing market price. A dealer may be able to show 
that its contemporaneous cost is (or proceeds are) not indicative of 
prevailing market price, and thus overcome the presumption, in 
instances where (i) interest rates changed after the dealer's 
contemporaneous transaction to a degree that such change would 
reasonably cause a change in debt securities pricing; (ii) the credit 
quality of the debt security changed significantly after the dealer's 
contemporaneous transaction; or (iii) news was issued or otherwise 
distributed and known to the marketplace that had an effect on the 
perceived value of the debt security after the dealer's contemporaneous 
transaction.
    (5) In instances where the dealer has established that the dealer's 
cost is (or, in a mark-down, proceeds are) no longer contemporaneous, 
or where the dealer has presented evidence that is sufficient to 
overcome the presumption that the dealer's contemporaneous cost (or 
proceeds) provides the best measure of the prevailing market price, 
such as those instances described in (b)(4)(i), (ii) and (iii), a 
member must consider, in the order listed, the following types of 
pricing information to determine prevailing market price:
    (A) Prices of any contemporaneous inter-dealer transactions in the 
security in question;
    (B) In the absence of transactions described in (A), prices of 
contemporaneous dealer purchases (sales) in the security in question 
from (to) institutional accounts with which any dealer regularly 
effects transactions in the same security; or
    (C) In the absence of transactions described in (A) and (B), for 
actively traded securities, contemporaneous bid (offer) quotations for 
the security in question made through an inter-dealer mechanism, 
through which transactions generally occur at the displayed quotations.
    (A member may consider a succeeding category of pricing information 
only when the prior category does not generate relevant pricing 
information (e.g., a member may consider pricing information under (B) 
only after the member has determined, after applying (A), that there 
are no contemporaneous inter-dealer transactions in the same 
security).) In reviewing the pricing information available within each 
category, the relative weight, for purposes of identifying prevailing 
market price, of such information (i.e., either a particular 
transaction price, or, in (C) above, a particular quotation) depends on 
the facts and circumstances of the comparison transaction or quotation 
(i.e., such as whether the dealer in the comparison transaction was on 
the same side of the market as the dealer is in the subject transaction 
and timeliness of the information).
    (6) In the event that, in particular circumstances, the above 
factors are not available, other factors that may be taken into 
consideration for the purpose of establishing the price from which a 
customer mark-up (mark-down) may be calculated, include but are not 
limited to:
     Prices of contemporaneous inter-dealer transactions in a 
``similar'' security, as defined below, or prices of contemporaneous 
dealer purchase (sale) transactions in a ``similar'' security with 
institutional accounts with which any dealer regularly effects 
transactions in the ``similar'' security with respect to customer mark-
ups (mark-downs);
     Yields calculated from prices of contemporaneous inter-
dealer transactions in ``similar'' securities;
     Yields calculated from prices of contemporaneous dealer 
purchase (sale) transactions with institutional accounts with which any 
dealer regularly effects transactions in ``similar'' securities with 
respect to customer mark-ups (mark-downs); and
     Yields calculated from validated contemporaneous inter-
dealer bid (offer) quotations in ``similar'' securities for customer 
mark-ups (mark-downs).

The relative weight, for purposes of identifying prevailing market 
price, of the pricing information obtained from the factors set forth 
above depends on the facts and circumstances surrounding the comparison 
transaction (i.e., whether the dealer in the comparison transaction was 
on the same side of the market as the dealer is in the subject 
transaction, timeliness of the information, and, with respect to the 
final factor listed above, the relative spread of the quotations in the 
similar security to the quotations in the subject security).
    (7) Finally, if information concerning the prevailing market price 
of the subject security cannot be obtained by applying any of the above 
factors, NASD or its members may consider as a factor in assessing the 
prevailing market price of a debt security the prices or yields derived 
from economic models (e.g., discounted cash flow models) that take into 
account measures such as credit quality, interest rates, industry 
sector, time to maturity, call provisions and any other embedded 
options, coupon rate, and face value; and consider all applicable 
pricing terms and conventions (e.g., coupon frequency and accrual 
methods). Such models currently may be in use by bond dealers or may be 
specifically developed by regulators for surveillance purposes.
    (8) Because the ultimate evidentiary issue is the prevailing market 
price, isolated transactions or isolated quotations generally will have 
little or no weight or relevance in establishing prevailing market 
price. For example, in considering yields of ``similar'' securities, 
except in extraordinary

[[Page 68858]]

circumstances, members may not rely exclusively on isolated 
transactions or a limited number of transactions that are not fairly 
representative of the yields of transactions in ``similar'' securities 
taken as a whole.
    (9) ``Customer,'' for purposes of Rule 2440, IM-2440-1 and this IM-
2440-2, shall not include a qualified institutional buyer (``QIB'') as 
defined in Rule 144A under the Securities Act of 1933 that is 
purchasing or selling a non-investment grade debt security when the 
dealer has determined, after considering the factors set forth in IM-
2310-3, that the QIB has the capacity to evaluate independently the 
investment risk and in fact is exercising independent judgment in 
deciding to enter into the transaction. For purposes of Rule 2440, IM-
2440-1 and this IM-2440-2, ``non-investment grade debt security'' means 
a debt security that: (i) If rated by only one nationally recognized 
statistical rating organization (``NRSRO''), is rated lower than one of 
the four highest generic rating categories; (ii) if rated by more than 
one NRSRO, is rated lower than one of the four highest generic rating 
categories by any of the NRSROs; or (iii) if unrated, either was 
analyzed as a non-investment grade debt security by the dealer and the 
dealer retains credit evaluation documentation and demonstrates to NASD 
(using credit evaluation or other demonstrable criteria) that the 
credit quality of the security is, in fact, equivalent to a non-
investment grade debt security, or was initially offered and sold and 
continues to be offered and sold pursuant to an exemption from 
registration under the Securities Act of 1933.

(c) ``Similar'' Securities

    (1) A ``similar'' security should be sufficiently similar to the 
subject security that it would serve as a reasonable alternative 
investment to the investor. At a minimum, the security or securities 
should be sufficiently similar that a market yield for the subject 
security can be fairly estimated from the yields of the ``similar'' 
security or securities. Where a security has several components, 
appropriate consideration may also be given to the prices or yields of 
the various components of the security.
    (2) The degree to which a security is ``similar,'' as that term is 
used in this IM-2440-2, to the subject security may be determined by 
factors that include but are not limited to the following:
    (A) Credit quality considerations, such as whether the security is 
issued by the same or similar entity, bears the same or similar credit 
rating, or is supported by a similarly strong guarantee or collateral 
as the subject security (to the extent securities of other issuers are 
designated as ``similar'' securities, significant recent information of 
either issuer that is not yet incorporated in credit ratings should be 
considered (e.g., changes to ratings outlooks));
    (B) The extent to which the spread (i.e., the spread over U.S. 
Treasury securities of a similar duration) at which the ``similar'' 
security trades is comparable to the spread at which the subject 
security trades;
    (C) General structural characteristics and provisions of the issue, 
such as coupon, maturity, duration, complexity or uniqueness of the 
structure, callability, the likelihood that the security will be 
called, tendered or exchanged, and other embedded options, as compared 
with the characteristics of the subject security; and
    (D) Technical factors such as the size of the issue, the float and 
recent turnover of the issue, and legal restrictions on transferability 
as compared with the subject security.
    (3) When a debt security's value and pricing is based substantially 
on, and is highly dependent on, the particular circumstances of the 
issuer, including creditworthiness and the ability and willingness of 
the issuer to meet the specific obligations of the security, in most 
cases other securities will not be sufficiently similar, and therefore, 
other securities may not be used to establish the prevailing market 
price.
* * * * *

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, NASD included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. NASD has prepared summaries, set forth in sections A, B, 
and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
Background and Introduction
    Under NASD Rule 2440, ``Fair Prices and Commissions,'' members are 
required to sell securities to a customer at a fair price.\7\ When a 
member acts in a principal capacity and sells a security to a customer, 
a dealer generally ``marks up'' the security, increasing the total 
price the customer pays. Conversely, when buying a security from a 
customer, a dealer that is a principal generally ``marks down'' the 
security, reducing the total proceeds the customer receives. NASD IM-
2440, ``Mark-Up Policy,'' provides additional guidance on mark-ups and 
fair pricing of securities transactions with customers.\8\ Both Rule 
2440 and IM-2440 apply to transactions in debt securities, and IM-2440 
provides that mark-ups for transactions in common stock are customarily 
higher than those for bond transactions of the same size.\9\
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    \7\ Rule 2440 specifically provides that a member is required to 
buy or sell a security at a fair price to customers, ``taking into 
consideration all relevant circumstances, including market 
conditions with respect to such security at the time of the 
transaction, the expense involved, and the fact that he is entitled 
to a profit * * * .'' Rule 2320, ``Best Execution and 
Interpositioning,'' also addresses a member's obligation in pricing 
customer transactions. In any transaction for or with a customer or 
a customer of another broker-dealer, NASD Rule 2320, as amended 
effective November 8, 2006, requires a member to ``use reasonable 
diligence to ascertain the best market for the subject security and 
buy or sell in such market so that the resultant price to the 
customer is as favorable as possible under prevailing market 
conditions.'' See Securities Exchange Act Release No. 54339 (August 
21, 2006), 71 FR 50959 (August 28, 2006) (order approving proposed 
rule change and Amendment Nos. 1 through 5; File No. SR-NASD-2004-
026); NASD Notice to Members 06-58 (October 2006). Together, Rule 
2440 and Rule 2320 impose broad responsibilities on broker-dealers 
to price customer transactions fairly. Cf. ``Review of Dealer 
Pricing Responsibilities,'' MSRB Notice 2004-3 (January 26, 2004) 
(discussing MSRB Rules requiring municipal securities dealers to 
``exercise diligence in establishing the market value of [a] 
security and the reasonableness of the compensation received on [a] 
transaction'').
    \8\ The terms ``mark-up'' and ``mark-down'' are not found in 
Rule 2440, but are used in IM-2440. Statements regarding mark-ups 
also apply generally to mark-downs unless mark-downs are discussed 
specifically in a separate statement.
    \9\ NASD IM-2440(b)(1).
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    Under Rule 2440 and IM-2440, when a customer buys a security from a 
dealer, the customer's total purchase price, and the mark-up included 
in the price, must be fair and reasonable. Similarly, when a customer 
sells a security to a dealer, the customer's total proceeds from the 
sale, which were reduced by the mark-down, and the mark-down, must be 
fair and reasonable. A key step in determining whether a mark-up (mark-
down) is fair and reasonable is correctly identifying the prevailing 
market price of the security, which is the basis from which the mark-up 
(mark-down) is calculated.\10\
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    \10\ IM-2440 states: ``It shall be deemed a violation of Rule 
2110 and Rule 2440 for a member to enter into any transaction with a 
customer in any security at any price not reasonably related to the 
current market price of the security or to charge a commission which 
is not reasonable.''

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[[Page 68859]]

    The Proposed Interpretation, ``IM-2440-2, Additional Mark-Up Policy 
For Transactions in Debt Securities, Except Municipal Securities'' 
(``Proposed Interpretation''), provides additional guidance on mark-ups 
(mark-downs) in debt securities transactions, except municipal 
securities transactions.\11\ The Proposed Interpretation addresses two 
fundamental issues in debt securities transactions: (1) How does a 
dealer correctly identify the prevailing market price of a debt 
security; and (2) what is a ``similar'' security and when may it be 
considered in determining the prevailing market price. As part of the 
discussion of prevailing market price, the Proposed Interpretation 
provides guidance on the meaning of ``contemporaneous.'' \12\ In 
addition, NASD proposes a significant exclusion from Rule 2440, IM-
2440-1 \13\ and the Proposed Interpretation for broker-dealers engaging 
in non-investment grade debt securities transactions with certain 
institutional accounts.\14\
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    \11\ MSRB rule G-30, ``Prices and Commissions,'' applies to 
transactions in municipal securities, and requires that a municipal 
securities dealer engaging in a transaction as a principal with a 
customer must buy or sell securities at an aggregate price that is 
``fair and reasonable.''
    \12\ See Proposed IM-2440-2(b)(3).
    \13\ If the Commission adopts the Proposed Interpretation, 
current IM-2440 will be re-numbered as IM-2440-1. IM-2440 is 
referred to hereinafter as IM-2440-1.
    \14\ See Proposed IM-2440-2(b)(9).
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Prevailing Market Price
    The Proposed Interpretation provides that when a dealer calculates 
a mark-up (or a mark-down), the best measure of the prevailing market 
price of the security is presumptively the dealer's contemporaneous 
cost (proceeds).\15\ Further, the dealer may look to countervailing 
evidence of the prevailing market price only where the dealer, when 
selling a security, made no contemporaneous purchases in the security 
or can show that in the particular circumstances the dealer's 
contemporaneous cost is not indicative of the prevailing market 
price.\16\ When buying a security from a customer, the dealer may look 
to countervailing evidence of the prevailing market price only where 
the dealer made no contemporaneous sales in the security or can show 
that in the particular circumstances the dealer's contemporaneous 
proceeds are not indicative of the prevailing market price.\17\
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    \15\ See Proposed IM-2440-2(b)(1). Of course, if a dealer 
violates NASD Rule 2320, the dealer's contemporaneous cost 
(proceeds) in such transactions would not be a reliable indicator of 
the prevailing market price for the purpose of determining a mark-up 
or mark-down. If a dealer violates Rule 2320 because the dealer 
fails to exercise diligence, fails to negotiate at arms length in 
the market, or engages in fraudulent transactions, including those 
entered into in collusion with other dealers or brokers, including 
inter-dealer brokers, the price that the dealer obtains is not a 
price reflecting market forces, and, therefore, is not a valid 
indicator of the prevailing market price and should not be used to 
calculate a mark-up (mark-down). In addition, if a dealer that is 
not a party to a transaction engages in conduct to improperly 
influence the pricing of such transaction, the dealer could not 
properly use the execution price as the basis from which to compute 
a mark-up (mark-down) because the execution price does not represent 
the prevailing market price of the security.
    \16\ See Proposed IM-2440-2(b)(2).
    \17\ See id.
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    The presumption that contemporaneous cost is the best evidence of 
prevailing market price is found in many cases and NASD decisions, and 
its specific applicability to debt securities transactions was 
addressed by the SEC as early as 1992 in F.B. Horner & Associates, 
Inc.\18\ (``F.B. Horner''), a debt mark-up case. In F. B. Horner, the 
SEC stated: ``We have consistently held that where, as in the present 
case, a dealer is not a market maker, the best evidence of the current 
market, absent countervailing evidence, is the dealer's contemporaneous 
cost.'' \19\ The basis for the standard was also restated by the 
Commission. ``That standard, which has received judicial approval, 
reflects the fact that the prices paid for a security by a dealer in 
transactions closely related in time to his retail sales are normally a 
highly reliable indication of the prevailing market.''\20\
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    \18\ 50 S.E.C. 1063 (1992), aff'd, 994 F.2d 61 (2d Cir. 1993).
    \19\ F.B. Horner, 50 S.E.C. at 1065-66. The term ``market 
maker'' is defined in Section 3(a)(38) of the Act, 15 U.S.C. 
78c(a)(38), and a dealer in debt securities must meet the legal 
requirements of Section 3(a)(38) to be considered a market maker.
    \20\ F.B. Horner, 50 S.E.C. at 1066 (citations omitted).
---------------------------------------------------------------------------

    The Proposed Interpretation recognizes that in some circumstances a 
dealer may seek to overcome the presumption that the dealer's own 
contemporaneous cost is (or proceeds are) the prevailing market price 
of the subject security for determining a mark-up (mark-down), and sets 
forth a process for identifying a value other than the dealer's own 
contemporaneous cost (proceeds).\21\
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    \21\ See Proposed IM-2440-2(b)(4).
---------------------------------------------------------------------------

Cases Where the Presumption May Be Overcome
    A dealer may seek to overcome the presumption that its 
contemporaneous cost or proceeds are not indicative of the prevailing 
market price in any of three instances: (i) Interest rates changed 
after the dealer's contemporaneous transaction to a degree that such 
change would reasonably cause a change in debt securities pricing; (ii) 
the credit quality of the debt security changed significantly after the 
dealer's contemporaneous transaction; or (iii) news was issued or 
otherwise distributed and known to the marketplace that had an effect 
on the perceived value of the debt security after the dealer's 
contemporaneous transaction.\22\
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    \22\ See id.
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Interest Rates
    The Proposed Interpretation provides that a dealer may seek to 
overcome the presumption that its contemporaneous cost or proceeds are 
not indicative of the prevailing market price where interest rates 
changed after the dealer's contemporaneous transaction to a degree that 
such change would reasonably cause a change in debt securities 
pricing.\23\ Changes in interest rates generally affect almost all debt 
securities pricing; when interest rates change, the price of a debt 
security is adjusted up or down so that the yield of the debt security 
remains comparable to other debt securities with the same or equivalent 
attributes, structures and characteristics (e.g., equivalent credit 
quality and ratings, equivalent call or put features, etc.).
---------------------------------------------------------------------------

    \23\ See id.
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Credit Quality
    The Proposed Interpretation also provides that a dealer may be able 
to show that its contemporaneous cost is not indicative of prevailing 
market price where the credit quality of the debt security changed 
significantly after the dealer's contemporaneous transaction.\24\ 
Although an announcement by a nationally recognized statistical rating 
organization (``NRSRO'') that it has reviewed the issuer's credit and 
has changed the issuer's credit rating is an easily identifiable 
incidence of a change of credit quality, the category is not limited to 
such announcements. It may be possible for a dealer to establish that 
the issuer's credit quality changed in the absence of such an 
announcement; conversely, NASD may determine that the issuer's credit 
quality had changed and such change was known to the market and 
factored into the price of the debt security before the dealer's 
transaction (the transaction used to

[[Page 68860]]

measure the dealer's contemporaneous cost) occurred.
---------------------------------------------------------------------------

    \24\ See id.
---------------------------------------------------------------------------

News
    NASD proposes that a dealer may be able to show that its 
contemporaneous cost is (or proceeds are) not indicative of prevailing 
market price where news was issued or otherwise distributed and known 
to the marketplace that had an effect on the perceived value of the 
debt security after the dealer's contemporaneous transaction.\25\ In 
such cases the dealer would be permitted to look at factors, as set out 
in the proposal, other than the dealer's own contemporaneous cost to 
establish prevailing market price. NASD proposes to include this 
provision in response to comments filed regarding the Proposed 
Interpretation. NASD agrees with commenters that certain news affecting 
an issuer, such as news of legislation, may affect either a particular 
issuer or a group or sector of issuer and may not clearly fit within 
the two previously identified categories--interest rate changes and 
credit quality changes. Such news may cause price shifts in a debt 
security, invalidating the dealer's own ``contemporaneous cost'' as a 
reliable and accurate measure of prevailing market price.\26\
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    \25\ See id.
    \26\ ``News'' referred to in paragraph (b)(4) of the Proposed 
Interpretation that may not be included in either of the other two 
categories referred to in paragraph (b)(4) may affect specific 
issuers, a group of issuers or an industry sector and includes news 
such as pending or contemplated legislative developments (e.g., 
relating to asbestos claims); the announcement of a judicial 
decision; the announcement of new pension regulation or a new 
interpretation; and the announcement of a natural disaster, an 
attack or a war.
---------------------------------------------------------------------------

Determining What Is Contemporaneous
    A broker-dealer must determine whether a transaction is 
contemporaneous to apply the guidance in the Proposed Interpretation, 
and, particularly, to identify the prevailing market price of a debt 
security. Although what is considered contemporaneous for purposes of 
determining a mark-up (mark-down) in a particular transaction is a 
facts-and-circumstances test, in response to the requests of 
commenters, NASD proposes to include in the Proposed Interpretation the 
following guidance:

    A dealer's cost is considered contemporaneous if the transaction 
occurs close enough in time to the subject transaction that it would 
reasonably be expected to reflect the current market price for the 
security. (Where a mark-down is being calculated, a dealer's 
proceeds would be considered contemporaneous if the transaction from 
which the proceeds result occurs close enough in time to the subject 
transaction that such proceeds would reasonably be expected to 
reflect the current market price for the security.) \27\
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    \27\ See Proposed IM-2440-2(b)(3).
---------------------------------------------------------------------------

Identifying Prevailing Market Price If Other Than Contemporaneous Cost 
or Proceeds
    When calculating a mark-up, where the dealer has established that 
the dealer's cost is (or in a mark-down, proceeds are) no longer 
contemporaneous,\28\ or where the dealer has presented evidence that is 
sufficient to overcome the presumption that the dealer's 
contemporaneous cost provides (or proceeds provide) the best measure of 
the prevailing market price, such as when there are interest rate 
changes, credit quality changes, or news events or announcements as 
described above and set forth in paragraph (b)(4) of the Proposed 
Interpretation, the dealer must follow a process for determining 
prevailing market price, considering certain factors in the appropriate 
order, as set forth in the Proposed Interpretation. Initially, a dealer 
must look to three factors or measures in the order they are presented 
(the ``Hierarchy'') to determine prevailing market price. The most 
important and first factor in the Hierarchy is the pricing of any 
contemporaneous inter-dealer transactions in the same security.\29\ The 
second most important factor in the Hierarchy recognizes the role of 
certain large institutions in the fixed income securities markets. In 
the absence of inter-dealer transactions, the second factor a dealer 
must consider is the prices of contemporaneous dealer purchases in the 
security in question from institutional accounts with which any dealer 
regularly effects transactions in the same security.\30\ If 
contemporaneous inter-dealer trades or dealer-institutional trades in 
the same security are not available, a dealer must look to the third 
factor in the Hierarchy, which may be applied only to actively traded 
securities. For actively traded securities, a dealer is required to 
look to contemporaneous bid (offer) quotations for the security in 
question for proof of the prevailing market price if such quotations 
are made through an inter-dealer mechanism through which transactions 
generally occur at the displayed quotations.\31\
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    \28\ A dealer that has not engaged in trading in the subject 
security for an extended period can evidence that it has no 
contemporaneous cost (proceeds) to refer to as a basis for computing 
a mark-up (mark-down).
    \29\ See Proposed IM-2440-2(b)(5)(A).
    \30\ See Proposed IM-2440-2(b)(5)(B). Contemporaneous dealer 
sales with such institutional accounts would be used to calculate a 
mark-down. If a dealer has overcome the presumption by establishing, 
for example, that the credit quality of the security changed 
significantly after the dealer's trade, any inter-dealer or dealer-
institutional trades in the same security that occurred prior to the 
change in credit quality would not be valid measures of the 
prevailing market price as such transactions would be subject to the 
same defect.
    \31\ See Proposed IM-2440-2(b)(5)(C).
---------------------------------------------------------------------------

Additional Factors That May Be Considered
    If none of the three factors in the Hierarchy is available, the 
dealer then may take into consideration the non-exclusive list of four 
factors in the Proposed Interpretation in trying to establish 
prevailing market price using a measure other than the dealer's 
contemporaneous cost (proceeds). In contrast to the Hierarchy of three 
factors discussed above, a dealer is not required to consider the four 
factors below in a particular order.
    The four factors reflect the particular nature of the debt markets 
and the trading and valuation of debt securities. They are:
     Prices of contemporaneous inter-dealer transactions in a 
``similar'' security, as defined below, or prices of contemporaneous 
dealer purchase (sale) transactions in a ``similar'' security with 
institutional accounts with which any dealer regularly effects 
transactions in the ``similar'' security with respect to customer mark-
ups (mark-downs);
     Yields calculated from prices of contemporaneous inter-
dealer transactions in ``similar'' securities;
     Yields calculated from prices of contemporaneous purchase 
(sale) transactions with institutional accounts with which any dealer 
regularly effects transactions in ``similar'' securities with respect 
to customer mark-ups (mark-downs); and
     Yields calculated from validated contemporaneous inter-
dealer bid (offer) quotations in ``similar'' securities for customer 
mark-ups (mark-downs).
    When applying one or more of the four factors, a dealer must 
consider that the ultimate evidentiary issue is whether the prevailing 
market price of the security will be correctly identified. As stated in 
the Proposed Interpretation, the relative weight of the pricing 
information obtained from the factors depends on the facts and 
circumstances surrounding the comparison transaction (i.e., whether the 
dealer in the comparison transaction was on the same side of the market 
as the dealer is in the subject transaction, timeliness of the 
information, and, with respect to the final factor listed above, the 
relative spread of the quotations in the ``similar''

[[Page 68861]]

security to the quotations in the subject security).\32\
---------------------------------------------------------------------------

    \32\ See Proposed IM-2440-2(b)(6).
---------------------------------------------------------------------------

    Finally, if information concerning the prevailing market price of 
the subject security cannot be obtained by applying any of the above 
factors, a member may consider as a factor in determining the 
prevailing market price the prices or yields derived from economic 
models that take into account measures such as credit quality, interest 
rates, industry sector, time to maturity, call provisions and any other 
embedded options, coupon rate, and face value; and consider all 
applicable pricing terms and conventions (e.g., coupon frequency and 
accrual methods).\33\ However, dealers may not use any economic model 
to establish the prevailing market price for mark-up (mark-down) 
purposes, except in limited instances where none of the three factors 
in the Hierarchy and none of the four factors in proposed paragraph 
(b)(6) apply. For example, application of the Hierarchy and the four 
factors in proposed paragraph (b)(6) may not yield pricing information 
when the subject security is infrequently traded, and the security is 
of such low credit quality (e.g., a distressed debt security) that a 
dealer cannot identify a ``similar'' security.\34\
---------------------------------------------------------------------------

    \33\ See Proposed IM-2440-2(b)(7).
    \34\ When a dealer seeks to identify prevailing market price 
using other than the dealer's contemporaneous cost or 
contemporaneous proceeds, the dealer must be prepared to provide 
evidence that will establish the dealer's basis for not using 
contemporaneous cost (proceeds), and information about the other 
values reviewed (e.g., the specific prices and/or yields of 
securities that were identified as similar securities) in order to 
determine the prevailing market price of the subject security. If a 
firm relies upon pricing information from a model the firm uses or 
has developed, the firm must be able to provide information that was 
used on the day of the transaction to develop the pricing 
information (i.e., the data that was input and the data that the 
model generated and the firm used to arrive at prevailing market 
price).
---------------------------------------------------------------------------

    The final principle in the Proposed Interpretation regarding 
prevailing market price addresses the use of pricing information from 
isolated transactions or quotations. The Proposed Interpretation 
provides that ``isolated transactions or isolated quotations generally 
will have little or no weight or relevance in establishing prevailing 
market price. For example, in considering yields of `similar' 
securities, except in extraordinary circumstances, members may not rely 
exclusively on isolated transactions or a limited number of 
transactions that are not fairly representative of the yields of 
transactions in `similar' securities taken as a whole.''\35\
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    \35\ See Proposed IM-2440-2(b)(8).
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Certain Institutions Not Treated As Customers in Transactions in Non-
Investment Grade Debt Securities
    Commenters expressed concerns about the application of the original 
proposed rule change, as amended, to transactions between broker-
dealers and large, knowledgeable institutions involving generally 
thinly traded, risky, and often volatile non-investment grade debt 
securities. In Amendment No. 5, NASD addresses these concerns and 
proposes, for purposes of Rule 2440, IM-2440-1 and the Proposed 
Interpretation, that in transactions in non-investment grade debt 
securities (including certain unrated securities), the term 
``customer'' shall not include a qualified institutional buyer 
(``QIB''), as defined in Rule 144A under the Securities Act of 1933 
(``Securities Act'') provided other conditions are met. Specifically, 
the Proposed Interpretation provides that, for purposes of Rule 2440, 
IM-2440-1 and the Proposed Interpretation, the term ``customer'' shall 
not include:

    A qualified institutional buyer (``QIB'') as defined in Rule 
144A under the Securities Act of 1933 that is purchasing or selling 
a non-investment grade debt security, when the member has 
determined, after considering the factors set forth in IM-2310-3, 
that the QIB has the capacity to evaluate independently the 
investment risk and in fact is exercising independent judgment in 
deciding to enter into the transaction.\36\
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    \36\ See Proposed IM-2440-2(b)(9).

    In NASD IM-2310-3, NASD sets forth a non-exclusive list of factors 
(or considerations) that a member may include in assessing and 
determining an institutional customer's capability to evaluate 
investment risk independently. These factors allow a member to examine 
the institutional customer's capability to make its own investment 
decisions, including examining the resources available to the 
institutional customer to make informed decisions, and include:
     The use of one or more consultants, investment advisers or 
bank trust departments;
     The general level of experience of the institutional 
customer in financial markets and specific experience with the type of 
instruments under consideration;
     The customer's ability to understand the economic features 
of the security involved;
     The customer's ability to independently evaluate how 
market developments would affect the security; and
     The complexity of the security or securities involved.
    In addition, IM-2310-3 contains a non-exclusive list of factors (or 
considerations) for a member to use in determining if an institutional 
customer is making an independent investment decision. These factors 
probe the nature of the relationship that exists between the member and 
institutional customer and include:
     Any written or oral understanding that exists between the 
member and the customer regarding the nature of the relationship 
between the member and the customer and the services to be rendered by 
the member;
     The presence or absence of a pattern of acceptance of the 
member's recommendations;
     The use by the customer of ideas, suggestions, market 
views and information obtained from other members or market 
professionals, particularly those relating to the same type of 
securities; and
     The extent to which the member has received from the 
customer current comprehensive portfolio information in connection with 
discussing recommended transactions or has not been provided important 
information regarding its portfolio or investment objectives.
    In addition, NASD proposes to define the term ``non-investment 
grade debt security'' broadly for purposes of NASD Rule 2440, IM-2440-1 
and the Proposed Interpretation. Specifically, ``non-investment grade 
debt security'' shall mean a debt security that (i) if rated by only 
one NRSRO, is rated lower than one of the four highest generic rating 
categories; (ii) if rated by more than one NRSRO, is rated lower than 
one of the four highest generic rating categories by any of the NRSROs; 
or (iii) if unrated, either was analyzed as a non-investment grade debt 
security by the member and the member retains credit evaluation 
documentation and demonstrates to NASD (using credit evaluation or 
other demonstrable criteria) that the credit quality of the security 
is, in fact, equivalent to a non-investment grade debt security, or was 
initially offered and sold and continues to be offered and sold 
pursuant to an exemption from registration under the Securities 
Act.\37\
---------------------------------------------------------------------------

    \37\ See Proposed IM-2440-2(b)(9).
---------------------------------------------------------------------------

    The Proposed Interpretation recognizes and broadly addresses the 
most significant concerns of the comments received regarding the 
original proposed rule change, as amended. Many large institutional 
investors have sufficient knowledge of the market or certain sectors of 
the market to trade debt securities with broker-dealers at prices 
negotiated at

[[Page 68862]]

arms length, reducing the need for such customers to be protected with 
respect to every transaction under Rule 2440, IM-2440-1 and the 
Proposed Interpretation. Further, the application of the Proposed 
Interpretation to generally illiquid market sectors, such as non-
investment grade debt securities and bespoke or unique structured 
products that are sold pursuant to an exemption from registration under 
the Securities Act, and thereafter continue to be resold in private 
transactions rather than in the public markets, often may yield little 
or no pricing information that a dealer may use with confidence to 
determine the prevailing market price and a fair mark-up or mark-down 
for such debt securities transactions. It should be noted that even 
with respect to transactions with institutions that do not qualify for 
the exemption under proposed paragraph (b)(9), it would still be 
possible for a dealer to identify prevailing market price using 
information other than the dealer's contemporaneous cost (or proceeds), 
if done in accordance with the other provisions of the Proposed 
Interpretation.
Previously Proposed Concepts About Prevailing Market Price That Are 
Withdrawn
    Specified Institutional Trade. In Amendment No. 1, NASD proposed 
that a dealer could seek to overcome the presumption that its 
contemporaneous cost or proceeds are indicative of the prevailing 
market price where the dealer establishes that the dealer's 
contemporaneous trade was a ``Specified Institutional Trade''--a trade 
with an institutional account with which the dealer regularly effected 
transactions in the same or a similar security under certain conditions 
(``SIT'').\38\ NASD subsequently withdrew the concept of SIT and 
substituted the size proposal set forth below.
---------------------------------------------------------------------------

    \38\ A ``Specified Institutional Trade'' was defined as a 
dealer's contemporaneous trade with an institutional account with 
which the dealer regularly effects transactions in the same or a 
``similar'' security, as defined in the Proposed Interpretation, and 
in the case of a sale to such an account, the trade was executed at 
a price higher than the then prevailing market price, or in the case 
of a purchase from such an account, the trade was executed at a 
price lower than the then prevailing market price, and the execution 
price was away from the prevailing market price because of the size 
and risk of the transaction. In instances when the dealer would have 
established that the dealer's contemporaneous trade was an SIT, to 
overcome the presumption that the dealer's contemporaneous cost was 
(or proceeds were) the best measure of the prevailing market price, 
the dealer would have been required to provide evidence of 
prevailing market price by referring exclusively to inter-dealer 
trades in the same security executed contemporaneously with the 
dealer's SIT.
---------------------------------------------------------------------------

    Size Proposal. In Amendment Nos. 3 and 4, NASD proposed, instead of 
Specified Institutional Trades, the size proposal (``Size proposal''). 
As NASD stated in its Statement of Purpose for Amendment No. 3, ``a 
large or a small transaction executed at a price away from the 
prevailing market price of the security, as evidenced by certain 
contemporaneous transactions, is an instance where it may be 
appropriate for the dealer to show that its contemporaneous cost 
(proceeds) is not indicative of prevailing market price.'' The proposed 
change was intended to provide dealers greater flexibility to identify 
prevailing market price using a non-contemporaneous cost value than 
provided by the SIT provision proposed in Amendment No. 1.\39\
---------------------------------------------------------------------------

    \39\ The SIT proposal was proposed in Amendment No. 1. In 
Amendment No. 3, NASD deleted the SIT proposal and replaced it with 
the Size proposal. Also in Amendment No. 3, references to size of 
trade as a consideration or a factor in pricing were added in other 
provisions. In Amendment No. 4, NASD submitted clarifications 
regarding the Size proposal. In Amendment No. 5, such references to 
size were deleted.
---------------------------------------------------------------------------

    NASD also withdraws the Size proposal. Instead, NASD is proposing 
that, for purposes of Rule 2440, IM-2440-1 and the Proposed 
Interpretation, broker-dealers would not be required to treat QIBs 
engaging in transactions in non-investment grade debt securities as 
customers, if the broker-dealer determines, ``after considering the 
factors set forth in IM-2310-3, that the QIB has the capacity to 
evaluate independently the investment risk and in fact is exercising 
independent judgment in deciding to enter into the transaction.'' The 
proposed amendment recognizes and addresses the concerns of commenters 
more clearly and more broadly than either the withdrawn SIT or Size 
proposals.
    ``Similar'' Securities. The definition of ``similar'' security, and 
the uses and limitations of ``similar'' securities are the second part 
of the Proposed Interpretation. Several of the factors referenced above 
to which a dealer may refer when determining the prevailing market 
price as a value that is other than the dealer's contemporaneous cost 
(proceeds) require a dealer to identify one or more ``similar'' 
securities.
    The Proposed Interpretation provides that a ``similar'' security 
should be sufficiently similar to the subject security that it would 
serve as a reasonable alternative investment. In addition, at a 
minimum, a dealer must be able to fairly estimate the market yield for 
the subject security from the yields of ``similar'' securities.\40\ 
Finally, to aid members in identifying ``similar'' securities when 
appropriate, the Proposed Interpretation sets forth a list of non-
exclusive factors to determine the similarity between the subject 
security and one or more other securities. The non-exclusive list of 
factors that can be used to assess similarity includes the following:
---------------------------------------------------------------------------

    \40\ See Proposed IM-2440-2(c)(1).
---------------------------------------------------------------------------

    (a) Credit quality considerations, such as whether the security is 
issued by the same or similar entity, bears the same or similar credit 
rating, or is supported by a similarly strong guarantee or collateral 
as the subject security (to the extent securities of other issuers are 
designated as ``similar'' securities, significant recent information of 
either issuer that is not yet incorporated in credit ratings should be 
considered (e.g., changes in ratings outlooks)); \41\
---------------------------------------------------------------------------

    \41\ See Proposed IM-2440-2(c)(2)(A).
---------------------------------------------------------------------------

    (b) The extent to which the spread (i.e., the spread over U.S. 
Treasury securities of a similar duration) at which the ``similar'' 
security trades is comparable to the spread at which the subject 
security trades; \42\
---------------------------------------------------------------------------

    \42\ See Proposed IM-2440-2(c)(2)(B).
---------------------------------------------------------------------------

    (c) General structural characteristics and provisions of the issue, 
such as coupon, maturity, duration, complexity or uniqueness of the 
structure, callability, the likelihood that the security will be 
called, tendered or exchanged, and other embedded options, as compared 
with the characteristics of the subject security;\43\ and
---------------------------------------------------------------------------

    \43\ See Proposed IM-2440-2(c)(2)(C).
---------------------------------------------------------------------------

    (d) Technical factors, such as the size of the issue, the float and 
recent turnover of the issue, and legal restrictions on transferability 
as compared with the subject security.\44\
---------------------------------------------------------------------------

    \44\ See Proposed IM-2440-2(c)(2)(D).
    The Proposed Interpretation also states that, for certain 
securities, there are no ``similar'' securities. Specifically, when 
a debt security's value and pricing is based substantially on, and 
is highly dependent on, the particular circumstances of the issuer, 
including creditworthiness and the ability and willingness of the 
issuer to meet the specific obligations of the security, in most 
cases other securities will not be sufficiently similar, and 
therefore, other securities may not be used to establish prevailing 
market price of the subject security. See Proposed IM-2440-2(c)(3). 
As noted above, NASD may consider a dealer's pricing information 
obtained from an economic model to establish prevailing market 
price, when ``similar'' securities do not exist and facts and 
circumstances have combined to create a price information void in 
the subject security. In addition, as provided in the Proposed 
Interpretation, NASD also may look to economic models other than the 
dealer's to make determinations as to the prevailing market price of 
a security.
---------------------------------------------------------------------------

    The provisions regarding ``similar'' securities, if adopted, would 
affirm

[[Page 68863]]

explicitly, for the first time, that it may be appropriate under 
specified circumstances to refer to ``similar'' securities to determine 
prevailing market price. In addition, the Proposed Interpretation 
provides guidance as to the degree of similarity that is required. 
Also, the Proposed Interpretation recognizes an additional source of 
pricing information, i.e., certain economic models, that a dealer may 
consider in determining prevailing market price when all other factors, 
including those employing ``similar'' securities, do not render 
relevant pricing information because transactions and quotes (that have 
been validated by active trading) have not occurred in the subject 
security and there are no ``similar'' securities. Thus, when all other 
factors have been considered but are irrelevant, such as when a very 
distressed, very illiquid security is traded, the Proposed 
Interpretation provides the flexibility to determine prevailing market 
price and an appropriate mark-up (mark-down).
    Conclusion. NASD believes that the Proposed Interpretation 
recognizes the special characteristics of debt instruments, reflects 
the particular nature of trading in the debt markets, and provides 
important guidance to all members engaged in debt securities 
transactions. The guidance sets forth clearly a basic principle in 
NASD's rules: a dealer's contemporaneous cost (or, when calculating a 
mark-down, a dealer's contemporaneous proceeds) is presumptively the 
prevailing market price in debt securities transactions. In addition, 
the Proposed Interpretation provides guidance on when this principle 
may not be applicable, and, in those cases, guidance on the dealer's 
obligation to provide evidence of the prevailing market price using the 
factors set forth above, and, as applicable, in the priority set forth 
above, and any other relevant evidence of prevailing market price. NASD 
also proposes to recognize, in limited circumstances, that a dealer may 
refer to an economic model to provide evidence of the prevailing market 
price of a security when the security is sufficiently illiquid that the 
debt market does not provide evidence of the prevailing market price, 
and the security does not meet other criteria and therefore cannot be 
compared with a ``similar'' security.
    The Proposed Interpretation now includes an exemption from Rule 
2440, IM-2440-1 and the Proposed Interpretation for certain 
transactions in non-investment grade debt securities between broker-
dealers and certain QIB customers. NASD believes that many of the 
concerns and objections raised by commenters regarding the regulation 
of mark-ups (mark-downs) in debt securities transactions between 
broker-dealers and institutional customers are addressed by the 
inclusion of the proposed exemption.
    Finally, the Proposed Interpretation announces explicitly that a 
dealer is permitted to use ``similar'' securities in some cases where 
the dealer is identifying the prevailing market price of a security 
using a measure other than the dealer's contemporaneous cost (or 
contemporaneous proceeds). NASD's recognition of the limited but 
appropriate use of a ``similar'' security includes guidance on which 
securities may be considered ``similar'' securities. NASD believes that 
the Proposed Interpretation is an important first step in developing 
additional mark-up guidance for members engaged in debt securities 
transactions with customers on a principal basis.
2. Statutory Basis
    NASD believes that the proposed rule change is consistent with the 
provisions of Section 15A(b)(6) of the Act,\45\ which requires, among 
other things, that NASD rules must be designed to prevent fraudulent 
and manipulative acts and practices, to promote just and equitable 
principles of trade, and, in general, to protect investors and the 
public interest. NASD believes that clarifying the standard for 
correctly identifying the prevailing market price of a debt security 
for purposes of calculating a mark-up (mark-down), clarifying the 
additional obligations of a member when it seeks to use a measure other 
than the member's own contemporaneous cost (proceeds) as the prevailing 
market price, and confirming that similar securities may be used in 
certain instances to determine the prevailing market price are measures 
designed to prevent fraudulent practices, promote just and equitable 
principles of trade, and protect investors and the public interest. 
Further, the inclusion of an exemption from Rule 2440, IM-2440-1 and 
the Proposed Interpretation for transactions in non-investment grade 
debt securities between broker-dealers and certain QIBs provides such 
parties flexibility and will not impair or burden the markets or the 
parties trading in non-investment grade debt securities.
---------------------------------------------------------------------------

    \45\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------

B. Self-Regulatory Organization's Statement on Burden on Competition

    NASD does not believe that the proposed rule change will result in 
any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    NASD has responded previously to industry and SEC comments 
regarding this rule change. See NASD Response to Comments, filed on 
October 4, 2005.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:
    (A) By order approve such proposed rule change, or
    (B) Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act.\46\ Comments may be submitted by any 
of the following methods:
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    \46\ The Commission will consider the comments we previously 
received. Commenters may reiterate or cross-reference previously 
submitted comments.
---------------------------------------------------------------------------

Electronic Comments

     Use the Commission's Internet comment form (https://
www.sec.gov/rules/sro.shtml); or
     Send an e-mail to rule-comments@sec.gov. Please include 
File Number SR-NASD-2003-141 on the subject line.

Paper Comments

     Send paper comments in triplicate to Nancy M. Morris, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-1090.
    All submissions should refer to File Number SR-NASD-2003-141. This 
file number should be included on the subject line if e-mail is used. 
To help the Commission process and review your comments more 
efficiently, please use only one method. The Commission will post all 
comments on the Commission's Internet Web site (https://www.sec.gov/
rules/sro.shtml). Copies of the submission, all subsequent

[[Page 68864]]

amendments, all written statements with respect to the proposed rule 
change that are filed with the Commission, and all written 
communications relating to the proposed rule change between the 
Commission and any person, other than those that may be withheld from 
the public in accordance with the provisions of 5 U.S.C. 552, will be 
available for inspection and copying in the Commission's Public 
Reference Room. Copies of such filing also will be available for 
inspection and copying at the principal office of NASD.
    All comments received will be posted without change; the Commission 
does not edit personal identifying information from submissions. You 
should submit only information that you wish to make available 
publicly. All submissions should refer to File Number SR-NASD-2003-141 
and should be submitted on or before December 19, 2006.
---------------------------------------------------------------------------

    \47\ 17 CFR 200.30-3(a)(12).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\47\
Nancy M. Morris,
Secretary.
 [FR Doc. E6-20068 Filed 11-27-06; 8:45 am]
BILLING CODE 8011-01-P

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