Application of Customer Account Information and Suitability requirements to member selling one type of security to narrow target audience.
August 4, 2000
Alan Feldstein, Esq.
Acting General Counsel
Development Corporation for Israel
575 Lexington Avenue
New York, NY 10022-6195
Re: NASD Conduct Rules 2310 and 3110
Dear Mr. Feldstein:
I am responding to your letter of February 17, 2000 to NASD Regulation, Inc., ("NASD Regulation") requesting an exemption from certain provisions of NASD Conduct Rules 2310 and 3110.
You describe the facts as follows. Development Corporation for Israel ("DCI") is a broker/dealer registered with the Securities and Exchange Commission ("SEC") and a member of the National Association of Securities Dealers, Inc. ("NASD"). DCI was founded nearly fifty years ago to raise funds for the then-fledging State of Israel. DCI only sells one type of security, Israeli government bonds. Each bond sold is newly underwritten, as part of a continuous, best-efforts, public offering, and each bond issue is registered with the SEC. There is no secondary market for Israel bonds. The bonds are backed by the full faith and credit of the State of Israel and are rated by nationally recognized statistical rating organizations. Israel has never defaulted on the payment of principal or interest.
Your registered representatives service investors interested in purchasing the bonds. Upon purchase, the investment information and proceeds (payable to the "State of Israel") are remitted to a fiscal agent bank for issuance of the bonds and all subsequent bondholder maintenance. The entire investment amount goes towards the face value of a new bond.
You state that DCI employees, including registered representatives, are represented by unions and that their earnings are governed by collective bargaining agreements. You also state that your registered representatives earn no commissions.
You state that your customer base is basically limited to those who have some religious, cultural or ideological affinity for Israel. Every bond prospectus indicates on its cover that Israel bonds are sold primarily to persons who have an interest in the State of Israel. You believe that many of these people choose to buy Israel bonds because of their emotional relationship with the State of Israel rather than the pure investment merits of the bonds themselves. You state that to your knowledge, there has never been a customer complaint brought to the NASD, SEC or other regulatory body against DCI. You seek an exemption from the provisions of NASD Conduct Rules 3110(c)(1)(C) and (2)(C), and 2310(b)(1), (2), and (3).
NASD Conduct Rule 3110(c)(1)(C) and (2)(C)
You state that DCI does not, and believes that it need not, inquire into whether a customer is an associated person of another member. You believe DCI has appropriate procedures in place for having a registered representative and a principal review each purchase. You believe that the primary rationale for ascertaining whether an individual account holder is associated with another member firm is to prevent insider trading or any related transgression based upon special access to information. You state that DCI does not buy, sell or trade in any equity securities, nor does it make a market in any equity securities. You also state that DCI does not receive any material non-public information regarding publicly traded companies or the bonds it sells, does not have a research department or an investment-banking department, and does not deal in hot issues, and thus invites no risk of freeriding and withholding or insider trading. You believe that therefore there is absolutely no risk of a suspect trade. Consequently, you conclude that it is unnecessary to supply other member firms with DCI purchase information.
In addition, DCI does not maintain customer accounts as is customary in the securities industry. Each purchase of a bond is a separate transaction. One purchase of a bond by a customer is not linked to any other purchase. In each instance that a customer purchases a new bond, he or she must complete an "Investment Form." An Investment Form requires that pertinent information be completed by the customer including, but not limited to, the name and residence of the purchaser and registered owner, whether the customer is of legal age, the customer's tax identification or Social Security number, the occupation of the customer and the name and address of the customer's employer.
You state that because each bond purchased is a separate transaction, the quantity of Investment Forms generated is quite voluminous. Therefore, a weekly Payment Summary Report is generated listing the pertinent information contained on the individual Investment Forms. The weekly Payment Summary Report is reviewed and signed by a registered representative (Series 62) and a registered principal (Series 24). You believe approval of these Investment Forms by a registered principal on a weekly basis is timely for the reason that bonds are generally issued only one calendar day each month by the respective fiscal agent bank.
NASD Conduct Rule 2310(b)(1), (2), and (3)
DCI also seeks an exemption from the requirement that members make reasonable efforts to obtain information regarding the financial status, tax status and investment objectives of their customers. You state that DCI has never obtained this information from its bond purchasers in its fifty-year history and has never been the subject of a single suitability complaint or inquiry. You believe that Rule 2310(b) is inapplicable because, according to your letter, DCI does not make recommendations to its customers. You state that it is DCI policy that its registered representatives simply inform customers of the few debt products that are available from the State of Israel through DCI.
You believe that to inquire into the financial status, tax status and investment objectives of DCI’s customers would be a major change in the way DCI has done business for the past fifty years. You state that your customers generally view DCI as a means to connect to their Jewish heritage and community and have expressed reluctance to disclose their financial and tax status, because it is irrelevant to DCI's offerings. You believe that for DCI to require such information, after not doing so for its entire history, would have a tremendously adverse impact on purchasers and would fundamentally alter DCI's business without providing any additional investor protection, public good or regulatory benefit.
As an initial matter, although some NASD rules contain provisions that provide NASD Regulation with the authority to grant exemptions from those rules, neither NASD Rule 3110 nor NASD Rule 2310 contain such provisions. As a result, the possibility does not exist for obtaining exemptions under Rules 3110 and 2310.
Regardless of whether such authority exists, we disagree with your analysis that the particular nature of DCI's business and clientele justifies relief from the registered representative and registered principal signature requirements of Rule 3110(c)(1)(C). The signatures both identify the salesperson of record for the account and provide the principal the opportunity to review the account information and, in many cases (including for your firm), the first transaction.
We also disagree with your analysis that the particular nature of DCI's business and clientele justifies relief from the requirement to make reasonable efforts to determine the customer's associated person status under Rule 3110(c)(2)(C). The associated person status determination helps to facilitate compliance with certain other NASD rules such as Rule 3050, which requires, among other things, that a firm executing a transaction for the account of an associated person of another firm notify the other firm before opening the account or executing the trade on behalf of the associated person.
Finally, we also disagree that the limited nature of DCI's product line and its more narrowly circumscribed target audience justifies relief from the suitability requirements of Rule 2310. Without addressing the issue of whether DCI "recommends" the purchase of Israel bonds to its customers, to the extent that such recommendations are made, DCI must comply with the suitability requirements set forth in Rule 2310, including the requirement to make reasonable efforts to obtain information regarding the financial status, tax status and investment objectives of the customers to whom the bonds are recommended. Moreover, regardless of whether DCI recommends securities transactions to its customers, certain customer information will be necessary to satisfy the firm’s "know-your-customer" obligations.1
Please free to call me at (202) 728-8451 if you have any further questions.
Robert J. Smith
Assistant General Counsel
1 See, e.g., NASD Special Notice to Members 96-32 (May 1996) (reminding members of their know-your-customer obligations under NASD Rule 2110). See also New York Stock Exchange Rule 405.