Application of NASD Rules, Interpretations, By-Laws, and Federal Securities Laws to the Secondary Market in Direct Participation Program Interests
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EXECUTIVE SUMMARY
The NASD recently completed a study of secondary market trading in direct participation program (DPP) securities. As a result, this notice is being issued to emphasize the applicability and relevance of certain NASD rules, Interpretations, By-laws, and federal securities laws for those members and associated persons participating in the growing secondary market for DPP securities.
The study uncovered many cases of unawareness of pertinent rules or inappropriate application of the rules. Therefore, members are reminded of their responsibilities to ensure compliance with relevant regulatory requirements when engaging in this secondary market. Furthermore, members must take steps to modify existing practices where necessary in a manner consistent with this Notice to Members and the applicable laws and rules. Among others, existing NASD rules involving markups, suitability of recommendations, and best execution are and have long been applicable to secondary market transactions with customers in DPP securities.
The NASD is committed to ensuring a fair and credible secondary market for all participants, including broker/dealers and investors. To achieve this result, strict adherence to all rules and regulations is necessary and expected. The NASD intends to closely surveil this market with that goal in mind.
BACKGROUND
In October 1990, the NASD through its Direct Participation Programs/Real Estate Committee (the "DPP Committee") initiated a study of the nature and functioning of the secondary market for public partnership securities. There were several factors that led the DPP Committee to conclude such a study was necessary. Concern was expressed about the growth in secondary markets for DPP securities, a relatively recent phenomenon brought about in large part by the Tax Reform Act of 1986, the inability of partnerships to liquidate their portfolios and distribute the proceeds, and the subsequent decline in oil and gas and real estate prices.
Also, during examinations of various members, examiners had found questionable practices involving DPP securities that raised concerns as to possible violations of NASD rules. In some cases, the violations appeared serious enough to warrant disciplinary action. Given the seriousness of these matters, the NASD continued to pursue its regulatory investigations of apparent abusive practices, while the DPP Committee conducted a parallel but distinctly separate review of industry practices in this evolving and growing market.
Data gathered during the study indicated that approximately $90 billion was invested in public DPP securities in the 1970s and 1980s by more than 10 million investors. The programs were organized to invest in a variety of industries including, but not limited to, real estate, oil and gas, cable television, commodities, and equipment leasing. Although these securities were generally not intended to be liquid and tradable, a secondary market in DPP securities nevertheless has developed.
The study also found that approximately two dozen participants (both NASD members and non-members) act as principal or agent for customers in a fragmented secondary market that, in the aggregate, transfers ownership of an estimated $250 to $300 million worth of public partnership securities annually. The primary concern of the study was to determine how the market currently operates, whether it functions efficiently, and whether members are in compliance with applicable securities laws and rules, including NASD rules.
The DPP Committee, through a subcommittee appointed specifically for this study, met with representatives from 10 NASD members and nonmembers that are engaged in secondary market transactions in DPP securities. In addition, the subcommittee solicited and received written submissions from other market participants. Each was asked to provide information as to how it conducted its business and for any insights or recommendations that it believed would be helpful to the Committee.
The NASD study, as well as the routine examinations conducted by NASD examiners, noted widespread differences in the manner in which DPP secondary trading is conducted by members and found that certain practices were at variance with applicable guidelines and regulations. The DPP Committee study was intentionally separated from the investigations and routine examinations being conducted by NASD examiners. Thus, the NASD Board of Governors has decided to issue this Notice to Members to: emphasize to members the applicability of existing rules to this business, apprise the membership of the general conclusions of its study, inform members of the apparent violative practices noted by examinations, and discuss various issues that may require further study and possible rulemaking.
Specifically, applicability of rules relating to markups, filing of advertising and sales literature, determinations of suitability prior to a transaction, solicitation and tender offers, disclosure, Schedule H reporting requirements, transactions with non-members, quotation dissemination, and best execution as to price are emphasized. This notice also addresses problems relating to settlement and transfer, net capital, and escrow procedures.
NASD RULES AND BY-LAWS
Markups and Markdowns
NASD disciplinary cases and the DPP secondary market study have shown that many members engaged in secondary market activities may not be complying with the NASD Mark-Up Policy ("Policy") as set forth in an Interpretation of the Board of Governors under Article III, Section 4 of the NASD Rules of Fair Practice. The "Mark-Up Policy" specifies that for a markup or markdown in a principal transaction with a customer in equity transactions to be fair, it should generally not exceed 5 percent of the prevailing market price. This longstanding "5% Policy" is based on the obligations of a broker/dealer to deal fairly with its customers, particularly the obligation to charge customers only prices that are reasonably and fairly related to the prevailing market price at the time of the transaction.
The 5% Policy applies to customer purchases and sales of all securities traded in the Nasdaq and over-the-counter markets, including DPP securities. Since the Policy acts as a general guide, not a rule, a markup or markdown of more than the 5 percent guideline could be considered fair or reasonable where the specific facts and circumstances of the transaction clearly justify that price. On the other hand, a markup of less than 5 percent could be considered unfair under the circumstances of a specific transaction.
According to the 5% Policy, pricing considerations should take into account all relevant factors, including the type of security involved, the availability of the security, the price of the security, the services rendered, the amount of money involved in the transaction, and disclosure. If a dealer seeks to charge its customers more than a 5 percent markup or markdown, it should be fully prepared to justify its reasons for the higher markup or mark-down with adequate documentation.
Markups or markdowns that exceed the prevailing market price by 10 percent or more may not only be deemed unfair under the Mark-Up Policy and a violation of Article III, Sections 1 and 4 of the NASD Rules of Fair Practice, but also could be viewed as fraudulent and a violation of Article III, Section 18 of the Rules. While a member firm may attempt to justify a markup or markdown greater than 10 percent, the current state of the law creates a presumption of a fraudulently excessive markup or markdown that will be very difficult to overcome or rebut.
A markup or markdown compensates a dealer for its ordinary costs and risks associated with its handling of a transaction with a customer. The 5% Policy was designed to cover ordinary selling expenses, such as a normal commission to salespersons and the normal cost of processing a trade. Thus, such ordinary expenses cannot be charged again to customers in the form of increased markups or markdowns. In addition, excessive expenses cannot be used to justify a higher markup or markdown. The NASD has consistently held that its markup policy does not guarantee a dealer a net profit regardless of unreasonable expenses, such as excessive commissions to salespersons, excessive salaries to officers, and excessive telephone costs.
The NASD study found that DPP secondary market transactions with customers often involved fixed expenses such as general partner fees, settlement charges, and state transfer charges. Where such expenses are required by the general partner or state law, they may be directly passed on to customers as a separate charge or expense provided they are fully documented, not shared in by the member, and are fully disclosed prior to the transaction. However, charges to a customer that seek to defray overhead or internal administrative charges of the member are clearly inappropriate and may not be passed on to the customer directly or indirectly, or used as a basis for justifying a markup or markdown in excess of 5 percent.
The NASD study also indicates that, generally speaking, dealers in the DPP secondary market do not act as "market makers" as that term is defined in the Securities Exchange Act of 19341 and interpreted by case law. Also, the overwhelming number of transactions reviewed by the NASD through its field examinations and in conjunction with this study indicate that a dealer purchasing or selling for its own proprietary account is usually doing so to fill a customer order and, as a result, does not generally incur market risk.
If a dealer is engaged in such a riskless transaction or is determined not to be a market maker with respect to a particular transaction, then the markup must be calculated by using the dealer's contemporaneous cost as the best evidence of the prevailing market price. Similarly, for markdowns, the dealer's most contemporaneous sales price to another dealer must be used. However, to the extent that a dealer actually functions as a market maker in an active, competitive market by placing its own capital at risk through buying and selling for its own account in the interdealer market, while providing and standing by its quotes in transactions with other dealers on a regular and continuous basis, the member may be able to use its actual contemporaneous sales prices (for markups) and contemporaneous purchase prices (for markdowns) with other broker/dealers as the best evidence of the prevailing market price at the time of its transactions with customers.
Thus, the current NASD Mark-Up Policy is fully applicable and must be complied with by members when determining the markup or mark-down of DPP securities. The Policy provides comfort to members that a markup or markdown of 5 percent or less will be acceptable for the vast majority of DPP trades. If a member incurs reasonable additional time or costs in effecting a trade because of the limited availability of the DPP securities, the flexibility of the Policy may permit a markup or markdown of greater than 5 percent. In fact, the Policy acknowledges that markups in DPP securities may be higher than for sales of common stock. But, the member should be fully prepared to support the reasons for the higher markup or markdown with adequate documentation of each transaction.
Advertising and Sales Literature
Communications with the public, such as advertisements and sales literature concerning direct participation programs, are regulated under Article III, Section 35 of the Rules of Fair Practice. Secondary market advertising and sales literature, including research reports on public partnerships, must be filed within 10 days of first use with the NASD's Advertising Department for review, as required by Section 35(c).
The filing requirement, in effect since 1986, applies to all public programs but does not distinguish between material used in an offering and that used in the secondary market. The rule language requires members to file both types of material. This determination was made by the DPP Committee in 1989.
"Advertisement" and "sales literature" are specifically defined in Article III, Section 35(a). These definitions should be carefully reviewed to be certain that all pertinent material has been properly filed.
Suitability of Recommendations
NASD members and associated persons are required pursuant to Article III, Section 2 and Appendix F to Article III, Section 34 of the Rules of Fair Practice, when recommending to an investor the purchase, sale, or exchange of a DPP security, to have reasonable grounds to believe the recommendation is suitable for the customer based on the customer's investment objectives, other investments, financial situation and needs, tax status, and any other information known by the member or associated person. Additionally, the member and associated person must determine that the investor has the appropriate investment objectives, is in a position to fully understand the risks and benefits of the transaction, and has a net worth sufficient to sustain the risks involved in an investment in a DPP security.
The requirement to make a suitability determination not only applies to any initial distribution of partnership securities but to secondary market transactions as well. This requirement also includes the obligation to make reasonable efforts to obtain the customer information necessary to make the suitability determination. In addition, members must consider the suitability standards that may be imposed by state law when making a finding of customer suitability.
In making recommendations, members also must be aware of their fundamental responsibility of fair dealing with customers including determining whether a reasonable basis exists for engaging in the DPP transaction, considering any tax implications to the customer, and the fairness of the recommended price for the purchase or sale.
Schedule H Reporting and Filing Requirements
Schedule H of the NASD's By-Laws requires daily electronic price and volume reporting of all non-Nasdaq securities, which encompass any equity security not included in Nasdaq or traded on any national securities exchange. Secondary market transactions in DPP securities are therefore re-portable securities under Schedule H. As a result, members must report requisite price and volume information through the non-Nasdaq Reporting System for all secondary market trades in DPP securities that are executed on a principal basis.
Additionally, members are required to make Schedule H filings with the NASD of other required information prior to disseminating quotations in non-Nasdaq securities to comply with SEC Rule 15c2-11. (See section on SEC Rule 15c2-11, infra.) This filing requirement aspect of Schedule H is also applicable to DPP securities.
Although Schedule H reporting and filing requirements clearly apply to DPP securities, the NASD recognizes that, since these obligations may not have been specifically delineated in the past, many members may need additional time and guidance in order to implement the necessary procedures that will facilitate compliance with the rule. Therefore, in an upcoming Notice to Members, the NASD will provide additional information and directives regarding members' Schedule H compliance for DPP secondary market transactions.
Best Execution of Customer Orders
In any transaction for or with a customer, an NASD member is required to provide that customer with best execution as to price. To ensure fair dealing with customers, the Interpretation of the Board of Governors — Execution of Retail Transactions in the Over-the-Counter Market — under Article III, Section 1 of Rules of Fair Practice requires a member to obtain quotations from at least three dealers (or all dealers if three or less) to determine the best interdealer market price for a non-Nasdaq security. Article III, Section 21 of the Rules of Fair Practice requires that the quotes and dealers contacted be recorded on the member's books and records.
Contrary to these requirements, some members have not obtained or recorded the required three quotes on order tickets nor obtained the best execution for their customers in the DPP secondary market. In addition, members holding themselves out as market makers have refused to quote prices when contacted by other members seeking quotes. NASD members are reminded that such conduct is inappropriate and may result in disciplinary action against the member. Thus, if a member holds itself out as a market maker, it is required to disseminate quote information to other members on request and stand by those quotes for execution purposes.
Uniform Clearance and Settlement
The NASD has found that one of the major problems in the secondary market for direct participation program securities is the inefficient and untimely transfer of limited partnership interests on the books of partnerships. Transfer problems can also lead to delays or mistakes in the allocation of cash distributions between buyers and sellers.
Since transfer difficulties have caused unacceptable delays in settlement and proved to be costly for all participants in the secondary market, the NASD intends to study the feasibility of developing a uniform system of transfers and settlements. The Board of Governors has authorized the appointment of a special committee for this purpose.
FEDERAL AND STATE SECURITIES LAW ISSUES
Numerous federal and state securities laws apply to the distribution of and secondary market transactions in DPP securities. Certain of these laws and regulations are outlined below. Members are urged to consult with counsel to ensure that they are in compliance with these and other pertinent laws.
Broker/Dealer Registration and Transactions With Nonmembers
The NASD is concerned that certain firms and individuals are buying and selling securities on behalf of public customers without being registered as broker/dealers or becoming members of the NASD. Such firms and individuals may be in violation of federal securities laws requiring brokers and dealers to register with the Securities and Exchange Commission (SEC) and to become a member of a self-regulatory organization. The NASD urges its members to take great care in selecting the firms with which they do business and to report the actions of any market participants that they believe are nonregistered broker/dealers to the SEC or state securities regulators who have the authority to enforce requirements of registration, licensing, and other securities laws. Information concerning the activities of nonregistered broker/dealers supplied to the NASD will be referred to these agencies.
Members are also reminded that Section 25 of the NASD Rules of Fair Practice regulates transactions with nonmember broker/dealers. It generally requires members to deal with any nonmember broker/dealer at the same prices, commissions, fees and terms as they accord the general public. Thus, NASD members that transact business with non-members in the same manner they would another NASD member are in violation of Section 25.
Tender Offers Rules
To the extent that members engage in blanket solicitations of all limited partners of a particular partnership, members should be certain that such solicitation activity is either not subject to the tender offer rules of the Securities Exchange Act of 1934, or is in full compliance if they are applicable. Under certain circumstances, offers to purchase partnership interests made to all limited partners may constitute an unconventional tender offer.
Prospectus Disclosure Requirement
NASD members affiliated with a sponsor or general partner that also operate an internal bulletin board (e.g., a matching service) to match persons who wish to buy and sell interests in affiliated programs may be in violation of the registration provisions of the Securities Act of 1933. The SEC has recently stated that attempts by the general partner or its broker/dealer affiliates to facilitate or create an alternative secondary market may require that an "evergreen prospectus" be maintained. An evergreen prospectus is a part of an SEC registration statement that is continuously amended and updated so that the registration statement is always current and effective. General partners or their affiliates involved in such matching services or crossing arrangements may cause the offer to be deemed a sale of securities by the partnership-issuer that requires registration.2
Solicitation Under State Law
The NASD also believes that members should be aware that the resale of limited partnership interests by DPP secondary market participants following the widespread solicitation of the limited partners of a partnership may also be inconsistent with the registration provisions of various state laws. Under the Uniform Securities Act of 1956,3 a registration statement for a class of outstanding securities is effective for only one year.4 If resales occur after one year, an exemption from the registration provisions of state law may not be available. If no exemption is available, then it may be necessary to file a special registration statement to permit a new distribution by the issuer.5
Compliance With SEC Rule 15c2-11
SEC Rule 15c2-11 governs the initiation and resumption of quotations in a non-Nasdaq "inter-dealer quotation medium" by a broker or dealer for over-the-counter securities, including DPP securities. An interdealer quotation medium is defined as a quotation system of general circulation to brokers or dealers that regularly disseminates quotations of identified brokers or dealers. The rule was designed to help prevent manipulative and fraudulent trading schemes by prohibiting brokers and dealers from furnishing such quotations in the absence of sufficient information about an issuer.
A violation of Rule 15c2-11 may occur regardless of whether the broker/dealer is engaged in retail activity in the security, whether interdealer transactions have occurred, or whether the subject security is thinly traded. Indeed, the NASD has initiated disciplinary actions against members that have failed to comply with Rule 15c2-11.
Unless a broker/dealer qualifies for an exemption from Rule 15c2-11, the rule's information maintenance requirements can be satisfied in one of only five ways. Should a member seek to quote a DPP security in any interdealer quotation system, excluding the Nasdaq system, one of the most common methods of complying with the rule would be to obtain a prospectus filed with the SEC that is less than 90 days old since the majority of DPP securities that trade in the secondary market were subject to a full registration statement.
Once the funding operation is completed for a DPP, a substantial portion of these issuers have the minimum number of holders and total assets necessary to trigger periodic reporting requirements with the SEC. As a result, another manner of complying with Rule 15c2-11 would be for the broker/dealer to obtain the issuer's latest 10-K report, and all subsequent 10-Qs and 8-Ks. Other methods of complying with the Rule include obtaining and reviewing any recent Regulation A filing or certain other specified information about the issuer, such as recent financial statements.6
Importantly, members that may decide to initiate or resume a quotation of a DPP security in an interdealer quotation medium must recognize duties that go beyond simply securing the referenced materials. The member must, for example, carefully review the Rule 15c2-11 information and documents and have a reasonable basis for believing that the information is accurate in all material respects. Additionally, an affirmative standard is imposed by the SEC that requires the broker/dealer to have a reasonable basis for concluding that the documents and information about the issuer are derived from a reliable source.
Although the rule is applicable, to date the NASD has not found members disseminating quotations in DPP securities in a non-Nasdaq interdealer quotation medium that would subject them to Rule 15c2-11. Nevertheless, members are advised that the NASD found that some broker/dealers active in the DPP secondary market are doing little, if any, due diligence or research to support prices they charge or quotations they disseminate to the public and other broker/dealers on request. Since Rule 15c2-11 applies to DPP securities traded in the non-Nasdaq market, members are urged to consult the full text of the rule and relevant SEC releases regarding any intended quotations activities in order to be certain they are in full compliance.
Although members should have been complying with Rule 15c2-11, the NASD recognizes that members engaged in secondary market DPP activities may not have clearly understood the applicability of the rule. Therefore, the follow-up Notice to Members referred to above in the discussion of Schedule H will provide further guidance and direction to members regarding compliance with this rule.
Confirmation Disclosure Requirements
SEC Rule 10b-10, the so-called "customer confirmation rule," is fully applicable to members' transactions with their customers in DPP securities. The Rule requires, before the completion of any transaction with a customer, that the member send written notification to the customer disclosing specific information about the transaction. Included in the required disclosure are: (1) the capacity in which the member is acting in the transaction (i.e., as agent for the customer or principal or otherwise); (2) the date of the transaction and the identity, price, and amount of the security purchased or sold by such customer; and (3) the amount of the markup or markdown charged the customer where the dealer has acted in a riskless principal or agent capacity.
The study generally found that members active in the DPP secondary market generally do not meet the definition of a market maker and therefore are required to comply with the provisions of Rule 10b-10 as it applies to each transaction they engage in with customers.
Net Capital
The NASD reminds members that broker/dealers that engage in principal transactions in the DPP secondary market must adhere to a minimum net capital requirement of $25,000. Under SEC Rule 15c3-1 (the "Net Capital Rule"), only $25,000 net capital broker/dealers may handle customer funds or make markets in equity securities. However, a $5,000 broker/dealer may act as agent in the secondary market provided it either introduces all customer accounts on a fully disclosed basis through another broker/dealer or utilizes a bank escrow account (similar to that required by SEC Rule 15c2-4) to process and hold all customers' funds and/or securities.
Members should also be aware that given the current lack of readily available price information and liquidity, the Net Capital Rule may require a 100 percent charge for such securities when held in inventory, as they will not generally meet the "ready market" test of the Net Capital Rule.
CONCLUSION
Market participants are urged to refocus their attention on the proper calculation of markups, markdowns, spreads, and expenses in the DPP securities market. Some firms make little effort to determine the investor's suitability to purchase DPP securities, have no knowledge as to the applicability of transaction reporting requirements, and violate NASD rules with predatory pricing practices, lack of best execution, and absence of due diligence on behalf of customers. In addition, some members are not making required filings of advertising and sales literature with the NASD and are improperly doing business with nonmember broker/dealers. Others are not properly disclosing expenses being charged in connection with a purchase or sale, conflicts of interest the broker/dealer may have with the customer, and the basis on which they are recommending the price at which the securities are being bought or sold.
The NASD understands that some of the shortfalls and deficiencies noted by NASD examiners and identified in the DPP Committee's study may be caused by a lack of knowledge on the part of members as to the applicability and relevance of existing NASD rules and federal securities laws. Nevertheless, the regulations applicable to this market are quite explicit as to the obligations of members. Members, in turn, have a responsibility to be aware of those regulations and to adhere to them. Thus, the purpose of this notice is to alert members to the relevance of these regulations and to assist in complying with the various requirements applicable to the DPP secondary market.
The NASD staff will continue to focus its regulatory efforts on DPP secondary market practices, and strict adherence to existing rules is expected. Members transacting business in the secondary market found to be in apparent violation of such rules may be subject to disciplinary action if such a determination is made by a District Business Conduct Committee. If members have questions as to the applicability of a given rule or law, or the bona fides of a course of conduct they are planning, they should not hesitate to contact their local NASD district office and seek clarification.
Questions concerning this notice may be directed to Charles L. Bennett, Director; Richard J. Fortwengler, Associate Director; or Carl R. Sperapani, Assistant Director, Corporate Financing Department at (202) 728-8258 or Daniel M. Sibears, Director, Compliance Division at (202) 728-8959.
1 See Section 3(a)(38) of the Securities Exchange Act of 1934, as amended.
2 See Securities Act Release 33-6900, pages 36-38, June 17, 1991.
3 The Uniform Securities Act of 1956 is a model act approved by the National Conference of Commissions on Uniform State Laws on August 25, 1956. It has been enacted into law by a majority of the states. Counsel should be consulted as to the provisions that may be applicable in the state or states involved.
4 See Section 302(a)(2) Uniform Securities Act of 1956.
5 See Section 305(i); and Note 9, NCCUSL Comment to Uniform Securities Act of 1956.
6 See 17 CFR 240.15c2-11(a)(1) through (a)(5).