New Rule of Fair Practice Relating to Private Securities Transactions
TO: All NASD Members and Other Interested Persons
On November 12, 1985, the Securities and Exchange Commission approved a new Article III, Section 40 of the NASD Rules of Fair Practice (SEC Release No. 34-22617). The rule establishes new requirements for the private securities transactions of persons associated with members, and entirely replaces the Private Securities Transactions Interpretation under Article III, Section 27 of the rules. The new rule became effective upon approval by the SEC.
The text of the new rule is attached.
The NASD has long been concerned about private securities transactions of persons associated with broker-dealers. These transactions can generally be grouped into two categories:
The first category of transactions presents serious, regulatory concerns because securities may be sold to public investors without the benefit of supervision or oversight by a member firm and, perhaps, without adequate attention to such regulatory protections as due-diligence investigations and suitability determinations. In some cases, investors may be misled into believing that the associated person's firm has analyzed the security being offered and "stands behind" the product and transaction. The firm, in fact, may be unaware of the associated person's participation in the transaction. Under some circumstances, the firm may be liable for the actions of the associated person even though the firm was not aware of his or her participation in the transaction.
In view of these concerns, the NASD promulgated the Private Securities Transactions Interpretation several years ago. The Interpretation required associated persons to notify their employer firms before participating in private securities transactions. A significant number of associated persons have been disciplined by the NASD for violation of this Interpretation in recent years. The Interpretation enabled firms to exercise better supervision over their associated persons.
At the same time, the Interpretation was a source of substantial confusion, because it addressed only the responsibility of associated persons to notify their member firms of these transactions and did not specifically address the supervisory and oversight responsibilities of the firms. The Board of Governors' Advisory Council and several District Business Conduct Committees requested that the Interpretation be amended to clarify the firms' responsibilities in this area. After careful study, the Board adopted a new rule of fair practice to replace the Interpretation.
The NASD published the proposed rule on private securities transactions for comment in Notice to Members 85-21 (March 29, 1985). In response to the comments received, and following further consideration of the proposed rule by the Board of Governors, the NASD published a slightly revised version for membership vote in Notice to Members 85-54 (August 13, 1985). The new rule was approved by the membership and filed with the SEC, which approved the new rule on November 12, 1985.
Based on an analysis of regulatory problems regarding the handling of private securities transactions, the rule distinguishes between transactions in which the associated person will receive compensation for selling the securities and those for which no compensation will be received. The most serious regulatory concerns relate to situations in which associated persons receive selling compensation and, therefore, have an incentive to execute sales, perhaps without adequate supervision or adequate attention to suitability and due-diligence responsibilities. Some transactions in which associated persons participate without compensation need not be subjected to the same level of scrutiny as other transactions — for example, a salesperson owning stock in a closely held family corporation may wish to transfer that stock to another family member. Whether or not compensation is involved, the new rule specifies the recordkeeping and supervisory responsibilities of member firms.
ANALYSIS OF NEW RULE
Applicability — The new rule, which is attached, applies to any situation in which an associated person of a member proposes to participate in any manner in a private securities transaction.
"Private securities transaction" is defined broadly and generally parallels the concept in the now-deleted Interpretation. Transactions subject to Article III, Section 28 of the NASD Rules of Fair Practice 1/and personal transactions in investment company and variable annuity securities are excluded, as are transactions among immediate family members (as defined in the Interpretation of the Board of Governors on Free-Riding and Withholding 2/) for which no associated person receives any selling compensation. Because regulatory problems most frequently occur in connection with private placements of new offerings, those transactions are specifically included within the definition of "private securities transaction."
Written Notice — The rule requires associated persons to provide written notice to the employer member before participating in any private securities transaction. The notice must include a detailed description of the proposed transaction and the associated person's proposed role. As the rule treats compensatory and noncompensatory transactions differently, the notice also must state whether the associated person will receive compensation for selling the securities.
Transactions for Compensation — For transactions in which an associated person has or may receive selling compensation, the rule requires that a member firm that receives written notice from an associated person of his or her intent to participate in a private securities transaction must indicate in writing whether the firm approves or disapproves of the associated person's participation in the proposed transaction. If participation is approved, the firm must supervise the associated person's participation to the same extent as if the transaction were executed on behalf of the member firm itself, and record the transaction on the firm's books and records.
If participation is not approved, the associated person is prohibited from participating in the transaction in any manner.
Transactions Not For Compensation — The rule requires that a member receiving notice that an associated person proposes to participate in a transaction, or a series of related transactions, without compensation, provide that associated person with written acknowledgment of the submitted notice.
The rule also gives the employer firm the right to impose conditions on each associated person's participation in noncompensatory transactions. The intention is to give a member firm full discretionary authority to restrict its associated persons' private securities activities, including activities performed on a noncompensatory basis, and to require the associated person to adhere to any condition imposed.
Definition of Selling Compensation — The definition of "selling compensation" plays a key role in the rule. Because the treatment of transactions varies significantly depending upon whether selling compensation is to be received, the definition of "selling compensation" is deliberately broad in its scope.
The definition includes "any compensation paid directly or indirectly from whatever source in connection with or as a result of the purchase or sale of a security." Certain examples are provided, including: commissions; finder's fees; securities; and rights of participation in profits, tax benefits, or dissolution proceeds as a general partner or otherwise. While these examples include some of the most common forms of compensation, the definition is not restricted to these examples. It includes any item of value received or to be received directly or indirectly.
It is important to note that the definition of "selling compensation" includes compensation received or to be received by anyone acting as a salesperson or in some other capacity, specifically including the capacity of a general partner. The definition is intended to address a practice in which associated persons function as general partners in the formation of limited partnerships and then sell limited-partnership interests to the public through private securities transactions. Any involvement in a securities transaction by an associated person of an NASD member firm may be subject to the panoply of regulatory requirements applicable to persons associated with a broker-dealer. Participation in transactions as a general partner, therefore, carries with it significant regulatory responsibilities.
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Questions concerning this notice may be directed to Dennis C. Hensley or Phillip A. Rosen, NASD Office of the General Counsel, at (202) 728-8446.
Executive Vice President
Legal and Compliance
NEW RULE OF FAIR PRACTICE*
Section 40: Private Securities Transactions
1/ Section 28 requires associated persons who handle personal securities transactions through a member other than their employer (the "executing member") to notify the executing member of their employment with another member of the NASD. The executing member is then required to notify the employer member of activity in the associated person's account. See NASD Manual (CCH) ¶2178
2/ NASD Manual (CCH) p. 2045.
* All language is new. This rule replaces the Private Securities Transactions Interpretation under Article III, Section 27 of the NASD Rules of Fair Practice.