Notice To Members 95-63

SEC Approves Amendments To Article III, Section 34 Of The NASD Rules Of Fair Practice Relating To Freely Tradeable Direct Participation Program Securities

Published Date:

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Executive Summary

On July 11, 1995, the Securities and Exchange Commission (SEC) approved amendments to Article III, Section 34 of the NASD Rules of Fair Practice to exclude initial placements and secondary market transactions in direct participation program (DPP) securities that are listed or for which an application has been submitted to The Nasdaq Stock MarketSM (Nasdaq®) or a registered national securities exchange from the prohibition on transactions in discretionary accounts without written approval.1 The rule change became effective on July 11, 1995. The exclusion is not available to a member that is an affiliate of the DPP.

Background

Article III, Section 34 of the Rules of Fair Practice regulates participation by members and persons associated with a member in DPP and limited partnership rollup transactions (rollup) and generally prohibits a member or a person associated with a member from participating in a public distribution of a DPP or a rollup unless the distribution or transaction conforms to certain suitability and disclosure requirements and standards of fairness and reasonableness (DPP rule). The DPP rule required that all DPP securities are subject to the discretionary account prohibitions in subsection (b)(3)(D) of the DPP rule, which state, in part, that ". . . no member shall execute any transaction in a direct participation program in a discretionary account without prior written approval of the transaction by the customer." The NASD considers discretionary transactions in DPP securities that are illiquid and for which no ready market exists to be an improper use of discretionary power.

Since the adoption of the DPP rule in 1982,2 an increasing number of DPPs, such as master limited partnerships, have issued partnership units, depositary receipts for such units, or assignee units of limited partnership units that are freely tradeable in a manner analogous to common stock and are quoted on Nasdaq or listed on registered national stock exchanges.

Recently, the NASD considered whether DPP securities listed on Nasdaq or a registered national stock exchange ought to be subject to the discretionary account restrictions in the DPP rule. The NASD determined that the concerns that attach to the use of discretionary authority for illiquid, unmarketable DPP securities are not present with freely tradeable DPP securities.

Description Of Amendments

The NASD has adopted amendments that reverse the order of current Subsections (b)(3)(C) and (D) to Section 34 of the DPP rule and add a reference to Subparagraph 3(C) in new Subparagraph 3(D) to exclude from the prohibition on transactions in discretionary accounts without written approval:

  • secondary public offerings of, or secondary market transactions in, a DPP security for which quotations are displayed on Nasdaq or which is listed on a registered national securities exchange, and

  • primary offerings of a DPP for which an application for inclusion on Nasdaq or listing on a registered national securities exchange has been approved. The exclusion for such freely tradeable DPP securities in newly designated Subparagraph (3)(D) is available only to members that are not an affiliate of the DPP, as the concept of "affiliate" is defined in Section (2)(a)(1) of Schedule E to the NASD By-Laws. Where such an affiliation is present, the NASD believes that substantial conflicts of interest and regulatory concerns continue to exist and the exclusion should not be made available.

Recognizing the use of discretionary authority for transactions in such freely tradeable DPP securities is consistent with the current provisions in the DPP rule, which exempt freely tradeable DPP securities from the suitability and disclosure requirements of the DPP rule. Such suitability and disclosure requirements, which are necessary where DPP securities lack liquidity and marketability, are unnecessary where a ready, liquid market exists.

Discretionary transactions in freely tradeable DPP securities remain subject to the general discretionary account requirements contained in Article III, Section 15 of the Rules of Fair Practice.

Questions regarding this Notice may be directed to Robert J. Smith, Attorney, Office of General Counsel, at (202) 728-8176.

1See, Securities Exchange Act Rel. No. 35954 (July 11,1995); 60 FR 36845 (July 18, 1995).

2 The DPP rule was initially approved by the Securities and Exchange Commission as Appendix F to Article III, Section 34 on September 16, 1982 (Securities Exchange Release No. 19054).

Text Of Amendments To Article III, Section 34 Of The Rules Of Fair Practice

(Note: New text is underlined; deletions are bracketed.)

Direct Participation Programs

Sec. 34.

(a) through (b)(2) No change.

Suitability

(3)
(A) A member or person associated with a member shall not underwrite or participate in a public offering of a direct participation program unless standards of suitability have been established by the program for participants therein and such standards are fully disclosed in the prospectus and are consistent with the provisions of subparagraph
(B) of this section.
(B) In recommending to a participant the purchase, sale or exchange of an interest in a direct participation program, a member or person associated with a member shall:
(i) have reasonable grounds to believe, on the basis of information obtained from the participant concerning his investment objectives, other investments, financial situation and needs, and any other information known by the member or associated person, that:
a. the participant is or will be in a financial position appropriate to enable him to realize to a significant extent the benefits described in the prospectus, including the tax benefits where they are a significant aspect of the program;
b. the participant has a fair market net worth sufficient to sustain the risks inherent in the program, including loss of investment and lack of liquidity; and
c. the program is otherwise suitable for the participant; and
(ii) maintain in the files of the member documents disclosing the basis upon which the determination of suitability was reached as to each participant.
(C) [(D)] Notwithstanding the provisions of subparagraphs (A) and (B) hereof, no member shall execute any transaction in a direct participation program in a discretionary account without prior written approval of the transaction by the customer.
(D) [(C)] Subparagraphs 3(A) and 3(B), and, only in situations where the member is not affiliated with the direct participation program, Subparagraph 3(C), shall not apply to:
(i) a secondary public offering of or a secondary market transaction in a unit, depositary receipt, or other interest in a direct participation program for which quotations are displayed on the NASDAQ System or which is listed on a registered national securities exchange, or
(ii) an initial public offering of a unit, depositary receipt or other interest in a direct participation program for which an application for inclusion on the NASDAQ System or listing on a registered national securities exchange has been approved by NASDAQ or such exchange and the applicant makes a good-faith representation that it believes such inclusion on NASDAQ or listing on an exchange will occur within a reasonable period of time following the formation of the program.