[Federal Register: November 28, 2006 (Volume 71, Number 228)]
[Notices]
[Page 68856-68864]
[DOCID:fr28no06-97]

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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.
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    \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superseded in its entirety the original rule filing, as amended by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

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

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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    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).
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    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).
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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.).
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    \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

measure the dealer's contemporaneous cost) occurred.
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    \24\ See id.
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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.
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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).
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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).
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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''

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

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

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:
---------------------------------------------------------------------------

    \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 (http://www.sec.gov/rules/sro.shtml.
); or     Send an e-mail to<EMAIL_ADDRESS>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 (http://www.sec.gov/rules/sro.shtml
). Copies of the submission, all subsequent

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