[Federal Register Volume 64, Number 39 (Monday, March 1, 1999)]
[Notices]
[Pages 10037-10041]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-4954]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-41075; File No. SR-NASD-99-4]
Self-Regulatory Organizations; Notice of Filing of Proposed Rule
Change by the National Association of Securities Dealers, Inc. Relating
to Microcap Initiative--Recommendation Rule
February 19, 1999.
Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934
(``Act'' or ``Exchange Act''),\1\ and Rule 19b-4 thereunder,\2\ notice
is hereby given that on January 13, 1999, the National Association of
Securities Dealers, Inc. (``NASD'' or ``Association''), through its
wholly-owned subsidiary, NASD Regulation, Inc. (``NASD Regulation'')
filed with the Securities and Exchange Commission (``SEC'' or
``Commission'') the proposed rule change as described in Items I, II,
and III below, which Items have been prepared by NASD Regulation. The
Commission is publishing this notice to solicit comments on the
proposed rule change from interested persons.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of
Substance of the Proposed Rule Change
The Association is proposing new NASD Rule 2315, which requires
members to review current financial statements of, and current business
information about, an issuer prior to recommending a transaction to a
customer in an over-the-counter (``OTC'') equity security.
Additionally, the proposed rule change would amend NASD Rule 6740 to
permit members to submit a certification to the Association that states
that the member has conducted a review of specified information and has
fulfilled its obligations under Rule 15c2-11 under the Act \3\ for
documents that currently reside on the SEC's Electronic Data Gathering
and Retrieval System (``EDGAR'') database. Below is the text
[[Page 10038]]
of the proposed rule change. Proposed new language is in italics.
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\3\ 17 CFR 240.15c2-11.
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* * * * *
2315. Recommendations to Customers in OTC Equity Securities
The requirements of this Rule are in addition to other existing
member obligations under NASD rules and the federal securities laws,
including obligations to determine suitability of particular securities
transactions with customers and to have a reasonable basis for any
recommendation made to a customer. This Rule is not intended to act or
operate as a presumption or as a safe harbor for purposes of
determining suitability or for any other legal obligation or
requirement imposed under NASD rules or the federal securities laws.
(a) (1) No member or person associated with a member shall
recommend to a customer the purchase, sale, or exchange of any equity
security that is not listed on Nasdaq or on a national securities
exchange and is published or quoted in a quotation medium unless the
member has reviewed current financial statements of, and current
business information about, the issuer, and makes a determination that
such information, and any other information available, provides a
reasonable basis under the circumstances for making the recommendation.
(2) For purposes of this Rule, ``current financial statements''
shall include:
(A) A balance sheet as of a date less than 16 months before the
date of the recommendation;
(B) A statement of profit and loss for the 12 months preceding the
date of the balance sheet;
(C) If the balance sheet is not as of a date less than 6 months
before the date of the recommendation, additional statements of profit
and loss for the period from the date of the balance sheet to a date
less than 6 months before the date of the recommendation;
Financial statements and other financial reports filed during the
12 months preceding the date of the recommendation and up to the date
of the recommendation with any regulatory authority, including the
Commission, foreign regulatory authorities, bank and insurance
regulators; and
(E) All financial information contained in registration statements,
including any amendments, with respect to securities transactions
registered under the Securities Act of 1933 (Securities Act), or in the
case of securities offered pursuant to the exemptions from
registrations provided by Regulation A, Rule 505, or Rule 506 under the
Securities Act, all financial information provided in connection with
offerings conducted pursuant to those rules.
(b) If an issuer has not made current filings required by any
regulatory authority, including the Commission, a foreign regulatory
authority, or bank and insurance regulators, such review must include
inquiry into the circumstances concerning the failure to make current
filings, and a determination, based on all the facts and circumstances,
that the recommendation is appropriate under the circumstances. Such a
determination must be made in writing and maintained by the member.
(c) For purposes of this Rule, ``quotation medium'' shall mean any
quotation system, publication, electronic communication network, or any
other device, including any issuer or inter-dealer quotation system,
that is used to regularly disseminate quotations or indications of
interest in transactions equity securities that are not listed on
Nasdaq or on a national securities exchange, including offers to buy or
sell at a stated price or otherwise or invitations of offers to buy or
sell.
(d) A member firm shall designate a registered individual to
conduct the review required by this rule. In making such designation,
the member firm must ensure that
(1) Either the individual is registered as a Series 24 principal,
or his conduct in complying with the provisions of this Rule is
appropriately supervised by a Series 24 individual; and
(2) Such designated individual has the requisite skills, background
and knowledge to conduct the review required under this rule.
(e) The requirements of this Rule shall not apply to:
(1) Transactions that meet the requirements of Rule 504 of
Regulation D under the Securities Act and transactions with an issuer
not involving and public offering pursuant to Section 4(2) of the
Securities Act;
(2) Transactions with or for an account that qualifies as an
``institutional account'' under Rule 3110(c)(4) or with a customer that
a ``qualified purchaser'' under Section 3(c)(7) of the Investment
Company Act;
(3) Transactions in an issuer's securities if the issuer has $100
million in assets and $10 million in shareholder's equity as of date of
the issuer's most recent audited balance sheet, which balance sheet
should be of a date within 6 months prior to the recommendation; or
(4) Transactions in securities of a bank under Section 3(a)(4) of
the Securities Exchange Act of 1934 and or insurance company subject to
regulation by a state or federal bank or insurance regulatory
authority.
* * * * *
6740. Submission of Rule 15c2-11 Information on Non-Nasdaq Securities
(a)-(d) No change.
(e) As an alternative to submitting to the Association a copy of
the documents required by paragraph (b) of the Rule, a member may
submit to the Association a certification signed by a principal of the
member firm stating that the firm has complied with the requirements of
SEC Rule 15c2-11, including the member's affirmative review obligation,
as to any submission with respect to which the required documents
currently reside in the SEC's EDGAR database.
* * * * *
II. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
In its filing with the Commission, the 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. The 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
The NASD has actively studied the OTC market in an effort to
address abuses in the trading and sales of thinly-traded, thinly-
capitalized (``microcap'') securities quoted on the OTC market. The
securities that are the subject of the proposed rule change are not
listed on Nasdaq or any exchange and are quoted on the OTC Bulletin
Board (``OTCBB''),\4\ in the ``pink sheets'' published by the
[[Page 10039]]
National Quotation Bureau, Inc. (``Pink Sheets''), and in other
quotation media where there are no listing requirements. The NASD is
concerned with actual and potential fraud or manipulation in the
markets for these securities, and the connection between potential
fraud and manipulation and the lack of reliable and current financial
information about issuers of microcap securities.
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\4\ The OTCBB is a quotation service that displays real-time
quotes, last sale prices, and volume information in domestic and
certain foreign securities. Eligible securities include national,
regional, and foreign equity issues, warrants, units, and American
Depositary Receipts not listed on any other U.S. national securities
market or exchange. Unlike Nasdaq or registered national securities
exchanges where individual companies apply for listing on the
market--and must meet and maintain strict listing and maintenance
standards--individual brokerage firms, or market makers, enter
quotations for specific securities on their own behalf through the
OTCBB.
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In the listed securities markets, the quoted price of a security
helps to reflect the information available about the listed security
and its issuer. In the OTC market, there are no listing standards and,
therefore, there is a greater need for firms to independently review
financial statements to verify that a recommended transaction in a
microcap security is suitable.\5\ This proposal is meant to address
this issue.
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\5\ The Commission notes that the NASD has recently adopted
amendments to NASD Rule 6530, OTCBB Eligible Securities, to prohibit
members from quoting certain securities through the OTCBB. See
Securities Exchange Act Release No. 40878 (January 4, 1999), 63 FR
1255 (January 8, 1999) (order approving SR-NASD-98-51).
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Proposed Rule 2315--Recommendation Rule. Proposed Rule 2315
(``Recommendation Rule'') would prohibit a member or associated person
from recommending a transaction to a customer in an OTC equity security
that is published or quoted regularly in a quotation medium unless the
member has first reviewed current financial statements and other
business information about an issuer and determined that this
information, along with other information available, provides a
reasonable basis for making the recommendation. Application of the rule
would be limited to equity securities that are not listed on Nasdaq or
any national securities exchange, and that are quoted on the OTCBB, in
the Pink Sheets, or in any other system that regularly disseminates
indications of interest and quotation information. Such systems would
include Web sites, issuer trading services, and other member or non-
member systems that provide this data to the public.
The requirements in the proposed rule would not affect requirements
under the federal securities laws and under NASD rules requiring a
broker-dealer that recommends securities to its customers to have a
reasonable basis for those recommendations.\6\ In addition, the
proposed rule expressly is not intended to act or operate as a
presumption or as a safe harbor for purposes of determining suitability
or for any other legal obligation or requirement imposed under NASD
rules or the federal securities laws.
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\6\ See, e.g., SEC v. Hasho, 784 F. Supp. 1059 (S.D.N.Y. 1992),
citing SEC v. Hanley, 415 F. 2d 589 (2nd Cir. 1969); Securities
Exchange Act Release No. 29094 (April 17, 1991), 56 FR 19148 (April
25, 1991) (adopting amendments to Rule 15c2-11), n.22; and NASD Rule
2310, Recommendations to Customers (Suitability), which requires a
member to have reasonable grounds for believing that a
recommendation to a customer is suitable based on the facts
disclosed, the customer's other security holdings, and his or her
financial situation and needs.
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The proposed rule requires members to obtain and review the
issuer's ``current financial statements'' as defined in paragraph
(a)(2) of the proposed rule. Specifically, members would be required to
obtain and review an issuer's balance sheet that is dated within 16
months of the date of the recommendation, as well as a profit and loss
statement for the period of 12 months preceding the date of the balance
sheet. Also, members would have to obtain and review any financial
statements filed during the 12 months preceding the date of the
recommendation.
Under circumstances in which a proposed recommendation to the
customer is not made within 6 months of the date of the issuer's
balance sheet, the member would be required to obtain and review an
additional profit and loss statement of the issuer from the date of the
balance sheet to a date within 6 months of the proposed recommendation
to the customer.\7\ For example, if a member proposes to make a
recommendation to a customer on March 15, 1999, the member would be
required to obtain and review the following information to satisfy the
proposed rule: A balance sheet of the issuer with a calendar year-end
of December 31, 1997; a profit and loss statement for the 12-month
period ended December 31, 1997; and a 9-month interim profit and loss
statement for the period of January 1, 1998, through at least September
30, 1998.
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\7\ This requirement is similar to language in paragraph (a)(5)
of Rule 15c2-11 under the Act, which specifies the information a
broker-dealer must review before initiating or resuming quotations
for non-reporting issuers' securities. Rule 15c2-11 requires a
broker-dealer to obtain and review certain information before
initiating or resuming quotations in a quotation medium. 17 CFR
240.15c2-11; see also Securities Exchange Act Release No. 29094
(April 17, 1991), 56 FR 19148 (April 25, 1991). On February 19,
1999, the Commission approved the publication of a release
reproposing amendments to Rule 15c2-11.
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When issuers file reports with the SEC or with other foreign or
domestic regulatory authorities, the proposed rule would require
members to collect and review all financial statements and other
financial reports filed by the issuer within the 12 months preceding
the recommendation. Members also must obtain and review financial
information contained in registration statements of registered
securities and all financial information provided in connection with
securities offered pursuant to an exemption from registration.
If an issuer has not made current filings as required by a
regulatory authority, a member must inquire into the circumstances
concerning the issuer's failure to file current reports, and determine
based on all the facts and circumstances whether a recommendation is
appropriate under the circumstances. The evidence of the determination
to make a recommendation in this situation should be in writing and
maintained by the member.
The proposed rule requires a member to designate registered
individual to conduct a review of the information specified in
paragraph (a)(2) of the proposed rule. In making this determination, a
member firm must ensure that either the individual is registered as a
Series 24 principal, or his conduct in complying with the provisions of
this proposed rule is appropriately supervised by a Series 24
individual. The designated individual should possess the requisite
skills, background, and knowledge to conduct the review required by the
proposed rule. The associated person making the recommendation to the
customer is obligated, prior to the recommendation, to assure that the
member has conducted such a review of the specified information in
accord with the proposed rule. The member should document the list of
information reviewed, the date of the review, and the name of the
person performing the review of the required information under the
proposed rule.
Exemptions. The proposed rule exempts from its coverage
transactions that are exempt from registration under Section 4(2) of
the Securities Act of 1933 (``Securities Act'') \8\ and transactions
that meet the requirements of Rule 504 of Securities Act Regulation
D.\9\ This exemption is based on the fact that, unlike the specific
disclosure requirements that apply to registered and other offerings,
the Securities Act does not mandate that Section 4(2) and Rule 504
issuers furnish specified information to purchasers.
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\8\ 15 U.S.C. 77d(2).
\9\ 17 CFR 230.504.
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Because of this exemption, there are no specific review
requirements under the proposed Recommendation Rule for broker-dealers
that recommend transactions in securities exempt from registration
under Rule 504 or Section
[[Page 10040]]
4(2) of the Securities Act. However, under prevailing law, including
Rule 10b-5 under the Act \10\ and NASD Rule 2310, a broker-dealer must
have a reasonable basis for recommending a securities transaction to a
customer and must make an appropriate suitability determination. In
order to satisfy these requirements with respect to Rule 504 or Section
4(2) exempt offerings, the broker-dealer must review any information
provided by the issuer as well as other relevant information, including
information obtained in response to ``red flags'' and otherwise.
Broker-dealers that recommend transactions covered by the
Recommendation Rule also must comply with these requirements, as well
as with the Rule's requirement to review specific identified
information.
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\10\ 17 CFR 240.10b-5.
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The rule also exempts transactions with or for institutional
investors. For purposes of this exemption, an account or customer must
qualify either as an ``institutional account'' under NASD Rule
3110(c)(4) or as a ``qualified purchaser'' under section 3(c)(7) \11\
of the Investment Company Act of 1940 (``ICA'').\12\ Transactions with
or for institutional investors are exempt from the proposed rule
because institutional customers are generally knowledgeable and
sophisticated regarding investments in this marketplace.
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\11\ 15 U.S.C. 80a-3(c)(7).
\12\ NASD Rule 3110(c)(4) defines an ``institutional account''
as the account of a bank, savings and loan association, insurance
company, or registered investment company; an investment adviser
registered under Section 203 of the Investment Advisers Act of 1940;
or any other entity (whether a natural person, corporation,
partnership, trust, or otherwise) with total assets of at least $50
million. The term ``qualified purchaser'' as used in Section 3(c)(7)
of the ICA is described in Section 2(a)(51) of the ICA as: (1)
individuals (including any shared ownership interest in an issuer
with the person's qualified purchaser spouse) who own not less than
$5 million in investments; (2) specified family-owned companies with
not less than $5 million in investments; (3) trusts established and
funded by qualified purchasers for which investment decisions are
made by a qualified purchaser; and (4) entities that in the
aggregate own and invest on a discretionary basis for their own
account, or for the accounts of other qualified purchasers, not less
than $25 million in investments. 15 U.S.C. 80a-2(a)(51).
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In addition, the exemption would exclude from the scope of the
proposed rule securities of certain issuers, including foreign issuers,
with at least $100 million in assets and $10 million in shareholders'
equity, that are not listed on a national securities exchange or
Nasdaq. The exemption is based on the premise that securities of these
issuers are more likely to be followed by market analysts, are less
likely to be the subject of fraudulent sales practices, and are
generally more liquid. This exemption also minimizes the potential that
the proposed rule may competitively disadvantage well-capitalized,
internationally-traded issuers that have chosen not to list on a
national securities exchange or Nasdaq.
In setting the financial criteria for an exemption, the NASD
selected financial criteria of at least $100 million of total assets
and stockholders' equity of at least $10 million. These criteria
comport with NASD Rule 4420(f) and Section 107(A) of the American Stock
Exchange Guide, which set forth the financial standards to qualify to
quote on the Nasdaq and the Amex, respectively, for ``other
securities'' that are not otherwise covered by conventional listing
criteria for domestic and foreign issuers. In order to rely on the size
exemption, a member must obtain the issuer's audited financial
statements prepared in accordance with either U.S. or foreign Generally
Accepted Accounting Principles and dated within 6 months of the date of
the recommendation or trade to determine whether the issuer's
securities quality for the exemption.
Under the proposed rule, securities of banks, as defined under
section 3(a)(6) of the Exchange Act,\13\ and insurance companies are
exempt from the proposed rule on the ground that banks and insurance
companies are subject to independent oversight by federal and state
regulatory authorities, and are less likely to be the subject of market
manipulation or issuer fraud.
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\13\ 15 U.S.C. 78c(a)(6).
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Amendments to NASD Rule 6740. Currently, NASD Rule 6740 requires
members to submit the Association certain specified information as
required by Rule 15c2-11 under the Act before the member can initiate
or resume quotations in a non-Nasdaq security in any quotation medium.
The proposed amendment to NASD Rule 6740 will permit members to elect
not to submit to the Association hard copies of issuer reports that are
filed by the issuer through the SEC's EDGAR database and that currently
reside on such system. Under this alternative, members may submit to
the NASD a certification that states that the member has conducted a
review of the relevant documents and has fulfilled its Rule 15c2-11
obligations, including the affirmative review obligation. This
certification must be reviewed and signed by a principal of the member
firm.
2. Statutory Basis
The NASD believes that the proposed rule change is consistent with
the provisions of section 15A(b)(6) \14\ of the Act, which requires,
among other things, that the Association's 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. The NASD believes that the proposed rule
change will address actual and potential fraud in the quotation and
trading of unlisted securities.
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\14\ 15 U.S.C. 78o-3(b)(6).
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B. Self-Regulatory Organization's Statement on Burden on Competition
The NASD does not believe that the proposed rule change will impose
any inappropriate burden on competition.
C. Self-Regulatory Organization's Statement on Comments on the Proposed
Rule Change Received From Members, Participants, or Others
The proposed rule change was published for comment in NASD Notice
to Members 98-15 (``Notice'' or ``NTM'') in January 1998. A total of 43
comments were received in response to the Notice. As published in the
Notice, proposed Rule 2315 would have required members to review
certain financial statements of an issuer prior to making a
recommendation in an OTC equity security to a customer and deliver to
customers a disclosure statement regarding the differences between
listed and OTC markets prior to the first purchase and annually
thereafter (Rule 2360, which was proposed to be numbered Rule 2350 at
the time the NTM was published).
Of the 43 responses received, most (25 responses, or approximately
60%) were from broker-dealer firms or registered persons and the
balance (18 comments, or approximately 40%) were from individual
investors, issuers, various state agencies, trade associations, and
other interested parties. In providing comments, a majority of
commenters expressed a position (i.e., approval or disapproval)
regarding each specific proposal. Other commenters did not provide a
stated position on each proposal, but identified particular issues with
certain proposals and provided written comments.
As to proposed Rule 2315, 11 commenters approved or approved with
qualification, and 18 commenters disapproved of, the rule proposal. The
comments generally in favor of the proposal approved of the
rule'placing responsibility on the firm that is soliciting an order and
indicated that, unless a broker-dealer is compelled to maintain
information and review this
[[Page 10041]]
information, fraudulent omission of material fact will occur. The
comments opposing the proposal generally maintained that the current
rules are sufficient and the proposed rules are extremely burdensome.
In particular, the opponents state that the record-keeping and
compliance burden is particularly chilling to these stocks and the time
it takes to locate and review financial statements on a company will
limit a firm's choice of stocks to recommend.
The Association is not proposing to adopt Rule 2360 at this time.
Therefore, this proposed rule change does not discuss the comments on
that proposed rule.
After the public comment process, the staff recommended and the
NASD and NASD Regulation Boards approved the following modifications to
the proposed rule at their meetings in May 1998. Proposed Rule 2315 was
amended to add exemptions for securities of certain financially sizable
issuers, securities of banks and insurance companies, and transactions
with institutional investors. In addition, the Rule was amended to
require a member to review certain current financial information and
other business information about the issuer, in addition to the
requirements set out in the original rule proposal, before making a
recommendation to a customer, and to require members to designate a
qualified registered individual to review the information required by
the rule.
After NASD Board approval of the modifications to the proposed
rules in May, the staff received an additional comment that requested
the staff to consider an additional exemption from the scope of
proposed Rule 2315. The commenter suggested that recommended sales
transactions in OTC equity securities with customers should be exempt
from proposed Rule 2315. The premise for the exemption is based on the
need to expedite liquidation of customer positions in OTC equity
securities without the need for a member to review specified
information regarding the issuer as required by the proposed rule. The
commenter suggested that a delay in processing the sale may preclude a
customer from capturing a particular market opportunity which may
result in the customer reducing his return or increasing his loss in a
particular investment. The suggested exemption would not apply to short
sales by investors in these securities. Due to the nature and the
timing of the comment, NASD staff requested that the Commission
specifically seek comment in its notice to the public on the potential
need for such an exemption from proposed Rule 2315.
At a subsequent Board meeting in December 1998, the staff
recommended and the Board approved further modifications to Rule 2315.
In particular, the Board approved an expansion of the definition of
``current financial statements'' in NTM 98-15 to include financial
information contained in the registration statements of Securities Act
registered securities and all financial information provided in
connection with securities offered in connection with exemptions from
registration provided by Regulation A,\15\ Rule 505,\16\ or Rule
506.\17\ The Board also approved a revision to the exclusions from the
Rule for initial public offerings and offerings conducted in compliance
with Regulation A and Rules 504-506 under the Securities Act. That
exemption is now limited to transactions that meet the requirements of
Rule 504 and Section 4(2) transactions.
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\15\ 17 CFR 230.251.
\16\ 17 CFR 230.505.
\17\ 17 CFR 230.506.
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III. Date of Effectiveness of the Proposed Rule Change and Timing
for Commission Action
Within 35 days of the 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 the 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 proposal is
consistent with the Act. Specifically, the Commission seeks comment on
the potential need for an exemption from proposed NASD Rule 2315 for
recommended sales transactions in OTC equity securities. Persons making
written submissions should file six copies thereof with the Secretary,
Securities and Exchange Commission, 450 Fifth Street, NW, Washington,
DC 20549. 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 at the Commission's Public Reference Room. Copies of such
filing will also be available for inspection and copying at the
principal office of the NASD.
All submissions should refer to File No. SR-NASD-99-4 and should be
submitted by March 22, 1999.
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\18\
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\18\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 99-4954 Filed 2-26-99; 8:45 am]
BILLING CODE 8010-01-M