| Release No. 34-30608 April 20, 1992
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 Table of Contents
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I. EXECUTIVE SUMMARY
The Commission is adopting the Rules in order to implement certain provisions of the Penny Stock Act and Section 15(g) 1 of the Exchange Act. Rules concerning these matters were proposed in Securities Exchange Act Release No. 29093 (April 17, 1991), 56 FR 19165 (the Proposing Release). The Commission has determined not to adopt at this time proposed Rule 15g-7, which would have required disclosure of the status of a broker-dealer as a sole market maker in connection with penny stock transactions. Specific provisions of each of the adopted Rules are summarized below.
Rule 3a51-1--Definition of Penny Stock
Rule 3a51-1 implements the provisions of Section 3(a)(51) of the Exchange Act by defining the term penny stock to exclude certain equity securities. In general, Rule 3a51-1 excludes from the definition of penny stock any security that is a reported security, 2 except that a security that is registered on the American Stock Exchange, Inc. (Amex) pursuant to the listing criteria of the Emerging Company Marketplace (ECM) is considered to be a penny stock solely for purposes of Section 15(b)(6) of the Exchange Act. Securities listed on the New York Stock Exchange, Inc. (NYSE) and Amex (other than ECM securities), as well as securities that meet NYSE or Amex listing standards but that are listed only on the regional exchanges, are reported securities for purposes of the rule. In addition, securities quoted on the National Association of Securities Dealers, Inc.s (NASD) automated quotation system (NASDAQ) that are designated as National Market System (NMS) securities are reported securities pursuant to Rule 11Aa3-1 of the Exchange Act.
Paragraph (e) of Rule 3a51-1 also excludes from the definition of penny stock for most purposes any security that is registered, or approved for registration upon notice of issuance, on a national securities exchange that makes transaction reports available pursuant to Rule 11Aa3-1, provided that: (1) current price and volume information with respect to transactions in that security is required to be reported and is made available to vendors pursuant to the rules of the national securities exchange; and (2) the security is purchased or sold in a transaction on or through the facilities of a national securities exchange, or as part of a distribution of the security. The rule contains a similar provision excluding any security that is authorized, or approved for authorization upon notice of issuance, for quotation on NASDAQ. This exclusion is subject to the condition that current price and volume information with respect to transactions in that security must be reported and be made available to vendors pursuant to the rules of the NASD.
Rule 3a51-1 further defines the term penny stock to exclude securities that have a price of five dollars or more (including any share of any unit that has an independent exercise price), as determined either on a per transaction basis or, in the absence of a transaction, on the basis of the inside bid quotation for the security displayed on an automated quotation system that has the characteristics set forth in Section 17B(b)(2) of the Exchange Act or any other system that is designated by the Commission for purposes of the rule (Qualifying Electronic Quotation System). If there is no such inside bid quotation, price is determined by the average of three or more interdealer bid quotations at specified prices displayed in an interdealer quotation system, as defined in Rule 15c2-7(c)(1), by three or more market makers in the security.
Paragraph (g) of Rule 3a51-1 excludes from the definition of penny stock securities whose issuer has either (1) net tangible assets in excess of $2 million, if that issuer has been in continuous operation for at least three years, or $5 million, if the issuer has been in continuous operation for less than three years; or (2) average revenue of at least $6 million for the last three years. 3 The required level of net tangible assets or revenues must be demonstrated by current, audited financial statements that the broker-dealer has reviewed and has a reasonable basis for believing are accurate.
Finally, Rule 3a51-1 excludes from the definition of penny stock securities that are issued by an investment company registered under the Investment Company Act of 1940 and put and call options issued by the Options Clearing Corporation (OCC).
Rule 15g-1--Exemptions
Rule 15g-1 exempts certain transactions from the broker-dealer disclosure requirements of Rules 15g-2 through 15g-6. First, Rule 15g-1 exempts transactions in penny stocks by broker-dealers that derive less than 5% of their revenues from sales of penny stocks during a specified period, unless they are acting as a market maker in the penny stock that is the subject of the transaction. Second, transactions in which the customer is an institutional accredited investor are exempt from Rules 15g-2 through 15g-6. Third, the rule exempts transactions that meet the requirements of Regulation D, or that are exempt from the registration requirements of the Securities Act of 1933 (Securities Act) pursuant to Section 4(2) of that Act. Fourth, transactions in which the customer is the issuer, or a director, officer, general partner, or direct or indirect beneficial owner of more than 5% of any class of equity security of the issuer, of the penny stock that is the subject of the transaction, are exempt from the Rules. Finally, the rule exempts transactions that are not recommended by the broker or dealer. Rule 15g-1 also contains a provision giving to the Commission the authority to exempt by order any other transactions or persons from the Rules, if such an exemption would be consistent with the public interest and the protection of investors.
Rule 15g-2--Risk Disclosure Document
Rule 15g-2 makes it unlawful for a broker-dealer to effect transactions in penny stocks without providing to the customer a standardized disclosure document as contained in Schedule 15G prior to such transactions. The first part of Schedule 15G is a one-page summary of the essential items required to be disclosed under Section 15(g)(2). The remainder explains the required information in greater detail: the risks of investing in penny stocks in both public offerings and secondary trading; terms important to an understanding of the functioning of the penny stock market, such as bid and offer quotes, a dealers spread, and broker-dealer compensation; the broker-dealers duties to its customers, including the disclosures required by the other penny stock disclosure rules, and the customers rights and remedies in cases of fraud in penny stock transactions; and the NASDs toll-free number and the central number of the North American Securities Administrators Association (NASAA) for information on the disciplinary history of broker-dealers and their associated persons.
Rule 15g-3--Bid-Offer Quotations
Rule 15g-3 makes it unlawful for a broker-dealer to effect a transaction in any penny stock without first disclosing and subsequently confirming to the customer current quotation prices or similar market information.
For transactions effected on a principal basis, the broker-dealer must provide the inside bid and offer quotations for a penny stock appearing on a Qualifying Electronic Quotation System. If this quotation information is unavailable, the rule requires that a broker-dealer effecting principal transactions in a penny stock must disclose its own bid and offer quotes in the stock to a customer if the broker-dealer has effected at least three bona fide interdealer transactions consistently at these bid or offer prices over the previous five business days, no less than 75% of these transactions have occurred consistently at such quotes, and the broker-dealer reasonably believes that such quotes accurately reflect the prices at which it is prepared to trade with other dealers. If the dealer cannot validate its own quotations in accordance with this procedure, the dealer must disclose that it has not traded consistently at its quotes, and it must disclose the price at which it last purchased the penny stock from, or sold the penny stock to, another dealer in a bona fide transaction.
In transactions effected on an agency or riskless principal basis, the broker-dealer must disclose the best interdealer bid and offer prices for the penny stock that the broker-dealer can obtain through reasonable diligence. For all transactions in penny stocks to which Rule 15g-3 applies, the broker-dealer must also disclose the number of shares for which the bid and offer prices are firm quotations.
Rule 15g-4--Broker-Dealer Compensation
Rule 15g-4 makes it unlawful for a broker-dealer to effect a penny stock transaction for a customer unless the broker-dealer discloses to the customer, both prior to effecting the transaction and at the time of confirming the transaction, the aggregate amount of any compensation received in connection with such transaction. Compensation is defined in the rule as: (1) in the case of an agency transaction, the amount of any remuneration received or to be received from a customer in connection with the transaction; (2) in the case of a riskless principal transaction, the difference between the price to the customer and the contemporaneous purchase or sale price to the broker-dealer; and (3) otherwise in the case of a principal transaction, the difference between the price to the customer and the prevailing market price in the security. This release contains a discussion of the criteria to be used for determining prevailing market price.
In addition, Rule 15g-4 provides an alternative method of calculating compensation in principal transactions, permitting market makers to use an active and competitive market standard in calculating prevailing market price solely for purposes of Rule 15g-4, provided that the aggregate volume of transactions effected by the market maker in the penny stock in the five business days preceding such transaction is less than 20% of the aggregate amount of all transactions in the penny stock reported on a Qualifying Electronic Quotation System. However, this option would not be available to market makers until last sale reporting is included on such a quotation system.
Rule 15g-5--Associated Person Compensation
Rule 15g-5 makes it unlawful for a broker-dealer to effect a transaction in any penny stock for a customer unless the broker-dealer first discloses and subsequently confirms to the customer specified information with respect to any associated person, other than a person whose functions are solely clerical or ministerial, that has communicated with the customer concerning the transaction at or prior to the receipt by the broker-dealer of the customers order. This information includes the aggregate amount of cash compensation that the associated person of the broker-dealer has received or will receive from any source in connection with the transaction and that is determined at or prior to the transaction, as well as separate disclosure of the source and amount of any compensation that is paid by persons other than the broker-dealer. In addition, if the associated person may receive contingent compensation that is not disclosed prior to the transaction because the amount of such compensation is not determined at or prior to the transaction, the written confirmation disclosure must describe the basis upon which such additional compensation is calculated.
Rule 15g-6--Monthly Account Statements
Rule 15g-6 requires a broker-dealer that has sold penny stocks to a customer in transactions that are not exempted by Rule 15g-1 to provide to that customer monthly account statements concerning these securities. The status of a security as a penny stock for purposes of this rule is determined on the last trading day of the month. The statement must be sent within ten days following the end of the month to which it pertains.
Each statement must disclose the identity and number of shares of each penny stock held in the customers account and the estimated market value of the security, based on the highest inside bid quotation displayed on a Qualifying Electronic Quotation System or recent purchases by the broker-dealer, if available. The statement also must contain a standardized legend that provides certain disclosures relating to the estimated market value shown on the statement.
Rule 15g-6 exempts a security from the monthly account statement requirement following a particular quarter, if the security consistently (during all but five trading days) trades at a price of at least five dollars per share during the quarter. In addition, if the broker-dealer has not effected any penny stock transactions for the customer for six consecutive months, the rule permits account statements to be provided on a quarterly basis.
II. INTRODUCTION
The Penny Stock Act and the Rules are part of a comprehensive effort by the Congress and the Commission to reduce fraud and manipulation in the penny stock market and to provide investors with important information concerning that market. Although speculation in penny stocks, often fueled by fraudulent sales practices, has long existed in the United States, advances in communications technology have contributed to substantial growth in these activities in recent years. False representations and manipulative trading patterns, often by repeat offenders, have been facilitated by the absence of a visible market and a lack of investor information and education. 4
In response to these developments, the Commission, along with other federal departments and agencies, the NASD, and state authorities have increased enforcement activities, promoted investor education, and adopted regulatory changes. 5 To date, the primary regulatory response by the Commission has been the adoption of Rule 15c2-6, 6 which became effective on January 1, 1990. 7 In general, that rule requires that a broker-dealer effecting transactions for customers in designated securities make a documented determination that the transactions are suitable for those customers and obtain the customers written agreement to the transactions.
The Penny Stock Act contains provisions designed to target abuses in the penny stock market in a variety of ways, including, among others, the expansion of the Commissions enforcement authority with respect to persons associated with penny stock offerings, promoting the development of automated quotation systems for penny stocks, restrictions on blank check offerings, and broker-dealer disclosure requirements. 8 The disclosure provisions are contained in Section 15(g) of the Exchange Act, which requires the Commission to adopt rules: (i) governing the content and form of a risk disclosure document required to be provided by broker-dealers to their customers prior to effecting transactions in penny stocks with those customers; (ii) requiring broker-dealers to disclose, prior to each penny stock transaction and on the customers confirmation, information concerning bid and ask prices and compensation to be paid to the broker-dealers and their associated persons; and (iii) requiring broker-dealers to provide to customers monthly statements showing the market value of penny stocks held in customer accounts. Section 15(g)(4) provides the Commission with authority to exempt classes of persons or transactions from these disclosure requirements or to adopt additional regulations not mandated by statute.
Pursuant to the Penny Stock Act, in the Proposing Release, the Commission proposed rules defining the term penny stock, covering each of the disclosure areas described above, and providing certain exemptions. In addition, the Commission proposed requiring disclosure of a broker-dealers role as a sole market maker in a penny stock when effecting transactions in the security for customers.
The Commission solicited comment in the Proposing Release relating to a variety of matters, including the effectiveness of the proposed rules in deterring fraud in the penny stock market, the value of the information required to be furnished to investors, and the costs and operational difficulties that would be faced by broker-dealers subject to the rules. In addition, the Commission was particularly concerned with the potential effect of the proposed rules on the ability of legitimate small issuers to obtain capital needed for growth.
The Commission received 73 written comments relating to the proposed rules. 9 In addition, members of the Commissions staff spoke directly to various broker-dealers, lawyers, and other securities market participants with respect to compliance issues and the potential impact of the proposed rules on small business capital formation. 10
The overwhelming majority of comments voiced general support for the need to prevent fraud in the penny stock market and for the Commissions efforts in this regard. However, the comments were sharply divided over the scope of the proposed rules, in terms of the classes of securities and transactions that would be covered, the comprehensiveness of the information required to be disclosed, and the manner and frequency with which it would be provided. One group of comments, submitted primarily by state regulatory authorities and consumer groups, supported the proposed rules in this respect or suggested that proposed definitional exclusions or transactional exemptions, or other provisions, would unduly limit the effectiveness of the rules. 11
A much larger group of comments claimed that the application of the proposed rules was too broad, or that they would pose unworkable compliance burdens on broker-dealer firms in one or more particular respects. The largest single objection raised by these comments was the inclusion of securities quoted on NASDAQ, other than NMS securities, within the penny stock definition. Many of these and other comments suggested that the proposed rules would significantly limit the ability of companies covered by the rules to raise capital in the securities markets and would negatively affect the existing market for the stock of these issuers, because of the compliance burdens caused by the rules, the unwillingness of broker-dealer firms to effect transactions in these securities, or the negative connotation of being classified as a penny stock.
The Rules adopted by the Commission today reflect its concern that the Rules not stifle the formation of capital for legitimate small companies or eliminate a viable secondary market for their securities. The Commission recognizes the important economic function served by small companies and recently has proposed to ease certain filing requirements and limitations applicable to limited offerings by small issuers and increase the percentage of investment company assets that may consist of illiquid assets, such as the securities of small issuers. 12
Many of the new provisions incorporated in the Rules are intended to maintain the access of small ventures to capital markets where this may be accomplished consistent with the Commissions primary charter to protect investors. In considering this issue, the Commission also recognizes that fraudulent sales practices, which have occurred disproportionately in this market, may themselves hinder economic growth, because they cause the loss of the productive use of investor funds and discourage further investment by those who have been defrauded. 13 Legitimate small business is thus harmed by the diversion of substantial capital to unscrupulous promoters and broker-dealers. Moreover, issuers of penny stocks that are fraudulently traded may themselves be victimized by this activity. 14
The Commission has also considered, in reviewing the Rules, certain recent developments, including increases in listing and maintenance standards applicable to NASDAQ securities 15 and the NASDs proposal, which has been approved, 16 to apply to non-NMS NASDAQ securities transaction reporting requirements similar to those already applicable to NMS securities. 17 The Commission believes that these developments significantly lessen the potential that NASDAQ securities will be subject to fraudulent sales practices. 18 In addition, the Commission has noted the experience of the NASD in operating its OTC Bulletin Board, which provides automated quotations by market makers in penny stocks (Bulletin Board). 19 The Commission believes that the Bulletin Board may presage the evolution of a more transparent and reliable market for the shares of promising small companies that are not quoted on NASDAQ or traded on a national securities exchange.
After considering these factors and the comments it has received, the Commission is adopting the Rules with modifications to certain provisions contained in the proposed rules. These changes are intended to limit potential negative effects of the Rules on small business capital formation by (i) modifying the definitional and exemptive provisions in order to limit the application of the Rules to those securities and transactions involving the greatest potential for abuse and (ii) streamlining certain operational aspects of the Rules in order to simplify compliance responsibilities for broker-dealer firms. Among the changes reflected in the Rules are the following: (i) the effective exclusion from the application of the Rules of non-NMS NASDAQ securities at the point in time when last sale reporting requirements are in place for such securities; (ii) an exclusion from the penny stock definition for securities of issuers with specified net tangible assets or revenues; (iii) an exemption for private placement and Regulation D offerings; (iv) expanded availability of the exemption for broker-dealers doing a de minimis business in penny stocks; (v) various changes to individual Rules designed to ameliorate compliance burdens, including the use of quotations on the NASDs Bulletin Board, where available, to satisfy various pricing provisions of the Rules; and (vi) deferral of action on proposed Rule 15g-7, requiring disclosure of a firms status as a sole market maker, which was not mandated by the Penny Stock Act. The Commission believes that these changes will implement the Congressional directive contained in the Penny Stock Act while maintaining the ability of viable small companies to obtain equity capital.
III. THE RULES
A. Rule 3a51-1; Definition of Penny Stock
New Section 3(a)(51)(A) of the Exchange Act defines the term penny stock as any equity security 20 other than a security that is: (1) registered, or approved for registration, and traded on a national securities exchange that meets criteria prescribed by the Commission; (2) authorized for quotation on an automated quotation system sponsored by a registered securities association, if such system was established and in operation before January 1, 1990, and meets criteria prescribed by the Commission; (3) issued by an investment company registered under the Investment Company Act of 1940; or (4) excluded or exempted, on the basis of exceeding a minimum price, net tangible assets of the issuer, or other relevant criteria, from the definition of the term penny stock by rule or regulation prescribed by the Commission. Section 3(a)(51)(A) determines the extent of the Commissions authority under Section 15(b)(6)(A) of the Exchange Act to censure, suspend, bar, or restrict the activities of persons participating in an offering of penny stock. This section also defines the Commissions authority to adopt rules under Section 15(g) of the Exchange Act imposing additional broker-dealer disclosure requirements or other obligations with respect to penny stocks and to prescribe rules under Section 7(b) of the Securities Act governing registration statements of blank check companies. 21
The Commission is adopting Rule 3a51-1 to implement the provisions of Section 3(a)(51) of the Act. Rule 3a51-1 excludes from the definition of penny stock any equity security that is: (1) a reported security; (2) a put or call option issued by the OCC; (3) priced at five dollars or more, as determined (a) on a per transaction basis, or (b) on the basis of the inside bid quotation displayed on a Qualifying Electronic Quotation System, or if there is no such inside bid quotation, the average of least three interdealer bid quotations displayed in an interdealer quotation system; (4) subject to last sale reporting and (a) registered, or approved for registration upon notice of issuance, on a national securities exchange and purchased or sold in a transaction executed on the exchange or in a distribution, or (b) authorized, or approved for authorization upon notice of issuance, for quotation on NASDAQ; or (5) whose issuer has (a) net tangible assets in excess of $2 million, if that issuer has been in continuous operation for at least three years, or $5 million, if the issuer has been in continuous operation for less than three years, or (b) average revenue of at least $6 million for the last three years. The most significant change from the proposed rule is the exclusion, subject to certain limitations, of regional exchange-listed and NASDAQ securities from the definition of penny stock. 22 As discussed further below, the rule contains several other modifications from the proposed rule that are designed to address the suggestions made in the comments.
1.Reported Securities
As adopted, Rule 3a51-1 excludes from the definition of penny stock any equity security that is a reported security--that is, any exchange-listed or NASDAQ security for which transaction reports are required to be made on a real-time basis pursuant to an effective transaction reporting plan. 23 The proposed rule also contained an exclusion for reported securities. In the Proposing Release, the Commission concluded that reported securities should be excluded from the penny stock rules because they are subject to rules of the self-regulatory organizations (SROs) that set specific standards for inclusion, promote efficient pricing and transaction execution procedures, and generate public price information for evaluation by professional securities analysts and the financial press. 24
The comments generally agreed with this conclusion, 25 and so Rule 3a51-1 continues to exclude reported securities from the definition of penny stock. Thus, securities listed on the NYSE, certain regional exchange-listed securities that meet NYSE or Amex original listing criteria, as well as NASDAQ NMS securities, are not considered penny stocks under paragraph (a) of the rule. 26
As reported securities, securities that are listed on Amex pursuant to Amexs original and junior tier, or ECM, listing criteria 27 also are not considered penny stocks for purposes of the Rules. Securities listed on Amex as part of the ECM, however, continue to be deemed penny stocks solely for purposes of Section 15(b)(6) of the Exchange Act. Although ECM securities are subject to real-time reporting requirements, they are not required to meet the same stringent listing and maintenance criteria as required for securities listed on Amex under the exchanges regular standards. In fact, the requirements for listing on the ECM are comparable to the current eligibility requirements for NASDAQ (non-NMS) securities. As discussed further below, securities that are quoted on NASDAQ are excluded from the definition of penny stock, except for purposes of Section 15(b)(6) of the Exchange Act.
The Commission believes that Amexs ECM securities should be treated in the same manner under the Rules as NASDAQ (non-NMS) securities. Excluding ECM securities from the definition of penny stock for all purposes would be unwarranted in view of the fact that the listing criteria for ECM and NASDAQ issuers are similar, and potentially could provide Amexs ECM with an unfair competitive advantage. The Commission therefore has determined to subject Amexs ECM securities to the same condition as is applicable to NASDAQ securities, discussed below, by including them in the definition of penny stock solely for purposes of Section 15(b)(6) of the Exchange Act.
2.Other NASDAQ and Exchange-Listed Securities
a. Last Sale Reporting
Although proposed Rule 3a51-1 excluded reported securities from the definition of penny stock, it did not exclude non-reported securities, such as securities that are quoted on NASDAQ but that are not designated as NMS securities. 28 The Commission reasoned that persons investing in these securities could benefit from the disclosure provided by the penny stock rules because, unlike reported securities, these securities are not traded in a market that is subject to a comprehensive regulatory scheme requiring real-time transaction reporting, nor are they required to meet the same minimum qualification and maintenance criteria. 29 The Commission requested comment on whether the definition of penny stock nevertheless should be narrowed in order to avoid unnecessarily inhibiting small business capital formation.
As discussed above, the majority of the comments on the proposed rules objected to the inclusion of securities quoted on NASDAQ in the definition of penny stock. 30 These comments argued that the rules of the NASD, particularly the increased listing and maintenance standards for issuers of NASDAQ securities and the requirement that market makers in NASDAQ securities display firm bid and ask quotations, provide an adequate substitute for the protections afforded by the penny stock rules. Many of these comments also stated that there was insufficient evidence of fraud in the NASDAQ market to include NASDAQ securities in the scope of the Rules; in any case, they believed that the NASDs surveillance capabilities were sufficient to address any existing fraud in that market.
The Commission approved a NASD proposal to increase the listing and maintenance standards for NASDAQ securities in August of 1991. 31 These new standards ensure that securities that are quoted on NASDAQ represent companies that have generated significant shareholder interest and that have a demonstrated financial history and minimum pricing levels. In addition, the Commission today approved the NASDs proposal to amend Schedule D to the NASD By-laws to implement last sale price and volume reporting requirements for NASDAQ securities. 32 Under this rule proposal, NASD members will be required to report to the NASD the execution price and the number of shares of each trade within 90 seconds after execution. This information will then be validated by the NASD and be made available to information vendors for dissemination to the investment community and the public. In the NASDs view, the resulting dissemination of real-time trade and volume data during market hours will significantly benefit investors by providing the same high degree of market visibility and more efficient price discovery for all ... NASDAQ issues that currently exists for NMS and major exchange listed securities. Moreover, rather than relying on end-of-the day statistics as the primary source of surveillance information for trades in NASDAQ securities, the NASD will have access to trading data through its equity audit trail, which currently integrates last sale, clearing, and inside quotation data for reported securities. The NASDs ability to detect and deter manipulative or abusive trading practices in the NASDAQ market thereby will be significantly enhanced.
The NASD also has filed a rule proposal to require all NASDAQ market makers to display minimum quotation sizes of five hundred shares. 33 If approved by the Commission, this rule change will provide investors with further information about the liquidity and depth of the market for NASDAQ securities. As the NASD stated in its comment letter, all of these rule changes will increase the transparency and liquidity of the market for NASDAQ securities, thus reducing the need for the additional disclosure provided by the penny stock rules.
In light of these comments and the NASDs rule changes, the Commission has amended Rule 3a51-1 to exclude from the definition of penny stock any security that is authorized, or approved for authorization upon notice of issuance, 34 for quotation on NASDAQ, provided that price and volume information with respect to transactions in that security is required to be reported on a current and continuing basis and is made available to vendors of market information pursuant to the rules of the NASD. 35 In the Proposing Release, the Commission emphasized that many of the abuses occurring in the penny stock market are a direct result of the lack of publicly available information about the market in general and about the price and trading volume of particular penny stocks. The Commission believes that the NASDs proposal to implement last sale reporting for NASDAQ securities will increase the transparency of the market for NASDAQ securities. This rule change, combined with the NASDs increased listing criteria for NASDAQ issuers and its surveillance of the NASDAQ market, will provide sufficient protection to investors to substitute for the disclosure provided by the penny stock rules. Therefore, when the NASD implements last sale reporting pursuant to the terms of its proposal, all NASDAQ securities will be excluded from the definition of penny stock under paragraph (f) of Rule 3a51-1. 36
For similar reasons, Rule 3a51-1 as adopted provides an exclusion in paragraph (e) for any security that is registered, or approved for registration upon notice of issuance, on a national securities exchange, 37 provided that current price and volume information with respect to transactions in that security is required to be reported and is made available to vendors pursuant to the rules of the national securities exchange. 38 Securities that are listed on the regional exchanges also are subject to general reporting requirements under the rules of those exchanges. Investors therefore have a greater ability to evaluate and to monitor the market price of listed securities without having to rely exclusively on the representations of their broker-dealer. In addition, issuers of these securities are required to meet minimum qualification and maintenance standards for listing on the exchange. The Commission believes that these requirements, together with comprehensive exchange surveillance, also make the protections provided by the penny stock rules less necessary for securities listed and traded on the regional exchanges. 39
The exclusion in paragraph (e) of Rule 3a51-1 is limited to exchange-listed securities that actually are purchased or sold through the facilities of the exchange or in a distribution. This restriction is intended to address Congress concern that securities that would otherwise be considered penny stocks because they are primarily traded in the non-NASDAQ OTC market nevertheless may be able to avoid the requirements of the Rules by becoming listed on an exchange. 40 By limiting the exclusion in paragraph (e) to specific transactions, the rule ensures that the information required under the Rules will be provided to customers in transactions executed by dealers as principal away from the exchange market, where the dealers quotations generally are not made public and electronic surveillance is less effective. 41
b. Section 15(b)(6)
Paragraphs (e) and (f) of Rule 3a51-1 generally remove exchange-listed and NASDAQ securities from the definition of penny stock for purposes of Section 15(g) of the Exchange Act and Section 7(b) of the Securities Act and the rules promulgated thereunder. These securities nevertheless continue to be deemed penny stocks for purposes of Section 15(b)(6) of the Exchange Act. 42
Section 15(b)(6) gives the Commission the authority to prohibit any person that has engaged in unlawful conduct while participating in a distribution of penny stocks, as defined in Rule 3a51-1, from associating with a broker-dealer or participating in a distribution of penny stock, if the Commission finds that such a restriction would be in the public interest. Under this section, broker-dealers also are prohibited from allowing such persons to participate in a distribution of penny stock without the Commissions consent. According to the House Report, subparagraph (6)(A) was added to Section 15(b) to enable the Commission to prohibit persons from participating in penny stock activities through remote affiliations with issuers and broker-dealers and to give the Commission broader prescriptive authority to address patterns of recidivism in the penny stock market. 43
In the Proposing Release, the Commission solicited comment on whether the exclusions from the definition of penny stock would provide particular opportunities for persons with a disciplinary history to become involved, as promoters or other associated persons of an issuer or broker-dealer, in offerings of penny stock. In response, several state securities regulators, NASAA, and the Consumer Federation of America (CFA) argued that regional exchange-listed and NASDAQ securities should be included in the definition of penny stock in part to prevent persons with an established record of fraudulent activity in the low-priced securities market from associating with issuers of those securities and their broker-dealers. 44
Although the Commission recognizes that last sale reporting and SRO supervision will address many of the problems that the penny stock disclosure rules are designed to remedy, the Commission believes that the markets for low-priced securities listed or quoted on the regional exchanges, Amexs ECM, and NASDAQ would be strengthened by protecting them from persons with a history of penny stock abuse. 45
The Commission therefore has retained the authority under Section 15(b)(6)(A) of the Exchange Act to restrict such persons from becoming involved in those markets by excluding regional exchange-listed, ECM, and NASDAQ securities only from the requirements of Section 15(g) of the Exchange Act and Section 7(b) of the Securities Act. Specifically, paragraphs (e)(2) and (f) of Rule 3a51-1 provide that exchange-listed and NASDAQ securities that are not otherwise excluded from the definition of penny stock are considered to be penny stocks solely for purposes of Section 15(b)(6) of the Exchange Act. As discussed above, under paragraph (a) of Rule 3a51-1, securities that are registered on Amex pursuant to its ECM listing criteria also are included in the definition of penny stock for purposes of Section 15(b)(6).
3.Price of the Security
a. Transactions
As adopted, Rule 3a51-1(d) excludes from the definition of penny stock securities that are priced at five dollars or more. In most cases, the price of a security for purposes of the rule will be the price at which it is purchased or sold in a particular transaction, excluding the amount of any broker-dealer commission, commission equivalent, mark-up, or mark-down.
The proposed rule contained a similar exclusion for securities priced at five dollars. The comments were sharply divided on whether the five dollar price threshold was appropriate. Several comments supported the five dollar price threshold on the ground that lower-priced securities are more susceptible to manipulation. In contrast, other comments argued that the five dollar price was arbitrary, and suggested alternative prices, ranging from one cent to three dollars, which they believed would more accurately reflect the common understanding of the term penny stock. The Regional Investment Brokers, Inc. recommended that the price threshold be entirely eliminated because, by itself, it does not provide an accurate indication of the quality of a company. 46
The Commission has determined to retain a five dollar price threshold in Rule 3a51-1 for several reasons. First, as noted in the Proposing Release, securities priced above five dollars are less frequently the vehicle for manipulation and high pressure sales campaigns because the percentage price spreads at that level are much lower. In contrast, securities selling for under five dollars are often used in manipulative schemes due to the potential for immediate profits from large percentage spreads. 47 A broker-dealer, for instance, can sell a large volume of securities priced below three dollars by representing to unwary customers that small absolute price increases constitute large returns in relation to the purchase price. 48 The higher the price of the security, however, the harder it is for a broker-dealer to maintain large percentage spreads or to tout a security based on small price increases; that is, it becomes more difficult to sell a large volume of securities solely for the purpose of generating rapid profits. 49 Thus, the Commission has included a five dollar price threshold in the rule because it believes that manipulation and sales practice abuses are less likely to occur at that level. The five dollar threshold, however, is not intended to provide any indication of the inherent worth of a company. 50
Second, the five dollar price threshold is consistent with the Uniform Limited Offering Registration (ULOR) project developed by the State Regulation of Securities Committee of the American Bar Association and NASAA to provide a short-form registration procedure for small business offerings priced above five dollars. 51 The price threshold also is consistent with a number of other existing price standards. 52
Finally, the minimum price threshold serves an important function by mitigating the impact of the penny stock rules on legitimate small business capital formation. The Commissions experience with a similar threshold in Rule 15c2-6, confirmed by discussions with a number of broker-dealers, indicates that the price threshold will allow small issuers to respond to the Rules by setting the initial offering price for their securities at five dollars or more, or by engaging in reverse stock splits to raise the price of their existing shares. Although a higher price structure reduces the number of shares of smaller issuers available for trading in the secondary market, it appears that, at a five dollar price level, this reduction does not substantially impede the liquidity of the market for those securities. Moreover, as discussed further below, the list of exempt transactions under Rule 15g-1 has been expanded to provide relief for legitimate small issuers attempting to raise capital. Accordingly, many small issuers will be able to avoid the requirements of the Penny Stock Act by relying on a transactional exemption from the disclosure rules. 53
Form the foregoing reasons, subparagraph (d)(1)(i) of the adopted rule excludes securities that are purchased or sold in a transaction at a price of five dollars or more. In order to prevent broker-dealers from charging excessive mark-ups to inflate the price of a penny stock above five dollars, the rule has been amended to provide that, in both agency and principal transactions, the price of a security is the price exclusive of the broker-dealers remuneration. 54
b. Bid Quotations
As indicated above, the price of a security typically will be determined by the price at which it is purchased or sold in a particular transaction. In the absence of a transaction, 55 however, Rule 3a51-1(d)(1)(ii) provides that the five dollar price may be based on the inside bid quotation for the security displayed on a Qualifying Electronic Quotation System (i.e., an automated interdealer quotation system that has the characteristics set forth in Section 17B(b)(2) of the Exchange Act or any other system that is designated by the Commission for purposes of the rule). 56 The term inside bid quotation is defined in the rule as the highest bid quotation for the security displayed by a market maker in the security on such Qualifying Electronic Quotation System, provided that at the same time there are at least two market makers contemporaneously displaying in such system bid and offer quotations for the security.
Where there is no such inside bid quotation, subparagraph (d)(1)(ii) of Rule 3a51-1 provides that the average of at least three interdealer bid quotations at specified prices displayed in an interdealer quotation system 57 by three or more market makers in the security must be five dollars or more. The rule requires that the price be based on at least three bid quotations because quotations for low-priced securities that are traded in the non-NASDAQ OTC market, such as the pink sheets, frequently are the subject of negotiation and may not accurately reflect the prevailing market price.
The rule does not require a broker-dealer to conduct an independent investigation into whether the inside bid quotation of the three bid quotations upon which it is relying for purposes of the rule are bona fide. A broker-dealer, however, may not rely on quotations if it knows, or if it has reason to know, that those quotations have been entered into the interdealer quotation system by broker-dealers for the purpose of circumventing the requirements of the rule. 58
As proposed, Rule 3a51-1 did not include a provision allowing broker-dealers to calculate the five dollar price based on the inside bid quotation displayed on a Qualifying Electronic Quotation System. This provision was added in response to the NASDs comment that the average price provision would be difficult for broker-dealers to comply with and for the Commission and the SROs to enforce. The Commission believes that permitting broker-dealers to determine the price of a security based on the inside bid quotation displayed on an automated quotation system that has the characteristics set forth in Section 17B(b)(2) of the Exchange Act will facilitate compliance with the rule because, as discussed below, such information is readily available to broker-dealers.
Currently, no automated quotation system satisfies all of the requirements of Section 17B(b)(2). 59 The Commission anticipates, however, that the Bulletin Board operated by the NASD may substantially meet those requirements by the effective date of the penny stock disclosure rules. 60 The NASD has made several enhancements to the Bulletin Board since it was first approved in May of 1990. 61 Specifically, NASD rules now require that quotations for domestic securities entered into the system by registered market makers must be firm for one unit of trading. 62 The NASD also calculates and distributes an inside quotation for each domestic security quoted in the Bulletin Board for which there are at least two registered market makers displaying firm two-sided quotations. Other changes have been made to the Bulletin Board to make the system more responsive to the operational needs of NASD member firms. 63 All of these changes are consistent with Section 17B of the Exchange Act and, assuming that the Bulletin Board meets the requirements of Section 17B(b)(2) by the effective date of the penny stock disclosure rules, 64 will facilitate broker-dealer compliance with Rule 3a51-1(d)(1)(ii) by providing readily available quotations upon which to calculate the five dollar price.
Finally, the NASD and the Securities Traders Association suggested that Rule 3a51-1(d) should be modified to account for price fluctuations occurring as a result of temporary market or economic conditions. Rather than complicate the five dollar price calculation in the definitional provision of Rule 3a51-1(d)(1)(ii) by taking into account temporary price fluctuations, the Commission has amended Rule 15g-6 to exempt from the monthly account statement requirement securities that are consistently priced above five dollars during any quarterly period. 65 Amending subparagraph (d)(1)(ii) of Rule 3a51-1 to account for price fluctuations could create investor confusion as to whether a security is a penny stock at a given point in time and would be difficult for broker-dealers, the Commission, and the SROs to monitor.
c. Unit Pricing
Paragraph (d)(2) of Rule 3a51-1 further provides that, in the case of a unit composed of different securities, the price divided by the number of shares of the unit that are not warrants, options, rights, or similar securities, must be five dollars or more, as determined in accordance with paragraph (d)(1) of the rule, and the exercise price of any warrant, option, or right, as well as the conversion price of any convertible security, included in the unit must be five dollars or more. 66 Merrill Lynch, Pierce, Fenner & Smith Inc. and the Securities Industry Association (SIA) suggested that this provision should be eliminated from the rule because it could create confusion, especially when one of the securities in a unit is a blue chip stock, or when a derivative security that is a penny stock is convertible into a non-penny stock. The Commission notes, however, that these securities usually would be excluded under paragraphs (e), (f), or (g) of Rule 3a51-1. 67 In addition, the Commission believes that a customer who is buying separately traded securities (such as warrants) in the non-NASDAQ OTC market that are priced below five dollars and issued by a company with less than $2 million in net tangible assets or $6 million in three year average revenues would benefit from the disclosure provided by the Rules.
4. Issuer Financial Standards
Finally, a new paragraph (g) has been added to Rule 3a51-1, which excludes any security issued by an issuer that has (1) net tangible assets in excess of $2 million, if that issuer has been in continuous operation for at least three years, or $5 million, if the issuer has been in continuous operation for less than three years, or (2) average revenue of at least $6 million for the last three years. As proposed, Rule 15g-1 contained a similar transactional exemption based on issuer net tangible assets. 68 The Proposing Release particularly solicited comment on whether the higher $5 million net tangible assets standard should apply to all issuers, regardless of their number of years in business.
The comments were divided on whether a two-tier standard for issuer net tangible assets was appropriate. While several comments responded that a single $2 million standard would be sufficient, NASAA and the State of Virginia indicated that the standard should either be eliminated, or raised to $5 million for all issuers. Four comments stated that Rule 15g-1 should not include any transactional exemption based on net tangible assets because such a standard is vague and easy to circumvent. In particular, one commenter believed that a net tangible assets standard would be unfair to certain industries (or companies within an industry) because accounting measurements may be evaluated differently depending on whether the industry of the issuer is oriented towards manufacturing or services. Several other comments, on the other hand, argued that the transactional exemption based on issuer net tangible assets should be replaced with a similar exclusion from the definition of penny stock so that securities that are issued by companies with substantial assets will not be considered penny stocks.
In response to these comments, the Commission has amended Rule 3a51-1 to add an exclusion for securities issued by an issuer with either $2 million or $5 million in net tangible assets, depending on whether the issuer has been in operation for three years or less. Including a definitional exclusion based on issuer net tangible assets, rather than a transactional exemption, will simplify the Rules and be more consistent with Rule 15c2-6. 69 In addition, to address the comment that the standard is vague, the term net tangible assets is defined in the rule as total assets minus intangible assets and total liabilities. For purposes of the rule, intangible assets include, among other assets, goodwill, patents, licenses, and trademarks. 70 The rule continues to impose a separate higher standard for start-up companies in order to prevent the types of abusive activities described in the Proposing Release that have occurred both prior to and since the adoption of Rule 15c2-6 in August of 1989. 71
Rule 3a51-1, however, also includes a new alternative revenue standard. Specifically, paragraph (g)(2) of the rule excludes any transaction in a penny stock issued by an issuer that has average revenues of $6 million for the prior three years. In other words, to satisfy the requirements of this provision, an issuer must have had total revenues of $18 million or more by the end of the three-year period. 72 The Commission believes that providing an alternative exclusion based on issuer revenue will ensure that the rule does not discriminate among issuers by industry, and will provide another basis upon which the securities of small issuers may be excluded from the application of the penny stock rules. The three-year revenue standard was selected over other standards 73 because it not only provides an indication of the financial history of a small company, but also because it can be readily derived from an issuers income statement.
The $6 million revenue level was chosen because the Commission believes that, as a general rule, companies historically subject to penny stock manipulations and sales practice abuses have not achieved this level of revenue. 74 Like the exclusion based on issuer net tangible assets, however, this exclusion is not designed to give investors an indication of the investment merits of an issuer. Rather, it is intended only to exclude companies whose financial condition makes them less likely to be vehicles for abusive market activities even though their securities are traded outside of a transparent market at prices below five dollars.
The rule further provides that, for domestic issuers, the required level of net tangible assets or revenues must be demonstrated by financial statements that are dated less than fifteen months prior to the date of the related transaction and that have been audited and reported on by an independent accountant in accordance with Regulation S-X. 75 For foreign private issuers, the rule requires that net tangible assets or revenues be reflected in financial statements that are dated less than fifteen months prior to the date of the related transaction, and that have been filed with or furnished to the Commission pursuant to Rule 12g3-2(b). 76 If the foreign private issuer has not been required to file or furnish financial statements during the previous fifteen months, however, the financial statements may be prepared and audited in compliance with generally accepted accounting principles of the country of incorporation and reported on by an accountant registered and in good standing in accordance with the regulations of that jurisdiction. To demonstrate compliance with the rule, broker-dealers are required to keep copies of the domestic or foreign issuers financial statements for at least three years following the date of the related transaction, the first two of which must be in an easily accessible place. 77
In all cases, the broker-dealer must review the financial statements and have a reasonable basis for believing that they were accurate as of their date and that the issuers financial condition has not substantially weakened by the date of the related transaction. A few comments argued that this requirement would impose a higher standard of review on broker-dealers than is required for auditors who report on the issuers financial statements. These comments suggested that the Commission should rephrase the language of the rule to require that broker-dealers have no reason to believe the statements are not accurate.
The Commission has not adopted this suggestion because, as noted in the Proposing Release, the existing standard does not require the type of due diligence investigation typically required of an underwriter or an auditor. 78 Rather, the rule requires broker-dealers to obtain audited financial statements from a reliable source, such as the issuer or the Commission, and to review those statements to ascertain whether the amount of the issuers net tangible assets or revenues are in compliance with the rule. Ordinarily, if the issuers audited balance sheet shows net tangible assets equaling either $2 million or $5 million (depending on the number of years the issuer has been in operation), or if its audited income statement shows average revenues of at least $6 million for the past three years, the broker-dealer will be entitled to rely on those statements to establish an exclusion under the rule. 79 Therefore, in most cases, the broker-dealer need not inquire about or independently verify any of the information contained in the issuers financial statements. Only if materially inconsistent or inaccurate information appears on the face of the financial statements, or if the broker-dealer becomes aware, in the course of its review, of material inconsistencies between the statements and information in the broker-dealers possession, would the broker-dealer need to satisfy itself that the information contained in the financial statements is accurate and complete. 80 The way in which a broker-dealer may satisfy itself as to the accuracy of an issuers financial statements under the rule will vary according to the circumstances. 81 The Commission emphasizes, however, that under no circumstances would the rule require the type of due diligence investigation typically conducted by an underwriter.
B. Rule 15g-1: Exempt Transactions
In the Proposing Release, the Commission recognized that the rules proposed pursuant to Section 15(g) of the Exchange Act potentially could affect legitimate small business capital formation. The Commission therefore proposed Rule 15g-1, which exempted certain transactions from the disclosure requirements of Rules 15g-2 through 15g-6. As originally proposed, the rule was organized in two parts: paragraph (a) exempted certain transactions from Rules 15g-2 through 15g-6, while paragraph (b) exempted transactions in securities listed on a national securities exchange or quoted on NASDAQ from Rules 15g-2, 15g-3, and 15g-6. Because exchange-listed and NASDAQ securities are now excluded from the definition of penny stock under Rule 3a51-1, paragraph (b) has been deleted from the final rule. In addition, as discussed below, the list of transactions that are exempt from Rules 15g-2 through 15g-6 has been expanded to include certain transactions identified by the comments as being less in need of the protections provided by the penny stock disclosure rules.
1.Limited Broker-Dealer Activity in Penny Stocks
Section 15(g)(4) of the Exchange Act, which gives the Commission the authority to exempt any person or transactions from the rules adopted pursuant to Section 15(g), requires the Commission to include an exemption for brokers-dealers that derive only an insignificant percentage of their total revenue from transactions in penny stocks. Accordingly, paragraph (a) of Rule 15g-1 exempts from Rules 15g-2 through 15g-6 transactions in penny stocks by broker-dealers that derive less than 5% of their total revenue from purchases and sales of penny stocks, except when they are acting as a market maker in the penny stock that is the subject of the transaction.
As adopted, the de minimis exemption differs from the proposed exemption in two significant respects. The 5% revenue calculation under the proposed rule was based on transactions in penny stocks, as defined in proposed Rule 3a51-1. As few comments pointed out that this would require broker-dealers to include in their 5% calculation transactions in low-priced securities that are issued by well-capitalized domestic and foreign issuers. 82 As a result, they indicated that the exemption would be too limited to be of much use to broker-dealers, even those broker-dealers that typically are not in the business of effecting transactions in penny stocks. In lieu of a transactional exemption, these comments recommended that the definition of penny stock include an exception based on the net tangible assets of the issuer.
As discussed above, to address the concerns expressed in these comment letters and to simplify the Rules, the Commission has amended the definition of penny stock in Rule 3a51-1 to exclude any security issued by an issuer that meets the financial standards set forth in paragraph (g) of that rule. Transactions in those securities therefore are not required to be included in the 5% revenue calculation for purposes of Rule 15g-1(a). 83 In addition, the rule has been revised to give broker-dealers the option of calculating their revenue over a six month period, rather on a monthly basis. 84
A few comments objected to the provision in Rule 15g-1(a)(2) that would preclude market makers from relying on the exemption because they believed it would create a strong disincentive for securities firms to make markets in lower-priced securities. 85 The Commission, however, has determined to retain this provision because it believes that market making constitutes a level of involvement in the penny stock market inconsistent with the use of a de minimis exemption. The rationale for the de minimis exemption is that there is less risk of abuse from firms whose business is not concentrated on the penny stock market because they have less incentive or opportunity to manipulate the price of a penny stock. Conversely, much of the abuse in the penny stock market has involved market makers, because their ability to control the prices of the securities in which they make a market gives them the opportunity to generate large profits. 86 The Commission thus believes that it is appropriate to limit the de minimis exemption to firms that are not acting as market makers in penny stocks. This limitation is supported by fairness considerations; allowing larger firms to use the de minimis exemption while making markets in penny stocks potentially could provide them with an unfair competitive advantage over their smaller counterparts. 87 Therefore, regardless of their percentage of revenue from penny stock transactions, market makers in a penny stock are not exempt under Rule 15g-1 with respect to transactions in that particular penny stock. 88
The Commission recognizes that broker-dealers relying on the de minimis exemption will need a period of time after the effective date of the Rules to modify their data retrieval systems in order to determine whether their revenue from penny stock transactions exceeds the 5% level. 89 The rule therefore includes a note indicating that broker-dealers may calculate their 5% revenue based on designated securities, as defined in Rule 15c2-6(d)(2) (as of April 15, 1992), rather than penny stocks, as defined in Rule 3a51-1, for a period of twelve months following the publication of this release in the Federal Register.
2.Institutional Accredited Investors
Proposed Rule 15g-1 provided an exemption for transactions with institutional accredited investors, as defined in Regulation D of the Securities Act. 90 No comments stated any objection to this provision. Therefore, for the reasons stated in the Proposing Release, the Commission has determined to include the exemption in paragraph (c) of the adopted rule. 91
3.Private Offerings
Although proposed Rule 15g-1 included an exemption for transactions with institutional accredited investors, it did not provide a similar exemption for individual accredited investors. 92 The Proposing Release specifically requested comment on whether transactions with individual accredited investors also should be exempt from the penny stock disclosure rules. In response, several comments argued that there are insufficient grounds for distinguishing between institutional and individual accredited investors, especially in light of the fact that the two types of investors are treated in the same manner under Regulation D of the Securities Act. They therefore suggested exempting all accredited investors from the Rules.
The Commission has determined not to provide a general exemption for transactions with individual investors based solely on their net worth or income. Unlike institutional investors, which generally do not purchase penny stocks, individual accredited investors are frequently the target of high pressure sales efforts involving speculative equity securities. Given the lack of publicly available information about the price and trading volume of particular penny stocks and the penny stock market in general, these investors often have few means of independently evaluating the market for the stock in question or the financial interest of the broker-dealer in the transaction. In the absence of this information, many individual investors of considerable financial means have been convinced through abusive sales practices to purchase penny stocks without sufficiently understanding the nature of the market. The penny stock disclosure rules are designed to give individual investors the information they need to make an independent and informed evaluation of a broker-dealers recommendation to invest in low-priced securities that are not traded in a visible public market. 93
The Commission recognizes, however, that many of the sales practice abuses that occur in the secondary market for penny stocks do not occur in initial private offerings. In general, private offerings are limited to a small number of investors who are familiar with the broker-dealer involved in the transaction and who have access to information about the issue of the securities. 94 In addition, securities that are sold in private placements are subject to certain restrictions on resale. 95 As a result, the market for these securities is limited and the securities typically are not used as vehicles for the types of market manipulation and broad scale sales efforts characteristic of fraudulent penny stock activities.
Accordingly, the list of transactions that are exempt under Rule 15g-1 has been expanded to include an exemption for transactions that meet the requirements of Regulation D under the Securities Act, 96 as well as transactions by an issuer not involving any public offering pursuant to Section 4(2) of the Securities Act. 97 Assuming that the requirements of either of those provisions have been met, this exemption applies even if the particular customer involved is not an accredited investor.
4.Insider Transactions
Under proposed Rule 15g-1, transactions by issuers repurchasing or redeeming their own securities were exempt on the basis that corporations have sufficient access to information about the market for their own securities to deal with broker-dealers without the additional disclosure provided by the Rules. Several comments suggested that, in addition to the issuer of the penny stock, officers, directors, and controlling shareholders of the issuer should be exempt from the Rules because, as insiders, they also have sufficient knowledge about the issuer to be aware of the risks of their investment. As one broker-dealer stated, insiders would have a ... better knowledge of the intrinsic value of the security than any market-maker, and should not require the protection of this rule. 98 The Commission agrees with these comments and therefore has expanded the issuer exemption in Rule 15g-1 to also exempt from Rules 15g-2 through 15g-6 transactions in which the customer is a director, officer, general partner, or direct or indirect beneficial owner of more than 5% of any class of equity security, 99 of the issuer of the penny stock that is the subject of the transaction.
5.Non-Recommended Transactions
Proposed Rule 15g-1 contained an exemption for transactions in penny stocks that are not recommended by a broker-dealer. All of the comments that addressed this provision supported the concept of an exemption for non-recommended transactions. Several comments, however, requested that the Commission clarify the scope of the exemption by distinguishing between retail broker-dealers who actively recommend stocks to individual investors and wholesale market makers who maintain lists of the types of specifications of stocks in which certain active investors have expressed an interest. These comments argued that the activities of whole broker-dealers should be considered non-recommended because the customers of those broker-dealers make their own investment decisions once they are alerted to the existence of a stock that meets their specifications. 100 Two commenters believed that the exemption would be clearer if it applied to non-solicited, rather than non-recommended, transactions.
The Commission has determined to retain the exemption for non-recommended transactions in paragraph (e) of Rule 15g-1. To be consistent with Rule 15c2-6, the exemption continues to apply to non-recommended rather than non-solicited trades. 101 Accordingly, the exemption is limited to situations in which a broker-dealer acts as an order taker for the customer, with little or no incentive to engage in manipulative sales tactics. The rule does not exempt situations in which a broker-dealer brings a penny stock to the attention of an investor because, in most cases, this action is intended, and is understood by the customer, as an implicit recommendation to buy the penny stock. Moreover, as a practical matter, the Commission believes that it would be difficult to determine whether a broker-dealer brought a penny stock to the attention of a customer, or whether it actively promoted the merits of that penny stock. In any case, wholesale market makers who maintain lists of stocks that they bring to the attention of institutional investors generally will be able to rely on the exemption for transactions with institutional accredited investors under paragraph (b) of Rule 15g-1. 102
6.Exemptive Authority
Finally, as in the proposed rule, Rule 15g-1 includes a provision giving the Commission the authority to exempt by order any transaction or persons or class of persons from Rules 15g-2 through 15g-6 if it determines that an exemption would be consistent with the public interest and the protection of investors. The Commission believes that this provision will give it the necessary flexibility to exempt transactions and persons that are subject to alternative disclosure requirements that are comparable to the requirements of the Penny Stock Act. 103
C. Rule 15g-2: Penny Stock Risk Disclosure Document
Section 15(g)(2) of the Exchange Act requires a broker-dealer to provide to each of its customers, prior to effecting any transaction in any penny stock, a document that discloses the risks of investing in the penny stock market. The statute enumerates the following specific items that broker-dealers must include in the disclosure document: (i) a description of the nature and level of risk in the market for penny stocks in both public offerings and secondary trading; (ii) a description of the broker-dealers duties to the customer and of the customers rights and remedies; (iii) a brief, clear, narrative description of a dealer market, including bid and ask prices for penny stocks and the significance of the spread between the bid and ask prices; (iv) the NASDs toll-free telephone number for inquiries on disciplinary actions; and (v) definitions of significant terms. 104 The statute grants the Commission specific rulemaking authority with respect to the language and the type size and format to be used in the risk disclosure document. 105 In enacting Section 15(g)(2), Congress recognized that basic information about the nature of the penny stock market, its depth and liquidity, and the risks of investing, is largely unavailable to many investors. 106
1.Description of the Rule
Pursuant to this statutory authority, the Commission is adopting Rule 15g-2. The rule makes it unlawful for a broker-dealer to effect a transaction in a penny stock with or for the account of a customer unless the broker-dealer distributes to the customer, prior to effecting a transaction in a penny stock, 107 a two-part document, as set forth in Schedule 15G.
The first part of the risk disclosure document, entitled Important Information on Penny Stocks (the Summary Document), summarizes on a single page the items required to be disclosed pursuant to Section 15(g)(2). The preamble urges investors to read the risk disclosure document before purchasing a penny stock. The first section of the Summary Document, entitled Penny stocks can be very risky, briefly defines penny stock and identifies certain risks of investing in penny stocks. The second section, entitled Information you should know, describes the penny stock market and terminology important to an understanding of that market. The final section, entitled Brokers duties and customers rights and remedies, informs customers who have questions or who have been defrauded that they may have rights or remedies under federal and state law, and provides a toll-free telephone number of the NASD and the central number of NASAA for information on the background and disciplinary history of the firms and salespersons with whom they are dealing, and the Commissions complaint number.
The remainder of Schedule 15G (the Explanatory Document) supplements and explains in greater detail the information provided in the Summary Document. The Explanatory Document begins with a section entitled Further Information, 108 which provides a non-technical definition of penny stock, and gives several warnings to investors concerning the penny stock market, including warnings against making a hurried investment decision, that salespersons are not impartial advisers, that investors should compare information from the salesperson with other information on the penny stock, and that salespersons may not legally state that a stock will increase in value or guarantee against loss. This section also discusses shell corporations, the high risks of initial public offerings, the speculative nature of penny stocks and the potential for significant losses, and suggests contacting the NASD and NASAA to obtain information on salespersons and broker-dealers and reading the prospectus in a public offering before making an investment. Investors are further informed that they do not have to transfer their stock if their salesperson leaves the firm and that they have the right to physical possession of their stock certificates.
The next section of the Explanatory Document, entitled Your Rights, informs investors about their rights and the broker-dealers duties under the new penny stock rules, including the particular disclosures that must be made to them under each rule, and of the timing requirements for such disclosures. The section also informs customers generally of their rights under Section 29(b) of the Exchange Act, as amended by the Penny Stock Act, which may allow a rescission of the purchase contract for broker-dealer transactions in violation, inter alia, of the disclosure rules under Section 15(g) of the Exchange Act. Customers also are informed of the availability of private litigation if they believe they have been defrauded or their rights otherwise violated, and the use of arbitration procedures, if they are subject to an arbitration agreement, and that they can report their grievances to regulatory authorities, including the Commission, the NASD, and their state securities administrator.
The final section of the Explanatory Document, entitled Market Information, provides an overview of important aspects of the market for low-priced securities. The first two paragraphs provide a general description of the non-NASDAQ market and an explanation of important concepts associated with that market, such as the role of brokers, dealers, and market makers, and the ability of firms in the penny stock to dominate the market in a penny stock and to control its prices. The next three paragraphs provide a detailed explanation of the relationship between mark-ups, mark-downs, the dealers spread, and broker-dealer compensation, and discuss the reason why the bid price of a low-priced stock purchased by a customer generally must rise substantially before the customer may profitably resell that stock. The final two paragraphs explain the initial public offering, warn investors of the especially high risk in such a market, and provide the Commissions address for investors who want additional information concerning penny stocks.
Schedule 15G contains instructions for production of the document by the broker-dealer. The instructions set forth the criteria for type size and typeface, so that the document will be uniform among broker-dealers, and so that the type will be sufficiently large to be legible to the average reader. 109 Schedule 15G may be reproduced by photographic copying, so long as the copy is clear, complete, and meets the minimum type size requirements set forth for a printed document. In addition, the instructions prohibit the broker-dealer from omitting, adding to, or altering the language of Schedule 15G in any way and from providing supplementary materials to the customer intended to detract from, rebut, or contradict Schedule 15G. Broker-dealers may not charge customers a fee for receipt of Schedule 15G. In addition, broker-dealers are required to distribute the Summary Document as the first page of the risk disclosure document, and on one page only.
2.Schedule 15G as Proposed
Schedule 15G as originally proposed consisted of a three-part document, entitled Penny Stock Disclosure Document, that outlined the items broker-dealers are required to disclose pursuant to the Penny Stock Act. The document defined a penny stock, provided several brief warnings to investors, discussed the disclosures required by the proposed penny stock disclosure rules and the available legal remedies under the section entitled Your Rights, and, under the caption Important Market Information, explained the functioning of the penny stock market. Specific features of the proposed rule are discussed below in connection with the comments.
3.Simplification
In the Proposing Release, the Commission requested comment whether the language of Schedule 15G as proposed accurately and concisely communicated the information required by the Penny Stock Act. While nearly all comments expressed general agreement with the philosophy of providing a risk disclosure document to customers in penny stock transactions, many comments also said that the schedule was too complicated for the average investor to read and comprehend. 110 Along the same line, some comments argued that a one-page document would achieve the purpose of a risk disclosure document more effectively. Three comments pointed to the risk disclosure document required under the Commodity Exchange Act, 111 which informs investors of the risks involved in trading commodity futures contracts in five brief paragraphs, as a good example.
In response to the comments, the Commission has revised Schedule 15G to make it more straightforward and comprehensible to the average reader. First, the Commission has added the new Summary Document to summarize the essential information. The Commission believes that a brief, one-page document, which succinctly states the main required items, would more effectively attract the average investors attention.
Second, the Commission has revised Schedule 15G as proposed, which has become the Explanatory Document as described above. Changes from proposed Rules 3a51-1 and 15g-1 through 15g-6 are reflected in the Explanatory Document. Where possible, without altering significantly the meaning of Schedule 15G as proposed, shorter, more commonly understood words have been substituted. Most paragraphs have been shortened; however, to incorporate some of the comments noted below, the Commission has expanded other sections.
4.Strengthening the Risk Disclosure Document
The Commission has accepted several suggestions proposed in the comment letters intended to strengthen the risk disclosure document. In response to one recommendation, the Commission has revised the discussion of the relationship between the bid and offer quotation prices, the spread, and the compensation of a broker-dealer. 112 Investors are warned that, in order to sell their stock at a profit, the bid price must rise above both the original offer price (constituting the dealers spread), and the compensation to the broker-dealer, consisting of the mark-up in the original transaction and the mark-down in the sales transaction.
The Commission also has included the Commissions own telephone number for reporting complaints and NASAAs central telephone number in addition to the NASD toll-free telephone number. Investors may call the latter two numbers for the disciplinary history of broker-dealers and their salespersons. 113
Several comments suggested broadening the description of the penny stock market to include the Bulletin Board, and other local or regional interdealer quotation services. The Commission has added the Bulletin Board to the description of the quotation media in which information about penny stocks may be obtained.
One comment suggested that prior to a transaction, investors should be required to sign and return a form to the broker-dealer stating that they had read the risk disclosure document. The Commission believes that the burden on broker-dealers of imposing such a requirement would be too high, both in terms of the delay in effecting a transaction, and the additional paperwork involved. Instead, compliance with the rule may be monitored by review of the broker-dealers internal procedures, and, if necessary, by contacting the clients of the broker-dealer.
Similarly, the Commission also has decided against requiring the firm to provide the risk disclosure document to all investors in penny stocks, including those investing in transactions exempted by Rule 15g-1, 114 as proposed by one comment. For the reasons stated in the Proposing Release, the Commission believes that such a requirement is not warranted. 115 Under the definition of a penny stock as set forth in Rule 3a51-1 as adopted, transactions in a stock registered and executed on a national securities exchange or quoted on NASDAQ are excluded from Rule 15g-2, in addition to the other penny stock disclosure rules being adopted today. 116 The availability of price and volume information in these markets enhances the ability of investors to investigate the accuracy of their broker-dealers or salespersons representations. Moreover, SRO rules impose certain restrictions on these quotations designed to protect investors. 117 The Commission believes that investors would not receive significantly greater protection from receiving a risk disclosure document in such transactions.
Several representatives from the industry felt that the risk disclosure document casts the penny stock market in an unduly pejorative light. 118 One broker-dealer stated that the term penny stock should not be used because its negative connotations may taint all securities that technically fall within that category. However, the objective of the risk disclosure document, as reflected in the Penny Stock Act and its legislative history, is to disclose the risks present in this market as well as the incidence of fraud that has been demonstrated. After reviewing the risk disclosure document, and making the revisions described above, the Commission believes that this document, which is necessarily a warning notice, achieves this objective in a measured way. 119
D. Rule 15g-3: Broker-Dealer Disclosure of Quotations and Other Information Relating to the Penny Stock Market
The Penny Stock Act requires the Commission to adopt a rule requiring broker-dealers to disclose to each customer, prior to effecting any transaction in, and at the time of confirming any transaction with respect to any penny stock, the bid and ask prices for the penny stock, and the number of shares to which such bid and ask prices apply. 120 If information is not available on bid and ask prices, broker-dealers must provide customers with other useful and reliable information relating to prices of penny stock, and other comparable information relating to the depth and liquidity of the market for the stock. 121
1.Description of the Rule
Pursuant to this statutory requirement, Rule 15g-3 requires a broker-dealer that effects a transaction in any penny stock with or for the account of a customer to disclose to its customers, prior to effecting the transaction, and in the written confirmation, 122 certain information relating to prices and quotations. Procedures for disclosing quotations derived from interdealer bid and offer prices are treated separately in principal transactions on the one hand, and riskless principal and agency transactions, on the other.
The rule sets forth three levels of disclosure in principal transactions, other than riskless principal transactions, 123 depending on the availability and reliability of price information. First, paragraph (a)(1) of Rule 15g-3 requires a broker-dealer effecting a transaction in a penny stock to provide the inside bid and offer quotations for the penny stock appearing on a Qualifying Electronic Quotation System, such as the Bulletin Board, on which there is both an inside bid and offer quotation for the security. 124
Second, if an inside quotation, as defined, is not available, the rule requires disclosure of the broker-dealers own quotations. For principal transactions other than riskless principal transactions, a broker-dealer is required to disclose its own bid and offer prices if, during the previous five business days, the dealer has effected at least three bona fide sales to, in the case of its current offer quotation, or purchases from, in the case of its current bid quotation, other dealers consistently at these respective bid or offer quotations at the time of those transactions. 125 In addition, the dealer must reasonably believe in good faith at the time of the transaction with the customer that its respective bid or offer price accurately reflects the price at which it is willing to sell to or buy from other dealers. 126
In order for a quotation to be disclosed under this second procedure, no less than 75% of a broker-dealers bona fide interdealer purchases or sales must have occurred consistently at the currently quoted price over the previous five-day period. At a minimum, dealers must have effected three bona fide transactions with other dealers. If only three interdealer transactions have occurred in the interdealer market, all three such transactions must have occurred at the dealers currently quoted bid or offer price, as the case may be.
Finally, if the dealers own bid and offer prices differ from its interdealer transaction prices over the previous five days, the rule requires the dealer to disclose that it has not consistently effected interdealer purchases or sales of the penny stock at its bid or offer price. The dealer also must disclose to the customer the price at which it last purchased the penny stock from, or sold the penny stock to, respectively, another dealer in a bona fide transaction.
In this situation, the dealer must state, in a clear manner, the price of its last transaction and its lack of trades consistent with its quotes. The Commission believes that under such circumstances it generally would be misleading to customers for dealers to provide, in addition, their own purported market quotations, since the broker-dealers own quotes would not reflect the prices at which it is trading. If the dealer nonetheless chooses to provide additional quotations, such quotations must be bona fide, and the dealer must communicate clearly the nature of those quotations, without rendering the required disclosures ineffectual. 127
In the case of a sole market maker in a penny stock, the market maker would be required to disclose its quotations, if validated by its trades, as required by the rule. Otherwise, it must disclose its last relevant trade price, and the fact that its trades and quotes were not consistent. In other instances where it has not been possible for a dealer to effect transactions consistently with other dealers over a five-day period, as, for example, during the first few days of an initial public offering, a dealer would be required to disclose to the customer that it has not effected previous, consistent interdealer purchases or sales. In the case of an initial public offering, the broker-dealer could explain that no trading market existed prior to the offering. This information should indicate to the customer that the market for the securities may be inactive or untested, because an interdealer market has not yet been established for the securities.
The rule provides for a separate procedure for disclosing transactions effected by a broker on an agency basis, or by a broker-dealer on a riskless principal basis. In these trades, the rule requires a broker-dealer to disclose the best interdealer bid and offer prices for the penny stock that the broker-dealer obtains through reasonable diligence. The Commission believes that the reasonable diligence standard would require the broker-dealer acting as agent or riskless principal, at a minimum, to follow standards set forth by the NASD, and generally accepted as industry practice, by presenting to the customer the best of three quotations obtained from market makers in the security. Quotations from all market makers would have to be provided if there are fewer than three. 128
Finally, paragraph (a)(3) of the rule requires broker-dealers to disclose the number of shares to which the bid and offer prices apply. 129
2. Comments on Rule 15g-3
The Commission requested comment concerning the procedure for validating quotations of broker-dealers, specifically, the adequacy and appropriateness of the provision of the proposed rule requiring that at least 75% of a dealers purchase or sales transactions during the previous five-day period occur at its bid or offer price. Six comments supported the manner in which the rule requires disclosure of quotations. 130 However, representatives of industry generally were critical of the validation process, stating that it posed substantial compliance and operational problems. 131 In particular, these comments asserted that it would be unduly burdensome for broker-dealers to determine whether quotations were consistent during the five-day period prior to effecting the penny stock transaction. The NASD stated that the 75% figure was too high, and would be ineffective without a minimum number of trades. The NASD preferred a process of validation based on Alstead, Dempsey & Company, Inc. (Alstead), 132 which permits use of properly validated quotations in the absence of contemporaneous transactions, without quantifying the percentage of trades required to validate the quotations.
In response to these comments, the Commission has concluded that broker-dealers should have available an objective procedure that would assist them in complying with the Penny Stock Acts requirement of disclosure of bid and offer quotations. In Section 17B of the Exchange Act, Congress directed the Commission to facilitate the wide-spread dissemination of reliable and accurate last sale and quotation information with respect to penny stocks, which would provide, among other things, bid and offer quotations of participating broker-dealers, or other comparably accurate and reliable pricing information. The Commission has incorporated the standards enumerated in Section 17B in the specifications of an automated quotation system for purposes of disclosure under Rule 15g-2. 133 The Commission believes that the use of such a quotation system will substantially ease the costs to broker-dealers of complying with the bid-offer disclosure requirement of the Penny Stock Act.
The rule requires use of the highest firm inside bid quotation and the lowest firm inside offer quotation displayed on a Qualifying Electronic Quotation System, when available. 134 Under paragraphs (c)(3)-(4) of the rule, in order for an inside bid quotation and an inside offer quotation to exist, at least two market makers in the security must contemporaneously be displaying on a Qualifying Electronic Quotation System bid and offer quotations for the security at specified prices. 135 Consequently, broker-dealers will provide these publicly disseminated quotations in the pre-trade disclosure and in the confirmation by drawing these quotes electronically from an external data source. The Commission believes that broker-dealers should be able to derive the inside quotes from an electronic system like the Bulletin Board in an efficient and straightforward manner, and that this will provide useful information to investors.
In its comment letter, the ABA hypothesized a situation where a broker-dealer has consistently effected bona fide sales to other dealers at its offer price, but has not effected purchases consistently at its bid price. The letter argued that this unfairly required the broker-dealer to disclose the unreliability of its quotations to its customers. However, one of the principal reasons for requiring broker-dealers to disclose bid as well as offer quotations is so that investors understand the problems that they may face when they attempt to sell a penny stock. A consistent bid price, validated by actual trades, evidences an active, liquid secondary market in the stock, and, therefore demonstrates that the customer may readily find a broker-dealer to repurchase that stock.
3. Validation of Quotations in Principal Transactions
Where qualifying inside quotations are not available, however, the Commission has retained the proposed validation procedure, while modifying certain features in accordance with the comments. The Commission believes that outside of an electronic quotation environment with multiple displayed quotations, quotations in the non-NASDAQ OTC market are not sufficiently reliable to require broker-dealers to give them to customers without a validation process. Moreover, as an operational matter, based on the comment letters and discussions with a number of broker-dealers, it appears that market makers generally are aware whether they are trading at their quoted prices. Although the Commission considered using a non-quantified validation standard, as suggested by the NASD, the Commission believes that a validation standard provides clearer guidance to broker-dealers in complying with the rule.
The Commission also believes that the proposed 75% standard is a fair gauge of the reliability of a broker-dealers quotes in the penny stock market. Given that there are often few trades in a penny stock, a figure lower than 75% would not accurately characterize the trading for a penny stock as consistent. 136 The Commission agrees with the NASD that the rule would be more effective if, in determining whether it has consistently traded at its offer or bid price to the customer, the dealer has effected a minimum number of transactions in the security during the relevant time period. Therefore, paragraph (a)(2)(i) of the rule as adopted now requires that there must have been at least three bona fide interdealer transactions in the security in the five days preceding the transaction with the customer. As a logical matter, if, in fact, the dealer has effected only three transactions, all three transactions must have occurred at its offer or bid price, as the case may be.
ice, as the case may be.
For those principal transactions that do not have qualifying inside bid and offer quotations displayed on a Qualifying Electronic Quotation System, and also cannot be properly validated, a dealer must disclose to customers that the dealer has not consistently effected interdealer purchases or sales of the penny stock at its bid or offer price. However, the Commission does not believe this requirement to be unduly burdensome, particularly in view of the benefits it would produce in terms of customer protection. 137 The alternative would be to tell the customer nothing. The Commission believes that this result would not comply with the mandates of the Penny Stock Act, as reflected in the legislative history, which underscored the importance that investors understand the nature of quotations in the penny stock market. 138
E. Rule 15g-4: Compensation of Brokers or Dealers
Section 15(g)(3)(A) of the Penny Stock Act requires the Commission to adopt a rule requiring broker-dealers to disclose to each customer, both prior to effecting any transaction in, and at the time of confirming any transaction with respect to, any penny stock, the amount and description of any compensation that the broker or dealer ... will receive or has received in connection with such transaction. 139 In enacting this provision, Congress was concerned that customers in the penny stock market have little notion of the often excessive compensation that broker-dealers obtain in penny stock transactions. 140
1.Description of the Rule
In accordance with the Penny Stock Act, Rule 15g-4 requires disclosure of aggregate broker-dealer compensation to any customer 141 both prior to effecting any transaction in, and at the time of confirming any transaction 142 with respect to, any penny stock. 143
Rule 15g-4 defines compensation of broker-dealers with respect to three separate types of transactions. First, the rule defines the compensation of a broker-dealer that is engaged in an agency transaction in a penny stock for a customer as the amount of any remuneration received or to be received by it from the customer. Compensation in agency transactions generally consists of a commission. The amount of remuneration to be received from the customer in agency transactions currently must be disclosed to the customer on the confirmation pursuant to Rule 10b-10(a)(7)(ii) 144 under the Exchange Act. Rule 15g-4 incorporates Rule 10b-10s general standard for agency transactions.
Second, Rule 15g-4 defines compensation of a broker-dealer, other than a dealer acting as a market maker, that executes a riskless principal transaction in a penny stock as the difference between the price to the customer and the contemporaneous purchase or sale that is made in connection with such transaction. A riskless principal transaction is a transaction in which a broker-dealer, after receiving (or receiving the commitment for) a buy or sell order, makes a purchase or sale of the penny stock as principal from or to another person to offset the sale or purchase as principal to or from the first person. Thus, riskless principal trades would be those trades in which there is a commitment on both the buy and the sell sides of a transaction at the time of the principal trades.
Third, Rule 15g-4 defines compensation of a dealer that executes principal transactions, other than riskless principal transactions, as the difference between the price to the customer charged by the dealer and the prevailing market price. The preamble to the rule refers broker-dealers to the standards for determining compensation in the Commissions Alstead 145 decision, which Congress, in its House Report on the Penny Stock Act, endorsed as the leading case establishing the principles for calculating mark-ups. 146
Paragraph (d) of the rule provides an alternative standard for use by market makers in calculating compensation, once last sale reporting becomes available in a Qualifying Electronic Quotation System, as defined in paragraph (c)(5) of Rule 15g-3. At that time, solely for purposes of Rule 15g-4, a market maker may use an active and competitive market standard in determining prevailing market price if the aggregate number of transactions effected by such market maker in the penny stock in the five business days preceding such transaction is less than 20% of the aggregate number of all transactions in the penny stock reported on a Qualifying Electronic Quotation System. Rule 15g-4 provides that there is no presumption that a market is not active and competitive solely because a market maker does not meet the conditions specified therein.
2.Alstead Standard
The Commissions general principles for calculating compensation in principal trades, enunciated in its decision in Alstead, provide guidance in determining prevailing market price. 147 Through administrative and judicial proceedings, the Commission has maintained the long-standing position that undisclosed excessive mark-ups and mark-downs 148 violate the antifraud provisions of the federal securities laws, 149 and has set forth the appropriate methods for calculating dealer mark-ups. In addition, since 1943, the NASD has deemed it inconsistent with just and equitable principles of trade under its Rules of Fair Practice for a member to enter into any securities transaction with a customer at a price not reasonably related to the current price of the security. 150
The Commission and the courts consistently have held in mark-up cases that, absent countervailing evidence, the prevailing market price is the price paid by a dealer in actual contemporaneous transactions with other dealers. 151 This standard, and a variation for certain dealer transactions, has been described most succinctly in the Commissions 1984 decision in Alstead. 152 The standards under Alstead as summarized in this release are intended to provide a framework for broker-dealers to use in calculating compensation when acting as principal in transactions in penny stocks. The Commission wishes to emphasize that this summary is not intended in any way to modify the standards of Alstead. Broker-dealers are encouraged to refer to that case in conjunction with this release for a statement of the Commissions standards regarding calculation of compensation.
The Commission in Almstead first reiterated the general contemporaneous cost standard. In one of the situations presented by the case, several market makers in an equity security were listed in the pink sheets, and the firm in question, Alstead, Dempsey & Co., also entered quotations in regional interdealer quotation sheets. Nonetheless, the Commission held that except for the prices Alstead, Dempsey & Co. charged another dealer in two transactions, the best evidence of prevailing market price was the price paid by Alstead, Dempsey & Co. in contemporaneous transactions, in view of the unreliability of Alstead, Dempsey & Co.s offer quote. 153
However, in Alstead, 154 and in other decisions, 155 the Commission modified the contemporaneous cost standard for certain principal trades in active and competitive markets. A dealer trading in such a market, that is acting as a market maker rather than effecting a riskless principal trade, would be able to use its own contemporaneous interdealer sales price or the sales prices of other deale