On March 16, 2000, the Securities and Exchange Commission approved amendments to rules G-8, on books and records, G-9, on preservation of records, and G-27, on supervision.[1] The amendments will become effective on September 19, 2000. The amendments will allow brokers, dealers and municipal securities dealers ("dealers") to develop flexible supervisory procedures for the review of correspondence with the public. This notice is being issued to provide guidance to dealers on how to implement these rules.

Background

Technology has greatly expanded how communications between dealers and their customers take place. These new means of communication (e.g., e-mail, Internet) will continue to significantly affect the manner in which dealers and their associated persons conduct their business. While these changes allow timely and efficient communication with customers, prospective customers, and others, the significant changes in communications media and capacity raise questions regarding supervision, review, and retention of correspondence with the public.

In May 1996, the SEC issued an Interpretive Release on the use of Electronic Media by Broker-Dealers, Transfer Agents, and Investment Advisors for Delivery of Information.[2] That release expressed the views of the SEC with respect to the delivery of information through electronic media in satisfaction of requirements in the federal securities laws, but did not address the applicability of any self-regulatory organization ("SRO") rules. In its release the SEC did, however, strongly encourage the SROs to work with broker/dealer firms to adapt SRO supervisory review requirements governing communications with customers to accommodate the use of electronic communications.[3]

On December 31, 1997, the SEC approved proposed rule changes filed by the National Association of Securities Dealers ("NASD")[4] and the New York Stock Exchange ("NYSE")[5] to update rules governing supervision of communication with the public. NASD Notice to Members 98-11 announced approval of the proposed rule change, provided guidance to firms on how to implement these rules and stated that the amendments to NASD Rules 3010 and 3110 would be effective on February 15, 1998. Over the next year, further amendments were made to NASD Rules 3010 and 3110. NASD Regulation received final SEC approval of amendments to Rule 3010 on November 30, 1998.[6] The rule amendments were effective on March 15, 1999.[7]

As amended, NASD Rule 3010(d)(1) provides that procedures for review of correspondence with the public relating to a member's investment banking or securities business be designed to provide reasonable supervision for each registered representative, be described in an organization's written supervisory procedures, and be evidenced in an appropriate manner. NASD Rule 3010(d)(2) requires each member to develop written policies and procedures for review of correspondence with the public relating to its investment banking or securities business tailored to its structure and the nature and size of its business and customers. These procedures must also include the review of incoming, written correspondence directed to registered representatives and related to the member's investment banking or securities business to properly identify and handle customer complaints and to ensure that customer funds and securities are handled in accordance with firm procedures.

The Board has determined to adopt substantially similar rule changes. The Board believes that conforming its rule language to the language in the NASD rules will help ensure a coordinated regulatory approach to the supervision of correspondence.

Amended Rules

Rule G-27(d)(i), as revised, provides that procedures for review of correspondence with the public relating to a dealer's municipal securities activities be designed to provide reasonable supervision for each municipal securities representative, be described in the dealer's written supervisory procedures, and be evidenced in an appropriate manner.

Rule G-27(d)(ii) requires each dealer to develop written policies and procedures for review of correspondence with the public relating to its municipal securities activities, tailored to its structure and the nature and size of its business and customers. The rule requires that any dealer that does not conduct either an electronic or manual pre-use review will be required to:

• develop appropriate supervisory procedures;

• monitor and test to ensure these policies and procedures are being implemented and complied with;

• provide education and training to all appropriate employees concerning the dealer's current policies and procedures governing correspondence, and update this training as policies and procedures are changed; and

• maintain records documenting how and when employees are educated and trained.

The rule change states that these procedures must also include the review of incoming, written correspondence directed to municipal securities representatives and related to the dealer's municipal securities activities to properly identify and handle customer complaints and to ensure that customer funds and securities are handled in accordance with the dealer's procedures.

It is the understanding and view of the Board that dealers possess the legal capacity to insist that mail addressed to their offices be deemed to be related to their businesses, even if marked to the attention of a particular associated person, if they advise associated persons that personal correspondence should not be received at their firms. Dealers, other than non-NASD member bank dealers, are reminded that SEC Rule 17a-4(b)(4) requires that "originals of all communications received . . . by such member, broker or dealer, relating to its business as such . . ." must be preserved for not less than three years.

The retention requirements of the amendments to rule G-27 cross reference rules G-8(a)(xx) and G-9(b)(viii) and (xiv) and state that the names of persons who prepared, reviewed and approved correspondence must be readily ascertainable from the retained records. The records must be made available, upon request, to the appropriate enforcement agency (i.e., NASD or federal bank regulatory agency).

Guidelines For Supervision And Review

In adopting review procedures pursuant to rule G-27(d)(i), dealers must:

• specify, in writing, the dealer's policies and procedures for reviewing different types of correspondence;

• identify how supervisory reviews will be conducted and documented;

• identify what types of correspondence will be pre- or post-reviewed;

• identify the organizational position(s) responsible for conducting review of the different types of correspondence;

• specify the minimum frequency of the reviews for each type of correspondence;

• monitor the implementation of and compliance with the dealer's procedures for reviewing public correspondence; and

• periodically re-evaluate the effectiveness of the dealer's procedures for reviewing public correspondence and consider any necessary revisions.

In conducting reviews, dealers may use reasonable sampling techniques. As an example of appropriate evidence of review, e-mail related to the dealer's municipal securities activities may be reviewed electronically and the evidence of review may be recorded electronically.

In developing supervisory procedures for the review of correspondence with the public pursuant to rule G-27(d)(ii), each dealer must consider its structure, the nature and size of its business, other pertinent characteristics, and the appropriateness of implementing uniform firm-wide procedures or tailored procedures (i.e., by specific function, office/location, individual, or group of persons).

In adopting review procedures pursuant to rule G-27(d)(ii), dealers must, at a minimum:

• specify procedures for reviewing municipal securities representatives' recommendations to customers;

• require supervisory review of some of each municipal securities representative's public correspondence, including recommendations to customers;

• consider the complaint and overall disciplinary history, if any, of municipal securities representatives and other employees (with particular emphasis on complaints regarding written or oral communications with clients); and

• consider the nature and extent of training provided municipal securities representatives and other employees, as well as their experience in using communications media (although a dealer's procedures may not eliminate or provide for minimal supervisory reviews based on an employee's training or level of experience in using communications media).

Although dealers may consider the number, size, and location of offices, as well as the volume of correspondence overall or in specific areas of the organization, dealers must nonetheless develop appropriate supervisory policies and procedures in light of their duty to supervise their associated persons. The factors listed above are not exclusive and dealers must consider all appropriate factors when developing their supervisory procedures and implementing their supervisory reviews.

Supervisory policy and procedures must also:

• provide that all customer complaints, whether received via e-mail or in written form from the customer, are kept and maintained;

• describe any dealer standards for the content of different types of correspondence; and

• prohibit municipal securities representatives' and other employees' use of electronic correspondence to the public unless such communications are subject to supervisory and review procedures developed by the dealer. For example, the Board would expect dealers to prohibit correspondence with customers from employees' home computers or through third party systems unless the dealer is capable of monitoring such communications.

The method used for conducting reviews of incoming, written correspondence to identify customer complaints and funds may vary depending on the dealer's office structure. Where the office structure permits review of all correspondence, dealers should designate a municipal securities representative or other appropriate person to open and review correspondence prior to use or distribution to identify customer complaints and funds. The designated person must not be supervised or under the control of the municipal securities representative whose correspondence is opened and reviewed. Unregistered persons who have received sufficient training to enable them to identify complaints and funds would be permitted to review correspondence.

Where the office structure does not permit the review of correspondence prior to use or distribution, appropriate procedures that could be adopted include the following:

• forwarding opened incoming written correspondence related to the dealer's municipal securities activities to a designated office, or supervising branch office, for review on a weekly basis;

• maintenance of a separate log for all checks received and securities products sold, which is forwarded to the supervising branch office on a weekly basis;

• communication to clients that they can contact the dealer directly for any matter, including the filing of a complaint, and providing them with an address and telephone number of a central office of the dealer for this purpose; and

• branch examination verification that the procedures are being followed.

Regardless of the method used for initial review of incoming, written correspondence, as with other types of correspondence, rule G-27 would still require review by a designated principal of some of each municipal securities representative's correspondence with the public relating to the dealer's municipal securities activities. Given the complexity and cost of establishing appropriate systems for effectively reviewing electronic communications, some members may determine to conduct a pre-use or distribution review of all incoming and outgoing correspondence (written or electronic).

Dealers must continually assess the effectiveness of these supervisory systems. Education and training must be timely (prior to or concurrent with implementation of the policies and procedures) and must include all appropriate employees. Dealers may incorporate the required education and training on correspondence into their Continuing Education Firm Element Training Program (see rule G-3(h) on continuing education requirements). The requirement for training regarding correspondence may also apply to employees who are not included under the Continuing Education requirements.

Concessions and discounts. This is in response to your October 13, 1986 letter asking if the Board's rules prohibit a dealer from granting a price concession on a new issue security to a customer. The Board's rules do not address the granting of concessions or price discounts to customers on new issue offerings; however, the terms of the applicable syndicate agreement may address this issue. MSRB interpretation of October 22, 1986.

Rules G-12(e)(x) and G-15(c)(viii) on deliveries of called securities provide that a certificate for which a notice of partial call has been published does not constitute good delivery unless it was identified as called at the time of trade. The rules also provide that, if a notice of call affecting an entire issue has been published on or prior to the trade date, called securities do not constitute good delivery unless identified as such at the time of trade.[1] Thus, a dealer, in some instances, must determine the date that a notice of call is published (the "publication date") to determine whether delivery of a called certificate constitutes good delivery for a particular transaction. The Board has adopted the following interpretation of rules G-12(e)(x) and G-15(e)(viii) to assist the industry in determining the publication date of a notice of a call. The Board understands this interpretation to be consistent with the procedure currently being used by certain depositories in allocating the results of partial calls.

In general, the publication date of a notice of call is the date of the edition of the publication in which the issuer, the issuer's agent or the trustee publishes the notice. To qualify as a notice of call under the rules, a notice must contain the date of the early redemption, and, for partial calls, must contain information that specifically identifies the certificates being called. If a notice of call is published on more than one date, the earliest date of publication constitutes the publication date for purposes of the rules.

If a notice of call for a registered security is not published, but is sent to registered owners, the publication date is the date shown on the notice. If no date is shown on the notice, the issuer, the trustee or the appropriate agent of the issuer should be contacted to determine the date of the notice of call.

If a notice of call of a registered security is published and also is sent directly to registered owners, the publication date is the earlier of the actual publication date or the date shown on the notice sent to registered owners. For bearer securities, the first date of publication always constitutes the publication date, even if another date is shown on the notice.

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[1] An inter-dealer delivery that does not meet these requirements may be rejected or reclaimed under rule G-12(g).

Rule G-8(a)(i) requires that dealers maintain records of original entry that include certificate numbers of all securities received or delivered. The Board has received inquiries whether a dealer must maintain in its records of original entry the certificate numbers of securities that are received or delivered by a clearing agent on behalf of the dealer or whether it is permissible for the clearing agent to maintain records of the certificate numbers for the dealer.

The Board has concluded that, for transactions in which physical securities are cleared by a clearing agent, records of the certificate numbers of the securities required by rule G-8(a)(i) may be maintained by the agent on behalf of the dealer if the dealer obtains an agreement in writing from the agent in which the following conditions are specified: (i) a complete and current record of certificate numbers of physical securities cleared by the agent will be maintained on behalf of the dealer by the agent; (ii) the agent will preserve such record, and will provide such record to the dealer promptly upon request, in a manner allowing the dealer to comply with Board rule G-9 on maintenance and preservation of records. The Board emphasizes that a dealer allowing a clearing agent to maintain records of certificate numbers on its behalf continues to be responsible for the accurate maintenance and preservation of such records in conformance with the Board’s recordkeeping rules.

Because of recent federal tax law changes which place additional restrictions on the issuance of tax-exempt municipal securities, issuers of municipal securities are issuing, or considering issuing, debt securities that are subject to federal taxation. As a result, the Municipal Securities Rulemaking Board has received numerous inquiries concerning the application of its rules to dealers effecting transactions in taxable municipal securities. The Board wishes to emphasize that its rules apply to transactions effected by brokers, dealers, and municipal securities dealers in all municipal securities. Thus, transactions in taxable municipal securities are subject to the Board's rules, including rules regarding uniform and fair practice, automated clearance and settlement, the payment of the underwriting assessment fee, and the professional qualifications of registered representatives and principals.

The Board has adopted a method for calculating the price of securities for which there are no scheduled interest payments for an initial period, generally for several years, after which periodic interest payments are scheduled. These securities, known by such names as "Growth and Income Securities," and "Capital Appreciation/Future Income Securities," function essentially as "zero coupon" securities for a period of time after issuance, accruing interest which is payable only upon redemption. On a certain date after issuance ("the interest commencement date"), the securities begin to accrue interest for semi-annual payment.

In March 1986, the Board published for comment a proposed method of calculating price from yield for such securities.[1] The Board received five comments on the proposed method, four expressing support for the method and one expressing no opinion. The commentators generally noted that the proposed method appeared to be accurate and could be used on bond calculators commonly available in the industry. The Board has adopted the proposed method of calculation, set forth below, as an interpretation of rule G-33 on calculations.

The general formula for calculating the price of securities with periodic interest payments is contained in rule G-33(b)(i)(B)(2). For securities with periodic payments, but with an initial non-interest paying period, this formula also is used.[2] For settlement dates occurring prior to the interest commencement date the price is computed by means of the following two-step process. First, a hypothetical price of the securities at the interest commencement date is calculated using the interest commencement date as the hypothetical settlement date,[3] the interest rate ("R" in the formula) for the securities during the interest payment period and the yield ("Y" in the formula) at which the securities are sold. This hypothetical price is computed to not less than six decimal places, and then is used as the redemption value ("RV" in the formula) in a second calculation using the G-33(b)(i)(B)(2) formula, with the interest commencement date as the redemption date, the actual settlement date for the transaction as the settlement date, and a value of zero for R, the interest rate. The resultant price, using the formula in G-33(b)(i)(B)(2), is the correct price of the securities.[4]

The price of such securities for settlement dates occurring after the interest commencement date, of course, should be calculated as for any other securities with periodic interest payments.[5]

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[1] MSRB Reports, Vol. 6, No. 2 (March 1986) at 13.

[2] This interpretation is not meant to apply to securities which have a long first coupon period, but which otherwise are periodic interest paying securities.

[3] For settlement dates less than 6 months to the hypothetical redemption date, the formula in rule G-33(b)(ii)(B)(1) should be used in lieu of the formula in rule G-33(b)(ii)(B)(2).

[4] Rule G-12(c)(v)(I) and G-15(a)(i)(I) [currently codified at rule G-15(a)(i)(A)(5)(c)] require that securities be priced to the lowest of price to call, price-to-par option, or price to maturity. Thus, the redemption date used for this calculation method should be the date of an "in whole" refunding call if this would result in a lower dollar price than a computation to maturity.

[5] The formula in G-33(b)(i)(B)(1) should be used for calculations in which settlement date is 6 months or less to redemption date.

Callable securities: pricing to mandatory sinking fund calls. This is in response to your February 21, 1986 letter concerning the application of rule G-15(a) regarding pricing to prerefunded bonds with mandatory sinking fund calls.

You give the following example:

Bonds, due 7/1/10, are prerefunded to 7/1/91 at 102. There are $17,605,000 of these bonds outstanding. However, there is a mandatory sinking fund which will operate to call $1,000,000 of these bonds at par every year from 7/1/86 to 7/1/91. The balance ($11,605,000) then will be redeemed 7/1/91 at 102. If this bond is priced to the 1991 prerefunded date in today's market at a 6.75 yield, the dollar price would be approximately 127.94. However, if this bond is called 7/1/86 at 100 and a customer paid the above price, his/her yield would be a minus 52 percent (-52%) on the called portion.

You state that the correct way to price the bond is to the 7/1/86 par call at a 5% level which equates to an approximate dollar price of 102.61. The subsequent yield to the 7/1/91 at 102 prerefunded date would be 12.33% if the bond survived all the mandatory calls to that date. You note that a June 8, 1978, MSRB interpretation states, "the calculation of dollar price to a premium call or par option date should be to that date at which the issuer may exercise an option to call the whole of a particular issue or, in the case of serial bonds, a particular maturity, and not to the date of a call in-part." You believe, however, that, as the rule is presently written, dealers are leaving themselves open for litigation from customers if bonds, which are trading at a premium, are not priced to the mandatory sinking fund call. You ask that the Board review this interpretation.

Your letter was referred to a Committee of the Board which has responsibility for interpreting the Board's fair practice rules. That Committee has authorized this response.

Rule G-15(a)(i)(I)[*] requires that on customer confirmations the yield and dollar price for the transaction be disclosed as the price (if the transaction is done on a yield basis) or yield (if the transaction is done on the basis of the dollar price) calculated to the lowest price or yield to call, to par option, or to maturity. The provision also requires, in cases in which the resulting dollar price or yield shown on the confirmation is calculated to call or par option, that this must be stated and the call or option date and price used in the calculation must be shown. The Board has determined that, for purposes of making this computation, only "in-whole" calls should be used.[1] This requirement reflects the longstanding practice of the municipal securities industry that a price calculated to an "in-part" call, such as a sinking fund call, is not adequate because, depending on the probability of the call provision being exercised and the portion of the issue subject to the call provision, the effective yield based on the price to a sinking fund date may not bear any relation to the likely return on the investment.

Rule G-15(a)(i)(I)[*] applies, however, only when the parties have not specified that the bonds are priced to a specific call date. In some circumstances, the parties to a particular transaction may agree that the transaction is effected on the basis of a yield to a particular date, e.g. put option date, and that the dollar price will be computed in this fashion. If that is the case, the yield to this agreed upon date must be included on confirmations as the yield at which the transaction was effected and the resulting dollar price computed to that date, together with a statement that it is a "yield to [date]." In an August 1979 interpretive notice on pricing of callable securities, the Board stated that, under rule G-30, a dealer pricing securities on the basis of a yield to a specified call feature should take into account the possibility that the call feature may not be exercised.[2] Accordingly, the price to be paid by the customer should reflect this possibility, and the resulting yield to maturity should bear a reasonable relationship to yields on securities of similar quality and maturity. Failure to price securities in such a manner may constitute a violation of rule G-30 since the price may not be "fair and reasonable" in the event the call feature is not exercised. The Board also noted that the fact that a customer in these circumstances may realize a yield in excess of the yield at which the transaction was effected does not relieve a municipal securities dealer of its responsibilities under rule G-30.

Accordingly, the calculation of the dollar price of a transaction in the securities in your example, unless the parties have agreed otherwise, should be made to the prerefunded date. Of course, under rule G-17 on fair dealing, dealers must explain to customers the existence of sinking fund calls at the time of trade. The sinking fund call, in addition, should be disclosed on the confirmation by an indication that the securities are "callable." The fact that the securities are prerefunded also should be noted on the confirmation. MSRB Interpretation of April 30, 1986.

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[1] See [Rule G-15 Interpretation - Notice Concerning Pricing to Call], December 10, 1980 at ¶ 3571.

[2] See [Rule G-30 Interpretation - Interpretive Notice on Pricing of Callable Securities], August 10, 1979 ... at ¶ 3646.

[*] [Currently codified at rule G-15(a)(i)(A)(5)]

Recently, the Board has received inquiries concerning the application of its inter-dealer and customer confirmation rules, rules G-12(c) and G-15(a) respectively, to municipal securities subject to call features. In particular, the Board has been made aware of instances in which dealers note one call date and price, usually the first in-whole call, on inter-dealer and customer confirmations without noting that the call information relates to the first in-whole call or that the bonds are otherwise callable.

Rules G-12(c) and G-15(a) require that confirmations set forth a

description of the securities, including... if the securities are... subject to redemption prior to maturity (callable)..., an indication to such effect...

Thus, municipal securities subject to in-whole or in-part calls must be described as callable. Rules G-12(c) and G-15(a) also require dealers, when securities transactions are effected on a yield basis, to set forth a dollar price that has been computed to the lowest of the price to call, price to par option, or price to maturity; rule G-15 requires that confirmations of customer transactions effected on a dollar price disclose a yield in a similar manner. These rules provide that when a price or yield is calculated to a call, this must be stated, and the call date and price used in the calculation must be shown.[1] These are the only instances in which specific call features must be identified on a confirmation.

The Board understands that confusion may arise when specific call features are noted on confirmations without an adequate description of such information. The Board has determined that confirmations that include specific call information not required to be included under the Board's confirmation rules also must include a notation that other call features exist and must provide clarifying information about the noted call, e.g. "first in-whole call." These disclosures should be sufficient to ensure that purchasing dealers and customers will be alerted to the need to obtain additional information.

The Board cautions dealers to ensure that confirmations of municipal securities with call features clearly describe the securities as "callable." If this information is erroneously noted on the confirmation, purchasing dealers have the right to reclaim the securities under rule G-12(g)(iii)(C)(3).

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[1] In addition, rule G-15(a)(iii)(D)[currently codified at rule G-15(a)(i)(C)(2)(a)] requires a legend to be placed on customer confirmations of transactions in callable securities which notes that "[additional] call features ... exist... [that may] affect yield; complete information will be provided upon request." [Note: Revised to reflect subsequent amendments]

Retroactive price adjustment for early redemption.  This is in response to your letter dated January 15, 1986, regarding the application of Board rules to a plan to guarantee a minimum return to customers who purchase certain municipal securities. You note that many [state deleted] municipalities issue General Obligation Temporary Notes with maturities of approximately one year. The municipalities also reserve the right to redeem at par any or all of the notes at any time prior to maturity. Historically, few notes are actually redeemed prior to their stated maturity.

You state that, acting as a municipal securities dealer, you desire to bid on these notes with the intent of selling them to your customers. The notes would be sold at a premium to generate trading profits. Because the notes can be redeemed by the issuer at any time at par, it is conceivable that someone who pays a premium for the notes could incur an actual return on their investment that is extremely small - even negative.

You ask whether, under Board rules, a municipal securities dealer may sell notes as described above, with the provision that if the notes are redeemed by the issuer prior to maturity, the dealer will adjust the original purchase price retroactively to provide a minimum return to the purchaser for the time held. The minimum return would be negotiated with the purchaser and confirmed in writing at the time of purchase from the dealer. You cite the following example:

The XYZ Bank, a municipal securities dealer, purchases from the City of Anywhere, $100,000 par value of its 6% General Obligation Temporary Notes, dated 1-1-86, maturing 1-1-87 at par, redeemable at anytime at the option of the issuer.

The XYZ Bank sells the notes to its customer, the ABC Bank, for settlement 1-1-86 to yield 5.75%. Can the XYZ bank agree that if the notes are redeemed prior to maturity by the issuer, it will adjust the original price at which the ABC Bank purchased the notes to provide a minimum return of at least 5% for the time held?

Board rule G-25(b) generally prohibits a municipal securities dealer from guaranteeing a customer against loss. Under the rule, put options and repurchase agreements are not deemed to be guarantees against loss if their terms are provided in writing to the customer with or on the confirmation of the transaction and recorded in accordance with rule G-8(a)(v). The rule is anti-manipulative in purpose and was designed, in part, to prevent a dealer from artificially stimulating the market in a security by selling securities to customers who assume no market risk.  In addition, rule G-25(c) prohibits a municipal securities dealer from sharing, directly or indirectly, in the profits or losses of a transaction in municipal securities with or for a customer. Finally, rule G-30 requires municipal securities dealers to effect transactions with customers at fair and reasonable prices, taking into consideration, among other matters, the price of securities of comparable quality.

The arrangement you pose may be viewed as a guarantee against loss because the dealer would guarantee the customer a minimum return on his investment. In addition, the arrangement may be viewed as a sharing of loss arising from the customer's transaction because the dealer would participate in any loss sustained by the customer when it retroactively readjusts the price of the securities downward to grant the customer the promised return. Finally, rule G-30, on prices and commissions, requires that the price charged the customer for the securities at the time of sale, without taking into account any readjustment to the price at some future date, must be fair. MSRB interpretation of January 31, 1986.