3. NNOTC Securities The market maker's interdealer sales

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Apr 23, 2013 at 3:41 PM

3. NNOTC Securities

The market maker's interdealer sales of NNOTC securities that occur contemporaneously with its retail sales are the best indication of the prevailing market price for an NNOTC security in an active, competitive market. In the absence of contemporaneous sales to other broker/dealers by a market maker, the lowest ask quotation may be used in limited circumstances as evidence of the prevailing market price if the quotations have been validated by comparing them with the member's actual interdealer transactions. Nevertheless, the Commission has required strong evidence that quotations accurately reflect prevailing market price for markup purposes before permitting such quotes to be used as a basis from which markups or mark-downs are computed.¹¹

In the absence of executed interdealer sales or validated quotes, the market maker's contemporaneous cost is the next best indicator of the prevailing market price. Should any other measure be used under these circumstances, the broker/dealer has the burden of demonstrating that the use of contemporaneous cost is not appropriate for computing markups or mark downs. For example, the NASD Board and the SEC have said that the burden is on broker/dealers, if they wish to base markups on another dealer's ask quotation, to demonstrate "the competitiveness of the market and the reliability of the quotations."¹²

Importantly, members should not confuse the requirement of validating quotes through a review of actual trades with the so-called "three call rule" under Article III, Sections 1¹³ and 21(b) of the NASD's Rules of Fair Practice. These sections require members to make a notation on the order ticket, before executing a transaction in a NNOTC security, which identifies the names of three dealers (or all dealers if less than three) contacted and the quotations received from each. Notice to Members 88-83 announcing the amendments to Article III, Section 21 states that the amendments do not change the NASD's markup policy and that "compliance with the new amendments will not necessarily assure compliance with the NASD Markup Policy." Thus, members may not automatically mark up or mark down an NNOTC security from quotations received from other dealers either over the telephone, electronically, or by other means, as those quotes are not validated and may be substantially different than the prevailing market price. So, for example, the mere fact that an inside bid/ask calculation appears with respect to a security quoted in the NASD's OTC Bulletin Board^® does not serve to validate the quotes or permit automatic execution at these prices. The validation process remains necessary, and the use of quotations is still secondary to reliance on actual interdealer transactions.

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