[Federal Register Volume 66, Number 50 (Wednesday, March 14, 2001)]
[Notices]
[Pages 14949-14969]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-6275]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-44044; File No. SR-NASD-00-04]
Self-Regulatory Organizations; Notice of Filing of Amendment No.
5 to a Proposed Rule Change by the National Association of Securities
Dealers, Inc. Relating to its Corporate Financing Rule
March 6, 2001.
Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that
on February 4, 2001, the National Association of Securities Dealers,
Inc. (``NASD''), through its wholly-owned subsidiary, NASD Regulation,
Inc. (``NASD Regulation''), filed with the Securities and Exchange
Commission (``SEC'' or ``Commission'') Amendment No. 5 \3\ to the
proposed rule change as described in Items I, II, and III below, which
Items have been prepared by NASD Regulation. The proposed rule change,
incorporating Amendment Nos. 1, 2, and 3, was published for comment in
the Federal Register on April 11, 2000.\4\ The Commission is publishing
this notice to solicit comments on Amendment No. 5 from interested
persons.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ Amendment No. 4, filed December 11, 2000, amends the
original filing and Amendment Nos. 1, 2, and 3 to respond to
comments. Amendment No. 5 supersedes Amendment No. 4 in its entirety
and makes certain technical corrections to the proposed rule change.
\4\ See Securities Exchange Act Release No. 42619 (April 4,
2000), 65 FR 19409.
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I. Self-Regulatory Organization's Statement of the Terms of
Substance of the Proposed Rule Change
In response to comments on the original proposal, NASD Regulation
is proposing additional amendments to Rules 2710 and 2720 of the NASD's
Conduct Rules. Below is the text of the proposed rule change. Proposed
new language is in italics; proposed deletions are in brackets. The
text of the proposed rule change is marked to show additions and
deletions from the NASD Corporate Financing Rule as it currently
exists. The discussion section of this notice, however, focuses on the
changes made in Amendment No. 5. For an explanation of the original
filing, see the release cited in footnote 4.
2710. Corporate Financing Rule--Underwriting Terms and Arrangements
(a) Definitions
(1) Issuer
The issuer of the securities offered to the public, any selling
security holders offering securities to the public, any affiliate of
the issuer or selling security holder, and the officers or general
partners, directors, employees and security holders thereof[;].
(2) Net Offering Proceeds
Offering proceeds less all expenses of issuance and
distribution[;].
(3) Offering Proceeds
Public offering price of all securities offered to the public, not
including securities subject to any overallotment option, securities to
be received by the underwriter and related persons, or securities
underlying other securities[;].
(4) Participating Member(s)
Any NASD member that is participating in a public offering, any
associated person of the member, any members of their immediate family,
and any affiliate of the member.
(5) Participation or Participating in a Public Offering
Participation in the preparation of the offering or other
documents, participation in the distribution of the offering on an
underwritten, non-underwritten, or any other basis, furnishing of
customer and/or broker lists for solicitation, or participation in any
advisory or consulting capacity to the issuer related to the offering,
but not the preparation of an appraisal in a savings and loan
conversion or a bank offering or the preparation of a fairness opinion
pursuant to SEC Rule 13e-3[; and].
[(5)] (6) Underwriter and Related Persons
[Includes underwriters,] Consists of underwriter's counsel,
financial consultants and advisors, finders, [members of the selling or
distribution group,] any participating member [participating in the
public offering], and any [and all] other persons [associated with or]
related to any participating member [and members of the immediate
family of any of the aforementioned persons].
(b) Filing Requirements
(1)-(3) No change.
(4) Requirement for Filing
(A) Unless filed by the issuer, the managing underwriter, or
another
[[Page 14950]]
member, a member that anticipates participating in a public offering of
securities subject to this Rule shall file with the Association the
documents and information with respect to the offering specified in
subparagraphs (5) and (6) below:
(i) No later than one business day after [the filing of:] any such
documents [with] are filed with or submitted to:
[(a)] a. The Commission; or
[(ii)] b. [with the] Any state securities commission or other
regulatory authority; or
[(iii)] (ii) If not filed with or submitted to any regulatory
authority, at least fifteen (15) business days prior to the anticipated
[offering] date on which offers will commence.
(B) No [offering] sales of securities subject to this Rule shall
commence unless:
(i) The documents and information specified in subparagraphs (5)
and (6) below have been filed with and reviewed by the Association; and
(ii) the Association has provided an opinion that it has no objections
to the proposed underwriting and other terms and arrangements or an
opinion that the proposed underwriting and other terms and arrangements
are unfair and unreasonable. If the Association's opinion states that
the proposed underwriting and other terms and arrangements are unfair
and unreasonable, the member may file modifications to the proposed
underwriting and other terms and arrangements for further review.
(C) No change.
(5) No change.
(6) Information Required to be Filed
(A) Any person filing documents with the Association pursuant to
subparagraph (4) above shall provide the following information with
respect to the offering:
(i)-(ii) No change.
(iii) a statement of the association or affiliation with any member
of any officer, or director of the issuer, of any [or security holder]
beneficial owner of [the issuer in an initial public offering of equity
securities, and with respect to any other offering provide such
information with respect to any officer, director or security holder of
five percent] 5% or more of any class of the issuer's securities, and
of any beneficial owner of the issuer's unregistered equity securities
that were purchased during the 180-day period immediately preceding the
required filing date of the public offering, except for purchases
described in subparagraph (c)(3)(B)(v) below. This statement must
identify [to include]:
a. [the identity of] The person;
b. [the identity of] The member and whether such member is
participating in any capacity in the public offering; and
c. The number of equity securities or the face value of debt
securities owned by such person, the date such securities were
acquired, and the price paid for such securities.
(iv) [A statement addressing the factors in subparagraphs (c)(4)(C)
and (D), where applicable;]
[(v)] A detailed explanation of any other arrangement entered into
during the [12-month] 180-day period immediately preceding the required
filing date of the public offering, which arrangement provides for the
receipt of any item of value [and/]or the transfer of any warrants,
options, or other securities from the issuer to the underwriter and
related persons; [and]
(v) A statement demonstrating compliance with all of the criteria
of an exception from underwriting compensation in subparagraph (d)(5)
below, when applicable; and
(vi) A detailed explanation and any documents related to:
a. The modification of any information or representation previously
provided to the Association or of any item of underwriting
compensation[,] ; or
b. Any new arrangement that provides for the receipt of any
additional item of value by any participating member subsequent to the
[review and approval of such compensation] issuance of an opinion of no
objections to the underwriting terms and arrangements by the
Association and within 90 days immediately following the date of
effectiveness or commencement of sales of the public offering.
(B) No change.
(7)-(11) No change.
(c) Underwriting Compensation and Arrangements
(1) General
No member or person associated with a member shall participate in
any manner in any public offering of securities in which the
underwriting or other terms or arrangements in connection with or
relating to the distribution of the securities, or the terms and
conditions related thereto, are unfair or unreasonable.
(2) Amount of Underwriting Compensation
(A) No member or person associated with a member shall receive an
amount of underwriting compensation in connection with a public
offering [which] that is unfair or unreasonable and no member or person
associated with a member shall underwrite or participate in a public
offering of securities if the underwriting compensation in connection
with the public offering is unfair or unreasonable.
(B)-(D) No change.
(E) The maximum amount of compensation (stated as a percentage of
the dollar amount of the offering proceeds) [which] that is considered
fair and reasonable generally will vary directly with the amount of
risk to be assumed by [the underwriter and related persons]
participating members and inversely with the dollar amount of the
offering proceeds.
(3) Items of [Compensation] Value
(A) For purposes of determining the amount of underwriting
compensation received or to be received by the underwriter and related
persons pursuant to subparagraph (c)(2) above, the following items and
all other items of value received or to be received by the underwriter
and related persons in connection with or related to the distribution
of the public offering, as determined pursuant to [sub]paragraph [(4)]
(d) below shall be included:
(i)-(iii) No change.
(iv) Finder's fees, whether in the form of cash, securities or any
other item of value;
(v) Wholesaler's fees;
(vi) Financial consulting and advisory fees, whether in the form of
cash, securities, or any other item of value;
(vii) Common or preferred stock, options, warrants, and other
equity securities, including debt securities convertible to or
exchangeable for equity securities, [including securities] received [as
underwriting compensation, for example]:
a. [in connection with a] For acting as private placement agent [of
securities] for the issuer;
b. For providing or arranging a loan, credit facility, [bridge
financing] merger or acquisition services, or any other service for the
issuer;
[c. As a finder's fee;]
[d. For consulting services to the issuer; and]
[e.] c. [securities purchased] As an investment in a private
placement made by the issuer; or
d. At the time of the public offering;
(viii) Special sales incentive items [in compliance with
subparagraph (6)(B)(xi)];
(ix) Any right of first refusal provided to [the underwriter and
related persons] any participating member to underwrite or participate
in future public offerings, private placements or other financings,
[[Page 14951]]
which will have a compensation value of 1% of the offering proceeds or
that dollar amount contractually agreed to by the issuer and
underwriter to waive or terminate the right of first refusal;
(x) No change.
(xi) commissions, expense reimbursements, or other compensation to
be received by the underwriter and related persons as a result of the
exercise or conversion, within twelve [(12)] months following the
effective date of the offering, of warrants, options, convertible
securities, or similar securities distributed as part of the public
offering; and
(xii) fees of a qualified independent underwriter[; and].
[(xiii) compensation, including expense reimbursements, paid in the
six (6) months prior to the initial or amended filing of the prospectus
or similar documents to any member or person associated with a member
for a public offering that was not completed.]
(B) Notwithstanding subparagraph (c)(3)(A) above, the following
shall not be considered an item of value:
(i) [E] expenses customarily borne by an issuer, such as printing
costs; SEC, ``blue sky'' and other registration fees; Association
filing fees; and accountant's fees, [shall be excluded from
underwriter's compensation] whether or not paid through [an
underwriter] a participating member;
(ii) Compensation, including expense reimbursements, previously
paid to any member in connection with a proposed public offering that
was not completed, if the member does not participate in the revised
public offering;
(iii) Cash compensation for acting as placement agent for a private
placement or for providing a loan, credit facility, or for services in
connection with a merger/acquisition;
(iv) Listed securities purchased in public market transactions;
(v) Securities acquired through any stock bonus, pension, or
profit-sharing plan that qualifies under Section 401 of the Internal
Revenue Code; and
(vi) Securities acquired by an investment company registered under
the Investment Company Act of 1940.
[(4)] (d) Determination of Whether [Compensation Is Received in
Connection With the Offering] Items of Value Are Included In
Underwriting Compensation
[(A)] (1) Pre-Offering Compensation
All items of value received [or to be received] and all
arrangements entered into for the future receipt of an item of value by
the underwriter and related persons during the [twelve (12) month]
period commencing 180 days immediately preceding the required filing
date of the registration statement or similar document pursuant to
subparagraph (b)(4) above[, and at the time of and subsequent to] until
the date of effectiveness or commencement of sales of the public
offering[,] will be [examined to determine whether such items of value
are] considered to be underwriting compensation in connection with the
public offering [and, if received during the six (6) month period
immediately preceding the filing of the registration statement or
similar document, will be presumed to be underwriting compensation
received in connection with the offering, provided, however, that such
presumption may be rebutted on the basis of information satisfactory to
the Association to support a finding that the receipt of an item is not
in connection with the offering and shall not include cash discounts or
commissions received in connection with a prior distribution of the
issuer's securities].
(2) Undisclosed and Post-Offering Compensation
All items of value received and all arrangements entered into for
the future receipt of an item of value by any participating member that
are not disclosed to the Association prior to the date of effectiveness
or commencement of sales of a public offering, including items of value
received subsequent to the public offering, are subject to post-
offering review to determine whether such items of value are, in fact,
underwriting compensation for the public offering.
[(B) Items of value received by an underwriter and related person
more than twelve (12) months immediately preceding the date of filing
of the registration statement or similar document will be presumed not
to be underwriting compensation. However, items received prior to such
twelve (12) month period may be included as underwriting compensation
on the basis of information to support a finding that receipt of the
item is in connection with the offering.]
[(C) For purposes of determining whether any item of value received
or to be received by the underwriter and related persons is in
connection with or related to the distribution of the public offering,
the following factors, as well as any other relevant factors and
circumstances, shall be considered:]
[(i) The length of time between the date of filing of the
registration statement or similar document and:]
[a. The date of the receipt of the item of value;]
[b. The date of any contractual agreement for services for which
the item of value was or is to be received; and]
[c. The date the performance of the service commenced, with a
shorter period of time tending to indicate that the item is received in
connection with the offering;]
[(ii) The details of the services provided or to be provided for
which the item of value was or is to be received;]
[(iii) The relationship between the services provided or to be
provided for which the item of value was or is to be received and:]
[a. The nature of the item of value;]
[b. The compensation value of the item; and]
[c. The proposed public offering;]
[(iv) The presence or absence of arm's length bargaining or the
existence of any affiliate relationship between the issuer and the
recipient of the item of value, with the absence of arm's length
bargaining or the presence of any affiliation tending to indicate that
the item of value is received in connection with the offering.]
[(D) For purposes of determining whether securities received or to
be received by the underwriter and related persons are in connection
with or related to the distribution of the public offering, the factors
in subparagraph (C) above and the following factors shall be
considered:]
[(i) Any disparity between the price paid and the offering price or
the market price, if a bona fide independent market exists at the time
of acquisition, with a greater disparity tending to indicate that the
securities constitute compensation;]
[(ii) The amount of risk assumed by the recipient of the
securities, as determined by:]
[a. The restrictions on exercise and resale;]
[b. The nature of the securities (e.g., warrant, stock, or debt);
and]
[c. The amount of securities, with a larger amount of readily
marketable securities without restrictions on resale or a warrant for
securities tending to indicate that the securities constitute
compensation; and]
[(iii) The relationship of the receipt of the securities to
purchases by unrelated purchasers on similar terms at approximately the
same time, with an absence of similar purchases tending to indicate
that the securities constitute compensation.]
[(E) Notwithstanding the provisions of subparagraph (3)(A)(vi)
above, financial consulting and advisory fees may be excluded from
underwriting compensation upon a finding by the
[[Page 14952]]
Association, on the basis of information satisfactory to it, that an
ongoing relationship between the issuer and the underwriter and related
person has been established at least twelve (12) months prior to the
filing of the registration statement or similar document or that the
relationship, if established subsequent to that time, was not entered
into in connection with the offering, and that actual services have
been or will be rendered which were not or will not be in connection
with or related to the offering.]
(3) Date of Receipt of Securities
Securities of the issuer acquired by the underwriter and related
persons will be considered to be received for purposes of subparagraphs
(d)(1) and (d)(5) as of the date of the:
(A) Closing of a private placement, if the securities were
purchased in or received for arranging a private placement; or
(B) Execution of a written contract with detailed provisions for
the receipt of securities as compensation for a loan, credit facility,
or put option; or
(C) transfer of beneficial ownership of the securities, if the
securities were received as compensation for consulting or advisory
services, merger or acquisition services, acting as a finder, or for
any other service.
(4) Definitions
For purposes of subparagraph (d)(5) below, the following terms will
have the meanings stated below.
(A) An entity:
(i) Includes a group of legal persons that either:
a. Are contractually obligated to make co-investments and have
previously made at least one such investment; or
b. Have filed a Form 13D or 13G with the SEC that identifies the
legal persons as members of a group who have agreed to act together for
the purpose of acquiring, holding, voting or disposing of equity
securities of an issuer in connection with a previous investment; and
(ii) May make its investment or loan through a wholly owned
subsidiary (except when the entity is a group of legal persons).
(B) An institutional investor is any individual or legal person
that has at least $50 million invested in securities in the aggregate
in its portfolio or under management, including investments held by its
wholly owned subsidiaries; provided that no participating member has an
equity interest in or manages or otherwise directs the institutional
investor's investments.
(C) A right of preemption means the right of a shareholder to
acquire additional securities in the same company in order to avoid
dilution when additional securities are issued, pursuant to:
(i) Any option, shareholder agreement, or other contractual right
entered into at the time of a purchase of securities;
(ii) The terms of the security purchased;
(iii) The issuer's charter or by-laws; or
(iv) The domestic law of a foreign jurisdiction that regulates the
issuance of the securities.
(D) ``Total equity securities'' means the aggregate of the total
shares of:
(i) Common stock outstanding of the issuer; and
(ii) Common stock of the issuer underlying all convertible
securities outstanding that convert without the payment of any
additional consideration.
(5) Exceptions From Underwriting Compensation
Notwithstanding subparagraph (d)(1) above, the following items of
value are excluded from underwriting compensation (but are subject to
the lock-up restriction in subparagraph (g)(1) below), provided that
the member does not condition its participation in the public offering
on an acquisition of securities under an exception and any securities
purchased are purchased at the same price and with the same terms as
the securities purchased by all other investors.
(A) Purchases and Loans by Certain Entities--Securities of the
issuer purchased in a private placement or received as compensation for
a loan or credit facility before the required filing date of the public
offering pursuant to subparagraph (b)(4) above by certain entities if:
(i) Each entity:
a. Either:
1. Manages capital contributions or commitments of $100 million or
more, at least $75 million of which has been contributed or committed
by persons that are not participating members;
2. Manages capital contributions or commitments of $25 million or
more, at least 75% of which has been contributed or committed by
persons that are not participating members;
3. Is an insurance company as defined in Section 2(a)(13) of the
Securities Act or is a foreign insurance company that has been granted
an exemption under this Rule; or
4. Is a bank as defined in Section 3(a)(6) of the Act or is a
foreign bank that has been granted an exemption under this Rule; and
b. Is a separate and distinct legal person from any member and is
not registered as a broker/dealer;
c. Makes investments or loans subject to the evaluation of
individuals who have a contractual or fiduciary duty to select
investments and loans based on the risks and rewards to the entity and
not based on opportunities for the member to earn investment banking
revenues;
d. Does not participate directly in investment banking fees
received by any participating member for underwriting public offerings;
and
e. Has been primarily engaged in the business of making investments
in or loans to other companies; and
(ii) The total amount of securities received by all entities
related to each member does not exceed 10% of the issuer's total equity
securities, calculated immediately following the transaction.
(B) Investments In and Loans to Certain Issuers--Securities of the
issuer purchased in a private placement or received as compensation for
a loan or credit facility before the required filing date of the public
offering pursuant to subparagraph (b)(4) above by certain entities if:
(i) Each entity:
a. Manages capital contributions or commitments of at least $50
million;
b. Is a separate and distinct legal person from any member and is
not registered as a broker/dealer;
c. Does not participate directly in investment banking fees
received by the member for underwriting public offerings; and
d. Has been primarily engaged in the business of making investments
in or loans to other companies; and
(ii) Institutional investors beneficially own at least 33% of the
issuer's total equity securities, calculated immediately prior to the
transaction;
(iii) The transaction was approved by a majority of the issuer's
board of directors and a majority of any institutional investors, or
the designees of institutional investors, that are board members; and
(iv) The total amount of securities received by all entities
related to each member does not exceed 10% of the issuer's total equity
securities, calculated immediately following the transaction.
(C) Private Placements With Institutional Investors--Securities of
the issuer purchased in, or received as placement agent compensation
for, a private placement before the required filing date of the public
offering pursuant to subparagraph (b)(4) above if:
[[Page 14953]]
(i) institutional investors purchase at least 51% of the ``total
offering'' (comprised of the total number of securities sold in the
private placement and received or to be received as placement agent
compensation by any member);
(ii) an institutional investor was the lead negotiator or, if the
terms were not negotiated, was the lead investor with the issuer to
establish or approve the terms of the private placement; and
(iii) underwriters and related persons did not, in the aggregate,
purchase or receive as placement agent compensation more than 20% of
the ``total offering'' (excluding purchases by any entity qualified
under subparagraph (d)(5)(A) above).
(D) Acquisitions and Conversions to Prevent Dilution--Securities of
the issuer if:
(i) The securities were acquired as the result of:
a. A right of preemption that was granted in connection with
securities that were purchased either:
1. In a private placement and the securities are not deemed by the
Association to be underwriting compensation; or
2. From a public offering or the public market; or
b. A stock-split or a pro-rata rights or similar offering; or
c. The conversion of securities that have not been deemed by the
Association to be underwriting compensation; and
(ii) The only terms of the purchased securities that are different
from the terms of securities purchased by other investors are pre-
existing contractual rights that were granted in connection with a
prior purchase;
(iii) The opportunity to purchase in a rights offering or pursuant
to a right of preemption, or to receive additional securities as the
result of a stock-split or conversion was provided to all similarly
situated securityholders; and
(iv) The amount of securities purchased or received did not
increase the recipient's percentage ownership of the same generic class
of securities of the issuer or of the class of securities underlying a
convertible security calculated immediately prior to the investment,
except in the case of conversions.
(E) Purchases Based On A Prior Investment History--Purchases of
securities of the issuer if:
(i) The amount of securities purchased did not increase the
purchaser's percentage ownership of the same generic class of
securities of the issuer or of the class of securities underlying a
convertible security calculated immediately prior to the investment;
and
(ii) An initial purchase of securities of the issuer was made at
least two years and a second purchase was made more than 180 days
before the required filing date of the public offering pursuant to
subparagraph (b)(4) above.
(F) Financial Consulting and Advisory Arrangements--Compensation
received by a financial consultant or advisor if:
(i) The consulting/advisory relationship was established pursuant
to a written and executed agreement entered into more than one year
before the required filing date of the public offering pursuant to
subparagraph (b)(4) above;
(ii) Any securities received or to be received do not exceed the
amount and type specified in the agreement;
(iii) Substantive services were provided on an ongoing basis to the
issuer during the one-year period; and
(iv) The consultant/advisor has routinely provided similar services
to other companies.
[(5)] (e) Valuation of Non-Cash Compensation
For purposes of determining the value to be assigned to securities
received as underwriting compensation, the following criteria and
procedures shall be applied[:].
[(A) No underwriter and related person may receive a security or a
warrant for a security as compensation in connection with the
distribution of a public offering that is different than the security
to be offered to the public unless the security received as
compensation has a bona fide independent market, provided, however,
that: (i) In exceptional and unusual circumstances, upon good cause
shown, such arrangement may be permitted by the Association; and (ii)
in an offering of units, the underwriter and related persons may only
receive a warrant for the unit offered to the public where the unit is
the same as the public unit and the terms are no more favorable than
the terms of the public unit.]
(1) Limitation on Securities Received Upon Exercise or Conversion of
Another Security
An underwriter and related person may not receive a security
(including securities in a unit), a warrant for a security, or a
security convertible into another security as underwriting compensation
in connection with a public offering unless:
(A) the security received or the security underlying the warrant or
convertible security received is identical to the security offered to
the public or to a security with a bona fide independent market; or
(B) the security can be accurately valued, as required by
subparagraph (f)(2)(I) below.
[(B)] (2) Valuation of Securities That Do Not Have an Exercise or
Conversion Price
[s] Securities that [are not options, warrants or convertible
securities] do not have an exercise or conversion price shall have a
compensation value [be valued on the basis of] based on:
[(i)] (A) The difference between [the per security cost and]:
(i) Either the market price per security on the date of
acquisition, [where a] or, if no bona fide independent market exists
for the security, [or] the [proposed (and actual)] public offering
price per security; and
(ii) The per security cost;
[(ii)] (B) Multiplied by the number of securities received or to be
received as underwriting compensation;
[(iii)] (C) Divided by the offering proceeds; and
[(iv)] (D) Multiplied by one hundred [(100)].
(3) Valuation of Securities That Have an Exercise or Conversion Price
[(C) o] Options, warrants or convertible securities that have an
exercise or conversion price (``warrants'') shall [be valued on the
basis of the following formula] have a compensation value based on:
[(i)] (A) The [proposed (and actual)] public offering price per
security multiplied by .65 [(65%)];
[(ii)] (B) Minus the [difference between] resultant of the exercise
or conversion price per [security] warrant [and] less either:
(i) The market price per security on the date of acquisition, where
a bona fide independent market exists for the security, or
(ii) The [proposed (and actual)] public offering price per
security;
[(iii)] (C) Divided by two [(2)];
[(iv)] (D) Multiplied by the number of securities underlying the
warrants[, options, and convertible securities received or to be
received as underwriting compensation];
[(v)] (E) Less the total price paid for the [securities] warrants;
[(vi)] (F) Divided by the offering proceeds; and
[(vii)] (G) Multiplied by one hundred [(100).];
(H) Provided, however, that such warrants shall have a compensation
value of at least .2% of the offering proceeds for each amount of
securities that is up to 1% of the securities being
[[Page 14954]]
offered to the public (excluding securities subject to an overallotment
option).
(4) Valuation Discount For Securities With a Longer Resale Restriction
[(D) a lower value equal to 80% and 60% of the calculated value
shall be assigned if securities, and where relevant, underlying
securities, are or will be restricted from sale, transfer, assignment
or other disposition for a period of one and two years, respectively,
beyond the one-year period of restriction required by subparagraph
(7)(A)(i) below.]
A lower value equal to 10% of the calculated value shall be
deducted for each 180-day period that the securities or underlying
securities are restricted from sale or other disposition beyond the
180-day period of the lock-up restriction required by subparagraph
(g)(1) below. The transfers permitted during the lock-up restriction by
subparagraphs (g)(2)(A)(iii)-(iv) are not available for such
securities.
[(6)] (f) Unreasonable Terms and Arrangements
[(A)] (1) General
No member or person associated with a member shall participate in
any manner in a public offering of securities after any arrangement
proposed in connection with the public offering, or the terms and
conditions relating thereto, has been determined to be unfair or
unreasonable pursuant to this Rule or inconsistent with any By-Law or
any Rule or regulation of the Association.
[(B)] (2) Prohibited Arrangements
Without limiting the foregoing, the following terms and
arrangements, when proposed in connection with [the distribution of] a
public offering of securities, shall be unfair and unreasonable[:].
[(i)] (A) [a]Any accountable expense allowance granted by an issuer
to the underwriter and related persons [which] that includes payment
for general overhead, salaries, supplies, or similar expenses of the
underwriter incurred in the normal conduct of business[;].
[(ii)] (B) [a]Any non-accountable expense allowance in excess of
[three (3) percent;] 3% of offering proceeds.
[(iii)] (C) [a]Any payment of commissions or reimbursement of
expenses directly or indirectly to the underwriter and related persons
prior to commencement of the public sale of the securities being
offered, except a reasonable advance against out-of-pocket accountable
expenses actually anticipated to be incurred by the underwriter and
related persons, which advance is reimbursed to the issuer to the
extent not actually incurred[;].
[(iv)] (D) [t]The payment of any compensation by an issuer to a
member or person associated with a member in connection with an
offering of securities [which] that is not completed according to the
terms of agreement between the issuer and underwriter, except those
negotiated and paid in connection with a transaction that occurs in
lieu of the proposed offering as a result of the efforts of the
underwriter and related persons and provided, however, that the
reimbursement of out-of-pocket accountable expenses actually incurred
by the member or person associated with a member shall not be presumed
to be unfair or unreasonable under normal circumstances[;].
[(v)] (E) [a]Any ``tail fee'' arrangement granted to the
underwriter and related persons that has a duration of more than two
[(2)] years from the date the member's services are terminated, in the
event that the offering is not completed in accordance with the
agreement between the issuer and the underwriter and the issuer
subsequently consummates a similar transaction, except that a member
may demonstrate on the basis of information satisfactory to the
Association that an arrangement of more than two [(2)] years is not
unfair or unreasonable under the circumstances.
[(vi)] (F) [a]Any right of first refusal provided to the
underwriter or related persons to underwrite or participate in future
public offerings, private placements or other financings [which] that:
[a.] (i) Has a duration of more than three [(3)] years from the
[effective] date of effectiveness or commencement of sales of the
public offering; or
[b.] (ii) Has more than one opportunity to waive or terminate the
right of first refusal in consideration of any payment or fee[;].
[(vii)] (G) [a]Any payment or fee to waive or terminate a right of
first refusal regarding future public offerings, private placements or
other financings provided to the underwriter and related persons
[which] that:
[a.](i) Has a value in excess of the greater of [one percent (] 1%
[)] of the offering proceeds in the public offering where the right of
first refusal was granted (or an amount in excess of [one percent] 1%
if additional compensation is available under the compensation
guideline of the original offering) or [five percent (] 5% [)] of the
underwriting discount or commission paid in connection with the future
financing (including any overallotment option that may be exercised),
regardless of whether the payment or fee is negotiated at the time of
or subsequent to the original public offering; or
[b.](ii) Is not paid in cash[;].
[(viii)] (H) The terms or the exercise of the terms of an agreement
for the receipt by the underwriter and related persons of underwriting
compensation consisting of any option, warrant or convertible security
[which] that:
[a.] (i) Is exercisable or convertible more than five [(5)] years
from the effective date of the offering;
[b. Is exerciseable or convertible at a price below either the
public offering price of the underlying security or, if a bona fide
independent market exists for the security or the underlying security,
the market price at the time of receipt;]
[c.] (ii) Is not in compliance with subparagraph [(5)(A)] (e)(1)
above;
[d.] (iii) Has more than one demand registration right at the
issuer's expense;
[e.] (iv) Has a demand registration right with a duration of more
than five [(5)] years from the [effective] date of effectiveness or the
commencement of sales of the public offering;
[f.] (v) Has a piggyback registration right with a duration of more
than seven [(7)] years from the [effective] date of effectiveness or
the commencement of sales of the public offering;
[g.] (vi) Has anti-dilution terms [designed to provide] that allow
the underwriter and related persons [with disproportionate rights,
privileges and economic benefits which are not provided to the
purchasers of the securities offered to the public (or the public
shareholders, if in compliance with subparagraph (5)(A) above)] to
receive more shares or to exercise at a lower price than originally
agreed upon at the time of the public offering, when the public
shareholders have not been proportionally affected by a stock split,
stock dividend, or other similar event; or
[h.] (vii) Has anti-dilution terms [designed to provide for the
receipt or accrual of] that allow the underwriter and related persons
to receive or accrue cash dividends prior to the exercise or conversion
of the security[; or].
[i. Is convertible or exercisable or otherwise is on terms more
favorable
[[Page 14955]]
than the terms of the securities being offered to the public;]
[(ix)] (I) [t]The receipt by the underwriter and related persons of
any item of compensation for which a value cannot be determined at the
time of the offering[;].
[(x)] (J) [w]When proposed in connection with the distribution of a
public offering of securities on a ``firm commitment'' basis, any over
allotment option providing for the over allotment of more than [fifteen
(15) percent] 15% of the amount of securities being offered, computed
excluding any securities offered pursuant to the over allotment
option[;].
[(xi) stock numerical limitation. The receipt by the underwriter
and related persons of securities which constitute underwriting
compensation in an aggregate amount greater than ten (10) percent of
the number or dollar amount of securities being offered to the public,
which is calculated to exclude:]
[a. any securities deemed to constitute underwriting compensation;]
[b. any securities issued pursuant to an overallotment option;]
[c. in the case of a ``best efforts'' offering, any securities not
actually sold; and]
[d. any securities underlying warrants, options, or convertible
securities which are part of the proposed offering, except where
acquired as part of a unit;]
[(xii)] (K) [t]The receipt by a member or person associated with a
member, pursuant to an agreement entered into at any time before or
after the effective date of a public offering of warrants, options,
convertible securities or units containing such securities, of any
compensation or expense reimbursement in connection with the exercise
or conversion of any such warrant, option, or convertible security in
any of the following circumstances:
[a.](i) The market price of the security into which the warrant,
option, or convertible security is exercisable or convertible is lower
than the exercise or conversion price;
[b.](ii) The warrant, option, or convertible security is held in a
discretionary account at the time of exercise or conversion, except
where prior specific written approval for exercise or conversion is
received from the customer;
[c.](iii) The arrangements whereby compensation is to be paid are
not disclosed:
[1.]a. In the prospectus or offering circular by which the
warrants, options, or convertible securities are offered to the public,
if such arrangements are contemplated or any agreement exists as to
such arrangements at that time, and
[2.]b. In the prospectus or offering circular provided to security
holders at the time of exercise or conversion; or
[d.](iv) The exercise or conversion of the warrants, options or
convertible securities is not solicited by the underwriter or related
person, provided however, that any request for exercise or conversion
will be presumed to be unsolicited unless the customer states in
writing that the transaction was solicited and designates in writing
the broker/dealer to receive compensation for the exercise or
conversion[;].
[(xiii)] (L) [f]For a member or person associated with a member to
accept, directly or indirectly, any non-cash sales incentive item
including, but not limited to, travel bonuses, prizes and awards, from
an issuer or an affiliate thereof in excess of $100 per person per
issuer annually. Notwithstanding the foregoing, a member may provide
non-cash sales incentive items to its associated persons provided that
no issuer, or an affiliate thereof, including specifically an affiliate
of the member, directly or indirectly participates in or contributes to
providing such non-cash sales incentive[; or].
[(xiv)] (M) [f]For a member to participate with an issuer in the
public distribution of a non-underwritten issue of securities if the
issuer hires persons primarily for the purpose of distributing or
assisting in the distribution of the issue, or for the purpose of
assisting in any way in connection with the underwriting, except to the
extent in compliance with 17 C.F.R. Sec. 240.3a4-1 and applicable state
law.
[(xv)] N [f] For a member or person associated with a member to
participate in a public offering of real estate investment trust
securities, as defined in Rule 2340(c)(4), unless the trustee will
disclose in each annual report distributed to investors pursuant to
Section 13(a) of the Act a per share estimated value of the trust
securities, the method by which it was developed, and the date of the
data used to develop the estimated value.
[(C) In the event that the underwriter and related persons receive
securities deemed to be underwriting compensation in an amount
constituting unfair and unreasonable compensation pursuant to the stock
numerical limitation in subparagraph (B)(ix) above, the recipient shall
return any excess securities to the issuer or the source from which
received at cost and without recourse, except that in exceptional and
unusual circumstances, upon good cause shown, a different arrangement
may be permitted.]
[(7)] (g) Lock-Up Restriction[s] on Securities
[(A) No member or person associated with a member shall participate
in any public offering which does not comply with the following
requirements:]
[(i) Securities deemed to be underwriting compensation shall not be
sold, transferred, assigned, pledged or hypothecated by any person,
except as provided in subparagraph (B) below, for a period of (a) one
year following the effective date of the offering. However, securities
deemed to be underwriting compensation may be transferred to any member
participating in the offering and the bona fide officers or partners
thereof and securities which are convertible into other types of
securities or which may be exercised for the purchase of other
securities may be so transferred, converted or exercised if all
securities so transferred or received remain subject to the
restrictions specified herein for the remainder of the initially
applicable time period;]
[(ii) Certificates or similar instruments representing securities
restricted pursuant to subparagraph (i) above shall bear an appropriate
legend describing the restriction and stating the time period for which
the restriction is operative; and]
[(iii) Securities to be received by a member as underwriting
compensation shall only be issued to a member participating in the
offering and the bona fide officers or partners thereof.]
(1) Lock-Up Restriction
Any common or preferred stock, options, warrants, and other equity
securities of the issuer, including debt securities convertible to or
exchangeable for equity securities of the issuer, that are beneficially
owned by any person that is an underwriter and related person on the
date of effectiveness or commencement of sales of the public offering
shall not be sold during the offering or sold, transferred, assigned,
pledged, or hypothecated, or be the subject of any hedging, short sale,
derivative, put, or call transaction that would result in the effective
economic disposition of the securities by any person for a period of
180 days immediately following the date of effectiveness or
commencement of sales of the public offering, except as provided in
subparagraph (g)(2) below.
(2) Exceptions to Lock-Up Restriction
[(B) The provisions of subparagraph (A) notwithstanding:]
Notwithstanding subparagraph (g)(1) above, the following shall not
be prohibited:
[[Page 14956]]
(A) The transfer of any security:
(i) By operation of law or by reason of reorganization of the
issuer [shall not be prohibited.];
(ii) To any member participating in the offering and the officers
or partners thereof, if all securities so transferred remain subject to
the lock-up restriction in subparagraph (g)(1) above for the remainder
of the time period;
[(C) Venture capital restrictions. When a member participates in
the initial public offering of an issuer's securities, such member or
any officer, director, general partner, controlling shareholder or
subsidiary of the member or subsidiary of such controlling shareholder
or a member of the immediate family of such persons, who beneficially
owns any securities of said issuer at the time of filing of the
offering, shall not sell such securities during the offering or sell,
transfer, assign or hypothecate such securities for ninety (90) days
following the effective date of the offering unless:]
[(i) The price at which the issue is to be distributed to the
public is established at a price no higher than that recommended by a
qualified independent underwriter who does not beneficially own 5% or
more of the outstanding voting securities of the issuer, who shall also
participate in the preparation of the registration statement and the
prospectus, offering circular, or similar document and who shall
exercise the usual standards of ``due diligence'' in respect thereto;
or]
[(ii)] (iii) If the aggregate amount of [such] securities of the
issuer held by [such a member and its related persons enumerated above
would] the underwriter or related person do not exceed 1% of the
securities being offered;
(iv) That is beneficially owned on a pro-rata basis by all equity
owners of an investment fund, provided that no participating member
manages or otherwise directs investments by the fund and participating
members in the aggregate do not own more than 10% of the equity in the
fund;
(v) That is not an item of value under subparagraphs (c)(3)(B)(iv)-
(vi) above;
(vi) That was previously but is no longer subject to the lock-up
restriction in subparagraph (g)(1) above in connection with a prior
public offering; or
(vii) That was acquired before the period commencing 180 days
immediately preceding the required filing date pursuant to subparagraph
(b)(4) above and:
a. The class of security qualifies as an ``actively traded
security'' under SEC Rule 101(c)(1) of Regulation M as of the date of
effectiveness or commencement of sales of the public offering; or
b. Is beneficially owned by a person that is not a participating
member; or
(B) The exercise or conversion of any security, if all securities
received remain subject to the lock-up restriction in subparagraph
(g)(1) above for the remainder of the time period.
[(8)] (h) [Conflicts of Interest] Proceeds Directed to a Member[:]
(1) Compliance With Rule 2720
No member shall participate in a public offering of an issuer's
securities where more than [ten (10) percent] 10% of the net offering
proceeds, not including underwriting compensation, are intended to be
paid to [members participating in the distribution of the offering or
associated or affiliated persons of such members, or members of the
immediate family of such persons] participating members, unless the
price at which an equity issue or the yield at which a debt issue is to
be distributed to the public is established pursuant to Rule
2720(c)(3).
[(A)] (2) Disclosure
All offerings included within the scope of [this] subparagraph
[(8)] (h)(1) shall disclose in the underwriting or plan of distribution
section of the registration statement, offering circular or other
similar document that the offering is being made pursuant to the
provisions of this subparagraph and, where applicable, the name of the
member acting as qualified independent underwriter, and that such
member is assuming the responsibilities of acting as a qualified
independent underwriter in pricing the offering and conducting due
diligence.
[(B)] (3) Exception From Compliance
The provisions of [this] subparagraphs [(8)] (h)(1) and (2) shall
not apply to:
[(i)] (A) An offering otherwise subject to the provisions of Rule
2720;
[(ii)] (B) An offering of securities exempt from registration with
the Commission under Section 3(a)(4) of the Securities Act of 1933;
[(iii)] (C) An offering of a real estate investment trust as
defined in Section 856 of the Internal Revenue Code; or
[(iv)] (D) An offering of securities subject to Rule 2810, unless
the net offering proceeds are intended to be paid to the above persons
for the purpose of repaying loans, advances or other types of financing
utilized to acquire an interest in a pre-existing company.
[(d)] (i) Exemptions
Pursuant to the Rule 9600 Series, the [Association may exempt a
member or person associated with a member from the provisions of this
Rule] staff, for good cause shown after taking into consideration all
relevant factors, may conditionally or unconditionally grant an
exemption from any provision of this Rule to the extent that such
exemption is consistent with the purposes of the Rule, the protection
of investors, and the public interest.
2720. Distribution of Securities of Members and Affiliates--Conflicts
of Interest
(a) General
No Change.
(b) Definitions
(1)-(8) No Change.
(9) Immediate family--the parents, mother-in-law, father-in-law,
[husband or wife] spouse, brother or sister, brother-in-law or sister-
in-law, son-in-law or daughter-in-law, and children of an employee or
associated person of a member, except any person other than the spouse
and children who does not live in the same household as, have a
business relationship with, provide material support to, or receive
material support from the employee or associated person of a member. In
addition, the immediate family includes [or] any other person who [is
supported, directly or indirectly, to a material extent by] either
lives in the same household as, provides material support to, or
receives material support from an employee [of,] or associated person
[associated, with] of a member.
II. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
In its filing with the Commission, NASD Regulation included
statements concerning the purpose of, and basis for, the proposed rule
change and discussed any comments it received on the proposed rule
change. The text of these statements may be examined at the places
specified in Item IV below. NASD Regulation has prepared summaries, set
forth in Sections A, B, and C below, of the most significant aspects of
such statements.
A. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
1. Purpose
On December 11, 2000 and February 1, 2001, NASD Regulation filed
[[Page 14957]]
proposed amendments to the Corporate Financing Rule (``Rule'') that
were intended to modernize and simplify the Rule (``original rule
filing'' or ``original proposal''). The original rule filing contained
an objective standard that members and the staff could follow to
determine whether any ``items of value,'' such as fees and securities,
provided by an issuer to underwriters and related persons should be
included in the calculation of underwriting compensation under the
Rule. Under this standard, all items of value received by underwriters
and related persons from 180 days before the filing of a registration
statement until the date of effectiveness or commencement of sales of
the public offering (``180-day review period'') would be deemed to be
underwriting compensation, unless the items were received in a
transaction that met one of four exceptions. The exceptions were
intended to establish transaction criteria that would distinguish
between securities acquired as bona fide investments from securities
acquired as underwriting compensation.
In addition, the original rule filing proposed a 180-day lock-up
restriction on sales of any securities of the issuer held by any person
covered by the definition of underwriter and related person at the time
of the public offering, with certain exceptions. The original rule
filing also proposed to delete the 10% limitation on the amount of
securities deemed to be underwriting compensation, known as the Stock
Numerical Limitation, and the prohibition on warrants having an
exercise price below the public offering price. In addition, the
original rule filing proposed to amend provisions that had become
problematic or unnecessary as applied to current industry practices or
particular types of issuers.
The SEC published the original proposal for comment \5\ and
received 14 comment letters.\6\ Commenters generally supported the
original proposal, but requested additional changes and clarifications.
In particular, commenters believed that the proposal did not go far
enough in excluding investments by affiliates of members in light of
the creation of large financial institutions that include commercial
and investment banking and insurance operations.
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\5\ Securities Exchange Release No. 42619 (April 4, 2000); 65 FR
19409 (April 11, 2000).
\6\ Akin, Gump, Strauss, Hauer & Feld (``Akin''); The Bond
Market Association (``TBMA''); Chase Manhattan Corporation
(``Chase''); CIBC World Markets Corporation (``CIBC''); Fried,
Frank, Harris, Shriver & Jacobson (``Fried Frank''); Goldman, Sachs
& Company (``Goldman''); Merrill Lynch (``Merrill''); Morgan Stanley
Dean Witter (``Morgan''); Morrison & Foerster (``M&F''); North
American Securities Administrators Association (``NASAA''); Ohio
Department of Commerce, Division of Securities (``Ohio'');
Prudential Securities, Inc. (``Prudential''); Salomon Smith Barney,
Inc. (``Salomon''); and Securities Industry Association (``SIA'').
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Amendment No. 5 responds to the comments received. Following is a
description of proposed amendments to the original proposal that: (i)
Expand the circumstances under which purchases and other acquisitions
of the issuer's securities by members and their affiliates will not be
considered underwriting compensation; (ii) incorporate increased
flexibility in the Rule while maintaining the objective review
standards of the original proposal; (iii) clarify parts of the original
proposal; and (iv) impose a minimum compensation value on warrants
deemed to be underwriting compensation (``amended proposal''). All
proposed amendments are in response to comments, except as indicated
and for non-substantive and conforming changes to the Rule. In
addition, the following description addresses, where appropriate,
comments that are opposed to provisions retained in the amended
proposal. Other comments are addressed in Section II.C. below.
The material in current paragraph (c) of Rule 2710 would be divided
into paragraphs (c) through (g). In addition, the amended proposal
would adopt a new definition of the term ``participating member'' in
subparagraph (a)(4)\7\ to include participating broker/dealers, their
associated persons and employees, any members of their immediate
family, and any affiliate of the member. This term is used in the Rule
and in the discussion below to distinguish between members that
participate in the public offering and the broader category in the
definition of ``underwriter and related persons'' that includes non-
members and other persons related to a member.
---------------------------------------------------------------------------
\7\ All references are to the provisions of Rule 2710, as
proposed to be amended, unless otherwise specified.
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a. Pre-Offering Objective Test
The original rule filing proposed to measure the 180-day review
period in the same manner as the one-year review period in the current
Rule.\8\ The amended proposal would modify subparagraph (d)(1) to
provide that the 180-day period is measured from the date the public
offering is required to be filed with the Association pursuant to
subparagraph (b)(4) (``required filing date'').\9\ NASD Regulation also
proposes to amend this provision to clarify that the review period
commences 180 days before the required filing date and ends when the
offering is effective or when the public offering commences.
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\8\ The original rule filing stated that the 180-day review
period would be measured from the earlier of the date of filing with
the SEC, state securities commission, or other regulatory authority,
or the date of filing with the Association.
\9\ This same calculation is used in the first three exceptions
for acquisitions of securities from underwriting compensation and in
the exceptions to the lock-up restriction on securities.
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Several commenters (SIA, Fried Frank, Goldman, Merrill, Morgan, and
Salomon) requested that the Rule be amended to provide that the 180-day
review period be measured from the date that the preliminary prospectus
is circulated, particularly because certain issuers file early with the
SEC. NASD Regulation believes that the commenters misunderstand the
purpose of measuring the review period from the filing date. Members
typically provide significant underwriting services in connection with
the preparation and filing of a registration statement or other
offering document. These underwriting activities are likely to have
commenced within the 180-day period preceding the filing date.
Accordingly, the Corporate Financing Department (``Department'') will
review any items of value received by the underwriters beginning 180
days prior to the filing date because they may constitute compensation
for underwriting services. Although the first distribution of a
preliminary prospectus is more relevant than the filing date in
determining whether an offering is likely to be completed, it is
irrelevant to determining whether an issuer has begun to pay its
investment bankers for underwriting services.
b. Common Requirements of the Exceptions From Underwriting Compensation
The original proposal included four ``safe harbors'' that establish
transaction criteria that are intended to distinguish between
securities acquired as bona fide investments from securities acquired
as underwriting compensation. NASD Regulation is proposing to clarify
and expand the ``safe harbors''--now called ``exceptions''--to cover
additional types of transactions. Following is a discussion of certain
of the requirements that are common to two or more exceptions.
1. Deletion of Reference to ``Safe Harbors''--The original rule
filing proposed four ``safe harbors'' that would exclude certain
acquisitions of the issuer's securities during the 180-day review
period from underwriting compensation. Some commenters (Fried Frank,
Goldman, Morgan, Prudential, M&F, and Merrill) were correct in
[[Page 14958]]
noting that, although described as ``safe harbors,'' the original rule
filing required that a transaction meet all of the criteria of a safe
harbor in order to qualify for exclusion from underwriting
compensation. Therefore, the proposed ``safe harbors'' in subparagraph
(d)(5) will be treated under the amended Rule as ``exceptions.'' \10\
---------------------------------------------------------------------------
\10\ Subparagraph (b)(6)(A)(v) would require that members submit
information to the Association that demonstrates compliance with all
of the criteria of the exception being relied upon.
---------------------------------------------------------------------------
2. Ninety-Day Limitation on Availability of Exceptions--The
original rule filing would have prohibited reliance on the first three
exceptions from underwriting compensation in the 90-day period prior to
the filing date of the public offering. NASD Regulation proposes to
amend the exceptions in subparagraphs (d)(5)(A)-(C) to delete the 90-
day limitation and include language stating that transactions that
occur before the required filing date are eligible for the
exceptions.\11\
---------------------------------------------------------------------------
\11\ The fourth, fifth, and sixth exceptions, discussed below,
would be available during the 180-day review period and subsequent
to the filing of the public offering.
---------------------------------------------------------------------------
The deletion of the 90-day limitation was recommended by many
commenters (SIA, TBMA, Fried Frank, Goldman, Merrill, Morgan,
Prudential, and Salomon) who stated that the other conditions in the
proposed exceptions were sufficient to prevent abusive practices during
the entire 180-day review period. For example, Prudential stated that
``the criteria in the safe harbors provide a more reliable guide than
proximity in time for distinguishing between a payment for services and
financing other than underwriting and compensation for underwriting.''
Consistent with the industry's position, NASD Regulation believes that
the other criteria should generally be retained as proposed.
3. Price and Terms of Securities--The third and fourth exceptions
would have required that any securities purchased under an exception
must be purchased at the same price and with the same terms as
securities purchased by other investors. NASD Regulation proposes to
amend the introduction to the exceptions in subparagraph (d)(5) to
apply this criterion to any purchase under any exception provided that
the purchase occurs at approximately the same time as purchases by
other investors. In addition, NASD Regulation agrees with commenters
(SIA and Goldman) that the price and terms requirement is not
applicable to securities received as placement agent fees and,
therefore, the language only refers to ``any securities purchased''
(emphasis provided).
4. Conditioning a Member's Participation on a Securities
Acquisition--The first three exceptions would have required that a
member have written procedures to ensure that its participation in the
public offering was not contingent on its participation in the private
placement or loan that is covered by the exception. Commenters (Merrill
and Fried Frank) recommended that this provision be eliminated as a
condition of the exceptions, stating that it would require that the
Department determine the intent of the member in each transaction, that
the original proposal was unclear on the type of written procedures
required, and that the provision is unnecessary in light of the other
criteria of each exception. Commenters also believed that the rule
language would require members to submit their written procedures for
compliance with this provision for Department review in order to rely
on an exception.
NASD Regulation agrees that the specific written procedures
requirement in the exceptions is not necessary, especially because
members remain subject to the general standards of NASD Rule
3010(b)(1), which requires members to establish written procedures that
are reasonably designed to ensure compliance with NASD rules. However,
NASD Regulation continues to be concerned that participating members
not use their position as an issuer's underwriter to require the issuer
to sell cheap stock or warrants to the member or the member's
affiliates in a transaction that is eligible for an exception. In
response to this concern, NASD Regulation proposes to include a
statement in the introduction to subparagraph (d)(5) emphasizing that
an exception is only available if a member has not conditioned its
participation in the public offering on an acquisition of securities
under the exception.
5. Definition of Institutional Investor--The second and third
exceptions rely on the involvement of ``institutional investors'' in
the issuer or private placement to help ensure that securities are
acquired by participating members in bona fide transactions that were
negotiated at ``arms-length.'' To ensure that the institutional
investors are in fact independent of any participating member,\12\ NASD
Regulation proposes to amend the definition of ``institutional
investor'' in subparagraph (d)(4)(B) to require that no participating
member may have an equity interest in or manage or otherwise direct the
institutional investor's investments.\13\ The definition in the
original proposal required that the ``institutional investor will not
include any member participating in the public offering, any of its
associated or affiliated persons, or any immediate family member of its
associated or affiliated persons.'' This amendment clarifies that the
word ``included'' was intended to prevent participating members from
being ``included'' as equity owners of the institutional investor. This
amendment also adds a requirement that none of the participating
members should manage or otherwise direct the institutional investor's
investments.
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\12\ However, an institutional investor may be or include equity
owners that are a member, or a person associated or affiliated with
a member, so long as the member is not participating in the public
offering.
\13\ In accordance with another comment (SIA and Goldman), the
word ``entity'' in the definition is proposed to be changed to
``legal person'' to avoid confusion with the separate definition of
the term ``entity'' intended for use under the first and second
exceptions.
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6. Investment/Lending Subsidiary--In response to a comment (Fried
Frank), NASD Regulation proposes to amend the definition of entity in
subparagraph (d)(4)(A) to permit a qualifying entity to make its
investment or loan through a wholly-owned subsidiary. NASD Regulation
is not persuaded by the argument, however, that a subsidiary formed by
two or more entities or institutional investors is indistinguishable
from its parents.
In addition, NASD Regulation proposes to amend the definition of
institutional investor in subparagraph (d)(4)(B) to provide that the
calculation of the $50 million threshold will include investments held
by a wholly owned subsidiary of an institutional investor. This
amendment will, therefore, also permit an institutional investor to
make its investment under the third exception through a wholly owned
subsidiary. (See comment of Akin).
7. Venture Capital Experience--NASD Regulation proposes to amend
the provision in the first and second exceptions requiring that the
investing/lending entity have prior experience in making venture
capital investments to require that the entity ``has been primarily
engaged in the business of making investments in or loans to other
companies'' (emphasis provided). Contrary to opposing comments (SIA and
Goldman), NASD Regulation believes that the protections of the criteria
in these exceptions cannot be effective unless the entity has a history
of at least one prior investment or loan transaction and that the
business of the
[[Page 14959]]
entity primarily involves investments in or loans to other
companies.\14\
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\14\ The definition of ``entity'' in subparagraph (d)(4) will
continue to require that there have been at least one prior joint
investment for a group of legal persons, to qualify as an entity.
Therefore, when an entity is composed of a group of legal persons,
one prior investment or loan by a group will also satisfy the
requirement for at least one prior investment or loan under
subparagraphs (d)(5)(A) and (B). In addition, each member of the
group will be required to demonstrate that it is primarily engaged
in the business of making investments in or loans to other
companies.
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c. Exceptions From Underwriting Compensation
1. First Exception: Purchases and Loans By Certain Entities--The
first exception in subparagraph (d)(5)(A) is intended for acquisitions
of the issuer's securities by certain entities that routinely make
investments in or provide loans or credit facilities to other
companies. The exception, as amended, would be available: (1) To any
qualifying entity related to a participating member that meets a
capital under management test, or is a bank or insurance company; and
(2) for purchases in a private placement and for the receipt of
securities as compensation for a loan or credit facility before the
required filing date of the public offering, with a 10% limitation on
the amount of securities acquired.
A. Expansion of Exception: A number of commenters (Chase, Goldman,
Merrill, Prudential, Salomon, and SIA) discussed the impact of the
current Rule and the original proposal on large financial institutions
that include commercial and investment banking and insurance
operations. The commenters recommended that NASD Regulation amend the
Rule to exclude purchases of the issuer's securities if a large
financial institution maintains information barriers between its
broker/dealer and its other affiliates in a distinct line of business
or it otherwise can demonstrate that it does not collaborate to secure
underwriting business.
The Department is concerned that information barriers are not an
appropriate mechanism for preventing abusive practices. However, to
address the impact of the Rule on large financial institutions
affiliated with members, NASD Regulation proposes to expand the first
exception in subparagraph (d)(5)(A) to be available to any insurance
company or bank. NASD Regulation believes that U.S. banks and insurance
companies generally are structured and regulated in a manner that
ensures that the institution is primarily engaged in a line of business
that is distinct from the underwriting business.
U.S. banks and insurance companies would be those that come within
the definitions of those terms in section 3(a)(6) of the Act and
section 2(a)(13) of the Securities Act of 1933 (``Securities Act''),
respectively. Foreign banks and insurance companies would not be able
to rely on the exception unless the staff grants an exemption on a
case-by-case basis under the NASD Rule 9600 Series. NASD Regulation
proposes to grant such an exemption based on information demonstrating
that the foreign institution operates and is regulated in a manner
similar to a bank or insurance company in the U.S.
B. Capital Under Management Test: NASD Regulation proposes to
revise the definition to allow the required capital to have been
contributed or committed to the qualifying entity.
C. Fiduciary Duty Requirement: NASD Regulation proposes to amend
the provision requiring an independent review of the investment or loan
to delete the word ``review'' as redundant of the word ``evaluation.''
D. Ten Percent Limitation on Acquisition: The amended rule filing
would restrict investments by all entities related to a member to 10%
of the issuer's ``total equity securities, calculated immediately
following the transaction.'' \15\ NASD Regulation believes this added
protection is necessary in light of the proposal to eliminate the 90-
day limitation on the availability of the exception and to eliminate
the stock numerical limitation.
The term ``total equity securities'' is defined in subparagraph
(d)(4) to include the total shares of common stock outstanding of the
issuer and the total shares of common stock of the issuer underlying
all convertible securities. The term includes voting and non-voting
common stock since the NASD does not differentiate between the two
types of securities. Also, the calculation aggregates all series of
common stock, i.e., series A and series B. By ``convertible,'' the NASD
means all securities that convert to common stock without payment of
any additional consideration. As a result, the calculation of total
equity securities does not include any warrants or options that give
the holder the right to purchase the issuer's securities at a
price.\16\ Further, the convertible securities need not be those of the
issuer; rather, the convertible securities can be those of any company
that converts, without the payment of additional consideration, to the
common stock of the issuer.\17\
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\15\ NASD Regulation agrees with commenters (Fried Frank,
Goldman, Merrill, and SIA) that the calculation should not include
stock options or employee options and warrants and, has, therefore
deleted the requirement that the amount of the issuer's securities
be calculated on a ``fully diluted'' basis.
\16\ In comparison, purchasers of convertible securities have
fully paid for the security and any underlying security regardless
of when or if they convert.
\17\ In some cases, a parent company will issue securities
convertible to securities of a subsidiary.
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E. Sharing in Investment Banking Fees: NASD Regulation agrees with
commenters (Goldman and SIA) that the requirement that the investing or
lending entity ``not participate directly in investment banking fees
received by the member for underwriting public offerings' is satisfied
even if the member is the general partner of the investing entity, so
long as no part of the underwriting fees are directed to the entity
itself.
2. Second Exception: Investments In and Loans to Certain Issuers--
The second exception in subparagraph (d)(5)(B) is intended for
acquisitions of securities of issuers that have significant
institutional investor involvement. The exception, as amended, would be
available: (1) When institutional investors own at least 33% of the
issuer's total equity securities, calculated on a pre-transaction
basis; (2) to any related entity of a participating member that manages
capital contributions or commitments of at least $50 million; and (3)
for purchases in a private placement and for the receipt of securities
as compensation for a loan or credit facility before the required
filing date of the public offering, with a 10% limitation on the amount
of securities acquired.
A. Ten Percent Limitation on Acquisition: NASD Regulation proposes
to increase the investment limitation on all entities related to each
participating member from 5% to 10% of the issuer's ``total equity
securities'' calculated on a post-transaction basis.
B. Board Membership Requirement: In response to commenter's
concerns that the original proposal appeared to require an issuer to
put an institutional investor on its board of directors in order for
its underwriters to be eligible to rely on the exception, NASD
Regulation proposes to delete the requirement that an institutional
investor be a member of the issuer's board of directors.
C. Board Vote: Consistent with the deletion of the requirement that
an institutional investor be a member of the issuer's board of
directors and other comments, NASD Regulation proposes
[[Page 14960]]
to revise the provision requiring approval of the investment by the
issuer's board of directors and the affirmative vote of all
institutional investors on the board, to require approval by a majority
of the issuer's board of directors and a majority of any institutional
investors, or their designees, that are board members.
3. Third Exception: Private Placements With Institutional
Investors--The third exception in paragraph (d)(5)(C) is intended for
acquisitions in private placements with institutional participation.
The exception, as amended, would be available to any person that is
covered under the definition of underwriter and related person for
purchases before the required filing date of the public offering of
securities in a private placement and for the receipt of securities as
placement agent compensation, so long as institutional investors
purchase at least 51% of the total offering and underwriters and
related persons, in the aggregate, do not purchase more than 20% of the
total offering.
A. Definition of the ``Total Offering'': NASD Regulation proposes
to revise the exception to clarify, as recommended by commenters, that
the 51% investment requirement for institutional investors and the 20%
limitation on investments by underwriters and related persons is based
on the ``total offering,'' which is comprised of the total number of
securities sold in the private placement and the securities received or
to be received as placement agent compensation by any member.\18\
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\18\ For example, if the private placement consists of 100,000
shares of common stock and the issuer pays placement agent
compensation that includes a warrant for 10,000 shares of common
stock, the total offering is 110,000 shares of common stock.
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B. Lead Negotiator Requirement: The original proposal required an
institutional investor to be the lead negotiator with the issuer to
establish the terms of the private placement. NASD Regulation proposes
to amend this requirement as recommended by the Corporate Financing
Committee of NASD Regulation to provide that, when the terms of the
private placement are not negotiated with an institutional investor, an
institutional investor must at least be the lead investor in
establishing or approving the terms of the private placement.
4. Fourth Exception: Acquisitions and Conversions to Prevent
Dilution--The fourth exception in paragraph (d)(5)(D) is intended for
the purchase or receipt of securities to prevent dilution of the
investor's position in the issuer. The exception, as amended, would be
available to any person who is covered under the definition of
underwriter and related person for acquisitions of securities before
the effective date of the public offering resulting from a preemptive
right or a pro-rata rights offering, and acquisitions resulting from a
stock-split or stock conversion, provided that: (1) The opportunity to
purchase or receive securities is provided to all similarly situated
securityholders; and (2) the amount of securities purchased or received
does not increase the investor's percentage ownership.
A. Availability of Exception: The exception would be available
during the 180-day review period and subsequent to the filing of the
public offering.
B. Definition of Right of Preemption: To clarify the application of
this exception, NASD Regulation proposes to include a definition of
``right of preemption'' in subparagraph (d)(4)(C) to list all the
circumstances under which it is anticipated that a purchaser may
receive a preemptive right.\19\
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\19\ An investor may only rely on this exception to purchase the
enumerated classes of the issuer's securities that are covered by
the right of preemption.
---------------------------------------------------------------------------
C. Revisions to Limitation on Acquisition of the Preemptive Right:
NASD Regulation proposes to exclude an acquisition under a right of
preemption acquired in connection with securities purchased in a
private placement from underwriting compensation so long as the
securities purchased in the private placement are not deemed to be
underwriting compensation.
D. Limitation on Securities Received Upon Conversion: The exception
is available to securities that are received upon conversion of
securities only if the convertible security is not deemed to be
underwriting compensation.
E. Limitation on Increasing the Purchaser's Percentage Ownership:
NASD Regulation proposes to amend the language prohibiting the investor
from increasing its percentage ownership of the same class of security
\20\ to refer to the ``same generic class of securities of the issuer''
and to the ``class of securities underlying any convertible security.''
In addition, NASD Regulation proposes to amend this provision to
clarify that the investor's level of percentage ownership will be
calculated immediately prior to the investment.
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\20\ This limitation does not apply in the case of conversions
of securities. For example, the calculation of percentage ownership
of preferred stock will be based on all series of preferred stock
outstanding and the calculation of percentage ownership of
convertible preferred stock will be based on the company's equity
outstanding on an as-converted basis.
---------------------------------------------------------------------------
F. Pre-Existing Contractual Rights: As previously discussed, any
securities purchased under an exception must be purchased at the same
price and with the same terms as securities purchased by any other
purchasers. NASD Regulation proposes to include a provision clarifying
that it is not contrary to this limitation for a purchaser to retain a
pre-existing contractual right, such as a preemptive right, that was
granted in connection with a prior purchase.
5. Fifth Exception: Purchases Based on a Prior Investment History--
A fifth exception in paragraph (d)(5)(E) is proposed in response to a
comment (CIBC) so that members or their affiliates that established a
long-term relationship with an issuer would be able to purchase
additional securities of the issuer to prevent dilution before the
effective date of the public offering. The exception would only be
available to investors that have previously purchased the issuer's
securities. NASD Regulation believes that the terms of this exception
are consistent with historic NASD Regulation practice.
A. Prior Investment Requirement: In order to be eligible for the
exception, the investor must have made at least two prior purchases of
the issuer's securities: One investment at 2 years before the required
filing date and another more than 180 days before the required filing
date of the public offering.
B. Limitation on Increasing the Purchaser's Percentage Ownership:
The securities purchased under the exception cannot increase the
investor's percentage ownership of the generic class of securities of
the issuer calculated immediately prior to the investment.
C. Availability of Exception: The exception would be available
during the 180-day review period and subsequent to the filing of the
public offering.
6. Sixth Exception: Financial Consulting and Advisory Agreements--A
sixth exception is proposed in subparagraph (d)(5)(F) for cash fees and
securities paid to a financial consultant or advisor to the issuer when
the relationship was established more than one year before the required
filing date of the public offering.
This exception is consistent with an exception in the Rule, which
excludes from the definition of ``item of value'' financial consulting
and advisory fees if an ongoing relationship between the issuer and the
financial advisor or consultant was established more than 12 months
before the filing date of the
[[Page 14961]]
public offering. The original proposal included this exclusion. The
sixth exception would codify objective standards that help clarify
which long-term arrangements can qualify for the exception.
Among other criteria, the consulting or advisory relationship must
have been entered into more than one year before the required filing
date of the public offering. Commenters (Chase and Fried Frank)
recommended that the time period be decreased to 180 days before the
filing date of the public offering. NASD Regulation does not agree that
a 180-day period is sufficient to identify a ``long term'' relationship
between a consultant and the issuer that justifies excluding fees and
securities paid to the consultant during the 180-day review period,
particularly when the consultant may have provided services related to
the preparation, structuring, or conduct of the public offering.
d. When Securities Are Considered ``Received''
In the original proposal, subparagraph (d)(3) included a provision
to establish when securities are considered ``received'' under the Rule
for purposes of determining if the securities were received within the
180-day review period and are, therefore, considered to be underwriting
compensation.
The original proposal treated securities received as compensation
for a loan or credit facility as ``received'' on the execution of the
agreement for the loan or credit facility. NASD Regulation proposes to
amend this provision to treat a put option like a loan or credit
facility and to require a written contract with detailed provisions for
any agreement for a loan, credit facility, or put option. Therefore, a
contract for a loan or credit facility must specify the amount and
terms of the loan or credit facility and the amount of securities that
will be paid as a fee. In the case of a put option, the contract must
unconditionally require the investor to purchase securities upon demand
of the issuer and must include a formula for determining the amount and
price of the securities that must be purchased. If the required
information is provided, the securities will be considered received as
of the date the written agreement is executed. Absent this required
information, securities received for a loan or credit facility or
purchased from the issuer in accordance with a put option will be
considered received as of the date of transfer of beneficial ownership.
Commenters (Chase, Fried Frank, Goldman, Merrill, and SIA)
recommended that the date a commitment letter is signed be relied upon
as the date of receipt with respect to securities purchased in a
private placement. NASD Regulation has not amended the Rule as
commenters suggest. In the NASD Regulation's experience, commitment
letters do not serve as reliable indicators of the date of ``receipt of
securities.'' In many cases, commitment letters allow one or both
parties to withdraw from the transaction or impose other contingencies
that may prevent the purchase of the securities. In NASD Regulation's
experience, the date that the private placement closes is a more
reliable indicator of when securities are ``received.'' Moreover,
beneficial transfer of the securities typically occurs at closing.
In addition, in response to a comment (M&F), the relevant ``closing
of a private placement'' for a private placement with different closing
dates would be the closing where the issuer receives its funding from
the investor.
e. Post-Offering Review Authority/ Undisclosed Compensation
The original proposal would have required the staff to examine
items of value received by underwriters and related persons during the
90-day period immediately following the effective date of a public
offering to determine whether they constitute underwriting
compensation. Commenters (Fried Frank, Goldman, Merrill, and SIA)
expressed concern that the provision may subject members to
disciplinary actions based upon the unknown activities by unaffiliated
entities included in the definition of ``underwriter and related
person.'' The purpose of this provision was to ensure that the staff
could consider whether items of value received after the public
offering need to be included as underwriting compensation in order to
avoid circumvention of the Rule.
NASD Regulation agrees that this provision could be more narrowly
tailored to address those specific circumstances where compensation
arrangements are not disclosed to the Association. New subparagraph
(d)(2) would provide that all items of value received and all
arrangements entered into for the future receipt of an item of value
that are not disclosed to the Association prior to the date of
effectiveness or the commencement of sales of a public offering
(including items of value received after the public offering), are
subject to post-offering review to determine whether such items of
value are additional underwriting compensation for the public offering.
Subparagraph (b)(6)(vi)(b) would require the filing of any new
arrangement that provides for receipt of an additional item of value
subsequent to the issuance of an opinion of no objections to the
underwriting arrangements by the Association and within 90 days
following the date of effectiveness or commencement of the public
offering.
f. Cash and Securities That Are Not Items of Value
The following amendments are proposed to subparagraph (b)(3)(B),
which lists the items of value that will be excluded from underwriting
compensation.\21\
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\21\ NASD Regulation also proposes to amend the language of
subparagraphs (c)(3)(a)(iv) and (vii) to eliminate redundancies.
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1. Cash Compensation Excluded As An Item of Value--The exception
for ``cash discounts or commissions received in connection with a prior
distribution of the issuer's securities'' was unintentionally deleted
in the original proposal. NASD Regulation proposes to reinstate and
broaden the exclusion from underwriting compensation to cover cash
compensation for services provided to the issuer for private placement
agent or merger and acquisition services, or for providing a loan or
credit facility, as recommended by commenters.
2. Securities Excluded As An Item of Value--In addition, as
recommended by commenters, the proposed Rule would exclude receipt of
the issuer's securities from being considered an item of value if they
are:
(1) Listed and purchased in the public market transactions;
(2) Purchased through the issuer's employee stock purchase plan; or
(3) Acquired by an investment company registered under the
Investment Company Act of 1940.
g. Flexibility in the Application of the Rule
1. General Request for Flexibility--Commenters (Fried Frank,
Goldman, Morgan, Prudential, and Merrill) requested that the Rule be
amended to allow the staff to grant exemptions from the Rule. The
commenters stated that exemptions should be granted in new or
unanticipated situations that were not contemplated by the Rule or
where a transaction narrowly fails to meet the criteria of one of the
enumerated exceptions. One of the commenters (Prudential) also stated
that the exemption process under the NASD Rule 9600 Series was too
cumbersome to be useful and preferred a structure where members can
receive a quick response from Department staff on a request to consider
a fact situation that
[[Page 14962]]
does not fall within one of the exceptions to the Rule.
NASD Regulation agrees with the commenters that the staff should be
able to grant exemptions to respond to new or unanticipated situations.
NASD Regulation proposes to amend paragraph (i) of Rule 2710 to
articulate the substantive standard upon which exemptions may be
granted. Specifically, paragraph (i) would state that the staff has
authority to grant an exemption from the Rule, if it is consistent with
the purposes of the Rule, the protection of investors, and the public
interest. NASD Regulation intends to use its exemption authority
sparingly, principally for situations not addressed in the Rule. NASD
Regulation generally does not believe that its exemption authority
should be used to exclude transactions that narrowly fail to meet one
or more criteria of the Rule, because these are the types of
transactions that are addressed in the Rule.\22\
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\22\ The original proposal stated, ``[t]he current subjective,
factor-weighing process for determining whether securities were
acquired in connection with a public offering is an inefficient
method * * * The subjectivity hampers the Department's ability to
provide clear and predictable guidance to members. The consequences
under the Rule of a particular venture capital or other private
placement financing are sometimes uncertain until a public offering
is filed and the Department's review is completed. This uncertainty
unnecessarily complicates the capital-raising process, to the
detriment of issuers and investors.''
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The NASD Rule 9600 Series sets forth the procedures to obtain
exemptive relief from those NASD Rules that provide for such relief.
NASD Regulation believes that the exemptive procedures set forth in the
Rule 9600 Series allow Department staff to consider and grant
exemptions from any provision of the Rule on an immediate basis.
2. Exemptions for Consulting Fees and Founder's Stock--Commenters
recommended that NASD Regulation adopt additional exceptions from
underwriting compensation. In certain situations, NASD Regulation
believes that there are circumstances where the recommended exception
is appropriate, but a specific exception with objective criteria cannot
be developed to ensure the bona fide nature of the transaction.
Therefore, NASD Regulation proposes to consider exemptions on a case-
by-case basis pursuant to the standards in paragraph (i) in the
following situations.
A. Financial Consulting and Advisory Fees: Commenters (Goldman and
SIA) objected that the original rule filing proposed to delete current
subparagraph (c)(4)(E), which excludes financial consulting and
advisory fees if ``the relationship * * * was not entered into in
connection with the offering and * * * actual services have been or
will be rendered which were not or will not be in connection with or
related to the offering.'' These commenters believed that there are
many services for which a member may legitimately be retained at the
time of or shortly before a public offering for which it ought to
receive financial and advisory fees that are not included as
underwriting compensation. It is our experience that the rule language
that NASD Regulation proposed to delete in the original proposal is so
indefinite in nature that it has not generally provided the guidance
sought by the commenters. NASD Regulation proposes instead to consider
on a case-by-case basis excluding securities and cash fees from
underwriting compensation for services that:
(1) Solely relate to the business or management of the issuer; and
(2) Are not related to the preparation, structuring, or conduct of
the public offering, or to raising capital in a transaction related to
the public offering.
For example, if an agreement is for post-offering merger and
acquisition services, NASD Regulation would consider excluding fees
that will only be paid upon the occurrence of a merger or acquisition.
If an agreement is for post-offering public relations services, NASD
Regulation would consider excluding fees paid to an experienced public
relations firm that is not affiliated with a member.
B. Founder's Stock: NASD Regulation proposes to consider on a case-
by-case basis excluding acquisitions of ``founder's stock'' and any
subsequent purchases by a founder from underwriting compensation.
Founder's stock is acquired at the time of incorporation of the issuer
as a start-up company or upon purchase of substantially all of the
assets of the issuer from another company.
3. Interpretations of Rule--Commenters also recommended amendments
to the Rule to exclude purchases of securities in a number of common-
sense situations. NASD Regulation proposes to interpret the Rule to
address on a case-by-case basis excluding purchases of securities when
the:
(1) Purchaser was not affiliated or associated with a member
participating in the public offering at the time of the acquisition;
(2) Securities acquired are those of the member or the parent of
the member and the purchaser is an associated person of the member or
employee of the parent, or members of their immediate family;
(3) Securities were acquired in a resale transaction under Rule
144A from a shareholder of the issuer who is not an affiliate, officer,
director, general partner, or employee of the issuer, or a selling
security holder in the public offering; or
(4) Securities were purchased from the issuer for immediate resale
under Rule 144A and the member failed to place the securities.
h. Lock-Up Restrictions on Securities
The original rule filing proposed to delete the current one-year
lock-up restriction on securities included in underwriting compensation
and the current three-month lock-up restriction on securities of the
issuer held by a member and certain senior persons and subsidiaries at
the time of the offering. These restrictions would have been replaced
by a single, 180-day lock-up restriction on all equity securities of
the issuer that are held by any underwriter and related person at the
time of effectiveness of the public offering, unless the securities or
transaction complied with an exception. NASD Regulation proposes to
clarify the language of the restriction and to adopt additional
exceptions, as discussed by commenters (Fried Frank, Goldman, M&F,
Merrill, and SIA).
1. Lock-Up Restriction Language--NASD Regulation proposes to amend
subparagraph (g)(1) to prohibit any hedging, short sale, derivative,
put, or call transaction that would result in the effective economic
disposition of the securities. This amendment was recommended by the
Corporate Financing Committee of NASD Regulation and is necessary to
ensure that the lock-up restriction remains effective in light of
practices that have developed since the restriction was first adopted
in the original version of the Rule.
2. Exceptions to Lock-Up Restriction For Securities Acquired At Any
Time--The original proposal included exceptions from the lock-up
restriction in subparagraph (g)(2) for transfers of securities: by
operation of law or reorganization of the issuer; to any member
participating in the offering and the officers and partners thereof; if
the aggregate amount of securities held by an underwriter and its
related persons do not exceed 1% of the securities being offered; and
if the class of security qualifies as an ``actively traded security''
for purposes of SEC Regulation M. NASD Regulation proposes to amend
subparagraph (g)(2)
[[Page 14963]]
to adopt additional exceptions from the lock-up restriction for
securities:
(1) Held by an investment fund, provided that no participating
member manages or otherwise directs the investments of the fund, and
members participating in the offering do not own more than 10% of the
equity in the fund;
(2) Previously subject to the lock-up restriction (thereby allowing
the sale of such securities after the expiration of the previous lock-
up restriction);
(3) That are listed and were purchased in the public market;
(4) Acquired under the issuer's employee stock purchase plan; or
(5) Purchased by an investment company registered under the
Investment Company Act of 1940.
3. Exceptions to the Lock-Up Restriction for Securities Acquired
Before the 180-Day Review Period--The original rule filing included an
exception from the lock-up restriction for securities considered
``actively traded'' under SEC Regulation M.\23\ NASD Regulation
proposes to narrow this exception to make it available only to
securities that were acquired before the 180-day review period. NASD
Regulation believes this revision is necessary because NASD Regulation
also proposes to eliminate the 90-day limitation on the availability of
the exceptions in subparagraphs (d)(5)(A)-(C). The application of the
lock-up restriction to securities acquired within the 180-day review
period will ensure that securities received in transactions that meet
an exception, and thus are not included in compensation calculations,
are held as an investment for at least six months. Accordingly, members
would be prevented from making a quick profit on securities received
from issuers to whom they are providing underwriting services.
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\23\ If a security qualifies as ``actively traded'' under SEC
Regulation M as of the date of effectiveness of the public offering,
then the security is considered ``actively traded'' at any time
thereafter when the securityholder determines to sell its
securities.
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In addition, NASD Regulation proposes a new exception from the
lock-up restriction for securities acquired before the 180-day review
period that are owned by any person that is not a participating member
(e.g., underwriter's counsel, consultants, and finders).
i. Regulation of Terms of Securities
1. Stock Numerical Limitation--The amended rule filing, like the
original rule filing, would eliminate the 10% stock numerical
limitation in current subparagraph (c)(6)(B)(xi). In making this
change, NASD Regulation believed that the number of securities received
by a member as underwriting compensation would be limited by the
compensation guideline applicable to the offering. Commenters (NASAA
and Ohio) pointed out that the compensation guidelines would not be
effective in this regard. They noted, for example, that warrants with
an exercise price of 165% of the public offering price do not have any
compensation value \24\ and, consequently, an unlimited amount of
warrants with such a high exercise price could be obtained as
underwriting compensation.
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\24\ The ``warrant formula'' for valuing warrants is in
subparagraph (e)(3) of the amended Rule.
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NASD Regulation believes that the low valuations that are assigned
to warrants that have an exercise price in excess of 125% of the public
offering price no longer accurately reflect the economic value of the
warrants. NASD Regulation proposes to amend subparagraph (e)(3) to
require that all warrants have a minimum compensation value of .2% of
the offering proceeds \25\ for each amount of securities that is up to
1% of the securities being offered to the public, excluding securities
subject to the overallotment option. \26\ As a result of this
amendment, the compensation guideline will limit the amount of
securities that can be obtained through the exercise of any warrant.
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\25\ The proposed valuation is the equivalent of the 2%
valuation that would be applied to warrants for 10% of the
securities underwritten on a firm-commitment basis that have an
exercise price of 125% of the public offering price. The standard
exercise price for warrants has long been 120% of the public
offering price.
\26\ For example, warrants exercisable for securities equal to
4% of the offered securities would have a compensation value of at
least .8%. Warrants exercisable for securities equal to 9% of the
offered securities would have a compensation value of at least 1.8%.
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2. Other Amendments to Regulation of Terms of Convertible/
Exercisable Securities--A commenter (Goldman) requested a number of
amendments to and questioned the continued usefulness of subparagraph
(f)(2)(H), which prohibits unfair and unreasonable arrangements in
connection with securities that are exercisable or convertible to
another security. NASD Regulation finds that this provision continues
to be necessary to prevent abusive arrangements when a member receives
exercisable or convertible securities as underwriting compensation and
proposes a number of modifications to clarify the applicability of the
requirements.
A. Scope of Regulation: NASD Regulation proposes to amend
subparagraph (f)(2)(H) to clarify that members are not only prohibited
from including terms and arrangements in agreements for exercisable or
convertible securities that are not permitted under the Rule, but they
also are prohibited from exercising the securities in a manner that is
prohibited under the Rule. Although this position is intuitively
obvious, some members have argued that if the terms of the agreement
are ambiguous, the securities can be exercised in a manner that
otherwise would violate the Rule.
B. Anti-Dilution Terms: NASD Regulation proposes to amend the
provisions prohibiting unfair ``anti-dilution'' arrangements in
subparagraphs (f)(2)(H)(vi) and (vii) to incorporate a clearer
explanation of the requirements. The revised language would state that
the recipient may only receive a larger amount of securities or
exercise at a lower price than originally agreed upon if the public
shareholders have been proportionally affected by a stock split, stock
dividend, or other similar event. NASD Regulation proposes minor
changes to the prohibition on receipt or accrual of cash dividends
prior to the exercise or conversion of the security.
C. Exercise Price of Security: NASD Regulation proposes to delete
the provisions in current subparagraphs (c)(6)(B)(viii)(b) and (i) that
prohibit underwriters and related persons from receiving a security
that is exercisable or convertible at a price below the public offering
price or on terms more favorable than the terms of the securities being
offered to the public.
3. Securities Received as Underwriting Compensation That Are
Different Than the Securities Offered to the Public \27\--The original
rule filing proposed to amend current subparagraph (c)(5)(A) to allow
``upon good cause shown'' the payment of underwriting compensation in
the form of securities that are not identical to those offered to the
public or to a security that has a bona fide independent market. A
commenter (Ohio) requested reinstating the requirement that an
exception only be permitted in ``exceptional and unusual
circumstances.'' NASD Regulation agrees with other commenters (TBMA
[[Page 14964]]
and Morgan) that the Rule should permit a member to receive securities
as underwriting compensation that are different than those offered to
the public, so long as the securities can be assigned a compensation
value. Therefore, NASD Regulation proposes to amend subparagraph (e)(1)
to require the security to be able to be accurately valued to comply
with subparagraph (f)(2)(I). The burden will be on the member to
demonstrate to the satisfaction of Association staff that the
securities can be assigned an appropriate value.
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\27\ NASD Regulation agrees with commenters (Goldman and SIA)
that securities that will be converted into the securities offered
to the public at the time of the public offering are considered to
the identical to the securities offered to the public.
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j. Other Proposed Amendments \28\
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\28\ Other amendments are proposed to the Rule to make minor
grammatical and punctuation changes. References in the Rule to the
``date of effectiveness'' have been amended to also refer to the
``commencement of sales'' to encompass offerings not filed with the
SEC.
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1. Definitions
A. Definition of Participating Member: NASD Regulation proposes to
add a definition in subparagraph (a)(4) of the term ``participating
member'' to include any member that is participating in a public
offering, any associated person of the member, any members of the
immediate family of the associated persons, and any affiliate of the
member. In developing the amended Rule, it became clear that certain
provisions were intended to apply only to the ``participating member,''
whereas others were to apply more broadly to all underwriters and
related persons, which includes certain non-members such as
underwriter's counsel, financial consultants and advisors, and finders
and persons that are related to a participating member.
B. Definition of Underwriter and Related Persons: In light of the
new term ``participating member,'' NASD Regulation also must amend the
term ``underwriter and related persons'' in subparagraph (a)(6). The
revised definition includes the term ``participating member'' and
deletes references to ``underwriters,'' ``members of the selling or
distribution group,'' and ``members of the immediate family of the
aforementioned person,'' all of which are now incorporated into the
Rule through the definition of ``participating member.''
C. Definition of Immediate Family: NASD Regulation proposes in
response to comments (Goldman, M&F, Morgan, and SIA) to amend the
definition of ``immediate family'' in Rule 2720(b)(9) to exclude family
members other than the spouse and children who do not live in the same
household as, have a business relationship with, and are not materially
supported by the employee or associated person. NASD Regulation
believes that the current definition is too broad and places
unnecessary burdens on members. With the new definition, members will
only be required to submit information to the Association under Rule
2710(b)(6)(A)(iii) on the shareholdings of the spouse and children of
the associated persons and employees of members, when other family
members qualify for an exclusion. In addition, the definition will be
expanded to include any other person living in the same household as
the associated person or employee.
2. Filing Requirements
A. Treatment of Confidential SEC Submissions: NASD Regulation
proposes to amend subparagraph (b)(4) to provide that the filing
requirements of the Rule apply when any offering document is ``filed
with or submitted to'' another regulatory authority, in order to
eliminate any ambiguity when offering documents are ``submitted'' to
the SEC for confidential review, thereby addressing comments (Fried
Frank, Morgan, and Salomon) received on the SEC's confidential
``submission'' process.\29\
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\29\ The use of the word ``filed'' in the Rule was intended to
have the common meaning of the term to identify a point in time when
offering documents have been submitted to a regulatory authority and
was not intended to distinguish between ``filed'' and ``submitted''
documents under SEC procedures for purposes of members' obligations
to file public offerings with the Association.
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B. Obligation to File Before Offers Commence: The current filing
requirements cover public offerings that are not filed or submitted to
the SEC or any other federal or state regulatory authority for review.
For these offerings, NASD Regulation proposes to amend the Rule to
state that the offering documents must be filed at least 15 business
days prior to the date ``on which offers will commence,'' replacing
current language that looked to the ``anticipated offering date.''
Thus, members may not commence any efforts to offer the securities
unless the offering memoranda and related documents and information
have been filed with the Association for at least 15 business days.\30\
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\30\ This amendment was developed in connection with
consideration of the comments on the treatment of confidential
submissions to the SEC under the filing requirements of the Rule.
---------------------------------------------------------------------------
C. Obligation to File and Receive Opinion of No Objections Before
Sales Commence: NASD Regulation proposes to revise the introduction of
subparagraph (b)(4)(B) to clarify that the documents and information
must have been filed as required by the Rule and the Association must
have issued an opinion of no objections prior to the commencement of
``sales of securities,'' replacing the current language that looked to
the commencement of the ``offering.'' \31\
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\31\ ID.
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D. Information on NASD Affiliation: Subparagraph (b)(6) requires
members to submit information to the Department on the NASD affiliation
or association with any member of any officer, director or security
holder of the issuer in an initial public offering and with respect to
any other offering provide such information with respect to any
officer, director or security holder of 5% or more of any class of the
issuer's securities. Commenters (Goldman, M&F, Morgan, and SIA) stated
that non-public companies increasingly have a large number of investors
and that the burden of compliance outweighs the value of the
information when each investor holds a small interest in the issuer.
NASD Regulation understand that members have had increasing difficulty
obtaining complete and accurate information about shareholder ownership
under the 5% threshold on a timely basis, thereby impacting the
schedule for requesting effectiveness for the offering. Information on
the NASD affiliation or association of issuer's shareholders that are
not officers or directors, are not 5% or greater shareholders, and that
have not purchased their securities within the 180 days preceding the
filing date of the public offering is only necessary for identifying
the persons who may be subject to the proposed 180-day restricted
period with respect to securities that are not included in underwriting
compensation.
NASD Regulation proposes to amend subparagraph (b)(6)(iii) to
eliminate the requirement to file information on the NASD affiliation
or association of all shareholders of the issuer. The revised provision
would require the filing of information on the NASD affiliation of any:
(1) Officer or director of the issuer;
(2) Beneficial owner of 5% or more of any class of the issuer's
securities; and
(3) Beneficial owner of the issuer's unregistered equity securities
purchased during the 180-day period immediately proceeding the filing
date of the public offering (except purchases through issuer's employee
stock purchase plan).
As a result of this change, members will be obligated to identify
those entities and persons that are covered by the proposed lock-up
restriction in subparagraph (g)(1) and beneficially own securities of
the issuer that were
[[Page 14965]]
acquired before the period commencing 180 days immediately preceding
the required filing date, and that are not also an officer, director,
or 5% or greater shareholder of the issuer. Members will be responsible
for ensuring compliance by any such shareholders with the lock-up
restrictions.
E. Information on New Arrangements: NASD Regulation proposes to
amend subparagraph (b)(6)(A)(vi), to narrow the filing requirement
relating to any new arrangements after the issuance of an opinion of no
objections. Under the revised proposal, the filing obligation will
apply only to participating members, rather than all persons covered by
the term ``underwriter and related persons.''
3. Valuation of Securities--Paragraph (e) regulates the manner in
which securities are assigned a value for purposes of the calculation
of underwriting compensation.
A. Distinguish Securities With an Exercise or Conversion Price:
NASD Regulation proposes to amend subparagraphs (e)(2) and (3),\32\ as
recommended by commenters (Goldman, M&F, and SIA), to clarify that the
application of the valuation method depends on whether the security has
an exercise or conversion price. Convertible securities that have no
conversion price will be valued in the same manner as common stock.
---------------------------------------------------------------------------
\32\ As discussed above, NASD Regulation also proposes to amend
subparagraph (e)(3) to impose a minimum conpensation value on
securities with an exercise or conversion price.
---------------------------------------------------------------------------
B. Valuation of Securities With a Longer Resale Restriction: NASD
Regulation proposes to amend subparagraph (e)(4) to clarify that a
lower value of 10% will be deducted for each 180-day period that
securities are restricted from resale beyond the mandatory lock-up
restriction.\33\
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\33\ For example, the underwriting compensation value of
securities with a value of 2.50% will be reduced to 2.25% if the
securities are restricted for one year from the effective date and
to 2% if the securities are restricted for 18 months following the
effective date.
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C. Valuation of Securities That Have an Exercise or Conversion
Price: As discussed above, NASD Regulation is proposing to amend the
Rule to no longer require that securities have an exercise or
conversion price that is at least equal to the public offering price.
As a result of this change, NASD Regulation proposes to amend
subparagraph (e)(3) to clarify that the market price or public offering
price of the underlying security is deducted from the exercise/
conversion price of the security. In the case of a security with an
exercise/conversion price below the public offering price, that
subtraction would result in a negative number.
4. Sales of Securities Considered To Be Underwriting Compensation
When members are found to have exceeded the permissible
underwriting compensation limits, they frequently seek to dispose of
securities that have been deemed to be underwriting compensation to
bring their compensation within acceptable levels. Current subparagraph
(c)(6)(C) addresses such sales by requiring securities to be returned
to the issuer or the source from which received at cost and without
recourse in order for the securities to be excluded from underwriting
compensation. NASD Regulation believes that this provision is
unnecessary because, under the Rule, the Department may consider
whether a sale of securities deemed to be underwriting compensation is
bona fide, without recourse, and at cost before excluding the
securities from underwriting compensation. Accordingly, NASD Regulation
proposes to eliminate this provision from the Rule.
5. Reorganization of the Rule
NASD Regulation proposes to reorganize the Rule to make it easier
to read by dividing it into more sections as follows:
(a) Definitions
(b) Filing Requirements
(c) Underwriting Compensation and Arrangements
(d) Determination of Whether Items of Value Are Included in
Underwriting Compensation
(e) Valuation of Non-Cash Compensation
(f) Unreasonable Terms and Arrangements
(g) Lock-Up Restriction on Securities
(h) Proceeds Directed to a Member
(i) Exemptions
2. Statutory Basis
NASD Regulation believes that the proposed rule change is
consistent with the provisions of section 15A(b)(6) of the Act,\34\
which requires, among other things, that the Association's rules be
designed to prevent fraudulent and manipulative acts and practices, to
promote just and equitable principles of trade and, in general, to
protect investors and the public interest. NASD Regulation believes
that the proposed rule change will eliminate burdensome rules that no
longer distinguish between bona fide capital-raising and lending
practices and abusive arrangements and will minimize the opportunity
for abusive practices by members in connection with underwriting public
offerings of securities.
---------------------------------------------------------------------------
\34\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------
B. Self-Regulatory Organization's Statement on Burden on Competition
Section C, below, includes a discussion of the potential impact on
small members of the proposed $50 million standard for entities
eligible to rely on the second exception from underwriting
compensation. NASD Regulation does not believe that the proposed rule
change will result in any burden on competition that is not necessary
or appropriate in furtherance of the purposes of the Act.
C. Self-Regulatory Organization's Statement on Comments on the Proposed
Rule Change Received From Members, Participants, or Others
On April 11, 2000, the SEC published the original proposal for
comment in the Federal Register.\35\ The SEC received fourteen comment
letters. Following is a discussion of the comments received that are
not addressed above because NASD Regulation did not incorporate them
into the proposed revisions.
---------------------------------------------------------------------------
\35\ See supra, note 4.
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1. Listed Company Exclusion
Some commenters (TBMA, Goldman, Merrill, and SIA) recommended that
the NASD adopt a ``listed company exception'' to the Rule. Under this
proposal, any public offering by an issuer that is listed or would be
listed after its initial public offering on the Nasdaq National Market,
the New York Stock Exchange, or the American Stock Exchange or any
issuer expecting to have market capitalization of at least $75 million
would be exempt from the Rule's filing requirements and substantive
provisions.\36\ The commenters argued that such issuers are
sufficiently large to negotiate favorable terms with prospective
underwriters without the protections of the Rule.
---------------------------------------------------------------------------
\36\ Morgan and Salomon recommended an exception for a company
with market capitalization of $100 million.
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Our experience indicates that abuses can occur in the underwriting
arrangements with listed companies. NASD Regulation does not believe
that the investor protection purposes of the listing standards are an
adequate proxy for the review of offering documents and underwriting
agreements to prevent unfair or unreasonable arrangements. Moreover,
the changes proposed to the Rule that modernize its provisions and
provide exceptions for legitimate investment transactions should
[[Page 14966]]
eliminate the need for such a sweeping exception.
2. Other Proposed Exclusions From Underwriting Compensation
a. Exclusion of Cash and Non-Cash Fees for Other Services--
Commenters (Chase, M&F, Prudential, and Salomon) recommended that fees
be excluded from underwriting compensation that are for merger and
acquisition advice, a loan or credit facility, a currency hedge, an
insurance policy, services provided by the business unit of a bank, and
other services provided at arm's length.
As discussed in Section II.A., NASD Regulation is proposing to
broaden the current exclusion from underwriting compensation for
private placement agent cash fees to include cash fees received by
participating members during the review period for providing a loan or
credit facility, or for services in connection with a merger or
acquisition. NASD Regulation has traditionally interpreted the Rule to
exclude cash fees received by banks for cash management or trust
services, and would extend that position to insurance policies
(although this issue has not arisen in connection with our review of an
offering). In addition, NASD Regulation has traditionally interpreted
the Rule to include in underwriting compensation any securities paid
during the review period to participating members for related capital
raising activities, including loans, credit facilities, and merger/
acquisition services. Services as a financial advisor and consultant
are specifically included within the definition of underwriter and
related person, and are addressed in Section II.A. above. NASD
Regulation will address the question about the payment of cash fees for
a currency hedge provided by a bank or member, when that issue actually
arises in connection with our review of a public offering.
b. Payments to a Previous Underwriter--The original rule filing
proposed to adopt an exclusion from the calculation of underwriting
compensation in subparagraph (b)(3)(ii) for any payment to a member in
connection with a proposed public offering that was not completed, if
the member does not participate in the revised offering. Several
commenters (SIA, Goldman, Fried Frank, and Merrill) urged NASD
Regulation to exclude fees paid to a member for a failed offering even
when the member participates in the revised offering. NASD Regulation
believes excluding these fees would provide an opportunity for members
to evade the compensation limits of the Rule and, thus, has not amended
the Rule as suggested by commenters.\37\
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\37\ The amendment proposed to subparagraph (b)(3)(ii) would
eliminate the current requirement that fees paid to a previous
underwriter for a failed offering be included in the calculation of
underwriting compensation, even if the previous underwriter does not
participate in the revised offering. The Rule would continue to
prohibit payment of any compensation to a member for a failed
offering, except for reimbursement of out-of-pocket expenses, in
subparagraph (f)(2)(D) of this amended rule filing.
---------------------------------------------------------------------------
c. Exclusion for Investments by Foreign Affiliates--Chase and CIBC
recommended that investments in the issuer's securities by foreign
affiliates of a member, particularly when the issuer is also domiciled
outside the U.S., should be excluded from the calculation of
underwriting compensation. NASD Regulation believes it is appropriate
to apply the compensation limitations of the Rule to all members
participating in a public offering made in the U.S., regardless of the
location of the issuer or any affiliate of a participating member. Any
other position would unfairly discriminate between members of the NASD
depending on where their affiliates are located and whether the member
has developed a business in underwriting the securities of foreign
companies. Moreover, NASD Regulation believes that an exclusion for
investments by foreign affiliates could easily be used to circumvent
the Rule's compensation limits.
d. Exclusion of Investments by Certain Employees/Employee
Investment Funds--Commenters (Merrill, Morgan, and Prudential)
requested that the Rule exclude investments by employees of the member,
either because the employees are not related to the member's
underwriting activities or because the employees (and their immediate
families) invest through an ``employee securities company.'' NASD
Regulation finds that the suggested exclusion for ``employee securities
companies'' would not distinguish between bona fide investments and
investments for the purpose of obtaining additional underwriting
compensation. Moreover, the six exceptions proposed herein provide
sufficient opportunity for employees of members, as well as members, to
acquire the securities of the issuer during the 180-day review period.
3. 180-Day Review Period
NASAA requested that NASD Regulation monitor the effectiveness of
the 180-day review period by reviewing arrangements between issuers and
underwriters in the 6-month period before the 180-day review period.
According to NASAA's proposal, if NASD Regulation determines that the
180-day review period is not effective in regulating underwriting
compensation, then it should expand the review period to 12 months.
NASD Regulation notes that the information requested by NASAA will be
contained in the public offering document filed with the Department for
review. Department staff will have an opportunity to be alerted to the
existence of any egregious arrangements that occur before the 180-day
review period.
NASD Regulation does not agree with the request by M&F that the
Rule should specifically exclude any items of value received by
underwriters and related persons prior to the 180-day review period
from the calculation of underwriting compensation, in light of the
Association's general regulatory goals.
4. Requirements of the Exceptions From Underwriting Compensation
Commenters recommended the elimination and/or modification of many
of the criteria and definitions of the proposed exceptions from
underwriting compensation, in many cases arguing that the criteria was
unnecessary to advance the purposes of the exception.\38\ Of these,
NASD Regulation has proposed to eliminate the provision prohibiting
reliance on the exceptions during the 90-day period prior to filing;
the provision in the second exception that would have required that an
institutional investor be a member of the issuer's board of directors;
and the requirement that members submit written procedures
demonstrating that the member did not make its participation in the
offering contingent on an acquisition of the issuer's securities. In
addition, in response to comments, NASD Regulation is clarifying the
application of many of the remaining criteria. NASD Regulation believes
that the criteria, as amended, will be effective in distinguishing
between securities acquired as bona fide investments from securities
that are underwriting compensation for the public offering.
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\38\ However, Goldman and the SIA agreed with the 51% standard
for institutional investor participation under the third exception.
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a. Definition of Entity--Commenters (Fried Frank, Goldman, and SIA)
recommend that two or more entities that propose to be treated as a
group should be permitted to demonstrate their bona fide identity as a
group, even though they have not previously made a joint investment,
through the terms of their contractual obligations, the occurrence of
subsequent investments or otherwise, and should include
[[Page 14967]]
entities that intend to file a Schedule 13D or 13G with the SEC in
connection with the investment under consideration or a subsequent
investment. Fried Frank also recommends that an entity include any
entity that is, or the control persons of which are, under common
control and entities whose investments are made under the direction of
a common investment advisor or financial advisor. Chase requests that
the definition of entity be expanded to include third-level
subsidiaries under the common control of second-level subsidiaries that
are contractually obligated to invest together and are under the common
control of a bank.
NASD Regulation believes that the structures proposed by commenters
would diminish the protections that are intended to be provided by the
capital-under-management and non-participating member capital
requirements in the first and second exceptions. Moreover, the
commenters' proposal would appear to contradict the requirement that
the entity (including a group qualifying as an entity) have a minimal
history in being ``primarily engaged in the business of making
investments in or loans to other companies.''
b. Definition of Institutional Investor--Fried Frank states that
the requirement that an institutional investor have $50 million in
securities under management for purposes of the second and third
exceptions is excessive because it will disadvantage small members and
prevent the issuer from choosing the underwriter that best suits its
needs. NASD Regulation notes that small members that act as
underwriters are generally better capitalized than members that engage
only in retail brokerage activity--in part because of the net capital
necessary to engage in underwriting activities. NASD Regulation does
not believe that the Rule improperly disadvantages smaller
underwriters, particularly as the exceptions are proposed to be
expanded in this filing.\39\
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\39\ Moreover, small members will benefit from the shortening of
the review period, the elimination of the 10% stock numerical
limitation, and the elimination of the prohibition on members
receiving warrants with an exercise price below the public offering
price.
---------------------------------------------------------------------------
c. Second Exception--33% Limitation--The second exception requires
that institutional investors beneficially own at least 33% of the
issuer's equity securities. Several commenters (Goldman, M&F, Merrill,
Morgan, Salomon, and SIA) suggested decreasing the 33% threshold. NASD
Regulation does not believe that this suggestion is consistent with the
purposes underlying the exception because the second exception does not
place any limitations on whether the investing entity is managed by a
member, is funded by a member or its associated persons, or is a
subsidiary of a member. Therefore, NASD Regulation believes that the
33% standard for institutional investor participation is necessary to
prevent potential overreaching by a participating member.
d. Fourth Exception--Limitation on Increasing Percentage
Ownership--The fourth exception prohibits investors from increasing
their percentage ownership of the issuer's securities in reliance on
the exception. Goldman and the SIA believe that investors should have
the benefit of indemnification provisions with issuers that give the
investor the right to receive additional shares if it appears later
that the issuer misrepresented, for example, its capitalization at the
time of the investment. NASD Regulation believes that the concerns
articulated by the commenters are best addressed on a case-by-case
basis.
These commenters recommend that the Association also permit
investors to take advantage of anti-dilution protection for subsequent
issuances to others, regardless of whether the investor has a
preemptive right. Under the proposed rule change, any purchases for
anti-dilution protection during the 180-day review period and
subsequent to filing of a public offering must comply with the fourth
or fifth exceptions in order to be excluded from underwriting
compensation. Thus, additional purchases of the issuer's securities to
prevent dilution are only permitted to maintain the purchaser's
percentage ownership of the issuer's securities, if the purchaser
exercises a preemptive right, is the subject of a pro-rata rights
offering, or has a two-year prior investment history.
Fried Frank, Goldman, and Merrill state that there are
circumstances in which some rights holders elect not to purchase, with
the result that other rights holders who elect to purchase experience
an increase in their percentage ownership. In addition, these
commenters state that rights holders are generally permitted to
purchase additional shares that are made available by the decision of
other rights holders not to exercise. They recommend that such
purchases not be treated as underwriting compensation. NASD Regulation
disagrees. This exception is intended to recognize that an investor
that has a preemptive right, or is the subject of a stock split, pro-
rata rights offering, or stock conversion should not be disadvantaged
by application of the Rule to the securities thereby acquired in order
to prevent the investor's interest from being diluted. Thus, except for
conversions, this exception, and exception five, allows the investor to
maintain its percentage interest in the issuer, but does not allow the
investor to improve its position.
5. Lock-Up Restriction
a. Application To Securities That Are Not Deemed To Be Underwriting
Compensation--Goldman, Fried Frank, Merrill, and the SIA recommend that
the lock-up restriction only apply to securities deemed to be
underwriting compensation, arguing that the scope of the lock-up
requirement does not protect investors when securities are not
considered to be underwriting compensation and seriously threatens the
economic interests of venture capital and other investors. NASD
Regulation disagrees. In regulating resales of securities, the goals of
the Rule are to:
Protect the issuer and public investors by ensuring that
the public market for the securities sold by participating members has
an opportunity to develop prior to the sale of securities into the
market by the underwriters and related persons that dilutes the public
investors; and
Prevent opportunities for fraud and manipulation in the
after-market of a company's initial public offering or an offering of
securities that are not sufficiently liquid when a member is an
underwriter, actively trades the securities, and is a selling
securityholder.
NASD Regulation's concern regarding potential market dilution and
the opportunity for fraud and manipulation is the same, regardless of
whether the securities that are sold by participating members into the
public market are deemed to be underwriting compensation or were
excluded from underwriting compensation.
b. Time Period of Lock-Up--Ohio favors the extension of the 90-day
venture capital lock-up from 90 to 180 days, but joins with NASAA in
opposing the shortening of the compensation lock-up to 180 days,
believing the current one-year period to be an appropriate and prudent
standard for securities deemed to be underwriting compensation,
particularly in smaller offerings where there may be less information
about the issuer. M&F is opposed to the imposition of a flat 180-day
lock-up period on securities of an issuer held by underwriters,
preferring that NASD Regulation lock-up be the same as that imposed by
the issuer on its management and other major
[[Page 14968]]
securityholders. In addition, Fried Frank and M&F suggest that the
lock-up be 30 or 90 days for follow-on offerings.
NASD Regulation continues to believe that a lock-up period of 180-
days for initial public offerings and follow-on or secondary offerings
where the market for the security is not sufficiently liquid is
necessary to protect the after-market from potential manipulation.
c. Exceptions to the Lock-Up--Goldman recommends an additional
exception from the proposed lock-up requirement for transfers to an
affiliate of a member. NASD Regulation believes that such transfers to
affiliates of members are best addressed on a case-by-case basis.
Department staff have previously permitted such transfers when the
securities were owned by the member firm, the transfer was without any
payment, and the purpose of the transfer was to avoid net capital or
other tax consequences to the member during the time of the resale
restriction.
Fried Frank requests that the exception for securities priced by a
qualified independent underwriter be retained, citing the statement in
Notice to Members 86-1 where the Association stated that ``[t]he
presence of an independent underwriter to conduct pricing and due
diligence is sufficient protection against potential conflicts of
interest to justify an exemption from the [venture capital]
restrictions.'' NASD Regulation has reconsidered the efficacy of this
exception and now believes that the presence of a qualified independent
underwriter fails to address the potential negative dilutive effect of
such sales on the public market in the case of an initial public
offering or any offering of a security that is not sufficiently liquid.
NASD Regulation believes that a better standard is the ``actively
traded security'' test of SEC Regulation M that is proposed as an
exception to the lock-up restriction for securities acquired prior to
the 180-day review period, as the Regulation M standard would define a
liquid market.
6. Other Comments
a. Exemption for Shelf Offerings on Forms S-3 and F-3--The SIA and
Merrill request that NASD Regulation amend its current exemption from
filing for shelf offerings on Forms S-3 and F-3 to rely on the current
standards for these forms to reduce unnecessary complexity and burden.
In addition, the SIA requested that the NASD eliminate its
interpretation published in Notice to Members 93-88 that the exemption
is only available for shelf offerings for which there is a genuine
intention to make a delayed offering (i.e., the filing exemption is not
available where the Rule 415 box is checked only for convenience).
Alternatively, the SIA recommends that NASD Regulation specifically
incorporate this interpretation into the Rule. The staff is currently
developing a proposal related to the application of the Rule to shelf
registered offerings and NASD Regulation plans to address these
comments in connection with that proposal.
b. Exemption from Compliance for Investment Grade Debt Offerings--
TBMA recommends that the exemption under Rule 2710(b)(7) for offerings
by issuers with investment grade debt outstanding and for investment
grade debt offerings should be moved to Rule 2710(b)(8) in order to
provide an exemption from the substantive requirements of the Rule.
Investment grade debt offerings rarely involve issues concerning
underwriting terms and arrangements. However, the practical effect of
TBMA's recommendation would be to exempt such offerings from the filing
and substantive requirements of Rule 2720, the NASD's conflict-of-
interest rule, when the offering is of the securities of a member, the
member's parent, or an affiliate of a member. NASD Regulation does not
believe this exemption is warranted at this time.
c. Delayed Offerings--Chase believes that the Rule should provide
that in situations where a registration statement has been on file for
more than three months without an amendment filing, the NASD Regulation
value underwriting compensation by reviewing the 180-day period prior
to filing of an amendment. The staff considers circumstances such as
these on a case-by-case basis. The Department has, at times, granted
requests to exclude from underwriting compensation securities that were
acquired within the 180-day review period, but more than a year before
the anticipated public offering date of a delayed offering.
d. Definition of Underwriter and Related Person--The SIA and
Goldman recommend that the definition of ``underwriters and related
persons'' be amended to exclude selling group members, arguing that
issuers do not have a relationship with selling group members and do
not have an economic incentive to provide extra or illicit compensation
to selling group members in the form of low-cost securities or
otherwise. These commenters argue that applying the compensation rules
to selling group members would present a burden on capital formation,
excluding willing sellers with no demonstrable benefit. NASD Regulation
believes that this proposal would provide an opportunity for
circumvention of the Rule's compensation limits by members willing to
limit their role in the offering in exchange for the ability to acquire
the securities of the issuer on a pre-offering basis. NASD Regulation
believes that the broad scope of the definition of underwriter and
related persons has operated effectively in carrying out the issuer and
investor protection purposes of the Rule.
Merrill recommends that the definition be amended to exclude only
those persons or entities affiliated with a member that have knowledge
of the offering based on their roles at the member or ownership
interest in the issuer. NASD Regulation does not believe that
``knowledge of the offering'' is a verifiable standard for determining
the scope of the application of the Rule to acquisitions of the
issuer's securities. In addition, if the purpose of this proposal is to
exclude cash fees received for ordinary business by affiliates of a
member, NASD Regulation believes that the proposed rule change properly
identifies situations where fees received by members' affiliates are
considered to be unrelated to the public offering.
e. Calculation of Underwriting Compensation Based on Integrated
Transactions--Morgan recommends that several registered transactions
that are part of a coherent financing schedule where each is contingent
on each other, should be treated as a single offering for the
calculation of underwriting compensation. NASD Regulation will consider
such treatment on a case-by-case basis, where allocation of a member's
acquisition of the issuer's securities to a coherent group of related
financing transactions appears appropriate in light of the total
capital-raising obligations of the member.
III. Date of Effectiveness of the Proposed Rule Change and Timing
for Commission Action
Within 35 days of the date of publication of this notice in the
Federal Register or within such longer period (i) as the Commission may
designate up to 90 days of such date if it finds such longer period to
be appropriate and publishes its reasons for so finding or (ii) as to
which NASD Regulation consents, the Commission will:
(A) By order approve such proposed rule change, or
(B) Institute proceedings to determine whether the proposed rule
change should be disapproved.
IV. Solicitation of Comments
Interested persons are invited to submit written data, views, and
[[Page 14969]]
arguments concerning the foregoing, including whether Amendment No. 5
is consistent with the Act. Persons making written submissions should
file six copies thereof with the Secretary, Securities and Exchange
Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. Copies of
the submission, all subsequent amendments, all written statements with
respect to the proposed rule change that are filed with the Commission,
and all written communications relating to the proposed rule change
between the Commission and any person, other than those that may be
withheld from the public in accordance with the provisions of 5 U.S.C.
552, will be available for inspection and copying in the Commission's
Public Reference Room. Copies of the filing will also be available for
inspection and copying at the principal office of the NASD. All
submissions should refer to the File No. SR-NASD-00-04 and should be
submitted by April 4, 2001.
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\40\
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\40\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-6275 Filed 3-13-01; 8:45 am]
BILLING CODE 8010-01-P