[Federal Register: October 31, 2003 (Volume 68, Number 211)]
[Notices]
[Page 62126-62146]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr31oc03-111]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-48701; File No. SR-NASD-99-60]
Self-Regulatory Organizations; Order Approving Proposed Rule
Change and Amendment Nos. 1 Through 4 Thereto and Notice of Filing and
Order Granting Accelerated Approval of Amendment No. 5 Thereto by the
National Association of Securities Dealers, Inc. Relating to
Restrictions on the Purchases and Sales of Initial Public Offerings of
Equity Securities
October 24, 2003.
I. Introduction
On October 15, 1999, the National Association of Securities
Dealers, Inc. (``NASD'') filed with the Securities and Exchange
Commission (``Commission'' or ``SEC''), pursuant to Section 19(b)(1) of
the Securities Exchange Act of 1934 (``Act'')\1\ and Rule 19b-4
thereunder,\2\ a proposed rule change that would govern purchases and
sales of ``hot equity'' offerings. On December 21, 1999, the NASD
submitted Amendment No. 1 to the proposed rule change.\3\ The proposed
rule change and Amendment No. 1 were published for comment in the
Federal Register on January 18, 2000.\4\ On October 11, 2000, the NASD
submitted Amendment No. 2 to the proposal \5\ which, among other
things, changed the subject of the proposed rule from ``hot issues'' to
``new issues.'' Amendment No. 2 was published for comment in the
Federal Register on December 6, 2000.\6\ The NASD submitted Amendment
No. 3 to the proposal on March 20, 2001,\7\ and Amendment No. 4 to the
proposal on June 27, 2002.\8\ The Commission published the proposal as
revised by Amendment Nos. 3 and 4 in the Federal Register on December
10, 2002.\9\ On October 23, 2003, the NASD submitted Amendment No. 5 to
the proposal.\10\ This notice and order approves the proposed rule
change and Amendment Nos. 1 to 4 thereto, solicits comment on Amendment
No. 5, and approves Amendment No. 5 on an accelerated basis.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ See Letter from Gary L. Goldsholle, NASD, to Katherine A.
England, Division of Market Regulation, SEC, dated December 20, 1999
(``Amendment No. 1'').
\4\ Securities Exchange Act Release No. 42325 (January 10,
2000), 65 FR 2656.
\5\ See Letter from Alden S. Adkins, NASD, to Katherine A.
England, Division of Market Regulation, SEC, dated October 10, 2000
(``Amendment No. 2'').
\6\ Securities Exchange Act Release No. 43627 (November 28,
2000), 65 FR 76316.
\7\ See Letter from Patrice M. Gliniecki, NASD, to Katherine A.
England, Division of Market Regulation, SEC, dated March 20, 2001
(``Amendment No. 3'').
\8\ See Letter from Gary L. Goldshalle, NASD, to Katherine A.
England, Division of Market Regulation, SEC, dated June 27, 2002
(``Amendment No. 4'').
\9\ See Securities Exchange Act Release No. 46942 (December 4,
2002), 67 FR 75889.
\10\ See Letter from Gary L. Goldsholle, NASD, to Katherine A.
England, Division of Market Regulation, SEC, dated October 22, 2003
(``Amendment No. 5'').
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II. Executive Summary
Currently, NASD Interpretative Material (``IM'') 2110-1, commonly
known as the ``Free-Riding and Withholding Interpretation''
(``Interpretation''), governs the manner in which NASD members may
distribute ``hot issues.'' The NASD has proposed to restructure and
make substantive amendments to the Interpretation; the result would be
codified as new NASD Rule 2790. The NASD has stated that the new rule,
like the Interpretation it would replace, is designed to protect the
integrity of the public offering process by ensuring that: (1) NASD
members make bona fide public offerings of securities at the offering
price; (2) members do not withhold securities in a public offering for
their own benefit or use such securities to reward persons who are in a
position to direct future business to members; and (3) industry
insiders, including NASD members and their associated persons, do not
take advantage of their ``insider'' position to purchase new issues for
their own benefit at the expense of public customers. The NASD believes
that the proposed rule is better designed to further the purposes of
the Interpretation, while at the same time being easier to understand.
Under new NASD Rule 2790, an NASD member generally would be
prohibited from selling a ``new issue'' to any account in which a
``restricted person'' had a beneficial interest. As discussed further
below, the term ``restricted person'' would include most broker-
dealers, most owners and affiliates of a broker-dealer, and certain
other classes of person. The proposed rule would require a member,
before selling a new issue to any account, to meet certain
``preconditions for sale.'' These preconditions generally would require
the member to obtain a representation from the beneficial owner of the
account that the account is eligible to purchase new issues in
compliance with the rule. The rule would provide several general
exemptions, the basic rationale of which is that sales to and purchases
by entities that have numerous beneficial owners--and, therefore, are
likely to have only a small percentage of restricted persons owners--
are not the types of transactions the rule should proscribe. The
details of proposed NASD Rule 2790 are discussed in Section IV below.
III. Procedural History and Comments Received
The proposal, as revised by Amendment No. 1, was published for
comment in the Federal Register on January 18, 2000.\11\ The Commission
received 24 comments on the original notice.\12\ In response to these
comments,
[[Page 62127]]
the NASD submitted Amendment No. 2, which was published for comment in
the Federal Register on December 6, 2000.\13\ Between December 2000 and
March 2001, the Commission received 14 comment letters on the proposed
rule change.\14\ The NASD reviewed the 14 comment letters and made
various revisions to proposed NASD Rule 2790 in Amendment Nos. 3 and 4.
After the NASD had filed Amendment No. 4 with the Commission, the
Commission received two additional comment letters that, among other
things, advocated publication of Amendment No. 4 in the Federal
Register.\15\ The proposal, as revised by Amendment Nos. 3 and 4, was
published for comment in the Federal Register on December 10, 2002.\16\
The Commission received four comments on the proposal after December
10, 2002,\17\ and responded to those comments in Amendment No. 5. The
proposed rule change, and the evolution of its various provisions
through the five amendments, are described below.
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\11\ See supra note 4.
\12\ See Letter from Willkie Farr & Gallagher to Jonathan G.
Katz, SEC, dated January 28, 2000 (``Willkie''); Letter from Faith
Colish to Jonathan G. Katz, SEC, dated January 31, 2000
(``Colish''); Letter from Katten Muchin Zavis to Jonathan G. Katz,
SEC, dated January 28, 2000 (``Katten''); Letter from Sandra K.
Smith to Jonathan G. Katz, SEC, dated February 1, 2000 (``Smith'');
Letter from Driehaus Capital Management, Inc. to Jonathan G. Katz,
SEC, dated February 4, 2000 (``Driehaus''); Letter from Cadwalader,
Wickersham & Taft to Jonathan G. Katz, SEC, dated February 4, 2000
(``Cadwalader''); Letter from Fu Associates, Ltd. to Jonathan G.
Katz, SEC, dated February 7, 2000 (``Fu''); Letter from Schulte Roth
& Zabel LLP to Jonathan G. Katz, SEC, dated February 7, 2000
(``Schulte''); Letter from Rosenman & Colin LLP to Jonathan G. Katz,
SEC, dated February 7, 2000 (``Rosenman''); Letter from Ropes & Gray
to Jonathan G. Katz, SEC, dated February 8, 2000 (``Ropes''); Letter
from The Washington Group to Jonathan G. Katz, SEC, dated February
8, 2000 (``Washington''); Letter from Testa, Hurwitz & Thibeault,
LLP to Jonathan G. Katz, SEC, dated February 8, 2000 (``Testa'');
Letter from Northern Trust Global Advisors, Inc. to Jonathan G.
Katz, SEC, dated February 13, 2000 (``Northern Trust''); Letter from
Chicago Board Options Exchange to Jonathan G. Katz, SEC, dated
February 14, 2000 (``CBOE''); Letter from Sullivan & Cromwell to
Jonathan G. Katz, SEC, dated February 15, 2000 (``Sullivan'');
Letter from Charles Schwab to Jonathan G. Katz, SEC, dated February
15, 2000 (``Schwab''); Letter from Sidley & Austin to Jonathan G.
Katz, SEC, dated February 16, 2000 (``Sidley''); Letter from North
American Securities Administrators Association, Inc. to Jonathan G.
Katz, SEC, dated February 18, 2000 (``NASAA''); Letter from
Securities Industry Association to Jonathan G. Katz, SEC, dated
February 18, 2000 (``SIA''); Letter from Mayor, Day, Caldwell &
Keeton, L.L.P. to SEC, dated March 8, 2000 (``Mayor Day''); Letter
from Morgan Stanley Dean Witter to Jonathan G. Katz, SEC, dated
March 17, 2000 (``MSDW''); Letter from Covington & Burling to
Jonathan G. Katz, SEC, dated April 14, 2000 (``Covington''); Letter
from Orrick, Herrington & Sutcliffe LLP to Jonathan G. Katz, SEC,
dated May 2, 2000 (``Orrick''); Letter from Fried, Frank, Harris,
Shriver & Jacobson to Jonathan G. Katz, SEC, dated May 9, 2000
(``Fried'').
\13\ See supra note 6.
\14\ See Letter from The Washington Group to Jonathan G. Katz,
SEC, dated December 21, 2000 (``Washington 2''); Letter from Fried,
Frank, Harris, Shriver & Jacobson to Jonathan G. Katz, SEC, dated
December 22, 2000 (``Fried 2''); Letter from Capital International,
Inc. to Jonathan G. Katz, SEC, dated December 22, 2000 (``CII'');
Letters from Cadwalader, Wickersham & Taft to Jonathan G. Katz, SEC,
dated December 22, 2000 and January 4, 2001 (``Cadwalader 2'');
Letter from Testa, Hurwitz & Thibeault to Jonathan G. Katz, SEC,
dated December 26, 2000 (``Testa 2''); Letter from Managed Funds
Association to Jonathan G. Katz, SEC, dated December 26, 2000
(``MFA''); Letter from Mayor, Day, Caldwell & Keeton, L.L.P. to
Jonathan G. Katz, SEC, dated December 26, 2000 (``Mayor Day 2'');
Letter from Sullivan & Cromwell to Jonathan G. Katz, SEC, dated
December 29, 2000 (``Sullivan 2''); Letter from Willkie Farr &
Gallagher to Jonathan G. Katz, SEC, dated January 8, 2001 (``Willkie
2''); Letter from Securities Industry Association to Margaret H.
McFarland, SEC, dated January 10, 2001 (``SIA 2''); Letter from
Chicago Board Options Exchange to Jonathan G. Katz, SEC, dated
January 12, 2001 (``CBOE 2''); Letter from Morgan Stanley Dean
Witter to Secretary, SEC, dated January 31, 2001 (``MSDW 2'');
Letter from The Washington Group to Laura S. Unger, SEC, dated March
27, 2001 (``Washington 3'').
\15\ See Letter from Willkie Farr & Gallagher to SEC dated
September 24, 2002 (``Willkie 3''); Letter from Managed Funds
Association to SEC dated October 15, 2002 (``MFA 2'').
\16\ See supra note 9.
\17\ See Letter from Willkie Farr & Gallagher to Jonathan G.
Katz, SEC, dated December 13, 2002 (``Willkie 4''); Letter from
Managed Funds Association to Jonathan G. Katz, SEC, dated December
31, 2002 (``MFA 3''); Letter from Sidley Austin Brown & Wood to
Jonathan G. Katz, SEC, dated January 9, 2003 (``Sidley 2''); Letter
from Mayer Brown Rowe & Maw to Jonathan G. Katz, SEC, dated January
13, 2003 (``Mayer Brown'').
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IV. Description of Proposal
A. Primary Differences Between NASD Rule 2790 and NASD IM-2110-1
1. ``New Issues'' Versus ``Hot Issues''
The Interpretation applies to any ``hot issue,'' defined as a
public offering of a security that trades at a premium whenever
secondary market trading begins.\18\ The proposed rule, in contrast,
would apply to any ``new issue,'' defined as an initial public offering
of an equity security.\19\ The initial proposal would have retained the
concept of ``hot issues'' but revised the Interpretation's definition
to provide a clearer standard for when an issue becomes ``hot'' (i.e.,
when it trades at the required premium). The NASD initially proposed to
define ``hot issue'' as a security that is part of a public offering
where the volume-weighted price during the first five minutes of
trading in the secondary market is 5% or more above the public offering
price.
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\18\ See NASD IM-2110-1(a)(1).
\19\ See paragraph (i)(10) of proposed NASD Rule 2790. This
provision would in turn define ``equity security'' to have the same
meaning as in Section 3(a)(11) of the Act, 15 U.S.C. 78c(a)(11).
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The proposed 5% threshold generated several comments. Three
commenters supported the NASD's proposal for a clear and measurable
standard for determining whether an issue becomes ``hot'' but believed
that the 5% threshold was too low.\20\ Several commenters questioned
whether the methodology proposed by the NASD would be effective in
identifying those offerings that should be subject to the proposed
rule.\21\
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\20\ See Driehaus; MSDW; Sullivan.
\21\ See Colish (stating that the NASD should supply data to
support the numerical thresholds chosen in the proposed rule);
Driehaus (recommending use of a threshold based on a security's
volume-weighted price on the first day, not just the first five
minutes of trading or any other short period of time during the
trading day); MSDW; NASAA; SIA (recommending a percentage based on
the first half hour of trading that occurs away from the lead
underwriter).
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Two commenters suggested an approach even more straightforward than
a 5% threshold: prohibiting allocations of all IPOs to restricted
persons.\22\ One of these commenters noted a significant drawback to
any definition that included a numerical threshold: prudent firms would
have to treat all IPOs as subject to the rule because they would not be
able to anticipate which offerings would trade through the
threshold.\23\ The second commenter agreed that, in practice, many
firms would treat all IPOs as subject to the rule even if many of them
were not hot issues.\24\ The second commenter added that, although the
Interpretation contains a cancellation provision, many firms do not
avail themselves of it because of the administrative costs of tracking
and canceling hot issue sales, the risks of noncompliance associated
with selling hot issues to restricted persons, and the ill will
generated by having to cancel a customer's allocation.
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\22\ See Schwab; SIA (arguing in the alternative for a higher
threshold premium).
\23\ See SIA.
\24\ See Schwab.
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Based on these comments, the NASD in Amendment No. 2 revised the
proposed rule to cover the purchase and sale of all initial equity
public offerings, not just those that open above a designated premium.
The NASD believes that this approach would be easier to understand and
would avoid many of the complexities associated with the cancellation
provision.
2. Elimination of Cancellation Provision
Currently, a member that sells a hot issue to a restricted person
or account will not be considered to have violated the Interpretation
if the member: (1) Cancels the trade before the end of the first
business day following the date on which secondary market trading
commences for that issue; and (2) reallocates such security at the
public offering price to a non-restricted person or account.\25\ This
provision allows members to cancel trades in the event an issue
unexpectedly becomes ``hot.'' With the decision to apply the proposed
rule to all new issues, the NASD no longer believes that a cancellation
provision is necessary. The NASD would expect members to determine the
status of all prospective purchasers prior to selling a new issue.
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\25\ See NASD IM-2110-1(a)(3).
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3. Elimination of ``Conditionally Restricted Person'' Status
Another significant difference between the proposed rule and the
Interpretation is the elimination of ``conditionally restricted
person'' status and the decision to treat all persons as either
restricted or non-restricted. Although the term ``conditionally
restricted person'' is not used in the Interpretation, the concept
generally includes: (1) Members of the immediate family of an
associated person who are not supported directly or indirectly by the
associated person; (2) finders in respect to the public offering; (3)
any person acting in a fiduciary capacity to the managing underwriter
(including accountants, attorneys, and consultants); and (4) senior
officers and directors of a bank, savings and loan
[[Page 62128]]
institution, insurance company, investment company, investment advisory
firm, or any other institutional-type account, or any person in the
securities department of any of the foregoing entities, or any other
employee who may influence, or whose activities directly or indirectly
involve or are related to, the function of buying or selling securities
for any of the foregoing entities.\26\ Under the Interpretation, a
conditionally restricted person generally may purchase hot issues if:
(1) The securities are sold to that person in accordance with the
person's normal investment practice; (2) the amount of securities sold
to such person is insubstantial; and (3) the member's aggregate sales
to conditionally restricted persons is insubstantial and not
disproportionate in amount as compared to sales to other members of the
public.
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\26\ See NASD IM-2110-1(b)(5).
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Several commenters urged the NASD to retain the concept of
conditionally restricted persons.\27\ The NASD believes, however, that
treating a person as conditionally restricted is, in many cases,
contrary to the public interest: although certain conditionally
restricted persons--such as investment advisers, hedge fund managers,
and other investment managers--may have the requisite investment
history to qualify for the exemption, they still may be in a position
to direct future business to a member. The NASD does not believe that
meeting the conditionally restricted person criteria alleviates these
concerns. The NASD now prefers a bright-line approach and, therefore,
has proposed to eliminate conditionally restricted person status. The
NASD acknowledges that, by doing so, certain persons who may purchase
hot issues under the Interpretation would be restricted persons under
the new rule. However, the rule contains new provisions that would
address some of their concerns.
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\27\ See Mayor Day 2; MFA; Washington 2.
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4. Introduction of 10% De Minimis Threshold for Restricted Person
Participation
The NASD has stated that some of the persons who previously
benefited from conditionally restricted person status could instead
benefit from a proposed de minimis threshold: restricted persons would
be permitted to hold interests in a collective investment account that
purchases new issues, provided that such persons account for no more
than 10% of the account's beneficial ownership.
The NASD initially proposed a de minimis threshold of 5%. Several
commenters urged the NASD to raise the threshold from 5% to 10% or
more.\28\ These commenters generally maintained that restricted persons
should be permitted to hold interests in an account that purchases new
issues, provided that they exercise no investment authority over the
account.\29\ The NASD responded that for many years it has received
similar requests to establish what would in effect be a ``passive
investor exemption.'' The NASD believes that such an exemption would
allow persons who are not public investors to receive substantial
allocations of new issues, which would be fundamentally at odds with
the purposes of the rule. The NASD believes, moreover, that
participation by restricted persons in an account might be known or
inferred by an NASD member allocating a new issue and, thus, create a
temptation for the member to reward that account in the hope of
receiving future business. For these reasons, the NASD has declined to
adopt a blanket exemption for passive investors.
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\28\ See Cadwalader; MSDW; Ropes; Schulte; Sidley.
\29\ See Cadwalader 2; Fried; Mayor; Ropes.
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Early commenters noted that investors generally expect a hedge fund
manager to make significant investments in the fund to align the
manager's interests with those of the investors; these commenters urged
the NASD to raise the de minimis threshold to allow such
arrangements.\30\ However, rather than increase the initially proposed
5% threshold, the NASD in Amendment No. 2 proposed a limited exemption
for portfolio managers: a person would not be restricted with respect
to a collective investment account for which he or she acted as a
portfolio manager.\31\
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\30\ See Cadwalader; Katten; Northern Trust; Schulte; Sullivan;
Washington; Willkie.
\31\ In any event, a portfolio manager would still be prohibited
from purchasing new issues through a personal account.
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One commenter argued that this limited exemption for portfolio
managers would not further the interests of the proposed rule because a
portfolio manager who benefits from the purchase of new issues through
an account that he or she manages would have far greater incentive and
opportunity to direct future business to an NASD member than the
restricted persons who were merely passive investors.\32\ In Amendment
No. 4, the NASD responded by reinstating portfolio managers as
restricted persons in all cases, including with respect to accounts for
which they act as portfolio manager, but raising the de minimis
threshold to 10%. Under this new approach, an account managed by a
portfolio manager would be permitted to invest in new issues, provided
that the interest of all restricted persons in the account (including
the portfolio manager) did not exceed 10%.\33\ The NASD observed that
this approach comported with earlier recommendations made by three
commenters.\34\
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\32\ See Mayor 2.
\33\ In Amendment No. 2, the NASD also proposed a requirement
that no restricted person who had an interest in a collective
investment account could receive through that account more than 100
shares of any new issue on a notional pro rata basis. This limit was
designed to reduce the incentive for self-dealing and the appearance
that restricted persons were receiving shares at the expense of
public investors. However, in Amendment No. 4, the NASD eliminated
the 100-share limitation to simplify application of the proposed
rule. Thus, member firms would not need to track the interest of the
largest restricted person or to perform calculations to determine on
an offering-by-offering basis whether that person would receive more
than 100 shares on a notional pro rata basis.
\34\ See Katten; Rosenman; Schulte.
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Three commenters criticized this new approach and urged the NASD to
return to its earlier proposal of a 5% de minimis threshold and deeming
the portfolio manager as a non-restricted person with respect to the
fund that he or she manages.\35\ These commenters again emphasized
their view that portfolio managers should be required, as one commenter
put it, to ``eat their own cooking.''\36\ They also argued that the new
approach would put the manager of a collective investment account in
competition with investors for ownership of interests in the account
because the manager would wish to obtain the entire 10% for himself or
herself. Further, the commenters stated that the revised approach would
create an incentive for portfolio managers to cash out investors in
their funds and manage their own money separately. Finally, the
commenters argued that the NASD did not offer any public policy
rationale or cite any instances of actual abuse that would support this
revision.
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\35\ See MFA 2; Sidley 2; Willkie 3; Willkie 4.
\36\ Sidley 2.
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In Amendment No. 5, the NASD declined to revise the de minimis
exemption and the proposed treatment of portfolio managers in the
manner suggested by the three commenters. The NASD believes that giving
portfolio managers unrestricted access to new issues--if only through
the funds that they manage--is inconsistent with the purposes of the
proposed rule. The NASD stated that portfolio managers are in a
position to direct substantial business to members and accordingly may
seek to use this influence to obtain access to IPOs. The
Interpretation,
[[Page 62129]]
recognizing this potential conflict, seeks to limit purchases of IPOs
by these persons by treating them as ``conditionally restricted.''
Proposed NASD Rule 2790, in turn, seeks to limit IPO purchases by
portfolio managers by treating them as restricted persons, subject to
the 10% de minimis exemption. Furthermore, the NASD does not believe
that the proposed rule would cause portfolio managers to cash out other
investors in their funds and to manage their own money separately. The
NASD expects that the fees received by portfolio managers for managing
money far exceed the profits that they receive from greater
participation in IPOs.
Finally, two commenters \37\ asked whether the establishment of the
de minimis exemption would eliminate carve-outs, which are contemplated
by the Interpretation.\38\ Such carve-out procedures allow a manager of
an account who wishes to purchase IPOs for such account to segregate
the interests of restricted persons from non-restricted persons. The
NASD responded that carve-outs would continue to be available.
Therefore, a collective investment account in which restricted persons
held an interest of 10% or greater could continue to invest in new
issues, provided that such restricted persons received no more than 10%
of the notional pro rata proceeds of the new issue. Therefore, the NASD
believes that the proposed rule would not prevent portfolio managers
from continuing to pool their money and sharing the same investment
risks with respect to every type of asset--except new issues.
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\37\ See MFA 2; MFA 3; Sidley.
\38\ See NASD IM-2110-1(g).
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In administering the procedures in the Interpretation, the NASD has
recognized that accounts may employ a variety of methods to carve out
the interests of restricted persons and that specifying a particular
method could exclude other equally effective methods. The NASD has
concluded, therefore, that the proposed rule should not prescribe a
particular manner for carving out the interests of restricted persons.
However, in Amendment No. 5 the NASD represented that it intends to
offer detailed guidance concerning the use of carve-out accounts in a
Notice to Members to be published after approval of the proposed rule
change.
5. Preconditions for Sale
Under the proposed rule, a member would not be permitted to sell a
new issue to an account until the member had met the rule's
preconditions for sale. Paragraph (b) of the proposed rule would
require a member to obtain a representation from the account holder(s),
or a person authorized to represent the beneficial owner(s) of the
account, that the account is eligible to purchase new issues in
compliance with the rule. If an interest in the account were held by a
bank, foreign bank, broker-dealer, investment adviser, or other
conduit, the member would be required to obtain from that conduit a
representation that all purchases of new issues would be in compliance
with the rule.\39\ Paragraph (b) also would provide that a member may
not rely on a representation that it believes, or has reason to
believe, is inaccurate. Furthermore, the member would be required to
retain a copy of all records and information relating to whether an
account is eligible to purchase new issues for at least three years
following the member's last sale of a new issue to that account.
Finally, paragraph (b) would require the member to obtain these
representations within the 12 months prior to a sale of new issues to
the account.\40\
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\39\ One commenter expressed concern that the proposed rule, in
the form presented in Amendment No. 2, would not adequately address
sales to intermediaries such as domestic banks, foreign banks,
broker-dealers, investment advisers, and other conduits that
purchase new issues on behalf of their customers. See Sullivan 2. In
response to these concerns, the NASD expanded the preconditions for
sale provisions to address such conduits, as described above.
\40\ The existing preconditions for sale provisions are
scattered throughout the Interpretation. See NASD IM-2110-1(b)(2),
(b)(5), (b)(7), and (f). The proposed rule change would revise and
consolidate these various provisions into a single paragraph of the
new rule.
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Several commenters had reservations about the proposed
preconditions for sale provisions.\41\ One of these commenters believed
that these provisions would impose significant and unnecessary
administrative burdens on members, especially those that distribute
shares to a large number of retail customers.\42\ Another commenter
feared that these provisions would require an annual mailing to all
customers who might be interested in purchasing new issues and would
prohibit the use of electronic communications.\43\ These two commenters
stated that firms should be permitted to develop their own methods to
verify the status of a customer, including the use of oral
representations, so long as such representations are documented
internally. A third commenter urged that NASD members be permitted to
continue to qualify accounts orally and to maintain records of these
oral representations.\44\ Finally, various commenters suggested
lengthening the verification period or allowing members to rely on
``negative consents.''\45\
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\41\ See Cadwalader; MSDW; Schwab; SIA.
\42\ See Schwab.
\43\ See MSDW.
\44\ See SIA.
\45\ Under a negative consent procedure, a broker-dealer member
would send notices to its customers asking if there had been a
change in their restricted status, and the broker-dealer would be
permitted to rely on its existing information regarding a particular
customer unless the customer affirmatively replied that his or her
status had changed. See MSDW; MSDW 2; SIA; Sullivan.
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In Amendment No. 5, the NASD reiterated that the initial
verification of a person's status under the proposed rule must be a
positive affirmation of non-restricted status, but that it intends to
permit annual verification of a person's status to be conducted though
the use of negative consents. The NASD noted that the Commission's new
books and records rules allow a firm to furnish a customer with account
information and ask that he or she verify that the information is
correct. The NASD believes, therefore, that similar disclosure,
confirming that an person is not a restricted person, would be
appropriate. The NASD also would allow the use of electronic
communications for eligible customers but, consistent with the Rule
17a-3 under the Act,\46\ a member would not be permitted to verify
customer account information orally.
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\46\ 17 CFR 240.17a-3.
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Certain commenters questioned how the documentation requirement
would apply given the possibility that a customer's status or
percentage of ownership in an account may change over the course of a
year.\47\ One commenter stated that a member should not be in violation
of the proposed rule if the member were unaware that an account is
beneficially owned by a restricted person due to false information
provided by the customer.\48\ In response, the NASD revised paragraph
(b) expressly to provide that a member may rely upon the information it
receives from a customer unless it believes, or has reason to believe,
that the information is inaccurate. Another commenter recommended that
the proposed rule expressly state that a member may rely upon
representations made by a person who the member ``reasonably believes''
is authorized to represent the beneficial owners of the account.\49\ In
Amendment
[[Page 62130]]
No. 5, the NASD stated that members should use an appropriate level of
diligence to determine whether an individual is authorized to represent
the beneficial owners of the accounts, and that it is unnecessary to
include the language suggested by this commenter.
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\47\ See Cadwalader; NASAA (suggesting a verification period
significantly shorter than one year to reflect possible changes in
ownership that could occur within that period); Ropes.
\48\ See Schwab.
\49\ See Fried.
---------------------------------------------------------------------------
Several commenters sought guidance on what type of information a
member would be required to review to ascertain whether an account is
beneficially owned by restricted persons, especially in the context of
a fund-of-funds.\50\ For example, one commenter urged the NASD to
eliminate the need to ``look through'' multiple layers of investors to
determine whether restricted persons are somewhere in the chain of
ownership.\51\ In Amendment No. 5, the NASD explained that a person
authorized to represent the beneficial owners of the master fund (i.e.,
the fund that purchases the new issues from the member directly) is
required to represent that the fund is able to purchase new issues. The
NASD expects that any such person, in making such representation, would
ascertain the status of investors in the feeder funds (i.e., funds that
invest in the master fund). If the representative of the master fund is
unable to ascertain the status of investors in a feeder fund, the
master fund must deem such feeder fund to be restricted and ensure that
the profits from new issues are not allocated to that fund (or consider
whether any other exemption, such as the de minimis exemption, might
apply to that feeder fund). Also in Amendment No. 5, the NASD stated
that it would address this matter further in a Notice to Members
following Commission approval of the proposed rule change.
---------------------------------------------------------------------------
\50\ See Cadwalader; Katten; Rosenman; Schulte; Sullivan.
\51\ See Cadwalader.
---------------------------------------------------------------------------
B. Other Aspects of NASD Rule 2790
1. Securities Excluded From the Rule
a. Securities Issued as Part of a Secondary Offering. The proposed
rule would not apply to secondary offerings, although the proposed rule
does not contain a specific exemption for them. The exemption is
implicit in the definition of ``new issue,'' which includes any initial
public offering of an equity security.
The NASD initially proposed to subject a secondary offering to the
new rule if it were ``hot'' (i.e., it traded at a 5% premium). Allowing
secondary issues to be considered hot issues would represent a reversal
of the position taken by the NASD under the Interpretation,\52\ and
several commenters criticized this aspect of the original proposal.\53\
These commenters questioned why the proposed rule should apply to
secondary offerings if the NASD believed that most secondary offerings
do not trade at a premium.\54\ They also stated that, without a clear
exemption for secondary issues, member firms generally would bar
allocations of all secondary offerings to restricted persons out of
concern that they could become hot.
---------------------------------------------------------------------------
\52\ In 1998, the NASD amended the Interpretation to exempt
secondary offerings of actively traded securities, based on its
findings that few secondary offerings traded at a premium, and where
there was a premium, it was generally very small. See Securities
Exchange Act Release No. 40001 (May 18, 1998), 63 FR 28535, 28537
(May 26, 1998) (approving SR-NASD-97-95) (``1998 amendments'').
\53\ See MSDW; Schwab; SIA; Sidley; Sullivan.
\54\ See, e.g., Schwab (``the remote possibility that an issue
could trade at a premium would cause many member firms to prohibit
allocations of any secondary issues to restricted customer accounts.
As a practical matter, the Rule would exclude broad categories of
investors from participating in secondary offerings. The negative
consequences to both issuers and customers of such a broad exclusion
outweigh any remote benefits associated with secondary offerings in
the scope of the Rule'').
---------------------------------------------------------------------------
With the decision to apply the proposed rule to new issues rather
than hot issues, secondary offerings would not be subject to the rule.
The NASD continues to believe that secondary offerings rarely if ever
trade at a significant premium to the public offering price and agrees
with the commenters that the negative consequences of applying the rule
to secondary offerings would outweigh any benefits.
b. Debt Securities. Another significant difference between the
proposed rule and the Interpretation is the treatment of debt
securities. Originally, the Interpretation applied to equity and debt
securities. However, as part of the 1998 amendments, the NASD exempted
from the Interpretation most types of investment-grade debt and
investment-grade asset-backed securities from the definition of ``hot
issue.'' \55\ The NASD is now going one step further and proposing to
eliminate application of the rule to all debt securities, including
those that are not investment-grade.\56\
---------------------------------------------------------------------------
\55\ See 1998 amendments, 63 FR at 28537.
\56\ In Amendment No. 5, the NASD acknowledged that, under
certain circumstances, the trading characteristics of junk debt more
closely resemble that of the issuer's equity securities rather than
its debt securities. However, the NASD believes that, for purposes
of the new rule, the point in time at which the pricing and trading
characteristics of a security are relevant are at the time of
offering. The NASD continues to believe that, at the time of an
offering, even junk debt will trade based primarily on interest
rates and the creditworthiness of the issuer and, therefore, that
the junk debt should not be treated in the same manner as equity
securities under the proposed rule.
---------------------------------------------------------------------------
One commenter recommended that the definition of ``new issue''
exclude offerings of securities of closed-end funds that invest solely
in debt securities.\57\ The commenter reasoned that, if offerings of
debt securities were excluded, offerings of funds that invest solely in
debt securities also should be excluded. In Amendment No. 4, the NASD
stated that offerings of such funds would be exempt from the proposed
rule pursuant to the exemption for offerings of securities of
investment companies registered under the Investment Company Act of
1940.\58\
---------------------------------------------------------------------------
\57\ See Schwab.
\58\ See infra notes 70-72 and accompanying text.
---------------------------------------------------------------------------
c. Other Securities Exempt From NASD Rule 2790. Paragraph
(i)(10)(A) of the proposed rule would exclude from the definition of
``new issue'' offerings of securities that are restricted under various
provisions of the Securities Act of 1933 \59\ and the Securities
Exchange Act of 1934.\60\ Paragraph (i)(10)(B) would exclude offerings
of ``exempt securities,'' as defined in Section 3(a)(12) of the
Securities Exchange Act of 1934.\61\
---------------------------------------------------------------------------
\59\ 15 U.S.C. 77a et seq.
\60\ 15 U.S.C. 78a et seq.
\61\ 15 U.S.C. 78c(a)(12).
---------------------------------------------------------------------------
Paragraph (i)(10)(C) would exclude from the definition of ``new
issue'' offerings of securities of a commodity pool operated by a
commodity pool operator, as defined in Section 1a(5) of the Commodity
Exchange Act.\62\ The original proposal did not contain such an
exemption. Two commenters argued that offerings of securities of
commodity pools should be excluded from the definition of ``new
issue.''\63\ The commenters noted that commodity pool securities,
whether offered publicly or privately, generally do not trade in the
secondary market, and that investors may redeem their interests from
the issuer at net asset value at selected intervals, much like open-end
mutual funds, which are exempt from the proposed rule. In addition,
they stated that the offering process is similar to that for registered
closed-end funds in that the commodity pool operator is generally
seeking as large an infusion of capital as possible and that such
offerings are rarely oversubscribed. In Amendment No. 3, the NASD
agreed and added a new paragraph (C) to paragraph (i)(10) of the
proposed rule.
---------------------------------------------------------------------------
\62\ 7 U.S.C. 1a(5).
\63\ See MFA; Cadwalader.
---------------------------------------------------------------------------
Three commenters recommended that the term ``new issue'' not
include rights offerings to existing shareholders, exchange offers, and
offerings made pursuant to a merger or acquisition.\64\
[[Page 62131]]
The NASD agreed, and this revision is reflected in paragraph (i)(10)(D)
of the proposed rule.
---------------------------------------------------------------------------
\64\ See MSDW; SIA; Sullivan.
---------------------------------------------------------------------------
Paragraph (i)(10)(E) would exclude offerings of investment-grade
asset-backed securities from the definition of ``new issue.'' This
provision would preserve an exemption in the Interpretation for
financing-instrument-backed securities that are rated investment-
grade.\65\ In Amendment No. 5, the NASD explained that a separate
exclusion for asset-backed securities was necessary even though the
proposed rule already contains an exclusion for debt securities;
certain types of asset-based securities may be considered equity rather
than debt and therefore might not be covered by the proposed rule's
implicit exemption for debt securities.
---------------------------------------------------------------------------
\65\ See NASD IM-2110-1(l)(1).
---------------------------------------------------------------------------
Paragraph (i)(10)(F) would exclude offerings of convertible
securities. Under the literal terms of the Interpretation, debt
securities that are convertible into common or preferred stock may be
hot issues.\66\ The NASD staff has exercised its exemptive authority
\67\ to exclude many convertible securities from the Interpretation.
The NASD has now proposed to codify this exemption in the proposed
rule.\68\
---------------------------------------------------------------------------
\66\ See id.
\67\ See NASD IM-2110-1(a)(5).
\68\ One commenter recommended that the proposed rule not apply
to debt securities that are convertible into ``actively traded''
equity securities. See MSDW. The NASD believes that, in view of the
decision to exclude all secondary offerings, all convertible
securities, not just those that are convertible into ``actively
traded'' securities, should be excluded.
---------------------------------------------------------------------------
Paragraph (i)(10)(G) would exclude offerings of preferred
securities. The NASD has stated that, in connection with the 1998
amendments, it considered--but deferred--an exemption for preferred
securities.\69\ However, the NASD is now proposing to exempt preferred
securities because it believes, on balance, that these securities
exhibit pricing and trading behavior more closely resembling that of
debt rather than equity securities and, thus, should not be considered
``new issues.''
---------------------------------------------------------------------------
\69\ See 1998 amendments, 63 FR at 28537.
---------------------------------------------------------------------------
Paragraph (i)(10)(H) would exclude offerings of securities of an
investment company registered under the Investment Company Act of
1940.\70\ The NASD initially proposed to exclude only the securities of
closed-end investment companies, as defined in Section 5(a)(2) of the
Investment Company Act.\71\ The NASD believes that these securities
typically commence trading at the public offering price with little
potential for trading at a premium because the fund's assets at the
time of the offering are the capital it has previously raised. The NASD
concluded, therefore, that deeming the securities of closed-end funds
to be new issues would do little to further the purposes of the
proposed rule. One commenter agreed with the NASD's decision to exempt
offerings of securities of closed-end investment companies but
questioned why the exemption did not extend to any type of investment
company registered under the Investment Company Act of 1940.\72\ The
NASD agreed and revised paragraph (i)(10)(H) accordingly.
---------------------------------------------------------------------------
\70\ 15 U.S.C. 80a-1 et seq.
\71\ 15 U.S.C. 80a-5(a)(2).
\72\ See Cadwalader 2.
---------------------------------------------------------------------------
Paragraph (i)(10)(I) would exclude an offering of securities (in
ordinary share form or American Depository Receipts (``ADRs'')
registered on Form F-6) that have a pre-existing market outside the
United States. One commenter suggested that the proposed rule should
exclude an offering of securities of which the initial public offering
price is based primarily on ``exogenous or market factors (such as, a
rating by a nationally recognized statistical rating organization or
the market price for a related security).'' \73\ The NASD believes that
this suggestion is too broad. However, in the case of an ADR, the NASD
agrees that application of the proposed rule is not necessary because
the price of the offering will be constrained by the price of the
shares in the underlying foreign market. Therefore, in Amendment No. 5,
the NASD added new paragraph (i)(10)(I) to the proposed rule. The NASD
notes that this exemption would apply only to initial offerings of ADRs
that are not part of a global initial public offering.
---------------------------------------------------------------------------
\73\ Sidley 2.
---------------------------------------------------------------------------
d. Miscellaneous Issues Regarding Scope of Term ``New Issue''. One
commenter \74\ recommended that the definition of ``new issue''
expressly exempt offerings of securities made pursuant to Regulation S
\75\ under the Securities Act of 1933. The NASD does not believe that
this commenter sufficiently demonstrated that this exemption would be
consistent with the purposes of the proposed rule and has determined
not to adopt it.
---------------------------------------------------------------------------
\74\ See Sullivan 2.
\75\ 17 CFR 230.901 et seq.
---------------------------------------------------------------------------
In Amendment No. 2, the definition of ``new issue'' proposed by the
NASD included ``other securities distributions of any kind whatsoever,
including securities that are specifically directed by the issuer on a
non-underwritten basis.'' Several commenters noted that this language
was surplusage and potentially misleading.\76\ The NASD agreed and
deleted this language from the definition.
---------------------------------------------------------------------------
\76\ See MSDW 2 (arguing that non-underwritten securities should
not be covered by the proposed rule since, by definition, NASD
members would not be involved in the offering); Sullivan 2 (noting
that this language would have the effect of including secondary
offerings in the rule, even though the NASD's stated intent was to
exempt secondary offerings); Willkie 2.
---------------------------------------------------------------------------
One commenter recommended that the definition of ``new issue''
exclude any offering of securities for which, at the time of the
offering, an organized trading market is not expected to develop.\77\
In Amendment No. 5, the NASD responded that it was not necessary to
draft a general exemption in the rule, and that offerings of this type
might be candidates for specific exemptions granted by the NASD staff
pursuant to their authority under paragraph (h) of the proposed
rule.\78\
---------------------------------------------------------------------------
\77\ See Sidley 2.
\78\ But see infra note and accompanying text.
---------------------------------------------------------------------------
The same commenter \79\ argued that the term ``initial public
offering'' used in the definition of ``new issue'' should be construed
to exclude any offering of securities made on a continuous basis (such
as under a ``shelf'' registration statement pursuant to Rule 415 of
Regulation C under the Securities Act of 1933 \80\). In Amendment No.
5, the NASD agreed that such an offering would not be part of an
``initial public offering'' unless it were the first registered
offering of the company's stock.
---------------------------------------------------------------------------
\79\ See id.
\80\ 17 CFR 230.415.
---------------------------------------------------------------------------
2. Restricted Persons
Paragraph (a)(1) of proposed NASD Rule 2790 would stipulate that a
member or associated person thereof may not sell a new issue to any
account in which a restricted person has a beneficial interest, unless
such sale qualifies for an enumerated exemption. The scope of the term
``restricted person'' is discussed below.
a. Broker-Dealers and Their Personnel. Paragraph (i)(11)(A) of the
proposed rule would define ``restricted person'' to include NASD
members and other broker-dealers. Paragraph (i)(11)(B)(i) would extend
the definition of ``restricted person'' to include any officer,
director, general partner, associated person, or employee of a member
or any other broker-dealer. Paragraph (i)(10)(B)(ii) would provide that
agents of a broker-dealer are not considered restricted persons unless
they are engaged in the investment banking or securities business.
[[Page 62132]]
b. Limited Business Broker-Dealers. Paragraph (i)(11)(B)
specifically would exclude from the definition of ``restricted person''
the personnel and agents of a ``limited business broker-dealer.''
Paragraph (i)(8) would define ``limited business broker-dealer'' as a
broker-dealer whose authorization to engage in the securities business
is limited solely to the purchase and sale of investment company/
variable contracts securities and direct participation program
securities. These provisions of the proposed rule would preserve an
exemption for associated persons of a limited business broker-dealer
under the Interpretation.\81\ The NASD has emphasized, however, that
this exemption would apply only to persons associated with such a
limited business broker-dealer, not to the limited business broker-
dealer itself.
---------------------------------------------------------------------------
\81\ See NASD IM-2110-1(c).
---------------------------------------------------------------------------
Several commenters argued that the proposed definition of ``limited
business broker-dealer'' is too narrow and should be expanded to
include broker-dealers that do not have any involvement in the capital
formation or equity underwriting business.\82\ The NASD has determined,
however, not to broaden the scope of this exemption. The NASD believes
that even broker-dealers engaged solely in, for example, proprietary
trading or merchant banking activities (or the associated persons of
such firms) might enter into reciprocal arrangements with other members
that could create improprieties that the proposed rule seeks to
address. In addition, the NASD believes that a rule requiring members
to determine whether a person is engaged in reciprocal arrangements
with a broker-dealer would be difficult to administer and enforce and
would eliminate the certainty sought by the proposed rule.
---------------------------------------------------------------------------
\82\ See Colish (suggesting that the definition of ``limited
business broker-dealer'' also include broker-dealers that engage
only in private placements); Fried (arguing that no broker-dealer
should be a restricted person without some nexus to equity IPOs);
Washington (suggesting that only broker-dealers that engage in an
equity securities business should be restricted).
---------------------------------------------------------------------------
One commenter, the Chicago Board Options Exchange (``CBOE''), urged
the NASD to revise the proposal to treat CBOE market makers and floor
brokers as limited business broker-dealers. CBOE stated that these
exchange members should not be considered ``industry insiders'' as they
are not in a position to take advantage of their position to
participate in IPOs for their own accounts at the expense of public
customers. CBOE maintained, therefore, that treating these CBOE members
as restricted persons would be unnecessary to accomplish the stated
purposes of the rule. CBOE also argued that the proposal would put CBOE
members at a competitive disadvantage relative to members of the
futures exchanges: Although many futures products are economically
similar to options, futures exchange members who trade them would not
be restricted persons under the new rule. CBOE suggested alternate rule
text that would allow a CBOE member to purchase new issues unless the
underwriter of the IPO were an NASD member that executed stock
transactions on behalf of the CBOE member.
In response to CBOE's comment, the NASD stated in Amendment No. 2
that the proposed rule should apply generally to all broker-dealers and
their associated persons. The NASD believes that a rule requiring
analysis of the activities of a particular broker-dealer would be more
difficult rule to administer and enforce than a rule based on a firm's
authorizations. The NASD recognizes that the Interpretation and the
proposed rule make an exception for associated persons and owners of a
broker-dealer that engages solely in the purchase and sale of
investment company/variable contract securities and direct
participation program securities. However, the NASD does not believe
that the existence of this exemption for ``limited business broker-
dealers'' necessitates additional exemptions.
With respect to the competitive issue between CBOE members and
members of futures exchanges that trade financial derivatives, the NASD
has acknowledged that futures exchange members would not--solely
because of their status as such--be restricted persons under the
proposed rule. However, the NASD believes that many futures exchange
members would be subject to the proposed rule because of changes to the
federal securities laws made by the Commodity Futures Modernization Act
of 2000 (``CFMA'').\83\ A futures exchange member that wishes to trade
security futures products must register as a broker-dealer pursuant to
Section 15(b)(11) of the Act, as amended by the CFMA.\84\ In Amendment
No. 5, the NASD clarified that the proposed rule would treat such
futures exchange members the same as ``conventional'' broker-
dealers.\85\
---------------------------------------------------------------------------
\83\ Pub. L. No. 106-554, Appendix E, 114 Stat. 2763. The CFMA
removed the prohibition on single-stock futures and set forth a
regulatory scheme whereby entities that trade single-stock futures
and other security futures products must register with both the
Commission (under the Securities Exchange Act) and the Commodity
Futures Trading Commission (under the Commodity Exchange Act).
\84\ 15 U.S.C. 78o(b)(11).
\85\ CBOE also recommended that members of that exchange who
lease their seats and who are not engaged in a securities business
not be considered restricted persons. In this matter, the NASD
agreed and stated in Amendment No. 5 that it would not treat such
persons as restricted persons under the new rule.
---------------------------------------------------------------------------
Finally, one commenter \86\ recommended that the proposed rule
include a provision that would allow an NASD member, in determining
whether a firm is a limited business broker-dealer, to rely on the
information contained in that firm's Form BD.\87\ In completing the
Form BD, a broker-dealer must list all lines of business that account
for 1% or more of its annual revenue. In the initial proposal, the NASD
stated that a member ``should look to the Form BD as well as any
Restrictive Agreement'' to determine the activities of a broker-dealer.
Upon further review, the NASD clarified in Amendment No. 3 that a
member may look to the Form BD as evidence of a firm's status, but must
inquire further about whether the firm meets the conditions of a
limited business broker-dealer.
---------------------------------------------------------------------------
\86\ See Fried 2.
\87\ 17 CFR 249.501.
---------------------------------------------------------------------------
c. Finders and Fiduciaries. Paragraph (i)(11)(C) of the proposed
rule would preserve a provision in the Interpretation that treats
finders and fiduciaries of the managing underwriter as restricted
persons. The NASD believes that finders and fiduciaries are industry
insiders and, therefore, should be subject to the new rule. The NASD
believes, moreover, that issuers must be prevented from circumventing
the underwriting compensation limits of existing NASD Rule 2710 by
offering finders or fiduciaries access to a new issue.\88\ However, the
NASD has proposed to treat finders and fiduciaries as restricted
persons only for those offerings for which they are acting in those
capacities. The NASD has added that, in the case of a law firm or
consulting firm, the restriction would apply only to those persons
working on the particular offering.
---------------------------------------------------------------------------
\88\ NASD Rule 2710 defines the term ``underwriter and related
persons'' to include ``financial consultants'' and ``finders.''
---------------------------------------------------------------------------
d. Portfolio Managers. The Interpretation prohibits the sale of hot
issues ``to any senior officer of a bank, savings and loan institution,
insurance company, investment company, investment advisory firm or any
other institutional type account.''\89\ These persons are restricted
because their position allows them the opportunity to direct business
to a member firm.
[[Page 62133]]
However, the NASD does not believe that all senior officers and
employees of a securities department of one of these entities need be
restricted. Therefore, the NASD devised a function-oriented approach
that, in its original form, would have treated as a restricted person
``[a]ny employee or other person who supervises, or whose activities
directly or indirectly involve or are related to, the buying or selling
of securities'' for one of the listed entities.
---------------------------------------------------------------------------
\89\ NASD IM-2110-1(b)(4).
---------------------------------------------------------------------------
In response to the original proposal, three commenters stated that
they supported the functional approach but believed that the proposed
rule language was too broad and could reach persons whose functions
were purely ministerial.\90\ These commenters suggested that only to
persons who have authority to make investment decisions should be
restricted. The NASD agreed and revised the proposed rule text
accordingly in Amendment No. 2.\91\ Accordingly, paragraph
(i)(11)(D)(i) of the proposed rule would define a portfolio manager as
any person who has authority to buy or sell securities for a bank,
savings and loan institution, insurance company, investment company,
investment advisor, or collective investment account.
---------------------------------------------------------------------------
\90\ See Ropes; Schwab; Testa.
\91\ However, one commenter suggested that a portfolio manager
should be restricted based on whether this person ``exercises''
authority to make investment decisions, not whether such person is
``authorized'' to make investment decisions. See Fried. The NASD
believes that the alternative standard proposed by this commenter is
too narrow and has not made this change.
---------------------------------------------------------------------------
One commenter sought clarification on whether an investment advisor
organized as a non-natural person would be deemed a restricted
person.\92\ This commenter stated that the proposed rule treats certain
employees of an investment advisor as restricted persons but is not
clear whether the investment advisor itself is a restricted person. In
Amendment No. 5, the NASD observed that the definition of ``portfolio
manager'' in paragraph (i)(1)(D)(i) encompasses non-natural persons.
Thus, an entity organized as an investment advisor that has authority
to buy and sell securities for any of the entities enumerated above
would be a portfolio manager for the purposes of the proposed rule and,
as such, a restricted person.
---------------------------------------------------------------------------
\92\ See Katten.
---------------------------------------------------------------------------
Another commenter recommended excluding from the definition of
``portfolio manager'' a hedge fund manager of a fund with less than
$200 million in assets.\93\ The NASD believes that the reasons for
treating hedge fund managers as restricted persons are not limited by
the size of the assets under management, especially with amounts as
significant as those proposed by the commenter. Therefore, the NASD
declined to accept this recommendation.
---------------------------------------------------------------------------
\93\ See Washington.
---------------------------------------------------------------------------
Finally, one commenter requested that the proposed rule include an
exemption for persons who, on a volunteer basis, make investment
decisions on behalf of a tax-exempt charitable organization.\94\ The
NASD believes that the purposes of the rule may be implicated by
persons who manage such organizations. The NASD, therefore, declined to
accept this suggestion.
---------------------------------------------------------------------------
\94\ See Schwab.
---------------------------------------------------------------------------
e. Owners of Broker-Dealers. In the view of the NASD, a prohibition
on new issue purchases by a broker-dealer could be circumvented if the
broker-dealer's owners were permitted to purchase the new issue.
Therefore, the NASD has proposed to deem owners of a broker-dealer as
restricted persons as well.
Under the original proposal, the term ``restricted person''
included any natural person (or member of the person's immediate
family) who owned 10% or more, or contributed 10% or more of the
capital, of a broker-dealer. Many of the commenters believed that this
restriction was too broad and would be overly burdensome.\95\ In
Amendment No. 2, the NASD adopted a new approach that bases ownership
of a broker-dealer for purposes of the rule on whether the broker-
dealer must report the ownership interest on Form BD. The NASD favors
this approach because it would not have to create new concepts of
ownership for purposes of the rule: The Form BD reporting requirements
are well understood by NASD members, who already maintain such
information.
---------------------------------------------------------------------------
\95\ See Colish; Orrick; SIA; Sidley; Willkie.
---------------------------------------------------------------------------
One commenter criticized this approach on the grounds that persons
who might in fact have very little voting power or beneficial interest
in the broker-dealer would be treated as restricted persons, which
would not further the purposes of the rule.\96\ A person must be
reported on Form BD if it holds a designated percentage of ``a class of
voting security'' of the reporting broker-dealer. The commenter noted
that, depending on the broker-dealer's capital structure, a particular
class of voting security might represent only a small portion of the
firm's capital. Nevertheless, a person owning 10% or more of that class
would be a restricted person under the proposed rule. The commenter
recommended that the ownership interests reported in Schedules A and B
of Form BD should be multiplied so that only the actual economic
interest would be used to determine whether the person is restricted.
---------------------------------------------------------------------------
\96\ See Fried 2.
---------------------------------------------------------------------------
The NASD has determined not to accept the commenter's suggestion.
In Amendment No. 4, the NASD stated that it seeks to aid members'
compliance efforts by eliminating the need to perform calculations in
determining ownership interests in a broker-dealer. In its experience,
such calculations are often difficult and frequently raise interpretive
issues with various ownership structures. The NASD deliberately sought
to eliminate that level of complexity by referencing persons listed on
Schedules A and B, noting that there are no special codes or
identifiers on Schedule B to identify persons with only a small
economic interest.
The same commenter also suggested an exemption from the proposed
definition of ``restricted person'' for an entity disclosed on Schedule
A or B of Form BD that is listed on a foreign exchange. Pursuant to
Form BD, a broker-dealer must report entities that have interests at
every level of its ownership structure that exceed designated
percentages. However, once a public reporting company is reached, no
ownership information further up the chain need be given.\97\ Only
those public reporting companies that are subject to Sections 12 or
15(d) of the Act \98\ may avail themselves of this exclusion. The NASD
has proposed to follow the Form BD in this regard; thus, a foreign
entity with an ownership interest in a broker-dealer would not be a
restricted person if that foreign entity were subject to Sections 12 or
15(d) of the Act.\99\
---------------------------------------------------------------------------
\97\ See Form BD, Schedule B, Instruction 3.
\98\ 15 U.S.C. 78l and 78o.
\99\ A foreign entity also might be eligible to purchase new
issues pursuant to the proposed rule's exemption for publicly traded
entities. See infra notes--and accompanying text.
---------------------------------------------------------------------------
The general restriction on owners of a broker-dealer would not
extend to owners of a limited business broker-dealer. One commenter
recommended that, because associated persons of a limited business
broker-dealer were not restricted, the owners of a limited business
broker-dealer also should not be restricted.\100\ The NASD agreed and
revised the proposed rule text accordingly.
---------------------------------------------------------------------------
\100\ See Willkie 2.
---------------------------------------------------------------------------
f. Affiliates of Broker-Dealers. The proposed rule would treat as
restricted persons not only owners of a broker-dealer, but also
affiliates of the broker-
[[Page 62134]]
dealer. While such affiliates would not specifically be included in the
definition of ``restricted person,'' paragraph (a)(1) of the proposed
rule would provide that a member may not sell a new issue to any
account in which a restricted person (such as an owner of a broker-
dealer) ``has a beneficial interest.'' The NASD has stated that an
owner of a broker-dealer--whom the proposed rule would explicitly deem
a restricted person `` would be viewed as having a beneficial interest
in an account held by a subsidiary (i.e., a sister company of the
broker-dealer).
Several commenters stated that applying the proposed rule to
affiliates has no policy justification.\101\ These commenters were
concerned, in part, that many financial services firms, which currently
may invest in hot issues under the Interpretation, would be prohibited
from purchasing new issues under the proposed rule simply by the
accident of having become affiliated with an NASD member firm in the
wake of the Gramm-Leach-Bliley Act,\102\ which repealed many
restrictions on affiliation among banks, insurance companies, and
securities firms.
---------------------------------------------------------------------------
\101\ See MSDW; Orrick; Rosenman; SIA; Sullivan; Willkie.
\102\ Pub. L. No. 106-102, 113 Stat. 1338 (1999).
---------------------------------------------------------------------------
The NASD believes, nevertheless, that broker-dealer affiliates
should be restricted persons. The NASD contends that, if the rule
failed to restrict an account in which a restricted person had a
beneficial interest, the restricted person could evade the restriction
by directing a subsidiary to purchase the new issue instead. However,
to offer some relief to entities that could be affected by the
restriction on broker-dealer affiliates, the NASD is establishing an
exemption for any such affiliate (except another broker-dealer) that is
publicly traded.\103\
---------------------------------------------------------------------------
\103\ See infra notes 127-136 and accompanying text.
---------------------------------------------------------------------------
g. Family Members. The proposed rule would restrict various persons
based on their functions in the financial services industry. In
addition, paragraph (i)(11)(D)(ii) would restrict certain other persons
based on their relationship with persons who work in the financial
services industry. The NASD believes that these collateral restrictions
are necessary to prevent a ``functionally'' restricted person from
circumventing the rule by purchasing new issues through the account of
an immediate family member. Paragraph (i)(5) would define ``immediate
family member'' to include a person's parents, mother-in-law or father-
in-law, spouse, brother or sister, brother-in-law or sister-in-law,
son-in-law or daughter-in-law, and children, and any other individual
to whom the person provides ``material support.'' This provision is
based on a provision in the Interpretation \104\ but supplements the
existing provision by adding a definition of ``material support'' in
paragraph (i)(9): the direct or indirect provision of more than 25% of
a person's income in the prior calendar year. Paragraph (i)(9) of the
new rule would deem members of the immediate family living in the same
household to be providing each other with material support.
---------------------------------------------------------------------------
\104\ See NASD IM-2110-1(l)(2).
---------------------------------------------------------------------------
The NASD originally proposed that ``material support'' would mean
providing 10% of another's income. One commenter supported the addition
of a bright-line definition of ``material support'' but recommended
that the threshold be raised to 25%, as measured in the prior calendar
year.\105\ The NASD agreed and revised the proposed rule text
accordingly. Another commenter argued that the definition of ``material
support'' was over-inclusive, as it was not necessarily based on the
economic reality of the situation.\106\ The NASD believes, however,
that the ``material support'' provisions as proposed are a reasonable
means to prevent evasion of the rule, and that, without clear and
straightforward standards for collateral restrictions on family
members, the rule would become difficult to administer. The NASD stated
in Amendment No. 2 that it will not evaluate ``material support''
issues on a case-by-case basis.
---------------------------------------------------------------------------
\105\ See Schwab.
\106\ See Fried 2 (hypothesizing that two cousins sharing an
apartment would be deemed to materially support each other under the
proposed rule, even though they might not in fact be materially
supporting each other).
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In addition, the proposed rule would modify the treatment of sales
to members of the immediate family of an officer, director, general
partner, employee, or agent of a member or other broker-dealer
(collectively referred to as ``associated persons''). Under the
Interpretation, members of the immediate family of an associated person
may not purchase hot issues from the firm employing the associated
person.\107\ The proposed rule would expand this prohibition to include
affiliates of the firm employing the associated person. The NASD
believes that this change is necessary to clarify that immediate family
members of associated persons may use neither traditional nor online
distribution channels to circumvent the prohibitions on sales to them.
---------------------------------------------------------------------------
\107\ See NASD IM-2110-1(b)(2)(B).
---------------------------------------------------------------------------
Finally, two commenters pointed out that the original proposal
appeared to have instances of faulty drafting where family members
should have been exempt from the proposed rule but were not.\108\ The
NASD agreed with these comments and revised the proposed rule text
accordingly.
---------------------------------------------------------------------------
\108\ See Sullivan; Testa.
---------------------------------------------------------------------------
h. Investment Clubs and Family Investment Vehicles. Two commenters
urged that the proposed rule not prohibit their investment clubs from
purchasing IPOs.\109\ In response, the NASD in Amendment No. 4 revised
the definition of ``collective investment account'' in paragraph (i)(2)
of the proposed rule to exclude ``investment clubs'' (as defined in
paragraph (i)(6)) and ``family investment vehicles'' (as defined in
paragraph (i)(4)). Therefore, a person who has authority to buy or sell
securities on behalf of an investment club or a family investment
vehicle would not be a portfolio manager under paragraph (i)(10)(D)(i)
and, therefore, not be a restricted person on that basis. In addition,
even if an investment club or family investment vehicle included
persons who were otherwise restricted (e.g., because they were
associated persons of a broker-dealer), such entity could still
purchase new issues if it qualified for the de minimis exemption of
paragraph (c)(4).\110\
---------------------------------------------------------------------------
\109\ See Fu; Smith.
\110\ One commenter stated that an earlier version of the
proposed rule appeared to inadvertently exclude investment clubs and
family partnerships from the de minimis exemption. See Sullivan. The
NASD has clarified that such entities may qualify for the de minimis
exemption.
---------------------------------------------------------------------------
Finally, one commenter recommended that the definition of ``family
investment vehicle'' be expanded to include long-term family
employees.\111\ In Amendment No. 5, the NASD stated that the commenter
had not presented sufficient reason to exclude such persons and
declined to make this change. Moreover, the NASD believes that
permitting non-family persons into the exemption for family investment
vehicles could open the exemption to abuse.
---------------------------------------------------------------------------
\111\ See Cadwalader 2.
---------------------------------------------------------------------------
i. Joint Back Office Broker-Dealers. Certain hedge funds, or
subsidiaries thereof, have opted to become registered broker-dealers.
These entities are generally known as ``joint back office broker-
dealers'' (``JBOs'') because they share a back office with another
registered broker-dealer. Under the Interpretation, hedge funds that
are (or are affiliated with) JBOs are not, solely on such basis,
precluded from
[[Page 62135]]
purchasing hot issues on behalf of their investors. The special
provisions for JBOs arise from an exemption granted by the NASD staff
responding to certain provisions of the 1998 amendments to the
Interpretation. Those provisions had the effect of precluding hedge
funds registered as JBOs (or with JBO subsidiaries) from purchasing hot
issues even if investors in the funds were not restricted. The NASD
staff determined that sales of hot issues to a hedge fund should be
based on the status of the beneficial owners of the fund, not simply
the fund's status as a broker-dealer.\112\ The proposed rule seeks to
codify this exemption.
---------------------------------------------------------------------------
\112\ See letter from Gary Goldsholle, NASD, to David Katz,
Sidley & Austin, dated January 20, 1999.
---------------------------------------------------------------------------
The NASD continues to believe that the election by an investment
fund to become (or be affiliated with) a JBO should not by itself
preclude the purchase of new issues by investors in that fund who are
not otherwise restricted persons. The original proposal provided that a
collective investment account--including a JBO--could avail itself of
the de minimis exemption and included a definition of ``joint back
office broker-dealer.'' In Amendment No. 2, the NASD removed any
explicit references to JBOs. The NASD stated that, as a result of its
revisions to the definition of ``beneficial interest'' and ``restricted
person,'' the conditions that gave rise to the need for the JBO
exemption had been removed. By clarifying that ``beneficial ownership''
includes a financial interest, such as the right to share in gains or
losses, the NASD believed it had clarified that a JBO's legal ownership
of securities would not constitute a ``beneficial interest'' for
purposes of the proposed rule. The NASD, therefore, concluded that a
specific exemption for JBOs was no longer necessary.
In Amendment No. 4, the NASD restored a specific reference to JBOs
in the de minimis exemption, now relocated to paragraph (c)(4) of the
proposed rule, as well as a definition of ``joint back office broker-
dealer'' in then paragraph (i)(7). Two commenters noted problems with
the definition.\113\ Under the NASD's final proposal, the NASD devised
an alternative manner of exempting purchases of new issues by JBOs. New
paragraph (a)(4) would provide an exemption for ``purchases by a
broker/dealer (or owner of a broker/dealer), organized as a investment
partnership, of a new issue at the public offering price, provided such
purchases are credited to the capital accounts of its partners in
accordance with paragraph (c)(4).'' This exemption would allow an
investment partnership (e.g., a hedge fund) that registers as a broker-
dealer or that has a broker-dealer subsidiary to purchase new issues on
the same terms as other investment partnerships. This approach is
consistent with the relief granted in the original exemptive letter.
Under Amendment No. 5, a hedge fund that registers as a broker-dealer
or that has a broker-dealer subsidiary could purchase new issues so
long as the beneficial interests of restricted persons do not exceed in
the aggregate 10% of the fund. Accounts that are beneficially owned by
restricted persons in excess of the 10% threshold may use carve-out
procedures to prevent the restricted persons from receiving more than
10% of the notional pro rata proceeds of a new issue.
---------------------------------------------------------------------------
\113\ See Sidley 2; Willkie 3.
---------------------------------------------------------------------------
One commenter argued that an entity that is a non-natural person
should be disregarded for the purposes of determining who holds the
beneficial interest in an account, and that the rule should look only
to natural persons who may hold beneficial interests in that
account.\114\ This commenter concluded, therefore, that there is no
need for a specific exemption for JBOs. In Amendment No. 5, the NASD
responded that the commenter was correct that, in determining whether a
person is a restricted person, one should ``look through'' to the
persons who have the actual beneficial interests in the account's gains
and losses. If one can look through until each of the natural persons
is reached and, along the way, encounters no beneficial owners who are
restricted persons, the account may purchase new issues. However, if
the process of looking through reveals a restricted person identified
in paragraph (i)(11) of the proposed rule--be it a natural person or a
legal person--then the account may be restricted. The next step in the
analysis, according to the NASD, is to determine whether the account
qualifies for an exemption under paragraph (c) of the rule. For this
reason, the NASD provided an exemption for JBOs: In the absence of an
exemption, a JBO would be restricted even if it were beneficially owned
entirely by non-restricted persons.
---------------------------------------------------------------------------
\114\ See Sidley 2.
---------------------------------------------------------------------------
The NASD has stated that the exemption for JBOs would not extend to
associated persons of a JBO. Three commenters argued that associated
persons of a JBO should not, solely by virtue of their association with
the JBO, be restricted persons.\115\ The NASD explained in Amendment
No. 4 that election to become a JBO bestows certain benefits on the
investment account, but also imposes certain obligations, including
restrictions on the ability of associated persons to purchase new
issues. The NASD further explained in Amendment No. 5 that the act of
registering a collective investment account as a JBO should not taint
the investors, who otherwise might not be restricted persons. However,
the NASD does not believe that this necessitates excluding associated
persons of the JBO from the definition of ``restricted person.''
---------------------------------------------------------------------------
\115\ See Rosenman; Sidley 2; Willkie 3.
---------------------------------------------------------------------------
3. General Prohibitions
Paragraph (a)(1) of the proposed rule sets forth the basic
prohibition that a member (or an associated person thereof) may not
sell a new issue to an account in which a restricted person has a
beneficial interest, except as otherwise permitted under the rule.
Paragraph (a)(2) would provide that a member (or associated person
thereof) may not purchase a new issue in any account in which such
member or associated person has a beneficial interest, except as
otherwise permitted under the rule. Paragraph (a)(3) would provide that
a member may not continue to hold new issues acquired as an
underwriter, selling group member, or otherwise, except as otherwise
permitted under the rule.
One commenter stated that these provisions could be read to
prohibit accommodation sales (i.e., sales to another broker-dealer at
the public offering price to enable that broker-dealer's customer to
purchase the new issue at the public offering price) as well as
purchases by and among members of the selling group while engaged in
the distribution of a new issue.\116\ The NASD agreed that neither of
these outcomes was intended and, in Amendment No. 3, added a new
paragraph (a)(4) to the proposed rule to address these concerns.
Paragraph (a)(4)(A) would allow sales or purchases from one member of
the selling group \117\ to another member that are incidental to the
distribution of a new issue to a non-restricted person at the public
offering price. Paragraph (a)(4)(B) would allow sales or purchases by a
broker-dealer of a new issue at the public offering price as an
[[Page 62136]]
accommodation to a non-restricted person customer of the broker-dealer.
---------------------------------------------------------------------------
\116\ See SIA.
\117\ The term ``selling group'' is defined in existing NASD
Rule 0120(p). In Amendment No. 4, the NASD replaced the term
``syndicate'' with the term ``selling group.'' The NASD elected to
use the more expansive term ``selling group'' because it did not
believe that whether a broker-dealer has made a financial commitment
to purchase securities in an IPO is relevant for purposes of the
rule.
---------------------------------------------------------------------------
4. General Exemptions
Paragraph (c) states that the proposed rule's general prohibitions
would not apply to sales to or purchases from several classes of
persons, whether directly or through accounts in which such persons
have a beneficial interest.\118\ These classes of person are described
below.
---------------------------------------------------------------------------
\118\ Sullivan expressed concern that the general exemptions, in
the form proposed in Amendment No. 2, applied only to the persons
specified in the proposed rule and did not extend to the accounts of
such persons. The NASD agreed that the general exemptions should
clearly state that they apply to the specified persons as well as to
the accounts of such persons, and revised the proposal accordingly.
---------------------------------------------------------------------------
a. Investment Companies. Paragraph (c)(1) of the proposed rule
states that sales of new issues to, or purchases by, an investment
company registered under the Investment Company Act of 1940 \119\ would
not be subject to the rule. This provision would preserve an existing
exemption in the Interpretation.\120\
---------------------------------------------------------------------------
\119\ 15 U.S.C. 80a-1 et seq.
\120\ See NASD IM-2110-1(f)(1).
---------------------------------------------------------------------------
b. Common Trust Funds and Insurance Companies. Paragraphs (c)(2)
and (c)(3) would provide exemptions for sales of new issues to, or
purchases by, certain trust funds and insurance company accounts,
respectively. To qualify for these exemptions, a trust fund would have
to have investments from 1,000 or more accounts, and an insurance
account would have to be funded by premiums from 1,000 or more
policyholders (or, if a general account, the insurance company would
have to have 1,000 or more policyholders).\121\ In addition, the fund
or insurance account may not limit its participation principally to
restricted persons.\122\
---------------------------------------------------------------------------
\121\ See paragraphs (c)(2)(A) and (c)(3)(A) of proposed NASD
Rule 2790.
\122\ See paragraphs (c)(2)(B) and (c)(3)(B) of proposed NASD
Rule 2790.
---------------------------------------------------------------------------
Under the original proposal, the exemption for general, separate,
or investment accounts of insurance companies would apply only if the
account ``has investments from'' 1,000 or more policyholders. One
commenter recommended that the proposed rule use the term ``funded by''
policyholders instead of ``has investments from'' policyholders; an
insurance company general account generally is owned by the insurance
company itself, so the policyholders do not technically invest in or
fund the account.\123\ The NASD agreed and in Amendment No. 5 revised
the proposed rule text accordingly.
---------------------------------------------------------------------------
\123\ See Mayer Brown.
---------------------------------------------------------------------------
One commenter suggested that the NASD delete the proposed
requirement that an insurance company account be funded by premiums
from 1,000 or more policyholders, reasoning that an account of any size
would not pose a problem under the new rule so long as the
policyholders were not, principally, restricted persons.\124\ In
Amendment No. 5, the NASD stated its intent to retain this numerical
threshold because it provides further assurance that new issues
purchased by an insurance company account are not targeted for
restricted persons. The NASD added that, if an insurance company
separate account has only a few policyholders (as suggested in the
commenter's hypothetical), it would be appropriate for the insurance
company to ascertain whether each of the individual policy holders was
a restricted person.
---------------------------------------------------------------------------
\124\ See Sidley 2.
---------------------------------------------------------------------------
The same commenter also recommended that the new rule specifically
confirm that the insurance company account exemption is not limited to
life insurance companies, but applies ``across all industries.'' \125\
In Amendment No. 5, the NASD stated that paragraph (c)(3) of the
proposed rule would apply to all types of insurance companies and that
amending the exemption to apply ``across all industries'' could create
unintended loopholes.
---------------------------------------------------------------------------
\125\ Id.
---------------------------------------------------------------------------
One commenter recommended that the proposed rule include a general
exemption for mutual banks, in the same way that it would exempt mutual
insurance companies.\126\ In Amendment No. 5, the NASD noted that an
exemption similar to the one for insurance company accounts is
contained in paragraph (c)(2) of the proposed rule for bank common
trust funds. The NASD does not, however, believe that the commenter has
articulated a sufficient rationale for an exemption for mutual banks.
---------------------------------------------------------------------------
\126\ See Fried.
---------------------------------------------------------------------------
c. Publicly Traded Entities. Paragraph (c)(5) of the proposed rule
would provide a general exemption for publicly traded entities (except
broker-dealers and certain affiliates thereof) that are listed on a
national securities exchange, are traded on the Nasdaq National Market,
or are foreign issuers whose securities meet the quantitative
designation criteria for listing on a national securities exchange or
the Nasdaq National Market. These entities have broad public ownership
and their securities may be purchased by any investor. The NASD
believes that an exemption for publicly traded entities recognizes the
practical limitations in attempting to identify every beneficial owner
of a publicly traded entity and that the benefits of investments in new
issues are, indirectly, shared by the public shareholders.
The original proposal would have exempted ``[a] publicly traded
corporation \127\ (other than an affiliate of a broker/dealer) listed
on an exchange or The Nasdaq Stock Market, in which no person with a
10% or more ownership interest is a restricted person.'' Three
commenters objected to the 10% proviso; they argued that the publicly
traded entity exemption should resemble the exemption for registered
investment companies and U.S. employee benefit plans in not requiring
member firms to ``look through'' an entity to determine whether the
beneficial owners were restricted persons.\128\ The NASD agreed with
these commenters and eliminated the ``look through'' provision.
---------------------------------------------------------------------------
\127\ One commenter pointed out that the text of the original
proposal referred only to publicly traded corporations and suggested
that the exemption be extended to legal persons other than
corporations. See Rosenman. The NASD agreed and revised the proposed
rule text accordingly.
\128\ See Colish; Sidley; Sullivan (``because * * * publicly
traded corporations are not likely to be used by restricted persons
as vehicles for investments in hot issues, NASD members should be
spared the administrative burden of confirming the restricted person
ownership of customers that are publicly traded corporations'').
---------------------------------------------------------------------------
As originally proposed, the publicly traded entity exemption did
not extend to entities listed on a foreign exchange. One commenter
stated that limiting the exemption to publicly traded entities listed
on U.S. markets would unfairly discriminate against foreign
companies.\129\ A second commenter recommended an exemption for an
initial equity offering in the United States by an issuer whose equity
is publicly traded in another country.\130\ In Amendment No. 3, the
NASD expanded the proposed exemption to permit purchases of new issues
by a publicly traded foreign entity so long as that entity meets the
quantitative designation criteria for listing on a national securities
exchange or the Nasdaq National Market.
---------------------------------------------------------------------------
\129\ See Sidley.
\130\ See Fried 2.
---------------------------------------------------------------------------
The publicly traded entity exemption would not apply to a publicly
traded broker-dealer or an affiliate of the broker-dealer where the
broker-dealer is authorized to engage in the public offering of new
issues either as underwriter or as a selling group member. Although the
shareholders of such publicly traded entities would indirectly receive
some of the benefit of
[[Page 62137]]
IPO purchases, the NASD does not believe that allowing such purchases
would be consistent with the purposes of the rule. The version of the
publicly traded entity exemption proposed in Amendment No. 3 could have
been construed to permit, for example, the holding company parent of a
broker-dealer to purchase new issues, even if the broker-dealer engaged
in a significant amount of investment banking business. The NASD stated
that this was never the intent of the proposed exemption. Therefore, in
Amendment No. 4, the NASD revised the public entity exemption to apply
only to publicly traded entities that are not affiliated \131\ with a
broker-dealer engaged in the public offering of new issues.
---------------------------------------------------------------------------
\131\ The NASD also stated in Amendment No. 4 that an
``affiliate'' for purposes of this provision would have the same
meaning as in NASD Rules 2710 and 2720.
---------------------------------------------------------------------------
The NASD believes that looking to whether a broker-dealer is
authorized to engage in public offerings \132\ excludes from the
publicly traded entity exemption the ``full service'' broker-dealers
and their parent companies that the rule is designed to reach. On the
other hand, the proposed rule would allow purchases of new issues by
the many publicly traded entities that have broker-dealer affiliates
established for limited corporate purposes. The NASD believes that
looking into whether a broker-dealer affiliate participates in
offerings of new issues is one of many possible tests for determining
the scope of the publicly traded entity exemption. The NASD stated that
it also considered looking at the percent of profits or revenues a
parent holding company derives from broker-dealer activities, but
concluded that such information is often difficult to determine and
frequently varies from year to year.\133\
---------------------------------------------------------------------------
\132\ Under NASD member admission rules, a broker-dealer that
seeks authority to engage in public offerings must make that part of
its membership application. If an existing NASD member that is not
authorized to engage in public offerings seeks to do so in the
future, such member must make an application under NASD Rule 1017.
In Amendment No. 4, the NASD stated that it intends to look to
whether a firm is authorized to engage in public offerings of new
issues, and that the information on Form BD may help firms identify
broker-dealers that are authorized to engage in public offerings.
The NASD noted, however, that the information on Form BD will not be
conclusive since Item 12 does not require an activity to be reported
if it is less than 1% of annual revenue.
\133\ In Amendment No. 5, the NASD offered the following example
of how the publicly traded entity exemption would work in
conjunction with the basic restriction on broker-dealers and their
affiliates. Assume that a parent company is publicly traded and has
a broker-dealer subsidiary that engages in public offerings. The
publicly traded parent company would be restricted under paragraph
(i)(11)(E) of the rule and would not qualify for the publicly traded
entity exemption. All accounts in which such parent company had a
beneficial interest (including entities in which the parent held an
interest of 10% or more) also would be restricted persons, even if
the business of the subsidiaries was wholly unrelated to the broker-
dealer activities. Now assume that the publicly traded parent
company has a broker-dealer subsidiary that does not engage in
public offerings. The parent company would qualify for the publicly
traded entity exemption in paragraph (c)(5) of the rule. The broker-
dealer subsidiary would continue to be a restricted person, but the
parent company and other non-restricted subsidiaries of the parent
company would be eligible to purchase new issues.
---------------------------------------------------------------------------
One commenter argued that purchases by a private company also
should be exempt from the proposed rule, if no more than 10% of its
shareholders are restricted persons.\134\ The NASD responded that a
private company may avail itself of the de minimis exemption in
paragraph (c)(4).
---------------------------------------------------------------------------
\134\ See Sullivan.
---------------------------------------------------------------------------
Finally, one commenter \135\ pointed out that the Nasdaq Stock
Market currently has an application pending with the Commission to
become registered as a national securities exchange pursuant to Section
6 of the Act.\136\ If that application is approved, securities traded
in both the Nasdaq National Market and the Nasdaq SmallCap Market would
be deemed to be traded on a national securities exchange. The commenter
stated that the distinction set forth in paragraphs (c)(5)(A) and (B)
between a security that is ``listed on a national securities exchange''
versus one that is ``traded on the Nasdaq National Market'' could
create confusion as to whether securities traded on the Nasdaq SmallCap
Market are exempt from the rule. In Amendment No. 5, the NASD stated
that the publicly traded entity exemption does not apply to securities
traded on the Nasdaq SmallCap Market. In addition, the NASD represented
that it would consider amending the publicly traded entity exemption if
and when Nasdaq becomes a national securities exchange.
---------------------------------------------------------------------------
\135\ See Sidley 2.
\136\ 15 U.S.C. 78f.
---------------------------------------------------------------------------
d. Foreign Investment Companies. The Interpretation contains a
general exemption for foreign investment companies.\137\ A ``foreign
investment company'' is defined as a fund company organized under the
laws of a foreign jurisdiction that has certified that: (1) The fund
has 100 or more investors; (2) it is listed on a foreign exchange or
authorized for sale to the public by a foreign regulatory authority;
(3) no more than 5% of its assets are invested in a particular hot
issue; and (4) no person owning more than a 5% interest in such company
is a restricted person.\138\ Paragraph (c)(6) of the proposed rule
would preserve this exemption, but reduce from four to two the number
of criteria that a foreign fund would be required to meet. Under the
proposed rule, the investment company must be listed on a foreign
exchange or authorized for sale to the public by a foreign regulatory
authority, and no person owning more than 5% of the shares of the
investment company may be a restricted person.\139\ However, as the
NASD clarified in Amendment No. 5, a foreign investment company that
failed to meet one or both of the criteria for the exemption in
paragraph (c)(6) might still qualify for the de minimis exemption in
paragraph (c)(4).
---------------------------------------------------------------------------
\137\ See NASD IM-2110-1(f)(1).
\138\ See NASD IM-2110-1(l)(6).
\139\ The NASD believes that condition (1) in the
Interpretation--the 100-investor requirement--addresses the same
concerns about concentration of ownership as condition (4).
Therefore, the NASD has decided to eliminate the 100-investor
requirement. In addition, the NASD believes that condition (3)--the
limitation on the size of the purchase in relation to the size of
the investment company--is unnecessary and potentially burdensome
for members to calculate. The NASD has stated, moreover, that for
very large funds the limitation is meaningless, inasmuch as 5% of
their total assets would often exceed the size of the entire IPO.
Therefore, the NASD has decided to eliminate condition (3).
---------------------------------------------------------------------------
One commenter \140\ suggested exempting any foreign investment
company that is traded on a ``designated offshore securities market,''
as defined in Rule 902(b) under the Securities Act.\141\ The NASD
believes that such an exemption would be too broad and that the
definition in Rule 902(b) is not related to the concerns underlying the
proposed rule. Moreover, although noting that qualifying as a
``designated offshore securities market'' requires oversight by a
governmental or self-regulatory body, the NASD is not confident that
such regulation would prevent restricted persons from using foreign
investment companies to circumvent the proposed rule. The NASD believes
that, because it is difficult to compare foreign investment company
laws to those in the United States, particularly as they relate to the
purposes of the proposed rule, it is necessary to impose specific
conditions on foreign investment companies to qualify for a general
exemption.
---------------------------------------------------------------------------
\140\ See MSDW.
\141\ 17 CFR 230.902(b).
---------------------------------------------------------------------------
In a second letter, the same commenter reiterated its
recommendation that the proposed rule exempt foreign investment
companies that are traded on a ``designated offshore securities
market'' because managers of foreign investment companies might be
unable to determine whether any 5%
[[Page 62138]]
shareholder is a restricted person due to foreign privacy laws
preventing them from obtaining the necessary ownership
information.\142\ Similarly, two other commenters suggested that the
NASD eliminate the second requirement of the exemption--that no person
owning more than 5% of the foreign investment company be a restricted
person `` because of the difficulties in ascertaining the ownership of
a foreign investment company.\143\ Despite these concerns, the NASD
believes that this requirement is necessary to prevent purchases of new
issues by funds in which restricted persons have concentrated ownership
interests.
e. ERISA Plans. Paragraph (c)(7) would provide a general exemption
for benefit plans established under the Employee Retirement Income
Security Act (``ERISA'') that are qualified under Section 401(a) of the
Internal Revenue Code.\144\ However, this exemption would not cover
ERISA plans sponsored solely by a broker-dealer. The exemption as
originally proposed also would have prevented an affiliate of a broker-
dealer from using this exemption. Several commenters objected to this
provision, arguing that they were unaware of any perceived or actual
abuses to cause the NASD to narrow the exemption from the
Interpretation.\145\ The NASD agreed, and the final proposal would
allow an ERISA plan sponsored by a broker-dealer affiliate--although
not a plan sponsored by the broker-dealer itself--to benefit from the
exemption.
---------------------------------------------------------------------------
\142\ See MSDW 2.
\143\ See Colish; Sullivan.
\144\ 29 U.S.C. 401(a).
\145\ See MSDW; SIA; Sullivan.
---------------------------------------------------------------------------
f. State and Municipal Government Benefits Plans. Paragraph (c)(8)
would provide a general exemption for a state or municipal government
plan that is subject to state and/or municipal regulation.
g. Tax-Exempt Charitable Organizations. Paragraph (c)(9) would
exempt sales of new issues to, and purchases by, tax exempt charities
organized under Section 501(c)(3) of the Internal Revenue Code.\146\
The NASD believes that new issue sales to charitable organizations are
consistent with the purposes of the rule and foster a bona fide public
distribution.
---------------------------------------------------------------------------
\146\ 29 U.S.C. 501(c)(3).
---------------------------------------------------------------------------
h. Church Plans. Paragraph (c)(10) would provide a general
exemption for church plans described in Section 414(e) of the Internal
Revenue Code.\147\ As originally proposed, the rule included an
exemption only for ERISA plans. One commenter stated that the same
rationale for exempting ERISA plans also applied to church plans, and
recommended that the NASD exempt such plans as well.\148\ The NASD
agreed and added the new paragraph (c)(10) in Amendment No. 3.
---------------------------------------------------------------------------
\147\ 29 U.S.C. 414(e).
\148\ See CII.
---------------------------------------------------------------------------
i. Foreign Employee Benefits Plans. The same commenter also
recommended that the proposed rule include a general exemption for
foreign governmental and foreign non-governmental employee benefits
plans.\149\ The commenter argued that foreign plan participants are not
in a position to influence the investment decisions of the plan sponsor
even if they might otherwise be restricted persons. The commenter
further noted that a number of foreign benefits plans are sponsored by
foreign subsidiaries of U.S. corporations, and that a restriction on
foreign plans could have illogical results: A U.S.-based employee of a
foreign firm might participate in a U.S. plan that is permitted to buy
new issues, while an American co-worker based in a foreign country who
invests in a foreign plan would not be allowed to participate through
the foreign plan in new issue allocations.
---------------------------------------------------------------------------
\149\ See id.
---------------------------------------------------------------------------
In Amendment No. 3, the NASD stated that it had declined to adopt a
blanket exemption for foreign employee benefit plans. Since that time,
however, the NASD has granted an exemption from the Interpretation to a
pension fund operated by the province of Qu[eacute]bec. The NASD stated
that it granted this exemption on the basis of the large number of plan
participants and the small notional pro rata allocation of each of the
fund's assets to any individual participant. Nevertheless, the NASD
does not believe that a blanket exemption for foreign plans would be
appropriate. In some cases, the NASD observed, foreign laws may permit
benefit plans to allocate new issues only to certain plan participants,
may provide for unequal distribution of profits from new issues, or may
benefit a very narrow category of restricted person. The NASD stated
that it also may be possible for a foreign benefits plan to be
constructed as a means to circumvent the rule; for example, a shell
corporation that consists entirely or principally of restricted persons
could establish a benefits plan that would purchase new issues. The
NASD stated in Amendment No. 4 that, as its staff becomes more familiar
with various types of foreign investment plans, it may consider issuing
additional guidance in this area.
Finally, the NASD has stated that a foreign employee benefits plan
that did not receive a specific exemption from the NASD staff could
purchase new issues if it qualified for the de minimis exemption in
paragraph (c)(4).
5. Issuer-Directed Securities
The Interpretation provides that employees and directors of an
issuer, a parent of an issuer, a subsidiary of an issuer, or any other
entity that controls or is controlled by an issuer, may purchase
securities that are part of a public offering that are specifically
directed by the issuer to such persons.\150\ The Interpretation extends
this exemption to potential employees and directors who would result
from an intended merger, acquisition, or other business combination.
The Interpretation requires, however, that the securities acquired
pursuant to the exemption be subject to a three-month lock-up period if
a bona fide independent market for such securities does not exist.
---------------------------------------------------------------------------
\150\ See NASD IM-2110-1(d).
---------------------------------------------------------------------------
Under its original proposal, the NASD would have revised the
provisions on issuer-directed securities in to two principal ways.
First, the scope of the exemption would have been extended to include
employees and directors of sister companies. The NASD stated that such
action would be consistent with the purposes of the rule and the
existing exemption, as well as decisions of the NASD staff rendered
pursuant to its exemptive authority. Second, the three-month lock-up
period in the Interpretation would have been eliminated. The NASD
believes that issuers should be free to set the conditions for sales of
their own securities to their employees (or employees of affiliated
companies) even if such employees are otherwise restricted persons.
While an issuer may decide to impose a lock-up period, the NASD does
not believe that such a period should be mandated by the proposed rule.
The NASD has stated that eliminating the lock-up period would relieve
members of having to investigate the status of employees and directors
of the issuer and its affiliated companies, which was previously
necessary solely to comply with the lock-up provision. This approach
would allow all employees and directors of the issuer and affiliated
companies to purchase securities of the issuer on equal terms. By
contrast, under the Interpretation, an employee of an issuer who has a
spouse in the securities industry must lock up a purchase of a
[[Page 62139]]
hot issue even though other employees are not required to do so.
In Amendment No. 2, the NASD provided additional detail to the
proposed exemption for issuer-directed securities. Pursuant to
Amendment No. 2, securities that the issuer specifically directed to
persons such as employees, directors, and their friends and family
would be exempt, even if such persons were restricted persons. The NASD
stated that in recent years it has been presented with situations in
which, for example, an employee of an issuer wanted to direct shares of
a new issue to his or her parent, but was unable to do so because the
parent was a restricted person (and not an employee or director of the
issuer). The proposed rule, as revised by Amendment No. 2, would allow
directed shares to be sold to the parent in this case.
One commenter recommended that all non-underwritten securities
directed by the issuer should be exempt from the proposed rule.\151\
The NASD believes, however, that a person who is otherwise restricted
should not be allowed to purchase new issues pursuant to the issuer-
directed security exemption unless such person (or a member of his or
her immediate family) is an employee or director of the issuer, the
issuer's parent, or a subsidiary of the issuer or the issuer's parent.
In the NASD's view, a general exemption for all issuer-directed or all
non-underwritten securities would be readily susceptible to abuse. The
NASD also believes that the issuer-directed exemption should apply only
when shares are in fact directed by the issuer; if a member firm asks
or otherwise suggests that an issuer direct securities to a restricted
person, the NASD does not believe that such securities should be exempt
from the proposed rule. The NASD has stated that it would continue its
practice of holding a managing underwriter responsible for ensuring
that all securities in the public offering be distributed in accordance
with the proposed rule.
---------------------------------------------------------------------------
\151\ See MSDW.
---------------------------------------------------------------------------
Paragraph (d)(1) of the proposed rule would provide that, for
purposes of the issuer-directed security exemption, a parent/subsidiary
relationship is established if the parent had the right to vote, sell,
or direct 50% or more of a class of voting security of the subsidiary.
One commenter argued that a 10% ownership standard should apply
instead.\152\ The NASD believes that it is not uncommon for a member,
through its merchant banking activities, to make venture capital
investments that constitute 10% or more of an issuer's capital. The
NASD replied that, if it accepted this comment, all employees and
directors of the member in such cases would be able to purchase the new
issue. The NASD does not believe that exempting broker-dealer personnel
by virtue of the broker-dealer's venture capital investments is
consistent with the purposes of the proposed rule or the exemption for
issuer-directed securities.\153\
---------------------------------------------------------------------------
\152\ See Sullivan. But see MSDW (recommending a 50% threshold).
\153\ The NASD notes that the proposed rule contains separate
provisions that would permit venture capital investors to purchase
new issues to avoid dilution in a public offering. See paragraph (e)
of proposed NASD Rule 2790. The NASD believes that going beyond
these protections for venture capital investors would be
inconsistent with the purposes of the rule.
---------------------------------------------------------------------------
One commenter \154\ suggested that the scope of permissible
purchasers under the issuer-directed exemption should be amended to
conform with the permitted categories of offerees set forth in Rule 701
under the Securities Act of 1933.\155\ The NASD determined not to act
on this suggestion because it believes that the commenter's approach
would be more difficult for members to implement.
---------------------------------------------------------------------------
\154\ See Sidley.
\155\ 17 CFR 230.701 (providing an exemption from the
registration provisions of the Securities Act for offers and sales
of securities under certain compensatory benefit plans or written
agreements relating to compensation).
---------------------------------------------------------------------------
Paragraph (d)(2) of the proposed rule would provide that the
restrictions on the purchase and sale of new issues would not apply to
securities that are part of a program sponsored by the issuer, or an
affiliate of the issuer, that meets four criteria: (1) The program has
at least 10,000 participants; (2) every participant is offered an
opportunity to purchase an equivalent number of shares, or will receive
a specified number of shares under a predetermined formula applied
uniformly across all participants; (3) if not all participants receive
shares under the program, the selection of the eligible participants is
based on a random or other non-discretionary allocation method; and (4)
the class of participants does not contain a disproportionate number of
restricted persons. As proposed in Amendment No. 2, paragraph (d)(2)
would have had a fifth criterion: that sales of the issuer-directed
security not be made to participants who are managing underwriters or
broker-dealers (or employees thereof) that are administering the
program. One commenter welcomed an exemption for issuer-directed
securities but argued that a requirement to investigate the facts about
each of 10,000 participants to prevent sales to persons listed in the
fifth criterion would vitiate the relief granted.\156\ The commenter
added that relying on the large number of offerees as a basis for
exemption would be consistent with the exemption for publicly traded
entities, which is not dependent on any basis other than that a large
number of persons would share the benefits of the new issue. The NASD
agreed with the commenter and eliminated the fifth criterion.\157\
---------------------------------------------------------------------------
\156\ See Fried 2.
\157\ This commenter also noted that the exemption for issuer-
directed securities, as proposed in Amendment No. 2, did not
expressly permit an issuer to allocate its securities to employees
and directors of sister companies, as described in the commentary to
the proposed rule change. See Fried 2. The NASD has stated that this
was an inadvertent omission and corrected the proposed rule text
accordingly.
---------------------------------------------------------------------------
Another commenter \158\ sought guidance on the meaning of the
fourth criterion, which requires that ``the class of participants does
not contain a disproportionate number of restricted persons as compared
to the investing public.'' In Amendment No. 5, the NASD stated that
this condition is designed to ensure that a program is not directed to
a group composed to a significant extent of restricted persons. The
NASD also stated that, if an issuer has any questions about whether a
specific program would qualify for this condition, the issuer should
contact the NASD's Office of General Counsel for interpretative
guidance.
---------------------------------------------------------------------------
\158\ See Testa 2.
---------------------------------------------------------------------------
6. Anti-Dilution Provisions
Paragraph (e) of the proposed rule would provide that the rule's
basic prohibitions do not apply to an account in which a restricted
person has a beneficial interest, if the account meets each of four
criteria: (1) The account has held an equity ownership interest in the
issuer for a period of one year prior to the effective date of the
offering; (2) the sale of the new issue to the account does not
increase the account's percentage equity ownership in the issuer above
the ownership level as of three months prior to the filing of the
registration statement in connection with the offering; (3) the sale of
the new issue to the account does not include any special terms; and
(4) the new issue purchased pursuant to this exemption is not sold or
transferred for three months following the effective date of the
offering. Paragraph (e) would supersede a similar provision in the
Interpretation \159\ and modify it slightly to allow an equity holder,
for purposes of meeting the requirement that the interest in the issuer
be held for one year, to count the period in which the
[[Page 62140]]
holder had an interest in another company purchased by the issuer. The
NASD has stated that this amendment is consistent with an NASD staff
interpretative position.
---------------------------------------------------------------------------
\159\ See NASD IM-2110-1(h).
---------------------------------------------------------------------------
One commenter questioned whether the NASD intended the anti-
dilution provisions to apply only to natural persons, arguing that
legal persons that have a prior equity ownership interest in an issuer
also should be able to avail themselves of this exemption.\160\ The
NASD stated that the failure to extend the anti-dilution provisions to
legal persons was inadvertent and revised the proposal
accordingly.\161\
---------------------------------------------------------------------------
\160\ See Testa.
\161\ Subsequently, the same commenter noted several drafting
errors with respect to the anti-dilution provisions as they appeared
in Amendment No. 2. See Testa 2. The NASD subsequently made the
necessary corrections.
---------------------------------------------------------------------------
7. Stand-By Purchasers and Under-Subscribed Offerings
The NASD notes that the decision to apply the proposed rule to all
new issues, not merely to hot issues, may create difficulties for
offerings for which there is insufficient investor demand. Under the
Interpretation, such offerings do not typically open at a premium and
thus are not hot issues. With a rule that applies to all new issues,
however, the rule should address circumstances in which purchases by
restricted persons are necessary for the successful completion of an
offering. Accordingly, paragraph (g) would provide that nothing in the
rule would prohibit an underwriter, pursuant to an underwriting
agreement, from placing a portion of a public offering in its
investment account if it were unable to sell that portion to the
public. In addition, paragraph (f) would provide that the prohibitions
on the purchase and sale of new issues do not apply to purchases and
sales made pursuant to a stand-by agreement that meets the following
four conditions: (1) The stand-by agreement is disclosed in the
prospectus; (2) the stand-by agreement is the subject of a formal
written agreement; (3) the managing underwriter represents in writing
that it is unable to find any other purchasers for the securities; and
(4) securities sold pursuant to the stand-by agreement are subject to a
three-month lock-up period. Paragraph (f) incorporates the existing
exemption for stand-by purchases and sales found in the
Interpretation.\162\
---------------------------------------------------------------------------
\162\ See NASD IM-2110-1(e).
---------------------------------------------------------------------------
Two commenters, although supporting the exemption relating to
under-subscribed offerings, believed that it should be extended to
permit an underwriter, in lieu of placing the securities in its own
investment account, to be able to sell such securities to one or more
restricted persons.\163\ One of these commenters stated that, if the
objective of the proposed rule were to ensure a broad public
distribution of securities for which there is significant demand, no
regulatory objective would be furthered by restricting sales of
offerings for which there is insufficient demand.\164\ The NASD
disagreed with these comments and stated that the provision was
designed to ensure that the rule is consistent with an underwriter's
contractual obligations to the issuer. The NASD believes that allowing
an underwriter to sell a new issue to a restricted person if the issue
turned ``cold'' would, in effect, reinstate the ``hot issue'' concept
that the NASD is seeking to replace.
---------------------------------------------------------------------------
\163\ See MSDW 2; Sullivan 2.
\164\ See MSDW 2. This commenter also suggested imposing minimum
capital contribution requirements for the stand-by provisions and
extending the lock-up requirements from three months to one year.
The NASD has stated that it does not believe that these additional
requirements are necessary.
---------------------------------------------------------------------------
One commenter \165\ asked for clarification that the proposed rule
would not affect stabilization activities conducted under the
Commission's Regulation M.\166\ The NASD stated in Amendment No. 3 that
the proposed rule would govern activities in connection with the
distribution of new issues and would not have any effect on an
underwriter's decision to engage in market stabilization activities,
which occur after the security has commenced trading in the secondary
market.
---------------------------------------------------------------------------
\165\ See Testa 2.
\166\ 17 CFR 242.100 et seq.
---------------------------------------------------------------------------
8. Exemptive Relief
The Interpretation contains a provision that allows the NASD staff
to grant an exemption from any or all of the provisions of the
Interpretation, if it determines that such exemption is consistent with
the purposes of the Interpretation, the protection of investors, and
the public interest.\167\ Paragraph (h) would reincorporate the
exemptive authority of the NASD staff into the new rule.
---------------------------------------------------------------------------
\167\ See NASD IM-2110-1(a)(5).
---------------------------------------------------------------------------
9. Definitions of Key Terms
a. Beneficial Interest. Paragraph (i)(1) of the proposed rule would
define the term ``beneficial interest'' as any economic interest, such
as the right to share in gains or losses. Consistent with a previously
articulated NASD staff position,\168\ the definition also would provide
that the receipt of a management fee or performance-based fee for
operating a collective investment account, or other fees for acting in
a fiduciary capacity, would not be considered a beneficial interest in
the account.
---------------------------------------------------------------------------
\168\ See NASD Notice to Members 97-5.
---------------------------------------------------------------------------
The term beneficial interest was defined in the original proposal
as ``any ownership or other direct financial interest.'' The NASD
became aware that members found the reference to ownership, as distinct
from a financial interest, unclear. The NASD believes that only those
who profit from an account, rather than those legally own it, are of
concern to the proposed rule and revised the proposal accordingly.
One commenter argued that the definition of ``beneficial interest''
should specifically exclude management or performance-based fees that
are deferred for bona fide taxation reasons.\169\ This commenter was
concerned about the effect that deferred management or performance fees
might have on a hedge fund manager's interest in a collective
investment account that he or she managed. Another commenter noted that
a portfolio manager might receive a management or performance-based fee
for operating a hedge fund, the amount of which fees may be based on
income from new issues.\170\ This commenter asked the NASD to clarify
whether these fees, if deferred for income tax purposes, would be
deemed to create a beneficial interest in the fund held by the
portfolio manager.
---------------------------------------------------------------------------
\169\ See Rosenman.
\170\ See Sidley 2.
---------------------------------------------------------------------------
The NASD does not believe that it is appropriate to amend the
definition of ``beneficial interest'' to expressly exclude performance-
based allocations and deferred performance-based fees. In Amendment No.
5, the NASD counseled that the initial receipt of the fee would not
constitute a beneficial interest in the collective investment account,
because the definition of ``beneficial interest'' excludes ``the
receipt of a management or performance based fee for operating a
collective investment account, or other fees for acting in a fiduciary
capacity.''\171\ The NASD believes, however, that the accumulation of
these payments, if subsequently invested in the collective investment
account (as a deferred fee arrangement or otherwise) would constitute a
beneficial interest in the account. The NASD believes that money
invested in a collective investment account is part of a person's
beneficial interest in that account even if the source of the money is
a deferred fee arrangement. The NASD does not
[[Page 62141]]
believe that a decision to defer recognition of earnings for income tax
purposes should alter the analysis of whether a person has a beneficial
interest in a collective investment account.
---------------------------------------------------------------------------
\171\ See paragraph (i)(1) of proposed NASD Rule 2790.
---------------------------------------------------------------------------
b. Collective Investment Account. Paragraph (i)(2) would define
``collective investment account'' as any hedge fund, investment
partnership, investment corporation, or any other collective investment
vehicle that is engaged primarily in the purchase and/or sale of
securities. The original proposal defined ``collective investment
account'' as any hedge fund, investment partnership, investment
corporation, or any other collective investment vehicle that manages
assets of other persons. One commenter pointed out that a hedge fund or
other investment partnership typically engages in the purchase and sale
of securities for its proprietary account, and that these entities do
not necessarily manage the assets of others.\172\ This commenter
recommended, therefore, that the NASD remove the phrase ``that manages
the assets of other persons'' from the definition. The NASD agreed and
revised the proposed definition accordingly.
---------------------------------------------------------------------------
\172\ See Sidley.
---------------------------------------------------------------------------
C. Transition Period
Three commenters urged the NASD to allow entities that would be
subject to the proposed rule a transition period before coming into
full compliance with it.\173\ The NASD believes that a transition
period would be reasonable and has proposed a three-month period during
which members could comply with either the Interpretation or the new
rule. This three-month period would begin upon the NASD's publication
of a Notice to Members announcing any Commission final action on the
proposed rule change. The NASD stated in Amendment No. 5 that it would
publish this Notice to Members no later than 60 days following a
Commission approval.
---------------------------------------------------------------------------
\173\ See Ropes (suggesting 90 days); Schulte (six months);
Sullivan 2 (90 days).
---------------------------------------------------------------------------
V. Discussion
After carefully considering the proposal and all the comments
received, the Commission finds that the proposal, as amended, is
consistent with the requirements of the Act and the regulations
thereunder applicable to a national securities association. In
particular, the Commission believes that the proposal is consistent
with Sections 15A(b)(6) and 15A(b)(9) of the Act.\174\ Section
15A(b)(6) requires, among other things, that the rules of a national
securities association be designed to prevent fraudulent and
manipulative acts and practices; to promote just and equitable
principles of trade; to remove impediments to and perfect the mechanism
of a free and open market and a national market system; and, in
general, to protect investors and the public interest. Section
15A(b)(6) also provides that the rules of an association may not be
designed to permit unfair discrimination between customers, issuers,
brokers, or dealers. Section 15A(b)(9) provides that the rules of an
association may not impose any burden on competition not necessary or
appropriate in furtherance of the purposes of the Act.
---------------------------------------------------------------------------
\174\ 15 U.S.C. 78o-3(b)(6) and (9).
---------------------------------------------------------------------------
The Commission finds that the proposal will protect investors and
is in the public interest. The Commission believes that the proposal is
a reasonable means of furthering the NASD's stated aims of ensuring
that: (1) NASD members make a bona fide public offering of securities
at the public offering price; (2) members do not withhold securities in
a public offering for their own benefit or use such securities to
reward certain persons who are in a position to direct future business
to the member; and (3) industry insiders, including NASD members and
their associated persons, do not take advantage of their ``insider''
position to purchase new issues for their own benefit at the expense of
public customers.
The proposal is to a large extent a reorganization of the existing
provisions of NASD IM-2110-1. The Commission has previously opined on
many of these provisions and found them to be consistent with the
Act.\175\ Furthermore, the Commission believes that the proposal
furthers the purposes of the Act by making the rule easier to
understand and administer. With respect to provisions of new NASD Rule
2790 that were not present in the Interpretation, the Commission finds
that they also are consistent with the Act. The most significant of
these new provisions are discussed below.
---------------------------------------------------------------------------
\175\ See, e.g., Securities Exchange Act Release No. 40001 (May
18, 1998), 63 FR 28535 (May 26, 1998) (SR-NASD-97-95) (approving
various revisions to NASD IM-2110-1); Securities Exchange Act
Release No. 35059 (December 7, 1994), 59 FR 64455 (December 14,
1994) (SR-NASD-94-15) (same).
---------------------------------------------------------------------------
A. Offerings Covered by NASD Rule 2790
The Commission believes that it is reasonable for the new rule to
apply to ``new issues'' rather than ``hot issues.'' Under the
Interpretation, restrictions are not triggered unless an issue becomes
``hot'' (i.e., it trades at a premium over the offering price). The
Commission believes that NASD members generally will find it simpler to
treat all new issues in the same manner. The Commission also believes
it reasonable to eliminate the cancellation provision; its primary
rationale no longer exists because all new issues are subject to the
rule from the moment that they are initially offered to the public, not
later when they become ``hot.'' Eliminating the cancellation provision
will enhance compliance with the new rule by encouraging NASD members
to identify all potential restricted persons prior to a new issue.
B. Restricted Persons
The Commission believes that the scope of the term ``restricted
person'' in the new rule is reasonable and consistent with the Act. As
under the Interpretation, broker-dealers and their associated persons
will be restricted. The Commission finds that it is consistent with the
Act for the NASD to restrict its members from purchasing new issues
from or selling new issues to other broker-dealers. The acquisition by
such persons of new issues could give the appearance that an initial
public offering was not in fact truly ``public.'' The Commission also
believes it is appropriate for the NASD to extend the restriction to
agents of a broker-dealer who are engaged in the investment banking or
securities business.
Under the new rule, as under the Interpretation, ``limited business
broker-dealers'' (i.e., broker-dealers that are authorized to engage
only the purchase and sale of investment company/variable contracts
securities and direct participation program securities) will not be
considered restricted persons. The Commission believes that this
provision is consistent with the Act because it exempts only a small
class of broker-dealers that, due to the nature of their business, are
unlikely to benefit unfairly from the purchase of a new issue.
The Commission has carefully considered CBOE's comment letter and
finds that the NASD's decision not to expand the concept of limited
business broker-dealers to include CBOE market makers and floor brokers
(and their associated persons) is reasonable. CBOE argued that
``options market makers and floor brokers perform specialized, limited
functions and should not be considered representative of the typical
broker-dealer population.'' However, the NASD's determination not to
make additional exemptions for CBOE members and other types of broker-
[[Page 62142]]
dealer is consistent with the new rule's general aim of ensuring that
public investors rather than securities industry insiders receive the
benefit of new issues. The Commission also agrees with the NASD that an
exemption for ``limited business broker-dealers''--based solely on what
the firm is authorized to do on its Form BD--is more transparent and
easier to administer than the type of standard for exempted broker-
dealers advocated by CBOE, which would require an analysis of the
activities actually conducted by the broker-dealer.
The Commission also believes that the new rule's treatment of joint
back office broker-dealers is consistent with the Act. Under the new
rule, a JBO would be able to purchase new issues provided that the
interests of restricted persons in the JBO do not exceed 10%, although
associated persons of the JBO will be restricted persons. JBOs are
hedge funds or hedge fund affiliates that often are active participants
in the securities markets. The associated persons of JBOs may be in a
position to direct future business to an NASD member, and the purchases
by such industry insiders of an IPO could create the appearance that
the offering was not truly ``public.''
Under the new rule, restricted person status will extend to any
immediate family member of a person who is ``directly restricted'' by
the new rule on account of his or her position in the industry (such as
an employee of a broker-dealer). The restriction on immediate family
members also will apply to persons who receive material support from a
directly restricted person. The Commission believes that these
provisions are appropriate to prevent evasion of the new rule while not
unduly extending the rule's restrictions to persons who could not
reasonably be viewed as an alter ego of a directly restricted person.
Similarly, the Commission believes that it is appropriate to extend
restricted person status to owners and affiliates of a broker-dealer.
In the absence of such a provision, the restriction on the broker-
dealer could easily be evaded. The Commission believes that it is
reasonable and consistent with the Act for the new rule to assign
restricted person status to persons listed on Schedules A and B of a
broker-dealer's Form BD. While Schedule A requires reporting of
interests of 5% or more in the broker-dealer, the new rule will
restrict only those persons appearing on Schedule A who hold interests
of 10% or more. The Commission believes that the 10% threshold for
ownership interests in a broker-dealer as a criterion for restricted
person status is appropriate because it is consistent with the 10% de
minimis threshold established in the rule's general exemptions.
Moreover, basing restricted person status on a 10% interest reported on
Schedule A (for direct owners of the broker-dealer) will lessen the
likelihood that an entity reported on Schedule B (for indirect owners)
will be deemed a restricted person even if the indirect owner has only
a small economic interest in the broker-dealer. The Commission believes
that the ownership classifications employed by the new rule are
reasonably based, are already understood by NASD members, and will
facilitate administration of the rule.
The Commission also believes that the publicly traded entity
exemption is reasonable and consistent with the Act. The proposed rule
assumes that a publicly traded entity generally will have wide public
ownership, thus reducing the likelihood that a large percentage of the
entity's shareholders are restricted persons who would unfairly benefit
from the entity's purchase of new issues. The Commission believes that
this assumption is reasonable in light of the quantitative standards
that companies must meet to list their securities on a national
securities exchange or the Nasdaq Stock Market.\176\ Although there may
be some publicly traded companies of which restricted persons
nevertheless constitute a significant percentage of the shareholders,
the Commission believes the general exemption for publicly traded
entities strikes an appropriate balance between carrying out the
purposes of the rule and minimizing its administrative burdens.
---------------------------------------------------------------------------
\176\ See, e.g., NASD Rule 4420(a)-(c) (requiring 1,100,000
publicly held shares for inclusion on the Nasdaq National Market);
New York Stock Exchange Listed Company Manual Rule 102.01A
(requiring 1,100,000 publicly held shares for listing on the NYSE).
---------------------------------------------------------------------------
The exemption for publicly traded entities will not cover broker-
dealers themselves or affiliates of broker-dealers that are authorized
to engage in the public offering of new issues (either as a selling
group member or underwriter). A broker-dealer, although publicly
traded, is likely to have a higher concentration of restricted persons
amongst its ownership. Therefore, the Commission believes that it is
reasonable for the NASD not to afford broker-dealers--or affiliates of
broker-dealers that sell or underwrite new issues--the benefits of the
publicly traded entity exemption. In the absence of such a provision,
significant potential to evade the new rule would exist.
Finally, the Commission agrees with the NASD that participation in
an investment club, by itself, should not cause a person to be
restricted under the new rule, and that the treatment of investment
clubs and family investment vehicles under the new rule is consistent
with the Act.
C. Elimination of Conditionally Restricted Person Status and New De
Minimis Threshold
The new rule will eliminate ``conditionally restricted person''
status and adopt a standard that will render all persons either
restricted or non-restricted. The Commission agrees with the NASD that,
in some cases, a person may purchase a hot issue pursuant to the
Interpretation's ``conditionally restricted person'' exemption even
when such purchase appears contrary to the principles underlying the
Interpretation. The Commission believes that the proposed rule change
will help eliminate such cases, and that the definition of ``restricted
person'' in the new rule will be more transparent and easier to
administer.
Although all persons under the rule will be either restricted or
non-restricted, the NASD has acknowledged that accommodation must be
made for some restricted person participation in collective investment
accounts. The alternative--prohibiting all new issue purchases by a
collective investment account if even a single restricted person is a
participant--would be unrealistic. The NASD has proposed, therefore, a
10% de minimis limit for restricted person participation in a
collective investment account. The Commission agrees with the NASD that
the purposes of the rule generally are not implicated if a member sells
a new issue to a collective investment account in which restricted
persons have only a small interest. The investors who are non-
restricted persons will still receive the majority of the new issue's
proceeds, and the notional portion of such proceeds accruing to the
restricted persons would be sufficiently small as to provide little
incentive for them to direct future business to the member as
compensation. The Commission, therefore, finds that that the 10%
threshold proposed by the NASD is reasonable and consistent with the
Act.
Three commenters criticized the NASD's decision to consider hedge
fund managers as restricted persons in all cases, even with respect to
the funds for which they act as portfolio manager.\177\ After carefully
considering these comments, the Commission finds that they do not raise
any issue that
[[Page 62143]]
precludes approval of the NASD's proposal. The Commission acknowledges
that it is reasonable for hedge fund investors to seek to align the
interests of hedge fund managers with their own. Contrary to the view
taken by these commenters, however, the new rule will not significantly
impede that effort. NASD Rule 2790 does not prohibit a hedge fund
manager from holding an interest of greater than 10% in a hedge fund
that he or she manages because of the availability of the carve-out
procedures. These carve-out procedures, which exist under the
Interpretation and will be carried over in the new rule, allow the fund
to segregate the interests of restricted from non-restricted persons
and to direct the proceeds of the fund's investments accordingly. Thus,
the rule merely prohibits such a fund from purchasing new issues in a
manner that allows the hedge fund manager (and other restricted
persons) to receive from such purchases an indirect, pro rata benefit
that exceeds the lesser of 10% or their actual percentage interest in
the fund. NASD Rule 2790 places no restrictions on the ability of a
hedge fund--whatever its ownership structure--to purchase any other
type of asset. The investors will still be able to align the interests
of hedge fund managers with their own with respect to every type of
investment opportunity other than new issues. The Commission believes
that the potential adverse consequences of preventing the alignment of
investor and manager interests with respect to this class of investment
are minimal.
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\177\ See MFA 3; Sidley 2; Willkie 3; Willkie 4. See also infra
notes 35-36 and accompanying text.
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By contrast, allowing hedge fund managers unlimited participation
in the benefits of new issues through the funds that they manage would
be much more likely to compromise investor protection and the public
interest. A portfolio manager is in a position to direct business to a
member and might be willing to do so in return for having received new
issues. The larger a hedge fund manager's interest in the fund, the
greater the manager's notional pro rata benefit from any particular
investment made by the fund and the greater the incentive for the
member to sell new issues to that fund in hopes of receiving future
business. Furthermore, allowing a portfolio manager to have unlimited
participation in a hedge fund that purchases new issues would further
the appearance that an industry insider was receiving a
disproportionate benefit from new issues. The Commission believes that
the proposed rule furthers the appearance, as well as the reality, of
fairness in the IPO process and thus will strengthen investor
confidence in the securities markets.
The Commission concludes that deeming hedge fund managers and other
portfolio managers as restricted persons, subject to the 10% de minimis
exemption for collective investment accounts, represents a reasonable
balance between the principles underlying the new rule and
consideration of the structure of the hedge fund industry.
D. Other Provisions
The Commission finds that the preconditions for sale provisions
strike a reasonable balance between, on the one hand, ensuring that
accounts to which NASD members sell new issues are in fact eligible
and, on the other hand, minimizing the administrative burdens on both
members and their customers. Specifically, the Commission believes that
12 months is a reasonable time frame within which members should update
eligibility information. The Commission also believes that the NASD's
proposed use of negative consent procedures is reasonable and
consistent with the Act.
With respect to the anti-dilution provisions of the proposed rule,
the Commission believes that the acquisition of new issues by
restricted persons for the purpose of preventing their existing
interests from being diluted does not run counter to either the
purposes of the rule or the provisions of the Act. The Commission also
believes that the holding period requirements of the anti-dilution
provisions are a reasonable means to prevent abuse of these provisions.
The Commission finds that the provisions of the new rule relating
to stand-by purchasers and under-subscribed offerings are consistent
with the Act. These provisions are a reasonable means to facilitate the
distribution of new issues and, although allowing restricted persons to
hold beneficial interests in new issues in some circumstances, do not
run counter to the purposes of the new rule.
Finally, the Commission believes that it is reasonable for
paragraph (h) of new NASD Rule 2790 to allow NASD staff to exempt any
person, security, or transaction from the rule, to the extent that such
exemption would be consistent with the purposes of the rule, the
protection of investors, and the public interest. However, the
Commission reminds the NASD that exemptions of general applicability
that would impose substantive binding requirements should be done
through the notice-and-comment rulemaking process prescribed by Rule
19b-4 under the Act.\178\ The only circumstance in which exemptive
authority of the NASD should be exercised without employing this
process is where the circumstances are truly unique. In most instances,
the circumstances involved are so common that the same exemption would
in fact be granted to all other similarly situated persons and thus
must be handled through the notice-and-comment rulemaking process.\179\
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\178\ 17 CFR 240.19b-4.
\179\ See letter to T. Grant Callery, NASD, from Annette L.
Nazareth, Division of Market Regulation, SEC, dated March 27, 2003.
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E. Effective Date
The Commission believes that it is reasonable and consistent with
the Act to allow NASD members the transition period specified above
\180\ in which to adjust their compliance programs to accommodate the
new rule. The Commission notes that it has approved similar transition
periods in previous cases.\181\ Accordingly, the proposed rule change
will take effect upon the issuance by the NASD of a Notice to Members
discussing the new rule, and the NASD has represented that it will
publish this Notice to Members no later than 60 days following
Commission approval. NASD members may comply with either the
Interpretation or new NASD Rule 2790 for three months following
publication of the Notice to Members.
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\180\ See supra note and accompanying text.
\181\ See, e.g., Securities Exchange Act Release No. 44499 (June
29, 2001), 66 FR 35819, 35822 (July 9, 2001) (SR-NASD-2001-14)
(allowing Nasdaq issuers a short period of time to comply with
either the old or newly approved listing standards).
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F. Accelerated Approval
Pursuant to Section 19(b)(2) of the Act,\182\ the Commission finds
good cause for approving the proposal, as revised by Amendment No. 5,
prior to the thirtieth day after the date of publication of notice of
the amended proposal in the Federal Register. The Commission believes
that Amendment No. 5 does not materially alter the operation of the
rule and is intended only to respond to comments and to make certain
technical corrections pointed out by certain of the commenters.
Accordingly, the Commission is accelerating approval of the proposal,
as amended.
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\182\ 15 U.S.C. 78s(b)(2).
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G. Impact on Efficiency, Competition, and Capital Formation
In approving this proposal, the Commission has considered its
impact on efficiency, competition, and capital
[[Page 62144]]
formation.\183\ The Commission believes that the proposed rule change
will further these aims by helping to ensure public confidence in the
IPO process and, thereby, encouraging investment in new issues. The
Commission also believes that the proposal will enhance efficiency,
competition, and capital formation by streamlining the Interpretation,
making it simpler to administer, and reducing the compliance costs of
affected persons.
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\183\ See 15 U.S.C. 78c(f).
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H. Additional Rulemaking Related to IPO Distribution
In a separate filing (SR-NASD-2003-140), the NASD has addressed
other issues relating to the IPO distribution process. Specifically,
the NASD in SR-NASD-2003-140 is proposing to prohibit ``quid pro quo
allocations'' (i.e., offering or threatening to withhold allocations of
IPO shares as consideration or inducement for the receipt of
compensation that is excessive in relation to the services provided by
an NASD member) and ``spinning'' (i.e., allocating IPO shares to
officers or directors of a company in hopes of winning future
investment banking business from that company). In approving this
filing (SR-NASD-99-60), the Commission is making no findings and
expressing no opinion on the proposals set forth in SR-NASD-2003-140.
VI. Amendment No. 5
Below are the provisions of proposed NASD Rule 2790 that were
changed by Amendment No. 5. The base text is that proposed in Amendment
No. 4. Text added by Amendment No. 5 is italicized; deleted text is in
brackets.
* * * * *
Rule 2790. Restrictions on the Purchase and Sale of Initial Equity
Public Offerings
(a) General Prohibitions
(1) A member or a person associated with a member may not sell, or
cause to be sold, a new issue to any account in which a restricted
person has a beneficial interest, except as otherwise permitted herein.
(2) A member or a person associated with a member may not purchase
a new issue in any account in which such member or person associated
with a member has a beneficial interest, except as otherwise permitted
herein.
(3) A member may not continue to hold new issues acquired by the
member as an underwriter, selling group member, or otherwise, except as
otherwise permitted herein.
(4) Nothing in this paragraph (a) shall prohibit:
(A) sales or purchases from one member of the selling group to
another member of the selling group that are incidental to the
distribution of a new issue to a non-restricted person at the public
offering price; [or]
(B) sales or purchases by a broker/dealer of a new issue at the
public offering price as part of an accommodation to a non-restricted
person customer of the broker/dealer; or
(C) purchases by a broker/dealer (or owner of a broker/dealer),
organized as an investment partnership, of a new issue at the public
offering price, provided such purchases are credited to the capital
accounts of its partners in accordance with paragraph (c)(4).
(b) Preconditions for Sale
Before selling a new issue to any account, a member must in good
faith have obtained within the twelve months prior to such sale, a
representation from:
(1) Beneficial Owners
the account holder(s), or a person authorized to represent the
beneficial owners of the account, that the account is eligible to
purchase new issues in compliance with this rule; or
(2) Conduits
a bank, foreign bank, broker/dealer, or investment adviser, or other
conduit that all purchases of new issues are in compliance with this
rule.
A member may not rely upon any representation that it believes, or
has reason to believe, is inaccurate. A member shall maintain a copy of
all records and information relating to whether an account is eligible
to purchase new issues in its files for at least three years following
the member's last sale of a new issue to that account.
(c) General Exemptions
The general prohibitions in paragraph (a) of this rule shall not
apply to sales to and purchases by the following accounts or persons,
whether directly or through accounts in which such persons have a
beneficial interest:
(1) An investment company registered under the Investment Company
Act of 1940;
(2) A common trust fund or similar fund as described in Section
3(a)(12)(A)(iii) of the Act, provided that:
(A) The fund has investments from 1,000 or more accounts; and
(B) The fund does not limit beneficial interests in the fund
principally to trust accounts of restricted persons;
(3) An insurance company general, separate or investment account,
provided that:
(A) The account [has investments from] is funded by premiums from
1,000 or more policyholders, or, if a general account, the insurance
company has 1,000 or more policyholders; and
(B) The insurance company does not limit [beneficial interests in]
the [account] policyholders whose premiums are used to fund the account
principally to restricted persons, or, if a general account, the
insurance company does not limit its policyholders principally to
restricted persons;
(4) An account [or joint back office broker/dealer (``JBO'') ]if
the beneficial interests of restricted persons do not exceed in the
aggregate 10% of such account[ or JBO];
(5) A publicly traded entity (other than a broker/dealer or an
affiliate of a broker/dealer where such broker/dealer is authorized to
engage in the public offering of new issues either as a selling group
member or underwriter) that:
(A) Is listed on a national securities exchange;
(B) Is traded on the Nasdaq National Market; or
(C) Is a foreign issuer whose securities meet the quantitative
designation criteria for listing on a national securities exchange or
trading on the Nasdaq National Market;
(6) An investment company organized under the laws of a foreign
jurisdiction, provided that:
(A) The investment company is listed on a foreign exchange or
authorized for sale to the public by a foreign regulatory authority;
and
(B) No person owning more than 5% of the shares of the investment
company is a restricted person;
(7) An Employee Retirement Income Security Act benefits plan that
is qualified under Section 401(a) of the Internal Revenue Code,
provided that such plan is not sponsored solely by a broker/dealer;
(8) A state or municipal government benefits plan that is subject
to state and/or municipal regulation;
(9) A tax exempt charitable organization under Section 501(c)(3) of
the Internal Revenue Code; or
(10) A church plan under Section 414(e) of the Internal Revenue
Code.
(d) Issuer-Directed Securities
The prohibitions on the purchase and sale of new issues in this
rule shall not apply to securities that:
(1) Are specifically directed by the issuer to persons that are
restricted under the rule; provided, however, that securities directed
by an issuer may not be sold to or purchased by an account in which any
restricted person specified in subparagraphs (i)(10[1])(B) or
(i)(10[1])(C) of this rule has a beneficial interest, unless such
person, or a
[[Page 62145]]
member of his or her immediate family, is an employee or director of
the issuer, the issuer's parent, or a subsidiary of the issuer or the
issuer's parent. Also, for purposes of this paragraph (d)(1) only, a
parent/subsidiary relationship is established if the parent has the
right to vote 50% or more of a class of voting security of the
subsidiary, or has the power to sell or direct 50% or more of a class
of voting security of the subsidiary;
(2) Are part of a program sponsored by the issuer or an affiliate
of the issuer that meets the following criteria:
(a) The opportunity to purchase a new issue under the program is
offered to at least 10,000 participants;
(b) Every participant is offered an opportunity to purchase an
equivalent number of shares, or will receive a specified number of
shares under a predetermined formula applied uniformly across all
participants;
(c) If not all participants receive shares under the program, the
selection of the participants eligible to purchase shares is based upon
a random or other non-discretionary allocation method; and
(d) The class of participants does not contain a disproportionate
number of restricted persons as compared to the investing public
generally; or
(3) Are directed to eligible purchasers who are otherwise
restricted under the rule as part of a conversion offering in
accordance with the standards of the governmental agency or
instrumentality having authority to regulate such conversion offering.
(e) Anti-Dilution Provisions
The prohibitions on the purchase and sale of new issues in this
rule shall not apply to an account in which a restricted person has a
beneficial interest that meets the following conditions:
(1) The account has held an equity ownership interest in the
issuer, or a company that has been acquired by the issuer in the past
year, for a period of one year prior to the effective date of the
offering;
(2) The sale of the new issue to the account shall not increase the
account's percentage equity ownership in the issuer above the ownership
level as of three months prior to the filing of the registration
statement in connection with the offering;
(3) The sale of the new issue to the account shall not include any
special terms; and
(4) The new issue purchased pursuant to this paragraph (e) shall
not be sold, transferred, assigned, pledged or hypothecated for a
period of three months following the effective date of the offering.
(f) Stand-By Purchasers
The prohibitions on the purchase and sale of new issues in this
rule shall not apply to the purchase and sale of securities pursuant to
a stand-by agreement that meets the following conditions:
(1) The stand-by agreement is disclosed in the prospectus;
(2) The stand-by agreement is the subject of a formal written
agreement;
(3) The managing underwriter(s) represents in writing that it was
unable to find any other purchasers for the securities; and
(4) The securities sold pursuant to the stand-by agreement shall
not be sold, transferred, assigned, pledged or hypothecated for a
period of three months following the effective date of the offering.
(g) Under-Subscribed Offerings
Nothing in this rule shall prohibit an underwriter, pursuant to an
underwriting agreement, from placing a portion of a public offering in
its investment account when it is unable to sell that portion to the
public.
(h) Exemptive Relief
Pursuant to the Rule 9600 series, the staff, for good cause shown
after taking into consideration all relevant factors, may conditionally
or unconditionally exempt any person, security or transaction (or any
class or classes of persons, securities or transactions) from this rule
to the extent that such exemption is consistent with the purposes of
the rule, the protection of investors, and the public interest.
(i) Definitions
(1) ``Beneficial interest'' means any economic interest, such as
the right to share in gains or losses. The receipt of a management or
performance based fee for operating a collective investment account, or
other fees for acting in a fiduciary capacity, shall not be considered
a beneficial interest in the account.
(2) ``Collective investment account'' means any hedge fund,
investment partnership, investment corporation, or any other collective
investment vehicle that is engaged primarily in the purchase and/or
sale of securities. A ``collective investment account'' does not
include a ``family investment vehicle'' or an ``investment club.''
(3) ``Conversion offering'' means any offering of securities made
as part of a plan by which a savings and loan association, insurance
company, or other organization converts from a mutual to a stock form
of ownership.
(4) ``Family investment vehicle'' means a legal entity that is
beneficially owned solely by immediate family members.
(5) ``Immediate family member'' means a person's parents, mother-
in-law or father-in-law, spouse, brother or sister, brother-in-law or
sister-in-law, son-in-law or daughter-in-law, and children, and any
other individual to whom the person provides material support.
(6) ``Investment club'' means a group of friends, neighbors,
business associates, or others that pool their money to invest in stock
or other securities and are collectively responsible for making
investment decisions.
(7) [''Joint Back Office Broker/Dealer'' means any domestic or
foreign private investment fund that has elected to register as a
broker/dealer solely to take advantage of the margin treatment afforded
under Section 220.7 of Regulation T of the Federal Reserve. The
activities of a joint back office broker/dealer must not require that
it register as a broker/dealer under Section 15(a) of the Act.]
([8]7) ``Limited business broker/dealer'' means any broker/dealer
whose authorization to engage in the securities business is limited
solely to the purchase and sale of investment company/variable
contracts securities and direct participation program securities.
([9]8) ``Material support'' means directly or indirectly providing
more than 25% of a person's income in the prior calendar year. Members
of the immediate family living in the same household are deemed to be
providing each other with material support.
([10]9) ``New issue'' means any initial public offering of an
equity security as defined in Section 3(a)(11) of the Act, made
pursuant to a registration statement or offering circular. New issue
shall not include:
(A) Offerings made pursuant to an exemption under Section 4(1),
4(2) or 4(6) of the Securities Act of 1933, or SEC Rule 504 if the
securities are ``restricted securities'' under SEC Rule 144(a)(3), or
Rule 144A or Rule 505 or Rule 506 adopted thereunder;
(B) Offerings of exempted securities as defined in Section 3(a)(12)
of the Act, and rules promulgated thereunder;
(C) Offerings of securities of a commodity pool operated by a
commodity pool operator as defined under Section 1a(5) of the Commodity
Exchange Act;
[[Page 62146]]
(D) Rights offerings, exchange offers, or offerings made pursuant
to a merger or acquisition;
(E) Offerings of investment grade asset-backed securities;
(F) Offerings of convertible securities;
(G) Offerings of preferred securities; [and]
(H) Offerings of an investment company registered under the
Investment Company Act of 1940; and
(I) Offerings of securities (in ordinary share form or ADRs
registered on Form F-6) that have a pre-existing market outside of the
United States.
([11]10) ``Restricted person'' means:
(A) Members or Other Broker/Dealers
(B) Broker/Dealer Personnel
(i) Any officer, director, general partner, associated person, or
employee of a member or any other broker/dealer (other than a limited
business broker/dealer);
(ii) Any agent of a member or any other broker/dealer (other than a
limited business broker/dealer) that is engaged in the investment
banking or securities business; or
(iii) An immediate family member of a person specified in
subparagraph (B)(i) or (ii) if the person specified in subparagraph
(B)(i) or (ii):
(a) Materially supports, or receives material support from, the
immediate family member;
(b) Is employed by or associated with the member, or an affiliate
of the member, selling the new issue to the immediate family member; or
(c) Has an ability to control the allocation of the new issue.
(C) Finders and Fiduciaries
(i) With respect to the security being offered, a finder or any
person acting in a fiduciary capacity to the managing underwriter,
including, but not limited to, attorneys, accountants and financial
consultants; and
(ii) An immediate family member of a person specified in
subparagraph (C)(i) if the person specified in subparagraph (C)(i)
materially supports, or receives material support from, the immediate
family member.
(D) Portfolio Managers
(i) Any person who has authority to buy or sell securities for a
bank, savings and loan institution, insurance company, investment
company, investment advisor, or collective investment account.
(ii) An immediate family member of a person specified in
subparagraph (D)(i) that materially supports, or receives material
support from, such person.
(E) Persons Owning a Broker/Dealer
(i) Any person listed, or required to be listed, in Schedule A of a
Form BD (other than with respect to a limited business broker/dealer),
except persons identified by an ownership code of less than 10%;
(ii) Any person listed, or required to be listed, in Schedule B of
a Form BD (other than with respect to a limited business broker/
dealer), except persons whose listing on Schedule B relates to an
ownership interest in a person listed on Schedule A identified by an
ownership code of less than 10%;
(iii) Any person listed, or required to be listed, in Schedule C of
a Form BD that meets the criteria of subparagraphs (E)(i) and (E)(ii)
above;
(iv) Any person that directly or indirectly owns 10% or more of a
public reporting company listed, or required to be listed, in Schedule
A of a Form BD (other than a reporting company that is listed on a
national securities exchange or is traded on the Nasdaq National
Market, or other than with respect to a limited business broker/
dealer);
(v) Any person that directly or indirectly owns 25% or more of a
public reporting company listed, or required to be listed, in Schedule
B of a Form BD (other than a reporting company that is listed on a
national securities exchange or is traded on the Nasdaq National
Market, or other than with respect to a limited business broker/
dealer).
(vi) An immediate family member of a person specified in
subparagraphs (E)(i)-(v) unless the person owning the broker/dealer:
(a) Does not materially support, or receive material support from,
the immediate family member;
(b) Is not an owner of the member, or an affiliate of the member,
selling the new issue to the immediate family member; and has no
ability to control the allocation of the new issue.
* * * * *
VII. Solicitation of Comments on Amendment No. 5
Interested persons are invited to submit written data, views, and
arguments on Amendment No. 5, including whether the amendment 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 such filing will also be available for
inspection and copying at the principal office of the NASD. All
submissions should refer to File No. SR-NASD-99-60 and should be
submitted by November 21, 2003.
VIII. Conclusion
It is therefore ordered, pursuant to Section 19(b)(2) of the
Act,\184\ that the proposal (SR-NASD-99-60) and Amendment Nos. 1 to 4
thereto are approved, and that Amendment No. 5 is approved on an
accelerated basis.
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\184\ Id.
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For the Commission, by the Division of Market Regulation, pursuant
to delegated authority.\185\
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\185\ 17 CFR 200.30-3(a)(12).
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 03-27463 Filed 10-30-03; 8:45 am]
BILLING CODE 8010-01-P