[Federal Register Volume 63, Number 28 (Wednesday, February 11, 1998)]
[Notices]
[Pages 7026-7033]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-3372]
-----------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-39620; File No. SR-NASD-97-95]
Self-Regulatory Organizations; Notice of Filing of Proposed Rule
Change by National Association of Securities Dealers, Inc. Relating to
Amendment to the Free-Riding and Withholding Interpretation
February 4, 1998.
Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act''),\1\ notice is hereby given that on December 23, 1997, NASD
Regulation, Inc. (``NASD Regulation'') filed with the Securities and
Exchange Commission (``SEC'' or ``Commission'') the proposed rule
change as described in Items I, II, and III below, which Items have
been prepared by NASD Regulation. The Commission is publishing this
notice to solicit comments on the proposed rule change from interested
persons.
---------------------------------------------------------------------------
\1\ 15 U.S.C. 78s(b)(1).
---------------------------------------------------------------------------
I. Self-Regulatory Organization's Statement of the Terms of Substance
of the Proposed Rule Change
NASD Regulation is proposing to amend National Association of
Securities Dealers, Inc. (``NASD'' or ``Association'') Interpretative
Material IM-2110-1 and Rule 2720, to revise certain aspects of the
Free-Riding and Withholding Interpretation. Below is the text of the
proposed rule change. Proposed new language is in italics; proposed
deletions are in brackets.
IM-2110-1. ``Free-Riding and Withholding''
(a) Introduction
(1) No change.
(2) As in the case of any other interpretation issued by the [Board
of Governors of the] Association, the implementation thereof is a
function of the NASD Regulation staff [District Business Conduct
Committee] and the [Board of Governors] NASD Regulation Board of
Directors. Thus, the interpretation will be applied to a given factual
situation by NASD Regulation staff, subject to oversight by the Board,
with staff soliciting input from individuals active in the investment
banking and securities business [who are serving on these committees or
on the Board. They] In making such interpretations, staff and the Board
will construe this interpretation to effectuate its overall purpose to
assure a public distribution of securities for which there is a public
demand.
* * * * *
(5) The NASD Regulation staff, upon written request, may, taking
into consideration all relevant factors, provide an exemption either
unconditionally or on specified terms from any or all of the provisions
of this interpretation upon a determination that such exemption is
consistent with the purposes of the interpretation, the protection of
investors, and the public interest. A member may appeal a decision
issued by NASD Regulation staff to the National Adjudicatory Council
pursuant to the Code of Procedure.
* * * * *
(b) Violations of Rule 2110
(9) Sell any of the securities to any person, or to a member of the
immediate family of such person, who owns or has contributed capital to
a broker/dealer, other than solely a limited business broker/dealer as
defined in paragraph (c) of the interpretation, or the account in which
any such person has a beneficial interest, provided, however, that:
(A) The prohibition shall not apply to any person who directly or
indirectly owns any class of equity securities of, or who has made a
contribution of capital to, a member, and whose ownership or capital
interest is passive and is less than 10% of the equity or capital of a
member, as long as:
(i) such person purchases hot issues from a person other than the
member in which it has such passive ownership and such person is not in
a position by virtue of its passive ownership interest to direct the
allocation of hot issues, or
(ii) such member's shares are publicly traded on an exchange or
Nasdaq.
(B) This prohibition shall not apply to sales to the account of any
person restricted under this subparagraph established for the benefit
of bona fide public customers, including an insurance company general
or separate account.
(C) For purposes of this paragraph, any person with an equity
ownership or capital interest in an entity that maintains an investment
in a member shall be deemed to have a percentage interest of the entity
in the member multiplied by the percentage interest of such person in
such entity.
* * * * *
(d) Issuer-Directed Securities
[(1) This interpretation shall apply to securities which are part
of a public offering nothwithstanding that some or all of those
securities are specifically directed by the issuer to accounts which
are included within the scope of paragraph (b)(3) through (8) above.
Therefore, if a person within the scope of those subparagraphs to whom
securities were directed did not have the required investment history,
the member would not be permitted to sell him such securities. Also,
the ``disproportionate'' and ``insubstantial'' test would apply as in
all other situations. Thus, the directing of a substantial number of
securities to any one person would be prohibited as would the directing
of securities to such accounts in amounts which would be
disproportionate as compared to sales to members of the public. If such
issuer-directed securities are sold to the issuer's employees or
directors or potential employees or directors resulting from an
intended merger, acquisition, or other business combination, such
securities may be sold without limitation as to amount and regardless
of whether such employees have an investment history as required by the
interpretation; provided, however, that in the case of an offering of
securities for which a bona fide independent market does not exist,
such securities shall not be sold, transferred, assigned, pledged, or
hypothecated for a period of three months following the effective date
of the offering. This interpretation shall also apply to securities
which are part of a public offering nothwithstanding that some of those
securities are specifically directed by the issuer on a non-
underwritten basis. In such cases, the managing underwriter of the
offering shall be responsible for issuing compliance with this
interpretation in respect to those securities.]
[[Page 7027]]
[(2) Notwithstanding the above, sales of issuer-directed securities
may be made to non-employee/director restricted persons without the
required investment history after receiving permission from the Board
of Governors. Permission will be given only if there is a demonstration
of valid business reasons for such sales (such as sales to distributors
and suppliers, who are in each case incidentally restricted persons),
and the member seeking permission is prepared to demonstrate that the
aggregate amount of securities so sold is insubstantial and not
disproportionate as compared to sales to members of the public, and
that the amount sold to any one of such persons is insubstantial in
amount; provided, however, that such securities shall not be sold,
transferred, assigned, pledged, or hypothecated for a period of three
months following the effective date of the offering.]
Employees or directors of an issuer, a parent of an issuer, a
subsidiary of an issuer, or any other entity which controls or is
controlled by an issuer, or potential employees or directors resulting
from an intended merger, acquisition, or other business combination of
an issuer otherwise subject to this interpretation in paragraphs (b)(2)
through (9) may purchase securities that are part of a public offering
that are specifically directed by the issuer to such persons; provided,
however, that in the case of an offering of securities for which a bona
fide independent market does not exist, such securities shall not be
sold, transferred, assigned, pledged, or hypothecated for a period of
three months following the effective date of the offering.
* * * * *
(f) Investment Partnerships and Corporations
(1) A member may not sell a hot issue to the account of any
investment partnership or corporation, domestic or foreign (except
companies registered under the Investment Company Act of 1940 or
foreign investment companies as defined herein) including but not
limited to hedge funds, investment clubs, and other like accounts
unless the member complies with either of the following alternatives:
* * * * *
(2) No change
(3) An employee benefits plan qualified under The Employee
Retirement Income Security Act shall be deemed restricted under the
Interpretation in accordance with the following provisions:
(A) Any plan sponsored by a broker/dealer is restricted;
(B) Any plan sponsored by an entity that is not involved in
financial services activities is not restricted whether or not any plan
participants may be restricted;
(C) Any plan sponsored by an entity that is engaged in financial
services activities, including but not limited to, banks, insurance
companies, investment advisors, or other money managers, is not
restricted, provided that the plan permits participation by a broad
class of participants and is not designed primarily for the benefit of
restricted persons.
* * * * *
(l) Explanation of Terms
The following explanation of terms is provided for the assistance
of members. Other words which are defined in the By-Laws and Rules
shall, unless the context otherwise requires, have the meaning as
defined therein.
[(1) Associated Person
A person associated with a member or any other broker/dealer, as
defined in Article I of the Association's By-Laws, shall not include a
person whose association with the member is limited to a passive
ownership interest in the member of 10% or less, and who does not
receive hot issues from the member in which he or she has the ownership
interest; and that such member is not in a position to direct hot
issues to such person.]
([2]1) Public Offering
The term public offering shall mean any primary or secondary
distribution of securities made pursuant to a registration statement or
offering circular including exchange offers, rights offerings,
offerings made pursuant to a merger or acquisition, straight debt
offerings, and all other securities distributions of any kind
whatsoever except any offering made pursuant to an exemption under
Section 4(l), 4(2) or 4(6) of the Securities Act of 1933, as amended.
The term public offering shall exclude exempted securities as defined
in Section 3(a)(12) of the Act, and debt securities (other than debt
securities convertible into common or preferred stock) or financing
instrument-backed securities that are rated by a nationally recognized
statistical rating organization in one of its four highest generic
rating categories. The term public offering shall exclude secondary
distributions by an issuer whose securities are actively-traded
securities.
([3]2) Immediate Family
The term immediate family shall include parents, mother-in-law or
father-in-law, husband or wife, brother or sister, brother-in-law or
sister-in-law, son-in-law or daughter-in-law, and children. In
addition, the term shall include any other person who is supported,
directly or indirectly, to a material extent by the member, person
associated with the member or other person specified in paragraph
(b)(2) above.
([4]3) Normal Investment Practice
Normal investment practice shall mean the history of investment of
a restricted person in an account or accounts maintained by the
restricted person. Usually the previous one-year period of securities
activity is the basis for determining the adequacy of a restricted
person's investment history. Where warranted, however, a longer or
shorter period may be reviewed. It is the responsibility of the
registered representative effecting the allocation, as well as the
member, to demonstrate that the restricted person's investment history
justifies the allocation of hot issues. Copies of customer account
statements or other records maintained by the registered representative
or the member may be utilized to demonstrate prior investment activity.
In analyzing a restricted person's investment history the Association
believes the following factors should be considered:
(A) The frequency of transactions in the account or accounts during
that period of time. Relevant in this respect are the nature and size
of investments.
(B) A comparison of the dollar amount of previous transactions with
the dollar amount of the hot-issue purchase. If a restricted person
purchases $1,000 of a hot issue and his account revealed a series of
purchases and sales in $100 amounts, the $1,000 purchase would not
appear to be consistent with the restricted person's normal investment
practice.
(C) The practice of purchasing mainly hot issues would not
constitute a normal investment practice. The Association does, however,
consider as contributing to the establishment of a normal investment
practice, the purchase of new issues which are not hot issues as well
as secondary market transactions.
([5]4) Disproportionate
(A) In respect to the determination of what constitutes a
disproportionate allocation, the Association uses a guideline of 10% of
the member's participation in the issue, however
[[Page 7028]]
acquired. It should be noted, however, that the 10% factor is merely a
guideline and is one of a number of factors which are considered in
reaching determinations of violations of the interpretation on the
basis of disproportionate allocations. These other factors include,
among other things:
(i) The size of the participation;
(ii) The offering price of the issue;
(iii) The amount of securities sold to restricted accounts; and
(iv) The price of the securities in the aftermarket.
(B) It should be noted that disciplinary action has been taken
against members for violations of the interpretation where the
allocations made to restricted accounts were less than 10% of the
member's participation. The 10% guideline is applied as to the
aggregate of the allocations.
(C) Notwithstanding the above, a normal unit of trading (100 shares
or 10 bonds) will in most cases not be considered a disproportionate
allocation regardless of the amount of the member's participation. This
means that if the aggregate number of shares of a member's
participation which is allocated to restricted accounts does not exceed
a normal unit of trading, such allocation will in most cases not be
considered disproportionate. For example, if a member receives 500
shares of a hot issue, he may allocate 100 shares to a restricted
account even though such allocation represents 20% of the member's
participation. Of course, all of the remaining shares would have to be
allocated to unrestricted accounts and all other provisions of the
interpretation would have to be satisfied. Specifically, the allocation
would have to be consistent with the normal investment practice of the
account to which it was allocated and the member would not be permitted
to sell to restricted persons who were totally prohibited from
receiving hot issues.
([6]5) Insubstantiality
This requirement is separate and distinct from the requirements
relating to disproportionate allocations and normal investment
practice. In addition, this term applies both to the aggregate of the
securities sold to restricted accounts and to each individual
allocation. In other words, there could be a substantial allocation to
an individual account in violation of the interpretation and yet be no
violation on that ground as to the total number of shares allocated to
all accounts. The determination of whether an allocation to a
restricted account or accounts is substantial is based upon, among
other things, the number of shares allocated and/or the dollar amount
of the purchase.
(6) Foreign Investment Company
The term foreign investment company shall include any fund company
organized under the laws of a foreign jurisdiction, which has provided
to the member a written certification prepared by counsel admitted to
practice law before the highest court of any state of the United States
or such foreign jurisdiction, or by an independent certified public
accountant licensed to practice in any state of the Untied States or
such foreign jurisdiction, that states that:
(A) The fund has 100 or more investors;
(B) The fund is listed on a foreign exchange or authorized for sale
to the public by a foreign regulatory authority;
(C) No more than 5% of the fund assets are to be invested in the
securities being offered, and,
(D) Any person owning more than 5% of the shares of fund is not a
person described in subparagraphs (b)(1), (2), (3) or (4) of the Rule,
(7) Actively-traded securities
(A) Actively-traded securities means securities that have an ADTV
value of at least $1 million and are issued by an issuer whose common
equity securities have a public float value of at least $150 million;
provided, however, that such securities are not issued by the
distribution participant or an affiliate of the distribution
participant.
(B) ``ADTV'' means the worldwide average daily trading volume,
during the two full calendar months immediately preceding, or any 60
consecutive calendar days ending within the 10 calendar days preceding,
the filing of the registration statement, or, if there is no
registration statement or if the distribution involves the sale of
securities on a delayed basis pursuant to Securities Act Rule 415, two
full calendar months immediately preceding, or any consecutive 60
calendar days ending within the 10 calendar days preceding, the
determination of the offering price.
* * * * *
2720. Distribution of Securities of Members and Affiliates--Conflicts
of Interest
[(m) Sales to Employees--No Limitations
Notwithstanding the provisions of IM-2110-1, ``Free-Riding and
Withholding,'' a members may sell securities issued by a member, a
parent of a member, an entity which who owns a member, an entity which
owns (alone or in the aggregate with any wholly-owned, non-public
subsidiary) at least 51% of the outstanding voting stock of a member or
by an issuer treated as a member or parent of a member under paragraph
(i) hereof to the member's employees' potential employees resulting
from an intended merger, acquisition, or other business combination of
members resulting in one public successor corporation; persons
associated with the member; and the immediate family of such employees
or associated persons without limitation as to amount and regardless of
whether such persons have an investment history with the member as
required by IM-2110-01; provided, however, that in the case of an
offering of equity securities for which a bona fide independent market
does not exist, such securities shall not be sold, transferred,
assigned, pledged, or hypothecated for a period of five months
following the effective date of the offering.]
([n]m) Filing Requirements; Coordination With Rule 2710
(1) Notwithstanding the provisions of Rule 2710 relating to factors
to be taken into consideration in determining underwriter's
compensation, the value of securities of a new corporate member
succeeding to a previously established partnership or sole
proprietorship member acquired by such member or person associated
therewith, or created as a result of such reorganization, shall not be
taken into consideration in determining such compensation.
(2) All offerings of securities included within the scope of this
Rule shall be subject to the provisions of Rule 2710, and documents and
filing fees relating to such offerings shall be filed with the
Association pursuant to the provisions of that Rule. The responsibility
for filing the required documents and fees shall be that of the member
issuing securities, or, in the case of an issue of an affiliate, the
managing underwriter or, if there is none, the member affiliated with
the issuer.
(3) All offerings included within the scope of this Rule are
required to be filed with the Association, with the appropriate
documents and filing fee referred to under subparagraph (2), above,
notwithstanding the fact that the offering may otherwise be expressly
exempted from filing under the provisions of Rule 2710.
([o]n) Predominance of Rule 2720
If the provisions of this Rule are inconsistent with any other
provisions
[[Page 7029]]
of the Association's By-Laws or Rules, or of any interpretation
thereof, the provisions of this Rule shall prevail.
([p]o) Requests for Exemption From Rule 2720
Pursuant to the Rule 9600 Series, the Association may in
exceptional and unusual circumstances, taking into consideration all
relevant factors, exempt a member unconditionally or on specified terms
from any or all of the provisions of this Rule which it deems
appropriate.
([q]p) Violation of Rule 2720
A violation of the provisions of this Rule shall constitute a
violation of Rule 2110, and possibly other Rules, especially Rules 2120
and 2310, as the circumstances of the case may indicate.
II. Self-Regulatory Organizations Statement of the Purpose of, and
Statutory Basis for the Proposed Rule Change
In its filling with the Commission, NASD Regulation included
statements concerning the purpose of and basis for the proposed rule
change and discussed any comments it received on the proposed rule
change. The text of these statements may be examined at the places
specified in Item IV below. NASD Regulation has prepared summaries, set
forth in Sections (A), (B), and (C) below, of the most significant
aspects of such statements.
(A) Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change
(a) Purpose
(i) Overview of the Free-Riding and Withholding Interpretation. The
Free-Riding and Withholding Interpretation (``Interpretation'')
protects the integrity of the public offering system by ensuring that
members make a bona fide public distribution at the public offering
price of ``hot issue'' securities and do not withhold such securities
for their own benefit or use such securities to reward other persons in
the financial services business who are in a position to direct future
business to the member. Improperly withholding securities or directing
securities to other persons in the financial services business who can
direct future business to the member leads to an impairment of public
confidence in the fairness of the investment banking and securities
business. The Interpretation also assures that members and participants
in the securities industry do not take unfair advantage of their inside
position in the industry to the detriment of public investors.
(ii) Notice to Members 97-30 (May 1997). In March 1997, the NASD
Regulation Board of Directors (``Board''), acting upon recommendation
from the National Business Conduct Committee (``NBCC''),\2\ considered
various amendments to the Interpretation. The Board submitted a series
of proposed rule amendments to the membership for comment in Notice to
Members 97-30 (``NTM 97-30''). The Board also decided that it would be
appropriate to examine the entire Interpretation in the context of
current market conditions and sought comment on whether the
Interpretation could be simplified and made easier to follow.
---------------------------------------------------------------------------
\2\ The name of this committee has been changed to National
Adjudicatory Council, See Securities Exchange Act Release No. 39470
(December 19, 1997), 62 FR 67927 (December 30, 1997).
---------------------------------------------------------------------------
NASD Regulation received 22 comment letters. Most of the commenters
did not address every proposed rule amendment, but only selected
issues. The proposed rule amendments, the comments received, and NASD
Regulation's response to the comments are set forth below.
(A) Treatment of Direct and/or Indirect Owners of Broker/Dealers
In 1994, NASD Regulation amended the Interpretation's definition of
``associated person'' to exempt certain passive investors in broker/
dealers.\3\ NASD Regulation now proposes further amendments to the
Interpretation to address two limitations from the previous amendments.
First, the definition of associated person as currently provided in the
Interpretation does not include non-natural persons that have an
ownership interest in or have contributed capital to a broker/
dealer.\4\ Second, the Interpretation does not affirmatively specify
any ownership levels at which a natural person becomes an associated
person by reason of his ownership interest in a broker/dealer. The
Interpretation only states when a natural person is not an associated
person. In NTM 97-30, NASD Regulation staff proposed modifying the
Interpretation to create a new definition of ``restricted person'' that
would include natural and non-natural persons that own or contribute
capital to a broker/dealer, subject to two exceptions. The first
exception was for passive investors that own or have contributed 10
percent or less of the firm's equity or capital and who purchase from a
member other than the member in which they maintain the ownership
interest, provided that the member in which they maintain the ownership
interest is not in a position to direct issues to the owner or
contributor. The second exception was for persons who passively own 10
percent or less of the shares of broker/dealers that are traded on an
exchange or Nasdaq.
---------------------------------------------------------------------------
\3\ Securities Exchange Act Release No. 35059 (December 7,
1994), 59 FR 64455, 64457 (December 14, 1994).
\4\ See In re Rocena Company, Ltd., No. C07950042, National
Business Conduct Committee, 1997 NASD Discip. LEXIS 12, (NBCC
January 8, 1997) (holding that a non-natural person is not
considered an associated person for purposes of the Interpretation).
---------------------------------------------------------------------------
The proposal also stated that indirect investors should be treated
the same as direct investors. To determine whether an indirect investor
meets the 10 percent threshold, noted above, the proposed amendment
provided that the percentage of the direct investment is multiplied by
the percentage interest in the investing entity. For example, an
investor with a 50 percent investment in a investment partnership that
in turn owns 18 percent of the equity capital of a broker/dealer would
be deemed to own 9 percent of the broker/dealer for the purposes of the
Interpretation.
Generally, the commenters did not object to the application of the
Interpretation to non-natural persons, but were concerned that as
drafted, the Interpretation would preclude purchases of hot issues by
any entity that owns 10 percent or more of a broker/dealer, or any
account in which such entity had a beneficial interest. The commenters
stated that these problems arose primarily due to the breadth of
paragraph (b)(5) of the Interpretation, which prohibits sales of hot
issues to any account in which a restricted person has a beneficial
interest. Several commenters stated that the proposed revisions would
have the effect of prohibiting participation in hot issues by all
entities within many insurance companies in which a parent company owns
10 percent or more of a broker/dealer. By way of example, one suggested
that the Interpretation, as proposed, would preclude companies such as
the American Insurance Group from purchasing hot issues for any account
in which they have a beneficial interest.
This result was not intended when NTM 97-30 was proposed, and NASD
Regulation staff has revised the amendments to address these concerns.
To avoid the effects of (b)(5), the proposed amendments no longer seek
to redefine the term ``restricted person.'' Rather, new paragraph
(b)(9)(A) has been created which expressly prohibits sales to any
person, or any account in which such person has a beneficial
[[Page 7030]]
interest, who owns or has contributed capital to a broker/dealer, other
than a limited purpose broker/dealer, with broad exceptions for passive
ownership interests less than 10 percent. These provisions are
consistent with the proposal in NTM 97-30. New paragraph (b)(9)(B) has
been created to respond to the concerns of several commenters that the
amendments proposed in NTM 97-30 would prohibit sales of hot issues to
all entities within many insurance companies that own a broker/dealer.
Paragraph (b)(9)(B) exempts sales of hot issues to any account
established for the benefit of bona fide public customers of a person
restricted pursuant to this subparagraph. The exception expressly notes
that such accounts would include, but are not limited to, an insurance
company's general or separate accounts. Lastly, new paragraph (b)(9)(C)
retains the indirect ownership provisions proposed in NTM 97-30.
Commenters also stated that the amendments proposed in NTM 97-30
would, by virtue of paragraph (b)(5), prohibit many bank holding
companies and industrial companies such as Ford and General Electric,
or any account in which such companies have a beneficial interest, from
purchasing hot issues because these companies have a wholly-owned
broker/dealer subsidiary. NASD Regulation does not agree with the
commenters that these entities should be able to purchase not issues
for their proprietary accounts because passing on the benefits of hot
issue purchases to shareholders is not equivalent to passing on
benefits directly to bona fide public customers. Accordingly, these
persons would be restricted from purchasing hot issues pursuant to
proposed paragraph (b)(9). However, as discussed below in section (F),
the Employment Retirement Income Security Act accounts of bank holding
companies and industrial companies such as Ford and General Electric
would normally be able to purchase hot issues.
Another commenter asked if the proposed definition would preclude
investment partnerships that have an equity stake in a broker/dealer
from purchasing hot issues. This commenter argued that such investment
partnerships should be able to purchase hot issues subject to the
restrictions in paragraph (g) of the Interpretation. NASD Regulation
does not believe that the purposes of paragraph (g) of the
Interpretation are to permit investment partnerships that own 10
percent or more of a broker/dealer to purchase hot issues. The
paragraph (g) ``carve out'' methodology permits investment partnerships
in which restricted persons have a beneficial interest to purchase hot
issues so long as the profits from the hot issues are not allocated to
any restricted persons. An investment partnership that is not otherwise
restricted and accepts an investment from a person that is restricted
pursuant to paragraph (b)(9) would be able to purchase hot issues as
long as hot issue profits are segregated from the restricted person
pursuant to the criteria of paragraph (g).
The Securities Industry Association (``SIA'') did not object to the
proposed definition of ``restricted person,'' but instead suggested
that NASD Regulation use the existing definition of the term
``affiliate'' from Rule 2720(b)(1). The SIA favored using the
definition of ``affiliate'' because it established a rebuttable
presumption of control. Another commenter noted that the term
``restricted person was already used throughout the Interpretation and
redefining it would cause confusion. NASD Regulation does not believe
that a rebuttable presumption would be a useful concept in the context
of the Interpretation. However, NASD Regulation appreciates that
redefining the term ``restricted person'' as originally proposed may
create confusion and has removed that term from the current proposal.
Finally, one commenter argued that the Interpretation should be
modified to provide exemptions for passive investors who contribute 10
percent or less of a broker/dealer's capital, but did not see any
``constructive purpose'' in holding investors in privately held firms
to a different and ``tougher'' standard than investors in publicly
traded firms. NASD Regulation believes as a general matter that
publicly traded firms are less susceptible to influence by passive
owners or investors than private firms and, thus, an exemption for such
firms is appropriate. Passive owners or investors in private firms can
purchase hot issues as long as they meet the criteria in paragraph
(b)(9)(A)(i).
(B) Rated Investment Grade Debt
Currently, debt offerings are included in the definition of
``public offering'' in the Interpretation. In NTM 97-30, NASD
Regulation proposed excluding rated investment grade debt offerings
from the Interpretation on the ground that such offerings do not raise
the same issues as equity offerings inasmuch as the price for a
particular debt security generally fluctuates based on interest rate
movements rather than demand factors. Based upon this rationale, NASD
Regulation staff proposed an exception for ``non-convertible debt
securities rated by a nationally recognized statistical rating
organization in one of its four highest generic rating categories.''
This proposal was enthusiastically supported by many of the
commenters. Many commenters, however, urged NASD Regulation to go
further. One commenter stated that all debt offerings should be
excluded. The SIA and PSA The Bond Market Trade Association (``PSA'')
agreed with the proposal but argued that NASD Regulation should adopt a
``functional'' standard that would exempt all ``investment grade
securities that trade primarily on the basis of yield and credit
quality.'' NASD Regulation staff does not support a ``functional''
standard because it provides less clarity than the current proposal and
would be difficult to administer. The SIA and PSA also both argued that
certain convertible securities may be converted into a security other
than common stock and that such convertible securities should be exempt
from the Interpretation. Other commenters proposed modifying the
exclusion to also include financing instrument-backed securities and
various forms of convertible securities. NASD Regulation proposes
modifying the exclusion for debt securities to include financing
instrument-backed securities and convertible debt securities as long as
they are not convertible into common or preferred stock. Although these
revisions are likely to affect only a few persons, they appear
consistent with the rationale for excluding rated investment grade
debt.
(C) Exemptive Authority Under the Interpretation
Presently, there is no provision in the Interpretation to allow for
the NBCC, the Board, or NASD Regulation staff to grant general
exemptive relief. In the past, the NBCC, relying on the NASD By-Law's
grant of authority to the Board and its Committees, has provided
exemptions in certain unique circumstances. NASD Rule 9600 delegates
exemptive authority in the Interpretation to the Office of General
Counsel. The Interpretation currently provides for exemptive relief
solely in cases involving sales of issuer-directed securities to non-
employee/director restricted persons pursuant to paragraph (d)(2). In
NTM 97-30, NASD Regulation stated that it believed that it was
important to provide express authority to grant exemptions in
individual cases, and proposed amendments accordingly. These amendments
grant NASD Regulation staff the authority to provide exemptions,
subject to oversight by the Board. The proposed amendments also provide
that persons may appeal
[[Page 7031]]
decisions of NASD Regulation staff to the NBCC.
All of the comments received on this issue expressed support for
this proposal. The text of the proposed amendment has been modified for
consistency with Rule 9610 and to reflect the renaming of the National
Business Conduct Committee to the National Adjudicatory Council.
(D) Foreign Mutual Funds
Purchases of shares of investment companies registered under the
Investment Company Act of 1940 are exempt from the Interpretation based
upon the rationale that the interest of any one restricted person in an
investment company ordinarily is de minimis and because ownership of
investment company shares generally is subject to frequent turnover,
determining compliance with the Interpretation would be extremely
difficult.
NASD Regulation proposed in NTM 97-30 to extend this rationale to
the purchase of shares of foreign investment companies. In particular,
NASD Regulation proposed exempting sales of hot issues to a foreign
investment company if such foreign investment company provides written
certification from a U.S. attorney or accountant stating that: (1) The
fund has 100 or more shareholders; (2) the fund is listed on a foreign
exchange or authorized for sale to the public by a foreign regulatory
authority; (3) no more than 5 percent of the fund's securities assets
are invested in the securities being offered, and; (4) any person
owning more than 5 percent of the shares of the fund is not a
restricted person as defined in subparagraphs (b)(1) through (b)(4) of
the Interpretation. These amendments seek to create roughly equivalent
standards between U.S. and foreign investment companies.
All of the comments received on this issue strongly supported an
exemption from the Interpretation for foreign investment companies. The
commenters, however, did not necessarily agree with the proposed
attestation procedures. Many of the commenters stated that the
requirement for a member to provide a written certification would
impose a substantial administrative burden and cost. The SIA took the
position that attestation should not be required at all. A few
commenters stated that if written certification is to be required, then
a foreign attorney or accountant should be able to make such
certification because many foreign investment companies may be
reluctant to hire U.S. counsel or accountants. NASD Regulation agrees
that foreign attorneys and accountants should be able to make the
required attestations and has modified the proposed amendments
accordingly.
A number of comment letters also suggested that rather than
obtaining a written certification from the foreign investment company
each time before a member permits it to purchase in an initial public
offering that may become a hot issue, the NASD should develop a
centralized electronic repository containing certifications that would
be accessible to members. NASD Regulation preliminarily supports such
an idea but believes that it raises a number of issues that deserve
consideration, including who would operate the repository. NASD
Regulation proposes communicating to the private sector its willingness
to consider applications by firms interested in maintaining a
centralized repository of foreign investment companies as well as any
investment partnerships or corporations that qualify to purchase hot
issues pursuant to paragraph (f) of the Interpretation. NASD Regulation
also may consider operating the system itself. The operator of such a
central repository must be concerned with maintaining accurate and
current information, since the participants in these investment
vehicles and their status under the Interpretation is likely to change
from time to time. NASD Regulation agrees that a centralized repository
may be an efficient and effective method of maintaining certifications,
but believes that investment companies should be permitted to purchase
hot issues subject to the verification procedures outlined in NTM 97-
30, as modified above, while NASD Regulation considers the
implementation of a centralized repository.
(E) Secondary Offerings
Primary and secondary distributions of securities are currently
included in the definition of ``public offering'' under the
Interpretation. In NTM 97-30, NASD Regulation proposed maintaining
secondary offerings subject to the Interpretation based upon
statistical evidence that approximately 33 percent of secondary
offerings trade at a premium, even though such premium is generally
small.
A number of commenters did not believe that the Interpretation
should apply to secondary offerings. Generally, these commenters noted
that secondary offerings rarely trade at a premium to the market and
even then, the premium often is very small. One commenter suggested an
exemption for secondary equity offerings of widely-held issuers with
established secondary markets provided that such secondary offerings
are not priced at a significant discount to the current market. This
commenter also urged NASD Regulation to adopt changes that were
consistent with the SEC's new Regulation M. Similarly, the SIA stated
that the Interpretation should not apply to any secondary offerings and
in the alternative, that NASD Regulation should exempt offerings of
liquid issues at appropriate thresholds.
NASD Regulation has reconsidered its earlier position and now
proposes an exemption for secondary offerings similar to the Regulation
M exception for actively-traded securities (which are defined as
securities that have an average daily trading volume of at least $1
million and are issued by an issuer whose equity securities have a
public float of at least $150 million). In light of the SEC's decision
to except actively-traded securities from its trading practice rules,
NASD Regulation believes that it is appropriate to exempt similarly
defined securities from the Interpretation with respect to secondary
offerings.
(F) Accounts for Qualified Plans Under The Employment Retirement Income
Security Act (``ERISA'')
Currently, there are no provisions in the Interpretation that
expressly address the status of qualified employee benefit plans under
ERISA. While NASD Regulation deferred proposing any specific amendments
to NTM 97-30 with respect to ERISA plans, it noted that there were two
frequently asked questions: whether a qualified ERISA plan is
considered an investment partnership or corporation under paragraph (f)
of the Interpretation; and, if so, whether the ``carve out'' mechanism
described in paragraph (g) could permit sales to be made to qualified
ERISA accounts. NASD Regulation stated in NTM 97-30 that it believes as
a general rule that a qualified ERISA plan should not be deemed an
``investment partnership or corporation'' and should not be considered
a ``restrict account.'' NASD Regulation added that the NBCC has
suggested the following methodology to determine under what
circumstances a qualified ERISA plan would be deemed restricted:
(i) Any plan sponsor that is not involved in financial services
activities would not be considered restricted even though some plan
participants may be restricted.
(ii) Any plan sponsored by a broker/dealer would be deemed per se
restricted.
(iii) All other financial services plans, including those involving
banks,
[[Page 7032]]
insurance companies, investment advisors, or other money managers,
would be exempt unless they had been created to circumvent the purposes
of the Interpretation, including where a financial services plan had
only restricted persons as beneficiaries.
NASD Regulation received only one comment on ERISA plans. The SIA
stated that an ERISA plan sponsored by a broker/dealer should be
restricted only with respect to the plan's transactions with such
broker/dealer. NASD Regulation believes that the SIA's proposal is
inconsistent with the purposes of the Interpretation and has declined
to make the modification. However, NASD Regulation believes that it
would be helpful to clarify the status of accounts for qualified plans
under ERISA and is proposing to include the NBCC interpretation as part
of IM-2110-1, with minor stylistic modifications.
(G) Issuer-Directed Share Exemption
Paragraph (d) of the Interpretation contains provisions relating to
issuer-directed securities plans. In 1994, paragraph (d) was amended to
allow members to allocate hot issues to restricted persons who also
were employees of the issuer, without having to receive prior approval
of the NBCC, NASD Regulation believes that issuer-directed securities
programs are a valuable tool in employee development and retention, and
are not likely to pose the risk of members using these securities to
reward other persons who are in a position to direct future business to
the member. In NTM 97-30, NASD Regulation stated that persons have
requested that the language of paragraph (d) be modified to clarify
that the exemption is available to employees of the issuer who are
materially supported by a restricted person and both employee and non-
employee directors. Several commenters also welcomed clarification to
the issuer-directed securities exception provisions more generally.
Based upon the comments received and its own initiative to clarify and
streamline the issuer-directed securities provisions more generally,
NASD Regulation proposes modifying paragraph (d) of the Interpretation
to permit persons associated with a member and their immediate family
members to purchase hot issues. The proposed amendments would apply the
issuer-directed share exemption to persons subject to the
Interpretation in paragraphs (2)-(9), instead of paragraphs (3)-(9) as
currently written. NASD Regulation believes that this is consistent
with the purposes of the issuer-directed exemption. In addition, by
expanding the scope of restricted persons that can purchase hot issues
under proposed paragraph (d) to include persons restricted under
paragraph (b)(2), NASD Regulation is incorporating the exemption for
issuer directed offerings of NASD members currently found at Rule
2720(m), which pertains to conflicts of interest in connection with the
distribution of securities of members and affiliates.
The proposed amendments to the issuer-directed provisions also
would clarify that exemptions apply to employees and directors of a
parent or subsidiary of the issuer, consistent with NASD Regulation's
past practice. Specifically, the proposed amendments exempt ``a parent
of an issuer, a subsidiary of an issuer, or any other entity which
controls or is controlled by an issuer.'' While no specific percentage
is mentioned to establish a control relationship, NASD Regulation
believes that a guideline of 50 percent should be used and is
consistent with provisions of former Rule 2720(m). Employees and
directors of sister corporations to the issuer would not be subject to
an exemption for issuer-directed securities, but could request
exemptive relief under paragraph (a)(5), which as noted above, provides
NASD Regulation with exemptive authority. Further, the proposed
amendments would shorten the lock-up period for persons formerly
covered under Rule 2720(m) from five months to three months for
consistency and simplicity. The five month lock-up period specified in
Rule 2720(m) is an historical anomaly (pertaining to taxation issues)
and the purposes of the Interpretation would not be frustrated if the
lock-up period for all persons was three months. NASD Regulation has
observed substantial confusion concerning the application of the
Interpretation to issuer directed offerings and believes that these
revisions will assist members with their compliance responsibilities.
In addition, because of the proposal to grant plenary exemptive
authority to NASD Regulation as noted above in item (c), there is no
longer any need for paragraph (d)(2), which grants to the Board of
Governors limited authority to exempt sales of issuer-directed
securities to non-employee/director restricted persons. Accordingly,
this paragraph has been deleted.
(H) General Comments
A few of the commenters addressed NASD Regulation's broad question
whether ``the Interpretation could be simplified and made easier to
follow.'' These commenters generally believed that more should be done
to streamline the Interpretation. The SIA stated the Interpretation has
been ``pulled and stretched'' beyond its original purpose and now has
become a set of provisions that try to address a host of abuses
relating to possible conflicts of interest and self-dealing in the
offering process. The SIA believed that many of these other issues are
already addressed by interpretations of what constitutes ``just and
equitable principles of trade,'' or elsewhere in the securities laws.
Another commenter stated this was the second major review of the
Interpretation in the last three years and that the changes adopted
three years ago as well as those proposed in NTM 97-30 represent only
minor adjustments to an ``overly complex and burdensome rule.'' Both
commenters stated that compliance with the Interpretation was time-
consuming and costly.
NASD Regulation agrees that the Interpretation is overly complex in
many respects. NASD Regulation is committed to a wholesale modification
of the Interpretation following these proposed rule changes. NASD
Regulation believes that the exemption for certain debt and secondary
offerings and the modifications to the issuer directed share provisions
provide greater clarity to the Interpretation and will reduce the
burdens of compliance for many members. NASD Regulation plans to
continue its review of the entire Interpretation to consider other ways
in which it may be simplified. NASD Regulation has communicated this
goal to members of the industry and plans to begin working on broad
reform once the current amendments are in place.
(I) Miscellaneous
In NTM 97-30, NASD Regulation requested comment on several other
issues for which it did not suggest any proposed amendments to the
Interpretation. These topics were non-member broker/dealers and their
associated persons, de minimis exemption, limited purpose broker/
dealers, and member verification of conduit for undisclosed principal.
NASD Regulation will consider the comments received on these issues as
it begins broad reform of the Interpretation.
(b) Statutory Basis
NASD Regulation believes that the proposed rule change is
consistent with the provisions of Section 15a(b)(6) of the Act,\5\ in
that it will promote just and equitable principles of trade, prevent
fraudulent and manipulative acts and
[[Page 7033]]
practices, and protect investors and the public interest, by
facilitating the bona fide distribution of hot issue securities to the
public, and protecting against the receipt of hot issues by persons in
the financial services business who are in a position to direct future
business to the member, or who have an unfair advantage due to their
inside position in the industry. Further, NASD Regulation believes that
the proposed changes and clarifications to the Interpretation are
consistent with Section 15A(b)(9) in that they alleviate certain
inequities caused by the Interpretation, which imposed burdens on
competition not necessary or appropriate in furtherance of the purposes
of the Act.
---------------------------------------------------------------------------
\5\ 15 U.S.C. 78o-3.
---------------------------------------------------------------------------
(B) Self-Regulatory Organization's Statement on Burden on Competition
NASD Regulation does not believe that the proposed rule change will
result in any burden on competition that is not necessary or
appropriate in furtherance of the purposes of the Act, as amended.
(C) Self-Regulatory Organization's Statement on comments on the
Proposed Rule Change Received From Members, Participants, or Others
The proposed rule change was published for comment in NASD Notice
to Members 97-30 (May 1997). Twenty-two comments were received in
response to the notice. The position of the commenters and their
specific comments are discussed above in section II(A).
III. Date of Effectiveness of the Proposed Rule Change and Timing
for Commission Action
Within 35 days of the date of publication of this notice in the
Federal Register or within such longer period (i) as the Commission may
designate up to 90 days of such date if it finds such longer period to
be appropriate and publishes its reasons for so finding or (ii) as to
which the self-regulatory organization consents, the Commission will:
A. By order approve such proposed rule change, or
B. Institute proceedings to determine whether the proposed rule
change should be disapproved.
IV. Solicitation of Comments
Interested persons are invited to submit written data, views, and
arguments concerning the foregoing. Persons making written submissions
should file six copies thereof with the Secretary, Securities and
Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549.
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 the file number SR-NASD-97-95 and
should be submitted by March 4, 1998.
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\6\
---------------------------------------------------------------------------
\6\ 17 CFR 200.30-3(a)(12).
---------------------------------------------------------------------------
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-3372 Filed 2-10-98; 8:45 am]
BILLING CODE 8010-01-M