Request for Comments on Proposed Amendment to the NASD Board of Governors' Corporate Financing Interpretation Concerning Public Offerings When Proceeds Are Directed to NASD Members

TO: All NASD Members and Other Interested Persons

LAST DATE FOR COMMENT: SEPTEMBER 12, 1987.

EXECUTIVE SUMMARY

The NASD requests comments on a proposed amendment to the Interpretation of the Board of Governors—Review of Corporate Financing, under Article III, Section 1 of the NASD Rules of Fair Practice. The amendment would require a qualified independent underwriter to provide a pricing opinion and conduct due diligence when 10 percent or more of the net proceeds of a public offering are directed to NASD members participating in the distribution of the offering.

The NASD Board of Governors believes this amendment is necessary to address potential conflicts of interest that arise when a portion of the proceeds of the offering are directed to a member responsible for pricing and due diligence.

The text of the proposed amendment is attached.

BACKGROUND

Recently NASD members have become more involved in corporate takeovers by providing their clients, directly from their own funds, large sums of money to facilitate leveraged buyouts. The takeover, or leveraged buyout, is accomplished primarily with borrowed funds from a lending group that includes NASD members. The capital committed by members is not intended as a long-term investment but rather, as bridge financing to allow clients to quickly complete the transaction. The bridge loan is intended to be repaid with the proceeds of a public offering, usually of high-yield, high-risk bonds underwritten by the member.

The SEC and the NASD Corporate Financing Committee have expressed concern regarding potential conflicts of interest by members that provide bridge loans to finance corporate acquisitions by their clients. The concern is that a member-lender might be compromised in fulfilling its due diligence and other responsibilities when underwriting subsequent offerings by its issuer-client, the proceeds of which will be used to repay the member's loan. In such situations, the member has a potential conflict of interest in evaluating the issuer objectively as part of its due-diligence responsibilities and when establishing an appropriate offering price, since a successful distribution of the issuer's securities directly benefits the member.

SUMMARY OF PROPOSED AMENDMENT

The NASD Corporate Financing Committee and the NASD Board of Governors reviewed this issue and determined that when a portion of the proceeds of a public offering is directed to a member that is responsible for pricing and due diligence, the member is subject to a potential conflict of interest. Particularly in the area of due diligence, the responsibility of the member to ensure disclosure of material facts adverse to the issuer may be influenced by the significant financial interest of the member in the offering and the incentive for the offering to be successful.

Therefore, the Committee and the Board of Governors believe an amendment to the Board of Governors' Interpretation on Corporate Financing under Article III, Section 1 of the Rules of Fair Practice is the most effective method of dealing with such potential conflicts of interest. The amendment would require participation of a qualified independent underwriter in any public offering in which 10 percent or more of the net proceeds of the offering will be directed to NASD members participating in the distribution of the offering, or to affiliated or associated persons of such members, or to members of the immediate family of such persons. The qualified independent underwriter would be required to provide an opinion that the yield is no lower (in a debt offering) or the price is no higher (in an equity offering) than it would recommend. The qualified independent underwriter would also perform due diligence in the preparation of the offering document.

To act as a qualified independent underwriter, an NASD member must meet the definition contained in Section 2(k) of Schedule E to the NASD By-Laws. Under the definition, a member must be and have been actively engaged in the investment banking or securities business and the underwriting of public offerings for at least five years preceding the offering; must have had net income from operations in at least three of the five years preceding the offering; and must have had a majority of its board of directors (if a corporation), a majority of its general partners (if a partnership), or its proprietor (if a sole proprietorship) actively engaged in the investment banking or securities business for the five-year period prior to the offering. In addition, the member must not be an affiliate of the issuer and must have agreed to undertake the legal responsibilities and liabilities of an underwriter under Section 11 of the Securities Act of 1933.

The NASD has historically relied on qualified independent underwriters to resolve potential conflicts of interest on behalf of underwriters in public offerings. Qualified independent underwriters have been used to resolve conflicts of interest in offerings by members of their own securities and offerings of affiliates since the adoption of Schedule E (the NASD's self-underwriting regulation) in 1972. In addition, in 1984, the NASD amended the "Venture Capital Restrictions" under the Corporate Financing Interpretation to provide an exemption from the restrictions if a qualified independent underwriter participated in the offering. The "Venture Capital Restrictions" apply to initial public offerings in which members participating in the offering own securities of the issuer. The exemption has been very effective in resolving problems that had been experienced by members prior to its adoption.

* * * * *

The NASD encourages all members and other interested persons to comment on the proposed amendment. The NASD requests that commentators address whether the participation of a qualified independent underwriter is necessary in an equity offering that has a bona fide independent market (as defined in Section 2(b)9 of Schedule E to the NASD By-Laws) or when the offering is of debt-rated investment grade, i.e., the four highest generic rating categories by a nationally recognized statistical rating organization. The NASD is also interested in receiving information on additional costs to members that may result from the proposed amendment.

In addition, the proposed amendment applies when 10 percent or more of the net proceeds of an offering are directed to members. Commentators may wish to address whether 10 percent is the appropriate level to use in determining that a qualified independent underwriter is required or whether a higher or lower level should be used.

Comments should be directed to:

Mr. Lynn Nellius
Secretary
National Association of Securities Dealers, Inc.
1735 K Street, N.W.
Washington, D.C. 20006-1506

Comments must be received no later than September 12, 1987. Comments received by this date will be reviewed by the NASD Corporate Financing Committee and the NASD Board of Governors. If the proposed amendment, or an amended version resulting from comments received, is approved by the Board, it must be filed with and approved by the Securities and Exchange Commission before becoming effective.

Questions regarding this notice may be directed to either Frank J. Formica or Richard J. Fortwengler, NASD Corporate Financing Department, at (202) 728-8258.

Sincerely,

Frank J. Wilson
Executive Vice President and General Counsel

Attachment

Proposed Amendment to The Interpretation of the Board of Governors—Review of Corporate Financing Under Article III, Section 1 of the NASD Rules of Fair Practice

(Follows section titled "Venture Capital Restrictions" at page 2033 of the NASD Manual.)

Proceeds Directed to a Member

No member shall participate in a public offering of an issuer's securities where more than 10 percent of the net offering proceeds are intended to be paid to members participating in the distribution of the offering or associated or affiliated persons of such members, or members of the immediate family* of such persons, unless the price at which an equity issue or the yield at which a debt issue is to be distributed to the public is established at a price no higher or yield no lower than that recommended by a qualified independent underwriter as defined in Section 2(k) of Schedule E to Article VII, Section l(a)(4) of the By-Laws, who shall participate in the preparation of the registration statement and the prospectus, offering circular, or similar document and who shall exercise the usual standards of "due diligence" in respect thereto. For purposes of this provision, the term "net offering proceeds" means the gross offering proceeds less all expenses of issuance and distribution.

* See definition of "immediate family," Interpretation of the Board of Governors—Free-Riding and Withholding, under Article III, Section 1 of the NASD Rules of Fair Practice.