Notice To Members 87-87

Request for Comments on Proposed Amendments to Schedule E to the NASD By-Laws Regarding the Definition of a Qualified Independent Underwriter

Published Date:

TO: All NASD Members and Other Interested Persons

LAST DATE FOR COMMENT: JANUARY 30, 1988.

EXECUTIVE SUMMARY

The NASD is requesting comments on proposed amendments to Schedule E to the NASD By-Laws relating to the definition of a qualified independent underwriter. A qualified independent underwriter is required by Schedule E to establish the price and conduct due diligence in public offerings of securities of a member or an affiliate of a member.

The proposed amendments would preclude a member from acting as a qualified independent underwriter if the member or its senior associated persons or a controlling shareholder has been convicted or enjoined for securities-related activities or has been the subject of serious disciplinary action by the NASD, the SEC, or any self-regulatory organization. Additionally, the proposed amendments would require a qualified independent underwriter to have experience in managing or co-managing public offerings of a size and type similar to the proposed offering and would restrict the qualified independent underwriter's direct or indirect ownership of the issuer's equity securities.

The text of the proposed amendments is attached.

BACKGROUND AND EXPLANATION

The NASD adopted Schedule E in 1972 to address the conflicts of interest present in a public distribution by a member of its own securities or those of an affiliate. A major conflict of interest arises when the member participates in establishing the price at which the securities are to be distributed to the public and in conducting due diligence. Schedule E addresses this conflict by requiring that a qualified independent underwriter, with a background in underwriting and a track record of profitable operations and experienced management, conduct due diligence, participate in the preparation of the offering documents, and provide an opinion as to the price at which an equity issue, or the yield at which a debt issue, is to be distributed. The NASD believes that the objectivity and independence provided by a qualified independent underwriter resolves the conflict of interest present in such offerings.

The NASD's Corporate Financing Committee reviewed the current criteria for a qualified independent underwriter, contained in Section 2(k) of Schedule E, and recommended to the NASD Board of Governors certain amendments, which the Board approved.

Currently, a qualified independent underwriter must be actively engaged in the underwriting of public offerings for at least five years immediately preceding the filing of the registration statement. The NASD proposes to amend Section 2(k)(4) of Schedule E to specifically require that a member acting as a qualified independent underwriter must have been actively engaged in the underwriting of public offerings of securities of a similar type and size as the proposed offering and has acted as a manager or co-manager of such offerings for the prior five-year period. The NASD believes that the five-year experience requirement should be as a manager or co-manager of public offerings since this is the type of experience necessary to conduct the pricing and due-diligence functions of a qualified independent underwriter.

In addition, the amendments require the qualified independent underwriter to be experienced in the same type and size of offering as the proposed offering. This requirement would prevent, for example, a member with experience as an underwriter of small equity offerings from acting as a qualified independent underwriter for a large firm-commitment offering of high-risk, high-yield debt.

The NASD also proposes to amend Section 2(k)(4) to preclude a member from acting as a qualified independent underwriter if the member or a senior associated person or controlling shareholder associated with the member at the time of the offering has had a previous conviction, injunction, or serious disciplinary history. Specifically, the proposed amendment would preclude a member from acting as a qualified independent underwriter if the member or any senior officer, director, general partner, or controlling shareholder of the member:

(1) has been convicted within five years prior to the filing of the registration statement of any felony or misdemeanor in connection with the purchase or sale of any security or arising out of the conduct of a broker-dealer;
(2) has been barred, expelled, or had its registration revoked by the NASD, SEC, or any self-regulatory organization;
(3) has been suspended from membership or association within the previous five years by the NASD, SEC, or any self- regulatory organization for any conduct or practice relating to a registered or unregistered offering of securities; or
(4) has been subject to any injunction within the previous five years for any conduct in connection with a registered or unregistered offering of securities.

The NASD also proposes to amend Section 2(k)(5) of Schedule E to require that the qualified independent underwriter not own 5 percent or more of the issuer's securities. Currently, Section 2(k)(5) requires that the qualified independent underwriter not be an affiliate of the entity issuing the securities. The definition of "affiliate" contained in Schedule E is based on common control, and control is not presumed until a member owns 10 percent of the voting securities of the issuer. Therefore, a qualified independent underwriter could, for example, own 8 percent of the outstanding securities of an issuer and function as a qualified independent underwriter.

The NASD believes that such an ownership interest is inconsistent with the intent of the requirement to establish objectivity and independence in the pricing and due-diligence functions. Therefore, the NASD proposes to amend the definition to require that a member that proposes to act as a qualified independent underwriter not own, directly or indirectly, 5 percent or more of the equity securities of the issuer. The 5 percent requirement would include all securities beneficially owned by the member including securities in the member's trading account.

REQUEST FOR COMMENTS

The NASD encourages all members and other interested persons to comment on the proposed amendment. 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 January 30, 1988. Comments received by this date will be reviewed by the NASD Corporate Financing Committee and the NASD Board of Governors. If approved by the Board, the proposed amendments must be filed with and approved by the Securities and Exchange Commission before becoming effective.

Questions regarding the proposed amendments can be directed to Charles L. Bennett, NASD Corporate Financing Department, at (202) 728-8258.

Sincerely,

Frank J. WilsonExecutive Vice President and General Counsel

Attachment

PROPOSED AMENDMENTS TO SCHEDULE E TO THE NASD BY-LAWS

[New language is underlined.]

Section 2—Definitions

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(k) Qualified independent underwriter* —a member which:

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(4) has actively engaged as a manager or co-manager in the underwriting of public offerings of securities of a similar size and type as the offering for at least the five-year period immediately preceding the filing of the registration statement, provided however that no member may act as a qualified independent underwriter if, as of the date of the filing of the registration statement and/or the effective date of the offering, the member, or any senior officer, director, general partner, or controlling shareholder associated with the member:
(i) has been convicted within five years prior to the filing of the registration statement of any felony or misdemeanor in connection with the purchase or sale of any security, or arising out of the conduct of the business of an underwriter, broker, or dealer; or
(ii) is subject to any order, judgment, or decree of any court of competent jurisdiction temporarily or preliminarily enjoining or restraining, or is subject to any order, judgment, or decree of any court of competent jurisdiction entered within five years prior to the filing of the registration statement permanently enjoining or restraining such person from engaging in or continuing any conduct or practice in connection with the registered or unregistered offering of securities; or
(iii) has been suspended from membership in or suspended from association with any member of the Corporation, or any self-regulatory organization, or has been suspended by an order of the Securities and Exchange Commission, within five years prior to the filing of the registration statement for any conduct or practice in connection with a registered or unregistered offering of securities; or
(iv) has been expelled from membership in, or barred from association with, a member of the Corporation, or any self-regulatory organization, or barred from association with any broker or dealer, or had its registration as a broker or dealer revoked by the Securities and Exchange Commission.
(5) is not an affiliate of the entity issuing securities pursuant to Section 3 of this Schedule and does not beneficially own 5 percent or more of the outstanding securities of such entity which is a corporation, or beneficially own a partnership interest in 5 percent or more of the distributable profits or losses of such entity which is a partnership; and

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* In the opinion of the National Association of Securities Dealers, Inc. and the Securities and Exchange Commission the full responsibilities and liabilities of an underwriter under the Securities Act of 1933 attach to a "qualified independent underwriter" performing the functions called for by the provisions of Section 3 hereof.