Amendment to the NASD Board of Governors' Corporate Financing Interpretation Regarding Public Offerings When Proceeds Are Directed to NASD Members

TO: All NASD Members and Other Interested Persons

EXECUTIVE SUMMARY

The Securities and Exchange Commission recently approved an 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, which becomes effective June 1, 1988, requires 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 text of the amendment is attached.

BACKGROUND AND SUMMARY OF AMENDMENT

The amendment to the Interpretation of the Board of Governors—Review of Corporate Financing was adopted in response to concerns over potential conflicts of interest that arise when a portion of the proceeds of a public offering are directed to members participating in the distribution of the offering. This most commonly occurs in connection with leveraged buy-outs when the underwriter or an affiliate of the underwriter provides a bridge loan to the issuer to finance a buy-out transaction and the member then underwrites a public offering, the proceeds of which are used to repay the loan. In such offerings, the member has a potential conflict of interest in evaluating the issuer objectively when establishing an appropriate offering price and in fulfilling its due-diligence responsibilities since a successful distribution of the issuer's securities directly benefits the member.

Since a qualified independent underwriter requirement has been successfully utilized to eliminate conflicts of interest in public offerings by members of their own or an affiliate's securities, the Board of Governors determined that an amendment to its Corporate Financing Interpretation to require the participation of a qualified independent underwriter was the most effective method of dealing with potential conflicts of interest when proceeds are directed to a member.

The amendment, which was approved by the SEC on April 29, 1988, requires the 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 the immediate family of such persons. The qualified independent underwriter will 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 will also be required to perform independent due diligence in the preparation of the offering document.

To act as a qualified independent underwriter under the amendment, an NASD member must meet the definition in Section 2(k) of Schedule E to the NASD By-Laws. Under the definition, a member must 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 agree to undertake the legal responsibilities and liabilities of an underwriter under Section 11 of the Securities Act of 1933.

The amendment contains certain exemptions when sufficient market or regulatory safeguards exist to protect investors. Therefore, exempt from the amendment are offerings of real estate investment trusts, traditional direct participation programs, offerings of a class of equity securities for which a bona fide independent market, as defined in Section 2(b) of Schedule E, exists, and offerings of a class of debt securities rated in one of the four highest generic rating categories of a nationally recognized statistical rating agency. In addition, offerings otherwise subject to Schedule E to the By-Laws are exempt. Further, offerings that qualify for exemption from SEC registration under Section 3(a)(4) of the Securities Act of 1933 are not subject to the requirements of the amendment. This would include offerings of securities issued by religious or charitable organizations.

To determine net offering proceeds, fees and commissions paid to members for underwriting services, as well as other organization and offering expenses related to the issuance and distribution of the securities, are deducted from gross offering proceeds.

The amendment becomes effective June 1, 1988. Therefore, all offerings declared effective by the SEC or, if SEC exempt, by another reviewing regulatory authority on or after June 1, will be subject to the provisions of the amendment.

* * * *

Questions regarding this notice can be directed to either Richard J. Fortwengler, Assistant Director, or Frank J. Formica, Vice President and Director, NASD Corporate Financing Department, at (202) 728-8258.

Sincerely,

Frank J. Wilson
Executive Vice President
and General Counsel

Attachment

AMENDMENT TO THE INTERPRETATION OF THE BOARD OF GOVERNORS—REVIEW OF CORPORATE FINANCING ARTICLE III, SECTION 1 OF THE NASD RULES OF FAIR PRACTICE

(New language is underlined. Follows section titled "Venture Capital Restrictions" at page 2034 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, not including underwriting compensation, are intended to be paid to members participating in the distribution of the offering or associated or affiliated persons of such members, or members of the immediate family of such persons, 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 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; provided, however, this paragraph shall not apply to (l) an offering of a class of equity securities for which a bona fide independent market as defined in Section 2(b) of Schedule E to the By^ Laws exists as of the date of the filing of the registration statement and as of the effective date thereof; (2) an offering of a class of securities rated Baa or better~by Moody's rating service or Bbb or better by Standard & Poor's rating service or rated in a comparable category by another rating service acceptable to the Association; (3) an offering otherwise subject to the provisions of Schedule E to the By-Laws;74) an offering of securities exempt from registration with the Securities and Exchange Commission under Section 3(a)(4) of the Securities Act of 1933; (5) an offering ofa real estate investment trust as defined in Section 856 of the Internal Revenue Code; or (6) an offering of securities subject to Appendix F to Article III, Section 34 of the Rules of Fair Practice unless the net proceeds of such offering are intended to be paid to the above persons for the purpose of repaying loans, advances or other types of financing utilized to acquire an interest in a pre-existing company. For purposes of this paragraph, the term "net offering proceeds" means the gross offering proceeds less all expenses of issuance and distribution and the term "immediate family" has the meaning set forth in Section 2(f) of Schedule E to the By-Laws.