Notice To Members 92-57

Proposed Amendments to Schedule E to the NASD By-Laws Regarding Potential Conflicts of Interest; Last Voting Date: December 21, 1992

Published Date:
Last Voting Date: December 21, 1992

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MAIL VOTE

EXECUTIVE SUMMARY

The NASD invites members to vote on proposed changes to Schedule E that would require compliance with its provisions if a member participating in a distribution of a public offering of debt or equity securities has a conflict of interest with the issuer. A conflict of interest would be deemed to exist if the member or its affiliates own an aggregate of 10 percent or more of the outstanding subordinated debt, 10 percent or more of the common equity or the preferred equity of a corporation; or 10 percent or more of the distributable profits or losses through a general, limited, or special partnership interest. The NASD is also proposing to adopt an exception to the requirement that a qualified independent underwriter provide a pricing opinion where the member affiliated with the issuer or a member that has a conflict of interest with the issuer is participating as a financial advisor in a restructuring or recapitalization. The text of the amendments follows the discussion below.

BACKGROUND

In 1972, the NASD adopted Schedule E to the By-Laws (Schedule E) to regulate the potential conflicts of interest that exist when a member participates in the public distribution of its own securities or the securities of an affiliate. The presumptions contained within Schedule E used to determine affiliation are generally either voting control through ownership of equity securities or common control of management through interlocking officerships or directorships. Schedule E addresses the conflicts by requiring a qualified independent underwriter to render an opinion on the price of the securities offered, conduct due diligence, and participate in the preparation of the registration statement, in the absence of an investment-grade rating for debt securities or a bona fide independent market for equity securities. The qualified independent underwriter also assumes underwriter's liability for the offering. The NASD has relied on the objectivity and independence of the qualified independent underwriter to resolve the conflicts of interest present when a member distributes its own securities or those of an affiliate.

PUBLICATION FOR COMMENT

In June 1990, the NASD published Notice to Members 90-39 (June 1990) requesting membership comment on proposed amendments to Schedule E to address the conflicts of interest that exist when a member participates in a public offering of an issuer while the member owns debt, preferred equity, or non-voting common equity of the issuer. The NASD is concerned regarding such offerings because members and their affiliates often become holders of risky, less-than-investment-grade debt securities as a result of their participation in leveraged buy-out transactions. This could influence the independence of members' pricing and due diligence functions in any subsequent related public offering.

COMMENTS RECEIVED

The NASD received 19 comment letters on the amendments to Schedule E published for comment in Notice to Members 90-39. None of the comments fully supported the proposed amendments as published for comment. The commenters were particularly concerned with the concept of expanding Schedule E to include certain types of offerings that have heretofore been excluded from the provisions of Schedule E and argued that the 10 percent threshold that would trigger the application of Schedule E is too low. Commenters also argued that ownership of debt and non-voting preferred and common stock does not permit members or their affiliates to control an issuer and does not affect the member's ability to independently perform pricing and due diligence in a public offering. Commenters also pointed out the practical difficulty of determining when debt and preferred securities are owned since such securities may have been acquired in the normal course of business and are being held in trading or investment accounts.

Questions were also raised regarding the impact of the proposed amendments on NASD members affiliated with banks or bank holding companies, since banks are most likely to act as a corporate lender, and the difficulties that members affiliated with banks would experience in complying with the provisions of Schedule E which require (1) that a majority of the members of the Board of Directors of the member have five years experience in the securities business; and (2) if the member intends to manage the underwriting, that the member have been involved in the securities business at least five years.

NASD REVIEW

The NASD has reviewed the comments received in response to Notice to Members 90-39. The NASD continues to believe that a member is subject to conflicts of interest in pricing an offering of securities and performing due diligence that require compliance with the provisions of Schedule E when the member owns at least 10 percent of the debt and non-voting preferred and common stock of an issuer. The NASD recognizes that the incidences of such ownership have decreased since the issue was first considered. A number of changes have been made to the proposed amendments to Schedule E that the NASD believes will address the most significant objections of commenters. Because of the negative comments generated by publication for comment of the original version of the proposed amendments to Schedule E, the NASD has published a revised proposal for member vote.

SUMMARY OF PROPOSED AMENDMENTS

Set forth below is a summary of the amendments proposed to each section of Schedule E. In each case, a description is provided of any modifications to the rule language as published in Notice to Members 90-39.

Section 1 — General

The NASD is proposing a new introductory paragraph to Schedule E that sets forth the applicability of Schedule E to conflict-of-interest situations by prohibiting members and their associated persons from participating in the distribution of a public offering of debt or equity securities if the member and/or its associated persons, parent, or affiliates have a conflict of interest with the company. No modifications have been made to the rule language of this provision as published in Notice to Members 90-39.

Section 2 — Definitions

Four new definitions are proposed to be added to the definitions section and one definition is proposed to be amended.

  • Common Equity — A new definition of "common equity" is proposed to include the total number of shares of common stock outstanding without regard to class, voting rights, or other distinguishing characteristics as reflected on the consolidated financial statements of the company. No modifications have been made to the rule language of this provision as published in Notice to Members 90-39.


  • Conflict of Interest — The principal new definition is that of "conflict of interest." Significant modifications have been made to the rule language of this provision as published in Notice to Members 90-39 to address the comments received which are reflected in this provision and the related definitions for "preferred equity" and "subordinated debt." The provision has been modified to exclude ownership of the common equity, preferred stock, or debt of the parent of the issuer. A conflict of interest will be deemed to exist if the member and/or its associated persons, parent, or affiliates in the aggregate beneficially own 10 percent or more of the:
    (1) outstanding subordinated debt of a company;
    (2) common equity of a company which is a corporation; or
    (3) preferred equity of a company. In addition, a conflict of interest will be deemed to exist if the member and/or its associated persons, parent, or affiliates beneficially owns a general, limited, or special partnership interest in 10 percent or more of the distributable profits or losses of a company.
    The calculation of the 10 percent threshold would be based on all securities of the issuer beneficially owned by the member at the time of the filing of the offering documents, including proprietary trading accounts and other fluctuating positions, regardless of whether any of the securities are sold prior to effectiveness of the offering.

    A new paragraph has been added to this provision to set forth a number of exclusions from the definition of "conflict of interest" in response to the requests of commenters. Exclusions would be available for: (1) offerings by not-for-profit and charitable organizations; (2) investment companies registered under the Investment Company Act; (3) "separate accounts" as defined in the Investment Company Act of 1940; (4) real estate investment trusts; (5) direct participation programs; (6) financing-instrument-backed securities that are rated investment grade; (7) equity securities for which a bona fide independent market exists; and (8) debt securities rated investment grade.1


  • Preferred Equity — The term "preferred equity" is proposed to be the same as that published in Notice to Members 90-39 and would include the aggregate capital invested by all persons in the preferred securities outstanding without regard to class, voting rights, or other distinguishing characteristics as reflected on the consolidated financial statements of the company.


  • Subordinated Debt — In response to comments, the NASD has modified the proposal published for comment, which included a definition of the term "debt" that would have provided that a conflict exists based on at least a 10 percent beneficial interest in the short- and long-term debt of a company. On review of the comments received, the NASD believes that the proposed amendments should not (and were not intended to) apply to banks or lending institutions that make loans to companies in the normal course of business. Since it is subordinated debt that is often is sued in a leveraged buy-out and restructuring transactions, the NASD has determined that these are the transactions of greatest concern. As a result, all senior debt, whether secured or unsecured, and all short-term with a maturity at issuance of less than one year would be excluded from the application of the proposed amendments.2

    In place of the prior proposed definition of the term "debt," the NASD is proposing to adopt a definition of "subordinated debt" to include debt of an issuer that is expressly subordinate in right of payment to, or with a claim on assets subordinate to, any existing or future debt of such issuer and all debt that is specified as subordinated at the time of issuance. The language of the definition specifically excludes short-term debt, as well as secured debt and bank debt not specified as subordinated debt at the time of issuance.


  • Qualified Independent Underwriter —A conforming amendment is proposed to subparagraph (6) of the definition of "qualified independent underwriter" currently included in Subsection 2(1) to Schedule E. Subsection 2(1) sets forth the requirement that a qualified independent underwriter not be an affiliate of the issuer and not beneficially own 5 percent or more of the outstanding voting securities of the issuer. The provision is proposed to be modified also to prohibit ownership of 5 percent or more of the common equity, preferred equity, or subordinated debt of the issuer.

Section 3 — Participation in Distribution of Securities of Member or Affiliate

Subsection 3(a) — It is proposed that Section 3 be retitled "Participation in Distribution of Securities." Subsection 3 (a) has been modified by the addition of a prohibition on any member underwriting or participating as a member of the underwriting syndicate or selling group or otherwise assisting in the distribution of a public offering of securities of a company with which the member or its associated persons, parent, or affiliates have a conflict of interest unless the member complies with Subsection 3(b) and Subsection 3(c). No modifications have been made to the rule language of this provision as published in Notice to Members 90-39.

Subsection 3(b) — The NASD is not proposing any changes to Subsection 3(b) which requires that the majority of the Board of Directors of the member that is deemed to have a conflict with the issuer must have been actively engaged in the investment banking or securities business for at least five years and, if the member intends to manage the underwriting, that the member have been involved in the securities business at least five years. With respect to the concerns of commenters that are bank-affiliated members, the NASD believes that if the members of the Board and the firm can demonstrate sufficient appropriate experience, the Corporate Financing Department has some flexibility in applying the provision and that exceptions, as appropriate, may be granted pursuant to Section 16 of Schedule E by a hearing subcommittee or by the Chairman of the Corporate Financing Committee in consultation with the Director of the Department on a case-by-case basis.

Subsection 3(c) — The NASD is proposing to amend Subsection 3(c) to indicate that if a member proposes to underwrite, participate as a member of the underwriting syndicate or selling group, or otherwise assist in the distribution of a public offering of securities of a company with which it or its associate persons, parent, or affiliate have a conflict, the offering must be made in compliance with paragraph 3(c)(1), which requires a qualified independent underwriter to participate in the preparation of the offering document, exercising the usual standards of due diligence with respect thereto, and issue an opinion on the pricing of the offering. As stated above, the definition of "conflict of interest" would specifically exclude the application of Schedule E to conflict-of-interest situations where the offering comports with the alternative forms of Schedule E compliance set forth in paragraphs 3(c)(2) and (3), which require either a bona fide independent market (in the case of an equity offering) or an investment-grade rating (in the case of a debt offering).

No modifications have been made to the rule language of Subsection 3(c) as published in Notice to Members 90-39. In response to comments, however, the NASD proposes to clarify the applicability of the requirements of paragraph 3(c)(1) to recapitalizations and restructurings where an NASD member offering securities of an affiliate or subject to the application of Schedule E because of a conflict of interest is acting as a financial advisor rather than an underwriter. In this event, the NASD believes that it is appropriate to recognize that the more limited functions of the member acting as a financial adviser would not require the qualified independent underwriter to provide a pricing opinion where the financial adviser has not been engaged to opine on the price or the exchange value. The NASD is, therefore, proposing to amend paragraph 3(c)(1) to set forth this exception in a parenthetical statement.

Section 4 — Disclosure

Subsection 4(b) — This Subsection of Schedule E is proposed to be amended to require the disclosure in the offering document if the offering is by an issuer with which a member has a conflict of interest. The provision currently requires that the offering document disclose that the offering is being made pursuant to the provisions of Schedule E, the name of the qualified independent underwriter and that such member is assuming the responsibilities of acting as a qualified independent underwriter. In the case of an offering subject to the conflict-of-interest provisions, the provision would require disclosure that the member or its associated persons, parent, or affiliates own the common stock, preferred stock, or subordinated debt of the company.

Members currently subject to Schedule E are only required to disclose whether the offering is being made by a member of its own securities or those of an affiliate and are not required to disclose that the member has a conflict of interest with the issuer. In response to comments received on the proposed amendments, the NASD has determined to delete the language originally included in Notice to Members 90-39 that would have required disclosure that the member is subject to a conflict of interest. Moreover, the NASD has long held the position that the application of Schedule E is not a determination that a conflict of interest actually exists, but is necessary to prevent at least the appearance of a conflict of interest.

Corporate Financing Filing Requirements

The filing requirements of the Corporate Financing Rule are contained in Section (b) to Article III, Section 44 of the NASD Rules of Fair Practice (Corporate Financing Rule). Paragraph (b)(6)(C) requires that members filing an offering subject to the filing requirements of the Rule or Schedule E3 submit a statement that is intended to elicit information on whether any member or person associated with a member has acquired any debt or equity securities of the issuer. The provision currently requires a statement of the association or affiliation with any member of any debt or equity securityholder of an issuer in an initial public offering. Where the offering is not an initial public offering, the same information is requested to any securityholder of five percent or more of any class of the issuer's securities. The provision sets forth the details of the information regarding such securityholdings that must be submitted in the statement.

The NASD believes that this provision is sufficiently broad to require the submission of information regarding the beneficial ownership by a member, its associated persons, parent, or affiliates of any equity, preferred stock, or subordinated debt of an issuer and the submission of supplemental information after the offering is filed if the ownership level changes during the registration period.

REQUEST FOR VOTE

The NASD Board of Governors believes that the proposed amendments to Schedule E are necessary to address the potential conflicts of interest that are present when a member (its associated persons, parent, or affiliates) participating in a debt or equity public offering owns 10 percent or more of the subordinated debt, preferred stock, or common equity of a company. The Board considers the proposed amendments necessary and appropriate and recommends that members vote their approval. The amendments will not be effective until filed with and approved by the Securities and Exchange Commission. Please mark the attached ballot according to your convictions and mail it in the enclosed stamped envelope to The Corporation Trust Company. Ballots must be postmarked no later than December 21, 1992.

Questions concerning this Notice should be directed to Charles L. Bennett, Director, NASD Corporate Financing Department, at (202) 728-8253.

1 For offerings subject to Schedule E on the basis that the securities are being issued by a member or an affiliate of a member, the offering is subject to the filing requirements of Schedule E regardless of whether the offering is of equity securities for which a bona fide independent market exists or of debt securities which are rated investment grade.

2 The calculation of the 10 percent threshold would be applicable to an issuer's entire subordinated debt outstanding. Senior and short-term debt would, therefore, be excluded when calculating the percentage of debt that would trigger application of the proposed amendments.

3 The filing requirements of Schedule E take precedence over the filing requirements of the Corporate Financing Rule pursuant to Section 15 of Schedule E. Therefore, offerings that are exempt from the filing requirements of the Rule are nonetheless subject to filing with the Corporate Financing Department for review if subject to the provisions of Schedule E. See subparagraph (7) to Section (b) to the Corporate Financing Rule.

Schedule E to the NASD By-Laws

(Note: New language is underlined; deleted text is in brackets.)

Distribution of Securities of Members and Affiliates — Conflicts of Interest

Section 1 — General

(a) No member or person associated with a member shall participate in the distribution of a public offering of debt or equity securities issued or to be issued by the member, the parent of the member, or an affiliate of the member and no member or parent of a member shall issue securities except in accordance with this Schedule.
(b) No member or person associated with a member shall participate in the distribution of a public offering of debt or equity securities issued or to be issued by a company if the member and/or its associated persons, parent or affiliates have a conflict of interest with the company, as defined herein, except in accordance with this Schedule.

Section 2 — Definitions

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(e) Common Equity — the total number of shares of common stock outstanding without regard to class, whether voting or non-voting, convertible or non-convertible, exchangeable or non-exchangeable, redeemable or non-redeemable, as reflected on the consolidated financial statements of the company.

* * * * *

(g) Conflict of Interest — shall be deemed to exist when:
(1) a member and/or its associated persons, parent or affiliates in the aggregate beneficially own 10% or more of the outstanding subordinated debt of a company;
(2) a member and/or its associated persons, parent or affiliates in the aggregate beneficially own 10% or more of the common equity of a company which is a corporation, or beneficially own a general limited or special partnership interest in 10 percent or more of the distributable profits or losses of a company; or
(3) a member and/or its associated persons, parent or affiliates in the aggregate beneficially own 10% or more of the preferred equity of a company.
(4) The provisions of paragraphs (1), (2) and (3) hereof notwithstanding, the conflict of interest provisions of this Schedule E shall not apply to:
(a) an offering of securities exempt from registration with the Securities and Exchange Commission under Section 3(a)(4) of the Securities Act of 1993;
(b) an investment company registered with the Securities and Exchange Commission pursuant to the Investment Company Act of 1940, as amended;
(c) a "separate account" as defined in Section 2(a)(37) of the Investment Company Act of 1940, as amended;
(d) a "real estate investment trust" as defined in Section 856 of the Internal Revenue Code;
(e) a "direct participation program" as defined in Article III, Section 34 of the Rules of Fair Practice;
(f) an offering of financing instrument-backed securities which are rated by a nationally recognized statistical rating organization in one of its four (4) highest generic rating categories;
(g) an offering of a class of equity securities for which a bona fide independent market as defined in Section 2(c) exists as of the date of the filing of the registration statement and as of the effective date thereof; and
(h) an offering of a class of securities rated in one of the four highest generic rating categories by a nationally recognized statistical rating organization.

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(l) Preferred Equity— the aggregate capital invested by all persons in the preferred securities outstanding without regard to class, whether voting or non-voting, convertible or non-convertible, ex-changeable or non-exchangeable, redeemable or non-redeemable, as reflected on the consolidated financial statements of the company.

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[l]o Qualified independent underwriter* — a member which:

* * * * *
(6) is not an affiliate of the entity issuing securities pursuant to Section 3 of this Schedule and does not beneficially own five percent or more of the outstanding voting securities, common equity, preferred equity or subordinated debt of such entity which is a corporation or beneficially own a partnership interest in five percent or more of the distributable profits or losses of such entity which is a partnership; and

* * * * *

(r) Subordinated Debt — includes (1) debt of an issuer which is expressly subordinate in right of payment to, or with a claim on assets subordinate to, any existing or future debt of such issuer; or (2) all debt that is specified as subordinated at the time of issuance. Subordinated debt shall not include short-term debt with maturity at issuance of less that one year and secured debt and bank debt not specified as subordinated debt at the time of issuance.

Section 3 — Participation in Distribution of Securities [of Member or Affiliate]

(a) No member shall underwrite, participate as a member of the underwriting syndicate or selling group, or otherwise assist in the distribution of a public offering of an issue of debt or equity securities issued or to be issued by the member of an affiliate of the member, or of a company with which the member or its associated persons, parent or affiliates have a conflict of interest, unless the member is in compliance with subsection 3(b) and subsection 3(c) below.
(b) In the case of a member which is a corporation, the majority of the board of directors, or in the case of a member which is a partnership, a majority of the general partners or, in the case of a member which is a sole proprietorship, the proprietor as of the date of the filing of the registration statement and as of the effective date of the offering shall have been actively engaged in the investment banking or securities business for the five year period immediately preceding the filing of the registration statement.
(c) If a member proposes to underwrite, participate as a member of the underwriting syndicate or selling group, or otherwise assist in the distribution of a public offering of its own or an affiliate's securities or proposes to underwrite, participate as a member of the underwriting syndicate or selling group, or otherwise assist in the distribution of a public offering of securities of a company with which it or its associated persons, parent or affiliates have a conflict of interest, subject to this Section without limitation as to the amount of securities to be distributed by the member, one or more of the following three criteria shall be met:
(1) 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, (except that in the case of an exchange offer or other transaction relating to a recapitalization or restructuring of a company, a qualified independent underwriter is not required to provide a recommendation on the price or yield at which a security shall be distributed if the member that is affiliated with the issuer or with which the member or its associated persons, parent or affiliates have a conflict of interest is not obligated to and does not provide a recommendation or opinion with respect to the price, yield, or exchange value of the transaction), which shall also participate in the preparation of the registration statement and prospectus, offering circular, or similar document and which shall exercise the usual standards of "due diligence" in respect thereto; provided, however, that an offering of securities by a member which has not been actively engaged in the investment banking or securities business, in its present form or as a predecessor broker/dealer, for at least the five years immediately preceding the filing of the registration statement shall be managed by a qualified independent underwriter;

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Section 4 — Disclosure

(a) Unchanged.
(b) All offerings included within the scope of this Schedule shall disclose in the underwriting section of the registration statement, offering circular or similar document that the offering is being made pursuant to the provisions of this Schedule, that the offering is either being made by a member of its own securities or those of an affiliate, or those of a company in which the member or its associated persons, parent or affiliates own the common stock, preferred stock or subordinated debt of the company, the name of the member acting as qualified independent underwriter, if any, and that such member is assuming the responsibilities of acting as a qualified independent underwriter in pricing the offering and conducting due diligence.

Section 11 — Suitability

Every member underwriting an issue of its securities, or securities of an affiliate, or the securities of a company with which it has a conflict of interest, pursuant to the provisions of Section 3 hereof, who recommends to a customer the purchase of a security of such an issue shall have reasonable grounds to believe that the recommendation is suitable for such customer on the basis of information furnished by such customer concerning the customer's investment objectives, financial situation, and needs, and any other information known by such member. In connection with all such determinations, the member must maintain in its files the basis for its determination.

Section 12 — Discretionary Accounts

Notwithstanding the provisions of Article III, Section 15 of the Corporation's Rules of Fair Practice, or any other provisions of law, a transaction in securities issued by a member or an affiliate of a member, or by a company with which a member has a conflict of interest shall not be executed by any member in a discretionary account without the prior specific written approval of the customer.

* 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.