SEC Approves Amendments Prohibiting Certain Anti-Dilution Terms in the Warrant Agreements of Underwriters and Related Persons;
Effective Date: December 15, 1993
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Executive Summary
On October 29, 1993, the Securities and Exchange Commission (SEC) approved amendments to the Corporate Financing Rule (Rule) under Article III, Section 44 of the Rules of Fair Practice to prohibit underwriters and related persons from accepting as underwriting compensation options, warrants, or convertible securities that (i) contain anti-dilution terms designed to provide the underwriter and related persons with disproportionate rights, privileges, and economic benefits that are not provided to the purchasers of the securities offered to the public, or (ii) contain terms that provide for the receipt or accrual of cash dividends before the exercise or conversion of the security.
The text of the amendment, which takes effect December 15, 1993, follows this Notice.
Background
The NASD recognizes that contracts between the company and investors that cover the issuance of options, warrants, and convertible securities may contain certain anti-dilution terms designed to protect the security holders from events that dilute their economic interest in the company. The NASD reviewed the anti-dilution terms contained in the contracts of underwriters and related persons for warrants received as underwriting compensation and found that underwriters and related persons sometimes negotiate to receive protection from dilution in their warrant contracts through certain "disproportionate" rights. These rights provide them with a larger number of shares upon exercise or lower exercise price than rights available to shareholders of the offering when events occur that do not affect all shareholders, such as additional issuances by the company, including issuances under stock option plans, or the conversion of existing convertible securities. The NASD found different variations of how adjustments to the exercise price and number of shares occur in response to such issuances of securities. Such variations included formulas that "weight" the effect of changes in the company's capitalization and that "rachet" the adjustment without regard to the actual dilutive effect of the new issuance of securities.
The NASD has determined that all variations of such disproportionate anti-dilution rights are unfair and unreasonable when not also provided to investors in the public offering. The receipt of such disproportionate benefits by underwriters and related persons, when such benefits are not received by other purchasers of the public securities, could result in the underwriter and related persons receiving securities as underwriting compensation in excess of 10 percent of the securities sold to the public in the offering, in violation of the Stock Numerical Limitation Rule contained in Subsection (c)(6)(B)(ix) of the Rule.
Description of Amendments
The NASD has adopted new Subsection (c)(6)(B)(vi)(7) of the Rule that defines as unfair and unreasonable the receipt by the underwriter and related persons of underwriting compensation consisting of any option, warrant, or convertible security that contains anti-dilution terms designed to provide the underwriter and related persons with disproportionate rights, privileges, and economic benefits that are not provided to the purchasers of the securities offered to the public. To address circumstances where the security received by the underwriter and related persons is different from the security to be offered to the public, new Subsection (c)(6)(B)(vi)(7) also provides that the rights, privileges, and economic benefits received by underwriters and related persons may be compared to the rights, privileges, and economic benefits of the public shareholders of the issuer whose shares have a bona fide independent market, in compliance with Subsection (c)(5)(A) of the Rule.
New Subsection (c)(6)(B)(vi)(8) defines as unfair and unreasonable the receipt by the underwriter and related persons of underwriting compensation consisting of any option, warrant, or convertible security that contains anti-dilution terms that provide for the receipt or accrual of cash dividends before the exercise or conversion of the security. The NASD has determined that the receipt or accrual arrangement is unfair and unreasonable under the Rule because it provides the underwriter and related person with economic rights, privileges, and benefits that are more favorable than the benefits received by investors in the public offering.
Questions concerning this Notice may be directed to Paul Mathews or Eugene Buchanan, Supervisors, Corporate Financing Department, at (202) 728-8258.
Text of Amendments to the Corporate Financing Rule Under Article III, Section 44 of the Rules Of Fair Practice
(Note: New language is underlined; deleted language is bracketed.)
Subsection (c)(6)(B)(vi)(7) of the Rule is renumbered Subsection (c)(6)(B)(vi)(9).