Notice To Members 94-45

SEC Approves Schedule E Conflict-Of-lnterest Provisions

Published Date:

SUGGESTED ROUTING

Senior Management
Corporate Finance
Legal & Compliance
Syndicate

Executive Summary

On May 10, 1994, the Securities and Exchange Commission (SEC) approved amendments to Schedule E to the NASD By-Laws (Schedule E) that 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 is 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 also adopted an exception to the requirement that a qualified independent underwriter provide a pricing opinion where a 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 and does not provide a pricing opinion with respect to the transaction. The text of the amendments, which took effect May 10, 1994, follows the discussion below.

Background

On May 10, 1994, the SEC approved amendments to Schedule E to the By-Laws, which prohibit 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 that arises as a result of ownership of the issuer's common equity, preferred equity, or subordinated debt or a partnership interest.1

Since 1972, Schedule E has regulated the potential conflicts of interest that exist with respect to the pricing of an offering and the conduct of due diligence when a member participates in the public distribution of its own securities, the securities of its parent, or the securities of an affiliate. The standards contained within Schedule E used to determine the presence of an affiliate relationship are either voting control through ownership of voting equity securities or common control of management through interlocking officerships or directorships.

Schedule E addresses the conflicts of interest with respect to pricing and due diligence raised when a member participates in an offering of its own securities or the securities of its parent or an affiliate 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 its parent or affiliate.

In 1989, the NASD Board of Governors asked the Corporate Financing Committee to consider whether the ownership of debt of an issuer by an NASD member that participates in an offering of an issuer's securities creates a conflict of interest and, if so, whether the conflict should be regulated by the provisions of Schedule E. The NASD was concerned about 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, which could influence the independence of members' pricing and due diligence functions in any subsequent related public offering. The Corporate Financing Committee concluded, after review of numerous leveraged buy-out offerings and discussions with several member firms, that a conflict of interest exists when a member owns subordinated debt, preferred equity, or nonvoting common equity of an issuer while engaged in an offering of the issuer's securities. In addition, as a result of its review, the Corporate Financing Committee recommended that Schedule E be amended to adopt an exception to the requirement that a qualified independent underwriter provide a pricing opinion where a 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, so long as the member does not provide a recommendation or opinion with respect to the price, yield, or exchange value of the transaction. The Board of Governors approved the recommendations of the Corporate Financing Committee. The NASD submitted the amendments to the SEC for approval and published the amendments for vote in Notice to Members 92-57 (November 1992).

In response to the publication of the proposed amendments by the SEC, one commenter noted that concerns about conflicts arising from an underwriter's ownership of issuers' debt and nonvoting equity arose as a result of the prevalence of leveraged buy-outs and bridge loans in the late 1980s and early 1990s. The commenter pointed out that these transactions are no longer prevalent and argued that the rule change should be postponed until these transactions again become prevalent. The NASD responded that a member's debt or nonvoting equity interest in an issuer can present a conflict regardless of the structure of the transaction and that, recently, companies once subject to leveraged buy-outs are now deleveraging by issuing equity. In these situations, the member, who served as financial advisor and acquired subordinated debt in the buy-out, may now serve as lead manager of the equity offering. The NASD believes that these situations raise conflicts that warrant the protections of Schedule E.

Description of Amendments

Section 1—General

The NASD is adding a new introductory paragraph to Schedule E that permits members and their associated persons to participate 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, provided that the member complies with, and the distribution conforms to, the applicable provisions of Schedule E.

Section 2 — Definitions

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

Common Equity A new definition of "common equity" includes 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.2

Conflict of Interest The principal new definition is that of "conflict of interest." 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 that 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 own a general, limited, or special partnership interest in 10 percent or more of the distributable profits or losses of a company. The term "conflict of interest" does not, by its terms, include ownership by a member, its associated persons, parent or affiliates of the common equity, preferred stock, or debt of the parent of the issuer.

The calculation of the 10 percent threshold will 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. If a member meets the 10 percent threshold at the time of filing the offering documents for review, the NASD will presume that the member who has a conflict of interest has conducted due diligence and participated in the preparation of the disclosures in the offering document. Therefore, the member's sale of sufficient securities to decrease its ownership below the 10 percent threshold after the filing of an offering will not cure the conflicts present when due diligence was conducted and the offering document prepared.

With respect to the ownership of subordinated debt, the calculation of the 10 percent threshold will be based on the issuer's entire subordinated debt outstanding, not just the class or series of subordinated debt owned by the member.

This provision sets forth exclusions from the definition of "conflict of interest" for offerings by not-for-profit and charitable organizations; investment companies registered under the Investment Company Act; "separate accounts" as denned in the Investment Company Act of 1940; real estate investment trusts; direct participation programs; financing-instrument-backed securities rated investment grade; equity securities for which a bona fide independent market exists; and debt securities rated investment grade.3

Preferred Equity The term "preferred equity" includes 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 The NASD is also adopting 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. All senior debt, whether secured or unsecured, and all short-term obligations with a maturity at issuance of less than one year are expressly excluded from the definition. The calculation of the 10 percent threshold would be applicable to an issuer's entire subordinated debt outstanding—not just to the specific class of subordinated debt owned by the member. Senior and short-term debt would, therefore, be excluded when calculating the percentage of debt that would trigger application of Schedule E.

Qualified Independent Underwriter A conforming amendment has been made to subparagraph (6) of the definition of "qualified independent underwriter" currently included in Subsection 2(1) to Schedule E, which is redesignated Subsection 2(o). Subsection 2(o) 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 modified to also 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) Section 3 is retitled "Participation in Distribution of Securities." Subsection 3(a) has been amended to require compliance with Subsections 3(b) and (c) where a member underwrites or participates as a member of the underwriting syndicate or selling group or otherwise assists 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.

Subsection 3(b) The NASD is not changing Subsection 3(b). This subsection 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.

Subsection 3(c) The NASD is amending Subsection 3(c) to require 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 associated persons, parent or affiliates have a conflict, the offering must be made in compliance with paragraph 3(c)(1). Paragraph 3(c)(1) 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 that 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 the qualified independent underwriter would recommend. 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).

The NASD is also amending paragraph 3(c)(1) to adopt an exception from the requirement that a qualified independent underwriter provide a pricing opinion where a member affiliated with the issuer or a member that has a conflict of interest is participating solely as a financial advisor in a restructuring or recapitalization and therefore the member is not obligated to and does not provide an opinion with respect to the price, yield, or exchange value of the transaction. The exception is not available for transactions involving an offering by a member of its own securities or those of a member's parent.4

Sections 4, 11, and 12

The NASD is also amending Sections 4, 11, and 12 of Schedule E to provide that the requirements with respect to disclosure, suitability, and discretionary accounts, respectively, apply to offerings by a company in which a member has a conflict of interest.

Corporate Financing Filing Requirements

The filing requirements of the Corporate Financing Rule are contained in Section (b) to Article DI, 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 E5 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 with respect to any securityholder of 5 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.

Questions regarding this Notice may be directed to the Corporate Financing Department, at (202) 728-8258.

1 Securities Exchange Act Rel. No. 34041 (May 10, 1994); 59 F.R. 25510 (May 16, 1994).

2 The NASD believes that the term "common equity" also includes warrants or rights for common equity that are exercisable within the 60-day period following the offering.

3 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 that are rated investment grade.

4 The modifications to Section 3(c) also include deletion of the words "subject to this Section without limitation as to the amount of securities to be distributed by the member," which were erroneously retained after a prior amendment deleted provisions that provided for two levels of participation in an offering by a member offering its own securities or those of a parent or affiliate, depending on whether one or two qualified independent underwriters participated in pricing and due diligence. Section 3(c) does not currently limit the percentage of a member's participation in an offering by the member subject to Schedule E. In addition, the reorganization of Subsection 3(c)(1) results in increased clarity with respect to the current requirement that the qualified independent underwriter must act as managing underwriter of an offering in which the member that is offering its own securities or those of a parent or affiliate or is subject to a conflict of interest has not been actively engaged in the investment banking or securities business for at least the five years immediately preceding the filing of the offering.

5 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.

Text Of Amendments To Schedule E Of The By-Laws

(Note: New language is underlined; deletions are in brackets.)

Schedule E

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

(a) – (d) No change.
(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.
[(e)] (f) No change.
(g) Conflict of Interest — shall be presumed 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% 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 1933:
(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.
(f) – (i) are redesignated (h) – (k) No change.
(1) 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, exchangeable or non-exchangeable, redeemable or non-redeemable, as reflected on the consolidated financial statements of the company.
(j) and (k) are redesignated (m) and (n) No change.
[1](0) Qualified independent underwriter*— a member which:
(1) – (5) No change.
(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
(7) No change.
(m) and (n) are redesignated (p) and (q) No change.
(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 than 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 or 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 firing 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 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 which shall also participate in the preparation of the registration statement and the prospectus, offering circular, or similar document and which shall exercise the usual standards of "due diligence" in respect thereto; provided, however, that
(i) 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; [or] and
(ii) the provision of this paragraph which requires that the price or yield of the securities be established based on the recommendation of a qualified independent underwriter shall not apply to an offering of equity or debt securities if:
a. the securities (except for the securities of a broker/dealer or its parent) are issued in an exchange offer or other transaction relating to a recapitalization or restructuring of a company; and
b. 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 with respect to the price, yield, or exchange value of the transaction;
(2) and (3) No change.

Section 4 – Disclosure

(a) Any member offering its securities pursuant to this schedule shall disclose in the registration statement, offering circular, or similar document a date by which the offering is reasonably expected to be completed and the terms upon which the proceeds will be released from the escrow account described in subsection 5(a).
(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 HI, 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.