NASD Solicits Comment On Proposed Amendment To The Corporate Financing Rule Relating To Rights Of First Refusal;

Comment Period Expires November 30, 1994

Executive Summary

The NASD is requesting comment on an amendment to its Corporate Financing Rule (the Rule) relating to rights of first refusal granted to underwriters and related persons in connection with the distribution of public offerings. The amendment would continue to permit the use of rights of first refusal, but would prohibit an underwriter from receiving a right of first refusal to underwrite or participate in future offerings of the issuer that has a duration of longer than three years, has more than one opportunity to waive or terminate the right in consideration of any payment or fee, and is paid other than in cash. The amendment would also require that a right of first refusal have a compensation value of the lesser of one percent of the offering proceeds or the dollar amount contractually agreed to for waiver or termination of the right. Finally, the amendment would prohibit any payment or fee to waive or terminate a right of first refusal that has a value in excess of the greater of one percent of the original offering (or an amount in excess of one percent if additional compensation is available under the compensation guideline of the original offering) or 5 percent of the underwriting discount or commission paid in connection with the future offering. The text of the amendment follows this Notice.

Background

The NASD developed its policy on the valuation of rights of first refusal in the early 1970s. Rights of first refusal are typically negotiated in connection with an issuer's initial public offering and grant the underwriter a right to underwrite or participate in any future public offerings, private placements, or other financings by the issuer for a certain period of years. The NASD values rights of first refusal as a non-cash item of compensation at one percent of the offering proceeds and currently limits the duration of the right to 5 years.¹ To the extent that an underwriting agreement includes a provision specifying a dollar amount for the waiver or termination of a right of first refusal, it has been the policy of the NASD Corporate Financing Department (the Department) to value the right of first refusal on the basis of the specified dollar amount in place of the one percent valuation.

The NASD believes that members should be permitted to negotiate to waive or terminate a right of first refusal in the event that the issuer wishes to use a different underwriter to subsequently raise additional capital through a public or private offering of its securities, provided that amounts negotiated are limited to an amount that has some relation to the size of the subsequent offering in which the member is not participating. Because use of rights of first refusal is primarily confined to certain underwriters of companies that are generally small and without significant operative history, the NASD has found that issuers negotiating with an underwriter for the first time in connection with an initial public offering often may not fully comprehend that they have agreed to extend their relationship with the underwriter for as many as five years, nor be in a position to influence the terms of the right. In addition, the NASD has observed that certain underwriters routinely negotiate to receive rights of first refusal at the time of an initial public offering and later negotiate to waive or terminate their rights, apparently without any original intent to actually underwrite any subsequent offering of securities by the issuer.

The NASD is concerned that underwriters not be permitted to avoid underwriting compensation limits by negotiating to waive or terminate a right of first refusal with no limitation whatsoever on the amount of compensation they might negotiate to receive. The NASD is also concerned that an issuer may find it difficult to negotiate appropriate underwriting compensation with a new underwriter, where the issuer has determined to sever its relationship with its former underwriter and the former underwriter requires a substantial payment to waive or terminate its right of first refusal. Finally, the NASD believes that the policy on rights of first refusal should also protect investors, who ultimately incur the cost when an issuer compensates an underwriter for waiving or terminating a right of first refusal.

NASD Proposal

The NASD is proposing to amend Section (c)(3)(A)(ix) and Section (c)(6)(B)(v) of the Rule to modify its current provisions regulating the receipt of a right of first refusal. The amendment is intended to preserve rights of first refusal as a valuable item of compensation to an underwriter, while protecting issuers from excessive payments to waive or terminate a right of first refusal granted to a former underwriter.

The amendment would prohibit an underwriter from receiving a right of first refusal that has a duration of longer than three years from the effective date of the offering. The NASD has concluded that a 5-year right is "overreaching" and determined a 3-year period more appropriate. The amendment would also prohibit a right of first refusal that grants the underwriter more than one opportunity to waive or terminate the right in consideration of any payment or fee. The NASD believes that only one payment should be received by a member for waiving a right of first refusal and that such a payment indicates that the originally negotiated relationship between the issuer and the member has been severed.

With respect to valuation of a right of first refusal in connection with the offering where the right is granted, the amendment would require that a right of first refusal have a compensation value of the lesser of one percent of the offering proceeds or the dollar amount contractually agreed to for waiver or termination of the right.

With respect to the amount of the fee permitted to be paid to a former underwriter in connection with the waiver or termination of a right of first refusal, the NASD has determined to continue to permit such payments, subject to limitations, and to not include the fee paid in connection with its review of the subsequent offering of securities. The amendment would permit the former underwriter to receive a payment or fee to waive or terminate a right of first refusal, so long as the payment or fee does not exceed the greater of one percent of the original offering (or an amount in excess of one percent if additional compensation is available under the compensation guideline of the original offering),² or 5 percent of the underwriting discount or commission paid in connection with the future offering (including any overallotment option that is exercised). The payment or fee would be permitted regardless of whether it is negotiated at the time of or subsequent to the original public offering. The NASD believes that it is appropriate that the former underwriter be permitted to negotiate a fee that is at least equal to the original valuation of the right of first refusal. With respect to the 5 percent alternative limitation, the NASD recognizes that a right of first refusal is intended to benefit the former underwriter that assumed the risk of distributing the issuer's initial public offering by allowing that underwriter to participate in the issuer's subsequent offering of securities, which is usually considerably larger. The NASD believes, therefore, that it is appropriate to permit the former underwriter to receive a fee based on the new underwriter's commission in the event that the issuer wishes to sever its relationship with the former underwriter.³

Finally, the amendment would require that any payment or fee for terminating or waiving a right of first refusal can only be in cash, not in securities or rights to acquire securities.

The NASD recognizes that a right of first refusal may be entered into between an issuer and an underwriter in connection with a private placement that occurs before a public offering, with the result that the underwriting agreement in connection with the public offering will not include this arrangement. The NASD recognizes that in most cases, the right of first refusal only relates to the right of the underwriter to distribute the subsequent public offering. In certain cases, however, the right may have a longer duration. Although private placements are not subject to the Rule, the underwriting arrangements entered into in connection with the distribution of the private placement are subject to review by the Department at the time it reviews a subsequent public offering that is subject to the Rule. Under the Rule, any compensation or securities received by the underwriter and related persons may be considered in connection with a public offering if received within the 12 months immediately preceding the filing of the public offering. The Department, therefore, intends to review any right of first refusal granted in connection with a private offering that occurs within the previous 12 months to determine if it should be considered compensation received in connection with the public offering. If the right is found to be in connection with the public offering, the terms of the right will be required to be in compliance with the Rule's limitations on rights of first refusal.

Request For Comments

The NASD encourages all members and other interested parties to comment on the proposed amendment to the Rule on rights of first refusal. Comments should be forwarded to: Joan C. Conley, Office of the Secretary, NASD, 1735 K Street, N.W., Washington, D.C. 20006-1506. Comments should be received by November 30, 1994.

Questions concerning this Notice may be directed to Richard J. Fortwengler or Paul M. Mathews, Corporate Financing Department, (301) 208-2700. Comments received on or before November 30, 1994, will be considered before final action by the Corporate Financing Committee and the NASD Board on the proposed amendment. If approved by the Committee and the Board, the amendment will be filed with the Securities and Exchange Commission (SEC). It is anticipated that the SEC will also publish the proposed amendment before acting on it. SEC approval of the amendment is required before it can become effective.

¹ See, Corporate Financing Rule at Article III, Section 44 of the Rules of Fair Practice (Corporate Financing Rule), Section (c)(3)(A)(ix) and Section (c)(6)(B)(v). NASD Manual, paragraph 2200D at pages 2206 and 2209.

² It is anticipated that the former underwriter will contact the Department when it is negotiating a waiver or termination of a right of first refusal to obtain information on whether additional compensation is available under the compensation guideline of the original offering.

³ For example, where the offering proceeds of the original offering were $10 million and the new offering was to be $150 million, with a discount of 6 percent or $9 million, the member could negotiate a fee for waiver or termination of the right of first refusal of up to $450,000 (5 percent of $6 million, or $450,000, which is greater than 1 percent of $10 million, or $100,000).

Text Of Proposed Amendment To The Corporate Financing Rule, Article III, Section 44 Of The Rules Of Fair Practice

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