[Federal Register Volume 60, Number 193 (Thursday, October 5, 1995)]
[Notices]
[Pages 52232-52234]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-24796]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36303; File No. SR-NASD-95-29]
Self-Regulatory Organizations; National Association of Securities
Dealers, Inc.; Order Approving Proposed Rule Change to the Corporate
Financing Rule at Article III, Section 44 of the Rules of Fair Practice
Regarding Rights of First Refusal
September 29, 1995.
I. Introduction
On June 1, 1995, the National Association of Securities Dealers,
Inc. (``NASD'' or ``Association'') filed with the Securities and
Exchange Commission (``SEC'' or ``Commission'') a proposed rule change
pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act'') \1\ and Rule 19b-4 thereunder.\2\ The rule change amends the
Rules of Fair Practice to: (a) Reduce the duration of the right of
first refusal from five years to three years; (b) limit a member to one
opportunity to waive or terminate a right of first refusal in
consideration of any payment or fee; (c) limit the amount of such
waiver/termination payments; and (d) specify
[[Page 52233]]
that compensation to members for waiving or terminating a right of
first refusal must be in the form of cash.
\1\ 15 U.S.C. 78s(b)(1) (1988).
\2\ 17 CFR 240.19b-4 (1994).
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Notice of the proposed rule change was provided by issuance of a
Commission release and by publication in the Federal Register.\3\ The
Commission received one comment in response to the release. For the
reasons discussed below, this order approves the proposed rule change.
\3\ Securities Exchange Act Release No. 35961 (July 12, 1995),
60 FR 37117 (July 19, 1995).
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II. Description of the Proposed Rule Change
The underwriting agreement between the issuer and its underwriter
often includes a provision granting the underwriter a ``right of first
refusal.'' Commonly, this provision is negotiated in connection with an
issuer's initial public offering and grants, for a certain number of
years, the underwriter a right to underwrite or participate in any
future public offerings, private placements, or other financings by the
issuer. Provided the amounts negotiated are reasonably related to the
size of the subsequent offering in which the member is not
participating, 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 in the subsequent
offering.
Typically, rights of first refusal are associated with
underwritings of small companies that lack significant operating
history and, in the NASD's experience, these companies often do not
comprehend fully the nature and extent of their relationship with the
underwriter. The NASD, therefore, believes certain minimum limitations
should be placed on the scope of rights of first refusal provisions in
underwriting agreements. Specifically, the NASD proposes to: \4\
\4\ In addition, the NASD proposes certain other technical
amendments to its Rules of Fair Practice concerning rights of first
refusal provisions.
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Decrease from five years to three years the maximum
duration for the effectiveness of a right of first refusal provision;
Limit to one the number of times compensation can be
received to waive or terminate a right of first refusal;
Limit the amount of any payment to waive or terminate a
right of first refusal to 1% of the original offering or 5% of the
underwriting discount or commission paid in connection with the future
offering; and
Require that compensation for waiving or terminating a
right of first refusal must be in the form of cash.
A. Three-Year Duration
Currently, the NASD prohibits, as unreasonable, any right of first
refusal with a duration of more than five years from the effective date
of the offering. The NASD proposes to decrease this period to three
years. In its proposal, the NASD expressed concern about whether
smaller issuers are able to evaluate fully the ramifications of
agreeing to a right of first refusal with a term of five years.
Further, the NASD is concerned that many of these provisions might not
be negotiated freely by the issuer and the underwriter. The NASD has
determined that a right of first refusal with a duration of five years
is overreaching and that a three-year period is more appropriate.
B. Number of Payments for Waiver/Termination
The NASD believes that often the right of first refusal is included
in the underwriting agreement without any original intent on the part
of the underwriter to underwrite any subsequent offerings of securities
by the issuer. Further, the NASD's experience indicates that certain
underwriters routinely receive multiple ``stand-aside'' payments, often
in cases where the underwriter is no longer providing any bona fide
services to the issuer.\5\ The NASD, therefore, proposes to limit
members to one opportunity to waive or terminate a right of first
refusal in consideration of any payment or fee.\6\
\5\ The NASD also is concerned that multiple stand-aside
payments by the issuer to a member result in difficulty for both the
member and the NASD in tracking the payments received over the term
of the right. Such tracking is important in order to insure
compliance with the Corporate Financing Rule's compensation
guidelines for the original offering. The NASD anticipates that the
former underwriter will contact the NASD Corporate Financing
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
applicable to the original offering.
\6\ An underwriter not wishing to terminate its right of first
refusal for future offerings may, however, preserve its right by
waiving its participation in a particular offering without accepting
payment for such waiver.
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C. Limitation on Waiver/Termination Compensation
The NASD continues to believe that members should be permitted to
negotiate to waive or terminate a right of first refusal. The NASD
believes, however, that the amounts negotiated for the waiver or
termination of the right should be limited to an amount that has some
relation either to the original offering or to the subsequent offering
in which the member is not participating. The NASD proposes, therefore,
to limit the amount of such waiver/termination payments. Specifically,
the NASD seeks to prohibit any payment to waive or terminate a right of
first refusal that has a value in excess of the greater of 1% of the
original offering (or a higher amount if additional compensation is
available under the compensation guideline applicable to the original
offering) or 5% of the underwriting discount or commission paid in
connection with the future offering (including any overallotment option
that may be exercised),\7\ regardless of whether the payment or fee is
negotiated at the time of or subsequent to the original public
offering.\8\
\7\ The proposed one percent limitation reflects the NASD's
belief that it is appropriate that the former underwriter be
permitted to negotiate a fee that is at least equal to the valuation
of the right of first refusal in connection with the NASD's review
of the original offering in the event that the issuer wishes to
sever its relationship with the former underwriter. The five percent
alternative limitation reflects the NASD's belief that the former
underwriter that assumed the risk of distributing the issuer's IPO
should be allowed to participate or equitably benefit from the
issuer's subsequent offering of securities, including any
overallotment option that may be exercised, regardless of whether
the payment or fee is negotiated at the time of or subsequent to the
original public offering.
\8\ The NASD does not include the payment to waive or terminate
a right of first refusal as compensation in connection with its
review of the subsequent offering of securities. The proposed rule
change does not modify this practice.
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D. Cash Payment Requirement
The NASD also proposes to require that compensation to members for
waiving or terminating a right of first refusal must be in the form of
cash. The NASD believes this provision will limit the waiver/
termination payment to a percentage of the capital raised in the
secondary offering and protect the company's shareholders from dilution
resulting from the issuance of shares to a former underwriter.
E. Additional Clarifications
The rule change also clarifies current policy that any right of
first refusal provided to the underwriter and related persons to
underwrite or participate is applicable to all future ``public''
offerings and ``private placements or other financings''. Finally, the
rule change clarifies current policy that all unreasonable terms and
arrangements, cited under Subparagraph (v) to Section 44(6)(B), shall
apply to any right of first refusal ``provided to the underwriter and
related persons to underwrite and participate in'' future public
offerings, private placements or other financings.
[[Page 52234]]
F. Effective Date of the Proposed Rule Change
The rule change will apply to filings that become effective with
the Commission on or after January 1, 1996. Thus, offerings filed with
the Corporate Financing Department of the NASD that have not become
effective with the Commission prior to January 1, 1996 will be required
to comply with the rule change, regardless of whether the Corporate
Financing Department has previously issued an opinion that it has no
objections to the terms and arrangements.
III. Comments
The Commission received one comment \9\ in response to its
publication of notice in the Federal Register. In addition, the NASD
received four comments \10\ in response to its solicitation of comment
from its membership.\11\ Generally, all the commenters opposed the
proposal.
\9\ Letter from Perry L. Taylor, Jr., Chairman, Capital Markets
Committee, Securities Industry Association, to Jonathan G. Katz,
Secretary, SEC (Aug. 29, 1995).
\10\ Letters from Stuart N. Kingoff, Associate Corporate
Counsel, Lew Lieberbaum and Co., Inc. (Nov. 18, 1994); Lawrence B.
Fisher, Kelley Drye and Warren (Nov. 30, 1994); and Bachner, Tally,
Polevoy and Misher (Nov. 30, 1994), to Joan C. Conley, Secretary,
NASD, and letter from Richard P. Woltman, President, Spelman & Co.,
Inc., to Jonathan G. Katz, Secretary, SEC (Nov. 16, 1994).
\11\ NASD Notice to Members 94-82 (Oct. 1994).
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All the significant arguments raised by the commenters were
summarized and responded to by the NASD in its proposal and were
included in the Commission's notice of publication and solicitation of
comment. Generally, commenters expressed concern that the NASD is
unnecessarily interfering with the contractual relationship between the
issuer and the underwriter, who are free to negotiate a termination of
the right if they so desire. For example, one commenter argued that the
NASD should limit its role to general review of the level of
underwriting compensation and not regulation of the ``method, manner,
nature, timing and other matters relat[ed] to [underwriting]
compensation.'' \12\
\12\ Letter from Perry L. Taylor, Jr., Chairman, Capital Markets
Committee, Securities Industry Association, to Jonathan G. Katz,
Secretary, SEC (Aug. 29, 1995).
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IV. Discussion
The Commission believes that the rule change is consistent with the
requirements of Section 15A of the Act and the rules and regulations
thereunder applicable to the NASD and, therefore, has determined to
approve the proposal. Section 15A requires that the rules of the NASD,
among other things, be designed to prevent fraudulent and manipulative
acts and practices, to promote just and equitable principles of trade,
and to remove impediments to and perfect the mechanism of a free and
open market, and, in general, to protect investors and the public
interest.\13\
\13\ 15 U.S.C. 78o-3(b)(6) (1988).
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The Commission believes this proposal strikes an appropriate
balance by allowing underwriters and issuers to continue to negotiate
compensation agreements tailored to the needs of the parties while
protecting issuers and investors from excessive and unfair payment
arrangement under these agreements. The Commission agrees that issuers
and underwriters should be allowed to enter into compensation
arrangements which include compensation for terminating a right of
first refusal. The Commission believes, however, that the NASD's
proposal to place certain limits on the terms of these provisions will
further the protection of issuers and investors and, thus, the public
interest.
V. Conclusion
For the reasons discussed, the Commission finds that the rule
change is consistent with the Act and the rules and regulations
thereunder applicable to the NASD, in a particular, Section 15A(b)(6).
It is therefore ordered, pursuant to Section 19(b)(2) of the Act,
that the proposed rule change SR-NASD-95-29 be, and hereby is,
approved.
For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\14\
\14\ 17 CFR 200.30-3(a)(12) (1994).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 95-24796 Filed 10-4-95; 8:45 am]
BILLING CODE 8010-01-M
