[Federal Register Volume 59, Number 93 (Monday, May 16, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-11801]
[[Page Unknown]]
[Federal Register: May 16, 1994]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34031; File No. SR-NASD-92-46]
Self-Regulatory Organizations; National Association of Securities
Dealers, Inc.; Order Approving Proposed Rule Change Relating to
Conflicts of Interest in the Distribution of Securities
May 10, 1994.
On November 12, 1992, 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 NASD has amended
the filing four times, most recently on April 8, 1994.\3\ As amended,
the proposal extends the provisions of Schedule E to the NASD By-
Laws\4\ to potential conflicts of interest that arise when a member
participating in an offering owns debt, preferred equity, or non-voting
equity of the issuer.
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\1\15 U.S.C. 78s(b)(1) (1988).
\2\17 CFR 240.19b-4 (1993).
\3\The first three amendments were submitted prior to and
incorporated in the notice if filing published by the Commission.
Amendment No. 4, filed on April 8, 1994, was a technical amendment
to reflect that the proposed standard for ``conflict of interest''
is a rebuttable presumption. Amendment No. 4 also responded to a
comment letter on the filing received by the Commission.
\4\NASD Manual, (CCH) 1881.
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Notice of the proposed rule change, together with its terms of
substance, appeared in the Federal Register on September 27, 1995.\5\
The Commission received one letter commenting on the proposal. This
order approves the rule change.
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\5\Securities Exchange Act Release No. 32930 (September 21,
1993), 58 FR 50373.
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I. Text of the Proposed Rule Change
Following is the text of the proposed rule change. Additions are
italicized, deletions are in brackets.
Schedule E to the NASD By-Laws
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
* * * * *
(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 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
subordinate 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 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.
* * * * *
(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.
* * * * *
[l](o) Qualified independent underwriter*--a member which:
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*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.
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* * * * *
(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 or 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 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 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;
or
* * * * *
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 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.
II. Background
Schedule E addresses potential conflicts of interest that arise
when a member participates in the public distribution of its own
securities or the securities of an affiliate. The standards for
determining affiliation under Schedule E are voting control through
ownership of equity securities, or common control of management through
interlocking officerships or directorships. Where such conflicts exist,
and absent an investment grade rating for debt securities or a bona
fide independent market for equity securities, Schedule E requires a
qualified independent underwriter to render an opinion on the offering
price of the securities, conduct due diligence, and participate in the
preparation of the registration statement. The qualified independent
underwriter also assumes underwriter's liability for the offering. The
NASD relies 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.
After discussions with several member firms and a review of
numerous leveraged buy-out offerings, the NASD determined that a
potential conflict of interest arises when a member engaged in an
offering of the issuer's securities owns subordinated debt, voting or
non-voting equity of the issuer. The NASD is concerned about these
offerings because members and their affiliates often become holders of
subordinated debt or non-voting equity 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 proposed rule change addresses
these potential conflicts by extending Schedule E to situations in
which a member participating in a public offering of debt or equity
securities owns debt, preferred equity, or non-voting common equity of
the issuer.
III. The Proposal
The rule change prohibits members and their associated persons from
participating in the distribution of a public offering of securities if
the member and/or its associated persons, parent, or affiliates have a
conflict of interest with the issuer. For purposes of the rule change,
a ``conflict of interest'' would be presumed to exist if the member
and/or its associated persons, parent, or affiliates in the aggregate
beneficially own 10% or more of the outstanding subordinated debt,\6\
common equity,\7\ or preferred equity\8\ of the issuer. In addition, a
``conflict of interest'' would exist if the member and/or its
associated persons, parent, or affiliates beneficially owns a general,
limited, or special partnership interest in 10% or more of the
distributable profits or losses of the issuer.
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\6\The NASD has determined that subordinated debt issued in a
leveraged buy-out or restructuring transaction raises the greatest
potential for a conflict of interest. In these situations, the
subordinated debt takes on many equity characteristics and the
likelihood of repayment may be substantially based on the success of
the new offering. The NASD has not observed similar levels of
conflict arising with respect to holders of short-term or senior
debt. As a result, the rule change does not apply either to senior
debt, whether secured or unsecured, or to short-term debt with a
maturity at issuance of less than one year. The calculation of the
10% threshold is applicable to an issuer's entire subordinated debt
outstanding. The calculation of the ownership level will not be
applied to the specific issue of subordinated debt owned by the
member but to the issuer's entire subordinated debt outstanding.
\7\``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.
\8\The term ``preferred equity'' 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.
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The calculation of the 10% 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. With
respect to the ownership of subordinated debt, the calculation of the
threshold would be based on the issuer's entire subordinated debt
outstanding--not just the issue owned by the member.
The rule change exempts (1) offerings by not-for-profit and
charitable organizations; (2) investment companies registered under the
Investment Company Act of 1940; (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 which are rated investment grade; (7) equity securities for
which a bona fide independent market exists; and (8) debt securities
rated investment grade.\9\
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\9\Offerings in which the securities are being issued by a
member or an affiliate of a member are 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.
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The rule change would also require disclosure of the conflict of
interest in the offering document. The provision currently requires
that the offering document disclose (i) that the offering is being made
pursuant to the provisions of Schedule E; and (ii) the name of the
qualified independent underwriter, and that such member is acting as a
qualified independent underwriter. In the case of an offering subject
to the conflict of interest provisions, Schedule E 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.
Finally, the rule change provides an exception from the QIU pricing
requirements of Schedule E in recapitalizations or restructurings for a
member who is acting solely as financial advisor but is otherwise
subject to Schedule E because of a conflict of interest or because the
member is participating in offerings of securities of an affiliate. The
NASD believes that the more limited functions of the member acting as a
financial advisor would not require the qualified independent
underwriter to provide a pricing opinion where the financial advisor
does not participate in the pricing opinion. The exception would not be
available in the context of an offering by a member of its own
securities or those of its parent.
IV. Comments
The Commission receive one letter opposing the rule change from the
Securities Industry Association (``SIA'').\10\ The NASD responded to
these comments in Amendment No. 4. The SIA's comments and the NASD's
responses are discussed below.
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\10\Letter from David E. Rosedahl, Chairman, Federal Regulation
Committee, SIA, to Jonathan G. Katz, Secretary, SEC (December 30,
1993).
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The SIA argues that ownership of an issuer's debt or non-voting
equity securities does not demonstrate a conflict of interest requiring
regulation under Schedule E. The SIA recognizes the NASD's concern that
an underwriter could obtain practical control of an issuer through
holding a substantial amount of debt securities with ``equity-type
control powers.'' Nevertheless, the SIA argues, the concept of control
in Schedule E is sufficiently broad to cover the situation where an
underwriter obtains practical control through holding a substantial
amount of debt securities with ``equity-type control powers.''
The NASD responds that it has identified situations in which a
member's ownership of the issuer's debt or non-voting equity results in
the absence of an arm's-length bargaining relationship, potentially
compromising due diligence, disclosure, and pricing. Furthermore, the
NASD disagrees that the concept of control in Schedule E is
sufficiently broad to cover a situation where an underwriter might
obtain practical control through holding a substantial amount of debt
securities with ``equity-type control powers.'' The NASD is not aware
of any situations in which the NASD staff has based a determination of
``control'' on debt ownership, nor does it believe it can distinguish
debt securities with ``equity-type control powers.''
The SIA argues further that disclosure in the offering document of
a significant relationship between the issuer and the underwriter
should be sufficient to address such potential conflicts of interest.
The NASD responds that it relies on a number of standards of fair
practice, including disclosure, to ensure the independence of members
participating in offerings. The NASD does not believe that disclosure
of a conflict, by itself, is sufficient to address the effects to the
conflict.
The SIA also notes that concerns about conflicts arising from an
underwriter's ownership of issuers' debt and non-voting equity arose as
a result of the prevalence of leveraged buy-outs and bridge loans in
the late 1980s and early 1990s. The SIA points out that these
transactions are no longer prevalent, and argues that the rule change
should be postponed until these transactions again become prevalent.
The NASD, however, believes that a member's debt or non-voting equity
interest in an issuer can present a conflict regardless of the
structure of the transaction. The NASD notes that recently, companies
once subject to leveraged buy-outs are now de-leveraging 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 potential conflicts that warrant the protections of
Schedule E.
Finally, the SIA argues that the 10% member ownership threshold for
determining whether there is a potential conflict should not apply to
the member's holdings in an individual class of securities but rather,
to the member's combined securities holdings in the issuer.\11\ For
example, under the SIA's approach, a member with a 10% interest in the
issuer's subordinated debt would not have a conflict of interest if its
interest in all other classes of the issuer's securities including
voting and non-voting equity, does not rise to the 10% threshold. The
NASD responds that it considered this approach but determined that the
potential conflict of interest occurs in connection with significant
ownership of securities within an individual class.
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\11\The SIA also argues that the aggregation standard for
measuring ownership for a conflict of interest is more strict than
that for measuring control under the definition of affiliation. The
NASD responds that the standards are in fact the same: the NASD will
aggregate the firm's trading and proprietary accounts, the
proprietary accounts of any associated persons or employees, and any
accounts over which members or associated persons or employees
exercise beneficial ownership as defined in Rule 13(d)(3) under the
Act.
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V. Discussion
The Commission has considered the above comments and has determined
to approve the NASD's proposed rule change. The Commission recognizes
the NASD's obligation to ensure the objectivity and independence of
members participating in a securities offering. Furthermore, the
Commission recognizes that a member's holdings of subordinated debt or
non-voting equity could influence the independence of the member's
pricing and due diligence functions in a subsequent offering of the
issuer's securities. The Commission believes that the absence of an
arms-length bargaining relationship in these transactions potentially
compromises due diligence, disclosure, and pricing.
Accordingly, the Commission believes that it is appropriate to
extend the requirements of Schedule E to situations in which a member
participating in a public offering owns debt or non-voting equity of
the issuer.\12\ The Commission does not believe that disclosure of the
member's interest in the issuer, by itself, is sufficient to address
the potential conflict of interest that arises when a member holds a
substantial interest in the debt or non-voting equity of an issuer.
Rather, the Commission believes that the additional protections
provided under Schedule E--including a pricing opinion and due
diligence by a qualified independent underwriter--are necessary to
address these potential conflicts.
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\12\The Commission also recognizes that the potential conflict
of interest that arises occurs in connection with the member's
interest in an individual class of securities. The Commission thus
believes that it is appropriate to apply the 10% member ownership
threshold for determining whether there is a potential conflict to
the member's holdings in an individual class of securities, rather
than to the member's combined securities holdings in the issuer.
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Finally, the Commission believes that it is appropriate to provide
an exception from the QIU pricing requirements of Schedule E in
recapitalizations or restructurings for members who are otherwise
subject to Schedule E but are acting solely as financial advisors. The
Commission understands that in these transactions, the member acting as
financial advisor would not be participating in the pricing opinion.
Consequently, it appears that in recapitalizations or retructurings in
which the conflicted financial advisor does not participate in the
pricing of the offering, an exception from the Schedule E qualified
independent underwriter pricing opinion would not reduce investor
protections.
For these reasons, and for the reasons stated above, the Commission
finds that the proposed rule change is consistent with the requirements
of the Act and the rules and regulations thereunder applicable to the
NASD and, in particular, the requirements of section 15A(b)(6) of the
Act.\13\ Section 15A(b)(6) requires that the NASD's rules be designed
to promote just and equitable principles of trade, to foster
cooperation and coordination with person engaged in regulating,
clearing and settling, processing information with respect to, and
facilitating transactions in securities, to remove impediments to and
perfect the mechanism of a free and open market and a national market
system, and, in general, to protect investors and the public interest.
The Commission believes that the proposed rule change will prevent
manipulative acts and practices, promote just and equitable principles
of trade, and otherwise protect the public interest in connection with
offerings in which a member and/or its associated persons, parent, or
affiliates may have a conflict of interest with the issuer.
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\13\15 U.S.C. 78o-3(b)(6).
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It is therefore ordered, pursuant to section 19(b)(2) of the Act,
that the proposed rule change SR-NASD-92-46 be, and hereby is,
approved.
For the Commission, by the Division of Market Regulation
pursuant to delegated authority.\14\
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\14\17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 94-11801 Filed 5-13-94; 8:45 am]
BILLING CODE 8010-01-M
