[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