[Federal Register Volume 59, Number 161 (Monday, August 22, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-20479]


[[Page Unknown]]

[Federal Register: August 22, 1994]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-34533; File No. SR-NASD-93-3]

 

Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Order Approving Proposed Rule Change and Notice of 
Filing and Order Granting Partial Accelerated Approval to Amendments to 
Proposed Rule Change Relating to Limited Partnership Rollup 
Transactions

August 15, 1994.

I. Introduction

    On February 3, 1993, 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)\1\ of the Securities Exchange Act 
of 1934 (``Exchange Act''), and Rule 19b-4 thereunder.\2\ The proposal 
subsequently was amended eight times. On April 14, 1993, May 7, 1993, 
May 13, 1993, May 14, 1993, August 26, 1993, October 21, 1993,\3\ April 
14, 1994, and July 27, 1994, the NASD filed Amendment Nos. 1, 2, 3, 4, 
5, 6, 7 and 8, respectively, to the proposed rule change.\4\ The 
proposed rule change would amend Article III, Section 34 of the Rules 
of Fair Practice to include rules which prevent NASD members or persons 
associated with an NASD member from participating in any ``limited 
partnership rollup transaction'' (as defined in the proposed rule 
change) unless the transaction includes certain specified provisions 
designed to protect the rights of limited partners. The proposed rule 
change also would amend Article III, Section 34(b)(6) to narrow the 
scope of transactions in which members are forbidden to receive 
differential compensation (``Differential Compensation Amendment''). 
Finally, the proposed rule change would amend Schedule D of the By-Laws 
(``Schedule D'') to prohibit the authorization for quotation on the 
Nasdaq National Market (``Nasdaq/NM'') of any security which results 
from a covered partnership rollup transaction unless the transaction 
was conducted in accordance with certain specified procedures designed 
to protect the rights of dissenting limited partners.
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    \1\15 U.S.C. 78s(b)(1) (1988).
    \2\17 CFR 19b-4 (1993).
    \3\On December 17, 1993, the Limited Partnership Rollup Reform 
Act of 1993 (``Rollup Reform Act'') was enacted.
    \4\Amendment No. 1 superseded the original rule filing. 
Amendment No. 2 amended the rule language and the NASD's Statement 
of Purpose in response to comments of the Commission staff. 
Amendment Nos. 3 and 4 made technical changes to the rule. Notice of 
the proposed rule change (Securities Exchange Act Release No. 32312, 
May 17, 1993) was then published in the Federal Register (58 FR 
29655, May 21, 1993). Amendment No. 5 made technical changes to the 
rule text and responded to the comment letters that the Commission 
received in response to the publication of the release in the 
Federal Register. Amendment No. 6 made changes to the rule text to 
address issues of state law addressed in comment letters. Amendment 
No. 7 amended the rule language to partially conform the rule to the 
Rollup Reform Act and narrowed the scope of transactions in which 
members were forbidden to receive differential compensation. 
Amendment No. 8 amended the rule language to conform the rule to the 
Rollup Reform Act in all relevant parts and reordered the text of 
the proposed rule change in accordance with Section 34 of the Rules 
of Fair Practice.
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    Notice of the proposed rule change, together with the substance of 
the proposal as amended by Amendment Nos. 1-4, was provided by the 
issuance of a Commission release (Securities Exchange Act Release No. 
32312, May 17, 1993) and by publication in the Federal Register (58 FR 
29655, May 21, 1993). Seven comment letters were received in response 
to the Commission release. Three comment letters expressed support for 
the proposed rule change.\5\ One comment letter stated that the 
proposed rule change should not be adopted ``in the absence of a 
legislative mandate.''\6\ Three comment letters neither supported nor 
opposed the proposed rule change but offered suggestions on how to 
enhance the NASD's rule.\7\
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    \5\See letter from Michael B. Pollack, Chairman, Securities Laws 
and Regulatory Affairs Committee, Investment Program Association 
(``IPA'') to Jonathan Katz, Secretary, SEC dated June 9, 1993; 
letter from Deborah A. DeMott, Professor of Law, Duke University 
School of Law (``DeMott'') to Jonathan Katz dated June 10, 1993; and 
letter from John F. Olson and Nicholas S. Hodge, Committee on 
Federal Regulation of Securities, American Bar Association (``ABA'') 
to Jonathan Katz dated June 23, 1993.
    \6\See letter from Joe M. Bridges, President, Kelley Oil Corp. 
(``Kelley'') to Jonathan Katz dated July 6, 1993.
    \7\See letter from Gene Oshman, Baker & Botts (``Baker & 
Botts'') to Jonathan Katz dated June 10, 1993; letter from Patricia 
Magee Daly, Kutak Rock (``Kutak Rock'') to Jonathan Katz dated June 
11, 1993; letter from James E. Showen, Hogan & Hartson (``Hogan & 
Hartson'') to Jonathan Katz dated November 3, 1993.
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    The Rollup Reform Act was enacted on December 17, 1993, as part of 
the Government Securities Act Amendments of 1993. Section 3(a) of the 
Rollup Reform Act added subparagraph (12) to Section 15A(b) of the 
Exchange Act to require that the rules of a registered securities 
association prevent members of the association from participating in 
any limited partnership rollup transaction unless the transaction 
provides procedures to protect certain rights of limited partners. 
Section 3(c) of the Rollup Reform Act amended Section 15A(b) of the 
Exchange Act to require that the rules of a registered securities 
association prohibit the authorization for quotation on an automated 
interdealer quotation system sponsored by the association of any 
security designated by the SEC as a national market system security 
resulting from a rollup transaction, unless the transaction provides 
certain rights for limited partners.\8\ The NASD subsequently amended 
the proposed rule change to conform the language of the rule to the 
Rollup Reform Act.\9\
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    \8\Section 3(b) of the Rollup Reform Act added Section 6(b)(9) 
to the Exchange Act imposing virtually identical requirements upon 
national securities exchanges. See 15 U.S.C. Sec. 78f(b)(9).
    \9\See supra n. 4.
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    By this release, the Commission: (i) solicits comment on the 
Differential Compensation Amendment; (ii) approves the proposed rule 
change as amended by Amendment Nos. 1-4; and (iii) grants approval on 
an accelerated basis to Amendment Nos. 5, 6 and 8, and grants approval 
on an accelerated basis to Amendment No. 7,\10\ except for that portion 
of that Amendment proposing the Differential Compensation Amendment, 
which the Commission is not approving by this release.\11\
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    \10\Interested persons are invited to submit written data, views 
and arguments concerning Amendment Nos. 5-8 to the proposed rule 
change. See infra Section V.
    \11\The Differential Compensation Amendment would eliminate the 
definition of ``rollup of a direct participation program'' contained 
in Subsections (b)(6)(A) and (B) of Article III, Section 34, which 
prohibits the receipt of differential compensation in connection 
with the solicitation of investor votes in rollup transactions, and 
substitute the term ``limited partnership rollup transaction'' 
wherever the term ``roll-up of a direct participation program'' 
currently appears in these Subsections. The effect would be to 
permit NASD members to receive diffential compensation in connection 
with the solicitation of investor votes in any ``roll-up of a direct 
participation program'' that does not also constitute a ``limited 
partnership rollup transaction.'' See infra Section III.B.1.
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    The text of the proposed rule change is available at the Office of 
the Secretary of the NASD and at the Commission.\12\ With respect to 
the Differential Compensation Amendment, language proposed to be added 
to Subsections (b)(6)(A) and (B) of Article III, Section 34 is in 
italics; proposed deletions are in brackets.
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    \12\The NASD also will publish the text of the proposed rule 
change in an NASA Notice to Members.
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Rules of Fair Practice

Article III

* * * * *
Direct Participation Programs
Sec. 34
* * * * *
    (b)
* * * * *

Participation in Rollups

    (6)(A) No member or person associated with a member shall 
participate in the solicitation of votes or tenders from limited 
partners [participants] in connection with a limited partnership rollup 
transaction [of a direct participation program or programs] 
irrespective of the form of the resulting entity [resulting from the 
rollup] (i.e., a partnership, real estate investment trust or 
corporation), unless [such] any compensation received by the member:
    (i) is payable and equal in amount regardless of whether the 
limited partner [participant] votes affirmatively or negatively in the 
proposed limited partnership rollup transaction;
    (ii) in the aggregate, does not exceed 2% of the exchange value of 
the newly-created securities; and
    (iii) is paid regardless of whether the limited partners 
[participants] reject the proposed limited partnership rollup 
transaction.
    (B) No member or person associated with a member shall participate 
in the solicitation of votes or tenders from limited partners 
[participants] in connection with a limited partnership rollup 
transaction [of a direct participation program or programs] unless the 
general partner(s) or sponsor(s) proposing the limited partnership 
rollup transaction agrees to pay all solicitation expenses related to 
the limited partnership rollup transaction, including all preparatory 
work related thereto, in the event the limited partnership rollup 
transaction is rejected.
    [For purposes of paragraphs (A) and (B), a rollup of a direct 
participation program shall mean a transaction involving an 
acquisition, merger or consolidation of at least one direct 
participation program, not currently listed on a registered national 
securities exchange or traded on the Nasdaq System, into another public 
direct participation program or a public corporation or a public 
trust.]
* * * * *

II. Background

    During the 1980s, over $150 billion of public limited partnership 
interests were sold to U.S. investors.\13\ Sources have estimated that 
11 million investors have purchased limited partnership interests, of 
which approximately eight million are small investors, with an average 
investment of about $10,000.\14\ Limited partnership interests 
typically are risky and illiquid, due to the lack of an active trading 
market for such interests.
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    \13\S. Rep. No. 121, 103d Cong., 1st Sess. 4 (1993) (``Senate 
Report'') citing testimony of James R. Doty, General Counsel, 
Commission, ``Concerning Limited Partnership Roll-Ups,'' before the 
Subcommittee on Energy and Agricultural Taxation, Committee on 
Finance, United States Senate, July 16, 1991, at 3.
    \14\Senate Report, Supra No. 13, at 3.
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A. Structure of A Limited Partnership

    In the typical publicly-offered limited partnership, a sponsoring 
organization solicits funds from investors to use in the purchase of 
real estate, oil and gas facilities, high technology research, or other 
enterprises. The sponsor usually serves as the general partner and is 
required to manage the assets and fulfill any obligations to the 
investors imposed under the terms of the partnership agreement. The 
investors are the limited partners. A partnership agreement typically 
will provide for limited partners to receive periodic payments during 
the term of their investment, a return of their principal, and a 
specified return or profit and a portion of any additional proceeds 
upon the liquidation of the partnership assets.

B. Reasons to Invest in a Limited Partnership

    Investors purchased limited partnerships for several reasons. 
Perhaps most important, in the case of real estate partnerships prior 
to the 1986 amendments to the Internal Revenue Code (''1986 Tax Act''), 
limited partnership investors enjoyed significant tax benefits.\15\ 
Limited partnerships permitted small investors to participate in 
commercial and multi-family real estate, oil and gas facilities, and 
other investments previously limited to institutional or other large 
investors.\16\ Investors in limited partnerships were promised that 
they would realize a return on their investment within a finite period 
of time. Investors also were promised that sponsors would not realize 
any return on partnership assets until investors received their share 
of the profits.
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    \15\Id. at 5.
    \16\Id.
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C. Advantages for partnership sponsors

    Sponsors have a financial incentive to organize limited 
partnerships for at least two reasons. First, the sponsor/general 
partner expects to realize a profit on any appreciation of the assets 
after the limited partners receive their share. Second, the sponsor/
general partner derives income on an on-going basis for the management 
services provided in maintaining and operating the property. The 
general partner also may receive up-front fees for organizing the 
limited partnership.

D. Recent partnership performance

    In the late 1980s, the financial climate for limited partnership 
deteriorated dramatically. Several factors contributed to limited 
partnerships' poor performance. The 1986 Tax Act took away any tax 
benefit for limited partnership investors. Real estate and oil and gas 
markets also declined precipitously. This, together with a series of 
other circumstances, caused many general partners to face a decreasing 
revenue base and a growing number of financial problems.\17\ Since 
January 1, 1985, the number of limited partnership offerings filed with 
the Commission has decreased substantially each year, from a high of 
428 in 1985 to a low of 39 in 1991.\18\ Interests in limited 
partnerships investing in real estate lost some or all of their 
economic value due to the dramatic decline in real estate values during 
the late 1980s.
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    \17\Id.
    \18\In 1992, 50 new limited partnership offerings were filed 
with the Commission. H.R. Rep. No. 21, 103d Cong., 1st Sess. 
10(1993) (''1993 house Report'').
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    Several consequences flowed from the deteriorating climate for 
limited partnerships. Many general partners stopped raising new capital 
altogether. Sales of assets from existing partnerships exceeded any new 
capital raised, thereby eroding assets under management and 
significantly reducing general partner management fees.\19\ Some 
general partners responded to their predicament by changing the 
original partnership agreements and restructuring the limited 
partnerships by proposing to reorganize or, in many cases, ``roll up'' 
existing limited partnership interests into new, publicly-traded 
securities.
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    \19\Senate Report, supra n. 12, at 5.
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E. Rollups

    From January 1, 1985 to June 30, 1994, approximately 82 limited 
partnership rollup transactions involving two or more entities were 
registered with the Commission. These rollups have involved over 1,900 
separate limited partnerships with an estimated aggregate value well 
over seven billion dollars.
1. Rollup structure
    A typical ``rollup'' will combine several non-traded individual 
limited partnerships into a single new entity that publicly trades on a 
national securities exchange or on Nasdaq/NM. This entity generally is 
an infinite life vehicle which is designed continually to reinvest 
proceeds from asset sales, unlike the provisions limited partnerships, 
which are investments with a limited or finite term that, at some point 
in time, distribute proceeds, if any, to investors. A rollup also can 
involve the reorganization of a single partnership into a new entity.
2. Benefits of rollups
    In some cases, reorganizing non-traded public limited partnerships 
that have lost substantial value and creating a new publicly-traded, 
infinite life vehicle can enhance the value of the investments of the 
limited partners.\20\ For example, the new entity may offer investors 
liquidity previously unavailable, create economies of scale and reduce 
administrative costs to improve performance, and create broader 
diversification of assets which will improve investment safety.
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    \20\Id. at 6.
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3. Criticism of rollup
    Critics have said that the vast majority of limited partnership 
rollups result in the newly-traded security immediately falling to a 
discount to its net asset value, as cash flow from the stronger 
partnerships is used to support losses from the weaker 
partnerships.\21\ They further argue that ongoing asset management fees 
and expenses assessed by the general partners offset, and in fact may 
exceed, the promised reduced administrative costs.\22\ As a result, the 
limited partners' equity is substantially diluted. One industry witness 
testified before Congress that, in the large rollup transactions, 
limited partners have realized, on average, a drop of 45 percent from 
the exchange value on the first day of trading in their newly issued 
rollup securities.\23\ Congressional testimony also disclosed estimates 
that these limited partners when taken as a whole have lost 
approximately $2 billion in equity, while rollup sponsors have earned 
over $250 million in fees.\24\ By one estimate, when compared to 
original exchange values, investors involved in public limited 
partnership rollups have experience a decline of approximately 70 
percent in limited partner equity.\25\
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    \21\Id.
    \22\Id.
    \23\Liquidity Fund, ``Roll-up Performance: Comparison of 
Exchange Value and Closing Prices, 1st Day, 90 Days, 120 days, 
Current Market Price,'' in ``Limited Partnership Reorganizations, or 
`Roll-ups','' Hearing before the Securities Subcommittee of the 
Senate Committee on Banking, Housing and Urban Affairs, February 27, 
1991, S. Hrg. 102-77, page 29.
    \24\Senate Report, supra n. 12 at 6-7.
    \25\Id. at 7.
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    While investor complaints have been sparked by the enormous 
declines in the value of the rollup security compared with the 
``exchange value'' stated in the prospectus, rollup sponsors have 
argued that the stated exchange value is not intended to be the trading 
price of the security, and thus, such comparisons tend to overstate the 
magnitude of investor losses.\26\ However, rollup disclosure documents 
generally have proven to be almost incomprehensible and it is likely 
that sponors did not clearly disclose to investors that the stated 
exchange value is not intended to be the trading price of the 
security.\27\
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    \26\Id.
    \27\See 1993 House Report, supra n. 18, at 12:
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    Congressinonal testimony revealed at least three other forms of 
abuses in connection with rollup transactions. First, financially sound 
partnerships are merged with partnerships that are experiencing 
financial difficulty, thereby diluting the interest of the limited 
partners of the sound partnerships.\28\ Second, some general partners 
have modified the original partnership's fee structure in order to give 
much larger equity interests or fees to themselves, to the detriment of 
the limited partners.\29\ Finally, when the unattractive terms of the 
new rolled up security become apparent, the market further discounts 
the newly traded security, pushing its price even lower.
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    \28\Senate Report, supra n. 13, at 7.
    \29\Id.
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F. The Rollup Reform Act

    The seriousness of the problem with rollup disclosure documents was 
underscored by Commission Chairman Richard Breeden when he stated in 
testimony before the Senate Banking Committee in the Spring of 1991 
that, ``I have taken a look at some of the documents filed with us in 
these roll-up transactions and I would like to meet the person who can 
understand all of the disclosures in some of those documents.'' The 
Committee notes that a disclosure document which the Chairman of the 
Securities and Exchange Commission has difficulty understanding is 
likely to prove daunting in complexity to the average small investor in 
a limited partnership.
    As noted above, Section 3(a) of the Rollup Reform Act amended 
Section 15A(b) of the Exchange Act to require that the NASD rules that 
promote just and equitable principles of trade include rules to prevent 
NASD members from participating in any limited partnership rollup 
transaction that does not provide procedures to protect certain 
specified rights of limited partners. Such rights include:

    (A) The right of dissenting limited partners to:
    (i) an appraisal and compensation;
    (ii) retention of a security under substantially the same terms 
and conditions of the original issue;
    (iii) approval of the limited partnership rollup transaction by 
at least 75 percent of the outstanding interests of each 
participating limited partnership; or
    (iv) other rights designed to protect dissenting limited 
partners;
    (B) The right not to have their voting power unfairly reduced or 
abridged;
    (C) The right not to bear an unfair portion of the costs of a 
proposed rollup transaction that is rejected; and
    (D) Restrictions on the general partner's conversion of 
contingent interests or fees into non-contingent interests or fees 
and restrictions on the general partner's receipt of a non-
contingent equity interest in exchange for fees for services which 
have not yet been provided.

    The Rollup Reform Act defines a ``dissenting limited partner'' as a 
person who, on the date on which rollup soliciting material is mailed 
to investors, holds a beneficial interest in a limited partnership that 
is the subject of a limited partnership rullup transaction and who 
votes against the transaction and complies with procedures established 
by the NASD to perfect dissenter's rights.
    Section 3(c) of the Rollup Reform Act amended Section 15A(b) of the 
Exchange Act to require that the rules of a registered securities 
association prohibit the authorization for quotation on an automated 
interdealer quotation system sponsored by that association of any 
security designated by the Commission as a national market system 
security resulting from a rollup transaction, unless such transaction 
provides certain rights for limited partners. The rights set forth 
under this section are identical to those set forth in Section 3(a) for 
registered securities associations.

III. Description of Proposed Rule Change and Comments Received

    The NASD's proposed rule change would prevent its members from 
participating in any ``limited partnership rollup transaction'' as that 
term is defined in the Rollup Reform Act if the transaction does not 
provide those procedures to protect the rights of limited partners that 
are mandated by the Rollup Reform Act. The proposed rule change also 
would narrow the scope of transactions in which members are forbidden 
to receive differential compensation. Finally, the proposed rule change 
would prohibit the authorization for quotation on Nasdaq of any 
security designated by the Commission as a national market system 
security resulting from a rollup transaction, unless the transaction 
provides certain rights for dissenting limited partners.

Proposed Rule Change to Article III, Section 34

A. Definitions
    Subsequent to publication of notice of the proposed rule change, 
the NASD proposed to amend the definitions of ``dissenting limited 
partner'' and ``limited partnership rollup transaction'' to be added to 
Subsection (b)(2)(B).\30\
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    \30\The terms ``cash available for distribution,'' ``cash 
flow,'' ``limited partner,'' ``limited partnership,'' ``management 
fee,'' ``solicitation expenses,'' and ``transaction costs'' are 
adopted as published in the notice of the proposed rule change. See 
Securities Exchange Release No. 32312, supra n. 4, 58 FR 29655, 
29655-56.
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    ``Dissenting Limited Partner'' is defined in new Subsection 
(b)(2)(B)(iii), in accordance with the Rollup Reform Act, as a person 
who, on the date on which rollup soliciting material is mailed to 
investors, is a holder of a beneficial interest in a limited 
partnership that is the subject of a limited partnership rollup 
transaction and who votes against the transaction and complies with 
procedures established by the NASD to assert dissenters' rights, except 
that for purposes of an exchange or tender offer, a person must file an 
objection in writing with the party responsible for tabulating votes or 
tenders during the period in which the offer is outstanding.31
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    \3\1By defining ``dissenting limited partner'' to mean a person 
who is a holder of the limited partnership interests on the date on 
which soliciting material is mailed, persons who buy limited 
partnership interests after that date are prevented from asserting 
dissenters' rights. These persons are on notice of the proposed 
rollup transaction when they purchase their limited partnership 
interests and, therefore, do not need the same type of protections 
granted to existing limited partners.
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    ``Limited Partnership Rollup Transaction'' is defined in new 
Subsection (b)(2)(B)(vii), in accordance with the Rollup Reform Act, as 
a transaction involving the combination or reorganization of limited 
partnerships, either directly or indirectly, where some or all 
investors in the limited partnerships receive new securities or 
securities in another entity. The definition provides exceptions for 
certain kinds of private transactions or other transactions which do 
not require the application of the protections of the Exchange Act. In 
addition, the term ``limited partnership rollup transaction'' is 
defined to include the reorganization of a single limited partnership, 
directly or indirectly, in which some or all investors receive new 
securities or securities in another entity, if the transaction meets 
certain specified criteria in the Rollup Reform Act. The definition 
covers both transactions in which securities received in single or 
multiple partnership rollups are received directly, and transactions in 
which securities are received indirectly through a step 
transaction.32
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    \3\2See discussion of umbrella partnership real estate 
investment trusts (``UPREITs'') infra n. 50 and accompanying text.
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    Exclusions The definition of ``limited partnership rollup 
transaction'' also incorporates six exclusions, in accordance with the 
Rollup Reform Act. A transaction will not be deemed to be a limited 
partnership rollup transaction of it: (1) involves only a limited 
partnership or partnerships having an operating policy or practice of 
retaining cash available for distribution and reinvesting proceeds from 
the sale, financing, or refinancing of assets in accordance with such 
criteria as the Commission determines appropriate; (2) involves only 
limited partnerships wherein the interests of the limited partners are 
repurchased, recalled, or exchanged in accordance with the terms of the 
preexisting limited partnership agreements for securities in an 
operating company specifically identified at the time of the formation 
of the original limited partnership; (3) involves only securities to be 
issued or exchanged that are not required to be and are not registered 
under the Securities Act of 1933 (``Securities Act''); (4) involves 
only issuers that are not required to register or report under Section 
12 of the Exchange Act, both before and after the transaction; (5) 
involves the combination or reorganization of one or more limited 
partnerships in which a non-affiliated party succeeds to the interests 
of a general partner or sponsor, except those types of transactions as 
the Commission may by rule deem to fall within the definition of 
``limited partnership rollup transaction,'' if: (a) such action is 
approved by not less than 66\2/3\ percent of the outstanding units of 
each of the participating limited partnerships; and (b) as a result of 
the transaction, the existing general partners will receive only 
compensation to which they are entitled as expressly provided for in 
the preexisting limited partnership agreements; or (6) involves a 
transaction, except as the Commission may by rule deem to fall within 
the definition of ``limited partnership rollup transaction,'' in which 
the securities offered to investors are securities of another entity 
that are reported under a transaction reporting plan declared effective 
by the Commission under Section 11A of the Exchange Act before the date 
of enactment of the Rollup Reform Act, if: (a) such other entity was 
formed, and such class of securities was reported and regularly traded, 
not less than 12 months before the date on which soliciting material is 
mailed to investors; and (b) the securities of that entity issued to 
investors in the transaction do not exceed 20 percent of the total 
outstanding securities of the entity, exclusive of any securities of 
such class held by or for the account of the entity or a subsidiary of 
the entity.
B. Participation in Rollups
    The Commission is soliciting comment on the Differential 
Compensation Amendment. As noted above, the Differential Compensation 
Amendment would amend Subsection (b)(6) to: (i) limit the scope of the 
prohibition upon receipt of differential compensation to transactions 
constituting ``limited partnership rollup transactions'' instead of 
transactions constituting ``rollups of direct participation 
programs'';33 and (ii) prohibit the participation of members and 
persons associated with members in a limited partnership rollup 
transaction unless the transaction includes provisions designed to 
protect the rights of limited partners.34
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    \3\3Section 34(a)(2) defines ``direct participation program'' as 
``a program which provides for flow-through tax consequences 
regardless of the structure of the legal entity or vehicle for 
distribution. . . .'' (emphasis added). By contrast, new Subsection 
(b)(2)(B)(vi) defines ``limited partnership'' as a DPP organized as 
a limited partnership. (emphasis added).
    \3\4Subsection (b)(6)(C) thus would regulate a member's 
solicitation activities, advisory activities, or the writing of a 
fairness opinion. Subsections (b)(6)(A) and (B) currently regulate 
only a member's receipt of differential compensation in the 
solicitation of votes or tenders.
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    1. Receipt of Differential Compensation in DPP Rollups Not Also 
Constituting Limited Partnership Rollup Transactions. Congress began to 
focus on investor protection, fairness and disclosure issues related to 
rollup transactions in 1990. One of the early abuses on which Congress 
focussed was payment of compensation to soliciting broker-dealer only 
when an investor voted in favor of a rollup transaction. The Rollup 
Reform Act requires the NASD to adopt rules proscribing the receipt by 
members of ``differential compensation'' when soliciting votes for a 
limited partnership rollup transaction. The Commission previously had 
approved an NASD rule regulating its members' receipt of differential 
compensation in DPP rollups.\35\
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    \35\See Securities Exchange Act Release No. 29582 (Aug. 19, 
1991), 56 FR 42095 (Aug. 26, 1991) (approving SR-NASD-91-24).
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    Current Subsections (b)(6) (A) and (B) were adopted in that rule 
change to regulate the participation of members in the solicitation of 
votes or tenders from participants in a rollup of a DPP. The NASD 
stated in Amendment No. 7 that at the time of its adoption, the SEC and 
NASD were aware that the definition of ``rollup of a direct 
participation program'' was broader than the definition of ``limited 
partnership rollup transaction'' then pending in Congress (and proposed 
to be amended in this proposed rule change) because it applies to 
``direct participation programs'' rather than ``limited partnerships'' 
and does not include all of the exclusions that are available from the 
``limited partnership rollup'' definition.\36\
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    \36\But see H.R. Rep. No. 254, 102d Cong., 1st Sess. 95 (1991), 
which proposed to define ``partnership'' to include ``such other 
entity having a substantially economically equivalent form of 
ownership instrument as the Commission determines, by rule 
consistent with the purposes of [the Limited Partnership Rollup 
Reform Act of 1991], to include within this definition.''
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    The NASD continues to be concerned that it may be confusing to have 
two definitions of a rollup transaction which are different in scope 
set forth in Subsection 34(b).\37\ Therefore, the NASD is proposing to 
amend Subsections (b)(6) (A) and (B) by replacing the special rollup 
definition in those Subsections with the new definition of ``limited 
partnership rollup transaction'' and by substituting the term ``limited 
partnership rollup transaction'' wherever the term ``rollup of a direct 
participation program'' currently appears. The NASD notes that the 
result of this amendment would be to limit the scope of these 
Subsections as they would not longer be applicable to almost any DPP 
rollup, but only to ``limited partnership rollup transactions'' as 
defined in the proposed rule change.
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    \37\But see e.g., Fryer, A Rollup Update 6 (Practicing Law 
Institute Real Estate Law and Practice Course Handbook No. 400, 
1994):
    In September 1991, in Notice to Members 91-56, the NASD adopted 
rules which restrict differential compensation in connection with 
the ``rollup of a direct participation program.'' The term ``rollup 
of a direct participation program'' is a broader concept than 
``limited partnership rollup transactions'' and accordingly the 
limitations in the receipt of compensation and the allocation of 
expenses which is addressed in this earlier release will apply even 
if the transaction is not considered a ``limited partnership rollup 
transaction.''
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    The Commission notes that its rules governing roll-up 
transactions\38\ apply to transactions that involve the combination or 
reorganization of one of more finite-life limited partnerships or 
similar entities. The Commission is soliciting comment from interested 
persons concerning the potential impact of the Differential 
Compensation Amendment on the investing public.
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    \38\See Items 901-15 of Regulation S-K, 17 CFR 229.901-915 
(1993).
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    2. When a Limited Partnership Rollup Transaction is Presumed Not to 
be Unfair or Unreasonable. Pursuant to new Subsection (b)(6)(C)(i), the 
NASD proposes to define a series of circumstances with respect to 
limited partnership rollup transactions which are presumed not to be 
unfair or unreasonable. In accordance with the Rollup Reform Act, it is 
presumed not to be unfair or unreasonable if dissenting limited 
partners are offered one of the following: an appraisal and 
compensation, retention of a security with substantially the same terms 
and conditions as the original limited partnership, approval of the 
rollup transaction by not less than 75 percent of the outstanding units 
of each participating limited partnership, or other comparable rights 
designed to protect dissenting limited partners. Protections for 
limited partners also include the right of limited partners not to have 
their voting power unfairly reduced, the right of limited partners not 
to bear unfair costs associated with a rollup transaction that is 
rejected, and certain restrictions on abusive changes in management 
fees and compensation. As noted above, dissenters' rights may be 
asserted only by a person who, on the date that rollup soliciting 
material is mailed to investors, is a holder of a beneficial interest 
in the limited partnership that is the subject of the rollup. The 
proposed rule change would require a transaction constituting a 
``limited partnership rollup transaction'' to include one of the 
provisions set forth in Subsections (b)(6)(C)(i) a., b., or c., 
discussed below.
    a. Compensation Based on Appraisal: New Subsection (b)(6)(C)(i)a. 
provides that dissenting limited partners must receive compensation 
based on an appraisal made by an independent appraiser, unaffiliated 
with the sponsor or general partner of the program. The appraisal 
provided should consist of an accurate measure of the present financial 
value of the dissenting investor's ownership interest in the underlying 
assets of the limited partnership.
    Forms of compensation based on appraisal may include cash, secured 
or unsecured debt instruments, or freely-tradable securities. 
Subsection (b)(6)(C)(i) imposes several conditions upon the issuance of 
debt instruments to ensure that the debt issued is equivalent in value 
to the cash payment and, if readily marketable, would likely trade in 
an aftermarket at such value.\39\ This is intended to prevent 
dissenting investors from being forced to accept debt instruments 
which, reflecting their below-market value, would immediately trade at 
a substantial discount.
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    \39\All debt instruments must provide for a trustee and an 
indenture, and provide for prepayment with 80% of the net proceeds 
of any sale or refinancing of the assets of the entity. All debt 
instruments must provide the holders with a market rate of interest 
equal to at least 120% of the applicable federal rate and have a 
term not longer than 8 years. Unsecured debt instruments may be used 
only when the entity issuing the debt has a limitation on total 
leverage not greater than 70% of the appraised value of its assets.
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    Freely-tradable securities may be utilized as compensation only if 
issued by a company which has been listed on a national securities 
exchange or traded on the Nasdaq Stock Market prior to the transaction. 
The number of freely-tradable securities offered in return for 
partnership interests would be determined in relation to the average 
last sale price of the securities in the 20-day period following the 
date of the meeting at which the vote on the rollup occurs.\40\ If the 
issuer of the freely-tradable securities and the sponsor or general 
partner are affiliated (i.e., if it receives any material compensation 
from the issuer or its affiliates in conjunction with the rollup 
transaction or the purchase of the general partner's interest), and the 
securities issued as compensation are new securities, such securities 
must not represent more than 20% of the issued and outstanding 
securities of that class after issuance. The 20% limitation on the 
amount of securities offered as compensation by an affiliate helps to 
establish a threshold below which significant dilution could be 
presumed not to have not occurred.
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    \40\In response to a comment by the ABA, the NASD clarified that 
the ``freely-tradable securities'' referred to in Subsection 
(b)(6)(C)(i)a.4. would be valued at a 20-day period ``following the 
date of the meeting at which the vote on the limited partnership 
rollup occurs. The `vote' referred to may be a vote, consent, or 
authorization.'' See Amendment No. 5.
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    b. Receipt of a Security With Substantially the Same Terms and 
Conditions: New Subsection (b)(6)(C)(i)b. provides that dissenting 
limited partners may receive or retain a security with substantially 
the same terms and conditions as the original issue if certain 
conditions are met. Retention of a security under the same terms and 
conditions as the original issue means the provision of a security that 
has the same characteristics as the dissenting limited partners' 
original limited partnership interest.
    c. Comparable Rights: Supermajority Approval, Review by Independent 
Committee, and Other Comparable Rights: New Subsection (b)(6)(C)(i)c. 
permits members and persons associated with members to participate in a 
limited partnership rollup transaction as long as the transaction 
includes ``other comparable rights'' provisions designed to protect the 
rights of limited partners. This Subsection is intended to provide 
flexibility for sponsors and general partners in structuring rollups, 
while at the same time providing protections for limited partners. 
``Comparable rights'' may include the right to supermajority approval 
of the transaction, the right to review of the transaction by an 
independent committee, or such other rights as the NASD deems 
comparable.
    (i) Supermajority Approval. General partners will not be required 
to provide the right of compensation, as provided in new Subsection 
(b)(6)(C)(i) where at least 75% of the outstanding units of each of the 
individual limited partnerships participating approve the rollup 
transaction. Any limited partnership that fails to reach the 75% 
threshold must be excluded from the rollup transaction. The proposed 
rule change, however, would permit a limited partnership rollup 
transaction to be consummated even though individual partnerships did 
not approve the transaction.
    (ii) Review by Independent Committee. The proposed rule change 
relating to review by an independent committee will require that the 
committee: (1) Be approved by a majority of the outstanding securities 
of each participating limited partnership; (2) have access to the books 
and records of the partnership; (3) prepare a report to the limited 
partners that are the subject of the rollup presenting its findings and 
recommendations, including any minority views; (4) have the authority 
to negotiate the proposed transaction with the general partner or 
sponsor on behalf of the limited partners, but not the authority to 
approve the transaction; (5) deliberate for a period no longer than 60 
days unless unanimously agreed upon by the members of the independent 
committee or if approved by the NASD; (6) may be compensated and 
reimbursed by the partnerships subject to the limited partnership 
rollup transaction and have the ability to retain independent counsel 
and financial advisors to represent all limited partners at the limited 
partnerships' expense; and (7) be entitled to indemnification to the 
maximum extent permitted by law from the general partners, sponsors, 
limited partnerships, and rolled-up entities against claims, causes of 
action or lawsuits initiated by any party in interest, including 
limited partnerships or limited partners, related to any action or 
decision made in furtherance of their responsibilities.
    (iii) Other Comparable Rights. Comparable rights for dissenting 
limited partners are not limited to supermajority approval or the 
establishment of an independent committee, but may include any other 
comparable right proposed by general partners or sponsors, provided 
that the general partners or sponsors demonstrate to the satisfaction 
of the NASD, or if the NASD determines appropriate, to the satisfaction 
of an independent committee, that the rights proposed are 
comparable.\41\
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    \41\The composition of such independent committee to review 
proposed alternative comparable rights under this provision may be 
different than the independent committee formed pursuant to proposed 
Subsection (b)(6)(C)(i)c.2. Additionally, the criteria utilized by 
the independent committee to review proposed alternative comparable 
rights under this provision may differ from that required by the 
independent committee formed pursuant to proposed Subsection 
(b)(6)(C)(i)c.2.
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    3. When a Rollup Transaction is Presumed to be Unfair or 
Unreasonable. Regardless of compliance with Subsection (b)(6)(C)(i), a 
limited partnership rollup transaction will be presumed to be unfair or 
unreasonable, pursuant to new Subsection (b)(6)(C)(ii)\42\ if: (1) 
Certain actions taken by the general partner result in the unfair 
conversion and valuation of general partner interests in a limited 
partnership rollup transaction; (2) a limited partnership rollup 
transaction fails to protect the voting rights of the limited partners; 
(3) the transaction costs of a rejected limited partnership rollup 
transaction are unfairly apportioned or allocated; or (4) the payment 
of fees to general partners in connection with limited partnership 
rollup transactions are unfair, unreasonable, or inappropriate.
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    \42\Where a limited partnership rollup transaction is determined 
by NASD staff to include one of the arrangements considered to be 
unfair or unreasonable, the member bears the burden of rebutting the 
presumption by demonstrating that the arrangement is not unfair or 
unreasonable or that the arrangement does not come within one of the 
enumerated unfair and unreasonable arrangement provisions.
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    a. Actions Taken By the General Partner: New Subsection 
(b)(6(C)(ii)a. provides that it presumptively unfair and unreasonable 
for general partners, when determining their interest in the new entity 
resulting from a limited partnership rollup transaction, to: (1) 
convert an equity interest for which consideration has not been paid 
into a voting interest in the new entity if the equity interest was not 
otherwise provided for in the limited partnership agreement and 
disclosed to limited partners; (2) fail to follow the valuation 
methods, if any, in the partnership agreements when valuing their 
partnership interests;43 or (3) utilize a projected value of their 
equity interest rather than the appraised current value of their equity 
interest when determining their interest in the new entity.
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    \4\3In its comment letter, the ABA pointed out that partnership 
agreements do not generally contain such valuation provisions. The 
NASD amended its rule to clarify that it applies to rollups that 
contain valuation provisions. See Amendment No. 5.
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    b. Voting Rights: New Subsection (b)(6(C)(ii)b. contains four 
provisions for the protection of investors with respect to voting 
rights. New Subsection (b)(6(C)(ii)b.1. provides that it is 
presumptively unfair if the voting rights in the entity resulting from 
the limited partnerships rollup transaction do not follow the original 
voting rights of the limited partnerships participating in the 
transaction. However, the NASD recognizes that certain material changes 
to voting rights may be necessary to conform disparate rights that may 
exist among participating partnerships. Material changes may be 
effected only if the NASD determines that the changes are not unfair or 
if an independent committee approves such changes.44
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    \4\4See supra n. 41.
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    New Subsection (b)(6(C)(ii)b.2. provides that it is presumptively 
unfair if a majority45 of the interests in an entity resulting 
from a limited partnership rollup transaction is unable to vote to 
cause the entity to take certain actions which are ordinarily the 
prerogative of the owners rather than management. Thus, it is 
presumptively unfair not to permit a vote to amend the limited 
partnership agreement, articles of incorporation, bylaws, or indenture. 
It is also presumptively unfair not to permit a vote to dissolve the 
entity. It is also presumptively unfair not to permit a vote to remove 
and elect the general partners, board of directors, trustee, or similar 
governing entity. Finally, it is presumptively unfair not to permit a 
vote to approve or disapprove the sale of substantially all the assets 
of the entity, without concurrence by the sponsor, general partner(s), 
board of directors, trustee, or similar governing entity, unless such 
actions would be inconsistent with state law.46
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    \4\5The term ``majority'' refers to a 50%-plus-one vote except 
as superseded by state law or the partnership agreement which may 
require a higher standard. See Amendment No. 5.
    \4\6In response to several commenters, the NASD amended its rule 
to make it clear that it would not conflict with or supersede state 
corporate law. See infra n. 54-55 and accompanying text.
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    New Subsection (b)(6(C)(ii)b.3. provides that it is presumptively 
unfair if the sponsor or general partner proposing a limited 
partnership rollup transaction is not required to provide a document 
which clearly delineates instructions and procedures of voting against 
or dissenting from a proposed transaction.
    New Subsection (b)(6(C)(ii)b.4. provides that it is presumptively 
unfair if the general partner or sponsor fails to utilize an 
independent third party to receive and tabulate all votes and dissents 
or fails to require the third party to make the tabulation available to 
the general partner and any limited partner upon request at any time 
during and after voting occurs.
    c. Transaction Costs: Subsection (b)(6(C)(ii)c. provides that it is 
presumptively unfair if transaction costs of a rejected limited 
partnership rollup transaction are not apportioned between the general 
and limited partners in accordance with the final vote as follows: (1) 
in the case of a limited partnership rollup transaction which is not 
approved, the general partner or sponsor bears transaction costs in 
proportion to the total number of abstentions and votes to reject the 
transaction, and the limited partners bear transaction costs in 
proportion to the number of votes to approve the transaction; or (2) in 
the case of a rollup transaction which is approved, but where some 
individual partnerships do not approve and are not included in the 
approved transaction, the general partner is required to pay costs on 
behalf of the limited partnerships who have voted not to approve the 
transaction.
    With respect to allocating total costs for a rejected limited 
partnership rollup transaction, the NASD believes that subsections 
(b)(6(B) and (b)(6(C)(ii)d. taken together require the general partner 
to pay all the solicitation expenses in addition to transaction costs 
in proportion to the total number of abstentions and votes to reject 
the transaction. Additionally, limited partnerships which vote to 
reject and which are not included in a limited partnership rollup 
transaction which is ultimately consummated, may not be assessed any 
transaction costs.
    d. Fees of the General Partners: New Subsection (b)(6(C)(ii)d. 
protects limited partners against the assessment of fees by a general 
partner which are unfair, unreasonable, or inappropriate. New 
Subsection (b)(6(C)(ii)d.1. provides that it is presumptively unfair 
for general partners to receive or convert unearned management fees 
discounted to a present value while also proposing to receive new 
asset-based fees. A similar presumption of unfairness applies if 
property management fees and other fees are inappropriate, 
unreasonable, greater than or not competitive with the fees that would 
be paid to third parties for performing similar services under proposed 
Subsection (b)(6(C)(ii)d.2. Subsection (b)(6(C)(ii)d.3. provides that 
substantial and adverse changes in fees are presumed unreasonable if 
not submitted to and approved by an independent committee.47
---------------------------------------------------------------------------

    \4\7See supra n. 41.
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Proposed Rule Change to Schedule D

    The NASD is proposing to amend Part I and III to Schedule D to the 
NASD By-Laws to establish listing standards for Nasdaq/NM securities 
resulting from a limited partnership rollup transaction, as required by 
new Section 15A(b)(13) of the Exchange Act. The rule language is the 
same as that proposed for inclusion in Subsection (b) of Article III, 
Section 34 of the Rules of Fair Practice with two minor exceptions. 
When the term ``direct participation program'' is used in the 
definition section, a cross-reference is provided to the definition of 
that term in Article III, Section 34 of the Rules of Fair Practice. In 
addition, the term ``management fee'' is modified to refer only to such 
fees related to a ``limited partnership.'' In comparison, the 
definition in Article III, Section 34(b) of the Rules of Fair Practice 
substituted the term ``direct participation program'' because the term 
``management fee'' is used elsewhere in Article III, Section 34(b) of 
the Rules of Fair Practice and the definition, therefore, should be 
applicable to any DPP.\48\
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    \48\The new listing criteria for limited partnership rollups are 
included in new Section 3 to Part III of Schedule D. Current 
Sections 3 through 7 are redesignated to reflect the addition of new 
Section 3 and are amended to reference the limited partnership 
rollup criteria. Proposed Section 8 is amended to permit the NASD to 
terminate an issue's designation if it no longer complies with the 
requirements in redesignated Sections 5 and 6 or 7.
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Application of Proposed Rule Change to UPREITs

    UPREIT transactions have certain general characteristics. A limited 
partnership or partnerships are consolidated into an operating limited 
partnership. The consolidation is generally conducted as a private 
placement. In order to effect a non-taxable exchange, the individual 
limited partnership interests or the properties are exchanged for the 
operating limited partnership units.\49\ The general partner of the 
operating limited partnership, a real estate investment trust 
(``REIT''), issues beneficial interests to investors in exchange for 
cash to raise capital that will purchase some of the operating 
partnership units. The operating partnership, in turn, may use the 
proceeds to pay the debts of the limited partnerships included in the 
operating partnership. It may use the proceeds for other purposes, such 
as buying additional properties. The REIT shares may be listed on a 
national securities exchange or Nasdaq/NM and, thus, reported under a 
transaction reporting plan. As part of the transaction, the unitholders 
of the new operating partnership are generally given an open-ended 
option after one year to redeem their operating partnership units for 
cash from the REIT. Instead of offering cash, the typical REIT may, at 
its option, offer unitholders REIT units for the operating partnership 
units pursuant to a private exchange offering or a registered exchange 
offering, depending on how the offering is structured. It is, however, 
optional to the operating partnership unitholders as to whether to 
exercise the redemption right.
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    \49\Built-in gain is deferred, not eliminated. Also, the 
exchange of old partnership interests for operating partnership 
units is not necessarily tax-free under all circumstances. After the 
proceeds of the public REIT offering are used to pay down debt, if a 
partner's share of liabilities of the operating partnership is less 
than the same partner's share of liabilities of the old partnership, 
the partner will be treated as having received a cash distribution. 
If the distribution exceeds the adjusted basis in the partner's 
operating units, the partner will recognize taxable gain. If the old 
partnerships partly sell and partly contribute property to the 
operating partnership, partners in the operating partnership may 
realize phantom income.
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A. UPREIT Structures

    UPREIT transactions have varying structures. The NASD is currently 
aware of at least three structures. First, UPREITs can be structured so 
that both the consolidation of limited partnership interests into the 
operating partnership and the issuance of REIT shares to investors are 
effected pursuant to bona fide private placement exemptions under 
Section 4(2) of the Securities Act (``private placement exemption''), 
after which the operating partnership units may be redeemed for cash 
or, at the REIT's option, exchanged for REIT shares in a private 
exchange offering.
    A second structure involves the consolidation of limited partners' 
interests into the operating limited partnership in a registered 
transaction, with a simultaneous public offering of REIT units. The 
REIT shares are listed on a national securities exchange or authorized 
for quotation on Nasdaq/NM and are reported under a transaction 
reporting plan. The offer by the REIT to the limited partners in the 
operating partnership to exchange their operating partnership units for 
REIT shares is effected as a registered exchange offer.
    A third structure involves the consolidation of limited partners' 
interests into the operating limited partnership pursuant to a bona 
fide private placement exemption, along with a public offering of units 
by the REIT general partner. The REIT is listed on a national 
securities exchange or Nasdaq/NM. The REIT is thus a reporting company 
prior to any exchange offer of REIT shares for operating partnership 
units. The offer by the REIT to the limited partners in the operating 
partnership to exchange their operating partnership units for REIT 
shares is effected as a separate bona fide private placement with the 
shares then registered by the REIT for the benefit of new holders 
through a shelf-registration statement or as a registered exchange 
offer.

B. Applicability of the Proposed Rule Change to UPREIT Transactions

    As a result of an understanding reached between the staffs of the 
NASD and the SEC, the NASD's Corporate Financing Department intends to 
work closely with the SEC's Division of Corporation Finance to review 
all direct, indirect and multi-step limited partnership rollup 
transactions in their entirety, including UPREIT transactions, for an 
initial determination of whether a transaction constitutes a ``limited 
partnership rollup transaction.''
    The NASD believes that the first type of UPREIT transaction 
described above is not subject to the proposed rule change 
where the claim of a private placement exemption for the exchange offer 
is bona fide. Such a transaction does not meet the definition of 
``limited partnership rollup transaction'' because the original limited 
partners are receiving securities in the operating partnership that are 
not required to be registered under the Securities Act.
    The NASD believes that the second type of UPREIT transaction 
described above is subject to the coverage of the proposed rule change 
because the transaction viewed in its entirety meets the definition of 
``limited partnership rollup transaction'' and does not qualify for any 
of the exemptions from the definition.
    Regarding the third type of UPREIT transaction described above, the 
NASD will conduct its review of applicability of the proposed rule 
change in conjunction with the SEC's review for an initial 
determination of whether the entire transaction should be reviewed as a 
roll-up because it is a step transaction that indirectly involves a 
roll-up.\50\ In the case of a valid private placement of operating 
partnership units followed by a registered exchange of units for REIT 
shares in a short period of time, the two transactions may be stepped 
together and therefore subject to full review under the proposed rule 
change. Another situation where the proposed rule change might be 
applicable to the third type of UPREIT transaction is if the claim of a 
private placement for the consolidation into the operating partnership 
is not bona fide and the operating partnership transaction is required 
to be registered with the Commission and conducted as a public offering 
at the same time that the public REIT offering occurs. In this instance 
also, the NASD would review the transaction for compliance with the 
terms of the proposed rule change.
---------------------------------------------------------------------------

    \50\See supra n. 32 and accompanying text.
---------------------------------------------------------------------------

Comments Received on Proposed Rule Change

    The Commission received seven comment letters. The comment letters 
from the IPA, DeMott, and the ABA expressed support for the proposed 
rule change. One comment letter, from Kelley, stated that the NASD 
rules should not be adopted ``in the absence of a legislative 
mandate.'' The comment letters from Baker & Botts, Kutak Rock, and 
Hogan & Hartson neither supported nor opposed the proposed rules but 
offered suggestions on how to enhance the NASD's rule.
    As noted above, Congress passed the Rollup Reform Act subsequent to 
the receipt of the comment letters. The Rollup Reform Act rendered moot 
many of the issues raised by commenters. The significant issues that 
were raised and not subsequently mooted by the Rollup Reform Act are 
addressed below. In addition, the NASD also made several technical 
amendments in response to the comment letters.\51\
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    \51\See Amendment No. 5.
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A. Right of Compensation Based on Appraisals

    Kelly noted that some partnerships, e.g. oil and gas, already 
include requirements for a supporting appraisal underlying the exchange 
value determination. Therefore, according to Kelley, the NASD's 
requirement that dissenters' rights of compensation be based on 
appraisal, would give the dissenters the right to a second appraisal 
which would be ``redundant and wasteful.''
    The NASD has stated that ``an appraisal that functions to determine 
the transaction's exchange value could also be used to determine the 
value of dissenters's compensation so long as the appraisal is done in 
a manner consistent with the appropriate industry practice.''
    Hogan & Hartson argues that the appraisal rights provisions under 
new Subsection (b)(6)(C)(i) should be clarified to permit one 
partnership participating in a rollup to offer one type of right while 
another partnership may offer another type of right, stating that such 
an option would be satisfactory from a fairness perspective.
    New Subsection (b)(6)(C)(i) does not by its terms prohibit 
structuring a rollup offering such that different rights may be offered 
to different partnerships involved in the same transaction. Further, 
the ``other comparable rights'' provision in Subsection 
(b)(6)(C)(i)c.3. allows for variations in structuring that, subject to 
NASD approval, are indeed comparable to rights provided in the proposed 
rule change, including variations in form as well as substance.

B. Compensation of Dissenters

    Two commentators\52\ expressed concern about the use of ``freely-
tradable securities'' as compensation for dissenting limited partners, 
pursuant to new Subsection (b)(6)(C)(i)a.
---------------------------------------------------------------------------

    \52\See DeMott and Kelley.
---------------------------------------------------------------------------

    The use of a ``freely-tradable security'' as compensation is 
reasonable. The listing standards of the exchanges and of Nasdaq should 
provide adequate protection against dilution when ``freely-tradable 
securities'' are offered as compensation.
    One the issue of valuation of the ``freely-tradable securities,'' 
the ABA voiced concern about the method that the NASD will use to 
calculate the value of the securities that will be used as 
compensation. New Subsection (b)(6)(C)(i) provides that the value of 
the freely-tradable security must be determined in relation to the last 
sale price ``in the 20-day period following the effective date.'' The 
ABA noted that the ``effective date'' must refer to the effective date 
of the registration statement rather than to the closing of the rollup 
occurs.''\53\
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    \53\See Amendment No. 5.
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C. Valuation Provisions

    Subsection (b)(6)(C)(ii)a.2. provides that a rollup is presumed to 
be unfair if the general partner fails to follow the valuation 
provision in the limited partnership agreement. The ABA pointed out 
that partnership agreements do not contain such valuation provisions, 
and suggested revised language to accommodate such a contingency and 
permit reliance on ``more favorable'' valuation provisions than those 
in limited partnership agreements ``if any.''
    The NASD stated that it does not want to make determinations as to 
whether a proposed valuation method is more favorable than those 
contained in limited partnership agreements to which investors have 
previously agreed. However, the NASD amended its rule to clarify that 
Subsection (b)(6)(C)(ii)b.1. applies to rollups which contain valuation 
provisions.
    Hogan & Hartson argues that the valuation requirements in new 
Subsections (b)(6)(C)(ii)a.2. and 3. should be clarified by 
explanations of how valuation provisions of limited partnership 
agreements and utilization of current value methodology can be both 
followed in the event of inconsistency, and requests that the NASD 
explain the meaning of the terms ``current value'' and ``future value'' 
in new Subsection (b)(6)(C)(ii)a.3.
    The NASD believes that the use of a ``current value'' for 
evaluating equity interests of the roll-up partnerships when 
determining the general partner's/sponsor's interest in the new entity 
is fair because the guesswork involved in arriving at any ``future 
value'' estimate may prejudice the limited partners in favor of the 
general partners, especially if the estimated value is exaggerated. 
However, the NASD also believes that the valuation of partnership 
interests should be appropriate to the particular industry, and that is 
permissible, for example, to interpret ``current value'' on a ``going 
concern'' or ``liquidation'' basis.
    With regard to Subsection (b)(6)(C)(ii)a.2., the NASD generally 
believes that the fairest valuation method of all is that method which 
reflects, as much as possible, the original agreement or contract 
between the general partner/sponsor and limited partners. However, the 
NASD believes that if the valuation provisions of the existing 
partnership agreements require a future valuation of general partner 
interests which would be inconsistent with the proposed rule change's 
requirement that current value be used, then the requirement to use 
current value supersedes the requirement to follow valuation models in 
the original partnership agreements.

D. Voting Rights

    When the proposed rule was published in the Federal Register the 
Commission specifically sought comment on any potential conflicts 
between the NASD's proposal and state contract or corporate law. The 
Commission received four comment letters concerning a conflict between 
the voting rights provision of proposed Subsection (b)(6)(C)(ii)b.2. 
and state corporate law.\54\ The NASD amended its rule to make it clear 
that it would not conflict with or supersede state corporate law. In 
response to the Commission's concerns and the comment letters received, 
the NASD amended its rule to make it clear that the rule would not 
conflict with or preempt state corporate law.\55\
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    \54\ABA, Baker & Botts, Kelley, and DeMott. The ABA noted that 
while the NASD's rule conflicts with most state law, it does not 
conflict with the laws of some states, such as Massachusetts.
    \55\Additionally, the term ``management'' in Subsection 
(b)(6)(C)(ii)2.C. was replaced with the phrase ``general partner, 
board of directors, trustee, or similar governing entity'' to 
comport with the introductory clause of Subsection (b)(6)(C)(ii)2.C. 
See Amendment No. 6.
---------------------------------------------------------------------------

    Hogan & Hartson argued that the Rollup Reform Act did not mandate 
that the NASD impose specific voting rights, especially for the 
operating partnership in UPREITs, because very few partnership 
agreements provide for such rights in any case.
    The Commission believes that the proposed rule change does not 
impose specific voting rights. First, as noted above, the rule is 
drafted in a manner that defers to applicable state law. Second, if the 
NASD staff determines that a particular voting arrangement is 
presumptively unfair or unreasonable, the member may nonetheless rebut 
the presumption if it demonstrates that the arrangement is not unfair 
or unreasonable or that the arrangement does not come within one of the 
enumerated unfair and unreasonable arrangement provisions.

E. Transaction Costs

    New Subsection (b)(6)(C)(ii)c. requires that transaction costs be 
apportioned according to voting so that, in a rejected rollup 
transaction, the general partner bears the costs of the transaction in 
proportion to the total number of rejections and abstentions. the IPA 
suggested that it was inappropriate to require the general partner to 
bear the cost of a rejected rollup transaction in proportion to 
abstentions.\56\
---------------------------------------------------------------------------

    \56\Hogan & Hartson argued that the Rollup Reform Act does not 
mandate that the general partner or sponsor bear all the costs of a 
rejected transaction. However, new Subsection (b)(6)(C)(ii)c.1. does 
not require the general partner/sponsor to bear ``all'' costs of a 
rollup transaction that is not approved, but only those costs in 
proportion to the total number of abstentions and votes to reject 
the transaction; limited partners bear costs in proportion to the 
number or votes to approve the transaction.
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    The Commission disagrees. In proposing Subsection (b)(6)(C)(ii)c., 
the NASD stated that it intended to ``encourage general partners to 
structure a fair transaction that will be approved by limited 
partners.'' By placing the transaction costs of a rejected rollup on 
the general partner or the sponsor, the NASD is imposing the 
appropriate burden on the general partner or sponsor to structure a 
rollup in a manner intended to secure as many favorable votes as 
possible.

F. Fees to the General Partner

    New Subsection (b)(6)(C)(ii)d. sets forth criteria to use in 
determining whether fees paid to the general partner in a rollup are 
presumptively unfair. Subsection (b)(6)(C)(iv)3. provides that changes 
in fees which are substantial and adverse to limited partners are 
presumed unreasonable if not submitted to or approved by an independent 
party. In order to simplify compliance with the terms of Subsection 
(b)(6)(C)(ii)(4)(C), the IPA suggested that the NASD, in addition to an 
independent committee, be permitted to approve changes in fees which 
are substantial and adverse to limited partners.
    In its response to this comment the NASD stated that it is not 
appropriate for the NASD to make a determination to approve fees that 
are substantial or adverse to the limited partners.

G. UPREITs

    Hogan & Hartson argues that UPREIT transactions do not trigger the 
application of the proposed rule change because such transactions 
either do not come under the definition of ``limited partnership rollup 
transaction,'' or, conceding the application of the definition, meet 
the requirements of one or more transactional exemptions from the 
definition. Hogan & Hartson concludes that the only part of the entire 
UPREIT transaction under consideration is the potential redemption/
exchange of operating units for cash or REIT shares, not the initial 
consolidation of individual partnership interests into operating 
partnership units, nor the initial consolidation in conjunction with 
the redemption/exchange. Hogan & Hartson argues that the initial 
consolidation of limited partnership interests into an operating 
partnership that does not have its shares traded on an exchange or 
authorized for quotation on Nasdaq/NM does not come within the 
definition of a limited partnership rollup transaction and, thus, falls 
outside the purview of the proposed rule change.
    The Commission disagrees. UPREIT transactions should not be viewed 
in discrete stages, as if each stage in the transaction were isolated 
from any other stage, with no contemplated interrelationship between 
the partners, promoters, investors and financing plans of the 
partnership consolidation stage and the partners, promoters, investors 
and financing plans of the exchange offering stage.

V. Discussion

    The Commission finds good cause for partially approving Amendments 
5-8 on an accelerated basis.\57\ As indicated above, the Commission 
recognizes that the rule change will provide important benefits to 
investors who may be subject to limited partnership rollup transactions 
in that the amended proposed rule change will ensure that investors' 
rights are protected in accordance with the intent of Congress as 
embodied in the Rollup Reform Act. In addition, the Commission finds 
that notice in advance of approval of those Amendments intended to 
conform the proposed rule change with the Rollup Reform Act is 
unnecessary because the Rollup Reform Act itself has given interested 
parties constructive notice of pertinent terms of the Amendments. The 
Commission also finds that, except as noted above, those amendments to 
the proposed rule change not intended to conform the proposed rule 
change with the Rollup Reform Act are intended merely to clarify the 
rule change. The NASD will implement the rule change on November 1, 
1994. The Commission believes that accelerated approval will avoid 
unnecessary delay in requiring members to ensure that they participate 
in limited partnership rollup transactions only if those transactions 
provide for fair treatment of limited partnership investors, protect 
the rights of all limited partners, including dissenting limited 
partners, and do not contain unfair or unreasonable terms.
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    \57\The Commission does not find good cause for approving the 
Differential Compensation Amendment.
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    The Commission finds that, with the exception of the Differential 
Compensation Amendment, the proposed rule change is consistent with the 
provisions of Section 15A(b)(6)\58\ of the Exchange Act, which require, 
in pertinent part, that the rules of a registered securities 
association be designed to prevent fraudulent and manipulative acts, 
promote just and equitable principles of trade, and protect investors 
and the public interest; the provisions of Section 15A(b)(12)\59\ of 
the Exchange Act, which require the rules of a registered securities 
association to promote just and equitable principles of trade include 
rules to prevent members of the association from participating in any 
limited partnership rollup transaction that does not provide procedures 
to protect certain specified rights of limited partners; and the 
provisions of Section 15A(b)(13)\60\ of the Exchange Act, which require 
that the rules of a registered securities association prohibit the 
authorization for quotation on an automated interdealer quotation 
system sponsored by the association any security designated by the SEC 
as a national market system security resulting from a limited 
partnership rollup transaction, unless such transaction provides 
certain rights for limited partners. The proposed rule change will 
restrict member participation in unfair rollup transactions and 
prohibit inclusion in Nasdaq/NM of any securities resulting from an 
unfair rollup transaction.
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    \58\15 U.S.C. Sec. 78o-3(b)(6).
    \59\15 U.S.C. Sec. 78o-3(b)(12).
    \60\Id.
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    The Rollup Reform Act reflects a brief that partnership rollup 
transactions, when properly structured, may offer significant benefits 
to investors and for businesses that have used these structures to 
raise capital. However, Congress has determined that abusive limited 
partnership rollup transactions harm investors, undermine investor 
confidence and threaten capital formation.\61\ The proposed rule change 
will permit rollups to take place but will curtail the abusive 
practices that have occurred in the past. The proposed rule change is 
designed to ensure the fairness of partnership rollup to the limited 
partners by giving dissenters the right to compensation, based on 
appraisal, rather than being forced into a rollup. In addition the 
proposed rule change contains provisions which prevent the unfair 
conversion and valuation of the general partner's interests in a rollup 
transaction, prevent investors' voting rights from being unfairly 
reduced or abridged, prevent the limited partners from having to bear 
an unfair portion of the cost of a transaction that has been rejected, 
and prevent the payment of fees to general partners in connection with 
a rollup that are unfair, unreasonable, or inappropriate.
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    \61\Senate Report, supra n. 9, at 9.
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    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment Nos. 5-8. Persons making written 
submissions should file six copies thereof with the Secretary, 
Securities and Exchange Commission, 450 Fifth Street, NW., Washington, 
DC 20549. Copies of the submission, all subsequent amendments, all 
written statements with respect to the proposed rule change that are 
filed with the Commission, and all written communications relating to 
the proposed rule change between the Commission and any person, other 
than those that may be withheld from the public in accordance with the 
provisions of 5 U.S.C. 552, will be available for inspection an copying 
in the Commission's Public Reference Room. Copies of the filing will 
also be available for inspection and copying at the principal office of 
the NASD. All submissions should refer to SR-NASD-93-03 and should be 
submitted by September 12, 1994.
    It Is Therefore Ordered, pursuant to Section 19(b)(2)\62\ of the 
Exchange Act, that the proposed rule change SR-NASD-93-3 be, and hereby 
is approved, except with respect to that portion of Amendment No. 7 
that proposes amendments to Subsections (b)(6)(A) and (b)(6)(B) of 
Article III, Section 34 of the NASD Rules of Fair Practice. For the 
Commission, by the Division of Market Regulation, pursuant to delegated 
authority.\63\
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    \62\15 U.S.C. Sec. 78s(b)(2).
    \63\17 CFR 200.30-3(a)(12).

[FR Doc. 94-20479 Filed 8-19-94; 8:45 am]
BILLING CODE 8010-01-M