[Federal Register Volume 60, Number 193 (Thursday, October 5, 1995)]
[Notices]
[Pages 52232-52234]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-24796]



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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-36303; File No. SR-NASD-95-29]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Order Approving Proposed Rule Change to the Corporate 
Financing Rule at Article III, Section 44 of the Rules of Fair Practice 
Regarding Rights of First Refusal

September 29, 1995.

I. Introduction

    On June 1, 1995, the National Association of Securities Dealers, 
Inc. (``NASD'' or ``Association'') filed with the Securities and 
Exchange Commission (``SEC'' or ``Commission'') a proposed rule change 
pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') \1\ and Rule 19b-4 thereunder.\2\ The rule change amends the 
Rules of Fair Practice to: (a) Reduce the duration of the right of 
first refusal from five years to three years; (b) limit a member to one 
opportunity to waive or terminate a right of first refusal in 
consideration of any payment or fee; (c) limit the amount of such 
waiver/termination payments; and (d) specify 

[[Page 52233]]
that compensation to members for waiving or terminating a right of 
first refusal must be in the form of cash.

    \1\ 15 U.S.C. 78s(b)(1) (1988).
    \2\ 17 CFR 240.19b-4 (1994).
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    Notice of the proposed rule change was provided by issuance of a 
Commission release and by publication in the Federal Register.\3\ The 
Commission received one comment in response to the release. For the 
reasons discussed below, this order approves the proposed rule change.

    \3\ Securities Exchange Act Release No. 35961 (July 12, 1995), 
60 FR 37117 (July 19, 1995).
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II. Description of the Proposed Rule Change

    The underwriting agreement between the issuer and its underwriter 
often includes a provision granting the underwriter a ``right of first 
refusal.'' Commonly, this provision is negotiated in connection with an 
issuer's initial public offering and grants, for a certain number of 
years, the underwriter a right to underwrite or participate in any 
future public offerings, private placements, or other financings by the 
issuer. Provided the amounts negotiated are reasonably related to the 
size of the subsequent offering in which the member is not 
participating, the NASD believes that members should be permitted to 
negotiate to waive or terminate a right of first refusal in the event 
that the issuer wishes to use a different underwriter in the subsequent 
offering.
    Typically, rights of first refusal are associated with 
underwritings of small companies that lack significant operating 
history and, in the NASD's experience, these companies often do not 
comprehend fully the nature and extent of their relationship with the 
underwriter. The NASD, therefore, believes certain minimum limitations 
should be placed on the scope of rights of first refusal provisions in 
underwriting agreements. Specifically, the NASD proposes to: \4\

    \4\ In addition, the NASD proposes certain other technical 
amendments to its Rules of Fair Practice concerning rights of first 
refusal provisions.
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     Decrease from five years to three years the maximum 
duration for the effectiveness of a right of first refusal provision;
     Limit to one the number of times compensation can be 
received to waive or terminate a right of first refusal;
     Limit the amount of any payment to waive or terminate a 
right of first refusal to 1% of the original offering or 5% of the 
underwriting discount or commission paid in connection with the future 
offering; and
     Require that compensation for waiving or terminating a 
right of first refusal must be in the form of cash.

A. Three-Year Duration

    Currently, the NASD prohibits, as unreasonable, any right of first 
refusal with a duration of more than five years from the effective date 
of the offering. The NASD proposes to decrease this period to three 
years. In its proposal, the NASD expressed concern about whether 
smaller issuers are able to evaluate fully the ramifications of 
agreeing to a right of first refusal with a term of five years. 
Further, the NASD is concerned that many of these provisions might not 
be negotiated freely by the issuer and the underwriter. The NASD has 
determined that a right of first refusal with a duration of five years 
is overreaching and that a three-year period is more appropriate.

B. Number of Payments for Waiver/Termination

    The NASD believes that often the right of first refusal is included 
in the underwriting agreement without any original intent on the part 
of the underwriter to underwrite any subsequent offerings of securities 
by the issuer. Further, the NASD's experience indicates that certain 
underwriters routinely receive multiple ``stand-aside'' payments, often 
in cases where the underwriter is no longer providing any bona fide 
services to the issuer.\5\ The NASD, therefore, proposes to limit 
members to one opportunity to waive or terminate a right of first 
refusal in consideration of any payment or fee.\6\

    \5\ The NASD also is concerned that multiple stand-aside 
payments by the issuer to a member result in difficulty for both the 
member and the NASD in tracking the payments received over the term 
of the right. Such tracking is important in order to insure 
compliance with the Corporate Financing Rule's compensation 
guidelines for the original offering. The NASD anticipates that the 
former underwriter will contact the NASD Corporate Financing 
Department when it is negotiating a waiver or termination of a right 
of first refusal to obtain information on whether additional 
compensation is available under the compensation guideline 
applicable to the original offering.
    \6\ An underwriter not wishing to terminate its right of first 
refusal for future offerings may, however, preserve its right by 
waiving its participation in a particular offering without accepting 
payment for such waiver.
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C. Limitation on Waiver/Termination Compensation

    The NASD continues to believe that members should be permitted to 
negotiate to waive or terminate a right of first refusal. The NASD 
believes, however, that the amounts negotiated for the waiver or 
termination of the right should be limited to an amount that has some 
relation either to the original offering or to the subsequent offering 
in which the member is not participating. The NASD proposes, therefore, 
to limit the amount of such waiver/termination payments. Specifically, 
the NASD seeks to prohibit any payment to waive or terminate a right of 
first refusal that has a value in excess of the greater of 1% of the 
original offering (or a higher amount if additional compensation is 
available under the compensation guideline applicable to the original 
offering) or 5% of the underwriting discount or commission paid in 
connection with the future offering (including any overallotment option 
that may be exercised),\7\ regardless of whether the payment or fee is 
negotiated at the time of or subsequent to the original public 
offering.\8\

    \7\ The proposed one percent limitation reflects the NASD's 
belief that it is appropriate that the former underwriter be 
permitted to negotiate a fee that is at least equal to the valuation 
of the right of first refusal in connection with the NASD's review 
of the original offering in the event that the issuer wishes to 
sever its relationship with the former underwriter. The five percent 
alternative limitation reflects the NASD's belief that the former 
underwriter that assumed the risk of distributing the issuer's IPO 
should be allowed to participate or equitably benefit from the 
issuer's subsequent offering of securities, including any 
overallotment option that may be exercised, regardless of whether 
the payment or fee is negotiated at the time of or subsequent to the 
original public offering.
    \8\ The NASD does not include the payment to waive or terminate 
a right of first refusal as compensation in connection with its 
review of the subsequent offering of securities. The proposed rule 
change does not modify this practice.
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D. Cash Payment Requirement

    The NASD also proposes to require that compensation to members for 
waiving or terminating a right of first refusal must be in the form of 
cash. The NASD believes this provision will limit the waiver/
termination payment to a percentage of the capital raised in the 
secondary offering and protect the company's shareholders from dilution 
resulting from the issuance of shares to a former underwriter.

E. Additional Clarifications

    The rule change also clarifies current policy that any right of 
first refusal provided to the underwriter and related persons to 
underwrite or participate is applicable to all future ``public'' 
offerings and ``private placements or other financings''. Finally, the 
rule change clarifies current policy that all unreasonable terms and 
arrangements, cited under Subparagraph (v) to Section 44(6)(B), shall 
apply to any right of first refusal ``provided to the underwriter and 
related persons to underwrite and participate in'' future public 
offerings, private placements or other financings.

[[Page 52234]]


F. Effective Date of the Proposed Rule Change

    The rule change will apply to filings that become effective with 
the Commission on or after January 1, 1996. Thus, offerings filed with 
the Corporate Financing Department of the NASD that have not become 
effective with the Commission prior to January 1, 1996 will be required 
to comply with the rule change, regardless of whether the Corporate 
Financing Department has previously issued an opinion that it has no 
objections to the terms and arrangements.

III. Comments

    The Commission received one comment \9\ in response to its 
publication of notice in the Federal Register. In addition, the NASD 
received four comments \10\ in response to its solicitation of comment 
from its membership.\11\ Generally, all the commenters opposed the 
proposal.

    \9\ Letter from Perry L. Taylor, Jr., Chairman, Capital Markets 
Committee, Securities Industry Association, to Jonathan G. Katz, 
Secretary, SEC (Aug. 29, 1995).
    \10\ Letters from Stuart N. Kingoff, Associate Corporate 
Counsel, Lew Lieberbaum and Co., Inc. (Nov. 18, 1994); Lawrence B. 
Fisher, Kelley Drye and Warren (Nov. 30, 1994); and Bachner, Tally, 
Polevoy and Misher (Nov. 30, 1994), to Joan C. Conley, Secretary, 
NASD, and letter from Richard P. Woltman, President, Spelman & Co., 
Inc., to Jonathan G. Katz, Secretary, SEC (Nov. 16, 1994).
    \11\ NASD Notice to Members 94-82 (Oct. 1994).
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    All the significant arguments raised by the commenters were 
summarized and responded to by the NASD in its proposal and were 
included in the Commission's notice of publication and solicitation of 
comment. Generally, commenters expressed concern that the NASD is 
unnecessarily interfering with the contractual relationship between the 
issuer and the underwriter, who are free to negotiate a termination of 
the right if they so desire. For example, one commenter argued that the 
NASD should limit its role to general review of the level of 
underwriting compensation and not regulation of the ``method, manner, 
nature, timing and other matters relat[ed] to [underwriting] 
compensation.'' \12\

    \12\ Letter from Perry L. Taylor, Jr., Chairman, Capital Markets 
Committee, Securities Industry Association, to Jonathan G. Katz, 
Secretary, SEC (Aug. 29, 1995).
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IV. Discussion

    The Commission believes that the rule change is consistent with the 
requirements of Section 15A of the Act and the rules and regulations 
thereunder applicable to the NASD and, therefore, has determined to 
approve the proposal. Section 15A requires that the rules of the NASD, 
among other things, be designed to prevent fraudulent and manipulative 
acts and practices, to promote just and equitable principles of trade, 
and to remove impediments to and perfect the mechanism of a free and 
open market, and, in general, to protect investors and the public 
interest.\13\

    \13\ 15 U.S.C. 78o-3(b)(6) (1988).
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    The Commission believes this proposal strikes an appropriate 
balance by allowing underwriters and issuers to continue to negotiate 
compensation agreements tailored to the needs of the parties while 
protecting issuers and investors from excessive and unfair payment 
arrangement under these agreements. The Commission agrees that issuers 
and underwriters should be allowed to enter into compensation 
arrangements which include compensation for terminating a right of 
first refusal. The Commission believes, however, that the NASD's 
proposal to place certain limits on the terms of these provisions will 
further the protection of issuers and investors and, thus, the public 
interest.

V. Conclusion

    For the reasons discussed, the Commission finds that the rule 
change is consistent with the Act and the rules and regulations 
thereunder applicable to the NASD, in a particular, Section 15A(b)(6).
    It is therefore ordered, pursuant to Section 19(b)(2) of the Act, 
that the proposed rule change SR-NASD-95-29 be, and hereby is, 
approved.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\14\

    \14\ 17 CFR 200.30-3(a)(12) (1994).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 95-24796 Filed 10-4-95; 8:45 am]
BILLING CODE 8010-01-M