[Federal Register Volume 62, Number 137 (Thursday, July 17, 1997)]
[Notices]
[Pages 38333-38335]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-18833]


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SECURITIES AND EXCHANGE COMMISSION

Release No. 34-38833; File No. SR-NASD-97-45]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc., Notice of Proposed Rule Change Relating to Modifications 
to the Definition of Qualified Independent Underwriter

July 11, 1997.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ notice is hereby given that on June 26, 1997, the 
National Association of Securities Dealers Regulation, Inc. (``NASD 
Regulation'') filed with the Securities and Exchange Commission 
(``SEC'' or ``Commission'') the proposed rule change as described in 
Items I, II, and III below, which Items have been prepared by NASD 
Regulation. The Commission is publishing this notice to solicit 
comments on the proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    NASD Regulation is proposing to amend Rule 2720 of the Conduct 
Rules of the National Association of Securities Dealers, Inc. (``NASD'' 
or ``Association''), that regulates the conduct of offerings by members 
of their own securities, those of the member's parent, or an affiliate, 
and other offerings in which a member has a conflict of interest. NASD 
Regulation proposes deleting the requirement that a qualified 
independent underwriter has had net income from operations of the 
broker/dealer entity or from the pro forma combined operations of 
predecessor broker/dealer entities, exclusive of extraordinary items, 
as computed in accordance with generally accepted accounting 
principles, in at least three of the five years immediately preceding 
the filing of the registration statement.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, NASD Regulation included 
statements concerning the purpose of and basis for the proposed rule 
change and discussed any comments it received on the proposed rule 
change. The text of these statements may be examined at the places 
specified in Item IV below. NASD Regulation has prepared summaries, set 
forth in Sections (A), (B), and (C) below, of the most significant, 
aspects of such statements.\2\
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    \2\ The text of the proposed rule change is available for review 
at the principal office of NASD Regulation and in the Commission's 
Public Reference Room.
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(A) Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    NASD Regulation is proposing to delete the eligibility criteria 
contained in the definition of ``qualified independent underwriter'' in 
NASD Rule 2720 that requires a member to have recorded net income in 
three of the five years immediately preceding the offering.
    When a member proposes to participate in the distribution of a 
public offering of its own or an affiliate's securities, or of 
securities of a company with which it otherwise has a conflict of 
interest, NASD Rule 2720 requires that the price at which an equity 
issue or the yield at which a debt issue is to be distributed to the 
public

[[Page 38334]]

must be established at a price no higher or a yield no lower than that 
recommended by a member acting as a ``qualified independent 
underwriter.'' The qualified independent underwriter must also 
participate in the preparation of the offering document and is expected 
to exercise the usual standards of due diligence in respect thereto. 
The participation of a qualified independent underwriter is intended to 
assure the public of the independence of the pricing and due diligence 
functions in a situation where a member is participating in an offering 
where the member has a conflict of interest.
    Because of the important investor protections provided by qualified 
independent underwriters, they must meet certain standards as 
prescribed in Rule 2720 of the Conduct Rules. Qualified independent 
underwriters must have a certain level of experience, demonstrated by 
having been engaged in the investment banking and securities business 
for at least five years, by recording net income in three of the five 
years immediately preceding the offering, by a majority of directors 
(or general partners) having been actively engaged in the investment 
banking and securities business for five years, and by acting as 
manager or co-manager in the underwriting of offerings of a similar 
size and type for a five-year period prior to the offering.\3\
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    \3\ In addition, qualified independent underwriters may not be 
an affiliate or own more than 5% of certain securities of the 
issuing company, are subject to provisions ensuring that associated 
persons of the member have not been convicted, suspended, barred or 
otherwise disciplined for actions related to an offering, and must 
agree to accept the legal responsibilities and liabilities of an 
underwriter under Section 11 of the Securities Act of 1933.
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    The net income requirement was adopted in 1972 as part of the 
original adoption of Rule 2720. At that time, this requirement was 
viewed as a gauge for monitoring a member's ability to act in such 
capacity. In the ensuing years, however, amendments to the definition 
of qualified independent underwriter have imposed more specific 
requirements that the NASD Regulation believes are more pertinent to 
ensuring that members have the experience and ability to be effective 
qualified independent underwriters.
    In 1988, the definition of qualified independent underwriter was 
amended to preclude a member from acting as a qualified independent 
underwriter if any of its associated persons having supervisory 
responsibility for organizing, structuring, or performing due diligence 
with respect to corporate public offerings of securities had within the 
previous five-year period been convicted, enjoined, suspended, barred, 
or otherwise subject to disciplinary action by the NASD, SEC or other 
self-regulatory organizations for violation of the anti-fraud 
provisions of the federal or state securities laws for distribution-
related activities.\4\ In addition, the amendments required a qualified 
independent underwriter to have experience in managing or co-managing 
public offerings of a size and type similar to the proposed offering. 
NASD Regulation believes the latter requirement is the most pertinent, 
because it most directly measures the member's experience in performing 
the duties and responsibilities necessary of a qualified independent 
underwriter.
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    \4\ See Securities Exchange Act Release No. 26214 (October 24, 
1988), 53 FR 43957 (order approving proposed rule change relating to 
amendment to definition of qualified independent underwriter); and 
NASD Notice to Members 88-89 (November 1988).
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    Finally, the amendments restricted the qualified independent 
underwriter's beneficial ownership of the issuer's voting equity 
securities to less than 5%. Later amendments in 1994 extended these 
ownership restrictions to non-voting equity securities, preferred 
equity and subordinated debt.\5\ NASD Regulation believes the 
amendments to the definition of qualified independent underwriter have 
significantly improved confidence in the ability, quality, and 
independence of qualified independent underwriters.
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    \5\ See Securities Exchange Act Release No. 34031 (May 10, 
1994), 59 FR 25510 (order approving proposed rule change relating to 
conflicts of interest in distribution of securities).
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    NASD Regulation believes that the net income requirement operates 
as an arbitrary standard for assessing the abilities of potential 
qualified independent underwriters, particularly where certain members 
(that may nonetheless meet high net capital requirements) intentionally 
avoid experiencing net income for tax reasons. This occurs where a 
member is organized as either a sole proprietorship, partnership, or 
subchapter S corporation that routinely distributes its net income to 
the owner, partners, or shareholders to minimize taxes. NASD Regulation 
believes the application of the net income requirement is not 
appropriate in these cases as the legal structure of the member is a 
business decision within the discretion of the member, and unrelated to 
the firm's underwriting activities.
    NASD Regulation believes a lack of net income also may not be 
directly connected to the profitability of the member's underwriting 
activities and thus, not a reliable indicia of underwriting experience, 
because the overall profitability of a member can be affected by the 
performance of other business lines within multi-functional members. 
NASD Regulation believes that losses in one or more departments of a 
member can unnecessarily disqualify a firm from acting as a qualified 
independent underwriter.\6\ Moreover, they believe lack of net income 
can reflect accounting anomalies related to infrequent events that 
result in charges against earnings for mergers, consolidations, 
restructuring, or divestitures. NASD Regulations believes the lack of 
net income is also subject to the vagaries of the market, when a 
decline in income will be attributable to trading activities rather 
than underwriting.\7\ According to NASD Regulation, this was apparent 
during the five-year periods following the market breaks that occurred 
in October 1987 and October 1989, when half of members' requests for 
relief from the net income requirement occurred.\8\
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    \6\ For example, one national broker/dealer failed the net 
income requirement due to its settlement of sales practice abuses in 
connection with the distribution of non-corporate securities, an 
activity totally unrelated to its corporate underwriting activities.
    \7\ The Corporate Financing Committee found that the net income 
requirement has the potential for increasing costs for issuers when 
the manager, co-manager, or other distribution participant is 
ineligible to act as the qualified independent underwriter due to 
the net income requirement. This will dictate the engagement of 
another member to act in that capacity for a fee instead of a 
portion of the gross spread, the cost of which may be passed on to 
the issuer. This impact is particularly felt by small issuers that 
may already be charged proportionally higher amounts of underwriting 
compensation than larger issuers by the qualified independent 
underwriter.
    \8\ Hearing Subcommittees of the Corporate Financing Committee 
have reviewed fourteen requests for exemption from proposed 
qualified independent underwriters not meeting the net income 
requirement. From 1984 to the present, Hearing Subcommittees 
provided thirteen exceptions from the net income requirement, 
relying on members' extensive underwriting experience managing or 
co-managing public offerings to compensate for any lack of ongoing 
profitability.
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    In light of the foregoing, NASD Regulation believes that the net 
income requirement may operate as an unfair barrier or restraint that 
disqualifies otherwise qualified firms from acting as qualified 
independent underwriters. NASD Regulation is therefore proposing to 
amend rule 2720 to eliminate the net income requirement due to its 
unreliability as an indicator of a members' ability to act as a 
qualified independent underwriter. NASD Regulation believes the 
elimination of the net income requirement will allow the staff to focus 
on these more substantive requirements when

[[Page 38335]]

approving members to be qualified independent underwriters.
    NASD Regulation believes that the proposed rule change is 
consistent with the provisions of Section 15A(b)(6) of the Act.\9\ in 
that the deletion of the net income requirement for qualified 
independent underwriters will eliminate a possible burden on 
competition that is not necessary in furtherance of the purposes of the 
Act and will allow the staff to focus on the more substantive 
requirements for a qualified independent underwriter in the interest of 
the public and the protection of investors.
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    \9\ 15 U.S.C. 780-3.
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(B) Self-Regulatory Organization's Statement on Burden on Competition

    NASD Regulation does not believe that the proposed rule change will 
result in any burden on competition that is not necessary or 
appropriate in furtherance of the purposes of the Act, as amended.

(C) Self-Regulatory Organization's Statement on Comments on the 
Proposed Rule Change Received From Members, Participants, or Others

    Written comments were neither solicited nor received.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:
    A. by order approve such proposed rule change, or
    B. institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing. 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 and copying in the 
Commission's Public Reference Room. Copies of such filing will also be 
available for inspection and copying at the principal office of the 
NASD. All submissions should refer to File No. SR-NASD-97-45, and 
should be submitted by August 7, 1997.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\10\
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    \10\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-18833 Filed 7-16-97; 8:45 am]
BILLING CODE 8010-01-M