[Federal Register Volume 63, Number 28 (Wednesday, February 11, 1998)]
[Notices]
[Pages 7026-7033]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-3372]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-39620; File No. SR-NASD-97-95]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by National Association of Securities Dealers, Inc. Relating to 
Amendment to the Free-Riding and Withholding Interpretation

February 4, 1998.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ notice is hereby given that on December 23, 1997, NASD 
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 National Association of 
Securities Dealers, Inc. (``NASD'' or ``Association'') Interpretative 
Material IM-2110-1 and Rule 2720, to revise certain aspects of the 
Free-Riding and Withholding Interpretation. Below is the text of the 
proposed rule change. Proposed new language is in italics; proposed 
deletions are in brackets.

IM-2110-1. ``Free-Riding and Withholding''

(a) Introduction
    (1) No change.
    (2) As in the case of any other interpretation issued by the [Board 
of Governors of the] Association, the implementation thereof is a 
function of the NASD Regulation staff [District Business Conduct 
Committee] and the [Board of Governors] NASD Regulation Board of 
Directors. Thus, the interpretation will be applied to a given factual 
situation by NASD Regulation staff, subject to oversight by the Board, 
with staff soliciting input from individuals active in the investment 
banking and securities business [who are serving on these committees or 
on the Board. They] In making such interpretations, staff and the Board 
will construe this interpretation to effectuate its overall purpose to 
assure a public distribution of securities for which there is a public 
demand.
* * * * *
    (5) The NASD Regulation staff, upon written request, may, taking 
into consideration all relevant factors, provide an exemption either 
unconditionally or on specified terms from any or all of the provisions 
of this interpretation upon a determination that such exemption is 
consistent with the purposes of the interpretation, the protection of 
investors, and the public interest. A member may appeal a decision 
issued by NASD Regulation staff to the National Adjudicatory Council 
pursuant to the Code of Procedure.
* * * * *
(b) Violations of Rule 2110
    (9) Sell any of the securities to any person, or to a member of the 
immediate family of such person, who owns or has contributed capital to 
a broker/dealer, other than solely a limited business broker/dealer as 
defined in paragraph (c) of the interpretation, or the account in which 
any such person has a beneficial interest, provided, however, that:
    (A) The prohibition shall not apply to any person who directly or 
indirectly owns any class of equity securities of, or who has made a 
contribution of capital to, a member, and whose ownership or capital 
interest is passive and is less than 10% of the equity or capital of a 
member, as long as:
    (i) such person purchases hot issues from a person other than the 
member in which it has such passive ownership and such person is not in 
a position by virtue of its passive ownership interest to direct the 
allocation of hot issues, or
    (ii) such member's shares are publicly traded on an exchange or 
Nasdaq.
    (B) This prohibition shall not apply to sales to the account of any 
person restricted under this subparagraph established for the benefit 
of bona fide public customers, including an insurance company general 
or separate account.
    (C) For purposes of this paragraph, any person with an equity 
ownership or capital interest in an entity that maintains an investment 
in a member shall be deemed to have a percentage interest of the entity 
in the member multiplied by the percentage interest of such person in 
such entity.
* * * * *
(d) Issuer-Directed Securities
    [(1) This interpretation shall apply to securities which are part 
of a public offering nothwithstanding that some or all of those 
securities are specifically directed by the issuer to accounts which 
are included within the scope of paragraph (b)(3) through (8) above. 
Therefore, if a person within the scope of those subparagraphs to whom 
securities were directed did not have the required investment history, 
the member would not be permitted to sell him such securities. Also, 
the ``disproportionate'' and ``insubstantial'' test would apply as in 
all other situations. Thus, the directing of a substantial number of 
securities to any one person would be prohibited as would the directing 
of securities to such accounts in amounts which would be 
disproportionate as compared to sales to members of the public. If such 
issuer-directed securities are sold to the issuer's employees or 
directors or potential employees or directors resulting from an 
intended merger, acquisition, or other business combination, such 
securities may be sold without limitation as to amount and regardless 
of whether such employees have an investment history as required by the 
interpretation; provided, however, that in the case of an offering of 
securities for which a bona fide independent market does not exist, 
such securities shall not be sold, transferred, assigned, pledged, or 
hypothecated for a period of three months following the effective date 
of the offering. This interpretation shall also apply to securities 
which are part of a public offering nothwithstanding that some of those 
securities are specifically directed by the issuer on a non-
underwritten basis. In such cases, the managing underwriter of the 
offering shall be responsible for issuing compliance with this 
interpretation in respect to those securities.]

[[Page 7027]]

    [(2) Notwithstanding the above, sales of issuer-directed securities 
may be made to non-employee/director restricted persons without the 
required investment history after receiving permission from the Board 
of Governors. Permission will be given only if there is a demonstration 
of valid business reasons for such sales (such as sales to distributors 
and suppliers, who are in each case incidentally restricted persons), 
and the member seeking permission is prepared to demonstrate that the 
aggregate amount of securities so sold is insubstantial and not 
disproportionate as compared to sales to members of the public, and 
that the amount sold to any one of such persons is insubstantial in 
amount; provided, however, that such securities shall not be sold, 
transferred, assigned, pledged, or hypothecated for a period of three 
months following the effective date of the offering.]
    Employees or directors of an issuer, a parent of an issuer, a 
subsidiary of an issuer, or any other entity which controls or is 
controlled by an issuer, or potential employees or directors resulting 
from an intended merger, acquisition, or other business combination of 
an issuer otherwise subject to this interpretation in paragraphs (b)(2) 
through (9) may purchase securities that are part of a public offering 
that are specifically directed by the issuer to such persons; provided, 
however, that in the case of an offering of securities for which a bona 
fide independent market does not exist, such securities shall not be 
sold, transferred, assigned, pledged, or hypothecated for a period of 
three months following the effective date of the offering.
* * * * *
(f) Investment Partnerships and Corporations
    (1) A member may not sell a hot issue to the account of any 
investment partnership or corporation, domestic or foreign (except 
companies registered under the Investment Company Act of 1940 or 
foreign investment companies as defined herein) including but not 
limited to hedge funds, investment clubs, and other like accounts 
unless the member complies with either of the following alternatives:
* * * * *
    (2) No change
    (3) An employee benefits plan qualified under The Employee 
Retirement Income Security Act shall be deemed restricted under the 
Interpretation in accordance with the following provisions:
    (A) Any plan sponsored by a broker/dealer is restricted;
    (B) Any plan sponsored by an entity that is not involved in 
financial services activities is not restricted whether or not any plan 
participants may be restricted;
    (C) Any plan sponsored by an entity that is engaged in financial 
services activities, including but not limited to, banks, insurance 
companies, investment advisors, or other money managers, is not 
restricted, provided that the plan permits participation by a broad 
class of participants and is not designed primarily for the benefit of 
restricted persons.
* * * * *
(l) Explanation of Terms
    The following explanation of terms is provided for the assistance 
of members. Other words which are defined in the By-Laws and Rules 
shall, unless the context otherwise requires, have the meaning as 
defined therein.
[(1) Associated Person
    A person associated with a member or any other broker/dealer, as 
defined in Article I of the Association's By-Laws, shall not include a 
person whose association with the member is limited to a passive 
ownership interest in the member of 10% or less, and who does not 
receive hot issues from the member in which he or she has the ownership 
interest; and that such member is not in a position to direct hot 
issues to such person.]
([2]1) Public Offering
    The term public offering shall mean any primary or secondary 
distribution of securities made pursuant to a registration statement or 
offering circular including exchange offers, rights offerings, 
offerings made pursuant to a merger or acquisition, straight debt 
offerings, and all other securities distributions of any kind 
whatsoever except any offering made pursuant to an exemption under 
Section 4(l), 4(2) or 4(6) of the Securities Act of 1933, as amended. 
The term public offering shall exclude exempted securities as defined 
in Section 3(a)(12) of the Act, and debt securities (other than debt 
securities convertible into common or preferred stock) or financing 
instrument-backed securities that are rated by a nationally recognized 
statistical rating organization in one of its four highest generic 
rating categories. The term public offering shall exclude secondary 
distributions by an issuer whose securities are actively-traded 
securities.
([3]2) Immediate Family
    The term immediate family shall include parents, mother-in-law or 
father-in-law, husband or wife, brother or sister, brother-in-law or 
sister-in-law, son-in-law or daughter-in-law, and children. In 
addition, the term shall include any other person who is supported, 
directly or indirectly, to a material extent by the member, person 
associated with the member or other person specified in paragraph 
(b)(2) above.
([4]3) Normal Investment Practice
    Normal investment practice shall mean the history of investment of 
a restricted person in an account or accounts maintained by the 
restricted person. Usually the previous one-year period of securities 
activity is the basis for determining the adequacy of a restricted 
person's investment history. Where warranted, however, a longer or 
shorter period may be reviewed. It is the responsibility of the 
registered representative effecting the allocation, as well as the 
member, to demonstrate that the restricted person's investment history 
justifies the allocation of hot issues. Copies of customer account 
statements or other records maintained by the registered representative 
or the member may be utilized to demonstrate prior investment activity. 
In analyzing a restricted person's investment history the Association 
believes the following factors should be considered:
    (A) The frequency of transactions in the account or accounts during 
that period of time. Relevant in this respect are the nature and size 
of investments.
    (B) A comparison of the dollar amount of previous transactions with 
the dollar amount of the hot-issue purchase. If a restricted person 
purchases $1,000 of a hot issue and his account revealed a series of 
purchases and sales in $100 amounts, the $1,000 purchase would not 
appear to be consistent with the restricted person's normal investment 
practice.
    (C) The practice of purchasing mainly hot issues would not 
constitute a normal investment practice. The Association does, however, 
consider as contributing to the establishment of a normal investment 
practice, the purchase of new issues which are not hot issues as well 
as secondary market transactions.
([5]4) Disproportionate
    (A) In respect to the determination of what constitutes a 
disproportionate allocation, the Association uses a guideline of 10% of 
the member's participation in the issue, however

[[Page 7028]]

acquired. It should be noted, however, that the 10% factor is merely a 
guideline and is one of a number of factors which are considered in 
reaching determinations of violations of the interpretation on the 
basis of disproportionate allocations. These other factors include, 
among other things:
    (i) The size of the participation;
    (ii) The offering price of the issue;
    (iii) The amount of securities sold to restricted accounts; and
    (iv) The price of the securities in the aftermarket.
    (B) It should be noted that disciplinary action has been taken 
against members for violations of the interpretation where the 
allocations made to restricted accounts were less than 10% of the 
member's participation. The 10% guideline is applied as to the 
aggregate of the allocations.
    (C) Notwithstanding the above, a normal unit of trading (100 shares 
or 10 bonds) will in most cases not be considered a disproportionate 
allocation regardless of the amount of the member's participation. This 
means that if the aggregate number of shares of a member's 
participation which is allocated to restricted accounts does not exceed 
a normal unit of trading, such allocation will in most cases not be 
considered disproportionate. For example, if a member receives 500 
shares of a hot issue, he may allocate 100 shares to a restricted 
account even though such allocation represents 20% of the member's 
participation. Of course, all of the remaining shares would have to be 
allocated to unrestricted accounts and all other provisions of the 
interpretation would have to be satisfied. Specifically, the allocation 
would have to be consistent with the normal investment practice of the 
account to which it was allocated and the member would not be permitted 
to sell to restricted persons who were totally prohibited from 
receiving hot issues.
([6]5) Insubstantiality
    This requirement is separate and distinct from the requirements 
relating to disproportionate allocations and normal investment 
practice. In addition, this term applies both to the aggregate of the 
securities sold to restricted accounts and to each individual 
allocation. In other words, there could be a substantial allocation to 
an individual account in violation of the interpretation and yet be no 
violation on that ground as to the total number of shares allocated to 
all accounts. The determination of whether an allocation to a 
restricted account or accounts is substantial is based upon, among 
other things, the number of shares allocated and/or the dollar amount 
of the purchase.

(6) Foreign Investment Company

    The term foreign investment company shall include any fund company 
organized under the laws of a foreign jurisdiction, which has provided 
to the member a written certification prepared by counsel admitted to 
practice law before the highest court of any state of the United States 
or such foreign jurisdiction, or by an independent certified public 
accountant licensed to practice in any state of the Untied States or 
such foreign jurisdiction, that states that:
    (A) The fund has 100 or more investors;
    (B) The fund is listed on a foreign exchange or authorized for sale 
to the public by a foreign regulatory authority;
    (C) No more than 5% of the fund assets are to be invested in the 
securities being offered, and,
    (D) Any person owning more than 5% of the shares of fund is not a 
person described in subparagraphs (b)(1), (2), (3) or (4) of the Rule, 
(7) Actively-traded securities
    (A) Actively-traded securities means securities that have an ADTV 
value of at least $1 million and are issued by an issuer whose common 
equity securities have a public float value of at least $150 million; 
provided, however, that such securities are not issued by the 
distribution participant or an affiliate of the distribution 
participant.
    (B) ``ADTV'' means the worldwide average daily trading volume, 
during the two full calendar months immediately preceding, or any 60 
consecutive calendar days ending within the 10 calendar days preceding, 
the filing of the registration statement, or, if there is no 
registration statement or if the distribution involves the sale of 
securities on a delayed basis pursuant to Securities Act Rule 415, two 
full calendar months immediately preceding, or any consecutive 60 
calendar days ending within the 10 calendar days preceding, the 
determination of the offering price.
* * * * *
2720. Distribution of Securities of Members and Affiliates--Conflicts 
of Interest
[(m) Sales to Employees--No Limitations
    Notwithstanding the provisions of IM-2110-1, ``Free-Riding and 
Withholding,'' a members may sell securities issued by a member, a 
parent of a member, an entity which who owns a member, an entity which 
owns (alone or in the aggregate with any wholly-owned, non-public 
subsidiary) at least 51% of the outstanding voting stock of a member or 
by an issuer treated as a member or parent of a member under paragraph 
(i) hereof to the member's employees' potential employees resulting 
from an intended merger, acquisition, or other business combination of 
members resulting in one public successor corporation; persons 
associated with the member; and the immediate family of such employees 
or associated persons without limitation as to amount and regardless of 
whether such persons have an investment history with the member as 
required by IM-2110-01; provided, however, that in the case of an 
offering of equity securities for which a bona fide independent market 
does not exist, such securities shall not be sold, transferred, 
assigned, pledged, or hypothecated for a period of five months 
following the effective date of the offering.]
([n]m) Filing Requirements; Coordination With Rule 2710
    (1) Notwithstanding the provisions of Rule 2710 relating to factors 
to be taken into consideration in determining underwriter's 
compensation, the value of securities of a new corporate member 
succeeding to a previously established partnership or sole 
proprietorship member acquired by such member or person associated 
therewith, or created as a result of such reorganization, shall not be 
taken into consideration in determining such compensation.
    (2) All offerings of securities included within the scope of this 
Rule shall be subject to the provisions of Rule 2710, and documents and 
filing fees relating to such offerings shall be filed with the 
Association pursuant to the provisions of that Rule. The responsibility 
for filing the required documents and fees shall be that of the member 
issuing securities, or, in the case of an issue of an affiliate, the 
managing underwriter or, if there is none, the member affiliated with 
the issuer.
    (3) All offerings included within the scope of this Rule are 
required to be filed with the Association, with the appropriate 
documents and filing fee referred to under subparagraph (2), above, 
notwithstanding the fact that the offering may otherwise be expressly 
exempted from filing under the provisions of Rule 2710.
([o]n) Predominance of Rule 2720
    If the provisions of this Rule are inconsistent with any other 
provisions

[[Page 7029]]

of the Association's By-Laws or Rules, or of any interpretation 
thereof, the provisions of this Rule shall prevail.
([p]o) Requests for Exemption From Rule 2720
    Pursuant to the Rule 9600 Series, the Association may in 
exceptional and unusual circumstances, taking into consideration all 
relevant factors, exempt a member unconditionally or on specified terms 
from any or all of the provisions of this Rule which it deems 
appropriate.
([q]p) Violation of Rule 2720
    A violation of the provisions of this Rule shall constitute a 
violation of Rule 2110, and possibly other Rules, especially Rules 2120 
and 2310, as the circumstances of the case may indicate.

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

    In its filling 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.

(A) Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

(a) Purpose
    (i) Overview of the Free-Riding and Withholding Interpretation. The 
Free-Riding and Withholding Interpretation (``Interpretation'') 
protects the integrity of the public offering system by ensuring that 
members make a bona fide public distribution at the public offering 
price of ``hot issue'' securities and do not withhold such securities 
for their own benefit or use such securities to reward other persons in 
the financial services business who are in a position to direct future 
business to the member. Improperly withholding securities or directing 
securities to other persons in the financial services business who can 
direct future business to the member leads to an impairment of public 
confidence in the fairness of the investment banking and securities 
business. The Interpretation also assures that members and participants 
in the securities industry do not take unfair advantage of their inside 
position in the industry to the detriment of public investors.
    (ii) Notice to Members 97-30 (May 1997). In March 1997, the NASD 
Regulation Board of Directors (``Board''), acting upon recommendation 
from the National Business Conduct Committee (``NBCC''),\2\ considered 
various amendments to the Interpretation. The Board submitted a series 
of proposed rule amendments to the membership for comment in Notice to 
Members 97-30 (``NTM 97-30''). The Board also decided that it would be 
appropriate to examine the entire Interpretation in the context of 
current market conditions and sought comment on whether the 
Interpretation could be simplified and made easier to follow.
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    \2\ The name of this committee has been changed to National 
Adjudicatory Council, See Securities Exchange Act Release No. 39470 
(December 19, 1997), 62 FR 67927 (December 30, 1997).
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    NASD Regulation received 22 comment letters. Most of the commenters 
did not address every proposed rule amendment, but only selected 
issues. The proposed rule amendments, the comments received, and NASD 
Regulation's response to the comments are set forth below.
(A) Treatment of Direct and/or Indirect Owners of Broker/Dealers
    In 1994, NASD Regulation amended the Interpretation's definition of 
``associated person'' to exempt certain passive investors in broker/
dealers.\3\ NASD Regulation now proposes further amendments to the 
Interpretation to address two limitations from the previous amendments. 
First, the definition of associated person as currently provided in the 
Interpretation does not include non-natural persons that have an 
ownership interest in or have contributed capital to a broker/
dealer.\4\ Second, the Interpretation does not affirmatively specify 
any ownership levels at which a natural person becomes an associated 
person by reason of his ownership interest in a broker/dealer. The 
Interpretation only states when a natural person is not an associated 
person. In NTM 97-30, NASD Regulation staff proposed modifying the 
Interpretation to create a new definition of ``restricted person'' that 
would include natural and non-natural persons that own or contribute 
capital to a broker/dealer, subject to two exceptions. The first 
exception was for passive investors that own or have contributed 10 
percent or less of the firm's equity or capital and who purchase from a 
member other than the member in which they maintain the ownership 
interest, provided that the member in which they maintain the ownership 
interest is not in a position to direct issues to the owner or 
contributor. The second exception was for persons who passively own 10 
percent or less of the shares of broker/dealers that are traded on an 
exchange or Nasdaq.
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    \3\ Securities Exchange Act Release No. 35059 (December 7, 
1994), 59 FR 64455, 64457 (December 14, 1994).
    \4\ See In re Rocena Company, Ltd., No. C07950042, National 
Business Conduct Committee, 1997 NASD Discip. LEXIS 12, (NBCC 
January 8, 1997) (holding that a non-natural person is not 
considered an associated person for purposes of the Interpretation).
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    The proposal also stated that indirect investors should be treated 
the same as direct investors. To determine whether an indirect investor 
meets the 10 percent threshold, noted above, the proposed amendment 
provided that the percentage of the direct investment is multiplied by 
the percentage interest in the investing entity. For example, an 
investor with a 50 percent investment in a investment partnership that 
in turn owns 18 percent of the equity capital of a broker/dealer would 
be deemed to own 9 percent of the broker/dealer for the purposes of the 
Interpretation.
    Generally, the commenters did not object to the application of the 
Interpretation to non-natural persons, but were concerned that as 
drafted, the Interpretation would preclude purchases of hot issues by 
any entity that owns 10 percent or more of a broker/dealer, or any 
account in which such entity had a beneficial interest. The commenters 
stated that these problems arose primarily due to the breadth of 
paragraph (b)(5) of the Interpretation, which prohibits sales of hot 
issues to any account in which a restricted person has a beneficial 
interest. Several commenters stated that the proposed revisions would 
have the effect of prohibiting participation in hot issues by all 
entities within many insurance companies in which a parent company owns 
10 percent or more of a broker/dealer. By way of example, one suggested 
that the Interpretation, as proposed, would preclude companies such as 
the American Insurance Group from purchasing hot issues for any account 
in which they have a beneficial interest.
    This result was not intended when NTM 97-30 was proposed, and NASD 
Regulation staff has revised the amendments to address these concerns. 
To avoid the effects of (b)(5), the proposed amendments no longer seek 
to redefine the term ``restricted person.'' Rather, new paragraph 
(b)(9)(A) has been created which expressly prohibits sales to any 
person, or any account in which such person has a beneficial

[[Page 7030]]

interest, who owns or has contributed capital to a broker/dealer, other 
than a limited purpose broker/dealer, with broad exceptions for passive 
ownership interests less than 10 percent. These provisions are 
consistent with the proposal in NTM 97-30. New paragraph (b)(9)(B) has 
been created to respond to the concerns of several commenters that the 
amendments proposed in NTM 97-30 would prohibit sales of hot issues to 
all entities within many insurance companies that own a broker/dealer. 
Paragraph (b)(9)(B) exempts sales of hot issues to any account 
established for the benefit of bona fide public customers of a person 
restricted pursuant to this subparagraph. The exception expressly notes 
that such accounts would include, but are not limited to, an insurance 
company's general or separate accounts. Lastly, new paragraph (b)(9)(C) 
retains the indirect ownership provisions proposed in NTM 97-30.
    Commenters also stated that the amendments proposed in NTM 97-30 
would, by virtue of paragraph (b)(5), prohibit many bank holding 
companies and industrial companies such as Ford and General Electric, 
or any account in which such companies have a beneficial interest, from 
purchasing hot issues because these companies have a wholly-owned 
broker/dealer subsidiary. NASD Regulation does not agree with the 
commenters that these entities should be able to purchase not issues 
for their proprietary accounts because passing on the benefits of hot 
issue purchases to shareholders is not equivalent to passing on 
benefits directly to bona fide public customers. Accordingly, these 
persons would be restricted from purchasing hot issues pursuant to 
proposed paragraph (b)(9). However, as discussed below in section (F), 
the Employment Retirement Income Security Act accounts of bank holding 
companies and industrial companies such as Ford and General Electric 
would normally be able to purchase hot issues.
    Another commenter asked if the proposed definition would preclude 
investment partnerships that have an equity stake in a broker/dealer 
from purchasing hot issues. This commenter argued that such investment 
partnerships should be able to purchase hot issues subject to the 
restrictions in paragraph (g) of the Interpretation. NASD Regulation 
does not believe that the purposes of paragraph (g) of the 
Interpretation are to permit investment partnerships that own 10 
percent or more of a broker/dealer to purchase hot issues. The 
paragraph (g) ``carve out'' methodology permits investment partnerships 
in which restricted persons have a beneficial interest to purchase hot 
issues so long as the profits from the hot issues are not allocated to 
any restricted persons. An investment partnership that is not otherwise 
restricted and accepts an investment from a person that is restricted 
pursuant to paragraph (b)(9) would be able to purchase hot issues as 
long as hot issue profits are segregated from the restricted person 
pursuant to the criteria of paragraph (g).
    The Securities Industry Association (``SIA'') did not object to the 
proposed definition of ``restricted person,'' but instead suggested 
that NASD Regulation use the existing definition of the term 
``affiliate'' from Rule 2720(b)(1). The SIA favored using the 
definition of ``affiliate'' because it established a rebuttable 
presumption of control. Another commenter noted that the term 
``restricted person was already used throughout the Interpretation and 
redefining it would cause confusion. NASD Regulation does not believe 
that a rebuttable presumption would be a useful concept in the context 
of the Interpretation. However, NASD Regulation appreciates that 
redefining the term ``restricted person'' as originally proposed may 
create confusion and has removed that term from the current proposal.
    Finally, one commenter argued that the Interpretation should be 
modified to provide exemptions for passive investors who contribute 10 
percent or less of a broker/dealer's capital, but did not see any 
``constructive purpose'' in holding investors in privately held firms 
to a different and ``tougher'' standard than investors in publicly 
traded firms. NASD Regulation believes as a general matter that 
publicly traded firms are less susceptible to influence by passive 
owners or investors than private firms and, thus, an exemption for such 
firms is appropriate. Passive owners or investors in private firms can 
purchase hot issues as long as they meet the criteria in paragraph 
(b)(9)(A)(i).
(B) Rated Investment Grade Debt
    Currently, debt offerings are included in the definition of 
``public offering'' in the Interpretation. In NTM 97-30, NASD 
Regulation proposed excluding rated investment grade debt offerings 
from the Interpretation on the ground that such offerings do not raise 
the same issues as equity offerings inasmuch as the price for a 
particular debt security generally fluctuates based on interest rate 
movements rather than demand factors. Based upon this rationale, NASD 
Regulation staff proposed an exception for ``non-convertible debt 
securities rated by a nationally recognized statistical rating 
organization in one of its four highest generic rating categories.''
    This proposal was enthusiastically supported by many of the 
commenters. Many commenters, however, urged NASD Regulation to go 
further. One commenter stated that all debt offerings should be 
excluded. The SIA and PSA The Bond Market Trade Association (``PSA'') 
agreed with the proposal but argued that NASD Regulation should adopt a 
``functional'' standard that would exempt all ``investment grade 
securities that trade primarily on the basis of yield and credit 
quality.'' NASD Regulation staff does not support a ``functional'' 
standard because it provides less clarity than the current proposal and 
would be difficult to administer. The SIA and PSA also both argued that 
certain convertible securities may be converted into a security other 
than common stock and that such convertible securities should be exempt 
from the Interpretation. Other commenters proposed modifying the 
exclusion to also include financing instrument-backed securities and 
various forms of convertible securities. NASD Regulation proposes 
modifying the exclusion for debt securities to include financing 
instrument-backed securities and convertible debt securities as long as 
they are not convertible into common or preferred stock. Although these 
revisions are likely to affect only a few persons, they appear 
consistent with the rationale for excluding rated investment grade 
debt.
(C) Exemptive Authority Under the Interpretation
    Presently, there is no provision in the Interpretation to allow for 
the NBCC, the Board, or NASD Regulation staff to grant general 
exemptive relief. In the past, the NBCC, relying on the NASD By-Law's 
grant of authority to the Board and its Committees, has provided 
exemptions in certain unique circumstances. NASD Rule 9600 delegates 
exemptive authority in the Interpretation to the Office of General 
Counsel. The Interpretation currently provides for exemptive relief 
solely in cases involving sales of issuer-directed securities to non-
employee/director restricted persons pursuant to paragraph (d)(2). In 
NTM 97-30, NASD Regulation stated that it believed that it was 
important to provide express authority to grant exemptions in 
individual cases, and proposed amendments accordingly. These amendments 
grant NASD Regulation staff the authority to provide exemptions, 
subject to oversight by the Board. The proposed amendments also provide 
that persons may appeal

[[Page 7031]]

decisions of NASD Regulation staff to the NBCC.
    All of the comments received on this issue expressed support for 
this proposal. The text of the proposed amendment has been modified for 
consistency with Rule 9610 and to reflect the renaming of the National 
Business Conduct Committee to the National Adjudicatory Council.
(D) Foreign Mutual Funds
    Purchases of shares of investment companies registered under the 
Investment Company Act of 1940 are exempt from the Interpretation based 
upon the rationale that the interest of any one restricted person in an 
investment company ordinarily is de minimis and because ownership of 
investment company shares generally is subject to frequent turnover, 
determining compliance with the Interpretation would be extremely 
difficult.
    NASD Regulation proposed in NTM 97-30 to extend this rationale to 
the purchase of shares of foreign investment companies. In particular, 
NASD Regulation proposed exempting sales of hot issues to a foreign 
investment company if such foreign investment company provides written 
certification from a U.S. attorney or accountant stating that: (1) The 
fund has 100 or more shareholders; (2) the fund is listed on a foreign 
exchange or authorized for sale to the public by a foreign regulatory 
authority; (3) no more than 5 percent of the fund's securities assets 
are invested in the securities being offered, and; (4) any person 
owning more than 5 percent of the shares of the fund is not a 
restricted person as defined in subparagraphs (b)(1) through (b)(4) of 
the Interpretation. These amendments seek to create roughly equivalent 
standards between U.S. and foreign investment companies.
    All of the comments received on this issue strongly supported an 
exemption from the Interpretation for foreign investment companies. The 
commenters, however, did not necessarily agree with the proposed 
attestation procedures. Many of the commenters stated that the 
requirement for a member to provide a written certification would 
impose a substantial administrative burden and cost. The SIA took the 
position that attestation should not be required at all. A few 
commenters stated that if written certification is to be required, then 
a foreign attorney or accountant should be able to make such 
certification because many foreign investment companies may be 
reluctant to hire U.S. counsel or accountants. NASD Regulation agrees 
that foreign attorneys and accountants should be able to make the 
required attestations and has modified the proposed amendments 
accordingly.
    A number of comment letters also suggested that rather than 
obtaining a written certification from the foreign investment company 
each time before a member permits it to purchase in an initial public 
offering that may become a hot issue, the NASD should develop a 
centralized electronic repository containing certifications that would 
be accessible to members. NASD Regulation preliminarily supports such 
an idea but believes that it raises a number of issues that deserve 
consideration, including who would operate the repository. NASD 
Regulation proposes communicating to the private sector its willingness 
to consider applications by firms interested in maintaining a 
centralized repository of foreign investment companies as well as any 
investment partnerships or corporations that qualify to purchase hot 
issues pursuant to paragraph (f) of the Interpretation. NASD Regulation 
also may consider operating the system itself. The operator of such a 
central repository must be concerned with maintaining accurate and 
current information, since the participants in these investment 
vehicles and their status under the Interpretation is likely to change 
from time to time. NASD Regulation agrees that a centralized repository 
may be an efficient and effective method of maintaining certifications, 
but believes that investment companies should be permitted to purchase 
hot issues subject to the verification procedures outlined in NTM 97-
30, as modified above, while NASD Regulation considers the 
implementation of a centralized repository.
(E) Secondary Offerings
    Primary and secondary distributions of securities are currently 
included in the definition of ``public offering'' under the 
Interpretation. In NTM 97-30, NASD Regulation proposed maintaining 
secondary offerings subject to the Interpretation based upon 
statistical evidence that approximately 33 percent of secondary 
offerings trade at a premium, even though such premium is generally 
small.
    A number of commenters did not believe that the Interpretation 
should apply to secondary offerings. Generally, these commenters noted 
that secondary offerings rarely trade at a premium to the market and 
even then, the premium often is very small. One commenter suggested an 
exemption for secondary equity offerings of widely-held issuers with 
established secondary markets provided that such secondary offerings 
are not priced at a significant discount to the current market. This 
commenter also urged NASD Regulation to adopt changes that were 
consistent with the SEC's new Regulation M. Similarly, the SIA stated 
that the Interpretation should not apply to any secondary offerings and 
in the alternative, that NASD Regulation should exempt offerings of 
liquid issues at appropriate thresholds.
    NASD Regulation has reconsidered its earlier position and now 
proposes an exemption for secondary offerings similar to the Regulation 
M exception for actively-traded securities (which are defined as 
securities that have an average daily trading volume of at least $1 
million and are issued by an issuer whose equity securities have a 
public float of at least $150 million). In light of the SEC's decision 
to except actively-traded securities from its trading practice rules, 
NASD Regulation believes that it is appropriate to exempt similarly 
defined securities from the Interpretation with respect to secondary 
offerings.
(F) Accounts for Qualified Plans Under The Employment Retirement Income 
Security Act (``ERISA'')
    Currently, there are no provisions in the Interpretation that 
expressly address the status of qualified employee benefit plans under 
ERISA. While NASD Regulation deferred proposing any specific amendments 
to NTM 97-30 with respect to ERISA plans, it noted that there were two 
frequently asked questions: whether a qualified ERISA plan is 
considered an investment partnership or corporation under paragraph (f) 
of the Interpretation; and, if so, whether the ``carve out'' mechanism 
described in paragraph (g) could permit sales to be made to qualified 
ERISA accounts. NASD Regulation stated in NTM 97-30 that it believes as 
a general rule that a qualified ERISA plan should not be deemed an 
``investment partnership or corporation'' and should not be considered 
a ``restrict account.'' NASD Regulation added that the NBCC has 
suggested the following methodology to determine under what 
circumstances a qualified ERISA plan would be deemed restricted:
    (i) Any plan sponsor that is not involved in financial services 
activities would not be considered restricted even though some plan 
participants may be restricted.
    (ii) Any plan sponsored by a broker/dealer would be deemed per se 
restricted.
    (iii) All other financial services plans, including those involving 
banks,

[[Page 7032]]

insurance companies, investment advisors, or other money managers, 
would be exempt unless they had been created to circumvent the purposes 
of the Interpretation, including where a financial services plan had 
only restricted persons as beneficiaries.
    NASD Regulation received only one comment on ERISA plans. The SIA 
stated that an ERISA plan sponsored by a broker/dealer should be 
restricted only with respect to the plan's transactions with such 
broker/dealer. NASD Regulation believes that the SIA's proposal is 
inconsistent with the purposes of the Interpretation and has declined 
to make the modification. However, NASD Regulation believes that it 
would be helpful to clarify the status of accounts for qualified plans 
under ERISA and is proposing to include the NBCC interpretation as part 
of IM-2110-1, with minor stylistic modifications.
(G) Issuer-Directed Share Exemption
    Paragraph (d) of the Interpretation contains provisions relating to 
issuer-directed securities plans. In 1994, paragraph (d) was amended to 
allow members to allocate hot issues to restricted persons who also 
were employees of the issuer, without having to receive prior approval 
of the NBCC, NASD Regulation believes that issuer-directed securities 
programs are a valuable tool in employee development and retention, and 
are not likely to pose the risk of members using these securities to 
reward other persons who are in a position to direct future business to 
the member. In NTM 97-30, NASD Regulation stated that persons have 
requested that the language of paragraph (d) be modified to clarify 
that the exemption is available to employees of the issuer who are 
materially supported by a restricted person and both employee and non-
employee directors. Several commenters also welcomed clarification to 
the issuer-directed securities exception provisions more generally. 
Based upon the comments received and its own initiative to clarify and 
streamline the issuer-directed securities provisions more generally, 
NASD Regulation proposes modifying paragraph (d) of the Interpretation 
to permit persons associated with a member and their immediate family 
members to purchase hot issues. The proposed amendments would apply the 
issuer-directed share exemption to persons subject to the 
Interpretation in paragraphs (2)-(9), instead of paragraphs (3)-(9) as 
currently written. NASD Regulation believes that this is consistent 
with the purposes of the issuer-directed exemption. In addition, by 
expanding the scope of restricted persons that can purchase hot issues 
under proposed paragraph (d) to include persons restricted under 
paragraph (b)(2), NASD Regulation is incorporating the exemption for 
issuer directed offerings of NASD members currently found at Rule 
2720(m), which pertains to conflicts of interest in connection with the 
distribution of securities of members and affiliates.
    The proposed amendments to the issuer-directed provisions also 
would clarify that exemptions apply to employees and directors of a 
parent or subsidiary of the issuer, consistent with NASD Regulation's 
past practice. Specifically, the proposed amendments exempt ``a parent 
of an issuer, a subsidiary of an issuer, or any other entity which 
controls or is controlled by an issuer.'' While no specific percentage 
is mentioned to establish a control relationship, NASD Regulation 
believes that a guideline of 50 percent should be used and is 
consistent with provisions of former Rule 2720(m). Employees and 
directors of sister corporations to the issuer would not be subject to 
an exemption for issuer-directed securities, but could request 
exemptive relief under paragraph (a)(5), which as noted above, provides 
NASD Regulation with exemptive authority. Further, the proposed 
amendments would shorten the lock-up period for persons formerly 
covered under Rule 2720(m) from five months to three months for 
consistency and simplicity. The five month lock-up period specified in 
Rule 2720(m) is an historical anomaly (pertaining to taxation issues) 
and the purposes of the Interpretation would not be frustrated if the 
lock-up period for all persons was three months. NASD Regulation has 
observed substantial confusion concerning the application of the 
Interpretation to issuer directed offerings and believes that these 
revisions will assist members with their compliance responsibilities.
    In addition, because of the proposal to grant plenary exemptive 
authority to NASD Regulation as noted above in item (c), there is no 
longer any need for paragraph (d)(2), which grants to the Board of 
Governors limited authority to exempt sales of issuer-directed 
securities to non-employee/director restricted persons. Accordingly, 
this paragraph has been deleted.
(H) General Comments
    A few of the commenters addressed NASD Regulation's broad question 
whether ``the Interpretation could be simplified and made easier to 
follow.'' These commenters generally believed that more should be done 
to streamline the Interpretation. The SIA stated the Interpretation has 
been ``pulled and stretched'' beyond its original purpose and now has 
become a set of provisions that try to address a host of abuses 
relating to possible conflicts of interest and self-dealing in the 
offering process. The SIA believed that many of these other issues are 
already addressed by interpretations of what constitutes ``just and 
equitable principles of trade,'' or elsewhere in the securities laws. 
Another commenter stated this was the second major review of the 
Interpretation in the last three years and that the changes adopted 
three years ago as well as those proposed in NTM 97-30 represent only 
minor adjustments to an ``overly complex and burdensome rule.'' Both 
commenters stated that compliance with the Interpretation was time-
consuming and costly.
    NASD Regulation agrees that the Interpretation is overly complex in 
many respects. NASD Regulation is committed to a wholesale modification 
of the Interpretation following these proposed rule changes. NASD 
Regulation believes that the exemption for certain debt and secondary 
offerings and the modifications to the issuer directed share provisions 
provide greater clarity to the Interpretation and will reduce the 
burdens of compliance for many members. NASD Regulation plans to 
continue its review of the entire Interpretation to consider other ways 
in which it may be simplified. NASD Regulation has communicated this 
goal to members of the industry and plans to begin working on broad 
reform once the current amendments are in place.
(I) Miscellaneous
    In NTM 97-30, NASD Regulation requested comment on several other 
issues for which it did not suggest any proposed amendments to the 
Interpretation. These topics were non-member broker/dealers and their 
associated persons, de minimis exemption, limited purpose broker/
dealers, and member verification of conduit for undisclosed principal. 
NASD Regulation will consider the comments received on these issues as 
it begins broad reform of the Interpretation.
(b) Statutory Basis
    NASD Regulation believes that the proposed rule change is 
consistent with the provisions of Section 15a(b)(6) of the Act,\5\ in 
that it will promote just and equitable principles of trade, prevent 
fraudulent and manipulative acts and

[[Page 7033]]

practices, and protect investors and the public interest, by 
facilitating the bona fide distribution of hot issue securities to the 
public, and protecting against the receipt of hot issues by persons in 
the financial services business who are in a position to direct future 
business to the member, or who have an unfair advantage due to their 
inside position in the industry. Further, NASD Regulation believes that 
the proposed changes and clarifications to the Interpretation are 
consistent with Section 15A(b)(9) in that they alleviate certain 
inequities caused by the Interpretation, which imposed burdens on 
competition not necessary or appropriate in furtherance of the purposes 
of the Act.
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    \5\ 15 U.S.C. 78o-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

    The proposed rule change was published for comment in NASD Notice 
to Members 97-30 (May 1997). Twenty-two comments were received in 
response to the notice. The position of the commenters and their 
specific comments are discussed above in section II(A).

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, N.W., Washington, D.C. 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 the file number SR-NASD-97-95 and 
should be submitted by March 4, 1998.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\6\
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    \6\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-3372 Filed 2-10-98; 8:45 am]
BILLING CODE 8010-01-M