[Federal Register Volume 65, Number 70 (Tuesday, April 11, 2000)]
[Notices]
[Pages 19409-19420]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-8876]



[[Page 19409]]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-42619; File No. SR-NASD-00-04]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by the National Association of Securities Dealers, Inc. Relating 
to its Corporate Financing Rule

April 4, 2000.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on January 21, 2000, the National Association of Securities Dealers, 
Inc. (``NASD''), through its wholly-owned subsidiary, NASD Regulations, 
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 Regulations. NASD Regulation filed Amendments No. 1, \3\ No. 2, 
\4\ and No. 3 \5\ to the proposed rule change on March 6, 2000, March 
21, 2000, and March 30, 2000, respectively, the substance of which has 
been incorporated into this filing. 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).
    \2\ 17 CFR 240.19b-4.
    \3\ Letter from Suzanne E. Rothwell. Chief Counsel, Corporate 
Financing, NASD Regulation, to Katherine A. England, Assistant 
Director, Division of Market Regulation (``Division''), Commission, 
dated March 3, 2000 (``Amendment No.. 1''). Amendment No. 1 makes 
certain clarifying and non-substantive changes to the proposed rule 
change.
    \4\ Letter from Suzanne E. Rothwell, Chief Counsel, Corporate 
Financing, NASD Regulations, to Katherine A. England, Assistant 
Director, Division, Commission, dated March 20, 2000 (``Amendment 
No. 2''). Amendment No. 2 revises the language of proposed Rule 
2710(c)(4)(D)(i) relating to ``members of a group.'' Amendment No. 2 
also states that NASD Regulations consents to a 90 day extension of 
the time period for Commission action specified in Section 19(b)(2) 
of the Act.
    \5\ Letter from Suzanne E. Rothwell, Chief Counsel, Corporate 
Financing, NASD Regulation, to Katherine A. England, Assistant 
Director, Division, Commission, dated March 29, 2000 (``Amendment 
No. 3''). Amendment No. 3 states NASD Regulation's rationale for 
deleting the exception from the current Venture Capital lock-up in 
Rule 2710(c)(C)(i) for transactions in which a qualified independent 
underwriter provides a pricing opinion and performs due diligence.
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    NASD Regulation proposes to amend NASD Conduct Rule 2710. Below is 
the text of the proposed rule change. Proposed new language is in 
italics; proposed deletions are in brackets.
* * * * *

2710. Corporate Financing Rule--Underwriting Terms and Arrangements

    (a) Definitions: No change.

(b) Filing Requirements

    (1)-(5) No change.
(6) Information Required to be Filed
    (A) Any person filing documents pursuant to subparagraph (4) above 
shall provide the following information with respect to the offering:
    (i)-(iii) No change.
    (iv) [a statement addressing the factors in subparagraph c)(4)(C) 
and(D), where applicable;]
    [(v)] a detailed explanation of any other arrangement entered into 
during the [12-month] 180-day period immediately preceding the filing 
date of the public offering, which arrangement provides for the receipt 
of any item of value [and/]or the transfer of any warrants, options, or 
other securities from the issuer to the underwriter and related 
persons; and
    [(iv)] (v) a detailed explanation and any documents related to:
    a. the modification of any information or representation previously 
provided to the Association or of any item of underwriting 
compensation[,]; or
    b. any new arrangement that provides for the receipt of any 
additional item of value by the underwriter and related persons 
subsequent to the [review and approval of such compensation] issuance 
of an opinion of no objections to the underwriting terms and 
arrangements by the Association and within 90 days immediately 
following the effective date of the public offering.
    (B) No change.
    (7)-(12) No change.

(c) Underwriting Compensation and Arrangements

    (1)-(2) No change.
(3) Items of Compensation
    (A) For purposes of determining the amount of underwriting 
compensation received or to be received by the underwriter and related 
persons pursuant to subparagraph (2) above, the following items and all 
other items of value received or to be received by the underwriter and 
related persons in connection with or related to the distribution of 
the public offering, as determined pursuant to subparagraph (4) below 
shall be included:
    (i)-(v) No change.
    (iv) financial consulting and advisory fees whether in the form of 
cash, securities, or any other item of value;
    (vii) common or preferred stock, options, warrants, and other 
equity securities, including debt securities convertible to or 
exchangeable for equity securities [including securities] received [as 
underwriting compensation, for example]:
    a. [in connection with] for arranging a private placement of 
securities for the issuer.
    b. for providing or arranging a loan, credit facility, or bridge 
financing for the issuer;
    c. as a finder's fee;
    d. for providing consulting services to the issuer; [and]
    e. [securities purchase] as an investment in private placement made 
by the issuer; or
    f. at the time of the public offering;
    (viii)-(x) No change.
    (xi) commissions, expense reimbursements, or other compensation to 
be received by the underwriter and related persons as a result of the 
exercise or conversion, within twelve (12) months following the 
effective date of offerings, of warrants, options, convertible 
securities, or similar securities distributed as part of the public 
offering; and
    (xii) fees of a qualified independent underwriter[; and].
    [(xiii) compensation, including expense reimbursements, paid in the 
six (6) months prior to the initial or amended filing of the prospectus 
or similar documents to any member or person associated with a member 
for a public offering that was not completed.]
    (B) Notwithstanding paragraph (c)(3)(A) above, the calculation of 
underwriting compensation shall not include:
    (i) [E] expenses customarily borne by an issuer, such as printing 
costs; SEC, ``blue sky'' and other registration fees; Association 
filing fees; and accountant's fees, [shall be excluded from 
underwriter's compensation] whether or not paid through an underwriter;
    (ii) compensation, including expense reimbursements, previously 
paid to any member in connection with a proposed public offering that 
was not completed, if the member does not participate in the revised 
public offering; and
    (iii) financial consulting and advisory fees, on the basis of 
information that establishes that an ongoing relationship between the 
issuer and the financial advisor or consultant was established more 
than twelve months before the filing date of the public offering.
(4) Determination of Whether Compensation Is Received in Connection 
With the Offering
    (A) All items of value received [or to be received] by the 
underwriter and

[[Page 19410]]

related persons during the [twelve (12) months] 180-day period 
immediately preceding the filing date of the registration statement or 
similar document, and at the time of [and subsequent to] the public 
offering, will be [examined to determine whether such items of value 
are] considered to be underwriting compensation in connection with the 
public offering [and, if received during the six (6) month period 
immediately preceding the filing of the registration statement or 
similar document, will be presumed to be underwriting compensation 
received in connection with the offering, provided, however, that such 
presumption may be rebutted on the basis of information satisfactory to 
the Association to support a finding that the receipt of an item is not 
in connection with the offering and shall not include cash discounts or 
commissions received in connection with a prior distribution of the 
issuer's securities].
    [(B) Items of value received by an underwriter and related person 
more than twelve (12) months immediately preceding the date of filing 
of the registration statement or similar document will be resumed not 
to be underwriting compensation. However, items received prior to such 
twelve (12) month period may be included as underwriting compensation 
on the basis of information to support a finding that receipt of the 
item is in connection with the offering.]
    [(C) For purposes of determining whether any item of value received 
or to be received by the underwriter and related persons is in 
connection with or related to the distribution of the public offering, 
the following factors, as well as any other relevant factors and 
circumstances, shall be considered:]
    [(i) the length of time between the date of filing of the 
registration statement or similar document and:]
    [a. the date of the receipt of the item of value;]
    [b. the date of any contractual agreement for services for which 
the item of value was or is to be received; and]
    [c. the date the performance of the service commenced, with a 
shorter period of time tending to indicate that the item is received in 
connection with the offering;]
    [(ii) the details of the services provided or to be provided for 
which the item of value was or is to be received;]
    [(iii) the relationship between the services provided or to be 
provided for which the item of value was or is to be received and:]
    [a. the nature of the item of value;]
    [b. the compensation value of the item; and]
    [c. the proposed public offering;]
    [(iv) the presence or absence of arm's length bargaining or the 
existence of any affiliate relationship between the issuer and the 
recipient of the item of value, with the absence of arm's length 
bargaining or the presence of any affiliation tending to indicate that 
the item of value is received in connection with the offering.]
    [(D) For purposes of determining whether securities received or to 
be received by the underwriter and related persons are in connection 
with or related to the distribution of the public offering, the factors 
in subparagraph (C) above and the following factors shall be 
considered:]
    [(i) any disparity between the price paid and the offering price or 
the market price, if a bona fide independent market exists at the time 
of acquisition, with a greater disparity tending to indicate that the 
securities constitute compensation;]
    [(ii) the amount of risk assumed by the recipient of the 
securities, as determined by:]
    [a. the restrictions on exercise and resale;]
    [b. the nature of the securities (e.g., warrant, stock, or debt); 
and]
    [c. the amount of securities, with a larger amount of readily 
marketable securities without restrictions on resale or a warrant for 
securities tending to indicate that the securities constitute 
compensation; and]
    [(iii) the relationship of the receipt of the securities to 
purchases by unrelated purchasers on similar terms at approximately the 
same time, with an absence of similar purchases tending to indicate 
that the securities constitute compensation.]
    [(E) Notwithstanding the provisions of subparagraph (3)(A)(vi) 
above, financial consulting and advisory fees may be excluded from 
underwriting compensation upon a finding by the Association, on the 
basis of information satisfactory to it, that an ongoing relationship 
between the issuer and the underwriter and related person has been 
established at least twelve (12) months prior to the filing of the 
registration statement or similar document or that the relationship, if 
established subsequent to that time, was not entered into in connection 
with the offering, and that actual services have been or will be 
rendered which were not or will not be in connection with or related to 
the offering.]
    (B) Securities of the issuer acquired by the underwriter and 
related persons before the filing date of a public offering will be 
considered to be received for purposes of subparagraph (c)(4)(A) and 
(E) as of the date of the:
    (i) closing of a private placement, if the securities were 
purchased from or received as compensation for the private placement;
    (ii) execution of an agreement for a loan or credit facility, if 
the securities were received as compensation for the loan or credit 
facility; or
    (iii) transfer of beneficial ownership of the securities to a 
consultant, if the securities were received as compensation for 
consulting services.
    (C) All items of value received by the underwriter and related 
persons during the 90-day period immediately following the effective 
date of a public offering will be examined to determine whether such 
items of value are considered underwriting compensation in connection 
with the public offering.
    (D) For purposes of subparagraph (c)(4)(E) below, the following 
terms will have the meanings stated below.
    (i) An entity will include a group of legal entities that either:
    a. are contractually obligated to make co-investments and have 
previously made at least one such investment; or
    b. have filed a Schedule 13D or 13G with the SEC that identifies 
the entities as members of a group who have agreed to act together for 
the purpose of acquiring, holding, voting or disposing of equity 
securities of an issuer for purposes of Section 13(d) or 13(g) of the 
Securities Exchange Act of 1934.
    (ii) An institutional investor will mean any individual or entity 
that has at least $50 million invested in securities in the aggregate 
in its portfolio or under management; provided that an institutional 
investor will not include any member participating in the public 
offering, any of its associated or affiliated persons, or an immediate 
family member of its associated or affiliated persons.
    (E) Notwithstanding subparagraph (c)(4)(A) above, the following 
acquisitions of securities will not be considered underwriting 
compensation:
    (i) Purchases and Loans by Certain Entities--Securities of the 
issuer purchased in a private placement or received as compensation for 
a loan or credit facility more than 90 days before the filing date of 
the public offering, by certain entities if:
    a. the entity:
    1. either:
    A. manages capital contributions of $100 million or more, at least 
$75 million of which has been committed by persons that are not 
underwriters or related persons; or
    B. manages capital contributions of $25 million or more, at least 
75% of

[[Page 19411]]

which has been committed by persons that are not underwriters or 
related persons;
    2. is a separate and distinct legal entity from the member and is 
not registered as a broker/dealer;
    3. makes investments or loans subject to the evaluation and review 
of individuals who have a contractual or fiduciary duty to select 
investments and loans based on the risks and rewards to the entity and 
not based on opportunities for the member to earn investment banking 
revenues;
    4. does not participate directly in investment banking fees 
received by the member for underwriting public offerings;
    5. is engaged primarily in the business of making investments in or 
loans to private or start-up companies or companies in the early 
process of developing products or services, or participating in 
leveraged buy-out transactions; and
    b. the member maintains and enforces written procedures reasonably 
designed to ensure that the member's participation in the public 
offering is not contingent on the entity's participation in the private 
placement or loan.
    (ii) Investments In and Loans to Certain Issuers--Securities of the 
issuer purchased in a private placement or received as compensation for 
a loan or credit facility more than 90 days before the filing date of 
the public offering, by certain entities if:
    a. the entity:
    1. manages capital contributions or loan commitments of at least 
$50 million;
    2. is a separate and distinct legal entity from the member and is 
not registered as a broker/dealer;
    3. does not participate directly in investment banking fees 
received by the member for underwriting public offerings;
    4. is engaged primarily in the business of making investments in or 
loans to private or start-up companies or companies in the early 
process of developing products or services, or participating in 
leveraged buy-out transactions; and
    b. institutional investors beneficially own at least 33% of the 
total number of the issuer's equity securities outstanding on a fully 
diluted basis;
    c. an institutional investor is a member of the issuer's board of 
directors;
    d. the transaction was approved by a majority of the issuer's board 
of directors and by the affirmative vote of institutional investors 
that are board members;
    e. the total amount of securities received by all entities related 
to each member does not exceed 5% of the total number of the issuer's 
equity securities outstanding on a fully diluted basis; and
    f. the member maintains and enforces written procedures reasonably 
designed to ensure that the member's participation in the public 
offering is not contingent on the entity's participation in the private 
placement or loan.
    (iii) Private Placements With Institutional Investors--Securities 
of the issuer purchased in or received as placement agent compensation 
for a private placement more than 90 days before the filing date of the 
public offering if:
    a. institutional investors purchase at least 51% of the total 
offering (comprised of the total number of securities, on a fully 
diluted basis, sold in the private placement and received as placement 
agent compensation by a member);
    b. an institutional investor was the lead negotiator with the 
issuer to establish the terms of the private placement;
    c. the underwriter and related persons (excluding any entities 
qualified under paragraph (c)(4)(D)(i) above):
    1. have not, in the aggregate, purchased or received as placement 
agent compensation more than 20% of the total offering; and
    2. have purchased securities that were at the same price and with 
the same terms as the securities purchased by other investors; and
    d. the member maintains and enforces written procedures reasonably 
designed to ensure that its participation in the public offering will 
not be contingent on its participation in the private placement.
    (iv) Purchases Under a preemptive Right--Securities of the issuer 
under a right of preemption if:
    a. the right of preemption was granted either:
    1. by contract or the terms of the security in connection with a 
purchase from a private placement of the issuer's securities made more 
than 180 days before the filing date of the public offering; or
    2. in connection with a security purchased from a public offering 
or the public market; and
    b. the purchase under the right of preemption:
    1. was exercised in connection with a private placement of the 
issuer's securities that was for cash;
    2. was to all similar preemptive right holders;
    3. was at the same price and had the same terms as the securities 
purchased by other investors; and
    4. did not increase the purchaser's percentage ownership of the 
same class of securities of the issuer.
(5) Valuation of Non-Cash Compensation
    For purposes of determining the value to be assigned to securities 
received as underwriting compensation, the following criteria and 
procedures shall be applied:
    (A) [No underwriter and related person may receive a security or a 
warrant for a security as compensation in connection with the 
distribution of a public offering that is different than the security 
to be offered to the public unless the security received as 
compensation has a bona fide independent market, provided, however, 
that: (i) in exceptional and unusual circumstances, upon good cause 
shown, such arrangement may be permitted by the Association; and (ii) 
in an offering of units, the underwriter and related persons may only 
receive a warrant for the unit offered to the public where the unit is 
the same as the public unit and the terms are no more favorable than 
the terms of the public unit.]
    An underwriter and related person may not receive a security 
(including securities in a unit) or a warrant for a security as 
underwriting compensation in connection with a public offering unless: 
(i) the security received or the security underlying the warrant 
received is identical to the security offered to the public or to a 
security with a bona fide independent market; or (ii) the arrangement, 
upon good cause shown, is permitted by the Association.
    (B) [s] Securities that are not options, warrants or convertible 
securities shall be valued on the basis of:
    (i) the difference between [the per security cost and]:
    a. either the market price per security on the date of acquisition, 
[where a] or, if no bona fide independent market exists for the 
security, [or] the [proposed (and actual)] public offering price per 
security; and
    b. the per security cost;
    (ii) multiplied by the number of securities received or to be 
received as underwriting compensation;
    (iii) divided by the public offering proceeds; and
    (iv) multiplied by one hundred [(100)].
    (C) [o] Options, warrants or convertible securities (``warrants'') 
shall be valued on the basis of [the following formula]:

[[Page 19412]]

    (i) the [proposed (and actual)] public offering price per security 
multiplied by .65 [(65%)];
    (ii) minus the difference between:
    a. the exercise or conversion price per [security] warrant; and
    b. either the market price per security on the date of acquisition, 
[where a] or, if no bona fide independent market exists for the 
security, [or] the [proposed (and actual)] public offering price per 
security;
    (iii) divided by two [(2)];
    (iv) multiplied by the number of securities underlying the 
warrants[, options, and convertible securities received or to be 
received as underwriting compensation];
    (v) less the total price paid for the [securities] warrants;
    (vi) divided by the public offering proceeds; and
    (vii) multiplied by one hundred [(100)].
    (D) [a lower value equal to 80% and 60% of the calculated value 
shall be assigned if securities, and where relevant, underlying 
securities, are or will be restricted from sale, transfer, assignment 
or other disposition for a period of one and two years, respectively, 
beyond the one-year period of restriction required by subparagraph 
(7)(A)(i) below.] A lower value equal to 10% of the calculated value 
shall be assigned for each 180-day period that the securities or 
underlying securities are restricted from sale or other disposition 
beyond the 180-day period of restriction required by subparagraph 
(c)(7)(A)(i) below. The transfers permitted by subparagraphs 
(c)(7)(B)(i)(c) and (d) are not available for the sale of such 
securities.
(6) Unreasonable Terms and Arrangements
    (A) No change.
    (B) Without limiting the foregoing, the following terms and 
arrangements, when proposed in connection with [the distribution of] a 
public offering of securities, shall be unfair and unreasonable:
    (i)-(vii) No change.
    (viii) the receipt by the underwriter and related persons of 
underwriting compensation consisting of any option, warrant or 
convertible security [which] that:
    a.-f. No change.
    g. has anti-dilution terms designed to provide the underwriter and 
related persons with disproportionate rights, privileges and economic 
benefits which are not provided to the purchasers of the securities 
offered to the public (or the public shareholders, if in compliance 
with subparagraph (5)(A) above); or
    h. has anti-dilution terms designed to provide for the receipt or 
accrual of cash dividends prior to the exercise or conversion of the 
security[;or];
    [i. is convertible or exercisable or otherwise is on terms more 
favorable than the terms of the securities being offered to the 
public;]
    (ix)-(x) No change.
    [(xi) stock numerical limitation. The receipt by the underwriter 
and related persons of securities which constitute underwriting 
compensation in an aggregate amount greater than ten (10) percent of 
the number or dollar amount of securities being offered to the public, 
which is calculated to exclude:]
    [a. any securities deemed to constitute underwriting compensation;
    b. any securities issued or to be issued pursuant to an 
overallotment option;]
    [c. in the case of a ``best efforts'' offering, any securities not 
actually sold; and]
    [d. any securities underlying warrants, options, or convertible 
securities which are part of the proposed offering, except where 
acquired as part of a unit;]
    (xii)-(xiv) Renumbered (xi)-(xiii).
    (C) In the event that the underwriter and related persons receive 
securities deemed to be underwriting compensation in an amount 
[constituting] that results in unfair and unreasonable compensation 
[pursuant to the stock numerical limitation in subparagraph (B)(ix) 
above], the recipient shall return any excess securities to the issuer 
or the source from which received at cost and without recourse, except 
that [in exceptional and unusual circumstances], upon good cause show, 
a different arrangement may be permitted.
(7) Restrictions on Securities
    (A) [No member or person associated with a member shall participate 
in a] Any public offering in which [does not] a member or person 
associated with a member participates must comply with the following 
requirements:
    (i) any common or preferred stock, options, warrants, and other 
equity securities [deemed to be underwriting compensation], including 
debt securities convertible to or exchangeable for equity securities, 
of the issuer beneficially owned by an underwriter and related person 
at the time of effectiveness of the public offering shall not be sold, 
transferred, assigned, pledged or hypothecated by any person, except as 
provided in subparagraph (B) below, for a period of [(a) one year] 180 
days immediately following the effective date of the public offering 
[for which the securities were received.];
    [However, securities deemed to be underwriting compensation may be 
transferred to any member participating in the offering and the bona 
fide officers or partners thereof and securities which are convertible 
into other types of securities or which may be exercised for the 
purchase of other securities may be so transferred, converted or 
exercised if all securities so transferred or received remain subject 
to the restrictions specified herein for the remainder of the initially 
applicable time period;]
    [(ii) certificates or similar instruments representing securities 
restricted pursuant to subparagraph (i) above shall bear an appropriate 
legend describing the restriction and stating the time period for which 
the restriction is operative;] and
    [(iii)] (ii) securities [to be] received by a member as 
underwriting compensation shall only be issued to a member 
participating in the offering and the [bona fide] officers or partners 
thereof.
    (B) [The provisions of] Notwithstanding subparagraph (A) 
[notwithstanding] above, the following shall not be prohibited:
    (i) the transfer of any security:
    a. by operation of law or by reason of reorganization of the issuer 
[shall not be prohibited.];
    b. to any member participating in the offering and the officers or 
partners thereof, if all securities so transferred remain subject to 
the restrictions in subparagraph (A) above for the remainder of the 
applicable time period;
    [(C) Venture capital restrictions. When a member participates in 
the initial public offering of an issuer's securities, such member or 
any officer, director, general partner, controlling shareholder or 
subsidiary of the member or subsidiary of such controlling shareholder 
or a member of the immediate family of such persons, who beneficially 
owns any securities of said issuer at the time of filing of the 
offering, shall not sell such securities during the offering or sell, 
transfer, assign or hypothecate such securities for ninety (90) days 
following the effective date of the offering unless:]
    [(i) the price at which the issue is to be distributed to the 
public is established at a price no higher than that recommended by a 
qualified independent underwriter who does not beneficially own 5% or 
more of the outstanding voting securities of the issuer, who shall also 
participate in the preparation of the registration statement and the 
prospectus, offering circular, or similar document and who shall 
exercise the usual standards of ``due diligence'' in respect thereto; 
or]

[[Page 19413]]

    [(ii)] c. if the aggregate amount of such securities held by [such 
a member and its related persons enumerated above would] an underwriter 
and its related persons do not exceed 1% of the securities being 
offered; or
    d. if the class of security qualifies as an ``actively traded 
security'' for purposes of SEC Regulation M as of the date of 
effectiveness of the public offering; and
    (ii) the exercise or conversion of any security, if all securities 
received remain subject to the restrictions in subparagraph (A) above 
for the remainder of the applicable time period.
    (8) Conflicts of Interest. No change.

(d) Exemptions

    Pursuant to the Rule 9600 Series, the Association may exempt a 
member or person associated with a member from the provisions of this 
Rule for good cause shown.
* * * * *

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.

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

1. Purpose

(a) Current Corporate Financing Rule

(1) Scope of the Corporate Financing Rule

    NASD Conduct Rule 2710 (``Corporate Financing Rule'' or ``Rule'') 
is intended to ensure that the underwriting terms and arrangements of a 
public offering \6\ in which an NASD member participates \7\ are fair 
and reasonable. The Rule requires a member to file certain information 
with NASD Regulation about the underwriting arrangements of a public 
offering in which the member participates. The Corporate Financing 
Department (``Department'') of NASD Regulation reviews this information 
prior to commencement of the offering in order to determine whether the 
underwriting compensation and other terms and arrangements meet the 
requirements of applicable NASD rules.\8\
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    \6\ Rule 2720(b)(14) defines ``public offering'' as ``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, offerings pursuant to SEC Rule 
504, and all other securities distributions of any kind whatsoever, 
except any offering made pursuant to an exemption from registration 
under Sections 4(1), 4(2), or 4(6) of the Securities Act of 1933, as 
amended, or pursuant to SEC Rule 504 if the securities are 
``restricted securities'' under SEC Rule 144(a)(3), SEC Rule 505, or 
SEC Rule 506 adopted under 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.'' This definition of 
``public offering'' also applies to Rule 2710.
    \7\ Rule 2710(a)(4) defines ``participation'' or ``participating 
in a public offering'' as ``participation in the preparation of the 
offering or other documents, participation in the distribution of 
the offering on an underwritten, non-underwritten, or any other 
basis, furnishing of customer and/or broker lists for solicitation, 
or participation in any advisory or consulting capacity to the 
issuer related to the offering, but not the preparation of an 
appraisal in a savings and loan conversion or a bank offering or the 
preparation of a fairness opinion pursuant to SEC Rule 13e-3.''
    \8\ Rule 461(b)(6) under the Securities Act of 1933, as amended, 
provides that the Commission may refuse to accelerate the effective 
date of an offering if the ``NASD has not issued a statement 
expressing no objections to the compensation and other 
arrangements.'' See 17 CFR 230.461(b)(6).
---------------------------------------------------------------------------

    The Corporate Financing Rule regulates, among other matters, the 
total amount of underwriting compensation that the ``underwriter'' and 
related persons \9\ may receive in connection with a public offering. 
The term ``underwritten and related persons'' includes all broker/
dealers (and the associated persons \10\ and affiliates \11\ of the 
broker/dealers) participating in any capacity in the proposed public 
offering, as well as other non-broker/dealers who act as counsel, 
finders, or consultants, or are members of the immediate family, or are 
related persons \12\ to other persons in the definition. In order to 
facilitate the following discussion, participating broker/dealers and 
their associated persons, affiliates, and related persons are together 
referred to as ``members.''
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    \9\ Rule 2710(a)(6) defines ``underwriter and related persons'' 
as ``underwriters, underwriter's counsel, financial consultants and 
advisors, finders, members of the selling or distribution group, any 
member participating in the public offering, and any and all other 
persons associated with or related to and members of the immediate 
family of any of the aforementioned persons.''
    \10\ Article I, paragraph (ee) of the NASD By-Laws defines 
``associated person of a member'' as ``(1) any natural person 
registered under the Rules of the Association; or (2) a sole 
proprietor, partner, officer, director, or branch manager of a 
member, or a natural person occupying a similar status or performing 
similar functions, or a natural person engaged in the investment 
banking or securities business who is directly or indirectly 
controlling or controlled by a member, whether or not any such 
person is registered or exempt from registration with the NASD under 
the By-Laws or the Rules of the Association.''
    \11\ For purposes of Rules 2710 and 2720, Rule 2720(b)(1) 
provides that an ``affiliate'' presumptively includes ``(1) a 
company that beneficially owns 10 percent or more of the outstanding 
voting securities of a member; (2) a member that beneficially owns 
10 percent or more of the outstanding voting securities of a 
company; and (3) a company and a member that are under the common 
control of a person or company who beneficially owns 10 percent or 
more of the outstanding voting securities of the company and/or 
member or who has the power to direct the management or policies of 
the company and/or member. The Department's long-standing practice 
is to deem any company or member that comes within these 
presumptions to be an affiliate.''
    \12\ In SR-NASD-01-19, the NASD stated that ``[t]he concept of 
whether the person is `related to' any of the enumerated persons in 
the definition is determined by whether there is an investment or 
business relationship between the parties an is based on objective 
facts.'' See Securities Exchange Act Release No. 29928 (Nov. 12 
1991), 56 FR 58257 (Nov. 18, 1991).
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(2) Calculating Underwriting Compensation

    The Corporate Financing Rule currently provides in paragraph (c)(4) 
that any item of values as set forth in Rule 2710(c)(3)(A), including 
certain securities of the issuer,\13\ acquired by the underwriter and 
related persons within the 12-month period before the filing date of a 
proposed public offering will be examined by the Department to 
determine whether it was acquired ``in connection with the public 
offering'' and therefore, is deemed to be underwriting compensation. 
The Rule presumes that any such item of value acquired within the six-
month period before filing is underwriting compensation, but this 
presumption may be rebutted by the member based on information 
satisfactory to the Department.\14\
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    \13\ The term ``issuer'' is defined in Rule 2710(a)(2) to 
include ``[t]he issuer of the securities offered to the public, any 
selling security holders offering securities to the public, any 
affiliate for the issuer or selling security holder, and the 
officers or general partners, directors, employees and security 
holders thereof.''
    \14\ Rule 2710(c)(4)(B) provides that items of value received 
more than 12 months before the filing date of the public offering 
are presumed not to be underwriting compensation unless the staff 
has satisfactory information supporting a conclusion that the item 
is additional underwriting compensation.
---------------------------------------------------------------------------

    The Corporate Financing Rule currently requires in paragraphs 
(c)(4)(C) and (D) that the Department weigh as many as ten different 
factors to determine whether the item of value received by the 
underwriter and related persons within the 12-month period before the 
filing date of a public offering is received ``in connection with the 
public offering'' and, therefore, included in the calculation of 
underwriting compensation. In many cases, an

[[Page 19414]]

underwriter or related person has acquired unregistered equity 
securities \15\ of the issuer. Members typically acquire these 
unregistered securities as an investment in a private placement, as 
compensation for the member's services as private placement agent, or 
for providing a loan or credit facility to the issuer.
---------------------------------------------------------------------------

    \15\ Securities purchased in the public market are not 
considered to be ``items of value.''
---------------------------------------------------------------------------

    The Rule requires the staff to consider the following factors--as 
well as ``any other relevant factors and circumstances''--to determine 
whether securities have been received in connection with the public 
offering:
     The length of time between the date of the receipt of the 
security and the filing date;
     Details of any services provided;
     The presence or absence of arm's length bargaining;
     The disparity between the price paid for a security and 
the proposed public offering price;
     The existence of restrictions on exercise and resale;
     The nature of the securities;
     The amount of securities; and
     The relationship of the receipt of securities to purchases 
by other unrelated purchasers.
    The factor-weighing process requires the staff to review each 
acquisition of the issuer's securities by members on a case-by-case 
basis. The value of any securities that the Department determines are 
underwriting compensation, as calculated under Rule 2710(c)(5), is 
added to the underwriting discount or commission and any fees or 
reimbursements received by underwriting syndicate to determine whether 
the compensation is unfair or unreasonable.

(3) Restrictions on Resale

    Securities included in the calculation of underwriting compensation 
are also restricted by the Rule from sale for one year following the 
effective date of the offering under Rule 2710(c)(7)(A) (``compensation 
lock-up''). In the case of an initial public offering, if the members 
and certain senior persons and subsidiaries of the member hold 
securities of the issuer that are not deemed to be underwriting 
compensation, a 90-day lock-up is nonetheless imposed under Rule 
2710(c)(7)(B) (``venture capital lock-up'').\16\
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    \16\ The venture capital lock-up only applies to securities of 
the issuer held by the member, or any officer, director, general 
partner, controlling shareholder or subsidiary of the member, or by 
a subsidiary of a controlling shareholder of the member, or by a 
member of the immediate family of such persons. In comparison, the 
compensation lock-up applies to all securities considered to be 
underwriting compensation that are held by the underwriter and 
related persons, as defined by Rule 2710(a)(b)
---------------------------------------------------------------------------

(4) Limitation on Amount of Securities

    Rule 2710(c)(6)(B)(xi) limits the amount of securities that can be 
received by the underwriter and related persons as underwriting 
compensation to 10% of the number of securities to be sold in the 
public offering (``stock numerical limitation'').

(b) Changes in the Capital Markets

    In recent years, many NASD members have expanded the variety of 
services that they provide to their corporate financing clients. These 
services may include venture capital investment, consulting, commercial 
lending, and investment banking. Moreover, the pace of corporate 
financing activities has accelerated, and the time period between 
private fundraising and the issuer's initial public offering has often 
been shortened. These developments necessitate a review of the 
Corporate Financing Rule to ensure that it accommodates the modern, 
legitimate capital financing activities of NASD members, while 
continuing to protect investors and issuers from unreasonable 
underwriting activities.
    The current subjective, factor-weighing process for determining 
whether securities were acquired in connection with a public offering 
is an inefficient method to achieve these objectives. The subjectivity 
hampers the Department's ability to provide clear and predictable 
guidance to members. The consequences under the Rule of a particular 
venture capital or other private placement financing are sometimes 
uncertain until a public offering is filed and the Department's review 
is completed. This uncertainty unnecessarily complicates the capital-
raising process, to the detriment of issuers and investors.

(c) Description of Proposed Rule Change

(1) Summary of Proposed Rule Change

    NASD Regulation proposes to amend the Corporate Financing Rule to 
allow members to provide legitimate capital-raising services to 
issuers, while adopting restrictions that are designed to minimize the 
opportunity for abusive practices by members. NASD Regulation also 
proposes to eliminate or revise other burdensome and obsolete 
provisions, including rules regulating the exercise price of warrants 
received as underwriting compensation and the treatment of fees paid to 
a previous underwriter for an uncompleted offering. In addition, the 
proposed rule change would clarify a member's obligation to update 
previously filed information.

(2) Treatment of Securities As Underwriting Compensation

(i) Six-Month Pre-Offering Objective Test

    The proximity of an acquisition of equity securities of an issuer 
(or any other item of value) to filing date of its public offering has 
proven to be the most significant factor in determining whether those 
securities constitute underwriting compensation. The Department has 
found that the application of the six-month presumption contained in 
the Rule generally minimizes the opportunity for abusive practices by 
members. Application of a longer time period has typically been 
unnecessary to achieve this goal.
    NASD Regulation proposes to amend the Corporate Financing Rule to 
provide greater clarity and predictability regarding whether equity 
securities \17\ of the issuer and other items of value acquired by the 
underwriter and related persons constitute underwriting compensation. 
The proposed rule change would replace the twelve-month review period, 
the six-month presumption, and the subjective review factors with an 
objective standard in Rule 2710(c)(4)(A) under which all items of value 
acquired during the 180-day period immediately preceding the filing 
date of the registration statement or similar document and at the time 
of the public offering will constitute underwriting compensation. The 
proposed rule change would also provide four safe harbors from this 
general standard.\18\ These safe harbors are described below.
---------------------------------------------------------------------------

    \17\ The proposed rule change would clarify that the securities 
that will be considered to be underwriting compensation include 
common or preferred stock, options, warrants, and debt securities 
convertible to or exchangeable for equity securities.
    \18\ Regardless of when an underwriter or related person 
acquires securities of the issuer, or the availability of any safe 
harbor, all securities held by the underwriter and related persons 
are proposed to be subject to a lock-up on their sale, as described 
below.
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    Replacement of the existing subjective analysis with an objective, 
bright-line test would provide greater clarity and predictability 
concerning application of the Rule to specific transactions. 
Consequently, members and their venture capital and lending affiliates 
should find it easier to determine at the time of a private placement 
or other financing whether their investment will be treated as 
underwriting

[[Page 19415]]

compensation when the subsequent public offering is filed with the 
Department for review.

(ii) Safe Harbor Provisions

    NASD Regulation proposes four safe harbors from the determination 
that certain acquisitions of securities during the 180-day review 
period are deemed to be underwriting compensation.\19\ The four safe 
harbors are intended to identify acquisitions that occur in bona fide 
capital-raising transactions and would impose restrictions designed to 
minimize the opportunity for abusive practices.
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    \19\ The Department will maintain its authority under the Rule 
9600 Series to grant exemptions on a case-by-case basis from the 
determination that certain securities are deemed to be underwriting 
compensation. The Department expects to exercise this authority 
sparingly and only in exceptional and unusual circumstances.
---------------------------------------------------------------------------

    The First three safe harbors in proposed Rule 2710(c)(4)(E)(i)-
(iii), would be available for acquisitions by certain entities that 
regularly make venture capital investments; for acquisitions in issuers 
with significant institutional investor involvement in their corporate 
governance; and for acquisitions in private placements that have 
significant institutional investor participation. The fourth safe 
harbor in Rule 2710(c)(4)(E)(iv) would exempt acquisitions that occur 
from the exercise of a preemptive right to purchase.
    The first three safe harbors would be available only for 
acquisitions that occur more than 90 days before the filing date of the 
public offering. These safe harbors would also require that the member 
maintain and enforce written procedures reasonably designed to ensure 
that the member's participation in the public offering is not 
contingent on the acquiring party's participation in the private 
placement or loan.

(A) Safe Harbor No. 1--Purchases And Loans By Certain Entities

    The first safe harbor, proposed in Rule 2710(c)(E)(i), is intended 
for acquisitions of the issuer's securities by certain entities that 
routinely make venture capital investments or provide loans or credit 
facilities. The safe harbor would be available (1) To any qualifying 
entities related to any member participating in an offering; (2) for 
purchases in a private placement and for the receipt of securities as 
compensation for a loan or credit facility; and (3) without any 
limitation on the amount of securities purchased or received.

(1) Legal Entity/Registration

    The related entity would have to be a legal entity that is separate 
and distinct from the member and not registered as a broker/dealer. The 
term ``entity'' would be defined in new Rule 2710(c)(4)(D)(i) to 
include a group of legal entities that either are contractually 
obligated to make co-investments and have previously made at least one 
such investment or have filed a Schedule 13D or 13G with the SEC that 
identifies the entities as members of a group who have agreed to act 
together for the purpose of acquiring, holding, voting or disposing of 
equity securities of an issuer for purposes of Section 13(d) or 13(g) 
of Act.

(2) Venture Capital/Fiduciary Duty

    The related entity must also be ``primarily engaged in the business 
of making investments in or loans to private or start-up companies or 
companies in the early process of developing products or services, or 
participating in leveraged buy-out transactions.'' The related entity 
can make investments or loans that are under the safe harbor only if 
they are subject to the evaluation and review of individuals who have a 
contractual or fiduciary duty to select investments and loans based on 
the risks and rewards to the related entity and not based on 
opportunities for the member to earn investment banking revenues.

(3) Sharing in Investment Banking Fees

    The related entity could not participate directly in investment 
banking fees received by the member for underwriting public offerings.

(4) Captil Under Management

    The related entity would have to either (1) manage capital 
contributions of $100 million or more, at least $75 million of which 
has been committed by persons that are not underwriters or related 
persons; or (2) manage capital contributions of $25 million or more, at 
least 75% of which has been committed by persons that are not 
underwriters or related persons.\20\ The requirement for significant 
third-party capital would protect against potentially abusive 
situations, as the related entity must make its investment or lending 
decision in the interest of investors who are not underwriters or 
related persons.
---------------------------------------------------------------------------

    \20\ In both instances, such third-party capital commitments 
could come from members and their associated and affiliated persons, 
so long as those members do not participate in the public offering.
---------------------------------------------------------------------------

(B) Safe Harbor No. 2--Investments in and Loans to Certain Issuers

    The second safe harbor, proposed in Rule 2710(c)(4)(E)(ii), is 
intended for acquisitions of securities of issuers that have 
significant institutional investor involvement in their corporate 
governance. The proposed safe harbor would be available for 
acquisitions by qualifying related entities: (1) in a private 
placement; and (2) as compensation for a loan or credit facility, with 
a limitation on the amount acquired.

(1) 5% Limitation on Acquisition

    The total amount of securities acquired by all entities that are 
related to a single member could not exceed 5% of the issuer's 
outstanding equity securities, on a fully diluted basis. The 5% 
limitation would apply on a member-by-member basis when more than one 
member proposes to rely on this safe harbor.

(2) Related Entity Qualifications

    The related entity would have to manage capital contributions and 
loan commitments of at least $50 million. Unlike the first safe harbor, 
there would not be a requirement that the entity manage third-party 
capital contributions. The related entity would also have to be a 
separate legal entity and not registered as a broker/dealer; could not 
participate directly in the member's investment banking fees; and would 
have to be primarily engaged in the business of making venture capital 
investments.

(3) 33% Institutional Investor Ownership

    The proposed safe harbor would require that institutional investors 
beneficially own at least 33% of the total number of the issuer's 
equity securities outstanding on a fully diluted basis. The term 
``institutional investor'' would be defined in Rule 2710(c)(4)(D)(ii) 
to include any individual or entity (including a group of legal 
entities as proposed to be defined in Rule 2710(c)(4)(D)(i)) that has 
at least $50 million invested in securities in the aggregate in its 
portfolio or under management and is not (1) a member participating in 
the public offering; (2) any of the member's associated or affiliated 
persons; or (3) an immediate family member of any associated or 
affiliated person of the member.\21\
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    \21\ An institutional investor could be a member, or a person 
associated or affiliated with a member, that is not participating in 
the public offering.

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[[Page 19416]]

(4) Participation on and Vote of Board of Directors

    At least one of those institutional investors would have to serve 
as a member of the issuer's board of directors and the transaction 
would have to be approved by a majority of the issuer's board of 
directors and by an affirmative vote of the institutional investors 
that are board members.

(C) Safe Harbor No. 3--Private Placements with Institutional Investors

    The third safe harbor, proposed in Rule 2710(c)(4)(E)(iii), is 
intended for acquisitions in private placements with significant 
institutional investor participation. The safe harbor would be 
available for purchases of securities in a private placement and for 
the receipt of securities as placement agent compensation.

(1) 20% of Total Offering Limitation

    The underwriter and related persons could not, in the aggregate, 
acquire more than 20% of the ``total offering''. The ``total offering'' 
would be defined to consist of the total number of securities, on a 
fully diluted basis, sold in the private placement and received as 
placement agent compensation by a member.\22\ The 20% calculation would 
exclude purchases by those affiliates and other related persons of a 
member that would be qualified to acquire securities of the issuer 
under the first safe harbor.

(2) Same Terms and Price
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    \22\ For example, if the private placement consists of 100,000 
shares of common stock and the issuer pays placement agent 
compensation to a member that includes a warrant for 10,000 shares 
of common stock, the total offering is 110,000 shares of common 
stock. The acquisition by the underwriter and related persons that 
are not qualified to purchase under the first safe harbor could not 
exceed 22,000 shares of common stock. Of these 22,000 shares, 10,000 
shares would be accounted for by the warrant and up to 12,000 shares 
could be purchased as an investment.
---------------------------------------------------------------------------

    All securities purchased by the underwriter and related persons 
from the private placement must have the same terms \23\ and be 
purchased at the same price \24\ as securities purchased by the other 
investors.
---------------------------------------------------------------------------

    \23\ A security would be considered to have the same terms if it 
is a security of the same class with the same rights as the security 
sold to other investors. Thus, in a unit offering, the unit 
purchased by a member must be composed of the same number and type 
of securities and any exerciseable security within a unit must have 
the same exercise price as the exerciseable security within the unit 
purchased by other investors.
    \24\ If the purchasing member is also acting as placement agent, 
purchases by the member at a price that is net of the commission it 
receives for sales to the other investors will be considered to be 
``at the same price'' for purposes of this provision.
---------------------------------------------------------------------------

(3) 51% Institutional Investor Participation

    Institutional investors would have to purchase at least 51% of the 
total offering.\25\ In addition, an institutional investor would have 
to be the lead negotiator with the issuer to establish the terms of the 
private placement. This requirement would not prevent an underwriter or 
related person from participating in the negotiation of the terms of 
the private placement.
---------------------------------------------------------------------------

    \25\ In the example provided above, institutional investors must 
purchase at least 56,100 shares of the total offering of 110,000. 
See supra, n.22.
---------------------------------------------------------------------------

(D) Safe Harbor No. 4--Purchases Under a Preemptive Right

    The fourth safe harbor, proposed in Rule 2710(c)(4)(E)(iv), is 
intended for any acquisition of the issuer's securities by any 
underwriter or related person that is made pursuant to a right of 
preemption, whether that preemptive right was granted by contract, by 
the terms of the securities, or by applicable law.\26\ Purchases 
pursuant to a right of preemption generally do not raise the sorts of 
concerns that the Rule was designed to address because they are based 
on a purchase right granted to the purchaser in a prior investment. The 
right of preemption merely protects the purchaser from dilution when 
the company issues additional securities.
---------------------------------------------------------------------------

    \26\ The Corporate Financing rule does not prohibit a member 
from exercising a preemptive right to purchase securities from the 
issuer's public offering. However, such purchases by members, their 
associated and related persons, and affiliates are regulated by SEC 
Regulation M and the NASD's Free-Riding and Withholding 
Interpretation, IM-2110-1. See also Securities Exchange Act Release 
No. 42325 (Jan. 10, 2000), 65 FR 2656 (Jan. 18, 2000).
---------------------------------------------------------------------------

(1) Requirements Applicable to Acquisition of Preemptive Right

    If the security with a preemptive right was acquired from a private 
placement, the private placement would have to occur more than 180 days 
before the filing date of the public offering. If the security with a 
preemptive right was acquired from the public market or from a public 
offering, there would be no limitation on when the security must have 
been purchased, i.e., the security could have been purchased less than 
180 days before the subsequent public offering is filed.

(2) Requirements Applicable to Purchase under the Preemptive Right

    Under the safe harbor: (1) the right of preemption must be 
exercised in connection with a private placement of the issuer's 
securities for cash; (2) the private placement must be to all similar 
preemptive right holders; (3) the price and terms of the securities 
purchased must be she same as that for all other investors in the 
private placement; and (4) the purchaser may not, through the exercise 
of its preemptive rights, increase its ownership of the same class of 
securities of the issuer.

(iii) Calculation of the 180-Day Review Period

    The 180-day review period and the 90-day safe harbor period are 
proposed to be calculated from the filing date of a public offering 
with the appropriate regulatory authority in order to provide a readily 
identifiable standard. Consistent with existing Department practice, 
the ``filing date'' for purposes of this calculation would be the 
earlier of the date of filing with the SEC, state securities 
commission, or other regulatory authority, or the date of filing with 
the Association. Thus, if an offering is filed with the SEC before it 
is filed with the NASD, the ``filing date'' will be the SEC filing 
date. In addition, offerings submitted to the SEC for review on a 
confidential basis will be considered filed with the SEC as of the date 
of the confidential submission for purposes of Rule 2710.

(iv) Determination of when Securities are Considered ``Received''

    The purposed rule change would adopt Rule 2710 (c)(4)(B) to clarify 
when securities will be considered to be ``received'' under the Rule 
for purposes of the 180-day review period under Rule 2710(c)(4)(A) and 
the 90-day safe harbor period under Rule 2710(c)(4)(E). Securities 
purchased from or received as compensation for a private placement will 
be deemed to have been received on the date of the closing of the 
private placement.\27\ Securities received as compensation for a loan 
or credit facility will be deemed to have been received on the date the 
loan or credit facility agreement is executed. Securities received for 
consulting services to the issuer will be deemed to have been received 
on the date that beneficial ownership of the securities is transferred 
to the consultant. These proposals are consistent with existing 
Departmental practice.

(v) 90-Day Post-Offering Objective Test

    Rule 2710(c)(4)(A) permits the staff to examine items of value 
received ``subsequent to the public offering'' to determine whether the 
items of value are considered to be underwriting compensation in 
connection with the

[[Page 19417]]

public offering. The ability of the staff to include items of value 
received after the public offering in the calculation of underwriting 
compensation is necessary to avoid circumvention of the Rule.
    In order to provide greater clarity concerning the extent of the 
``subsequent'' time period, the proposed rule change would replace this 
language with new Rule 2710(c)(4)(C), under which items of value 
received within the 90-day period immediately following the effective 
date of a public offering would be examined to determine whether they 
constitute underwriting compensation.
---------------------------------------------------------------------------

    \27\ The Department relies on the closing date rather than the 
date of a commitment letter because a commitment letter does not 
transfer beneficial ownership of the securities.
---------------------------------------------------------------------------

(vi) Valuation of Warrants

    Rule 2710(c)(6)(B)(viii)(i) provides that any option, warrant or 
convertible securities received by the underwriter and related persons 
as underwriting compensation may not be convertible or exercisable on 
terms more favorable than the terms of the securities being offered to 
the public. The provision, therefore, prohibits members from receiving 
compensation in the form of warrants that have an exercise price below 
the proposed public offering price.
    The Rule requires that the warrants be valued, that they be 
included in the calculation of the underwriting compensation, and that 
they be subject to the Rule's compensation provisions. Therefore, the 
requirement that members revise the exercise price of their warrants 
seems unnecessary and Rule 2710(c)(6)(B)(viii)(i) is proposed to be 
deleted.
    The proposed rule change would amend Rule 2710(c)(5)(A), which 
prohibits the payment of underwriting compensation in the form of 
securities that are not identical to those offered to the public or to 
a security that has a bona fide independent market, in order to clarify 
the application of this prohibition.

(3) Restrictions on Resale of Securities

    As discussed above, the Corporate Financing Rule currently imposes 
a one-year compensation lock-up on securities that constitute 
underwriting compensation or, in the case of an initial public 
offering, a 90-day venture capital lock-up on all securities held by 
members and certain senior persons and subsidiaries.

(i) Background--Compensation Lock-Up

    The compensation lock-up was adopted primarily to protect the 
aftermarket in a new security from the potential for fraud and 
manipulation that exists when a member is an underwriter, actively 
trades the securities, and is a selling securityholder. These multiple 
roles for a broker/dealer were a basic concern discussed at length in 
the Report of the Special role for a broker/dealer were a basic concern 
discussed at length in the Report of the Special Study of the 
Securities Markets of the Securities and Exchange Commission issued in 
1963 (``Special Study'').\28\ In the testimony underlying the Special 
Study, industry members also stated that sales of an underwriter's 
private placement investments in an issuer shortly after the completion 
of an offering creates a negative appearance as the member has 
previously recommended the purchase of the security to its customers.
---------------------------------------------------------------------------

    \28\ Report of the Special Study of the Securities Markets of 
the Securities and Exchange Commission, 88th Cong., 1st Session, 
House Document No. 95, Part 1, Chapter IV.
---------------------------------------------------------------------------

(ii) Background--Venture Capital Lock-Up

    The venture capital lock-up was intended to address similar 
potentials for abuse in the context of an initial public offering, by 
imposing a lock-up restriction that prohibits the sale of any of the 
issuer's securities (not just those considered to be underwriting 
compensation) held by a member and certain senior persons and 
subsidiaries at the time of the offering and for 90 days thereafter. 
The venture capital lock-up does provide exceptions for de minimis 
transactions and transactions in which a qualified independent 
underwrither \29\ provides due diligence and a pricing opinion.
---------------------------------------------------------------------------

    \29\ The term ``qualified independent underwriter'' is defined 
in NASD Rule 2720(b)(15).
---------------------------------------------------------------------------

(iii) Proposed 180-Day Lock-Up

    NASD Regulation understands that it is common industry practice to 
impose a 180-day lock-up on the securities of the issuer held by 
certain officers and directors of the issuer. Consistent with this 
industry practice, NASD Regulation proposes to amend Rule 2710(c)(7)(A) 
and delete Rule 2710(c)(7)(C) to impose a 180-day lock-up on all equity 
securities of the issuer held by the underwriter and related persons at 
the time of effectiveness of the public offering. Securities purchased 
from the public market would not be subject to the lock-up. The new 
180-day lock-up would replace the one-year compensation lock-up and the 
90-day venture capital lock-up. It would apply to both initial public 
offerings'' and to secondary offerings, subject to the following 
exceptions in amended Rule 2710(c)(7)(B) for:
     Transfers of otherwise restricted securities that occur by 
operation of law or by reason of reorganization of the issuer;
     Transfers to participating members and their officers and 
partners, so long as the transferred securities remain subject to any 
remaining lock-up period;
     Transfers if a member and its related persons do not, in 
the aggregate, own more than 1% of the securities being offered; and
     The exercise of securities, so long as the exercised 
securities remain subject to any remaining lock-up period.
    In addition, secondary offerings of securities would be able to 
rely on an exception for transfers of securities that qualify as an 
``actively traded security'' for purposes of SEC Regulation M as of the 
date of effectiveness of the public offering.\30\
---------------------------------------------------------------------------

    \30\ Under SEC Regulation M, a security is considered to be an 
``actively traded security'' if it has at least $1 million average 
daily trading volume and $150 million public float value. 17 CFR 
242.100 through 242.105.
---------------------------------------------------------------------------

    The proposal would eliminate the existing exception in Rule 
2710(c)(7)(C)(i) from the venture capital lock-up for transactions in 
which a qualified independent underwriter provides a pricing opinion 
and performs due diligence. The exception does not adequately address 
the potential negative impact of immediate sales of members' securities 
into the after-market of an initial public offering or of securities 
with a thinly traded market nor the conflicts-of-interest present when 
an underwriter is also a selling securityholder.
    The proposed 180-day lock-up would address the concerns discussed 
in Part 1, Chapter IV of the Special Study related to the disposition 
of securities considered underwriting compensation. The Special Study 
did not focus on a particular time period that was appropriate for such 
a lock-up, but note with approval testimony that underwriting 
compensation securities were held by underwriters for some time period 
after the initial public offering and the practice of one broker/dealer 
that imposed a minimum six-month holding period.\31\
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    \31\ Special Study, at 541-542.
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    The discussion in the Special Study expressed concern regarding the 
opportunities for fraud and manipulation in the after-market of a 
company's initial public offering when a member is an underwriter, 
actively trades the securities, and is a selling securityholder, 
stating that the underwriter may be placed ``in situations where its 
duties and obligations to the issuer's stockholders, its own customers, 
and the general investing public may come into conflict.

[[Page 19418]]

* * *'' \32\ NASD Regulation believes it is appropriate to extend the 
protections intended for the after-market of an initial public offering 
to secondary offering of securities that do not have a sufficiently 
liquid market to address these conflicts-of-interest and to apply the 
lock-up to all equity securities of the issuer held by underwriters and 
related persons. This category of persons would include broker/dealers 
that are participating in the public offering and all of the broker/
dealer's associated, affiliated, and related persons.\33\
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    \32\ Special Study, at 539.
    \33\ In comparison, the current one-year compensation lock-up 
only covers those securities deemed to be underwriting compensation 
and, therefore, does not restrict the resale of other securities of 
the issuer by participating members. Further, the current 90-day 
venture capital lock-up only applies in the case of an initial 
public offering and only covers securities held by the member, its 
officers, directors, and certain of its affiliates. The 90-day 
venture capital lock-up, therefore, does not apply to secondary 
offerings and does cover securities held by other associated, 
affiliated, and related persons to the member.
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    The proposed exception for sales of an ``actively traded security'' 
will permit a member to sell the issuer's equity securities during the 
lock-up period in the case of a secondary public offering only if the 
security's market has sufficient liquidity to decrease the opportunity 
for a member to engage in fraud and manipulation in connection with the 
sale transaction. As stated by the Commission, ``[t]he costs of 
manipulating such securities generally are high. In addition, because 
actively-traded securities are widely followed by the investment 
community, aberrations in price are more likely to be discovered and 
quickly corrected. Moreover, actively-traded securities are generally 
traded on exchanges or other organized markets with high levels of 
transparency and surveillance.'' \34\
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    \34\ Securities Act Release No. 7375 (Dec. 20, 1996); 62 FR 520 
(Jan. 3, 1997).
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(iv) Lower Compensation Value for Longer Lock-Up

    In valuing any securities considered to be underwriting 
compensation, current Rule 2710(c)(5)(D) permits a lower valuation when 
the securities are subject to a lock-up beyond the one-year 
compensation lock-up period. This paragraph would be amended to 
discount the compensation value of securities by 10% for each 180-day 
period that the securities (or underlying securities) are restricted 
from sale beyond the proposed 180-day lock-up period.
    When a person agrees to such a longer lock-up in order to obtain a 
lower compensation value for the securities, the person would not be 
able to later rely on the exceptions from the 180-day lock-up for de 
minimis sales and sales of an ``actively traded security.'' However, 
the other exceptions would be available.

(v) Restrictive Legend

    The proposed rule change would delete Rule 2710(c)(7)(A)(ii), which 
requires that certificates representing any security subject to a lock-
up bear a restrictive legend describing the lock-up. NASD Regulation 
understands that members are required to obtain a CUSIP number for the 
securities subject to the lock-up imposed by the rule that is different 
from the number assigned to other securities of the same issue. NASD 
Regulation proposes to delete this requirement, as it places an 
unintended burden on members that is unnecessary. Members would still 
be required to establish appropriate written procedures pursuant to 
NASD Rule 3010(b)(1) for ensuring compliance with the proposed 180-day 
lock-up.

(4) Stock Numerical Limitation

(i) Elimination of Requirement

    The proposed rule change would eliminate the 10% stock numerical 
limitation in Rule 2710(c)(6)(B)(xi) on the amount of securities that 
participating underwriters and related persons may receive as 
underwriting compensation. The Rule already restricts the total value 
of all items that a member may receive as compensation, and Rule 2720 
addresses the conflicts-of-interest that may arise when a member is an 
affiliate of the issuer. Therefore, the stock numerical limitation is 
unnecessary to achieve the purposes of the Rule.

(ii) Sales of Securities Considered to be Underwriting Compensation

    Rule 2710(c)(6)(C) requires that when the stock numerical 
limitation has been exceeded, the recipient of the securities must 
return any excess securities to the issuer or the source from which 
received at cost and without recourse. A different arrangement may be 
permitted by the Association. In light of the proposed elimination of 
the stock numerical limitation, this provision would be amended to 
apply to an acquisition of securities that results in unfair and 
unreasonable compensation.

(5) Other Amendments \35\
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    \35\ The proposed rule change includes non-substantive 
amendments to Rule 2710 that are intended to provide clarity and 
consistency.
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(i) Types of Securities Considered to be Items of Value

    NASD Regulation proposes to amend Rule 2710(c)(3)(vii) to make non-
substantive amendments to the description of the types of equity 
securities that are considered items of value to be included in the 
calculation of underwriting compensation.

(ii) Exclusions From the Calculation of Underwriting Compensation

    The proposed rule change would amend Rule 2710(c)(3)(B) to put into 
one place all items of value that will be excluded from the calculation 
of underwriting compensation.

(A) Payments to a Previous Underwriter

    Rule 2710(c)(3)(A)(xiii) requires the Department to include any 
fees paid to a previous underwriter that failed to complete a public 
offering in the calculation of underwriting compensation for a 
subsequent underwriter. This provision is intended to restrict the 
total amount of compensation paid to all underwriters, but it has 
imposed an unfair restriction on the compensation of replacement 
underwriters. Consequently, the proposed rule change would delete this 
provision.
    The proposed rule change would further codify this determination in 
new Rule 2710(c)(3)(B)(ii) by excluding from the calculation of 
underwriting compensation any payment to a member in connection with a 
proposed public offering that was not completed, if the member does not 
participate in the revised offering.\36\
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    \36\ NASD Rule 2710(c)(6)(B)(iv) would continue to prohibit 
payment of any compensation by an issuer to a member in connection 
with an offering of securities that is not completed according to 
the terms of agreement between the issuer and underwriter, except 
for reimbursement of out-of-pocket accountable expenses actually 
incurred by the member.
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(B) Consulting Agreements

    The requirements of Rule 2710(c)(4)(E) would be moved to new Rule 
2710(c)(3)(B)(iii), which would continue to exclude from the 
calculation of underwriting compensation any payments received under a 
consulting agreement entered into more than one year before the filing 
date of the public offering.

(iii) Members' Obligation to File Information

    Current Rule 2710(b) requires that members file certain documents 
and

[[Page 19419]]

other information with the Department in connection with a public 
offering. The Department must rely on the adequacy and accuracy of the 
information filed by members in order to carry out its regulatory 
obligations under the rules that apply to public offerings of 
securities. To the extent, therefore, that a member or its counsel or 
other agent fails to provide all of the facts necessary for the 
Department's review of a public offering, files inaccurate information, 
fails to update or correct previously filed information, or fails to 
comply with representations made to the Department, the member would 
violate the Rule and NASD Conduct Rule 2110 (the Association's basic 
ethical conduct rule).
    The proposed rule change would clarify this obligation of the 
member in several respects. First, Rule 2710(b)(6)(A)(v) would be 
amended to require members to provide the Department with a detailed 
explanation and documents related to a modification of any information 
or representation previously provided to the Association or of any item 
of underwriting compensation. Thus, in the event that the member (or 
member's counsel or other agent) determines that subsequent events have 
made inaccurate any information or representations previously provided 
to the Department, the member must inform the Department regarding the 
change. This obligation applies regardless of whether the change occurs 
before or after the issuance of the Department's opinion of a ``no 
objections'' to the underwriting terms and arrangements.
    Second, proposed Rule 2710(b)(6)(A)(v)(b) would provide that if an 
underwriter or related person receives any additional item of value 
subsequent to the Department's issuance of a ``no objections'' opinion 
and within 90 days following the offering's effective date, then the 
member must provide a detailed explanation and any documents related to 
the new arrangement to the Department.
    The proposed rule change would also delete Rule 2710(b)(6)(iv), as 
it requires the submission of information addressing the subjective 
review factors in Rules 2710(c)(4)(C) and (D). As set forth above, 
paragraphs (C) and (D) are proposed to be deleted.

(d) Implementation of Proposed Rule Change

    NASD Regulation proposes to implement the proposed rule change upon 
approval by the SEC. Any public offering filed subsequent to the 
adoption of the amendments and any public offering that had been filed 
with the Department but for which a ``no objections'' letter has yet to 
be issued, would be subject to the new requirements. In addition, with 
respect to public offerings for which a ``no objections'' letter has 
been issued at the time the amendments are adopted, the one-year 
compensation lock-up on securities would be shortened to 180 days and 
members could rely on the exceptions from the 180 day lock-up.\37\ Upon 
adoption of the amendments, any securities that are subject to the 90-
day venture capital lock-up would remain subject to that lock-up until 
it expires, but any person holding such securities could rely on the 
exceptions from the 180-day lock-up.
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    \37\ For these offerings, the lock-up period would apply only to 
securities deemed to be underwriting compensation, as required by 
current Rule 2710(c)(7)(A)(i). Telephone call between Katherine 
England, Assistant Director, Division, Commission, Sonia Patton, 
Attorney, Division, Commission, and Suzanne Rothwell, Chief Counsel, 
Corporate Financing, NASD Regulation (March 28, 2000).
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2. Statutory Basis
    NASD Regulation believes that the proposed rule change is 
consistent with the provisions of Section 15A(b)(6) of the Act,\38\ 
which requires, among other things, that the Association's rules be 
designed to prevent fraudulent and manipulative acts and practices, to 
promote just equitable principles of trade and, in general, to protect 
investors and the public interest. The NASD believes that the proposed 
rule change will burdensome rules that no longer distinguish between 
bona fide capital-raising and lending practices and abusive 
arrangements and will minimize the opportunity for abusive practices by 
members in connection with underwriting public offerings of securities.
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    \38\ 15 U.S.C. 78o-3(b)(6).
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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.

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

    Written comments were not solicited on the proposed rule change. 
However, NASD Notice to Members 98-81 requested comment on whether any 
NASD rules are obsolete. NASD Regulation received a comment letter from 
The Bond Market Association (``TBMA'') that included two recommended 
amendments to Rule 2710 that are pertinent to the proposed rule 
change.\39\ The recommendations of TBMA to amend other provisions of 
Rule 2710 are under consideration by the Association and are not 
pertinent to the proposed rule change.
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    \39\ Letter dated January 15, 1999, from TBMA, to Joan Conley, 
Office of the Corporate Secretary, NASD Regulation (``TBMA'').
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    TBMA recommends that the subjective review factors of Rule 
2710(c)(4)(D) be amended to consider whether there is a bona fide 
business purpose for an acquisition of securities.\40\ Rule 
2710(c)(4)(D) is proposed to be deleted and Rule 2710(c)(4)(A) would be 
amended to adopt an objective, bright-line test to include in the 
calculation of underwriting compensation all items of value received by 
the underwriter and related persons during the 180-day period 
immediately preceding the filing of the public offering and during the 
public offering. Thus, the subjective factor proposed by TBMA is no 
longer necessary to the Department's review of underwriting 
compensation.
---------------------------------------------------------------------------

    \40\ TBMA Letter, at 18.
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    In addition, TBMA recommends that Rule 2710(c)(5)(A) be amended to 
permit the underwriter and related person to receive as compensation a 
security different than the security offered to the public if there is 
a reasonable method to value the security received.\41\ The proposed 
rule change would amend Rule 2710(c)(5)(A) to clarify the current 
language of the provision, which allows the Department to permit the 
underwriter and related person to receive a security that is different 
than the security offered to the public and that does not have a bona 
fide independent market, if good cause can be shown for the 
arrangement. One of the considerations in permitting such an 
arrangement would be whether the Department can value the security for 
compensation purposes. In the absense of a bona fide independent market 
for a security, the decision on whether a security that is different 
than the security to be offered to the public can be reliably valued is 
subjective and, therefore, not amenable to codification.
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    \41\ Id.
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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

[[Page 19420]]

(ii) as to which NASD Regulation consents,\42\ the Commission will:
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    \42\ NASD Regulation has consented to a 90-day extension of the 
time period for Commission action. See Amendment No. 2, supra n. 4.
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    (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, including whether the proposal is 
consistent with the Act. Persons making written submissions should file 
six copies thereof with the Secretary, Securities and Exchange 
Commission, 450 Fifth Street, NW, Washington, DC 20549-0609. 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 the filing will also be available for 
inspection and copying at the principal office of the NASD. All 
submissions should refer to the File No. SR-NASD-00-04 and should be 
submitted by May 26, 2000.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\43\
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    \43\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 00-8876 Filed 4-10-00; 8:45 am]
BILLING CODE 8010-01-M