[Federal Register Volume 65, Number 235 (Wednesday, December 6, 2000)]
[Notices]
[Pages 76316-76329]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-30976]



[[Page 76316]]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-43627; File No. SR-NASD-99-60]


Self-Regulatory Organizations; Notice of Filing of Amendment No. 
2 to Proposed Rule Change by the National Association of Securities 
Dealers, Inc. Relating to Trading in Hot Equity Offerings

November 28, 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 November 15, 2000, the National Association of Securities Dealers, 
Inc. (``NASD'' or ``Association''), through its wholly owned subsidiary 
NASD Regulation, Inc. (``NASD Regulation''), filed with the Securities 
and Exchange Commission (``Commission'' or ``SEC'') Amendment No. 2 to 
the proposed rule change \3\ as described in Items I, II, and III 
below, which Items have been prepared by NASD Regulation. The 
Commission is publishing this notice of Amendment No. 2 to solicit 
comments on the amended 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\ See Letter from Alden S. Adkins, Senior vice President and 
General Counsel, NASD Regulation, to Katherine A. England, Assistant 
Director, Division of Market Regulation (``Division''), Commission, 
dated November 14, 2000 (``Amendment No. 2''). In response to the 
comment letters, Amendment No. 2 was filed to replace the proposed 
rule change and Amendment No. 1 in their entirety.
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    On October 15, 1999, NASD Regulation submitted the proposed rule 
change to the Commission. On December 21, 1999, NASD Regulation 
submitted Amendment No. 1 to the proposed rule change.\4\ The proposed 
rule change and Amendment No. 1 were published for comment in the 
Federal Register on January 18, 2000.\5\ The Commission received 
twenty-four comment letters on the proposed rule change.\6\ NASD 
Regulation is responding to the comment letters with Amendment No. 2.
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    \4\ See Letter from Gary L. Goldsholle, Assistant General 
Counsel, NASD Regulation, to Katherine A. England, Assistant 
Director, Division, Commission, dated December 20, 1999 (``Amendment 
No. 1''). In Amendment No. 1, NASD Regulation makes certain 
technical amendments to the proposed rule change.
    \5\ Securities Exchange Act Release No. 42325 (January 10, 
2000), 65 FR 2656.
    \6\ Letter from Willkie Farr & Gallagher to Jonathan G. Katz, 
SEC, dated January 28, 2000 (``Willkie''); Letter from Faith Colish 
to Jonathan G. Katz, SEC, dated January 31, 2000 (``Colish''); 
Letter from Katten Muchin Zavis to Jonathan G. Katz, SEC, dated 
January 28, 2000 (``Katten''); Letter from Driehaus Capital 
Management, Inc. to Jonathan G. Katz, SEC, dated February 4, 2000 
(``Driehaus''); Letter from Fu Associates, Ltd. to Jonathan G. Katz, 
SEC, dated February 7, 2000 (``Fu''); Letter from Cadwalader, 
Wickersham & Taft to Jonathan G. Katz, SEC, dated February 4, 2000 
(``Cadwalader''); Letter from Schulte Roth & Zabel LLP to Jonathan 
G. Katz, SEC, dated February 7, 2000 (``Schulte''); Letter from 
Rosenman & Colin LLP to Jonathan G. Katz, SEC, dated February 7, 
2000 (``Rosenman''); Letter from Fried, Frank, Harris, Shriver & 
Jacobson to Jonathan G. Katz, SEC, dated May 9, 2000 (``Fried''); 
Letter from Ropes & Gray to Jonathan G. Katz, SEC, dated February 8, 
2000 (``Ropes''); Letter from The Washington Group to Jonathan G. 
Katz, SEC, dated February 8, 2000 (``Washington''); Letter from 
Testa, Hurwitz & Thibeault, LLP to Jonathan G. Katz, SEC, dated 
February 8, 2000 (``Testa''); Letter from Chicago Board Options 
Exchange to Jonathan G. Katz, SEC, dated February 14, 2000 
(``CBOE''); Letter from Sullivan & Cromwell to Jonathan G. Katz, 
SEC, dated February 15, 2000 (``Sullivan''); Letter from Charles 
Schwab to Jonathan G. Katz, SEC, dated February 15, 2000 
(``Schwab''); Letter from Sidley & Austin to Jonathan G. Katz, SEC, 
dated February 16, 2000 (``Sidley''); Letter from North American 
Securities Administrators Association, Inc. to Jonathan G. Katz, 
SEC, dated February 18, 2000 (``NASAA''); Letter from Northern Trust 
Global Advisors, Inc. to Jonathan G. Katz, SEC, dated February 13, 
2000 (``Northern''); Letter from Securities Industry Association to 
Jonathan G. Katz, dated February 18, 2000 (``SIA''); Letter from 
Morgan Stanley Dean Witter to Jonathan G. Katz, SEC, dated March 17, 
2000 (``MSDW''); Letter from Mayor, Day, Caldwell & Keeton, LLP to 
Jonathan G. Katz, SEC, dated June 2, 2000 (``Mayor''); Letter from 
Covington & Burling to Jonathan G. Katz, SEC, dated April 14, 2000 
(``Covington''); Letter from Orrick, Herrington & Sutcliffe LLP to 
Jonathan G. Katz, SEC, dated May 2, 2000 (``Orrick''); and Letter 
from Sandra K. Smith to Jonathan G. Katz, SEC, dated February 1, 
2000 (``Smith'').
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    NASD Regulation proposes to establish NASD Rule 2790, Restrictions 
on the Purchase and Sale of Initial Equity Public Offerings, to replace 
the Free-Riding and Withholding Interpretation, IM-2110-1. Below is the 
amended text of the proposed rule change as proposed in Amendment No. 
2. Additions are italicized and deletions are bracketed. (Note: Section 
(a) ``Definitions'' has been renumbered as Section (i). The comparison 
of changes to the defintions is located under Section (i).

Rule 2790. [Trading in Hot Equity Offerings]

[(b)] Restrictions on the Purchase and Sale of Initial Equity Public 
Offerings
(a) General Prohibitions
    (1) A member or a person associated with a member may not sell, or 
cause to [sell,] be sold, a [hot] new issue [in a public offering] to 
any account in which a restricted person [or a member of the restricted 
person's immediate family] has a beneficial interest, except as 
otherwise permitted herein [or through an exemption pursuant to the 
Rule 9600 Series].
    (2) A member or a person associated with a member may not purchase 
a [hot issue in a public offering, except as permitted herein or 
through an exemption pursuant to the Rule 9600 Series.] new issue in 
any account in which such member or person associate with a member has 
a beneficial interest, except as otherwise permitted herein.
    (3) A member may not continue to hold [hot issues acquired in a 
public offering except as permitted herein or through an exemption 
pursuant to the Rule 9600 Series.] new issues acquired by the member as 
an underwriter, selling group member, or otherwise, except as otherwise 
permitted herein.
[(c) Canceling Trades
    A member or a person associated with a member does not violate this 
rule if it cancels a sale of a hot issue made to the account of a 
restricted person or a member of the person's immediate family prior to 
the end of the first business day following the date that market 
trading commences (i.e., T+1) and reallocates such hot issue at the 
public offering price to a non-restricted person.
(d)](b) Preconditions for Sale
    Before selling a [hot] new issue to any account, a member must in 
good faith have obtained within the [previous] twelve months 
[documentary evidence] prior to such sale, a representation from the 
account holder(s), or a person authorized to represent the beneficial 
owners of the account [or the ultimate purchasers if the account is a 
conduit account, demonstrating that no restricted person or ultimate 
purchasere in the case of a conduit account, has a beneficial interest 
in the account, except as permitted under the rule. Members], that the 
account is eligible to purchase new issues in compliance with this 
rule. A member may not rely upon any representation that it believes, 
or has reason to believe, is inaccurate. A member shall maintain a copy 
of all records and information [used to determine that] relating to 
whether an account [does not contain a restricted person] is eligible 
to purchase new issues in its files for at least three years following 
the member's last sale of a [hot] new issue to that account.
    [(e) General Exemptions] (c) General Exemptions
    [A member or a person associated with a member may sell hot issues 
to:] The general prohibitions in paragraph (a) of this rule shall not 
apply to sales to and purchases by:

[[Page 76317]]

    [(1) A registered investment company] (1) An investment company 
registered under the Investment Company Act of 1940[.];
    [(2) A collective investment account (including a joint back office 
broker/dealer or a collective investment account with a joint back 
office broker/dealer subsidiary),] (2) A common trust fund or similar 
fund as described in Section 3(a)(12)(A)(iii) of the Act, provided 
that:
    (A) the fund has investments from 1,000 or more trust accounts; and
    (B) the fund does not limit beneficial interests in the fund 
principally to trust accounts of restricted persons;
    (3) An insurance company general, separate or investment account, 
provided that:
    (A) the account has investments from 1,000 or more policyholders; 
and
    (B) the insurance company does not limit beneficial interests in 
the account principally to restricted persons;
    (4) An account that is beneifically owned in part by restricted 
persons, provided that such restricted persons in the aggregate own 
less than 5% of such account, and that:[.]
    [(3) A publicly traded corporation (other than an affiliate of a 
broker/dealer) listed on an exchange or The Nasdaq Stock Market, in 
which no person with a 10% or more ownership interest in a restricted 
person.] (A) each such restricted person does not manage or otherwise 
direct investments in the account; and
    [(4) A foreign] (B) on a pro rata basis, each such restricted 
person who is a natural person receives less than 100 shares of any new 
issue;
    (5) A publicly traded entity (other than a broker/dealer) that is 
listed on a national securities exchange or is traded on the Nasdaq 
National Market, provided that the gains or losses from new issues are 
passed on directly or indirectly to public shareholders;
    (6) An investment company organized under the laws of a foreign 
jurisdiction, [meeting the following criteria:] provided that:
    [(A) the company has 100 or more investors;
    (B) the](A) the investment company is listed on a foreign exchange 
or authorized for sale to the public by a foreign regulatory authority; 
and
    (B)[(C)] no person owning more than 5% of the shares of the 
investment [company's assets shall be invested in a particular hot 
issue; and,
    (D) no person owning more than 5% interest in such] company is a 
restricted person[.];
    [(5) An employee benefits plan qualified under the] (7) An Employee 
Retirement Income Security Act [provided that the plan sponsor is not a 
member or an affiliate; or a state or foreign government employee 
benefit] benefits plan that is qualified under Section 401(a) of the 
Internal Revenue Code, provided that such plan is not sponsored solely 
by a broker/dealer;
    (8) A state or municipal government benefits plan that is subject 
to [separate] state [and] and/or municipal regulation; or[.]
    [6](9) A tax exempt charitable organization under Section 501(c)(3) 
of the Internal Revenue Code.
    [(7) Employees and directors of the issuer, an entity which 
controls, is controlled by, or is under common control of the issuer.]

(d) Issuer-Directed Securities

    [(8) An immediate family member of a restricted person in paragraph 
(a)(11)(B) if:] The prohibitions on the purchase and sale of new issues 
in this rule shall not apply to securities that:
    [(A) such restricted person does not directly or indirectly provide 
material support to, or receive material support from, the immediate 
family member;]
    (1) are specifically directed by the issuer; provided, however, 
that this exemption shall not apply to securities directed by the 
issuer to an account in which any restricted person specified in 
subparagraphs (i)(10)(B) or (i)(10)(C) of this rule has a beneficial 
interest, unless such person, or a member of his or her immediate 
family, is an employee or director of the issuer, the issuer's parent, 
or a subsidiary of the issuer. Also, for purposes of this subparagraph 
(d)(1) only, a parent/subsidiary relationship is established if the 
parent has the right to vote 50% or more of a class of voting security 
of the subsidiary, or has the power to sell or direct 50% or more of a 
class of voting securities of the subsidiary;
    [(B) such restricted person is not employed by the member,]
    (2) are part of a program sponsored by the issuer or an affiliate 
of the issuer that [member, selling the hot issue to the immediate 
family member; and
    (C) such restricted person has no ability to control the allocation 
of the hot issue.
    (9) An immediate family member of a restricted person in paragraphs 
(a)(11)(C)-(D) if such restricted person does not directly or 
indirectly provide material support to the member of the immediate 
family;
    (10) A restricted person in paragraph (a)(11)(E) provided that the 
sale is to an account established for the benefit of bona fide public 
customers, including insurance company general, separate and investment 
accounts, and bank trust accounts.
(f) Anti-Dilution Provisions
    The restrictions on the sale of hot issued in this rule shall not 
apply to sales to a restricted person in an initial public offering 
who] meets the following criteria:
    (a) the opportunity to purchase a new issue under the program is 
offered to at least 10,000 participants;
    (b) every participant is offered an opportunity to purchase an 
equivalent number of shares, or will receive a specified number of 
shares under a predetermined formula applied uniformly across all 
participants;
    (c) if not all participants receive shares under the program, the 
selection of the participants eligible to purchase shares is based upon 
a random or other non-discretionary allocation method;
    (d) the class of participants does not contain a disproportionate 
number of restricted persons as compared to the investing public 
generally; and
    (e) sales are not made to participants who are managing 
underwriter(s), the broker/dealer administering the program 
(``Administering Broker/Dealer''), the officers or directors of the 
managing underwriter(s) or Administering Broker/Dealer, or any employee 
of the managing underwriter(s) or Administering Broker/Dealer with 
access to non-publicly available information about the new issue; or
    (3) are directed to eligible purchasers as part of a conversion 
offering in accordance with the standards of the governmental agency or 
instrumentality having authority to regulate such conversion offering.

(e) Anti-Dilution Provisions

    The prohibitions on the purchase and sale of new issues in this 
rule shall not apply to an account in which a restricted person has a 
beneficial interest that meets the following conditions:
    (1) the restricted person has held an equity ownership interest in 
the issuer, or a company that has been acquired by the issuer in the 
past year, for a period of one year prior to the effective date of the 
[public] offering;
    (2) the sale of the [hot issues] new issue to the [restricted 
person] account shall not increase the restricted person's percentage 
equity ownership in the issuer above the ownership level as of three 
months prior to the filing of the registration statement [with the SEC] 
in connection with the offering;

[[Page 76318]]

    (3) the sale of [hot issues to the restricted person must not 
include any special terms; and
    (4) the hot issues purchased pursuant to this subsection shall be 
restricted from sale or transfer for a period of three months following 
the effective date of the offering.
(g) Conversion Offerings
    The rule shall not apply to the sale of securities directed by the 
issuer of a conversion offering, either on an underwritten or non-
underwritten basis, to any person eligible to purchase securities in 
accordance with the governmental agency or instrumentality having 
authority to regulate such conversion offering.] the new issue to the 
account shall not include any special terms; and
    (4) the new issue purchased pursuant to this subparagraph (e) shall 
not be sold, transferred, assigned, pledged or hypothecated for a 
period of three months following the effective date of the offering.

(f) Stand-by Purchasers

    The prohibitions on the purchase and sale of new issues in this 
rule shall not apply to the purchase and sale of securities pursuant to 
a stand-by agreement that meets the following conditions:
    (1) the stand-by agreement is disclosed in the prospectus;
    (2) the stand-by agreement is the subject of a formal written 
agreement;
    (3) the managing underwriter(s) represents in writing that is was 
unable to find any other purchasers for the securities; and
    (4) the securities sold pursuant to the stand-by agreement shall 
not be sold, transferred, assigned, pledged or hypothecated for a 
period of three months following the effective date of the offering.

(g) Under-Subscribed Offerings

    Nothing in this rule shall prohibit an underwriter, pursuant to an 
underwriting agreement, from placing a portion of a public offering in 
its investment account when it is unable to sell that portion to the 
public.

(h) Exemptive Relief

    Pursuant to the Rule 9600 series, the staff, for good cause shown 
after taking into consideration all relevant factors, may conditionally 
or unconditionally exempt any person, security or transaction (or any 
class or classes of persons, securities or transactions) from this rule 
to the extent that such exemption is consistent with the purposes of 
the rule, the protection of investors, and the public interest.

(i) Definitions

    (1) [``Affiliate'' shall have the same meaning as in Rule 
2720(b)(1). (2) ``Beneficial interest'' means any [ownership or other 
direct financial interest] economic interest, such as the right to 
share in gains or losses. The receipt of a management or performance 
based fee for operating a collective investment account shall not be 
considered a beneficial interest in the account.
    [(3)](2) ``Collective investment account'' means any hedge fund, 
investment partnership, investment corporation, or any other collective 
investment vehicle [that manages assets of other persons. Collective 
investment account shall not include any entity in which the decision 
to buy or sell securities is made jointly by each of the persons 
investing in the entity or by a member of their immediate family.].
    [(4)](3) ``Conversion offering'' means any offering of securities 
made as part of a plan by which a savings and loan association, 
insurance company, or other organization converts from a mutual to a 
stock form of ownership.
    [(5) ``Hot issue'' means any security that is part of a public 
offering if the volume weighted price during the first five minutes of 
trading in the secondary market is 5% or more above the public offering 
price.]
    (4) ``Family partnership'' means a partnership comprised solely of 
immediate family members.
    [(6)](5) ``Immediate family member'' [shall include] means a 
person's parents, mother-in-law or father-in-law, spouse, brother or 
sister, brother-in-law or sister-in-law, son-in-law or daughter-in-law, 
and children, and any other individual to whom the person[, directly or 
indirectly,] provides material support.
    [(7) ``Joint back office broker/dealer'' means any domestic or 
foreign private investment fund that has voluntarily registered as a 
broker/dealer solely to take advantage of more favorable margin 
treatment afforded under Section 220.7 of Regulation T of the Federal 
Reserve. The activities of a joint back office broker/dealer must not 
require that it register as a broker/dealer under Section 15(a) of the 
Act.]
    (6) ``Investment club'' means a group of friends, neighbors, 
business associates, or others that pool their money to invest in stock 
or other securities and are collectively responsible for making 
investment decisions.
    [(8)](7) ``Limited business broker/dealer'' means any broker/dealer 
whose authorization to engage in the securities business is limited 
solely to the purchase [or] and sale of [either] investment company/
variable contracts securities [or] and direct participation program 
securities.
    [(9)](8) ``Material support'' means directly or indirectly 
providing more than [10%] 25% of a person's income [or expenses. 
Material support shall be presumed for members] in the current or prior 
calendar year. Members of the immediate family living in the same 
household are deemed to be providing each other with material support.
    (9) ``New issue'' means any initial [.(10) ``Public offering'' 
means any initial or secondary] public offering of an equity security 
as defined in [section] Section 3(a)(11) of the Act, made pursuant to a 
registration statement or offering cicrcular, [including exchange 
offers, rights offerings, offerings made pursuant to a merger or 
acquisition,] or other securities distributions of any kind whatsoever, 
including securities that are specifically directed by the issuer on a 
non-underwritten basis. [Public offering] New issue shall not include:
    (A) [Offerings] offerings made pursuant to an exemption under 
Section 4(1), 4(2) or 4(6) of the Securities Act of [1993 or SEC Rule 
504, 505 or]1933, or SEC Rule 504 if the securities are ``restricted 
securities'' under SEC Rule 144(a)(3), or Rule 505 or Rule 506 adopted 
thereunder; [and]
    (B) [Offerings] offerings of exempted securities as defined in 
Section 3(a)(12) of the Act;
    (C) rights offerings, exchange offers, or offerings made pursuant 
to a merger or acquisition;
    (D) offerings of investment grade asset-backed securities;
    (E) offerings of convertible securities;
    (F) offerings of preferred securities; and
    (G) offerings of securities of closed-end companies as defined 
under Section (5)(a)(2) of the Investment Company Act of 1940. 
(10)[(11)] ``Restricted person'' [includes] means:
    (A) Members or other broker/dealers[, unless the ultimate purchaser 
is a non-restricted person purchasing the security at the public 
offering price;];
    [(B) Officers, directors, general partners, employees or agents] 
(B) Broker/Dealer Personnel
    (i) Any officer, director, general partner, associated person, or 
employee of a member or any other broker/dealer (other than a limited 
business broker/dealer), or any agent of a member or any other broker/
dealer (other than a limited

[[Page 76319]]

business broker/dealer) that is engaged in the investment banking or 
securities business;[;]
    [(C)](ii) An immediate family member of a person specified in 
subparagraph (B)(i) if the person specified in subparagraph (B)(i):
    (a) materially supports, or receives material support from, the 
immediate family member;
    (b) is employed by or associated with the member, or an affiliate 
of the member, selling the new issue to the immediate family member; or
    (c) has an ability to control the allocation of the new issue.

(C) Finders and Fiduciaries

    (i) With respect to the security being offered, [finders] a finder 
or any person acting in a fiduciary capacity to the managing 
underwriter, including, but not limited to, attorneys, accountants and 
financial consultants; and
    (ii) An immediate family member of a person specified in 
subparagraph (C)(i) if the person specified in subparagraph (C)(i) 
materially supports, or receives material support from, the immediate 
family member.

(D) Portfolio Managers

    (i) Any person who has authority to buy or sell[(D) Any employee or 
other person who supervises, or whose activities directly or indirectly 
involve or are related to, the buying or selling of] securities for a 
bank, savings and loan institution, insurance company, investment 
company, investment advisor, or collective investment account, other 
than with respect to a beneficial interest in the bank, savings and 
loan institution, insurance company, investment company, investment 
advisor, or collective investment account over which such person has 
investment authority; [;]
    [(E) Any affiliate of a broker/dealer (other than a limited 
business broker/dealer); and](ii) An immediate family member of a 
person specified in subparagraph (D)(i) that is materially supported by 
such person, other than with respect to a beneficial interest in the 
bank, savings and loan institution, insurance company, investment 
company, investment advisor, or collective investment account over 
which such person has investment authority.
    [(F) Any natural person or member of the person's immediate family 
who owns 10% or more or has contributed 10% or more of the capital of a 
broker/dealer (other than a limited business broker/dealer).] Provided, 
however, that the term ``restricted person'' under this subparagraph 
(D) shall not include a person solely because he or she is a 
participant in an investment club or a family partnership.

(E) Persons Owning a Broker/Dealer

    (i) Any person listed, or required to be listed, in Schedule A of a 
Form BD, except persons with ownership interests of less than 10%;
    (ii) any person listed, or required to be listed, in Schedule B of 
a Form BD, except persons whose listing on Schedule B relates to an 
ownership interest in a person listed on Schedule A with an ownership 
interest of less than 10%;
    (iii) any person listed, or required to be listed, in Schedule C of 
a Form BD that meets the criteria of subparagraphs (E)(i) and (E)(ii) 
above;
    (iv) any person that directly or indirectly owns 10% or more of a 
public reporting company listed on Schedule A of a Form BD (other than 
a reporting company that is listed on a national securities exchange or 
is traded on the Nasdaq National Market, provided that the gains or 
losses from new issues are passed on directly or indirectly to public 
shareholders);
    (v) Any person that directly or indirectly owns 25% or more of a 
public reporting company listed on Schedule B of a Form BD (other than 
a reporting company that is listed on a national securities exchange or 
is traded on the Nasdaq National Market, provided that the gains or 
losses from new issues are passed on directly or indirectly to public 
shareholders).
    (vi) An immediate family member of a person specified in 
subparagraphs (E)(i)-(v) unless the person owning the broker/dealer:
    (a) does not materially support, or receive material support from, 
the immediate family member;
    (b) is not an owner of the member, or an affiliate of the member, 
selling the new issue to the immediate family member; and
    (c) has no ability to control the allocation of the new issue.

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
    (i) Background. In general, NASD Regulation believes that the 
commenters supported its efforts to reform the Free-Riding and 
Withholding Interpretation.\7\ Several commenters believed that the 
proposed rule change was a significant improvement over the 
Interpretation. Testa stated that ``[i]n general, the Proposal presents 
a much more easily understood and more workable regulatory scheme.'' 
Kattan and Schwab stated that the proposed rule change was more 
carefully targeted towards the purpose of the rule while at the same 
time it was easier for firms, institutional investors and the investing 
public in general to understand and follow. Katten also added that 
protecting the integrity of the public offering process is a noteworthy 
objective that benefits all investors.
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    \7\ See, e.g., Sullivan, SIA, and Schwab.
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    As NASD Regulation expected, the commenters supported certain 
elements of the proposed rule change, opposed others, and made 
suggestions for further changes. A summary and analysis of the specific 
comments are provided below.
    (ii) Scope of Securities Covered by the Proposed Rule Change. The 
area that generated the most comment was the proposed definition of 
``hot issue.'' Currently, under the Interpretation, a hot issue is any 
security in a public offering that trades at a ``premium'' in the 
secondary market. In the October 1999 filing, NASD Regulation defined a 
hot issue as a security that is part of a public offering ``if the 
volume weighted price during the first five minutes of trading in the 
secondary market was 5% or more above the public offering price.'' Many 
commenters supported NASD Regulation's decision to adopt a clear and 
measurable standard for determining whether an offering is a hot issue, 
but believed that the 5% threshold was too low. Colish, Driehaus, SIA, 
and MSDW questioned whether the methodology proposed by NASD Regulation 
would be effective in identifying those offerings that should be 
subject to the rule. Colish and Dreihaus added that NASD Regulation 
should supply data to support its chosen methodology.
    By contrast, Schwab and the SIA suggested what they termed a more 
``straightforward'' approach: prohibiting

[[Page 76320]]

allocations of all initial public offerings (``IPOs'') to restricted 
persons. Schwab stated that even though the Interpretation and the 
proposed rule change contain a safe harbor for canceling a sale and 
reallocating the security to a non-restricted account, many firms do 
not and would not avail themselves of the safe harbor. In practice, 
Schwab said, under the proposed hot issue definition, firms would 
continue too treat all IPOs as hot issues. The SIA, which argued in the 
alternative for a higher threshold premium, agreed and stated that if a 
5% threshold were adopted, firms would continue to treat all IPOs as 
being subject to the rule because they cannot be in a position of 
having to anticipate which offerings will trade through the 5% 
threshold.
    Based on these comments, NASD Regulation has amended the proposed 
rule change to restrict the purchase and sale of all initial equity 
public offerings,\8\ not just those that open above a certain premium. 
Like Schwab and the SIA, NASD Regulation believes that this approach is 
the most straightforward way to achieve the purposes of the rule. It is 
both easier to understand and avoids many of the complexities 
associated with canceling and reallocating the sale of an IPO to a non-
restricted person in the event that an offering unexpectedly becomes a 
hot issue. NASD Regulation disagrees with those commenters who 
recommended a higher threshold premium, such as 10% or more. In NASD 
Regulation's view, allocating IPOs with such notable gains (approaching 
10% or even more) to restricted persons is precisely the type of 
conduct that the rule is designed to prevent.
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    \8\ Amendment No. 2, like the October 1999 filing, limits the 
application of the proposed rule change to equity offerings only.
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    As a corollary to the proposal to apply the proposed rule change to 
all IPOs, NASD Regulation is proposing to exempt secondary offerings. 
Many of the commenters opposed NASD Regulation's decision in the 
October 1999 filing to roll back the exemption for secondary offerings 
of actively traded securities. As NASD Regulation stated in the October 
1999 filing, the decision to roll back the exemption for secondary 
offerings was premised upon the decision to adopt a 5% threshold 
premium for hot issues. NASD Regulation believed that with a 5% 
premium, as a practical matter, all secondary offerings would be exempt 
from the rule. In proposing to eliminate the requirement for a 5% 
threshold premium, however, NASD Regulation believes that reinstating 
the exemption for secondary offerings is now appropriate. NASD 
Regulation has observed that secondary offerings rarely, if at all, 
trade at a significant premium to the public offering price. We also 
agree with Schwab that the negative consequences to both issuers and 
customers in applying the rule to secondary offerings would outweigh 
any benefits associated with including such offerings in the proposed 
rule change.
    Schwab, Sullivan and others also recommended that all secondary 
offerings, not just those that are actively traded, should be excluded 
from the proposed rule change. NASD Regulation has not observed any 
unique concerns with respect to secondary offerings of non-actively 
traded securities. Accordingly, consistent with its objective to 
develop a more streamlined rule, NASD Regulation has proposed expanding 
the exemption for secondary offerings to include all secondary 
offerings.
    The decision to apply the proposed rule change to all IPOs, not 
just those that are hot issues, may lead to problems in offerings for 
which there is insufficient investor demand. Under the current 
Interpretation, such offerings would typically not open at a premium 
and would not be hot issues. With a rule that applies to all IPOs, 
however, NASD Regulation is proposing to add provisions to address 
circumstances where purchases by restricted persons are necessary for 
the successful completion of an offering. Amendment No. 2 contains 
provisions for stand-by purchasers that are identical to the stand-by 
provisions in the Interpretation. With respect to the stand-by 
provisions, MSDW suggested imposing minimum capital contribution 
requirements and extending the lock-up requirements from three months 
to one year. NASD Regulation does not believe that these additional 
requirements are necessary. Amendment No. 2 also contains provisions 
addressing under-subscribed offerings. Specifically, the proposed rule 
change states that nothing in the rule shall prohibit an underwriter, 
pursuant to an underwriting agreement, from placing a portion of a 
public offering in its investment account when it is unable to sell 
that portion to the public.
    In the October 1999 filing, NASD Regulation targeted the proposed 
rule change to equity offerings only. Historically, the Interpretation 
applied to equity and debt offerings; in a series of amendments in 
1998, however, NASD Regulation exempted most types of debt. Several 
commenters, including the SIA and Sullivan, expressed support for the 
elimination of debt securities entirely from the rule's coverage. These 
commenters generally believed that debt offerings do not raise the same 
issues as equity offerings and for that reason should be excluded.
    There are a number of other categories of offerings that NASD 
Regulation does not believe should be covered by the proposed rule 
change. First, NASD Regulation recommends exempting public offerings of 
investment grade asset-backed securities as defined in SEC Form S-3, 
some of which may otherwise fall within the definition of new issue. 
The Interpretation currently exempts investment grade, financing 
instrument-backed securities and, in view of the decision to eliminate 
the 5% threshold, NASD Regulation believes that it is appropriate to 
reinstate the exemption.
    Second, NASD Regulation recommends exempting convertible 
securities.\9\ NASD Regulation staff has already exempted many 
convertible securities from the Interpretation under its exemptive 
authority.\10\ NASD Regulation found that in light of the 
Interpretation's current exclusion for debt securities and secondary 
offerings, the failure to exclude convertible securities led to an 
anomalous result. A law firm noted that an issuer could issue a non-
convertible debt security and make a secondary offering of an actively 
traded security and neither would be subject to the Interpretation. 
Yet, if an issuer decided to, in effect, combine these two securities 
and issue a debt security that had the additional feature of being 
convertible into an actively traded security, then the Interpretation 
would apply. To correct this inconsistency, NASD Regulation staff has 
used its exemptive authority to exempt from the Interpretation debt 
securities that are convertible into an actively traded security. NASD 
Regulation now proposes to codify this exemption. However, in view of 
the decision to exclude all secondary offerings from the proposed rule 
change, NASD Regulation has expanded the exemption to include all 
convertible securities, not just those that are convertible into 
actively traded securities.
---------------------------------------------------------------------------

    \9\ Although the proposed change applies only to equity 
securities, the definition of equity security in section 3(a)(11) of 
the Exchange Act, which is used in the proposed rule change, 
includes any security, including a debt security, that is 
convertible into stock.
    \10\ See Letter to Peter C. Manbeck, Sullivan, from Gary L. 
Goldsholle, NASD Regulation, dated December 21, 1998.
---------------------------------------------------------------------------

    Third, NASD Regulation recommends exempting preferred securities. 
In

[[Page 76321]]

connection with amendments to the Interpretation in 1998, NASD 
Regulation considered, but deferred an exemption for preferred 
securities.\11\ Specifically, NASD Regulation stated that it would 
``evaluate the impact of excluding investment grade debt and investment 
grade financing backed securities from the Interpretation and will 
consider in the future whether preferred [securities] should also be 
excluded.''\12\ Based upon its experience with the 1998 amendments, and 
the purposes of the proposed rule change, NASD Regulation now 
recommends excluding preferred securities. On balance, NASD Regulation 
believes that preferred securities exhibit pricing and trading behavior 
that more closely resemble debt than equity securities.
---------------------------------------------------------------------------

    \11\ Securities Exchange Act Release No. 40001 (May 18, 1998), 
63 FR 28535 (May 26, 1998).
    \12\ Id.
---------------------------------------------------------------------------

    Fourth, NASD Regulation recommends exempting offerings of closed-
end company securities as defined under Section 5(a)(2) of the 
Investment Company Act of 1940 from the restriction of the rule. 
Generally, when closed-end companies make a public offering they are 
seeking as large an infusion of capital as possible and will expand the 
number of shares offered to meet the demand. These shares typically 
commence trading at the public offering price; if there is a premium, 
it is very small. Accordingly, applying the proposed rule change to 
closed-end companies does not further the purposes of the rule and may 
impair the ability of closed-end companies to obtain capital. NASD 
Regulation therefore recommends an exemption for closed-end companies.
    (iii) Portfolio Fund Managers. Another area that generated a 
significant amount of comment was the proposed definition and treatment 
of portfolio managers. In the October 1999 filing, NASD Regulation 
proposed a ``more function-oriented approach'' towards personnel with 
respect to the securities activities of a bank, insurance company, 
investment company, investment adviser, or collective investment 
account. NASD Regulation suggested that only persons who supervise or 
whose activities are directly or indirectly related to the buying or 
selling of securities for one of the listed entities should be 
restricted. Ropes, Testa, and Schwab supported this function-oriented 
approach, but believed that the proposed rule change was still too 
broad and could reach persons whose functions were purely ministerial. 
These commenters suggested that the restrictions in the proposed rule 
change should apply only to those persons who have ``the authority to 
make investment decisions.'' Ropes believed that this would be a better 
and more precise indicator of whether a person is in a position to 
direct business to a member. NASD Regulation believes that this is a 
useful clarification and has amended the proposed rule change 
accordingly.\13\
---------------------------------------------------------------------------

    \13\ Schwab also requested an exemption for persons who, on a 
volunteer basis, make investment decisions of behalf of a tax-exempt 
charitable organization. NASD Regulation is not proposing such an 
exemption. Depending on the particular facts, NASD Regulation 
believes the purposes of the rule may be implicated by a person who 
manages the investments of a tax-exempt charitable organization.
---------------------------------------------------------------------------

    The proposed rule change also sought to remove the restrictions on 
persons who participate in an investment club or manage a family 
partnership. Fu, Sullivan, Smith and Schwab all strongly supported 
these changes. Fu, the general partner of a small investment club, 
believed that he had been unfairly restricted access to IPOs because 
the Interpretation treated an investment club as an ``institutional 
account.'' Similarly, Smith viewed her participation in an investment 
club as a ``learning and social activity'' and did not believe that her 
participation in an investment club should affect her, or her 
husband's, ability to purchase an IPO. Cadwalader noted, however, that, 
as drafted, the exemption for investment clubs and family partnerships 
would inadvertently exempt sales to an investment club or family 
partnership consisting solely or predominantly of restricted persons. 
NASD Regulation agrees that this was not an intended result. To correct 
this problem, the proposed rule change no longer exempts investment 
clubs or family partnerships per se, but rather states that 
participation in an investment club or family partnership does not by 
itself make a person restricted.
    A number of commenters, including Willkie, Katten, Washington, and 
Northern, were strongly opposed to the restrictions on portfolio 
managers, and in particular hedge fund managers, because they would 
prohibit a hedge fund manager from investing in hot issues through a 
fund he or she manages. Although the proposed rule change allowed 
portfolio managers and other restricted persons in aggregate to own up 
to 5% of a collective investment account that invests in hot issues, 
these commenters believed that the 5% figure was too low. They added 
that investors generally expect portfolio managers to make significant 
investments in accounts they manage as it helps to align the managers' 
interests with those of investors. Several commenters, including 
Rosenman, Willkie, and Northern urged NASD Regulation to exempt hedge 
fund managers with respect to the accounts they manage, while retaining 
the restriction with respect to purchases of IPOs in their personal 
accounts. Northern, for example, stated ``[w]e would not be in favor of 
letting a hedge fund manager receive benefits on the side that might 
permit the manager to divert hot issues to his or her own personal 
account.'' Willkie added that the fiduciary duty of a hedge fund 
manager would prevent him or her from profiting from new issues 
personally at the expense of hedge fund investors.
    Based upon these comments, NASD Regulation has amended the 
restriction on portfolio managers. NASD Regulation agrees with the 
commenters that the 5% exemption in the October 1999 filing did not 
achieve its intended purpose and could, as discussed below, undermine 
the purposes of the rule by allowing broker/dealer personnel and other 
restricted persons to purchase substantial quantities of IPOs. 
Amendment No. 2 treats a portfolio manager and certain members of his 
or her immediate family as restricted persons other than with respect 
to a beneficial interest in the bank, savings and loan institution, 
insurance company, investment company, investment adviser, or 
collective investment account, over which such person has investment 
authority. Amendment No. 2 thus permits a hedge fund manager who in not 
otherwise restricted to invest in IPOs through a fund he or she 
manages. Under Amendment No. 2, however, a portfolio manager may not 
purchase IPOs in his or her personal accounts. Several commenters, 
including Willkie and Rosenman, proposed language that is substantively 
similar to that proposed by NASD Regulation.
    Amendment No. 2 does not define what constitutes a personal account 
of a portfolio manager. NASD Regulation believes that a number of 
factors will contribute to a determination of whether an account is a 
personal account. These factors include, but are not limited to, the 
number of beneficial owners in the account, the identity of the 
participants, whether the account participants are members of the 
portfolio manager's immediate family, the compensation scheme, the 
manner in which profits and losses are distributed, the expectations of 
the account participants, and the overall trading activity in the 
account.

[[Page 76322]]

    Despite this change, NASD Regulation does not believe that the 
treatment of portfolio managers in Amendment No. 2 will lead to an 
environment that is significantly different from that under the current 
Interpretation. Under the Interpretation, portfolio managers are 
entitled to purchase hot issues if such purchases are, among other 
things, consistent with their normal investment practices. They also 
are entitled to receive benefits from new issues in accounts they 
manage in the form of performance fees.
    Katten sought clarification on whether an investment adviser 
organized as an entity is a restricted person. Katten stated that the 
proposed rule change treats certain employees of an investment adviser 
as restricted but does not state whether an investment adviser 
organized as an entity is a restricted person. NASD Regulation believes 
that the status of an entity organized as an investment adviser would 
depend on the status of its beneficial owners. If the beneficial owners 
are restricted persons because of their investment advisory activities 
or otherwise, then the entity would be a restricted person.
    (iv) Preconditions for Sale/Documentation. The proposed rule change 
streamlined the requirements for members to demonstrate that sales of 
IPOs were made in conformity with the rule. NASD Regulation replaced 
the myriad means for members to demonstrate that they have not sold 
IPOs to restricted persons, with a single requirement applicable to all 
accounts--a representation from the account holder, or a person 
authorized to represent the beneficial owners of the account, that the 
account is eligible to purchase new issues in compliance with the rule. 
Colish supported these changes. The SIA stated that the requirement as 
to the type of evidence that is needed ``is a significant improvement 
over current requirements.'' Commenters also had concerns. Schwab and 
MSDW were concerned that the proposed rule change would require an 
annual mailing to all customers that may be interested in purchasing 
new issues and would prohibit the use of electronic communications. The 
SIA and MSDW stated that firms should be permitted to develop their own 
methods to verify the status of a customer, including the use of oral 
representations so long as such representations are documented 
internally. In response to these comments, NASD Regulation intends to 
state in a Notice to Members announcing SEC approval of the proposed 
rule change that an annual mailing is not required, and that electronic 
or oral communications are permitted so long as such communications and 
the response are documented internally by the member firm.
    MSDW also stated that the documentation requirements may hinder a 
bona fide public distribution if members withhold securities from 
public customers because they have not provided the necessary 
information. NASD Regulation disagrees and believes that MSDW's comment 
may be based on a misinterpretation of the nature of the required 
documentation. In general, NASD Regulation does not believe that 
adhering to these requirements, even if it means that certain public 
customers cannot purchase IPOs, will cause a member to fail to make a 
bona fide public offering. In addition, NASD Regulation expects that 
public customers will provide the necessary information or 
certifications to afford them the opportunity to purchase IPOs.
    NASD Regulation also is maintaining the interval required for 
verification at one year. The SIA, Sullivan, and MSDW suggested 
lengthening the verification period from one year to every two or three 
years. By contrast, NASAA suggested shortening the verification period 
to something significantly shorter than one year, to reflect possible 
changes in ownership that could occur within that period. NASD 
Regulation believes that as a matter of policy, allowing members to 
wait longer between verifying that their customers are eligible to 
purchase new issues undermines the effectiveness of the rule. 
Currently, under the Interpretation, verification is required as 
frequently as before every sale or as long as every 18 months. With the 
streamlined documentation procedures and the availability of electronic 
and oral communications, NASD Regulation believes that an annual 
verification requirement strikes an appropriate balance between benefit 
and burden. We anticipate that in light of the clarifications made 
above, the commenters generally will agree with NASD Regulation that 
the burdens of ensuring that customers are eligible to purchase IPOs on 
an annual basis are not unreasonable. NASAA's concerns are addressed by 
the fact that a member may not rely on a representation that it has 
reason to believe is inaccurate.
    Several commenters, including Cadwalader and Ropers, were concerned 
about how the documentation requirement would apply in light of the 
fact that a customer's status or percentage ownership in a collective 
investment account may change over the course of a year. NASD 
Regulation recognizes that the potential exists for a customer's status 
under the rule to change, but believes that members may rely upon 
information obtained as part of the ordinary, annual verification 
process, so long as the member does not believe or have reason to 
believe that an account is restricted. Currently, under the 
Interpretation, NASD Regulation allows members to rely upon certain 
certifications dated not more than 18 months prior to the date of sale 
of the hot issue. Under the proposed rule change, members would be able 
to rely, in good faith, on representations dated not more than twelve 
months prior to the date of sale of the new issue.
    On the issue of intent, Schwab stated that the rule should not 
impose a strict liability standard. Specifically, Schwab believed that 
a member should not be in violation of the proposed rule change if the 
member is unaware that an account is beneficially owned by a restricted 
person because the customer provided false information. On this point, 
we agree. As stated in the October 1999 filing, a member may rely upon 
the information it has received from a customer unless it believes, or 
has reason to believe, that the information is inaccurate. The proposed 
rule change has been amended to expressly include this standard.
    Several commenters, particularly law firms such as Katten, Schulte, 
Rosenman, and Sullivan, sought guidance on what type of information a 
member would be required to review to determine whether an account is 
beneficially owned by restricted persons, especially in a fund of funds 
context. The proposed rule change allows an account holder, or a person 
authorized to represent the beneficial owners of the account, to 
represent that an account is eligible to purchase new issues. So long 
as a member has no reason to believe that the representation is not 
accurate, it may rely upon the representation. Alternatively, a 
registered representative may ask questions of a customer to allow him 
or her to determine whether an account is eligible to purchase new 
issues under the rule. The application of the rule would be the same 
for a fund of funds. In that case, a member could secure a 
representation from a person authorized to represent the beneficial 
owners of the fund that is purchasing the new issue from the member 
(such as the fund's general partner) that the account is eligible to 
purchase new issues. Naturally, the ability of a general partner to 
make such a representation will be contingent on his or her

[[Page 76323]]

receiving similar representations from general partners of the other 
funds investing in the fund, or by reviewing information about the 
investors in such funds. However, unlike the current Interpretation, 
there are no provisions requiring certifications by attorneys or 
certified public accountants. While members may wish to rely upon 
counsel or an accountant to investigate the status of an account, such 
an approach is no longer required by the rule.
    NASD Regulation will announce in the Notice to Members announcing 
approval of Rule 2790 that members may use negative consent letters in 
all but the initial account verification. Several commenters, including 
MSDW, believed that the ability to use negative consent letters would 
greatly ease the burden of complying with the rule without undermining 
its effectiveness. NASD Regulation believes that once a member firm 
verifies the status of an account, it may use negative consent 
procedures for each subsequent, annual verification.
    Finally, the SIA asked NASD Regulation to explore an automated 
means of updating certain account information regarding restricted 
person status. While NASD Regulation does not currently intend to 
develop such a system, NASD Regulation is not opposed to third party 
vendors compiling or aggregating information about the status of 
persons under the rule. If a private vendor developed a reliable 
automated application to track the status of purchasers under the rule, 
NASD Regulation believes that members generally could rely upon data 
from such a vendor.
    (v) De Minimis Exemption. As stated above, one purpose behind the 
proposed rule change is to streamline the rule. One area in which NASD 
Regulation believes that it can benefit investors without sacrificing 
the integrity and protections of the rule is with respect to certain de 
minimis owners. The de minimis ownership exemption avoids imposing on 
investors the burden of creating segregated accounts in those instances 
where restricted persons have only a nominal and passive interest in an 
account that purchases new issues. Commenters appreciated the 
efficiencies that the de minimis exemption would provide and generally 
urged that it be expanded.
    Several commenters asked NASD Regulation to expand the de minimis 
exemption to include a collective investment account that is owned 10% 
or more by restricted persons. NASD Regulation, however, does not 
support an expansion. One of the rationales for the de minimis 
exemption was to alleviate the impact of the October 1999 filing's 
decision to treat portfolio managers as restricted persons. As 
discussed in the previous section, that issue has been addressed 
separately. Thus, a large class of persons for whom the de minimis 
exemption was intended have already been excluded from the rule. In 
view of this change, NASD Regulation is maintaining the de minimis 
level at 5%. This comports with recommendations by Katten, Schulte, and 
Rosenman, which supported a 5% de mimimis level so long as portfolio 
managers were excluded.
    Northern noted that as originally proposed, the de minimis 
exemption may ``tempt some brokers to favor hedge funds that permit the 
brokers themselves or their senior executives or friends to invest in 
the hedge funds, which would cut against the purposes of the NASD 
proposal.'' In response to this comment and to ensure that the de 
minimis exemption is consistent with the purposes of the rule and the 
public interest, NASD Regulation has revised the de minimis exemption 
to impose a strict numerical limit of 100 shares on the number of 
shares that any one person can purchase under the de minimis exemption. 
In complying with the 100 share limit, members may look through an 
investing entity to a person's beneficial interest. The numerical limit 
reduces the incentive for self-dealing and the appearance that 
restricted persons are receiving shares at the expense of public 
investors. Under Amendment No. 2, the de minimis exemption also 
requires that a restricted person does not manage or otherwise direct 
investments in the account.
    Members should be aware that the de minimis exemption does not 
allow restricted persons to purchase 100 shares directly. The de 
minimis exemption was developed as an accommodation to collective 
investment accounts with only a small percentage of restricted persons. 
Because the sale of IPOs to such a collective investment account 
principally benefits non-restricted persons, NASD Regulation believes, 
for administration purposes, it should not be necessary to carve-out 
the restricted persons or exclude the account altogether. On the other 
hand, direct purchasers of IPOs by restricted persons do not in any way 
facilitate a public distribution and will continue to be prohibited 
under the proposed rule change.
    Several commenters, such as Cadwalader, Ropes, Covington, and 
Fried, suggested a variation on the de minimis exemption in that the 
proposed rule change should be amended to exempt all passive investors 
in a collective investment account, regardless of the size of their 
interest. While passive investors have no control over the investment 
decisions made by a collective investment account, their participation 
in a particular account may be known or inferred by the member 
allocating new issues. A passive investor exemption would allow 
restricted persons to circumvent the purposes of the rule by having 
such purchases made on their behalf by a portfolio manager. For these 
reasons, NASD Regulation is not proposing to exempt all passive 
investors.
    NASD Regulation also disagrees with MSDW's recommendation that the 
de minimis exemption be amended to apply if a collective investment 
account invests less than 10% of its assets in new issues. For many 
collective investment accounts, and certainly all large accounts, such 
a limitation would be tantamount to no limitation at all. MSDW's 
recommendation would allow a fund comprised solely of broker/dealer 
personnel to invest up to 10% of their assets in new issues. NASD 
Regulation believes that such an expansion of the de minimis exemption 
is unwarranted and would be inconsistent with the purposes of the rule.
    Sidley asked whether the proposed rule change and the creation of 
the de minimis exemption eliminated the ability for collective 
investment accounts to create carve-out accounts that segregate the 
interests of restricted persons. NASD Regulation did not intend for the 
proposed rule change to eliminate the ability of a collective 
investment account that does not meet the de minimis exemption to 
create a separate account and carve out the interests of restricted 
persons from the account investing in new issues. Accordingly, an 
account that wishes to purchase a greater number of shares such that a 
restricted person's pro rata allocation would exceed 100 shares, or an 
account that wishes to allow restricted persons to own collectively 
more than 5% of the fund's assets, would be able to use carve-out 
procedures and segregate the new issue activity from restricted persons 
to keep it below the threshold in the proposed rule. However, unlike 
the current Interpretation, the proposed rule change does not contain 
detailed procedures concerning how an account is required to carve-out 
the interests of restricted persons. A member's obligation under the 
proposed rule change is to receive a representation from the account 
holder, or a person authorized to represent the beneficial owners of 
the account, that the account is not

[[Page 76324]]

restricted from purchasing new issues under the rule. At this time, 
NASD Regulation does not intend to regulate the manner in which an 
account carves out restricted persons. If NASD Regulation has reason to 
believe that closer scrutiny of carve-out accounts is necessary, it 
will consider additional rulemaking in this area.
    Sidley also asked NASD Regulation to revise the proposal to permit 
funds to transfer securities from a carve-out account to a general 
account without undertaking a secondary market transaction, which it 
argued is inefficient and unnecessarily costly. Sidley correctly noted 
that current NASD Regulation policy requires a transfer from a carve-
out account with non-restricted persons to a fund's general account 
that is beneficially owned by restricted person to be effected in a 
market transaction. Under the proposed rule change a fund manager would 
be permitted to determine how best to transfer new issues that he or 
she intends to keep for investment purposes from one account to 
another, consistent with all other applicable laws and regulations. 
NASD Regulation cautions that where a carve-out account purchases new 
issues with a view towards distributing such shares to another account, 
that such carve-out account may be viewed as an ``underwriter'' under 
section 2(a)(11) of the Securities Act of 1933.
    (vi) Owners of Broker/Dealers. NASD Regulation has substantially 
revised the restrictions on owners of broker/dealers. The October 1999 
filing treated as restricted persons affiliates of a broker/dealer and 
natural persons, and certain members of their immediate family, who 
owned 10% or more, or contributed 10% or more of the capital of a 
broker/dealer. Many of the commenters, including Willkie, Colish, 
Sidley, and the SIA, stated that this approach was too broad. Several 
commenters stated that reaching all companies that are under common 
control with a broker/dealer, and in particular sister companies, would 
reach entities without any nexus to the securities industry. The 
commenters also were concerned about the impact on affiliates in light 
of the repeal of the restrictions on affiliation among banks, insurance 
companies and securities firms under the Gramm-Leach-Bliley Act of 
1999.\14\
---------------------------------------------------------------------------

    \14\ Pub. L. No. 106-102, 113 Stat. 1338 (1999).
---------------------------------------------------------------------------

    Amendment No. 2 adopts a new approach and treats as restricted 
persons owners of broker/dealers as defined in Schedule A of Form BD, 
with at least a 10% ownership interest,\15\ and as defined in Schedule 
B of Form BD. NASD Regulation believes that this approach is desirable 
from a compliance perspective because the definitions are understood by 
members and the information is already required to be maintained. NASD 
Regulation opted to use existing ownership standards rather than create 
a new concept for purposes of this rule. From a technical standpoint, 
this approach no longer treats affiliates of broker/dealers as 
restricted persons per se. The ownership provisions look only at the 
direct and indirect owners of a broker/dealer. Moreover, the standard 
of control for indirect owners in Schedule B of Form BD is a 25% 
interest, not a 10% interest as proposed in the October 1999 filing. In 
this regard, Amendment No. 2 is narrower in scope than the October 1999 
filing.
---------------------------------------------------------------------------

    \15\ Schedule A of Form BD lists all direct owners with 
ownership interests of 5% or more in a broker/dealer. The ownership 
level is indicated by various ``ownership codes'': A for 5% but less 
than 10%, B for 10% but less than 25%, and so on. For purposes of 
Rule 2790, only persons with a 10% or more interest, as indicated by 
ownership codes B and higher will be restricted persons.
---------------------------------------------------------------------------

    The rationale for applying the rule to owners of broker/dealers is 
straightforward. A prohibition on a broker/dealer could be easily 
circumvented if IPOs could be purchased by the broker/dealer's parent. 
Similarly, to avoid circumventing the restriction on the owners and the 
broker/dealer itself, it is necessary for the rule to prohibit sales of 
new issues to any account in which the owner or broker/dealer has a 
beneficial interest. If the rule did not restrict any account in which 
a restricted person had a beneficial interest, restricted persons could 
purchase new issues in downstream affiliates and flow the profits back 
up to the restricted person. The application of the rule to all 
accounts in which a restricted person has a beneficial interest is a 
fundamental principle of the proposed rule change and the 
Interpretation.
    The net effect of these provisions is that both upstream and 
downstream affiliates, including sister companies, are restricted 
persons. Although commenters may view this approach as unnecessarily 
broad, NASD Regulation believes that it is necessary to effectuate the 
purposes of the rule. However, NASD Regulation has made a number of 
reforms that we believe address many of the commenters' concerns.
    The primary source of relief comes from NASD Regulation's decision 
to exempt sales to and purchases by nearly all publicly traded 
companies. The commenters generally supported the exemption in the 
October 1999 filing for publicly traded companies. Sullivan, for 
example, stated ``that a blanket exemption * * * for sales to publicly 
traded corporations would substantially lighten the administrative 
burden of implementing the rule without undermining the underlying 
objectives of the rule in any meaningful way.''
    Amendment No. 2 expands the exemption for publicly traded companies 
to now include all publicly traded companies listed on a national 
securities exchange or traded on the Nasdaq National Market, even those 
that are affiliates of a broker/dealer.\16\ NASD Regulation believes 
that purchases of new issues by this class of publicly traded 
companies, which in turn have broad public ownership and whose 
securities may be purchased by any investor, is not the type of 
activity the rule is designed to prevent. Purchases in these instances 
benefit public investors in much the same way that IPO purchases by 
mutual funds benefit their shareholders. To ensure that purchases by 
publicly traded companies do in fact benefit their shareholders, the 
exemption requires that the gains or losses from the IPOs must be 
passed on to shareholders.
---------------------------------------------------------------------------

    \16\ The exemption does not apply to a broker/dealer itself. 
NASD Regulation continues to believe that broker/dealers, even 
publicly traded broker/dealers, should not purchase or withhold 
IPOs. As discussed below, NASD Regulation believes that an exemption 
for publicly traded companies, even affiliates of a broker/dealer, 
was appropriate in light of protections against self-dealing under 
NASD Rule 2750, which applies to related persons of the broker/
dealer, but not the broker/dealer itself.
---------------------------------------------------------------------------

    The decision to exempt publicly traded companies in Amendment No. 2 
greatly minimizes the rule's impact on many financial services 
conglomerates and industrial companies that own a broker/dealer. Where 
the owner is a publicly traded company with a broker/dealer subsidiary, 
the rule would no longer apply, either at the parent level or at the 
downstream affiliate level. Thus, for example, a manufacturing unit of 
an exchange listed financial services holding company would not be a 
restricted person. For publicly traded companies, therefore, Amendment 
No. 2 would exempt sales to and purchases by affiliates.
    NASD Regulation is not, however, expanding the exemption for owners 
of broker/dealers that are private companies. The purchase of IPOs in 
this case does not reach public investors because ownership of private 
companies is not open to the public. NASD Regulation also is not 
expanding the exemption to include owners of broker/dealers listed 
solely on a foreign

[[Page 76325]]

exchange. Sidley was concerned that limiting the exemption to publicly 
traded companies listed on a domestic exchange would disadvantage 
publicly owned foreign companies without a U.S. listing. Despite these 
concerns, NASD Regulation does not believe at this time that foreign 
publicly traded companies should be exempt from the proposed rule 
change. Foreign jurisdictions have various listing standards and levels 
of regulatory oversight. As such, there is greater potential that a 
foreign publicly traded company could be used to circumvent the 
purposes of the rule. NASD Regulation will, however, consider its 
experience under the proposed rule change and may in the future 
consider whether it is appropriate to extend the exemption to publicly 
traded companies listed or traded solely on foreign markets.
    Amendment No. 2 also contains an exemption for the purchase of new 
issues by a bank common trust fund or an insurance company general, 
separate or investment account, provided that the account has 
investments from 1,000 or more investors, and is not limited 
principally to restricted persons. These exemptions will allow, for 
example, private banks and mutual and private insurance companies with 
broker/dealer subsidiaries to purchase new issues for these accounts. 
NASD Regulation believes that, collectively, these restrictions on the 
owners of broker/dealers will address many commenters' concerns about 
the application of the rule to broker/dealer affiliates.
    The SIA was concerned that the proposed rule change would adversely 
affect ``asset management affiliates that manage discretionary accounts 
as well as accounts for unaffiliated persons.'' The SIA stated that to 
the extent that affiliates of broker/dealers become restricted persons 
under the rule, the rule should more clearly exempt certain classes of 
accounts maintained by broker/dealers affiliates. The SIA's concerns 
appear unfounded. To the extent that broker/dealers affiliates manage 
accounts for non-restricted persons, such accounts would not be 
restricted under the proposed rule change. On the other hand, if the 
SIA is concerned about accounts at broker/dealers affiliates that are 
owned by restricted persons, NASD Regulation believes that the rule 
should apply.
    In proposing to allow purchases by publicly traded companies that 
are affiliates of broker/dealers, NASA Regulation is relying in part on 
the restrictions on a member engaged in a fixed price offering under 
Rule 2750, Transactions with Related Persons. Specifically, Rule 2750 
prohibits a member from selling any securities in a fixed price 
offering to any person or account that is a related person of the 
member. NASD Regulation believes that Rule 2750 addresses the potential 
for self-dealing in allocating new issues to a publicly traded 
affiliate of a broker/dealer.
    Finally, Sullivan asked why immediate family members of owners of 
broker/dealers were treated differently than immediate family members 
of associated persons of a broker/dealer. NASD Regulation did not 
intend for different treatment of such family members and has corrected 
the proposed rule change.
    (vii) Beneficial Interest Definition. At its own initiative, NASD 
Regulation is revising the definition of ``beneficial interest.'' The 
term beneficial interest was defined in the October 1999 filing as 
``any ownership or other direct financial interest.'' NASD Regulation 
is aware that members found the reference to ownership as distinct from 
a financial interest misleading. Because the rule is intended to 
prohibit sales of new issues to certain persons who stand to profit 
from them, legal ownership, such as that held by a trustee for 
beneficiaries, or a hedge fund for its limited partners, is not the 
type of interest that is the focus of the rule.
    NASD Regulation also is recommending eliminating the term 
``direct'' from the definition. In determining whether an account is 
beneficially owned by restricted persons, members are often required to 
look through a number of investment vehicles. For instance, if Fund A 
invests in Fund B, a member may not sell new issues to Fund B unless it 
determines the sale is consistent with the rule, taking into account 
the status of each beneficial owner of Fund A. To some, the owners of 
Fund A may be viewed as having an ``indirect'' ownership in Fund B.
    Rosenman stated that the definition of beneficial interest should 
specifically exclude management or performance based fees that are 
deferred for bona fide taxation reasons. Rosenman was concerned of the 
effect that deferred management or performances fees may have on a 
hedge fund manager's interest in a collective investment account that 
he or she manages. Because NASD Regulation has eliminated the 
restrictions on a hedge fund manager with respect to a collective 
investment account that he or she manages, we do not believe it is 
necessary to amend the definition of beneficial interest as Rosenman 
suggests.
    Finally, as a result of the amendments to the definition of 
beneficial interest and the definition of restricted person, the 
conditions that gave rise to the need for the exemption for joint back 
office broker/dealers in the October 1999 filing have been removed. By 
clarifying that beneficial ownership means a financial interest, such 
as the right to share in gains or losses, we have clarified that a 
hedge fund broker/dealer's legal ownership of securities does not 
constitute a beneficial interest for purposes of the rule. As a result, 
the rule no longer needs a separate exemption for joint back office 
broker/dealers.\17\
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    \17\ The rationale for the joint back office broker/dealer 
exemption was that a collective investment account registered as a 
broker/dealer or with a broker/dealer subsidiary would be precluded 
from purchasing new issues even if none of its investors were 
restricted persons. Under the revised definition of beneficial 
interest, such a collective investment account would no longer be 
restricted.
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    (viii) Issuer-Directed Share Programs. In the October 1999 filing, 
NASD Regulation proposed amendments to the exemption for securities 
distributed as part of an issuer-directed share program to all 
employees and directors of the issuer, or an entity that controls, is 
controlled by, or is under common control with the issuer. NASD 
Regulation proposed expanding the scope of employees and directors of 
the issuer that are covered by the exemption to include employees and 
directors of sister companies. NASD Regulation also proposed 
eliminating the requirement for a three-month lock up for those issuer-
directed shares that are sold to restricted persons. Schwab supported 
the elimination of the lock-up and stated that it provides substantive 
relief to members who will no longer be required to investigate the 
status of employee or director participants.
    Issuer-directed share programs are a valuable tool in employee 
development and retention, and are often an integral part of the 
employer/employee relationship. In recent years, issuer-directed share 
programs have become more popular, and issuers have sought to expand 
the lists of persons invited to participate in an IPO to include 
business contacts, family and friends. In general, NASD Regulation 
believes that sales directed by an issuer are outside the scope of 
activities that the proposed rule change is designed to address. 
Accordingly, Amendment No. 2 proposes to exempt IPO shares that 
specifically are directed by the issuer to such persons as employees, 
directors, and friends and family of the issuer. NASD Regulation 
believes, however, that whether directed by the issuer or

[[Page 76326]]

otherwise, broker/dealers, broker/dealer personnel and their immediate 
family, and certain persons acting as finders or in a fiduciary 
capacity to the managing underwriter, should not purchase IPOs, unless 
such persons are employees or directors of the issuer, the issuer's 
parent, or a subsidiary of the issuer or members of the immediate 
family of an employee or director of the issuer.\18\ Similarly, NASD 
Regulation disagrees with MSDW that all non-underwritten securities 
directed by the issuer should be exempt from the proposed rule change. 
NASD Regulation believes that a general exclusion for all issuer-
directed or all non-underwritten securities would be readily 
susceptible to abuse. Consequently, NASD Regulation will continue its 
practice of holding a managing underwriter responsible for ensuring 
that all securities that are part of the public offering are 
distributed in accordance with the rule.
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    \18\ NASD Regulation proposes allowing an employee or director 
of an issuer to direct shares in the issuer's initial public 
offering to members of his or her immediate family, even if such 
persons are otherwise restricted persons. In recent years, the staff 
has been presented with situations in which, for example, an 
employee of a issuer wanted to direct shares to his or her parent, 
but was unable to do so because the parent was a restricted person 
(and not an employee or director of the issuer). As amended, the 
proposed rule change would allow directed shares to be sold to, for 
example, a parent of an issuer's employee.
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    As recommended by Testa, the proposed rule change now expressly 
states that for purposes of the issuer-directed exemption only, a 
parent/subsidiary relationship is established if the parent has the 
right to vote 50% or more of a class of voting security or has the 
power to sell or direct 50% or more of a class of voting securities of 
the subsidiary. NASD Regulation does not agree with Sullivan that a 10% 
ownership standard should apply for this exemption. NASD Regulation 
believes that it is not uncommon for a member through its merchant 
banking activities or otherwise to make venture capital investments in 
issuers that exceed 10% of the issuer's securities. In such cases, all 
employees of the member would be able to purchase the new issue. NASD 
Regulation does not believe that exempting broker/dealer personnel by 
virtue of venture capital investments is consistent with the purposes 
of the rule or the issuer-directed exemption.\19\
---------------------------------------------------------------------------

    \19\ The proposed rule change contains separate provisions that 
permit venture capital investors to participate in IPOs to avoid 
dilution in a public offering. NASD Regulation believes that going 
beyond these protections for venture capital investors would be 
inconsistent with the purposes of the proposed rule change.
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    NASD Regulation believes that Amendment No. 2 strikes the correct 
balance between providing issuers with flexibility to direct shares 
while preserving the objectives of the rule. NASD Regulation also 
believes that the issuer-directed exemption should apply only when 
shares are in fact directed by the issuer; if a member firm asks or 
otherwise suggests that an issuer direct securities to a restricted 
person, NASD Regulation does not believe that such securities should be 
exempt from the rule.
    Sidley suggested that the scope of permissible purchasers under the 
issuer-directed share provisions should be amended to conform with the 
permitted categories of offerees set forth in Rule 701 of the 
Securities Act of 1933. Rule 701 provides an exemption for private 
companies to sell securities to their employees without a need to file 
a registration statement. Rule 701 provides an exemption from the 
registration provisions of the Securities Act of 1933 for offers and 
sales of securities under certain compensatory benefit plans or written 
agreements relating to compensation. NASD Regulation believes that this 
approach is potentially less broad and is far more difficult for 
members to implement.
    The SIA, Sullivan, and MSDW all believed that the proposed rule 
change should exclude exchange offers, rights offerings and offerings 
made pursuant to a merger or acquisition. MSDW stated that ``[i]f 
rights or other securities are offered to existing shareholders, 
particularly shareholders of a publicly traded company, it would seem 
the purpose of the [proposed rule change] (i.e., to assure a bona fide 
public distribution of securities) is achieved.'' Sullivan noted that 
the NASD has previously stated that the Interpretation does not apply 
to ``exchange offers'' and ``offerings made pursuant to an merger or 
acquisition.'' SIA and MSDW noted with approval the exemptive relief 
NASD Regulation staff has granted in connection with certain rights 
offerings. NASD Regulation agrees with the commenters and has amended 
the proposed rule change to exclude from the definition of public 
offering, exchange offers, rights offerings and offerings made pursuant 
to a merger or acquisition. NASD Regulation also has codified the 
staff's existing exemptive positions regarding certain directed share 
programs. The conditions imposed on such offerings in the proposed rule 
change generally tract those in the exemptive letters and continue to 
ensure that these offerings are conducted in a manner that is 
consistent with the purposes of the proposed rule.
    (ix) Limited Business Broker/Dealers. The proposed rule change, 
like the Interpretation, does not apply to persons associated with a 
limited business broker/dealer. The proposed rule change defined a 
limited business broker/dealer as a broker/dealer whose authorization 
to engage in the securities business is limited solely to the purchase 
and sale of investment company/variable contracts securities and direct 
participation program securities. Several commenters believed that this 
definition was too narrow. The CBOE believed that its market-makers and 
floor brokers also should be treated as limited business broker/
dealers.\20\ The CBOE stated that ``[a]n options market-maker typically 
is not a professional equities trader and is generally removed from the 
equities side of trading.'' The CBOE also stated that the ``functions 
of a floor broker on the CBOE * * * are limited to the execution of 
orders for other market professionals or public customers of other 
broker/dealers. Floor brokers, with the exception of a transaction 
effected for their error accounts, do not effect principal 
transactions.'' Despite these limited activities, NASD Regulation does 
not believe that market-makers and floor brokers should be treated as 
limited business broker/dealers. Notwithstanding the limited nature of 
their activities, NASD Regulation believes that market-makers and floor 
brokers are in a position to direct business to a member. The CBOE also 
appeared to recognize the potential for these individuals to direct 
business to a member in seeking to exclude from the exemption an ``IPO 
[that] is underwritten by the broker/dealer which clears and carries 
the member's professional CBOE business.'' NASD Regulation also 
believes that the relationships between market-makers and member firms 
and floor brokers and member firms, even in the absence of an 
established clearing relationship, may give rise to preferential 
allocations of new issues. Moreover, the potential to direct business 
to a member in exchange for IPOs is just one of the reasons for 
restricting broker/dealers. As noted in the October 1999 filing, the 
proposed rule change also is designed to ensure that industry insiders 
do not take advantage of their insider position in the industry to 
purchase IPOs for their

[[Page 76327]]

own benefit at the expense of public customers. NASD Regulation 
believes that options market-makers and options floor brokers are 
integral to the functioning of an exchange and properly characterized 
and perceived as industry insiders.
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    \20\ The CBOE also stated that members that lease out their 
seats and who are not engaged in a securities business should not be 
restricted persons. NASD Regulation agrees. NASD Regulation does not 
believe that a person who merely leases out a seat to a broker/
dealer should be treated as a restricted person.
---------------------------------------------------------------------------

    Colish, Washington, and Fried also believed the definition of 
limited business broker/dealers should be expanded. They suggested 
including broker/dealers that do not have any involvement in the 
capital formation or underwriting business, such as market-makers and 
electronic communications networks. Colish suggested including broker/
dealers that engage in private placements. Washington suggested that 
the proposed rule change should apply only to broker/dealers that 
engage in an equity securities business.\21\ NASD Regulation disagrees. 
NASD Regulation believes that persons associated with members engaged 
in these activities are, like persons associated with other broker/
dealers, in a position to direct business to, and to enter into 
reciprocal arrangements with, other members. They also are industry 
insiders. While it is undoubtedly true that not every person associated 
with a member engaged in these activities is in a position to enter 
into reciprocal arrangements, many persons are. The proposed rule 
change, like the current Interpretation, is a prophylactic rule. It 
achieves its goals by applying across a class of persons to whom sales 
of IPOs may violate the purposes of the rule.
---------------------------------------------------------------------------

    \21\ These requests are similar to requests previously 
considered by NASD Regulation. As noted in Notice to Members 97-30, 
NASD Regulation continues to believe that persons associated with 
firms engaged solely in proprietary trading or investment or 
merchant banking activities may enter into reciprocal arrangements 
with other members that would violate the purposes of the rule. In 
Notice to Members 97-30, NASD Regulation stated that the limited 
business broker/dealers definition should not be expanded to include 
such firms ``because of the difficulty in defining those firms'' and 
because ``such broker/dealers may influence or be involved in 
various aspects of the underwriting process.'' Further, NASD 
Regulation was concerned that ``such firms may enter into reciprocal 
arrangements with other members that would violate the intent of the 
Interpretation.''
---------------------------------------------------------------------------

    In general, the SIA agreed with NASD Regulation that reciprocal 
arrangements between industry members in the allocation of public 
offerings must be prevented. The SIA, however, stated that a rule 
targeted towards ``conduct which has the purpose or effect of creating 
reciprocal arrangements, rather than one [that is] * * * based on 
complex definitions of status in the industry, would better serve the 
capital markets and would be more fair to industry members, their 
relatives, and other market participants.'' The SIA did not offer any 
suggestion on how such a rule would operate in practice. NASD 
Regulation believes that a rule that requires members to determine 
whether a particular individual is engaged in reciprocal arrangements 
with a broker/dealer would be difficult both from an administration and 
examination standpoint, and would eliminate the certainty sought by the 
proposed rule change.
    (x) Elimination of Conditionally Restricted Persons. Another 
significant reform in the proposed rule change was the elimination of 
the so-called ``conditionally restricted'' status \22\ and the decision 
to treat persons as either restricted or non-restricted. Commenters 
generally supported the decision to eliminate the conditionally 
restricted status. The proposed rule change continues to treat persons 
as either restricted or non-restricted as NASD Regulation continues to 
believe that this bright-line approach best serves investors and 
members.
---------------------------------------------------------------------------

    \22\ Under the Interpretation, conditionally restricted persons 
can purchase hot issues ``if the member is prepared to demonstrate 
that the securities were sold to such persons in accordance with 
their normal investment practice, that the aggregate of the 
securities so sold is insubstantial and not disproportionate in 
amount as compared to sales to members of the public and that the 
amount sold to any one of such persons is insubstantial in amount.''
---------------------------------------------------------------------------

    (xi) ERISA Plans. NASD Regulation has further simplified the 
restrictions on Employee Retirement Income Security Act (``ERISA'') 
plans. The October 1999 filing proposed exempting tax-qualified plans 
under ERISA, so long as such plans were not sponsored by a broker/
dealer or an affiliate. A number of commenters, including SIA, MSDW, 
and Sullivan, believed that this exemption was unnecessarily narrow and 
would exclude a large number of non-restricted plan participants in 
plans sponsored by financial services companies. The commenters added 
that ERISA plans are already subject to a separate regulatory scheme 
and that they were unaware of any perceived or actual abuses to cause 
NASD Regulation to narrow the exemption for ERISA plans from the 
current Interpretation.
    NASD Regulation agrees with the commenters that the treatment of 
ERISA plans in the October 1999 filing could reach many non-restricted 
persons participating in a plan sponsored by an affiliate of a broker/
dealer. Amendment No. 2 exempts an ERISA plan that is qualified under 
section 401(a) of the Internal Revenue Code, provided that such plan is 
not sponsored solely by a broker/dealer.
    (xii) Foreign Investment Companies. The October 1999 filing 
proposed an exemption for foreign investment companies that is 
substantially similar to the Interpretation. Specifically, it stated 
that a foreign investment company is exempt from the proposed rule 
change if: (1) It has 100 or more investors; (2) it is listed on a 
foreign exchange or authorized for sale to the public by a foreign 
regulatory authority; (3) no more than 5% of its assets are invested in 
a particular hot issue; and (4) no person owning more than a 5% 
interest in such company is a restricted person.
    MSDW suggested exempting all foreign investment companies that are 
traded on a ``designated offshore securities market'' as defined in 
Rule 902(b) under the Securities Act of 1933.\23\ NASD Regulation 
believes that such an exemption would be too broad. The standards for 
inclusion in Rule 902(b) do not appear related to the concerns 
underlying the proposed rule change. Although inclusion in Rule 902(9b) 
requires oversight by a governmental or self-regulatory body, NASD 
Regulation is not confident that such regulation would prevent 
restricted persons from suing foreign investment companies to 
circumvent the rule. The NASD continues to believe that it is often 
difficult to assess the comparability of a foreign country's investment 
company statutes and regulation to those in the United States, 
particularly as it relates to the purposes of this rule, and believes, 
therefore, that it is necessary to impose certain conditions.
---------------------------------------------------------------------------

    \23\ This is similar to a request made during the 1994 
rulemaking when the exemption for foreign investment companies was 
first proposed.
---------------------------------------------------------------------------

    Colish and Sullivan suggested that NASD Regulation eliminate the 
fourth condition--a requirement that no person owning more than 5% of 
the foreign investment company is a restricted person--because it is 
often difficult to ascertain the ownership of a foreign investment 
company. Despite these concerns, NASD Regulation believes that this 
requirement is necessary to avoid purchases of new issues by funds with 
concentrated ownership interests of restricted persons.
    However, in response to concerns generally about the exemption for 
foreign investment companies, NASD Regulation has simplified the 
exemption by eliminating the 100 person requirement and the limitation 
on the size of the purchase in relation to the size of the investment 
company. The 100 person condition basically

[[Page 76328]]

addressed the same concerns about concentration of ownership as 
condition (4) and, therefore, was eliminated. The limitation on the 
size of the purchase in relation to the size of the investment company 
appeared unnecessary and was potentially burdensome for members to 
calculate. Moreover, for very large funds, the limitation was 
meaningless inasmuch as 5% of their total assets would often exceed the 
size of the entire IPO. The other conditions are maintained.
    (xiii) Minor or Technical Revision. In addition to the changes 
discussed above, NASD Regulation made a number of minor or technical 
amendments in response to the comment letters.
    Testa stated that the anti-dilution provisions, which were similar 
in scope to the venture capital provisions of paragraph (g) of the 
Interpretation, applied to natural persons only. Testa believed that 
entities as well as natural persons that have a prior equity ownership 
interest in an issuer, should be able to avail themselves of the anti-
dilution provisions. The omission of entities in the anti-dilution 
provisions was inadvertent and has been changed. The anti-dilution 
provisions thus allow an entity or a natural person investing in such 
entity to retain the percentage equity ownership in the issuer at a 
level up to the ownership interest as of three months prior to the 
filing of the registration statement.
    Testa also stated that, as a general matter, family members of a 
restricted person who receive ``material support'' from the restricted 
person should be treated similarly to the restricted person. Testa 
noted that the proposed rule change in some cases made an exemption for 
a restricted person to purchase new issues, but did not extend the 
exemption to the restricted person's immediate family members. NASD 
Regulation believes that an exemption for a restricted person also 
should be available to an immediate family member who is restricted 
under the rule, and it has amended the proposed rule change 
accordingly.
    Several commenters, including Colish and Washington, stated that 
the use of the word ``includes'' in the definition of restricted person 
creates uncertainty by suggesting that the list is non-exclusive. NASD 
Regulation agrees and has removed the word ``includes'' from the 
definition of restricted person.
    Schwab stated that the definition of restricted person should 
exlude consultants or contractors of a broker/dealer member who are not 
engaged in securities-related activities. Schwab stated that the policy 
concerns underlying the rule do not require restricting these 
individuals from participating in new issues. NASD Regulation agrees 
that consultants or contractors of a broker/dealer should not be 
restricted persons unless they are engaged in the investment banking or 
securities business. If, for example, Schwab hires a contractor or 
consultant to perform photocopying services or a compensation survey, 
it should not preclude such contractor or consultant from purchasing 
new issues. The definition of restricted person has been revised to 
exclude agents of a broker/dealer who are not engaged in the investment 
banking or securities business.
    Schwab also supported the addition of a bright line definition of 
``material support'' but believed that the 10% threshold for support is 
too low and recommended that a time frame be established for measuring 
support. NASD Regulation agrees and has revised the definition of 
``material support'' to providing more than 25% of a person's income in 
the current or prior calendar year. Separately, NASD Regulation 
recommends clarifying that members of the immediate family living in 
the same household will be deemed to be providing each other with 
material support. Using this language makes clear that the proposed 
rule change establishes a bright line test, and NASD Regulation will 
not evaluate material support issues on a case-by-case basis.
2. Statutory Basis
    NASD Regulation believes that Amendment No. 2 is consistent with 
the provisions of section 15A(b)(6) of the Act,\24\ and, in general, to 
protect investors and the public interest. NASD Regulation believes 
that the provision of Amendment No. 2 protect investors and the public 
interest by ensuring that members make a bona fide public offering of 
securities at the public offering price; ensuring that members do not 
withhold securities in a public offering for their own benefit or use 
such securities to reward certain persons who are in a position to 
direct future business to the member; and ensuring that industry 
``insiders,'' including members and their associated persons, do not 
take advantage of their ``insider'' position in the industry to 
purchase new issues for their own benefit at the expense of public 
customers.
---------------------------------------------------------------------------

    \24\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------

B. Self-Regulatory Organizations Statement on Burden on Competition

    NASD Regulation does not believe that Amendment No. 2 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

    The Commission received twenty-four comment letter. NASD Regulation 
responded to those comment letters with Amendment No. 2.

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 Amendment No. 2, including whether the amendment 
is consistent with the Act. Persons making written submissions should 
file six copies therof 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 such filing will also be available for 
inspection and copying at the principal office of the NASD. All 
submissions should refer to File No. SR-NASD-99-60 and should be 
submitted by December 26, 2000.


[[Page 76329]]


    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\25\
Margaret H. McFarland,
Deputy Secretary.
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    \25\ 17 CFR 200.30-3(a)(12).
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[FR Doc. 00-30976 Filed 12-5-00; 8:45 am]
BILLING CODE 8010-01-M