[Federal Register Volume 66, Number 50 (Wednesday, March 14, 2001)]
[Notices]
[Pages 14949-14969]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-6275]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-44044; File No. SR-NASD-00-04]


Self-Regulatory Organizations; Notice of Filing of Amendment No. 
5 to a Proposed Rule Change by the National Association of Securities 
Dealers, Inc. Relating to its Corporate Financing Rule

March 6, 2001.
    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 February 4, 2001, the National Association of Securities Dealers, 
Inc. (``NASD''), through its wholly-owned subsidiary, NASD Regulation, 
Inc. (``NASD Regulation''), filed with the Securities and Exchange 
Commission (``SEC'' or ``Commission'') Amendment No. 5 \3\ to the 
proposed rule change as described in Items I, II, and III below, which 
Items have been prepared by NASD Regulation. The proposed rule change, 
incorporating Amendment Nos. 1, 2, and 3, was published for comment in 
the Federal Register on April 11, 2000.\4\ The Commission is publishing 
this notice to solicit comments on Amendment No. 5 from interested 
persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ Amendment No. 4, filed December 11, 2000, amends the 
original filing and Amendment Nos. 1, 2, and 3 to respond to 
comments. Amendment No. 5 supersedes Amendment No. 4 in its entirety 
and makes certain technical corrections to the proposed rule change.
    \4\ See Securities Exchange Act Release No. 42619 (April 4, 
2000), 65 FR 19409.
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    In response to comments on the original proposal, NASD Regulation 
is proposing additional amendments to Rules 2710 and 2720 of the NASD's 
Conduct Rules. Below is the text of the proposed rule change. Proposed 
new language is in italics; proposed deletions are in brackets. The 
text of the proposed rule change is marked to show additions and 
deletions from the NASD Corporate Financing Rule as it currently 
exists. The discussion section of this notice, however, focuses on the 
changes made in Amendment No. 5. For an explanation of the original 
filing, see the release cited in footnote 4.
2710. Corporate Financing Rule--Underwriting Terms and Arrangements
(a) Definitions
(1) Issuer
    The issuer of the securities offered to the public, any selling 
security holders offering securities to the public, any affiliate of 
the issuer or selling security holder, and the officers or general 
partners, directors, employees and security holders thereof[;].
(2) Net Offering Proceeds
    Offering proceeds less all expenses of issuance and 
distribution[;].
(3) Offering Proceeds
    Public offering price of all securities offered to the public, not 
including securities subject to any overallotment option, securities to 
be received by the underwriter and related persons, or securities 
underlying other securities[;].
(4) Participating Member(s)
    Any NASD member that is participating in a public offering, any 
associated person of the member, any members of their immediate family, 
and any affiliate of the member.
(5) Participation or Participating in a Public Offering
    Participation in the preparation of the offering or other 
documents, participation in the distribution of the offering on an 
underwritten, non-underwritten, or any other basis, furnishing of 
customer and/or broker lists for solicitation, or participation in any 
advisory or consulting capacity to the issuer related to the offering, 
but not the preparation of an appraisal in a savings and loan 
conversion or a bank offering or the preparation of a fairness opinion 
pursuant to SEC Rule 13e-3[; and].
[(5)] (6) Underwriter and Related Persons
    [Includes underwriters,] Consists of underwriter's counsel, 
financial consultants and advisors, finders, [members of the selling or 
distribution group,] any participating member [participating in the 
public offering], and any [and all] other persons [associated with or] 
related to any participating member [and members of the immediate 
family of any of the aforementioned persons].
(b) Filing Requirements
    (1)-(3) No change.
(4) Requirement for Filing
    (A) Unless filed by the issuer, the managing underwriter, or 
another

[[Page 14950]]

member, a member that anticipates participating in a public offering of 
securities subject to this Rule shall file with the Association the 
documents and information with respect to the offering specified in 
subparagraphs (5) and (6) below:
    (i) No later than one business day after [the filing of:] any such 
documents [with] are filed with or submitted to:
    [(a)] a. The Commission; or
    [(ii)] b. [with the] Any state securities commission or other 
regulatory authority; or
    [(iii)] (ii) If not filed with or submitted to any regulatory 
authority, at least fifteen (15) business days prior to the anticipated 
[offering] date on which offers will commence.
    (B) No [offering] sales of securities subject to this Rule shall 
commence unless:
    (i) The documents and information specified in subparagraphs (5) 
and (6) below have been filed with and reviewed by the Association; and 
(ii) the Association has provided an opinion that it has no objections 
to the proposed underwriting and other terms and arrangements or an 
opinion that the proposed underwriting and other terms and arrangements 
are unfair and unreasonable. If the Association's opinion states that 
the proposed underwriting and other terms and arrangements are unfair 
and unreasonable, the member may file modifications to the proposed 
underwriting and other terms and arrangements for further review.
    (C) No change.
(5) No change.
(6) Information Required to be Filed
    (A) Any person filing documents with the Association pursuant to 
subparagraph (4) above shall provide the following information with 
respect to the offering:
    (i)-(ii) No change.
    (iii) a statement of the association or affiliation with any member 
of any officer, or director of the issuer, of any [or security holder] 
beneficial owner of [the issuer in an initial public offering of equity 
securities, and with respect to any other offering provide such 
information with respect to any officer, director or security holder of 
five percent] 5% or more of any class of the issuer's securities, and 
of any beneficial owner of the issuer's unregistered equity securities 
that were purchased during the 180-day period immediately preceding the 
required filing date of the public offering, except for purchases 
described in subparagraph (c)(3)(B)(v) below. This statement must 
identify [to include]:
    a. [the identity of] The person;
    b. [the identity of] The member and whether such member is 
participating in any capacity in the public offering; and
    c. The number of equity securities or the face value of debt 
securities owned by such person, the date such securities were 
acquired, and the price paid for such securities.
    (iv) [A statement addressing the factors in subparagraphs (c)(4)(C) 
and (D), where applicable;]
    [(v)] A detailed explanation of any other arrangement entered into 
during the [12-month] 180-day period immediately preceding the required 
filing date of the public offering, which arrangement provides for the 
receipt of any item of value [and/]or the transfer of any warrants, 
options, or other securities from the issuer to the underwriter and 
related persons; [and]
    (v) A statement demonstrating compliance with all of the criteria 
of an exception from underwriting compensation in subparagraph (d)(5) 
below, when applicable; and
    (vi) A detailed explanation and any documents related to:
    a. The modification of any information or representation previously 
provided to the Association or of any item of underwriting 
compensation[,] ; or
    b. Any new arrangement that provides for the receipt of any 
additional item of value by any participating member subsequent to the 
[review and approval of such compensation] issuance of an opinion of no 
objections to the underwriting terms and arrangements by the 
Association and within 90 days immediately following the date of 
effectiveness or commencement of sales of the public offering.
    (B) No change.
    (7)-(11) No change.
(c) Underwriting Compensation and Arrangements
(1) General
    No member or person associated with a member shall participate in 
any manner in any public offering of securities in which the 
underwriting or other terms or arrangements in connection with or 
relating to the distribution of the securities, or the terms and 
conditions related thereto, are unfair or unreasonable.
(2) Amount of Underwriting Compensation
    (A) No member or person associated with a member shall receive an 
amount of underwriting compensation in connection with a public 
offering [which] that is unfair or unreasonable and no member or person 
associated with a member shall underwrite or participate in a public 
offering of securities if the underwriting compensation in connection 
with the public offering is unfair or unreasonable.
    (B)-(D) No change.
    (E) The maximum amount of compensation (stated as a percentage of 
the dollar amount of the offering proceeds) [which] that is considered 
fair and reasonable generally will vary directly with the amount of 
risk to be assumed by [the underwriter and related persons] 
participating members and inversely with the dollar amount of the 
offering proceeds.
(3) Items of [Compensation] Value
    (A) For purposes of determining the amount of underwriting 
compensation received or to be received by the underwriter and related 
persons pursuant to subparagraph (c)(2) above, the following items and 
all other items of value received or to be received by the underwriter 
and related persons in connection with or related to the distribution 
of the public offering, as determined pursuant to [sub]paragraph [(4)] 
(d) below shall be included:
    (i)-(iii) No change.
    (iv) Finder's fees, whether in the form of cash, securities or any 
other item of value;
    (v) Wholesaler's fees;
    (vi) Financial consulting and advisory fees, whether in the form of 
cash, securities, or any other item of value;
    (vii) Common or preferred stock, options, warrants, and other 
equity securities, including debt securities convertible to or 
exchangeable for equity securities, [including securities] received [as 
underwriting compensation, for example]:
    a. [in connection with a] For acting as private placement agent [of 
securities] for the issuer;
    b. For providing or arranging a loan, credit facility, [bridge 
financing] merger or acquisition services, or any other service for the 
issuer;
    [c. As a finder's fee;]
    [d. For consulting services to the issuer; and]
    [e.] c. [securities purchased] As an investment in a private 
placement made by the issuer; or
    d. At the time of the public offering;
    (viii) Special sales incentive items [in compliance with 
subparagraph (6)(B)(xi)];
    (ix) Any right of first refusal provided to [the underwriter and 
related persons] any participating member to underwrite or participate 
in future public offerings, private placements or other financings,

[[Page 14951]]

which will have a compensation value of 1% of the offering proceeds or 
that dollar amount contractually agreed to by the issuer and 
underwriter to waive or terminate the right of first refusal;
    (x) No change.
    (xi) commissions, expense reimbursements, or other compensation to 
be received by the underwriter and related persons as a result of the 
exercise or conversion, within twelve [(12)] months following the 
effective date of the offering, of warrants, options, convertible 
securities, or similar securities distributed as part of the public 
offering; and
    (xii) fees of a qualified independent underwriter[; and].
    [(xiii) compensation, including expense reimbursements, paid in the 
six (6) months prior to the initial or amended filing of the prospectus 
or similar documents to any member or person associated with a member 
for a public offering that was not completed.]
    (B) Notwithstanding subparagraph (c)(3)(A) above, the following 
shall not be considered an item of value:
    (i) [E] expenses customarily borne by an issuer, such as printing 
costs; SEC, ``blue sky'' and other registration fees; Association 
filing fees; and accountant's fees, [shall be excluded from 
underwriter's compensation] whether or not paid through [an 
underwriter] a participating member;
    (ii) Compensation, including expense reimbursements, previously 
paid to any member in connection with a proposed public offering that 
was not completed, if the member does not participate in the revised 
public offering;
    (iii) Cash compensation for acting as placement agent for a private 
placement or for providing a loan, credit facility, or for services in 
connection with a merger/acquisition;
    (iv) Listed securities purchased in public market transactions;
    (v) Securities acquired through any stock bonus, pension, or 
profit-sharing plan that qualifies under Section 401 of the Internal 
Revenue Code; and
    (vi) Securities acquired by an investment company registered under 
the Investment Company Act of 1940.
[(4)] (d) Determination of Whether [Compensation Is Received in 
Connection With the Offering] Items of Value Are Included In 
Underwriting Compensation
[(A)] (1) Pre-Offering Compensation
    All items of value received [or to be received] and all 
arrangements entered into for the future receipt of an item of value by 
the underwriter and related persons during the [twelve (12) month] 
period commencing 180 days immediately preceding the required filing 
date of the registration statement or similar document pursuant to 
subparagraph (b)(4) above[, and at the time of and subsequent to] until 
the date of effectiveness or commencement of sales of the public 
offering[,] will be [examined to determine whether such items of value 
are] considered to be underwriting compensation in connection with the 
public offering [and, if received during the six (6) month period 
immediately preceding the filing of the registration statement or 
similar document, will be presumed to be underwriting compensation 
received in connection with the offering, provided, however, that such 
presumption may be rebutted on the basis of information satisfactory to 
the Association to support a finding that the receipt of an item is not 
in connection with the offering and shall not include cash discounts or 
commissions received in connection with a prior distribution of the 
issuer's securities].

(2) Undisclosed and Post-Offering Compensation

    All items of value received and all arrangements entered into for 
the future receipt of an item of value by any participating member that 
are not disclosed to the Association prior to the date of effectiveness 
or commencement of sales of a public offering, including items of value 
received subsequent to the public offering, are subject to post-
offering review to determine whether such items of value are, in fact, 
underwriting compensation for the public offering.
    [(B) Items of value received by an underwriter and related person 
more than twelve (12) months immediately preceding the date of filing 
of the registration statement or similar document will be presumed not 
to be underwriting compensation. However, items received prior to such 
twelve (12) month period may be included as underwriting compensation 
on the basis of information to support a finding that receipt of the 
item is in connection with the offering.]
    [(C) For purposes of determining whether any item of value received 
or to be received by the underwriter and related persons is in 
connection with or related to the distribution of the public offering, 
the following factors, as well as any other relevant factors and 
circumstances, shall be considered:]
    [(i) The length of time between the date of filing of the 
registration statement or similar document and:]
    [a. The date of the receipt of the item of value;]
    [b. The date of any contractual agreement for services for which 
the item of value was or is to be received; and]
    [c. The date the performance of the service commenced, with a 
shorter period of time tending to indicate that the item is received in 
connection with the offering;]
    [(ii) The details of the services provided or to be provided for 
which the item of value was or is to be received;]
    [(iii) The relationship between the services provided or to be 
provided for which the item of value was or is to be received and:]
    [a. The nature of the item of value;]
    [b. The compensation value of the item; and]
    [c. The proposed public offering;]
    [(iv) The presence or absence of arm's length bargaining or the 
existence of any affiliate relationship between the issuer and the 
recipient of the item of value, with the absence of arm's length 
bargaining or the presence of any affiliation tending to indicate that 
the item of value is received in connection with the offering.]
    [(D) For purposes of determining whether securities received or to 
be received by the underwriter and related persons are in connection 
with or related to the distribution of the public offering, the factors 
in subparagraph (C) above and the following factors shall be 
considered:]
    [(i) Any disparity between the price paid and the offering price or 
the market price, if a bona fide independent market exists at the time 
of acquisition, with a greater disparity tending to indicate that the 
securities constitute compensation;]
    [(ii) The amount of risk assumed by the recipient of the 
securities, as determined by:]
    [a. The restrictions on exercise and resale;]
    [b. The nature of the securities (e.g., warrant, stock, or debt); 
and]
    [c. The amount of securities, with a larger amount of readily 
marketable securities without restrictions on resale or a warrant for 
securities tending to indicate that the securities constitute 
compensation; and]
    [(iii) The relationship of the receipt of the securities to 
purchases by unrelated purchasers on similar terms at approximately the 
same time, with an absence of similar purchases tending to indicate 
that the securities constitute compensation.]
    [(E) Notwithstanding the provisions of subparagraph (3)(A)(vi) 
above, financial consulting and advisory fees may be excluded from 
underwriting compensation upon a finding by the

[[Page 14952]]

Association, on the basis of information satisfactory to it, that an 
ongoing relationship between the issuer and the underwriter and related 
person has been established at least twelve (12) months prior to the 
filing of the registration statement or similar document or that the 
relationship, if established subsequent to that time, was not entered 
into in connection with the offering, and that actual services have 
been or will be rendered which were not or will not be in connection 
with or related to the offering.]

(3) Date of Receipt of Securities

    Securities of the issuer acquired by the underwriter and related 
persons will be considered to be received for purposes of subparagraphs 
(d)(1) and (d)(5) as of the date of the:
    (A) Closing of a private placement, if the securities were 
purchased in or received for arranging a private placement; or
    (B) Execution of a written contract with detailed provisions for 
the receipt of securities as compensation for a loan, credit facility, 
or put option; or
    (C) transfer of beneficial ownership of the securities, if the 
securities were received as compensation for consulting or advisory 
services, merger or acquisition services, acting as a finder, or for 
any other service.

(4) Definitions

    For purposes of subparagraph (d)(5) below, the following terms will 
have the meanings stated below.
    (A) An entity:
    (i) Includes a group of legal persons that either:
    a. Are contractually obligated to make co-investments and have 
previously made at least one such investment; or
    b. Have filed a Form 13D or 13G with the SEC that identifies the 
legal persons as members of a group who have agreed to act together for 
the purpose of acquiring, holding, voting or disposing of equity 
securities of an issuer in connection with a previous investment; and
    (ii) May make its investment or loan through a wholly owned 
subsidiary (except when the entity is a group of legal persons).
    (B) An institutional investor is any individual or legal person 
that has at least $50 million invested in securities in the aggregate 
in its portfolio or under management, including investments held by its 
wholly owned subsidiaries; provided that no participating member has an 
equity interest in or manages or otherwise directs the institutional 
investor's investments.
    (C) A right of preemption means the right of a shareholder to 
acquire additional securities in the same company in order to avoid 
dilution when additional securities are issued, pursuant to:
    (i) Any option, shareholder agreement, or other contractual right 
entered into at the time of a purchase of securities;
    (ii) The terms of the security purchased;
    (iii) The issuer's charter or by-laws; or
    (iv) The domestic law of a foreign jurisdiction that regulates the 
issuance of the securities.
    (D) ``Total equity securities'' means the aggregate of the total 
shares of:
    (i) Common stock outstanding of the issuer; and
    (ii) Common stock of the issuer underlying all convertible 
securities outstanding that convert without the payment of any 
additional consideration.

(5) Exceptions From Underwriting Compensation

    Notwithstanding subparagraph (d)(1) above, the following items of 
value are excluded from underwriting compensation (but are subject to 
the lock-up restriction in subparagraph (g)(1) below), provided that 
the member does not condition its participation in the public offering 
on an acquisition of securities under an exception and any securities 
purchased are purchased at the same price and with the same terms as 
the securities purchased by all other investors.
    (A) Purchases and Loans by Certain Entities--Securities of the 
issuer purchased in a private placement or received as compensation for 
a loan or credit facility before the required filing date of the public 
offering pursuant to subparagraph (b)(4) above by certain entities if:
    (i) Each entity:
    a. Either:
    1. Manages capital contributions or commitments of $100 million or 
more, at least $75 million of which has been contributed or committed 
by persons that are not participating members;
    2. Manages capital contributions or commitments of $25 million or 
more, at least 75% of which has been contributed or committed by 
persons that are not participating members;
    3. Is an insurance company as defined in Section 2(a)(13) of the 
Securities Act or is a foreign insurance company that has been granted 
an exemption under this Rule; or
    4. Is a bank as defined in Section 3(a)(6) of the Act or is a 
foreign bank that has been granted an exemption under this Rule; and
    b. Is a separate and distinct legal person from any member and is 
not registered as a broker/dealer;
    c. Makes investments or loans subject to the evaluation of 
individuals who have a contractual or fiduciary duty to select 
investments and loans based on the risks and rewards to the entity and 
not based on opportunities for the member to earn investment banking 
revenues;
    d. Does not participate directly in investment banking fees 
received by any participating member for underwriting public offerings; 
and
    e. Has been primarily engaged in the business of making investments 
in or loans to other companies; and
    (ii) The total amount of securities received by all entities 
related to each member does not exceed 10% of the issuer's total equity 
securities, calculated immediately following the transaction.
    (B) Investments In and Loans to Certain Issuers--Securities of the 
issuer purchased in a private placement or received as compensation for 
a loan or credit facility before the required filing date of the public 
offering pursuant to subparagraph (b)(4) above by certain entities if:
    (i) Each entity:
    a. Manages capital contributions or commitments of at least $50 
million;
    b. Is a separate and distinct legal person from any member and is 
not registered as a broker/dealer;
    c. Does not participate directly in investment banking fees 
received by the member for underwriting public offerings; and
    d. Has been primarily engaged in the business of making investments 
in or loans to other companies; and
    (ii) Institutional investors beneficially own at least 33% of the 
issuer's total equity securities, calculated immediately prior to the 
transaction;
    (iii) The transaction was approved by a majority of the issuer's 
board of directors and a majority of any institutional investors, or 
the designees of institutional investors, that are board members; and
    (iv) The total amount of securities received by all entities 
related to each member does not exceed 10% of the issuer's total equity 
securities, calculated immediately following the transaction.
    (C) Private Placements With Institutional Investors--Securities of 
the issuer purchased in, or received as placement agent compensation 
for, a private placement before the required filing date of the public 
offering pursuant to subparagraph (b)(4) above if:

[[Page 14953]]

    (i) institutional investors purchase at least 51% of the ``total 
offering'' (comprised of the total number of securities sold in the 
private placement and received or to be received as placement agent 
compensation by any member);
    (ii) an institutional investor was the lead negotiator or, if the 
terms were not negotiated, was the lead investor with the issuer to 
establish or approve the terms of the private placement; and
     (iii) underwriters and related persons did not, in the aggregate, 
purchase or receive as placement agent compensation more than 20% of 
the ``total offering'' (excluding purchases by any entity qualified 
under subparagraph (d)(5)(A) above).
    (D) Acquisitions and Conversions to Prevent Dilution--Securities of 
the issuer if:
    (i) The securities were acquired as the result of:
     a. A right of preemption that was granted in connection with 
securities that were purchased either:
    1. In a private placement and the securities are not deemed by the 
Association to be underwriting compensation; or
     2. From a public offering or the public market; or
    b. A stock-split or a pro-rata rights or similar offering; or
    c. The conversion of securities that have not been deemed by the 
Association to be underwriting compensation; and
    (ii) The only terms of the purchased securities that are different 
from the terms of securities purchased by other investors are pre-
existing contractual rights that were granted in connection with a 
prior purchase;
    (iii) The opportunity to purchase in a rights offering or pursuant 
to a right of preemption, or to receive additional securities as the 
result of a stock-split or conversion was provided to all similarly 
situated securityholders; and
     (iv) The amount of securities purchased or received did not 
increase the recipient's percentage ownership of the same generic class 
of securities of the issuer or of the class of securities underlying a 
convertible security calculated immediately prior to the investment, 
except in the case of conversions.
    (E) Purchases Based On A Prior Investment History--Purchases of 
securities of the issuer if:
    (i) The amount of securities purchased did not increase the 
purchaser's percentage ownership of the same generic class of 
securities of the issuer or of the class of securities underlying a 
convertible security calculated immediately prior to the investment; 
and
    (ii) An initial purchase of securities of the issuer was made at 
least two years and a second purchase was made more than 180 days 
before the required filing date of the public offering pursuant to 
subparagraph (b)(4) above.
    (F) Financial Consulting and Advisory Arrangements--Compensation 
received by a financial consultant or advisor if:
    (i) The consulting/advisory relationship was established pursuant 
to a written and executed agreement entered into more than one year 
before the required filing date of the public offering pursuant to 
subparagraph (b)(4) above;
    (ii) Any securities received or to be received do not exceed the 
amount and type specified in the agreement;
    (iii) Substantive services were provided on an ongoing basis to the 
issuer during the one-year period; and
    (iv) The consultant/advisor has routinely provided similar services 
to other companies.
[(5)] (e) Valuation of Non-Cash Compensation
    For purposes of determining the value to be assigned to securities 
received as underwriting compensation, the following criteria and 
procedures shall be applied[:].
    [(A) No underwriter and related person may receive a security or a 
warrant for a security as compensation in connection with the 
distribution of a public offering that is different than the security 
to be offered to the public unless the security received as 
compensation has a bona fide independent market, provided, however, 
that: (i) In exceptional and unusual circumstances, upon good cause 
shown, such arrangement may be permitted by the Association; and (ii) 
in an offering of units, the underwriter and related persons may only 
receive a warrant for the unit offered to the public where the unit is 
the same as the public unit and the terms are no more favorable than 
the terms of the public unit.]

(1) Limitation on Securities Received Upon Exercise or Conversion of 
Another Security

    An underwriter and related person may not receive a security 
(including securities in a unit), a warrant for a security, or a 
security convertible into another security as underwriting compensation 
in connection with a public offering unless:
    (A) the security received or the security underlying the warrant or 
convertible security received is identical to the security offered to 
the public or to a security with a bona fide independent market; or
    (B) the security can be accurately valued, as required by 
subparagraph (f)(2)(I) below.
[(B)] (2) Valuation of Securities That Do Not Have an Exercise or 
Conversion Price 
    [s] Securities that [are not options, warrants or convertible 
securities] do not have an exercise or conversion price shall have a 
compensation value [be valued on the basis of] based on:
    [(i)] (A) The difference between [the per security cost and]:
    (i) Either the market price per security on the date of 
acquisition, [where a] or, if no bona fide independent market exists 
for the security, [or] the [proposed (and actual)] public offering 
price per security; and
    (ii) The per security cost;
    [(ii)] (B) Multiplied by the number of securities received or to be 
received as underwriting compensation;
    [(iii)] (C) Divided by the offering proceeds; and
    [(iv)] (D) Multiplied by one hundred [(100)].

(3) Valuation of Securities That Have an Exercise or Conversion Price

    [(C) o] Options, warrants or convertible securities that have an 
exercise or conversion price (``warrants'') shall [be valued on the 
basis of the following formula] have a compensation value based on:
    [(i)] (A) The [proposed (and actual)] public offering price per 
security multiplied by .65 [(65%)];
    [(ii)] (B) Minus the [difference between] resultant of the exercise 
or conversion price per [security] warrant [and] less either:
    (i) The market price per security on the date of acquisition, where 
a bona fide independent market exists for the security, or
    (ii) The [proposed (and actual)] public offering price per 
security;
    [(iii)] (C) Divided by two [(2)];
    [(iv)] (D) Multiplied by the number of securities underlying the 
warrants[, options, and convertible securities received or to be 
received as underwriting compensation];
    [(v)] (E) Less the total price paid for the [securities] warrants;
    [(vi)] (F) Divided by the offering proceeds; and
    [(vii)] (G) Multiplied by one hundred [(100).];
    (H) Provided, however, that such warrants shall have a compensation 
value of at least .2% of the offering proceeds for each amount of 
securities that is up to 1% of the securities being

[[Page 14954]]

offered to the public (excluding securities subject to an overallotment 
option).

(4) Valuation Discount For Securities With a Longer Resale Restriction

    [(D) a lower value equal to 80% and 60% of the calculated value 
shall be assigned if securities, and where relevant, underlying 
securities, are or will be restricted from sale, transfer, assignment 
or other disposition for a period of one and two years, respectively, 
beyond the one-year period of restriction required by subparagraph 
(7)(A)(i) below.]
    A lower value equal to 10% of the calculated value shall be 
deducted for each 180-day period that the securities or underlying 
securities are restricted from sale or other disposition beyond the 
180-day period of the lock-up restriction required by subparagraph 
(g)(1) below. The transfers permitted during the lock-up restriction by 
subparagraphs (g)(2)(A)(iii)-(iv) are not available for such 
securities.
[(6)] (f) Unreasonable Terms and Arrangements
[(A)] (1) General
    No member or person associated with a member shall participate in 
any manner in a public offering of securities after any arrangement 
proposed in connection with the public offering, or the terms and 
conditions relating thereto, has been determined to be unfair or 
unreasonable pursuant to this Rule or inconsistent with any By-Law or 
any Rule or regulation of the Association.
[(B)] (2) Prohibited Arrangements
    Without limiting the foregoing, the following terms and 
arrangements, when proposed in connection with [the distribution of] a 
public offering of securities, shall be unfair and unreasonable[:].
    [(i)] (A) [a]Any accountable expense allowance granted by an issuer 
to the underwriter and related persons [which] that includes payment 
for general overhead, salaries, supplies, or similar expenses of the 
underwriter incurred in the normal conduct of business[;].
    [(ii)] (B) [a]Any non-accountable expense allowance in excess of 
[three (3) percent;] 3% of offering proceeds.
    [(iii)] (C) [a]Any payment of commissions or reimbursement of 
expenses directly or indirectly to the underwriter and related persons 
prior to commencement of the public sale of the securities being 
offered, except a reasonable advance against out-of-pocket accountable 
expenses actually anticipated to be incurred by the underwriter and 
related persons, which advance is reimbursed to the issuer to the 
extent not actually incurred[;].
    [(iv)] (D) [t]The payment of any compensation by an issuer to a 
member or person associated with a member in connection with an 
offering of securities [which] that is not completed according to the 
terms of agreement between the issuer and underwriter, except those 
negotiated and paid in connection with a transaction that occurs in 
lieu of the proposed offering as a result of the efforts of the 
underwriter and related persons and provided, however, that the 
reimbursement of out-of-pocket accountable expenses actually incurred 
by the member or person associated with a member shall not be presumed 
to be unfair or unreasonable under normal circumstances[;].
    [(v)] (E) [a]Any ``tail fee'' arrangement granted to the 
underwriter and related persons that has a duration of more than two 
[(2)] years from the date the member's services are terminated, in the 
event that the offering is not completed in accordance with the 
agreement between the issuer and the underwriter and the issuer 
subsequently consummates a similar transaction, except that a member 
may demonstrate on the basis of information satisfactory to the 
Association that an arrangement of more than two [(2)] years is not 
unfair or unreasonable under the circumstances.
    [(vi)] (F) [a]Any right of first refusal provided to the 
underwriter or related persons to underwrite or participate in future 
public offerings, private placements or other financings [which] that:
    [a.] (i) Has a duration of more than three [(3)] years from the 
[effective] date of effectiveness or commencement of sales of the 
public offering; or
    [b.] (ii) Has more than one opportunity to waive or terminate the 
right of first refusal in consideration of any payment or fee[;].
    [(vii)] (G) [a]Any payment or fee to waive or terminate a right of 
first refusal regarding future public offerings, private placements or 
other financings provided to the underwriter and related persons 
[which] that:
    [a.](i) Has a value in excess of the greater of [one percent (] 1% 
[)] of the offering proceeds in the public offering where the right of 
first refusal was granted (or an amount in excess of [one percent] 1% 
if additional compensation is available under the compensation 
guideline of the original offering) or [five percent (] 5% [)] of the 
underwriting discount or commission paid in connection with the future 
financing (including any overallotment option that may be exercised), 
regardless of whether the payment or fee is negotiated at the time of 
or subsequent to the original public offering; or
    [b.](ii) Is not paid in cash[;].
    [(viii)] (H) The terms or the exercise of the terms of an agreement 
for the receipt by the underwriter and related persons of underwriting 
compensation consisting of any option, warrant or convertible security 
[which] that:
    [a.] (i) Is exercisable or convertible more than five [(5)] years 
from the effective date of the offering;
    [b. Is exerciseable or convertible at a price below either the 
public offering price of the underlying security or, if a bona fide 
independent market exists for the security or the underlying security, 
the market price at the time of receipt;]
    [c.] (ii) Is not in compliance with subparagraph [(5)(A)] (e)(1) 
above;
    [d.] (iii) Has more than one demand registration right at the 
issuer's expense;
    [e.] (iv) Has a demand registration right with a duration of more 
than five [(5)] years from the [effective] date of effectiveness or the 
commencement of sales of the public offering;
    [f.] (v) Has a piggyback registration right with a duration of more 
than seven [(7)] years from the [effective] date of effectiveness or 
the commencement of sales of the public offering;
    [g.] (vi) Has anti-dilution terms [designed to provide] that allow 
the underwriter and related persons [with disproportionate rights, 
privileges and economic benefits which are not provided to the 
purchasers of the securities offered to the public (or the public 
shareholders, if in compliance with subparagraph (5)(A) above)] to 
receive more shares or to exercise at a lower price than originally 
agreed upon at the time of the public offering, when the public 
shareholders have not been proportionally affected by a stock split, 
stock dividend, or other similar event; or
    [h.] (vii) Has anti-dilution terms [designed to provide for the 
receipt or accrual of] that allow the underwriter and related persons 
to receive or accrue cash dividends prior to the exercise or conversion 
of the security[; or].
    [i. Is convertible or exercisable or otherwise is on terms more 
favorable

[[Page 14955]]

than the terms of the securities being offered to the public;]
    [(ix)] (I) [t]The receipt by the underwriter and related persons of 
any item of compensation for which a value cannot be determined at the 
time of the offering[;].
    [(x)] (J) [w]When proposed in connection with the distribution of a 
public offering of securities on a ``firm commitment'' basis, any over 
allotment option providing for the over allotment of more than [fifteen 
(15) percent] 15% of the amount of securities being offered, computed 
excluding any securities offered pursuant to the over allotment 
option[;].
    [(xi) stock numerical limitation. The receipt by the underwriter 
and related persons of securities which constitute underwriting 
compensation in an aggregate amount greater than ten (10) percent of 
the number or dollar amount of securities being offered to the public, 
which is calculated to exclude:]
    [a. any securities deemed to constitute underwriting compensation;]
    [b. any securities issued pursuant to an overallotment option;]
    [c. in the case of a ``best efforts'' offering, any securities not 
actually sold; and]
    [d. any securities underlying warrants, options, or convertible 
securities which are part of the proposed offering, except where 
acquired as part of a unit;]
    [(xii)] (K) [t]The receipt by a member or person associated with a 
member, pursuant to an agreement entered into at any time before or 
after the effective date of a public offering of warrants, options, 
convertible securities or units containing such securities, of any 
compensation or expense reimbursement in connection with the exercise 
or conversion of any such warrant, option, or convertible security in 
any of the following circumstances:
    [a.](i) The market price of the security into which the warrant, 
option, or convertible security is exercisable or convertible is lower 
than the exercise or conversion price;
    [b.](ii) The warrant, option, or convertible security is held in a 
discretionary account at the time of exercise or conversion, except 
where prior specific written approval for exercise or conversion is 
received from the customer;
    [c.](iii) The arrangements whereby compensation is to be paid are 
not disclosed:
    [1.]a. In the prospectus or offering circular by which the 
warrants, options, or convertible securities are offered to the public, 
if such arrangements are contemplated or any agreement exists as to 
such arrangements at that time, and
    [2.]b. In the prospectus or offering circular provided to security 
holders at the time of exercise or conversion; or
    [d.](iv) The exercise or conversion of the warrants, options or 
convertible securities is not solicited by the underwriter or related 
person, provided however, that any request for exercise or conversion 
will be presumed to be unsolicited unless the customer states in 
writing that the transaction was solicited and designates in writing 
the broker/dealer to receive compensation for the exercise or 
conversion[;].
    [(xiii)] (L) [f]For a member or person associated with a member to 
accept, directly or indirectly, any non-cash sales incentive item 
including, but not limited to, travel bonuses, prizes and awards, from 
an issuer or an affiliate thereof in excess of $100 per person per 
issuer annually. Notwithstanding the foregoing, a member may provide 
non-cash sales incentive items to its associated persons provided that 
no issuer, or an affiliate thereof, including specifically an affiliate 
of the member, directly or indirectly participates in or contributes to 
providing such non-cash sales incentive[; or].
    [(xiv)] (M) [f]For a member to participate with an issuer in the 
public distribution of a non-underwritten issue of securities if the 
issuer hires persons primarily for the purpose of distributing or 
assisting in the distribution of the issue, or for the purpose of 
assisting in any way in connection with the underwriting, except to the 
extent in compliance with 17 C.F.R. Sec. 240.3a4-1 and applicable state 
law.
    [(xv)] N [f] For a member or person associated with a member to 
participate in a public offering of real estate investment trust 
securities, as defined in Rule 2340(c)(4), unless the trustee will 
disclose in each annual report distributed to investors pursuant to 
Section 13(a) of the Act a per share estimated value of the trust 
securities, the method by which it was developed, and the date of the 
data used to develop the estimated value.
    [(C) In the event that the underwriter and related persons receive 
securities deemed to be underwriting compensation in an amount 
constituting unfair and unreasonable compensation pursuant to the stock 
numerical limitation in subparagraph (B)(ix) above, the recipient shall 
return any excess securities to the issuer or the source from which 
received at cost and without recourse, except that in exceptional and 
unusual circumstances, upon good cause shown, a different arrangement 
may be permitted.]
[(7)] (g) Lock-Up Restriction[s] on Securities
    [(A) No member or person associated with a member shall participate 
in any public offering which does not comply with the following 
requirements:]
    [(i) Securities deemed to be underwriting compensation shall not be 
sold, transferred, assigned, pledged or hypothecated by any person, 
except as provided in subparagraph (B) below, for a period of (a) one 
year following the effective date of the offering. However, securities 
deemed to be underwriting compensation may be transferred to any member 
participating in the offering and the bona fide officers or partners 
thereof and securities which are convertible into other types of 
securities or which may be exercised for the purchase of other 
securities may be so transferred, converted or exercised if all 
securities so transferred or received remain subject to the 
restrictions specified herein for the remainder of the initially 
applicable time period;]
    [(ii) Certificates or similar instruments representing securities 
restricted pursuant to subparagraph (i) above shall bear an appropriate 
legend describing the restriction and stating the time period for which 
the restriction is operative; and]
    [(iii) Securities to be received by a member as underwriting 
compensation shall only be issued to a member participating in the 
offering and the bona fide officers or partners thereof.]

(1) Lock-Up Restriction

    Any common or preferred stock, options, warrants, and other equity 
securities of the issuer, including debt securities convertible to or 
exchangeable for equity securities of the issuer, that are beneficially 
owned by any person that is an underwriter and related person on the 
date of effectiveness or commencement of sales of the public offering 
shall not be sold during the offering or sold, transferred, assigned, 
pledged, or hypothecated, or be the subject of any hedging, short sale, 
derivative, put, or call transaction that would result in the effective 
economic disposition of the securities by any person for a period of 
180 days immediately following the date of effectiveness or 
commencement of sales of the public offering, except as provided in 
subparagraph (g)(2) below.

(2) Exceptions to Lock-Up Restriction

    [(B) The provisions of subparagraph (A) notwithstanding:]
    Notwithstanding subparagraph (g)(1) above, the following shall not 
be prohibited:

[[Page 14956]]

    (A) The transfer of any security:
    (i) By operation of law or by reason of reorganization of the 
issuer [shall not be prohibited.];
    (ii) To any member participating in the offering and the officers 
or partners thereof, if all securities so transferred remain subject to 
the lock-up restriction in subparagraph (g)(1) above for the remainder 
of the time period;
    [(C) Venture capital restrictions. When a member participates in 
the initial public offering of an issuer's securities, such member or 
any officer, director, general partner, controlling shareholder or 
subsidiary of the member or subsidiary of such controlling shareholder 
or a member of the immediate family of such persons, who beneficially 
owns any securities of said issuer at the time of filing of the 
offering, shall not sell such securities during the offering or sell, 
transfer, assign or hypothecate such securities for ninety (90) days 
following the effective date of the offering unless:]
    [(i) The price at which the issue is to be distributed to the 
public is established at a price no higher than that recommended by a 
qualified independent underwriter who does not beneficially own 5% or 
more of the outstanding voting securities of the issuer, who shall also 
participate in the preparation of the registration statement and the 
prospectus, offering circular, or similar document and who shall 
exercise the usual standards of ``due diligence'' in respect thereto; 
or]
    [(ii)] (iii) If the aggregate amount of [such] securities of the 
issuer held by [such a member and its related persons enumerated above 
would] the underwriter or related person do not exceed 1% of the 
securities being offered;
    (iv) That is beneficially owned on a pro-rata basis by all equity 
owners of an investment fund, provided that no participating member 
manages or otherwise directs investments by the fund and participating 
members in the aggregate do not own more than 10% of the equity in the 
fund;
    (v) That is not an item of value under subparagraphs (c)(3)(B)(iv)-
(vi) above;
    (vi) That was previously but is no longer subject to the lock-up 
restriction in subparagraph (g)(1) above in connection with a prior 
public offering; or
     (vii) That was acquired before the period commencing 180 days 
immediately preceding the required filing date pursuant to subparagraph 
(b)(4) above and:
    a. The class of security qualifies as an ``actively traded 
security'' under SEC Rule 101(c)(1) of Regulation M as of the date of 
effectiveness or commencement of sales of the public offering; or
    b. Is beneficially owned by a person that is not a participating 
member; or
    (B) The exercise or conversion of any security, if all securities 
received remain subject to the lock-up restriction in subparagraph 
(g)(1) above for the remainder of the time period.
[(8)] (h) [Conflicts of Interest] Proceeds Directed to a Member[:]

(1) Compliance With Rule 2720

    No member shall participate in a public offering of an issuer's 
securities where more than [ten (10) percent] 10% of the net offering 
proceeds, not including underwriting compensation, are intended to be 
paid to [members participating in the distribution of the offering or 
associated or affiliated persons of such members, or members of the 
immediate family of such persons] participating members, unless the 
price at which an equity issue or the yield at which a debt issue is to 
be distributed to the public is established pursuant to Rule 
2720(c)(3).
[(A)] (2) Disclosure
    All offerings included within the scope of [this] subparagraph 
[(8)] (h)(1) shall disclose in the underwriting or plan of distribution 
section of the registration statement, offering circular or other 
similar document that the offering is being made pursuant to the 
provisions of this subparagraph and, where applicable, the name of the 
member acting as qualified independent underwriter, and that such 
member is assuming the responsibilities of acting as a qualified 
independent underwriter in pricing the offering and conducting due 
diligence.
[(B)] (3) Exception From Compliance
    The provisions of [this] subparagraphs [(8)] (h)(1) and (2) shall 
not apply to:
    [(i)] (A) An offering otherwise subject to the provisions of Rule 
2720;
    [(ii)] (B) An offering of securities exempt from registration with 
the Commission under Section 3(a)(4) of the Securities Act of 1933;
    [(iii)] (C) An offering of a real estate investment trust as 
defined in Section 856 of the Internal Revenue Code; or
    [(iv)] (D) An offering of securities subject to Rule 2810, unless 
the net offering proceeds are intended to be paid to the above persons 
for the purpose of repaying loans, advances or other types of financing 
utilized to acquire an interest in a pre-existing company.
[(d)] (i) Exemptions
    Pursuant to the Rule 9600 Series, the [Association may exempt a 
member or person associated with a member from the provisions of this 
Rule] staff, for good cause shown after taking into consideration all 
relevant factors, may conditionally or unconditionally grant an 
exemption from any provision of this Rule to the extent that such 
exemption is consistent with the purposes of the Rule, the protection 
of investors, and the public interest.
2720. Distribution of Securities of Members and Affiliates--Conflicts 
of Interest
(a) General
    No Change.
(b) Definitions
    (1)-(8) No Change.
    (9) Immediate family--the parents, mother-in-law, father-in-law, 
[husband or wife] spouse, brother or sister, brother-in-law or sister-
in-law, son-in-law or daughter-in-law, and children of an employee or 
associated person of a member, except any person other than the spouse 
and children who does not live in the same household as, have a 
business relationship with, provide material support to, or receive 
material support from the employee or associated person of a member. In 
addition, the immediate family includes [or] any other person who [is 
supported, directly or indirectly, to a material extent by] either 
lives in the same household as, provides material support to, or 
receives material support from an employee [of,] or associated person 
[associated, with] of a member.

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
    On December 11, 2000 and February 1, 2001, NASD Regulation filed

[[Page 14957]]

proposed amendments to the Corporate Financing Rule (``Rule'') that 
were intended to modernize and simplify the Rule (``original rule 
filing'' or ``original proposal''). The original rule filing contained 
an objective standard that members and the staff could follow to 
determine whether any ``items of value,'' such as fees and securities, 
provided by an issuer to underwriters and related persons should be 
included in the calculation of underwriting compensation under the 
Rule. Under this standard, all items of value received by underwriters 
and related persons from 180 days before the filing of a registration 
statement until the date of effectiveness or commencement of sales of 
the public offering (``180-day review period'') would be deemed to be 
underwriting compensation, unless the items were received in a 
transaction that met one of four exceptions. The exceptions were 
intended to establish transaction criteria that would distinguish 
between securities acquired as bona fide investments from securities 
acquired as underwriting compensation.
    In addition, the original rule filing proposed a 180-day lock-up 
restriction on sales of any securities of the issuer held by any person 
covered by the definition of underwriter and related person at the time 
of the public offering, with certain exceptions. The original rule 
filing also proposed to delete the 10% limitation on the amount of 
securities deemed to be underwriting compensation, known as the Stock 
Numerical Limitation, and the prohibition on warrants having an 
exercise price below the public offering price. In addition, the 
original rule filing proposed to amend provisions that had become 
problematic or unnecessary as applied to current industry practices or 
particular types of issuers.
    The SEC published the original proposal for comment \5\ and 
received 14 comment letters.\6\ Commenters generally supported the 
original proposal, but requested additional changes and clarifications. 
In particular, commenters believed that the proposal did not go far 
enough in excluding investments by affiliates of members in light of 
the creation of large financial institutions that include commercial 
and investment banking and insurance operations.
---------------------------------------------------------------------------

    \5\ Securities Exchange Release No. 42619 (April 4, 2000); 65 FR 
19409 (April 11, 2000).
    \6\ Akin, Gump, Strauss, Hauer & Feld (``Akin''); The Bond 
Market Association (``TBMA''); Chase Manhattan Corporation 
(``Chase''); CIBC World Markets Corporation (``CIBC''); Fried, 
Frank, Harris, Shriver & Jacobson (``Fried Frank''); Goldman, Sachs 
& Company (``Goldman''); Merrill Lynch (``Merrill''); Morgan Stanley 
Dean Witter (``Morgan''); Morrison & Foerster (``M&F''); North 
American Securities Administrators Association (``NASAA''); Ohio 
Department of Commerce, Division of Securities (``Ohio''); 
Prudential Securities, Inc. (``Prudential''); Salomon Smith Barney, 
Inc. (``Salomon''); and Securities Industry Association (``SIA'').
---------------------------------------------------------------------------

    Amendment No. 5 responds to the comments received. Following is a 
description of proposed amendments to the original proposal that: (i) 
Expand the circumstances under which purchases and other acquisitions 
of the issuer's securities by members and their affiliates will not be 
considered underwriting compensation; (ii) incorporate increased 
flexibility in the Rule while maintaining the objective review 
standards of the original proposal; (iii) clarify parts of the original 
proposal; and (iv) impose a minimum compensation value on warrants 
deemed to be underwriting compensation (``amended proposal''). All 
proposed amendments are in response to comments, except as indicated 
and for non-substantive and conforming changes to the Rule. In 
addition, the following description addresses, where appropriate, 
comments that are opposed to provisions retained in the amended 
proposal. Other comments are addressed in Section II.C. below.
    The material in current paragraph (c) of Rule 2710 would be divided 
into paragraphs (c) through (g). In addition, the amended proposal 
would adopt a new definition of the term ``participating member'' in 
subparagraph (a)(4)\7\ to include participating broker/dealers, their 
associated persons and employees, any members of their immediate 
family, and any affiliate of the member. This term is used in the Rule 
and in the discussion below to distinguish between members that 
participate in the public offering and the broader category in the 
definition of ``underwriter and related persons'' that includes non-
members and other persons related to a member.
---------------------------------------------------------------------------

    \7\ All references are to the provisions of Rule 2710, as 
proposed to be amended, unless otherwise specified.
---------------------------------------------------------------------------

a. Pre-Offering Objective Test
    The original rule filing proposed to measure the 180-day review 
period in the same manner as the one-year review period in the current 
Rule.\8\ The amended proposal would modify subparagraph (d)(1) to 
provide that the 180-day period is measured from the date the public 
offering is required to be filed with the Association pursuant to 
subparagraph (b)(4) (``required filing date'').\9\ NASD Regulation also 
proposes to amend this provision to clarify that the review period 
commences 180 days before the required filing date and ends when the 
offering is effective or when the public offering commences.
---------------------------------------------------------------------------

    \8\ The original rule filing stated that the 180-day review 
period would be measured from the earlier of the date of filing with 
the SEC, state securities commission, or other regulatory authority, 
or the date of filing with the Association.
    \9\ This same calculation is used in the first three exceptions 
for acquisitions of securities from underwriting compensation and in 
the exceptions to the lock-up restriction on securities.
---------------------------------------------------------------------------

    Several commenters (SIA, Fried Frank, Goldman, Merrill, Morgan, and 
Salomon) requested that the Rule be amended to provide that the 180-day 
review period be measured from the date that the preliminary prospectus 
is circulated, particularly because certain issuers file early with the 
SEC. NASD Regulation believes that the commenters misunderstand the 
purpose of measuring the review period from the filing date. Members 
typically provide significant underwriting services in connection with 
the preparation and filing of a registration statement or other 
offering document. These underwriting activities are likely to have 
commenced within the 180-day period preceding the filing date. 
Accordingly, the Corporate Financing Department (``Department'') will 
review any items of value received by the underwriters beginning 180 
days prior to the filing date because they may constitute compensation 
for underwriting services. Although the first distribution of a 
preliminary prospectus is more relevant than the filing date in 
determining whether an offering is likely to be completed, it is 
irrelevant to determining whether an issuer has begun to pay its 
investment bankers for underwriting services.
b. Common Requirements of the Exceptions From Underwriting Compensation
    The original proposal included four ``safe harbors'' that establish 
transaction criteria that are intended to distinguish between 
securities acquired as bona fide investments from securities acquired 
as underwriting compensation. NASD Regulation is proposing to clarify 
and expand the ``safe harbors''--now called ``exceptions''--to cover 
additional types of transactions. Following is a discussion of certain 
of the requirements that are common to two or more exceptions.
    1. Deletion of Reference to ``Safe Harbors''--The original rule 
filing proposed four ``safe harbors'' that would exclude certain 
acquisitions of the issuer's securities during the 180-day review 
period from underwriting compensation. Some commenters (Fried Frank, 
Goldman, Morgan, Prudential, M&F, and Merrill) were correct in

[[Page 14958]]

noting that, although described as ``safe harbors,'' the original rule 
filing required that a transaction meet all of the criteria of a safe 
harbor in order to qualify for exclusion from underwriting 
compensation. Therefore, the proposed ``safe harbors'' in subparagraph 
(d)(5) will be treated under the amended Rule as ``exceptions.'' \10\
---------------------------------------------------------------------------

    \10\ Subparagraph (b)(6)(A)(v) would require that members submit 
information to the Association that demonstrates compliance with all 
of the criteria of the exception being relied upon.
---------------------------------------------------------------------------

    2. Ninety-Day Limitation on Availability of Exceptions--The 
original rule filing would have prohibited reliance on the first three 
exceptions from underwriting compensation in the 90-day period prior to 
the filing date of the public offering. NASD Regulation proposes to 
amend the exceptions in subparagraphs (d)(5)(A)-(C) to delete the 90-
day limitation and include language stating that transactions that 
occur before the required filing date are eligible for the 
exceptions.\11\
---------------------------------------------------------------------------

    \11\ The fourth, fifth, and sixth exceptions, discussed below, 
would be available during the 180-day review period and subsequent 
to the filing of the public offering.
---------------------------------------------------------------------------

    The deletion of the 90-day limitation was recommended by many 
commenters (SIA, TBMA, Fried Frank, Goldman, Merrill, Morgan, 
Prudential, and Salomon) who stated that the other conditions in the 
proposed exceptions were sufficient to prevent abusive practices during 
the entire 180-day review period. For example, Prudential stated that 
``the criteria in the safe harbors provide a more reliable guide than 
proximity in time for distinguishing between a payment for services and 
financing other than underwriting and compensation for underwriting.'' 
Consistent with the industry's position, NASD Regulation believes that 
the other criteria should generally be retained as proposed.
    3. Price and Terms of Securities--The third and fourth exceptions 
would have required that any securities purchased under an exception 
must be purchased at the same price and with the same terms as 
securities purchased by other investors. NASD Regulation proposes to 
amend the introduction to the exceptions in subparagraph (d)(5) to 
apply this criterion to any purchase under any exception provided that 
the purchase occurs at approximately the same time as purchases by 
other investors. In addition, NASD Regulation agrees with commenters 
(SIA and Goldman) that the price and terms requirement is not 
applicable to securities received as placement agent fees and, 
therefore, the language only refers to ``any securities purchased'' 
(emphasis provided).
    4. Conditioning a Member's Participation on a Securities 
Acquisition--The first three exceptions would have required that a 
member have written procedures to ensure that its participation in the 
public offering was not contingent on its participation in the private 
placement or loan that is covered by the exception. Commenters (Merrill 
and Fried Frank) recommended that this provision be eliminated as a 
condition of the exceptions, stating that it would require that the 
Department determine the intent of the member in each transaction, that 
the original proposal was unclear on the type of written procedures 
required, and that the provision is unnecessary in light of the other 
criteria of each exception. Commenters also believed that the rule 
language would require members to submit their written procedures for 
compliance with this provision for Department review in order to rely 
on an exception.
    NASD Regulation agrees that the specific written procedures 
requirement in the exceptions is not necessary, especially because 
members remain subject to the general standards of NASD Rule 
3010(b)(1), which requires members to establish written procedures that 
are reasonably designed to ensure compliance with NASD rules. However, 
NASD Regulation continues to be concerned that participating members 
not use their position as an issuer's underwriter to require the issuer 
to sell cheap stock or warrants to the member or the member's 
affiliates in a transaction that is eligible for an exception. In 
response to this concern, NASD Regulation proposes to include a 
statement in the introduction to subparagraph (d)(5) emphasizing that 
an exception is only available if a member has not conditioned its 
participation in the public offering on an acquisition of securities 
under the exception.
    5. Definition of Institutional Investor--The second and third 
exceptions rely on the involvement of ``institutional investors'' in 
the issuer or private placement to help ensure that securities are 
acquired by participating members in bona fide transactions that were 
negotiated at ``arms-length.'' To ensure that the institutional 
investors are in fact independent of any participating member,\12\ NASD 
Regulation proposes to amend the definition of ``institutional 
investor'' in subparagraph (d)(4)(B) to require that no participating 
member may have an equity interest in or manage or otherwise direct the 
institutional investor's investments.\13\ The definition in the 
original proposal required that the ``institutional investor will not 
include any member participating in the public offering, any of its 
associated or affiliated persons, or any immediate family member of its 
associated or affiliated persons.'' This amendment clarifies that the 
word ``included'' was intended to prevent participating members from 
being ``included'' as equity owners of the institutional investor. This 
amendment also adds a requirement that none of the participating 
members should manage or otherwise direct the institutional investor's 
investments.
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    \12\ However, an institutional investor may be or include equity 
owners that are a member, or a person associated or affiliated with 
a member, so long as the member is not participating in the public 
offering.
    \13\ In accordance with another comment (SIA and Goldman), the 
word ``entity'' in the definition is proposed to be changed to 
``legal person'' to avoid confusion with the separate definition of 
the term ``entity'' intended for use under the first and second 
exceptions.
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    6. Investment/Lending Subsidiary--In response to a comment (Fried 
Frank), NASD Regulation proposes to amend the definition of entity in 
subparagraph (d)(4)(A) to permit a qualifying entity to make its 
investment or loan through a wholly-owned subsidiary. NASD Regulation 
is not persuaded by the argument, however, that a subsidiary formed by 
two or more entities or institutional investors is indistinguishable 
from its parents.
    In addition, NASD Regulation proposes to amend the definition of 
institutional investor in subparagraph (d)(4)(B) to provide that the 
calculation of the $50 million threshold will include investments held 
by a wholly owned subsidiary of an institutional investor. This 
amendment will, therefore, also permit an institutional investor to 
make its investment under the third exception through a wholly owned 
subsidiary. (See comment of Akin).
    7. Venture Capital Experience--NASD Regulation proposes to amend 
the provision in the first and second exceptions requiring that the 
investing/lending entity have prior experience in making venture 
capital investments to require that the entity ``has been primarily 
engaged in the business of making investments in or loans to other 
companies'' (emphasis provided). Contrary to opposing comments (SIA and 
Goldman), NASD Regulation believes that the protections of the criteria 
in these exceptions cannot be effective unless the entity has a history 
of at least one prior investment or loan transaction and that the 
business of the

[[Page 14959]]

entity primarily involves investments in or loans to other 
companies.\14\
---------------------------------------------------------------------------

    \14\ The definition of ``entity'' in subparagraph (d)(4) will 
continue to require that there have been at least one prior joint 
investment for a group of legal persons, to qualify as an entity. 
Therefore, when an entity is composed of a group of legal persons, 
one prior investment or loan by a group will also satisfy the 
requirement for at least one prior investment or loan under 
subparagraphs (d)(5)(A) and (B). In addition, each member of the 
group will be required to demonstrate that it is primarily engaged 
in the business of making investments in or loans to other 
companies.
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c. Exceptions From Underwriting Compensation
    1. First Exception: Purchases and Loans By Certain Entities--The 
first exception in subparagraph (d)(5)(A) is intended for acquisitions 
of the issuer's securities by certain entities that routinely make 
investments in or provide loans or credit facilities to other 
companies. The exception, as amended, would be available: (1) To any 
qualifying entity related to a participating member that meets a 
capital under management test, or is a bank or insurance company; and 
(2) for purchases in a private placement and for the receipt of 
securities as compensation for a loan or credit facility before the 
required filing date of the public offering, with a 10% limitation on 
the amount of securities acquired.
    A. Expansion of Exception: A number of commenters (Chase, Goldman, 
Merrill, Prudential, Salomon, and SIA) discussed the impact of the 
current Rule and the original proposal on large financial institutions 
that include commercial and investment banking and insurance 
operations. The commenters recommended that NASD Regulation amend the 
Rule to exclude purchases of the issuer's securities if a large 
financial institution maintains information barriers between its 
broker/dealer and its other affiliates in a distinct line of business 
or it otherwise can demonstrate that it does not collaborate to secure 
underwriting business.
    The Department is concerned that information barriers are not an 
appropriate mechanism for preventing abusive practices. However, to 
address the impact of the Rule on large financial institutions 
affiliated with members, NASD Regulation proposes to expand the first 
exception in subparagraph (d)(5)(A) to be available to any insurance 
company or bank. NASD Regulation believes that U.S. banks and insurance 
companies generally are structured and regulated in a manner that 
ensures that the institution is primarily engaged in a line of business 
that is distinct from the underwriting business.
    U.S. banks and insurance companies would be those that come within 
the definitions of those terms in section 3(a)(6) of the Act and 
section 2(a)(13) of the Securities Act of 1933 (``Securities Act''), 
respectively. Foreign banks and insurance companies would not be able 
to rely on the exception unless the staff grants an exemption on a 
case-by-case basis under the NASD Rule 9600 Series. NASD Regulation 
proposes to grant such an exemption based on information demonstrating 
that the foreign institution operates and is regulated in a manner 
similar to a bank or insurance company in the U.S.
    B. Capital Under Management Test: NASD Regulation proposes to 
revise the definition to allow the required capital to have been 
contributed or committed to the qualifying entity.
    C. Fiduciary Duty Requirement: NASD Regulation proposes to amend 
the provision requiring an independent review of the investment or loan 
to delete the word ``review'' as redundant of the word ``evaluation.''
    D. Ten Percent Limitation on Acquisition: The amended rule filing 
would restrict investments by all entities related to a member to 10% 
of the issuer's ``total equity securities, calculated immediately 
following the transaction.'' \15\ NASD Regulation believes this added 
protection is necessary in light of the proposal to eliminate the 90-
day limitation on the availability of the exception and to eliminate 
the stock numerical limitation.
    The term ``total equity securities'' is defined in subparagraph 
(d)(4) to include the total shares of common stock outstanding of the 
issuer and the total shares of common stock of the issuer underlying 
all convertible securities. The term includes voting and non-voting 
common stock since the NASD does not differentiate between the two 
types of securities. Also, the calculation aggregates all series of 
common stock, i.e., series A and series B. By ``convertible,'' the NASD 
means all securities that convert to common stock without payment of 
any additional consideration. As a result, the calculation of total 
equity securities does not include any warrants or options that give 
the holder the right to purchase the issuer's securities at a 
price.\16\ Further, the convertible securities need not be those of the 
issuer; rather, the convertible securities can be those of any company 
that converts, without the payment of additional consideration, to the 
common stock of the issuer.\17\
---------------------------------------------------------------------------

    \15\ NASD Regulation agrees with commenters (Fried Frank, 
Goldman, Merrill, and SIA) that the calculation should not include 
stock options or employee options and warrants and, has, therefore 
deleted the requirement that the amount of the issuer's securities 
be calculated on a ``fully diluted'' basis.
    \16\ In comparison, purchasers of convertible securities have 
fully paid for the security and any underlying security regardless 
of when or if they convert.
    \17\ In some cases, a parent company will issue securities 
convertible to securities of a subsidiary.
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    E. Sharing in Investment Banking Fees: NASD Regulation agrees with 
commenters (Goldman and SIA) that the requirement that the investing or 
lending entity ``not participate directly in investment banking fees 
received by the member for underwriting public offerings' is satisfied 
even if the member is the general partner of the investing entity, so 
long as no part of the underwriting fees are directed to the entity 
itself.
    2. Second Exception: Investments In and Loans to Certain Issuers--
The second exception in subparagraph (d)(5)(B) is intended for 
acquisitions of securities of issuers that have significant 
institutional investor involvement. The exception, as amended, would be 
available: (1) When institutional investors own at least 33% of the 
issuer's total equity securities, calculated on a pre-transaction 
basis; (2) to any related entity of a participating member that manages 
capital contributions or commitments of at least $50 million; and (3) 
for purchases in a private placement and for the receipt of securities 
as compensation for a loan or credit facility before the required 
filing date of the public offering, with a 10% limitation on the amount 
of securities acquired.
    A. Ten Percent Limitation on Acquisition: NASD Regulation proposes 
to increase the investment limitation on all entities related to each 
participating member from 5% to 10% of the issuer's ``total equity 
securities'' calculated on a post-transaction basis.
    B. Board Membership Requirement: In response to commenter's 
concerns that the original proposal appeared to require an issuer to 
put an institutional investor on its board of directors in order for 
its underwriters to be eligible to rely on the exception, NASD 
Regulation proposes to delete the requirement that an institutional 
investor be a member of the issuer's board of directors.
    C. Board Vote: Consistent with the deletion of the requirement that 
an institutional investor be a member of the issuer's board of 
directors and other comments, NASD Regulation proposes

[[Page 14960]]

to revise the provision requiring approval of the investment by the 
issuer's board of directors and the affirmative vote of all 
institutional investors on the board, to require approval by a majority 
of the issuer's board of directors and a majority of any institutional 
investors, or their designees, that are board members.
    3. Third Exception: Private Placements With Institutional 
Investors--The third exception in paragraph (d)(5)(C) is intended for 
acquisitions in private placements with institutional participation. 
The exception, as amended, would be available to any person that is 
covered under the definition of underwriter and related person for 
purchases before the required filing date of the public offering of 
securities in a private placement and for the receipt of securities as 
placement agent compensation, so long as institutional investors 
purchase at least 51% of the total offering and underwriters and 
related persons, in the aggregate, do not purchase more than 20% of the 
total offering.
    A. Definition of the ``Total Offering'': NASD Regulation proposes 
to revise the exception to clarify, as recommended by commenters, that 
the 51% investment requirement for institutional investors and the 20% 
limitation on investments by underwriters and related persons is based 
on the ``total offering,'' which is comprised of the total number of 
securities sold in the private placement and the securities received or 
to be received as placement agent compensation by any member.\18\
---------------------------------------------------------------------------

    \18\ For example, if the private placement consists of 100,000 
shares of common stock and the issuer pays placement agent 
compensation that includes a warrant for 10,000 shares of common 
stock, the total offering is 110,000 shares of common stock.
---------------------------------------------------------------------------

    B. Lead Negotiator Requirement: The original proposal required an 
institutional investor to be the lead negotiator with the issuer to 
establish the terms of the private placement. NASD Regulation proposes 
to amend this requirement as recommended by the Corporate Financing 
Committee of NASD Regulation to provide that, when the terms of the 
private placement are not negotiated with an institutional investor, an 
institutional investor must at least be the lead investor in 
establishing or approving the terms of the private placement.
    4. Fourth Exception: Acquisitions and Conversions to Prevent 
Dilution--The fourth exception in paragraph (d)(5)(D) is intended for 
the purchase or receipt of securities to prevent dilution of the 
investor's position in the issuer. The exception, as amended, would be 
available to any person who is covered under the definition of 
underwriter and related person for acquisitions of securities before 
the effective date of the public offering resulting from a preemptive 
right or a pro-rata rights offering, and acquisitions resulting from a 
stock-split or stock conversion, provided that: (1) The opportunity to 
purchase or receive securities is provided to all similarly situated 
securityholders; and (2) the amount of securities purchased or received 
does not increase the investor's percentage ownership.
    A. Availability of Exception: The exception would be available 
during the 180-day review period and subsequent to the filing of the 
public offering.
    B. Definition of Right of Preemption: To clarify the application of 
this exception, NASD Regulation proposes to include a definition of 
``right of preemption'' in subparagraph (d)(4)(C) to list all the 
circumstances under which it is anticipated that a purchaser may 
receive a preemptive right.\19\
---------------------------------------------------------------------------

    \19\ An investor may only rely on this exception to purchase the 
enumerated classes of the issuer's securities that are covered by 
the right of preemption.
---------------------------------------------------------------------------

    C. Revisions to Limitation on Acquisition of the Preemptive Right: 
NASD Regulation proposes to exclude an acquisition under a right of 
preemption acquired in connection with securities purchased in a 
private placement from underwriting compensation so long as the 
securities purchased in the private placement are not deemed to be 
underwriting compensation.
    D. Limitation on Securities Received Upon Conversion: The exception 
is available to securities that are received upon conversion of 
securities only if the convertible security is not deemed to be 
underwriting compensation.
    E. Limitation on Increasing the Purchaser's Percentage Ownership: 
NASD Regulation proposes to amend the language prohibiting the investor 
from increasing its percentage ownership of the same class of security 
\20\ to refer to the ``same generic class of securities of the issuer'' 
and to the ``class of securities underlying any convertible security.'' 
In addition, NASD Regulation proposes to amend this provision to 
clarify that the investor's level of percentage ownership will be 
calculated immediately prior to the investment.
---------------------------------------------------------------------------

    \20\ This limitation does not apply in the case of conversions 
of securities. For example, the calculation of percentage ownership 
of preferred stock will be based on all series of preferred stock 
outstanding and the calculation of percentage ownership of 
convertible preferred stock will be based on the company's equity 
outstanding on an as-converted basis.
---------------------------------------------------------------------------

    F. Pre-Existing Contractual Rights: As previously discussed, any 
securities purchased under an exception must be purchased at the same 
price and with the same terms as securities purchased by any other 
purchasers. NASD Regulation proposes to include a provision clarifying 
that it is not contrary to this limitation for a purchaser to retain a 
pre-existing contractual right, such as a preemptive right, that was 
granted in connection with a prior purchase.
    5. Fifth Exception: Purchases Based on a Prior Investment History--
A fifth exception in paragraph (d)(5)(E) is proposed in response to a 
comment (CIBC) so that members or their affiliates that established a 
long-term relationship with an issuer would be able to purchase 
additional securities of the issuer to prevent dilution before the 
effective date of the public offering. The exception would only be 
available to investors that have previously purchased the issuer's 
securities. NASD Regulation believes that the terms of this exception 
are consistent with historic NASD Regulation practice.
    A. Prior Investment Requirement: In order to be eligible for the 
exception, the investor must have made at least two prior purchases of 
the issuer's securities: One investment at 2 years before the required 
filing date and another more than 180 days before the required filing 
date of the public offering.
    B. Limitation on Increasing the Purchaser's Percentage Ownership: 
The securities purchased under the exception cannot increase the 
investor's percentage ownership of the generic class of securities of 
the issuer calculated immediately prior to the investment.
    C. Availability of Exception: The exception would be available 
during the 180-day review period and subsequent to the filing of the 
public offering.
    6. Sixth Exception: Financial Consulting and Advisory Agreements--A 
sixth exception is proposed in subparagraph (d)(5)(F) for cash fees and 
securities paid to a financial consultant or advisor to the issuer when 
the relationship was established more than one year before the required 
filing date of the public offering.
    This exception is consistent with an exception in the Rule, which 
excludes from the definition of ``item of value'' financial consulting 
and advisory fees if an ongoing relationship between the issuer and the 
financial advisor or consultant was established more than 12 months 
before the filing date of the

[[Page 14961]]

public offering. The original proposal included this exclusion. The 
sixth exception would codify objective standards that help clarify 
which long-term arrangements can qualify for the exception.
    Among other criteria, the consulting or advisory relationship must 
have been entered into more than one year before the required filing 
date of the public offering. Commenters (Chase and Fried Frank) 
recommended that the time period be decreased to 180 days before the 
filing date of the public offering. NASD Regulation does not agree that 
a 180-day period is sufficient to identify a ``long term'' relationship 
between a consultant and the issuer that justifies excluding fees and 
securities paid to the consultant during the 180-day review period, 
particularly when the consultant may have provided services related to 
the preparation, structuring, or conduct of the public offering.
d. When Securities Are Considered ``Received''
    In the original proposal, subparagraph (d)(3) included a provision 
to establish when securities are considered ``received'' under the Rule 
for purposes of determining if the securities were received within the 
180-day review period and are, therefore, considered to be underwriting 
compensation.
    The original proposal treated securities received as compensation 
for a loan or credit facility as ``received'' on the execution of the 
agreement for the loan or credit facility. NASD Regulation proposes to 
amend this provision to treat a put option like a loan or credit 
facility and to require a written contract with detailed provisions for 
any agreement for a loan, credit facility, or put option. Therefore, a 
contract for a loan or credit facility must specify the amount and 
terms of the loan or credit facility and the amount of securities that 
will be paid as a fee. In the case of a put option, the contract must 
unconditionally require the investor to purchase securities upon demand 
of the issuer and must include a formula for determining the amount and 
price of the securities that must be purchased. If the required 
information is provided, the securities will be considered received as 
of the date the written agreement is executed. Absent this required 
information, securities received for a loan or credit facility or 
purchased from the issuer in accordance with a put option will be 
considered received as of the date of transfer of beneficial ownership.
    Commenters (Chase, Fried Frank, Goldman, Merrill, and SIA) 
recommended that the date a commitment letter is signed be relied upon 
as the date of receipt with respect to securities purchased in a 
private placement. NASD Regulation has not amended the Rule as 
commenters suggest. In the NASD Regulation's experience, commitment 
letters do not serve as reliable indicators of the date of ``receipt of 
securities.'' In many cases, commitment letters allow one or both 
parties to withdraw from the transaction or impose other contingencies 
that may prevent the purchase of the securities. In NASD Regulation's 
experience, the date that the private placement closes is a more 
reliable indicator of when securities are ``received.'' Moreover, 
beneficial transfer of the securities typically occurs at closing.
    In addition, in response to a comment (M&F), the relevant ``closing 
of a private placement'' for a private placement with different closing 
dates would be the closing where the issuer receives its funding from 
the investor.
e. Post-Offering Review Authority/ Undisclosed Compensation
    The original proposal would have required the staff to examine 
items of value received by underwriters and related persons during the 
90-day period immediately following the effective date of a public 
offering to determine whether they constitute underwriting 
compensation. Commenters (Fried Frank, Goldman, Merrill, and SIA) 
expressed concern that the provision may subject members to 
disciplinary actions based upon the unknown activities by unaffiliated 
entities included in the definition of ``underwriter and related 
person.'' The purpose of this provision was to ensure that the staff 
could consider whether items of value received after the public 
offering need to be included as underwriting compensation in order to 
avoid circumvention of the Rule.
    NASD Regulation agrees that this provision could be more narrowly 
tailored to address those specific circumstances where compensation 
arrangements are not disclosed to the Association. New subparagraph 
(d)(2) would provide that all items of value received and all 
arrangements entered into for the future receipt of an item of value 
that are not disclosed to the Association prior to the date of 
effectiveness or the commencement of sales of a public offering 
(including items of value received after the public offering), are 
subject to post-offering review to determine whether such items of 
value are additional underwriting compensation for the public offering. 
Subparagraph (b)(6)(vi)(b) would require the filing of any new 
arrangement that provides for receipt of an additional item of value 
subsequent to the issuance of an opinion of no objections to the 
underwriting arrangements by the Association and within 90 days 
following the date of effectiveness or commencement of the public 
offering.
f. Cash and Securities That Are Not Items of Value
    The following amendments are proposed to subparagraph (b)(3)(B), 
which lists the items of value that will be excluded from underwriting 
compensation.\21\
---------------------------------------------------------------------------

    \21\ NASD Regulation also proposes to amend the language of 
subparagraphs (c)(3)(a)(iv) and (vii) to eliminate redundancies.
---------------------------------------------------------------------------

    1. Cash Compensation Excluded As An Item of Value--The exception 
for ``cash discounts or commissions received in connection with a prior 
distribution of the issuer's securities'' was unintentionally deleted 
in the original proposal. NASD Regulation proposes to reinstate and 
broaden the exclusion from underwriting compensation to cover cash 
compensation for services provided to the issuer for private placement 
agent or merger and acquisition services, or for providing a loan or 
credit facility, as recommended by commenters.
    2. Securities Excluded As An Item of Value--In addition, as 
recommended by commenters, the proposed Rule would exclude receipt of 
the issuer's securities from being considered an item of value if they 
are:
    (1) Listed and purchased in the public market transactions;
    (2) Purchased through the issuer's employee stock purchase plan; or
    (3) Acquired by an investment company registered under the 
Investment Company Act of 1940.
g. Flexibility in the Application of the Rule
    1. General Request for Flexibility--Commenters (Fried Frank, 
Goldman, Morgan, Prudential, and Merrill) requested that the Rule be 
amended to allow the staff to grant exemptions from the Rule. The 
commenters stated that exemptions should be granted in new or 
unanticipated situations that were not contemplated by the Rule or 
where a transaction narrowly fails to meet the criteria of one of the 
enumerated exceptions. One of the commenters (Prudential) also stated 
that the exemption process under the NASD Rule 9600 Series was too 
cumbersome to be useful and preferred a structure where members can 
receive a quick response from Department staff on a request to consider 
a fact situation that

[[Page 14962]]

does not fall within one of the exceptions to the Rule.
    NASD Regulation agrees with the commenters that the staff should be 
able to grant exemptions to respond to new or unanticipated situations. 
NASD Regulation proposes to amend paragraph (i) of Rule 2710 to 
articulate the substantive standard upon which exemptions may be 
granted. Specifically, paragraph (i) would state that the staff has 
authority to grant an exemption from the Rule, if it is consistent with 
the purposes of the Rule, the protection of investors, and the public 
interest. NASD Regulation intends to use its exemption authority 
sparingly, principally for situations not addressed in the Rule. NASD 
Regulation generally does not believe that its exemption authority 
should be used to exclude transactions that narrowly fail to meet one 
or more criteria of the Rule, because these are the types of 
transactions that are addressed in the Rule.\22\
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    \22\ The original proposal stated, ``[t]he current subjective, 
factor-weighing process for determining whether securities were 
acquired in connection with a public offering is an inefficient 
method * * * The subjectivity hampers the Department's ability to 
provide clear and predictable guidance to members. The consequences 
under the Rule of a particular venture capital or other private 
placement financing are sometimes uncertain until a public offering 
is filed and the Department's review is completed. This uncertainty 
unnecessarily complicates the capital-raising process, to the 
detriment of issuers and investors.''
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    The NASD Rule 9600 Series sets forth the procedures to obtain 
exemptive relief from those NASD Rules that provide for such relief. 
NASD Regulation believes that the exemptive procedures set forth in the 
Rule 9600 Series allow Department staff to consider and grant 
exemptions from any provision of the Rule on an immediate basis.
    2. Exemptions for Consulting Fees and Founder's Stock--Commenters 
recommended that NASD Regulation adopt additional exceptions from 
underwriting compensation. In certain situations, NASD Regulation 
believes that there are circumstances where the recommended exception 
is appropriate, but a specific exception with objective criteria cannot 
be developed to ensure the bona fide nature of the transaction. 
Therefore, NASD Regulation proposes to consider exemptions on a case-
by-case basis pursuant to the standards in paragraph (i) in the 
following situations.
    A. Financial Consulting and Advisory Fees: Commenters (Goldman and 
SIA) objected that the original rule filing proposed to delete current 
subparagraph (c)(4)(E), which excludes financial consulting and 
advisory fees if ``the relationship * * * was not entered into in 
connection with the offering and * * * actual services have been or 
will be rendered which were not or will not be in connection with or 
related to the offering.'' These commenters believed that there are 
many services for which a member may legitimately be retained at the 
time of or shortly before a public offering for which it ought to 
receive financial and advisory fees that are not included as 
underwriting compensation. It is our experience that the rule language 
that NASD Regulation proposed to delete in the original proposal is so 
indefinite in nature that it has not generally provided the guidance 
sought by the commenters. NASD Regulation proposes instead to consider 
on a case-by-case basis excluding securities and cash fees from 
underwriting compensation for services that:
    (1) Solely relate to the business or management of the issuer; and
    (2) Are not related to the preparation, structuring, or conduct of 
the public offering, or to raising capital in a transaction related to 
the public offering.
    For example, if an agreement is for post-offering merger and 
acquisition services, NASD Regulation would consider excluding fees 
that will only be paid upon the occurrence of a merger or acquisition. 
If an agreement is for post-offering public relations services, NASD 
Regulation would consider excluding fees paid to an experienced public 
relations firm that is not affiliated with a member.
    B. Founder's Stock: NASD Regulation proposes to consider on a case-
by-case basis excluding acquisitions of ``founder's stock'' and any 
subsequent purchases by a founder from underwriting compensation. 
Founder's stock is acquired at the time of incorporation of the issuer 
as a start-up company or upon purchase of substantially all of the 
assets of the issuer from another company.
    3. Interpretations of Rule--Commenters also recommended amendments 
to the Rule to exclude purchases of securities in a number of common-
sense situations. NASD Regulation proposes to interpret the Rule to 
address on a case-by-case basis excluding purchases of securities when 
the:
    (1) Purchaser was not affiliated or associated with a member 
participating in the public offering at the time of the acquisition;
    (2) Securities acquired are those of the member or the parent of 
the member and the purchaser is an associated person of the member or 
employee of the parent, or members of their immediate family;
    (3) Securities were acquired in a resale transaction under Rule 
144A from a shareholder of the issuer who is not an affiliate, officer, 
director, general partner, or employee of the issuer, or a selling 
security holder in the public offering; or
    (4) Securities were purchased from the issuer for immediate resale 
under Rule 144A and the member failed to place the securities.
h. Lock-Up Restrictions on Securities
    The original rule filing proposed to delete the current one-year 
lock-up restriction on securities included in underwriting compensation 
and the current three-month lock-up restriction on securities of the 
issuer held by a member and certain senior persons and subsidiaries at 
the time of the offering. These restrictions would have been replaced 
by a single, 180-day lock-up restriction on all equity securities of 
the issuer that are held by any underwriter and related person at the 
time of effectiveness of the public offering, unless the securities or 
transaction complied with an exception. NASD Regulation proposes to 
clarify the language of the restriction and to adopt additional 
exceptions, as discussed by commenters (Fried Frank, Goldman, M&F, 
Merrill, and SIA).
    1. Lock-Up Restriction Language--NASD Regulation proposes to amend 
subparagraph (g)(1) to prohibit any hedging, short sale, derivative, 
put, or call transaction that would result in the effective economic 
disposition of the securities. This amendment was recommended by the 
Corporate Financing Committee of NASD Regulation and is necessary to 
ensure that the lock-up restriction remains effective in light of 
practices that have developed since the restriction was first adopted 
in the original version of the Rule.
    2. Exceptions to Lock-Up Restriction For Securities Acquired At Any 
Time--The original proposal included exceptions from the lock-up 
restriction in subparagraph (g)(2) for transfers of securities: by 
operation of law or reorganization of the issuer; to any member 
participating in the offering and the officers and partners thereof; if 
the aggregate amount of securities held by an underwriter and its 
related persons do not exceed 1% of the securities being offered; and 
if the class of security qualifies as an ``actively traded security'' 
for purposes of SEC Regulation M. NASD Regulation proposes to amend 
subparagraph (g)(2)

[[Page 14963]]

to adopt additional exceptions from the lock-up restriction for 
securities:
    (1) Held by an investment fund, provided that no participating 
member manages or otherwise directs the investments of the fund, and 
members participating in the offering do not own more than 10% of the 
equity in the fund;
    (2) Previously subject to the lock-up restriction (thereby allowing 
the sale of such securities after the expiration of the previous lock-
up restriction);
    (3) That are listed and were purchased in the public market;
    (4) Acquired under the issuer's employee stock purchase plan; or
    (5) Purchased by an investment company registered under the 
Investment Company Act of 1940.
    3. Exceptions to the Lock-Up Restriction for Securities Acquired 
Before the 180-Day Review Period--The original rule filing included an 
exception from the lock-up restriction for securities considered 
``actively traded'' under SEC Regulation M.\23\ NASD Regulation 
proposes to narrow this exception to make it available only to 
securities that were acquired before the 180-day review period. NASD 
Regulation believes this revision is necessary because NASD Regulation 
also proposes to eliminate the 90-day limitation on the availability of 
the exceptions in subparagraphs (d)(5)(A)-(C). The application of the 
lock-up restriction to securities acquired within the 180-day review 
period will ensure that securities received in transactions that meet 
an exception, and thus are not included in compensation calculations, 
are held as an investment for at least six months. Accordingly, members 
would be prevented from making a quick profit on securities received 
from issuers to whom they are providing underwriting services.
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    \23\ If a security qualifies as ``actively traded'' under SEC 
Regulation M as of the date of effectiveness of the public offering, 
then the security is considered ``actively traded'' at any time 
thereafter when the securityholder determines to sell its 
securities.
---------------------------------------------------------------------------

    In addition, NASD Regulation proposes a new exception from the 
lock-up restriction for securities acquired before the 180-day review 
period that are owned by any person that is not a participating member 
(e.g., underwriter's counsel, consultants, and finders).
i. Regulation of Terms of Securities
1. Stock Numerical Limitation--The amended rule filing, like the 
original rule filing, would eliminate the 10% stock numerical 
limitation in current subparagraph (c)(6)(B)(xi). In making this 
change, NASD Regulation believed that the number of securities received 
by a member as underwriting compensation would be limited by the 
compensation guideline applicable to the offering. Commenters (NASAA 
and Ohio) pointed out that the compensation guidelines would not be 
effective in this regard. They noted, for example, that warrants with 
an exercise price of 165% of the public offering price do not have any 
compensation value \24\ and, consequently, an unlimited amount of 
warrants with such a high exercise price could be obtained as 
underwriting compensation.
---------------------------------------------------------------------------

    \24\ The ``warrant formula'' for valuing warrants is in 
subparagraph (e)(3) of the amended Rule.
---------------------------------------------------------------------------

    NASD Regulation believes that the low valuations that are assigned 
to warrants that have an exercise price in excess of 125% of the public 
offering price no longer accurately reflect the economic value of the 
warrants. NASD Regulation proposes to amend subparagraph (e)(3) to 
require that all warrants have a minimum compensation value of .2% of 
the offering proceeds \25\ for each amount of securities that is up to 
1% of the securities being offered to the public, excluding securities 
subject to the overallotment option. \26\ As a result of this 
amendment, the compensation guideline will limit the amount of 
securities that can be obtained through the exercise of any warrant.
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    \25\ The proposed valuation is the equivalent of the 2% 
valuation that would be applied to warrants for 10% of the 
securities underwritten on a firm-commitment basis that have an 
exercise price of 125% of the public offering price. The standard 
exercise price for warrants has long been 120% of the public 
offering price.
    \26\ For example, warrants exercisable for securities equal to 
4% of the offered securities would have a compensation value of at 
least .8%. Warrants exercisable for securities equal to 9% of the 
offered securities would have a compensation value of at least 1.8%.
---------------------------------------------------------------------------

    2. Other Amendments to Regulation of Terms of Convertible/
Exercisable Securities--A commenter (Goldman) requested a number of 
amendments to and questioned the continued usefulness of subparagraph 
(f)(2)(H), which prohibits unfair and unreasonable arrangements in 
connection with securities that are exercisable or convertible to 
another security. NASD Regulation finds that this provision continues 
to be necessary to prevent abusive arrangements when a member receives 
exercisable or convertible securities as underwriting compensation and 
proposes a number of modifications to clarify the applicability of the 
requirements.
    A. Scope of Regulation: NASD Regulation proposes to amend 
subparagraph (f)(2)(H) to clarify that members are not only prohibited 
from including terms and arrangements in agreements for exercisable or 
convertible securities that are not permitted under the Rule, but they 
also are prohibited from exercising the securities in a manner that is 
prohibited under the Rule. Although this position is intuitively 
obvious, some members have argued that if the terms of the agreement 
are ambiguous, the securities can be exercised in a manner that 
otherwise would violate the Rule.
    B. Anti-Dilution Terms: NASD Regulation proposes to amend the 
provisions prohibiting unfair ``anti-dilution'' arrangements in 
subparagraphs (f)(2)(H)(vi) and (vii) to incorporate a clearer 
explanation of the requirements. The revised language would state that 
the recipient may only receive a larger amount of securities or 
exercise at a lower price than originally agreed upon if the public 
shareholders have been proportionally affected by a stock split, stock 
dividend, or other similar event. NASD Regulation proposes minor 
changes to the prohibition on receipt or accrual of cash dividends 
prior to the exercise or conversion of the security.
    C. Exercise Price of Security: NASD Regulation proposes to delete 
the provisions in current subparagraphs (c)(6)(B)(viii)(b) and (i) that 
prohibit underwriters and related persons from receiving a security 
that is exercisable or convertible at a price below the public offering 
price or on terms more favorable than the terms of the securities being 
offered to the public.
    3. Securities Received as Underwriting Compensation That Are 
Different Than the Securities Offered to the Public \27\--The original 
rule filing proposed to amend current subparagraph (c)(5)(A) to allow 
``upon good cause shown'' the payment of underwriting compensation in 
the form of securities that are not identical to those offered to the 
public or to a security that has a bona fide independent market. A 
commenter (Ohio) requested reinstating the requirement that an 
exception only be permitted in ``exceptional and unusual 
circumstances.'' NASD Regulation agrees with other commenters (TBMA

[[Page 14964]]

and Morgan) that the Rule should permit a member to receive securities 
as underwriting compensation that are different than those offered to 
the public, so long as the securities can be assigned a compensation 
value. Therefore, NASD Regulation proposes to amend subparagraph (e)(1) 
to require the security to be able to be accurately valued to comply 
with subparagraph (f)(2)(I). The burden will be on the member to 
demonstrate to the satisfaction of Association staff that the 
securities can be assigned an appropriate value.
---------------------------------------------------------------------------

    \27\ NASD Regulation agrees with commenters (Goldman and SIA) 
that securities that will be converted into the securities offered 
to the public at the time of the public offering are considered to 
the identical to the securities offered to the public.
---------------------------------------------------------------------------

j. Other Proposed Amendments \28\
---------------------------------------------------------------------------

    \28\ Other amendments are proposed to the Rule to make minor 
grammatical and punctuation changes. References in the Rule to the 
``date of effectiveness'' have been amended to also refer to the 
``commencement of sales'' to encompass offerings not filed with the 
SEC.
---------------------------------------------------------------------------

1. Definitions
    A. Definition of Participating Member: NASD Regulation proposes to 
add a definition in subparagraph (a)(4) of the term ``participating 
member'' to include any member that is participating in a public 
offering, any associated person of the member, any members of the 
immediate family of the associated persons, and any affiliate of the 
member. In developing the amended Rule, it became clear that certain 
provisions were intended to apply only to the ``participating member,'' 
whereas others were to apply more broadly to all underwriters and 
related persons, which includes certain non-members such as 
underwriter's counsel, financial consultants and advisors, and finders 
and persons that are related to a participating member.
    B. Definition of Underwriter and Related Persons: In light of the 
new term ``participating member,'' NASD Regulation also must amend the 
term ``underwriter and related persons'' in subparagraph (a)(6). The 
revised definition includes the term ``participating member'' and 
deletes references to ``underwriters,'' ``members of the selling or 
distribution group,'' and ``members of the immediate family of the 
aforementioned person,'' all of which are now incorporated into the 
Rule through the definition of ``participating member.''
    C. Definition of Immediate Family: NASD Regulation proposes in 
response to comments (Goldman, M&F, Morgan, and SIA) to amend the 
definition of ``immediate family'' in Rule 2720(b)(9) to exclude family 
members other than the spouse and children who do not live in the same 
household as, have a business relationship with, and are not materially 
supported by the employee or associated person. NASD Regulation 
believes that the current definition is too broad and places 
unnecessary burdens on members. With the new definition, members will 
only be required to submit information to the Association under Rule 
2710(b)(6)(A)(iii) on the shareholdings of the spouse and children of 
the associated persons and employees of members, when other family 
members qualify for an exclusion. In addition, the definition will be 
expanded to include any other person living in the same household as 
the associated person or employee.
    2. Filing Requirements
    A. Treatment of Confidential SEC Submissions: NASD Regulation 
proposes to amend subparagraph (b)(4) to provide that the filing 
requirements of the Rule apply when any offering document is ``filed 
with or submitted to'' another regulatory authority, in order to 
eliminate any ambiguity when offering documents are ``submitted'' to 
the SEC for confidential review, thereby addressing comments (Fried 
Frank, Morgan, and Salomon) received on the SEC's confidential 
``submission'' process.\29\
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    \29\ The use of the word ``filed'' in the Rule was intended to 
have the common meaning of the term to identify a point in time when 
offering documents have been submitted to a regulatory authority and 
was not intended to distinguish between ``filed'' and ``submitted'' 
documents under SEC procedures for purposes of members' obligations 
to file public offerings with the Association.
---------------------------------------------------------------------------

    B. Obligation to File Before Offers Commence: The current filing 
requirements cover public offerings that are not filed or submitted to 
the SEC or any other federal or state regulatory authority for review. 
For these offerings, NASD Regulation proposes to amend the Rule to 
state that the offering documents must be filed at least 15 business 
days prior to the date ``on which offers will commence,'' replacing 
current language that looked to the ``anticipated offering date.'' 
Thus, members may not commence any efforts to offer the securities 
unless the offering memoranda and related documents and information 
have been filed with the Association for at least 15 business days.\30\
---------------------------------------------------------------------------

    \30\ This amendment was developed in connection with 
consideration of the comments on the treatment of confidential 
submissions to the SEC under the filing requirements of the Rule.
---------------------------------------------------------------------------

    C. Obligation to File and Receive Opinion of No Objections Before 
Sales Commence: NASD Regulation proposes to revise the introduction of 
subparagraph (b)(4)(B) to clarify that the documents and information 
must have been filed as required by the Rule and the Association must 
have issued an opinion of no objections prior to the commencement of 
``sales of securities,'' replacing the current language that looked to 
the commencement of the ``offering.'' \31\
---------------------------------------------------------------------------

    \31\ ID.
---------------------------------------------------------------------------

    D. Information on NASD Affiliation: Subparagraph (b)(6) requires 
members to submit information to the Department on the NASD affiliation 
or association with any member of any officer, director or security 
holder of the issuer in an initial public offering and with respect to 
any other offering provide such information with respect to any 
officer, director or security holder of 5% or more of any class of the 
issuer's securities. Commenters (Goldman, M&F, Morgan, and SIA) stated 
that non-public companies increasingly have a large number of investors 
and that the burden of compliance outweighs the value of the 
information when each investor holds a small interest in the issuer. 
NASD Regulation understand that members have had increasing difficulty 
obtaining complete and accurate information about shareholder ownership 
under the 5% threshold on a timely basis, thereby impacting the 
schedule for requesting effectiveness for the offering. Information on 
the NASD affiliation or association of issuer's shareholders that are 
not officers or directors, are not 5% or greater shareholders, and that 
have not purchased their securities within the 180 days preceding the 
filing date of the public offering is only necessary for identifying 
the persons who may be subject to the proposed 180-day restricted 
period with respect to securities that are not included in underwriting 
compensation.
    NASD Regulation proposes to amend subparagraph (b)(6)(iii) to 
eliminate the requirement to file information on the NASD affiliation 
or association of all shareholders of the issuer. The revised provision 
would require the filing of information on the NASD affiliation of any:
    (1) Officer or director of the issuer;
    (2) Beneficial owner of 5% or more of any class of the issuer's 
securities; and
    (3) Beneficial owner of the issuer's unregistered equity securities 
purchased during the 180-day period immediately proceeding the filing 
date of the public offering (except purchases through issuer's employee 
stock purchase plan).
    As a result of this change, members will be obligated to identify 
those entities and persons that are covered by the proposed lock-up 
restriction in subparagraph (g)(1) and beneficially own securities of 
the issuer that were

[[Page 14965]]

acquired before the period commencing 180 days immediately preceding 
the required filing date, and that are not also an officer, director, 
or 5% or greater shareholder of the issuer. Members will be responsible 
for ensuring compliance by any such shareholders with the lock-up 
restrictions.
    E. Information on New Arrangements: NASD Regulation proposes to 
amend subparagraph (b)(6)(A)(vi), to narrow the filing requirement 
relating to any new arrangements after the issuance of an opinion of no 
objections. Under the revised proposal, the filing obligation will 
apply only to participating members, rather than all persons covered by 
the term ``underwriter and related persons.''
    3. Valuation of Securities--Paragraph (e) regulates the manner in 
which securities are assigned a value for purposes of the calculation 
of underwriting compensation.
    A. Distinguish Securities With an Exercise or Conversion Price: 
NASD Regulation proposes to amend subparagraphs (e)(2) and (3),\32\ as 
recommended by commenters (Goldman, M&F, and SIA), to clarify that the 
application of the valuation method depends on whether the security has 
an exercise or conversion price. Convertible securities that have no 
conversion price will be valued in the same manner as common stock.
---------------------------------------------------------------------------

    \32\ As discussed above, NASD Regulation also proposes to amend 
subparagraph (e)(3) to impose a minimum conpensation value on 
securities with an exercise or conversion price.
---------------------------------------------------------------------------

    B. Valuation of Securities With a Longer Resale Restriction: NASD 
Regulation proposes to amend subparagraph (e)(4) to clarify that a 
lower value of 10% will be deducted for each 180-day period that 
securities are restricted from resale beyond the mandatory lock-up 
restriction.\33\
---------------------------------------------------------------------------

    \33\ For example, the underwriting compensation value of 
securities with a value of 2.50% will be reduced to 2.25% if the 
securities are restricted for one year from the effective date and 
to 2% if the securities are restricted for 18 months following the 
effective date.
---------------------------------------------------------------------------

    C. Valuation of Securities That Have an Exercise or Conversion 
Price: As discussed above, NASD Regulation is proposing to amend the 
Rule to no longer require that securities have an exercise or 
conversion price that is at least equal to the public offering price. 
As a result of this change, NASD Regulation proposes to amend 
subparagraph (e)(3) to clarify that the market price or public offering 
price of the underlying security is deducted from the exercise/
conversion price of the security. In the case of a security with an 
exercise/conversion price below the public offering price, that 
subtraction would result in a negative number.
4. Sales of Securities Considered To Be Underwriting Compensation
    When members are found to have exceeded the permissible 
underwriting compensation limits, they frequently seek to dispose of 
securities that have been deemed to be underwriting compensation to 
bring their compensation within acceptable levels. Current subparagraph 
(c)(6)(C) addresses such sales by requiring securities to be returned 
to the issuer or the source from which received at cost and without 
recourse in order for the securities to be excluded from underwriting 
compensation. NASD Regulation believes that this provision is 
unnecessary because, under the Rule, the Department may consider 
whether a sale of securities deemed to be underwriting compensation is 
bona fide, without recourse, and at cost before excluding the 
securities from underwriting compensation. Accordingly, NASD Regulation 
proposes to eliminate this provision from the Rule.
5. Reorganization of the Rule
    NASD Regulation proposes to reorganize the Rule to make it easier 
to read by dividing it into more sections as follows:

(a) Definitions
(b) Filing Requirements
(c) Underwriting Compensation and Arrangements
(d) Determination of Whether Items of Value Are Included in 
Underwriting Compensation
(e) Valuation of Non-Cash Compensation
(f) Unreasonable Terms and Arrangements
(g) Lock-Up Restriction on Securities
(h) Proceeds Directed to a Member
(i) Exemptions
2. Statutory Basis
    NASD Regulation believes that the proposed rule change is 
consistent with the provisions of section 15A(b)(6) of the Act,\34\ 
which requires, among other things, that the Association's rules be 
designed to prevent fraudulent and manipulative acts and practices, to 
promote just and equitable principles of trade and, in general, to 
protect investors and the public interest. NASD Regulation believes 
that the proposed rule change will eliminate burdensome rules that no 
longer distinguish between bona fide capital-raising and lending 
practices and abusive arrangements and will minimize the opportunity 
for abusive practices by members in connection with underwriting public 
offerings of securities.
---------------------------------------------------------------------------

    \34\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------

B. Self-Regulatory Organization's Statement on Burden on Competition

    Section C, below, includes a discussion of the potential impact on 
small members of the proposed $50 million standard for entities 
eligible to rely on the second exception from underwriting 
compensation. NASD Regulation does not believe that the proposed rule 
change will result in any burden on competition that is not necessary 
or appropriate in furtherance of the purposes of the Act.

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

    On April 11, 2000, the SEC published the original proposal for 
comment in the Federal Register.\35\ The SEC received fourteen comment 
letters. Following is a discussion of the comments received that are 
not addressed above because NASD Regulation did not incorporate them 
into the proposed revisions.
---------------------------------------------------------------------------

    \35\ See supra, note 4.
---------------------------------------------------------------------------

1. Listed Company Exclusion
    Some commenters (TBMA, Goldman, Merrill, and SIA) recommended that 
the NASD adopt a ``listed company exception'' to the Rule. Under this 
proposal, any public offering by an issuer that is listed or would be 
listed after its initial public offering on the Nasdaq National Market, 
the New York Stock Exchange, or the American Stock Exchange or any 
issuer expecting to have market capitalization of at least $75 million 
would be exempt from the Rule's filing requirements and substantive 
provisions.\36\ The commenters argued that such issuers are 
sufficiently large to negotiate favorable terms with prospective 
underwriters without the protections of the Rule.
---------------------------------------------------------------------------

    \36\ Morgan and Salomon recommended an exception for a company 
with market capitalization of $100 million.
---------------------------------------------------------------------------

    Our experience indicates that abuses can occur in the underwriting 
arrangements with listed companies. NASD Regulation does not believe 
that the investor protection purposes of the listing standards are an 
adequate proxy for the review of offering documents and underwriting 
agreements to prevent unfair or unreasonable arrangements. Moreover, 
the changes proposed to the Rule that modernize its provisions and 
provide exceptions for legitimate investment transactions should

[[Page 14966]]

eliminate the need for such a sweeping exception.
2. Other Proposed Exclusions From Underwriting Compensation
    a. Exclusion of Cash and Non-Cash Fees for Other Services--
Commenters (Chase, M&F, Prudential, and Salomon) recommended that fees 
be excluded from underwriting compensation that are for merger and 
acquisition advice, a loan or credit facility, a currency hedge, an 
insurance policy, services provided by the business unit of a bank, and 
other services provided at arm's length.
    As discussed in Section II.A., NASD Regulation is proposing to 
broaden the current exclusion from underwriting compensation for 
private placement agent cash fees to include cash fees received by 
participating members during the review period for providing a loan or 
credit facility, or for services in connection with a merger or 
acquisition. NASD Regulation has traditionally interpreted the Rule to 
exclude cash fees received by banks for cash management or trust 
services, and would extend that position to insurance policies 
(although this issue has not arisen in connection with our review of an 
offering). In addition, NASD Regulation has traditionally interpreted 
the Rule to include in underwriting compensation any securities paid 
during the review period to participating members for related capital 
raising activities, including loans, credit facilities, and merger/
acquisition services. Services as a financial advisor and consultant 
are specifically included within the definition of underwriter and 
related person, and are addressed in Section II.A. above. NASD 
Regulation will address the question about the payment of cash fees for 
a currency hedge provided by a bank or member, when that issue actually 
arises in connection with our review of a public offering.
    b. Payments to a Previous Underwriter--The original rule filing 
proposed to adopt an exclusion from the calculation of underwriting 
compensation in subparagraph (b)(3)(ii) for any payment to a member in 
connection with a proposed public offering that was not completed, if 
the member does not participate in the revised offering. Several 
commenters (SIA, Goldman, Fried Frank, and Merrill) urged NASD 
Regulation to exclude fees paid to a member for a failed offering even 
when the member participates in the revised offering. NASD Regulation 
believes excluding these fees would provide an opportunity for members 
to evade the compensation limits of the Rule and, thus, has not amended 
the Rule as suggested by commenters.\37\
---------------------------------------------------------------------------

    \37\ The amendment proposed to subparagraph (b)(3)(ii) would 
eliminate the current requirement that fees paid to a previous 
underwriter for a failed offering be included in the calculation of 
underwriting compensation, even if the previous underwriter does not 
participate in the revised offering. The Rule would continue to 
prohibit payment of any compensation to a member for a failed 
offering, except for reimbursement of out-of-pocket expenses, in 
subparagraph (f)(2)(D) of this amended rule filing.
---------------------------------------------------------------------------

    c. Exclusion for Investments by Foreign Affiliates--Chase and CIBC 
recommended that investments in the issuer's securities by foreign 
affiliates of a member, particularly when the issuer is also domiciled 
outside the U.S., should be excluded from the calculation of 
underwriting compensation. NASD Regulation believes it is appropriate 
to apply the compensation limitations of the Rule to all members 
participating in a public offering made in the U.S., regardless of the 
location of the issuer or any affiliate of a participating member. Any 
other position would unfairly discriminate between members of the NASD 
depending on where their affiliates are located and whether the member 
has developed a business in underwriting the securities of foreign 
companies. Moreover, NASD Regulation believes that an exclusion for 
investments by foreign affiliates could easily be used to circumvent 
the Rule's compensation limits.
     d. Exclusion of Investments by Certain Employees/Employee 
Investment Funds--Commenters (Merrill, Morgan, and Prudential) 
requested that the Rule exclude investments by employees of the member, 
either because the employees are not related to the member's 
underwriting activities or because the employees (and their immediate 
families) invest through an ``employee securities company.'' NASD 
Regulation finds that the suggested exclusion for ``employee securities 
companies'' would not distinguish between bona fide investments and 
investments for the purpose of obtaining additional underwriting 
compensation. Moreover, the six exceptions proposed herein provide 
sufficient opportunity for employees of members, as well as members, to 
acquire the securities of the issuer during the 180-day review period.
3. 180-Day Review Period
    NASAA requested that NASD Regulation monitor the effectiveness of 
the 180-day review period by reviewing arrangements between issuers and 
underwriters in the 6-month period before the 180-day review period. 
According to NASAA's proposal, if NASD Regulation determines that the 
180-day review period is not effective in regulating underwriting 
compensation, then it should expand the review period to 12 months. 
NASD Regulation notes that the information requested by NASAA will be 
contained in the public offering document filed with the Department for 
review. Department staff will have an opportunity to be alerted to the 
existence of any egregious arrangements that occur before the 180-day 
review period.
    NASD Regulation does not agree with the request by M&F that the 
Rule should specifically exclude any items of value received by 
underwriters and related persons prior to the 180-day review period 
from the calculation of underwriting compensation, in light of the 
Association's general regulatory goals.
4. Requirements of the Exceptions From Underwriting Compensation
    Commenters recommended the elimination and/or modification of many 
of the criteria and definitions of the proposed exceptions from 
underwriting compensation, in many cases arguing that the criteria was 
unnecessary to advance the purposes of the exception.\38\ Of these, 
NASD Regulation has proposed to eliminate the provision prohibiting 
reliance on the exceptions during the 90-day period prior to filing; 
the provision in the second exception that would have required that an 
institutional investor be a member of the issuer's board of directors; 
and the requirement that members submit written procedures 
demonstrating that the member did not make its participation in the 
offering contingent on an acquisition of the issuer's securities. In 
addition, in response to comments, NASD Regulation is clarifying the 
application of many of the remaining criteria. NASD Regulation believes 
that the criteria, as amended, will be effective in distinguishing 
between securities acquired as bona fide investments from securities 
that are underwriting compensation for the public offering.
---------------------------------------------------------------------------

    \38\ However, Goldman and the SIA agreed with the 51% standard 
for institutional investor participation under the third exception.
---------------------------------------------------------------------------

    a. Definition of Entity--Commenters (Fried Frank, Goldman, and SIA) 
recommend that two or more entities that propose to be treated as a 
group should be permitted to demonstrate their bona fide identity as a 
group, even though they have not previously made a joint investment, 
through the terms of their contractual obligations, the occurrence of 
subsequent investments or otherwise, and should include

[[Page 14967]]

entities that intend to file a Schedule 13D or 13G with the SEC in 
connection with the investment under consideration or a subsequent 
investment. Fried Frank also recommends that an entity include any 
entity that is, or the control persons of which are, under common 
control and entities whose investments are made under the direction of 
a common investment advisor or financial advisor. Chase requests that 
the definition of entity be expanded to include third-level 
subsidiaries under the common control of second-level subsidiaries that 
are contractually obligated to invest together and are under the common 
control of a bank.
    NASD Regulation believes that the structures proposed by commenters 
would diminish the protections that are intended to be provided by the 
capital-under-management and non-participating member capital 
requirements in the first and second exceptions. Moreover, the 
commenters' proposal would appear to contradict the requirement that 
the entity (including a group qualifying as an entity) have a minimal 
history in being ``primarily engaged in the business of making 
investments in or loans to other companies.''
    b. Definition of Institutional Investor--Fried Frank states that 
the requirement that an institutional investor have $50 million in 
securities under management for purposes of the second and third 
exceptions is excessive because it will disadvantage small members and 
prevent the issuer from choosing the underwriter that best suits its 
needs. NASD Regulation notes that small members that act as 
underwriters are generally better capitalized than members that engage 
only in retail brokerage activity--in part because of the net capital 
necessary to engage in underwriting activities. NASD Regulation does 
not believe that the Rule improperly disadvantages smaller 
underwriters, particularly as the exceptions are proposed to be 
expanded in this filing.\39\
---------------------------------------------------------------------------

    \39\ Moreover, small members will benefit from the shortening of 
the review period, the elimination of the 10% stock numerical 
limitation, and the elimination of the prohibition on members 
receiving warrants with an exercise price below the public offering 
price.
---------------------------------------------------------------------------

    c. Second Exception--33% Limitation--The second exception requires 
that institutional investors beneficially own at least 33% of the 
issuer's equity securities. Several commenters (Goldman, M&F, Merrill, 
Morgan, Salomon, and SIA) suggested decreasing the 33% threshold. NASD 
Regulation does not believe that this suggestion is consistent with the 
purposes underlying the exception because the second exception does not 
place any limitations on whether the investing entity is managed by a 
member, is funded by a member or its associated persons, or is a 
subsidiary of a member. Therefore, NASD Regulation believes that the 
33% standard for institutional investor participation is necessary to 
prevent potential overreaching by a participating member.
    d. Fourth Exception--Limitation on Increasing Percentage 
Ownership--The fourth exception prohibits investors from increasing 
their percentage ownership of the issuer's securities in reliance on 
the exception. Goldman and the SIA believe that investors should have 
the benefit of indemnification provisions with issuers that give the 
investor the right to receive additional shares if it appears later 
that the issuer misrepresented, for example, its capitalization at the 
time of the investment. NASD Regulation believes that the concerns 
articulated by the commenters are best addressed on a case-by-case 
basis.
    These commenters recommend that the Association also permit 
investors to take advantage of anti-dilution protection for subsequent 
issuances to others, regardless of whether the investor has a 
preemptive right. Under the proposed rule change, any purchases for 
anti-dilution protection during the 180-day review period and 
subsequent to filing of a public offering must comply with the fourth 
or fifth exceptions in order to be excluded from underwriting 
compensation. Thus, additional purchases of the issuer's securities to 
prevent dilution are only permitted to maintain the purchaser's 
percentage ownership of the issuer's securities, if the purchaser 
exercises a preemptive right, is the subject of a pro-rata rights 
offering, or has a two-year prior investment history.
    Fried Frank, Goldman, and Merrill state that there are 
circumstances in which some rights holders elect not to purchase, with 
the result that other rights holders who elect to purchase experience 
an increase in their percentage ownership. In addition, these 
commenters state that rights holders are generally permitted to 
purchase additional shares that are made available by the decision of 
other rights holders not to exercise. They recommend that such 
purchases not be treated as underwriting compensation. NASD Regulation 
disagrees. This exception is intended to recognize that an investor 
that has a preemptive right, or is the subject of a stock split, pro-
rata rights offering, or stock conversion should not be disadvantaged 
by application of the Rule to the securities thereby acquired in order 
to prevent the investor's interest from being diluted. Thus, except for 
conversions, this exception, and exception five, allows the investor to 
maintain its percentage interest in the issuer, but does not allow the 
investor to improve its position.
5. Lock-Up Restriction
    a. Application To Securities That Are Not Deemed To Be Underwriting 
Compensation--Goldman, Fried Frank, Merrill, and the SIA recommend that 
the lock-up restriction only apply to securities deemed to be 
underwriting compensation, arguing that the scope of the lock-up 
requirement does not protect investors when securities are not 
considered to be underwriting compensation and seriously threatens the 
economic interests of venture capital and other investors. NASD 
Regulation disagrees. In regulating resales of securities, the goals of 
the Rule are to:
     Protect the issuer and public investors by ensuring that 
the public market for the securities sold by participating members has 
an opportunity to develop prior to the sale of securities into the 
market by the underwriters and related persons that dilutes the public 
investors; and
     Prevent opportunities for fraud and manipulation in the 
after-market of a company's initial public offering or an offering of 
securities that are not sufficiently liquid when a member is an 
underwriter, actively trades the securities, and is a selling 
securityholder.
    NASD Regulation's concern regarding potential market dilution and 
the opportunity for fraud and manipulation is the same, regardless of 
whether the securities that are sold by participating members into the 
public market are deemed to be underwriting compensation or were 
excluded from underwriting compensation.
    b. Time Period of Lock-Up--Ohio favors the extension of the 90-day 
venture capital lock-up from 90 to 180 days, but joins with NASAA in 
opposing the shortening of the compensation lock-up to 180 days, 
believing the current one-year period to be an appropriate and prudent 
standard for securities deemed to be underwriting compensation, 
particularly in smaller offerings where there may be less information 
about the issuer. M&F is opposed to the imposition of a flat 180-day 
lock-up period on securities of an issuer held by underwriters, 
preferring that NASD Regulation lock-up be the same as that imposed by 
the issuer on its management and other major

[[Page 14968]]

securityholders. In addition, Fried Frank and M&F suggest that the 
lock-up be 30 or 90 days for follow-on offerings.
    NASD Regulation continues to believe that a lock-up period of 180-
days for initial public offerings and follow-on or secondary offerings 
where the market for the security is not sufficiently liquid is 
necessary to protect the after-market from potential manipulation.
    c. Exceptions to the Lock-Up--Goldman recommends an additional 
exception from the proposed lock-up requirement for transfers to an 
affiliate of a member. NASD Regulation believes that such transfers to 
affiliates of members are best addressed on a case-by-case basis. 
Department staff have previously permitted such transfers when the 
securities were owned by the member firm, the transfer was without any 
payment, and the purpose of the transfer was to avoid net capital or 
other tax consequences to the member during the time of the resale 
restriction.
    Fried Frank requests that the exception for securities priced by a 
qualified independent underwriter be retained, citing the statement in 
Notice to Members 86-1 where the Association stated that ``[t]he 
presence of an independent underwriter to conduct pricing and due 
diligence is sufficient protection against potential conflicts of 
interest to justify an exemption from the [venture capital] 
restrictions.'' NASD Regulation has reconsidered the efficacy of this 
exception and now believes that the presence of a qualified independent 
underwriter fails to address the potential negative dilutive effect of 
such sales on the public market in the case of an initial public 
offering or any offering of a security that is not sufficiently liquid. 
NASD Regulation believes that a better standard is the ``actively 
traded security'' test of SEC Regulation M that is proposed as an 
exception to the lock-up restriction for securities acquired prior to 
the 180-day review period, as the Regulation M standard would define a 
liquid market.
6. Other Comments
    a. Exemption for Shelf Offerings on Forms S-3 and F-3--The SIA and 
Merrill request that NASD Regulation amend its current exemption from 
filing for shelf offerings on Forms S-3 and F-3 to rely on the current 
standards for these forms to reduce unnecessary complexity and burden. 
In addition, the SIA requested that the NASD eliminate its 
interpretation published in Notice to Members 93-88 that the exemption 
is only available for shelf offerings for which there is a genuine 
intention to make a delayed offering (i.e., the filing exemption is not 
available where the Rule 415 box is checked only for convenience). 
Alternatively, the SIA recommends that NASD Regulation specifically 
incorporate this interpretation into the Rule. The staff is currently 
developing a proposal related to the application of the Rule to shelf 
registered offerings and NASD Regulation plans to address these 
comments in connection with that proposal.
    b. Exemption from Compliance for Investment Grade Debt Offerings--
TBMA recommends that the exemption under Rule 2710(b)(7) for offerings 
by issuers with investment grade debt outstanding and for investment 
grade debt offerings should be moved to Rule 2710(b)(8) in order to 
provide an exemption from the substantive requirements of the Rule. 
Investment grade debt offerings rarely involve issues concerning 
underwriting terms and arrangements. However, the practical effect of 
TBMA's recommendation would be to exempt such offerings from the filing 
and substantive requirements of Rule 2720, the NASD's conflict-of-
interest rule, when the offering is of the securities of a member, the 
member's parent, or an affiliate of a member. NASD Regulation does not 
believe this exemption is warranted at this time.
    c. Delayed Offerings--Chase believes that the Rule should provide 
that in situations where a registration statement has been on file for 
more than three months without an amendment filing, the NASD Regulation 
value underwriting compensation by reviewing the 180-day period prior 
to filing of an amendment. The staff considers circumstances such as 
these on a case-by-case basis. The Department has, at times, granted 
requests to exclude from underwriting compensation securities that were 
acquired within the 180-day review period, but more than a year before 
the anticipated public offering date of a delayed offering.
    d. Definition of Underwriter and Related Person--The SIA and 
Goldman recommend that the definition of ``underwriters and related 
persons'' be amended to exclude selling group members, arguing that 
issuers do not have a relationship with selling group members and do 
not have an economic incentive to provide extra or illicit compensation 
to selling group members in the form of low-cost securities or 
otherwise. These commenters argue that applying the compensation rules 
to selling group members would present a burden on capital formation, 
excluding willing sellers with no demonstrable benefit. NASD Regulation 
believes that this proposal would provide an opportunity for 
circumvention of the Rule's compensation limits by members willing to 
limit their role in the offering in exchange for the ability to acquire 
the securities of the issuer on a pre-offering basis. NASD Regulation 
believes that the broad scope of the definition of underwriter and 
related persons has operated effectively in carrying out the issuer and 
investor protection purposes of the Rule.
    Merrill recommends that the definition be amended to exclude only 
those persons or entities affiliated with a member that have knowledge 
of the offering based on their roles at the member or ownership 
interest in the issuer. NASD Regulation does not believe that 
``knowledge of the offering'' is a verifiable standard for determining 
the scope of the application of the Rule to acquisitions of the 
issuer's securities. In addition, if the purpose of this proposal is to 
exclude cash fees received for ordinary business by affiliates of a 
member, NASD Regulation believes that the proposed rule change properly 
identifies situations where fees received by members' affiliates are 
considered to be unrelated to the public offering.
    e. Calculation of Underwriting Compensation Based on Integrated 
Transactions--Morgan recommends that several registered transactions 
that are part of a coherent financing schedule where each is contingent 
on each other, should be treated as a single offering for the 
calculation of underwriting compensation. NASD Regulation will consider 
such treatment on a case-by-case basis, where allocation of a member's 
acquisition of the issuer's securities to a coherent group of related 
financing transactions appears appropriate in light of the total 
capital-raising obligations of the member.

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 NASD Regulation 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

[[Page 14969]]

arguments concerning the foregoing, including whether Amendment No. 5 
is consistent with the Act. Persons making written submissions should 
file six copies thereof with the Secretary, Securities and Exchange 
Commission, 450 Fifth Street, NW., Washington, DC 20549-0609. Copies of 
the submission, all subsequent amendments, all written statements with 
respect to the proposed rule change that are filed with the Commission, 
and all written communications relating to the proposed rule change 
between the Commission and any person, other than those that may be 
withheld from the public in accordance with the provisions of 5 U.S.C. 
552, will be available for inspection and copying in the Commission's 
Public Reference Room. Copies of the filing will also be available for 
inspection and copying at the principal office of the NASD. All 
submissions should refer to the File No. SR-NASD-00-04 and should be 
submitted by April 4, 2001.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\40\
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    \40\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-6275 Filed 3-13-01; 8:45 am]
BILLING CODE 8010-01-P