[Federal Register Volume 68, Number 211 (Friday, October 31, 2003)]
[Notices]
[Pages 62126-62146]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-27463]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-48701; File No. SR-NASD-99-60]


Self-Regulatory Organizations; Order Approving Proposed Rule 
Change and Amendment Nos. 1 Through 4 Thereto and Notice of Filing and 
Order Granting Accelerated Approval of Amendment No. 5 Thereto by the 
National Association of Securities Dealers, Inc. Relating to 
Restrictions on the Purchases and Sales of Initial Public Offerings of 
Equity Securities

October 24, 2003.

I. Introduction

    On October 15, 1999, the National Association of Securities 
Dealers, Inc. (``NASD'') filed with the Securities and Exchange 
Commission (``Commission'' or ``SEC''), pursuant to Section 19(b)(1) of 
the Securities Exchange Act of 1934 (``Act'')\1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change that would govern purchases and 
sales of ``hot equity'' offerings. On December 21, 1999, the NASD 
submitted Amendment No. 1 to the proposed rule change.\3\ The proposed 
rule change and Amendment No. 1 were published for comment in the 
Federal Register on January 18, 2000.\4\ On October 11, 2000, the NASD 
submitted Amendment No. 2 to the proposal \5\ which, among other 
things, changed the subject of the proposed rule from ``hot issues'' to 
``new issues.'' Amendment No. 2 was published for comment in the 
Federal Register on December 6, 2000.\6\ The NASD submitted Amendment 
No. 3 to the proposal on March 20, 2001,\7\ and Amendment No. 4 to the 
proposal on June 27, 2002.\8\ The Commission published the proposal as 
revised by Amendment Nos. 3 and 4 in the Federal Register on December 
10, 2002.\9\ On October 23, 2003, the NASD submitted Amendment No. 5 to 
the proposal.\10\ This notice and order approves the proposed rule 
change and Amendment Nos. 1 to 4 thereto, solicits comment on Amendment 
No. 5, and approves Amendment No. 5 on an accelerated basis.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Letter from Gary L. Goldsholle, NASD, to Katherine A. 
England, Division of Market Regulation, SEC, dated December 20, 1999 
(``Amendment No. 1'').
    \4\ Securities Exchange Act Release No. 42325 (January 10, 
2000), 65 FR 2656.
    \5\ See Letter from Alden S. Adkins, NASD, to Katherine A. 
England, Division of Market Regulation, SEC, dated October 10, 2000 
(``Amendment No. 2'').
    \6\ Securities Exchange Act Release No. 43627 (November 28, 
2000), 65 FR 76316.
    \7\ See Letter from Patrice M. Gliniecki, NASD, to Katherine A. 
England, Division of Market Regulation, SEC, dated March 20, 2001 
(``Amendment No. 3'').
    \8\ See Letter from Gary L. Goldshalle, NASD, to Katherine A. 
England, Division of Market Regulation, SEC, dated June 27, 2002 
(``Amendment No. 4'').
    \9\ See Securities Exchange Act Release No. 46942 (December 4, 
2002), 67 FR 75889.
    \10\ See Letter from Gary L. Goldsholle, NASD, to Katherine A. 
England, Division of Market Regulation, SEC, dated October 22, 2003 
(``Amendment No. 5'').
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II. Executive Summary

    Currently, NASD Interpretative Material (``IM'') 2110-1, commonly 
known as the ``Free-Riding and Withholding Interpretation'' 
(``Interpretation''), governs the manner in which NASD members may 
distribute ``hot issues.'' The NASD has proposed to restructure and 
make substantive amendments to the Interpretation; the result would be 
codified as new NASD Rule 2790. The NASD has stated that the new rule, 
like the Interpretation it would replace, is designed to protect the 
integrity of the public offering process by ensuring that: (1) NASD 
members make bona fide public offerings of securities at the offering 
price; (2) members do not withhold securities in a public offering for 
their own benefit or use such securities to reward persons who are in a 
position to direct future business to members; and (3) industry 
insiders, including NASD members and their associated persons, do not 
take advantage of their ``insider'' position to purchase new issues for 
their own benefit at the expense of public customers. The NASD believes 
that the proposed rule is better designed to further the purposes of 
the Interpretation, while at the same time being easier to understand.
    Under new NASD Rule 2790, an NASD member generally would be 
prohibited from selling a ``new issue'' to any account in which a 
``restricted person'' had a beneficial interest. As discussed further 
below, the term ``restricted person'' would include most broker-
dealers, most owners and affiliates of a broker-dealer, and certain 
other classes of person. The proposed rule would require a member, 
before selling a new issue to any account, to meet certain 
``preconditions for sale.'' These preconditions generally would require 
the member to obtain a representation from the beneficial owner of the 
account that the account is eligible to purchase new issues in 
compliance with the rule. The rule would provide several general 
exemptions, the basic rationale of which is that sales to and purchases 
by entities that have numerous beneficial owners--and, therefore, are 
likely to have only a small percentage of restricted persons owners--
are not the types of transactions the rule should proscribe. The 
details of proposed NASD Rule 2790 are discussed in Section IV below.

III. Procedural History and Comments Received

    The proposal, as revised by Amendment No. 1, was published for 
comment in the Federal Register on January 18, 2000.\11\ The Commission 
received 24 comments on the original notice.\12\ In response to these 
comments,

[[Page 62127]]

the NASD submitted Amendment No. 2, which was published for comment in 
the Federal Register on December 6, 2000.\13\ Between December 2000 and 
March 2001, the Commission received 14 comment letters on the proposed 
rule change.\14\ The NASD reviewed the 14 comment letters and made 
various revisions to proposed NASD Rule 2790 in Amendment Nos. 3 and 4. 
After the NASD had filed Amendment No. 4 with the Commission, the 
Commission received two additional comment letters that, among other 
things, advocated publication of Amendment No. 4 in the Federal 
Register.\15\ The proposal, as revised by Amendment Nos. 3 and 4, was 
published for comment in the Federal Register on December 10, 2002.\16\ 
The Commission received four comments on the proposal after December 
10, 2002,\17\ and responded to those comments in Amendment No. 5. The 
proposed rule change, and the evolution of its various provisions 
through the five amendments, are described below.
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    \11\ See supra note 4.
    \12\ See Letter from Willkie Farr & Gallagher to Jonathan G. 
Katz, SEC, dated January 28, 2000 (``Willkie''); Letter from Faith 
Colish to Jonathan G. Katz, SEC, dated January 31, 2000 
(``Colish''); Letter from Katten Muchin Zavis to Jonathan G. Katz, 
SEC, dated January 28, 2000 (``Katten''); Letter from Sandra K. 
Smith to Jonathan G. Katz, SEC, dated February 1, 2000 (``Smith''); 
Letter from Driehaus Capital Management, Inc. to Jonathan G. Katz, 
SEC, dated February 4, 2000 (``Driehaus''); Letter from Cadwalader, 
Wickersham & Taft to Jonathan G. Katz, SEC, dated February 4, 2000 
(``Cadwalader''); Letter from Fu Associates, Ltd. to Jonathan G. 
Katz, SEC, dated February 7, 2000 (``Fu''); Letter from Schulte Roth 
& Zabel LLP to Jonathan G. Katz, SEC, dated February 7, 2000 
(``Schulte''); Letter from Rosenman & Colin LLP to Jonathan G. Katz, 
SEC, dated February 7, 2000 (``Rosenman''); Letter from Ropes & Gray 
to Jonathan G. Katz, SEC, dated February 8, 2000 (``Ropes''); Letter 
from The Washington Group to Jonathan G. Katz, SEC, dated February 
8, 2000 (``Washington''); Letter from Testa, Hurwitz & Thibeault, 
LLP to Jonathan G. Katz, SEC, dated February 8, 2000 (``Testa''); 
Letter from Northern Trust Global Advisors, Inc. to Jonathan G. 
Katz, SEC, dated February 13, 2000 (``Northern Trust''); Letter from 
Chicago Board Options Exchange to Jonathan G. Katz, SEC, dated 
February 14, 2000 (``CBOE''); Letter from Sullivan & Cromwell to 
Jonathan G. Katz, SEC, dated February 15, 2000 (``Sullivan''); 
Letter from Charles Schwab to Jonathan G. Katz, SEC, dated February 
15, 2000 (``Schwab''); Letter from Sidley & Austin to Jonathan G. 
Katz, SEC, dated February 16, 2000 (``Sidley''); Letter from North 
American Securities Administrators Association, Inc. to Jonathan G. 
Katz, SEC, dated February 18, 2000 (``NASAA''); Letter from 
Securities Industry Association to Jonathan G. Katz, SEC, dated 
February 18, 2000 (``SIA''); Letter from Mayor, Day, Caldwell & 
Keeton, L.L.P. to SEC, dated March 8, 2000 (``Mayor Day''); Letter 
from Morgan Stanley Dean Witter to Jonathan G. Katz, SEC, dated 
March 17, 2000 (``MSDW''); Letter from Covington & Burling to 
Jonathan G. Katz, SEC, dated April 14, 2000 (``Covington''); Letter 
from Orrick, Herrington & Sutcliffe LLP to Jonathan G. Katz, SEC, 
dated May 2, 2000 (``Orrick''); Letter from Fried, Frank, Harris, 
Shriver & Jacobson to Jonathan G. Katz, SEC, dated May 9, 2000 
(``Fried'').
    \13\ See supra note 6.
    \14\ See Letter from The Washington Group to Jonathan G. Katz, 
SEC, dated December 21, 2000 (``Washington 2''); Letter from Fried, 
Frank, Harris, Shriver & Jacobson to Jonathan G. Katz, SEC, dated 
December 22, 2000 (``Fried 2''); Letter from Capital International, 
Inc. to Jonathan G. Katz, SEC, dated December 22, 2000 (``CII''); 
Letters from Cadwalader, Wickersham & Taft to Jonathan G. Katz, SEC, 
dated December 22, 2000 and January 4, 2001 (``Cadwalader 2''); 
Letter from Testa, Hurwitz & Thibeault to Jonathan G. Katz, SEC, 
dated December 26, 2000 (``Testa 2''); Letter from Managed Funds 
Association to Jonathan G. Katz, SEC, dated December 26, 2000 
(``MFA''); Letter from Mayor, Day, Caldwell & Keeton, L.L.P. to 
Jonathan G. Katz, SEC, dated December 26, 2000 (``Mayor Day 2''); 
Letter from Sullivan & Cromwell to Jonathan G. Katz, SEC, dated 
December 29, 2000 (``Sullivan 2''); Letter from Willkie Farr & 
Gallagher to Jonathan G. Katz, SEC, dated January 8, 2001 (``Willkie 
2''); Letter from Securities Industry Association to Margaret H. 
McFarland, SEC, dated January 10, 2001 (``SIA 2''); Letter from 
Chicago Board Options Exchange to Jonathan G. Katz, SEC, dated 
January 12, 2001 (``CBOE 2''); Letter from Morgan Stanley Dean 
Witter to Secretary, SEC, dated January 31, 2001 (``MSDW 2''); 
Letter from The Washington Group to Laura S. Unger, SEC, dated March 
27, 2001 (``Washington 3'').
    \15\ See Letter from Willkie Farr & Gallagher to SEC dated 
September 24, 2002 (``Willkie 3''); Letter from Managed Funds 
Association to SEC dated October 15, 2002 (``MFA 2'').
    \16\ See supra note 9.
    \17\ See Letter from Willkie Farr & Gallagher to Jonathan G. 
Katz, SEC, dated December 13, 2002 (``Willkie 4''); Letter from 
Managed Funds Association to Jonathan G. Katz, SEC, dated December 
31, 2002 (``MFA 3''); Letter from Sidley Austin Brown & Wood to 
Jonathan G. Katz, SEC, dated January 9, 2003 (``Sidley 2''); Letter 
from Mayer Brown Rowe & Maw to Jonathan G. Katz, SEC, dated January 
13, 2003 (``Mayer Brown'').
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IV. Description of Proposal

A. Primary Differences Between NASD Rule 2790 and NASD IM-2110-1

1. ``New Issues'' Versus ``Hot Issues''
    The Interpretation applies to any ``hot issue,'' defined as a 
public offering of a security that trades at a premium whenever 
secondary market trading begins.\18\ The proposed rule, in contrast, 
would apply to any ``new issue,'' defined as an initial public offering 
of an equity security.\19\ The initial proposal would have retained the 
concept of ``hot issues'' but revised the Interpretation's definition 
to provide a clearer standard for when an issue becomes ``hot'' (i.e., 
when it trades at the required premium). The NASD initially proposed to 
define ``hot issue'' as a security that is part of a public offering 
where the volume-weighted price during the first five minutes of 
trading in the secondary market is 5% or more above the public offering 
price.
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    \18\ See NASD IM-2110-1(a)(1).
    \19\ See paragraph (i)(10) of proposed NASD Rule 2790. This 
provision would in turn define ``equity security'' to have the same 
meaning as in Section 3(a)(11) of the Act, 15 U.S.C. 78c(a)(11).
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    The proposed 5% threshold generated several comments. Three 
commenters supported the NASD's proposal for a clear and measurable 
standard for determining whether an issue becomes ``hot'' but believed 
that the 5% threshold was too low.\20\ Several commenters questioned 
whether the methodology proposed by the NASD would be effective in 
identifying those offerings that should be subject to the proposed 
rule.\21\
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    \20\ See Driehaus; MSDW; Sullivan.
    \21\ See Colish (stating that the NASD should supply data to 
support the numerical thresholds chosen in the proposed rule); 
Driehaus (recommending use of a threshold based on a security's 
volume-weighted price on the first day, not just the first five 
minutes of trading or any other short period of time during the 
trading day); MSDW; NASAA; SIA (recommending a percentage based on 
the first half hour of trading that occurs away from the lead 
underwriter).
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    Two commenters suggested an approach even more straightforward than 
a 5% threshold: prohibiting allocations of all IPOs to restricted 
persons.\22\ One of these commenters noted a significant drawback to 
any definition that included a numerical threshold: prudent firms would 
have to treat all IPOs as subject to the rule because they would not be 
able to anticipate which offerings would trade through the 
threshold.\23\ The second commenter agreed that, in practice, many 
firms would treat all IPOs as subject to the rule even if many of them 
were not hot issues.\24\ The second commenter added that, although the 
Interpretation contains a cancellation provision, many firms do not 
avail themselves of it because of the administrative costs of tracking 
and canceling hot issue sales, the risks of noncompliance associated 
with selling hot issues to restricted persons, and the ill will 
generated by having to cancel a customer's allocation.
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    \22\ See Schwab; SIA (arguing in the alternative for a higher 
threshold premium).
    \23\ See SIA.
    \24\ See Schwab.
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    Based on these comments, the NASD in Amendment No. 2 revised the 
proposed rule to cover the purchase and sale of all initial equity 
public offerings, not just those that open above a designated premium. 
The NASD believes that this approach would be easier to understand and 
would avoid many of the complexities associated with the cancellation 
provision.
2. Elimination of Cancellation Provision
    Currently, a member that sells a hot issue to a restricted person 
or account will not be considered to have violated the Interpretation 
if the member: (1) Cancels the trade before the end of the first 
business day following the date on which secondary market trading 
commences for that issue; and (2) reallocates such security at the 
public offering price to a non-restricted person or account.\25\ This 
provision allows members to cancel trades in the event an issue 
unexpectedly becomes ``hot.'' With the decision to apply the proposed 
rule to all new issues, the NASD no longer believes that a cancellation 
provision is necessary. The NASD would expect members to determine the 
status of all prospective purchasers prior to selling a new issue.
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    \25\ See NASD IM-2110-1(a)(3).
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3. Elimination of ``Conditionally Restricted Person'' Status
    Another significant difference between the proposed rule and the 
Interpretation is the elimination of ``conditionally restricted 
person'' status and the decision to treat all persons as either 
restricted or non-restricted. Although the term ``conditionally 
restricted person'' is not used in the Interpretation, the concept 
generally includes: (1) Members of the immediate family of an 
associated person who are not supported directly or indirectly by the 
associated person; (2) finders in respect to the public offering; (3) 
any person acting in a fiduciary capacity to the managing underwriter 
(including accountants, attorneys, and consultants); and (4) senior 
officers and directors of a bank, savings and loan

[[Page 62128]]

institution, insurance company, investment company, investment advisory 
firm, or any other institutional-type account, or any person in the 
securities department of any of the foregoing entities, or any other 
employee who may influence, or whose activities directly or indirectly 
involve or are related to, the function of buying or selling securities 
for any of the foregoing entities.\26\ Under the Interpretation, a 
conditionally restricted person generally may purchase hot issues if: 
(1) The securities are sold to that person in accordance with the 
person's normal investment practice; (2) the amount of securities sold 
to such person is insubstantial; and (3) the member's aggregate sales 
to conditionally restricted persons is insubstantial and not 
disproportionate in amount as compared to sales to other members of the 
public.
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    \26\ See NASD IM-2110-1(b)(5).
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    Several commenters urged the NASD to retain the concept of 
conditionally restricted persons.\27\ The NASD believes, however, that 
treating a person as conditionally restricted is, in many cases, 
contrary to the public interest: although certain conditionally 
restricted persons--such as investment advisers, hedge fund managers, 
and other investment managers--may have the requisite investment 
history to qualify for the exemption, they still may be in a position 
to direct future business to a member. The NASD does not believe that 
meeting the conditionally restricted person criteria alleviates these 
concerns. The NASD now prefers a bright-line approach and, therefore, 
has proposed to eliminate conditionally restricted person status. The 
NASD acknowledges that, by doing so, certain persons who may purchase 
hot issues under the Interpretation would be restricted persons under 
the new rule. However, the rule contains new provisions that would 
address some of their concerns.
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    \27\ See Mayor Day 2; MFA; Washington 2.
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4. Introduction of 10% De Minimis Threshold for Restricted Person 
Participation
    The NASD has stated that some of the persons who previously 
benefited from conditionally restricted person status could instead 
benefit from a proposed de minimis threshold: restricted persons would 
be permitted to hold interests in a collective investment account that 
purchases new issues, provided that such persons account for no more 
than 10% of the account's beneficial ownership.
    The NASD initially proposed a de minimis threshold of 5%. Several 
commenters urged the NASD to raise the threshold from 5% to 10% or 
more.\28\ These commenters generally maintained that restricted persons 
should be permitted to hold interests in an account that purchases new 
issues, provided that they exercise no investment authority over the 
account.\29\ The NASD responded that for many years it has received 
similar requests to establish what would in effect be a ``passive 
investor exemption.'' The NASD believes that such an exemption would 
allow persons who are not public investors to receive substantial 
allocations of new issues, which would be fundamentally at odds with 
the purposes of the rule. The NASD believes, moreover, that 
participation by restricted persons in an account might be known or 
inferred by an NASD member allocating a new issue and, thus, create a 
temptation for the member to reward that account in the hope of 
receiving future business. For these reasons, the NASD has declined to 
adopt a blanket exemption for passive investors.
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    \28\ See Cadwalader; MSDW; Ropes; Schulte; Sidley.
    \29\ See Cadwalader 2; Fried; Mayor; Ropes.
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    Early commenters noted that investors generally expect a hedge fund 
manager to make significant investments in the fund to align the 
manager's interests with those of the investors; these commenters urged 
the NASD to raise the de minimis threshold to allow such 
arrangements.\30\ However, rather than increase the initially proposed 
5% threshold, the NASD in Amendment No. 2 proposed a limited exemption 
for portfolio managers: a person would not be restricted with respect 
to a collective investment account for which he or she acted as a 
portfolio manager.\31\
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    \30\ See Cadwalader; Katten; Northern Trust; Schulte; Sullivan; 
Washington; Willkie.
    \31\ In any event, a portfolio manager would still be prohibited 
from purchasing new issues through a personal account.
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    One commenter argued that this limited exemption for portfolio 
managers would not further the interests of the proposed rule because a 
portfolio manager who benefits from the purchase of new issues through 
an account that he or she manages would have far greater incentive and 
opportunity to direct future business to an NASD member than the 
restricted persons who were merely passive investors.\32\ In Amendment 
No. 4, the NASD responded by reinstating portfolio managers as 
restricted persons in all cases, including with respect to accounts for 
which they act as portfolio manager, but raising the de minimis 
threshold to 10%. Under this new approach, an account managed by a 
portfolio manager would be permitted to invest in new issues, provided 
that the interest of all restricted persons in the account (including 
the portfolio manager) did not exceed 10%.\33\ The NASD observed that 
this approach comported with earlier recommendations made by three 
commenters.\34\
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    \32\ See Mayor 2.
    \33\ In Amendment No. 2, the NASD also proposed a requirement 
that no restricted person who had an interest in a collective 
investment account could receive through that account more than 100 
shares of any new issue on a notional pro rata basis. This limit was 
designed to reduce the incentive for self-dealing and the appearance 
that restricted persons were receiving shares at the expense of 
public investors. However, in Amendment No. 4, the NASD eliminated 
the 100-share limitation to simplify application of the proposed 
rule. Thus, member firms would not need to track the interest of the 
largest restricted person or to perform calculations to determine on 
an offering-by-offering basis whether that person would receive more 
than 100 shares on a notional pro rata basis.
    \34\ See Katten; Rosenman; Schulte.
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    Three commenters criticized this new approach and urged the NASD to 
return to its earlier proposal of a 5% de minimis threshold and deeming 
the portfolio manager as a non-restricted person with respect to the 
fund that he or she manages.\35\ These commenters again emphasized 
their view that portfolio managers should be required, as one commenter 
put it, to ``eat their own cooking.''\36\ They also argued that the new 
approach would put the manager of a collective investment account in 
competition with investors for ownership of interests in the account 
because the manager would wish to obtain the entire 10% for himself or 
herself. Further, the commenters stated that the revised approach would 
create an incentive for portfolio managers to cash out investors in 
their funds and manage their own money separately. Finally, the 
commenters argued that the NASD did not offer any public policy 
rationale or cite any instances of actual abuse that would support this 
revision.
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    \35\ See MFA 2; Sidley 2; Willkie 3; Willkie 4.
    \36\ Sidley 2.
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    In Amendment No. 5, the NASD declined to revise the de minimis 
exemption and the proposed treatment of portfolio managers in the 
manner suggested by the three commenters. The NASD believes that giving 
portfolio managers unrestricted access to new issues--if only through 
the funds that they manage--is inconsistent with the purposes of the 
proposed rule. The NASD stated that portfolio managers are in a 
position to direct substantial business to members and accordingly may 
seek to use this influence to obtain access to IPOs. The 
Interpretation,

[[Page 62129]]

recognizing this potential conflict, seeks to limit purchases of IPOs 
by these persons by treating them as ``conditionally restricted.'' 
Proposed NASD Rule 2790, in turn, seeks to limit IPO purchases by 
portfolio managers by treating them as restricted persons, subject to 
the 10% de minimis exemption. Furthermore, the NASD does not believe 
that the proposed rule would cause portfolio managers to cash out other 
investors in their funds and to manage their own money separately. The 
NASD expects that the fees received by portfolio managers for managing 
money far exceed the profits that they receive from greater 
participation in IPOs.
    Finally, two commenters \37\ asked whether the establishment of the 
de minimis exemption would eliminate carve-outs, which are contemplated 
by the Interpretation.\38\ Such carve-out procedures allow a manager of 
an account who wishes to purchase IPOs for such account to segregate 
the interests of restricted persons from non-restricted persons. The 
NASD responded that carve-outs would continue to be available. 
Therefore, a collective investment account in which restricted persons 
held an interest of 10% or greater could continue to invest in new 
issues, provided that such restricted persons received no more than 10% 
of the notional pro rata proceeds of the new issue. Therefore, the NASD 
believes that the proposed rule would not prevent portfolio managers 
from continuing to pool their money and sharing the same investment 
risks with respect to every type of asset--except new issues.
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    \37\ See MFA 2; MFA 3; Sidley.
    \38\ See NASD IM-2110-1(g).
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    In administering the procedures in the Interpretation, the NASD has 
recognized that accounts may employ a variety of methods to carve out 
the interests of restricted persons and that specifying a particular 
method could exclude other equally effective methods. The NASD has 
concluded, therefore, that the proposed rule should not prescribe a 
particular manner for carving out the interests of restricted persons. 
However, in Amendment No. 5 the NASD represented that it intends to 
offer detailed guidance concerning the use of carve-out accounts in a 
Notice to Members to be published after approval of the proposed rule 
change.
5. Preconditions for Sale
    Under the proposed rule, a member would not be permitted to sell a 
new issue to an account until the member had met the rule's 
preconditions for sale. Paragraph (b) of the proposed rule would 
require a member to obtain a representation from the account holder(s), 
or a person authorized to represent the beneficial owner(s) of the 
account, that the account is eligible to purchase new issues in 
compliance with the rule. If an interest in the account were held by a 
bank, foreign bank, broker-dealer, investment adviser, or other 
conduit, the member would be required to obtain from that conduit a 
representation that all purchases of new issues would be in compliance 
with the rule.\39\ Paragraph (b) also would provide that a member may 
not rely on a representation that it believes, or has reason to 
believe, is inaccurate. Furthermore, the member would be required to 
retain a copy of all records and information relating to whether an 
account is eligible to purchase new issues for at least three years 
following the member's last sale of a new issue to that account. 
Finally, paragraph (b) would require the member to obtain these 
representations within the 12 months prior to a sale of new issues to 
the account.\40\
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    \39\ One commenter expressed concern that the proposed rule, in 
the form presented in Amendment No. 2, would not adequately address 
sales to intermediaries such as domestic banks, foreign banks, 
broker-dealers, investment advisers, and other conduits that 
purchase new issues on behalf of their customers. See Sullivan 2. In 
response to these concerns, the NASD expanded the preconditions for 
sale provisions to address such conduits, as described above.
    \40\ The existing preconditions for sale provisions are 
scattered throughout the Interpretation. See NASD IM-2110-1(b)(2), 
(b)(5), (b)(7), and (f). The proposed rule change would revise and 
consolidate these various provisions into a single paragraph of the 
new rule.
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    Several commenters had reservations about the proposed 
preconditions for sale provisions.\41\ One of these commenters believed 
that these provisions would impose significant and unnecessary 
administrative burdens on members, especially those that distribute 
shares to a large number of retail customers.\42\ Another commenter 
feared that these provisions would require an annual mailing to all 
customers who might be interested in purchasing new issues and would 
prohibit the use of electronic communications.\43\ These two commenters 
stated that firms should be permitted to develop their own methods to 
verify the status of a customer, including the use of oral 
representations, so long as such representations are documented 
internally. A third commenter urged that NASD members be permitted to 
continue to qualify accounts orally and to maintain records of these 
oral representations.\44\ Finally, various commenters suggested 
lengthening the verification period or allowing members to rely on 
``negative consents.''\45\
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    \41\ See Cadwalader; MSDW; Schwab; SIA.
    \42\ See Schwab.
    \43\ See MSDW.
    \44\ See SIA.
    \45\ Under a negative consent procedure, a broker-dealer member 
would send notices to its customers asking if there had been a 
change in their restricted status, and the broker-dealer would be 
permitted to rely on its existing information regarding a particular 
customer unless the customer affirmatively replied that his or her 
status had changed. See MSDW; MSDW 2; SIA; Sullivan.
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    In Amendment No. 5, the NASD reiterated that the initial 
verification of a person's status under the proposed rule must be a 
positive affirmation of non-restricted status, but that it intends to 
permit annual verification of a person's status to be conducted though 
the use of negative consents. The NASD noted that the Commission's new 
books and records rules allow a firm to furnish a customer with account 
information and ask that he or she verify that the information is 
correct. The NASD believes, therefore, that similar disclosure, 
confirming that an person is not a restricted person, would be 
appropriate. The NASD also would allow the use of electronic 
communications for eligible customers but, consistent with the Rule 
17a-3 under the Act,\46\ a member would not be permitted to verify 
customer account information orally.
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    \46\ 17 CFR 240.17a-3.
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    Certain commenters questioned how the documentation requirement 
would apply given the possibility that a customer's status or 
percentage of ownership in an account may change over the course of a 
year.\47\ One commenter stated that a member should not be in violation 
of the proposed rule if the member were unaware that an account is 
beneficially owned by a restricted person due to false information 
provided by the customer.\48\ In response, the NASD revised paragraph 
(b) expressly to provide that a member may rely upon the information it 
receives from a customer unless it believes, or has reason to believe, 
that the information is inaccurate. Another commenter recommended that 
the proposed rule expressly state that a member may rely upon 
representations made by a person who the member ``reasonably believes'' 
is authorized to represent the beneficial owners of the account.\49\ In 
Amendment

[[Page 62130]]

No. 5, the NASD stated that members should use an appropriate level of 
diligence to determine whether an individual is authorized to represent 
the beneficial owners of the accounts, and that it is unnecessary to 
include the language suggested by this commenter.
---------------------------------------------------------------------------

    \47\ See Cadwalader; NASAA (suggesting a verification period 
significantly shorter than one year to reflect possible changes in 
ownership that could occur within that period); Ropes.
    \48\ See Schwab.
    \49\ See Fried.
---------------------------------------------------------------------------

    Several commenters sought guidance on what type of information a 
member would be required to review to ascertain whether an account is 
beneficially owned by restricted persons, especially in the context of 
a fund-of-funds.\50\ For example, one commenter urged the NASD to 
eliminate the need to ``look through'' multiple layers of investors to 
determine whether restricted persons are somewhere in the chain of 
ownership.\51\ In Amendment No. 5, the NASD explained that a person 
authorized to represent the beneficial owners of the master fund (i.e., 
the fund that purchases the new issues from the member directly) is 
required to represent that the fund is able to purchase new issues. The 
NASD expects that any such person, in making such representation, would 
ascertain the status of investors in the feeder funds (i.e., funds that 
invest in the master fund). If the representative of the master fund is 
unable to ascertain the status of investors in a feeder fund, the 
master fund must deem such feeder fund to be restricted and ensure that 
the profits from new issues are not allocated to that fund (or consider 
whether any other exemption, such as the de minimis exemption, might 
apply to that feeder fund). Also in Amendment No. 5, the NASD stated 
that it would address this matter further in a Notice to Members 
following Commission approval of the proposed rule change.
---------------------------------------------------------------------------

    \50\ See Cadwalader; Katten; Rosenman; Schulte; Sullivan.
    \51\ See Cadwalader.
---------------------------------------------------------------------------

B. Other Aspects of NASD Rule 2790

1. Securities Excluded From the Rule
    a. Securities Issued as Part of a Secondary Offering. The proposed 
rule would not apply to secondary offerings, although the proposed rule 
does not contain a specific exemption for them. The exemption is 
implicit in the definition of ``new issue,'' which includes any initial 
public offering of an equity security.
    The NASD initially proposed to subject a secondary offering to the 
new rule if it were ``hot'' (i.e., it traded at a 5% premium). Allowing 
secondary issues to be considered hot issues would represent a reversal 
of the position taken by the NASD under the Interpretation,\52\ and 
several commenters criticized this aspect of the original proposal.\53\ 
These commenters questioned why the proposed rule should apply to 
secondary offerings if the NASD believed that most secondary offerings 
do not trade at a premium.\54\ They also stated that, without a clear 
exemption for secondary issues, member firms generally would bar 
allocations of all secondary offerings to restricted persons out of 
concern that they could become hot.
---------------------------------------------------------------------------

    \52\ In 1998, the NASD amended the Interpretation to exempt 
secondary offerings of actively traded securities, based on its 
findings that few secondary offerings traded at a premium, and where 
there was a premium, it was generally very small. See Securities 
Exchange Act Release No. 40001 (May 18, 1998), 63 FR 28535, 28537 
(May 26, 1998) (approving SR-NASD-97-95) (``1998 amendments'').
    \53\ See MSDW; Schwab; SIA; Sidley; Sullivan.
    \54\ See, e.g., Schwab (``the remote possibility that an issue 
could trade at a premium would cause many member firms to prohibit 
allocations of any secondary issues to restricted customer accounts. 
As a practical matter, the Rule would exclude broad categories of 
investors from participating in secondary offerings. The negative 
consequences to both issuers and customers of such a broad exclusion 
outweigh any remote benefits associated with secondary offerings in 
the scope of the Rule'').
---------------------------------------------------------------------------

    With the decision to apply the proposed rule to new issues rather 
than hot issues, secondary offerings would not be subject to the rule. 
The NASD continues to believe that secondary offerings rarely if ever 
trade at a significant premium to the public offering price and agrees 
with the commenters that the negative consequences of applying the rule 
to secondary offerings would outweigh any benefits.
    b. Debt Securities. Another significant difference between the 
proposed rule and the Interpretation is the treatment of debt 
securities. Originally, the Interpretation applied to equity and debt 
securities. However, as part of the 1998 amendments, the NASD exempted 
from the Interpretation most types of investment-grade debt and 
investment-grade asset-backed securities from the definition of ``hot 
issue.'' \55\ The NASD is now going one step further and proposing to 
eliminate application of the rule to all debt securities, including 
those that are not investment-grade.\56\
---------------------------------------------------------------------------

    \55\ See 1998 amendments, 63 FR at 28537.
    \56\ In Amendment No. 5, the NASD acknowledged that, under 
certain circumstances, the trading characteristics of junk debt more 
closely resemble that of the issuer's equity securities rather than 
its debt securities. However, the NASD believes that, for purposes 
of the new rule, the point in time at which the pricing and trading 
characteristics of a security are relevant are at the time of 
offering. The NASD continues to believe that, at the time of an 
offering, even junk debt will trade based primarily on interest 
rates and the creditworthiness of the issuer and, therefore, that 
the junk debt should not be treated in the same manner as equity 
securities under the proposed rule.
---------------------------------------------------------------------------

    One commenter recommended that the definition of ``new issue'' 
exclude offerings of securities of closed-end funds that invest solely 
in debt securities.\57\ The commenter reasoned that, if offerings of 
debt securities were excluded, offerings of funds that invest solely in 
debt securities also should be excluded. In Amendment No. 4, the NASD 
stated that offerings of such funds would be exempt from the proposed 
rule pursuant to the exemption for offerings of securities of 
investment companies registered under the Investment Company Act of 
1940.\58\
---------------------------------------------------------------------------

    \57\ See Schwab.
    \58\ See infra notes 70-72 and accompanying text.
---------------------------------------------------------------------------

    c. Other Securities Exempt From NASD Rule 2790. Paragraph 
(i)(10)(A) of the proposed rule would exclude from the definition of 
``new issue'' offerings of securities that are restricted under various 
provisions of the Securities Act of 1933 \59\ and the Securities 
Exchange Act of 1934.\60\ Paragraph (i)(10)(B) would exclude offerings 
of ``exempt securities,'' as defined in Section 3(a)(12) of the 
Securities Exchange Act of 1934.\61\
---------------------------------------------------------------------------

    \59\ 15 U.S.C. 77a et seq.
    \60\ 15 U.S.C. 78a et seq.
    \61\ 15 U.S.C. 78c(a)(12).
---------------------------------------------------------------------------

    Paragraph (i)(10)(C) would exclude from the definition of ``new 
issue'' offerings of securities of a commodity pool operated by a 
commodity pool operator, as defined in Section 1a(5) of the Commodity 
Exchange Act.\62\ The original proposal did not contain such an 
exemption. Two commenters argued that offerings of securities of 
commodity pools should be excluded from the definition of ``new 
issue.''\63\ The commenters noted that commodity pool securities, 
whether offered publicly or privately, generally do not trade in the 
secondary market, and that investors may redeem their interests from 
the issuer at net asset value at selected intervals, much like open-end 
mutual funds, which are exempt from the proposed rule. In addition, 
they stated that the offering process is similar to that for registered 
closed-end funds in that the commodity pool operator is generally 
seeking as large an infusion of capital as possible and that such 
offerings are rarely oversubscribed. In Amendment No. 3, the NASD 
agreed and added a new paragraph (C) to paragraph (i)(10) of the 
proposed rule.
---------------------------------------------------------------------------

    \62\ 7 U.S.C. 1a(5).
    \63\ See MFA; Cadwalader.
---------------------------------------------------------------------------

    Three commenters recommended that the term ``new issue'' not 
include rights offerings to existing shareholders, exchange offers, and 
offerings made pursuant to a merger or acquisition.\64\

[[Page 62131]]

The NASD agreed, and this revision is reflected in paragraph (i)(10)(D) 
of the proposed rule.
---------------------------------------------------------------------------

    \64\ See MSDW; SIA; Sullivan.
---------------------------------------------------------------------------

    Paragraph (i)(10)(E) would exclude offerings of investment-grade 
asset-backed securities from the definition of ``new issue.'' This 
provision would preserve an exemption in the Interpretation for 
financing-instrument-backed securities that are rated investment-
grade.\65\ In Amendment No. 5, the NASD explained that a separate 
exclusion for asset-backed securities was necessary even though the 
proposed rule already contains an exclusion for debt securities; 
certain types of asset-based securities may be considered equity rather 
than debt and therefore might not be covered by the proposed rule's 
implicit exemption for debt securities.
---------------------------------------------------------------------------

    \65\ See NASD IM-2110-1(l)(1).
---------------------------------------------------------------------------

    Paragraph (i)(10)(F) would exclude offerings of convertible 
securities. Under the literal terms of the Interpretation, debt 
securities that are convertible into common or preferred stock may be 
hot issues.\66\ The NASD staff has exercised its exemptive authority 
\67\ to exclude many convertible securities from the Interpretation. 
The NASD has now proposed to codify this exemption in the proposed 
rule.\68\
---------------------------------------------------------------------------

    \66\ See id.
    \67\ See NASD IM-2110-1(a)(5).
    \68\ One commenter recommended that the proposed rule not apply 
to debt securities that are convertible into ``actively traded'' 
equity securities. See MSDW. The NASD believes that, in view of the 
decision to exclude all secondary offerings, all convertible 
securities, not just those that are convertible into ``actively 
traded'' securities, should be excluded.
---------------------------------------------------------------------------

    Paragraph (i)(10)(G) would exclude offerings of preferred 
securities. The NASD has stated that, in connection with the 1998 
amendments, it considered--but deferred--an exemption for preferred 
securities.\69\ However, the NASD is now proposing to exempt preferred 
securities because it believes, on balance, that these securities 
exhibit pricing and trading behavior more closely resembling that of 
debt rather than equity securities and, thus, should not be considered 
``new issues.''
---------------------------------------------------------------------------

    \69\ See 1998 amendments, 63 FR at 28537.
---------------------------------------------------------------------------

    Paragraph (i)(10)(H) would exclude offerings of securities of an 
investment company registered under the Investment Company Act of 
1940.\70\ The NASD initially proposed to exclude only the securities of 
closed-end investment companies, as defined in Section 5(a)(2) of the 
Investment Company Act.\71\ The NASD believes that these securities 
typically commence trading at the public offering price with little 
potential for trading at a premium because the fund's assets at the 
time of the offering are the capital it has previously raised. The NASD 
concluded, therefore, that deeming the securities of closed-end funds 
to be new issues would do little to further the purposes of the 
proposed rule. One commenter agreed with the NASD's decision to exempt 
offerings of securities of closed-end investment companies but 
questioned why the exemption did not extend to any type of investment 
company registered under the Investment Company Act of 1940.\72\ The 
NASD agreed and revised paragraph (i)(10)(H) accordingly.
---------------------------------------------------------------------------

    \70\ 15 U.S.C. 80a-1 et seq.
    \71\ 15 U.S.C. 80a-5(a)(2).
    \72\ See Cadwalader 2.
---------------------------------------------------------------------------

    Paragraph (i)(10)(I) would exclude an offering of securities (in 
ordinary share form or American Depository Receipts (``ADRs'') 
registered on Form F-6) that have a pre-existing market outside the 
United States. One commenter suggested that the proposed rule should 
exclude an offering of securities of which the initial public offering 
price is based primarily on ``exogenous or market factors (such as, a 
rating by a nationally recognized statistical rating organization or 
the market price for a related security).'' \73\ The NASD believes that 
this suggestion is too broad. However, in the case of an ADR, the NASD 
agrees that application of the proposed rule is not necessary because 
the price of the offering will be constrained by the price of the 
shares in the underlying foreign market. Therefore, in Amendment No. 5, 
the NASD added new paragraph (i)(10)(I) to the proposed rule. The NASD 
notes that this exemption would apply only to initial offerings of ADRs 
that are not part of a global initial public offering.
---------------------------------------------------------------------------

    \73\ Sidley 2.
---------------------------------------------------------------------------

    d. Miscellaneous Issues Regarding Scope of Term ``New Issue''. One 
commenter \74\ recommended that the definition of ``new issue'' 
expressly exempt offerings of securities made pursuant to Regulation S 
\75\ under the Securities Act of 1933. The NASD does not believe that 
this commenter sufficiently demonstrated that this exemption would be 
consistent with the purposes of the proposed rule and has determined 
not to adopt it.
---------------------------------------------------------------------------

    \74\ See Sullivan 2.
    \75\ 17 CFR 230.901 et seq.
---------------------------------------------------------------------------

    In Amendment No. 2, the definition of ``new issue'' proposed by the 
NASD included ``other securities distributions of any kind whatsoever, 
including securities that are specifically directed by the issuer on a 
non-underwritten basis.'' Several commenters noted that this language 
was surplusage and potentially misleading.\76\ The NASD agreed and 
deleted this language from the definition.
---------------------------------------------------------------------------

    \76\ See MSDW 2 (arguing that non-underwritten securities should 
not be covered by the proposed rule since, by definition, NASD 
members would not be involved in the offering); Sullivan 2 (noting 
that this language would have the effect of including secondary 
offerings in the rule, even though the NASD's stated intent was to 
exempt secondary offerings); Willkie 2.
---------------------------------------------------------------------------

    One commenter recommended that the definition of ``new issue'' 
exclude any offering of securities for which, at the time of the 
offering, an organized trading market is not expected to develop.\77\ 
In Amendment No. 5, the NASD responded that it was not necessary to 
draft a general exemption in the rule, and that offerings of this type 
might be candidates for specific exemptions granted by the NASD staff 
pursuant to their authority under paragraph (h) of the proposed 
rule.\78\
---------------------------------------------------------------------------

    \77\ See Sidley 2.
    \78\ But see infra note and accompanying text.
---------------------------------------------------------------------------

    The same commenter \79\ argued that the term ``initial public 
offering'' used in the definition of ``new issue'' should be construed 
to exclude any offering of securities made on a continuous basis (such 
as under a ``shelf'' registration statement pursuant to Rule 415 of 
Regulation C under the Securities Act of 1933 \80\). In Amendment No. 
5, the NASD agreed that such an offering would not be part of an 
``initial public offering'' unless it were the first registered 
offering of the company's stock.
---------------------------------------------------------------------------

    \79\ See id.
    \80\ 17 CFR 230.415.
---------------------------------------------------------------------------

2. Restricted Persons
    Paragraph (a)(1) of proposed NASD Rule 2790 would stipulate that a 
member or associated person thereof may not sell a new issue to any 
account in which a restricted person has a beneficial interest, unless 
such sale qualifies for an enumerated exemption. The scope of the term 
``restricted person'' is discussed below.
    a. Broker-Dealers and Their Personnel. Paragraph (i)(11)(A) of the 
proposed rule would define ``restricted person'' to include NASD 
members and other broker-dealers. Paragraph (i)(11)(B)(i) would extend 
the definition of ``restricted person'' to include any officer, 
director, general partner, associated person, or employee of a member 
or any other broker-dealer. Paragraph (i)(10)(B)(ii) would provide that 
agents of a broker-dealer are not considered restricted persons unless 
they are engaged in the investment banking or securities business.

[[Page 62132]]

    b. Limited Business Broker-Dealers. Paragraph (i)(11)(B) 
specifically would exclude from the definition of ``restricted person'' 
the personnel and agents of a ``limited business broker-dealer.'' 
Paragraph (i)(8) would define ``limited business broker-dealer'' as a 
broker-dealer whose authorization to engage in the securities business 
is limited solely to the purchase and sale of investment company/
variable contracts securities and direct participation program 
securities. These provisions of the proposed rule would preserve an 
exemption for associated persons of a limited business broker-dealer 
under the Interpretation.\81\ The NASD has emphasized, however, that 
this exemption would apply only to persons associated with such a 
limited business broker-dealer, not to the limited business broker-
dealer itself.
---------------------------------------------------------------------------

    \81\ See NASD IM-2110-1(c).
---------------------------------------------------------------------------

    Several commenters argued that the proposed definition of ``limited 
business broker-dealer'' is too narrow and should be expanded to 
include broker-dealers that do not have any involvement in the capital 
formation or equity underwriting business.\82\ The NASD has determined, 
however, not to broaden the scope of this exemption. The NASD believes 
that even broker-dealers engaged solely in, for example, proprietary 
trading or merchant banking activities (or the associated persons of 
such firms) might enter into reciprocal arrangements with other members 
that could create improprieties that the proposed rule seeks to 
address. In addition, the NASD believes that a rule requiring members 
to determine whether a person is engaged in reciprocal arrangements 
with a broker-dealer would be difficult to administer and enforce and 
would eliminate the certainty sought by the proposed rule.
---------------------------------------------------------------------------

    \82\ See Colish (suggesting that the definition of ``limited 
business broker-dealer'' also include broker-dealers that engage 
only in private placements); Fried (arguing that no broker-dealer 
should be a restricted person without some nexus to equity IPOs); 
Washington (suggesting that only broker-dealers that engage in an 
equity securities business should be restricted).
---------------------------------------------------------------------------

    One commenter, the Chicago Board Options Exchange (``CBOE''), urged 
the NASD to revise the proposal to treat CBOE market makers and floor 
brokers as limited business broker-dealers. CBOE stated that these 
exchange members should not be considered ``industry insiders'' as they 
are not in a position to take advantage of their position to 
participate in IPOs for their own accounts at the expense of public 
customers. CBOE maintained, therefore, that treating these CBOE members 
as restricted persons would be unnecessary to accomplish the stated 
purposes of the rule. CBOE also argued that the proposal would put CBOE 
members at a competitive disadvantage relative to members of the 
futures exchanges: Although many futures products are economically 
similar to options, futures exchange members who trade them would not 
be restricted persons under the new rule. CBOE suggested alternate rule 
text that would allow a CBOE member to purchase new issues unless the 
underwriter of the IPO were an NASD member that executed stock 
transactions on behalf of the CBOE member.
    In response to CBOE's comment, the NASD stated in Amendment No. 2 
that the proposed rule should apply generally to all broker-dealers and 
their associated persons. The NASD believes that a rule requiring 
analysis of the activities of a particular broker-dealer would be more 
difficult rule to administer and enforce than a rule based on a firm's 
authorizations. The NASD recognizes that the Interpretation and the 
proposed rule make an exception for associated persons and owners of a 
broker-dealer that engages solely in the purchase and sale of 
investment company/variable contract securities and direct 
participation program securities. However, the NASD does not believe 
that the existence of this exemption for ``limited business broker-
dealers'' necessitates additional exemptions.
    With respect to the competitive issue between CBOE members and 
members of futures exchanges that trade financial derivatives, the NASD 
has acknowledged that futures exchange members would not--solely 
because of their status as such--be restricted persons under the 
proposed rule. However, the NASD believes that many futures exchange 
members would be subject to the proposed rule because of changes to the 
federal securities laws made by the Commodity Futures Modernization Act 
of 2000 (``CFMA'').\83\ A futures exchange member that wishes to trade 
security futures products must register as a broker-dealer pursuant to 
Section 15(b)(11) of the Act, as amended by the CFMA.\84\ In Amendment 
No. 5, the NASD clarified that the proposed rule would treat such 
futures exchange members the same as ``conventional'' broker-
dealers.\85\
---------------------------------------------------------------------------

    \83\ Pub. L. No. 106-554, Appendix E, 114 Stat. 2763. The CFMA 
removed the prohibition on single-stock futures and set forth a 
regulatory scheme whereby entities that trade single-stock futures 
and other security futures products must register with both the 
Commission (under the Securities Exchange Act) and the Commodity 
Futures Trading Commission (under the Commodity Exchange Act).
    \84\ 15 U.S.C. 78o(b)(11).
    \85\ CBOE also recommended that members of that exchange who 
lease their seats and who are not engaged in a securities business 
not be considered restricted persons. In this matter, the NASD 
agreed and stated in Amendment No. 5 that it would not treat such 
persons as restricted persons under the new rule.
---------------------------------------------------------------------------

    Finally, one commenter \86\ recommended that the proposed rule 
include a provision that would allow an NASD member, in determining 
whether a firm is a limited business broker-dealer, to rely on the 
information contained in that firm's Form BD.\87\ In completing the 
Form BD, a broker-dealer must list all lines of business that account 
for 1% or more of its annual revenue. In the initial proposal, the NASD 
stated that a member ``should look to the Form BD as well as any 
Restrictive Agreement'' to determine the activities of a broker-dealer. 
Upon further review, the NASD clarified in Amendment No. 3 that a 
member may look to the Form BD as evidence of a firm's status, but must 
inquire further about whether the firm meets the conditions of a 
limited business broker-dealer.
---------------------------------------------------------------------------

    \86\ See Fried 2.
    \87\ 17 CFR 249.501.
---------------------------------------------------------------------------

    c. Finders and Fiduciaries. Paragraph (i)(11)(C) of the proposed 
rule would preserve a provision in the Interpretation that treats 
finders and fiduciaries of the managing underwriter as restricted 
persons. The NASD believes that finders and fiduciaries are industry 
insiders and, therefore, should be subject to the new rule. The NASD 
believes, moreover, that issuers must be prevented from circumventing 
the underwriting compensation limits of existing NASD Rule 2710 by 
offering finders or fiduciaries access to a new issue.\88\ However, the 
NASD has proposed to treat finders and fiduciaries as restricted 
persons only for those offerings for which they are acting in those 
capacities. The NASD has added that, in the case of a law firm or 
consulting firm, the restriction would apply only to those persons 
working on the particular offering.
---------------------------------------------------------------------------

    \88\ NASD Rule 2710 defines the term ``underwriter and related 
persons'' to include ``financial consultants'' and ``finders.''
---------------------------------------------------------------------------

    d. Portfolio Managers. The Interpretation prohibits the sale of hot 
issues ``to any senior officer of a bank, savings and loan institution, 
insurance company, investment company, investment advisory firm or any 
other institutional type account.''\89\ These persons are restricted 
because their position allows them the opportunity to direct business 
to a member firm.

[[Page 62133]]

However, the NASD does not believe that all senior officers and 
employees of a securities department of one of these entities need be 
restricted. Therefore, the NASD devised a function-oriented approach 
that, in its original form, would have treated as a restricted person 
``[a]ny employee or other person who supervises, or whose activities 
directly or indirectly involve or are related to, the buying or selling 
of securities'' for one of the listed entities.
---------------------------------------------------------------------------

    \89\ NASD IM-2110-1(b)(4).
---------------------------------------------------------------------------

    In response to the original proposal, three commenters stated that 
they supported the functional approach but believed that the proposed 
rule language was too broad and could reach persons whose functions 
were purely ministerial.\90\ These commenters suggested that only to 
persons who have authority to make investment decisions should be 
restricted. The NASD agreed and revised the proposed rule text 
accordingly in Amendment No. 2.\91\ Accordingly, paragraph 
(i)(11)(D)(i) of the proposed rule would define a portfolio manager as 
any person who has authority to buy or sell securities for a bank, 
savings and loan institution, insurance company, investment company, 
investment advisor, or collective investment account.
---------------------------------------------------------------------------

    \90\ See Ropes; Schwab; Testa.
    \91\ However, one commenter suggested that a portfolio manager 
should be restricted based on whether this person ``exercises'' 
authority to make investment decisions, not whether such person is 
``authorized'' to make investment decisions. See Fried. The NASD 
believes that the alternative standard proposed by this commenter is 
too narrow and has not made this change.
---------------------------------------------------------------------------

    One commenter sought clarification on whether an investment advisor 
organized as a non-natural person would be deemed a restricted 
person.\92\ This commenter stated that the proposed rule treats certain 
employees of an investment advisor as restricted persons but is not 
clear whether the investment advisor itself is a restricted person. In 
Amendment No. 5, the NASD observed that the definition of ``portfolio 
manager'' in paragraph (i)(1)(D)(i) encompasses non-natural persons. 
Thus, an entity organized as an investment advisor that has authority 
to buy and sell securities for any of the entities enumerated above 
would be a portfolio manager for the purposes of the proposed rule and, 
as such, a restricted person.
---------------------------------------------------------------------------

    \92\ See Katten.
---------------------------------------------------------------------------

    Another commenter recommended excluding from the definition of 
``portfolio manager'' a hedge fund manager of a fund with less than 
$200 million in assets.\93\ The NASD believes that the reasons for 
treating hedge fund managers as restricted persons are not limited by 
the size of the assets under management, especially with amounts as 
significant as those proposed by the commenter. Therefore, the NASD 
declined to accept this recommendation.
---------------------------------------------------------------------------

    \93\ See Washington.
---------------------------------------------------------------------------

    Finally, one commenter requested that the proposed rule include an 
exemption for persons who, on a volunteer basis, make investment 
decisions on behalf of a tax-exempt charitable organization.\94\ The 
NASD believes that the purposes of the rule may be implicated by 
persons who manage such organizations. The NASD, therefore, declined to 
accept this suggestion.
---------------------------------------------------------------------------

    \94\ See Schwab.
---------------------------------------------------------------------------

    e. Owners of Broker-Dealers. In the view of the NASD, a prohibition 
on new issue purchases by a broker-dealer could be circumvented if the 
broker-dealer's owners were permitted to purchase the new issue. 
Therefore, the NASD has proposed to deem owners of a broker-dealer as 
restricted persons as well.
    Under the original proposal, the term ``restricted person'' 
included any natural person (or member of the person's immediate 
family) who owned 10% or more, or contributed 10% or more of the 
capital, of a broker-dealer. Many of the commenters believed that this 
restriction was too broad and would be overly burdensome.\95\ In 
Amendment No. 2, the NASD adopted a new approach that bases ownership 
of a broker-dealer for purposes of the rule on whether the broker-
dealer must report the ownership interest on Form BD. The NASD favors 
this approach because it would not have to create new concepts of 
ownership for purposes of the rule: The Form BD reporting requirements 
are well understood by NASD members, who already maintain such 
information.
---------------------------------------------------------------------------

    \95\ See Colish; Orrick; SIA; Sidley; Willkie.
---------------------------------------------------------------------------

    One commenter criticized this approach on the grounds that persons 
who might in fact have very little voting power or beneficial interest 
in the broker-dealer would be treated as restricted persons, which 
would not further the purposes of the rule.\96\ A person must be 
reported on Form BD if it holds a designated percentage of ``a class of 
voting security'' of the reporting broker-dealer. The commenter noted 
that, depending on the broker-dealer's capital structure, a particular 
class of voting security might represent only a small portion of the 
firm's capital. Nevertheless, a person owning 10% or more of that class 
would be a restricted person under the proposed rule. The commenter 
recommended that the ownership interests reported in Schedules A and B 
of Form BD should be multiplied so that only the actual economic 
interest would be used to determine whether the person is restricted.
---------------------------------------------------------------------------

    \96\ See Fried 2.
---------------------------------------------------------------------------

    The NASD has determined not to accept the commenter's suggestion. 
In Amendment No. 4, the NASD stated that it seeks to aid members' 
compliance efforts by eliminating the need to perform calculations in 
determining ownership interests in a broker-dealer. In its experience, 
such calculations are often difficult and frequently raise interpretive 
issues with various ownership structures. The NASD deliberately sought 
to eliminate that level of complexity by referencing persons listed on 
Schedules A and B, noting that there are no special codes or 
identifiers on Schedule B to identify persons with only a small 
economic interest.
    The same commenter also suggested an exemption from the proposed 
definition of ``restricted person'' for an entity disclosed on Schedule 
A or B of Form BD that is listed on a foreign exchange. Pursuant to 
Form BD, a broker-dealer must report entities that have interests at 
every level of its ownership structure that exceed designated 
percentages. However, once a public reporting company is reached, no 
ownership information further up the chain need be given.\97\ Only 
those public reporting companies that are subject to Sections 12 or 
15(d) of the Act \98\ may avail themselves of this exclusion. The NASD 
has proposed to follow the Form BD in this regard; thus, a foreign 
entity with an ownership interest in a broker-dealer would not be a 
restricted person if that foreign entity were subject to Sections 12 or 
15(d) of the Act.\99\
---------------------------------------------------------------------------

    \97\ See Form BD, Schedule B, Instruction 3.
    \98\ 15 U.S.C. 78l and 78o.
    \99\ A foreign entity also might be eligible to purchase new 
issues pursuant to the proposed rule's exemption for publicly traded 
entities. See infra notes--and accompanying text.
---------------------------------------------------------------------------

    The general restriction on owners of a broker-dealer would not 
extend to owners of a limited business broker-dealer. One commenter 
recommended that, because associated persons of a limited business 
broker-dealer were not restricted, the owners of a limited business 
broker-dealer also should not be restricted.\100\ The NASD agreed and 
revised the proposed rule text accordingly.
---------------------------------------------------------------------------

    \100\ See Willkie 2.
---------------------------------------------------------------------------

    f. Affiliates of Broker-Dealers. The proposed rule would treat as 
restricted persons not only owners of a broker-dealer, but also 
affiliates of the broker-

[[Page 62134]]

dealer. While such affiliates would not specifically be included in the 
definition of ``restricted person,'' paragraph (a)(1) of the proposed 
rule would provide that a member may not sell a new issue to any 
account in which a restricted person (such as an owner of a broker-
dealer) ``has a beneficial interest.'' The NASD has stated that an 
owner of a broker-dealer--whom the proposed rule would explicitly deem 
a restricted person `` would be viewed as having a beneficial interest 
in an account held by a subsidiary (i.e., a sister company of the 
broker-dealer).
    Several commenters stated that applying the proposed rule to 
affiliates has no policy justification.\101\ These commenters were 
concerned, in part, that many financial services firms, which currently 
may invest in hot issues under the Interpretation, would be prohibited 
from purchasing new issues under the proposed rule simply by the 
accident of having become affiliated with an NASD member firm in the 
wake of the Gramm-Leach-Bliley Act,\102\ which repealed many 
restrictions on affiliation among banks, insurance companies, and 
securities firms.
---------------------------------------------------------------------------

    \101\ See MSDW; Orrick; Rosenman; SIA; Sullivan; Willkie.
    \102\ Pub. L. No. 106-102, 113 Stat. 1338 (1999).
---------------------------------------------------------------------------

    The NASD believes, nevertheless, that broker-dealer affiliates 
should be restricted persons. The NASD contends that, if the rule 
failed to restrict an account in which a restricted person had a 
beneficial interest, the restricted person could evade the restriction 
by directing a subsidiary to purchase the new issue instead. However, 
to offer some relief to entities that could be affected by the 
restriction on broker-dealer affiliates, the NASD is establishing an 
exemption for any such affiliate (except another broker-dealer) that is 
publicly traded.\103\
---------------------------------------------------------------------------

    \103\ See infra notes 127-136 and accompanying text.
---------------------------------------------------------------------------

    g. Family Members. The proposed rule would restrict various persons 
based on their functions in the financial services industry. In 
addition, paragraph (i)(11)(D)(ii) would restrict certain other persons 
based on their relationship with persons who work in the financial 
services industry. The NASD believes that these collateral restrictions 
are necessary to prevent a ``functionally'' restricted person from 
circumventing the rule by purchasing new issues through the account of 
an immediate family member. Paragraph (i)(5) would define ``immediate 
family member'' to include a person's parents, mother-in-law or father-
in-law, spouse, brother or sister, brother-in-law or sister-in-law, 
son-in-law or daughter-in-law, and children, and any other individual 
to whom the person provides ``material support.'' This provision is 
based on a provision in the Interpretation \104\ but supplements the 
existing provision by adding a definition of ``material support'' in 
paragraph (i)(9): the direct or indirect provision of more than 25% of 
a person's income in the prior calendar year. Paragraph (i)(9) of the 
new rule would deem members of the immediate family living in the same 
household to be providing each other with material support.
---------------------------------------------------------------------------

    \104\ See NASD IM-2110-1(l)(2).
---------------------------------------------------------------------------

    The NASD originally proposed that ``material support'' would mean 
providing 10% of another's income. One commenter supported the addition 
of a bright-line definition of ``material support'' but recommended 
that the threshold be raised to 25%, as measured in the prior calendar 
year.\105\ The NASD agreed and revised the proposed rule text 
accordingly. Another commenter argued that the definition of ``material 
support'' was over-inclusive, as it was not necessarily based on the 
economic reality of the situation.\106\ The NASD believes, however, 
that the ``material support'' provisions as proposed are a reasonable 
means to prevent evasion of the rule, and that, without clear and 
straightforward standards for collateral restrictions on family 
members, the rule would become difficult to administer. The NASD stated 
in Amendment No. 2 that it will not evaluate ``material support'' 
issues on a case-by-case basis.
---------------------------------------------------------------------------

    \105\ See Schwab.
    \106\ See Fried 2 (hypothesizing that two cousins sharing an 
apartment would be deemed to materially support each other under the 
proposed rule, even though they might not in fact be materially 
supporting each other).
---------------------------------------------------------------------------

    In addition, the proposed rule would modify the treatment of sales 
to members of the immediate family of an officer, director, general 
partner, employee, or agent of a member or other broker-dealer 
(collectively referred to as ``associated persons''). Under the 
Interpretation, members of the immediate family of an associated person 
may not purchase hot issues from the firm employing the associated 
person.\107\ The proposed rule would expand this prohibition to include 
affiliates of the firm employing the associated person. The NASD 
believes that this change is necessary to clarify that immediate family 
members of associated persons may use neither traditional nor online 
distribution channels to circumvent the prohibitions on sales to them.
---------------------------------------------------------------------------

    \107\ See NASD IM-2110-1(b)(2)(B).
---------------------------------------------------------------------------

    Finally, two commenters pointed out that the original proposal 
appeared to have instances of faulty drafting where family members 
should have been exempt from the proposed rule but were not.\108\ The 
NASD agreed with these comments and revised the proposed rule text 
accordingly.
---------------------------------------------------------------------------

    \108\ See Sullivan; Testa.
---------------------------------------------------------------------------

    h. Investment Clubs and Family Investment Vehicles. Two commenters 
urged that the proposed rule not prohibit their investment clubs from 
purchasing IPOs.\109\ In response, the NASD in Amendment No. 4 revised 
the definition of ``collective investment account'' in paragraph (i)(2) 
of the proposed rule to exclude ``investment clubs'' (as defined in 
paragraph (i)(6)) and ``family investment vehicles'' (as defined in 
paragraph (i)(4)). Therefore, a person who has authority to buy or sell 
securities on behalf of an investment club or a family investment 
vehicle would not be a portfolio manager under paragraph (i)(10)(D)(i) 
and, therefore, not be a restricted person on that basis. In addition, 
even if an investment club or family investment vehicle included 
persons who were otherwise restricted (e.g., because they were 
associated persons of a broker-dealer), such entity could still 
purchase new issues if it qualified for the de minimis exemption of 
paragraph (c)(4).\110\
---------------------------------------------------------------------------

    \109\ See Fu; Smith.
    \110\ One commenter stated that an earlier version of the 
proposed rule appeared to inadvertently exclude investment clubs and 
family partnerships from the de minimis exemption. See Sullivan. The 
NASD has clarified that such entities may qualify for the de minimis 
exemption.
---------------------------------------------------------------------------

    Finally, one commenter recommended that the definition of ``family 
investment vehicle'' be expanded to include long-term family 
employees.\111\ In Amendment No. 5, the NASD stated that the commenter 
had not presented sufficient reason to exclude such persons and 
declined to make this change. Moreover, the NASD believes that 
permitting non-family persons into the exemption for family investment 
vehicles could open the exemption to abuse.
---------------------------------------------------------------------------

    \111\ See Cadwalader 2.
---------------------------------------------------------------------------

    i. Joint Back Office Broker-Dealers. Certain hedge funds, or 
subsidiaries thereof, have opted to become registered broker-dealers. 
These entities are generally known as ``joint back office broker-
dealers'' (``JBOs'') because they share a back office with another 
registered broker-dealer. Under the Interpretation, hedge funds that 
are (or are affiliated with) JBOs are not, solely on such basis, 
precluded from

[[Page 62135]]

purchasing hot issues on behalf of their investors. The special 
provisions for JBOs arise from an exemption granted by the NASD staff 
responding to certain provisions of the 1998 amendments to the 
Interpretation. Those provisions had the effect of precluding hedge 
funds registered as JBOs (or with JBO subsidiaries) from purchasing hot 
issues even if investors in the funds were not restricted. The NASD 
staff determined that sales of hot issues to a hedge fund should be 
based on the status of the beneficial owners of the fund, not simply 
the fund's status as a broker-dealer.\112\ The proposed rule seeks to 
codify this exemption.
---------------------------------------------------------------------------

    \112\ See letter from Gary Goldsholle, NASD, to David Katz, 
Sidley & Austin, dated January 20, 1999.
---------------------------------------------------------------------------

    The NASD continues to believe that the election by an investment 
fund to become (or be affiliated with) a JBO should not by itself 
preclude the purchase of new issues by investors in that fund who are 
not otherwise restricted persons. The original proposal provided that a 
collective investment account--including a JBO--could avail itself of 
the de minimis exemption and included a definition of ``joint back 
office broker-dealer.'' In Amendment No. 2, the NASD removed any 
explicit references to JBOs. The NASD stated that, as a result of its 
revisions to the definition of ``beneficial interest'' and ``restricted 
person,'' the conditions that gave rise to the need for the JBO 
exemption had been removed. By clarifying that ``beneficial ownership'' 
includes a financial interest, such as the right to share in gains or 
losses, the NASD believed it had clarified that a JBO's legal ownership 
of securities would not constitute a ``beneficial interest'' for 
purposes of the proposed rule. The NASD, therefore, concluded that a 
specific exemption for JBOs was no longer necessary.
    In Amendment No. 4, the NASD restored a specific reference to JBOs 
in the de minimis exemption, now relocated to paragraph (c)(4) of the 
proposed rule, as well as a definition of ``joint back office broker-
dealer'' in then paragraph (i)(7). Two commenters noted problems with 
the definition.\113\ Under the NASD's final proposal, the NASD devised 
an alternative manner of exempting purchases of new issues by JBOs. New 
paragraph (a)(4) would provide an exemption for ``purchases by a 
broker/dealer (or owner of a broker/dealer), organized as a investment 
partnership, of a new issue at the public offering price, provided such 
purchases are credited to the capital accounts of its partners in 
accordance with paragraph (c)(4).'' This exemption would allow an 
investment partnership (e.g., a hedge fund) that registers as a broker-
dealer or that has a broker-dealer subsidiary to purchase new issues on 
the same terms as other investment partnerships. This approach is 
consistent with the relief granted in the original exemptive letter. 
Under Amendment No. 5, a hedge fund that registers as a broker-dealer 
or that has a broker-dealer subsidiary could purchase new issues so 
long as the beneficial interests of restricted persons do not exceed in 
the aggregate 10% of the fund. Accounts that are beneficially owned by 
restricted persons in excess of the 10% threshold may use carve-out 
procedures to prevent the restricted persons from receiving more than 
10% of the notional pro rata proceeds of a new issue.
---------------------------------------------------------------------------

    \113\ See Sidley 2; Willkie 3.
---------------------------------------------------------------------------

    One commenter argued that an entity that is a non-natural person 
should be disregarded for the purposes of determining who holds the 
beneficial interest in an account, and that the rule should look only 
to natural persons who may hold beneficial interests in that 
account.\114\ This commenter concluded, therefore, that there is no 
need for a specific exemption for JBOs. In Amendment No. 5, the NASD 
responded that the commenter was correct that, in determining whether a 
person is a restricted person, one should ``look through'' to the 
persons who have the actual beneficial interests in the account's gains 
and losses. If one can look through until each of the natural persons 
is reached and, along the way, encounters no beneficial owners who are 
restricted persons, the account may purchase new issues. However, if 
the process of looking through reveals a restricted person identified 
in paragraph (i)(11) of the proposed rule--be it a natural person or a 
legal person--then the account may be restricted. The next step in the 
analysis, according to the NASD, is to determine whether the account 
qualifies for an exemption under paragraph (c) of the rule. For this 
reason, the NASD provided an exemption for JBOs: In the absence of an 
exemption, a JBO would be restricted even if it were beneficially owned 
entirely by non-restricted persons.
---------------------------------------------------------------------------

    \114\ See Sidley 2.
---------------------------------------------------------------------------

    The NASD has stated that the exemption for JBOs would not extend to 
associated persons of a JBO. Three commenters argued that associated 
persons of a JBO should not, solely by virtue of their association with 
the JBO, be restricted persons.\115\ The NASD explained in Amendment 
No. 4 that election to become a JBO bestows certain benefits on the 
investment account, but also imposes certain obligations, including 
restrictions on the ability of associated persons to purchase new 
issues. The NASD further explained in Amendment No. 5 that the act of 
registering a collective investment account as a JBO should not taint 
the investors, who otherwise might not be restricted persons. However, 
the NASD does not believe that this necessitates excluding associated 
persons of the JBO from the definition of ``restricted person.''
---------------------------------------------------------------------------

    \115\ See Rosenman; Sidley 2; Willkie 3.
---------------------------------------------------------------------------

3. General Prohibitions
    Paragraph (a)(1) of the proposed rule sets forth the basic 
prohibition that a member (or an associated person thereof) may not 
sell a new issue to an account in which a restricted person has a 
beneficial interest, except as otherwise permitted under the rule. 
Paragraph (a)(2) would provide that a member (or associated person 
thereof) may not purchase a new issue in any account in which such 
member or associated person has a beneficial interest, except as 
otherwise permitted under the rule. Paragraph (a)(3) would provide that 
a member may not continue to hold new issues acquired as an 
underwriter, selling group member, or otherwise, except as otherwise 
permitted under the rule.
    One commenter stated that these provisions could be read to 
prohibit accommodation sales (i.e., sales to another broker-dealer at 
the public offering price to enable that broker-dealer's customer to 
purchase the new issue at the public offering price) as well as 
purchases by and among members of the selling group while engaged in 
the distribution of a new issue.\116\ The NASD agreed that neither of 
these outcomes was intended and, in Amendment No. 3, added a new 
paragraph (a)(4) to the proposed rule to address these concerns. 
Paragraph (a)(4)(A) would allow sales or purchases from one member of 
the selling group \117\ to another member that are incidental to the 
distribution of a new issue to a non-restricted person at the public 
offering price. Paragraph (a)(4)(B) would allow sales or purchases by a 
broker-dealer of a new issue at the public offering price as an

[[Page 62136]]

accommodation to a non-restricted person customer of the broker-dealer.
---------------------------------------------------------------------------

    \116\ See SIA.
    \117\ The term ``selling group'' is defined in existing NASD 
Rule 0120(p). In Amendment No. 4, the NASD replaced the term 
``syndicate'' with the term ``selling group.'' The NASD elected to 
use the more expansive term ``selling group'' because it did not 
believe that whether a broker-dealer has made a financial commitment 
to purchase securities in an IPO is relevant for purposes of the 
rule.
---------------------------------------------------------------------------

4. General Exemptions
    Paragraph (c) states that the proposed rule's general prohibitions 
would not apply to sales to or purchases from several classes of 
persons, whether directly or through accounts in which such persons 
have a beneficial interest.\118\ These classes of person are described 
below.
---------------------------------------------------------------------------

    \118\ Sullivan expressed concern that the general exemptions, in 
the form proposed in Amendment No. 2, applied only to the persons 
specified in the proposed rule and did not extend to the accounts of 
such persons. The NASD agreed that the general exemptions should 
clearly state that they apply to the specified persons as well as to 
the accounts of such persons, and revised the proposal accordingly.
---------------------------------------------------------------------------

    a. Investment Companies. Paragraph (c)(1) of the proposed rule 
states that sales of new issues to, or purchases by, an investment 
company registered under the Investment Company Act of 1940 \119\ would 
not be subject to the rule. This provision would preserve an existing 
exemption in the Interpretation.\120\
---------------------------------------------------------------------------

    \119\ 15 U.S.C. 80a-1 et seq.
    \120\ See NASD IM-2110-1(f)(1).
---------------------------------------------------------------------------

    b. Common Trust Funds and Insurance Companies. Paragraphs (c)(2) 
and (c)(3) would provide exemptions for sales of new issues to, or 
purchases by, certain trust funds and insurance company accounts, 
respectively. To qualify for these exemptions, a trust fund would have 
to have investments from 1,000 or more accounts, and an insurance 
account would have to be funded by premiums from 1,000 or more 
policyholders (or, if a general account, the insurance company would 
have to have 1,000 or more policyholders).\121\ In addition, the fund 
or insurance account may not limit its participation principally to 
restricted persons.\122\
---------------------------------------------------------------------------

    \121\ See paragraphs (c)(2)(A) and (c)(3)(A) of proposed NASD 
Rule 2790.
    \122\ See paragraphs (c)(2)(B) and (c)(3)(B) of proposed NASD 
Rule 2790.
---------------------------------------------------------------------------

    Under the original proposal, the exemption for general, separate, 
or investment accounts of insurance companies would apply only if the 
account ``has investments from'' 1,000 or more policyholders. One 
commenter recommended that the proposed rule use the term ``funded by'' 
policyholders instead of ``has investments from'' policyholders; an 
insurance company general account generally is owned by the insurance 
company itself, so the policyholders do not technically invest in or 
fund the account.\123\ The NASD agreed and in Amendment No. 5 revised 
the proposed rule text accordingly.
---------------------------------------------------------------------------

    \123\ See Mayer Brown.
---------------------------------------------------------------------------

    One commenter suggested that the NASD delete the proposed 
requirement that an insurance company account be funded by premiums 
from 1,000 or more policyholders, reasoning that an account of any size 
would not pose a problem under the new rule so long as the 
policyholders were not, principally, restricted persons.\124\ In 
Amendment No. 5, the NASD stated its intent to retain this numerical 
threshold because it provides further assurance that new issues 
purchased by an insurance company account are not targeted for 
restricted persons. The NASD added that, if an insurance company 
separate account has only a few policyholders (as suggested in the 
commenter's hypothetical), it would be appropriate for the insurance 
company to ascertain whether each of the individual policy holders was 
a restricted person.
---------------------------------------------------------------------------

    \124\ See Sidley 2.
---------------------------------------------------------------------------

    The same commenter also recommended that the new rule specifically 
confirm that the insurance company account exemption is not limited to 
life insurance companies, but applies ``across all industries.'' \125\ 
In Amendment No. 5, the NASD stated that paragraph (c)(3) of the 
proposed rule would apply to all types of insurance companies and that 
amending the exemption to apply ``across all industries'' could create 
unintended loopholes.
---------------------------------------------------------------------------

    \125\ Id.
---------------------------------------------------------------------------

    One commenter recommended that the proposed rule include a general 
exemption for mutual banks, in the same way that it would exempt mutual 
insurance companies.\126\ In Amendment No. 5, the NASD noted that an 
exemption similar to the one for insurance company accounts is 
contained in paragraph (c)(2) of the proposed rule for bank common 
trust funds. The NASD does not, however, believe that the commenter has 
articulated a sufficient rationale for an exemption for mutual banks.
---------------------------------------------------------------------------

    \126\ See Fried.
---------------------------------------------------------------------------

    c. Publicly Traded Entities. Paragraph (c)(5) of the proposed rule 
would provide a general exemption for publicly traded entities (except 
broker-dealers and certain affiliates thereof) that are listed on a 
national securities exchange, are traded on the Nasdaq National Market, 
or are foreign issuers whose securities meet the quantitative 
designation criteria for listing on a national securities exchange or 
the Nasdaq National Market. These entities have broad public ownership 
and their securities may be purchased by any investor. The NASD 
believes that an exemption for publicly traded entities recognizes the 
practical limitations in attempting to identify every beneficial owner 
of a publicly traded entity and that the benefits of investments in new 
issues are, indirectly, shared by the public shareholders.
    The original proposal would have exempted ``[a] publicly traded 
corporation \127\ (other than an affiliate of a broker/dealer) listed 
on an exchange or The Nasdaq Stock Market, in which no person with a 
10% or more ownership interest is a restricted person.'' Three 
commenters objected to the 10% proviso; they argued that the publicly 
traded entity exemption should resemble the exemption for registered 
investment companies and U.S. employee benefit plans in not requiring 
member firms to ``look through'' an entity to determine whether the 
beneficial owners were restricted persons.\128\ The NASD agreed with 
these commenters and eliminated the ``look through'' provision.
---------------------------------------------------------------------------

    \127\ One commenter pointed out that the text of the original 
proposal referred only to publicly traded corporations and suggested 
that the exemption be extended to legal persons other than 
corporations. See Rosenman. The NASD agreed and revised the proposed 
rule text accordingly.
    \128\ See Colish; Sidley; Sullivan (``because * * * publicly 
traded corporations are not likely to be used by restricted persons 
as vehicles for investments in hot issues, NASD members should be 
spared the administrative burden of confirming the restricted person 
ownership of customers that are publicly traded corporations'').
---------------------------------------------------------------------------

    As originally proposed, the publicly traded entity exemption did 
not extend to entities listed on a foreign exchange. One commenter 
stated that limiting the exemption to publicly traded entities listed 
on U.S. markets would unfairly discriminate against foreign 
companies.\129\ A second commenter recommended an exemption for an 
initial equity offering in the United States by an issuer whose equity 
is publicly traded in another country.\130\ In Amendment No. 3, the 
NASD expanded the proposed exemption to permit purchases of new issues 
by a publicly traded foreign entity so long as that entity meets the 
quantitative designation criteria for listing on a national securities 
exchange or the Nasdaq National Market.
---------------------------------------------------------------------------

    \129\ See Sidley.
    \130\ See Fried 2.
---------------------------------------------------------------------------

    The publicly traded entity exemption would not apply to a publicly 
traded broker-dealer or an affiliate of the broker-dealer where the 
broker-dealer is authorized to engage in the public offering of new 
issues either as underwriter or as a selling group member. Although the 
shareholders of such publicly traded entities would indirectly receive 
some of the benefit of

[[Page 62137]]

IPO purchases, the NASD does not believe that allowing such purchases 
would be consistent with the purposes of the rule. The version of the 
publicly traded entity exemption proposed in Amendment No. 3 could have 
been construed to permit, for example, the holding company parent of a 
broker-dealer to purchase new issues, even if the broker-dealer engaged 
in a significant amount of investment banking business. The NASD stated 
that this was never the intent of the proposed exemption. Therefore, in 
Amendment No. 4, the NASD revised the public entity exemption to apply 
only to publicly traded entities that are not affiliated \131\ with a 
broker-dealer engaged in the public offering of new issues.
---------------------------------------------------------------------------

    \131\ The NASD also stated in Amendment No. 4 that an 
``affiliate'' for purposes of this provision would have the same 
meaning as in NASD Rules 2710 and 2720.
---------------------------------------------------------------------------

    The NASD believes that looking to whether a broker-dealer is 
authorized to engage in public offerings \132\ excludes from the 
publicly traded entity exemption the ``full service'' broker-dealers 
and their parent companies that the rule is designed to reach. On the 
other hand, the proposed rule would allow purchases of new issues by 
the many publicly traded entities that have broker-dealer affiliates 
established for limited corporate purposes. The NASD believes that 
looking into whether a broker-dealer affiliate participates in 
offerings of new issues is one of many possible tests for determining 
the scope of the publicly traded entity exemption. The NASD stated that 
it also considered looking at the percent of profits or revenues a 
parent holding company derives from broker-dealer activities, but 
concluded that such information is often difficult to determine and 
frequently varies from year to year.\133\
---------------------------------------------------------------------------

    \132\ Under NASD member admission rules, a broker-dealer that 
seeks authority to engage in public offerings must make that part of 
its membership application. If an existing NASD member that is not 
authorized to engage in public offerings seeks to do so in the 
future, such member must make an application under NASD Rule 1017. 
In Amendment No. 4, the NASD stated that it intends to look to 
whether a firm is authorized to engage in public offerings of new 
issues, and that the information on Form BD may help firms identify 
broker-dealers that are authorized to engage in public offerings. 
The NASD noted, however, that the information on Form BD will not be 
conclusive since Item 12 does not require an activity to be reported 
if it is less than 1% of annual revenue.
    \133\ In Amendment No. 5, the NASD offered the following example 
of how the publicly traded entity exemption would work in 
conjunction with the basic restriction on broker-dealers and their 
affiliates. Assume that a parent company is publicly traded and has 
a broker-dealer subsidiary that engages in public offerings. The 
publicly traded parent company would be restricted under paragraph 
(i)(11)(E) of the rule and would not qualify for the publicly traded 
entity exemption. All accounts in which such parent company had a 
beneficial interest (including entities in which the parent held an 
interest of 10% or more) also would be restricted persons, even if 
the business of the subsidiaries was wholly unrelated to the broker-
dealer activities. Now assume that the publicly traded parent 
company has a broker-dealer subsidiary that does not engage in 
public offerings. The parent company would qualify for the publicly 
traded entity exemption in paragraph (c)(5) of the rule. The broker-
dealer subsidiary would continue to be a restricted person, but the 
parent company and other non-restricted subsidiaries of the parent 
company would be eligible to purchase new issues.
---------------------------------------------------------------------------

    One commenter argued that purchases by a private company also 
should be exempt from the proposed rule, if no more than 10% of its 
shareholders are restricted persons.\134\ The NASD responded that a 
private company may avail itself of the de minimis exemption in 
paragraph (c)(4).
---------------------------------------------------------------------------

    \134\ See Sullivan.
---------------------------------------------------------------------------

    Finally, one commenter \135\ pointed out that the Nasdaq Stock 
Market currently has an application pending with the Commission to 
become registered as a national securities exchange pursuant to Section 
6 of the Act.\136\ If that application is approved, securities traded 
in both the Nasdaq National Market and the Nasdaq SmallCap Market would 
be deemed to be traded on a national securities exchange. The commenter 
stated that the distinction set forth in paragraphs (c)(5)(A) and (B) 
between a security that is ``listed on a national securities exchange'' 
versus one that is ``traded on the Nasdaq National Market'' could 
create confusion as to whether securities traded on the Nasdaq SmallCap 
Market are exempt from the rule. In Amendment No. 5, the NASD stated 
that the publicly traded entity exemption does not apply to securities 
traded on the Nasdaq SmallCap Market. In addition, the NASD represented 
that it would consider amending the publicly traded entity exemption if 
and when Nasdaq becomes a national securities exchange.
---------------------------------------------------------------------------

    \135\ See Sidley 2.
    \136\ 15 U.S.C. 78f.
---------------------------------------------------------------------------

    d. Foreign Investment Companies. The Interpretation contains a 
general exemption for foreign investment companies.\137\ A ``foreign 
investment company'' is defined as a fund company organized under the 
laws of a foreign jurisdiction that has certified that: (1) The fund 
has 100 or more investors; (2) it is listed on a foreign exchange or 
authorized for sale to the public by a foreign regulatory authority; 
(3) no more than 5% of its assets are invested in a particular hot 
issue; and (4) no person owning more than a 5% interest in such company 
is a restricted person.\138\ Paragraph (c)(6) of the proposed rule 
would preserve this exemption, but reduce from four to two the number 
of criteria that a foreign fund would be required to meet. Under the 
proposed rule, the investment company must be listed on a foreign 
exchange or authorized for sale to the public by a foreign regulatory 
authority, and no person owning more than 5% of the shares of the 
investment company may be a restricted person.\139\ However, as the 
NASD clarified in Amendment No. 5, a foreign investment company that 
failed to meet one or both of the criteria for the exemption in 
paragraph (c)(6) might still qualify for the de minimis exemption in 
paragraph (c)(4).
---------------------------------------------------------------------------

    \137\ See NASD IM-2110-1(f)(1).
    \138\ See NASD IM-2110-1(l)(6).
    \139\ The NASD believes that condition (1) in the 
Interpretation--the 100-investor requirement--addresses the same 
concerns about concentration of ownership as condition (4). 
Therefore, the NASD has decided to eliminate the 100-investor 
requirement. In addition, the NASD believes that condition (3)--the 
limitation on the size of the purchase in relation to the size of 
the investment company--is unnecessary and potentially burdensome 
for members to calculate. The NASD has stated, moreover, that for 
very large funds the limitation is meaningless, inasmuch as 5% of 
their total assets would often exceed the size of the entire IPO. 
Therefore, the NASD has decided to eliminate condition (3).
---------------------------------------------------------------------------

    One commenter \140\ suggested exempting any foreign investment 
company that is traded on a ``designated offshore securities market,'' 
as defined in Rule 902(b) under the Securities Act.\141\ The NASD 
believes that such an exemption would be too broad and that the 
definition in Rule 902(b) is not related to the concerns underlying the 
proposed rule. Moreover, although noting that qualifying as a 
``designated offshore securities market'' requires oversight by a 
governmental or self-regulatory body, the NASD is not confident that 
such regulation would prevent restricted persons from using foreign 
investment companies to circumvent the proposed rule. The NASD believes 
that, because it is difficult to compare foreign investment company 
laws to those in the United States, particularly as they relate to the 
purposes of the proposed rule, it is necessary to impose specific 
conditions on foreign investment companies to qualify for a general 
exemption.
---------------------------------------------------------------------------

    \140\ See MSDW.
    \141\ 17 CFR 230.902(b).
---------------------------------------------------------------------------

    In a second letter, the same commenter reiterated its 
recommendation that the proposed rule exempt foreign investment 
companies that are traded on a ``designated offshore securities 
market'' because managers of foreign investment companies might be 
unable to determine whether any 5%

[[Page 62138]]

shareholder is a restricted person due to foreign privacy laws 
preventing them from obtaining the necessary ownership 
information.\142\ Similarly, two other commenters suggested that the 
NASD eliminate the second requirement of the exemption--that no person 
owning more than 5% of the foreign investment company be a restricted 
person `` because of the difficulties in ascertaining the ownership of 
a foreign investment company.\143\ Despite these concerns, the NASD 
believes that this requirement is necessary to prevent purchases of new 
issues by funds in which restricted persons have concentrated ownership 
interests.
    e. ERISA Plans. Paragraph (c)(7) would provide a general exemption 
for benefit plans established under the Employee Retirement Income 
Security Act (``ERISA'') that are qualified under Section 401(a) of the 
Internal Revenue Code.\144\ However, this exemption would not cover 
ERISA plans sponsored solely by a broker-dealer. The exemption as 
originally proposed also would have prevented an affiliate of a broker-
dealer from using this exemption. Several commenters objected to this 
provision, arguing that they were unaware of any perceived or actual 
abuses to cause the NASD to narrow the exemption from the 
Interpretation.\145\ The NASD agreed, and the final proposal would 
allow an ERISA plan sponsored by a broker-dealer affiliate--although 
not a plan sponsored by the broker-dealer itself--to benefit from the 
exemption.
---------------------------------------------------------------------------

    \142\ See MSDW 2.
    \143\ See Colish; Sullivan.
    \144\ 29 U.S.C. 401(a).
    \145\ See MSDW; SIA; Sullivan.
---------------------------------------------------------------------------

    f. State and Municipal Government Benefits Plans. Paragraph (c)(8) 
would provide a general exemption for a state or municipal government 
plan that is subject to state and/or municipal regulation.
    g. Tax-Exempt Charitable Organizations. Paragraph (c)(9) would 
exempt sales of new issues to, and purchases by, tax exempt charities 
organized under Section 501(c)(3) of the Internal Revenue Code.\146\ 
The NASD believes that new issue sales to charitable organizations are 
consistent with the purposes of the rule and foster a bona fide public 
distribution.
---------------------------------------------------------------------------

    \146\ 29 U.S.C. 501(c)(3).
---------------------------------------------------------------------------

    h. Church Plans. Paragraph (c)(10) would provide a general 
exemption for church plans described in Section 414(e) of the Internal 
Revenue Code.\147\ As originally proposed, the rule included an 
exemption only for ERISA plans. One commenter stated that the same 
rationale for exempting ERISA plans also applied to church plans, and 
recommended that the NASD exempt such plans as well.\148\ The NASD 
agreed and added the new paragraph (c)(10) in Amendment No. 3.
---------------------------------------------------------------------------

    \147\ 29 U.S.C. 414(e).
    \148\ See CII.
---------------------------------------------------------------------------

    i. Foreign Employee Benefits Plans. The same commenter also 
recommended that the proposed rule include a general exemption for 
foreign governmental and foreign non-governmental employee benefits 
plans.\149\ The commenter argued that foreign plan participants are not 
in a position to influence the investment decisions of the plan sponsor 
even if they might otherwise be restricted persons. The commenter 
further noted that a number of foreign benefits plans are sponsored by 
foreign subsidiaries of U.S. corporations, and that a restriction on 
foreign plans could have illogical results: A U.S.-based employee of a 
foreign firm might participate in a U.S. plan that is permitted to buy 
new issues, while an American co-worker based in a foreign country who 
invests in a foreign plan would not be allowed to participate through 
the foreign plan in new issue allocations.
---------------------------------------------------------------------------

    \149\ See id.
---------------------------------------------------------------------------

    In Amendment No. 3, the NASD stated that it had declined to adopt a 
blanket exemption for foreign employee benefit plans. Since that time, 
however, the NASD has granted an exemption from the Interpretation to a 
pension fund operated by the province of Qu[eacute]bec. The NASD stated 
that it granted this exemption on the basis of the large number of plan 
participants and the small notional pro rata allocation of each of the 
fund's assets to any individual participant. Nevertheless, the NASD 
does not believe that a blanket exemption for foreign plans would be 
appropriate. In some cases, the NASD observed, foreign laws may permit 
benefit plans to allocate new issues only to certain plan participants, 
may provide for unequal distribution of profits from new issues, or may 
benefit a very narrow category of restricted person. The NASD stated 
that it also may be possible for a foreign benefits plan to be 
constructed as a means to circumvent the rule; for example, a shell 
corporation that consists entirely or principally of restricted persons 
could establish a benefits plan that would purchase new issues. The 
NASD stated in Amendment No. 4 that, as its staff becomes more familiar 
with various types of foreign investment plans, it may consider issuing 
additional guidance in this area.
    Finally, the NASD has stated that a foreign employee benefits plan 
that did not receive a specific exemption from the NASD staff could 
purchase new issues if it qualified for the de minimis exemption in 
paragraph (c)(4).
5. Issuer-Directed Securities
    The Interpretation provides that employees and directors of an 
issuer, a parent of an issuer, a subsidiary of an issuer, or any other 
entity that controls or is controlled by an issuer, may purchase 
securities that are part of a public offering that are specifically 
directed by the issuer to such persons.\150\ The Interpretation extends 
this exemption to potential employees and directors who would result 
from an intended merger, acquisition, or other business combination. 
The Interpretation requires, however, that the securities acquired 
pursuant to the exemption be subject to a three-month lock-up period if 
a bona fide independent market for such securities does not exist.
---------------------------------------------------------------------------

    \150\ See NASD IM-2110-1(d).
---------------------------------------------------------------------------

    Under its original proposal, the NASD would have revised the 
provisions on issuer-directed securities in to two principal ways. 
First, the scope of the exemption would have been extended to include 
employees and directors of sister companies. The NASD stated that such 
action would be consistent with the purposes of the rule and the 
existing exemption, as well as decisions of the NASD staff rendered 
pursuant to its exemptive authority. Second, the three-month lock-up 
period in the Interpretation would have been eliminated. The NASD 
believes that issuers should be free to set the conditions for sales of 
their own securities to their employees (or employees of affiliated 
companies) even if such employees are otherwise restricted persons. 
While an issuer may decide to impose a lock-up period, the NASD does 
not believe that such a period should be mandated by the proposed rule. 
The NASD has stated that eliminating the lock-up period would relieve 
members of having to investigate the status of employees and directors 
of the issuer and its affiliated companies, which was previously 
necessary solely to comply with the lock-up provision. This approach 
would allow all employees and directors of the issuer and affiliated 
companies to purchase securities of the issuer on equal terms. By 
contrast, under the Interpretation, an employee of an issuer who has a 
spouse in the securities industry must lock up a purchase of a

[[Page 62139]]

hot issue even though other employees are not required to do so.
    In Amendment No. 2, the NASD provided additional detail to the 
proposed exemption for issuer-directed securities. Pursuant to 
Amendment No. 2, securities that the issuer specifically directed to 
persons such as employees, directors, and their friends and family 
would be exempt, even if such persons were restricted persons. The NASD 
stated that in recent years it has been presented with situations in 
which, for example, an employee of an issuer wanted to direct shares of 
a new issue to his or her parent, but was unable to do so because the 
parent was a restricted person (and not an employee or director of the 
issuer). The proposed rule, as revised by Amendment No. 2, would allow 
directed shares to be sold to the parent in this case.
    One commenter recommended that all non-underwritten securities 
directed by the issuer should be exempt from the proposed rule.\151\ 
The NASD believes, however, that a person who is otherwise restricted 
should not be allowed to purchase new issues pursuant to the issuer-
directed security exemption unless such person (or a member of his or 
her immediate family) is an employee or director of the issuer, the 
issuer's parent, or a subsidiary of the issuer or the issuer's parent. 
In the NASD's view, a general exemption for all issuer-directed or all 
non-underwritten securities would be readily susceptible to abuse. The 
NASD also believes that the issuer-directed exemption should apply only 
when shares are in fact directed by the issuer; if a member firm asks 
or otherwise suggests that an issuer direct securities to a restricted 
person, the NASD does not believe that such securities should be exempt 
from the proposed rule. The NASD has stated that it would continue its 
practice of holding a managing underwriter responsible for ensuring 
that all securities in the public offering be distributed in accordance 
with the proposed rule.
---------------------------------------------------------------------------

    \151\ See MSDW.
---------------------------------------------------------------------------

    Paragraph (d)(1) of the proposed rule would provide that, for 
purposes of the issuer-directed security exemption, a parent/subsidiary 
relationship is established if the parent had the right to vote, sell, 
or direct 50% or more of a class of voting security of the subsidiary. 
One commenter argued that a 10% ownership standard should apply 
instead.\152\ The NASD believes that it is not uncommon for a member, 
through its merchant banking activities, to make venture capital 
investments that constitute 10% or more of an issuer's capital. The 
NASD replied that, if it accepted this comment, all employees and 
directors of the member in such cases would be able to purchase the new 
issue. The NASD does not believe that exempting broker-dealer personnel 
by virtue of the broker-dealer's venture capital investments is 
consistent with the purposes of the proposed rule or the exemption for 
issuer-directed securities.\153\
---------------------------------------------------------------------------

    \152\ See Sullivan. But see MSDW (recommending a 50% threshold).
    \153\ The NASD notes that the proposed rule contains separate 
provisions that would permit venture capital investors to purchase 
new issues to avoid dilution in a public offering. See paragraph (e) 
of proposed NASD Rule 2790. The NASD believes that going beyond 
these protections for venture capital investors would be 
inconsistent with the purposes of the rule.
---------------------------------------------------------------------------

    One commenter \154\ suggested that the scope of permissible 
purchasers under the issuer-directed exemption should be amended to 
conform with the permitted categories of offerees set forth in Rule 701 
under the Securities Act of 1933.\155\ The NASD determined not to act 
on this suggestion because it believes that the commenter's approach 
would be more difficult for members to implement.
---------------------------------------------------------------------------

    \154\ See Sidley.
    \155\ 17 CFR 230.701 (providing an exemption from the 
registration provisions of the Securities Act for offers and sales 
of securities under certain compensatory benefit plans or written 
agreements relating to compensation).
---------------------------------------------------------------------------

    Paragraph (d)(2) of the proposed rule would provide that the 
restrictions on the purchase and sale of new issues would not apply to 
securities that are part of a program sponsored by the issuer, or an 
affiliate of the issuer, that meets four criteria: (1) The program has 
at least 10,000 participants; (2) every participant is offered an 
opportunity to purchase an equivalent number of shares, or will receive 
a specified number of shares under a predetermined formula applied 
uniformly across all participants; (3) if not all participants receive 
shares under the program, the selection of the eligible participants is 
based on a random or other non-discretionary allocation method; and (4) 
the class of participants does not contain a disproportionate number of 
restricted persons. As proposed in Amendment No. 2, paragraph (d)(2) 
would have had a fifth criterion: that sales of the issuer-directed 
security not be made to participants who are managing underwriters or 
broker-dealers (or employees thereof) that are administering the 
program. One commenter welcomed an exemption for issuer-directed 
securities but argued that a requirement to investigate the facts about 
each of 10,000 participants to prevent sales to persons listed in the 
fifth criterion would vitiate the relief granted.\156\ The commenter 
added that relying on the large number of offerees as a basis for 
exemption would be consistent with the exemption for publicly traded 
entities, which is not dependent on any basis other than that a large 
number of persons would share the benefits of the new issue. The NASD 
agreed with the commenter and eliminated the fifth criterion.\157\
---------------------------------------------------------------------------

    \156\ See Fried 2.
    \157\ This commenter also noted that the exemption for issuer-
directed securities, as proposed in Amendment No. 2, did not 
expressly permit an issuer to allocate its securities to employees 
and directors of sister companies, as described in the commentary to 
the proposed rule change. See Fried 2. The NASD has stated that this 
was an inadvertent omission and corrected the proposed rule text 
accordingly.
---------------------------------------------------------------------------

    Another commenter \158\ sought guidance on the meaning of the 
fourth criterion, which requires that ``the class of participants does 
not contain a disproportionate number of restricted persons as compared 
to the investing public.'' In Amendment No. 5, the NASD stated that 
this condition is designed to ensure that a program is not directed to 
a group composed to a significant extent of restricted persons. The 
NASD also stated that, if an issuer has any questions about whether a 
specific program would qualify for this condition, the issuer should 
contact the NASD's Office of General Counsel for interpretative 
guidance.
---------------------------------------------------------------------------

    \158\ See Testa 2.
---------------------------------------------------------------------------

6. Anti-Dilution Provisions
    Paragraph (e) of the proposed rule would provide that the rule's 
basic prohibitions do not apply to an account in which a restricted 
person has a beneficial interest, if the account meets each of four 
criteria: (1) The account has held an equity ownership interest in the 
issuer for a period of one year prior to the effective date of the 
offering; (2) the sale of the new issue to the account does not 
increase the account's percentage equity ownership in the issuer above 
the ownership level as of three months prior to the filing of the 
registration statement in connection with the offering; (3) the sale of 
the new issue to the account does not include any special terms; and 
(4) the new issue purchased pursuant to this exemption is not sold or 
transferred for three months following the effective date of the 
offering. Paragraph (e) would supersede a similar provision in the 
Interpretation \159\ and modify it slightly to allow an equity holder, 
for purposes of meeting the requirement that the interest in the issuer 
be held for one year, to count the period in which the

[[Page 62140]]

holder had an interest in another company purchased by the issuer. The 
NASD has stated that this amendment is consistent with an NASD staff 
interpretative position.
---------------------------------------------------------------------------

    \159\ See NASD IM-2110-1(h).
---------------------------------------------------------------------------

    One commenter questioned whether the NASD intended the anti-
dilution provisions to apply only to natural persons, arguing that 
legal persons that have a prior equity ownership interest in an issuer 
also should be able to avail themselves of this exemption.\160\ The 
NASD stated that the failure to extend the anti-dilution provisions to 
legal persons was inadvertent and revised the proposal 
accordingly.\161\
---------------------------------------------------------------------------

    \160\ See Testa.
    \161\ Subsequently, the same commenter noted several drafting 
errors with respect to the anti-dilution provisions as they appeared 
in Amendment No. 2. See Testa 2. The NASD subsequently made the 
necessary corrections.
---------------------------------------------------------------------------

7. Stand-By Purchasers and Under-Subscribed Offerings
    The NASD notes that the decision to apply the proposed rule to all 
new issues, not merely to hot issues, may create difficulties for 
offerings for which there is insufficient investor demand. Under the 
Interpretation, such offerings do not typically open at a premium and 
thus are not hot issues. With a rule that applies to all new issues, 
however, the rule should address circumstances in which purchases by 
restricted persons are necessary for the successful completion of an 
offering. Accordingly, paragraph (g) would provide that nothing in the 
rule would prohibit an underwriter, pursuant to an underwriting 
agreement, from placing a portion of a public offering in its 
investment account if it were unable to sell that portion to the 
public. In addition, paragraph (f) would provide that the prohibitions 
on the purchase and sale of new issues do not apply to purchases and 
sales made pursuant to a stand-by agreement that meets the following 
four conditions: (1) The stand-by agreement is disclosed in the 
prospectus; (2) the stand-by agreement is the subject of a formal 
written agreement; (3) the managing underwriter represents in writing 
that it is unable to find any other purchasers for the securities; and 
(4) securities sold pursuant to the stand-by agreement are subject to a 
three-month lock-up period. Paragraph (f) incorporates the existing 
exemption for stand-by purchases and sales found in the 
Interpretation.\162\
---------------------------------------------------------------------------

    \162\ See NASD IM-2110-1(e).
---------------------------------------------------------------------------

    Two commenters, although supporting the exemption relating to 
under-subscribed offerings, believed that it should be extended to 
permit an underwriter, in lieu of placing the securities in its own 
investment account, to be able to sell such securities to one or more 
restricted persons.\163\ One of these commenters stated that, if the 
objective of the proposed rule were to ensure a broad public 
distribution of securities for which there is significant demand, no 
regulatory objective would be furthered by restricting sales of 
offerings for which there is insufficient demand.\164\ The NASD 
disagreed with these comments and stated that the provision was 
designed to ensure that the rule is consistent with an underwriter's 
contractual obligations to the issuer. The NASD believes that allowing 
an underwriter to sell a new issue to a restricted person if the issue 
turned ``cold'' would, in effect, reinstate the ``hot issue'' concept 
that the NASD is seeking to replace.
---------------------------------------------------------------------------

    \163\ See MSDW 2; Sullivan 2.
    \164\ See MSDW 2. This commenter also suggested imposing minimum 
capital contribution requirements for the stand-by provisions and 
extending the lock-up requirements from three months to one year. 
The NASD has stated that it does not believe that these additional 
requirements are necessary.
---------------------------------------------------------------------------

    One commenter \165\ asked for clarification that the proposed rule 
would not affect stabilization activities conducted under the 
Commission's Regulation M.\166\ The NASD stated in Amendment No. 3 that 
the proposed rule would govern activities in connection with the 
distribution of new issues and would not have any effect on an 
underwriter's decision to engage in market stabilization activities, 
which occur after the security has commenced trading in the secondary 
market.
---------------------------------------------------------------------------

    \165\ See Testa 2.
    \166\ 17 CFR 242.100 et seq.
---------------------------------------------------------------------------

8. Exemptive Relief
    The Interpretation contains a provision that allows the NASD staff 
to grant an exemption from any or all of the provisions of the 
Interpretation, if it determines that such exemption is consistent with 
the purposes of the Interpretation, the protection of investors, and 
the public interest.\167\ Paragraph (h) would reincorporate the 
exemptive authority of the NASD staff into the new rule.
---------------------------------------------------------------------------

    \167\ See NASD IM-2110-1(a)(5).
---------------------------------------------------------------------------

9. Definitions of Key Terms
    a. Beneficial Interest. Paragraph (i)(1) of the proposed rule would 
define the term ``beneficial interest'' as any economic interest, such 
as the right to share in gains or losses. Consistent with a previously 
articulated NASD staff position,\168\ the definition also would provide 
that the receipt of a management fee or performance-based fee for 
operating a collective investment account, or other fees for acting in 
a fiduciary capacity, would not be considered a beneficial interest in 
the account.
---------------------------------------------------------------------------

    \168\ See NASD Notice to Members 97-5.
---------------------------------------------------------------------------

    The term beneficial interest was defined in the original proposal 
as ``any ownership or other direct financial interest.'' The NASD 
became aware that members found the reference to ownership, as distinct 
from a financial interest, unclear. The NASD believes that only those 
who profit from an account, rather than those legally own it, are of 
concern to the proposed rule and revised the proposal accordingly.
    One commenter argued that the definition of ``beneficial interest'' 
should specifically exclude management or performance-based fees that 
are deferred for bona fide taxation reasons.\169\ This commenter was 
concerned about the effect that deferred management or performance fees 
might have on a hedge fund manager's interest in a collective 
investment account that he or she managed. Another commenter noted that 
a portfolio manager might receive a management or performance-based fee 
for operating a hedge fund, the amount of which fees may be based on 
income from new issues.\170\ This commenter asked the NASD to clarify 
whether these fees, if deferred for income tax purposes, would be 
deemed to create a beneficial interest in the fund held by the 
portfolio manager.
---------------------------------------------------------------------------

    \169\ See Rosenman.
    \170\ See Sidley 2.
---------------------------------------------------------------------------

    The NASD does not believe that it is appropriate to amend the 
definition of ``beneficial interest'' to expressly exclude performance-
based allocations and deferred performance-based fees. In Amendment No. 
5, the NASD counseled that the initial receipt of the fee would not 
constitute a beneficial interest in the collective investment account, 
because the definition of ``beneficial interest'' excludes ``the 
receipt of a management or performance based fee for operating a 
collective investment account, or other fees for acting in a fiduciary 
capacity.''\171\ The NASD believes, however, that the accumulation of 
these payments, if subsequently invested in the collective investment 
account (as a deferred fee arrangement or otherwise) would constitute a 
beneficial interest in the account. The NASD believes that money 
invested in a collective investment account is part of a person's 
beneficial interest in that account even if the source of the money is 
a deferred fee arrangement. The NASD does not

[[Page 62141]]

believe that a decision to defer recognition of earnings for income tax 
purposes should alter the analysis of whether a person has a beneficial 
interest in a collective investment account.
---------------------------------------------------------------------------

    \171\ See paragraph (i)(1) of proposed NASD Rule 2790.
---------------------------------------------------------------------------

    b. Collective Investment Account. Paragraph (i)(2) would define 
``collective investment account'' as any hedge fund, investment 
partnership, investment corporation, or any other collective investment 
vehicle that is engaged primarily in the purchase and/or sale of 
securities. The original proposal defined ``collective investment 
account'' as any hedge fund, investment partnership, investment 
corporation, or any other collective investment vehicle that manages 
assets of other persons. One commenter pointed out that a hedge fund or 
other investment partnership typically engages in the purchase and sale 
of securities for its proprietary account, and that these entities do 
not necessarily manage the assets of others.\172\ This commenter 
recommended, therefore, that the NASD remove the phrase ``that manages 
the assets of other persons'' from the definition. The NASD agreed and 
revised the proposed definition accordingly.
---------------------------------------------------------------------------

    \172\ See Sidley.
---------------------------------------------------------------------------

C. Transition Period

    Three commenters urged the NASD to allow entities that would be 
subject to the proposed rule a transition period before coming into 
full compliance with it.\173\ The NASD believes that a transition 
period would be reasonable and has proposed a three-month period during 
which members could comply with either the Interpretation or the new 
rule. This three-month period would begin upon the NASD's publication 
of a Notice to Members announcing any Commission final action on the 
proposed rule change. The NASD stated in Amendment No. 5 that it would 
publish this Notice to Members no later than 60 days following a 
Commission approval.
---------------------------------------------------------------------------

    \173\ See Ropes (suggesting 90 days); Schulte (six months); 
Sullivan 2 (90 days).
---------------------------------------------------------------------------

V. Discussion

    After carefully considering the proposal and all the comments 
received, the Commission finds that the proposal, as amended, is 
consistent with the requirements of the Act and the regulations 
thereunder applicable to a national securities association. In 
particular, the Commission believes that the proposal is consistent 
with Sections 15A(b)(6) and 15A(b)(9) of the Act.\174\ Section 
15A(b)(6) requires, among other things, that the rules of a national 
securities association be designed to prevent fraudulent and 
manipulative acts and practices; to promote just and equitable 
principles of trade; to remove impediments to and perfect the mechanism 
of a free and open market and a national market system; and, in 
general, to protect investors and the public interest. Section 
15A(b)(6) also provides that the rules of an association may not be 
designed to permit unfair discrimination between customers, issuers, 
brokers, or dealers. Section 15A(b)(9) provides that the rules of an 
association may not impose any burden on competition not necessary or 
appropriate in furtherance of the purposes of the Act.
---------------------------------------------------------------------------

    \174\ 15 U.S.C. 78o-3(b)(6) and (9).
---------------------------------------------------------------------------

    The Commission finds that the proposal will protect investors and 
is in the public interest. The Commission believes that the proposal is 
a reasonable means of furthering the NASD's stated aims of ensuring 
that: (1) NASD members make a bona fide public offering of securities 
at the public offering price; (2) members do not withhold securities in 
a public offering for their own benefit or use such securities to 
reward certain persons who are in a position to direct future business 
to the member; and (3) industry insiders, including NASD members and 
their associated persons, do not take advantage of their ``insider'' 
position to purchase new issues for their own benefit at the expense of 
public customers.
    The proposal is to a large extent a reorganization of the existing 
provisions of NASD IM-2110-1. The Commission has previously opined on 
many of these provisions and found them to be consistent with the 
Act.\175\ Furthermore, the Commission believes that the proposal 
furthers the purposes of the Act by making the rule easier to 
understand and administer. With respect to provisions of new NASD Rule 
2790 that were not present in the Interpretation, the Commission finds 
that they also are consistent with the Act. The most significant of 
these new provisions are discussed below.
---------------------------------------------------------------------------

    \175\ See, e.g., Securities Exchange Act Release No. 40001 (May 
18, 1998), 63 FR 28535 (May 26, 1998) (SR-NASD-97-95) (approving 
various revisions to NASD IM-2110-1); Securities Exchange Act 
Release No. 35059 (December 7, 1994), 59 FR 64455 (December 14, 
1994) (SR-NASD-94-15) (same).
---------------------------------------------------------------------------

A. Offerings Covered by NASD Rule 2790

    The Commission believes that it is reasonable for the new rule to 
apply to ``new issues'' rather than ``hot issues.'' Under the 
Interpretation, restrictions are not triggered unless an issue becomes 
``hot'' (i.e., it trades at a premium over the offering price). The 
Commission believes that NASD members generally will find it simpler to 
treat all new issues in the same manner. The Commission also believes 
it reasonable to eliminate the cancellation provision; its primary 
rationale no longer exists because all new issues are subject to the 
rule from the moment that they are initially offered to the public, not 
later when they become ``hot.'' Eliminating the cancellation provision 
will enhance compliance with the new rule by encouraging NASD members 
to identify all potential restricted persons prior to a new issue.

B. Restricted Persons

    The Commission believes that the scope of the term ``restricted 
person'' in the new rule is reasonable and consistent with the Act. As 
under the Interpretation, broker-dealers and their associated persons 
will be restricted. The Commission finds that it is consistent with the 
Act for the NASD to restrict its members from purchasing new issues 
from or selling new issues to other broker-dealers. The acquisition by 
such persons of new issues could give the appearance that an initial 
public offering was not in fact truly ``public.'' The Commission also 
believes it is appropriate for the NASD to extend the restriction to 
agents of a broker-dealer who are engaged in the investment banking or 
securities business.
    Under the new rule, as under the Interpretation, ``limited business 
broker-dealers'' (i.e., broker-dealers that are authorized to engage 
only the purchase and sale of investment company/variable contracts 
securities and direct participation program securities) will not be 
considered restricted persons. The Commission believes that this 
provision is consistent with the Act because it exempts only a small 
class of broker-dealers that, due to the nature of their business, are 
unlikely to benefit unfairly from the purchase of a new issue.
    The Commission has carefully considered CBOE's comment letter and 
finds that the NASD's decision not to expand the concept of limited 
business broker-dealers to include CBOE market makers and floor brokers 
(and their associated persons) is reasonable. CBOE argued that 
``options market makers and floor brokers perform specialized, limited 
functions and should not be considered representative of the typical 
broker-dealer population.'' However, the NASD's determination not to 
make additional exemptions for CBOE members and other types of broker-

[[Page 62142]]

dealer is consistent with the new rule's general aim of ensuring that 
public investors rather than securities industry insiders receive the 
benefit of new issues. The Commission also agrees with the NASD that an 
exemption for ``limited business broker-dealers''--based solely on what 
the firm is authorized to do on its Form BD--is more transparent and 
easier to administer than the type of standard for exempted broker-
dealers advocated by CBOE, which would require an analysis of the 
activities actually conducted by the broker-dealer.
    The Commission also believes that the new rule's treatment of joint 
back office broker-dealers is consistent with the Act. Under the new 
rule, a JBO would be able to purchase new issues provided that the 
interests of restricted persons in the JBO do not exceed 10%, although 
associated persons of the JBO will be restricted persons. JBOs are 
hedge funds or hedge fund affiliates that often are active participants 
in the securities markets. The associated persons of JBOs may be in a 
position to direct future business to an NASD member, and the purchases 
by such industry insiders of an IPO could create the appearance that 
the offering was not truly ``public.''
    Under the new rule, restricted person status will extend to any 
immediate family member of a person who is ``directly restricted'' by 
the new rule on account of his or her position in the industry (such as 
an employee of a broker-dealer). The restriction on immediate family 
members also will apply to persons who receive material support from a 
directly restricted person. The Commission believes that these 
provisions are appropriate to prevent evasion of the new rule while not 
unduly extending the rule's restrictions to persons who could not 
reasonably be viewed as an alter ego of a directly restricted person.
    Similarly, the Commission believes that it is appropriate to extend 
restricted person status to owners and affiliates of a broker-dealer. 
In the absence of such a provision, the restriction on the broker-
dealer could easily be evaded. The Commission believes that it is 
reasonable and consistent with the Act for the new rule to assign 
restricted person status to persons listed on Schedules A and B of a 
broker-dealer's Form BD. While Schedule A requires reporting of 
interests of 5% or more in the broker-dealer, the new rule will 
restrict only those persons appearing on Schedule A who hold interests 
of 10% or more. The Commission believes that the 10% threshold for 
ownership interests in a broker-dealer as a criterion for restricted 
person status is appropriate because it is consistent with the 10% de 
minimis threshold established in the rule's general exemptions. 
Moreover, basing restricted person status on a 10% interest reported on 
Schedule A (for direct owners of the broker-dealer) will lessen the 
likelihood that an entity reported on Schedule B (for indirect owners) 
will be deemed a restricted person even if the indirect owner has only 
a small economic interest in the broker-dealer. The Commission believes 
that the ownership classifications employed by the new rule are 
reasonably based, are already understood by NASD members, and will 
facilitate administration of the rule.
    The Commission also believes that the publicly traded entity 
exemption is reasonable and consistent with the Act. The proposed rule 
assumes that a publicly traded entity generally will have wide public 
ownership, thus reducing the likelihood that a large percentage of the 
entity's shareholders are restricted persons who would unfairly benefit 
from the entity's purchase of new issues. The Commission believes that 
this assumption is reasonable in light of the quantitative standards 
that companies must meet to list their securities on a national 
securities exchange or the Nasdaq Stock Market.\176\ Although there may 
be some publicly traded companies of which restricted persons 
nevertheless constitute a significant percentage of the shareholders, 
the Commission believes the general exemption for publicly traded 
entities strikes an appropriate balance between carrying out the 
purposes of the rule and minimizing its administrative burdens.
---------------------------------------------------------------------------

    \176\ See, e.g., NASD Rule 4420(a)-(c) (requiring 1,100,000 
publicly held shares for inclusion on the Nasdaq National Market); 
New York Stock Exchange Listed Company Manual Rule 102.01A 
(requiring 1,100,000 publicly held shares for listing on the NYSE).
---------------------------------------------------------------------------

    The exemption for publicly traded entities will not cover broker-
dealers themselves or affiliates of broker-dealers that are authorized 
to engage in the public offering of new issues (either as a selling 
group member or underwriter). A broker-dealer, although publicly 
traded, is likely to have a higher concentration of restricted persons 
amongst its ownership. Therefore, the Commission believes that it is 
reasonable for the NASD not to afford broker-dealers--or affiliates of 
broker-dealers that sell or underwrite new issues--the benefits of the 
publicly traded entity exemption. In the absence of such a provision, 
significant potential to evade the new rule would exist.
    Finally, the Commission agrees with the NASD that participation in 
an investment club, by itself, should not cause a person to be 
restricted under the new rule, and that the treatment of investment 
clubs and family investment vehicles under the new rule is consistent 
with the Act.

C. Elimination of Conditionally Restricted Person Status and New De 
Minimis Threshold

    The new rule will eliminate ``conditionally restricted person'' 
status and adopt a standard that will render all persons either 
restricted or non-restricted. The Commission agrees with the NASD that, 
in some cases, a person may purchase a hot issue pursuant to the 
Interpretation's ``conditionally restricted person'' exemption even 
when such purchase appears contrary to the principles underlying the 
Interpretation. The Commission believes that the proposed rule change 
will help eliminate such cases, and that the definition of ``restricted 
person'' in the new rule will be more transparent and easier to 
administer.
    Although all persons under the rule will be either restricted or 
non-restricted, the NASD has acknowledged that accommodation must be 
made for some restricted person participation in collective investment 
accounts. The alternative--prohibiting all new issue purchases by a 
collective investment account if even a single restricted person is a 
participant--would be unrealistic. The NASD has proposed, therefore, a 
10% de minimis limit for restricted person participation in a 
collective investment account. The Commission agrees with the NASD that 
the purposes of the rule generally are not implicated if a member sells 
a new issue to a collective investment account in which restricted 
persons have only a small interest. The investors who are non-
restricted persons will still receive the majority of the new issue's 
proceeds, and the notional portion of such proceeds accruing to the 
restricted persons would be sufficiently small as to provide little 
incentive for them to direct future business to the member as 
compensation. The Commission, therefore, finds that that the 10% 
threshold proposed by the NASD is reasonable and consistent with the 
Act.
    Three commenters criticized the NASD's decision to consider hedge 
fund managers as restricted persons in all cases, even with respect to 
the funds for which they act as portfolio manager.\177\ After carefully 
considering these comments, the Commission finds that they do not raise 
any issue that

[[Page 62143]]

precludes approval of the NASD's proposal. The Commission acknowledges 
that it is reasonable for hedge fund investors to seek to align the 
interests of hedge fund managers with their own. Contrary to the view 
taken by these commenters, however, the new rule will not significantly 
impede that effort. NASD Rule 2790 does not prohibit a hedge fund 
manager from holding an interest of greater than 10% in a hedge fund 
that he or she manages because of the availability of the carve-out 
procedures. These carve-out procedures, which exist under the 
Interpretation and will be carried over in the new rule, allow the fund 
to segregate the interests of restricted from non-restricted persons 
and to direct the proceeds of the fund's investments accordingly. Thus, 
the rule merely prohibits such a fund from purchasing new issues in a 
manner that allows the hedge fund manager (and other restricted 
persons) to receive from such purchases an indirect, pro rata benefit 
that exceeds the lesser of 10% or their actual percentage interest in 
the fund. NASD Rule 2790 places no restrictions on the ability of a 
hedge fund--whatever its ownership structure--to purchase any other 
type of asset. The investors will still be able to align the interests 
of hedge fund managers with their own with respect to every type of 
investment opportunity other than new issues. The Commission believes 
that the potential adverse consequences of preventing the alignment of 
investor and manager interests with respect to this class of investment 
are minimal.
---------------------------------------------------------------------------

    \177\ See MFA 3; Sidley 2; Willkie 3; Willkie 4. See also infra 
notes 35-36 and accompanying text.
---------------------------------------------------------------------------

    By contrast, allowing hedge fund managers unlimited participation 
in the benefits of new issues through the funds that they manage would 
be much more likely to compromise investor protection and the public 
interest. A portfolio manager is in a position to direct business to a 
member and might be willing to do so in return for having received new 
issues. The larger a hedge fund manager's interest in the fund, the 
greater the manager's notional pro rata benefit from any particular 
investment made by the fund and the greater the incentive for the 
member to sell new issues to that fund in hopes of receiving future 
business. Furthermore, allowing a portfolio manager to have unlimited 
participation in a hedge fund that purchases new issues would further 
the appearance that an industry insider was receiving a 
disproportionate benefit from new issues. The Commission believes that 
the proposed rule furthers the appearance, as well as the reality, of 
fairness in the IPO process and thus will strengthen investor 
confidence in the securities markets.
    The Commission concludes that deeming hedge fund managers and other 
portfolio managers as restricted persons, subject to the 10% de minimis 
exemption for collective investment accounts, represents a reasonable 
balance between the principles underlying the new rule and 
consideration of the structure of the hedge fund industry.

D. Other Provisions

    The Commission finds that the preconditions for sale provisions 
strike a reasonable balance between, on the one hand, ensuring that 
accounts to which NASD members sell new issues are in fact eligible 
and, on the other hand, minimizing the administrative burdens on both 
members and their customers. Specifically, the Commission believes that 
12 months is a reasonable time frame within which members should update 
eligibility information. The Commission also believes that the NASD's 
proposed use of negative consent procedures is reasonable and 
consistent with the Act.
    With respect to the anti-dilution provisions of the proposed rule, 
the Commission believes that the acquisition of new issues by 
restricted persons for the purpose of preventing their existing 
interests from being diluted does not run counter to either the 
purposes of the rule or the provisions of the Act. The Commission also 
believes that the holding period requirements of the anti-dilution 
provisions are a reasonable means to prevent abuse of these provisions.
    The Commission finds that the provisions of the new rule relating 
to stand-by purchasers and under-subscribed offerings are consistent 
with the Act. These provisions are a reasonable means to facilitate the 
distribution of new issues and, although allowing restricted persons to 
hold beneficial interests in new issues in some circumstances, do not 
run counter to the purposes of the new rule.
    Finally, the Commission believes that it is reasonable for 
paragraph (h) of new NASD Rule 2790 to allow NASD staff to exempt any 
person, security, or transaction from the rule, to the extent that such 
exemption would be consistent with the purposes of the rule, the 
protection of investors, and the public interest. However, the 
Commission reminds the NASD that exemptions of general applicability 
that would impose substantive binding requirements should be done 
through the notice-and-comment rulemaking process prescribed by Rule 
19b-4 under the Act.\178\ The only circumstance in which exemptive 
authority of the NASD should be exercised without employing this 
process is where the circumstances are truly unique. In most instances, 
the circumstances involved are so common that the same exemption would 
in fact be granted to all other similarly situated persons and thus 
must be handled through the notice-and-comment rulemaking process.\179\
---------------------------------------------------------------------------

    \178\ 17 CFR 240.19b-4.
    \179\ See letter to T. Grant Callery, NASD, from Annette L. 
Nazareth, Division of Market Regulation, SEC, dated March 27, 2003.
---------------------------------------------------------------------------

E. Effective Date

    The Commission believes that it is reasonable and consistent with 
the Act to allow NASD members the transition period specified above 
\180\ in which to adjust their compliance programs to accommodate the 
new rule. The Commission notes that it has approved similar transition 
periods in previous cases.\181\ Accordingly, the proposed rule change 
will take effect upon the issuance by the NASD of a Notice to Members 
discussing the new rule, and the NASD has represented that it will 
publish this Notice to Members no later than 60 days following 
Commission approval. NASD members may comply with either the 
Interpretation or new NASD Rule 2790 for three months following 
publication of the Notice to Members.
---------------------------------------------------------------------------

    \180\ See supra note and accompanying text.
    \181\ See, e.g., Securities Exchange Act Release No. 44499 (June 
29, 2001), 66 FR 35819, 35822 (July 9, 2001) (SR-NASD-2001-14) 
(allowing Nasdaq issuers a short period of time to comply with 
either the old or newly approved listing standards).
---------------------------------------------------------------------------

F. Accelerated Approval

    Pursuant to Section 19(b)(2) of the Act,\182\ the Commission finds 
good cause for approving the proposal, as revised by Amendment No. 5, 
prior to the thirtieth day after the date of publication of notice of 
the amended proposal in the Federal Register. The Commission believes 
that Amendment No. 5 does not materially alter the operation of the 
rule and is intended only to respond to comments and to make certain 
technical corrections pointed out by certain of the commenters. 
Accordingly, the Commission is accelerating approval of the proposal, 
as amended.
---------------------------------------------------------------------------

    \182\ 15 U.S.C. 78s(b)(2).
---------------------------------------------------------------------------

G. Impact on Efficiency, Competition, and Capital Formation

    In approving this proposal, the Commission has considered its 
impact on efficiency, competition, and capital

[[Page 62144]]

formation.\183\ The Commission believes that the proposed rule change 
will further these aims by helping to ensure public confidence in the 
IPO process and, thereby, encouraging investment in new issues. The 
Commission also believes that the proposal will enhance efficiency, 
competition, and capital formation by streamlining the Interpretation, 
making it simpler to administer, and reducing the compliance costs of 
affected persons.
---------------------------------------------------------------------------

    \183\ See 15 U.S.C. 78c(f).
---------------------------------------------------------------------------

H. Additional Rulemaking Related to IPO Distribution

    In a separate filing (SR-NASD-2003-140), the NASD has addressed 
other issues relating to the IPO distribution process. Specifically, 
the NASD in SR-NASD-2003-140 is proposing to prohibit ``quid pro quo 
allocations'' (i.e., offering or threatening to withhold allocations of 
IPO shares as consideration or inducement for the receipt of 
compensation that is excessive in relation to the services provided by 
an NASD member) and ``spinning'' (i.e., allocating IPO shares to 
officers or directors of a company in hopes of winning future 
investment banking business from that company). In approving this 
filing (SR-NASD-99-60), the Commission is making no findings and 
expressing no opinion on the proposals set forth in SR-NASD-2003-140.

VI. Amendment No. 5

    Below are the provisions of proposed NASD Rule 2790 that were 
changed by Amendment No. 5. The base text is that proposed in Amendment 
No. 4. Text added by Amendment No. 5 is italicized; deleted text is in 
brackets.
* * * * *
Rule 2790. Restrictions on the Purchase and Sale of Initial Equity 
Public Offerings
(a) General Prohibitions
    (1) A member or a person associated with a member may not sell, or 
cause to be sold, a new issue to any account in which a restricted 
person has a beneficial interest, except as otherwise permitted herein.
    (2) A member or a person associated with a member may not purchase 
a new issue in any account in which such member or person associated 
with a member has a beneficial interest, except as otherwise permitted 
herein.
    (3) A member may not continue to hold new issues acquired by the 
member as an underwriter, selling group member, or otherwise, except as 
otherwise permitted herein.
    (4) Nothing in this paragraph (a) shall prohibit:
    (A) sales or purchases from one member of the selling group to 
another member of the selling group that are incidental to the 
distribution of a new issue to a non-restricted person at the public 
offering price; [or]
    (B) sales or purchases by a broker/dealer of a new issue at the 
public offering price as part of an accommodation to a non-restricted 
person customer of the broker/dealer; or
    (C) purchases by a broker/dealer (or owner of a broker/dealer), 
organized as an investment partnership, of a new issue at the public 
offering price, provided such purchases are credited to the capital 
accounts of its partners in accordance with paragraph (c)(4).
(b) Preconditions for Sale
    Before selling a new issue to any account, a member must in good 
faith have obtained within the twelve months prior to such sale, a 
representation from:
    (1) Beneficial Owners
the account holder(s), or a person authorized to represent the 
beneficial owners of the account, that the account is eligible to 
purchase new issues in compliance with this rule; or
    (2) Conduits
a bank, foreign bank, broker/dealer, or investment adviser, or other 
conduit that all purchases of new issues are in compliance with this 
rule.
    A member may not rely upon any representation that it believes, or 
has reason to believe, is inaccurate. A member shall maintain a copy of 
all records and information relating to whether an account is eligible 
to purchase new issues in its files for at least three years following 
the member's last sale of a new issue to that account.
(c) General Exemptions
    The general prohibitions in paragraph (a) of this rule shall not 
apply to sales to and purchases by the following accounts or persons, 
whether directly or through accounts in which such persons have a 
beneficial interest:
    (1) An investment company registered under the Investment Company 
Act of 1940;
    (2) A common trust fund or similar fund as described in Section 
3(a)(12)(A)(iii) of the Act, provided that:
    (A) The fund has investments from 1,000 or more accounts; and
    (B) The fund does not limit beneficial interests in the fund 
principally to trust accounts of restricted persons;
    (3) An insurance company general, separate or investment account, 
provided that:
    (A) The account [has investments from] is funded by premiums from 
1,000 or more policyholders, or, if a general account, the insurance 
company has 1,000 or more policyholders; and
    (B) The insurance company does not limit [beneficial interests in] 
the [account] policyholders whose premiums are used to fund the account 
principally to restricted persons, or, if a general account, the 
insurance company does not limit its policyholders principally to 
restricted persons;
    (4) An account [or joint back office broker/dealer (``JBO'') ]if 
the beneficial interests of restricted persons do not exceed in the 
aggregate 10% of such account[ or JBO];
    (5) A publicly traded entity (other than a broker/dealer or an 
affiliate of a broker/dealer where such broker/dealer is authorized to 
engage in the public offering of new issues either as a selling group 
member or underwriter) that:
    (A) Is listed on a national securities exchange;
    (B) Is traded on the Nasdaq National Market; or
    (C) Is a foreign issuer whose securities meet the quantitative 
designation criteria for listing on a national securities exchange or 
trading on the Nasdaq National Market;
    (6) An investment company organized under the laws of a foreign 
jurisdiction, provided that:
    (A) The investment company is listed on a foreign exchange or 
authorized for sale to the public by a foreign regulatory authority; 
and
    (B) No person owning more than 5% of the shares of the investment 
company is a restricted person;
    (7) An Employee Retirement Income Security Act benefits plan that 
is qualified under Section 401(a) of the Internal Revenue Code, 
provided that such plan is not sponsored solely by a broker/dealer;
    (8) A state or municipal government benefits plan that is subject 
to state and/or municipal regulation;
    (9) A tax exempt charitable organization under Section 501(c)(3) of 
the Internal Revenue Code; or
    (10) A church plan under Section 414(e) of the Internal Revenue 
Code.
(d) Issuer-Directed Securities
    The prohibitions on the purchase and sale of new issues in this 
rule shall not apply to securities that:
    (1) Are specifically directed by the issuer to persons that are 
restricted under the rule; provided, however, that securities directed 
by an issuer may not be sold to or purchased by an account in which any 
restricted person specified in subparagraphs (i)(10[1])(B) or 
(i)(10[1])(C) of this rule has a beneficial interest, unless such 
person, or a

[[Page 62145]]

member of his or her immediate family, is an employee or director of 
the issuer, the issuer's parent, or a subsidiary of the issuer or the 
issuer's parent. Also, for purposes of this paragraph (d)(1) only, a 
parent/subsidiary relationship is established if the parent has the 
right to vote 50% or more of a class of voting security of the 
subsidiary, or has the power to sell or direct 50% or more of a class 
of voting security of the subsidiary;
    (2) Are part of a program sponsored by the issuer or an affiliate 
of the issuer that meets the following criteria:
    (a) The opportunity to purchase a new issue under the program is 
offered to at least 10,000 participants;
    (b) Every participant is offered an opportunity to purchase an 
equivalent number of shares, or will receive a specified number of 
shares under a predetermined formula applied uniformly across all 
participants;
    (c) If not all participants receive shares under the program, the 
selection of the participants eligible to purchase shares is based upon 
a random or other non-discretionary allocation method; and
    (d) The class of participants does not contain a disproportionate 
number of restricted persons as compared to the investing public 
generally; or
    (3) Are directed to eligible purchasers who are otherwise 
restricted under the rule as part of a conversion offering in 
accordance with the standards of the governmental agency or 
instrumentality having authority to regulate such conversion offering.
(e) Anti-Dilution Provisions
    The prohibitions on the purchase and sale of new issues in this 
rule shall not apply to an account in which a restricted person has a 
beneficial interest that meets the following conditions:
    (1) The account has held an equity ownership interest in the 
issuer, or a company that has been acquired by the issuer in the past 
year, for a period of one year prior to the effective date of the 
offering;
    (2) The sale of the new issue to the account shall not increase the 
account's percentage equity ownership in the issuer above the ownership 
level as of three months prior to the filing of the registration 
statement in connection with the offering;
    (3) The sale of the new issue to the account shall not include any 
special terms; and
    (4) The new issue purchased pursuant to this paragraph (e) shall 
not be sold, transferred, assigned, pledged or hypothecated for a 
period of three months following the effective date of the offering.
(f) Stand-By Purchasers
    The prohibitions on the purchase and sale of new issues in this 
rule shall not apply to the purchase and sale of securities pursuant to 
a stand-by agreement that meets the following conditions:
    (1) The stand-by agreement is disclosed in the prospectus;
    (2) The stand-by agreement is the subject of a formal written 
agreement;
    (3) The managing underwriter(s) represents in writing that it was 
unable to find any other purchasers for the securities; and
    (4) The securities sold pursuant to the stand-by agreement shall 
not be sold, transferred, assigned, pledged or hypothecated for a 
period of three months following the effective date of the offering.
(g) Under-Subscribed Offerings
    Nothing in this rule shall prohibit an underwriter, pursuant to an 
underwriting agreement, from placing a portion of a public offering in 
its investment account when it is unable to sell that portion to the 
public.
(h) Exemptive Relief
    Pursuant to the Rule 9600 series, the staff, for good cause shown 
after taking into consideration all relevant factors, may conditionally 
or unconditionally exempt any person, security or transaction (or any 
class or classes of persons, securities or transactions) from this rule 
to the extent that such exemption is consistent with the purposes of 
the rule, the protection of investors, and the public interest.
(i) Definitions
    (1) ``Beneficial interest'' means any economic interest, such as 
the right to share in gains or losses. The receipt of a management or 
performance based fee for operating a collective investment account, or 
other fees for acting in a fiduciary capacity, shall not be considered 
a beneficial interest in the account.
    (2) ``Collective investment account'' means any hedge fund, 
investment partnership, investment corporation, or any other collective 
investment vehicle that is engaged primarily in the purchase and/or 
sale of securities. A ``collective investment account'' does not 
include a ``family investment vehicle'' or an ``investment club.''
    (3) ``Conversion offering'' means any offering of securities made 
as part of a plan by which a savings and loan association, insurance 
company, or other organization converts from a mutual to a stock form 
of ownership.
    (4) ``Family investment vehicle'' means a legal entity that is 
beneficially owned solely by immediate family members.
    (5) ``Immediate family member'' means a person's parents, mother-
in-law or father-in-law, spouse, brother or sister, brother-in-law or 
sister-in-law, son-in-law or daughter-in-law, and children, and any 
other individual to whom the person provides material support.
    (6) ``Investment club'' means a group of friends, neighbors, 
business associates, or others that pool their money to invest in stock 
or other securities and are collectively responsible for making 
investment decisions.
    (7) [''Joint Back Office Broker/Dealer'' means any domestic or 
foreign private investment fund that has elected to register as a 
broker/dealer solely to take advantage of the margin treatment afforded 
under Section 220.7 of Regulation T of the Federal Reserve. The 
activities of a joint back office broker/dealer must not require that 
it register as a broker/dealer under Section 15(a) of the Act.]
    ([8]7) ``Limited business broker/dealer'' means any broker/dealer 
whose authorization to engage in the securities business is limited 
solely to the purchase and sale of investment company/variable 
contracts securities and direct participation program securities.
    ([9]8) ``Material support'' means directly or indirectly providing 
more than 25% of a person's income in the prior calendar year. Members 
of the immediate family living in the same household are deemed to be 
providing each other with material support.
    ([10]9) ``New issue'' means any initial public offering of an 
equity security as defined in Section 3(a)(11) of the Act, made 
pursuant to a registration statement or offering circular. New issue 
shall not include:
    (A) Offerings made pursuant to an exemption under Section 4(1), 
4(2) or 4(6) of the Securities Act of 1933, or SEC Rule 504 if the 
securities are ``restricted securities'' under SEC Rule 144(a)(3), or 
Rule 144A or Rule 505 or Rule 506 adopted thereunder;
    (B) Offerings of exempted securities as defined in Section 3(a)(12) 
of the Act, and rules promulgated thereunder;
    (C) Offerings of securities of a commodity pool operated by a 
commodity pool operator as defined under Section 1a(5) of the Commodity 
Exchange Act;

[[Page 62146]]

    (D) Rights offerings, exchange offers, or offerings made pursuant 
to a merger or acquisition;
    (E) Offerings of investment grade asset-backed securities;
    (F) Offerings of convertible securities;
    (G) Offerings of preferred securities; [and]
    (H) Offerings of an investment company registered under the 
Investment Company Act of 1940; and
    (I) Offerings of securities (in ordinary share form or ADRs 
registered on Form F-6) that have a pre-existing market outside of the 
United States.
    ([11]10) ``Restricted person'' means:
(A) Members or Other Broker/Dealers
(B) Broker/Dealer Personnel
    (i) Any officer, director, general partner, associated person, or 
employee of a member or any other broker/dealer (other than a limited 
business broker/dealer);
    (ii) Any agent of a member or any other broker/dealer (other than a 
limited business broker/dealer) that is engaged in the investment 
banking or securities business; or
    (iii) An immediate family member of a person specified in 
subparagraph (B)(i) or (ii) if the person specified in subparagraph 
(B)(i) or (ii):
    (a) Materially supports, or receives material support from, the 
immediate family member;
    (b) Is employed by or associated with the member, or an affiliate 
of the member, selling the new issue to the immediate family member; or
    (c) Has an ability to control the allocation of the new issue.
(C) Finders and Fiduciaries
    (i) With respect to the security being offered, a finder or any 
person acting in a fiduciary capacity to the managing underwriter, 
including, but not limited to, attorneys, accountants and financial 
consultants; and
    (ii) An immediate family member of a person specified in 
subparagraph (C)(i) if the person specified in subparagraph (C)(i) 
materially supports, or receives material support from, the immediate 
family member.
(D) Portfolio Managers
    (i) Any person who has authority to buy or sell securities for a 
bank, savings and loan institution, insurance company, investment 
company, investment advisor, or collective investment account.
    (ii) An immediate family member of a person specified in 
subparagraph (D)(i) that materially supports, or receives material 
support from, such person.
(E) Persons Owning a Broker/Dealer
    (i) Any person listed, or required to be listed, in Schedule A of a 
Form BD (other than with respect to a limited business broker/dealer), 
except persons identified by an ownership code of less than 10%;
    (ii) Any person listed, or required to be listed, in Schedule B of 
a Form BD (other than with respect to a limited business broker/
dealer), except persons whose listing on Schedule B relates to an 
ownership interest in a person listed on Schedule A identified by an 
ownership code of less than 10%;
    (iii) Any person listed, or required to be listed, in Schedule C of 
a Form BD that meets the criteria of subparagraphs (E)(i) and (E)(ii) 
above;
    (iv) Any person that directly or indirectly owns 10% or more of a 
public reporting company listed, or required to be listed, in Schedule 
A of a Form BD (other than a reporting company that is listed on a 
national securities exchange or is traded on the Nasdaq National 
Market, or other than with respect to a limited business broker/
dealer);
    (v) Any person that directly or indirectly owns 25% or more of a 
public reporting company listed, or required to be listed, in Schedule 
B of a Form BD (other than a reporting company that is listed on a 
national securities exchange or is traded on the Nasdaq National 
Market, or other than with respect to a limited business broker/
dealer).
    (vi) An immediate family member of a person specified in 
subparagraphs (E)(i)-(v) unless the person owning the broker/dealer:
    (a) Does not materially support, or receive material support from, 
the immediate family member;
    (b) Is not an owner of the member, or an affiliate of the member, 
selling the new issue to the immediate family member; and has no 
ability to control the allocation of the new issue.
* * * * *

VII. Solicitation of Comments on Amendment No. 5

    Interested persons are invited to submit written data, views, and 
arguments on Amendment No. 5, including whether the amendment 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 such filing will also be available for 
inspection and copying at the principal office of the NASD. All 
submissions should refer to File No. SR-NASD-99-60 and should be 
submitted by November 21, 2003.

VIII. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\184\ that the proposal (SR-NASD-99-60) and Amendment Nos. 1 to 4 
thereto are approved, and that Amendment No. 5 is approved on an 
accelerated basis.
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    \184\ Id.
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    For the Commission, by the Division of Market Regulation, pursuant 
to delegated authority.\185\
---------------------------------------------------------------------------

    \185\ 17 CFR 200.30-3(a)(12).

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 03-27463 Filed 10-30-03; 8:45 am]
BILLING CODE 8010-01-P