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86-66 Due Diligence Expense Reimbursements in Connection with Direct Participation Programs
TO: All NASD Members and Other Interested Persons
ATTN: Direct Participation Programs Department
This notice examines a number of due diligence reimbursement practices that have arisen in the area of public offerings of direct participation programs and the appropriateness of those practices under the NASD's underwriting compensation guidelines. This notice is a amplification of earlier NASD notices on this subject.
The NASD Direct Participation Programs/Real Estate Committee has reviewed information received from members and their counsel regarding certain practices that have developed with respect to members' charges for reimbursement of due diligence expenses. The purpose of this notice is to assist the membership by clarifying the scope of what is considered a permissible reimbursement of due diligence expenses incurred by a member in connection with a public offering of a direct participation program.
In 1982, the NASD adopted Appendix F to Article III, Section 34 of the NASD Rules of Fair Practice. Appendix F applies to public offerings of direct participation programs and, among other things, provides that underwriting compensation from any source may not exceed NASD guidelines. In connection therewith, the NASD published Notice to Members 82-51 (October 19, 1982), which announced the NASD guidelines on underwriting compensation referenced in Subsection 5(b) of Appendix F. Underwriting compensation may not exceed 10 percent of the gross proceeds of the offering, with the exception that up to an additional 0.5 percent may be reimbursed to underwriters for "bona fide due diligence expenses."
Subsequently, the NASD issued Notice to Members 85-29 (April 19, 1985) to clarify the application of the compensation guidelines under Appendix F. The NASD indicated in that notice that the due diligence expenditures that may exceed the 10 percent limitation by 0.5 percent include only reimbursable expenses incurred by a member in affirmatively discharging its responsibility pursuant to Section 4 of Appendix F to ensure that all material facts pertaining to the program are adequately and accurately disclosed in the offering document. The notice addressed the issue of "due diligence meetings" in exotic locations and indicated that sales incentive vacations awarded to top producers at the close of the offering may not be allocated to due diligence. Instead, where the NASD review identified such allocations to due diligence, the expenses should be reallocated as incentive compensation subject to Subsections 5(e) and 5(f) of Appendix F, and are required to be disclosed in the offering document as part of the 10 percent underwriting compensation guideline.
The notice further clarified that if travel is necessary to discharge the member's due diligence obligations, it should ordinarily be undertaken by responsible officials of the member visiting the partnership offices to verify the information provided to the member. Reimbursement of the member's travel expenses may be properly allocated to the 0.5 percent limitation. On the other hand, expenses incurred by the issuer's officials in traveling to due diligence meetings should be allocated to the issuer's organization and offering expenses.
Pursuant to information reviewed by the Direct Participation Programs/Real Estate Committee, it appears that certain members, either alone or in cooperation with other members, are conducting due diligence as a profit center. Appendix F permits an additional 0.5 percent compensation to NASD members above the 10 percent underwriting guideline only for reimbursement of members' bona fide due diligence expenses. Thus, any bill presented by a member to a sponsor or dealer-manager for reimbursement of costs associated with its due diligence activities must be for actual costs incurred by the member and may not include a profit margin.
The NASD believes it is also the responsibility of the program sponsor and dealer-manager to ensure compliance with the compensation guidelines contained in Appendix F. It appears that some members have submitted non-itemized bills to program sponsors or dealer-managers representing their aggregate expenses for conducting due diligence. While the sponsor is not required to obtain an itemized expense statement before paying out due diligence expenses, any bill for due diligence submitted by a member to a sponsor must be based on the member's actual expenses incurred in conducting due diligence. In the event a sponsor or dealer-manager receives a non-itemized bill for due diligence that it has reason to question, it has the obligation to ensure compliance with Appendix F by requesting an itemized statement to support the bill submitted by the member. If such a due diligence bill cannot be justified, any excess over actual due diligence expenses that is paid is considered by the NASD to be undisclosed underwriting compensation and is required to be included within the 10 percent compensation guideline, disclosed in the offering document and reflected on the books and records of the member.
In addition, a number of members have formed entities for conducting due diligence to lower the cost of due diligence individually. Where such entity is not operated at a profit, each of the members' allocable share of the due diligence expenses of the entity is permissible to be included in the 0.5 percent guideline.* Such due diligence entities formed by members generally obtain operating capital by soliciting sponsors for contributions as founders. However, any payment made by a sponsor to such a due diligence entity as a "founder's contribution," if not related to actual due diligence expenses, will be considered undisclosed underwriting compensation to the members, and is required to be included in the 10 percent guideline, disclosed in the offering document and reflected on the books and records of the members as compensation in connection with an offering of the sponsor's program.
Further, such due diligence entities generally charge a sponsor a flat fee for conducting due diligence with respect to each program of the sponsor. To the extent such due diligence fee represents reimbursement of members' actual costs for conducting their due diligence investigation, such fee may be reimbursed by the sponsor and included within the 0.5 percent due diligence guideline for the program. However, any amount of such fee that exceeds members' bona fide due diligence expenses will be considered undisclosed underwriting compensation.
The Direct Participation Programs/Real Estate Committee has also considered whether a member's request for reimbursement of due diligence expenses may include expenses to cover the overhead of the member's due diligence department. The NASD believes that the reimbursement of a reasonable allocation of the member's overhead, including salaries and office overhead, may be included in the member's request for reimbursement of due diligence expenses. However, as indicated above, if the allocation is excessive, the excess will be considered underwriting compensation subject to the 10 percent guideline.
In addition, the committee considered whether the due diligence fees received from a sponsor with respect to a particular offering must be used to cover only expenses with respect to that offering or if all due diligence fees could be aggregated to cover the member's complete due diligence expenses related to all programs it underwrites. The NASD believes that any due diligence fees received from a sponsor by a member may only be applied to its due diligence activities with respect to the particular program of that sponsor.
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The NASD hopes that this notice will aid the membership and sponsors by providing clarification of permissible reimbursement of due diligence expenses in direct participation program offerings. Any comments or questions regarding this notice should be directed to either Frank J. Formica or Suzanne E. Rothwell of the NASD's Corporate Financing Department, at (202) 728-8258.
Frank J. Wilson
Executive Vice President
Legal and Compliance
Notice to members 86-66
NOT AVAILABLE AT THIS TIME
* In comparison, the bill for conducting due diligence of a consulting firm that is not a member or an affiliate of a member is considered a bona fide reimbursement of the member's actual expenses for due diligence even though the consulting firm may include a profit margin in its bill.