FINRA Manual: Contents
|View Whole Section||Text only||Print Manager||Link|
86-26 Request for Comments on Proposed Exemption From Free-Riding Interpretation for Conversion of Savings and Loan Associations
TO: All NASD Members and Other Interested Persons
LAST DATE FOR COMMENT: APRIL 28, 1986
The National Association of Securities Dealers, Inc. (NASD), is requesting comments on a proposed amendment that would provide limited exemptions for certain persons purchasing securities in connection with the conversion to stock ownership of mutual savings and loan associations, savings banks and certain other organizations from the provisions of the NASD Board of Governors' Interpretation with respect to Free-Riding and Withholding 1/under Article III, Section 1 of the NASD Rules of Fair Practice.
The proposed amendment is a revision of an earlier proposal which was sent to members and other interested persons for comments late last year. 2/ The NASD received a number of comments on the original proposal which have been reviewed and considered by the NASD's National Business Conduct Committee (NBCC) and Board of Governors.
The revised amendment, and the history and background leading to its proposal, are discussed in this notice. The text of the proposed amendment is attached.
BACKGROUND OF THE PROPOSAL
The NASD Free-Riding and Withholding Interpretation (Interpretation) is based upon the basic premise that members have an obligation to make a bona fide public offering of securities that trade at a premium in the aftermarket (hot issue securities). To accomplish this broad purpose, the Interpretation prohibits members and associated persons of members from participating in the offering of hot issue securities if the offerings are made to certain persons who come within specified classes, unless prescribed conditions are satisfied. The Interpretation also prohibits members and associated persons of members from withholding or purchasing securities that are part of a hot issue.
To assure compliance with the Interpretation, most firms establish procedures to monitor sales of new issues. Since application of the Interpretation depends on whether an offering will be a "hot issue," the Interpretation as a practical matter limits the abilities of members, associated persons of members and other restricted persons to purchase new issues in general.
A growing number of savings and loan associations recently have converted from the mutual form of ownership, issuing securities in the process. Under the rules of the Federal Home Loan Bank Board (FHLBB), savings and loan associations usually offer their depositors, borrowers and community residents the opportunity to subscribe to their securities prior to any underwritten public offering. In some cases, a savings and loan association's entire offering may be sold by the issuing institution without the assistance of an NASD member selling as an underwriter. More commonly, however, the issuing institution will sell a portion of the offering during the subscription period, with the remaining securities being underwritten and distributed by an underwriter.
With the proliferation of savings and loan conversions, numerous questions have arisen concerning the ability of persons subject to the Interpretation to purchase securities directly from a savings and loan association during its subscription period. Similar questions have been raised concerning the responsibilities of members under the Interpretation for securities sold directly by the issuing institutions without the assistance of underwriters. These questions involve several difficult issues, especially when a restricted person is entitled under FHLBB rules to purchase securities in the capacity of a depositor, borrower or member of the community. The complexity of the issues are exacerbated because, in any given savings and loan association conversion, it is not always clear whether an NASD member will become involved in the offering, and the nature and time of any such participation also may vary materially.
In view of the obvious importance of the impact of the existing provisions on purchases in savings and loan conversion offerings, the issues have been the subject of careful review and study by the Board of Governors and the NBCC over a number of months. Because of the complexity of the issues and the variety of possible approaches toward resolution, the Subcommittee on Savings and Loan Conversions (Subcommittee) was appointed to assist the NBCC. In the course of their review and study, the Subcommittee, the NBCC and the Board of Governors have reviewed the rules of the FHLBB, the practices involved in savings and loan conversion offerings and the policies behind the prohibitions and restrictions that are imposed by the existing Interpretation.
At the time the original amendment was approved for comment, the NBCC and the Board of Governors believed that exemptive relief was necessary and appropriate. They continue to believe that relief is warranted, but feel that the amendment proposed earlier would fall short of providing, as a practical matter, any meaningful relief because of the complex conditions of the proposal. The revised proposed amendment, therefore, is intended to expand the area where relief is granted and remove the problems of application and enforcement of the exemptions by simplifying the requirements.
The existing Interpretation does not recognize any special or unique aspects of savings and loan conversion offerings to set them apart from conventional public offerings. Accordingly, members and associated persons participating in such offerings have the same responsibilities, and persons purchasing the securities are subject to the same limitations and restrictions, as in the case of any other offering of a hot issue security.
The basic restrictions of the Interpretation, insofar as applicable to savings and loan association conversion offerings, are found in several inter-related provisions covering three broad areas:
The first area is subdivided into several categories of purchasers. The Interpretation prohibits a member or associated person of a member from selling a hot issue security to any person associated with a member or any other broker-dealer, to members of the immediate family of such persons with limited exceptions, or to accounts such as certain private investment corporations or partnerships in which an associated person of a member has a beneficial interest. The Interpretation also prohibits sales by a member or associated person of a member to another category of persons who, although not associated persons of members, are covered because of their status as senior officers and employees of banks, insurance companies and certain other financial institutions, members of the immediate family of such persons and accounts in which such persons have a beneficial interest.
The prohibition upon member sales to these non-associated persons is not absolute, however, and sales are permissible if the purchaser has an investment history, the amount purchased is insubstantial and the aggregate amount sold by a member to all restricted persons is insubstantial and not disproportionate compared to the member's sales to the public. In addition, sales by members to another category of purchaser, comprising foreign and domestic banks, broker-dealers, investment advisory firms and other types of purchasers that commonly act as conduits for undisclosed principals, are prohibited unless assurances or representations are received that the ultimate purchasers will not be within one of the other two prohibited and restricted classes. 3/ All of the foregoing restrictions currently apply to sales by members participating in savings and loan conversion offerings when the purchasers come within any of these categories.
The second area of coverage makes members responsible for assuring compliance with these same prohibitions and restrictions when sales are made directly by the issuer on a non-underwritten basis. 4/ In savings and loan conversion offerings, a portion of the securities is typically sold by the issuing institution. The Interpretation now applies to make it a violation for a member to participate in a savings and loan conversion offering where non-underwritten sales are made by the issuing institution to persons within any of the restricted categories if the sales fail to comply with the applicable standards. The restrictions on members participating in such offerings presently apply irrespective of whether persons purchasing the shares are depositors, borrowers, lenders or members of the community if the purchasers are covered by the Interpretation's prohibitions and restrictions.
Under the third area of coverage, the Interpretation currently makes it a separate, specific violation for a member or associated person of a member to purchase any hot issue security from another member or from the issuer selling non-underwritten securities. 5/This companion provision to the basic restrictions likewise makes no distinction as to whether in a savings and loan association conversion offering the purchaser is a depositor, borrower, lender or member of the community. Thus, the Interpretation currently prohibits any person associated with any member from purchasing any hot issue security, regardless of whether the security is purchased directly from the issuer and regardless of whether any NASD member is involved in the offering in any way.
To simplify the amendment, the Board of Governors and the NBCC have determined to change the approach of the original proposal. The revised amendment would grant exemptions under certain circumstances for sales to restricted persons made by the issuer. Unlike the earlier proposal, the revised amendment would not provide an exemption for sales made by NASD members. The exemptions under the revised amendment are based on the class of purchaser and distinguish between two basic situations that members participating in conversion offerings face: (1) issuer sales to other members and associated persons of members as well as to certain related persons and (2) issuer sales to all other persons now covered by the Interpretation.
Subsection (a)(l) of the amendment would define "conversion offering" as an offering of securities made as part of a plan by which a savings and loan association or other organization converts from a mutual form to a stock form of ownership. The definition would cover, in addition to savings and loan association conversions, the conversion of other types of organizations such as mutual savings banks and insurance companies. The definition is substantially the same as originally proposed.
The amendment would also define in Subsection (a)(2) "eligible purchaser" to mean a person eligible to purchase securities under the rules of the FHLBB or any other governmental agency or instrumentality having authority to regulate conversion offerings. Savings and loan association conversion offerings typically describe the classes of persons eligible to purchase shares directly from the issuer in transactions that are not handled by an underwriter. Such persons are usually permitted to purchase prior to any underwritten public offering. Under FHLBB rules, the persons permitted to purchase shares during this phase of a conversion are depositors, borrowers, officers, employees and residents, at least of the community serviced by the converting institution.
The amendment as originally proposed would have made the exemption inapplicable to community residents even though they are treated substantially the same as depositors and other eligible purchasers under FHLBB rules. The Board of Governors and the NBCC, however, have reconsidered the definition and believe that proper deference should be given to the FHLBB's determination .as to the means of effecting the public policies that the FHLBB is charged by law with implementing. The Board and the NBCC also believe that, in light of the new structure of the amendment being proposed, a narrow definition of "eligible purchaser" is not necessary to preserve the policies underlying the NASD's Interpretation. Accordingly, the new definition would cover anyone eligible to purchase under the rules of the FHLBB or other similar agency.
Sales to Members, Associated Persons of Members and Certain Related Persons
The amendment would provide under Subsection (b) that the Interpretation shall not apply in a conversion offering to any of the securities sold directly by the issuing institution on a non-underwritten basis, subject to certain conditions. This is the basic exemptive provision established by the amendment. The conditions to be met before an exemption is available depend on whether the purchaser falls within one of the following classes: (1) members, persons associated with members and certain related persons, and (2) all other persons covered by the Interpretation.
The existing Interpretation makes it a violation for a member or associated person of a member to participate in a conversion offering when issuer sales are made to members or associated persons of members and certain related persons. The Board of Governors and the NBCC are aware that the purpose of the prohibition is to prevent such persons who may have inside knowledge of the acutal demand for an offering from exploiting public investors by taking advantage of their superior information. As originally proposed, the amendment would have provided no exemption from the existing Interpretation for this situation. A number of commentators on the original proposal objected to the lack of an exemption for purchases made by such persons directly from the issuing institution, where they are eligible to purchase under FHLBB rules because they are depositors or have some other connection to the issuer unrelated to their occupations in the securities industry. It was pointed out that such persons, even if associated with a member that later acts as underwriter, may have little information concerning actual demand at the time they subscribe. Some commentators also expressed the view that a suitable holding period following completion of an offering should be adequate to assure that such persons acquire for investment, thereby eliminating any temptation to misuse whatever inside information they may have about demand.
The Board of Governors and the NBCC believe that several conditions, including a minimum holding period, should be met before any exemption can be made available for issuer sales to members and associated persons of members. The amendment establishes three conditions for an exemption for members and associated persons participating in conversion offerings in which the issuing institution makes sales to persons who are members or persons associated with members.
The original proposal also contained a number of other conditions that the Board and the NBCC have determined are unnecessary to achieve the Interpretation's purposes and that make the exemption unduly complicated from the standpoint of compliance and enforcement. The exemption established by the revised amendment is intended to apply only to issuer sales to members and associated persons of members. It would not cover direct sales by members to other members or associated persons of members, and these sales are required to comply in all respects with the restrictions of the existing Interpretation. This is a change from the original proposal that would have exempted direct sales by members and associated persons subject to seven detailed conditions. A number of commentators on the original proposal argued that the nature and number of these conditions on direct sales by members raised questions concerning compliance and enforcement of the exemption and suggested that steps be taken to eliminate or lessen them.
The Board of Governors and the NBCC have determined that there should be no exemption for sales by members and associated persons of members. The Board and the NBCC believe that application of the existing provisions should present no hardship to members and associated persons who, although unable to purchase from a member underwriter, would be permitted to exercise subscriptions and acquire the securities directly from the issuing institution subject to compliance with the proposed conditions which, in the view of the Board and the NBCC, are not onerous or unreasonable. The Board and the NBCC also do not believe that problems of compliance by member underwriters in connection with their own sales should give rise to any special reasons to warrant relief from the existing requirements that member underwriters must now comply with in all offerings.
Sales to Other Restricted Persons
The amendment under Subsection (b)(2) would establish a separate exemption to cover issuer sales to persons who are not members or associated persons of members but who are presently covered by other provisions of the Interpretation. As noted above, these persons consist of several broad categories, including senior officers and employees of certain financial institutions, members of their immediate families, accounts in which they may have beneficial interests, as well as certain banks and other organizations that may act as conduits for other persons prohibited or restricted under the Interpretation from purchasing a hot issue security. The amendment would condition the exemption on the fact that any person within this class must be an eligible purchaser under FHLBB rules as defined by Subsection (a)(2) of the amendment. If the exemptive condition is met, the effect is to eliminate with respect to this class of purchaser the existing prohibitions and restrictions, such as the requirement of an investment history, and to remove impediments that now prevent a number of these persons from becoming equity owners of savings and loan associations as specifically allowed by the FHLBB rules.
In sum, the amendment would permit members and associated persons of members to participate in conversion offerings when purchases from the issuing savings and loan association are made by persons now covered by the Interpretation who are not members or associated persons of members, with the sole condition being that such persons are eligible to purchase under the FHLBB rules. The proposed exemption for this class of persons differs in two major respects from the original proposal:
The Board of Governors and the NBCC believe that by balancing the purposes of the savings and loan regulatory scheme with the aims of the NASD's Interpretation, no overriding purpose is served by continuing the present prohibitions and restrictions or by replacing them with a difficult or impossible condition to administer. Among other things, the Board and the NBCC have considered the fact that the possibility that a member may be "buying business" from officers and employees of financial institutions is a valid policy concern underlying the existing provisions of the Interpretation. They believe, however, that the danger is not present to the same extent as in other types of offerings, given the fact that sales by the converting institution often occur before any actual underwriting commences, and member underwriters generally do not know the identity of the purchasers from the issuer.
Purchases by Members and Associated Persons of Members
The amendment would provide in Subsection (c) that the Interpretation's existing provision, which makes it a separate violation for a member or person associated with a member to purchase a hot issue, shall not apply to purchases by such persons from the issuer if the three conditions of Subsections (b)(l)(A)-(C) are satisfied. The Board and the NBCC have concluded that the existing prohibition is unnecessary for the reasons previously discussed in connection with the proposed exemption for sales to members and associated persons of members.
Substantiality and Disproportionateness
As noted, the existing Interpretation establishes an overall limitation by prohibiting members from participating in a conversion offering unless the aggregate amount sold by the member and the issuer to all restricted persons is insubstantial and not disproportionate compared to sales to the pubic. The wording of the amendment should eliminate areas of uncertainty that may be expected to arise in complying with and enforcing the overall limitations of the Interpretation. Thus, the exemptions under Subsections (b)(l) and (2) apply to "a sale" of securities by the issuer. The intent of the exemptions is to exclude all securities in conversion offerings sold by the issuer from consideration in complying with and enforcing the overall restrictions of the Interpretation. For example, a member's direct sales to restricted persons covered by the Interpretation are not intended to be combined with exempted issuer sales in applying the insubstantiality and disproportionate requirements.
* * * * *
All members and other interested persons are invited to submit comments on the proposed rule. Comments should be received no later than April 28, 1986, and should be directed to:
Mr. James M. Cangiano, Secretary
National Association of Securities Dealers, Inc.
1735 K Street, N.W.
Washington, D.C. 20006
Comments received by this date will be considered by the NBCC and the NASD Board of Governors. Any rule change approved by the Board must be filed with and approved by the Securities and Exchange Commission before becoming effective.
Questions concerning this notice may be directed to either Dennis C. Hensley, Vice President and Deputy General Counsel, or John F. Mylod, Assistant General Counsel, at (202) 728-8294.
Frank J. Wilson
Executive Vice President and General Counsel
TEXT OF PROPOSED AMENDMENT
Amend the Board of Governors' Interpretation with respect to Free-Riding and Withholding under Article III, Section 1 of the NASD Rules of Fair Practice by adding at the end thereof the following language:
SALES BY ISSUERS IN CONVERSION OFFERINGS
Conditions for Exemption
If the purchaser is a member, person associated with a member, member of the immediate family of any such person to whose support such person contributes, directly or indirectly, or an account in which a member or person associated with a member has a beneficial interest:
If the purchaser is not a person specified in Subsection (b)(l) above, the purchaser shall be an eligible purchaser.
1/ NASD Manual, ¶2151.
2/ NASD Notice to Members 85-81 (December 2, 1985).
3/ Interpretation, ¶1-8, NASD Manual, pp. 2040-2042.
4/ Interpretation, "Issuer Directed Securities," NASD Manual, p. 2043.
5/ Interpretation, "Violations by Recipient," NASD Manual, p. 2044.
6/ Such notification is presently required under Article III, Section 40 of the NASD Rules of Fair Practice covering private securities transactions by persons associated with members.