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86-1 Amendments to Venture Capital Restrictions Effective

TO: All NASD Members and Other Interested Persons

The National Association of Securities Dealers, Inc., has adopted amendments to the Venture Capital Restrictions of the Corporate Financing Interpretation under Article III, Section 1 of the NASD Rules of Fair Practice, which apply to venture capital investments by NASD members and certain of their associated and affiliated control persons prior to the initial public offering of a corporation.

The amendments were effective upon approval by the Securities and Exchange Commission (Securities Exchange Act Release No. 22402). Certain of the amendments incorporate interpretations previously announced in NASD Notice to Members 84-37 (July 18, 1984). Following is an explanation of the revised Venture Capital Restrictions, along with a discussion of such prior interpretations. The text of the amendments is attached.

SUMMARY OF AMENDMENTS

The Venture Capital Restrictions provide that when a member participates in an initial public offering of a security, such member and certain control persons of that member who own any securities of the issuer may not sell those securities during the offering and may not sell those securities for a specified period following the offering. The basis for the restrictions is to protect against a potential conflict of interest present when a member or its control persons own securities of an issuer and is also involved in pricing and due diligence in its initial public offering.

The amendments clarify the categories of control persons covered by the Venture Capital Restrictions and shorten the holding period applied to securities held by such persons from one year to 90 days. Securities currently subject to the one-year lock-up are relieved of further lock-up if such securities are held for 90 days following the effective date of the offering. In addition, the amendments provide two exemptions from compliance with these requirements.

The first exemption is provided when a qualified independent underwriter who does not own any securities of the issuer establishes the price for the issue and also conducts due diligence for the offering. The presence of an independent underwriter to conduct pricing and due diligence is sufficient protection against potential conflicts of interest to justify an exemption from the restrictions. The second exemption applies when the member and certain of its control persons own less than 1 percent of the securities being offered. Such a small amount of securities does not result in the conflicts of interest that the restrictions are intended to address.

BACKGROUND

In the late 1960s, the NASD promulgated the Policy of the Board of Governors on Venture Capital and Other Investments by Broker-Dealers Prior to Public Offerings ("Venture Capital Policy") under the Interpretation of the Board of Governors—Review of Corporate Financing, Article III, Section 1 of the NASD Rules of Fair Practice. The Venture Capital Policy was originally intended to regulate members' venture capital activities to resolve conflicts of interest in negotiating the public offering price and conducting due diligence when a member or its control persons own shares of the issuer while it also functions as an underwriter in the issuer's initial public offering. The Venture Capital Policy was amended in 1983 to prohibit members participating in an initial public offering from selling their holdings during the initial public offering period and for 12 months following the effective date.

The NASD found the Venture Capital Restrictions effective in resolving the potential conflicts of interest encountered by a member in negotiating the public offering price and conducting due diligence in its capacity as an underwriter for an issuer's initial public offering of equity securities when the member and certain of its associated or affiliated control persons own shares of the issuer. However, the NASD also found that in certain circumstances the restrictions created a burden on the bona fide venture capital operations of members and their associated and affiliated persons. Therefore, to afford some measure of relief to members and their associated or affiliated control persons who engage in dual occupations as venture capitalists and underwriters while addressing the conflicts of interest inherent in such dual occupation, the NASD approved amendments that narrow the application of the Venture Capital Restrictions.

EXPLANATION OF THE VENTURE CAPITAL RESTRICTIONS

The terms of the Venture Capital Restrictions apply to the initial public offering of equity securities of a corporation regardless of when the securities were acquired. The prohibitions of the restrictions apply only to the equity securities of the issuer beneficially owned by:

1. a member participating in the public offering;
2. an officer, director or general partner of such member;
3. a controlling shareholder or subsidiary of a controlling shareholder of such member, i.e., a "sister subsidiary";
4. a subsidiary of such member; and
5. any member of the immediate family of the foregoing persons.

Securities subject to the Venture Capital Restrictions may not be sold in the initial public offering and for 90 days after the effective date of the offering.

Participation of a Qualified Independent Underwriter

An exemption from the provisions of the Venture Capital Restrictions is provided if a qualified independent underwriter, as defined in Section 2(k) of Schedule E to the NASD By-Laws, provides an opinion that the price at which the issue is to be distributed to the public is no higher than its recommendation. Schedule E is the NASD's rule that regulates a member's offering of its own or an affiliate's securities.

To qualify as an independent underwriter, Schedule E requires that a broker-dealer must have been actively engaged in underwriting public offerings for the immediately preceding five years and been profitable in three of those five years, and that a majority of its board of directors or general partners have actively engaged in the securities business for the immediately preceding five years. In addition, the Venture Capital Restrictions specify that the qualified independent underwriter may not own securities of the issuer, must participate in the preparation of the registration statement and other offering documents, and must exercise the usual standards of "due diligence" with respect to such participation.

The NASD believes the provisions of Schedule E have worked effectively to protect investors from a member's potential conflicts of interest when selling its own shares or those of an affiliate. It is anticipated that the participation of a qualified independent underwriter will effectively alleviate any conflicts of interest on the part of members and their control persons who participate in an initial public offering while selling their holdings.

De Minimis Transactions

An exemption from the provisions of the Venture Capital Restrictions is also provided when the total amount of securities held or proposed to be sold by a member and certain of its control persons does not exceed 1 percent of the equity securities being offered. The NASD believes that the ownership of such a small amount of securities does not result in the conflicts of interest addressed by the restrictions. To qualify for this exemption, the total amount of securities held by a member and certain of its associated and affiliated control persons, including those to be sold in the offering, may not exceed 1 percent of the equity securities being offered.

Immediate Family

A footnote to the Venture Capital Restrictions indicates that the definition of the term "immediate family" as used in the restrictions is the same as that defined in the NASD's Interpretation of the Board of Governors on Free-Riding and Withholding, Article III, Section 1 of the NASD Rules of Fair Practice. Pursuant to that definition, the term "immediate family" includes the parents, mother-in-law or father-in-law, husband or wife, brother or sister, brother-in-law or sister-in-law, son-in-law or daughter-in-law, and children, as well as any other person who is supported, directly or indirectly, to a material extent by the person specified in the Venture Capital Restrictions.

Beneficial Ownership

The concept of beneficial ownership as used in the Venture Capital Restrictions refers to an ownership interest in the economic benefits of the security. This reflects the fact that the conflicts the Venture Capital Restrictions address are present only when the enumerated person stands to gain economically from an ownership interest.

For securities held in accounts managed by a member, the right to receive a management fee based on performance does not constitute beneficial ownership because the economic participation is usually of a sufficiently limited nature and does not present a meaningful conflict. Therefore, the Venture Capital Restrictions do not apply to securities held in managed accounts (including securities held in the name of a broker-dealer) so long as no participating member or its enumerated affiliated or associated persons beneficially own the securities. When a portion of the securities in an account are benefically owned by a restricted firm or person, that portion of the account's position is subject to the Venture Capital Restrictions. In this event, the restrictions can be satisfied either by delivering these securities to the restricted parties to remove the restrictions on the remaining holdings, or by implementing procedures to assure that no restricted party receives any economic benefit from the sale of the unrestricted portion of the holdings.

* * * *

All comments or questions pertaining to the amendments may be directed to Suzanne E. Rothwell, NASD Corporate Financing Department, at (202) 728-8258.

Sincerely,

Frank J. Wilson
Executive Vice President
Legal and Compliance

Attachment

VENTURE CAPITAL RESTRICTIONS*

[No member or officer, director, general partner or controlling shareholder of a member which participates in the initial public offering of an issuer's securities and which beneficially owns any securities of said issuer at the time of filing of the offering shall sell those securities during the offering or sell, transfer, assign or hypothecate those securities for one year following the effective date of the offering.]

When a member participates in the initial public offering of an issuer's securities, such member or any officer, director, general partner, controlling shareholder or subsidiary of the member or subsidiary of such controlling shareholder or a member of the immediate family** of such persons, who beneficially' owns any securities of said issuer at the time of filing of the offering, shall not sell such securities during the offering or sell, transfer, assign or hypothecate such securities for ninety days following the effective date of the offering unless;

(1) the price at which the issue is to be distributed to the public is established at a price no higher than that recommended by a qualified independent underwriter, as defined in Section 2(k) of Schedule E to Article VII, Section l(a)(4) of the By-Laws, who does not beneficially own securities of the issuer, who shall also participate in the preparation of the registration statement and the prospectus, offering circular, or similar document and who shall exercise the usual standards of "due diligence" in respect thereto; or
(2) the sale of such securities by such member or related person would not exceed one percent of the securities being offered.

National Association of Securities Dealers, Inc.
1735 K Street, N. W.
Washington, D.C. 20006
(202) 723-8000

January 8, 1986

TO: All NASD Members and Other Interested Persons

RE: NASD Guide to Information and Services

Enclosed is the latest edition of the NASD Guide to Information and Services. In it, you will find the names and phone numbers of the NASD staff who work with our various services, rules and regulations.

The reference guide, which was first published in 1981, is designed to help you receive prompt and efficient service when you call the NASD. For your information, the directory is being mailed to all main offices and branch offices of members, as well as to other interested persons.

If you would like additional copies of the directory, please let us know how many you require and send a self-addressed mailing label to:

National Association of Securities Dealers, Inc.
Attention: Communications Group
1735 K Street, N.W.
Washington, D.C. 20006

We hope you find the directory useful and if you have suggestions for improving it, we would be most anxious to hear from you.

Sincerely,

John T. Wall
Executive Vice President
Member and Market Services

Enclosure


* New material is underlined. Deleted material is in brackets.

** See definition of "immediate family," Interpretation of the Board of Governors on Free-Riding and Withholding, Article III, Section 1 of the NASD Rules of Fair Practice.



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