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90-39 Amendments to Schedule E to the NASD By-Laws Regarding Potential Conflicts of Interest; Last Date for Comment: July 5, 1990

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REQUEST FOR COMMENTS

EXECUTIVE SUMMARY

The NASD requests membership comment on proposed changes to Schedule E to the NASD By-Laws that, if adopted, would require compliance with its provisions if a member participating in a distribution of a public offering of debt or equity securities has a conflict of interest with the issuer. A conflict of interest would be deemed to exist if the member or its affiliates own an aggregate of 10 percent or more of the debt, 10 percent or more of preferred stock, or 10 percent or more of the common stock of an issuer.

BACKGROUND

In 1972, the NASD adopted Schedule E to the By-Laws to regulate the potential conflicts of interest that exist when a member participates in the public distribution of its own securities or the securities of an affiliate. The presumptions contained within Schedule E used to determine affiliation are generally either voting control through ownership of equity securities or common control of management through interlocking officerships or director-ships. Schedule E addresses the conflicts by requiring a qualified independent underwriter to render an opinion on the price of the securities offered, conduct due diligence, and participate in the preparation of the registration statement and prospectus. The qualified independent underwriter also assumes underwriter's liability for the offering. The NASD believes that the objectivity and independence provided by a qualified independent underwriter resolves these conflicts.

Last year, the NASD Board of Governors asked the Corporate Financing Committee to consider whether the ownership of debt of an issuer by an NASD member that intends to distribute the issuer's securities creates a conflict of interest and, if so, whether the conflict should be regulated by the provisions of Schedule E.

In December 1989, the Committee concluded, after review of numerous leveraged buy-out offerings and discussions with several member firms, that a potential conflict of interest exists when a member owns debt, preferred equity, or voting or nonvoting common equity of an issuer while engaged in an offering of the issuer's securities. As a result, the Board of Governors is soliciting comments on a proposal to apply the provisions of Schedule E to any public distribution of the securities of an issuer when a member that proposes to participate in the distribution or its associated persons, parent, or affiliates own 10 percent or more of the aggregate dollar amount of the outstanding debt of the issuer, 10 percent or more of the aggregate dollar amount of the outstanding preferred stock of the issuer, or 10 percent or more of the combined voting and nonvoting common stock of an issuer.

EXPLANATION

The proposed changes to Schedule E include modifications to the general provisions of the Schedule, the addition of four definitions, and modifications to four sections of the Schedule. A section-by-section analysis of the proposed modifications appears below. Initially, the NASD proposes to modify the title of Schedule E by adding "... Conflicts of Interest" to more appropriately describe the proposed breadth of the Schedule.

Section 1 — General

A new subsection (b) is proposed that will provide that no member or person associated with a member shall participate in the distribution of a public offering of debt or equity securities of a company if the member, its associated persons, parent, or affiliates have a conflict of interest with the company. The holdings of debt or equity by a member and its associated persons and affiliates will be aggregated to determine whether the prohibition will be applicable. However, holdings by one or more members will not be aggregated.

Section 2 — Definitions

The proposal would amend Section 2 of Schedule E to add four definitions. The principal definition to be added is "conflict of interest." A conflict of interest will be deemed to exist if the member owns 10 percent or more of the dollar amount of a company's aggregate debt outstanding. Similarly a conflict will be deemed to exist if the member owns in the aggregate 10 percent or more of the dollar amount of the preferred stock outstanding without regard to class, whether voting or nonvoting, convertible or nonconvertible. Finally, a conflict will be deemed to exist if a member owns 10 percent or more of the total number of shares of common stock outstanding without regard to class, whether voting or nonvoting, convertible or nonconvertible.

The definition of conflict of interest does not include conflicts that may arise as a result of an issuer owing 10 percent or more of the aggregate debt, aggregate preferred stock, or voting and non-voting common equity of a member. The NASD seeks comment on whether a conflict should be deemed to exist and, if so, whether the provisions of the Schedule should apply.

With respect to the ownership of debt, a conflict of interest would exist when the member owns 10 percent or more of the short- and long-term outstanding debt of the issuer. For purposes of calculating the percentage of debt, the NASD would include all long-term debt as well as the current portion of long-term debt, bank credit facilities, and bridge loans. A member's ownership of the preferred equity of a company would be measured by comparing the aggregate capital invested by all persons in the preferred equity outstanding with the member's holdings of preferred equity without regard to whether one or more classes of preferred stock are outstanding or whether the preferred stock has any distinguishing characteristics such as convertibility or exchangeability.

The amendments also propose to aggregate all shares of all classes of common stock outstanding, whether voting or nonvoting, convertible or nonconvertible, and compare that amount to the shares of common stock of the company owned by the member, its associated persons, parent, or affiliates to determine whether a conflict exists.

Definitions of debt, common equity, and preferred equity are also proposed to be added to the Schedule. Common equity is defined as the total number of shares of common stock outstanding without regard to class, voting rights, or other distinguishing characteristics as reflected on the consolidated financial statements of the company.

The term debt is defined as the short- and long-term debt as reflected on the consolidated financial statements of the company. The term preferred equity is defined to include the aggregate capital invested by all persons in the preferred securities outstanding without regard to class, voting rights, or other distinguishing characteristics as reflected on the consolidated financial statements of the company.

Section 3 — Participation in Distribution of Securities of Member or Affiliate

It is proposed that Section 3 be retitled "Participation in Distribution of Securities." Subsection (a) has been modified by the addition of a prohibition on any member underwriting or participating as a member of the underwriting syndicate or selling group or otherwise assisting in the distribution of a public offering of the securities of a company with which the member or its associated persons, parent, or affiliates have a conflict of interest unless the member complies with subsection 3(b) and subsection 3(c).

Subsection 3(b) remains unchanged. The majority of the Board of Directors of the member that is deemed to have a conflict with the issuer must have been actively engaged in the investment banking or securities business as that term is defined in Article I, Section l(h) of the NASD By-Laws. Section 3(c) has been amended to indicate that if a member proposes to underwrite, participate as a member of the underwriting syndicate or selling group, or otherwise assist in the distribution of a public offering of securities of a company with which it or its associated persons, parent, or affiliates have a conflict, one or more of the three criteria of Section 3(c) must be met.

As proposed under subsection 3(c)(l), if a member has a conflict of interest with an issuer, in order for the member to participate in the distribution of a public offering of the issuer's securities, a qualified independent underwriter that satisfies the objective criteria of the definition found at subsection 2(1) must be engaged. The qualified independent underwriter will be required to participate in the preparation of the registration statement and the prospectus or offering circular or other similar document and exercise the usual standards of due diligence in respect thereto. It will also be required to issue an opinion that the price at which an equity issue or the yield at which a debt issue is to be distributed to the public has been established at a price no higher or a yield no lower than that which it recommends.

Alternatively, if the public offering is of a class of equity securities for which a bona fide independent market exists as of the date of filing and as of the effective date of the registration statement, or if the offering is a class of securities rated investment grade by a nationally recognized rating agency, then a qualified independent underwriter will not be required.

Section 4 — Disclosure

As proposed, Section 4 of Schedule E would be amended at subsection (b) to require the disclosure in the registration statement, offering circular, or similar document that the offering is being made pursuant to the provisions of Schedule E because member(s) that have a conflict of interest with the company are participating in the distribution.

Section 11 — Suitability;

Section 12 — Discretionary Accounts

Similarly, the suitability provisions of Section 11 and the prohibition on sales to discretionary accounts contained within Sections 11 and 12 of Schedule E, respectively, are being modified to require compliance by member(s) if the offering is one in which a conflict of interest exists.

The NASD encourages all members and other interested persons to comment on the proposed amendments to Schedule E. Comments should be directed to:

Mr. Lynn Nellius, Corporate Secretary
National Association of Securities Dealers, Inc.
1735 K Street, NW
Washington, DC 20006-1506.

Comments should be received no later than July 5, 1990. Comments received by this date will be considered by the Corporate Financing Committee and the NASD Board of Governors. Any changes to the Schedule that are approved by the Board must be filed with and approved by the Securities and Exchange Commission before becoming effective.

Questions regarding this notice may be directed to Charles L. Bennett, Assistant Director, NASD Corporate Financing Department, at (202) 728-8258.

NASD MANUAL SCHEDULES TO THE BY-LAWS

Schedule E

(Note: New language is underlined; deleted text appears in brackets.)

Distribution of Securities of Members and Affiliates — Conflicts of Interest

Section 1 — General

(a) No member or person associated with a member shall participate in the distribution of a public offering of debt or equity securities issued or to be issued by the member, the parent of the member, or an affiliate of the member and no member or parent of a member shall issue securities except in accordance with this Schedule.
(b) No member or person associated with a member shall participate in the distribution of a public offering of debt or equity securities issued or to be issued by a company if the member and/or its associated persons, parent, or affiliates have a conflict of interest with the company as defined herein, except in accordance with this Schedule.

Section 2 — Definitions

Note: Definitions in this section appear in alphabetical order designated by letters. Existing definitions will be given new letters on adoption of the proposed amendments to maintain alphabetical order.

* * * * *

(e) Common Equity — the total number of shares of common stock outstanding without regard to class, whether voting or nonvoting, convertible or nonconvertible, exchangeable or nonexchangeable, redeemable or nonredeemable, as reflected on the consolidated financial statements of the company.

* * * * *

(g) Conflict of Interest — shall be deemed to exist if:
(1) a member and/or its associated persons, parent, or affiliates in the aggregate beneficially own 10% or more of the outstanding debt of a company or its parent;
(2) a member and/or its associated persons, parent, or affiliates in the aggregate beneficially own 10% or more of the common equity of a company, or its parent which is a corporation, or in the case of a partnership, beneficially own a general, limited, or special partnership interest, in 10% or more of the distributable profits or losses of a company or its parent;
(3) a member and/or its associated persons, parent, or affiliates in the aggregate beneficially own 10% or more of the preferred equity of a company or its parent.
(h) Debt — the short- and long-term debt as reflected on the consolidated financial statements of the company.

* * * * *

(m) Preferred Equity — the aggregate capital invested by all persons in the preferred securities outstanding without regard to class, whether voting or nonvoting, convertible or nonconvertible, exchangeable or nonexchangeable, redeemable or nonredeemable, as reflected on the consolidated financial statements of the company.

Section 3 — Participation in Distribution of Securities [of Member or Affiliate]

(a) No member shall underwrite, participate as a member of the underwriting syndicate or selling group, or otherwise assist in the distribution of a public offering of an issue of debt or equity securities issued or to be issued by the member or an affiliate of the member, or of a company with which the member or its associated persons, parent, or affiliates have a conflict of interest, unless the member is in compliance with subsection 3(b) and subsection 3(c) below.

* * * * *

(c) If a member proposes to underwrite, participate as a member of the underwriting syndicate or selling group, or otherwise assist in the distribution of a public offering of its own or an affiliate's securities or proposes to underwrite, participate as a member of the underwriting syndicate or selling group, or otherwise assist in the distribution of a public offering of securities of a company with which it or its associated persons, parent, or affiliates have a conflict of interest, subject to this Section without limitation as to the amount of securities to be distributed by the member, one or more of the following three criteria shall be met:

* * * * *

Section 4 — Disclosure

* * * * *

(b) All offerings included within the scope of this Schedule shall disclose in the underwriting section of the registration statement, offering circular or similar document that the offering is being made pursuant to the provisions of this Schedule, that the offering is being made by a member of its own securities or those of an affiliate, or those of a company with which the member or its associated persons, parent, or affiliates have a conflict of interest, the name of the member acting as qualified independent underwriter, if any, and that such member is assuming the responsibilities of acting as a qualified independent underwriter in pricing the offering and conducting due diligence.

Section 11 — Suitability

Every member underwriting an issue of its securities, or securities of an affiliate, or the securities of a company with which it has a conflict of interest, pursuant to the provisions of Section 3 hereof, who recommends to a customer the purchase of a security of such an issue shall have reasonable grounds to believe that the recommendation is suitable for such customer on the basis of information furnished by such customer concerning the customer's investment objectives, financial situation, and needs, and any other information known by such member. In connection with all such determinations, the member must maintain in its files the basis for its determination.

Section 12 — Discretionary Accounts

Notwithstanding the provisions of Article III, Section 15 of the Corporation's Rules of Fair Practice, or any other provisions of law, a transaction in securities issued by a member or an affiliate of a member, or by a company with which a member has a conflict of interest shall not be executed by any member in a discretionary account without the prior specific written approval of the customer.


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