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89-16 Amendment to Appendix F Permitting Indeterminate Compensation in Public Direct Participation Programs — Effective February 1, 1989
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NASD members are advised that on January 13, 1989, the Securities and Exchange Commission (SEC) approved an amendment to Appendix F under Article III, Section 34 of the NASD Rules of Fair Practice (Securities Exchange Act Release No. 34-26458). The amendment, which permits the receipt of indeterminate compensation as underwriting compensation in connection with the sale of public direct participation programs, becomes effective February 1, 1989. The text of the amendment follows this notice.
NASD policies with respect to the regulation of underwriting compensation received by members in connection with the distribution of public direct participation programs are contained in Appendix F to Article III, Section 34 of the NASD Rules of Fair Practice (Appendix F). Appendix F provides that "all items of compensation paid by the program directly or indirectly from whatever source to underwriters, broker-dealers, or affiliates thereof, including, but not limited to, sales commissions, wholesaling fees, due diligence expenses, other underwriter's expenses, underwriter's counsel's fees, securities or rights to acquire securities, rights of first refusal, consulting fees, finder's fees, investor relations fees, and any other items of compensation for services of any kind or description, which are deemed to be in connection with or related to the public offering, shall be taken into consideration ..." in determining the fairness and reasonableness of underwriting compensation. Notice to Members 82-51 (dated October 19,1982) contains the NASD's currently effective compensation guidelines for public direct participation programs of 10 percent plus .5 percent reimbursement for bona fide due diligence expenses.
Section 5(b)(5) of Appendix F effectively precludes members from receiving underwriting compensation of an indeterminate value in connection with the public offering of a direct participation program. Compensation is deemed to be indeterminate if the total value that eventually will accrue to the member as a result of a compensation arrangement cannot be determined definitively. Types of compensation prohibited as indeterminate include, but are not limited to: a percentage of the management fee, a profit-sharing arrangement, an overriding royalty interest, a net-profits interest, a percentage of revenues, a reversionary interest, a working interest, a security or right to acquire a security having an indeterminate value, and other similar items.
Since Appendix F applies only to public offerings of direct participation programs, private program offerings frequently are sold with an underwriting compensation arrangement that includes a percentage interest in program distributions. The NASD has developed the amendment to Appendix F to permit members distributing an offering to forgo front-end compensation in a program in exchange for a possible participation in distributions from the program.
Permitting members to receive back-end compensation in lieu of front-end compensation allows a greater percentage of offering proceeds to be directed to the business of the partnership, thereby benefitting investors. The trade-off of front-end compensation for an interest in program distributions also helps to focus the selling efforts of members on quality public programs, since members take on the risk that the program will be successful enough to generate sufficient distributions to provide returns to investors as well as an amount of compensation to the member.
EXPLANATION OF AMENDMENT
The amendment to Appendix F permits indeterminate compensation to be paid to a member or person associated with a member in connection with a public offering of a direct participation program if four conditions are satisfied. The first condition, Item (i) of Subsection 5(b)(5), is that the member's continuing compensation may be received only after all investors have received cash distributions from the program equal to 100 percent of their cash investment plus a 6 percent cumulative annual return on their adjusted investment. The "cash investment" includes the amount paid by the investor for the security in cash, payments of assessments, and reinvestment of a limited partner's income in the same program. The cash investment does not include any amounts represented by an outstanding promissory note on unpaid installments. The "adjusted investment" is the investor's cash investment less cash distributions from the program. The 6 percent cumulative annual return, chosen as a prerequisite to the receipt by members of continuing compensation, coincides with a similar provision in the North American Securities Administrators Association (NASAA) guidelines.
Item (ii) of the amendment requires that the member's continuing compensation be calculated as a percentage of cash distributions from the program. There is no restriction on the source of such cash distributions, so members may receive continuing compensation from operations, the sale of program assets, program investments and financing, dissolution of the program, etc.
Item (iii) restricts the amount of back-end compensation that a member may receive to 3 percent of the partnership's cash distributions for each one percentage point that the total of all underwriting compensation received at the time of the offering falls below 9 percent. Therefore, continuing compensation is permitted only when the aggregate of all categories of front-end compensation is below 9 percent. Front-end compensation includes retail and wholesale commissions, expense reimbursements, and other items of compensation that are enumerated in Section 5(c) of Appendix F. The trade-off ratio of 3-for-l was based on an analysis indicating that members will realize a meaningful benefit by deferring compensation only if the program provides an attractive return to investors. Further, it was determined that such a ratio assures that members have sufficient incentive to give up front-end compensation in return for continuing compensation of an indeterminate value.
Item (iii) also restricts the total amount of continuing compensation that a member may receive to 12 percent of the cash distributions from the program. The limit on continuing compensation is intended to assure some consistency in the compensation structure of public programs. It is also intended to prevent undue discrimination against smaller member firms that might not be able to absorb all the costs of the distribution of a program in exchange for deferred compensation.
Item (iv) provides that the percentage of a member's continuing compensation from the limited partner's interest in program distributions cannot exceed the percentage that limited partners are entitled to receive. The purpose of this provision is to ensure that if any of the distributions of a program payable to limited partners is to be used to pay the member's continuing compensation, the percentage of that compensation paid from the limited partner's distributions cannot exceed the percentage of program distributions payable to the limited partners.
It should be noted that the amendment is permissive only; that is, it does not require members to exchange front-end compensation for deferred indeterminate compensation. It only permits members and issuers to negotiate previously prohibited indeterminate compensation arrangements as an alternative to the current practice of paying all underwriting compensation at the time of the offering.
EFFECTIVENESS OF AMENDMENT
The amendment to Appendix F is effective February 1, 1989. Public direct participation programs on file for review with the NASD Corporate Financing Department as of February 1, 1989, which have not received an opinion of "no objections" to the underwriting terms and arrangements, and direct participation programs subsequently filed with the department on or after February 1, 1989, may include an underwriting arrangement that complies with the new indeterminate compensation provision of Appendix F. In addition, any direct participation program offering that previously has received an opinion of "no objections" from the department may be resubmitted on or after February 1, 1989, for review of revised underwriting terms that include an indeterminate compensation arrangement, so long as the SEC or state regulatory authority (if an intrastate offering) has not declared the offering effective.
Questions concerning this notice can be directed to Richard J. Fortwengler, Assistant Director, NASD Corporate Financing Department, at (202) 728-8258
APPENDIX F TO ARTICLE III, SECTION 34 OF THE NASD RULES OF FAIR PRACTICE
(Note: New language is underlined.)
Section 5. Organization and Offering Expenses