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93-51 Mail Vote — Proposed Amendment to the Corporate Financing Rule Relating to Fairness and Reasonableness of Anti-Dilution Provisions in Underwriters' Warrants, Options, and Convertible Securities;

Last Voting Date: September 27,

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Executive Summary

The NASD® invites members to vote on a proposed amendment to the Corporate Financing Rule under Article III, Section 44 of the Rules of Fair Practice that is intended to prohibit certain anti-dilution provisions of options, warrants, or convertible securities received as underwriting compensation. The amendment would provide that underwriters and related persons may not receive options, warrants, or convertible securities as compensation if the provisions of such securities include anti-dilution provisions with disproportionate rights, privileges, and economic benefits that are not provided to investors purchasing the issuer's securities in the public offering. The amendment would also prohibit the receipt by underwriters and related persons of options, warrants, or convertible securities containing provisions for the receipt or accrual of cash dividends before exercise or conversion of the securities.

Background

The NASD Corporate Financing Rule (Rule) contained in Article III, Section 44 of the Rules of Fair Practice prohibits an NASD member or associated person from participating in any manner in any public offering of securities in which the underwriting or other terms or arrangements in connection with or related to the distribution of the securities are unfair or unreasonable. Subsection (c)(6)(B) of the Rule codifies the presumption that certain arrangements are unfair and unreasonable and Subsection (c)(6)(B)(vi) sets forth unreasonable arrangements applicable to options, warrants, or convertible securities received by the underwriter and related persons as underwriting compensation.

This latter Subsection provides that terms and arrangements contained in warrants, options, or convertible securities received as underwriting compensation are unfair and unreasonable if the security: (1) has a duration of more than five years; (2) is exercisable or convertible below the public offering price or the market price at the time of receipt; (3) is not in compliance with Subsection (c)(5)(A), i.e., is different from the security offered to the public or without a bona fide independent market; (4) has more than one demand registration right at the issuer's expense; (5) has a demand registration right lasting more than five years from the effective date of the offering; (6) has a piggyback registration right lasting more than seven years from the effective date of the offering; or (7) is convertible or exercisable, or otherwise is on terms more favorable than the terms of the securities being offered to the public.

This last Subsection (7) is referred to as the "General Fairness Standard" of Subsection (c)(6)(B) to the Rule. In addition, Subsection (c)(6)(B)(ix) of the Rule prohibits the receipt of securities as underwriting compensation in an amount in excess of 10 percent of the securities sold to the public (Stock Numerical Limitation Rule).

The NASD's Corporate Finance Committee (Committee) reviewed the anti-dilution provisions contained in the contracts of underwriters and related persons for warrants received as underwriting compensation. The Committee found that certain of such warrants have included anti-dilution arrangements that appear to be unfair and unreasonable under the above General Fairness Standard by providing disproportionate benefits to the underwriter and related persons that are not provided to investors in the public offering.

As a result of the Committee's review, the NASD has identified certain arrangements considered unfair and unreasonable with respect to warrants (as well as options and convertible securities) received by underwriters and related persons and has determined to amend the Corporate Financing Rule to prohibit the receipt of such options, warrants, or convertible securities by underwriters and related persons when such securities contain disproportionate anti-dilution provisions that are not also provided to the investors in the public offering.

In its review, the Committee also identified another arrangement related to these warrants that provided for the receipt or accrual of cash dividends before the member exercised its warrants. The NASD believes that such an arrangement is unfair and unreasonable under the Rule because it provides the underwriter and related person with economic rights, privileges, and benefits that are more favorable than the benefits received by investors in the public offering. The NASD has determined to amend the Rule to prohibit underwriters and related persons from receiving warrants, as well as options and convertible securities, that contain such a provision.

Description of the Amendment

Prohibition of Effecting Disproportionate Benefits

The proposal defines as unfair and unreasonable receipt by the underwriter and related persons of any underwriting compensation consisting of any option, warrant, or convertible security containing anti-dilution provisions that provide the underwriter and related persons with disproportionate rights, privileges, and economic benefits that are not provided to the purchasers of the securities offered to the public.

The NASD recognizes that contracts between the company and investors covering the issuance of options, warrants, and convertible securities may contain certain anti-dilution provisions designed to protect shareholders from events that dilute their economic interest in the company. The NASD has found that underwriters and related persons sometimes negotiate to receive protection from dilution in their warrant contracts through certain rights that provide them with a larger number of shares on exercise or lower exercise price than that available to shareholders of the offering when events occur that do not affect all shareholders, such as additional issuances by the company. The Committee review found different variations of how adjustments to the exercise price and number of shares occur in response to such issuances of securities. Such variations included formulas that "weight" the effect of changes in the company's capitalization and also formulas that "rachet" the adjustment without regard to the actual dilative affect of the new issuance of securities.

The NASD believes all variations of such disproportionate anti-dilution provision are unfair and unreasonable when not also provided to investors in the public offering. The NASD also notes that the receipt of such disproportionate benefits by underwriters and related persons, when such benefits are not received by other purchasers of the public securities, would result in the underwriter and related persons receiving securities as underwriting compensation in excess of 10 percent of the securities sold to the public in the offering in violation of the Stock Numerical Limitation Rule contained in Subsection (c)(6)(B)(ix) of the Rule.

In comparison, the NASD has identified certain anti-dilution provisions as not unfair and unreasonable under the Rule. These provisions contain proportionate benefits that provide anti-dilution adjustments to the exercise price and number of securities in response to events affecting all shareholders, such as, among others, stock dividends, combinations, reclassification, and recapitalizations. These provisions entitle the underwriter to participate in the corporate event as if it was a shareholder of the underlying security before the event. The benefits received under these provisions, therefore, only result from treating the warrants, options, and convertible securities as if exercised or converted, to determine any adjustments. In this case, regulatory issues are not raised under the Stock Numerical Limitation Rule because the increase in the number of securities issued to the underwriter and related persons in exercise of the warrant maintains the 10 percent relationship to the amount of securities sold in the offering to public investors.

The Rule recognizes situations where the options, warrants, and convertible securities to be received by the underwriter and related persons are different from the securities being sold in the offering. Subsection (c)(5)(A) of the Rule provides that no underwriter and related person may receive a security or a warrant for a security as compensation in the distribution of a public offering that differs from the security to be offered to the public unless the security received as compensation has a bona fide independent market. To address circumstances where the security received by the underwriter and related persons is different from the security to be offered to the public, the proposed rule change provides that the rights, privileges, and economic benefits received by underwriters and related persons may be compared to the rights, privileges, and economic benefits of the public shareholders of the issuer whose shares have a bona fide independent market, in compliance with Subsection (c)(5)(A) of the Rule.

Prohibition Affecting Cash Dividends

The amendment would prohibit as unfair and unreasonable receipt, by the underwriter and related persons, of underwriting compensation consisting of any option, warrant, or convertible security that provides for the receipt or accrual of cash dividends before exercise or conversion of the security.

Member Comment

The proposed amendment, published for comment in Notice to Members 93-10 in February 1993, generated six comment letters. Of these, one favored the amendment and five were generally opposed. Although discussed in the text of the Notice, the proposed rule language did not include language prohibiting arrangements that provide for the receipt or accrual of cash dividends before exercise or conversion.

Commenters argued that the higher level of risk experienced by underwriters compared to public investors justifies the receipt by the underwriter and related persons of warrants containing disproportionate anti-dilution provisions. These commenters believe that the amendment would significantly reduce the ability of underwriters to protect the value of warrants received as underwriting compensation, making it a riskier form of compensation. They believe that underwriters should not be in the same position as their customers after a public offering because, unlike the public purchasers in an offering, an underwriter must comply with Subsection (c)(7)(A) of the Rule subjecting warrants, options, and convertible securities acquired as compensation to a one-year holding period on resale, hypothecation, or assignment.

However, the NASD does not believe the risk taken by underwriters and related persons justifies receipt of disproportionate anti-dilution benefits not received by purchasers of securities of the public offering. In the NASD's view, the exercise of such disproportionate anti-dilution provisions not provided to public investors may effectively allow the underwriter to obtain more than 10 percent of the offering in circumvention of the Rule's Stock Numerical Limitation Rule. The NASD also believes that the one-year holding requirement does not place the underwriters at an undue disadvantage to their customers. One of the principle purposes of the one-year prohibition is to foster a commonality of interest among the issuer, underwriters, and the investing public by encouraging the underwriter to provide post-distribution support and advice to develop the market for the issuer's shares and to allow the public market to develop for one year before the member sells securities received as underwriting compensation.

One commenter supported the prohibition against disproportionate anti-dilution provisions that adjust the exercise price or number of securities by using a "rachet-type" formula, but opposed prohibiting weighted formulas that reflect the changes in the company's capitalization. The NASD believes provisions using weighted formulas allow an underwriter to maintain a level percentage in the total capitalization of the issuer, but, if not provided to other investors of the public offering, will result in the underwriter receiving a disproportionate benefit relative to investors in the offering. This action can result in the underwriter receiving more than 10 percent of such offering contrary to the intent of the Stock Numerical Limitation Rule.

Commenters also stated that underwriter warrants contain "disproportionate" anti-dilution provisions to discourage the company from subsequently issuing "cheap stock" to insiders. They believe that, without the distinctive effect of the anti-dilution provisions contained in the warrants, a company would be free to issue "cheap stock" without restraint. The NASD believes the terms of the underwriter's options, warrants, or convertible securities should not be designed as a vehicle to discourage additional new issuances by the company. Such provisions, based on the commenters' argument, could make it prohibitive for an issuer to seek legitimate private or public financing and would inhibit the ability of the issuer to attract quality management through the issuance of stock option plans.

One commenter stated that the proposed amendment was vague, overbroad, and would vest undue discretion to the NASD staff in determining where anti-dilution provisions are considered disproportionate. The commenter also expressed concern that the proposed amendment would result in unwritten and unpublished policies causing hardships in terms of time and expense required in the review of public offerings by the NASD staff. The NASD believes the proposed rule language of the amendment and the explanation contained in the Notice (and to be included in the rule filing submitted to the SEC) sufficiently identifies the terms and arrangements proposed to be prohibited as unfair and unreasonable provisions in options, warrants, and convertible securities received as compensation by underwriters and related persons. Thus, the adoption of the amendment cannot be described as an "unwritten policy." As such, the proposed amendment would vest no more discretion with NASD staff than is necessary and appropriate for the staff to identify arrangements considered unfair and unreasonable. The NASD does not believe that the proposed amendment would result in delays and additional expense in the review of public offerings by the NASD staff.

One commenter argued that large underwriters generally do not receive underwriter warrants as part of their compensation because the gross proceeds of their underwritten offerings are substantially larger than the offerings of smaller underwriters and the risk is smaller due to the nature of the company and size of underwriter. The commenter, therefore, argues that the proposed amendment would discriminate against small underwriters and discourage them from participating in offerings of securities of small, early-stage companies.

The NASD does not believe the amendment discriminates against small underwriters and small companies. The NASD agrees that there are risks involved in small firm-commitment underwritings, but notes that this risk is one of the reasons why the NASD's underwriting compensation guidelines permit a greater percentage of the gross proceeds as underwriting compensation for smaller firm-commitment offerings. The fact that the NASD has only recently determined that such unfair arrangements are present in underwriters' warrants should not inhibit the NASD from amending its rules to specifically prohibit such unfair arrangements.

Two commenters argued that the amendment should be withdrawn since an underwriter's warrant is assigned a value by the NASD Corporate Financing Department and is taken in lieu of other cash compensation. Further, because this "investment" is made by giving up present compensation for potential future compensation, it should be protected through disproportionate anti-dilution arrangements. In response, the NASD believes that an underwriter's warrant, option, or convertible security, regardless of the value assigned to it in the offering review process, is adequately protected by proportionate anti-dilution rights that will continue to be permitted under the Rule. Moreover, regardless of the valuation assigned to the warrant, the NASD has traditionally prohibited a number of warrant arrangements as unfair and unreasonable.

Notice to Members 93-10 expressed the Committee's determination regarding the unfairness and unreasonableness of allowing underwriter warrants that contain provisions that provide for the receipt or accrual of cash dividends during the term of the warrant, but did not include proposed rule language covering such situations. No comments were received regarding the Committee's determination on this issue, and the text of the amendment has been amended to clarify the prohibition of such an arrangement for options, warrants, or convertible securities.

Request for Vote

The NASD Board of Governors believes that it is appropriate to amend the Rule to prohibit disproportionate anti-dilution provisions and the receipt or accrual of cash dividends by the underwriter and related persons for options, warrants, and convertible securities received as underwriting compensation and recommends that members vote their approval. Before becoming effective, the amendment must be approved by the NASD membership and thereafter by the Securities and Exchange Commission.

Please mark the attached ballot according to your convictions and return it in the enclosed, stamped envelope to the Corporate Trust Company. Ballots must be received postmarked no later than September 27, 1993.

Questions concerning this Notice may be directed to Paul M. Mathews, Supervisor, NASD Corporate Financing Department, at (202) 728-8258.

Text of Proposed Amendment to Article III, Section 44 of the Rules of Fair Practice

(Note: Proposed language is underlined.)

* * * * *

(c) Underwriting Compensation and Arrangements
(c)(1)-(c)(6)(B)(vi)(6) — no change
(7) has anti-dilution terms designed to provide the underwriter and related persons with disproportionate rights, privileges and economic benefits which are not provided to the purchasers of the securities offered to the public (or the public shareholders, if in compliance with subsection (c)(5)(A) above);
(8) has anti-dilution terms designed to provide for the receipt or accrual of cash dividends prior to the exercise or conversion of the security.

Subsection (c)(6)(B)(vi)(7) of the Rule is renumbered Subsection (c)(6)(B)(vi)(9).


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