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93-40 Request for Comments on Proposed Amendments to the Free-Riding and Withholding Interpretation Under Article III, Section 1 of the Rules of Fair Practice
The NASD requests comment on proposed amendments to the Free-Riding and Withholding Interpretation under Article III, Section 1 of the Rules of Fair Practice. These amendments would change a number of the Interpretation's provisions. The complete text of the Interpretation follows this Notice.
At its May 1992 meeting, the NASD Board of Governors (Board) appointed a special committee to examine the Free-Riding and Withholding Interpretation (Free-Riding Committee) to determine if the Interpretation's restrictions, definitions and obligations are relevant in today's securities markets. The Committee was comprised of representatives of the NASD's National Business Conduct, Corporate Financing, and Insurance Affiliated Members Committees as well as the members of the Board. The Board also asked the Committee to examine various interpretative issues that had been raised with the NASD. The Free-Riding Committee met numerous times from May 1992 until April 1993 and received input and suggestions, both in writing and in person, from members, issuers, law firms, the NASD Legal Advisory Board, and the staff of various NASD departments.
Overview of Free-Riding and Withholding Interpretation
The purpose of the Interpretation is to protect the integrity of the public offering system by ensuring that members make a bona fide public distribution of "hot issue" securities and neither withhold such securities for their own benefit nor use the securities to reward other persons in a position to direct future business to the member. As defined by the Interpretation, hot issues are securities of a public offering that trade at a premium in the secondary market when such trading commences. The Interpretation prohibits members from retaining such securities in their own accounts and prohibits members from using sales of such securities to directors, officers, employees, and associated persons of members and other broker/dealers. It also restricts member sales of hot-issue securities to the accounts of specified categories of persons, including among others, senior officers of banks, insurance companies, registered investment companies, registered investment advisory firms, and any other persons within such organizations whose activities influence or include the buying or selling of securities. These basic prohibitions and restrictions also apply to sales by members of hot-issue securities to accounts in which any such persons may have a beneficial interest and, with limited exceptions, to members of the immediate family of those persons restricted by the Interpretation.
NASD Compliance Department Procedures
As part of its deliberations, the Committee considered redefining the term "hot issue" to provide more guidance to the membership as to those offerings which are subject to the Interpretation. Rather than taking this approach, however, the Committee asked the staff of the NASD Compliance Department to provide guidance on the internal NASD procedures regarding hot issues. The following description is intended to provide that guidance.
The NASD's Compliance Department in Washington, D.C. has the responsibility of reviewing the after-market quotation and trading activity of all public offerings to determine whether the securities traded in the secondary market at a price which is higher than the public offering price. If the immediate bid quotations of market makers and trade reports by broker/dealers of purchases are at prices above the public offering price on the first day of trading, the offering is deemed to be a "hot issue." The determination of a hot issue is not necessarily based on the opening bid quotation or the first reported transaction; rather, the NASD's focus is on the overall market activity as the secondary market commences and continues, which includes consideration of a pattern of bid quotations and purchases at prices exceeding the public offering price.
This review by the Compliance Department is centralized to insure consistency and uniformity throughout the NASD's 14 district offices. For a security that is characterized by current quotations, real-time trade reporting and secondary market activity which develops on completion of the offering, the NASD takes a number of factors into consideration when determining whether the issue is hot. In active and competitive securities which are normally associated with issues that list on Nasdaq or an exchange, the NASD analyzes inside bid quotations in the immediate secondary market, actual initial transactions, the volume, and the amount of the premium.
While there is no formula or absolute rule that determines precisely at what point in time secondary market trading in securities that have the characteristics described above would result in an issue being deemed hot, the primary factors that are considered are fairly basic. Was there unsatisfied public demand for the issue at the time of the offering; was there immediate demand to buy the stock when it first opened for trading in the secondary market; could the shares purchased in the public offering be sold at a profit in the immediate secondary market?
As an example, a security with a public offering price of $10 that opens for trading on Nasdaq or on a national securities exchange at $10, and trades at that price for several hours, and then moves up to $11 by the close of trading would not be considered a hot issue. Nor would a similarly priced Nasdaq or exchange listed new issue that trades down initially at $9 3/4 from its public offering price of $10, only to move up after several hours to close at $10 1/2. Thus, the NASD focus is on immediate secondary market bids and transaction activity.
As referenced earlier, the regulatory process described above applies to issues where current price, volume and transactional information are accessible on a real-time basis, typically (i.e., Nasdaq or exchange-listed issues). For underwritings of issues that do not have those characteristics, or that may be subject to other conditions such as being dominated and controlled by a particular dealer or group of dealers, or are very inactive or infrequently traded, other criteria may be used by the NASD in determining whether the issue is deemed hot. The NASD also reviews such offerings and subsequent secondary market activity for indications of possible violations of other NASD rules or federal securities laws.
The NASD through its Compliance Department will authorize the issuance of a Free-Riding and Withholding Questionnaire (Free-Riding Questionnaire) for those hot issues that exceed certain preset and predetermined regulatory parameters determined by the NASD. While not all offerings that open at a premium are subject to a Free-Riding Questionnaire, any public offering that opens at a premium is considered a hot issue under the Free-Riding and Withholding Interpretation. District examiners routinely review for compliance with the Free-Riding Interpretation during field examinations for those hot issues that are not the subject of a Free-Riding Questionnaire.
Proposed Modifications for Member Comment
Securities to Be Covered
The Free-Riding Committee recommended that the Interpretation continue to apply to both equity and debt securities, but is seeking comment, including the views of the NASD Fixed Income Committee, on applying the Interpretation to "straight" debt securities. The Free-Riding Committee clearly believes that the Interpretation should continue to apply to convertible and high-yield debt securities. In addition, comments are solicited as to the Legal Advisory Board's suggestion that the NASD consider excluding, at least, "rated" debt from the Interpretation.
The Free-Riding Committee believes that closed-end mutual funds should remain covered by the Interpretation.
The Free-Riding Committee concluded that securities purchased under a stand-by arrangement by a restricted account should not be subject to the Interpretation if:
- The stand-by arrangement is disclosed in the prospectus.
- The arrangement is the subject of a formal agreement.
- There is a representation from the underwriter that it was unable to find any other purchaser for the securities.
- An appropriate holding period for the securities be included. The Free-Riding Committee determined that for purposes of soliciting comment on the proposal it would apply the holding period of five months currently included in the Interpretation's provisions relating to conversion offerings. Comments are specifically solicited on the appropriate holding period for securities purchased under a standby agreement.
Cancellation of Trades as "Safeharbor"
The Free-Riding Committee believes that the Interpretation should make it clear that it is not a violation for a member to allocate a hot issue to a restricted person or account if the member cancels the trade and reallocates the security, at the public offering price, to a nonrestricted account prior to the settlement date. The Committee understands that there may be implications of such cancellations and reallocations under Securities Exchange Act Rule 10b-6 and seeks comment on this issue.
Definition of Immediate Family
The Interpretation now restricts immediate family members of persons enumerated in paragraph 2 which covers persons associated with broker/dealers, and paragraphs 3 and 4 of the Interpretation which relate to persons having a relationship with the offering and individuals related to banks, insurance companies, and other institutional type accounts (see page 262) from participating in hot issues. The rule defines immediate family members very broadly and includes such persons as father-, mother-, brother, and sister-in-law. Members have expressed concern over the compliance difficulties of monitoring whether such persons are restricted or become restricted. The Interpretation also contains a provision that allows for immediate family members of persons designated in paragraph 2 and for persons designated in paragraphs 3 and 4 of the rule to purchase hot issues if they have the requisite investment history with the member making the hot-issue allocation, and the allocation meets certain other requirements.
The Committee's recommendations are:
Applicability to Persons With Limited Registration or Limited Purpose Broker/Dealers
The Free-Riding Committee believes that individuals with various limited purpose registrations should not be considered to be restricted persons. The categories would be persons registered as representatives or principals in registration categories limited to investment company securities, variable contracts, and Direct Participation Program securities. Comment is solicited on the propriety of exempting any securities industry professionals and, if appropriate, the proper scope of such an exclusion.
The Interpretation, in dealing with the topic of "Investment Partnerships and Corporations," generally disallows sales to the partnership or corporation if restricted persons have a beneficial interest in the entity. In the August 1992 Notice to Members, the Board announced it was going to allow investment partnerships on an interim basis to use a "carve out" mechanism to prevent restricted persons in the partnerships from participating in hot-issue allocations. This carve-out mechanism involves the member making such allocation to set up a separate account for these transactions and obtaining from the partnership and its accountants documentation (the partnership agreement) that indicates the restricted persons are prevented from participating in hot-issue allocation.
The Free-Riding Committee believes the carve-out methodology is the most appropriate and should apply both to investment partnerships having restricted persons as investors (as allowed by the August 1992 Notice) and to partnerships that the restricted person or entity is engaged in the manages. The Free-Riding Committee recommends substituting an independent certified public accountant's opinion for the opinion of counsel currently called for in the Interpretation as well as those described below since such opinions are more certifications of fact than a true legal opinion and obtaining such an opinion from a law firm creates undue expense.
The required mechanisms are as follows:
Foreign Mutual Funds
The Interpretation excludes from entities restricted as Investment Partnerships or Corporations, investment companies registered under the Investment Company Act of 1940. The Free-Riding Committee believes foreign mutual funds which are subject to a similar scheme of regulation as that governing domestic funds should be similarly exempted. Comments are solicited on the proper scope of such an exemption and the appropriate methodology for determining the similarity of regulation.
Venture Capital Investors
The Committee recommends allowing purchases by a venture capital investor (either a fund or an individual) if the following conditions are met:
Comment is solicited on the appropriate lock-up period.
Requests for Comments
The NASD asks members and other interested persons to comment on the proposed amendments to the Free-Riding Interpretation. Comments should be directed to Mr. Stephen D. Hickman, Corporate Secretary, National Association of Securities Dealers, Inc., 1735 K Street, NW, Washington, DC 20006-1500.
Comments must be received no later than July 31, 1993. Comments received by this date will be considered by the National Business Conduct Committee and the Board. Before becoming effective, the proposed amendment must be approved by the Board, adopted by the membership, and filed with the SEC for final approval.
Questions concerning this Notice should be directed to T. Grant Callery, Vice President and General Counsel, at (202) 728-8285, or Craig L. Landauer, Associate General Counsel, at (202) 7288291. Questions concerning the Compliance Department procedures should be directed to P. William Hotchkiss, Director, at (202) 728-8235.
Text of Proposed Amendments to Free-Riding and Withholding Interpretation Under Article III, Section 1 of the Rules of Fair Practice
(Note: Proposed language is underlined; deleted language is in brackets.)
Interpretation of the Board of Governors
"Free-Riding and Withholding"
The following Interpretation of Article III, Section 1 of the Association's Rules of Fair Practice is adopted by the Board of Governors of the Association pursuant to the provisions of Article VII, Section 3(a) of the Association's By-Laws and Article I, Section 3 of the Rules of Fair Practice.
This Interpretation is based upon the premise that members have an obligation to make a bona fide public distribution at the public offering price of securities of a public offering which trade at a premium in the secondary market whenever such secondary market begins (a "hot issue") regardless of whether such securities are acquired by the member as an underwriter, as a selling group member, or from a member participating in the distribution as an underwriter or a selling group member, or otherwise. The failure to make a bona fide public distribution when there is a demand for an issue can be a factor in artificially raising the price. Thus, the failure to do so, especially when the member may have information relating to the demand for the securities or other factors not generally known to the public, is inconsistent with high standards of commercial honor and just and equitable principles of trade and leads to an impairment of public confidence in the fairness of the investment banking and securities business. Such conduct is, therefore, in violation of Article III, Section 1 of the Association's Rules of Fair Practice and this Interpretation thereof which establishes guidelines in respect to such activity.
As in the case of any other Interpretation issued by the Board of Governors of the Association, the implementation thereof is a function of the District Business Conduct Committees and the Board of Governors. Thus, the Interpretation will be applied to a given factual situation by individuals active in the investment banking and securities business who are serving on these committees or on the Board.
They will construe this Interpretation to effectuate its overall purpose to assure a public distribution of securities for which there is a public demand.
The Board of Governors has determined that it shall not be considered a violation of this Interpretation if a member which makes an allocation to a restricted person or account of an offering that trades at a premium in the secondary market, cancels the trade for such restricted person or account, prior to settlement date and reallocates such security at the public offering price to a non-restricted person or account.
Except as provided herein, it shall be inconsistent with high standards of commercial honor and just and equitable principles of trade and a violation of Article III, Section 1 of the Association's Rules of Fair Practice for a member, or a person associated with a member, to fail to make a bona fide public distribution at the public offering price of securities of a public offering which trade at a premium in the secondary market whenever such secondary market begins regardless of whether such securities are acquired by the member as an underwriter, a selling group member or from a member participating in the distribution as an underwriter or selling group or otherwise. Therefore, it shall be a violation of Article III, Section 1 for a member, or a person associated with a member, to:
Provided, however, a member may sell part of its securities acquired as described above to:
Scope and Intent of Interpretation
In addition to the obvious scope and intent of the above provisions, the intent of the Board of Governors in the following specific situations is outlined for the guidance of members.
Limited Registration Category
The term limited representative shall include persons registered solely as either investment company and variable contracts products principal or representative, direct participation program principal or representative.
Issuer Directed Securities
This Interpretation shall apply to securities which are part of a public offering notwithstanding that some or all of those securities are specifically directed by the issuer to accounts which are included within the scope of paragraphs (3) through (8) above. Therefore, if a person within the scope of those paragraphs to whom securities were directed did not have an investment history with the member or registered representative from whom they were to be purchased, the member would not be permitted to sell him such securities. Also, the "disproportionate" and "insubstantial" tests would apply as in all other situations. Thus, the directing of a substantial number of securities to any one person would be prohibited as would the directing of securities to such accounts in amounts which would be disproportionate as compared to sales to members of the public. This Interpretation shall also apply to securities which are part of a public offering notwithstanding that some of those securities are specifically directed by the issuer on a non-underwritten basis. In such cases, the managing underwriter of the offering shall be responsible for insuring compliance with this Interpretation in respect to those securities.
Notwithstanding the above, sales of issuer directed securities may be made to restricted persons without the required investment history after receiving permission from the Board of Governors. Permission will be given only if there is a demonstration of valid business reasons for such sales (such as sales to distributors and suppliers or key employees, who are in each case incidentally restricted persons), and the member seeking permission is prepared to demonstrate that the aggregate amount of securities so sold is insubstantial and not disproportionate as compared to sales to members of the public, and that the amount sold to any one of such persons is insubstantial in amount.
Securities purchased pursuant to a stand-by arrangement shall not be subject to the provisions of the Interpretation if the following conditions are met:
Investment Partnerships and Corporations
A member may not sell securities of a public offering which trade at a premium in the secondary market whenever such secondary market begins ("hot issue"), to the account of any investment partnership or corporation, domestic or foreign (except companies registered under the Investment Company Act of 1940) including but not limited to, hedge funds, investment clubs, and other like accounts unless the member complies with either of the following alternatives:
The term beneficial interest means not only ownership interests, but every type of direct financial interest of any persons enumerated in paragraphs (1) through (4) hereof in such account, including, without limitation, management fees based on the performance of the account.
Provided, however, that no restricted person shall be deemed to have a beneficial interest in an account receiving a hot issue as a result of ownership of an interest in or the receipt of management fees from an investment partnership or corporation if the following conditions are met.
Venture Capital Investors
This Interpretation shall not prohibit the sale of hot issues in an initital public offering to a person enumerated in paragraphs (1) through (4) hereof or to an entity in which such restricted person has a beneficial interest (a "Venture Capital Investor") if the following conditions are met:
Violations by Recipient
In those cases where a member or person associated with a member has been the recipient of securities of a public offering to the extent that such violated the Interpretation, the member or person associated with a member shall be deemed to be in violation of Article III, Section 1 of the Rules of Fair Practice and this Interpretation as well as the member who sold the securities since their responsibility in relation to the public distribution is equally as great as that of the member selling them. In those cases where a member or a person associated with a member has caused, directly or indirectly, the distribution of securities to a person falling within the restrictive provisions of this Interpretation the member or person associated with a member shall also be deemed to be in violation of Article III, Section 1 of the Rules of Fair Practice and this Interpretation. Receipt by a member or a person associated with a member of securities of a hot issue which are being distributed by an issuer itself without the assistance of an underwriter and/or selling group is also intended to be subject to the provisions of this Interpretation.
Violations by Registered Representative Executing Transaction
The obligation which members have to make a bona fide public distribution at the public offering price of securities of a hot issue is also an obligation of every person associated with a member who causes a transaction to be executed. Therefore, where sales are made by such persons in a manner inconsistent with the provisions of this Interpretation, such persons associated with a member will be considered equally culpable with the member for the violations found taking into consideration the facts and circumstances of the particular case under consideration.
The fact that a disclosure is made in the prospectus or offering circular that a sale of securities would be made in a manner inconsistent with this Interpretation does not take the matter out of its scope. In sum, therefore, disclosure does not affect the proscriptions of this Interpretation.
Explanation of Terms
The following explanation of terms is provided for the assistance of members. Other words which are defined in the By-Laws and Rules of Fair Practice shall, unless the context otherwise requires, have the meaning as defined therein.
The term public offering shall mean all distribution of securities whether underwritten or not; whether registered, unregistered or exempt from registration under the Securities Act of 1933, and whether they are primary or secondary distributions, including intrastate distributions and Regulation A issues, which sell at an immediate premium, in the secondary market. It shall not mean exempted securities as defined in Section 3(a)(12) of the Securities Exchange Act of 1934.
The term immediate family shall include 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. In addition, the term shall include any other person who is supported, directly or indirectly, to a material extent by the member, person associated with the member or other person specified in paragraph[s] (2)[, (3), or (4)] above.
Normal Investment Practice
Normal investment practice shall mean the history of investment of a restricted person in an account or accounts maintained with the member making the allocation. In cases where an account was previously maintained with another member, but serviced by the same registered representative as the one currently servicing the account for the member making the allocation, such earlier investment activity may be included in the restricted person's investment history. Usually the previous one-year period of securities activity is the basis for determining the adequacy of a restricted person's investment history. Where warranted, however, a longer or shorter period may be reviewed. It is the responsibility of the registered representative effecting the allocation, as well as the member, to demonstrate that the restricted person's investment history justifies the allocation of hot issues. Copies of customer account statements or other records maintained by the registered representative or the member may be utilized to demonstrate prior investment activity. In analyzing a restricted person's investment history the Association believes the following factors should be considered:
In respect to the determination of what constitutes a disproportionate allocation, the Association uses a guideline 10% of the member's participation in the issue, however acquired. It should be noted, however, that 10% factor is merely a guideline and is one of a number of factors which are considered in reaching determinations of violations of the Interpretation on the basis of disproportionate allocations. These other factors include, among other things: the size of the participation;
the offering price of the issue;
the amount of securities sold to restricted accounts;
the price of the securities in the aftermarket.
It should be noted that disciplinary action has been taken against members for violations of the Interpretation where the allocations made to restricted accounts were less than 10% of the member's participation. The 10% guideline is applied as to the aggregate of the allocations.
Notwithstanding the above, a normal unit of trading (100 shares or 10 bonds) will in most cases not be considered a disproportionate allocation regardless of the amount of the member's participation. This means that if the aggregate number of shares of a member's participation which is allocated to restricted accounts does not exceed a normal unit of trading, such allocation will in most cases not be considered disproportionate. For example, if a member receives 500 shares of a hot issue, he may allocate 100 shares to a restricted account even though such allocation represents 20% of the member's participation. Of course, all of the remaining shares would have to be allocated to unrestricted accounts and all other provisions of the Interpretation would have to be satisfied. Specifically, the allocation would have to be consistent with the normal investment practice of the account to which it was allocated and the member would not be permitted to sell to restricted persons who were totally prohibited from receiving hot issues.
This requirement is separate and distinct from the requirements relating to disproportionate allocations and normal investment practice. In addition, this term applies both to the aggregate of the securities sold to restricted accounts and to each individual allocation. In other words, there could be a substantial allocation to an individual account in violation of the Interpretation and yet be no violation on that ground as to the total number of shares allocated to all accounts. The determination of whether an allocation to a restricted account or accounts is substantial is based upon, among other things, the number of shares allocated and/or the dollar amount of the purchase.
[Interpretation adopted effective November 1, 1970; amended effective January 11, 1972, March 21, 1972, December 1, 1973, June 1, 1983, July 16, 1983 and August 29, 1988].
Sales By Issuers in Conversion Offerings
Conditions for Exemption
Sales to Members, Associated Persons of Members and Certain Related Persons
Sales to Other Restricted Persons
[Added effective September 25, 1986.]