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93-10 Request for Comments On Proposed Amendment to the Corporate Financing Rule Relating to the Fairness And Reasonableness of Underwriter Warrant's Anti-Dilution Provisions


Senior Management
Corporate Finance
Legal & Compliance

Executive Summary

The NASD® requests comment on a proposed amendment to the Corporate Financing Rule under Article III, Section 44 of the Rules of Fair Practice intended to regulate the anti-dilution provisions of warrants received as underwriting compensation. The amendment would provide that underwriters and related persons may not receive warrants as compensation if the warrant contract includes anti-dilution provisions with disproportionate rights, privileges, and economic benefits that are not provided to existing shareholders of a company or to investors purchasing the company's securities in a public offering. The text of the proposed amendment follows this Notice.


The NASD's Corporate Financing Committee (Committee) has reviewed the anti-dilution provisions of warrants received as underwriting compensation by members participating in public offerings of securities. In some instances, the underwriter's warrants acquired by member firms have included arrangements that appear to be unfair and unreasonable under the Corporate Financing Rule, Article III, Section 44 of the Rules of Fair Practice (Rule). Documents filed with the Securities and Exchange Commission (SEC) in 1991 regarding the Rule included a suggestion to clarify the provisions of Subsection (c)(6)(B)(vi)(7) by excluding from its scope any inference that the anti-dilution provisions of an underwriter's warrant could be viewed as unfair or unreasonable because its terms would permit an underwriter to exercise or convert the warrant on terms more favorable than the terms of the securities being offered to the public. The NASD rejected that position because it had recently reviewed a number of anti-dilution provisions that appeared to give underwriters the ability to acquire stock substantially in excess of the Rules' Stock Numerical Limitation, and exercise the warrant at prices substantially below the price established at the date of grant. The Committee also concluded that warrants received by members as compensation for a public offering should not be structured to provide these types of disproportionate benefits through the operation of anti-dilution provisions.

The Committee believes that the underlying principle guiding the application of the Rule to anti-dilution provisions of warrants acquired as compensation in public offerings should be to ensure that an underwriter does not negotiate to receive securities as underwriting compensation that contain terms more favorable than the terms of the securities offered to the public. Since an underwriter should not receive securities on terms more favorable than its customers, the anti-dilution clauses pertaining to any warrants received as compensation should not provide a potential for economic benefit that is not also received by the purchasers of the securities offered to the public.

Overall, the Committee believes that the anti-dilution rights associated with any security acquired as compensation by a member in a public offering should not put the member at an advantage over its customers based on the occurrence of any event affecting the issuer's capitalization. Accordingly, anti-dilution clauses should provide an underwriter only with those benefits it would have received had the warrant been exercised immediately before any event.

The Committee also believes that the provisions of an underwriter's warrant should encourage a commonality of interest by the underwriter, issuer, and public investors. Thus, the member should have an incentive to follow the company's progress and provide research and trading support to the stock in the aftermarket. Any clauses of a warrant contract that provide a member with an incentive that may be inconsistent with these premises are inappropriate.

The proposal would prohibit anti-dilution provisions of underwriter's warrants that provide all the benefits of a shareholder plus various degrees of protection not afforded to public shareholders. These include provisions that provide protection from dilution or adjustments to exercise price in the event of new issuances of securities in public or private offerings, stock option plans, or the conversion of existing convertible securities. These types of anti-dilution protections are common in agreements designed to protect venture capital investors that have taken on the bona fide investment risk of providing early stage financing. However, the Committee does not believe such protections are appropriate in underwriter's warrant contracts where the underlying service provided is a distribution of securities and the warrants are part of a compensation package.

Findings by the Committee

The Committee reviewed a number of underwriter's warrant agreements to determine the nature of the various anti-dilution clauses contained in these documents. In general, anti-dilution clauses can be divided into two distinct classes:

  • Proportionate Benefits: These provide customary anti-dilution adjustments to exercise price and number of securities in response to events affecting all shareholders such as, among others, stock dividends, combinations, reclassifications, and recapitalizations that entitle the underwriter to participate in the event as if it had been a shareholder before the event. These standard anti-dilution rights do not protect from dilution caused by new public or private issuances of securities or issuances under stock option plans. In addition, the rights generally assume the warrant has been exercised to determine any required adjustments.

  • Disproportionate Benefits: These provide the holder of the warrant with all shareholder benefits, as well as varying degrees of protection from dilution by any new issuances of securities. This category may provide adjustments in the event of issuances under stock option plans, the conversion of existing convertible securities, and may even provide for the receipt of accrued cash dividends where dividends are declared before exercise of the warrant. Adjustments to exercise price and number of shares in response to new issuances of securities include variations which "weight" the effect of changes in the company's capitalization and also those which "ratchet" the adjustment without regard to the actual dilutive affect of the new issuance of securities.

Certain warrant contracts in this category can include anti-dilution clauses that provide adjustments to exercise price and number of shares that far exceed the actual dilution experienced by the holder of the warrant. Such clauses can penalize an issuer by causing the exercise price for the entire warrant to drop in response to the issuance of a single option to an employee. This "ratchet" type adjustment mechanism, if triggered repeatedly, can result in the exercise price of an underwriter's warrant dropping to a price far below the price of the new issuance that triggered the anti-dilution clause. This is because the underwriter's exercise price is typically reduced with each issuance below either the market price of the issuer's shares or the exercise price of the warrant, resulting in the underwriter's exercise price being ratcheted lower with each successive issuance but never readjusting upwards.

In addition to wholesale reductions in the exercise price without giving effect to the price or number of shares sold, certain warrant contracts can further penalize the issuer by increasing the amount of shares subject to the warrant without any relationship to actual dilution (i.e., if one option is issued at half the underwriter's warrant exercise price, the underwriter's warrant will become exercisable at half the original price for double the original amount of shares). The Committee believes that such anti-dilution clauses should also be considered unfair and unreasonable under the Rule.

Explanation of Amendment

As noted above, adjustments to exercise price and number of shares that result from these unfair provisions include variations which "weight" the effect of changes in the company's capitalization and those that "ratchet" the adjustment without regard to the actual effect of the new issuance of securities. These provisions are constructed in a manner that provides disproportionate benefits to an underwriter relative to public shareholders or provides benefits that are simply unique to the underwriter, such as the accrual of cash dividends relating to the securities underlying the underwriter's warrant.

The proposed rule language reflects the general fairness standard held by the Committee that it is inequitable for the underwriter to receive rights, privileges, or economic benefits that are more favorable than the benefits received by public investors who purchase securities in public offerings. Specifically, the rule language prohibits the grant of any anti-dilution privilege to the underwriter and related person that is not also available to shareholders or investors.

Request for Comments

The NASD asks members and other interested persons to comment on the proposed amendment to the Corporate Financing Rule. 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 March 31, 1993. Comments received by this date will be considered by the Corporate Financing Committee and the Board of Governors. 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 Paul Mathews, Supervisor, 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)(7) - no change
(8) Contains anti-dilution provisions designed to provide the underwriter and related persons with disproportionate rights, privileges and economic benefits which are not provided to shareholders or the purchasers of the securities offered to the public.

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