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95-95 SEC Approves Amendments To The Corporate Financing Rule Relating To Rights Of First Refusal

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Executive Summary

On September 29, 1995, the Securities and Exchange Commission (SEC) approved amendments to the Corporate Financing Rule, Article III, Section 44 of the NASD Rules of Fair Practice relating to rights of first refusal. The amendment continues to permit the use of rights of first refusal, but prohibits an underwriter from receiving a right of first refusal to underwrite or participate in the issuer's future offerings that:

  • have a duration of longer than three years;

  • have more than one opportunity to waive or terminate the right in consideration of any payment of fee; and

  • are paid other than in cash.

The amended rule also requires that a right of first refusal has a compensation value of one percent of the offering proceeds or the dollar amount contractually agreed to for waiver or termination of the right. The amendment prohibits payment of any fee to waive or terminate a right of first refusal that has a value in excess of the greater of one percent of the original offering (or an amount in excess of one percent if additional compensation is available under the compensation guideline of the original offering) or five percent of the underwriting discount or commission paid in connection with future offering. The full text of the amendment, which becomes effective January 1, 1996, follows the discussion below.1

Background And Discussion Of The Rule Change

The NASD® developed its policy on the valuation of rights of first refusal in the early 1970s. Rights of first refusal are typically negotiated in connection with an issuer's initial public offering (IPO) and grant the underwriter a right to underwrite or participate in any future public offerings, private placements, or other financings by the issuer for a certain period of years.2 The NASD values rights of first refusal as a noncash item of compensation at one percent of the offering proceeds and currently limits the duration of the right to five years. To the extent that an underwriting agreement includes a provision specifying a dollar amount for the waiver or termination of a right of first refusal, the Corporate Financing Rule also requires that the right of first refusal be valued at the dollar amount contractually agreed to for waiver of the right in place of the one percent valuation.3

The NASD believes that members should be permitted to negotiate to waive or terminate a right of first refusal if the issuer wishes to use a different underwriter to subsequently raise additional capital through a public or private offering of its securities, provided that amounts negotiated are limited to an amount that has some relation to the size of the subsequent offering in which the member is not participating. The NASD is concerned that smaller issuers entering into these agreements may not be in a position to evaluate fully the ramifications of agreeing to a right of first refusal with a five-year term. The NASD staff rarely sees a right of first refusal with a term of less than five years, thus there is a concern that the duration of rights may not be freely negotiated by the issuer and the underwriter. The NASD has observed that certain underwriters routinely negotiate to receive rights of first refusal at the time of an IPO and later negotiate to waive or terminate their rights, without any original intent to underwrite any subsequent offering of securities by the issuer.

The NASD is concerned that an issuer may find it difficult to negotiate appropriate underwriting compensation with a new underwriter, where the issuer has determined to sever its relationship with its former underwriter and the former underwriter requires a substantial payment to waive or terminate its right of first refusal. The NASD has determined that underwriters should not be permitted to avoid underwriting compensation limits by negotiating to waive or terminate a right of first refusal with no limitation whatsoever on the amount of compensation they might negotiate to receive.

Three-Year Duration

Currently, Subsection 44(c)(6)(B)(v) of the Corporate Financing Rule prohibits, as unreasonable, any "right of first refusal" regarding future public offerings, private placements or other financings that has a duration of more than five years from the effective date of the offering. The NASD has determined that a right of first refusal with a duration of five years is overreaching and that three years are more appropriate. The NASD has, therefore, amended Subsection 44(c)(6)(B)(v) to reduce the duration of the right of first refusal from five years to three years.

Number Of Payments For Waiver/Termination

The NASD is also amending the Corporate Financing Rule to address the practice of certain underwriters to routinely negotiate to receive rights of first refusal at the time of an IPO and later negotiate, repeatedly, to waive or terminate their rights, without any original intent to actually underwrite any subsequent offerings of securities by the issuer. The NASD has amended the Corporate Financing Rule to add new subparagraph (v)(2) to Subsection 44(c)(6)(B) to limit a member to one opportunity to waive or terminate a right of first refusal in consideration of any payment or fee. An underwriter that does not wish to terminate its right of first refusal for future offerings may preserve its right by waiving its participation in a particular offering without accepting payment for such waiver.4

Limitation On Waiver/ Termination Compensation

The NASD believes that members should be permitted to negotiate to waive or terminate a right of first refusal if the issuer wishes to use a different underwriter to subsequently raise additional capital through a public or private offering of its securities. However, the NASD believes that the amounts negotiated for the waiver or termination of the right should be limited to an amount that has some relation to the size of the subsequent offering in which the member is not participating. The NASD has, therefore, adopted an amendment limiting the amount of such waiver/termination payments by adding a new subparagraph (vi)(1) to Subsection 44(c)(6)(B) to the Corporate Financing Rule to prohibit any payment to waive or terminate a right of first refusal that has a value in excess of the greater of one percent of the original offering (or a higher amount if additional compensation is available under the compensation guideline applicable to the original offering) or five percent of the underwriting discount or commission paid in connection with the future offering (including any overallotment option that may be exercised), regardless of whether the payment or fee is negotiated at the time of or subsequent to the original public offering.5

The one percent limitation reflects the NASD's belief that it is appropriate that the former underwriter be permitted to negotiate a fee that is at least equal to the valuation of the right of first refusal in connection with the NASD's review of the original offering if the issuer wishes to sever its relationship with the former underwriter. The five percent alternative limitation reflects the NASD's belief that the former underwriter that assumed the risk of distributing the issuer's IPO should be allowed to participate or equitably benefit in the issuer's subsequent offering of securities, including any overallotment option that may be exercised, regardless of whether the payment or fee is negotiated at the time of or subsequent to the original public offering.

Cash Payment Requirement

The NASD has also adopted new subparagraph (vi)(2) of Subsection 44(c)(6)(B) of the Corporate Financing Rule to specify that compensation to members for waiving or terminating a right of first refusal must be in cash. The NASD believes this provision will limit the waiver/ termination payment to a percentage of the capital raised in the secondary offering and protect the company's shareholders from dilution from issuing shares to a former underwriter.

Implementation Of Rule

The rule change is applicable to filings that become effective with the SEC on or after January 1, 1996. Thus offerings filed with the NASD Corporate Financing Department that have not become effective with the SEC before January 1, 1996, must comply with the rule change, regardless of whether the Corporate Financing Department has previously issued an opinion that it has no objections to the terms and arrangements.

Questions about this Notice may be directed to the Corporate Financing Department, at (301) 208–2700.


1 Securities Exchange Act Release No. 34–36303 (September 29, 1995); 60 F. R. 52232 (October 5, 1995).

2 Rights of first refusal are also granted in connection with private venture capital investments and leveraged buy-out transactions. The rights granted in connection with private venture capital investments are to underwrite the issuer's initial equity public offering and, therefore, would not normally be considered compensation received in connection with the issuer's IPO. Rights granted in connection with leveraged buy-out transactions are for future financings of the issuer and may be considered received in connection with the issuer's offering of new equity securities or in connection with the secondary offering of debt securities by private debt-holders of the issuer.

3 Subsection 44(c)(3)(A)(ix) has been amended to make the rule language consistent with Subsection 44(c)(6)(B)(v), and add the words "or terminate" to clarify that the dollar amount contractually agreed to by the issuer and underwriter to waive or terminate the right of first refusal will be considered in lieu of the one percent compensation valuation.

4 The NASD anticipates that the former underwriter will contact the NASD Corporate Financing Department when it is negotiating a waiver or termination of a right of first refusal to obtain information on whether additional compensation is available under the compensation guideline applicable to the original offering.

5 The NASD does not include the payment to waive or terminate a right of first refusal as compensation in connection with its review of the subsequent offering of securities. The rule change does not modify this practice.


Text Of Amendments

(Note: New text is underlined; deletions are bracketed.)

The Corporate Financing Rule

Underwriting Terms and Arrangements

Article III, Section 44 of the Rules of Fair Practice

(a) and (b) No change.
(c) Underwriting Compensation and Arrangements
(1) and (2) No change.
(3) Items of Compensation
(A) For purposes of determining the amount of underwriting compensation received or to be received by the underwriter and related persons pursuant to paragraph (c)(2) above, the following items and all other items of value received or to be received by the underwriter and related persons in connection with or related to the distribution of the offering, as determined pursuant to paragraph (c)(4) below shall be included:
(i) through (viii) No change.
(ix) any right of first refusal provided to the underwriter and related persons to underwrite or participate in future public offerings, private placements or other financings [by the issuer], which will have a compensation value of one percent (1 %) of the offering proceeds or that dollar amount contractually agreed to by the issuer and underwriter to waive or terminate the right of first refusal;
(4) and (5) No change.
(6) Unreasonable Terms and Arrangements
(A) No change.
(B) Without limiting the foregoing, the following terms and arrangements, when proposed in connection with the distribution of a public offering of securities, shall be unfair and unreasonable:
(i) through (iv) No change.
(v) any right of first refusal provided to the underwriter or related persons [regarding] to underwrite or participate in future public offerings, private placements or other financings which:
(1) has a duration of more than [five (5)] three (3) years from the effective date of the offering; or
(2) has more than one opportunity to waive or terminate the right of first refusal in consideration of any payment or fee;
(vi) any payment or fee to waive or terminate a right of first refusal regarding future public offerings, private placements or other financings provided to the underwriter and related persons which:
(1) has a value in excess of the greater of one percent (1 %) of the offering proceeds in the public offering where the right of first refusal was granted (or an amount in excess of one percent if additional compensation is available under the compensation guideline of the original offering) or five percent (5%) of the underwriting discount or commission paid in connection with the future financing (including any overallotment option that may be exercised), regardless of whether the payment or fee is negotiated at the time of or subsequent to the original public offering: or
(2) is not paid in cash. Subsections (vi) through (xii) are renumbered (vii) through (xiii).

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