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85-29 Compensation Received in Connection with Direct Participation Programs
TO: All NASD Members and Other Interested Persons
ATTN: Direct Participation Programs Department
The NASD's Direct Participation Programs and Real Estate Committees have reviewed certain information received from members and their affiliates through the review process carried out by the NASD Corporate Financing Department. The Committees reviewed the costs associated with issuing and distributing direct participation program securities, specifically, the allocation of offering costs between underwriting compensation and the issuer's organization and offering expenses. The purpose of this notice is to inform the membership and sponsors of direct participation programs of the Committees' findings and to clarify the application of NASD compensation guidelines in certain areas.
On October 19, 1982, the NASD published Notice to Members 82-50, which announced the adoption of Appendix F to Article III, Section 34 of the NASD's Rules of Fair Practice. Appendix F applies to public offerings of direct participation programs and, among other things, provides that underwriting compensation from any source may not exceed Association guidelines. In addition, where a program sponsor is affiliated with an NASD member distributing the program, the issuer's organization and offering expenses payable from offering proceeds or program distributions may not exceed Association guidelines. Simultaneously, the Association published Notice to Members 82-51, which announced the Association's guidelines on underwriting compensation and organization and offering expenses referenced in Appendix F. Underwriting compensation may not exceed 10 percent of the gross proceeds of the offering, regardless of the source, with the exception that up to an additional 0.5 percent may be reimbursed to underwriters for bona fide due diligence expenses. Where a sponsor is affiliated with a distributing NASD member, the issuer's organization and offering expenses may not exceed 15 percent of the proceeds of the offering, which includes the 10 percent underwriting compensation. Organization and offering expenses in excess of 15 percent may be paid from sources other than the program or its offering proceeds. While the 10 percent limitation on underwriting compensation is applied to all public direct participation programs, the 15 percent limitation on organization and offering expenses is only applied to sponsors that are affiliated with NASD members. Organization and offering expenses ordinarily include legal, printing, accounting and other fees of the issuer attributable to the preparation of a program for registration and subsequently offering interests to the public.
Compensation arrangements reviewed by the Department are for the most part properly allocated between underwriting compensation and organization and offering expenses. There are four areas, however, in which the Committees believe clarification of the Association's application of Appendix F and, in some instances, the federal securities laws is required. These areas are wholesaling, due diligence reimbursement, advertising and sales literature, and retail seminars.
The issues surrounding wholesaling are long-standing and have frequently arisen in the Association's review of direct participation program offerings. Where contacts with the broker-dealer community are made by bona fide employees of the issuer who do not perform wholesaling activities on a regular basis, without transaction-based compensation and incidental to their other duties and responsibilities, such persons generally are not required to register as broker-dealers. A problem arises, however, when the sponsor assigns the responsibility for contact between the issuer and the retail brokerage community to full-time specialists. The sponsor often assigns these persons geographic areas of responsibility and provides compensation in the form of salary or commissions based on the sales levels that occur within their areas of responsibility.
The information gathered by the Department has been useful in identifying when this occurs. The Department has found such wholesaling activities within both the sponsor and the general partner. In addition, a number of programs have been reviewed where a sponsor that maintains internal wholesaling capabilities has an NASD member affiliate as well. In this event, the Department found that the wholesaling expenses of the sponsor are not properly allocated by the sponsor to underwriting compensation, but are attributed solely to the sponsor's organization and offering expenses.
When the Department determines that such a wholesaling function exists within the sponsor or general partner, the Department will request that the Securities and Exchange Commission be contacted to determine whether the individuals are required to be registered as broker-dealers under the Securities Exchange Act of 1934. If the sponsor has an NASD member affiliate, the individuals will be requested to register with the member. In any event, the Department will include all salaries, expense reimbursements, bonuses and other forms of compensation associated with the wholesaling function in the 10 percent guideline on underwriting compensation.
A second area needing clarification involves the proper allocation of due diligence expenses. Appendix F permits an additional 0.5 percent due diligence expense reimbursement above the 10 percent maximum on underwriting compensation. Many sponsors appear to misunderstand the activities that are properly included within the due diligence expense reimbursement. The Department observed, for example, that sales incentive vacations awarded to top producers at the close of the offering were allocated to due diligence. If this occurs, the Department will exclude such expenses from the additional 0.5 percent allowed for bona fide due diligence and reallocate such payments as incentive compensation subject to Sections 5(e) and (f) of Appendix F and the 10 percent underwriting compensation guideline.
The proper characterization of due diligence expenditures that may exceed the 10 percent limitation by 0.5 percent includes reimbursable expenses incurred by a member in affirmatively discharging its responsibility pursuant to Section 4 of Appendix F to ensure that all material facts pertaining to the program are adequately and accurately disclosed in the prospectus. If travel is necessary to discharge this obligation, it would ordinarily be undertaken by the responsible officials of the member to the partnership offices to verify the information provided to the member. Expenses associated with travel by the issuer's officials to due diligence meetings are, on the other hand, allocated to the issuer's organization and offering expenses.
Advertising and Sales Literature
A third area involves the proper characterization of the expenses of advertising materials generated to promote the sale of the sponsor's securities. Generally, sponsors wish to maintain control over the accuracy and the consistency with the prospectus of their advertising disseminated to the public. In most programs, the costs associated with creating advertising and sales promotion literature are borne by the sponsor. Therefore, the sponsor's advertising and promotional material expenses are allocated to the issuer's organization and offering expenses. However, supplemental sales literature generated by the broker-dealer with the associated costs reimbursed by the sponsor are required to be allocated to underwriting compensation and are subject to the 10 percent guideline.
The last issue involves the proper allocation of expenses for retail seminars. Generally, a sponsor's expenses for retail seminars are not included in underwriting compensation. Sponsor's expenses in this regard are normally related to officials of the sponsor appearing at seminars for the purpose of explaining the details of the program. However, any reimbursement by the sponsor of the expenses of broker-dealers for their activities at such seminars is allocated to the broker-dealer as underwriting compensation and included in the 10 percent guideline.
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The NASD hopes that this notice will aid the membership and sponsors by providing clarification of the policies of the Corporate Financing Department in its review of underwriting arrangements in direct participation program offerings. Any comments or questions regarding this notice should be directed to Richard J. Fortwengler or Larry M. Worrell of the NASD's Corporate Financing Department at (202) 728-8258.
Frank J. Wilson
Executive Vice President
Legal and Compliance