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84-37 Interpretation of Venture Capital Restrictions
TO: All NASD Members and Other Interested Persons
The National Association of Securities Dealers, Inc. ("Association" or "NASD") is publishing interpretations of restrictions which apply to venture capital investments by NASD members and certain of their control persons. 1/ These restrictions (hereinafter the "Venture Capital Restrictions") were added to the Interpretation of the Board of Governors — Review of Corporate Financing ("Corporate Financing Interpretation") under Article III, Section 1 of the NASD Rules of Fair Practice on May 31, 1983. 2/ The text of the Venture Capital Restrictions is as follows:
No member or officer, director, general partner or controlling shareholder of a member which participates in the initial public offering of an issuer's securities and which beneficially owns any securities of said issuer at the time of filing of the offering shall sell those securities during the offering or sell, transfer, assign or hypothecate those securities for one year following the effective date of the offering. 3/
A similar provision is contained in the proposed Corporate Financing Rule which, if approved by the Securities and Exchange Commission ("SEC" or "Commission"), will replace the Corporate Financing Interpretation. 4/
Shortly after adoption of the Venture Capital Restrictions, several interpretive questions arose regarding the applicability of the Restrictions in various fact situations. These questions have now been considered by the Association's Corporate Financing Committee ("Committee") and Board of Governors ("Board") in conjunction with discussions with the SEC staff and their views are described herein. The following interpretations do not exclude application of the Venture Capital Restrictions in other fact situations. In addition, it should be noted that these interpretations relate to the present language of the Venture Capital Restrictions and will not necessarily apply if the language is revised.
Sister Subsidiaries — Numerous questions have arisen concerning the applicability of the Venture Capital Restrictions to "sister" subsidiaries of a broker/dealer, i.e., corporations or partnerships which are controlled by the entity which controls the broker /dealer. The Association has taken the position from the outset that the Restrictions apply to "downstream" subsidiaries of a broker/dealer, i.e., corporations or partnerships controlled by the broker /dealer, because profits realized on securities held by such subsidiaries are assumed to inure to the economic benefit of the broker/dealer. Securities owned by downstream subsidiaries are therefore viewed as beneficially owned by the broker/dealer.
It has been less clear whether securities owned by sister subsidiaries should be viewed as beneficially owned by a broker/dealer. Some maintain that the conflict addressed by the Venture Capital Restrictions, the potential conflict of interest in setting price and performing due diligence, is present only when a participating broker/dealer or its officers, directors, or general partners stand to benefit from the contemplated public offering. Others maintain, however, that similar conflicts are present when a controlling shareholder of a participating broker/dealer stands to realize a benefit and that such a shareholder should be seen as benefiting from sales of securities held by a subsidiary it controls.
On the basis of a review of the language and discussions with the SEC staff, the Association's Committee and Board have concluded that the Venture Capital Restriction should apply equally to securities which are beneficially owned by sister subsidiaries of broker/dealers and securities which are directly owned by such broker/dealers. A controlling shareholder realizes direct or indirect economic benefit from profits earned by the controlled entity and securities owned by a sister subsidiary of a broker/dealer will be viewed as beneficially owned by the controlling shareholder of the broker/dealer and therefore subject to the Venture Capital Restrictions.
For purposes of determining whether an entity is a sister subsidiary, a downstream subsidiary, or a controlling shareholder, the Association will look to the definition of "affiliate" contained in Schedule E to Article IV, Section 2 of the NASD By-Laws. 5/ Under that definition, any corporation or partnership which controls, is controlled by, of is under common control with, a broker/dealer is an affiliate. The definition creates a presumption of control whenever one entity beneficially owns 10 percent or more of the outstanding voting securities of another.
Immediate Family Members — The Venture Capital Restrictions apply to securities which are beneficially owned by an officer, director, general partner, or controlling shareholder of a broker/dealer participating in an initial public offering. The SEC staff has raised questions concerning the status of immediate family members of these persons, arguing that one could evade the Restrictions by placing securities in the name of a family member and in fact realize directly or indirectly the economic benefit of an unreasonably high public offering price. Others maintain that the concept of beneficial ownership is broad enough to encompass situations of this nature.
In deference to the Commission staff, however, and in order to more specifically define the scope of beneficial ownership, the Association's Board and Committee have concluded that the Venture Capital Restrictions should apply to immediate family members of officers, directors, general partners, and controlling shareholders of a broker/dealer participating in an initial public offering.
For purposes of the Venture Capital Restrictions, "immediate family" shall have the same meaning as in the Interpretation of the Board of Governors on Free-Riding and Withholding under Article III, Section 1 of the NASD Rules of Fair Practice. 6/
Managed Accounts — Questions have arisen as to whether securities held in accounts managed by a broker/dealer should be viewed as beneficially owned by the broker/dealer for purposes of the Venture Capital Restrictions. The principal purpose of the Venture Capital Restrictions is to alleviate conflicts which could exist when a firm or individual setting the price of an initial public offering stands to profit from an unreasonably high price. That conflict is not present unless the firm or individual is entitled to receive profit realized upon sale of the securities.
The Association's Board and Committee have concluded, therefore, that the Venture Capital Restrictions do not apply to securities held in managed accounts (including securities held in the name of a broker/dealer) so long as no participating broker/dealer or officer, director, general partner, or controlling shareholder of such a broker/dealer beneficially owns the securities. Where a portion of the securities in an account are beneficially owned by a restricted firm or person, that portion of the account's position is subject to the Venture Capital Restrictions. The Restrictions can be satisfied in such instances either by delivering securities in-kind to the restricted parties so as to remove restrictions on the remaining holdings, or by implementing procedures to assure that no restricted party receives any economic benefit from the sale of the unrestricted portion of the holdings.
The Association is informed that it is not uncommon for certain types of investment partnerships to provide compensation to the account manager in the form of a participation in account profits after certain conditions are satisfied. For purposes of the Venture Capital Restrictions, the Association will not view such compensation arrangements as providing the account manager with a beneficial ownership interest in the account.
Securities Issued By Broker/Dealers — A literal application of the Venture Capital Restrictions to distributions by a broker/dealer of its own securities might result in a finding that the broker/dealer could not sell such securities because it beneficially owned them at the time the offering was filed. This result was obviously not intended. While there is little dispute as to the application of the Restrictions to sales by a broker/dealer firm, questions have arisen concerning sales by officers, directors, general partners, or controlling shareholders of a broker/dealer when the broker/dealer issues securities. Some argue that application of the Restrictions is unduly onerous when an otherwise restricted person proposes to sell a relatively small portion of securities which he or she has owned for several years. The SEC staff has expressed some concern, however, about potential conflicts when an individual proposes to sell a large portion of recently acquired securities while actively participating in the pricing of a broker/dealer's new offering. The Association has been reviewing such situations on a case-by-case basis.
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We are hopeful that these interpretations will serve to clarify the application of the Venture Capital Restrictions. The Committee will continue to address further interpretive questions which arise.
Gordon S. Macklin
1/ The Association is also publishing today proposed amendments to the restrictions on venture capital which, if adopted, would substantially alter those restrictions and, therefore, the interpretations contained herein. See NASD Notice to Members 84-36 (July 18, 1984).
2/ See NASD Notice to Members 83-43 (Aug. 17, 1983).
3/ NASD Manual (CCH) p. 2033. A discussion of the background of the Venture Capital Restrictions is included in NASD Notice to Members 83-43 (Aug. 17, 1983).
4/ See NASD Notice to Members 83-24 (May 19, 1983); SEC File No. SR-NASD-83-27.
5/ NASD Manual (CCH) p. 1101-3.
6/ NASD Manual (CCH) p. 2045.