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84-36 Request for Comments on Possible Amendments to Venture Capital Restrictions
To: All NASD Members and Other Interested Persons
COMMENT PERIOD CLOSES ON: AUGUST 17, 1984
The National Association of Securities Dealers, Inc. ("Association" or "NASD") is requesting comments on possible amendments to restrictions which apply to venture capital investments by NASD members and certain of their control persons. 1/ The proposed amendments, which are discussed in concept below, generally would liberalize the present restrictions.
Currently, 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 states in part 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. 2/
These restrictions (hereinafter the "Venture Capital Restrictions") were added to the Corporate Financing Interpretation on May 31, 1983. 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. 3/
One of the principal concerns leading to adoption of the Venture Capital Restrictions was the potential conflict of interest which may exist when a broker/dealer or its control persons set the public offering price and perform a due diligence investigation for an initial public offering at the same time the firm or persons are selling their own holdings in the company. In this situation, the economic incentive of the firm or persons may be contrary to the financial interests of public investors because, instead of seeking to identify and disclose any adverse information on the issuer and to establish a fair public offering price, the firm or persons arguably would have an incentive to set a high price and adhere to less stringent disclosure standards. The Venture Capital Restrictions, however, are not limited to firms and persons performing pricing and due diligence functions, but apply to any broker/dealer (and its control persons) which participate in any manner in an initial public offering. 4/ For example, a director of a broker/dealer which is acting only as a selling group member for a de_ minimis portion of an offering is prohibited from selling his holdings as part of the offering or for one year thereafter. Many have suggested that the current approach of the Venture Capital Restrictions is unduly broad and imposes an onerous burden on firms and persons who have no influence on the pricing or due diligence for an offering.
The Association's Board of Governors ("Board") and Corporate Financing Committee ("Committee") have carefully considered the present scope of the Venture Capital Restrictions and have concluded that those provisions are unduly expansive and impose unnecessary burdens upon certain broker/dealers and persons without apparent commensurate public benefit. The Association is therefore requesting comments on several proposed amendments to the Restrictions which would narrow their application to situations in which a more specifically identifiable conflict exists.
Proposed Amendments to Venture Capital Restrictions
The Association is proposing to amend the Venture Capital Restrictions to exempt offerings in which a qualified independent underwriter performs pricing and due diligence functions. Additional amendments have been proposed by others. These proposals are discussed below and comments are requested on each.
Participation of Independent Underwriter — The Committee has given particular attention to the conflicts which were intended to be addressed by the Venture Capital Restrictions and the scope of restriction appropriate to assure protection of the public offering process. The potential conflict which exists when a broker/dealer or its control persons seek to sell their holdings while setting an offering price and performing due diligence is not unlike the conflict which exists when a broker /dealer issues its own securities or underwrites securities of an affiliate. Since the early 1970s, the latter conflict has been regulated by Schedule E to Article IV, Section 2 of the NASD By-Laws ("Schedule E"). 5/ Under Schedule E, a broker/dealer which controls, is controlled by, or is under common control with an issuer generally cannot participate in that issuer's initial public offering unless the price is no higher than that recommended by a qualified independent, underwriter who also is responsible for the exercise of usual due diligence. 6/ A qualified independent underwriter must participate in preparing the offering materials and assume underwriter liability pursuant to the Securities Act of 1933. Broker/dealers are required to satisfy specified criteria relating to experience and profitability in order to qualify as independent underwriters 7/
The Committee believes Schedule E has worked effectively to protect investors from underwriters' potential conflicts of interest and that participation by a qualified independent underwriter could effectively address potential conflicts in situations covered by the Venture Capital Restrictions. Accordingly, the Association is today proposing an amendment to the Venture Capital Restrictions to exempt from the Restrictions any offering in which the price is established by a qualified independent underwriter which exercises the usual standards of due diligence and undertakes underwriter liability pursuant to the Securities Act of 1933. To qualify as an independent underwriter, 8/ a broker/dealer must have been actively engaged in the underwriting of public offerings for five years, have been profitable for three of those five years, and be managed by persons with five years experience in the securities business. The Board and Committee have concluded that the participation of an independent underwriter should effectively alleviate any conflicts of interest on the part of firms or persons who participate in distributing an initial public offering while selling their holdings.
While the Board and Committee believe that a good approach to correcting difficulties in the Venture Capital Restrictions lies in exempting offerings in which there is an independent underwriter, we recognize that other approaches may be equally effective. The Association therefore encourages commentators to come forward with suggestions for other amendments. Certain other approaches have already been proposed and are under consideration.
Holding Period — Some have suggested that the Association reinstitute the approach followed for many years prior to adoption of the Venture Capital Restrictions whereby limitations on participation in initial public offerings were inapplicable to securities owned for a specified period prior to the offering. This approach rests on the premise that persons who have had capital at risk for a substantial period should not be penalized by a prohibition against the sale of their holdings as part of the initial public offering or for some period thereafter. As an alternative, a pre-offering holding period could be combined with a shortened post-offering holding period.
Others have suggested that participating broker/dealers and their control persons be permitted to sell their holdings in a manner similar to that available under SEC Rule 144. 9/ Thus, firms and persons could begin selling their holdings 90 days after completion of the initial public offering but would be subject to the limitations contained in Rule 144 regarding the amount of securities which can be sold. One attraction of this approach lies in the familiarity of the SEC staff, the securities bar, and the industry with the concepts and mechanics of Rule 144.
Irrespective of the basis for a holding period, the resulting exemption should be clear as to whether securities can be sold as part of the initial offering or only in subsequent offerings or into a trading market. Some suggest prohibiting any sales in an initial public offering by participating broker/dealers or their control persons, irrespective of their satisfaction of a holding period. The earlier NASD rule was interpreted to permit one to register shares which had been held for an appropriate period.
De Minimis Transactions — Others have suggested that one of the most burdensome inequities of the Venture Capital Restrictions would be alleviated by exempting any broker/dealer whose participation in an offering constitutes a de minimis percentage of the overall offering amount. Similarly, an exemption could be provided for sales of holdings in de minimis amounts. In either case, the exemption could be stated as either a percentage of the offering size or a dollar amount or some combination of both.
Multiple Exemptions — Several persons have emphasized the need for flexibility in structuring initial public offerings and have recommended that any amendments to the Venture Capital Restrictions should provide more than one type of exemption. For example, all of the exemptive approaches discussed above could be incorporated into the rule as alternatives to be utilized under various circumstances.
The NASD solicits comments on each of the proposals described above. There are undoubtedly other approaches which could effectively deal with the potential conflicts addressed by the Venture Capital Restrictions. The Association welcomes any comments or suggestions concerning such alternative approaches.
All comments should be in writing and should be addressed to the following:
James M. Cangiano
National Association of Securities Dealers, Inc.
1735 K Street, N.W.
Washington, D.C. 20006
Comments must be received by August 17, 1984 to be assured of consideration. All comments received will be made available for public inspection.
All comments received during this comment period will be reviewed by the Corporate Financing Committee and changes to the proposed amendments will be recommended as deemed appropriate. If the Board approves amendments to the Corporate Financing Interpretation, those amendments must be filed with, and approved by, the SEC before they become effective. 10/
Gordon S. Macklin
1/ The Association is also publishing today several interpretations of the present restrictions on venture capital. See NASD Notice to Members 84-37 (July 18, 1984) ("Notice 84-37"). A discussion of the background of the restrictions is included in NASD Notice to Members 83-43 (Aug. 17, 1983).
2/ NASD Manual (CCH) p. 2033.
3/ See, NASD Notice to Members 83-24 (May 19, 1983); SEC File No. SR-NASD-83-27.
4/ As explained in Notice 84-37, the restrictions also apply to "downstream" and "sister" subsidiaries of a broker/dealer and control persons' immediate family members.
5/ NASD Manual (CCH) p. 1101-3.
6/ Schedule E, Section 3(c)(l), NASD Manual (CCH) p. 1101-6.
7/ Schedule E, Section 2(k), NASD Manual (CCH) pp.1101-5 and 1101-6.
8/ The criteria for an independent underwriter in Schedule E include a prohibition against affiliation with the issuer. For purposes of the Venture Capital Restrictions, a prohibition against affiliation with any selling shareholder may be appropriate.
9/ 17 CFR Section 230.144.
10/ In addition to these procedures, any amendments to the proposed Corporate Financing Rule would require a vote of the NASD membership.