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83-49 Request for Comments on Proposed Amendment to Appendix F Concerning Associate General Partners of Direct Participation Programs
TO: All NASD Members and Other Interested Persons
Attention: Direct Participation Program Department
The Association is requesting comments on a proposed amendment to Appendix F to Article III, Section 34 of the Rules of Fair Practice ("Appendix F"). Appendix F relates primarily to public offerings of direct participation programs, most of which are limited partnerships. The amendment would clarify the status under Appendix F of certain broker/dealer affiliates when those affiliates receive ongoing compensation as an associate or co-general partner of a public program distributed by the broker/dealer.
The background and terms of the proposed amendment are discussed below.
The Direct Participation Programs Committee ("Committee") of the Association's Board of Governors has become concerned about an evolving practice whereby subsidiaries or other affiliates of member firms seek to obtain continuing compensation in the form of general partner compensation under circumstances in which that compensation is apparently received as a reward for the distribution of a public direct participation program.
Historically, most direct participation programs were sponsored and managed by organizations with an operating history in the area of program activity, e.g. real estate, oil and gas, and without a direct affiliation with traditional broker/dealers. While the Association has never prohibited members from creating or acquiring bona fide operating sponsors, most programs continue to be managed by traditional, unaffiliated sponsors. Recently, however, an increasing number of programs have been structured with affiliates of traditional broker/dealers acting as associate or co-general partners with programs' operating general partners. These associate general partners typically receive substantial amounts of compensation during the life of the program. The Committee is concerned that the associate general partner structure is being used in some cases to enable broker/dealers to receive otherwise impermissible forms and amounts of underwriting compensation disguised as general partner compensation. Typical arrangements and their status under existing rules are described below.
In a typical arrangement, the broker/dealer which will distribute a new program's units forms a subsidiary (or sister subsidiary under a common holding company) which joins the traditional operating general partner as an associate general partner. The associate general partner can contribute minimal capital because the operating general partner's capital is used to satisfy state securities and tax law requirements. The associate general partner can negotiate to receive any proportion of general partner compensation, however, and that compensation typically is a percentage of program revenues and dissolution proceeds, payable throughout the life of the program.
The associate general partner may not be required to perform any functions in return to its compensation or may perform functions such as investor relations work which are usually performed by broker/dealers. The associate general partner is often able to negotiate both its compensation and functions from a strong position because of its affiliation with the broker/dealer which raises proceeds for the program.
Application of Present Rule
Pursuant to Section 5(b)(l) of Appendix F, the Association presumes underwriting compensation to be unfair and unreasonable if
the total amount of all items of compensation from whatever source payable to underwriters, broker/dealers, or affiliates thereof ... in connection with ... the distribution of the public offering ...
exceeds 10 percent of offering proceeds (plus 0.5 percent for reimbursed due diligence expenses). (Emphasis added.) Section 5(b)(5) of Appendix F contains a presumption against
compensation of an indeterminate nature ... paid to members or persons associated with members for sales of program units, or for services o£ any kind rendered in connection with ... the distribution....*
Fees, such as associate general partner compensation fees, which take the form of participation in program revenues and dissolution profits virtually always are subject to both Subsection 5(b)(1) and (5) if the fees are received "in connection with" the sales effort for a public offering. General partner compensation received for bona fide functions and not "in connection with" a public offering is generally not regulated by the Association.
The critical question under Appendix F in each case of an associate general partner arrangement, therefore, is whether the compensation is received in connection with the public offering. Section 5(d) of Appendix F contains four factors which determine whether compensation is connected to an offering. That section states that
[t]he determination of whether compensation paid to underwriters, broker/dealers, or affiliates thereof is in connection with or related to a public offering ... shall be made on the basis of such factors as the timing of the transaction, the consideration rendered, the investment risk, and the role of the member in the organization, management and direction of the enterprise in which the sponsor is involved. Emphasis added.
The NASD Corporate Financing Department ("Department") applies these factors in deciding whether a connection exists.
The last two factors — risk and the role in management — usually receive the greatest attention when there is a question as to whether a connection exists between an associate general partner arrangement and the sales effort for the offering. The risk factor can be viewed as being two separate factors. First is the risk that any consideration paid or contribution to the program will be lost if the program does poorly. The amounts committed in these capacities are usually small, minimizing risks and suggesting that these are compensation arrangements.
The second aspect of risk in associate general partner structures is the risk of assuming unlimited liability as a general partner, and, therefore, the risk to the capital of the associate general partner. In reviewing offerings, the Department seeks to determine whether associate general partners are bearing full general partner liability. In some cases, agreements have been found indemnifying the associate general partner against any loss. In other cases, there may be full general partner liability but it is borne by a newly-created corporation which has been capitalized with minimal funds.
The final factor — role in management — is viewed as a means of determining whether an associate general partner is performing a bona fide function in return for the compensation to be received or whether the compensation is further payment for the sales effort. As a result of the difficulty in weighing this factor, the Department seeks substantial detail on the anticipated role of a proposed associate general partner, the relevant expertise and experience of its employees, and the need which it is going to fill. Partnership and other agreements are studied to determine whether the associate general partner is legally obligated to perform any service or provide any specific number of man-hours or any facilities. In some cases, personnel of the associate general partners are permitted but not required to attend meetings of the operating general partner's decision-making body. In other eases, such persons are required to attend meetings or provide services if requested by the operating general partner, but there is no indication that the general partner will ever need or want to call on the associate general partner.
After weighing all four factors, the Department concludes whether there is a connection between the proposed compensation of the associate general partner and the distribution of the public offering. If a connection is found, the compensation to the associate general partner is treated as underwriting compensation and, if continuing in nature, is not permitted under Section 5(b)(5) of Appendix F.
On the basis of a review of the applicability of the present provisions of Appendix F to evolving practices, the Committee concluded that it is necessary to amend the language of Appendix F to clarify the applicability of its provisions to these evolving practices.
The Association is therefore publishing for comment a proposed amendment to Section 5(d) of Appendix F which would clarify those instances in which associate general partners will be presumed to be bearing sufficient risk as to satisfy that criteria in determining whether a connection exists between a proposed associate general partner arrangement and a public offering. The conclusion to clarify instances in which the risk test would be satisfied reflects the conclusion of the Committee that the other three tests contained in Section 5(d) are not usually in issue or are sufficiently subjective as to be difficult to refine further. Under the proposed amendment, however, those criteria would be retained and would need to be satisfied for each offering.
Under the proposed amendment, an associate general partner would be presumed to be bearing investment risk when it meets four criteria. First, the associate general partner must be bearing full general partner liability. Secondly, the associate general partner cannot be indemnified against general partner liability by any party.
Thirdly, the associate general partner must have assets equal to at least five percent of the net proceeds of the proposed public offering or $1.0 million, whichever is less. This is intended to assure that a substantial amount of assets are placed at risk and in turn to assure that the associate general partner is performing a bona fide function.
Lastly, the associate general partner must have agreed to retain the above-referenced assets under its control until the dissolution of the program. This is intended to assure that the associate general partner will continue to bear substantial risk throughout the life of the program.
Although not specified in the language of the proposed amendment, it is the Committee's intent that the capital required for associate general partners reflect the capitalization of the associate general partner irrespective of the number of programs for which it acts in that capacity.
Request for Comments
The Association's Board of Governors is given the authority to adopt changes to Appendix F without a vote of the membership by Article III, Section 34 of the Rules of Fair Practice. The Board contemplates adopting the proposed amendments pursuant to that authority.
The Association is requesting comments on the proposed amendments prior to final Board consideration. All comments received during this comment period will be reviewed by the Direct Participation Programs Committee and changes to the amendments will be recommended as deemed appropriate. The Board of Governors will then consider the amendments again. If the Board approves the amendments, they must be filed with, and approved by, the Securities and Exchange Commission before they become effective.
All written comments should be addressed to the following:
S. William Broka, Secretary
National Association of Securities Dealers, Inc.
1735 K Street, N. W.
Washington, D.C. 20006
All comments must be received by October 7, 1983. All comments received will be made available for public inspection.
Any questions regarding this notice should be directed to Dennis C. Hensley or Harry E. Tutwiler of the Corporate Financing Department at (202) 728-8258.
Gordon S. Macklin
Proposed Amendment to Appendix F to Article III, Section 34 of the Rules of Fair Practice*
The determination of whether compensation paid to underwriters, broker/dealers, or affiliates thereof is in connection with or related to a public offering, for purposes of this section, shall be made on the basis of such factors as the timing of the transaction, the consideration rendered, the investment risk, and the role of the member or affiliate in the organization, management and direction of the enterprise in which the sponsor is involved; provided however, that an affiliate of a member which acts or proposes to act as a general partner, associate general partner, or other sponsor of a program shall be presumed to be bearing investment risk if the affiliate is subject to liability as a general partner; is not indemnified against such liability; has assets equal to at least five percent of the net proceeds of the proposed public offering or $1.0 million, whichever is less; and has agreed that said assets will be retained under the affiliate's control until dissolution of the program. For purposes of determining the factors to be utilized in computing compensation derived from securities received in connection with a public offering, the guidelines set forth in the Interpretation of the Board of Governors — Review of Corporate Financing shall govern to the extent applicable.
* The NASD Board of Governors recently approved an amendment to Section 5(b)(5) which will permit continuing compensation to be received under certain circumstances. Among other things, such compensation will only be permitted if cash distribution is less than that normally permitted and the continuing compensation is limited in percentage amount. That amendment must be approved by the Securities and Exchange Commission before it becomes effective. If the amendment were effective, associate general partner compensation received in connection with the offering would be permitted only if all of the amendment's restrictions were satisfied.
* New material is underlined.