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88-98 Proposed Amendment to Schedule E Re: Exemption From the Pricing Requirements For Shelf Offerings to Institutional Investors

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REQUEST FOR COMMENTS

EXECUTIVE SUMMARY

The NASD is publishing for comment an amendment to Schedule E to the NASD By-Laws that would exempt a qualified independent underwriter from the pricing requirements of Section 3(c)(1) of Schedule E in connection with "shelf offerings" distributed pursuant to SEC Rule 415 that are to be distributed solely to "institutional investors." The qualified independent underwriter would be required to participate in the preparation of the registration statement and prospectus and to conduct due diligence throughout the effectiveness of the registration statement.

The text of the amendment follows this notice.

BACKGROUND

For the past two years, a Subcommittee of the Corporate Financing Committee has studied the corporate financing activities in which members engage for the benefit of their issuer-clients in connection with takeover transactions, corporate reorganizations, and merchant-banking activities. The subcommittee also studied how members use SEC Rule 415 (17CFR 230.415, referred to as "Rule 415"), which governs the offering of securities on a delayed or continuous basis ("shelf offerings") to refinance those takeover transactions.

The Subcommittee has reported on these activities to the full Committee and has made recommendations on how Schedule E to the NASD By-Laws ("Schedule E") and the Interpretation of the Board of Governors — Review of Corporate Financing (the "Interpretation") should be amended to regulate the distribution-related issues that were identified. The Subcommittee reviewed numerous transactions in which members acted as financial advisors, consultants, and underwriters in connection with private placements of high-yield debt securities to institutional customers. The placement of the high-yield debt securities in a private offering permits a rapid acquisition or restructuring of the target company. In addition, member firms often were permitted to participate as a "partner" in the takeover transaction by purchasing equity securities of the company on the same terms as were other insiders. In these latter cases, the member departs from the traditional role of financial consultant or advisor and becomes a principal in the takeover transaction.

In such transactions, the member also agrees to provide liquidity to its institutional customers, and the issuer usually grants demand registration rights to the institutional investors. The registration rights generally obligate the issuer to file a registration statement covering the securities and use its best efforts to have the registration statement declared effective within six months of the closing of the private offering. As a result, the securities become freely transferable, and the institutional investor can act as a selling security holder in a public distribution of the securities and sell or otherwise transfer the securities on a delayed or continuous basis under Rule 415.

SUMMARY OF PROPOSED AMENDMENTS

As noted above, in many of these situations the member purchases an equity interest in the issuer. In cases where the ownership interest of the member rises to the level of affiliation as defined in Schedule E, and the member represents that it intends to provide liquidity to its institutional customers or to execute sale transactions in the "shelf securities on their behalf, Schedule E would apply to the offering.

Schedule E contains requirements intended to deal with the conflicts of interest present when a member underwrites its own securities or the securities of an affiliate. These conflicts generally arise when the member engages in pricing the offering and conducting due diligence. Schedule E, therefore, requires the participation of a "qualified independent underwriter" in the offering. The qualified independent underwriter is required to perform independent due diligence, participate in the preparation of the registration statement and prospectus and to provide a recommendation stating that, in its opinion, the securities being distributed to the public are offered at a yield that is no lower or a price that is no higher than that which it would recommend.

The Committee recognizes, however, that transactions in "high-yield" debt securities generally take place in negotiated transactions between institutional investors and are usually in large amounts. In light of this fact, the Committee believes that it is neither practical nor necessary to require a pricing opinion from a qualified independent underwriter every time a selling security holder wishes to sell a portion of its securities off the shelf. The Committee recognizes that many institutional investors regularly invest large amounts of money in high-yield securities and that they are capable of determining a fair yield or dividend for such securities. As a result, the Committee believes that it is appropriate to exempt a qualified independent underwriter from rendering an opinion on the price of the securities to be offered as required under Section 3(c)(l) of Schedule E if the securities are sold solely to institutional investors.

Under the proposal, Section 2 of Schedule E would be amended to define an institutional investor as:

a bank, savings and loan association, insurance company, registered investment company, or investment advisor that has more than $100 million under management, or an entity (whether a natural person, corporation, partnership, trust or otherwise) with gross assets of at least $100 million that can demonstrate that it regularly invests in the type and dollar amount of the securities being offered.

Additionally, proposed subsection 3(d) of Schedule E provides conditions under which the pricing recommendation of a qualified independent underwriter would not be required. They are: (1) the securities offered are registered with the SEC pursuant to the Securities Act of 1933; (2) the securities are to be offered or sold pursuant to Rule 415 adopted under the Securities Act of 1933; (3) the securities will be offered or sold from time to time in negotiated transactions; (4) sales by the affiliated member must be made solely to institutional investors defined in Subsection 2(n); and (5) the qualified independent underwriter complies with its due diligence responsibility on a continuous basis as long as the registration statement is effective.

With respect to the qualified independent underwriter's due diligence responsibilities, the Committee is aware that members acting as qualified independent underwriters employ different procedures in order to comply with their obligation to "... exercise the usual standards of 'due diligence' ... "in connection with the distribution of a public offering. The qualified independent underwriters and their counsel must determine which procedures they will use and whether those procedures will permit them to represent to the NASD that they have exercised the usual standards of due diligence. The NASD believes that, as long as the registration statement is effective, a qualified independent underwriter must, at a minimum, receive the following information: all correspondence with the SEC relating to the offering; all press releases; and all other documents customarily reviewed by underwriters in connection with a due diligence review, including quarterly and annual financial statements and reports. The NASD will require that a qualified independent underwriter be contractually obligated to receive this information on a continuous basis, as long as the registration statement is effective, so that it can comply with its due diligence responsibility.

On June 1, 1988, the NASD adopted an amendment to the Interpretation entitled "Proceeds Directed to a Member." This provision governs members' participation in public offerings where more than 10 percent of the net offering proceeds are intended to be paid to members participating in the distribution of the offering, or associated or affiliated persons of such members, or members of the immediate family of such persons. Such participation requires the pricing opinion and due diligence of a qualified independent underwriter. The exception for Rule 415, Schedule E offerings discussed above also has been proposed to apply to "proceeds offerings" where a qualified independent underwriter is required. That proposed amendment is contained in the proposed Corporate Financing Rule [see Section C(8)(ii)], which was published for comment in NASD Notice to Members 88-92, November 1988. The last date for comment on that proposal is December 31, 1988.

Comments on the proposed amendment to Schedule E should be directed to:

Mr. Lynn Nellius, Secretary
National Association of Securities Dealers, Inc.
1735 K Street, NW
Washington, DC 20006-1506

Comments must be received no later than December 31, 1988. Comments received by this date will be reviewed by the NASD Corporate Financing Committee and the NASD Board of Governors. If the proposed amendment, or an amended version resulting from comments received, is approved by the Board, it must be filed with and approved by the Securities and Exchange Commission before becoming effective.

Questions concerning this notice can be directed to Richard J. Fortwengler, Assistant Director, Corporate Financing, at (202) 728-8254.

Proposed Amendments to Schedule E to the By-Laws of the NASD

Section 2

Definitions

(h) Institutional Investor - an investor which comes within any of the following categories:
(a) a bank, savings and loan association, insurance company or registered investment company;
(b) an investment advisor registered under Section 203 of the Investment Advisors Act of 1940 that has more than $100 million under management; or
(c) an entity (whether a natural person, corporation, partnership, trust or otherwise) with gross assets of at least $100 million which can demonstrate that it regularly invests in the type and dollar amount of the securities being offered.

Section 3

Participation in Distribution of Securities of Member or Affiliate

(d) The provision of Subsection 3(c)(l) which requires that the price of the securities be established based on the recommendation of a qualified independent underwriter shall not apply to an offering if:
(1) the securities are registered with the Securities and Exchange Commission pursuant to the Securities Act of 1933, as amended;
(2) the registration statement pertains only to securities which are offered or sold pursuant to Rule 415 adopted under the Securities Act of 1933, as amended;
(3) the securities will only be offered or sold from time to time in negotiated transactions;
(4) sales by the affiliated member will be made solely to institutional investors; and
(5) the qualified independent underwriter complies with Section 2(1) and fulfills all other requirements of Section 3(c)(l) on a continuous basis throughout the effectiveness of the registration statement.

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