04.20.2004
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Updates
While the Securities and Exchange Commission and self-regulatory organizations like the stock exchanges and Nasdaq have been preoccupied over the past two years with disclosure and governance reforms mandated by the Sarbanes-Oxley Act of 2002, a recently adopted National Association of Securities Dealers rule, Rule 2790, is designed to help reform the initial public offering market, which is showing increasing signs of life. The new NASD rule generally prohibits NASD members from selling equity securities from IPOs to any account in which NASD members, broker-dealers or other "restricted persons" have a beneficial interest. Compliance with the rule became mandatory on March 23, 2004.
The new rule is designed to protect the integrity of the IPO process by ensuring that:
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NASD members make bona fide public offerings of securities at the offering price;
- members do not withhold securities in a public offering for their own benefit or use such securities to reward persons who are in a position to direct future business to members; and
- industry insiders, including NASD members and their associated persons, do not take advantage of their insider position to purchase IPO securities at the expense of other investors.
The new rule codifies, simplifies and expands the prior NASD Free-Riding and Withholding Interpretive Material 2110-1 (the "Interpretation") addressing the same concerns.
The following questions and answers outline the new rule and the manner in which it varies materially from the Interpretation:
Q: Does the new rule, like the Interpretation, apply to only "hot issue" securities?
A: No.
Unlike the Interpretation, which applied only to "hot issues," the new rule covers the purchase and sale of all equity securities in IPOs, whether or not they trade at a premium in the aftermarket.
Q: Does the new rule expand the definition of a "restricted person"?
A: Yes.
The new rule prohibits the sale of IPO equity securities to:
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NASD members;
- other broker-dealers;
- owners and affiliates of broker-dealers;
- any officer, director, general partner, associated person, or employee of a member or broker-dealer;
- any agent of a member or broker-dealer engaged in the investment banking or securities business;
- finders and fiduciaries of the managing underwriter of the IPO;
- portfolio managers; and
- immediate family members of the restricted persons referred to above and other persons to whom the restricted person provides "material support" (25% of the recipient's income as measured in the prior calendar year).
The Interpretation previously permitted certain restricted persons, referred to as "conditionally restricted persons," to purchase "hot issue" securities under limited circumstances. The new rule eliminates this concept in favor of a bright-line rule categorizing persons as either restricted or nonrestricted. The new rule excludes from the new definition of "restricted persons" the personnel, agents and owners of a broker-dealer whose authorization is "limited solely to the purchase and sale of investment company/variable contracts securities and direct participation program securities."
Q: Are there certain classes of persons excluded from the rule?
A: Yes.
The new rule does not apply to sales of equity securities to registered investment companies, widely held trust funds and insurance company accounts, most publicly traded entities, publicly held foreign investment companies, qualified ERISA plans, state or municipal government benefits plans, tax-exempt charitable organizations and certain church plans.
Q: Does the new rule contemplate any exceptions from the application of the rule?
A: Yes.
There are five general exceptions recognized by the new rule: a new de minimis exception, an issuer-directed exception, an anti-dilution exception, an under-subscribed offering exception and an issuer sponsored program exception.
Under the de minimis exception, an account in which a "restricted person" has a beneficial interest of no more than 10%, such as a hedge fund, may purchase IPO securities. The new rule continues the practice permitted under the Interpretation that involves segregating the interests of restricted persons from nonrestricted persons ("referred to as "carve-outs"). Accordingly, an account in which restricted persons hold more than a 10% beneficial ownership interest may continue to purchase IPO securities as long as the restricted persons receive no more than 10% of the notional pro rata proceeds of the IPO securities.
The new rule expands the prior issuer-directed exemption to cover securities directed by an issuer for sale to an employee or director of the issuer, the issuer's parent, or a subsidiary of the issuer or the issuer's parent. The new rule also expands the anti-dilution exemption to cover persons holding an equity interest in the issuer, or another company purchased by the issuer, for at least one year. Certain programs for the sale of securities sponsored by the issuer, or an affiliate of the issuer, and the purchase of securities by underwriters or stand-by purchasers where an offering is under-subscribed are also exempt under the new rule, subject to the satisfaction of certain criteria.
Q: Does the new rule apply to all public offerings of securities?
A: No.
The new rule applies only to a company's IPO of equity securities, and excludes, for example, rights offerings to existing shareholders, exchange offers, offerings made pursuant to a merger or acquisition, convertible securities, preferred securities, securities of an investment company, and securities of foreign private issuers that have a pre-existing market outside the United States.
Q: Are there any procedural requirements under the new rule?
A: Yes.
A member must obtain a representation from an account holder, or the person authorized to represent the beneficial owners of the account, that the account is eligible to purchase new securities in compliance with the rule. The representation must be obtained within 12 months prior to the sale and must be in writing. Oral representations, which were permitted under the Interpretation, are no longer allowed. A member may rely on the information it receives from a customer unless the member believes, or has reason to believe, that the information is inaccurate. The member must maintain records of an account's eligibility for at least three years following the last sale of IPO securities to that account.
Text of the Proposal
This Update is only a summary of the new rule adopted by NASD. You can find a general discussion of related proposals and of other recent laws, regulations and rule proposals of interest to public companies on our website.
