The Securities and Exchange Commission (the "SEC") is soliciting comment on a proposed rule filed by the National Association of Securities Dealers, Inc. (the "NASD"). The proposed new rule, Rule 2790, would govern allocations of "hot issues" and replace the Free-Riding and Withholding Interpretation under NASD Rule 2110. The new rule would differ from the existing interpretation in several important respects:
- A formula would determine whether an offering is a "hot issue;"
- All public equity offerings - including secondaries - would be covered, and all debt offerings would be excluded;
- Affiliates of a broker-dealer would be restricted persons under the rule;
- Broker-dealers would be required to maintain a current certification for every account purchasing hot issues;
- The exemption for sales of hot issues to persons in a manner consistent with their "normal investment history" would be eliminated; and
- The rule would simplify sales to hedge funds and other "collective investment accounts" whose members include restricted persons.
The SEC published the rule for comment on January 10, 2000. See Exchange Act Release No. 42325 (January 10, 2000). Comments must be submitted to the SEC no later than February 8, 2000.
- General Scope and Application of the Rule
- Definition of a "Hot Issue"
For purposes of the new rule, an offering would be defined as a "hot issue" if, within the first five minutes of trading, the volume weighted price of the security is five percent or more above the offering price.
- Initial and Secondary Equity Offerings
Proposed Rule 2790 would apply to all initial and secondary public offerings of equity securities (including convertible debt offerings and other offerings with an equity component) that are "hot issues." All nonconvertible debt securities would be exempted from the rule. This represents a departure from the scope of the existing interpretation, which applies to offerings of non-investment grade debt but exempts secondary offerings of securities that are "actively-traded."
- Definition of "Restricted Person"; Scope of Rule's Prohibitions
The proposed rule purports to simplify the categories of "restricted persons" to whom sales of hot issues are prohibited. Some categories are narrowed and others are expanded.
- "Conditionally restricted persons". One of the most significant proposed changes is the elimination of "conditionally restricted persons" (i.e., restricted persons who were permitted to purchase hot issues if they could demonstrate that such purchases were consistent with their normal investment practice). While the elimination of the conditionally restricted category of persons would likely streamline a member firm's compliance with the rule, it also would preclude sales to many persons permitted to purchase hot issues under the existing interpretation.
- Senior managers of financial institutions. Persons who supervise or whose activities involve the buying or selling of securities for banks, savings and loan institutions, insurance companies, investment companies, investment advisory firms or "collective investment accounts" would be restricted persons under the rule. By limiting the restriction to these persons, the rule would be more narrowly tailored than the interpretation, which also includes senior officers of the above institutions.
- Affiliates of broker-dealers. The proposed rule expands the category of restricted persons to include companies affiliated through a control relationship with most broker-dealers.
- Definition of "Collective Investment Account"
The new rule defines a "collective investment account" as "any hedge fund, investment partnership, investment corporation, or any other collective investment vehicle that manages assets of other persons." The definition attempts to draw a distinction between persons directing investments of their own money and persons directing investments of other people's money, with only the latter group being restricted under the rule. As a result, entities such as investment clubs in which the decision to buy or sell securities is made jointly by each of the persons investing in the entity or by a member of their immediate family would not be collective investment accounts.
- Definition of a "Hot Issue"
- Exemptions from the General Prohibitions of the Rule
As with the existing interpretation, proposed Rule 2790 contains a number of specific exemptions from the rule's general prohibitions. In this regard, one of the most significant changes from the current interpretation is the elimination of the exemption for "conditionally restricted persons" that can demonstrate the requisite investment history. See Section I.C., above. The new rule also would modify several other existing exemptions:
- Sales to Collective Investment Accounts
The proposed rule attempts (with limited success) to simplify the prohibitions on sales to collective investment accounts in which restricted persons have a very limited ownership interest. Under the current interpretation, sales to hedge funds and investment partnerships or corporations in which a restricted person has a beneficial interest are prohibited unless that person's interest is "carved out" -- a condition that can be quite burdensome. The proposed new rule would permit sales to collective investment accounts in which restricted persons' aggregate beneficial ownership is less than 5%. Although the new rule does not provide for a carve-out where restricted persons beneficially own more than 5% of an account, the NASD rule filing states that such an approach will still be acceptable. No specific procedures are provided for carving out such restricted persons.
- Issuer-Directed Share Purchase Programs
The proposed new rule would retain a modified version of the prior exemption for issuer-directed securities. Specifically, the exemption would be expanded to include employees and directors of an entity under common control with the issuer and would eliminate the current three-month lock-up requirement for sales to restricted persons of securities for which a bona fide independent market does not exist.
- Sales to Collective Investment Accounts
- Documentation and Recordkeeping Requirements
A broker-dealer would be required to maintain and update at least annually a verification from every account to which it sells hot issues certifying that no "restricted person" has a beneficial interest in the account (i.e., the certification must be dated no earlier than 12 months prior to the date of the sale of a hot issue to the account). This will create a significant burden. As a practical matter, firms would be required to maintain a current certification for every account to which they may potentially sell a portion of any initial or secondary offering of equity securities. A firm would be permitted to rely upon the customer's certification unless the firm had reason to believe the representation was inaccurate. Moreover, the firm would be required to retain the certification on file for at least three years following the date of the member's last sale of a hot issue to that account.
If you have any questions regarding the proposed new rule or if you would like assistance in preparing a comment letter, please contact any of the following Brown & Wood LLP lawyers:
- NEW YORK OFFICE
- Dennis C. Hensley
- 212-839-5731
- Joseph McLaughlin
- 212-839-5312
- Norman D. Slonaker
- 212-839-5356
- Judith Welcom
- 212-839-5362
- SAN FRANCISCO OFFICE
- Eric Haueter
- 415-772-1231
- Paul Pringle
- 415-772-1249
- WASHINGTON, D.C. OFFICE
- Barbara J. Endres
- 202-533-1412
- John Arnholz
- 202-533-1444
- Frank R. Goldstein
- 202-533-1400
- LONDON OFFICE
- Christopher B. Mead
- 011-44-171-778-1821
- E. Mark Walsh
- 011-44-171-778-1851
- Scott P.F. Cameron
- 011-44-171-778-1856
- HONG KONG OFFICE
- Kenneth Cote
- 011-852-2509-7890