Willkie Farr & Gallagher
787 Seventh Avenue
New York, NY 10019-6099
Direct: 212 728 8206
Fax: 212-728-8111
rblanc@willkie.com

September 24, 2002

U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Attention: Mr. Jonathan G. Katz, Secretary

    Re: File No. SR-NASD-99-60
    NASD Proposed Rule 2790

Dear Mr. Katz:

We are commenting on Amendment No. 4, submitted by NASD, Inc. ("NASD") on June 27, 2002, on Form 19b-4 to proposed Rule 2790, Restrictions on the Purchase and Sale of Initial Equity Public Offerings ("Proposed Rule 2790"). Proposed Rule 2790 would replace the existing Free-Riding and Withholding Interpretation (the "Interpretation"). The Interpretation and the Proposed Rule 2790 preclude NASD member firm broker-dealers from selling certain securities to specified persons ("Restricted Persons").

Collective Investment Account Managers. While a number of the revisions in Amendment No. 4 are helpful, one eliminates a provision NASD had added in the Amendment No. 2 addressing a concern we previously raised with respect to the managers of private investment companies. Proposed Rule 2790 would include such persons in the term "Portfolio Managers".1 In the case of Portfolio Managers whose only "disqualifying" factor is that they manage a Collective Investment Account as defined in Proposed Rule 2790, the proposed rule change, if approved by the Securities and Exchange Commission (the "Commission"), would not permit Portfolio Managers to participate to the extent of their capital accounts in "New Issue Securities"2 purchased by the Collective Investment Accounts they manage if the beneficial interest in the Collective Investment Account on behalf of the Portfolio Manager and all other Restricted Persons exceeds 10%.

Under the Interpretation as it now stands, certain types of Restricted Person are "conditionally" restricted.3 An NASD member firm ("Member") can currently sell Hot Issue Securities to such "conditionally" Restricted Persons provided the person can demonstrate that the purchases are in accordance with his or her normal investment practice and that the aggregate amount of securities sold is insubstantial and not disproportionate in amount compared to sales to the general public.

The "normal investment practice" exemption, and the recordkeeping required to demonstrate compliance, would be deleted in Proposed Rule 2790. In its place, NASD initially proposed a carefully tailored exemption for Portfolio Managers under which Portfolio Managers would not be restricted with respect to any beneficial interest in the bank, savings and loan institution, insurance company, investment company, investment adviser or other Collective Investment Account over which they person had investment authority. As a result, for example, the manager of a hedge fund, if he or she were not otherwise a Restricted Person, would have been permitted to invest in New Issue Securities through the hedge fund that he or she managed in proportion to his or her capital account in the Collective Investment Account. Immediate family members materially supported by such persons would also be able to invest through the Collective Investment Account. The Portfolio manager and his or her immediate family, however, would be restricted for purposes of any personal accounts that were not the Collective Investment Account he or she managed. That would have addressed a real fiduciary risk, the risk that a Collective Investment Account manager could obtain the benefit of hot issues for his or her own account without sharing the benefits with the Collective Investment Account in accordance with the investors' several capital accounts. Particularly if the hot issue allocations are based at least in part on the Collective Investment Account's payment of commissions and other transaction charges to the brokers on secondary market transactions, the benefits of the hot issue allocations should accrue to the Collective Investment Account itself and through it to the investors, including the manager, in accordance with their capital accounts.

Proposed Rule 2790 as now revised would delete the exemption for Collective Account Managers to participate in accordance with their capital accounts and in its place would raise from 5% to 10% the "de minimis" exemption for the amount of beneficial interests held by Restricted Persons in a Collective Investment Account. We believe this most recent revision is inappropriate and does not effectuate the stated purposes of the Proposed Rule 2790. In fact, it puts the manager of the Collective Investment Account in competition with investors for ownership of interests in the Collective Investment Account since the manager will wish to retain the entire 10% for himself or herself.

In our letter to the Commission dated January 28, 2000, a copy of which is attached, we recommended that NASD modify Proposed Rule 2790 to provide relief to Portfolio Managers because NASD was proposing to eliminate the "normal investment practice" exemption and the entire category of conditionally restricted person and had not provided any public policy rationale or cited any instances of actual abuse that would support that change. In its Amendment No. 2, filed thereafter, NASD addressed our concern by adding the exemption described above. The exemption would allow Portfolio Managers to invest in New Issues through the Collective Investment Account they manage. As noted above, NASD now proposes to delete this provision.

The concerns outlined in our letter of January 28, 2000 to the Commission are still very much applicable. In particular, as described in our prior letter, investors in Collective Investment Accounts almost universally require the Portfolio Manager to make and maintain a considerable personal investment in the Collective Investment Account. That personal investment often includes investments for family members and, in the aggregate may often exceed 10% of the total beneficial interest of all investors in the Collective Investment Account. Even if the Portfolio Manager's initial capital position is less than 10% of the Collective Investment Account, his or her compensation typically includes a percentage of the "upside", that is, successful performance of the account. With even modestly successful returns, which the Portfolio Manager will often reinvest (after taxes) into the Collective Investment Account, the Portfolio Manager's capital account will grow rapidly as a percentage of the Collective Investment Account and will soon exceed 10% of the total.

The investment by the Portfolio Manager in the very account he or she manages for the investors in the Collective Investment Account and permitting the Portfolio Manager to be eligible for the same rewards as the other investors in the account avoids giving the Portfolio Manager any disproportionate benefit while it provides considerable comfort and protection to the independent investors in these Collective Investment Accounts because the Portfolio Manager is made to take the same risks with his or her own personal capital, and frequently that of other members of his or her own family, that the other investors in the Collective Investment Account are asked to take.

Requiring the Portfolio Manager to make a significant investment of his or her own capital in the Collective Investment Account alongside the other investors helps to ensure that the Portfolio Manager's interests and incentives in operating the Collective Investment Account are more aligned with those of the passive investors than they might be if the Portfolio Manager did not make such an investment. Merely raising the limit from the prior proposed 5% limit to 10% is not a substitute to removing the prior proposed provision.

In his letter to Ms. Katherine England submitting Amendment No. 4 to the Commission, Mr. Gary Goldsholle of NASD stated that the proposed removal of the exemption proposed in Amendment No. 2 for portfolio managers participating proportionately through their capital accounts in Collective Investment Accounts they manage responded to a comment letter submitted by Mayor, Day Caldwell & Keeton, L.L.P. ("Mayor Day"). The Mayor Day letter incorrectly asserts that the relief for Portfolio Managers would have provided them with the power to achieve "disproportionate investments" in New Issues-it would not do so if, as the NASD Amendment No 2 provided, the relief afforded was limited to giving the Portfolio Manager no greater participation in the New Issues than its capital account provided.

Upon reviewing the Mayor Day letter, we note that it specifically states that the writers do not advocate greater regulation of Portfolio Managers than the current rule imposes but were seeking relief for passive investors in Collective Investment Accounts. Currently, the Interpretation allows Portfolio Managers to invest pursuant to the normal investment practice exemption. This exemption in the Interpretation is not available for other restricted persons such as Member firms, their associated persons and owners of broker-dealers. The provision in Amendment No. 2 did not provide Portfolio Managers with the ability to invest in New Issues generally, but only through the Collective Investment Account they manage. A Portfolio Manager would remain a restricted person, and be counted towards any 10% limitation in any fund that they did not manage. Therefore, we remain convinced that NASD has not shown the justification for deleting the conditionally restricted category without providing some other mechanism for Portfolio Managers to continue to be invested and be at risk with the other investors in the Collective Investment Accounts they manage.

If, as is often the case a Portfolio Manager becomes so successful that he or she can afford to return the managed capital to the investors and then invest only his or her own money in future, he or she would be free under the current Interpretation and under Rule 2790, as NASD would now revise it, to receive hot issue allocations without limit since he or she would not, by definition be a Portfolio Manager4. Accordingly, Proposed Rule 2790 as currently amended would provide an incentive for Portfolio Managers to cash out other investors in their funds and manage their own money. We question whether that result would serve the purposes for which Rule 2790 is purportedly intended to serve. It certainly would not serve the public interest to provide greater incentives than now exist for the most successful account managers to cease to serve public investors.

The increase of the general "de minimis" exemption to 10% is not a cure for the problem we raised. As noted above, the most successful account managers often account for more than 10% of the capital in their funds. In any event, a numeric limit such as that serves no demonstrable purpose and is in any event unrelated to the purposes of the rule. We would recommend, therefore, that NASD add back the provision allowing a Portfolio Manager to invest in New Issue Securities through the Portfolio he or she manages to Proposed Rule 2790.

Joint Back Office Brokers. We further note that Amendment No. 4 would define "joint back office broker-dealer" ("JBO") as a domestic or foreign private investment fund that has elected to register as a broker-dealer solely to take advantage of preferable margin treatment. This type of entity would be allowed to invest pursuant to the proposed 10% "de minimis" exemption described above.

The definition should be modified. To qualify under the current proposed definition of JBO a broker-dealer would have to demonstrate that the only reason it registered was for preferable Reg. T treatment. We are concerned that if the definition of JBO is based on the reason behind such firm applying for registration, it would be difficult if not impossible to verify that no other factor was behind the decision to register.

In addition, to qualify as a JBO, an investment fund registered as a broker-dealer may not engage in any activities that would require it to register as a broker-dealer under Section 15(a) of the Securities Exchange Act of 1934 (the "Exchange Act"). This definition is cumbersome and as a practical matter would be difficult to apply with any certainty. 5 We point out, in addition, that such a test would appear to run afoul of Section 15(b)(5) of the Exchange Act, which provides: "If the Commission finds that any registered broker or dealer, or any broker or dealer for whom an application for registration is pending, is no longer in existence or has ceased to do business as a broker or dealer, the Commission shall by order cancel the registration or application of such broker or dealer."

We think that a JBO should be defined by what the broker dealer is permitted to do by NASD in its Membership Agreement with NASD as opposed to the motivation for registration as a broker-dealer. We would recommend, therefore, that a JBO be treated in the same way as a Collective Investment Account (which is defined in Proposed Rule 2790, rather than as a private investment fund, which is not), and that is registered as a broker-dealer but is not authorized in its Membership Agreement to engage in the public offering of New Issues either as an underwriter or as a selling group member. This category of broker-dealer would mirror one already in Proposed Rule 2790. The proposed exemption for publicly traded entities provides that it is not available if the entity is or is affiliated with a broker-dealer authorized to act as an underwriter or selling group member. If NASD is comfortable in exempting public entities that are or are affiliated with broker-dealers as long as such broker-dealers are not underwriters or distributors of New Issues, then NASD should be comfortable with JBOs' being defined to include broker-dealers that are not permitted to underwrite New Issues.

Finally, associated persons of JBOs should be excluded from the Restricted Person category which includes broker-dealer personnel. Otherwise any person who is a Portfolio Manager of a JBO would be a Restricted Person. Associated persons of limited business broker-dealers are excluded along with their firms. NASD has provided any empirical or regulatory basis why, if the JBO firm is excluded from the prohibitions in Proposed Rule 2790, it is proposed that its associated persons should not also be. The "justification" provided in Mr. Goldsholle's letter does nothing more than assert that the treatment of such associated persons in Proposed Rule 2790 is what it is.

Please contact me or my colleague, Martin Miller, with any comments or questions you may have.

Very truly yours,

Roger D. Blanc

RDB/co

Attachment

cc(w/att): Annette L. Nazareth, Esq., Director,
Division of Market Regulation

Robert L. D. Colby, Deputy Director,
Division of Market Regulation

Katherine A. England, Esq., Assistant Director,
Division of Market Regulation

Michael J. Gaw, Esq.,
Division of Market Regulation

T. Grant Callery, Esq., General Counsel
NASD, Inc.

Gary L. Goldsholle, Assistant General Counse,l
NASD, Inc.

____________________________
1 The term "Portfolio Manager" would include any person who has authority to buy or sell securities for a bank, savings and loan institution, insurance company, investment company, investment advisor, or Collective Investment Account. "Collective Investment Account" would be defined as "any hedge fund, investment partnership, investment corporation, or any collective investment vehicle that is engaged primarily in the purchase and/or sale of securities."
2 Proposed Rule 2790 would define the securities to which restrictions would apply as "New Issue" securities. The Interpretation uses the term "Hot Issue" securities to describe securities to which current restrictions apply. Since the terms describe different securities, we use the term "New Issue Securities" in this letter to discuss the proposed provisions and "Hot Issue Securities" to discuss the current restrictions.
3 Conditionally Restricted Persons under the Interpretation include: (i) finders or persons acting in a fiduciary capacity to the managing underwriter, including, among others, attorneys, accountants and financial consultants; (ii) senior officers and persons in the securities departments of banks, savings and loan associations, insurance companies, investment companies, investment advisory firms, hedge funds and other investment vehicles; and (iii) persons materially supported by such persons.
4 As mentioned in note 1 supra, a Portfolio Manager is any person who has authority to buy or sell securities for, among other entities, a Collective Investment Account. Collective Investment Account is defined to exclude "family investment vehicles" (which are defined as legal entities that are beneficially owned solely by immediate family members) or "investment clubs", (which are defined as a group of business associates who pool their money and are collectively responsible for making investment decisions). See Proposed Rule 2790(i)(1)(2)(4) and (6).
5 The Commission staff have issued a large number of no-action letters focusing on a variety of factors concerning the status of businesses as brokers or dealers under the Exchange Act. In addition, the position taken by the staff has changed over time. For example, the Commission staff, acknowledging their more conservative interpretation of the law concerning status as a broker or dealer and the advent of technologies such as the internet resulting in new securities-related activities revoked a 1985 no-action letter given to Dominion Resources, Inc., see Dominion Resources, Inc. (Recon), March 7, 2000.


Attachment

Willkie Farr & Gallagher
787 Seventh Avenue
New York, NY 10019-6099
Direct: 212 728 8206
Fax: 212-728-8111
rblanc@willkie.com

Roger D. Blanc

January 28, 2000
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549
Attention: Mr. Jonathan G. Katz, Secretary

Re: SEC File No. SR-NASD-99-60

Ladies and Gentlemen:

We appreciate the opportunity to comment, in response to the Commission's request in Securities Exchange Act Release No. 44325 (January 10, 2000) (the "Release"), on the proposed rule change submitted on Form 19b-4 on October 15, 1999 by the National Association of Securities Dealers, Inc. (the "NASD"), through its wholly owned subsidiary, NASD Regulation, Inc., in SEC File No. SR-NASD-99-60, and amended by the NASD on December 21, 1999. The proposed rule change, as amended (referred to below as the "proposed rule change"), would replace the existing Free-Riding and Withholding Interpretation (the "Interpretation")1 with a new Rule 2790.

While a number of the revisions are helpful, one is of particular concern to several of our clients that manage private investment companies and other collective investment accounts (referred to below as "collective investment accounts"). In the case of collective investment account managers whose only "disqualifying" factor was that they managed the collective investment account, the proposed rule change, if it ever were approved by the Commission, would deprive the managers of the ability to participate to the extent of their capital accounts in "hot issues" purchased by the collective investment accounts they manage if the beneficial interest in the collective investment account on behalf of the manager and all other restricted persons equaled or exceeded 5%.

For the reasons set forth below, we urge on behalf of our clients that the Commission not approve the proposed rule change in its current form but instead invite the NASD to revise the rule in the manner suggested at the end of this letter to cure the problems discussed below.

DISCUSSION

The proposed rule change is beneficial insofar as it clarifies and rationalizes many aspects of the Interpretation.2 A provision that concerns us, however, would discriminate inappropriately against collective investment account managers that are not associated with NASD members or certain other broker-dealers ("Independent Collective Investment Account Managers"),3 without serving any demonstrable public purpose. It would eliminate a current provision that permits Independent Collective Investment Account Managers to participate in hot issues for their own accounts if the allocation of the hot issue securities to the managers meets three tests: (i) it must have been in accordance with the particular Independent Collective Investment Account Manager's "normal investment practice";4 (ii) the amount allocated to all conditionally restricted persons by the NASD member must be "insubstantial and not disproportionate in amount as compared to sales to members of the public"; and (iii) the amount of hot issue securities in which the particular Independent Collective Investment Account Manager participates must be "insubstantial in amount."5

Stated purposes of the regulation. In its filing on Form 19b-4 with respect to the proposed rule change, the NASD ascribes three principal purposes to the Free-Riding and Withholding Interpretation (the "Interpretation"). The Interpretation, the NASD states, is designed to ensure that: (i) NASD members make a bona fide public offering of securities at the public offering price; (ii) NASD members do not either withhold securities in a public offering for their own benefit or use such securities to reward certain persons who are in a position to direct future business to the member; and (iii) securities industry "insiders", including NASD members and their associated persons, do not take advantage of their "insider" positions in the industry to purchase hot issues for their own benefit at the expense of public customers.6

Current practice consistent with purposes. In the view of a number of our Independent Collective Investment Account Manager clients, the NASD should have but did not distinguish in amending the Interpretation as it applies to Independent Collective Investment Account Managers between hot issues purchased by the manager for his or her own account and hot issues purchased for the collective investment account itself. For many years now, collective investment accounts that purchase hot issues have maintained separate accounts to exclude from participation in the hot issues investors to whom hot issues may not be allocated. If the collective investment account manager is associated with an NASD member or other broker-dealer that causes the collective investment account manager to be unable to purchase hot issues, the manager has been excluded from the collective investment account's hot issues allocations. If, on the other hand, the collective investment account manager is an Independent Collective Investment Account Manager and thus has been only a conditionally restricted person under the Interpretation, and if permitting the manager to share in a particular hot-issue purchase would meet the three-prong test referred to above, the Independent Collective Investment Account Manager has been permitted to participate pro rata, in accordance with his or her capital account in the collective investment account.

That regime is entirely consistent with the purposes underlying the Interpretation. By spreading the benefit of hot issues among all the investors in the fund, and not exclusively for the manager, the risk of abuse is eliminated. If, instead, an Independent Collective Investment Account Manager purchased hot issues outside of the collective investment account for the manager's own personal account, that would raise the same problems of conflicts of interest, which the NASD has now addressed, as would permitting a portfolio manager employed by a mutual fund, a bank or an insurance company to buy hot issues for his or her own personal account. If, on the other hand, an Independent Collective Investment Account Manager instead is buying the securities for the collective investment account itself, the manager's interests are aligned with those of the investors in the fund. There is not a conflict of interest or other regulatory issue that needs to be addressed in such a case.

Investors in collective investment accounts almost universally require the collective investment account manager to make and maintain a considerable personal investment in the collective investment account. That personal investment often includes investments for family members and, in the aggregate, exceeds 5%, often by a considerable margin. That provides considerable comfort and protection to the independent investors in these collective investment accounts because the Independent Collective Investment Account Manager is made to take the same risks with his or her own personal capital, and frequently that of other members of her own family, that the other investors in the collective investment account are asked to take. That requirement is imposed by competitive forces in the investment market and it is aimed at giving the Independent Collective Investment Account Manager a powerful incentive to manage the collective investment account for the benefit of the investors. Requiring the collective investment account manager to make a significant investment of his or her own capital in the collective investment account alongside the other investors helps to ensure that the manager's interests and incentives in operating the collective investment account are more aligned with those of the passive investors than they might be if the manager did not make such an investment.

If an Independent Collective Investment Account Manager is taking the same risks as the investors, the manager should be able to reap the same rewards from the investment, including rewards due to appreciation in hot-issue securities, as are realized by the passive investor. Any other result would uniquely penalize the manager's investment and would be inequitable.7

Problems inherent in the NASD's proposed approach. To limit an Independent Collective Investment Account Manager's investment, and that of all other restricted persons, in a collective investment account to less than 5% would not serve the public interest or the protection of investors. In fact, it might well do the opposite. In a number of cases of which we are aware, the external money in collective investment accounts managed by Independent Collective Investment Account Managers is substantially less than 50% today.8 As a result, one effect of penalizing an Independent Collective Investment Account Manager whose investment was equal to or greater than 5%, simply on the basis that he or she was managing other people's money in addition to the manager's own money and that of his or her family members, would be to give the manager an incentive to stop managing external money and instead to trade only for his or her own account and that of other family members since the prohibition in proposed Rule 2790 would no longer apply in such a case.

The proposed discrimination against Independent Collective Investment Account Managers whose investment (together with that of other restricted persons) is equal to or greater than 5% does not serve any of the purposes the NASD articulated for the rule, as discussed below.

1. Bona Fide Public Offerings

As applied to Independent Collective Investment Account Managers, the NASD's proposed approach does not have anything to do with whether NASD members do or do not conduct a bona fide public offering. An Independent Collective Investment Account Manager is, by definition, not an associated person of an NASD member. In the proposed rule change, as noted above, the NASD would continue allowing registered broker-dealers to participate in hot issues as long as they have registered solely for the purpose of obtaining favorable credit by participating in joint back office arrangements. By similar reasoning, the NASD should have recognized that Independent Collective Investment Account Managers that do not engage in any of the activities associated with securities distribution or customary broker-dealer activities should not be regarded any differently, particularly if they do not take hot issues for their own personal accounts away from the collective investment account but instead receive the hot-issue benefit only through the collective investment account.

2. Withholding securities for members' benefit
or using allocations to reward persons sending
business to the member.  

The NASD states in its filing that collective investment account managers, among others, would be considered restricted persons "because their position allows them the opportunity to direct business to a member [of the NASD], and it is believed that members would direct hot issues to the accounts of these persons in an effort to attract or retain business."9 The NASD's objective, however, to ensure that NASD members do not use hot-issue securities to reward certain persons who are in a position to direct future business to the member, is difficult to understand unless it is interpreted to mean "direct future business on behalf of accounts other than their own personal accounts." All customers of an NASD member are, by definition, "in a position to direct future business to the member." As the NASD itself recognizes in the filing, "[t]he Interpretation implicitly recognizes the practice of member firms awarding hot issues to their best customers."10

Assuming that the basic prohibition in the Interpretation is useful, the objective of preventing evasion of the prohibition is obviously sensible. Nevertheless, such an objective should not extend to a collective investment account where the Independent Collective Investment Account Manager does not receive allocations in his or her personal accounts, separate and apart from the collective investment account itself. An NASD member allocating hot issues likely would be motivated to allocate the securities to customers that trade actively regardless of whether the customer is an individual wealthy customer, a family trust or collective investment account, or a collective investment account that has independent investors. So long as the Independent Collective Investment Account Manager's beneficial interest in the hot-issue allocations derives directly from the collective investment account itself, there is no regulatory basis for a discriminating against the Independent Collective Investment Account Manager.

3. Regulating the "Insiders"

The third stated purpose of the rule, ensuring that industry "insiders", including members and their associated persons, do not take advantage of their "insider" position in the industry to purchase hot issues for their own benefit at the expense of public customers, also does not support the NASD's proposed approach.11 Indeed, as noted above, the rule would exempt entirely an investment manager of a collective investment account whose only investors were members of the manager's own family. In addition to providing a disincentive to making the manager's talents available to public investors, the proposed rule change would make an odd and insupportable distinction between the family-owned vehicle and one that incorporated money from a few or many other investors who pool their capital and arrange to have one of the individuals act as the manager. The NASD does not provide any convincing or legally sufficient rationalefor subjecting any of these vehicles to a hot-issue prohibition or for distinguishing between or among them. Investors' interests are well served by permitting the Independent Collective Investment Account Manager to establish and maintain a substantial personal investment in the collective investment account, one that may well exceed 5%, and it would not serve the public interest to change that pattern.

Legal Infirmities. As the Commission knows, Section 19(b) of the Exchange Act requires the Commission to approve a proposed rule change by the NASD if it finds that the proposed rule change is consistent with the provisions of the Exchange Act and the rules and regulations thereunder applicable to the NASD and to disapprove the proposed rule change if the Commission does not make that finding. In its application to Independent Collective Investment Account Managers, the proposed rule change as currently formulated is not consistent with the provisions of the Exchange Act applicable to the NASD. These legal problems, and a recommended solution, are discussed below.

The NASD's proposed rule change does not solve an existing regulatory problem or address an actual incidence of abuse, or a substantial likelihood of abuse. In its treatment of Independent Collective Investment Account Managers, the proposed rule change is therefore arbitrary and capricious and is inconsistent with the requirements of the Exchange Act applicable to NASD rulemaking, including particularly the following:

1. Section 15A(b)(6).

(a) This section requires that NASD rules be designed to "perfect the mechanism of a free and open market." All regulation, by its nature, restricts conduct that would otherwise be unrestricted. If the restriction is rationally related to a valid regulatory goal, the restriction is tolerable under this standard. If, as here, the restriction instead is not rationally related to a valid regulatory goal, its imposition on market forces is intolerable under this standard.

(b) This section further requires that NASD rules not be "designed to permit unfair discrimination between customers . . . ." The proposed rule change's discrimination between an NASD member's customer trading his or her own money and that member's customer trading on behalf of a collective investment account in which an Independent Collective Investment Account Manager has invested his or her own money fails to comply with the standards applicable to the NASD under this section. If the discrimination is not in fact necessary or appropriate to address a valid regulatory purpose, and in the case of this proposed rule change it is not, it violates Section 15A(b)(6).

(c) This section further requires that NASD rules not be designed to "regulate by virtue of any authority conferred by [the Exchange Act] matters not related to the purposes of [the Exchange Act] or the administration of the [NASD]." This provision is violated where, as here, a proposed rule change is not rationally related to a valid regulatory goal. The fact that the proposed rule change is arbitrary and capricious means that, on its face, the rule change fails this test.12 As the United States Court of Appeals for the District of Columbia observed in City of Chicago v. Federal Power Commission, 458 F.2d 731 (D.C. Cir. 1971):

"A regulation perfectly reasonable in the face of a given problem may be highly capricious if that problem does not exist."

2. Section 15A(b)(9). This section requires that NASD rules "not impose any burden on competition not necessary or appropriate in furtherance of the purposes of [the Exchange Act]." By discriminating inappropriately against Independent Collective Investment Account Managers in a manner that is not imposed on other traders who are trading for their own accounts, the proposed rule change burdens commerce, and competition in the market, without serving any goal cognizable as valid under the Exchange Act, and thereby violates this section. Indeed, as noted above, competition for investors' funds effectively forces many collective investment account managers to invest a considerable portion of their own personal wealth, and that of their families, into the collective investment account as a condition of attracting investment from outsiders. The proposed rule change would work toward curbing that competitive force because a collective investment account manager that exceeded the proposed 5% ceiling13 would suffer a severe disadvantage, one imposed not by the forces of competition but by regulatory fiat.

Deficiencies in the Rule 19b-4 filing. The competitive issues as well as, more generally, issues of the likely impact on Independent Collective Investment Account Managers discussed above are not addressed at any point in the NASD's filing or in the Release.14 The NASD has, therefore, not given the Commission a legally sufficient basis to make the finding it must make before approving a proposed rule change under Section 19(b) of the Exchange Act, that the proposed rule change is "consistent with the requirements of [the Exchange Act] and the rules and regulations thereunder applicable to the [NASD]."15 Accordingly, the Commission cannot find, on the basis of the record in SR-NASD-99-60, that the NASD's proposed rule change is consistent with the requirements of the Exchange Act and the rules and regulations thereunder applicable to the NASD.

Recommended solution. The problems discussed above would be resolved if the NASD revised its proposed Rule 2790 to permit Independent Collective Investment Account Managers to receive, in connection with purchases of hot-issue securities by the collective investment accounts they manage, the benefit of capital invested in the collective investment accounts they manage. The NASD could achieve that result by adding to the definition of the term "restricted person", in subparagraph (a)(11)(D) of its proposed Rule 2790, the proviso set forth below [new language in italics]:

(D) Any employee or other person who supervises, or whose activities directly or indirectly involve or are related to, the buying or selling of securities for a bank, savings and loan institution, insurance company, investment company, investment advisor, or collective investment account; provided, however, that the term "restricted person" shall not include any person who would be a restricted person solely by reason of supervising, or engaging in activities directly or indirectly involving or related to, the buying or selling of securities (together, "covered activities") for one or more collective investment accounts, but the term "restricted person" shall include any such person with respect to accounts, other than such collective investment accounts, in which such person has a beneficial interest and in which such person purchases or receives the economic benefit of hot issue securities in a public offering.16

The revision we recommend would not disturb the current approach taken by the NASD with respect to other restricted persons and it would resolve the problems discussed above.17 It would permit a person that would be a restricted person solely by reason of being an Independent Collective Investment Account Manager to receive the economic benefit, in accordance with his or her invested capital, in hot issues purchased by the collective investment account(s) he or she managed.

CONCLUSION

For the reasons set forth above, the Commission should not approve the proposed rule change in its current form but should invite the NASD to revise the rule in the manner suggested to cure the problems outlined above.

* * *

If members of the Commission or of the staff believe we may be of further assistance in these matters, please let us know.

            Very truly yours,

            /s/ Roger D. Blanc

            Roger D. Blanc

cc: The Hon. Arthur Levitt, Chairman
The Hon. Isaac C. Hunt, Jr., Commissioner
The Hon. Norman S. Johnson, Commissioner
The Hon. Paul R. Carey, Commissioner
The Hon. Laura S. Unger, Commissioner

Annette Nazareth, Esq., Director,
Division of Market Regulation

Robert L. D. Colby, Esq., Deputy Director,
Division of Market Regulation

Belinda Blaine, Esq., Associate Director,
Division of Market Regulation

Katherine A. England, Esq., Assistant Director,
Division of Market Regulation

Joseph P. Corcoran, Esq.,
Division of Market Regulation

Mr. Richard G. Ketchum, President, National Association of
Securities Dealers, Inc.

Edward S. Knight, Esq., Executive Vice President
and Chief Legal Officer, National Association of
Securities Dealers, Inc.

T. Grant Callery, Esq., Senior Vice President
and General Counsel, National Association of
Securities Dealers, Inc.

Ms. Mary L. Schapiro, President, NASD Regulation, Inc.

Elisse B. Walter, Executive Vice President, NASD
Regulation, Inc.

Alden S. Atkins, Esq. Senior Vice President and General
Counsel, NASD Regulation, Inc.

Gary L. Goldscholle, Esq., Assistant General Counsel,
NASD Regulation, Inc.

660418.9

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1 NASD Interpretation IM-2110-1.
2 In addition to the impact on certain collective investment account managers, however, the clarifications are not helpful in an additional way, the deletion of the exclusion of actively traded securities from the prohibition. The current Interpretation excludes from the hot-issue prohibitions secondary offerings of "actively traded securities". See the definition of "public offering" at IM-2110-1(1)(l). For that purpose, the definition of actively traded securities tracks the SEC's Regulation M (Rule 101(c)(1)). Proposed Rule 2790, however, would not exclude actively traded securities from the definition of "hot issue". The proposed new definition of hot issue in paragraph (a)(5) of Rule 2790 would include any security that is part of a public offering if the volume-weighted price during the first five minutes of trading in the secondary market were 5% or more above the public offering price. In today's volatile markets, many securities could be subject to price swings, which might well not be related to the "hotness" or "coldness" of a particular follow-on offering, that would result in their being classified as hot issues under this definition. In addition, it would be difficult if not impossible for a broker-dealer's firm's compliance department to determine in advance whether an issue would or would not be a hot issue under this proposed new definition. As a result, the new definition would likely require broker-dealers to preclude sales of any new offering of securities in the secondary market to any restricted account so they would not have to reallocate should the 5% threshold be exceeded. This would be in sharp contrast to the determination as to whether a security is an actively traded security, which may be made before the offering. The current Interpretation's exclusion of actively traded securities meeting that definition is useful and helpful. It is not at all clear why the NASD is now changing course and proposing a test that will require NASD members to guess whether an issue will be a hot issue.
3 The NASD itself has recognized that certain broker-dealers whose activities are limited and who do not engage in underwriting should not be precluded from purchasing hot issues. See IM-2110-1, ¶ (c). See also, Letter from Gary L. Goldscholle, NASD Regulation, Inc. to David Katz (January 20, 1999) (class exemption, from , relieving the otherwise absolute prohibition, in ¶¶ (b)(6) and (b)(9) of the Interpretation, on hot-issue allocations to broker-dealers and their associated persons, for all collective investment accounts that elect to register as broker-dealers solely to take advantage of more favorable margin treatment from joint back office arrangements and that do not engage in certain enumerated activities) (available on the Internet at NASD-R.com/2910/IM21101_04.htm). The proposed rule change would codify the latter exemption in ¶¶ (a)(7) and (e)(2) of proposed Rule 2790.
4 The NASD staff has clarified that a conditionally restricted person's experience in investing in the collective investment account itself over a period of not less than 12 months may be considered in determining his or her own "normal investment practice." Interpretive letter from Gary L. Goldscholle, NASD Regulation, Inc. to Ted S. Meikle (October 20, 1997), available on the Internet at www.NASD-R.com/2910/IM2110-1_01.htm.
5 NASD Conduct Rules, IM-2110-1, ¶ (b)(5). Subparagraphs (l)(3), (l)(4) and (l)(5), respectively, of IM-2110-1 define the terms "normal investment practice", "disproportionate" and "insubstantiality".
6 See the NASD's Form 19b-4 with respect to the proposed rule change, at p. 12.
7 Given the competition among institutional investors and others for hot issues, the amount allocated to a particular collective investment account in any single offering is likely to be insubstantial, but in the aggregate hot issues can be a significant contributor to a collective investment account's performance over time.
8 Collective investment accounts are typically smaller than offshore mutual funds to which the NASD applies a 5% rule. In the case of private collective investment accounts, investors often demand that the manager invest more than 5% of the fund.
9 NASD Form 19b-4 with respect to the proposed rule change, at 18.
10 Id. at 19.
11 We note, moreover, that the persons classified as restricted persons under the proposed rule would for the first time sweep in sister corporations of broker-dealers, regardless of whether the sister corporations' businesses are functionally related to the broker-dealer's business. Today, the Interpretation covers natural persons who are associated with a broker-dealer (see the definition of "person associated with a broker-dealer" in Art. I, § (ee) of the NASD's By-Laws), and paragraph (c)(9) of IM-2110-1 captures certain persons who have contributed capital to a broker-dealer, but not other affiliates of such person that have not themselves made such contributions, such as sister corporations of the broker-dealer. The new inclusion of sister corporations would have effects, none of which are explored or justified, on financial services companies such as bank holding companies that have a broker-dealer subsidiary and one or several other subsidiaries in the financial sector. Particularly given the repeal of the Glass-Steagall Act, this new prohibition may have far-reaching effects that deserve careful scrutiny and analysis.
12 The NASD in its discussion of the proposed rule describes the concept of conditionally restricted persons as a compromise which in its current view may in many cases be contrary to the public interest. For many years, however, the brokerage community has worked within the NASD parameters of selling hot issues to persons who are "conditionally restricted". The NASD is now taking a position in sharp contrast to what it has established through its rules as accepted practice, but it has not provided any demonstration, or even any statistical or empirical evidence, of harm to the public interest in support of this change.
13 In fact, the Independent Collective Investment Account Manager might find itself obliged to share the 5% with others that would now be permitted to participate in hot issues, and therefore the Independent Collective Investment Account Manager would have to reduce his or her own investment in the collective investment account.
14 Form 19b-4 requires the NASD to address burdens on competition in fashion that is "sufficiently detailed and specific to support a Commission finding that the proposed rule change does not impose any unnecessary or inappropriate burden on competition." Id., Information to Be Included in the Completed Form, ¶ 4. The NASD's filing, however, simply restates the statutory standard of Section 15A(b)(9) as a formulaic incantation and does not provide any discussion or analysis: "NASD Regulation does not believe that the proposed rule change will result in any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Act." Id. at § 4. That does not give the Commission a legally sufficient basis on which to determine whether the proposed rule change is or is not consistent with the provisions of the Exchange Act applicable to the NASD. See, e.g., Senate Report on S.249, supra, at 29: "It is the Committee's intention in adopting [the Section 19(b)] standard to hold the self-regulatory organizations to the same standards of policy justification that the Administrative Procedure Act imposes on the SEC." See also, Home Box Office v. Fed'l Communications Comm'n, 567 F.2d 9, 36 (D.C. Cir. 1977):
From this survey of the case law emerge two dominant principles. First, an agency proposing informal rulemaking has an obligation to make its views known to the public in a concrete and focused form so as to make criticism or formulation of alternatives possible. Second, the 'concise and general' statement that must accompany the rules finally promulgated 'must be accommodated to the realities of judicial scrutiny, which do not contemplate that the court itself will, by a laborious examination of the record, formulate in the first instance the significant issues faced by the agency and articulate the rationale of their resolution. . . . [The record must] enable us to see what major issues of policy were ventilated by the informal proceedings and why the agency reacted to them as it did'[citations omitted].
15 Section 15A(b) of the Exchange Act sets forth both affirmative requirements for the NASD's rules and negative injunctions against NASD rules that would have improper purposes or effects. Not every NASD rule need promote each affirmative purpose so long as the NASD's rules as a group promote those purposes. At the same time, however, the NASD's proposed rule change would not be consistent with the Exchange Act if it violated even one of the negative injunctions (e.g., the provisions of Section 15A(b)(6) and Section 15A(b)(9) referred to above). See Matter of National Association of Securities Dealers, Inc., Order Approving Proposed Rule Change, Securities Exchange Act Release No. 17371 (December 12, 1980), in text following n.71. See also, with respect to the similar provisions of Section 6(b) of the Exchange Act, Matter of New York Stock Exchange, Inc., Notice of Proceeding to Consider Disapproval of Proposed Rule Change, Securities Exchange Act Release No. 12249 (March 23, 1976):
In the view of the Commission, a proposed rule change would not be consistent with the Act and the rules and regulations thereunder if, among other things, the Commission could not make the determinations required under Section 6(b) of the [Exchange] Act with respect to the rules of an exchange which included the proposed rule change prior to registration of an exchange.

Id. in text following n.8.

16 As in the case of the Interpretation and proposed Rule 2790, the term "beneficial interest" would not include the receipt of a management or performance based fee for operating a collective investment account. See ¶ (a)(2) of proposed Rule 2790.
17 The fiduciary duty of an Independent Collective Investment Account Manager would require that it respond appropriately in allocating hot issue securities among collective investment accounts he or she managed. In many cases, for example, availability of buying power, suitability considerations and the investment objectives of different collective investment accounts might prevent allocations of equity securities or new issues to some collective investment accounts but not others or might limit the quantity of such securities that a given account could receive.