Sullivan & Cromwell
December 29, 2000
Mr. Jonathan G. Katz,
Re: Amendment No. 2 to Proposed Rule 2790 of
Dear Mr. Katz:
We are pleased to respond to the Commission's request for comments on Amendment No. 2 to the proposal of NASD Regulation, Inc. ("NASD Regulation") to replace its Free-Riding and Withholding Interpretation ("Interpretation") with new Rule 2790, Restrictions on the Purchase and Sale of Initial Equity Public Offerings.1
We strongly support NASD Regulation's amended proposal, and believe that Rule 2790, as now proposed, will represent a significant improvement over the current Interpretation. The proposed rule is more precisely targeted to the types of offerings in which free-riding and withholding are concerns, and to the types of persons who should be subject to restrictions. The proposed rule is also clearer, better organized, and easier to apply.
We believe, however, that a few new provisions in the amended proposal require additional clarification, in most cases simply to reflect the intent of NASD Regulation as indicated in its statement of the purpose of the proposed rule change. We also propose that there be a transitional period for the effectiveness of the new rule.
I. Effectiveness and Transition Period
Early adoption of proposed Rule 2790 is desirable. However, a number of our investment bank clients have advised us that the transition from the Interpretation to the proposed rule will take time. At the level of the investment bank, new policies and questionnaires must be prepared, salespersons must be trained, and customers must be contacted to determine whether they will be restricted persons under the new rule. At the customer level, those customers that are collective investment accounts must seek information from their beneficial interest holders to determine whether they are restricted. We know from experience that many customers or beneficial interest holders will seek the advice of their own counsel for assistance in determining whether they are restricted persons.
In order to facilitate an orderly transition to the new rule, we request that, for a period of 90 days after the effective date of the new rule, NASD Regulation permit member firms to use either the Interpretation or the new rule for the purpose of determining whether a person would be prohibited from purchasing, and to rely on documentation permitted under either the Interpretation or the new rule. The risk of harm resulting in the sale to a person who is restricted under the new rule but not the Interpretation during that 90-day period is small compared to the burden of ensuring compliance with the new rule during the period immediately following effectiveness.
II. Clarification of Specific Provisions
A. Preconditions for Sale - Sales to Banks and Broker-Dealers
The proposed rule does not specifically address the sale of new issue securities to members of a syndicate or selling group, foreign broker-dealers and foreign and domestic banks which are purchasing the securities for the account of customers. Under the Interpretation, a member is permitted to sells securities to other broker-dealers (para. (b)(6)), domestic banks ((b)(7)) and foreign banks and broker-dealers ((6)(8)), provided that the selling member receives representations that the securities will be sold in compliance with the Interpretation, and maintains appropriate records, as described in those paragraphs.
Under the proposed rule, it appears that a member would be permitted to sell to each of the persons described above as intermediaries in the chain of distribution to the accounts of persons who are either non-restricted or subject to general exemption. However, the preconditions for sale described in paragraph (b) of the proposed rule would be very difficult to satisfy in the context of sales to intermediaries in the chain of distribution. Paragraph (b) provides: "Before selling a new issue to any account, a member must in good faith have obtained . . . a representation from the account holder(s), or a person authorized to represent the beneficial owners of the account, that the account is eligible to purchase new issues in compliance with this rule." At the time the member sells the securities to the bank or broker-dealer intermediary, the intermediary may not yet have identified the ultimate purchasers, and may not in any case be authorized to represent the beneficial owners of the purchasing accounts.
We believe that when sales are made to qualified intermediaries in the chain of distribution, a more suitable precondition for sale would be for the selling member to have received an agreement from the intermediary, within the twelve months prior to the sale, to sell the new issue securities only in compliance with the requirements of Rule 2790. Such a provision would track the basic requirement of paragraphs (b)(6)-(8) of the Interpretation and facilitate distributions to the public in compliance with the proposed rule.
B. General Exemptions
1. Application to Accounts.
We are concerned that the application of the general exemptions to accounts of persons covered by the exemptions, as well as to those persons themselves, is not clear from the text of the rule itself. Where the general prohibitions in paragraph (a) speak of sales to, or purchases by, any account in which certain persons have a beneficial interest, the general exemptions in paragraph (c) speak instead of sales to and purchases by listed persons.
For example, under the proposed rule, the general prohibition in paragraph (a)(1) would bar sales to an affiliate of a broker-dealer if the affiliate and the broker/dealer are subsidiaries of an entity that is a "person owning a broker/dealer" as defined in paragraph (i)(10)(E), because the affiliate would be an "account in which a restricted person has a beneficial interest." If the parent entity is a publicly traded entity, then the general exemption in paragraph (c)(5) provides that the general prohibitions in paragraph (a) "shall not apply to sales to and purchases by" the publicly traded entity. NASD Regulation makes it clear, in its statement of purpose, that the general prohibitions should also not apply to the affiliate: "Where the owner is a publicly-traded company with a broker/dealer subsidiary, the rule would no longer apply either at the parent level or at the downstream affiliate level." However, it is not clear from the rule itself that the general exemption also covers the company's beneficial interest in accounts.
In order to make the intent of the rule clearer, we suggest that the first sentence of paragraph (c) be amended by adding the underlined language, as follows: "The general prohibitions in paragraph (a) of the rule shall not apply to sales to and purchases by the following persons, whether directly or through accounts in which such persons have a beneficial interest:" As a word of caution, we note that if paragraph (c) were amended to more closely parallel the language of the general prohibitions by providing that the rule shall not apply to sales to and purchases by "accounts in which the following persons have a beneficial interest," that change would have the undesirable consequence of exempting sales to accounts owned by more than one restricted person, at least one of which might not be entitled to an exemption.
2. An Account Less than 5%-Owned by Restricted Persons
Paragraph (c)(4) exempts an account beneficially owned in part by restricted persons, provided that such restricted persons in the aggregate own less than 5% of such account, and further provided that, "(B) on a pro rata basis, each such restricted person who is a natural person receives less than 100 shares of any new issue." We believe that the under-100 share limitation is so small as to seriously undermine the purpose of the exemption, as stated by NASD Regulation, to "principally benefit non-restricted persons" in collective investment accounts. If a single restricted person holds 5% of the interests in the collective investment account, the account would be limited to purchasing less than 2,000 shares. Yet if ten restricted persons each held 0.5% of the interests in the account, the account would be permitted to purchase nearly 20,000 shares. In order to adjust for the imbalance caused when a small number of restricted persons hold up to 5% of the interests in the collective investment account, we urge NASD Regulation to amend the limitation in subparagraph (B) to replace the words following "on a pro rata basis," with the following: "the restricted persons receive no more than the greater of [2,000] shares of any new issue in the aggregate, or 100 shares per person."
In any case, if NASD Regulation determines not to adopt the change described above, the phrase "less than 100 shares" should be changed to "no more than 100 shares." The change will facilitate purchases in standard 100-share blocks.
Subparagraph (A) makes it a condition of the exemption that "each such restricted person does not manage or otherwise direct investments in the account." There are funds in which the persons holding beneficial interests have the power by vote or otherwise to hire and fire the investment manager and to make decisions about the investment objectives of the fund. We do not interpret the language of the provision as encompassing those activities, provided that the restricted persons are not involved in the decisions to purchase and sell particular securities. We believe that it would be clearer and more consistent to use the same formulation used in the definition of portfolio managers ((i)(10)(D)) and amend the condition to read as follows: "(A) each such restricted person does not have the authority to buy or sell securities for the account." In any event, we request that NASD Regulation confirm that our interpretation of the language is correct.
3. Passing Gains and Losses on to Public Shareholders
The general exemption for publicly-traded entities in paragraph (c)(5) contains the following condition: ". . . provided that the gains and losses from new issues are passed on directly or indirectly to public shareholders." We do not interpret that language to prohibit, for example, payments out of the company's earnings in the form of bonuses to employees and directors or dividends to preferred shareholders, and would appreciate the confirmation of NASD Regulation that our interpretation is correct.
C. Under-Subscribed Offerings
We support the provision in paragraph (g) of the rule that permits an underwriter to place a portion of a public offering in its investment account when it is unable to sell that portion to the public. We believe that the provision should be expanded to permit an underwriter to sell a portion of a public offering to one or more restricted persons in addition to, or in lieu of, placing a portion in its own investment account when it is unable to sell that portion to the public.
1. "New Issue"
The definition of "new issue" in paragraph (i)(9) provides in part that it means "any initial public offering of an equity security. . . made pursuant to a registration statement or offering circular, or other securities distributions of any kind whatsoever. . ." We believe that the phrase "or other securities distributions of any kind whatsoever" is overbroad, and that it may include types of distributions not excluded by subparagraphs (A) through (G), but not intended to be included within the prohibitions of the rule. Significantly, although NASD Regulation states in its statement of purpose that it "is proposing to exempt secondary offerings," the cited language would have the effect of including secondary offerings of equity securities within the definition of "new issue." The phrase "or other securities distributions of any kind whatsoever" appears to be unnecessary, and should be deleted.
The list of excluded transactions in subparagraph (i)(9)(A) should be amended to include offerings exempt under Section 3(b) of the Securities Act of 1933 and to expressly include transactions under Rule 144A and offshore transactions under Regulation S. Section 3(b) authorizes the Commission to exempt by rule certain types of offerings up to a maximum of $5 million. Such exemptions include Rule 504, Rule 505, Rule 701 and Rule 1001, which is coordinated with an exemption available under California law. A Rule 144A offering is technically an offering exempt under Section 4(1), but for ease of reference Rule 144A should be specifically mentioned, just as Rule 506 is mentioned although it was adopted under Section 4(2). In addition, the proposed rule should make clear that it does not apply to offshore transactions under Regulation S, which take place outside the United States.
Finally, subparagraph (i)(9)(e) should be amended to include exchangeable securities as well as convertible securities, to cover, among other things, securities of one issuer exchangeable into securities of another issuer.
2. "Portfolio Managers"
A person who has authority to buy or sell securities for one of several enumerated entities or collective investment accounts is a restricted person "other than with respect to a beneficial interest" in the entity or collective investment account over which such person has investment authority. Thus, a hedge fund manager who is not otherwise restricted and who has a beneficial interest in the fund that she manages would not be restricted from participating in purchases of new issues by the fund. We support the exclusion in the definition, but believe that it does not clearly exclude from restricted person status portfolio managers who have authority to buy or sell securities for more than one entity or collective investment account. Paragraph (i)(10)(D) should be amended to exclude from the definition of restricted persons a person who has authority to buy or sell securities for one or more entities or collective investment accounts specified in that paragraph, with respect to the person's beneficial interest in any of such entities or collective investment accounts.
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We urge that proposed Rule 2790 be adopted with the modifications we have suggested.
We appreciate having had the opportunity to comment on proposed Rule 2790. If you would like to discuss any of our comments or if we may be of assistance, please contact, Peter W. LaVigne at 212-558-7402 or Daniel Dunson at 212-558-3644.
Very truly yours,
/s/ Sullivan & Cromwell
cc: Annette Nazareth, Esq., Director
Ms. Mary L. Schapiro, President