Direct Dial (617) 248-7278

December 26, 2000

By Mail and Email

Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609

Re: Release No. 34-43627; File No. SR-NASD-99-60 Amendment No. 2 to Proposed Rule Change by the National Association of Securities Dealers, Inc. Relating to Trading in Hot Equity Offerings

Dear Mr. Katz:

This letter is submitted to comment on Amendment No. 2 (the "Reproposal") to the proposal by NASD Regulation, Inc. ("NASDR") to establish Rule 2790, which would replace the Free-Riding and Withholding Interpretation, IM-2110-1 (the "Interpretation").

Many of the concerns addressed in our prior comment letter to the original October 1999 NASDR proposal concerning Rule 2790 (as amended by Amendment No. 1, the "Original Proposal") have been addressed in the Reproposal. However, there remain some areas in which we would like to seek clarification and some areas where we believe that technical corrections should be made. In addition, we are concerned about the implications of extending Rule 2790 to all initial public offerings, including offerings that perform poorly in the aftermarket.

I. Anti-Dilution Provisions (proposed Rule 2790(e))

We are concerned that the version of the Anti-Dilution Provisions contained in Paragraph (e) of the Reproposal does not achieve NASD Regulation's stated intent to make Anti-Dilution exemption available to an account in which a restricted person has a beneficial interest. Portions of this exemption appear to allow sales to an account in which a restricted person has a beneficial interest; other portions of the exemption, however, speak directly of the restricted person and do not appear to extend to an account in which the person has a beneficial interest. In particular, subparagraph (1) remains unchanged and continues to require that the preexisting equity ownership be satisfied by the restricted person directly. We believe that the stated intention of NASD Regulation could be accomplished by changing the references to "restricted person" in subparagraphs (1) and (2) to "account" so that the provisions read as follows:

(1) the account has held an equity ownership interest . . .

(2) the sale of the new issue to the account shall not increase the account's percentage equity ownership in the issuer. . .

Without these changes, the ability of a venture capital fund with restricted persons as limited partners to make purchases to maintain its percentage interest would depend on the ownership of these restricted persons, not on the ownership of the fund. We believe that this result would not advance the policy objectives of Rule 2790 and would represent a significant departure from the current Interpretation,.

II. Definition of Portfolio Managers (proposed Rule 2790(i)(10)(D))

The intended meaning of the phrase "other than with respect to a beneficial interest in the bank, savings and loan institution, insurance company, investment company, investment advisor, or collective investment account over which such person has investment authority" in subparagraphs (i) and (ii) is hard to decipher. Our understanding is that the phrase is intended to permit an entity to purchase a new issue when it is only the manager's relationship with the portfolio that makes him or her "restricted"; otherwise, a portfolio entity in which no other "restricted" persons had a beneficial interest could be precluded from purchasing due to the beneficial interest of the manager in the portfolio. We believe that these provisions might be clearer if they were revised to read as follows:

(i) Any person who has authority to buy or sell securities for a bank, savings and loan institution, insurance company, investment advisor, or collective investment account, provided however, that the bank, savings and loan institution, insurance company, investment advisor, or collective investment account will not be deemed to be an account in which a restricted person has a beneficial interest solely as a result of any beneficial interest of any person who has authority to buy or sell securities for such bank, savings and loan institution, insurance company, investment advisor, or collective investment account;

(ii) An immediate family member of a person specified in subparagraph (D)(i) that is materially supported by such person; provided however, that the bank, savings and loan institution, insurance company, investment advisor, or collective investment account for which the person specified in subparagraph (D)(i) has authority to buy or sell securities will not be deemed to be an account in which a restricted person has a beneficial interest solely as a result of any beneficial interest of any immediate family member materially supported by any person who has authority to buy or sell securities for such bank, savings and loan institution, insurance company, investment advisor, or collective investment account.

We prefer the language set forth above because it makes explicit the status of the entity or account over which the portfolio manager has investment authority, and it is precisely this entity or account that is intended to be covered by the proviso.

III. Offerings that Perform Poorly

We are concerned that the shift in the scope of the Reproposal to cover all new issues - regardless of aftermarket performance - may have some unintended consequences. From an issuer point of view, we note that it is not uncommon in the context of weak initial public offerings for existing holders to support the offering by purchasing a portion of the shares offered in the offering. Under the Reproposal, these purchases could be made only if the met the requirements of the Anti-Dilution Provisions or some other exemption; by contrast under the Original Proposal as well as the current Interpretation such purchases would be allowed to stand if the offering did not exceed the specified aftermarket price appreciation targets, whereas if the targets were exceeded the purchases could be broken and the shares reapportioned to other investors (who would presumably be willing to buy them at the offering price given the increase in the aftermarket price). We are concerned that the loss of this flexibility will harm issuers without advancing any of the policy objectives of the Reproposal.

Similarly, from the point of view of underwriters, we are concerned that the extension of Rule 2790 to weak offerings will have unintended, adverse consequences. For example, in poorly received offerings - that is, offerings where the share price holds steady or even declines - underwriters may engage in stabilization activities in order to support the share price during periods when the imbalance of supply and demand could dramatically reduce the share price. These activities are already heavily regulated under Regulation M and elsewhere, and it is unclear to us what objective is served by extending Rule 2790 to cover weak offerings as well. We note that the only relief offered in the Reproposal for weak offerings appears to be quite underinclusive, as it apples to only a very small portion of weak offerings - namely, those where the underwriters are unable to sell the entire offering to the public - and only allows the underwriters to retain the unallocated shares in their investment accounts.

If, as called for in the Reproposal, Rule 2790 is extended to all new issues, then we believe that it is critical to limit the reach of the Rule so that it does not extend to stabilization and other purchases by underwriters that do not involve purchases of shares allocated in the offering itself. In this regard we note that it is unclear whether subparagraphs (a)(2) and (a)(3) or the Reproposal are intended to pick up purchases and subsequent holdings by underwriters on the open market pursuant to their market stabilization activities. We believe that there is no basis in the policy or practice under the Interpretation to support this result.

IV. Repeal of Ability to Break Trades

We note that the Reproposal eliminates the ability to cancel a trade made in violation of Rule 2790 if such cancellation is effected by T+1. We believe that this mechanism should be restored. In our experience, this provision was not used primarily for deals that unexpectedly turned out to be "hot" (since underwriters assume all deals will be hot for purposes of the Interpretation), but rather for situations in which the restricted status of a purchaser becomes apparent late in the process of allocating an offering. Even if the application of the Reproposal to all new issues is not modified, the ability to cancel a trade by T+1 should be retained to protect against the situation in which the status of a buyer as a restricted person does not become apparent until after the allocation to the restricted account.

V. Points of Clarification

There are several other provisions in the Reproposal that may need to be clarified:

A. De Minimis Exception. There is a requirement in subparagraph (c)(4)(B) that "each such restricted person who is a natural person receives less than 100 shares of any new issue". Does this mean that if, for example, a limited partner of a fund is an entity, the limitation does not apply? Or should one look through the entity to natural persons who own the entity? We do not understand the rationale behind adding this new 100 share limit, and believe that it will impose heavy burdens on entities that would otherwise seek to avail themselves of the de minimis exemption without producing any significant benefit.

B. Publicly Traded Entity Exception. The exception for certain publicly traded entities in subparagraph (c)(5) is only available if "gains or losses from the new issues are passed on directly or indirectly to public shareholders". What does this mean? Does it mean that the only publicly traded entities that could qualify are entities such as partnerships that pass through tax gains and losses? It does not appear that the intent of the provision is that narrow. Otherwise, how would a corporate entity be expected to pass through gains and losses? By in kind dividends of the shares? Is the intention of this language to prohibit publicly traded entities from establishing any performance based compensation for portfolio managers who purchase new issues? We believe that publicly traded companies are already subject to extensive disclosure and substantive legal requirements, and that this exemption would work much more efficiently without the additional, amorphous requirement re passing on benefits to public shareholders.

C. Issuer-Directed Exception. In the exemption for directed share programs offered to at least 10,000 participants, there is a requirement in subparagraph (d)(2)(d) that "the class of participants does not contain a disproportionate number of restricted persons as compared to the investing public generally". How much due diligence is required to satisfy this requirement? Does the underwriter have to obtain a written representation from each participant and tabulate the proportion of restricted persons among all 10,000 participants? Or does it mean that the exception would not be available if the class of persons to whom the program was offered could be assumed to contain a large number of restricted persons (e.g. the program is offered to employees of a broker dealer)? We are concerned that unless additional guidance is offered on this point then this exemption may prove to be of little practical benefit.


We would like to express our thanks to the Commission for providing this opportunity to comment on the Reproposal. We hope that the Commission will find these comments helpful. If you have any questions or would like further information regarding this letter, please feel free to contact me at (617) 248-7278 or my colleague Anne G. Plimpton at (617) 248-7514.

Very truly yours,

William J. Schnoor, Jr.