[Federal Register Volume 65, Number 11 (Tuesday, January 18, 2000)]
[Notices]
[Pages 2656-2663]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-995]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-42325; File No. SR-NASD-99-60]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by the National Association of Securities Dealers, Inc. Relating 
to Trading in Hot Equity Offerings

January 10, 2000.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on October 15, 1999, the National Association of Securities Dealers, 
Inc. (``NASD'' or ``Association''), through its wholly owned subsidiary 
NASD Regulation, Inc. (``NASD Regulation''), filed with the Securities 
and Exchange Commission (``Commission'' or ``SEC'') the proposed rule 
change as described in Items I, II, and III below, which Items have 
been prepared by NASD Regulation. On December 21, 1999, NASD Regulation 
submitted Amendment No. 1 to the proposed rule change.\3\ The 
Commission is publishing this notice of the rule change, as amended, to 
solicit comments on the proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See letter from Gary L. Goldsholle, Assistant General 
Counsel, NASD Regulation, to Katherine A. England, Assistant 
Director, Division of Market Regulation, Commission, dated December 
20, 1999 (``Amendment No. 1''). In Amendment No. 1, NASD Regulation 
makes certain technical amendments to the proposed rule change.
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    NASD Regulation proposes to establish Rule 2790, Trading in Hot 
Equity Offerings, to replace the Free-Riding and Withholding 
Interpretation, IM-2110-1. Below is the text of the proposed rule 
change. Proposed Rule 2790 contains all new language. In the other 
proposed changes, additions are italicized and deletions are bracketed.
IM-2110-1. [``Free-Riding and Withholding''[
    Deleted in its entirety and replaced with:
    Reserved.
* * * * *
IM-2750. Transactions with Related Persons
    A member who is acting, or plans to act, as sponsor of a unit 
investment trust will not violate Rule 2750 if it accumulates 
securities with respect to which the member has acted as a syndicate 
member, selling group member or reallowance dealer in an account of the 
member or related person of the member if, at the time of accumulation, 
the member in good faith intends to deposit the securities into the 
unit investment trust at the public offering price and intends to make 
a bona fide public offering of the participation units of that trust. 
Members engaged in such activity, however, will continue to be subject 
to Rule 2790. [IM-2110-1, ``Free-Riding and Withholding.'']
Rule 2790. Trading in Hot Equity Offerings
(a) Definitions
    (1) ``Affiliate'' shall have the same meaning as in Rule 
2720(b)(1).
    (2) ``Beneficial interest'' means any ownership or other direct 
financial interest.
(3) ``Collective investment account'' means any hedge fund, investment 
partnership, investment corporation, or any other collective investment 
vehicle that manages assets of other persons. Collective investment 
account shall not include any entity in which the decision to buy or 
sell securities is made jointly

[[Page 2657]]

by each of the persons investing in the entity or by a member of their 
immediate family.
    (4) ``Conversion offering'' means any offering of securities made 
as part of a plan by which a savings and loan association, insurance 
company, or other organization converts from a mutual to a stock form 
of ownership.
    (5) ``Hot issue'' means 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 is 5% or more above the public offering 
price.
    (6) ``Immediate family member'' shall include a person's parents, 
mother-in-law or father-in-law, spouse, brother or sister, brother-in-
law or sister-in-law, son-in-law or daughter-in-law, and children, and 
any other individual for whom the person, directly or indirectly, 
provides material support.
    (7) ``Joint back office broker/dealer'' means any domestic or 
foreign private investment fund that has voluntarily registered as a 
broker/dealer solely to take advantage of more favorable margin 
treatment afforded under Section 220.7 of Regulation T of the Federal 
Reserve. The activities of a joint back office broker/dealer must not 
require that it register as a broker/dealer under Section 15(a) of the 
Act.
    (8) ``Limited business broker/dealer'' means any broker/dealer 
whose authorization to engage in the securities business is limited 
solely to the purchase or sale of either investment company/variable 
contracts securities or direct participation program securities.
    (9) ``Material support'' means providing more than 10% of a 
person's income or expenses. Material support shall be presumed for 
members of the immediate family living in the same household.
    (10) ``Public offering'' means any initial or secondary public 
offering of an equity security as defined in Section 3(a)(11) of the 
Act, made pursuant to a registration statement or offering circular, 
including exchange offers, rights offerings, offerings made pursuant to 
a merger or acquisition, or other securities distributions of any kind 
whatsoever, including securities that are specifically directed by the 
issuer on a non-underwritten basis. Public offering shall not include:
    (A) offerings made pursuant to an exemption under Section 4(1), 
4(2) or 4(6) of the Securities Act of 1993 or SEC Rule 504, 505 or 506 
adopted thereunder; and
    (B) offerings of exempted securities as defined in Section 
3(a)(12).
    (11) ``Restricted person'' includes:
    (A) members or other broker/dealers, unless the ultimate purchaser 
is a non-restricted person purchasing the security at the public 
offering price;
    (B) officers, directors, general partners, employees or agents of a 
member or any other broker/dealer (other than a limited business 
broker/dealer);
    (C) with respect to the security being offered, finders or any 
person acting in a fiduciary capacity to the managing underwriter, 
including, but not limited to, attorneys, accountants and financial 
consultants;
    (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;
    (E) any affiliate of a broker/dealer (other than a limited business 
broker/dealer); and
    (F) any natural person or member of the person's immediate family 
who owns 10% or more or has contributed 10% or more of the capital of a 
broker/dealer (other than a limited business broker/dealer).
(b) General Prohibitions
    (1) A member or a person associated with a member may not sell, or 
cause to sell, a hot issue in a public offering to any account in which 
a restricted person or a member of the restricted person's immediate 
family has a beneficial interest, expect as permitted herein or through 
an exemption pursuant to the Rule 9600 Series.
    (2) A member or a person associated with a member may not purchase 
a hot issue in a public offering, except as permitted herein or through 
an exemption pursuant to the Rule 9600 Series.
    (3) A member may not continue to hold hot issues acquired in a 
public offering except as permitted herein or through an exemption 
pursuant to the Rule 9600 Series.
(c) Canceling Trades
    A member or a person associated with a member does not violate this 
rule if it cancels a sale of a hot issue made to the account of a 
restricted person or a member of the person's immediate family prior to 
the end of the first business day following the date that trading 
commences (i.e., T+1) and reallocates such hot issue at the public 
offering price to a non-restricted person.
(d) Preconditions for Sale
    Before selling a hot issue to any account, a member must have 
obtained within the previous twelve months documentary evidence from 
the account holder, or a person authorized to represent the beneficial 
owners of the account or the ultimate purchasers if the account is a 
conduit account, demonstrating that no restricted person or ultimate 
purchaser in the case of a conduit account, has a beneficial interest 
in the account, except as permitted under the rule. Members shall 
maintain a copy of all records and information used to determine that 
an account does not contain a restricted person in its files for at 
least three years following the members's last sale of a hot issue to 
that account.
(e) General Exemptions
    A member or a person associated with a member with a member may 
sell hot issues to:
    (1) A registered investment company under the Investment Company 
Act of 1940.
    (2) A collective investment account (including a joint back office 
broker/dealer or a collective investment account with a joint back 
office broker/dealer subsidiary), that is beneficially owned in part by 
restricted persons, provided that such restricted persons in aggregate 
own less than 5% of such account.
    (3) A publicly traded corporation (other than an affiliate of a 
broker/dealer) listed on an exchange or The Nasdaq Stock Market, in 
which no person with a 10% or more ownership interest is a restricted 
person.
    (4) A foreign investment company organized under the laws of a 
foreign jurisdiction, meeting the following criteria:
    (A) the company has 100 or more investors:
    (B) the company is listed on a foreign exchange or authorized for 
sale to the public by a foreign regulatory authority;
    (C) no more than 5% of the company's assets shall be invested in a 
particular hot issue; and,
    (D) no person owning more than a 5% interest in such company is a 
restricted person.
    (5) An employee benefits plan qualified under the Employee 
Retirement Income Security Act provided that the plan sponsor is not a 
member or an affiliate; or a state or foreign government employee 
benefit plan that is subject to separate state and municipal 
regulation.
    (6) A tax exempt charitable organization under Section 501(c)(3) of 
the Internal Revenue Code.

[[Page 2658]]

    (7) Employees and directors of the issuer, an entity which 
controls, is controlled by, or is under common control of this issuer.
    (8) An immediate family member of a restricted person in paragraph 
(a)(11)(B) if:
    (A) such restricted person does not directly or indirectly provide 
material support to, or receive material support from, the immediate 
family member;
    (B) such restricted person is not employed by the member, or an 
affiliate of the member, selling the hot issue to the immediate family 
members; and
    (C) such restricted person has no ability to control the allocation 
of the hot issue.
    (9) An immediate family member of a restricted person in paragraphs 
(a)(11)(C)-(D) if such restricted person does not directly or 
indirectly provide material support to the member of the immediate 
family;
    (10) A restricted person in paragraph (a)(11)(E) provided that the 
sale is to an account established for the benefit of bona fide public 
customers, including insurance company general, separate and investment 
accounts, and bank trust accounts.
(f) Anti-Dilution Provisions
    The restrictions on the sale of hot issues in this rule shall not 
apply to sales to a restricted person in an initial public offering who 
meets the following criteria:
    (1) the restricted person has held an equity ownership interest in 
the issuer, or a company that has been acquired by the issuer in the 
past year, for a period of one year prior to the effective date of the 
public offering;
    (2) the sale of the hot issues to the restricted person shall 
increase the restricted person's percentage equity ownership in the 
issuer above the ownership level as of three months prior to the filing 
of the registration statement with the SEC in connection with the 
offering;
    (3) the sale of hot issues to the restricted person must not 
include any special terms; and
    (4) the hot issues purchased pursuant to this subsection shall be 
restricted from sale or transfer for a period of three months following 
the effective date of the offering.
(g) Conversion Offerings
    The rule shall not apply to the sale of securities directed by the 
issuer of a conversion offering, either on an underwritten or non-
underwritten basis, to any person eligible to purchase securities in 
accordance with the rules of a governmental agency or instrumentality 
having authority to regulate such conversion offering.
* * * * *
Rule 3040. Private Securities Transaction of an Associated Person
* * * * *
(e) Definitions
    For purposes of this Rule, the following terms shall have the 
stated meanings:
    (1) ``Private securities transaction'' shall mean any securities 
transaction outside the regular course or scope of an associated 
person's employment with a member, including, through not limited to, 
new offerings of securities which are not registered with the 
Commission, provided however that transactions subject to the 
notification requirements of Rule 3050, transactions among immediate 
family members (as defined in Rule 2790 [IM-2110-1, Free-Riding and 
Withholding]), for which no associated person receives any selling 
compensation, and personal transactions in investment company and 
variable annuity securities, shall be excluded.
* * * * *
5392. Rules of the Association
    (d) The following Rules of the Association and Interpretative 
Material thereunder are not applicable to transactions and business 
activities relating to the PORTAL Market:
    (1) Rules 1130, 2450, 2710, 2730, 2740, 2750, 2790, 2810, 2820, 
2830, 2860, 3210, and 3360[; and
    (2) IM-2110-1].
* * * * *
9600. PROCEDURES FOR EXEMPTIONS
9610. Application
(a) Where to File
    A member seeking an exemption from Rules 1021, 1022, 1070, 2210, 
2320, 2340, 2520, 2710, 2720, 2790, 2810, 2850, 2851, 2860, 
Interpretive Material 2860-1, 3010(b)(2), 3210, 3350, 8211 8212, 8213, 
11870, or 11900, [Interpretive Material 2110-1,] or Municipal 
Securities Rulemaking Board Rule G-37 shall file a written application 
with the appropriate department or staff of the Association and provide 
a copy of the application to the Office of General Counsel of NASD 
Regulation.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, NASD Regulation included 
statements concerning the purpose of and basis for the proposed rule 
change and discussed any comments it received on the proposed rule 
change. The text of these statements may be examined at the places 
specified in Item IV below. NASD Regulation has prepared summaries, set 
forth in Sections A, B, and C below, of the most significant aspects of 
such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    NASD Regulation is proposing Rule 2790, Trading in Hot Equity 
Offerings, to replace the Free-Riding and Withholding Interpretation, 
IM-2110-1 (``Interpretation''). The proposed new rule is an effort to 
focus and streamline the Interpretation, as well as to address feedback 
received in response to our request for comment on NASD rules in need 
of modernization in Notice to Members 98-81. NASD Regulation believes 
that the proposed rule is more carefully targeted towards the purposes 
of the Interpretation, while at the same time is significantly easier 
for the membership and the investing public to understand and follow.
    Before addressing the specifics of the proposed rule change, it is 
important to understand its purpose. The purpose of the proposed rule, 
like the Interpretation it would replace, is to protect the integrity 
of the public offering process by:
    (1) ensuring that members make a bona fide public offering of 
securities at the public offering price;
    (2) ensuring that members do not 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
    (3) ensuring that industry ``insiders,'' including members and 
their associated persons, do not take advantage of their ``insiders'' 
position in the industry to purchase hot issues for their own benefit 
at the expense of public customers.
    The proposed rule contains several significant changes from the 
Interpretation, which are discussed in detail below. Members should be 
aware that notwithstanding the Board of Governors' endorsement of the 
proposed

[[Page 2659]]

new rule, members must comply with the Interpretation as written. 
Additionally, members should be aware that NASD Regulation staff will 
not grant exemption from the current Interpretation on the basis of 
proposals or policy statements contained in proposed Rule 2790.
    1. Threshold Premium for ``Hot Issue''. Perhaps the most 
significant change in the proposed rule is the decision to define the 
term ``hot issue'' with reference to a threshold premium. The current 
Interpretation defines a hot issue as any security that trades ``at a 
premium,'' whenever secondary market trading begins. The NASD and the 
SEC have stated that any premium, no matter how small, makes an 
offering a hot issue.\4\ Thus, under the current Interpretation, a 
security that prices at $15 per share and begins trading at $15\1/32\ 
is a ``hot issue.''
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    \4\ See In re Wedbush, Noble, Cooke, Inc., 47 S.E.C. 1031, 1032-
1033 (1984).
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    NASD Regulation believes that defining a hot issue with reference 
to a threshold premium is more consistent with the purposes of the rule 
and avoids imposing limitations on the distribution of securities in a 
public offering for which there is no substantial or immediate 
secondary market demand. The proposed rule change defines a hot issue 
as 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 is 5% or more above the public offering price. NASD 
Regulation selected 5% as the threshold premium because it 
preliminarily believes that a 5% premium effectively distinguishes 
between offerings for which there is substantial excess investor demand 
and those that are generally satiated by the market supply. NASD 
Regulation recognizes that the selection of any threshold is to an 
extent arbitrary, and expects to receive comments from members and 
investors on whether 5% is the correct premium
    NASD Regulation selected the volume weighted price during the first 
five minutes of trading as the benchmark price for determining whether 
an offering is a hot issue in part because it is a calculation that can 
readily be performed by any member or investor with access to trade 
data. It also is similar to the method currently used by Corporate 
Financing staff in issuing determinations about whether an offering is 
a ``hot issue.'' NASD Regulation also selected the volume weighted 
price because it is generally not susceptible to manipulation. In fact, 
this same methodology is used to determine the settlement value of 
Nasdaq-100 options on the Chicago Options Exchange.\5\
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    \5\ See Release No. 34-37089 (April 9, 1996); Release No. 34-
37659 (September 6, 1996), 61 FR 48722 (September 16, 1996).
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    2. Application to Equity Offerings Only. Another significant change 
is that the proposed rule would apply to equity offerings only. 
Specifically, the proposed rule incorporates the definition of equity 
security, as the term is defined in section 3(a)(11) of the Act. 
Historically, the Interpretation has applied to equity and debt 
securities. However, as part of a series of amendments in 1998, NASD 
Regulation exempted most types of investment grade debt and investment 
grade asset-backed securities from the Interpretation on the grounds 
that ``such offerings do not raise the same issues as equity offerings 
inasmuch as the price for a particular debt security generally 
fluctuates based on interest rate movements rather than demand 
factors.'' \6\ With this proposed rule change, NASD Regulation is going 
one step further and eliminating application of the rule to non-
investment grade debt. NASD Regulation believes that the price of non-
investment grade debt is based primarily upon interest rates and the 
creditworthiness of the issuer rather than the demand factors that 
typically govern equity securities. In addition, since the debt markets 
are primarily institutional, debt offerings do not typically attract a 
lot of retail interest and, thus, the rule's purpose of protecting 
public customers would not be served in these markets. NASD Regulation, 
however, believes that offerings of convertible securities or warrants 
bundled with debt securities more closely resemble equity offerings and 
should not be exempt from the proposed rule.
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    \6\ See Release No. 34-39620 (February 4, 1998), 63 FR 7026 
(February 11, 1998) (Notice of filing of SR-NASD-97-95); Release No. 
34-40001 (May 18, 1998), 63 FR 28535 (May 26, 1998) (Order approving 
SR-NASD-97-95).
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    3. Secondary Offerings. The proposed rule differs from the 
Interpretation in that it would apply to all secondary offerings. In 
1998, NASD Regulation amended the Interpretation to exempt secondary 
offerings of actively-traded securities because it found that few 
secondary offerings traded at a premium, and where there was a premium, 
it was generally very small. In light of the decision to define a hot 
issue as requiring a 5% premium, NASD Regulation believes that it is no 
longer appropriate to exclude all secondary offerings as a class. In 
practice, most secondary offerings will continue to be exempt from the 
rule because there will not be a 5% premium. However, for those few 
offerings that do open at a 5% premium, the proposed rule would apply. 
NASD Regulation believes that any secondary offering for which there is 
excess demand, as evidenced by a 5% or more price increase, should not 
be purchased by restricted persons.
    4. Elimination of the ``Conditionally Restricted'' Status. Another 
significant change in the proposed rule is the decision to eliminate 
the so-called ``conditionally restricted'' status and treat persons 
either as restricted or non-restricted. Conditionally restricted 
persons are listed in paragraphs (b)(5)(A)-(C) of the Interpretation 
and include:
    (1) members of the immediate family of an associated person who are 
not supported directly or indirectly by such associated person;
    (2) finders in respect to the public offering or any person acting 
in a fiduciary capacity to the managing underwriter (including 
accountants, attorneys and consultants); and
    (3) senior officers and directors of a bank, savings and loan 
institution, insurance company, investment company, investment advisory 
firm, or any other institutional type account, or any person in the 
securities department of any of the foregoing entities, or any other 
employee who may influence or whose activities directly or indirectly 
involve or are related to the function of buying or selling securities 
for any of the foregoing entities.
    Under the Interpretation, conditionally restricted persons can 
purchase hot issues if:
    (1) the securities are sold to the customer in accordance with the 
customer's normal investment practice;
    (2) the amount of securities sold to any one such person is 
insubstantial; and
    (3) the member's aggregate sales to conditionally restricted 
persons is insubstantial and not disproportionate in amount as compared 
to sales to other members of the public.
    The concept of conditionally restricted persons establishes a 
compromise between an outright prohibition against purchasing hot 
issues and imposing no restrictions whatsoever. In many cases, treating 
a person was only conditionally restricted is contrary to the public 
interest. Many of the persons treated as conditionally restricted are 
in a position to direct business to a member. If a determination is 
made that members should not sell hot issues to persons who can direct 
business to the member, NASD Regulation does not believe that these

[[Page 2660]]

concerns are alleviated if the person can meet certain criteria, such 
as a ``normal investment practice.'' Moreover, as a practical matter, 
certain of these persons, such as hedge fund managers, investment 
advisers, and other investment and portfolio managers, may have the 
requisite investment history despite being in a position to direct and 
control future business to a member. NASD Regulation proposes 
eliminating the conditionally restricted person status while at the 
same time more precisely targeting those persons to whom the rule 
applies.
    5. Reconsidering the Category of Restricted Persons. In light of 
the recommendation to eliminate the conditionally restricted status, 
NASD Regulation is revising the category of persons subject to the 
rule.

    a. Finders and fiduciaries

    NASD Regulation will continue to treat finders and fiduciaries to 
the managing underwriter as restricted persons. NASD Regulation 
believes that finders and fiduciaries to the managing underwriter are 
for practical purposes industry ``insiders.'' There is additional 
support for this position in the Corporate Financing Rule, Rule 2710, 
which defines the term ``underwriter and related persons'' as including 
``financial consultants and advisors, finders, * * *'' Rule 2710(a)(6). 
Moreover, it is necessary to include finders and fiduciaries within the 
proposed rule to prevent issuers from circumventing the underwriting 
compensation limits of Rule 2710 by offering finders or fiduciaries 
access to the hot issue. NASD Regulation proposes treating these 
persons as restricted only for those offerings for which they are 
acting in the capacity as a finder or fiduciary. In the case of a law 
firm or consulting firm, the restriction would apply only to those 
persons working on a particular offering.

    b. Personnel with respect to the securities activities of a 
bank, insurance company, investment company, investment advisor, or 
collective investment account

    With respect to the Interpretation's restricted employees of a 
bank, savings and loan institution, insurance company, investment 
company, investment advisory firm, or any other institutional type 
account, NASD Regulation recommends several changes. The persons 
identified in this category are subject to the Interpretation because 
their position allows them the opportunity to direct business to a 
member, and it is believed that members would direct hot issues to the 
accounts of these persons in an effort to attract or retain business. 
NASD Regulation believes that this provision protects an important 
policy, but that the scope of persons covered may be too broad. NASD 
Regulation does not believe that all senior officers and all employees 
in the securities department of the covered entities should be 
restricted. Rather, a more function-oriented approach is proposed by 
treating as restricted persons only those employees or other persons 
who supervise, 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.
    The proposed rule also eliminates the term ``institutional type 
account'' which has been confusing and misleading to members since many 
of the covered entities are not ``institutional.'' The term 
institutional type account covers a broad range of accounts, including 
a corporation's investment account, a hedge fund, a family partnership, 
and an investment club. NASD Regulation notes that this category of 
persons is restricted under the Interpretation because they are in a 
position to direct investments. The Interpretation, however, implicitly 
accepts the practice of member firms awarding hot issues to their best 
customers. NASD Regulation is developing a distinction between 
directing investments of one's own money and other peoples' money. This 
concept is addressed in the proposed rule's definition of ``collective 
investment account'' which is defined as ``any hedge fund, investment 
partnership, investment corporation, or any other collective investment 
vehicle that manages assets of other persons.'' The proposed rule 
clarifies that a collective investment account shall not include any 
entity 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. NASD Regulation does not believe that participation 
in an investment club, where, for example, ten people contribute their 
own money and make decisions as a group, is the type of activity that 
should preclude a person from purchasing hot issues. Likewise, NASD 
Regulation also does not believe that establishing and managing a 
family partnership should preclude a person from purchasing hot issues. 
Family partnerships are often established for tax and estate planning 
purposes and, because they do not involve managing other peoples' 
money, they do not implicate the concerns addressed by the proposed 
rule.

    c. Collective investment accounts with very limited ownership by 
restricted persons


    The proposed rule also contains an exemption for collective 
investment accounts owned by restricted persons to a very limited 
extent. Currently, the Interpretation states that investment 
partnerships and corporations in which a restricted person has a 
beneficial interest are prohibited form purchasing hot issues unless 
the investment partnership or corporation ``carves-out'' the interest 
of the restricted persons. NASD Regulation is aware that investment 
partnerships and corporations frequently incur significant expense in 
determining the status of every participant, particularly in the fund 
of fund contexts. In an effort to eliminate some of the burdens 
associated with the Interpretation, the proposed rule creates an 
exemption from the rule for a collective investment account that is 
beneficially owned in part by restricted persons, provided that such 
restricted persons in aggregate own less than 5% of such account. NASD 
Regulation believes that creating an exemption to accommodate these 
minimal interests in collective investment accounts is consistent with 
the purposes of the rule. Investors frequently like to see a general 
partner invest in the accounts they manage, and the proposed rule will 
now allow the general partner of a collective investment account to 
have a small but direct capital interest.
    In addition, the 5% limit allows restricted persons who were 
previously only conditionally restricted, such as hedge fund managers, 
investment advisors, and other investment and portfolio managers, to 
participate in hot issues to a limited extent. Under the new rule, 
however, the participation by restricted persons will be incidental to 
what is otherwise a bona fide public distribution to investors 
beneficially owning 95% or more of the collective investment account. 
Lastly, this exemption for minimal ownership interests is consistent 
with the rationales for exempting registered investment companies and 
foreign investment companies.
    As with the current Interpretation, a collective investment account 
that is beneficially owned 5% or more in aggregate by restricted 
persons would be able to purchase hot issues so long as the restricted 
persons do not participate in the hot issue activity, i.e., if their 
interests have been carved out from the account that purchases hot 
issues. The proposed rule does not contain specific procedures for 
carving out the interests of restricted persons. Rather, this

[[Page 2661]]

requirement is addressed under the general prohibition that states ``a 
member or a person associated with a member may not sell, or cause to 
sell, a hot issue in a public offering to any account in which a 
restricted person * * * has a beneficial interest.'' Pursuant to the 
provisions on preconditions for sale, discussed below, a member may not 
sell a hot issue to a collective investment account unless it has 
obtained documentary evidence from a person authorized to represent the 
beneficial owners of the account demonstrating that no restricted 
person has a beneficial interest in the account, except as permitted 
under the rule. In the case of sales to a collective investment account 
that is beneficially owned 5% or more by restricted persons, the 
documentary evidence furnished to the member would be required to 
demonstrate that the interests of the restricted persons have been 
carved out of the collective investment account.
    6. Issuer-Directed Share Programs. Currently, the Interpretation 
permits members to sell hot issue securities to employees and directors 
of an issuer, a parent of an issuer, a subsidiary of an issuer, or any 
other entity that controls or is controlled by an issuer, when these 
persons are otherwise subject to the Interpretation, provided that in 
the case of an offering of securities for which a bona fide independent 
market does not exist, such securities are ``locked-up'' for three 
months. The proposed rule makes two changes. First, the rule would 
expand the exemption to reach ``employees and directors of the issuer, 
an entity which controls, is controlled by, or is under common control 
of the issuer'' (``eligible related companies''). For this 
subparagraph, a company will be presumed to control another if the 
company beneficially owns 50% or more of the outstanding voting 
securities of the company. Expanding the scope to reach sister 
companies of the issuer is consistent with the purposes of the rule and 
with staff decisions under the exemptive authority.\7\
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    \7\ See Letter to Phillip D. Parker, Debevoise & Plimpton, from 
Gary L. Goldsholle, NASD Regulation, dated May 28, 1999; Letter to 
Mark D. Fitterman, Morgan, Lewis & Bockius LLP, from Gary L. 
Goldsholle, NASD Regulation, dated May 17, 1999. (Copies of NASD 
Regulation exemptive and interpretative letters cited herein are 
available at the NASD Regulation web site at www.nasdr.com.)
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    Second, the rule would eliminate the requirement for a three month 
lock-up for sales to restricted persons. The exemptive provisions 
addressing issuer-directed share programs were adopted in 1994. In 
announcing these amendments, the NASD explained that issuer-directed 
share programs are a valuable tool in employee development and 
retention. The NASD explained that the Interpretation should not 
interfere with programs that are part of an employer/employee 
relationship. NASD Regulation believes that issuers should be free to 
set the conditions for sales of their own securities to their 
employees, or employees of eligible related companies, even if such 
employees are otherwise restricted persons. While in many cases issuers 
impose lock-up periods, we do not believe they should be mandated by 
the proposed rule. Eliminating the lock-up period will eliminate the 
need for members to investigate the status of employees and directors 
of the issuer and eligible related companies, which was previously 
necessary solely to comply with the lock-up provisions.
    Also, the proposed rule change will allow all employees and 
directors of the issuer and eligible related companies to be able to 
purchase securities of the issuer on equal terms. Currently, under the 
Interpretation, an employee of an issuer with a spouse in the 
securities business is required to lock-up the securities even though 
other employees may have no similar lock-up requirement.
    7. Preconditions for Sale. Finally, the proposed rule also 
eliminates the myriad means members must use to demonstrate that they 
have not sold hot issues to restricted persons. The current 
Interpretation ranges from:
    (1) Providing no specific guidance whatsoever with respect to sales 
to associated persons of a member;
    (2) to requiring written certifications from foreign broker/dealers 
and foreign banks;
    (3) to requiring notations on and principal review of order tickets 
for sales to domestic banks and conduits for undisclosed principal 
(including registered investment advisers); and
    (4) to written representations from attorneys and/or certified 
public accountants for sales to certain hedge funds or investment 
partnerships.
The proposed rule eliminates these various requirements and instead 
imposes an annual verification requirement on those accounts that 
purchase hot issues. Specifically, the proposed rule states that 
``[b]efore selling a hot issue to any account, a member must have 
obtained within the previous twelve months documentary evidence from 
the account holder, or a person authorized to represent the beneficial 
owners of the account or the ultimate purchasers if the account is a 
conduit account, demonstrating that no restricted person or ultimate 
purchaser in the case of a conduit account, has a beneficial interest 
in the account, except as permitted under the rule.'' Under the 
proposed rule, a member may rely upon the written representation 
furnished by the customer unless it has reason to believe that the 
representation is inaccurate. The proposed rule requires that members 
shall maintain a copy of all records and information used to determine 
that an account does not contain restricted persons in its files for at 
least three years following the member's last sale of a hot issue to 
that account.
    8. Other Changes/Miscellaneous. In addition to the changes 
described above, the proposed rule also makes a number of minor 
modifications.
    Sales to Certain Immediate Family Members of Associated Persons. 
The proposed rule modifies the exemption for sales to members of the 
immediate family of an officer, director, general partner, employee or 
agent of a member or another broker/dealer (collectively referred to as 
``associated persons''). Currently, members of the immediate family of 
an associated person may not purchase hot issues from the firm 
employing the associated person. The proposed rule would expand this 
prohibition to include affiliates of the firm employing the associated 
person. As some firms establish affiliated broker/dealers, including 
online affiliates, this change is necessary to clarify that immediate 
family members of associated persons cannot use either the traditional 
or online distribution channel to circumvent the prohibitions on sales 
to them.
    Second, the proposed rule modifies the exemption for sales of hot 
issues to immediate family members of an associated person to prevent 
sales to any immediate family members if the associated person directly 
or indirectly provides material support to, or receives material 
support from, the immediate family member. The decision to include the 
receipt of support from an immediate family member avoids situations 
where a broker, in exchange for money or other support from his or her 
parents, allocates hot issues to them.
    Affiliates of Brokers/Dealers. The proposed rule also clarifies the 
restrictions on persons, natural and non-natural, that own more than a 
specified percentage of a broker/dealer. The definition of restricted 
person in the proposed rule includes an affiliate of a broker/dealer 
(other than a limited business broker/dealer) and any natural person or 
member of the person's immediate family who owns 10% or more or has 
contributed 10% or more of

[[Page 2662]]

the capital of a broker/dealer (other than a limited business broker/
dealer). NASD Regulation believes that these standards are similar in 
scope but more clearly articulated than paragraph (b)(9) of the 
Interpretation.
    Limited Business Broker/Dealer. The proposed rule also clarifies 
the meaning of limited business broker/dealer. The Interpretation 
currently treats as a limited business broker/dealer a member engaged 
solely in the purchase or sale of either investment company/variable 
contracts securities or direct participation program securities. The 
use of the term ``engaged'' has created some ambiguity where a firm is 
planning to expand into or phase out of a line of business. NASD 
Regulation believes it is more appropriate to look to what businesses a 
firm is ``authorized'' to engage in. In determining what business a 
firm is authorized to engage in, a member should look to the Form BD as 
well as any Restrictive Agreement.
    Joint Back Office Broker/Dealers. The proposed rule also states 
that collective investment accounts that voluntarily register as 
broker/dealers for margin purposes (``joint back office broker/
dealers''), or that have a joint back officer broker/dealer subsidiary, 
are not automatically precluded from purchasing hot issues. This issue 
of joint back office broker/dealers first arose following the 1998 
amendments to the Interpretation. Because the 1998 amendments expressly 
precluded sales of hot issues to an entity that owned a broker/dealer, 
the staff was approached by several hedge funds with joint back office 
broker/dealer subsidiaries that were suddenly precluded from purchasing 
hot issues even though investors in the funds were not restricted. 
Pursuant to its exemptive authority, the staff stated that the decision 
of a hedge fund or a subsidiary of a hedge fund to voluntarily register 
a broker/dealer for the purpose of receiving more favorable margin 
treatment under Federal Reserve Regulation T should not automatically 
preclude the hedge fund from purchasing hot issues. Rather, the staff 
concluded that sales of hot issues to a hedge fund should be based upon 
a determination of the beneficial owners, and not be a function of 
whether the fund has sought more favorable margin treatment. The 
proposed rule codifies this exemptive position\8\
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    \8\ See Letter to David Katz, Sidley & Austin, from Gary L. 
Goldsholle, NASD Regulation, dated January 20, 1999.
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    Beneficial Interest. The proposed rule also defines the term 
``beneficial interest.'' Specifically, the term ``beneficial interest'' 
is defined as any ownership or other direct financial interest. In 
addition, consistent with the staff position articulated in Notice to 
Members 95-7, the definition states that the receipt of a management 
fee or performance based fee for operating a collective investment 
account shall not be considered a beneficial interest in the account.
    Charitable Organizations. The proposed rule exempt sales to tax 
exempt charities organized under Section 501(c)(3) of the Internal 
Revenue Code. NASD Regulation believes that sales to charitable 
organizations are consistent with the purposes of the rule and foster a 
bona fide public distribution.
    Anti-Dilution Provisions. The proposed rule also renames the 
``Venture Capital Investors'' provisions of paragraph (h) of the 
Interpretation to ``Anti-Dilution Provisions'' to more accurately 
describe their effect and to avoid confusion about their scope. In 
addition, these provisions have been modified slightly to allow an 
equity holder to tack ownership where a company has been acquired by an 
issuer for purposes of meeting the one year holding period. This 
amendment is consistent with a staff interpretative position.\9\
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    \9\ See Letter to Jeffrey Freiburger, Robert W. Baird & Co., 
Inc., from Gary L. Goldsholle, NASD Regulation, dated October 14, 
1998.
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    Sales to Employee Benefits Plans. The provisions addressing 
employee benefits plans qualified under the Employee Retirement Income 
Security Act (``ERISA'') also have been amended. The proposed new rule 
would exempt employee benefits plans qualified under ERISA so long as 
the plan sponsor is not a member or an affiliate. NASD Regulation 
believes that the concept of an ``affiliate'' is a more appropriate 
method for determining whether an ERISA plan should be able to purchase 
hot issues. The proposed new rule also exempts state and foreign 
government employee benefits plans that are subject to separate state 
or municipal regulation, consistent with a staff interpretative 
position.\10\
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    \10\ See Letter to Adam J. Kansler, Proskauer Rose LLP, from 
Gary L. Goldsholle, NASD Regulation, dated April 26, 1999.
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    Conversion Offerings. Finally, the provisions addressing conversion 
offerings have been streamlined. The new provisions have been amended 
to expressly include insurance company demutualizations. In addition, 
the provisions exempt conversion offerings regardless of whether the 
shares offered to eligible participants are part of the underwritten or 
non-underwritten offering. The proposed rule also eliminates the 
specific requirement for written notification to the member firm where 
the eligible purchaser is an associated person. The supervision of 
securities activity by associated persons is addressed in the NASD's 
supervision rules and need not be separately addressed or duplicated in 
the proposed rule.
    Effective Date. The NASD will announce the effective date of the 
proposed rule change in a Notice to Members to be published no later 
than 60 days following Commission approval. The effective date will be 
30 days following publication of the Notice to Members announcing 
Commission approval.
2. Statutory Basis
    NASD Regulation believes that the proposed rule change is 
consistent with the provisions of Section 15A(b)(6) \11\ of the Act, 
which requires, among other things, that the Association's rules must 
be designed to prevent fraudulent and manipulative acts and practices, 
to promote just and equitable principles of trade, and, in general, to 
protect investors and the public interest. NASD Regulation believes 
that the provisions of the new rule protect investors and the public 
interest by: ensuring that members make a bona fide public offering of 
securities at the public offering price; ensuring that members do not 
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 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.
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    \11\ 15 U.S.C. 78o-3(b)(6).
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B. Self-Regulatory Organization's Statement on Burden on Competition

    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, as amended.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    Written comments were neither solicited nor received.

[[Page 2663]]

III. Date of Effectiveness of the Proposed Rule Change and Timing 
for Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:
    (A) by order approve such proposed rule change, or
    (B) institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
is consistent with the Act. Persons making written submissions should 
file six copies thereof with the Secretary, Securities and Exchange 
Commission, 450 Fifth Street, N.W., Washington, DC 20549-0609. Copies 
of the submission, all subsequent amendments, all written statements 
with respect to the proposed rule change that are filed with the 
Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C 552, will be available for inspection and copying in the 
Commission's Public Reference Room. Copies of such filing will also be 
available for inspection and copying at the principal office of the 
NASD. All submissions should refer to File No. SR-NASD-99-60 and should 
be submitted by February 8, 2000.

    For the Commission, by the Division of Market Regulations, 
pursuant to delegated authority.\12\
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    \12\ 17 CFR 200.30-3(a)(12).

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 00-995 Filed 1-14-00; 8:45 am]
BILLING CODE 8010-01-M