Restrictions on the Purchase and Sale of Initial Equity Public Offerings - Rule 2790

The staff granted an exemption from NASD Rule 2790 in connection with new issue offering of a registered securities exchange for certain allocations as part of its issuer-directed share program.    

 

December 3, 2004

 

Dana G. Fleischman, Esq.
Cleary, Gottlieb, Steen & Hamilton
One Liberty Plaza
New York, NY 10006-1470

 

Re:  Request for Exemption from Rule 2790

 

Dear Ms. Fleischman:

 

This is in response to your letter dated July 27, 2004, in which you request an exemption from NASD Rule 2790 in connection with the proposed initial public offering ("IPO") of the Class A common stock of the International Securities Exchange, Inc. ("ISE").  This letter supercedes our previous correspondence on this subject dated November 26, 2004. 

 

Pursuant to paragraph (h) of Rule 2790, the staff, for good cause shown after taking into consideration all relevant factors, may conditionally or unconditionally exempt any person, security or transaction (or any class or classes of persons, securities or transactions) from Rule 2790 to the extent that such exemption is consistent with the purposes of the Rule, the protection of investors, and the public interest.  For the reasons set forth below, the staff grants your request for an exemption from Rule 2790. 

 

Background

 

Based upon your letter and our subsequent telephone conversations, we understand the facts to be as follows.  The ISE is a registered national securities exchange that provides a trading platform in listed equity options.  In April 2002, the ISE completed a substantial reorganization involving a number of related transactions, including a demutualization and its conversion from a limited liability company to a corporation.  In the demutualization, the ISE converted its limited liability company members' single ownership interests, which represented both equity interests and trading rights, into separate equity interests and trading rights.  The demutualization allowed the limited liability company members to convert their original interests into shares of common stock that could be traded separately from exchange trading privileges.  This conversion resulted in the creation of Class A common stock, which represents equity interests and voting rights.  The Class A common stock was distributed to the ISE members based on their respective ownership interests prior to the 2002 demutualization.  The conversion also resulted in the creation of Class B common stock, which represents trading rights and limited voting rights, but does not convey any equity interests.   The Class B common stock is divided into three series:  Series B-1 common stock, Series B-2 common stock, and Series B-3 common stock.  To distinguish its Class B common stock from traditional common stock, the ISE refers to its Class B common stock as "Class B memberships," and to each series of its Class B common stock as "Class B-1 memberships," "Class B-2 memberships," and "Class B-3 memberships," respectively.

 

The ISE has three classifications of members - Primary Market Makers ("PMMs"), Competitive Market Makers ("CMMs") and Electronic Access Members ("EAMs") - all of which must be registered broker-dealers under the Securities Exchange Act of 1934.  The members of the ISE are essential to the ISE's operations and have a strategic relationship with the ISE.  The ISE's listed options are divided into ten groups, known as bins.    

 

PMMs are market makers with significant responsibilities, including oversight of the opening of trading in their assigned bins and continuous quoting in 100% of their assigned bins.  PMMs also are responsible for ensuring that customer orders are executed at the best available price whether it is available on the ISE or another options exchange and are responsible for maintaining linkages to other exchanges so that orders can be rerouted when necessary to capture the best price.  Each bin has one PMM and contains the stock options for which the PMM is responsible.  In addition to maintaining quotations in the options in their assigned bins, PMMs may conduct a limited amount of trading (up to 10% of their quarterly contract volume) in options outside their bin.  In order to become a PMM, an ISE member must purchase or lease a Class B-1 membership.  The ISE currently has ten PMM members. 
 
CMMs are required to provide continuous quotations in no less than 60% of the options in their assigned bin.  There may be up to 16 CMMs appointed to each of the ten bins on the ISE.  In addition to providing quotations in the stock options in their assigned bins, CMMs also may conduct a limited amount of trading (up to 25% of their quarterly contract volume) in options outside their bin.  An ISE member must purchase or lease a Class B-2 membership in order to become a CMM.  As of September 30, 2004, the ISE had 142 CMM members.   
 
EAMs are registered broker-dealers that may place orders for their own accounts and the accounts of institutional and retail investors, but may not submit quotations or otherwise make markets on the ISE.  EAMs are permitted to trade in any bin.  EAMs pay only an access fee.  The Class B-3 memberships are associated with the right to trade as an EAM on the ISE.  As of November 10, 2004, the ISE had 124 EAM members.   

 

The ISE is planning a forthcoming IPO of its Class A common stock.  The ISE also is contemplating a directed share program ("DSP") in connection with the IPO.  Through the DSP, the ISE intends to reserve up to five percent of its Class A common stock for purchase by employees and certain non-industry directors of the ISE, certain other individuals designated by such employees and directors (excluding individuals that are "restricted persons" as defined in Rule 2790), and 11 PMMs and CMMs that currently do not own any equity interest in the ISE.1 These PMMs and CMMs acquired their memberships, either through purchase or lease, after the 2002 demutualization, and thus they did not receive any equity interests in the ISE.  The DSP is intended, in part, to provide the 11 PMMs and CMMs an opportunity to own equity in the ISE similar to other PMMs and CMMs.  The 11 PMMs and CMMs would not be involved in the distribution of the IPO.  Further, any shares directed to these PMMs and CMMs through the DSP would be divided equally among them or otherwise allocated on a pro rata or other non-discriminatory basis.  The proposed inclusion of the 11 PMMs and CMMs in the DSP was made by the ISE.  Moreover, the PMMs and CMMs that purchase in the DSP would be subject to a 180-day lock-up.   

 

The 11 PMMs and CMMs are registered broker-dealers and thus are "restricted persons" as defined in Rule 2790.  Rule 2790 prohibits the participation of the 11 PMMs and CMMs in the DSP.  You are requesting an exemption in connection with the ISE's forthcoming IPO so that the ISE can direct shares of its Class A common stock to the 11 PMMs and CMMs.

 

Analysis

 

Rule 2790 is designed to protect the integrity of the public offering process by ensuring that: (1) NASD members make bona fide public offerings of securities at the offering price; (2) members do not withhold securities in a public offering for their own benefit or use such securities to reward persons who are in a position to direct future business to members; and (3) industry insiders, including NASD members and their associated persons, do not take advantage of their insider position to purchase "new issues" for their own benefit at the expense of public customers.  The Rule plays an important part in maintaining investor confidence in the capital raising and public offering process. 

 

Pursuant to Rule 2790(d)(1), the prohibitions on the purchase and sale of "new issues" in Rule 2790 generally do not apply to "new issue" securities that are specifically directed by the issuer to "restricted persons" as defined in the Rule.  However, issuer-directed securities cannot be sold to or purchased by an account in which any "broker-dealer personnel" has a beneficial interest, unless such person, or a member of his or her immediate family, is an employee or director of the issuer, the issuer's parent, or a subsidiary of the issuer or the issuer's parent.  The term "broker-dealer personnel" includes, among others, any officer, director, general partner, associated person, or employee of a broker-dealer (and certain immediate family members of such persons).

 

The inclusion of this additional requirement in Rule 2790(d)(1) (i.e., that "broker-dealer personnel," or members of their immediate family, must be employees or directors of the issuer, the issuer's parent, or a subsidiary of the issuer or the issuer's parent before they can receive issuer-directed securities) is designed to ensure that such persons, who typically have the greatest potential to influence the IPO allocation process, have a demonstrated basis for purchasing shares in the IPO other than immediate capital appreciation.  Issuer-directed securities to broker-dealers, similar to "broker-dealer personnel," implicate the concerns Rule 2790(d)(1) is designed to prevent.2   However, in the case of an IPO of a registered securities exchange and under the unique circumstances described in your letter, the staff believes that there is a valid demonstrated basis for such allocations.    

 

You represent that, absent an exemption, Rule 2790 would prohibit the 11 PMMs and CMMs from participating in the ISE's DSP.  You note that these 11 PMMs and CMMs currently do not own equity interests in the ISE and that including them in the DSP is intended to place them on an equal footing with other PMMs and CMMs.  In addition, you note that the 11 PMMs and CMMs would not be involved in the distribution of the IPO, and they would be subject to a 180-day lock-up.  You further represent that the members of the ISE, including the 11 PMMs and CMMs, are essential to the ISE's operations.  Rule 2790(d)(1) allows employees and directors of an issuer to receive issuer-directed securities despite their status as "broker-dealer personnel" because employees and directors are an integral part of the issuer's operations.  The staff believes that this rationale equally applies to the circumstances described in your letter, whereby in connection with its IPO, the ISE intends to direct its shares to members that are vital to its operations.  Accordingly, based on the unique facts and circumstances of this matter, the staff finds that granting the 11 PMMs and CMMs an exemption is consistent with the purposes of Rule 2790, the protection of investors, and the public interest.  For these reasons, the staff grants an exemption from Rule 2790 for the limited purpose of ISE directing shares of its Class A common stock to the 11 PMMs and CMMs through the DSP, subject to the terms and conditions discussed above.

 

If you have any questions on this matter, please do not hesitate to contact me at (202) 728-8902.

 

Very truly yours,

 


Afshin Atabaki
Attorney

 

cc:   

 

Gary L. Goldsholle
Associate Vice President and 
Associate General Counsel

 

Hans Reich, Senior Vice President, 
New York District Office
 

 

1 There are 12 PMMs and CMMs that currently do not own an equity interest, but one of them will be excluded from participating in the DSP because of its involvement in the distribution of the IPO.

 

2 While broker-dealers are not expressly subject to the limitations applicable to "broker-dealer personnel" in Rule 2790(d)(1), to the extent that "broker-dealer personnel" have a beneficial interest in a broker-dealer, as is the case with the 11 PMMs and CMMs, the broker-dealer would be subject to the limitations in Rule 2790(d)(1).  Consequently, the broker-dealer could not purchase any issuer-directed "new issues" unless each "broker-dealer personnel" that has a beneficial interest in the broker-dealer, or a member of their immediate family, also is an employee or director of the issuer, the issuer's parent, or a subsidiary of the issuer or the issuer's parent.