Notice To Members 85-81

Request for Comments on Proposed Exemption from Free-Riding Interpretation for Conversions of Savings and Loan Associations

Published Date:

TO: All NASD Members and Other Interested Persons

LAST DATE FOR COMMENT: JANUARY 2, 1986

The National Association of Securities Dealers, Inc., (NASD) is requesting comments on a proposed amendment that would exempt certain persons purchasing securities in connection with the conversion of a savings and loan association or other organization from mutual to stock ownership from the restrictions of the Interpretation of the Board of Governors, Free-Riding and Withholding (the "Free-Riding Interpretation") under Article III, Section 1 of the NASD Rules of Fair Practice. The proposed amendment, and the history and background leading to its proposal, are discussed in this notice. The text of the amendment is attached.

HISTORY AND BACKGROUND

The Free-Riding Interpretation restricts certain persons from purchasing securities in a public offering if those securities trade at a premium in the immediate aftermarket. The Interpretation prohibits member firms, persons associated with members, immediate family members of such associated persons and other specified persons from purchasing or retaining securities that are part of a "hot" issue. It also requires members to make a bona fide public offering of such securities. To assure compliance with the Interpretation, most firms establish procedures to monitor purchases of new issues. As a practical matter, application of the Interpretation generally restricts the ability of members and their associated persons to purchase new issues.

In recent years, a growing number of savings and loan associations have converted from the mutual form of ownership to stock ownership, issuing securities in the process. Under the rules of the Federal Home Loan Bank Board (FHLBB), federally chartered institutions usually offer their depositors, borrowers and community residents the opportunity to subscribe to their securities prior to any under-written public offering. In some cases, an association's entire offering will be sold through this subscription process, without participation by a broker-dealer. More commonly, the issuing institution will sell a portion of the offering during the subscription period, with the remaining securities being underwritten and distributed by a broker-dealer. The point at which the broker-dealer becomes involved, and the role performed, varies.

With the proliferation of savings and loan conversions, numerous questions have arisen concerning the ability of persons subject to the Free-Riding Interpretation to purchase securities directly from a savings and loan association during its subscription period. These questions involve several complex issues, especially when a restricted person is entitled under FHLBB rules to purchase securities in the capacity of a depositor or borrower, or when it is unclear whether a broker-dealer will be involved in the offering.

PROPOSED AMENDMENT

In view of these numerous issues, the National Business Conduct Committee (NBCC) of the NASD Board of Governors has reviewed the FHLBB rules, the practices involved in savings and loan conversions and the policy considerations behind the restrictions of the Free-Riding Interpretation. On the basis of this analysis, the NBCC concluded that it is appropriate to exempt certain persons from the Free-Riding Interpretation under specified conditions. In doing so, the NBCC also concluded that it is appropriate to make a distinction between member firms, their associated persons and immediate family members on the one hand and all other restricted persons covered under the Interpretation on the other hand.

Definitions

The proposed amendment would define "conversion offering" as an offering that is part of a plan whereby a savings and loan association or other organization converts from the mutual form to the stock form of ownership. The definition includes offerings by other organizations and would make the language applicable, for example, to conversions by mutual insurance companies.

The amendment would define "eligible purchaser" to mean a person who is eligible to purchase securities directly from the issuer in a savings and loan conversion offering under FHLBB rules and who has a direct relationship with the issuer as a depositor, borrower, officer, director or employee, or serves in a similar capacity.

The terms of savings and loan conversions specify those persons eligible to purchase directly from the issuer in transactions that are not handled by the underwriter. Often, persons eligible to make such purchases can do so prior to the public, underwritten offering. In some cases, the entire offering is distributed to such purchasers. Under FHLBB rules, eligibility to purchase may be extended to residents of the community in which the converting association is located. After careful consideration, the NBCC concluded that it is appropriate to extend the proposed exemption from the Free-Riding Interpretation only to those purchasers who have a direct relationship with the issuer. Thus, depositors, borrowers, officers, directors or employees could claim the exemption (assuming they meet all other criteria), but persons who are eligible under FHLBB rules solely due to their residence could not.

Sales by the Issuer

The proposed amendment provides an exemption from the Free-Riding Interpretation in two different situations:

1. Sales directly by the issuer.
2. Sales by members.

In the first situation, the amendment must address sales by the issuer because the Interpretation otherwise would indirectly prohibit some such sales. When a member or associated person participates in an offering, all transactions that are part of the offering are scrutinized for compliance with the Interpretation. In a typical savings and loan conversion, therefore, sales made directly by the issuer to restricted persons may constitute violations of the Interpretation by NASD members participating in the offering.

The amendment would permit members and associated persons to participate in a conversion offering notwithstanding the fact that the issuer may have sold, or may sell, securities of the offering to persons restricted by the Interpretation. For the exemption to be available, however, any such sales by the issuer must be made only to eligible purchasers as defined. Those purchasers may not be members, their associated persons or immediate family members of associated persons, and the sales must be effected without any direct or indirect participation by a member or associated person. In a savings and loan conversion, therefore, a member could participate in the offering even though the issuer has directly sold shares to restricted persons as long as no sales were made to a member, associated person or immediate family member.

Sales to Members, Associated Persons and Their Immediate Families

The proposed amendment would deal separately with sales to member firms, their associated persons and members of their immediate families and would impose more stringent conditions on the exemption. The NBCC believes there are inherent conflicts of interest between participation in the securities industry and the purchase of "hot" issues, even in the context of the conversion of a savings and loan association. The NBCC concluded that it is necessary to require persons in this category to satisfy additional conditions beyond those previously mentioned for non-securities industry persons.

Subsection (c) would permit members and associated persons to sell securities as part of a conversion offering to members and associated persons and their immediate families if seven conditions are met:

1. Any purchaser must be an eligible purchaser as defined.
2. If a member firm has agreed to serve for compensation as the managing underwriter, appraiser or financial advisor to the issuer in connection with the conversion, neither that member, its associated persons nor their immediate family members can take advantage of the exemption. This restriction becomes applicable when the firm has reached an understanding with the issuer. Persons may claim the exemption prior to the point when such an understanding is reached.
3. Any purchaser claiming the exemption under this category would be required to provide written notice to the issuer of his restricted status under the Free-Riding Interpretation. This condition will enable the issuer and any broker- dealer that may participate in the offering to identify those persons who are subject to the Free-Riding Interpretation to determine whether they have properly satisfied the conditions of this exemption.
4. As a further means of assuring compliance with the conditions of the exemption, associated persons and their immediate family members would be required to provide the person's employer firm with written notice of the subscription.
5. The amount of securities purchased by a person claiming this exemption would be required to be consistent with his or her normal investment history. This limitation is intended to assure that members of the securities industry do not abuse the privilege of purchasing securities in converting institutions to the exclusion of public investors.
6. Securities purchased under this subsection would be restricted from sale, transfer or hypothecation for 90 days following the conclusion of the public offering. This condition is intended to assure that members, their associated persons and immediate families are purchasing the securities for at least a short-term investment and not with the intent of immediately reselling those securities at a premium. The 90-day "lock up" will assure that those persons bear market risk for a reasonable period of time. Such persons thereby would have less incentive to influence prices in the immediate aftermarket to realize profit and would have an incentive to establish a fair public offering price.
7. No member firm, associated person or immediate family member would be permitted to collect solicitation fees from the issuer in connection with purchases made under this subsection. The NBCC concluded that it would be unfair to permit those parties to obtain the potential benefit of an investment under the exemption as well as the payment of a solicitation fee from the issuer.

* * * *

All members and other interested persons are invited to submit comments on the proposed rule. Comments should be received no later than January 2, 1986, and should be directed to:

Mr. James M. Cangiano, Secretary
National Association of Securities Dealers, Inc.
1735 K Street, N.W.
Washington, D.C. 20006

Comments received by the indicated date will be considered by the NBCC and the NASD Board of Governors. Any rule change approved by the Board must be filed with and approved by the Securities and Exchange Commission before becoming effective.

Questions concerning this notice may be directed to Dennis C. Hensley, Vice President and Deputy General Counsel, at (202) 728-8245.

Sincerely,

Frank J. Wilson
Executive Vice President and General Counsel

Attachment

TEXT OF PROPOSED AMENDMENT

Amend the Interpretation of the Board of Governors, Free-Riding and Withholding under Article III, Section 1 of the Rules of Fair Practice by adding at the end thereof the following language:

Conversion Offerings

(a) Definitions — For purposes of this subsection, the following terms shall have the meanings stated.
(i) "Conversion offering" shall mean an offering of securities made as part of a plan by which a savings and loan association or other organization converts from the mutual form to the stock form of ownership.
(ii) "Eligible purchaser" shall mean a person who is eligible to purchase securities pursuant to the rules of the Federal Home Loan Bank Board or similar agency governing conversion offerings and who has a direct relationship with the issuer as a depositor, borrower, officer, director or employee, or serves in a similar capacity.
(b) Sales by Issuer — This Interpretation shall not prohibit a member or person associated with a member from participating in a conversion offering notwithstanding the fact that the issuer may have sold or may sell securities of the offering to persons otherwise restricted by this Interpretation, provided that any such sale is made in compliance with all of the following conditions:
(i) the purchaser is an eligible purchaser;
(ii) the purchaser is not a member, a person associated with a member or a member of the immediate family of a person associated with a member; and
(iii) the sale is effected without the participation directly or indirectly of a member or person associated with a member.
(c) Sales to Members, Associated Persons and Immediate Family Members — This Interpretation shall not prohibit a member or person associated with a member from selling securities as a part of a conversion offering to a member, a person associated with a member or a member of the immediate family of a person associated with a member, provided that such sale is made in compliance with all of the following conditions:
(i) the purchaser shall be an eligible purchaser;
(ii) the purchaser shall not be, nor be associated with, nor be a member of the immediate family of a person associated with, a broker-dealer that has agreed to receive compensation for acting as managing underwriter, appraiser or financial advisor to the issuer in connection with the conversion, or for providing any other service to the issuer;
(iii) the purchaser shall provide written notice to the issuer, on the subscription form or otherwise, of his or her restricted status under this Interpretation;
(iv) a person associated with a member shall provide that member with written notice of a purchase by the associated person or a member of his or her immediate family;
(v) the amount of securities purchased shall be consistent with the purchaser's normal investment history;
(vi) the securities purchased shall be restricted from sale, transfer or hypothecation for 90 days following the conclusion of the public offering; and
(vii) neither the purchaser nor the broker-dealer with which he or she or a member of his or her immediate family is associated shall receive any solicitation fees or similar compensation for sales to the broker-dealer, associated person or immediate family member.