Notice To Members 87-73

Request for Comments on Amendment to Board of Governors' Free-Riding Interpretation Concerning Investment Partnerships

Published Date:

TO: All NASD Members and Other Interested Persons

LAST DATE FOR COMMENT: DECEMBER 4, 1987.

EXECUTIVE SUMMARY

The NASD is publishing for comment a revision to its proposed amendment to the Interpretation of the Board of Governors on Free-Riding and Withholding that would provide members with an alternative means of complying with the Interpretation for sales of new issues to investment partnerships.

The text of the proposed amendment is attached.

BACKGROUND

In Notice to Members 86-40, dated May 23, 1986, the NASD published for comment a proposed amendment to the Interpretation of the Board of Governors on Free-Riding and Withholding (Free-Riding Interpretation)1/ that would provide members with an alternative means of complying with the Interpretation for sales of new issues to investment partnerships. The section of the Free-Riding Interpretation titled "Investment Partnerships and Corporations"2/ currently prohibits members and their associated persons from selling securities of a new issue that trades at a premium ("hot issue" securities) to any investment partnership, corporation, of similar account unless "the member receives from such account, prior to the execution of the transaction, the names arid business connections of all persons having any beneficial interest in the account." If the information discloses that a restricted person has a beneficial interest in the account, the transaction can be effected only in compliance with the restrictions of the Interpretation.

The Free-Riding Interpretation has been interpreted strictly by the NASD and is intended to protect the integrity of the public offering system by ensuring that underwriters make a bona fide public distribution of "hot issue" securities and do not retain those securities for their own benefit or use those securities to favor persons who can direct future business to the firm. Without restricting purchases by investment partnerships, the provisions of the Interpretation could be evaded easily.

The NASD National Business Conduct Committee (NBCC) and the NASD Board of Governors determined that it would be appropriate to propose an amendment to the Free-Riding Interpretation that would provide an alternative means for members to comply with the Interpretation when selling "hot issue" securities to investment partnerships and similar accounts. Because members often encounter difficulty in complying with the requirements of the provision (since persons responsible for the management of investment partnerships and similar accounts may be hesitant to release the names of persons holding beneficial interests in such accounts), the NASD proposed in Notice to Members 86-40 that a member or associated person would be presumed to be in compliance with the requirements of the Interpretation's section on investment partnerships either by obtaining the list of actual names pursuant to the existing requirement or by receiving from the account manager specific written representations that none of the beneficial owners are restricted persons.

The NBCC reviewed 10 comment letters received concerning the proposed amendment to the Interpretation. Generally, commentators either made recommendations on specific provisions of the amendment or requested clarification of its scope. However, one commentator pointed out that the proposed amendment did not adequately address the problem members experience when seeking to comply with the Interpretation's section on investment partnerships.

The NBCC noted that, as proposed, the amendment could result in pressure on the account manager from beneficial owners and its reliability would be determined by the time and effort expended by the account manager to understand and properly apply the complex provisions of the Interpretation. As a result, the NBCC determined that it should consider other approaches to provide members with an effective means of ensuring that restricted accounts are not recipients of "hot issue" securities in violation of the Interpretation.

The NBCC appointed a subcommittee to consider alternatives to amending the Free-Riding Interpretation, including the May 1986 proposal and subsequent proposed modifications to it, as well as a new proposal to establish a "safe harbor" procedure by requiring a member to obtain an opinion of counsel through the account manager.

Based on the subcommittee's study of the alternative proposals, the NBCC concluded that the original proposal appeared to be a less-effective means of ensuring that members are correctly advised of the restricted status of an account than is offered by the opinion-of-counsel approach (discussed below). The NBCC also concluded that an assurance by the account manager may be accurate in many situations, but does not offer as positive an assurance as does the opinion of counsel. In particular, it was also noted that account managers are not subject to NASD jurisdiction and cannot be held responsible or accountable for inaccurate or false information.

In consideration of these concerns, the NBCC and the NASD Board of Governors determined that it would be appropriate to propose a revised amendment to the Free-Riding Interpretation.

EXPLANATION OF PROPOSED AMENDMENT

New "Safe Harbor." The proposed amendment is intended to provide an alternative means for members to comply with the Free-Riding Interpretation when selling "hot issue" securities to investment partnerships and similar accounts. The amendment would provide a member or associated person a "safe harbor" presumption of compliance with the requirements of the Free-Riding Interpretation if, prior to executing a transaction with an investment partnership, the member has obtained a copy of a current opinion from counsel stating that counsel reasonably believes that no person with a beneficial interest in the account is a restricted person under the Free-Riding Interpretation and stating that, in providing such opinion, counsel:

1. has reviewed and is familiar with the Interpretation;
2. has reviewed a current list of all persons with a beneficial interest in the account supplied by the account manager;
3. has reviewed information supplied by the account manager with respect to each person with a beneficial interest in the account, including identity, employment, and any other business connections of such persons; and
4. has requested and reviewed other documents and other pertinent information and made inquiries of the account manager and received responses thereto, if counsel determines that such further review and inquiry are necessary and relevant to determine the correct status of such persons under the Interpretation.

In addition, the member would be required to maintain in its files a copy of the current opinion of counsel for at least three years following the member's last sale of a new issue to that account.

Alternatively, the member could comply with the current requirements of the Interpretation's section on investment partnerships by obtaining a list of the names and business connections of all persons having a beneficial interest in the account from the account manager.

The NBCC and the NASD Board of Governors believe that an opinion of counsel has the advantage of building into a "safe harbor" procedure a greater degree of accountability than a representation by the account manager.

Amendment to Present TSafe Harbor." The NBCC also concluded that, to be consistent, the existing provisions of the Free-Riding Interpretation should be amended to specify that information obtained from the account manager is current. Thus, a firm would be required to hold a current list of beneficial owners when selling a "hot issue" to the partnership.

Definition of "Current." Both amendments would require members to hold "current" documents at the time of a sale to an investment partnership. The NBCC and the NASD Board considered two approaches to ensure that the information regarding beneficial ownership of account holders or the opinion of counsel relied on by the member is current. Under the first approach, members would be required to have information as of a date not more than 18 months prior to a transaction. The attached text of the proposed amendment reflects the first approach.

Under the second approach, the member would be required to have current information, but the term "current" would not be defined. If the second approach is adopted, the last sentence of the proposed new language would be deleted.

The NASD is specifically soliciting comments on both approaches.

* * * * *

The NASD encourages all members and other interested persons to comment on this proposed amendment. In particular, the NASD is soliciting comments on alternative approaches to ensure that the information provided regarding beneficial ownership of account holders or the opinion of counsel relied upon by the member is current. Comments should be addressed to:

Mr. Lynn Nellius
Secretary
National Association of Securities Dealers, Inc.
1735 K Street, N.W.
Washington, D.C. 20006-1506

Comments must be received no later than December 4, 1987. Comments received by this date will be considered by the NBCC and the NASD Board of Governors. If the proposed amendment is approved by the Board, the amendment must be filed with and approved by the Securities and Exchange Commission before becoming effective.

Questions concerning this notice may be directed to either Dennis C. Hensley, NASD Vice President and Deputy General Counsel, or John F. Mylod, NASD Assistant General Counsel, at (202) 728-8294.

Sincerely,

Frank J. Wilson
Executive Vice President
Legal and Compliance

PROPOSED AMENDMENT TO FREE-RIDING INTERPRETATION

Amend the section titled "Investment Partnerships and Corporations" of the Interpretation of the Board of Governors, Free-Riding and Withholding, as follows:*

Investment Partnerships and Corporations

A member may not sell securities of a public offering which trade at a premium in the secondary market whenever such secondary market begins ("hot issue"), to the account of any investment partnership or corporation, domestic or foreign (except companies registered under the Investment Company Act of 1940) including but not limited to, hedge funds, investment clubs, and other like accounts unless the member complies with either of the following alternatives:

(A) [receives from such account,] prior to the execution of the transaction, the member has received from the account a current list of the names and business connections of all persons having any beneficial interest in the account, and if such information discloses that any person enumerated in paragraphs (1) through (4) hereof has a beneficial interest in such account, any sale of securities to such account must be consistent with the provisions of this Interpretation [; provided, however, that if the disclosure of such information by the account is prohibited by law, then in such case, the member must receive written assurance from the account that no person enumerated in paragraphs (1) through (4) hereof has a beneficial interest in such account], or
(B) prior to the execution of the transaction, the member has obtained a copy of a current opinion from counsel admitted to practice law before the highest court of any state stating that counsel reasonably believes that no person with a beneficial interest in the account is a restricted person under this Interpretation and stating that, in providing such opinion, counsel:
(1) has reviewed and is familiar with this Interpretation;
(2) has reviewed a current list of all persons with a beneficial interest in the account supplied by the account manager;
(3) has reviewed information supplied by the account manager with respect to each person with a beneficial interest in the account, including the identity, the nature of employment, and any other business connections of such persons; and
(4) has requested and reviewed other documents and other pertinent information and made inquiries 37 the account manager and received responses thereto, if counsel determines that such further review and inquiry are necessary and relevant to determine the correct status of such persons under the Interpretation.
The member shall maintain a copy of the names and business connections of all persons having any beneficial interest in the account or a copy of the current opinion of counsel in its riles for at least three years following the member's last sale of a new issue to the account, depending upon which of the above requirements the member elects to follow. For purposes of this section, a list or opinion shall be deemed to be current if it is based upon the status of the account as of a date not more than 18 months prior to the date of the transaction.

The term beneficial interest means not only ownership interests, but every type of direct financial interest of any persons enumerated in paragraphs (1) through (4) hereof in such account, including, without limitation, management fees based on the performance of the account.

1/ The complete text of the Free-Riding Interpretation can be found beginning on page 2039-3 of the NASD Manual (CCH).

2/NASD Manual (CCH), p. 2043.

* New language is underlined, deleted language is in brackets.