Interpretive Letter to Dana Fleischman, Esq., Cleary, Gottlieb, Steen & Hamilton
November 24, 2003
Dana Fleischman, Esq.
Cleary, Gottlieb, Steen & Hamilton
One Liberty Plaza
New York, NY 10006-1470
Re: NASD Rule 2740
Dear Ms. Fleishman:
This is in response to your letter dated August 29, 2003, as supplemented by telephone conversations with NASD staff, in which you seek an interpretation under NASD Rule 2740. Specifically, you ask whether Rule 2740 would prohibit an underwriter in a fixed price offering from paying to another broker/dealer an advisory or referral fee. For the reasons set forth below, NASD staff does not believe that such an arrangement violates Rule 2740.
In responding to your question, NASD staff has reviewed the history of Rule 2740. As you may be aware, the origins of Rule 2740 predate NASD; it is based upon codes approved by President Franklin Roosevelt in 1933 acting under the authority of the National Industrial Recovery Act ("NIRA"). The precursor to Rule 2740 was drafted by a committee as part of the Code of Fair Competition for the Investment Bankers Association of America ("IBAA"), and established "one price for all investors irrespective of the size of the transaction or the importance of the purchaser."1 The IBAA believed that the one price provision was essential to success of the public offering process, noting that if certain purchasers bought shares at a discount with the goal of capturing the underwriting spread, it would discourage others from buying at the public offering price.2
The IBAA’s Code of Fair Competition was amended in 1935 to require that an investment banker receiving a selling concession certify that his purchase was solely for the account of clients or, if for his own account, that he intended to redistribute the securities to his clients in the ordinary course of business. This amendment was approved by the National Industrial Recovery Board, which found that the "effect of the amendment would be to consistently maintain the principle of no discrimination between investors by putting all investment bankers on a level with private investors when they purchase securities solely for investment and not for distribution. It proceeds on the theory that an investment banker is entitled to a lower price than that available to the public only when the investment banker actively participates in the distribution to others of the securities in question."3
After the NIRA was declared unconstitutional, the Investment Bankers Conference, Inc. ("IBC") was formed to continue self-regulation on a voluntary basis. In 1937, the IBC adopted rules of fair practice, including a provision comparable to its predecessor in the IBAA’s Code of Fair Competition. When the NASD was established in 1939, the IBC passed out of existence and many of the restrictions on underwriting and selling concessions were incorporated into NASD rules, including Rule 2740, which remained unchanged until 1980.
The amendments in 1980 were in response to the legal uncertainty created by the decision in Papilsky v. Berndt.4 In Papilsky, a shareholder of an investment company brought a derivative suit against the directors of an investment company and its advisor, alleging violations of fiduciary duties in failing to "recapture" brokerage commissions, underwriting commissions and tender offer fees for the investment company and its shareholders. The advisor claimed that recapture was not permitted under the applicable SEC and SRO rules. The court rejected this defense and held that in the absence of an SEC or SRO rule to the contrary, recapture was both available and legal. The court concluded that the failure to present the possibility of recapture to the attention of the independent directors of the fund constituted a breach of fiduciary duty.
The decision in Papilsky caused great concern among managers of investment companies. NASD stated that it interpreted Rule 2740 as forbidding underwriting recapture. In learning of NASD’s interpretation, the Commission stated that the interpretation was a change in NASD rules that can only be accomplished through a rule change approved by the SEC under Section 19(b) of the Securities Exchange Act. In response, NASD submitted a formal rule proposal that barred underwriting recapture. After extensive public hearings on the proposal, the Commission suggested a change to allow designated orders in return for research. NASD incorporated this change and the SEC approved amended Rule 2740. In the Adopting Release, the SEC noted that amended Rule 2740 "prevents a . . . customer from directly or indirectly receiving a discount from the public offering price."5
As the foregoing suggests, Rule 2740 is intended to ensure that all purchasers in a fixed price offering pay the fixed offering price. The Rule allows selling concessions, discounts and other allowances only to brokers or dealers actually engaged in the investment banking or securities business and only as consideration for services rendered in distribution. The Rule contains an exception to allow a member to sell securities to any person to whom it has provided or will provide bona fide research.6 The Rule also requires that when a member grants a selling concession, discount, or other allowance, it must obtain a written agreement from the recipient that it will comply with the Rule. Finally, the Rule contains a specific reporting requirement when member receives an order from a person designating another broker or dealer to receive credit for a sale. In sum, these provisions are aimed at preventing discounting from the fixed offering price.
Based upon your letter, we understand the facts to be as follows. Broker/Dealer #1 provides capital markets and other securities-related advice to various market participants, including issuers, institutional investors and underwriters. From time to time, Broker/Dealer #1 is invited to become a member of an underwriting syndicate for a securities offering in which, for various reasons, it is unable to participate.7 Although it is unable to participate in the underwriting syndicate, Broker/Dealer #1 may be in a position to inform the issuer or lead underwriter that Broker/Dealer #2 (a firm with which Broker/Dealer #1 has an advisory or other relationship) is interested in acting as a member of the underwriter syndicate. In some cases, Broker/Dealer #1 may provide advisory services to Broker/Dealer #2 in connection with the offering. You have represented that these advisory services may include advice regarding market conditions, pricing, timing, investor preferences, issuer’s reputation, credit rating, and general creditworthiness. In other cases, Broker/Dealer #1’s activities may be limited solely to referring Broker/Dealer #2 to be a member of underwriting syndicate.
Broker Dealer #2 wishes to compensate Broker/Dealer #1 with a portion of the fees it receives as being an underwriter in the offering, either as a fee for advisory services, or a referral fee, or both. The fees paid by Broker/Dealer #2 will pertain solely to services provided by Broker/Dealer #1, and not any services provided by affiliates of Broker/Dealer #1. In addition, neither Broker/Dealer #1 nor any of its affiliates will purchase shares in the offering for their own accounts or on behalf of customers.
Rule 2740 provides in pertinent part that:
A member may not grant or receive selling concessions, discounts, or other allowances except as consideration for services rendered in distribution and may not grant such concessions, discounts or other allowances to anyone other than a broker or dealer actually engaged in the investment banking or securities business; provided, however, that nothing in this Rule shall prevent any member from (1) selling any such securities to any person, or account managed by any person, to whom it has provided or will provide bona fide research, if the stated public offering price for such securities is paid by the purchaser; or (2) selling any such securities owned by him to any person at any net price which may be fixed by him unless prevented therefrom by agreement.8
Both the text and history of Rule 2740 evidence intent by NASD (and predecessor organizations) of maintaining the nature of a "fixed price offering." Discounting, it is believed, would erode confidence in fixed price offerings and could be disruptive to the capital formation process.9 To preserve the nature of the fixed price offering, Rule 2740 prohibits sharing of any concessions, discounts or other allowances except as for: (i) services rendered in distribution, and (ii) only to a broker/dealer actually engaged in the investment banking and securities business. The Rule permits sharing of concessions, discounts or other allowances with a broker/dealer that provides or agrees to provide bona fide research to the person to whom or at whose discretion the sale is made if such purchaser pays the stated public offering price.
Implicit in Rule 2740 is the fact that it is designed to prevent purchasers from receiving discounts from the fixed public offering price. In response to Papilksy, Rule 2740 prohibits a purchaser from designating that a selling concession be paid to the affiliated broker/dealer, which in turn would credit the purchaser for a portion of the selling concession (through a reduction in management fees). As noted above, the SEC observed that Rule 2740 prevents customers from directly or indirectly receiving a discount from the public offering price.
In the facts of your letter, Broker/Dealer #2 would compensate Broker/Dealer #1 for advisory services, for making a referral, or both. This compensation would pertain solely to services provided by Broker/Dealer #1, and not any services provided by its affiliates. To the extent that payment of the advisory or referral fee does not directly or indirectly discount the fixed offering price for any purchaser in the offering, the staff believes that Rule 2740 would not prohibit the payment. NASD staff believes that history of Rule 2740 described above supports this interpretation.10
Please note that the opinions expressed in this letter are staff opinions only and have not been reviewed or endorsed by the Board of NASD. This letter responds only to the issues you have raised based on the facts as you have described them in your letter, and does not necessarily address any other rule or interpretation of NASD or all the possible regulatory and legal issues involved.
If you have any further questions, please do not hesitate to contact us at (202) 728-8104.
Gary L. Goldsholle
1 Letter from Administrator Hugh S. Johnson to President Franklin D. Roosevelt transmitting Approved Code No. 141 – Amendment No. 2 for approval (Mar. 23, 1934), VIII NRA Codes 659-60 (cited in In re NASD, Inc., Order Approving Proposed Rule Change, Exchange Act Release No. 17371 45 Fed. Reg. 83707 (Dec. 19, 1980) ("Adopting Release")).
2 Brief submitted by Joseph C. Hostetler, Counsel, Investment Bankers Code Committee to the National Recovery Administration at the public hearings on the fair practice amendments (Mar. 15, 1934) (cited in Adopting Release).
3 Approved Code No. 141 – Amendment No. 4, Report to President and Order (Feb. 27, 1935), XX NRA Codes 433 (cited in Adopting Release).
4 [1976-1977 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 95,627 (S.D.N.Y.).
5 Adopting Release at 83717 n74.
6 The exception for research was viewed necessary because free research is in a sense a discount from the offering price.
7 You have represented that one such reason might be if that Broker/Dealer #1 is affiliated with a banking organization that is not a "financial holding company" under the Bank Holding Company Act, and, for U.S. bank regulatory purposes, does not have the ability to engage in underwriting activity.
8 Rule 2740(a).
9 Adopting Release at 83722.
10 Furthermore, your letter cites an NASD staff letter to Daniel Schloendorn, Willkie Farr & Gallagher, dated June 18, 1998, regarding Shoreline Pacific ("Shoreline"), for the proposition that a member may pay a finder’s fee for the referral of issuers that are potential corporate finance clients. We note that the referral payments in Shoreline involved payment of a finder’s fee to an entity outside the jurisdiction of the SEC and, therefore, did not raise broker/dealer registration concerns under the federal securities laws.