Notice To Members 95-44

Request For Comments On Proposed Amendments To The Exception To The Qualified Independent Underwriter Requirement In Schedule E To The NASD By-Laws;

Published Date:

Comment Period Expires August 1, 1995

SUGGESTED ROUTING

Senior Management
Corporate Finance
Legal & Compliance
Syndicate

Executive Summary

The NASD® requests member comment on proposed amendments to Section 2 of Schedule E to the NASD By-Laws to amend the exception from the qualified independent underwriter requirement for offerings of securities with a bona fide independent market. The amendment would modify:

  • the definition of "bona fide independent market" by providing for a national exchange or The Nasdaq Stock MarketSM listing requirement and per-share price test, and changing the trading volume, public float, and independent market-maker provisions; and

  • the definition of "bona fide independent market maker" by requiring registration with The Nasdaq Stock Market, and requiring that it neither be affiliated with the issuer nor receive any portion of the net proceeds of the offering. Comments must be received by August 1, 1995.

Background

The NASD adopted Schedule E to the NASD By-Laws (Schedule E) in 1972 to address concerns that public investors be protected adequately when investing in securities issued by an NASD member, its parent, or an affiliate of a member that is going public. To address conflicts of interest regarding the conduct of due diligence and the pricing of the securities, Schedule E requires that a qualified independent underwriter (that is, a member with a background in underwriting and a history of profitable operations) conduct due diligence; participate in the preparation of the prospectus, offering memorandum, or similar document; and provide an opinion that the public-offering price of an equity security is no higher or the yield of a debt security no lower than it recommends. Exceptions are provided to the qualified independent underwriter requirement where the offering is of rated investment grade debt or where the offering is of equity with a bona fide independent market.

The NASD Corporate Financing Committee (Committee) reviewed the bona fide independent market exception from the requirement for a qualified independent underwriter as in Section 3(c) of Schedule E, which was part of the original version of Schedule E adopted in 1972. The Committee reaffirmed its long-held view that the standards for determining a bona fide independent market should be stringent enough to properly regulate public distributions where a member issues its own securities or a conflict or control relationship with a parent or affiliate exists, and provide protection for investors that the conflicts as to pricing and due diligence are properly addressed. The criteria in the definition of bona fide independent market are to assure the public that a market of sufficient depth and duration exists to constitute an efficient pricing mechanism for the securities to be distributed.

The Committee is proposing to revise the definition of bona fide independent market and the related definition of bona fide independent market maker to incorporate more current standards for liquidity in a security. The Committee believes the proposed new requirements for listing, public float, trading volume, price, and number of bona fide independent market makers vastly improve the criteria used for determining the presence of a bona fide independent market. While still focusing on investor protection issues, the Committee believes that the proposed new definitions will permit a significant number of Nasdaq® and exchange-listed issuers to conduct a secondary offering without the unnecessary burden and expense of engaging a qualified independent underwriter, while providing the public with the added protection of a qualified independent underwriter in situations where the market cannot be relied on to price the securities appropriately.

Description Of Proposed Amendments

Bona Fide Independent Market Definition

Listing Test

The Committee believes that listing on a national securities exchange (as defined by the Securities Exchange Act of 1934) or The Nasdaq Stock Market indicates that the security trades in an efficient, regulated, and active market. Therefore, the Committee is proposing that such listing be made part of the definitional requirement of a bona fide independent market. The Committee also believes that a listing requirement brings to the definition the qualitative standards of a regulated trading environment, such as quote transparency, real-time transaction reporting, and corporate governance standards. Securities quoted on the NASD OTC Bulletin Board® service and those traded in the general over-the-counter market, such as the "pink sheets," will be excluded under this test.

Trading Volume Test

The Committee believes that the current aggregate 12-month trading volume of 100,000 shares requirement should be raised to a level that is more indicative of an active, efficient market, and the time period over which trading volume is measured should be adjusted to reflect the minimum period necessary to establish that a bona fide market exists for the security. The Committee is proposing to raise the trading volume requirement to at least 500,000 shares in the 90-calendar-day period before the filing of a registration statement (which is an average of 8,500 shares daily) to establish a better benchmark for justifying an exemption from the requirement that a qualified independent underwriter participate in the offering.

Public Float Test

The Committee is proposing to require a five-million-share public float, as the minimum necessary to assure that the market for an issuer's securities will not suffer undue volatility from the dilution that occurs when a large number of shares is offered to the public. The Committee noted that a typical follow-on offering of a company's stock places between one- and two-million additional shares in public float, which is equal to a 40 percent dilution, even at the five-million-share level.

Price Test

The Committee expressed concern that a public float test without a corresponding standard for the market price of the securities may be detrimental to establishing a valid benchmark for a bona fide independent market. Therefore, the Committee is proposing to adopt a market-price requirement of at least $5 a share as of the close of trading on the day immediately preceding the filing of the registration statement, coupled with the requirement that the security trade at a price of $5 or more per share on at least 20 of the 30 trading days preceding the date on which the registration statement was filed. The Committee believes that these requirements are consistent with the purpose and intent of the SEC's Penny Stock Rules and Rule 10b-6.

Market-Maker Test

The current definition of a bona fide independent market requires a security to have three bona fide independent market makers. Given that a security may be listed on The Nasdaq Stock Market with two market makers, the Committee is proposing to amend the definition to require only two bona fide independent market makers (as defined below), which it believes are sufficient to demonstrate the presence of a bona fide independent market away from any Schedule E affiliate that may also be making a market in the issuer's securities.

Bona Fide Independent Market Maker Definition

The current definition of "bona fide independent market maker" in Schedule E focuses on net capital requirements and the regular publication of two-sided quotations by the market maker. This definition was developed at the time Schedule E was drafted in 1971. The Committee is proposing to modify the definition to provide that a bona fide independent market maker must be unaffiliated with the issuer and beneficially own—together with its associated persons and their immediate family, parent, and affiliates—less than five percent of the outstanding voting securities, common equity, preferred equity, or subordinated debt of an issuer. The bona fide independent market maker will also be prohibited from receiving any of the net proceeds of an offering. The Committee believes these amendments provide investors with greater assurance that the market maker's activities are independent of any influences that may arise when the ownership of an issuer's securities or interest in the offering become material. These standards are largely drawn from the current definition of qualified independent underwriter in Schedule E and from the reporting requirements imposed on beneficial owners by Section 13 of the Securities Exchange Act of 1934.

Questions regarding this Notice may be directed to Richard J. Fortwengler, Associate Director, or Paul M. Mathews, Supervisor, NASD Corporate Financing Department, at (301) 208-2700.

Request For Comments

The NASD requests all members and interested persons to comment on these proposed amendments. Comments should be directed to:

Ms. Joan C. Conley
Corporate Secretary
National Association of
Securities Dealers, Inc.
1735 K Street, NW
Washington, DC 20006-1500.

Comments must be received no later than August 1, 1995. Comments will be reviewed by the NASD Corporate Financing Committee. Changes to proposed amendments must be approved by the NASD Board of Governors and filed with and approved by the Securities and Exchange Commission before becoming effective.

Text Of Proposed Amendments To Section 2 Of Schedule E To The NASD By-Laws

(Note: New text is underlined; deletions are bracketed.)

Schedule E

Distribution of Securities of Members and Affiliates—Conflicts of Interest

Section 1. General

(a) No member or person associated with a member shall participate in the distribution of a public offering of debt or equity securities issued or to be issued by the member, the parent of the member, or an affiliate of the member and no member or parent of a member shall issue securities except in accordance with this Schedule.
(b) No member or person associated with a member shall participate in the distribution of a public offering of debt or equity securities issued or to be issued by a company if the member and/or its associated persons, parent or affiliates have a conflict of interest with the company, as defined herein, except in accordance with this Schedule.

Section 2. Definitions

For purposes of this Schedule, the following words shall have the stated meanings:

(a) and (b) No change.
(c) Bona fide independent market—amarket in a security which:
(1) is registered pursuant to the pro-visions of Sections 12(b) or 12(g) of the Securities Exchange Act of 1934 or issued by a company subject to Section 15(d) of such Act, unless exempt from those provisions;
[(2) has an aggregate trading volume for the 12 months immediately preceding the filing of the registration statement of at least 100,000 shares;]
[(3) has outstanding for the entire twelve-month period immediately preceding the filing of the registration statement, a minimum of 250,000 publicly held shares; and]
[(4) in the case of over-the-counter securities, has had at least three bona fide independent market makers for a period of at least 30 days immediately preceding the filing of the registration statement and the effective date of the offering.]
(2) has a market price as of the close of trading on the trade date immediately preceding filing of the registration statement or offering circular of five dollars or more per share, and which has traded at a price of five dollars or more per share in at least 20 of the 30 trading days, immediately preceding the filing of the registration statement or offering circular; and
(3)
(i) for at least 90 calendar days immediately preceding the filing of the registration statement with the Department has been listed on and is in compliance with the listing requirements of a national securities exchange; or
(ii) for at least 90 calendar days immediately preceding the filing of the registration statement with the Department has been listed on and is in compliance with the listing requirements of The Nasdaq Stock Market and has had at least two bona fide independent market makers for a period of at least 30 trading days immediately preceding the filing of the registration statement and the effective date of the offering; and
(4)
(i) has an aggregate trading volume of at least 500,000 shares over the 90 calendar day period immediately preceding the filing of the registration statement (Trading Volume Test); or
(ii) has outstanding for the 90 calendar day period immediately preceding the filing of the registration statement or offering circular, a minimum of 5,000,000 publicly held shares.
(d) Bona fide independent marketmaker—a market maker which:
[(1) continually maintains net capital as determined by Rule 15c 3-1 of the General Rules and Regulations under the Securities Exchange Act of 1934 of $50,000 or $5,000 for each security in which it makes a market, whichever is less;]
[(2) regularly publishes bona fide competitive bid and offer quotations in a recognized interdealer quotation system;]
[(3) furnishes bona fide competitive bid and offer quotations to other brokers and dealers on request; and]
[(4) stands ready, willing and able to effect transactions in reasonable amounts, and at his quoted prices, with other brokers and dealers.]
(1) is registered as a Nasdaq marketmaker in the security to be distributed pursuant to this Schedule;
(2) is not an affiliate of the entity issuing securities pursuant to Section 3 of this Schedule and together with its associated persons and their immediate family, parent and affiliates, does not in the aggregate beneficially own, at the time of the filing of the registration statement and at the commencement of the distribution, five percent or more of the outstanding voting securities, common equity, preferred equity or subordinated debt of such entity which is a corporation or beneficially own a partnership interest in five percent or more of the distributable profits or losses of such entity which is a partnership; and
(3) is not a recipient of any of the net proceeds of the offering.