Investment Management
NOVEMBER 2003
SEC Approves NASD “New Issues Rule” to Replace
“Hot Issues Interpretation”
On October 15, 1999, at the height of a raging market
for initial public offerings (“IPOs”), the National
Association of Securities Dealers, Inc. (“NASD”) first
proposed significant amendments to its so-called
“hot issues interpretation” (“Interpretation”), which
is intended to assure that brokerage firms and their
employees make a true public distribution of IPO
securities, rather than bestowing those securities on
themselves, their employees, favored institutions that
direct them business, and similar “restricted
persons.” On October 24, 2003—over four years
after the amendments had first been proposed, and
after five amendments to that proposal—the
Securities and Exchange Commission (“SEC”)
approved those amendments, which are in the form of
a new rule (the “New Issues Rule”), during what can
fairly be described as a long-running drought for
IPOs.
Nonetheless, the IPO market will rebound, and the
amendments to the hot issues Interpretation will have
significant effects on, among others, hedge funds
and similar pooled investment vehicles that from time
to time invest in IPOs. In summary, and as discussed
more fully below:
n
a hedge fund or similar pooled investment vehicle
may invest in IPOs of equity securities (referred to
in the rule as “new issues,” and the only securities
now covered by the rule), as long as restricted
persons do not own more than 10% of the
beneficial interests in the fund or other vehicle;
n
for purposes of the rule, a hedge fund manager
will be considered to be a restricted person, and
the manager’s beneficial interest in the fund will be
counted toward the 10% limit. A manager’s
management and performance-based fees are not
considered to be beneficial interests, unless those
fees are reinvested in the fund. Amounts held in
an offshore or other fund pursuant to a deferred
compensation arrangement, and amounts invested
in the fund by the manager, are beneficial
interests, and are counted toward the 10% limit;
n
a hedge fund also may continue to “carve out”
restricted persons from participation in hot issues,
just as is currently done. As a result, if a hedge
fund will have more than 10% of its beneficial
interests owned by restricted persons, a hedge
fund manager might opt to carve out some of
those restricted persons, to the extent doing so
would be consistent with the manager’s fiduciary
responsibilities to the fund’s investors, so that no
more than 10% of the investors participating in
new issues would be restricted persons, or the
manager might decide to carve out all restricted
persons from having a more than 10% interest in
each new issue; and
n
the hedge fund manager must provide to the
underwriters or brokers from which it receives IPO
allocations, at least once a year, a representation
that the hedge fund is in compliance with the rule.
Under the rule, hedge fund managers no longer
will be required to provide to underwriters and
brokers a letter from counsel or an accountant to
the effect that the fund is in compliance with the
rule.
Ironically, even after the rule’s four-year gestation
period, underwriters and brokers still cannot yet rely
on it. First, the NASD must publish a notice to
members announcing the adoption of the rule, which
is required to be published by December 23, 2003.
Kirkpatrick & Lockhart LLP
Then, underwriters and brokers will be given a threemonth transition period, during which they will be
able to comply either with the new rule, or the
existing hot issues rule. As a result, the rule may not
be fully in effect until late March, 2004.
The remainder of this alert summarizes significant
aspects of the New Issues Rule.
PRIMARY DIFFERENCES BETWEEN THE NEW
ISSUES RULE AND THE INTERPRETATION
“New Issues” vs. “Hot Issues.” Under the
Interpretation, a “hot issue” is defined as any
security that is part of a public offering that trades at
a premium in the secondary market. The New Issues
Rule, however, applies to any “new issue,” defined as
an initial public offering of an equity security,
regardless of whether it trades at a premium in the
secondary market. In practice, all IPOs of equity
securities also were treated as being subject to the
Interpretation, because no one could predict which
IPOs would trade at a premium.
Securities Excluded from the New Issues Rule. The
New Issues Rule, as adopted, excludes a number of
types of securities from coverage. Specifically, the
New Issues Rule does not apply to any secondary
offerings, any debt securities (whether or not
investment grade), any offerings of “restricted
securities,” and any offerings of “exempt securities,”
as defined in Section 3(a)(12) of the Securities
Exchange Act of 1934 (such as government,
municipal, and certain other securities).
Other securities exempted from the New Issues Rule
include:
n
Securities of a commodity pool operated by a
commodity pool operator;
n
Rights offerings to existing shareholders,
exchange offers, and offerings made pursuant to a
merger or acquisition;
n
Offerings of investment-grade, asset-backed
securities;
n
Offerings of convertible securities;
n
Offerings of preferred securities;
n
Offerings of securities of an investment company
registered under the Investment Company Act of
1940; and
n
Offerings of securities that have a pre-existing
market outside the United States.
Introduction of 10% De Minimis Threshold. The
New Issues Rule introduces a 10% de minimis
threshold for restricted person participation. Under
this threshold, restricted persons (including the
account’s portfolio manager) would be permitted to
hold interests in a collective investment account
(such as a private investment fund or hedge fund)
that purchases new issues as long as such persons
account for no more than 10% of the beneficial
ownership of the account. Under the New Issues
Rule, “collective investment account” is defined as
any hedge fund, investment partnership, investment
corporation, or any other collective investment
vehicle that is engaged primarily in the purchase and/
or sale of securities.
In response to the concerns of some commenters, the
NASD stated that carve-out procedures that, in the
past, allowed the manager of a collective investment
account to segregate the interests of restricted
persons from non-restricted persons would still be
available. The NASD has also stated that it intends
to provide detailed guidance on the use of carve-outs
following approval of the New Issues Rule.
Preconditions for Sale. Under the New Issues Rule,
members are prohibited from selling a new issue to an
account until the member meets the rule’s
preconditions for sale. The preconditions require a
member to: (1) obtain a representation from the
account holder, or person authorized to represent the
beneficial owner, that the account is eligible to
purchase new issues; (2) not rely on representations
that the member believes, or has reason to believe,
are inaccurate; (3) retain a copy of all records and
information relating to the eligibility of an account for
at least three years; and (4) obtain these
representations within the 12 months prior to the sale
of new issues to the account.
The NASD stated that the initial verification of the
status of a person cannot be done orally, but does
intend to permit the annual verification of a person’s
status to be done through negative consents.
Several commenters have sought guidance on the
type of information required to determine if an
account is beneficially owned by restricted persons.
In the context of fund-of-funds structures, the NASD
stated that a person authorized to represent the
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beneficial owners of a master fund would be required
to represent that the master fund is able to purchase
new issues. The NASD further stated that it expects
such person to ascertain the status of investors in
the feeder funds, and if such status cannot be
ascertained, then to ensure that the profits from new
issues are not allocated to that fund (or comply with
another exemption such as the de minimis exemption
or assure that a carve-out is used). The NASD stated
that it would provide further guidance on this matter.
OTHER ASPECTS OF THE NEW ISSUES RULE
Definition of Beneficial Interest. Under the New
Issues Rule, “beneficial interest” is defined as any
economic interest, such as the right to share in gains
or losses. This definition also provides that the
receipt of a management fee or performance-based
fee for operating a collective investment account, or
other fees for acting in a fiduciary capacity, would
not be considered a beneficial interest in the account.
The NASD believes, however, that the accumulation
of fee payments, if subsequently invested in the
collective investment account (as a deferred fee
arrangement or otherwise) would constitute a
beneficial interest in the account. The NASD
believes that money invested in a collective
investment account is part of a person’s beneficial
interest in that account even if the source of the
money is a deferred fee arrangement. The NASD
does not believe that a decision to defer recognition
of earnings for income tax purposes should alter the
analysis of whether a person has a beneficial interest
in a collective investment account.
General Exemptions. The New Issues Rule’s general
prohibitions would not apply to sales to or purchases
from the following classes of persons:
n
Investment companies registered under the
Investment Company Act of 1940;
n
Most common trust funds having investments
from 1,000 or more accounts;
n
Most insurance company general, separate and
investment accounts;
n
Publicly traded entities (other than broker-dealers
and their affiliates) that are listed on a national
securities exchange or traded on the Nasdaq
National Market or that are foreign issuers who
meet certain criteria;
n
Certain foreign investment companies;
n
ERISA plans, unless sponsored solely by a
broker-dealer;
n
State and municipal government benefits plans;
n
Tax-exempt charitable organizations; and
n
Church plans.
Restricted Persons. The New Issues Rule codifies
the definition of “restricted persons.” A “restricted
person” includes:
n
NASD members and other broker-dealers
(including any officer, director, general partner,
associated person, or employee of a member or
any other broker-dealer);
n
Agents of members or any other broker-dealer that
is engaged in the investment banking or securities
business;
n
Finders and fiduciaries of the managing
underwriter for those offerings for which they are
acting in those capacities;
n
Any employee or other person (including nonnatural persons) who supervises, or whose
activities directly or indirectly involve or are
related to, the buying or selling of securities for a
bank, savings and loan institution, insurance
company, investment company, investment
advisor, or collective investment account;
n
Owners of broker-dealers (unless identified by an
ownership code of less than 10% on Form BD);
n
Affiliates of broker-dealers (unless publicly
traded); and
n
Certain “immediate family members” (including a
person’s parents, mother-in-law, father-in-law,
spouse, brother, sister, brother-in-law, sister-inlaw, son-in-law, daughter-in-law, and children) of
any of the foregoing persons and any other
individual to whom any of the foregoing persons
provides, or from whom any of the foregoing
persons receives, “material support.” Material
support is defined as providing 25% or more of
another’s income, as measured in the prior
calendar year. Members of the immediate family
that live in the same household are deemed to
provide material support to one another.
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3
A “restricted person” does not include:
n
A broker-dealer whose authorization to engage in
the securities business is limited solely to the
purchase and sale of investment company/
variable contracts securities and direct
participation program securities;
n
Investment clubs and family investment vehicles;
and
n
Joint back office broker-dealers (however, an
associated person of a joint back office brokerdealer would be viewed as a restricted person).
The NASD has also eliminated the “conditionally
restricted person” status and has determined that all
persons should be treated as either restricted or nonrestricted.
Anti-Dilution Provisions. The New Issues Rule
provides that the rule’s basic prohibitions do not
apply to an account in which a restricted person has
a beneficial interest, provided:
n
The account has held an equity ownership
interest in the issuer for a period of one year prior
to the effective date of the offering;
n
The sale of the new issue to the account does not
increase the account’s percentage equity
ownership in the issuer above the ownership level
as of three months prior to the filing of the
registration in connection with the offering;
n
The sale of the new issue to the account does not
include any special terms; and
n
The new issue purchased pursuant to this
exemption is not sold or transferred for three
months following the effective date of the
offering.
Elimination of Cancellation Provision. Under the
Interpretation, if a member sells a hot issue to a
restricted person or account, the member will not
have violated the Interpretation if the member: (1)
cancels the trade before the end of the first trading
day following the date on which secondary market
trading commences for that issue; and (2) reallocates
the security at the public offering price to nonrestricted persons or accounts. Since the New Issues
Rule applies to all new issues, this provision has
been eliminated.
Exemptive Relief. The New Issues Rule allows the
NASD staff to grant an exemption from any or all of
the provisions of the rule if it determines that
providing such exemption is consistent with the
purposes of the rule, the protection of investors, and
the public interest.
CONCLUSION
This article does not address all of the issues
contained in the New Issues Rule. If you want to
know more about the changes, please call your
Kirkpatrick & Lockhart LLP relationship attorney or
one of the authors of this memorandum, Cary J. Meer
at (202) 778-9107, Robert H. Rosenblum at (202) 7789464 or David J. Michehl at (202) 778-9274.
CARY J. MEER
202.778.9107
cmeer@kl.com
ROBERT H. ROSENBLUM
202.778.9464
rrosenblum@kl.com
DAVID J. MICHEHL
202.778.9274
dmichehl@kl.com
Kirkpatrick & Lockhart LLP
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This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein
should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.
© 2003 KIRKPATRICK & LOCKHART LLP.
ALL RIGHTS RESERVED.