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, 2003over four years after the amendments had first been proposed, and after five amendments to that proposalthe 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 managers beneficial interest in the fund will be counted toward the 10% limit. A managers 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 managers fiduciary responsibilities to the funds 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 rules 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 accounts 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 rules 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 persons 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 Kirkpatrick & Lockhart LLP 2 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 persons 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 Rules 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 persons 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 anothers 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. Kirkpatrick & Lockhart LLP 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 rules 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 accounts 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 4 Kirkpatrick & Lockhart LLP maintains one of the leading investment management practices in the United States, with more than 60 lawyers devoting all or a substantial portion of their practice to this area and its related specialties. The American Lawyer Corporate Scorecard, published in April 2003, lists K&L as a primary legal counsel to the investment companies, board members or advisory firms for 15 of the 25 largest mutual fund complexes. No law firm was mentioned more frequently in the Scorecard. 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