Self-Regulatory Organizations; Financial Industry Regulatory Authority, Inc.; Order Approving Proposed Rule Change, as Modified by Amendment No. 1 Thereto, To Modernize and Simplify NASD Rule 2720, 29255-29261 [E9-14367]

Agencies

• SECURITIES AND EXCHANGE COMMISSION

[Federal Register Volume 74, Number 117 (Friday, June 19, 2009)]
[Notices]
[Pages 29255-29261]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E9-14367]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-60113; File No. SR-FINRA-2007-009]


Self-Regulatory Organizations; Financial Industry Regulatory 
Authority, Inc.; Order Approving Proposed Rule Change, as Modified by 
Amendment No. 1 Thereto, To Modernize and Simplify NASD Rule 2720

June 15, 2009.

I. Introduction

    The Financial Industry Regulatory Authority, Inc. (``FINRA'') (f/k/
a National Association of Securities Dealers, Inc. (``NASD'')) filed 
with the Securities and Exchange Commission (``Commission'' or ``SEC'') 
on September 6, 2007, and amended on May 1, 2009,\1\ pursuant to 
Section 19(b)(1) of the Securities Exchange Act of 1934 (``Exchange 
Act'' or ``Act'') \2\ and Rule 19b-4 thereunder,\3\ a proposal to 
modernize and simplify NASD Rule 2720 (Distributions of Securities of 
Members and Affiliates--Conflicts of Interest) (``Rule 2720'' or 
``Rule''), which governs public offerings of securities in which a 
member with a conflict of interest participates, and make corresponding 
changes to FINRA Rule 5110 (Corporate Financing Rule) (``Rule 5110''). 
This proposal was published for comment in the Federal Register on May 
13, 2009.\4\ The Commission received no comments on the proposal. This 
order approves the proposed rule change, as modified by Amendment No. 
1.
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    \1\ This Amendment No. 1 to SR-FINRA-2007-009 replaces and 
supersedes the original filing submitted on September 6, 2007, 
except with regard to Exhibit 2 (NASD Notice to Members 06-52 and 
comments received in response to NASD Notice to Members 06-52).
    \2\ 15 U.S.C. 78s(b)(1).
    \3\ 17 CFR 240.19b-4.
    \4\ Exchange Act Release No. 59880 (May 7, 2009), 74 FR 22600 
(May 13, 2009) (SR-FINRA-2007-009).
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II. Description of the Proposed Rule Change

    Rule 2720 governs public offerings of securities issued by 
participating members or their affiliates, public offerings in which a 
member or any of its associated persons or affiliates has a conflict of 
interest, and public offerings that result in a member becoming a 
public company. The Rule regulates the potential conflicts of interest 
that exist with respect to the pricing of such offerings and the 
conduct of due diligence when a member participates in such offerings.
    In September 2006, FINRA published NASD Notice to Members 06-52 
requesting comment on proposed amendments to Rule 2720 (the ``original 
proposal''). FINRA received two comment letters that generally 
supported the proposal and recognized the need to modernize the 
Rule.\5\ However, in response to the comments received, FINRA staff 
made certain revisions to the original proposal in its September 6, 
2007 filing with the Commission. In order to address Commission staff's 
comments, FINRA filed Amendment No. 1 to SR-FINRA-2007-009 on May 1, 
2009.
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    \5\ Letter from the Securities Industry and Financial Markets 
Association, dated November 1, 2006 (the ``SIFMA Letter''); and 
Letter from the American Bar Association, dated December 4, 2006 
(the ``ABA Letter'').
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    The proposed rule change would replace the current Rule in its 
entirety with proposed Rule 2720 entitled ``Public Offerings of 
Securities With Conflicts of Interest.'' The proposal would, among 
other things: (1) Exempt from the filing and qualified independent 
underwriter (``QIU'') requirements public offerings of investment grade 
rated securities, public offerings of securities that have a bona fide 
public market, and public offerings in which the member primarily 
responsible for managing the offering does not have a conflict of 
interest and can meet the disciplinary history requirements for a QIU; 
(2) Amend the definition of ``conflict of interest'' to include public 
offerings in which at least five percent of the offering proceeds are 
directed to a participating member or its affiliates; (3) Modify the 
Rule's disclosure requirements to provide more prominent disclosure of 
conflicts of interest in the offering documents; and (4) Amend the 
Rule's provisions regarding the use of a QIU to eliminate the 
requirement that the QIU render a pricing opinion. In addition, the 
proposed rule change would amend the QIU qualification requirements to 
focus on the experience of the firm

[[Page 29256]]

rather than its board of directors, prohibit a member from acting as a 
QIU if it would receive more than five percent of the proceeds of an 
offering, and lengthen from five to ten years the amount of time that a 
person involved in due diligence in a supervisory capacity must have a 
clean disciplinary history. These and the other proposed amendments are 
discussed in greater detail below.

A. Proposed Rule 2720(a)

    Proposed Rule 2720(a) would provide that no member that has a 
conflict of interest may participate in a public offering unless the 
offering meets one of the exemptions set forth in paragraph (a)(1) or a 
QIU participates in the offering pursuant to paragraph (a)(2).
1. Offerings Exempt From the QIU and Filing Requirements Under 
Paragraph (a)(1)
    FINRA proposed an exemption from the QIU and filing requirements 
for public offerings in which the member primarily responsible for 
managing the offering (e.g., the book-running lead manager or lead 
placement agent) does not have a conflict of interest, is not an 
affiliate of a member that has a conflict of interest, and can meet the 
disciplinary history requirements for a QIU under proposed paragraph 
(f)(12)(E).\6\ FINRA staff believed that a QIU should not be required 
for such offerings because the book-running lead manager or lead 
placement agent (or member acting in a similar capacity), which does 
not have conflict of interest, would be expected to perform the 
necessary due diligence that would otherwise be required of a QIU.\7\
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    \6\ See proposed Rule 2720(a)(1)(A).
    \7\ FINRA clarified their understanding that all syndicate 
members have due diligence responsibility, but the book-runner(s) in 
a firm commitment offering and the lead placement agent(s) in a best 
efforts offering typically hire outside counsel to help members meet 
their due diligence obligations.
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    In response to comments on the original proposal,\8\ FINRA amended 
this provision to clarify that it would apply to public offerings in 
which there are joint books or that are best efforts offerings. 
However, where there are two or more co-lead managers or co-lead 
placement agents that have equal responsibilities with regard to due 
diligence, FINRA clarified that each would need to be free of conflicts 
of interest. FINRA believes that, due to the important role a book-
runner or dealer-manager can be expected to play in the due diligence 
process in an offering, even if that responsibility is shared equally 
with other members, the Rule's QIU provisions would apply and the 
offering would have to be filed for review if any book-runner or 
dealer-manager has a conflict.
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    \8\ SIFMA Letter.
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    FINRA also proposed an exemption from the QIU and filing 
requirements for public offerings of securities that have a bona fide 
public market.\9\ The current Rule exempts public offerings of 
securities for which there is a ``bona fide independent market'' from 
Rule 2720's QIU requirement, but not the filing requirement.\10\ The 
proposed rule change would replace the term ``bona fide independent 
market'' with ``bona fide public market,'' which is defined in proposed 
Rule 2720(f)(3) in accordance with the numerical standards set forth in 
Regulation M.\11\ Specifically, ``bona fide public market'' would be 
defined in the proposal as a market for a security issued by a company 
that has been reporting under the Exchange Act for at least 90 days, is 
current in its reporting requirements and whose securities are listed 
on a national securities exchange with an average daily trading volume 
of at least $1 million, provided that the issuer's common equity 
securities have a public float value of at least $150 million. One 
commenter expressed strong support for the proposed definition of 
``bona fide public market.'' \12\
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    \9\ See proposed Rule 2720(a)(1)(B).
    \10\ ``Bona fide independent market'' is defined in current Rule 
2720(b)(3) as a market in a security that is listed on a national 
securities exchange or Nasdaq with a market price of $5 per share, 
aggregate trading volume of 500,000 shares over 90 days and a public 
float of 5 million shares.
    \11\ 17 CFR 242.100 to 105.
    \12\ ABA Letter.
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    FINRA also proposed to exempt from the filing requirement (and 
retain the existing exemption from the QIU requirement) public 
offerings of investment grade rated securities and securities in the 
same series that have equal rights and obligations as investment grade 
rated securities.\13\ In response to comments on the original 
proposal,\14\ FINRA proposed to define ``investment grade rated'' in 
proposed Rule 2720(f)(8) to refer to securities that are rated by a 
nationally recognized statistical rating organization in one of its 
four highest generic rating categories. This definition is consistent 
with the definition proposed by FINRA in SR-NASD-2004-022 relating to 
the filing requirements and the regulation of public offerings of 
securities registered with the Commission and offered by members 
pursuant to Securities Act Rule 415 (the ``proposed shelf 
amendments'').\15\
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    \13\ See proposed Rule 2720(a)(1)(C). Thus, proposed Rule 
2720(a)(1)(C) would apply to public offerings of securities that 
have not received an individual rating, but are of the same class or 
series and are considered ``pari passu'' with other investment grade 
rated securities issued by the same company.
    \14\ ABA Letter.
    \15\ See Exchange Act Release No. 50749 (November 29, 2004), 69 
FR 70735 (December 7, 2004) (notice of filing of SR-NASD-2004-022) 
and Amendment No. 5 (filed on August 31, 2007), available at https://www.finra.org/Industry/Regulation/RuleFilings/2004/P036671.
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    These three types of public offerings described above and 
enumerated in paragraphs (a)(1)(A) through (a)(1)(C) of proposed Rule 
2720 would not be subject to the QIU requirements of the proposed Rule 
and, by operation of proposed Rule 2720(d), they would not be subject 
to the filing requirements of Rule 5110 (formerly NASD Rule 2710).\16\ 
They would be, however, subject to the other provisions of proposed 
Rule 2720, e.g., the escrow and discretionary account requirements in 
paragraphs (b) and (c) respectively, if applicable. Additionally, these 
public offerings would be subject to certain disclosure requirements. 
Proposed Rule 2720(a)(1) would require prominent disclosure of the 
nature of the conflict of interest in the prospectus, offering 
circular, or similar document for the public offering.
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    \16\ On September 11, 2008, the Commission approved proposed 
rule change SR-FINRA-2008-039, in which FINRA proposed, among other 
things, to adopt NASD Rule 2710 as Rule 5110 in the Consolidated 
FINRA Rulebook. See Exchange Act Release No. 58514 (September 11, 
2008), 73 FR 54190 (September 18, 2008). SR-FINRA-2008-039 was 
implemented on December 15, 2008. See Regulatory Notice 08-57 
(October 2008).
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    In response to the original proposal, one commenter requested 
clarification regarding the ``prominent disclosure'' requirement in the 
proposed Rule.\17\ Proposed Rule 2720(f)(10) provides a description of 
how a member could make ``prominent disclosure'' for purposes of 
paragraphs (a)(1) and (a)(2)(B) of the proposed Rule. Specifically, a 
member could make the notation ``(Conflicts of Interest)'' following 
the listing of the Plan of Distribution in the Table of Contents 
section required in Item 502 of Regulation S-K, and provide such 
disclosures in the Plan of Distribution section required in Item 508 
and any Prospectus Summary section required in Item 503 of Regulation 
S-K. For offering documents not subject to Regulation S-K, ``prominent 
disclosure'' could be made by providing disclosure on the front page of 
the offering document that a conflict exists, with a cross-reference to 
the discussion within the offering document and in the summary of the 
offering document if one is included.

[[Page 29257]]

FINRA stated that these methods of disclosure would be considered a 
non-exclusive safe harbor for effecting ``prominent disclosure,'' and 
clarified it would consider alternative but equally prominent 
disclosures on a case-by-case basis.
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    \17\ ABA Letter.
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2. Offerings in Which a QIU Must Participate Under Paragraph (a)(2)
    If a member with a conflict of interest participates in a public 
offering that does not meet the conditions of proposed Rule 2720(a)(1), 
then proposed Rule 2720(a)(2)(A) would require that a QIU participate 
in the preparation of the registration statement and the prospectus, 
offering circular or similar document and exercise the usual standards 
of ``due diligence'' with respect thereto.\18\
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    \18\ The requisite qualifications of a QIU are set forth in the 
definition of ``qualified independent underwriter'' in proposed Rule 
2720(f)(12), which is discussed in greater detail below.
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    Like proposed Rule 2720(a)(1), proposed Rule 2720(a)(2)(B) would 
require ``prominent disclosure'' (as defined in proposed Rule 
2720(f)(10)) in the prospectus, offering circular, or similar document 
of the nature of the conflict of interest. In addition, proposed Rule 
2720(a)(2)(B) would require disclosure of the name of the member acting 
as QIU and a brief statement regarding the role and responsibilities of 
the QIU. The disclosure requirements contained in current Rule 2720(d) 
require that, among other things, the offering documents expressly 
state that the member acting as QIU (if one is required for the 
offering) is assuming its responsibilities in pricing the offering and 
conducting due diligence. In response to commenters' concerns that such 
a statement potentially could give rise to liability on the part of the 
QIU,\19\ FINRA proposed to replace this disclosure requirement with a 
more general statement about the role and responsibilities of a QIU.
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    \19\ ABA Letter; SIFMA Letter.
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    FINRA clarified that a public offering in which a QIU participates 
pursuant to proposed paragraph (a)(2) would continue to be subject to 
the filing requirements of Rule 5110.\20\ Additionally, as in the Rule 
currently, a public offering in which a QIU participates would be 
required to meet proposed Rule 2720's escrow and discretionary account 
requirements, if applicable.
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    \20\ See proposed Rule 2720(d).
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    Current Rule 2720 requires that a QIU provide an opinion that the 
price at which equity securities are offered to the public is no 
higher, or the yield for debt securities is no lower, than that 
recommended by the QIU. The proposed rule change would eliminate the 
requirement that a QIU provide a pricing opinion. FINRA staff stated 
that they were unaware of instances where QIUs have made 
recommendations that were inconsistent with pricing decisions by the 
book-running lead manager or lead placement agent. In addition, FINRA 
staff stated that they believe QIU pricing opinions in at-the-market 
offerings are of little to no value. Both commenters expressed strong 
support for eliminating the QIU pricing requirement.\21\
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    \21\ ABA Letter; SIFMA Letter.
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B. Escrow of Proceeds; Net Capital Computation

    Proposed Rule 2720(b)(1) would require that all proceeds from a 
public offering by a member of its securities be placed in a duly 
established escrow account and not be released therefrom or used by the 
member in any manner until the member has complied with the net capital 
requirements set forth in paragraph (b)(2). This proposed provision 
mirrors current Rule 2720(e).\22\
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    \22\ Members are reminded that additional escrow account 
maintenance and payment requirements may be applicable under 
Exchange Act Rule 15c2-4.
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    The net capital requirements set forth in proposed Rule 2720(b)(2) 
mirror current Rule 2720(e)(2), except that FINRA is proposing to 
replace the reference to Exchange Act Rule 15c3-1(f) with a reference 
in proposed Rule 2720(b)(2) to the alternative standard for calculating 
net capital under Exchange Act Rule 15c3-1(a)(1)(ii).
    In addition, proposed Rule 2720(b)(3) would require that any member 
offering its securities pursuant to the proposed Rule disclose in the 
registration statement, offering circular, or similar document a date 
by which the offering is reasonably expected to be completed and the 
terms upon which the proceeds will be released from the escrow account 
described in paragraph (b)(1). This provision mirrors current Rule 
2720(d)(1).

C. Disclosure

    Current Rule 2720(d)(1) requires disclosure in the registration 
statement or offering circular regarding the date the offering will be 
completed and the terms upon which proceeds will be released from the 
escrow account. Current Rule 2720(d)(2) requires disclosure: (1) That 
the offering is being made pursuant to Rule 2720; (2) Relating to the 
member's status in the offering; and (3) Relating to the QIU (if one is 
required).
    The proposed rule change would delete current paragraph (d) of Rule 
2720. As discussed above, the proposal would move the disclosure 
requirements in current paragraph (d)(1) to proposed paragraph (b)(3) 
and establish separate disclosure requirements for public offerings in 
which a QIU participates (proposed Rule 2720(a)(2)(B)) and public 
offerings in which a QIU does not participate (proposed Rule 
2720(a)(1)).

D. Discretionary Accounts

    Proposed Rule 2720(c) would prohibit, notwithstanding NASD Rule 
2510 (Discretionary Accounts), members that have a conflict of interest 
from selling to a discretionary account any security with respect to 
which the conflict exists, unless the member has received specific 
written approval of the transaction from the account holder and retains 
documentation of the approval in its records. This provision differs 
from current Rule 2720(l), which also places limitations on sales to 
discretionary accounts, in that proposed Rule 2720(c) would only apply 
to the sale of securities by the member with the conflict of interest. 
Current Rule 2720(l) limits discretionary sales by all firms 
participating in the offering, even those that do not have a conflict 
of interest. One commenter expressed support for limiting this 
provision to the member that has a conflict.\23\ FINRA has clarified 
that the ``specific written approval'' requirement in this provision 
could be satisfied by an e-mail from the customer.
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    \23\ ABA Letter.
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E. Application of Rule 5110

    As noted above, proposed Rule 2720(d) would provide that any public 
offering subject to the QIU requirements of paragraph (a)(2) would also 
be subject to Rule 5110, whether or not the offering would otherwise be 
exempted from Rule 5110's filing or other requirements. Rule 5110 
generally requires members to file with FINRA public offerings for 
review of the proposed underwriting terms and arrangements. Rule 5110 
contains certain exemptions from the filing requirements for, among 
others, public offerings of the securities of seasoned issuers and 
offerings of investment grade debt.\24\ However, pursuant to

[[Page 29258]]

current Rule 2720(m), these exemptions are inapplicable to public 
offerings that fall within the scope of Rule 2720. Thus, for example, 
while a public offering of the securities of a seasoned issuer is 
normally exempt from filing under Rule 5110, if a member participating 
in the offering has a conflict of interest with the seasoned issuer, it 
must be filed and comply with Rule 5110. The proposed rule change would 
narrow this filing requirement to apply only to those public offerings 
that fall within the scope of proposed Rule 2720(a)(2).
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    \24\ The ``seasoned issuer'' filing exemption in Rule 
5110(b)(7)(C) currently exempts offerings registered on Forms S-3 
and F-3 by issuers that meet the standards for those Forms prior to 
October 21, 1992 (i.e., a three-year reporting history and either 
$150 million float or $100 million float and annual trading volume 
of three million shares). The proposed shelf amendments (see supra 
note 14) would preserve the current filing requirements and amend 
the Rule to specifically describe the pre-October 21, 1992 
standards.
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    In response to comments on the original proposal,\25\ FINRA 
proposed to amend current Rule 5110(b)(7), which lists offerings that 
are exempt from the Rule 5110 filing requirements, to specify that 
documents and information related to the public offerings listed in 
Rule 5110(b)(7) are not required to be filed with FINRA for review, 
unless the public offering is subject to the QIU requirements of Rule 
2720(a)(2). This would clarify that if a public offering listed in Rule 
5110(b)(7) is subject to Rule 2720(a)(1), such offering would not be 
subject to the filing requirements of Rule 5110.
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    \25\ SIFMA Letter.
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F. Requests for Exemption From Rule 2720

    Proposed Rule 2720(e) would permit, pursuant to the Rule 9600 
Series, FINRA in exceptional and unusual circumstances, taking into 
consideration all relevant factors, to exempt a member unconditionally 
or on specified terms from any or all of the provisions of the proposed 
Rule that it would deem appropriate. This provision mirrors existing 
Rule 2720(o).

G. Definition of ``Affiliate''

    Proposed Rule 2720(f)(1) would define the term ``affiliate'' as an 
entity that controls, is controlled by or is under common control with 
a member. While current Rule 2720(b)(1) incorporates the ``control'' 
standard in the definition of affiliate, FINRA proposed instead to 
adopt a separate definition of ``control,'' which is discussed below.
    In response to comments on the original proposal,\26\ FINRA 
narrowed the proposed definition of ``affiliate'' to apply only where 
an entity controls, is controlled by or is under common control with a 
member. As originally proposed, the definition would have applied where 
an entity was under common control with another entity that controls, 
was controlled by or was under common control with a member.
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    \26\ ABA Letter.
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H. Definition of ``Beneficial Ownership''

    Proposed Rule 2720(f)(2) would define ``beneficial ownership'' as 
the right to the economic benefits of a security. This provision 
mirrors the definition contained in current Rule 2720(b)(2). In NASD 
Notice to Members 06-52, FINRA requested comment on whether Rule 2720 
should incorporate the definition of ``beneficial ownership'' found in 
Exchange Act Rule 13d-3. That definition includes the right to dispose 
and vote the securities, which would apply to many investment funds. In 
response to comments suggesting that the definition should be confined 
to economic interests in which the member can profit directly,\27\ 
FINRA is proposing to retain the current definition of ``beneficial 
ownership.''
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    \27\ Id.
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I. Definition of ``Common Equity''

    Proposed Rule 2720(f)(4) would define ``common equity'' as the 
total number of shares of common stock outstanding without regard to 
class, whether voting or non-voting, convertible or non-convertible, 
exchangeable or non-exchangeable, redeemable or non-redeemable, as 
reflected on the consolidated financial statements of the company. This 
definition mirrors current Rule 2720(b)(5).

J. Definition of ``Conflict of Interest''

    Proposed Rule 2720(f)(5) would define ``conflict of interest'' to 
be the situation where, at the time of a member's participation in an 
entity's public offering, any of four conditions applies. The proposed 
Rule would operate much as it does currently. However, the proposed 
rule change would relocate many of the current Rule's substantive 
concepts to the definition of ``conflict of interest.''
    First, pursuant to proposed Rule 2720(f)(5)(A), a conflict of 
interest would exist if the securities are to be issued by the member.
    Second, pursuant to proposed Rule 2720(f)(5)(B), a conflict of 
interest would exist if the issuer controls, is controlled by, or is 
under common control with the member or the member's associated 
persons. ``Control'' is defined in proposed Rule 2720(f)(6) and is 
discussed below.
    Third, pursuant to proposed Rule 2720(f)(5)(C), a conflict of 
interest would exist where at least five percent of the net offering 
proceeds, not including underwriting compensation, are intended to be 
either used to reduce or retire the balance of a loan or credit 
facility extended by the member, its affiliates, and its associated 
persons (in the aggregate) or otherwise directed to the member, its 
affiliates, and associated persons (in the aggregate). In response to 
comments on the original proposal,\28\ FINRA amended the proposed 
definition to clarify that the proceeds are net of underwriting 
compensation.
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    \28\ SIFMA Letter.
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    Currently, Rule 5110(h) requires public offerings in which ten 
percent or more of the offering proceeds (not including the 
underwriting discount) will be paid to participating members to comply 
with Rule 2720's QIU requirements. Pursuant to this proposed rule 
change, FINRA proposed to delete Rule 5110(h) and move the proceeds 
requirement to Rule 2720 by defining ``conflict of interest'' to 
include a member's participation in a public offering where proceeds 
are directed to the member. Although the threshold for proceeds 
directed to a member would be lowered from ten percent to five percent, 
the new threshold would apply to each participating member individually 
(including the member's affiliates and its associated persons), not on 
an aggregate basis for all participating members, as is currently the 
case. Thus, for example, a conflict of interest would exist where a 
member received five percent of the proceeds, but not where two 
unaffiliated members each received three percent of the proceeds.
    Fourth, pursuant to proposed Rule 2720(f)(5)(D), a conflict of 
interest would exist if, as a result of the public offering and any 
transactions contemplated at the time of the public offering, the 
member will be an affiliate of the issuer, the member will become 
publicly owned, or the issuer will become a member or form a broker-
dealer subsidiary.
    In response to comments on the original proposal,\29\ FINRA 
clarified that for purposes of Rule 2720, ``participation in a public 
offering'' has the same meaning as in Rule 5110. Rule 5110(a)(5) 
provides that ``participation or participating in a public offering'' 
means:
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    \29\ Id.

    Participation in the preparation of the offering or other 
documents, participation in the distribution of the offering on an 
underwritten, non-underwritten, or any other basis, furnishing of 
customer and/or broker lists for solicitation, or participation in 
any advisory or consulting capacity to the issuer

[[Page 29259]]

related to the offering, but not the preparation of an appraisal in 
a savings and loan conversion or a bank offering or the preparation 
of a fairness opinion pursuant to [Exchange Act] Rule 13e-3.\30\
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    \30\ Rule 5110(a)(5). Pursuant to the proposed shelf amendments 
(see supra note 15), this definition in former NASD Rule 2710 (which 
has since been moved to the Consolidated FINRA Rulebook as Rule 
5110) would be amended to specify participation in the distribution 
of the offering on an ``underwritten, non-underwritten, principal, 
agency or any other basis'' and to include ``participation in a 
shelf takedown.''
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K. Definition of ``Control''

    As noted above, under the current Rule, the control standard is 
incorporated in the definition of ``affiliate.'' The proposal would 
create a separate definition of ``control,'' which would be defined as 
any of the following: (1) Beneficial ownership of ten percent or more 
of the outstanding common equity of an entity, including any right to 
receive such securities within 60 days of the member's participation in 
the public offering; \31\ (2) The right to ten percent or more of the 
distributable profits or losses of an entity that is a partnership, 
including any right to receive an interest in such distributable 
profits or losses within 60 days of the member's participation in the 
public offering; \32\ (3) Beneficial ownership of ten percent or more 
of the outstanding subordinated debt of an entity, including any right 
to receive such subordinated debt within 60 days of the member's 
participation in the public offering; \33\ (4) Beneficial ownership of 
ten percent or more of the outstanding preferred equity of an entity, 
including any right to receive such preferred equity within 60 days of 
the member's participation in the public offering; \34\ or (5) The 
power to direct or cause the direction of the management or policies of 
an entity.\35\ FINRA believed it was important in subparagraph (i) to 
include entities other than corporations in order to expressly include 
conflicts that may arise in connection with the offerings of, for 
example, trusts.
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    \31\ Proposed Rule 2720(f)(6)(A)(i). The term ``beneficial 
ownership'' is defined in proposed paragraph (f)(2).
    \32\ Proposed Rule 2720(f)(6)(A)(ii).
    \33\ Proposed Rule 2720(f)(6)(A)(iii).
    \34\ Proposed Rule 2720(f)(6)(A)(iv).
    \35\ Proposed Rule 2720(f)(6)(A)(v).
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    FINRA had originally proposed that the definition of control would 
eliminate ownership of subordinated debt and preferred equity as a 
basis for a conflict of interest.\36\ However, in response to comments 
from Commission staff, FINRA proposed to include beneficial ownership 
of ten percent or more of the outstanding common equity (which is 
defined expressly to include non-voting stock), subordinated debt or 
preferred equity in the proposed definition of control. Thus, for 
example, ``control'' could derive from the restrictive covenants 
typically found in debt indentures, preferred rights to dividends given 
to holders of non-voting common or preferred stock or special voting 
rights given to certain classes of (generally) non-voting stock. While 
FINRA specifically requested comment on whether such forms of ownership 
give rise to a conflict of interest and should be included in the 
proposed rule, no comments were received in regards to this filing.
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    \36\ See current Rule 2720(b)(7)(A) and (C).
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    The proposed definition of control would not only include shares 
beneficially owned by a participating member, but also the right to 
receive such securities within 60 days of the member's participation in 
the public offering. In its original filing of September 6, 2007, FINRA 
proposed that for purposes of this provision, 60 days would be from the 
effective date of the offering. However, in Amendment No. 1, FINRA 
revised the proposed rule text to provide that the relevant time frame 
is ``within 60 days of the member's participation in the public 
offering.'' \37\ This would ensure that the Rule properly applies to 
takedowns from an effective shelf registration. FINRA stated their 
belief that the determination of control should be when the member 
participates in an offering, not the date that a registration statement 
for the offering is declared effective.
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    \37\ For purposes of Rule 2720, ``participation in a public 
offering'' has the same meaning as in Rule 5110(a)(5). See supra for 
further discussion of the definition of the term ``participation in 
a public offering.''
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    Thus, under the proposed rule change, warrants or rights for voting 
securities that are exercisable within 60 days of the member's 
participation in the public offering would be included in the 
calculation of voting securities when determining whether control 
exists. In response to comments on the original proposal, FINRA 
clarified that in calculating the percentage beneficial ownership, it 
would be appropriate to include the potential ownership of shares in 
both the numerator and denominator.\38\ FINRA did not believe, however, 
that this calculation should include securities that could be received 
by all investors. Rather, FINRA clarified that the calculation would be 
limited to warrants or rights that are exercisable within 60 days and 
received by the participating member only and would not include 
warrants or rights held by other investors.
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    \38\ See ABA Letter (requesting that FINRA clarify whether the 
amount of securities to be received by a member and any other person 
within 60 days of the offering will be included in the denominator 
in order to calculate the member's total ownership interest in the 
issuer's securities).
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L. Definition of ``Entity''

    Currently, Rule 2720 does not contain a definition of ``entity.'' 
Pursuant to proposed Rule 2720(f)(7), an ``entity'' would be defined, 
for purposes of the definitions of affiliate, conflict of interest, and 
control under the Rule, as ``a company, corporation, partnership, 
trust, sole proprietorship, association or organized group of 
persons.''
    The proposed definition would expressly exclude: (1) An investment 
company registered under the Investment Company Act of 1940 
(``Investment Company Act''); \39\ (2) A ``separate account'' as 
defined in Section 2(a)(37) of the Investment Company Act; \40\ (3) A 
``real estate investment trust'' as defined in Section 856 of the 
Internal Revenue Code; \41\ and (4) A ``direct participation program'' 
as defined in NASD Rule 2810.\42\ These exclusions are substantially 
similar to the exemptions from the ``conflict of interest'' provisions 
contained in current Rule 2720(b)(7)(D). In response to comments on the 
original proposal,\43\ FINRA revised the proposed definition of 
``conflict of interest'' to apply only to a public offering of an 
``entity.''
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    \39\ Proposed Rule 2720(f)(7)(B)(i).
    \40\ Proposed Rule 2720(f)(7)(B)(ii).
    \41\ Proposed Rule 2720(f)(7)(B)(iii).
    \42\ Proposed Rule 2720(f)(7)(B)(iv).
    \43\ SIFMA Letter.
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M. Definition of ``Preferred Equity''

    Proposed Rule 2720(f)(9) would define the term ``preferred equity'' 
as the aggregate capital invested by all persons in the preferred 
securities outstanding without regard to class, whether voting or non-
voting, convertible or non-convertible, exchangeable or non-
exchangeable, redeemable or non-redeemable, as reflected on the 
consolidated financial statements of the company. This definition 
mirrors current Rule 2720(b)(12).

N. Definition of ``Public Offering''

    Proposed Rule 2720(f)(11) is substantively similar to the 
definition of ``public offering'' in current Rule 2720(b)(14) and would 
define the term as any primary or secondary offering of securities made 
pursuant to a registration statement or offering circular including 
exchange offers, rights offerings, offerings made pursuant

[[Page 29260]]

to a merger or acquisition and all other securities offerings of any 
kind whatsoever. The proposed definition excludes from its scope any 
offering made pursuant to an exemption from registration under Sections 
4(1), 4(2) or 4(6) of the Securities Act of 1933 (``Securities 
Act''),\44\ Securities Act Rule 504, if the securities are ``restricted 
securities'' under Securities Act Rule 144(a)(3), Securities Act Rule 
505, or Securities Act Rule 506, and Securities Act Rule 144A or 
Regulation S. FINRA currently does not interpret an offering made 
pursuant to Regulation S to be within the scope of a ``public 
offering'' under this Rule and as such, proposed also to exclude these 
offerings from the definition. Additionally, in response to comments on 
the original proposal,\45\ FINRA amended the proposed definition of 
``public offering'' to expressly exclude exempted securities as defined 
in Section 3(a)(12) of the Exchange Act,\46\ as in the current Rule.
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    \44\ 15 U.S.C. 77d(1), (2), and (6).
    \45\ ABA Letter.
    \46\ 15 U.S.C. 78c(a)(12).
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    One commenter suggested that the proposed rule should provide an 
express exclusion for offerings made pursuant to Securities Act Rule 
144A.\47\ FINRA agreed and added an express exclusion for offerings 
under Securities Act Rule 144A. FINRA also noted that it currently does 
not interpret an offering made pursuant to Securities Act Rule 144A to 
be within the scope of either Rule 5110 or Rule 2720.
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    \47\ ABA Letter.
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O. Definition of ``Qualified Independent Underwriter''

    Proposed Rule 2720(f)(12) defines the term ``qualified independent 
underwriter'' as a member that meets five specified conditions. 
Specifically, the member must first not have a conflict of interest and 
must not be an affiliate of any member that has a conflict of 
interest.\48\ The Rule currently does not disqualify or prohibit a QIU 
from receiving proceeds from an offering. The proposed rule change 
would prohibit a QIU from receiving more than five percent of the 
offering proceeds because the receipt of such proceeds would disqualify 
a member from acting as a QIU because it would fall within the proposed 
definition of ``conflict of interest.''
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    \48\ Proposed Rule 2720(f)(12)(A).
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    The second condition for being considered a QIU in the proposed 
Rule is the member could not beneficially own, as of the date of the 
member's participation in the public offering, more than five percent 
of the class of securities that would give rise to a conflict of 
interest, including any right to receive any such securities 
exercisable within 60 days.\49\ Current Rule 2720(b)(15)(E) prohibits a 
member from acting as a QIU if it is an affiliate of the issuer or if 
it beneficially owns at least five percent of the equity, subordinated 
debt or partnership interest of the issuer. The proposed rule change 
would maintain these prohibitions.
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    \49\ Proposed Rule 2720(f)(12)(B).
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    Third, the member would need to have agreed, in acting as a QIU, to 
undertake the legal responsibilities and liabilities of an underwriter 
under the Securities Act, specifically including those inherent in 
Section 11 thereof.\50\ The proposed provision mirrors current Rule 
2720(b)(15)(F).
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    \50\ Proposed Rule 2720(f)(12)(C).
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    Fourth, the member would need to have served as underwriter in at 
least three public offerings of a similar size and type during the 
three-year period immediately preceding the filing of the registration 
statement or the date of first sale in an offering for which there is 
no registration statement.\51\ This requirement would be deemed 
satisfied if, during the past three years, the member, with respect to 
a proposed public offering of debt securities, has acted as sole 
underwriter or book-running lead or co-manager of at least three public 
offerings of debt securities each with gross proceeds of not less than 
25% of the anticipated gross proceeds of the proposed offering. With 
respect to a proposed public offering of equity securities, this 
requirement would be deemed satisfied if, during the past three years, 
the member has acted as sole underwriter or book-running lead or co-
manager of at least three public offerings of equity securities (or of 
securities convertible into equity securities), each with gross 
proceeds of not less than 50% of the anticipated gross proceeds of the 
proposed offering. While FINRA specifically requested comment on 
whether the 50% threshold should be lowered if an equity offering is 
particularly large (e.g., over $1 billion), no comments were received 
in regards to the filing. The proposed requirements would be similar 
those set forth in current Rule 2720(b)(15)(C). The proposal would, 
however, shorten the relevant period from five to three years and would 
impose, as discussed above, the requirement that a QIU must have acted 
as a managing underwriter in at least three similar offerings during 
that time.
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    \51\ Proposed Rule 2720(f)(12)(D).
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    Additionally, Rule 2720(b)(15)(B) currently permits a member to 
serve as a QIU only if the member is a sole proprietorship and the sole 
proprietor has been actively engaged in the investment banking or 
securities business for the five-year period immediately preceding the 
filing of the registration statement, or is a corporation or 
partnership and a majority of its board of directors or general 
partners has been similarly engaged in the investment banking or 
securities business. The proposed rule change would eliminate the 
requirement regarding board or partner experience, since FINRA staff 
believed that the experience of the firm is more relevant.
    The fifth and final condition for being considered a QIU in the 
proposed Rule would be that the member's associated persons in a 
supervisory capacity who are responsible for organizing, structuring, 
or performing due diligence with respect to corporate public offerings 
of securities could not have certain criminal or disciplinary 
histories.\52\ These associated persons could not have been convicted 
within ten years prior to the filing of the registration statement or 
the preparation of an offering circular in an offering without a 
registration statement of a violation of the anti-fraud provisions of 
the federal or state securities laws, or any rules or regulations 
promulgated thereunder, in connection with a registered or unregistered 
offering of securities. These associated persons also could not be 
subject to any order, judgment, or decree of any court of competent 
jurisdiction entered within ten years prior to the filing of the 
registration statement, or the preparation of an offering circular in 
an offering without a registration statement, permanently enjoining or 
restraining such person from engaging in or continuing any conduct or 
practice in violation of the anti-fraud provisions of the federal or 
state securities laws, or any rules or regulations promulgated 
thereunder in connection with a registered or unregistered offering of 
securities. Finally, these associated persons could not have been 
suspended or barred from association with any member by an order or 
decision of the Commission, any state, FINRA, or any other self-
regulatory organization within ten years prior to the filing of the 
registration statement, or the preparation of an offering circular in 
an offering without a registration statement, for any conduct or 
practice in violation of the anti-fraud provisions of the federal or 
state securities laws, or

[[Page 29261]]

any rules, or regulations promulgated thereunder, or the anti-fraud 
rules of any self-regulatory organization in connection with a 
registered or unregistered offering of securities. The Rule currently 
prohibits an associated person's involvement in the due diligence 
process in a supervisory capacity if that person has been subject to 
certain criminal and disciplinary actions pertaining to the offering of 
securities within five years prior to the filing of the registration 
statement. The proposed rule change, as described above, would lengthen 
this period from five to ten years.
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    \52\ See proposed Rule 2720(f)(12)(E).
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P. Definition of ``Registration Statement''

    Proposed Rule 2720(f)(13) would define the term ``registration 
statement'' as a registration statement as defined by Section 2(a)(8) 
of the Securities Act,\53\ notification on Form 1A filed with the 
Commission pursuant to the provisions of Securities Act Rule 252, or 
any other document, by whatever name known, initiating a registration 
or similar process for an issue of securities which is required to be 
filed by the laws or regulations of any federal or state agency. This 
definition mirrors current Rule 2720(b)(16), except for technical 
changes to correct the references in the current Rule to Securities Act 
Section 2(8) and Securities Act Rule 255.
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    \53\ 15 U.S.C. 77b(a)(8).
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Q. Definition of ``Subordinated Debt''

    Proposed Rule 2720(f)(14) would define ``subordinated debt'' to 
include debt of an issuer which is expressly subordinate in right of 
payment to (or with a claim on assets subordinate to) any existing or 
future debt of such issuer or all debt that is specified as 
subordinated at the time of issuance. Subordinated debt would not 
include short-term debt with maturity at issuance of less than one year 
and secured debt and bank debt not specified as subordinated debt at 
the time of issuance. This definition mirrors current Rule 2720(b)(18).

R. Deleted Definitions

    Proposed Rule 2720 would not include definitions for some terms 
that appear in current Rule 2720. These would be the definitions for 
``company,'' ``effective date,'' ``immediate family,'' ``parent,'' 
``person,'' ``public director,'' and ``settlement.'' In response to 
comments on the original proposal,\54\ FINRA proposed to adopt the 
current Rule 2720 definitions of ``company,'' ``effective date,'' 
``immediate family,'' and ``person'' as new paragraphs (a)(11) through 
(14) of Rule 5110 because they are used in that rule. Proposed Rule 
2720(f) provides that the definitions in Rule 5110 are incorporated by 
reference in Rule 2720.
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    \54\ ABA Letter.
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S. Corporate Governance and Periodic Reporting

    Rule 2720 currently includes certain provisions that do not apply 
to the public offering itself and instead require the issuer to adopt 
corporate governance policies relating to an audit committee, public 
directors, and to issue periodic reports to shareholders.\55\ With the 
enactment of the Sarbanes-Oxley Act of 2002 and recent SEC rulemaking 
and interpretive actions, FINRA enunciated its belief that issuers' 
periodic reporting requirements under the Exchange Act have been 
enhanced and listing standard changes intended to improve corporate 
governance and enhance the role of audit committees have been adopted. 
Accordingly, FINRA decided that separate Rule 2720 requirements for 
corporate governance and periodic reporting would be unnecessary. One 
commenter expressed support for eliminating these provisions from Rule 
2720.\56\
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    \55\ See current Rule 2720(f), (g), and (h).
    \56\ ABA Letter.
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T. Intrastate Offerings

    Rule 2720(j) currently requires any member offering its securities 
pursuant to the intrastate offering exemption under the Securities Act 
to include in the offering documents information required in a release 
that the Commission published in 1972. The proposed amendments would 
delete this requirement from Rule 2720. FINRA stated their belief that 
disclosure requirements for unregistered offerings should be addressed 
in a more comprehensive manner by the Commission, the states, or FINRA, 
and not imposed under the narrow scope of Rule 2720 or limited to 
intrastate offerings. One commenter suggested that FINRA should not 
adopt disclosure requirements for intrastate offerings because such 
offerings are subject to the disclosure requirements of the state where 
the securities are offered.\57\
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    \57\ Id.
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U. Suitability

    Rule 2720(k) currently requires that every member underwriting an 
issue of its own securities, or securities of an affiliate or company 
with which it has a conflict of interest, that recommends to a customer 
the purchase of a security of such issue must have reasonable grounds 
to believe that the recommendation is suitable for the customer. FINRA 
did not propose a similar provision in proposed Rule 2720 because NASD 
Rule 2310 already addresses a member's obligations relating to 
suitability.

III. Discussion and Findings

    After careful review of the proposed rule change, the Commission 
finds that the proposed rule change is consistent with the requirements 
of the Act, and the rules and regulations thereunder that are 
applicable to a national securities association.\58\ In particular, the 
Commission believes that the proposed rule change is consistent with 
the provisions of Section 15A(b)(6) of the Act,\59\ which requires, 
among other things, that FINRA rules be designed to prevent fraudulent 
and manipulative acts and practices, to promote just and equitable 
principles of trade, and, in general, to protect investors and the 
public interest. The Commission believes that FINRA has substantially 
streamlined the Rule thus enhancing its members' ability to comply with 
the rule while maintaining investor protections. The Rule, as amended 
in the proposal, continues regulation that protects investors in 
offerings where the member has a conflict of interest.
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    \58\ In approving this proposal, the Commission has considered 
the proposed rule's impact on efficiency, competition, and capital 
formation. See 15 U.S.C. 78c(f).
    \59\ 15 U.S.C. 78o-3(b)(6).
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IV. Conclusion

    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\60\ that the proposed rule change (File No. SR-FINRA-2007-009), as 
modified by Amendment No. 1, be, and hereby is, approved.
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    \60\ 15 U.S.C. 78s(b)(2).
    \61\ 17 CFR 200.30-3(a)(12).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\61\
Florence E. Harmon,
Deputy Secretary.
[FR Doc. E9-14367 Filed 6-18-09; 8:45 am]
BILLING CODE 8010-01-P