• New NASD Rule Changes How IPOs Can Be Sold
  • January 16, 2004 | Author: Gregory J. Nowak
  • Law Firm: Pepper Hamilton LLP - Philadelphia Office
  • New Developments Affecting Registered Funds, Hedge Funds and Investment Advisers

    On October 24, 2003, the Securities and Exchange Commission (SEC) approved the National Association of Securities Dealers' (NASD) new Rule 2790, which restricts the purchase and sale of initial public offerings of equity securities. Rule 2790, which replaces NASD's old "free-riding and withholding" rules, generally prohibits a member from selling a "new issue" to any account in which a "restricted person" has a beneficial interest. Before selling a new issue to any account, broker/dealers generally must obtain a representation from the beneficial owner of the account that the account is eligible to purchase new issues in accordance with the rule. Some exemptions apply in certain circumstances.

    The text of the new rule is available online at www.sec.gov/rules/sro/34-48701.htm. A summary also is available on NASD's Web site at www.nasdr.com/pdf-text/0379ntm.txt. Several important issues need to be considered:

    1. The rule is effective December 23, 2003, with a mandatory deadline for compliance of March 23, 2004. All NASD members will be required to prohibit sales of new issues to a purchaser unless the broker has certification from the customer that the customer is eligible to receive an allocation of new issue securities. So, for example, a fund of funds that invests in hedge funds will need to be able to certify to the hedge funds that the fund of funds is not a "restricted person" as defined in the new rule. The underlying hedge funds will then need to certify to the brokers that the hedge funds are not restricted persons (or the percentage of them that is restricted).

    2. The new rules apply to all new issues of equity securities, not just to those that trade at a premium to their issue price in the secondary market. The new rules do not apply to debt securities or convertible securities. Other exceptions are outlined in the rule.

    3. The conditionally restricted person exception of the old free-riding and withholding rules is eliminated. So, just because a person was a traditional IPO investor no longer qualifies that person to purchase new issues under the new rule. If that person is a restricted person, he or she must fit within the de minimis rule or be carved out of participation in the IPO.

    4. Under the de minimis exception, restricted persons may hold up to 10 percent of a collective investment account. And, collective accounts still can "carve out" restricted persons. But, portfolio managers, such as hedge fund managers who invest in their own hedge funds, are considered restricted persons and their investments count against the 10 percent.

    5. Restricted persons include:

      • NASD members or other broker/dealers; broker/dealer personnel including officers, directors, general partners, associated persons, or employees of NASD members or other broker/dealers (other than limited business broker/dealers)
      • immediate family members of NASD members or any of the persons listed above who either materially support or receive material support from one of the persons named above any person who has authority to buy or sell securities for a bank, savings and loan, insurance company, investment company, investment adviser or collective investment account, and their
      • immediate family members who either materially support or are materially supported by the person listed above
      • plus a host of others (see the rule for details).

    What You Need To Do

    First, at a minimum, subscription questionnaires for hedge funds, funds of funds and similar collective investment accounts that invest or expect to invest directly or indirectly in new issues need to be updated to reflect the new language.

    Second, the rule will be enforced by selling broker/dealers, by requiring broker/dealers to have a representation from the purchaser that the purchaser is not a restricted person. The comments to the release state that NASD expects the first confirmation to be a positive affirmation of non-restricted status; annual verification may be in the form of a negative consent. Verification can be in electronic form for eligible customers but verification must not be an oral confirmation.

    Verifications that predate a proposed sale of a new issue to an account by more than 12 months may not be relied upon by the selling broker/dealer.