David Feldman's book, Reverse Mergers: Taking a Company
Public Without an IPO, now in its third printing, was published in 2006
by Bloomberg Press (available on http://www.amazon.com).
View David Feldman's reverse merger blog at www.reversemergerblog.com.
Joseph Smith and David Feldman are coauthors of PIPES:
Revised and Updated Edition - A Guide to Private Investments in Public Equity
(Bloomberg Press, 2005) available on http://www.amazon.com.
In the News
Joseph
Smith quoted in an article about NASD
and the Corporate Finance Rule in The
Pipes Report on September 1, 2006.
NASD
Seeks (Again) to Clarify Corporate Finance
Rule
by
Steven Uslander
The
NASD recently filed a proposed rule
change with the Securities and Exchange
Commission to amend NASD Rule 2710-
the Corporate Finance Rule. The long
awaited proposals come on the heels
of strong opposition by players in the
PIPE community in response to prior
attempts by the NASD to amend the rule.
The proposals may be published for comment
by the SEC by the end of the month and
reflect the NASD's efforts to modernize
the filing requirements and improve
the regulation of shell offerings. In
other words, the NASD wants their member
firms to start complying with the rule
in the context of shelf offerings, which
include primary offerings by larger
issuers who sell their shares "off the
shelf" from time to time and resale
registration statements which follow
most PIPE offerings.
Rule 2710 regulates the underwriting
terms and arrangements of most public
offerings of securities sold through
broker-dealers or NASD members. Prior
to participating in a public offering,
NASD members are required to make a
filing with the NASD setting forth proposed
underwriting compensation and other
required information. Members are required
to receive an opinion of "no objection"
from the corporate financing department
of the NASD prior to participating in
the offering.
There has long been confusion in the
application for the Corporate Finance
Rule to shelf offerings made pursuant
to Rule 415 under the Securities Act
of 1933. There were questions as to
who makes the filing if more than one
member participates in the offering,
what types of transactions trigger the
filing and the manner in which underwriting
compensation is calculated in this context.
This confusion has resulted in violations
of the rule and has continued to the
present time even though the NASD has
made it clear since at least 1988 that
they consider shelf offerings to be
public offerings within the scope of
the Corporate Finance Rule.
The proposals make it absolutely clear
that the NASD will regulate compensation
paid to broker-dealers participating
in shelf offerings, including PIPE resale
registration statements. The broad definitions
contained in the proposals provide that
"participation" can include selling
securities in a principal transaction
(a selling shareholder) or an agency
(executing a trade in the normal course
for a retail customer) or any other
basis. It is certainly not clear what
the NASD means by the term "any other
basis."
Requiring a filing in the context of
an unsolicited agency transaction has
met substantial resistance from PIPE
practitioners and although addressed
in part by the proposal, serious concerns
remain. "These proposals represent
real progress, but they continue to
punish investment banks whose clients
also trade securities through the bank,"
says Joseph Smith, a partner with Feldman
Weinstein & Smith, who submitted
comments to the earlier proposals.
In general, an unsolicited agency transaction
such as when a retail customer calls
his broker to sell his stock that was
included to a PIPE resale registration
statement would be exempt from the 2710
filing under the Shelf Takedown Exemption
contained in the proposals, provided
that the broker earns no more than a
standard markup of 5%. However, that
same broker would have a difficult time
relying on the STE if it had received
placement agent warrants from the issuer
since those warrants would in most cases
be deemed to be "items of value" received
in connection with his "participation
in the public offering."
A related practical area of concern
not addressed by the proposals is when
the broker makes its 2710 filing and
discloses that it will earn a 5% markup
with respect to these ordinary trading
transactions. The NASD will typically
assume that the 5% commission will be
earned on the entire offering despite
the fact that the member may only have
brokerage accounts with a small minority
of selling shareholders listed in the
registration statement. This may be
problematic when the NASD values the
other compensation (e.g., placement
agent awards, rights of first refusal,
etc.) earned in connection with the
shelf offering.
Critics of the prior proposals also
voiced displeasure concerning the inability
of stocks of OTC Bulletin Board or Pink
Sheet issuers to qualify for an exemption
to avoid the 2710 filing. Previously,
a Market Transaction Exemption was only
available to NASDAQ or national exchange
issuers. Critics argue that this disparate
treatment would result in a substantial
increase in the cost of raising capital
to those who could least afford it.
Based on these comments, the MTE was
eliminated in the proposal and replaced
with the STE which is available to small
issuers. The STE includes provisions
respecting ordinary market transactions,
solicited agency transactions and principal
transactions that meet volume thresholds
based on Rule 144.
In addition, the STE would only be available
to issuers who have been reporting companies
under the Exchange Act for at least
90 days and are current in their reporting
requirements. Thus, an NASD member participating
in a shelf offering that is filled within
90 days of the consummation of an initial
public offering (including a company
becoming public through a reverse merger
transaction) would always be required
to make a 2710 filing to clear its compensation
prior to participating in such an offering.
The inherent difficulty that many member
firms will have in qualifying for the
STE apparently reflects the NASD's longstanding
view that shelf offerings present an
opportunity for abuse, thus justifying
the NASD's interest in reviewing compensation
earned by member firms in this space.
It is likely that the proposals will
continue to meet strong resistance from
smaller issuers and broker-dealers representing
this segment of the PIPE market since
shell offerings of larger issuers (known
as seasoned issuers and well know seasoned
issuers) will not generally be subject
to a Rule 2710 filing. While exemption
available to these larger issuers was
inherently necessary given the SEC's
securities offering reform amendments,
this will provide little consolation
to PIPE players who provide capital
to smaller issuers. "Once again, it's
the little guy that gets hurt," says
Brian Friedman, director for corporate
finance at National Securities Corporation,
an active PIPE placement agent. "The
filing requirements set forth in the
proposals will result in an increased
cost for small issuers looking to access
capital in one of the few markets available
to them."
While the Corporate Finance Rules are
designed to protect issuers from abusive
practices by underwriters, it remains
to be seen whether the proposals create
unnecessary complexities and burdens
for members in an area where the NASD
has yet to provide any empirical evidence
of abuse by its members. Stay tuned
to see how the SEC responds to the proposals.
