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 PIPES Reports article
on NASD proposed rules regarding resales.
December 15, 2004.
Pre-Clearing
the Order: NASD Proposes Rules for PIPE
Offering Resales
by
Joe Gose
The
National Association of Securities Dealers
filed a long-anticipated proposed rule
change on November 29 that would require
brokers to clear commissions with the
NASD before they execute trades on behalf
of PIPE investors. The proposals specifically
amends Rule 2710--known as the Corporate
Financing Rule--in an effort to enforce
limits on compensation. The rule changes
would generally affect illiquid securities,
particularly those traded on the OTCBB
and Pink Sheet markets.
The proposal stems from the NASD's concern
that some placement agents are collecting
compensation in excess of the 8% cap
imposed on stock offerings. They do
this by generating revenue through three
separate vehicles in conjunction with
a private placement: collecting fees
for underwriting the PIPE, collecting
a spread by acting as a principal market
maker, and collecting commissions by
acting as the only broker for resales.
The NASD wants to aggregate that compensation
when determining whether a placement
agent has exceeded the cap.
Mere discussion of the proposed changes
to Rule 2710 has created dismay among
private placement players for several
months. Now that the suggested changes
have been officially announced, PIPE
participants are criticizing the proposal
on several different fronts. They warn
that the changes will prevent investors
from selling thinly-traded, volatile
shares in a timely manner, which will
eventually choke the flow of capital
to issuers.
Investor counsel Kreifer & Prager
fired off its comments to the Securities
and Exchange Commission on December
13, and among other items, argued that
the NASD had failed to make its case
for the changes. "NASD has provided
no empirical evidence as to any abuses
with respect to the matters addressed
by the proposed Rule change," the comment
letter states. Later, it continues,
"We believe that if the concern is solely
regarding excessive compensation, the
proposed rule should apply only if the
participating member, acting as the
broker for the selling securities holder,
has entered into an underwriting distribution,
equity line or other agreement with
the issuer with respect to the sale
of securities offered."
Joseph Canouse, president of the general
partner of Cache Capital, posted the
proposal's first assessment with the
Securities and Exchange Commission,
which is taking comments for 21 days
after the filing appears in the Federal
Register. Canouse maintains that the
suggested changes are over-reaching.
"This rule will seriously damage the
only real secondary market that is viable
today--mainly PIPE transactions," Canouse
writes. "In doing so it will also hurt
the many public companies that depend
on this financing in order to survive
the subsequently their shareholders
and employees."
Joseph Price, vice president of corporate
financing at the NASD and the primary
author of the proposal could not be
reached for comment. However, Price
delivered a thumbnail sketch of the
proposal at The PIPEs Conference in
October and encouraged comment in the
rulemaking process while defending the
NASD's actions against critics. "Shelf
offerings present an opportunity for
manipulation, in the sense you're taking
shares down, you can sell them at various
priceshow you got the shares and resale
registration statements I think present
a lot of issues," he said at the time.
"I think theres a lot of legitimate
regulatory interest from the NASD here."
Future Filing Frenzy
Rule 2710 primarily regulates the amount
of fees underwriters can charge issuers
for public offerings, and underwriters
and placement agents are required to
seek NASD approval of the compensation
before completing a deal. Placement
agents are not required to pre-clear
fees eared in PIPEs and that remains
the case under the proposed reforms.
The proposed changes to Rule 2710 took
toot in 2001 in an effort to clarify
issues surrounding compensation related
to shelf offerings. The offerings, which
are considered public distributions
required brokers or NASD members
to receive NASD approval for fees before
executing trades, and that approval
often took weeks. After discussing potential
changes to the rule and seeking feedback
from its members, the NASD released
the current proposal, which in its view
"amends NASD's Corporate Financing Rule
to provide greater clarity regarding
when to making filings for shelf offerings
while also ensuring that such filing
requirements do not undermine the flexibility
intended by the shelf registration process,"
according to the proposals text.
The NASD, however, now has determined
that registered resales resulting from
a PIPE are public distributions; heretofore
investors and brokers have treated the
registered resales as ordinary sell
orders. Thus, with a few exceptions,
under the new rules all members who
receive orders to trade registered resale
shares from a PIPE -- even if brokers
were not involved in facilitating the
placement -- would be required to first
clear their fees with the NASD before
they could execute the trades. The NASD
is proposing to introduce three filing
classifications: Issuer Filings, under
which an issuer can file and pay all
associated costs, Initial Member Filings,
and Subsequent Filings.
Heres how the NASD sees the system
working: before a member participates
in a trade that is subject to a filing
requirement, the member would review
the NASDs online filing application,
known as COBRADesk, to determine whether
an initial filing already has been made.
If not, the broker makes the initial
filing and pays the associated fees
(unless the issuer has already done
so). The NASD review the filing, which
could take several days or weeks, and
approves it by rendering a "no-objections"
opinion.
According to the proposed rule, that
clearance will last for the "life of
the shelf," provided the shelf registration
statement "discloses a maximum amount
of underwriting compensation that will
not be exceeded by participating members
in takedowns," and that there is no
material change to the information that
NASD relied upon to issue the no-objections
opinion.
Generally, if an initial filing has
been made but the member has not yet
been cleared for the shelf takedown,
then the broker makes a subsequent member
filing. In that case, NASD says it will
develop an automated review and clearance
process (ARC), which should provide
a no-objections opinion in 24 hours.
PIPE experts, however, have concerns
about the NASD's technological ability
in general, and in particular, they
note that ARC is not yet in place. According
to comments submitted by Krieger &
Prager, "If the Commission decides to
approve the proposed rule change in
whole or in part it should delay the
effectiveness until such automated system
is in place, has been actually tested,
and NASD has sufficient trained personnel
to administer the system."
Discrimination?
The rule changes would most affect stocks
listed on the OTCBB and Pink Sheets,
which have accounted for 41% of all
PIPE activity since 2001, according
to Private Raise, NASD is proposing
that brokers, on a daily basis, may
bypass the pre-clearance rules if they
are selling stocks listed on Nasdaq
or a national securities exchange, and
if the trade represents no more than
2% of the issuers average daily trading
volume.
In its comments to the SEC, however,
Krieger & Prager argue that such
an exemption is discriminatory, "By
making the rule mandatory for all OTCBB
transactions, NASD is able to discourage
listings on the OTC Bulletin Board and
require issuers to list on the Nasdaq
Stock Market with all its attendant
higher costs and listing fees."
Moreover, the 2% figure is unrealistic
for PIPE investors, who often trade
more than 2% on a given day as they
liquidate their holdings, says Joseph
Smith, a partner with Feldman Weinstein.
He illustrates this scenario: in the
event a broker has yet to secure a no-objections
opinion, investors who want to trade
more than 2% would have to move shares
out of their main account and split
them among other brokers. Of course,
that could create conflicts between
investors and brokers. And if that remedy
fails, Rule 144 or 144A may be the only
exit strategy for investors, he adds.
Obviously, investors in OTCBB or Pink
Sheet companies potentially face a more
dismal scenario. For example, in an
initial filing has been made on a particular
issue, a broker who has received an
order to trade those securities but
who has yet to file for pre-clearance
with the NASD would file electronically
for subsequent approval. Although the
NASD predict it will issue a no-objections
opinion in 24 hours to subsequent filers,
thats more than enough time for any
upside in highly volatile and thinly-traded
securitiesor any security, for that
matterto vanish.
In addition to providing an exception
for stocks listed on the NASDAQ or a
national exchange, the NASD's proposal
also would generally exempt from the
pre-clearance rules seasoned issuers
that meet certain conditions. According
to NASD S Price, the association had
originally sought to include the same
exemptions from OTCBB stocks but was
rebuffed by SEC staff, which insisted
on requiring pre-approval of all resales
from offerings of OTCBB and Pink Sheet
companies.
Soaking Issuers
Some PIPE experts already have started
planning for the proposed changes even
while pushing for major revisions --
if not an outright withdrawal -- of
the reforms. Smith, for example,
says he'll advise investors to start
pulling onus on issuers to pre-clear
resales. Under a best-case scenario,
issuers would make the filing with the
NASD at the same time they submit their
registration statement to the SEC. trades
and potential brokers would then be
pre-cleared (brokers would still have
to make a simplified filing) before
or as the registration statement is
declared effective.
Still, Smith says, the price that issuers
will end up paying for the suggested
rule changes is going to be high compared
with any benefits. Like other critics,
he predicts the rules will simply make
it tougher and more expensive for OTCBB
and Pink Sheet issuers to raise capital.
"What I find ironic is that everything
the NASD does here to protect public
companies from being plundered by brokers,"
Smith says. "But if this goes through,
it's just going to create a new layer
of things to do and more transaction
costs, which will end up being changed
against the issuers."
