SEC posts FINRA proposal to amend NASD Rule 2720 re conflicts of interest

By Cydney Posner

The SEC has posted a FINRA proposal to modernize and simplify NASD Rule 2720 (Distributions of Securities of Members and Affiliates – Conflicts of Interest), which governs public offerings of securities in which a member with a conflict of interest participates, and to make corresponding changes to FINRA Rule 5110 (Corporate Financing Rule). The proposed rule change would replace the current rule in its entirety and be renamed "Public Offerings of Securities With Conflicts of Interest."

Rule 2720 regulates, among other things, the pricing and conduct of due diligence for public offerings in which a member or any of its associated persons or affiliates has a conflict of interest. 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 specified exemptions or a qualified independent underwriter ("QIU") participates in the offering. Under the proposal, a conflict of interest would exist:

• If the securities are to be issued by the member;
• If the issuer controls, is controlled by or is under common control with the member or the member’s associated persons (including a revised definition of "control");
• Where at least 5% (lowered from 10%) 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) (i.e., with participating members viewed individually, not in the aggregate with all other unaffiliated participating members); or
• 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.

Some of the other more significant amendments that FINRA is proposing in this proposed rule change are to:

• Exempt from the filing and QIU requirements
  • public offerings of investment grade-rated securities (securities that are rated by one of those crack, highly reliable nationally recognized statistical rating organization in one of its four highest generic rating categories),
  • public offerings of securities that have a bona fide public market (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), and
  • public offerings in which the member (or members, in the case of co-managers) 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;
• Modify the rule’s disclosure requirements to provide more prominent disclosure of conflicts of interest in the offering documents; Delete the separate Rule 2720 requirements for corporate governance and periodic reporting as unnecessary in light of SOX and recent SEC requirements;
• Amend the rule’s provisions regarding the use of a QIU to focus on the QIU’s due diligence responsibilities and eliminate the requirement that the QIU render a pricing opinion,
  • e.g., 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 a filing would be required (even if otherwise exempt under the filing requirements), and a QIU would be required to participate in the preparation of the registration statement and the prospectus, offering circular or similar document and to exercise the usual standards of "due diligence" with respect to that document;
• Delete the separate Rule 2720 requirements for corporate governance and periodic reporting as unnecessary in light of SOX and recent SEC requirements; and
• Amend the definition of QIU to require that
  • the member must not have a conflict of interest or be an affiliate of any member that has a conflict of interest (including a prohibition on receiving more than 5% of the offering proceeds),
  • the member cannot beneficially own, as of the date of the member’s participation in the public offering, more than 5% 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, cannot be an affiliate of the issuer or beneficially own 5% or more of the equity, subordinated debt or partnership interest of the issuer,
  • the member must 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,
  • the member must 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 (eliminating a requirement for experience by the board of directors), and
  • 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 cannot have certain criminal or disciplinary histories within the preceding 10 years (a change from the current five years).

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