NASD Proposals to Curtail Abusive IPO Allocation Practices

The National Association of Securities Dealers ("NASD") has responded to recent high-profile incidents and allegations of abuses¹ in the allocation and distribution of securities by investment banks during initial public offerings ("IPOs") by proposing for comment a new rule governing the IPO allocation and distribution process that would prohibit abusive allocation arrangements, after-market tie-in agreements, and the practices of "spinning" and inequitably penalizing "flipping." The NASD has also proposed for comment amending the Corporate Financing Rule to allow the NASD to collect certain data on "spinning" and monitor IPO allocation practices.² IPO allocation and distribution practices continue to draw the attention of the federal government. Harvey Pitt, the Chairman of the Securities and Exchange Commission, recently requested the NASD and the New York Stock Exchange to review the IPO process, including allocation practices and the roles of issuers and underwriters in price setting and the offering process³ and the House Financial Services Committee is continuing with its high profile investigation of hot IPOs in the late 1990s.

The NASD intends the proposals to both aid member compliance efforts and help restore investor confidence in the IPO process, which the NASD views as critical to the success of the capital markets. The proposed rules are intended to supplement federal securities laws⁴ and existing NASD rules⁵ which already prohibit certain IPO allocation abuses, and are not intended to be construed as a safe harbor with respect to any such applicable laws and rules.

The proposed new rule – NASD Conduct Rule 2712 ("Rule 2712") – would prohibit certain conduct identified by the NASD as improper, and would require members to adopt procedures reasonably designed to ensure that the requirements and prohibitions of the rule are followed.

Rule 2712(a) would prohibit members from offering or threatening to withhold shares allocated in an IPO as consideration or inducement for the receipt of compensation that is excessive in relation to the services provided by the member. This provision would prohibit not only IPO allocations in return for inflated commissions, but also allocations in return for a "pay-up" for any service offered by the member.⁶

According to the NASD, this prohibition is not intended to interfere with legitimate customer relationships. By way of example, the NASD was careful to point out that it does not intend to prevent a member from allocating IPO shares to a customer simply because the customer has separately retained the member for other services, when the customer has not paid excessive compensation in relation to those services. Rather, since NASD Conduct Rule 2710 ("Rule 2710") already regulates underwriting compensation for an IPO and prohibits "unfair" or "unreasonable" compensation arrangements, it is believed that this proposal is intended to prevent underwriters from allocating IPO shares in return for excessive payment for other services.

Since the NASD did not define "excessive compensation," NASD members would be well-advised to ensure that separate services provided to customers likely to participate in IPOs are priced in a manner consistent with pricing practices applicable to customers generally. Where there is a departure from such pricing practices, associated persons of members should consult with the firm’s compliance or legal departments to ensure that appropriate documentation is generated to demonstrate that the pricing decision was unrelated to the customer’s participation in IPOs. Moreover, since proposed Rule 2712(a) regulates "compensation that is excessive in relation to the services provided by the member," it is unclear what effect proposed Rule 2712(a) will have on an IPO underwriter’s ability to provide further investment banking services to an issuer which obtains from the firm an allocation of IPO shares directed to its designees as part of a "friends and family program."

Rule 2712(b) would prohibit members participating in an IPO from requesting that a customer purchase shares in the aftermarket as a condition to being allocated shares in the IPO distribution. It should be noted that this rule would supplement existing SEC and NASD rules which already prohibit such agreements. For example, in August 2000, the SEC’s Division of Market Regulation issued Staff Legal Bulletin No.10, in which it explained that aftermarket tie-in agreements are a particularly egregious form of solicited transaction prohibited by Regulation M because "they undermine the integrity of the market as an independent pricing mechanism."

Rule 2712(c) would prohibit members from "spinning" IPO shares. This is the practice of allocating IPO shares to an executive officer or a director of a company on the condition that the officer or director direct the company’s investment banking business to the member. The provision would also prohibit an IPO allocation to an executive officer or director as consideration for investment banking services previously rendered.

According to the NASD, the practice of "spinning" divides the loyalty of these agents from their companies and is inconsistent with just and equitable principles of trade. Nevertheless, according to the NASD, this proposal should not be construed as precluding a member from allocating IPO shares to a customer merely because the customer is an officer or director of a company.

Rule 2712(d) would prohibit members from penalizing registered representatives whose customers have "flipped"⁷ IPO shares that they have purchased through the member, unless a penalty bid⁸ , as defined in Rule 101 of Regulation M, has been imposed. The provision seeks to address the problem of members penalizing their registered representatives in connection with flipping by retail customers, even when the managing underwriter has not imposed a penalty bid on the syndicate members.

According to the NASD, the practical effect of this practice is that registered representatives are penalized, and their retail customers may be pressured to retain their long position in the IPO shares, while representatives for institutional customers are generally not penalized at all for their flipping activity. The NASD believes Rule 2712(d) would better ensure a level playing field by prohibiting NASD members from penalizing registered representatives whose retail customers have "flipped" IPO shares when similar penalties have not been imposed with respect to institutional accounts.

Rule 2712(e) requires members that engage in IPO allocations or distributions to adopt and implement written procedures reasonably designed to ensure that the member and its employees comply with the provisions of Rule 2712.⁹

Rule 2710, otherwise known as the Corporate Financing Rule, regulates the total amount of underwriting compensation the "underwriter and related persons" may receive in connection with a public offering.¹⁰ To enable the NASD to perform its examination of an offering’s under-writing terms, Rule 2710 presently requires members to file offering documents, including registration statements, underwriting agreements, and various other supplemental materials with the NASD’s Corporate Financing Department which then reviews the underwriting terms and arrangements for the offering.

In addition to the existing filing requirements, the NASD’s proposed amendments to Rule 2710 would require members to file a statement regarding whether any executive officer or director of the issuer acquired from the book-running managing underwriter of the public offering any shares in an IPO during the 180 day period immediately preceding the required filing date of the offering. Members would also be required to file such a statement if the executive officer or director acquires from the book-running managing underwriter any shares in an IPO within the 180 day period after the effective date of the offering. According to the NASD, this additional filing is required to assist its staff in monitoring the possibility of improper allocations being made to executive officers or directors in violation of proposed Rule 2712(c) and to alert the staff to abusive allocations that violate pro-posed Rule 2712(a).

The proposals must be formally submitted to and approved by the Securities and Exchange Commission ("SEC") before becoming effective.

© 2002 Paul, Hastings, Janofsky & Walker LLP