Davis Polk & Wardwell

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1 Davis Polk & Wardwell Memorandum for: Interested Persons 450 Lexington Avenue New York, N.Y Re: NASD Shelf Proposal December 15, 2004 The NASD s new shelf proposal has been published by the SEC for comment 1. The proposal entails amendments to NASD Rule 2710 (the "Corporate Financing Rule" or the "Rule") as well as minor amendments to Rules 2720, 2810, IM and Schedule A to the NASD By-laws. The NASD views the proposal as providing a more streamlined automated process by which NASD members will be cleared to participate in shelf offerings subject to the filing requirements of the Corporate Financing Rule. The proposal relates primarily to procedural changes for filing and approval of offerings subject to review by the Corporate Financing Department under the Rule. Most shelf offerings are exempt from filing under the Rule 3 and are therefore not affected by these changes. The proposal does not modify the existing exemptions from the filing requirements. Unfortunately, the proposal does not address problems that seasoned issuers, subject to the filing requirements because of Rule 2720, encounter in trying to satisfy the information requirements of the Rule. With respect to offerings required to be filed under the Rule, the biggest change is the requirement that, under certain circumstances, members obtain approval to participate in a shelf takedown immediately preceding the offering, notwithstanding the fact that a filing with respect to the shelf has already been made and approved by the NASD. As a result, certain seasoned issuers may not have the quick access to the market contemplated by the recent SEC securities offering reform proposals Fed. Reg (December 7, 2004), SEC Release No , available on the SEC website at 2 Rule 2720 regulates offerings in which a distribution participant is an affiliate of or has a conflict of interest with a member. Rule 2810 regulates direct participation programs. IM is the Mark-up Policy. 3 Exemptions from filing are available for shelf offerings of investment grade nonconvertible debt or preferred, offerings of issuers that have certain investment grade debt or preferred outstanding and offerings of issuers that have been reporting under the 34 Act for three years and have the requisite public equity float unless, in each case, the offering is subject to Rule Rule 2720 applies when a broker-dealer that is affiliated or has a conflict of interest with the issuer participates in the offering. These exemptions are set forth in more detail in Exemptions from Shelf Filing Requirements on page 5.

2 There are portions of the proposal that will affect offerings whether or not subject to review under the Corporate Financing Rule. For example, there is a provision that describes how to calculate the underwriting discount for transactions for which there is no distribution agreement or when the agreement is silent as to the underwriting discount, as could be the case in at-the-market offerings. Existing Filing Procedure. Currently, a shelf registration statement subject to review under the Rule is required to be filed by the issuer or a prospective underwriter at the time the registration statement is filed with the SEC. The filing requires, among other things, disclosure of all items of value, including securities, acquired by underwriter and related persons in the 180-day period preceding the filing. The review can take as little as two weeks or last several months. Upon approval of the filing, a conditional no objections letter is issued. The no objections letter is conditioned upon the subsequent filing of (i) all amendments or supplements to the registration statement, (ii) a list of distribution participants at the time of each takedown along with information as to items of value acquired by such participants and their affiliates in the 180-day period preceding the offering 4 and (iii) any modifications to the underwriting terms and arrangements previously filed. Once the no objections letter is received, clearance is not required prior to any offering off the shelf unless there is a change in the underwriting terms and arrangements that would make reliance on the no objections letter inappropriate. Takedowns can occur without pre-clearance whether or not members intending to participate in the offering were disclosed in the initial filing. The no objections letter is good for the life of the shelf, subject to the limitations stated above (e.g., material change in underwriting terms that impacts clearance). Proposed Filing Procedure. Unlike the existing procedure, under the proposal, a no objections letter will be granted to an individual member rather than to the shelf as a whole. To effect this change, the proposal contemplates two kinds of filings by members. Initial filings. The initial filing appears to have the same substantive requirements as the initial filing under the existing procedure described above. An initial filing can be made by one or more members or the issuer. The proposal states that clearance will be granted to every member that has "entered into an underwriting agreement at the time the initial filing is made. Since no underwriting agreement can be entered into prior to the issuance of the no objections letter, we believe the NASD intends to issue no objections letters to members named in the registration 4 While the existing Rule appears to require disclosure of the receipt of items of value 180 days before filing the registration statement, many practitioners have been reporting items of value received 180 days before the offering, which is required under the proposal. 2

3 statement or members that execute the underwriting agreement reviewed in connection with the initial filing. However, the mechanics of how this will be achieved are hazy. A no objections letter issued to a member in connection with the initial filing is valid for the life of the shelf, assuming the maximum amount of underwriting compensation payable is approved and disclosed in the offering document 5, unless there is a material change in the terms of the member's participation. Examples of material changes include (i) receipt by the member or its affiliate of items of value subsequent to the initial filing that constitute underwriting compensation and (ii) development of a conflict of interest between the issuer and the member. Subsequent filings. A subsequent filing will be required of a member not cleared for participation in the initial filing or by a member cleared initially, the terms of whose participation have materially changed, as described above. This approach is a significant change from the existing procedure. Members that did not participate in the first offering off the shelf will have to wait to be approved until they can participate in a subsequent offering. The NASD has suggested that there will be expedited review of subsequent member filings if the shelf meets certain eligibility criteria but not if a qualified independent underwriter is required as the result of such member's participation. These criteria are not set forth in the proposal. Even if there is expedited review, a member may be unable to obtain clearance prior to a takedown because there may be insufficient time for the member to collect information as to items of value it or its affiliates have received from the issuer in the 180 days preceding the takedown. As a result, the takedown may have to be delayed. Market Transaction Exception. ("MTE") The proposal notes that members have been unclear whether a shelf is required to be filed under the Rule when it is expected that members will only sell a small amount of securities off the shelf or will only execute unsolicited transactions in the securities. In response, the NASD proposes to modify the definition of participation in a public offering to include participation in an offering on a principal or agency basis but to exclude participation in offerings that meet the MTE. This exception is available for unsolicited transactions in securities off a shelf that do not exceed the greater of 2% of the ADTV for the security or 10,000 shares for a given day. MTE is not available for a member affiliated with the issuer or that has a conflict of interest with the issuer. Additional limitations on the exception are contained in the proposal. 5 Currently, the NASD requires that the base prospectus or prospectus supplement state that underwriting compensation will not exceed 8% of gross offering proceeds. 3

4 Underwriting Compensation. Calculation when no distribution agreement or no relevant provision in distribution agreement. The proposal includes a provision that describes how to calculate the underwriting discount in transactions for which there is no distribution agreement and transactions governed by a distribution agreement that does not state the discount. This provision is applicable to all shelf offerings (i.e., whether or not subject to the filing requirements of the Rule). In a principal transaction, when the discount from the public offering price is not set forth in an agreement or the transaction is not governed by an agreement, it is proposed that the underwriting discount will be the difference between the purchase price of securities off the shelf and their resale price. In a principal transaction relating to a security for which there is a bona fide independent market, as defined in Rule 2720, or an actively traded security under Regulation M, the discount or commission is proposed to be the difference between the purchase price and (i) the prevailing market price in the principal market at the time of purchase, as calculated by reference to the Mark-Up Policy (IM-2440) or (ii) the initial resale price, as long as the amount of securities purchased in the takedown (a) is at least $10 million but no more than $50 million and at least 50% of the securities are sold at the initial resale price or lower prices or (b) exceeds $50 million and at least 25% of the securities are sold at the initial resale price or lower prices. This formulaic approach could be problematic in offerings made at the market. Definition of underwriter and related person. This term currently includes members, their affiliates and associated persons as well as underwriter s counsel, financial consultants and advisors. Under the proposal, any person that receives an item of value that would be considered underwriting compensation will also be included in the definition. Thus, for example, a business consultant to the issuer who acquired unregistered securities of the issuer in the 180-day period preceding the filing of the issuer s registration statement or a shelf takedown could be deemed an underwriter related person. The value of the consultant s securities would be aggregated with the compensation of the distribution participants to determine total underwriting compensation. This will cause significant problems both for shelf and non-shelf offerings. This approach is inconsistent with the goal of this year s sweeping changes to the Corporate Financing Rule, which was to replace the staff s subjective determination as to what constitutes underwriting compensation with a bright line test. Other Issues. Exemptions from Shelf Filing Requirements. Exemptions from the filing requirements of the Corporate Financing Rule are available for shelf offerings if the securities offered are (i) investment grade rated non-convertible debt or preferred securities, (ii) securities of an issuer that has investment grade rated non-convertible debt or preferred securities outstanding that meet the 4

5 requirements of Rule 2710(b)(7)(A) 6 or are (iii) registered with the SEC on Forms S-3 or F-3 and meet the eligibility criteria for those forms in effect prior to October 21, 1992 (the "old S-3/F-3 eligibility criteria"). 7 NASD Rejects Exemption for all S-3/F-3 Shelf Offerings. In the proposal, the NASD makes it clear that it will not provide an exemption from the filing requirements for offerings eligible to use Form S-3 or Form F-3 (i.e., delete the requirement that the issuer meet the old S-3/F-3 eligibility criteria). Their position is that criteria that determine which SEC form an issuer can utilize should not be the basis for an exemption from the NASD filing requirements. The NASD took this position prior to publication of the SEC securities offering reform proposals that would permit automatic registration of shelf offerings of well-known seasoned issuers ( WKSIs ). It is hoped that the NASD will rethink this exemption in light of the SEC proposal. NASD Rejects Limited Review of Offerings Subject to Rule Many seasoned issuers (including issuers that exceed the WKSI size requirement) that meet the exemptions from the NASD filing requirements are nonetheless required to file their shelf offerings because they fall within Rule Rule 2720 is applicable to offerings in which a distribution participant is an affiliate of or has a conflict of interest with the issuer. These issuers commonly include financial conglomerates that have a broker-dealer in their chain of ownership. If the broker-dealer affiliate would like to participate in the parent company s shelf offering, the entire offering is subjected to a full review under the Rule. Thus, for example, in connection with a shelf offering of a foreign holding company owning a bank and several broker-dealers, some of which are participating in offerings off the shelf, all prospective distribution participants would have to disclose whether they, their affiliates or associated persons acquired the issuer s unregistered securities in the 180-day period preceding the filing of the issuer s shelf registration statement, including securities issued under Rule 144A and securities issued outside the United States. This is because unregistered securities constitute items of value under the Rule and all items of value must be disclosed to the NASD under the filing requirements. These requirements can be very difficult to satisfy 6 The exemption from filing is available for securities offered by a corporate, foreign government or foreign government agency issuer that has unsecured non-convertible investment grade rated debt with a term of issue of at least 4 years or unsecured non-convertible investment grade rated preferred securities. 7 Generally, the old S-3/F-3 eligibility criteria require that the issuer has filed reports under the 34 Act for three years and has a specified public equity float. For domestic issuers, the aggregate market value of the issuer s voting stock held by non-affiliates must be $150 million or, alternatively, $100 million if the stock has had an annual trading volume of three million shares. For foreign issuers, the aggregate market value worldwide of the issuer s voting stock held by non-affiliates must be $300 million. Also exempt are offerings registered on Form F-10 of Canadian foreign private issuers that have reported under Canadian reporting requirements for three years and whose outstanding equity has an aggregate market value of (CN) $360 million. 5

6 It has been suggested to the NASD that they limit their review solely to conflicts of interest in connection with shelf offerings required to be filed under the Rule only because they fall within Rule 2720 (i.e., offerings of issuers that have filed reports under the 34 Act for more than three years, which offerings are registered on Forms S-3 or F-3 and in which a broker-dealer affiliate of the issuer will participate). Issues of underwriting compensation, and the corresponding information requirements, would be eliminated. Without the delay of a lengthy NASD review, these issuers could have the quick access to the market contemplated by the SEC offering reform proposals. However, the NASD appears to have rejected this suggestion. NASD Rejects Exemption for Shelf Offerings of Sovereign Issuers. In the proposal, the NASD rejects the suggestion to exempt offerings of foreign sovereigns on a delayed or continuous basis. These offerings are registered on Schedule B rather than Form F-3 so do not fall within the exemption under the Rule. * * * It is expected that these issues will be brought to the SEC s attention in the comment process. The deadline for comments on the proposal is January 25, Should you have any questions with regard to the foregoing, please do not hesitate to contact me at Marcie Goldstein 2004 Davis Polk & Wardwell 6