Number 1069 August 5, 2010 Client Alert Latham & Watkins Corporate Department New FINRA Rule 5141 to Replace Current Papilsky Rules Relating to the Sale of Securities in Fixed Price Offerings However, in addition to modifying policies and procedures to reflect the provisions of the new rule and the elimination of certain of the requirements of the old Papilsky Rules, members should also be reviewing their underwriting agreements and related documents to make appropriate changes. On July 21, 2010, the Securities and Exchange Commission approved a proposal by the Financial Industry Regulatory Authority, Inc. (FINRA and formerly, the National Association of Securities Dealers, Inc. or NASD) to delete current NASD Rules 2730, 2740 and 2750 (commonly known as the Papilsky Rules) and adopt in their stead new FINRA Rule 5141. 1 NASD Rule 0120(h), which defines the term fixed price offering for purposes of the Papilsky Rules, and associated NASD interpretive materials set forth in IM-2730, IM-2740 and IM-2750 are also being eliminated in connection with the adoption of FINRA Rule 5141. 2 FINRA has not yet indicated the effective date for the new rule. Background The stated purpose of the Papilsky Rules was to protect the integrity of fixed price offerings by ensuring that securities in such offerings are sold to the public at the stated public offering price or prices, thereby preventing an undisclosed better price. 3 The Papilsky Rules were designed to prevent FINRA members from discounting the price of securities sold in a fixed price offering below the stated public offering price or prices. In particular, the Papilsky Rules provided that: FINRA members who purchase or arrange for the purchase of securities taken in trade in a fixed price offering must purchase (or arrange for the purchase of) the securities taken in trade at a fair market price at the time of purchase. (NASD Rule 2730). 4 FINRA members may not grant any selling concessions, discounts or other allowances in connection with a fixed price offering to anyone other than a broker or dealer that is participating in the distribution of the offering. (NASD Rule 2740). 5 FINRA members may not retain securities sold in a fixed price offering for their own accounts or sell such securities to certain of their affiliates or related persons unless the member has made a bona fide offering of the securities to the public and has been unable to sell the securities in such offering at the stated fixed price. (NASD Rule 2750). 6 New FINRA Rule 5141 FINRA Rule 5141 will replace certain outdated requirements of the Papilsky Rules and simplify their provisions while still preserving the primary purpose of the original rules (i.e., protecting Latham & Watkins operates worldwide as a limited liability partnership organized under the laws of the State of Delaware (USA) with affiliated limited liability partnerships conducting the practice in the United Kingdom, France, Italy and Singapore and an affiliated partnership conducting the practice in Hong Kong and Japan. Latham & Watkins practices in Saudi Arabia in association with the Law Office of Mohammed Al-Sheikh. Under New York s Code of Professional Responsibility, portions of this communication contain attorney advertising. Prior results do not guarantee a similar outcome. Results depend upon a variety of factors unique to each representation. Please direct all inquiries regarding our conduct under New York s Disciplinary Rules to Latham & Watkins LLP, 885 Third Avenue, New York, NY 10022-4834, Phone: +1.212.906.1200. Copyright 2010 Latham & Watkins. All Rights Reserved.
the integrity of the fixed price offering process). Specifically, as approved by the SEC, FINRA Rule 5141 provides that no FINRA member that: participates in a selling syndicate or selling group or that acts as the single underwriter in connection with a fixed price offering shall offer or grant, directly or indirectly, to any person or account that is not a member of such selling syndicate or selling group or that is a person or account other than the single underwriter any securities in the offering at a price below the stated public offering price (reduced price). 7 FINRA Rule 5141(b) states, however, that this general prohibition will not impact the ability of members of a selling syndicate or selling group to purchase and sell securities in the offering among themselves. Moreover, dispensing with the prohibition currently contained in NASD Rule 2750, new FINRA Rule 5141 expressly permits (subject to the restrictions contained in FINRA Rule 5130) 8 a single underwriter or member of the selling syndicate or selling group to sell securities in the offering to an affiliated person so long as the affiliated person purchases the securities at the fixed public offering price and not at a reduced price. 9 Supplementary material provided in respect of FINRA Rule 5141 clarifies that the term reduced price includes, without limitation, the offer or grant of any selling concession, discount or other allowance, credit, rebate, reduction of any fee (including any advisory or service fee), any sale of products or services at prices below reasonable commercially available rates for similar products and services... or any purchase of or arrangement to purchase securities from the person or account at more than their fair market price in exchange for securities in the offering. 10 The new rule continues to provide an exception with respect to the provision of research. In particular, FINRA Rule 5141 will not prevent a member from selling securities in a fixed price offering to a person or account to which it has provided research so long as the recipient of the research pays the stated public offering price for the securities and the research is provided pursuant to the requirements of Section 28(e) of the Securities Exchange Act of 1934. 11 The new rule also provides guidance to FINRA members that also serve as investment advisers, noting that such a member may exempt securities that are purchased as part of a fixed price offering from the calculation of annual or periodic asset-based fees that such member charges to a customer, provided such exemption is part of the member s normal and ordinary course of business with the customer and is not in connection with an offering. 12 Although the new rule does not address the alternative practice employed by certain participating members whereby two fixed public offering prices are disclosed one price that includes the full underwriting discount and a second price that excludes all or a portion of the underwriting discount and is applicable to those purchasers who already pay asset-based fees to the selling member it would appear that this alternative practice should also continue to be permitted under the new rule provided the multiple fixed prices are adequately disclosed in the prospectus or other offering document. Practical Impact of the Rule Change FINRA has not yet indicated the implementation date for new FINRA Rule 5141. However, in addition to modifying policies and procedures to reflect the provisions of the new rule and the elimination of certain of the requirements of the old Papilsky Rules, 2 Number 1069 August 5, 2010
members should also be reviewing their underwriting agreements and related documents to make appropriate changes. Significantly, unlike NASD Rule 2740(c), FINRA Rule 5141 does not require members to obtain the written agreement of non-us broker-dealers participating in a fixed price offering to comply with the provisions of the Papilsky Rules and NASD Rule 2420. 13 FINRA Rule 5141 also does not require members to make quarterly filings with FINRA with respect to designated sales, nor does it require specific records to be kept and maintained by members that are designated by their customers to receive selling credit as now required by NASD Rule 2740 (although FINRA does note that such members remain subject to other applicable FINRA and SEC recordkeeping requirements). 14 Moreover, new FINRA Rule 5141 may permit the establishment of certain referral and advisory arrangements previously thought to be prohibited by the literal words of current NASD Rule 2740. In particular, outside the parameters of an interpretive letter issued by FINRA (then NASD) staff in 2003, 15 most referral and advisory arrangements between a FINRA member that was participating in a fixed price offering and another entity that was not itself a broker-dealer that was also participating in the offering were thought to be impermissible under NASD Rule 2740 since the arrangement, if it involved the payment of compensation based on or tied to the amount of compensation received by the FINRA member in the fixed price offering, could be viewed as the grant (or sharing) of a concession or other allowance in connection with the fixed price offering. It now appears, however, that such an arrangement would not be prohibited by new FINRA Rule 5141, provided it does not, directly or indirectly, confer a reduced price in respect of any securities purchased or sold in the offering, and, accordingly, should be permissible to the extent the terms of the arrangement are not inconsistent with NASD Rule 2420 (or, assuming it is ultimately adopted, proposed FINRA Rule 2040) or any other applicable laws, rules and regulations. Finally, it is worth noting that new FINRA Rule 5141 provides that the prohibition with respect to selling the offered securities at a reduced price applies only until the termination of the offering or until a member, having made a bona fide public offering of the securities, is unable to continue selling such securities at the stated public offering price. 16 This language should preserve the ability of underwriters to change the initial offering price shown on the cover of the prospectus from time to time if they are unable to sell all the offered securities at such initial fixed offering price and, in connection with under-subscribed offerings, should continue to permit underwriters to place securities they are unable to sell to the public in the offering in an investment account or with an affiliate without running afoul of the rule. 17 Accordingly, new FINRA Rule 5141 should not change customary practices in connection with sticky deals. 3 Number 1069 August 5, 2010
Endnotes 1 See SEC Release No. 34-62539; File No. SR-FINRA-2010-029 (July 21, 2010). NASD Rules 2730, 2740 and 2750 are generally referred to as the Papilsky Rules because of the court decision with which they are often associated, Papilsky v. Berndt, Fed. Sec. L. Rep (CCH) 95,627 (S.D.N.Y. June 24, 1976). FINRA issued a notice to its members relating to the proposed rule on August 4, 2009 and originally submitted the rule proposal to the SEC shortly thereafter, but then withdrew it for technical reasons in November 2009. The proposed rule was re-submitted to the SEC, without substantive change, on May 27, 2010. See FINRA Regulatory Notice 09-45 (August 2009) (FINRA Notice 09-45); SEC Release No. 34-62299 (June 16, 2010) (the Proposing Release). 2 The definition of fixed price offering is now set forth in the supplementary materials to FINRA Rule 5141 and is essentially unchanged from the definition currently set forth in NASD Rule 0120(h). As so defined, the term fixed price offering refers to securities publicly offered (in whole or in part) in the United States at a stated offering price or prices. See FINRA Rule 5141.04. The term includes offerings registered in the United States under the Securities Act of 1933, as well as offerings that, although public, are not required to be registered under the Securities Act pursuant to an applicable exemption (e.g., bank securities offered pursuant to Section 3(a)(2) of the Securities Act). The term, however, does not include offerings of securities that are privately placed or offered and sold pursuant to Rule 144A under the Securities Act. It is also important to note that the term fixed price offering does not prohibit multiple price offerings so long as the different fixed prices are adequately disclosed. See Proposing Release; NASD Notice to Members 81-3. 3 FINRA Notice 09-45. 4 NASD Rule 2730 was intended to prevent members from paying a higher price for the securities taken in trade, thereby lowering the purchase price of the securities purchased by the investor in the fixed price offering. 5 The purpose of NASD Rule 2740 was to prevent members from granting discounts to favored investors, such that those investors would be able to purchase securities in the offering at a lower price than other investors. 6 NASD Rule 2750 was intended to prevent purchasers from obtaining a discount through the establishment of an affiliated broker-dealer that would receive designated selling credit for the sale. 7 FINRA Rule 5141(a). 8 FINRA Rule 5130 generally prohibits FINRA members from selling equity securities offered in initial public offerings to certain restricted persons (a term which includes, among others, broker-dealers and certain persons having a beneficial interest in a broker-dealer). 9 FINRA Rule 5141.03 provides that ordinary course transactions between a member and its affiliates that are unrelated to the purchase or sale of securities in a fixed price offering will not be deemed to confer a reduced price under the rule. 10 FINRA Rule 5141.01. 11 FINRA Rule 5141.02. 12 FINRA Rule 5141.05. 13 The adoption of FINRA Rule 5141 does not impact existing NASD Rule 2420 (Dealing with Non-Members), although such rule is the subject of another pending FINRA rule proposal. See FINRA Regulatory Notice 09-69 (December 2009) (proposing, among other things, to delete current NASD Rule 2420 and replace it with new FINRA Rule 2040) (FINRA Notice 09-69). Also note that current NASD Rule 2420(c) continues to require an agreement by any non-us broker-dealer that receives a selling concession, discount or other allowance from a FINRA member to agree to the restrictions set forth in the rule as if it were itself a FINRA member in respect of any sales of securities it makes to persons in the United States. The FINRA proposal discussed in FINRA Notice 09-69 would eliminate this requirement and further simplify the provisions of existing NASD Rule 2420. In particular, if adopted as proposed, new FINRA Rule 2040 would (in pertinent part) prohibit members from, directly or indirectly, paying or offering to pay any compensation, fees, concessions, discounts, commissions or other allowances to... any person that is not registered as a broker-dealer under Section 15(a) of the Exchange Act but, by reason of receipt of any such payments, is required to be so registered under applicable federal securities laws and [Exchange Act] rules, regulations and published guidance issued by the SEC or its staff in the form of releases, no-action letters or interpretations. See FINRA Notice 09-69. 4 Number 1069 August 5, 2010
14 See, e.g., Rules 17a-3 and 17a-4 under the Exchange Act. 15 See Interpretive Letter to Dana Fleischman issued November 24, 2003 (permitting certain types of advisory and/or referral payments to non-participating broker-dealers under certain circumstances) available at http://www.finra.org/ Industry/Regulation/Guidance/InterpretiveLetters/ P002636 16 FINRA Rule 5141(a). Similar to current NASD Rule 2750(d), securities offered for sale in a fixed price offering are presumed salable for purposes of FINRA Rule 5141 if the securities immediately trade in the secondary market at a price or prices which are above the stated public offering price. Note, however, that under NASD Rule 2750, the presumption as to the failure to make a bona fide public offering is triggered if the securities trade immediately in the secondary market at or above the public offering price. See NASD Rule 2750(d). 17 In this context, however, FINRA notes that the appropriateness of placing unsold shares in a member s investment account, and the subsequent resale of the shares, raises other potential issues under the federal securities laws or other FINRA rules and is beyond the scope of the proposed rule change. See Proposing Release. 5 Number 1069 August 5, 2010
If you have any questions about this Client Alert, please contact Dana G. Fleischman or any of the Latham attorneys with whom you normally consult. Dana G. Fleischman +1.212.906.1220 dana.fleischman@lw.com New York Client Alert is published by Latham & Watkins as a news reporting service to clients and other friends. The information contained in this publication should not be construed as legal advice. Should further analysis or explanation of the subject matter be required, please contact the attorney with whom you normally consult. A complete list of our Client Alerts can be found on our website at www.lw.com. If you wish to update your contact details or customize the information you receive from Latham & Watkins, please visit www.lw.com/lathammail.aspx to subscribe to our global client mailings program. Abu Dhabi Barcelona Beijing Brussels Chicago Doha Dubai Frankfurt Hamburg Hong Kong Houston London Los Angeles Madrid Milan Moscow Munich New Jersey New York Orange County Paris Riyadh* Rome San Diego San Francisco Shanghai Silicon Valley Singapore Tokyo Washington, D.C. * In association with the Law Office of Mohammed A. Al-Sheikh 6 Number 1069 August 5, 2010