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Negotiations with prospective underwriters and Letter of Intent The company contemplating a public offering of securities generally must find an investment banking firm to act as underwriter. The company should make available to the prospective underwriter whatever is necessary for an intelligent evaluation of the company’s prospects and potential for growth. There are no restrictions on the materials that can be given to the underwriter. This is a result of the fact that Section 2(3) of the Securities Act excludes from the definition of sale and offer “preliminary negotiations or agreements between an issuer . . . and any underwriter or among underwriters who are or are to be in privity of contract with an issuer.” If all ingredients are present, an issuer and underwriter may agree in principle to a proposed securities distribution and counsel will be called upon to assist in incorporating the essential terms of the underwriting arrangement in the form of a “Letter of Intent.” The attached Letter of Intent is somewhat more detailed than may be typical. Note the following: Although the letter of intent includes some provisions that are intended to be incorporated in a formal underwriting agreement, the only provisions that are binding are those imposing expenses on the issuer. See paragraph 18. In spite of the fact that the underwriter has no legal obligation to proceed with the proposed offering, the issuer will incur very substantial expenses in preparing the necessary registration documents over a lengthy period of time. See paragraph 15 The nature of the underwriter’s ultimate obligation will generally take one of two forms: (i) a “firm commitment underwriting”; or (ii) a “best-efforts underwriting.” The attached Letter of Intent contemplates a firm underwriting, but note how it is qualified. See paragraphs 3 and 15. Letters of intent are often sketchy in part because the underwriter is attempting to avoid any obligation and believes it will be able to dictate the ultimate terms as the issuer commits more time and expense to the process. Some underwriters insist on proceeding without a letter of intent. In view of the fact that the letter of intent will govern the relationship of the parties for a substantial period of time, it may be preferable to have a more detailed letter of intent. The attached letter of intent reflects underwriter’s counsel effort to incorporate some of the features the underwriter is going to insist on. Both the issuer and the underwriter will spend substantial sums before the formal underwriting agreement is executed and neither should be in the position of having to threaten to abort the issue to resolve a last minute disagreement over the terms of the underwriting agreement. As a practical matter, the form and basic content of the underwriting agreement will have been drafted and tacitly agreed to except as to pricing at or shortly after the time the registration statement is filed since in unexecuted form it will have to be included as an exhibit to the registration statement before the registration statement becomes effective. . Among other things, counsel should include the following in letters of intent so that no later misunderstandings will develop with the underwriter and so that clients understand the nature and extent of their obligations and the underwriter’s expectations. · If a firm commitment, will there be overallotment provisions? See paragraph 3. If a best efforts commitment, will there be a minimum maximum? · Who is responsible for the payment of expenses (i.e., lawyers, accountants, engineers, printers, federal and state filing fees, etc.)? Will the underwriter be paid an expense reimbursement? On an accountable or nonaccountable basis? In any event or only if the offering is concluded? Does the expense burden change if one of the parties unilaterally decides not to proceed? See paragraph 15 and 11. · Will the underwriter attempt to dictate the issuer’s choice of counsel, accountants, printers, etc.? See paragraph 1. · What approximate percentage of equity will the issuer be forced to give up to obtain the offering proceeds? Will the offering price be fixed at the outset (likely only in the case of a best-efforts underwriting)? Or later? See paragraph 1 · What will be the amount of the underwriter’s cash discount or sales commission? See paragraph 10. Will the underwriter be entitled to earn warrants to purchase the issuer’s securities? At what rate? Exercise price? Exercise period? Attendant registration or piggyback right? See paragraph 12 and 13. · Are finders involved? If not, so state; if finders are involved, define expectations and consider impact on the underwriter’s compensation. See paragraph 16 · In which states does the underwriter expect “blue sky” qualification efforts to be undertaken? By whom and at whose expense? Will the issuer and insiders be expected to acquiesce in some states’ escrow and/or other requirements? See paragraph 9 · Does the underwriter expect preferential rights on future financings by the issuer? On what sorts of financing transactions? For what period? See paragraph 14 · Provided for Exchange Act registration? Nasdaq or stock exchange listing? Financial manual listings for secondary trading? See paragraph 17 The Underwriting Agreement The matters referenced in the letter of intent are ultimately fleshed out with greater specificity and as terms embodied in the underwriting agreement between the issuer and the underwriter. The focus of negotiations shifts from the basic structure set forth in the letter of intent and addresses in detail other distribution related issues in the underwriting agreement such as cross-indemnification provisions, opinion letters from counsel and comfort letters from independent accountants, conditions to closing, market out provisions, etc. What goes into the agreement depends on many factors, e.g.: — sophistication of issuer’s management — financial and operating history and strength of issuer — nature of securities market and receptivity to primary offerings — experience and strength of the underwriting firm the relative bargaining strength of the issuer and underwriter unfold, but generally speaking, the underwriter has the better negotiating position and may be able to dictate the critical terms of the agreement. During the waiting period the only formal agreement relating to the offering is the letter of intent. This does not mean that the participants have no clue as to the content of the underwriting agreement and agreement among underwriters. A form of underwriting agreement, without the pricing information, generally is filed as an exhibit if not with the registration statement with an early amendment, and the prospective members of the underwriting group have some understanding as to how the underwriting discount will be shared among the lead underwriter, members of the underwriting group, and the selected dealers. Further, members of the underwriting group at some point in the process (generally shortly before or concurrently with pricing) will have committed to the lead underwriter and given the lead underwriter a power of attorney to execute the underwriting agreement and the agreement among underwriters on their behalf. This section and the ensuing two sections describe the agreements that formalize the underwriting arrangement with the issuer, the agreement among underwriters, and the selected dealers by referring to and commenting on some of the more important features of such agreements. We have included three underwriting—SalesForce-J.P.Morgan; Domino’s-J.P.Morgan/CitiGroup; Generic Form, but will refer primarily to the generic agreement. The underwriting agreements reflect the structure of the underwriting syndicate. There are people behind each agreement who have to function as a unit in completing the distribution. The underwriting agreement with the issuer is negotiated by the lead underwriter, but all members of the underwriting group will become parties to the underwriting agreement. Members of the underwriting group may not and likely will not be determined until shortly before pricing. The lead underwriter during the waiting period is conducting negotiations with prospective members of the underwriting group to persuade them to enter into the agreement among underwriters. Those that are invited to become members of the underwriting group will become signatories to the underwriting agreement and will have received a copy of the form of the underwriting agreement, which has to be filed as an exhibit to the registration statement, and a form of the agreement among underwriters that is not filed as an exhibit to the registration statement. The function of the investment banking firms that become members of the underwriting group is to share the underwriting risk as distinguished from selling the offering, although some members may also retain some shares for sale. The underwriting agreement will specify the specific amount of shares each member of the underwriting group is obligated to purchase. If the distribution is successful they in fact will purchase none except in form. The selling is done in large part by broker-dealers who become members of the selling group and who unlike the members of the underwriting group are not a party to the underwriting agreement with the issuer. The following sections refer to the generic Underwriting Agreement. (1) Section 3.01.. Observe that the underwriter has agreed to purchase the shares at a specified price which is the proposed public offering price less the underwriting discount. Observe also that the underwritesr has an overallotment option, which it does not have to exercise until 30 days after the closing, to purchase an additional ten percent of the number of shares offered at the discounted price. This allows the underwriter to allot in excess of the shares being offered and to protect against the possibility that a member of the selling group will not sell its allotment. It also permits gives the underwriter the alternative to fill the short position resulting from selling in excess of the shares offered up to the amount of the over-allotment option and to cover that position by purchases in the market if necessary to support the market in the immediate aftermarket. Alternatively, if the market does need not that support, the option is exercised to cover the short position.. The NASD’s Corporate Finance Rule (2710(f)(2)(J) does not allow overallotment options in excess of 15 percent of the amount of securities offered excluding the over-allotment option.. (2) Section 3.02.02 generally assumes that the offering will be completely sold on the day the distribution commences by providing for a closing date of three business days after the trade date. This is a shorter period than the underwriter might desire, but is now mandated by T+3 (Rule 15c6-1), although there is some flexibility to provide for a longer settlement period by agreement of the issuer and underwriter. In a best-efforts underwriting, the proceeds would probably be escrowed until a specified minimum is on deposit and the offering could not be closed until the minimum amount is in escrow. (3) Section 4.02 and 4.03. Note the issuer’s unlimited obligation in terms of defraying the printing costs of the prospectus. This will typically involve several thousand copies and there may be two editions of the preliminary prospectus distributed before the registration statement becomes effective and a final prospectus delivered after the registration statement becomes effective. Consideration should be given to some of the alternatives now available to reduce printing costs related to the final prospectus. Some thought should also be given to the potential for delivering the preliminary prospectus and the final prospectus by electronic media, including the World Wide Web on the Internet. (4) Section 5.12. Observe lock-up undertakings required with respect to Rule 144 stock to avoid it depressing the market. The SEC tacitly accepts that such provisions do not constitute a manipulative practice. (5) Section 5.19. Although the Company does not have to register under the Exchange Act until within 120 days after the end of its next fiscal year, underwriters generally insist this process be accelerated by registering voluntarily at an earlier date. If the company expects to be concurrently designated a Nasdaq/NMS security, which is our assumption, it must register that class of security under the Exchange Act concurrently with the effectiveness of the Securities Act registration statement. (6) Section 8.07. Observe detailed opinion required of counsel to the issuer. The underwriter expects a similar opinion from its counsel. Opinions of counsel are discussed in greater detail BELOW. (7) Section 8.08.01. Observe that two comfort letters from the accountants are called for — one on date of execution of the underwriting agreement and the other on the date of closing. Where comfort letter verifies statistical etc. information in the financial narrative of the prospectus, it is particularly helpful to receive it before the effective date as it will still be possible to make corrections in the prospectus. Learning of inaccuracies at the time of closing may create difficult issues of materiality and may necessitate a delay in the closing pending dissemination of corrected information. Ideally, a comfort letter should be received before the filing of the registration statement with a view to reducing the possibility that it may be necessary to recirculate the preliminary prospectus because of material amendments to the registration statement during the preeffective period. (8) Section 9.02. This is the market-out clause that under limited circumstances permits the underwriters not to purchase the securities at closing. At one time it was not uncommon to include a provision allowing termination by the underwriter in the event of “substantial and material changes in the condition of the market (either generally or with reference to the sale of the securities to be offered hereby) beyond normal fluctuations etc.” The Commission’s staff has taken the position that such a provision turns it into a bestefforts underwriting and requires the proceeds to be escrowed under Rule 10b-9. Cf. First Boston Corp., SEC No-Action Letter (Sept. 2, 1985), 1985 WL 54285. See ATTACHED (9) Section 11.02. Note the time limits on the company’s opportunity to enter into an underwriting agreement with someone else if it is unable to reach agreement with the underwriter under the right of first refusal. If these time frames are too short, the practical effect may be that the issuer is unable to enter into a subsequent underwriting agreement with anyone other than the original underwriter. The underwriter in particular must take into account that the NASD Corporate Financing Rule (Rule 2710(c)(3)(A)(ix) assigns a value of 1% of the offering proceeds for any right of first refusal to the underwriter as underwriting compensation in determining whether the aggregate underwriting commissions are fair and reasonable. (10) Note that par. 3.03 contemplates that the company on closing will sell warrants to the Underwriter in accordance with terms set forth in an attached document. The Corporate Financing Rule also limits the amount of warrants that can be issued, by including them as underwriting compensation and placing a valuation on them determined by a formula in determining whether the underwriting compensation is fair and reasonable. The Corporate Financing Rule no longer permits the inclusion of a so-called anti-dilution rachet provisions under which the number of warrants is increased and/or the exercise price reduced if the issuer issues additional securities below the exercise price of the warrants.. The Underwriting Agreement is a firm underwriting agreement as evidenced by Section 3.01, which provides that the company agrees to sell and the underwriters agree to purchase the number of shares specified in the attached schedule. The typical underwriting agreement calls for two opinions of counsel, both of which are a condition to the underwriter’s obligation to purchase the shares under the agreement. One of them is from counsel to the company, typically outside counsel engaged to assist the issuer in preparing the registration statement. See par. 8.07 The other opinion is from counsel to the Underwriters. See par. 8.06 Note that the opinion of underwriter’s counsel calls for substantially the same opinion as that required of company’s counsel, but with respect to par. 8.07(8), which is a critical aspect of the opinion, the underwriter’s opinion may be “qualified in such manner as the Underwriter may deem acceptable.” Receipt of the opinions of both counsel are a condition to the underwriter’s obligation under the Underwriting Agreement. A primary purpose is to provide the underwriter the opportunity at closing to not purchase the shares in the event either counsel is unable to render the opinion called for. Although not always recognized, the opinion of the underwriters’ counsel serves a second purpose ¾ to satisfy in part the underwriters’ due diligence obligation in the event an action is brought under § 11 of the Securities Act for false or misleading statements in the registration statement. BarChris[1] is regarded by practitioners and courts as the seminal case defining the scope of the underwriter’s due diligence obligation as to the non-expertised portion of the registration statement. The underwriter’s obligation under BarChris is to verify that which is reasonably verifiable, including factual representations. The underwriter cannot accept factual representations of the issuer, issuer’s employees, and counsel without taking reasonable steps to verify that information if it is reasonably verifiable. The underwriter must play the role of the devil’s advocate. If the underwriter has delegated that responsibility to its counsel, which is often the case although too often implicitly rather than explicitly, then counsel’s failure is the underwriter’s failure. In BarChris Judge McLean recited a laundry list of what counsel had failed to do to that could reasonably have been done to verify what he had been told by issuer’s representatives and concluded: “[T]he underwriters’ counsel did not make a reasonable investigation of the truth of those portions of the prospectus which were not made on the authority of Peat, Marwick as an expert. Drexel is bound by their failure. It is not a matter of relying upon counsel for legal advice. Here the attorneys were dealing with matters of fact.”[2] Underwriter’s counsel had opined in part as follows:[3] We are of the opinion that the data presented to us are accurately reflected in the Registration Statement and Prospectus and that there has been omitted from the Registration Statement no material facts included in such data. Although we have not otherwise verified the completeness or accuracy of the information furnished to us, on the basis of the foregoing and with the exception of the financial statements and schedules (which this opinion does not pass upon), we have no reason to believe that the Registration Statement or Prospectus contains any untrue statement of any material fact or omits to state a material fact required to be stated therein or necessary in order to make the statements therein not misleading. This was prefaced with the following qualification: In the course of the preparation of the Registration Statement and Prospectus by the Company, we have had numerous conferences with representatives of and counsel for the Company and with its auditors and we have raised many questions regarding the business of the Company. Satisfactory answers to such questions were in each case given us, and all other information and documents we requested have been supplied. Judge McLean focused on this language after noting that underwriter’s counsel had relied on issuer’s chief financial officer without attempting to verify it and on statements made to him by the issuer’s counsel. “The formal opinion which Ballard’s firm rendered to the underwriters at the closing on May 24, 1961 made clear that this is what he had done.”[4] The underwriters argued that their understanding with counsel was to do more than that, to which Judge McLean responded: “It is difficult to square this understanding with the formal opinion of Ballard’s firm which expressly disclaimed any attempt to verify information supplied by the company and its counsel. In any event, it is clear that no effectual attempt at verification was made. The question is whether due diligence required that it be made. Stated another way, is it sufficient to ask questions, to obtain answers which, if true, would be thought satisfactory, and to let it go at that, without seeking to ascertain from the records whether the answers in fact are true and complete?”[5] As noted above, the court answered this question in the negative. Attached is an example of an opinion rendered by underwriters’ counsel.. Note that it bears an uncanny resemblance to the opinion rendered by underwriters’ counsel in BarChris. The opinion is prefaced by setting forth the basis upon which the opinion is predicated: We have participated in conferences with officers and other representatives of the Company, counsel for the Company, representatives of the independent public accountants of the Company and your representatives at which the contents of the Registration Statement and Prospectus and related matters were discussed. Although we are not passing upon, and do not assume any responsibility for, the accuracy, completeness or fairness of the statements contained in the Registration Statement and the Prospectus (except for the statements referred to in paragraph 4 above. upon which we are passing to the extent stated therein), we advise you that, on the basis of the foregoing (relying as to materiality to a large extent upon officers and other representatives of the Company and your representatives). This does not go as far as the BarChris opinion in that no reference is made to having raised questions and having received satisfactory answers and it contains a qualification as to materiality attempting to place the responsibility on everyone else, including the underwriters’ representatives. The one matter not qualified (reference to paragraph 4) is the description of the security. Elsewhere in the opinion there is reference to documents examined and reliance on certificates from officers of the company as to factual matters. It is not clear whether this recitation is applicable only to the numbered paragraphs or also includes the opinion as to the registration statement and prospectus, which has its own qualifications. Subject to the qualifications, the opinion continues: [N]o facts have come to our attention which lead us to believe that the Registration Statement (other than (i) the financial statements and schedules (including the notes thereto and the auditors’ reports thereon) included therein, (ii) the other financial and statistical information included therein and (iii) the exhibits thereto, as to which we have not been asked to comment), as of the time it became effective, contained any untrue statement of a material fact or omitted to state any material fact required to be stated therein or necessary to make the statements therein not misleading or that the Prospectus (other than (i) the financial statements (including the notes thereto and the auditors’ report thereon) included therein and (ii) the other financial and statistical information included therein, as to which we have not been asked to comment), as of the issue date thereof, contained any untrue statement of a material fact or omitted to state any material fact required to be stated therein or necessary to make the statements therein, in light of the circumstances under which they were made, not misleading. The conferences referred to, presumably, are drafting sessions which can focus on style, grammar, organization, materiality and, to some degree, due diligence. Due diligence at such sessions is likely to consist of questions posed by underwriters’ counsel and representatives to the company’s counsel and representatives and their responses. This is the type of due diligence that BarChris suggests is not enough. That does not mean that it has no value. A good deal will have come to attention of counsel at such conferences and otherwise, and counsel must opine that nothing has come to counsel’s attention etc. The second opinion of underwriter’s counsel states that counsel has examined such corporate records and other documents “as we have deemed necessary as a basis for the opinions hereinafter expressed. As to the various questions of fact material to such opinions, we have, when relevant facts were not independently established, relied upon certificates of responsible officers of the Company and upon certificates of public officials.” The opinion then opines on the validity of the securities to be issued and the corporate authorization of the underwriting agreement. Separately it includes the critical opinion that the registration statement etc. does not include false or misleading statements. For this purpose it includes the following (which also appears to incorporate the above recitations as to examination of documents): Although we cannot guarantee the accuracy or completeness of the statements contained in the Registration Statement or the Prospectus, on the basis of conferences at which the Registration Statement and Prospectus were discussed, our examination of the documents referred to in the registration statement, and our investigation forming the basis for the foregoing opinions, nothing has come to our attention that leads us to believe that the Registration Statement, as of the time it became effective under the Act [etc. was false or misleading]. This also comes short of assuring that the reasonable investigation required by BarChris was undertaken, but it goes part of the way. First, it states that documents “deemed necessary” for the opinions rendered were examined, which goes beyond the statement concerning examination of the documents referred to in the registration statement. Second, it suggests that some factual matters were “independently established,” qualifying the reliance on officer’s certificates as to factual matters. This at least permits underwriter to argue that counsel verified factual matters that were reasonably verifiable. The representation that counsel examined documents “deemed necessary” for the opinions and to facts “independently established,” however, relates directly to the numbered paragraph opinions, which are relatively routine. The opinion pertaining to the content of the registration statement and prospectus incorporates the “investigation forming the basis for the foregoing opinions” brings them to some degree into the basis for opinion that the registration statement was not false or misleading. For another negative assurance
opinion ("no facts have come to our attention") see the
Morgan Stanley/SalesForce.com
underwriting agreement.
SEE ALSO mutual
arrangement of counsel to avoid responsibility. Perhaps, not unusual in
view of the Report on Negative Assurances in Securities Offerings of the
ABA Section of Business Law, published in the August 2004 issue of
The Business Lawyer. The
Report notes that the "negative assurance" of counsel is intended to
assist underwriters in satisfying a due diligence defence. According to
the Report negative assurance is not an opinion, but a statement
of belief based on participation in the process of preparing the
registration statement. The negative assurance should-- From the underwriter’s perspective, the opinion of counsel to the issuer may be a basis for asserting a claim for professional negligence, but does not satisfy its due diligence obligation. The opinion of counsel to the underwriter is relevant in this regard, but only if in fact a reasonable investigation was undertaken by counsel. In the last analysis, from a due diligence perspective, what underwriter’s counsel opines is not as important as what was actually done, although, as in BarChris, the recitals may confirm that very little was done other than to take someone’s word for it. (1) Observe that the agreement is structured so that the managing underwriter controls the allocation to members of the selling group. This is done first by limiting the amount that members of the underwriting group can reallow as a concession to half of the dealer’s concession whereas the managing underwriter can allow members of the selling group up to 70 percent of the discount. Secondly, in paragraph 3, the managing underwriter controls the number of shares that members of the underwriting group can retain for sale by their own retail people. The agreement contemplates that except for shares the managing underwriter allows members of the underwriting group to retain for sale, the managing underwriter will place the shares for retail either through its own retail department and/or selling group members. The function of allotting shares for sale is sometimes referred to as “running the books.” Even if there are two lead underwriters, one of them normally performs the function of running the books. (2) Members of the underwriting group will receive a fixed percentage of the underwriting discount per share on all shares for which they assumed the underwriting risk without regard to who sells them. They will receive the selling concession only on shares they are allowed to retain for sale. (3) Observe that each member of the underwriting group at Section 3.01 of the Underwriting Agreement (purchases its part of the underwriting severally and not jointly. See also Section 3.01.01 as to the options open to remaining members of the underwriting group if a member defaults as to his several portion. Section 11(e) of the Securities Act provides, in effect, with respect to the underwriters’ liability for misrepresentations in the registration statement that no member of the underwriting group shall be liable under Section 11 for damages in excess of its several portion of the underwriting. This, among other reasons, accentuates the importance of the several but not joint language. (1) Selected Dealers Agreements often do no more than provide for a revocable allotment from the underwriter to the dealer with no contractual commitment until the registration statement becomes effective and confirmations are exchanged. (2) The Selected Dealers Agreement set forth herein involves an offer to purchase by the selected dealers that is revocable any time prior to acceptance. (3) Acceptance by the underwriter cannot take place until the registration statement becomes effective. It typically is effectuated by a telephone call accepting the offer as soon as the registration statement is effective followed by an exchange of confirmations. (4) Observe at paragraph 5 that the dealer is to make payment on normal settlement date, that is, three business days after the transaction date. (5) Observe that paragraph 13 requires a representation that the purchase of shares by the dealer will not place it in violation of the net capital rules. Since dealers often have no commitment to purchase under a selected dealers agreement, they should be cautioned that this agreement imposes such a commitment and that they must take it into account in determining compliance with the net capital rule. The NASD is likely to seek confirmation from them that they will be in compliance with the net capital rule. (6) Note that transmittal letter to dealers is designed to make it clear that dealers are submitting offers to buy and not mere indications of interest. NASD Corporate Financing Rule Companies going public overlook at their peril the NASD’s corporate financing rule (Rule 2710[6]) and the NASD’s Corporate Financing Department, the arbiter of the fairness and reasonableness of underwriting compensation. The approval of the Corporate Financing Department adds another layer of review for virtually all registered and exempt public offerings of securities, other than municipal securities and securities issued by a registered mutual fund. The SEC will not allow a Securities Act registration statement to go effective without assurance that such approval is to be forthcoming. NASD members and associated persons are specifically prohibited from (1) commencing or participating in an offering subject to the filing requirements of Rule 2710 until the Corporate Financing Department has approved the underwriting terms and arrangements;[7] (2) participating in an offering if the underwriting terms or arrangements are unfair or unreasonable;[8] (3) receiving an amount of compensation in connection with an underwriting that is unfair or unreasonable;[9] (4) participating in an offering that the Corporate Financing Department has determined the underwriting terms or arrangements to be unfair or unreasonable.[10] In determining whether underwriting compensation is unfair or unreasonable, the Corporate Financing Department takes into account not only what is received by the underwriters but “related persons” of the underwriter, which is a misnomer as in many instances related persons are not underwriters and have no relationship to the underwriters. Nor is underwriting compensation for this purpose limited to what is provided for in the underwriting agreement and directly related to the underwriting. Underwriting compensation for this purpose may be received during what we refer to as the Review Period, which extends to a period commencing well before the offering commences and includes compensation, particularly cheap stock, received during that period by the underwriters and related persons. A company contemplating going public that does not take the Corporate Financing Rule into account may discover that by being too generous in awarding cheap stock to finders, financial advisers, those providing seed financing and the like during the Review Period may have seriously jeopardized its chance of obtaining a reputable underwriter. Even worse, the company and the underwriter may find after completing the marketing of the issue that the Corporate Financing Department is withholding its approval because of a transaction that took place during the Review Period puts the underwriting compensation over the undefined limit of fair and reasonable. The SEC in approving the codification of the Corporate Financing Interpretations as the Corporate Financing Rule in 1992, presumably referring to the above standards, stated: “[T]he Rule . . . codifies for the first time a number of different unpublished factors the NASD uses to determine the fairness and reasonableness of underwriting terms and arrangements of NASD members.”[11] The standards, however, are so vague and general that they provide little assistance to practitioners in quantifying underwriting compensation that would be deemed fair and reasonable. The NASD justified its refusal to be more specific, and the Commission accepted the NASD’s rationalization, because “to publish the permissible limits of underwriting compensation for NASD members . . . would be counterproductive and discourage competition. Specifically, it would tend to encourage members to charge issuers the maximum compensation allowed . . . .”[12] The provisions incorporated into Rule 2710 version that became effective on March 22, 2004 did not modify or add to the foregoing criteria in any way. The NASD in October of 1992 published the results of a study reflecting the amount of actual compensation received in various categories of offerings as disclosed in the final offering document or prospectus for 874 equity corporate equity offerings filed during the calendar year 1991.[13] Since the study was based on the amount of compensation reflected by final offering documents determined “fair and reasonable,” it is based on the amounts allowed by the Corporate Finance Department rather than the amount reflected in the initial filings. The study included a table indicating at various offering levels “the predicted percentage of gross proceeds, exclusive of any over-allotment option, that might be allocated to underwriting compensation for firm commitment IPOs, firm commitment secondary offerings, and best efforts corporate equity offerings.”[14] The Notice to Members stated:[15] “These predicted compensation values, expressed as a percentage of offering proceeds, should provide members and their counsel with guidance regarding the typical amount of underwriting compensation for various offerings and the generally accepted levels of underwriting compensation as determined by the NASD.” We assume the table no longer reflects an accurate guide and repeat it for only three levels—the lowest, highest and median gross offering price:[16] Total Underwriting Compensation
_____________________ 1 This table contains the results of a regression analysis of an overall population and not mathematical averages for each category. This data should be considered only in connection with the explanation of the methodology contained in the attached Notice. A study of underwriting commissions in connection with IPOs comparing commercial bank underwritten offerings with investment bank underwritten offerings attempts to take into account not only the difference in the underwriting spread but also in the relative amounts of underpricing (the cost to the company resulting from completing the offering at a price significantly lower than the price at which the stock opens on the commencement of trading). This study notes that there was no significant difference in terms of the spread although the cost was significantly less in commercial bank underwritten offerings as such IPOs according to the study tend to be less underpriced. The Corporate Financing Department presumably does not take underpricing into account as there is no way to measure it before the offering is completed. What is significant for our purpose is that the study suggests that “considerable evidence suggests that gross margins for IPO underwriting cluster around 7%.”[17] The study, which was based on IPO’s underwritten between 1991 and 1997 found as to those underwritten by investment banks 65.5% were at exactly 7%; 15.35% were below 7%, and 19.13 were above 7%.[18] The author on April 26, 2004 at random selected the five offerings that Hoover’s Online showed as the most recent IPOs to be priced and four[19] of the five had underwriting spreads of exactly 7%, and the underwriting spread of the fifth was approximately 4.6%. The aggregate amount of the offering of those with a 7% underwriting discount varied from $78 million to $132 million; the fifth[20] with an underwriting discount of 4.6% involved gross offering proceeds of in excess of $900 million. The filing must be made (typically by the managing underwriter) with the NASD’s Corporate Financing Department at at 9509 Key West Avenue, Rockville, Maryland 20850 The filing must be made no later than one day after the filing or submission of such documents with the SEC or state or appropriate regulatory authority.[21] Filing is facilitated, however, in that all documents filed electronically through EDGAR with the SEC are deemed filed with the NASD.[22] We don't know how SOR will change underwriting agreements, but given the ongoing tension between issuer and underwriters' counsel there will be some changes. Some possible concerns of underwriters' counsel. The timely filing of a 424(b) pricing supplement by the issuer to assure the availability of Rule 172. Assurance that issuer complies with appropriate conditions to use a Rule 433 free writing prospectus and that the same does not include false or misleading statements. Will they want an opinion of counsel? What about interviews to the press and material on websites? See Part 7. The issuer may want similar assurances from the underwriter re free writing prospectuses used by the underwriter. 1] Escott v. BarChris Constr. Corp., 283 F. Supp. 643 (S.D.N.Y. 1968). [2] Id. at 697. [3] See id. at 695-96. [4] Id. at 695. [5] Id. at 696.
[6] Rule
2710 is available on the NASD webside (www.nasd.com) under NASD Manual
[7] Rule 2710(b)(4)(B)(ii). [8] Rule 2710(c)(1). [9]Rule 2710(c)(2)(A). [10] Rule 2710(b)(C)(4). [11] Exch. Act Release No. 30,587 (April 15, 1992), 1992 WL 81746, at *2. [12] Exch. Act Release No. 30,587 (April 15, 1992), 1992 WL 81746, at *7.
[13] NASD,
Notice to Members 92-53 (Oct. 1992), at 371, available at the
NASD website (http://cchwallstreet.com/NASD/NASDViewer.asp?filename=%2FNASD%2Fnotices%2F1992 [14] Id. at 372. [15] Id. at 371. [16] Id. at 373. [17] Paige Fields, Donald Fraser, Rahul Bhargava, A Comparison of Underwriting Costs of Initial Public Offerings by Investment and Commercial Banks, The Journal of Financial Reasearch (Vol. XXVI-Winger 2003), 519. [18] Paige Fields, Donald Fraser, Rahul Bhargava, A Comparison of Underwriting Costs of Initial Public Offerings by Investment and Commercial Banks, The Journal of Financial Reasearch (Vol. XXVI-Winger 2003), Table 1, 528.. [19] ProCentury Corporation, SiRF Technology Holdings, Gander Mt., and Immunicon Corp. [20] Assured Guaranty, Ltd. [21] Rule 2710(b)(4)(A)(i). [22] Rule 2710(b)(5)(B).
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