SEC Adopts Amendments to NASD Rule 2720 - Conflicts of Interest in Securities Offerings

On June 15, 2009, the Securities and Exchange Commission (“SEC”) issued SEC Release No. 34-60113 approving an amendment to NASD Rule 2720 proposed by the Financial Industry Regulatory Authority (“FINRA”). This amendment will become effective on September 14, 2009. Rule 2720 governs public offerings of securities issued by a FINRA member or its affiliates, public offerings in which a FINRA member or its affiliate has a conflict of interest, and offerings that would result in a FINRA member becoming a public company. Rule 2720 regulates conflicts of interest in such offerings and generally requires that such offerings undergo a filing review with the FINRA Corporate Finance Department and be supported by a pricing opinion from a qualified independent underwriter (“QIU”) unless the offering meets the criteria for one of several limited exemptions.

As discussed in greater detail below, the amendments to Rule 2720 will (1) amend the definition of “conflict of interest” to widen the scope of transactions covered by Rule 2720, (2) create exemptions from the filing and QIU requirements for additional types of transactions, (3) expand disclosure requirements to require more “prominent disclosure” of conflicts of interest in the offering documents, and (4) relax the QIU requirements to require that the QIU merely participate in due diligence and the preparation of the offering documents and remove the requirement that the QIU also provide a pricing opinion.

“Conflict of Interest”

Amended Rule 2720 expands the definition of “conflict of interest” in two key ways. First, a “conflict of interest” now exists in any offering in which a participating FINRA member receives at least 5% of the net offering proceeds, not including underwriting compensation. This amendment reduces the threshold from 10% to 5%; however, the 5% threshold now applies to each participating FINRA member rather than aggregating all participating FINRA members, as the 10% threshold did.

The definition of “conflict of interest” has also been expanded in offerings in which the issuer controls, is controlled by, or is under common control with a participating FINRA member. Previously, Rule 2720 was only triggered in situations where the participating FINRA member owned the issuer’s securities. Amended Rule 2720 expands the definition of “conflict of interest to also include offerings in which the issuer has beneficial ownership of 10% or more of the securities of the participating FINRA member. Additionally, the definition now expressly includes non-voting as well as voting securities.

Exempt Transactions

Amended Rule 2720 creates several new exemptions from the filing and QIU requirements. These new exemptions include:

  • investment grade-rated debt or preferred securities or un-rated securities that have equal rights and obligations to the issuer’s securities that are investment grade-rated;
  • securities that have a “bona fide public market,” meaning that the issuer has been a public reporting company for at least 90 days, is current in all its reporting requirements, and has securities listed on a national securities exchange with an average daily trading volume of at least $1 million and a public float of at least $150 million; and
  • transactions where the book-running lead manager or FINRA member who is primarily responsible for managing the offering has no conflict of interest and meets certain disciplinary history requirements.

These exemptions only exempt offerings from the filing and QIU requirements of Rule 2720. Other aspects of Rule 2720, such as the disclosure requirements and the prohibition on sales to discretionary accounts are still applicable.

Disclosure Requirements

Rule 2720 now requires more “prominent disclosure” of all conflicts of interest in the offering documents. As amended, Rule 2720 provides suggestions for how such “prominent disclosure” could be made. These suggestions include making the notation “(Conflicts of Interest)” after the “Plan of Distribution” heading in the Table of Contents along with similar disclosure in the “Plan of Distribution” section and the “Prospectus Summary” section required by Regulation S-K. For those offering documents not subject to Regulation S-K, “prominent disclosure” could include a notation on the front page that a conflict exists, accompanied by a cross reference to more detailed discussion of the conflict within the document. These particular methods of disclosure are considered a non-exclusive safe harbor for effecting “prominent disclosure.” FINRA will also consider alternative methods on a case by case basis.

QIU Requirements

 Offerings that do not meet the criteria of a particular exemption are subject to the QIU requirements of Rule 2720. Previously, Rule 2720 required that the QIU provide a pricing opinion stating that the price at which equity securities were being offered to the public was no higher, or the yield on debt securities was no lower, than that which was recommended by the QIU. This requirement has now been removed as the FINRA staff stated that they were unaware of any instances where a QIU had made recommendations that were inconsistent with the pricing decisions of the lead placement agent. Instead of providing a pricing opinion, the QIU must now only participate in the preparation of the registration statement or other similar document and exercise the usual standards of due diligence.

Additionally, modified Rule 2720 amends the QIU qualification requirements to eliminate the board experience requirement, focusing instead on the experience of the firm as a whole. To qualify as a QIU, a member firm must have at least three years’ experience underwriting similar offerings and must have engaged in at least three public offerings during such three year period. The QIU requirements now also prohibit members from acting as QIUs if they would receive more than 5% of the offering proceeds. Finally, any person involved in due diligence in a supervisory capacity must have ten years’ clean disciplinary history, an increase from the previous five year requirement.

The amendments reflect FINRA’s interest in modernizing Rule 2720 and making it more accurately reflect modern market practice, while still ensuring an appropriate level of regulation in offerings where a conflict of interest is present. The more encompassing definition of “conflict of interest” and the requirement for “prominent disclosure” show that FINRA is increasing its focus on conflict of interest offerings. Additionally, the elimination of the QIU pricing opinion requirement and the addition of new exemptions will have the effect of streamlining the offering process.

If you have any questions regarding the changes to Rule 2720 or want further information regarding these matters, please contact the Kaufman & Canoles Corporate and Public Finance Group.


The contents of this publication are intended for general information only and should not be construed as legal advice or a legal opinion on specific facts and circumstances. Copyright 2017.

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