NYSE/NASD IPO ADVISORY COMMITTEE REPORT AND RECOMMENDATIONS TO IMPROVE THE IPO PROCESS

[16158] June 4, 2003 TO: EQUITY MARKETS ADVISORY COMMITTEE No. 13-03 SEC RULES MEMBERS No. 68-03 SMALL FUNDS MEMBERS No. 25-03 RE: NYSE/NASD IPO ADVISORY COMMITTEE REPORT AND RECOMMENDATIONS TO IMPROVE THE IPO PROCESS In October 2002, the New York Stock Exchange and the National Association of Securities Dealers formed the NYSE/NASD IPO Advisory Committee at the request of the Securities and Exchange Commission to review the IPO process and recommend changes necessary to address the problems that have been observed in the process. The Committee recently published its report, which identifies harmful practices that have eroded public confidence in the integrity of the IPO process and recommends various revisions to address these practices.1 The practices identified by the Committee and their 20 recommendations are summarized below. I. HARMFUL PRACTICES IDENTIFIED BY THE COMMITTEE Overall, the Committee was concerned with behavior during the late 1990s and 2000 that resulted in an unusually large number of offerings trading at extraordinary and immediate aftermarket premiums, which affected the allocation process by creating a pool of instant profits for underwriters to distribute. The most harmful practices identified by the Committee are: • Spinning – which consists of certain underwriters allocating “hot” IPO shares to directors and/or executives of potential investment banking clients in exchange for investment banking business; • Artificial Inflation of Aftermarket Prices – which consists of an underwriter engaging in inequitable or unlawful tactics to support aftermarket prices and boost demand;2 1 See “Report and Recommendations of a committee convened by the New York Stock Exchange, Inc. and NASD at the request of the U.S. Securities and Exchange Commission,” (NYSE/NASD IPO Advisory Committee, May 2003) (the “Report”). The Report is available through the NASD’s website, www.nasdr.com. 2 Examples of this include allocating IPO shares based on a potential investor’s commitment to purchase additional shares in the aftermarket at specified prices and imposing penalties on retail brokers who “flip” retail IPO investors but not other investors (e.g., institutions). 2 • Unlawful Quid Pro Quo Arrangements – such as an underwriter unlawfully allocating IPO shares based on a potential investor’s agreement to pay excessive commissions on trades of unrelated securities; and • Biased Recommendations by Research Analysts – which results in research analysts issuing and maintaining “buy” recommendations on certain stocks despite aftermarket prices that jumped to multiples of their IPO prices. II. THE COMMITTEE’S RECOMMENDATIONS The Committee’s 20 recommendations follow four basic themes: (1) the IPO process must promote transparency in pricing and avoid aftermarket distortions; (2) abusive allocation practices must be eliminated; (3) regulators must improve the flow of, and access to, information regarding IPOs; and (4) regulators must encourage underwriters to maintain the highest possible standards, establish issuer education programs regarding the IPO process, and promote investor education about the advantages and risks of IPO investing. The Committee’s recommendations are summarized below. A. Promoting Transparency and Avoiding Aftermarket Distortions To promote transparency and avoid aftermarket distortions the Committee recommends the following: 1. SROs should require each issuer to establish an IPO pricing committee of its board of directors – including at least one director who is independent of management (if any director qualifies) – to oversee the pricing process. According to the Committee, the pricing committee’s responsibilities should include receiving periodic updates from the underwriters and management, reviewing the IPO order book during the marketing period, making the final pricing decision, and reviewing the final allocation of shares. 2. SROs should require underwriters to provide to the issuer’s pricing committee all indications of interest before the issuer determines the IPO price. This sharing of information is intended to better enable the issuer to understand investors’ demand for the offering at difference price levels. 3. The SEC and SROs should redress and prevent prohibited IPO laddering.3 3 “Laddering” refers to one form of prohibited conduct involving inducing investors to give orders to purchase shares in the aftermarket at particular prices in exchange for receiving IPO allocations. According to the Committee, such conduct distorts the offering and aftermarket and impairs investor confidence in the IPO process. 3 Without being more specific, the Committee recommends that the SEC and the SROs take appropriate measures to redress and prevent laddering. They also encourage underwriters, in consultation with the regulators, to develop effective internal policies and procedures to prevent prohibited secondary market activity. 4. Prohibit, for the first trading day following the IPO, the placing of unpriced orders to purchase an issuer’s shares. The Committee expressed concern with the fact that initial market orders – orders to purchase “at any price” placed in the early minutes or hours of the IPO’s launch – may result in purchases at prices that reflect neither the investor’s true investment decisions nor their reasonable expectations. Disallowing orders without a price cap for the first trading day following an IPO will allow the market to develop some trading information, thereby making subsequent uncapped orders more appropriate. 5. The SEC and SROs should prohibit the inequitable imposition of “flipping” penalties. Current SEC and SRO rules generally permit underwriters to impose penalty bids on syndicate members.4 Apparently, in cases where penalty bids have not been imposed on syndicate members, individual members have imposed penalties on individual brokers for flipping their small retail customer, but not for flipping other IPO participants.5 The Committee recommends that the SEC and the SROs address this discrimination by requiring, in the absence of a penalty bid on a syndicate member, that a member may not impose penalties on a retail broker or investor. 6. SROs should establish clear parameters for underwriters’ sales of returned shares after secondary market trading has commenced. The Committee believes that it is imperative that it eliminate any opportunity for abuse that may arise as a result of “hot” IPO shares being returned to the underwriter after secondary trading commences.6 Failure to eliminate such abuse may result in the underwriter being in a position to allocate any returned shares to favored customers at the IPO price, thus unfairly granting such customers the opportunity to collect an immediate profit. To address these concerns, the Committee recommends that SROs require that IPO shares that are returned to the underwriter for any reason first be allotted to reducing any existing syndicate short position. It further recommends that SROs require underwriters to sell the remaining returned shares on the open market and return any net profits on such sales to the issuer. Where the market price does not rise about the offering price, the Committee recommends that the underwriter be 4 A penalty bid permits the managing underwriter to reclaim a selling concession from a syndicate members if the syndicate member’s customers sell the IPO shares originally allocated to them shortly after the IPO. Penalty bids are intended to promote the development of a stable aftermarket. 5 These penalties may include withdrawn commissions or exclusions from future IPO allocations. Faced with such potential penalties, brokers may discourage their retail customers from immediately selling their IPO shares. 6 Such return may result from factors such as mistaken allocations, incomplete information or other problems relating to the delivery of shares or the settlement of trades. 4 permitted to sell the shares for its own account or retain the shares by placing them in its investment account. 7. Raise the SEC’s threshold requirement for amendment to the prospectus from 20% to 40% in cases of increases to the offering price or number of shares offered. Under current SEC rules, issuers must often amend their registration statement or file a new registration statement not eligible for immediate effectiveness when the number of shares to be offered or the offering price in the aggregate change by more than 20%. According to the Committee, these rules can operate to discourage increases to the offering price or number of shares offered in excess of 20% because issuers generally avoid risking the possibility of even a short delay that could result from the SEC filing process. Because a late-stage increase in proceeds essentially indicates a significant level of excess investor demand at the prior price, issuers and the investing public would be well served by more flexibility in upward adjustments. Accordingly, the Committee recommends that this threshold be increased from 20% to 40% and any amended or supplemental filing be immediately effective, without the need for SEC staff review or the need to delay the offering, unless the increase results in a material change in the prospectus disclosure beyond that related to price or number of shares offered. 8. The SEC and SROs should eliminate regulatory impediments to the development of alternatives to bookbuilding. In the view of the Committee, the market, and not regulators, should determine whether bookbuilding, a Dutch auction, or another method is desirable for a particular IPO.7 Accordingly, the Committee recommends that the SEC and the SROs review their rules with a view to addressing provisions that may impede the use of such alternative pricing methods. The SEC should also consider eliminating an underwriter’s obligation to reconfirm an offer outside the initial price range from a bidder who has already indicated a willingness to purchase at a higher price. B. Eliminating Abusive Allocation Practices The Report notes that there are competing objectives and conflicting interests in the IPO allocation process. For instance, while the issuer generally desires that shares be placed with long-term investors, the availability of an aftermarket is part of the inducement to participate in the IPO. Also, underwriters may desire to allocate at least some shares to their best customers in order to maintain client relationships. The Committee offers the following four recommendations in order to provide greater transparency to this process, to properly balance these competing objectives, and to fairly resolve these conflicting interests. 7 According to the Report, in the traditional bookbuilding IPO, the underwriter that serves as bookrunner retains the discretion to determine the final IPO share allocations. By contrast, in a Dutch auction, pricing and allocation are removed from the realm of issuer and underwriter discretion. Investors express their interest level and price threshold, and the offering price is set at the highest level at which all of the shares to be offered can be sold. The final IPO price in an auction represents, or is at least close to, the maximum price that the market is willing to pay for the issuer’s security so an IPO offered through such a process should not experience enormous aftermarket price spikes like those that fueled the abuses of the bubble period. 5 9. The SEC and SROs should prohibit the allocation of IPO shares (1) to executive officers and directors (and their immediate families) of companies that have an investment banking relationship with the underwriter, or (2) as a quid pro quo for investment banking business. This recommendation is intended to prohibit spinning. To further address their concerns with this practice, the Committee additionally recommends that regulators restrict conduct that may be viewed as or evolve into spinning. The Report notes that existing and proposed NASD rules provide a starting point,8 but recommends that these restrictions be expanded to include selected affiliates of an executive officer or director, such as members of the covered person’s immediate family. In addition, an investment banking relationship should bar all directors and executive officers of the underwriter’s investment banking client from receiving any IPO shares from the underwriter.9 10. Provide that a listed company’s code of business conduct and ethics should include a policy regarding receipt of IPO shares by the company’s directors and executive officers. According to the Committee, “all companies should reexamine their corporate governance policies and procedures regarding the receipt of IPO shares by their directors and executive officers” in order to “provide investors with comfort that IPO allocations do not unduly interfere with the fulfillment of directors’ and officers’ fiduciary duties.” With respect to each listed company, the Committee recommends that its required code of business conduct and ethics include a policy regarding these IPO allocations. Such a policy may take the form of a complete ban on the purchase of IPO shares or a policy requiring pre-approval by the company’s directors and officers. 11. Strengthen existing prohibitions on unlawful quid pro quo allocations. While SEC and SRO rules prohibit an underwriter’s allocation of IPO shares based on the recipient’s agreement to “kick back” a portion of the flipping profits to the underwriter, the Committee supports provisions in proposed NASD Rule 2712 that would add a more explicit restriction by prohibiting the allocation of IPO shares as consideration or inducement for the payment of excessive compensation for other services provided by the underwriter. The Report 8 In particular, the Report cites proposed NASD Rule 2712 that would, among other things, prohibit an underwriter from allocating IPO shares (1) to an executive officer or director of a company on the condition that the officer or director send the company’s investment banking business to the underwriter, or (2) as consideration for investment banking services previously rendered. In addition, NASD’s free-riding and withholding interpretation generally imposes restrictions on allocations of “hot issues” to money managers, such as venture capitalists and hedge fund managers, who are in a position to direct business to a broker-dealer. NASD’s proposed Rule 2790, which would replace this interpretation, would impose additional restrictions on such persons by, for example, eliminating an investment bank’s ability to allocate IPOs to such persons even if such allocations are consistent with the person’s “normal investment practice.” 9 The Report notes that the Committee had completed its deliberations prior to the announcement of the Global Settlement, which, in part, included the ten settling firms entering into a voluntary comprehensive ban on allocation of “hot” IPO securities to executive officers and directors of public companies and a restriction on participation of investment banking personnel in allocation decisions. The Committee recommends that this voluntary initiative be considered by the SROs and the SEC in connection with their future rulemaking activities in this area. 6 clarifies, however, that the Committee’s recommendation is in no way intended to restrict the underwriter’s lawful exercise of its allocation discretion or to interfere with legitimate relationships between an underwriter and its customers. 12. The SEC and SROs should impose substantive limits on issuers’ “friends and family” programs.10 To address concerns with abuses resulting from “friends and family” programs, the SEC and the SROs should establish reasonable parameters for the fair use of issuer-directed share programs by: (1) imposing a 5% maximum size for an issuer’s directed share program; and (2) requiring that any lock-up that applies to shares owned by officers and directors include the shares purchased by those individuals in the “friends and family” program. C. Improving Information Regarding IPOs To fulfill its goals of (1) the SEC and SROs fostering clearer channels of communication among the underwriter, the issuer, and the general investment community, (2) ensuring that all investors have sufficient access to information necessary to make informed investment decisions about an IPO, and (3) ensuring that the exchange of information between the underwriter and the issuer is characterized by transparency and not opaqueness, the Committee offers the following five recommendations. 13. Require issuers to make a version of their IPO roadshow available electronically to unrestricted audiences. While roadshow attendees will likely constitute the bulk of the issuer’s shareholder base once the company goes public, electronic roadshows often are not made available to retail investors. As such, there may be a disparity in information among retail and institutional investors, which may disadvantage retail investors who are not able or not invited to attend a roadshow. To address this gap in information, the SEC should amend current rule interpretations to state affirmatively that electronic roadshows, although subject to general antifraud provisions of the securities laws, are permitted under the Securities Act of 1933. The Committee further recommends that the SEC require any issuer that elects to use a roadshow as part of its marketing of the offering to post the roadshow on its website, accompanied by a link to the prospectus, or otherwise make the roadshow widely accessible without charge. 14. Require that the underwriter disclose the final IPO allocations to the issuer. To assure trust in the allocation decision process and better enable an issuer to assess the performance of the underwriter that serves as the bookrunner, the Committee recommends that the SROs require, subject to any applicable financial privacy limitations, that the managing underwriter disclose and explain to the issuer the final allocation of its IPO shares. 10 The term “friends and family” programs refers to the practice whereby an IPO includes an issuer-based allocation of a portion of the offering, which may be used to permit company employees to invest in their employer at the IPO price or permit strategic business partners to have a small investment in the issuer. 7 15. Require that the prospectus include a clear description of lock-up agreements and of whether the underwriter expects to grant exceptions relating to hedging or other transactions. According to the Report, while lock-up agreements11 are disclosed in the prospectus, such disclosure is usually in broad terms without details concerning the terms of the lockup or any exceptions to it. Because the ending or granting of exceptions to a lock-up agreement is at least as material to shareholders as the initial agreement, the Committee recommends that prospective investors be more fully informed of the terms of all lock-ups agreements between the underwriter and covered persons. 16. Reiterate existing requirements that all collars and other custom derivatives relating to initial insider holdings be promptly filed electronically with the SEC on Form 4. SEC Form 4 currently requires all company directors, executive officers, and large shareholders to report transactions in the issuer’s securities, including all collars and derivatives contracts relating to a director’s or officer’s shares, within two business days of completion of the transaction. The Committee recommends that the SEC consider whether additional clarification or other measures are needed to reinforce these requirements. 17. Require improved disclosure regarding exemptions by an underwriter to an IPO lock-up agreement. Specifically: (1) require that underwriters notify issuers prior to granting any exemption to a lock-up, and require issuers to file a current report on Form 8-K at least one business day prior to the time the insider commences the transaction; and (2) require that, prior to the transaction, the lead underwriter announce the exemption by broad communication to the investment community through a major news service. This recommendation is intended to ensure that investors are made aware, in a timely manner, of any development that would counter the established expectation that the issuer’s directors, officers, and large pre-IPO shareholders who entered into lock-ups will be bound by them for the stated period. Such disclosure requirements should ensure that the market had the information at the appropriate time – not after the sale by the executive. 18. The SEC should require more complete prospectus disclosure about the nature and size of the issuer’s “friends and family” program. The Committee recommends that the SEC promote greater transparency of any “friends and family” program by additional disclosure of information such as the total size of the program, the number of individuals or institutions who participate, the largest, smallest, and average purchase under the program, the minimum percentage being allocated to employees, and the categories of recipients and allocations to participants that exceed a specified threshold. 11 Lock-up agreements, which underwriters typically require of directors, officers, and certain pre-IPO shareholders of an issuer, restrict the sale of the company shares for a specified period, typically six months. Such agreements usually contain exceptions that may be waived in whole or part by the lead underwriter in its discretion. 8 D. Improving the Quality of Underwriter Performance and Public Awareness Regarding IPOs In the Committee’s view, the basic and most essential ingredients to ensure the integrity of IPOs are: an issuer’s awareness and discharge of its obligations in the IPO context; an underwriter’s ethical and fair performance of its duties; and, the participation of an informed investing public that understands the inherent volatility in the IPO market and the risks of investing. To promote underwriter standards and to educate issuers and investors, the Committee recommends the following: 19. Impose additional requirements to promote the highest standards of conduct for underwriters, including (1) enhanced periodic internal review by the underwriter of its IPO supervisory procedures and (2) a heightened focus on the IPO process in SRO examinations for investment banking personnel. 20. The SEC and SROs should launch an education campaign for new issuers and IPO investors. Tamara K. Salmon Senior Associate Counsel