Self-Regulatory Organizations; National Association of Securities Dealers, Inc.; Order Approving Proposed Rule Change and Notice of Filing and Order Granting Partial Accelerated Approval to Amendments to Proposed Rule Change Relating to Limited Partnership Rollup Transactions

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-34533; File No. SR-NASD-93-3]

Self-Regulatory Organizations; National Association of Securities

Dealers, Inc.; Order Approving Proposed Rule Change and Notice of

Filing and Order Granting Partial Accelerated Approval to Amendments to

Proposed Rule Change Relating to Limited Partnership Rollup

Transactions

August 15, 1994.

I. Introduction

On February 3, 1993, the National Association of Securities

Dealers, Inc. (``NASD'' or ``Association'') filed with the Securities

and Exchange Commission (``SEC'' or ``Commission'') a proposed rule

change pursuant to Section 19(b)(1)\1\ of the Securities Exchange Act

of 1934 (``Exchange Act''), and Rule 19b-4 thereunder.\2\ The proposal

subsequently was amended eight times. On April 14, 1993, May 7, 1993,

May 13, 1993, May 14, 1993, August 26, 1993, October 21, 1993,\3\ April

14, 1994, and July 27, 1994, the NASD filed Amendment Nos. 1, 2, 3, 4,

5, 6, 7 and 8, respectively, to the proposed rule change.\4\ The

proposed rule change would amend Article III, Section 34 of the Rules

of Fair Practice to include rules which prevent NASD members or persons

associated with an NASD member from participating in any ``limited

partnership rollup transaction'' (as defined in the proposed rule

change) unless the transaction includes certain specified provisions

designed to protect the rights of limited partners. The proposed rule

change also would amend Article III, Section 34(b)(6) to narrow the

scope of transactions in which members are forbidden to receive

differential compensation (``Differential Compensation Amendment'').

Finally, the proposed rule change would amend Schedule D of the By-Laws

(``Schedule D'') to prohibit the authorization for quotation on the

Nasdaq National Market (``Nasdaq/NM'') of any security which results

from a covered partnership rollup transaction unless the transaction

was conducted in accordance with certain specified procedures designed

to protect the rights of dissenting limited partners.

---------------------------------------------------------------------------

\1\15 U.S.C. 78s(b)(1) (1988).

\2\17 CFR 19b-4 (1993).

\3\On December 17, 1993, the Limited Partnership Rollup Reform

Act of 1993 (``Rollup Reform Act'') was enacted.

\4\Amendment No. 1 superseded the original rule filing.

Amendment No. 2 amended the rule language and the NASD's Statement

of Purpose in response to comments of the Commission staff.

Amendment Nos. 3 and 4 made technical changes to the rule. Notice of

the proposed rule change (Securities Exchange Act Release No. 32312,

May 17, 1993) was then published in the Federal Register (58 FR

29655, May 21, 1993). Amendment No. 5 made technical changes to the

rule text and responded to the comment letters that the Commission

received in response to the publication of the release in the

Federal Register. Amendment No. 6 made changes to the rule text to

address issues of state law addressed in comment letters. Amendment

No. 7 amended the rule language to partially conform the rule to the

Rollup Reform Act and narrowed the scope of transactions in which

members were forbidden to receive differential compensation.

Amendment No. 8 amended the rule language to conform the rule to the

Rollup Reform Act in all relevant parts and reordered the text of

the proposed rule change in accordance with Section 34 of the Rules

of Fair Practice.

---------------------------------------------------------------------------

Notice of the proposed rule change, together with the substance of

the proposal as amended by Amendment Nos. 1-4, was provided by the

issuance of a Commission release (Securities Exchange Act Release No.

32312, May 17, 1993) and by publication in the Federal Register (58 FR

29655, May 21, 1993). Seven comment letters were received in response

to the Commission release. Three comment letters expressed support for

the proposed rule change.\5\ One comment letter stated that the

proposed rule change should not be adopted ``in the absence of a

legislative mandate.''\6\ Three comment letters neither supported nor

opposed the proposed rule change but offered suggestions on how to

enhance the NASD's rule.\7\

---------------------------------------------------------------------------

\5\See letter from Michael B. Pollack, Chairman, Securities Laws

and Regulatory Affairs Committee, Investment Program Association

(``IPA'') to Jonathan Katz, Secretary, SEC dated June 9, 1993;

letter from Deborah A. DeMott, Professor of Law, Duke University

School of Law (``DeMott'') to Jonathan Katz dated June 10, 1993; and

letter from John F. Olson and Nicholas S. Hodge, Committee on

Federal Regulation of Securities, American Bar Association (``ABA'')

to Jonathan Katz dated June 23, 1993.

\6\See letter from Joe M. Bridges, President, Kelley Oil Corp.

(``Kelley'') to Jonathan Katz dated July 6, 1993.

\7\See letter from Gene Oshman, Baker & Botts (``Baker &

Botts'') to Jonathan Katz dated June 10, 1993; letter from Patricia

Magee Daly, Kutak Rock (``Kutak Rock'') to Jonathan Katz dated June

11, 1993; letter from James E. Showen, Hogan & Hartson (``Hogan &

Hartson'') to Jonathan Katz dated November 3, 1993.

---------------------------------------------------------------------------

The Rollup Reform Act was enacted on December 17, 1993, as part of

the Government Securities Act Amendments of 1993. Section 3(a) of the

Rollup Reform Act added subparagraph (12) to Section 15A(b) of the

Exchange Act to require that the rules of a registered securities

association prevent members of the association from participating in

any limited partnership rollup transaction unless the transaction

provides procedures to protect certain rights of limited partners.

Section 3(c) of the Rollup Reform Act amended Section 15A(b) of the

Exchange Act to require that the rules of a registered securities

association prohibit the authorization for quotation on an automated

interdealer quotation system sponsored by the association of any

security designated by the SEC as a national market system security

resulting from a rollup transaction, unless the transaction provides

certain rights for limited partners.\8\ The NASD subsequently amended

the proposed rule change to conform the language of the rule to the

Rollup Reform Act.\9\

---------------------------------------------------------------------------

\8\Section 3(b) of the Rollup Reform Act added Section 6(b)(9)

to the Exchange Act imposing virtually identical requirements upon

national securities exchanges. See 15 U.S.C. Sec. 78f(b)(9).

\9\See supra n. 4.

---------------------------------------------------------------------------

By this release, the Commission: (i) solicits comment on the

Differential Compensation Amendment; (ii) approves the proposed rule

change as amended by Amendment Nos. 1-4; and (iii) grants approval on

an accelerated basis to Amendment Nos. 5, 6 and 8, and grants approval

on an accelerated basis to Amendment No. 7,\10\ except for that portion

of that Amendment proposing the Differential Compensation Amendment,

which the Commission is not approving by this release.\11\

---------------------------------------------------------------------------

\10\Interested persons are invited to submit written data, views

and arguments concerning Amendment Nos. 5-8 to the proposed rule

change. See infra Section V.

\11\The Differential Compensation Amendment would eliminate the

definition of ``rollup of a direct participation program'' contained

in Subsections (b)(6)(A) and (B) of Article III, Section 34, which

prohibits the receipt of differential compensation in connection

with the solicitation of investor votes in rollup transactions, and

substitute the term ``limited partnership rollup transaction''

wherever the term ``roll-up of a direct participation program''

currently appears in these Subsections. The effect would be to

permit NASD members to receive diffential compensation in connection

with the solicitation of investor votes in any ``roll-up of a direct

participation program'' that does not also constitute a ``limited

partnership rollup transaction.'' See infra Section III.B.1.

---------------------------------------------------------------------------

The text of the proposed rule change is available at the Office of

the Secretary of the NASD and at the Commission.\12\ With respect to

the Differential Compensation Amendment, language proposed to be added

to Subsections (b)(6)(A) and (B) of Article III, Section 34 is in

italics; proposed deletions are in brackets.

---------------------------------------------------------------------------

\12\The NASD also will publish the text of the proposed rule

change in an NASA Notice to Members.

---------------------------------------------------------------------------

Rules of Fair Practice

Article III

* * * * *

Direct Participation Programs

Sec. 34

* * * * *

(b)

* * * * *

Participation in Rollups

(6)(A) No member or person associated with a member shall

participate in the solicitation of votes or tenders from limited

partners [participants] in connection with a limited partnership rollup

transaction [of a direct participation program or programs]

irrespective of the form of the resulting entity [resulting from the

rollup] (i.e., a partnership, real estate investment trust or

corporation), unless [such] any compensation received by the member:

(i) is payable and equal in amount regardless of whether the

limited partner [participant] votes affirmatively or negatively in the

proposed limited partnership rollup transaction;

(ii) in the aggregate, does not exceed 2% of the exchange value of

the newly-created securities; and

(iii) is paid regardless of whether the limited partners

[participants] reject the proposed limited partnership rollup

transaction.

(B) No member or person associated with a member shall participate

in the solicitation of votes or tenders from limited partners

[participants] in connection with a limited partnership rollup

transaction [of a direct participation program or programs] unless the

general partner(s) or sponsor(s) proposing the limited partnership

rollup transaction agrees to pay all solicitation expenses related to

the limited partnership rollup transaction, including all preparatory

work related thereto, in the event the limited partnership rollup

transaction is rejected.

[For purposes of paragraphs (A) and (B), a rollup of a direct

participation program shall mean a transaction involving an

acquisition, merger or consolidation of at least one direct

participation program, not currently listed on a registered national

securities exchange or traded on the Nasdaq System, into another public

direct participation program or a public corporation or a public

trust.]

* * * * *

II. Background

During the 1980s, over $150 billion of public limited partnership

interests were sold to U.S. investors.\13\ Sources have estimated that

11 million investors have purchased limited partnership interests, of

which approximately eight million are small investors, with an average

investment of about $10,000.\14\ Limited partnership interests

typically are risky and illiquid, due to the lack of an active trading

market for such interests.

---------------------------------------------------------------------------

\13\S. Rep. No. 121, 103d Cong., 1st Sess. 4 (1993) (``Senate

Report'') citing testimony of James R. Doty, General Counsel,

Commission, ``Concerning Limited Partnership Roll-Ups,'' before the

Subcommittee on Energy and Agricultural Taxation, Committee on

Finance, United States Senate, July 16, 1991, at 3.

\14\Senate Report, Supra No. 13, at 3.

---------------------------------------------------------------------------

A. Structure of A Limited Partnership

In the typical publicly-offered limited partnership, a sponsoring

organization solicits funds from investors to use in the purchase of

real estate, oil and gas facilities, high technology research, or other

enterprises. The sponsor usually serves as the general partner and is

required to manage the assets and fulfill any obligations to the

investors imposed under the terms of the partnership agreement. The

investors are the limited partners. A partnership agreement typically

will provide for limited partners to receive periodic payments during

the term of their investment, a return of their principal, and a

specified return or profit and a portion of any additional proceeds

upon the liquidation of the partnership assets.

B. Reasons to Invest in a Limited Partnership

Investors purchased limited partnerships for several reasons.

Perhaps most important, in the case of real estate partnerships prior

to the 1986 amendments to the Internal Revenue Code (''1986 Tax Act''),

limited partnership investors enjoyed significant tax benefits.\15\

Limited partnerships permitted small investors to participate in

commercial and multi-family real estate, oil and gas facilities, and

other investments previously limited to institutional or other large

investors.\16\ Investors in limited partnerships were promised that

they would realize a return on their investment within a finite period

of time. Investors also were promised that sponsors would not realize

any return on partnership assets until investors received their share

of the profits.

---------------------------------------------------------------------------

\15\Id. at 5.

\16\Id.

---------------------------------------------------------------------------

C. Advantages for partnership sponsors

Sponsors have a financial incentive to organize limited

partnerships for at least two reasons. First, the sponsor/general

partner expects to realize a profit on any appreciation of the assets

after the limited partners receive their share. Second, the sponsor/

general partner derives income on an on-going basis for the management

services provided in maintaining and operating the property. The

general partner also may receive up-front fees for organizing the

limited partnership.

D. Recent partnership performance

In the late 1980s, the financial climate for limited partnership

deteriorated dramatically. Several factors contributed to limited

partnerships' poor performance. The 1986 Tax Act took away any tax

benefit for limited partnership investors. Real estate and oil and gas

markets also declined precipitously. This, together with a series of

other circumstances, caused many general partners to face a decreasing

revenue base and a growing number of financial problems.\17\ Since

January 1, 1985, the number of limited partnership offerings filed with

the Commission has decreased substantially each year, from a high of

428 in 1985 to a low of 39 in 1991.\18\ Interests in limited

partnerships investing in real estate lost some or all of their

economic value due to the dramatic decline in real estate values during

the late 1980s.

---------------------------------------------------------------------------

\17\Id.

\18\In 1992, 50 new limited partnership offerings were filed

with the Commission. H.R. Rep. No. 21, 103d Cong., 1st Sess.

10(1993) (''1993 house Report'').

---------------------------------------------------------------------------

Several consequences flowed from the deteriorating climate for

limited partnerships. Many general partners stopped raising new capital

altogether. Sales of assets from existing partnerships exceeded any new

capital raised, thereby eroding assets under management and

significantly reducing general partner management fees.\19\ Some

general partners responded to their predicament by changing the

original partnership agreements and restructuring the limited

partnerships by proposing to reorganize or, in many cases, ``roll up''

existing limited partnership interests into new, publicly-traded

securities.

---------------------------------------------------------------------------

\19\Senate Report, supra n. 12, at 5.

---------------------------------------------------------------------------

E. Rollups

From January 1, 1985 to June 30, 1994, approximately 82 limited

partnership rollup transactions involving two or more entities were

registered with the Commission. These rollups have involved over 1,900

separate limited partnerships with an estimated aggregate value well

over seven billion dollars.

1. Rollup structure

A typical ``rollup'' will combine several non-traded individual

limited partnerships into a single new entity that publicly trades on a

national securities exchange or on Nasdaq/NM. This entity generally is

an infinite life vehicle which is designed continually to reinvest

proceeds from asset sales, unlike the provisions limited partnerships,

which are investments with a limited or finite term that, at some point

in time, distribute proceeds, if any, to investors. A rollup also can

involve the reorganization of a single partnership into a new entity.

2. Benefits of rollups

In some cases, reorganizing non-traded public limited partnerships

that have lost substantial value and creating a new publicly-traded,

infinite life vehicle can enhance the value of the investments of the

limited partners.\20\ For example, the new entity may offer investors

liquidity previously unavailable, create economies of scale and reduce

administrative costs to improve performance, and create broader

diversification of assets which will improve investment safety.

---------------------------------------------------------------------------

\20\Id. at 6.

---------------------------------------------------------------------------

3. Criticism of rollup

Critics have said that the vast majority of limited partnership

rollups result in the newly-traded security immediately falling to a

discount to its net asset value, as cash flow from the stronger

partnerships is used to support losses from the weaker

partnerships.\21\ They further argue that ongoing asset management fees

and expenses assessed by the general partners offset, and in fact may

exceed, the promised reduced administrative costs.\22\ As a result, the

limited partners' equity is substantially diluted. One industry witness

testified before Congress that, in the large rollup transactions,

limited partners have realized, on average, a drop of 45 percent from

the exchange value on the first day of trading in their newly issued

rollup securities.\23\ Congressional testimony also disclosed estimates

that these limited partners when taken as a whole have lost

approximately $2 billion in equity, while rollup sponsors have earned

over $250 million in fees.\24\ By one estimate, when compared to

original exchange values, investors involved in public limited

partnership rollups have experience a decline of approximately 70

percent in limited partner equity.\25\

---------------------------------------------------------------------------

\21\Id.

\22\Id.

\23\Liquidity Fund, ``Roll-up Performance: Comparison of

Exchange Value and Closing Prices, 1st Day, 90 Days, 120 days,

Current Market Price,'' in ``Limited Partnership Reorganizations, or

`Roll-ups','' Hearing before the Securities Subcommittee of the

Senate Committee on Banking, Housing and Urban Affairs, February 27,

1991, S. Hrg. 102-77, page 29.

\24\Senate Report, supra n. 12 at 6-7.

\25\Id. at 7.

---------------------------------------------------------------------------

While investor complaints have been sparked by the enormous

declines in the value of the rollup security compared with the

``exchange value'' stated in the prospectus, rollup sponsors have

argued that the stated exchange value is not intended to be the trading

price of the security, and thus, such comparisons tend to overstate the

magnitude of investor losses.\26\ However, rollup disclosure documents

generally have proven to be almost incomprehensible and it is likely

that sponors did not clearly disclose to investors that the stated

exchange value is not intended to be the trading price of the

security.\27\

---------------------------------------------------------------------------

\26\Id.

\27\See 1993 House Report, supra n. 18, at 12:

---------------------------------------------------------------------------

Congressinonal testimony revealed at least three other forms of

abuses in connection with rollup transactions. First, financially sound

partnerships are merged with partnerships that are experiencing

financial difficulty, thereby diluting the interest of the limited

partners of the sound partnerships.\28\ Second, some general partners

have modified the original partnership's fee structure in order to give

much larger equity interests or fees to themselves, to the detriment of

the limited partners.\29\ Finally, when the unattractive terms of the

new rolled up security become apparent, the market further discounts

the newly traded security, pushing its price even lower.

---------------------------------------------------------------------------

\28\Senate Report, supra n. 13, at 7.

\29\Id.

---------------------------------------------------------------------------

F. The Rollup Reform Act

The seriousness of the problem with rollup disclosure documents was

underscored by Commission Chairman Richard Breeden when he stated in

testimony before the Senate Banking Committee in the Spring of 1991

that, ``I have taken a look at some of the documents filed with us in

these roll-up transactions and I would like to meet the person who can

understand all of the disclosures in some of those documents.'' The

Committee notes that a disclosure document which the Chairman of the

Securities and Exchange Commission has difficulty understanding is

likely to prove daunting in complexity to the average small investor in

a limited partnership.

As noted above, Section 3(a) of the Rollup Reform Act amended

Section 15A(b) of the Exchange Act to require that the NASD rules that

promote just and equitable principles of trade include rules to prevent

NASD members from participating in any limited partnership rollup

transaction that does not provide procedures to protect certain

specified rights of limited partners. Such rights include:

(A) The right of dissenting limited partners to:

(i) an appraisal and compensation;

(ii) retention of a security under substantially the same terms

and conditions of the original issue;

(iii) approval of the limited partnership rollup transaction by

at least 75 percent of the outstanding interests of each

participating limited partnership; or

(iv) other rights designed to protect dissenting limited

partners;

(B) The right not to have their voting power unfairly reduced or

abridged;

(C) The right not to bear an unfair portion of the costs of a

proposed rollup transaction that is rejected; and

(D) Restrictions on the general partner's conversion of

contingent interests or fees into non-contingent interests or fees

and restrictions on the general partner's receipt of a non-

contingent equity interest in exchange for fees for services which

have not yet been provided.

The Rollup Reform Act defines a ``dissenting limited partner'' as a

person who, on the date on which rollup soliciting material is mailed

to investors, holds a beneficial interest in a limited partnership that

is the subject of a limited partnership rullup transaction and who

votes against the transaction and complies with procedures established

by the NASD to perfect dissenter's rights.

Section 3(c) of the Rollup Reform Act amended Section 15A(b) of the

Exchange Act to require that the rules of a registered securities

association prohibit the authorization for quotation on an automated

interdealer quotation system sponsored by that association of any

security designated by the Commission as a national market system

security resulting from a rollup transaction, unless such transaction

provides certain rights for limited partners. The rights set forth

under this section are identical to those set forth in Section 3(a) for

registered securities associations.

III. Description of Proposed Rule Change and Comments Received

The NASD's proposed rule change would prevent its members from

participating in any ``limited partnership rollup transaction'' as that

term is defined in the Rollup Reform Act if the transaction does not

provide those procedures to protect the rights of limited partners that

are mandated by the Rollup Reform Act. The proposed rule change also

would narrow the scope of transactions in which members are forbidden

to receive differential compensation. Finally, the proposed rule change

would prohibit the authorization for quotation on Nasdaq of any

security designated by the Commission as a national market system

security resulting from a rollup transaction, unless the transaction

provides certain rights for dissenting limited partners.

Proposed Rule Change to Article III, Section 34

A. Definitions

Subsequent to publication of notice of the proposed rule change,

the NASD proposed to amend the definitions of ``dissenting limited

partner'' and ``limited partnership rollup transaction'' to be added to

Subsection (b)(2)(B).\30\

---------------------------------------------------------------------------

\30\The terms ``cash available for distribution,'' ``cash

flow,'' ``limited partner,'' ``limited partnership,'' ``management

fee,'' ``solicitation expenses,'' and ``transaction costs'' are

adopted as published in the notice of the proposed rule change. See

Securities Exchange Release No. 32312, supra n. 4, 58 FR 29655,

29655-56.

---------------------------------------------------------------------------

``Dissenting Limited Partner'' is defined in new Subsection

(b)(2)(B)(iii), in accordance with the Rollup Reform Act, as a person

who, on the date on which rollup soliciting material is mailed to

investors, is a holder of a beneficial interest in a limited

partnership that is the subject of a limited partnership rollup

transaction and who votes against the transaction and complies with

procedures established by the NASD to assert dissenters' rights, except

that for purposes of an exchange or tender offer, a person must file an

objection in writing with the party responsible for tabulating votes or

tenders during the period in which the offer is outstanding.31

---------------------------------------------------------------------------

\3\1By defining ``dissenting limited partner'' to mean a person

who is a holder of the limited partnership interests on the date on

which soliciting material is mailed, persons who buy limited

partnership interests after that date are prevented from asserting

dissenters' rights. These persons are on notice of the proposed

rollup transaction when they purchase their limited partnership

interests and, therefore, do not need the same type of protections

granted to existing limited partners.

---------------------------------------------------------------------------

``Limited Partnership Rollup Transaction'' is defined in new

Subsection (b)(2)(B)(vii), in accordance with the Rollup Reform Act, as

a transaction involving the combination or reorganization of limited

partnerships, either directly or indirectly, where some or all

investors in the limited partnerships receive new securities or

securities in another entity. The definition provides exceptions for

certain kinds of private transactions or other transactions which do

not require the application of the protections of the Exchange Act. In

addition, the term ``limited partnership rollup transaction'' is

defined to include the reorganization of a single limited partnership,

directly or indirectly, in which some or all investors receive new

securities or securities in another entity, if the transaction meets

certain specified criteria in the Rollup Reform Act. The definition

covers both transactions in which securities received in single or

multiple partnership rollups are received directly, and transactions in

which securities are received indirectly through a step

transaction.32

---------------------------------------------------------------------------

\3\2See discussion of umbrella partnership real estate

investment trusts (``UPREITs'') infra n. 50 and accompanying text.

---------------------------------------------------------------------------

Exclusions The definition of ``limited partnership rollup

transaction'' also incorporates six exclusions, in accordance with the

Rollup Reform Act. A transaction will not be deemed to be a limited

partnership rollup transaction of it: (1) involves only a limited

partnership or partnerships having an operating policy or practice of

retaining cash available for distribution and reinvesting proceeds from

the sale, financing, or refinancing of assets in accordance with such

criteria as the Commission determines appropriate; (2) involves only

limited partnerships wherein the interests of the limited partners are

repurchased, recalled, or exchanged in accordance with the terms of the

preexisting limited partnership agreements for securities in an

operating company specifically identified at the time of the formation

of the original limited partnership; (3) involves only securities to be

issued or exchanged that are not required to be and are not registered

under the Securities Act of 1933 (``Securities Act''); (4) involves

only issuers that are not required to register or report under Section

12 of the Exchange Act, both before and after the transaction; (5)

involves the combination or reorganization of one or more limited

partnerships in which a non-affiliated party succeeds to the interests

of a general partner or sponsor, except those types of transactions as

the Commission may by rule deem to fall within the definition of

``limited partnership rollup transaction,'' if: (a) such action is

approved by not less than 66\2/3\ percent of the outstanding units of

each of the participating limited partnerships; and (b) as a result of

the transaction, the existing general partners will receive only

compensation to which they are entitled as expressly provided for in

the preexisting limited partnership agreements; or (6) involves a

transaction, except as the Commission may by rule deem to fall within

the definition of ``limited partnership rollup transaction,'' in which

the securities offered to investors are securities of another entity

that are reported under a transaction reporting plan declared effective

by the Commission under Section 11A of the Exchange Act before the date

of enactment of the Rollup Reform Act, if: (a) such other entity was

formed, and such class of securities was reported and regularly traded,

not less than 12 months before the date on which soliciting material is

mailed to investors; and (b) the securities of that entity issued to

investors in the transaction do not exceed 20 percent of the total

outstanding securities of the entity, exclusive of any securities of

such class held by or for the account of the entity or a subsidiary of

the entity.

B. Participation in Rollups

The Commission is soliciting comment on the Differential

Compensation Amendment. As noted above, the Differential Compensation

Amendment would amend Subsection (b)(6) to: (i) limit the scope of the

prohibition upon receipt of differential compensation to transactions

constituting ``limited partnership rollup transactions'' instead of

transactions constituting ``rollups of direct participation

programs'';33 and (ii) prohibit the participation of members and

persons associated with members in a limited partnership rollup

transaction unless the transaction includes provisions designed to

protect the rights of limited partners.34

---------------------------------------------------------------------------

\3\3Section 34(a)(2) defines ``direct participation program'' as

``a program which provides for flow-through tax consequences

regardless of the structure of the legal entity or vehicle for

distribution. . . .'' (emphasis added). By contrast, new Subsection

(b)(2)(B)(vi) defines ``limited partnership'' as a DPP organized as

a limited partnership. (emphasis added).

\3\4Subsection (b)(6)(C) thus would regulate a member's

solicitation activities, advisory activities, or the writing of a

fairness opinion. Subsections (b)(6)(A) and (B) currently regulate

only a member's receipt of differential compensation in the

solicitation of votes or tenders.

---------------------------------------------------------------------------

1. Receipt of Differential Compensation in DPP Rollups Not Also

Constituting Limited Partnership Rollup Transactions. Congress began to

focus on investor protection, fairness and disclosure issues related to

rollup transactions in 1990. One of the early abuses on which Congress

focussed was payment of compensation to soliciting broker-dealer only

when an investor voted in favor of a rollup transaction. The Rollup

Reform Act requires the NASD to adopt rules proscribing the receipt by

members of ``differential compensation'' when soliciting votes for a

limited partnership rollup transaction. The Commission previously had

approved an NASD rule regulating its members' receipt of differential

compensation in DPP rollups.\35\

---------------------------------------------------------------------------

\35\See Securities Exchange Act Release No. 29582 (Aug. 19,

1991), 56 FR 42095 (Aug. 26, 1991) (approving SR-NASD-91-24).

---------------------------------------------------------------------------

Current Subsections (b)(6) (A) and (B) were adopted in that rule

change to regulate the participation of members in the solicitation of

votes or tenders from participants in a rollup of a DPP. The NASD

stated in Amendment No. 7 that at the time of its adoption, the SEC and

NASD were aware that the definition of ``rollup of a direct

participation program'' was broader than the definition of ``limited

partnership rollup transaction'' then pending in Congress (and proposed

to be amended in this proposed rule change) because it applies to

``direct participation programs'' rather than ``limited partnerships''

and does not include all of the exclusions that are available from the

``limited partnership rollup'' definition.\36\

---------------------------------------------------------------------------

\36\But see H.R. Rep. No. 254, 102d Cong., 1st Sess. 95 (1991),

which proposed to define ``partnership'' to include ``such other

entity having a substantially economically equivalent form of

ownership instrument as the Commission determines, by rule

consistent with the purposes of [the Limited Partnership Rollup

Reform Act of 1991], to include within this definition.''

---------------------------------------------------------------------------

The NASD continues to be concerned that it may be confusing to have

two definitions of a rollup transaction which are different in scope

set forth in Subsection 34(b).\37\ Therefore, the NASD is proposing to

amend Subsections (b)(6) (A) and (B) by replacing the special rollup

definition in those Subsections with the new definition of ``limited

partnership rollup transaction'' and by substituting the term ``limited

partnership rollup transaction'' wherever the term ``rollup of a direct

participation program'' currently appears. The NASD notes that the

result of this amendment would be to limit the scope of these

Subsections as they would not longer be applicable to almost any DPP

rollup, but only to ``limited partnership rollup transactions'' as

defined in the proposed rule change.

---------------------------------------------------------------------------

\37\But see e.g., Fryer, A Rollup Update 6 (Practicing Law

Institute Real Estate Law and Practice Course Handbook No. 400,

1994):

In September 1991, in Notice to Members 91-56, the NASD adopted

rules which restrict differential compensation in connection with

the ``rollup of a direct participation program.'' The term ``rollup

of a direct participation program'' is a broader concept than

``limited partnership rollup transactions'' and accordingly the

limitations in the receipt of compensation and the allocation of

expenses which is addressed in this earlier release will apply even

if the transaction is not considered a ``limited partnership rollup

transaction.''

---------------------------------------------------------------------------

The Commission notes that its rules governing roll-up

transactions\38\ apply to transactions that involve the combination or

reorganization of one of more finite-life limited partnerships or

similar entities. The Commission is soliciting comment from interested

persons concerning the potential impact of the Differential

Compensation Amendment on the investing public.

---------------------------------------------------------------------------

\38\See Items 901-15 of Regulation S-K, 17 CFR 229.901-915

(1993).

---------------------------------------------------------------------------

2. When a Limited Partnership Rollup Transaction is Presumed Not to

be Unfair or Unreasonable. Pursuant to new Subsection (b)(6)(C)(i), the

NASD proposes to define a series of circumstances with respect to

limited partnership rollup transactions which are presumed not to be

unfair or unreasonable. In accordance with the Rollup Reform Act, it is

presumed not to be unfair or unreasonable if dissenting limited

partners are offered one of the following: an appraisal and

compensation, retention of a security with substantially the same terms

and conditions as the original limited partnership, approval of the

rollup transaction by not less than 75 percent of the outstanding units

of each participating limited partnership, or other comparable rights

designed to protect dissenting limited partners. Protections for

limited partners also include the right of limited partners not to have

their voting power unfairly reduced, the right of limited partners not

to bear unfair costs associated with a rollup transaction that is

rejected, and certain restrictions on abusive changes in management

fees and compensation. As noted above, dissenters' rights may be

asserted only by a person who, on the date that rollup soliciting

material is mailed to investors, is a holder of a beneficial interest

in the limited partnership that is the subject of the rollup. The

proposed rule change would require a transaction constituting a

``limited partnership rollup transaction'' to include one of the

provisions set forth in Subsections (b)(6)(C)(i) a., b., or c.,

discussed below.

a. Compensation Based on Appraisal: New Subsection (b)(6)(C)(i)a.

provides that dissenting limited partners must receive compensation

based on an appraisal made by an independent appraiser, unaffiliated

with the sponsor or general partner of the program. The appraisal

provided should consist of an accurate measure of the present financial

value of the dissenting investor's ownership interest in the underlying

assets of the limited partnership.

Forms of compensation based on appraisal may include cash, secured

or unsecured debt instruments, or freely-tradable securities.

Subsection (b)(6)(C)(i) imposes several conditions upon the issuance of

debt instruments to ensure that the debt issued is equivalent in value

to the cash payment and, if readily marketable, would likely trade in

an aftermarket at such value.\39\ This is intended to prevent

dissenting investors from being forced to accept debt instruments

which, reflecting their below-market value, would immediately trade at

a substantial discount.

---------------------------------------------------------------------------

\39\All debt instruments must provide for a trustee and an

indenture, and provide for prepayment with 80% of the net proceeds

of any sale or refinancing of the assets of the entity. All debt

instruments must provide the holders with a market rate of interest

equal to at least 120% of the applicable federal rate and have a

term not longer than 8 years. Unsecured debt instruments may be used

only when the entity issuing the debt has a limitation on total

leverage not greater than 70% of the appraised value of its assets.

---------------------------------------------------------------------------

Freely-tradable securities may be utilized as compensation only if

issued by a company which has been listed on a national securities

exchange or traded on the Nasdaq Stock Market prior to the transaction.

The number of freely-tradable securities offered in return for

partnership interests would be determined in relation to the average

last sale price of the securities in the 20-day period following the

date of the meeting at which the vote on the rollup occurs.\40\ If the

issuer of the freely-tradable securities and the sponsor or general

partner are affiliated (i.e., if it receives any material compensation

from the issuer or its affiliates in conjunction with the rollup

transaction or the purchase of the general partner's interest), and the

securities issued as compensation are new securities, such securities

must not represent more than 20% of the issued and outstanding

securities of that class after issuance. The 20% limitation on the

amount of securities offered as compensation by an affiliate helps to

establish a threshold below which significant dilution could be

presumed not to have not occurred.

---------------------------------------------------------------------------

\40\In response to a comment by the ABA, the NASD clarified that

the ``freely-tradable securities'' referred to in Subsection

(b)(6)(C)(i)a.4. would be valued at a 20-day period ``following the

date of the meeting at which the vote on the limited partnership

rollup occurs. The `vote' referred to may be a vote, consent, or

authorization.'' See Amendment No. 5.

---------------------------------------------------------------------------

b. Receipt of a Security With Substantially the Same Terms and

Conditions: New Subsection (b)(6)(C)(i)b. provides that dissenting

limited partners may receive or retain a security with substantially

the same terms and conditions as the original issue if certain

conditions are met. Retention of a security under the same terms and

conditions as the original issue means the provision of a security that

has the same characteristics as the dissenting limited partners'

original limited partnership interest.

c. Comparable Rights: Supermajority Approval, Review by Independent

Committee, and Other Comparable Rights: New Subsection (b)(6)(C)(i)c.

permits members and persons associated with members to participate in a

limited partnership rollup transaction as long as the transaction

includes ``other comparable rights'' provisions designed to protect the

rights of limited partners. This Subsection is intended to provide

flexibility for sponsors and general partners in structuring rollups,

while at the same time providing protections for limited partners.

``Comparable rights'' may include the right to supermajority approval

of the transaction, the right to review of the transaction by an

independent committee, or such other rights as the NASD deems

comparable.

(i) Supermajority Approval. General partners will not be required

to provide the right of compensation, as provided in new Subsection

(b)(6)(C)(i) where at least 75% of the outstanding units of each of the

individual limited partnerships participating approve the rollup

transaction. Any limited partnership that fails to reach the 75%

threshold must be excluded from the rollup transaction. The proposed

rule change, however, would permit a limited partnership rollup

transaction to be consummated even though individual partnerships did

not approve the transaction.

(ii) Review by Independent Committee. The proposed rule change

relating to review by an independent committee will require that the

committee: (1) Be approved by a majority of the outstanding securities

of each participating limited partnership; (2) have access to the books

and records of the partnership; (3) prepare a report to the limited

partners that are the subject of the rollup presenting its findings and

recommendations, including any minority views; (4) have the authority

to negotiate the proposed transaction with the general partner or

sponsor on behalf of the limited partners, but not the authority to

approve the transaction; (5) deliberate for a period no longer than 60

days unless unanimously agreed upon by the members of the independent

committee or if approved by the NASD; (6) may be compensated and

reimbursed by the partnerships subject to the limited partnership

rollup transaction and have the ability to retain independent counsel

and financial advisors to represent all limited partners at the limited

partnerships' expense; and (7) be entitled to indemnification to the

maximum extent permitted by law from the general partners, sponsors,

limited partnerships, and rolled-up entities against claims, causes of

action or lawsuits initiated by any party in interest, including

limited partnerships or limited partners, related to any action or

decision made in furtherance of their responsibilities.

(iii) Other Comparable Rights. Comparable rights for dissenting

limited partners are not limited to supermajority approval or the

establishment of an independent committee, but may include any other

comparable right proposed by general partners or sponsors, provided

that the general partners or sponsors demonstrate to the satisfaction

of the NASD, or if the NASD determines appropriate, to the satisfaction

of an independent committee, that the rights proposed are

comparable.\41\

---------------------------------------------------------------------------

\41\The composition of such independent committee to review

proposed alternative comparable rights under this provision may be

different than the independent committee formed pursuant to proposed

Subsection (b)(6)(C)(i)c.2. Additionally, the criteria utilized by

the independent committee to review proposed alternative comparable

rights under this provision may differ from that required by the

independent committee formed pursuant to proposed Subsection

(b)(6)(C)(i)c.2.

---------------------------------------------------------------------------

3. When a Rollup Transaction is Presumed to be Unfair or

Unreasonable. Regardless of compliance with Subsection (b)(6)(C)(i), a

limited partnership rollup transaction will be presumed to be unfair or

unreasonable, pursuant to new Subsection (b)(6)(C)(ii)\42\ if: (1)

Certain actions taken by the general partner result in the unfair

conversion and valuation of general partner interests in a limited

partnership rollup transaction; (2) a limited partnership rollup

transaction fails to protect the voting rights of the limited partners;

(3) the transaction costs of a rejected limited partnership rollup

transaction are unfairly apportioned or allocated; or (4) the payment

of fees to general partners in connection with limited partnership

rollup transactions are unfair, unreasonable, or inappropriate.

---------------------------------------------------------------------------

\42\Where a limited partnership rollup transaction is determined

by NASD staff to include one of the arrangements considered to be

unfair or unreasonable, the member bears the burden of rebutting the

presumption by demonstrating that the arrangement is not unfair or

unreasonable or that the arrangement does not come within one of the

enumerated unfair and unreasonable arrangement provisions.

---------------------------------------------------------------------------

a. Actions Taken By the General Partner: New Subsection

(b)(6(C)(ii)a. provides that it presumptively unfair and unreasonable

for general partners, when determining their interest in the new entity

resulting from a limited partnership rollup transaction, to: (1)

convert an equity interest for which consideration has not been paid

into a voting interest in the new entity if the equity interest was not

otherwise provided for in the limited partnership agreement and

disclosed to limited partners; (2) fail to follow the valuation

methods, if any, in the partnership agreements when valuing their

partnership interests;43 or (3) utilize a projected value of their

equity interest rather than the appraised current value of their equity

interest when determining their interest in the new entity.

---------------------------------------------------------------------------

\4\3In its comment letter, the ABA pointed out that partnership

agreements do not generally contain such valuation provisions. The

NASD amended its rule to clarify that it applies to rollups that

contain valuation provisions. See Amendment No. 5.

---------------------------------------------------------------------------

b. Voting Rights: New Subsection (b)(6(C)(ii)b. contains four

provisions for the protection of investors with respect to voting

rights. New Subsection (b)(6(C)(ii)b.1. provides that it is

presumptively unfair if the voting rights in the entity resulting from

the limited partnerships rollup transaction do not follow the original

voting rights of the limited partnerships participating in the

transaction. However, the NASD recognizes that certain material changes

to voting rights may be necessary to conform disparate rights that may

exist among participating partnerships. Material changes may be

effected only if the NASD determines that the changes are not unfair or

if an independent committee approves such changes.44

---------------------------------------------------------------------------

\4\4See supra n. 41.

---------------------------------------------------------------------------

New Subsection (b)(6(C)(ii)b.2. provides that it is presumptively

unfair if a majority45 of the interests in an entity resulting

from a limited partnership rollup transaction is unable to vote to

cause the entity to take certain actions which are ordinarily the

prerogative of the owners rather than management. Thus, it is

presumptively unfair not to permit a vote to amend the limited

partnership agreement, articles of incorporation, bylaws, or indenture.

It is also presumptively unfair not to permit a vote to dissolve the

entity. It is also presumptively unfair not to permit a vote to remove

and elect the general partners, board of directors, trustee, or similar

governing entity. Finally, it is presumptively unfair not to permit a

vote to approve or disapprove the sale of substantially all the assets

of the entity, without concurrence by the sponsor, general partner(s),

board of directors, trustee, or similar governing entity, unless such

actions would be inconsistent with state law.46

---------------------------------------------------------------------------

\4\5The term ``majority'' refers to a 50%-plus-one vote except

as superseded by state law or the partnership agreement which may

require a higher standard. See Amendment No. 5.

\4\6In response to several commenters, the NASD amended its rule

to make it clear that it would not conflict with or supersede state

corporate law. See infra n. 54-55 and accompanying text.

---------------------------------------------------------------------------

New Subsection (b)(6(C)(ii)b.3. provides that it is presumptively

unfair if the sponsor or general partner proposing a limited

partnership rollup transaction is not required to provide a document

which clearly delineates instructions and procedures of voting against

or dissenting from a proposed transaction.

New Subsection (b)(6(C)(ii)b.4. provides that it is presumptively

unfair if the general partner or sponsor fails to utilize an

independent third party to receive and tabulate all votes and dissents

or fails to require the third party to make the tabulation available to

the general partner and any limited partner upon request at any time

during and after voting occurs.

c. Transaction Costs: Subsection (b)(6(C)(ii)c. provides that it is

presumptively unfair if transaction costs of a rejected limited

partnership rollup transaction are not apportioned between the general

and limited partners in accordance with the final vote as follows: (1)

in the case of a limited partnership rollup transaction which is not

approved, the general partner or sponsor bears transaction costs in

proportion to the total number of abstentions and votes to reject the

transaction, and the limited partners bear transaction costs in

proportion to the number of votes to approve the transaction; or (2) in

the case of a rollup transaction which is approved, but where some

individual partnerships do not approve and are not included in the

approved transaction, the general partner is required to pay costs on

behalf of the limited partnerships who have voted not to approve the

transaction.

With respect to allocating total costs for a rejected limited

partnership rollup transaction, the NASD believes that subsections

(b)(6(B) and (b)(6(C)(ii)d. taken together require the general partner

to pay all the solicitation expenses in addition to transaction costs

in proportion to the total number of abstentions and votes to reject

the transaction. Additionally, limited partnerships which vote to

reject and which are not included in a limited partnership rollup

transaction which is ultimately consummated, may not be assessed any

transaction costs.

d. Fees of the General Partners: New Subsection (b)(6(C)(ii)d.

protects limited partners against the assessment of fees by a general

partner which are unfair, unreasonable, or inappropriate. New

Subsection (b)(6(C)(ii)d.1. provides that it is presumptively unfair

for general partners to receive or convert unearned management fees

discounted to a present value while also proposing to receive new

asset-based fees. A similar presumption of unfairness applies if

property management fees and other fees are inappropriate,

unreasonable, greater than or not competitive with the fees that would

be paid to third parties for performing similar services under proposed

Subsection (b)(6(C)(ii)d.2. Subsection (b)(6(C)(ii)d.3. provides that

substantial and adverse changes in fees are presumed unreasonable if

not submitted to and approved by an independent committee.47

---------------------------------------------------------------------------

\4\7See supra n. 41.

---------------------------------------------------------------------------

Proposed Rule Change to Schedule D

The NASD is proposing to amend Part I and III to Schedule D to the

NASD By-Laws to establish listing standards for Nasdaq/NM securities

resulting from a limited partnership rollup transaction, as required by

new Section 15A(b)(13) of the Exchange Act. The rule language is the

same as that proposed for inclusion in Subsection (b) of Article III,

Section 34 of the Rules of Fair Practice with two minor exceptions.

When the term ``direct participation program'' is used in the

definition section, a cross-reference is provided to the definition of

that term in Article III, Section 34 of the Rules of Fair Practice. In

addition, the term ``management fee'' is modified to refer only to such

fees related to a ``limited partnership.'' In comparison, the

definition in Article III, Section 34(b) of the Rules of Fair Practice

substituted the term ``direct participation program'' because the term

``management fee'' is used elsewhere in Article III, Section 34(b) of

the Rules of Fair Practice and the definition, therefore, should be

applicable to any DPP.\48\

---------------------------------------------------------------------------

\48\The new listing criteria for limited partnership rollups are

included in new Section 3 to Part III of Schedule D. Current

Sections 3 through 7 are redesignated to reflect the addition of new

Section 3 and are amended to reference the limited partnership

rollup criteria. Proposed Section 8 is amended to permit the NASD to

terminate an issue's designation if it no longer complies with the

requirements in redesignated Sections 5 and 6 or 7.

---------------------------------------------------------------------------

Application of Proposed Rule Change to UPREITs

UPREIT transactions have certain general characteristics. A limited

partnership or partnerships are consolidated into an operating limited

partnership. The consolidation is generally conducted as a private

placement. In order to effect a non-taxable exchange, the individual

limited partnership interests or the properties are exchanged for the

operating limited partnership units.\49\ The general partner of the

operating limited partnership, a real estate investment trust

(``REIT''), issues beneficial interests to investors in exchange for

cash to raise capital that will purchase some of the operating

partnership units. The operating partnership, in turn, may use the

proceeds to pay the debts of the limited partnerships included in the

operating partnership. It may use the proceeds for other purposes, such

as buying additional properties. The REIT shares may be listed on a

national securities exchange or Nasdaq/NM and, thus, reported under a

transaction reporting plan. As part of the transaction, the unitholders

of the new operating partnership are generally given an open-ended

option after one year to redeem their operating partnership units for

cash from the REIT. Instead of offering cash, the typical REIT may, at

its option, offer unitholders REIT units for the operating partnership

units pursuant to a private exchange offering or a registered exchange

offering, depending on how the offering is structured. It is, however,

optional to the operating partnership unitholders as to whether to

exercise the redemption right.

---------------------------------------------------------------------------

\49\Built-in gain is deferred, not eliminated. Also, the

exchange of old partnership interests for operating partnership

units is not necessarily tax-free under all circumstances. After the

proceeds of the public REIT offering are used to pay down debt, if a

partner's share of liabilities of the operating partnership is less

than the same partner's share of liabilities of the old partnership,

the partner will be treated as having received a cash distribution.

If the distribution exceeds the adjusted basis in the partner's

operating units, the partner will recognize taxable gain. If the old

partnerships partly sell and partly contribute property to the

operating partnership, partners in the operating partnership may

realize phantom income.

---------------------------------------------------------------------------

A. UPREIT Structures

UPREIT transactions have varying structures. The NASD is currently

aware of at least three structures. First, UPREITs can be structured so

that both the consolidation of limited partnership interests into the

operating partnership and the issuance of REIT shares to investors are

effected pursuant to bona fide private placement exemptions under

Section 4(2) of the Securities Act (``private placement exemption''),

after which the operating partnership units may be redeemed for cash

or, at the REIT's option, exchanged for REIT shares in a private

exchange offering.

A second structure involves the consolidation of limited partners'

interests into the operating limited partnership in a registered

transaction, with a simultaneous public offering of REIT units. The

REIT shares are listed on a national securities exchange or authorized

for quotation on Nasdaq/NM and are reported under a transaction

reporting plan. The offer by the REIT to the limited partners in the

operating partnership to exchange their operating partnership units for

REIT shares is effected as a registered exchange offer.

A third structure involves the consolidation of limited partners'

interests into the operating limited partnership pursuant to a bona

fide private placement exemption, along with a public offering of units

by the REIT general partner. The REIT is listed on a national

securities exchange or Nasdaq/NM. The REIT is thus a reporting company

prior to any exchange offer of REIT shares for operating partnership

units. The offer by the REIT to the limited partners in the operating

partnership to exchange their operating partnership units for REIT

shares is effected as a separate bona fide private placement with the

shares then registered by the REIT for the benefit of new holders

through a shelf-registration statement or as a registered exchange

offer.

B. Applicability of the Proposed Rule Change to UPREIT Transactions

As a result of an understanding reached between the staffs of the

NASD and the SEC, the NASD's Corporate Financing Department intends to

work closely with the SEC's Division of Corporation Finance to review

all direct, indirect and multi-step limited partnership rollup

transactions in their entirety, including UPREIT transactions, for an

initial determination of whether a transaction constitutes a ``limited

partnership rollup transaction.''

The NASD believes that the first type of UPREIT transaction

described above is not subject to the proposed rule change

where the claim of a private placement exemption for the exchange offer

is bona fide. Such a transaction does not meet the definition of

``limited partnership rollup transaction'' because the original limited

partners are receiving securities in the operating partnership that are

not required to be registered under the Securities Act.

The NASD believes that the second type of UPREIT transaction

described above is subject to the coverage of the proposed rule change

because the transaction viewed in its entirety meets the definition of

``limited partnership rollup transaction'' and does not qualify for any

of the exemptions from the definition.

Regarding the third type of UPREIT transaction described above, the

NASD will conduct its review of applicability of the proposed rule

change in conjunction with the SEC's review for an initial

determination of whether the entire transaction should be reviewed as a

roll-up because it is a step transaction that indirectly involves a

roll-up.\50\ In the case of a valid private placement of operating

partnership units followed by a registered exchange of units for REIT

shares in a short period of time, the two transactions may be stepped

together and therefore subject to full review under the proposed rule

change. Another situation where the proposed rule change might be

applicable to the third type of UPREIT transaction is if the claim of a

private placement for the consolidation into the operating partnership

is not bona fide and the operating partnership transaction is required

to be registered with the Commission and conducted as a public offering

at the same time that the public REIT offering occurs. In this instance

also, the NASD would review the transaction for compliance with the

terms of the proposed rule change.

---------------------------------------------------------------------------

\50\See supra n. 32 and accompanying text.

---------------------------------------------------------------------------

Comments Received on Proposed Rule Change

The Commission received seven comment letters. The comment letters

from the IPA, DeMott, and the ABA expressed support for the proposed

rule change. One comment letter, from Kelley, stated that the NASD

rules should not be adopted ``in the absence of a legislative

mandate.'' The comment letters from Baker & Botts, Kutak Rock, and

Hogan & Hartson neither supported nor opposed the proposed rules but

offered suggestions on how to enhance the NASD's rule.

As noted above, Congress passed the Rollup Reform Act subsequent to

the receipt of the comment letters. The Rollup Reform Act rendered moot

many of the issues raised by commenters. The significant issues that

were raised and not subsequently mooted by the Rollup Reform Act are

addressed below. In addition, the NASD also made several technical

amendments in response to the comment letters.\51\

---------------------------------------------------------------------------

\51\See Amendment No. 5.

---------------------------------------------------------------------------

A. Right of Compensation Based on Appraisals

Kelly noted that some partnerships, e.g. oil and gas, already

include requirements for a supporting appraisal underlying the exchange

value determination. Therefore, according to Kelley, the NASD's

requirement that dissenters' rights of compensation be based on

appraisal, would give the dissenters the right to a second appraisal

which would be ``redundant and wasteful.''

The NASD has stated that ``an appraisal that functions to determine

the transaction's exchange value could also be used to determine the

value of dissenters's compensation so long as the appraisal is done in

a manner consistent with the appropriate industry practice.''

Hogan & Hartson argues that the appraisal rights provisions under

new Subsection (b)(6)(C)(i) should be clarified to permit one

partnership participating in a rollup to offer one type of right while

another partnership may offer another type of right, stating that such

an option would be satisfactory from a fairness perspective.

New Subsection (b)(6)(C)(i) does not by its terms prohibit

structuring a rollup offering such that different rights may be offered

to different partnerships involved in the same transaction. Further,

the ``other comparable rights'' provision in Subsection

(b)(6)(C)(i)c.3. allows for variations in structuring that, subject to

NASD approval, are indeed comparable to rights provided in the proposed

rule change, including variations in form as well as substance.

B. Compensation of Dissenters

Two commentators\52\ expressed concern about the use of ``freely-

tradable securities'' as compensation for dissenting limited partners,

pursuant to new Subsection (b)(6)(C)(i)a.

---------------------------------------------------------------------------

\52\See DeMott and Kelley.

---------------------------------------------------------------------------

The use of a ``freely-tradable security'' as compensation is

reasonable. The listing standards of the exchanges and of Nasdaq should

provide adequate protection against dilution when ``freely-tradable

securities'' are offered as compensation.

One the issue of valuation of the ``freely-tradable securities,''

the ABA voiced concern about the method that the NASD will use to

calculate the value of the securities that will be used as

compensation. New Subsection (b)(6)(C)(i) provides that the value of

the freely-tradable security must be determined in relation to the last

sale price ``in the 20-day period following the effective date.'' The

ABA noted that the ``effective date'' must refer to the effective date

of the registration statement rather than to the closing of the rollup

occurs.''\53\

---------------------------------------------------------------------------

\53\See Amendment No. 5.

---------------------------------------------------------------------------

C. Valuation Provisions

Subsection (b)(6)(C)(ii)a.2. provides that a rollup is presumed to

be unfair if the general partner fails to follow the valuation

provision in the limited partnership agreement. The ABA pointed out

that partnership agreements do not contain such valuation provisions,

and suggested revised language to accommodate such a contingency and

permit reliance on ``more favorable'' valuation provisions than those

in limited partnership agreements ``if any.''

The NASD stated that it does not want to make determinations as to

whether a proposed valuation method is more favorable than those

contained in limited partnership agreements to which investors have

previously agreed. However, the NASD amended its rule to clarify that

Subsection (b)(6)(C)(ii)b.1. applies to rollups which contain valuation

provisions.

Hogan & Hartson argues that the valuation requirements in new

Subsections (b)(6)(C)(ii)a.2. and 3. should be clarified by

explanations of how valuation provisions of limited partnership

agreements and utilization of current value methodology can be both

followed in the event of inconsistency, and requests that the NASD

explain the meaning of the terms ``current value'' and ``future value''

in new Subsection (b)(6)(C)(ii)a.3.

The NASD believes that the use of a ``current value'' for

evaluating equity interests of the roll-up partnerships when

determining the general partner's/sponsor's interest in the new entity

is fair because the guesswork involved in arriving at any ``future

value'' estimate may prejudice the limited partners in favor of the

general partners, especially if the estimated value is exaggerated.

However, the NASD also believes that the valuation of partnership

interests should be appropriate to the particular industry, and that is

permissible, for example, to interpret ``current value'' on a ``going

concern'' or ``liquidation'' basis.

With regard to Subsection (b)(6)(C)(ii)a.2., the NASD generally

believes that the fairest valuation method of all is that method which

reflects, as much as possible, the original agreement or contract

between the general partner/sponsor and limited partners. However, the

NASD believes that if the valuation provisions of the existing

partnership agreements require a future valuation of general partner

interests which would be inconsistent with the proposed rule change's

requirement that current value be used, then the requirement to use

current value supersedes the requirement to follow valuation models in

the original partnership agreements.

D. Voting Rights

When the proposed rule was published in the Federal Register the

Commission specifically sought comment on any potential conflicts

between the NASD's proposal and state contract or corporate law. The

Commission received four comment letters concerning a conflict between

the voting rights provision of proposed Subsection (b)(6)(C)(ii)b.2.

and state corporate law.\54\ The NASD amended its rule to make it clear

that it would not conflict with or supersede state corporate law. In

response to the Commission's concerns and the comment letters received,

the NASD amended its rule to make it clear that the rule would not

conflict with or preempt state corporate law.\55\

---------------------------------------------------------------------------

\54\ABA, Baker & Botts, Kelley, and DeMott. The ABA noted that

while the NASD's rule conflicts with most state law, it does not

conflict with the laws of some states, such as Massachusetts.

\55\Additionally, the term ``management'' in Subsection

(b)(6)(C)(ii)2.C. was replaced with the phrase ``general partner,

board of directors, trustee, or similar governing entity'' to

comport with the introductory clause of Subsection (b)(6)(C)(ii)2.C.

See Amendment No. 6.

---------------------------------------------------------------------------

Hogan & Hartson argued that the Rollup Reform Act did not mandate

that the NASD impose specific voting rights, especially for the

operating partnership in UPREITs, because very few partnership

agreements provide for such rights in any case.

The Commission believes that the proposed rule change does not

impose specific voting rights. First, as noted above, the rule is

drafted in a manner that defers to applicable state law. Second, if the

NASD staff determines that a particular voting arrangement is

presumptively unfair or unreasonable, the member may nonetheless rebut

the presumption if it demonstrates that the arrangement is not unfair

or unreasonable or that the arrangement does not come within one of the

enumerated unfair and unreasonable arrangement provisions.

E. Transaction Costs

New Subsection (b)(6)(C)(ii)c. requires that transaction costs be

apportioned according to voting so that, in a rejected rollup

transaction, the general partner bears the costs of the transaction in

proportion to the total number of rejections and abstentions. the IPA

suggested that it was inappropriate to require the general partner to

bear the cost of a rejected rollup transaction in proportion to

abstentions.\56\

---------------------------------------------------------------------------

\56\Hogan & Hartson argued that the Rollup Reform Act does not

mandate that the general partner or sponsor bear all the costs of a

rejected transaction. However, new Subsection (b)(6)(C)(ii)c.1. does

not require the general partner/sponsor to bear ``all'' costs of a

rollup transaction that is not approved, but only those costs in

proportion to the total number of abstentions and votes to reject

the transaction; limited partners bear costs in proportion to the

number or votes to approve the transaction.

---------------------------------------------------------------------------

The Commission disagrees. In proposing Subsection (b)(6)(C)(ii)c.,

the NASD stated that it intended to ``encourage general partners to

structure a fair transaction that will be approved by limited

partners.'' By placing the transaction costs of a rejected rollup on

the general partner or the sponsor, the NASD is imposing the

appropriate burden on the general partner or sponsor to structure a

rollup in a manner intended to secure as many favorable votes as

possible.

F. Fees to the General Partner

New Subsection (b)(6)(C)(ii)d. sets forth criteria to use in

determining whether fees paid to the general partner in a rollup are

presumptively unfair. Subsection (b)(6)(C)(iv)3. provides that changes

in fees which are substantial and adverse to limited partners are

presumed unreasonable if not submitted to or approved by an independent

party. In order to simplify compliance with the terms of Subsection

(b)(6)(C)(ii)(4)(C), the IPA suggested that the NASD, in addition to an

independent committee, be permitted to approve changes in fees which

are substantial and adverse to limited partners.

In its response to this comment the NASD stated that it is not

appropriate for the NASD to make a determination to approve fees that

are substantial or adverse to the limited partners.

G. UPREITs

Hogan & Hartson argues that UPREIT transactions do not trigger the

application of the proposed rule change because such transactions

either do not come under the definition of ``limited partnership rollup

transaction,'' or, conceding the application of the definition, meet

the requirements of one or more transactional exemptions from the

definition. Hogan & Hartson concludes that the only part of the entire

UPREIT transaction under consideration is the potential redemption/

exchange of operating units for cash or REIT shares, not the initial

consolidation of individual partnership interests into operating

partnership units, nor the initial consolidation in conjunction with

the redemption/exchange. Hogan & Hartson argues that the initial

consolidation of limited partnership interests into an operating

partnership that does not have its shares traded on an exchange or

authorized for quotation on Nasdaq/NM does not come within the

definition of a limited partnership rollup transaction and, thus, falls

outside the purview of the proposed rule change.

The Commission disagrees. UPREIT transactions should not be viewed

in discrete stages, as if each stage in the transaction were isolated

from any other stage, with no contemplated interrelationship between

the partners, promoters, investors and financing plans of the

partnership consolidation stage and the partners, promoters, investors

and financing plans of the exchange offering stage.

V. Discussion

The Commission finds good cause for partially approving Amendments

5-8 on an accelerated basis.\57\ As indicated above, the Commission

recognizes that the rule change will provide important benefits to

investors who may be subject to limited partnership rollup transactions

in that the amended proposed rule change will ensure that investors'

rights are protected in accordance with the intent of Congress as

embodied in the Rollup Reform Act. In addition, the Commission finds

that notice in advance of approval of those Amendments intended to

conform the proposed rule change with the Rollup Reform Act is

unnecessary because the Rollup Reform Act itself has given interested

parties constructive notice of pertinent terms of the Amendments. The

Commission also finds that, except as noted above, those amendments to

the proposed rule change not intended to conform the proposed rule

change with the Rollup Reform Act are intended merely to clarify the

rule change. The NASD will implement the rule change on November 1,

1994. The Commission believes that accelerated approval will avoid

unnecessary delay in requiring members to ensure that they participate

in limited partnership rollup transactions only if those transactions

provide for fair treatment of limited partnership investors, protect

the rights of all limited partners, including dissenting limited

partners, and do not contain unfair or unreasonable terms.

---------------------------------------------------------------------------

\57\The Commission does not find good cause for approving the

Differential Compensation Amendment.

---------------------------------------------------------------------------

The Commission finds that, with the exception of the Differential

Compensation Amendment, the proposed rule change is consistent with the

provisions of Section 15A(b)(6)\58\ of the Exchange Act, which require,

in pertinent part, that the rules of a registered securities

association be designed to prevent fraudulent and manipulative acts,

promote just and equitable principles of trade, and protect investors

and the public interest; the provisions of Section 15A(b)(12)\59\ of

the Exchange Act, which require the rules of a registered securities

association to promote just and equitable principles of trade include

rules to prevent members of the association from participating in any

limited partnership rollup transaction that does not provide procedures

to protect certain specified rights of limited partners; and the

provisions of Section 15A(b)(13)\60\ of the Exchange Act, which require

that the rules of a registered securities association prohibit the

authorization for quotation on an automated interdealer quotation

system sponsored by the association any security designated by the SEC

as a national market system security resulting from a limited

partnership rollup transaction, unless such transaction provides

certain rights for limited partners. The proposed rule change will

restrict member participation in unfair rollup transactions and

prohibit inclusion in Nasdaq/NM of any securities resulting from an

unfair rollup transaction.

---------------------------------------------------------------------------

\58\15 U.S.C. Sec. 78o-3(b)(6).

\59\15 U.S.C. Sec. 78o-3(b)(12).

\60\Id.

---------------------------------------------------------------------------

The Rollup Reform Act reflects a brief that partnership rollup

transactions, when properly structured, may offer significant benefits

to investors and for businesses that have used these structures to

raise capital. However, Congress has determined that abusive limited

partnership rollup transactions harm investors, undermine investor

confidence and threaten capital formation.\61\ The proposed rule change

will permit rollups to take place but will curtail the abusive

practices that have occurred in the past. The proposed rule change is

designed to ensure the fairness of partnership rollup to the limited

partners by giving dissenters the right to compensation, based on

appraisal, rather than being forced into a rollup. In addition the

proposed rule change contains provisions which prevent the unfair

conversion and valuation of the general partner's interests in a rollup

transaction, prevent investors' voting rights from being unfairly

reduced or abridged, prevent the limited partners from having to bear

an unfair portion of the cost of a transaction that has been rejected,

and prevent the payment of fees to general partners in connection with

a rollup that are unfair, unreasonable, or inappropriate.

---------------------------------------------------------------------------

\61\Senate Report, supra n. 9, at 9.

---------------------------------------------------------------------------

Interested persons are invited to submit written data, views, and

arguments concerning Amendment Nos. 5-8. Persons making written

submissions should file six copies thereof with the Secretary,

Securities and Exchange Commission, 450 Fifth Street, NW., Washington,

DC 20549. Copies of the submission, all subsequent amendments, all

written statements with respect to the proposed rule change that are

filed with the Commission, and all written communications relating to

the proposed rule change between the Commission and any person, other

than those that may be withheld from the public in accordance with the

provisions of 5 U.S.C. 552, will be available for inspection an copying

in the Commission's Public Reference Room. Copies of the filing will

also be available for inspection and copying at the principal office of

the NASD. All submissions should refer to SR-NASD-93-03 and should be

submitted by September 12, 1994.

It Is Therefore Ordered, pursuant to Section 19(b)(2)\62\ of the

Exchange Act, that the proposed rule change SR-NASD-93-3 be, and hereby

is approved, except with respect to that portion of Amendment No. 7

that proposes amendments to Subsections (b)(6)(A) and (b)(6)(B) of

Article III, Section 34 of the NASD Rules of Fair Practice. For the

Commission, by the Division of Market Regulation, pursuant to delegated

authority.\63\

---------------------------------------------------------------------------

\62\15 U.S.C. Sec. 78s(b)(2).

\63\17 CFR 200.30-3(a)(12).

[FR Doc. 94-20479 Filed 8-19-94; 8:45 am]

BILLING CODE 8010-01-M