National Venture Capital Association

NVCA Standard on Trading Practices

TO: NVCA Membership

FROM: Thomas C. McConnell
Chairman, NVCA Standards/Bylaws Committee

SUBJECT: Reaffirmation of NVCA Standard on Trading Practices
Of Members of the National Venture Capital Association

DATE: August 20, 2002

In July, 1996 the NVCA Board of Directors promulgated the attached Standard of Conduct regarding "directed shares". Every venture capitalist whose firm was a member of the NVCA at that time received a copy of this Standard of Conduct. Since that time, NVCA periodically sends the standard to all existing NVCA member firms to underscore the importance of the Standard and to make certain all new members are aware of the Standard's existence.

As Chairman of the Standard/Bylaws Committee, I want to reaffirm the Association's policy on this matter. I urge you to once again review this memorandum in detail and discuss it within your firm so that all employees are aware of the Association's position. Recent events underscore the importance of making certain that the venture capital community remains above reproach in all its professional dealings.

Thank you for your interest in this matter.

M E M O R A N D U M

TO: Mr. James F. Morgan
OneLiberty Ventures
FROM: Testa, Hurwitz & Thibeault, LLP
DATE July 15, 1996
RE: Trading Practices of Members of the National Venture Capital Association ("NVCA")

INTRODUCTION

Growth in the venture capital industry and increased activity of the securities markets, as well as trading restrictions recently imposed by other segments of the securities industry, have highlighted a need to focus on the internal compliance procedures of venture capital firms with regard to the trading practices of their partners and employees.

One area in particular which should be addressed by all venture capital firms is the allocation of "directed shares" by an underwriter in a public offering to partners or employees of a venture capital firm, and the potential for abuse in such practice. Although the companies whose securities are purchased by the general partners or employees in such offerings may not be portfolio companies of the funds which they manage (such transactions are tightly regulated by securities laws), such individuals often have a current or potential business relationship with the underwriters directing the shares by virtue of such individuals' positions of responsibility within their venture firms. In a "hot issue" (one which trades at a premium in the secondary market when the secondary market begins), the return on "directed shares" "flipped" (or sold back into the market within a relatively short period of time) can be quite lucrative.

Depending on the specific partnership agreement language and the specific circumstances involved, a venture capitalist receiving "directed shares" as a result of his position within a venture capital firm could be a direct violation of his contractual and/or fiduciary responsibilities, particularly in the case where the "directed shares" are flipped. At a minimum, the receipt of "directed shares" under such circumstances would be tainted with the appearance of impropriety. If it became a prevalent industry practice and were to draw the attention of the limited partner community or financial press, trading in and flipping of "directed shares" by venture capitalists could create a public relations issue for the industry.

You have asked us to draft a memorandum to discuss this "directed shares" issue as a component of the trading practices of partners and employees of venture capital firms. As trading by securities professionals comes under increasing scrutiny and the venture capital industry matures, the venture community should consider steps to police itself and to develop standards of conduct for its members with respect to this issue.

This memorandum outlines the "directed shares" issue in the context of the various restrictions and reporting obligations governing or affecting venture capital firms and the investing activities of their partners and employees, including: (i) the contractual restrictions and obligations in the limited partnership agreements of such firms; (ii) federal securities laws and the rules and regulations thereunder, including the Securities Exchange Act of 1934, as amended (the "Exchange Act"); (iii) the rules applicable to registered investment advisers ("Investment Advisers") under the Investment Advisers Act of 1940, as amended (the "Advisers Act"); and (iv) the rules and regulations of the National Association of Securities Dealers, Inc. (the "NASD").

DISCUSSION

I. Contractual Restrictions and Fiduciary Obligations

Limited partnership agreements between venture capital firms and their limited partners contain provisions outlining the obligations of the general partners to the limited partners. Often these agreements require the general partners (i) to devote substantially all of their business time to the affairs of the partnership, (ii) to make available to the partnership all investment opportunities appropriate to the partnership that come to their attention, (iii) to promote the interests of the partnership before their own interests, and (iv) to avoid conflicts of interest. These obligations, in fact, generally reflect the fiduciary obligations imposed on general partners under state partnership laws. In addition, there are often very specific prohibitions or limitations on general partners' trading in the securities of partnership portfolio companies. What is not typically addressed in partnership agreements, however, is trading by general partners in the securities of other companies. As we will discuss, such trading also may lead to conflicts of interest or the appearance of such conflicts.

Depending on the specific partnership agreement language and the specific circumstances involved, a venture capitalist receiving "directed shares" as a result of his position in a venture capital firm could be a direct violation of his contractual and/or fiduciary responsibilities, particularly in the case where the "directed shares" are flipped. For example, let us assume for the moment that a venture capitalist were to arrange for receipt of "directed shares" from an underwriter for his own account with the express or implied understanding that the "quid pro quo" for such purchase opportunity would be to place such underwriter on a "short list" of eligible recipients for future business from the venture capitalist's firm. Let us further assume that this individual "flips" the "directed shares" for an immediate gain. In establishing such an arrangement, the general partner has improperly used his position of influence within his firm for personal gain. It is possible as well that he has breached the terms of his partnership agreement; (e.g., by diverting this investment opportunity away from the partnership for his personal use.)

Taking this example one step further, let's assume this individual subsequently bases a decision as to which underwriter to recommend to a portfolio company on the past or future ability of such underwriter to deliver "directed shares" to such individual. At this point, the individual has breached his fiduciary duty to the partnership (as well as to the portfolio company if he sits on its Board of Directors) to promote the interests of these entities before his own interests.

Taking a step back from the foregoing example, it is unlikely that the simple receipt of "directed shares" by an individual venture capitalist would result in the pattern of conduct described above. However, engaging in such a practice ( particularly when "flipping" the shares is involved) leaves a venture capitalist and his firm vulnerable to the appearance of impropriety precisely because of the potential for abuse as described in the preceding example.

II. Federal Securities Laws

The venture capital community presently works within a framework of limitations and reporting obligations of the Federal securities laws with respect to trading in the securities of portfolio companies. Participation in "directed shares" trading of portfolio and nonportfolio companies may also trigger such limitations and reporting obligations (by the specific individuals engaged in such activities, their general partner entities, their partnerships, or some combination of the foregoing), although the precise impact will depend on the facts and circumstances of each specific situation. General partners should be aware of the following categories of statutory regulation in any securities transaction:

Rule 10b-5. Firms should have safeguards in place to prevent even the appearance that the firm or any of its partners or employees are profiting from inside information.
Rule 10b-6. Prohibits trading in a distribution of securities by interested persons.
Section 13. Governs reporting requirements of five percent stockholders of reporting companies under the Exchange Act.
Section 16. In addition to the everfamiliar Forms 3, 4 and 5, general partners should always be cognizant of the shortswing profits rule under the Exchange Act.

Venture capital firms vary on their internal compliance controls designed to monitor their partners' and employees' activities under these regulations. Due to the possible consequences of non-compliance with federal securities laws, venture capital firms should enact compliance programs if they have not already done so.

III. Advisers Act

Most venture capital firms are not subject to the restrictions imposed by the Advisers Act. Regulations regarding personal trading by securities professionals under this Act are relevant for comparison purposes, however. The Advisers Act requires the adoption of a code of ethics (to assist in the prevention of fraudulent conduct in securities transactions) and sets forth specific rules for notice and recordkeeping of all securities transactions by Investment Adviser principals.

In addition to such statutory guidelines, a special Advisory Group (the "Advisory Group") to the Investment Company Institute, a mutual fund trade organization, recently made the following recommendations on personal investing by advisers to the mutual fund industry: (i) incorporation into every code of ethics general fiduciary principles that govern personal investment activities, including (a) the duty to place the interests of clients first, (b) a requirement that all personal securities transactions be conducted in accordance with such code of ethics and in such a manner as to avoid any actual or potential conflict of interest, and (c) the principle that advisers should not take inappropriate advantage of their position; (ii) a prohibition on advisers acquiring securities in an initial public offering (an "IPO"), in order to preclude any possibility of their profiting improperly from their positions; (iii) a ban on short-term (60 days) profits; and (iv) preclearance of personal securities transactions by all persons with access to information about a purchase or sale of securities by a mutual fund.

The Advisory Group noted that purchases by investment personnel in IPOs posed two potential conflicts of interest: (i) that such personnel took inappropriate advantage of their positions for personal profit, particularly with regard to hot issues, which may have created the impression that future investment decisions for the mutual fund were not necessarily in the best interest of the fund's shareholders, and (ii) realization of short-term profits may have created the appearance that the investment opportunity should have been made available to the fund. Venture capital firms have similar, although not identical, conflicts issues; the primary differences being (i) the overall focus of mutual funds on the public markets as compared to a venture partnership's focus on private companies, and (ii) the relatively short term strategy of mutual fund investing as compared to the long term focus of a venture partnership's investment strategy. Nevertheless, the Advisory Group's recommendations are an instructive comparison.

IV. NASD Rules

The NASD FreeRiding and Withholding Rule, which is outlined in detail in Exhibit A hereto, prohibits underwriters and other members of the NASD from allocating "directed shares" to certain "restricted" persons. While the venture capital industry is well aware of this NASD rule and its application to partnership portfolio companies the industry lobbied for and received a specific exemption from the rule in such context a conservative, literal reading of the rule would also appear to preclude an NASD member from allocating any "directed shares" in a hot issue to any venture capitalist.
Since the principal purpose of the NASD rule is to ensure that NASD members, in a distribution, do not use the hot issue securities as a reward to other persons who are in a position to direct further business to such NASD member, the prohibition is applicable to the underwriter of the deal, not the general partner receiving the shares or his firm. Nevertheless, prudence dictates that the venture industry avoid the appearance of any conflict or impropriety.

RECOMMENDATION

Although it is difficult to develop a single set of standards that will address the diversity of the venture capital industry, we recommend that every venture capital firm consider the adoption of a code of ethics which includes standard fiduciary principles, including all or some of the following: (i) fair dealing by the general partners with their limited partners, (ii) the requirement that personal securities transactions be conducted in such a manner as to avoid any actual or potential conflict of interest, (iii) the requirement that the general partners of such firms not take inappropriate advantage of their positions, (iv) the implementation of appropriate, specific restrictions on trading by the partners and employees of the firm, and (v) the establishment of an internal committee or appointment of an internal compliance officer to address conflict of interest issues and to monitor compliance with the policies and procedures established by the venture firms. With respect to the specific issue of "directed shares", firms should consider requiring that shares be held for a minimum period (for example, 6090 days) in order to avoid the appearance of impropriety associated with flipping for short term profit and to demonstrate investment intent.

Please do not hesitate to call either Dick Testa or Robin Painter if you require any further assistance or have questions about the material presented herein.

Exhibit A

NASD FreeRiding Rule

The NASD Interpretation with Respect to Free-Riding and Withholding (the "Free-Riding Rule") precludes members of the NASD ("NASD Members") from allocating shares sold in a public offering to certain "restricted" persons if the offering turns out to be a hot issue (one which trades at a premium in the secondary market when the secondary market begins). The Free-Riding Rule is intended to prevent participants in a distribution from "withholding" shares for their own account when there is a demand, which may artificially increase the market price, so that they may later sell at a substantial profit, thereby benefiting from a "free ride." The Free-Riding Rule is also intended to ensure that NASD Members, in the distribution of hot issue securities, do not use the securities to reward other persons who are in a position to direct further business to a NASD Member. The Free Riding Rule was adopted as an additional measure in the NASD's continual effort to ensure the integrity of the public offering system. In order to prevent these abusive practices, the NASD's Free-Riding Rule includes a broad list of restricted persons.

The Free-Riding Rule restricts a NASD Member or a person associated with a NASD Member from continuing to hold any of such securities in any of the NASD Member's accounts or from selling such securities, except in compliance with the Free-Riding Rule, to certain categories of restricted persons, including:

Any officer, director, general partner, employee or agent of the NASD Member or of any other broker/dealer, or to a person associated with the NASD Member or with any other broker/dealer, or to a member of the immediate family of any such person.
A person who is a finder in respect to the public offering or to any person acting in a fiduciary capacity to the managing underwriter, including, among others, attorneys, accountants and financial consultants, or to any other person who is supported directly or indirectly, to a material extent, by any such person.
Any senior officer of a bank, savings and loan institution, insurance company, investment company, investment advisory firm or any other institutional type account (including, but not limited to, hedge funds, investment partnerships, investment corporations, or investment clubs), domestic or foreign, or to any person in the securities department of, or to any employee or any other person who may influence or whose activities directly or indirectly involve or are related to the function of buying or selling securities for any bank, savings and loan institution, insurance company, investment company, investment advisory firm, or other institutional type account, domestic or foreign, or to any other person who is supported directly or indirectly, to a material extent, by any such person.¹
Any account in which a NASD Member or any person specified in (1), (2) or (3) above has a beneficial interest.

Notwithstanding the above limitations, a NASD Member may sell part of its securities to the persons enumerated in (2) or (3) above; to members of the immediate family of persons enumerated in paragraph (1) above (provided that such person enumerated in paragraph (1) does not contribute directly or indirectly to the support of such member of the immediate family); and to any account in which any of such persons has a beneficial interest; if the NASD Member is prepared to demonstrate that the securities were sold to such persons in accordance with their normal investment practice, that the aggregate of the securities so sold is insubstantial and not disproportionate in amount as compared to sales to members of the public, and that the amount sold to any one of such persons is insubstantial in amount.

Normal Investment Practice: Normal investment practice means the history of investment of a restricted person in an account or accounts maintained by the restricted person and maintained with the NASD Member making the allocation. Usually the previous one-year period of securities activity is the basis for determining the adequacy of a restricted person's investment history. In analyzing a restricted person's investment history the NASD has stated that the following factors should be considered:

The frequency of transactions in the account or accounts during that period of time focusing on the nature and size of investments;
A comparison of the dollar amount of previous transactions with the dollar amount of the hot issue purchase. By way of example, the Free-Riding Rule explains that if a restricted person purchases $1,000 of a hot issue and his account showed a series of purchases and sales in $100 amounts, the $1,000 purchase would not appear to be consistent with the restricted person's normal investment practice; and
The practice of purchasing mainly hot issues would not constitute a normal investment practice.

Disproportionate: The NASD uses a guideline of 10% of the NASD Member's participation in an issue to the determine whether an allocation to a restricted person constitutes a disproportionate allocation. Other factors which should be considered in reaching a determination of disproportionate allocations include: (i) the size of the participation; (ii) the offering price of the issue; (iii) the amount of securities sold to restricted accounts; and (iv) the price of the securities in the aftermarket.

Insubstantiality: This requirement is separate from the requirements relating to disproportionate allocations and normal investment practice. The Free-Riding Rules notes that this term applies both to the aggregate of the securities sold to restricted accounts and to each individual allocation (i.e., there could be a substantial allocation to an individual account in violation of the Free-Riding Rule and yet be no violation on that ground as to the total number of shares allocated to all accounts was insubstantial). The determination of whether an allocation to a restricted account or accounts is substantial is based upon, amount other things, the number of shares allocated and/or the dollar amount of the purchase.

The principal purpose of this restricted category is to ensure that NASD Members, in a distribution of hot issue securities, do not use the hot issue securities as a reward to other persons who are in a position to direct further business to a NASD Member. The terms Œsenior officer' and Œinvestment partnership' are not defined in the Free-Riding Rule or the NASD's by-laws. While it seems to be generally accepted that one of the goals of this provision was to curtail the abusive activities of hedge funds and similar entities who invest primarily in the securities of publicly traded companies, a literal interpretation would suggest that the individual general partners of a venture capital partnership investing primarily in private companies would fall within this provision. Moreover, the NASD, in responding to commentators' questions as to whether managers/advisors of hedge funds, investments partnerships or other similar entities are considered restricted persons, has stated that "managers of investment partnerships or corporations, hedge funds, and other similar accounts are clearly involved with buying and selling securities for an institutional type account and, as such, are restricted" under the Free-Riding Rule. See Exchange Act Release 34-34485 (August 3, 1994) 57 SEC Docket 755 at page 770.

The Commission and NASD have assisted the venture capital industry by approving a special safe harbor (the "Venture Capital Safe Harbor") to the Free-Riding Rule. Prior to such carve-out, the Free-Riding Rule was extremely broad. Although venture capital firms are typically organized with a view toward making investments in private companies, underwriters occasionally ask the venture capital firms to "support" an IPO of a portfolio company by purchasing securities in the offering. Additionally, venture capital firms sometimes wished to maintain an appropriate level of ownership in a portfolio company by investing in the IPO. The Venture Capital Safe Harbor was added to the Free-Riding Rule to allow for such special circumstances.

The Venture Capital Safe Harbor provides that a person otherwise restricted under the Free-Riding Rule may purchase hot issues if the following conditions are met: (i) the investor has held an ownership interest in the company issuing the hot issue securities for a period of one year prior to the effective date of the offering; (ii) the purchase of the hot issue securities in the offering did not increase the percentage equity ownership of the investor in the company above that held by the investor three months prior to the filing of the registration statement in connection with the offering; (iii) the investor received no special terms in connection with the purchase; and (iv) the hot issue securities purchased were restricted from sale or transfer for a period of three months following the conclusion of the offering.

Given the extent that the Free-Riding Rule governs NASD affiliate venture capital firms and investments in IPOs, it is important for compliance purposes that venture capital firms track personal investment transactions of general partners at a minimum.

¹The underlined language was added to the Free-Riding Rule by Exchange Act Release No. 34-35059 effective December 7, 1994 (the "December 1994 Release"). See also NASD Notice to Members 95-07.