October 9, 2007
Please accept this response to your request for comment with respect to the proposed Revisions of Limited Offering Exemptions in Regulation D included in File No. S7-18-07. For the reasons stated below, I believe the proposed changes to Regulation D are wide of the mark. Conceding that offerings in the Regulation D context may benefit from re-examination, an emphasis on disclosure, rather than investor wealth, would provide a more effective administrative response.
The Commissions charge is to provide regulatory oversight so that prospective investors receive adequate information to make a conscious, adult decision as to the investment opportunity provided by the total mix of information. Since its inception of the 33 Act Congress and the Commission have resisted various calls to impose various types of merit review or investor pre-qualification to provide adequate disclosure to prospective investors.
Theoretically, the Regulation D exemptions provide a framework for offerings that do not provide the meaningful disclosure required in a registration statement. Essentially all of the Rule 506 offerings in my experience are limited to accredited investors to avoid the burdensome registration requirement imposed with non-accredited investors are included.
Rule 504
The seed capital formation function of Rule 504 offerings has been greatly diminished due to state law. If the pool of prospective investors is going to be altered, it would make more sense to also provide an alternative private placement disclosure method, pre-empting state blue sky registration, to allow small companies without access to the groups to lawfully raise capital. Mindful of the alleged pump and dump schemes and abuses specified in the release, the evolution or devolution of Rule 504 has essentially eliminated promising, viable companies in need of capital. In its place has been a cottage industry of finders, shell merchants, and other unsavory practices.
The purpose of the earlier amendments to Rule 504 were to provide an avenue for seed capital that essentially eliminated the biggest hurdle to attracting investor attention – the illiquidity of the investment. The amendments were intended to dovetail with the efforts of NASAA in promulgating the Form U-7 SCOR type offerings.
The loophole employed by the unsavory was the handful of states that had no effective regulation of 504 type offerings. A flood of offerings originated in those states for Companies that were pump and dump vehicles with the intention of subsequent trading in the pink sheets.
The abuses in Rule 504 could be eliminated with less drastic regulatory action, in my opinion, by adoption of a regulatory scheme that simply re-introduced the original intents.
In this regard I suggest:
a. A more meaningful Form D with electronic filing so that some information about the issuers would be readily available to interested parties and regulators
b. Imposition of Reg A type disclosure requirements, lesser than required by SB-2 but substantially more than was typical, perhaps by sanctioning the SCOR type disclosure document or alternatives
c. Standard Notices to be included in Subscription Agreements and disclosure documents setting forth the regulatory concerns with offerings for small and developmental stage companies
d. Preemption of state law as to the offer and sale of the security but not for filing, fees and fraud as is typical in Rule 506 offerings.
I concur that the current state of Rule 504 has failed its objectives, but it seems to me that the Commissions proposal is simply to eliminate, for all practical purposes, the ability of small business to compete for investment seed capital dollars.
Super Accredited Investors
I also have comments as to the Commissions proposal to adopt a new tier of super-accredited investor with limited solicitation allowed. First, I find the solicitation proposal reminiscent of the Reg A test the waters provisions. My belief is that the test the waters has virtually no effect on the use of Reg A in capital raising. I am not involved in sales, but I hazard a guess that super-accredited investors will not likely open the financial papers with morning coffee to determine their investments.
I believe this proposal would more appropriately fill a need if the securities offered were both covered securities and freely tradable for many of the same reasons as set forth above with respect to the current Rule 504. This advantage would create more incentive for both offeror and offeree to consider this private placement in lieu of other capital raising mechanisms. Otherwise, there is really no advantage to the super accredited investor to consider these offerings. The sophistry of this proposal is that the foundation for the lesser-accredited investor was the ability to fend for themselves in considering the merits and risks of an investment. If that is still valid, then setting another tier of accredited investor only makes sense if new tier produces some further economic benefit.
Finally, these measures would not be necessary if the Commission would create a viable small business registration framework that can be completed in a reasonable timeframe and at a reasonable cost. Providing a prospective investor with adequate information about the potential investment need not be the corporate equivalent of an archeological dig. Under the current registration system even Companies with audits from respected PCAOB firms and well respected counsel nonetheless go through a registration process taking months and costing tens, if not hundreds, of thousands of dollars. It is not uncommon to see Small Business registrations that go through 6, 7, or 8 rounds of staff comment over periods of many months. Each round of comments typically require updates of the financial information, refiling and waiting for the Staff to again respond, only to start the process over again.
This bureaucratic morass effectively prices most promising younger companies out of the registration process and drains Commission resources. Instead of furthering investor protection, this process relegates most small businesses to a context with less disclosure or none at all. Often those attempts are in the areas that are fraught with sharp operators.
Is there really any value added by belaboring the comment process past 1 or 2 rounds of comments? And if the process is sending small business to the seamy side of the street, is it consistent with the Commissions mission? Would a more streamlined approach not result in reduced administrative cost and far better disclosure to investors than in a private or non-reporting context? And does the accredited investor status, whatever criteria the Commission mandates, adequately substitute for disclosures that are publicly available and subject to scrutiny by a broad array of interested persons?
The proposed Regulation D amendments effectively foreclose participation in those investments to the overwhelming majority of adult citizens, providing instead a net investment litmus test as to prospective investor qualification. Theoretically, a state securities examiner or an assistant professor of corporate finance would be disqualified while an elderly widow who inherited $3,000,000 may be qualified. If this reflects the Congressional intent of the 33 Act, would it not have been easier for Congress to eliminate the Commissions role altogether and simply decree that persons falling below a specified threshold may not participate in investing activities?
There is no inherent reason why the protection of investors should foreclose investment participation by any competent, adult person who has been provided disclosures pertinent to the investment decision in either the public or private context. The in terrorum aspects of the fraud rules give adequate redress to instances where this privilege is abused. If it doesnt, that should be addressed by Congressional action.
The widespread activities of reverse mergers, shell merchants, consultants and other grey area participants would be unnecessary if a small company could simply register in a reasonable time and at a reasonable cost, by public registration or private offering, and offer some semblance of the liquidity that the investor would find in many other investment options. While the proposed changes are not objectionable, I believe they really dont address the issues that have been confronting this area for many years.
Notwithstanding the above, I appreciate the attempts by the Staff to find more workable alternatives that meet the goal of capital raising and investor protection.
Respectfully submitted,
Very truly yours,
Charles W. Barkley