==========================================START OF PAGE 1====== APPENDIX B ESSENTIAL ELEMENTS OF THE COMPANY REGISTRATION SYSTEM I. Disclosure Company registration would further the traditional goals of the disclosure requirements under the federal securities laws -- to provide investors with the information necessary to make an informed investment decision and to deter fraud and overreaching. While company registration would maintain and in some cases expand the level of information about companies and their offerings that currently is made available to the markets through Commission filings, such information would be required to be made public earlier than under the current system, thereby benefitting investors in both the primary issuance market and the secondary trading markets. At the same time, company registration would afford companies offering their securities to the public the flexibility to tailor the disclosure documents delivered to investors to the nature of the transaction and the demands of the offering participants. Company registration also would maintain and reinforce the roles of outside gatekeepers and monitors and their due diligence functions in fostering the reliability of that information to meet the realities of today's markets. The primary goals of disclosure under the federal securities laws are to provide investors and the marketplace with information necessary to make informed investment decisions, and to deter fraud. Capital allocation decisions are best made on the basis of well-informed private decision-making by market participants. In an oft-quoted passage, Justice William Douglas, who once served as Commission Chairman, stated: The truth about the securities having been told, the matter is left to the investor. . . . The requirement that the truth of the securities be told will in and of ==========================================START OF PAGE 2====== itself prevent some fraudulent transactions which cannot stand the scrutiny of publicity.-[1]- Full and fair disclosure is the key to an efficient capital allocation process. Under the current regulatory scheme for public offerings, disclosure of information material to investment and voting decisions is effectuated in two principal ways. First, information is made public through the filing of a disclosure document with the Commission. This information then is available to investors, either directly by investors accessing the information themselves, or indirectly through intermediaries such as investment advisers, research analysts, and other investment professionals who analyze and redistribute that information to the investing public. The requirement under the Securities Act that a registration statement be on file with the Commission before the offering process commences is an example of this form of disclosure. This method of information dissemination is also the principal means by which the trading markets are provided with current information about issuers. The annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K are examples of this method of disclosure. Second, information is disseminated directly to investors by the issuer of the securities. The Securities Act requirement to deliver a prospectus to an investor no later than the time the ---------FOOTNOTES---------- -[1]- William O. Douglas, Protecting the Investor, 23 Yale L. Rev. 521, 523-24 (1934). ==========================================START OF PAGE 3====== confirmation of the sale is sent falls into this category, as do the requirements for delivery of a proxy statement and annual report to shareholders in connection with an election of directors, or an offer to purchase in connection with a tender offer. Prospectuses that are filed publicly with the Commission likewise serve to inform the trading markets. Experience has demonstrated that actual delivery of information to investors -- as opposed to delivery of such information to the markets through a Commission filing -- frequently is not necessary to convey information and deter fraud. Public disclosure of information concerning the issuer through Exchange Act filings, and its consequent ready availability, serve as an efficient means to facilitate informed assessments of the issuer's business prospects and financial condition and the security being offered. Public disclosure also serves to deter many of the more unsavory practices witnessed before the adoption of the Securities Act, such as self dealing by insiders and underwriters. Finally, the public availability of information also can serve to counteract overzealous selling efforts. Milton Cohen, in his seminal article "Truth in Securities Revisited," established a blueprint for rationalizing the two securities acts with respect to prospectus delivery: This is, indeed, an area for pragmatic and not merely logical answers, and I believe that the best approach in a coordinated law will be to introduce a greater degree of pragmatism -- primarily in distinguishing continuous registrants from others but also in ==========================================START OF PAGE 4====== distinguishing among different types of transactions. . . . First, a prospectus of a continuous registrant should not be required to contain information that is of no different significance or greater materiality to an offeree in a distribution than to any other investor or potential investor in securities of the same issuer. Second, a prospectus that is not required to be delivered in time to affect investment decisions should not be required at all, unless serving a purpose not adequately served by public filing alone . . . .-[2]- The Wheat Report, published in 1969, also reflected a recognition that the traditional prospectus delivery requirements mandated under the Securities Act may not be the most efficient means to disseminate information relevant to an investment decision. First, the unsophisticated investor may not be able to understand and make use of the information contained in the prospectus without the benefit of a market intermediary.-[3]- Second, in any event, because the use of a preliminary prospectus is not mandated, investors often do not receive prospectus information until delivery of the confirmation. In addition, requiring an issuer that was subject to the continual reporting requirements of the Exchange Act to put information regarding the company, as contrasted with the specific offering, in the prospectus was recognized as ---------FOOTNOTES---------- -[2]- Milton H. Cohen, "Truth in Securities" Revisited, 79 Harv. L. Rev. 1340, 1386 (1966). -[3]- See Disclosure to Investors, A Reappraisal of Administrative Policies Under the 1933 and 1934 Acts, Report and Recommendations to the SEC from the Disclosure Policy Study, at 53 (March 27, 1969) (the "Wheat Report"). ==========================================START OF PAGE 5====== duplicative and unnecessary, at least in those instances where the issuer was widely followed by the analyst community. Based upon the conclusions of the Wheat Report, as well as the recommendations of the Commission's Advisory Committee on Corporate Disclosure published in 1977,-[4]- the Commission moved to integration of the disclosure requirements of the Securities Act and the Exchange Act. Under the integrated disclosure scheme implemented in 1982, seasoned issuers can avoid providing prospectus disclosure duplicative of company information that already has been provided in its Exchange Act reports through incorporation by reference of that information into the prospectus. Under this approach, critical company- specific information required under the prospectus disclosure provisions of the Securities Act is made available to investors through the public filing of a company's periodic reports, but is not required to be repeated in the prospectus delivered to purchasers in the offering. Instead, the short-form prospectus physically delivered must provide information specific to the transaction, but generally can refer the investor to the filed reports for information regarding the seasoned company's business, management, financial condition and similar matters. ---------FOOTNOTES---------- -[4]- Wheat Report, supra n.3; Report of the Advisory Committee on Corporate Disclosure to the Securities and Exchange Commission, 95th Cong., 1st Sess. (Comm. Print 1977 ) (the "1977 Advisory Committee Report"). ==========================================START OF PAGE 6====== Thus, for more than a decade, with respect to the core financial and operating information regarding seasoned issuers, the Commission has deemed the prospectus disclosure objectives of the Securities Act to be satisfied by reliance on the public filing of this information and its incorporation by reference into an offering document, without any physical delivery of such information to investors. In addition, and as discussed more fully below, technological innovations are facilitating inexpensive electronic access to filed documents by the market and by investors and their intermediaries, thereby raising further questions regarding the continued need for delivery of disclosure documents directly to investors in the context of public offerings. ==========================================START OF PAGE 7====== A. Disclosure and Prospectus Delivery Under the Company Registration System Company registration would improve upon the crucial disclosure goals of the current filing and prospectus delivery requirements by requiring that mandated disclosure be made public, or delivered to investors, at an earlier point in time than under the current system. So long as all mandated information already has been publicly disclosed, company registration would create greater flexibility regarding the prospectus information to be delivered directly to investors. Such information would be provided based upon the issuer's and underwriter's assessment of the informational demands of the markets and participants in the offering.-[5]- 1. Company Registration Statement Under the company registration scheme, to become company- registered, an eligible company would file a Form C-1 registration statement disclosing its plans to sell securities from time to time in the indefinite future on a company- registered basis. The Form C-1 would be kept current by incorporating all existing and future Exchange Act reports into the Form C-1. The Form C-1 would contain a generic description of the type of securities the issuer anticipated issuing, as well as a general discussion of its financing plans. In essence, the registration statement would not be a single document, but rather a composite of the initial Form C-1, all existing and subsequently filed Exchange Act reports incorporated into that registration statement, as well as any post-effective amendments ---------FOOTNOTES---------- -[5]- A comparison of the proposed company registration system and the current short-form shelf registration system is included in an addendum to this Appendix B. ==========================================START OF PAGE 8====== thereto. Only a nominal registration fee would be required to be paid at the time of the Form C-1's filing, accompanied by an undertaking by the issuer to pay a fee upon each sale of securities under the Form C-1. This approach would create a "pay-as-you-go" system. Once a company is registered, no further registration process would be necessary to offer securities. To accomplish that result during the pilot under the current statutory scheme, the Form C-1 would serve as a registration statement for purposes of Section 5 of the Securities Act and register generically all types of securities and offerings (including affiliate resales) contemplated at the time of the company's registration. The issuer is given discretion to the extent it wishes to include all or just some of its securities on the Form C-1, depending on the degree of participation. Even under full participation in the system, a registered company may exclude non-convertible debt sold only to institutional buyers -- but not equity securities (including equity convertibles) or debt sold to retail buyers -- from the system. With respect to those companies electing to take full advantage of the system,-[6]- all subsequent sales of securities by registered companies and their affiliates would be deemed covered by the Form C-1 registration statement, and thus would be registered for purposes of the Securities Act. If the company had outstanding restricted securities at the time it ---------FOOTNOTES---------- -[6]- See infra p. 34-40. ==========================================START OF PAGE 9====== became company-registered, the company could effect a transition to the company registration system by specifically registering any or all of its outstanding restricted securities for resale on the Form C-1 (and paying a fee at that time), or merely allow the restricted securities to retain their restricted status until the expiration of the Rule 144 restricted periods.-[7]- All purchasers of securities from the issuer or its affiliates, therefore, regardless of the nature of the transaction, would receive freely tradeable securities, as well as the benefit of all statutory remedies that now attach to information disseminated in connection with a registered offering of securities. Thus, investor protection would be preserved and extended to a broader class of transactions, while regulatory concepts that are no longer necessary under a company registration system to protect investors -- such as gun-jumping and restricted securities -- would be eliminated. 2. File and Go Under the company registration system, a registered company could go to market in most transactions without encountering regulatory delays. Sales would be permitted immediately upon, or shortly following, the public filing of mandated disclosure regarding the transaction and any recent material developments ---------FOOTNOTES---------- -[7]- In the case of privately placed debt securities, the issuer also would have to execute a qualified indenture at the time it registers its outstanding debt to satisfy the requirements of the Trust Indenture Act, absent an exemption. ==========================================START OF PAGE 10====== concerning the company not previously disclosed in filings, along with the payment of the fee. As noted previously, the Committee considered, but determined not to review specific line-item disclosure requirements applicable to public offerings in connection with its development of a company registration scheme. Accordingly, the transactional information that must be on file at the time of an offering would be essentially the same as that required today.-[8]- Transactional information would be required to be filed at the time of the offering to provide notice of the transaction, pay the fee and provide other information material to the transaction to the extent the information was not previously disclosed in the Form C-1 (including in any post- effective amendments to, or Exchange Act reports incorporated ---------FOOTNOTES---------- -[8]- Thus, for example, in financings, in addition to updating its company-related disclosure (to the extent necessary), the issuer would need to have on file with the Commission at the time of an offering the transactional information required by the following disclosure items under Regulation S- K, to the extent applicable: Item 202: Description of the Securities Item 503: Summary Information, Risk Factors and Ratio of Earnings to Fixed Charges Item 504: Use of Proceeds Item 505: Determination of Offering Price Item 506: Dilution Item 507: Selling security holders Item 508: Plan of distribution Item 509: Interests of Named Experts and Counsel Similarly, in the case of business combinations, the information called for by current Form S-4 would be filed with the Commission. ==========================================START OF PAGE 11====== into, the Form C-1). As an example, the Form C-1 could describe the plan of distribution or possible alternative plans of distribution, and the filing at the time of the transaction need only disclose which offering technique is being employed. Similarly, use of proceeds could be generically disclosed in the Form C-1 and updated as necessary at the time of the transaction. Summary financial information and pro forma data would only be required where not previously disclosed and where material to investors. In the case of offerings under the company registration system of equity securities over a de minimis threshold (e.g., three percent), the transactional information (which would be, at a minimum, the fact that the transaction is occurring) would be required to be filed with the Commission on a Form 8-K no later than at the time of the transaction. The Committee also recommends that this Form 8-K filing requirement be applied to takedowns off the shelf under the current system. The purposes of this filing, which is not required today for short-form shelf offerings, is to ensure that this information is disclosed to the market at the time of the offering, to ensure that it is incorporated into the registration statement (and thus within the coverage of Section 11 liability),-[9]- and to provide a document prepared at the time of the offering that will facilitate the due diligence inquiries of underwriters and other ---------FOOTNOTES---------- -[9]- See infra pp. 63-64. ==========================================START OF PAGE 12====== gatekeepers or monitors. The Commission may wish to consider devising some minimal integration period for measuring offerings against the de minimis threshold (e.g., two or three business days) to provide clarity as to the filing requirement.-[10]- Separately, if the issuer's filings need to be updated with material company developments (except in a "limited placement, see Section III.E below), the issuer must disclose those developments in a Form 8-K filed in advance of the transaction. That filing also could serve as the transactional Form 8-K filing if the appropriate information is included. If this material updating information is to be provided to investors solely by incorporating it by reference into the prospectus (see next section below), then it will have to be on file a sufficient amount of time for the market to have absorbed the information before a sale is made. In de minimis equity offerings and in all debt offerings covered by the Form C-1 (see supra p. 5-6), the issuer would have a choice with respect to the appropriate means to effect the filing of the requisite transactional and material developments disclosure. It could include that information in a Form 8-K, as described above; alternatively, the company could include all of the required disclosure in the prospectus supplement that is ---------FOOTNOTES---------- -[10]- This prompt filing requirement at the time of sale may require the Commission to make accommodations to accept Form 8-K filings with respect to transactions taking place outside of normal business hours. ==========================================START OF PAGE 13====== delivered to investors, and simultaneously filed with the Commission. Consequently, in these de minimis equity offerings and debt offerings, the company registration model was made consistent with current practice under shelf registration in that the prospectus supplement would not be subject to Section 11 liability, because it is not deemed part of the registration statement,-[11]- except that company registration would require the prospectus supplement to be filed with the Commission at an earlier point in time than under the current system.-[12]- As noted, the transactional filing at the time of the offering could disclose any material changes in the registrant's affairs that have occurred since the latest filing (which could be a Form 8-K filed shortly before the offering) updating the company registration statement. Where necessary to avoid misleading investors, for example, this information would include an update of the company's MD&A disclosure. Where the updating ---------FOOTNOTES---------- -[11]- See infra p. 63-64. -[12]- Under current Rule 424(b)(2) [17 C.F.R. 230.424(b)(2)], a prospectus supplement prepared in connection with a shelf offering must be filed no later than the second business day following the earlier of the determination of the offering price or its first use. Thus, under the current system, the information in the prospectus supplement may not be disclosed to the secondary trading markets for as many as two days after its dissemination to investors in the offering. Company registration would accelerate the required filing of the prospectus supplement by at least two days since the prospectus supplement would be required to be filed simultaneously with its use. ==========================================START OF PAGE 14====== information represents a fundamental change in the information previously disclosed regarding the issuer in Commission filings, consistent with current requirements for shelf offerings,-[13]- that information must be provided either by means of a post-effective amendment or an Exchange Act report filed in lieu thereof. A prospectus supplement would not suffice for this purpose. Thus, the company registration system not only would maintain the level of information currently required to be disclosed in Commission filings concerning a particular transaction, but also would reinforce the existing obligation of a company offering securities to the market to ensure that its public disclosures are current and complete in every material respect,-[14]- and would accelerate the public disclosure of such information to investors in both the primary and secondary markets. 3. Prospectus Delivery The company registration system also would address the need to disseminate a statutory prospectus to participants in an offering. A principal goal of the Committee has been to recast the prospectus from what in many cases is its current function -- a document prepared to comply with regulatory requirements and to ---------FOOTNOTES---------- -[13]- See, e.g., Item 512(a)(1)(ii) of Regulation S-K [17 C.F.R.  229.512(a)(1)(ii)]. -[14]- See Shaw v. Digital Equipment Corp., 82 F.3d 1194 (1st Cir. 1996). ==========================================START OF PAGE 15====== provide the issuer with a defense in the event of litigation, which often is not sent to investors until after the investment decision is made -- into a tool to convey meaningful information at the time of the investment decision. The system would continue to require transactional information to be physically delivered as part of the prospectus in those circumstances where it may be argued that delivery of that information might serve to facilitate an investor's evaluation of the issuer and the security. For example, if the company is issuing a new security, the company registration system would require that the terms of the new security, along with the specific risks of investing in the security, be delivered to potential investors. However, the company registration system also would provide the flexibility for issuers to file the information with the Commission without physical delivery to investors, where delivery is not necessary for that purpose and such information already has been disclosed to the markets through a public filing with the Commission. More significantly, company registration would allow for the use of a meaningful summary prospectus, the content of which would be dictated primarily by the informational demands of investors, rather than by regulatory mandates and litigation concerns.-[15]- Since in almost all but the smallest ---------FOOTNOTES---------- -[15]- The AIMR suggested that the Committee recommend that every offering of securities be accompanied by an offering circular that would include the key terms of the offering, but "no boilerplate or (continued...) ==========================================START OF PAGE 16====== equity offerings the company would be required to file with the Commission all mandated transactional and updating disclosure prior to any sales of securities, thereby enhancing investor protection through the earlier disclosure of this information to the markets than under the current system, issuers would be granted the flexibility and the responsibility to decide what information should physically be delivered to investors. The Committee expects that the disclosure contained in the prospectus delivered to investors, whether this prospectus is a document that resembles a traditional prospectus, selling materials, or the confirmation of sale, will be that information the issuer deems most relevant and material to the potential investors. ---------FOOTNOTES---------- -[15]-(...continued) legalese." See Documents for Advisory Committee Meeting, September 29, 1995, Tab E (Letter dated September 27, 1995 from the AIMR to Commissioner Wallman, at 3). Though not mandated, the Committee anticipates that the elimination of the prospectus delivery requirement in routine transactions will promote the use of such short- form offering documents. See also John C. Coffee, Jr., Re-Engineering Corporate Disclosure: The Coming Debate Over Company Registration, 52 Wash. & Lee L. Rev. 1143, 1159 (1995) ("Coffee, Re- engineering Disclosure"), discussing the impact of shelf registration on the disclosure in prospectuses: Of course, the prospectus largely deteriorated into a legal fiction as a result of [the transition to shelf registration]. Only the one or two page summary table at the front of the typical Form S-3 registration statement is today coherent to the average investor. Shelf registration and incorporation by reference really implied that disclosure to the market through [Exchange Act] filings replaced disclosure to individual investors through prospectuses. ==========================================START OF PAGE 17====== Since all mandated disclosure must either be filed with the Commission or delivered to investors at or prior to any sale of securities (and must be filed no later than any sale in a non-de minimis equity offering), the market and all investors will receive the information at the same time, or at an earlier point in time than under the current system. In addition, the issuer and other offering participants will have the same, or greater, liability for such information, as under the current system. The fact that all the mandated information is publicly available allows the issuer to include only the information most useful to an investor's understanding in the document physically delivered to investors, presented in a plain-English format that is readily accessible and understandable by the investor. The desired flexibility regarding prospectus delivery would be achieved under the pilot in a manner consistent with current prospectus delivery requirements of the Securities Act. Under company registration, issuers would be permitted to use incorporation by reference in a manner similar to that now available to seasoned companies to omit core, company-specific information from the prospectus delivered to investors. Subject to certain exceptions, a registered company could, but need not, use incorporation by reference to meet its prospectus delivery obligation with respect to the mandated transactional information as well. It can do so by incorporating, rather than physically delivering, all or portions of that information from any filed document such as a Form 8-K (whether mandated or filed solely for ==========================================START OF PAGE 18====== this purpose). This incorporation by reference could be into a document serving as the prospectus that is delivered at the time of confirmation of sale. Just as they currently have with respect to material company information, these issuers thus would have the flexibility to include all, some, or even none of the transactional information in the prospectus delivered to investors. In "routine transactions," the confirmation of sale itself could serve as the prospectus, so long as it expressly incorporates the necessary information on file with the Commission. Broker-dealer firms would satisfy their prospectus delivery obligations with respect to the distributed securities and aftermarket transactions in the same fashion.-[16]- This flexibility in the informational content of the prospectus to be delivered represents a further extension of current law. Since the adoption of incorporation by reference, the Commission has allowed company-related disclosure (which comprises a large portion of the mandated disclosure in a public offering) to be incorporated, rather than repeated in full, in the prospectus without any apparent loss of investor protection. Permitting transactional information in some instances also to be incorporated by reference amounts to a further incremental step. Just as issuers today often include a "recent developments" ---------FOOTNOTES---------- -[16]- See Section 4(3) of the Securities Act [15 U.S.C. 77(e)(3)]; Rules 174 and 434 under the Securities Act [15 C.F.R. 230.174 and 230.434]; Rule 15c2-8 under the Exchange Act [17 C.F.R. 240.15c2-8]. ==========================================START OF PAGE 19====== section in shelf takedown prospectuses, the Committee anticipates that issuers will continue to use their judgment in including any transactional information in the prospectus to the extent that public filing alone of such information might not afford adequate notice to a potential investor. The Committee believes that delivery of a prospectus as a marketing device in equity offerings likely would remain the common practice under the company registration system. Use of the prospectus would continue to depend on factors such as the nature and name recognition of the issuer, the size of the offering relative to the issuer's public float, the retail or institutional nature of the targeted investors, the price expectations of the issuer relative to the current market value and whether or not the public filing of the disclosure is effective dissemination to the potential investors. Because market forces reasonably can be relied upon to ensure the delivery of the appropriate level of information (at least in the case of seasoned issuers), a substantial argument could be made that there is no need to mandate prospectus delivery in any instance.-[17]- ---------FOOTNOTES---------- -[17]- In other jurisdictions such as Australia that have eliminated mandated specified line item disclosure requirements in favor of a general materiality standard, often prospectuses continue to contain most, if not all, of the same disclosure as when specific disclosure requirements were mandated. See Documents for Advisory Committee Meeting, June 15, 1995, Tab F (Study of Foreign Regulatory Processes). ==========================================START OF PAGE 20====== The Committee nevertheless concluded that physical delivery of a formal prospectus containing the transactional information should be required in certain circumstances. For the purposes of the pilot, the issuer will be required to deliver (rather than incorporate) the transactional information as part of the prospectus in the case of substantial offerings of equity securities (i.e., "non-routine" transactions). Those offerings, because of their size, are likely to alter substantially the information previously provided to the market and to involve significant oral and written selling efforts.-[18]- Accordingly, during the pilot, traditional prospectus delivery would be retained for offerings of voting securities in an amount in excess of (or potentially representing in excess of, in the case of warrants and convertible securities) 20 percent of the ---------FOOTNOTES---------- -[18]- The Committee considered a suggestion that the prospectus delivery requirement be imposed whenever "special selling efforts" were employed in the marketing of the offering. See Documents for Advisory Committee Meeting, July 26, 1995, Tab E (Letter dated June 27, 1995 from Richard Phillips to Commissioner Wallman). Special selling efforts could be evidenced by brokers' compensation beyond ordinary commissions and fees, as well as the distribution of selling materials. Although various members of the Committee agreed that heightened disclosure and liability should accompany special selling efforts (see Transcript of July 26, 1995 Advisory Committee Meeting at 256-57, 260), the Committee was concerned that the use of these concepts to identify transactions that require prospectus delivery would perpetuate existing confusion engendered by the use of that concept in other contexts under the federal securities laws, and that a simpler approach of the type recommended could satisfy the perceived needs to the same extent. Id. at 260-264. ==========================================START OF PAGE 21====== current market value of the issuer's voting securities held by non-affiliates. As today under shelf registration, the prospectus normally would be filed with, but would not be subject to prior review by, the Commission.-[19]- After reviewing data on the distribution of recent public offerings of equity as a percentage of an issuer's outstanding capital, the Committee chose 20 percent as the minimum delivery threshold.-[20]- In setting this threshold, the Committee sought to provide registered companies with flexibility to conduct a transaction (or series of transactions) that increase a company's public float by an amount that could be sold into the market without use of a formal prospectus -- for example, through regular trading transactions or placements of blocks -- without preparing a traditional prospectus. In these latter "routine" transactions, investors least expect the information traditionally provided in a prospectus to make an investment decision.-[21]- Rather, absent unique circumstances ---------FOOTNOTES---------- -[19]- The one exception would be extraordinary transactions in equity securities, exceeding 40 percent of the issuer's existing capital base, which would require the filing of a post-effective amendment to the company registration statement and would be subject to staff review. -[20]- See Documents for Advisory Committee Meeting, November 21, 1995, Tab D. -[21]- See Coffee, Re-engineering Disclosure, supra n.15, at 1145 (stating Milton Cohen's view that "[b]ecause the [Exchange] Act creates a system of continuous, periodic disclosure, the existence of this system profoundly reduces the need for transaction-specific disclosure at the time when (continued...) ==========================================START OF PAGE 22====== regarding the transaction, investors will tend to focus on the company-related disclosure already disseminated to the market and reflected in the company's stock price. In other words, consistent with the guideline articulated by Milton Cohen, the appropriate delivery threshold would allow those transactions that today involve delivery of a prospectus only at the time of the confirmation, and not as part of the marketing process, to proceed without any formal delivery of a prospectus.-[22]- Conversely, where transactional disclosure is required to be delivered in a prospectus, the Committee feels strongly that it should be delivered to investors in sufficient time to influence and inform their investment decision. The Committee therefore determined that any prospectus required to be delivered in these substantial equity offerings should be delivered prior to the time the investor determines to purchase.-[23]- ---------FOOTNOTES---------- -[21]-(...continued) an issuer later seeks to sell its securities. Logically, a corporate issuer seeking to sell securities under a continuous disclosure system would only be required to disclose any additional material information that it had not previously disclosed pursuant to the continuous disclosure system.") -[22]- Cohen, supra n.2, at 1386; see also Linda C. Quinn, Reforming the Securities Act of 1933 - A Conceptual Framework, INSIGHTS at 25 (January 1996) (the "Quinn Speech"). -[23]- Cf. Rule 15c2-8 under the Exchange Act [17 C.F.R. 240.15c2-8] (prospectus required to be delivered 48 hours prior to sending the confirmation of sale in IPOs which may still be after the investor agrees to the sale). The Committee recognizes that the prospectus delivered at the time of sale (continued...) ==========================================START OF PAGE 23====== Because of the Committee's belief that it should be investors' informational needs that dictate the need for a prospectus as a selling document and the content of that prospectus,-[24]- and that the elimination of regulatory mandates with respect to seasoned issuers would not result in less useful information being provided to investors, the Committee was comfortable in establishing a generous threshold in order to preserve maximum issuer flexibility.-[25]- Nevertheless, the determination of the appropriate threshold is best made with the benefit of the comment process that ---------FOOTNOTES---------- -[23]-(...continued) in these non-routine transactions will resemble preliminary prospectuses (i.e., "red herring") in that price-related and other current information normally would have to be omitted and provided on a supplemental basis. That information would otherwise be available, in any event, through the filing of the transactional Form 8-K at the time of sale. -[24]- The Committee has been informed on an anecdotal basis that disclosure documents in Rule 144A placements closely resemble prospectuses in registered offerings, even though there are no Commission-specified disclosure requirements in a Rule 144A placement other than under a general antifraud standard. -[25]- Based upon data reflecting market capitalization, rather than public float, approximately 68 percent of underwritten repeat offerings of common stock in 1992-1994 would fall below the 20 percent recommended threshold for mandatory prospectus delivery. Thus, prospectus delivery would not have been required in over two-thirds of such offerings. If the threshold were lowered to 10 percent, prospectus delivery would have been eliminated for only 30 percent of such transactions. See Figure 6 in the Addendum to Appendix A of the Report. ==========================================START OF PAGE 24====== accompanies Commission rulemaking proceedings, and could be significantly lower or greater than 20 percent-[26]- and involve factors other than a percentage of the public float.-[27]- Indeed, this threshold could be increased and combined with the extraordinary transaction tier with resulting simplification of the system. While not formally recommended for the pilot, the Commission may wish to consider whether similar thresholds should be developed for offerings of senior non-voting equity securities as well as non-investment grade debt. Where required to deliver a prospectus, the issuer still would be permitted to take advantage of incorporation by reference of company information to the same extent as permitted today, and still would be allowed to include any additional information it deems material in the prospectus. Similarly, delivery of the statutory prospectus could be accomplished in the same manner as permitted today, provided the prospectus was ---------FOOTNOTES---------- -[26]- In France, Germany and the United Kingdom, no prospectus is required if the offering is for less than 10 percent of an existing class listed on an exchange and certain other conditions are met. See Documents for Advisory Committee Meeting, June 15, 1995, Tab F (Study of Foreign Regulatory Processes). -[27]- See, e.g., Exchange Act Rel. 37094 (April 11, 1996) [61 FR 17108 (April 18, 1996)] (proposing use of Average Daily Trading Volume as basis for applicability of proposed Regulation M). See also NYSE Listed Company Manual, 312(c)(i) (July 1989). ==========================================START OF PAGE 25====== received in time to influence the investment decision.-[28]- Thus, in these circumstances, the prospectus would be expected to contain, at a minimum, the same level of information found in a prospectus used today by a seasoned issuer in an offering conducted on Form S-3. Other circumstances in which physical delivery of transactional information, rather than incorporation by reference, would be necessary, include: Information Necessary To Avoid Misleading Investors Just as, and to the same extent as, under the current shelf system, reliance on incorporation by reference into the prospectus or selling materials would not be appropriate where statements appearing in the physically delivered materials would be rendered misleading by the absence of information appearing only in filed documents.-[29]- Similarly, incorporation by reference of material developments that have not been disclosed sufficiently in advance of the use of the prospectus to allow the market to access and absorb the information would not be appropriate. Use of Selling Materials Under the current system, to the extent written selling materials that do not satisfy prospectus disclosure requirements are distributed to investors in the course of the offering, a prospectus containing the mandated information has to be delivered prior to or simultaneous with the materials.-[30]- Under company registration, an ---------FOOTNOTES---------- -[28]- See, e.g., Rules 430A and 434 under the Securities Act [17 C.F.R. 230.430A and 230.434]. -[29]- See Proposed Revision of Regulation S-K and Guides for the Preparation and Filing of Registration Statements and Reports, Securities Act Rel. 6276 (December 23, 1980) [46 FR 79 (January 2, 1981)] . -[30]- Section 5(b) of the Securities Act [15 U.S.C. 77e(b)] prohibits the use of any prospectus to sell a security even after the registration statement is declared effective, unless the prospectus contains all the information mandated (continued...) ==========================================START OF PAGE 26====== issuer could avoid delivery of two different documents by either including or incorporating by reference the required information into the selling materials and treating the selling materials as the statutory prospectus. That approach would require the materials to be filed and subject them to liability under Section 12(a)(2) of the Securities Act (whereas generally such documents are subject only to fraud liability under the current system). The Committee recommends that, after a period of time, the Commission revisit the circumstances under which physical prospectus delivery requirements should be retained.-[31]- Under the current system, prospectuses frequently are not provided to investors until after an investment decision is made, do not carry the appropriate level of liability, and do not inform the market at an appropriate time. Under company registration, these issues are resolved through enhanced and ---------FOOTNOTES---------- -[30]-(...continued) by the Act and Commission rules. Selling materials are excluded from the definition of prospectus under Section 2(10) of the Act [15 U.S.C. 77b(10)] only if their delivery is accompanied or preceded by a statutory prospectus. -[31]- The Commission views delivery through electronic means as satisfying the delivery or transmission requirements of the federal securities laws if such distribution results in the delivery to the intended recipients of the required information -- the means are not relevant. See Use of Electronic Media for Delivery Purposes, Securities Act Rel. 7233 (October 6, 1995) [60 FR 53458 (October 13, 1995)]; see also Use of Electronic Media by Broker-Dealers, Transfer Agents, and Investment Advisers for Delivery of Information; Additional Examples Under the Securities Act of 1933, Securities Exchange Act of 1934, and Investment Company Act of 1940, Securities Act Rel. 7288 (May 9, 1996) [61 FR 24644 (May 15, 1996)]. ==========================================START OF PAGE 27====== accelerated transactional filing requirements. Consequently, it may be possible to dispense with a physical prospectus delivery requirement in all but extraordinary circumstances.-[32]- For the present, however, the Committee was not prepared to conclude that delivery of prospectus information to the market at large through filed documents is an adequate substitute for physical delivery to all investors in all cases, and thus determined to recommend that delivery of a traditional prospectus still be required to be made to non-accredited investors in non- routine transactions. The Committee was concerned that individual investors may not have access to alternative information sources for obtaining information on file with the ---------FOOTNOTES---------- -[32]- A number of countries do not require that the prospectus be delivered to offerees and purchasers other than by publication. France, Germany and the United Kingdom call for either the publication of the prospectus, with investors offered an opportunity to request additional information, or merely the publication of the availability of the prospectus, including specification of the place where investors may go to obtain a prospectus. In addition, subject to certain conditions, in Germany and the United Kingdom, for repeat offerings of less than 10 percent of the market capital of a previously listed security, the prospectus requirement has been eliminated. If such securities also are to be listed, the relevant exchange still must approve the additional listing application, but no disclosure document is required as part of the applications process. However, the United Kingdom does require publication of the number and type of securities to be listed as well as the circumstances of their issuance. France has a similar exemption, but imposes far more conditions on its use. See Documents for Advisory Committee Meeting, June 15, 1995, Tab F (Study of Foreign Regulatory Processes). ==========================================START OF PAGE 28====== Commission, even if access to such filed information is provided earlier via these sources than the more traditional means used under the current system.-[33]- In all instances, physical prospectus delivery would not be required to be made to accredited investors. Such investors would benefit under company registration from access to information required to be filed with the Commission earlier than it is now required to be provided to any investor under the current Form S-3 primary shelf offering process. Moreover, such accredited investors are in a position to have such information delivered directly to them if they so prefer. ---------FOOTNOTES---------- -[33]- See Transcript of May 8, 1995 Advisory Committee Meeting at 233-236. ==========================================START OF PAGE 29====== B. Role of the Commission and Other Gatekeepers or Monitors Outside gatekeepers -- the regulators, lawyers, underwriters, accountants and other professionals -- are critical to the integrity of the securities markets. Current offering procedures allow an issuer to market securities with little notice and without adequate opportunity for meaningful review and investigation at the time of the offering by the traditional gatekeepers. The Committee thus explored means to enhance their roles. Company registration will facilitate the due diligence process by reordering and rationalizing the gatekeeping functions in a manner that will improve their effectiveness in ensuring the dissemination of quality disclosure to the market, not only in connection with public offerings, but on a continuous basis as well. Company registration would make the necessary adjustments to this traditional function by encouraging ongoing monitoring of the issuer's disclosures by the parties in the best position to perform that function. 1. The Commission Review Process As noted, neither the Form C-1 nor the transactional disclosure filed with the Commission and publicly disseminated at the time of the offering normally would be subject to staff review prior to the commencement of the offering. This approach would not reflect a significant change in current Commission administrative practice. The Commission already has shifted a significant part of its gatekeeping function to reviewing company related and financial information in Exchange Act reports, although a public offering remains a selection factor even for seasoned issuers. As reported in Table 2 to Appendix B, only approximately 16 percent of filings by seasoned issuers on Form ==========================================START OF PAGE 30====== S-3 are reviewed by the staff.-[34]- With regard to securities sold off an already effective shelf registration statement, prospectus supplements disseminated upon takedown are never subject to staff pre-review. Some have argued that the mere possibility that an offering could be selected for review remains an important deterrent to inadequate or misleading disclosure practices. The Committee concluded, however, that this deterrent effect comes at the cost of significant uncertainty in the timing of securities offerings that often lead even seasoned issuers to resort to alternative capital-raising techniques that generally offer less investor protection. Even with the adoption of the universal shelf system, issuers still are drawn to alternative markets. This is apparently due in part to issuer demand for immediate access to the market, which could be delayed by the potential review of the Form S-3 shelf registration statement. In the Committee's view, the significant deterrent to the sale of securities with less than complete and accurate information would be preserved for these seasoned issuers through Commission staff review of transactional documents at the time it reviews the company's Exchange Act reports, just as is currently ---------FOOTNOTES---------- -[34]- In FY 1995, of the 3900 reporting companies reviewed, two-thirds were reviewed in an Exchange Act, rather than transactional, context. Of the reporting issuer reviews in a transactional context, approximately half included a review of the registrant's Exchange Act reports. See Quinn Speech, supra n.22, at 30 n.21. ==========================================START OF PAGE 31====== the practice regarding takedown prospectuses for offerings of securities off already effective shelf registration statements. As with the current system, the presence of significant financing or acquisition activity should remain a factor considered by the Commission staff in determining whether to select an issuer for review. The prospect that the Commission staff could issue significant comments and insist on material revisions to disclosures already relied upon in connection with an offering of securities (a possibility that also exists today) should provide adequate incentive to ensure that the company's disclosure is of the highest quality. The Committee nevertheless determined, at least for purposes of the pilot, that extraordinary distributions of equity securities by registered companies should remain potentially subject to staff pre-review. Offerings of voting securities exceeding 40 percent of the existing public float should be required to be filed on an amendment to the Form C-1 registration statement that would not become effective absent acceleration by the staff. In addition, the likelihood of staff review of proxy materials in connection with extraordinary transactions will continue to ensure that transactional reviews take place in those cases where investor rights are most likely to be affected.-[35]- For this reason, the Committee considered ---------FOOTNOTES---------- -[35]- The New York Stock Exchange requires, as part of its listing requirements, shareholder approval for the issuance of stock with voting power equal to or in excess of 20 percent of the voting power (continued...) ==========================================START OF PAGE 32====== limiting staff pre-review to mergers, acquisitions, and other types of restructurings, but not straight financings. However, the Committee determined that such a distinction would be difficult to administer. Moreover, significant financings can cause a fundamental change in the nature of the company depending on the use of proceeds and, at the extreme, could resemble an initial public offering by a new enterprise. If other criteria exist for identifying circumstances where staff review of a transaction may be particularly beneficial to investors (for example, offerings by distressed issuers), yet afford issuers predictability regarding whether the filing will be reviewed, they should be explored. There remains a concern that an issuer planning an offering under the company registration system will discover during the planning process that the staff has selected its Exchange Act filings for review. The issuer then would have to determine whether to delay the offering, and thus risk the closing of a market window, or go to market with the risk that the staff may have significant comments that may require revisions to existing disclosure or additional disclosure. Issuers face this dilemma today in deciding whether to proceed with a shelf offering after learning that the staff has commenced a review of its Exchange Act filings. To address this concern in part, the Committee ---------FOOTNOTES---------- -[35]-(...continued) outstanding, in other than public offerings for cash. NYSE Listed Company Manual, 312.03(c)(i) (July 1989). ==========================================START OF PAGE 33====== believes that the Commission could establish a procedure under which issuers could seek a review, possibly on a nonpublic basis, when planning to go to market.-[36]- By requesting a review prior to the offering, registered companies would benefit by minimizing the chance that the staff would select their filings for review on the eve of a planned offering. Such a procedure may be particularly useful where a transaction poses novel disclosure and accounting issues. 2. The Underwriter The Committee was advised of the concerns of the underwriting community that the adoption of a company registration scheme -- and the wider use of the shelf registration system, particularly for equity and non-investment grade debt -- could further erode their ability to conduct effective due diligence. Consideration was given to what measures, if any, are necessary to ensure ample opportunity for underwriter due diligence. These measures could serve either as a "speed bump" to ensure that underwriters are engaged early enough in the offering process to provide an adequate opportunity to review the issuer's disclosures or as a "focal point" to ---------FOOTNOTES---------- -[36]- This process could be similar to that afforded confidential merger proxies, as well as Securities Act filings of foreign issuers when necessary to preserve the confidentiality of a transaction prior to the marketing of the offer consistent with home country practice. See Exchange Act Rule 14a-6(e)(2) [17 C.F.R. 240.14a-6(e)(2)]. See also Transcript of June 15, 1995 Advisory Committee Meeting at 39 (statement of Edward Greene). ==========================================START OF PAGE 34====== concentrate attention on due diligence responsibilities. One suggestion required the issuer to hire or select the underwriters eligible to participate in the offering at least three days prior to the offering in the case of underwritten offerings of more than 10 percent of the issuer's voting securities.-[37]- The Committee concluded that this suggestion would impose an artificial burden on the offering process, and that the parties are in a best position to determine the amount of time necessary to conduct adequate due diligence. Consequently, the Committee rejected the notion of a "speed bump" that artificially disrupts the process. The Committee was informed by underwriters that the requirement to file a Form 8-K at the time of the offering containing the transactional disclosure and any material company-related updating disclosure in connection with equity takedowns in excess of a certain percentage of the equity outstanding would help to "focus" the due diligence inquiries by underwriters. This requirement also would ensure that the market is informed of both the offering and of the transactional and material updating information, and that such information is subjected to the liability provisions of ---------FOOTNOTES---------- -[37]- In his 1985 article, Milton Cohen proposed to address this question by imposing a waiting period of at least five days, at least in equity offerings if not all offerings, unless the underwriter joins in a request for acceleration of that period. Milton H. Cohen, The Integrated Disclosure System -- Unfinished Business, 40 Bus. Law. 987, 994 (1985)("Cohen, Unfinished Business"). ==========================================START OF PAGE 35====== Securities Act Sections 11 and 12(a)(2). For these reasons, the Committee recommends this type of Form 8-K filing for both company registration and shelf registration equity offerings of a non-de minimis amount. Moreover, the separate recommendations that information regarding material developments either be delivered in a prospectus or be on file prior to its incorporation by reference into the prospectus, as well as the proposal to deliver the prospectus prior to sale in the case of substantial equity offerings, should provide the underwriter with sufficient additional time to investigate the disclosures. Finally, the proposed guidance regarding due diligence practices (discussed in greater detail below) likewise should create incentives for issuers and underwriters to adopt disclosure practices that involve the parties best able to ensure the accuracy of the disclosures in the due diligence process. The proposed guidance should assist the underwriter in performing due diligence by identifying the parties to whom the underwriter can turn with inquiries regarding specific aspects of the issuer's disclosure. 3. The Auditor Under the company registration system, just as under today's shelf registration system, an auditor's consent to the use of its report, dated as of, or shortly before, the effective date of the registration statement (as updated by the filing of audited financial statements on Form 10-K) would have to be on file with ==========================================START OF PAGE 36====== the Commission at the time of the offering.-[38]- Consistent with current practice with respect to the shelf, the auditor could consent to incorporation of its audit report into the company registration statement at the time the Form 10-K containing the auditor's report is filed. That consent, unless withdrawn by the auditor, would be applicable to all offerings pursuant to the Form C-1 until the issuance of a new set of audited financial statements, or other filings are made that have the effect of resetting the effective date of the registration statement. Alternatively, the auditor could determine that its consent could be filed and currently dated for each specific issuance of securities, or conditions could be attached to its use, all as permitted under current practice. Consideration was given whether to mandate further auditor review of the Form 10-Q's interim financial statements at the time of their filing, rather than as part of the annual audit. A special committee of the AICPA recently called for greater association by independent accounting firms with the non-audited information of their corporate clients as a means to enhance the value of business ---------FOOTNOTES---------- -[38]- Auditors generally may not provide "prospective consents," or consents that are provided significantly in advance of the effective date of the registration statement. Under Section 11(b)(3)(B) of the Securities Act, the adequacy of an auditor's due diligence inquiry will be judged "at the time such part of the registration statement became effective . . . ." [15 U.S.C. 77k(b)(3)(B)]. ==========================================START OF PAGE 37====== reporting to end-users.-[39]- Many seasoned public companies now engage their outside auditors to perform a review of interim financial information in accordance with Statement on Auditing Standards ("SAS") No. 71.-[40]- Pursuant to this standard, an independent accounting firm will make inquiry regarding the company's internal control structure and any significant changes therein since the most recent financial statement audit or interim review to determine the possible impact on the preparation of interim financial information, and will apply analytical procedures to such information to "provide a basis for inquiry about relationships and individual items that appear to be unusual."-[41]- For purposes of the pilot, the Committee did not believe it necessary to mandate use of SAS No. 71 reviews by registered companies. First, there already appears to be growing use of SAS ---------FOOTNOTES---------- -[39]- See generally Improving Business Reporting - A Customer Focus: Meeting the Needs of Investors and Creditors, Comprehensive Report of the Special Committee on Financial Reporting, American Institute of Certified Public Investors (1994) (the "Jenkins Committee Report"). -[40]- The Committee was informed that at least one major accounting firm requires a review of interim financial information as a condition to their accepting a SEC audit client. See Transcript of September 29, 1995 Advisory Committee Meeting at 192 (statements of Mr. Elliott). -[41]- SAS No. 71.13. Rule 436 under the Securities Act states that an independent accountant will not be deemed to have "expertized" a report on unaudited interim financial information [17 C.F.R. 230.436(c)]. ==========================================START OF PAGE 38====== No. 71 reviews by seasoned issuers.-[42]- Moreover, for larger, more seasoned companies, auditors do not visit the company just once or even four times a year, but rather can be there "virtually continuously."-[43]- By clarifying that SAS No. 71 reviews and any other more detailed reviews of interim information are appropriate factors to be considered in determining the proper scope of underwriter and outside director due diligence, the Committee anticipates that there will be adequate incentives to adopt the practice.-[44]- As a ---------FOOTNOTES---------- -[42]- A recent survey of approximately 25 percent of the firm's SEC clients conducted by Price Waterhouse revealed that "most large companies -- i.e., those which would initially be eligible for the company registration process -- already have some kind of auditor involvement with their quarterly data." Letter from Arthur Siegel, Price Waterhouse LLP, to Steven M.H. Wallman, Securities and Exchange Commission, dated July 3, 1996 (the "Price Waterhouse Survey"). -[43]- Transcript of September 29, 1995 Advisory Committee Meeting at 192 (statements of Mr. Elliott). -[44]- In debating whether any form of review of interim financials, or even non-financial information, by auditors should be mandated as a condition of opting into the company registration system, the Committee was concerned about imposing undue burdens on issuers in the form of additional costs. In 1989, the Commission considered, among other matters, revising its rules to require interim financial information of registrants be reviewed by independent auditors before such information was filed with the Commission, and requested public comment on both the perceived need for such revisions and any incremental costs and benefits of imposing such requirement. In a comment letter from Arthur Andersen & Co., the firm estimated that the incremental cost of mandating timely interim reviews to a majority of (continued...) ==========================================START OF PAGE 39====== result, the auditor's gatekeeping function would be enhanced by causing its reviews of interim financial information to occur on a more current basis when corrections can be made in filed reports before they are disseminated to the public, rather than after the close of the fiscal year.-[45]- ---------FOOTNOTES---------- -[44]-(...continued) its clients who already had some form of timely review performed was in the range of 5-20 percent. For those clients that did not already have a timely review performed, incremental costs may be higher. The larger the client, the lower the incremental cost in percentage terms. In addition, Arthur Andersen stated that, notwithstanding the burden of additional cost, the benefits of mandating such reviews on smaller companies would be proportionately greater because of their generally less sophisticated accounting systems. In Arthur Andersen's view, while the performance of interim reviews "would not detect reporting problems to the same extent of an audit, ... it would enhance the overall quality of smaller registrants' financial information and reduce the possibility of the issuance of misleading interim reports." Letter from Richard Dieter, Arthur Andersen & Co., to Jonathan G. Katz, Secretary, Securities and Exchange Commission, dated September 12, 1989. A more recent survey conducted by Price Waterhouse estimated that, for those clients for which full, timely SAS 71 reviews are not currently conducted, the average cost per quarter increase in annual audit fees if such reviews were to be conducted was 2-7 percent of annual audit fees, assuming a report is issued only to management and the board of directors. The average cost would increase to the extent the report was issued to underwriters or shareholders. Price Waterhouse Survey, supra n.42. -[45]- See Transcript of September 29, 1995 Advisory Committee Meeting at 193 (statements of then SEC General Counsel Simon Lorne). ==========================================START OF PAGE 40====== The auditor also can serve an important function at the time of the offering. In many cases, the underwriter or its counsel will discuss the issuer's financial statements with the issuer's outside auditing firm, and will request comfort from that firm with respect to financial information contained in the prospectus. Since mid-1993, the accounting profession has followed the guidance prescribed in SAS No. 72 in this context. An SAS No. 72 engagement relating to a registered public offering may encompass either or both the audited financial statements and unaudited financial data set forth in the prospectus. The auditor may provide positive assurance on compliance with applicable Commission rules and regulations (such as Regulations S-X or S-K) as to financial statements and schedules that the accountant itself has audited. Finally, an auditor can perform an additional gatekeeping function at the time of the offering when asked to furnish or update a consent to the use of his or her report. Prior to providing such a consent, an auditor makes inquiries and performs other procedures under SAS No. 37 to satisfy itself that events subsequent to the date of the annual audited financial statements do not indicate that adjustments to those statements are necessary. II. Company Eligibility When fully implemented, the benefits of company registration would be extended to virtually all public companies that previously had conducted a public offering of their securities. The concepts of company registration, however, will be tested under a pilot open only to certain seasoned companies. The exact ==========================================START OF PAGE 41====== criteria for participation in the system and what, if any, additional conditions would be necessary for smaller issuers, will be determined based on experience with the pilot. The Advisory Committee considered several approaches for defining which companies would be eligible for company registration. The Committee's goal was to extend the benefits of company registration to as many companies as possible, yet preserve the current scheme in those instances where it has proven cost-effective and beneficial to investors. For the reasons outlined below, for the purposes of the pilot, the Committee ultimately settled upon the following eligibility requirements: completion of an initial public offering, a two- year reporting history, $75 million public float, and a class of securities listed on the New York Stock Exchange, the American Stock Exchange, or the Nasdaq-NMS stock market. The Committee believed that the current process for initial public offerings ("IPOs") generally works well in assisting a company in the transition from a private to a public company. Although in many respects there may be ways to lower the transaction costs and delays inherent in the "going-public" process, the Committee determined that those issues should be addressed separately from the consideration of a company registration process.-[46]- In the Committee's view, the ---------FOOTNOTES---------- -[46]- An example of such a measure would be the Commission's current proposal to allow issuers to "test the waters" in connection with an IPO. See Solicitations of Interest Prior to an Initial Public Offering, Securities Act Rel. 7188 (June (continued...) ==========================================START OF PAGE 42====== current filing and staff review process is instrumental in assisting the private company to acquaint itself with the disclosure obligations of a publicly owned company. The delay inherent in the process allows the company's advisers to help its management put its books and records in order (including obtaining audited financial statements) and resolve any insider transactions or arrangements that may be inappropriate for a public company. In the Committee's view, there is no alternative to full due diligence by all outside advisers and gatekeepers in the context of an IPO. For these purposes, the Committee recommended that an IPO be defined as the first registered offering of securities by an issuer.-[47]- Thus, even a company that has been subject to reporting requirements for a period of time because its equity is held by more than 500 record holders and it has more than $10 million in assets,-[48]- or it has securities listed on an exchange,-[49]- would not be eligible for company registration until it has made at least one registered offering ---------FOOTNOTES---------- -[46]-(...continued) 27, 1995) [60 FR 35648 (July 10, 1995)]. -[47]- A registered offering by a company that previously had conducted registered offerings and had been a reporting company, but thereafter went private and ceased reporting, would be considered an IPO for these purposes. -[48]- Section 12(g) of the Exchange Act [15 U.S.C. 78l(g)] and Rule 12g-1 [17 C.F.R. 240.12g-1]. -[49]- Section 12(b) of the Exchange Act [15 U.S.C. 78l(b)]. ==========================================START OF PAGE 43====== of securities under the Securities Act. While a company filing a Form 10 under the Exchange Act to register a class of securities is subject to substantially the same disclosure requirements as a Securities Act registrant, and a Form 10 normally is selected for staff review, the level of professional outside involvement and due diligence may be significantly less absent an offering of securities and the potential application of the strict liability provisions of Section 11 of the Securities Act. During the pilot, and perhaps in the initial stages of full implementation, the company registration system would be voluntary; eligible companies could opt in as they desired. Once this election is made, a company could opt out by withdrawing its registration, but it would not be eligible to use the system again for a specified period of time (two years is recommended). This voluntary approach offers the benefit of providing a market test for the system. Once experience is gained with company registration, the benefits of company registration should be made available to virtually all publicly traded companies to conduct repeat offerings. One of the advantages of the company registration system is that, by virtue of the integral enhancements to the disclosure process, the system will allow the extension of streamlined access to the capital markets to companies currently not eligible to use shelf registration. Under the universal shelf registration process, large companies currently have significant flexibility. Thus, if eligibility for company ==========================================START OF PAGE 44====== registration were limited to large companies, the benefit for issuers aided by the system would not be as great as if the system were extended to other issuers. The Committee recognizes, however, that extension of the system beyond S-3 eligible issuers may require additional disclosure enhancements or conditions, depending upon the experience with the pilot. For example, any smaller companies permitted to take advantage of the company registration process that have little market following and therefore a less efficient market for their securities might be required to continue to comply with traditional prospectus delivery requirements for all public offerings regardless of the amount offered, or to undergo staff review of audited financial statements prior to their use. Those determinations necessarily can be made only by the Commission on the basis of experience gained under the pilot. For that reason, the Committee concluded that the system should be phased in gradually, starting with the pilot under which only larger, more seasoned companies would be eligible to participate. In this manner, the system could be tested and fine-tuned with the help of those companies most experienced with the disclosure responsibilities of public companies and with access to the most experienced counsel and underwriters. Initially, the Committee considered using for pilot eligibility the existing standards established by the Commission ==========================================START OF PAGE 45====== for eligibility to register securities on Form S-3.-[50]- The Committee concluded, however, that additional criteria would be useful at the pilot stage. Because the company registration system would place greater reliance on the quality of the issuer's Exchange Act reports, the Committee determined that only companies with a reporting experience of at least two years would be eligible for participation in the system. In the view of the Committee, it often takes at least two years following an IPO for a company and its management to become fully comfortable with the disclosure obligations of a public company and to have all their mechanisms for gathering and disseminating information in place and properly functioning.-[51]- The Committee also concluded that initial pilot eligibility should be limited to companies listed on the New York Stock Exchange or The American Stock Exchange, or quoted in the National Market System of the Nasdaq Stock Market. Limiting the eligibility to listed companies has the benefit of adding the overlay of listing standards, including the agreement to provide ---------FOOTNOTES---------- -[50]- Eligibility for the shelf is generally limited to companies eligible to register securities on the Form S-3 short form registration statement. S-3 companies generally include only those that have a $75 million public float; one-year reporting history; and are current with respect to their reporting requirements and certain fixed obligations. With respect to equity, the public float requirement is eliminated for secondary offerings. -[51]- Transcript of September 29, 1995 Advisory Committee Meeting at 13-18. ==========================================START OF PAGE 46====== prompt disclosure to the markets of material developments. Such a criterion is useful at the pilot stage, because it would minimize the amount of coordination with the states needed because of the common exemption under state "Blue Sky" laws for listed companies. After incorporating each of these criteria, based upon information available to the Committee staff, roughly 30 percent of all reporting companies should qualify for the pilot.-[52]- To be eligible, a company must adopt the enhanced disclosure practices discussed below. During the pilot, noncompliance with the issuer eligibility conditions or any of the disclosure enhancements as of the time the issuer's Annual Report on Form 10-K update is filed would result in loss of eligibility to make offerings pursuant to the company registration form. Similarly, the issuer must be current with respect to its Exchange Act reporting obligations at the time of the offering. Voluntary or involuntary withdrawal from the system would render the issuer ---------FOOTNOTES---------- -[52]- The Committee had considered whether eligibility should be limited to a senior class of S-3 companies that have a public float of $150 million (the threshold used prior to 1992), rather than $75 million. Based upon data available to the Committee staff, this increase over the S-3 standard would reduce by one-third the percentage of reporting companies eligible for the system as compared to the S-3 standard. Because the $150 million level of capitalization may prevent a fair test for extending the system beyond S-3 eligible issuers, the Committee determined to retain the $75 million eligibility standard. ==========================================START OF PAGE 47====== ineligible to elect back into the system for a period of two years. Consideration also was given to whether the degree of research coverage by independent analysts should be an eligibility criterion. This criterion is not recommended by the Committee in light of concerns with defining what constitutes "research coverage." Several commenters also suggested that eligibility be limited to companies with an investment grade rating for senior securities. Because many companies do not obtain ratings, or do so only on the basis of credit enhancements, and may have different ratings for different classes of senior securities, this factor was not believed to be a useful determinant of the quality of the issuer's disclosures or otherwise consistent with the concept of company registration. Further, consideration was given to whether eligibility should be extended to closed-end investment companies. Registered investment companies are subject to a different set of reporting requirements under the Investment Company Act of 1940 and the rules and forms adopted thereunder. In the Committee's view, the company registration system may not be that useful for these companies. Accordingly, at least for the purposes of the pilot, the Committee did not recommend inclusion of closed-end funds, but left the issue to the Commission for any further review it deemed necessary. ==========================================START OF PAGE 48====== For similar reasons, foreign private issuers generally would be eligible for the pilot if they file the same forms and meet the same disclosure requirements as domestic companies. Since many foreign regulatory schemes do not require the filing of quarterly reports and any required semi-annual reports generally are based upon home country disclosure rules and practices,-[53]- it is possible that participation by these companies in the pilot may not be appropriate absent their providing disclosure comparable to domestic companies. Nevertheless, the Committee urges the Commission to consider whether a practice analogous to the current practice of some foreign issuers using the shelf on Form F-3 to provide reconciled interim financials on Form 6-K on a semi-annual basis, and incorporating those financials into the shelf registration statement, would suffice for company registration. ---------FOOTNOTES---------- -[53]- Under the foreign integrated disclosure system, reporting foreign private issuers file an annual report on Form 20-F. All other interim financial information required to be made public under home- country law is based upon home-country disclosure rules and practices. Consequently, foreign private issuers are not required to file quarterly financials on Form 10-Q or current reports on Form 8-K in accordance with U.S. disclosure requirements. See Exchange Act Rule 13a-16 [17 C.F.R. 240.13a-16]. ==========================================START OF PAGE 49====== III. Transactions Covered All sales of securities by a registered company will be afforded the same legal status as a registered offering of securities under the current scheme, thereby eliminating or greatly reducing the need for resale restrictions and other artificial restraints, such as those necessitated by the concepts of gun-jumping, restricted securities, affiliate sales, integration of offers, general solicitation, and flowback of offshore offerings. Under the voluntary pilot, companies would be provided the choice of obtaining these benefits by treating all offers and sales as covered by the company registration statement, or choosing to preserve the option to engage in exempt transactions at the cost of continued regulatory restrictions on resales. A. Affiliate and Underwriter Resales With limited exceptions, the company registration system would be available for all offerings of any securities by eligible companies. Similarly, sales by affiliates and by any person acting for a registered company or its affiliates would be covered by the Form C-1. The Securities Act addresses resales of securities primarily as a means to prohibit the distribution of securities of issuers for which there is inadequate information available to the public,-[54]- and to protect the integrity of the transactional registration process. This concern is particularly important when the issuer is not yet a public company and private sales and redistributions could serve as a means of developing a trading market in the security without the issuer being subjected to the registration process. It has long been recognized that this concern is of less importance where the ---------FOOTNOTES---------- -[54]- See Preliminary note to Rule 144 [17 C.F.R. 230.144]. ==========================================START OF PAGE 50====== issuer already is a reporting company and is currently subject to ongoing disclosure requirements.-[55]- 1. Sales of Restricted Securities A company registration system would further alleviate these concerns by eliminating the notion of exempt private placements and restricted securities altogether. Under full company registration, regardless of the nature of the transaction in which securities were initially sold by the issuer or its affiliates, there would be no need to impose resale restrictions on outstanding securities. All sales by registered companies and their affiliates made under Form C-1 would have the same legal status and carry the same or higher liability and investor protections as registered offerings do today. For that reason, the provisions of Rule 144 governing resales of restricted securities would not be necessary since all shares would be registered if issued by a registered company. A purchaser in the secondary market would be better protected under the company registration scheme, especially given the more current and reliable information being provided by the issuer pursuant to the various disclosure enhancements. Because all issuer and affiliate sales would be deemed to be made under the ---------FOOTNOTES---------- -[55]- See Cohen, supra n.2, at 1395. ==========================================START OF PAGE 51====== Form C-1 (where a company has opted into full company registration-[56]-), an issuer cannot use indirect sales through a conduit as a means to distribute securities without registration and disclosure, nor as a means to escape liability. All securities issued under the company registration system would be subject to Section 11 liability for any misleading statements or information in the issuers' public reports that are incorporated by reference into the registration statement at the time of original issuance by the issuer. This liability would run to any purchaser that can trace the security back to the misleading registration statement. Indeed, in the case where it can be demonstrated that the seller was a mere "strawman" for the issuer and was selling on its behalf, the resale itself will be considered an issuer transaction made pursuant to the registration statement. Since all securities would be deemed registered upon issuance under company registration, the Committee has determined that a safe harbor from the broad definition of "underwriter" in Section 2(11) of the Securities Act should be adopted for purposes of resales of securities issued by a registered company. The safe harbor would limit the application of the underwriter ---------FOOTNOTES---------- -[56]- As noted (supra p. 5-6), a registered company opting for full participation in the system would have the choice whether to sell non-convertible debt securities within the system. However, no such choice would be available for equity securities and securities convertible to equity -- all such securities issued by the fully participating company must be sold pursuant to the company registration system. ==========================================START OF PAGE 52====== concept to persons engaged in the business of a broker-dealer, whether or not registered as such (including banks not required to register as a broker-dealer), who participate in the distribution of securities by an issuer or an affiliate.-[57]- The Commission may wish to consider whether it would be helpful to specify a time after which a broker-dealer would no longer be deemed a participant in the distribution (e.g., after it has sold out its allotment or the expiration of six months, whichever is earlier), especially if the Commission otherwise shortens the period in which a distribution will be deemed to occur. The purpose of this provision would be to ensure that only the underwriting firms participating in the offering incur responsibility under Section 11 liability and due diligence provisions, while providing more certainty as to when resales may freely take place. ---------FOOTNOTES---------- -[57]- The use of a narrower definition of underwriter for the purpose of resales of securities sold under the company registration system is appropriate, since it would only apply in the context of registered offerings. Except in the case of broker-dealer firms in the business of underwriting securities, in the absence of arrangements with, or compensation for selling on behalf of, the issuer, and if certain other conditions are satisfied, nonaffiliated purchasers in a registered offering have not been considered to be underwriters under current interpretations of that definition, even when they purchase a substantial portion of the registered offering or immediately resell the securities following the offering. See American Council of Life Insurance, SEC No-Action Letter, [1983 Transfer Binder] Fed. Sec. L. Rep. (CCH) 77,526 (May 10, 1983). ==========================================START OF PAGE 53====== A final benefit of this more narrow definition of underwriter would apply in the context of acquisitions. Current law deems affiliates of acquired companies to be underwriters when they resell the registered company's securities received in the acquisition.-[58]- Registered companies participating fully in the system, and thus entitled to take advantage of this narrower definition of underwriter, could make acquisitions without issuing restricted stock to the acquired company's insiders. ---------FOOTNOTES---------- -[58]- See Securities Act Rule 145(c) [17 C.F.R. 230.145(c)]. ==========================================START OF PAGE 54====== 2. Sales by Affiliates Under the current system, substantial affiliate resales (those exceeding the limits set by Rule 144) have been subjected to registration requirements, even with respect to nonrestricted securities purchased by the affiliate in registered transactions or in the open market. Again, the primary purpose of this provision was to ensure that companies do not create a public market for their shares indirectly through sales by their controlling or controlled persons when adequate information is not available concerning the issuer. As in the case of restricted securities, the need to preserve existing constraints on affiliate resales largely disappears under a company registration scheme. Since registered companies would be subject to continuous reporting obligations, and the issuer would be exposed to statutory liability for any sales made by the issuer to an affiliate, or any subsequent purchaser from the affiliate who can trace the securities back to the company registration statement, there is little concern that an affiliate may be acting as a conduit to facilitate the distribution of unregistered securities without the protections of the registration process. Similarly, resales by affiliates should not require prospectus disclosure since the sale would not affect the financial condition of the issuer. The antifraud, beneficial ownership, and Section 16 "insider" reporting and short-swing profit rules, all promulgated under the Exchange Act, apply to ==========================================START OF PAGE 55====== ensure adequate disclosure of these transactions, to the extent a sale by an affiliate impacts on the control of the issuer or the available supply of its securities in the public markets, or is indicative of possible insider trading.-[59]- The Committee proposes, therefore, that the class of persons subject to the registration requirements and resale limitations be significantly narrowed. In the case of registered companies taking full advantage of the company registration system, those persons subject to resale restrictions would include only holders of 20 percent of the voting power, or holders of 10 percent of the voting power with at least one director on the board, persons who can be presumed to be in a position to exercise control.-[60]- That presumption of a control relationship would be rebuttable.-[61]- Also ---------FOOTNOTES---------- -[59]- Milton Cohen expressed the view that delivery of a prospectus for affiliate sales was unnecessary in most instances. Cohen, supra n.2, at 1395. This concern could be further addressed under full company registration system by requiring affiliates to make prior disclosure of plans to make sales, similar to the notice provided on Form 144 today. A similar notice provision for 15% holders was proposed by the ALI Code. See Federal Securities Code 510 (Am. Law. Inst.) (Proposed Official Draft 1978). -[60]- A shareholder would not be deemed to hold a board seat merely as a result of its voting power derived pro rata as a holder of a class of securities. Rather, the right to appoint a member of the board must be derived by independent agreement or arrangement with the issuer, management or other shareholders. -[61]- While a finding of "control" will always depend upon an examination of all the facts and (continued...) ==========================================START OF PAGE 56====== included would be the CEO and inside directors, as well as the director representatives of the controlling shareholders. This class of persons subject to resale limitations is significantly narrower than that prescribed by current law, which under certain circumstances could encompass all executive officers or directors, as well as significant shareholders.-[62]- The narrower class is justified in light of the diminished concern with affiliates acting as conduits for the distribution of issuer securities.-[63]- This proposal affects solely the registration and resale requirements, not any other provisions under the federal securities laws, such as the "controlling person" liability ---------FOOTNOTES---------- -[61]-(...continued) circumstances, one significant factor in determining who controls the issuer for Securities Act registration purposes has been the ability to obtain the signatures necessary to complete the registration process. See III L. Loss & J. Seligman, Securities Regulation 1111 (3d ed. 1989); Cohen, supra n.2, at 1393. -[62]- See generally A.A. Sommer, Jr., Who's "In Control" -- the SEC, 21 Bus. Law. 559, 567-83 (1966). -[63]- The Committee recognized that contractual and other relationships also can give rise to a control relationship. However, the Committee believes that, given the inability to use conduits to avoid registration or liability under the company registration system, the narrower application of the resale restrictions is appropriate. ==========================================START OF PAGE 57====== provision under the Securities Act or the Exchange Act.-[64]- The Committee considered requiring all sales by those affiliates subject to resale restrictions under full company registration, no matter how de minimis, to be registered under the C-1 registration statement, thereby eliminating the need to apply Rule 144 to these affiliate resales as well. However, in the Committee's view, that approach would be unnecessarily broad and restrictive, since affiliates are currently permitted to sell without registration if they comply with Rule 144. Accordingly, affiliate sales meeting the applicable Rule 144 conditions need not be made under the company registration statement. The current flexibility of Rule 144 should provide those affiliates still subject to resale limitations under company registration with ample opportunity to sell securities without the necessity of obtaining the issuer's assistance in completing the registration process, as well as the payment of a fee, at the time of the resale. Issuers certainly can oversee resales by their CEO and inside directors to ensure compliance with these requirements, and avoid sales at a time when the issuer has not disclosed material developments to the market. The same is true in the case of significant shareholders who purchased from, or at ---------FOOTNOTES---------- -[64]- Section 15 of the Securities Act [15 U.S.C. 77o]; Section 20(a) of the Exchange Act [15 U.S.C. 78t(a)]. ==========================================START OF PAGE 58====== the invitation of, the issuer.-[65]- In those instances, an issuer can protect itself by obtaining a contractual agreement from the affiliate not to resell without the issuer's permission. In those cases where the affiliate's investment in the company was uninvited, the Committee considered whether special provision should be made to allow the affiliate to sell under the company registration system without the cooperation of the issuer. Unlike the case with current law, during the pilot, the affiliate of a company participating fully -- with no private placement exemption -- in the system cannot simply sell a large block of the company's securities in one or more exempt private placements, since that sale would be deemed registered for purposes of the Securities Act.-[66]- That registered sale would require an updating of the issuer's disclosure at the time of sale in order to comply with the Securities Act. The Committee did not want an issuer to be subjected to Securities Act liability for a resale transaction that it could not control. The Committee believed that it would be extremely rare that an ---------FOOTNOTES---------- -[65]- The issuer's cooperation often is required for an investor to obtain affiliate status through significant purchases of outstanding securities as a result of state takeover statutes and "poison pill" rights plans. -[66]- As discussed below, under an option to elect a modified version of the company registration system, the issuer could preserve the option to conduct exempt private placements for itself and all affiliates. See infra p. 42-45. ==========================================START OF PAGE 59====== issuer would object to an uninvited affiliate reselling into the market in a broad-based distribution. Consequently, the potential for a significant shareholder of a registered company to be locked into its investment by an uncooperative issuer seems more theoretical than real. In any event, a substantial shareholder that could not secure the assistance of the issuer in its resales may be able to demonstrate that it does not have the requisite control over the issuer, and thus rebut the presumption of control in the definition of affiliate. Absent affiliate status, the shareholder is free to resell without the registration process and the corresponding Securities Act liabilities. B. Exclusions As noted, initial public offerings would continue to be subject to a transactional registration-type regulatory process, since only companies that have conducted a registered public offering would be eligible to use the company registration system. In addition, securities not valued on the basis of the issuing company's business and financial information, such as asset-backed or special purpose issues, would not be eligible for the system. Securities that are valued in part on the basis of the issuer's performance, such as structured securities or tracking securities (e.g., GM Series H), could be made eligible subject to special disclosure requirements. Further, issuers could opt in without subjecting issuances of the types of securities currently exempt from the registration requirements of ==========================================START OF PAGE 60====== the Securities Act to the company registration system. Thus, commercial paper, tax-exempt private activity bonds and bank- guaranteed debt would remain exempt from the system. Even in the case of a company taking full advantage of the system, the Committee concluded that, during the pilot stage, placements of straight (i.e., non-convertible) debt could be excluded from the company registration system at the issuer's election; debt securities, of course, also could be included at the issuer's option. The Committee believed that straight debt placements, either on an agency basis or into the Rule 144A market, are efficient, involve mostly institutions, and therefore may not necessitate the protections provided by the registration scheme. Moreover, unlike the case with equity securities, the integration and restricted securities concepts do not appear to have created significant problems in the debt markets due to the lack of fungibility among various debt issuances. C. Offshore Offerings Under full company registration, purchasers of securities of registered companies in the U.S. trading markets would have the same disclosure and liability protections regardless of whether the securities initially were sold overseas or in this country. Offshore sales to non-U.S. persons would not have to be covered by the company registration statement. The adoption of a company registration system is not intended to result in an indirect assertion of U.S. registration jurisdiction over an issuer's offshore financing transactions. However, under full company ==========================================START OF PAGE 61====== registration, in light of the concerns regarding flowback of equity securities initially sold offshore, a participating issuer would be required to include equity securities on its company registration statement on the Form C-1 for purposes of their reentry into the United States in flowback transactions. The amount to be registered for this purpose would be based on the issuer's reasonable estimate of the likely flowback into the United States. Thus, U.S. purchasers of equity securities initially offered overseas would benefit from whatever statutory protections are afforded to secondary market purchasers by Section 11 of the Securities Act for the period of the applicable statute of limitations, running from the time of the initial sale by the issuer. As a result, the concerns that have arisen with respect to Regulation S offerings of equity securities with an established trading market in this country-[67]- would evaporate as a practical matter in the context of sales by registered companies, because U.S. purchasers would be protected to the same extent as if the securities initially had been issued in the United States. D. Preservation of Transactional Exemptions The Committee engaged in considerable discussion on whether companies participating in the company registration system should be able to rely on exemptions for private placements and other ---------FOOTNOTES---------- -[67]- Problematic Practices Under Regulation S, Securities Act Rel. 7190 (June 27, 1995) [60 FR 35663 (July 10, 1995)]. ==========================================START OF PAGE 62====== transactions that are available today from the registration and liability provisions of the Securities Act. On the one hand, the inclusive nature of company registration ensures that issuers could not use conduits to avoid liability that results from the registration of securities. Treating all sales as registered generally eliminates the need for such concepts as restricted securities, integration, general solicitation and flowback of unregistered securities issued abroad, with respect to securities issued by companies opting into the system. To the extent company-registered issuers or affiliates are permitted to engage in unregistered private placements, the need for resale restrictions and other concepts that burden the current scheme would remain, thereby costing the new system some of its expected benefits. On the other hand, the loss of the private placement option, and thus the potential for increased liability and possible disclosure concerns arising from the need to update the company's public disclosures and file the transactional information, as well the need to pay a registration fee, when making a company-registered offering could be a deterrent to the use of the company registration system.-[68]- ---------FOOTNOTES---------- -[68]- Transcript of May 8, 1995 Advisory Committee Meeting at 177 (statements of Professor Coffee). The same concern may arise with respect to the ability to conduct an offshore offering under Regulation S without having to register the securities offered for flowback purposes or otherwise. If the issuer is contemplating an acquisition, Regulation S offers a means for the issuer to avoid delaying the offer until the full acquisition disclosure is available. The (continued...) ==========================================START OF PAGE 63====== Therefore, to permit a fair test of the company registration concepts during the pilot stage, the Committee believed that issuers should be afforded the option of continuing to conduct private placements, while still taking advantage of most of the benefits of the system. Companies could choose either to waive transactional exemptions, such as those for small issuances (3(b) and Regulation A), private offerings (4(2)) and Regulation D (Rules 504, 505 and 506)), intrastate offerings (3(a)(11) and Rule 147), issuer exchange offers (3(a)(9)), and transactions pursuant to fairness hearings (3(a)(10)), as well as the jurisdictional safe harbor of Regulation S, or determine to preserve the option to exclude those transactions from the company registration system under a modified or less comprehensive version of this system. In the case of participation in full company registration, other than the limited exclusions for exempt securities discussed above (commercial paper, bank debt, etc.), all issuer and affiliate sales (outside Rule 144) would be deemed "registered" for Securities Act purposes. Thus, regardless of the nature of ---------FOOTNOTES---------- -[68]-(...continued) Commission has proposed to address that concern by conforming the acquisition disclosure and accounting requirements under the Securities Act to the same standard as under the Exchange Act. See Streamlining Disclosure Requirements Relating to Significant Business Acquisitions and Requiring Quarterly Reporting of Unregistered Equity Sales, Securities Act Rel. 7189 (June 27, 1995) [60 FR 35656 (July 10, 1995)] (the "Streamlining Business Acquisitions Release"). ==========================================START OF PAGE 64====== the transaction in which the securities were originally issued, the securities would be freely tradeable. Purchasers of those securities from the issuer or an affiliate (outside Rule 144) would enjoy the same remedies and disclosure protections as would be the case if they purchased securities issued today in a registered public offering. Companies participating in the modified version of the system still would benefit from the "file and go" registration process, so long as they agree to the disclosure enhancements. Securities issued in excluded transactions, however, would be restricted securities subject to current holding periods and resale limitations to the same extent they are today.-[69]- The new, more limited, applicability of resale limitations to affiliates and definitions of underwriter would not apply with respect to those issuers and transactions.-[70]- These ---------FOOTNOTES---------- -[69]- Although certain of the forms of exempt transactions do not result in the issuance of restricted securities under current law, they are subject to limitations and restrictions that condition the exemption, as well as potential integration, that would not apply if conducted on a registered basis. -[70]- The company registration model envisioned by the ALI Code also provided for exempt limited offerings. Those offerings were defined as sales up to 35 buyers as well as an unlimited number of institutional investors. See Federal Securities Code Section 242(b) (Proposed Official Draft 1978) (Am. Law Inst.). While strict resale limitations were not imposed, securities issued in those transactions could not be held by more than 35 noninstitutional investors for one year after the issuance in the case of seasoned issuers. Id. ==========================================START OF PAGE 65====== exempt offerings, however, would not be subject to integration with registered offerings conducted on the Form C-1. This dual approach, while adding complexity to the company registration system during the pilot stage, would permit issuers and their purchasers to weigh the costs and benefits of full registration of all transactions versus private placements. In the Committee's view, even during the pilot stage, the benefits resulting from registration, including the issuance of freely tradeable securities in what otherwise would have been a private transaction resulting in restricted securities, should outweigh any additional costs imposed by registering the securities under the system. In addition, given the extensive representations and warranties that normally are provided to purchasers in a private placement, the fact that company- registered transactions would be subject to Securities Act statutory liability should not be a significant deterrent. Similarly, the discount that normally adheres to private placements (as high as 20 percent for equity securities) should far outweigh the registration fee paid in registered offerings (.034 percent). E. Limited Placements An issuer participating in the full company registration system may be concerned that it will not be able to raise capital at a time when it is not in a position to disclose information currently required in a registered offering. This situation may arise due to a material business development that must remain ==========================================START OF PAGE 66====== nonpublic for legitimate business reasons, the need to update financial statements that have "gone stale," its offering documentation (for example, the Form 8-K filing) not being completed in time to take advantage of a market opportunity, or a company's auditor not consenting to the use of its report in connection with a registered offering. All of these reasons may induce a company to continue to conduct private placements. In these cases, an issuer could conduct a limited placement of securities to one or more accredited investors, so long as those securities (and any price-related securities) are not traded by the purchaser until full disclosure is provided to the public through a Form 8-K or other public filing of such information and its inclusion in the Form C-1. Of course, the issuer still would have to make full disclosure to the purchaser at the time of the sale (which could be done in writing as well as orally), subject to whatever confidentiality agreements with the purchaser that the issuer deems necessary. In this manner, once the disclosure is made to the public, the purchaser would have freely tradeable securities. The duration of any restriction on resale would be determined by the parties, not a fixed holding period set by Commission rule. In addition, unlike an exempt offering, the liability provisions of the Securities Act would attach to the securities originally issued in these limited offerings. ==========================================START OF PAGE 67====== IV. Disclosure Enhancements Under the Recommended Company Registration Model Adoption of a company registration system creates the opportunity for raising the quality and integrity of disclosure provided routinely to the markets through the company's Exchange Act reports in a variety of ways: (a) by requiring a heightened focus on the part of senior managers and directors on their existing financial reporting responsibilities; (b) by increasing the scope and currency of disclosure to the markets of specified material developments; and (c) by increasing the opportunity for outside gatekeepers or monitors to participate. Because company registration relies on the integrity of publicly available information and an efficient market for an issuer's securities, adherence to the recommended enhancements would be a condition to continued participation in the company registration system. As a result, investors in the secondary trading markets, as well as those participating in primary offerings, would benefit from more comprehensive, current and reliable information. As envisioned by the Committee, company registration relies heavily on the public availability of accurate and complete information relating to a registered company's business and financial condition. Viewed in this light, the Committee's model of company registration represents a logical extension of the Commission's integrated disclosure scheme. Despite integration and a gradual shift in emphasis of Commission staff review over the past decade away from Securities Act transactional documents and toward Exchange Act periodic reports, there remain substantial differences in the quality of the disclosures provided under each statute.-[71]- The expense of ---------FOOTNOTES---------- -[71]- As such, not much has changed since Milton Cohen observed in 1985: (continued...) ==========================================START OF PAGE 68====== continuous due diligence of the caliber expected in a primary distribution, coupled with issuers' legitimate need to control the timing of public disclosure of material developments, make it difficult for Exchange Act documents always to achieve true parity in terms of reliability and currency with documents filed in connection with registered offerings.-[72]- However, ---------FOOTNOTES---------- -[71]-(...continued) Disclosure for [Exchange] Act purposes still tend to be taken far less seriously, and to be of lower quality, than those historically provided, and still aspired to, under the [Securities] Act. . . . Because of this disparity, and the disparity in liability provisions that it reflects, the SEC has considered it necessary for a registrant, on the occasion of a public offering, not merely to supplement its latest [Exchange] Act disclosures but to bring them within the coverage of section 11 by, at least, incorporating them by reference into a [Securities] Act registration statement. Cohen, Unfinished Business, supra n.37, at 992. See 1977 Advisory Committee Report, supra n.4, at 425-26. -[72]- Traditionally, there have been "[t]wo principal qualitative reasons for placing particular stress" on Securities Act filings by comparison with Exchange Act filings, as suggested by the Wheat Report in 1968: First, the buyer of securities in an initial distribution is in a somewhat different position from the buyer in the trading markets. Not only the [Securities] Act but much of the legislation previously passed by the states in the securities field rests on this premise. The compensation that dealers and salesmen receive when they participate in a [Securities] Act offering is almost always appreciably more generous than that customarily received in exchange or over-the-counter trading. New securities have to be distributed in short order. Special efforts (continued...) ==========================================START OF PAGE 69====== the Committee believes that additional improvements in Exchange Act disclosures -- especially with respect to the attention paid by senior management, outside directors and other gatekeepers or monitors -- would achieve more fully the intent of the Commission when it integrated the disclosure requirements of the two statutes in 1982. Accordingly, the Committee recommends that the Commission implement a series of mandatory disclosure enhancements applicable to registered companies. Voluntary, but encouraged, measures such as SAS No. 71 reviews and appointment of a disclosure committee, should operate in tandem with the mandated ---------FOOTNOTES---------- -[72]-(...continued) are necessary if disclosure is to serve as a useful shield against the dangers inherent in such a situation. Second, new public offerings, especially those for the accounts of issuers, have a special economic significance. The transaction in which one investor purchases from another a security originally issued many years ago has less impact on the economy than one in which the investor's dollars go directly into the treasury of a corporation in order to help it to develop a mine, construct a new plant, or exploit a new technological development. A special disclosure effort may well be justified when allocation of capital in a free society is affected. . . . . . . For these reasons, among others, quantitative differences between the new issue and trading markets must be regarded with caution. Nevertheless, in the Study's judgment, the statistics demonstrate the need to achieve a better balance in disclosure policy, with greater emphasis on continuing disclosures for the trading markets. Wheat Report, supra n.3, at 60-61. ==========================================START OF PAGE 70====== enhancements to facilitate greater outside director, auditor, and underwriter attention to existing Securities Act due diligence responsibilities. Both the mandatory and voluntary measures recommended by the Committee, therefore, should improve the quality and integrity of corporate disclosure in connection with not only primary distributions, but also the Exchange Act reports upon which the trading markets depend. A. Mandatory Disclosure Enhancements Committee member Robert Elliott has urged the Committee to expand its primary focus on the reliability of the corporate reporting process to address perceived problems in the content of the resultant disclosures. Mr. Elliott raised the concern, echoed in the Jenkins Committee Report,-[73]- that much SEC-prescribed financial reporting may have become obsolete, redundant of generally accepted accounting principles ("GAAP") or otherwise of marginal utility to the investing public.-[74]- These financial reporting issues are ---------FOOTNOTES---------- -[73]- See supra n.39. Mr. Elliott was a member of the Jenkins Committee. -[74]- In a letter dated November 10, 1995 from Mr. Elliott to Committee Chairman Wallman, Mr. Elliott suggested that the Commission conduct research into investor informational demands that focuses on "[t]he trade-off between relevance and reliability," noting that Jenkins Committee data show that investors "would prefer more relevance, even at the cost of reliability." See Documents for Advisory Committee Meeting, November 21, 1995, Tab E (Letter dated November 10, 1995 from Robert Elliott to Commissioner Wallman at 2). As Mr. Elliott points out: (continued...) ==========================================START OF PAGE 71====== relevant to the Commission's administration of its disclosure program regardless of whether the Commission determines to move to a company registration system. In addition, the recommendations of the Jenkins Committee already were being considered by representatives of the affected constituencies prior to the establishment of the Advisory Committee.-[75]- For these reasons, the Committee determined to defer to these other ongoing evaluations of the need to reform financial ---------FOOTNOTES---------- -[74]-(...continued) If registrants are willing to pay some measure of cost to become C-1 companies, they should be just as willing to devote that measure to the incremental relevance it would purchase as to the incremental reliability it would purchase. This is a policy choice that the SEC can and should make for the sake of its investor- protection mission. . . . Companies often misperceive costs because they fail to count the capital-cost reduction benefit from clear, honest, complete disclosure policies. The SEC should undertake to study these benefits through independent economic analysis and make the case to registrants that disclosures helpful to investors' decision making provide capital-cost reductions (as long as they don't reveal matters to competitors that (a) are economically deleterious and (b) the competitors didn't already know). Id. at 2-3. -[75]- The Committee was advised by the analyst community that it would be premature to take up the Jenkins Committee Report recommendations before they are thoroughly examined by the accounting, corporate and end-user communities, as well as the FASB. See Documents for Advisory Committee Meeting, September 29, 1995, Tab E (Letter dated September 27, 1995 from the AIMR to Commissioner Wallman, at 6). ==========================================START OF PAGE 72====== reporting and confine its recommendations in this area to the substantial enhancement of reporting procedures and the reliability of reported information. The Committee did make substantive reporting proposals, however, such as the proposed changes to the existing Forms 10-K and 8-K disclosures, where it believed they were necessary.-[76]- 1. Enhanced Involvement by Senior Management When the Commission mandated in 1980 that senior managers and at least a majority of the board of directors sign a registrant's annual report on Form 10-K,-[77]- the Commission expected management and the board to focus their attention on the disclosures in the annual report. In practice, ---------FOOTNOTES---------- -[76]- The Committee also considered, but rejected as unnecessarily burdensome when balanced against likely investor benefits, a requirement that registered companies report in a timely manner all material developments similar to the obligation issuers now incur as a condition to listing on the New York Stock Exchange. See NYSE Listed Company Manual 202.05 (listed companies expected to "release quickly to the public any news or information which might reasonably be expected to materially affect the market for its securities"); see also American Stock Exchange Company Guide 1102, and National Association of Securities Dealers By-laws, Schedule D. For substantially the same reason, the Committee did not require registered companies to procure auditor attestation of their management discussion and analysis, or obtain an opinion of counsel on periodic reports. -[77]- See General Instruction D to Form 10-K, adopted in Amendments to Annual Report Form, Related Forms, Rules, Regulations,and Guides: Integration of Securities Acts Disclosure Systems, Securities Act Rel. 6231 (Sept. 2, 1980) [45 FR 63630 (September 25, 1980)] (the "Annual Report Release"). ==========================================START OF PAGE 73====== however, some of these corporate officials still devote far less attention and care to the preparation and review of the Form 10-K and other periodic and current Exchange Act reports than are generally seen in the Securities Act context. When presenting and discussing this issue, both the Committee and its staff repeatedly were advised that a routine practice among some reporting companies is merely to have senior management (and directors for the Form 10-K) execute the signature pages of a required Exchange Act report without receiving, and hence reviewing, the remainder of the document.-[78]- Whatever the causes of the disparities between the level of attention given to the preparation of Securities Act and Exchange Act disclosure documents, the result is clear -- the senior management of many registrants could do far more than they are doing today to assure the quality and reliability of information disseminated to the nation's public trading markets. Two measures recommended by the Committee are intended to heighten top managers' compliance with present reporting responsibilities: (i) the certification by top management to the Commission that specified Exchange Act disclosure documents have been reviewed by them and do not, to the reviewing manager's knowledge, contain any materially false or misleading information, and (ii) a senior management report addressed and submitted to the audit committee of the board of directors (or its equivalent) describing ---------FOOTNOTES---------- -[78]- See pp. 46 and 51 of Appendix A to the Report. ==========================================START OF PAGE 74====== procedures adopted both to ensure the integrity and accuracy of such disclosure documents, and to prevent insider trading. a. Top Management Certifications In requiring certification by responsible senior managers that each Exchange Act report has been read, and that the particular manager is not aware of any material misstatement or omission in that report, the Committee hopes that the Commission's longstanding objective of encouraging management (as well as directors, accountants and attorneys) to refocus its attention on the sufficiency of Exchange Act filings in order to instill "a sufficient degree of discipline ... in the [integrated disclosure] system to make it work" might be fulfilled.-[79]- Rather than create additional ---------FOOTNOTES---------- -[79]- Annual Report Release, supra n.77 (discussing reasons for imposing obligation to sign the Form 10-K upon the issuer's principal executive officer, certain additional officers, and a majority of the board of directors). Compare 1977 Advisory Committee Report, supra n.4, at 426-27 (rejecting a suggested requirement that a majority of the issuer's board of directors sign each Exchange Act report that would be incorporated by reference into a short-form registration statement, based on commenters' concerns that the increased liability the director signatories thus might incur would deter use of the short form; however, the Committee "encourage[d] the Commission to consider this concept as a possible means of upgrading the quality of reporting by improved attention by directors and top officers to their filings and the consequent enhanced possibility of liability"). Without addressing directly the 1977 Advisory Committee's conclusion, the Commission in expanding the Form 10-K signature requirement to require a majority of the board to execute this document regardless of its potential incorporation by reference into a (continued...) ==========================================START OF PAGE 75====== managerial duties or liabilities, the new certification requirement is intended to prompt the dissemination of more reliable and informative disclosures to the markets for registered companies' securities. An affirmative attestation obligation may well succeed in accomplishing what signature requirements alone apparently have not -- underscoring top management's duty to monitor the accuracy and integrity of all information contained in its corporate reports. The Committee recommends that a minimum of two of four designated senior executive officers (or their functional equivalents) in a position to influence the content and quality of a registered company's disclosures -- the Chief Executive Officer, the Chief Operating Officer, Chief Financial Officer, or Chief Accounting Officer -- provide this attestation to the Commission in connection with the filing of each Form 10-K, Form 10-Q, and mandatory Form 8-K.-[80]- In the Committee's view, these ---------FOOTNOTES---------- -[79]-(...continued) Securities Act form, reasoned that "this added measure of discipline is vital to the disclosure objectives of the federal securities laws, and outweighs the potential impact, if any, of the signature on legal liability." Annual Report Release, supra n.77 [45 FR at 63630]. -[80]- A Form 8-K must be filed in connection with any one of the following per se material events: (a) change in control of the registrant (Item 1); (b) acquisition or disposition of a significant amount of assets outside the ordinary course of business (Item 2); (c) bankruptcy or receivership (Item 3); (d) changes in registrant's certifying accountants (Item 4); and (e) resignations of directors (Item 6). The five additional mandatory 8-K line items that the Committee recommends the Commission (continued...) ==========================================START OF PAGE 76====== four senior officials (or their functional equivalents) are in the best position to ensure that the company's disclosures fully and fairly describe the company's financial condition, results of operations and prospects. b. Management Report to the Audit Committee Complementing the requirement of senior management attestation, the Committee also recommends the adoption of a management report addressed to the audit committee of the board of directors on mechanisms established to assure accurate and complete Exchange Act reporting. Specifically, the management of registered companies should be required to prepare and submit to the board's audit committee (or a functionally equivalent committee, including the disclosure committee if appointed and different from the audit committee, or in the absence of either, the entire board) a report describing the company's practices and procedures, if any, to assure the integrity of all periodic and current reports filed under the Exchange Act. This report should also contain a description of any procedures adopted by the company to deter and/or detect insider trading abuse.-[81]- ---------FOOTNOTES---------- -[80]-(...continued) adopt, discussed infra at p. 55-56, also would trigger the proposed attestation obligation. However, no such obligation would result from the voluntary filing of a Form 8-K pursuant to Item 5 thereof. -[81]- For example, many public companies require all executive officers to obtain prior approval of any purchase or sale of company securities. The Committee included this provision because of the belief that appropriate mechanisms to deter (continued...) ==========================================START OF PAGE 77====== The Committee suggests that the Commission require the new report to be filed as an exhibit to the registered company's Form 10-K. Absent a material change in its content, the report would not need to be refiled on an annual basis. While the Committee is not recommending that the Commission compel the adoption of any specific set of procedures, public disclosure of actual procedures used by registered companies to ensure the integrity and quality of their Exchange Act filings should lead to the development of a private sector set of "best disclosure practices." Members of the board, investors and management of registered companies likely will explore whether procedures followed by competitors and comparable issuers might function to improve the quality of their own reports. The scope of the required "procedures" disclosure should include a detailed description of the steps currently taken by the company to prepare its required reports so that investors and others can gauge the quality of the preparation procedures. This report would not require an assessment of the overall adequacy of a registered company's broader system of internal controls designed to protect and preserve the integrity of ---------FOOTNOTES---------- -[81]-(...continued) insider trading will increase the expected level of integrity of the company's public reports, and because the reduction in resale limitations on some insiders could warrant better controls and monitoring within a company on insider transactions. ==========================================START OF PAGE 78====== financial reporting, compliance with GAAP, and operations.-[82]- Thus, the recommendation is far narrower than prior Commission rulemaking proposals calling for management reports on internal controls.-[83]- The Committee does not ---------FOOTNOTES---------- -[82]- See ABA Committee on Law and Accounting, "Management" Reports on Internal Control: A Legal Perspective, 49 Bus. Law. 889, 920 (1994) (the "ABA Report") (observing that "it appears that the SEC and the COSO [Committee of the Sponsoring Organizations of the Treadway Commission, a private-sector group of accounting experts formed in 1985 to study the U.S. financial reporting system] believe that controls cannot be immutably characterized as exclusively related to just one category of objectives -- of operations, or financial reporting, or compliance -- and for this reason, they no longer will use the term internal accounting control"). -[83]- See Report of Management's Responsibilities, Securities Act Rel. 6789 (July 19, 1988) [53 FR 28009 (July 26,1988)] (proposing a management report to the board of directors or its audit committee -- to be published in the company's Form 10-K and annual report to shareholders -- to describe management's responsibilities for the preparation of the company's financial statements and other related information and for establishing and maintaining a system of internal controls for financial reporting.) Almost a decade earlier, the Commission had proposed to require inclusion in each Form 10-K and annual report to securityholders (filed under the proxy/information statement rules) of a statement of management's opinion as to whether the registrant's system of internal accounting controls offered reasonable assurance that only appropriately authorized transactions were executed consistent with the books and records provisions of the Foreign Corrupt Practices Act of 1977 (now codified in Section 13(b)(2) of the Exchange Act [15 U.S.C. 78(m)(b)(2)]), and that transactions were recorded as necessary to permit preparation of financial statements in accordance with GAAP and to maintain accountability for assets. See Statement of Management on Internal Accounting (continued...) ==========================================START OF PAGE 79====== believe it is necessary, and therefore recommends that the Commission not require, senior management of registered companies to provide a public evaluation of internal controls. Similarly, the Committee does not support a requirement that the report represent that prescribed procedures were followed with respect to the preparation of any particular filing. Indeed, an adequate description of procedures could recognize expressly management discretion to depart from the standards under appropriate circumstances.-[84]- ---------FOOTNOTES---------- -[83]-(...continued) Control, Exchange Act Rel. 15772 (April 30, 1979) [44 FR 26702 (May 4, 1979)]. This proposal was withdrawn one year later. Statement of Management on Internal Accounting Control, Exchange Act Rel. 16877 (June 6, 1980) [45 FR 40134 (June 13, 1980)]. -[84]- Some have raised concerns that public disclosure of the report would expose the certifying officials to a greater risk of private litigation or a Commission enforcement action. The fact that a report detailing procedures for preparation of a document is publicly filed would not enhance a company's potential liability in a suit premised upon materially false or misleading disclosures made in Commission documents. Even if viewed as an implicit representation to the market that the disclosed procedures were followed, it would be difficult for a plaintiff to argue that noncompliance with these procedures added to the damages suffered by investors. Any such suit would be premised on a misrepresented material fact or material omission regarding the issuer or its securities, not the lack of devotion to a particular procedure. Though potentially relevant to whether the defendant met the requisite standard of care or mental state, a company's procedures and management's compliance therewith likely would be discoverable whether or not those procedures are contained in a filed report. The issuer could be liable, however, in a Commission (continued...) ==========================================START OF PAGE 80====== 2. Improvements in the Content and Timeliness of 1934 Act Reporting The Committee also recommends that the Commission effect certain enhancements to the content and timeliness of corporate disclosures provided to the markets by companies participating in the company registration system. These enhancements increase the currency of disclosure of material developments relating to a registered company, and add key information on investment risk to the annual report on Form 10-K. a. More Timely and Informative Reports on Form 8- K The Committee recommends that expansion of the current Form 8-K reporting obligation to mandate or accelerate disclosure of the following five additional material developments. Of these, two would entail no more than earlier reporting of information already prescribed by Form 10-Q (Nos. 1 and 3, below). The remaining three requirements would, in many instances, already be required to be disclosed promptly either due to general liability concerns under antifraud provisions-[85]- or listing requirements.-[86]- 1. Material modifications to rights of holders of registered company securities, whether favorable or unfavorable, now reportable only on a quarterly basis ---------FOOTNOTES---------- -[84]-(...continued) action for a materially false or misleading filing if the reports were, for example, fraudulent. -[85]- See Basic Inc. v. Levinson, 485 U.S. 224 (1988). -[86]- See, e.g., NYSE Listed Company Manual 2. ==========================================START OF PAGE 81====== in Form 10-Q.-[87]- A common criticism of quarterly reports today is that this and other key information is stale by the time it reaches the broader investing public, whereas more sophisticated institutional investors and analysts obtain timely access to such information directly from senior management. The Committee believes that more prompt disclosure of important changes in securityholder rights, such as the imposition of restrictions on (or cessation of) dividend payments or the elimination of preemptive rights, both of which currently need not be reported until 45 days after the end of the quarter in which they occur, should level any perceived informational imbalance among investors and improve market efficiency. 2. Resignation or removal of any of a registered company's five most senior executive officers, currently required in the Form 8-K exclusively for directors. Because general principles of materiality and listing standards in any event often result in prompt disclosure of the termination of the CEO and other members of top management,-[88]- the creation of a bright line test prescribing the timing of and vehicle for such disclosure should not impose appreciably greater compliance burdens on registered companies when measured against the obvious investor and market informational benefits. 3. Specified material defaults upon senior securities, which today must be disclosed solely in Form 10- Q.-[89]- For the same reasons outlined above, the Committee recommends that the Commission accelerate disclosure of this information. 4. Sales of a significant percentage of the company's outstanding equity, whether in the form of common shares or convertible securities, or made on a registered or exempt basis. In proposing to require quarterly disclosure of unregistered equity sales during the covered period, whether pursuant to a ---------FOOTNOTES---------- -[87]- See Item 2 of Form 10-Q. -[88]- See NYSE Listed Company Manual  204.15 ("[p]rompt notice is required to be given to the exchange of any changes in directors or officers of the company"). -[89]- See Item 3 to Form 10-Q. ==========================================START OF PAGE 82====== private placement, a Regulation S offering or otherwise, the Commission already has recognized the importance of this information to the markets.-[90]- Comment was sought in the relevant proposing release on whether this information will be disclosed in a sufficiently timely manner if required on Form 10-Q, or instead should be reported on a mandatory Form 8-K or notice of sale similar to that used for Regulation D offerings. The Committee believes that such information is material to investors and should be disseminated to the markets on a more timely basis than in a quarterly report. 5. The issuer's receipt of notice from its independent auditor that reliance on an audit report included in previous filings is no longer permissible because of the auditor's concerns with respect to the continuing viability of the company as a going concern or a variety of other matters. Also reportable would be an issuer's effort to engage another auditor to reaudit a period covered by a prior filed audited report, whether due to the predecessor auditor's withdrawal of its consent or any other reason. Timely disclosure of this information will serve to reinforce the auditor's role as a gatekeeper or monitor on a continuous basis, a principal goal of company registration. b. Form 10-K Risk Disclosure An analysis of risks associated with investment in a company's securities is now required in all Securities Act filings, to the extent material.-[91]- No such requirement currently applies in the context of Exchange Act reporting. As a result, investors in the trading markets do not have access to the company's own evaluation of the mix of material factors ---------FOOTNOTES---------- -[90]- See Streamlining Business Acquisitions Release, supra n.68. -[91]- See Regulation S-K, Item 503 [17 C.F.R. 229.503]; see also Regulation S-K, Item 506 [17 C.F.R. 229.506] (dilution of existing holders), referenced in Forms S-1, S-2, S-3, and S-4, among other forms. ==========================================START OF PAGE 83====== bearing on investment risk except when the company elects to raise capital through a public offering of securities. This information traditionally has been viewed as extremely useful for both potential and existing investors.-[92]- The Committee believes that participating companies, investors, and the markets, would benefit from the inclusion of risk disclosure requirements in the annual report on Form 10-K, for those companies that currently would be required to provide such information in a Securities Act filing. The Committee recognizes that for many of the companies initially subject to the pilot, no such disclosure is currently required and none would be required in the Exchange Act reports. However, where a discussion of material risk factors would be required when the company is selling its own securities, it also should be required when investors are purchasing the securities in the secondary trading markets. Provided that the mandatory risk disclosures are not obscured or rendered materially false or misleading, the company could (and, in fact, should be encouraged to) amplify such disclosure with a discussion of the benefits of ownership of a particular class of securities. Registered companies would gain the advantage of being able to incorporate the risk factor analysis by reference from the Form 10-K to satisfy line item requirements in other documents prescribed by ---------FOOTNOTES---------- -[92]- See, e.g., Jenkins Committee Report, supra n.39, at 29. See also 1977 Advisory Committee Report, supra n.4, at 486-487. ==========================================START OF PAGE 84====== Commission rule under the Securities Act and the Exchange Act.-[93]- In addition, any material change in the risk disclosure should be provided in the next Form 10-Q. ---------FOOTNOTES---------- -[93]- Obviously, companies could not rely on general disclosures in the Form 10-K to describe the unique risks of investing in certain classes of complex or novel securities. Those unique risks would have to be separately described, as today. ==========================================START OF PAGE 85====== B. Conclusion The Committee anticipates that the mandatory disclosure enhancements should improve the quality of information provided by registered companies in connection not only with episodic securities distributions, but also disclosures made on a continuous basis through periodic and current reports filed under the Exchange Act. Some members of the Committee have indicated that they would not limit the recommendation to companies participating in the company registration system since, in either offerings under the shelf or recommended company registration system, issuers can access the markets quickly without intervention by the Commission staff. The current universal shelf has raised the same concerns regarding adequate opportunity for due diligence that also have been raised with respect to company registration. For these reasons, some members urged that the disclosure enhancements be made a condition to the use of the shelf for equity offerings over a specified amount. Put simply, the price for this speedy, unfettered access to the markets in the case of substantial equity offerings, whether under a shelf or the company registration system, should be the enhancements designed to improve the level and reliability of corporate reports and facilitate the gatekeeping function. If required to comply with the disclosure enhancements and investor protections (such as Form 8-K filing for non-de minimis equity offerings) in order to conduct a shelf offering, there would be little reason for current shelf issuers not to opt into ==========================================START OF PAGE 86====== the company registration system, at least the modified version, in order to benefit from the added flexibility of the company registration system. Taken together, while imposing requirements to enhance the level of disclosure and investor protection, the resulting system would represent a significant expansion and liberalization of the shelf procedure. On balance, the Committee concluded that modification of the existing shelf registration to impose all the disclosure enhancements is not necessary just to implement company registration, at least on a pilot basis. At the same time, the Committee recommends that a Form 8-K be required for non-de minimis equity offerings conducted on the current shelf, and that the Commission give careful consideration to whether requiring disclosure enhancements across the board for shelf registrants as well, could lead to measurable improvements in the current disclosure. V. Liability and Due Diligence Under Company Registration Company registration will preserve the current statutory liability provisions and, indeed, will extend those protections to transactions that today are conducted without registration, such as private placements and offshore offerings. Company registration also will promote more effective and continuous due diligence. Directors, underwriters and other parties with due diligence obligations will receive more useful guidance on their ability to consider, in meeting those obligations, the ongoing oversight of the company's disclosures conducted by persons who are better positioned to perform that role. A. Liability Under Company Registration 1. Other Liability Approaches Considered ==========================================START OF PAGE 87====== The Committee considered several liability schemes that could be applied under a company registration system with the goal of preserving and enhancing the gatekeepers' or monitors' existing roles in protecting investors. In recommending the proposed company registration model and pilot project, the Committee concluded that retention of the current liability scheme, at least during the pilot stage, would maintain important investor protections while achieving the objectives of company registration, provided that additional guidance was furnished to gatekeepers on the factors relevant to establishing a due diligence defense under Sections 11 and 12(a)(2) of the Securities Act. Section 11 creates strict liability for the benefit of any purchaser of a security sold pursuant to a materially false or misleading registration statement on offering participants (including the issuer, officers and directors, underwriters and experts, such as the accountants), but provides the defendants other than the issuer with a defense based essentially upon proof that they engaged in a reasonable investigation and had reasonable grounds to believe in the accuracy of the disclosure.-[94]- Section 12(a)(2) allows purchasers to ---------FOOTNOTES---------- -[94]- Under Section 11 of the Securities Act, a lower standard of due diligence must be met as to "expertized" portions of the registration statement by persons other than the certifying expert. The defendant invoking this affirmative defense must show that, "he had no reasonable ground to believe and did not believe, at the time such part of the registration statement became (continued...) ==========================================START OF PAGE 88====== recover against their sellers (a much more narrow class than that covered by Section 11), unless the sellers can show that they were not negligent in failing to discover false and misleading statements. Remedies available pursuant to Section 12(a)(1) of the Securities Act for Section 5 violations, as well as Sections 10 and 18 of the Exchange Act, and Rule 10b-5 adopted thereunder for fraud, also would continue to be available in the same manner as today under the shelf registration system. During the July 26, 1995 Advisory Committee Meeting, the Committee analyzed, in addition to maintaining the current liability scheme, the following alternatives: (i) a liability structure in which issuers would incur Section 11 liability only for IPOs and extraordinary distributions, and Section 12(a)(2) liability for routine transactions. Under this approach, Section 12(a)(2) would apply to all prospectus disclosure, including information incorporated by reference; (ii) extending Sections 11 and 12(a)(2) remedies to all purchasers in primary offerings and in secondary market transactions contemporaneous with the offering. The company's total liability would have been limited to the lesser of the dollar amount of the offering proceeds or damages caused. Awarded damages then would be prorated among investors in the primary and secondary markets; (iii) eliminating Section 11 liability and extending Section 12(a)(2) liability to all statements by the issuer (including those currently subject only to Rule ---------FOOTNOTES---------- -[94]-(...continued) effective, that the statements therein were untrue or that there was an omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading." Section 11(b)(3)(C) of the Securities Act [15 U.S.C. 77k(b)(3)(C)]. ==========================================START OF PAGE 89====== 10b-5) regardless of whether the issuer is selling securities or its securities are trading in the secondary market;-[95]- and (iv) limiting liability for a registered company's routine financings to Rule 10b-5 liability only.-[96]- In this regard, the Committee considered differing views on the impact of Sections 11 and 12(a)(2). In its analysis, the Committee found it difficult to determine the full extent of Section 11 litigation and the effects of Section 11 liability exposure on issuers' financing choices. According to several commenters, there are few reported cases actually decided on Section 11 grounds,-[97]- but in meetings with industry representatives the Committee staff was informed that a significant number of potential Section 11 claims are settled without actions being instituted or without reported decisions.-[98]- ---------FOOTNOTES---------- -[95]- For a discussion of a somewhat similar liability scheme in which a negligence standard like Section 12(a)(2) would be extended to Exchange Act documents, and consequently a civil remedy would be available for purchasers of a company's securities in the open market as well as in capital raisings, see Margaret Bancroft, Responding to Gustafson: Company Registration and a New Negligence Standard, INSIGHTS, July 1995, at 14. -[96]- See Documents for Advisory Committee Meeting, July 26, 1995, Tab C. -[97]- Transcript of July 26, 1995 Advisory Committee Meeting at 287 (statements of Commissioner Wallman and Professor Coffee). -[98]- Some have suggested, however, that Section 11(e)'s requirement of an undertaking for the payment of (continued...) ==========================================START OF PAGE 90====== Notwithstanding the absence of dispositive evidence of the effect of Section 11 on disclosure practices and an issuer's choice of whether to engage in a public or private offering, it is the Committee's view that Section 11 liability continues to play an integral role in compelling "truth in securities." Congress explicitly recognized the importance of the role of underwriters and other monitors in the offering process by including them in the group of persons potentially liable for omissions or misstatements in registration statements. As Milton Cohen stated, the liability provisions have "had the in terrorem effect of creating an extraordinarily high sense of care and responsibility in the preparation of registration statements."-[99]- Consequently, the Committee believed that Section 11 should continue to be applied under a company registration system in a manner similar to its current application.-[100]- ---------FOOTNOTES---------- -[98]-(...continued) litigation costs if the court determines the suit or defense to be without merit and the difficulty faced by purchasers in the open market of tracing the securities back to the registration statement in question act as an impediment to Section 11 suits. See Edward F. Greene, Determining the Responsibilities of Underwriters Distributing Securities Within an Integrated Disclosure System, 56 Notre Dame L. Rev. 755, 770 n.90 (1981). -[99]- Cohen, supra n.2, at 1355. -[100]- It also has been suggested that the Committee should urge the Commission to express disagreement with the well-established policy against indemnification of underwriters for Section 11 liability, at least in the context of shelf and (continued...) ==========================================START OF PAGE 91====== 2. Preservation and Expansion of Statutory Liability During the pilot stage, purchasers in offerings by registered companies would have recourse pursuant to Section 11 to the same extent as under the current liability system. Issuers, officers, directors, experts, and underwriters would be subject to Section 11 liability for false or misleading statements in the Form C-1, including all incorporated information filed in Exchange Act reports. Indeed, for those issuers that elect to take full advantage of the system and register all of their securities issuances, the Section 11 remedy would be available to purchasers in private placement transactions that otherwise would be exempt under the current system. Similarly, U.S. purchasers of securities initially issued overseas in offerings that today would qualify for the Regulation S safe harbor, would under full company registration have Section 11 remedies against the issuer to the extent the flowback is registered and the U.S. purchaser can trace the purchased securities back to the company registration statement. Moreover, again under full company registration, because all ---------FOOTNOTES---------- -[100]-(...continued) company registration offerings. See Documents for Advisory Committee Meeting, November 21, 1995, Tab E (Letter dated November 2, 1995 from the Securities Industry Association to the Advisory Committee at 9-10) (the "SIA Letter"). The Committee has determined to make no recommendation either way concerning this issue. The current statutory provision for contribution, however, provides in essence for economic indemnification with respect to almost all of a potential claim against an underwriter. ==========================================START OF PAGE 92====== affiliate resales (except those that continue to be effected under Rule 144) are registered on the Form C-1 rather than sold in exempt transactions, Section 11 liability would apply with respect to each such sale. Likewise, broker-dealer underwriting firms participating in a registered company's offering would remain subject to Sections 11 and 12(a)(2) liability. In addition, under the shelf registration system, issuers may provide transactional disclosure, including material updating information, in a prospectus supplement rather than by means of a filing included in the registration statement. As a result, investors are denied the core protections of Section 11 regarding such information. As the Commission has noted, "Section 11 ordinarily does not apply to statements omitted from an effective registration statement and subsequently disclosed in a prospectus or prospectus supplement, rather than a post-effective amendment."-[101]- The pilot will make Section 11 more effective than today (both for company registration and shelf offerings, if the Form 8-K requirement is extended to the shelf), since the transactional information disclosed in a Form 8-K filed at the commencement of non-de minimis equity offerings must be ---------FOOTNOTES---------- -[101]- Elimination of Certain Pricing Amendments and Revision of Prospectus Filing Procedures, Securities Act Rel. 6672 (Oct. 27, 1986) [51 FR 39868 (November 3, 1986)]. But cf. Shaw v. Digital Equipment Corp., 82 F.3d 1194 (1st Cir. 1996) (though not discussing issue, allowing Section 11 (along with Section 12(a)(2)) claim predicated on prospectus supplement on motion to dismiss). ==========================================START OF PAGE 93====== incorporated into the registration statement and thus would be covered by Section 11.-[102]- In addition, the opportunity to avoid preparing and delivering a separate prospectus by incorporating by reference into sales literature or the confirmation of sale, transactional information filed in an Exchange Act report will provide an incentive for issuers to file that information on a Form 8-K, even when not required. In connection with further implementation of the company registration system, including extending the system to a broader class of issuers, the Commission could consider whether it is necessary to extend full Section 11 liability to the information provided at the time of an offering under the company registration system, regardless of whether filed with the Commission on a Form 8-K or in a prospectus supplement delivered to investors. With respect to Section 12(a)(2), some have expressed the view that one of the reasons companies may choose to raise capital in the private markets is the differential liability ---------FOOTNOTES---------- -[102]- Reports filed under the Exchange Act automatically become part of the registration statement and thus are subject to Section 11 liability. See Wielgos v. Commonwealth Edison, 688 F.Supp. 331, 338-40 (N.D. Ill. 1988). However, unless the information represents a fundamental change in the information previously provided in the registration statement, the report will not have the legal effect of a post-effective amendment or a new registration statement or change the effective date for liability purposes. See Regulation S-K Item 512(a) [17 C.F.R. 229.512(a)]; Irving Bank Corp. v. Bank of N.Y. Co., Inc., 692 F. Supp. 172, 176-80 (S.D.N.Y. 1988). ==========================================START OF PAGE 94====== standards between the negligence standard of liability in Section 12(a)(2) and the strict liability standard of Section 11.-[103]- After Gustafson, it would appear that only Rule 10b-5 liability may attach to private placements, although it is unclear what impact the decision will have on the number or dollar volume of private placements. The Committee believes that Rule 10b-5 liability will continue to provide significant deterrence to fraud in private placements,-[104]- and that Section 12(a)(2) should continue to be applied as under current law. To the extent an issuer chooses to register transactions under company registration that otherwise would qualify as exempt private placements, the effect of the Gustafson decision on the applicability of Section 12(a)(2) should be minimized since both ---------FOOTNOTES---------- -[103]- Gustafson v. Alloyd Co., 115 S.Ct. 106 (1995). Prior to Gustafson, most practitioners and the Commission believed that Section 12(a)(2) liability applied to secondary market transactions and exempt offerings. As a result, due diligence for private offerings tended to be as extensive as it is for public offerings (see, e.g., Robert F. Quaintance Jr., Getting Comfortable with 'Public- Style' Rule 144A Offerings', INSIGHTS, September 1993, at 8). In its extreme application, Gustafson would mean that Section 12(a)(2) does not apply to private placements. As a result, although underwriting techniques in the Rule 144A market closely resemble that of a public offering, including the absence of negotiations and an opportunity for individual due diligence, purchasers would not receive any of the statutory protections of a public offering. -[104]- Transcript of September 29, 1995 Advisory Committee Meeting at 27-29 (statements of Mr. Sonsini). ==========================================START OF PAGE 95====== Section 11 and Section 12(a)(2) would be applicable. In addition, to the extent that an issuer chooses to use selling materials as the statutory prospectus by incorporating filed information from the Form 8-K, Section 12(a)(2), rather than Rule 10b-5, would apply to those selling materials. B. Due Diligence Under Company Registration The Commission's development of the integrated disclosure system over the last decade and a half has shifted the primary source of key disclosures concerning the company from the sporadic or infrequent disclosures contained in public offering documents under the Securities Act to the updated reservoirs of information regarding a company contained in Exchange Act reports. The gatekeepers have tried to adapt to these changes since the inception of the integrated disclosure system. The underwriter community, in particular, has voiced longstanding concerns regarding the impact of these reforms on traditional due diligence functions.-[105]- The Committee is cognizant of the concerns raised by underwriters and outside directors that market changes have altered the dynamics and ---------FOOTNOTES---------- -[105]- See SIA Letter, supra n.100 (recommending that the Committee and the Commission consider recommending amendments to Section 11 with respect to underwriters to eliminate the requirement that, in establishing their due diligence defense, they prove that they made a reasonable investigation); see also American Bar Association Committee on Federal Regulation of Securities, Report of the Task Force on Sellers' Due Diligence and Similar Defenses Under the Federal Securities Laws, 48 Bus. Law. 1185 (May 1993) (the "ABA Due Diligence Report"). ==========================================START OF PAGE 96====== nature of their relationships with issuers and, consequently, their traditional due diligence functions. In particular, the Committee acknowledges that the tightened time constraints may make it more difficult for underwriters and outside directors to discharge their due diligence obligations. In order to protect investors by maintaining the integrity of the disclosure system, the Committee has concluded that continued emphasis on the due diligence obligations of underwriters and outside directors is critical to maintaining and increasing investor protection. Moreover, between the choices of simply limiting liability for participants versus providing reasonable procedures so that participants can better perform their due diligence obligations and, therefore, as a practical matter limit their exposure by reducing the opportunity for material misstatements to be disseminated to the public, the Committee strongly prefers the latter. Following the lead of the ABA Task Force appointed to study due diligence practices under integrated disclosure and shelf registration,-[106]- the Committee determined that, rather than excusing monitors from their due diligence responsibilities, more guidance regarding their respective responsibilities should be furnished by the Commission. The Committee recommends providing additional guidance, within the framework of current Commission Rule 176, that would elaborate upon the factors courts ---------FOOTNOTES---------- -[106]- See ABA Due Diligence Report, supra note 105. ==========================================START OF PAGE 97====== may consider as indicia of "reasonable investigation" and/or "reasonable care" for purposes of determining whether the particular defendant has met its due diligence obligations under Sections 11 and 12(a)(2) in the context of an offering made under the company registration system.-[107]- The Committee determined not to recommend that additional Commission guidance regarding the due diligence function take the form of a safe harbor from liability or an evidentiary presumption. The Committee agrees with the district court in Escott v. BarChris, which stated that "[i]t is impossible to lay down a rigid rule suitable for every case defining the extent to which such verification must go. It is a question of degree, a matter of judgment in each case."-[108]- To the extent changes in the offering process require greater reliance on other gatekeepers in order to deter fraud and provide incentives for the highest quality disclosures, the Committee believes that underwriters and outside directors should ---------FOOTNOTES---------- -[107]- The ABA Due Diligence Report recommends extension of Rule 176's enumeration of "relevant circumstances" to an underwriter's or agent's exercise of "reasonable care" under Section 12(a)(2). See id. Notably, Section 12(a)(2) does not refer to the need for a "reasonable investigation," and consequently raises the question about whether Congress intended to require a lesser standard of care. For a discussion of legislative history and case law on whether different levels of due diligence are required, see id. at 1190. -[108]- Escott v. BarChris Construction Corporation, 283 F. Supp. 643, 697 (S.D.N.Y. 1968). ==========================================START OF PAGE 98====== be able to take the efforts of those other persons into account in evaluating the appropriate due diligence they should perform at the time of the offering. This facts and circumstances approach to due diligence was embraced by the Commission when it adopted Rule 176 in response to identical concerns raised by the underwriting community and others when the integrated disclosure system was implemented in 1982: For example, the Commission believes that a court would not expect the investigation undertaken in connection with a short form registration of a seasoned company to be the same as that which would be reasonable in connection with an initial public offering.-[109]- Under the recommended approach, as under current Rule 176, persons who are eligible for the due diligence/reasonable care defenses codified in Sections 11 and 12(a)(2), respectively, could consider the due diligence inquiries of those persons in the best position on an ongoing basis to oversee the quality and accuracy of the requisite disclosure in determining the degree of due diligence investigation they themselves need to perform to satisfy their statutory obligation. As under current Rule 176, the factors are meant to be illustrative, not exhaustive, and the weight given to each factor necessarily must vary with the facts and circumstances of a particular offering, including whether the offering is a routine financing, or involves equity or debt. As outlined below, this guidance should create incentives for those ---------FOOTNOTES---------- -[109]- Securities Act Release No. 6383 (March 3, 1982), note 101 [47 FR 113800, 11400 n.101]; SIA Letter, supra n.100, at 9. ==========================================START OF PAGE 99====== engaging in due diligence to make better use of others who are in a position to help ensure the quality and integrity of the disclosure -- to the ultimate benefit of investors. The Committee believes SAS No. 71 interim financial reviews by the company's outside auditor to be particularly relevant in this context.-[110]- By recognizing the appropriateness of an underwriter's and outside director's reliance on those reviews in discharging their due diligence duties, the Commission will encourage registered companies to involve this outside monitor more extensively and on a more continuous basis with unaudited information. As a result, widespread use of interim reviews should increase investor confidence in the quality of quarterly reporting. Comfort letters provided by the company's outside auditing firm to the underwriters in accordance with SAS No. 72 also may be relevant. Although the legal effect of an auditor's comfort letter necessarily varies with the audited or non-audited character of the underlying financial information, and the letter alone normally will not be determinative of whether a reasonable investigation was conducted, such a letter nevertheless adds important independent oversight of the issuer's financial reporting in connection with an offering. Consequently, the receipt of a comfort letter appropriately should be recognized as a factor to be weighed in evaluating how a gatekeeper must ---------FOOTNOTES---------- -[110]- See supra pp. 24-28. ==========================================START OF PAGE 100====== perform its due diligence in order to discharge its responsibilities under all the relevant facts and circumstances. 1. Underwriters Although underwriters would not be relieved of responsibility for the accuracy and completeness of the issuer's disclosure, their review at the time of the offering should be facilitated by the continuous review conducted by other monitors as well as the enhanced disclosure practices recommended by the Committee.-[111]- This assistance would be in addition to the other recommendations of the Committee, such as the filing of a Form 8-K at the time of the offering, that are intended in part to facilitate the underwriter's due diligence review at the time of most equity offerings.-[112]- The underwriters' ability to confer with other persons familiar with the issuer as well as with management to assess the scope of their review preserves the underwriters' central, independent role in ensuring the quality of disclosures regarding the securities they bring to market. Accordingly, the Committee determined that (in addition to the factors in the current Rule 176) the relevant factors to be considered in connection with the underwriter's due diligence defense should include the following: (i) The Senior Management Certifications (described above); ---------FOOTNOTES---------- -[111]- Transcript of September 29, 1995 Advisory Committee Meeting at 189-194 (statements of Mr. Sutton and Mr. Elliott). -[112]- See supra p. 23-24. ==========================================START OF PAGE 101====== (ii) The Management Report to the Audit Committee (described above); (iii) Whether other outside professionals have reviewed the relevant documents, for example, pursuant to a review of the issuer's interim financial statements by the company's auditors in accordance with SAS No. 71, the performance of procedures with respect to events subsequent to the date of the audited financial statements in accordance with SAS No. 37, and the receipt of a "comfort letter" under SAS No. 72, or whether the board or a committee of the board received a Rule 10b-5 opinion letter from counsel regarding the non-financial and non-expertized portions of the periodic reports; (iv) The extent of the underwriter's access to their own or outside analysts that have followed the issuer for a significant period of time;-[113]- (v) Whether a board disclosure committee was appointed and the quality of the review engaged in by the disclosure committee; and (vi) The size of the offering, both in absolute and relative terms, vis-a-vis the size of the issuer. Ultimately, however, underwriters bringing offerings to market will continue to have significant responsibility for the disclosures used in connection with that offering. Even apart from the potential for civil liability under Sections 11 and 12(a)(2), an underwriter has a legal obligation under the antifraud provisions of the federal securities laws to have a ---------FOOTNOTES---------- -[113]- See Circumstances Affecting the Determination of What Constitutes Reasonable Investigation and Reasonable Grounds for Belief Under Section 11 of the Securities Act; Treatment of Information Incorporated by Reference Into Registration Statements, Securities Act Rel. 6335 (Aug. 6, 1981) [46 FR 42015 (August 18, 1981)]. ==========================================START OF PAGE 102====== reasonable basis for its recommendations and its belief in the accuracy of the statements contained in the offering materials.-[114]- As a result, notwithstanding the comfort afforded by the proposed guidance regarding the due diligence defense, the underwriter must take care to ensure that it has performed all the procedures and investigations necessary to form a reasonable basis for its belief regarding the accuracy and adequacy of the issuer's disclosures. 2. Outside Directors Certain Committee members expressed particular concern about exposing outside directors to greater liability under the company registration system.-[115]- The Committee believes that outside directors of public corporations currently are not always properly positioned to perform a full investigative function. For example, because of timing constraints characteristic of shelf takedowns, outside directors may not have sufficient time ---------FOOTNOTES---------- -[114]- See In re Donaldson, Lufkin & Jenrette Securities Corporation, Securities Act Rel. 6959 (Sept. 22, 1992); Justin Klein, Underwriter Beware: SEC Brings Proceeding for Failure to Conduct Adequate Due Diligence, INSIGHTS, March 1993, at 17. See also Exchange Act Rule 15c2-12 (Municipal Securities Disclosure) [17 C.F.R. 240.15c2-12]; Municipal Securities Disclosure, Exchange Act Rel. 26100 (September 22, 1988) [53 FR 37778 (September 28, 1988)]; Municipal Securities Disclosure, Exchange Act Rel. 26985 (June 28, 1989) [54 FR 28799 (July 10, 1989)]. -[115]- See, e.g., Transcript of July 26, 1995 Advisory Committee Meeting at 247-52 (statements of Professor Coffee); Concurring Statement of John C. Coffee, Jr., Edward F. Greene and Lawrence W. Sonsini. ==========================================START OF PAGE 103====== to review any disclosure documents other than the Form 10-Ks. Frequent, repetitive equity takedowns, such as those effected pursuant to the at-the-market provisions of the shelf rules, may pose difficult problems for outside directors.-[116]- The potential extension of director liability under Section 11 to transactions that today would be conducted as exempt private placements could exacerbate those concerns for outside directors. Outside directors, however, also are almost uniquely positioned to maintain continuous oversight of the company's disclosures, provided a practical mechanism were established to permit them to do so. The audit committee is an obvious example of such an initiative to formalize the role of outside directors. The Committee sought similar approaches to strengthen the role of outside directors in the disclosure process in order to ensure that the promise of appropriate outside director gatekeeping could be realized. As discussed previously, the establishment of a disclosure committee would provide such a formal mechanism for outside directors to accomplish that goal. The Committee also believes that the outside directors, like the underwriters, should be able to consider management certifications and reports, and the preparation or review of relevant documents by various independent professionals, in determining the appropriate level of due diligence necessary to satisfy the directors' statutory obligation. Specifically, the Committee determined that, in addition to the factors in current Rule 176, the relevant factors ---------FOOTNOTES---------- -[116]- See n. 79 to Appendix A to the Report. ==========================================START OF PAGE 104====== that courts should consider in connection with an outside director's establishment of a due diligence defense should include, but not be limited to, the following: (i) The Senior Management Certifications (described above); (ii) The Management Report to the Audit Committee (described above); and (iii) Whether outside professionals have reviewed the relevant documents, for example, pursuant to a review of the issuer's interim financial statements by the company's auditors in accordance with SAS No. 71 and a "comfort letter" under SAS No. 72, or whether the board or a committee of the board received a 10b-5 opinion letter from counsel regarding the non-financial and non-expertized portions of the periodic reports. C. Conclusion The Committee has determined to preserve, and in the case of all non-de minimis equity offerings expand, the current Section 11 and 12(a)(2) liability scheme and to provide additional guidance regarding due diligence defenses. The pilot gives the Commission a meaningful opportunity to test the company registration system while monitoring the effects on participants of continued exposure to current standards of liability. If experience with the pilot demonstrates that more concrete guidance is appropriate, the Commission could consider further measures in connection with steps towards final implementation of the company registration system. The Committee thus encourages the Commission during the pilot stage to monitor the due diligence practices that evolve generally from the use of company registration, and specifically from the application of the new ==========================================START OF PAGE 105====== guidance, and to evaluate the consequences for due diligence and investor protection.