Law Offices of
PETILLON & HANSEN
A Partnership of Professional Corporations
Del Amo Financial Center
21515 Hawthorne Boulevard, Suite 1260
Torrance, California 90503
Telephone (310) 543-0500
February 24, 2002
VIA E-MAIL/HARD COPY TO FOLLOW
Jonathan G. Katz, Secretary
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549-0609
Re: Release No. 33-8041, File No. S7-23-01
This letter is to comment on the proposed rules defining the term "qualified purchaser" under the Securities Act of 1933 as set forth in Release No. 33-8041 (the "Release").
Ladies and Gentlemen:
First, the Staff is to be commended on a thorough and fair exposition in the Release of the issues underlying the proposed rule.
Improving access to capital for small issuers is believed to be the most important single issue in facilitating the growth of the nation out of recession. As stated in a recent press release of the National Commission on Entrepreneurship in Washington, D.C.:
"Policy makers in Congress and across the country should begin the year working to address the persistent capital gap which supports start-up of more entrepreneurial growth companies.... Entrepreneurial growth companies largely led the nation out of its last recession a decade ago, and history suggests this likely will be the case once again. As law makers in the states and in Congress prepare for new legislative sessions, they need to ask themselves what decisions can be made to foster the growth of entrepreneurial start-ups in their communities. Addressing the capital gap should be a priority,"
Patrick Van Bargan, Executive Director of the National Commission on Entrepreneurship, urged law makers to consider proposals that would spur investment in new companies trapped in the capital gap in the $300,000 to $3,000,000 range.
The undersigned supports the Commission's proposal to define "qualified purchaser" to mean an accredited investor, as defined in Rule 501(a) of Regulation D. The regulatory history of the accredited investor definition is such that it has long been equated with financial sophistication and sufficient bargaining power to gain access to enough information with which to make an intelligent investment decision. Both Congress and the Commission have stated that accredited investors do not need the statutory protections of the Securities Act of 1933.
We believe, however, that the staff's concern that by rescinding Rule 504(b)(1)(iii), issuers might be disadvantaged in their ability to raise capital under Rule 504 because they would no longer be able to use general solicitation and advertising to offer securities to accredited investors is well founded. Rescinding Rule 504(b)(1)(iii) would significantly restrict small businesses' access to capital since these issuers could not then generally solicit and advertise to find accredited investors.
We believe the second of the two alternative approaches under consideration by the staff to preserve the ability of issuers to offer and sell to accredited investors without the need to register the offerings - to create a new, uniform federal accredited investor exemption - will preserve the capital-raising mechanism, while insuring investor protection.
We have set forth in Part I below a proposal for a new, uniform federal accredited investor exemption, intended to provide a capital-raising mechanism that addresses the now well publicized "funding gap," which is increasingly creating a barrier to entrepreneurial activity. We have set forth in Part II of this letter the reasons we believe the first approach offered by the staff - excluding accredited investors purchasing in Rule 504 offerings from the definition of qualified purchaser - does not adequately address the "funding gap." Finally, in Part III below we address other questions raised by the staff.
Part I: A new, uniform federal accredited investor exemption will close the "Funding Gap"
The now well-publicized proliferation of institutional venture capital funds during the past 10 years and the increase in the size of these funds has resulted in a systemic move by these funds to later stage and larger investments. Since the $1,000,000 limitation was established for Rule 504 in 1992, the size of institutional venture capital investments has increased dramatically. In 1994, the institutional venture capital industry invested $2.7 billion in about 1000 companies. In 2000, although total dollars invested increased 37-fold to close to $100 billion, the number of transactions increased only 5-fold to 5,485. According to Venture Economics/National Association of Venture Funds, the average venture capital investment in 2001 was $9.75 million, compared with $4.4 million in 1995. The $1,000,000 limit in 1992 dollars would be equivalent to $790,000 today, based on the BLS/cost-of-living index. These dramatic changes in the venture capital industry since 1992 have resulted in a widening of the "funding gap" that we believe Rule 504 was intended to address.
The Center for Venture Research at the University of New Hampshire has identified two substantial funding gaps in the private equity market: the first occurs primarily in the see and start-up financing stage and ranges from $100,000 to $2,000,0001; and the second, which emerged as recently as 1998, occurs in the $2,000,000 to $5,000,000 range. These gaps exist despite the increasing presence of "angel" capital.2
Economists believe that a major cause of these funding gaps is market inefficiency resulting from an "information gap" between financing sources and investment opportunities. Financial theory is predicated on the assumption of efficient capital markets where there exists fully informed buyers and sellers and low transaction costs, and an efficient market implies an open and timely flow of reliable information concerning financing sources and investment opportunities.3 We believe that prohibiting issuers to use means of general solicitation in offering its securities is a significant cause of this "information gap."
For these reasons, we recommend that a new proposed Rule 504A be adopted, which would exempt offerings up to $3,000,000 annually for sales only to accredited investors [or "qualified purchasers" if the proposed rule is adopted defining qualified purchasers as accredited investors]. The proposed rule, attached to this letter as Appendix A, would permit general solicitation and general advertising (not limited to dissemination of a general announcement as is provided in the Model Accredited Investor Exemption "MAIE" promulgated by the North American Securities Administrators Association ("NASAA") in May, 1997).
It is patterned after the MAIE, but with three additional investor protections:
We submit that limiting general solicitation and advertising to a "tombstone" type advertisement has not proved effective, as evidenced by the experience of California with its Section 25102(n), which was the model for the MAIE. For the year ended January 31, 1999, there were only 63 Section 25102(n) notices filed with the California Department of Corporations (required to be filed for each offering pursuant to Section 25102(n)), compared with 38,325 notices of exempt private offerings pursuant to Section 25102(f) of the California Corporate Securities Law. Since then, only about 80 25102(n) filings are received annually by the Department of Corporations compared with about 35,000 25102(f) filings.
It is our experience that angel investors are not interested in tombstone type advertisements and do not respond to them. These sophisticated investors are likely to respond to an issuer, only if the issuer has had an opportunity to provide a disclosure document to the potential angel investor. Practitioners and financial consultants that work with small issuers report that small issuers do not have access to accredited investors, even with the general announcement procedure in Section 25102(n), and cannot attract broker-dealers who have access to accredited investors for small offerings.
Allowing general solicitation and advertising, without being restricted to the general announcement, will permit small issuers to gain access to accredited investors and will also allow them to conduct multi-state offerings without having to comply with the blue sky laws of each of the 37 states that have adopted or are considering adopting a variation of the MAIE, as well as to try to comply with the laws of, or forego the offering in, the other 13 states that have no such exemption.
Although we believe that permitting general solicitations in offerings only to accredited investors will not increase the occurrence of fraud, we believe it is advisable to exclude from permissible general solicitation unsolicited telephone solicitations to a persons home by someone other than the issuer. Approximately 5 states (Minnesota, Nebraska, Wisconsin, Pennsylvania and Iowa) have statutes or rules that allow general solicitation to accredited investors without being limited to the general announcement, as is required under the MAIE and California's Section 25102(n). Since these 5 states adopted these exemptions permitting unrestricted general solicitation, we believe that there has been no significant increase in enforcement activity or fraud in connection with such exempt offerings. Similarly, we do not believe that the Commission has experienced any significant increase in fraudulent offers pursuant to Rule 504(b)(1)(iii) since its adoption in April, 1999.
Finally, we believe that since an MAIE type exemption has presumably been approved by all or most of the states that are members of NASAA, a national exemption based on the MAIE should not be objectionable to most of the 50 states.
Part II: Excluding accredited investors purchasing in public Rule 504 offerings from the definition of qualified purchaser - does not adequately address the "funding gap" problem
We believe that merely excluding accredited investors purchasing in public Rule 504 offerings under States' MAIE from the definition of qualified purchaser will not adequately address the "funding gap" problem, because most states do not permit unrestricted general solicitation and complying with various blue-sky exemptions is costly.
Only about 28 states have adopted the state exemption that generally follows the NASAA's MAIE. Of these 28 states, only 12 states have adopted the NASAA MAIE word for word; 16 have adopted the MAIE with significant variations; 4 adopted exemptions for sales to accredited to investors similar to MAIE; 5 permit general solicitation and advertising so long as only accredited investors are sold; and 4 are currently considering adoption of MAIE in some version or another, according to a NASAA Survey dated April 14, 2000. Thus, an issuer who wishes to effect a multi-state offering must now research the state securities laws of all states having an MAIE or similar or exemption to ensure compliance with all such states in which the offering is to be made.
Even then the issuer is precluded from the exemption in the remaining 13 or so states that have not adopted the MAIE or a variation thereof, and the likelihood that these states will ever adopt an MAIE or similar exemption is uncertain. As an example of how difficult it is to persuade states to enact a state exemption along the lines of the MAIE model, 13 states still have not enacted the MAIE or some version thereof despite the imprimatur of NASAA. Also, the California Small Business Association, a non-profit association representing 180,000 California small businesses, has been trying unsuccessfully for two years to obtain passage of a bill that would exempt offerings to accredited investors pursuant to Rule 504(b)(1)(iii).
Part III: Comments in Response to Other Staff Inquiries
If the proposed Rule 504A is adopted and offerings under Rule 504(b)(1)(iii) are retained, the states could continue to regulate such offerings under the present Rule 504(b)(1)(iii) up to $1,000,000 annually. Accordingly, we suggest that the Commission exclude from the definition of qualified purchaser offerings that are made pursuant to Rule 504(b)(1)(iii), only if a new uniform federal model accredited investor exemption, such as the proposed Rule 504A, is adopted.
Similarly, in response to the question raised under Section II. A. 2. of the Release, we recommend that the public offering under the small corporate offering registration (SCOR) provisions qualified by states pursuant to Rule 504(b)(1)(i) be retained, since those offerings can be made to non-accredited investors, subject to state registration and oversight. Accordingly, if the proposed definition excludes offerings under Rule 504(b)(1)(i), small issuers will not be prejudiced, as they will have available three alternatives: (a) the accredited investor exemption under the present Rule 504(b)(1)(iii), (b) the exemption under the new proposed Rule 504A, if adopted, or (c) a SCOR offering under Rule 504(b)(1)(i).
The Staff inquired whether, assuming the second approach where Rule 504 would be replaced with the uniform federal exemption, the exemption should impose conditions similar to those found in MAIE? The undersigned believes that the federal exemption should incorporate the conditions in MAIE, which are generally sound, and have, after all, been approved by the member states, 37 of which have enacted the MAIE or a variation thereof. However, the limitation of general solicitation to the general announcement should be eliminated, since this restriction is believed to unduly restrict the ability of small issuers to access accredited investors, and has failed in the case of California's §25102(n) to be of much value to small issuers in finding qualified purchasers.
With across the board general solicitation, small issuers would have the same access to accredited investors as larger issuers who can retain investment banking firms that maintain customer lists of accredited investors. Thus, for example, lists of accredited investors that are available to investment banking firms would also be available to small issuers.
With respect to the last inquiry under Section II. A. 2. of the Release, whether state registered offerings to nonqualified purchasers should be permitted contemporaneously with a general solicitation to qualified purchasers, the undersigned recommends that such a dual offering be permitted, to give the small issuer greater flexibility in raising capital.
As to the question raised by the Staff under Section II. B., whether the Commission's definition should be related to the nature of the investment rather than the investor, the undersigned believes that the definition should not be restricted to investments in certain securities but rather should address the nature of the investor. It makes no difference, as far as the sophistication of the investor is concerned, whether the investment security is common stock, preferred stock or a debenture.
As to the question in Section II. B., whether the issuer should be a reporting company, we recommend that such requirement not be adopted. When and if the issuer's securities are desired to be traded, the issuer must be a reporting company under the Exchange Act if it wishes to be listed and traded under NASDAQ or the OTC Bulletin Board. This requirement would place an undue burden on issuers to require them to become a 12(g) reporting company prematurely in order to effect a private offering under the proposed national exemption.
In conclusion, we believe that small issuers need this national exemption to gain better access to capital. They are generally unable to attract the services of investment banking firms who regard these small offerings as too risky and which do not generate sufficient compensation. Since these small issuers are not in the business of raising capital, and do not ordinarily maintain a coterie of accredited investors, the proposed rule will significantly expand their access to accredited investors, particularly if adopted in conjunction with the proposed Rule 504A.
Lee R. Petillon
Mark T. Hiraide
|1||In 2000 venture capital seed and start-up investments amounted to a mere $2.2 billion in 382 deals, which represents 2.4% of the total capital invested and 6.8% of the total deals. In the first three quarters of 2001, these amounts are $319 million (1.25% of total capital) in 71 deals (3.3% of total deals). (See, Sohl, Jeffrey, 2002, "The Private Equity Market in the US: What a Long Strange Trip It Has Been," at p.13, "If the goal is public policy initiatives to spurn the commercialization of innovation in the United States, one needs to look no further than initiative directed at the angel investor." )|
|2||Estimates suggest that the number of latent or potential self-made, private investors exceeds the number of active investors by a factor of five to one. The typical anel deal is n early-stage round (seed or start-up) in the $100 thousand to $2 million range, raised from six or eight investors. * * * Research indicates that angel investors provide close to 80% of the seed and start-up capital for high tech entrepreneurial ventures. Sohl, Id. at pps. 10, 12.|
|3||"In the informal venture capital market, with the suppliers of capital seeking a degree of anonymity, often in conflict with the need to maintain quality deal flow, information flows very inefficiently. An entrepreneur's search for equity capital is often a time consuming process, resulting in missed market opportunities and unsuccessful avenues. Likewise, as investors seek a balance between quality deal flow and the desire to maintain a reasonable degree of anonymity, promising technologies are often overlooked or prematurely discarded." Sohl, Id. at p.12.|
Rule 504A Exemption for Limited Offerings and Sales of Securities Not Exceeding $3,000,000.
(a) Exemption. Offers and sales of securities that satisfy the conditions in paragraph (b) of this Rule 504A by an issuer that is not:
(1) Subject to the reporting requirements of Section 13 or 15(d) of the Exchange Act;
(2) An investment company; or
(3) A development stage company that either has no specific business plan or purpose or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies, or other entity or person, shall be exempt from the provision of Section 5 of the Act under Section 3(b) of the Act.
(b) Conditions to be Met.
(1) General Conditions. To qualify for exemption under this Rule 504A, offers and sales must satisfy the terms and conditions of Rule 501 and Rule 502(a), (c) and (d), except that the provisions of Rule 502(c) and (d) will not apply to offers and sales of securities under this Rule 504; provided, however, that neither the issuer nor its agents shall make unsolicited person-to-person or telephonic calls to the residence of a purchaser.
(2) Specific Conditions.
(i) Limitation on Aggregate Offering Price. The aggregate offering price for an offering of securities under this Rule 504A, as defined in Rule 501(c), shall not exceed $3,000,000, less the aggregate offering price for all securities sold within the 12 months before the start of and during the offering of securities under this Rule 504A in reliance on any exemption under Section 3(b), or in violation of Section 5(a) of the Securities Act.
(ii) Nature of Purchasers. Each purchaser (A) is, or the issuer reasonably believes immediately before the sale and after reasonable inquiry, an "accredited investor" as defined in Rule 501(a); and (B) either alone or with his purchaser representative(s) has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or the issuer reasonably believes immediately prior to making any sale that such purchaser comes within this description. If an accredited investor is a natural person, the amount of his or her investment shall not exceed 10 percent of his or her net worth.
(iii) Disqualifications. No exemption under this section shall be available for the securities of any issuer described in Rule 262 of Regulation A, except that for purposes of this section only:
(A) The term "filing of the offering statement required by Rule 252" as used in Rule 262(a), (b) and (c) shall mean the first sale of securities under this section;
(B) The term "underwriter" as used in Rule 262(b) and (c) shall mean a person that has been or will be paid directly or indirectly remuneration for solicitation of purchasers in connection with sales of securities under this section; and
(C) Paragraph (b)(2)(iii) of this Rule 504A shall not apply to any issuer if the Commission determines, upon a showing of good cause, that it is not necessary under the circumstances that the exemption be denied. Any such determination shall be without prejudice to any other action by the Commission in any other proceeding or matter with respect to the issuer or any other person.