February 12, 2002
United States Securities and Exchange Commission
Attn.: Mr. Jonathan G. Katz, Secretary
450 Fifth Street, N.W.
Washington, DC 20549-0609
Re: File No. S7-23-01
Dear Mr. Katz:
As a journalist who has been covering small business finance for almost 10 years, my comments are not those of one versed in the history and philosophy of securities law, but rather of one who reports on the efficacy of various congressional, Commission and state attempts to open the doors to capital for small business. My comments are based on interviews with, and surveys of, more than 2,000 small business issuers who have attempted to raise money using Rule 504, Regulation A, Rule Section 3(a)(11) and self-directed SB-2.
Successful small business issuers tell me that small business benefits most when the investors believe they are getting a fair shake from issuers they know and companies they can watch. Small business issuers and their representatives who rail at the difficulty in getting their deals registered, have lost sight of the objective. The idea is to raise money and to do that the issuer has to give the investors what they want, not try to make them take what is easiest for the issuer. With the creation of Regional Review, difficulty in multi-state registration says more about the issuer and his counsel than it does about the actual difficulties arising from differences between state registration requirements. Some attorneys seem to have no trouble dealing with registrations, others can't seem to do it at all and the majority fall somewhere between.
As to the matter at hand, it seems to me that the Commission has several possible approaches in defining qualified purchaser. It can define the purchaser. It can define which securities are available to qualified purchasers. It can set standards that issuers must meet before they can sell to qualified purchasers, or it can require salespersons to register before they sell to qualified purchasers, regardless of whether they receive compensation for doing so.
My view is that the definition of qualified purchaser should be set as high as possible and should include as few people as possible. While this was admittedly not Congress's intent at the time, subsequent events may have derailed the deregulation express.
Since, the Commission received contradictory instructions from Congress, it has considerable leeway. The House seemed to be saying that it should regulate the security while the Senate thought defined investors should be able to buy anything they wanted.
According to Release 33-8041:
"The qualified purchaser definition should reduce the regulatory burdens on companies that seek to raise capital, without compromising investor protection. First, the definition should increase issuer's ability to offer and sell securities without state registration. Second, a nationwide, uniform definition of qualified purchaser would override diverse state exemptions for financially sophisticated investors. The federal definition permits issuer to conduct offerings in several states without having to comply with different state exemptions. This uniformity would simplify the securities registration and offering process, and possibly cause more companies to sell their securities to accredited investors because of the smaller burdens upon and costs of capital formation. It also promotes capital formation by permitting issuers to conduct offerings in more states."
In considering the first requirement, that the definition should increase the issuer's ability to offer and sell securities without state registration, it seems to me that the key word is "sell." That is the object of the exercise. It requires that we look at the situation from buyer's as well as the seller's point of view.
For years a number of commentators have lobbied the Commission for carte blanche. Their view is that state regulators should be excluded from everything and that the Commission should not look too closely either.
Of course, if they were to get their wish, bad offers would inevitably drive out good and the only buyers would be penny stock mullets and lottery players. The already elusive qualified purchaser would be the first out the door. That market would no longer be a place that reputable companies went for capital. Those with no other choice would starve or hold their noses, jump in and starve anyway.
There must be some control. The only question is has the Commission the resources, local knowledge and contacts to do the job? It is quite probable that if the Commission were to take over, small businesses would soon complain that Washington does not know the situation in Paducah and therefore cannot adequately regulate there.
As to the second point, there can be no question that a "nationwide, uniform definition of qualified purchaser would override diverse state exemptions for financially sophisticated investors." But, will it also knock the 35 non-accredited investors out of Rule 506? Those supposedly sophisticated, but less than wealthy investors are the key to Rule 506's super start popularity. One has to wonder if Congress was correct in its belief that what is needed is another preemption. Rule 506 has certainly become the flavor for all seasons since NSMIA, but I am unaware that there is any support for a more restrictive version.
Apparently, Congress has been bombarded by small business issuers complaining that they are being denied access to capital because it is too difficult to register offerings in more than one state. That represents the benefit of being a squeaking wheel, rather than a groundswell of dissatisfaction with the registration process. Based on our surveys, about half those with complaints think it is too hard to sell their offerings once they have been registered. The remainder are about the registration process, but they seem equally divided between venting that counsel didn't know what he was doing or charged too much for the little he did, and complaints about state regulators. To be sure, some states are notoriously tough. Florida springs immediately to mind for 504 and Regulation A filings, but that seems to be the way the people of Florida want things.
Across the country there is a growing feeling that Regulation A is not worth the effort. Or, put another way, it takes just as much money, time and effort to do an SB-2 as it does a Regulation A, which is why Regulation A filings have declined and self-directed SB-2 filings have soared.
The release further states that congressional intent is to exempt securities that are national in character, which certainly rules out offerings under 3(a)(11). Rule 504 doesn't travel well, except in cases such as catalog companies with customers throughout the country. Regulation A seems to be used more as a safe harbor for intrastate offerings of more than $1 million, than as a way of reaching investors in a number of states. The Commission acknowledges this in the following example:
"For example, an issuer whose securities are quoted on the Nasdaq SmallCap market could conduct a private securities offering exempt from federal registration under Section 4(2) of the Securities Act but not satisfying the Rule 506 safe harbor requirements. At the state level, the issuer could offer and sell securities to qualified purchasers privately in any state it wishes without either registration or reliance upon any state exemption. Also, the issuer could offer and sell securities in the same offering to non-qualified purchasers in any state where the offering satisfies a state exemption, such as a limited offering exemption or isolated purchaser exemption. If the same issuer desired to register a securities offering with the Commission, one not otherwise preempted from state regulation, it could offer and sell to qualified purchasers in any state without registration or exemption. At the same time, if the issuer desired to include non-qualified purchasers in the same offering, it could register or rely on an available state exemption for offers and sales to those purchasers."
Congressional intent is further refined by mentioning that trusts or other special purpose vehicles that offer asset-backed, mortgage-backed or other structured securities generally are unable to list on the national markets. Consequently, their securities would not qualify for state preemption as national market securities.
Given the far-reaching consequences of the proposed definition, the example seems inappropriately narrow.
The issuer who is to take advantage of the proposed exemption is not only a reporting company, but also a company whose shares are quoted on a system with listing standards. If the exemption is to be restricted to such companies, I would recommend creating a definition that did so. That is to define qualified purchasers as those with sufficient wealth and expertise to deal in non-registered securities issued by reporting companies that are ineligible for quotation on the preempted national or regional markets. The measure of their ability to traffic in those securities would be a portfolio in excess of $1million.
The preemption would apply to primary sales only since we are talking about private placements, and one of the factors determining the existence of a private placement is the absence of redistribution. Trades among qualified purchasers would be permitted as isolated transactions. Beyond that the securities would have to be registered before resale could occur.
If the Commission is determined to hold on to its position that that the investor rather than the issuer should be restricted, perhaps it would consider regulating the salespersons. Under most states, various people are excused from full registration as broker-dealers if they are not compensated for selling. It is also an open secret that many unregistered deals are put together by "finders" who should be registered as broker-dealers. With the creation of a national preemption, it might be time to consider a "broker-dealer lite" registration for finders.
For years, people have attempted to win recognition of "finders," people who are not broker-dealers, but do accept money for introducing issuers and investors and effecting deals. Since the Commission seems to be moving toward more and more ways in which to offer unregistered securities, perhaps prudence demands some regulatory control over the sellers. Since most of these deals are very small, there is little chance of interesting NASD broker-dealers. For a fuller discussion of this idea, please see "Private Offerings Using Non-Registered Finders: Risks and Realities" by Lee R. Petillon, Petillon and Hansen, Torrance, California. This handout was prepared for the 34th Annual Securities Regulation Seminar of the Los Angeles Securities Bar, October 25, 2001 and is available from the author.
While there is room to debate whether Congress wished the definition to allow to the security or the investor, there can be no doubt that Congress was thinking only of securities that were to be sold throughout the land. Since Congress instructed that the exemption apply to securities which are national in character, there is no need to create a definition that affects investments which are almost entirely local in character.
"National" must mean securities of issuers who are known to investors in all parts of the country-either because it is a reporting company quoted on a widely reported market, or because the issuer's securities are traded by a large network of investors, either through brokers or through a less formal arrangement.
Congressional intent is far from the realities of Regulations A and D, and thus it would be inappropriate to use Rule 501 as the definition of qualified purchaser.
Unfortunately, choosing to define qualified purchasers as accredited investors not only ignores the nature of the security entirely, but also drags non-national offerings into the exemption. The Commission has wrestled mightily with this problem, but as long as the definition is part of Regulation D, "national in character" will not be a factor.
By choosing to define qualified purchaser as an accredited investor, the Commission has taken what was supposed to apply to national securities and put it squarely in the realm of largely local of securities, those offered under Rule 504.
Part of the problem is the contradictory instructions issued by Congress. As we have seen, qualified purchasers could be few and far between investors in a few securities that are national in character, but which are not eligible for other preemptions. At the same time, the exemption is to be widely available to increase small business access to capital. The Senate also wanted uniform definitions that would reduce the confusion of conflicting definitions that make federal and state registration such a costly process.
Just how choosing a term that is already defined in the Securities Act, and which could be used by some of the same small business issuers who are considering Rule 1001 would reduce confusion and conflict is something only the august minds of the Senate can fathom.
It doesn't take much imagination to see that, were the proposed definition of qualified purchaser adopted, issuers in California would create their own exemptions by taking, say the unlimited ceiling and the wealth test, from qualified purchaser and adding general solicitation from Rule 1001 in the same manor that microcap fraudsters took elements of the public and private nature of Rule 504 to create their little goldmines.
Congress intended to help small businesses find capital, a laudable aim, but will it be achieved by taking state regulators out of the process? Small business, like any participant in capital markets, no matter how informal; rely on the belief that that market is straight. If the investing public loses faith in the market, small businesses will have a much harder time raising money with exempt offerings than they did having to deal with differing state requirements.
Public confidence in our capital markets has been badly shaken already, and fresh temblors continue. Now is probably not the time to tinker. Better to wait until confidence returns and a fair appraisal of the actual effects of any changes can be gauged.
In the meantime, Rule 506 has already been preempted. It offers more latitude than the proposed qualified purchaser exemption and makes the Commission's proposal largely superfluous.
Some years ago the Commission told the states if they would come up with an exemption that permitted general solicitation of wealthy individuals, the Commission would incorporate it into the Securities Act along with California's Section 25102(n) exemption which became Securities Act Rule 1001. NASAA came up with the Model Accredited Investor Exemption (MAIE), which the Commission declined to adopt. If the Commission adopts the proposed qualified purchaser definition, those states that adopted the MAIE as written would be preempted, while those that adopted some other standard would not.
The Commission proposes to rescind Rule 504(b)(1)(iii) which permits general solicitation so long as sales are made only to accredited investors.
NASAA created the MAIE because the Commission incomprehensively decided that the Angel Capital Electronic Network (ACE-Net), which was doing the same thing as IPONet, would be involved in public solicitation while IPO-Net would not. The only difference was that IPONet involved brokers who would make money if the deal sold and ACE-Net did not. ACE-Net was relegated to Rule 504 offerings with a $1 million ceiling instead of Rule 506, a more common vehicle for angel investments.
Rescinding 504(b)(1)(iii) would complete a murder begun years before.
Other than ACE-Net, it doesn't seem to matter whether issuers are permitted to chum for investors. The MAIE and its relatives are rarely used.
Can the Commission come up with an exemption that would better serve small business? Given the lines of thought set out in the release, there seem to be two avenues to explore. One is to create a universal exemption that permits general solicitation. The other is to preempt the so-called private Rule 504.
The Commission has already done the former with its adoption of Rule 1001 from California and found that it was leading a parade of one. Some 40 states came up with their own version of an exemption that would permit issuers to troll for wealthy investors. So far, their efforts don't seem justified. Arguments that the Model Accredited Investor Exemption is not used because it is limited to offers of $1 million or less don't hold water because the California exemption reaches up to $5 million and it too is not used.
In 1994 California created the exemption that the Commission adopted as Rule 1001. Five years later, the California State Assembly asked the California Research Bureau to study securities regulations and their effects on small business. The result, "Securities Regulation and their Effect on Small Business" by Rosa Maria Moller, Ph.D. (www.librady.ca.gov/crb/00/04/00-005.pdf) was published in April 2000 and is the only study of its kind that I know of. I commend it to anyone interested in helping small businesses gain access to capital or is interested in rewriting the Uniform Securities Act.
Among the things Dr. Moller discovered was that in 1999, only 63 issuers took advantage of California's general solicitation exemption (Section 25102(n). That compares with 38,321 issuers who used the state's private placement exemption found in section 25102(f), which does not permit general solicitation. Regulators in states that have adopted the MAIE, or something like it, report that not many issuers are using it. Clearly issuers, like anybody else, have figured out that wealthy people are not willing to tell strangers that they have money so strangers can ask them for it.
The proposed exemption does not permit general solicitation or advertising. It proposes a single exemption so that an issuer can sell to qualified purchasers in every state without supervision. While this sounds like a good idea, from the small business point of view in reality it would be of limited use. Ten years of tracking public Rule 504, Regulation A and Intrastate offers has shown me that investors want to know the companies they are investing in and the people who run those companies. That means they invest close to home, usually within in radius of 25 miles from their home. Angel and venture capital investors tend to have the same neighborhood bias. Thus the ability to sell in all states is of little, if any benefit. In the few instances in which investors feel they know distant issuers well enough to hazard money on them, the current system should continue to suffice since it already does.
It would be useful to have the same laws, rules and regulations for adjoining states or multi-state metropolitan areas, but those are situations that would be best handled by state regulators who know and understand local market dynamics and can take investor comfort into account. Most of the work already has been done through regional review.
Preempt the private 504
That brings us to the other possibility, the preemption of the so-called private Rule 504 offering. Since I have always felt that much of the micro-cap fraud brouhaha of five years ago was occasioned by the yoking of two dissimilar exemptions in the same rule, I can only applaud the Commission for asking if they should be severed.
Separating the public and private offering components of Rule 504 makes sense. However, preempting the private side is counter to the whole idea of Rule 504. In 1982, when the rule was adopted, the Commission left Rule 504 up to the states on the sensible grounds that, being so small, it would probably be a local issue. Unless the Commission is prepared to raise the $1 million ceiling, this exemption will continue to get smaller and more local as inflation inevitably makes it worth less and less. Perhaps it should be left to the elected officials of the states to decide how much, if any, protection their constituents should have. They are probably more alive to the needs of the small businesses and the capabilities of the investors in their states than the Commission. A small business issuer would bother with a private Rule 504 offering because he hopes to raise money. His chances of doing that are improved if the deal conforms to local standards and customs.
If the investors have a complaint, they are going to take it to their state regulators. Surely, the Commission does not have the resources to deal with low dollar complaints involves a limited number of investors even though those investors deserve protection.
Resale of securities from preempted offers
The Commission asks if it should permit qualified purchasers to resell the exempt securities they have purchased. Two of the elements of a private placement are availability of information and the absence of redistribution. Over time the thesis of interchangeable accredited investors came about. Under this theory one accredited investor is just like any other, so trading among accredited investors does not amount to redistribution. But that overlooks the availability of information requirement. As long as the issuer is a reporting company, that requirement is more or less met. The purchaser has access to information. Whether that information is worth having is something Congress, the Commission, the AICPA and the investing public are trying to determine.
What if the issuer is not a reporting company? The initial investor can wrest information from the issuer by statute and by negotiating for any additional things he may want to know. That ability ends when the check clears. But secondary purchasers have no such access since the deal doesn't involve the issuer.
The belief that this doesn't matter because the accredited investor can take care of himself is fine as long as we are talking about a natural person. If he is putting other people's money at risk, at the least, prudence demands that he have a way of explaining his investment decision. Thus it seems to me that the qualified purchaser exemption ought to be available only to reporting companies and that resale should be restricted to other qualified purchasers.
In summation, Congress and President Clinton were in error in the enactment of NSMIA. The Commission has been correct in delaying another definition for qualified purchaser and should continue to search assiduously for the perfect definition.
In the meantime, Rule 504 should be split into two separate exemptions, one for private offerings and the other for public ones. The states should retain regulatory authority over both. That authority should continue to address the manner of sale and eligible purchaser determinations.
Editor, SCOR Report